EFTA Document EFTA01466396

Deutsche Bank Markets Research Global Strategy GEM Equity Strategy Outlook 2014 Negative year in prospect but underperformance should slow GEM equities cheapness at aggregate level is misleading We would largely discount the apparent cheapness of GEM equity markets for 3 reasons - 1) Much of the value resides in the financial sector where investors are rightly sceptical about the declared level of NPLs, especially in the BRIC markets; 2) There is no sign of a reversal in the degradation of margins of GEM non-financial companies relative to their DM counterparts; if anything, the negative drivers are becoming more pronounced in EM; 3) The polarisation between overvalued sectors on the back of good governance (Healthcare, Consumer Staples) and their badly governed peers (Energy, Financials) remains at extreme levels, highlighting the difficulty facing EM investors. Investors should focus on the relationship between state and corporate sector, not on short term fund flows as the key driver of EM economies and equities Investors have become overly focused on the potential impact of short term fund flows over recent years. We believe that their time would be better spent analysing the underlying dynamics of corporate level governance, in particular the relationship between the corporate sector and the state which has been the most important driver of emerging equity markets since the financial crisis. By our reckoning, the relationship is most dysfunctional in the BRIC markets, particularly China, where we can envisage the potential for a debt trap in the industrials/materials sectors, which could eventually trigger an economy-wide financial crisis. By contrast, we believe that the impact of any potential tapering of QE is largely priced in to most of those markets whose economies are running sizeable current account deficits, with the partial exception of Brazil. Breakout from low dispersion and volatility more likely on downside in 2014 It might not have always felt like it, but the volatility and dispersion of EM equities continued to fall in 2013 which resulted in another year of poor performance for momentum-based strategies. The immediate outlook is for more range bound trading as liquidity and fundamental drivers remain finely balanced, so a contrarian strategy should continue to pay off. It is even possible that emerging equities will begin the year strongly as fears concerning the impact of tapering recede. Nevertheless we believe that the year will be defined by increasingly negative sentiment towards the ability of the EFTA01466396 authorities in Beijing to manage a soft landing for the Chinese economy. There will eventually be beneficiaries within GEM from lower commodity prices but the initial impact will be to raise risk premiums and redemptions across GEM. Absolute returns likely to be negative with (lower) underperformance vs DM We would tentatively forecast a negative return of around 10% for MSCI EMF in 2014, but with a greater degree of volatility and dispersion between constituents. The relative call is harder following massive underperformance in 2014, which has left DM valuations expensive, but economic and governance drivers indicate further potential underperformance from GEM of around 10%. Within EM, we continue to advocate overweight positions in markets with lower exposure to China, beneficiaries of lower commodity prices and improving sovereign and/or corporate governance characteristics. Deutsche Bank AG/London Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 054/04/2013. Date 11 December 2013 Strategy Update John-Paul Smith Strate ist (+ Priyal Mulji Strategist (+ EFTA01466397 11 December 2013 GEM Equity Strategy Outlook 2014 Table Of Contents Summary 3 Negative year in prospect but relative underperformance should slow 3 Valuations & Margins 13 Why emerging equities are not as cheap as they appear to be in aggregate 13 Taper versus governance 18 BRICs at most risk of 'classic' EM crisis based on dysfunctional relationship between state and companies 18 Still bearish on China 21 Positive sentiment overdone given risks of debt trap in corporate sector and local government 21 Country conclusions 25 ASIA EX- JAPAN 25 China — corporate sector risks are rising 25 Korea — not as good as overseas investors believe 27 Taiwan — defensive merits no longer unappreciated 28 India — range bound until post-election outlook clearer 29 Indonesia — first stress test since 1997; equities expensive 31 Malaysia — low-beta but fundamentally without merit 33 Thailand — tempting only to a tactical contrarian 34 Philippines — superior fundamentals more than priced in 35 LATIN AMERICA 37 Brazil — cheap but fundamentals continue to deteriorate 37 Mexico — expensive but still better than the alternatives 39 Chile — continued breakdown of the neo-liberal EFTA01466398 model 41 CEEMEA 42 South Africa — cheap currency but expensive equities Russia — cheap but fundamentals remain very negative 43 Turkey - risk reward has improved at current levels 45 Poland — still defensive in GEM context 47 Page 2 Deutsche Bank AG/London 42 EFTA01466399 11 December 2013 GEM Equity Strategy Outlook 2014 Summary Negative year in prospect but relative underperformance should slow GEM equities set to underperform in 2013 by even more than we had anticipated We intend to review the absolute and relative performance for GEM equities during 2013 in more detail alongside the outcome of our own forecasts later in this document, but with only a few weeks to go, it is very likely that EM will have underperformed DM and in particular the US, by even more than our forecast of 20-25%. The most noteworthy feature of 2013 has been the very sharp decoupling of EM from US equities which has been even more pronounced than during 2008-09 (Figure 1). Whilst discussion of EM markets has been dominated by the potential impact of Fed tapering, we would attribute this sudden shift in the relationship to the structural factors, which we first identified in our initiation of GEM strategy coverage almost exactly three years ago (Structural challenges drive performance, 1 December 2010). Whilst we would very much like to become more optimistic about the prospects for 2014, we anticipate another year of negative absolute returns, albeit with higher levels of dispersion and volatility, along with further underpeformance against DM although by a smaller margin than 2013. Figure 1: 1-year, 3-year and 5-year rolling correlation between MSCI EM and MSCI US 1.2 0.2 0.4 0.6 0.8 1 -0.4 -0.2 0 1 yr 3 year 5 year Source: Deutsche Bank, Bloomberg LP EM relative valuations are not as cheap as they appear at face value EM equities have been cheap relative to their DM peers on both earnings and asset-based valuations for some time. The value case for overweighting EM appears almost overwhelming now when the asset class is viewed in aggregate against DM, but is somewhat less compelling when the country and sector constituents are examined in a more granular fashion for the following reasons. Deutsche Bank AG/London EFTA01466400 Page 3 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul -06 Jan-07 Jul -07 Jan-08 Jul-08 Jan-09 Jul -09 Jan-10 Jul -10 Jan-11 Jul-11 Jan-12 Jul -12 Jan-13 Jul-13 EFTA01466401 11 December 2013 GEM Equity Strategy Outlook 2014 Much of the relative value resides in the financial sector, where EM price-to-book valuations appear very low relative to ROE both in absolute terms and relative to their historical relationship. We believe that this shift is due mainly to a very high level of investor scepticism about the level of potential NPLs in the BRIC markets in particular, which is entirely rational in our view. By contrast, DM financials are trading in line with their historic valuation/return relationship. T. The majority of non-financial sectors within GEM have margins which have underperformed their DM peers; the overall ROE for EM nonfinancial stocks is now below the level of DM non-financials, based on an aggregate margin which has now almost converged with DM, having historically been much higher. There is a pronounced polarisation of valuations within the EM universe on an ROE versus P/BV basis between sectors both in absolute terms (Figure 2) and relative to DM (Figure 3), where valuations and returns are more closely correlated. Financials and Energy stocks have extremely low valuations, while the Healthcare and Consumer Staples sectors appear very expensive. We identified this gap as the biggest reason to be bearish EM one year ago because it is driven by aversion towards those sectors which face the most severe structural challenges, and nothing has changed in the past twelve months. Figure 2: EM — P/BV (x) versus RoE (%) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 Healthcare Consumer Staples Consumer Discretionary Industrials Financials Materials Utilities 5 Energy 10152025 ROE (%) Source: Deutsche Bank, Bloomberg Finance LP Telco IT Figure 3: DM — P/BV (x) versus RoE (%) EFTA01466402 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 5 Healthcare Consumer Staples Consumer Discretionary Telco Materials Utilities Financials Industrials Energy IT 10152025 ROE (%) Source: Deutsche Bank, Bloomberg Finance LP Better governance and /or growth necessary to unlock value in EM equities Given the extremely high level of valuations for the better governed higher ROE sectors, the prospects for an upwards re-rating of EM in either absolute or relative terms depends on prospects improving for the value-related markets and sectors in our view. There are two potential catalysts. First is faster global growth, which would revive the more cyclical and commodity-related sectors — China is an especially important source of demand but one which would benefit from an acceleration of economic activity in developed economies via increased export demand. Second is that the markets may begin to detect a marginal improvement in governance within EM, at either the sovereign and/or the corporate level. We are sceptical that DM growth will come to the rescue as in 2002-07, whilst there is very little indication of an incrementally positive shift in governance across most emerging markets in our view, with the partial exception of Mexico, (Rhetoric versus reality; governance drivers still mainly negative, 6 November 2013). Page 4 Deutsche Bank AG/London P/BV (x) P/BV (x) EFTA01466403 11 December 2013 GEM Equity Strategy Outlook 2014 Global growth is unlikely to become as EM friendly as in 2002-07 In the wake of the global financial crisis, the majority of economists and investors failed to anticipate the resilience of the US economic and corporate governance models, which has underpinned the massive outperformance of US equities over the past three years. Whilst we retain a structurally bullish view on the US economy, the growth cycle will continue to be qualitatively different to the consumer debt driven growth that proved so beneficial for emerging market exports between 2002 and 2007. There has been a further shift of pricing power away from emerging market producers, which is currently being exacerbated by the ongoing depreciation of the yen. The US will become more competitive in industrial goods due to more favourable cost comparisons in energy and labour as well as a technological shift to more distributed manufacturing techniques. Meanwhile the structural slowdown in emerging market economic growth is likely to have a pronounced impact on the commodity intensive exporters which are a much bigger constituent of the emerging market universe. Micro structural factors threaten EM economies more than Fed taper Investors are currently fixated on the impact of potential shifts in funds flows on EM financial assets, through the Fed tapering policy and have a largely onedimensional view of risk based on the level of current account deficits in the respective GEM economies. We believe that the real risk is that we are starting to see a greater reluctance by foreign investors to put money to work in EM because they are increasingly focusing on the underlying structural issues, which up to now have been much more obvious at a corporate micro level than in the macro-economic aggregates. The sudden break in correlation between DM and EM equities at the start of 2013 preceded talk of Fed tapering by several months and was the direct result of investors beginning to discount more favourable structural factors for the US against the bulk of the EM universe. The biggest risks are in those economies with weak hard budget constraints, often as a result of a dysfunctional relationship between the state and the corporate sector, as the absence of enforceable exit mechanisms ultimately undermines returns on capital. BRICs most at risk — beware short FX/long commodities across GEM On this basis the BRIC markets with the possible exception of India are eventually more liable to a 'classic' emerging type crisis compared to Indonesia, South Africa or Turkey, though we accept that there is a risk with Indonesia in particular, that predictions of a crisis, which lead to a rapid rundown in FX reserves, could become self-fulfilling. China in particular has become much more dependent on foreign funding to prop up 'acceptable' rates of economic growth against a steady deterioration of the underlying EFTA01466404 return on invested capital across much of the listed corporate sector. There is also a risk across all emerging markets that any sustained rally in the dollar will reveal 'hidden' short FX exposure, often linked to exposure to commodity related assets, which were acquired at top of the market prices. Whilst some EM currencies are now cheap, we would expect widespread further weakness against the dollar in 2014 to include the Korean won and possibly the Renminbi. Although Beijing's post-Plenum drive to attract foreign fund flows depends on a stronger currency, it is difficult to think of many emerging economies which have undergone a significant level of structural reforms without the benefits of either an undervalued currency or a devaluation to bring liquidity into the corporate sector — the renminbi is no longer undervalued in our view and is becoming increasingly vulnerable. Deutsche Bank AG/London Page 5 EFTA01466405 11 December 2013 GEM Equity Strategy Outlook 2014 China likely to be a more negative driver for GEM in 2014 Sentiment towards the Chinese economy and financial assets has once again swung wildly over 2013, because of the relative lack of transparency in terms of the underlying drivers of both the economy and the corporate sector, but the overall influence of China on the rest of the asset class has been relatively neutral. We believe that there is a significant chance of a decisive break in a negative direction in 2014, due to the increasing pressure from the build-up of debt through much of the corporate sector and local government, which raises the risk of a debt trap (Figure 34 and Figure 35) as nominal rates of sales and GDP growth slow. Most investors are ending the year with a relatively positive view of China following the perceived success of the CP Plenum in presenting an agenda for reform. The Plenum represents a strong statement of intent, but did not really lay down a template for implementation in the area which matters most, namely the dysfunctional fiscal relationship between local government and Beijing, which is the underlying cause of rising debt and falling productivity in the broader economy. We do not believe that the authorities in Beijing have sufficient time to implement the policy shifts laid out in the post-Plenum document, and that at some point over the course of 2014, borrowers and investors will begin to lose confidence in their ability to pursue what we see as the irreconcilable objectives of 7%+ growth and financial stability. We therefore see the potential for deterioration in growth expectations for China to influence the rest of GEM in terms of trade, fund flows and commodity prices. Unresolved structural issues and polarised valuations imply negative returns Overall, we do not feel that the outlook for absolute returns has changed very much since we made a tentative forecast of a negative return of 10-15% for 2013. At the time of writing, the MSCI EM total return is only -2%, so whilst we may have got the direction right, we were too pessimistic, mainly because Chinese equities have recorded a single digit positive return in contrast to the other BRIC markets. The two main reasons for our negative view have not really changed, namely the structural factors we discussed in the preceding paragraphs and the polarisation of the asset class between what might characterised as the overvalued versus the uninvestible. Accordingly, we are basically just rolling our position into 2014 with a forecast of -10% for the year as a whole, but with increased volatility and dispersion between markets (see below). Once again we would place China, not Fed-driven liquidity flows as the most important driver of absolute returns throughout GEM. Maintain long DM call though fundamental attractions of US have diminished EFTA01466406 By contrast, we were actually too optimistic towards EM in terms of performance versus DM and the US, when we forecast that the US would outperform by 20-25% in 2013, as the figure to date is just under 30% and around 25% against the DM benchmark, MSCI World. We maintain our recommendation for investors to overweight DM against EM in 2014, but it has become a more difficult call as DM has outperformed EM by +39.5% since we initiated coverage on 1 December 2010 while our favoured market the US has outperformed by +52.1%. We were able to make a strong case at the end of 2010 that almost everybody underestimated the strengths and resilience of the US economic and corporate models — following the strong outperformance, it is no longer possible to make that case as the structural advantages of the US relative to EM are now largely priced in as we show later in this report (Figure 30 and Figure 31). US valuations are clearly not in bubble territory though they may get there over the medium term, given the relatively positive outlook for flows, but the US equity market is nothing like the one-way bet that Page 6 Deutsche Bank AG/London EFTA01466407 11 December 2013 GEM Equity Strategy Outlook 2014 it has appeared to be for most of the past five years. Accordingly, our continued pro-DM stance has become increasing reliant on what we still see as the very negative fundamental outlook for EM equities and we tentatively forecast that EM will underperform the DM by around 15%. More volatility and greater dispersion between GEM markets likely in 2014 It might not always have felt that way, but 2013 has been relatively dull in terms of both EM volatility and the level of dispersion between markets (Figure 4 and Figure 5). We believe that both dispersion and volatility are likely to pick up over 2014 as a whole and make life more interesting for investors, though most likely not in a very positive way for the following reasons. Figure 4: Histogram of standard deviation (100 = 31 December 2007) Figure 5: Annual return by EM country — Box plots of range, median and quartiles Source: Deutsche Bank, Bloomberg Finance LP Source: Deutsche Bank, Bloomberg Finance LP 1. Chinese economy and companies remain low visibility & high risk; Most of us have strong opinions about China, which is likely to remain the single most important influence on GEM, but the relatively low level of transparency concerning almost every aspect of economic policy and much of the corporate sector means that sentiment towards China, and by implication GEM, is likely to swing wildly once again. 2. No clear trend in liquidity flows; There are likely to be conflicting fund flow influences over 2014 as developed financial markets walk the bubble-taper tightrope (courtesy of DB credit guru Jim Reid). Overall demand for EM equities should be weaker than DM given the massive net buying of EM assets over the past ten years relative to the US by retail — there is also likely to be much more supply across EM relative to market cap. One potential source of funds for EM assets is if Japanese retail investors accelerate their overseas purchases in response to the falling yen, so we will monitor this closely via DB FX strategist and Japan expert James Malcolm. Deutsche Bank AG/London Page 7 EFTA01466408 11 December 2013 GEM Equity Strategy Outlook 2014 Figure 6: Total return of selected emerging market equity indices since 1 May 2013, USD 10 -40 -35 -30 -25 -20 -15 -10 -5 0 5 Since May 1 May 1 to trough (1) Correct as at market close on 9 December 2013. Source: Deutsche Bank, Bloomberg Finance LP 3. Potential for lower oil prices; Will 2014 finally be the year when oil prices, ex-WTI, finally break down through their narrow range to reflect the deterioration in the supply/demand fundamentals which has been apparent for some time? The bearish factors seem to be mounting up, namely continuing upwards revisions of US supply, less unfavourable geopolitical factors including the partial rehabilitation of Iran, less disruption to non-OPEC supply and lower EM demand — on the latter point, senior DB Asian energy analyst David Hurd points out the marked decrease in purchasing power brought about by currency depreciation for Brazil, India and Indonesia, who have collectively accounted for around 25% of the increase in oil demand over recent years. Figure 7: 2013 versus 2007 — EV/NCI (x) and CROCI (%) for main EM markets x 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 0% 2% 4% 6% 8% 10% 12% 14% EFTA01466409 16% EV/NCI (2007) - LHS EV/NCI (2013) - LHS CROCI (2007) - RHS CROCI (2013) - RHS Source: Deutsche Bank, Bloomberg Finance LP Page 8 Deutsche Bank AG/London EFTA01466410 11 December 2013 GEM Equity Strategy Outlook 2014 4. Low GEM valuations give some option value; The relatively low level of valuations for some GEM markets and sectors, especially in terms of replacement cost (Figure 7 - EV/NCI is a reasonable proxy for replacement cost), mean that any positive turn in sentiment is likely to produce sharp rallies, albeit in an overall absolute and relative context that remains bearish. Investors should take long-term structural positions and live with volatility, or else take shorter term disciplined contrarian approach We prefer to base our recommendations on longer term strategic considerations rather than the more flow-based tactical calls, which are generally made on a post hoc basis to generate turnover. For those funds who feel the urge to pursue more active strategies however, we have continued to advocate a contrarian approach, which would have worked since early 2009 due largely to the increasing influence of momentum-based investors who focus on anticipated fund flows, which is an ultimately self-defeating strategy for most participants. The contrarian approach has continued to work well over 2013, both for GEM overall and for most individual markets, including all of the BRICs with the partial exception of Brazil. The pattern appears set to continue for the first part of 2014 but could shift if both China and the oil price finally break down, which should give dedicated investors the opportunity to generate some longer lasting alpha within the asset class. Figure 8: Net foreign inflows (USD millions) India Last 1 week YTD 2012 2011 2010 2009 2008 2007 2006 2005 2004 315 17,252 24,574 -564 29,338 17,644 12,900 EFTA01466411 18,558 8,356 10,905 8,642 (1) Correct as at 22 November 2013. Source: Deutsche Bank, Bloomberg Finance LP Country weightings unchanged — based on governance, oil and China view We discuss the outlook for the individual markets at greater length, later in the report, but our country weightings for GEM remain unchanged and are still driven by the underweight positions which we have found much easier to determine, whilst we continue to find it very difficult to identify compelling overweights. Underweight China; Whilst China appears cheap in aggregate, this is largely due to the dominant financials sector, where investors are discounting major book value impairments from NPLs; Materials stocks also generally have very low valuations whilst Healthcare and Consumer Staples stocks are among the more expensive in the asset class. MSCI China has outperformed our expectations over 2013 and sentiment appears somewhat elevated, which if the past four years is any guide, suggests Deutsche Bank AG/London Page 9 Indonesia -26 -1,397 1,707 2,950 2,390 1,383 1,732 3,598 1,942 -1,735 2,126 Korea Philippines 80 6,047 15,069 -8,584 19,800 24,659 -36,641 -29,269 -12,659 -3,561 10,134 -32 808 2,548 EFTA01466412 1,329 1,224 420 -1,135 1,354 720 354 278 Taiwan -611 7,068 4,916 -9,488 9,241 14,752 -14,719 2,073 17,424 22,212 9,865 Thailand -210 -4,336 2,504 -167 2,687 1,136 -4,788 1,548 2,067 2,949 103 ASEAN Asia ex-Japan -268 -484 -4,925 6,759 4,112 6,301 2,938 -4,191 6,500 4,730 1,568 2,507 25,442 51,317 -14,523 64,680 5,993 -68,451 EFTA01466413 -2,138 17,852 31,123 30,647 Japan 12,924 124,175 27,733 -323 22,926 -6,513 -66,817 32,759 68,885 113,338 95,603 EFTA01466414 11 December 2013 GEM Equity Strategy Outlook 2014 that investors should lighten holdings even if they do not share our pessimistic view about the likely endgame for the Chinese economy and equities. Of all the markets in GEM, the risks of extreme outcomes on both the upside and the downside are highest for Chinese equities in our view. The downside risk would materialise with a sudden stop in financing as the debt trap facing local government and the corporate sector becomes more obvious, while there would be significant upside if Beijing could present a credible plan for a complete overhaul of local government finances, which would also include Beijing led consolidation in key manufacturing and commodity-related industries. gE Russia; This is by far the cheapest market within GEM on almost any valuation criteria, most notably replacement cost (Figure 7), but we do not share the increasingly widespread perception among our clients that governance at either the sovereign or the corporate level, is about to get better. Indeed, we would actually suggest that any apparent improvement is largely cosmetic given that real economic reform has been almost entirely absent and the interests of minority shareholders in the vast majority of listed companies are increasingly irrelevant to those in control, be they state or private. The market is now so cheap that certain sectors now have option-like characteristics, which can drive sharp rallies, but given the fundamental backdrop and our continued bearish views on commodity prices, we remain underweight. 3E Brazil; Brazil has been by far the worst-performing major emerging market over the past three years, largely because of the policy shift towards state capitalism, which has taken place since the financial crisis. Just as with Russia, asset-based valuations are low, so there will inevitably be sharp rallies when everyone is bearish, but we cannot identify any positive inflection point which might reverse the government-induced redistribution from capital, at least until the election(s) in the autumn. Our biggest fundamental concern is now the underlying economy where the impact of heterodox polices is likely to have a long-lasting detrimental impact, which cannot be easily unwound. Korea; This is our lowest conviction underweight but historically a highly cyclical market with a pronounced exposure to Chinese demand and vulnerable to any further depreciation in the yen. Korea, along with its North Asian counterparts, China and Taiwan, has been the beneficiary of sustained inflows on foreign capital due to its perceived status as a safe haven, through the current account surplus and so might prove vulnerable to potential redemptions from EM equity funds. Korea is possibly the biggest consensus overweight among active GEM managers although most concede that it is difficult to find compelling stock ideas. Overweight gE Taiwan; Being one of the best-performing major EM markets over 2013 to date, it owes this status to its perceived defensive qualities and the relative lack of interest among GEM-dedicated investors EFTA01466415 before taper talk began in May. It has also been the most direct play on US growth via the dominant IT sector, though the non-IT stocks have generally performed better. We have been overweight for over eighteen months as the counterpoint to our stance on Korea, but the positive attractions of Taiwan have diminished, along with the dividend yield and valuation relative to the rest of GEM. Page 10 Deutsche Bank AG/London EFTA01466416 11 December 2013 GEM Equity Strategy Outlook 2014 3E Mexico; This remains overweight largely because it is one of the few GEM constituents where governance is clearly moving in a positive direction, in sharp contrast to its Latam peers, Chile and Brazil. Still, whilst reforms to the oil sector and labour market should raise the level of sustainable economic growth over the longer term, the more immediate impact on the margins of many of the listed companies will be negative. Mexican equities are clearly expensive at current levels to an extent which leaves little room for positive absolute returns over the medium term, but in default of any compelling alternatives, we remain overweight. Poland; Poland is one of the few emerging equity markets to deliver a positive total return in dollar terms over 2013 at the time of writing, despite the partial nationalisation of the pension fund industry which has absorbed the majority of investors' attention over recent months. Poland still appears to be relatively low risk/low reward compared to the rest of GEM given that financial flows from the EU are likely to meet the domestic funding deficit, while the equity market still yields just under 4%. Our main fundamental reservation concerns the potential for the government to meddle further in the management of some of the state-controlled companies which comprise the overwhelming majority of MSCI Poland, but we intend to remain overweight for the time-being. 3E Turkey; This is by far the least successful of our recommendations for 2013 because both equities and the currency fell precipitously during the taper scare from late May to August, with only a partial recovery since then. We have three reasons for clinging on to our overweight position. First, valuations now look more reasonable, especially in the dominant financial sector. Second, we are sceptical about the extent and the impact of potential tapering, while we believe that the current account could benefit from a decline in the oil price. Finally, the major problems in Turkey are essentially cyclical — while the AKP-led government under PM Erdogan has made some unhelpful statements and the geopolitical situation in the area surrounding Turkey has been noisy to say the least, the private sector has largely been left to get on with business without the same level of state interference or negligence visible in some other emerging economies. Neutral/overweight g India; We do not really have a strong view on Indian equities at the current level in front of the nationwide elections in May. Valuations may appear cheap by historical standards, but are probably just fair, given the extent to which growth prospects have deteriorated over the past three years. The election is of course vital not so much in terms of who wins, but more how they win; in other words, will Congress, or more likely the BJP, be able to assemble a coalition which is able to enact and more importantly implement the economic reforms which investors and the policy-making elite alike deem necessary to restore India's growth potential? We suspect that at current levels, a marketfriendly EFTA01466417 outcome in May is now partially priced in, whilst the financial situation for a significant part of the corporate sector is likely to deteriorate further over the coming months. Indian equities and the Rupee are likely to be very volatile through 2014 and we would prefer to wait for another period of weakness before adding to positions. Deutsche Bank AG/London Page 11 EFTA01466418 11 December 2013 GEM Equity Strategy Outlook 2014 Figure 9: EM markets - Current P/BV versus its 10-year average -60% -40% -20% 0% 20% 40% 60% Figure 10: EM markets - Current P/BV relative to EM P/BV, versus 10-year historical average -60% -40% -20% 0% 20% 40% 60% 80% Source: Deutsche Bank, Bloomberg Finance LP Source: Deutsche Bank, Bloomberg Finance LP Figure 11: EM sectors - Current P/BV versus its 10-year average -50% -40% -30% -20% -10% 0% 10% 20% Figure 12: EM sectors - Current P/BV relative to EM P/BV, versus 10-year historical average -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% Source: Deutsche Bank, Bloomberg Finance LP Source: Deutsche Bank, Bloomberg Finance LP Page 12 Deutsche Bank AG/London Consumer Staples Philippines EFTA01466419 Greece Health Care Consumer Discretionary Utilities Telco Information Technology Industrial Financials Materials Russia Egypt Energy Hungary Thailand Malaysia South Africa Mexico Taiwan Indonesia Turkey Chile Poland Korea Brazil India Czech Republic China Consumer Staples Philippines Greece Health Care Consumer Discretionary Utilities Telco Information Technology Industrial Financials Materials Russia Egypt Energy Hungary Thailand Malaysia South Africa Mexico Taiwan Indonesia Turkey Chile Poland EFTA01466420 Korea Brazil India Czech Republic China EFTA01466421 11 December 2013 GEM Equity Strategy Outlook 2014 Valuations & Margins Why emerging equities are not as cheap as they appear to be in aggregate EM equity valuations appear cheap against DM equities The charts on the following pages illustrate why we believe that emerging market equities in aggregate deserve to trade at a discount to their developed market peers, which is an argument we first made three years ago (Structural challenges to drive performance, 1 December 2010) when MSCI EM was trading at its highest ever premium to MSCI World. 1) Valuation discount reflects scepticism about EM financials returns. EM equities appear extremely cheap on a P/BV versus ROE basis (Figure 13 and Figure 14) largely as a result of the Financials sector trading at a massive discount relative to ROE compared with the DM financial universe (Figure 15 and Figure 16). Figure 13: EM aggregate — P/BV (x) versus RoE (%) 10 12 14 16 18 0 2 4 6 8 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 Figure 14: DM aggregate — P/BV (x) versus RoE (%) 10 12 14 16 18 x 2 4 6 8 EFTA01466422 0.0 0.5 1.0 1.5 2.0 2.5 3.0 x RoE - LHS P/BV - RHS Source: Deutsche Bank, Bloomberg Finance LP RoE - LHS Source: Deutsche Bank, Bloomberg Finance LP P/BV - RHS Figure 15: EM Financials — P/BV (x) versus RoE (%) Figure 16: DM Financials - P/BV (x) versus RoE (%) 10 12 14 16 18 96 0 2 4 6 8 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 10 12 14 16 18 x 96 -4 -2 0 2 4 6 8 RoE - LHS Source: Deutsche Bank, Bloomberg Finance LP EFTA01466423 P/BV - RHS RoE - LHS Source: Deutsche Bank, Bloomberg Finance LP P/BV - RHS 0.0 0.5 1.0 1.5 2.0 2.5 x Deutsche Bank AG/London Page 13 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 EFTA01466424 Dec-11 Jun-12 Dec-12 Jun-13 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 EFTA01466425 11 December 2013 GEM Equity Strategy Outlook 2014 2) Value spread is more nuanced through the EM non-financial universe. The valuation spread is far more varied across the non-financial sectors (Figure 17). Energy is the most obvious example of a cheap EM sector relative to returns compared with DM, while Consumer Discretionary, IT and Telcos also look better value. In contrast both Healthcare and Consumer Staples look better in DM whilst Industrials and Materials are relatively even, although EM is a little cheaper in both cases. Figure 17: EM versus DM by sector — P/BV (x) and RoE (%) Sector Financials Energy Materials Consumer Discretionary Consumer Staples Industrials Utilities Telco Information Technology Healthcare AGGREGATE EM P/BV (x) EM ROE (%) 1.46 0.94 1.35 2.24 3.82 1.47 1.06 2.39 2.08 3.90 1.59 13.82 12.97 7.64 15.42 14.31 7.33 5.96 16.75 17.17 12.15 12.76 Source: Deutsche Bank, Bloomberg Finance LP 3) DM ROE in non-financials sector is now better than EM as aggregate margins have converged. A straightforward side-by-side comparison of the DuPont decomposition of the EFTA01466426 non-financial sectors in DM and EM reveals that the marginal shift of ROE in favour of DM which has taken place over recent years (Figure 18) is mainly due to the almost continual convergence of margins with EM (Figure 19). Whilst leverage has made on increasing contribution to EM returns (Figure 20), it remains lower than in DM, whilst asset turnover has been volatile on a gently rising trend (Figure 21). Figure 18: EM vs DM non-financials — ROE (%) EM Non Financials ROE 10 12 14 16 18 20 0 2 4 6 8 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Deutsche Bank, Bloomberg Finance LP DM Non Financials ROE Figure 19: EM vs DM non-financials — Net margin (%) EM Non Financials Net Margin Net Margin 10 12 14 16 0 2 4 6 8 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Deutsche Bank, Bloomberg Finance LP DM Non Financials Net Margin DM P/BV (x) 1.25 1.72 1.93 2.94 3.63 2.55 1.47 2.24 3.19 3.54 2.10 DM ROE (%) EFTA01466427 8.16 12.98 9.28 15.46 19.33 13.51 8.05 11.74 17.32 16.84 12.00 Page 14 Deutsche Bank AG/London EFTA01466428 11 December 2013 GEM Equity Strategy Outlook 2014 Figure 20: EM vs DM non-financials — Leverage (%) EM Non Financials Assets/Equity 1.65 1.70 1.75 1.80 1.85 1.90 1.95 2.00 2.05 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Deutsche Bank, Bloomberg Finance LP DM Non Financials Assets/Equity (RHS) Figure 21: EM vs DM non-financials — Asset turnover (%) EM Non Financials Sales/Assets DM Non Financials Sales/Assets 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Deutsche Bank, Bloomberg Finance LP 4) EM consumer-related sectors have relatively positive margin performance. Figure 22: EM vs DM net margins (%) — Consumer Discretionary Net Margin (%) MSCI EM - Consumer Discretionary 10 0 1 2 EFTA01466429 3 4 5 6 7 8 9 MSCI DM - Consumer Discretionary Figure 23: EM vs DM net margins (%) — Consumer Staples MSCI EM - Consumer Staples Net Margin (%) 10 4 5 6 7 8 9 MSCI DM - Consumer Staples Source: Deutsche Bank, Bloomberg Finance LP Source: Deutsche Bank, Bloomberg Finance LP 5) Regulated sectors have fared badly in both EM and DM, but worse in EM; this is especially so in Utilities as governments have reduced returns to capital to help offset the impact of low growth on living standards. Figure 24: EM vs DM net margins (%) — Utilities MSCI EM - Utilities Net Margin (%) 10 12 14 16 0 2 4 6 8 MSCI DM - Utilities Figure 25: EM vs DM net margins (%) — Telco Net Margin (%) 10 12 14 16 18 20 0 2 4 6 EFTA01466430 8 MSCI EM - Telecommunication Services MSCI DM - Telecommunication Services Source: Deutsche Bank, Bloomberg Finance LP Source: Deutsche Bank, Bloomberg Finance LP Deutsche Bank AG/London Page 15 May-04 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 May-04 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 May-04 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 May-04 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 EFTA01466431 11 December 2013 GEM Equity Strategy Outlook 2014 6) IT and industrials have moved in favour of DM which reflects favourable secular trends, most notably outsourcing from DM to EM companies and the growing importance of DM intellectual capital. Figure 26: EM vs DM net margins (%) — Industrials Net Margin (%) 10 12 14 -2 0 2 4 6 8 Source: Deutsche Bank, Bloomberg Finance LP MSCI EM - Industrials MSCI DM - Industrials Figure 27: EM vs DM net margins (%) — Information Technology Net Margin (%) 10 12 14 16 18 0 2 4 6 8 MSCI EM - Information Technology MSCI DM - Information Technology Source: Deutsche Bank, Bloomberg Finance LP 7) EMs have fared especially badly in energy and materials primarily due to the impact of policies based on state capitalism and resource nationalism, which have reduced returns to capital. Figure 28: EM vs DM net margins (%) — Materials MSCI EM - Materials Net Margin (%) 10 15 20 25 0 5 MSCI DM - Materials Figure 29: EM vs DM net margins (%) — Energy MSCI EM - Energy EFTA01466432 Net Margin (%) 10 12 14 16 18 0 2 4 6 8 MSCI DM - Energy Source: Deutsche Bank, Bloomberg Finance LP Source: Deutsche Bank, Bloomberg Finance LP Conclusion; valuation now ambivalent, but the secular decline of EM profitability relative to DM is likely to continue across most sectors. Whilst the secular strengths of the US model are increasingly factored into valuations (Figure 30 and Figure 31), there is no obvious end to the likely degradation of margins of EM companies in the regulated and resource sectors, relative to their DM peers. Continued DM outperformance in Industrials and IT is also highly likely in our view, given the ongoing secular trends, whilst EM staples stocks appear very expensive relative to their DM counterparts based on their respective return profiles. Financials are a much more difficult call, but given our negative structural view on China, we believe that investors are right to price in a very substantial impairment of assets in China, Brazil and Russia, while India is also problematic. The DM financials sector is still under pressure from increasingly burdensome regulation and litigation relating to the financial crisis, but would appear to be at a better position in the economic cycle than most GEM economies. Page 16 Deutsche Bank AG/London May-04 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 May-04 May-05 May-06 May-07 May-08 May-09 EFTA01466433 May-10 May-11 May-12 May-13 May-04 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 May-04 May- 05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 EFTA01466434 11 December 2013 GEM Equity Strategy Outlook 2014 Figure 30: US and EM — Absolute P/BV since 1996 (x) MSCI US Figure 31: P/BV of US relative to EM (x) MSCI EM 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 Source: Deutsche Bank, Bloomberg Finance LP Source: Deutsche Bank, Bloomberg Finance LP Deutsche Bank AG/London Page 17 Feb-96 Jun-97 Oct-98 Feb-00 Jun-01 Oct-02 Feb-04 Jun-05 Oct-06 Feb-08 Jun-09 Oct-10 Feb-12 Jun-13 Feb-96 Jun-97 Oct-98 Feb-00 Jun-01 Oct-02 EFTA01466435 Feb-04 Jun-05 Oct -06 Feb-08 Jun-09 Oct -10 Feb-12 Jun-13 EFTA01466436 11 December 2013 GEM Equity Strategy Outlook 2014 Taper versus governance BRICs at most risk of 'classic' EM crisis based on dysfunctional relationship between state and companies Micro structural factors threaten EM economies more than Fed taper There is increasing discussion about the possibility of a financial/economic crisis in one or more emerging markets, based on purely macro considerations, namely the impact of tighter Fed policy on those countries with high external financing requirements. We are sceptical for two reasons. First we believe that the Fed will be extremely cautious in tightening policy, largely because of the potential impact on emerging economies and financial markets which will then feed back into dampening growth prospects in the US. Second, the taper concerns reveal an excessively one-dimensional focus on a single macroeconomic aggregate whereas the history of EM shows that more micro related factors around the corporate sector are ultimately the key drivers of EM economies and financial markets. The sudden break in correlation between DM and EM equities at the start of 2013 preceded talk of Fed tapering by several months and was the direct result of investors beginning to discount more favourable structural factors for the US against the bulk of the EM universe. Going forward, the greatest potential for an EM-style financial crisis resides in those countries with the most dysfunctional relationship between the state and the corporate sector. Our conclusion is that at least three of the four BRICs economies, with the possible exception of India, are eventually more liable to a 'classic' EM-type crisis compared to Indonesia, South Africa or Turkey, though we accept that there is a risk with Indonesia in particular that predictions of a crisis, which lead to a rapid run-down in FX reserves, could become self-fulfilling. BRIC economies most vulnerable because of failure to implement reforms Emerging economies and financial markets have historically been highly cyclical and prone to boom-bust cycles largely because the mechanisms to impose a hard budget constraint on enterprises are generally underdeveloped. The result is the accumulation of imbalances that become visible at a micro level some time before they begin to influence the macro-economic statistics. Financial markets are very influential in forcing policy responses, but the history of emerging markets suggests that a crisis or near-crisis situation is often necessary to force policymakers to implement structural reforms. The current cycle has now shifted from the widespread hubris which was so evident among EM investors and policy makers three years ago, to one of concern at the visible deterioration in growth rates and financial markets across the majority of the EM universe. Unfortunately whilst this concern is manifested in policy rhetoric, there is little evidence of a concerted attempt at EFTA01466437 implementation across the BRIC markets in particular. We write about China at greater length later in the report, but our view postPlenum is basically unchanged, namely that the mooted reforms fail to address the real driver of the deteriorating rate of productivity in the Chinese economy, namely the blurred boundaries between the state and private sector, which is the root cause of the widespread misallocation of capital. The result is that it requires an ever-increasing amount of finance to maintain growth rates of 7% which suggests that both the economy and equity market are extremely Page 18 Deutsche Bank AG/London EFTA01466438 11 December 2013 GEM Equity Strategy Outlook 2014 vulnerable to any deterioration of confidence among the providers of finance who are mostly in China, but with a growing proportion of external funding. The extent of the potential problem is visible in the debt levels for the Industrials and Materials H-share listed sectors which have been rising rapidly over recent years despite strong sales growth (Figure 34 and Figure 35), which has itself been boosted by the increase in debt/GDP for the broader economy which Fitch estimates at around 80% over the past five years. Whilst the Renminbi has been extremely strong this year, we continue to think that at some stage China will need to engineer a devaluation of the currency to inject liquidity into the corporate sector and that the main issue concerns whether this adjustment will, be orderly or disorderly. In Russia, the increasing state dominance of both the economy and the corporate sector has resulted in an economy which is almost wholly dependent on commodities both in terms of export revenues and support for domestic industry. There has been much discussion of reform but nothing of substance has been achieved so that even if oil prices remain at current levels, the outlook for the economy remains dismal for 2014 while lower commodity prices could trigger severe economic and political disruption. Russia has very little in the way of external debt but company indebtedness in some key sectors is rising fast (Figure 67 and Figure 68), which will further increase the burden on the listed energy and banking sectors to support the broader economy There is no obvious respite for shareholders in Brazilian companies from the government-inflicted pressures on both listed companies and the broader economy. As in Russia, a vicious circle has developed whereby lower economic growth leads to more populist policies which undermine private sector confidence in the prospects for the economy thus lowering growth and so it goes. The full impact of expansionary fiscal policies, conducted off balance sheet and also the distortions caused by fuel subsidies is likely to become more visible in 2014, so unless there is a major policy change, which is unlikely before the election(s) late in the year, sentiment towards the Brazilian economy or financial markets is unlikely to improve. Brazil also runs a current account deficit, much of which is financed by FDI which is likely to decline as the prospects for both commodity prices and the Brazilian economy continue to deteriorate. The result is likely to be an ongoing decline in the value of the Real. The outlook in India is a little more positive than the other BRICs because the political elite appears committed to the implementation of structural economic reforms if the election in May produces a working coalition; India would also benefit from any fall in oil prices from current elevated levels. Also, EFTA01466439 India has along with Brazil been a victim of the taper-related sell-off, but in India's case the lower value of the Rupee does appear to be helping the current account. Nevertheless, the economy will suffer for a considerable time from the unwinding of a number of state-induced distortions, in particular widespread subsidies and an overly lenient regime for defining doubtful loans in the banking system. The state-induced distortions for the listed corporate sector are less pronounced than in the other BRICs, but we see no real indication of a revival in the investment activity which is necessary to revive the very strong growth rates in India seen over most of the previous decade. Deutsche Bank AG/London Page 19 EFTA01466440 11 December 2013 GEM Equity Strategy Outlook 2014 Elsewhere, growth/consumption under threat but crises unlikely The other markets in addition to Brazil and India which have been singled out as especially susceptible to a taper-induced withdrawal of foreign capital flows do not display structural fault-lines at a micro level to the same extent as Brazil, Russia and China in our view. There have certainly been well publicized political problems in Turkey over the course of 2013, but for the most part the corporate sector is able to operate in a relatively autonomous manner. The biggest risk is that investors have little confidence in the central banks unorthodox monetary policies, but a similar type of stand-off was successfully resolved in 2011, while the current account deficit would be ameliorated by falls in energy prices. South Africa would also benefit from a fall in the price of oil relative to industrial metals and gold while the integrity of the central bank and corporate governance means that the economy is almost free of the governance distortions found elsewhere in GEM. Also, the South African rand is largely intervention-free, which means that it tends to adjust very quickly to changing financial conditions. The relatively positive structural backdrop is why South African assets have performed relatively well during the taper period in our view despite the apparently alarming level of fiscal and current account deficits. Finally, Indonesia has been singled out by the markets as most vulnerable for a combination of reasons including its history of capital flight, the forthcoming election, and the extent to which the economy has been operating over capacity during the past couple of years. Whilst there are still serious questions about sovereign and corporate level governance in Indonesia, financial vulnerability at a corporate level is much lower than was the case before the financial crisis (Figure 51 and Figure 52). Whilst we do not especially like Indonesian equities, and of all EM countries, the risk of investors essentially provoking a crisis by the withdrawal of capital is probably highest there, we would be very surprised if anything approaching a classic EM crisis were to take place in 2014. Ultimately, the biggest risk to all three of these countries might well come from a liquidation of positions in EM equities due to poor sentiment emanating from China, rather than the taper. Page 20 Deutsche Bank AG/London EFTA01466441 11 December 2013 GEM Equity Strategy Outlook 2014 Still bearish on China Positive sentiment overdone given risks of debt trap in corporate sector and local government Ongoing deterioration in China real ROIC undermines growth prospects As regular readers will be only too aware, our negative view on both the Chinese economy and equity market derives from a micro-level perspective of the structure and returns of the corporate sector. For the past three years, we have been using the CROCI data provided by Francesco Curto and his team in which they analyse the real level of cash returns from about 68% of the MSCI non-financial universe as an advance warning of the extent to which productivity is deteriorating throughout the broader economy (Figure 32 and Figure 33). So far this appears to be working — most economists, including DB's own senior Asian economist, Michael Spencer, now acknowledge the extent to which the incremental capital to output ratio (ICOR) has deteriorated since the financial crisis, as the Chinese authorities have thrown capital at the economies in a so far successful attempt to maintain growth at what they deem to be an acceptable level. According to rating agency Fitch, the level of debt to GDP has risen by around eighty percentage points since the middle of 2008. Figure 32: China ex-financials — CROCI 0% 2% 4% 6% 8% 10% 12% 14% 16% 1997 1999 2001 2003 2005 2007 2009 2011 2013E CROCI ex Goodwill CROCI cum Goodwill Source: Deutsche Bank CROCI team COC Implied LT CROCI Figure 33: China ex-financials — CROCI drivers 10% 15% 20% 25% 30% 35% 0% 5% 1997 1999 2001 2003 2005 2007 2009 2011 2013E EFTA01466442 CROCI Cash Flow Margin Sales / Gross Capital Invested (RHS) Source: Deutsche Bank CROCI team 0.00x 0.10x 0.20x 0.30x 0.40x 0.50x 0.60x 0.70x 0.80x Dysfunctional relationship between local government & corporate sector The dysfunctional relationship between local government and the corporate sector is the underlying cause of much of the misallocation of resources in China in our view. As a result of the 1994 fiscal reforms, local government is chronically underfunded as tax revenues are inadequate to meet social and other expenditure obligations. At the same time, local government has been able to exert a relatively high degree of control over locally-based industrial enterprises and the local branches of state-controlled banks. One consequence is that wherever possible, local governments have subsidised costs for industry using household savings or what are nominally centrally controlled resources to maintain high levels of local employment and growth. This has had the effect of dragging down returns across almost all of the industrial and materials sector via overcapacity and diverting resources away from potentially more productive uses, thus undermining the potential growth rate for the entire economy. Deutsche Bank AG/London Page 21 EFTA01466443 11 December 2013 GEM Equity Strategy Outlook 2014 Debt situation is becoming critical for materials and industrials sectors The debt levels of the Industrials and Materials sectors reveal how close the entire system is to reaching a tipping point. The balance sheet leverage of both sectors has risen sharply since 2008 (Figure 34 and Figure 35) despite a level of capital expenditure which has generally been falling relative to sales (Figure 36 and Figure 37). The implication is that whilst the listed companies have in general been behaving in a rational manner, the widespread provision of cost subsidies especially to A- or non-listed enterprises creates a level of overcapacity which drives returns far below the real cost of capital for entire industries. The situation is becoming increasingly critical in our view, since these enterprises are leveraging into an economy which is itself increasing leverage by a considerable amount, led by the local government financing vehicles, many of which offer direct support to the enterprise sector. There is no definitive figure for the extent of LGFV debt — the National Audit Office has been conducting an investigation, the results of which were supposedly going to be released in the lead up to the Plenum, but have failed to appear as yet for some reason. Our best guess is that the level is some way ahead of RMB2Otrn compared with the RMB10trn in 2010, which was the last official estimate. Figure 34: Chinese Materials — Debt/Equity (%), rolling 12m average 100% 120% 140% 160% 180% 20% 40% 60% 80% 0% Figure 35: Chinese Industrials — Debt/Equity (%), rolling 12m average 100% 120% 140% 160% 20% 40% 60% 80% 0% EFTA01466444 (1) Bottom-up aggregation of relevant stocks in MSCI EM index. Source: Deutsche Bank, Bloomberg Finance LP (1) Bottom-up aggregation of relevant stocks in MSCI EM index. Source: Deutsche Bank, Bloomberg Finance LP Figure 36: Chinese Materials — Capex/Sales (%), rolling 12m average 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% Figure 37: Chinese Industrials — Capex/Sales (%), rolling 12m average 0% 2% 4% 6% 8% 10% 12% 14% (1) Bottom-up aggregation of relevant stocks in MSCI EM index. Source: Deutsche Bank, Bloomberg Finance LP (1) Bottom-up aggregation of relevant stocks in MSCI EM index. Source: Deutsche Bank, Bloomberg Finance LP Page 22 Deutsche Bank AG/London Q4 02 Q2 03 Q4 03 Q2 04 Q4 04 Q2 05 Q4 05 Q2 06 Q4 06 Q2 07 Q4 07 Q2 08 Q4 08 Q2 09 Q4 09 Q2 10 Q4 10 Q2 11 Q4 11 EFTA01466445