Despite a plethora of lurking dangers, markets had continued to bark until recently, when the outbreak of the coronavirus started dogging investors as to if and when the bark might turn into a whimper. But the new decade calls for restoring more bite than (central bank induced) bark as portfolios crave for sustainable growth to fight a universally accepted low-return environment, ahead. With uncontrollable macro variables and rapidly changing market dynamics overwhelming fundamentals, the need for an even stronger bite is perhaps more urgent than ever.
As we know, traditional asset allocation models (e.g. 60/40) grounded in principles of asset class diversification have been upended by the central driving force in vogue over the last decade i.e. central banks and by extension the Fed and US. While one might hope for QE/forward guidance to continue propelling markets ahead, the stark reality is it won’t (with the law of diminishing returns setting in). However, which force (s) will take over the baton from central banks is anybody’s guess. To still say that diversification is the only free lunch available to us, could fall short. Faced with this new reality, it warrants revisiting one’s methodology for allocating risk-dollars. If the starting premise is to seek a return for (investment) risk assumed, then it pays (we hope) to identify the litany of risks (or at least the categories of risk) facing all of us and figure out multiple ways to overcome and exploit those risks to generate returns.
From all accounts, the biggest risk facing investors today is dwindling earnings and yields, especially in DM. Proactively targeting multiple streams of earnings and yield across global markets, capital structure and liquidity spectrum should be intuitive to most. Aiding this, an equally proactive posture to capitalize on fluctuating macro variables and ever-changing market dynamics is probably a different tack for those inclined to hunker down. However, if consciously attempted, this two-fold strategy should go a long way to provide a portfolio bite for unfolding situations-good and bad. So, let us solve for waning fundamentals (earnings/yield), and rising macro and market risks in our quest to seek needle-moving returns, recognizing that all three often get intertwined and would require creative ways to separate one from each other.
a) Risk of Dwindling Earnings/Yield: In a traditional portfolio construct, most allocators are predisposed to emerging markets, encouraged that it is home to over three quarters of global economic growth, which one hopes will percolate through to corporate earnings. Coupled with lower (vs. DM) valuations, it grounds their rationale for overweighting emerging market equities and local currency emerging market bonds for higher real yields (amid a dollar softening stance). But that is easier said than done.
As argued in our last post EM Vision 20-20 For Some Inconvenient Truths, EM is not a monolithic bloc and presents regional disparities across multiple dimensions-economic drivers, demographics, politics, policies, trade flows, currency, etc. Moreover, economic progress does not necessarily translate into commensurate equity returns. At best, countries especially in South East Asia like Indonesia, Philippines, Vietnam etc. that have some combination of growing population, rising productivity, expanding trade or a robust domestic market, and a lower debt burden provide a good economic backdrop for businesses to prosper. Little wonder then, that McKinsey Global Institute (MGI)2020 report on Corporate Asia shows that over a decade ending 2017, Asian companies have increased their share of the G5000 (the world’s largest 5,000 largest firms by annual revenue)—by six percentage points to stand at 43% today. That’s the largest share of any region in the world. In comparison, Europe has 25% of the G5000 and North America 24%- both of which have witnessed declining shares of two and four percentage points, respectively.
However, industry/sector concentration varies across markets within EM and even within regional blocks. For example, Indonesia thrives on industrials (e.g. petroleum, textiles etc.) and services but Singapore is driven by manufacturing, trade and financial services. The aim should therefore be to harvest cash flow compounding businesses with pricing power within a country’s true economic drivers beyond just its stock index names (generally concentrated in bellwethers-financials, telecom, commodities, utilities, etc.). For example, Indonesia’s stock index is dominated by financial services companies without any significant representation from its consumption upgrade story, better reflected in healthcare services, travel/leisure, etc.
If such cash compounders are publicly listed even though not very liquid, bottom up security selection both on the long and short sides is a viable solution, packaged in high conviction concentrated portfolios with longer lock ups, to allow for some relatively illiquid positions. An emphasis on core business fundamentals away from just a top-down country, region, or sector call also helps discover hidden gems. According to MGI, 32 % of Asia’ top-performing companies operate in underperforming sectors in their home economies. By the same token, even though China’s manufacturing sector (29% of its GDP) is experiencing a steady decline, its services sector representing 53% of its GDP is running at nominal growth of nine percent year-over-year (Source: China National Bureau of Statistics) though its profitability is suspect (see below).
Companies struggling to find organic growth opportunities, helped by cheap leverage might also acquire secular growers (e.g. software and innovation companies), carve-outs with operational upside, and enter into complex cross-border deals. Private equity might also be eager to deploy its mountain ($1.3 trillion) of dry powder into M&A thus lifting Asia ex Japan deal volumes from a 2019 five year low (Source: Dealogic), creating merger arbitrage opportunities.
Activists have also shifted their focus abroad with more non-US/EM companies being targeted, according to Lazard statistics. In 2019, non-U.S. targets made up 40% of all campaigns, up from 30% in 2015 with 19 campaigns in Japan. Governance, shareholder-friendly changes, operational and strategic improvements besides, green and social issues provide a rich playbook for activists.
Outside public markets, compelling opportunities in sunrise sectors like healthcare innovation, technological change, renewables, food safety, environmental safety, waste management, workforce development, semiconductors, robotics, artificial intelligence, etc., EM venture/growth capital are good access routes with potential for 2-3x return on capital, provided managers wake up to investors’ calls to pursue paths-to-profitability. Asia, yet again is promising representing, less than 3% of private markets (Source: McKinsey) with higher barriers to entry, rich talent pool and less congested themes/opportunities (e.g. healthcare, secondaries, etc.) than in DM. Moreover, in more mature markets of US and Europe, investors are grappling with the issue of persistency of performance from mega-fund managers and even individual deal-makers (empirically more statistically significant).
In private markets, it helps to be capital-structure agnostic for often equity-like returns can be derived from concentrated exposures to idiosyncratic credit risk of borrowers. Asia is home to the world’s largest number of small and medium enterprises (Source: IFC) who often borrow to pursue strategic acquisitions and for developmental projects aimed at reducing costs and improving margins especially for commodity exports. Short duration (3-4 years), asset-based finance against cash flowing businesses with good collateral and controlled counter-party risks can afford low to mid-teen returns sometimes including equity kickers. Such real-economy financing serves well to secure above-average steady returns in a slow growth world provided LPs can diligence GPs with a toothcomb for the multiple moving parts in these types of transactions.
Counter-intuitive to perhaps many traditional investors, dwindling earnings in and of itself presents an attractive investment opportunity outside of just providing short bets. Notwithstanding value creators in EM, there are also value-destroyers in emerging markets, especially Asia. According to MGI, Asia accounts for half of the deterioration in global economic profits from $726 billion to an economic loss of $34 billion from 2005-07 to 2015-17. Although Asian firms outperform on growth in invested capital, Asian firms led by China have underperformed when turning it into “economic profit,” calculated after subtracting cost of capital from a firm’s profit. 87 percent of the decline in ROIC can be attributed to an increase in capital intensity (i.e. excess capital to offset declining revenues), with the remainder attributable to a decrease in margins. To fuel its economic development, China’s average capital expenditure in the oil and gas sector, was more than five times (as a share of GDP), over 2006-2012 compared to the previous five years. As oil prices started declining 2011 onwards, hurting revenues and margins of oil producers, China again doubled its investment in the energy sector between 2012-2015.
Over the past ten years, almost $10 trillion of capital has been invested in China, and 80% of it went to sectors that earned below their cost of capital. Domestic services sectors (e.g. utilities, telecommunications, transportation, and real estate and construction) accounted for half of the investment with a quarter invested in capital goods (e.g., machinery, automotive, chemicals, fabricated components) and the rest into energy and materials. Both, domestic services and energy and materials suffered outsized losses with smaller losses in capital-goods
The rest of Asia outside China did marginally better with around 68% of net new invested capital (albeit at a lower capital intensity than China) going to sectors earning below the cost of capital.
These unhealthy businesses are only likely to get worse amid a slower growth environment potentially translating into special situations for local managers to harvest for high teen IRRs through spin-offs, restructurings/workouts, asset sales, etc. Underachieving multinationals in Europe (e.g. Airbus, Nestle, Unilever etc.), directly or indirectly part of this malaise, could potentially shed their non-core unprofitable subsidiaries, just as over-leveraged promoters in India seek restructurings across steel, cement, and real estate sectors. MGI estimates, that Asia could unlock $440 billion of incremental economic profit from turning around troubled companies and capturing companies’ latent potential to create more profit champions.
Lastly, non-performing loans to zombie companies sitting on banks’ loan books in China, India, Brazil etc. afford rich distressed debt plays for local managers well-versed with local laws, business practices, culture, labor-intensive operating infrastructures and extensive sourcing and asset-servicing networks. China NPLs (that we have been following since 2012) assume greater appeal in the aftermath of the US-China Phase 1 deal. According to a China NPL expert, foreigners who can acquire Beijing’s planned new provincial licenses can now source NPLs additionally from provinces, outside of just the four big asset management companies set up initially to dispose off bad loans. In the same vein, a new crop of distressed situations could develop arising out of aggressive underwriting, ambitious pricing, loose covenants, etc. of cyclical companies now facing a downturn in pockets of Asia (e.g. Australia, China) saddled with debt, obtained abundantly from private channels, flushed with capital from record fund-raising rounds by some managers.
b) Rising Macro Risks: Probably everyone is heaving a sigh of relief at the US China trade truce though no one is convinced that it’s either a deal or end of trade wars. For starters, China’s commitment for ambitious imports at the expense of their other trading partners could leave many aggrieved and it would not be surprising to see either US or China cry “foul” at the first sign of any “perceived” breach. More important issues around technology remain to be resolved portending round-two of wars escalating further to an economic warfare (See our post: No China for You). The global economy remains on edge for myriad reasons and the jury is still out on whether tighter wages and housing supply would bake into inflation expectations or long rates decline on uncertainty/concerns around growth. Who shall be the next Fed chair post US elections, also remains a concern though a lower-for-longer stance is the broad consensus regardless of any Fed chair. How US financial conditions matter most to EM, has been further confirmed by a new (2020) working paper from International Finance titled: How ETFs Amplify the Global Financial Cycle in Emerging Markets by Converse, Nathan, Eduardo Levy-Yeyati, and Tomas Williams. The paper concludes that the increasing role of ETFs as a channel for international capital flows has amplified the global financial cycle in emerging markets as equity ETFs are 2.5 times more sensitive than mutual funds to global financial conditions and bond ETFs 2.25 times more sensitive than bond mutual funds. With retail investors a big market force in most EM (80% of trading volume in China) this phenomenon seems further plausible.
And of course, politics remains the biggest elephant in the room impacting every investment decision today, so much so that it requires a closer ear to the ground, literally and figuratively. It’s as important to learn from local sources about the motivations, intent, direction and implications of Hong Kong protests as it is for CAA (Citizen Amendment Act) related chaos in India. We emphasize the use of local news and networks because unfortunately the western media (including journalists/op-ed writers from respectable publications like WSJ and Economist) often miss the entire picture and regurgitate narratives formed on misperceptions divorced from facts. For example, what’s made out to be BJP’s (ruling party) religious nationalist agenda as the reason for the CAA protests, has been confirmed (substantiated with evidence) by the Enforcement Directorate (India’s law enforcement and economic intelligence agency overseeing matters like money laundering), as “terrorism” sponsored by countries in the Middle East and the Indian sub-continent, in conjunction with India’s opposition parties especially the Congress party, whose dynastic rule has been upended by Modi’s radical policies and house-cleansing efforts. Moreover, no western media appears to have dug deep enough to relate the amendment of the Act to enacting the wishes of the forefathers of India (at the time of partition) who promised to provide safe surroundings to religious minorities caught on either side of the border. Further still, it requires one to closely follow local political analysts to study Mideast politics as it poses grave danger to economies, businesses and markets stemming from conflicts with Iran, Palestine, Turkey etc., that could manifest itself in oil- supply disruptions through the strait of Hormuz to cyber attacks and beyond.
Our purpose here to discuss some macro risks dogging global investors is to highlight that along with changing market dynamics (discussed below) these events can add to market volatility creating a fertile environment for long volatility strategies practiced by EM based macro managers, who have a close ear on the ground. Sellers of structured products (as in Asia to hordes of HNW/retail clients), that typically short volatility provide a good and inexpensive supply of volatility for long vol. managers, who can potentially provide portfolio upside while protecting downside risks.
c) Rising Market Risks: Besides foreign capital flows that have an outsized impact on emerging markets, the increased emphasis on ESG especially among ETF behemoths, could lead to divestments of companies suspected of “greenwashing” likely to spawn “green swans”. EM is a hotbed for all E, S, and G concerns (even though Asian corporates’ adoption of ESG is only second to Europe’s-Source: CoreData Research) and potential investor agitation could provide a new source of volatility, intermittently. The uncertainty of fiscal or monetary policy could weigh on rates, forex and equity markets as much as PBOC vacillations between cutting reserve requirements to combat onshore defaults and tightening credit to cool real estate speculation. Additionally, the Fed’s repo tool to manage short term liquidity is a new market dynamic for global investors to worry about. As mentioned above, increased market volatility can often also create opportunities for EM relative value managers who can arbitrage valuation differentials across markets, asset classes, capital structure, instruments, etc. Any extreme dislocations is fodder for managers who can trade stressed/distressed paper.
In a nutshell, emerging markets are both proven bastions of growth as well as storehouses of business irregularities with capital markets exposed to anomalies and a multitude of volatility-inducing factors. Thus, if investors were to approach portfolio construction bottom-up, driven by their need to solve for growth and yield while posturing to profit from any slowdown, volatility and market disruptions ahead, it shouldn’t be surprising that their portfolios will inevitably find more solutions arising from/related to the emerging markets. Now that should give your portfolios enough bite and probably a bark of its own!
ÊMA remains alert to the new world order and is glad to conduct independent portfolio reviews for LPs to ensure if there is adequate EM bite while also welcoming GP conversations to evaluate if their EM alternative strategies, execution and operations can deliver the potential bite for LPs’ portfolios. Stay tuned.
Wishing you safety and good health in the year ahead.
Kamal Suppal, CFA
Chief Investment Auditor
January 29, 2020
The above content is intended for sophisticated audiences as in institutional investors or accredited investors. Readers are advised that any theme or idea discussed above is not an offer to buy or sell any investment.