This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Tyler Mordy, president and chief investment officer of Toronto-based Forstrong Global.
Emerging markets—deflating, despised, discounted—are the subject at hand. Even a casual browse through today’s financial media highlights a seeming shortage of magazine covers on which to announce the coming collapse of China and its now-enlarged economic ecosystem. Bearishness has become a universally approved view (much like bullishness on almost anything else).
To be sure, this treatment is far removed from the red carpet on which emerging markets (EMs) trod during China’s roaring bull years. But is it warranted?
The following is a departure from the voluminous stacks of negative commentary. Enough exists. Our interest lies in the strong consensus that has surfaced. Whenever a deeply unified one appears, it’s always useful to question what could be missing from the analysis. As the old saying goes, “When everyone is thinking the same, no one is thinking at all.”
Skipping to the bottom line, our actionable takeaway is that EMs are forming a bottom, albeit with new leadership underway. This conclusion rests on two foundations—one of the fundamental variety and another of the behavioral kind. Both point to a favorable entry point immediately ahead.
3 Misunderstandings On EMs
Starting with the fundamentals, three issues are widely misunderstood.
First, revulsion toward China. The consensus has spun a narrative that policy has finally pivoted to pursuing a weak yuan, providing evidence of an imminent hard-landing scenario. While growth is slowing and should not be trivialized, the more important story is China’s solid progress on the road to rebalancing; namely, a shift away from manufacturing and construction activity toward consumers and services. Urban hiring trends are still growing at a robust clip, and services expanded by 8.5 percent in the first half of 2015—hardly statistics associated with economic recessions.
The above is encouraging. And, exactly what well-intentioned Western economists urged EMs to do: Rebalance economies away from cheap exports to a more self-sustaining middle class. While Beijing can be criticized for a poorly communicated agenda, its longer-running ambitions shouldn’t be understated—internationalize the currency, modernize the financial system, address excesses in debt markets and transform state-owned enterprises—all couched in a nationalistic revival of the “China dream.”
Higher-Quality Growth For China
This transition will be bumpy, but investors should not lose sight of the longer-running game. Over the next several years, China will see slower but higher-quality growth—thanks to reduced capital waste (less inefficient infrastructure spending, less corruption, less unproductive debt). This is enormously positive for asset prices.
Second, forecasts of a widespread EM crisis are also off the mark. Here, the commentary has focused on slowing growth and high debt, with extravagant comparisons to the 1997-98 Asian crisis. Yes, exports are slowing. But this is concentrated in the commodity exporters (declining by almost 40 percent in July on year-on-year terms).
And the outlook is actually improving for a number of countries. It’s important to recognize that EMs already had a large slowdown between 2010 and 2012. Since then, currencies have weakened (boosting competitiveness), commodities have fallen (raising consumption) and policy has turned stimulative (lowering the cost of capital). These benefits always show up with a lag. Why should this time be different?
The other dominant worry has been high foreign-denominated debt and resulting capital flight. Again, these worries should be confined to resource exporters made fragile by the commodity bust. A wider look at EM countries shows much less vulnerability. The number of nations with floating exchange rates has increased sharply allowing “automatic stabilizers” to balance growth.
More importantly, there has been a huge improvement in EM balance sheets, where levels of external debt have dramatically dropped and foreign exchange reserves have soared.
All of which brings us to the third point: the impact of Fed policy on EM asset prices. Most investors continue to assume that the Fed is eager to raise interest rates before inflation accelerates (because monetary policy works with long and variable lags).
Such pre-emptive tightening is a fair description of policymaking pre-2008. But in the post-crisis world, the assumption that any central bank can raise interest rates before inflation surfaces in a meaningful way is simply misguided. How do we know this? Because central bankers have repeatedly said that policy normalization will only occur once higher inflation is firmly embedded in consumer and business expectations. This is a long way off.
Why is this important for EM asset prices? If the “lower for longer” interest-rate view remains correct, then any EM sell-offs caused by expectations of U.S. monetary tightening will prove unjustified. As long as the Fed and other central bankers are determined to remain behind the curve of rising inflation, these panics present buying opportunities—as they have since 2009.
Investors Behaving Badly
Turning to the behavioral arguments, some scene-setting is required. Unflatteringly, physicists rightfully smirk at the pretensions of Wall Street’s quants. The history of their decision-making systems—to put the most charitable spin on it—haven’t always accounted for all variables (notably the human component).
But in the matter of investor behavior, financial analysts have discovered an actual law of nature: investing is the only business where, when things go on sale, everyone runs out of the store (to paraphrase Warren Buffett).
What is the data telling us today? Our firm tracks a variety of fund flow and opinion surveys—a kind of investor voyeurism, providing a statistical snapshot of both professional and public portfolio positioning.
While EM assets are marked down and deeply in the bargain bin, investors are indeed vacating the store. This is confirmed in a variety of investor channels and positioning. In the retail world, EM mutual fund outflows totaled a net $30 billion over the last three weeks. This was only matched in 2008 and 2011, and was followed by significant rallies. Who’s left to put in the marginal sell order?
Rating agencies can also provide useful signals. The number of downgrades is the most since 2002 and the 1998 panic prior to that. Notably, Brazil’s credit was recently relegated to junk status. But downgrades are lagging indicators and normally only serve to confirm the issue in hindsight.
In the institutional universe, fund managers are similarly sour. EM “underweight” positions are at a record net 34 percent, and “aggressive” underweights just hit an all-time high (a few managers had the temerity to be “equal weight”). Contrarians take note.
No Country For Old Views
Much EM analysis misses the important nuances between countries and regions. As leadership rotates away from commodity exporters, outlooks can be especially confusing. Old assumptions melt away. In their place, new perspectives take hold. These shifts always heighten volatility.
As the EM story transitions, consider favoring domestic-focused, reform-minded, commodity-importing countries. Most of these are found in Asian nations—countries like India [iShares MSCI India (INDA | C-96)], the Philippines [iShares MSCI Philippines (EPHE | C-99)] and yes, China [(Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-53), iShares China Large-Cap (FXI | B-37)].
Conversely, those economies that have been complacent about a slowing of China’s rapid industrialization era are likely to continue faltering. Global investors should position for significant country reratings.
Tyler Mordy, president and chief investment officer of Forstrong Global, is a recognized innovator in the design and application of global macro ETF managed portfolios. He is widely interviewed by the financial media for his global investment strategy views, as well as ETF trends. CNBC has called him one of the “best independent ETF experts.” At the time of this writing, the author and his firm owned positions in INDA, ASHR and FXI.