A good six months - despite panicking markets
For the half year to end June the index was buffeted, falling 3.1%. In contrast, the portfolio managed a gain of 8.3%, more than 1,000basis points better. During the month of June, the Emerging Market index was whacked by 6.4%; the portfolio's value also fell, but by a lesser 6.2%. The relative year-to-date and longer term falls in some of the regional indices have been grim (Chart 1,p.4): for example, in the first six months of 2013, EM equities underperformed those in developed markets on a total return basis by 16%, and by 14% over the last 12 months. This was even worse when compared to US equities, where the EM countries underperformed by 23% and 17% respectively over the same periods.
Since 2004, foreign investment into the capital markets of these disparate countries soared to new records, an estimated $8 trillion. Many of these flows ignored value, risk or earnings growth: in short, investors – foreigners especially - blindly chased momentum. In the six months to the end of March 2013, they were so sure that EM investment was a one-way bet that equity flows into them were 50% greater than those into developed market funds. Developing bond markets particularly benefitted from the indiscriminate buying of obviously mispriced bonds given the impressive track records of many EM governments failing to repay, or defaulting. Although these flows began to ebb in the second quarter, it was the early June announcement by the Federal Reserve Bank, that it might reduce gradually its enormous bond purchase programme later this year, which caused the brutal reaction. Justifiable concerns included that bond yield spreads in EM countries would blow out and their currencies weaken (Charts 2 & 3, p.4). Latest foreign exchange reserves data shows significant outflows from some countries as they tried to support their currencies: Turkey spent 5% of its reserves on a single day's intervention; in the first half of the year, Indonesia's forex reserves fell 13%. Some of those countries which have been running large current account deficits and been over-reliant on foreign capital will suffer more pain because of a looming liquidity squeeze. They will be forced to devalue. Yet for most, changes in capital flow are manageable.
Although Emerging Markets are down, they are not out. For nearly a decade, conditions for EM markets have been extraordinarily favourable. These are now worsening. Yet to tar them all with the same brush is as naive as it was to buy their bonds irrespective of specific national circumstances. Economic stress tests for countries such as India, China, Indonesia or South Africa continue to suggest a weak outlook; in contrast, countries such as Malaysia, Emerging Europe, Russia and Israel, and to a lesser extent, Hong Kong and Singapore stand out as being in a relatively strong position; of the larger Latin American countries, Mexico comes out well. This strength is confirmed by generally improving Purchasing Manager Indices (PMI) and the trend in corporate profits. Moreover, it is worth noting that the size of
recent capital inflows into the EM financial systems, whilst large, was less extreme than in 2007/8 and that the dependency by most EM countries on external financing is not particularly important.
Yet the first half of 2013 does represent a watershed. Most global economic data indicates flat or falling growth, such as manufacturing output where softer PMI readings are widespread (with the stand-out exception of Japan). Growth in trade, once driven by China, is also in a steady downtrend. Concern too has been expressed that countries as diverse as Brazil and Turkey have seen a significant upturn in middle class social unrest, expressing a desire for a larger share of the pie. Other worries include that high growth has come at a price which now must be repaid, such as joint Sino-US research covering a 20 year period to2001. It showed that average life expectancy north of the Huai River (500m + people) has been reduced by 5½ years, because of pollution (the level of which has more than doubled since).
These fears are not new, but recycled news. Exaggeration happens in every panic. No one can be truly shocked by the likelihood that world economic growth will at best sputter along, that G7 consumption will be flat, or that amongst the 35+ EM nations in the index, at any time a few will suffer political unrest: nor even that China's Communist Party has criminally ignored public health (but to survive, it will have to address this problem; an investment opportunity).
There is no point in denying that economic growth in the developing nations will be slower. Controversially perhaps, the most probable outcome – based on the history of now mature EM countries - is an improvement in the growth rate in earnings per share because of better capital allocation. In periods of plentiful money and over-optimism, the first casualty is capital efficiency (hence relatively poor EPS growth in China or India). Sweating less available capital better was a clear trend in the 90s in Korea, Hong Kong and Singapore as the GDP growth rate halved versus the previous decade; EPS growth and return on capital accelerated, as index volatility reduced.
The most important feature of the last quarter, however, is the breaking of the 32 year old bull market in G7 government bonds. It was always a dubious theory that bonds are somehow less risky than equities. There is no doubt that this perception will gradually reverse, as it did during the 1948-81 bond bear market. Thus neither “safe bonds” nor “cheap” index funds are likely top reserve, let alone increase, real wealth. This must come from specific stock selection.
© Bedlam Asset Management
