Monday, December 18, 2017

Global investors see renewed promise in emerging markets

Updated 1.4.2018 at 9:42 a.m.

By Rex Mathew
Guest Columnist

After nearly five years of underperformance, emerging market equities regained some favor from global investors in 2016 and have outperformed so far this year as well. Yet, many investors still worry about the risks, perceived as well as real. Is it yet another false dawn that could quickly fade when the United States Federal Reserve and other major central banks start scaling back their balance sheets? Or could the pessimism reappear if commodity prices falter again?

I believe emerging market fundamentals are much healthier now when compared to recent years. Helped by sustained gains in domestic demand and the recovery in export shipments, the economic growth outlook for the major emerging countries has brightened. I do see growth stabilizing in China, even as the country is rapidly shifting to a consumer-driven economy and several other Asian economies are accelerating. Domestic demand has become the growth driver for the emerging world and rate cuts by central banks are helping consumer spending. Commodity exporters are gradually recovering, as the demand outlook for energy and industrial materials continues to improve.

Finally, and perhaps most importantly, emerging market corporations are now growing more confident in their revenue and earnings growth outlook.

Growth differential with the developed world is widening

For nearly a decade before the 2008 global financial crisis, the appreciably faster economic growth in Emerging Markets attracted global investors. At the peak in 2007, emerging and developing economies were expanding at an annual pace of over 8.5 percent, compared to around 3 percent for the developed world. After the dip in 2008 and 2009, short-term fiscal spending by governments helped emerging economies accelerate again. However, as commodity prices started to moderate and global trade slowed, growth in emerging economies cooled off. In 2015, when the developed economies expanded at an average rate of 2 percent, emerging economies registered a not so impressive 4 percent. 

Nevertheless, it now appears likely that emerging markets could regain some of the growth momenta and widen the growth differential with the developed world. The International Monetary Fund estimates that average the growth rate for emerging markets could rise to 5 percent annualized by 2019, and that rate could be sustained through 2022, while the developed countries are unlikely to expand faster than 2 percent. Though the pace is nowhere close to the pre-crisis high, even a moderate acceleration would be much appreciated in a world starved for growth.

Energy and commodity prices: not too cold, not too hot

The sharp decline in energy and commodity prices after 2014 did benefit large importing countries such as China, South Korea and India. But the abrupt fall in export realizations hurt Brazil, Russia, and other emerging countries, and pushed some of them into recession. The weak outlook forced energy producers and mining groups to cancel or delay capital investments, hurting equipment manufacturers and their supplies even in countries that have benefited from low commodity prices. On balance, the boost from cheaper commodities for the emerging world as a whole fell short of expectations.

Last year’s rebound in crude oil and other industrial materials such as iron ore helped the resource exporting countries recover from deep recessions. Brazil and Russia are expanding again, while most Latin American countries should grow faster by next year. At the same time, commodity prices have not moved high enough to appreciably detract from growth rates in China and other resource importers.

Governments in select countries are pushing reforms

After dramatically opening up their economies to join the globalizing world, and enjoying the growth boost afterward, governments in several emerging countries lost the urgency to initiate additional reforms to support businesses and make them more competitive. In some countries, governments became embroiled in corruption scandals and lost the political goodwill to make policy changes. The current governments in India and Indonesia did not have those constraints and have implemented significant policy initiatives, even at the risk of short-term disruptions to economic activity. Both governments have also proactively taken steps to reduce corruption and make it easier to do business in their countries. Similarly, several of the smaller Latin American countries are implementing business-friendly policies and reducing public spending.

Political risks in other emerging countries have also eased, though some of the governments have become more authoritarian and their policies have become somewhat unpredictable. Governments in Brazil, South Africa and Malaysia are facing corruption allegations, but the risk of these governments losing power appears low. If reform-oriented governments come to power in elections scheduled in 2018 and 2019, it is possible that some of these countries could see policy measures that enable faster economic growth.

Emerging market valuations remain attractive

Despite outperforming the developed markets for the last eighteen months, we believe equity valuations in emerging markets remain relatively more attractive and continue to offer long-term opportunities. Unlike earlier when most large emerging market corporations were energy or material producers in a handful of countries, investors now have the opportunity to participate in the growth of a broad array of industries and geographies.   

To conclude, the economic and political environments in several large emerging markets have become more favorable for businesses to grow their revenues and earnings. Years of slow demand growth have forced emerging market corporations to trim their costs and become more efficient. Some of them have used this period to invest in capacity expansion that should help them grow their market share. We are now seeing clear signs of a revival in earnings, across most sectors, in emerging markets. If the environment remains supportive and the earnings cycle continues to revive, emerging market equities may deserve more favorable consideration from international investors.  

The views expressed in the article do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Thomas White International or TEXPERS.

About the Author:

Rex Mathew
Rex Mathew is senior vice president of Thomas White International, responsible for research on companies based in Asia and Latin America for the firm's international and emerging markets portfolios. He leads the global markets, economy and industry analysis efforts that support the firm's investment research as well as the development of written content that highlight investment and market insights. In addition, he is responsible for the portfolio reviews and commentary for the Thomas White Funds as well as institutional accounts at the firm. 

Four key forecasts for stocks and bonds

By Matt Peron and Colin Robertson
Guest Columnists

Consider taking a global approach to investing, as emerging markets and Europe should present interesting opportunities. While global yields should remain low, relatively attractive yields can be found in the United States fixed income market. 

Here are just some of our forecasts for the next five years:

Emerging Markets Should Outperform

Investors may want to keep emerging markets in mind, as they represent attractive opportunities for stocks and bonds. We expect emerging markets to return 8.4 percent for equities and 5.3 percent for bonds, exceeding developed markets. Emerging market performance may reflect relatively strong economic growth and increasing demand from within their home markets. Valuations should increase, as they are too low for the stable economic environment we expect.

Look for U.S. Yields to Lead

We think the U.S. should continue to have the highest rates across the yield curve of all major economies with a 3 percent yield for 10-year Treasurys. Outside the U.S., we expect other countries’ rates to move out of negative territory, although Japan may remain close to 0 percent.

Investors may find that higher government yields will translate into higher yields across the U.S. fixed income market. We think returns from U.S. investment-grade bonds should lead globally, at a 3.2 percent return.

Still, global yields are low versus historical averages, reflecting low inflation and cautious central banks. Although central banks should begin the process of reducing the size of their balance sheets, we believe this should occur at a very slow, gradual and transparent pace and be unlikely to cause market volatility.

U.S. Equities to Lag Other Developed Markets

Keep a global perspective. Beyond just the opportunities in emerging markets discussed above, Europe and Asia may present more opportunities for investors than they have in the past. Globally, developed market equities are in a sweet spot of steady growth and low inflation. However, when breaking down regional contributions, we see a 5.9 percent return in the U.S., trailing other developed markets (see Exhibit 1 below). We think profit margins in the U.S. should fall slightly but remain high in Europe and Japan. We are encouraged by European regulatory developments, which we expect will boost economic growth and financial markets. 

High-Yield Defaults Should Fall

In the high-yield market, investors are unlikely to benefit from a contraction in credit spreads. The global high-yield market looks much different than it did a year ago, when volatile oil prices threatened energy companies. Since then, defaults have slowed and credit spreads have narrowed to more normal levels.

We don’t think there is as much opportunity for spreads to narrow further. We see a 4.5% return for global high yield, 1% lower from current yields. This represents a lower hit from defaults than we have realized historically in the past.

Stay Fully Invested and Well Diversified

While steady global growth provides a bedrock for investing in the coming years, this is not a high-performance investing environment. We expect traditional stock and bond portfolios to return 4 percent to 6 percent. Cash returns are very low, so investors who are not fully invested are penalized even further by taking money out of the market. We think that investors should stay fully invested with a diversified portfolio throughout market cycles for the best chance to reach their portfolio goals. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Northern Trust or TEXPERS.

About the Authors:

Matt Peron
Colin Robertson
Matt Peron and Colin Robertson are with Northern Trust Asset Management. Peron is head of global equity and Robertson is head of fixed income.

Inflation happens when you least expect it

By Stewart Taylor
Guest Columnist

Inflation can be tricky to navigate. It can remain low for years before suddenly moving sharply higher. 

During the quiet periods, investors can forget how prior inflationary periods have damaged savings and lifestyles. The period following the Great Recession has left investors particularly vulnerable. Not only have the fears generated by the great inflations of the 1970s become distant memories for Baby Boomers, but the younger Millennial and Gen Xers, having never experienced anything other than steady disinflation, have no frame of reference. 

Perhaps my own experience can provide some perspective. I graduated from high school in June of 1972, still basking in the afterglow of the release of "Led Zeppelin IV." At that time, inflation, after printing as high as 6.2 percent year-over-year in December of 1969, had fallen to 2.7 percent. Unfortunately, a scant 21 months later, year-over-year inflation reached double digits, and nine months later was 12.3 year-over-year (the circles in the figure below show some periods when inflation quickly moved higher). 

The dent in the living standard for someone like me making $2.25 an hour was substantial. Bologna sandwiches became ketchup sandwiches. My yellow VW bug sat unused for days at a time due to lack of gas money. While I didn’t understand it at the time, the downgrade to ketchup sandwiches and the dent in my social life were my first experiences with inflation.   

Fast forward to December 1986. Partly due to the large decline in energy in 1985, year-over-year headline inflation was running a modest 1.1 percent, the lowest inflation in nearly 25 years. Even better, the combination of low inflation and high nominal interest rates created significant returns for bond investors. A scant four months later, the year-over-year headline inflation rate was 3.8 percent and rising, on its way to an ultimate 6.3 percent in late 1990. Meanwhile, 10-year treasury yields also rose swiftly to peak above 9 percent in March 1989.

Once again, the rapid rise blindsided the vast majority of economists and investors. On a more positive personal note, this time around I wasn’t forced to alter my eating habits. However, the small but promising savings that I had been building suffered a significant loss of its purchasing power over the next several years. Not a disaster, particularly as I had many more years in front of me to earn, but still, very unpleasant.   

Now, in 2017, my retirement is much closer. Along with 80 million other baby boomers, I face the challenge of protecting the purchasing power of a lifetime of saving and investing. For many of us, protecting against unexpected inflation shocks may mean the difference between having a comfortable retirement, or not. Knowing that inflation often appears with little or no warning and that it often moves much higher than anyone expects strongly argues that inflation protection, much like insurance, should be pre-positioned prior to its need. 

Bottom line: I continue to believe that the inflation trend changed in early 2015 and that inflation is more likely to rise than fall going forward.   

The views expressed in the article do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Eaton Vance Management or TEXPERS.

About the Author:

Stewart Taylor
Stewart Taylor is a vice president of Eaton Vance Management and a portfolio manager on Eaton Vance’s quantitative strategies team within diversified fixed income. He is also responsible for overseeing residential mortgage trading and inflation protection strategies. He joined Eaton Vance in 2005.

Callen survey examines institutional private equity programs

By Jay Nayak
Guest Columnist

A recent survey found that an array of governance, oversight, staffing, and other administration issues affect how institutional private equity portfolios are constructed, monitored, and managed.

Investment consulting firm Callan conducted a survey of institutional private equity investors to identify considerations and practices that impact how the limited partner community accesses and implements private equity investment programs. The firm focused on implementation approaches (e.g., internal staff, non-discretionary consultant, etc.), patterns of investment and commitment activities over time, governance and oversight, staffing, and resource considerations, and the resulting effects for private equity program administration functions. Callan's 2017 Private Equity Survey included 69 institutional investors with $1.2 trillion of total plan assets and $103.3 billion in private equity assets, spread across 540 unique general partners and 2,715 unique partnership investments.

At a broad level, the survey found governance, oversight, staffing, and other administration issues often led to less than ideal implementation approaches, often including sub-optimal use of the discretionary consultant/fund-of-funds model for private equity programs that have matured, or that have significant scale.

Other highlights from the survey:

  • Investors’ private equity programs were similarly constructed, with a heavy emphasis on a narrow universe of private equity sponsors. Survey respondents collectively invested with a small cadre of 540 private equity sponsors, with the top 50 firms managing approximately 41 percent of reported private equity assets. Further reflecting this concentration, 197 firms were reported to manage only one commitment across all Survey respondents.
  • Toward the later stages of market cycles, investors tend to significantly broaden their relationships with existing private equity sponsors. Commitment rates to existing general partners greatly widened in peaking markets, driven by investors’ active investment in new strategies or geographically focused offerings.  In 2016, 82 percent of private equity commitments reported were with existing general partners, the highest follow-on commitment rate across all years analyzed. Alternatively, many investors actively upgraded private equity sponsor relationships in trough periods.
  • Governance procedures and oversight body involvement directly affect how investors implemented their private equity programs. Private equity programs administered by internal staff reported wide latitude to make operational, strategic, and implementation decisions. Investors using non-discretionary consultants reported moderate flexibility to manage their private equity teams and programs, while discretionary consultants/fund-of-funds were primarily used for plans where approvals from oversight bodies were widely required across an array of operational, strategic, and implementation decisions.
  • Staffing was a widespread source of frustration. Challenges primarily stemmed from limited personnel resources and challenges in hiring and retaining experienced staff. In a parallel study, Callan found private equity staffing was top-heavy, with 63 percent of reported staff qualifying as senior-level, relative to 25 percent for comparable private equity consulting firms and fund-of-funds. Further, the firm found a segment of large plans disproportionately understaffed, with the portfolio oversight responsibilities nearly double that of other institutional private equity investors. Finally, Callan found that ambiguity around the path of career progression and compensation growth drove elevated turnover levels; there was nearly an 81 percent turnover rate between junior-level to mid-level private equity staff and a 23 percent turnover rate between mid-level and senior-level staff.
  • In administering institutional private equity programs, investors valued core disciplines. These included strategic planning, structuring, and pacing; qualitative manager monitoring; performance reporting, benchmarking, and audit; and primary partnership due diligence. Many of these tasks were led by external consulting or other resources, while private equity staff, previously characterized as top-heavy, was often relegated to performing back office and administrative tasks.

The full survey is available on Callan’s website here.
The views expressed in the article do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Callan or TEXPERS.

About the Authors:

Jay Nayak
Jay Nayak is a senior vice president in Callan's Private Equity Research group, based in the firm's San Francisco office. His role includes research coverage of private equity strategies and private credit on behalf of the firm's clients. This due diligence process includes a review of investment strategies, organizational structures, investment processes, track records and other firm-,, investment vehicle-, or asset class-specific considerations. Nayak is also responsible for performing research on private market investments for internal and external distribution.

Snapchat logo

Snap out of it

Prominent indices reject Snap Inc.'s non-voting share structure

By Nicole Lavallee and A. Chowning Poppler
Guest Columnists

After months of consultation with market participants, three prominent indices banned companies with non-voting stock.

Among them, the parent company of popular mobile messaging app Snapchat, Snap Inc. The tech company made headlines in March 2017 with its novel IPO selling Class A common shares without any voting rights. Of the 200 million shares sold at $17 apiece, none came with a right to vote on directors, executive compensation, mergers, acquisitions or other corporate matters. Instead, Snap’s two co-founders retained 88.5 percent of the company’s voting power, with the remainder left to executives of the company and some early investors. This was a remarkable shift away from the standard practice of taking an investor’s capital in exchange for the right to hold the company’s management accountable.

Concerned that Snap was disenfranchising shareholders, investor advocates spoke out against dual-class share structures prior to Snap’s IPO. Unpersuaded, Snap went public as planned, raising $3.4 billion for the company without relinquishing any decision-making power to investors. Since then, industry leaders and stakeholders have considered the implications of such a sea change. Proponents argue that consolidated voting power in the hands of founders allows them to build long-term value without worrying about short-term share price pressures. Opponents argue that, even if the structure is efficient at the time of the IPO, the potential advantages are short-lived and potential costs tend to rise as time passes from the IPO. Specifically, dual-class structures remove investors from oversight roles, eliminate management’s incentives to perform or face ouster and result in higher pay for CEOs without comparable payoffs for shareholders.

Investor advocacy groups turned their attention to index providers because many institutional investors hold some portion of their portfolios in one or more established indices. Institutional investors would inevitably end up holding non-voting shares if companies like Snap were added to a popularly tracked index.

Now, three prominent indices banned companies with non-voting stock (one on a temporary basis). In July 2017, S&P Dow Jones announced that the S&P Composite 1500 would no longer add companies with multiple share class structures. Starting in September 2017, five percent of available voting rights must be in the hands of unrestricted shareholders for a new IPO company to be included in British index provider FTSE Russell. A third index, MSCI, announced in November 2017 that it will temporarily treat any securities of companies exhibiting unequal voting structures as ineligible for addition to the MSCI ACWI IMI and MSCI US Investable Market 2500 Index.

Time will tell if these index rules will have an impact on whether tech wunderkinds will continue to push for classes of non-voting shares when their companies go public. Nonetheless, by tightening standards to foreclose companies from including non-voting stock, the S&P Dow Jones, FTSE Russell and MCSI have effectively blocked Snap from being included in their indices. More importantly, these exchanges have taken a meaningful step to protect investors’ rights and preserve the fundamental principle of “one share, one vote”.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Berman Tabacco or TEXPERS.

About the Authors:

Nicole Lavallee
A. Chowniing Poppler

Nicole Lavallee is the managing partner of Berman Tabacco’s San Francisco office and A. Chowning Poppler is an associate in the San Francisco office.

How to keep your balance if volatility returns in 2018

By Douglas J. Peebles and Matthew Sheridan
Guest Columnists

The volatility bond investors expected when 2017 began never showed up. We suspect it will come out of hiding in 2018. With valuations stretched and monetary policy turning, investors will want to think carefully about which risks they take.

This year was supposed to be the one that would shake up the status quo of modest growth, tepid inflation and low bond yields. The Federal Reserve did its part by raising interest rates and starting to reverse the asset purchases that created trillions of dollars of liquidity after the financial crisis.

But the markets didn’t stick to the script. Risk assets such as equities and high-yield bonds have continued to rise and the US dollar has been falling. Long-term US Treasury yields, meanwhile, have declined and the yield curve, which plots the gap between two- and 10-year yields, has become flatter. In other words, financial conditions eased substantially—the opposite of what the Fed intended.

Why Is the Yield Curve Flattening?
A flattening yield curve is typically seen as a warning sign for markets. It suggests that growth is slowing and a recession may be near (Display). Is that what’s happening here? We don’t think so. At least, not yet.

If a recession were just around the corner, it would mean that the Fed has been tightening policy too quickly. But if that were the case, you would expect to see equity valuations take a hit and economic data to deteriorate. What’s more, the Fed’s benchmark interest rate—in nominal and real, or inflation-adjusted, terms—is still low and the curve is steeper than it was in the run-up to previous recessions.

So why are long-term yields so low? A more likely explanation, in our view, is that there’s still a tremendous amount of liquidity in the financial system. During and after the financial crisis, the Fed flooded the economy and markets with money and kept long-term rates low by buying trillions of dollars of bonds. That distorted many market signals. By letting some of the bonds on its balance sheet mature, the Fed has slowly started to drain that excess liquidity. But it has a long way to go.

At the same time, the Bank of Japan and European Central Bank are still buying bonds and other financial assets, which helps to offset the Fed’s modest tightening. Even so, a flatter yield curve can’t be dismissed outright. We think caution is warranted.

Don’t Count the Fed Out
Of course, none of this means yields will remain low forever. With the economy operating at full capacity, the Fed is widely expected to raise rates several times in 2018. If big changes to US tax policy become law and boost growth and inflation, the Fed may be forced to tighten even more aggressively.

This action would likely increase volatility and have implications for various sectors of the bond market. That’s why investors will have to be careful about how they manage their exposure to the market’s two primary risks—interest rates and credit.

Normally, return-seeking credit assets such as high-yield corporate bonds and emerging-market debt do well when growth accelerates and interest rates rise. Treasuries and other high-quality bonds—we like to call them risk-reducing assets—struggle in these conditions because higher rates and rising inflation reduce these securities’ market value. In such circumstances, investors may be tempted to reduce their interest-rate risk—or duration—and increase their credit risk.

Want Balance? Consider a Credit Barbell
But these aren’t normal times. Years of central bank asset purchases and low rates encouraged global investors to crowd into the same high-yielding credit assets. That’s raised valuations and compressed yield spreads—the extra yield they offer over comparable government bonds. 

There are certainly still opportunities with credit markets, but we think investors should think twice about taking on too much credit risk, given current prices and conditions. A better approach, in our view, would be to pair Treasuries and other interest-rate-sensitive assets and growth-sensitive credit assets in a single strategy known as a credit barbell. Because the returns from the two types of assets are negatively correlated, strong returns on one side of the barbell can outweigh weakness on the other.

U.S. Treasuries, of course, will struggle over the short term if tighter Fed policy eventually causes the curve to steepen. But even in rising-rate environments, these assets provide crucial stability, diversification and income.

Exposure can also keep your bond portfolio liquid. Eventually, higher rates will slow growth and put an end to the credit cycle. In these periods, Treasuries tend to beat assets such as high-yield bonds. This means investors can rebalance their portfolios by selling outperforming US Treasuries and buying underperforming credit assets at discount prices.

The key to success, in our view, is having the ability to actively adjust your interest rate and credit weightings as conditions and valuations change. If markets do get more volatile in 2018, the balance will be more important than ever. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams or TEXPERS.

About the Authors:

Douglas J. Peebles
Douglas J. Peebles is the chief investment officer of AB Fixed Income and a Partner of the firm, focusing on fixed-income investment processes, strategy and performance across portfolios globally. As CIO, he is also co-chairman of the Interest Rates and Currencies Research Review team, which is responsible for setting interest-rate and currency policy for all fixed-income portfolios. In addition, Peebles serves as lead portfolio manager for AB’s Unconstrained Bond Strategy and focuses on managing the firm’s strategic client relationships.

Matthew Sheridan
Matthew Sheridan is a senior vice president and portfolio manager at AB, primarily focusing on the global multi-sector strategy portfolios. He is a member of the global fixed income, global high income and emerging market debt portfolio-management teams. Additionally, Sheridan is a member of the rates and currency research review team and the emerging market debt research review team.