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Seeing a light where others mostly predict dark clouds

Handful of managers seeing a brighter but more selective future

Robert Arnott
Robert Arnott argues that Donald Trump’s maverick victory is helping in part to set the stage for great opportunities in emerging markets.

Portfolio managers awaiting details of Donald Trump's anti-globalization crusade predict they'll be spending more time in coming years culling emerging markets winners from losers, but one industry veteran insists the opportunity in that market segment now remains a broad-based one.

Investors fixated now on “noise” regarding which elements of Mr. Trump's protectionist campaign rhetoric he'll translate into policy could miss out on the opportunity already on offer from the market consensus that the president is bad news for emerging markets, noted Robert Arnott, chairman of Newport Beach, Calif.-based Research Affiliates LLC, in an interview.

Political upheavals set the stage for great investment opportunities, and a combination of low equity and bond valuations and beaten down local currencies are serving one up in emerging markets, he said.

Given even a modest dose of mean reversion over the coming 10 years, Research Affiliates expects a market-cap-weighted MSCI Emerging Markets strategy to deliver annualized returns of 7.5%, he said.

Even after a 2016 gain of roughly 10% for that emerging markets strategy, its Shiller P/E — which smooths out earnings volatility by using a 10-year average for earnings — stands at just above 11, compared with a historic average of 17, so “there's still quite a bit of juice left in the orange,” said Mr. Arnott.

Grantham Mayo van Otterloo pegs annualized returns for emerging markets equities over the coming seven years at 6%, but GMO's figures are predicated on a full reversion to the mean, noted Mr. Arnott. Research Affiliates bases its forecasts on a 50% reversion to the mean, or a Shiller P/E of 14 at the end of 10 years.

Returns would be even stronger for a value-focused smart-beta emerging markets strategy that breaks the link between a stock's price and its weight in an index, such as the Research Affiliates Fundamental Index strategy, or RAFI, said Mr. Arnott.

Market veterans said the merits of Mr. Arnott's valuation-focused argument must be weighed against growing uncertainties, which will force investors to be choosier when picking emerging market stocks and bonds.

Unlocking value

Emerging market equities are cheap on the basis of price-to-book and Shiller P/E, but without a catalyst to unlock that value — such as an improvement in returns on equity — they “can stay cheap for a long time,” said Alan Ayres, a London-based emerging market equities product manager with Schroders Investments.

Catalysts had started to appear last year, but with the U.S. election boosting tail risks, continued improvement in those returns can't be taken for granted, he said.

Robert Samson, senior portfolio manager with Nikko Asset Management's multiasset business in Singapore, said as a generalized comment, he fully agrees with Mr. Arnott that emerging markets valuations appear attractive now, with the pace of reforms in a number of key countries adding to the positive outlook.

Even so, “being selective on what assets you're in” looks to be an ever-greater focus this year, marking a continued retreat from before the global financial crisis when “emerging markets were just a beta play on global growth,” Mr. Samson said.

Variants of the global growth story that has driven investments in emerging markets — the commodity cycle, more focused on Latin America, and globalization, focused on competitive Asian producers — are largely played out, said Daniel Morris, London-based senior investment strategist with BNP Paribas Investment Partners.

The trade engine which lifted emerging markets in Asia in recent decades sputtered following the global financial crisis, even before last year's political hammer blows from the U.K.'s Brexit vote and Mr. Trump's election victory. It remains to be seen whether elections scheduled for 2017 in key countries such as France and Germany will add to the anti-globalization wave.

While Mr. Trump didn't set in motion that emerging market evolution from beta play to alpha opportunity, the steps he promised on the campaign trail — such as huge tax cuts, heavy infrastructure spending and less regulation — or threatened, such as erecting trade barriers aimed at China and Mexico, promise to accelerate the trend, market players said.

Against that backdrop, opportunities in emerging markets will be more focused on big countries such as China, India and Indonesia, which have rising middle classes driving growth in consumption and demand for services, predicted Mr. Morris.

There will be “more country differentiation,” agreed Sergei Strigo, head of emerging markets debt management at Amundi in London. Mr. Strigo said he's favoring economies now that could prove less vulnerable should Mr. Trump follow through on his protectionist campaign rhetoric.

Days into Mr. Trump's term, the critical mass of uncertainty that remains with regard to what he wants to do and what he'll be able to do is forcing portfolio managers to read between the lines.

'Exploding with assumptions'

Markets now “are exploding with assumptions,” as investors await a government “experimenting with macro-policy in ways that we haven't seen before,” said Steven Wieting, New York-based global chief strategist with Citi Private Bank in a Jan. 10 briefing in Singapore on the outlook for 2017.

Putting aside the wild card of protectionism, “the broader policies Mr. Trump has been talking about — tax cuts, fiscal stimulus — are everything you would want to see from an equity perspective,” provided the president can deliver, said Nikko's Mr. Samson.

Nikko's “key concern” is that the immediate, post-election headwinds from rising bond yields, a stronger dollar and higher wages could trip up the U.S. economy before offsetting stimulus policies have a chance to take hold, he said.

Mr. Morris said the post-election rise in 10-year Treasury yields and the dollar's gains against most currencies — both negative developments for emerging markets — have left BNP Paribas's multiasset portfolios underweight emerging markets for now.

But with that initial wave of optimism about U.S. economic prospects leaving the dollar and U.S. bond yields “priced for disappointment,” the firm's multiasset portfolios could shift to a strategic overweight for emerging markets as early as the second quarter, he said.

Mr. Samson predicted that taking a selective approach to emerging markets — weighing political risks and macro vulnerabilities in search of the highest risk adjusted returns - will prove superior to pursuing “blind beta.”

“Given the divergence of the opportunity set, why would you want” to own everything, he said.

This article originally appeared in the January 23, 2017 print issue as, "Seeing a light where others mostly predict dark clouds".