Emerging markets: last refuge in a low-return desert?

Transcription

1 Global Perspective Emerging markets: last refuge in a low-return desert? November 216 Executive summary Traditional risk premia are currently subdued, and interest rates in key developed markets look likely to remain historically low for some time, leading investors to look elsewhere to generate returns. We believe that emerging market equities and bonds offer compelling opportunities through their improving fundamentals and attractive valuations. The outlook for developed economies remains weak: heavy debt burdens, declines in potential growth and the inability of policy makers to deploy impactful fiscal policy imply that monetary policy (manifested in low rates) remains the only source of stimulus. Even in the US, where economic conditions are much stronger than in other key advanced economies, the risk of negative external shocks have prompted the Fed to take a very cautious stance, which has been reflected in declining long-term growth and interest rate projections. Salman Ahmed Chief Investment Strategist Lombard Odier Investment Managers From an investment perspective, an environment of sustained low yields and weak expected returns (reflected in expensive valuations across most of the developed world) is leading to renewed focus on emerging market (EM) asset classes. Over the 213/15 period, EM assets came under considerable pressure against a backdrop of weak economic fundamentals, a sharp increase in idiosyncratic risks (such as in Brazil and Russia) and the broad-based rise in the USD. However, we now believe that the case for the asset class is becoming more positive. This is based on a risk/reward assessment of three key aspects, namely fundamentals, valuations and risk factors. On the fundamentals front, recent data shows a pickup in economic activity alongside a visible improvement in the external balances of a number of emerging economies. Focusing on valuations, despite the improvement in fundamentals, the current situation is reminiscent of crisis type pricing, while potential systematic risk factors emanating from a China-centric financial meltdown and a hawkish Fed are starting to fade. Lombard Odier Investment Managers Emerging markets: last refuge in a low-return desert? November 216 Page 1/12

2 Fundamentals: signs of a positive shift Starting with macro fundamentals, although many EM economies struggled in , recent data shows clear signs of a pickup in EM economic activity. More importantly, the spread between EM and developed market (DM) growth, which had narrowed in every year during , is starting to widen again. This spread has historically been a key indicator of EM asset outperformance (Figures 1 and 2). FIG. 1 1% 8% 6% REAL GDP GROWTH (ANNUAL RATE): GROWTH IN EM ECONOMIES IS ACCELERATING AGAIN, OUTPACING DEVELOPED ECONOMIES Developed economies (%) Emerging economies (%) Difference (%) 4% 2% % -2% -4% Source: IMF, July 216. Data in local currencies. FIG. 2 25% 2% 15% % Changes 1% 5% % -5% -1% CYCLICAL UPTURNS IN EM ECONOMIES HAVE HISTORICALLY INCREASED ASSET PRICES EM equity perf. (USD, YoY%) RHS EM GDP growth (USD, YoY%) 1% 8% 6% 4% 2% % -2% -4% -15% -6% Source: Bloomberg, 31 July 216. Data in USD. Emerging markets (EM) as defined by Morningstar. Past performance is not a guarantee of future performance. Page 2/12 Lombard Odier Investment Managers Emerging markets: last refuge in a low-return desert? November 216

3 As noted in a recent IMF report, economic activity in a number of emerging countries is now undergoing a cyclical upswing after several years of downward pressure. The policy stance taken by a number of countries (allowing their currencies to depreciate sharply) has helped to avoid a full-blown balance of payments crisis (in contrast to 1997, when fixed exchange rate regimes contributed to the instability). This economic stimulus has been visible in the improving external imbalances in a number of countries, including commodity exporters (such as Russia), which have seen their current account balances improve over the last three years (Figure 3). FIG. 3 CURRENT ACCOUNT PROFILE DYNAMICS ACROSS EMERGING MARKETS Current account level in % of GDP Q3 current account level Q3 level Thailand Russia India Chile Czech Republic South Africa Turkey Korea Indonesia China Israel Hungary Mexico Romania Brazil Argentina Philippines Poland Peru Malaysia Colombia Source: Bloomberg, LOIM, Goldman Sachs Q3 time period when pressure on EM countries started to build. Overall, regarding fundamentals, we believe that a number of EMs are entering a virtuous cycle in which improved macro fundamentals are able to support rising asset prices, which in turn reinforces the positive cycle. We also think that the Brexit vote shock is amplifying this process, as it is forcing key central banks to become more cautious. This, in turn, allows EM countries to reduce real rates via lower nominal rates as domestic inflation falls, thereby providing an additional source of policy stimulus for their respective economies. EM valuations: pricing reminiscent of the crisis era Turning to valuations, after more than five years of underperformance (Figures 4a and 4b overleaf), EM assets are starting to show signs of deep under-valuation. EMs have faced several shocks over this period, including the Fed s taper-tantrum in 213, lower commodity prices and specific idiosyncratic risks (such as corruption scandals in Brazil, Russia s annexation of Crimea and the anti-graft campaign in China) which have acted as strong headwinds to both relative and absolute asset performance, generating similarities with the cycle (Figure 4b overleaf). Lombard Odier Investment Managers Emerging markets: last refuge in a low-return desert? November 216 Page 3/12

4 FIG. 4 12% 9% 6% 3% % -3% ALREADY 5 YEARS OF UNDERPERFORMANCE, AND EMERGING MARKET EQUITIES ARE NOW CLOSE TO 1998/99 LEVELS 4A. MSCI EMERGING MARKETS VERSUS MSCI WORLD 4B. MSCI EMERGING MARKETS COMPARED TO CYCLE % Jan-9 Sep-96 May-3 Dec-9 Jul Source: Bloomberg as at 31 July 216. Past performance is not a guarantee of future results. For instance, looking at EM equities price-to-book ratios shown in Figure 5, current valuations are similar to the dark days of 28-9, while the gap with world equities is close to the crisis levels seen in the late-199s. Such depressed valuations are rare amongst global assets at the moment and, more importantly, we think are inconsistent with the improvement in fundamentals that a number of emerging economies are experiencing. FIG PRICE-TO-BOOK (P/B) RATIOS OF DEVELOPED AND EMERGING MARKETS P/B MSCI World P/B MSCI EM P/B MSCI EM ASIA Ratio Oct-95 Dec-99 Feb-4 Mar-8 May-12 Jul-16 Source: Bloomberg as at 31 July 216. Past performance is not a guarantee of future results. Page 4/12 Lombard Odier Investment Managers Emerging markets: last refuge in a low-return desert? November 216

5 In fixed income, the relatively high real rates in the EM space (in both absolute terms and relative to DMs) also highlight the presence of attractive valuations, particularly given the strengthening trend of falling inflation that is currently taking hold across a number of emerging economies (Figure 6). FIG EM ECONOMIES EXPERIENCING FALL IN INFLATION Avg EM 3 months rates Avg EM CPI rates (YoY) Avg DM 3 months rates Avg DM CPI rates (YoY) In percentage Mar-11 Dec-11 Sep-12 Jun-13 Mar-14 Dec-14 Sep-15 Jun-16 Source: Bloomberg as at 31 July 216, LOIM calculation/illustration. With respect to nominal yields as shown in Figure 7, severe interest-rate compression in advanced economies over the last six months has pushed EM yield differentials (in local currency terms) to around 5.2% p.a. versus the US and nearly 7% p.a. versus Germany. 2 The current climate of low-to-negative interest rates in developed countries, coupled with sustained easing by central banks, has created a strong yield differential in favour of the EM space. FIG EM YIELD DIFFERENTIAL VERSUS ADVANCED ECONOMIES AT MULTI-YEAR HIGHS US Germany Japan Percentage points Jan-11 Jan-12 Mar-13 Mar-14 Apr-15 Jun-16 Source: JP Morgan GBI-EM Index yields used for EM, 5-Yr Government Bond yields used for advanced economies. Source: Bloomberg, JP Morgan, June Source: Bloomberg. Lombard Odier Investment Managers Emerging markets: last refuge in a low-return desert? November 216 Page 5/12

6 Focusing on currencies, the sharp depreciation trend in nominal exchange rates (Figure 8), which accelerated in 213, has resulted in under-valuation across a range of fair value metrics. For example, the depth of under-valuation becomes clear using a purchasing power parity-based fair value model (PPP), which takes into account per-capita income differentials (specifically, the model stipulates that richer countries can tolerate a stronger exchange rate). Sharp deviations from fair values exist across a number of EM countries (the extent of which is shown in Figure 9). FIG. 8 2 In percentage FX MARKETS ARE STARTING TO RECOVER Chinese Yuan Offshore Mexican Peso Indian Rupee JP Morgan EM Currency Index Indonesian Rupiah Turkish Lyra South African Rand Brazilian Real Russian Ruble -8 Aug-1 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16 Source: Bloomberg as at 31 July 216. Past performance is not a guarantee of future results. FIG. 9 PPP SCREENS SHOW STRONG SIGNS OF UNDER-VALUATION IN THE EMERGING MARKET FX UNIVERSE 4% Over-valuation 2% Valuation % -2% -4% -6% Israel Philippines China Peru Brazil Korea Argentina India Mexico Chile South Africa Turkey Colombia Hong Kong Indonesia Thailand Czech Republic Hungary Romania Poland Malaysia Singapore Russia Taiwan Source: Goldman Sachs Global Investment Research. Note: (i) Poland, Hungary, Czech Republic and Romania valuations are shown against the EUR and rest are against the USD; (ii) based on 216 Q4 forward valuations. There is strong evidence across a range of metrics that EM equities, fixed income and currencies are under-valued. This under-valuation is starting to reverse. However, given the scope for a continued catch-up against a backdrop of improving fundamentals, we believe this trend has the potential to last. Page 6/12 Lombard Odier Investment Managers Emerging markets: last refuge in a low-return desert? November 216

7 The key risk factors: China and the Fed When assessing the medium-term outlook for EMs, fears of a China-led financial crisis are often at the forefront of investors minds. These concerns first surfaced in April 215, when the CNY fix depreciated by roughly 3% over three days, causing widespread stress among EMs, especially for China s EM competitors in the external sector. In addition, for emerging economies with strong import links to China (mainly commodity exporters), the sharp depreciation was interpreted as confirmation of a steep slowdown in Chinese growth. Several months later, as the currency fix weakened further, first in mid-december and then violently in early January, market concerns about a full-blown financial meltdown peaked, with widespread damage to EM asset returns. Since then, stability in the CNY and visible easing in both monetary and fiscal policies by the Chinese authorities have helped put a floor under economic growth (as highlighted by a number of high-frequency surveys and hard data). This stabilisation has been a significant factor in the rally in EM assets in recent months. Here, it is also important to note that part of the fall in foreign reserves which took place in 215 (see Figure 1a) was driven by a decline in the external liabilities of Chinese firms as USD denominated debt was switched back into domestic CNY obligations (Figure 1b). Indeed, as the losses of foreign reserves are used to pay down outstanding foreign debt, it helps to rebalance China s balance of payment. FIG. 1A CHINA S FOREIGN RESERVES DECREASED SHARPLY IN Foreign reserve change FIG. 1B THE CORPORATE SECTOR INCREASED FOREIGN DEBT REPAYMENT 2 1 Foreign debt repayment USD billion 2 USD billion Source: CEIC and BBVA Research Looking ahead, China is presently running a current account surplus of around USD 5 billion per month, which, alongside a rise in the country s share of world exports, implies that policymakers have less incentive to use the CNY as a stimulus tool (via a large devaluation). The sharp re-leveraging witnessed in China in the aftermath of the 28-9 crisis is clearly worrying. The Economist reported recently that the country s total debt/gdp ratio has surged from 15% then to a current level nearing 26%. The risk of a fullblown financial meltdown remains, should a sustained default cycle take hold and overcapacity be shed. However, when assessing the risk of such a hard landing, it is important to note that China is a net creditor to the world (to the tune of USD 2 trillion as at December 213, after which capital outflows started in earnest), and has an external balance sheet with a very liquid asset profile. In addition, China runs a relatively closed capital account, which acts as a dam with regard to domestic capital flight. We view this very strong international investment position as a key backstop against the risk of full financial meltdown, although we continue to envisage a sustained period of slow growth in China. Lombard Odier Investment Managers Emerging markets: last refuge in a low-return desert? November 216 Page 7/12

8 FIG. 11 USD billion 6, 5, 4, 3, 2, 1, -1, -2, -3, -4, CHINA S INTERNATIONAL INVESTMENT POSITION IS AN IMPORTANT BACKSTOP TO THE SYSTEM TOTAL STOCK, ASSETS (+) AND LIABILITIES (-) Reserves Other investments 6 Portfolio investments Outward FDI Inward FDI Portfolio investments Other investments 6 Net foreign assets Assets Liabilities ,88 1, , ,231 Source: PBOC, SAFE, Bloomberg. 3 Other investment categories include credit loans, currency and deposits and other investments. Secondly, to re-engage in EMs, investors must feel confident that the strength of the USD has peaked at a time when the Fed is undertaking a hiking cycle. There are a number of channels through which an appreciating USD can pose a problem for the emerging economies. Firstly, for commodity exporters, the negative link between USD and commodity prices (which trade in USDs) can generate a negative income shock. More generally, there is a further detrimental impact on the existing external debt of EM countries linked to the tightening of global financial conditions and a rising USD. In our view, the fundamentals no longer point to an ever-rising USD. Here, it is important to differentiate between the risk of higher interest rates and the risk of a stronger USD, as the empirical relationship between US interest rates and EM asset pricing has historically been tenuous at best, and has only held true through influence on the reserve currency (i.e., the USD). Page 8/12 Lombard Odier Investment Managers Emerging markets: last refuge in a low-return desert? November 216

9 We believe that there has been a strong shift in the Fed s working framework in recent months, with USD movements (as a driver of financial conditions) becoming an increasingly significant consideration when the Fed is determining its overall policy objectives. This shift has been apparent in a number of speeches by key Fed officials, including New York Fed President William Dudley, Fed Governor Jerome Powell and Fed Chair Janet Yellen herself, in which the focus on international developments has received significantly more attention than in the past. Other key advanced economies (Japan, Eurozone, UK) are at least a business cycle behind the US in terms of the monetary policy cycle. This means that the impact on the USD of hiking by the Fed is significantly magnified. Given the US s key role in defining global financial conditions, it is perhaps unsurprising to see signs of a shift in the Fed s thinking. This is likely to manifest itself further as the upswing that began recently in domestic labour market data is downplayed. More structurally, there has been a clear reduction in the estimates of potential long-term US economic growth, as well as in estimates of the terminal federal funds rate (as shown in Figure 12), both key determinants of overall economic performance. Within this revised framework, we believe that the Fed will remain very sensitive to financial conditions and that the current emphasis on USD trends will persist. A cautious Fed, coupled with additional easing by other major central banks implies tailwinds for EMs overall, in contrast to last year s headwinds. FIG % FED S PROJECTIONS OF LONG-TERM FUNDS RATE: CLEAR DOWNWARD TREND HIGHLIGHTING INCREASINGLY CAUTIOUS FED 3.5% 3.% 2.5% Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Source: Summary of Economic Projections by the Fed, June 216. Conclusion: Implementation matters Overall, we believe that the fundamentals and valuations-driven case for investing in EMs looks strong against a backdrop of global disinflation and low/negative interest rates in a number of developed economies. Portfolio flows into EMs over recent months (Figure 13 overleaf) have already begun to show signs of a turnaround in both bonds and, more recently, equities, as the top-down case for EM investing starts to reassert itself. Here, it is important to note that the inflows seen recently are still a fraction of the outflows that the EM universe saw from 213 to early 216 when a number of investors (both institutional and retail) went underweight. Lombard Odier Investment Managers Emerging markets: last refuge in a low-return desert? November 216 Page 9/12

10 FIG. 13 EM PORTFOLIO FLOWS FOR EQUITY AND BOND FUNDS 15 1 Monthly flows into dedicated EM bond funds Cum. flows into EM bond funds (RHS) Monthly flows into dedicated EM equity funds Cum. flows into EM equity funds (RHS) USD billion -5-1 USD billion Jan 8 Jul 8 Jan 9 Jul 9 Jan 1 Jul 1 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Jul 15 Jan 16 Jul 16-2 Source: EPFR Global and JP Morgan, released in August 216. However, when it comes to investment implementation in the fixed income world, central-bank dominance and tightening regulations mean that today s world is characterised by fractured liquidity (an issue we discuss in detail in our recent research piece entitled A new paradigm in fixed income markets and implications for portfolio management ). Risks when investing in EM debt include concentrations in the same few positions being increased ( herding ). Together, fractured liquidity and herding leave investors heavily exposed to growing liquidity and market risks. With underlying economic differentials within the EM space becoming wider (for example, the impact of lower commodity prices on exporters versus importers) and the ability to exit positions in a frictionless manner decreasing, focusing on quality becomes critical. We believe that, rather than following the traditional market-cap approach that dominates EM debt investing and is designed to reward leverage, investors should focus on issuers underlying fundamentals. This would entail assessing each country on its own merits and bringing quality to the heart of portfolio construction, especially within a low turnover framework. That said, the reality is different in equity markets, where studies (such as the H1 216 market highlights by the World Federation of Exchanges) continue to show quite benign liquidity conditions. This means that when it comes to EM equity investing, the degrees of freedom still available lend themselves to high-conviction-driven approaches, which utilise manager skill based value-added versus the traditional market-cap approach (which effectively favours only size and momentum). We believe that, in the current environment, assessing the risk/ return profile of an asset class needs to be augmented with careful consideration of implementation design, given the current seismic shifts in the nature and shape of the global financial system and their consequent implications on traditional investing frameworks. Page 1/12 Lombard Odier Investment Managers Emerging markets: last refuge in a low-return desert? November 216

11 Important information For professional investor use only. This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the FCA ), and entered on the FCA register with registration number Lombard Odier Investment Managers ( LOIM ) is a trade name. This document contains the views and opinions of LOIM. It does not constitute a recommendation by LOIM to buy, sell or hold any security and should not be construed as investment advice. This document is provided for informational purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This document does not contain personalised recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipients exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. The contents of this document are intended for persons who are sophisticated investment professionals and who are either authorised or regulated to operate in the financial markets or persons who have been vetted by LOIM as having the expertise, experience and knowledge of the investment matters set out in this document and in respect of whom LOIM has received an assurance that they are capable of making their own investment decisions and understanding the risks involved in making investments of the type included in this document or other persons that LOIM has expressly confirmed as being appropriate recipients of this document. If you are not a person falling within the above categories you are kindly asked to either return this document to LOIM or to destroy it and are expressly warned that you must not rely upon its contents or have regard to any of the matters set out in this document in relation to investment matters and must not transmit this document to any other person. This document contains the opinions of LOIM, as at the date of issue. The information and analysis contained herein are based on sources believed to be reliable. However, LOIM does not guarantee the timeliness, accuracy, or completeness of the information contained in this document, nor does it accept any liability for any loss or damage resulting from its use. All information and opinions as well as the prices indicated may change without notice. Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term United States Person shall mean any citizen, national or resident of the United States of America, partnership organised or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income. 216 Lombard Odier Investment Managers all rights reserved. Lombard Odier Investment Managers Emerging markets: last refuge in a low-return desert? November 216 Page 11/12

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