- While EM assets have bounced from March lows, structural headwinds face EM FX…
- …and EM equity faces a potential correction of EM Banks "overshoot".
- EM banks continue to contribute an increasing portion to aggregate EM corporate profits…
- …where most EMs have seen greater EPS growth in Banks than in other parts of the market.
- Going forward, the expectation that US rates may rise in the coming quarters is a challenge for EM banks…
- …as tighter liquidity conditions poses a potential risk to further profit growth.
EM equity rally has stalled; have we not adjusted enough for structural outperformance?
EM equities posted a formidable rally between mid-March and late-April (+13% vs. DM +4%, in USD terms), which we believe was caused by the combination of a dovish Fed, improving growth views on the back of China easing policy, and a bounce in commodity prices. However, over the past month, EM equities have fallen 3% as DM rates have risen and China growth data continues to disappoint. Under the surface, the cyclical, commodity-exposed EMs, which had been substantial underperformers over the past year, have posted the strongest gains since the mid-March lows, including Brazil (+18% in USD, 11% in BRL) and Russia +27% in USD, 3% in RUB). We have preferred EM equity to currency, given the necessarily macro adjustments will probably require FX weakness in several EMs (not to mention our bullish view on the USD).
As we wrote last week, a decline in commodity prices has clear negative implications for EMs with direct commodity exposure (see EM Weekly 15/13: Oil - low for long; EMs polarisation to prolong, May 22, 2015), but perhaps more worrying is the outlook for EMs where banks' profit growth has apparently "overshot", which we discuss below.
We have long noted that aggregate EM corporate profits have been stagnant since 2010 (see EM Strategy: What happened to the EM growth story, March 24, 2015), and below we separate out EM Banks, highlighting their relative strength. In simple terms, EM bank earnings have grown 47% since 2010, EM commodity companies have seen earnings decline 48%, and the "rest of EM" has posted 15% profit growth. Put in a different context, EM banks used to generate roughly 20% of overall EM profits (in 2010), but now represent over 30% (2014). In our view, this is an "overshoot" that has been driven by a strong credit cycle in recent years, and will ultimately need to be corrected. Conversely, commodity companies have historically tended to generate 32% of EM profits and currently represent only 17%. Going forward, risks to banks’ profits seem much more worrying than further potential declines in commodity-related profits.
Given that most EM banks are in the savings and loans business (Diversified Financial Services comprise 8% of EM Financials float capitalization) and are economic "middlemen", we are surprised by their impressive growth rates in recent years when the rest of EM corporates seem to be facing significant growth headwinds. Historically, EM banks have generated an average 18% of overall profits, which, even after taking stock issuance and index changes into consideration, suggests their earnings outperformance is unlikely to continue. For comparison, Financials have generated an average 16% of profits in the S&P 500 since 1974.
From a strategic perspective, an EM banks "overshoot" poses a challenge to our EM vs. DM framework, which is centered on the "growth differential" view. Given their 1/3 share of overall EM profits; banks may keep overall EM growth rates subdued relative to DM if they indeed face headwinds in coming quarters. Furthermore, the probability of a banking crisis is much higher following a significant credit accumulation cycle (see Untangling China’s Credit Conundrum: Deleveraging after a credit boom requires years of adjustment, January 27, 2015), which suggests that investors may discount bank stocks’ valuations in coming quarters. As we discuss below, not all EMs face the same banking challenges, but this is a key issue preventing us from adopting a strategically positive view on EM equity relative to DM at this point.
Bank earnings have outpaced the market across most EMs: Brazil and ASEAN appear risky areas
Markets have been focused on the banking sector in China for a number of years now, given the size of the sector and headlines regarding potential non-performing loans since the 2009 stimulus package. However, we find that the "EM bank overshoot" issue is one that extends well beyond just China. As we show below, banks have posted much higher EPS growth rates than the rest of the local market in almost all EMs.
A stark example of this is found in Brazil, where we have noted that credit growth has proven to be surprisingly stable, likely emanating from public banks through non-market operations (see Latin America Economic Analyst 15/10: Brazil: BRL should depreciate further to facilitate macro adjustment, May 15, 2015). Brazil faces a challenging macro backdrop, with low growth, high inflation, and a significant current account deficit, yet the equity market has posted a strong relief rally, as we noted earlier. These macro imbalances are a key driver of our bearish view on the currency (BRL at 3.45 in 12-mo), but we would note that this "micro" imbalance is an important challenge to adopting a favourable view on the equity market at this point.
Other areas of potential vulnerability are the south-east Asian markets that have likely benefitted from significant liquidity injected into their economies as a consequence of unconventional monetary policy in the DMs. These include Thailand and Indonesia, where banks have averaged EPS growth in the high teens since 2010 and where our Asia strategy team remains relatively cautious (see Asia-Pacific Strategy: Parsing the Growth/Rates debate, March 29, 2015).
Interestingly, two of the vulnerable markets in the CEEMEA region, Turkey and South Africa, do not appear particularly at risk by this metric. In Turkey, the banking sector has already stumbled – with earnings falling 6% in 2014, likely driven by tight liquidity caused by 2013’s taper tantrum. While the Turkish economy still faces a number of challenges, reflected in its falling productivity and debt accumulation (see CEEMEA Economics Analyst 15/17: An anatomy of Turkey’s economic slowdown, May 15, 2015), we believe the equity market has reflected these risks more transparently here than in other EMs, such as the ASEAN markets. In terms of valuation, Turkish banks trade at 9.0x forward EPS and 1.1x book value, whereas ASEAN banks trade at 12.2x forward EPS and 2.3x book value. Separately, China banks trade at just 6.5x forward earnings, which suggest there is significant "left-tail" risk priced into these stocks; and the current administration’s reform agenda may help lower the risk premium embedded in China bank stock valuations and drive their shares even higher.
EM Bank earnings at risk in a tighter liquidity world
Looking forward, our expectation that DM rates will likely rise in coming quarters poses a challenge for EM banks’ profits. As we have noted previously, EM local rates are largely influenced by US rates (see Emerging Markets Weekly 15/10: The Fed grants a reprieve, for now, March 24, 2015), and, accordingly, the Fed’s "lift-off" remains an event risk.
Historically, EM banks' earnings have flowed with the broad EM credit cycle (illustrated below using M2 growth). Although higher local rates may provide some net-interest-margin support for EM banks, we believe the volume story is the more compelling one, and that slowing credit growth due to higher rates would trump potential margin improvement. Furthermore, liquidity conditions could tighten across EMs if capital outflows result from a Fed lift-off or expectations thereof.
In conclusion, we highlight that equity remains our favoured asset class across the EM complex, but even equities face risks from macro imbalances that are generally tied to the currency and rates story in EM. Global markets have seemingly swayed back and forth in terms of their expectations of lift-off, which has in turn pulled EM assets up and down. In order for EM equity to outperform DM on a structural basis, we believe the banking sector, which now represents 30% of earnings and 19% of float capitalization, will first need to discount a potential credit growth slowdown.
