Outlook 2014

Outlook 2014

Russia and China the most attractive markets 2014 will be another divergent year
Executive summary
We believe in a modest global economic recovery in 2014. One result of the recovery will be that some of the monetary stimulus programs will start to be wound down during the course of the year. At the same time, there are plenty of remaining issues in the US and Euro zone, but we do not see any systemic risks. We do expect some of the emerging market pessimism to linger. And we also believe that commodity prices will continue to ease somewhat, partly as a result of USD appreciation. Eastern Europe, which broadly follows the global trend, will experience a moderate economic acceleration in 2014, from a relatively low base. Although the divergence in terms of economic growth has reduced lately, there are important differences in terms of external support and vulnerability. On balance, we find Russia to be one of the most attractive macro stories in 2014, while Turkey looks like one of the riskier. Central Europe is attractive from a macro perspective, but risky from a regulatory standpoint. We expect continued divergence in the frontier economies. The macro situation in Asia is expected to show an uneven growth outlook from a relatively uneven base. The investors rotation that began in 2013, favouring North Asia over South Asia, will probably continue, especially if China starts delivering on its promises to implement a very ambitious reform program, which we believe it will. The improvement of the Japanese economy following the Japanese quantitative easing will also continue to give spillover effects in the region. Still, several ASEAN countries are more vulnerable to US tapering and also enter 2014 with relatively high valuation levels, both from a regional and historical average perspective. The situation can however change quickly, and we do believe in the strong potential of ASEAN in the medium to long term. We find Russia and China as the most attractive markets from a top down perspective. We are, however, conscious of the fact that financial markets do not trade on fundamentals alone. Even though some of the excitement about frontier markets has reduced, we see substantial upside for selected frontier markets in emerging Europe and Asia. So, on balance, we expect 2014 to be another divergent year. Moreover, tapering is likely to be very gradual and we do not expect any rate hikes in the developed world during the course of the year, which suggests that monetary policy will remain highly accommodative. Tapering will thus continue to dominate the news flow in 2014 and may cause some volatility in some emerging markets, but the fact that the guessing game ends when it starts should be welcomed. There are plenty of remaining issues in the US and EU but we do not see any systemic risks. We expect the US to deal with its fiscal and debt problems in a more constructive way in 1H 2014 than was the case in 2H 2013, and the Euro zone will manage existing and potentially new program countries more smoothly in 2014 than has been the case previously. We expect some of the emerging market pessimism to linger. Some of the concerns about the sustainability of EM growth, which surfaced during the summer of 2013, are warranted and may linger during the course of 2014. We do, at the same time, believe that the financial market pessimism is exaggerated and that we will return to a more nuanced sentiment that also takes into account the divergence within the emerging universe. We also believe that commodity prices will continue to ease somewhat, partly as a result of USD appreciation. The trend is not expected to be very strong though, and there are factors that may limit or even reverse the development. In particular, renewed tension in the Middle East is likely to put upward pressure on energy prices, but things can also go the opposite way if the preliminary deal with Iran is closed, and any further delay in tapering should postpone the USD appreciation.

Eastern European outlook

Eastern Europe, which broadly follows the global trend, will experience a moderate economic acceleration from a relatively low base. Inflation is close to all-time lows and some economies have room to cut rates further. Inflationary pressure will start to build up however, and the rate cycle will start to be reversed towards the end of the year. Even though the divergence in terms of economic growth has been reduced lately, there are important differences in terms of external support and vulnerability. The Central European and Baltic economies will benefit the most from the pick-up in Western Europe, given their openness to trade and high degree of integration. The economies in Southeastern Europe are likely to start to benefit as well. Some of these economies are, however, also the most vulnerable to tapering. The economies further east are neither as leveraged to the Euro zone nor as vulnerable to tapering. On balance, we find Russia as one of the most attractive macro stories in 2014 while Turkey looks like one of the riskier. Russian growth surprised on the downside for most of 2013, while Turkey grew faster than expected. Russian growth is likely to accelerate going forward, partly due to the low base, but will nevertheless remain below potential. The opposite is true for Turkey, as the market is growing close to potential and may decelerate somewhat. Moreover, Russia has one of the strong-

Global assumptions
We believe in a modest global economic recovery in 2014. We are quite confident in this assumption, as most major economies are expected to grow faster than in 2013, supported by a favorable base, accommodative monetary policies and a lower fiscal drag. The recovery will, however, be a modest one, and many economies will grow at a lower rate than their potential. This is happening as a number of emerging economies are struggling to rebalance their growth models, while many developed economies continue to wrestle with large debt pools. One result of the recovery is that some of the monetary stimulus programs will start to be wound down during the course of the year. In particular, a reduction of US asset purchases by the FED (tapering) will likely start in 1H 2014, although this is partially discounted already.

est public balance sheets in the emerging world, while Turkey has one of the worst. Turkey is also the least export-orientated of all the economies in the region. The view of these two economies may change rapidly however, as much depends on the timing and extent of external monetary policies. Central Europe looks attractive from a macro perspective but risky from a regulatory standpoint. Growth will accelerate on the back of a low base and external support from the Euro zone recovery. But politics in the region has been an issue in 2013 and may continue to be a drag on financial markets, at least for the first half of 2014. We believe the market has not yet fully priced in the negative effects of the Polish pension reform and the populist policies expected in connection with the Hungarian parliamentary elections. We expect continued divergence in the frontier markets. The Baltic economies look the best from a macro perspective and should benefit from Latvian Euro zone accession but may struggle to continue to surprise positively while the Balkans may start to do relatively better. A few of the Western Balkan economies may need external support through IMF/Euro zone programs, but this should be uncontroversial and may serve as a reform anchor. The recent turmoil in Ukraine is likely to make an already precarious economic situation worse in the short term, increasing the need for an external financing package, but may lead to something positive in the longer term. Kazakhstan, on the other hand, seems as strong as ever from a pure macro perspective. But other issues will surely affect the view of these markets as well.

limited and short lived impact on the overall economy. Japans Abenomics is expected to have a positive effect on the region, with spillover effects. Vietnam, which increasingly attracts FDI by multinationals keen to benefit from low labour costs compared to China, should be able to maintain its relatively high growth rate, also spurred by trade, as the Asian Free Trade Agreement, AFTA, will be realised as early as 1 January 2015 for Cambodia, Laos, Vietnam and Myanmar. Overall, we expect an improved external environment with more export opportunities and continued focus on infrastructure investments in ASEAN, which should have a positive impact on growth as it increases productivity. Although most economies in the region are running healthy current account surpluses, there are notable exceptions, such as Indonesia. Indonesia also has the highest inflation rate in the region. Much of this is well known though, and the financial markets in the region are likely to be influenced by other factors as well. The investors rotation that began in 2013, favouring North Asia over South Asia, will probably continue. The Third Plenum of the 18th CCPCC resulted in a massive reform package, expected to be launched gradually in the coming years. The main features of the reforms include deregulations in order to decrease the states influence over companies and markets, as well as land reform, fiscal and financial reforms. As details emerge, policies will create volatility on the market and also divergence in the developments in some parts of the economy. But we feel that the Chinese government has a good track record of getting things done and these reforms will form the foundation of future growth. The reforms may further help to eliminate tail risks, which often seem to fuel the low risk appetite of global investors for Chinese equities. We expect the positive flows to Korean equities to continue going forward. Although there are other Asian economies that are more export-dependent than Korea and thus more prone to benefit from an improved external environment, the Korean equity market is reflecting most closely the export manufacturing sector. Taiwan is another obvious beneficiary of a global economic recovery. The stock market there is however very much geared to the tech sector.

Asian outlook
The macro situation in Asia is expected to show an uneven growth outlook from a relatively uneven base. A number of export-driven economies most notably Korea, Taiwan and Thailand, but also Malaysia are expected to accelerate from a relatively modest base, while countries like China and the Philippines are expected to maintain their relatively high growth rates, or perhaps decelerate slightly. Although very tragic, the typhoon in the Philippines is expected to have only a

Eastern Europe macro indicators, 2014

GDP growth CPI C/A balance Exp/GDP
Sources: IMF, UN, World Bank

Russia Turkey Poland Romania Kazakh Baltics Hungary Czech Ukraine 3.0 3.5 2.4 2.2 5.2 3.4 1.3 1.5 1.5 5.7 5.3 1.9 2.8 6.3 2.3 3.0 1.8 1.9 2.3 -7.2 -3.2 -2.5 3.1 -0.9 2.0 -1.5 -7.4 30 24 45 40 50 76 91 73 54

Emerging Asia macro indicators, 2014

GDP growth CPI C/A balance Exp/GDP
Sources: IMF, UN, World Bank

China Indonesia Korea Thailand Philippines Malaysia Vietnam Taiwan 7.3 5.5 3.7 5.2 6.0 4.9 5.4 3.8 3.0 7.5 2.3 2.1 3.5 2.6 7.4 2.0 2.7 -3.1 3.9 -0.2 2.2 3.6 3.3 9.6 31 26 56 77 32 92 87 66

Within ASEAN, Singapore remains most attractive in the short term, as the economy is strongly geared toward a global economic recovery and thus a pickup in global trade. Singapore faces relatively less headwinds and the market is less vulnerable to foreign outflows. Malaysia ranks high among our preferred macro stories for next year, valuations are however also high on a relative basis. The Philippines has the strongest macro fundamentals in the region, demographics are very favourable and the political situation has very much improved over recent years. But as in the case of Malaysia, valuations are slightly high. Thailand is late in its investment cycle and has a unique geographical position, benefitting not only from its own economic development, but also from the economic development of its neighbouring countries. The political tensions lately are spoiling the picture, but we believe that the market offers attractive entry points for the medium to longer term. Among all the ASEAN countries, Indonesia offers probably the most compelling story in the longer term, thanks to very strong demographics, a vast internal market and large needs for infrastructure investments that should support growth and improve productivity. However, the economy is currently facing a tougher macro situation, mainly due to its current account deficit.

This should, preferably, be combined with equity markets that (i) are cheap, (ii) are paying high dividends, (iii) are far below their peaks, and (iv) have high earnings growth. When summarising these stylised indicators, we conclude that Russia and China are the most attractive. We also believe there is more upside in the frontier space even though there is likely to continue to be a degree of divergence across markets. We are, however, conscious of the fact that financial markets do not trade on fundamentals alone. Sentiment plays an important role and there is, for instance, a lot of deeply-rooted scepticism towards Russian politics and Chinese economics that, at least from time to time, reduces the appetite for these markets. We also look for triggers that can move particular markets sharply in either direction. On this note, we are carefully optimistic that the privatisation drive in Southeastern Europe, financial market and business reforms in Russia, and economic reforms in China that started towards the end of 2013, will gain momentum in 2014. We remain concerned about the regulatory changes in Poland and Hungary, and believe the elections in Turkey, Hungary, and Indonesia may cause some uncertainty in the lead-up, although we do not expect any dramatic changes. So, on balance, we expect 2014 to be another divergent year. Not only in terms of performance across emerging Europe and Asia, but also within particular markets during the course of the year. The modest global economic recovery, combined with reduced tail risks, should however, provide a decent backdrop for emerging market equities, even if some of the monetary stimulus starts to be reduced.

What do we like?
Russia and China are the most attractive from a top down perspective. We like economies where (i) growth accelerates, (ii) inflation stays flat or falls, (iii) rates can be cut, and (iv) there is resilience to tapering.

Note Every effort has been made to ensure the accuracy of the information in this document but it may be based on unaudited or unverified figures or sources.

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