The decoupling theory may not at first have stood up to intense scrutiny but in time it became apparent that Asia and South America had been through their own pain in previous years and were fundamentally in much better shape than US and EU states which were crippled with debt and with banking sectors in need of intensive care.
Jai Jacob, head of the multi-strategy team at Lazard, believes the decoupling theory may have been overstated at times but he does remain positive on emerging markets.
“There are trade links that are too strong to break and the increased speed of global communications adds to the argument that the emerging and developed regions are more tightly coupled. Having said that, what the emerging markets have come through has been more of a normal recession, while what the developed world has been through has been much harder.”
Improvement in the US and EU has actually triggered a rally in emerging markets. But does the recent rally mean valuations are now largely unattractive?
“No” is Jacob’s response, though he concedes investment managers are having to be far more selective (less top-down) right now.
Explaining Lazard’s investment process, he says: “At the moment our highest weighting is in growth equities (where growth is not reflected in the price). Growth equities rather than value equities or fixed income have been the largest weighting since the beginning of November. Despite the recent rally, valuations are supportive in emerging market equities, which are still trading at a significant discount to developed markets in P/E terms.”
He adds: “Back in November investment opportunities in emerging market growth equities were easier to find as they were trading at massive discounts. Today they are trading at a minor discount so there is a need to be far more stock-specific.”
The move into growth equities at the tail end of 2011 represented a significant shift in asset allocation at Lazard as Jacob explains: “We were very defensively focused in our portfolio strategy back in July last year. There were fears about China with regards to poor manufacturing data and there were ongoing concerns about the US recovery and problems in the eurozone. Back then we were most heavily weighted in fixed income which reflected our bearish stance.”
So why the move from fixed income and currency plays to a more bullish stance on equity markets in Q4 2011?
“The EU summit in October 2011 was a turning point. Firstly Chancellor Merkel had prepared well before going to the negotiating table. The LTRO (Long-Term Refinancing Operation) announcement also proved good for global risk appetite – it lowered the probability of a liquidity crisis.”
Eyes open to risk
Despite a more bullish outlook on emerging markets, Jacob is under no illusion as to the current geopolitical risks that could turn everything upside down and force a move back into an ultra-defensive mode.
“I would agree with the forecast that there is a one-in-five chance of major geopolitical dislocation. There is the question of whether the situation in Iran is being mishandled; there is a delicate balance in the Middle East among major oil producing regions; also the EU could start reversing – we will soon see what happens in Greece with regards to CDS entanglement and how that works out. If the situation in Greece is not improved, then the impact will be felt in emerging markets.”
When people talk about emerging markets they focus most prominently on the BRICs. Some would argue that BRIC regions are well picked over by investors now and the quality companies are now overvalued.
Jacob does not wholly agree: “India is certainly expensive from a valuation perspective but there are some good growth sectors such as healthcare and financials. India is most susceptible to food price inflation as food is a big part of their inflation index so severe weather conditions can also have a massive effect on markets there. It is a market in which you have to tread carefully – currency is one way of playing India.”
Russia, he believes, may be unfairly overlooked, offering investors good opportunities despite the political backdrop. “In Russia all companies are being punished for political risk. From a top-down view many might discount Russia outright but on a pure valuation basis we see Russia as the most attractive BRIC option and this is why it represents the largest weighting in our growth portfolio. From a positive perspective Russia joined the World Trade Organisation in December which will help it diversify away from oil dependence.”
Lat Am: beyond Brazil
In Latin America Jacob says there is more to the story there than just Brazil. “On the debt side, Chile looks interesting. It has a good central bank and the fixed interest market is attractive. We also have exposure to Peru.”
Argentina is seen in a similar light to Russia with regards to attractive valuations for investors prepared to take a little risk. “I think Argentina looks quite interesting. Once again top-down investors are just ignoring the country because of the risks. In reality we believe there are very few markets you would just avoid completely.”
The China syndrome
How important is China to emerging market performance in 2012 and beyond? James Donald, portfolio manager at Lazard, referred recently to China as being the “most important company in the world” and his view is largely shared by Jacob.
“China is critically important to emerging market performance and there are issues to watch out for. With inflation, I am less concerned than I was six months ago. In my opinion, slowing inflationary pressures in China are likely to assist authorities in their attempt to engineer a soft landing.”
He adds: “The risk in China is always on policy – there is always a blurred line between state-owned and private. Having said that, the government has shown a degree of flexibility and effectiveness in how it deals with banks, namely on a bank-by- bank basis. But you have to be aware that if the government had to choose between inflation and growth, it would choose growth.
China requires GDP growth or it risks major social unrest. They can keep inflation in check with price controls but with slow growth, things could slip out of their control.”
In essence, Jacob believes China is well equipped to accelerate growth when needed and slow things down too if necessary: “The dial can be turned up and down. There may be stories about empty towns with new buildings unoccupied but these projects kept people in work and in time these towns will be populated.
“There is a danger of looking at these things in the short term when in reality the timeframe for investment is a lot longer. Financial risks are part of the game there.”
He also points out that in 2008, if it hadn’t been for the massive infrastructure build in China, the whole world could have fallen into a much deeper recession.
Whether in relation to geographical weightings or different asset classes, Jacob insists that the philosophy at Lazard is that you don’t have to have the same approach at all times.
It is about getting the balance right at any one time between growth or value equities and credit and debt. It is also worth remembering that the investable universe has grown markedly of late – there are now 2,700 listed emerging market equities whereas back in 2002 you were looking at around 1,300.
Having the necessary resources and skills to pick out the winners in this expanding, high risk/reward arena will increasingly be the challenge for investment houses in the future.