Category Archives for General Commentary

On Rising Rates: Fixed Income Strategy

In Part 1 of our fixed income series, we discussed our thoughts on the expected interest rate environment and the effects of rising interest rates on fixed income instruments. As it currently stands, though we believe that rates will rise going forward, any such rise will occur much more slowly than currently anticipated because the global growth outlook remains challenging and inflationary pressure remains muted. As such, we see any rise in rates occurring strictly based on monetary policy. Monetary policy will remain, at least in the short term, the driver of interest rates and, as such, interest rate movements will be more volatile.

In Part 2, we discussed the technical mechanics of the yield curve and conclude that magnitude and speed of interest rate movements, as well as time horizon, are important components of fixed income returns. If the rising rates scenario implied by the forward rates were to materialize, yield curve technicals and time would provide good hedges.

In this, the final post of the series, we will focus on portfolio strategy. We will start by emphasizing the importance of a clearly defined investment objective when constructing a fixed income portfolio. Then, we introduce and define our generalized thematic buckets for fixed income assets. Finally, we will take a look at fixed income portfolio construction in the context of the current macroeconomic environment.

Portfolio Objectives

One of the most important steps when constructing any portfolio is to have a clear objective. This step is important at both the aggregate portfolio and asset class levels. Unfortunately, this step is often overlooked (at least explicitly) by investors. Typically, a fixed income portfolio serves the following purposes:

  • Capital Preservation/Income. These objectives are arguably the most common objectives for a fixed income portfolio. However, the degree to which each portfolio is exposed to either/both of these objectives needs to be addressed.
  • Diversification. A fixed income portfolio can be a part of a larger multi-asset portfolio or a stand-alone. Either way, it is important to note that different fixed income products are designed to react differently in different economic environments. We will discuss this point briefly in the next section.
  • Liquidity. Cash and cash equivalents are useful, especially in the events of rebalancing and general expenditure. In this post, we will exclude cash and cash equivalents from our analysis.

The objective of a fixed income portfolio may be one or a combination of the objectives above. In this post, we will focus on the capital preservation/income and diversification attributes of the fixed income products/portfolio.

Asset Objectives

Different fixed income products are designed to react differently in different economic environments. This point, though widely known, is often misunderstood. We classify fixed income assets into the following general thematic buckets:

  • Market Hedge: includes US treasuries, developed market sovereign bonds, agency mortgage-backed securities, and investment grade corporate bonds.
  • Yield Seeker: includes high yield corporate bonds, emerging market bonds, preferred stocks, and floating-rate bonds.
  • Inflation Hedge: includes TIPS and Linkers along with Real Assets (i.e commodities, real estate, etc.). Please note that given the subdued outlook for inflation, we will exclude inflation hedge assets and reserve this topic for future posts.
  • Absolute Return Strategies: diversified, multi-sector unconstrained bond strategy

In an effort to review how each thematic bucket behaves in different macroeconomic environments, we charted (and tabled) the cumulative performance of three indices since 2011.

  • Barclays US Treasury, representing Market Hedge Asset;
  • Barclays US TIPS, representing Inflation Hedge Asset; and
  • Barclays US High Yield, representing Yield Seeker Asset

This particular time period provides several economic scenarios. Please note that the performance of the absolute return strategy is not included because it is a combination of multiple types of fixed income assets.



In the chart and table above, we observe that Treasuries work well during a crisis (Scenario II) and when equity risk is perceived to be higher (Scenario IV), providing added value to a portfolio by acting as a market hedge. When liquidity is abundant (scenario I, III, V), yield seeker assets are the winner as they are more correlated to equity. However, we would like to note that in the event of rising expected risk premiums, no asset is spared (Scenario VI).

In addition to asset behavior in various economic environments, the chart below depicts the behavior among various fixed income assets in relation to one another. Below is the average blended correlation along with the path of the 3-year correlation over the past 10 years.


Portfolio Positioning

Given what we have discussed so far, let’s revisit the central question of this post: what can be done to protect a fixed income portfolio in the current and expected environments? While we believe that interest rates will rise, any such rise will occur more slowly and in a more volatile manner. As such, we believe that there are some prudent moves that can be made to design/position your portfolio. We summarize our thoughts below:

  • Manage exposure to credit and interest rate risk. Despite dominating the headlines recently, interest rate risk is not the only risk in the fixed income space. Credit risk exists and if the economy heads into recession, credit risk will expose a portfolio and create challenges. As a side note, we believe that given the stage of the deleveraging cycle in the US, the credit-worthiness of US fixed income is getting better. We view that as an opportunity.
  • Take note of cash flow type. As not all assets are created equal, nor are their cash flows. Amortized securities, such as pass through MBS, will return principal and interest to investors as the loan is repaid. This quality presents at least two benefits: reducing the credit risk and duration of such securities
  • There is a big difference between risk avoidance and risk management. Lowering the duration of a portfolio will decrease interest rate risk but it will also reduce the return potential. As we discussed in part 2 of the series, time will provide a good hedge against a rise in interest rates. We believe that targeting an intermediate duration (4 – 6 years) is appropriate but also involves just as much “art” as “science.”
  • Allocate a part of the portfolio into absolute return strategies. Managers of absolute return strategies are allowed to make tactical shifts in sector, issuer, duration, and yield curve profiles. If there is a sudden, rapid movement in the economy, these managers can respond more quickly.
  • Design your portfolio according to the yield curve, asset quality, and duration. Balancing exposures in the context of the yield curve and asset quality is important. We believe it to be prudent to design a barbell portfolio in which higher quality assets (market hedge assets) occupy the long end of the curve and lower quality assets (yield seeker assets) occupy the short end. There is no need to expose the longer end of your portfolio to both credit and interest rate risk.

As a side note, the points we made above are not meant for a liability hedging strategy. Being careful to not over generalize and without commenting on the fixed income portion of such a portfolio, we would note that an increase in rates is likely good news as it reduces the present value of the liabilities. Most likely, these investors do not need to make any change to the portfolio as the benefits of rising rates outweigh the underperformance, especially if the allocation to fixed income is less than half.

Sample Portfolio

We would like to show sample fixed income portfolios that offer a starting point for the scenario that we have discussed in the series (slowly rising but more volatile interest rate environment). The sample fixed income portfolios below are assumed to be part of an aggregate portfolio with a defensive portfolio objective and roughly 50%-60% allocation to cash, growth engine assets, real assets, and alternatives (excluding fixed income absolute return strategies).


The resulting portfolio duration and yield characteristics are summarized in the following table. As noted above, we have attempted to construct both sample portfolios by balancing the higher yielding, lesser credit quality, shorter duration assets with higher quality, longer duration assets. Please note that the table below shows the characteristics of the indices. There are additional fixed income assets, such as municipal bonds or preferred stocks (to name just 2), that could be potentially considered depending on investor circumstances and objectives.


* Note: Due to the limitation of benchmarks in the absolute return unconstrained strategies, we use one of OFA’s recommended funds in the space to calculate the weighted duration and weighted yield.

Final Remarks

With the global macroeconomic outlook challenging and uncertain, as well as global central bank involvement in the markets, the investment landscape, broadly, has become noticeably more difficult. As these macro developments continue to unfold, the writing contained in this post will hopefully provide the reader with some thoughts on how to move forward as well as generate conversation. We would welcome the opportunity to be a part of that conversation.

Disclaimer: Please note that all investors should consider circumstances, risk tolerance, and investment objectives when making any investment decisions. Opinions expressed herein are solely those of OFA, should not be construed as investment advice and are for discussion purposes only.


 

On Rising Rates: Fixed Income Investing

In the first post of this three part series, On Rising Interest Rates, we shared our thoughts on the current and expected interest rate environments. The current outlooks for US economic growth and inflation are both currently low. Regarding inflation expectations, there is an interesting paper on “structural traps” (written in 2004 and found here) that provides some explanation on why quantitative easing has not generated higher inflation expectations. The argument in the paper may explain why inflation expectations collapse when the Fed telegraphs their intention to taper. Combining that with the fact that real growth has not been as strong, the outlook for nominal growth remains muted. Though we believe that rates will rise going forward, the size of those movements may not be as pronounced as the current forward rates imply. However, this “sideways” movement in rates will be more volatile as the Fed has stressed that asset purchases remain dependent on the economic outlook.

In this post, we will discuss the effects of rising interest rates on fixed income instruments. We will focus on the technical mechanics of the yield curve along with economic fundamentals and monetary policy. We think it is important to understand this particular aspect of fixed income investing. Importantly, we do not focus on credit risk during this series of posts. In the final post of this series, we will share our thoughts on how best to structure a fixed income portfolio in such an environment, especially from a multi-manager (as opposed to individual bond) point of view.

Roll Down Math

The total return of a fixed income instrument can be decomposed into two components:

  1. Income (coupon/interest payments) and
  2. Price (capital gain/loss when a bond matures, is sold or called).

For this particular discussion, we are interested in one subcomponent of price return: roll down return. Roll down occurs as a bond with a fixed maturity date gets closer to maturity. In a normal market environment, yields tend to decline as the maturity date gets closer and prices tend to rise as investors price the bond relative to a shorter maturity date on the yield curve.

Roll Down — Example

For simplicity, we will use zero-coupon Treasury bonds, which are priced exactly at their respective present values. On October 11th, 2013, 10-yr and a 5-yr zero-coupon Treasury bonds are purchased at yields of 2.69% and 1.42%, respectively. We will assume that the forward curves accurately reflect the level of future yields. The yield paths are represented by the red and orange dots on the chart below. Please note that the intermediate years’ yield is estimated using linear interpolation.


The chart above suggests that over the next 5 years, from the day of investment, yields will keep increasing. We will calculate the price of the bond per $100 par value using the following formula:

Price = (100/((1+yield)^maturity)

The results are shown in the table below.


Several caveats/observations from the above exercise:

  • Trading costs and premiums/discounts have not been factored in. This example applies to the purchase of individual bonds. As such, we will present a modified example that considers the purchase of duration managed funds below.
  • Despite having a theoretically higher return, the 10-yr bond underperforms the 5-yr bond. This result is due to the steepness of the yield curve. On a 5-yr time horizon, the steepest part of the curve occurs at a duration of 3-4 years.

Modified Example Number 1

As we noted above, and based on a majority of OFA’s client base, we will modify the exercise to consider an investment in duration managed funds. Suppose that 10-yr and 5-yr zero-coupon Treasury bonds are purchased. Exactly one year from the date of purchase, the bonds are sold and the cash proceeds are used to purchase 10-yr and 5-yr zero-coupon Treasury bonds. In a way, Treasury bond portfolios with an average duration of 9.5 and 4.5 years, respectively, are created. Please refer to the chart below for the estimated yield paths. Again, we will assume that the forward curves accurately reflect the level of future yields. The table following the charts presents the results of the exercise.



The results of the modified example closely mimic the first exercise, suggesting that there are multiple approaches to manage your fixed income exposure during a rising rate environment. We will discuss these strategies using some historical information in the next post.

“The Path of Zero Return”

While loss of principal would imply a negative credit event, we have been faced with considering circumstances in which holding a bond/bond portfolio would produce zero return. In this example, we will consider “the path of zero return”. Using the zero-coupon 10-yr Treasury yielding 2.70% as an example, in order for an investment in the bond to have a 0% return three years from now, the 7-year yield needs to be at 3.88% (the forward curve suggests that the 3 year forward 7-yr yield as of September 9th, 2013 stands at 3.58%). For that same bond to have a 0% return five years from now, the 5-year yield needs to stand at 5.47% (the forward curve suggests 5-year forward 5-yr yield at 4.07%). This calculation can be done quickly by setting the price of different maturities equal to each other. In the chart below, we give a simple depiction of the “path of zero return”.


The chart above indicates that rates would have to move up very quickly and significantly in order for negative returns to be generated over three and five-year time periods. The current forward curves imply that returns may closely mirror the yields, however, in the long-run, the theoretical zero-return yield level will not be reached.

The Fed’s zero interest rate policy and asset purchase program are designed to stimulate economic growth. In so doing, yields have been suppressed. Given that economic fundamentals remain muted (low growth with deflationary/low inflation pressures), we believe that an accommodative monetary policy stance will remain in place for some time. However, it is prudent to think about the possibility of rising rates as well as the impact such policy has had, and will have, on the shape of the yield curve. This post shows that the magnitude and speed of interest rate moves, as well as time horizon, are important components of fixed income return. If the rising rates scenario implied by the forward rates were to materialize, yield curve technicals and time will provide a good hedge. In the final post, we will discuss some implementable ideas.

Unless otherwise specified, all charts and data points are as of 9/30/2013
Source: FactSet Research Systems

Q3 2013 Capital Market Review

The full Capital Market Review Deck is now available.

General Comment

The third quarter of 2013 marked the 5-year anniversary of the collapse of Lehman Brothers and the onset of one of the worst recessions in history. Five years later, and after extraordinary monetary policy intervention, the US recovery remains fragile but is advancing. After several months of internal debates within the FOMC, and subsequently telegraphing to the market their intentions to begin tapering their bond buying program as early as Q4 2013 (please read our post here), the Fed decided not to taper in September, citing tightening credit markets, sluggish employment, and fiscal policy uncertainty as reasons to delay the tapering. The 10-yr Treasury yield, which advanced 126 bps between May and mid-September based on the Fed’s announcement regarding their intentions to taper, retreated back to 2.61% at the end of the quarter after reaching as high as 3.00%. The current US growth outlook is likely to be lower as the effects of higher interest rates flow through the economy. Additionally, US monetary policy actions rippled through global markets, especially the emerging market complex (please read our post here).

In Europe, the economic outlook remained fragile. The EU’s current growth rate has not been enough to counter deflationary pressures, reduce credit problems, and relieve the social/political unrest due to austerity measures put in place by various EU member states. At the end of the third quarter, Angela Merkel was reelected as the Chancellor of Germany and, as a staunch proponent of the EU, is expected to reengage in policy discussions that she backed away from during her reelection campaign. In terms of policy decisions, Europe will be faced with many in the coming months. Having been granted authority to supervise the euro area’s largest banks, Mario Draghi (ECB president) is expected to announce the standards of the Asset Quality Review. He made it clear that “liquidity ought to be provided to the banking system as needed, but it should not be a replacement for a lack of capital.” Additionally, Portugal has hinted at the need for an additional round of support which will have broad implications on how the ECB will treat other troubled countries.

Geopolitically, Africa and the Middle East dominated headlines. In July, Muhammad Morsi was ousted as the President of Egypt by a combination of civilian revolt and military force. The ouster was highly contested by Morsi’s supporters and resulted in hundreds killed. Tensions and uncertainty remain elevated as Egypt continues to resolve their political issues. The on-going civil war in Syria and President Bashar Assad’s use of chemical weapons was the other major story during the quarter. While political debate ensued among US leaders about how to respond, the end result was a proposed weapon removal program backed by Russia, the US and the UN. The implementation and execution of this plan will be important to monitor as it will involve bringing together nations with historically strained relationships.

Fiscal Turmoil

As of the end of the third quarter, the government was shut down for the first time in 17 years as both Republican and Democratic parties were unable to agree on how to fund federal discretionary spending (Continuing Resolution). While the budget issues are troubling, the real concerns arise as the federal debt limit approaches and will have to be raised in order for the US to avoid defaulting on its obligations. As of this writing, the Treasury will run out of any extraordinary measures to keep paying obligations (US reached its technical debt limit in May 2013) no later than October 17th, 2013. The political brinksmanship displayed during the budget discussions makes the more important debt ceiling discussion that much more uncertain.

The partisan rhetoric that has characterized, and paralyzed, Congress for the last few years has led to the most recent inability of Democrats and Republicans to negotiate. There is no appetite for further spending cuts beyond those made as part of the sequestration deal nor is their further appetite for tax increases beyond those made as part of the fiscal cliff deal. As such, negotiations have focused on highly contentious entitlement reforms. Given that the CR and debt ceiling deals come in the shadow of the implementation of the Affordable Care Act (ACA), we have seen opponents of the ACA try to package together the repeal or postponement thereof into any CR or debt ceiling deal. As of right now, neither side has shown any interest in adjusting their respective positions regarding the ACA.

The Bipartisan Policy Center issued an interesting report in which they lay out two scenarios in the event that the debt ceiling is not raised: (1) Payment Delay, (2) Payment Prioritization. In addition, Bridgewater Associates added two more scenarios: (3) Asset Sales, (4) Payment Reduction across the board. Ultimately, none of these scenarios are positive for the US.

Because of the US’s position in global commerce, any failure to meet their financial obligations (by missing interest or coupon payments) would have severe negative ramifications for global markets.

Financial Sector

We note that the outlook for the financial sector got hit relatively hard this quarter as revenues from trading decreased, mortgage origination and refinancing activity slowed significantly and expensive regulatory costs were paid to settle violations incurred during the 2008 housing crisis. In the near-to-midterm, we note that conventional mortgage rates rose by almost 50 basis points during the third quarter, leading to a sharp decline in mortgage-refinance activity. As the core of Fed policy has been to induce borrowing, particularly in the housing market, we watch this headwind closely as we come into year end.

Municipal Bond Market

In July, Detroit became the largest American city to file for bankruptcy. Prices in the muni market moved down and yields rose. As such, the yield curve of AAA General Obligation Muni Bonds shifted above the Treasury yield curve. As most income generated from munis is tax-exempt, when considering muni yields on a tax equivalent basis, this yield curve behavior could signal value. However, the events in Detroit belie the need for a bottom-up credit analysis of the municipality and the individual bonds.

On Rising Interest Rates

Last weekend, a former colleague asked whether investing in fixed income carries the risk of principal loss. Though my immediate answer was a no, I felt the need to provide a more comprehensive answer. Over the course of a two part series, I will focus on the impact monetary policy has had on interest rates and discuss the interest rate outlook in the context of the current implied forward yield curves. In part two, I will consider these implications on fixed income investing and discuss some ideas on how to structure the fixed income portion of your portfolio.

Some Perspective

In September 2012, the FOMC released a statement officially launching a third round of asset purchases, dubbed “QE3.” Under the terms of this announcement, the Fed committed to the open ended purchase of $40 billion of Mortgage Backed Securities (MBS) per month. In their December 2012 statement, the Fed went further by committing to the open ended, monthly purchase of $45 billion of longer-term Treasuries in addition to the monthly MBS purchases. The December announcement also included language related to inflation-targeting. This led many analysts to interpret the Fed’s program as de-facto nominal GDP targeting. Rates remained low, and relatively calm, as the market had expected this action. At this point, the 10-year US Treasury yield was around 1.70%.


The January 2013 FOMC statement shed light on an internal discussion amongst members regarding the potential costs versus benefits of the asset purchase program, with some members becoming concerned about the costs. The Fed’s staff was instructed to conduct an analysis of the program. For the next few months, market participants shrugged off the FOMC’s concerns. The yield on the 10-year Treasury remained stable. Real yields remained negative and the era of financial repression continued.

Interest rate stability changed course dramatically when the Fed published its April/May 2013 FOMC statement which included, for the first time, language regarding the consideration of tapering the size/pace of asset purchases. The June 2013 FOMC statement further indicated that tapering was possible as early as the third quarter of 2013. From early May through September 15, 2013, the 10-year Treasury yield rose from 1.63% to 2.89%, a 77% increase. During the same time period, as inflation remained muted, real yields turned positive in June. As a side note (and we will revisit this point later), breakeven rates plunged by more than 50 bps, suggesting that the market was pricing in a lower inflation premium.

Outlook for Rising Rates

Based on the Fed’s tapering discussions, market participants are currently pricing in rising rates. The forward yield curves imply that the market is expecting the 10-year Treasury yield to increase to 4.69% in five years. Interestingly, as the chart below suggests, the short-end of the curve is expected to be under more upward pressure than the long-end. Despite the Fed’s forward guidance suggesting they will anchor short term rates near zero for the next couple of years, the market appears less optimistic about such forecasts and are pricing in the worst case scenario, which is a hike in the Fed Funds Rate.


At this point, it is fair to question the likelihood that the 10-year Treasury will yield 4.69% in 5 years. Though this scenario is possible, without a significant boost in economic growth or a major shift in policy, such a scenario is hard to imagine. The chart below depicts the annual growth of the economy and the 10-year yield. The five dots on the right hand side of the chart show where the forward curves imply 10-year yields may end up. The latest 10-year yield stands at 2.91%. Meanwhile, the latest nominal GDP report suggests the economy is growing at 3.14%. However, as the chart below shows, the market is pricing in a gradually higher yield for the next 5 years. Two important variables are at play here: nominal growth and monetary/fiscal policy.

Nominal Growth and Monetary/Fiscal Policy


Based on expected yields rising, the market appears confident that the recovery in nominal growth will be strong. However, there is no immediate evidence that this will be the case as economic conditions have been slowing which may cause the pace of growth to moderate. Recent slowing has been driven by housing (sales of building materials fell by 10% in August) and household demand (August retail sales and September consumer sentiment weakened). Inflation expectations have remained subdued as breakeven rates fell by 50 basis points.

In the coming days, the Fed is faced with a difficult monetary policy decision regarding the degree to which they will taper their asset purchases as well as the timing of such tapering. This decision is made difficult based on positive, but sluggish, economic growth. Goldman Sachs expects $10-$15 billion of taper. On the fiscal side, a debate by a deeply divided Congress to raise the debt ceiling and keep the government running will ensue towards the end of this year. While it is expected that the debt ceiling will be raised, the debate process will be contentious and will have an adverse effect on the fiscal outlook.

In order for the economy to function “normally,” nominal growth needs to be roughly equal to, if not greater than, the cost to borrow (i.e. 10 Year yields). As growth continues to be sluggish and the fiscal deficit continues to mount, it would appear that the Fed will likely be very cautious as to how fast/much they taper their asset purchases. As such, while we believe that rates will rise going forward, we also believe that the size of those movements may be more muted than currently forecast thereby giving way to opportunities to invest in, and adjust, fixed income portfolios.

Unless specified otherwise, all charts and data points are as of 9/13/2013. Source: FactSet Research System, PIMCO, and Minyanville.

August 2013 Monthly Market Update

August saw U.S. Q2 GDP revised up to 2.5% on expectations of 2.3%. Despite this upward revision, as we have stated in a number of previous posts, the U.S. economy continues to show signs of improvement but still faces numerous headwinds. Additional macro data reported in August can be found below.

Apart from economic data reported in August:

  • Markets became increasingly focused on expectations that the Fed will begin to taper its asset purchases sometime later this year. Such expectations caused volatility in both equity and fixed income markets;
  • As expectations of the Fed tapering gathered steam, the Emerging Market complex saw their respective currencies and markets pull back significantly. Please see OFA’s “On Emerging Market Equity” for more details;
  • A massive crackdown by Egypt’s military regime resulting in the death of hundreds of protesters and a chemical weapons attack by Syria’s Bashar Assad on Syrian rebels brought heightened uncertainty and tensions to the Middle East and resulted in additional market volatility.

Regarding the outlook and impact of the Fed tapering, the Federal Reserve Bank of San Francisco published an article on the stimulatory impacts of the Fed’s asset purchases and noted that it is the Fed’s forward guidance on interest rates, less so than actual bond purchases, that appear to be having the most stimulatory impact on the economy at this point. That will be an important point for investors to weigh as they move forward.

The events in Egypt and Syria highlight the ongoing social and political unrest that has gripped the region for the last several years. The events in Syria were particularly heinous and may lead to military strikes by the U.S. However, such strikes will be apart from the U.N. and without the support of U.S. allies abroad. The turmoil and unrest in the Middle East will continue to present geopolitical risks that may impact global markets.

August saw most financial markets, both domestic and foreign, pull back. Domestically, the S&P 500 lost 2.9% while the Barclays Aggregate lost 0.5%. Globally, the MSCI EAFE lost 1.3% while the MSCI Emerging Market Index lost 1.7% and is down over 10% for the year.


U.S. Macro Overview

  • Housing data reported in August showed mixed results as existing home sales increased to 896,000 in July from 846,000 in June while new home sales decreased 13.4% in July. As rates continue to rise, the housing recovery will be tested.
  • Employment data showed that initial unemployment claims for the week ending August 23 were 331,000, down 6,000 from the previous week and 43,000 from the year earlier period. However, average hourly earnings were down, the labor force participation rate was down and the composition of the labor force continues to be of concern.
  • The ISM Manufacturing Report printed 55.7 for August on expectations of 53.8 after printing 55.4 on expectation of 53.1 in July, indicating a relatively strong pick up in manufacturing activity. However, durable goods orders also decreased 7.3% in July.
  • An important note to end the capital market review is slowing household demand. Retail sales growth, consumer expenditures and consumer confidence gains slowed in July.

     


 

On Emerging Market (EM) Equity

In light of the recent economic turmoil that has gripped Emerging Markets, OFA will use this post as an opportunity to discuss, broadly, the cause of that turmoil, the investment opportunity which EM equity still represents and provide our opinion on the best way to gain access to the EM equity asset class.

Comment on the Latest Turmoil in Emerging Markets

In 2009, the Federal Reserve decided to start a mix of unconventional monetary measures, zero interest rates, aggressive forward guidance, and large scale asset purchases / quantitative easing program. These programs pushed investment capital out of the US and toward the emerging markets as carry trade dynamics became favorable and as investors sought assets with better return/yield potential. Due to these investment flows, EM assets appreciated and outperformed while also attracting more capital. According to Bridgewater, the amount of capital accumulated by these markets is close to $9 trillion. Until recently, the capital flows into EM have been quite strong. However, as the Fed has begun to discuss its plan to taper, these capital flows have begun to slow and reverse.

The slowing and/or reversing capital flows affect each country differently. In some cases (like Singapore and South Korea), the level of foreign investment is not as high, given that these countries have more domestic funding; as such, these countries are not nearly as dependent on foreign capital. In other cases (like India, Indonesia, and Turkey), foreign investment is a significant component of GDP which makes those countries more dependent on the capital. In such countries, a reversal of foreign capital flows has meaningfully weakened their respective currencies (versus USD in particular). Combined with the fact that these countries have large current account deficits, the respective governments are faced with limited options to fend off the adverse impacts of capital flowing out of the domestic economy. They can choose to defend their currencies, which would likely entail raising interest rates (Indonesia and Brazil did last week), or they can reduce their current account deficits, which could include measures such as raising exported good taxes. Undertaking either initiative would likely inhibit/reduce economic growth.

Performance

EM equity has generally been considered a higher return, higher risk asset class. Below is a table comparing the 10 year return, volatility and max drawdown during the financial crisis of the MSCI EM Index, the MSCI EAFE Index and the S&P 500 Index.


 

Opportunity in EM Equity

Emerging markets contain promising investment opportunities. In aggregate, EM represents roughly 85% of the world’s population and 49% the world’s output (PPP adjusted). Fundamentally, the emerging markets are supported by favorable trends. Among them:

  • Growing share of Global GDP


  • Natural Resources and Demographics: The emerging markets have an abundance of natural resources and the vast majority of the world’s population. Furthermore, unlike the developed countries’ aging population, a large proportion of emerging markets’ population falls between the productive working ages of 25 and 59.
  • Rising Consumption Trend: The size of the middle class in the emerging markets has risen considerably. As a result, domestic consumption has become increasingly important. In fact, EM consumption overtook that of the US in 2008 (JP Morgan). Going forward, the spending patterns of the emerging market consumer will be the dominant feature in global consumption.
  • Rising Investment Trend: Investment spending as a percent of GDP is higher in emerging markets than in developed markets, which is a trend we believe will continue. However, this point creates a problem of its own, which we touched upon in the first section of this post.

Despite these favorable trends, emerging markets represent only 11% of the MSCI All Country World (ACW) Index (as of July 2013). As countries move up the development curve, their equity markets are expected to grow, resulting in a rising market capitalization-to-GDP ratio. In other words, EM is expected to represent more of MSCI ACW Index in the future.

Gaining Exposure to Emerging Market Equity

OFA believes that the best way to participate in emerging market equity is to invest with active managers who demonstrate a deep and sustained understanding of the countries and the companies they are invested in. Those managers will have the proper perspective to manage risk and generate attractive returns.

The MSCI EM Index’s largest country holding is China at 19.74%. The next two largest country holdings are Korea and Taiwan, combined to represent 27.59% of the index. On the sector level, the MSCI EM Index consists of 78.73% cyclical industries with its largest holdings being Financials, IT, and Energy at 26.80%, 15.18%, 12.05%, respectively. On the company level, the two largest holdings are Samsung and Taiwan Semiconductor, which derive most of their revenues from North America and Europe. With these types of exposures, a passive investment approach may not provide investors access to the risk factors they are seeking.

On a valuation basis, JP Morgan’s Guide to the Markets creates excellent charts that depict the variation in valuation of various countries, grouping them by developed and emerging. Depicted below, the variation bands in the EM countries are noticeably wider than those of developed market country indexes.



An active approach can provide better exposure to the attractive growth dynamics within emerging markets. A good manager will be able to identify key trends in emerging markets and invest in companies that will benefit from the trend. Furthermore, investors will also get true emerging market exposure.

Source: IMF, Bridgewater, JPMorgan