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Geopolitical risks weigh heavily on emerging markets

Feroz Basa on how SA is being affected relative to its emerging market peers.

RYK VAN NIEKERK: Welcome to this Market Commentator podcast – Moneyweb’s weekly podcast, where I speak to leading investment professionals. My guest this week is Feroz Basa.

Feroz, I’m reading from your Old Mutual website and it says you are the joint boutique head of global emerging markets and you are responsible for managing and building the investment boutique – one of ten Old Mutual investment boutiques. Now I always thought a boutique is a place where you get your nails done or where you buy expensive clothing. Where did this name of boutiques come from?

FEROZ BASA: Yes, I think it’s a very interesting comment Ryk. We run independent businesses at Old Mutual, so we really focus on what we do. The boutique structure emerged ten years ago, where we spilt up the business where the SA guys focus solely on SA and the global guys focus solely on global. So we were tasked to build the global emerging markets business. [There were] obviously very exciting opportunities, because when you look at the South African market there are very limited opportunities for any fund that manages in excess of R5 billion and that’s most of the big asset managers.

The investment universe has shrunk significantly in South Africa and we took a view that emerging and developed markets would be a big opportunity going forward and that’s where we started these boutiques. I jointly managed the emerging market boutique with my colleague, Siboniso Nxumalo, and it’s been a really good investment opportunity for clients both in South Africa and abroad.

RYK VAN NIEKERK: But let’s talk emerging markets. You are one of the premier investment specialists in emerging markets around the world. On Thursday in the Financial Times there was a pretty comprehensive article, stating that there seems to be an exodus of investment money from emerging markets and that is mostly due to the political situation internationally. What is the impact, and is the South African market more or less affected than other emerging markets?

FEROZ BASA: I saw that article and I pulled up the latest equity flows because I was also interested. We did see a selloff. If we go back to the beginning of the year in the emerging markets there was very strong growth. Global growth was really strong, so emerging markets do well in that scenario. The valuation of developed markets was also very attractive and still is, and we saw these big flows coming into emerging markets. I think if you look at the cumulative flow for the last four months it’s been close to US$51 billion. That compared to last year, the total, and that was one of the biggest inflows in the last five years, $79 billion, so you can see a sharp increase in allocation to emerging markets.

What we’ve seen in January and February was a risk on moving emerging markets – the index outperformed by 10%. Since then we’ve seen the markets come off and we are actually down 12% from that high. So there has been some selloff in emerging markets. I think it’s a combination of things….

If you look at the geopolitical situation globally, people are getting a bit uneasy; there’s talk about reinstating sanctions in Iran; there were these jitters around Russia, together with Turkey, around the Middle Eastern region and particularly the uprising in Syria again; the US sending missiles into that region. So geopolitical risk increased a bit and then also the [US] Fed continues to increase the rates. More importantly the US ten-year yield, which people monitor very carefully, has now increased to just below 3%. So there’s expectation of the Fed increasing rates significantly and you know when that happens people start to look at the US ten-year, the risk-free asset. If inflation is 2% in the US and the potential in a year or two’s time is to get 3% on a risk-free asset, they tend to sell off their risk assets, which is emerging markets. So that’s what we’ve seen, Ryk.

Gold lacklustre in current market  

RYK VAN NIEKERK: So it is a conservative approach, but why don’t we see increases in gold counters as well as other defensive stocks?

FEROZ BASA: That’s a very good question Ryk. I think particularly the one in the gold space. Normally when we’re in a risk-off market investors tend to use gold as a safe haven, but gold hasn’t really done what you would have expected it to do in this current market. And I think it’s more a trade longer term when it’s completely risk off and something happens, like we’ve seen in the global financial crisis and then gold actually does very well.

On the defensive side it’s also been different this time. Before people were saying yields have gone close to zero in the US, in Japan and in Europe, and you can get 2.5% yield on some of these high-quality businesses like Heineken, AB InBev, British American Tobacco and they use that almost as bond proxies, saying that’s where I am going to put my investment because I’m getting zero on risk-free assets. So that trade is also unwinding [significantly] as expectations for US ten-year yields are going up significantly.

So we’ve seen this massive sell off, particularly in British American Tobacco. Okay there have been some issues around the tobacco industry, but a large portion of the selloff has come on the back of this bond proxy selloff and it’s created some very good opportunities in very well-run businesses with big competitive advantages and very strong cash flows.

RYK VAN NIEKERK: Capital flows, how volatile are they? We are seeing an outflow now, but can it return or change tomorrow and can we see significant inflows again?

FEROZ BASA: Ryk, we’re in unchartered territory from an economic perspective globally. We’ve seen central banks use unorthodox methods. So you had the likes of quantitative easing, going to zero rates to stimulate economies, massive inflows into financial markets. So we’re in unchartered territory. We haven’t seen this in the past and the unwinding mechanism is creating unease in the market. So where we don’t have history to go back on to see what happened when something of this magnitude happens, we don’t have some reference point. So investors are sitting back and saying, actually, with all these unwinds coming I’d like to sit on the sidelines and see what happens. Now having said that, global growth is still reasonable. I’ve just come back from China and actually China is doing very well. Some of these other emerging markets are also doing very well, so people are sitting on the sidelines. As we have the growth numbers come out and – obviously the key driver is earnings globally – as we see earnings outperforming analysts’ expectations globally, we could see this capital come back into the market.

RYK VAN NIEKERK: Looking at your fund fact sheet for your global emerging markets fund, I see only 2.6% in cash at the end of March 31. I assume you will not become more conservative within this context and stay invested in equities?

FEROZ BASA: Yes, I think post the selloff, Ryk. If you remember correctly when I told you at the end of February, emerging markets had a further rally on the back of a very strong performance in 2016 and 2017. At the time when we looked at our portfolio, we measured the upside of our portfolio on a relative basis and there was less than 30% upside. So that upside is measured normally with a three- to five-year view. So if you look at those returns they came down significantly because the market was strong and, hence us having less cash in our portfolio, we participated on the up. But as we sold off in some of these shares, we have built up a bit more cash in our portfolio and built up a few more defensives in our portfolio.

US/China trade war

RYK VAN NIEKERK: China seems to be your favourite investment destination – nearly 20% of your portfolio is invested there. There are some concerns about China, as well as the impact a trade war with the US may have. What are your views now of the valuations we see in China?

FEROZ BASA: China is very big in the emerging market index, Ryk, so it’s close to 30%. I think if you add our weighting in Naspers, which is purely a proxy for Tencent, we probably have 4% to 5% underweight. We’ve done very well from our China trade. China over the last two years has performed very well relative to other emerging markets and we are starting to take profits.

On the issue of this trade war, trade wars are not good. We are living in a global economy. The US and China are two of the world’s biggest economies; one saying they are going to put tariffs on and the other retaliating, it’s not good for anybody: it’s not good for global growth, it’s not good for global trade. I think there’s somewhere in the middle where there is a compromise in that big deficit that the US has with China starts reducing a bit, but there’s something on both sides. So I don’t think a big full-blown trade war will emerge, but having said that, anything is possible.

If we look at global leaders, a year or two ago we wouldn’t have said that that we have the leaders where we are. The most significant thing over the last few months is that the president of North Korea has made a historic visit to South Korea and now there is talk of him meeting the US president, which if I had told you that a year ago you would have told me I’m crazy. So anything is possible but I think these two big economies globally can’t afford a trade war on either side. China is the biggest investor in US treasuries as well – people tend to forget that – and if they start pulling back what happens to the US current account in all these matrix, as they are heavily indebted? So I think a full trade war won’t emerge and there will be some compromises on both sides.

RYK VAN NIEKERK: Just another interesting counter in your portfolio is the Sasol-sponsored ADR, obviously that is the US-listed ADR. Why go that route and not buy the share in South Africa?

FEROZ BASA: I think if you look at our fund we have South African investors and we have global investors but our fund is purely a dollar-based fund. So when we get South African investment we do convert that to US dollar cash because that’s the reference currency we use. So for us, you taking those US dollars and buying Sasol in the local market doesn’t make sense, so we use US dollar cash to buy Sasol. Sasol is a very interesting one in the global oil space because we can buy in that space, Sasol stands out on a valuation basis, with the oil price where it is and their investment in the US starting to pay off and less capital being invested, the free cash flow yield of Sasol looks phenomenal. So it’s a very exciting opportunity and it’s merely us using our US dollars to buy the ADR because it moves exactly in line with the SA share.

Short to medium-term market expectations

RYK VAN NIEKERK: When we were starting this interview off-air you described the market as a funny market and it is really difficult to read. What are your expectations for the short and medium term for markets?

FEROZ BASA: Like I told you, Ryk, gold is not moving like it should when geopolitical risk increases. When the market sells off, usually defensives do well, but they’ve sold off even more value-type shares and any whiff of them underperforming and underperforming their expectations and they’ve sold off significantly. So there’s no clear sign. Even the tech stocks that have been the darlings for a while: we’ve seen a bit of a selloff in Tencent in Alibaba; lately Facebook have had their issues, so they’ve also sold off a bit. So even the high-growth tech space has sold off a bit and it’s not increasing as it did before. So that’s what I mean about the funny market and with this unease around global monetary policy, the market has become much more volatile in the short term.

…I looked at our portfolio, the aggregate of the valuations that we have in our portfolio, and there’s close to 50% upside on our emerging market fund now. So that buying opportunity seems to have emerged now. But I know markets are volatile, so what we tend to do is … look three to five years out: purely what does growth look like in emerging markets versus developed markets and you can see that growth differential has increased.

The average emerging market aggregate is expected to grow 5%, whereas the developed market is close to 2%, so there’s a nice 3% differential.

Also if I look at the emerging market index, it’s now trading on a 12 times multiple, versus developed markets on 16 times and South Africa on close to 15 times. So that’s where I start looking at the longer-term opportunity and saying the emerging markets are offering value again. Aalso some of these currencies have sold off, so not only do the shares offer value but also there’s a bit of an underpin in currencies.

Now having said that, in the short term there will be lots of volatility; but if I take a three- to five-year view I think emerging markets are exciting – there are very good opportunities. Barring a significant incident globally, this is my preferred asset class and that’s where I tend to have clients diversify some of their offshore holdings to add a bit more of the emerging markets.

Also [regarding] emerging markets versus South Africa, South Africa is an emerging market. South Africa confidence has come back in since the new government has come in, but if you look at the overall valuation the relative attractive of SA versus emerging markets is not there.

RYK VAN NIEKERK: Within this context we have differing valuations within the emerging and the developed markets, but if we take out the short-term volatility what do you think of overall valuations and the potential for them medium- to long term?

FEROZ BASA: Yes, I think the starting point is always valuation, which is a very good point. The price you pay today determines your future returns, Ryk, and it’s been our philosophy all the time. So if you take the developed world trading on 16 times, the US is even trading on much higher multiples because people have been flooding capital to the US market. Emerging markets are on 12 times earnings. I think what’s very important is what are the key drivers longer term of growth and where do you see that coming out in earnings. So for us the way we look at it is emerging markets have very low penetration.

So, penetration, Ryk, in most goods relative to the developed market is low. I think valuation stands for itself, but growth is also a premium in emerging markets. But the most important thing, Ryk, is that in emerging markets you have this thing called the demographic dividend. We have younger populations who are the future consumers of the world. So these are the young people who would come through and replace the older people in doing the jobs of the future, whereas in the developed world you have ageing populations, who will become a burden on the state. From a healthcare perspective people are living longer – so people … access their pensions longer, use the facilities longer…. So I think if you take out the short-term volatility and the short-term news flow and you take a longer-term view, emerging markets are where you are going to make that excess return in the global [market].

RYK VAN NIEKERK: We’ll have to leave it there. Thank you so much for your time, Feroz Basa, he’s the joint boutique head of global emerging markets at Old Mutual.

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