Highlights

  • Emerging markets an opportunity hiding in plain sight,
  • The quarter that was,
  • Current positioning and looking ahead

Emerging Market Equities: Hiding in plain sight?

Sometimes remarkable things hide in plain sight. In 1960 Arno Penzias and Robert Wilson were testing a horn antenna to detect faint radio waves, yet they just could not eliminate an annoying background “noise” from interfering with their observations. They tried everything to eliminate it, including removing pigeon nesting and pigeon droppings from the antenna. Yet the noise remained. After deciding there had to be an explanation for this, the duo along with other scientists eventually concluded that it was not just an annoying noise. It was actually the heat signature of residual radiation emanating from the big bang, providing proof that the big bang occurred.
Since the onset of lockdowns in March 2020, we have remained bullish on risk assets given the rise in our Obsidian global economic indicator. With the indicator now at historic highs, one should expect the second derivate of global growth to decelerate.

Accelerating Global Growth coming to an end

Source: INet, Obsidian Capital, July 2021

Asset prices are extremely sensitive to this rate of change in global growth. While it may be tempting to significantly cut back risk assets given this backdrop, we still feel there are ample opportunities for outsized returns. Select emerging market equities, fixed income and currencies are one of these opportunities we feel are hiding in plain sight.

Commodity prices drive asset prices in emerging markets such as South Africa, Latin America and Russia. This is not merely from market sentiment but commodity prices boost local manufacturing activity and government revenues.  This all filters into company earnings. Nothing illustrates this better than the chart below which shows JSE earnings and the industrial metals index.

Commodity prices driving a powerful JSE earnings cycle

Yet, in spite of strong commodity prices driving one of the most powerful JSE earnings cycle in recent history, asset prices are just not reflecting this. The multiples of the JSE continue to remain at decade lows. To put it in even starker terms JSE earnings (in dollars) are outperforming global equities earnings but continue to underperform on price!

JSE earnings exceeding global equities yet underperforming on price

This is not unique to South Africa, other markets we have investments in such as Brazil, Mexico and Russia, all exhibit similar characteristics.

High Beta Commodity LATAM indices are incredibly cheap

Not only do commodity prices bode well for these countries but most have:

  • Interest rates which are low by historical standards.
  • Core inflation that is contained
  • Record trade surpluses

All these factors combined provide one of the best economic conditions for emerging markets in years. One has buoyant commodities to boost industrial production and easy monetary policy to support consumer spending. However, we are cognisant of the vulnerable debt profiles of South Africa and Brazil. Although commodity prices will not fix this overnight, they can provide some breathing room for government balance sheets. The R138 billion tax overrun in South Africa during the last tax year driven by mining company profits, aptly illustrates this.

EM Tax Revenues & EPS to be boosted by high commodity prices

It is important to note we are not investing in these markets just because they are cheap. It is core to our investment philosophy that over the long term, earnings drive share prices. With the economic backdrop described above we believe there is a powerful momentum in emerging market earnings that the market is underappreciating.
So, while global growth may decelerate, it should remain strong as employment and industrial production recover to pre-pandemic levels.

US industrial production & employment still to recover to 2019 levels

Added to this are low global interest rates, excess private saving rates and continuing fiscal stimulus.  While it is unlikely to be a repeat of the spectacular price gains in commodities since March 2020, robust global growth should keep them buoyant. Thus, a major stimulant to emerging market economies should remain in place.

The Quarter that was

Global equities continued to climb in Q2, with the MSCI World index up 7.9% in US$. Conditions for risk assets remained supportive with most economic indicators pointing to strong global growth. What has been particularly pleasing is the outperformance of Brazilian (+22.9%) and Russian equities (+14.4%) in Q2. Key offshore holdings such as Itaú Unibanco (Brazilian bank), Sberbank, Lukoil and iShares Brazil ETF have all participated.

The JSE All Share Index was flat for the quarter. However, there was a significant dispersion of sector returns. The resources sector was down 5% while index heavyweight Naspers was down 15%. On the flip side, domestic-centric sectors had a strong quarter with retailers and financials up 14% and 8% respectively. A stronger rand against the dollar of 3.3% combined with an increase in P/E multiples from historically cheap levels supported the outperformance in domestics. Our overweight positioning in domestics contributed to fund outperformance during the quarter.

South African fixed income continued to perform well (+6.9%), particularly at the long end of the curve. As some of the worst fears about government’s short-term fiscal situation abate there has been significant compression in our yield curve.

Current Positioning

Significant portfolio transactions for the quarter included the following:

  • Decreased some equity exposure to buy South African bonds
  • Reduced our combined Naspers and Prosus holding
  • Increased our holding in Standard Bank
  • Introduced inflation-linked bonds into our fixed income exposure
  • Initiated a Rand Yen position
  • Increased our Itaú Unibanco, Facebook and Lukoil holdings within our offshore exposure
  • Shorts in Foschini and Clicks funded more promising domestic counters in our hedge funds

As we move into the second half of the year, we continue to be overweight South African and other emerging market equities. As mentioned, we do expect global growth to decelerate. Thus, we have slightly reduced total equity exposure, especially considering the compelling local bond yields on offer. Given the significant run in the rand, we initiated a rand/yen position to take advantage of the rand overvaluation and provide some protection to the portfolio.

Rand overvalued relative to the crosses (ex. USD)

We also introduced inflation-linked bonds to the portfolio, through the I2029. For a major part of the last 15 years South African inflation-linkers outperformed nominal bonds, as both actual inflation and market-expected inflation continued to remain elevated. In the last five years core inflation has meaningfully collapsed in South Africa, leading to inflation-linkers outperformance being unwound. We now feel there is both compelling real yields and adequate margin of safety vis-à-vis nominal bonds to augment our fixed income exposure with inflation linkers.

SA inflation-linkers looking attractive relative to SA bond market

A brief word on the reduction of our Naspers and Prosus holdings, given the news flow of the Chinese government clamp down on tech companies. As to be further explored in an upcoming article, we feel there are deeper reasons for the recent sell off.  Not only were Chinese tech companies’ valuations trading at excessive valuations, but in recent results calls most management teams are committing to accelerating investments into their business which should dampen near-term earnings. Tencent was no different.  It is for this reason we have reallocated some of our holdings to companies where we feel there is a better earnings outlook and more palatable valuations, such as Facebook and Standard Bank.

Tencent rating has been under pressure

In summary, we acknowledge global growth may decelerate in the latter part of this year and have added some protection to the portfolio in light of this. However, both the undervaluation and earnings momentum of many domestic and emerging market shares are too compelling to ignore. The conditions are there for these counters to deliver a “big bang” in returns to our investors.