Webinar Replay: Looking for Opportunities Abroad
With slowing global growth and rising geopolitical tensions, many investors favor bringing money home to invest in low risk assets. Yet, many international equity markets feature lower valuations or have unique risks, which may provide investors with opportunities to diversify their portfolio. In this webinar, we highlight potential opportunities across Europe, Latin America, and Asia.
Natalie: Hello, and welcome to today’s webcast, “Looking for Opportunities Abroad,” sponsored by Global X ETFs. With that, I’d like to turn it over to today’s first speaker, Jay Jacobs, Head of Research and Strategy for Global X ETFs; Jay.
Jay Jacobs: Thanks, Natalie, and thank you, everyone, for joining today’s webinar. I’m joined here by a group of experts from around Global X and a special guest from Glovista Investments as well. I’ll be MCing today’s webinar. First, Jon Maier, our CIO, and head of the model portfolio business at Global X will be discussing some of the major macroeconomic risks and geopolitical tensions that are affecting today’s markets, especially outside of the United States, but affecting the US equity markets as well.
Then we’ll turn it over to Chelsea Rodstrom, our Research Analyst covering the international space who will highlight some of the brighter spots around the world that are maybe more immune to some of these risks or just possess more attractive structural opportunities than some of the broad international exposures. Last, we’ll turn it over to Darshan Bhatt from Glovista Investments. He will be focused more on looking at the emerging market space, looking at valuations and trends, and digging more specifically into how to approach China given the tensions and global economic slowdown that we’re seeing today. After we run through each of those sections, we will leave time for a Q&A at the end.
With that, very briefly, I’ll give a little bit of background about Global X and then we’ll continue with the webinar. Global X, we are based out of New York, an ETF manager only doing ETFs, 69 of them currently. Just shy of 11 billion in assets under management. Our first ETF was the Global X MSCI Colombia ETF. Our roots are deeply planted in providing international exposures. Today, we have 22 international access ETFs with over one billion in assets.
You can see our suite here. We have a variety of different exposures from very broad, smart-beta funds to single-country exposures, a full China Sector Suite with each of the 11 GICS sectors, and a couple of regional funds as well. With that, let me turn it over to Jon Maier, who will take us through the state of the world right now.
Jon Maier: Thanks, Jay.
What I’m going to talk about today is a few topics. Many of you are aware of the topics: the US-China trade dispute. I don’t like to use the word war, but hopefully, we get some clarity there. Slowing economic growth around the world, falling interest rates, in some cases negative interest rates, Brexit, which is always a fun one with no great solution, and the implication of a strong US dollar and how that’s impacting the world, and central bank support around the world that’s help trying to stimulate growth globally.
Just some broad comments. We’ve certainly seen headlines that global growth is slowing. We’ve certainly seen that central banks around the world have been trying to assist. If you look at some of the statistics from the International Monetary Fund, the IMF, the IMF is growing more pessimistic about the global economy. That has a lot to do with higher tariffs around the world, which is hurting manufacturing in international trade.
Global growth, according to the IMF, it’s expected to fall to a 3% growth rate. This is the slowest pace of growth since the financial crisis in 2008, down from 3.8% in 2017. The IMF indicates that a 3% growth rate is essential for the world. We are at that tipping point where it gets – it’s going to be of greater concern to stimulate growth. There’s no room for policy mistakes. There’s a real urgent need to de-escalate some of these trade conflicts around the world, some geopolitical tensions.
They’re estimating that the trade dispute, US-China trade dispute has shaved about 60 to 80 basis points off of global growth. While it’s not a huge number in aggregate as a percentage, it is a huge number. The trade wars have not helped. In terms of US growth, GDP has dropped to 1.8% for the third quarter. We are seeing profits declining through this earning season. Negative growth in terms of earnings appears to be here after many years of earnings growth.
Let’s take on the US-China trade war. I put up a chart here showing the back and forth of all the trade announcements over the past couple of years relating to the US-China trade dispute. It would be nice to put the US-China trade negotiations in the review mirror and get back to just growing the world, but we have to get through this. There appears to be a Phase One trade deal a couple weeks ago; some call it the skinny deal where China agreed to purchase – repurchase or start purchasing again agriculture products, opening – some opening of their financial sector, currency pact, and progress on intellectual property. Within this deal, there was no rollback of tariffs that are currently in place, but there was no escalation of the current tariffs or the promised escalation of tariffs.
The markets bounced on the news. The Trump administration basically said it’s a done deal. Then China came back and said it’s not a done deal. We’re still reviewing. We expect that the skinny deal or the Phase One trade deal to occur in November. The markets would react rather negatively if this wasn’t the case.
Let’s put this one on China for a second. If policymakers in China continue to delay, there’s a higher risk of policy falling behind the curve. This puts greater pressure on downward growth. We have seen the China GDP numbers come down to about 6%, potentially lower. That’s a low number for China.
Now, despite all the trade uncertainties in the US, we believe that the consumer is really holding up the economy. So far, they’re still purchasing. It’s not likely to last forever. We need some sort of catalyst like a resolution to the trade deal for growth to continue.
Another topic is yield curve and interest rates around the world. This is a pretty interesting chart. You have the policy rate and then you have different parts of the curve: three-month, two-year, ten-year. If you look at countries in Europe like Germany for example, they have a negative rate on a ten-year of 61 basis points, but the policy rate’s zero. You have policy rates zero for many European countries and some are negative.
Then if you go further up in the curve, basically rates are negative. That’s potentially saying policy is not aggressive enough and perhaps they should go negative. You look at Japan, you have a negative policy rate, but your ten-year rate is actually lower – or higher than Germany, so perhaps Europe is not being aggressive enough and perhaps they should go negative. If you look at Japan, you have a negative policy rate, but your ten-year grade is actually higher than Germany. So perhaps, Europe is not being aggressive enough.
The ECB is going to begin quantitative – restart quantitative easing. That’s an important thing, but it may not last forever in terms of stimulating the economy. It looks like Europe does have a long-term issue. If you look at Japan, quantitative easing and negative rates haven’t really resolved the growth issues in Japan. Perhaps that’s relating to demographic shifts. If you’ll go back to Europe, growth has been declining since the ‘70s.
Now, the next topic I’d like to talk about is the dollar. The dollar strength has certainly caused weakness around the world. It’s made our exports more expensive. Until we see some weakening of the dollar, I think that is going to be some issue.
If you look at the past few days when there was some slight positive news about Brexit being resolved, you did see the pound move up to about 1.29. You saw the EM improve some in terms of strength a little bit. You also saw the euro improve as well. The dollar trend could partially attribute to higher rates in the US versus other developed countries remembering there’s negative rates in Europe, many countries in Europe, and Japan. Central banks are now in easing mode, the biggest proportion since the aftermath of the financial crisis. I think a lot of it all comes back to the trade war, unfortunately.
In terms of Brexit, Brexit is – I don’t have an answer here. I don’t think anyone has an answer here. The latest deal was not approved by Parliament. They wanted several more days to review the deal. Boris Johnson was not okay with that. He’s looking for a general election which also has to be approved by Parliament. That’s unlikely to happen.
I think back to a Paul McCartney song, a Beatles song, “The Long and Winding Road,” which is written in the ‘70s just three years before Britain joined the EU. Clearly, this was not written about Brexit, but it does resonate. The long and winding road relating to Brexit certainly continues. It remains to be seen there; I’m not going to make any predictions on Brexit.
Some people just make – turn up their hands and saying whatever happens, happens. If you really break it down, Brexit is not necessarily good for the UK; it’s not necessarily good for the EU; potentially, it’s okay for the US. I’m on the fringes in terms of re-negotiating a small deal with the US in terms of open trade. That’s the Brexit story.
In terms of anything positive out there, EM has certainly been depressed. On technical, you can certainly see a bounce in EU in the EM space. EM ex-China, the accommodative monetary policies both in EM as well as developed economies potentially could assist and just by pure inertia in some of these countries. Ex-China potentially could be an area of interest. Lots of gloom and doom on the global fronts, but we will prevail.
Jay Jacobs: Alright, thank, Jon. I’m glad you picked “The Long and Winding Road” and not “Help!” a more positive sign for the British situation. With this, we’ll turn it over to our next expert, Chelsea Rodstrom, who will focus on some of the bright spots around the world and perhaps how to tackle some these challenges that Jon mentioned in his section; Chelsea.
Chelsea Rodstrom: Thanks, Jay. While powerful macro-level headwinds are impacting large regions, as Jon mentioned, they do so in an incongruous way. This suggests opportunity for those paying close attention or with an interest in allocating in a more tactical way. We’ll start by identifying some broad risks and provide alternative approaches to allocating regionally around these risks. Then we’ll dive deeper into some of the drivers within specific markets that fall into these buckets and for which there are single-country or regional funds that allow investors to access these markets.
The first of five macroeconomic concerns we’ve identified is sluggish global growth. Great to see that’s something that’s top of mind for all of you. To combat this, we suggest looking toward higher growth emerging market countries or subregions. Within the Southeast Asia subregion, we’ll consider Vietnam and Indonesia which both have had higher growth despite a slowdown across the broader region.
To allocate around the second concern of a strong dollar, investors may want to consider emerging markets that are big exporters and export in dollars or those countries that might benefit from falling rates and from tackling or refinance in their debt in a lower rate environment. Here, we’ll look at Greece, Portugal, and Colombia. Perhaps the most top of mind concern will be the ongoing trade tensions which have had implications for domestic and international investors alike.
Internationally, several European countries, Germany, France, the UK have been perhaps the most in the spotlight. Those with exposure to this region might want to consider countries less exposed to the ex-regional trade tensions. That would include countries like again, Greece and Portugal, but also would include countries in the Nordic regions like Norway or Sweden, which trade mainly within the EU or the greater eurozone. Investors may also want to consider countries that have offset their export exposure with a growing domestic demand. That would come from – we’d see that in a country like Indonesia.
Another prominent concern for investors, especially with those with heavy European exposure, is Brexit. A lot of investors have been concerned with the implications of a hard Brexit or the stability of the European financial system without London. While some of this risk, it’s been reduced or priced in with a migration to Frankfurt, countries with less developed financial sectors like Greece and Portugal may be left less directly exposed to this.
Lastly, we consider geopolitics in the Middle East to be a concern. Low oil prices last year hurt a lot of oil producers and exporters. This year, they’ve faced a host of new challenges.
OPEC member countries, which tend to be exposed to greater levels of political risks, especially to the Middle East, definitely feel this pain more sharply. They have less levers of control in their pricing and output and can do little to offset these headwinds. Whereas countries like Norway or Colombia are non-OPEC members, so they’re not subject to the same price, production, or output controls – making them good spots to gain that oil exposure without the political risk in the Middle East or the price controls associated with OPEC membership.
Just to give you a broad overview of the opportunities we see around the world, you can see on the map that we’ve highlighted some pockets within each region to give you more targeted access to these growth space despite the global slowdown. You’ll see in Southeast Asia, we’ve highlighted Indonesia and Vietnam. We’ve also highlighted a couple of sectors within China. I’ll let Darshan talk about that more later. We’ve also picked Colombia in Latin America. Then in Europe, we’ve separated it out into two groups: peripheral Europe countries like Greece and Portugal as well as the Nordic region.
Despite the macroeconomic and geopolitical challenges facing the world today, many broad market indices are showing relatively full valuations. Some of this is attributable to the low interest rate environment which has driven many investors to seek returns from equities rather than bonds and has pushed up valuation higher for certain regions. Many of the bright spots we have highlighted exhibit lower valuations than their regional benchmarks which adds to their appeal.
Relative to broader Europe, Greece, Portugal, and Norway all exhibit comparable or lower evaluations from a price to earnings, price to sales, and price to book metrics. Similarly, Colombia and Southeast Asia, including Vietnam, exhibit lower evaluations than their broad benchmarks. In an environment with loft evaluations in many regions, including the US and falling growth expectations, lower multiples can play an important role in contributing to returns should those valuations begin to normalize or dividends and buyback support higher total returns.
The first region we’ll discuss is Latin America. LATAM is broadly facing a host of headwinds from stagnating growth to policy and political uncertainty and the overhang of high debt levels. Within the region, Colombia stands out as our bright spot. It’s got stable growth, strong political institutions, and prudent macro policies.
In broad Latin America, portfolios flows have weakened despite a very strong inflow that we saw earlier in the year. A lot of this is related to the policy uncertainty which has weighed on sentiment with uncertainties surrounding Brazilian pension reforms, Mexican energy and education policy, not to mention Argentine politics following the primaries in August and more generally with the first round of presidential elections coming up this weekend. Peru and Ecuador have also made the news recently with President Vizcarra in Peru calling for the dissolution of Congress because of deep-seated corruption and because of the removal of oil subsidies in Ecuador which sparked protests and ended in President Moreno fleeing the country just to reverse the policy back and reinstate the subsidies. Both of these issues seem have quelled a bit, but they’ll likely continue to be the source of some regional political instability as we move forward.
The instability in Ecuador also highlights another problem, which is high levels of debt within several Latin American countries, especially in the bigger economies like Argentina and Brazil. Although these debt profiles are distinct, with Argentina having a higher level of dollar-dominated sovereign debt, and Brazil having a higher level of municipal but real-denominated debt, continued fiscal consolidation is also needed throughout the region. Aside from this policy and fiscal prudence, regional growth has also been hurt by external forces including US-China trade tensions and lower commodity prices globally.
To turn it back to Colombia, the country’s economic recovery is projected to continue despite these external headwinds. Compared to their region, Colombia is expected to have higher growth, has experienced an acceleration in capital inflows, and has implemented several reforms consistent with Colombia’s long history of macroeconomic prudence. The government recently announced that the headline deficit target for 2019 is expected to be met and has recently introduced tax and capital markets reforms to lower corporate taxes and support domestic demand, foreign inflows, which will all help support the projected growth of around 3.5% in 2019 to 2020. Other tailwinds which support the Colombian economy in the medium to long-term include monetary policy easing, election-year spending by subnational governments, migration from Venezuela, and the continued implementation of the 4G – sorry, 4G infrastructure, not technology, projects throughout the country which should link Colombia to the rest of the world.
Next, we’ll move to Europe. European markets as we discussed earlier have been riddled this year by stagnating growth and are set to face additional headwinds as the US imposes WTO supported tariffs for illegal EU subsidies given to Airbus. Before the WTO ruling, US policymakers and ongoing US-China trade war were two culprits of mounting pressures on other major European industries like the auto industry in Germany or the wine industry in France and helped dampen economic data throughout their region. Although macro weakness and trade tensions continued to spread across Europe, there is still pockets of opportunity for investors allocating to the region.
One bright spot we see is Greece. After a strong start to 2019, Greek equity markets still maintain their spot as the best performing emerging market. Economic growth in Greece is recovering, unemployment has been falling steadily, and the new government is pushing forward on key market-friendly reforms including lowering taxes for households and business.
Manufacturing has also recovered. It’s continued into its 27th consecutive month of expansion against the backdrop of PMI slowdown across Europe. Over the last month, bond yields in Greece have also fallen into negative territory, suggesting that investors looking to play Greece’s continued rebound may increasingly look towards equities as bond markets become more saturated.
Similarly, we’ll look at Portugal. Portugal is a few years ahead of Greece. Its GDP is now above pre-crisis levels and unemployment is actually at a decade-low.
It’s a bit further along in reducing its nonperforming loan exposure as well. Even though continued progress is certainly needed in both Greece and Portugal, strength is both country’s bond markets and early payments to IMF suggests longer-term tailwinds for these peripheral European countries. Both countries also have many of their exports destined for other EU countries, which does help to offset some the pressure created by tensions on countries like Germany or France which are derived outside of the region.
Lastly, we’ll take a quick look at the Nordic region. A lot of euro-centric investors might look north of the EU if they’re looking to maintain their European presence but want to mitigate their exposure to a slowdown or trade sensitivities in the eurozone. The Nordic region benefits from being relatively insulated from the trade and political tensions which have hurt broader Europe and could potentially even benefit from some of it as Nordic tech and comms firms become favored over their Chinese competitors within US and European policy circles.
Firms in these countries stand to benefit from global government-sponsored infrastructure contracts that these policies wonks bring these policies to the fore. If you’re looking to get narrower country exposure within the Nordic regions, Norway offers the added benefit of higher correlation to oil prices but is not an OPEC member. It benefits from less sensitivity to geopolitics in the Middle East, as we discussed before, and the price and output controls imposed on other countries.
Now, we’re going to shift to Asia-Pacific. Given the varying sizes of the economies within Asia, it’s helpful to consider subregions when looking for bright spots there. It’s also helpful for contextualizing the incongruous impact that a slowdown in China is having on the region and how those solely dependent on – or more dependent on the Chinese supply chain – might be hurt more.
By GDP, the US is obviously the largest economy followed by China, Japan, and then surprisingly the ASEAN region collectively. The ASEAN region or the Association of Southeast Asian Nations is a free trade organization that includes several countries within Southeast Asia including some of the world’s fastest-growing economies like Indonesia and Vietnam. Although the ASEAN region did see capital outflows in 2018 under tighter financial conditions, this is expected to turn around in the medium term and could further benefit from lower rates globally.
While the ASEAN region is very US-centric in terms of export destinations, the region is also heavily engaged in the RCEP negations. RCEP is a free trade agreement initiative which is China’s answer to CP TPP and has the potential to reduce the regions’ reliance on US trade, to boost regional cooperation, and has the potential to grow the global economy by 285 billion dollars annually which is two times the size of CP TPP. One of the direct beneficiaries of this trade and of – as a bright spot within the ASEAN region is Vietnam. Vietnam is a direct beneficiary of trade with both China and the US and is expected to grow much faster than the region at 6.5% over the coming years.
Despite facing the negative impacts of trade tensions, the economy has been resilient with growth reaching a ten-year high of 7.1%. Although it’s supposed to be slightly slower over the next year or two, it remains high on a regional basis. Fueling its growth are Vietnam’s competitive labor costs and manufacturing capabilities, as well as an expanding middle-class driving consumerism on the demand side. Urbanization and reforms implemented by the Vietnamese government have also aided growth by expanding credit, access to capital markets, and the private sector.
Next, we’ll move to Indonesia. Indonesia is the largest economy in Southeast Asia following Vietnam in having one of the highest growth rates in the region at 5% GDP growth over the next year. Although the economy faces headwinds again related to trade, which did result in capital outflows in 2018, Indonesia has performed well with falling net exports offset by domestic demand, credit growth, and responsive policy mechanisms. The outlook for Indonesia is also positive given the expected policy continuity. The current administration just began its second term and has set a substantial reform agenda to improve infrastructure, streamline regulations in health and education, allow for greater foreign direct inflows, and reduce the presence of state-owned enterprises to boost competition and innovation.
Lastly, we’ll talk about China. Darshan will go into more detail on this, but we do see more opportunity in China at the sector level rather than using a broad china approach given the dispersion of returns and distinct drivers across different sectors within China which is the world’s second-largest economy. China’s shift to a consumption-led economy and the divergence between sectors demonstrates the value of this more selective approach to China and also reaffirms the thesis of the long-term opportunities created by an economy that has shifted away from an export-led model to one that is consumption-driven. To wrap this section up, we’d like to highlight that with macroeconomic and geopolitical indicators flashing warning signs, it’s understandable that investors may seek the safety and familiarity of US assets, but we’d also like to point out that not all markets are impacted in the same way by these risks and that many have attractive characteristics and valuations. We believe investors ought to consider a more selective approach to their exposure outside the US to capture such opportunities or to avoid the risks that threaten broader benchmarks.
Jay Jacobs: Excellent, thank you, Chelsea. This brings us to transition to Darshan, who’s going to give us a good overview of the emerging market space as a whole and more specifically think about how to approach China given everything that we’re seeing in the global climate today. Darshan, feel free to take it away from here.
Darshan Bhatt: Excellent, thank you, Jay, and thank you to the Global X team for inviting me today on this webinar, and thank you all the participants for logging in. As you might know, Glovista is a preeminent emerging markets-focused firm with decades of experience of investing in emerging markets, particularly on the equity side. Then we also run a whole host of global macro-based strategies.
Again, the topic is very interesting. I can spend a whole amount of time talking about emerging markets in general and China in particular because we are at a very interesting juncture in markets right now. My objective really today is to highlight certain points to actually start a thought process from an investment perspective because why do we think this is an interesting juncture and where do the opportunities lay as we look at not only the next quarter but as we look at the next years as we invest our clients’ portfolios.
First, I would like to say to everyone is whether we like emerging markets, whether we hate emerging markets, it’s very tough to ignore emerging markets now, and it’s going to get every tougher and tougher as we go along over the next few years. The transition over the last 45 to 50 years that these economies have gone through has been nothing unprecedented and tremendous. If you look at in 1995, when you talk about E7, the Top Seven countries within emerging markets, and you compare it to G7, the Top Seven countries globally, the E7 were roughly half the size of G7. Right now, and by 2015, they were around the same size. Just in 25 years from there around 2040, the E7 is going to be double the size of G7.
This has tremendous implications. This has implications not only in terms of power of these countries and international organizations, trade organizations, but this is also the economic reality we are facing with. That as a result, yes, we are interested in looking at portfolios, investing for the next quarter, and the next month, and generating returns for our clients, but we also have to keep in mind at times, take a step back and where the world is going, and are we positioned for it?
Now, having said that, we have been at a very interesting juncture if we look at the last nine years. Particularly since 2010, we have been in an environment where the returns globally, particularly in the equity side, have been dominated by the US. If you look at the US markets, it has outperformed, and particularly S&P 500 has outperformed MSCI emerging markets by about 178%.
The gray line is MSCI World, but that includes 61% US. If I were to take out the US component from it, the resulting line which would essentially be the international developed markets, they are up about 60% over the last 10 years. That in next line would be at 160%.
As I said, a lot of the outperformance has been very US-centric, okay. One question that arises is why that has been the case and is this likely to continue going forward. There are a whole host of reasons and explanations people will give from our perspective. Very briefly, we think there are three main reasons why this has been the case.
Number One, the non-traditional monetary policy that the central banks, particularly, in the developed world has been pursuing particularly since 2010 where you had the Federal Reserve, ECB, Bank of Finland, and the BOJ from a more longer period of time have been following quantitative easing and expanding their balance sheets. What that has done is essentially it has provided a whole vast amount of liquidity to those economies. That has benefited the equity markets, in particularly, the US much more than anywhere else.
Now, again, that has benefited other regions as well. When you talk about in the EM, clearly, what this has meant is there has been lots of flow toward the EM fixed income side. The spreads are very tight in that space right now. The great majority of the benefit has occurred to the US. That’s one.
Number Two, over this period, the US dollar has rallied very strongly, close to around 25, 30% as a major currency. That has, of course, impacted the returns as well because when we’re looking at these returns, we are looking at the dollar-based returns. Why has that been the case?
Number One, you could say, well, US was the least dirty shirt amongst all the ones out there. You had problems in Europe; you had problems in Japan; you had problems in UK. Emerging markets had their own set of issues. US probably was the safest place. Although the yields were coming low, people migrated towards US for safety. That clearly impacted the returns on the dollar.
Number Two, as we know in currencies, it’s always one currency versus the other. What we had is particularly in 2014, ECB started their quantitative easing program. They were later than most of the central banks. The euro against the dollar had a large sell-off starting 2014. That impacted dollars returns as well.
Then lastly, you had major developments since 2015. We all forget right it has been – there has been so many things happening. Just but a few years back, we went through the Grexit crisis. Now, we’re going through the Brexit crisis. China in August 2015 devalued their currency for the first time in 20 years.
These are unprecedented events that we have witnessed over the last eight or nine years. All of these are mounting to helping the dollar strengthen. One of the things that we can talk about is why has the dollar strengthened? There’s a lot of these other factors that have supported the dollar.
Then lastly, there has not been much written about it, but the role the shared buybacks help played for the US to outperform in international markets has been really unprecedented. When you look at the flow of funds data, the only net buyer of US equities over the last few years has been the corporates themselves, essentially issuing debt at very cheap levels and using those funds to buy back their own shares. That from a controlled perspective is a very US-specific phenomenon.
That impacts the US equities a lot more positively than what you’ll see in Europe, Japan, or in emerging markets. Europe and in emerging markets, it has been pretty much no culture of share buybacks. Japan and Korea now from a regulatory perspective are nudging their companies to start with some share buybacks. We have seen some nascent share buyback going on in India, but in general, this is a US-specific phenomenon. That has really impacted the US markets.
We all as investors have to think whether this performance, what we have seen over the last nine years, when we look at the forward-looking nine years is the same going to be repeated? Because in the words of Gretzky, we want to skate where the puck is going to be, not in terms of where the puck is right now. From that perspective, again, that’s why I say this is a very interesting juncture in market. This has been very strong underperformance.
Now, second, let’s look at valuations. When you look at valuations, the US equity market, as all of you are probably reading it everywhere, are trading at what I would call full valuations. As opposed to that, when you look at emerging markets or international equities, on a relative basis, they’re trading at cheaper valuations. This difference is at if not the widest, it’s close to low end of the spectrum. This is the relative valuation in emerging markets and international markets versus the valuation in the US.
Now, clearly, a lot of the arguments in terms of equities having a higher valuation in this environment are all relevant because when you compare the bond yields, globally close to 15 trillion dollars of debt is trading in negative yields. You have US 10-year yield at 1.74 in that environment. Clearly, the equity valuations would be higher than normal so that EYBY earning, yield to bond argument in terms – in favor of equity valuation is valid, but even within that, you have not seen as much benefits accruing to emerging markets or to international markets.
Now, the question that arises is, okay, that’s great. Historically, emerging markets have not performed well. Over the last nine years, the valuations are cheap. As we all know, valuations is not a pricing – a timing device. What does it mean going forward? What do we think about and what does the consensus think about emerging markets going forward? How do we invest in it?
Again, here, I’m using Blue-Chip consensus data. By that, I mean this is a consensus of all the economists on Wall Street when they look at decisions and they put out the consensus numbers. This has got no Glovista views in it. We do have views, but I just wanted to use that consensus information here to prove a point.
If you look at that top part of the table which on the left gives you a GDP growth and right gives you inflation, notice the change between 2019 and 2020. Emerging markets is the only region where actually growth is accelerating and inflation is going down. Because at most other places, you have growth actually coming down and inflation increasing slightly. As we all know as investors in equities, you want an environment, a Goldilocks type of an environment where there is good growth without a lot of inflation.
Again, using consensus information, what they’re telling you is that’s what is going to be the environment in emerging markets. Valuations I already touched. Let’s take the consensus of bottom-up analysts. These are all the analysts not only here in the US, but also in emerging markets and all over the world who are following these companies. When they come up with their consensus estimates at their revenue and earnings growth level, what you’ll find is from a revenue growth perspective and also from earnings growth perspective, they expect emerging markets to be the fastest-growing region.
Again, there is no – this is already expected by the market right now. A lot of people could have expectations which are better than that or higher than this as well. Number one from a growth perspective and also from an inflation perspective. This environment is going to be good for emerging markets.
In a nutshell, just rounding out first on emerging market asset class side before moving on to focusing on a little bit more on China is to say emerging market is an asset class which growing very strongly, expected to grow very strongly. The margins as reflected in earnings estimates are actually faster than developed markets. Valuation, it’s not at an all-time low on a relative basis but close to all-time low. You also have an environment where depending on the US dollar view, our house view is that US dollar should weaken from here. Depending on the US dollar view, if your view is the US dollar is going to weaken, that would further support the thesis for emerging markets.
Then lastly, emerging markets is a very under-allocated asset class. I have a couple of slides ahead which I’ll point out. In general, with every top reporting institutional clients, or our retail clients, or adviser clients, nobody is all with emerging markets, or very few people are all with emerging markets. From that perspective, this is an asset class as momentum comes back as we saw in 2017, there will be a rush towards allocation through emerging markets. Clearly, something to start looking at right now as we look at the year ahead.
Very often, I compare this – and if you can word this to stock example. If somebody were to give you stock A and stock B and you say stock A is growing revenues at a faster level. Stock A has better margins. As a result, your earnings growth is better. Stock A is trading at 28% valuation discount versus stock B. Stock A is under-allocated by institutional and retail community.
If you give that to any portfolio manager, they will say, wow, I’m going to buy stock A all day versus stock B. From that perspective, clearly, there is something. There is a lot of value in emerging markets. Clearly, if you initiate a program to look at emerging markets, this would be a very fortunate time to do that.
Now, changing gears a little bit as we move towards another important topic which is China. Because anybody who invests in emerging markets, and these days as we would argue anybody who invests in markets, have to consider what’s going on with China because China is increasingly becoming a very important part of the global economy. One could argue that it is as important part of the global economy as the USA, if not more.
Again, here we are using IMF data, so there are no assumptions or estimates that Glovista is providing here. According to IMF, when you look at it from a nominal value perspective, China’s GDP right now is almost close to the US. They are at 19% of their global share of GDP; US is at 22%.
Purchasing power, that means it adjusts for difference in levels at which you can buy goods and services. Clearly, in emerging markets and Asia, those are more cheaper. The size of the Chinese market is about one and a half times the US Market.
The message from this is China is a very important part of global economy. From a globally macroeconomic perspective, a few years back, we never used to consider China as an important part when we were looking at global economy and coming up with our views of the world. Now, we increasingly focus on China much more than Japan actually.
More importantly, when we translate this into the equity market side, the participation of China within equity markets so far has not been as large when you look at most of the benchmarks. Again, this has got history in terms of opening of their financial sector; this has got history in terms of free float or state-owned enterprises owning huge part of the Chinese economies and companies; as a result, not being accessible to global investors. For a whole host of intuitional reasons, when you look at index providers such as MSCI, Footsie, etc, they had not fully reflected China’s weight. If you look MSCI ACWI, which is All Country World Index right now, China is roughly 3.5% of that index. Again, when you look at data from some of the people who track a lot of exposures and who track fund flows like Lipper, MSCI, etc, what they find is global managers are underweight China even compared to that small benchmark.
When you look at MSCI emerging markets, where China is close to around 31, 32% of the benchmark. Remember, there was a huge change for those who have followed this closely in 2015 when MSCI made the decision to include US-listed Chinese stocks within their benchmarks. China benchmarks weight jumped massively.
Now, they’re going through another change by including the Chinese A-shares. Currently, we are just going through a transition where the Chinese A-shares weight is only included up to 20%. Between 5 and 20%, that’s the change going on. If they fully reflect China A-share’s weight within these indices, China’s weight would be close to around 40% of the MSCI emerging markets.
What they find, again these managers, most of the mangers are underweight China within their portfolios. Clearly, this is an important market. It is going to continue to be an important part of the world economy. I’m looking beyond a trade deal. Again, our view is trade deal, at the end of the day, unless you think that the global trade is going to breakdown, but it’s an extremely difficult proposition, we think that trade deal eventually is going to happen.
Chelsea talked a little bit about RCEP. I think that’s something that has not been talked in media and press here at all. It is a very important deal. The RCEP deal is between if you think about the countries, it’s Japan, Korea, China, you have India, Australia, and New Zealand, those six countries plus ten countries from ASEAN combining together to come up with a free-trade deal.
When you think about sizes, this is 39% or 40% of the world’s GDP right now. By 2050, it’s expected these countries will be more than half of the world GDP. They have more than 45% of the world population living there. All of these countries are closer to each other relative to rest of the world.
If they are able – so US being pulling out of TPP has given impetus to this deal. If this goes through, this will be very positive for Asia and 75% of emerging markets benchmark right now is in Asia. Again, when you think about the asset class, extremely positive once you start looking beyond what’s happening right now.
The question always that happens is Darshan, you talked about China. We know that China’s weight is going to increase in benchmarks; it is a given, okay. Most of these indices are going to do there, so that’s where focus is going to be. How do we invest in China? How do we get exposure to China once we start looking beyond this immediate future?
There are various approaches that people are taking, the institutional investors are thinking about. There’s a thought process going on. First is what they call integrated or what I call the passive approach which means to say we’re going to choose MSCI ACWI or MSCI Emerging Markets as our benchmark. We are going to follow whatever those index providers do.
As a result, either we buy passive products or we are going to buy – we’re going to allocate to active managers while using these benchmarks. As their allocation to China increases, our allocation to China increases. That’s one way to do it.
A lot of pension funds, it’s very easy to implement. That’s something that a lot of clients are following right now. That’s why I call it a passive approach because your allocation to China and how much to do, you’re outsourcing it essentially to the index providers.
The second one is what we call the future. It’s a China dedicated plus a carve-out approach. Again, the world has experience with this. If you go back to the ‘90s when Japan became a huge part of the global market, people started looking at international equity mandates and international equity markets ex-Japan. From that perspective, this is an approach where you look at China and you create mandates which are EM ex-China.
This would happen in the future. Right now, this is harder to implement because you don’t find managers which are focusing on EM ex-China as much. Again, that’s something to look at, but it’s difficult to implement right now.
The other one which is more easier to do to say is okay, we’re going to what we call is an add-on approach which is to say we continue with our process of allocating to broad indices, but as we like, we’re going to allocate specifically to China because we want to get all with China in certain areas, in certain forms and ways because we really believe in this macroeconomic theme. That’s how people are managing their allocations to China.
Now, you can do passive allocations. We saw in our polls that close to 59% of people when they are looking at international equities, the easiest job is to allocate to passive equities. We think there is a whole large case to be made for allocating to some form of active allocations within those passive indices because the opportunity for alpha that you give up is very large in these sectors.
When we look about China, this is a chart that we always refer to. This is only China-specific. When you look at the light blue bars on top, these are the performance of the Top Three performing sectors within China each of those years. The gray bar is a performance of the Bottom Three performing sectors. The blue bar, the dark blue bar, is the performance of MSCI China.
Again, we are showing this for the last five years just for example. You can go back any number of years, any number of periods. What you’ll find is that irrespective of what the index does and what it returns, the difference between the Top Three and the Bottom Three sectors is extremely large. The differences could be some years as high as 56%, but on average between 25 and 30%. That’s a huge amount of alpha that can be extracted if somebody, of course, follows a strategy of doing a sector rotation within China.
Again, by no means this is easy. This is, of course, with 20/20 vision that we are talking about, so nobody can capture exactly all of that alpha. Of course, it does not have any risk management protocols incorporated in this slide. In respect of that, the alpha opportunity is so large that you can easily capture few percentage points of alpha by looking at sectors within China and specifically looking at countries within emerging markets as well. I know we are approaching close to the one-hour mark. I’ll be happy to take questions along with the Global X team.
Jay Jacobs: Excellent, thank you for that analysis, Darshan. We’ll quickly show disclosures from the Glovista side. Just to wrap things up, of course, Global X is an ETF provider with a pretty extensive list of international funds, including our China Sector Suite. Darshan was talking extensively about looking at sectors as a way of generating alpha within China as well as Chelsea discussing some single-country and regional exposures that might make sense given the macro environment.
As Jon discussed on the webinar earlier, a lot of international fixed income is negative-yielding right now whether you’re looking at Europe or Japan. How does one get diversification in this space while not essentially guaranteeing losses?
Jon Maier: The fixed income space is particularly challenging. When you have yields on equities matching yields on fixed income in the US in aggregate, it becomes a challenge. The question is say, for example, in the US, if the fed funds are rated 1.75 and 2, we go down to zero. What does that do to long rates?
In that scenario, there’s actually the case to buy treasuries. If that scenario doesn’t play out and yields have popped up a little bit recently, I would say look in the equity income space. Look at higher-yielding areas whether it be preferred, whether it be utilities, or mortgage REITs. Those are some areas where you can still receive fairly high yields potentially good for total returns.
Jay Jacobs: Excellent, and then last question before we send people on their way, are there any near-term solutions for Europe’s slow growth environment?
Jon Maier: The simple answer is, I don’t think so or no. Even if trade tensions were resolved in the short-term, given shifts away from globalization and towards regionalism, I don’t think Europe’s issues would disappear. You have policy rates at zero. You have interest rates at below zero. Likely, more QE incoming. That potentially is losing its effectiveness as well.
In some ways, the situation Europe may be worse than Japan because in Europe you have many different countries. They have to coordinate with each other. In some cases, there’s a lack of coordination where say Japan, there – it’s one country, so one set of policymakers.
Jay Jacobs: Excellent; well, with that, we kept people a little long today. Thank you, everyone, for dialing in. If you wanted to download today’s presentation or follow along with our research, please don’t hesitate to visit globalxetfs.com/research. A special thanks to Darshan Bhatt from Glovista Investments. We will look forward to speaking to everyone again sometime soon.