Please find below the notes from GAM Investments’ Weekly Investment Meeting held on 31 October 2018 – this week’s speakers were Larry Hatheway, who talked about how investors are viewing risk differently in a ‘post-peak’ world, and Tim Love, who believes we could be at a fascinating entry point for emerging market equities.
The start of the month sees the publication of several key data reports from the US; we believe these are likely to confirm that the US economy is continuing to grow in a positive direction and is very resilient to the various types of shocks that are now arriving. The most closely watched numbers will be the average hourly earnings, which is now nearing a 3% rate of increase year on year. We believe that if the reading surpasses this level it will reconfirm the Federal Reserve’s (Fed) mind, and the market’s, that it should continue to push policy towards the neutral level. Forecasts are still estimating a 70% probability of a December rate hike, and while market expectations for 2018 have subsided, we think the Fed will continue to reinforce the idea that it is more inclined to raise rates than to pause, given the high economic momentum.
Clearly October was a very challenging market environment, particularly for equities, although there was increased volatility across other asset classes too. We could cite a number of factors that have concerned market participants – protectionism, Italian fiscal policy, the mid-term US elections – but I would argue that these were all essentially ‘known knowns’. In other words, most of these news items were already on the market’s radar during August and September (or earlier) but were disregarded by the market. What has changed in terms of market psychology, in our view, is a phenomenon known as ‘post peak’; namely that US and global growth peaked in the middle of the year and are no longer quite as strong or certainly not accelerating from here. This has been compounded by the likelihood that US earnings growth has also peaked, both in year-on-year and quarter-on-quarter terms, and therefore in this ‘post peak’ world investors are thinking a little differently about potential risk. It has also coincided with an absence of any apparent new catalysts for growth in the US and we are not seeing any leadership on that score coming from Europe, Japan or the emerging complex. Right now, we think the market is trying to find a bottom, and in many respects looks oversold, but while many of these issues remain unresolved we are not expecting to see a v-shaped recovery just yet.
EMERGING MARKET EQUITIES
It has been a challenging month and a challenging year for emerging markets (EM), but our mantra is ‘don't lose the faith’. In our view, we could be at a fascinating entrance point. The length of time that EM equities have been consistently falling is abnormally long at around 10 months. If one casts aside technical arguments and liquidity factors and just look at fundamentals, EM valuations are cheaper now than they were before the Q1 2016 rally, which led to markets doubling by the end of January 2018.
So we believe we are in fascinating territory for EMs. We remain focused on fundamentals, valuations and the risk/return logic for buying this asset class. Eight of the top 10 EMs are investment grade – the two exceptions being South Africa and Brazil. Looking at other sharp falls over the last 30 years, at this stage in the cycle we would normally be looking at only three out of the top 10 being investment grade. Therefore it has not been as much of a wipeout as it initially appeared; markets are down 20% or so in US dollar terms and valuations and fundamentals are giving off strong buy signals. That is a much more compelling story than catching falling knives on a liquidity or technical story.
EMs currently account for 55% in terms of contribution to global growth. Consensus figures from the World Bank estimate this may grow to close to 66% by 2023. This also suggests EMs should account for significantly more than 11% of the MSCI World index, as it does currently. This is especially so for those reviewing trends in corporate governance and ESG. This improving trend argues for greater free float adjusted weights for EM equities in global MSCI indices. Combine these two factors and EM equities should be further supported by positive fundamental change. Furthermore, the weights of domestic demand within the EM indices have become materially higher in the past five years versus EM metals / mining and energy which now only make up circa 12% of the MSCI EM Index (versus circa 48% at its highs five years back). Domestic demand is aided by domestic reform programmes in both China and India.
EMs continue to look very attractive on a growth at reasonable price (GARP) basis. Similarly, we believe they are equally attractive for value investors, versus markets such as the US and remain a fertile environment for picking up attractively valued stocks.
Looking at the period from January 2017 to now, everything in EMs has de-rated, with the price/earnings ratio (PER) falling, (from 12.8x to 9.8x) despite earnings continuing to kick in across a number of asset classes, not just EMs. The robust global backdrop should give a degree of top-line support to that continuing. So when should we get a multiple expansion coming through to these markets? Whatever the catalyst, we believe all it requires is an abatement of negatives given the conditions outlined above. It is akin to a coiled spring waiting to unwind. Meanwhile many other equity asset classes have de-rated, so on a head-to-head risk/return basis EMs look more attractive, albeit not as obviously as they did in previous times. Similarly, P/E for EMs is down to levels as low as they were before Q1 2016.
In terms of yield, we are looking at a dividend yield for 2019 of 3.8%, which is in excess of yields on US treasuries. On top of that is a free cash flow yield of around 16.0%, as well as the positive carry trade yield in places like Brazil of around 5% (CPI 4.5% and with circa 10% on the 10-year bonds). So unleveraged investment grade yield looks appealing across EM equities. Brazil has been a strong overweight for us going into the October election.
In our view, there is no point being in EM equities via a defensive strategy where you are not positioned to catch any bounce, as we saw in 2016/17. We believe it is necessary to have the ability to outperform on the upside, not via beta, but by alpha - buying high quality into dips. Furthermore, our country attribution is designed with an aim that when we get things wrong we are hurt rather than killed, as to us risk management is critical. We use diversification to reduce the risk of being wrong, by generally limiting our difference to generally 1% at relative stock level and 3% per country and seek not to deviate from our risk management budget.
Liquidity is also key in an environment when a risk-off environment is potentially around the corner, as we believe it is important to be able to exit a position quickly if needed. With this in mind, we favour higher quality holdings (in terms of free cash flow and working capital), as well as positioning further up the market capitalisation scale.
From a country perspective, we continue to favour Brazil and Russia, VARPS (Vietnam, Argentina, Romania, Pakistan and Saudi Arabia) and South Korea, as well as Turkey. Despite our models underweighting Brazil, we believe Brazilian valuations remain extremely attractive and the probability of a recovery is high post-election, while favourable demographics remain amid a young population and pent-up demand. Frontier markets also continue to offer up opportunities, especially the prime two drivers of Romania and Vietnam.
We continue to watch the Chinese currency closely. With the renminbi falling by double digits in just one quarter, the China A-share market has also suffered year-to-date. This has not helped us, but the underlying “A” share exposure remains attractive. It is also important to note the MSCI index continues to contain only H-shares, although A-shares will be added next year.
Current underweights include Malaysia, South Africa, Chile, Thailand and Taiwan. An underweight in Taiwan has proven costly this year, given technology had not collapsed prior to September 2018. As indicated by our models, Taiwan tech led the declines in EMs in October 2018, finally paying us out for this relative underweight.
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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 trends.