By Roeloff Horne
It has been a devastating eight months for investors in Emerging Market (EM) bonds and equities. In US$ terms, investors in EM equities (using the MSCI EM ETF as proxy) have now faced four years of basically zero returns, while the MSCI South Africa ETF is now down 19% in US$ terms over four years and 36% down from its peak on 26 January 2018.
One could suggest several reasons for this setback in asset prices: fear of continued trade wars between the US & China, fear of more US Dollar interest rate hikes/higher treasury yields, fear of higher inflation in the US, fear of slower economic growth in China and the rest of the world, fear of a higher oil price (a form of tax for most EM consumers) and divided political headwinds involving other EM, to name a few…
SA investors tend to reason that the main cause for the drop in SA asset prices was corruption, poor investment spending by the Government, poor fiscal prudence and high unemployment which have all resulted in no private sector investment into SA. Although it plays a role in the relative underperformance of the SA stock market, the main catalysts for the JSE All Share Index remain more correlated to actions relating to EM and developed market (DM) capital markets. It is fair to agree that the past four years of political interference and poor economic growth in the SA economy played a large role in our market’s underperformance relative to other EM and DM equity indices.
The graph overleaf indicates that – in US$ terms – the MSCI EM and SA Equity Indices Total Return have had zero performance from pre-credit crisis levels in 2007!
We continue to ask the question: Why are people referring to the end of the bull market? Only the US Equity market has experienced an equity bull market since the global credit crisis. The only expensive sector in the global equity market remains the US technology sector. It is fair to reason that this sector has priced in exponential earnings growth and it was reasonable to expect a pull-back in technology stocks, given the levels they were trading at before the current equity market correction. To name a few, several global technology stocks have now corrected significantly from their 52-week price peak:
Why was it reasonable to expect these falls? Well, when one examines the valuation ratios before the correction, the following ratios depict very expensive stocks (according to fundamentalists), despite their high earnings growth potential:
The unfortunate market euphoria of buying market beta using ETFs leads to a ‘crowded’ trade effect as other fundamentally sound businesses with attractive valuations that are part of major indices (example: S&P 500 Index), are sold off simultaneously. This leads to even more attractive prices for ‘unloved’ stocks.
In the SA equity market, we have a similar situation. Naspers (which owns 30% of Tencent in China) is 29% of the MSCI SA ETF and, on average, 22% of the SWIX or Top 40 ETFs. While one can hardly find any sell recommendation by analysts over the past year, Naspers also de-rated significantly from its 52-week highs (falling 30%) and most of our underlying managers hold Naspers as their top holding in their equity/multi-asset funds. It must be added that many of these managers caused the de-rating of the stock as many changed their equity benchmarks from SWIX to a Capped SWIX benchmark (which means a 10% cap on Naspers exposure) and therefore did reduce exposure to Naspers to conform to the ‘adopted’ benchmark.
When it comes to the potential future price action of these ‘disruptive’, expensive technology stocks, we will err on the side of caution and agree that these companies may remain global disruptors and have a high potential to continue the market leading earnings expectations.However, it remains inappropriate for any equity portfolio/allocation to have highly concentrated allocations to these technology stocks, despite their ever-growing market capitalization and disruptive nature.
When one analyses the ‘rest of the equity market’ (globally or in SA) a lot of bad news is priced in due to all the reasons mentioned above. From a SA perspective, one can safely say, that many parts of the market, especially those parts related to ‘SA Incorporated’ stocks, are trading at very attractive levels. Satrix compiled the following table for MitonOptimal to demonstrate the current valuations based on consensus earnings forecasts (which have been de-rated significantly recently).
Although valuations do not tell one anything about timing markets, if one excludes Naspers from SA indices, all of them trade well below long term averages and in some cases (Dividend and SA Property Indices) trade close to credit crisis valuations. It is reasonable to conclude that the SA Mid and Small cap sectors are two of the cheapest sectors to invest in globally. According to two of our underlying EM equity managers (Coronation and Denker), the upside to fair value in the EM equity stocks they hold is close to 60%!
Looking at global equity valuations, it is not news that the S&P 500 PE has reduced due to 20% earnings growth this year. Currently it has a historic PE ratio of close to 20 and a dividend yield of 1.9%, and if one compares that to the MSCI EM Equity ETF which has a historic PE of 12.7 and a dividend yield of 3.1%…this is a big discount indeed.
Capital Economics Research has been of the view that the US stock market would take monetary tightening and higher Treasury yields in its stride while the economy will continue to fare well. They have, however, consistently argued that monetary tightening would take a toll on activity next year, and that when this became apparent, the stock market would fall, as it did before and during the last two economic downturns. With this in mind, they still expect US equity prices to fall further in 2019, even if there isn’t a full-blown recession. Could this make investors turn to emerging markets?
The questions we as SA Portfolio Managers are facing from clients are two-fold:
- Existing investors in emerging market and SA equities/bonds have had a meaningful valuation drawdown in local currency and US$ terms – is it now time to give up and sell these holdings for developed market assets or cash?
- If one held cash on the side-line as an opportunity to invest as long-term investors, would now be the appropriate time to invest in EM & SA equities/bonds?• Existing investors in emerging market and SA equities/bonds have had a meaningful valuation drawdown in local currency and US$ terms – is it now time to give up and sell these holdings for developed market assets or cash?
- If one held cash on the side-line as an opportunity to invest as long-term investors, would now be the appropriate time to invest in EM & SA equities/bonds?
Our current response to these questions will border on the following:
While market sentiment could continue to drive asset prices lower, we believe that we do not currently have sufficient evidence to expect a US recession soon, nor any major collapse in economic growth throughout the rest of the world (Global GDP growth for 2019 is expected to be close to 3%). If fear could be replaced with more US policy certainty, this could contribute to a change in sentiment. Although it is hard to determine which factor will serve as the catalyst to ignite a risk asset rally in EM’s, any of the following could be a catalyst for a significant rally in EM assets and currencies and the ‘rest of the DM ex US’ as well:
- A US economic slowdown or lower than expected US inflation (maybe as oil prices fall?) motivating the Fed to pause hiking interest rates and causing a weaker Dollar
- No escalation of the US-China trade war and certainty in terms of any agreements
- More China stimulus through fiscal rather than monetary/currency channels
- Key technical levels breaking through to the upside
- Accelerating inflation in the Eurozone and a hawkish European Central Bank – we concede that this is the most unlikely scenario
Another factor could simply be algorithm trading! We were exposed to a specialist who wrote his university majors’ thesis on algorithm trading. One of his conclusions was that the acceleration in algorithm trading is higher on the downside than on the upside of risk assets. We have high conviction that the “algo traders” had a lot to do with the extensive market correction and volatility in October. Fundamentals have not collapsed to the degree that would warrant the price collapse in non-US Technology stocks.
Based on the valuations of the MSCI World ex US Technology – now is not a good time to sell or give up your long-term investment strategy. It is a good time to phase-in more MSCI World ex US Technology stocks into portfolios based on valuations and fundamentals.
SA investors should also not give up on SA risk assets as the right noises are being made by Ramaphosa and his leadership. They need time to fix what is broken but remember: the market is forward-looking and will react swiftly when global catalysts appear, and this is backed-up by positive SA rhetoric.