It’s the yield, stupid

Emerging markets have turned. Is the rally sustainable?

While we have no idea about what’s going to happen in the future, we do however know that the biggest determinants of longer-term investment returns are valuations and growth in shareholder value. Further, good managements are better at growing shareholder value consistently and find it easier to do so in a positive and predictable environment, says Kokkie Kooyman, Portfolio Manager for Denker Capital, previously SIM Global.

So as company-focused “bottom-up” fund managers, we always look at the valuation and spend a lot of time studying the track records of companies and managements. However, one can never do that without understanding both the past and present macro-economic environment and understand that the future could be any of a range of unpredictable scenarios.

However, within the context of the above, we think that the market could be wrong in assessing the prospects of emerging markets and global financials.

In both cases, the investment case rests on attractive valuations and a contrarian view, i.e. that everybody has sold and is underweight.

But this is the difficulty. Most investors find it difficult to change their minds after a long cycle. They find it difficult to envisage the possibility of change, or even worse, positive events (think South Africa, the rand or resource shares in Jan 2016). That is the point in time when an investment can be most rewarding as everybody has sold and few want to buy and in the case of both emerging market and financial shares there are reasons why the majority of investors are afraid or hesitant.

So, telling you to invest simply going on a contrarian standpoint is not good enough. Contrarian investing should only be done when the fundamental investment case supports it. But to do this, one’s mind has to be open to the existence of alternative scenarios. In both Emerging Markets (EM) and financials, the alternative scenarios are very plausible, however in the case of global financials the situation is more complex because the threats to profitability in the USA, Europe and emerging market financials differ.

So what are the positives for emerging markets?

Structurally they have a higher and more sustainable growth rate, especially relative to Europe, the UK and Japan. This is sustainable because of younger and growing populations, as well as low but growing levels of industrialisation and financial product penetration. These factors give companies higher turnover growth at wider margins.

We’re not telling you anything new here. The MSCI Emerging Markets Index has outperformed its counterpart the MSCI Developed Markets Index at a compound rate of 5% over the past 45 years (see graph below). The current attraction is high bond yields (The Merrill Lynch emerging market sovereign bond yields ~5.8% vs the 1.6% US 10-year bond yields, in USD) as well as currencies that have depreciated significantly since 2011 (refer Figure 3).

Bond yields

European bond fund managers have benefited from a very long bond rally. But with interest rates now at record lows (negative) the only way they’ll be able to generate returns for clients is to move into emerging market bonds. Those that remain invested in Europe do so in the hope that European interest rates get pushed even deeper into negative territory. In this regard it seems that the Brexit vote was a wake-up call. Investors seem to suddenly “see” the structural impediments to higher growth in Europe and the risk of a recession in the UK. I know we can’t forecast the future, but their 30 year bonds are predicting that the probability of higher yields (and hence a higher growth rate) is very low indeed.

Figure 1: Global industrial production … a decade of stagnation in advanced economies

Source: CPB Netherlands Bureau for Economic Policy Analysis, Wolfstreet

Investors are now forced to seek yield potentially triggering a virtuous cycle of stronger EM currencies, lower inflation, lower interest rates and stronger growth.

It is true that developed markets give a higher degree of certainty in terms of institutional quality and regulatory oversight (too much in fact), but investors are sacrificing significant potential upside for that. I’m not saying invest in emerging markets because it’s the less ugly sister, I’m saying that they are structurally better positioned and even more so in a global low growth environment. But the attractiveness is increased because nobody has paid attention and a lot of suitors may soon arrive – and scarcity sets in motion its own dynamics.

Figure 2: Monthly flows to dedicated EM equity funds (excl. China A share funds)

Source: RMB Morgan Stanley

The market and currency weakness between 2011 and 2015 has led to many investors to miss the fact that emerging market companies have continued to generate good earnings and shareholder value growth in their local currency, banks being the most notable. A selection of a few developed market (DM) and EM banks highlights the large difference over these 5 years.

Figure 3: 5-year compound growth in shareholder value (incl dividends) in local currency

Source: Denker Capital, Company financials

Figure 1 compares shareholder value (with dividends added back) over the past 5 years of a few DM and EM banks. Even Itau in Brazil has managed 16% compound growth rate over the period.

So why did their share price underperform over the past 5 years? The answer lies in the pressure put on the markets and currencies of investors switching out of EM to US dollars. Figure 4 shows the significant depreciation of EM currencies over this period (the Chinese yuan was the exception). But Figure 4 also shows that measured in local currencies EM’s didn’t do poorly at all relative to DM’s. Despite stronger shareholder value creation EM’s de-rated whilst DM’s re-rated.

Figure 4: Currency weakness hides good operational performance

Source: Denker Capital, Company financials, Bloomberg

The risk when investing in (a spread of) EM’s is currency weakness

The risk of investing in emerging markets now is a much stronger US economy and higher interest rates. However, there is no consistent relationship between stronger US growth and the direction of the US dollar or EM’s. Currently, stronger US growth can only be good for other economies. Besides, EM currencies have depreciated significantly since 2011 plus commodity prices have fallen significantly from their peaks.

This brings us back to where we started. We can’t tell the future, but we must bear different scenarios in mind and how markets are positioned for them.

Reflections

• Markets do not rate the probability of continued strong US GDP growth with a number of interest rate increases highly (hence financials in the US are undervalued).
• The US economy remains sluggish and it is unlikely that the Fed will hike more than twice in the next 12 months.
• If the US growth does surprise on the upside and we get more rate hikes, it cannot be good for the euro.
• If commodity prices do fall because of US rate hikes, only commodity exporters like Russia, Brazil, Peru and South Africa, etc. will be affected. Countries like India, Indonesia, Turkey and Georgia benefit.
• Whilst short term stronger US growth could be negative for EM currencies, it will be a positive for most of them.
• Even if you disagree with these views on emerging markets, you should consider adding a percentage EM to your portfolio as a hedge.

Conclusion

Based on the yield differential, the large underweight positions of fund managers, the long-term structural growth differential and finally the quality of the companies and the growth potential available, investors should seriously consider increasing their emerging market exposure, especially in the current low growth low yield developed market environment.

True, the risk of currency loss is always present, but based on current portfolio positioning and declines over the past 5 years, the risk is low.

Getting turning points right

The ideal in investments is to get turning points right. But doing this means going against popular opinion. An interesting article highlighting how many investors missed out on good returns since early 2009 because they focused on macro headlines was published by The Irrelevant Investor recently. It highlights how many investors are their own worst enemies. The article shows that even people buying index funds sell at the worst possible time. The message is: Valuations and management track records are better predictors of future performance than the headlines.

The yield differential (or simply the low global yields) could force a trend change that you have to consider now.

Denker Capital is an appointed investment adviser to Sanlam Investment Management (Pty) Ltd, an authorised Financial Services Provider.