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26 November 2018 | 6:08PM EST

EM Strategy Views

Outlook at the Margin - 8 Themes to drive

Outperformance in 2019

Caesar Maasry

+1(212)902-8763 | caesar.maasry@gs.com Goldman Sachs & Co. LLC

See all our year-ahead forecasts in one place. Visit the page.

Ron Gray

+1(212)357-6762 | ron.gray@gs.com

 

Goldman Sachs & Co. LLC

Over the past two weeks we have published our year-ahead outlook across economies and asset classes, and subsequent client meetings suggest to us that the prevailing mood is one of “hopeful pessimism” (as opposed to the somewhat cliched “cautious optimism”). Recent market turbulence has undoubtedly contributed to this sentiment, but the main focus of client concern is the basic macro cycle - that the US economy is late and likely to slow alongside a Fed that is likely to continue tightening. This is not new news, yet it remains front-and-center in client conversations.

Our EM and FX outlook reports outlined the case for modest positive returns next year - with a focus on relative value opportunities. While most macro investors have not pushed back on these forecasts particularly strongly, our sense is that most portfolio managers are still more concerned with downside risks and view our outlook as being on the optimistic side. In this report, we do not attempt to re-hash our outlook forecasts, but focus on eight of the most common topics regarding the EM outlook for next year at the margin.

Outlook at the Margin - 8 Themes to drive

Outperformance in 2019

(1) The Narrative vs. the Numbers on the US slowdown’s impact to EM

Bottom Line: consensus GDP forecasts for US next year appear priced in currently, so the path should be set by revisions, not the deceleration itself; EM assets should face less pressure from external growth concerns.

Of primary concern to EM investors looking into 2019 is the widespread consensus

view that the US economy will meaningfully slow (from a high level) and that EM

Goldman Sachs does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S.

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EM Strategy Views

rarely performs well when DM growth and markets are under pressure. We have argued that the acceleration in the US this year was not import heavy and therefore the subsequent slowdown should similarly not pressure EM fundamentals as much.

In addition, the recent volatility of the US equity market has been top of mind to EM investors as it has coincided with sharp sell-offs in EM equity and credit as well. It seems to us that many EM portfolio managers hold their views contingent on US markets in the current environment - that is, if US volatility declines, EM assets may recover their recent losses. From this perspective we find it important to note that our cross-asset benchmarking of growth across major regions suggest that US assets are pricing in roughly 2.5% GDP growth currently. This figure coincides with the consensus forecast for 2019 growth, and in turn suggests to us that the conversation should focus on potential revisions to that consensus view, not the mere fact that it suggests a further slowing from the current level of activity in the 3.5% range.

Investors have pointed out that the path of US growth matters, as most forecasters expect the sequential pattern to slow steadily over the course of 2019 (and our own estimates put US growth at below 2% by year-end 2019 on a sequential basis), and we expect the market to price this incremental slower growth through a further flattening of the yield curve and modestly weaker USD (as opposed to a further equity drawdown).

In both EM and Europe, we find that our cross-asset index is pricing in a similar level of growth to the current ‘spot’ reading - which in turn suggests that market oscillations may indeed follow the path of growth data itself. It is also worth noting that this is the norm: these cross-asset indices tend to move relatively coincidentally with spot growth data over time, but the move in the US index over the past two months has been a marked outlier. There has been a significant downward pricing of growth by US assets despite the data set itself being quite stable - and this is another incremental data point to keep in mind that the US slowdown is very well telegraphed by markets.

Exhibit 1: Our X-Asset growth indicators suggest US assets are pricing ~2.5% GDP growth

110

105

100

95

90

85

80

75

 

 

 

 

 

 

 

 

 

USA

 

 

 

 

 

 

6.0%

95

 

 

 

 

 

 

EUROPE

 

 

 

 

 

 

5.0%

115

EM

 

7.0

 

 

 

 

 

 

 

 

 

 

US Growth

 

 

5.5%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EM Growth

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4.5%

110

 

6.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Factor

 

 

 

 

 

 

 

 

 

 

 

 

 

Factor

 

 

5.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

6.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

90

 

 

 

 

 

 

 

EUR Growth

 

 

 

 

 

4.0%

 

EM Activity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

105

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4.5%

 

 

 

 

 

 

 

 

 

Factor

 

 

 

 

 

 

 

(CAI, equal-weighted)

 

5.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

3.5%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

100

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

5.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

85

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

3.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

3.5%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

95

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

US

 

 

3.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2.5%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Euro Area

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Activity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

90

 

 

4.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2.5%

 

 

 

 

 

 

 

 

 

 

 

Activity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(CAI, RHS)

 

80

 

 

 

 

 

 

 

 

 

(CAI, RHS)

 

 

 

2.0%

 

 

 

3.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

85

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1.5%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1.5%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

3.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

80

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

75

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2.5

 

 

 

 

 

 

 

 

 

 

Growth Factors

 

 

1.0%

 

 

 

 

 

 

 

 

 

Growth Factors

 

 

 

Growth Factors

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1. cyc vs. def equities

 

 

0.5%

 

 

 

 

 

 

 

 

 

 

1. cyc vs. def equities

 

 

0.5%

75

1. cyc vs. def equities

 

2.0

 

 

 

 

 

 

 

 

 

 

2. local rate curve (2y vs 5yr)

 

 

 

 

 

 

 

 

 

 

 

2. local rate curve (2y vs 5yr)

 

 

2. local rate curve (2y vs 10yr)

 

 

 

 

 

 

 

 

 

 

 

3. Trade-weigted FX

 

 

0.0%

70

 

 

 

 

 

 

 

 

 

3. Trade-weigted FX

 

 

 

0.0%

70

3. Trade-weigted FX

 

1.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Aug-10 Jan-11 Jun-11 Nov-11 Apr-12 Sep-12 Feb-13 Jul-13 Dec-13 May-14 Oct-14 Mar-15 Aug-15 Jan-16 Jun-16

Nov-16 Apr-17 Sep-17 Feb-18 Jul-18 Dec-18

Dec-14

Mar-15

Jun-15

Sep-15

Dec-15

Mar-16

Jun-16

Sep-16

Dec-16

Mar-17

Jun-17

Sep-17

Dec-17

Mar-18

Jun-18

Sep-18

Dec-18

 

Dec-14

Mar-15

Jun-15

Sep-15

Dec-15

Mar-16

Jun-16

Sep-16

Dec-16

Mar-17

Jun-17

Sep-17

Dec-17

Mar-18

Jun-18

Sep-18

Dec-18

 

Mar-10

 

Source: FactSet, Datastream, Goldman Sachs Global Investment Research

(2) A positive base case, but the path will undoubtedly be varied

Bottom Line: Most years have at least 5 “up” or “down” months regardless of the full year return being positive or negative for risk assets; 2015 was the roughest year with 9 down months and only 3 up months. If 2019 is to have any tradable rallies, we suspect they will occur sooner rather than later in the year.

26 November 2018

2

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EM Strategy Views

As most market participants focus on the outlook for the next 12 months and hone in on bullish vs. bearish calls, the path of risk assets will undoubtedly vary and consensus market views will likely swing from positive to negative over the course of 2019. Predicting market swings is by no means controversial, but we find a few observations in Exhibit 2 below to be important in considering the strategic view.

Below, we plot the annual return of our EM cross-asset benchmark (composed of volatility-adjusted FX, credit, local bonds, and equity returns) and compute the number of months in the calendar year with a positive return. The obvious pattern of strong performance years containing a higher number of months with a positive return is readily apparent, but the absolute numbers are somewhat surprising to us. For example, 2008 posted the worst returns across EM assets, but the monthly-split of up vs. down months is 5 to 7, a strikingly high share in our view.

In more recent history, 2012 and 2017 were the steadiest years of EM gains, and 2015 was the toughest year, with only 3 up months. Interestingly, the returns in 2015 and 2018 have been similarly painful, but 2018 has offered a more even split of up and down months so far. Our point here is that even if 2019 represents another painful year for EM assets as some macro investors suspect, there will likely be a good number of tradable rallies. Perhaps 2014 sets an interesting precedent; that year came after a very rough 2013 (taper tantrum) and EM assets declined from a full calendar year basis, but actually there were 7 months of the year with positive returns.

Exhibit 2: The path of EM assets is anything but steady - negative return years often post at least 5 months of positive returns

30% EM Cross-Asset Index Return (annual)

Number of

12

 

"Up Months"

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

in the year

 

 

20%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(diamonds)

 

10

 

 

 

 

 

 

 

 

 

 

 

 

2012, 2015, & 2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

were trending years

 

 

10%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

8

0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

6

-10%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4

-20%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2

-30%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Source: Datastream, FactSet, Goldman Sachs Global Investment Research

More to the point of the current market environment, our growth estimates suggest that EM activity will likely improve early in 2019 (of a low base from 3Q 2018) and ‘even out’ as the year progresses (see Exhibit 3). There is of course large uncertainty around the specific quarterly path, but we see a greater likelihood that weakness in key EM

26 November 2018

3

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economies (Brazil, South Africa, and Russia) will pick up in coming months and that China will stimulate growth from levels that appear to be running below the State’s long-term plan goals. In addition, it is worth noting that our numbers suggest the path of US growth will be less sharp looking out into 2Q 2019 than it has been since peak growth of 2Q 2018.

Exhibit 3: Our forecasts suggest EM growth will improve over the next 2Q and then flatten out

5.0%

 

Strong re-acceleration expected in Q4-2018 and Q2-2019

 

 

 

 

 

(GDP Growth, Q/Q Annualized)

 

 

 

 

4.5%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EM Ex-China

 

4.0%

 

 

 

 

 

 

 

 

 

(Eq wgt avg)

 

3.5%

 

 

 

 

 

 

 

 

 

 

 

3.0%

 

 

 

 

 

 

 

 

 

 

 

2.5%

 

 

 

 

 

 

 

 

US

 

 

2.0%

 

 

 

 

 

 

 

 

 

 

 

1.5%

 

 

 

 

 

 

 

Europe

 

 

 

 

 

 

 

 

 

 

 

(GDP weighted)

 

 

1.0%

Q2-2017

 

 

 

 

 

 

Q1-2019

 

Q3-2019

 

Q1-2017

Q3-2017

Q4-2017

Q1-2018

Q2-2018

Q3-2018

Q4-2018

Q2-2019

Q4-2019

Source: Goldman Sachs Global Investment Research

(3) The growth/rates matrix is top of mind; and the skew in return profiles suggest equity over credit

Bottom Line: the combination of weaker growth and higher rates is the focus of negativity for EM next year; and we view credit as more fragile than equity in this environment; with FX and local bonds in-between.

Market research on the impact of US growth and interest rates on risk assets has been quite prolific in recent years (in focus since the taper tantrum), with the overarching conclusion being that ‘as long as growth is robust, higher rates should be well tolerated’. The quadrant of the so-called growth/rates matrix has actually not really been tested in recent years - as 2017 was primarily a year of lower rates and stronger growth and 2018 has been one of higher rates and weaker growth (at least from an EM perspective) - with shorter periods of the other combinations.

As we look into 2019 the macro consensus seems quite set on a US picture of weaker growth and higher rates (although again we would note that markets will price in the incremental growth revisions, not necessarily the actual growth rate). Below, we show the median return of EM assets across the US growth/rates matrix (divided in 3 categories of up, down, and stable which correspond to 25bp (+/-) of GDP growth acceleration or 25bp (+/-) changes in US 10-year rates over a given quarter), based on data of the past 20 years.

26 November 2018

4

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In this exercise, we emphasize the skew of returns within each bucket in addition to the median return outcome, particularly for the “weaker growth and rates up” category. For example, we find that EM FX and EM equity (local FX) have a pretty similar flat median return when US growth weakens and US rates rise, but the distribution of returns is more heavily skewed to the downside for EM FX than for EM equity (see Exhibit 4).

There are a number of possible explanations for this, including a rate differential argument (which stacks more heavily against FX than equity) as well as a capital allocation one (US investors may de-risk when US growth is weak, with local EM investors not necessarily doing the same thing in their domestic markets). Interestingly, a ‘US growth weak and rates down’ environment has the widest distribution of outcomes, with EM FX typically performing poorest across assets (no duration exposure and likely a de-risking impact of US based investors). October of 2018 was an example of this environment, and a particularly weak one for EM equity and credit.

For fixed income, the median return in a weaker US growth and higher US rates environment is negative - and our positive return forecasts for both USD and local denominated bonds is in part a function of the starting point, that EM fixed income has faced a significant drawdown in 2018 (-6% and -8%, respectively). The return distributions for this environment appear quite wide (with skew to the upside for EM credit), but this is a bit misleading - the strong returns of EM fixed income occur when US rates are rising in anticipation of better growth (even though the incoming data set is still negative), such as early 2009 (removing the GFC lowers the skew shown below). This further suggests narrow scope for EM credit to perform strongly in 2019.

Exhibit 4: The empirical distribution of returns in a tough macro environment favor equity over credit

 

6.0%

EM FX spot performance in US growth and rates environments

25.0%

EM equity performance in US growth and rates environments

4.0%

Quarterly FX Performance

 

 

20.0%

Quarterly MSCI EM Performance

 

 

vs USD

 

 

 

 

 

 

 

 

 

 

 

 

2.0%

 

 

 

15.0%

Weaker US

 

 

 

 

 

 

 

 

 

0.0%

 

 

 

10.0%

Growth and

 

 

 

 

 

Higher Rates

 

 

(2.0%)

 

Median

 

5.0%

 

Median

 

 

 

 

 

 

 

(4.0%)

 

 

 

0.0%

 

 

 

(6.0%)

Weaker US

 

 

 

 

 

 

Growth and

 

 

(5.0%)

 

 

 

 

Higher Rates

 

25th - 75th percentile

 

 

25th - 75th percentile

 

(8.0%)

 

 

 

 

 

 

 

 

(10.0%)

 

 

 

(10.0%)

Weaker US Growth and..

Stable US Growth and..

Stronger US Growth and..

(15.0%)

Weaker US Growth and..

Stable US Growth and..

Stronger US Growth and..

 

 

 

 

Rates

Rates

Rates

 

Rates

Rates

Rates

Rates

Rates

Rates

 

 

 

Rates

Rates

Rates

Rates

Rates

Rates

Rates

Rates

Rates

 

 

 

 

 

 

 

UP

Stable

DOWN

UP

Stable

DOWN

UP

Stable

DOWN

 

 

 

UP

Stable

DOWN

 

UP

Stable

DOWN

UP

Stable

DOWN

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

8.0%

 

 

EM credit total return in US growth and rates environments

 

 

 

8.0%

 

 

 

EM local bond total return in US growth and rates environments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Quarterly EMBI

 

 

 

 

 

 

 

 

 

 

 

 

6.0%

 

 

Quarterly GBI-EM

 

 

 

 

 

 

 

 

 

 

 

 

 

6.0%

 

Total Return

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Return

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4.0%

 

 

Weaker US

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Growth and

 

 

 

 

 

 

 

 

 

 

 

 

2.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Higher Rates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Median

 

 

 

 

 

 

 

 

2.0%

 

 

 

 

 

Median

 

 

 

 

 

 

 

 

0.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

0.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(2.0%)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(4.0%)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(2.0%)

 

 

 

 

 

 

 

25th - 75th percentile

 

 

 

 

(6.0%)

 

 

 

Weaker US

 

 

 

 

25th - 75th percentile

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Growth and

 

 

 

 

 

 

 

 

 

 

 

 

 

(4.0%)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(8.0%)

 

 

 

Higher Rates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weaker US Growth and..

 

 

Stable US Growth and..

 

Stronger US Growth and..

 

 

 

 

 

Weaker US Growth and..

 

 

Stable US Growth and..

 

 

Stronger US Growth and..

 

 

Rates

Rates

Rates

 

Rates

Rates

Rates

 

Rates

Rates

Rates

 

 

 

 

 

Rates

Rates

Rates

 

Rates

Rates

Rates

 

Rates

Rates

Rates

 

 

 

UP

Stable

DOWN

 

 

UP

Stable

DOWN

 

UP

Stable

DOWN

 

 

 

 

 

UP

Stable

DOWN

 

UP

Stable

DOWN

 

UP

Stable

DOWN

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Source: FactSet, Datastream, Goldman Sachs Global Investment Research

26 November 2018

5

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Goldman Sachs

EM Strategy Views

(4) The Cycle - a tougher grind, but early cycle stories still trending higher in EM equity

Bottom Line: the cycle may be getting late and present ‘a tougher grind’, but the early cycle stories across EMs are playing out smoothly on a relative basis and we would press this trade higher.

The powerful rally across EM equities since early 2016 has been entirely fueled by rising earnings (prices +27% since February 2016, EPS up 35%, P/E down 7%); and a large part of this EPS rise has been due to improving profit margins. However, a lot of this improvement is behind us, in our view and EPS growth is likely to stall to 6% over the next 12 months according to our top-down models.

Nonetheless, we see a powerful theme in EM equity continuing under the surface - that early cycle stories (as measured through profit margins) are likely to continue their outperformance trend. Below, we show the performance during 2018 of EM equities with low profit margins (relative to their own history) vs. those with full margins. At the country index level, this theme has been a consistent outperformer, despite the large oscillations in risk assets over the course of the year. Importantly, this theme has not played out at the single stock level nearly as strongly.

This may be due to how investors are trading emerging markets (at the country level given the political and macro risks currently at the fore), and it could also be related to the strong performance of information technology stocks (until recently) which have been favorites of dedicated-EM managers. We do expect this trend to work at the single stock level, but the timing could be centered around the next bear market when dedicated investors turn more defensive (which we do not believe has happened during the sell-off in 2018).

Exhibit 5: The theme of “early cycle” EM equity markets has been a steady performer during 2018

106

Performance of Depressed vs Stretched Margins

105

(Long/short basket of lowest vs highest margins vs history in Dec 2017)

Longs: Czech Rep, Russia, Malaysia,

Shorts: Qatar, Greece, Thailand,

 

 

Colombia, Chile, Indonesia, Mexico,

Pakistan, UAE, Taiwan, Hungary,

104

Argentina, Brazil, Saudi Arabia, India,

Poland, South Africa, South Korea,

 

Peru, Philippines

China, Turkey, Egypt

 

103

Country Indices

 

 

 

102

 

 

 

101

 

 

 

100

 

 

 

99

 

 

 

98

Companies

 

 

 

 

97

 

 

 

Jan-18 Feb-18 Mar-18 Apr-18

May-18 Jun-18 Jul-18

Aug-18 Sep-18 Oct-18 Nov-18

Source: FactSet, I/B/E/S, Goldman Sachs Global Investment Research

Looking forward into 2019, we see ‘early cycle’ signals in a number of emerging markets. These are mostly in Latin America, but South Africa, Indonesia, and even India

26 November 2018

6

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Goldman Sachs

EM Strategy Views

and China appear to have lower margins than recent history (these figures are based on estimates of profit margins - and recent downward revisions have had an impact on a number of EMs). In contrast, Korea and Taiwan appear ‘full’ in terms of margins (and our Asia equity strategists have an underweight on those markets for 2019).

Exhibit 6: We see continued outperformance in EMs where margins still have room to rise

100%

Current percentile vs

Current margins vs history since 2010

90%

history

 

 

 

80%

Margins have room

 

70%

to expand

 

60%

 

 

50%

 

 

40%

 

 

30%

 

 

20%

 

 

10%

 

 

0%

Mexico

Indonesia

Poland

Peru

Czech Rep

India

Philippines

Pakistan

Argentina

South Africa

China

Colombia

Chile

Saudi Arabia

UAE

Greece

Malaysia

Brazil

Taiwan

Qatar

Turkey

Hungary

Thailand

South Korea

Russia

105

104

103

102

101

100

99

98

97

EgyptJan-1

Source: FactSet, I/B/E/S, Goldman Sachs Global Investment Research

(5) Harvesting yield - Local bonds vs. Credit (USD-denominated bonds)

Bottom Line: we expect EM fixed income to post low positive returns next year, but tactically we see a better risk/reward in EM local over hard-currency bonds. “Carry trades” are risky as recession risks rise, but we do not see local vs. hard as a pro-cyclical trade here.

As mentioned above, we see a tough macro environment for EM fixed income ahead - but the starting point is also quite low. Even in EM credit, where we see the least upside across asset classes, it is worth noting that 2018 is on course to be just the 3rd year on record (since 2000) with a negative return for the EMBI (total returns); whereas equity is likely to post a negative return year for the 8th time over the same period. Most of our EM recommendations are relative value in nature, and we are cautious of recommending ‘carry trades’ heading into 2019. The precipitous drawdown in global credit over the past two weeks suggests there will be tactical buying opportunities (particularly if oil prices stabilize) but we again emphasize that the macro environment is likely to make EM credit a low Sharpe ratio trade going forward.

Typically, EM local bonds trade with a higher beta than USD-denominated sovereign bonds, and are considered a pro-cyclical trade. Hard currency managers often go ‘off benchmark’ to take additional beta in the local bonds, and we expect this strategy will pay off tactically as we head into 2019 for three reasons. First, the outperformance of EM credit vs. local during the first three quarters of 2018 had ‘overshot’ the DXY move (there is a steady historical relationship between the EMBI and GBI-EM relative to DXY,

26 November 2018

7

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Goldman Sachs

EM Strategy Views

see Exhbiti 7 right-hand side). As we noted last month, we see further ‘catch-up’ room for EM local bonds to outperform in the near-term on this technical basis.

Second, we find that the yield on EM local bonds relative to the credit (adjusting for inflation) is still towards the high end of the historical range (though it has come off record highs during the credit sell-off over the past month). We forecast modest USD weakness which should help the relative trade, but here we note that duration also favors EM local, especially among high yielders. Finally, we note that EM local bond managers have reduced their beta, whereas EM credit managers still appear “geared up”, based on our own survey of the largest fixed income mutual funds. Specifically, we find that EM local managers have shifted down their beta relative to GBI-EM from 0.97 in July to 0.90 currently, while EMBI-benchmarked managers are still running a beta of 1.21 vs. the index (up from 1.16 in July).

Exhibit 7: EM local bonds are closing the gap with EM credit relative to DXY performance

2.5%

 

 

EM Local Bond Yield Premium

 

 

150

 

(Local currency bond yield - USD bond yield - inflation differential to US)

 

 

 

 

 

 

 

 

 

 

140

2.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

130

1.5%

 

 

 

 

 

 

 

 

120

 

 

 

 

 

 

 

 

 

110

1.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

100

0.5%

 

 

 

 

 

 

 

 

90

 

 

 

 

 

 

 

 

 

80

0.0%

 

 

 

 

 

 

 

 

 

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

 

 

 

 

 

 

 

 

 

 

 

 

 

 

110

 

 

 

 

 

 

 

 

 

 

Dislocation formed

 

 

 

 

 

 

 

 

 

 

 

vs DXY level

105

 

 

 

 

 

 

 

 

 

 

 

 

 

 

100

 

 

 

EM Credit

 

 

 

 

 

 

 

 

 

95

 

 

vs. Local Bonds

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(total return)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

90

 

 

 

 

 

 

 

 

 

 

USD Index

85

 

 

 

 

 

 

 

 

 

 

 

(DXY)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

80

 

 

 

 

 

 

 

 

 

 

 

 

 

 

75

Dec-11

 

 

 

 

 

 

 

 

 

 

 

 

 

70

Jun-12

Dec-12

Jun-13

Dec-13

Jun-14

Dec-14

Jun-15

Dec-15

Jun-16

Dec-16

Jun-17

Dec-17

Jun-18

Dec-18

Source: Datastream, Goldman Sachs Global Investment Research

(6) The commodity cycle - look for positive carry in commodity FX and rates

Bottom Line: Commodity-linked FX has underperformed the physical since mid-2017, but total returns have held in better; we still see some carry cushion to downside, particularly in local bonds.

A recurring theme for EM specialists is the sensitivity of asset prices in commodity exporting EMs to changes in physical commodity prices - which vary over time. The underperformance of EM FX in commodity-EMs over the past 1-2 years has come back in focus given their relative stability during the recent commodity price downdraft. We think the performance trends are in part “pay back” for the underperformance from earlier but also the deviations are smaller when accounting for broad Dollar moves; and we also find that relative views within EM FX (exporters vs. importers) have tracked physical commodity prices better.

Here we note two important issues - first, that total returns of EM commodity FX have held in much better than spot returns. This is of course due to elevated levels of carry that formed during the 2014-16 EM bear market, when EM central banks raised rates to combat inflation and FX fears. For investors that worry about investing in commodity EMs (several of which still appear early cycle) due to global growth concerns, we note

26 November 2018

8

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Goldman Sachs

EM Strategy Views

that EM FX carry has typically offset up to 5% losses in physical commodity prices during a given quarter; we think this is ample buffer to the downside given the 20% decline in commodity prices already posted since early October. Our base case FX forecasts suggest COP, ZAR, RUB, and CLP will yield over 5% in total return terms over the next 12-months.

Exhibit 8: EM ‘commodity’ FX has underperform the physical, though carry seems to provide decent cushion to the downside from here

120

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

800

15%

 

 

 

 

 

 

EM Commodity FX:

 

 

 

 

 

 

 

EM Commodity FX: Spot vs. Total Returns

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Returns vs. Physical Commodity Prices

 

110

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

700

10%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EM FX Total Return

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EM Commodity FX

 

 

 

 

 

 

 

 

 

 

 

 

100

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(CLP, COP, ZAR, RUB)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Return

 

600

5%

 

 

 

Total returns flat

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

when commods are modestly

 

 

 

 

 

 

 

90

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

lower

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

500

0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

80

 

 

 

 

 

 

 

 

 

 

 

 

Commodity

 

 

 

 

 

 

 

 

 

 

 

 

 

EM FX Spot Move

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Prices

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

-5%

 

 

 

 

 

 

 

(CLP, COP, ZAR, RUB)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

400

 

 

 

 

 

 

 

 

 

70

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EM FX

 

 

 

300

-10%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

60

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Spot Return

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

13-Dec

14-Mar

14-Jun

14-Sep

14-Dec

15-Mar

15-Jun

15-Sep

15-Dec

16-Mar

16-Jun

16-Sep

16-Dec

17-Mar

17-Jun

17-Sep

17-Dec

18-Mar

18-Jun

18-Sep

18-Dec

-15%

(20%)

(15%)

(10%)

(8%)

(6%)

(4%)

(2%)

0%

2%

4%

6%

8%

10%

15%

20%

50

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

200

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commodity Price Move (3-mo)

 

 

 

 

Source: Datastream, Goldman Sachs Global Investment Research

We are positive on duration trades broadly in commodity exporting economies (perhaps less so in CLP), especially given the fact that the yield curves have widened back to near the highs of the post-GFC era (see Exhibit 9). For local bond investors, EM FX still accounts for roughly 80% of the returns in these markets, but, relative to market pricing, we see the potential for duration to work favorably as well. Outside Chile, we forecast fewer hikes than priced in Colombia, Russia, and South Africa (for the latter two we forecast cuts vs. the market’s pricing of hikes over the next 12 months).

26 November 2018

9

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EM Strategy Views

Exhibit 9: EM commodity-exporters’ yield curves are near their widest levels

1.2pp

 

 

 

 

 

 

 

 

 

 

 

 

 

EM "Commodity" Curves

 

 

 

 

 

 

 

 

 

 

 

 

 

1.0pp

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

10y vs. 2y Local Yield

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

0.8pp

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(CLP,COP,RUB,ZAR)

 

 

 

 

 

 

 

 

 

 

 

 

 

0.6pp

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

0.4pp

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

0.2pp

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

0.0pp

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

-0.2pp

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

-0.4pp

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

-0.6pp

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

-0.8pp

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

-1.0pp

Feb-13

 

Jun-13

Aug-13

 

Dec-13

Feb-14

 

Jun-14

 

 

 

 

 

Jun-15 Aug-15 Oct-15 Dec-15 Feb-16 Apr-16 Jun-16 Aug-16 Oct-16

 

 

Apr-17

Jun-17

 

Oct-17

 

 

Apr-18

Jun-18

 

Oct-18

 

Dec-12

Apr-13

Oct-13

Apr-14

Aug-14

Oct-14

Dec-14

Feb-15

Apr-15

Dec-16

Feb-17

Aug-17

Dec-17

Feb-18

Aug-18

Dec-18

Source: Datastream, Goldman Sachs Global Investment Research

(7) Market rotation - a “constant change” year-to-year

Bottom Line: relative performance leadership rotates markedly from year to year, with underperformers frequently leading the next cycle; we see potential for Indonesia, Chile, South Africa, and the Philippines to move back on top, with Brazil likely to fall.

Similar to our comment about the path of EM assets over the course of a year, we find that EM leadership often rotates at the extremes; the weakest performer of one year often is among the strongest of the next year (and vice-versa). In particular, the “focus” EMs of Brazil, South Africa, and Russia have been notable rotation-stories in recent years. As we show below, a ranking of cross-asset indices across individual EMs shows a high degree of rotation since 2014 (see Exhibit 10). If this trend continues, the proposed outperformers for next year would include South Africa, Indonesia, the Philippines, and Turkey (we agree with the first three, particularly in local assets). Our outlook reports highlight the idiosyncratic stories therein, but this top-down story of rotation is incrementally supportive.

26 November 2018

10