Oxstones Investment Club™By Nathan Rowader, Forward Management,
Seeking a Clear Path Through the Turmoil
A conversation with Nathan Rowader, Forward Director of Investments & Senior Market Strategist
Emerging markets (EM) have been an enduring growth story, but their recent stretch of underperformance and fears of a global economic slowdown are chilling investors’ enthusiasm. Pulled between opportunity and risk avoidance, many investors have been left uncertain as to what they should do next.
For those with substantial allocations to emerging markets, 2013 performance numbers raised troubling questions. In a year when the S&P 500 Index jumped
32.39%, the MSCI Emerging Markets Index declined by -2.27%. Warnings of an economic slowdown across a broad swath of nations, coupled with civil unrest in hotspots like Brazil, Turkey, Thailand and Ukraine, only fueled concerns.
Between June 2013 and February 2014, nervous investors have pulled over $10 billion out of EM equity funds, the withdrawals accelerating in early 2014.
On the other hand, astute investors understand that emerging economies continue to grow more rapidly than developed nations, and that falling valuations can add to their appeal. Those investors equipped to look beyond broad-brush trends may find opportunity in particular countries or even individual stocks.
How can global investors navigate a market presenting such mixed signals? We sat down with Nathan Rowader, Director of Investments & Senior Market Strategist at Forward, to explore his thoughts on these issues.
Investors are clearly reacting to the negative news about emerging markets, especially their underperformance last year. What’s behind that trend?
I imagine many investors were surprised when EM declined while the U.S. market surged ahead in 2013. Emerging market stocks in general qualify as high beta, meaning higher volatility, and normally we would expect those types of stocks to post strong performance in a bull market like the one we saw last year. The last time the U.S. gained while the emerging markets fell was during 1998’s Asian currency crisis. Today’s drivers of underperformance are a bit more nuanced than they were in 1998.
From a long-term perspective, the key trend is slowing economic growth in the large nations that drive the index, most notably China, Brazil and India. Take China for example: for the past 30 years its real gross domestic product (GDP) has expanded by 10% per year on average, but its GDP is forecast to grow at a rate of 7.7% over the next decade.1
Is this economic slowdown due to the natural maturing of these economies? That’s likely a large part of the reason, but some of the deceleration can be attributed to policy missteps as well. Brazil is one example. Its president, Dilma Rousseff, unwound many of the economically advantageous monetary policies her predecessor put in place. Instead, she has favored more populist policies and fiscal actions such as manipulating gasoline prices. The consequent uncertainty about Brazil’s economic policies has driven off foreign investors and put a damper on domestic business investments.
A shorter-term factor in the slowing growth is the decline in currency values of some emerging markets. U.S. monetary and fiscal policies have made our exports more competitive and, as a result, the U.S. dollar has gained strength. So EM nations that import our goods and have a current account deficit, such as South Africa, Turkey and Chile, are in effect short the U.S. dollar (Figure 1). In some cases, those current account deficits are directly tied to the economic slowdown in China and other big EM economies.
As those major economies stabilize, it’s likely that some of the smaller EM economies will do so as well. The weakening of EM currencies has also been compounded by rising U.S. interest rates, which is forcing levered investors to cover their short positions in U.S. dollar-denominated securities (such as Treasurys) while selling long positions in certain emerging market securities (such as sovereign bonds) in high-yielding countries like Turkey. Finally, weak currencies and slower growth are leading to lower corporate earnings growth, especially in the countries with the hardest-hit currencies, such as Turkey and South Africa.
Should investors be anticipating some kind of crisis, like the Asian financial crisis in late 1997 and 1998?
No; market conditions today are very different from those back then. The Asian crisis really stemmed from the fact that, in one way or another, EM currencies and debt were pegged to the U.S. dollar. As the U.S. dollar rallied in the late 1990s, the cost of servicing dollar-denominated debt skyrocketed. Having learned from that experience, many of the same countries now have a more flexible policy and may issue debt in either the U.S. dollar or the local currency— however their government financial agencies deem fit. At the same time, these nations no longer directly tie their currencies to the U.S. dollar, giving themselves more room to adjust currencies and interest rates in light of current economic conditions. Beyond that, the fiscal health of EM nations is generally much better than it was in the nineties. In fact, many have higher reserve levels and lower debt than developed nations.
Given current and potential future market conditions, should investors be thinking about changing their EM exposure?
Investors should certainly expect continued and increased volatility and make sure they are taking steps to diversify or hedge investments to mitigate risks. But, meanwhile, the drop in EM has some long-term investors thinking in terms of opportunity. The numbers certainly suggest that emerging and frontier countries offer some of the most compelling valuations in the global equity market today (Figure 2). At the end of February 2014, the MSCI Emerging Markets Index was trading at a price-to-earnings (P/E) ratio of 11.2, compared with 18.7 for the MSCI USA Index and 20.8 for the MSCI Europe Index. Emerging markets look equally attractive in terms of other valuation metrics, such as dividend yield and price-to-book (P/B) ratio.
The long-term economic growth outlook for EM is also favorable. EM countries are expected to grow faster than their developed counterparts (Figure 3), with the MSCI Emerging Markets Index forecast to grow earnings at 14.7% versus 13.8% for the U.S. and 7.5% for Europe.
A key question here is whether we’ve reached the point where EM countries are oversold and prices are going to begin climbing again. To shed light on that, we can look at technical measures like the 14-week Relative Strength Index (RSI), a momentum indicator that compares recent gains and losses on a 100-point scale. At the end of January 2014, the relative strength of the MSCI Emerging Markets Index was 36, which, though low, suggests that there is still room for further selling in EM before they become oversold.
Depending on investors’ allocations to EM stocks and tolerance for volatility, some interim reduction in exposure might be a prudent move. Alternatively, investors who want to be nimble can elect to use an active manager. One of the challenges with using an index fund in this space is the very large exposure to countries that are presently carrying sizable account deficits, such as Brazil, India and Mexico. An active manager could look either at specific companies that are less affected by changing currency values or at countries that aren’t suffering the effects of large account deficits, such as China, South Korea and Taiwan. Another option is to invest tactically in country-specific exchange-traded funds (ETFs), with a focus on nations that currently have account surpluses, strong earnings growth projections and low levels of debt.
What would you consider to be a prudent allocation to emerging markets?
This is an important question because I would guess that most U.S. investors are already substantially underweight EM in relation to their share of the global economy, which is most often measured by market capitalization. The market cap of emerging markets equates to roughly 18% of global equity markets, as measured by the MSCI ACWI.2 So I believe that, at a minimum, investors should start with an 18% weight of their equity exposure.
The wrinkle here is that most indexes, including MSCI ACWI, adjust market capitalization by using a “free float” method that subtracts shares not necessarily available to the public, such as those held by governments. If you eliminate that adjustment, emerging markets account for more than 25% of the global equity markets (Figure 4). I would argue that even if investors base their equity allocations on that figure, it is still a small position when considering the importance of EM economies to the overall global economy.
How do you measure the importance of emerging markets in the global economy? And how do those measures factor into your thinking on portfolio allocations?
I believe a strong case can be made for looking at EM economies in terms of GDP and not just market cap. At the end of 2012, EM nations accounted for nearly 32% of global nominal GDP in current U.S. dollars. That means that EMs contribute more to the global economy than the United States, which comprised roughly 22% of global GDP.3
But even these numbers may not accurately portray the economic size and importance of EM countries. Some economists believe that nominal GDP should be adjusted for purchasing power parity because that takes into account the value of currencies, which are sometimes manipulated by governments. If you view the global economy through this lens, emerging and frontier countries collectively make up about 43% of the world’s economy while the U.S. makes up a little less than 19%.
Together these varying measures suggest that investors might reasonably allocate anywhere from a minimum of 18% to as much as 43% of their equity portfolios to EM stocks. As I mentioned, it’s likely that many investors currently are not even close to the 18% allocation, let alone 43%. The good news is that the current market environment could give investors a historic opportunity to adjust their portfolios toward a larger EM equity allocation.
But doesn’t a 43% allocation to EM stocks sound a little high?
It’s certainly above the levels investors have been accustomed to; but then, the world has shifted fundamentally. Twenty-five years ago, emerging markets represented just 1% of global GDP. Now they account for about a third, or even more, depending on what measure is used. The growth in global economic share of EM may slow or may accelerate but, given the rapidly growing populations and rising affluence of emerging markets, it’s highly unlikely to reverse.
One more metric that underscores the long-term value of EM is the difference between market capitalization and GDP, a ratio popularized by entrepreneur and investor Warren Buffett. It bears some resemblance to P/E ratios since corporate earnings historically have tended to grow in line with GDP. This ratio tends to be a long-term measure of value as EM stock prices will likely converge with GDP as they become more integrated with the global economy. At the end of 2013, EM had a market capitalization-to-GDP ratio of 0.37 while the U.S. had a ratio of 1.14. These measurements tell us that EM equity markets have a long way to go before they fully reflect the economic power of emerging nations, and investors can benefit from this process of convergence over the long term.
Economic growth forecasts can also help investors think about their EM allocations. Emerging economies are predicted to grow at a real rate of 4.3% annually over the next 10 years, while the U.S. is expected to grow 2.7% per year. Based on these forecasts, investors may readily calculate a fairly reasonable expected return and use that as the basis for their EM equity allocation.4
Is this convergence of market cap and GDP a consistent, predictable occurrence in emerging markets?
Yes, because equities in the developed world have always commanded a valuation premium over those in emerging nations. This is typically attributed to the shareholder-friendly legal framework, stable government and established banking systems in industrialized nations, as well as their long history of stable corporate earnings growth. That premium, however, has narrowed over the past three decades as emerging markets have gained more access to capital and modernized their financial and legal structures. The most obvious sign of these changes is the privatization of state-owned enterprises, which often unlocks large stores of value, thus narrowing the value premium in terms of both traditional measures and the market cap to GDP ratio.
A current example of this is the performance gap between Petrobras, the partially privatized Brazilian oil company, and Pemex, the entirely state-owned Mexican oil company. Petrobras was listed on the New York Stock Exchange in 2000 and is now the ninth largest oil company in the world based on market capitalization.
The two companies are similar in proven oil reserves—Brazil ranks fifteenth in the world and Mexico, sixteenth—but the main difference between these two companies is in their ownership. The semiprivate Petrobras is forced to compete with other private companies in Brazil and has access to many different sources of capital, while Pemex is a state-owned monopoly with limited access to capital. This difference has led Petrobras to beat Pemex in both 2013 revenue and 5-year growth in revenue. Many analysts believe that Pemex will continue to lag as limited capital will hamper its ability to tap oil and gas in areas where drilling is difficult, such as deep sea and shale deposits. Ultimately, the difference in the productivity of these two companies may be best demonstrated by their growth: over the last 10 years Petrobras has increased its oil (and oil equivalents) production by over a million barrels per day whereas Pemex has actually decreased production by 600,000 barrels per day.
This tale of two companies has not gone unnoticed. At the end of 2013 the Mexican government introduced some major reforms to the energy sector, paving the way for privatization. Soon foreign companies will be allowed to operate in Mexico through production- and profit-sharing agreements. The comparison of Petrobras and Pemex also illustrates why EM stock prices converge with GDP over time, as companies increasingly compete in global markets, gaining efficiency and productivity in the process.
To wrap up this discussion, let’s talk about what investors should be monitoring as they think about their EM exposure.
Based on the relative strength measure I mentioned, we could describe investor sentiment for EM as being within the neutral range. On the other hand, investor sentiment for the S&P 500 Index is very high, and the valuation of U.S. stocks is somewhat high as well. In my view, it makes sense for investors to wait for both the U.S. and EM to reach an oversold condition before allocating back into emerging markets. When that happens, it would likely signal a very healthy market for EM stocks and, to my mind, a great opportunity to increase an overall EM equity allocation.
When investors allocate for broad exposure to EM, they are investing in macro trends that are playing out over a matter of decades. It certainly makes sense to adjust tactically to major events and dislocations. At the same time, it’s important to be thinking about what the world economy will look like five or 10 years from now. There’s nothing like investing in emerging markets to exercise investors’ capacity for long-term thinking.
Definition of Terms
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
Dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its share price.
MSCI ACWI (All Country World Index) is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global developed and emerging markets.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
MSCI Europe Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed markets in Europe.
MSCI USA Index is a free float adjusted market capitalization index that is designed to measure large and mid cap U.S. equity market performance.
Price-to-book (P/B) ratio is used to compare a stock’s market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share.
Price-to-earnings (P/E) ratio of a stock is a measure of the price paid for a share relative to the annual income or profit earned by the firm per share. A higher P/E ratio means that investors are paying more for each unit of income.
Purchasing power parity is an economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency’s purchasing power.
Relative Strength Index is a technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset.
S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.
Valuation is the process of determining the value of an asset or company based on earnings and the market value of assets.
Volatility is a statistical measure of the dispersion of returns for a given security or market index.
One cannot invest directly in an index.
You should consider the investment objectives, risks, charges and expenses of the Forward Funds carefully before investing. A prospectus with this and other information may be obtained by calling 
(800) 999-6809 or by downloading one from www.forwardinvesting.com. It should be read carefully before investing.
RISKS
There are risks involved with investing, including loss of principal. Past performance does not guarantee future results, share prices will fluctuate and you may have a gain or loss when you redeem shares.
Investing in exchange-traded funds (ETFs) will subject a fund to substantially the same risks as those associated with the direct ownership of the securities or other property held by the ETFs.
Foreign securities, especially emerging or frontier markets, will involve additional risks including exchange rate fluctuations, social and political instability, less liquidity, greater volatility, and less regulation.
Diversification and asset allocation do not assure profit or protect against loss.
Data and statistics presented have been obtained from sources we believe to be reliable, but we cannot guarantee their accuracy or completeness. All expressions of opinion are subject to change without notice.
As of 12/31/13 none of the Forward Funds had holdings in Petrobras. Holdings subject to change.
The new direction of investing
The world has changed, leading investors to seek new strategies that better fit an evolving global climate. Forward’s investment solutions are built around the outcomes we believe investors need to be pursuing – non-correlated return, investment income, global exposure and diversification. With a propensity for unbounded thinking, we focus especially on developing innovative alternative strategies that may help investors build all-weather portfolios. An independent, privately held firm founded in 1998, Forward (Forward Management, LLC) is the advisor to the Forward Funds. As of December 31, 2013, we manage $5.2 billion in a diverse product set offered to individual investors, financial advisors and institutions.
Nathan Rowader is a registered representative of ALPS Distributors, Inc. Forward Funds are distributed by Forward Securities, LLC.
Not FDIC Insured. No Bank Guarantee. May Lose Value.
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