What were the major recent events and impacts on your asset class?
Emerging market equities in the first three quarters of 2023 have had a pretty spectacular ride on the upside and then given a lot of that back in late August early September. The tailwinds in their favour included a whole host of factors on cyclical and secular, but primarily just valuations benefiting from lower cost of capital expectations on the grounds that there would be some form of Goldilocks backdrop to the markets. That helped the value side of the market, the Brazil's, the South Africa's, the oil's, etc, tremendously. It hurts the growth side of the market, the growth at a reasonable price (GARP) stocks, the tech angle. Having said that, net, double digit returns to end of July, a lot of that has been given back in August, September. Why so? Why the give back? Well, the key behind it is the Fed policy and the Fed policy obviously tighter, higher for longer versus Goldilocks. And that's reinforced by the stronger-than-expected US data and indeed tighter labour conditions in the US. That led obviously towards a perception change in emerging markets as the US came down, as the dollar went materially higher to 26-year high and therefore risk-off, liquidity outflow. So with that kind of change in backdrop, emerging markets gave back a lot of its initial gains into the end of the third quarter (Q). But nonetheless, very marginally positive.
What can your asset class offer in the current environment?
Well, Emerging Market (EM) equities can offer a heck of a lot in the short and the long term. Even despite that reversal in markets in the end of the third Q, certain pockets of strength came through, namely those helped by the oil price, which went through 90 bucks convincingly helped by OPEC goosing the figures to the upside in terms of supply and demand. So you had the Gulf doing extremely well, banks in the Gulf specifically. You also had secondary stocks in India. Despite the oil price up being a negative for India generally, secondary stocks beat to their own drum, domestic demand, and that's booming. So by definition, secondary higher quality, positive free cash India did very well. On top of which you had the consistency of the nearshoring, onshoring, secure shoring thematic, whether it be played through Vietnam, Romania, Poland, Northern Mexico. All of those logistic hubs went through the roof. So despite a sell-off, courtesy of geopolitics, higher dollar etc, there were pockets of strength. So in that sense, emerging markets can offer an awful lot of idiosyncratic returns, namely those three areas I've just mentioned just in the third Q. How much more is there to come? Another question, but a huge amount as you're in that sweet spot in the cycle. That's cheaper now or as cheap as, close to two thirds of the way down, if not 80% of the way down on the GFC, or indeed at the take off point in 2004 before emerging markets, knocked the cotton socks off a developed world in 2004, 2005, 2006, 2007 and 2008 by a factor of four times. So a coil spring on the cyclical side. That's before you take into account the secular further tailwinds coming to reality, the domestic pension fund growth, the underlying domestic demand pick up, especially in India, and the underlying benefits you're seeing from a secular growth from luxury coming through in terms of the whole of the Southeast Asian continent, plus of course, the EV chain finding a base at the lows, and by that I mean materials. So lithium, platinum, etc. So a whole host of aspects either idiosyncratic or secular and cyclical in nature, which are very positive for the medium and long term for emerging markets at this juncture. So I said it's an enviable risk return, more limited downside than that of the S&P 500 and materially more upside is my view at this juncture.
What is your outlook in the near and medium term?
I think there are some tea leaves stirring in emerging markets which indicate that the worst is behind us. And by that I think if I look at some of yesterday's concept plays which have been artificially ramped by Johnny-come-lately kind of retail concept flows, they've given back 70, 75, 80% in dollars already from their peak, lithium, platinum, as an example, solar, China solar and these will be in demand. Alternative energy will be in demand, EV will be in demand. So at some point that secular support will kick in. And you've had this ridiculous cyclical blow off helped by retail, right back down onto the secular support and you're in this kind of bottoming process. In that, I think whether you're talking lithium, platinum, rare earths, I think there's some tremendous opportunities for picking up cheap, long-term secular assets with positive free cash flow, which are basing at this stage, not falling on down days, which are giving you very long support, comfort. So whether it be on an earnings basis or a balance sheet basis, I think, or a free cash flow basis, I think there's a very logical reason to get into them. So I think in that sense, emerging markets offers some tremendous positive tea leaves in certain select areas. I mentioned Indian secondaries earlier. I mentioned some on-shoring earlier as well.
I think step back a million miles. What is emerging market index composition today? It's a fundamentally different one to that of yesterday. And perception is not reality. Reality is that, in simple terms, Latin America ex Brazil Central America edition, Africa ex South Africa, most of Eastern Europe, Russia, Turkey, Bangladesh, Pakistan, Sri Lanka, Vietnam, that all makes up less than 1.5% of the MSCI EM Index. What is the EM index? It is basically Korea. It is EV. It is top-end gaming. It is autos, it is EV autos, it is semiconductors, Taiwan, it is the centres of excellence and indeed economies of scale of China in a whole host of areas, in addition to their consumer demand. It is the same consumer demand pick up on an even bigger population demographic, younger and growing faster in India. It is the consulting services in India feeding to the US. It is the Gulf. It is the GDP per capita of the Gulf materially higher than that of DM markets, developed world markets, by a factor of about four or five. It is on top of which the onshore / re-shoring benefits you’re seeing in Mexico. So this is not the emerging markets of old. It’s robotics, it’s semis, it’s high-end consultancy, it is high-end EV, it’s EV materials. This is modern, this is resilient, this is predictable. And as such, if they continue to keep their GDP per capita growth relative to that of developed and they keep their GDP premium of growth to the developed, 4.5, 5 for emerging for 1.5, 2 for developed, there’s no logical reason why eventually that coil spring of valuation shouldn’t unfold in your favour, especially when eight of the top nine emerging markets are now investment grade. Only four were, back in 2004. Yet in 2004, when the catch-up trade occurred after the Asian crisis and SARS, similar to what we’ve seen more recently with Covid, you’re at that take off point on valuations. So a long answer to a simple question, I think both cyclicals, secular and risk return favour very strongly emerging market risk return quadrants at this juncture. I’ve given you some favourite tea leaves that I’m playing in addition.
So I am bullish. I think it’s a coiled spring and I am optimistic. What are the catalysts to give me that? Peaking dollar and FOMC movement towards a less tight monetary policy profile. 26-year high on the dollar does not help flows towards emerging markets. Without the oil in the engine to arbitrage that valuation opportunity, it's of nothing. So by definition you need the catalyst to spin it in the right direction. And that is outstanding until we see the peak of the dollar and indeed the cycle of tight monetary policy abate somewhat. And I think at that juncture, after the 15 years of volatile sideways in emerging markets while everybody's been hugging the dollar, credit and then AI I think there's a lot of rotation towards reality of the new perception of what really shouldn't be called emerging at all. It should be called semi-developed in many cases, especially the Gulf.
Is there one chart you’re currently monitoring, such as the US dollar already mentioned?
That would be the top factor. Together with the consistency and the resiliency of the aggregate emerging market earnings, playing to the resiliency and modern facing nature of the change of those earnings. If I'm right and they are able to withstand a modest pullback in developed world demand because they are more high value add and domestic-facing in many cases, then there's no reason why even a modest pickup in a dollar from here on a further extension of the tighter monetary policy from here should upset them because they are not the emerging markets of old. Those ones have already gone. They are in the frontier and that's a fundamentally different aspect. So perception does not equal reality. So to answer your question specifically, dollar on a trade weighted basis, especially as it affects South Africa and Brazil, which are the only non-investment grade currencies in my asset class, which are already down 75-80. And secondly, the resiliency of the continued expectation of 12 to 16%, a very wide range, of emerging market earnings from consensus. As long as it's roughly in the middle of 14, then the coil spring argument on the cyclical, before you even discount the secular, feeds that risk return quadrant, which is very favourable.
Andrea Quapp highlights the fact both stocks and bonds are currently attractively rated, which is presenting her with asset allocation opportunities. She also mentions the importance of innovations such as artificial intelligence and, specifically for Switzerland, the appeal of the Swiss real estate market.
Christian Munafo of Liberty Street Advisors notes an improvement in market conditions for investors in late-stage private companies; many of these companies are similar to what public market investors used to seek in small to mid-cap growth stocks. He also stresses that many of them are not just high growth, they are also at or approaching profitability.
Goro Takahashi describes the key factors that influenced the Japanese market over the third quarter, particularly the main stock exchange’s ongoing initiative to improve listed companies’ financial indicators, and the areas he thinks investors should focus on into the turn of the year.
Julian Howard reflects on the combination of stretched valuation and a tight equity risk premium that has made equities less attractive in the short term. However, it does not undermine the very long-term case for equities, in his view. He also notes the long-term structural case for China.
GAM Systematic’s Dr Chris Longworth and Guglielmo Mazzola highlight bond sell offs and a commodities rally as significant market events, and note that systematic investment approaches can help provide investors with much-needed diversification for their portfolios.
Atlanti’s Gregoire Mivelaz highlights the three major events of Q3 that impacted his investment universe: earnings, bond call dates and the reopening of primary markets. He believes given we are now in a late credit cycle, credit quality matters for investors. And he notes that market mispricing is continuing to lead to opportunities.
Jian Shi Cortesi notes that weak sentiment in China is keeping Chinese equities at very low valuations, due to the soft economic growth, real estate drag and the ongoing China-US rivalry. However, she is optimistic about long-term prospects, with the conviction that in the long term earnings growth will drive stock prices.
Niall Gallagher shares his views on the implications of rising real bond yields and why he thinks central banks will continue to have to fight inflation rather than deflation. Niall also discusses the sheer scale of capital required to enable the energy transition, and some of the companies he believes stand to capitalise.
Tim Love, Joaquim Nogueira and Rachit Chirania of GAM Investments’ Emerging Markets Equity team believe India could lead emerging market outperformance over the course of this decade. They outline seven reasons why they think the country presents a rare secular and cyclical growth story at a time when major economies are struggling.
Given an improving risk/return backdrop for emerging markets (EM), Tim Love, believes now is a good time to revisit a grouping he coined in November 2020 called “START” (Samsung Electronics, Tencent, Alibaba, Reliance and TSMC) which represent well the cyclical and secular opportunities for the EM region.