Fund performance summary for Q2 2018
Uncertainty breaking fundamentals
Our positioning remains broadly the same as it was in Q1 2018. Normally this is a relatively routine statement to make, but not this time. Our long-standing preference for emerging market assets has been tested in the extreme.
The macroeconomic indicators we monitor suggest that global trade is still healthy. But the assets usually buoyant in this environment have been battered. We think that this dynamic is likely a result of heightened uncertainty bought on by multiple factors, some of which are very difficult to forecast.
To name the more pertinent ones, we have escalating tit-for-tat protectionist economic policies that may or may not jam the world’s economic cogs; tax cuts on an already white-hot American economy that could potentially supercharge near-term economic activity and bring forward the timing and amplitude of US interest rate normalisation; and emerging markets that are having their economic fundamentals undermined by idiosyncratic dynamics like Russian sanctions, a Turkish dictatorship, political fluidity in Brazil, and a potential debt crisis in Italy.
This pervasive uncertainty, in tandem with a runaway US economy, is fertile ground for a stronger US dollar. This is, first, a major problem for the performance of any risk asset not denominated in US dollars and second, a real anomaly considering how the greenback usually behaves when global growth is strong – hint, it’s normally weak!
It is our opinion that the outcome (both in magnitude and impact) of some of these variables is very difficult to forecast because many are new phenomena. They require daily monitoring, particularly in the context of how they might affect economic global growth.
Making drastic portfolio changes at this juncture is therefore something we are not willing to do as the fundamental indicators that underpin our investment process do not suggest this course of action.
This is not to say we are dogmatic about our current emerging market biased positioning; should the fundamental global growth metrics deteriorate, there would be no qualms about making appropriate changes to our existing construction.
What happened, what next?
Chart 1 illustrates just how violent the Q2 emerging market (EM) underperformance has been relative to the S&P 500 index; in short, nearly all the relative outperformance seen since 2016 is gone. Bringing it home, Chart 2 shows that our domestic-centric assets are indeed EM in nature. SA Banks (with their share prices in USD) are unquestionably correlated to the MSCI EM equity index.
The one variable that has historically coincided with strong EM performance is buoyant commodity prices. So given the heavy selloff in EM, metals prices must have fallen off a cliff, right? Not so, says Chart 3.
You could argue that commodity prices have indeed turned down (small dip of blue line above) and that it’s time to abandon EM assets. But if the magnitude of this pullback in commodity prices is reason to jump ship, you’d already have gone overboard a few times, sacrificing returns and running up trading costs as you climb back aboard, drenched. But we wouldn’t blame you. The rhetoric around the booming US economy and the supposed inevitability of a stronger US dollar (bearish for EM assets) has had us near the rails a few times. What keeps us from jumping? First, valuation. Chart 4 depicts an expensive greenback using PPP analysis.
Chart 4 tells us that the US dollar is expensive relative to the Aussie dollar, the Japanese yen, and the euro. Interestingly, an acknowledgement that the greenback has been weakening against competing currencies (since global growth began accelerating in 2016) is absent from most commentary. But with a lot of noise in between, it has indeed shown weakness. But not to the extent we would have liked!
So the first thing that gives us comfort on a weaker US dollar stance is valuation. But we always factor in the cycle when making investment decisions. Chart 5 shows this leg of our analysis.
This is a pivotal chart for us. The dotted line is global trade, inverted. So when the line falls, global trade is improving. The solid line is the trade-weighted value of the US dollar. The correlation is good enough for us to state, with some conviction, that when global growth is accelerating (rising global exports are an indication of that acceleration) the greenback usually enters a period of weakness. Part of the underlying mechanism here is that US consumers (the biggest consumers during global economic expansions) are generally buying goods manufactured by other countries; this leads to improved trade balances for these exporters, allowing their currencies to strengthen against the US dollar.
Why we’re not afraid of the carry trade
So why has the US dollar been resilient in the face of strong global growth? The most common reasoning you’ll hear has to do with the “carry trade”; the story here is that interest rates are higher in the US which will attract capital and underpin greenback appreciation.
We agree that rates in the US are going up, the relevant economic data demands so. But we do not agree that that, in itself, guarantees a stronger US dollar. Firstly, the “carry trade” works as follows: The territory in which yields are going up faster will have the currency that appreciates. As we stand today, the US 10-year Treasury has a yield of 2.9% while the German bund equivalent is at 0.4%. US inflation is slightly higher, but not enough to justify this dislocation. And, on many measures, growth in Germany is just as healthy as that in the US. Also, our work on US rates suggests it’ll be difficult for the US 10-year yield to surpass 3.5% without materially slowing the economy. So from these yield starting points, we think that German yields could rise faster than US yields, a stronger Euro the result. Caveat: An Italian crisis may delay EU rate normalisation.
Our second, more anecdotal observation is that the “carry trade” isn’t something that’s coming – it’s already here. Starting with Chart 6 we can see that the spread between US and Aussie yields has been widening (falling blue line) in favour of the US since 2010. However, since global growth turned in 2016, the Aussie $ has been stronger (but less than we expected) against the US $. Chart 7 tells a similar story, this time using the Norwegian krona. Given the meteoric rise in the oil price, the krona should have been much stronger. So the “carry trade” tends to blunt dollar weakness, but doesn’t necessarily remove it.
The tax cuts levied on US corporates are also part of our “problem”. At this stage of the economic cycle, fiscal stimulus of this ilk is very unusual, as depicted in Chart 8. For the last 60 years, fiscal stimulus has only been applied when unemployment has risen. Now, the stimulus package is being applied at record low levels of unemployment. This is likely to be inflationary.
Looking at the above chart in tandem with the very strong economic data coming out of the US and you really can’t blame anyone for believing that interest rate normalisation may happen faster (and may require a higher level) than the Fed has guided for. But, as we’ve demonstrated, higher yields don’t necessarily guarantee a stronger dollar.
To recap one final time, our view of a weaker US dollar is based on it being overvalued on a purchasing power parity basis, its historical weakness during periods of strong global growth, and the belief that the “carry trade” merely blunts dollar weakness rather than reversing it.
This thesis is crucial for our portfolio construction, not just because our offshore allocation is predominantly denominated in EM territories, but also because of how influential the rand dollar exchange rate is on the performance of our local equity, particularly our corporates that rely on a flourishing SA economy.
Staying with the rand/dollar theme, Chart 9 illustrates how correlated our domestic bonds have been to the gyrations of the rand in the short term. If our call on a weaker US dollar prevails, a stronger rand should be supportive of falling bond yields which in turn will have a positive impact on many of our domestic centric, interest rate sensitive equity counters. The spanner in this thesis is the lack of confidence of both the consumer (despite recent wild statistics) and domestic businesses. This dynamic hampers earnings generation, which makes it hard to have conviction on these equities despite their attractive valuations.
The current health of the global economy would usually be accompanied by emerging market asset outperformance. The reality is that EM assets were sold off indiscriminately in Q2 2018 and now offer some of the best value among global financial assets. Against this, there are multiple dynamics at play that have the ability to put the breaks on global growth. Therefore, the potential for these assets to bounce back and demonstrate the leadership they usually do at this point in the economic cycle, is being questioned.
When dealing with this kind of uncertainty, we see no other option but to play what’s in front of us, using the tools that have long formed the basis of our investment philosophy and process. Again, if those metrics should change, we will act accordingly.