At GAM Investments’ Weekly Investment Meeting held on 6 March 2019 the speakers were William Mejia, who outlined the prevailing dynamics for an emerging market equity long / short strategy, and Adrian Owens, who provided a fascinating insight into global macroeconomic-related investment opportunities.
Emerging Markets Long/Short Equity
Although the strategy is a fundamental one based on earnings revisions, for strong behavioural finance reasons it is deeply correlated to share price momentum. Our view is that current stock prices reflect all available market information, and this is reflected in analysts’ consensus earnings expectations, so we buy stocks we believe will beat analyst expectations and sell those we believe will miss analyst expectations. The challenge is to deploy this intuitive strategy effectively.
What drives performance is the correlation between share prices and earnings revisions. Statistically speaking, if we simply plot the performance of the top quintile of stocks, in terms of earnings revisions, against those in the bottom quintile, we believe the results provide ample support for the main premise of our investment approach. Furthermore, since we have exhibited the ability to potentially anticipate earnings revisions (by analysing a variety of market and macro data sources), we can conceivably outperform such ‘ex-post’ results. However, we should emphasise that the strategy typically struggles during periods of market rotation, and this is true of other momentum-based strategies. For example, in recent months, markets have been strongly influenced by geopolitical noise – particularly in respect of Sino-US trade tensions – and this has resulted in some pricing distortions. However, fundamentals invariably hold sway in the longer run, so periods of relative underperformance can potentially provide attractive entry points.
In terms of idea generation we use a quant screen, followed by a targeted consensus screen to narrow down the investment universe – which is, in practice, constrained to around 2,300 investable stocks after taking liquidity, market cap and analyst coverage into consideration. We garner insights from brokers and undertake around 1000 company meetings a year in order to identify the stocks with the greatest potential for re-ratings. Earnings revisions are the key criterion, but we also scrutinise valuations and share-price momentum as part of the stock selection process. The portfolio is subsequently constructed with the help of pre-trade risk analysis.
In terms of market dynamics, we have seen a strong start to the year, with emerging market (EM) indices rebounding from the sharp falls witnessed in the second-half of 2018. This has proved a tide that has lifted all boats and pricing action has largely been indiscriminate. At current levels, strong growth in the US and accelerating EM economic momentum appear priced in. However, we do not believe lead indicators support such a scenario. As such, we have restructured our portfolio to a significantly more defensive orientation than that of this time last year. In the prevailing environment, we are placing additional emphasis on the non-cyclical consumer and healthcare segments of the market as these typically offer high visibility in terms of cash flows.
Interest Rates and Currencies
One objective of our global rates strategy is to deliver equity-like returns with fixed income levels of risk. The strategy remains focused on trying to generate alpha. With the current level of liquidity, it has been a market where the rising tide has delivered good returns for beta. Many alpha-orientated strategies, such as ours, have found life more difficult in such an environment, which has predominantly been driven by central banking policy, in particular quantitative easing (QE), at the expense of fundamentals. However, we would reiterate the importance of our strategy’s diversification qualities and low correlation to other asset classes, such as equities and government bonds, and believe there are currently some very attractive investment opportunities available.
From a macro perspective, we believe growth is likely to remain around trend but there are clearly some downside risks stemming from China which are already having an impact on US activity, most notably manufacturing. Recent weak economic data appears to justify the Federal Reserve’s (Fed) decision to put its rate hiking programme on pause and we believe this stance is likely to be further vindicated in the short term by headline inflation trending lower in the US. Headline US inflation could possibly fall to 1% by the middle of this year. However, when we look beneath the surface we find a different story. US labour markets are now very tight and wage pressures are emerging. Unless higher rates are offset by a pickup in productivity growth, corporate profitability should be negatively impacted. This suggests to us that while growth should remain reasonably solid in the near term, inflation could re-emerge later in the year and prompt the Fed to reconsider its decision to pause its hiking strategy earlier than the market is currently pricing in. We believe a resolution to the US / China trade talks will provide a further boost to this thesis.
Against this backdrop, we think an alpha-generating strategy could really come into its own because it has the potential to generate value regardless of how traditional risk markets are performing. We have identified a host of idiosyncratic opportunities that have the potential to generate returns which are lowly correlated to broader market activity.
Any opportunities within UK markets, at present, are clearly caught up in how Brexit ultimately plays out. However, in our view, UK fixed income is currently very expensively priced in relation to other markets – notably Europe and Canada – and we believe there are opportunities to exploit this mispricing regardless of what happens with Brexit. Looking at Europe first, official interest rates in Europe are 115 bps below those of the UK, however longer-dated swaps price in significant rate convergence. Given our views on economic prospects in the UK and Euro area, as well as relative inflation, we see such convergence as unlikely. It is a similar story with the UK versus Canada – the market appears pessimistic about the prospect of reaching a satisfactory Brexit deal and therefore not pricing in much of a recovery. Our central view is that some form of deal is the most likely outcome, but even if that does not happen we expect the subsequent pressure on sterling should cause inflation to spike. Neither of these scenarios are positive for UK fixed income in our view.
Mexico is an interesting story given it currently has one of the highest interest rates in the world – with selective swaps yielding around 9%. However, from a macro perspective the currency has been stable despite a slight slowing of the economy and ongoing US tension in terms of migration and trade, while inflation seems to be heading lower, suggesting the central bank may have capacity to start easing policy towards year end.
We are not the first to observe that the US yield curve has been too flat and have been positioned to take advantage of any steepening. This started to take place in December 2018, but we expect to see this progress further over coming months, given a Fed on hold, sharp increases in bond supply and amid pressure from signs of underlying inflation.
Australia and Korea are good examples of trades that are largely uncorrelated to global market trends. Markets have become quite bearish on the Australian economy and investors are now pricing around 35 bps of rate cuts over the next two years. In contrast, while the Korean economy seems just as weak, the market is not so pessimistic in its outlook and therefore we are positioned to potentially capitalise on any moves.
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