Wednesday, November 17, 2010

Frontier Markets lagging the largest Emerging Markets: What does it mean?



Since March 2009 the MSCI BRIC Index rose 150 percent. Nice return in one-and-half years! The Frontier Market Index went up 65 percent, and as so often people - see the attached article below - find that 'lagging performance'. Nothing changed after the crisis: we are back to interest rate shopping in Western banks where private investors waste lots of time trying to find savings accounts or bonds that pay 0.5 or 1.0 percent more on an annual basis, and simply forget that when asset classes are considered (almost) risk-free this additional margin is most likely some kind of risk premium. From Icesave to Irish Banks...

FM a laggard?

This morning the Dutch financial newspaper presented information on how a few of its largest banks have advised their clients to buy Irish government bonds, even at a time when PIGS (Portugal Ireland Greece Spain) stories were already in the newspapers and/or research reports of firms like ours. Idea: 'Well, you cannot compare Northern European Ireland to those Southern European countries. There is a difference in budget discipline.'. We all know now that Irish yields went up to 8.5 percent and bond prices down some 30 percent since that moment. So much for interest rate hunting.

A lesson in optimization

Good thing for LMG is of course that we write a lot and that no one can find any articles in which we advised that stuff, because we simply didn't. We don't really see the added value of a lot of 'shopping' for higher returns in what is supposedly the low risk component of your portfolio. The nice thing of our Markowitz-van Dijk asset allocation framework is that when you follow its strategies for longer periods, you will notice that when aiming for a target risk level of X the optimizer prefers portfolios with the following structure:

* Large overweight in extremely low risk (say risks of 0.5 X and lower)
* Large overweight in extremely high risk (say risks of 1.5 X and higher)

to such an extent that a risk level of X is achieved.

The middle zone is left out or underweighted.

And that is actually quite a smart thing of the optimization to do. Not from a 'quant' perspective only, but also when incorporating behavioral factors. The attached article tells us in an indirect fashion WHY.

A lesson about herding

Now that it is clear to the herds that 2008-09 was not the end of the world, we see a move back into Emerging Markets. Logical, because the Global Crisis wasn't really Global. It was a situation in which Western markets found out that they didn't dominate anymore on the one hand, and that their banks - albeit still top of the bill in terms of human capital and expertise - were in a totally wrong business model. With equity positions of less than 10 percent and debt levels of more than 90 banks in the Western world were to a large extent hedge funds that played the idea that people normally bring their cash to banks to save, leave it there and then even when borrowing leave a lot of money in non-cash form. If everybody would go back to the bank to get their cash, it isn't there.

Is that a problem or scam? No: there is nothing wrong with debt financing to the extent that you can repay it. It is just to stay that in this 'game' banks went to far (9 to 1 is too much), especially when taking into account that the Globalized World has changed the rules of the game in one way: a lot of the Western money is now not staying within our own market spectrum (North America and Europe) but leaking into Emerging countries like Brazil, Russia, India, China etc. In a way that is what we see here in the attached graph.

Every individual no-no in the Western world knows about Emerging Markets now. So all of them have heard about growth in the BRIC nations. Add to that that poor advisers can best advise these markets (if you are right you sell a story that people wanna hear, if you are wrong you can easily get away with it saying 'China's growth is so fantastic, how could I know that it did not translate into higher equity market growth?') for reasons not related to their clients' expected return but their own personal job-related return-risk considerations and we do immediately understand why the recovery in the largest Emerging Markets was so much bigger than that elsewhere.

Add to that the cultural factor (we are currently writing a paper on that one) which implies that we somehow overrate the risks when talking about the likes of Africa, Middle East, Eastern Europe, Russia etc and underestimate the Asian risks because the first groups of nations are associated with international political quarrels and violence while the latter are associated with smiling people, friendly restaurant owners etc and we are getting somewhere with our explanations.

Why Frontier Markets link LMG and Roubini

In a previous entry we did already indicate that - although we are often in disagreement with Nouriel Roubini - we do shake hands on this one. Frontier Markets will have a better future over the next 3-5 years than ever before. Actually: before it was simply too early to invest full-fledge in them. Again: we are happy to be able to proof that we had those countries in our system on the one hand but didn't do much in terms of investment weight on the other.

LMG and Roubini agree: Hmm, looks like we agree on more than just our vision about FMs versus main-stream EMs!


Yep, with us probably being the institutional market asset allocators with the largest number of Frontier Markets in our models we were also among the most underweighted ones (not counting those that didn't have them in the systems in the first place, because then the weight is obviously zero). When it is too early to participate, just sit and wait.


So what does the graph tell us? It tells us that while Frontier Markets are now gradually being discovered, in EMs the idiots are out again to a large extent spending Ben Bernanke's QE2 money.

Actually: we are even already playing a bit with scenario's in which during the next 3-5 years the order of performance in equities will be something like this:

1) Frontier Markets the place to be - especially on a portfolio level due to their low correlations with other markets
2) Western markets becoming interesting 'value' investing, contrarian places with reasonable dividend levels
3) Overrated main-stream Emerging Markets: not in terms of general economic growth levels, but in terms of stock market returns.

With respect to 3: we do believe though that Emerging Markets Debt markets (government bonds etc) of main-stream larger EMs will be more than interesting. So don't think we are doctors of doom or something!

How will it be possible, main-stream EMs underperforming stagnant mature developed markets in equities? Very simple: with money flowing into main-stream Emerging Markets like crazy the pockets of Wealth Funds and Big Banks in those nations get fuller. Who said that they will always focus on local investments? These people did also study Markowitz and understand that global diversification of portfolios is in their interest.

Result: when knowing that the West is struggling and still holds quite a bit of advantage in terms of knowledge, human resources, efficiency etc, be ready for spectacular growth in portfolio and direct investment flows from the main stream Emerging Markets into the West! Within 3-5 years China Investment Corporation, Temasek and GSIC (from Singapore so not really developing but still not well known), ADIA, KIA, QIA, Mubadala, Gazprom, Sberbank etc ...They might all become household names in the West.

And that could translate into return-risk ratios in Western markets that are far better than current economic climate conditions seem to warrant.

We are not saying that this order 1,2,3 is already our 100 percent conviction. But we are more or less convinced that the one all investors seem to consider as most likely right now with

1) Emerging Market leaders
2) Western Markets
3) Frontier Markets

is far more unlikely.

Time will tell and we are happy that we have added this to the internet now. Our industry was already too much talk in vague wording and then lots of talk later to polish away the mistakes. If we are wrong, fine as well, every month we update part of the systems so in that case we are pretty confident that we have told the world via one or the other paper what went wrong and what we learned. We know already that the quality of our approach is not that we are right all the time, but that we are right about 7 out of 10 times.

But one of the things we can learn already right now is that when ALL seem to believe that situation Y is happening, it won't. So the West won't collapse and Emerging Market leaders won't continue to outperform like crazy in terms of returns. Logical: with their risk levels going down they will transform into main stream and that will lead to lower equity returns. Markets are inefficient but not to the extent that they are crazy! And that explains why we considered lower risk securities from EMs as an alternative: with risk levels coming down prices and yields will go up leaving investors with nice returns. So instead of interest shopping within the Western world, consider - within the fixed income/low risk component of your portfolio a bit more allocation to the least risky EMs.

Attachment: Article from Frontier Market Blog

No comments:

Post a Comment