DM growth inflection, EM reforms to drive equities higher in 2014
*The DM growth inflection to finally aid EM in 2014 We expect EM GDP growth to rise slightly to 5.3%, and earnings to grow 8% in 2014. With some valuation expansion in China and Russia, we expect 18% price returns in 2014 (vs. 0% in 2013) similar to DM on a volatilityadjusted basis. US tapering and regional elections could be destabilizing in 1H, but EM should rebound as the DM recovery becomes more evident.
* Countries: DM-facing, C/A surpluses, and reform We upgrade China and Russia to Overweight, both of which have embarked on reform processes and are working more closely together in energy. We keep Korea and Mexico Overweight on DM growth acceleration. Sector P/E dispersion is wide but should decline: low-multiple areas (SOEs, Exporters) may re-rate on better DM growth and EM reforms. High-multiple sectors (Defensives, Domestics Cyclicals) may de-rate due to macro rebalancing.
* Themes we’re watching: Tapering, BRICs, flows US tapering and regional C/A deficits remain an issue for EM but the delay in tapering has allowed some countries to move closer to stability, reducing the magnitude of EM vulnerability. The 5-yr underperformance of BRICs vs. EM may finally reverse mid-year. EM bond flows may slow more than equity, which could drive continued divergence between EM equity & currency.
* What to do: Buy EWY FXI EWW RSX; exporters Given a more upbeat outlook, we would focus on long-exposure in our overweight countries, as well as Exporters, while fading Domestic Cyclicals and Financials especially in C/A deficit countries.