State Street’s Michael Ho sees particular macro shifts to EM equities, fixed income and currencies
Michael Ho, chief investment officer for State Street’s Active Emerging Markets Equities and Global Macro capabilities, sees a number of macro shifts ongoing towards the area of emerging market equities, fixed income and currencies.
Economic growth in Developed Markets (DMs) may well remain sluggish for some years. Consequently, many investors now expect better returns over the next decade will be found in Emerging markets (EMs), which have better fiscal and balance sheet positions and more favourable demographics.
EM companies have on average low price-to-book valuations and offer much higher return on equity or ROE. ROE measures the efficiency of firms to generate profits. We will use the MSCI definition of ROE, or net income from the continuing operations, excluding extraordinary items, minority interest and preferred dividends divided by book value. Using this measure of ROE, EM equities delivered poorer ROE of roughly 9% per annum from the mid-90s until 2001 than the 12% in DMs.
However, from the dot-com bust to today, this ROE has accelerated to an average 14% per annum in EMs while in DMs it has remained around 12%. Despite the temporary slowdown in profitability, EM companies in the MSCI Index maintained their 14% ROE on average from 2010 to today, while DM companies have seen a 1% decline in ROE to 11% per annum.
The primary risk now is that the ROE for EM firms reverts to either the 11% for DM firms or to the 9% level seen in EMs during the mid-1990s to 2001. But the risk of this is small. This is because EM equities tend to be dominated by large firms that are either financials or commodity producers. These firms can extract higher profits either due to their dominant local market position or their natural resource endowment.
Another important reason is that EM economies are not leveraged to the same extent as advanced economies. Much like how Bank of Japan’s QE flowed to the rest of the world in the 1990s, liquidity created by global central banks could channel to EM if DM growth continue to be slow. The larger decline in ROE for DM firms after 2009 seems synonymous to 2001-03, when stimulative actions by the Fed and other central banks benefited EMs more than DMs. In the current environment of global QE, the probability of a significant decline in profitability of EM firms is small.
EM and DM equity returns now have roughly the same volatility with correlation close to one. Given that EMs have a ROE-carry advantage, and yet are priced at a 10% discount in P/B valuation vs DMs, we prefer emerging over developed market equities. If time horizon is long and liquidity is not a concern, it makes sense to allocate more to EM rather than DM equities. In particular, investing in illiquid EMs can yield a significant premium without overreaction to risk-on risk-off market action.
Today, many central banks are setting deposit rates below short-term inflation expectations and long-term yields do not offer much premium for taking inflation risk. For those weary of inflation surprises, Investing in sovereign debt can seem like picking up pennies in front of a steamroller. It is important to recognize that not all sovereign debts are created equal. The fundamentals in EM sovereign debt are much better than in DMs. Our research shows some EM sovereign names do seem overvalued, such as the Czech Republic, South Africa and Turkey. Nevertheless, DM sovereign debt such as those of US and UK are significantly worse. Not only are their yields below respective expected rates of inflation, their issuing countries run elevated debt to GDP ratios, experience slower real growth and have large budget deficits. Using the same criteria to assess relative-value basis, EM sovereign debt appears most attractive in several East European countries and in Peru.
In a liquidity-fuelled global environment, EM economies should grow faster given the rise of their domestic demand and their demographic profiles. Research by the Bank for International Settlements on real effective exchange rates shows that EM currencies are more undervalued than DM currencies. Indeed, investing in many DM currencies like USD, EUR and GBP would realize negative real carry, whereas many EM currencies continue to yield higher than domestic inflation.
Considering risk versus return, EM equities, sovereign debt and currencies all look more attractive than their DM counterparts. Investors with a long term horizon could potentially benefit by leaning against the currency depreciation policy of the developed countries by picking up yield through significant reallocation of all assets away from developed to emerging markets.