Divergent – the breakdown of stock market correlations, temp or perm?

Divergent – the breakdown of stock market correlations, temp or perm?

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Macro Letter – No 101 – 31-08-2018

Divergent – the breakdown of stock market correlations, temp or perm?

  • Emerging market stocks have stabilised, helped by the strength of US equities
  • Rising emerging market bond yields are beginning to attract investor attention
  • US tariffs and domestic tax cuts support US economic growth
  • US$ strength is dampening US inflation, doing the work of the Federal Reserve

To begin delving into the recent out-performance of the US stock market relative to its international peers, we need to reflect on the global fiscal and monetary response to the last crisis. After the great financial recession of 2008/2009, the main driver of stock market performance was the combined reduction of interest rates by the world’s largest central banks. When rate cuts failed to stimulate sufficient economic growth – and conscious of the failure of monetary largesse to stimulate the Japanese economy – the Federal Reserve embarked on successive rounds of ‘experimental’ quantitative easing. The US government also played its part, introducing the Troubled Asset Relief Program – TARP. Despite these substantial interventions, the velocity of circulation of money supply plummeted: and, although it had met elements of its dual-mandate (stable prices and full employment), the Fed remained concerned that whilst unemployment declined, average earnings stubbornly refused to rise.

Eventually the US economy began to grow and, after almost a decade, the Federal Reserve, cautiously attempted to reverse the temporary, emergency measures it had been forced to adopt. It was helped by the election of a new president who, during his election campaign, had pledged to cut taxes and impose tariffs on imported goods which he believed were being dumped on the US market.

Europe and Japan, meanwhile, struggled to gain economic traction, the overhang of debt more than offsetting the even lower level of interest rates in these markets. Emerging markets, which had recovered from the crisis of 1998 but adopted fiscal rectitude in the process, now resorted to debt in order to maintain growth. They had room to manoeuvre, having deleveraged for more than a decade, but the spectre of a trade war with the US has made them vulnerable to any strengthening of the reserve currency. They need to raise interest rates, by more than is required to control domestic inflation, in order to defend against capital flight.

In light of these developments, the recent divergence between developed and emerging markets – and especially the outperformance of US stocks – is understandable. US rates are rising, elsewhere in developed markets they are generally not; added to which, US tariffs are biting, especially in mercantilist economies which have relied, for so many years, on exporting to the ‘buyer of last resort’ – namely the US. Nonetheless, the chart below shows that divergence has occurred quite frequently over the past 15 years, this phenomenon is likely to be temporary: –

MSCI Developed vs MSCI EM 24-8-2018 Yardeni Research

Source: MSCI, Yardeni Research

Another factor is at work, which benefits US stocks, the outperformance of the technology sector. As finance costs have fallen, to levels never witnessed in recorded history, it has become easier for zombie companies to survive, crowding out more favourable investment opportunities, but it has also allowed, technology companies, with no expectation of near-term positive earnings, to continue raising capital and servicing their debts for far longer than during the tech-bubble of the 1990’s; added to which, the most successful technology companies, which evolved in the aftermath of the bursting of the tech bubble, have come to dominate their niches, often, globally. Cheap capital has helped prolong their market dominance.

Finally, capital flows have played a significant part. As emerging market stocks came under pressure, international asset managers were quick to redeem. These assets, repatriated most often to the US, need to be reallocated: US stocks have been an obvious destination, supported by a business-friendly administration, tax cuts and tariff barriers to international competition. These factors may be short-term but so is the stock holding period of the average investment manager.

Among the most important questions to consider looking ahead over the next five years are these: –

  1. Will US tariffs start to have a negative impact on US inflation, economic growth and employment?
  2. Will the US$ continue to rise? And, if so, will commodity prices suffer, forcing the Federal Reserve to reverse its tightening as import price inflation collapses?
  3. Will the collapse in the value of the Turkish Lira and the Argentine Peso prompt further competitive devaluation of other emerging market currencies?

In answer to the first question, I believe it will take a considerable amount of time for employment and economic growth to be affected, provided that consumer and business confidence remains strong. Inflation will rise unless the US$ rises faster.

Which brings us to the second question. With higher interest rates and broad-based economic growth, primed by a tax cut and tariffs barriers, I expect the US$ to be well supported. Unemployment maybe at a record low, but the quality of employment remains poor. The Gig economy offers workers flexibility, but at the cost of earning potential. Inflation in raw materials will continued to be tempered by a lack of purchasing power among the vastly expanded ranks of the temporarily and cheaply employed.

Switching to the question of contagion. I believe the ramifications of the recent collapse in the value of the Turkish Lira will spread, but only to vulnerable countries; trade deficit countries will be the beneficiaries as import prices fall (see the table at the end of this letter for a recent snapshot of the impact since mid-July).

At a recent symposium hosted by Aberdeen Standard Asset Management – Emerging Markets: increasing or decreasing risks? they polled delegates about the prospects for emerging markets, these were their findings: –

83% believe risks in EMs are increasing; 17% believe they are decreasing

46% consider rising U.S. interest rates/rising U.S. dollar to be the greatest risk for EMs over the next 12 months; 25% say a slowdown in China is the biggest threat

50% believe Asia offers the best EM opportunities over the next 12 months; 20% consider Latin America to have the greatest potential

64% believe EM bonds offer the best risk-adjusted returns over the next three years; 36% voted for EM equities.

The increase in EM bond yields may be encouraging investors back into fixed income, but as I wrote recently in Macro Letter – No 99 – 22-06-2018 – Where in the world? Hunting for value in the bond market there are a limited number of markets where the 10yr yield offers more than 2% above the base rate and the real-yield is greater than 1.5%. That Turkey has now joined there ranks, with a base rate of 17.75%, inflation at 15.85% and a 10yr government bond yield of 21.03%, should not be regarded as a recommendation to invest. Here is a table looking at the way yields have evolved over the past two months, for a selection of emerging markets, sorted by largest increase in real-yield (for the purposes of this table I’ve ignored the shape of the yield curve): –

EM Real Yield change June to August 2018

Source: Investing.com

Turkish bonds may begin to look good value from a real-yield perspective, but their new government’s approach to the imposition of US tariffs has not been constructive for financial markets: now, sanctions have ensued. With more than half of all Turkish borrowing denominated in foreign currencies, the fortunes of the Lira are unlikely to rebound, bond yields may well rise further too, but Argentina, with inflation at 31% and 10yr (actually it’s a 9yr benchmark bond) yielding 18% there may be cause for hope.

Emerging market currencies have been mixed since July. The Turkish Lira is down another 28%, the Argentinian Peso by 12%, Brazilian Real shed 6.3% and the South African Rand is 5.7% weaker, however the Indonesian Rupiah has declined by just 1.6%. The table below is updated from Macro Letter 100 – 13-07-2018 – Canary in the coal-mine – Emerging market contagion. It shows the performance of currencies and stocks in the period January to mid-July and from mid-July to the 28th August, the countries are arranged by size of economy, largest to smallest: –

EM FX and stocks Jan-Jul and Jul-Aug 2018

Source: Investing.com

It is not unusual to see an emerging stock market rise in response to a collapse in its domestic currency, especially where the country runs a trade surplus with developed countries, but, as the US closes its doors to imports and growth in Europe and Japan stalls, fear could spread. Capital flight may hasten a ‘sudden stop’ sending some of the most vulnerable emerging markets into a sharp and painful recession.

Conclusions and Investment Opportunities

My prediction of six weeks ago was that Turkey would be the market to watch. Contagion has been evident in the wake of the decline of the Lira and the rise in bond yields, but it has not been widespread. Those countries with twin deficits remain vulnerable. In terms of stock markets Indonesia looks remarkably expensive by many measures, India is not far behind. Russia – and to a lesser extent Turkey – continues to appear cheap… ‘The markets can remain irrational longer than I can remain solvent,’ as Keynes once said.

Emerging market bonds may recover if the Federal Reserve tightening cycle is truncated. This will only occur if the pace of US economic growth slows in 2019 and 2020. Another possibility is that the Trump administration manage to achieve their goal, of fairer trading arrangements with China, Europe and beyond, then the impact of tariffs on emerging market economies may be relatively short-lived. The price action in global stock markets have been divergent recently, but the worst of the contagion may be past. Mexico and the US have made progress on replacing NAFTA. Other countries may acquiesce to the new Trumpian compact.

The bull market in US stocks is now the longest ever recorded, it would be incautious to recommend stocks except for the very long-run at this stage in the cycle. In the near-term emerging market volatility should diminish and over-sold markets are likely to rebound. Medium-term, those countries hardest hit by the recent crisis will languish until the inflationary effects of currency depreciations have fed through. In the Long Run, a number of emerging markets, Turkey included, offer value: they have demographics on their side.

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Canary in the coal-mine – Emerging market contagion

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Macro Letter – No 100 – 13-07-2018

Canary in the coal-mine – Emerging market contagion

  • Emerging market currencies, bonds and stocks have weakened
  • Fears about the impact of US tariffs have been felt here most clearly
  • The risk to Europe and Japan is significant
  • Turkey may be the key market to watch

As US interest rates continue to normalise and US tariffs begin to bite, a number of emerging markets (EM’s) have come under pressure. Of course, the largest market to exhibit signs of stress is China, the MSCI China Index is down 7% since mid-June, whilst the RMB has also weakened against the US$ by more than 6% since its April low. Will contagion spread to developed markets and, if so, which country might be the ‘carrier’?

To begin to answer these questions we need to investigate this year’s casualties. Argentina is an obvious candidate. Other troubled countries include Brazil, Egypt and Turkey. In each case, government debt has exacerbated instability, as each country’s currency came under pressure. Other measures of instability include budget and trade deficits.

In an effort to narrow the breadth of this Macro Letter, I will confine my analysis to those countries with twin government and current account deficits. In the table which follow, the countries are sorted by percentage of world GDP. The colour coding reflects the latest MSCI categorisation; yellow, denotes a fully-fledged EM, white, equals a standard EM, green, is on the secondary list and blue is reserved for those countries which are so ‘frontier’ in nature as not to be currently assessed by MSCI: –

EM Debt and GDP

Source: Trading Economics, Investing.com, IMF, World Bank

For the purposes of this analysis, the larger the EM as a percentage of world GDP and the higher its investment rating, the more likely it is to act as a catalyst for contagion. Whilst this is a simplistic approach, it represents a useful the starting point.

Back in 2005, in a futile attempt to control the profligacy of European governments, the European Commission introduced the Stability and Growth Pact. It established at maximum debt to GDP ratio of 60% and budget deficit ceiling of 3%, to be applied to all members of the Eurozone. If applied to the EM’s listed above, the budget deficit constraint could probably be relaxed: these are, generally, faster growing economies. The ratio of debt to GDP should, however, be capped at a lower percentage. The government debt overhang weighs more heavily on smaller economies, especially ones where the percentage of international investors tends to be higher. Capital flight is a greater risk for EM’s than for developed economies, which are insulated by a larger pool of domestic investors.

Looking at the table again, from a financial stability perspective, the percentage of non-domestic debt to GDP, is critical. A sudden growth stop, followed by capital flight, usually precipitates a collapse in the currency. External debt can prove toxic, even if it represents only a small percentage of GDP, since the default risk associated with a collapsing currency leads to a rapid rise in yields, prompting further capital flight – this is a viscous circle, not easily broken. The Latin American debt crisis of the 1980’s was one of the more poignant examples of this pattern. Unsurprisingly, in the table above, the percentage of external debt to GDP grows as the economies become smaller, although there is a slight bias for South American countries to continue to borrow abroad. Perhaps a function of their proximity to the US capital markets. Interestingly, by comparison with developed nations, the debt to GDP ratios in most of these EM countries is relatively modest: a sad indictment of the effectiveness of QE as a policy to strengthen the world financial system – but I digress.

Our next concern ought to be the trade balance. Given the impact that US tariffs are likely to have on export nations, both emerging and developed, it is overly simplistic to look, merely, at EM country exports to the US. EM exports to Europe, Japan and China are also likely to be vulnerable, as US tariffs are enforced. Chile and Mexico currently run trade surpluses, but, since their largest trading partner is the US, they still remain exposed.

This brings us to the second table which looks at inflation, interest rates, 10yr bond yields, currencies and stock market performance: –

EM Markets and Inflation

Source: Trading Economics, Investing.com, IMF, World Bank

In addition to its absolute level, the trend of inflation is also an important factor to consider. India has seen a moderate increase since 2017, but price increases appear steady not scary. Brazil has seen a recent rebound after the significant moderation which followed the 2016 spike. Mexican inflation has moderated since late 2017, posing little cause for concern. Indonesian price rises are at the lower end of their post Asian crisis range. Turkey, however, is an entirely different matter. It inflation is at its highest since 2004 and has broken to multiyear highs in the last two months. Inflation trends exert a strong influence on interest rate expectations and Turkish 10yr yields have risen by more than 5% this year, whilst it currency has fallen further than any in this group, barring the Argentinian Peso. For comparison, the Brazilian Real is the third weakest, followed, at some distance, by the Indian Rupee.

India, Brazil, Mexico and Indonesia may be among the largest economies in this ‘contagion risk’ group, but Turkey, given its geographic proximity to the EU may be the linchpin.

Is Turkey the canary?

The recent Turkish elections gave President Erdogan an increased majority. His strengthened mandate does not entirely remove geopolitical risk, but it simplifies our analysis of the country from an economic perspective. Short-term interest rates are 17.75%, the second highest in the group, behind Argentina. The yield curve is inverted: and both the currency and stock market have fared poorly YTD. Over the last 20 years, Turkish GDP has averaged slightly less than 5%, but this figure is skewed by three sharp recessions (‘98, ‘01 and ‘08). The recent trend has been volatile but solid. 10yr bond yields, by contrast, have been influenced by a more than doubling of short-term interest rates, in defence of the Turkish Lira. This aggressive action, by their central bank, makes the economy vulnerable to an implosion of growth, as credit conditions deteriorate rapidly.

Conclusion and investment opportunities

In Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession? I concluded in respect of Europe that: –

…the [stock] market has failed to rise substantially on a positive slew of earnings news. This may be because there is a more important factor driving sentiment: the direction of US rates. It certainly appears to have engendered a revival of the US$. It rallied last month having been in a downtrend since January 2017 despite a steadily tightening Federal Reserve. For EURUSD the move from 1.10 to 1.25 appears to have taken its toll. On the basis of the CESI chart, above, if Wall Street sneezes, the Eurozone might catch pneumonia.

Over the past few months EM currencies have declined, their bond yields have increased and their stock markets have generally fallen. In respect of tariffs, President Trump has done what he promised. Markets, like Mexico and Chile, reacted early and seem to have stabilised. Argentina had its own internal issues with which to contend. The Indian economy continues its rapid expansion, despite higher oil prices and US tariffs. It is Turkey that appears to be the weakest link, but this may be as much a function of the actions of its central bank.

If, over the next few months, the Turkish Lira stabilises and official rates moderate, the wider economy may avoid recession. Whilst much commentary concerning EM risks will focus on the fortunes of China, it is still a relatively closed, command economy: and, therefore, difficult to predict. It will be at least as useful to focus on the fortunes of Turkey. It may give advanced warning, like the canary in the coal-mine, which makes it my leading indicator of choice.

 

 

Where in the world? Hunting for value in the bond market

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Macro Letter – No 99 – 22-06-2018

Where in the world? Hunting for value in the bond market

  • Few government bond markets offer a positive real return
  • Those that do tend to have high associated currency risk
  • Active management of fixed income portfolios is the only real solution
  • Italy is the only G7 country offering a real-yield greater than 1.5%

In my last Macro Letter – Italy and the repricing of European government debt – I said: –

I have never been a great advocate of long-term investment in fixed income securities, not in a world of artificially low official inflation indices and fiat currencies. Given the de minimis real rate of return I regard them as trading assets.

Suffice to say, I received a barrage of advice from some of my good friends who have worked in the fixed income markets for the majority of their careers. I felt I had perhaps been flippant in dismissing an entire asset class without so much as a qualm. In this letter I distil an analysis of more than one hundred markets around the world into a short list of markets which may be worthy of further analysis.

To begin with I organised countries by their most recent inflation rate, then I added their short term interest rate and finally, where I was able to find reliable information, a 10 year yield for the government bond of each country. I then calculated the real interest rate, real yield and shape of the yield curve.

At this point I applied three criteria, firstly that the real yield should be greater than 1.5%, second, that the real interest rate should also exceed that level: and finally, that the yield curve should be more than 2% positive. These measures are not entirely arbitrary. A real return of 1.5% is below the long-run average (1.7%) for fixed income securities in the US since 1900, though not by much. For an analysis of the data, this article from Observations and Notes is informative – U.S. 10-Year Treasury Note Real Return History: –

As you might have expected, the real returns earned were consistently below the initial coupon rate. The only exceptions occur around the time of the Great Depression. During this period, because of deflation, the value of some or all of the yearly interest payments was often higher than the original coupon rate, increasing the yield. (For more on this important period see The 1929 Stock Market Crash Revisited)

While the average coupon rate/nominal return was 4.9%, the average real return was only1.7%. Not surprisingly, the 3.2% difference between the two is the average inflation experienced for the century.

As an investor I require a positive expected real return with the minimum of risk, therefore if short term interest rates offer a real return of more than 1.5% I will incline to favour a floating rate rather than a fixed rate investment. Students of von Mises and Rothbard may beg to differ perhaps; for those of you who are unfamiliar with the Austrian view of the shape of the yield curve in an unhampered market, this article by Frank Shostak – How to Interpret the Shape of the Yield Curve provides an excellent primer. Markets are not unhampered and Central Banks, at the behest of their respective governments, have, since the dawn of the modern state, had an incentive to artificially lower short-term interest rates: and, latterly, rates across the entire maturity spectrum. For more on this subject (6,000 words) I refer you to my essay for the Cobden Centre – A History of Fractional Reserve Banking – the link will take you to part one, click here for part two.

Back to this week’s analysis. I am only interested in buying 10yr government bonds of credit worthy countries, where I can obtain a real yield on 10yr maturity which exceeds 1.5%, but I also require a positive yield curve of 2%. As you may observe in the table below, my original list of 100 countries diminishes rapidly: –

Real Bond yields 1.5 and 2 percent curve

Source: Investing.com, Trading Economics, WorldBondMarkets.com

Five members of this list have negative real interest rates – Italy (the only G7 country) included. Despite the recent prolonged period of negative rates, this situation is not normal. Once rates eventually normalise, either the yield curve will flatten or 10yr yields will rise. Setting aside geopolitical risks, as a non-domicile investor, do I really want to hold the obligations of nations whose short-term real interest rates are less than 1.5%? Probably not.

Thus, I arrive at my final cut. Those markets where short-term real interest rates exceed 1.5% and the yield curve is 2% positive. Only nine countries make it onto the table and, perhaps a testament to their governments ability to raise finance, not a single developed economy makes the grade: –

REal Bond yields 1.5 and 2 pecent curve and 1.5 real IR

Source: Investing.com, Trading Economics, WorldBondMarkets.com

There are a couple of caveats. The Ukrainian 10yr yield is derived, I therefore doubt its accuracy. 3yr Ukrainian bonds yield 16.83% and the yield curve is mildly inverted relative to official short-term rates. Brazilian bonds might look tempting, but it is important to remember that its currency, the Real, has declined by 14% against the US$ since January. The Indonesian Rupiah has been more stable, losing less than 3% this year, but, seen in the context of the move since 2012, during which time the currency has lost 35% of its purchasing power, Indonesian bonds cannot but considered ‘risk-free’. I could go on – each of these markets has lesser or greater currency risk.

I recant. For the long term investor there are bond markets which are worth consideration, but, setting aside access, liquidity and the uncertainty of exchange controls, they all require active currency management, which will inevitably reduce the expected return, due to factors such as the negative carry entailed in hedging.

Conclusions and investment opportunities

Investing in bond markets should be approached from a fundamental or technical perspective using strategies such as value or momentum. Since February 2012 Greek 10yr yields have fallen from a high of 41.77% to a low of 3.63%, although from the July 2014 low of 5.47% they rose to 19.44% in July 2015, before falling to recent lows in January of this year. For a trend following strategy, this move has presented abundant opportunity – it increases further if the strategy allows the investor to be short as well as long. Compare Greek bonds with Japanese 10yr JGBs which, over the same period, have fallen in yield from 1.02 in January 2012 to a low of -0.29% in July 2016. That is still a clear trend, although the current BoJ policy of yield curve control have created a roughly 10bp straight-jacket beyond which the central bank is committed to intervene. The value investor can still buy at zero and sell at 10bp – if you trust the resolve of the BoJ – it is likely to be profitable.

The idea of buying bonds and holding them to maturity may be profitable on occasion, but active management is the only logical approach in the current global environment, especially if one hopes to achieve acceptable real returns.

Is there any value in the government bond markets?

Is there any value in the government bond markets?

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Macro Letter – Supplemental – No 4 – 12-5-2017

Is there any value in the government bond markets?

  • Since 2008 US 10yr T-bond yields have fallen from more than 5% to less than 2%
  • German 10yr Bunds yields have fallen even further from 4.5% to less than zero
  • With Central Bank inflation targets of 2% many bond markets offer little or no real return
  • In developed markets the inverse yield gap between dividend and bond has disappeared

Since the end of the great financial recession, bond yields in developed countries have fallen to historic lows. The bull market in stocks which began in March 2009, has been driven, more than any other factor, by the fall in the yield of government bonds.

With the Federal Reserve now increasing interest rates, investors are faced with a dilemma. If they own bonds already, should they continue to remain invested? Inflation is reasonable subdued and commodity prices have weakened recently as economic growth expectations have moderated once more. If investors own stocks they need to be watching the progress of the bond market: bonds drove stocks up, it is likely they will drive them back down as well.

The table below looks at the relative valuation between stocks and bonds in the major equity markets. The table (second item below) is ranked by the final column, DY-BY – Dividend Yield – Bond Yield, sometimes referred to as the yield gap. During most of the last fifty years the yield gap has been inverse, in other words dividend yields have been lower than bond yields, the chart directly below shows the pattern for the S&P500 and US 10yr government bonds going back to 1900:-

Chart-2-the-reverse-yield-gap-in-a-longer-term-con

Source: Newton Investment Management

Bonds_versus_Equities

Source: StarCapital, Investing.com, Trading Economics

The CAPE – Cyclically Adjusted Price Earnings Ratio and Dividend Yield Data is from the end of March, bond yields were taken on Monday morning 8th May, so these are not direct comparisons. The first thing to notice is that an inverse yield gap tends to be associated with countries which have higher inflation. This is logical, an equity investment ought to offer the investor an inflation hedge, a fixed income investor, by contrast, is naturally hedged against deflation.

Looking at the table in more detail, Turkey tops the list, with an excess return, for owning bonds rather than stocks, of more than 7%, yet with inflation running at a higher rate than the bond yield, the case for investment (based simple on this data) is not compelling – Turkish bonds offer a negative real yield. Brazil offers a more interesting prospect. The real bond yield is close to 6% whilst the Bovespa real dividend yield is negative.

Some weeks ago in Low cost manufacturing in Asia – The Mighty Five – MITI VI looked more closely at India and Indonesia. For the international bond investor it is important to remember currency risk:-

Currency_changes_MITI_V (1)

Source: Trading Economics, World Bank

If past performance is any guide to future returns, and all investment advisors disclaim this, then you should factor in between 2% and 4% per annum for a decline in the value of the capital invested in Indian and Indonesian bonds over the long run. This is not to suggest that there is no value in Indian or Indonesian bonds, merely that an investor must first decide about the currency risk. A 7% yield over ten years may appear attractive but if the value of the asset falls by a third, as has been the case in India during the past decade, this may not necessarily suffice.

Looking at the first table again, the relationship between bond yields in the Eurozone has been distorted by the actions of the ECB, nonetheless the real dividend yield for Finnish stocks at 3.2% is noteworthy, whilst Finnish bonds are not. Greek 10yr bonds are testing their lowest levels since August 2014 this week (5.61%) which is a long way from their highs of 2012 when yields briefly breached 40% during the Eurozone crisis. Emmanuel Macron’s election as France’s new President certainly helped but the German’s continue to baulk at issuing Eurobonds to bail out their profligate neighbours.

Conclusion and Investment Opportunity

Returning to the investor’s dilemma. Stocks and bonds are both historically expensive. They have been driven higher by a combination of monetary and quantitative easing by Central Banks and subdued inflation. For long-term investors such as pension funds, which need to invest in fixed income securities to match liabilities, the task is Herculean, precious few developed markets offer a real yield at all and none offer sufficient yield to match those pension liabilities.

During the bull-market these long-term investors actively increased the duration of their portfolios whilst at the same time the coupons on new issues fell steadily: new issues have a longer duration as well. It would seem sensible to shorten portfolio duration until one remembers that the Federal Reserve are scheduled to increase short term interest rates again in June. Short rates, in this scenario will rise faster than long-term rates. Where can the fixed income portfolio manager seek shelter?

Emerging market bonds offer limited liquidity since their markets are much smaller than those of the US and Europe. They offer the investor higher returns, but expose them to heady cocktail of currency risk, credit risk and the kind of geopolitical risk that ultra-long dated developed country bonds do not.

A workable solution is to consider credit and geopolitical risk at the outset and then actively manage the currency risk, or sub-contract this to an overlay manager. Sell long duration, low yielding developed country bonds and buy a diversified basket of emerging market bonds offering acceptable real return and, given that in many emerging markets corporate bonds offer lower credit risk than their respective government bond market, buy a carefully considered selection of liquid corporate names too. Sadly, many pension fund managers will not be permitted to make this type of investment for fiduciary reasons.

In answer to the original question in my title? Yes, I do believe there is still value in the government bond markets, but, given the absence of liquidity in many of the less developed markets – which are the ones offering identifiable value – the portfolio manager must be prepared to actively hedge using liquid markets to avoid a forced liquidation – currency hedging is one aspect of the strategy but the judicious use of interest rate swaps and options is a further refinement managers should consider.

This strategy shortens the duration of the bond portfolio because, not only purchase bonds with a shorter maturity, but also ones with a higher coupon. Actively managing currency risk (or delegating this role to a specialist currency overlay operator) whilst not entirely mitigating foreign exchange exposures, substantially reduces them.

Emerging market equities may well offer the best long run return, but a portfolio of emerging market bonds, with positive rather than negative real-yields, is far more compelling than continuously extending duration among the obligations of the governments of the developed world.

Will technology change the prospects for emerging market growth?

Will technology change the prospects for emerging market growth?

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Macro Letter – No 75 – 21-04-2017

Will technology change the prospects for emerging market growth?

  • The challenge to low-cost manufacturing in emerging markets is from technology
  • Some industries will benefit but many jobs will be displaced globally
  • The mercantilist model of emerging market growth will need to adapt
  • Technology will solve some of the demographic challenges of the developed world

In July 2016 the International Labor Organisation (ILO) released a report entitled – ASEAN in Transformationin the preface it relates the apocryphal story of a 1950’s conversation between Henry Ford, Chairman of Ford Motor Company, and Walter Reuther, Leader of the United Automobile Workers Union.

Ford asked, “Walter, how are you going to get those robots to pay your union dues?” to which Reuther responded, “Henry, how are you going to get them to buy your cars?” It reminds us that disruptive technology is not new. As the latest wave of innovation begins to disrupt employment globally, it makes sense to reassess the prospects for some of the world’s fastest growing economies.

The ILO report goes on to focus on the impact of technology on ASEAN countries, a region with 632mln people. This is an under-researched topic. They highlight the industries which are most likely to be affected and suggest ways countries can adapt to minimise the impact of automation on employment. This is their conclusion:-

Considerable opportunities for growth exist within ASEAN. Importantly, the local domestic market is expanding, and ASEAN’s middle class is expected to grow to 125 million by 2025. This represents a massive and emerging regional market.

However, threats remain, and in some cases, are intensifying. In particular, a range of labour-intensive sectors in a number of less developed countries are susceptible to major technological disruption, leading to potential large-scale job displacement. The consequences for these countries could be profoundly negative if they are unprepared to adapt.

We are witnessing the emergence of new markets, the potential relocation of production, the rise of new hiring trends and the displacement of lower skilled jobs. Supplying workers with the appropriate skills and competencies remains a major challenge. Overall, concerted efforts are required from all ASEAN stakeholders. They should act now to build a future of innovation and growth shaped with better employment opportunities.

The World Bank Development Report 2016 – Digital Dividends provides a global perspective. Here are a couple of graphs which illuminate the challenging landscape:-

World_Bank_-_Impact_of_Automation_on_employment_20

Source: World Bank

If the unadjusted percentages indicated in the graph above are realised the social and political stability of many countries maybe undermined, however, the next graph shows which occupations are likely to be most at risk. It also shows which occupations can be expected to benefit from the productivity enhancing impact of new technology:-

World_Bank_-_probability_of_being_computerised_and

Source: World Bank

Educational challenge

Be an expensive complement (stats knowhow) to something that’s getting cheaper (data).

—Hal Varian, Chief Economist, Google, 2014

Going back to the ILO report, the key to creating workers with the correct skills is designing appropriate education. According to Asian Nation:-

50.5% Asians, age 25 and older, who have a bachelor’s degree or higher level of education. Asians have the highest proportion of college graduates of any race or ethnic group in the country and this compares with 28 percent for all Americans 25 and older.

This graph shows the educational attainment across ASEAN:-

ASEAN_Student_Survey_-_ILO

Source: ILO

Singapore scores highly but so does Cambodia, however, it is the low skilled worker who will suffer; the retraining challenges, for Asia and elsewhere, will be substantial. More than 60% of salaried workers in Indonesia and 73% in Thailand are at risk from automation. The highest risk group are employed in Textiles, Clothing and Footware.  More than 9mln people are employed in this sector across ASEAN and the ILO estimate that 64% are at risk in Indonesia, 86% in Vietnam whilst in Cambodia that figure rises to 88%.

Business Process Outsourcing (BPO) is another industry which is ripe for automation. There is a heavy concentration of BPO in the Philippines where more than 1mln salaried working are employed. The ILO estimate that 89% are at risk from automation.

Earlier this year I discussed the demise of China as a low-cost manufacturing hub in – Low cost manufacturing in Asia – The Mighty Five – MITI V – Malaysia, India, Thailand, Indonesia and Vietnam. I concluded:-

Vietnamese stocks look attractive, the country has the highest level of FDI of the group (6.1% of GDP) but there is a favourable case for investing in the stocks of the other members of the MITI V, even with FDI nearer 3%. They all have favourable demographics, except perhaps Thailand, and its age dependency ratio is quite low. High literacy, above 90% in all except India, should also be advantageous.

Over the next few years I remain confident about these economies but the headwinds of technology will blow through these markets, nonetheless. Low cost manufacturing has to be set alongside, efficient inventory management and transit costs. In the apparel industry, where trends change in a rapid and unpredictable fashion, the advantage of fast design to production lead times makes the benefits of robotic production, geographically close to the consumer, much more alluring.

In a fascinating post on LinkedIn – Robots Take Over – The Apparel Production – Susanna Koelblin – discusses the decision by Adidas to transfer a part of the production of their sports shoes back to Germany for the first time in more than 20 years. Another “Speed factory” will open in the US later this year. Here are some of her observations:-

It took 50 years for the world to install the first million industrial robots. The next million will take only eight. Importantly, much of the recent growth happened in particular in China, which has an aging population and where wages have risen…

German robot maker Kuka, acquired last year by China’s Midea, estimates a typical industrial robot costs about 5 euros an hour. Manufacturers spend 50 euros an hour to employ someone in Germany and about 10 euros an hour in China. Rather than seek out an even cheaper source of labor elsewhere – in another emerging Asian economy, say – Chinese manufacturers are choosing to install more robots, especially for more complex tasks. China isn’t getting rid of the work, just the workers…

It is in fact China which is leading the world in terms of the installation of industrial robots, but relative to the size of its workforce these concentrations are still relatively low. China boasts 4.9 robots/1,000 workers while Germany tops the world ranking at 30.1/1,000. That is almost twice the concentration of the US and four times that of the UK.

The current level of earnings in manufacturing still favours the work force of the MITI V but as the cost of automation continues to fall and average earnings in, lower cost Asia, rises, an inflection point will be reached:-

Wage_costs_-_inflation_and_currency_MITI_V_-_Tradi

Source: Trading Economics

Manufacturing wage inflation has been high in Indonesia partly in response to earlier currency depreciations – over 10 years the Rupiah has declined by 46% against the US$ whilst manufacturing wages have increased by 164%. All these emerging economies maintain a manufacturing cost advantage relative to robotic automation, however, for countries like Malaysia, which has seen its currency decline by 46.7% over the last five years, whilst manufacturing wages have only risen by 37.6%, the competitive advantage versus robotic automation is narrowing. Malaysia now has a manufacturing wage cost which is slightly higher than China’s.

Interestingly, India has seen a real-terms improvement in export competitiveness. Its currency has fallen 21.4% over five years but manufacturing wages have only risen by 14.6%. Vietnam and Thailand have seen export competitiveness decline, yet in both cases they have had considerable room for manoeuvre.

I am in agreement with Dr. Jing Bing Zhang, Research Director of IDC Worldwide Robotics, we should not be worried about automation derailing the emerging market growth model over the next decade. This is what he said in a recent interview with the Diplomat:-

There are different schools of thought…  From my research, I don’t see it. Maybe we will be less dependent on human labor. But there is no way this will eliminate the need for people in the next 15-20 years. We are entering high speed growth for robotics but in 2014 global density for robotics was still very low at 66 per 10,000 employees, 36 in China, 57 in Thailand, and close to none in India.

The uptake of robots does not appear to have damaged employment in Germany where unemployment recently dipped below 4%, the lowest level since 1981. One can argue that demographic forces are at work here but Germany has the highest concentration of robots relative to workers globally.

Chatham House – Robots and pensioners to the rescue – examines a different aspect of automation and demographics, focussing on Japan:-

Bleak demographics saddle Japan with a potential growth rate of less than 1 per cent, economists say, unless there are aggressive moves to accept more immigrants, boost the role of women in the workforce and overhaul workplace inefficiencies to increase productivity.

Yet despite its real and chronic problems, Japan may arguably be faring better than the image often projected of a country on the brink of an abyss. Japan still feels safe, prosperous and dazzlingly futuristic. While the overall economy has stagnated, GDP per head has outperformed most of the developed world, including Germany and France, according to World Bank figures − partly a consequence of the population crunch…

Most importantly, a shrinking population fosters innovation to boost productivity. Writing in the Financial Times, Michael Lind, a senior fellow at New America, a Washington think-tank, argued that a labour shortage can be a blessing rather than a curse: ‘Where labour is scarce and expensive, businesses have an incentive to invest in labour-saving technology,’ he wrote, ‘which boosts productivity growth by enabling fewer workers to produce more.’

That is precisely what is happening in today’s Japan, with investment pouring into robotics, industrial automation and artificial intelligence. Furuta notes that a similar phenomenon took place in 18th-century Japan, under the Tokugawa shoguns, when sharp population declines due to famine and natural disaster spurred an age of innovation in science, the arts and agriculture. Such thinking has prompted Prime Minister Abe to embrace the idea that Japan’s population crunch may have a silver lining: ‘Japan may be losing its population. But these are incentives,’ Abe said in a speech last year. ‘Japan’s demography, paradoxically, is not an onus, but a bonus.’

In my previous Macro Letter – No 72 – Low cost manufacturing in Asia – The Mighty Five – MITI VI reproduced the latest Deloitte Global Manufacturing Competitiveness Index, here it is again:-

Deloitte_-_gx-us-global-manufacturing-table-rankin

Source: Deloitte

The MITI V are all expected to rise up the competitiveness ranking over the next three years – with the exception of Thailand which remains unchanged in 14th place.

I remain optimistic about emerging market growth, but keep in mind the industries which will benefit from technology and those which will be harmed. For example, the software developers of India look well placed to thrive; the garment workers of China may not.

Low cost manufacturing in Asia – The Mighty Five – MITI V

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Macro Letter – No 72 – 10-03-2017

Low cost manufacturing in Asia – The Mighty Five – MITI V

  • Low cost manufacturing is moving away from China
  • Malaysia, India, Thailand, Indonesia and Vietnam will continue to benefit
  • Currency risks remain substantial
  • Stock market valuations are not cheap but they offer long term value

The MITI V is the latest acronym to emerge from the wordsmiths at Deloitte’s. Malaysia, India, Thailand, Indonesia and Vietnam. All these countries have a competitive advantage over China in the manufacture of labour intensive commodity type products like apparel, toys, textiles and basic consumer electronics. According to Deloitte’s 2016 Global Manufacturing Competitiveness Index they are either among, or destined to join, the top 15 most competitive countries in the world for manufacturing, by the end of the decade. Here is the Deliotte 2016 ranking:-

Deloitte_-_gx-us-global-manufacturing-table-rankin

Source: Deliotte

The difficulty with grouping disparate countries together is that their differences are coalesced. Malaysia and Thailand are likely to excel in high to medium technology industries, their administrations are cognizant of the advantages of international trade. India, whilst it has enormous potential, both as an exporter and as a manufacturer for its vast domestic market, has, until recently, been less favourably disposed towards international trade and investment. Vietnam continues to benefit from its proximity to China. Indonesia, by contrast, has struggled with endemic corruption: its economy is decentralised and this vast country has major infrastructure challenges.

The table below is sorted by average earnings:-

MITI_V_-_Stats

Source: World Bank, Trading Economics

India and Vietnam look well placed to become the low-cost manufacturer of choice (though there are other contenders such as Bangladesh which should not be forgotten when considering comparative advantage).

Another factor to bear in mind is the inexorable march of technology. Bill Gates recently floated the idea of a Robot Tax, it met with condemnation in many quarters – Mises Institute – Bill Gates’s Robot Tax Is a Terrible Ideaexamines the issue. The mere fact that a Robot Tax is being contemplated, points to the greatest single challenge to low-cost producers of goods, namely automation. Deliotte’s does not see this aspect of innovation displacing the low-cost manufacturing countries over the next few years, but it is important not to forget this factor in one’s assessment.

Before looking at the relative merits of each market from an investment perspective, here is what Deliotte’s describe as the opportunities and challenges facing each of these Asian Tigers:-

 

Malaysia

…has a low cost base with workers earning a quarter of what their counterparts earn in neighboring Singapore. The country also remains strongly focused on assembly, testing, design, and development involved in component parts and systems production, making it well suited to support high-tech sectors.

…is challenged by a talent shortage, political unrest, and comparatively low productivity.

India

Sixty-two percent of global manufacturing executives’ surveyed rank India as highly competitive on cost, closely mirroring China’s performance on this metric.

…highly skilled workforce and a particularly rich pool of English speaking scientists, researchers, and engineers which makes it well-suited to support high-tech sectors. India’s government also offers support in the form of initiatives and funding that focus on attracting manufacturing investments.

…challenged by poor infrastructure and a governance model that is slow to react

…As 43 percent of its US$174 billion in manufacturing exports require high-skill and technological intensity, India may have a strong incentive to solve its regulatory and bureaucratic challenges if it is to strengthen its candidacy as an alternative to China.

Thailand

When it comes to manufacturing exports (US$167 billion in 2014), Thailand stands slightly below India, but exceeds Malaysia, Vietnam, and Indonesia. This output is driven largely by the nation’s skilled workforce and high labor productivity, supported by a 90 percent national literacy rate, and approximately 100,000 engineering, technology, and science graduates every year.

…highly skilled and productive workforce creates relatively high labor costs at US$2.78 per hour in 2013.

…remains attractive to manufacturing companies, offering a lower corporate tax rate (20 percent) than Vietnam, India, Malaysia or Indonesia. Already well established with a booming automotive industry, Thailand may provide an option for manufacturers willing to navigate the political uncertainty that persists in the region.

Indonesia

Manufacturing labor costs in Indonesia are less than one-fifth of those in China.

…The island nation’s overall 10-year growth in productivity (50 percent) exceeds that of Thailand, Malaysia, and Vietnam,

…manufacturing GDP represents a significant portion of its overall GDP and with such a strong manufacturing focus, particularly in electronics, coupled with the sheer size of its population, Indonesia remains high on the list of alternatives for manufacturers looking to shift production capacity away from China in the future.

Vietnam

…comparatively low overall labor costs.

…has raised its overall productivity over the last 10 years, growing 49 percent during the period, outpacing other nations like Thailand and Malaysia. Such productivity has prompted manufacturers to construct billion-dollar manufacturing complexes in the country.

Deliotte’s go on to describe the incentives offered to multinational corporations by these countries:-

(1) numerous tax incentives in the form of tax holidays ranging from three to 10 years, (2) tax exemptions or reduced import duties, and (3) reduced duties on capital goods and raw materials used in export-oriented production.

Forecasts for 2017

In the nearer term the MITI V have more varied prospects, here are Focus Economics latest consensus GDP growth expectations from last month:-

Malaysia Economic Outlook 2017 GDP forecast 4.3%

…GDP recorded the strongest performance in four quarters in Q4, expanding at a better-than-expected rate of 4.5%.

…acceleration in fixed investment and resilient private consumption. Exports also showed a significant improvement, growing at the fastest pace since Q4 2015, thanks to a weaker ringgit and rising oil prices. However, the external sector’s net contribution to growth remained stable as imports also gained steam. Government consumption, which contracted for the first time since Q2 2014, was the only drag on growth in Q4, reflecting the government’s commitment to its fiscal consolidation agenda for 2016.

India Economic Outlook 2017 GDP forecast – 7.4%

Economic activity is beginning to firm after demonetization shocked the economy in the October to December period. The manufacturing PMI crossed into expansionary territory in January and imports rebounded.

…Despite the backdrop of more moderate growth, the government stuck to a market friendly budget for FY 2017

…which was presented on 1 February, pursues growth-supportive policies while targeting a narrower deficit of 3.2% of GDP…

…five states will conduct elections in February, with results to be announced on 11 March. The elections will test the electorate’s mood regarding the government after the economy’s tumultuous past months and ahead of the 2019 general vote.

Thailand Economic Outlook 2017 GDP forecast 3.2%

Growth decelerated mildly in the final quarter of 2016 due to subdued private consumption and a smaller contribution from the external sector. The economy expanded 3.0% annually in Q4, down from 3.2% in Q3.

…January, consumer confidence hit a nearly one-year high, while business sentiment receded mildly. On 27 January, the government announced supplementary fiscal stimulus of USD 5.4 billion for this year’s budget, which ends in September. The sum will be disbursed specifically in rural areas in a bid to close the growing inequality between urban and rural infrastructure and income. This shows that the military government is set to continue providing fiscal stimulus to GDP this year, which should spill over in the private sector via higher employment and improved economic sentiment.

Indonesia Economic Outlook 2017 GDP forecast 5.2%

…economy lost steam in the fourth quarter of last year as diminished government revenues caused public spending to fall at a multi-year low.

…household consumption remained healthy and the recent uptick in commodities prices boosted export revenues.

…for the start of 2017…momentum firmed up: the manufacturing PMI crossed into expansionary territory in January and surging exports pushed the trade surplus to an over three-year high.

…poised for a credit ratings upgrade after Moody’s elevated its outlook from stable to positive on 8 February. All three major ratings agencies now have a positive outlook on Indonesia’s credit rating and an upgrade could be a catalyst for improving investor sentiment.

Vietnam Economic Outlook 2017 GDP forecast 6.4%

…particularly strong performance in the external sector in 2016. Despite slower demand from important trading partners, merchandise exports, which consist largely of manufactured goods, grew 9.0% annually. The manufacturing sector is quickly expanding thanks to the country’s competitive labor costs, fueling manufacturing exports and bolstering job creation in the sector.

…industrial production nearly stagnated in January, it mostly reflected a seasonal effect from the Lunar New Year, which disrupted supply chains across the region.

…manufacturing Purchasing Manager’s Index, though it inched down in January, continues to sit well above the 50-point line, reflecting that business conditions remain solid in the sector. Moreover, the New Year festivities boosted retail sales, which grew robustly in January.

Currency Risk

The table below shows the structural nature of the MITI V’s exchange rate depreciation against the US$. The 20 year column winds the clock back to the period just before the Asian Financial Crisis in 1997:-

Currency_changes_MITI_V (1)

Source: Trading Economics, World Bank

Looking at the table another way, when investing in Indonesia it would make sense to factor in a 4% annual decline in the value of the Rupiah, a 2.2% to 2.4% decline in the Ringgit, Rupee and Dong and a 1.3% fall in the value of the Baht.

The continuous decline in these currencies has fuelled inflation and this is reflected to the yield and real yields available in their 10 year government bond markets. The table below shows the current bond yields together with inflation and their governments’ fiscal positions:-

MITI_V_-_Bonds_Inflation_Fiscal

Source: Trading Economics

Indonesian bonds offer insufficient real-yield to cover the average annual decline in the value of the Rupiah. Vietnam has an inverted yield curve which suggests shorter duration bonds would offer better value, its 10 year maturity offers the lowest real-yield of the group.

Whilst all these countries are running government budget deficits, Malaysia, Thailand and Indonesia have current account surpluses and Indonesia’s government debt to GDP is a more manageable 27% – this is probable due to its difficulty in attracting international investors on account of the 82% decline in its currency over the past two decades.

Stock Market Valuations

All five countries have seen their stock markets rise this year, although the SET 50 (Thailand) has backed off from its recent high. To compare with the currency table above here are the five stock markets, plus the S&P500, over one, two, five, ten and twenty years:-

MITI_V and US_Stocks_in_20yr

Source: Investing.com

For the US investor, India and Indonesia have been the star performers since 1997, each returning more than six-fold. Thailand, which was at the heart of the Asian crisis of 1997/98, has only delivered 114% over the same period whilst Malaysia, which imposed exchange controls to stave off the worst excesses of the Asian crisis, has failed to deliver equity returns capable of countering the fall in its currency. Finally, Vietnam, which only opened its first stock exchange in 2000, is still recovering from the boom and bust of 2007. The table below translates the performance into US$:-

MITI_V_-_Stock_performance_in_US_20yr

Source: Investing.com

Putting this data in perspective, over the last five years the S&P has beaten the MITI V not only in US$, but also in absolute terms. Looking forward, however, there are supportive valuation metrics which underpin some of the MITI V stock markets. The table below is calculated at 30-12-2016:-

MITI_V_PEs_etc

Source: Starcapital.de, *Author’s estimates

Conclusion and Investment Opportunities

Vietnamese stocks look attractive, the country has the highest level of FDI of the group (6.1% of GDP) but there is a favourable case for investing in the stocks of the other members of the MITI V, even with FDI nearer 3%. They all have favourable demographics, except perhaps Thailand, and its age dependency ratio is quite low. High literacy, above 90% in all except India, should also be advantageous.

Thailand and Malaysia look less expensive from a price to earnings perspective, than India and Indonesia. Their dividend yields also look attractive relative to their bond yields, perhaps a hangover from the Asian Crisis of 1997.

Technically all five stock markets are at or near recent highs:-

MITI_V_-_stocks_-_distance_to_high

Source: Investing.com

The Vietnamese VN Index is a long way below its high and on a P/E, P/B and dividend yield basis it is the cheapest of the five stock markets, but it is worth remembering that it is still regarded at a Frontier Market, It was not included in the MSCI Emerging Markets indices last year. This remains a prospect at the next MSCI review in May/June.

Given how far global equity markets have travelled since the November US elections, it makes sense to be cautious about stock markets in general. Technically a break to new highs in any of these markets is likely to generate further upside momentum but Vietnam looks constructive both over the shorter term (as it makes new highs for the year) and over the longer term (being well below its all-time highs of 2007). In the Long Run, I expect these economies to the engines of world growth and their stock markets to reflect that growth.

The Risks and Rewards of Asian Real Estate

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Macro Letter – No 69 – 27-01-2017

The Risks and Rewards of Asian Real Estate

  • Shanghai house prices increased 26.5% in 2016
  • International investment in Asian Real Estate is forecast to grow 64% by 2020
  • Chinese and Indian Real Estate has underperformed US stocks since 2009
  • Economic and demographic growth is supportive Real Estate in several Asian countries

Donald Trump may have torn up the Trans-Pacific Partnership trade agreement, but the economic fortunes of Asia are unlikely to be severely dented. This week Blackstone Group – which at $102bln AUM is one of the largest Real Estate investors in the world – announced that they intend to raise $5bln for a second Asian Real Estate fund. Their first $5bln fund – Blackstone Real Estate Partners (BREP) Asia – which launched in 2014, is now 70% invested and generated a 17% return through September 2016. Blackstone’s new vehicle is expected to invest over the next 12 to 18 months across assets such as warehouses and shopping malls in China, India, South-East Asia and Australia.

Last year 22 Asia-focused property funds raised a total of $10.6bln. Recent research by Preqin estimates that $33bln of cash is currently waiting to be allocated by existing Real Estate managers.

Blackrock, which has $21bln in Real Estate assets, predicts the amount invested in Real Estate assets will grow by 75% in the five years to 2020. In their March 2016 Global Real Estate Review they estimated that Global REITs returned 10% over five years, 6% over 10 years and 11% over 15 years.

This year – following the lead of countries such as Australia, Japan and Singapore – India is due to introduce Real Estate Investment Trusts (REITs) they also plan to permit infrastructure investment trusts (InvITs). Other Asian markets have introduced REITs but not many have been successful in achieving adequate liquidity. India, however, has the seventh highest home ownership rate in the world (86.6%) which bodes well for potential REIT investment demand.

UK asset manager M&G, make an excellent case for Asian Real Estate, emphasis mine:-

Exposure to a diversified and maturing region which accounts for a third of the world’s economic output and offers a sustainable growth premium over the US and Europe.

Diversification benefits. An allocation to Asian real estate boosts risk-adjusted returns as part of a global property portfolio; plus there are diverse opportunities within Asia itself.

Defensive characteristics, with underlying occupier demand supported by robust economic fundamentals, as showcased by Asia’s resilience during the European and US downturns of the recent financial crisis.

What M&G omit to mention is that investing in Real Estate is unlike investing in stocks (Companies can change and evolve) or Bonds which exhibit significant homogeneity – Real Estate might be termed the ultimate Fixed AssetLocation is a critical part of any investment decision. Mark Twain may have said, “Buy land. They’re not making it anymore.” but unless the land has commercial utility it is technically worthless.

The most developed regions of Asia, such as Singapore, Hong Kong, Japan and Australia, offer similar transparency to North America and Europe. They will also benefit from the growth of emerging Asian economies together with the expansion of their own domestic middle-income population. However, some of these markets, such as China, have witnessed multi-year price increases. Where is the long-term value and how great is the risk of contagion, should the US and Europe suffer another economic crisis?

In 2013 the IMF estimated that the Asia-Pacific Region accounted for approximately 30% of global GDP, by this juncture the region’s Real Estate assets had reached $4.2trln, nearly one third of the global total. During the past decade the average GDP growth of the region has been 7.4% – more than twice the rate of the US or Europe.

The problem for investors in Asia-Pacific Real Estate is the heavy weighting, especially for REIT investors, to markets which are more highly correlated to global equity markets. The MSCI AC Asia Pacific Real Estate Index, for example, is a free float-adjusted market capitalization index that consists of large and mid-cap equity across five Developed Markets (Australia, Hong Kong, Japan, New Zealand and Singapore) and eight Emerging Markets (China, India, Indonesia, Korea, Malaysia, the Philippines, Taiwan and Thailand) however, the percentage weighting is heavily skewed to developed markets:-

Country Weight
Japan 32.94%
Hong Kong 26.40%
Australia 19.81%
China 9.62%
Singapore 6.30%
Other 4.93%

Source: MSCI

Here is how the Index performed relative to the boarder Asia-Pacific Equity Index and  ACWI, which is a close proxy for the MSCI World Index:-

msci_asian_real_estate_etf

Source: MSCI

 

The MSCI Real-Estate Index has outperformed since 2002 but it is more volatile and yet closely correlated to the Asia-Pacific Equity or the ACWI. The 2008-2009 decline was particularly brutal.

Under what conditions will Real Estate investments perform?

  • There are several supply and demand factors which drive Real Estate returns, this list is not exhaustive:-
  • Population growth – this may be due to internal demographic trends, such as higher birth rates, a rising working age population, inward migration or urbanisation.
  • Geographic constraints – lack of space drives prices higher.
  • Planning restrictions – limitations on development and redevelopment drive prices higher.
  • Economic growth – this can be at the country level or on a per-capita basis.
  • Economic policy – fiscal stimulus, in the form of infrastructure development, drives economic opportunity which in turn drives demand.
  • Monetary policy – interest rates – especially real-interest rates – and credit controls, drive demand: although supply may follow.
  • Taxation policy – transaction taxes directly impact liquidity – a decline in liquidity is detrimental to prices. Annual duties based on assessable value, directly reduce returns.
  • Legal framework – uncertain security of tenure and risk of curtailment or confiscation, reduces demand and prices.

The markets and countries which will offer lasting diversification benefits are those which exhibit strong economic growth and have low existing international investment in their Real Estate markets. The UN predicts that 380mln people will migrate to cities around the world in the next five years – 95mln in China alone. It is these metropoles, in growing economies, which should be the focus of investment. Since 1990, an estimated 470 new cities have been established in Asia, of which 393 were in China and India.

In their January 2017 update, the IMF – World Economic Outlook growth forecasts for Asian economies have been revised downwards, except for China:-

Country/Region 2017 Change
ASEAN* 4.90% -0.20%
India 7.20% -0.40%
China 6.50% 0.40%

*Indonesia, Malaysia, Philippines, Thailand, Vietnam

Source: IMF

The moderation of the Indian forecast is related to the negative consumption shock, induced by cash shortages and payment disruptions, associated with the recent currency note withdrawal. I am indebted to Focus Economics for allowing me to share their consensus forecast for February 2017. It is slightly lower for China (6.4%) and slightly higher for India (7.4%) suggesting that Indian growth will be less curtailed.

China and India

Research by Knight Frank and Sumitomo Mitsui from early 2016, indicates that the Prime Yield on Real Estate in Bengaluru was 10.5%, in Mumbai, 10% and 9.5% in Delhi. With lower official interest rates in China, yields in Beijing and Shanghai were a less tempting 6.3%. These yields remain attractive when compared to London and New York at 4%, Tokyo at 3.7% and Hong Kong 2.9%. They are also well above the rental yields for the broader residential Real Estate market – India 3.10% and China 3.20%: it’s yet another case of Location, Location, Location.

This brings us to three other risk factors which are especially pertinent for the international Real Estate investor: currency movements, capital flows and the correlation to US stocks.

Since the Chinese currency became tradable in the 1990’s it has been closely pegged to the value of the US$. After 2006 the currency was permitted to rise from USDCNY 8.3 to reach USDCNY 6.04 in 2014. Since then the direction of the Chinese currency has reversed, declining by around 15%.

This recent currency depreciation may be connected to the reversal in capital flows since Q4, 2014. Between 2000 and 2014 China saw $3.6trln of inflows, around 60% of which was Foreign Direct Investment (FDI). Since 2014 these flows have reversed, but the rate of outflow has been modest; the trickle may become a spate, if the new US administration continues to shoot from the hip. A move back to USDCNY 8.3 is not inconceivable:-

usdcny-1994-2017

Source: Trading Economics

Chinese inflation has averaged 3.86% since 1994, but since the GFC it has moderated to an annualised 2.38%.

The Indian Rupee, which has been freely exchangeable since 1993, has been considerably more volatile: and more inclined to decline. The chart below covers the period since January 2007:-

usdinr-10-yr

Source: Trading Economics

Since 1993 Indian inflation has averaged 7.29%, but since 2008 it has picked up to 8.65%. The sharp currency depreciation in 2013 saw inflation spike to nearly 11% – last year it averaged 5.22% helped, by declining oil prices. Official rates, which hit 8% in 2014, are back to 6.25%, bond yields have fallen in their wake. Barring an external shock, Indian inflation should trend lower.

Capital flows have had a more dramatic impact on India than China, due to the absence of Indian exchange controls. A February 2016 working paper from the World Bank – Capital Flows and Central Banking – The Indian Experience concludes:-

Going forward, under the new inflation targeting framework, monetary policy will likely respond even more than before to meet the inflation target and adjust less than before to the capital flow cycles. One concern some people have with the move of a developing country such as India to inflation targeting is that it could result in greater exchange rate flexibility. Having liberalized the capital account progressively over the last two and a half decades, the scope to use capital flow measures countercyclically has perhaps diminished as well.

Thus in years ahead, reserve management and macroprudential measures are likely to play a more significant role in helping respond to capital flow cycles, just as the policy makers and the economy develop greater tolerance for exchange rate adjustments.

The surge and sudden stop nature of international capital flows, to and from India, are likely to continue; the most recent episode (2013) is sobering – the Rupee declined by 28% against the US$ in just four months, between May and August. The Sensex Stock Index fell 10.3% over the same period. The stock Index subsequently rallied 72%, making a new all-time high in March 2015. Since March 2015 the Rupee has weakened by a further 10.3% versus the US$ and the stock market has declined by 7.7% – although the Sensex was considerably lower during the Emerging Market rout of Q1, 2016.

Stock market correlations are the next factor to investigate. The three year correlation between the S&P500 and China is 0.37 whilst for India it is 0.60. Since the Great Financial Crisis (GFC) however, the IMF has observed a marked increase in synchronicity between Asian markets and China. The IMF WP16/173 – China’s Growing Influence on Asian Financial Markets is insightful, the table below shows the rising correlation seen in Asian equity and bond markets:-

imf_china_correlation_rising_-_march_2016

Source: IMF

With so many variables, the best way to look at the relative merits, of China versus India and Real Estate versus Equities, is by translating their returns into US$. Since the GFC stock market low in March 2009, returns in US$ have been as follows. I have added the current dividend and residential rental yield:-

Index Performance – March 09 – December 16 Performance in US$ Current Yield
S&P500 207% 207% 2%
FHFA House Price Index (US) 9.70% 9.70% 2.20%
Shanghai Composite (China) 50% 49.20% 4.20%
Shanghai Second Hand House Price Index 74% 72.85% 3.20%
S&P BSE Sensex (India) 204% 135.25% 1.50%
National Housing Bank Index (India) 58%* 38.45% 3.10%
*Data to end Q1 2016

Source: Investing.com, FHFA, eHomeday, National Housing Bank, Global Property Guide

There are a number of weaknesses with this analysis. Firstly, it does not include reinvested income from dividends or rent – whilst the current yields are deceptively low. Data for the S&P500 suggests reinvested dividend income would have added a further 40% to the return over this period, however, I have been unable to obtain reliable data for the other markets. Secondly, the rental yield data is for residential property. You will note that Frank Knight estimate Prime Yields for Bengaluru at 10.5%, 10% for Mumbai and 9.5% for Delhi. Prime Yields in Beijing and Shanghai offer the investor 6.3% – Location, Location, Location.

The chart below shows the evolution of the Shanghai Second Hand House Price Index since 2003:-

china_-_ehomeday_-_shanghai_second_hand_house_pric

Source: eHomeday, Global Property Guide

For comparison here is the National Housing Bank Index since 2007:-

india_-_national_housing_bank_-_house_price_index

Source: National Housing Bank, Global Property Guide

Finally, for global comparison, this is the FHFA – House Price Index going back to 1991:-

us_-_federal_housing_finance_agency_-_house_price_

Source: FHFA, Global Property Guide

The Rest of Asia

In this Letter I have focused on China and India, but this article is about Asian Real Estate. The 2004-2014 annual return on Real Estate investment in Hong Kong was 14.4% – the market may have cooled but demand remains. Singapore has delivered 11.7% per annum over the same period. Cities such as Kuala Lumpur and Bangkok remain attractive. Vietnam, with a GDP forecast of 6.6% for 2017 and favourable demographics, offers significant potential – Hanoi and Ho Chi Minh are the cities on which to focus. Indonesia and the Philippines also offer economic and demographic potential, Jakarta and Manilla having obvious appeal. The table below, sorted by the Mortgage to Income ratio, compares the valuation for residential property and economic growth across the region:-

Country Price/Income Ratio Rental Yield City Price/Rent Ratio City Mortgage As % of Income GDP f/c 2017
Malaysia 9.53 4.07 24.6 72.87 4%
Taiwan 12.87 1.54 64.91 78.76 1.80%
South Korea 12.38 2.04 49.1 85.47 2.40%
India 10.28 3.08 32.44 123.44 7.40%
Singapore 21.63 2.75 36.41 134.33 1.60%
Pakistan 12.09 4.08 24.51 156.97 5.10%
Philippines 16.91 3.75 26.69 162.87 6.60%
Bangladesh 12.89 3.25 30.81 181.3 6.80%
China 23.29 2.23 44.83 189.71 6.40%
Mongolia 15.77 9.78 10.22 203.47 1.80%
Thailand 24.43 3.8 26.29 212.03 3.30%
Hong Kong 36.15 2.25 44.35 224.85 1.80%
Sri Lanka 17.49 4.91 20.38 238.64 4.80%
Indonesia 21.03 4.67 21.41 247.68 5.10%
Vietnam 26.76 4.52 22.1 285.55 6.60%
Cambodia 24.32 7.44 13.44 292.43 7%

Source: Numbeo, Focus Economics, Trading Economics

There are opportunities and contradictions which make it difficult to draw investment conclusions from the table above: and this is just a country by country analysis.

Conclusions and Investment Opportunities

Real Estate, more so than any of the other major asset classes, is individual asset specific. Since we are looking for diversification we need to evaluate the two types of collective vehicle available to the investor.

Investing via REITs exposes you to the volatility of the stock market as well as the underlying asset. Investing directly via unlisted funds has been the preferred choice of pension fund managers in the UK for many years. There are pros and cons to this approach, but, for diversification, this is likely to be the less correlated strategy. Make sure, however, that you understand the liquidity constraints, not just of the fund, but also of the constituents of the portfolio. The GFC was, in particular, a crisis of liquidity: and property is not a liquid investment.

Unsurprisingly Norway’s $894bln Sovereign Wealth Fund – Norges Bank Investment Management – invests in Real Estate for the long run. This is how they describe their approach to the asset class, emphasis mine:-

The fund invests for future generations. It has no short term liabilities and is not subject to rules that could require costly adjustments at inopportune times.

…Our goal is to build a global, but concentrated, real estate portfolio…The strategy is to invest in a limited number of major cities in key markets.

According to Institutional Real Estate Inc. the largest investment managers in the Asia-Pacific Region at 31st December 2014 were. I’m sure they will be happy to take your call:-

Investment Manager Asian AUM $Blns Total AUM $Blns
UBS Global Asset Management 9.33 64.89
Global Logistic Properties 9.26 20.14
CBRE Global Investors 8.56 91.27
LaSalle Investment Management 8.05 55.75
Blackstone Group 7.58 121.88
Alpha Investment Partners 7.48 8.70
Blackrock 7.32 22.92
Pramerica Real Estate Investors 6.84 59.17
Gaw Capital Partners 6.64 9.16
Prologis 6.08 29.98

Source: Institutional Real Estate Inc.

In their August 2016 H2, 2016 Outlook, UBS Global Asset Management made the following observations:-

Although property yields across the APAC region are at, or close to, historical lows, demand for real estate exposure in a multi-asset context is set to remain healthy in the near-to-medium term. Capital inflows into the asset class will continue to be supported by broad structural shifts across the region related to demographics and demand for income producing assets on the one hand, and (ex-ante) excess supply of private (household and/or corporate) sector savings on the other. Part of this excess savings will continue to find its way into real estate, both in APAC and in other regions…

Real Estate investment in Asia offers opportunity in the long run, but for markets such as Shanghai (+26.5% in 2016) the next year may see a return from the ether. India, by contrast, has stronger growth, stronger demographics, higher interest rates and an already weak currency. The currency may not offer protection, inflation is still relatively high and the Rupee has been falling for decades – nonetheless, Indian cities offer a compelling growth story for Real Estate investors. Other developing Asian countries may perform better still but they are likely to be less liquid and less transparent. The developed countries of the region offer greater transparency and liquidity but their returns are likely to be lower. A specialist portfolio manager offers the best solution for most investors – that’s assuming you’re not a Sovereign Wealth Fund.