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How to Invest in Emerging Markets
Emerging Markets should no longer be looked at as a homogeneous asset class. Watch as three experts discuss the current situation in Emerging Markets amid multiple headwinds
Jose Gerardo Morales - Chief Investment Officer at Mirae Asset Global Investments (USA)
Anupam Damani, CFA - Portfolio Manager, Emerging Markets Debt Strategy at TIAA-CREF Asset Management
Scott Thomas - Associate Portfolio Manager, Wasatch Emerging Markets Small Cap Fund
Duration:
01:00:01
Transcript:
Courtney: Welcome to Asset TV’s Emerging Markets Masterclass. We’re going to hear about oil, Central Bank divergence, the strong dollar and how you can invest in this market. Joining us today are: Jose Morales, US CIO, Mirae Global Asset Management; Anupam Damani, Co Portfolio Manager, TIAA_CREF Emerging Markets Debt Strategy, TIAA-CREF Asset Management; Scott Thomas, Associate Portfolio Manager, Wasatch Emerging Markets Small Cap Fund, Wasatch Funds. There’s a lot to talk about with emerging markets right now, oil, the strong dollar and a lot of Central Bank divergence, so everyone, welcome to our Asset TV Emerging Markets Masterclass. I want to start off with the broader strokes; we’ll get to the finer points later. But, Jose, can you tell us what you’re seeing right now in emerging markets?
Jose: [00:00:47] Yeah, sure. I think, you know, what we saw last year and what we’ve seen recently in the past few years at least with regards to emerging equity markets is a pretty, you know, disperse range of returns. Last year for example we saw the best performing market was up about 20/25%, it was a group of markets. And the worst performing markets were down somewhere between 20 and 40% on a sector basis. The best performing sector was up 20%, the worst was down 30. So that actually on a sector basis was the widest range of returns that we’ve seen since the crisis. And the reasons I think are pretty straightforward and that is that, you know, we’ve got so many different factors going on in the backdrop. You mentioned stronger dollar, a lower oil price, obviously the global cycle is recovering but it’s still pretty fragile. And then there’s geopolitical issues as well. And so sectors, companies and countries are pretty much positioned differently for all these factors. And so I think that given that those factors are still ongoing this year, that we’re going to see another year of pretty wide dispersion of returns. So you know, in terms of how we’re looking at it, we’re looking for several things. Firstly we’re looking for defensive growth. And for that really, you know, takes us to Asia and Asia’s obviously a beneficiary of lower commodity prices. Outside of Asia we’re looking at other areas such as Mexico which is leveraged to the stronger recovery in the US.
So, defensive growth in the sense of beneficiaries of lower commodity prices as well as linkages to areas of the world that’s seeing stronger cyclical growth. Outside of that we’re looking at countries that are focusing on structural reforms. There’s been a pick up in structural reform focusing in emerging markets over the last several years, you know, it’s only a handful at this stage to be fair, there’s still some key countries that are missing or lagging behind on that in that space. But we think that those markets that are, you know, focusing on India, Indonesia, China, Mexico for example, are the key markets in that space. I think on the equity side they’re going to continue to command a premium. And so that’s an area of focus to that and for us. Aside from those two on a third level, I think that despite the current, you know, cyclical fragility, if you can say that, you know, we’re still looking at very attractive demographics in the emerging markets, you know, there’s still rising income levels. There’s a growth of the middle class, there’s increased consumption in general. And so you know, when you look at all these factors put together it’s providing some very interesting mega trends that is offering attractive secular growth. And I think on the equity side, you kind of need to focus on these secular growth opportunities while the cycle still is kind of coming through.
Courtney: [00:03:36] So a secular growth story and that it’s not just one emerging markets trade anymore, that it’s really there’s a lot of singularity in emerging markets.
Jose: [00:03:43] Absolutely, you know, differentiation, I mean, you know, emerging markets used to be a lot more homogeneous than today, you need to really focus on differentiating across countries, across sectors, because that’s really no longer the case anymore.
Courtney: [00:03:58] So broad strokes, Anupam, what are you seeing from the debt perspective?
Anupam: [00:04:02] So just picking up on what Jose and you mentioned that EM is not a homogenous or a monolithic asset class despite the broad narrative in the market being that the global macro is quite challenging for EM, be it from Central Banking – core Central Banking perspective or a stronger dollar, the commodity price shock. And if you can add the homegrown vulnerabilities in some of the EM markets, I mean the temptation is to write off EM. The reality is a lot more nuanced than that. In emerging debt markets for example, the number of countries in the broad indices has grown to over 60. The individual prospects for each country vary quite dramatically. And how they get impacted by global forces also vary accordingly. So I would echo what Jose was saying, differentiation remains a key theme. I think from a fundamental perspective it’s fair to say short term we are seeing more credit deterioration within large parts of EM. But then again these are some of the bigger countries so which are mostly in the news, and people tend to associate the broader BRICs with just EM. But the EM asset class has grown, evolved and matured over time. You no longer see the same sort of contagion happening throughout the asset class because of one country or one event beyond the very immediate term. So I think from a fundamental perspective we believe the differentiation will remain a key theme.
We tend to classify emerging markets or categorize them as laggered, reformers, fragile countries, frontier countries and then the steady as you go. And within all those [unclear 00:06:01] these categories are very fluid, countries move in and out of them. And it’s not to say that there are not good opportunities to be found within the fragile group or the laggered group. I think technicals and valuations matter. And on that note I would say the technicals in the market on the emerging market debt side look actually quite healthy. There are about 460 billion in coupons and amortizations coming due this year within those EM sovereign and corporate hard currency debt. And large parts of the market are actually blocked away from issuance, if you look at a lot of the Russian corporates or even the Russian sovereign, a lot of the oil exporting names and increasingly Brazilian corporates have blocked a lot of the oil, exporter names are blocked to a large extent. And what you’re seeing in core markets is the negative yields in many of the core markets or very low yields is going to have increasingly, you’re going to see the crossover investor move into EM with its high yields [00:07:07]. And finally on the valuation side, I think the valuations which had gotten very tight before the taper tantrum happened in 2013, is actually looking quite fair. And a lot of the bad news is in the price of a lot of the large countries which are at the fear or the precipice of being downgraded are already trading as below investment grade countries.
Courtney: [00:07:33] So a lot of opportunity on the debt side.
Anupam: [00:07:36] Sure.
Courtney: [00:07:36] And, Scott, what are you seeing?
Scott: [00:07:37] Very similar, I mean from our perspective it’s becoming a stock pickers market. This EM beta trade that maybe could happen five years ago isn’t the case today. I think Jose touched on it; this divergence is likely to continue. Last year was the … had the biggest winners and loser spread that we’ve seen since 2009. But that said, I mean emerging markets, the expectations are low, valuations are reasonable. You’ve had four years of a flat market. And currency two years in a row of currency depreciation, so it’s shaping up to where we’re pretty constructive on this space, but again you have to be very selective. From our end we’re pretty much bottoms up stock pickers, and we think you can find opportunity in any market. Brazil last year was in a tough space, it’s in a tough spot again this year. But we found some of our best stock picks out of Brazil last year; it’s entering sort of a stagflation environment, little room to maneuver from a monetary standpoint. But there’s pockets of opportunity everywhere.
Courtney: [00:08:38] Interesting. So I think I want to drill down now with Central Banks, the US led the charge then the ECB and then just yesterday we saw India cut rates for the second time just this year, China cut their rates. And so we’re kind of seeing this Central Bank divergence. Jose, could you comment a little bit on what you’re seeing there?
Jose: [00:08:57] I mean I think we’re all seeing it, you know, the expectations obviously, the consensus, everyone is expecting for The Fed to begin to hike interest rates later on this year, I believe the consensus is currently somewhere around September. The pace is expected to be gradual very much, you know, data dependent as they’ve been saying for some time. And so you know, I think that’s not going to be a surprise to anyone. However, you know, while all this is happening, clearly the ECB is already embarking; I believe they announced today that they’re going to start their QE program in March. So they’re obviously embarking on their own program, the BOJ stance, prepare to carry on with more QE should they need to. And you know China also is loosening. And so we’re seeing those, you know, next three large Central Banks pretty much offsetting, you know, the expectations, or the impact that The Fed would have from their expected rate hikes. So I think, the net impact on the markets I believe is likely to be relatively limited, you know, I know that, you know, in the past when the word ‘taper’ was first mentioned, it had a pretty dramatic impact on many of the emerging markets, particularly the fragile five. I don’t think that that’s likely to have a similar type of impact this time around for various reasons. One is what I just said, it’s expected, secondly, there’s an offset coming from other Central Banks, thirdly there’s been some improvement in some of those markets, not all. And we can get into that later if you like.
But certainly there has been in at least in one or two of those markets, some improvement. The issue that I would see and the risk I think is, you know, not if The Fed comes and starts hiking rates in September on a gradual basis as is expected but instead it would be if the data that comes out in the US is such that it forces them to do it earlier, although again there’s not much time between now and September anyway. So it wouldn’t be that much of a shock, but let’s say if they needed to do it in a more aggressive way, and I think, you know, that would probably result in volatility. I think it would surprise the markets. I think that, you know, the concern then would be that The Fed’s probably behind the curve. And so I think that would cause volatility. I don’t believe it would be long lasting because again at the end of the day so much of it is already expected. But a lot of it really does depend on the data specific and how aggressive The Fed actually becomes.
Courtney: [00:11:27] And what kind of scenario would prompt that happening?
Jose: [00:11:30] Well, I mean you know, the data on the US continues to come out or accelerates in terms of how strong it is, the labor market. I think they’re talking about what the takeoff point is and you know, and the last time that Yellen spoke, she was looking at some time later on in the year, if that needs to be moved earlier. You know, that obviously would be a factor. So you know, it’s very much, I think, economic, US economic data dependent. And if you look around the world as well, because that’s something that they also … and I don’t think officially talk about necessarily, but probably that’s something that they’re thinking about, is what they’re looking … what’s going on elsewhere in the world. And you have a situation where oil prices is, you know, deflationary around the world. You know, there’s currently a ceasefire on the geopolitical situation in Russia. You know, there’s several factors, you know, Europe seems to be kind of, you know, still fragile but it seems to be kind of gaining momentum. So they could just decide that this is a good moment to do it. And so that could be a factor as well, that pushes them to do it sooner and more aggressively.
Courtney: [00:12:32] So, Jose, mentioned the deflationary pressures and these countries are trying to combat it but do you think it’s working around the world, Anupam?
Anupam: [00:12:40] So, I think inflation, there is a lot of debate about inflation and what’s going on and if it’s a structural issue, how much of it is structural versus how much of it is cyclical. I mean by that is the declining inflation and cyclically I think the oil price decline certainly gives room to a lot of countries, room to maneuver on the monetary policy side to you know, lower rates further. I think inflation expectations is something that we watch quite closely and around the world they continue to come down. And so in that environment I think with The Fed too even though US is a more domestic oriented economy and more consumption based, I think the global disinflationary pressures are quite strong. China, which is going through a deleveraging cycle, is quite disinflationary for the globe. And you still have large parts of Europe which are in the midst of a deleveraging cycle. So I think, you know, within that framework it’s hard to see The Fed being too aggressive in its rate hike. I think that’s certainly a risk as Jose pointed out in terms of, you know if the labor data picks up or inflation expectations continue to rise. But we believe that’s still a little bit far away. I think in terms of more just specifically focusing to emerging markets debt, you know, The Fed rises, there’s always a lot of fear related to The Fed hike. And again I would caution that it should be more to the pace of the hiking cycle than to the first hike per se.
The last taper tantrum in late 2013 did wake up a lot of EM policymakers. And the external balances, imbalances then have been reduced. The oil price is providing somewhat of a tailwind. And within that space if you look at historically The Fed hikes, if you were a long term investor in EM debt, The Fed shocks are easily absorbed by the spread and the income that you earn over time. And the re-pricing that happens is not very long lasting.
Courtney: [00:15:21] So will we see a reaction again like the taper tantrum if, when The Fed raises rates?
Anupam: [00:15:28] I think you can say that there may be a short term re-pricing that may happen again. But I would say a lot of it is pretty much baked in, into the prices and the valuations. And I would say the same thing again I think you have to differentiate between credit. I think the reforming countries who are on a reform agenda and who have a sound policy framework in place along with oil importers would probably fair a lot better than maybe some countries that have large external financing needs or their policy framework or credibility is in doubt.
Courtney: [00:16:15] And, Scott, if The Fed raises rates how is this going to affect emerging markets?
Scott: [00:16:18] You know, I think this time around The Fed has well telegraphed their moves. And in the past you haven’t seen that. And so it’s given since 2013, since the fragile five in this taper tantrum, it’s given these countries who, you know, I should mention, who had these external imbalances, high current account deficits, issues with their foreign reserves. It’s given them two years to fix some of these imbalances, repair their balance sheets. And oil is a big deal as well, the foreign oil helps these fragile five countries, they’re big importers most of them, of oil. And then also you haven’t seen a big binge on foreign debt like you’ve seen in the past. And so compared to … call it the Asian financial crisis in the early part of the decade, you don’t have those kind of external foreign debt levels that you have … that you had back then.
Courtney: [00:17:09] Right. And also I think the strong dollar is such an important theme as well, Scott. It’s typically a headwind for commodities, how is this playing out among the emerging markets?
Scott: [00:17:17] You know, it’s really a mix, I mean if you look at countries who are close to the US, Mexico is a great example, its proximity to the US benefits it. Those who export to the US, Taiwan’s another one. Mexico would be a classic case where the currency’s been weak for … last year it was weak. Half of Mexico’s GDP or I will say about a third of Mexico’s GDP is from exports and the lion’s share of that, 80% goes to the US. So a weaker currency helps and then also Mexico’s in a process of energy reform. And so electricity for example is two times that in Mexico as is in the US. And so as they go through this energy reform, there’s big opportunity to improve some of those input costs and make energy much less expensive which also helps their manufacturing, makes it a lower cost. And you know, over the years, Mexico historically has lost share to places like China who have had a lower labor cost and now that’s about at parity. And so if you look at the strong dollar there are places where it can be really positive. And I think Mexico’s set up to be in good shape on that front.
Courtney: [00:18:23] You’re agreeing, Jose?
Jose: [00:18:25] Yeah, I agree. I think it’s … on a broad level a stronger dollar does provide headwinds for emerging markets, but you really do, you know, need to look a little deeper and see, you know, what exactly is going on. So countries, you know, as Scott mentioned, countries that have current account deficits, commodity exporters, countries with FX debt levels that are high, so you would highlight places like Brazil, South Africa, Chile, I mean these countries are going to be a lot more vulnerable than those countries that, you know, are commodity importers, have current account surpluses or even low levels of FX debt or have exports directly to the US and so obviously, you know, Mexico, Taiwan, Korea, these kind of markets, even China are much, much less vulnerable. So you really need to differentiate and then kind of look to see what exactly is going on and how the stronger dollar does actually impact emerging markets.
Courtney: [00:19:17] And is it fair to say that it’s heightening currency volatility broadly?
Jose: [00:19:21] That it’s…
Courtney: [00:19:22] The strong dollar is…
Jose: [00:19:24] Yeah. I mean it’s … you’ve seen a broad weakness in emerging market currencies recently but that’s a lot more to do with the stronger dollar. Obviously there’s sort of individual situations, you know, Brazil for example, where it is the stronger dollar but there’s a lot going on domestically that is leading to that weaker, you know, currency situation, the ruble is another example. But generally speaking it’s really all linked back to the stronger dollar.
Courtney: [00:19:50] Okay. Anupam, what are you seeing with the strong dollar, how is it affecting the countries that you look at?
Anupam: [00:19:55] Yeah. So I think the one point I would make on the stronger dollar on a macro basis is historically if you look at it, the broad gains that the dollar makes is usually six months ahead of the first Fed hike. So I think a lot of the dollar strength is in the price, I think there are certainly tailwinds to further dollar strength. But I would say it’s unlikely to be that linear going forward. And then secondly, the second point I would make is EM currencies which used to be in the 1990s, bulk of the EM currencies used to be packed to the dollar. And from … and now most of them are floating or a managed float. So that acts as a huge shock absorber for the macroeconomic adjustment for the economy at least. And I think that’s been … so it doesn’t erode the balance sheet as much. Certainly if … and what you have also seen over the past decade or so is more and more emerging market countries have tried to issue locally in their local debt rather than in the external debt markets. And local debt markets are getting deeper. So there is increasing liquidity there. So the balance sheets don’t erode as much as you would have thought, in what happened what we saw in the 1990s. The reserve buffers are a lot larger for most of these economies. So there are buffers in place, not to say it still is … it can be quite negative for a lot of countries. Again, I would mention that the dispersion is huge.
You have countries, what we have seen is we have [unclear 00:21:47] countries like Philippine peso or Indian rupee which are stable reform oriented countries and oil importers that have actually benefitted and those currencies have strengthened against the dollar for the year. Likewise the Korean won which is a huge manufacturer and benefits from the global trade cycle or the upswing in the global trade cycle, has benefitted much more. And the currencies that have faced the bigger challenges have been not only because of due to the broad dollar strength but also to homegrown larger external imbalances or poor growth inflation tradeoffs such as Brazil and Russia where you can add on … in the case of Russia, even the sanctions regime, or where their external financing needs are high such as Turkey.
Courtney: [00:22:44] Interesting. So there’s a lot more built in shock absorbers than there were say 20 years ago?
Anupam: [00:22:49] Yes.
Jose: [00:22:51] I think another interesting point here as well is if you look at it from … and Anupam will have a much better feel for this as well, but you know, in terms of corporate debt, you’ve seen, you know, a large expansion in corporate debt especially out of Asia, you know, certainly, you know, since like, you know, the mid 2000s. And so I think you know, whenever this whole conversation about the stronger US dollar comes up, there’s always a sort of concern of, well what about companies especially in Asia. And so you know, I think, you know, the sense that we get is, you know, certainly, yes, on a notional level, debt levels are higher. But what the real issue is, is if you look at the liabilities, they’re pretty much still matching their external earnings, so on that basis it doesn’t seem at this stage to be that big of a concern, but certainly one to keep an eye on.
Anupam: [00:23:34] So I agree with Jose, I think the risks in emerging markets lie more on the corporate side where the corporates have increasingly issued debt in the external debt markets rather than the sovereigns which have been issuing more locally. And with weaker growth in many EM countries and currency depreciation pressures, that’s a sector that we need to watch out for. And the corporate sector defaults, I think, as a result are probably likely to increase. And the one thing from the sovereign perspective that we are watching is the corporate sector or the quasi sovereign sector liabilities coming on the sovereign balance sheet as a result of the weakness on the corporate market.
Courtney: [00:24:27] [Unclear 00:24:27], I just read that South Korea just had a corporate debt binge and it’s, you know, it’s had an impact. But I want to pivot to oil. Scott, give me your thoughts on how oil is impacting the emerging markets now.
Scott: [00:24:39] Sure. Well, oil, it’s a net positive for about 80% of the emerging market countries. And so as a whole it’s a big deal. And I think you have to really look country by country to see the effects. If you take a place like India for example, half of the import balance is energy. And so that’s a big deal. It helps improve inflation. Inflation is now at five year lows in India. It gives the Central Bank more ability to maneuver, to go through an easing cycle and start reducing rates. India’s historically a market that’s been a high inflation, structurally high inflation, high cost of capital market. And so for the first time in years and years and years you’re seeing the ability to lower rates, that means lower discount rates, lower cost of equity, higher valuations, it’s hugely positive. If you go to a place like South Africa, about a year and a half ago South Africa was one of the fragile five, it had big issues, big pressure on the currency, consumer was over-levered and under pressure as well. And what lower oil did was it eased some of that pressure. So inflation comes off, it was expectations for rates to go up, now they’re expected to be flattish to down. And consumers, they were able to repair that balance sheet and then hopefully in a year’s time start to grow again.
Indonesia, another example where you have a new government that came in, they’re pushing big reforms. One of those big reforms is tearing off the Band Aid of fuel subsidies. And so as they’ve done this it’s almost had a neutral impact. And so I was in Indonesia last year and huge headwinds of ripping off that Band Aid of fuel subsidies, you were looking at higher inflation, rates expected to go up, pressure on the consumer and some big weakness there. And so lower oil almost neutralized that effect to where we’re very constructive on the country now in what’s happened. So it’s really country by country, I’d say these fragile five that everyone was worried about in 2013, are probably the largest beneficiaries and it really helps on easing some of those inflation pressures, giving them ability to lower rates, even with The Fed raising rates potentially.
Anupam: [0:26:49.0] I would pick up on Scott’s last point related to Indonesia reducing fuel subsidies. And I think this is a very interesting time because with the sharp declines in oil prices, what has been very politically challenging for a lot of emerging market economies is to cut subsidies. But this environment of your oil prices makes it socially palatable for them, so politically feasible for them to cut subsidies. And we haven’t seen that just in Indonesia, we saw that in India, we’ve seen that in Nigeria, we’ve seen that in Egypt. So a large … so we’ve seen that in Malaysia, so increasingly governments are able to do what they weren’t able to do before. And just like Scott said, I think there’s a whole spectrum of countries, the oil importers tend to benefit both on the inflation and the current account deficit side. So it’s a huge tailwind. On the oil exporter side, yes, broadly, right, it’s a huge terms of trade shock so it impacts negatively their fiscal deficit, their current account deficit and negatively impacts growth. But I think even within the oil exporting countries there’s a huge spectrum. So you have countries like Nigeria for example that generates over 90% of their revenues through oil, right. So that is in a bit more vulnerable situation, although its balance sheet is a bit stronger, so it can afford to come to the market and raise debt. But compared to Columbia who is also an oil exporter, however it generates only 20% of its revenues from oil.
So there are large dispersions, even within the oil exporters. And what happens is when significant declines like the ones we saw in late December and early this year, you know, the market tends to overshoot actually and you can actually … that’s when differentiation comes in between credits and you doing your fundamental analysis comes in where you can actually differentiate between credits and pick up good value.
Courtney: [0:28:58.9] Interesting. And, Jose, what’s your perspective on oil with the emerging markets?
Jose: [0:29:02.4] I think a lot of the key points have been covered, I mean I think you know, certainly policy flexibility is one of the biggest, you know, benefits throughout emerging markets. As Scott said, the vast majority of emerging markets benefit from a lower oil price. I’ve seen studies, you know, every sort of $15 drop in oil price has a sort of a specific impact on GDP growth for various emerging markets. But for places like Russia, every $15 drop is something like about a percent or just over a percent drop in GDP growth. But for the vast majority of the emerging markets it’s anywhere from 20-80 basis points for every $15. So it’s a net positive. And I think we see it here as well in the US and in the developed world where, you know, a drop in oil prices means lower gas prices, you’re paying less for energy, that means you spend more on other things and so consumption rises. So that’s a key benefit as well and especially throughout many parts of Asia. But I would say, yes, increased consumption which impacts GDP growth positively and obviously policy flexibility are the main benefits.
Courtney: [0:30:09.8] And when we saw, you know, India and China, their main iShare is ETF just kind of saw 17% for China and 10% for India once Brent slid from 1.10 to $60 a barrel. Is it more nuanced than that or was oil, you know, how much of that can you attribute to oil versus other things like, you know, going on in those countries?
Jose: [0:30:31.4] You know, I think because of the significant drop that we saw in oil, from 100 to, you know, whatever it was, in the 50s, in the 40s even for Brent. You know, I think that it was … when it did bounce back up to what is currently around 60, it was almost such a relief to see that, I think that it probably had a very big impact on those oil exporting countries, and I’m talking about the recent bounce back, back in February, and vice versa, obviously for when the oil price was falling for those commodity importers. So I think Turkey was another beneficiary market that did well. And we saw just a reversal of that pretty much in February for the equity market. So I do think it is … it has been at least in the last several months the key driver for a lot of what’s going on for these sharp movements. I mean obviously in India you’ve got other factors, you know, you’ve got the whole reform momentum and what’s going on there and you know there’s also Central Bank activities throughout various parts of the emerging markets that will have an impact as well. But I would say, you know, the oil price has been a very key driver of the equity markets in the last, you know, sort of four or five/six months.
Scott: [0:31:39.6] You know, maybe just add on to that, I mean the point had been made but I think it’s worth highlighting again, the ability for these countries to fix some of the structural imbalances that they had in the past really goes up. And India I think is probably the classic case where if you go back to 2013, it was one of the fragile five, it had issues with the currency, twin deficits, nobody wanted to touch India. And then you had a few things that happened, you had a new Central Bank had come in; he started fixing some of these external imbalances. And then you had protocol change where you’ve gone from a very left government that’s been in for a decade to a more pro business government. And so a big center middle shift there and then at the same time right after that you had a gift fall in their lap of lower oil, and I mentioned the benefits to India before. But that’s a big change in that market. And then from there we’re in a bit of a wait and see mode, we had the budget that came out last week, it gives us some insight into what they’re thinking, what they’re trying to accomplish. And it’s very pro business; I mean they’re really pushing to eliminate some of those bureaucratic corruption and bottlenecks you’ve had in the past. And you know we’ve started to see earnings have been okay, but you haven’t yet seen the bottoms up on the ground change and call it revenue, and that’s what we’re waiting to see, it would be odd not to see it, everything seems to be pointing in the right direction.
Courtney: [0:33:06.1] Interesting.
Jose: [0:33:07.2] Yeah. And I mean I think again, differentiating even amongst those beneficiaries, you can, you know, do this all day long. But I think if you look at India, you know, when the whole taper tantrum started at the time, I think it was at what, four or five percent current account deficit, I think it’s sort of less than 1% and kind of going to sort of a break even. So a very big change, oil has obviously helped. And in line with that, given, you know, the sort of momentum that reform has picked up there, you know, it’s attracted FDI. So even on the financing side, that things generally have improved in India. But we can look at a place like Turkey, obviously a key beneficiary on the current account side from lower oil prices. But unfortunately not the same can be said with regards to the financing situation, so still very much reliant on portfolio flows which are very volatile, very much dependent on global liquidity and so on. And the reason is because, you know, it’s in a very difficult area geopolitically speaking, there’s political concerns with regards to the influence that the government is trying to have on the Central Bank and other factors. So again, every beneficiary of low oil isn’t necessarily the same.
Anupam: [0:34:14.6] So the one thing I think, I broadly agree with them on India, I think the reform momentum is huge and it’s a remarkable change because the government came in with a mandate – with a large mandate and it has had the buy in from the investor community in terms of its vision and what it wants to do within the country. I think the political constellation in the upper house and the states still remains challenging for the government to pass through some of the heavy duty legislation that is required. So we just always remain cautious that the optimism in the market doesn’t get way ahead of what we actually see develop on the ground. I mean we like India as a reform story as well, but I think we just … I think it’s a very consensus [unclear 0:34:58.9] so we always stay a bit cautious on that.
Courtney: [0:35:02.5] And I’ve heard you all mention the fragile five so far and I think people who aren’t that familiar with emerging markets, might know the BRICs, Brazil, Russia, India, China, but there’s frontier markets, there’s the fragile five, who are the fragile five?
Anupam: [0:35:15.4] So the fragile five, a large part of those we tend to categorize in our [unclear 0:35:23.0] category, I would say Brazil, Russia, South Africa, China, are certainly, you know, you could include Turkey in there, are probably the new fragile five. You know, Brazil and Russia, so let’s take Brazil for example, right. It’s had a very challenging economic environment where the growth inflation tradeoff remains quite poor. The external backdrop remains quite challenging for Brazil. There are huge competitiveness issues within the economy. But what’s constructive has been the new administration that has been put in place in terms of the Finance Minister who has come up with a plan. But again is being challenged increasingly in the senate, so the political backdrop has deteriorated as well along with the economic backdrop, not only with the challenge to the fiscal but also with what we are seeing with the Petrobras candle that is involving a lot of politicians as well. So I think Brazil certainly remains in that fragile five. I think there are … you can be cautiously optimistic that if they implement the policies right, if the Central Bank can regain its credibility in terms of, you know, anchoring inflation and inflation expectations and the fiscal authorities stay on a fiscal consolidation pad, even though in short term, it’s all detractory for growth and inflation because [unclear 0:37:06.6] will rise. You can see possibly towards the later part of the year a more positive sentiment arising.
Russia, you know, Russia came into the crisis with a very strong starting position, with a strong balance sheet, large current account surplus. I think the geopolitical tensions and the sanctions regime combined with the oil price decline has been extremely negative both for growth, for sentiment in general, for issuance for the reserves and for the current account. But I think in Russia when you think about it, the response by the policymakers so far still has been very textbook in terms of macroeconomic orthodoxy. So they floated their exchange rate which is the right thing to do, they rebalanced their budget quickly to a lower oil price, they provided financial assistance to the financial sector in terms of recapitalizations. The Central Bank hasn’t per se given up its inflation targeting, but has postponed that given the financial stability risk and is trying to stabilize the ruble [0:38:18.2]. So I think, you know, again, there … as well when there are overshoots that happen in valuations, we tend to think of as opportunity. But the sanctions and the geopolitics will remain and overhang for Russia to a large extent.
Courtney: [0:38:35.7] And, Scott, what are you seeing in terms of the fragile five then, and are they the same countries that Anupam sees?
Scott: [0:38:40.6] You know, the original definition of the fragile five was those countries who had … were in deficit positions, so called budget deficit and current account deficit, so external deficit, originally was South Africa, India, Indonesia, Turkey, to name them. And you know, I would say the big change has been the lower oil, originally in 2013 those were the countries that were most susceptible to rising rates in the US and a strong dollar. And what’s happened is you’ve had two and a half or I guess two years now roughly, of repairing their balance sheet. They’ve been able to fix some of these external imbalances and overall we’ve become quite constructive to most of them. But that said, I mean we’re very much bottoms up investors. And if you were to look back at the start of last year in Indonesia and South Africa, you would have been quite negative on the two countries. And if we only invested from a macro perspective we would have missed the boat on those two. We think you can find opportunities in any market. And a good example is now back to Brazil, is a country where it’s in tough shape as far as entering a stagflation type scenario. You have these corruption issues that have come out. But again there’s pockets of opportunities one can find there. For example, if you look at the banking sector there, credit growth had a rapid expansion over the last say five to ten years and hit a wall. So there was little credit growth and capital requirements in the banking sector are ever increasing and the banks for the most part are pretty light on capital. And so they’re starving for capital light sources of income. One name that we really like there is BB Seguridade which is the insurance partner of Banco de Brasil which is one of the largest banks in Brazil. And they’ve filled this void, basically what they do is through this bank assurance partnership is sell insurance products to a underpenetrated client base of Banco de Brasil. And insurance is underpenetrated and growing in Brazil as well. So while the Brazil market in US dollar terms and the equity market was down over 10% last year, BB Seguridade was up over 20%. So the list goes on. And I think if you really dig down and do the work and pound the pavement you can find opportunities or pockets of opportunities anywhere.
Courtney: [0:41:04.4] Interesting. And Anupam touched on this with the new Brazilian Finance Minister, Levy, how much … I know you look at things from a bottom up perspective, but how much is he going to impact the companies in Brazil that you were just talking about?
Scott: [0:41:19.1] You know, it depends, I really don’t see a lot of maneuverability from a monetary standpoint there. If you lower rates there’s issues, if you raise rates there is issues as well. And for us, I think it’s really digging down and finding those companies who can operate and the fundamentals can outpace any sort of headwinds that are present from a top down perspective.
Courtney: [0:41:43.1] Jose, your take on this?
Jose: [0:41:44.6] Yeah. I mean same sort of point of view, I mean I think, you know, if you stick to the example of Brazil and things are going to get worse before they get better. You know, we’ve been surprised actually by the … by the sort of amount of discussion and targets and focus on, actually focusing on implementing changes and improving the fiscal situation in Brazil, which is required, which is necessary. You know, so I think if he stays, assuming he doesn’t get, you know, let go, because it is, you know, obviously very politically driven down there. And so if he stays, yes, in the near terms things get worse, but ultimately I think that comes … that is a better situation for Brazil. And I think if you look at the equity market, it’s been pretty interesting because you have Petrobras, you know, being downgraded, now there’s a scandal, you know, you’ve got these situations coming up. And yet the market, you know, it was up in local currency terms, actually it was up in February when all these announcements were made. And I think, you know, for starters, anyone who wants to be underweight, Brazil at the moment already is.
But also I think people might actually be looking through the cycle and looking through all this. And as long as Levy stays, as long as he, you know, it doesn’t matter if he gets to 1.2 fiscal surplus, if he gets, you know, it’s negative now. I mean if it gets, you know, if the momentum towards that actually begins, I think that’s a positive for the currency and generally for the discount. Because there’s a very big discount on the equity market in Brazil, no one believes it. So if they start to see steps in the right direction, you don’t need to go all the way, I think that goes a long way for Brazil. So completely agree, you can find, you know, investment opportunities anywhere.
I mean the fragile five, yes, South Africa’s another example, you know, which was in a very bad shape when the whole taper tantrum began. Things really, I mean, they’ve improved a little bit but I think, you know, there’s still a lot of complication, growth is kind of difficult to find, inflation, although it seems to have kind of slowed, it still has been problematic. You know, there’s still the risk and the threats of more strikes in the mining sector which is going to put even more pressure on growth. So you know, it’s a sort of, you know, muddling through type of situation. But yet, you know, some of the best investments that we’ve, you know, we had last year was in South Africa and particular in the healthcare sector which, you know, the healthcare for us is one of the mega trends that we’re seeing, not just in South Africa but throughout other parts of emerging markets, just purely on the back of the fact that, you know, incomes are rising, government programs are being pushed through, and there’s a severe under-penetration situation. So we’re seeing, you know, the rise of investment opportunities in drug manufacturers as well as medical service providers and South Africa was a very good example of that.
But you know, I think for us, in terms of the original fragile five, we have a sort of somewhat mixed opinion [0:44:41.0]. So you know, India, no longer really part of that group clearly, Indonesia kind of probably close to exiting. Turkey is probably somewhere in the middle, I kind of highlighted before that, yes, current account has improved but, you know, financing situation is still kind of risky. But we see South Africa and Brazil still, you know, pretty risky. And then whether or not those new members, Russia would certainly be a good candidate for that, but yeah.
Courtney: [0:44:41.0] I think that’s really interesting, because people look at … people hear about South Africa and they think coal and precious metals, but you know, you found a healthcare company that was great. And that takes me to process, and you talked about you have a fundamental approach, Scott. Can you tell me more about your process for selecting emerging market investments?
Scott: [0:45:21.3] Sure. So, we’re very much as I mentioned before, bottoms up investors. And I think our bread and butter’s on the small cap space. And the challenge one has is looking at a universe of thousands and thousands of investable companies, and narrowing that down to kind of like the 100 highest quality growth companies within emerging markets. And so there’s a lot of ways to skin the cat. You know, some investors are theme based investors or top down macro investors. So for us it really starts with the numbers. And so we run a really rigorous quantitative process where we use a multi proprietary, multi factor model. And score companies based on the criteria we’re looking for and what we define as a quality growth company. And so from there it’s about pounding the pavement. We get out, we probably travel four to six months out of the year. We get out and meet with these companies in these markets and do our assessment. And then from there it’s building the portfolio, assessing valuation and where it fits in. I think the benefit you also have on the small cap side is a lot of these companies are domestic demand driven. And so the correlations are quite low, if I look at a consumer or a bank in the Philippines versus a bank in Qatar for example, the correlation might be very, very low.
And so constructing a portfolio you have huge benefits from that low correlation. And from there, there is a lot of … we’re very much bottoms up to where you can find companies in different sectors that can still put up numbers and operate agnostic to the macro environment. One area we found a lot of opportunity in is micro finance. And so you have this void, especially in emerging markets between formal banks and loan sharks lending. And so there’s companies around the world, a handful that we own, Credito Real in Mexico is a good example, or [unclear 0:47:18.1] Power in Thailand, Suriname Citibank in India, all these companies, they would define themselves more as collection based companies. And so it’s an area that banks shy away from, in times when there’s a lot of liquidity they tend to dabble in this area and burn their fingers and then we’ll move away from it. It tends to be a very defensive space as well, it almost operates in a vacuum to where when times are good and there’s lots of liquidity, banks will rush into this market. And asset quality, credit quality is good, when times turn the other way they pull the liquidity out, people still need this, call it working finance type lending and these companies are able to fill that void and grow. And so as I mentioned before there’s opportunities everywhere. And this process of screening through the universe, and going from first the numbers to then finding the companies who service well.
Courtney: [0:48:16.8] Great. And Anupam, when you’re constructing a debt portfolio, what is your process?
Anupam: [0:48:20.6] Yeah. So we tend to marry the top down with bottom up approach. We believe that EM can never delink itself from the macro – global macro picture, so understanding and appreciating the global macro and where the forces lie is extremely important. And then we marry it with a bottom up fundamental analysis. We look at countries, not only from a sovereign debt sustainability perspective but more from a comprehensive country risk perspective because that allows us to see how adventurous we want to be in that particular country, going beyond the sovereign external debt into the corporate debt market or the local debt market. And that’s a very important tool, the comprehensive risk framework because that takes into account corporate governance transparency, checks and balances within the economy. You know both the ability and the willingness to pay but also the quantifiable but also the non-quantifiable factors in EM which are actually quite important or as equally important as the quantifiable factors. We run a blended strategy which marries both external currency and local currency and it marries sovereigns, corporates and local and we believe that as active managers we can nimbly move between the different segments as the opportunities arise between the different segments of EM, between sovereigns, corporates and local markets. And that allows us to generate a high risk adjusted return over longer periods of time.
Courtney: [0:49:58.1] Interesting. And, Jose, can you tell me a little bit about your process?
Jose: [0:50:01.1] Sure. I mean we look to achieve long term capital growth by investing in companies that are sector leaders. These are companies that have sustainable competitiveness, companies that are either currently maintaining or will be achieving dominance in their respective market. We employ an extensive bottom up approach as well, when it’s team based. We’ve got teams around the world. And we look to leverage off those resources and those teams by constructing concentrated portfolios that are high conviction. We believe that the emerging market benchmarks are pretty inefficient and we also think that it’s just as important to avoid the losers in emerging markets as it is to identify the winners. And so we’re very much benchmark agnostic when we’re putting together our portfolios, we believe that an active approach is really the most important way to invest as opposed to a passive approach in emerging markets. In terms of where we look, clearly what drives us, especially in the last few years when as I’ve said, the cycle for emerging markets has been relatively fragile and relatively weak. I think that, you know, what we look for is that secular mega trend, that sort of secular growth where, you know, it will do well irrespective of what the macro does. I mean clearly the macro is an important driver as well, we don’t ignore it. But we believe that if we focus, if we identify and focus on those, you know, powerful investment themes, that the secular growth there is strong enough to get us through the cycle.
Courtney: [0:51:42.0] Interesting. So I think active management is the word of the day here with your processes. Quickly before we go to final takeaways, I want to ask you Anupam, about Venezuela. Can you tell me a little bit about that?
Anupam: [0:51:53.7] Sure. It’s been in the headlines a lot. The market is pricing very high probability of default for the country. I think we categorize it in our fragile or the critical state category where you know, the prognosis is poor there. And the emergency ward, we don’t know if they’re going to come out alive. But the jury is still out. And so even though the market is pricing, a very high probability of default, I think the timing of default and the nature of that restructuring remains quite uncertain. And what I would say is the economy has large macroeconomic imbalances. This was even before the sharp decline in oil prices, which impacts Venezuela extremely negatively as one of the larger oil producers. However, the government’s willingness to pay its debt has been extremely strong. It continues to prioritize debt holders over its own local population base. And there’s something to be said for that. And so the room for maneuver, so the government is implementing short term ad hoc measures to monetize its assets. So Venezuela used to have these deal … this Petrocaribe deal with the Caribbean nations where it gave oil to the Caribbean countries at a heavy discount. It just monetized that, the Dominican Republic, it has been issuing debt under Citgo. It got some loans from China. It does, you know, some stopgap measures to remove some distortions in the economy. But they’re never at the comprehensive level. So I think fair to say from political, social and economic standpoint, the deterioration continues, how to figure out where the tipping point lies, because the government certainly has shown its willingness to monetize assets and continue to pay debt holders.
Courtney: [0:54:09.2] And I want to shift gears a little bit. We have a viewer question. We love hearing from our viewers at Asset TV, it’s from Ben Wheeler of Dygos Schwarz and Wheeler. Ben, go ahead?
Ben: [0:54:17.6] Well, thank you very much for having me, Courtney. And my question is, with Russian equities currently having a dividend yield that is higher than the forward P/E, do you see this as an attractive opportunity from a risk reward standpoint?
Courtney: [0:54:28.5] Well, Jose, what do you think about this?
Jose: [0:54:30.3] Well, I think first of all, I think, you know, the dividend yield at the moment is somewhat kind of equal to where the forward P/E is. What I would say about Russia is that, you know, it’s not a market where valuations have ever really been a key driver. I mean Russia’s been a cheap market on the equity side for many, many years as far as I can remember. So I think, you know, the fact that, yes, okay, dividend yield is where the forward P/E is currently is a positive. But that does not mean that that can’t change in a sense that dividends … the dividend yield could actually be reduced. I think, you know, in an environment where Russia is going into further recession, inflationary pressures are there, you know, rates are being hiked. The macro situation there is just so difficult for them and obviously there’s ongoing sanctions and you know, I think for me, at the moment in terms of a risk reward for Russia it’s very difficult to see. So I’m a little bit cautious I would say on Russia, especially if you’re just basing it on valuations where for Russia it really hasn’t been a driver.
Courtney: [0:55:32.5] So a little bit cautious, okay. What, do you think, Scott?
Scott: [0:55:35.2] Sure. We’ve been out of Russia for over a year now. And similar to what Jose has said, the risk reward is just not quite there. Politically where does this end? It’s hard to say, so from an investor perspective it’s hard to get excited about it right here. I think Russia is on the precipice of falling down into a frontier market. The debt was just downgraded, I don’t want to say it feels uninvestable but it’s close to.
Courtney: [0:56:05.2] Okay. Close to uninvestable and from the debt perspective, how do you see this, I know this is an equity question, but what do you think, Anupam?
Anupam: [0:56:10.3] Yeah. So I think the two things that we are watching is any sign of not increasing further sanctions or sanctions lifting. So currently the minister agreement is broadly holding. We’re cautiously optimistic only because you have to be given that we’ve seen this story before. And then it is … the other thing that we are watching is the reserve level on … at the Central Bank. And if they can sort of maintain that. So I think earlier in the year we saw Russian valuations on the debt side really blow out. And then we thought that the overshot had happened, that the market had overshot. And so we looked at it as a good opportunity. I think now valuations look fair, the ruble looks fair. So we’ve had a strong rally since the beginning of the year both in local debt markets, the currency and external debt markets. So at this point we think it’s fair and if anything, you want to wait for better opportunities to come back and see if this minister agreement can hold and oil prices can at least stay here, if not go higher.
Courtney: [0:57:21.8] Interesting. And this has been such an interesting class but before we go I want to get everyone’s final takeaways. And I’d like to start with you, Scott, what are your final takeaways on emerging markets?
Scott: [0:57:30.9] I think with emerging markets in general we’re quite constructive. I mean two years in a row of currency depreciation, valuations are reasonable. And you’ve had flat markets for four years. But I think the big takeaway here is you need to be as selective as ever. This divergence that we’ve seen over the last year is likely to continue. I don’t think emerging markets is just about top down GDP growth, it’s more about change. So, Jose touched on it, some of these medical themes, it’s about changing the economy reform and beneficiaries of that and infrastructure etc, etc. So it’s a stock pickers market right now.
Courtney: [0:58:13.2] Stock pickers market, okay. Anupam, what are your final takeaways?
Anupam: [0:58:16.0] I would say the secular story for EM is [unclear 0:58:19.7] alive. I think cyclically we are having some troubles but we are seeing reform after almost a decade, reform being implemented. And you usually see that only when governments are pushed against the wall. So I think that we are going to be in a better place. And the valuations and the technicals are actually quite supportive of the market but differentiation will remain key, despite EM constantly being in the headlines. Last year emerging markets debt had a very solid return, this year too. I think as long as you have a nimble approach to investing and you differentiate and do fundamental analysis, you can make … you can find very good opportunities in the market and make good returns.
Courtney: [0:59:04.6] Interesting, and, Jose, your final takeaways.
Jose: [0:59:06.5] And for the emerging market equity class, and we’ve seen something somewhat different in terms of the performance. Obviously we’ve seen an underperformance now going on five years relative to the developed markets. And a lot of that has been driven due to the narrowing difference between GDP growth in emerging markets and developed markets. And so really what we need to see before we get some, you know, a pick up on a sustainable basis of performance from emerging equity markets, is for that to stabilize, for that shrinkage of the differential to stabilize. On the cyclical side of things, things are improving, all be it quite moderately. But you know, clearly should the US continue to do well, should Europe pick up, should Japan turn around as well then obviously that’s all positive. And that would be supportive of emerging markets. So in the meantime we stay focused on those countries in emerging markets that are, you know, focusing on structural reforms, we stay focused on those companies that are well run, quality companies that are within those secular growth sort of themes that I mentioned before, and that’s really the way to invest in emerging markets today.
Courtney: [1:00:09.5] Interesting. Well, thank you all so much, we’ve learned so much about emerging markets and appreciate you being here.
Important Disclosures
The content above represents the views of Anupam Damani as of March 5, 2014. These views may change in response to changing economic and market conditions. Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, are not bank deposits, are not insured by any federal government agency, are not a condition to any banking service or activity, and may lose value.
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MASTERCLASS: Emerging Markets - March 2015
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