GEM Financials - Why Fed will tone down rate rhetoric and what to do with GEMs

Why FED should reverse the course

Near-term risks to global growth as a source of deflation.

Strong dollar is further hurting already weakened EM economies. Slow growth in emerging markets, notably China will sooner or later show up in LEI readings in the U.S. What is happening to iPhone 6s sales is a case in the point. EM inventories of new iPhone models have grown steadily since the 6s was launched largely due to weaker demand around the globe but specifically in emerging markets. Now, Apple is widely expected to cut the new line's production significantly to the extend iPhone 6s sales in 1Q16 could fall up to 30% short of iPhone 6 sales same period last year.

Shrinking U.S. repo market as banks implement Basel III.

The U.S. financial institutions have started implementing Basel III requirements. In fact, the year 2015 was the first full year of implementation of supplementary leverage ratio, the SLR, which has a much wider definition of balance sheet. The introduction of SLR is forcing banks and dealers to reduce their "low-margin" exposures. One area banks have cut exposure to is the repo business, where volumes continue to decline reducing liquidity also via higher swap costs. Funding costs at U.S. banks and dealers have increased particularly after October. We reckon Fed policy action of late last year did not adequately factor in Basel III implementation risks; 2016 policy decisions may have to accommodate to help banks mitigate the liquidity risks.

Excess capacity in China and her trade links as sources of deflation longer term.

Longer term deflationary risks in relation to excess capacity in Asia/Asia Pacific economies remain. Chinese manufacturing base alone significantly alters global excess demand dynamics. There is probably nothing new here with the facts; but we reckon the markets find it rather inconvenient to even talk about risk of a prolonged recession in China. Market shares in global production of China-based manufacturers in a range of products are in multiples of China's share in world population (19%). The production capacity in each of aluminum, construction equipment, cement, steel, and construction glass is well in excess of 40% of corresponding world capacity. China also commands 25-40% of global production in plastics, various chemicals, cotton fiber, and automobiles among others. That some of these products are cyclical in nature does not change the argument: prices have to adjust to clear the market unless excess supply is shut down. Because of strong trade links between China and net commodity importing EM economies (e.g. Brazil, Russia), almost any price adjustment, inflationary or deflationary, is imported with the trade.

Below are the risk sources, in no particular order, which should prevent FED from further tightening

In summary, the risk of a prolonged recession heightened around the globe. We list below the risk sources in point form.

• There is potentially further downside risk to growth in developed markets. 
• Global credit market conditions are likely to remain rough.
• There is risk of contagion in emerging markets particularly from China.
• There is now added risk to emerging market currencies.
• We reckon search for dividend yields will intensify earlier in the year.

Global emerging market stand and updated values

As for equity markets, investors should stay defensive. Earnings predictability is lower than usual in most industries saving a handful of consumer discretionary companies. We reckon search for dividend yields will intensify earlier in the year. The share values of most high-yielding stocks will adjust to reduce dividend yields throughout 2016. 

Among the larger emerging markets, Russia is an outlier on the low-end of valuation, Turkey is a distant second followed by China. Russia offers the highest earnings yield on 2016 consensus estimates (18.5%). Turkey (12.0%) is a distant second followed by China (10.6%). The street expects nearly 30% of net income earned in each of these three markets will be distributed to shareholders: the numbers displayed on the bar chart are dividend yields. 

At the bottom of earnings yield scale (high PE), we see Mexico (5.7%), and India (5.9%). Brazil, Taiwan, Poland, Hong Kong and South Africa lie half-way between the "the most and the least attractively valued" markets based on a combination of earnings yields and dividend yields. What these four have in common is that they all have high dividend yields, which somewhat justifies "lower" earnings yields. 

On expected earnings growth (2016E), Mexico (+30%), Turkey (+16%), India (+16%) and South Africa (+15%) rise above others. There is relatively modest earnings growth expected in most other larger emerging markets. EM Asia is set to grow corporate earnings by an average 5.6% on the latest street estimates. Poland and Russia appear the weakest spots amongst the larger EMs. Indeed, Polish earnings are expected to fall 11% in 2016 while the consensus has Russian earnings growing at 4.9%.