25 July 2019
With the global market environment still being distorted by the consequences of QE, GAM Investments’ Tim Love outlines three different scenarios for emerging market equities which could signal a take off point.
The current business cycle has been unusually long and this continues to defy the sceptics. We believe a key factor behind this is that economic activity has been, and still is being, heavily distorted by quantitative easing (QE), as well as very selective attempts at quantitative tightening (QT) in the US and UK, and which continues to result in unintended consequences that are both political and market-led in nature. In our view, it is now very difficult to assess what could prompt the ‘end of this business cycle.’
In our view, one of the distortions of excessive QE – other than the length of the business cycle – is the political implications. So far we have seen protectionism (such as America First), nationalism and political backlashes against incumbent long-term parties become commonplace globally. This has increasingly weakened the ‘rules-based’ liberal orthodoxy that has been broadly established since WWII. Moreover, US trade sanctions, the increasing balkanisation of the internet and the polarisation of world power into either the US or China-orientated spheres of influence have also continued to force many emerging market (EM) countries to align to one side or the other (often to their detriment). Additionally, the seeds of future discourse are also being sown: Russia has ended the 1987 Intermediate Range Nuclear Forces (IRNF) treaty and Iran has breached the uranium enrichment tolerances of the 2015 nuclear deal programme. Similarly, the Ebola outbreak has crossed into the war zone in South Sudan from the DR Congo, threatening further escalation. These factors all serve to increase the risk of oil shocks / the use of nuclear warfare in regional theatres and ‘SARS’-like pandemic which devastated Asia in 2002/3 and all pose significant negatives to EM economies.
We believe this all leads to continued abnormal tailwinds for EM equities, both in terms of an artificially low driver for the weighted cost of capital (which lifts equity valuations even higher) and also for a larger and more continuous focus on the ‘search for yield’.
Even if the S&P 500 index consolidates in the second half of 2019 (after its large first half rally which saw it reach new record highs), we believe the EM equity asset class should find valuation supports fairly quickly as it is not coming off a high price-to-earnings ratio (PER) or EV / EBITDA base. Indeed, it is trading at relative lows to history and nine out of the 10 larger EM markets are investment grade, with corporate balance sheets in a fairly solid condition.
If our above views are correct, then we anticipate this distorted world of the US Federal Reserve (Fed) put and QE (EU / Japan and at times China despite their deleveraging aims) could lead to three basic outcomes:
- 1. 35% probability: ‘Good is good for equities.’ Stronger EM equity earnings per share (EPS) supported by top line growth and margins and pricing power support PER re-ratings. This is underpinned by a ‘goldilocks’ economic backdrop of healthy, moderate growth supported by a modestly dovish Fed and a peaking US dollar (the dollar DXY Spot Index has been falling since its April 2019 highs). In this scenario EM equities should re-rate positively with returns being helped by strong double digit EPS growth and 3%+ yields on good coverage ratios. We would favour maintaining a broad value and growth at a reasonable price (GARP) bias.
- 2. 35% probability: ‘Bad is also good for equities.’ A lower weighted cost of capital should cushion the slower implied economic growth, signalled by sub 2-3% global growth and negatively yielding debt rising above the present USD 13 trillion or further reductions in overnight indexed swap (OIS) spreads, which presently anticipate up to 75 bps reductions by the Fed before year end. A sub-US treasury yield under 2% could lead to a further ‘search for yield’ in more marginal asset classes, which would be a strong support to EM equities. 5 year USD OIS Swaps continuing to fall below 2% could also drive this further. In our view, the EM equity ‘investment grade laggard’ asset class would continue to attract some of those ‘cross over’ and ‘positive carry’ flows in the third quarter of 2019. In this scenario, we would favour keeping a higher quality, liquid GARP bias and expect EM equities to have similar – not greater – downside moves to developed markets in any volatility episodes.
In either of these two scenarios, an investment process built around the philosophy of buying quality laggards cheaply should continue to generate alpha; this has been proven over the past seven years of markets oscillating between these two scenarios and we expect this to continue. To further hedge any temporary downside (and hence improve the risk / reward potential), we favour buying such stocks in positive carry trades / undervalued currencies and in more liquid value stocks with positive free cash flow (FCF).
- 3a. 20% probability: ‘Bad is bad option for EM equity.’ This scenario is centred on a central bank misjudgement. Weak global growth and a hawkish Fed could mean there is little counter cyclical fiscal or orthodox monetary weaponry left to stimulate the economy. In such an environment, we believe a 1987-style crash is possible as weighted average cost of capital (WACC) and economic growth slowdown fears materialise simultaneously. A resulting US dollar safe haven rally would further exacerbate the unwinding of the positive trade and we would expect to see hedging with cash, gold and quality positive FCF liquid plays in investment grade countries and insurers.
- 3b. 10% probability: Exogenous shock. Here, an oil supply side shock or, our greatest fear, an outbreak of a major disease, such as Ebola, generates fears of another Asian flu-style outcome. In this scenario a crevasse could open up. With this in mind, we would anticipate a US dollar safe haven rally and, given the relatively small size of the EM equity liquidity pool, would need to consider the distorting effects of such flows unwinding, especially if the ‘lower for longer’ rates environment is exited. For EM equities, we view this as a ‘the tail on the dog’ situation, the equity market is dwarfed in size by the volumes in EM currency and EM debt, as well as EM credit. Therefore we would anticipate, ‘crossover’ flows of capital from EMBI+ / credit worlds or positive carry flows from traders, who are chasing the positive real rates in EM currencies, which would likely have a material effect on EM equities should they ‘unwind’ their positions. In short, EM equities are very correlated to their inflows – and sudden outflows can cause disruption. The Asian crisis in 1998/9 is a relevant example as it exhibited an R squared of -0.98 correlation to a sudden negative reversal in flows on EM equity prices.
So how would we expect EM equities investors to react to either version of scenario 3? We would favour maintaining a higher cash weighting, raising gold exposure and buying life assurers in times of weakness as this sector should mature in Q3 2019. We would also maintain a focus on positive FCF and working capital plays, as well as countries with cheap currencies and investment grade status. This is in line with our view that quality should be supportive among liquid, investment grade countries and could well be the difference between having a ‘risk budget at the lows’ and not. It would also test our above assertion that EM equities should have a similar response to their DM counterparts in any 10-15% pullback.
We believe the most probable outcome is scenario 1 followed by episodes of Scenario 2, both of which are relatively positive and should create opportunities to exploit market volatility and upgrade overall quality during any pullbacks.
In our view, the highest probability will be that the Fed is likely to maintain a dovish bias (following a July cut) until after next year’s elections. Equity and bond markets are priced for subdued but sustained growth over the next year, as we believe President Trump is not likely to jeopardise his 2020 chances by escalating the existing trade disputes. The Fed and other central banks could still take advantage of the current soft patch to provide additional stimulus.
Therefore, a slight easing in trade tensions and overly dovish monetary policy are supportive for risk assets, albeit within the context of a mature investment cycle. Near-term sentiment reversals should be seen as buying opportunities, as the US dollar is likely to remain range-bound, making cross currency bets and select EM assets appealing.
Any potential bounce in bond yields and further political / trade whipsaws should act as headwinds to exploit for EM equity investors, even though US earnings growth is slowing and non-US momentum is lacking. Unlike US EPS, EM equities are at an early cycle rebound and domestic stimulus in both China and India still remains possible, should it be needed (despite China deleveraging efforts and / or India’s sensitivity to external shocks like the oil price).
As an investment grade laggard, the asset class tends to outperform EM debt and credit in short violent spurts (as happened in 2004-2008). Therefore upside positioning into any weakness becomes very important.
We are fast approaching another ‘take-off’ point in our opinion. Whether this is relative to EM debt / EM credit / DM equity or an absolute return opportunity above other asset classes / cash depends on whether the abnormal drivers mentioned above continue. Either way, in a ‘good is good’ or ‘bad is good’ scenario, we believe EM equities should outperform in relative and absolute terms.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.