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Courtney: [0:00:05] Emerging markets are one of the least expensive asset classes to own today. And if you look at the US, trading at 17 times PE on S&P, very richly valued in comparison. As an equity portfolio manager specializing in EM, where are you seeing the best value?
Joe Gubler: [0:00:20] Yeah. I mean I would agree with that idea that emerging markets, equities are very cheap. So one of the challenges that we have is to invest in an asset class that’s already cheap compared to developed markets, and see if we can find opportunities within that asset class that are even cheaper. And so, you know, we … the portfolio we build has sort of high single digit forward PE ratios which obviously puts you much lower than developed markets. In terms of where we see those opportunities it may not be in the obvious places that you would expect. So materials are somewhat cheap in emerging markets, although not cheap enough relative to their history to make them interesting. And there are other problems in that space. We don’t use just value; we use growth and momentum, certain top down considerations. And so we’re actually underweight materials, even though that’s a very cheap sector. But energy is a place that is cheap and where we do find interesting opportunities. And so that’s a sector where we’re currently overweight.
Courtney: [0:01:22] Great. And we’re going to definitely get into the different sectors as we move into the program. Olga, what are you seeing in terms of where you’re allocating on the debt side?
Olga V Yangol: [0:01:29] So, looking at EM debt, I would say that the environment has changed a lot over the past decade or so. What’s important to consider is the approach to investing in EM. Throughout the 2000s there were a lot of tailwinds for EM, with rising commodity prices on the back of the growth in China. We also saw quantitative easing (QE) supporting the inflows of capital to EM in search of yield. All this was helping EM. Many EM countries also went through a number of reforms; they accumulated reserves and moved to floating currency regimes, etc. It was a virtuous cycle, essentially. Now, over the past three years, we’re seeing a far more challenging environment with declining commodity prices, and an end to QE in the US. And we have seen highly differentiated performance, across dollar-denominated and local currency-denominated EM bonds. What’s important today is really the selection of countries in the EMD space, finding countries that are in a better position to withstand the current challenging environment. It’s also important to focus on valuations in EMD and to choose among energy importers and exporters and to rotate among EMD segments including hard currency bonds, corporate and local currency bonds.
Courtney: [0:03:04] Yeah. So that 2002-2011 period was great for beta trades in EM, not the case anymore. It’s really kind of the time for active management I would say, what are your thoughts, Andy?
Andy Kapyrin: [0:03:14] I’d say so. So the thing about emerging markets is it’s a very easy asset class to dislike today because the news flow is very bearish. If I would just Google emerging markets and try to look for investment advice I would find negative articles about China, articles about ghost cities, articles about, well, today Brazil is potentially impeaching its president. It is hard to find good news about the market. But as a value investor for me that is good news on its own, and the most unvarnished good in emerging markets is the price of stocks. I look at the S&P 500, just a blend of large American companies, trades that are priced to earnings ratio of about 17-18, that’s on the expensive side of what’s normal. Stocks in emerging markets, again just a simple index, if you look at a broad slate of them, are trading at around 10-11. That is a very cheap valuation. And you can look at other metrics, things like price to book, price to sales, price to cash flow, anything that makes a company fundamentally worth something. Any of those metrics are at very cheap levels, in some cases approaching where they were in 2009. So pessimism, if you have valuations as a measure of pessimism rather than attractiveness of investment. Pessimism in emerging markets is near all time highs.
Courtney: [0:04:34] Yeah. So great for the value investor?
Joe Gubler: [0:04:36] Yeah. And one point I wanted to add to what Andy said is that if you look under the hood in emerging markets, there is a lot of variation by sector in terms of where those valuation multiples come in. So one of the things that we’ve seen since the financial crisis is that there’s a lot of risk aversion in emerging markets, investors have been attracted to sectors where they think earnings are going to grow, where they think they’re going to be very stable, they’re going to have high visibility about earnings. And so what you’ve seen is sort of more defensive sectors, consumer staples, telecom, healthcare, have seen very high … very large increases in their PE multiples. And a lot of other sectors in emerging markets have been left behind. So when you look at those valuation levels, if you’re buying consumer staple stocks in emerging markets or some consumer discretionary or some other defensive sectors, you’re actually not getting stocks that are that much cheaper than the developed world. You do have to stick to that value devotion and say, “If I want to go into emerging markets and go into it because it’s a cheap asset class, I do have to go to the right sectors.”
Courtney: [0:05:36] Alright. So avoiding defensive, and this goes back to Olga’s point where you hear it’s not the model of the trade it was, you know, through 2002-2011 where it was great beta trade.
Olga V Yangol: [0:05:46] It was really a rising tide that lifted all boats. It was not important whether you were invested in a AA country or a less highly rated country, everything did fairly well. Now it’s much more important to select your players.
Courtney: [0:06:01] Yeah. And let’s go back to the headlines, Andy that you brought up. I mean investors are seeing a lot of headlines, political certainly headlines in Brazil, commodities are a huge story, currencies, Central Bank divergence. How do you parse through all this when you do, you know, from more of a top down perspective when you’re allocating?
Joe Gubler: [0:06:20] Well, do you want to jump in on that?
Andy Kapyrin: [0:06:22] Yeah. Actually so, you know, from a top down perspective, you look at China, China’s driving 90% of the [inaudible] and maybe today’s different because of what’s happening in Brazil. But China’s not as big of a portion of emerging markets as you might expect. I mean on the debt side, they don’t have meaningful government debt to talk about.
Olga V Yangol: [0:06:39] Yes. In China we invest primarily in state owned enterprises (SOEs). But I would agree with you, China’s really important in terms of its impact on commodity prices. You still have two-thirds of EM countries that are commodity exporters. But the link is different.
Joe Gubler: [0:06:54] It’s the secondary effects.
Olga V Yangol: [0:06:55] It’s the secondary effects, exactly.
Andy Kapyrin: [0:06:56] But even within stocks, you look at China, China represents, depending on the index you look at, MSCI has a different opinion than FTSE. But basically a fifth of the asset class, that’s big, but that’s not the entire asset class. You’re missing out on five other continents, 23 other emerging markets, all of which have some great businesses, some cheap businesses, and a completely different story about their growth and their demographic dynamics and everything else.
Joe Gubler: [0:07:25] And to that point about EM as a model, what’s interesting to me is that the commodity story and the energy story is a big headline issue for emerging markets. Yes, if you’re Russia, if you’re Brazil, commodity, energy is very important. But Russia is actually a very small portion of the index now. Russia’s around 5% weight. It was much smaller before the recent rebound. There was a point recently where Russia was about the same size as Malaysia in index. And so people need to, I think, adjust a little bit to the new reality that EM will respond a little bit differently to a certain type of news flow than it might have in the past.
Courtney: [0:08:30] And it even seems like, you know, India seems like a great case study for the tailwind of the energy or the commodity importer, [inaudible] India.
Joe Gubler: [0:08:39] Yeah. If you think about the Indian economy, the way it’s structured, there’s a lot of healthcare, a lot of IT services. But from a consumer perspective, lower energy prices, lower commodity prices, these can be … these can be good things, so.
Courtney: [0:08:50] A huge benefit.
Olga V Yangol: [0:08:53] Yes. I would say on the debt side however, there is a strong weighting in commodity exporters. Two-thirds of the EM countries are commodity and energy exporters. But at the same time, this means that the other one-third is comprised of commodity importers. Here again, we come back to valuations. Last year, for example, with the decline in oil prices we saw a widening in spreads of commodity exporters. And again, earlier in this year, commodity exporters underperformed while the importers outperformed. We took the opportunity to add exposure to the exporters based on relative valuations. And now we’re seeing the opposite. In the past couple of months as oil prices have recovered, and because we saw stabilization in China, and central bank policy support that’s helping everybody, we saw the reverse. Here, energy exporters actually performed better, while importers lagged. At this point we chose to take profits, and then considered switching into some importing countries in Eastern Europe. And that’s why we prefer an active management and total return approach. In EM debt, in contrast to equities, valuations are relatively tight, if we look back to historical levels in terms of spreads; there is also a lot of dispersion. So you have 63 countries in the EMD hard currency sovereign index, and you have 16 countries in the EMD local bond index, and 23 currencies. There are a lot of opportunities to pick and choose from.
Courtney: [0:10:43] Certainly. What about the impact of, you know, both Central Bank divergence and the fact that we had a very accommodative US Central Bank policy for a while, that’s arguably changing, what’s the impact there for EM?
Andy Kapyrin: [0:10:56] You know, one of the biggest issues in EM is it tends to be very … it tends to move in the opposite direction of the dollar, a strong dollar has been bad for emerging markets for the past five years. The reversal of the strong dollar so far this year is making a huge difference. You look at the dollar’s moves so far this year, let’s just plodder against the euro because that’s the most common pairing. The dollar’s up 5% so far this year. Sorry, the euro is up 5% so far this year against the dollar, that is helping emerging markets post some of their strongest relative returns in euros. I look at a number of major asset classes, the US large cap stocks, large cap foreign stocks, small companies, energy companies etc, out of all of those, emerging markets are actually at the top of the list. They’re up about 6 or 7% so far this year, depending on the index. A lot of that has to do with dollar weakness.
Courtney: [0:11:43] And how much of that is attributable to, you know, the fact that commodities are priced in US dollars?
Andy Kapyrin: [0:11:49] A little bit. I think it has more to do with what’s gone on with The Fed. The Fed made a promise last year and nobody really believed that promise. But it was the promise nonetheless and maybe some of the most hopeful bond traders were hoping for four hikes this year. They backed away from their promise in March.
Olga V Yangol: [0:12:05] It’s a big factor for us as well, if you look at the performance of our asset class. For example, dollar-denominated bonds are up 5%. Local currency-denominated bonds are up 11%. And in terms of factors on the hard currency side, so dollar denominated bonds are priced off of treasuries. So of course, you know, treasury yields going down from 2.20% to about 1.7%, now has a lot to do with it. We also saw of course the tightening in spreads. So that’s what helped the performance on the … in terms of dollar denominated bonds. And then local bonds you have two factors, first of all currencies, so very much similar to your asset class, but also the other factor is the yield on local currency bonds. So as The Fed, you know, takes their foot off the pedal, that gives some room for EM countries as well to delay potentially hiking their policy rates, you know, they have to sort of compete in this global beauty context in terms of real yields where the investors will allocate their capital. And the other factor as well, as currencies appreciate, that diminishes the inflationary pressure in these countries from the effects, pastor effects, that also buys them time. So we’ve actually seen yields in the local space decline at the peak from its average 7.2% to about 6½ now. But in countries like Brazil there are various reasons, we’ll get to Brazil of course, yields came down by 300 and more basis points. So in other countries like Turkey, Russia as we well, we saw similarly local yields declining. So I would say The Fed was a big factor, but again commodities probably help our space a little bit more as well.
Courtney: [0:13:57] What’s the bigger factor for you, would you say commodities or Central Bank policy and the impact top down when you’re looking at individual stocks?
Joe Gubler: [0:14:06] Yeah. You know, it can be difficult because I think one thing that we’re seeing in emerging markets right now is sort of this … kind of this oscillation between risk aversion and risk seeking. And I think when people are a little bit unclear about what The Fed is going to do, I think you’ve seen this over the last six months, we sort of flip back and forth between those two moods. And I don’t think the market has really sort of found a footing in terms of where that goes.
Courtney: [0:14:35] Yeah. Are we risk on or risk off in EM?
Olga V Yangol: [0:14:38] I don’t think we’re out of the woods.
Joe Gubler: [0:14:40] Yeah. Yeah, it feels like the bias is still towards, you know, risk off at this point. But you know, one of the … we touched on this a little bit earlier, but you know, one of the challenges that that creates is that it produces distortions within the asset class. So you know we’re constantly monitoring what you have to pay in terms of the price to earnings ratio for the most defensive stocks in emerging markets compared to the most cyclical stocks. If you break those into quintiles and you look at the most defensive versus the most cyclical, the most defensive ones traded at about a 90% premium to the most cyclical ones. And so you look … you hear that number and you say, “Okay. That sounds extreme.” You do then have to think, well, what’s normal over the course of time? I would say it’s reasonable for investors to potentially want to pay a slight premium for defensive stocks. They have an attractive characteristic. They hold up well in downturns. We all like that. But how much is it worth paying for that? And what we find historically is that investors have been willing to pay in equities, maybe a 10% premium for defensiveness versus cyclicality. And so a 90% premium produces a situation where there was a lot of risk aversion after the financial crisis, investors sought what they thought was a low risk trade. But I would argue that’s sort of become a high risk trade now.
I mean if you’re paying a wrong … dramatically wrong price for something, you’ve now created what is potentially a risky trade. Imagine that that premium comes back halfway towards what’s normal, that creates a huge headwind at some point for defensive stocks. But we’re going to have to clear a lot of these macro issues, a lot of these top down issues. But what it does mean is that there’s going to come a point where that becomes a challenge for aggressively defensive EM investors.
Courtney: [0:16:23] So to put it in perspective, I mean certainly trading at a 90% premium is huge to its cyclical counterparts. But you know what kind of PEs, what kind of EBITDAs are you seeing in the defensive space?
Joe Gubler: [0:16:35] So as we mentioned before, the most defensive quintile stocks in EM, they traded around 17/18 times forward earnings. And so if your premise is that I like EM because it’s cheap, and then you go into EM and you buy defensive stocks, you’ve sort of missed out on the premise of your investment. To really get that advantage in EM now you have to have the risk tolerance to go after some of these value stocks, some of these cheaper names that are more out of favor. And if you don’t again, I think if you run the risk that that trade reverts at some point, that could be very challenging.
Courtney: [0:17:15] And what about the, you know, we saw a number of credit downgrades in emerging markets, what impact is that having, is it creating a buying opportunity?
Olga V Yangol: [0:17:23] Yes, in EMD what we saw over the past decade was a one-way rating story. For example, if you look at the JP Morgan Emerging Markets Bond Index Global (“EMBI Global”) one of the common indices used for tracking US dollar denominated sovereign bonds—the index went from 30% investment grade at the beginning of the 2000s to 70% investment grade at the peak, in 2011. Now we’re talking about around 67% investment grade, so it has come down a little, as a result of both Brazil and Russia losing their investment grade status. Now there are some other issuers in EM that have split ratings, who may be at risk of a downgrade. This may create opportunities to the extent that there could be a widening in spreads, because some investors are limited as to where they can invest based on ratings. For example, towards the end of last year we saw an opportunity in Brazil when spreads widened considerably following the first downgrade by S&P. In the case of Brazil we saw an opportunity and it paid off. Nevertheless, in the face of a downgrade investors must always evaluate a country’s willingness and ability to pay.
Courtney: [0:18:56] Sure. And I guess, I mean for some of the insurance companies and institutional investors, it’s part of their mandate that they can’t hold either any or a certain percentage below investment grade. And with that credit downgrade that could potentially theoretically, but as you just pointed out, it’s nuanced, great opportunity.
Olga V Yangol: [0:19:14] Yes. In our space you have to recognize that this can mean an opportunity. The tricky part about EMD indices is they actually don’t differentiate across the credit spectrum. So countries like Mexico which is BBB rated and countries like Venezuela which is CCC rated are in the same index. The entire gamut is in the index. Therefore it is important to consider this fact in portfolio construction. We actually advocate for a benchmark agnostic approach to investing in EMD because the benchmarks do not differentiate among EM country ratings.
Courtney: [0:19:56] Sure. You see that there’s limitation in EM benchmarks?
Andy Kapyrin: [0:19:59] Absolutely. I’m looking at say the equity benchmarks. And really what they’re … they’re a good measure of market size. They’re a good measure of company size. They are not a good suggested investment. And the reason for that is they’re going to have sloppy lopsided country weightings. They’re going to have sloppy lopsided sector weightings. But the biggest issue with them is when you invest in one of these market cap weighted indices, you as an emerging market investor might have the idea, well, I like emerging markets because I think the emerging market consumer is really going to take over. Or I like emerging markets because they have this, that or the other quality. You’re usually not buying that quality. One example that I’ll use is most of these cap weighted indices are very light, if they have that weight at all to smaller companies. Smaller companies in the emerging markets as investments are some of the most attractive. They play into the hands of the story that you’re telling yourself, why you like emerging markets. I like the consumer. I like the demographics. I like that the economy’s growing. And the smaller companies are the more entrepreneurial. They are more dynamic. They’re more focused on their local market and they’re actually not very China heavy at all. So if China’s what’s scaring you, if you look at an emerging market fund that focuses more on smaller companies, you’re not finding a lot of China there.
Joe Gubler: [0:21:18] Yeah, I wholeheartedly agree with that. One big focus for us is to try to make sure that we can maintain significant exposure to small cap names in emerging markets, so we’re probably … probably 10 or 11% overweight small cap names relative to the benchmark and for the reasons you stated. They give you that emerging markets economic growth story, right, if you build an EM portfolio that’s too packed with exporters to the developed world then suddenly you have a portfolio whose economic profile looks like the developed world. And then there’s sort of the efficiency argument. These names are not as efficiently covered. You’re more likely to be able to find mis-pricings there to sustain themselves for long enough for you to make the investment. And so it’s a very attractive area for us. We find our models just work better there. Our process is primarily quantitative. And that process over time typically just finds some of the best opportunities there. There’s been a lot of alpha generation from that segment of the EM universe.
Courtney: [0:22:16] So it seems almost like, you know, the same reasons that a domestic investor would find small cap compelling, it’s even amplified in EM.
Joe Gubler: [0:22:24] I think so. I think that that extra story about why you’re coming to emerging markets, what kind of real economic profile are you getting. That maybe isn’t as much the case in US small cap.
Olga V Yangol: [0:22:34] In the EM debt space, weightings are actually based on the amount of debt outstanding. So it’s a similar problem in that you get the most exposure to the most indebted countries, and the most indebted issuers. And, we have a hard currency index covering 63 countries as I’ve mentioned, and 50% of the index performance is driven by just 7 countries. EM local bond indices are even more concentrated, having 16 countries in total with 90% of the index getting driven by 9 countries. So the indices are not necessarily exposed to what we think are the reasonable opportunities for yield. Another consideration in debt is duration, and exposure to interest rate risk. Naturally countries have longer-term needs, and they want to secure longer-term funding. So we’ve seen EMD index duration has gradually increased. Currently it’s close to 7 years, which may be at odds with investors who want to minimize their interest rate risk exposure.
Courtney: [0:24:10] So where’s the ideal or sweet spot in terms of duration, are you shorter duration?
Olga V Yangol: [0:24:14] Well, in the flagship unconstrained or total return strategy that we run, we’ve been running duration between 1 and 4 years. And we have been able to achieve stronger risk-adjusted returns and better risk/return profile than the EMD indices. So it’s not necessary to go out in terms of duration risk to deliver attractive performance. Results also depend on sector rotation within the asset class. At the moment, we prefer opportunities where we can maximize the roll down, or the steeper part of yield curves. We also currently have a bias towards rates in the US going higher versus what the market is pricing in. In this context, we definitely prefer lower duration than what’s obtainable through EMD indices.
Courtney: [0:25:12] And let me go back to currencies for a minute. You know, we look at the Asian financial crisis 1998/1999, a lot of the countries that you guys cover were pegged to the dollar, a lot lesser pegged now, those that are, you know, China comes to mind, four trillion in reserves. It’s a really different story. I’d just love to get everybody’s thoughts on how that’s playing into how you’re investing.
Andy Kapyrin: [0:25:34] You know, a big part of the 1998 crisis, 1997 crisis was that these countries were trying to adopt an untenable currency peg, marking the value of the currency far higher than was really sustainable and the fundamentals dictated. Now, they had a reason for that, they had a lot of foreign currency debt that they couldn’t service. They’ve solved that issue in both ways. One is they don’t try to peg their currencies to untenable pegs anymore. Now, the flipside of that is currency volatility day-to-day. But the good part of that is more stability. The other reason emerging markets are a little bit more stable today than they were in the late 90s is they issue a lot less foreign currency denominated debt now. It’s still an issue; you still see a lot of that in indices.
Olga V Yangol: [0:26:13] I would echo that. Floating currency regimes are very important when we consider investing in a country. We think they represent a positive because they act as shock absorbers, essentially. While you can see more currency volatility, fundamentally floating currencies are a positive. And the composition of a country’s debt is another important point. In Brazil, it has been a key point.
Andy Kapyrin: [0:26:35] Yeah. And it also gives their internal Central Banks much more control over their own economic policy. When you try to peg your currency to the dollar, you have to follow step for step what the US Fed does. That’s one of the things China’s found itself doing over the past few years is they’ve had to run a tighter monetary policy or maybe a looser monetary policy, some of the time, than the actual fundamentals in the country dictated. We’re seeing China start to break with that, we certainly saw it over the past two years; they’re starting to allow their currency to move up and down, small notches, baby steps at first. But I’d say that’s a healthy development, it’s something that’s good for stability long term.
Joe Gubler: [0:27:09] Yes. You take this extra volatility in currency to avoid these sort of seismic shifts, right, where you have a pegged currency, pressure builds up, and then you get this very large move that happens at a potentially unpredictable time. I think we can manage the volatility. You know, one thing that we do in our process is we have a currency aspect to our top down model so we try to assess, because we’re going to make local equity investments, we’re going to be exposed to the currencies, which currencies do we think are going to be stronger or weaker. And we try to have that reflected in the decision making. It’s not entirely about whether we like the stock or not, but it’s also about which currency exposure do we inherit when we make that investment. So that helps us I think, you know, be on the right side of that more often than not. And then for us we do take a pretty strict approach to risk where we’re at the country level, we don’t take active weights that are more than 5% overweight or underweight relative to the benchmark. And what that means is on an active basis we’re never going to have a currency exposure that’s extremely large relative to that benchmark.
Courtney: [0:28:10] Alright. So that’s part of the top down portfolio construction and risk management. And you know, echoing Olga’s point, do you also find the floating currencies to be more interesting, better, bigger shock absorber?
Joe Gubler: [0:28:26] Well, I think currently, yeah, right now, some of the currencies that look better to us have those characteristics. You’re finding as we discussed, fewer and fewer aware that peg is an issue. China, look at the kind of the headlines you get about that. They started with large [inaudible] reserves but people with a straight face were saying a year ago, I had people … maybe they were on the outlying edge but people were saying, “Aren’t you worried about your Chinese currency exposure? I have heard that it can depreciate 20, 30, 40%.” And the reason people have those concerns is in part due to the peg and this concern that this pressure is going to build up and they’re not going to be able to maintain it and that you’re going to see that sort of a shift. So yeah, I think I’d much rather be in a currency where I can sort of see that volatility day-to-day, where the movements in the currency sort of reflect what’s going on in the underlying fundamentals. And there will be volatility but here you can use diversification to your benefit. Some currencies move in different ways compared to others, you can max it, you can put limits on how much exposure you take to a given currency. Now, unfortunately currency hedging is expensive in emerging markets, and so it is, from our perspective, difficult to hedge out that risk overall relative to the dollar. But there are a lot of things we can do to manage it and mitigate it.
Courtney: [0:29:45] So more from a portfolio management perspective. I mean last year it was so popular, we saw in the developed markets, you know, buy into Europe, hedge out the euro, buy into Japan, hedge out the yen. It’s much … it’s just more expensive to do that in EM, right, just operationally?
Olga V Yangol: [0:30:00] So I can clarify one point about currencies for a little more nuance. And this relates to hedging as well. I have mentioned that floating currencies can act a shock absorber and I have suggested how it can help a country. We’ve seen this in Russia and Brazil, for example. If a country has a floating currency regime and an inflation-targeted monetary policy (it uses mainstream tools to control inflation) then, when its currency depreciates, the Central Bank doesn’t have to defend the currency and spend reserves. In addition, we can see an adjustment in the external sector of its economy. Last year in Brazil, for example, although the Brazilian economy contracted by 4%, -6% was driven by domestic contraction, while the external side of the economy added 2% growth. This was primarily due to a contraction in imports; nevertheless its weaker currency allowed Brazil to smooth out the deep economic contraction that it had experienced. Similarly, in Russia we saw a contraction in its imports, which enabled the current account to remain relatively strong. At the same time Russia also continued to accumulate reserves.
From the perspective of an investor investing in dollar-denominated bonds, we want to see a currency that actually depreciates if necessary at the time. If I look separately at currencies as an asset class, it is also important to see when the currency becomes very cheap, and we look at various metrics to evaluate the attractiveness of the currency. If we see a currency become very cheap relative to historical levels, and we see that the country’s trade balance is improving, and we see that the implied interest rate that can be earned on a currency is high, then all these factors are a positive for that currency. This tends to play out in floating currencies.
Courtney: [0:32:32] Okay. So in a non-floating currency like in China for instance, their central planners have cut the Yuan numerous times over the past 12 months, I mean how does that play in?
Olga V Yangol: [0:32:40] Well, in China’s case you have to recognize or try to understand the reaction function of the Central Bank. Generally we express more active views in currencies that are floating because that reaction function is more predictable, and the movements in currency value are driven by market forces. In the case of China, while not necessarily expressing our view directly on the Chinese Yuan, we do see that other currencies in the region—ones that are tied to the Chinese Yuan—are relatively more expensive, relative to the rest of the EM currency universe. In addition, the interest rate that we would be earning in these currencies is low, and sometimes it’s even negative. So definitely we see more relative value in thigher beta currencies, such as the ruble (until recently) and, even in, the Turkish lira or Colombian peso. Some of those currencies are relatively attractive versus Asian currencies that we find more expensive and less attractive.
Andy Kapyrin: [0:33:54] You know, with emerging marketing currencies you have to be careful about the headlines and the reality. I remember last summer I read a headline that China devalues its currency. And I was thinking to myself, oh my, what could they really have done? How big of a move is this really? And I remember looking it up on my Bloomberg, kind of tapping the screen, oh, it’s not even 2%. I remember growing up in Russia in the 1990s. Now, I wasn’t working in finance yet, I was a teenager. But I remember what a devaluation really looks like. The ruble could lose 80% of its value in a year or in a period of years. That’s devaluation. China, China resetting the peg a little bit to be more in line with market reality is if anything smart macroeconomics, and not devaluation whatsoever.
Joe Gubler: [0:34:37] Yeah. And potentially that was overdue compared with what had been happening with other currencies that were sort of competitors for China, so. I mean one challenge that China poses for us in our quantitative process is that we have a currency model and we look at things like credit account surplus and deficit dynamics. We look at the sovereign debt situation. We look at inflation. And then we also include a component of that model that looks at sale side forecasts for where the currency’s going to go over the next couple of years. Those other components, other than the forecast don’t really work for the Chinese currency. And so in that case it reduces sort of the scope of our model. We’re now relying on one piece of input, whereas for all the other currencies, we have a lot more inputs, it gives us higher confidence that we’re going to make the right call about the strength or weakness of that currency.
Courtney: [0:35:28] Alright. So a kind of … China’s in its own kind of category and what a great illustration about the ruble going down 80%.
Joe Gubler: [0:35:35] Not that I think that’s going to happen with any currency that I’m looking at today. It’s an idea of how different today is from the 90s.
Courtney: [0:35:43] Sure. Sure, yeah. Let’s dig into Brazil, I mean Brazil is really in the headlines. China’s in the headlines all the time but Brazil is really coming to the headlines especially because of the potential ousting of President Dilma Rousseff. You know, how are you guys watching and digesting all of the news that’s coming from Brazil?
Joe Gubler: [0:36:01] I mean actually Brazil has been a little bit of a challenge for us. We’re modestly underweight Brazil, a percent or two. Brazil’s been a great performer year to date, up about 30%. So a lot of that is in response to the idea that Dilma could be removed, and somebody more market friendly, somebody who’s a bit more of a reformer to be put in place. That’s looking more and more likely now. So a lot of the upside of that may have already played out. But we’ve been underweight Brazil for quite some time because on the flipside of that this is an economy that’s got a lot of problems. So if you look at it from a macro perspective it looks like trouble. You look at it from a valuation perspective, growth perspective, momentum perspective; there are a lot of problems there. The currency looks weak. So that’s sort of pushed us towards this modest underweight. And this is an example where sort of politics can come into play. And I just think politics are an incredibly hard thing to handicap in emerging markets. I think this is one of the reasons that you’ll often see people saying, “Look, no matter what I think of a country there’s a limit to how much I want to be overweight there.” Because it’s actually not that hard to get these top down country calls wrong. And so do I want to be 5% overweight? Maybe. Do I want to be 15% overweight? You’re taking on a lot more risk that way in something that, you know, what’s your probably of being right about that country call? It may not be high enough to justify that kind of a weight.
Courtney: [0:37:31] Is there a political or otherwise macro step function change that would get you constructive on Brazil at this point?
Joe Gubler: [0:37:38] Well, I think the most likely scenario in Brazil is that if you do see Dilma removed and you get somebody who’s more market friendly, you will start to see some reforms. But this is difficult; we had this in India a few years ago. The market was extremely excited about the election of Narendra Modi, I think the market got ahead of itself a little bit. There was a lot of truth to the idea that he was going to be a reformer. But I think any assessment of what people thought was going to happen compared to what has happened over the last couple of years, there’s a big disconnect there. And so what you could see in Brazil is that it’s possible it’s rallied a little bit too far, given how fast somebody could actually make these changes. But eventually you will see that, that optimism will start to spill through into the macro numbers and into the top down considerations that we think about. But I see no sign of it yet.
Andy Kapyrin: [0:38:30] You know, I see a similar cautionary story in Mexico where they looked at a reformer government, they started to put in place a lot of great reforms, advertising, the oil industry getting a little bit more competition IN the telecom sector which in Mexico as a poor country within the US, the average Mexican was spending more on their cell phone plan than the average American, which frankly is an outrage. They can do all these right things and then out comes the drop in the price of oil and partially derails that entire story. And that’s why you’ve got to be careful with emerging markets and simply limit your concentrations.
Courtney: [0:39:06] Olga, what about Brazil, you know, on the debt side, what are you seeing there?
Olga V Yangol: [0:39:09] We have been thinking about Brazil somewhat differently, although this could be due to the fact that we are looking at debt and valuations in the EMD space. When we saw the spreads widening in Brazil’s hard currency debt and the yields increasing, we became quite positive on Brazil. On the one hand we saw very attractive valuations, and the country was trading as if the sky was falling. Market commentators discussed the possibility of default or IMF involvement. What we were seeing was a country that has come a long way, a country with a lot of buffers and a lot of good things in terms of stability indicators. We looked at reserves, for example. With $370 billion in reserves that Brazil could tap into, we saw what was needed in terms of currency stabilization. We also were looking at the cash account at the treasury that the government has available, which is 16% of GDP; even if funding became prohibitively expensive in local markets, they could tap into that. Also less than 5% of Brazil’s sovereign debt is denominated in a foreign currency, the rest is in local.
So for those reasons we were comfortable with exposure to Brazil because we saw that their spreads were trading in single B levels, or comparable to a much weaker country in dollar-denominated debt. Further, in local currency bonds we saw yields at nearly 17% earlier in the year. Now, for local bonds the considerations are slightly different. Inflation was very high in Brazil last year, close to 11%. But one must recognize that a lot of this rate was actually driven by Brazil’s regulated prices, the prices set by the government, such as electricity and transportation, which comprises 25% of Brazil’s CPI basket. So to the extent that there are no longer such increases this year, we expect inflation to come down significantly. Also we are seeing the economy contract, potentially by as much as 10% after this quarter. In these conditions, as the economy contracts and we see inflation gradually decreasing, we could see the Central Bank keep rates where they are, not increasing them. However market participants have been pricing in some 250 basis points in rate hikes. So for all these reasons, we believed valuations were attractive relative to the fundamentals. Fast forward to today in terms of total return: Brazil has been the best performing country in the local space, with local bonds up 26%, in the hard currency space, with dollar-denominated bonds up 13%, and in currency, with the real having appreciated 17%.
Now, we have to take a more balanced view. And to Joe’s point, impeachment is a binary event, it could be one way or the other. Very soon the world’s attention will turn to what’s next. And the problems that Brazil is experiencing in its fiscal position, in its economic contraction, in its structural reforms—all of these issues need to be addressed.
Courtney: [0:43:21] Alright. What other countries are really attractive right now?
Joe Gubler: [0:43:26] Well, we find interesting opportunities in South Korea. Some smaller countries where we’ve got some overweights are Poland is an interesting country for us, Turkey. And so, you know, and for us that can be a combination of do we like the country from a top down perspective? South Korea, that’s part of the reason, there are a lot of things that we like about Korea from a top down perspective. The currency looks stable to us. There are a lot of macro indicators that look good. It’s not a terribly expensive country at the moment. So our overweight there is sort of driven to some extent by top down considerations. That’s less the case in Poland or Turkey, they’re smaller countries, they’re smaller in the benchmark, if we find a handful of really attractive opportunities there we’re going to be overweight. And so this is where, you know, your overweights are driven by a combination of two things, either sort of you like the country on average and so that drives an overweight. Or the distribution of names in that country is such that, you know, maybe the country itself isn’t great, but you’ve got some names on the table that look really attractive. That can also drive that overweight.
Courtney: [0:44:36] So in Poland and Turkey, you know, less of the top down. But you are finding individual securities where you like the story of the also small caps?
Joe Gubler: [0:44:43] Yeah. These are smaller names, they’re not at the smallest end of the spectrum. But one thing that’s interesting in Poland and in Turkey is that we find oil refiners there that we like in both cases. And the situation for them has been that their import price has come down a lot and stayed there. But demand for their end product has been fairly stable in those economies. And so there’s this very attractive spread for them that’s held up over time. That may be starting to come to an end, but that’s been very good for those names. And it’s interesting you see that theme sort of playing itself out in those two countries.
Courtney: [0:45:22] What about on a sector basis, are there any sectors that look particularly attractive, any that you’re avoiding?
Olga V Yangol: [0:45:29] Well, I’ll probably leave it up to Joe and Andy to comment on sectors, because at the end of the day our calls are more at the country level. And we focus predominately on relative value. As I mentioned earlier, at the end of last year and earlier this year when the spreads for commodity exporters widened, we thought that was an opportunity to add exposure to countries like, Colombia, and Brazil, perhaps Kazakhstan, and even Mexico. More recently, we saw that some of these countries indeed outperformed. So, in this context, we’re looking to shift exposure opportunistically to some countries that have lagged in the recent rally, such as certain countries in Eastern Europe like Hungary. This is primarily driven by valuations. To generalize, we look for three factors in a country. We like to see a combination of strong policies, and a history of monetary and fiscal policies that are sound, responsible, and predictable. We also like countries with a lot of buffers, in terms of reserves; this is quite important, as it buys EM countries time, when the external environment becomes less favorable. Finally, we think that floating currency regimes are very important.
We’re actually surprised that not many EM countries in the universe meet these criteria, in fact, there are probably only about 14. But this is important in the current environment, as these 14 countries represent where we likely have most of our exposure. Opportunistically, we may look at some third tier countries where evaluations have improved. Some countries in Central America, where we have been looking recently actually have a very different story because they benefit from the recovery in the US. They also benefit from lower commodity prices because they are importers. And in countries like Costa Rica or Dominican Republic tend focus on services and tourism industries, and also remittances from the US. So some of these stories may bepockets of opportunities and are becoming interesting and attractive. But again we are very focused on understanding their ability and willingness to pay, whereas in the higher quality countries that I mentioned earlier, that’s a little bit more relative value.
Courtney: [0:48:08] Very interesting though is Central America getting a tailwind from the US.
Olga V Yangol: [0:48:12] Yes.
Andy Kapyrin: [0:48:14] And the sector story within equities, there’s a shallow one and there’s a deeper one there. The shallow one is of course energy is cheap, materials are cheap, and technology’s expensive. But once you get beyond that, that really simple story, you can find values within a whole range of sectors in emerging markets. So one fairly traditional sector that’s available in just about every emerging market country is telecoms, telecoms are critical to modern life. You have them in just about every single emerging market country, frankly even every single developed market country has its own local telecom company. There are utility companies that are available to buy that can be decent value, depending on the dynamics of any given country. You know, Russia it gets dismissed as an energy haven, in particular on the stock side. But they have very dynamic businesses on the consumer side. One of the largest consumer companies in Europe is actually Magnit in Russia which is a great store, on the expensive side, but it gives you the idea that there are … there are businesses outside of what might be expected in any of these countries and some of them are cheap.
Courtney: [0:49:24] Alright. And as we’re just about out of time, I just want to get everybody’s final thoughts on portfolio construction, if you could just kind of tie a bow on it for us.
Joe Gubler: [0:49:33] Yeah. I mean very simple we … we use bottom up information, so value growth and momentum, that gets most of the weight in our decision making process, about 75%. But we do include top down information, so that’s going to be attractiveness of the sector, the country. And the country’s going to be evaluated on its valuation levels but also on macro considerations. And then we look at the currency as I mentioned. And all of that information then comes together for a stock to give us an assessment of why we like it. And so different stocks will be in there for different reasons, some of them will be more value players, others might be more of a growth play, all of them incorporating sort of the, you know, some of the challenges in the top down environment.
Olga V Yangol: [0:50:13] We think that the optimal approach to accessing the EMD asset class is through a total return vehicle that is unconstrained by an index. We think that with such an approach you can focus on trying to capture the upside across a blend of EMD indices, rather than using the indices as a starting point for portfolio construction. And in that framework, when you no longer have to track a benchmark, you can actually focus on managing risk, on maximizing your Sharpe ratio and on minimizing your drawdown. Given that EMD indices are generally segmented according to whether they are dollar-denominated, local currency bonds or corporates. In a total return, unconstrained approach, a manager can rotate among these segments, depending on where the opportunities present themselves. And a manager can actually manage beta relative to the EMD space. If you are tracking an index rather closely, by definition your beta is close to 1, and you can only vary it by plus or minus a little bit. But in a total return approach you can tactically use cash or hedging to substantially reduce your beta. And in difficult years such as 2008 or 2013, we were able to be quite defensive. This really served us well as the market fell between negative -6% to -9%.
Courtney: [0:52:03] Sure, [inaudible] were correlated then.
Olga V Yangol: [0:52:06] We think an unconstrained approach is critical to investing in this asset class.
Courtney: [0:52:11] And, Andy, if you can give us kind of the unique perspective of the … you’re allocating both to equity and debt funds in EM. What are you looking for when you evaluate a manager?
Andy Kapyrin: [0:52:22] So actually before we even dive into a manager, should you even invest in these asset classes? And the answer is absolutely yes. If I look at all … the whole slate of asset classes that we US investors can invest in, and we have a pretty broad spectrum, everything from developed markets to small stocks, to emerging markets. Emerging markets are the single asset class that I think has the highest chance of delivering a double digit return over the next 10 years. It does require a long time horizon because there are risks. And what’s a smart way to invest in emerging markets? It’s to be aware of the benchmarks but not to stick too close to them, because the benchmarks are based on market size. It’s not an investment recommendation. It might lead you into sectors you don’t really want, might lead you into countries you don’t really want. Make sure you get a sprinkling of smaller companies. And on the debt side that can be a great diversifier too. Again it can be more risky than your bonds. But you should look at, well, what are the spreads on emerging market sovereign bonds, so especially on the local … sorry, on the hard currency side. And on the local currency side, are the currencies cheap or expensive? There are a number of measures you can look at, you know, the simplest one might be just purchasing power parity. Look at a mosaic of information, I think if you do you’ll find that both equities and bonds are pretty attractively valued today.
Courtney: [0:53:41] Yeah. And you know if you just kind of widen the aperture even more as you mention, there’s a whole investing universe. About what percent are you allocating, for people who have at least, as you said, a decade plus time horizon, about what percent are you allocating to EM?
Andy Kapyrin: [0:53:57] So EM stocks in particular, somebody with a balanced portfolio with a mix of stocks and bonds will have about 10% in emerging market equities, about 4% in emerging market bonds. Somebody who’s a 100% in growth assets, those are our most risk seeking clients and usually younger, they’ll invest as much as 16% in emerging market stocks. And that we consider a large overweight relative to what’s normal.
Courtney: [0:54:20] Right. So, some significant allocations. Before I let everybody go, I’d love to just get everyone’s final thoughts on the space that you’re looking at within emerging markets, and we’ll start with you, Joe.
Joe Gubler: [0:54:29] Yeah, look, I think it’s an interesting time to be in this space. As we’ve discussed, we’ve seen a lot of opportunities created by some of the headline turmoil. To Andy’s point I think this is an asset class where if you have a long horizon, if you’re a 5 or 10 year horizon investor, it’s almost a no brainer, this is a very attractive asset class. If you’re very concerned about short term volatility you may have a different view. And I think that is one of the things that’s been sort of challenging for emerging markets over the last four or five years is that there is not as much tolerance for that risk among investors. But I think it’s important to understand that you know going against the herd, taking those risks at times is the way to get returns. And you know, remember, EM has this diversification benefit. So even, yes, it may be higher volatility than developed equity markets. But if you take a portfolio of developed equities and EM equities, the combination has lower volatility than just the developed markets portfolio. So you know it’s important not to be misled by the standalone volatility of the asset class.
Courtney: [0:55:37] I mean as you probably see, people are pushing out on the yield curve across the board to find yield, right. I mean you could either just buy high yield oil credits right now, right, or you could get into EM. And you’d probably have a lot better outcome for the same [inaudible] long term.
Joe Gubler: [0:55:55] Yeah. I mean it’s certainly an interesting proposition that I think is being underutilized.
Courtney: [0:55:59] Yeah. Olga, your final thoughts.
Olga V Yangol: [0:56:01] Yes, although we do see a less supportive environment for EM versus over the past decade, it’s a large asset class that’s certainly not going to disappear. It just has to be approached in the right way. To echo Joe’s point, looking for value is extremely important. And today it’s much more important than it used to be. We look at fundamentals. Is the EM country likely to pay us back? Does it have the willingness to pay? And then we consider all the metrics and valuations. We look at spreads, we look at yield levels in local bonds, we look at currency pricing, and the dynamics to the trade. All these factors are extremely important. We also look at some of the technical factors. Here it’s actually important to monitor one’s positioning relative to the marketplace. There are times when you may want to take a contrarian approach because, since the end of the financial crisis, banks have less capacity to intermediate trading, especially in hard currency debt. There are many factors to consider in EM debt. But I agree that this is an asset class that deserves to have a structural allocation in a client portfolio. And if approached in the right way, the asset class can offer very attractive Sharpe ratios and risk/return profiles.
Courtney: [0:57:36] Alright, Andy, your final thoughts.
Andy Kapyrin: [0:57:36] Emerging markets tend to earn their returns in short spurts. I look back on the asset class and you basically have history going back to the late 80s. And there’s always some kind of catalyst set it off that you couldn’t really have predicted at the time. The fall of the Soviet Union helped, the emergence of the South East Asian and then South Korean, Taiwan, the tiger economies, the emergence of China, the 2009 recovery from very low valuations. All of those, if you waited until things looked good, until they looked confident, you missed the rally. Emerging markets are doing something rare today, which is they’re giving you a second chance. If you didn’t buy emerging markets in 2009, you have an opportunity to buy them at the same valuation today as we had that March, that February when things looked at their worst. I think you would be remiss not to take it.
Courtney: [0:58:27] Alright, great insights, thanks so much. And we want to continue this conversation about emerging markets, follow us on our social media, on LinkedIn, Twitter and Instagram, from our studios in New York I’m Courtney Woodworth.
Important Information
This material is for information only and does not constitute investment advice, a solicitation or a recommendation to buy, sell or subscribe to any investment.
The views expressed by Olga Yangol of HSBC Global Asset Management were held as of April 12, 2016 and are subject to change without notice. The information and opinions expressed are derived from sources deemed by HSBC Global Asset Management to be reliable, but are not necessarily all inclusive and are not guaranteed as to accuracy or completeness.
The value of investments may go down as well as up and you may not get back the amount originally invested. Portfolios may be subject to certain additional risks, which should be considered carefully along with their investment objectives and fees. Investments in foreign markets involve risks such as currency rate fluctuations, potential differences in accounting and taxation policies, as well as possible political, economic, and market risks. These risks are heightened for investments in emerging markets which are also subject to greater illiquidity and volatility than developed foreign markets.
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