Strategy Note /

Frontier-Emerging Equity Monthly, June

    Hasnain Malik
    Hasnain Malik

    Strategy & Head of Equity Research

    Tellimer Research
    1 July 2019
    Published by

    In this report, we pick out this month’s FM and EM equity market highlights, updating our top-down views on the biggest out and under performers (in US$ total return terms), with links to published research and updated country data snapshots. Our most recent country ranking of the 33 markets in our coverage, based on valuation, FX rate risk, growth prospects and political risk, is accessible via this link – Beggars Banquet.

    EM and DM bounces back, FM trails

    After its outperformance in May, FM (up 2.3%) underperformed FEM (up 4.9%), EM (both up 6.3%) and DM (up 6.6%). Lower equity market liquidity in FM is likely the best explanation for this, both on the way down for EM in May and the bounce back in June. The global backdrop was characterised by a drop in US yield (10-year down 9bp) and US$ (trade-weighted down 1.5%), expectations of resumption in US-China trade talks (post the G20 summit), tanker attacks in the Gulf of Oman, and additional US sanctions (partly driving another 3% increase in oil price in advance of OPEC+ talks, where expectations are for a continuation of output restraint).

    Large EM: India underperforms a broad rally 

    Across large EM, FX rates appreciated, and equities rallied, with the exception of India: Russia (up 9% with the absence of new US sanctions thus far, higher oil price, and a positive grain harvest outlook offsetting continuing anaemic economic indicators and mild protests), China (up 8% on expectations of progress on trade talks, government stimulus, and index inflows related to the higher weight for China A-shares in MSCI EM, offset weaker economic data) and South Korea (up 8% on expectations of lower interest rates) outperformed and India (flat with higher US tariffs and another central bank head departure offsetting Modi’s electoral landslide victory) underperformed. 

    A clear sign of burgeoning global risk appetite, in the short term at least, was South Africa (up 7% after the ANC electoral win in May amidst a sharp economic contraction, another senior departure from the central bank and credit rating agency comments on downside risks).

    Small EM: Argentina, Romania, Thailand, Tunisia, Turkey outperform 

    This greater risk tolerance extended to parts of FM and small EM, with the greatest outperformance from Argentina (up 27%), Romania (up 8%), Thailand (up 9%), Tunisia (up 6%) and Turkey (up 8%); these are five markets with some of the most fraught politics and (except for Thailand) least credible policy frameworks and most vulnerable FX rates over the last 18 months. The worst underperformance was seen in Pakistan (down 11%, largely driven by 8% FX devaluation and the hit to growth from structural adjustment), Georgia (down 8%, tensions with Russia) and Ghana (down 3%, fiscal deficit concerns).

    Performance in US$ total return terms, month to date

    Source: Bloomberg, Twitter

    Our review of FM and small EM by region are below, while the data appendix is available in the full report.

    Asia: Thailand, Indonesia outperform; Pakistan, Vietnam underperform 

    In Asia, Thailand (up 9%) and Indonesia (up 6%) outperformed on expectations of an easing of interest rates and relatively more political certainty post-official election results. We remain positive on Indonesia which is valued 9% below 5-year median PB. (We are also still positive on Philippines which is on an 18% discount on this measure). However, we remain concerned that in Thailand the ruling parliamentary majority is too small and fragile to drive structural reform but we acknowledge that this likely results in fiscal populism (which should relatively benefit the consumer sector). 

    Vietnam (flat) underperformed after it was added to the US Treasury watchlist for FX rate manipulation and US President Trump referred to it as an “almost the single worst abuser” on trade, both factors which offset ongoing strong economic data (GDP growth of 6.7% yoy in Q2, above 6.6% consensus forecast, and full year inflation target still below 4%). We argue that US-China trade, technology, and territory are not likely to be resolved completely or permanently, that Vietnam (and Bangladesh, up 2%, where, separately, the final version of the finance bill should be positive for dividend pay-out) are beneficiaries in terms of marginal purchasing and investment decisions but that there is no immunity from slower global growth and potential China FX rate devaluation (which would have to be mirrored to maintain export competitiveness). However, we think the more durable part of US foreign-trade policy is geopolitical competition with China, rather than the repatriation to the US of low-cost manufacturing jobs; in other words, the fallout from US-China friction is a more material risk than the US targeting of any low-cost manufacturing locations. 

    Pakistan (down 11%) underperformed due to FX devaluation of 8%, another interest rate hike and contractionary primary fiscal budget (all of which impair short-term growth but are necessary for economic stabilisation and the IMF Board approval of a new loan). While not our favourite market, because FX reserves are still below 3 months of import cover and domestic and external government debt is high, we remain positive on Pakistan because equities are their cheapest for a decade (only distressed and dysfunctional Lebanon is on a similar 35% discount to 5-year median PB), economic policy is orthodox, and politics supports a positive structural transformation (security, governance, fiscal management and infrastructure improvements).


    MENA: Turkey, Saudi outperform; Oman, UAE underperform 

    Turkey (up 7%) outperformed as more benign US rate and US$ and President Erdogan’s acceptance of the electoral loss in the Istanbul mayoral election offset higher risks of sanctions from the US, due to arms purchases from Russia, and from the EU, due to offshore gas drilling near Cyprus, and higher oil price. Our view remains that the investment case in Turkey is riddled with risk on market-unfriendly economic policy but that this is well understood and asset prices can snap back sharply in a more tolerant global risk environment and with any incremental positive news (a situation which resonates that of the other extremely vulnerable FX rate in small EM, Argentina).

    Lebanon (up 6%) outperformed as local banks baulked at government proposals for issuing new debt, equivalent to 13% of GDP compared to outstanding debt of 160%, at well below market rates, Qatar purchases of Lebanon government debt, spreads over EMBI for the 2028 sovereign US$ bond narrowed by c70bp from mid-June, and data pointing to a 14% increase in FDI in 2018 all, for a while at least, offset ongoing risks to implementation of a contractionary budget, release of pent-up external financing commitments made at CEDRE in April 2018, amounting to 18% of GDP, and what remain very wide spreads over EMBI (463bp). On Lebanon equities, we see risks as largely priced in with banks on trailing PB of 0.5, PE of 3x and DY of 14%.

    Saudi (up 4%) outperformed as MSCI EM index-related foreign inflows, the removal of the 49% foreign ownership limit for strategic investors, and higher oil price offset escalated tensions with Iran and attacks from Yemen. We acknowledge it is futile, in the short-term, to fight the tyranny of index flows but we see little value in most of Saudi large cap and while Iran tensions are unlikely to result in hot, inter-state conflict (as opposed to the last four decades of proxy battles) they will keep Saudi defence spending elevated, already 9% of GDP (note, as an example, US efforts to lobby other countries to pay for its enhanced security patrols in the Straits of Hormuz).

    UAE (down 1%) and Oman (down 3%) underperformed as perceived risks associated with their economic and physical proximity to Iran outweighed positive fundamental developments: in the case of the UAE, improving business confidence (PMI increased from 55.7 to 59.4, the highest level since 3Q 2015) and visa reform (10-year residency applications opened up to salaried expats above cUS$100k pa), and in the case of Oman, narrowing US$ sovereign bond spreads (the z-spread of the 2028 over EMBI narrowed from 105bp in the third week of June, the widest spread post-January 2018 issue, to 81bp, driven perhaps by the introduction, after a delay of 18 months, of “sin” taxes to raise fiscal revenue). We continue to view Dubai and Oman equities, at 21% and 30% discounts to 5-year median trailing PB, respectively, as reflecting their low growth outlook and we still regard the prospect of hot military conflict with Iran as unlikely.


    LatAm: Argentina outperforms region-wide rally 

    Argentina (up 27%) outperformed on the back of more benign US rate and US$ outlook, decelerating inflation, narrowing current account deficit (FX rate appreciated 5%), better unofficial polling figures for incumbent President Macri, MSCI EM index-related inflows and the announcement of candidates for the October 2019 Presidential election. The embrace of moderate Peronist running-mates and allies, who voted in favour of the last fiscal budget, by both Macri and rival Cristina Fernandez (who is running for VP this time) have made the election outcome no clearer but may well have improved the prospects of pro-market, orthodox economic policy persisting after that election (although Alberto Fernandez, Cristina’s running mate for President, has publicly questioned the IMF deal). We reiterate our view that despite deep scepticism on Argentina’s ability to structurally reform, we can construct a case for its equities to outperform this year (the Peronists are split, austerity persists, US$ outlook softens, IMF protects its own credibility, soybean harvest improves, Brazil growth accelerates, bank NPLs remain manageable, other LatAm equity markets remain impaired).

    Colombia (up 10%) outperformed due to tailwinds from the FX rate (5% appreciation, following a period of central bank FX reserves accumulation, which now appears to be drawing to a close, and a more benign US rate and US$ environment), oil price and oil output (up 3% yoy in May and ytd). These offset weaker than expected GDP growth (up 2.3% yoy versus central bank expectations of 3.2% growth, mainly due to a shortfall in non-commodity sectors) and unchanged interest rates. 

    In our view, small EM countries in LatAm (Argentina, Colombia, Peru) remain fundamentally relatively unattractive versus the global opportunity set (i.e. there is not the distressed value, high growth or credible structural transformation on offer elsewhere) but the easy accessibility to the largest stocks via ADRs and the large pool of LatAm dedicated funds (particularly when there are risks to government unity and reform implementation in Brazil and policy credibility in Mexico) mean that they perhaps do not need to. Within LatAm small EM, the oil price and output backdrop for Colombia looks more attractive than the copper price and (partially disrupted) output of Chile and Peru. Its trailing PB is at a smaller premium to 5-year median than Peru (3% versus 10%) but less attractive than the 10% discount in Chile. Particularly for those who find Argentina volatility (i.e. its gearing to global risk appetite) intolerable, Colombia offers a lower risk play and remains our top regional pick.


    Africa: Morocco, Tunisia outperform, Ghana underperforms 

    Morocco (up 6%) outperformed on local equity inflows after restrictions on local pension fund holdings of single stocks allowed those funds to fully reflect the local index weights of IAM and ATW. We maintain our view that Morocco’s top-down attraction (transformation from a predominantly commodity to manufacturing exporter, FX rate stability, low political risk) is not matched by its equity valuation of its largest stocks (MSCI Morocco trailing PB of 3.2x is at a 10% premium to 5-year median and looks excessive alongside ROE of 17%). 

    Tunisia (up 6%) outperformed due to a 4% appreciation in the FX rate; we struggle to explain this given another reminder of material downside risks on security (bomb attack) and politics (poor health of the President with the next election in October).

    Nigeria (flat) underperformed despite higher oil price and the appointment of allies of President Buhari as leaders of the upper and lower houses of parliament (leadership of the legislature by politicians who ultimately defected back to the opposition PDP may partly explain the absence of structural reform in Buhari’s last term). Our view on Nigeria remains that in an environment of low growth, high interest rate (sticky inflation), stable FX rate (at the margin, retention of oil revenues in FX reserves rather than their use in public project spend and private consumption of imports) and near exhaustion of non-dedicated foreign investors liquidating their last Nigerian positions, the tier one banks offer compelling value from a global FM and small EM perspective and relative to local, more pro-cyclical plays in cement and consumer.

    Ghana (down 3%) underperformed as the latest tax collection data showed a 10% miss versus target in 1Q 2019, the target for universal electricity coverage was pushed back from 2020 to 2025 and fears grew over potential fiscal largesse after the expiry of the IMF deal in April 2019 and prior to the 2020 election. In our view, although we are sceptical on structural reform (e.g. industrialisation beyond commodity output growth and state enterprise restructuring), risk of a fiscal blowout should be tempered by the introduction of a fiscal rule in 2018, which legally limits deficits to 5% of GDP, the banking sector is being cleaned up and the largest stocks remain cheap.


    CEE-former CIS: Romania outperforms, Georgia underperforms 

    Romania (up 7%) outperformed on hopes that significant setbacks for the ruling coalition (dominated by the PSD) at the end of May 2019 (jail sentence for former PSD leader Dragnea, PSD losses in the EU Parliament elections, defeat in the anti-corruption referendum) improve the prospects of a return to more market-friendly and predictable policies (either via a change of course as PM Dancila takes over the PSD, a vote of no confidence in the government if coalition partners defect or after the next domestic parliamentary elections, due in late 2020). 

    Kazakhstan (up 7%) outperformed on orderly political transition from Nursultan Nazarbayev to Kassym-Jomart Tokayev (and potentially to Nazarbayev’s daughter, Dariga Nazarbayeva), pro-reform rhetoric from Tokayev after his 9 June Presidential election victory, shorter than expected maintenance on the main Kashagan oil field (which accounts for about 20% of Kazakhstan’s 1.8mbpd output) and the oil price tailwind. 

    Georgia (down 8%) underperformed due to a ratchet up in tensions with Russia: violent anti-Russia protests in Tbilisi, description of Russia as an “occupier” by the Georgian President, and curbs by Russia on wine imports from and air travel to Georgia (Russia is the largest consumer of Georgia wine exports and the largest source of its tourists). 

    We continue to prefer Kazakhstan (oil revenues, reform potential, low political risk, China BRI investment) over Romania (the populist policy framework needs to change and while the prospects for this are improving there is no guarantee) and Georgia (dependence on foreign capital inflow which may be vulnerable to any deterioration in relations with Russia) in our CEE-former CIS coverage. The banks in all three markets do screen very well for value though.