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Emerging markets: Beyond Pavlov’s dogs and towards Schrödinger’s cat

14 June 2016

Goldman Sachs Asset Management’s James Ashley explains why Nobel-prize winning physicist Erwin Schrödinger might be able to offer some insight into emerging market investing.

By James Ashley,

Goldman Sachs Asset Management

For many investors, the topic of emerging markets elicits something of a Pavlovian response: some ‘like’ EM, some do not. Our view is that both positions are incomplete.

The reality is that a single reductive characterisation of emerging markets (EMs) ignores the rich diversity of economies in a broad and heterogeneous category.

In our opinion, some EMs combine a healthy cyclical outlook with an attractive longer-term demographic and structural story. India is a prime example; in others, fragility and economic challenges are painfully apparent, for instance Venezuela.  

Consistent with that heterogeneous landscape, when thinking about where to allocate capital, investors should appreciate that some EMs potentially offer a highly attractive and rich opportunity set, while others are simultaneously unappealing and fraught with difficulty.

Performance of indices over 5yrs

 

Source: FE Analytics

As a result, we do not have ‘a’ view on emerging markets. Rather, we have a multiplicity of views depending on the specific economy, market segment and (where applicable) individual stocks under consideration. 

The importance of granularity becomes obvious when one considers the factors which determine the investment climate for EMs.  There are some ‘common factors’ driving broader investor sentiment around EM (the most obvious of which are the outlook for commodities, China, and US rates/FX) but, in our view, they tend to be much less important than the idiosyncratic factors affecting any given EM economy.

Moreover, even once we’ve gone down to the level of the individual economy and the associated idiosyncratic factors shaping its outlook, for that macro framework to be useful it’s then necessary to go a step further and relate that assessment back to how the market is priced.


For example, as noted above, at GSAM we have a very constructive view on the Indian economic outlook at present but that does not mean that we recommend buying Indian assets irrespective of their price level. Valuations and entry points are hugely important.

And the same holds true in those more challenged EMs where a difficult macro outlook might have caused markets to sell off too far and there may be upside investment potential as pricing comes back into line with fundamentals.

That need for granular assessment and active management becomes even more apparent when focusing on EM equity.

For investors in this space, the economic outlook provides an important context for the equity market outlook, but it is the bottom-up selection of stocks over a long-term horizon that is typically a more consistent source of alpha-generation; in other words, macro might matter but micro matters more. And, in our view, the importance of actively-managed stock-selection is immediately evident when one considers how EM equity has performed in the recent past.

EM equity: Macro might matter but micro matters more

 

Source: FactSet and GSAM

The chart above shows the performance of 23 different MSCI EM indices over a three-year period ending Q3-15 which, clearly, spans a challenging period for EM assets. It is perhaps unsurprising, therefore, to see that only 32 per cent of those indices delivered positive returns during that period.

What is notable is the discrepancy between that index-level performance and the performance at the individual stock level. If, instead of looking at index performance, we focus on the performance of individual EM stocks, then the number recording positive returns over the same period almost doubles to 61 per cent.

That apparent discrepancy can be explained relatively easily: the 39 per cent of stocks that did not deliver positive returns were (on average) not only fairly poor performers, but also dominant parts of the indices.  That 39 per cent includes a number of commodity-based corporates whose earnings have been crushed by the collapse in global commodity prices (causing a huge earnings overhang for EM equity over the past few years), but also a good number of state-owned enterprises which (in our view) can all-too-often offer value traps for minority shareholders (and which, therefore, represent more of a perennial structural problem with sticking close to EM indices).


So although the EM equity space has provided rich pickings for discerning active managers operating selectively outside of benchmark indices, those who have sought passive exposure have been hit hard by the least desirable parts of the index. Selectivity matters immensely.

EM equity now trades at a discount to developed markets of around 25 per cent (similar in magnitude to what was observed in 2008~09), and looking at earnings on a cyclically-adjusted basis, EM equity is now trading in the bottom decile in terms of long-term valuation. In our view, those valuations offer interesting entry points but, to reiterate, only on a selective basis.

Those familiar with the work of Nobel-prize winning physicist Erwin Schrödinger will be familiar with his thought-experiment in which he asks us to imagine a cat that is both simultaneously alive and dead. Not sequentially alive then dead; not either alive or dead; but simultaneously both alive and dead.

And that is how we should think of emerging markets: some parts are vital and alive with opportunity for investors constructing well-designed balanced portfolios, whereas other parts are moribund and have the appeal of, well, a dead cat.  But as a general principle, when it comes to EM investing, the complex sophistication of Schrödinger’s cat beats the simplistic reflexive ‘good or bad’ instinct of Pavlov’s dogs.

James Ashley is head of international market strategy at Goldman Sachs Asset Management. The views expressed above are his own and should not be taken as investment advice.

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