Good Morning, Vietnam

| About: VanEck Vectors (VNM)

By Ashley Kindergan

Quick: Name the Asian country whose cheap labor costs have attracted droves of foreign manufacturers, driving an explosion in export-driven economic activity that is now transitioning to more moderate, consumer-based growth. Did you say China? Vietnam would have been correct, too.

As labor costs have risen dramatically in China over the last several years, a growing number of manufacturers have moved operations from the Middle Kingdom to Vietnam or even decided to set up shop there in the first place. Vietnam's growing popularity as a global manufacturing hub is one of the reasons Credit Suisse expects the country's GDP to rise 6.3 percent next year, the third-fastest rate of growth in emerging market economies after China (6.6 percent) and India (7.8 percent).

Even that relatively strong growth rate is a step down from the 6.7 percent growth rate of 2015, however, thanks to sluggish global growth. Still, even as Vietnamese exports slow, Credit Suisse analysts note that burgeoning domestic consumption is helping sustain economic expansion - a growth pattern the bank's analysts call "slower, but safer."

Vietnamese exports grew at a staggering pace at the beginning of the decade, peaking at 34.2 percent growth in 2011. That growth has slowed gradually since, alongside China's declining appetite for imports. (Exports to China amount to about 5.5 percent of Vietnamese GDP.) A recent growth slowdown in the United States, to which Vietnam is more exposed than any other Southeast Asian country, is likely to hurt exports this year, too. Credit Suisse expects Vietnam's export growth to moderate slightly from 7.1 percent in 2015 to 6.9 percent in 2016.

It's important to keep the slowdown in perspective, however. Vietnamese export growth has outstripped that of non-Japan Asia by between 10 and 15 percentage points for the last five years, and foreign investors are still flocking to the country. Credit Suisse expects total foreign direct investment (FDI) of $13 billion this year, still quite strong, albeit down from a spectacular $14.5 billion in 2015.

The manufacturing sector, which accounts for 24 percent of Vietnamese GDP, accounted for 57 percent of foreign direct investment inflows last year. The country stands to gain even more investment from the Trans-Pacific Partnership, a free-trade agreement among 12 countries. Vietnam could see around a 10% boost to GDP by 2025, according to a Peterson Institute for International Economics study. Vietnam also signed a separate free-trade agreement with Europe last year.

In the meantime, domestic spending has been making up for lackluster external conditions. Real retail sales grew by 8.4 percent in 2014 and 9.2 percent in 2015. A drop in fuel and food prices has boosted Vietnamese purchasing power, pushing real wage growth from 10 percent in 2014 to 14 percent in 2015, despite flat nominal wage growth. Banks have also stepped up their lending to consumers. Major banks made 43 percent more loans to individuals in the first half of 2015 than in the previous year. Inflation is low, and the central bank is expected to cut interest rates this year, which should further support consumer spending.

How to take advantage of Vietnam's growth story? The Vietnamese equities market still has its challenges - namely, liquidity, a relatively small number of listed firms, and limits on foreign ownership. Credit Suisse equities analysts suggest focusing on strong consumer plays, such as food and beverage company Vinamilk and broadband Internet and IT company FTP Corp.

The bank's equities analysts are more cautious on credit-related assets, including banks and real estate companies. An increase in non-performing loans in the wake of a credit-fueled property bubble over the last five years has put pressure on banks' capital ratios. If lending continues at the pace of the last several years, four of the six largest banks will have capital adequacy ratios of less than 10 percent by the end of 2016.

Furthermore, the Vietnamese government has tapped 10 major banks to implement Basel II capital requirements, and Credit Suisse believes capital ratios could fall by up to three percentage points as banks put the more stringent requirements in place. That would leave half of the six largest banks with capital ratios below the 9 percent level that international banking standards require, necessitating capital raises of between $0.4 and $0.9 billion (between 8 percent and 35 percent of their market caps) to come into compliance. Though Credit Suisse does not expect a banking crisis - and believes that while property lending will decline, infrastructure lending will not - bank shareholders could be in for a rough ride.

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