Why Bother Investing Outside the United States?
This is a question we have been getting more frequently in recent times. We were getting similar questions back in the late 1990s after U.S. stocks experienced a great run of outperformance over international stocks. Developed international stocks subsequently went on to outperform U.S. stocks for six years, and emerging-markets stocks did even better.
It is important to revisit why we have investments outside the United States as part of our very long-term or “strategic” allocations. The strategic allocations are the starting point for our investment process. They are intended to be an appropriate, fixed-asset allocation for a long-term investor, as they reflect a weighted mix of asset classes we believe offer the best long-term-return potential for a given risk threshold, which we define as a maximum acceptable loss over a 12-month normal worst-case period. Our investment horizon in regard to strategic allocations is 10 years or longer. The most important reason for having a globally diversified strategic mix is that it should provide a much smoother ride than just being invested in U.S. stocks (Chart 2). The second reason to invest outside the United States is to tap into a broader investment opportunity set. This is especially true for emerging markets.
The case for having a dedicated long-term allocation to emerging markets is particularly compelling. On a purchasing-power-parity basis, emerging-markets’ share of world GDP has grown from 37% in the late 1990s to nearly 50% as of 2012, and currently has a share of about 11% of world market-cap (in contrast, the United States has a 19% share of world GDP and 48% of world market-cap) (Chart 3). Emerging markets are home to a large proportion of the globe’s young working-age population, and are benefiting from the transfer of knowledge from developed nations that is happening at a rate faster than any other time in human history. This process ultimately leads to higher productivity, per-capita incomes, and GDP. We know higher GDP and/or faster GDP growth does not necessarily lead to higher stock market capitalization in the shorter term, but over the long term, if profits are not squandered away via mismanagement or devalued via inflation, faster GDP growth does lead to faster profit growth and a deepening of capital markets (where we are already seeing significant progress). As this happens, emerging-market countries will see the gap narrow between their shares of world GDP and market cap. We want our clients to benefit from this long-term opportunity. The problems we’ve seen this year in emerging markets is only a blip on what we expect to be a very long-term, upward path. In the next section, we discuss the risks in emerging markets over the shorter term, but even that does not negate the strategic case for owning emerging markets—stocks and bonds—in client portfolios.
Taking Stock of Emerging Markets
Emerging-markets stocks were hit especially hard this year after the Fed indicated its intent to taper QE, and over the last couple of years have underperformed U.S. stocks. During this time we have taken advantage of price weakness in emerging-markets stocks by moving toward our strategic weighting at a gradual, measured pace. As such we are only one percentage point overweighted to emerging-markets stocks in our typical balanced model (taking into account our look-through analysis of our international stock-fund holdings as well as our dedicated emerging-markets funds). As we’ve reiterated along the way, the primary reason we have not increased our weighting further is our longstanding concern related to China’s credit and infrastructure bubble.
This summer it became clear to us that this China risk might well play out. The Chinese government’s actions to rein in credit growth suggest they are concerned about past overinvestment and potential bad debts. China’s actions, in turn, are slowing growth there as well as in the rest of the emerging markets. When we model in the China risk, returns from emerging-markets stocks could be as low as mid- to upper-single-digits (nominal) five years out, which, adjusted for their relatively high risks, puts them roughly in fair-value territory in relative terms, and not attractive in absolute terms. However, there is also a decent possibility that the infrastructure bubble is not as significant as we fear and/or China might be able to unwind this bubble in a relatively orderly fashion. Assuming these China-related headwinds end up not as material as we fear, we get low double-digit returns in our likely scenario, which are attractive in both absolute and relative terms (even after we discount these returns substantially because our emerging-markets modeling is based on a very short data history that lowers our confidence level). Hence, we are sticking with our current, very slight overweight position in emerging-markets stocks.
Coming to emerging-markets local-currency bonds, they too suffered this spring and summer as emerging-markets currencies declined versus the U.S. dollar. Before delving into our analysis of emerging-markets local-currency sovereign bonds, it is important to review how we think about this allocation, which we have through PIMCO’s Emerging Local Bond fund. Our time horizon for this position has always been longer than the five years typical for our tactical positions. We see it as a good way to hedge a potential decline in the U.S. dollar/U.S. inflation. As covered earlier, insuring against this risk remains prudent in our view, given the Fed’s unprecedented monetary policies in recent years that have bloated its balance sheet (Chart 4). In aggregate, long-term fundamentals—primarily balance sheets and growth prospects—for emerging markets are stronger than the United States. As such, in a normal scenario we believe we can get at least mid- to upper-single-digit returns over our investment horizon. These returns are better than what we expect from U.S. stocks in our likely subpar recovery scenario. Finally, to adequately factor in emerging-markets currencies’ equity-like risk, which we clearly experienced this summer, we fund them mostly from U.S. stocks. Overall, looking out five years and longer, given the role they are playing in the portfolio and taking into account the risk from our allocation to emerging-markets stocks, we have thus far been comfortable holding a four percentage-point allocation in emerging-markets local-currency sovereign bonds in our balanced models.
What’s Behind the Recent Declines in Emerging-Markets Currencies?
We have been surprised by the magnitude of decline in emerging-markets currencies following talks of the Fed tapering its QE program (though they have recovered nicely from the bottom). We can’t imagine anyone believing that QE is a permanent state of affairs. So it’s hard to not conclude that many investors were playing a game of musical chairs and reaching for yield, without a proper appreciation of emerging-markets fundamentals. Moreover, even if the Fed tapers, which would likely be a gradual process, and despite the slowdown we have witnessed in some emerging-market countries, the differential in growth rates and real interest rates between U.S. and emerging markets would remain attractive, in our view. That said, this decline also raised a question in our minds as to whether we were missing something in our own assessment of emerging-markets fundamentals. So, the past few months we have been spending a lot of time re-evaluating our thesis and beliefs, verifying a lot of data, and, as we constantly do, asking ourselves what can go wrong. This effort is continuing but we can share some findings and conclusions, including outstanding questions and risks that require more analysis and continuous monitoring.
Our broad thesis on emerging markets rests on the belief that their macroeconomic fundamentals are much better than they used to be during their crisis-prone years. So, one key question we asked ourselves again recently is: are emerging markets fundamentally better than they were in the late 1990s, around the time of the Asian crisis that led to severe currency declines? Another question we are wrestling with is whether or not there is a risk of contagion in emerging markets, where even countries with decent fundamentals can see some sort of a run-on-the-bank, contaminating their fundamentals. We don’t think we have all the answers we need yet, but here are our current thoughts and findings:
In the past, fixed-exchange rates resulted in overvalued emerging-markets currencies, which in turn resulted in large current-account deficits, making emerging-market countries vulnerable to capital outflows and currency crises. (If a country imports more than it exports, it runs a current-account deficit that it has to finance by attracting capital from abroad. The United States runs a current-account deficit and needs to do the same, for example.) So, as a first step, we verified whether or not emerging-market countries today are as vulnerable to capital outflows as they were back in the 1990s.
We looked at current-account deficits across different emerging markets with and without China. We wanted to evaluate current-account deficit without China because its large current-account surplus might hide vulnerabilities in the rest of the emerging-markets universe. While there are fewer emerging-market countries running current-account deficits today than in the late 1990s, some regions are clearly vulnerable (Chart 5). Emerging Europe and Africa are running relatively large current-account deficits; Latin America is not, though their current level is similar to what Asia’s was before they experienced a currency crisis in the late 1990s. Asia’s aggregate current-account deficit level doesn’t look threatening, but hidden in those numbers is India, which could face a crisis if capital outflows continue. Moreover, in recent years the trend in Asia’s current-account balances has been negative. Looking at current-account deficit in isolation, it seems that emerging markets are susceptible to a major crisis akin to the 1990s. However, in our view current-account deficit should not be looked at in isolation.
First, most emerging-market countries today have floating (rather than fixed) exchange rates. This allows currency moves to release pressure that might develop due to fundamental imbalances. For example, if a country’s terms of trade are deteriorating, i.e., it is becoming less competitive, currency declines help correct that imbalance. Declines in currency also help fix the current-account deficit problem. In the past, most emerging-market countries had fixed-exchange rates, so there was no pressure-release valve, leading to larger imbalances in the economy and ultimately larger devaluation events.
Second, the true indicator of an economy’s dependence on foreign capital is the sum of current-account deficit and external debt burden, especially debt denominated in a foreign currency (typically in U.S. dollars). Today, most emerging-market countries do not have as significant an amount of dollar-denominated debt (as a % of GDP) as they did back in the late 1990s (Chart 6). Their external liabilities are thus unlikely to shoot up astronomically when their currencies decline versus the U.S. dollar. This rapid rise in liabilities in the late 1990s forced emerging-market countries to spend their foreign-exchange reserves to stem the currency declines, which made them more vulnerable, compounding the vicious cycle. Also, it forced them to raise interest rates sharply (to attract investors via higher yields, and to counter inflation resulting from a weak currency) at a time when their economy was already slowing, leading to a much sharper economic downturn/recession (a worrying dynamic we are seeing played out in India at present). In the past decade, most emerging-market countries have started issuing local-currency debt (which is what we have been investing in for many years), lowering their need to issue dollar debt. So, the risk of currency declines contaminating emerging-markets balance sheets is much less today. This is a key fundamental difference between the two periods.
Finally, most emerging-market countries have relatively large foreign-exchange reserves. These reserves allow current-account deficit countries to pay for necessary imports when capital flow dries up (Chart 7). They also serve as a deterrent to speculators, as the central banks in question can expend these reserves to support their currencies. The fear of loss is a powerful deterrent to speculators, or else the United States would have had a crisis long ago.
Weighing the positives, while the current-account deficit situation across emerging-market countries makes us nervous, we think a broad-based emerging-markets contagion is unlikely. That said, contagion risk cannot be completely ruled out either. There are some key unknowns that we cannot analyze with a high level of confidence. These unknowns, which impact our thinking on both emerging-markets stocks and bonds, warrant close monitoring:
- If capital outflows from emerging markets continue, such that long-term-oriented investors also throw in the towel, there is a risk that technical factors (i.e., capital outflows) could contaminate fundamentals, i.e., the damage becomes sort of a feedback loop. Emerging-markets foreign-exchange reserves are healthier than they were in the past, but in absolute terms they are not large enough to ward off a sustained bout of capital outflows. If outflows continue, we may revisit the negative cycles the emerging markets went through in previous crises.
- If emerging-market countries start abandoning their relatively newfound inflation discipline due to political pressures and/or factors beyond their control that will impair our long-term thesis, especially for emerging-markets local-currency sovereign bonds and the role (discussed above) we see them playing in our portfolios.
- If China’s credit and infrastructure bubble unwinds in a more destructive fashion than we currently envision, it would be a major drag on emerging-markets growth and a major negative for emerging-markets risk assets.
- If the commodity cycle goes in reverse in a major and sustained way, due to China’s slowing demand and/or significant increases in supply of commodities, it will negatively impact macroeconomic fundamentals of some key emerging-market countries, such as Brazil and Russia, and could result in higher risk-aversion toward all emerging-markets assets.
- We have witnessed a relatively sharp increase in dollar-denominated debt among emerging-markets corporations. Based on our discussion with emerging-markets fund managers thus far, this does not appear to be a material risk; it’s more a company-specific risk. But we are not confident that is the case, and will keep digging to assess this risk factor further.
In the case of emerging markets, the unknowns are too many for our liking. This means that the bar to add to emerging-markets stocks and/or emerging-markets bonds is much higher than normal (though our concerns have not yet led us to unwind our existing holdings because their risk/reward still looks relatively attractive in most scenarios). If any of the above-mentioned concerns begin to play out, we may change our current view on these asset classes quickly. It is also possible, if and when these risks play out, that prices will decline enough to make them attractive in our minds. The bottom line is that the downside associated with the above-mentioned risks and our mandate to manage to specific 12-month-risk thresholds are key reasons why we want to see a greater margin of safety or lower prices before we allocate more to emerging-markets stocks and/or bonds.
An important part of our investment discipline is to protect client portfolios against risk scenarios we believe are plausible and not already adequately factored into asset prices. Taking this precaution means we will likely underperform in the shorter term if these risk scenarios do not play out. The fear of underperforming our benchmarks over the short term is not good cause to deviate from the investment discipline that has served our clients well over the long term. We will continue to work hard to assess the environment around us and not shy away from deviating from our benchmarks and/or peers if we believe that is the prudent thing to do for our clients.
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Sam Alaoui and your Capital Trust & Associates, LLC Research Team.