MASTERCLASS: Gold - September 2020
September 3, 2020
Jenna Dagenhart: Welcome to Asset TV's Emerging Markets Masterclass. We'll cover the current EM market environment, the impact of geopolitics and the implications of the COVID 19 pandemic. Joining us now to share their outlooks and more are two expert panelists are Arjun Jayaraman, Head of Quantitative Research and Quantitative Portfolio Manager at Causeway Capital Management and Dave Robbins Emerging Markets Portfolio Manager at TCW. Everyone, thank you for joining us and I want to kick things off by discussing the coronavirus crisis because we are still in the midst of a global pandemic. Arjun starting with you, what are the implications of the COVID 19 pandemic for EM?
Arjun Jayaraman: Well for emerging market equities it's interesting. When you compare emerging to developed markets, emerging markets some countries are doing very well with the pandemic and I'd highlight, Taiwan, also China, which incidentally was the first ago and is now recovering, at least economically from the pandemic and even Korea. What's interesting about the emerging market equity universe is that those three countries make up almost 70% of the benchmark. They're doing better than a lot of developed markets including us here in the US. Now, I can contrast those three countries with other parts of EM which are not doing so well. I'd put in that list countries like India, Brazil, even Russia to a certain extent, Mexico, these are countries with underdeveloped healthcare infrastructures with not as much economic firepower to offset the effects of the pandemic.
Arjun Jayaraman: But what investors should take to heart in emerging markets equities is that these are much smaller parts of the benchmark. Most of the emerging market benchmark is doing fairly well with respect to the pandemic. The other thing I want to highlight is the development of the online economy. Those countries which have a more developed online economy are able to carry on economic activity through the pandemic given all the restrictions on social interactions. I'd highlight first and foremost in that category, China, which right after the US has the most online companies including E-commerce, social networking, even education, stocks, things like that. On that front as well China, Korea and Taiwan have done pretty well through this pandemic. On net given that these three countries are dominant part of the benchmark, EM seems to be doing fine through this crisis.
Jenna Dagenhart: Dave turning to you, how would you describe the pandemic response from emerging markets?
David Robbins: Well, as Arjun said different countries have reacted differently to what's gone on in the crisis. I think the first reaction for most countries and most central bankers which has really been different this time in emerging markets is they've been very aggressive in terms of reducing short-term rates. Central bankers across the EM spectrum have reduced rates pretty substantially over this period really to focus on stronger growth. At the same time those countries that have the flexibility to pursue a fiscal policies are able to do that, those tend to be the higher quality countries and emerging those countries that have [inaudible 00:03:48] are having a more difficult time. We're seeing across the EM debt spectrum it tends to be that the higher quality the investment grade credits have that flexibility and really have been able to respond more aggressively to the COVID crisis.
David Robbins: It's the countries in Latin America or countries that have large portions of the population that really live day-to-day which is much more difficult to really lock down the economy in that case. Those countries are really having to balance social distancing with other issues. As a result, we're seeing a differentiated response across the EM. Clearly, there are countries that are doing better. China absolutely has much more of a V-shaped recovery and many countries in Asia than the countries in Latin America. That really points to indications of places to invest because with China and central Eastern Europe doing better than Latin America, as you get that stronger growth, you're getting a better response in terms of inflows into the countries and opportunities in both the debt markets and I imagine also the equity markets.
Jenna Dagenhart: With those differentiated responses that you mentioned, Dave, what opportunities have been created and where are you finding more areas of concern?
David Robbins: What we really think is that the investment grade space still looks very attractive in emerging markets. Higher quality bonds have widened out substantially during the march period. Now, they've tightened since then, but they are still attractive relative to their history and certainly relative to US fixed income. The asset class that's lagged the most has been an emerging market sovereign high yield bonds. They've only recouped about 50% of the downtrend and we still think there are some attractive opportunities there. The market has priced in a fairly negative [inaudible 00:05:52] and I think initially in March there was the panic of the sudden stop of inflows into these countries.
David Robbins: It turned out that was very short lived and that as we got the programs from both the Fed, fiscal stimulus from the US and elsewhere, these markets started to open up again. That's been really a big source of the rally we've seen from the wides of 720 over in emerging market index to currently 450 over is really those countries that have had access to liquidity. As they've had access to liquidity their spreads have tightened, and those markets have done better.
Jenna Dagenhart: Arjun turning to you, how would you say the current crisis differs from the great financial crisis?
Arjun Jayaraman: It's interesting because the current crisis I would characterize as an exogenous shock. A healthcare crisis that basically was outside the system has impacted economic activity whereas the GFC, the great financial crisis back in 08 was I would say more of an endogenous shock. We had a lot of risk taking, we had a lot of financial institutions having a lot of leverage to the real estate market which crashed especially in this country. You had that difference there. Other differences are when we look at the financial crisis it came out of a very strong period of economic growth in the 2000s where we had the commodity boom in that time. We had very strong GDP growth rates from countries like China and India.
Arjun Jayaraman: What that means for governments especially in the emerging side is that they had much more fiscal and monetary firepower case in point is China which had a lot more levers to pull to combat the effects of that crisis. Fast forward 10 years when we're in this crisis, there's not as many levers to pull. In fact, if you look at what has happened in China, China has had a very muted fiscal response to this crisis. Admittedly the US and Europe had very strong responses to the crisis. The US especially given that we have the world's reserve currency, we can do a lot of things. We can run up fiscal deficits and we can do significant monetary easing, QE type policies to try to get this economy restarted.
Arjun Jayaraman: But in the emerging world they don't have that firepower especially after 10 years of very low rates in the emerging world the ability to continue lower rates, especially for countries like China which already have so much debt is limited. That's the downside of this crisis, I think. But the upside is as I said before, the development of the online economy which to me is one of the most bull cases for emerging markets equities that I've seen in quite some time.
Arjun Jayaraman: We've seen in the case especially in China, but also in countries like Korea and Taiwan the ability to carry on economic activity through shutdowns, through lockdowns. That's a very different dynamic than what we had 10 years ago. I think if we had a similar crisis, a healthcare crisis that led to these shutdowns 10 years ago, I think the effects on economies would have been much more draconian especially the Chinese economy. There's pluses and minuses when we compare to that period. The last thing I want to emphasize is the issue of moral hazard. That was a big issue going back to 2008.
Arjun Jayaraman: Do you want to help out financial institutions which got you into this mess in the first place? That was a big question that policymakers had to deal with. Who do you bail out? That was a big question that we had in the United States. What do you bail out? Do you bail out Goldman? Do you bail out Morgan Stanley? Some choice had to be made there. Here, at least in the developed world governments can do more policies because there's no issue of moral hazard. Once again, this is more a developed market phenomena but what it's resulted in is a huge increase in global liquidity which benefits emerging markets. I would highlight that one last difference.
David Robbins: Certainly that increase, the response by the Fed and the response by the US government in terms of fiscal policy and monetary policy really did put a floor on the markets and you really saw the markets rally after those programs were introduced or even announced. I think part of it is there was a $1 funding squeeze that existed, there was tremendous illiquidity even in the most liquid markets in the world. US Treasury market and the US mortgage market and all of these issues had to be dealt with by the Central Bank providing liquidity. That really did benefit and really trickle down into emerging markets. Initially, I think investors were everyone wanted to buy what the Fed was buying.
David Robbins: You were buying treasuries, you were buying mortgage backs, you were buying investment grade fixed income, you were buying even high yield US fixed income but you really did see the benefit to emerging markets because when that happened we did start to see spreads tighten from some very wide levels. I think, as I said before the first rally that we saw was really those countries that have access to liquidity. I think Arjun makes a really good point that there's a second phase to this process is after all the QE and after all the fiscal stimulus is done, we really have to look at these countries and say, "Okay, who has the flexibility to deal with this issue because in 2021 debt to GDP in some of these countries is going to be increasing by anywhere from 20 to 25%?"
David Robbins: That's a substantial increase. If they don't during that period focus again on fiscal conservatism or if growth is slower than expected, how are they going to be able to consolidate fiscally in that time period and those countries that can't are going to need to go to the international financial institutions and may need to go to the IMF. At that point the IMF may ask those type of countries and say, if you're going to need an IMF program maybe you also need some private sector involvement. I think a lot of what we're doing in the fixed income universe is trying to look for those countries and focus on those countries that really have lasting power and the stability and the flexibility to ride through this situation and really avoid those countries that are ultimately going to need to get some further help down the road.
Jenna Dagenhart: You raised some important points there. Now, looking at the new economy versus old economy Arjun, what comparisons can you draw?
Arjun Jayaraman: I think the new economy aspect of emerging markets is one of the most interesting parts of the asset class. The new economy whether it's E-commerce, whether it's social networking, online education, so many online food delivery, these are such incredible growth opportunities for emerging markets. It's very attractive, very interesting. On the old economy side and these stocks certainly trade at cheaper valuations and therefore there is some attractiveness from that perspective but when we look at a country like China, and you think about old economy in China, you think about the banks, you think about infrastructure stocks, China's pretty well built out. I think most of the growth in a country like China is going to come from the new economy segment.
Arjun Jayaraman: On the other hand there are parts of emerging markets that have under invested in infrastructure over the years. I'd highlight India being number one, parts of Latin America. In these countries we can certainly see more prospects for old economy, more of the infrastructure stocks, materials, we think about the commodity space and materials, the countries that fall in that category are Brazil, Russia, South Africa. There is certainly prospects for growth there but the marginal buyer which historically has been China is not going to be buying as much of those type of things going forward as that economy transitions into more of a consumption led economy therefore other economies are going to have to pick up the slack there and I'd highlight countries like India, also, Brazil.
Arjun Jayaraman: That's the comparison I would draw. Without a doubt over the last 10 years new economy has done very well in terms of the performance of those stocks and it's very similar to the phenomenon we see here in the US with the Fang stocks doing so well. But it's with good reason because that's where the future lies. We are transitioning into more of a new economy type of world. If you think about things like spending on 5G infrastructure. This pandemic has really brought a lot of that forward. We're doing the old economy activities; face-to-face interaction has been limited and so the new economies had to bridge that gap. That's a quick lay of the land in terms of old economy versus new economy.
Jenna Dagenhart: Now, Dave, turning to geopolitics, how are you monitoring trade tensions as they make their way back into the headlines? What are the implications for China and emerging markets?
David Robbins: Look, I think trade tensions are a fact of life for the markets right now. Whoever gets elected and as we go through up to the presidential election, I think both candidates are going to be perceived as tough on China. I do think that depending on who gets elected the style in terms of dealing with the relationship will certainly change. I think under President Trump tariffs have been a big focus. I think under Biden, I think there will be more of a focus on technology, more of a focus on a multilateral approach to dealing with China. But I think China really is right now one of the few economies into 2020 in fact one of the only large economies that's going to have positive growth this year.
David Robbins: I think that positive growth is driving demand for economies and does benefit much of emerging markets which is very highly correlated to Chinese growth and Chinese trade. One of the interesting things that we've seen in this crisis is that even for emerging markets trade has declined between emerging markets and developed markets but trade between emerging market countries has increased or declined less. We think that's a positive signal and part of that has to do I think with the fact that China really first to come into this crisis and first to come out and I think Europe is coming out of this lockdown situation a lot more smoothly than what's going on in the US.
David Robbins: European growth also was important driver of growth for many emerging markets there. The only emerging markets that really are highly correlated to the US are really countries like Mexico and then some other Central American countries. But we think that in general while the geopolitics certainly are getting more difficult. We do think that it benefits both countries to continue to work together. I think ultimately while it will be a difficult process, I think ultimately it will be a little bit smoother than it's been particularly if we have a Biden presidency.
Jenna Dagenhart: Arjun, anything you would add there?
Arjun Jayaraman: I think Dave made a lot of great points running up into the election. The headlines are not going to be good. There's going to be a lot of rhetoric coming back and forth. I agree that Biden will take more of a multilateral approach as opposed to Trump's approach which is basically negotiate with each country individually. But then after the election what's going to happen? I don't think things are going to de-escalate in any meaningful way. I think you're going to have that tension there but as Dave said, there's a lot of vested interest on both sides to have a working relationship between the two countries. A lot of businesses have been quite cross invested. Therefore, there's a lot of reason for the relationship to continue in some form or other. I think in terms of globalization which was the big beneficiary for China since it got admitted to the World Trade Organization WTO back in 2002, I would say since maybe 2016, 2015 globalization has peaked.
Arjun Jayaraman: Now we're having more of this localization theme where companies are pulling back. They're trying to create supply chains within their countries. Certainly, the Huawei entity list issue is front and center in that regard. Huawei is a national champion in China and the fact that the US can throttle Huawei by restricting the sale of semiconductor chips to Huawei is a big deal for China. They're going to want to have more localization in terms of that supply chain especially in the semiconductor space and then the flip side we see here in the US most recently in terms of our dependence on pharmaceuticals to China. There's been a push here to get more localization as well. But we've also seen other effects with Taiwan semi which is the world's foremost foundry agreeing to build a plant in Arizona. This localization theme has taken hold and will continue to get legs behind it going forward due to the geopolitical issues. But that being said there is always going to be some degree of cross pollination between the world's two largest economies.
David Robbins: Clearly that change in supply chain is going to benefit other emerging market countries whether it's Mexico or Vietnam or Malaysia. Countries will take up the slack as people try and move their supply chains elsewhere to diversify the risk.
Arjun Jayaraman: I agree.
Jenna Dagenhart: Sticking with China here, how is China's inclusion in the index impacted the EM debt market? Dave, you mentioned that China is better positioned than a lot of other emerging economies.
David Robbins: Well China is an investment grade credit. It has yields of roughly let's say three to three and a half percent for its government bonds. It's one of the highest yielding investment grade credits in emerging markets. It's also a highly indebted economy. The rates' story in China, longer term looks like an attractive one. But adding China to the index and it's started in February and by the end of this year will be about 10% of the index it's one of the largest and most liquid markets in the local currency space. It will lower the volatility of the index as a whole and upgrade the credit quality. The local currency index in emerging markets is already investment grade but I think adding a lower yielding lower volatility credit within the index helps dampen the volatility of that asset class.
David Robbins: I think it will make it more attractive particularly for sovereign wealth funds and other investors in the local currency space. Because I think one of the concerns has always been with the local currency market is you do get attractive yields but there's a lot of FX volatility that you have to deal with when you add a large higher quality credit like that dampening volatility and still giving you significantly better yields than what you're seeing in the developed market. I think ultimately it should make the index more attractive to a broader group of investors.
Jenna Dagenhart: Are there any other geopolitical situations that could have a profound impact on the markets Arjun that you'd like to highlight?
Arjun Jayaraman: Well, when you look at EM in general you can make a case for political issues or geopolitical issues everywhere. First, I'd highlight Russia of course. It seems that with all this talk around China Russia has gotten pushed to the periphery which I'm sure the Russians love. But for the last six years basically since the annexation of Crimea, Russia has been front and center as a place that there is a lot of political risk associated with that. The risk of more sanctions levied by the US as well as the EU. That's something that EM investors have to be concerned about. One of the countries that we like in our portfolio is Taiwan. When we think about Taiwan it's such an amazing country in the sense that it's a technology powerhouse.
Arjun Jayaraman: But on the flip side, it's located next to China. We've seen what's happened in Hong Kong with the Hong Kong security law. I'd also highlight a recent speech by Li Keqiang, the premier of China who basically for years and past, they've always talked about peaceful reunification with Taiwan. In the latest speech that he gave he dropped the word peaceful. The Press made a big deal about it. There is geopolitical risk when you invest in Taiwan, i.e. how will China deal with Taiwan going forward? Without a doubt China has ratcheted up some of its actions. We look at punk, what's going on in Hong Kong, we look at some of the other issues like the Muslim Uyghurs and the international community have been pretty negative on these things.
Arjun Jayaraman: At some point we'll decide, "Hey, Taiwan is the hub of semiconductor manufacturing, We're way behind in terms of our technology in that regard. Why don't we make a move?" I would highlight Taiwan as well. Look at India for instance. India has had some recent skirmishes with China. It's had some longer-term skirmishes with Pakistan. Something to be aware of there. Then more on the political side I'd also highlight some of the more left leaning countries. First off Mexico, with the President Amlo there who is much more left leaning. Investors need to be cautious about investing in Mexico to the extent that he starts implementing more left leaning policies.
Arjun Jayaraman: What's interesting about Mexico is through this crisis, this pandemic, they've actually done very little stimulus which is counterintuitive because you think left leaning politicians would do more of that, but we haven't seen that in Mexico. But what we will in my mind see is more legislation against business's, banks, that kind of thing. The other country I'd highlight is Korea which also has a more left leaning administration. Now, we like Korea. We think the valuations are very attractive. It's got a very strong IT infrastructure companies. But by the same token it has more left leaning administration perhaps there's going to be more crackdown on telecom companies in terms of tariff increases, utilities, even on banks. That's another thing that investors need to be aware of.
Jenna Dagenhart: Now taking a closer look at performance, Dave, EM debt had a strong rebound in the second quarter. What's your outlook for the second half and where do you see value?
David Robbins: The second quarter as I said before was all about having access to liquidity and we saw spreads tightened significantly from 720 over at the wides on the index to about 450 over where they are right now. We still think there's more room for spreads to tighten. Part of the reason is the technical story is pretty good. There was so much issuance in the second quarter than most really do in the second half of the year. The technicals will remain strong and classically when you've bought the index wider than 450 over, you've made money over the next six months. The index is cheap to its history. It's also cheap to other fixed income asset classes like US investment grade and US high yield and European investment grade and European high yield.
David Robbins: We continue to see interest in the asset class. The real interesting question is when is local currency debt going to really start to rally pretty significantly and are, we at a point where the dollar has finally peaked? Because local currency over the last 10 years has been more of a tactical asset class than a long-term investment. As a result, you've had, in the last 10 years, I think you've had two years where local currency has outperformed hard currency. We may be getting to a point with the large fiscal deficits and large current account deficits in the US the fact that the Fed has lowered interest rates dramatically so they're very similar to other developed markets.
David Robbins: Finally, if you're getting growth in the rest of the world this may be the time where you finally see the dollar start to decline. The dollar has been in a long-term rally from 2011 to the present. Usually these long-term rallies are followed by longer term declines. We could see the dollar peeking particularly as you get into the uncertainty of the election and as fiscal deficits balloon in the US and that could be an interesting opportunity. You're already seeing the Euro rally substantially post the recovery fund. We could see that follow through into emerging market local currency. Emerging market FX could potentially be a very interesting opportunity in the second half of the year.
David Robbins: But even the hard currency space you're getting yields on portfolios of anywhere from let's say, five and a half to six and a half percent. That's very attractive relative to what you can see in developed markets particularly in a world where 80% of developed market debt yields below 50 basis points and 14 trillion of developed market debt has negative yields. People are going to continue to look for carry in this environment and look for interest income and certainly emerging markets is going to look very attractive.
Arjun Jayaraman: I want to echo Dave sentiments. In the equity space when we look at emerging markets, over the last 15 years it's made a pretty dramatic change in the sense that from a market cap perspective some of the domestic consumption companies and the online companies and all those things have significantly increased in size. When people think emerging markets 15 years ago, people thought, okay, energy commodities. Those are all dollar revenue companies. When we look at dollar weakness which is what we've seen since the peak of the crisis in March, historically, that would not have been as strong a tailwind for EM.
Arjun Jayaraman: Because if you're an energy company Lukoil selling in dollars, there's a hedging effect. Yes, the ruble is appreciating but you're selling in $1 so your revenues are in dollars so there's a hedging there. But now, given the increased weight of domestic consumption and domestic economy in emerging markets, you get more bang for your buck when you see that dollar depreciation EM currency appreciation. That's why I think we've seen such a strong rally in emerging market equities as well from the bottom because it's a double whammy now. You get that bang for your buck from the increased presence of the domestic consumption story in emerging markets.
David Robbins: I think a weaker dollar also helps commodity prices pretty significantly. That does help emerging markets and you're seeing some big rallies obviously in gold and copper, iron ore. All of these are quite beneficial to emerging markets and a weaker dollar reinforces that trend.
Jenna Dagenhart: To quickly follow up on the dollar conversation here, the dollar hit a two year low following the feds July news conference. How are you monitoring monetary policy and central bank actions Dave that could impact EM?
David Robbins: Well, I think the EM reaction to the COVID crisis as I said before was really to reduce rates dramatically as central banks across the board cut rates. What was interesting this time was that they weren't really concerned about their weakening currencies. In the past, there was a lot of pass through between weakening current currencies and inflation. But this time there has really been no pass through from inflation from weakening currencies to inflation and as a result it gave them a lot more flexibility.
David Robbins: They were able to really adjust and use the currency really as a buffer in this process to make them essentially more competitive. What we've seen in many countries like South Africa, Brazil, and others is we've seen current account deficits move to current account surpluses. We have seen a change in the balance of payments. That's one of the reasons why we've seen currencies in emerging markets rally from their lowest levels in the second quarter and the dollar has been really under pressure of late.
Jenna Dagenhart: I see you nodding your head Arjun. Anything you want to add to that?
Arjun Jayaraman: I just want to back that up. I think EM central banks have much more room to engage a stimulus than EM treasuries in the sense that you can do much more monetary stimulus than fiscal stimulus. I'd look at a country like India or Brazil, these are countries that are pretty worried about their deficits. We've seen much more activity on the monetary side on the fiscal side. Then of course you have China which has had a huge run up in debt over the last 15 years. They're also very circumspect in terms of the fiscal stimulus. Of course, in the case of China they've gotten past the worst part of the pandemic relatively quickly I would say so there's less need for that stimulus. That's what we're seeing. But agreed, given the weak dollar background and the amount of stimulus that's coming out of the developed economies, that's given some cover for the EM central banks to also engage in monetary stimulus without seeing dramatic currency appreciation as what we see.
Jenna Dagenhart: Dave, how are you managing portfolio liquidity? Are there certain segments of emerging market debt that are more liquid than others?
David Robbins: That's definitely the case. I would say the market as a whole hasn't yet fully recovered from the illiquidity that we saw in March, but it's gone a very long way. I think initially in March as you had a combination of COVID-19 and disintegration of OPEC plus and people trading from home, it made it very difficult to execute transactions. I think as we've moved away from that period liquidity has improved substantially. We're still subject to bouts of illiquidity and it's generally tied to volatility so as volatility increases illiquidity increases in the market. As volatility comes down, liquidity improves substantially. That's generally what we're seeing. The local currency market and the high-quality end of the sovereign debt market is extremely liquid.
David Robbins: It tends to be in the higher yielding credits the single B space in both sovereign and corporates. The high yield private sector corporates those tend to be less liquid and are subject to price gap risk. But I think in general I would say while we're not back to the levels we saw in January and February liquidity has improved substantially from the worst levels we saw in March. But I think that's something we're going to have to live with because this situation with liquidity is really created by both structural reasons and regulatory reasons within the market and those aren't going away. I think in general I think all markets are going to have to deal with these bouts of illiquidity when they come and as I said before it's very highly correlated to increases in volatility.
Jenna Dagenhart: Now pivoting to EM equity Arjun, is there a discount for value stocks versus growth in emerging markets?
Arjun Jayaraman: This has been one of the big trends that's happened over the course of the last 10 years. Basically, since the great financial crisis we've seen a pretty steady derating of value in emerging markets. For us as value-oriented investors, it's been a challenge. In our strategy, we're not just pure value. We balanced value with growth and momentum. We do certainly own some of the growth year momentum names in the online space, but the value part of our portfolio is suffering. Now, in a year like this where we've had this exogenous shock, a pandemic, it's not surprising to see value under Perform. But at some point, we'd expect value to get back on track and outperform especially since the cumulative under performance in value has been tremendous.
Arjun Jayaraman: If you look at some standard metrics like next 12 months PE ratio value trades in emerging markets at about a fee of 10 versus 23 for the growth index on a price to book value basically trades in book versus a three times book for the growth index. The dividend yields are a double in the value segment compared to the growth segment. These are very dramatic discounts to value and it's not just the case. Admittedly growth has had higher EPS growth rate for the last few years, but the prices have more than discounted those increases in those higher growth rates, so value has depreciated pretty dramatically to the tune of growth having a premium of more than 100% depending on the metric which you look at.
Arjun Jayaraman: We don't think that's sustainable. At some point it's got to revert. We would say that, yes, the sexier part of EM is on the growth space, the online economy space, but things like financials, materials, energy, they still play real parts in the economy. I know that energy has a lot of ticks against it in terms of ESG and things like that. But most of the world's economy still runs on oil. You still need oil to power things. It's not the story of the year which is electric vehicles or electric batteries but it's still the backbone of the global economy and these companies pay very significant yields as well.
Arjun Jayaraman: The broad side of things does not pay a significant yield. The value side of the EM universe equity universe, whether it's energy stocks, whether it's financials, they pay a pretty significant dividend yields. In a globally lower environment globally these should be attractive. At some point we think that value should start to close some of that discount versus growth.
Jenna Dagenhart: Talk to us a little bit about the concentration of the largest stocks in the EM benchmark.
Arjun Jayaraman: This is primitive of that phenomena. Not surprisingly, the four largest stocks in EM equity universe today are more of the growthy names. Tencent, Alibaba, the two big Chinese internet companies. Number three is Taiwan semiconductor, the world's leading foundry that manufactures semiconductor chips and number four, is Samsung Electronics, which is a very diversified tech company obviously making smartphones. Memory's a big part of their business. They also make us base stations. They're also involved infrastructure also display. Very diversified company. These four companies make up over 20% of the index. If you include another company called Naspers which basically derives all of its market cap from its holding in Tencent, those five companies make up 25% of the index.
Arjun Jayaraman: This is a bit of a challenge for active managers who we believe in greater breath. The technical term for this is the breath of the market is very narrow. This is similar to the phenomenon that we're seeing in the US with the big names like Amazon, Google, Netflix, Apple, dominating the market. It's a similar phenomenon. It poses challenges to active managers and it's something that we have to deal with as active managers. Thus far those companies have demonstrated in very strong top line and EPS growth rates. I think their evaluations have some justification.
Arjun Jayaraman: I don't think we're in the year 1999 where you had the big crash in NASDAQ in 2000 and going onward. I don't think we're that but we're certainly in a world where growth is slowing, China growth is slowing so the notion that these companies can continue to post 30 40% top line growth at some point you have to question that. The index is very concentrated today. I'm not saying that those large gaps are going to get smaller going forward but at some point, they will have baked in a lot of good news going forward.
Jenna Dagenhart: Dave, back to you here. How would you describe TCW's overall approach to managing emerging markets portfolios?
David Robbins: In our largest funds we really take a total return approach. We look at the entire asset class which is comprised of hard currency sovereign debt, hard currency corporate debt and local currency debt and really cherry pick what we think are the best risk reward opportunities across the whole space. Right now, we're predominantly focused on hard currency debt both on the sovereign and the corporate side and predominantly on the sovereign side because we see more value there and we're looking to add incrementally to our local currency exposure as we see opportunities on the local currency side. What we've done essentially is taken a barbell approach.
David Robbins: A large portion of our portfolio is focused on high quality investment grade names that we think have the ability for spreads to tighten and are lower volatility type names and then a portion of our portfolio are focused on those high yield opportunities. Those countries that are going through turning points either potential restructurings or change in political environment which will benefit bondholders. Using that barbell approach has really helped us in this period on both capturing a consistent yield and actually having made nice almost equity type returns on those turnaround stories.
Jenna Dagenhart: Arjun, how do you incorporate alternative data and fundamental insights into your process?
Arjun Jayaraman: That's a great question. In our process at Causeway for emerging markets is primarily a quantitative process but we are trying to broaden out some of the tools at our disposal. First and foremost, I would highlight alternative data. We realized that if you compare investing today compared to 20 years ago, the amount of data out there is just increased tremendously. As quantitative investors we want to look to some of that data to see is there anything that we can harness to improve our process? I'm going to highlight a couple of data sources that we've added to our process in the last couple of years that really added value.
Arjun Jayaraman: The first is a data source called Jiguang. It's a Chinese app data source. What this company does or has done historically is they've designed apps for businesses. Then when a user installs that app on their smartphone, Jiguang can then track usage of that user across all the apps on that phone. That's very powerful. This is mainly for Android phones and most of the phones in China are Android phones. That's very powerful. By installing some app now Jiguang can track the usage of Alibaba’s' website, team all Tower Bottle, Tencent, WeChat, all those real big powerhouse companies in China. They have an installed user base of something like 800 million people in China. We're buying data from them and some of the data we get is the daily active users. The amount of time a user spends on an app.
Arjun Jayaraman: The amount of times the user opens an app and the number of users who have installed that app or what they call penetration rates. This data is very valuable to us. It really helps us in terms of navigating some of the real-time metrics of some of these online companies in China. That's one data source. Second data source I want to highlight is social media. Specifically, how we use Twitter in our process. When you look at Twitter, there's certainly a lot of information out there. Of course, our president first and foremost as being a big user of it but most of the information we would argue is noise especially as it relates to stocks. But where we have found good information on Twitter is as it relates to political events and first and foremost, I would highlight elections.
Arjun Jayaraman: We've been doing our Twitter analysis now for about one and a half years. There's a few elections that we use Twitter to help us gauge the outcome of the election. First and foremost, I want to highlight the Indian election back in 2019. Going back to 2019 the Prime Minister of India, Narendra Modi was ending his first term. Going from 2014 to 2019. His first term had some ups and downs. The economy coming into 2019 was not doing that well and he did a couple of things. One was called demonetization. Taking cash out of the economy that had some negative impacts, although long-term we think it's a good thing. His popularity was starting to flag a little bit in early 2019. His opponent, a guy named Rahul Gandhi was improving.
Arjun Jayaraman: But then what happened in March of 2019 is you had the skirmishes between India and Pakistan. In the northern border we had a bit of skirmish there. India being a very nationalistic country, really rally behind Modi at that point. We saw this on a real time basis on Twitter where we saw Modis' popularity starting to increase more positive tweets about Modi started coming through. We started forecasting an increased probability of a Modi election. Much of the much of the consensus was that Modi would win but with not as strong a majority as he had in 2014. We saw something different.
Arjun Jayaraman: We saw a very strong sentiment in favor of Modi more from a nationalistic perspective. In fact, when the results came in for the 2019 election, Modi and his party the BJP had a stronger victory than they had back in 2014. Which it was positive for business as Modis' party is more business friendly compared to the Congress Party. I'd highlight that I'd also highlight other types of political events. We also looked at the Brazilian pension reform that was enacted last year which is a big deal because Brazil has very big fiscal deficits and this is going to improve their fiscal deficit trajectory going out over the next 10 years.
Arjun Jayaraman: We saw a very strong sentiment in favor of pension reform from our Twitter analysis which when you think about it is very counterintuitive. Most people, especially people in emerging markets, do not want to see their pensions cut, do not want to see the age at which they can retire increased. But we got from our Twitter feed that the politicians in Brazil conveyed the message very well to the populace that deficits are not sustainable and if they want a strong economy going forward, they need to do some type of reform. We saw that in our Twitter analysis. Those are a couple of the ways in which we've incorporated alternative data into our process. I want to also highlight the fundamental aspect.
Arjun Jayaraman: Here at Causeway, we have a strong fundamental analysts’ team who covers stocks globally. The way we work with them on the Quan site is we try to incorporate some of their assessments and insight into our process more from a risk management perspective. First and foremost, let me highlight one example, an ESG example. We know that ESG, which is environment social governance is a big thing globally in terms of directing portfolio managers. We would highlight the G part the governance as being the most important of those three at least in the context of our process. What's important with ESG is that there are data providers out there and we use a proprietary source that's based on MSCI ESG ratings.
Arjun Jayaraman: But we also realized that the ESG providers, there are some faults with their data. We always get our fundamental team to vet the data. To give you an example of a company where we disagree with the ESG provider, the example is a company called JBS which is a big Brazilian meat processing company with a lot of operations in the US. The ESG rating, personally the governance rating on JPS was very negative. We realized that was due to what has happened in the past. JBS was very caught up in the Lava Jato scandal that's been in Brazil now for a few years. But what's happened since then is they've gotten rid of old management, they brought in new management and now they have a plan to list their international operations in the US.
Arjun Jayaraman: All of these events will improve corporate governance at JBS. This is an example of where our fundamental team told us listen, things are improving in a big way at JBS so don't be so concerned about the negative ESG rating. A second example I want to highlight is one of the value parts of the EM benchmark is Chinese banks. Chinese banks have looked cheap for a long time and they may go cheap for a long time going forward. Our quantum model tends to like Chinese banks. They pay a strong dividend yield; they look very cheap on most metrics. The problem with Chinese banks, however, is that we think they're very opaque institutions. To give you an example of why that's an issue, we did analysis with our fundamental team recently where we looked at the amount of bank assets to GDP, the increase in China compared to other countries and EM.
Arjun Jayaraman: Bank assets to GDP has increased significantly over the last 10 years in China way more than GDP has increased. It's at the left tail or the highest increase in China. Leverage has increased significantly in China. But when you look at NPL situation, non-performing loan situation, China is almost at the lowest side of things sub 2% NPLs. Those things don't jive. As a contrast, I would highlight India. India as a country it's also a large high growth country like China. India has over the last 10 years has had basically bank asset increase that's been in line with GDP. But they've had 10% NPL. This is 2017. Data 10% NPS. What's the difference? The difference is that the regulator in India has encouraged Indian banks to recognize these bad loans. That transparency was rewarded by markets. In China on the other hand they're very opaque. We think that what's called the extend and pretend phenomena is the reason why the NPL situation in China is quite low. For that reason, we are overriding our model based on our fundamental at work and not letting it have a big overweight to Chinese banks.
Jenna Dagenhart: Dave, how should an investor be thinking about allocating to emerging market debt within a fixed income sleeve?
David Robbins: Well, clearly in this environment as we talked about before where interest rates are extremely low in the developed world there's clearly a desire for income. It's one of the few asset classes that really provides you with significant yield advantage over developed market fixed income. What we're seeing is more and more interest particularly from pension funds to add exposure to the emerging market space and we're seeing more and more broader platforms take EM from a tactical allocation to a more permanent allocation in their fixed income portfolios. If you run an optimization of a global fixed income portfolio, generally EM should be about 40% percent of your global fixed income portfolio. No one is anywhere near that allocation. On average people are somewhere between five and 10% allocation. I'd say the US is probably at the lower end of that range.
David Robbins: Europe is probably at the higher end of that range. But we continue to see it's very interesting that the added carry and the yield that you get in emerging markets fixed income really has a significant impact on overall portfolios. In fact, when we look at emerging markets more broadly, if you take a portfolio 50% emerging market debt and 50% emerging market equity that outperforms an emerging market equity portfolio over the cycle. Simply because the added interest income that you got really provides some insulation and you don't have those big draw downs that you have when the market goes down. The sharp ratios on emerging market fixed income are very attractive. We continue to see people interested in the asset class and we expect that over time it's going to become a more permanent part I think of people's global fixed income portfolios.
Jenna Dagenhart: Building off of that, what are the benefits of investing in the EMD corporate markets Dave?
David Robbins: Well, EMD corporates we think look very interesting and part of it is that when we look at it relative to US fixed income whether it's investment grade or high yield, generally you're getting higher yields in emerging markets and you have less leverage on a credit by credit basis. If I look at spread per turn of leverage in emerging markets at every level of credit rating from single A to single B, your spread per turn of leverage is anywhere from one and a half to two times what you get in US fixed income. I think the other thing about emerging market corporates is we really look for those deleveraging opportunities. We want to invest in countries that are managing their balance sheets and focus on reducing debt.
David Robbins: As they reduce debt, you improve credit quality spreads tightened. From our perspective corporates are a very interesting opportunity but it's idiosyncratic in the sense that there are strong deleveraging opportunities in the emerging market space and there are also corporates that you want to avoid. From our perspective having a real focus on fundamental research in terms of looking at corporate credit is extremely important. But I would say that the corporate space in emerging markets is going to continue to be a space that I think not only emerging market investors, but crossover investors are continuing to look at and we're seeing that in the new issues that we're seeing over the last several months. We're seeing a lot of crossover investors participate simply because emerging markets spreads currently are more attractive and wider than what they're seeing in their own markets.
Jenna Dagenhart: Now, as we wrap up this masterclass discussion here, Arjun, what's your outlook on EM in general including long-term prospects?
Arjun Jayaraman: I think the outlook is very good for EM. The asset class overall is still trading at a reasonable multiple especially compared to the US where things are pre weighted pretty dramatically. When I think about equities in general, I look at three regions, the US, EFA, which is Europe and Japan, and then EM. EM has some very similar characteristics to the US a big IT sector, a big online sector but at a huge discount. At a multiple that's similar to EFA. If you are value oriented, EM certainly has some value stocks in it, but gets better growth prospects than EFA and has the online and IT type of exposure that you get in the US.
Arjun Jayaraman: Then when you look at other metrics like market cap to GDP, EM is huge in terms of the GDP contribution to the world especially at the margin. You have the second largest economy, China, you have a country like India which I think is now number seven but by the end of this decade some people are forecasting that's going to come in at number four, maybe number three, number four. You have a lot of room for growth. The GDP per capita in some of these economies, especially like India, or Brazil or even at Russia are anywhere in that two to $5,000 range. They could easily double. They can grow much more than the US or some of the developed economies of the world. The workforce is much younger. We talk about aging workforces that's a more developed market phenomena. The population is much younger in emerging markets.
Arjun Jayaraman: Emerging Market countries in general have done a better job with currency risk. 25 years ago, you had significant currency volatility, not to say that it's all gone away. There are certainly a couple of currencies out there. Argentina and Turkey which are probably more problematic but much of the EM world today the risk is much more manageable. I would highlight currency as being one of the big risks in investing in emerging markets. From a risk reward perspective, we think that things look pretty good for emerging markets. From a fiscal deficit and one last point I want to make is the fiscal deficit situation.
Arjun Jayaraman: The US has run up huge fiscal deficits and certainly we have some leeway to do so given that we're the world's reserve currency. But EM has been much more circumspect on that front. They're trying to do the right thing. They don't have the luxury of having the world's reserve currency. They need to do the right thing there especially countries like Taiwan and Korea which run fiscal and current account surpluses. These risks aren't there. I think the prognosis for long-term returns for emerging certainly once we get past this pandemic which we did say is having differentiated effects depending on where you are in the emerging space. But once we get past this pandemic, I think things look pretty good for emerging markets.
Jenna Dagenhart: Dave, you mentioned looking for inflection points when you invest, given the current economic and political challenges globally do you see any of those inflection points on the horizon and any other final thoughts you'd like to add here?
David Robbins: Look, we are going through a cyclical turning point in the global economy. We've had one of the deepest, fastest recessions that we've ever had in the global economy and we're slowly coming out of it. As growth returns to the world and it seems to be returning to the world outside the US more forcefully than within the US, I think in general that benefits the EM space and as Arjun said, the balance sheets in EM are in better shape than the developed world they have balanced while debt to GDP has increased. It's still significantly lower than where it is in the developed world.
David Robbins: I think the other important point is that many of these emerging markets now are financing in their own currency. They're not financing in dollars anymore. The fact that they've developed local markets and deepen those local markets with local pension funds, local banks, local investors, has really helped prevent some of these currency crises. I've been investing in this market for over 30 years. The early crises that we saw in EM in the 90s and even before in the 80s were the result of bad policies that many of these countries pursued.
David Robbins: With each crisis that occurred improvements were made in Policy, in Governance. The market has come a tremendous way, a long way since that period. Right now, on the index there are 70 plus countries in the index to invest in the emerging market debt space. There is the ability to really pick the winners and avoid the losers in the space. I think that's going to be the key going forward is focusing on differentiation and trying to understand those credits that in 2021 are going to be able to survive and muddle through and those credits that aren't and that's what we're focusing on.
Jenna Dagenhart: Well, gentlemen, thank you so much for joining us. Really great to have you.
David Robbins: Thanks very much.
Jenna Dagenhart: Thank you for watching this Emerging Markets Masterclass. I was joined by Arjun Jayaraman, Head of Quantitative Research and Quantitative Portfolio Manager at Causeway capital Management and Dave Robbins Emerging Markets Portfolio Manager at TCW. I'm Jenna Dagenhart with Asset TV.