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

Feeling a Bit Deflated This Year?

With the rough start to 2016 most investors are feeling a bit deflated. Not only are most asset classes in the red but now there is even talk about the dreaded D word – Deflation.

In this report we look at deflationary conditions around the globe and the likelihood that such forces persist over the foreseeable future.

We share our thoughts on the issue of negative short-term interest rates and the ability of monetary policy to spur growth to levels more consistent with the potential productive capacity of the global economy.

Finally we assess the implications for key asset classes in the face of changing inflation expectations.

Some of our report conclusions:

The specter of deflation is already present in countries such as Greece and Switzerland and is not far off in a large number of other economies particularly those in Continental Europe
Over the last ten years no country in our sample has experienced a negative annualized inflation rate but Switzerland (0.25%) and Japan (0.31%) have come close
When using the Output-Gap to measure the divergence between current and potential levels of production, global growth has been disappointing for seven straight years
Despite massive monetary stimulus, the negative global Output-Gap of the last seven years highlights that impediments to global growth are likely to be structural in nature
Using negative policy rates are unlikely to sufficiently boost global growth and most likely will bring about an increase in investor uncertainty
Equity oriented asset classes would dis-proportionally benefit from an increase in inflationary expectations while high quality bonds would suffer
According to our macro risk factor model, the primary beneficiary of rising inflationary expectations would be at the moment Emerging Market Equities

Click here to download the report: “Being Back That Old Inflation Please”

Sincerely,

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

eweigel@gf-cap.com

Is It Time to Get the Bear Market Cufflinks Out?

It’s been a while. In fact, I think I bought my cufflinks when there was no such thing as business casual. In other words, a long time ago!

I was in business school during the 1987 crash (so that does not count), went through the 2000-2002 bear market as a growth manager and hopelessly repeated the experience in 2008. I do not recall those markets with any fondness. Learning opportunities yes, but painful nonetheless. I still would have preferred watching a three day long cricket match!

It sure feels like we are entering one of these ugly markets again. I did not think that we were going to have such a nerve wracking start to the New Year, but Bear Markets are unpredictable.

While the warning signs were there for subdued equity market returns – high valuations, little to no EPS growth, collapsing commodity prices – our research still favored risky assets over safer investments such as Treasuries. Especially in a low inflation, accommodative monetary policy environment.

We have been in the “low return environment” camp for a while now, but have favored over-weighting equities and REITS over long-term horizons. But as Keynes once said “in the long-run we are all dead” so that leaves us to live our investment lives in the present. And that is precisely the problem.

With all this noise around us the fundamentals start looking fuzzy. We know it’s been bad but just how bad?

We use our Technical Classification system to learn about the positioning of the overall equity market.

Our system employs 50 and 200 day moving averages in relation to the current price and classifies each stock into one of six technical stages.

Currently, 60% of stocks in our global universe are in the Down Trend Stage – these are Bear Market numbers!

Bear Markets are typically categorized by a large proportion of stocks in the Down Trend Stage – typically 60% or more.

In the early stages of a Bear Market the next highest proportions tend to occur in the Deteriorating and Break Down Stages – these are stocks that most often were the last Up Trend stocks of the now gone previous Bull Market.

The situation as of mid-January resembles that of an early stage Bear Market.

60% of our global sample is in the Down Trend Stage.
18% are in the Break Down and 9% in the Deteriorating Stages.
Only 8% of our global sample is in the Up Trend Stage – as of a year ago that number stood at close to 60%.

Is the whole global equity market in the Down Trend Stage? Let’s look at some equity markets around the world.

In the US things have been nasty (only 6% in Up Trend) but things have actually been worse north of the border in Canada where 81% of stocks are in the Down Trend Stage.

In China 62% of companies reside in the Down Trend Stage.

Among the largest markets only Germany and Japan enjoy less than 50% of stocks in the Down Trend Stage. All of these numbers are significantly higher than 30 days ago!

The highest pain market is Brazil. Somehow, I doubt that the “Olympic Games” effect will be sufficient to offset the downturn in equity values.

Is this the beginning of a Bear Market or just a Correction?

Equity Market turning points are, in our opinion, impossible to predict with any reasonable amount of confidence. Our approach examines the weight of the evidence and as of now we still believe that we are in a correction rather than in the early stages of a Bear Market.

Our perspective is that equity markets are in for a long-period of below average returns, but not a Financial Crisis type of meltdown. In a slow growth, low cost of money environment our research still favors risky assets such as equities. We would view the current period of market stress as an opportunity to deploy capital at more favorable return-to-risk terms.

Eric J. Weigel

Managing Partner

eweigel@gf-cap.com

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. IS NO

It’s Already Been a Stomach Churning Ride!

Hope you’re buckled up

Who would have expected this start to the New Year? After a fairly humbling 2015 most investors were looking for a bit of a break heading into this year.

Yes, equity markets, especially the US looked expensive when judged relative to history using traditional metrics such as P/E and P/B.

But in the context of low interest rates and relative to other major asset classes our research was more consistent with a “dull” equity market offering below average returns, not a meltdown off the bat.

Of course we have also been saying for a while now that capitalmarket volatility is too low and that a whole generation of investors has become hyper sensitized to the smallest blip in uncertainty.

The memory of 2008 unfortunately still permeates our thinking. Investors as a whole have forgotten that while equities tend to out-perform safer assets occasionally you have to go along the ride and find yourself holding on for dear life on a roller coaster.

While everybody has already heard all the usual explanations for the correction, in all honesty, we have been taken aback by the suddenness and magnitude of the equity market downdraft. Let’s briefly review.

High Quality Fixed Income Has Been the Only Place to Hide

Fixed income strategies have been the only true hedge for equity market risk
Superior fixed income performance has been associated with higher credit quality and extended maturity
US small caps have dropped the most, down over 8% (as of 1/11)
Precious metals have behaved like in the old days, i.e., as a safe haven asset during periods of market stress

All Equity Regions, Industries and Styles Have Suffered

All major global regions have suffered with Latin American equities down the most
China is YTD the worst performing equity market
Energy and Materials have once again been the worst hit sectors
Some “smart” beta tilts such as Low Volatility and Dividend Growth have delivered smaller losses than core indices

Mixing and Matching Asset Classes Has Not Immunized Investors From Pain

Of the six multi-asset class strategies that we track, only our All Fixed Income strategy is in positive territory for the year
The more equities in the mix the more pain investors have felt
Even the plain vanilla 60/40 strategy was down more than 3% last week

Equity Downdrafts Create Some of the Best Stock Picking Opportunities

Early in my career I used to hear how corrections were healthy for investors. However I never felt that corrections did anything but make my stomach churn. Corrections have always made me nervous, but with the benefit of experience I have come to see corrections as often ideal starting points for picking up beleaguered stocks assuming an unchanged fundamental picture.

Our view at Global Focus Capital is that equity market fundamentals have not materially deteriorated thus creating additional opportunities for stock selection. The list above highlights some stocks ranked by market cap deemed as attractive by our stock selection methodologies. All these stocks have had losses exceeding 10% YTD.

We offer this list purely as an illustration of possible attractive stock selection opportunities and make no representation as to the suitability of the stocks in an investor’s portfolio. We view such a screening exercise the same way a fisherman uses a fish finder – it alerts you to opportunities but you must still exercise judgment and possess skill to make the catch!

Sincerely,

Eric J. Weigel

Managing Director and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

(617) 529-2913

The Equity Observer – Issue 1

This month, you can download the first issue of my monthly equity-oriented publication, The Equity Observer, for free.

In this issue, we thoroughly examine the global equity markets by breaking down performance along region/country, sector/industry and style factors. Our goal is to identify pockets in the markets with attractive reward to risk opportunity both from top-down as well as bottom-up perspectives.

Taking a holistic view of the global capital markets, The Equity Observer answers the critical questions that impact forward looking portfolio returns.

What is the current state of investor risk aversion? What regions or industrial sectors show the greatest potential for attractive returns? What does this mean for long-term and short-term oriented investment strategies? What equity styles are being currently rewarded and are there any nascent emerging trends?

Perspectives on Global Regions, Sectors and Stock Selection Themes – Free Report

The Equity Observer

Facing slowing global economic growth, no inflation, currency market turmoil, and high levels of political tension, the final quarter of 2015 poses unique challenges for today’s investors. Regardless, among these significant market risks and question marks, opportunities are available in many market sectors and geographic regions for savvy equity investors.

In this month’s free report, we examine equity performance in the U.S., Asia, Europe and Latin America as well as various industrial sectors throughout 2015 as a whole and in recent weeks. We provide insight into stock selection opportunities and analyze the key issues facing equity investors in the coming year. Most importantly, we breakdown the implications of these factors and provide recommendations on equity portfolio positioning strategies.

Enter your email address below to receive this free report instantly.

Perspectives On Potential Asset Class Returns, Risks and Portfolio Positioning – Free Report

After years of consistent growth and above average market returns, mid-2015 has brought a return to volatility raising new levels of investor fear not witnessed since the financial crisis. Is this volatility here to stay? Is this the calm before the storm? How should investors react to this new market turmoil?

In this month’s report, we offer the latest research on the potential risks and returns of various asset classes including bonds, stocks, real estate and commodities. We also break down the risk profile of various multi-asset strategies including macro-economic factors. Assessing the level and source of risk is key in understanding portfolio positioning. Using this framework, we then provide options for portfolio diversification based upon investor goals and time horizons using our signature Global Focus Capital multi-asset class approach.

Enter your email address below to download this free report.

Category Archives: Global Macro

Is It Time to Get the Bear Market Cufflinks Out?

High Quality Fixed Income Has Been the Only Place to Hide

All Equity Regions, Industries and Styles Have Suffered

Mixing and Matching Asset Classes Has Not Immunized Investors From Pain

Equity Downdrafts Create Some of the Best Stock Picking Opportunities