Strategy Note /

The pulse of US investors in FM and small EM equities

    Hasnain Malik
    Hasnain Malik

    Strategy & Head of Equity Research

    Tellimer Research
    10 November 2019
    Published byTellimer Research

    During our recent US marketing trip to meet Frontier and small Emerging market equity investors, the following are the most common comments and questions (with our response) that we encountered. 

    Generally, there is extreme pessimism about the commercial viability of the asset class and this is reflected in redemptions from buy-side funds and retrenchment and exits from international sell-side research providers and brokerages. 

    Ironically, the investment opportunity in these markets, relative to large Emerging and Developed equities, may never have been better. But this is an opportunity for those asset allocators with patience and those buy-side funds and sell-side firms with financial staying power. And it is likely that, with the international pool of dedicated capital now so small and risk-averse, that local investors in these markets will increasingly lead market moves. As we recently wrote, To the Survivors the Spoils.

    In this report, we have tried to capture the mood from the other side of the table on the overall asset class as accurately as possible. We acknowledge that the feedback on countries most often discussed (if not the actual topics debated in those countries) were naturally biased by the portfolio strategy presented from our side. 

    Asset class in crisis just as its relative case is improving 

    Survivor stupor: The asset gathering (retention) environment for funds focused on Frontier and small Emerging equity remains extremely depressed. It also has not gone unnoticed by most investors that sell-side research coverage from international firms (as opposed to local brokers) has been cut sharply in Africa, Middle East, smaller country Asia and pan-Frontier.

    Ironically, this trauma on the buy and sell side is occurring just as a number of factors are aligning in support of the relative case for the Frontier and small Emerging market asset class: 

    • Lower rates and quantitative easing resumes in developed markets (which drives higher risk appetite; 
    • The search for yield and the easier availability of capital for sovereigns in Frontier and Emerging markets (that are more indebted than a decade ago but at much lower levels than Developed peers); 
    • Slower growth in the US and the EU (which makes more glaring the gap between macroeconomic growth in Frontier and Emerging compared to Developed, and which likely caps strength in the US$); 
    • Questions are increasing over the very long-term stature of the US$ as the default reserve (safe-haven) currency (with high overall debt levels in the US economy, less policy predictability in an era of populist politicians, the ramp-up of economic tools, such as sanctions, in the US foreign policy kit, and increasing trade flows, for the Frontier and Emerging markets, with China, which encourages international powers to establish contracts in alternative currencies to the US$);
    • Political populism, propensity for protest, and vulnerability to terror and insecurity are no longer so clearly more common in Frontier and small Emerging compared with Developed and large Emerging; 
    • Growth in the two largest emerging markets, China and India, is decelerating (which means that these two markets alone and the EM index they dominate may no longer offer such a straightforward option for international diversification outside developed markets for US asset allocators); 
    • Mega-cap tech in both developed and emerging (which have handsomely outperformed all other equities globally) is slowing (the law of large numbers);
    • Many of the most vulnerable currencies in Frontier and small Emerging have already collapsed or significantly weakened (eg Argentina, Egypt, Ghana, Kazakhstan, Mexico, Nigeria, Pakistan, Philippines, Turkey, Zimbabwe); 
    • Economic policies and political transitions in most Frontier and small Emerging are increasingly orthodox and orderly (even the newly elected Peronists in Argentina are dominated by their moderate, rather than Kirchnerist wing and economic policies of the type seen in eg Dragnea’s Romania, Erdogan’s Turkey, or Magafuli’s Tanzania are the exceptions, not the norm).

    Survivor serendipity: Good companies have rarely been valued so attractively and ignored so widely by international and local investors. 

    Beneath the surface of index valuation versus history, where Frontier, Emerging and Developed are all within 5-10% of their 5-year median price/book, there are, for example, listed banks, with reasonable capital adequacy and liquidity on price/earning valuations of about 5-6x (Argentina, Dubai, Egypt ex-COMI, Georgia, Ghana, Jordan, Kazakhstan, Lithuania, Nigeria, Romania, Slovenia, Sri Lanka, Tanzania, and Turkey).

    Local lead: Local investors are now the spark for rallies, not internationals. 

    The onus has shifted to local investor flows to act as a catalyst for cheap but underperforming local equities. International assets dedicated to these markets have shrunk so dramatically (and redemptions have likely not terminated as yet) and the remaining funds are so shell-shocked by the recent experience of trapped positions in low liquidity stocks and markets that, unlike five years ago, they are waiting for locals to react to macroeconomic stabilisation and improvement and low equity valuations. 

    And there is some anecdotal evidence that, often for quite country-specific reasons, the indigenous high net worth and institutional investor base is revisiting the equity market. The start-of-year rally in Romania, the Q3 rally in Pakistan and the very recent (post-rate cap repeal) rally in Kenya were sparked by locals. 

    As bank liquidity eases in Bangladesh, local currency government security yields come down in Egypt, access to high-yielding central bank securities in Nigeria is restricted (with local pension funds also at perhaps less than half their historic peak allocation to equities), and the local mobilisation of funds for Aramco IPO subscription passes, perhaps these are the next candidates for locally-sparked rallies.

    Argentina and Kuwait: Everyone dislikes having to deal with Argentina (so big, at least in the MSCI FEM and FTSE FM indices, and wildly unpredictable, both because of uncertainly on Alberto Fernandez’ imminent debt restructuring and because the ease of foreign access via ADRs and relatively large pool of dedicated LatAm regional funds mean share prices move dramatically on any change in Argentina macro fundamentals or global risk appetite) and Kuwait (so big in MSCI FM, such a strong performer due to index-related inflow in advance of its re-classification to MSCI EM, and overvalued relative to unappealing fundamentals).

    Passive EM fund pollution: Everyone, with a fundamentally-driven investment process, is frustrated by the last three years of massive distortions in share price performance driven by index-related EM passive fund inflows related to index re-classification of countries (Argentina, Kuwait, Pakistan, Qatar, Saudi, UAE), and increasing index weights for companies after foreign ownership limit increases and M&A (particularly in the UAE and Qatar). 

    It may be the case, unless Vietnam addresses the foreign ownership limit problem far quicker than we anticipate, that this era of significant country upgrades to the EM index has passed.

    Benchmark bananas: No planned new fund wants to set up with, and no existing fund wants to retain, the MSCI FM (Frontier Markets) benchmark (which, shortly, is going to have both Bangladesh and Iceland in it because MSCI criteria are based mainly on the state of sophistication in the stock market, not the state of development of the economy); instead, more index customisation and more persistent “off-benchmark” portfolio weights are the norm. 

    In addition to Colombia, Egypt, the GCC, Pakistan, Peru, and the Philippines, the likes of Malaysia, Mexico, Thailand and Turkey (ie markets traditionally in the mainstream emerging markets domain) are all increasingly part of the debate. 

    The reasons for this are the search for greater liquidity for traditionally Frontier funds, the more typically “Frontier” fundamentals of these countries and their orphaning as the MSCI EM index is dominated by China, Taiwan, Korea, India, Brazil, and South Africa.

    Protest proliferation: Algeria, Bolivia, Ecuador, Egypt, Ethiopia, Indonesia, Iraq, Jordan, Lebanon, Pakistan, Peru, Romania, Sudan, Venezuela, and Zimbabwe have all seen significant protests this year and many wonder whether there a pattern to these. 

    In our view, inequality (of economic opportunity and wealth or of political rights and representation) is a feature of many societies and the discontent that results can now be mobilised quicker than before because of social media. 

    But this is neither a problem specific to low income per capita or “Frontier” countries (witness the mass protests in richer EM (Chile), larger EM (Hong Kong, South Africa, South Korea), or indeed Developed (France, Spain, UK), nor do most of these protests cause lasting economic damage or political destabilisation, unless the regime is deeply divided (compare the quick suppression of protests in Egypt with the upheaval in Lebanon).

    Country-specific issues commonly discussed 

    Bangladesh FX: With real effective exchange rate implying a c30% over-valuation, high inflation differentials not reflected in the last few years of FX rate stability, the swing from current account surplus to deficit, the 2018 garment sector wage hike and the China FX rate devaluation eroding competitiveness, the increased competitiveness of Vietnam, after signing its own FTA with the EU (Bangladesh’s core market), and the passing of any election campaign-related reluctance to devalue, many are concerned that a significant FX rate adjustment is looming. 

    We agree that the FX rate is overvalued and that the Bangladesh government (which is unchallenged politically) should engage in gradual devaluation. 

    But we do not regard the FX rate as vulnerable (absent a disorderly Chinese devaluation) because external debt is low (merely 10% of GDP), the current account has moved to a deficit but the level is still modest (c2% on a full-year basis) and the reason is mainly benign (import of machinery and building materials to upgrade power generation and road network), and import cover is 6-7 months.

    Vietnam FOLs: Vietnam evokes a universally positive top-down view but equally widespread frustration that there is such little foreign accessible free float, in the better quality companies, into which fresh capital can be deployed. 

    We see more likelihood of an introduction of non-voting shares than a loosening of foreign ownership limits, but even this measure is likely some way off.

    Pakistan performance: Perhaps over two months of outperformance made many willing to discuss Pakistan. (When we pushed a positive case at the start of this year there was comparatively little appetite for such a discussion). 

    Critically, more comfort on the FX rate outlook was generally the starting point. 

    Lingering concerns were that banks need to see returns on equity expansion to make their valuations very attractive, mass disaffection with austerity and macroeconomic adjustment (ie a sharp slowdown) derails orthodox policy and the IMF program, and exports could take many years to pick up. We agree with much of this, except that in a political system where the military is paramount (its vote counts the most during elections and protests are suffocated unless it provides them oxygen), the military has determined that reforms (FX rate devaluation, wider tax collection, much more thorough documentation of the black economy) are both necessary and best implemented via a civilian political party (PM Khan’s PTI) which does not represent the undocumented economic interests, which have impeded these reforms historically, and faithfully projects the military’s message on foreign policy. 

    Furthermore, the context for these concerns is an equity market valued close to its 10-year low on price/book.

    Sri Lanka sorted: We found many counterparts are hopeful of a return to more market-friendly government next year and enthused by cheap valuations. 

    We agree on valuation but see significant uncertainty over the necessary steps for this political transition. The presidential election is merely one of those steps. 

    The change needed to drive faster growth is an absolute parliamentary majority (because, despite the high profile of the presidential office, Sri Lanka has a parliamentary political system). 

    For that to happen, a number MPs need to effectively “cross the floor” after the presidential election (either to form a new government or to trigger a successful vote of no confidence which allows the president to call an early parliamentary election).

    Nigeria nodding off: Most have given up on Nigeria growth and are concerned by the recent erosion of FX reserves (with President Buhari prioritising FX stability over all else) and fear that there is no catalyst for the very cheap stocks they still own. 

    We agree with the concern on growth. But we regard a full-blown FX crisis as unlikely (ironically, the call on FX reserves from imports is low, compared to 2014 preceding the oil price crash, precisely because growth is so anaemic) and feel the local pension funds will revisit equities given very high dividend yields on offer.

    Egypt’s errant small caps: Given FX rate appreciation, collapsing inflation, and accelerating GDP growth, many are surprised by the underperformance of equities once the largest stock, bank COMI, and a special situation takeover play, GTHE, are stripped out. 

    In our view, this is a result of the much greater liquidity requirements of the mainstream EM funds which have revisited Egypt, the absence of firepower (assets under managment) for most Frontier and Africa ex-SA funds and insufficient volumes from the local investor base. 

    We expect the return of local investors as interest rates and local currency government security yields drop sharply (as inflation plummets). 

    The one aspect in an otherwise positive view of Egypt is the absence of foreign direct investment in labour-intensive manufacturing (FDI is not dependent on low local interest rates unlike local corporate capex and should have found the legal protections in the Suez Canal zone more conducive following the Industrial Licensing law, and labour costs more competitive after the 2016 devaluation). Perhaps they await more plentiful supply of electricity and gas, or a pick up in EU demand. We hope these are the reasons rather than lingering fear that the playing field is not level with army-related enterprises.

    Saudi salsa: Saudi was often discussed but for diverse reasons, and rarely were all discussed in the same meeting – the Aramco IPO, the Aramco attack and Iran, US sanctions risk, and social liberalisation. 

    In our view the Aramco valuation should reflect its weaknesses (minority interest alignment, physical security of assets concentrated in one country, burden of output restraint when oil price is low, lack of scarcity in existing oil-related equities) as well as its strengths (low cost of production and low depletion rate) but the surplus of local liquidity (or international funds in which Saudi is a significant investor, or sovereign wealth funds in Saudi’s large customers) likely overwhelms the valuation debate. From the point of view of the funding of non-oil diversification this year, the government’s dividend receipts this year from Aramco likely outweigh the proceeds from its sale-down of equity.

    It is unclear to us if the Aramco attack marks a moment after which regional tensions significantly deteriorate (mutual destabilisation will intensify) or improve (the physical vulnerability of Saudi assets, if not its ability to manage oil sales smoothly with spare capacity, will temper its forthright foreign policy and this, in turn, will moderate the behaviour of Iran. 

    We are, however, more confident in the view that there is a limit to Saudi-Iran conflict which falls short of inter-state war (the erosion of US security cover for Saudi in an era of US shale and after the unpopular and costly Iraq and Afghanistan wars, and the partial alignment of Iran with Russia, China and Turkey).

    Turkey temptation:  We found several investors tempted by the very cheap value exhibited by Turkey’s generally formidable listed companies and its cheap FX rate (on a real effective exchange rate basis and after the rapid contraction of the current account deficit), despite readily acknowledging the multiple material top-down risks (unorthodox economic policy, high fiscal deficit, partial restrictions in the operations of the FX market, US and EU sanctions risk, security risks, risk of policy adventurism should President Erdogan’s domestic popularity come under threat). 

    Compared to most of the investors we met, we are less worried about geopolitical risk (the strategic importance of Turkey to both the US and EU – NATO membership, regional ballast versus Iran and Russia, buffer for migrants – likely continue to outweigh the misalignment of policies on, for example, Russian arms purchases, gas exploration in Cyprus-disputed waters, Syria invasion) and domestic political risk (Erdogan and the AKP are not what they once were but the opposition remains too divided to wrestle power at the national level). 

    But we fear that it is only a matter of time before the laws of (economic) nature prompt another crisis (triggered by a fiscal deficit that is too high).