Churchouse Letter
October 2015          by Peter Churchouse

A “Universally Hated” Opportunity

A lesson from Lyford Cay... and why when everyone runs you should pay attention...

Global Emerging Markets have taken an absolute hammering in the past several months.
Currencies and equity markets are getting crushed... there's a LOT of fear out there.
We believe these fears are overdone. There are risks for sure, but we also believe we'll soon be facing a great opportunity in this space. We show you a brilliant way to play this market when the time is right.

Investment banking is a young man’s game. It’s rare that someone in their late 30s joins that rat race. By that age most bankers have been in the industry for 15 years or so. Many are thinking towards retirement – or moving to a less-stressful line of work.

Me? I happened to be a 39-year-old rookie when I went into the world of investment banking. I’d spent years as an economic and planning consultant in Africa, Europe, the Middle East, Asia and New Zealand. And in 1987, I agreed to join Morgan Stanley as an analyst.

I can tell you it was the best career move I ever made. Yes, it was stressful. There were 16-hour days and a lot of travel. But I loved the analysis, the cut and thrust of the markets.

The 1990s in particular were a fascinating time to be right on the front line of Asian markets. Most importantly, I loved working with some of the brightest minds on the planet in the world of economics and finance. This included colleagues like Byron Wien, Steve Roach, David Roche and my mentor, the late Barton Biggs. My clients were no slouches either.

All of which reminds me of a very important lesson in investing that I learned from one of the brightest investment minds of that time. In fact, one of the best investment minds of all time. It is advice that has stuck with me, and I believe we can put to very profitable use during the stock market terror we’re experiencing in late 2015. Let me explain …

My boss at Morgan Stanley used to host a very exclusive round-table event each year at the delightful Lyford Cay Club in the Bahamas.

This was a very high-powered group of people, limited to 40 of the firm’s top buy-side clients. These were the key minds behind the biggest brand name money management houses, as well as major hedge funds, mutual funds, and sovereign wealth funds. The biggest of big hitters.

The bulk of attendees were from the United States, with a few from Europe and just a sprinkling from Asia.

Spaces for our bank’s staff were highly restricted. The format involved key analysts from the firm giving short presentations followed by lots of no-holds-barred discussion.

Afternoons were spent on the golf course, fishing, in the gym or hanging around the pool chatting. We’d then have an early evening session, guest speakers, more discussion, and dinner followed by cigars and nightcaps.

Almost three years into my stint at the bank, I was hugely privileged to be invited as the first Asia ex-Japan analyst to attend the event and speak to these legends of finance. Many of these names are still major players in the world of money management today. To rub shoulders with these investing giants in a relaxed setting over several days is something I will always remember.

My first event was in November 1990. The world was entering crisis mode. The Savings and Loan meltdown in the United States was in full swing. The U.S. was entering a recession. Many other Western countries faced the same fate.

The spectacular Japanese bubble was on the brink of bursting. To be honest, Asian emerging markets were only just coming onto the radar screens of major U.S. money managers. But these markets were being crushed by events in the West.

These were bleak times for us in Asian markets, despite regional economies doing pretty well.

The short sellers were having a field day.

On Day 2 there was a heated debate about the state of the U.S. markets and particularly its financial sector. Bank stocks were taking a pounding. At one point, one of the major hedge fund guys stood up, proclaiming loudly “Citibank is going to zero!” Others echoed this view.

Things were looking ugly for Citibank. The stock had fallen by 50% from mid-July to November of 1990.

Maybe the “hedgies” were right – financial Armageddon was upon us. Food for thought – and for a restless night.

On Day 3, at lunch I happened to sit next to one of the all-time-great investment gurus, Sir John Templeton. I’ve mentioned the encounter before – but it was so remarkable that it’s worth repeating. Its conclusion is highly pertinent today.

Sir John lived at Lyford Cay and his fund management firm had a small office there. We shared a fascinating and quiet conversation over our meal.

He had barely said anything over the previous two days. He probably found it difficult to get a word in edgewise given the volume and strength of opinion in the room.

In the late afternoon session, my boss deliberately asked Sir John to comment on his view of the world and how he saw the markets.

After a quick preamble on his Christian faith, he simply recounted the famous adage from Baron Rothschild to buy when there is blood in the streets – even if it’s your own.

“So where are you putting your money these days, Sir John?” my boss quizzed.

“I am buying Citibank and Asian markets,” he replied.

There was a deathly silence from the hedge-fund crowd that had been baying for Citibank blood.

And of course he was right.

As you can see in Figure 1 below, Citibank’s shares bottomed out exactly that month and went on to provide triple-digit gains over the next couple of years.

Citibank stock vs MSCI's emerging markets fund fron November 1988-1992

A Key Lesson

Today, the prevailing sentiment on investing in emerging markets (EM) reminds me of that event in Lyford Cay.

Emerging markets are simply off the menu for a huge swathe of the investing community right now.

Equities, debt and currencies in EMs have all taken a pasting.

There are clear reasons for this. But first, a quick outline of what countries constitute “emerging markets.”

We’re going to use the member nations of the MSCI Emerging Markets index as our general framework.

The constituent countries of MSCI's Global Emerging Markets fund: (Asia) China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan, Thailand. (Europe, Middle East & Africa) Czech Republic, Egypt, Greece, Hungary, Poland, Qatar, Russia, South Africa, Turkey, U.A.E. (Americas) Brazil, Chile, Colombia, Mexico, Peru.

There’s no doubt about it, growth in the emerging market universe has slowed.

Five years ago, emerging market growth was a boisterous 7.2%. The IMF expects that to fall to around 4.2% this year.

Some of the biggest emerging markets such as Brazil and Russia are in recession. The Big Daddy of them all, China, is slowing to a rate of growth not seen in 25 years.

But 4.2% is more than twice the growth rate of the developed world.

Still, as a U.S. dollar-based investor, you have been on the receiving end of a double whammy in many emerging markets. Both stocks and currencies have taken a beating.

Let’s take a closer look at recent EM performance – my apologies if this next section is a little chart-heavy!

Currencies

We start with currencies. They’ve been getting hammered across the entire EM spectrum this year, especially in the past three months. Look at the table below – there’s a lot of red ink there.

Emerging Market's Currencies vs USD in 2015

Some currencies in Asia are flirting with levels last seen during the Asian currency crisis back in 1997/98. And for South American countries, it’s even worse.

The Brazilian Real is down 63% in four years. It is now at its all-time low against the dollar.

Foreign currency denominated debt becomes more expensive in local currency terms to service and repay (for both sovereigns and corporates). This can lead to a deterioration in credit spreads and a higher cost of borrowing.

Equity, Fund and Capital Flows

Not surprisingly, EM equity markets are down year-to-date. The broad measure (using the MSCI Emerging Market Index) is down over 25% since the end of April.

Having said that, there’s a wide range of performance.

In the past three months, India, Malaysia, Korea and the Philippines have fared relatively well, dropping by only single digits in percentage terms.

At the other end of the Asia spectrum, China, Indonesia and Taiwan have seen substantial drawdowns.

Brazil again, as with its currency, is showing signs of free-fall right now.

Emerging Market's Equity Markets - 3 month percentage change 2015

The second element of this equity-market pounding is the level of fund flows that we’ve seen.

If you look at Figure 5 you’ll see that year-to-date equity fund flows out of emerging markets have been huge. In fact, more money has poured out in 2015 that either during the GFC or the big hit in 2011.

Annual Emerging Market Equity Fund Flows 2004-2015

This is reinforced by a look at the number of shares outstanding in MSCI’s Emerging Markets ETF. Since early 2013, the number of shares has dropped by roughly 45%. It shows investors are running for the hills – when ETFs are sold and redeemed, the number of shares outstanding declines.

MSCI Emerging Markets ETF - Shares Outstanding 2013-5

Capital flows are of course closely related to equity and fund flows.

In 2015, EMs are facing a net outflow of capital for the first time since the 1980s. These flows combined with weaker currencies against the dollar will put stress on EM companies with large amounts of U.S. dollar debt in particular.

Credit Concerns

It is not just about equities, but debt also.

Just how creditworthy does the market view these EM sovereign bonds? We can look to the market for credit default swaps (CDS) for clues.

The CDS market shows us the cost of “insuring” our EM sovereign bonds every year (in this case the annual cost over a period of five years). This spread is shown in basis points per year i.e. 100 basis points per year means 1%, so if the five-year credit default swap is 100 basis points, then I pay 1% per year to insure my EM bonds against default.

Note that in all the examples below, we’re looking at the U.S. dollar-denominated debt of these countries, to ensure consistency.

Figure 6 clearly show that since June of this year for Asian emerging markets, and since mid-2014 for major emerging markets outside Asia, credit spreads have widened. The financial world is telling us that the risk of default is increasing

Emerging Markets Sovereign 5 year CDS (Top: Malaysia, Indonesia, Thailand, Philippines, Vietnam. Bottom: Brazil, Russia, Turkey, South Africa)

Headlines

Moving from the “quantitative” world of hard numbers to the “qualitative,” just ask yourself “When I think of emerging markets, what’s my immediate perception?”

Let’s be honest, try as we might, a huge amount of our “perception” is driven by what we’re seeing on TV and reading in the newspapers. It’s hard to filter out the noise, but sometimes it’s worth a little listen, too.

I don’t know about you, but the message I get from most of what I see or read about emerging markets right now is extremely negative.

In fact, I struggle to find anything positive at all.

“Is it time to declare an emerging markets crisis?” – Financial Times, 7th September 2015

“Hedge fund leader bets on emerging market rout” – Financial Times, 21st September 2015

“China, Brazil Among Emerging Markets at Risk of Bank Crisis” – Bloomberg, 14th September 2015

“Fed Rate Caution: China’s Crisis May Spread to Emerging Markets” - Newsweek, 18th September 2015

“ETF Investors Exit Emerging-Market Stock Bets as China Falters” - Bloomberg, 1st October 2015

Why is this of interest? Because when I think back to 1990 in Lyford Cay and Sir John Templeton, it reminds me of just how wrong the general consensus can be, especially when a sector is “hated” so much.

And it reminds me just how much more profitable things can be when you bet against the crowd.

“Emerging markets are universally hated, and investors continue to not find a catalyst for a reversal in performance.” – David Mazza, Head of ETF research, State Street Global Advisors

Please note, I am NOT saying just go out there and buy things that everybody hates!

What I’m saying is that when we see generalisations and consensus in investing, we should be taking a closer look.

There are other causes for concern. The prospect of U.S. interest rate tightening is one of them. Higher U.S. interest rates reduce the attractiveness of assets that are not in U.S. dollars, especially against a backdrop of weakening currencies and a pattern in the rest of the world of cutting rates.

Then there’s all the political risk out there as well just to keep you on your toes!

In Malaysia, the 1MDB scandal has the potential to bring down the political career of Prime Minister Najib Razak (if you’re not aware of the story behind this scandal, I’d strongly recommend you take a few minutes and read this article from Bloomberg).

We’ve also got political instability in traditional EM heavyweights like Turkey.

In Brazil, President Dilma Rousseff’s approval rating is now just 8%. This is already exacerbating currency and equity market selloffs.

And finally, the prices of industrial metals like copper and zinc have collapsed. The price of copper, for ex-ample, is often used as a proxy for consumer demand because it is used in a lot of big-ticket white goods like TVs and refrigerators… and right now it’s at a six-year low. Zinc is at a five-year low.

So emerging markets, which are often the key source of commodities, are facing significant headwinds in terms of their exports. And demand looks to be under pressure as well.

The outlook for emerging markets as an asset class looks bleak…

But has the pessimism gone too far?



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