Emerging Markets and the US & Asian rotation?

  • The Emerging Market/Developed Market rotation trade is tracking the US$ closely, but we suspect the next rotation into EM may actually have a stronger Asia/China bias.
  • The Cult of Alternatives has replaced the Cult of the Equity. In particular a dash after Private Equity rather than listed equity risks starving markets of liquidity.
  • The sell-off in emerging markets has hit Chinese equities through index composition offering some interesting opportunities, but in our view the real opportunities are being thrown up in the offshore bond markets.

As discussed in recent notes, we remain in the midst of a classic Emerging Market (EM) versus Developed Market (DM) rotation. This is a variation of the cyclical/defensive rotation that tends to follow the macro news flow and when it is magnified, as now, produces a mix of interwoven cash-flow and currency effects. The proximate cause being given is the trade tensions, but in my view that is more of an ex-post justification for end quarter rotation. To repeat the recent description of the mechanism as I see it, we note that at a simple level a weaker dollar such as we had last year tends to lead to EM outperforming DM and vice versa. This is shown quite clearly in Chart 1 below which compares the trade weighted dollar index (gold line) with the ratio between two ETFs, the Vanguard Developed Markets (ex US) ETF and the I-Shares Emerging market equities ETF.

Chart 1: Emerging Markets outperform developed markets when $ is weak and vice versa

Source: Bloomberg/ AXA IM, July 2018

The fit isn’t always as strong as this, but when it has been strong in one direction, it tends to mean revert quite powerfully, as now. There is also a powerful economic logic behind this which means that a stronger dollar is both a cause and an effect of the rotation. As emerging countries with large amounts of dollar-denominated debt – effectively those with large and persistent current account deficits encounter a weaker dollar then the local currency cost of their coupon payments falls, providing a domestic stimulus. It also increases the returns to dollar-based investors, which tends to encourage greater inflows across the capital account, putting further upward pressure on the local currency. This stimulus, because it is usually associated with more borrowing, especially by consumers, tends to be inflationary and produces a classic domestic monetary response of higher interest rates, which temporarily at least brings in even more foreign capital into the capital markets. A combination of higher domestic interest rates and a stronger currency killing the export sector then rapidly bring the economy to a halt, at which point the virtuous circle becomes vicious. Rinse and repeat. This is why EM investors have to be far more tactical than DM investors – the EM/DM index is essentially back to where it was ten years ago at a normalised 103, having rotated between 78 and 123 over the period.

Of course, given the strong macro nature of the EM story this is in many ways much more of a currency story than an asset story, which is why the following chart is so interesting in my view.

Chart 2: Emerging Market exchange rates, index to 2008

Source: Bloomberg AXA IM, July 2018

The chart takes a number of major EM currencies – Brazilian Real, Turkish Lira, Indonesian Rupiah and Indian Rupee against the dollar and indexes them back to ten years ago, together with the CNY, the offshore RMB. The latter of course looks incredibly stable by comparison. If we look more closely we can see that it has certainly moved within tradeable bands – strengthening around 12% from 2009 and 2014, before reversing and weakening 15%, then strengthening 10%, now weakening 6% or so year to date, but this is much more like a developed economy exchange rate.

This brings me to what I suspect may be an upcoming secular shift. For all the talk about China becoming a bigger part of the EM indices, I suspect it may in fact see the decline of EM as an asset class. A parallel I would use is the old notion of TMT stocks back in the late 1990s. While a lot of attention was focussed on the hyper extended multiples of dot.com companies, the reality was that this was actually the final throws of a distortion produced by the then obsession with benchmark weightings. Just as UK based unit trust managers were struggling with 10% limits on a single stock when Vodafone was approaching 20% of the UK market, so the Investment Banks were exploiting the ability to float 20% of a company and yet have the full market cap reflected in the benchmark, giving what were in reality small cap companies large cap weightings and more importantly inflows.  When it all went wrong, the market cap effects worked in the reverse direction and also redemption flows from the funds exaggerated the effects. Huge amounts of money has flowed into so called TMT (Telecom Media and Technology) funds over the previous three or four years which had inflated valuations and encouraged mega mergers and takeovers often funded by enormous amounts of debt. When valuations collapsed, small tech companies disappeared but the Telecom and Media companies were left not only with large amounts of debt and stretched debt to equity ratios, but no natural buyer. As such they basically traded sideways for the following decade, while the ‘new tech’ stocks like Amazon and Netflix tripled and Apple  - which had traded like a cyclical stock for the previous decade then went up 13 times.

My suspicion therefore is that once this latest rotation out of EM stocks is complete, the next rotation in, will essentially not happen, instead, the attraction of diversification and non-correlated growth combined with low valuations – the usual entry triggers for investors – will be better represented by an Asian, or even a Chinese allocation. As I said to a number of institutional investors on a recent visit to Europe, China should now be a permanent buy and hold allocation, although importantly it needs to be managed in an active manner and the current wide range of index options that range from being very ‘old economy’ (Shanghai Composite) to very tech orientated (MSCI China) do not represent a sensible portfolio construction in my opinion, from market cap weighting to sector bias. To continue the TMT parallel, I suspect that the focus of the next rotation will be towards companies with growth opportunities, but also with strong balance sheets and good cash flows.

Visiting London recently I was reminded once more of the stark contrast between the institutional investor in the west and the emerging retail and wholesale investors here in Asia. As previously noted, when I started out on the sell side in London in the late 1980s, the UK pension fund industry owned around 60% of the UK stock market. Now, thanks to maturing/closing  pension funds and regulation, they probably own around a 10th of that, while overseas investors account for almost half. Western Pension funds have long since abandoned the cult of the equity and are now little more than asset/liability managers in the manner of the life companies and are now ironically facing the same issues that they did back in the 1950s, when George Ross-Goobey of the Imperial Tobacco pension fund began the cult of the equity. The yield on conventional government bonds remains too low to match liabilities, just as it did back then, but rather than return to equities, they are embracing alternatives. A recent survey* shows that UK pension schemes intend to raise allocations to alternatives by 51%, to 6.5%, while UK insurers intend to raise it by 14%, from 7.3% to 8.3%. Continental institutions are looking to do something similar. According to the authors, part of this (pretty much equal percentage of survey)  is the attraction offered by downside protection, diversification and an illiquidity premium.

The dominant alternative asset remains private corporate debt, but one area of particular growth is  Private Equity. This is reflected in the latest news coming out of US Private Equity giant Blackstone, which is just launching a new pool with a target of $20bn. Interesting that according to a their latest earnings report, the Blackstone Private Equity funds launched post the Global Financial Crisis (GFC) have all produced net returns (IRRs) in the 12-15% range, while the Real Estate Funds were in the 15-20% range. This no doubt is partly behind the attraction to institutional investors, particularly as Private Equity has no negative marks for volatility, since it doesn’t have any.

However, it will be interesting to see if those returns can be sustained.  The industry overall took in a record $453bn last year, but the problem they have is that they are sitting on dry powder of over $1trn. In Blackstone’s case it is sitting on almost $100bn of dry powder, 80% of which has been raised since the beginning of 2015 as money has come in in pursuit of replicating historic returns but in effect the managers are suggesting they are not available at current prices. 

Which brings me back to Emerging Markets and particularly the Chinese offshore bond markets. As I highlighted in the last note, the Chinese authorities, as part of their build out of a developed non-bank financial system, are trying to discourage lending to the shadow banks and the property sector and encourage banks to lend directly to SMEs. As part of the process property companies have been driven offshore and have raised a lot of capital in the offshore bond markets and it is concerns about the impact of dollar funding on these corporates (in effect being like current account deficit country EM borrowers) that has combined with a general redemption flow dynamics to offer significant potential value in offshore China bonds.

However, the selloff has been pretty indiscriminate and as my colleague Jim Veneau, Head of Asian Fixed Income at AXA IM, points out, this type of selloff is rare, the last being in 2011 and he notes that there are now 101 issues in the JP Morgan Asia High Yield In (JACI) Index offering a yield of more than 10%, with a simple average for the basket of 16.3%. Our high yield team here in Asia calculate that even with a cumulative default rate of 40% over a five year period and a below average recovery rate of 20% that the total return to even a passive portfolio of these bonds would still be around 8%. Normalising to historical average default and recovery rates puts it nearer to 12%. This of course is for a passive portfolio; we would naturally suggest that active management could enhance that further.  There are numerous technicalities at work here – Jim mentions differences between onshore and offshore bonds, the behaviour of perpetuals versus straight bonds and so on.

This, in our view, should be an important subject for discussion amongst institutional investors willing to accept illiquidity in their portfolio – as those embracing private markets are clearly willing to do. This is not to say that these bonds are illiquid, rather that if the investor is willing and able to hold to redemption and take mark to market volatility, then the risk return looks extremely attractive.

To conclude; the latest rotation out of EM into DM coincides with a strengthening in the US$ and essentially unwinds most of the relative strength of 2017, looking more like simple mean reversion than anything else. In my view the trade talks are largely an excuse rather than a fundamental driver to this, but it is my suspicion that it may also be the start of a fundamental shift away from bundling China and parts of Asia in with the more genuine and volatile Emerging markets, both from an economic and a currency hedging perspective. Currently Asia represents a small part of international portfolios and China is less than 2% owned by foreigners. Strategically both of these ae going to rise and the future growth of the Asian middle class and mass affluent saving will obviously have Asia as more of a home market with Europe and the US as diversification rather than core. It is also extremely interesting to us to observe at a time when western institutional investors are rushing into alternative asset classes in pursuit of yield, diversification and downside protection (according to surveys) that the offshore Chinese bond markets, which in the wake of the forced selling engendered by EM rotation are now as attractively priced as they are unloved, now offer all of the above and for those institutional investors happy to accept a so called  illiquidity premium in private debt and equity  markets a yield to redemption strategy is likely to offer very attractive returns.


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