Emerging markets – deflating, despised, discounted – are the subject at hand. Even a casual browse through today’s financial media highlights a seeming shortage of magazine covers that are not announcing the coming collapse of China and its now enlarged economic ecosystem. Pessimism has become a universally approved view (much like optimism on almost anything else). To be sure, this treatment is far removed from the red carpet on which emerging markets trod during China’s roaring bull years. But is the pessimism warranted?
The following is a departure from the voluminous stacks of negative commentary. Enough exists. Our interest lies in the strong consensus that has surfaced in the investment community. Whenever a deeply unified one appears, it’s always useful to question what could be missing from the analysis. As the old saying goes, “When everyone is thinking the same, no one is thinking at all.”
Skipping to the bottom line, our actionable takeaway for client portfolios is that some emerging markets (EM) have a very bright future, although new country leadership underway. This conclusion rests on two foundations – one of the fundamental variety and another of the behavioral kind.
EM thinking, fast and slow
Starting with the fundamentals, three issues are widely misunderstood.
1. Revulsion toward China.The consensus has spun a narrative that policy has finally pivoted to pursuing a weak domestic currency (i.e., the renminbi), providing evidence of an imminent hard-landing scenario. While growth is slowing and should not be trivialized, the more important story is China’s solid progress on the road to rebalancing – namely, a shift away from manufacturing and construction activity toward consumers and services. Urban hiring trends are still growing at a robust clip and services expanded by 8.5% in the first half of 2015 – hardly statistics associated with economic recessions.
The above is encouraging. And, exactly what well-intentioned Western economists urged EMs to do: Rebalance economies away from cheap exports to a more self-sustaining middle class. While Beijing can be criticized for a poorly communicated agenda, its longer-running ambitions shouldn’t be understated – internationalize the currency, modernize the financial system, address excesses in debt markets and transform state-owned enterprises – all couched in a nationalistic revival of the “China dream.”
This transition will be bumpy but investors should not lose sight of the longer running game. Over the next several years China will see slower but higher quality growth – thanks to reduced capital waste (less inefficient infrastructure spending, less corruption, less unproductive debt). This is enormously positive for asset prices.
2. Forecasts of a widespread EM crisis are also off the mark.Here, the commentary has focused on slowing growth and high debt, with extravagant comparisons to the 1997-98 Asian crisis. Yes, exports are slowing. But this is concentrated in the commodity exporters (declining by almost 40% in July on year-on-year terms). And the outlook is actually improving for a number of countries. It’s important to recognize that EMs already had a large slowdown between 2010-2012. Since then, currencies have weakened (boosting competitiveness), commodities have fallen (raising consumption), and policy has turned stimulative (lowering the cost of capital). These benefits always show up with a lag. Why should this time be different?
3. The impact of Fed policy on EM asset prices.Most investors continue to assume that the Fed is eager to raise interest rates before inflation accelerates (because monetary policy works with long and variable lags). Such preemptive tightening is a fair description of policymaking pre-2008. But in the post-crisis world, the assumption that any central bank can raise interest rates before inflation surfaces in a meaningful way is simply misguided. How do we know this? Because bankers have repeatedly said that policy normalization will only occur once higher inflation is firmly embedded in consumer and business expectations. This is a long way off.
Why is this important for EM asset prices? If our “lower for longer” interest rate view remains correct, then any EM selloffs caused by expectations of U.S. monetary tightening will prove unjustified. As long as the Fed and other central bankers are determined to remain behind the curve of rising inflation, these panics present buying opportunities – as they have since 2009.
Investors behaving badly
Turning to the behavioral arguments, some scene setting is required. Unflatteringly, physicists rightfully smirk at the pretensions of Wall Street’s quants. The history of their decision-making systems – to put the most charitable spin on it – hasn’t always accounted for all variables (notably the human component).
But, in the matter of investor behavior, financial analysts have discovered an actual law of nature: Investing is the only business where, when things go on sale, everyone runs out of the store (to paraphrase Warren Buffett).
What are the data telling us today? Our firm tracks a variety of fund flow and opinion surveys – a kind of investor voyeurism, providing a statistical snapshot of both professional and public portfolio positioning.
While EM assets are marked down and deeply in the bargain bin, investors are indeed vacating the store. This is confirmed in a variety of investor channels and positioning. In the retail world, EM mutual fund outflows in the three weeks ended Sept.10 totaled a net $30 billion.* This was only matched in 2008 and 2011, and were followed by significant rallies. Who’s left to put in the marginal sell order?
In the institutional universe, fund managers are similarly sour. EM “underweight” positions are at a record net 34% and “aggressive” underweights just hit an all-time high (a few managers had the temerity to be “equal weight”).** Contrarians take note.
