Written By: Jamie Cumming
Globalisation of financial markets has led some to expect a degree of correlation in performance from developed and emerging markets. Jamie Cumming of Aberdeen Asset Management looks at how reality has differed from expectations
Developed and emerging markets are not mutually exclusive. Given the global nature of business it is misguided to think of them as separate entities. However, a cursory glance at the recent (three years’ worth) disparity of performance between them would indicate otherwise. Although global equity markets generated considerable absolute returns for investors during 2013 – with developed markets in Japan, Europe and North America leading the charge, many Asian and emerging equity markets were left firmly in their wake. Indeed, by October last year the MSCI World Index had recorded its fourth highest rolling 10-month period of returns since 1987. The S&P 500 finished the year delivering its best returns since 1997.
These are remarkable returns almost five years into an economic recovery. From our perspective, what makes these developed market returns all the more impressive has been the extent of the gains in light of the anaemic global earnings growth. Sentiment has therefore been the key driver of this divergence of returns between developed and emerging markets. People have felt better about developed markets because they have been going up and worse about emerging markets because they have been going down. It’s the classic psychology of markets, with confidence and momentum at the heart.
The co-ordinated effort by global central banks to add liquidity to the financial markets and maintain low interest rates helped spur increased investor risk appetite. However, the US Federal Reserve’s guidance that it will start tapering combined with concerns over China’s slowing growth rates, weighed on many emerging markets and sent currencies tumbling. As a result, central banks in those countries have sought to support their currencies. The impact has been a cyclical slowing of growth in 2013 and a flow of capital out of the developing world.
However, investors should not confuse economics with stock market returns, as long-term correlations tend to be very low between the two. Indeed, the quality of earnings in the US was actually very poor last year, with over 75% coming from share buybacks, not earnings growth. Often referred to as financial engineering, this is essentially a form of financial alchemy. Companies can borrow for next to nothing and use this debt to buy back stock and pay dividends. Such behaviour does not inspire confidence about the outlook for US corporate profitability.
It is wrong, therefore, to think in terms of the “great rotation”. A pass-the-bomb analogy is more pertinent. And the big question is: “Who’s going to be holding the bomb when the music stops?”
It is this caution and curious outperformance from developed markets that lies at the heart of the conundrum. The flip side of our favouring of Asian and emerging markets is that we have been underweight to developed markets such as the US and Japan. To recap, in Japan, Abenomics1 and the quantitative easing drive by the Bank of Japan provided a catalyst for the dramatic rise in the market. The continued underweight position to this market has ultimately been driven by our view that, on a case-by-case basis, we have been able to find more attractive long-term investment opportunities elsewhere in the world compared to those in Japan. This has also led us to favour more export-oriented Japanese businesses over domestic ones.
Looking at the other side of the developed/developing coin, emerging markets have clearly suffered as concerns over the Fed’s tapering plans and China’s slowing growth have sparked a flow of capital from these markets. This resulted in currency weakness in the short term. However, by focusing on the underlying businesses and valuations, we have actually used this weakness to add to these positions at the margin. Indeed, stocks within the energy and materials sectors have been among the weakest in the market and an area where we have been finding individual cases of opportunity.
While the past year has been a difficult one, our focus remains on the long-term fundamental characteristics of the investments we are making on our clients’ behalf. Instead of trying to time the market on its highs and lows, we have been focusing on capital preservation and dividend growth. Of more importance to us is finding value in good quality investments rather than following benchmarks, which is why we haven’t benefited from the rallies in the US and Japanese markets.
Overall we remain comfortable with the companies in our portfolios given the quality of management, balance sheet strength and business models, and will not compromise our investment process to invest in poor-quality companies or chase short-term gains.
A world without robust profit growth set against a backdrop of excessive indebtedness, stubbornly high unemployment, negative real income growth, diminishing purchasing power and rising bond yields seems to be of no concern to current conventional judgement. Investing in concepts, in hope, and in expectation has, and will no doubt always, inflate equity prices, but only solid earnings growth and sustainable dividends can fundamentally support long-term valuations. Our portfolios remain acutely aware of prevailing distorted valuations and hence very much focused on the latter.
1. Economic measures consisting of quantitive easing, fiscal stimulus and structural reform introduced by Shinzo Abe after his 2012 re-election to the post of prime minister in Japan