MOVING TO NORMAL
Our main theme for the next 12 months is moving back to ‘normal’. We believe that investors will leave behind the mindset of doom that reigned during the last two years and go back to a more rationalassessment of the newly found economic balance. This is what we think will become to be defined as the ‘new normal’ and will be characterized by the following factors:
REFOCUSING ON THE STABLE LONG TERM CONVERGENCE OF EMERGING MARKETS.
The last two years have been, from a variety of perspectives, one of the most challenging periods in financial history. Many certainties have broken down and even as we speak, most investors are still struggling to comprehend the end results. However, during this period, emerging markets have shown resilience and their long term convergence has accelerated.
The world is moving to its pre-industrial revolution economic configuration where productivity differences among the various regions were low. Historically, Europe and the US accounted for not more than 15-25% of the World’s GDP. After the industrial revolution, this started to significantly increase and reached a peak of 53% in 1950. As both Capital and information have globalised, this share of GDP gradually slid to the 36% it represents today. Throughout history, Africa and Middle East’s share of GDP accounted for 60%-80% only to shrink to 22% in 1950.
In the last 60 years, we have seen a consistent convergence of these regions, bringing them back to their historic levels and their current share of global GDP stands at 46%. Most investors, however, have not sufficiently adapted their portfolios to profit from this shift and tend to allocate not more than 10% to these three regions. Moreover, most of this allocation is invested in Asia, despite the fact that Africa and Middle East are increasingly better positioned in the new global economic order and, just like Asia, they have shown strong resilience to the global downturn in 2009.
VOLATILITY, CORE AND SATELLITE.
Moving back to normal does not mean moving back to low volatility. Global markets have experienced during the last few years long periods of relatively low volatility combined with short periods of extreme swings in both valuations and investor sentiment.
Average annualized volatility in the period 2003-2007 settled down to less than 10% but it returned in 2008 and we believe it will stay with us for the foreseeable future. The form of this volatility will, however, be different. We will see more extreme spikes.
Historically, stock markets move 20% or more in only in 1% of quarterly periods. However, during the last 5 years this was the case in 6% of quarterly periods. It is increasingly clear that Investors need to position themselves to benefit from long term cycles and be prepared to deal with moments of high volatility in the short term.
During the recent past, most investors have failed to manage their asset allocation in a way that protects them for short term woes and destroyed much long term value by making poor decisions driven by sentiment. They have sold their best long term bets during periods of volatility, often only shortly after having invested. The best example is how even the most sophisticated investors sold completely (or partly) their emerging markets exposure at the end of 2008. Most of them went back into the same emerging markets in the summer of 2009 missing out on a big part of the recovery as many of these markets increased more than 100% versus their lows. To avoid situations like these, investors need to turn their understanding of the traditional core satellite approach upside down by putting in the core of the portfolio the long term, less liquid and often more volatile investments. At the same time, investors would gain more control of the risk profile of their portfolios by building the satellite portion of the portfolio out of the more liquid and less volatile asset classes. They are usually easier and more economic to trade and have the benefit of the existence of derivatives to offset the occasional volatility of the core investments. As an example, consider the allocation to low yielding euro fixed income as a tactical decision while the allocation to emerging markets should be a core part of the portfolio.
This will allow investors to avoid selling their best bets at the wrong moment and buying them back when they are close to becoming ‘expensive’. There is empirical evidence that in traditional asset allocation, most investors are often forced to make the wrong decisions at the wrong time.
HOW DEBT AND LOW CAPACITY CAN CREATE INFLATION
Inflation in developed countries in the last 20 years somehow seems to have vanished. It may be coming back but the timing is uncertain. The case that supports this is the combination of overleveraged economies and decreasing capacity in the corporate sector. Total issued debt by governments and private sector accounts for more than 200% of GDP in most developed economies.
The fact that low interest rates over the past decade have spurred a glut of lending could be exasperated by the possibility of an increase in rise of marginal lending rates. Every 1% increase in rates has a multiplier effect and essentially shaves off 2% from the actual total GDP. This in turn pushes governments to increase taxes to the same extent and will force the corporate sector to increase prices.
The major debate is not ‘if’ but ‘when’ this happens and unless economies remain in a nil growth scenario, higher inflation levels are due to return. The second factor supporting the case for the return of inflation is the successful effort by companies in cutting down their excess capacity and increasing their pricing power during the latest downturn. As a result, corporate net earnings delivered surprisingly strong numbers for 2009. While sales numbers declined, many companies were somehow able to increase net earnings. This may be good for investors but in many cases it was bad news for the consumer. Two examples are the retailing and airline industries which have both kept their losses to a minimum by consolidation and in many cases price increases.
A return to positive growth could result in supply disruptions (where the suppliers do not increase capacity but simply increase prices). We observe that emerging markets are moving in the other direction. Essentially, they have been cutting interest rates as their governments have been increasing tax revenues while proving to be better at managing inflation. In addition, they have been increasing capacity and competition is intensifying. An interesting example that booking a European economy flight from London to Helsinki can easily cost you more than an intercontinental flight from Europe to Asia using a stopover in the Middle East.
LOOK AT JAPAN FOR WHY DEFLATION IS ALSO POSSIBLE.
Especially in Europe, deflation is a probable scenario and the markets are focusing on this rather than the return of inflation. This problem is mainly created by low population and anaemic levels of productivity growth. The first factor is relatively straightforward: an ageing population and a hostile immigration environment do not help to increase internal demand.
The other factor is how investment attitudes could be a catalyst for deflation. Japan has in the last years been relying almost exclusively on its domestic investor base to finance its budget deficits. Bear in mind that around 93% of Japanese public debt is held by local Japanese investors. Europe increasingly seems to be following a similar path where its pension funds and savers are happily putting their money in low yielding instruments without demanding a real return on their money. Whereas mutual fund assets to GDP in the US account for around 70%, Europe invests less than 35% in such vehicles and prefers to keep its money in savings accounts.
Furthermore the equity exposure in a typical investment portfolio or pension fund is much lower than that of the US. European countries are showing many similarities to what is going on in Japan and are financing their deficits in a similar way. Once again, while short term concerns about deflation persist, investors will be lured to the growth dynamics of emerging markets. As such, short term deflation concerns or long term inflation fears will both, ultimately, play in favour of our vision of investing in Africa, the Middle East and Central Asia.
THE UTOPIA OF A FREE LUNCH
Investors will keep on looking for strategies which promise great returns without risks. The reality is that complex financial products eventually contain risk, governments can default and hedge funds do not always hedge. The most recent example of the ‘free lunch’ was Dubai’s Nakheel. Investors were expecting to receive full governmental support despite the fact that this was not stated in the investor prospectus. Investors received a spread above governmental yields, so there was clearly a degree of risk that was priced in with regards to this debtor. Investors got a ticket to a ‘free lunch’ as the Nakheel bonds were repaid in full. This was however a rare and benign gesture as most issuers would not be expected to be so hospitable towards investors.
Investors should become more realistic and avoid being caught by panic when market sentiment turns negative. There are clearly solid long term trends in this world but one must be prepared to face short term surprises. It pays off to diversify your investments and to remain invested for the long term. The good news is that the basics still apply: achieving returns goes hand in hand with taking measured risks.
WHY 2010 WILL BE THE YEAR FOR AFRICA, THE MIDDLE EAST AND EURASIA.
2009 was a great year for emerging markets but the smaller markets did not follow this major trend and some have ended the year underperforming the major EM indexes. While the BRIC equity markets ended the year with an 86% increase in value, the frontier African markets showed a negative return of -16%. The Arab markets ex-Saudi Arabia ended the year with a very modest positive return of around 5%. South Africa and Saudi Arabia did relatively well but even these two regional heavy weights could not keep up with their peers in the emerging markets space. We can’t find any real logical reason to explain why a country like Russia can go up by more than 100% while so many Arab and African markets have ended the year with a negative return. Especially when considered that the underlying macro dynamics are very similar.
Despite the global slowdown, most Arab, African and Eurasian economies have continued to expand and are projected to achieve significant growth rates in 2010, ranging between 2% for South Africa to close to 18.5% for Qatar. This places these countries amongst the fastest
growing economies in the world and again highlights the resilience of these markets. The local companies are directly benefiting from this strength as they are best positioned to profit from these favourable dynamics. Over time we have seen that earnings have typically grown at multiples of 3-5 times that of GDP growth and this rule is also likely to apply in 2010. It doesn’t require too much thinking to realize that investing in a Qatari firm which is servicing an economy which will grow by 18.5% is a pretty good investment idea, even if earnings only grow at the same rate as its underlying economy.
However, many investors still need to comprehend this reality. The countries in our target regions are relatively new on the global investor’s radar screen and local players needed time to absorb and react to the big correction that most of the markets have witnessed. It may take some time before the global financial community gets a good understanding of this investment case, but there are potentially large rewards for those who are first to move. It is often too late to reap the benefits when an opportunity has gone into the mainstream. In addition, it also takes time for local investors to understand that corrections are healthy and create an environment in which strong businesses can be distinguished from the weaker ones.
Looking back, it took time and a dose of growing pains before Asia and Latin America became the mature emerging markets they are today. Many of those who remained invested over the past 10 years or more can testify to having enjoyed returns in excess of those derived from developed markets.
Most economies in Africa, the Middle East and Central Asia have proven in 2009 that they are able to deal with a downturn in the global economic cycle. Their economies have grown despite a drop in global trade and commodity prices. Generally, global investors have failed to recognize this achievement which resulted in an underperformance of the African and Arab markets versus the major emerging markets, also known as ‘BRIC ’.
Over the last few years, Arab markets are down close to 50% while African markets are up close to 20%. Compare this to the ‘BRIC ’ markets, which are up around 140% from their lows. What is interesting to note is that African markets quite closely tracked the performance of the BRIC s in 2008 but failed to do so in 2009. This relative underperformance should dissolve over time as these regions represent similar growth dynamics as the BRIC countries. They have similar GDP growth rates, high reserves, big populations and an increasingly diversified corporate sector. On average these countries score around the
same level when comparing strength of institutions, ease of doing business or levels of corruption.
The capital markets of Africa, Middle East and Eurasia are in an early stage of development and their initial investment case was too much positioned as non-correlated bullet proof asset class or even more simplistic, it was often regarded as a pure commodity play. The most important catalyst for economic growth in Africa is the impressive improvement of institutions and infrastructure. Somalia is as much an exception to Africa as is North Korea to Asia.
The Middle East has found its niche in the world economy and has already rebuilt its historic Silk Road connections to Asia and Africa. Its petrochemical and logistics sectors are among the most competitive in the world and its open business climate has attracted talented professionals from all over the world. This is the real reason why these economies have done so much better than other regions rich in commodities.
The big lesson for investors going forward is thatdespite the fact that their economies are resilient, it doesn’t always mean that their capital markets enjoy the same strength. Furthermore resilience does not mean the same as being ‘bullet proof’ and should tolerate failures such as the recent example that we have seen in the real estate sector in Dubai.
Valuations serve as a good guide to explain the failure of investors to fully recognize the investment opportunities in Africa, the Middle East and Eurasia. In these markets, companies trade at price earnings averages of 10-15 times while those of their emerging market peers are at around the 20-25 mark. Most economic studies have shown that investing in markets with low PE levels eventually pays off and in this respect investors currently have a unique investment opportunity to invest in this high growth region at distressed valuation levels.
With regards to fixed income, we are seeing a similar picture as global emerging market debt spreads moved from spreads in excess of 700bps end of 2008 to below 300bps as of present.
Most African, Arab and Central Asian countries are still trading at near crisis level spreads. As markets revert back to ‘normal’ in 2010, we expect that our markets should also go back to their historic valuation levels, which would mean that they will catch up with their emerging markets peers. This represents significant upside potential and for some markets it could very well result in an upside potential close to 100% in a short period of time. BRIC markets have shown in 2009 that such moves are possible.
CONCLUSIONS
The world will return to a more ‘normal’ environment in 2010. This does not mean that investors should return back to the best practices of the past. The economic environment has changed and the new normal is different from the old. Investors should work on reconfiguring their portfolios to profit from the long term convergence of emerging markets; they should accommodate investments in Africa, the Middle East and Central Asia as a core position in their portfolios and apply a more tactical approach to investing in more liquid and developed markets. Not only do we believe this should be done in order profit from the economic growth potential of these regions but it would also allow investors to cope with inflation/deflation risks of the developed world. Africa, Middle East and Eurasia have, at the economic level, shown great results in 2009. Their equity and fixed income markets have lagged. This is however an anomaly that will sort itself out as markets return back to ‘normal’.
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