On Why Continue to Invest in Emerging Market Bonds and Equities, and How to Lose Weight!

From Aditya Rana
Date: Sat, Jan 19, 2013 at 2:39 PM
Subject: On Why Continue to Invest in Emerging Market Bonds and Equities, and How to Lose Weight!

Hi!,

Emerging markets have outperformed developed markets in 2012, with EM equities returning 18% (versus 16% for developed world equities) and EM dollar (and local currency) bonds also returning about 18%. So what does the outlook hold for 2013? Michael Gomez, head of EM investment at PIMCO (http://www.pimco.com/EN/Insights/Pages/The-Year-Past-The-Year-Ahead.aspx), looks at drivers of return in 2012 and identifies the areas of opportunity for 2013. To summarise:

-2012 was an exceptional year for all EM asset classes-driven by excess liquidity created by central banks in the developed world, as well as by central banks in developing countries which eased aggressively in reaction to the pronounced economic slowdown leading to a surge in EM bonds and equities during the second-half of last year.

-The value proposition for EM assets was a higher current return, cleaner balance sheets and the prospects for higher growth. This feature, combined with negative real interest rates in developed world government bonds caused by financial repression, pushed investors to allocate record amounts to EM bonds ($94BN), in particular doubling inflows into EM external bonds.

-The multi-year outperformance by EM external debt has been characterised by improving credit quality and falling yields – with the market bond index at the end of 2012 having a composite credit quality of BBB-, an average duration of 7.7 years and a yield of 4.5%.

-However, the index includes a high weighting to Venezuela and Argentina, both higher risk countries and excluding them would reduce the yield to a less attractive 3.8% and an increase in duration to almost 12 years with a BBB credit quality. This makes the index at fair value when compared to investment grade alternatives in the developed world.

-In the high yield sector , the EM index has a duration of 7 years, a BB+ rating and a spread over U.S. treasuries of only 2.74%, which compares poorly to developed world HY indices which have shorter duration and higher spreads.

-However, one sector which continues to offer attractive valuations are EM corporate bonds which offer similar yields to EM sovereigns but with a one notch higher credit rating and 1.5 years less duration. In addition, EM corporate bonds provide an attractive pick-up over developed world corporate debt.

-While EM local debt has had outstanding performance in 2012, the sector continues to offer attractive value with a credit quality of BBB+, a short duration of 5 years and an aggregate local currency yield of 5.5%. In addition, the index is not skewed by a few countries and 90% of the index is made up of countries with at least one investment grade rating.

-Investors moving from developed world government bonds into EM local debt pick-up over 4% of yield and lower duration by approximately 2 years. While the current credit quality of EM local debt is lower than that of the developed world, the rating differential is rapidly converging.

-EM local debt also offers the possibility of currency appreciation – with developed world currencies being debased by central bank policies and EM countries offering higher growth , capital inflows and a tightening bias by central banks if global growth surprises on the upside.

-While EM equities performed well in 2012, being a warrant on EM growth, they have underperformed over the last few years following downward economic growth adjustments. This has made the EM equity index offer attractive valuations with a forward P/E of 11 times (about 1 standard deviation below the historical average), which is at a discount to EM historical levels as well as to the world equity index.

-In particular, EM cyclical stocks are poised for superior performance as they are coming off a 2 year period of flat earnings growth and a pick-up in EM and Chinese growth, excess liquidity and low interest rates should provide a supportive environment.

-EM growth prospects remain attractive, driven by long-term secular trends in wage growth and urbanization to offset structural challenges of the middle-class transition in China and the likelihood of prolonged subdued growth in the developed world.

A succinct analysis of why having a significant weighting in EM equities, local currency bonds and select external EM corporate debt continues to make sense, despite a stellar performance in 2012. An important point not made in the above analysis (and made in a newsletter from late 2012 which summarised a PIMCO note Inflation Regime Shifts: Implications for Asset Allocation) , is the added feature of EM currencies providing a hedge against eventual higher inflation in the developed world. While inflation remains subdued, and is likely to remain so for a few years more, it is likely to dominate the investment horizon over the second-half of this decade – ravaging portfolios without adequate allocation to commodities, commodity equities and EM local currencies, and with excess allocations to long duration bonds. In addition, while equities are likely to initially underperform in an environment of higher inflation, having adequate allocations to equities today provides an opportunity to build a substantial buffer as a result of the ongoing cyclical bull market.

An international bond fund with a long and successful track record (12% per annum over 5 years) and which provides exposure to mainly non-$ and non-Euro global bond markets is the Templeton Global Total Return bond fund (TGTRX) which is exposed to EM local currency bonds and select developed market local currency bonds, issued by government as well as corporate. An ETF which provides exposure to 8 local currency Asian government bonds (China, Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore and Thailand) is the ABF Pan Asia Bond Index Fund (2821.HK) . The ETF pays about a 3% dividend yield and has returned 6% per annum (9% with dividends) over the last 5 years.

As the chart below illustrates clearly, EM countries (and in particular the BRICS) continue to be the drivers of global economic growth. Institutional investors in the developed world continue to be grossly underweight in EM equities and bonds (as detailed in a previous newsletter from 2012), compared to their contributions to global growth, and they are likely to only increase this allocation over the course of this decade.

-In addition to offering higher economic growth, EM corporate also provide superior Earnings per Share (EPS) growth with lower volatility (including China) when compared to the developed world.

On losing weight:

I get a lot of questions on diets to lose weight, and based on my own experience (as well as research) cutting down on fat is one of the most easy, effective and sustainable ways to do so. So it’s with interest that I present below a note on a recent study which points in the same direction:

Friday, December 7, 2012. Newsmax health.

Just cutting back on fat intake, not necessarily dieting, can help you shed pounds, according to a new study Researchers from the University of East Anglia (published Dec. 7 in the journal BMJ) found that simply replacing high-fat foods with low-fat alternatives helped people lose roughly 3.5 pounds. Reducing fat intake also resulted in lower blood pressure and improved cholesterol levels. The study authors suggested that the findings may play a critical role in global dietary recommendations, because being overweight or obese increases the risk for many cancers, heart disease, and stroke.

The British researchers reviewed 33 randomized, controlled trials in North America, Europe, and New Zealand that involved over 73,500 men, women, and children with a variety of health histories. A randomized, controlled study is one in which people are randomly assigned to different groups: One group receives the treatment and the other does not receive the treatment (the "control" group). For at least six months, the investigators compared the weight and waistline measurements of those who cut back on their fat intake with the same measurements of those who did not alter their eating habits.

In addition to losing weight, the study found that eating less fat reduced the participants’ body mass index (BMI, a measurement of body fat based on height and weight) and waist circumference slightly. The researchers pointed out that none of the participants were dieting or trying to lose weight, and they added that the weight came off quickly and wasn’t regained for at least seven years.

"The weight reduction that we found when people ate less fat was remarkably consistent — we saw it in almost every trial. Those who cut down more on fat, lost more weight," study leader Dr. Lee Hooper, from the university’s Norwich Medical School, said in a journal news release. "The effect isn’t dramatic, like going on a diet. The research specifically looked at people who were cutting down on fat, but didn’t aim to lose weight, so they were continuing to consume a normal amount of food. What surprised us was that they did lose weight, their BMI decreased, and their waists became slimmer," Hooper added. Although the study did not differentiate between types of fat, Hooper’s team pointed out that cutting down on saturated fat is the healthiest approach since it reduces the risk of heart disease and strokes.

"Fat calories are more dense, and the fat that we add to food is usually palatable, increasing our desire to want to eat more," said Sharon Zarabi, a nutritionist and fitness trainer at Lenox Hill Hospital in New York City. "So, figure you decrease your fat intake, which decreases your total caloric intake and [leaves] you less likely to crave and overeat."

"This means having low-fat milk and yogurt, cutting down on butter and cheese and cutting the fat off meat," noted Hooper. "Most importantly, have fruit instead of fatty snacks like biscuits, cake, and crisps. And remember, this isn’t a diet, so don’t take it to extremes, but work out a way of eating that you can stick to permanently."

Commenting in the news release, study co-author Carolyn Summerbell, from Durham University, said, "A healthy diet is a way of eating that people can sustain over time. That’s the trick, to find a comfortable way to eat that you can stick to for life, which helps you maintain your weight. Cutting down on fat will help."

Here is to eating less fat!

Regards,

Aditya

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