“Emerging markets remain in a much better position…but it is important to monitor where value is developing”
James Syme, Senior Portfolio Manager, Pendal Global Emerging Markets Opportunities Fund
A number of emerging markets have felt the impacts of a strong US dollar, volatility in the oil price and a tightening of the reins on US trade policy so far in 2018, resulting in varied performance across different countries.
In this quarterly update, Senior Portfolio Manager James Syme:
– explains the role of major policy decisions in driving performance dispersion across emerging markets
– highlights the key markets which are in fundamentally better shape; and
– sets out the team’s rationale for key country-level overweight and underweight positions
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Fund Manager commentary for the month ended 31 October 2018 covering market reviews, Pendal fund performance and our outlook for the period ahead.
Access the monthly commentary here.
Settle down, calm down — a change is taking place in the country
Mexican President-elect Andres Manuel Lopez Obrador, 30 October 2018
The global environment continues to pose challenges for emerging markets, with tight US dollar liquidity, a slowdown in China and stresses about the global trade system all acting as headwinds. However, emerging markets will continue to also be driven by country-specific factors, very much including changes in the outlook for politics and governance, and this has very much been the case in both Brazil and Mexico in the last few weeks.
In Brazil…
In Brazil, the political order has been shaken by the election as president of the right-wing populist Jair Bolsanaro, who stood on a platform of generally liberal economic policies and illiberal social policies. His economic policy ambitions include proposals to reduce both state spending and state intervention in the economy, although he has sent mixed messages regarding the privatisation of large state-owned companies such as oil producer Petrobras and electricity utility Eletrobras. The prospect of the adoption of these policies has been well-received by financial markets.
Brazilian President-elect Jair Bolsonaro
As followers of our views will be aware, though, we believe that the critical policy measure for Brazil is pension reform. It is generally accepted that Brazil needs to run a primary fiscal surplus (ie before paying interest on government debt) to achieve economic stability. Brazil has been running a primary deficit since 2014, largely because of uncontrolled growth in social security expenses, the majority of which is related to pensions. As an example, 10 years ago, in September 2008, the Brazilian federal government had revenues of BRL 50.7bn, expenses of BRL 44.6bn (of which BRL 20.9bn were for social security), a primary surplus of BRL 6.1bn and interest costs of BRL 4.1bn. Ten years later, revenues have grown to BRL 96.7bn, but expenses to BRL 119.6bn, with BRL 61.5bn of that being social security costs, leaving a primary deficit of BRL 22.9bn before interest costs estimated at BRL 49.2bn. We believe that for Brazil to avoid a fully-fledged sovereign debt crisis, the social security system must be reformed within the next few years.
“We remain in a wait-and-see mode on Brazil, with the portfolio holding a small underweight position relative to benchmark.”
James Syme, Senior Portfolio Manager JOHCM
To do this, President-elect Bolsonaro must get a reform bill approved by a three-fifths super majority twice in each of the chambers of Congress. In the lower house, that requires at least 308 votes of the 513 members. While more right-wing parties did well in the Congressional election, it will be very difficult to pass pension reforms, particularly if illiberal social policies alienate more centrist politicians. We remain in a wait-and-see mode on Brazil, with the portfolio holding a small underweight position relative to benchmark.
Mexico, meanwhile…
Mexico, meanwhile, has seen financial markets react negatively to one of the first major policy steps of President-elect Andres Manuel Lopez Obrador (known as AMLO), which will be to cancel the controversial new airport for Mexico City. The decision, legitimised by a chaotic referendum, has been taken particularly badly by bond markets (where US$6bn of airport bonds are now at risk), with a concurrent sell-off in equity markets. Investors are particularly concerned that the AMLO administration will continue to enact populist policies via direct democracy.
Returning to the global environment, though, we continue to find a lot to like about Mexico. Mexico exports US$300bn of goods and services to the US, 81% of its total exports, and is also a beneficiary of the strong US economy through remittances (about US$28 billion in 2017, the vast majority of which came from the US). The renegotiation of NAFTA removes key risks to the Mexican economy, while Mexico is among the few emerging markets to be a net oil exporter. As with Brazil, we remain in wait-and-see mode, with a broadly neutral position relative to the benchmark, but do wonder if Mexico will prove the better medium-term investment.
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The script gaining popularity this year is that Australia’s housing bust is finally coming. From 2013 to 2017 foreign buyers and local investors pushed up prices to levels that were unaffordable for local owner occupiers but very profitable for developers, spurring on supply which only now is hitting the market. Government policy meanwhile has put the screws on foreigners and investors, meaning there is a long way to fall before new buyers step up. A Labor government potentially banning negative gearing outside of new developments suggests further downward price pressure.
This script has a lot going for it, but many people have been calling the death of Australian property since 2009.
In our six page Australian Housing Review, Pendal Portfolio Manager Tim Hext takes a dispassionate look at the underlying data and potential tax changes to draw conclusions on the prospects for residential property prices.
Read our Australian Housing Review
If my daughter wins a hundred-metre dash by hiding the other kids’ runners whilst giving herself a pair of jet-powered wheelies, I’d credit her cunning and ingenuity, but I’d hardly applaud her sprinting skills.
That kind of winning also describes what’s currently fuelling the narrative of US “exceptionalism”. By itself, the fiscal stimulus that the US has been enjoying since the end of last year doesn’t make a whole lot of sense.
Not only has it been a pro-cyclical use of fiscal policy, but outside times of war and recession, this is the largest stimulus the country has seen in its economic history.
But as Donald Trump turns up the heat on Sino-US trade relations and China scrambles for ways to offset the effects, it becomes apparent that this Republican fiscal reform was designed to build a fortress around US growth, from which an attack could be launched. This was cunning, and may eventually prove ingenious.
China’s biggest miscalculation was to underestimate Trump. Through waging an ideological war against China via the proxy of trade imbalances, he saw clearer than anyone the path along which this war would unfold, and the inevitable casualties that the US would also have to suffer along the way.
With third-quarter earnings season under way, the impact of US trade tariffs on Chinese goods are already being felt across American industries, from automakers to farmers, from Fortune 500 companies to “mom and pop” shops.
Ironically, as the tariffs currently stand, finished goods imported from China that have not yet been touched by US tariffs may enjoy an advantage over US-made goods with Chinese components. The inevitable conclusion there, would be to ensure tariffs expand to cover all Chinese imports to the US.
Knowing the pain that would accompany the process of on-shoring production back to the US, Trump effectively delivered a pre-emptive “whatever it takes” fiscal package.
Tax cuts ensure that corporate profitability is bolstered ahead of a likely period of margin erosion. Corporate repatriations ensure that liquidity conditions stay protected in the US whilst the rest of the world feels the drain. And stimulating the economy past full employment should put even more money into the pockets of the average American.
China’s changing approach
Trump certainly wasn’t kidding when he said “America first”.
As the path has become clearer, the focus has to now shift back to China’s reaction function. The tit-for-tat strategy engaged by China this year is no longer deemed to be appropriate now that the full extent of the threat has been recognised.
Rather than provoking more attacks by Trump, attention is now centred on boosting domestic demand. China’s tolerance for hard landings remains limited, less so due to a desire to save face, but more for reasons tied to the root of its ideological difference with the US.
Socialism under a one-party system needs buy-in from its people. China’s Communist Party may exert an authoritarian grip over the nation, but this can also be undermined by falling living standards and growing unemployment rates. Especially for a nation addicted to a near-doubling of per capita GDP every decade since the late 1970s.
In sharp contrast to last year’s resilience, trade wars have barely scratched the surface and yet the world’s second-largest economy is showing signs of greater damage.
The contraction in shadow banking that was kick-started by the deleveraging campaign has gathered internal momentum. Corporate defaults are piling up, both onshore and offshore, and that’s not even counting the ones saved or postponed by takeovers by state-owned companies.
Local governments are being asked to spend again, but until now have been fearful of the conflicting deleveraging agenda pushed by Xi Jinping. The fiscal lever is being pulled, but the transmission mechanism seems busted. Against this backdrop, the certainty of trade war escalation makes Chinese leadership all the more determined to underwrite economic growth.
‘Whatever it takes’
It is meaningful that in a letter to private entrepreneurs this month, Xi vowed his “unwavering support” for the country’s private sector. Such support will come in the form of tax cuts, liquidity back-stops, bond raises and likely even stock market support (a method of intervention that met with much controversy in 2015-16).
At the same time, private enterprises are being urged to focus on innovation. Sounds like a leaf from the Republican tax plan, taken one (or 10) steps further. Sounds like “whatever it takes” with Chinese characteristics.
Unfortunately, the results thus far have been disappointing. Economic activity continues to slide, led by the old economy. Given China’s importance in providing a safety harness for major parts of the global economy at every key juncture over the past decade, many still await the reflationary pulse to be delivered by China’s stimulus measures.
This is the biggest miscalculation the world can make about China. Just as US stimulus is more self-contained, it would be wrong to expect that China’s can save one and all.
Not only would broad-based Chinese stimulus undo much of the hard work of the past two years, it would also stall the growth engine of China’s new economy. It is no coincidence, for example, that consumers have remained resilient, and industrial upgrading continues to bolster the manufacturing sectors.
Through the US initiation of deglobalisation, a number of tough choices now lie ahead. China must choose quickly and strategically those allies most needed for her future. Luckily for Australia, China still needs to build more railways and to seek out high-quality education for its students.
For now, China also needs high-end imports from Japan, South Korea and Europe. Unfortunately Australia and much of Asia will all be forced to pick a side somewhere down the line.
If China’s Made in China 2025 plans are successful, high-end imports will eventually be displaced by domestically produced Chinese goods. Just because they’ve stopped bragging about it doesn’t mean they’ve abandoned this strategy.
Quite the opposite.
This article was first published by the Australian Financial Review on 29 October 2018
Regnan has completed research into the contribution to investment performance from integration of its ESG ratings. New analysis and back-testing of Regnan’s proprietary ‘valDA’ scores has been conducted by Dr Darren Lee, an academic specialising in responsible investment, to examine whether its ratings continue to provide additional investment information.
Dr Lee’s analysis shows that ASX200 stocks which Regnan gave high ESG scores significantly outperformed the ASX200 average over the seven-year observation period. Those that were given low ESG scores underperformed the average.
Download a copy of ESG Integration for Investment Performance and visit Regnan.com.au for additional insights and research reports on responsible investing.
About Regnan
Regnan – Governance Research & Engagement Pty Ltd was established in 2007 to evaluate the relationship between environmental, social and corporate governance (ESG) factors and investment value. Regnan has evolved to become a global leader in long term value, systemic risk analysis and sustainable investment advisory.
Regnan provides ESG integration, advisory and stewardship services on behalf of institutional investors including asset owners, fund managers, wealth managers, retail and investment banks to drive improved ESG performance in S&P/ASX200 listed companies. Regnan meets with directors and senior company leaders, in a constructive manner, to influence change on issues with the potential to impact value over the long term.
Regnan is also a regular contributor to the public debate on long term value and sustainability, and is an active commentator in the media and at corporate and financial industry events. Regnan also provides submissions to government and other policy makers to improve both sustainable investment and the identification of systemic risks.
Regnan’s research insights are applied to Pendal’s Sustainable, Ethical and mainstream funds where relevant, as well as enabling us to work with other institutional investors in meeting their sustainability objectives.
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The changing landscape of the Indian economy
In Asia, we have witnessed several months of outflows, first on trade concerns, now on geopolitical rumblings. On one hand, index providers are likely to increase their allocation to China ‘A’ shares, yet sentiment could not be softer. India has finally found itself caught up in the selling bout. Its economy epitomises the macro weakness that are common in almost all Asian economies: a dependence on oil imports and excessive reliance on foreign capital flows.
Some months ago I had mentioned the relentless rise in unsecured lending in India. Overall credit statistics showed a benign picture. Yet, under the surface, some established and several newly created non-bank finance companies (NBFCs) took up the baton of lending from beleaguered government-owned banks. In the end, they repeated the classic mistake of an asset-liability mismatch, compounded by borrowing increasingly larger amounts from wholesale funding sources like money markets and commercial paper.
That has now come home to roost as rising oil prices, a depreciating currency and lower liquidity are exposing those who thought lending was an easy business. In my opinion, growth in India will disappoint. Higher oil prices and higher interest rates will affect demand. The additional driver that will dampen Indian growth will be the retrenchment of lending by these NBFCs. In the two years after demonitisation (remember that demon?) most of the NBFCs stepped on the accelerator to lend copious amounts of credit to the needy and the unsuspecting. Home loans, loans against property (nothing but a charade to provide working capital loans to SMEs by mortgaging their shops and offices), car loans, consumer durable loans, education loans, foreign travel loans and more. On a trip to Bombay about 18 months ago, I was surprised to learn that tailoring shops associated with big branded fabric companies were willing to finance a purchase of a suit for your wedding. That cost 3-4 months’ average monthly salary, yet there were many who did borrow on that scheme.
“In my opinion, growth in India will disappoint”
Samir Mehta, Senior Fund Manager, JOHCM
The paradox of India has always been that there are some very well-managed businesses able to operate in challenging macroeconomic conditions. In our portfolio, I have bought into what I think are some of those very businesses, knowing that we might face trying economic times ahead. As the market sell-off has continued into early October, it has given me an opportunity to add to some of our holdings. The direction of the currency is anyone’s guess, while poor sentiment amongst domestic investors could lead to lower multiples for some names. I would welcome that development. Finally, it seems like valuations are coming down to levels that we can live with over the next 3-5 years. Given the state of markets and the sentiment, it is better to be cautious in adding to our names. I hope to be in a position to expound on some of these businesses in the coming months.
In this Australian Quarterly Update, we analyse the hot-button issue of negative gearing and the potential effects of proposed Labor policies on the domestic housing market. We also look at why some of the broader global concerns appear to be easing for local credit investors, as well as developments in the local cash market. Finally, we examine ESG trends in Australia and distinguish between the range of different classifications in the area.
I hope you find the piece useful and we welcome feedback from readers.
View our Australian Quarterly Update here.
Fund Manager commentary for the month and quarter ended 30 September 2018 covering market reviews, Pendal fund performance and our outlook for the period ahead.
Access the monthly commentary here.
Access the quarterly commentary here.
This time last year we highlighted some of the factors that we believed would drive a resurgence of volatility in markets. The most significant force was the global withdrawal of unprecedented central bank stimulus and draining of liquidity from the financial system. One year on, we have witnessed one of the largest spikes in volatility since the GFC, a 10% peak-to-trough sell-off for the S&P 500, routs in high yield credit and a dramatic downturn within emerging markets. As central bankers continue to march down the path of policy normalisation, alongside the heightened spectre of political disruption, we believe volatility is likely to persist in the near term.
Despite some of the sizeable market swings experienced in 2018 thus far, policymakers have shown little sign of shying away from monetary tightening. The Federal Reserve has already delivered two rate hikes this year and is widely expected to deliver at least one more before year end, while a further two are priced in for 2019. Its peers are following suit with the Bank of England and Bank of Canada having ratcheted up rates further this year and the ECB forecast to do the same in 2019. Compounding this global policy tightening is the reduction of central bank balance sheets. The Fed continues to sell down large blocks of its securities each month, while the ECB will halt its purchases of corporate and government bonds this quarter. Together, the annual change in global central bank balance sheets is now forecast to shrink next year, as illustrated in the chart below.
When we started to identify the risks posed by this thematic, we flagged several areas that we believed would be most vulnerable, namely those that had benefited most from the swell of liquidity in prior years and those that had lured investors with the potential for higher returns in an era of low yields. This included high yield credit, pockets of emerging markets, as well as regions particularly susceptible to political disruption. On the reverse side, we believed as investors unwound their higher risk positions, safe-havens like the US Dollar would benefit.
Of course, timing such a reversal in risk sentiment and change in market regime from a long period of calm seas to one of crashing waves can prove difficult.
When we saw the S&P’s 10% correction and 308% VIX spike in February this year, we knew the volatility regime change we had been expecting was underway. Several subsequent episodes of volatility helped reinforce this view and benefited our positioning. One such episode was the well-publicised Italian political turmoil. This reflected a theme we had identified around heightened political risk, particularly in Italy ahead of its general election. We positioned our portfolios accordingly and they subsequently benefited significantly from the large spike in the country’s yields.
Looking forward, we believe Italy’s experience reflects a growing trend across broader Europe away from the prevailing centrist political views, to the extremes. This is likely to feed further fiscal policy uncertainty in the near term and trigger additional bouts of market volatility. The ECB removing stimulus is also effectively pulling the rug out from overvalued asset prices in the region, leaving European credit particularly exposed.
Despite some of the sizeable market swings experienced in 2018 thus far, policymakers have shown little sign of shying away from monetary tightening.
Vimal Gor, Head of Income & Fixed Interest
Emerging markets (EM) have been another area of significant volatility and political disruption, with specific pockets more at-risk than others. During the years of low yields, many market participants were tempted into developing economies in their search for higher returns. Now as global stimulus is being withdrawn these positions are being unwound, causing rapid capital outflows and dramatic downturns in their currency and bond markets. Turkey has been a prime case study this year with the Turkish Lira having plunged 42% to the end of August. It is just one example among a growing list of suffering EMs that includes South Africa, Brazil and Argentina.
Their experience is just one symptom of the global liquidity drain and has in turn revealed a number of pain points across markets. If we consider that the ’taper tantrum’ headache of 2013 was driven by the mere slowing of asset purchases, then their reversal should be a very long and painful hangover. With less liquidity and the implicit support under overvalued asset prices being removed, we are likely to see much more extreme reactions going forward. This represents both a risk and an opportunity for investors. It is a risk for investors that are reliant on areas like high yield credit and certain emerging market debt. At the same time, it is an opportunity for investors that are positioned to benefit from the underperformance of those asset classes and have a long volatility bias. In turn, we believe an allocation to a defensive and active fixed interest manager remains a critical part of an investor’s portfolio.