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 drivers
The 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).
Implications for EM equity investing
Given the importance of country and currency factors in EM equity returns, we believe the clear implication for EM investment approaches is that investors must incorporate macroeconomic perspectives as part of their process. Strategies that are purely bottom up, country neutral or have currency exposures that are simply the residual of equity weights or hedged to the benchmark, may be missing a potentially significant alpha opportunity.
So how does one incorporate macroeconomic research into an investment process that is ultimately investing in individual equities? One possibility is that an investor could approach this as a two-step process: 1) determine the country weights from a top-down perspective, then 2) “fill in” the country buckets with stocks, either through benchmark-like exposure or more selectively based on bottom-up research. One risk to this type of approach is that it may lend itself to more of a short-term orientation, leading, for example, to a process of country rotation.
More importantly, though, we believe this approach of separating the country and company view misses the key insight that macroeconomic perspectives should be integrated with company-specific research to create a more holistic research view. In other words, rather than viewing the macro and micro independently, the macro outlook creates a framework necessary to help anticipate industry trends and the path of earnings growth rates. So let’s focus on the ways in which a macroeconomic perspective can be critical to EM equity returns.
Government policies
Over the next 12 months, there will be elections in countries representing just under half of global GDP! Presidential elections will take place in the U.S., France, Russia, Finland, Taiwan and Mexico. China will see a change in leadership, and legislative elections will be held in Egypt and South Korea. The results of these elections and the policy decisions that follow are likely to have a great impact on growth, inflation and interest rates. And there is no doubt in our opinion that we will see a greater amount of policy experimentation, varying degrees of effectiveness, and unintended consequences.
We’re seeing it already. In October alone, we saw a wide range of policy initiatives given the diverse challenges facing EM countries: India hiked its benchmark rate by 25 basis points due to renewed inflationary pressures and a weaker rupee. Turkey further reduced lira liquidity via repo operations in an attempt to stem lira weakness and fight elevated inflation. Hungary left its policy rate unchanged despite moderating economic activity to reduce the country’s external vulnerability to exogenous factors. Finally, central banks in Brazil, Indonesia and Israel began easing rates amid a worsening global growth outlook.
Some of the important potential ramifications for equity investors are:
- Sustainability of policy path: The unconventional policies of Turkey serve as a good example here. Faced with a significant current account deficit driven by strong domestic demand, Turkey has taken the unusual step of cutting rates in an effort to weaken its currency. If this approach leads to higher inflation, it could affect credit growth, and the Turkish banks that currently appear attractive could become a value trap.
- Impact of unintended consequences: Developed market policies are important as well. As the U.S. and Europe look to address their debt burdens through financial repression, or maintaining negative real rates, a potential consequence is that capital is driven to EM, ultimately creating inflationary pressures. The macro prudential measures enacted by EM central banks to contain inflation are likely to directly impact earnings growth and returns on equity, generally rendering historical returns and valuation ranges less useful.
- Influence on domestic demand: While ultimately we believe it is the secular growth themes that create opportunities in EM, understanding cyclical periods of adjustment can be critical to managing risk. While some industries are global in nature, others are driven by the domestic economy, reinforcing the need to have a perspective on both DM and EM economic growth. In our opinion, anticipating rates of change in revenue growth, earnings growth and margins is key to properly valuing businesses.
Currencies
As detailed above, currencies are an important driver of EM equity returns, and the cost of hedging has meaningfully declined over time. As a result, currency views can more readily be implemented in an attempt to drive returns or manage risk. We see several opportunities for investors:
- Currency as driver of operating leverage: This dynamic tends to be particularly strong in commodity-oriented businesses that have USD earnings. These mining and materials companies have revenues driven by commodity prices but costs driven by their local currency. As a result, the direction of the local currency is perhaps the most important factor in determining the path of margins.
- Currency as indicator of export or domestic strength: Historically, EM FX has enhanced the competitiveness of many global emerging market companies as cheaper currencies have driven export growth. Depending on the direction of currencies, some economies will be able to maintain this export advantage while others will be forced to move up the value chain, leading to an investment focus on innovative growth companies (please see our September 2011 Viewpoints on “China’s Escalation up the Value Chain: From Low-Cost Manufacturers to World Leaders?”).
- Currency overlays to manage risk-adjusted returns: The important takeaway from the fact that hedging costs have come down is that investors are now able to separate the equity and currency investment decisions, with the goal of each distinct decision contributing to returns. For example, in the second quarter of 2011 an investor could have been underweight Brazilian equities while at the same time, given high real interest rates, long BRL funded by USD. As shown in Figure 4, each of these decisions on its own could have made a meaningful contribution to performance.
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:
- High trend inflation in EM drives focus on dividend-paying businesses with a high fixed asset base.
- Rising real rates in EM creates the risk of de-rating of concept stocks that fail to produce free cash flow.
- Rising incomes in EM suggests a bias for businesses with strong top-line growth in supply-constrained industries.
- Further polarization of incomes in EM (gap between rich and poor widening) bodes well for luxury goods companies that benefit from EM nouveau riches.
- Growing energy intensity of EM economies speaks to need for energy solutions such as nuclear power.
Conclusion
Emerging markets are a complex and diverse set of economies and markets. Government policies, currency movements, secular and cyclical trends are just some of the factors that tend to drive EM returns. We believe that deep analysis of the macro provides EM equity investors a framework to perform company-specific, fundamental research. Yes, bottom-up research is very important, particularly in a historically less efficient asset class like EM. A company’s market share, margins, balance sheet, cash flows, returns on invested capital, and management decisions can all be used to help determine intrinsic value. But in our opinion, company-specific research is not enough. To avoid buying the best house in a bad neighborhood, we believe incorporating macro views is essential, as more so than in other equity asset classes, in EM the macro matters.
Andrew Pyne contributed to this article, with additional contributions from Manny Hunjan, Ken Miller and Pouyan Poormosleh.