From the Desk of Bill Hornbarger, Chief Investment Strategist, Moneta Group
In the middle of the last decade, the economic/market theory of decoupling gained a tremendous amount of popularity. Decoupling assumed emerging countries would economically advance based on demographic and fiscal/monetary changes even while growth in the developed world slowed and potentially slipped into recession. This was a time when emerging markets (EM) were a ‘hot’ investment and subject to tremendous investment inflows. In hindsight, the theory of decoupling had some merit. Emerging economies have ascended over the past decade plus, with higher growth rates, the establishment of better monetary and fiscal policies, more liquid and robust financial markets, and the beginning of an ascendant middle class. This was, and still is, the investment thesis for emerging market investment.
As always, there is a ‘but.’ The ‘but’ in this case is the difference between an economic theory and economic reality. Buoyed by the interest and attention, the MSCI Emerging Markets Index outperformed the S&P 500 (and by a very wide margin) for every single calendar year from 2001 through 2007. Directionally, both indexes had parallel performance in positive and negative years. The difference was the degree, or magnitude, of the ups or downs. A major split in this relationship occurred during the credit crisis of 2008. Emerging Markets were down -53% (vs. -37% for the S&P 500) and experienced a drawdown of -62% (vs. -51% for the S&P 500). While the emerging world as a whole continued to slowly grow, in aggregate the markets for their securities were not immune to the global financial crisis.
In the wake of 2008, many of these economies performed very well. Growth rates have generally been higher than the developed world, the middle class in many of these countries has continued to progress, and monetary and fiscal policies have continued to improve. Decoupling? One could make a strong argument that the story from an economic perspective hasn’t changed since the idea of decoupling was first advanced in the early part of the last decade. However, we invest in markets and securities in those markets, not the actual economies themselves. In the almost five years since the tumult of 2008, there has again been a divergence in performance between emerging and developed markets, however, it has actually swung back in favor of the United States. In two of the five years (2011 and 2013), the MSCI EM Index had a negative return while the S&P 500 was positive (in 2009, 2010, and 2012 they moved in the same direction), and the S&P has outperformed MSCI EM since the end of 2008 point to point and with a lower volatility.
So, where are we today? Growth in the emerging economies slowed in the first half of 2012, and investors have generally pulled assets from both emerging equity and local currency debt. The MSCI EM Index is down -9.6% through August and the JP Morgan Government Bond Index (GBI) EM Global Diversified (the local currency debt benchmark) is down -11.45%. These losses come as investors ponder the ramifications of slower economic growth rates and the potential of additional capital outflows if the U.S. and other developed countries see bond yields increase further. There is even the possibility of tighter monetary policy in emerging markets to “defend” currencies, which adds to the uncertainty. The broad weakness has left these markets more attractively priced than they were at the beginning of the year, even as the improving outlook in the U.S. and Euro Zone and stable domestic demand argue that EM growth rates could stabilize and even improve in the second half of 2013. At the end of August, the Price-Earnings Ratio (PE) of the MSCI EM Index was 10.9x with a dividend yield of 2.81% (per Bloomberg), the lowest PE in more than 18 months. Yields in the emerging local currency debt have also risen with both Moneta managers yielding approximately 6%. Longer term, the EM growth story remains very much intact. There continues to be a growing middle class, the financial infrastructure and policies continue to improve, and growth rates should generally be higher without the overhang of excessive government debt. However, it is clear while Emerging Markets remain volatile and subject to investor flows, the EM and developed world are to a large degree intertwined, just at different stages in their economic and demographic lifecycles. I feel strongly that it is a good practice to have exposure to EM, while acknowledging it is, and will continue to be for the intermediate term, volatile. Because of the wide divergence in performance (in the neighborhood of 25% YTD) between the MSCI EM and S&P 500, now might be a good time to check allocations and rebalance into emerging markets.
A few notes on our managers
Touchstone Emerging Markets Equity Fund (TEMYX) – After outperforming the benchmark index in 2011 and 2012, Touchstone is lagging in 2013. TEMYX showed performance very similar to the benchmark through the first four months of the year, however, as global bond markets sold off, the performance of Touchstone diverged. Remember, as part of AGF’s process (sub advisor to the fund) they look at a company’s willingness and history of paying dividends. In the portfolio manager’s mind, this exhibits “shareholder friendliness,” which they feel is important in EM. As dividend stocks were punished (relative to other types of equities) in the global bond sell off, the relative performance of TEMYX suffered. We remain very positive on the manager and the longer term track record.
Stone Harbor Local Market Fund (SHLMX) – SHLMX outperformed the index in 2011 and has lagged in 2012 and 2013. The underperformance the last two years was mostly attributable to duration (too conservative last year and slightly long this year), and to a lesser degree, country selection. The benchmark index is very constrained (only 14 countries included and some with small opportunity sets), so both of our managers will go off benchmark to build a more diversified portfolio. From the latest data available (end of July), the current yield of the fund is 6.23%, average quality of A-, duration of 5.2 years and maturity of 7.43 years. As a basis of comparison, the Barclays Aggregate has a current yield of 2.45%, 5.1 year duration and 6.9 year average maturity.
TCW Emerging Markets Local Currency Fund (TGWIX) – TCW, our more recent addition, has done an excellent job the last three years outperforming the JP Morgan GBI EM Global Diversified Index each calendar year, including year-to-date 2013 where the fund is 125 bps ahead of the benchmark. TCW was more aggressive in terms of duration in 2012 and has maintained that stance through 2013, however, they have done an excellent job with country selection and a small allocation to floating-rate debt has also helped performance. The latest data available shows a yield of approximately 6%, a maturity of 8.4 years, and duration of 5.2 years.
Finally, I want to mention that like so many things in Morningstar, the category for the two debt managers is not accurate. Morningstar combines local and hard currency managers in one category, despite the two strategies having completely different risk and reward profiles. The result is many of these local currency managers have poor Morningstar ratings this year.
Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance.
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