Since the start of the year to date, the portfolio has whupped the index by over 1,100 basis points, with a real gain against an index loss. Overall, the developed market (DM) index easily outperformed that for emerging markets (EM). This is expected to continue at the index level, partially because of weaker earnings growth and for political/social reasons. Analysts crank out studies on their companies, yet few look up from their spreadsheets to take a wider view encompassing politics and real people. In the advanced countries, politics is rarely important. Historically, earnings and indices are little affected by changes of government. In the EM nations, such issues can make all the difference. Two examples suffice.
In India, PM Manmohan Singh was once seen as a great reformer, the man to reverse six decades of bad policies under the Nehru- Ghandi dynasty. Following independence in 1947, India accounted for nearly 5% of world trade; by 2010 this was 1.4%. In August, Mr. Singh announced “with great pride” a bill to subsidise food prices for up to 67% of the population, or over 800m people. No one would deny that a reduction in India‟s chronic malnutrition problem is desirable, yet one of its prime causes has been the continuous and massive misallocation of capital. India does not need its space rocket or nuclear missile programmes, but investment in better farming practices.
Along China‟s five largest rivers, one third of children born since 1995 already have an average level of toxic heavy metals within their systems over four times the accepted World Health Organisation's "safe" maximum. The dire physical and mental consequences are well-known, thus the economic consequences must be significant. In its rush to develop heavy industry and manufacturing, China too misallocated capital woefully and ignored all welfare issues. Reform is never easy. India and China (and other large EM nations such as Indonesia) failed to reform when capital was ample and cheap; now that growth has slowed, it is harder still. These failures have a direct equity market consequence. Basic demands for some health, pension and welfare investment or simple clean water can no longer be ignored. It is one reason why DM indices will continue to beat those of EM.
In the EM indices, a significant proportion of the largest companies are government-controlled. Slowly they will be compelled to carry the costs of government failures from health care to food subsidies. Nor will they be allowed to close loss making plants or shed excess workers. Thus in a true capitalist sense, they are not companies at all, but listed government entities. In times of high growth this is a major benefit, as governments flush with money give preference for large contracts to their own listed departments, which in turn buy goods and services from other listed government entities, a virtuous spiral. In a downturn, they are doomed to pick up the tab for the failure Despite Bedlam‟s seemingly gloomy EM index suggestion, the majority of companies in the universe are truly private sector. Less circumscribed by the state, already many are adapting to weaker export demand, lower commodity prices, over-capacity and less available foreign credit. These should produce easily superior returns to their DM equivalents; the more so if they focus on their domestic consumer and service sectors, which across most EM countries remain under-developed. Hence emerging market investment must differentiate between those countries which used the boom times to restructure, and those which seem to be striving stubbornly to increase their inefficiencies. Although this latter group is depressingly large (including India, South Africa, Indonesia and…. Greece - now officially an EM), more are seizing the opportunities. For them, the thumping falls in local indices, often combined with weak exchange rates (chart 2, p. 4) have dramatically improved valuations. Using the simplistic guide of Cyclically Adjusted PEs (CAPE - starting 1 January 2006), since December 2012 the EM multiple has fallen from 18.0x to 14.9x, close to the panic low of March 2009. Several countries which did not become over-reliant on foreign capital to fund their deficits have been pummelled unduly harshly, such as Brazil from 14.5x to 10.7x, or Russia from 9.4x to 7.6x (this makes it the fourth cheapest market in the world: simply the wrong price). Ordinary PERs show a similar picture (chart 3, p. 4). Save for the second half of 2009, EM PERs were at 10-year lows. Meanwhile, their dividend yield average of 3.5% - barring two brief spikes during the banking crisis - is at an eight-year high.
Sentiment should turn soon. Foreign investors became over- enamoured with the prospects for EM; they then ignored the political, social and economic risks that EM sovereign bonds became valued too close to far safer government debt such as those of the US and UK. Given that some investors remain embarrassingly overweight, further selling pressure may arise – particularly in government listed companies where their holdings are concentrated – but this will wane. Moreover, given Bedlam's programmes slowly (failing which, recession is inevitable and will view that central banks will only reduce their bond purchase to reform.
© Bedlam Asset Management
