Interest Rates & Emerging Markets: That Late ’90s Feeling

Financial Markets recovered partially from a sharp sell-off in the first quarter.  Returns in the U.S. were positive, with the S&P 500 index rising by over 3% in the second quarter.  Value stocks gained 2%, while growth stocks gained nearly 6%; the latter were led by the ‘FAANG’ stocks and related tech/internet names.  The quarter continues a sharp divergence of growth over value that commenced in early 2017 and has not seriously abated.  Outside the U.S., local currency returns were generally positive but offset by a 4% gain in the U.S. dollar versus other currencies.  Net, the EAFE index lost 1% measured in dollar terms.  Emerging market returns were strongly negative, declining by over 8% in the quarter.  Emerging markets generally do not perform well during periods of dollar appreciation, and returns in the quarter were consistent with this trend.

The dollar has been in a low-level tug-of-war thus far in 2018.  The bear case is anchored by higher structural trade and budget deficits, which lead to a weaker currency.  The dollar bull case stems from higher interest rates versus other developed market currencies.  The dollar is in fact about where it was for much of 2017 versus reserve currencies such as the Euro and Yen, which we attribute to the fact that these currencies are already “cheap” on a trade-weighted basis and the Eurozone and Japan generate structural trade surpluses.  However, versus Emerging Market currencies, higher U.S. rates have created significant pressure.  As long as the Fed is expected to keep raising rates (we see this as basically a lock into 2019) the pressure on EM will likely persist.  Higher short rates have led to a flatter yield curve.

At the end of 2017, financial markets and economists rejoiced in synchronized global growth across all major regions of the world.  We commented at the time that conditions were nearly perfect, but therefore unlikely to be sustained.  This more cautious view has unfolded thus this year, with growth rates falling off meaningfully in several regions.  The U.S. will post uniquely strong GDP growth in the first half of 2018, however, leading to upward pressure on the dollar.  Below is a chart of the Citigroup Eurozone Economic Surprise Index, which shows positive or negative divergences versus a myriad of economic forecasts.  It is a (somewhat) self-reversing index; periods of very strong positive or negative surprises are likely to be followed by the opposite.  Oddly, after a strong positive run in 2017, it descended to levels not sustained since the 2008-09 GFC lows.  We don’t have a clear explanation for this other than that Europe does not grow very fast in general…were economists surprised to learn this?

That Late ‘90s Feeling

On the airwaves and outdoor patios, the sounds of 1980s pop music has re-emerged (for better or for worse).  It’s part of a persistent cycle of recirculating fashion, media, and nostalgia outside its relevant time and place.  Very wide shoulder-padded suits and Arnold Schwarzenegger movie remakes may shortly ensue, if previous cycles are a guide.

Financial markets are in a sense forward-looking and ahead of their time, as they have already leaped to the late 1990s.  Twenty years ago market forces included:

1. An astonishingly dominant U.S. technology sector and faster economic growth in the U.S. as compared to other developed countries.
2. A surging U.S. interest rate cycle on the heels of several years of historically loose monetary policy, leading to a persistently strong U.S. dollar versus most other currencies.
3. The combination of items 1) and 2) led to severe pressure on Emerging Market funding costs in the 1997-98 time period, precipitating numerous currency crises, multiple sovereign defaults, and near depressionary conditions in East Asian countries as the Asian contagion swept across the continent.
4. A severe divide in developed markets between stocks representing the “old economy” of manufacturing, finance, and physical forms of commerce and the “new economy” of digital markets, electronic devices, and high-bandwidth communications infrastructure. Valuations for new economy plays became increasingly unbounded, while old economy plays lagged badly.

While the new economy bubble raged upwards and deflated into its aftermath, Emerging Market nations faced an uncomfortable multi-year reality.  New economy startup companies and their employees could conveniently fold or jump to new positions at the next intriguing concept.  Emerging Market capital formation and nation building has always faced an inordinate burden: nobody really trusts their currencies.  They historically fail to be stable stores of value or liquidity under stress, which leads to limited local funding options.  Investors’ quest for yield and yield tourism during long periods of declining rates let both reasonably and unreasonably managed economies paper over this basic issue.  As real yields rise, the tourists suddenly depart and locals get uncomfortable.  This form of instability feeds upon itself.  Under fresh conditions of stress, investors and local citizens sell first and ask questions later, reinforcing the lack of trust.  Local central banks cannot act as lenders of last resort, and instead must tighten rates to stem capital flight.

As the expression goes, history does not always repeat itself, but often rhymes.  A full repeat of the tech bubble-bust of the late 1990s and parallel emerging markets currency debacles seems like a bit of a reach.  However, the parallels are similar.  The scale of American tech dominance and valuation-related exuberance has reached exceptional levels – at $12.4 trillion, the value of the tech-heavy Nasdaq 100 Index currently approximates the value of the entire Bloomberg European 500 Index ($9.4 trillion) plus Japan’s Nikkei Index ($3.5 trillion).  In addition, this $12.4 trillion figure equates to ~60% of the value of the United States’ 2018 GDP, while actually only being about 8% of GDP (source – U.S. Department of Commerce).  A lot of lower-margined parts of the technology value chain reside offshore or generate earnings outside the U.S.; nonetheless, this seems rather high.  The top of the 1990s tech bubble featured what became known as “worst deal of all time” – the $200+ bn merger of Time-Warner with America Online, an astonishingly large bet on a declining form of media access (dial-up modems).  In 2018, a few years after fully reversing the AOL-TWX debacle, Time Warner was bought by AT&T in an astonishingly large bet on a declining form of media access, linear television.  AT&T completed this merger in the second quarter and is presently the world’s most heavily indebted corporation.  We can’t see what could possibly go wrong…

Outside the U.S., funding pressures from a rising rate cycle have begun to land heavy blows on Emerging Market currencies.  The pressure 20+ years ago started in more dicey jurisdictions such as Malaysia and Thailand, before eventually sweeping across both hemispheres in 1998.  Just 10 months ago, Argentina issued a first of its kind 100-year bond.  Its currency and the Turkish Lira blew up roughly 6 months later.  Funding pressures have weakened the Brazilian Real, Russian Rouble, and Chinese Renminbi, albeit to much lesser extents.  There has not been a fresh round of debt service problems, but the interest rate cycle remains early right now.

Will we go full circle and see sovereign debt defaults and a tech bubble pop?  Or is this kind of thinking far too speculative and negative?  In the later innings of an economic cycle, how does one invest?

To address these and other topics du jour, we will use a mock Q&A format.  The discussion is between myself as President of Cambiar Investors and an imaginary client.

Q – Based on your commentary, how concerned are you that Emerging Markets (EM) may repeat the late 1990s and become financially unstable?

A – The situation is both very similar and very different versus 20 years ago.  In the early to mid 1990s, many EM countries relied on foreign credit access to keep their exchange rates stable and for development capital.  This proved to be a fickle source, as interest rates rose and/or their external trade balances deteriorated.  The end result was financial shock and economic dislocation during the late 1990s.  In the aftermath, EM countries reached similar conclusions: they needed to run chronic trade surpluses and build large stashes of foreign reserves, mainly the U.S. dollar.  Their local currencies became more trust-able with large FX reserves in place, leading to fairly successful economic development in the 2000s.

In essence, a mercantilist economic model wound up prevailing, with dollars and dollar reserve accumulation an economically necessary condition for EM economies to meaningfully advance.  In the 2000s, the U.S. seemed happy to oblige, running up massive trade deficits of up to 6% of GDP.  Following the 2008-09 GFC, the U.S. trade deficit has declined closer to 3% of GDP.  Some of this improvement has been structural, such as due to the shale oil boom and more localized manufacturing of foreign branded cars in the U.S.  The offset has been a rising dollar and relatively fewer excess dollars available to pad reserves abroad.

More recently, the U.S. tax cuts announced at the end of 2017 leads to higher structural budget deficits –

which on paper would require more external funding, and therefore bigger trade deficits.  Larger trade deficits mean a larger supply of dollars, and therefore these would flatter EM financial conditions.  It’s a curious relationship that the U.S. has with the rest of the world, financially speaking.  From the days of Bretton Woods when the world was on a dollar-linked gold standard, to the post-Asian Financial Crisis era of the 2000s, the dollar is the world currency for lack of alternatives.  Even though EM economies have advanced significantly since the end of the Cold War, they have not been able to break free of the lack of trust in their local currencies.  It subsequently makes them hostage to the U.S. rate cycle in varying degrees.

Q – The question was whether or not Emerging Markets would become unstable.  You seem to be saying they have a lot more reserves now, and the U.S. trade gap may widen.

A – They do have more reserves, but they also have not faced a rising interest rate cycle in the developed world since pre-2008.  So far, some peripheral EM currencies have not been able to withstand higher nominal rates in the U.S.  By the end of 2019, rates will probably be higher in both the U.S. and Europe.  The rate pressure bears on EM funding costs and the attractiveness of local currencies versus dollars or other alternatives.  Countries with large and persistent trade surpluses, such as China, may better withstand this form of pressure.

Fifteen years ago the term “BRIC” was coined to denote Brazil, Russia, China, and India as the dominant EMs, largely based on populations and the potential therein.  You don’t really hear that term any longer because the economic structure of the BRICs are so different today.  The Brazil and Russian economies have not advanced meaningfully from their dependence on commodities, and will be very sensitive to interest rate pressure.  China has advanced substantially, and is such a big portion of the EM landscape that it almost ought to be in its own category.  There are some benefits to dictatorial control of an economy in that they can restrict foreign currency outflows.  For now, our house view is that between China’s capacity to generate FX through trade, state money-flow controls, and greater technological advancement, they can wall off much of the pressure from higher rates on reserve currencies.

One other key difference between Emerging Markets today versus 20+ years ago is the level of industrial advancement.  China, Korea, Taiwan, and other parts of Asia have moved much further up the value-added curve, and have come to dominate key supply capabilities.  For example, it is well understood that the only place you can currently make an iPhone is in China.  The ability to sustain leadership in key technologies and price them accordingly will also help these more technologically advanced countries distance themselves from a repeat of the 1990s.  Should China tighten screws on FX leakage, it may retain domestic financial stability, but actions such as this make it hard to take the Renminbi seriously as a reserve currency.

Q – What about Latin America?

A – We are unable to identify much basis for optimism.  Mexico has elected a left wing populist and Brazil has been rudderless for years following massive political scandals.  They will dangle in the breeze, so to speak.

Q – How does this view affect your International investing? 

A – We have been through some version of this before in the 2011-2015 timeframe, where Emerging Market financial conditions deteriorated owing to the FX-reserve generation issue discussed above and the rupture in commodity prices.  We found plenty of ways to tap the growth potential in Emerging Markets without having to mainline EM financial risks – via Developed Market auto/advanced materials/consumable franchises that had substantial Emerging Market operations.  We see the current situation as generally similar, though for market segments such as industrials and autos, you have later-cycle risks in the developed economies that make this approach trickier to execute.

A key difference in the financial landscape of 2018 versus just 3-4 years ago is the scope of EM technology and internet platforms.  China in particular has developed its own internet champions in search, marketplaces, travel booking, payments, and online media.  While the operational histories are short(er) than U.S. equivalents, this is another way of getting exposure to EM growth and greater affluence.

Q – You mentioned “later cycle” issues above.  How hard is it to invest late in an economic cycle?

A – This is one of several factors leading to the bifurcation of value and growth strategies in stock markets.  In a recession, margins and business rates of return will deteriorate…potentially sharply.  An auto stock, airline, or manufacturing business trading at a low P/E multiple on 2018 earnings may be trading at a very high multiple of 2021 earnings.  Low P/E multiples on cyclical names late in the cycle is more of an expression of cynicism than outright value.

There are a couple of options for investors.  One is to simply vacate most later cyclicals and focus on more secular growth stocks, which investors have been doing heartily for the last 18 months.  These names are crowded, and keep getting more crowded it seems.  Another route would be to look at “through-the-cycle” margin ranges, where we re-value earnings potential based on average margins over a multi-year economic cycle, and not cyclically elevated margins.  If stock XYZ is cheap on early to mid-cycle margins that incorporate less than ideal business contractions, then there is some or potentially substantial attractiveness.

Q – Are you saying investors are wrong for just focusing on secular growth names?  It sure seems to be working!

 A – That mentality has certainly prevailed so far.  We have had plenty to say in the last 2 years on the growth/value divide, and why this may be occurring to the extent that it has.  The “late cycle issues” are yet another reason to eschew value names.  It’s getting tiresome, and feels an awful lot like the late 1990s, in the sense that several of us find ourselves wondering why we are analyzing through-the-cycle margin trends, or credit-loss patterns, or oil inventory movements, when there is a raging party each and every day in gigantic internet platforms that seems unbounded.  This…is exactly what it felt like to have a valuation-sensitive discipline in 1999, a stranger in a strange land.

Many years ago I developed a theory of fundamental stock-price attractiveness that I call the “10 times” theory.  If you think Amazon is a great buy at $1,800 per share, you need to believe that at some point in the future it will earn at least $180 per share.  Not in 2019 or 2020 mind you, but somewhere out there.  Otherwise, you won’t generate a favorable return.  In raw dollar terms, Amazon would need to earn about $90 billion after-tax to achieve $180 in per-share earnings, given that it has about 500 million shares outstanding.  Apple earned $53 billion in 2015, which is the largest corporate profit level ever recorded thus far.  Is a $90 billion corporate profit in retailing and cloud services possible?  I suppose, but that’s a lot of growth, even for Amazon (Amazon is expected to earn about $10 bn in 2018, based on current Wall Street consensus forecasts).  If Amazon tops out at $50 billion of earnings similar to Apple, it would be a great accomplishment, but based on this model, your future returns from here won’t be that great.

Q – Does this theory actually work?

A – We believe that in the past it has worked, but that during periods of rampant exuberance, and this may be one of those periods, it may be pretty limiting.

Q – Maybe the more pertinent question is whether these old economy/value stocks can perform from here, or are they doomed to need to prove themselves through a downturn first?

A – I cannot answer that question with much precision.  The narrative has become very convoluted, as investors see disruption on top of cyclicality in so many sectors.  For example, automotive companies lie on the wrong end of the late-cycle narrative as well as the wrong side of history – as new paradigms (electric cars, ride sharing services) are expected to proliferate.  Until Mercedes, GM, Porsche, etc… prove they can compete directly with Tesla, they are guilty until proven innocent.  It may currently feel like an unwinnable war, but projecting the future and only betting on the ‘cool kid’ stocks does not comport to historical experiences and oversimplifies the narrative.  The major OEMs are expected to have competitive electric offerings within 12 months, obviating the disruptor versus disrupted argument.  The global auto cycle has become much less dependent on the U.S. cycle, and is really an Asian-volume driven phenomenon now.  Will these arguments prevail?  One cannot know.  Similarly, the giant social media platform companies have shown exceptional growth and seem impervious to cyclicality.  Yet the bulk of their revenue is tied to a cyclical variable (ad-spending), which tends to be cut easily and quickly in an economic downturn.  It’s not so black and white.

Q – What do you worry about the most?

A – I worry about the structure of stock (and bond) markets as the indexation of ownership and computerization of trading go deeper than they ever have before.  Market structure problems lie at the root of numerous financial wipeouts of the past.  When markets cannot clear because you cannot match buyers and sellers and yet there are motivated sellers, that is how moderate volatility events get out of hand.  The indexing and passive phenomena have reached breathtaking proportions.  According to a Financial Times article earlier this year, there are now 70 times as many stock indexes as there are stocks (there are over 3 million equity indexes versus 43,000 publicly traded companies around the world, if you were curious as to the figure).  While most of these indexes are very small, in a negative liquidity or panic type event, who are these going to be sold to, exactly, and who is taking the other side of the trades for individual stocks that reside in these indexes?  Rate cycles tend to induce negative liquidity or panic events at some point, it’s worth noting.

Q – Are you taking any precautions?

A – It would be impossible to time such a thing.  I would tend to hold onto a little bit of excess cash personally.  We are trying our best not to reward aggressive balance sheets and speculative M&A or other forms of financial engineering.  But if the issue is a market structure issue, as opposed to business cycle, credit, or valuation issues, it may take a lot of time to sort out, and short of having some extra cash in your portfolio, finding completely effective bomb shelters would be a challenge.  There may be some merit in leaning towards a more ‘boring’ equity portfolio.

Q – Last question: You sound negative, is that what I should take away from this?

A – I am not nearly as negative as this discussion sounds.  Business in the USA is really booming, and Europe should get moving more positively from whatever little issues it had earlier this year. There are a good number of modest to outright cheap stocks out there on the fuzzy end of the digital divide whose prospects seem fine to me – they just are not nearly as sexy as the FAANG stocks.  There are even some good businesses with demonstrated earning capacities in the digital marketplace and platform realm that seem pretty rock solid as well.  There is so much less liquidity and fundamental-based trading going on that it is hard to fully trust the eyes.

While the above discussion may not come across as overly sanguine about the forward trajectory for equities, we do believe that attractive investment opportunities exist – it just will not be the easy pickings that have been available in recent years.  On that basis, active management should be at an advantage.  Regardless of the environment, the Cambiar playbook remains the same: (1) identify quality businesses where current valuation is less indicative of their normalized earnings power, (2) uncover inflection points that can drive mean reversion in fundamentals/earnings, and (3) exercise patience in waiting for the stock to reflect the inherent value.