‘Tis the season for holiday cheer. Alas, many a Grinch is out to ruin the holidays for investors of our global Whoville by attacking them geopolitically, economically, and psychologically. Though ongoing Sino-US trade/technology wars take centerstage, oil’s slide and leadership challenges across the Western world in UK, France, Germany, and Italy also share the blame. Bogging down sentiments are also threats of a yield curve (2-10) inversion, uncertainty around pace of Fed hikes, over-leveraged corporates, gloomy earnings forecasts, increasing regulation of technology companies, rising dry powder in private markets, etc.
Most trained minds are either questioning “which is the next shoe to drop” and hunkering down by selling into short-lived recoveries, or (the gutsy) are mustering courage to go bargain-hunting. Those tasked to look ahead with the turn of the calendar are gazing at their hazy crystal balls to make 1-3-5-7-year capital market assumptions with little, if any, conviction as to what awaits us even tomorrow. In this regard, consensus seems to favor emerging markets, speculating that EM is oversold (i.e. attractively valued at 10.5 PE vs. US at 15, Global stocks 13.3 based on 2019 earnings) given strong fundamentals, which has driven recent flows back into Asia.
Frustratingly, once bitten is not twice shy when it comes to emerging markets for many traditional investors as their beta-chasing mentality (even in the garb of active management) remains exposed to herding (and humbling experiences) blurring the line between victims and perpetrators. Notwithstanding our ardent belief in emerging markets, we refrain from slapping blanket “buy” recommendations on emerging markets, recognizing well that it is not a monolithic asset class that can be merely bought or sold on perceptions of valuation.
In today’s unprecedented times in the capital markets there seems to be no place to hide, the tried and tested 60/40 is failing and even risk-factor based approaches remain challenged. It behooves investors to step away from conventional thinking and develop portfolio responses to risks and opportunities of our new era from each asset/risk allocation beyond mapping only economic growth and inflation scenarios.
For our emerging markets’ remit, across the liquidity spectrum in both public and private markets, we beseech no divinity for market punditry but adopt a simplistic approach to develop the following key portfolio responses:
- Does an opportunity generate high yielding current income?
- Does an opportunity tap into structural growth led by innovation, infrastructure, demands for healthcare, etc.?
- Does an opportunity exploit disruption: supply chains/trade networks, digital revolution, regulation, etc.?
- Does an opportunity exploit market stress or distress?
We illustrate our thinking here with some high conviction ideas, some of which we might have shared with you in our earlier posts.
High Yielding Current Income: As financial assets begin to lose support of accommodative monetary policies globally, assets that are driven by the real economy gain favor. Taking a conservative stance, gains from real-economy assets that afford more upfront contractual current income are more attractive than uncertain capital appreciation driven by market action or technical bids steering one toward high-yielding current income opportunities away from a total return focus. While a traditional investor might adopt “going to cash” in troubled times, an alternative focus allows for “generating higher yielding income”. In this regard, short-term lending to SMEs in a niche sector (e.g. commodities) linked to the real economy in South East Asia market (ex. China) or Sub Saharan Africa and Eastern Africa to finance processing of commodities into value-added products for higher margins, offers a differentiated and less correlated return stream and a premium for capital (typical targets 12-15% annualized net IRRs) for mostly senior positions in the capital stack. With regulatory restrictions like Basel III still dogging banks from lending freely, it opens a lucrative opportunity for commodity-specialist private lenders. This is quite distinct from over-crowded generalist direct lenders in US/Europe who are facing origination issues (as reflected in rising dry powder levels worsened by over-subscription to their funds), yield compression and covenant-lite terms that are likely to face a day of reckoning in the next credit downturn. Overall, commodity-linked asset-based lending acts as a less-duration sensitive fixed income proxy since fixed income remains challenged to fulfill its traditional role as a safe harbor in portfolios. For more details, please visit our previous post: Real Solutions in Real Economy for Real Money.
Structural Growth: EM is less afflicted by DM’s dire situation of slowing growth, as it presents a deepening pool of opportunities driven by an ever-expanding middle class fueling demands for consumerism, enabling technologies and infrastructure. Asia, home to 60% of global population, has attracted over a third of venture capital raised in EM in early stage companies over the last decade for sound economic reasons. Asian venture deals continue to account for over 60% of aggregate deal value across EM (40% of the global total vs. 44 % from US), with over 80% attributable to Greater China deals in internet, telecom, and software (AI, AR/VR) sectors mostly in Series A, B, D funding (Preqin). India is set to become a $6 trillion economy by the mid-2020s, driven in large part by digitization, and tech ventures, besides its demographic dividend and accompanying consumption story that lays the foundation for homegrown Indian brands. Fintech too remains an attractive opportunity in microlending or providing small loans to entrepreneurs who live outside the large metros.
Most other industries in Asia are also highly under-funded/capitalized with sufficient room for upside as many industries are growing at over 10% per annum (exceeding GDP growth) thus proving a magnet for private capital (debt and equity) as public equity markets are quite sentiment-driven and debt from banks and bond markets remains a privilege for only a select few. For example, according to the World Health Organization there is about $60 billion of underspend each year just to get Asia to minimum standards which makes the healthcare sector a defensive and attractive play.
Adding to this, is a growing trend of going public-to-private. While historically absent, Asia is gradually warming up to control buyouts as a generational shift is underway where families are willing to sell to financial buyers and many entrepreneurs with bigger aspirations than before want to move on and find PE a solution to consolidate and run those businesses/adapt traditional models to the digital world. With bigger capital needs, the average companies are growing larger and allowing control transactions/path-to-control provisions offering increased stakes from an average of 5-10% to 15-20% as well as board seats.
Across from Asia, the general shallowness of African capital markets and the high cost of debt finance, positions growth PE to play an important role in helping to unlock and grow the potential of individual companies, expand their footprint, improve governance, and contribute to the region’s broader commercial ecosystem by deepening capital markets and expanding supply chains. 25 global investors like Softbank and a growing list of global tech companies, including Amazon, Google, Facebook, etc. have recently provided funding into later stage deals even in LATAM in marketplace, fintech and transportation.
Many emerging countries like Indonesia, India, China, Mexico, and Brazil as well as parts of Africa and the Middle East have structural drivers for infrastructure growth to meet the needs of their growing populations, economies, and cities to keep pace with urbanization trends. One example is China’s “One Belt One Road” initiative which would potentially enhance transportation infrastructure linking 65 countries. Beyond higher return potential and structural drivers, infrastructure in EM has a broader definition with wide-ranging socio-economic benefits. EM investments in electricity production, energy renewables, health, water, security, transport, banking, and school systems, improve macroeconomic sustainability, reduce poverty by promoting productivity, address resource depletion, and provide access to public services. Usage of mobile banking is likely to continue as mobile broadband usage and coverage accelerates in the developing world. Since cash still dominates most rural money transactions, digitizing payments within the agricultural sector integrates agriculture, finance, and telecom infrastructure, to create new rural service delivery models to benefit entire value chains-producers, buyers, SMEs engaged in transportation, storage, processing, and packaging. Managers peg OECD private infrastructure equity returns at 11-12% annualized with a potential to capture an emerging market risk premium of 6-7%.
Overseas investors (including institutions) both passive and active (traditional mutual funds) who seek participation in EM growth, typically flock to more liquid bellwether stocks, only to see their fortunes rise and fall with retail investors, sometimes following the herds, and at other times leading the pack. With growth as the central driving force attracting DM institutions to EM, it is important to remind ourselves that catalyzing growth takes a multitude of structural changes (e.g. reforms sweeping across economy, financial, capital markets, industries, etc.) that one cannot expect to materialize overnight, rendering baseless, any investor reaction to short term-disappointment(s). Hence our bias toward private markets which allows patient growth of capital without succumbing to short term market panic.
Disruption: The all-round uncertainty (war on/off sentiments) in global capital markets, is proving to be more unsettling than the risk-on/risk-off days (created by dovish/hawkish sentiments of central banks) making a conducive climate for relative value strategies that thrive (up 2% YTD through November 2018 per HFRI) on temporary dislocations across the board. History is rife with examples where EM has been a poster child for volatility with EM catching the proverbial cold whenever the US/DM sneezed, which we saw even recently. If volatility is here to stay and will only gather momentum from this point on permeating various markets and asset classes, traditional investors might brace for volatile times ahead, but for alternative investors especially in EM, it’s probably opportune to exploit volatility. EM presents a diverse set of monetary policies, currencies, and credit. To add, there are many idiosyncratic opportunities that are too small and specialized for large traditional asset managers. On-the-ground EM alternative investors can adopt short, intermediate or slightly longer time frames to develop trades to generate alpha through longs and shorts in multiple asset classes-equities, fixed income, rates, forex, commodities. These “relative value” or “mean reversion” strategies can thrive, even as the individual assets seemingly chop around. When disruptions arise, they can lock in attractive valuations till the securities reprice with dislocations correcting.
Trade restrictions coupled with maritime threats (e.g. South China Seas) when added to the vagaries of weather patterns, threaten agriculture supplies and bodes well for arbitraging agricultural commodities. Dislocation in oil prices due to over-supplied markets (driven by US shale oil warranting production cuts from OPEC and others) offers another relative value play (though it has taken a death-toll on some commodity managers for mis-timed directional bets).
Besides market disruptions, supply chains are being reorganized. Persisting trade tension is pushing South Korea to increase production capacity in Vietnam rather than China which has drawn many South Korean conglomerates such as Samsung, LG, Lotte, and Korean banks and financial institutions to expand business activities in Vietnam. This creates positive momentum for Vietnam that de-regulated retail, real estate etc. and recently received Fitch’s country upgrade as well as for its three state banks. Coalescing around each other is only likely to boost intra-EM trade that has grown significantly over the past twenty years with EM exports to other EM climbing from 25% of total exports to 40% (IMF) buoyed by both vast consuming populations (namely China, India, ASEAN) and infrastructure needs.
The changing world order from globalization to localization gives birth to small cap industrials in ecommerce, logistics, and process automation across EM that can be tapped into through both public and private (equity and debt) markets. This stands in sharp contrast to US small caps facing threats of a slowing economy and rising debt servicing costs.
Market Stress: The cliched “buy the dip” strategy, also leads EM alternative investors with dry powder to buy any baby thrown out with the bath water though with the caveat of catching a falling knife. As discussed in one of our earlier posts, Spreading for Spread: EM Long/Short Corporate Debt, investors can benefit from any intermittent spread widening with rising volatility, on both the long and short sides, a different place from traditional investing. If investors commit to the opportunity with patient, longer lock-up capital, it also makes a good recipe for a stressed/distressed play allowing time for spread compression or some form of corporate restructuring yet again outside the purview of traditional EM debt investors. Regulatory changes have reduced dealer holdings of corporate bonds. Banks’ inventories of bonds have been declining at exactly the same time that investors, from big asset managers to ETFs, have poured money in. This aggravates liquidity conditions (i.e. the ability to easily get in or out of a position without taking a huge loss), a persisting concern in EM to begin with. If there’s a dislocation in markets — say, some sort of credit event, or mass automated selling or increased margin requirements for derivative traders — and investors of all stripes want to liquidate, the concern is that there won’t be anyone to take the other side of these trades. So, EM focused credit funds can be liquidity providers, to selectively buy dislocated credit, but it requires patience.
While we subscribe to the aforesaid framework in evaluating and diligencing emerging market opportunities, it would be little surprise if this structure (along the liquidity spectrum in public and private markets addressing portfolio concerns and priorities of a new era) when extended to a broader portfolio construct would inevitably lead investors to most of the same emerging market opportunities. In other words, many of the portfolio responses we seek are inevitably found in the emerging markets today.
Despondent, we bring down the curtain on 2018 with no end in sight to our growing list of concerns though ready to be surprised by a reversal of sentiments sparking a relief rally, anytime. Increased borrowing needs of the US government, a decline in treasury buying by the Fed and foreign governments, and rising inflationary pressures due to wage pressures and tariffs, probably offer less of a savory concoction for the Fed to continue offering a life-line to markets as in years past. With equity and bond markets continuing to be equally susceptible to market declines, it begs a new framework to combat adverse forces while still attempting to keep portfolios growing. Diversification across assets, risk factors and investment managers, while still an important tenet of investing, remains challenged. Our simple minds guide us to seek practical risk and reward responses from every EM opportunity that crosses our desks. We remain hopeful as EM continues to offer many niche ideas to help investors in the interim, well into the future. Thus, rather than consolidating into a few household managers, investors should remain open to pursuing every idiosyncratic idea that even a stray EM manager might have to offer if it is additive to their bottom-lines. With a scarcity of such ideas, GPs from EM have become equally selective in onboarding US LPs into their capacity constrained ideas that now find more receptive institutional audiences in the Far East and Middle East (as also confirmed by Preqin’s 2018 survey on the Future of Alternatives).
Even as the Grinch (es) comes down from his mountaintop home and sneaks into town to swipe everything holiday-related, ÊMA remains alert to the new world order by identifying opportunities that can strategically capitalize on trade tensions, supply chain disruptions, protectionism, etc. and provide practical portfolio solutions for the new investing era. ÊMA continues to conduct independent investment audit 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 2019.
Kamal Suppal, CFA
Chief Investment Auditor
December 13, 2018
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.