Gem strategy november theme investing lower return

STRATEGY

Global

Highlights of this Issue

	•
	•
EESA Strategist, MLPF&S (UK)	•
(44) 207-996-2348	•
	•
	•
	•	Is Indonesia the new Brazil?
LATAM Strategist, Merrill Lynch (Brazil)	•	Is Indonesia the new Brazil?
LATAM Strategist, Merrill Lynch (Brazil)

	•

John Morris>>
S.A. Strategist, Merrill Lynch (South
Africa)
(27) 11 305 5151

john_morris@ml.com

>>Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under NYSE/NASD rules.

Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report.


Table 1: Total Return (%) YTD as of				1.	Investment Ideas
Table 1: Total Return (%) YTD as of
2004			4-Nov-05
MSCI (US$)
World	15.2		5.3	GEM equities are up 17% year-to-date. Russia, Brazil, Korea, Mexico & Turkey have been the strongest markets in dollar terms. Energy, utilities, staples and health care have seen the largest sector gains. EM debt is up 7.7% year-to-date. EM currencies have had a mixed performance relative to the resurgent U.S. dollar. Only the Brazilian real and the Korean won have racked up notable gains versus the greenback.
EMF	26.0		21.1
Russia	5.7		59.3
Brazil	36.5		49.0
South Korea	22.9		35.7
Mexico	48.3		33.6
Turkey	42.0		32.6
India	19.1		29.0
Chile	29.0		19.4
Israel	20.3		16.7
Poland	61.5		16.0
Thailand	-0.9		4.6
Taiwan	9.8		-5.4
Sectors (US dollar terms)
Energy	25.4		51.5
Utilities	21.5		27.2
Staples	28.2		26.5
Health Care	7.7		21.3
Telecom	34.6		17.9
Financials	39.5		16.9
Cons. Disc	28.3		15.7
Inf. Technology		10.0	13.8
Industrials	33.3		12.2
Bond Indices (US dollar terms)
EM Debt	11.8		7.7	currency; an inflection point in inflation looks imminent and India is the most expensive large market within GEM. �Indonesia is the New Brazil
EM Corp. Debt	13.7		5.6
US High Yield	10.8		1.5
UST 10 Year	4.8		-0.5
Commodities
Oil (WTI)	33.6		39.4	ML is positive on EM FX. Our FX strategists forecast a 5-7% appreciation of the Chinese RMB over the next 12-18 months and thus Asian currency strength should resume. On the margin the team sees upside risk in FX EMEA and downside risk for LATAM.
CRB Index	11.2		12.3
Gold	5.2		5.3
Foreign Exchange*
USD (trd-wgt)	-7		12.9
Brazilian Real	8.9		20.1
Korean Won	1.5		15.6
Mexican Peso	0.7		3.7
Chilean Peso	6.7		2.9
Thai Baht	1.7		1.7
Turkish Lira	4.7		-0.4
Russian Ruble	5.5		-3.0
Indian Rupee	5		-4.6
Taiwan Dollar	7		-5.7
Israeli Shekel	1.6		-7.3
Czech Koruna	14.7		-9.4
Polish Zloty	24		-11.2
Hungary Forint	15.3		-14.3
SA Rand	18		-15.4

Source: Bloomberg. * (-) depreciation, (+) appreciation
vs. the US dollar. Total Return assumes dividends were
reinvested where applicable.

Sector	Weight*		Rationale
Materials		Overweight
Staples	5.76%	Overweight	relative to history
Staples	5.76%	Overweight
Technology		Overweight
Energy	13.82%	Neutral	Sentiment too positive
Utilities		Neutral
Telecom	11.55%	Neutral	Rising GEM interest rates negates high dividend positive Fed/GEM stops tightening
Financials		Neutral
Consumer Disc.		Underweight	Slowing U.S. consumer	Stronger U.S. housing market
Health Care		Underweight
Industrials		Underweight	Higher GEM interest rates a negative	Rising government spending and private sector Capex.
Refer to important disclosures on page 35.			3

� The Late Cycle Show

Inflation Rises

We are currently “late-cycle”, a	Growth Recovers	"Recovery"	Stocks
			Bonds	Cash	"Stagflation"
shines			Bonds	Cash	"Stagflation"

Inflation Falls

GEM Strategy – 8 November 2005

•	A slump in growth and trade: A sharp slowdown in global growth would hit

Table 3: Commodity-Heavy		Hungary, Mexico and India are least likely to be negatively impacted.
	Energy + Materials

Table 4: GEM Bull & Bear Markets and Drivers

The catalysts and drivers of the		Bull 1988-94		Bull 2003-
	GEM CAC Balance	Surplus	Deficit	Surplus
	GEM CAC Balance	Surplus	Deficit	Surplus
	Relative Valuation	Overvalued		Undervalued
	Relative Valuation	Overvalued		Undervalued
currently visible	US Real Short Rates	Falling/Low	Rising	Falling/Low
	Equity Volatility	Decreasing	Increasing	Decreasing
	EM Debt Spreads	Falling	Rising	Falling
	US$ (trade-weighted)	Falling	Rising	Falling

Refer to important disclosures on page 35. 6

1.Capital inflows are abating. This is the message from the recent weak Indian rupee (worst performer within EM Asia this past month). Note that capital inflows have been a key driver of the +20% year-to-date total return from India (local currency terms).

2.An inflection point in inflation is imminent. Indian Economist Rajeev Varma predicts a rise in wholesale price inflation from 3% to 6% in the next 6 months. Indian short-rates will rise by at least 75bps over this period. Our mid-year bullishness on India was predicated on lower inflation keeping rates low and liquidity high. As inflation trends higher instead of lower in coming months, the liquidity story reverses.

Chart 8: Chronology of the 2002 Brazil Crisis

27	Selic Interest Rate (%)	Bovespa Index (US$)	Easing	8000

22 5000

20	Tightening	36%		4000
19	begins	36%		4000

GEM Strategy – 8 November 2005

�Theme Investing in 2006

1.GEM Consumer Theme

2.Urbanization Theme

Themes	Rationale	Investment Ideas
The GEM Consumer	Consumption % GDP in EM = 56%. In the USA = 70%.GEM consumption

Urbanization in Emerging
Urbanization in Emerging	The UN forecasts that the urban population in the developing world will grow
Markets	at close to one million persons per week in the next 25 years. Cities such as	homebuilders)

	Further strong GEM inflows could force investors to move further along the geographical risk curve. The surplus of the oil exporting nations could exceed $200bn this year, equivalent to 19% of GDP. Big spend likely in Middle East.	Middle East, Pakistan, Vietnam, Colombia

GEM Strategy – 8 November 2005


	View	•	Low inflation = low rates = ample liquidity (currently up 10% y/y).
Liquidity	↑	•
Liquidity	↑	•
	↑	•
	↓	•	G7 interest rates remain low in nominal and real terms. A spike in U.S.
	↓	•
	↓	Treasury yields above 5% would threaten liquidity story.
Risk Appetite	↑	Treasury yields above 5% would threaten liquidity story.
Risk Appetite	↑	•
		•

GEM underperforms only once Fed has done enough to halt

Chart 10: EMF & U.S. 10-Year Bond Yield

Chart 11: Global Liquidity*

We forecast ample growth (+10%) in our global liquidity

measure.

Refer to important disclosures on page 35. 10

GEM Strategy – 8 November 2005

Table 6: GEM Investment Drivers		•
Driver
Liquidity	↑	•	But ML’s Fund Manager Survey shows a sharp drop in net % increasing
Growth		•
Sentiment
Sentiment
Valuation	↓
Risk Appetite	↑	•
↑ = Positive, ↓ = Negative, ⎯ = Neutral

Fund managers on balance want to remain overweight GEM…

Chart 19: Weekly Emerging Market Equity Inflows, US$ bn

Chart 20: Cash Levels in GEM Equity Portfolios

5.0

3.5


										350	2.5
											2.5
											2.0
-0.30
96	97	98	99	00	01	02	03	04	05

											00	01	02	03	04	05
MSCI EM (US$, rhs)											Cash in GEM Equity Funds (US$ bn)
Source: AMG, Merrill Lynch. Weekly reporters only, five-week moving average.

GEM Strategy – 8 November 2005

•

Liquidity

↑

•

Sentiment

↓

•

↑

•

And GEM earnings yield in line with EM corporate bond yield (7-8%).

↑ = Positive, ↓ = Negative, ⎯ = Neutral

Chart 21: EMF Price-to-Book Ratio

Chart 22: EMF Forward PE Relative to World

1.4 1.2

Risk Appetite: Positive

Chart 25: EMF Relative & VIX Index

Driver

View

Liquidity

↑

•

Growth

↑

•

EM debt spreads once again close to all-time lows.

Sentiment

↓

Valuation

↓

•

High yield spreads remain tight.

Risk Appetite

↑

•

↑ = Positive, ↓ = Negative, ⎯ = Neutral

Chart 30: U.S. High Yield Spreads

5. Country Views Underweight/Overweight

GEM Strategy – 8 November 2005

Chart 37: Price Relative & GEM Fund Allocation

GEM Strategy – 8 November 2005

Underweight/Overweight
Underweight/Overweight		•
Country		•
Russia	Overweight	•
Brazil	Overweight	•
Brazil	Overweight	•	Current account likely to swing back into surplus in 2006.
Korea	Overweight	•	Current account likely to swing back into surplus in 2006.
Indonesia	Overweight	•	Inflation and interest rates rising but FX stability implies crisis over.
Turkey	Overweight
Taiwan	Overweight
Mexico	Neutral
South Africa	Neutral
Israel	Neutral
Thailand	Neutral
India
Central Europe
China
Chile

Chart 45: Price Relative & GEM Fund Allocation

Lowest exposure to Indonesia since end of 2001.

Chart 47: Indonesia Current Account Balance (US$ mn)

Chart 48: Indonesia Target Rate and FX Rate


Country	Current ML View	•
	Overweight	•
	Overweight	•	Liquidity-story a positive. Debt spreads tight. Rates to be cut 50bps.
	Overweight	•
	Overweight	•	Financials continue to outperform.
Indonesia	Overweight	•	Financials continue to outperform.
		•
	Overweight	•
Mexico	Neutral	moment.
	Neutral	•
	Neutral
	Neutral
India	Underweight


Chile	Underweight