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Hermes: Populism means we all need to think like emerging market managers

24 April 2017

Gary Greenberg, head of emerging markets at Hermes Investment Management, considers whether fund managers focused on developed markets can learn anything from their emerging markets counterparts.

By Gary Greenberg,

Hermes Investment Management

Some investors say emerging markets managers have nothing to teach developed markets managers. After all, advanced bottom-up analysis can be applied to greater effect in developed markets than in the emerging world, with the ravages of the Great Depression, two world wars and the 1970s oil crisis now distant memories – and the 2008 financial crisis considered a rare meltdown.

Therefore, many developed markets specialists choose to sideline top-down analysis. As Peter Lynch, a fund manager famous for his outperformance against the S&P 500 from 1977 to 1990, remarked: “If you spend 13 minutes analysing economic and market forecasts, you’ve wasted 10 minutes.” How has such a view been working out for developed markets managers?

Very well, it turns out. Ignoring macro has been a fantastic approach – not because macro hasn’t mattered, but because it’s been supportive of market performance. Over the past 30 years, the developed world index has a compounded cumulative return of 400 per cent. Three powerful tailwinds have supported developed market stock returns: corporate tax rates, interest charges and the rate used to discount corporate cash flows have all fallen substantially and steadily throughout this period.

Performance of MSCI World vs MSCI EM since 2000

  

Source: FE Analytics

While industry analysis is actively practiced by many developed markets investors, macro modelling for equity portfolios has fallen by the wayside. Of course, there are excellent reasons for this: 27 European countries have tied their economic fortunes together, while the remainder of the developed world has targeted the same low inflation, globalised policy framework. But recent events in the developed world are challenging this global order, which has presided since the end of the Cold War.

Right-wing populism threatens global order

In the developed world, political paradigms are diverging as populist leaders question the viability of the European Union, the North Atlantic Treaty Organisation (NATO), the World Trade Organisation, and the independence of central banks. In effect, they are kicking out the institutional underpinnings of the current world order. The tools of country and currency analysis of developed-world investors may need to be dusted off.


Let’s examine how they could be applied. For example, emerging markets managers looking at Brazil have been assessing the implications of an indictment of president Michel Temer on corruption charges, and what this might mean for the passage of critical pension reforms and the trajectory of interest-rate cuts. We could also apply this top-down lens to Italy: if Italian economic policy became independent of Brussels, the cost of capital of Italian assets would go up. Interest rates, exchange rates, and growth rates would all become ‘liberated’, meaning a new and challenging dimension would need to be assessed, discounted, and incorporated into the bottom-up analysis of stocks.

Return implications of exchange rate swings

Similarly, exchange-rate movements are examined and assessed because they have obvious implications for returns. UK investors buying domestic stocks don’t need to think much about sterling, except so far as export revenues and import costs are concerned, but those investing in Brazil have watched the real depreciate 61 per cent since the taper tantrum in 2013 and then soar by 68 per cent by the end of February.

Performance of Brazilian real vs sterling over 5yrs

  Source: FE Analytics

Are these currency swings predictable? Possibly. Do they impact returns? Definitely. Is this relevant to developed markets? Yes. A break-up of the euro, the dissolution of NATO, the US’s abrogation of the North American Free Trade Agreement and threatened withdrawal from the WTO – any of these events would introduce currency volatility that could call into question many valuation assumptions and methodologies in vogue today.

Will fiscal stimulus make the world great again?

One driver that tends to accelerate economic activity is the cost of debt and low interest rates. Might corporations jump on the once-in-a-lifetime opportunity to take out cheap loans and embark, as Jeff Immelt, CEO of GE, suggests, on massive investment programmes to expand capacity, create jobs and make America (and maybe by extension Europe and the rest of the world) great again?


One way to judge whether this is actually happening, as opposed to being merely promised, is to look for an acceleration in lending, commonly known as the credit impulse. Alas, across the world, it is moribund, having even faded in China, a source of massive stimulus for the past several years.

Causes of economic catatonia

The causes of this catatonia are demography and disruption. As populations age, they buy fewer goods. Meanwhile, millennials don’t have spending power, so it’s down to the baby boomers to keep consumption, the primary engine of growth, running strong. But it doesn’t take Warren Buffet to realise that aging boomers are entering a quiescent stage, and if they want to live as long as him, they will have to go easy on the burgers and Cokes.

And for millennials, good jobs for humans are disappearing as computing power ramps up. In China and India, the factories we visit are mostly automated. And while the manufacturing work GE and other US multinationals brings back to the US may spark keen headlines on Breitbart News or Fox News about jobs coming back home, in reality most new capacity will be automated.

Just like the savings made from lower taxes and interest rates, we suspect most of the dollars that are repatriated in a tax amnesty will end up being used to buy back shares, just like in 2004. Sure, lots of new factories with plenty of highly paid skilled workers are on their way but only, unfortunately, if you believe in an ‘alternative’ future.

For developed market managers, an extra layer of macroeconomic complexity has been added by the dynamics of rising populism and they need to re-discover tools to interpret it. In a new age of uncertainty, it is time to think like an emerging market manager.

Gary Greenberg is head of emerging markets at Hermes Investment Management. The views expressed above are his own and should not be taken as investment advice. 

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