Identifier: Emerging Markets

Oil pumpjacks in silhouette at sunset.

Much of the initial spike in inflation that the Federal Reserve (the Fed) is now working so hard to curb came from strong energy prices. After WTI crude crossed $120 a barrel, energy prices are back in the $70 range. Today’s bear case for oil is widely discussed – from an impending recession to China’s tepid economic rebound and the eventual transition to EV vehicles. These are sensible arguments, but the oil and gas industry has undergone some structural changes. The seeds of these changes can be traced back to the last big run up in oil prices in 2008 when oil peaked at close to $140 a barrel.

After the demand-driven boom that peaked in 2008, encouraged by the recent high prices oil, drillers in the US began exploring ways to reach previously untouchable deposits using fracking and horizontal drilling. While fracking and horizontal drilling had been around since 1998, the spike in oil prices incentivized US producers to leverage this technology. The result was a shale boom with US production that had been in terminal decline since the 1960s, doubling from about five million barrels per day in 2008 to 10 million per day over the next 10 years.

Line graph illustrating growth in US field production of crude oil, 1920 to today.

With OPEC unwilling to cede market share to a new generation of American drillers, elevated rates of supply eventually led to a fall in prices in 2014-15. In retrospect, this marked the beginning of the end of the US shale boom. Then came the one-two punch of slowing demand from China (the largest driver of incremental demand for oil) and COVID-related lockdowns that caused oil prices to hit lows of $20 per barrel in 2020 after a brief reprieve in 2018-19.

The two price shocks that occurred over a short period led to two changes in behaviour that we think has structurally changed the industry.

  • First, a new base of conservative investors replaced the more growth-oriented cohort from the shale boom. The new investor base now pushed for an end to risky new projects, instead focusing on debt reduction and returning excess cash in the form of buybacks and dividends.
  • Second, taking a cue from their investor base, management of companies that survived this boom-bust cycle vowed to be conservative with their capital expenditure programs and promised to divert their future capex to more renewable projects.

In the past, for every dollar of dividends and buybacks, oil companies would reinvest $3 to $4 back in the business. Now as we can see in the following chart, every $1 of reinvestment is matched by $1 of buybacks and dividends.

Bar graph illustrating decline in level of share buybacks by oil companies since 2008.

The result of this structural change in the market is that big oil producers will continue to be conservative with projects that take a decade or more to earn returns on investment. We are now in a situation where supply is tight due to both long-term factors, such as limited new exploration projects, and short-term factors like replenishment of the Strategic Petroleum Reserve (SPR) by the US, increasing from current levels of 350 million barrels to 650 million barrels. Adding to this, OPEC has committed to restricting supply until the end of 2023 by cutting 1.16 million barrels per day.

On the demand side, we are seeing record demand in 2023 at 101.9 million barrels per day, an increase of two million barrels from last year. While we anticipate an eventual transition away from oil, the combination of tight supply and persistent rising demand could lead to a messy transition with price spikes near-term volatility.

We think this new normal allows small and nimble players to quickly respond to a stronger pricing environment with ramped up spending. A good example of such a player is Parex Resources (PXT CN), which is part of our emerging markets portfolio.

Parex is the largest independent oil and gas exploration company in Colombia sitting on over 200 million barrels of reserves and exploration opportunities. In 2023, it added 18 new blocks and expanded its exploration land by four million acres over the last five years. Currently, it produces 60,000 barrels of oil equivalent (BOE) per day and its production has grown at an 8% CAGR over the last five years, as seen in the following chart. Absolute proved developed producing (PDP) reserves have registered a 10% CAGR over the same period.

Consistent growth in oil production (barrels per day)

Bar graph illustrating growth in CAGR of Parex Resources, 2013 to 2022.

If we were to sum up our thesis on Parex, it would be capital efficiency with best-in-class execution. All of this in a country that has faced its fair share of curveballs with natural disasters, political uncertainty and infrastructure bottlenecks. To elaborate further:

  • We like Parex’s transition from a single-asset operator to a countrywide operation, with new asset acquisitions and an MOU with state giant EcoPetrol.
  • This had led to product diversity, moving from heavy oil to adding light oil, gas and condensates.
  • Parex has a track record of using of proven exploration technologies from the West to tap into easy-to-produce reservoirs with low risk.
  • We appreciate the management team’s commitment to adding shareholder value while maintaining strict cost control.
  • Finally, Parex has shown consistent growth that has been self-funded, with zero debt on the balance sheet.

Parex has maintained a simple and consistent capital allocation framework. A full two-thirds of its funds from operations are reinvested into the business, while the remaining one-third is returned to shareholders. As seen in the chart below, Parex has reduced its free float of shares by 33% over last five years and returned $1.3 billion back to shareholders. In 2021, it announced a dividend policy to further reward shareholders, with the company offering a 5% dividend yield at current prices.

33% reduction in shares outstanding

Bar graph illustrating 33% reduction in free float of Parex Resources shares since 2017.

Parex also scores well on our ESG framework. It has reduced GHG intensity by 43% since 2019, linked executive compensation to ESG metrics and has a diverse and independent board. With a low cash cost, Parex has performed well even at today’s subdued oil prices. If a sustained period of high oil prices does materialize as we anticipate, we expect Parex to continue delivering shareholder value from a position of strength.

Several boats along the coast line of the fishing village of Jamestown, Accra, Ghana.

While the headline returns were negative for the quarter, there were several encouraging signals in the underlying performance drivers that give us confidence in the future:

  1. The strategy’s Africa portfolio has finally contributed positively to returns after being the main drag on returns over the past 18 months.

    While there are still high levels of uncertainty looming over the economies of Egypt, Kenya, and Ghana, the prices of the securities we own there appear to have stabilised. We attribute this to valuations (a lot of bad news is in the price, in our opinion), apparent flushing out of forced foreign sellers, and early signs that these countries are emerging from their respective economic crises. We observed a tightening of credit spreads across the three African countries amid a weaker US dollar, moderating food and energy inflation, and signs that policy makers are starting to address some of the structural issues that have plagued their countries’ balance sheets and impaired the functioning of their foreign currency markets. We did not mention Morocco in the above list of countries, despite it being the strategy’s largest African country exposure. Morocco’s diverse economy helped it navigate the challenges that most countries in the continent have been dealing with, and so has not been a source of drag on the strategy’s returns.   
  2. The negative quarterly returns were generated from two core holdings that we remain fundamentally bullish on in the medium to long term.

    In our previous letters, we discussed our investment thesis on Wilcon Depot (the leading Philippines-based home improvement retailer), and Indonesia’s Sido Muncul (an herbal medicine manufacturer). While the share prices of both companies were under pressure in the quarter, we see no fundamental reason to change our constructive view on these businesses. In other words, we are more bullish on these investments at current levels.
  3. Our companies continue to invest in their markets, and insiders are buying stock.

    Across most of the portfolio, capital spending is growing at a faster rate than inflation and depreciation, and management teams are hiring and adding new products and services to further their value proposition to customers.

    A good example of this is HPS, the Morocco-listed payments technology company, which has just released version 4.0 of its flagship payment software product, PowerCard. Another example is Abdullah Al Othaim Markets, the Saudi discount grocery retailer that is winning the ~$40 billion size market by doubling down on its value-for-money proposition through the opening of 10 store a quarter, to take advantage of weakening competition, a shift in shopping behaviour to more value-for-money options, and the general growth in population in the central region, to which Al Othaim is over-indexed.

    In Malaysia, we were pleased to see buying by Tan Yu Ye, the founder and executive chairman of MRDIY, the value variety store chain that has seen a weakness in share price year-to-date on a souring of consumer stocks in the country, and a technical overhang from previous private equity ownership.

After nearly two years of unprecedented dislocation in frontier and certain emerging markets, we are seeing early signs that the opportunity set for the strategy is opening again. While these are early days, we are encouraged by the IMF’s approval of a $3 billion stand-by arrangement for Pakistan, Sri Lanka’s domestic debt restructuring, Egypt’s state asset sale program, Turkey’s market-friendly appointments at the Ministry of Finance and Central Bank, and its backing of Sweden’s NATO membership bid. In Nigeria, the abrupt removal of the crippling fuel subsidies and the liberalisation of the dislocated FX market by newly elected President Bola Tinubu are necessary remedies on the long road to restoring credibility with the market. These policy developments, along with early signs of a macroeconomic bottoming in the strategy’s core markets, and historically low valuations on a few portfolio companies, bode well for our ability to deploy capital, and for the strategy to seize on the long-term growth opportunities that these markets offer.

Vergent Asset Management LLP

Beautiful morning sunrise in seaside Dammam, Saudi Arabia.

Gulf equity markets broke a streak of four consecutive negative quarterly returns in the second quarter of 2023, and materially outperformed the MSCI Emerging Markets Index.  

In Saudi, the market performed impressively, with the MSCI Saudi Index posting a 5.5% gain in the second quarter, despite the backdrop of softer oil prices and lower production through OPEC+, muted earnings expectations from the banking sector (~35% of the Saudi index), and weak Chinese data that tempered hopes of a recovery in petrochemical earnings (~15% of the Saudi index).  

The mid-cap run in Saudi that we highlighted in our last letter continued to gain strength in the second quarter, with the MSCI Saudi Midcap Index up 9.9%, building on a 7.7% gain in the first quarter. The Saudi mid-cap space has been responsible for a significant proportion of the market’s year-to-date returns, as large index sectors like banks and materials underperformed. The sustainability of the mid-cap rally is currently the subject of intense debate. On the one hand, the bar for earnings to meet the expectations embedded in the price of many mid-cap securities has meaningfully risen. On the other hand, there is increasing evidence that the opportunity for multi-year earnings growth – underpinned by Vision 2030 reforms – is most visible in mid-cap sectors such as education, healthcare, tourism, transport, and technology. This setup is a challenge for our investment process, as we aim to balance growth expectations with a price at which we believe this growth will generate attractive returns on our cost basis. 

We talked in our previous letter about our willingness to make bold decisions to preserve a relatively attractive return profile for the strategy. During the second quarter, this involved the following actions: 

  1. Continuing to back companies that trade at high near-term multiples, but that we believe will grow into those multiples over time. The best example of this is Abdullah Al Othaim Markets, the discount grocery retailer that is capturing significant share of its ~$40 billion market by doubling down on its value-for-money proposition to take advantage of weakening competition, a shift in shopping behavior to more value-for-money options, and the general growth in population in the central region, to which Al Othaim is over-indexed.
  2. Reducing or exiting positions where we believe valuations have all but caught up with the blue-sky scenario in our forecasts. This is a painful but necessary decision, as it often means parting ways with companies (and management teams) we admire, but which we can no longer justify owning at current valuations. A good example here is National Company for Learning and Education, a K-12 owner/operator with a market capitalisation of $1.2 billion based on an operating income of less than $30 million. 
  3. Buying companies with highly defensive characteristics, or those where we believe the market has left valuation room for earnings to surprise to the upside in the next six to 12 months. A good example of the former is Qatar Gas Transport, the sole distributor of Qatari liquified natural gas exports, whose vessels are chartered on long-term fixed-rate contracts, with growth optionality from Qatar’s North Field expansion project. While we will refrain from sharing examples of the latter at this stage, our focus is on high-quality businesses where near-term growth rates are moderate, but whose characteristics support a high level of free cash-flow generation relative to market capitalisation.   

Our outlook statement from the last letter remains largely unchanged, but we have introduced new language in the last paragraph regarding our thinking around valuations. We continue to see favourable opportunities for the strategy. The macroeconomic backdrop remains supportive, with healthy FX reserves and balance-of-payments positions across most of the Gulf. While still early days, the Saudi-Iranian reproachment is a key event that warrants our attention, as any progress there can lead to a lower geopolitical risk premium on regional assets. OPEC+ remains committed to maintaining high oil prices to support government spending plans, which could benefit equity markets. We also note that positioning from global emerging market funds remains light and governments in the region are intent on growing their share in the emerging market capitalization, which we believe will end up manifesting itself in a quasi-short squeeze on those funds.  

We believe that valuations in the region – particularly in Saudi – will continue to remain elevated relative to their historic levels. The political will to push through an unprecedented and transformative socioeconomic agenda, coupled with enormous financial capacity, is likely to unlock significant growth opportunities for public market companies for years to come in our view. Furthermore, governments in the region have never been more vocal about the role that their stock markets will play in crystalising their growth agendas. This is a powerful combination that, if successful, can reduce the historical oil price-induced economic and asset price volatility that has long been a characteristic of investing in the region, and consequently underpins above-average valuations through cycle. We do not, however, believe this is a tide that will lift all boats. Adhering to our investment principles will be key to identifying winning companies that can deliver attractive returns to our investors. 

Vergent Asset Management LLP

Beautiful view of a Puerto Vallarta beach on the Pacific coast of Mexico.

Latin America has outperformed other emerging markets over the past two years and this positive performance can be attributed to several key factors. However, the challenge lies in sustaining this momentum and ensuring it is not merely temporary.

MSCI World Small Cap Index vs MSCI Emerging Markets Latin America Index, 2021 to 2023

Graph showing the outperformance of the Latin America small cap index relative to its global peers between June 2021 and June 2023.

Source: Bloomberg

Notably, the combination of currency rallies among some Latin American countries and an emerging markets rally is uncommon. Reasons for this mismatch include:

  • Latin America leads the way in interest rate hikes worldwide. Starting in the first half of 2021, Chile and Brazil raised rates, helping control inflation levels, although they are still high but manageable. Chile will likely start its easing process next week, followed by Brazil within the year. This has boosted their respective stock markets, which were already undervalued in our view.
  • Additionally, Mexico has benefitted from the “nearshoring” theme. Nearshoring is nothing new to local investors, having been present in the region for decades. What is new is the level of intensity and amount of investment expected over the next three to five years. This has resulted in increased earnings per share (EPS) of 15% to 20% CAGR in the near term for some Mexican companies, outperforming the MSCI Emerging Markets Small Cap Index and contributing to higher valuations in Mexico’s market compared to its Latin American peers. However, there are questions about whether Mexico’s growth is comparable to its peers or to countries like Indonesia or Vietnam that are also heavily dependent on US imports.
  • Commodities also play a significant role in the region’s performance. Despite a global slowdown, certain commodities, like copper, have maintained high prices due to supply constraints. We believe the anticipated electric vehicle (EV) boom will further drive copper demand, ensuring a deficit in the market from 2026 onwards. For example, every EV, which weigh approximately two tons each, consumes around 60 additional kilos of copper.
  • Furthermore, the region has demonstrated better fiscal discipline, with countries like Chile and Mexico ending 2022 with fiscal surpluses or manageable deficits, respectively. This responsible fiscal approach has also supported their currencies. There is always the potential for Brazil to surprise on the downside due to its high fiscal spending and debt levels; however, the country has seen no “disruptive” events lately.
  • US rates hikes have favoured value over growth factors in emerging markets, benefitting markets like Latin America’s over countries perceived as growth-driven, such as Korea or India.
  • Innovation has not been a main driver for Latin America, but that is starting to slowly change. Moreover, the market has begun recognizing and crediting good companies with sustained growth expectations, which has historically been uncommon in the region. This trend in recognizing innovation and good companies is crucial for bottom-up investors like us who prioritize companies with solid balance sheets, strong cash flow generation and sustained competitive advantages. More Latin American companies have started to share these characteristics.

Latin America is still a small region relative to the rest of the world and it is dominated by, and benefits from, global trends, even though its politics are not always market friendly. However, sustained positive factors like the commodities momentum and nearshoring may make global investors more indifferent to the region’s internal dynamics.

What needs to happen for long-term compounder growth stories to emerge, like Nestle in India or TSMC in Taiwan? To maintain sustainable growth, we believe the region needs to align with external factors and foster strong domestic sectors and companies that promote growth. Improving innovation and adapting to rapidly changing environments are also key. For example, the financial sector in Mexico and Chile remains solid, while the transport-logistics sector in Mexico offers interesting opportunities. Brazil’s large population presents significant potential for emerging middle-class growth, creating opportunities in various sectors.

Latin America has growth engines and the key is to identify the best companies capable of maintaining a sustained differentiation over time. By focusing on these opportunities, our portfolio is well-positioning to capture their potential growth.

Company example

JSL (JSLG3 BZ) has the largest portfolio of logistics in Brazil, with long expertise operating in a variety of sectors and a nationwide scale of services. The company has long-lasting business relationships with clients that operate in several economic sectors, including pulp and paper, steel, mining, agribusiness, automotive, food, chemical and consumer goods, among others. JSL also has a unique position in the Brazilian highway logistics market, as leader for 19 years and much larger than its nearest competitor.

The logistics industry in Brazil is highly fragmented, with a high level of informality and low capitalization among players. This creates opportunities for further consolidation, especially for companies with structured businesses. According to Citibank, the top 10 companies have close to a 2% market share. JSL has roughly 1% market share (almost 5x the second-largest player) and is well placed to continue consolidating the industry. JSL also has a favourable M&A track record, which has been a growth driver in recent years. JSL has acquired seven companies since its re-IPO in October 2020 implying c20% annual organic growth and c60% EBITDA growth considering the acquisitions, maintaining strong returns. 

We also expect JSL to continue expanding its ROIC going forward, driven by the ongoing consolidation of new acquisitions into JSL’s financials, the company’s strategy to becoming a less capital intensive, asset light business, and strong revenue growth to maintain gaining scale and operating leverage. The logistics industry offers a lot of opportunities to implement tech-driven innovation, and we see JSL well-positioned to use its sector platform and status as a leading tech player. The stock has performed very well this year, partially driven by rate cut expectations and also strong earnings. We expect the company to continue delivering good results in upcoming quarters amid a highly fragmented sector, creating both organic and inorganic growth engines.

Historical Museum, St. Basil Cathedral, Red Square, Kremlin in Moscow.

Summary

  • Improving politics and continued economic strength in Greece propelled strong returns, the market up nearly 10% in USD terms over the month.
  • More cyclical markets caught a bid, boosting Brazilian and Chilean equities. Given the deterioration of money numbers globally, we are not tempted to chase rallies across materials and energy as the likelihood of a sharp recession increases.
  • Indian stocks have been beneficiaries of reallocation by foreign investors abandoning China in recent months, with portfolio names across Industrials, Financials and Health Care posting modest gains. The challenge in India, as ever, is weighing up India’s incredible development story with rich valuations. However, we know that relying on mean reversion tables can be a fraught exercise when structural change is occurring. An economy is not a zero-sum game, or a closed loop where everything must revert to the mean. India’s ascent up the development ladder will expand the domain of the economy, and often in ways that are underappreciated and underestimated by the market.
  • Chinese equities were steady, capping off a poor quarter overall. We maintain a slight overweight in China, with positive money numbers continuing to support a modest recovery, low inflation, incredibly cheap real exchanges rates, and modest valuations for a host of high-quality businesses. However, more support from the authorities is needed to ensure weakness in the property sector does not feed into a vicious economic cycle that spills into other sectors.

Greek summer

Greek stocks continued their strong run into summer, boosted in June by the re-election of conservative leader Kyriakos Mitsotakis. The result vindicates the decision by Mitsotakis to call a snap election after his party fell short of a clear majority in April elections. His New Democracy party commands 40.5% of the national vote, almost 23 percentage points ahead of Alexis Tsipras’ Syriza party. The result marks an incredible turnaround from the brutal downturn of the European financial crisis, three IMF bailouts and painful economic restructuring, to Greek government bonds shedding junk status earlier this year, with the yield discount to Italian counterparts at its highest level since 1999. Further improvement to investment-grade status would unlock greater foreign investment, and lower borrowing costs for government and businesses. If Mitsotakis can deliver on campaign promises to boost salaries, lower taxes, restructure the healthcare system and upgrade Greece’s infrastructure, then the future is bright.

Thailand’s post-election limbo

Political risk following Thailand’s national elections appears to be rising, as uncertainty grows over whether the progressive Move Forward party will be allowed to form government despite its strong showing in recent national elections. The Thai electoral commission announced that it is investigating whether party leader Pita Limjaroenrat broke campaign rules through ownership of shares in a media company. The presidential candidate has denied any wrongdoing. However, the investigation may threaten the chances for Move Forward to garner enough support in Thailand’s unelected Senate (appointed under the previous conservative military-aligned government) to confirm a ruling coalition led by Pita. Failure to confirm the Move Forward coalition would represent a significant step backward for Thailand’s institutional quality and damage the trust of voters, and would limit the country’s development trajectory. It is likely that the post-election political wrangling and horse trading to form government has only just begun.

China’s authorities need to get creative to end the slump

Xi Jinping faces some monumental challenges both at home and abroad. High youth unemployment has the potential to become socially destabilising if it continues to worsen, and a renewed slump in property prices threatens to further dent the already brittle psyche of consumers and corporates. We agree that meaningful stimulus is needed to break consumers and corporates out of this coma. It needs to be a fiscal and/or monetary bazooka, and not the sniper shots we have seen over the past few months. The big question is whether this message is getting to the man at the top? Economic tsar Li Qiang has been talking up support for the private sector in recent months, and he is right to do so given it generates 95% of jobs in China. But this positive rhetoric does not appear to have been embraced by Xi, who has stuck to pledges of deleveraging at all costs, limiting policy options for dealing with China’s slump. Given Xi’s directive to avoid resorting to excessive leverage in property and infrastructure to boost the economy, authorities may need to get creative. If meaningful stimulus can charge the recovery, sentiment for Chinese equities will turn quickly.

Warlordism undermines state power in Russia

Poor Sino-US relations and fears that China may seek to take Taiwan by force remain a headline risk for many EM investors. Last year we wrote that Russia’s botched invasion of Ukraine and the strength of the Western response painted a clear picture to Beijing of the risks associated with conflict and further deterioration of relations with the West. Yevgeny Prigozhin’s jolly through Russia with his band of Wagner mercenaries underlined this risk, as the mutineers moved virtually unopposed through Russia, taking the southern military command post in Rostov-on-Don and breezing through a series of supine military checkpoints as they barrelled towards Moscow. While the uprising was eventually put down thanks to the intervention of Putin’s Belarussian stooge president Lukashenko, it suggests that the government no longer commands a monopoly on violence in Russia. The risk is that this emboldens would-be usurpers in the Kremlin and secessionists in Russia’s vast periphery, risking the rise of warlordism reminiscent of Republican China. While the CCP has tightened its grip over the People’s Liberation Army under Xi, a high-risk amphibious assault on Taiwan inviting a US military response and harsh Western sanctions would place incredible pressure on state power structures at a time of economic fragility and high youth unemployment. Recent chaos in Russia reinforces our view that Russia’s invasion of Ukraine actually lowers the risk of China attempting to take Taiwan by force.

A recession likelihood gauge placing weight on monetary variables indicates a high probability of a contraction in UK GDP / gross value added (GVA) over the remainder of 2023. 

The indicator, regularly referenced in posts here, is based on a model that generates projections for the four-quarter change in GVA three quarters in advance using current and lagged values of a range of monetary and financial inputs. 

Using data up to June 2022, the model assigned a 70% probability to the four-quarter change in GVA being negative in Q1 2023. The current ONS estimate of this change is +0.2%. 

UK Gross Value Added (% yoy) & Recession Probability Indicator. Source: Refinitiv Datastream.

The probability reading rises to 96% incorporating data through March 2023, i.e. there is a 96% likelihood of the four-quarter change in GVA in Q4 2023 being negative, according to the model. 

The statistical analysis underlying the model indicates that GDP prospects are significantly influenced by movements in real narrow money (non-financial M1) and real corporate broad money (M4). Six-month rates of change of these measures have moved deeper into negative territory since mid-2022. 

The model’s increased pessimism also reflects a deepening inversion of the yield curve and falling real house prices. Other inputs include credit spreads and local share prices, which have yet to display recession-scale weakness.

DM flash results released last week suggest that the global manufacturing PMI new orders index fell sharply in June, having moved sideways in April and May following a Q1 recovery – see chart 1. 

Chart 1

Global Manufacturing PMI New Orders, & G7 + E7 Real Narrow Money (% 6m). Source: Refinitiv Datastream.

The relapse is consistent with a decline in global six-month real narrow money momentum from a local peak in December 2022. A recovery in real money momentum during H2 2022 had presaged the Q1 PMI revival. 

Real narrow money momentum is estimated to have fallen again in May, based on partial data, suggesting further PMI weakness into late 2023. 

The global earnings revisions ratio has been contemporaneously correlated with manufacturing PMI new orders historically but remained at an above-average level in June, widening a recent divergence – chart 2. 

Chart 2

Global Manufacturing PMI New Orders, & MSCI ACWI Earnings Revisions Ratio. Source: Refinitiv Datastream.

Based on monetary trends, a reconvergence is more likely to occur via weaker earnings revisions than a PMI rebound. 

Charts 3 and 4 show that revisions resilience has been driven by cyclical sectors – in particular, IT, industrials and consumer discretionary. Notable weakness has been confined to the materials sector. Cyclical sectors may be at greater risk of downgrades if the global revisions ratio heads south. 

Defensive sector revisions have underperformed recently but are likely to be less sensitive to economic weakness. 

Chart 3

MSCI ACWI Earnings Revisions Ratios - Cyclical Sectors. Source: Refinitiv Datastream.

Chart 4

MSCI ACWI Earnings Revisions Ratios - Defensive Sectors. Source: Refinitiv Datastream.

The positive divergence of earnings revisions from the PMI may reflect firms’ ability to push through price increases to compensate for slower volumes. The deviation of the global revisions ratio (rescaled) from manufacturing PMI new orders – i.e. the gap between the blue and black lines in chart 2 – has displayed a weak positive correlation with the PMI output price index historically (contemporaneous correlation coefficient = +0.41). 

Any earnings support from pricing gains is now going into reverse: the output price index has crashed from an April 2022 peak of 63.8 to 49.8 in May, with DM flash results suggesting a further fall last month.

Why believe the “monetarist” forecast that recent G7 monetary weakness will feed through to low inflation in 2024-25? 

Monetary trends correctly warned of a coming inflationary upsurge in 2020 when most economists were emphasising deflation risk. 

The forecast of rapid disinflation is on track in terms of the usual sequencing, with commodity prices down heavily, producer prices slowing sharply and services / wage pressures showing signs of cooling. 

A further compelling consideration is that the monetary disinflation expected in G7 economies has already played out in emerging markets. 

A GDP-weighted average of CPI inflation rates in the “E7” large emerging economies* crossed below its pre-pandemic (i.e. 2015-19) average in March, falling further into May – see chart 1. 

Chart 1

G7 & E7 Consumer Prices (% yoy). Source: Refinitiv Datastream.

The E7 average is dominated by China but inflation rates are also below or close to pre-pandemic levels in Brazil, India and Russia. 

Inflation rose by much less in the E7 than the G7 in 2021-22, opening up an unprecedented negative deviation that has persisted. 

The recent plunge in the E7 measure reflects a significant core slowdown as well as lower food / energy inflation. 

The divergent G7 / E7 experiences are explained by monetary trends. Annual broad money growth rose by much less in the E7 than the G7 in 2020 and returned to its pre-pandemic average much sooner – chart 2. 

Chart 2

G7 & E7 Broad Money (% yoy). Source: Refinitiv Datastream.

E7 broad money growth crossed below the pre-pandemic average in May 2021. CPI inflation, as noted, followed in March 2023, i.e. consistent with the monetarist rule of thumb of a roughly two-year lead from money to prices. 

G7 broad money growth crossed below its pre-pandemic average in August 2022 and has yet to bottom, suggesting a return of inflation to average in summer 2024 and a subsequent undershoot. 

E7 disinflation, however, may be close to an end. Annual broad money growth has recovered strongly from a low in September 2021, signalling a likely inflation rebound during 2024 – chart 3. Broad money acceleration has been driven by China, Russia and Brazil. 

Chart 3

E7 Consumer Prices & Broad Money (% yoy). Source: Refinitiv Datastream.

E7 annual broad money growth is around the middle of its longer-term historical range and has eased since February. Chinese numbers may have been temporarily inflated by a shift in banks’ funding mix in favour of deposits. 

The expected rise in E7 inflation may not extend far but restoration of a positive E7 / G7 differential is likely in 2024.

*E7 defined here as BRIC + Korea, Mexico, Taiwan.

The FOMC’s updated economic forecast for the remainder of 2023 is inconsistent with Committee members’ median expectation of a further 50 bp rise in official rates during H2, according to a model based on the Fed’s past behaviour. Policy is more likely to be eased than tightened if the forecast plays out. 

The model estimates the probability of the Fed tightening or easing each month from current and lagged values of core PCE inflation, the unemployment rate and the ISM supplier deliveries index, a measure of production bottlenecks. It provides a simple but satisfactory explanation of the Fed’s historical decision-making, i.e. the probability estimate was above 50% in most tightening months and below 50% in most easing months – see chart. 

US Fed Funds Rate & Fed Policy Direction Probability Indicator.

The probability of the Fed tightening at yesterday’s meeting had been estimated by the model at 36%, the first sub-50% reading since September 2021. (The FOMC started to taper QE at the following meeting in November.) 

The FOMC’s median forecast for core PCE inflation in Q4 was revised up to 3.9% from 3.6% previously (currently 4.7%). The unemployment rate forecast was lowered to 4.1% from 4.5% (currently 3.7%). 

The model projections shown in the chart assume that core PCE inflation and the unemployment rate converge smoothly to the Q4 forecasts, while the ISM supplier deliveries index remains at its current level. Despite the revisions, the probability estimate still falls to below 10% in Q4, consistent with the Fed beginning to ease by then. 

The projections highlight the Fed’s historical sensitivity to the rates of change of core inflation and unemployment as well as their levels. It would be unusual for policy-makers to continue to tighten when inflation and unemployment are trending in the “right” directions, especially given the magnitude of the increase in rates to date. 

One difference from the past is that Fed now forecasts its own actions. Has yesterday’s guidance that rates have yet to peak boxed policy-makers into at least one further rise? This may mean that the model’s probability estimate for July – currently 29% – is too low. Still, next month’s decision will hinge on data, with inertia plausible barring stronger-than-expected news.

India Gate, New Dehli, India.

Summary

  • EM equities were down through the month, with China the key drag as investors were disappointed by weaker than expected consumption figures.
  • Cyclical markets exposed to energy and commodities including the Gulf states and South Africa posted negative returns. Our view is that these parts of the market will remain vulnerable as the global economy deteriorates on the back of very weak money numbers.
  • Pro-democracy parties swept Thailand’s national elections, led by the progressive Move Forward Party which is set to form a governing coalition with Pheu Thai and four other smaller parties. However, a Senate dominated by figures appointed by the military government that seized power in a 2014 coup threatens to delay the appointment of the governing coalition and the appointment of Move Forward’s leader Pita Limjaroenrat as Prime Minister. Uncertainty will hang over Thai equities as the tussle between the coalition and the Senate plays out in the coming months.
  • Despite unorthodox economic policy sparking surging inflation and a collapsing economy, Turkish President Recep Tayyip Erdogan secured a third decade in power, winning a second round run-off against opposition coalition leader Kemal Kilicdaroglu.
  • Semiconductor names in Taiwan and Korea surged on the investor frenzy over AI technology sparked by Nvidia reporting Q1 sales and management guidance which were streets ahead of sell-side expectations.

India remains one of the best structural stories in EM

NS Co-CIO Ian Beattie returned from a research trip in India this month, and he was keen to emphasise that the story of India’s rapid rise is still on:

“My thesis that this still feels like China 30 years ago is intact. Now imagine that with strong institutions and democracy. Of course, we are dealing with a massive and diverse country – you have to embrace the mess, chaos, bureaucracy, the riots, shocking Gini coefficient and all that entails. BUT, it is improving in almost all of the important areas. And you make money on the delta, don’t you?

India as the fastest growing major economy has grabbed headlines but it is ongoing. Structural reform, societal change (slow), tax and social reform (incredible), it feels like a virtuous circle. United Payments Interface (UPI) is now a success on a global scale.

Sustained progress buttressed the popularity of Prime Minister Modi, liked by the poor as well as the shopkeepers. The poor and middle classes are getting wealthier and feel that there is less skimming from the top.

Infrastructure is improving, employment is up. Tax collection is up. It feels like things are improving for almost everyone.

I am seeing first-hand the increasing aspirations in younger generations. Though it will be a challenge for the government to stay ahead of this I imagine it opens up a completely new political landscape and many opposition parties will be unable to resort to traditional tactics.

Indian stocks are relatively less expensive than on my last visit, having traded lower and recovered to similar levels, whilst very strong GDP growth and good earnings have come through.

Foreign investors in Indian equities are back to a very small overweight, while locals fear a retreat by retail investors as positive momentum has faded.

Foreign investor positioning – modest overweight

Chart showing India weight in EM funds as compared to benchmark weight.

Source: Jefferies, 2023.

However, this misses the structural story at play which is becoming increasingly important – that is the rising importance of domestic flows from local mutual funds seeing inflows from Systematic Investment Plans (SIPs).

Structural change in EM can be a key return driver

Chart showing SIP contribution compared to number of SIP accounts (m), RHS from January 2018 to April 2023.

Source: Jefferies, 2023.

Flows from a young and growing cohort into domestic mutual funds are boosting local liquidity, with long time horizons suited to equities exposure and more incentivised than foreign investors to push on Indian corporates to improve governance.

Be careful of relying too much on your mean reversion tables when structural change like this is underway. Prices are no longer set in London or New York, but rather in Delhi or Mumbai.”

India’s embrace of digital payments infrastructure is supercharging its development

India is a country of 1.4 billion people, 22 languages, 1 billion mobile connections and 800 million internet users. Yet only 6% are income taxpayers and only 6% transact digitally for commerce.

Leveraging technology and widespread connectivity is seen by policymakers as a massive development opportunity to draw more people into the formal economy while supporting innovation and relieving economic bottlenecks in India.

Enabling access to banking is an early example of how digital technology is being utilised – banking penetration went from 20% of the population in 2008 to 100% by 2017/18. During the pandemic, banking access – linked up to the Aadhaar digital identification program and the United Payments Interface (UPI) – was pivotal in enabling the swift and targeted transfer of around $4.5 billion worth of benefits to 160 million beneficiaries.

India has emerged as a leader in the development of Digital Public Infrastructure (DPI), which is pervasive and inclusive with 1.36 billion unique digital IDs, facilitating tens of billions of payments each year, and covering 10 million GST-registered companies.

At the heart of this is UPI, a real-time payments system established in 2016 which has quickly become the world’s largest real-time digital payments market. In 2020, 25.5 billion transactions were registered on UPI. The technology allows users across India to use their smartphones to quickly set up and transact using cardless accounts accessed using personalised QR codes, and utilise services including overdrafts, autopayments and voice-based payments. The system is even being expanded internationally, enabling free and instant cross-border transactions (versus pricey transactions via SWIFT) in a number of different currencies to and from India, which is the world’s largest remittances market – worth over US$100 billion in 2022 (World Bank). 

This has been a game-changer for India. Besides our oft-quoted reforms (bankruptcy law, demonetisation, clean water and electricity roll out, infrastructure spending, public toilets in rural areas, etc.), UPI has proven incredibly successful and has been crucial in ensuring welfare payments get to the right people, reducing waste and corruption, increasing tax revenues and giving more people bank accounts and phones.

What does this all mean for investors in emerging markets? While positive, initiatives like UPI, bankruptcy reform or sanitation may seem relatively trivial in isolation. However, it is the compounding effect of these incremental steps over a sustained period that can create a virtuous circle that unlocks the next upward shift on the development ladder. For a country the size of India, that progress will see several hundred million Indians join the formal economy and accumulate wealth, which can in turn present a host of opportunities for investors with the framework to harness these structural tailwinds.