Lake Wobegon is a fictional town created by American writer Garrison Keillor. It is a place where “all the women are strong, all the men are good looking, and all the children are above average”. The term has come to associate with an American pastoral Eden, particularly in the lake culture of the northern Midwest. As the Northern Hemisphere heads into peak summer, we are reminded of lazy days by lakes and seashore. Could it get any better? Maybe not. It’s time to start packing the bags.
Against a backdrop of many mature markets making new highs, it is worth noting that volatility is not dead. With the US market trading at the higher percentile valuations, the door is open to a rotation elsewhere.
Many commentators have noted the unusually low level of volatility in global markets recently. In recent weeks, the VIX index has discounted a benign global outlook. Over the last 18 months or so, investors appear to have reached a truly sanguine state. While Washington debate tax reform and social contract, investors are apparently happy to watch progress from a lawn chair, as the chart shows.
Source: Bloomberg as at 26 May 2017
Is this an unusual pattern? Long term VIX averages 19.06, while the 5 year volatility averages around 12.84, so the immediate conclusion is that the market is apparently a little less worried than normal, but not meaningfully so. Why should investors even worry about shaking off the stupor?
One reason: VIX just recorded a 2 sigma event for the first time since 2011. What VIX provides is a market estimate of future volatility, which is a forward looking indicator. The absolute level of the index matters, but so does the distribution of the returns the index records. What a 2 sigma event in VIX means is that the market is getting a less comfortable in the lawn chair. The chart below shows how these returns have distributed over the last year. The most recent “blip” that saw VIX run up from 10 to 15.5 should remind us that the market’s current focus may be due a challenge.
Source: Bloomberg as at 26 May 2017
Challenging the consensus means challenging a bullish American household. Over the past 6 months, US data has taken an interesting turn, with sentiment indicators running ahead of activity surveys and hard data. Consumer confidence has printed levels not seen since the December 2000 highs, while the Michigan Surveys have confirmed the trend. There is an active debate about what is behind the move, with recent tightness in the US labor market clearly a contributing factor; a bigger factor might be tied back into expectations that the Trump Administration might lower the cost of living, and thus potentially enhance household cash flow. Americans, it appears, believe that things are great because they can see their household income or free cash flow potentially rising.
Source: Bloomberg as at 30 April 2017
There is only one problem: American expectations have lurched ahead of the real economy’s performance. Recent work from Charles Himmelberg at Goldman Sachs shows that sentiment indicators discount an optimistic view that stems directly from the administration’s agenda, which is commonly viewed as “pro growth”. Since election night in November, sentiment among Republicans and swing voters has recovered noticeably, while geographies that showed high Trump vote share have also seen increases in consumer sentiment.
This swing in sentiment immediately begs a question around sustainability.
Source: Goldman Sachs as at 30 May 2017
The corollary to “buy when there is blood on the streets” is “sell when it cannot possibly get better.”
Attributed to Lord Rothschild, “buy when there is blood on the streets” is a core aphorism in Emerging Market investment. Equally true is its corollary: “sell when it cannot possibly get better.” Because Emerging Markets are frequently less transparent than their mature peers, sentiment driven swings in valuation can be quite extreme. On the upside, this can be a satisfying experience and, on the downside, something akin to complete misery. What we know about investing in these places is that when markets are discounting the unsustainable, it is time to take a contrarian view.
Hope and expectations are different, as American investors have discovered in the past. With sentiment indicators running at highs, and US households expecting an apparent uptick in fortune, it is tempting to apply a belief in American exceptionalism to asset returns. The problem with this view lies in historic performances, specifically around the correlation of future equity returns with elevated sentiment. While past performance is no guide to the future, we note research reporting a 75% correlation between S&P returns and US consumer sentiment over the last 10 years.
The problem? Too much of a good thing can be unsustainable. The chart below, also from Goldman Sachs, shows the distribution of returns as a function of Consumer confidence. At current levels, the chart suggests a material downside risk forming. Many market observers might recall Fed Chairman Greenspan’s comments about “irrational exuberance” and “animal spirits” driving markets in the late 1990s; Today’s sentiments are approaching comparable levels of optimism. We believe that as this happens, US equity sponsorship deepens and expectations rise. We have now entered a period where US equities may offer a material risk to the downside.
For investors who may be seeking alternatives to US equity exposure, two alternatives have emerged in the form of European and Emerging Market equities. Of the two, Emerging Markets has benefitted from a period of relatively stronger inflows across asset class. These flows show an increasing correlation to rising earnings estimates, which is consistent with increasing EM exports. This makes EM assets sensitive to global commodity prices, even if the majority of EM exports are manufactured goods. To us turning bullish on EM assets means being bullish on commodities and exports, which can help explain why asset allocators sometimes look at the space to add cyclical sensitivity to global growth. Given that US growth appears to be accelerating at a time when European growth is coming through a cyclical low, recent positive inflows make some sense. However, note that Emerging Markets can be subject to additional risk.
Not the same Emerging Markets, because some things are changing
Promoters of Emerging Market investment often cite superior GDP growth as a central argument for the space’s relative appeal. While an alleged growth premium has been a consistent feature of the asset class, it has reflected a relatively more volatile performance track record. Comparing Emerging Market flows, market capitalisations (and debt face value) of various EM debt and equity indexes reveals, in our view, that investors have been more likely to engage with emerging market debt than equity, on average over time. Cost of equity in Emerging Markets has typically been priced above mature market peers, regardless of growth.
We believe a partial explanation of this elevated equity risk premium lies in investor confidence in EM corporates to convert growth into equity capital. Investors have shown relatively greater confidence in EM credit over EM equity because of the relatively narrower set of parameters that the space has offered. As a general rule, many debt investor only need to be satisfied by a company’s ability and willingness to repay debt, while an equity investor may need to consider a wider range of factors. This feature may help explain why many investors are happier to play mature market equities as global growth proxies, as they have greater confidence in efficiency and governance. We believe this is beginning to change.
We have seen it in meetings with corporates, in estimates, and in written research: EM are slowly catching the corporate governance wave that has swept across mature markets. This has reflected in improved profit margins, better capital allocation, more efficient entities and smoother returns. In our view, this is isn’t a feature of growth; rather it is a recognition of scarcity of capital, of the real threat of multinationals (that have tended to enjoy far lower costs of funding than local peers) and the avoidance of activist investors.
Has it made a difference? We recently compared the returns from the MSCI Emerging Markets Index with the returns from the MSCI Emerging Markets ESG index. These two are quite different: the ESG index strips out companies with high levels of state influence, as well as stripping out those companies with substantial controlling shareholders.
Source: Bloomberg as at 12 June 2017
Regardless of asset class, what we found has confirmed for us that we believe investors should consider looking for emerging markets companies with better governance and active management.