Mark Dow’s Emerging Market Sweet Spot

June 21, 2016

Emerging markets have rebounded in 2016 from multiyear lows, but should you own it? And if so, what part of the segment—equities, fixed income—should you even consider investing in? There are some big differences right now between the two asset classes, according to Mark Dow.

Dow, founder of Dow Global Advisors, based in Laguna Beach, California, and author of the Behavioral Macro blog, has 20 years’ experience as a policymaker, investor and trader focused on global macro and emerging markets. Let's start off with the Fed. I’m guessing you weren’t surprised that it left rates unchanged?

Dow: No, but there is some new information, and it's been happening incrementally. There's always been a split between what’s structural and what's cyclical. Fed officials believe monetary policy can fix what's cyclical, and the structural stuff they really can't do much about.

So their response has been, “OK, we'll just do more and more QE when things are weak.” But now they're grudgingly realizing that the U.S. economic problems are not as cyclical as they thought it was; it's much more structural. Whether you want to call it the new normal or secular stagnation, they're moving toward that camp.

If you ask three people what secular stagnation is, you're going to get three different opinions. But for me it's very simple: The potential growth rate of the economy, post-crisis, is much slower than it was precrisis. Why are these economic issues now structural and not cyclical?

Dow: The speed limit on the highway for us used to be 70 miles an hour, and now our speed limit is 55 in terms of economic growth. We just can't grow as fast as we were growing.

Why is the rebound from the great financial crisis so tepid, so modest? For a long time, it had to do with the debt overhang, the household sector and the financial sector working out from under their debt burdens. But that's pretty much happened. Yet we haven't been growing fast.

There are demographic, technological and globalization trends below the surface that we papered over for a long time with credit growth. Median income hasn't been good for a long time in the U.S., but we didn't notice it because we had access to credit. Our growth numbers were faster as a result, and we felt richer. But the underlying growth rate was deteriorating.

Why has it been deteriorating? Because the baby boomers were getting older and they weren't as productive. The labor force was shrinking. The effect of women coming into the labor force had maxxed out. China joined the WTO. And all of a sudden it was like a huge supply shock to the labor market. Technology was making it easier to produce in any country in the world pretty much whatever you wanted to produce. All of these things were dampening the growth rate and wages in the U.S. But we only really noticed it after the financial crisis, because that's when the credit stopped papering over the structural weaknesses.

By taking its Fed funds rate projection for 2018 down from 3% to 2.4%, the Fed is acknowledging that the equilibrium policy rate is lower than we thought it was. Every time they're revising down their growth forecast, they've been too optimistic. They've done a better job on inflation, but on growth, everybody's been too optimistic.

That's the structural story. People can talk about fixing the tax regime, or all these other things, but I don't think any of it really fixes it. We’re in a world where we're going to grow more slowly for a while. How should advisors and investors approach this current slow-growing, muddled economic picture?

Dow: You have to ask yourself, are you afraid of inflation? Well, not so much, if we're not running that hot. Are you afraid of recession? Well, not so much, if we're not running that cold. This is going to be the longest shallow cycle ever. And that's what's happening.

There's another factor as well, and that's the seasonality of it. We load up on risk at the beginning of the year, and we load up on risk at the end of the year. In the middle of the year, often, we go into what I call the “summer chop.” And that's where we are now. The economic indicators aren't strong enough up or down to really drive us to a breakout or a breakdown.

And if you're a financial advisor, you want to stick with the plan, which—at least for me—has been keeping a fair amount of cash on hand and in interest-bearing assets. My asset of choice has been emerging market local fixed income. Emerging markets and commodities are in a long bottoming process, an L-shaped bottom. It looks like we're rallying, everyone gets excited about emerging markets, and then something turns, and oh, no, we're going back to the lows.

We're going to do this for a while. Emerging markets are going through a version of what we did with the deleveraging process. The emerging markets have their boom based on credit, not on commodities. They have to work their way out from underneath that credit overhang before they can grow again. And before you can get a sustainable rally in emerging markets, a really good one, you need some signs of growth. They're still a ways from getting to that point. How do you access the emerging market local debt? Is it through an ETF or do you buy straight-up bonds?

Dow: It depends. There are not very many vehicles. I go through a closed-end fund. I'm hesitant to recommend it. So if emerging market local debt is bottoming out, what about emerging market equities?

Dow: You don't want to be in the assets that rely on growth for the reasons I just explained. Earnings aren't going to rebound. Currencies should probably stabilize; they'll go up and down a little bit, but they're not going to move dramatically. And with emerging market local fixed income, you get the carry, and you get the interest, which you're not going to get in the equities.

If you want to buy EM equities, you just need a better dip. Same thing with emerging market fixed income; you just don’t need quite as dramatic a sell-off to get involved, because the risk/reward is a little bit more in your favor.

There are three factors you need for emerging markets to take off. You need some sense of where the Fed is going with interest rates, and I think we're realizing that they want to raise rates, but they're not going to go very far.

The second thing is the dollar. When the dollar is sprinting to the top side, people are not going to want to get involved in emerging markets of any shape. But the dollar is not doing the exciting things that people thought it was going to do when we were predicting a more aggressive rate cycle. So, those two pieces have fallen into place.

The third piece was growth. You need a growth differential to compensate the credit risk in emerging markets. That growth differential is just not there yet with respect to the U.S., because they're working out from under their credit buildup from the last cycle. Is that sovereign debt, or corporate debt or high-yield debt?

Dow: I like sovereign, because you're not really taking as much credit risk with local-currency sovereign debt. It tends to carry pretty well. But the closed-end fund, which we're not mentioning, yields around 11%. That's quite attractive.

Again, you have to share my view that we're bottoming. It's important to say an L-shaped bottom, because when you say something is bottoming, people think V-shaped. That's their first thought. This is more of an L-shaped bottom. From a very simplistic point of view—not that you're recommending this—but a 60/40 portfolio actually sounds like it makes more and more sense in this slow-growth world at best.

Dow: Particularly if 40% is cash. Everyone has the parameters within which they have to manage. Some people need to be fully invested; other people have more discretion on the cash side. I'm keeping a large amount of cash, and I have my core positions in emerging markets and a couple of other things I think will play out over the long term. I'm waiting for a better entry point.

Think about it from a sentiment standpoint. People are very bearish, yet we're not very off from all-time highs. That means we probably can't go down massively unless something really dramatic happens fundamentally. I just don't think that's likely. So are you not in U.S. equities?

Dow: It's not attractive to buy. Our bearishness is deep but not acute. Bearishness is very widespread but it's not that panicky bearishness that you can step in and buy something. That's what I would be waiting for.

I don't have that many U.S. equity positions. I have various and sundry positions. It's mostly idiosyncratic stuff, and I'm hanging on to things I bought in February when things got a little panicky, and a lot of them are correlated to a weak dollar. They kind of go up and down. But most of what I have is correlated to a weak dollar I bought at good levels, and it pays a reasonable rate of interest.

I’m waiting for something dramatic to happen when the bearishness becomes acute and not just pervasive.

Contact Drew Voros at [email protected].


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