Why Emerging Markets Offer Opportunity

December 29, 2016

Tyler Mordy is president and chief investment officer of Toronto-based Forstrong Global, an asset allocation firm known for its big-picture outlook. He’s also one of the speakers at next month’s Inside ETFs conference, and will present “Supercharging Your ETF Practice: 5 Keys to Striking It Big in Canada” at the conference. He spoke with ETF.com about the global risks faced by investors and the opportunities to be found in international markets.

ETF.com: Are there any big concerns about the Canadian markets right now? Any red flags?

Tyler Mordy: The market's seen really good performance in 2016, but we're still at a very different stage of the cycle now. In the post-crisis period, you learned that the country that deleverages fastest, wins. And currently that's the U.S. In Canada, we've had a bit of a change from macro tail winds to head winds. The star has fallen a little bit.

There have been several macro head winds that have surfaced, including a fragile housing market. We just hit a household debt record of $2 trillion, representing liabilities of over 100% of GDP; so, larger than the economy. There's pretty weak private sector job growth. And of course, the big one is the end of the multiyear uptrend in commodity leadership. Those are all sort of weighing on the outlook for Canada.

We have a newly elected anti-austerity prime minister, Justin Trudeau. He's sort of revived hopes that Canada can regain its former glory, funded in part by what he calls “responsible deficits.” This is another example of another leader on the world stage being elected based on more of a fiscal-stimulus-type program. He's definitely engineered some optimism in Canada, just like Trump has done in the U.S.

But I think the more important story for Canada is the ongoing commodity bear market. I think there's more downside risk than upside risk at this stage. And Canadians continue to be overexposed to domestic assets. That's kind of going into reverse now. You can see a lot of Canadians, and even our new clients, coming to Forstrong to embrace global diversification.

 

ETF.com: Where should they be looking outside of Canada?

Mordy: If you look at the world economy right now and, again, frame it in the post-crisis period, and look at the countries that have deleveraged quickest, obviously the U.S. has been a good place to be.

But right now, our emphasis at a balance level is much more on the emerging markets. Emerging markets aren't popular at all right now; it's been a long and punishing period of underperformance, really.

If you look at the narrative that the consensus has spun, there are some pretty unrealistic scenarios. There have been forecasts of a widespread EM crisis. That hasn't materialized. The commentary that's focused on slowing growth and high debt was making comparisons to the Asian crisis of the 1990s.

Yes, they've had a slowdown, but the outlook is actually radically improving for a number of the countries. And it's important to recognize that emerging markets already had a large slowdown between 2010 and 2012.

Since then, the currencies have dramatically weakened, which boosts competitiveness. Commodities have obviously fallen, which raises consumption in a lot of those oil- and commodity-importing nations. And importantly, policy has turned stimulative, which lowers the cost of capital.

Those benefits always show up with a lag, and I don't see why this time should be different. You have leading indicators pointing to growth. You've got really good valuations in emerging markets. From our approach, that's a good time to get in.

 

ETF.com: China has always been a market that you've favored. What's the outlook right now?

Mordy: China's really interesting, and we're still very positive on China. Again, I think here is another example of a narrative that’s emerged in the marketplace, that China's supposed to crash at some point.

Instead, our focus has been on monitoring the progress towards rebalancing; namely, a shift away from manufacturing and construction activity toward consumer and services. That's been bumpy, admittedly; but it’s happening at the margin, which is good.

One of the interesting things about the Trump election, too, is that everybody thinks Trump's protectionism will really harm China. The flip side is that if you look at some of the things Trump’s said, such as canceling TPP and so forth, I think Chinese leadership would view those relatively positive, because, for example, Obama's so-called pivot to Asia with the TPP being the centerpiece is now dead. And that leaves China's, “One Belt, One Road” strategy as the uncontested blueprint for future economic integration with Asia.

They view a Trump win as their own victory in terms of, again, enlarging their own economic ecosystem within the region.

ETF.com: What ETFs are you looking at right now?

Mordy: This is probably not too consensus, but a big focus is on the emerging markets. And so, I think when you see big rotations into EM, one of the first things that happens is the money flows into—or chases, let's say—the bigger markets. It doesn't go into the smaller markets quite yet.

We're definitely focused on China through the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR) and the iShares China Large-Cap ETF (FXI). We're also focused on India through the Shares MSCI India ETF (INDA).

 

Another interesting area in the world right now is Japan. I always say that everybody understands the macro of Japan, but nobody understands the micro. Even my mother can rehearse the negatives of Japan: They've got an aging demographic and high debt levels, and interest rates that are right on the floor, and that type of thing.

Particularly over the last decade, Japanese companies were faced with twin burdens of chronic deflation and overvalued currency, and that's made them extremely lean and efficient. And secondarily, Japanese equities are priced really cheaply. More than a third of Japanese companies are generating a cash flow yield of 15% or more; that's twice as much as in the U.S. or the U.K.

Ideal Position

And then, I think maybe more tactically here is the fact that Japan is ideally positioned in Trump's protectionist world. What you can see is Japanese corporations have really capitalized on the earnings boost they've had since the post-2012 depreciation of the yen. And they've capitalized on it by aggressive overseas M&A, building up overseas operations with production and distribution bases for their foreign markets.

Given that they have a shrinking population, it’s made a lot of sense to move these production facilities closer to the end market. Japanese corporations are highly globalized, and they produce more goods and services outside of Japan than inside.

As a macro investor looking at a combination of the tactical side, the valuations and some of these unique circumstances, it makes a lot of sense. We're long the iShares MSCI Japan ETF (EWJ) and the WisdomTree Japan Hedged Real Estate Fund (DXJR), which is the Japanese property market, if you can believe it. It's definitely at the frontier of value.

 

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