Hindsight is 20-20, as we all know. Look around and forward vision for 2020 is cloudy at best, be it for geopolitics, economies, businesses or markets. Markets might look great having bounced back (through April from the sharp declines end of 2018 and then since October), due to corporate buybacks, extended monetary-easing across both developed and emerging markets, consumer spending and a false dawn of phase one China-US deal. But cash buffers are rising in portfolios as is the cost of hedging against sharp market declines. At the same time government bonds and gold have appreciated while U.S. high yield spreads especially CCC widened even as U.S. equities made new highs. In sum, investors’ euphoria comes mixed with anxiety. Hoping against hope for the rally to continue, some investors take comfort in calls (as in Japan, New Zealand, UK, India and South Korea) for increased government spending/fiscal stimulus as their confidence in central bank support (QE) is waning. Similarly, investors’ failing optimism is drawing support from the relatively less trade-sensitive services sector (with expansionary PMIs) when manufacturing and capex are declining amidst business uncertainty. And still our inboxes continue to overflow with dubious capital market assumptions when tomorrow remains anyone’s guess.

Unlike many respectable market veterans, we are no market-pundits to divine economic conditions and markets just because it’s that time of the year. While our vision for 2020 is as hazy as anybody’s, we’d like to share our near 20-20 vision (an irresistible pun) of some inconvenient truths that investors face today that investors in EM can draw upon for both lessons and solutions. We summarize our vision below based on our observations and conversations with local investors from LATAM to Asia and MENA in between.

1) China too big to ignore, too big to fail: As the second largest economy accounting for a third of global growth, China’s economic clout is well known. But as investors we need to recognize its growing heft in global politics, financial markets and of course technology. With the US withdrawing from multi-lateral institutions like the UN, China is trying hard to wedge its way through. China’s efforts span a broad range of UN activity, from human rights to matters relating to economic development.  According to the Economist, it has dramatically increased its spending at the UN. It is now the second-largest contributor, after America, to both the general budget and the peacekeeping one. It has also secured leading roles for its diplomats in several UN bodies (to gain bureaucratic levers) and enjoys support of smaller nations in Africa and Middle East where it is a strategic investor through its Belt and Road Initiative. China is trying to “make Chinese policies UN policies,” says a diplomat on the UN Security Council.

Secondly, China has stepped up its efforts to launch a digital version of the yuan, shortly. While Facebook’s endeavor to launch Libra, a cryptocurrency got nipped in the bud by US Congress, the rhetoric to launch an international cryptocurrency to replace the dollar as the world’s new reserve currency, is growing louder as also recently voiced by the Bank of England. This could weaken US’s ability to impose economic sanctions as nations like North Korea could circumvent sanctions using the digital yuan to finance its nuclear program. So, while most investors are oversold on following substantial flows triggered by the inclusion of domestic A-shares or for that matter Chinese local bonds into global indexes, there’s a greater play at work with far-reaching consequences that speaks volumes about China’s growing prominence on the world-stage.

From mobile internet to fintech to artificial intelligence, China is redefining the 21^st century, an almost foregone conclusion that few would dispute. It seems the ongoing trade-wars has only fueled further, China’s urgency to dominate every sphere of technology to the point that it has introduced a sweeping policy (known as the 3-5-2 rule) to swap the foreign technology products the government uses with indigenous ones. If one can vouch for the accuracy of a report from China Academy of Information and Communications Technology (CAICT), China’s digital economy reached a value of nearly US$4.5trn, just over a third of its current GDP in 2018 (expected to drive 65% of China’s GDP by 2022) accounting for 25% of total employment in the country. Traditional sectors like energy, pharmaceuticals, banking, retailing, etc. also boast of behemoths like Sinopec, Alibaba, ICBC, China Resources, TenCent, PingAn, etc.

On a more defensive note, China has adopted an uneasy balancing act of stabilizing growth and avoiding excessive credit expansion, having learnt its lessons from indiscriminate lending to stimulate fixed asset growth in 2009 now resulting in billions of non-performing loans of state-owned enterprises clogging its banks’ balance sheets. The bottom line is still the same: to contain social unrest (especially with HK spiraling out of control) by ensuring unemployment remains low. So, while defaults have picked up to introduce a discipline for pricing risk as China opens up to global investors (e.g. removal of qualified foreign institutional investors quotas), the economic damage will likely always be contained by ensuring that Chinese consumers and its service sector continue to offset any slowdown in the export-oriented manufacturing sector or from lower productivity gains. As voiced in our last post “No China for You” and similar echoes heard since then, preventing US investment into China and/or limiting China’s access to US capital markets or further still, forcing US investors to divest from China would be further antagonizing a force to be reckoned with. On the contrary, investors should have a proactive, concerted, and exclusive China-strategy as discussed in one of our previous posts: A Chinese Menu for China.

2) Politics of haves and have-nots-forever true:  From time immemorial, almost all societies are made up of haves and have-nots. But when social inequality as also measured by the Gini Coefficient is huge and widening, especially in the African countries and LATAM, it gives rise to violent protests as witnessed recently in Chile, Ecuador, Bolivia, Lebanon and Iraq. While these countries might be outliers for the investing world, their cause is telling for in some instances as in Mexico and Brazil, socioeconomic divides have led to populist governments who appeal to their people’s sensitivities to weed out corruption, provide social benefits and bridge the social divide. However, populism often tips the balance and leads to populist dictatorships (as seen with both left-wing AMLO in Mexico and far right Jair Bolsonaro in Brazil) to the detriment of their economies. Mexico is on the brink of recession and Brazil is still fighting a chronic fiscal deficit and is barely out of a two-year recession pre Bolsonaro (though to his credit much awaited pension reforms were accomplished). In other words, structural reforms, economic turnarounds and/or political stability from regime changes might not always pan out and requires closer monitoring to the extent it potentially impacts portfolio positions current and proposed. Thus “political wave” investing, riding on Macri in Argentina or Modi in India or Jokowi in Indonesia is always a risky proposition as political polarization often restricts structural reforms as envisioned initially also impacting credit flows. However, markets might forgive and overlook the state of affairs as observed in both Mexico and Brazil up 7%, and 26% (YTD), respectively (Source: Bloomberg).

3) Economic growth or recession≠ Market/Investment performance: As discussed above, both Mexico and Brazil prove the point that equity market performance is not necessarily correlated to economic performance, good or bad. But despite that, fundamental thinking resorts to spending hours on end estimating economic growth and how that translates into market-level earnings which is then assessed for its relative attractiveness based on valuations as indicated by PE multiples. For instance, currently Asia is expected to grow at 4.5% in 2020 vs. DM’s 1.5% growth (Source: Moody’s). Asian earnings are estimated at ~13% for 2020 at 11x multiple that compares quite favorably to DM’s ~10% earnings growth at 17 PE for US and 13 PE for Europe and so EM becomes an attractive BUY. With all due respect to traditional investors, this thinking is quite limiting in nature. First, EM is not a monolithic bloc and presents regional disparities across multiple dimensions-economic drivers, demographics, politics, policies, trade flows, currency, etc.  Secondly, industry/sector concentration varies across markets within EM. Thirdly, more recent research, for example one from Empirical Research Partners shows that as EM companies have become more established on the global stage, 64% of their stock returns can be explained by company fundamentals as in developed markets. So country, region, sector factors have come to take a back seat in the new era and, company or business fundamentals are pulled to the fore. This lends itself to bottom up security selection both on the long and short sides to build high conviction concentrated portfolios away from restrictive benchmark weights. Notwithstanding the importance of the micro, macro awareness (not obsession) still counts to the extent it helps identify business cash flows, foreign institutional flows and domestic investor flows.

As Bob Prince of Bridgewater implies, the integrated economic block in Asia which has the same economic output of Europe and US combined, and two and a half times the contribution, ought to command a greater portion of investor portfolios due to all cashflows and not necessarily be restricted to business cash flows that are securitized and traded in public markets. This also implies that business cash flows outside public markets should be consciously targeted in portfolios through private market strategies to capture a bigger portion of economic activity within markets and regions. FII flows are important to the extent one can capitalize on any additional tailwinds (beta) going in but get ahead of (exit or hedge) any impending erratic outflows. Domestic flows are increasingly a dominant force in countries like India (thanks to the growth of Systematic Investment Plans (SIPs) mobilizing retail investors) which help buttress downdrafts when FIIs pull out (on “political wave” investing), say when Modi’s economic miracle seems to be fading (e.g. disappointing economic growth, declining auto sales, losing consumer confidence, sluggish credit, etc.) only to return when something like corporate tax cuts revives their hopes.

4) Localization NOT globalization in connected NOT disconnected world: If business cash flows is the key driving force of earnings and returns, then prudence warrants greater stability and predictability of cash flows. The less a business’s cash flows are affected by exogenous factors the more predictable they are. Hence the focus ought to shift to businesses where local factors are a greater determining force than global influences. With the world transforming from globalization to localization in the wake of trade wars, the new investing paradigm lends itself further to pursuing such local business stories in EM and further strengthens the argument for bottom up security selection both on the long and short sides of the book to build high conviction concentrated portfolios. However, despite globalization trending downward, the world is increasingly connected, thanks to the internet and increasing global travel. Thus, global themes and business ideas might travel, translate and manifest in unique ways in local markets enriching an investor’s opportunity set. For example, Beyond Meat and Impossible Foods, which are quite the rage among food-lovers today, now find comparable products (e.g. Zhenmeat, Green Monday’s Omni Pork) taking birth locally in China that is advocating healthy alternatives amid a swine epidemic to its legions of meat-eaters. Nationalist sentiments have swayed youngsters to prefer local Chinese sneaker Li-Ning over foreign brands like Addidas, Nike, etc. and Luckin Coffee is giving Starbucks a run for its money. Adopting China’s playbook in some ways, India too has changed its e-commerce rules (data to be stored locally requiring more data centers and server farms within India) to protect/promote local businesses at the expense of foreigners like Amazon and Walmart eyeing potentially a~$200 billion e-commerce market (Source: Govt of India). If local brands overtake foreign brands in EM, the local consumer and her preferences, purchasing power and average spend would matter most, directing attention yet again to local factors.

Also, if globalization caused inflation to fall then reversal of globalization could see a rebound of inflation (though presently a global slowdown is guiding monetary easing across most EM) in local markets which would require a closer watch on domestic monetary policies (and related forex policies) away from just what the Fed is doing. When local monetary and fiscal polies assert a greater role than the Fed’s influence, EM central bankers hope that their structural reforms would percolate better down to the grassroots of their respective economies imparting greater stability.

5) Consumer-it ain’t all !: The consumer has long been the central driving force for most economies and businesses and consequently investors have flocked to the ever-expanding universe of goods and services that one can sell to consumers. Wanting a share of the consumer’s wallet has been the universal mantra partly because these make easy and interesting stories for fund managers. The challenge however, from a DM perspective, is that often the average consumer spend is quite low. For instance, the average annual online spend by Indian consumers remains low ~$200 vs. $1800 in China, and $2000 US and constitutes ~ 15% of private consumption per capita compared to 55% in China (Source: Redseer Consulting). Therefore, many consumer-oriented opportunities are not scalable enough and thus might not move the needle for DM investors. That said, there is no shying away from it with most consumers wallets expanding overall,consumer credit proving an empowering force and greater mobile penetration reaching millions more to overcome low margins. To diversify, investors need to look beyond just consumer staples and discretionary spending to the evolving needs of consumers. With growing urbanization, technological innovation, changing demographics, and the need to address social inequality (through social commerce=a combination of social objectives with ecommerce) infrastructure investments like student housing, multifamily homes, senior housing, hospitals and rehab facilities, educational institutions, nonbank financial centers, warehouses, cell towers, data centers, last-mile logistics, ghost and cloud kitchens, etc. all afford new vistas of growth and investments. As mentioned above, not all opportunities will be securitized and traded in public markets immediately which necessitates consideration of private investments in real assets across the capital structure to participate in such secular economic activity.

6) Valuation ≠ What’s in your wallet:  If business cash flows is the focal point, what one pays for it is equally essential. Thus, valuation becomes the most important driver of any asset’s return as it marks the starting point for any investor. The equity risk premium has been consistently high in recent years as global bond yields continued to fall. But when that attracts hordes of capital as in PE and VC- land coupled with cheap leverage, it creates a buying frenzy with business owners equally spoilt to ask: “what’s in your wallet”. We’ve seen lofty expectations with both WeWork and Aramco recently, which fortunately were given a reality check before investors sustained losses as ill-fated high-profile unicorns like Uber, Lyft, Snap, Cloudera, etc. comprising a third of all IPOs from 2011 to 2016 that fell ~40% from their last private-funding rounds (Source: Pitchbook). Not only traditional VCs accorded many startups unrealistic valuations despite lacking or declining profitability, corporate venture capitalists were equally to be blamed for throwing money in their desperate bid to capture growth through acquisitions of new avenues and technologies when organic growth remains challenged and the need to innovate is stronger than ever. For example, in 2018, 25 supersized rounds represented over 25 % of all VC deal volume (Source: Preqin). The lesson for innovative businesses that are proliferating across LATAM, Asia and Africa is to avoid hard knocks for investors -domestic and overseas-who are warming up to their nascent public/private capital markets as providers of capital. In other words, businesses and fund managers investing in them must act as stewards of investors’ capital and deploy capital diligently with an eye toward profitability not what some “greater fool” would pay down the road- The problem with the greater-fool theory is that sometimes the greater fool doesn’t show up. (Source: WSJ)

7) Regulatory watchdogs- watch and be watched:  As experienced recently in the US and Europe, newer technologies touching every sphere of life, are evoking newer regulations, in many instances by trial and error. Taking a cue from this, technology innovation in EM would be much better placed to anticipate the far-reaching impacts on societies and warrants working with their (and global) regulators to develop regulations proactively (When Technology Gets Ahead of Society-Harvard Business Review) as opposed to facing restrictive protocols subsequently threatening to clamp down nascent businesses as witnessed with Juul Labs. Equally important is privacy and consumer protection practices adopted proactively as opposed to suffering rigorous curtailments and threats of a break up as faced by Big Tech today. However, it must also be recognized that consumer privacy and data protection fly in the face of strict monitoring, oversight and breach of privacy in state-controlled regimes like Russia and China.

Besides newer technologies, other areas for legal/regulatory reforms in EM bear watching. For instance, the Insolvency and Bankruptcy Code introduced in India in 2016, espoused a time-bound resolution of bad debts congesting the Indian banking system. After an encouraging start, institutional investors (e.g. CDPQ) and distressed shops (e.g. Apollo, Blackstone) are still playing the waiting game due to inordinate delays, administrative nightmares and deal fatigue pending resolutions inside or outside the appellate authority, National Company Law Tribunal (NCLT). In other words, regulatory reform is welcome but local laws need deep understanding, close monitoring, and local know-how to understand cultural and business practices influencing regulations.

8) Disruptions galore: It will not be much of a stretch to surmise that all round disruption is likely to stay with us into the foreseeable future. New technologies, supply-chains, regulation, etc. could disrupt businesses and residual geopolitical risks, crowded positions, liquidity scares, credit defaults, etc. might also create market upheavals.  In other words, intermittent bouts of headline and intra-market volatility in both public and private markets (though it might not be quite obvious) is expected to continue, especially in EM that is the poster-child for volatility given a multitude of local and external factors at play. The key for the savvy investor would be to exploit the inevitable dislocations without getting caught wrong-footed. Managers with a longer-term investment horizon, a higher-quality capital base, and more restrictive fund liquidity terms should be particularly well- positioned. Investors targeting stressed and distressed strategies with either a trading or a workout/restructuring bent could have their moment in the sun. To profit from constrained liquidity, investors could act as liquidity providers lending into stressed situations at a premium. For example, China’s government issued new asset management regulations that prevents nonfinancial entities from borrowing capital to invest in venture and other PE funds, as well as banning commercial banks from using the proceeds from selling short-term wealth management products to invest in PE. This has constrained capital flows into private markets in China, which has made fundraising more challenging for some private firms which opens door for local private creditors with offshore capital.

9) Yield hunt continues: With capital appreciation iffy to meet spending targets and bridge funding shortfalls, a chase for yield by institutions has compressed overall yields generally with episodic widening as in CCCs or agency MBS (due to shrinking Fed portfolio and probably reduction of primary dealer holdings). In their hunt for yield, investors have tilted toward levered loans, CLO debt, non-agency MBS looking for a relative spread. CLO debt is attractive despite concerns over the quality of new loan issuance as spreads are wider relative to liquid equivalents (e.g., BB-rated CLO debt offers 3x the spread of BB corporate bonds), and the structure has historically proven resilient given excess collateralization and incentives for managers to remove downgraded assets. However, 60% of the loan market is single-B rated or less, in part because new leveraged loans carry almost a full turn more leverage than was the case coming out of the GFC. Legacy non-agency mortgage pools continue to shrink but new opportunities (such as agency “credit risk transfer” deals) have arisen in their place. Along the same continuum, local and hard currency EM yield spreads over US Treasuries appear attractive vs. US investment grade and US high yield, luring investors to funnel a total of $3.2 billion into EM debt strategies, with 75% of flows going to hard currency strategies and the remaining going to local currency strategies (Source: Bloomberg). This is guided mostly by their belief that lower USD funding costs are supportive for emerging market credit in general and should the US economy avoid recession, but growth remain sluggish, selected BBB and BB EM local government bonds should fare well.

To earn further yield premiums, private credit which began with direct lending in the aftermath of the financial crisis has now morphed into various other forms (securitized credit, structured credit across corporate, consumer, real assets, etc.) attracting record amounts of capital (CAGR ~ 9% 2013-2018 Source: Preqin) leading to mountains of dry powder in North America and Europe, the latter having attracted more capital. With direct lending yields compressed to mid-single digits, leverage levels escalating, covenant-lite rising (as reported by ~40% of North American private credit lenders in a survey by Alternative Credit Council threatening an onslaught of defaults) and deal origination trapped in over-crowdedness, the new game in town is multisector private capital. It aims to allow megafunds ($5 billion +, termed best-of- breed) + get a broader mandate to deploy their war chests (that dominate 30% of fund raising in private markets (Source: Preqin) and account for most of the 14% CAGR in dry powder since 2012), and diversify away their potential default risks while shifting control from asset owners to asset managers. It remains to be seen how engaged these asset managers are with underlying borrowers when covenants are breached, especially since many are part of “big boy” syndicates. Also, as McKinsey highlights in its Global Private Markets Review 2019, creating bespoke solutions for an ever more diverse client base, while responding to LPs’ demand for new strategies, custom vehicles, access to co-investment, strategic relationships, and so on, has added extraordinary complexity to the operational systems and functions of the larger GPs. This not only adds cost but also inhibits scalability.

While multi-sector credit could be a new recipe for DM, throwing in a dash of EM private credit to gain a flavor for diversification is probably forsaking a much broader opportunity set and return premiums, an edge for local EM private debt managers who unlike their DM counterparts (with offshore EM offices beholden to NY or London HQs) neither have to compete for portfolio dollars nor lose their nimbleness while continuing to enjoy their local networks and expertise. On the contrary, DM investors can today build a dedicated multi-sector EM private credit portfolio across performing/stressed and primary and secondary origination to tap into cash flows diversified by geography/legal jurisdiction, industry, borrower type, collateral type and borrower term sheet. Best of all, EM/Asia private credit represents ~1% of all private credit capital thus far and does not suffer from glut of capital or a paucity of deals that has bred over-crowdedness, in US and Europe.

10) The New 60/40 =Private Equity/Alternative (Private) Credit: With bond yields plumbing to new depths and failing to zigg when equity markets zagg, investors are seeking more predictable yields from all forms of alternative credit. Similarly, public equity investing is like walking on egg-shells, and with earnings outlook cloudy, investors who are willing to lock up capital for some illiquidity premium and pursue diversified global growth have ventured beyond FAANGs in private equity (buyouts and venture). Moreover, private markets inherently allow investing through cycles (including downturns) over multiple years while potentially creating value through operational improvements. Thus, private markets have graduated from the fringes to the mainstream and is today a $6 trillion market across buyout, venture, real estate, private debt, infrastructure and resources.Global PE net asset value has grown 7.5 time since 2002, more than twice as fast as public market capitalization, which has grown approximately 3.5 times over the same period.The number of US-private-equity backed companies increased by 106 percent from about 4,000 in 2006 to about 8,000 in 2017, while publicly traded firms fell by 16 percent from5,100 to 4,300 (Source: McKinsey)

However, PE valuations (11x EBITDA Source: Pitchbook) are through the roof in DM and with opportunities constrained amid fund-raising at a frenetic pace, dry powder levels have been rising at 14% CAGR since 2012. This is true especially in VC where fund raising has grown at a CAGR of 18% over last 5 years vs. buyout’s more modest 4% growth. As a result, median net IRR ~13% of PE and VC in DM (2007-2016) is inducing investors to pare back return expectations (10-15% annualized) though still retains/bolsters their conviction in private markets for reasons cited above.

But should private market investors in DM necessarily peg their expectations so low when a world of private equity, venture and private debt opportunities await them in EM with potential for 2-3x return on capital. In this milieu, EM especially Asia is an oasis representing less than 3% of private markets (Source: McKinsey), with higher barriers to entry and less populated 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 megafund managers and even individual deal-makers (empirically more statistically significant). If that’s elusive, and one has to now take a chance, odds probably are better with even a B manager in an A-type environment in EM rather than the other way round though new entrants to Asia and other EM private markets would be positively surprised with the deep talent pool second to none.

The above are some of many inconvenient truths that today’s investors face. However, each inconvenient truth finds a convenient solution or a lesson for investors in EM provided an investor is willing to undertake the inconvenience of diligencing each such opportunity. Rather than wallow in doubt about growth, recession, rate cuts, late-cycle or mid-cycle, fiscal stimulus, overvaluation, trade wars, and so on, DM investors might be better off finding a solution for these inconvenient truths in EM with a deeper dive into investment managers knocking on investors’ doors from all frontiers of the globe. Mere past fund performance no longer cuts it in a rapidly evolving market environment and the onus is on asset owners to diligence managers for the solutions they bring and how they measure up to a new investing order. By the same token asset managers should share similar responsibility to discuss transparently how prepared they stand to navigate their opportunity set amid uncertain conditions with or without the benefit of hindsight.

ÊMA remains alert to the new world order and is committed to distilling the truth about investment managers from the farthest corners of the investment universe who can opportunistically generate yield, capture growth, and exploit disruption in every sense, to provide practical portfolio solutions for the new investing era. ÊMA continues to conduct independent investment due diligence for LPs and GPs alike, on various such alternative strategies offering more predictable, visible, and sustainable returns, to the benefit LPs’ portfolios. Stay tuned.

Wishing you and your loved ones, happy tidings of joy and peace in 2020.

Yours truly,

Kamal Suppal, CFA

Chief Investment Auditor

December 12, 2019

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.