Focal Point the Fifth Element Renaissance Capital Investment Summary 12 June 2017
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Focal Point The Fifth Element Renaissance Capital Investment summary 12 June 2017 The Focal Point No, we’re not referring to Quintessence, Boron, or the film by Luc Besson, or even the Daniel Salter album by Bounty Killer. The Fifth Element that we are adding to our top-down asset +44 (207) 005-7824 allocation model for emerging market (EM) equities is the interest rate cycle – [email protected] alongside GDP acceleration, credit acceleration, real effective exchange rate (REER) Charles Robertson currency valuation and scope for credit rating upgrades. Vikram Lopez shows that interest +44 (207) 005-7835 rate cuts tend to coincide with periods of EM country outperformance (for more on this, [email protected] see p. 77). Vikram Lopez +44 (207) 005-7974 EM equities are benefitting from global tailwinds which could continue through [email protected] year-end – although following MSCI EM’s 17% US dollar return over the first five months Yvonne Mhango of the year, and with several global lead indicators having rolled over (albeit from strong +27 (11) 750-1488 levels), we would expect the pace of returns to slow and to be interspersed with [email protected] occasional profit taking. The eight-year bull market in developed markets (DM) has been Oleg Kouzmin a pain trade for a sceptical investor base, and we see EM’s 18-month old bull market as +7 (495)258-7770 x4506 having similar characteristics. [email protected] Despite strong performance YtD, EM equities have yet to fully close their US Research analysts election-related underperformance vs DM. Fears of overt protectionism, so-called ‘Trumpflation’ (and the associated strong dollar, higher bond yields and rapid Fed hikes) have subsided. With US stocks appearing priced for perfection (on 18x 12M FWD P/E vs a 10-year average of 14x) the upwards pull on EM valuations (with EM on 12x vs a 10- year average of 11x) is there, but so is a potential external correction source. Frontier is cheaper still (on 11x) but is failing to attract the ETF flows that have buoyed EM (which has 30x better liquidity). Meanwhile, the EMBI global debt spread of 322 points has tightened significantly from November’s 407 peak, but is still not as tight as the 240-point post global financial crisis (GFC) low. And EM’s 12.3x 12M FWD P/E multiple has yet to breach the post-2010 high of 12.8x (in April 2015). Consensus now expects the strongest EPS growth in EM since 2010, of 28%. The IMF’s recently published World Economic Outlook points to 2017 being the second year of relative economic acceleration for EMs vs DMs, a trend which the IMF believes is likely to continue for several years to come. Global growth in 2017 is also likely to be much more synchronised with all of the world’s top 40 economies expected to grow this year, for the first time since 2007. World trade growth is currently 1.4% YoY (on a three- month moving average basis) and though off recent highs appears to have broken out of its sluggish 0.5% rate of 2011-2016. The global manufacturing PMI of 52.6 for May is well into expansion territory and EM current account deficits have been reduced significantly from 2012-2013 peaks, suggesting greater resilience to gradually tighter global monetary policy. Meanwhile, the market’s re-assessment of the Trump administration’s ability to streamline passing legislation and willingness to engage in damaging trade wars has put an end to the dollar rally, put a lid on US inflation expectations and with it US bond yields, helping global markets (so far) to rally. Futures suggest just one-to-two further Fed hikes by year-end, while ECB President Mario Draghi is “firmly convinced that an extraordinary amount of monetary policy support is still necessary” (and Brexit argues for a focus on growth by EU policymakers). The IMF’s expected global growth of 3.5-3.7% in 2017-2019, includes a gradual acceleration, but not to the kind of pace which would suggest the kind of commodity/inflation spike that we saw in 2007-2008 as the world “ran out” of oil and other commodities after annual average growth exceeded 5% pa over 2004-2007. Energy and materials make up just 14% of MSCI EM (IT and telecoms are twice as important) but 24% of MSCI EMEA. EM can manage gradual Fed hikes: between 2004 and 2006 the Fed hiked rates from 1% to 5.25% in a period of major outperformance for EM equities. Range-bound oil is a positive for reform in energy exporters (and good for global inflation). And, although the US expansion is now much longer in duration than the average post 1945, cumulative real GDP growth in the current expansion is still below the average (17% vs 25%): the window is thus still open for EM, 2 Renaissance Capital 12 June 2017 The Focal Point we believe, and we may yet be a year or so away from the next major US equity sell-off. Our work shows that it is when US CPI hits 3% (currently 2.2%) that we believe investors should prepare to take money off the table in EM. After a long period of EM underperformance (as EM economies slowed relative to DM), portfolio flows are returning. According to the Institute of International Finance, cross-border flows in to EM bonds and equities exceeded $20bn for the third consecutive month in April (a record since 2014). EPFR data show that EM equity funds have seen inflows of $28bn in 2017 YtD, with EM debt funds receiving inflows of $33bn. But the recent inflow comes after $155bn of outflows from EM equity funds over 2013-2016, and to date, just $37bn has returned (less than one quarter of the outflow). Debt funds have seen 85% of their 2013-2016 outflows return, suggesting EM debt flows may be more mature. In conclusion, the EM drivers are a combination of a cyclical upturn globally, with more synchronised global growth, and benign inflation giving central banks wiggle room; improved EM growth relative to DM, as well as an earnings pick-up and returning flows. To be sure, EMs are not without their challenges. Considering the BRICS, Brazil and Russia are still struggling with low growth, Brazil has fallen in to a new political crisis and hopes for an easing of sanctions on Russia have faded; South Africa’s lacklustre economy fell into its second recession in eight years in 1Q17, and political challenges remain unresolved; while China’s attempts to slow the housing market and tackle the shadow banking system risk slower growth and increased volatility. Meanwhile, Indian bank lending has now dropped to the slowest pace in 63 years. That said, both Brazil and Russia are exiting multi-year recessions, China is unlikely to want (and has the tools to prevent) growth being hit too much ahead of October’s 19th National Communist Party Congress, and South Africa’s political issues could yet see more market-friendly ANC leadership (or failing that, the 2019 polls could lead to change). The IMF expects India’s growth to exceed China’s for the third year running in 2017 (and to accelerate for the next five years). We look for exposure to seven main themes in EMEA and FM: . Economic recovery stories in 2017 and 2018: For 2017, that suggests to us Russia, Greece, Hungary, Qatar and Poland within EMEA. Argentina, Morocco, Nigeria (at least according to IMF data), Kazakhstan, Pakistan and Vietnam in Frontier. For 2018 though, the list changes somewhat, with UAE, Egypt, Turkey, South Africa and Greece leading the pack in EM, and Kuwait, Oman, Nigeria, Kazakhstan, Saudi Arabia and Kenya in Frontier. Cheap currencies: In EMEA, Egypt remains one of the cheapest currencies in our 20-year REER model (with Colombia and Mexico also looking cheap). South Africa (5% cheap), Greece (2.2%) and Turkey (3%) are just slightly cheap and some would argue ought to be cheap given political issues; while in Frontier, Tunisia and Kazakhstan have cheap currencies, as apparently does Argentina using official CPI data (though using an alternate CPI history may make it slightly expensive), with Serbia (8%) and Senegal (4%) on the cheap side of fair value. Morocco is close to fair value. Potential upgrade stories: We see the Czech Republic and Greece, as potential credit upgrade stories in 2017, with Egypt also a potential upgrade story (but only towards year-end) in EMEA, Argentina in Frontier. Bank lending acceleration: We see Hungary, Russia, Turkey and Greece well placed within EMEA, and Kazakhstan, Romania and Pakistan within Frontier. 3 Renaissance Capital 12 June 2017 The Focal Point . Scope for rate cuts: With Russia, Turkey (as inflation eases in 2H) and Egypt (perhaps by year-end) as candidates to cut rates in EMEA, and Kazakhstan, Argentina and Kenya in Frontier. Exposure to the EU rebound: Poland, Czech, Hungary and Turkey (and perhaps Greece) we see as particular beneficiaries of an improving Eurozone economy. Romania, Morocco and the smaller EU markets in Frontier. Idiosyncratic stories: e.g. MSCI inclusion – on the positive side, Argentina (which we see as a strong candidate for inclusion in MSCI EM - we should find out the results of MSCI’s review on 20 June); and less positively Pakistan (which has already transitioned from MSCI FM to MSCI EM at end-May, and where we see Frontier funds as likely to be net sellers, with EM investors taking their time to learn a small, volatile, new market, despite the striking discount to neighbouring India: 11.0x vs 17.3x for India on a 12M FWD P/E basis).