“How do you incorporate “macro” into your investment process?” This is a question I am often asked. I’d like to illustrate my answer with an example. As a bottom-up stock picker, the easy response is just to say that I ignore the macro completely, preferring to focus only on the pure fundamentals of the businesses I am invested in. But the truth is more nuanced than this. In reality, I think it is quite difficult to invest without expressing some sort of limited macro view, whether explicit or implicit.
Macro intrigues me because it can often become very consensual. The herd mentality is strong when everyone sees the same headlines day in day out. This can cause positioning to become one sided, potentially creating investment opportunities if the consensus view is flawed. In my experience, consensual macro views are most often wrong when they are contradicted by the bottom-up fundamentals. But in order to assess whether this is the case it is necessary both to understand the macro thesis itself and cross reference it with the bottom-up fundamentals. The current “emerging markets bear case” is an excellent example.
Anyone involved in financial markets will be well aware of how badly emerging market financial assets have performed over the last three years. Back in 2011, investor expectations towards emerging markets were elevated. The Chinese economy had come roaring back after the 2009 slowdown. Commodity prices were soaring again and exports to the developed economies were recovering strongly. Since then, Chinese economic growth has consistently disappointed causing commodity prices to collapse. Many other emerging markets have also experienced slower growth whilst some that are heavily commodity dependent such as Brazil and Russia have drifted into recession.
This change has certainly not gone unnoticed. Since the beginning of 2011, the MSCI Emerging Markets Index has underperformed the MSCI World Index by 57%1. Moreover, investor sentiment remains very negative, with many people worried about an imminent “emerging markets crisis”.
This bear case is a classic macro thesis. It runs something like this:
– With the US economy growing strongly, an interest rate rise is on the horizon. Meanwhile China’s economy is slowing fast. This is causing the dollar to rise and commodity prices to fall. Emerging market economies rely on commodity exports and therefore their economies will suffer.
– Emerging market corporates and governments have borrowed heavily in US dollars. As the dollar strengthens against emerging market currencies these debt obligations will rise in local currency terms making them more onerous and potentially causing a rise in defaults.
– Emerging markets are dependent on external finance from the developed world. As the economic situation deteriorates further, this money will be repatriated exacerbating the problems still further.
It is easy to see why this view is so widespread. Not only does it sound credible, it is also consistent with past experience. Anyone who has studied the Asian financial crisis of 1997-98 or the Latin American crises of the 1980s will no doubt recognise the above narrative.
The problem with this thesis is that the fundamentals of the emerging markets suggest a different picture:
– Whilst it is true that in the past emerging markets were heavily dependent on commodity exports, this is less the case today, outside of a few high profile examples. One cross-country study I have seen concluded that emerging markets as a group have actually benefited from the fall in commodity prices. This is because so many of them import commodities (particularly oil) as well as exporting them. It is the net effect – the terms of trade – that matters.
– Despite the US dollar rising for the best part of three years, corporate default rates in emerging markets have remained low. I am not aware of any individual examples where default has occurred due to foreign currency borrowing. How can this be? The answer, in my view, is that emerging market governments and companies are in a much sounder financial position than in any of the past crises. Many now hedge their foreign currency liabilities or they have US dollar denominated revenues to offset their US dollar liabilities. They appear to have learned the lessons of the past.
– The idea that emerging markets are totally reliant on external finance also looks very outdated to me. One simple way to show this is to look at who actually owns emerging market financial assets. In 2000, nearly 25% of emerging market debt was external – i.e. denominated in US dollars and therefore likely owned by foreigners. As at the end of 2013 that figure was under 14%. The remaining 86% is all in local currency2. Whilst some of this local currency debt will be owned by foreigners, only a very small percentage of it appears in the benchmarks, suggesting the bulk of it is probably owned by domestic financial institutions. This is not that surprising given how much deeper the domestic capital markets have become after 15-20 years of strong economic growth.
To be clear, I am not arguing that investors should rush out and buy all emerging markets. Rather, I am pointing out that emerging markets today are a diverse group of countries and many are in much better economic shape than in the past. Comparisons with the crises of old appear increasingly less relevant.
I have written before that successful investing is about distinguishing between fundamentals and expectations. With respect to emerging markets, expectations are currently very depressed, yet the fundamentals suggest things may not be so bad. As a bottom up stock picker this interests me because it means I may be able to find good quality companies where a degree of emerging markets exposure may be causing their shares to be mispriced. In a forthcoming post I will discuss one such company.
1. Source: Bloomberg, 23/06/2015
2. Sources: BoAML, BIS, Ashmore, May 2015