Emerging Market Equities: Sailing into headwinds
Top-down forces have been buffeting emerging markets for some years now, exacerbated by the threat of Fed ‘tapering’ in 2013. But Joseph Mariathasan finds these forces translating into stock-market performance and portfolio strategies in complex, often unexpected ways
Gaining exposure to economies that are rapidly becoming the major component of global GDP would appear to be a no-brainer – and that seems to be the position for institutional investors as well as everyone else. By November 2013, State Street Global Advisors had already received twice as many RFPs for emerging market equity mandates in 2013 as it had in 2011 and 2012, according to Gaurav Mallik, a senior member of the firm’s Global Active Quantitative Equity Team.
“The five billion emerging-world population is clearly growing faster than the developed world with long-term growth rates similar to Europe and the US in the years following 1945,” says Odile Lange Broussy of Lombard Odier Investment Managers. “A 20-year view, past and future, confirms that Europe is in decline and we expect that to continue. The US is rebounding, but much less vigorously than after previous recessions.”
But, as Lange Broussy concedes, the problem is that emerging market investors have gone through one of the worst periods of underperformance compared with developed markets of any point during the last two decades. Some of that – especially the volatility of 2013 – is no doubt due to the Federal Reserve’s proposed ‘tapering’ of its quantitative easing (QE) programme. But some of it is also due to concerns about the ability of these economies to continue to grow at the rate we have all become used to.
As Gary Greenberg, head of emerging markets at Hermes Fund Managers, puts it: “We would like the US Fed not to be so involved with the markets on a daily basis.”
How significant are these factors for individual stocks in individual markets? After all, one notable feature of recent volatility in emerging markets has been the dispersion of the response to macro shocks – the spectre of decreasing global US dollar liquidity has hit countries trying to fund current account deficits the hardest. And when it comes to longer-term growth, should a resources stock respond in the same way as a domestically-focused consumer staples stock or a semi-conductor exporter in Taiwan?
The fact is that emerging market stocks have been distinct from developed market stocks in the higher correlation they have exhibited with their local markets. Stock-level differentiation is less pronounced – country effects are significant and portfolio managers need to make a conscious decision on how much credence is given to these top-down factors alongside – and indeed as part of – their stock selection processes. But are macroeconomic factors exploitable, or just noise to be risk-managed or ignored?
In the very short run, Lange Broussy, like most fund managers, would argue that solid risk management is vital to survive volatile markets.
“Risk management, macro exposure and stock selection are the three keys in dealing with such periods,” she says. “We know that emerging currencies have a strong tendency to correlate in crises and that means that any investor’s biggest exposure, and therefore risk, is in their foreign exchange exposure.”
Central banks in the so called ‘fragile five’ of India, Indonesia, Brazil, South Africa and Turkey are faced with dilemmas as currency depreciation sets off inflationary pressures. Most would agree that Brazil should be lowering interest rates to support growth but is having to do the opposite to fight inflation, while the same is true in Indonesia and India.
Like many of his peers Greenberg is wary. “I am not brave enough to go way overweight any of the five,” he reveals. “Turkey, with a 7% current account deficit is particularly vulnerable.”
And yet there is no doubt that these countries also hold many attractive investment opportunities. Getting the right balance between macro factors and stock valuations is not easy: during 2013 the Indian rupee suffered a 20% depreciation as the local stock market hit an all-time high.
The objective for portfolio managers, as Lewis Kaufman at Thornburg Investment Management explains, is to find companies that can transcend the macro headwinds that constrain growth.
“Getting the trade-off right between consumption facing sectors versus non-consumption is key,” Kaufman says, pointing out that the GDP growth of the BRICs, that averaged 6.2% for a number of years, fell to around 4.6% in 2013. “Two-thirds of that decline has been caused by investment and one-third by consumption, even though consumption accounts for two-thirds of GDP in total. So consumption is slowing – but not so much as other parts of GDP. In the consumer-facing parts of GDP, it is still possible to find opportunities that can be attractive.”
Greenberg makes a similar point when he says that, while export sectors such as IT and pharma should benefit from the currency depreciation, those sectors rallied, leaving little further opportunity for investors. He adds: “More generally, with the western consumer now sated with over-consumption, I don’t see a great deal of hope for emerging market exporters other than to other emerging markets.”
There is more to macroeconomics than just currency effects. India and Indonesia are facing key political leadership changes and China is emerging from its November Plenary Session of the Communist Party Central Committee. The consensus is that all three present an opportunity for beneficial effects on growth and investment returns.
“What could shape the future of Asia for the next five years or more would be Narendra Modi coming into power in India in the early 2014 elections, the moves to a more efficient market-led economy in China by President Xi Jingping and the possible election of Jakarta governor Joko Widodo as Indonesia’s next president in the July/August 2014 elections,” says Rahul Chadha, co-CIO for Mirae Asset Global Investments. “Each leader is an epitome of hope for the youth of their respective countries.”
Greenberg says that even Russia is facing challenges that President Vladimir Putin seems to be grasping by creating a more investor-friendly environment.
“The Russian economy was tied to oil prices in Europe and growth is stopping,” he says. “The country may have to look for a different model and adapt. Putin needs to be able to deliver growth, just like in China.”
Greenberg argues that there are Russian companies capable of producing yields of 8-18%, even if they are not doing so at the moment, should pressure to return cash flow to shareholders rather than ploughing it into excess capex and the enormous kickbacks associated with such projects come to bear. In contrast, as Greenberg points out, President Dilma Rousseff of Brazil is moving in the opposite direction by introducing the less market-friendly measures that had originally been expected from her predecessor, Luiz Inácio Lula da Silva.
Hermes finds 25% of its performance can be attributed to top-down decisions and once a quarter it undertakes a top-down analysis, including quantitative modelling.
Kaufman is also an advocate of incorporating macro analysis. “I would never say we are solely bottom-up stock pickers,” he says. “There has to be a balance between the two. But there are always company-specific opportunities in tough places. This summer, Brazil went down 35% in dollar terms, so it may be a good time to buy into some company-specific opportunities while the market is weak.”
On the other hand, Kaufman sometimes finds that macroeconomics does overrule everything. “My favourite bank is in Egypt, but I have not invested in it because the currency risk means that we could see a decline,” he says.
Chadha is keen on domestic consumption in Asia, but makes a key distinction between countries with high valuations and a weak currency because of current account deficits, and surplus countries like China.
“We have an extremely high level of comfort on China currency risk exposure,” he explains. “In current-account surplus countries, we are comfortable with buying consumption-driven companies at current levels. But in current-account deficit countries, where growth can slow down, we want to buy consumer companies at lower valuations – so we are looking to buy good businesses when they are cheap.”
Chadha focuses on export-led sectors in countries like India with current-account deficits: “India’s pharma and IT sectors export to the US and Europe and benefit from currency depreciation.”
The mix between exporters and domestic consumption-led companies is therefore a function of the macroeconomic environment.
“Once the interest rate cycle has turned, domestic consumption names will bounce back,” Chadha says. “Currently, we are 70% exposed to exporters and 30% to domestic consumption driven companies, which have little US dollar debt on their balance sheets. We calibrate our overall country exposure with our view of the monetary cycle.”
Macro factors are clearly critical to the future success of any company, but not all fund managers see macro-factors as relevant to making actual investment decisions. Peter Taylor, senior portfolio manager at Aberdeen Asset Management, explains that his firm’s process is fully focused on stock selection.
“It is very easy for fund managers to get distracted by the noise that macroeconomic factors bring and it is not clear that analysis can bring any competitive advantages,” he insists. “Much of the impact of macro factors is already reflected in the price of stocks. Clearly, company fundamentals are impacted by economic developments, but not necessarily in the most predictable, consistent fashion. It is simply wrong to say, for example, that India has problems and therefore all Indian companies have problems.”
And indeed, Aberdeen is overweight the ‘fragile five’, in some respects because of, rather than despite of, their problems.
“If I have to try to pick some link between macroeconomics and these companies, it might actually be because harder macroeconomic environments require better quality companies,” he reflects. “Those markets have been volatile for decades. In that environment, you have to be a better quality company to prosper with better and sustainable business models.”
In any case, Taylor points to the debate over the ‘fragile five’ nickname among economists, and also notes that the market is beginning to distinguish a bit more among these five – as well as between these five and the rest of the emerging world.
“Of the emerging markets, they are the ones most dependent on capital flows and therefore investors became nervous in the summer of 2013,” he concedes. “But that nervousness dissipated by September and October. Turkey’s dependence on portfolio capital flows is greater than Brazil’s, while Brazil is able to attract more FDI flows, which tend to be more stable. The vulnerability of high current-account deficit countries is to short-term asset price movements. If there is tapering and a flow of capital back to the US, that should not be conflated with the shorter-term cyclical decline in GDP growth and cyclical earnings that we are seeing in emerging markets.”
This all suggests that the old paradigms governing emerging market investment may be on the way out. Even the relatively new ones focused on the emerging consumer, growth from a low base of GDP-per-capita and credit penetration may not fully capture the nature of the alpha opportunity anymore.
Greenberg sees another future model for emerging market investment just being born – companies that are “streamlined and efficient”, that see themselves competing within a global business, legal and regulatory environment, and therefore taking full advantage of infrastructure, software and automation. That may be a small fraction of the emerging market universe, but it is an increasingly important one.
“We are looking for just 65 stocks out of an emerging market universe of 33,000 stocks altogether, and 2,400 liquid stocks,” says Greenberg. For fund managers with strategies like that, the importance of macro-country specific factors becomes much less important. But to get there, of course, the over-arching macro story of the emerging world’s convergence with the developed world – with all that entails of slowing growth and changing economic composition – has to play itself out.