Finding Alpha Despite Macro Risks

The tug-of-war between the potential ratcheting up of tariffs and technology war, lower global growth and the rapid shift to easing monetary policy globally continued to unfold in the second quarter. The rally in emerging markets and Chinese equities in 2019 was interrupted as trade tensions between the U.S. and China resurfaced. Emerging markets once again underperformed U.S. equities. On a country level, Argentina, Russia and Greece were among the top performers in the second quarter, while Pakistan, Hungary and China performed worst. On a sector level, consumer staples and utilities performed best, while healthcare and communication services performed worst.

The G20 meeting between President Trump and President Xi did little to alleviate investors’ concerns regarding protracted trade and tech wars and their implications on global growth. Furthermore, the industrial and manufacturing sectors in China continued to struggle to generate momentum. Consumption, on the other hand, remains robust helped by stimulus. We were encouraged by the strong growth in retail sales, and the continued determination of the Chinese government to support growth.

India performed generally in line with the MSCI Emerging Markets Investable Market Index during the second quarter helped by a late-quarter bounce as investors cheered the sweeping victory of the BJP party. Following the elections, we wait to see what the government will do about getting a business cycle going. For a number of years, its record on this front has been disappointing. It also faces a fiscal situation, which continues to be somewhat challenging. Although the previous administration did have some successes, for example, the introduction of the GST (goods and services tax) and demonetization, there are still issues that need to be resolved. We believe valuations in India remain on the expensive side not only on an absolute basis, but also compared to its peers in emerging markets.

In Brazil, all eyes remain on the progress of pension reform. It appears to be working its way through the system, albeit with a certain amount of horse trading and the usual political compromises. While the original proposal will be watered down, we remain reasonably optimistic that progress will be made.

Outlook

In a world where we are revising down expectations of global growth, substantial headline risk remains. We expect the tug of war between lower global rates and lower global growth to continue, and highlight the potential risks emanating from protracted trade and tech wars between the U.S. and China. Following the G20 meeting in Tokyo, there appear to be expectations of things getting better and negotiations starting again. However, there remain some big issues over which it is hard to see the U.S. and China coming to a compromise. Political expediency and the cost impact on both sides would argue for some resolution on the trade front, but how you resolve the technology part is much more challenging. It seems to us that there is a complete lack of trust and that supply chains may inevitably bifurcate.

We continue to believe that the most probable scenario for the U.S. dollar going forward is flat to drifting lower, as the U.S. economy becomes less exceptional than it has been compared to other developed and emerging economies, and as headlines begin to focus more on the large twin deficits. A stable to weaker U.S. dollar tends to be good for emerging markets.

On a micro level, we are still seeing both healthy free cash flow and balance sheets. Valuations generally in emerging markets ended the quarter on the cheap side. Small-cap valuations, however, are at multi-year lows and well below relative (compared to large-caps) and absolute long-term averages. In our view, today’s companies are both healthier and “better” compared to the past decade: they are more private, entrepreneurial and less state owned. We believe they ought to be more expensive than they have been in the past. While capital expenditure may be low, companies continue to find it hard to return capital to shareholders. We do however believe the time will come.