A guideline to investing in offshore markets

Franklin Templeton finds investment opportunities in emerging markets.
Picture: Shutterstock

As South Africa grapples with three bruising downgrades to its sovereign credit rating, an economy in a technical recession and increasing political uncertainty, offshore investment opportunities are on the radar of investors. Although the drawcard for going offshore is hard currency earnings, investors are increasingly warned about the risk of currency fluctuations and volatility.

Sukumar Rajah, the MD and CIO (Asian Equity) for Franklin Templeton Investment’s Local Asset Management Group, weighs in on where investors can find investment opportunities in global markets.

While South Africa is now in a technical recession, global growth appears to be steady, so it’s little wonder that local investors are continuing to invest offshore. There is, however, a concern that global markets are expensive. 

Sukumar Rajah (SR): Though select equity markets such as the US are trading at historically high valuations, many other markets still look relatively reasonable on a PE basis. Even for the US, the implied equity risk premium is lower relative to the long-term average. Unless we assume that bond rates move back to long-term average, this implies that there is still support for the US market to trade at current valuation levels. As bottom-up investors, we continue to find opportunities despite potential pockets of overvaluation as the dispersion within individual markets continues to be high.

What is the likelihood of a correction in global markets in the near future?

SR: Growth momentum is slowing but should remain stable for the rest of the year.

There could be a slowdown in growth from the first half of this year as expectations of US fiscal stimulus, tax reform and repatriation are lower, Chinese growth moderates due to cooling measures in the real estate sector and tightening liquidity in the financial system, and commodities move back into oversupply.

However, we do not believe that markets will significantly correct as growth should remain at reasonable levels given that the US economic trajectory remains firm, China emphasises economic stability in the run-up to the Fall Party Congress, and Europe continues to see improving growth momentum and diminishing election risk.  Importantly, the recovery of economic growth since last year is translating into corporate earnings growth, which continues to be broadly supportive of global markets.

We think the highest risks are geopolitical in nature. The key risk for EM markets on the geopolitical side is the increasing tension in North Asia related to North Korea and the risk of potential changes to US trade policy. On the positive side, Eurozone election risks are now diminishing.

If there was to be a correction, how would Franklin Templeton assist investors in not making the common mistakes that lose investors’ money?

SR: As bottom-up investors, Franklin Templeton focuses on the longer-term value and fundamentals of each individual stock we invest in. Because of this, we do not overpay for stocks and are able to find investment opportunities during market corrections. As such, we can mitigate the downside risk of pronounced market corrections and create upside when market conditions improve. We believe that this protects and enhances investor capital over the long term.

Where should investors place their money now? Developed markets that are more stable or emerging markets that offer exposure to new growth?

SR: As bottom-up investors, we continue to find opportunities in global equity markets given the dispersion within each individual market. However, we currently find many opportunities in EM markets due to the ongoing EM recovery and valuation support, with potential for a performance catch-up of EM to DM. Longer-term EM market performance is also underpinned by structural growth trends (i.e. Urbanisation, rising middle class, young population etc). Importantly, active stock selection contributes a high value-add in terms of performance in EM markets because of market inefficiencies, the frequent occurrence of structural changes and higher prevalence of new companies emerging and gaining share in the EM indexes.

In China, private-sector borrowing is now more than two-and-a-half times annual economic output. What sort of risk does this pose to the global economy?

SR: While we recognise that risks related to leverage in the Chinese financial system are significant and increasing, we believe it is inaccurate to evaluate the Chinese economy in the same way as its DM peers given the high degree of government control over the economy and stock market. A good example of this government control is the implementation of stringent capital controls to prevent outflows and defend the capital account after the significant outflows earlier last year.

After the turbulence in 2015 and 2016, we believe the risks related to the Chinese economy are well appreciated and that global investors and counterparties have put in place mitigating strategies to limit the negative impact should a sharp downturn in the Chinese economy occur.

We continue to track the government’s efforts to de-risk the financial system and are hopeful that the government will be able to accelerate reforms after the expected leadership consolidation within the Standing Party Committee during the Fall Party Congress. We believe that a more rapid rebalancing of the economy away from investment and towards consumption will result in lower but more sustainable economic growth for the Chinese economy that would be more positive for the global economy in the longer term.

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In “Fooled by Randomness” Nassim Taleb describes how, in an effort to gain control, we use factors in our analysis that may have little, or no influence on the outcome. The more risky the environment we enter, the more we tend to focus on what we have control over, in this case our metrics of analysis. Think of the soldier who cleans his rifle while facing an artillery bombardment.

With our “bottom-up” or “top-down” investment style we use metrics like P/E, Schiller P/E, dividend yield, price-to-book and many more in an effort to add a sense of control, management and sophistication to what we do.

In reality the longer term movement of the market is always only the result of either credit creation, or credit deflation. The cost of capital determines the tide for asset classes and “when the tide comes in, all boats rise”. The smaller movement of boats on the waves is simply random.

When do Reserve Banks “stimulate” credit creation? When the economy is under pressure and growth is slow. When does the Fed taper?- When the economy is firing on all pistons. So, the state of the economy is a counter-indicator of market movement. The indices rise because the economy is under pressure and crash because the economy is strong.

Laymen would notice that the South African economy has been under pressure for the past 3+ years and it just ain’t rising.

Explain?

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