Shaping a Portfolio for 2017: emerging markets (ii)

Ex China, emerging markets are a motley crew.

MSCI Emerging Markets Index

countries

The MSCI Emerging Markets index consists of 23 countries.  At about 28% of the total, China is the largest component.  After that come, in order, South Korea at 15%, Taiwan at 12%, and India and Brazil at 8% each. The rest average 1.6% apiece.

sectors

The biggest sectors are IT and (mostly state-controlled) Financials, at about a quarter of the index each, and Natural Resources at 15%.

individual stocks

The five largest individual components of the index, comprising 15% of the total are, again in order:  Samsung Electronics, TSMC, Tencent, Alibaba and China Mobile.  All of these can be bought as individual stocks either in Hong Kong or in the US.

my take

To my mind, the most foreign investor-friendly country of the bunch is mainland China.  The rest are either not open to foreigners or are subject to the heavy hand of government control.  A big virtue of the index is that we can obtain exposure to 22 problematic places for foreigners to invest in one package and in a highly liquid form.

The big question is whether we want this exposure or not.  The merits of individual countries/securities aside, this has typically been a good thing when the world economy is expanding rapidly and when trade is in a high-beta relationship with overall growth (as it has been throughout almost all my investing career).  It has typically been a bad thing when the world is in recession.

At present, I don’t see the positive case as particularly compelling.  In addition, the high-beta relationship between trade and growth which has worked to the benefit of emerging nations for decades has been showing recent signs of breaking down.  So it’s at least thinkable that the payoff from taking the risk of investing in the more frontier-ish of these countries will be less than in the past.  Personally, I’d prefer to own developed markets + China right now.

 

 

 

Shaping a Portfolio for 2017: emerging markets

Let’s divide emerging markets into two categories:  China and the rest of them.

China

Measuring using Purchasing Power Parity, China is the largest country in the world.  It’s much faster growing than other large economic areas, like the US or the EU.  It’s also accessible to foreigners in several ways:  through Hong Kong-traded stocks, through China-centric mutual funds and ETFs and for individual mainland equities through connections among the Hong Kong, Shanghai and Shenzhen stock exchanges.

I have conflicting thoughts about China today.

The country is currently going through a transition from GDP growth through low value-added, export-oriented industries to expansion through consumer-oriented domestic demand.  This is never smooth sailing.  At the same time, two of its biggest export markets, the EU and Japan, have undergone massive currency devaluations.  This makes the transition more urgent–and potentially much more choppy, since China-sourced products are now much more expensive there.

That’s the near-term bad news.

On the longer-term positive side, the inward, anti-trade turn being signaled by the incoming Trump administration will, I think, mark the shifting of the mantle of world leadership–with its attendant pluses and minuses–from the US to China.  (To be clear:  although I think this may be the signature result of the Trump administration, I don’t think Mr. Trump intends this outcome;  he’s just clueless.  And the real cause is policy failure by the two major domestic political parties over the past decade or more.)

One plus will likely be a greater desire  by foreigners to own Chinese stocks and, because of this, a gradual PE multiple expansion for them.  A potential minus will be more pressure on Beijing to loosen Communist Party control over its financial institutions and its currency, which will subject the renminbi to the speculative ups and downs of currency traders.

My bottom line:  I mostly see bumps in the road for China in 2017.  I’m keeping a small China position, comprised of mutual funds and Macau casino stocks.  But I feel no strong urge to buy more.

Make in India?

I’m not sure exactly why I’m on a foreign markets/economies kick, but I think I’m pretty close to the end of it.

India and me

I’ve been fascinated/horrified by India economically for over twenty years.  On the one hand, the country has lots of potential, based on a huge internal market and a large, well-educated workforce.  On the other, economic success for India continues to rely on how favorable the monsoon season is.  The country’s leaders are clearly aware of, and dismayed by, the fact that nations they may regard at any given time as peers soon leave India behind in the dust.  But not that much has changed over the time I’ve been observing.

“Make in India’

“Make in India” is the marketing slogan the Narendra Modi administration has chosen to promote foreign direct investment, a time-honored tool for simulating economic progress through technology transfer.  Think:  Japan, Korea, Thailand, Malaysia, China…  The road map is clear.  The only question is whether a country has the political will to make the journey.

rules for success

I thought I’d try to list in this post, loosely in order of importance, what’s needed to attract foreign firms to create a business in a developing country.  They are:

–a large pool of trained, or trainable, workers

–roads and ports, to get output from the manufacturing site to market

–sources of electric power, clean water and telecommunications

–a stable legal system, so the rules of the game are clear at the outset and the goalposts don’t get moved after a firm has committed capital

–protection for intellectual property.  A generation ago, multinationals dealt with this crucial issue by sending to the Third World only the tools to make machines that were already obsolete in the First.  By and large, that’s no longer a viable option.   Because in today’s world technology transfer means not only how to organize and run a business but also current trade secrets, protection of intellectual property is more crucial than ever.

–it’s always nice to have a large internal market, so that the success of a factory doesn’t depend solely on export orders

–it’s also nice to have an eco-system of available suppliers and support industries grouped nearby.

How does India stack up?

It has a large internal market and a big pool of potentially available workers.

The physical infrastructure has never been great, in my experience   …and India has never seemed to me to have effectively in made infrastructure development a high government priority.

India has always struck me as distinctly unwelcoming to newcomers, and to foreign enterprises in particular.

Mr. Modi says he wants to change that.  Whether he will be able to is another question.  So, too, is whether he really means what he says.

 

 

 

Shaping a Portfolio for 2016: emerging markets

your father’s emerging markets…

I started working in emerging markets in 1984.  At that time, the most important were Hong Kong and Singapore.  If one were feeling adventurous, Thailand, Malaysia and even Indonesia (shudder!) beckoned.  Taiwan and Korea were also on the list, but not easily accessible to foreigners.

At that time, there was a certain equivocation in the “emerging markets” term.  Yes, the stock markets were relatively rudimentary and overlooked by investors in the US and the EU.  But the economies of the big ones, Hong Kong, Singapore, Taiwan and Korea, were all advanced, with living standards for the average resident somewhere between those in Europe and the US.

With the notable exception of Indonesia, the 1980s-style emerging markets were all oil importers (Malaysia and Thailand have large reserves of natural gas, and export LNG, but that’s a different thing).

Back in the day, investing in Hong Kong was all about the then-colony, now SAR, with exposure to the mainland limited to the successors to the nineteenth-century opium traders and a few small manufacturers with operations on the mainland.

Mexico was the notable emerging market not in the Pacific.

 

…and today’s

China is now, of course, the emerging markets behemoth.  Direct access to foreign portfolio investors isn’t seamless.  Nor, in my view, is it desirable.  However, the investment significance of Hong Kong has radically shifted, from a focus on the physical place to the access its China-related listings allows to the mainland.

Perhaps more important for today’s economic situation, however, the emerging markets arena has expanded to include much more of Latin America (think: Brazil or Venezuela)–and, after the fall of the Berlin Wall, Russia and Eastern Europe as well.  Some thrill-seeking investors have tiptoed into the Middle East as well.

Two strong net effects:

–the emerging markets category contains many more emerging economies, with less stable politics, and

–today’s emerging markets are heavily weighted toward exporters of natural resources, especially oil.

for 2016:

China is several years into a transition from being an export-oriented manufacturer to being a domestic demand-oriented service economy.  The way I look at it, China is doing better than the consensus thinks–and will continue to do so in 2016.

The rest of the emerging markets arena is a mess.  Economically, that’s mostly because so many countries depend on mineral exports.  From a stock market point of view, it’s that plus the high weighting of natural resource issues (including banks that finance them) in the local indices.

My guesstimate is that Greater China will show 6% real GDP growth in 2016.  As a group, the rest will be in the minus column.  I have no idea what the net result will be.  I’m planning on it being mildly positive.

Until the oil price begins to recover–mid-year at the earliest, I think–I don’t see this as a time to hold an emerging markets index.  Individual stocks or a China fund/ETF is the way to go.  Other than China, developed markets, rather than emerging markets, are the place to be.

 

 

 

 

 

 

 

 

is the e-commerce market in China saturated?

I’ve recently begun receiving emails again from the Fung Business Intelligence Center, an arm of the Hong Kong-based, garment-oriented logistics company Li and Fung.  One of the latest poses the question that’s the title of this post.

The answer:  yes  …and no.

Yes, the market in the developed areas of China is close to saturation today.  However, rural areas of the Asian giant remain relatively unexploited, both by internet and traditional bricks-and-mortar retail.  FBIC thinks that the rural sector, which now makes up about 10% of Chinese e-commerce revenue will be at least as large as the urban sector in as little as 10 years.  My back of the envelope calculation is that rural e-commerce growth will add at least five percentage points annually to what overall e-commerce expansion would otherwise be.  Presumably, some Chinese e-commerce players will be more adept at wooing this business than others, meaning their rural business could add 10% or so to annual sales growth.

The FBIC report, which is relatively short, is well worth taking a look at.

thinking about 2016: currencies

There’s no overall theory of how world currencies interact with one another.  Rather, there’s  patchwork of general relationships.  I find two most useful:

general creditworthiness, or would I lend money to these guys (WILMTTG)?.

Another way of asking the same question is whether a country can generate enough foreign exchange to pay for its imports and meet the minimum service requirements on its foreign borrowings.  A “No” answer means trouble.

Natural resources-oriented emerging countries, both in the Middle East and in Latin America, are going to flunk this test, suggesting that for them currency depreciation is in store.

relative interest rates 

Generally speaking, countries where interest rates are rising will have stronger currencies than those where rates are stable or falling.

This rule suggests that the US$ will continue to rise against the euro, yen renminbi and emerging markets currencies–meaning just about everything.

 

As a practical matter, domestic stock markets seem to work best when a currency is stable or depreciating slightly.  A rising currency, because it lowers the domestic currency value of foreign earnings, acts as an earnings headwind.

 

I’ve found that the currency markets–read: traders in the big multinational commercial banks–are always three or four steps ahead of me in figuring out where currencies are going.  For equity investors, there may also be an issue of how the companies whose stocks they hold are acting internally to hedge their foreign currency exposure.

Typically, this second isn’t as big an issue as it might seem at first.  Stock markets most often understand that hedges now protecting profits will soon expire and, in consequence, pretty much ignore the earnings per share generated by hedging.

The question of what’s already baked in the currency trading cake is a more serious one.  It has me questioning whether any interest rate rises that may come in the US next year aren’t already factored into today’s currency rates.

my conclusions

The US$ will be flat to up vs. all other currencies next year.

The yen will be down, on my “No!” answer to the WILMTTG question.

Emerging market currencies will generally be weak.

The renminbi will be flattish, on weak relative rates but “Yes to WILMTTG.

Too soon to act on, but will the euro be stronger in the second half?

stock market implications

All other things being equal, companies with costs in weak currencies and revenues in strong currencies will have the best financial results.

Multinational companies based in the US with exposure to natural resources emerging markets may do poorly.

Those with EU exposure may show slim growth, if any, in their operations there in the first half.  Better news in the second?

As a general rule, when the domestic currency is rising, look for purely domestic companies and for importers.

 

thinking about 2016: commodities

commodities

In the broadest sense, commodities are undifferentiated products or services.  Producers are price takers–that is, they are forced to accept whatever price the market offers.

Commodity products are often marked by boom and bust cycles, that is, periods where supply exceeds demand, in which case prices can plummet, followed by ones where supplies fall short and prices soar.

 

For agricultural commodities, the cycle can be very short.  For crops, the move from boom to bust and back may be as little at one planting season, or three-six months.  For farm animals, like pigs, chickens or cows, it may be two years.

 

For minerals, which right now is probably the most important commodity category for stock market investors, cycles can be much longer.  Base and precious metals have recently entered a period of overcapacity.  The previous one lasted around 15 years.  One might argue that prices for many metals have already bottomed.  I’m not sure.  But I think it’s highly unlikely that they will rise significantly for an extended period of time.

 

Oil is a special case among mined commodities.  Lots of reasons

–the market is huge, dwarfing all the metals other than iron/steel.

–there’s a significant mismatch between countries where oil is produced and where it’s consumed.

–there’s one gigantic user, the US.

–for many years, there was an effective cartel, OPEC, that regulated prices.

To my mind, the most important characteristic of oil for investors at present is the wide disparity in out-of-pocket production costs between Saudi crude ($2 a barrel) on the one hand, and Canadian tar sands ($70? a barrel) on the other.  US fracked oil ($40? a barrel) is somewhere in the middle.  The lower-cost producers have gigantic capacity, and the potential to ramp output up if they choose.  This wide variation in costs makes it very difficult to figure out at what price enough capacity is forced off the market that the price will stabilize.  For example, Goldman, which has an extensive commodities expertise, has argued that under certain conditions crude might have to fall to $20 a barrel before it bottoms.

 

The oil and metals situation is important for any assessment of 2016, because:

–about 25% of the earnings of the S&P come from commerce with emerging markets, many of which depend heavily on exports of metals and/or oil for their GDP growth

–the earnings for about 10% of the S&P 500–the Energy, Materials and Industrials sectors–are positively correlated withe the price of metals and oil.

–a low oil price is a significant economic stimulus for most developed countries, meaning margins expand for companies that use oil as an input  and consumers spending less on oil will have more money left to spend elsewhere.

As a result, one of the biggest variables in figuring out earnings fo the S&P next year will be one’s assumptions about mining commodities prices, especially oil.

 

More tomorrow.