Thu, 4 Oct 2012
Accuvest Global Advisors' David Garff discusses the benefits of using CDS spreads in evaluating country-specific risk, how he looks at country correlations, themes driving non-U.S. equities, and more.
Andrew Gogerty: Hi, this Andy Gogerty at the Morningstar ETF Invest Conference, and we're looking at global equities today with David Garff, the president and CIO of Accuvest Global Advisors. David, thank you for joining me.
David Garff: Thanks for having me.
Gogerty: So, a lot of people--and even in the ETF managed portfolio space--there's this resurgent or this focus on U.S. equities. The S&P is up 10, we have an election, we have financial considerations and constraints in the market, but some of the global markets haven't exactly been a slouch. EFS is up around 10 and so are emerging markets. What are some of the key themes kind of driving non-U.S. equities this year?
David Garff: That’s a good question. A couple of things about the way we think about the world. First of all, we think about it from a country-by-country perspective. So, for example, if you said emerging markets are up 12, well, you might be surprised to know that India is up 25 and Brazil is down 4, right, because they are part of the BRICs. If you look at Europe and said oh, Europe's a disaster. You know, Spain is down 8, Italy is up 3, well, you'd be surprised to know that Germany is up 26 and Belgium is up 34. So there's a great difference from our perspective in terms of what the individual countries are doing, and so that's the way we look at the world.
If you look at the countries that have done well, they have a couple of characteristics. Number one: They have very strong fundamentals. So, earnings growth, sales growth, acceleration are leading indicators. They also have strong momentum. They've done well in the short and intermediate term. So those countries have continued that trend. They tend to have a little bit lower risk profile, so narrowing CDS is an example or currencies that are maybe a little bit less valued or less overvalued, more undervalued. And then the countries that really actually have not performed as well are those countries that were cheaper and so if you looked at them from a factor perspective, you know, value factors really didn't do anything well as momentum has been extremely strong.
Gogerty: How about the factor, you know, you mentioned some of the overarching or macro factors you would look at. You talked about earnings growth. Where does either GDP, or relation of debt to GDP, play in, because obviously the U.S. story is going to be one of the focal points this year especially with an election? But I think a lot of people might be not focused on it because the S&P is up 10 despite all this uncertainty. Where does that GDP debt consideration come into some of the factors and some of the outcomes this year of the different countries?
Garff: We don't look at GDP. Actually, we look at acceleration and deceleration of leading indicators. If you look at a correlation of GDP to performance, it's essentially 0.1 and so--because GDP is a lagging indicator and gets revised, it's not predictive of anything, so that's the first thing. The second thing is on the risk side we are very, very careful about thinking about things like CDS.
So, if you look at the CDS level of a country, it is one of those few numbers that you get that you can compare across countries that really tells you what the world thinks about “risk” in that country and so a country with the CDS like the U.S., which is 25 basis points, and a country like Spain, which has CDS of 350, there is a big difference.
However, Spain has come from 600 basis points to 350 basis points, and so the risk profile there, despite the fact that the CDS is extremely wide, has narrowed considerably and so the world is starting to vote with their money, if you will. So we take those into consideration a lot. The debt aspect of things really gets encapsulated into that number, which is one that’s very important to us.
Gogerty: That sentiment looking at CDS is kind of like a sentiment of strength. Does that drive the momentum? If other countries came in like Spain or blew out would that be reflected in the momentum of the indexes of those single countries that you're looking at or is it not correlated? Is it a different input?
Garff: So for the risk factor, or the risk ranking, we want lower-risk countries on average than high-risk countries. So countries with narrowing CDS get moved up in the rankings. Countries that have low CDS in absolute terms get moved up in the rankings. The momentum really is the relative price movement in local currency terms, so not in dollars, but local currency terms of the different indexes.
So if you think about it: A country that has really strong three-month or six-month price momentum is going to be affected a lot by the last couple of months. Whereas a country that has strong 12 minus 1 momentum, let's say, it's going to be a little bit longer to process. One of the things that we have seen for sure and this is across literature, it's across asset classes, in securities and regions and everything is that momentum is persistent and so we want to make sure that that price momentum, that relative price momentum, is something that we take advantage of.
The other side of that is--again coming back to the risk element of it--is CDS narrowing? We like that, because risk is then decreasing. In a similar way if you took a portfolio of minimum-vol securities--absolute vol and semi-standard deviations are some things that we actually look at, as well. But if you think about lower vol as being something that's good, you just have to think about at a country level rather than an individual security level, and that's where we kind of come out on that.
Gogerty: Going back--maybe taking a step up in the big view away from the technicals into the portfolio construction: If you want a non-U.S. equity exposure, ETFs give you the ability to do it. You can do it by country, you can do it by region, or you could do emerging markets versus developed and you’re done. What are the considerations that advisors need to be aware of if they are going to outsource to a single-country manager versus a broad-based regional manager that isn't looking at 25 or 30 specific countries? He is looking at maybe seven or eight regions around the globe, but still being tactical. What are some of the trade-offs or the discussions that have to be made with the client to set the right expectation there?
Garff: This comes back to the way we look at the world. We are global managers. Our Latin clients say we're the most Latin gringos they've ever met. So, we think about the world from a top-down perspective, always have--that's in the DNA of our firm.
Just look at the difference in returns. Just look at Spain versus Germany. Germany has been in the top half of our model, Spain has been in the bottom half of our model, and there is alpha to be generated there--and sometimes substantial, even within countries that you might find in different regions. So, if I said to you, we're going to buy Europe 12 months ago, you'd be like, I don't think that's a good idea.
Gogerty: Mainly because of Spain.
Garff: Mainly because of Spain, Italy, France, the Netherlands, Belgium--all basket cases. Germany may be strengthening, but you don't want to buy all of that other stuff that you don't want to get the one country that you do want. So, from our perspective there is opportunity out there. I would never say that you can't make money rotating between emerging markets and developed markets or between regions.
We just think that it's a better mouse trap to look more in a detailed level at the countries. And really to be honest, the most important thing is to be consistent and disciplined in your approach. I mean we are not going to be the smartest guys in the room every day. I'm just telling you that right now. For a money manager to say that, I guess that's not good marketing.
I mean to say, I like Brazil. I mean just think about Brazil for a second: 12 months ago, what's the word on Brazil? Resource economy, they have the Olympics, they have the World Cup--everything is going to go right for Brazil. Yet, Brazil is one of the worst-performing countries in emerging markets this year.
We don't want to be reading the research report from the sell side that says buy this, and that sounds pretty good so I think we'll buy it. We want a way to look at the countries again from a consistent and disciplined and repeatable way, so that we can separate the wheat from the chaff. It works most of the time; sometimes it doesn't, like any other strategy. But at the end of the day, I can go to sleep at night, saying we've looked at this from as many perspectives as humanly possible. We've compared these countries apples-to-apples, and so therefore somebody should feel good about allocating some assets to the strategy. Whether that's a global core type strategy, kind of an all-world strategy, or something more concentrated like global opportunities.
Gogerty: One last follow-up to that about not taking the regions, but taking the countries. Going back, looking over the last three to five years, what has been the correlation between the 10, 15, or even 20 biggest countries? Does the correlation matrix between them, of how they move on the different factors, oscillate or are they pretty consistently diversifiers to one another? Just because if I buy a region, I'm getting the whole region--you're saying there's value there. I'm sure the correlations have changed, but what's been the trend in that matrix over time?
Garff: I actually wrote a white paper about this in 2011, about if countries still matter. One of the questions we asked was what are the correlations, what are the average correlations between the countries and the equity? What you see is there have been, since 1990, five times that we've hit these correlation levels which are like on average 0.8.
So you might say well that's not very good diversification, Dave. I mean, 0.8 doesn't really help very much. But having said that, those cycle and those average correlations have been as low as 0.5, 0.4, 0.2 over 12-month periods. Those tend to be times when you're not getting what we saw in the great moderation, which is fiscal and monetary policy that is concerted across the globe by all that.
So 12 months ago or 14 months ago, you started to see divergence. You started to see certain countries raising grades, like Australia and Canada, and so as they take their own pass from the fiscal monetary standpoint, there's going to be more divergence. The average difference in performance between the highest-performing country and the lowest-performing country since 1986 is 32% per month. That's an average, and obviously some months are much higher and some months are lower, but we've run for the last five years about a 22% average differential on a monthly basis.
Even in those really, really tight highly correlated markets, that number is about 15%. So despite the fact that they might be more highly correlated, you still get a benefit in terms of trying to generate some outperformance. And for anybody that says correlations are one, I challenge you to show me how Germany’s and Spain's performance for the last 12 months equates a correlation of 1, when one is down 8%, and the other one is up 25%.
Gogerty: Great. Well, thank you for your perspective today, not only on global equity, but on the technical factors driving it. I appreciate your time.
Gogerty: This is Andrew Gogerty with Morningstar and David Garff from Accuvest Global Advisors. For more information on ETF managed portfolios, visit MorningstarAdvisor.com. Thank you.