1 Outlook on Emerging Markets JUL Summary A trend toward high-multiple emerging markets stocks has resulted in inefficiencies that our equity teams are selectively pursuing. Economic stabilization should unlock further value. US interest rate hikes could help restore emerging markets capital discipline by raising borrowing costs. China s A-share turmoil does not currently affect our opportunity set; we currently have no A-share holdings in our portfolios. Emerging markets debt is one of the few fixed income asset classes where it appears that US interest rate normalization has already been priced in. As emerging markets yields and currencies have recently sold off, our debt team sees compelling valuations, in both absolute and risk-adjusted terms. Lazard s emerging markets platform consists of experienced investment teams with differentiated philosophies and portfolio management processes. Each team has independent views that have been enriched through discussions with colleagues throughout the platform and the firm. Thus, opinions across the platform may vary. A June pullback in emerging markets equities was fueled by seesawing Chinese shares and uncertainty over Greek debt negotiations. During the second quarter the MSCI Emerging Markets Index increased 0.7%, as measured in US dollar terms. Year to date, it has gained 2.9%. Hard currency debt, as measured by the J.P. Morgan EMBI Global Diversified Index, returned -1.56% during the quarter as bond market volatility rippled across emerging markets debt asset classes. Local currency debt resumed its downward trend in the second quarter as the J.P. Morgan GBI-EM Global Diversified Index returned 0.96%, with negative performance driven entirely by spot currency depreciation. Emerging Markets Equity Over the past twelve months, there have been similarities in the drivers of large-cap and small-cap emerging markets stocks. Investors in both universes have strongly favored stocks with strong earnings momentum, return on equity, and historical earnings growth characteristics (Exhibit 1). Interestingly, there seems to be little appetite in both segments for stocks with strong forecast earnings growth. From a valuation standpoint, relatively cheap stocks have tended to lag when looking at a variety of metrics such as price-to-book and earnings yield. This environment has tested our teams value sensibilities as some stocks at the intersection of attractive fundamentals (e.g., strong earnings growth, return on equity, dividend yield) and relatively low valuations have not done well. We are finding the disconnect between fundamentals and valuations to be pronounced in some cases as fundamentally attractive stocks may be either commanding premiums that are not justified or that are not being rewarded due to their relatively low valuations. What would it take for this market to change? In an uncertain economic environment, investors have been pursuing safer investments whether that means traditional safe harbors (health care and telecom services) or stocks that seem to offer rapid growth (Internet-related). Therefore, we think it is important for the macroeconomic context to stabilize in order for us to see a change in investor preferences. This would entail moderate global and local economic growth, moderate inflation, and a moderate interest rate environment. If these conditions are broadly met, emerging markets companies should be able to restore the health of their balance sheets and deliver better-quality growth, which would help multiples expand. For small caps in particular, we need to see some of the liquidity driven speculation in Chinese and Korean small cap stocks recede for our fundamental strategies to perform better. US Rate Hikes: A Catalyst for Progress The US Federal Reserve has telegraphed its rate hike intentions for several years now and recent analyst polls suggest that the first increase could occur as early as this September and as late as next year. Even though we believe these expectations are largely priced into emerging markets equities, largely through movements in foreign exchange markets, we would still not be surprised to see a market upset after the Fed s initial hike. RD12136
2 2 Although there are concerns that rising borrowing costs will dampen growth in the emerging world, we think they could help restore capital discipline among companies where it has been missing, as lax capital management has been abetted by years of easy money. This has been one of the reasons for weaker profits in developing markets, which have declined to levels comparable to those in the developed world. If tighter credit conditions begin to put pressure on weak managements and bring out the skill of strong ones, we believe this could encourage the market to differentiate more strongly between companies and pay more attention to valuations. For this to happen, however, we believe US rate hikes must be carried out gradually and in small increments to avoid shocking the market. China: Froth vs. Fundamentals It is not news that China s economic growth is slowing this downdraft began in 2007, when growth peaked at about 14%. More important to us is how this slowdown is managed. It appears that China, possibly in observing the recoveries in Europe and the United States, has decided that stimulus is appropriate for its own economy. In June, Beijing made two significant decisions: (1) Bank reserve ratios have been lowered. This should boost lenders willingness to lend and increase liquidity in the system. While this could mean it takes longer for China to delever, continued strength in the Chinese equity market (notwithstanding June s turbulence) could also create opportunities for issuers to recapitalize their balance sheets through equity issuance. (2) The benchmark lending rate has been cut. This rate declined by 25 basis points to 4.85%. A second cut is widely expected this year. China has more levers to pull to meet its 7% growth target for, including reform by state-owned enterprises (SOEs), the launch of the Shenzhen Hong Kong trading conduit, and the launch of QDII2. Chinese SOEs are revealing that they will for the first time have their performance evaluated on their ability to manage profitability. This is a significant shift in management culture as Chinese companies have historically been more growth-oriented than profit-oriented, and concerns that reforms have not yet translated to earnings-per-share growth could ease. China s efforts to promote a wealth effect through local participation in the stock market do not appear to be yielding the intended consequences. Chinese onshore equities, also known as A-share stocks, abruptly transitioned from a boom period to a volatile decline that has extended into July as of this writing. Central authorities rapidly unleashed a barrage of policy changes in June to prop up its onshore stock markets. These included: (1) A new ability for pension funds to invest in local equities. China s $560 billion government pension fund is now permitted to invest up to 30% in local equities. At an early glance, this appears to be a positive development as institutional participation should boost the market s liquidity and stability. (2) Loosened margin lending requirements. Exhibit 1 Certain Fundamentals Have Worked, and Low-Multiple Stocks Are Out of Favor 12-Month Factor Returns, Emerging Markets Large Cap Equities Earnings Momentum (H-L) Debt/EV (L-H) Historical Earnings Growth (H-L) ROIC (H-L) 12m Price Momentum (H-L) ROE (H-L) Volatility 12m (L-H) 6m Price Momentum (H-L) Dividend Yield (H-L) 1m Price Momentum (H-L) Free Cash Flow Yield (H-L) Capex/Depreciation (L-H) Dividend Cover (H-L) Forecast Earnings Growth (H-L) Dividend Growth (H-L) PEG (L-H) Market Cap (L-H) Earnings Yield (H-L) Book/Price (H-L) Value/Growth Composite (V-G) EBIT/EV (H-L) Sales Yield (H-L) Month Factor Returns, Emerging Markets Small Cap Equities 1m Price Momentum (H-L) Historical Earnings Growth (H-L) 12m Price Momentum (H-L) 6m Price Momentum (H-L) Earnings Momentum (H-L) ROE (H-L) Volatility 12m (L-H) Dividend Yield (H-L) Dividend Growth (H-L) Free Cash Flow Yield (H-L) ROIC (H-L) Sales Yield (H-L) Dividend Cover (H-L) Earnings Yield (H-L) EBIT/EV (H-L) Value/Growth Composite (V-G) PEG (L-H) Debt/EV (L-H) Market Cap (L-H) Book/Price (H-L) Forecast Earnings Growth (H-L) Capex/Depreciation (L-H) As of 30 June Large-cap factor returns are based on the MSCI Emerging Markets Index; small-cap factor returns are based on the MSCI Emerging Markets Small Cap Index. Not intended to represent any product or strategy currently managed by Lazard. Source: UBS The recent volatility in Chinese equities has largely been limited to stocks on two of China s three stock exchanges. This is an important distinction as they attract different types of company listings and, thus, different types of investors. The rout has been most pronounced in the mainland-based Shanghai and Shenzhen indices (Exhibit 2), which generally consist of smaller-cap companies listed as A-shares (renminbi-based) and B-shares (foreign currency-based). Meanwhile, the Hong Kong based exchange has been significantly less volatile. Its listings primarily consist of blue-chip Chinese companies floated as H-shares in Hong Kong dollars.
3 3 The A-share volatility occurred after China s securities regulator eased restrictions on cross-border trading last November. Trading on the mainland exchanges was previously restricted to China s mainland residents, who were simultaneously barred from investment in Hong Kong listed Chinese stocks. This changed with the Hong Kong Shanghai Stock Connect program, which broadened access to A-share and H-share stocks for foreign and local investors, within preset daily trading volume limits. The retail-fueled boom in the A-share market began late last year, and spilled over into the H-share market in March. Our analysis suggests that much of this recent activity in A-shares and certain H-shares is not fundamentally driven. While we don t disagree with China s economic policies, and welcome the institutional presence granted by pension investments, we continue to look for the evolution of China s economy and markets to be driven less by state-directed investment and more by the private sector. The backdrop is also unorthodox as local stock investments are being encouraged as part of a national rallying cry to build household wealth. Exhibit 2 Chinese Indices Show Similar Return Trends but Intensity Has Differed Shenzhen Stock Exchange A-share Index Shanghai Stock Exchange A-share Index YTD 12/31/2014 to Peak 1 Peak to 6/30/ Hong Kong Hang Seng Index MSCI China Index As of 30 June 1 A-share markets peaked on 12 June, the Hang Seng Index peaked on 28 April, and the MSCI China Index peaked on 6 May. Source: MSCI, Shanghai Stock Exchange, Shenzhen Stock Exchange What do we make of this? In the near term, we think this is noise. Longer term, this market segment could take on more significance to us, especially if China A-shares are added to MSCI s widely tracked Emerging Markets Index. By MSCI s estimate, this could happen in May 2017 and possibly even earlier. We currently have no A-share holdings in our portfolios. Our large-cap and small-cap relative value teams both have significantly lower weights in China than the MSCI Emerging Markets Index and MSCI Emerging Markets Small Cap Index, respectively. They are finding opportunities elsewhere such as Brazil, Thailand, and Turkey. Both teams continue to focus on stocks that offer attractive valuations and trimmed their China positions in April s strong rally. They are considering adding to select positions given recent market weakness. Our relative growth and core teams are significantly more heavily weighted in China. The growth team is positioned to capture growth in China s railways and in well-run Chinese banks, among other stock-specific theses. The core team, which is style- and market cap-unconstrained, has broad exposure to all sectors of the economy, including investments in beneficiaries of China s migration to 4G networks as well as other pockets of the economy where the outlook for earnings growth and profitability still looks healthy. New Gate to the Middle East After a long wait, the US$560 billion Saudi Arabian equity market opened up to foreign investors for direct investment on 15 June. Estimates of current foreign ownership levels range between 2% and 5% of overall market value, and this is expected to increase in the coming months. Saudi Arabia s inclusion in one or more MSCI indices (Frontier and/or Emerging Markets) is another potential area of development, one MSCI suggests is likely to take place between 2017 and Such a move would put this market on the maps of several international asset managers and attract more significant equity flows into the country. In their recent publication, Opening the Door: Key Questions on Foreign Investment in Saudi Arabian Equities, our Middle East and North Africa team observes that while this is a deep and liquid market, it trades at a premium to most other emerging markets. As a result, they are underweight Saudi Arabia in their portfolios in favor of exposure to countries such as the United Arab Emirates, Kuwait, and Jordan. Process Discipline, Market Differentiation Emerging markets equities were trading at a 10% forward price-to-earnings discount to their historical average as of 30 June and a 28% discount to developed markets. Although the discounts rightly reflect the structural problems in emerging markets, it also suggests that a value opportunity may be at hand considering that meaningful reform efforts are underway in many developing countries. At a stock-specific level, we are still finding companies that are not just navigating the environment well, but also profiting from it by taking market share from weakened competitors. Over time, as economies globally and locally recover, there should be more widespread support for emerging markets equities. Shorter term, tighter emerging markets credit conditions from US rate hikes could force better capital discipline among companies, which should translate into improved profitability and allow for multiple expansion.
4 4 Emerging Markets Debt It Is Time to Buy Emerging Markets Debt In June emerging markets debt sold off for a second consecutive month, as a combination of global macro concerns and emerging markets specific events roiled capital markets. Phase one of the sell-off, in May, centered on correcting stretched yields in local debt, while phase two of the sell-off, in June, pushed US dollar denominated emerging markets bond spreads and yields higher. With the recent market correction, returns are now negative for the broad asset class on a yearto-date basis, with its attractive carry having been erased. For the past quarter, our emerging markets debt strategies have been defensively positioned in anticipation of this type of market retracement. While we were surprised by the speed of the correction, the underlying drivers have been well covered in the global media. Global fixed income has been hit by worries about Greece s possible exit from the euro zone, along with the steady drumbeat of the Fed s possible exit from zero-bound interest rates in September or December. Market movements over the past two months have resulted in emerging markets yields (blended between US dollar and local currency debt) that are now trading at roughly one standard deviation above their five-year average (Exhibit 3). Emerging markets debt never recovered from the taper tantrum in mid In sharp contrast to US Treasury yields (Exhibit 4), emerging markets permanently shifted away from the lower for longer regime in late 2013/early We believe the positive repercussion of this shift is that emerging markets, for all intents and purposes, are already trading at levels commensurate with the worst of the worries of imminent Fed balance sheet tightening and, therefore, it is unlikely that yields need to move higher when lift-off finally arrives. In other words, emerging markets debt is one of the few fixed income asset classes where US interest rate normalization has already been priced in. Even more dramatic has been the re-pricing of emerging markets currencies, which just completed their fourth year (June 2011 June ) of a vicious bear market (Exhibit 5). Emerging markets currencies are now trading at record low spot levels, but more importantly, at real effective exchange rate (REER) levels close to one standard deviation below their average exchange rate versus the US dollar. It should be noted that when calculating REER models in local debt, we default to a 10+ year model to incorporate the current environment of low commodity prices. Emerging markets currencies began to display an interesting trading pattern over the last several months. Currency markets have, in fact, outperformed many other fixed income segments over this time period, due to the glaring cheapness of the asset class and limited participation by international investors. In fact, since the more-dovish-than-expected outcome of the Fed meeting on 18 March, emerging markets currencies have marginally appreciated against the US dollar on a spot basis. While we are not calling a bottom for emerging markets debt, we are signaling to investors that it is time to deploy capital back in that may still be on the sidelines due to compelling valuations, in both absolute Exhibit 3 Yields on Emerging Markets Debt Are Elevated Exhibit 5 Emerging Markets Currencies Have Dramatically Re-priced on a Spot Basis Index, 100 = June Blended Yield Long-Term Average=5.94% -1 Std. Deviation 2011 Five years ended 30 June Source: Bloomberg, J.P. Morgan +1 Std. Deviation Data through 2 July Average of the yields on the J.P. Morgan EMBI Global Diversified Index and the J.P. Morgan GBI-EM Global Diversified Index. Source: Bloomberg, J.P. Morgan Exhibit 4 10-Year Treasury Yields Have Moderated Post Taper Tantrum Five years ended 30 June Source: Bloomberg
5 Outlook on Emerging Markets and risk-adjusted terms. A lack of spread or currency movements in the emerging markets fixed income and currency markets will still result in the emerging markets debt asset class delivering its yield to maturity. Those yields have risen to the upper ranges of their trading bands. In addition to the running yield (6.37% as of early July), there are a number of global macro triggers on the horizon that can potentially serve as a catalyst for returns above and beyond the asset class yield. As a start, the events that caused dollar strength to stop firmly in its tracks over the past several months were negative surprises in US jobs and wages, followed by dovish Fed language acknowledging those moves. More recently, June s US employment data showed misses in job gains, negative revisions to past numbers and, most concerning, limited gains in average hourly earnings. It is our view that the market will take these data, along with potentially dovish Fed commentary in the months ahead, and begin to price in a later lift-off date, which may very well result in dollar strength pausing for the rest of the year. In that type of environment, US Treasury yields are likely to establish a slightly lower trading range, thus opening up the opportunity for emerging markets debt spreads to marginally tighten. Five years later and markets are still talking about Greece. Each time Greece surprises to the downside, the market s reaction becomes more muted. More important than the events in Greece is that we are closer to a final resolution. Whether that comes in the form of a Greek bankruptcy, coupled with an unveiling of super-charged European quantitative easing, or whether Greece and the euro zone come to a compromise, markets are likely to cheer the culmination of a sad tug-of-war between a heavily indebted nation and its lenders, who piled good debt upon bad. As such, Greece is unlikely, in our view, to be a source of further negative surprises. Rather, we are back to watching the United States and Europe take two steps forward in economic resurgence, followed by one step back. This pervasive training-wheel global economic recovery gives us even more confidence in adding a significant amount of exposure to emerging markets debt as emerging markets yields and spot exchange rates have sold off in recent months. In the second half of this year we expect to be close to fully invested in our emerging markets debt portfolios, and for the first time in years, we plan to increase local currency debt to an overweight position versus US dollar denominated debt. Important Information Published on 14 July. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of 8 July and are subject to change. This report is being provided for informational purposes only. It is not intended to be, and does not constitute, an offer to enter into any contract or investment agreement with respect to any product offered by Lazard Asset Management, and should not be considered as an offer or solicitation with respect to any product, security, or service in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging-market securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging-market countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in emerging-market countries. An investment in emerging markets debt positions are subject to the general risks associated with fixed income investing, such as interest rate risk and credit risk, as well as the risks associated with emerging-market investments, including currency fluctuation, devaluation, and confiscatory taxation. Investments in global currencies are subject to the general risks associated with fixed income investing, such as interest rate risk, as well as the risks associated with non-domestic investments, which include, but are not limited to, currency fluctuation, devaluation, and confiscatory taxation. Furthermore, certain investment techniques required to access certain emerging markets currencies, such as swaps, forwards, structured notes, and loans of portfolio securities, involve risk that the counterparty to such instruments or transactions will become insolvent or otherwise default on its obligation to perform as agreed. In the event of such default, an investor may have limited recourse against the counterparty and may experience delays in recovery or loss. Investments denominated in currencies other than US dollars involve certain considerations not typically associated with investments in US issuers or securities denominated or traded in US dollars. There may be less publicly available information about issuers in non-us countries that may not be subject to uniform accounting, auditing, and financial reporting standards and other disclosure requirements comparable to those applicable to US issuers. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Past performance is not a reliable indicator of future results. This material is for informational purposes only. It is not intended to, and does not constitute financial advice, fund management services, an offer of financial products or to enter into any contract or investment agreement in respect of any product offered by Lazard Asset Management and shall not be considered as an offer or solicitation with respect to any product, security, or service in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited. Australia: FOR WHOLESALE INVESTORS ONLY. Issued by Lazard Asset Management Pacific Co., ABN , AFS License , Level 39 Gateway, 1 Macquarie Place, Sydney NSW Dubai: Issued and approved by Lazard Gulf Limited, Gate Village 1, Level 2, Dubai International Financial Centre, PO Box , Dubai, United Arab Emirates. Registered in Dubai International Financial Centre Authorised and regulated by the Dubai Financial Services Authority to deal with Professional Clients only. Germany: Issued by Lazard Asset Management (Deutschland) GmbH, Neue Mainzer Strasse 75, D Frankfurt am Main. Hong Kong: Issued by Lazard Asset Management (Hong Kong) Limited (AQZ743), Unit 30, Level 8, Two Exchange Square, 8 Connaught Place, Central, Hong Kong. Lazard Asset Management (Hong Kong) Limited is a corporation licensed by the Hong Kong Securities and Futures Commission to conduct Type 1 (dealing in securities) and Type 4 (advising on securities) regulated activities. This document is only for professional investors as defined under the Hong Kong Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) and its subsidiary legislation and may not be distributed or otherwise made available to any other person. Japan: Issued by Lazard Japan Asset Management K.K., ATT Annex 7th Floor, Akasaka, Minato-ku, Tokyo Korea: Issued by Lazard Korea Asset Management Co. Ltd., 10F Seoul Finance Center, 136 Sejong-daero, Jung-gu, Seoul, Singapore: Issued by Lazard Asset Management (Singapore) Pte. Ltd., 1 Raffles Place, #15-02 One Raffles Place Tower 1, Singapore Company Registration Number W. This document is for institutional investors or accredited investors as defined under the Securities and Futures Act, Chapter 289 of Singapore and may not be distributed to any other person. United Kingdom: FOR PROFESSIONAL INVESTORS ONLY. Issued by Lazard Asset Management Ltd., 50 Stratton Street, London W1J 8LL. Registered in England Number Authorised and regulated by the Financial Conduct Authority (FCA). United States: Issued by Lazard Asset Management LLC, 30 Rockefeller Plaza, New York, NY