Curtis A. Mewbourne, Maria (Masha) Gordon
While secular economic trends ultimately may drive markets over the long term, we believe global policymakers are the main influence on markets today. Countries face different challenges, ranging from structural debt burdens and sluggish growth to inflation risks and potential asset bubbles. As policy responses also differ accordingly, often leading to unintended consequences, we believe a deep understanding of the macroeconomic landscape is critical to navigating global markets. In the second of a series of three articles, portfolio managers Curtis Mewbourne and Maria (Masha) Gordon make the case for incorporating top-down views as part of an emerging market equities investment process. In our first article, we made the case for proactively managing “tail risk” in emerging market equities, and in our final article, PIMCO investment professionals will discuss the importance of managing portfolios with high “active share,” or less of a benchmark orientation.
The secular case for emerging markets (EM) is a compelling one. Strong balance sheets, favorable demographics, growing middle classes and productivity gains are a few of the reasons why PIMCO believes EM economies will sustainably grow at higher rates than structurally challenged developed market economies.
While EM growth represents an opportunity for investors, the challenge comes in attempting to navigate markets that are anything but homogeneous. Across regions and countries – even within countries – there can be great differences in growth rates, income levels, inflation, interest rates and government policies. While we often discuss emerging markets broadly, differentiation is critical because the realities of each country are far more nuanced.
The greater diversity and complexities that characterize EM argue for a deep understanding of the macroeconomic influences that will shape country, regional, industry and company-specific growth. We believe incorporating a global macro framework with a bottom-up stock selection process can be a key advantage in providing compelling risk-adjusted returns in EM equities.
Equity return driversThe differences between developed and emerging economies may be well known, but many investors are less aware of the differences in what drives equity returns. Using a multi-factor risk model that attributes returns of stocks in an index to risk factors, we can see the key drivers of equity returns (see Figure 1). Although a number of risk factors contribute to returns, we show only country and currency risk in this illustration for the sake of simplicity.
Over the period 2003-2011, over 50% of returns of the MSCI Emerging Markets Index can be attributed to country and currency factors. In developed markets, as represented by the MSCI World Index, currencies remain an important driver of returns but the country factor is less relevant. This is likely due to the fact that developed market economies tend to be less differentiated than those of emerging markets.
Looking further at country returns, cross-country return volatility analysis shows that dispersion among EM country returns has been greater than that of developed markets (see Figure 2).
Even excluding the period of EM crisis in the late 1990s, as shown in Figure 2, the average monthly cross-country return volatility in EM of just over 5% is 82% higher than the DM average of 2.8% from 2001 to mid-2011, as reflected by the MSCI EM Index and MSCI World Index country return volatility. We believe this higher cross-country return volatility presents more opportunities to add value through country selection in EM.
Currency has also been a big contributor to global equity returns, particularly in EM. Historically, in many emerging markets investors were not able to harness these return opportunities given the prohibitive cost of hedging. As many emerging economies were quite undeveloped, and there were very real concerns about credit risk, interest rates were often literally off the charts. Given that interest rate differentials represent the cost of hedging, in this environment the general view was, “If you don’t like the currency, then you shouldn’t own the equity.”
But EM has evolved, and now with many countries exhibiting strong sovereign balance sheets, greater fiscal discipline, and credible policies aimed at containing inflation, EM rates have been converging with those of developed markets, a trend we expect to continue in the New Normal. The result is that the cost of hedging has come down, allowing investors the potential to efficiently make separate equity and currency investment decisions (see figure 3).
Secular and cyclical themes The foundation of the PIMCO investment process is our Forums. The annual Secular Forum is an opportunity for all of us to gather and debate what the next three to five years hold for the global economy and markets. Our Cyclical Forums occur the other three quarters of the year and are focused on growth and inflation outlooks for the 6-12 month time horizon. Participating in these forums and benefitting from the perspectives of our global colleagues allows us to consider how short-term and long-term themes may impact industries and company earnings growth. Examples of themes and portfolio implications that align with our current thinking include:
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