Month: March 2019

An Update on Active vs. Passive Investing in Emerging Markets

The  most under-rated aspect of investing is simplicity. Investors feel obliged to pursue complex methods to predict the future of the economy, the markets and corporate earnings and they then develop elaborate trading systems to leverage “superior” insights. This is often driven by clients who demand large teams of highly paid experts involved in complex strategies in order to justify paying management fees. If a process is too simple and transparent, the client may conclude that the manager is dispensable .

This dilemma is heightened  by the growing preponderance of passive indexing and “smart-beta” strategies, which offer market performance (“beta”) or the promise of factor-driven market outperformance (“alpha”) at ever-declining prices. These computer-driven quantitative strategies are the image of simplicity and transparency and can be manufactured cheaply.

These “passive “products increase the pressure on actively managed funds in two ways; first, they compress fees; second, they push managers to add skill and complexity which increases costs. This bad combination of lower fees and higher costs can only lead to a concentration of assets in those few active managers who can offer highly differentiated products.

These trends can be seen in the Year-end 2018 SPIVA Scorecard (Link, Link), which compares returns for U.S. mutual funds with their respective benchmarks. Here are some highlights from the report which concern emerging markets funds:

  • The number of available funds is declining, from 233 in 2015 to 210 a year-end 2018.
  • Larger funds perform better than smaller ones. This is seen in the higher returns on an asset-weighted basis than on an equal-weighted-by-fund basis. This advantage of larger funds over smaller funds is persistent over all time-periods and can be attributed to lower fees and higher skill.
  • 2018 was a difficult year for active managers, with 78% of managers underperforming their indices. The data for the past 15 years is shown below. Beyond, a one year time-frame, around 90% of managers underperform their indices.

Rolling three-year returns have also deteriorated, as shown in the following graph. This deterioration is also seen for global and  international funds.

     

  • Finally, SPIVA identifies low persistency in results for EM managers. While 41% of EM funds outperformed their indices for the 2012-2015 3-year period, only 7.5% of these funds continued to outperform the next year  (2016), 4.5% outperformed over the next two years (2016-2017) and zero outperformed for the next three years (2016-2018).

  Conclusion

The sobering data from the SPIVA scorecard highlights the challenges of active managers. To be successful, increasingly, active managers will need to focus on market niches where they can deploy unique skills and expertise, and/or pursue strategies that provide returns that are uncorrelated  to mainstream emerging market products. Some areas where active management may continue to be highly successful in “harvesting alpha” are the following:

  • Deep value contrarian investing. This strategy is highly out-of-favor because of a long period of underperformance of the value factor. Consequently, though it requires skillful fundamental research, it is under-researched because most managers have abandoned this discipline. This is the case at a time when opportunities are plentiful in the Indian and Brazilian markets, and particularly in the China A-share market.
  • Hedge Fund structures: Pure Alpha, shorting and trend following (CTA) strategies can provide returns uncorrelated to EM equities and valuable diversification.
  • Long-only, mainstream EM investors with low cost structures, long-term horizons and the ability to pursue strategies with high “tracking error” (the degree of  portfolio return uncorrelation with the benchmark). The problem is finding clients with long-term horizons and tolerance for “tracking error”.  The vast majority of both investors and clients prefer strategies that “hug” the benchmark, which makes alpha creation a remote possibility.

Trade Wars

  • Xi needs a trade deal (FT)
  • The reemergence of a two-bloc world (FT)
  • The deepening U.S. China crisis (Carnegie)
  • European Commission report on China relations (EC)
  • Should the U.S. run a trade surplus (Carnegie, Michael Pettis)
  • Why the U.S. debt must continue to rise (Carnegie, Pettis)
  • Turkey and India denied preferential U.S. trading status (FT)

India Watch  

  • India’s internet users are addicted to these apps from China (WSJ)
  • How India conquered youtube (FT)
  • Modi’s track record on the economy (The economist)
  • Increasing Indian demand for copper (Gorozen)
  • India’s growing share of oil imports (blog)
  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)

China Watch:

  • Quality will drive China A- share returns (FT)
  • Lessons from Li Keqiang’s report to Congress (SCMP)
  • China breaks world box office record (SCMP)
  • Why China supports North Korea (Lowy)
  • China’s PM frets about the economy (The Economist)
  • China has no choice (Alhambra)
  • China’s economy is bottoming (SCMP)

China Technology  

Brazil Watch

EM Investor Watch

  • AMLO’s first 100 days (Wilson Center)
  • South Africa’s electricity sector woes (FT)
  • OECD Report on Global Corporate Debt (OECD)
  • Russia’s global ambitions in perspective (Carnegie)
  • South Africa stagnates as confidence wanes  (Bloomberg)
  • Postcard from Malaysia (Foreign Policy Journal)

Tech Watch

Investing

 

Bond market risk and emerging markets

 One of the most salient concerns with the current state of the the global economy  is the very high level of corporate debt. This past week the OECD, the Dallas Federal Reserve and the Bank for International Settlements all warned that in an eventual economic downturn the solvency of corporate debt issuers  is likely to deteriorate quickly and deepen the contraction. 

The warning is highly relevant for emerging markets investors for two reasons; first, EM corporates have been active particants in the ramp up of debt, eagerly satisfying the chase for yield that lenders have pursued in response to quantitative easing policies; second, EM borrowers can be expected to suffer disproportionately if the lending cycle were to turn sour.

Rob Kaplan of the Dallas Federal Resrve did not mince his words this week (Link) in issuing a stark warning of the risk to the economy caused by the buildup of U.S. Corporate debt. Kaplan is concerned that the current high level of corporate debt will sharply deepen an eventual economic downturn. He points out that a preponderance of recent debt issuance has been used for non-productive and non-self-liquidating activities, mainly dividends, debt buy-backs and M&A activity. In addition, to an unprecedented degree, the debt has been rated BBB (barely one notch above high-yield, “junk”), and has come with more relaxed covenants. This is shown in the following chart two charts. The first shows the cyclical behavior of the corporate debt market and the current very high level relative to GDP, and the second shows the growing preponderance of lower quality issuers.

  Kaplan notes that “in the event of an economic downturn and some credit-quality deterioration, the reduction in bank broker-dealer inventories and market-making capability could mean that credit spreads might widen more significantly, and potentially in a more volatile manner, than they have historically.” As in past recessions, downgrades of BBB-rated debt may flood the relatively illiquid market for high-yield bonds and cause severe dislocations.

Unfortunately for investors in EM debt, the U.S. high-yield bond market and the market for EM debt are extremely correlated. Therefore, any disruption in the U.S. high-yield market will be felt immediately in an accentuated fashion in the EM debt market.

This is the view expressed in the recently published OECD study, “Corporate Bond Markets in a Time of Unconventional Monetary Policy.” The report  describes in ample detail a “prolonged decline in overall  bond quality…and  decrease in covenant  protection” and  predicts that many corporates issuers will suffer a downgrade to “junk” in an eventual economic downturn  and face amplified borrowing costs. The report repeats the concerns expressed by Kaplan with regards to the size and low quality of global corporate debt. In addition, it focuses on the specifics of the EM debt market.

The OECD points to an “extraordinary acceleration of corporate bond issuance in emerging markets,”  from$70 billion/year in 2007 to $711 billion in 2016. This is shown in the chart below.

  The rise in borrowing has been particularly acute in China, but also highly significant across the rest of the emerging markets. Total EM corporate debt reached $2.78 trillion in 2018, up 395% in ten years. 

 The OECD identifies an alarming decline of the overall quality of the global corporate bond market. According to OECD analysis, by historical standards the quality of bonds is exceptionally low for where we are in the economic cycle. This is shown in the chart below.

 The decline in quality is particularly severe for the overall quality of EM bonds, which just barely qualify as investment grade in 2018 after falling into junk status in 2017. The chart  below compares the quality of EM bonds to developed market bonds, according to the rating methodology ued by the OECD.

To make matters worse, the repayment profile for emrging markets is considerably worse than for DM, with 80% of loans due over the next five years.

 Interestingly, even though concerns of a global slowdown are growing, high yield bonds in general are  performing well, displaying very low premiums by historical standards to risk-free bonds. This is partially because of QE (especially in Europe) but also because of desperate efforts to secure yield in a low-return environment. Look, for example, at the chart below of the HYEM, the emerging markets high yield bond ETF, which has rallied strongly since last September.

Conclusion

 Investors in emerging markets should be aware of the considerable risks presented by the bond market. Any significant downturn in the global economy would likely lead to significant downgrades to high yield bonds and a strengthening of the U.S. dollar, and this may cause severe disruption of the high-yield market. The performance of emerging market equity markets, which are highly correlated to the EM high yield market, would suffer accordingly.

Trade Wars  

  • Xi needs a trade deal (FT)
  • Should the U.S. run a trade surplus (Carnegie, Michael Pettis)
  • Why the U.S. debt must continue to rise (Carnegie, Pettis)
  • Turkey and India denied preferential U.S. trading status (FT)
  • China, India and the rise of the civilisation state (FT)
  • When democracy is no longer the only path (WSJ)
  • The tremendous impact of the China-U.S. tech war (Lowy)
  • Huawei hits back at the U.S. (FT)

India Watch

  • Modi’s track record on the economy (The economist)
  • Increasing Indian demand for copper (Gorozen)
  • India’s growing share of oil imports (blog)
  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)

China Watch:

  • Quality will drive China A- share returns (FT)
  • China breaks world box office record (SCMP)
  • Why China supports North Korea (Lowy)
  • China’s PM frets about the economy (The Economist)
  • China has no choice (Alhambra)
  • China’s economy is bottoming (SCMP)
  • MBS in Beijing (WIC)
  • The story of the world’s biggest building (The Economist)
  • U.S. cars are strugling in China (NYT)
  • China’s tourist have political clout (The Economist)

China Technology

  • Huawei’s big AI ambitions (MIT Tech)
  • China’s EV startup Xpeng (WIC)
  • An interview with fintech Creditease CEO (Mcinsey)

Brazil Watch

EM Investor Watch

  • OECD Report on Global Corporate Debt (OECD)
  • Russia’s global ambitions in perspective (Carnegie)
  • South Africa stagnates as confidence wanes  (Bloomberg)
  • Postcard from Malaysia (Foreign Policy Journal)
  • South Africa slumps (Barrons) South Africa Innovation (FT)
  • Make hay while the sun shines in emerging markets (FT)
  • Globalization in Transition (mckinsey)

Tech Watch

Investing

 

 

 

 

 

Does China have a Debt Problem?

For many years concerns have been raised that imbalances in China’s financial system are a threat to economic stability.

Way back in 2007, Premier Wen Jiabao, asserted  that China’s economy was  “unstable, unbalanced, uncoordinated and unsustainable”. This idea was reiterated by a People’s Bank of China report this week that warned of an “arduous task to prevent and defuse financial risks.”

The sentiment is echoed by prominent U.S. hedge funds that for years have bet that the financial system’s fragility would cause a collapse of the yuan. Prominent China bear, Kyle Bass of Hayman Capital Management, recently repeated his case to CNBC, saying “China is running the largest financial experiment the world has ever seen. And the economic tides have turned negative for them.” Hedge Fund, Crescat Capital, echoed this sentiment last week, opining that”the Chinese banking asset bubble is currently the largest of any country ever with 400% on-balance-sheet banking asset growth relative to GDP in the last decade to $40 trillion.”

At the center of the concerns lies an unprecedented accumulation of total debt.  The chart below from the Bank for International Settlements (BIS) shows that China’s debt as a % of GDP  has more than doubled over the past decade. This is a high level of debt for a developing country like China, putting it at a level in line with many advanced economies. The concern is that the economy has become over-reliant on credit, of which much is mis-allocated to low-return activities. The risk is that at one point the debt could become an impediment to growth, leading to a “Japanification” of the economy, characterized by over-leveraged “zombie” companies.

Much of the criticism revolves around the nature of the Chinese financial system, which, in the tradition of the East-Asia developmental model, is much more driven by official policy goals than by the profit motive. In China the banks are seen as the instrument to channel household savings to the government’s priority activities.

Like Japan, the Chinese financial system is fully anchored in domestic savings, and, therefore not vulnerable to the mood-swings of foreign investors.

But, the Chinese may have additional advantages over Japan. Regulators are powerful and highly credible and have enormous flexibility to fix problems.  Their power and effectiveness is enhanced by the reality that the banks are owned by the state and can  rely on the government for capital injections. This means that bank liabilities – mainly loans to state entities – can be restructured at will.

Also, Beijing has the advantage of being exceptionally asset rich, because of the Communist legacy of state-ownership of productive assets.  The following chart from a recent IMF report, illustrates this clearly. Imagine if the United States government owned 80% of corporate America; concerns over the U.S. national debt would probably not exist. In any case, the Chinese authorities are well aware of market concerns with the high-rate of debt-accumulation and they are trying to manage them. Since the huge stimulus implemented during 2009-10 in the wake of the global financial crisis, China has consistently slowed down credit growth, as shown below in the chart from Goldman Sachs. Monetary authorities have sought to gradually slow credit growth, while at the same time using temporary stimulus to smoothen business cycles.  The following chart, from Macro-ops, shows how monetary authorities have eased on two occasions since 2010 but then returned to the credit- tightening trend. In late-2018, the PBOC initiated a third easing phase which continues to today. In addition to sharply reducing the rate of credit growth, the government has also redirected lending to households. As the BIS data shows in the first chart above, about half of credit growth has been funneled to households, mainly for mortgages. Since 2011, credit to households has risen from nearly zero to 58% of GDP. Credit for residential construction also makes up a large part of new loans. Adding these two items together, we see that a significant part of credit expansion has gone to support residential housing. The chart below shows the strong ties between Total Socal Lending — the Chinese term for total lending — and construction activity. In essence, since the great stimulus period after the GFC the Chinese financial system has become increasingly tied to residential real estate.  This is a natural development of the government’s efforts to transition the economy from dependence on infrastructure and exports to one that is driven by household consumption. While in the past  the  very high savings of the population had been channeled to state companies for nation-building investments, increasingly they are going to households in the form of mortgages and personal loans.

This is not exceptional by international standards. The quirk in the Chinese system, is that residential real estate also serves as a primary destination for long-term investments. This is also the case in many developing countries like Brazil and Turkey, where savers see residential investments as a safe harbor for long-term savings, but it may be going to extremes in China. We see this in reports of 65 million empty apartments.

The enormous amount of savings that the Chinese have in real estate means that the government is very concerned with maintaining consistent appreciation for housing and is careful to manage supply and demand for through financial measures. This can be seen in the chart below from Gavekal, which shows clearly how the monetary policy cycle is adjusted according to the trend of residential real estate prices, the objective being to engineer steady appreciation. It appears that, to a considerable degree, Chinese monetary policy is now aimed at guaranteeing stable returns for China’s owners of real estate. The current dilemma for monetary authorities is that, though the economy needs stimulus, the real estate market does not. In general, housing prices are relatively high at this time and are in no need of stimulus, as we see in the following chart.

However, the Chinese monetary authorities have many tools available. Given the current need for stimulus, the authorities are clearly rechanneling lending to SOE’s for recently announced large infrastructure investments. This means we are likely to see a temporary boost in total lending growth, with a focus on economic stimulus through traditional fixed asset investments, as the authorities try to steer through the current economic malaise.  

Trade Wars  

India Watch

  •  Increasing Indian demand for copper (Gorozen)
  • India’s growing share of oil imports (blog)
  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)
  • China is leading FDI in India (SCMP)
  • India curbs create chaos for Amazon and Walmart (Bloomberg)

China Watch:

  • China’s economy is bottoming (SCMP)
  • MBS in Beijing (WIC)
  • The story of the world’s biggest building (The Economist)
  • U.S. cars are strugling in China (NYT)
  • China’s tourist have political clout (The Economist)
  • MSCI boosts China A-share weight in EM index (WSJ)
  • Chinese consumers; your country needs you (FT)
  • China’s property market slowdown (WSJ)
  • Cracking China’s asset management business (Institutional Investor)
  • Haier’s turnaround of GE Appliances (Bloomberg)

China Technology

  • China will corner the 5G market (Wired)
  • CTrip’s strategy (Mckinsey)
  • DJI’s rise (SCMP)
  • China’s decade-long Bullet-train revolution (WIC)

Brazil Watch

  • Brazil’s crucial pension reform (Washington Post)
  • Brazil’s finance guru (FT)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

Tech Watch

Investing