There are concerns about the impact of low volatility and cash flows into risk assets, against a background of negative real interest rates and continued economic growth.
Combined with a disproportionate amount of money flow into ETFs, and index strategies in general, we have been seeking areas where we can invest for exposure in equity returns, but at more reasonable valuations, and with less downside risk, should the process reverse.
One such area is emerging markets (EM). We have for some time been fans of Indian equities, on the back of the long-term growth story. However, we have recently been trimming these positions, and growing our holdings in the Hong Kong listed Chinese stocks and Latin American equities.
The trimming of India is largely a risk management exercise, as we tend to reduce positions as they become a bigger contributor to risk in the funds, and we continue to believe in the long-term.
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Our argument for Latin America and Hong Kong is that we’re in a broadly positive environment for risk assets, as economic growth remains buoyant, while interest rates remain negative in real terms. However, in the current market, given the dominance of index buying and quantitative driven strategies, the downside risk is that an unexpected event could come along and materially change sentiment and drive the model-driven buying into reverse.
We can’t predict what that event might be, but we can look to examples from the past for guidance. A classic one would be the Russian crisis which led to the demise of the highly leveraged hedge fund LTCM. The parallels are clear in that there are many currently highly leveraged funds, many of which are driven by models. Of course, we haven’t yet seen an event that leads to a sustained spike in volatility or reduction in risk appetite.
When that change does eventually occur, we don’t want to be overly exposed to the assets that have become most overvalued as a consequence of the model-driven buying, but, in the meantime, we want to be exposed to the strong macro environment for equity markets. This ultimately leads us to consider the markets least driven by those factors. Previously, Europe may have been a place to go but there have been strong inflows into EAFE (Europe, Asia and Far East) funds, so we’ve been reducing European exposure and thinking about where to look next for lower risk value. This brought us to revisiting Latin America and considering Hong Kong listed Chinese companies.
The argument for Latin America is straightforward: Mexico and Brazil have been long term laggards, with Brazil overshadowed by political uncertainty and Mexico tarnished by talks about US trade renegotiations. At the same time, we can find relatively attractive companies, with businesses less driven by factors related to the broad equity market rise, in this case Brazilian domestic equities and Mexican airports.
Brazilian domestic equities, particularly in the consumer area, are benefiting from an aggressive reduction in interest rates, while the political situation seems to be largely priced into the markets now. In Mexico, the currency has stabilized and the potentially negative impact of Trump appears increasingly less relevant, with the airport basket exhibiting decent momentum (we hold baskets of stocks to help monitor volatility, correlation and liquidity).
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Looking at our new theme in Hong Kong listed Chinese stocks (which aren’t in the EAFE), we come to a completely unrelated area. The attraction here is genuinely low valuations, with single digit price earnings ratios and high yields, but improving fundamentals.
The Chinese state has decided it’s time to clean up the state-owned enterprises, which have for so long been policy vehicles to drive economic growth rather than profit seeking entities. The intention can be seen in their actions, whether it is the recent merger of some of the major shipping groups, or the change in the structure of all remaining local government run state owned enterprises into limited companies.
The intention is to reduce capital misallocation, corruption and improve financial performance and therefore facilitate the next stage of China’s development towards a modern economy. The potential for profit improvement is clearly material and, while the valuations remain typically in single digits and with yields above 4 per cent, there is very little good news priced in.
As always, our positions are well diversified and scaled for risk, but these two areas diversify us away from the big potentially overcrowded trades and help reduce the downside risk in portfolios from an external shock.