Whose Right: EM “Skeptics” Are Growing
With Emerging Market equities on a tear and outperforming the worlds developed market equity markets by a significant margin YTD (+1470bps to the SPX), they are suddenly target of the bears who argue this is just a bounce from oversold conditions.
The argument is that this could be near a point of inflection where it might be appropriate to reverse field on this trade. At Emerging Money not only do we take a bottom up view to discussing the asset class and individual names, we also focus on asset allocation and the top down metrics (fundamental and technical) that shape these allocation calls. Arguably, allocation decisions are the most important investment decisions over the long term. Get your asset class right and stay within the lines and you will outperform.
Today we post an article from the always insightful and industry respected Barron’s, authored by the extremely knowledgeable and a friend of Emerging Money, Craig Mellow, entitled “Five Reasons Why EM May be Overhyped”. The article discusses views from the investment community on the state of investing in EM equities at this point in the rally. Barron’s has raised some important points about perennial and current reasons for caution on EM right now.
We wanted to present the article then give our counter to each of the five arguments made regarding caution on EM after a big move.
Here is what Barron’s wrote:
5 Reasons to Doubt the Rally
Skeptics warn investors that developing markets still hold dangers.
Nothing succeeds like success, especially on Wall Street. A 27% surge this year in the major emerging markets index has brought out a flock of analysts to explain why the developing world is back to stay as an outperformer. Not everyone agrees, though. Before you jump on the bandwagon, it might be wise to consider these five die-hard emerging market bear arguments.
. As President Xi Jinping nears the end of his first five-year term, his promised structural changes have proved a nothing burger, says J.P. Smith, a former Deutsche Bank and Pictet emerging markets analyst who now runs Ecstrat, a political and global markets consultant in London. State-owned enterprises and the financial system that feeds them are as bloated and opaque as ever. “We’ve seen bailout after bailout, and the underlying debt system is very fragile,” says Smith.
Xi goosed China’s gross-domestic-product growth a bit with new government stimulus that is turning to tightening, adds David Donabedian, Baltimore-based chief investment officer at CIBC Atlantic Trust, which manages $40 billion in private wealth. China accounts for 29% of the global emerging markets index itself, and drags along smaller economies that sell it commodities. So a downturn there would rock the whole asset class.
The Dollar Has Hit Bottom. Impotence in Washington has driven the greenback’s trade-weighted value down more than 8% this year, creating a bonanza for ex-U.S. investments. But it may steady or rebound from here. The Federal Reserve had a muscular Sept. 20 meeting, reiterating tightening pledges and committing at last to balance-sheet reduction. The euro’s short-lived luster meanwhile faded, thanks to Angela Merkel’s underperformance in German elections. “[Emmanuel] Macron’s victory in France revived talk of a more cohesive euro zone, but that isn’t going to happen after Germany,” Smith says. The dollar gains by default as a global safe-harbor currency.
Low Valuations Are an Illusion. The average trailing price/earnings ratio for the MSCI Emerging Markets Index is still less than 16, compared with 25 for the Standard & Poor’s 500 index of U.S. stocks. But for many of the state-owned whales that dominate emerging markets—think Chinese banks or Russian oil companies—“there is no reason to believe the E,” Donabedian says. More-transparent private-sector companies that are firmly linked to the great middle-class growth story already trade at P/Es above 20, he notes.
Governance Still Stinks. Emerging market governments have made impressive strides on macro fiscal and monetary policy—arguably more impressive than their highly developed brethren. But corporate governance often remains a black hole down which investors throw their money and hope for the best. “Everybody likes to talk about high-quality emerging market companies, but there may be, like, two of them,” says Richard Bernstein, who runs his own investment advisory and made a prescient bear call in Barron’s in 2011. Bernstein is tactically overweight on emerging markets “as a cyclical beta play on global profit acceleration.” But he rejects arguments that they’ve improved structurally.
India Can’t Do It Alone. Even bears are more hopeful for Narendra Modi’s India than for its fellow BRICs (Brazil, Russia, and China). But Indian equities make up less than 9% of the global emerging markets index, not enough to bolster the asset class against a broad sentiment shift. And Mumbai markets are already “priced for perfection,” Donabedian says, a term that seems out of place in a chaotic nation of 1.2 billion.
There are many sides to the EM investment thesis and there are always dynamics that will have more or less validity depending on where we are in the cycle. Based on prevailing conditions and our view of longer term trends, here are our responses to the Barron’s points:
There Is No China Reform: Investors don’t understand China’s policy reality and requirements and nowhere on their radar is traditional liberal democratic reform, nor should it be. China is successfully slowly shifting to a consumption economy. The numbers are clear. China’s consumption as a % of GDP is >10% higher than it was 10yrs ago. Also, the current Debt/GDP trend trajectory in the USA is worse than China.
The Dollar Has Hit Bottom: We believe the Dollar found a definite ST to MT bottom on the German elections when we were suddenly reminded that political consensus in Europe is not clear, and that fiscal union will always be a challenge. The Fed has re-engaged recently as US labor, ISM, leading indicators provide a foundation for the Dollar’s oversold condition to correct. Having said all that, it is difficult to see the Dollar breaking above 97.50 on the DXY without some major change in the Fed’s approach. The bigger issue for EM and the Dollar however is that EM got destroyed when the Dollar was weak AND the when Dollar was strong. Its not an inverse linear rule of law how EM and the USD interact. See chart below. QE 1-QE3 was in no way a boon for EM assets. The weaker Dollar was perceived to be due to a recessionary backdrop thus bad for EM, which in a circular flow then had the Fed put the pedal to the metal, which in turn pushed the Dollar lower. During this period from 2012-2014 EM moved aggressively lower.
Low Valuations Are an Illusion: No doubt Petrobras, Gazprom and Sinopec et al weigh down the P/E of the asset class. But we think, for every SOE weighting down the P/E in MSCI EM there is a higher growth story as a counterbalance. And we see the same in the SPX. Apple skews the SPX P/E downward as well. On a relative basis to the P/E of the SPX/EM is near a 2SD moment. That’s all that matters in terms of global allocation.
Governance Still Stinks: Do we really think that any company that needs to compete in capital markets can have poor governance, anywhere in the world? Do we really think that high growth cowboy E&P companies in the US O&G patch are examples of pristine governance?? EM corporate governance is in most cases is no different than that of DM companies around the world. I would argue the company size and regulation requirements have as much to do with the behavior as the motivation of management. Some EM companies are not required to live by the same regs as western companies and thus do not have the same approach. Any EM company, however that seeks access to western capital and global institutions must maintain the same governance score as a developed market company or risk being shut out. If they can’t afford to be shut out they will be as accommodating on governance as required by the market.
India Can’t Do It Alone: India has always been priced to perfection and a place where tourists to the EM asset class have felt most secure in their investments because of perceived best demographics/governance. This is a misperception.
So there you have it. Let the debate continue on as there should always be a healthy dose of cynicism and risk review of EM equities. In closing we are not dismissive to many risks that confront not only EM equities but global equities at this point in a 9 year bull market with central banks lurking to normalize policy. Our core view however, is that the move in EM is a small bounce after 6.5 years of massive underperformance that was not entirely justified, but also where we have seen major fiscal adjustments in the EM currencies and economies leaving the asset class in a different place relative to DM equities than we have seen in multiple years.