Mind the Gap! Emerging Markets Are Out-Running Developed Market Stocks

Many years ago when my family and I took a trip to London my children took great delight in hearing the loud warning of “mind the gap” when taking the Tube.

To this day we still joke about it and hearing the expression always brings back a flash of fond memories.

But what I had in mind for this note was a different type of gap. Specifically, the gap that is developing between developed equity markets and emerging market stocks.

Going into 2016 sentiment was pretty bearish on emerging market equities. Institutional investors were having a hard time hanging on to allocations that significantly under-performed expectations and retail investors had long been fleeing the asset class.

Moreover, over the prior ten years (2015-2006) emerging markets had only out-performed international developed markets by an annualized 0.45%. Clearly not enough once transaction costs and the usually higher management fees are taken into account. Never mind the higher volatility of the asset class.

So what had happened to the emerging markets story? Investors once justifying their EM allocations on the growth of the middle class in these markets (the shift from export-driven to domestic consumption growth) had reverted back to explaining the disappointing performance of EM equities as a function of the collapse in global commodity prices.

At the end of 2015 it was hard to find investors willingly delinking expectations for EM equities from those of global commodity markets. Both asset classes ranked at or near the bottom of the pile in terms of 2016 prospects.

Not that every investors was bearish but you had to be a true contrarian to in the face of public ridicule increase allocations to EM or commodities. The short EM/Commodity trade had become very crowded indeed!

What usually happens when you have a crowded trade? The short answer is nothing good for the crowd except for the small number of contrarians still hanging on. Let’s think back to two recent examples of crowded trades:

The rise and subsequent bursting of the TMT bubble of the late 90’s. Every portfolio manager back in those days felt the pressure to increase their exposure to companies in these sectors despite a lack of sound fundamentals and exorbitant valuations.

The real estate finance smorgasbord of builders, mortgage issuers, insurers and credit re-packagers of the 2004-2007 period. The finance sector as a whole was gorging on low interest rates in the context of a low volatility capital market environment. The end result was not unpredictable but in its day there was comfort in numbers and the possibility of something seriously going wrong was summarily dismissed by the vast horde of investors then making money on the trade.
The funny thing about crowded trades is that before they burst few people are willing to take a count of the players at the party. Sometimes people will fail to even acknowledge that a party is taking place. Tunnel vision sets in and investors are subsequently surprised when a turn of events has party attendees suddenly sprinting for the exits.

Is the short EM equities trade finally nearing exhaustion? It sure feels like it. Systematic ways of looking at the “numbers” will invariably lag price behavior. Our own allocation models have been pointing to a closing of the gap between expectations for developed and emerging market forward returns but we still slightly prefer the former.

Let’s take a look at major asset class performance in 2016.

Last week EM equities were up 3.3% – best of the major asset class categories.
For the year, EM equities are up 4.4% -best among all equity sub-asset classes.
The gap between emerging and developed international market (EAFE) performance is widening. Year to date the gap stands at over 7%.
The MSCI EAFE index is down 2.68% for the year while the MSCI ACWI-x US index (which has an EM weight close to 20%) is down approximately 0.4%.

The performance gap between developed international and emerging market equities is already causing some anxiety among international equity managers. Managers tied to the broader ACWI index are clearly having to swim upstream given their likely beginning of year under-weight to EM stocks.

Last year the consensus underweight to EM equities paid off handsomely. EAFE out-performed EM equities by a whopping 14%. An under-weight to EM equities could have hidden a lot of sins elsewhere in the portfolio but this year the tide has turned.

Having been a money manager for over 20 years I know the feeling when a previously ignored/disliked segment of the markets suddenly changes course and gaps up.

It’s never a good feeling and leaves portfolio managers in search of answers. In the course of my career I have seen three types of generic responses by managers:

Ignoring the problem and remaining steadfast in the belief that the portfolio is correctly positioned. The likely outcome of the “no action” manager is binary – at the end of the year the manager will either be a hero or a goat.
Gradually changing course acknowledging that the trade might have been crowded. The manager works at finding investments with the right exposures thus gradually minimizing the under-weight to the previously ignored/disliked segment. In all likelihood the manager will initially make small adjustments and is praying that the performance gap does not widen too rapidly
Throwing in the towel and joining the new party by aggressively over-weighting the previously maligned investment. The potential to be a hero or a goat is large. Such a response is usually driven by “gut” feelings that things have changed

Only in hindsight will investors be able to tell which course of action resulted in the best outcome. Portfolio managers live in the present and must make decisions. With that in mind here is set of principles to adhere to:

All predictions contain a certain amount of error – be humble about your ability to predict the future. Low probability events happen more frequently than we would like to
Seek to understand opposing points of view as a way to discover flows in your thinking. You will gain a greater appreciation of what can go wrong
Strike a balance between what is happening now (recent evidence) and longer-term information. Don’t let your decisions succumb to feelings of either fear or greed
Research-based views are better than reactive off-the cuff conclusions – at least you will understand why you made certain decisions. Do your homework
Gradually changing one’s views given changing/new information is not a sign of weakness. Making better decisions involves the constant calibration of new probabilities
There is no substitute for experience in providing context to the decision at hand, but experience without analysis is no way to make decisions in an ever evolving capital market environment
Understand the consequence of your decisions – never bet the farm on one major decision unless you (and your clients) are comfortable with binary outcomes

Sincerely,

Eric J. Weigel
Managing Partner of Global Focus Capital LLC

eweigel@gf-cap.com

Can This Russian Bear Learn To Samba?

Last week we wrote about the amazing year to date performance of the Brazilian equity market. Despite all the awful headlines and negative investor sentiment the Brazilian market was up over 20% and last week it went up a further 4%.

A similarly widely disliked equity market fraught with negative headlines having a great start to the year is Russia.

Russian equities were up 2.5% last week and in 2016 they are up about 11%. Not bad for a market that like Brazil comes with lots and lots of baggage.

All resource-oriented equity markets have benefited from the resurgence of commodities and both economies are expected to contract further in 2016, but Russia and Brazil are not cut from the same cloth.

There are at least three key differences that investors should note before lumping these emerging markets together:

Economic Sector Composition
Fundamental Drivers of Return
Value Add of Top-Down versus Bottom-Up Implementation Approaches

Click to read the full report Can This Russian Bear Learn To Samba?

Sincerely,

Eric J. Weigel
Managing Partner of Global Focus Capital LLC

eweigel@gf-cap.com

Surprise – The First Gold Medal Goes to Brazil!

With all the bad news coming out of Brazil investors must be perplexed by the strength of the Brazilian equity market this year. After a strong jump up last week in both equity prices and the Real, the MSCI Brazil index is up 20% for 2016.

The news last week was not good. It was reported that GDP growth clocked in at -3.8% with little hope for a rebound this year. The Zika virus keeps wreaking havoc on the local population, Olympic Game preparations are over-budget and behind schedule, and lastly Ex-President Lula De Silva was detained in a corruption scandal involving the country’s largest company Petrobras.

Capital markets are unforgiving to those foolhardy enough to believe that short-term predictions can be made with any accuracy and the example of Brazil hammers home the point. Just when you think that certain investments are basket cases with no hope things turn around.

A great example of this happened last week in global capital markets.

Now, I am not all that confident that Brazil is out of the woods yet and in fact our country allocation model rates Brazilian equities toward the bottom of the pack.

The point is that capital markets are always full of surprises.

When do we get the biggest surprises? Usually when the consensus view is at an extreme.

After the walloping that commodities and emerging market investments have been taking in the last few years, it is not too surprising to find investor sentiment heavily skewed against these beaten up sectors.

Click here to download the report: EM & Commodity Resurgence

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

Beyond the Fog of Daily Capital Markets

As an active manager one of the toughest psychological tasks is to invest for the long-term but have to deal with the daily noise and chatter of the markets. The unrealistic expectation of having superior performance over all measurable holding periods leads to behavior often inconsistent with the goal of prudent long-term capital accumulation.

Given the volatility of capital markets a lot can happen over the short-term that over time gets washed away and becomes a mere blip on the radar. Conversely, other things that in the hustle and bustle of the markets seem minor turn out to be much more impactful over the long-term. Empirical research shows that returns typically are more volatile in the short-term than warranted by changing fundamentals. The net result is a lot of noise that dissipates once investors take a longer term view.

Taking a Step Back. In recent years we have started thinking that stepping back a bit and watching the whole landscape unfold perhaps gives us a better sense of what really matters.

As archaic as this may sound to a high frequency trader in our research we have started focusing more on looking at company and capital market fundamentals over longer time periods. Looking for example at year by year annual company financials gives us a better sense where business fundamentals are going. Same with broad capital market relationships at the asset class level. Aggregating annual periods to look at secular trends gives us another way to process information in a manner that may seem old-fashioned but that hopefully removes some of the noise.

Shifting our Focus toward Long-Term Performance. We recently put together heat maps of annual performance for a variety of capital market breakdowns. We looked across the major asset classes as well as within each asset class. The results were revealing in each case. We found a lot of surprises especially when looking at cumulative returns over the last ten years!

In this note I will share the heat map for the ten major asset classes used in our asset allocation strategies. The returns for 2016 are as of January 22. All returns are in US dollars and correspond to commonly used indices.

What We Expected:

Lots of variability from year to year – this we expected. After all this is the point of creating a heat map.
We did not see a lot of relative mean reversion over one or two calendar years. Again this was expected given the strong empirical evidence that momentum persists for up to three years. We did not see a lot of “going from worst to best” or vice versa.
Not all higher risk categories outperformed lower risk assets – this we expected given the hits suffered by equity-oriented assets during the Financial Crisis. For example, US bonds have out-performed international equity investments over the last ten years. Needless to say this was achieved with much lower volatility.
US stocks had below average ten-year returns. The annualized return on US Large Caps (S&P 500) was 7.7%, more than 2% below historical averages. US Bonds (Barclay Aggregate) also had below average returns compared to history.

What Surprised Us?

A big surprise was the extremely poor performance of commodities (COM) – down 48% over the last ten years. For most investors the promise of uncorrelated returns to the stock market has come at a very high price. Bye-bye commodity super-cycle!
I was also surprised by the 2X out-performance of US stocks compared to international equity indices. Some was due to currency but not all. There were major geographic performance differences over the last ten years.
US REITS (RE) edged out US large cap stocks by a slight margin over the last ten years. We expected a larger margin of out-performance but we had forgotten that in 2007 REITS were a precursor to what would happen during the Financial Crisis.
Emerging Market Debt proved to be a revealing surprise with a 97% total return. Pretty close to US equity market returns and vastly superior to international equities. Much lower volatility too.
The 91.7% return to the 60% S&P 500/40% Barclay Aggregate portfolio. The balanced portfolio lagged the S&P 500 by only 0.59% on an annualized basis but with much lower short-term volatility. Not bad for such a simple portfolio.

Insights to Share:

The short-term noise in the capital markets can obfuscate long-term secular changes as well as disproportionally focus the mind on events that over the long-term have little to no significance.
Expect lots of variability from year to year in terms of performance but over longer-term periods asset values will converge toward the fundamental drivers of return – income generation, growth and valuation.
To reinforce the previous point, a lot of capital market volatility is just noise and should be ignored unless there is a change to fundamentals.
Simple strategies such as the annually rebalanced 60/40 portfolio can prove sometimes incredibly effective at managing through the daily fog of markets
Effectively distinguishing noise from fundamental signal is the key goal of capital market research. Capital markets are always evolving but the fundamental drivers of return and associated risk should be the backbone guiding your perspectives.

Sincerely,

Eric J. Weigel

Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

A Marriage of Necessity but with Benefits

One of the key underpinnings of modern-day investing is the concept of diversification. Adding assets to a portfolio will almost universally lower the overall volatility of a portfolio assuming that the correlation between the investment in question and the portfolio is lower than one. As the correlation falls the greater the drop in the volatility of the portfolio, i.e. the greater the diversification benefit.

Investors often fret about the lack of diversification opportunities in capital markets. The sentiment is especially pronounced during equity market selloffs such as what we have experienced this year.

Investors have been often discouraged by the high correlations observed among investments in the same asset class. For example, the early day (70’s and 80’s) arguments for increasing exposure to international equities hinged on the portfolio diversification benefits accruing from the low correlation between US and international stocks.

Sometimes expectations need to be re-adjusted. Unfortunately, as US investors increased their exposure to international investments and both US and foreign domiciled companies became more globally integrated the net result was a significant upward drift in correlations and a loss of diversification benefit.

The same story can be told about emerging market and even domestic small-cap investing. Investors looking for significant divergent behavior among equity sub-asset classes have been generally disappointed. Our latest estimates of the correlations of the S&P 500 to US Small Caps, International Stocks and Emerging Market Equity are all north of 0.7.

The long-term performance of these equity sub-asset classes will naturally gravitate towards their fundamental value, but over shorter holding periods the pull of the broad equity market factor will be unmistakable. Style, market cap and sector membership are secondary to what happens to the broad equity market. The market effect dominates.

The same applies within other asset classes. For example, in fixed income markets the most significant pull comes from the interest rate on sovereign bonds. Other factors such as credit are often secondary in explaining return movements. Again the market effect dominates especially over shorter holding periods

So where does that leave investors looking for a little zig when their portfolio zags? The answer is so simply and obvious but the message is often ignored. Bonds, bonds and more bonds. In recent times investors have shown a strong dislike for fixed income especially in light of the low prevailing interest rates.The same applies within other asset classes. For example, in fixed income markets the most significant pull comes from the interest rate on sovereign bonds. Other factors such as credit are often secondary in explaining return movements. Again the market effect dominates especially over shorter holding periods

From a prospective return perspective we agree, but, in our opinion, investors are forgetting about the diversification benefits of bonds. Bonds (especially high quality) represent the most direct and least expensive form of portfolio risk reduction available in todays’ markets.

Our current estimates of the correlation of US stocks to high quality domestic and developed international debt markets are south of -0.3. Ok, correlations have been lower in the past, but they have also been higher. In fact the average correlation of US stocks and bonds over annual holding periods is indistinguishable from zero.

Is it a free lunch? No, not given the low interest rates on bonds today, but compared to the costs of using other forms of portfolio protection plain old bonds seem to offer the lowest opportunity cost with the lowest execution risk. The way we look at it is that the below normal yields are the premium you must pay to protect your portfolio.

Let’s look at a simple case using a portfolio composed 60% of the S&P 500 and 40% of the Barclays Aggregate. We are assuming that stocks have a volatility of 16% and bonds of 6% (these are currently our long-term normalized estimates).

The benefits depend on the volatility of stocks and bonds as well as their degree of co-movement. Historically, the correlation between stocks and bonds in the US has been about zero. Under such a scenario, the 60/40 portfolio would have a volatility of 9.9%.

There have been long periods of time, however, when the correlation has actually been positive. Stocks and bonds moving in the same direction either up or down. Let’s assume a modest correlation of 0.2. Under such a scenario the diversification benefits still accrue but at a lower rate. The 60/40 mix now exhibits a volatility of 10.4%.

What happens when the correlation between US stocks and bonds is actually negative? The simple answer is that the diversification benefits are significantly enhanced. Let’s assume a correlation of -0.2. This estimate is in line with our current estimate from our proprietary multi-asset class model. Now the 60/40 portfolio has a volatility of 9.4%, a full point lower than the earlier case.

Why stop there? Let’s push the envelope and assume a stock/bond correlation of -0.6. Quite dramatic for sure but not out-of-bounds from previous capital market experience. Now the benefits are further enhanced with the portfolio exhibiting a volatility of 8.4%

The role of bonds should be seen from the perspective of the total package of benefits. Historically, the role of fixed income has been income generation, but in today’s environment investors should focus as well on the diversification benefits created by mixing bonds with equity-like assets.

Bonds (especially high quality) represent the most direct and least expensive form of portfolio risk reduction available in todays’ markets. Incorporating bonds into the mix will be especially important in risk on/off markets such as those we expect to prevail over the next few years.

Let us hope that the marriage between stocks and bonds which at times has been a bit awkward remains beneficial as we transition into a low capital market return environment.

Sincerely,

Eric J. Weigel

eweigel@gf-cap.com

Managing Partner and Founder of Global Focus Capital LLC

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

Category Archives: Asset Allocation Strategies

What We Expected:

What Surprised Us?

Insights to Share: