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Emerging market cycle shows that quality wins over long-term

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The writer is head of global emerging markets at the international business of Federated Hermes

For long-term investors in emerging markets, the current phase in the global economic crisis has echoes of the past. It is not their first rodeo when it comes to dealing with scarred markets recovering from a crisis.

Previous cycles are instructive in how emerging markets react to broader trends and how cheaper value stocks within that equity universe trade compared with more pricey growth shares. Value stocks — such as more cyclical companies — tend to outperform coming out of a crisis. However, in the longer term, quality growth has won out.

The 1997 Asian financial crisis, triggered by a currency crash in Thailand and at which I had a ringside seat, seemed to herald the end of the region’s growth. With contagion still raging, the Russian debt crisis erupted and seemed to announce the chaos of a failing state. In 1997, the emerging-markets benchmark collapsed almost 57 per cent. But it recovered by February 2005.

Value stocks underperformed growth companies by about 27 per cent in the 36 months to March 2000, when fear was ascendant. The tables then turned decisively: value outperformed by 65 per cent from March 2000 to December 2008. China’s entry into the World Trade Organization created unprecedented demand for raw materials. These crises abated with support from the developed world and its multilateral institutions. The pattern held until 2008.

On September 15 of that year, when Lehman Brothers was allowed to fail, I watched as bids vanished from my screen and share prices of the world’s best companies dived into the abyss. This time, the developed world caused the strife. In a clear debunking of the theory that developing economies had decoupled from more developed counterparts, emerging markets fell by about 61 per cent and took 36 months to recover. In this period, value edged ahead of growth by about 5.7 per cent.

But it has since been vanquished: from January 2012 to date, growth has outperformed by 80 per cent. The so-called “taper tantrum”, when rising US bond yields spooked the more fragile emerging markets, encouraged investors to look for less cyclical investments and they jumped on Alibaba’s initial public offering, and fast-growing social networks.

Line chart of Value stocks relative to Growth stocks in the MSCI Emerging Markets index showing Cheaper EM value stocks have tended to perform best in post-crisis periods

Most big emerging economies went into the 2008 financial crisis with current accounts and foreign-exchange reserves in surplus and dollar liabilities better matched with dollar assets than in the past. There were notable exceptions, but it was evident that the emerging world was maturing.

China, in conjunction with the world’s central banks, stimulated enough demand to resurrect the global markets and economy. In subsequent years, structural changes in many emerging economies — from economic liberalisation in China to digitisation across the board — showed that the “emerging” label was outdated.

In emerging markets and the S&P 500 alike, intellectual property has become the new quality investment. Companies with such assets outnumber those surviving from earlier days. Energy and materials companies in the MSCI Emerging Markets Index have shrunk from 37 per cent before the financial crisis to less than 10 per cent now. The technology sector currently commands the same benchmark weighting in emerging markets as in its S&P 500 counterpart of more than 30 per cent.

There are sound reasons to invest now, especially on a cyclical basis. Indicators of economic activity such as purchasing managers’ indices are recovering, the threat of trade wars with the US has faded and the export and the tourism sectors should bounce back as vaccines are distributed. An Asian free-trade zone is on the horizon, building on the Regional Comprehensive Economic Partnership.

Investment metrics also tell an attractive story. Emerging markets trade at a 20 per cent discount to developed ones on a sector-adjusted basis, close to a 20-year low. A weaker dollar should allow emerging-market currencies to appreciate, along with equity markets, buoyed by relief on a collective $5.2tn debt burden. A lower dollar would also benefit commodity exporters.

But investors should temper their enthusiasm for 2021 with the knowledge that debt levels, demographics and investment for a more sustainable economic system may constrain profits over the medium term.

Slower macroeconomic expansion will ensure that quality growth retains a premium. In the short term, value will have its day in the sun. But for investors with a longer time horizon, quality will remain king.



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European stocks stabilise ahead of US inflation data

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European equities stabilised on Wednesday after a US central banker soothed concerns about inflation and an eventual tightening of monetary policy that had driven global stock markets lower in the previous session.

The Stoxx 600 index gained 0.4 per cent and the UK’s FTSE 100 rose 0.6 per cent. Asian bourses mostly dropped, with Japan’s Nikkei 225 and South Korea’s Kospi 200 each losing more than 1.5 per cent for the second consecutive session.

The yield on the 10-year US Treasury bond, which has dropped in price this year as traders anticipated higher inflation that erodes the returns from the fixed interest securities, added 0.01 percentage points to 1.613 per cent.

Global markets had ended Tuesday in the red as concerns mounted that US inflation data released later on Wednesday could pressure the Federal Reserve to start reducing its $120bn of monthly bond purchases that have boosted asset prices throughout the Covid-19 pandemic.

Analysts expect headline consumer prices in the US to have risen 3.6 per cent in April over the same month last year, which would be the biggest increase since 2011. Core CPI is expected to advance 2.3 per cent. Data on Tuesday also showed Chinese factory gate prices rose at their strongest level in three years last month.

Late on Tuesday, however, Fed governor Lael Brainard stepped in to urge a “patient” approach that looks through price rises as economies emerge from lockdown restrictions.

The world’s most powerful central bank has regularly repeated that it will wait for several months or more of persistent inflation before withdrawing its monetary support programmes, which have been followed by most other major global rate setters since last March. Investors are increasingly speculating about when the Fed will step on the brake pedal.

“Markets are intensely focused on inflation because if it really does accelerate into this time near year, that will force central banks into removing accommodation,” said David Stubbs, global head of market strategy at JPMorgan Private Bank.

Stubbs added that investors should look more closely at the month-by-month inflation figure instead of the comparison with April last year, which was “distorted” by pandemic effects such as the price of international oil benchmark Brent crude falling briefly below zero. Brent on Wednesday gained 0.5 per cent to $69.06 a barrel.

“If you get two or three back-to-back inflation reports that are very high and above expectations” that would show “we are later into the economic recovery cycle,” said Emiel van den Heiligenberg, head of asset allocation at Legal & General Investment Management.

He added that the pandemic had sped up deflationary forces that would moderate cost pressures over time, such as the growth of online shopping that economists believe constrains retailers’ abilities to raise prices. Widespread working from home would also encourage more parents and carers into full-time work, he said, “increasing the labour supply” and keeping a lid on wage growth.

In currency markets on Wednesday, sterling was flat against the dollar, purchasing $1.141. The euro was also steady at $1.214. The dollar index, which measures the greenback against a group of trading partners’ currencies, dipped 0.1 per cent to stay around its lowest since late February.



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Potash/grains: prices out of sync with fundamentals

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The rising tide of commodity prices is lifting the ricketiest of boats. High prices for fertiliser mean that heavily indebted potash producer K+S was able to report an unusually strong first quarter on Tuesday. Some €60m has been added to the German group’s full year ebitda expectations to reach €600m. Its share price has gone back above pre-pandemic levels.

Demand for agricultural commodities has pushed prices for corn and soyabeans from decade lows to near decade highs in less than a year. Chinese grain consumption is at a record as the country rebuilds its pork herd. Meanwhile, the slowest Brazilian soyabean harvest in a decade, according to S&P Global, has led to supply disruptions. Fertiliser prices have risen sharply as a result.

But commodity traders have positioned themselves for the rally to continue for some time to come. Record speculative positions in agricultural commodities appear out of sync even with a bullish supply and demand outlook. US commodity traders have not held so much corn since at least 1994. There are $48bn worth of net speculative long positions in agricultural commodities, according to Saxo Bank.

Agricultural suppliers may continue to benefit in the short term but fundamentals for fertiliser producers suggest high product prices cannot last long. The debt overhang at K+S, almost eight times forward ebitda, has swelled in recent years after hefty capacity additions in 2017. Meanwhile, utilisation rates for potash producers are expected to fall towards 75 per cent over the next five years as new supply arrives, partly from Russia. 

Yet K+S’s debt swollen enterprise value is still nine times the most bullish analyst’s ebitda estimate, and 12 times consensus, this year. Both are a substantial premium to its North American rivals Mosaic and Nutrien, and OCI of the Netherlands, even after their own share prices have rallied.

Any further price rises in agricultural commodities will depend on the success of harvests being planted in the US and Europe. Beyond restocking there is little that supports sustained demand.

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Amazon sets records in $18.5bn bond issue

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Amazon set a record in the corporate bond market on Monday, getting closer to the level of interest paid by the US government than any US company has previously managed in a fundraising. 

The ecommerce group raised $18.5bn of debt across bonds of eight different maturities, ranging from two to 40 years, according to people familiar with the deal. On its $1bn two-year bond, it paid just 0.1 percentage points more than the yield on equivalent US Treasury debt, a record according to data from Refinitiv.

The additional yield above Treasuries paid by companies, or spread, is an indication of investors’ perception of the risk of lending to a company versus the supposedly risk-free rate on US government debt.

Amazon, one of the pandemic’s runaway winners, last week posted its second consecutive quarter of $100bn-plus revenue and said its net income tripled in the first quarter from the same period a year ago, to $8.1bn.

The company had $33.8bn in cash and cash equivalents on hand at the end of March, according to a recent filing, a high for the period.

“They don’t need the cash but money is cheap,” said Monica Erickson, head of the investment-grade corporate team at DoubleLine Capital in Los Angeles.

Spreads have fallen dramatically since the Federal Reserve stepped in to shore up the corporate bond market in the face of a severe sell-off caused by the pandemic, and now average levels below those from before coronavirus struck.

That means it is a very attractive time for companies to borrow cash from investors, even if they do not have an urgent need to.

Amazon also set a record for the lowest spread on a 20-year corporate bond, 0.7 percentage points, breaking through Alphabet’s borrowing cost record from last year, according to Refinitiv data. It also matched the 0.2 percentage point spread first paid by Apple for a three-year bond in 2013 and fell just shy of the 0.47 percentage points paid by Procter & Gamble for a 10-year bond last year.

Investor orders for Amazon’s fundraising fell just short of $50bn, according to the people, in a sign of the rampant demand from investors for US corporate debt, even as rising interest rates have eroded the value of higher-quality fixed-rate bonds.

Highly rated US corporate bonds still offer interest rates above much of the rest of the world.

Amazon’s two-year bond also carried a sustainability label that has become increasingly attractive to investors. The company said the money would be used to fund projects in five areas, including renewable energy, clean transport and sustainable housing. 

It listed a number of other potential uses for the rest of the debt including buying back stock, acquisitions and capital expenditure. 

In a recent investor call, Brian Olsavsky, chief financial officer, said the company would be “investing heavily” in the “middle mile” of delivery, which includes air cargo and road haulage, on top of expanding its “last mile” network of vans and home delivery drivers.



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