Fri, 6 Dec 2013
The growth story is intact for emerging markets, but it won't unfold overnight, says Seafarer Capital Partners CIO Andrew Foster.
Jason Stipp: I'm Jason Stipp for Morningstar. Even as the S&P 500 heads toward a 30% year-to-date gain, diversified emerging markets funds, as a group, are still narrowly in the red. But Andrew Foster, CIO of Seafarer Capital Partners says that investors need to keep perspective on emerging markets. He's called in today to explain. Thanks for joining us, Andrew.
Andrew Foster: It's my pleasure, Jason.
Stipp: In your November letter to shareholders, you wrote, "As frustrating as this year has been, I do not think it matters much to the long-term investor with an objective perspective." We've heard the story about emerging-markets' potential for many years, especially coming out of the financial crisis. But this year, developed markets not just beating emerging markets by a little bit, but by quite a lot. So, what kind of perspective can you give investors to keep us on track?
Foster: It's tricky to answer that question succinctly. One thing that folks often throw out is valuations. Right now, the emerging markets, at least on the surface, appear a lot cheaper than the developed markets in the U.S. They're trading at about 10.3 times forward earnings.
But even I would concede that valuations can be deceptive. There are some very beaten-up sectors within the emerging markets that drag the average down, and a lot of the good stuff that investors might pay attention to, and be excited about, is still trading at fairly high valuations, well above that 10 times multiple. So, I wouldn't say valuations are the easy thing to latch on to.
I struggle with this issue myself--keeping good perspective--but what I often do is go back to history. History helps ground me. I first study what's going on in the emerging world, and right now, there is a lot of structural change taking place. A lot of reform efforts are going on. They're messy, and they don't mean an immediate kick-start to growth, either at the macroeconomic level or the corporate profit level, but there are some good things happening.
I then spend a lot of time looking for analogs from history, often in other markets, and I especially tend to look at the U.S. itself in this regard. I look back at where the U.S. was in its historical development, and try to plot where I think the emerging markets are in that timeframe.
One interesting thing that I've been looking at is the structure of economic output in the emerging world. It's heavily driven by manufacturing, exports, and extraction of commodities and resources to the tune of almost 50% of the emerging world's output. The analog for that is the U.S. in about 1947--post-World War II. In other words, the emerging markets today look a lot like the U.S. did in 1947.
Today, our economy has almost 85% of its output in services, in non-physical goods, non-commodities, non-exports, non-manufactured products. I personally think this is where the emerging world will go, and the reforms that are taking place right now will unlock that potential to transition to more of a service-led economic model--one that is not so export-led. It's going to take time, though. The U.S. made this transition over 65 years.
So, I think about the history and think about the scale of time necessary to unlock that raw-growth potential, and I try and be as patient as possible. You don't invent a service-led economy that has a lot of the great stuff that we produce in the United States--research and development, software, biotechnology--overnight. I think it's coming for the emerging world. I see the seeds of it now. Reminding myself of the raw growth potential that the U.S.'s own history suggests, and then giving a sense of the timeframe, help.
Stipp: A lot of folks have their eye on China right now as one of the regions that is experiencing a lot of big change, as it is shifting from an investment-led to more of a consumer-led economy. This shift has caused divergent opinions about what kind of short- or intermediate-term impacts might come for the Chinese economy. As China is making the shift to have more internal consumption, what drivers are you looking at to gauge how smoothly that transition is going?
Foster: I mentioned the low portion of service-sector contribution to economic output [in the emerging markets]; China is the poster child for this issue. The economy is heavily tilted--historically, especially, although a little less so today--toward exports and manufacturing products for overseas markets versus internal domestic consumption, and especially, I would say, consumption of services versus goods. The Chinese have a lot of goods that they already consume, but it's the soft stuff--health care, transport, logistics, and leisure--that I think is where the growth is.
The transition is tricky, though, because it means there are certain delicate reforms that need to be undertaken that might go to the heart of undermining the Communist Party's power in the country. I'm happy to say the Communist Party seems to be embracing most of the key reforms. Here are some that I would single out as being probably the four most important in my mind:
First, I would highlight financial system liberalization and deregulation. Interest rates are controlled in the country, basically to prop up the banking system there, which is under the government's control. And also the currency is highly, highly regulated. It's not a free-floating or market-based currency at this stage. Happily, the government seems to be embracing at least a higher degree of financial system deregulation on both of those fronts, and I think that's a good thing.
The second thing, I would pay attention to is called "hukou reform." Hukou is basically a social entitlement system roughly equivalent in a very broad sense to our own Social Security system, but it's a very different implementation in China. It's basically the third rail of Chinese politics in a similar way. There is a reform effort going on in China right now to clean up that system. I think it's quite encouraging that they are seemingly going to touch the third rail and try to clean it up.
The third thing I would highlight is property rights. Property rights is a broad term, meaning legal property rights, but I especially mean in this case physical property--real estate. There are some really messy systems in place in China right now that have robbed individuals and households of their physical property rights, especially in the countryside, and that needs to be cleaned up. And again, the Chinese government seems to be making some progress, or at least is talking about doing the right things there. So, three out of four sound pretty good.
The fourth one is the most dangerous of all, arguably, for the Chinese party, and there's no progress on this front at this stage, and that's making an independent judiciary. The legal system, especially the judges, are very much beholden to the Chinese government. And while there's a little bit of progress on this front, I'm afraid until the courts are really independent and can enforce contractual rights, legal rights, and human rights, I think that China has some more transition ahead of itself.
Otherwise, some of the other changes that are taking place in the Chinese economy sound very fearful, and I'm afraid of some of them as well. Shadow banking often comes up. Shadow banking is a very complex issue. It is dangerous for China because it's opaque. It's basically private entities running end-around the official banking system, and there are some risks embedded in that. But it's not quite the same set of risks as our own shadow banking that we experienced in 2008. What you see happening in China is private entities trying to work around a broken banking system that is under state control, and at some level, this is a sign of innovation by the private marketplace. I admit it's very dangerous and risky innovation. But at the same time, it is modernization in a way that we shouldn't entirely dismiss. So, there is some good along with the bad.
Anyway, I think there are risks ahead for China, but I'm happy to report that at least ostensibly the Chinese government is addressing what I would call three of the four most important issues ahead of them. Time will tell whether or not they succeed.
Stipp: As we look at the performance of emerging markets this year, we've seen certainly there have been some headwinds, and perhaps one of the bigger ones is the Federal Reserve here in the U.S. and its plans to taper its stimulus programs. How are you thinking about this extraordinary federal stimulus that we've had from the Fed when you're investing in the emerging markets, which seem at least in the short term to be very sensitive to those activities?
Foster: It may sound crazy, but I don't think that tapering is as important as most people think. There is obviously a knee-jerk response happening right now when tapering is mentioned and emerging markets fall--currencies, bonds, and stocks all fall in unison. I think this is a red herring for the most part with a few key exceptions.
The emerging markets are facing a deficit of growth right now. They're not growing fast enough. But they do not have the sort of solvency concerns that higher global interest rates would prompt, like they did in the peso crisis of 1995 or the Asian crisis of 1998.
In the past, these economies borrowed too many dollars, and they were very sensitive to interest-rate adjustments as a consequence of that. This is really not the issue right now. What we've seen is a pricking of a mini bubble in emerging-markets fixed income and currencies. There has been an overindulgence in these two asset classes by some global investors, and so those investors are sensitive to interest-rate hikes, and it has hurt them. But it hasn't really gone to the heart of the economic growth of these markets.
I think the central banks in the emerging world need to focus on higher employment and focus on growth, and not worry about defending their currencies, quote-unquote, versus the dollar via rate hikes, because that was essential in the past when they borrowed too much in dollars. It's not so today.
A few markets are exceptions to the rule. India and probably Brazil and Indonesia all face some structural deficit issues, which means they have structural inflationary problems. They don't have the luxury of keeping rates low to stimulate employment and growth, as most other markets in the emerging world do. And I'm worried that those economies are going to have to hike rates at the same time the Fed does in order to quell inflationary problems. So, they may see their growth stall out as a consequence. But for the most part, I think this tapering issue is a red herring for emerging markets.
Stipp: Whether it's caused by the Fed making some movements that are perhaps overblown or oversold by some investors, or something else that causes a shock in emerging markets, how does your investment process come into play? Are these the sorts of markets that you can go in and find some of the opportunities that you look for? Do you expect to find or have you been finding opportunities in emerging markets?
Foster: We have been finding opportunities. I think the volatility this year in particular has thrown up a lot of opportunities as we have moved through it. There has been an enormous amount of intra-year volatility within the emerging markets, and more so than average that does present opportunities, because I really do think this tapering has been something of a broad-based red herring, even though some specific markets are more highly impacted by it.
We've been able to establish positions in some of the companies I think will be important not just for the next year or two, but really will be key parts of the industries that are driving growth over the next decade.
We are particularly interested in companies that are helping governments modernize--companies that are helping the public sector modernize the services they deliver to households. Companies in Brazil, for instance, even though Brazil has been very tricky. We have a holding there called Valid that is helping the government modernize the postal system and drivers licenses, the delivery of these key documents and licenses. This volatility intra-year has helped us accumulate positions at better prices. I think being patient and keeping your eye on the long term with the perspective I mentioned, means the volatility can work to your advantage.
Stipp: We track investor flows, when investors put money to work and when they take money out, and certainly volatility can be something that causes investors to have trouble capturing the returns of certain asset classes. When you are thinking about it from an investor's perspective, someone who wants to get access to these long-term trends that you've mentioned, how can we set ourselves up for success and not be distracted by the inevitable volatility we are going to see in the short term?
Foster: I think the age-old advice is to have a long-term investment horizon. I really do believe it applies to the emerging markets. They are too volatile to try and time in a one-year context. I personally would advise that unless a client or a shareholder can segregate some portion of their capital that they don't have to access and don't even really need to look at for five years, I would say, really think twice about whether you have the stomach for the volatility that the emerging markets present.
The second piece of advice I would have is this: Be careful about your foreign exchange and foreign currency risk in your emerging-market investments. I think a lot of folks were cheerleading both fixed income and especially foreign currencies to get away from the dollar. Not very long ago, just a couple of years ago, people believed that was a very stable trade.
I think there is a lot of foreign exchange and currency risk in these markets, especially in the short to medium term. I'm an advocate over only the longest horizons of these foreign currency markets.
What I would suggest is that investors need to look at their portfolio very carefully and decide, how many dollar liabilities do I expect in the future for fixed payments or known outflows. If I have mortgage payments, college tuitions, etc., segregate that in a dollar portion of your market and only use the surplus to invest in foreign currencies, especially in the emerging markets.
Put differently, if you have $100 and you know you have liabilities in the future that are worth $90, if you were to capitalize in the present-day values, you should only play around with the $10 that are left, or less. You really shouldn't be investing 20%, 30%, 40% of your portfolio. Really only look at investing that $10 that you have in excess of your known liabilities. That will help you sleep a lot better at night and help you stay invested over the long term, because you won't be bearing these hidden and very challenging currency risks that are embedded in investing in the emerging markets or even overseas more broadly.
Stipp: Andrew Foster, CIO of Seafarer Capital Partners, thanks for calling in today and for those great insights on emerging markets.
Foster: It's been my pleasure, Jason. Thank you.