Emerging Markets – Vive La Difference! (long live the difference)

•1

Summary

•2

Emerging market assets were sold off significantly in 2018 on the back of both external and domesticfactors.

Reversal in some of these influences coupled with attractive valuations led to an undifferentiated rallyin EM assets towards the end of 2018.

The rally continued in 2019 but started showing signs of petering out in the month of February.

Has the rally gone too far? For some EM economies that have a valuation advantage and are backed bysound fundamentals, the rally could sustain.

However, various risks loom. Given that a number of important risk factors for the EMs are fairly wellknown, the risk emerges from factors and events that are not yet priced in.

The response to these uncertain risk events will unlikely be uniform across EM countries.

In a nutshell, we could see a differentiated rally across EMs. Countries with greater domestic resilience(such as India, Indonesia, Brazil) are likely to perform better than the rest.

Emerging market assets fell significantly in 2018…..

4 Factors that weighed on EM assets in 2018

1. Higher US yields and the USD on the back of ongoing Fed monetary tightening2. Global risk-off sentiment fueled by the US’s protectionist measures3. Volatile oil prices4. Country-specific turmoil in e.g. Turkey and Argentina

-50.0

-40.0

-30.0

-20.0

-10.0

0.0

10.0

20.0

USD

THB

MXN

MYR JPY

EURO GBP

CNY

IDR

INR

BRL

RUB

TRY

% y/y

2017 2018

EM currencies performance

Source: Reuters, investing.com, media reports HDFC Bank

Asset class 2018 Over 3 yearsUS Inv Grade Bonds (Bloomberg US Agg Bond) 0.0 2.1

TIPS ( Bloomberg Treasury TIPS) -1.3 2.1

iBoxx US Liquid High Yield corporate bond market) -1.6 6.5

FTSE Emerging Markets Government Bond Index -1.5 6.7

FTSE World Government Bond Index -1.8 3.3

FTSE Russell Non-$ Corp -6.0 3.0

Markit Global ex US High yield -7.7 5.0

Commodities (Bloomberg Commodity) -11.3 0.3

Total Return (%)

-30

-20

-10

0

10

20

30

40

50

MSCI EM DJIA CAC 40 FTSE 100 DAX Nikkei 225

Equity market performance (%)

2018 2017

The Bloomberg US Aggregate Bond Index is a market capitalization-weighted indexincluding treasury securities, Government agency bonds, Mortgage-backedbonds, Corporate bonds, and a small amount of foreign bonds traded in U.S. It excludesMunicipal bonds, and Treasury Inflation-Protected Securities

•3

.......but supporting factors started emerging at the turn of the year

A ”Dovish” Fed and a fading dollar rally Growth premiums expected make a comeback … …coupled with attractive valuations

0

0.5

1

1.5

2

2.5

4

4.2

4.4

4.6

4.8

5

2016 2017 2018 2019 2020

Growth premium between G-7 and EMs likely to widen again in 2019 (GDP growth, y/y %)

Emerging market and developing economies G-7 (RHS)1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

40

20

0

-20

-40

-60

MSCI EM P/E (L12M) relative to US equities (S&P 500)

As of 31 Dec’18

MSCI EM Index was down to 11.8x trailing earnings, a

discount of about 35% compared to US equities.

This discount is wider than the 20 yr average, which is

around 20%

Source: IMF, investing.com, MSCI, Lazard asset management & HDFC Bank

•4

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

Jan-18

Feb-18

Mar-18

Apr-18

May

-18

Jun-18

Jul-18

Aug

-18

Sep-18

Oct-18

Nov

-18

Dec-18

Jan-19

USD Index (DXY) - Monthly performance

The outliers also started seeing favorable developments…

Argentina

1. IMF loaned the government $57.1billion

2. Austerity plan (including a "zerodeficit” budget)

3. To be incorporated into the MSCI EMIndex in mid-2019

Turkey

1. Lira rebounded2. CAD moved into positive territory in

Q3 2018

Brazil1. Economy re-accelerated while

inflation declined in Q3 200182. Presidential election of Jair Bolsonaro

- seen as pro reform and business

India/Indonesia

Net oil importer benefitted with easing in oil prices

RussiaSome US sanctions on Russia were lifted

at the end of 2018

•5

EMs saw an undifferentiated rally across regions and assets

Source: Reuters, Bloomberg, MSCI and HDFC Bank

-10

-5

0

5

10

15

TRY

ARS BR

L

INR

IDR

USD

MYR

THB

CNY

EURO GBP JP

Y

MXN RU

B

Performance (% change)

Q4 2018 Jan-19

Recovery started in 4Q and picked up pace (homogenously) in January 2019

• Local EM currencies started bottoming in early September as the US dollar stabilized.

• Equities staged a recovery beginning in late October as valuations became extremely cheap and flows returned to theasset class.

• Debt markets began to recover in late November, benefiting from the drop in treasury yields as the Fed appears closerto the end of its tightening cycle.

• The rally sustained in January 2019EM currencies performance

0123456789

10

MSCI EM stocks Index MSCI EM FX Index Bloomberg Barclays global EM local currency

bond index

Performance %, January 2019

•6

The big question: Has the rally gone too far?

Source: Bloomberg, ,MSCI and HDFC Bank

EM stocks in overbought territory!

Relative strength Index for MSCI EM

Other asset classes also pulled back in February

The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of pricemovements. The RSI oscillates between zero and 100. Traditionally the RSI is considered overbought when above 70and oversold when below 30.

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

25 Jan'19 1 Feb'19 8 Feb'19 15 Feb'19

Weekly Performance (%) MSCI EM stocks IndexMSCI EM FX IndexBloomberg Barclays global EM local currency bond index

•7

However despite the run-up some EMs attractive as a pure “value plays”.....

While some reversal of the “EM long” trade might happen, valuation catching up and carry-trade will still hold for some markets

Source: MSCI, investing.com, Yardeni Research & HDFC Bank

As of Jan 31, 2019 Div yield % P/E P/E Fwd P/BVMSCI EM 2.76 12.77 11.44 1.61MSCI ACWI 2.61 16.45 14.07 2.19MSCI World 2.59 17.12 14.52 2.3

02468

101214161820

Russ

ia

Turk

ey

Arge

ntin

a

Chin

a

Braz

il

Mex

ico

Indo

nesia

Indi

a

12M Fwd P/E(as of 14th feb 2019)

• The MSCI ACWI (All Country World Index) is a market capitalization weighted index capturinglarge and mid cap representation across 23 Developed Markets (DM) and 24 Emerging Markets.

• The MSCI World Index captures large and mid cap representation across 23 Developed Markets(DM) countries

0

5

10

15

20

Turk

ey

Braz

il

Sout

h A

fric

a

Russ

ia

Indo

nesi

a

Indi

a

Mal

aysi

a

Chin

a

Interest rate differential with the US yield (%) Jan end 2019

10 Year 2 Year

•8

…...with some markets backed by potentially greater growth opportunities

-5

0

5

10

15

20

25

30

Indi

a

Braz

il

Sout

h Afri

ca

Mex

ico

Arge

ntin

a

Chin

a

Phili

ppin

es

Indo

nesia EM

Thai

land

Wor

ld US

Mal

aysia

Turk

ey

Russ

ia

MSCI earning growth rate 2019e

In 2019, EM earnings growth is likely to outpace growth for the US and the world

Source: Charles Schwab, MSCI , Yardeni Research & HDFC Bank

•9

Besides offering value quite a few EMs promise improved fundamentals

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

Indi

a

Phili

ppin

es

Chin

a

Indo

nesia

Mal

aysia

Thai

land US

Mex

ico

Braz

il

Russ

ia

Sout

h Af

rica

Turk

ey

Arge

ntin

a

GDP growth (% y/y)

2018 2019

Despite moderation, in 2018 EMs still outpaced developed markets. This trend is expected to continue in 2019

Some of these countries maintained stronger balance sheets than did during the “taper tantrum”

-8-6-4-202468

10

Thai

land

Russ

ia

Mal

aysi

a

Chin

a

Mex

ico

Turk

ey

Phili

ppin

es

Braz

il

Indo

nesi

a

Indi

a

Arg

entin

a

Sout

h A

fric

a

Current account balance (as % of GDP)

2013 2018 2019

-8

-6

-4

-2

0

2

4

Russ

ia

Arg

entin

a

Thai

land

Phili

ppin

es

Indo

nesi

a

Mal

aysi

a

Mex

ico

Sout

h A

fric

a

Chin

a

Turk

ey

Indi

a

Braz

il

General government structural balance (% of GDP)

2013 2019

And barring for few, fiscal deficits remain in a better shape than were in 2013, setting these markets up for solid growth, as the headwinds subside

Source: IMF & HDFC Bank

•10

Other structural factors support a selective long EM trade

Many emerging markets have favorable demographics

15

20

25

30

35

40

45

50

Phili

ppin

es

Sout

h A

fric

a

Indi

a

Mex

ico

Mal

aysi

a

Indo

nesi

a

Braz

il

Thai

land U

S

Aus

tral

ia UK

Ger

man

y

Japa

n

Median age (2018)

0

20

40

60

80

100

120

15

20

25

30

35

40

45

50

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Exports of goods and services (% of GDP)

Indonesia Philippines Malaysia (RHS)

…with the share of exports in their economies trending lower

40

50

60

70

80

90

Brazil China India Indonesia Malaysia Philippines

Final consumption expenditure (% of GDP)

2010 2017

…. while that of consumption is on the rise Evolving sector dominance

0

5

10

15

20

Energy Materials Consumer sectors Technology

% share of MSCI EM Index

2007 Jan'19

•11

Source: World Bank, MSCI, World population review and HDFC Bank

But risks bear monitoring!Given that a number of important risk factors for the EMs are fairly wellknown, the risk emerges from what is already priced in by the markets and whatis not. However, these uncertain risk events will likely have a differentiatedimpact across EM countries. Thus we are not short on EMs as an asset class andacross-the board dips could be buying opportunities in select markets

•12

1. A “less dovish” Fed and continued dollar strength

• What is priced in? Ours's and market’s base case is that the Fed will likelyremain on hold in 2019 with a slight chance of a rate cut in 2020.

• Risk: A “less dovish” stance by the Fed than what is anticipated by themarkets or further rate hikes could lead to repricing of assets and diversionof funds away from EMs

2.5

2.6

2.7

2.8

2.9

3

3.1

Dec

02,

201

8D

ec 0

5, 2

018

Dec

09,

201

8D

ec 1

2, 2

018

Dec

16,

201

8D

ec 1

9, 2

018

Dec

23,

201

8D

ec 2

6, 2

018

Dec

30,

201

8Ja

n 02

, 201

9Ja

n 06

, 201

9Ja

n 09

, 201

9Ja

n 13

, 201

9Ja

n 16

, 201

9Ja

n 21

, 201

9Ja

n 24

, 201

9Ja

n 28

, 201

9Ja

n 31

, 201

9Fe

b 04

, 201

9Fe

b 07

, 201

9Fe

b 11

, 201

9Fe

b 14

, 201

9Fe

b 19

, 201

9Fe

b 22

, 201

9

US 10 year bond yield (%)

The Fed US Dollar

What is priced in? A slowdown in the US economy is largely priced in. Whatremains uncertain at the moment is the pace of moderation relative to othereconomies.

Our base case –Economic performance in both the Euro zone and China could berelatively more disappointing than the US. Consequently, the pace of downside inthe USD is likely to be moderate. Our base case assumes that the DXY stay broadlyunchanged for the most part of the year.

Risk - If US growth vis-à-vis other key economies surprises on the upside, wecould see renewed strength in the dollar which would be EM negative at leasttemporarily

-150

-100

-50

0

50

100

150

Mar-17

Apr-1

7May-17

Jun-17

Jul-1

7Au

g-17

Sep-17

Oct-1

7No

v-17

Dec-1

7Jan

-18Feb-18

Mar-18

Apr-1

8May-18

Jun-18

Jul-1

8Jul-1

8Au

g-18

Sep-18

Oct-1

8No

v-18

Dec-1

8Jan

-19

US EU EconomicSurpriseIndex

Source: Reuters, US Fed and HDFC Bank

•13

2. Sharper than anticipated deceleration in global growth

0

1

2

3

4

5

6

7

China Japan United States Euro area World

Global growth is set to decelerate in coming years

2018 2019 2020

Synchronized slowdown

• Emerging markets remain vulnerable to the pace of growth of the global economy in 2019, most notably through the exports channel among others.

• Markets are pricing in a moderated but synchronized slowdown in global growth.

• A steeper correction, therefore, may lead to “risk-off” sentiment and affect some EM countries more than others – for instance emerging Europe remain highly sensitive to German growth.

-1

0

1

2

3

4

5

6

-15

-10

-5

0

5

10

15

20

Global GDP and Emerging Europe exports (% y/y)

Emerging & Developing Europe exports World GDP(RHS)

-1

0

1

2

3

4

5

6

-15

-10

-5

0

5

10

15

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

Global GDP and ASEAN 5 exports (% y/y)

ASEAN-5 exports World GDP (RHS)

-1

0

1

2

3

4

5

6

-15

-10

-5

0

5

10

15

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

Global GDP and LATAM exports (% y/y)

Latin America and the Caribbean exports Global GDP (RHS)

-1

0

1

2

3

4

5

6

-10

-5

0

5

10

15

20

Global GDP and EM exports (% y/y)

EM & developing economies export growth World GDP (RHS)

Global growth & EM exports

Source: IMF and HDFC Bank

•14

3. Escalation in trade tariffs

• At the moment, markets are not pricing in any further escalation in US-China trade war. • US decision to extend the March-1, 2019 deadline to increase U.S. tariffs on Chinese goods from 10% to 25% on $200 billion worth of Chinese imports into the US has provided

relief to EM assets.

• Risk, however, still persists of any potential increase in tension between the US and China until a final agreement is reached • Potential tariff hikes on European automakers may also make the markets jittery.

• Impact on trade will be differentiated across EM countries contingent upon how inter linked their supply chains are.

While stakes for a trade war remains high, EMs will not be affected equally

01020304050607080

Taiw

an

Kore

a

Sing

apor

e

Mal

aysia

Pola

nd

Thai

land

Vietn

am

Russ

ia

Phili

ppin

es

Chin

a

Mex

ico SA

Indo

nesia

Indi

a

Turk

ey

Braz

il

Participation in the global value chains

Forward participation index Backward participation index

Note: As defined by OECD-WTO, the Global Value Chains (GVC) participation index is composed of two components reflecting theupstream and downstream links in the chain. Forward participation to GVCs corresponds to the indicator "Domestic value added sent tothird economies". Backward participation to GVCs refers to the "Foreign value added content of exports"

•15Source: BofA Merrill Lynch Global Research, WTO and HDFC Bank

There is a brighter side to it as well!

Trade diversions, as a consequence of tariff hikes in selected countries, could benefit other countries that have a similar export mix. For instance,

• Producers of agricultural goods in Argentina and Brazil benefitted from Chinese tariffs on US soybeans.

• With higher tariffs on China, US companies could buy semiconductor parts from Malaysia, data storage units from Thailand, or ready madegarments from India.

• Reallocations in terms of foreign direct investments - markets in Southeast Asia or Latin America might benefit as manufacturingdestinations with geographical advantage and competitive labor costs.

•16Source: Economist Intelligence Unit and HDFC Bank

Strong benefits Mild benefits DisruptionMalaysia India Philippines

Vietnam Indonesia Japan

Thailand Singapore

South Korea

Taiwan

Thailand India Japan

Malaysia Indonesia South Korea

Philippines Taiwan

Vietnam Singapore

Bangladesh Sri lanka Indonesia

Vietnam Pakistan Cambodia

India Myanmar

Information and

communications technology

Automotive

Readymade garments

Asia’s winners in the US-China trade war: A report by the Economist Intelligence Unit

4. Chinese stimulus fails to cushion the economy

China’s slowdown - the most important variable to emerging markets' performance in 2019

Fall in China’s growth is largely priced in. Markets expect the Chinese economy to start recovering in H2 2019 as the stimulus measures already announced (and expected to be buffered up) by the government start to make an impact. Thus we are betting on a 6 per cent plus growth for 2019

A sharper than anticipated slowdown despite the stimulus is what could spook the markets.

6.2

6.3

6.4

6.5

6.6

6.7

6.8

6.9

Q1 2016

Q2 2016

Q3 2016

Q4 2016

Q1 2017

Q2 2017

Q3 2017

Q4 2017

Q1 2018

Q2 2018

Q3 2018

Q4 2018

Chinese GDP (% y/y)

GDP growth decelerated sharply in 2H 2018 raising fears among investors China government spending growth: Past vs Present

•17Source: Bloomberg, investing.com, Macrobond and HDFC Bank

Impact on EMs to vary across countries depending on their exposure to China.

ASEAN has started to feel the heat - headline PMI edged down to49.6 in February, from 49.7 in January, to signal the first back-to-backmonthly deterioration in business conditions for over two years.

The impact is likely to come through two channels – 1) direct impact - trade/manufacturing channel and 2) “sentiment” effect– making all EM economies a blanket case

Spillover implications of China’s slowdown for international trade – An IMF study

•18

Source: Bloomberg, investing.com, IHS Markit and HDFC Bank

45464748495051525354

Mya

nmar

Phili

ppin

es

Vie

tnam

Indo

nesi

a

Thai

land

Mal

aysi

a

Sing

apor

e

Manufacturing PMI (Feb'19)Individual-Country Level Impact of China Demand Shock

(Impact on Export Level of a 1 Percent China Demand Shock after One Year; %)

(Trade in value added)

5. Volatile commodity prices

• Oil – Volatility expected to continue in 2019 as well but prices expected to stabilize around $65/bbl – slowing global demand, record production of U.S. shale oil and political uncertainty likely to cap prices. A sharp spike up or a drastic fall back in prices as was seen in 2018 could impact EMs though selectively.

• Metals – prices to remain broadly unchanged in 2019. China’s environmental policies, tariff negotiations between the US and China, and Chinese policy responses aimed at stimulating the economy are the key determining factors

•19Source: Credit Suisse, Oxford Economics and HDFC Bank

Food Energy MetalsBrazil -0.3 0.0 -0.2Mexico 0.1 -0.1 0.0Colombia 0.0 -0.9 0.0Chile -0.3 0.6 -1.7Peru 0.2 0.0 -0.8Argentina -0.8 0.1 0.0Venezuela 0.3 -2.1 -0.1Russia 0.2 -1.7 -0.1Turkey -0.1 0.7 0.2South Africa 0.0 0.5 -0.8Poland 0.2 0.4 0.0Hungary -0.3 0.6 0.2India -0.1 0.6 0.1Indonesia -0.2 0.1 0.0Malaysia -0.3 -0.6 0.3Thailand -0.5 1.2 0.5

Historically estimated commodity price impact on EM current accounts (% of GDP)

Current account sensitivity to 10% price decline

6. Political risk: EM elections in focus

2019 political calendar is set to be very busy with general elections in several key EMs, especially Asia, where India, Indonesia, the Philippines, and Thailand will hold polls. Sub-Saharan Africa's two biggest economies, Nigeria and South Africa, will hold elections as

will Greece, Poland, and Ukraine in Europe.

While markets expect continuity of the current political dispensation in upcoming elections in some of these key economies, risk in the form of populist rhetoric that may delay/reverse the reform process looms.

•20

Source: Fitch solutions and HDFC Bank

Country Month EventProspect of continuity of

governmentReform outlook

Nigeria February General electionThailand March General electionUkraine March General electionIndonesia April General electionIndia April-May General electionPhilippines May Mid-term electionSouth Africa May General electionGreece October General electionArgentina October General electionPoland November General election

Major election in 2019

Green = positive, yellow = neutral, red =negative

In a nutshell – Differentiation is the way to play the EM theme!

•21

Countries with greater domestic resilience to external shocks are likely to outperform

Some of the other countries such as Turkey and Argentina which were massively sold off last year could see bouts of rally purely driven by attractive valuations. However, these economies remain highly vulnerable to external shocks given their macros.

BrazilMarket friendly government

Attractive valuations and yield differentials

High earning prospects

Indonesia5% + GDP growth prospects

Massive infrastructure investment

Competitive advantage in resource-based industries

Risks - Crude oil prices, elections and relatively higher valuations

IndiaGrowth outperformer with 7%+ GDP growthBetter macro fundamentals among peers

Risks - Crude oil prices, elections and relatively higher valuations

RussiaAttractive valuations

Growth gradually improving along with other macro economic variables

Further sanctions remain the biggest risk

ThailandDemocratically-elected government in upcoming electionsLikely to benefit from US-China trade warMassive infrastructure development -$50 bn Eastern Economic Corridor Risk - Unattractive valuations and yield differentials

MalaysiaSentiments improved after the unpopular administration of Prime Minister Najib Razak was replaced in 2018 elections

Likely to benefit from the US-China trade war

Domestic infrastructure investmentSound macros

Higher oil prices could provide a fillip

HDFC Bank Treasury economics research team

Abheek BaruaChief EconomistPhone number: +91 (0) 124-4664305Email ID: abheek.barua@hdfcbank.com

Tanvi Garg,EconomistPhone number: +91 (0) 124-4664354Email ID: tanvi.garg@hdfcbank.com

Disclaimer: This document has been prepared for your information only and does not constitute any offer/commitment to transact. Such an offer would be subject to contractual confirmations, satisfactorydocumentation and prevailing market conditions. Reasonable care has been taken to prepare this document. HDFC Bank and its employees do not accept any responsibility for action taken on the basis of this document.

Tushar Arora, Senior EconomistPhone number: +91(0)124-4664338Email ID: tushar.arora@hdfcbank.com

Sakshi Gupta,EconomistPhone number: +91 (0) 124-4664372Email ID: sakshi.gupta3@hdfcbank.com

•22