Morgan Stanley Research, Key Regional Debates:  Economics: Rise in Real Rates

Key Regional Debates:
 Economics: Rise in Real Rates – Why It Feels Like the 1990s?
 Equity Strategy: Will the rising interest rate continue to give equities pressure to de-rate?
 Credit Strategy: Is Asia now in the adverse part of the credit cycle?
 FX Strategy: Are AxJ currencies stabilizing now?
 Oil: Will rising tensions in Syria propel oil higher? How will macro headwinds affect oil markets?
 Base Metals: What is the impact of interest rate pressure on the warehouse trade?

Key Country Debates – India

Economics: How Long Will Funding Risks Prevail?
Our View: India has been running a persistently high current
account deficit alongside negative real rates since the credit crisis.
The high current account deficit (CAD) was being funded as long as
the US ran negative real rates. However, the rise in US real rates
has exposed the economy to funding risks with pressure on the
currency. The sharp depreciation pressure on the currency has
forced RBI to explicitly initiate monetary tightening and lift real rates.
We believe that India will remain exposed to the trend of the US
dollar and real interest rates as long as India’s current account
deficit remains higher than a more sustainable level of 2.5% of GDP
and CPI inflation remains higher than 7%. In the near term (within
six months), while we do expect some moderation in CPI inflation
and the current account deficit, it will remain high. During this
period, the rupee and interest rate environment in India will remain
highly dependent on the expectations of the Fed’s monetary policy
action (India Economics: Longer Duration Slowdown Risks Vicious
Loop )
Equity Strategy: Should Investors Stay Away from
Banks?
India’s policy response to the global financial crisis has been to reduce
public savings to boost growth. The collateral damage has been
persistent consumer inflation and declining corporate savings or profit
share in GDP. Consequently, in the past five years, debt has been
transferred from the public sector to the private corporate sector (the
opposite of what’s taken place in DM). Persistent inflation has deflated
public debt relative to GDP – but it has also punctured corporate profits
(and, thus equity), causing corporate financial leverage to rise.
The world’s reserve currency is no longer interested in funding India’s
external deficit (caused by the persistent fall in savings). Thus, it
becomes imperative for India to reduce this deficit. The only path forward
is to keep real rates high at the cost of growth à la 1998. The return on
assets (ROA) for Corporate India has plummeted to all-time lows. The
only reason for ROE to be higher than its historical low is that debt is
higher than ever. However, with high interest rates, this will change in
the coming months. Given the similarities with 1998, the valuation
template is also 1998. No doubt, the absolute multiple – especially the
ever-reliable P/B – is about to enter the bottom decile – a point from
where losing money is a rarity. However, this does not work when the
equity yield is less than the short-term yield – as in 1998. The short-term
yield hinges on US outcomes. If the US labor data remain strong, Indian
yields will struggle to fall. In the end, of course, India’s macro imbalances
will moderate because of high real rates (as in 1998) and cause a
correction in yields. From a portfolio perspective, bulk of the pain resides
in the banks whereas US$ hedges will likely outperform the market

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Key Regional Debates: Economics & Strategy

Economics: Rise in real rates – Why It Feels Like the
1990s?
Our View: Real rates in Asia are facing upward pressure from two
factors: 1) the region’s declining excess saving, and 2) the rise in US
real rates and the appreciation of the US dollar as a result of an
improving US economy and market expectations of Fed tapering. We
believe that we are at the beginning of the cycle of a rise in the US dollar
and rates, implying that the upward pressures on real rates in Asia will
likely remain as a trend. The developments in the current cycle have
largely mirrored those from the mid-1990s to 2001, in our view. In this
cycle, like that in 1995 to 2011, US real rates moved up along with an
appreciating dollar, causing Asian currencies to weaken and real rates
to rise. Real rates in Asia are rising at a time when its GDP growth has
already been slowing – in other words, a pro-cyclical monetary
tightening. An environment of moderate GDP growth and higher real
rates tend to be less supportive of risk assets. Higher real rates will also
slow down the pace of credit growth and hence domestic demand
growth, but will also increase the risks of a build up in banking sector
non-performing loans. (see Asia Pacific Economics: Rise in Real Rates -
Why It Feels Like the 1990s , August 22, 2013).
Rise in Real Rates Relative to Real GDP Growth – A
Challenge for the Region
Source: CEIC, Morgan Stanley Research
Equity Strategy: Will the Rising Interest Rate
Continue to Give Equities Pressure to De-rate?
Our View: Higher core government bond yields and wider spreads
on EM sovereign debt (proxy EMBI+) are raising the prospective
return on the key alternative asset to APxJ / EM equities. This is
having the effect of driving higher the earnings yield / implied cost of
equity on equities, hence valuations are de-rating. At the same time
higher domestic real interest rates are exerting downward pressure
on economic activity in many geographies and leading to further
downward EPS revisions, particularly in cyclical sectors. We
recently downgraded our APxJ index target to 493 partly due to this
process.


Credit Strategy: Is Asia Now in the Adverse Part of the
Credit Cycle?
Our View: Asian credit markets are facing a fundamental environment
that, for many corporate borrowers, will feel like a recession.
Deteriorating cash generation and adverse borrowing conditions on
already leveraged balance sheets open up a new downside scenario,
particularly for high yield. After three years of rising leverage, corporate
Asia has the most levered balance sheets globally. Slower economic
growth in the region is putting pressure on earnings and rising real rates
on funding costs resulting in poorer liquidity as represented by worsening
EBITDA /interest cover. At the same, banks in Asia are tightening lending
standards, which would increase the supply risk in USD bond markets.
Such tighter lending conditions have also preceded higher defaults.
Nevertheless, the environment for global credit is still benign, which
should limit the downside, at least for parts of IG. We would stay
defensive, preferring Financials over corporates and adding Hong Kong
IG on weakness. For further details, see Fundamental Outlook: Into
Darkness, August 22, 2013.
Many AxJ Currencies Are Now Closer to Fair Value
FX Strategy: Are AxJ Currencies Stabilising Now?
Our View: AxJ currencies remain exposed to external risks, and we
believe that AxJ FX could see further weakness if US treasury yields
rise sharply higher on positive US data, or if geopolitical risks in Syria
worsen. INR and IDR, the two current account deficit economies in
the region remain vulnerable to these risks.
However, after the sharp depreciation in AXJ FX over the past few
weeks, we believe that many AxJ currencies are now closer to their
fair values on a technical basis and expect the price action to be less
volatile over the rest of the year. Sentiment on Asia is also improving
after the better China PMI data and the pick up in Korean exports that
we see as the leading indicator for exports in the region. With Asian
policymakers now spurred into action to protect their currencies and
correct the underlying economic imbalances, we expect that AxJ
currencies will see more stability going into the year end


Oil: Will Rising Tensions in Syria Propel Oil Higher?
Over View: Concerns about US involvement in Syria are bringing a risk
premium back to oil markets and compounding already tight
fundamentals. A strike in Syria of some sort remains a possibility,
according to newswires, but we doubt that a spike in oil prices will prove
to be enduring. This is for a number of reasons:
1. Few political commentators expect a sustained involvement of the US
in Syria.
2. There is little oil at risk in Syria.
3. Any response to a strike is hard to predict, but we believe it is unlikely
to have a major impact on oil markets.
4. Military intervention could provoke a coordinated SPR release amongst
OECD countries.
Oil: How Will Macro Headwinds Affect Oil Markets?
Our View: Given speculative positioning near its highs, incremental
buyers will be tough to find given a relatively poor macro outlook. FED
tapering will likely impede healthy YoY demand comps within the US,
while destabilizing capital outflows from the EM and China’s deleveraging
have already brought into question somewhat tepid demand growth from
the non-OECD. With more Fed news around the corner, the potential for
a broader market correction may be rising. If true, oil could sell off with
the broader market, much as it did in the fall of 2011.
USD strength could add an additional headwind for commodities.
Correlations between the USD and oil have fallen off of late, but rising US
yields, Fed tapering and US GDP outperformance could also buoy the
USD, providing another headwind for commodity prices.

Base Metals: What is the Impact of Interest Rate
Pressure on the Warehouse Trade?
Our view: The pronounced increase in regulatory scrutiny of financial
holding companies’ [FHC] participation in physical commodity trading,
changing LME rules on warehouse load-out rates and rising global
interest rates has already resulted in a sharp fall in aluminium physical
premiums. However, we expect further wash-back effects from these
developments, notably renewed pressure on underlying prices in heavily
oversupplied markets such as aluminium and zinc, where the warehouse
trade is prominent, and second order effects on feedstock prices, most
notably alumina where the loss of the physical aluminium premium is
expected to put downward pressure on spot alumina prices.
The long-awaited demise of inventory financing deals in a number of
LME traded metals (notably in aluminium, zinc, copper and, to a lesser
extent, nickel) appears to have arrived. While this story has a way to run,
the sharp rise in global interest rates in June that followed the US Fed’s
attempts to identify a timeline for tapering on bond purchases and any
subsequent tightening in monetary policy, marked the first step toward an
environment where yield spreads between physical commodities and
financial instruments became sustainably less favorable. This threat
become a reality following the largely unexpected announcement on
July 1 of a proposal to introduce significant new rule changes to load-out
rates in LME warehouses that had seen significant concentration of metal
and subsequent delays in customer delivery times. While still a proposal,
the rule change, if adopted, against the backdrop of increased regulatory
scrutiny in the US and a less-favorable interest rate environment, is
almost certain to prompt further fall out in the markets most affected by
these changes, notably aluminium and zinc. The fall in physical
premiums for aluminium over the past two weeks is, in our view, only the
beginning of this process. We expect increased availability of physical
metal to also put downward pressure on the LME price, and by extension
the feedstock market of alumina, which has a historical link to the
underlying aluminium price

Key Country Debates – China
Economics: What is the Impact on China If Interest Rates
Rise in Asia?
Our View: The market’s attention is focused on capital outflow from India
and part of ASEAN economies, as well as their central bank actions to
raise nominal interest rates in response. Compared to other EM
economies in the region, we believe China is less vulnerable to significant
pressure from capital outflow because of its remaining controls on capital
account. After all, foreign investors have limited access to portfolio
investment in China and their security positions are well contained and
regulated under the QFII schemes. Consequently, the probability of a
disorderly capital outflow from China remains low, in our view. Meanwhile,
we believe there is a good chance that the continued decline in RMB
position for FX purchase in the previous two months will reverse in
August, possibly reflecting a small amount of capital inflow, as macro
stability in China stands out more against elsewhere. On the other hand,
rising real rates in neighboring economies could potentially hurt their
growth and become a drag on China's export growth.
Equity Strategy: How Important Is Real Interest Rate to
China Deleveraging and Equity Performances?
Our View: We believe that a rapid falling and below real GDP growth
real interest rate is important to China deleveraging. Currently, China’s
real interest rates (based on one-year lending rate and weighted
PPI/CPI inflation) are high and have been hovering at around 6% for
more than one year. It is unlikely for China to achieve a beautiful
deleveraging if real interest rates maintain their current course.
Based on the performances in the past five years, we note that the
correlation between MSCI China and real interest rate is not significant.
However, correlations among sectors vary significantly. The top three
sectors having relative high positive correlations with real interest rates
are Utilities, Real Estate and Diversified Financials, while Consumer
Staples, IT, Consumer Discretionary and Healthcare have relatively
high negative correlations. The latter sectors tend to outperform during
deleveraging based on historical experience of other countries