- The EM/ DM divergence trade has been overdone.
- The PE spread differential between S&P 500 and MSCI EM is similar to the one seen in the 1997 Asian crisis.
- Investors are seeing EM for all their flaws but are ignoring DM flaws with “don’t fight the fed”.
- Lower correlation between EM economies is a given as Good Governments outperform Bad Governments.
My early thoughts in January and February was that the EM/ DM divergence trade had definitely been overdone. S&P 500 trading at a very healthy 17x - 18x PE vs. MSCI EM trading at a depressing 11x 2014 earnings in my mind was too wide of a spread. This spread of 6x - 7x is actually similar in quantum to the one seen in the 1997 Asian crisis. Some economist will argue that these emerging economies are in a worse place then they were almost 20 years ago. I absolutely disagree.
I've spent some time developing a framework for how to think about individual economies in order to refine my top down views on markets. I have come to the following perspectives: In my mind, the best way to look at these economies is the same way you would look at a company. The President/ Leadership should be viewed as the CEO. The Parliament is effectively the Board of Directors. The board's job is typically to oversee the CEO and management to make sure they are acting in the best interest of shareholders and preventing them from putting their personal interests first. The shareholders in theory should be the People who are the ultimate beneficiaries and stakeholders of a society.
As history has taught us when it comes to corporations, CEOs that consistently act in the best interest of their shareholders and make decisions based on a long term vision, witness their companies outperform over time. Good corporate governance/ transparency are as critical for the success of a company as it is for an economy. I contrast CEOs that act in their own interest and don't prioritize the interests of shareholders to governments who only work to serve an elite few. Governments that are corrupt and consistently misallocate resources almost always underperform over time. Markets will undoubtedly reflect that eventually.
I don't ignore the theory of competitive advantage here. Companies that have a significant competitive advantage be it sustainable or not, always find ways to stay profitable for a certain period of time. I compare this to economies that have a natural competitive advantage such as Saudi Arabia or Russia in the Energy space. China with its cheap labor force (not so much now). The list goes on. Companies with a temporary competitive advantage usually face a critical challenge. The easiest example that comes to my mind for a corporate would be a pharmaceutical company for example. A Pharma company can possess a patent on a drug that can maintain an advantage for an extended period of time. The challenge for those companies during that grace period is to use this time wisely, build capital, and allocate it in areas that can sustain a long term healthy market position. For economies, this is practically the same. Leadership that allocates resources and implements the right reforms will be able to sustain a healthy competitive position in the long run. The easiest way to think about this is to look at economies such as China, Russia, KSA and so on. Are managements thinking about their companies the right way? Are the leaders thinking about their economies the right way? Did they accumulate ample reserves in the good times? and are they allocating their capital efficiently in a way that maximizes value to their shareholders? Is the leadership accountable and willing to be flexible? Is the size and nature of their Economy nimble enough to adapt to any required adjustment? Is the Social contract between Leadership and People/ CEOs and Shareholders resilient enough to withstand any short term pain in exchange for Long term gain?
These are the type of questions I tried to answer myself as I thought about the spread trade and the differential in sentiment between EM and DM generally.
This analysis doesn't include a country by country analysis for EM. It does however, try to capture in aggregate, the essential differentials between the DM corporation and the EM corporation and what Management/ Leadership have done with their capital and what is the market rewarding them for.
I will not bore you with too much US macro analysis as I am sure you have read your fair share of that. I will however, try to highlight a few key points that I believe underline the perspective I am adopting.
The global economy today is much more interconnected than back in the 90s or any other era for that matter. In 2008, we kept hearing about "when the US sneezes, the World catches a cold". Well, how about when EM has the flu? Do we think the US has full immunity? And How much vitamin C (QE) can the US take before it eventually damages its liver?
Since 2008, the US has effectively socialized capitalism. They have transformed private company problems into public problems. They have socialized the costs but kept the profits private. To me, the biggest indicator of that is the fact that income inequality in the US is the highest it has ever been. Is that a sign of good management? Granted, US management has a more proven track record and better history of consistent success. However, income inequality today gives us a good insight as to whether the US management is working in the best interest of their shareholders. I do not doubt that the social contract in the US is much more solid and better built than anywhere else. It is designed to withstand much more social inequality before we start seeing any riots or things of that nature. But let's not forget that the American people expect a high standard of living and are used to consuming beyond their limits. This gap is not something that should be ignored neither in the short run nor the long run. And for a GDP that is 68% driven by consumer spending, I think this problem is actually even more critical than energy self-sufficiency at this juncture. US corporates need their consumers as badly as their consumers need the system. We get so busy criticizing corrupt models in Russia and China. But aren't we also seeing a sign of bad management and agency problems in the US?
The environment of mixed data is a clear constant for the medium term. At this point, not many people can debate that.
C + G + I + Net Ex = GDP
C. A few interesting numbers that I found: Consumer spending in the US has essentially represented 65% of the recovery in economic growth since 2008. Consumer spending has historically represented 68% of the US economy. Basic math tells us that if this trend continues, consumer spending is going to represent a smaller share of GDP growth going forward. We all know that the bulk of the job recovery (which hasn't been that great) has been concentrated on low paying jobs such as retail and consumer related businesses. Wage growth is not really happening and consumer purchasing power has been more or less the same if not worse. I appreciate that Obama has a legacy he wants to create and so, Obamacare to him is not negotiable. The timing of it however, is a different discussion. I keep reading online that places like KFC are forcing employees to work less than 30 hours a week so that they don't qualify for Obamacare. How is that going to stimulate job creation and in turn consumer spending? I don't get it.
G. Government spending has always played a critical role in the US story. The budget deficit expanded to $1.1tn during the crisis to help support the ailing economy. This deficit has shrunk to $680 bn. Since then, everyone has been talking about "fiscal drag". Is this likely to continue? My thought are, yes. With the constant struggles between democrats and republicans on fiscal prudence with each party trying to promote selfish political agendas. This dynamic in my mind will remain a constant. They know what's at stake here, so they are cautious with each other, however, both of them seem to be fighting an existential fight for a very different long term visions of the US. I expect them to be as stubborn as they ever were in their decisions and votes. The government factor in my opinion will remain as it is for the near future.
Net Ex. One thing I noticed across the board since 2008 was that every economy seems to want to export their way out of their problems. Some are super well positioned for that, like Germany which has been running this model for a long time and is an expert at it. Newcomers to the game like the US and Sothern Europe are also trying to promote themselves as exporters. Everyone talks about protectionism these days from Japan to peripheral Europe to the US. Apart from Energy, it doesn't feel real to me that the US is realistically able to compete on a global scale with its exports in a meaningful way. Democracies are burdensome and very expensive machines to manage. People have expectations on quality of life and they won't really trade down that easily. As long as there is major inequality in the world in places like East Asia or Africa, no one can realistically compete with this artificially low labor cost on low value add products. Granted, the US is at a stage where its exporting technology and services, but how many jobs does a Facebook create? How much does it reinforce the US economy? I don't think much. These companies need very little human resources and only rely on value add talent. How is that going to help the US economy significantly and recycle jobs to the consumer?
I. The I. part "Investment" was the most anticipated element of the economy for 2014. Everyone was banking on US corporate cash which is at an all-time high to flood into the markets and spur capital spending and therefore growth. We haven't seen that yet. Why do corporates need to spend that much? And on what exactly? Yes, utilization rates are close to 75%, but apart from specific sectors, what's the incentive for CEOs to spend more? Two years ago, most CEOs claimed that what was slowing down their spending was visibility and economic stability. Well, now we do have visibility given that most of the tail risk has been somewhat erased by Father Fed. Despite all that, CEOs still prefer buying back stock and paying dividends. I refer you to the McKinsey corporate survey sent around a couple of weeks ago that highlights the same points. This payback loop ultimately continues to reinforce income inequality and doesn't really touch the consuming American in a meaningful way. Two additional things worth mentioning here. A very large chunk of US corporate cash is stuck abroad, and with repatriation tax the way it is today, this cash is probably staying where it is. Second; something close to 30% of US corporate cash is with technology companies like IBM, Google, Apple and Ebay. What exactly can these companies spend on that will reenergize the US economy meaningfully? M&A doesn't really create much jobs! It actually destroys them.
The final point here to me is corporate profitability. Yes, US corporates have done an amazing jobs at cutting costs and optimizing balance sheets. But isn't that at the expense of the employees that are eventual consumers? The second question here is: how much more upside is there in this whole margin expansion story? And if capital spending is so low; where will top line growth come from then?
Thinking about it academically, when I added C + I + G + Net-Ex together which is effectively GDP; a 2.5% GDP Growth that the market seems to expect sounded great to me! I hope we actually get there!
What is the US market saying?
The market today is effectively paying the US model 18x earnings. That's 18$ for every dollar of earnings their corporates generate. After spending some time on Bloomberg, I realized that 18x is more or less close to the historical average of where the S&P trades. The cyclically adjusted multiple is actually lower than that. Most investors are finding this number absolutely warranted. I might agree that this may remain so for a while. However, this 17 - 18x multiple historically was paid when the implied US GDP growth was closer to 4 - 5%. And when markets paid 18x, they weren't really expecting mixed data and a mixed US economy. Corporates are indeed in a very healthy balance sheet and EPS position. But how much more room do they have to run on their margin expansion without significant revenue growth?
I would note however, that I absolutely agree that US management is way more proven and with a better track record. They definitely warrant a premium. But how much premium?
The market has already started being ruthless with corporates. Any company that has missed earnings recently has been punished with a vengeance. This gives us a great idea of where we are with market hesitation and overall sentiment.
There is so much money that flew into US equities past two years simply because of the super low interest rate environment that effectively brought down opportunity cost to 0. More so, everyone likes the US on a relative basis. Are they liking it too much at this point?
Where is Europe in all this?
I won't spend too much time on Europe. I will however, use an analogy to try and explain how I actually view the EU. Europe, in my mind, is an 85 year old lady that's trying to look like she's 30! She keeps debating how much plastic surgery she wants to do and keep trying to figure what type of look she wants. Bottom line, she is 85 and as many procedures as she might do, there are things about her she will not be able to change. She has lived more than any of her neighbors and has had a great life so far. But at one point in time, age has to catch up to you, u know?
Despite the age thing, I do like the UK model at the moment. UK management have always found ways to reinvent themselves and adapt to the new world. They are easier to manage then the Europeans. Like I mentioned earlier, democracies are expensive. They are extremely expensive when you are facing a demographic cliff. Which is the case with Europe today.
The markets should reflect that in my view.
I don't know if I like Germany as much as the market does. Granted they are the first movers with the export model and are better positioned. But everyone is trying to compete on exports these days and implementing protectionist policies to promote local production. Shouldn't that be reflected somewhere?
Draghi's words were golden in the past couple of years as he has managed to bring down the tab at the restaurant significantly. But Germany is the only one who has money at the dinner table and is the only one that can afford the tab. Yes, Draghi spoke to the manager and reduced the tab quite significantly. But Germany is in a situation where they need everyone with them at the dinner table so their export model survives but is being super stingy every time the waiter comes with the check. The markets seems to have forgotten about that recently.
Europe management has not really proven to be that superior compared to anyone else. On top of that, as you can imagine would be the case for an 85 year old lady, she needs to worry about her own health more than anything else at this point. Neighbors can always take advantage of that! (Russia and co.).
The communication revolution of the 90s and 2000s in my mind has played a great advantage to Emerging Markets they never had in the past. Their leaders are actually reading the same reports and criticisms about their economies that US policy makers are reading. They have access to the same exact information. These leaders realize, or at least the smart ones do, that going forward they will need to address their problems in a very well thought out way. They are drawing upon the US playbook in many instances. These economies are here to stay and they understand what they need to do to at least stay afloat. They also want to keep their social contracts stable, they don't really have much choice at this point than to do the right things.
The Elephant, China, is as we all know trying to add a consuming middle class to its mix. They want to be less dependent on exports, which is only natural in any story of economic evolution. They have a massive company to manage with more than enough employees! They naturally raised their wages over time, so clearly their export competitiveness has diminished. They want to replace that with a consuming middle class, and that's normal. But no one seems to believe they can do it anymore? Let's also not forget that in today's world of low inflation and cheaper commodity prices, it's the ones who are importing that stand the most to gain. US energy export plans are maybe happening at the wrong time in the commodity cycle…
So, why shouldn't China be able to convert its socialist system to quasi capitalist? Clearly consumer behavior is super hard to change. Going from savers to consumers takes a lot of time and additional personal freedoms are needed. It takes a solid pension system to get people comfortable to spend today at the expense of tomorrow. They have tons of challenges ahead. But here's the thing, investors are paying them 10x for every $1 of 2014 earnings…So are they actually expecting them to pull it off? I don't think so. They don't even believe in them anymore.
New Chinese management is clearly untested. However we can safely make the point that the leadership is very keen on staying relevant and doing the right things to eventually create that consuming middle class and remain a dominant force in the global economy. They need to diffuse the credit bubble while growing. But as I mentioned before about companies that develop a competitive advantage for a while and accumulate resources. Their challenge is to allocate resources efficiently so that they are able to adapt to the new rules. Well, China management knows that this is their challenge, and they are in the process of figuring out how to do that. And they still have tons of reserves to experiment with. They also benefit from more history of other countries' experiences. I'm not so sure they will do that bad of a job. Now, I don't expect China management to do a breathtaking job, don't get me wrong. But at 10x PE, am I really expecting them to?
As I had mentioned earlier, the US management is kind of behaving like an EM corrupt economy given how bad the income inequality situation is. Clearly with much better marketing and more social stability. But the inequality story is somewhat the same everywhere these days. What's funny here, is that the US actually need its consumers more than China or Russia need theirs. The market seems to want to pay so much more for the US model today than the EM model although they are being run very similarly on income distribution.
Yes, EM corporates are not better managed than US corporates. And yes, they do lag on innovation and efficiency. But in my mind, they have so much more room to run from a margin expansion standpoint as well as top line growth! There are so many things they can do at this point. They simply have to do the right things and the demand market is there. They don't have to worry about creating demand like developed countries do. Companies with the best managements in these Emerging Markets, in my view, will create exceptional value in the next 2 years. And they are still not that expensive at this point...
I am not an EM bull, nor do I want to be understood as one. My perspective here is however, that the market is not really giving any of those economies any credit for any of the potential upside. At the same time, they are paying the US 18x on 2014 earnings as if nothing is wrong over there. The differential in sentiment in my view in unwarranted. Is US management worth a 55% premium to EM management on a PE basis? Well, historically this multiple has been closer to 30% if we ignore the zealous days of the "BRICs" during the mid-2000s when everyone thought EM was the place to be. In my view the EM/ DM relationship is neither as good as the mid-2000s nor as bad a 2013/ 2014. Its somewhere in the middle. It always is.
My argument here is not that China will overtake the US as a hegemonic power or anything like that. My argument is quite simply: The investing world is ignoring the US flaws completely with the "don't fight the Fed" trade and is seeing EMs for all of their flaws and then some. Is the US a better place to invest? Absolutely. However in my mind, not by that big of a difference.
This is why I believe that the EM/ DM spread trade should do great over the next 12 months. There are four scenarios here:
1. US economy will continue to do well and EM also recovers. In this case, the S&P will finish slightly higher on the year. MSCI EM however, will outperform given where it is trading at today. The trade will make money in this scenario.
2. US economy slows down and the global economic growth gets revised downward. In this case, the S&P will probably finish slightly negative on the year. MSCI EM, however, will underperform but by a much smaller differential given the low base. In this case the SPX / MSCI EM multiples spread would still compress and the trade would still make good money.
3. US economy does well (not amazing) and EM stays where they are. In this case, the trade might still make money. As EM stabilizes, and outflows cool off (which is already happening) there would still be a turn or two left in the MSCI EM. (13x is the multiple I have in mind) and S&P should posts low single digit returns. This trade in this case might make a little money or finish flat on the year.
4. The forth scenario here, is one where the trade could lose money. This will happen if US does amazing (which I don't think is likely) in which case, the SPX multiple will be re-rated closer to 19 - 20x. if EM deteriorates even further and gets downgraded to 10 - 9x on a PE basis, then the trade loses money.
I would add here that January kind of gave us an idea of where EM bottom is. Let's not forget EM has been struggling for two years. I think those who wanted to get out of EM have done so already. I assign much higher probabilities to the first two scenarios compared to the latter two.
In line with my expectations in January, Emerging Markets have performed well recently due in part to expectations for additional economic stimulus. (EM Equities up 7% vs. 5.8% for SPX in Feb.). The bullish emerging markets move is near a critical point of resistance where reversals have usually occurred. There might be some headwinds to this trade over the next 6 months as investors might get re-discouraged about EM prospects. But over 12 months' time, they will realize that the spread is too wide…At least this is what I believe.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.