GEMOLOGIST Paradise, purgatory or the pit: what can DM managers learn from EM managers about forecasting?
Gary Greenberg, CFA Head of Hermes Emerging Markets
Hermes Emerging Markets Newsletter Q2 2017
For professional investors only www.hermes-investment.com 2 GEMOLOGIST PARADISE, PURGATORY OR THE PIT PARADISE, PURGATORY OR THE PIT: WHAT CAN DM MANAGERS LEARN FROM EM MANAGERS ABOUT FORECASTING?
The cracks in the global economic WHAT TWO WORLD WARS AND DONALD firmament, while real, are unlikely TRUMP TELL US ABOUT THE MARKET’S to bring the sky crashing down right PREDICTIVE POWERS There’s a widely held belief that the financial markets are prescient, away. Institutions are resilient, and the current consensus view is that the post-US election bull having been strengthened throughout market heralds a bright economic future. But a careful look at the decades of exercising power, but the performance of the German stock market in the 1930s and 1940s should provoke questions about the assumed infallibility of markets problems in the developed world will (see figure 1). foment in the years to come and Figure 1. Blitz then bust: performance of the German stock market, 1930-1950 manifest as significant investment risks. 12 Prices frozen This results in a comparatively upbeat 11 Barbarossa view of emerging markets – however, 10 Battle of Britain Market closed Stalingrad August 1944 if developed markets collapse, 9 Blitzkrieg euphoria 8 all bets are off anyway. Worries that 7 Hitler comes Hitler has gone too far 6 to power
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4 KEY POINTS 3 Market closed due to credit crisis 2 1931 1941 1937 1947 1932 1935 1942 1933 1945 1939 1950 1936 1934 1943 1938 1949 1930 1946 1944 1948 1940
uuCan financial markets predict the future? Source: “Wealth, War and Wisdom” by Barton Biggs, published by Wiley in 2008 During some pivotal episodes in modern history, investors have collectively made disastrously wrong The rise of the market in the early and mid-1930s made sense – in forecasts. Hollywood, meanwhile, has envisaged events financial terms, at least, despite the horrific events in store – as Hitler to come with more clarity had found a way to revive industrial production and boost uuAfter more than three decades, the largely benign employment. The market rose through the Anschluss of Austria and macroeconomic environment in developed markets invasion of Czechoslovakia, and became euphoric throughout the seems to be changing for the worse. This requires blitzkrieg. Finally, during the siege of Stalingrad, when things started investors to dust off old analytical toolkits still used by going south, badly, prices were frozen. And when the market reopened emerging markets managers for top-down research in 1948, valuations reflected the ruination of much of Europe.
uuWe illustrate how top-down analysis can inform a But it wasn’t only German investors who failed to see clearly in the fog bottom-up stock portfolio and provide an emerging of war. After World War I started, it took US investors two years to markets outlook for the next two years – which seems realise that the effects would be felt outside Europe (see figure 2). calm relative to the tumult of the world political economy HERMES EMERGING MARKETS 3 NEWSLETTER Q2 2017
Figure 2. The US market took two years to figure out that WWI is a disaster MACRO RISK RETURNS 14.0 6.0 TO DEVELOPED MARKETS Assassination of 12.0 4.0 Duke Ferdinand Some investors may say that EM managers have nothing to teach 10.0 2.0 DM managers. After all, advanced bottom-up analysis can be applied
8.0 0.0 to greater effect in DMs than in the emerging world, with the ravages % of the Great Depression, two world wars and the 1970s oil crises being 6.0 -2.0 distant memories and the 2008 financial crisis seen as a rare 4.0 -4.0 meltdown. Therefore many DM specialists sideline top-down analysis. 2.0 -6.0 As Peter Lynch, a fund manager famous for his track record of 0.0 -8.0 outperformance against the S&P500 from 1977 to 1990, remarked: “If you spend 13 minutes analysing economic and market forecasts, Oct 1913 Oct 1914 Oct 1915 Oct 1916 Apr 1913 Apr 1914 Apr 1915 Apr 1916 Apr 1917 Jun 1913 Jun 1914 Jun 1915 Jun 1916 Jun 1917 Feb 1913 Feb 1914 Feb 1915 Feb 1916 Feb 1917 Dec 1912 Dec 1913 Dec 1914 Dec 1915 Dec 1916 Aug 1913 Aug 1914 Aug 1915 Aug 1916 Aug 1917 you’ve wasted 10 minutes.” S&P LHS ERP LHS SPX 3MMA Change (%) How has such a view been working out for DM managers? Very well, it Source: Robert Shiller, Macquarie Research as at February 2017 turns out. Ignoring macro has been a fantastic approach – not because macro hasn’t mattered, but because it’s been very supportive of So, given these telling instances of the market being wrong-footed by market performance. Over the past 30 years, the maximum span of major historical events, investors in search of an oracle may be better many investment careers, the developed-world index has been served by cosmic synchronicity – or Hollywood. In Back to the Future II, compounding at 5% a year, accumulating to 400% for the period. released in 1989, the local bully, Biff Tannen, makes a fortune at the Take out Japan, which has returned nothing, and the numbers look race track, uses it exclusively and unashamedly for himself to build a even better, with the S&P500 compounding at nearly 8% a year. It gambling empire, and publicly advocates plastic surgery by pointing to would seem that the Philosopher’s Stone, which can turn base metals the women in his family as case studies. Biff uses the profits from his into gold, might exist after all. In truth, however, positive forces of 27-floor casino to gain political power, turning Hill Valley into a finance rather than alchemy have been at work. lawless, dystopian wasteland where hooliganism reigns, dissent is crushed and propaganda hails Biff as America’s greatest living folk Three powerful tailwinds have supported DM stock returns: hero. Shortly after the US presidential election, Bob Gale, the film’s corporate tax rates, interest charges and the rate used to discount screenwriter, revealed that he had modeled Biff the gambling mogul corporate cash flows have all fallen substantially and steadily on a real-life 1980s New York real-estate mogul: Donald Trump. throughout this period.
So here we are, back in the future! Although descending into the pit, Since peaking in 1981, US 10-year bond yields, which determine the like Hill Valley, is only one possible future for the US, the risk of risk-free rate of return, have declined steadily from 15.8% to the American society unravelling is becoming all too real. Sadly, this current level of 2.4%. Equity-market valuations have moved by a problem also extends to other major developed economies, which similar extent, though in the opposite direction (see figure 3). brings us to the chief question we aim to answer in this issue of Figure 3. The S&P500 has re-rated substantially as interest rates fell Gemologist: what can developed market (DM) managers can learn from emerging market (EM) managers? S&P 500 Trailing P/E Ratio vs US 10 year generic bond yield Feb 1977 to Feb 2017 30 20
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Many DM specialists P/E Ratio 15
5 sideline top-down analysis. 10
As Peter Lynch, a fund manager 5 0
famous for his track record Feb 11 Feb 17 Feb 15 Feb 77 Feb 13 Feb 91 Feb 81 Feb 01 Feb 97 Feb 79 Feb 87 Feb 07 Feb 95 Feb 85 Feb 93 Feb 99 Feb 05 Feb 83 Feb 89 Feb 03 Feb 09 of outperformance against S&P 500 US Generic Govt 10 Year Yield the S&P500, remarked: Source: Bloomberg as at March 2017 “If you spend 13 minutes analysing economic and market forecasts, you’ve wasted 10 minutes.” 4 GEMOLOGIST PARADISE, PURGATORY OR THE PIT
This decline in the 10-year bond yield is significant because the risk- demographics and weak demand growth, have not been needed to free rate is one of the key determinants of the value of a security, fund capacity expansion and have therefore been available to buy back discounting the cash flow of the underlying company. The risk-free shares. In turn, this has boosted earnings per share and therefore rate is the main component of the denominator, and it is obvious that valuations and, coincidentally, c-suite compensation. a number divided by 15.8 will be a whole lot less than the same number by 2.4! In effect, the rate used to discount cash flows has Little wonder few in DM pay a lot of attention to macro risk. The dropped by 85%, boosting valuations significantly. In the US market, tailwinds of lower and lower tax, discount and corporate interest rates the trailing price-to-earnings (P/E) ratio has almost tripled from less have bailed out investors during volatile periods in the last 30 years. than 8x in 1981 to nearly 22x today – despite Black Monday, the Naive optimism has been a winning investment philosophy. US Russian and Asian currency crises, the dotcom bubble and the 2008 investors, especially those who have never experienced an financial crash. environment with rising tax, discount or corporate interest rates can be forgiven for assuming that this is a normal state of affairs.1 Even better, in 1980 the top US marginal personal tax rate was 70%, which declined to 50% in 1986 and is 39% today. For corporates, the This paints a picture of DMs in the past 30 years as being reminiscent of top tax rate has fallen from 46% in 1980 to 35% today. In addition, a bucolic Thomas Gainsborough landscape piece. In contrast, EMs have the interest rate that businesses pay has dropped in line with the more closely resembled the world of Hieronymus Bosch (in whose time, discount rate, further boosting net profits. And the icing on the cake outcomes for all people were limited to three) (see figure 4). has been that the tax and interest rate benefits, given aging
Figure 4. Worlds apart: the contrast between DM and EM macro environments for the past 30 years This paints a picture of DMs in the past 30 years as being reminiscent of a bucolic Thomas Gainsborough landscape piece. In contrast, EMs have more closely resembled the world of Hieronymus Bosch.
Thomas Gainsborough, Landschaft mit dem Dorfe Cornard
Source: Wikipedia Commons, accessed March 2017. “Landschaft mit dem Dorfe Cornard”, by Thomas Gainsborough, was created in the third quarter of the 18th century. “The Garden of Earthly Delights”, by Hieronymous Bosch, was created between 1480 Hieronymus Bosch, The Garden of Earthly Delights and 1505
1 However, one important tailwind that has been missing is improved profitability. Returns to capital in DMs have moved with the cycle but don’t support the steady upward progression of P/E ratios. Over this 30 year period, DM return on equity has averaged 13%, ranging from 2.9% to 19%, but has failed to exhibit any clear upward trend. HERMES EMERGING MARKETS 5 NEWSLETTER Q2 2017
USING MACRO TOOLS There is no doubt that DM TO DEAL WITH COMPLEXITY economies have traditionally As EM managers, we use tools like foreign-exchange forecasting, boasted substantial advantages: sector, industry and country analyses to assess the relative merits of the markets we invest in. Given the currency volatility we face, it is stable institutions, responsible clear that the exchange rate is an important component of returns. leadership, a liberal press and That is not to say it is easy to forecast, especially on a short-term basis. Over the longer term, however, there are valuable clues: inflation more highly educated differentials affect relative competitiveness, which eventually has an workforces. But many of these, effect on exchange rates. And given that nearly all of our investors are which DM investors have long based in what are currently low-inflation economies and hard currencies, this matters. taken for granted, are no longer the certainties they once were. Industry and sector outlooks also matter. Understanding the dynamics of an industry is crucial to understanding the fundamentals of companies within it. But the winner in a bad sector might outperform its peers and still be a poor performer in absolute terms. So while industry expertise is vital to company analysis, not all industry In EMs, the tailwinds have come and gone, but they’ve been prospects are equal. Some industries may underperform for decades, interspersed with buffeting headwinds. EM institutions have lacked the or simply disappear. strength and sophistication to steer a steady course of economic growth, resulting in a series of crises from which recovery has been While industry analysis is actively and expertly practiced by many DM difficult and precipitated radical policy shifts. The Tequila, Asian, investors, macro modeling for equity portfolios has largely fallen by Russian and current Venezuelan crises all resulted or likely will result in the wayside. Of course, there are excellent reasons for this: 27 dramatic economic restructuring. European countries have tied their economic fortunes together, and the remainder of the developed world has targeted the same low- EMs mirror DMs in their least positive aspect, unfortunately: inflation, globalised policy framework. Therefore DMs display far more profitability fails to show any clear secular improvement. What we can economic homogeneity than emerging. And most of the world’s say in defence of EM, though, is that the absence of long-term multiple largest companies, be they American, French, Japanese or British, expansion means that prospects for businesses are more sober, operate across international borders, many with little home-country especially compared to those of the FANGS – Facebook, Amazon, revenue bias, further homogenising the global economy. Netflix, Google, Snap and the like. But recent events in the developed world are challenging this global There is no doubt that DM economies have traditionally boasted order, which has presided since the end of the Cold War. Of course, substantial advantages: stable institutions, responsible leadership, a while right-wing populism is gaining momentum in the US and liberal press and more highly educated workforces. But many of these, Western Europe, it has yet to become firmly established as institutions which DM investors have long taken for granted, are no longer the remain strong and will not give up ground easily. This is an area where, certainties they once were. sadly, EMs are much further ‘advanced’, with nearly 45% of the benchmark consisting of single-party or illiberal democracies. Not only are DMs’ tailwinds flagging, the rise of populism threatens Autocracies, in the long run anyway, aren’t good for growth: the the fabric of civil society and widespread social cohesion on which economic problem with this type of political leadership is the absence commerce is based. In the US, for example, tax cuts funded by cutting of debate, often resulting in poor decisions by leaders. Of course, bad health care for low-income earners, the Environmental Protection macro decisions are not exclusive to authoritarian EM regimes, but Agency and the Food and Drug Administration will only be tolerated meagre growth rates in Russia, Turkey and Venezuela, and the debt, for so long until the white working class realises it has been had, and pollution and overcapacity crises that China is starting to face, follows its initial revolt against the political class – voting for Trump – highlight the problems that can result. in an even more revolting manner.
Even if we ignore the probability that the new US president has held inappropriate communications with Russia, Trump has jettisoned decorum and probity from the highest office in the land. He is failing to separate his business interests from his management of the country, throws racial slurs against judges and seems almost eager to abrogate the duties of government to protect minorities, the environment, and small-scale savers. They say populists campaign from the left, championing the rights of everyday workers, and govern from the right. This has been typical of populist leaders in EMs, like Juan Perón of Argentina. Trump was elected on a platform of nativism and the rejection of official institutions. Germany, France, Greece and Italy face similar populist challenges, which leads us to say, with some regret, that we are all in EMs now. 6 GEMOLOGIST PARADISE, PURGATORY OR THE PIT
After all, autocracies soon turn into kleptocracies, and kleptocracies are reforms and the trajectory of interest-rate cuts. All of these have barren environments for foreign minority investors. This highlights the significant implications for the discount rate, corporate profits and necessity of understanding the direction of travel in countries where equity valuations. Will rate cuts continue? With interest rates of nearly divergent economic policies can create wildly different economic 14% for borrowers in Brazil, another 300bps decline will make a huge outcomes. Economics drives politics, but politics also drives economic difference in the denominator used to discount future cash flows. policy. And policy errors can cause wild swings in exchange rates, crowd out private borrowing and result in currency shocks – such as Similarly, exchange-rate movements are examined and assessed what occurred recently in India – all of which have noticeable effects because they have obvious implications for returns. UK investors on hard-currency returns. There isn’t much to choose from between buying domestic stocks don’t need to think much about sterling, the economic outlooks or policies of Taiwan and Korea, but the except so far as export revenues and import costs are concerned, but difference between the outlook and policy frameworks of these those investing in Brazil have watched the real depreciate 61% since countries and Turkey or South Africa is, as we say, chalk and cheese. the taper tantrum in 2013 and then soar by 68% by the end of February (see figure 5). In the developed world, political paradigms are now diverging as populist leaders question the viability of the European Union, the North Atlantic Treaty Organisation (NATO), the World Trade Organisation, and the independence of central banks. In effect, they are kicking out the institutional underpinnings of the current world order. And the tools of country and currency analysis, which lie In the developed world, political untouched on the bookshelves of developed-world investors, may paradigms are now diverging as need to be dusted off. populist leaders question the Let’s examine how they could be applied. For instance, if Italian viability of the European Union, the economic policy became independent of Brussels, the cost of capital of Italian assets would certainly go up. Interest rates, exchange rates, and North Atlantic Treaty Organisation, growth rates would all become ‘liberated’, meaning a new and the World Trade Organisation, and challenging dimension would need to be assessed, discounted, and the independence of central banks. incorporated into the bottom-up analysis of stocks. In effect, they are kicking out the Similarly, EM managers looking at Brazil have been assessing the institutional underpinnings of the implications of an indictment of President Temer on corruption charges, and what this might mean for the passage of critical pension current world order.
Figure 5. Huge swings in Brazilian real certainly impact returns
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-60 Jul 11 Jul 12 Jul 15 Jul 13 Jul 16 Jul 14 Jan 17 Jan 12 Jan 15 Jan 13 Jan 16 Jan 14 Sep 11 Sep 12 Sep 15 Sep 13 Sep 16 Sep 14 Mar 12 Mar 15 Nov 11 Mar 13 Mar 16 Mar 14 May 11 Nov 12 Nov 15 Nov 13 Nov 16 May 12 May 15 Nov 14 May 13 May 16 May 14 Cumulative Spot Exchange Rate Return %
Source: Bloomberg as at March 2017 HERMES EMERGING MARKETS 7 NEWSLETTER Q2 2017
Figure 6. No credit impulse visible anywhere
% GDP % GDP % GDP 5 US 5 China 5 Japan 4 4 4 3 3 3 2 2 2 1 1 1 0 0 0 -1 -1 -1 -2 -2 -2 -3 -3 -3 -4 -4 -4 -5 -5 -5 -6 -6 -6 -7 -7 -7 93 95 97 99 01 03 05 07 09 11 13 15 17 93 95 97 99 01 03 05 07 09 11 13 15 17 93 95 97 99 01 03 05 07 09 11 13 15 17 US China Japan
% GDP % GDP % GDP 5 Germany 5 India 5 UK 4 4 4 3 3 3 2 2 2 1 1 1 0 0 0 -1 -1 -1 -2 -2 -2 -3 -3 -3 -4 -4 -4 -5 -5 -5 -6 -6 -6 -7 -7 -7 93 95 97 99 01 03 05 07 09 11 13 15 17 93 95 97 99 01 03 05 07 09 11 13 15 17 93 95 97 99 01 03 05 07 09 11 13 15 17 Germany India UK
Source: Bloomberg as at March 2017
Are these currency swings predictable? Possibly. Do they impact But how about those animal spirits? One driver that tends to returns? Definitely. Is this relevant to DM? Yes. A break-up of the euro, accelerate economic activity is the cost of debt, and low interest rates, the dissolution of NATO, the US’s abrogation of the North American when investment opportunities abound, can spark an acceleration in Free Trade Agreement and threatened withdrawal from the WTO – investment and spending. Might corporations jump on the once-in-a- any of these events would introduce currency volatility that could call lifetime opportunity to take out cheap loans and embark, as Jeff into question many of the valuation assumptions and methodologies Immelt, CEO of GE, suggests, on massive investment programmes to in vogue today. expand capacity, create jobs and make America (and maybe by extension Europe and the rest of the world) great again? But what is the likelihood of these disruptive events occurring, and what should investors do about it – short of buying a beautiful lakeside Well, one way to judge whether this is actually happening, as opposed property in New Zealand (like billionaire Trump supporter Peter Theil)? to being merely promised, is to look for an acceleration in lending, commonly known as the credit impulse. Alas, across the world, it is The consensus view is that the world is reflating and growth is moribund, having even faded in China, a source of massive stimulus for resuming after a number of sub-par years, thanks to the animal spirits the past several years (see figure 6). unleashed by that witch doctor in the White House and his pledges of fiscal stimulus. As evidenced by new all-time highs on the US indices, happy days are apparently here again. And by happy coincidence, China is supposedly reflating, reforming, and re-accelerating. US infrastructure renewal is not likely In our view, none of this is, as some market participants say, bankable. to begin before 2019, if ever, and US infrastructure renewal is not likely to begin before 2019, if ever, and probably wouldn’t provide much stimulus even if it does. Tax cuts, a probably wouldn’t provide much stimulus perennial investor favourite, will require draconian cuts to government even if it does. Tax cuts, a perennial agencies, health care, social security, and environmental protection measures to pay for them. This will not endear the Congress to its white investor favorite, will require draconian working-class constituents. Of course the high earners won’t complain cuts to government agencies, health care, (and they won’t hear the cries from the working class in their bolt holes in the antipodes anyway!). Protectionism has been already tried and has social security, and environmental failed, and will compound the woes of Trump’s gullible constituency. protection measures to pay for them. 8 GEMOLOGIST PARADISE, PURGATORY OR THE PIT
The causes of this catatonia are demography and disruption. As USING MACRO TOOLS TO ASSESS populations age, they may go to the cinema and frequent cafes more THE CURRENT EM OUTLOOK often, but they buy fewer goods. Millennials, meanwhile, don’t have enough money to consume much, so it’s down to the baby boomers Moving on to our actual area of expertise, EMs rose from a four-year to keep consumption, the primary engine of growth, running strong. bear market last year to post an 8.5% gain, and have built on this in But it wouldn’t take Warren Buffet to realise that aging boomers are 2017 so far, gaining 11.1% through to the end of March. The reasons entering a quiescent stage, and if they want to live as long as him, they for this recovery are primarily cyclical, and indeed performance has will have to go easy on the burgers and Cherry Cokes. And for been led by the energy and materials sectors, which have returned millennials, good jobs for humans are disappearing as computing 48% and 40% respectively since the beginning of 2016. power ramps up. Even in China and India, the factories we visit are Given China’s high level of indebtedness and highly unattractive mostly automated (of course, there is a selection bias here), and any incremental capital output ratio (it takes $7 of debt to generate $1 of manufacturing work that GE and other US multinationals brings back GDP growth), speculating on a fresh Chinese debt-fuelled stimulus to the US may spark keen headlines on Breitbart News, InfoWars, or looks foolish. But some businesses in China still look good, and the Fox News about jobs coming back home, but in reality most of the broader EM space, we believe, continues to offer value. And as new capacity will be automated. mentioned earlier, here we are focusing on the next year or two and Just like the savings made from lower taxes and interest rates, we assuming that the DM problems we outlined earlier take a little longer suspect most of the dollars that are repatriated in a tax amnesty will than that to manifest. end up being used to buy back shares, just like in 2004. Sure, lots of The headwinds facing EMs during their bear market have abated new factories with plenty of highly paid skilled workers are on their somewhat, and the new ones may be weaker than many people way but only, unfortunately, if you believe in an ‘alternative’ future. believe. A strong dollar is one of them. US dollar bull markets have averaged between six and seven years in length since 1975, and the current one will turn six in April (see figure 7). Also, a stronger dollar is A stronger dollar is inconsistent with inconsistent with bringing back manufacturing jobs to the US, since, according to Trump, the stronger dollar is “killing us”. bringing back manufacturing jobs to the US, since, according to Trump, the stronger dollar is “killing us”.
Figure 7. The current cycle for US dollar strength is mature
180 6 yrs 10 yrs 7 yrs 9.5 yrs 5 yrs +67% -47% +40% -39% 42%
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Trade-weighted US dollar First US rate hike of each tightening cycle Source: Credit Suisse as at March 2017 HERMES EMERGING MARKETS 9 NEWSLETTER Q2 2017
The fragile five – Brazil, Indonesia, India, Turkey, and South Africa – Therefore, with healthy external accounts and some normalisation aren’t so fragile any more. There has been a sharp improvement in the in DM economic activity, the outlook for EM economies is at least aggregate external position of EM economies, making them more stabilising, if not improving. We don’t think this is fully discounted, resilient to higher US rates. In 2013, the aggregate current account especially in EM currencies. For example, metals prices are often seen deficit of the fragile five was 4.5% of their GDP, making them highly as leading economic indicators, and they have bounced strongly. dependent on foreign capital and particularly vulnerable to a rise in US However, EM foreign-exchange markets have significantly lagged yields. The taper tantrum of that year hit these currencies hard. But the rally in metals (see figure 10). now their combined deficit has fallen to 1.5%, and US rates could probably rise another 1% before the most vulnerable EM countries Figure 10. Soon to close: the gap between EM currencies and metals have to start tightening their belts further (see figure 8). 970 55 920 53 Figure 8. US yields can gain 1% before EMs become vulnerable 870 51 2.5 0.0 820 49 -0.5 770 2.0 47 -1.0 720 1.5 45 670 Sample includes Brazil, India, -1.5 Indonesia,Turkey and South Africa 1.0 43 620 -2.0 % 41 570 0.5 -2.5 -3.0 39 520 0.0 Feb 14 Aug 14 Feb 15 Aug 15 Feb 16 Aug 16 Feb 17 -3.5 EM nominal foreign-exchange index (ex-China) (LHS) CRB Metals Index (RHS) -0.5 -4.0
-1.0 -4.5 Source: Credit Suisse as at March 2017 2009 2010 2011 2013 2014 2015 2017 EMs 6-month rolling current-account deficits as a % of GDP (RHS) 10-year TIPS yield with a 6-month lead (LHS) Commodity prices have largely recovered, and renewed Chinese Source: Credit Suisse as at February 2017 stimulus is unlikely, so betting on EM as a commodity punt should be seen as last year’s trade. In any case, resource stocks account for only 18% of the EM market, and resource-exporting countries only 42%. Of course, some rise in US rates is likely given wage pressures and low This means that the outlook for EM is more likely to be decided by other unemployment, but at least this is partially discounted, as shown by sectors – consumer staples, discretionary, IT, industrials and financials – the calm response of EM stock markets to the latest rise in the and by the other 58% of countries which import commodities. benchmark US interest rate. Here the analysis is also positive, though more nascent. From 2011 One important benefit of this decline in deficits is that the relationship through to 2015, EMs de-rated as their price-to-book valuations between DM bond yields and EM equities could revert to its historical dropped from 2.1x to 1.2x following a precipitous decline in return on norm: that is, a positive correlation between DM bond yields and EM equity (RoE) during the period, from 16.6% to 10.3%. What happened? equity performance (see figure 9). The majority of the decline in EM RoE was driven by a fall in margins, especially from the collapse in commodity prices, but this has started Figure 9. EMs’ positive correlation with US bond yields should return to improve and the RoE is now higher than that of DMs. 0.5 Of course, a lot of the margin recovery is linked with strengthening 0.3 resources prices. But there are also secular developments that signal improvements in corporate profitability. Indeed, we believe that we are 0.1 witnessing the beginning of a sustainable margin recovery among EM -0.1 companies (see figure 11).
-0.3 Figure 11. On the rise: EM corporate margins
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10 -0.7 2001 2003 2005 2008 2010 2012 2014 2017 9 EM relative performance and 12-month correlation with US 10-year bond yields
Source: Credit Suisse as at March 2017 8 % 7
Given the high operational leverage of EM economies, this makes 6 economic sense. As DM economies strengthen, their bond yields rise, 5 followed by EM exports. It was only after 2010, as EM current accounts 4 fell into large deficits as a result of the aftermath of the financial crisis, 1995 1998 2001 2004 2007 2010 2013 2016 that this correlation became negative. DM yields rising should now Predicted Actual result in EM equities outperforming. Source: Credit Suisse as at March 2017 10 GEMOLOGIST PARADISE, PURGATORY OR THE PIT
And if the global reflation theme is sustained, there is room for non- Figure 13. EM valuations relative to DM are at a 10-year low inflationary growth in EMs, where unemployment is now high relative 110 to history in many countries. In addition, the output gap of the region, according to estimates by the European Central Bank, has been in 100 negative territory since 2015. The output gap in developed countries, 90
in contrast, is in the process of closing. Therefore wage and inflation 80
pressures are beginning to diminish, providing relief for margins. % 70
Balance-sheet management is also improving. After periods of 60 euphoric over-investment in the late 1990s, early 2000s, and 2009-10, 50 the capital expenditure-to-sales ratio has been in steady decline, 40
though still somewhat higher than that of DMs (see figure 12). 1 20 1 1997 2017 2012 2015 2013 1999 2016 2014 1998 2001 2010 2007 2002 2005 2003 2009 2006 2004 2008 2000 Figure 12. Capital expenditure in EMs continues to decline EM sector-adjusted 12-month forward P/E relative to DM Average (+/- 1 standard deviation)
Capex/sales, ex-financials Source: Credit Suisse as at March 2017 16 15 14 13 Figure 14. Relative to US stocks, EM companies are very cheap 12 30 28.7x 11 % 10 25 9 8 7 20 6 5 15 1995 1998 2001 2004 2007 2010 2014 2017 DM EM China panic, stimulus added 10.2x 10 Source: Credit Suisse as at March 2017
5 2005 2006 2007 2009 2010 2011 2013 2014 2015 2017 This drop signals a decline in capital intensity, and therefore better US: Shiller P/E EM: Shiller P/E corporate free cash flow generation. It should lead to better capital structures and stronger potential returns to shareholders, which can Source: Credit Suisse as at March 2017 support a higher multiple for the market (see figure 12).
The sector – adjusted P/E ratio of EM has fallen back to its 10-year low compared with DM, so a recovery looks probable. And we should remember that EM equity valuations are depressed relative to the US on a Shiller P/E ratio basis. With a competitive RoE and improving capital discipline, there is certainly potential for this gap to close (see figure 13). Focusing on working capital
But what about flows? If bond yields are too low, capital won’t be analysis has its place, and may attracted to EMs. EM equities tend to follow bond spreads, and real be fine while a strong tide lifts all bond yields are high relative to their historical averages, meaning they should continue to attract capital. And we think EM equities boats as it has been doing for the are attractive relative to debt, the former having lagged the past 30 years in DMs. But as this latter recently. tide goes out, macro tools such as After the constructive returns of the last 14 months, investors may be those used by EM managers will concerned that the party is over. We don’t think so. Flows have not yet be increasingly useful in making turned significantly, and more than half of what entered EMs to drive its peak in 2013 has now left (see figure 14). sense of diverging market drivers. HERMES EMERGING MARKETS 11 NEWSLETTER Q2 2017
Figure 15. EMs: still a contrarian play
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-10 2001 2003 2005 2007 2009 2011 2013 2015 2017 Cumulative flows into EM equity funds, USD million
Source: Credit Suisse as at March 2017
Cumulative flows into EMs are 58% lower compared to their peak. Apart from brief periods in 2014 and 2016, outflows have been dominant since the taper tantrum. So EMs still qualify as a contrarian play, although the first 15% move has already taken place.
Spurred by a rebound in the commodity cycle, EMs are furthering their cyclical recovery with the prospect of better profitability, solid free cash flow generation and improved returns to shareholders.
EMs AND THE DOORS OF PERCEPTION Despite the manically positive market response to Trump’s victory, our view is that complexity is intensifying and policies are at risk of becoming chaotic. Focusing on working capital analysis has its place, and may be fine while a strong tide lifts all boats as it has been doing for the past 30 years in DMs. But as this tide goes out, macro tools such as those used by EM managers will be increasingly useful in making sense of diverging market drivers.
In this environment, EMs have the advantage of having already discounted much of this complexity, and many are reforming to strengthen their institutions and competitiveness. If the forces of light are able to contain the Biff Tannens of the world, the supportive cyclical and self-driven dynamics could make EMs an attractive destination for investment over the next several years. But it’s a dicey world, and as Jim Morrison said, after he woke up one morning and got himself a beer “the future’s uncertain and the end is always near”. HERMES INVESTMENT MANAGEMENT We are an asset manager with a difference. We believe that, while our primary purpose is to help savers and beneficiaries by providing world class active investment management and stewardship services, our role goes further. We believe we have a duty to deliver holistic returns – outcomes for our clients that go far beyond the financial – and consider the impact our decisions have on society, the environment and the wider world. Our goal is to help people invest better, retire better and create a better society for all.
Our investment solutions include: Why Hermes Emerging Markets? Private markets From top to bottom Infrastructure, Private Debt, Private Equity, Commercial and Bottom-up analysis finds quality companies trading at attractive residential real estate valuations. This is rooted in a top-down framework that identifies countries with conditions supportive of growth. High active share equities Asia, global emerging markets, Europe, US, global, and small Quality and safety and mid cap Buying quality companies at a discount gives a margin of safety in a volatile asset class. Credit Absolute return, global high yield, multi strategy, real estate Truly active management debt and direct lending A concentrated portfolio with a high active share, invested with a longterm perspective. Multi asset Multi asset inflation Experience and rigour Manager Gary Greenberg has three decades of investment Stewardship experience, and is supported by a team of six. Active engagement, advocacy, intelligent voting and sustainable development Integrated ESG Environmental, social and governance factors are integrated Offices into our analysis for a comprehensive view of risk. London | New York | Singapore Multi-cap The portfolio invests across the market cap spectrum, fully able to benefit from mid-cap exposure.
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