Posts tagged Emerging Markets
In this holiday-shortened week, our thoughts easily start to drift towards all the delicious, rich food we will be ingesting between now and early January when we wake up with newfound determination to go out and conquer the next marathon, or the first triathlon, or just the first visit in months to the nearest fitness center. With these sentiments in mind, let us invoke the theme of turkeys for this week’s missive. The metaphorical kind of turkey, as an easy stand in for “seemed like a good investment idea at the time, but…” Now, the year has been a generally benign one for most asset classes. But there were turkeys aplenty that caught investors off guard. Here is a random selection of three of the gems that have caught our eye over the past months.
#1: The Reflation-Infrastructure Trade
In a sense, many of the year’s turkeys flow from the granddaddy of them all, the “reflation-infrastructure trade” theme that caught fire literally within minutes of Trump giving his election night victory speech. The idea behind this trade was that a new, Republican-controlled government was going to unleash a flood of new money into the world through a combination of hefty tax cuts and massive spending from both the public and private sectors on new infrastructure projects. It’s fair to say that this trade caught the vast majority of the investment world by surprise, since almost nobody expected the Republicans to capture the White House (their victories in the House and Senate were rather more predictable). But the trade dominated the last two months of 2016, with the key beneficiaries being financial institutions (net interest margins!), resource and industrial companies (lots of new projects!), the dollar and intermediate-long interest rates (because, reflation!).
The trade wasn’t a turkey for anyone who took a wager on it from November 9 through New Year’s Day and then sold out. But the fundamental rationale for the trade, which was never strong to begin with, proved wildly off base. Core inflation never breached, let alone smashed through, the Fed’s 2 percent target level. A year later, low inflation continues to exist right alongside 4 percent unemployment. In fairness, nobody including the Fed’s Board of Governors knows with assurance why this is so. As for infrastructure, anyone who has paid any attention at all to Washington politics for the last couple decades would understand that public infrastructure spending has never been a priority item on Republican policy agendas. As for taxes – again, a passing knowledge of GOP politics would lead one to conclude that, yes, tax cuts would certainly be up for legislative action, but complex, actual tax reform that broadened the base (i.e. killing off corporate loopholes) while lowering statutory rates might be a bridge too far for a party beset by fractious differences among its own members, let alone those across the political aisle.
In any event, most elements of this trade, led by the US dollar, had fizzled out by late winter. Periodically talk of the reflation trade recurs, mostly because financial news anchors love to say “the Trump trade is back!” while grinning foolishly into the camera. Caveat emptor.
#2 The Return of Volatility
The twin surprises of 2016 – the Brexit vote in Britain and the US presidential election – set the stage for much chatter about the political land mines in store for the year ahead. Mostly the prognosticators looked to Europe, where the springtime calendar included potentially explosive elections in the Netherlands and France, to be followed in early fall with the German contest. Then there were the ever-present concerns about central banks weaning dependent investors off the easy QE money, a hard economic landing in China, the possibility of trade wars with an ascendant hyper-nationalist contingent in the White House and even the possibility of actual wars as tensions ratcheted between the US and North Korea.
All these events – and many more besides – had their various days of reckoning. Each day came and went with asset price volatility barely budging from all-time lows. The CBOE VIX index, a measure of volatility dubbed the “fear gauge” by investors, had fallen below a level of 10 (the lower the VIX, the less risk) only a handful of times between its launch in 1990 and 2016. The index has closed below 10 a grand total of 40 times in the year 2017 to date, making this the “safest” year by the VIX measure in 27 years. Meanwhile the intraday volatility of the S&P 500 index is lower this year than any time since 1963. Anyone long VIX risk – and for defensible reasons! – will be ruing that bet.
Interestingly, the European election with potentially the most far-reaching consequences for 2018 may well be the one deemed the safest bet – Germany. Chancellor Angela Merkel’s CDU/CSU party came first in the elections two months ago, but has since failed to secure a governing coalition with other representative parties. Political discord in Europe’s most stable power could signal much uncertainty ahead. So far, though, markets are as relaxed as ever.
#3 Another Bad Year for Emerging Markets
We finish out our gallery of turkeys with a look at emerging markets, a surprise 2017 darling. Now, the success of emerging market (both equities and debt) is in a way the flip side of that reflation-infrastructure trade. But we believe this to be a useful morality tale on the perils of asset allocation assumptions. Let’s consider the following. As portfolio managers were making their 2017 asset allocation decisions, late last year, two things about emerging markets were known to them.
First, the asset class had performed dismally, on a relative basis, for several years. While the S&P 500 went on a tear in 2012 and never looked back, EM equities had a very bumpy ride up and down, but mostly down. US large cap stocks passed their earlier historical highs in 2013, but emerging markets remained well shy of theirs in both dollar and local currency terms (they finally regained the high ground in local currency, but not dollar terms in 2017). In fact, on a risk-adjusted basis EM equities have produced negative value relative to blue chip US stocks on an annual average basis over the past 30 years. Any quantitative asset allocation model based on some variation of modern portfolio theory would have recommended deep underweights, or zero allocation, to emerging markets.
The second thing portfolio managers knew in December 2016 was that emerging markets were getting pummeled by the reflation-infrastructure trade. What reason would there have been to make a large allocation to this asset class? Well, to be sure, there are enough contrarians in the world who, at any given time, will put their chips on asset class X because asset class X has been out of favor for a while. Some managers did that, and were amply rewarded. But – and here is the key point – that decision boils down to a single variable: luck. Asset price trends will almost always exhibit mean reversion over time. But pinpointing the time – getting that inflexion point right – is a matter of luck. Emerging markets did well in 2017. They may well do so again in 2018 – or they may not. But questions about the long-term underperformance of this asset class are not answered by a single year’s outcome.
There will be much at stake in 2018. As always, we and our fellow practitioners in this industry will be diligently at work over the next several weeks to try and figure out how to be positioned for 2018 and beyond. Meanwhile we leave you with this sentiment: may the turkeys be on your dinner table, and not in your portfolios. Happy Thanksgiving!
One of the odder stories in a year of general strangeness in the capital markets is emerging markets. Contrary to the vast majority of expectations in the wake of last November’s presidential election, this asset class has been the darling of diversified portfolios in the year to date. The MSCI Emerging Markets index was up more than 28 percent YTD at the end of the third quarter – double the performance of the not shabby 14 percent logged by the S&P 500. Nor is the good news limited to equities; EM currencies have mostly risen against the dollar. Perhaps to underscore the weird irony of the situation the Mexican peso – the currency on the receiving end of all those nativist threats of security walls and trade wars and the like – has gained more than 15 percent against the dollar since January 1.
Reclaiming Lost Heights
In local currency terms, emerging markets equities reached all-time highs this year. In the dollar terms by which US-based investors measure their profits, though, EM stocks still have a bit of ground to make up from their peak during the great growth spurt of 2003-07. The chart below shows the MSCI EM Index (in dollar terms) for the past 15 years.
That 2003-07 run came courtesy of several factors unlikely to repeat themselves. These were the years of the great China boom: the country’s record-breaking surge to become the world’s second largest economy and largest producer / consumer of so many raw materials and finished goods happened in what seemed the blink of an eye. These years also witnessed what is likely to be the final phase of an extended commodities supercycle, which gave resource exporters like Russia and South Africa a few extra points of GDP growth to tack on. Emerging markets became synonymous with “growth” – often real GDP growth of the double digit variety.
Then it all came crashing down. The financial follies concocted in the quant labs of Wall Street and the City took down emerging and developed asset markets alike. The slow pace of growth in the ensuing global recovery has not been kind to many of those former growth market Wunderkinder. Brazil and Russia experienced deep recessions, South Africa and Turkey faced increasingly onerous repayment burdens on their outstanding dollar-denominated borrowings, and China has grappled with the complexities of managing stable currency and credit markets while still trying to hit their growth targets. Given all the challenges, perhaps the most surprising thing about that chart shown above is that this asset class didn’t fare worse than it did during those sideways years of 2010-16.
What Flavor Crisis This Decade?
So where do they go from here – and are investors wise or foolish to follow? One of the important things an investor should always keep in mind about emerging markets is their dynamism – in the sense that the composition of these economies changes more fluidly from year to year than their developed world counterparts. Their installed base of productive resources, their monetary policies and the consumption habits of their citizens are all vastly different today from what they were fifteen or twenty years ago.
That is important because it was precisely twenty years ago that emerging markets fell into one of their periodic traps that turn investors’ stomachs. A crisis in the baht, Thailand’s national currency, went viral and wreaked havoc on currencies and central bank balance sheets from Seoul to Jakarta and beyond. A year later Russia defaulted on its sovereign debt obligations, swallowing up local punters and rich world hedge funds alike. There is a “crisis a decade” school of thought among long-term EM observers, going back to the Latin American debt crises of the 1970s and 1980s to Asia and Russia in the 1990s, Argentina in the 2000s and on and on.
The practical effect of these crises is well-documented: never contained as a local affair, the pain spreads as investors treat their emerging market exposures as one asset class. Never mind if Argentina and Malaysia have almost nothing in common: they rise together and fall together in the capricious ebbs and flows of portfolio capital. For this reason, the asset class as a whole has been a long term loser. Since the beginning of 1990, the average annual return of the MSCI EM index has been about 1 percent lower than that of the S&P 500 – but the risk, measured by standard deviation, has been a full 8 percent higher. “No gain, lots of pain” sums up this portfolio contribution.
Traps Old and New
It would be unwise to project the failures of 1997-98 onto possible negative scenarios for the near future. EM central banks have become much more robust in terms of foreign exchange reserve defenses, and their vulnerability to developed market currencies is mitigated by a growing portion of local currency credit instruments to fund their domestic investment initiatives. Many emerging markets today look…well, less “emerging” and more mature than they did even a decade ago.
But with maturity comes a new set of challenges, and potentially new kinds of traps. Resource exporters like Russia and South Africa will remain vulnerable to a potential weak secular cycle in commodities. Countries whose primary source of competitive advantage is cheap labor are at risk in a world where AI threatens to upend traditional employment patterns in industry after industry. Technology is widening the gap between the handful of companies able to leverage leading-edge technology in their business models and the legions of stragglers struggling to keep up. These are all traps that could trip up countries and regions in that delicate transition from widespread poverty to wealth. And all of this is to say nothing of the lurking threat of protectionism and nationalist nativism from disgruntled voters and their political avatars in the US or the EU.
The developed world is not growing quickly, and this pattern is likelier than not set to continue. If the combined heft of emerging markets can unlock a formula for higher sustainable growth then these markets are worth keeping in strategic asset allocations – and one would expect the risk-return composition to be more favorable than it has been in the past. But these are still significant ifs. We believe investing in emerging markets will call for more nuance going forward, starting with the practice of not treating this widely diverse collection of markets as one asset class.
It may be as good a sign of the times in which we live as any: in the space of five business days, Argentina (1) stunned global credit markets with a $2.75 billion 100-year bond (yes, a bond that will come due long after all of us reading this article have gracefully shuffled off this mortal coil), and (2) saw the Argentine peso fall to a record low after MSCI declined to upgrade the country’s equity market from frontier to emerging market status. This seeming contradiction in fortunes comes at a time when emerging market equities hang on as one of the best asset class performers of the year, while investors have plowed more than $35 billion into developing market bond funds. Are there still opportunities here, or is the EM glow due for one of its not infrequent fizzles?
Unlikeliest of Success Stories
Pundits cheerleading the emerging market story were few and far between as 2017 got underway. After the surprise outcome of last November’s US election the asset class fell 6.4 percent through year-end, along with everything else on the flip side of the “Trump trade.” EM assets – debt and equity alike – were imagined to be in for a period of protracted weakness as US interest rates and inflation soared to the fanciful revving up of a $1 trillion tsunami of infrastructure spend. A better square on which to place your growth-and-risk-seeking chips, it would have seemed, was US small cap stocks. As it turned out, though, EM equities, currencies and bond prices all rallied. The chart below shows a 12-month snapshot of the MSCI EM stock index, denominated both in local currency and in US dollars.
Yield: What Matters Most
One of the factors -- not the only one, but key nonetheless -- explaining the updraft in EM equities is currency. After being pummeled by the US dollar more or less constantly since 2015, key emerging market currencies from the renminbi to the Indian rupee, Mexican peso and Russian ruble stepped on the gas after their post-Trump trade declines. That currency strength, in turn, is of a part with the remarkable push by global investors into emerging credit markets. For this there is an easy explanation. The investing world is on a collective, frantic search for yield in a world awash in central bank stimulus. Yield is the Holy Grail of the second decade of the 21st century.
Why was that 100-year Argentine bond deal thoroughly oversubscribed? Because investors could not resist the temptation of a 7.91 percent yield. Same goes for Russia, which unloaded $3 billion worth of 10- and 30-year Eurobonds into the markets this week (4.25 and 5.25 percent yields, respectively). Does it matter that Argentina has defaulted on its debt five times since 2000? Does anyone remember Russia’s bailing on its sovereign debt obligations in 1998, sending the propeller-head mavens of Long Term Capital Management and their backers to the poor house? Not today, not in a world of yield above all else.
Lower for Longer, or Tantrum 2.0?
The punters who scooped up the Russian and Argentine paper this week may well be vindicated for their boldness if the market’s view on the Fed turns out to be right. That view – the opposite of the reflation trade that had everyone so excited last year – is that low inflation and anemic wage growth are here to stay for the foreseeable future, just as they have been for most of the duration of the slow-growth recovery to date. If inflation and wages fail to kick in over the next several months, even with labor market conditions that according to many should suggest full employment, then it is quite possible that the FOMC will hold off even on the one further cut they have in their sights this year. That would potentially keep the dollar from embarking on another punishing rally, and the quest for yield would continue (pushing bond prices ever lower).
Then again, there is an alternative, quite valid argument to make that the low levels of volatility in asset markets today are woefully mispricing the amount of latent risk that could be unleashed at any time. It’s worth noting that many of the EM currencies that have been doing so well of late have run into some headwinds recently. The Brazilian real took a tumble back in May when the newest batch of political scandal headlines hit the wires. The ruble and the renminbi are both well off their recent highs, while the rupee and the Mexican peso are marking time in a relatively narrow corridor. The year’s gains to date have been impressive. Experienced EM investors know that they are anything but certain to last.
The S&P 500 has taken something of a breather this past month. After notching yet another all-time record on March 1, the index has mostly been content to tread water while the animal spirits of investors’ limbic brains wrestle with the rational processors in their prefrontal cortices. This past Tuesday’s pullback – gasp, more than one percent! – brought out a number of obituaries on the Trump trade. We imagine those obits might be a bit premature. As we write this, we do not know whether today’s planned House vote on the so-called American Health Care Act will pass or not (let alone what its subsequent fate would be in the Senate). But markets appear tightly coiled and ready to spring forth with another bout of head-scratching giddiness if enough Members, ever fearful of a mean tweet from 1600 Pennsylvania – knuckle under and find their inner “yea.” An outcome we would find wholly unsurprising.
Risk On with an Asterisk
If the melt-up is still going strong, we might want to look farther out on the risk frontier to see how traditionally more volatile assets are faring. All else being equal, a “risk-on” sentiment should facilitate a favorable environment for the likes of small cap stocks and emerging markets. Here, though, we have a somewhat mixed picture. The chart below illustrates the year-to-date performance of small caps and EM relative to the S&P 500.
In a time where US interest rates are expected to rise and the fortunes of export-dependent developing economies are at the mercy of developed-market protectionist sentiments beyond their control, emerging markets are going gangbusters. Meanwhile domestic small caps, which could plausibly be equated to more of a pure play on an “America first” theme, are languishing with almost no price gains for the year. This seems odd. What’s going on?
Rubles and Pesos and Rands, Oh My!
We’ll start with emerging markets, where the driving force is crystal clear even if the reasons behind it are not. The Brazilian real is up about seven percent against the dollar this year, while the much-beleaguered South African rand has enjoyed a nine percent tailwind over the past three months. Seven of the ten top-performing foreign currencies against the US dollar this year come from emerging markets. So when you look at the outperformance of EM equities in the above chart (which shows dollar-denominated performance), understand that a big chunk of that outperformance is pure currency. Not all – there is still some outperformance in local currency terms – but to a large extent this is an FX story. Moreover, it is not necessarily an FX story based on some inherently favorable conditions in these countries that would lead to stronger currencies. It is much more about a pullback of late in the US dollar’s bull run, a trend which has surprised and puzzled a number of onlookers. Whether you believe the EM equity rally has lots more fuel behind it comes down to whether you believe the dollar’s recent weakness is temporary and likely, on the basis of fundamentals, to reverse in the coming weeks or months.
Value Stocks Running on Empty
Back in the world of US small caps, the performance of the Russell 2000 index shown in the above chart owes much of its listless energy to…well, energy. Namely, the small energy exploration & development companies that populate a good proportion of the value side of the small cap spectrum. Value stocks were more or less holding their own through the first two months of the year (though still underperforming large caps), but they got hit hard when oil prices plunged in the early part of this month.
And it’s not just oil and energy commodities, but also industrial metals that have weakened in recent weeks, leaving shares in the materials and industrial sectors – high fliers in the early days of the reflation trade – underperforming the broader market. So this leaves investors to ponder what exactly is left of the tailwinds that drove this trade. The Republicans’ clumsy handling of their first big policy test – repealing and replacing a law they’ve been calling doom on for seven years – may signal a much larger dollop of execution risk (for all those tax and infrastructure dreams) than baked into current prices.
On the other hand, one could make the case that tax reform – likely the next item on the policy agenda – is less complicated than healthcare. If a consensus builds around the idea that Tax Santa is arriving sooner rather than later, one could expect at least one more brisk uptrend for the reflation trade. That outcome could very well catalyze a reversal of the performance trends shown in the above chart, with emerging markets pulling back while small caps gain the upper hand. Of course, there is always the option of staying focused on the long term, and playing through the noise of the moment without getting sucked into the siren song of market timing.
The big news after last month’s National People’s Congress in Beijing was the announcement by Premier Li Keqiang of the government’s intention to set a range, rather than an individual target, for annual real GDP growth. The range was to be between 6.5 and 7.0 percent, seen as striking a balance between the admission that a steady rate of seven percent, the previous target, was not sustainable, while still delivering enough top-line growth to reach the country’s GDP targets for 2020. Today China released its GDP results for the first quarter of 2016 and – lo and behold – the number came in at 6.7 percent. Observers met the release with the usual skepticism over how much the reported figure varied from what is actually going on in the world’s second largest economy. We’re less concerned about whether the “real” top line is 6.7 or 7.0 or even 5.5 percent, and more concerned about what recent data tell us about the progress, or lack thereof, towards China’s much ballyhooed economic rebalancing.
More Bridges to Nowhere?
Specifically, much of the data released since the March NPC meeting points to an apparently deliberate decision on the part of Beijing policymakers to reach for the elixir of investment-driven stimulus – the key growth driver for much of the past 10-plus years – as a way to head off concerns that efforts to rebalance towards a more domestic consumption-driven economy may be falling short. Those concerns have manifested in recent months in the form of massive capital outflows and a resulting 20 percent decline from peak foreign exchange reserves. Premier Li’s NPC remarks reflected the view that a sugar fix is the best response. Markets took note: iron ore prices jumped by a ridiculous amount on the Monday after the NPC, and commodities generally surged in anticipation of a pickup in China demand. Were they right? Consider the chart below showing other recent key data releases.
Among these four charts, you can see the sharpest reversal of recent trends in industrial production and wholesale prices, both of which came in comfortably ahead of analyst expectations. Fixed asset growth – a key metric for China’s activity in infrastructure and property development – is still nowhere near the levels of recent years, but has actually increased for the first time since 2014. Meanwhile the growth rate of retail sales, an important benchmark of consumer activity, is lower than at any time in the past twelve months.
Corporate Debt – China’s Mountain Dew
Fixed asset investment doesn’t happen without infusions of new debt capital. New bank loans in China are up $351 billion in March, on the heels of an even brisker pace of $385 billion in January new loan creation. That January number represents the fastest pace of monthly loan growth on record. While January is often the busiest month of the year for new loan creation, with newly-approved projects tapping their sources of credit financing, the strong follow-up in March raises expectations that China’s outstanding debt will continue to set new high ground. Bear in mind that China’s total non-financial debt to GDP has soared from around 100 percent of GDP in 2009, at the outset of a new bank lending stimulus program, to 250 percent of GDP today.
The aggregate level of debt is not the only concern; much of the lending is still tied to the so-called “zombies” – troubled state-owned companies whose loans constitute a potentially significant credit quality problem for the banks that originate them. Bankruptcies and loan write-downs are a delicate matter in China, and reminiscent of the chronically inept way Japan’s financial institutions and regulators tried to deal with that country’s nonperforming debt problems in the 1990s.
When the Sugar Wears Off
All sugar highs come to an end, a fact not lost on Beijing’s Mandarins. We do not think it is on anyone’s agenda to try and embark on another decade of hypergrowth fueled by bank loans and fixed asset investment. The Mountain Dew is meant to buy some time and give the urban services sector a chance to establish enough momentum to take over as the economy’s growth engine. This is China’s own version of “kick the can,” a game in which almost every globally significant economy has indulged over the past seven years. For the time being we expect the China story to be net-neutral to positive in its contribution to the overall market narrative, premised on expectations of no imminent hard landing and a stimulative effect on commodities prices. Come autumn, though, policymakers may need to show they have an effective antidote to the sugar high.