“A fragile Europe and messy UK leadership race on top of an already low-growth world makes for an extremely tough macro backdrop for investors”, says Neal Smith, Portfolio Manager of the SIM Global Emerging Markets fund at Denker Capital.
It may be time for investors to reconsider emerging markets, where consistent outflows over the past 24 months have increased their attractiveness.
Brexit has toppled the first domino and uncertainty is high. The likelihood of an EU break-up has increased considerably since the “leave” vote on Friday, 23 June 2016 (refer our article “The morning after Brexit”). Similar referendums in other EU countries such as Italy, the Netherlands and France could have the same outcome. This is the risk the EU leadership face against the backdrop of an increasingly acrimonious divorce.
Despite the uncertainty, markets have rallied over the past few days. But this was after a large sell-off brought about by a massive repositioning by fund managers reducing their equity exposure, specifically UK, Europe and also US bank positions. In considering “What now?” it is important to bear the most probable base case in mind and not be swung along with market sentiments.
The world’s most complex divorce begins
The UK has to re-negotiate the best possible trade agreements for itself, while the EU plays hardball as it attempts to discourage further referendums by other EU member states. German Chancellor Angela Merkel has said: “As of this evening, I see no way back from the Brexit vote. This is no time for wishful thinking..”
Given the fragile state of the EU, it can barely afford to spar with one of its major trading partners. Germany in particular is heavily reliant on its exports. However, news headlines report that the official languages for EU documents will no longer include English and French president, Francois Hollande has added fuel to the fire by saying he will move to block London clearing Euro trades.
Negotiations will be long and drawn out. Each new agreement has to be approved by each of the 27 member countries (excluding the UK). With its leadership and the country divided, Britain will undergo a period of strife and a battle for leadership. In most developed markets, the frustration of blue-collar workers with politicians and the increased competition from immigration will ensure continued political volatility.
Mohamed El-Erian (Chief Economic Advisor at Allianz, Chair of President Obama’s Global Development Council) recently noted that: “The most striking element when you look at the US or Europe is the emergence of anti-establishment movements. There is nothing surprising in this, however, because if you run sophisticated economies at low growth for a long time, and if the benefits of that low growth only go to a very small section of society, then people will get angry” ….and….. “It is very hard to predict the politics of anger.”
What about the US?
Will the US electorate learn from the Brexit vote? Unlikely. Donald Trump is already fighting his election on a trade protection basis: “We’ll protect your jobs against the Chinese”. He has threatened to withdraw from the North American Free Trade Agreement and has vowed to label China a currency manipulator and impose punitive tariffs on Chinese goods. Brexit could trigger a move away from globalisation, restricting free trade, pushing up costs, restricting the optimal allocation of capital and driving down returns on capital.
So much uncertainty……what does this mean for investors?
Valuations in the UK and Europe are now very attractive (particularly the financial sector), but the probability of a weaker pound and a recession lie ahead. Chinese and Korean banks stocks have been trading at even more attractive levels in recent years. If the UK/Europe do experience a recession or continued low growth, these stocks could remain value traps for a while.
Reduce risk and enhance returns: invest a percentage of your portfolio in emerging markets
From a portfolio perspective, diversification into emerging markets over the long term has had the dual benefit of increasing returns as well as decreasing risk. Figure 1 below shows this relationship over the past 45 years. Since 2011 this has not worked, but the exodus of the past 4 years has made emerging markets very attractive again.
True, emerging markets generally remain somewhat more volatile than developed markets, but the diversification of risk makes up for that. Investors seem to be re-assessing the risk associated with investing in emerging markets and Figure 2 below shows the extent of emerging market outperformance year-to-date (5.4% in US$ to 30 June 2016). Contrary to common wisdom, the case can be made that emerging markets are now more predictable than the developed countries.
Generally speaking, the states of most emerging market economies are in a much healthier state than the developed world, and the growth outlook for the foreseeable future looks promising. Year-to-date, emerging markets as a category have outperformed developed markets and investors would have benefited from adding emerging markets to their portfolios. There is still a huge opportunity for investors with a long-term time horizon, as the extent of this outperformance is set to increase further with time.
It is vital to understand that emerging markets have underperformed since 2011 due to a de-rating. But Figure 3 shows that, for example, emerging market bank sectors have consistently grown shareholder value at a higher rate than that of developed market banks over the past 14 years (measured in US$). Shareholder value is measured as tangible net asset value with net dividends added back.
So where to invest?
Emerging market valuations are looking particularly attractive and they are under-owned. Their currencies have been weak for more than five years, reflecting global investor pessimism towards this asset class. Debt levels in many emerging market countries are low compared to their developed market peers. On top of this, many countries have their own internal growth dynamics (such as India and Indonesia) and positive reform agendas. As referred to above, the future economic growth outlook for emerging markets continues to look significantly more attractive than that of their developed market counterparts.
What now? No set course
Investors face an extremely tough macro backdrop. There are no clear guidelines on how to proceed, but we can say with certainty that volatility will continue. As always, our approach at Denker remains unchanged: we will continue to invest in great businesses which are attractively valued. The volatility creates opportunities and we are very well placed to capitalise on them.
We are convinced that now is the right time to start allocating capital to emerging markets. Emerging markets materially outperform developed markets over time, as shown in Figure 4 below. All the structural drivers of this outperformance remain in place. Emerging markets have plenty of tailwinds, such as 82% of the world’s population lives in this region, it has 75% of all land and 63% of all natural resources. There are powerful trends at play in emerging markets that will continue to support their growth (e.g. urbanisation). As previously mentioned, investors can benefit tremendously by diversifying into emerging markets, reducing their risk and enhancing their returns. Most importantly valuations in emerging markets are extremely attractive.
Denker Capital – SIM Global Emerging Market Fund
Denker Capital launched the SIM Global Emerging Markets Fund 13 months ago. The performance track record since inception has been good, having outperformed the MSCI Emerging Market Index by 13.2% to the end of July 2016, placing it in the top position vs other global emerging market funds in its Morningstar category over that time horizon. We are finding many exceptional businesses to invest in that are trading materially below our assessment of what we believe they are worth. Emerging markets are cheap, unloved and are very under owned by global investors. Emerging markets have possibly started their next cycle of outperformance.