Global Equity Strategy - GEM; Tactical headwinds, structurally sound - Credit Suisse

Headwinds for emerging markets lead us to reduce GEM weightings from 25% to 10% overweight on a two-month (i.e. tactical) view. Yet, we stress that on a 3- to 12-month basis, we remain 25% overweight.

Tactical headwinds include: Economic lead indicators suggest a sharp deterioration of GEM IP momentum relative to developed markets; high food prices (a third of CPI) mean headline inflation may not peak until mid-year; capitulation in emerging markets is not yet advanced.

We stay overweight of GEM strategically: We think emerging markets should be trading on a 20–30% P/E premium to developed markets (compared with a 10% discount currently), given: their superior trend growth (on the back of superior productivity growth); better balance sheets (government, private and banks); higher RoE versus cost of debt than the US; nominal GDP and EPS volatility in line with that of developed markets; and undervalued currencies (except for the Brazilian real and the Turkish lira).

The problem is inflation, but we find: (i) only Brazil, Argentina and India have severe overheating (and only India has an abnormally loose monetary policy); (ii) historically, emerging markets do not discount overheating becoming a problem until there are large current account deficits (India, Brazil and Turkey have mild current account deficits); and (iii) inflation historically had to rise above 7% for P/Es to contract.

Although developed market growth continues to surprise on the upside, we would note that: (a) GEM outperforms 86% of the time when global growth is accelerating (owing to its openness and commodity sensitivity); and (b) lead indicators in GEM relative to the US are already close to ten-year lows.

We think the call within GEM is now more important than the call on GEM, with country correlations at a four-year low. Russia, Korea and China are the cheapest markets on our P/E model and our GEM strategist Sakthi Siva’s preferred picks, while the most expensive is India.

The P/E premium of the indirect plays on the GEM consumer has fallen to 16% (back to the 2005–08 norm). We would focus on HSBC, Swatch, ABI, WPP, Coca-Cola.

Why the tactical downgrade?
We downgrade emerging markets from 25% to 10% for the following reasons: Historically, capitulation in emerging markets has happened at lower levels:
GEMs typically do not trough until three-month cumulative flows have been strongly negative (this would require another US$30bn of outflows); relative risk appetite has already corrected, yet historically current levels of relative risk appetite have been associated with GEM underperformance over the subsequent three months; finally, the average correction in emerging markets’ relative performance has been 18%, relative to 9% from the peak so far.

Year-on-year inflation in GEM is likely to peak in the middle of the year: even if food prices are flat from here, headline food inflation will not fall until the second half of the year. The threat in the near term is that food prices rise a little further especially given the drought in northern China (but our central case would be that food prices fall over the next six to twelve months).

Economic lead indicators suggest relative GEM IP momentum will slow sharply over the next months. However, when this has happened in the past, emerging markets have still managed to outperform.