August 2024 – CC&L Financial Group Ltd.

Investors have long been attracted to emerging market equities for their growth potential and unique investment opportunities. However, consideration of emerging market opportunities in fixed income has been less common. You may be surprised by the investment case for emerging markets credit and how an allocation can contribute to portfolio diversification and enhanced returns, as explored in this article.

Emerging markets credit refers to the debt securities issued by corporations and sovereign entities domiciled in emerging economies. The debt is denominated in either the ‘local’ currency of the issuer, or in currency of a developed market, such as the US dollar, which is referred to as external or ‘hard’ currency credit. Like their developed market counterparts, a credit rating is assigned to distinguish between investment grade and non-investment grade (high yield) debt.

Some of the key attributes of emerging markets credit include:

Large, diversified asset class: combined market value of emerging market local and external currency sovereign and corporate issuers is greater than the US treasury market.
Higher yield: can provide a spread premium over comparably rated, developed market
Less levered: borrowers are generally less levered than borrowers in developed markets
at a similar credit rating.
Lower default experience: default experience has been at a lower rate than comparably rated, developed markets
Diversification merits: low correlation to developed markets credit due to economic cycles and market dynamics being different from those of developed markets provides diversification benefits.

Size of Market

The size of the emerging markets credit issuance may surprise many investors, especially when including both the local and external currency sovereign and corporate market, which when taken together has a market value greater than US treasuries (Figure 1).

Figure 1 – Major Fixed Income Markets

Major Fixed Income Markets	Opportunity Set ($B)
US Treasuries	$23,900
Other Developed markets Sovereigns	$14,700
Emerging markets local currency sovereigns	$11,100
Emerging markets local currency corporates	$10,700
US Agency Mortgage Backed Securities	$8,400
US Investment Grade	$7,800
Emerging markets external currency corporates	$2,500
Emerging markets external currency sovereigns	$1,500
US High Yield	$1,400

Source: JP Morgan

Emerging markets local currency sovereign and corporate credit have the largest market value. From the perspective of the borrower, the issuance of local currency debt recognizes that if a country has significant debt, say in US dollars, and its currency falls relative to the US dollar, the debt becomes more costly to pay back. However, the issuance of external currency debt can help diversify funding sources by allowing the emerging market countries to tap into international capital markets.

From the perspective of an asset manager, the added benefit from investing in emerging markets external currency credit, both sovereign and corporate, is it can help manage the risks associated with local exchange rate fluctuations. Moreover, emerging markets external currency credit is generally governed by New York or UK law, whereas emerging markets local currency credit is subject to the specific laws of the issuing emerging market country. Emerging markets external currency credit also offers a more diversified universe of investment opportunities. The focus of the balance of this article is therefore on emerging markets external currency credit.

Transformation of the Investment Landscape

There has been a significant transformation in the emerging markets credit landscape. In the early 1990s, the indices consisted of just 10 countries and had a heavy bias to Latin American economies. Today, there is a much healthier universe of countries, and unlike the equity market index whose market capitalization is dominated by a small number of countries, the sovereign and corporate credit indices are much more diversified in terms of country representation (Figure 2).

Figure 2 – Emerging Markets Sovereign and Corporate Credit Index

*JP Morgan EMBI Global Diversified Index **JP Morgan CEMBI Broad Diversified Index

Source: JP Morgan, Bloomberg

There has also been a healthy annual issuance of emerging markets credit, with corporate issuance tending to be a larger component of the issuance compared to sovereign credit (Figure 3).

Figure 3 – Emerging Markets Credit Issuance

Source: JP Morgan & FortWood Capital

Key Merits of Emerging Markets Credit

Higher yield: emerging markets credit market offers a spread premium over comparably rated developed markets peers due to perceived higher risks. Currently emerging markets offer some of the highest yields since the global financial crisis (Figure 4).

Figure 4 – Emerging markets credit yield vs. US 10-year treasuries

Note: EM Sovereign Index – EMBI Global Diversified, EM Corporate Index – CEMBI Broad Diversified
Source: JP Morgan, Bloomberg

Emerging markets are often susceptible to political and economic volatility. Changes in government, policy shifts, and geopolitical tensions can impact the creditworthiness of issuers. Sovereign credit also tends to have a longer duration (sensitivity to interest rate changes) and when combining these factors has led to emerging markets sovereign credit generally offering higher yields than emerging markets corporate credit.

Less levered: the perceived risk of emerging markets credit is not always justified despite the higher yield. For example, emerging markets corporate issuers, both investment grade and high yield, carry less debt relative to their ability to generate cashflow to service that debt, and are less levered than developed markets borrowers at the same credit rating (Figure 5). Despite carrying less leverage, emerging markets bonds have generally provided higher yields to investors for the same credit rating.

Figure 5 – Net Leverage Comparison

Source: JP Morgan (as of 2023) & FortWood Capital

Lower default experience: emerging markets issuers have historically defaulted at a lower rate than comparably rated developed markets peers (Figure 6). Many emerging markets exhibit robust economic growth, which can support the creditworthiness of issuers. For example, higher economic growth can increase corporate revenues, making the repayment of debt easier.

Figure 6 – Emerging markets corporates default less than developed markets peers
Average 10 year cumulative default rate (1981-2020)Source: S&P Global Ratings Research & FortWood Capital

Diversification merits: the economic cycles and market dynamics of emerging market countries often differ from those of developed markets. The different experience reduces the correlation, thereby providing a source of portfolio diversification. Investing across different countries, sectors, and issuers can reduce the impact of localized issues and enhance overall portfolio resilience.

Portfolio Construction Considerations

Currency management: for Canadian investors to manage any undesirable impact of fluctuations between US dollar denominated emerging markets credit and the Canadian dollar (CAD), the portfolio is typically hedged back to CAD, providing more predictable returns. This can be achieved in a cost-effective manner by the investment manager of the strategy using currency forwards, or other currency instruments.

Liquidity: emerging markets credit is generally a liquid asset class. For example, the liquidity of emerging markets corporate credit bonds is broadly comparable to that of developed market corporate bonds in normal market conditions.

Active management: there are numerous idiosyncratic economic and policy cycles across the different countries, which can contribute to added value opportunities for active managers. Also, like for emerging market equity, there are fewer sell-side research specialist for emerging markets credit compared to developed market credit, which creates opportunities for independent research. Skilled active managers can navigate market nuances, identify attractive opportunities, and adjust exposures in response to changing conditions.

Responsible investing: despite the political and social challenges associated with emerging market countries, governments and companies are increasingly recognizing the importance of environmental, social and governance (ESG) considerations.

Seize the Opportunity

Emerging markets credit presents a compelling investment opportunity with potential for higher yields, diversification benefits, and exposure to high-growth economies. Emerging markets credit can be a valuable addition to a well-rounded investment portfolio.

The assessment here remains that the global economy has entered a “double dip” currently focused on manufacturing but likely to extend to services / labour markets, reigniting worries about a hard landing. Economic weakness is expected to be accompanied by an inflation undershoot into H1 2025.

DM flash manufacturing PMI results for August were mixed across countries but on balance weak, suggesting a further small reduction in global manufacturing PMI new orders following a July plunge to below 50 (assuming no change for China and other non-flash countries) – see chart 1.

Chart 1

Services results were again much stronger than for manufacturing but there are hints of emerging weakness in a fall in output expectations since May and a drop in US / Eurozone employment indices to below 50 this month.

A previous post suggested that the OECD’s US composite leading indicator has reversed lower since publication of the last official data point, for June. An update based on partial data points to a further decline in August – chart 2. The OECD will release July / August data for its indicators on 5 September.

Chart 2

The OECD’s Chinese leading indicator has been falling since late 2023 and the decline is estimated to have continued in July / August – chart 3.

Chart 3

Weaker economic momentum and pricing power are feeding through to company earnings. Revisions ratios have turned down since April in the US, Eurozone and UK, with the August Eurozone reading the weakest since 2020 – chart 4.

Chart 4

By MSCI World sector, August revisions ratios were most negative in consumer discretionary followed by energy, consumer staples and materials. The ratios for consumer discretionary and staples were the weakest since 2020, suggesting that a fall-off in consumer demand has been a key driver of the renewed downturn in manufacturing – chart 5.

Chart 5

This week’s announcement by the BLS of a preliminary 818,000 or 0.5% downward revision to the March 2024 level of non-farm payrolls, meanwhile, raises the possibility that US employment has already stalled.

The revision is based on the comprehensive Quarterly Census of Employment and Wages (QCEW). A monthly QCEW employment series is available through March but is not seasonally adjusted. Chart 6 compares the monthly change in non-farm payrolls, as currently reported before incorporating the revision, with the change in a seasonally-adjusted version of the QCEW measure.

Chart 6

The increase in non-farm payrolls was 133k per month higher than growth of the seasonally-adjusted QCEW series during Q1. If overstatement of this magnitude has continued since Q1, reported growth of 108k and 114k in non-farm payrolls in April and July could imply small declines in “true” employment in those months.

On May 15, 2024, Singapore swore in its first new prime minister in 20 years. Lawence Wong, at the age of 51, previously the deputy prime minister, succeeded Lee Hsien Loong.

While Lee Hsieng Loong is the son of Lee Kuan Yew (the founding father of Singapore), Lawence Wong was born to a family he described as ordinary, growing up in a public housing flat. He started his career as an economist at the Ministry of Trade and Industry (MTI), and later held several important positions in energy, culture, national development, education, healthcare and finance, among other departments.

Last week, Wong delivered his maiden National Day Rally speech and called for major reset of policies and attitudes. He is expected to keep the city-state as open as possible, maintaining independence through a wide network of bilateral and regional free-trade agreement. He pledged to look after various groups of Singaporeans, including the elderly, families and lower-income households. A few highlighted policy changes from his speech include: more paid paternity leave and shared paternity leave; temporary financial help for lower and middle-income workers who lose their jobs; discontinuation of the Gifted Education Program in primary schools; increasing support for affordable housing; and strengthening of the sporting culture.

A top-5 country by GDP per capita

Once known as one of the four Asian Tigers, Singapore experienced rapid economic growth thanks to exports and industrialization between 1960s and the Asian Financial Crisis of 1997. The 2000s were a tumultuous period for the country, however. Faced with the dot.com bust, SARS and the global financial crisis, Singapore restructured and diversified its economy. It began to bounce back, and is now the fifth richest country in the world based on GDP per capita, according to The Economist.

Resilient economic growth

2024 Q1 GDP growth of 3.0% and Q2 of 2.9% were both better than expected. Last week, MTI raised Singapore’s annual GDP growth forecast in 2024 to 2-3%, adding that external demand outlook is expected to be resilient for the rest of the year. Growth sectors will be manufacturing (especially electronics related to smartphones, PC, and AI-related chips), chemicals, tourism, aviation, finance and insurance.

A home to multinationals

Singapore and Hong Kong have traditionally been viewed as rivals, attracting many international companies and talents to work and live there. But Hong Kong’s ever-closer ties with mainland China have raised increasing concern among some people about democracy and safety, causing more and more foreign companies and foreign nationals to leave Hong Kong for Singapore. While Hong Kong’s standard corporate tax rate is as low as 16.5%, Singapore’s 17% tax rate can be cut to 13.5% or less for some activities. As a matter of fact, Singapore was regional headquarters to 4,200 multinational companies in 2023, compared to 1,336 in Hong Kong. A list of such companies includes FedEx Corp., Microsoft Corp., Google, TikTok, Shein and General Motors Co., etc. The often-cited reasons for this big gap are better relations with the West, a broader talent pool, diversified economy, and tax incentives.

Asia’s top financial center

According to the latest 2024 Global Financial Centres Index, Singapore overtook Hong Kong for the third year in a row to become Asia’s top financial center, ranking third globally, behind New York and London. Singapore has also become an attractive asset management hub. Wealth overseen has doubled in the past six years, to about US$4 trillion, and about 80% of that is foreign. Government initiatives are the key driving forces. For example, in 2020, the government introduced a new legal structure called a variable capital company that provides tax and legal incentives to hedge funds, venture capital and private equity firms to set up in Singapore, comparable to Cayman Islands and Luxembourg.

Singapore’s economic backyard is Association of Southeast Asian Nations (ASEAN), a 10-nation region with a population of 680 million and an economy of US$3.6 trillion. Singapore’s stable political climate and high living standards make it an ideal destination for high-net-worth individuals and global financial professionals.

Our portfolio holding in Singapore – Raffles Medical Group

Founded in 1976, Raffles Medical is Singapore’s largest homegrown private healthcare provider and the first member in Asia to join the Mayo Clinic Care Network. It owns four hospitals and over 100 clinics in five countries including Singapore, China, Japan, Vietnam and Cambodia. It has over 7,000 corporate clients and 2.2 million patients.

Covid impacts on the company were mixed. On the one hand, hospital development in China was seriously delayed. On the other hand, Singapore business accelerated thanks to government-related Covid services.

Like many stocks that benefited from upticks in Covid-related revenue, Raffles Medical experienced tough comps following the pandemic. However, we are very confident about its growth potential thanks to its strong reputation in the industry, net cash position and consistent growth strategy in Asia.

Since February 2024, Dr. Loo Choon Yong, the owner and founder of Raffles Medical, has spent almost S$35 million of his own money to buy back shares in his company.

New chapter for Singapore

Although Singapore came into being only in 1965, it has developed from a red dot to a shining star in Asia. Looking ahead, Lawrence Wong, the fourth Prime Minister, will have to navigate through a challenging time with increasing geo-political tension, weak global economy and deglobalization. His party’s popularity will be tested, as will his personal popularity, in the general election to be held no later than November 2025. Let’s hope Singapore’s best years are ahead of us.

The questioning of the no/soft economic landing narrative and the partial unwind of the yen carry trade have seen equity markets whipsaw in recent weeks. While we are always scrutinising the fundamentals of the companies we own, and the wider investment universe, it is in periods of high uncertainty like this where our incorporation of macro analysis is vital. This helps us navigate the risks, opportunities and regime change which can occur when volatility skyrockets.

VIX Index explodes as US recession fears rise and yen carry reverses
Source: NS Partners & Bloomberg

Goldilocks thinking unravelling

Last October we published a piece warning against complacency in markets, given a poor monetary backdrop signalling economic weakness ahead – Is this a Wile E. Coyote moment for markets?

Our view was that central banks were maintaining policy that was unnecessarily tight and that a rosy consensus on the macro outlook appeared misguided:

The delayed impact of vertiginous rate hikes across DMs on all maturing debt is now hitting consumption and investment. Yet central banks continue to talk tough and market pundits fret over the implications of “higher for longer rates.” It feels like we are in a critical juncture for markets and the economy. Resilience of assets outside of fixed income appear out of step with the reality of higher rates and a weakening global economy, as illustrated by global PMIs falling for a fourth consecutive month.

Poor money numbers globally suggest that further economic contraction is likely. Despite this, central banks continue to talk tough on rates and many investors cling to hopes of a no landing/immaculate disinflation scenario unfolding, despite the cracks emerging in the global economy.

This underpinned a shift to a more defensive portfolio exposure in the expectation that economic growth was set to surprise to the downside over the next “3-6 months.”

In hindsight this was slightly early. What we missed was the buffer provided by the huge stock of money built up during the pandemic, cushioning the economy from rapid monetary tightening.

However, as you can see in the chart below, this stock has been burnt down below the pre-pandemic trend.

Money stock below trend

Source: NS Partners & LSEG Datastream

The effects of tighter liquidity are now flowing through to the real economy, with global manufacturing PMIs falling sharply in July.

PMI dip corresponds to low in six-month real narrow money momentum a year earlier

Source: NS Partners & LSEG Datastream

Investors panicked in late July as deteriorating US employment data set off calls for the Fed to deliver an emergency rate cut before the September FOMC meeting.

Unemployment boosted by a sharp rise in temporary layoffs (ex-temp rate is also trending higher)

Source: NS Partners & LSEG Datastream

Japan’s attempt to exit zero interest rate policy (ZIRP) roils markets

Meanwhile in Tokyo, the Bank of Japan announced that it would take steps to end decades of unconventional monetary policy by raising rates, with an eye to acting against signs of inflation and currency weakness. The hawkish turn saw the yen surge relative to the USD, blowing up speculators shorting the yen. It also forced the unwind of some carry trades exploiting lower interest rates in Japan by borrowing in yen, and then investing in currencies with high rates such as the USD, Mexican peso or Brazilian reai.

JPY surge leaves it still lagging collapsing yield spreads

Source: NS Partners & LSEG Datastream

Japan’s decades-long deflationary trap has been the basis for BOJ monetary experiments going back to the 1990s, which gave rise to the yen carry trade phenomenon. Financial historian Russell Napier recounts the “rise of carry” in his book The Asian Financial Crisis, emphasising its tendency to yank liquidity from markets in response to shifts in monetary policy:

What has changed to turn global equity markets bearish? The only surprise over the past few weeks has come from Japan. In the United States, the bond market has been well behaved, the shape of the yield curve unchanged and Greenspan’s comments supportive. Earnings growth in the United States has been ahead of expectations. However, in a three day period, the yen rallied 3.1% against the US dollar on speculation that Japanese interest rates would rise. This currency movement would appear to be the catalyst for the sell-off.

The sudden strength of the yen is indicating that the flow of excess liquidity out of Japan had been the source of liquidity which had been driving the US equity and bond markets. The reason that the flows overseas are probably abating is that the economic recovery in Japan is requiring these funds. The period of history when an accommodative stance by the BOJ drove markets is over.

The experience of July 1996 that Napier recounts rhymes with today’s volatility, fed by speculators who had borrowed yen to finance investments in the US and other markets forced to liquidate positions to buy yen and reduce yen borrowings.

Tech names routed

When liquidity drains out of a market, it is often the “speculations of choice” which are hit hardest, as investors sell profitable trades to raise cash. Names with exposure to the boom in enthusiasm for AI technology were among the victims of the unwind, an example of where liquidity can overwhelm even stellar fundamentals.

July pullback for tech as defensive sectors such as healthcare outperform

Source: NS Partners & LSEG Datastream

Buy the dip or steer clear?

In the lead up to July, we had been steadily reducing our above-benchmark exposure to IT names in the GEM strategy, and now maintain a modest overweight. Much of this shift has been through selling down more niche semiconductor names which rallied hard on demand for AI chips. The highest quality names such as TSMC were hammered through July despite posting outstanding results, and look attractive at these levels.

Our view is that the risks of carry trade unwind will ultimately be constrained by economic realities in Japan (despite the domestic unpopularity of yen weakness).

Broad money weakness suggests that the BoJ’s latest attempt to exit ZIRP will be no more successful than previous efforts in 2000 and 2006

Source: NS Partners & LSEG Datastream

The monetary backdrop in Japan suggests that all is not well in the economy, and that raising rates will make the situation worse. However, it is entirely possible the BOJ will look to push its luck again. In addition, while speculative bets against the yen have been reduced significantly, JGB yield spreads versus US Treasuries suggest potential for further yen strength. Given this backdrop, our bias is to avoid reflexively buying dips here.

Implications for EM

Last month’s commentary made the case that the vicious cycle weighing down emerging market equities was coming to an end: Are emerging markets on the cusp of a “virtuous circle”?

It emphasised the importance of a weak dollar and supportive liquidity as key drivers of EM outperformance. While the slowing economy and carry trade volatility warrant some caution over the next few months, they may also support a shift to a backdrop more supportive of EM equities in the long run.

Big move down in the USD on slowing US economy and carry trade unwind

Source: NS Partners & Bloomberg

It argued that the balance of factors we monitor to assess prospects of EM vs DM equities (relative money growth, global excess money, valuations, earnings, industrial momentum, commodity prices and USD strength/weakness) favours EM for the first time in years. Recent downward moves in Treasury yields and the dollar support the positive trend. Although global money growth has slipped with poor numbers in China and Japan.

Favour liquidity sensitive exposure

The tech cycle upswing and the story of India’s rise up the development ladder have dominated EM returns in recent years. While these trends remain intact, a falling dollar and Fed cuts are likely to see other winners emerge. This easing is set to take pressure off EM central banks forced into tight monetary policy to stabilise their currencies. This should boost the prospects of more liquidity sensitive economies, which are typically open, trading economies with managed exchange rates.

Indonesia is a potential winner in this respect. Its central bank surprised investors with a Q2 rate rise to support the rupiah, leading to a market selloff. US Fed cuts and a dollar bear market should allow for a shift to monetary easing in Indonesia to prevent excessive appreciation of the currency that would harm the competitiveness of its exporters.

US Treasuries yields falling

Source: NS Partners & Bloomberg

As well as rate cuts, easing would likely involve the central bank buying US dollars from Indonesian commercial banks, crediting the banks’ reserve accounts in payment. Additional reserves would encourage bank lending and money creation, with positive follow-through to asset prices, economic growth and corporate earnings, consistent with the virtuous circle sketched out below. While fundamentals matter, we think it pays to understand how liquidity can often act to shape these fundamentals, particularly in emerging markets which are highly sensitive to the monetary backdrop.

Virtuous liquidity circle

Source: NS Partners

The most important issue in the global economic outlook is the meaning of Chinese monetary weakness.

Six-month rates of change of narrow / broad money, bank lending and total social financing (on both new and old definitions*) reached record lows in June / July – see chart 1.

Chart 1

Monetary weakness has been entirely focused on the corporate sector: M2 deposits of non-financial enterprises plunged 6.6% (13.6% annualised) in the six months to July (own seasonal adjustment) – chart 2.

Chart 2

Recent regulatory changes appear to account for only a small portion of the corporate broad money decline.

A clampdown on banks paying interest above regulatory ceilings has resulted in a shift out of demand deposits but money has largely stayed in the banking system – available data suggest modest inflows to wealth management products and other non-monetary assets.

The clampdown has also discouraged the practice of “fund idling” (round-tripping in UK monetary parlance), whereby banks offered loans to corporate borrowers to meet official lending targets, with borrowers incentivised to hold the funds on deposit.

If an unwinding of such activity accounted for the decline in corporate money, however, short-term bank lending to corporations would be expected to show equivalent weakness. Such lending has continued to grow, albeit at a slower pace recently, as have longer-term loans.

A trend decline in the ratio of corporate M2 deposits to bank borrowing, therefore, has accelerated – chart 3.

Chart 3

Household money holdings, by contrast, have been growing solidly – chart 2. An alternative explanation for the corporate money decline is simply that households are still hunkering down as the property crisis deepens, with weakening demand for consumer goods / services and housing transferring income and liquidity from the corporate sector.

The latest PBoC and NBS consumer surveys confirm rock-bottom sentiment – chart 4. If this explanation is correct, corporate money weakness may presage a collapse in profits – chart 5.

Chart 4

Chart 5

Why hasn’t the PBoC hit the panic button? Policy easing has been constrained by currency weakness: the most comprehensive measure of f/x intervention (h/t Brad Setser) reached $58 billion in July, the highest since 2016 – chart 6. The recent yen rally has offered some relief, reflected in a narrower offshore forward discount, but the authorities may be concerned that this will prove temporary.

Chart 6

The strange policy of trying to push longer-term yields higher against a recessionary / deflationary backdrop may represent an attempt to support the currency, rather than being motivated primarily by concern about financial risks. To the extent that the policy results in banks selling bonds, however, the result will be to exacerbate monetary weakness and economic woes.

*The previous definition excludes government bonds so is a measure of credit expansion to the “real economy”.

This summer has been anything but calm in financial markets, despite the distractions from the Olympics and constant political headlines. Global equities have declined, with the MSCI ACWI falling 8.3% from its July 16 peak before finding a bottom in early August. The biggest price moves were seen in Asia, led by the Nikkei that fell 25% over three weeks, but other markets including South Korea and Taiwan also declined significantly. The sell off was rapid and accelerated in the wake of the July 30 Federal Open Market Committee (FOMC) decision to keep interest rates unchanged.

Three key events piled on top of each other over this period, and drove a material risk-off move across global markets. First, data releases following the FOMC decision showed evidence of a significant slowing economy. The US ISM Index dropped to its lowest level of the year at 46.8, with the employment and production components, in particular, dropping to their lows for the year. US employment also disappointed on the headline gain of 114k, but notably the unemployment rate rose to 4.3%, more than half a percent above recent lows, which is historically a signal of a recession. Second, the world’s most dovish major central bank, the Bank of Japan (BoJ), surprised markets with an interest rate increase on July 31, from 0.1% to 0.25% and slowed the pace of its bond buying by half. This narrowed the anticipated spread on Japanese and US rates as the respective central banks policies diverge. This, in turn, caused the Japanese yen to appreciate relative to the US dollar from 162 to 145. The outcome was to reverse the attractive characteristics surrounding the Japanese yen carry-trade that profits from borrowing at low Japanese rates in a cheap currency and investing in higher yielding assets in other countries. Japanese companies, many of which are global conglomerates that will be hurt by a rising yen, also saw their share prices sell off. Third, US mega cap technology companies reported generally softer earnings, and investors questioned when the mass investment into AI related technology companies would finally pay off.

The messages beneath the surface

Even without the main triggers of the recent volatility, it has become evident that simply put, valuations have gotten rather expensive (see Chart 1). It is hard to see much upside to stocks overall, given they were priced for a pretty optimal scenario of decelerating inflation, steady growth and easing rates. Stocks were basically priced for a perfect outcome, with positioning consistently searching for upside and not protecting for downside. Indeed, beneath the surface, the rotation in stocks has been telling. US equities had been driven by a narrow group of stocks (Magnificent 7), that were increasingly being culled from 7 towards just 1 (Nvidia). This implied that on a capitalization-weighted basis, the gains were driven by fewer stocks, and reached a 40-year high relative to an index that weighted every stock equally (see Chart 2). However, during these past weeks, that trend began to reverse. The very expensive mega cap stocks were sold in favour of other industry groups. The broadening in leadership even saw small cap stocks outperform, at the same time as the utilities, consumer staples and real estate sectors, a highly unusual concurrence.

Chart 1: Valuations are high

Source: I/B/E/S

Chart 2: Narrow leadership was over-extendedSource: S&P Global, Macrobond

Moreover, equity market volatility spiked to an unusually high level during this period (see Chart 3). Intraday, the VIX Index jumped to its third highest level on record after the 2008 Lehman Brothers collapse and the onset of the Covid crisis in 2020. It’s especially unusual to see the surge in uncertainty, without a clear trigger event. It is also telling that gold prices actually sold off during the worst days in early August. All of this suggests that the market was experiencing a broad liquidation from extreme positioning, rather than a material risk-off event. Indeed, markets rebounded and settled down in the following few days.

Chart 3: Intraday volatility spiked to third highest level on record

Source: Chicago Board Options Exchange (CBOE), Macrobond

Where are we going from here?

Taking stock of the recent moves and sentiment, it appears that markets are looking somewhat vulnerable at the moment. Refocusing on fundamentals, it would seem that either growth needs to rebound or risk assets will look for soothing via central bank rate cuts. Worth noting however is that any emergency inter-meeting or outsized cut would likely be interpreted poorly, as a signal that something is terribly wrong. The former growth rebound scenario may still be possible – we have been through a see-saw period of financial conditions that led to rapid responses in the economy, and this recent period has seen conditions ease. But we are cautious about the prospects for a growth resurgence at this time. Spending is critical and it typically relies on people having and keeping their jobs. The trend in employment data suggest a deterioration in labour markets is underway. But more recently, we have noted that an increasingly important factor in confidence to spend relates to the wealth effect. Indeed, since the pandemic, new households, particularly those in the lower net worth groups, have started to become shareholders, taking their stimulus cheques and putting that into stock markets (see Chart 4). The values of both stocks and homes have gone up significantly, but both are now wobbling. As rate cuts begin, this should provide some support. However, where policy easing will have the biggest support is in countries with high levels of debt held at variable rates or with high turnover of debt. That is exactly the opposite of the US, where private sector debt has largely been termed out. For instance, much of the stimulus in the US arises from the refinancing activity of mortgages when interest rates drop. However, a significant portion of American households have 30-year mortgages with effective rates in the mid-3% range. With current rates in the US around 6.75%, mortgage rates have a long way to go to even start consumer stimulus (see Chart 5).

Chart 4: Change in equity markets mattering for a growing group of US households
Equity participation by wealth distribution in the USSource: Federal Reserve, Macrobond

Chart 5: Mortgage refinancing has flatlinedSource: MBA, Bankrate, Macrobond

Putting all of this together, markets are growing guarded, and becoming more attuned to a growth slowdown. Spending is becoming more cautious with less support in the US from anticipated rate cuts, all while the unemployment rate is climbing. Sentiment towards the AI boom is wavering and the last cheap place to borrow in the world has signaled the party is now over. Change is afoot in terms of market themes that have dominated in recent years, and volatility is likely to stay elevated.

Capital markets

Equity markets were broadly positive through the second quarter up until mid-July. The stability of US economic data and easing inflation supported the goldilocks outlook despite the myriad of surprising election outcomes globally, US election gyrations and escalating geopolitical tensions. Central banks began easing synchronously, with the Bank of Canada joined by the BoE, ECB and SNB. In the second quarter, the MSCI ACWI rose 4%, taking gains for the first half of the year to 15.5%. The Magnificent 7 drove the S&P 500 to all-time highs, posting a 5.4% gain in Q2 for a 19.6% first half performance, before the volatility set in through July. Second quarter earnings growth, with about 80% of companies having reported, continued at a strong pace, albeit moderating slightly from Q1. The TSX Composite lagged relative to broader equity markets, edging down 0.5% in Q2 for a more modest 6.1% gain in the first half. In mid-July, the market tone shifted and the TSX posted a 5.9% gain for the month, with a reversal in leadership notably favouring defensive sectors.

Though there has been much equity market volatility, currency and bond markets were, at least relatively, tamer. In Q2, the FTSE Canada Universe Bond Index rose 0.9%, and advanced a further 2.4% in July following the spate of weak data noted earlier. While day to day moves were generally orderly, short term interest rates in both Canada and the US dropped by nearly a full percent in the third quarter, as investors looked for safety in bonds. Credit spreads widened, alongside the risk off tone. While volatility has been evident in equities, it appears contained for now as demand for credit surfaced and issuance remained surprisingly strong through this rocky period as issuers looked to take advantage of lower rates and any positive tone. Important bond market moves included the widening in French spreads relative to other eurozone countries, given its large deficit and high government debt level drawing concerns following the outcome of the French legislative election. Commodities were broadly weaker, with declines in industrial metals, agriculture and energy.

Portfolio strategy

Confidence in a soft-landing has been high over the past year and equity markets priced in anticipation of that goldilocks scenario. This past month, a new environment has emerged. Anxiety among market participants has now shifted from inflation to growth. As a result, much of what was priced in before has been reverting, and markets are still adjusting to the changing dynamics of the yen carry trade and concern over when to expect a return from the massive investments in AI. While this anxiety persists, markets are pressuring central banks to provide stimulus, pushing short term interest rates lower. But in order to meet that demand, inflation trends need to continue declining, which is likely but not certain. Uncertainty and volatility are likely to persist over the second half of the year. As a result, we are shifting portfolio holdings towards more defensive stocks and away from cyclical stocks that are more tied to the health of the economy. For example, we are adding to utilities and consumer staples companies. Fixed income portfolios continue to hold positions that benefit when the yield curve normalizes away from inversion, while holding a modest underweight in corporate credit. Balanced portfolios remain modestly underweight equities and overweight bonds and cash, and we lean towards increasing this defensive posture if an economic downturn proves more durable. On a positive note, periods of volatility often create good opportunities, and we are on alert for stretched valuations while remaining prudent and cognizant of the growing risks.

Can the Japanese bubble of the 80s serve as a warning for the US real estate and stock markets today?

The mid to late-80s were the years of Japan’s “bubble economy”. A time when the country was at its economic peak. A time when everything was made in Japan and Japanese companies would conquer the world. A time when the US put tariffs on Japanese goods and engineered a currency accord that meant a rapid appreciation of the yen.

Consider a few historical economic facts about Japan around that time.

At the end of 1989, the Nikkei 225 stock market reached 39,000, a historic high it would only see again in 2024.
The Japanese property market was worth four times more than the US property market. It was rumoured (although not for sale) that the land on which the Japanese emperor’s imperial palace sits was worth more than the entire state of California.
By 1989, the market capitalization as a percentage of GDP was 151%, while it was 62% in the US.
Over the same time period, Japan represented 42% of global equity markets. This was almost 18% of the global economy, or approximately 71% of that of the United States.

Those were the heydays for Japan. And then came the decline.

So, what caused the crash of both real estate and stock market? There are several reasons, but two stand out:

First was the Bank of Japan (“BOJ”) was too slow in tightening, creating an asset bubble. One reason given for the reluctance of the BOJ was the US stock market crash in October 1987 (aka Black Monday).
Second was the rapid appreciation of the yen following the Plaza Accord of September 1985 when most major economies agreed to depreciate the US dollar.

US dollar / Japanese yen exchange rate
Source: Bank of Japan

Now, let’s look at the US in the 2020s.

The relentless rise and outperformance of the US stock market(s) over the last few years has led many to believe it is entirely justified and pointless to diversify beyond the US market – but that narrow perspective comes at a cost.

Let’s review a few facts, keeping in mind our description of Japan’s bubble economy:

The US stock market is now 65% of the MSCI ACWI (All Country World Index), while the US economy is only 25% of the global economy.
By sharp contrast, the second largest country in MSCI ACWI is Japan, with a weight of 5%. Its economy is about 4.5% of the global economy.
The weight of China, the second largest economy with 18% of global GDP, is only 2.6% of the MSCI ACWI. That is less than the market cap of Alphabet (Google). Indeed, the individual market cap of Apple, Microsoft and Nvidia are all higher than any single stock market in the world, except Japan.

So, is the US market in a bubble at the moment?

A favourite bubble indicator used by Warren Buffet, is the ratio of the US total market cap over GDP. As seen in the following chart, that ratio is currently around 190% (and helps explain Warren’s approximate $300B cash pile).

US ratio of total market cap over GDP
Source: public

As a comparison, the same market-to-GDP metric applied to China is 61%, 48% for Germany, and 71% for the UK.

Japanese vs US stock market: 1975-2024

Source: Dallas Federal Reserve

Moving to real estate, US housing prices are at an all-time high, and housing affordability has hit the lowest level on record this month.

US vs Japanese housing prices: 1975-2024

Source: Dallas Federal Reserve

This commentary is not meant to signal an imminent crash of US house prices or stock market. Rather, it is just meant to show how we are in uncharted territory, and how looking at what happened to the Japanese economy could help navigate the present US economy.

Consider some events from the past few years:

Did the decision to raise rates come too late, potentially lead to an inflated asset bubble?
Has the US dollar shown signs of strengthening against other currencies?
Is the fiscal deficit in the US inflationary?
Is the US resorting to tariffs?

Arguably, the answers to all the above would be “Yes”. This begs the question – should we consider the similar historical context of both economies?

Given what I’ve said earlier on the narrow perspective of investors flooding the US market in the last year, there are many troubling signs on the horizon, while there is continued growth in the US market, it would be prudent to consider diversification – now more than ever.

And as a conclusion, here is a graph of the S&P 500 in a past period.

S&P 500 Index: 1928-1949

Source: public

A sharp fall in the global manufacturing PMI new orders index in July confirms renewed industrial weakness. The companion services survey, however, reported an uptick in the new business component, which is close to its post-GFC average. Will services resilience sustain respectable overall growth?

The understanding here is that economic fluctuations originate in the goods sector, reflecting cycles in three components of investment – stockbuilding, business fixed capex and housing. Multiplier effects transmit these fluctuations to the services sector – there is no independent services cycle.

The manufacturing new orders and services new business indices have been strongly correlated historically, with Granger-causality tests indicating that the former leads the latter but not vice versa*.

Several considerations suggest that the recent divergence will be resolved by the services new business index moving lower:

1. The services future output index correlates with new business and fell to an eight-month low in July – see chart 1.

Chart 1

2. Recent new business readings have been inflated by strength in financial services – chart 2. Financial services new business correlates with stock market movements, suggesting weakness ahead.

Chart 2

3. Consumer services new business correlates with the manufacturing consumer goods new orders index, which fell below 50 in July – chart 3.

Chart 3

Output price indices for consumer goods and services support the optimism here about inflation prospects through mid-2025. A weighted average has fallen back to its October 2009-December 2019 average, a period in which G7 annual CPI inflation excluding food / energy averaged 1.5% – chart 4.

Chart 4

*Contemporaneous correlation coefficient since 1998 = +0.84. Granger-causality tests included six lags. Manufacturing terms were significant in the services equation but not vice versa.

The strategy focuses on investing in frontier and emerging market companies that our team expects will benefit from demographic trends, changing consumer behavior, policy and regulatory reform, and technological advancements.

Below, we explore several key factors influencing returns and share observations on the portfolio and the markets.

Retail Portfolio

The strategy saw healthy returns during the period from the ASEAN retail portfolio, led by Philippines Seven Corp. (the master franchisee of 7-11 stores in the Philippines) and Mr. DIY Group (the multi-price point value retailer in Malaysia).

Our investment in Philippines Seven Corp. (SEVN) is premised on its first-mover advantage in convenience store (CVS) retailing in the country. As of the end of March 2024, SEVN has a network of 3,829 stores, ~9x that of its closest competitor. The magnitude of SEVN’s scale advantage is perhaps best captured by the fact that its annual store openings nearly match the entire store network of its closest competitor. Scale and location are key success factors in convenience retail, especially in an archipelago where an efficient and agile supply chain requires significant capital and operating investment.

From a top-down perspective, the Philippines’ large and young population (+100 million people with a median age of 25), expanding cities, and growing tourism sector should provide a long growth runway for CVS retail, resulting in a narrowing of the penetration gap (measured in CVS stores per capita) with neighboring countries like Malaysia and Thailand.

In addition to scale, location, and market opportunity, SEVN’s management team has proven over the years to be formidable operators and good stewards of shareholder capital.

Our team turned more bullish on SEVN at the end of last year, encouraged by evidence of an inflection point in store productivity, resilient operating margins, and an acceleration in store openings. Unusually, the stock was trading at all-time low multiples despite the company reporting three consecutive quarters of strong results. The team also identified a catalyst for the shares in the form of an expectation that SEVN will resume paying dividends after a three-year hiatus due to an SEC (the Philippines Capital Markets Regulatory Agency) mandated technicality. This technicality resulted from the implementation of IFRS 16 accounting standards in the Philippines in 2019. For SEVN, the capitalization of leases mandated by IFRS 16 standards created a large, deferred tax asset which, according to SEC rules, is deducted from the retained earnings base from which the company can pay dividends. On a recent earnings call, management estimated that the company is sitting on twice the amount of cash it needs to run and grow the business due to its inability to pay out excess cash. As SEVN’s operations accumulated cash (reaching ~20% of its market capitalization), retained earnings finally exceeded the regulatory hurdle above which dividends can be paid, and management was able to recommend a dividend to its board. Furthermore, management announced it is in the process of crafting a dividend policy that will entail distributing excess cash on an annual basis, a positive step.

Mr. DIY Group’s (MDIY) shares benefited from the anticipation of a recovery in demand from the B40 group of Malaysian households (B40 refers to the bottom 40% income group). This optimism stemmed from the restructuring of the Employee Provident Fund (EPF), which created a new “flexible” sleeve that allows for early withdrawals from beneficiaries below the age of 55 (previously, early withdrawals were only possible for critical needs like healthcare, housing, and education). The expectation is that this new feature (effective from May 11, 2024) will support disposable incomes and lead to a boost in spending among the B40 group.

MDIY is well-positioned to benefit from this given it is over-indexed to shoppers from the B40 group. For context, the company operates 1,283 stores in Malaysia (as of the end of March 2024) and has been expanding stores at a net rate of ~150 per year since 2017. This rapid expansion in stores has been internally funded by a highly cash-generative business model characterized by fast breakeven periods on new stores (2-3 years), reflected in industry-leading returns.

This profitability is supported by a virtuous cycle of supply chain optimization and store-level operating efficiency that enables the company to invest in price and offer shoppers value-for-money across the +10k SKUs it carries on its shelves. Low prices and new store expansion drive demand and larger volumes, which the company uses to negotiate with suppliers and unlock further discounts. Overlaying that cycle is a highly scientific approach to SKU management, which ensures optimized inventory turnover and minimizes drags on operations and the shopping experience. MDIY has also become more progressive with dividends in the last twelve months, with a quarterly payout policy of 50-65% of earnings, an appropriate level that balances the company’s strong cash position and growth requirements.

Internet and Technology Portfolio

Investments that the team made and wrote about in previous letters, including Vietnam’s FPT Corporation (FPT) and Turkey’s Logo Yazilim Sanayi (LOGO), performed well in the quarter.

We are especially pleased to see that FPT’s early foray into the AI space through global partnerships and acquisitions is helping it sustain a robust growth profile in global IT services. This was evident in the first half 2024 results, wherein global IT services revenue grew at ~30% in the first half of 2024 and is showing no signs of slowing down. FPT’s global IT services business exceeded $1bn in revenue in 2023, and recent underlying trends are positive with a larger proportion of higher-value digital transformation projects in the mix (47%), a diversified and growing geographical revenue stream across APAC, US, and Europe, and an increase in the number of contract wins in excess of $5m. FPT is also reinforcing its human resource advantage by adding AI and other technology modules to its university curriculum, which will help its own workforce and supply future skilled workers for other technology companies in Asia and around the world. For example, FPT University is expected to admit 1,000 students for the first batch of its semiconductor major, specializing in integrated circuit design.

LOGO shares performed well in the period as investor confidence in Turkey’s outlook strengthens. The government seems intent on pursuing macroeconomic policy orthodoxy that started a year ago. This policy goodwill is reflecting itself in Turkish assets, with the BIST 30 index up ~30% in the first half of 2024, and Moody’s upgrading its credit rating of the country by two notches from B3 to B1 in July. While it is early days and inflation remains stubbornly high (a staggering 75% in May 2024), Moody’s forecasts that inflation will begin to moderate from elevated levels and exit the year with a print of 45%.

If the economy does indeed turn a corner and business confidence grows, this will reflect positively on LOGO, which has so far underperformed the broader market (on a twelve-month basis) due to margin pressure from wage inflation and headcount investments, softness in its core SME segment in Turkey, and drag from its EUR-denominated low-margin business in Romania. Nevertheless, we remain confident in LOGO’s position as the leading enterprise resource planning (ERP) provider for Turkey’s large SME corporate market and are constructive on management’s initiatives to improve product flexibility through Software-as-a-Service (SaaS), and expand the product suite to new segments of the market (large retail customers, micro SMEs, e-government services, and HR). This should drive the penetration of ERP software in the country and position the company for strong earnings growth as business confidence returns.

Outlook

We continue to be constructive on the opportunity set for the strategy for the second half of the year. We believe we positioned the portfolio to be considerate of changes in the interest rate cycle, political environment, and portfolio company valuations. As always, the ultimate objective of our decision-making process is to express our best research opinions through a diversified portfolio of high-quality businesses that we believe will help us deliver on the strategy’s return promise to investors.

We look forward to continuing to update you on the strategy over the rest of the year.

MENA equity markets had a weak second quarter of 2024 with returns of -4.2% (for the S&P Pan Arabian Index Total Return), trailing the MSCI Emerging Markets Index which was up 5% in the same period. For the first half of 2024, MENA equity markets are up 3.0% compared to 7.5% for the MSCI EM index.

The performance drag in the quarter can be partly attributed to a surge in equity capital market activity that led investors to sell existing positions to fund a long list of initial public offerings and secondary sales. Top of the list was the $12bn secondary share sale of Saudi Aramco, which drew strong demand from foreign and local investors and was reportedly multiple times oversubscribed. For context, the Saudi Aramco equity raise is equivalent to 5.5x the average daily traded value for the entire Saudi market in the second quarter of 2024 and resulted in an increase of ~3% in the market’s aggregate free float market capitalisation. (Note: much more money was actually drained out of the market given oversubscription levels).

In November 2019, when Saudi Aramco first listed, foreign investors were demonstrably absent from the deal, as many viewed both the company and the country as non-core and even un-investable. Less than five years later, foreign investors are reported to have accounted for over 60% of the $12bn Aramco share placement. This is a strong vote of confidence in the Saudi market, and an indication of the credibility that it has deservedly earned with foreign investors in a short period of time. Excluding Aramco, seven other transactions concluded in Saudi and the UAE in the second quarter, with an aggregate amount raised of $3.4bn. While this pace of capital raising is typically associated with a rich valuation environment (i.e., a low cost of equity and high multiples), we believe it serves the strategy well as it strengthens our long-term thesis on capital market development in the region.

As discussed in previous letters, we believe the region’s share of global market capitalisation will steadily increase over time and we have expressed that theme through an investment in Saudi Tadawul Group, the country’s stock exchange holding company. Moreover, the combination of new listings and higher free floats is deepening the strategy’s investable universe and opening opportunities for the strategy to invest in strong businesses in healthcare, technology, and infrastructure, sectors that have not been well represented in MENA public markets historically.

Two key, related events in the quarter were the dissolution of the Kuwaiti National Assembly and the suspension of certain articles in the Constitution related to legislative powers in the country. This surprise announcement was made in a televised speech on Friday May 10th by Kuwait’s Emir Sheikh Meshal Al Ahmad Al Sabbah. The Emir came to power in December 2023 after the passing of his predecessor. His televised speech demonstrated clear intentions to break the cycle of policy paralysis and deadlock that has plagued the country due to the hostile and volatile relationship between parliament and government.

Kuwait has had four elections in the last five years and its economy has suffered from very low economic growth, a bloated public sector, rising levels of corruption, and crumbling infrastructure (most recently on display in late June when the country announced power cuts due to peak seasonal demand in the summer). The decision by the Emir to strip parliament of nearly all its powers and transfer control to the government will likely mean that stalled and much-needed economic policy legislations like the debt and mortgage laws, approval of national development plans, and fiscal reforms will now see the light of day.

This is a significant development for Kuwait that we expect will unlock a capex cycle that will have to catch up on nearly twenty years of significant under-investment. To position for this, the strategy invested in National Bank of Kuwait (NBK), the country’s largest corporate bank with over 30% share of system loans. We believe NBK’s strong deposit franchise and market leadership puts it in a strong position to benefit from a multi-year loan growth cycle that we expect will commence in the second half of 2025.

Our team spent some time in Morocco this quarter meeting with portfolio and prospective companies. The primary objective of this trip was to validate the strategy’s investment in Aktidal Group (AKT), a leading healthcare provider in the country with ~15% of the private bed capacity in the country. (Note: the private sector accounts for ~30% of total bed capacity). AKT operates 2,532 beds in 23 sites spread across 11 cities. The clinics managed by AKT are reputed for their quality of care and are known for the strength of their oncology department (~30% of consolidated revenue). The Moroccan healthcare market is severely under-served, with bed and physician per 1,000 persons below regional averages and well below WHO recommended levels. (A WHO study ranks Morocco 79th of 115 countries in doctors per capita). To address this shortage, the Moroccan government embarked on a series of reforms including the rolling out of a universal healthcare scheme and the removal of a restriction that allowed only doctors to invest in the sector. AKT is at the forefront of the growth in the sector, as has been validated in its 2023 results which showed revenue and operating profit growth of 84% and 86% respectively. Site visits and meetings with Moroccan doctors and competitors of AKT during our trip validated the company’s brand and reputation in the market, and highlighted the growth opportunity that lies ahead for the company.

We look forward to continuing to update you on the strategy in the next letter.