On Why EM Debt and Equities Continue to be Attractive; Grains Protect Against Heart Disease!

From: aditya rana

Date: Sat, Oct 22, 2016 at 1:51 PM
Subject: On Why EM Debt and Equities Continue to be Attractive; Grains Protect Against Heart Disease!


Early autumn has traditionally not been a favourable period for global stock markets, with market typically giving back a large part of the gains from the first half of the year. 2016 has been an atypical year, with a sizeable downdraft during the first quarter of the year followed by a strong rally into the summer (with Brexit being a mere blip). The corrections in September and October were relatively muted this year, with the MSCI global stock market index being down 2.5% over the period, while the MSCI EM index was down a paltry 1.5%. Year-to-date the World index has posted a respectable 6% return (including dividends) while the EM index has turned in a stellar 17.5% return. Looking at individual countries, MSCI Brazil continued its world beating performance by posting a spectacular return of 84%, followed by Russia (32.5%), with Indonesia (27.5%) leading Asian markets. MSCI China (which includes offshore listed stocks) posted a respectable 9.5% return. Clearly, EM markets have dominated world markets (and economies) this year so the question to ask is whether it is still attractive to invest in EM assets (debt and equity)? Rob Arnott who heads Research Affiliates, and Michael Gomez who heads PIMCO’s EM business, argued recently that it is still early in the cycle for EM assets. The key points:

Michael Gomez (PIMCO):

-Global conditions have been supportive for most assets, with a more dovish Fed limiting dollar strength, lower-for-longer rates spurring a search for yield, supply destruction in energy market putting a floor on oil prices and China’s rebalancing and CNY depreciation proceeding at a steady pace. In addition, EM macro fundamentals have stabilized with improving growth and current account balances (see chart below).

-EM debt assets (both hard currency and local markets ) continue to offer attractive valuations relative to credit fundamentals and when compared to low/negative yields in developed markets (DM). Additionally, increasing allocations to this assets class from strategic investors and lower net issuance provide support from a technical perspective. Lastly, the carry cushion versus DM provides a high hurdle to underperform over the long run.

-Hard currency EM debt have provided a 12% return YTD, while local currency EM debt posted 14% followed by corporate debt at 10% and EM local currencies at 6%. With current EM yields of about 5.5% – 6.5%, yields are close to their pre-2007 levels and spreads over UST treasuries have actually increased. Even adjusting for credit quality, EM debt offers more value relative to developed markets and the embedded risk premia more than compensates investors for the default risk.

-Looking at expected returns over the next 10 years, all EM assets (equities, local debt, US$ debt and corporates) offer significantly higher potential returns than DM assets (see chart below).

-In particular, local currency EM debt offers attractive expected returns given the higher yields (carry) as well as cheap currencies. Comparing across a group of EM countries, Brazil, Turkey and Russia seem the most attractive (see chart below). For example, a 5 year Brazilian BRL bond offering a yield of 11.90% , would require a 40% depreciation of the BRL to lose money if held until maturity. Since 2007, the power of compounding this high carry (despite the high volatility in recent years) has resulted in EM hard currency debt to return 96%, while local currency debt has returned 52%.

Rob Arnott (Research Affiliates):

-EM stocks offer significantly more attractive valuations when compared to DM markets, with a Shiller price-to-earnings ratio (i.e. price relative to 10 year earnings) of 14x, which is about half of the U.S. valuation of 27x. This is despite the 30% rally since January.

-In particular, value stocks dominated by financials and energy sectors, are trading at a P/E of 7.4x and provide a dividend yield which is 70% higher than the S&P 500 (and that’s after a 40% rebound since January. In late January, stock representing half of the world’s GDP were trading at a remarkable level of less than 6x long-term earnings).

-In addition, EM currencies fell from being 25% overvalued in 2011 to being 30% below fair value in January of this year, and they currently trade at about a 20% discount to the US$ based on historical norms. Even if they recover only half of the discount, it will provide an extra 1% return per annum over the next decade (on top of the higher current yield). The recovery of EM assets could come from a reversion to mean, a fast-growing working age population and continued productivity growth as they borrow technological advances from the DM world.

As has been highlighted in this newsletter on numerous occasions, the underperformance of EM assets over the last several years provided investors with a unique opportunity to slowly add assets. It is still early in the current bull cycle, so continuing theat strategy should pay dividends over time.

-Turning to China, the economy has clearly turned the corner after the down trend over the last four years (spurring the doomsday China hard landings calls in the western media!), as the economic activity (currently running at 8%) chart below from Fulcrum Asset Management illustrates. This has been driven by policy easing on all three fronts – fiscal, monetary and the exchange rate. It is likely that policy easing will be curbed in the coming months which should settle growth at the 6.5-7% trend level. The exchange rate depreciation (on a trade weighted basis) is also likely to have bottomed out as the second graph below illustrates rather clearly.

Grains Protect Against Heart Disease:

Interesting research which shows that both whole grains and refined grains are protective against heart disease. Of course, whole grains are preferable, but if not readily available it’s better to have refined grains (i.e. white rice or bread) than replacing with meat or dairy.

PRCM, 22/10/2016:


Consumption of both refined and whole grains helped reduce weight, blood pressure, and total and LDL cholesterol among overweight and obese patients, according to a study published in the Journal of Nutrition. Researchers compared heart disease risk factors in 40 participants on either a whole-grain diet, including rice, wheat, and oats, or a refined-grain diet. While both groups saw health improvements, decreased diastolic blood pressure was three times greater in the whole-grain group, compared to the refined-grain group. Researchers suspect similar dietary interventions may prove effective for hypertension prevention and lower mortality risks for heart disease.

Here’s to making sure to have whole grains with every meal!




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