March 15, 2019
A Word from the Editor
By Kit-Victoria (Weil) Wells – Culture & Communications Officer
Many of us may lament the way our children and grandchildren spend their days staring into small boxes with faces aglow or sitting in their family rooms fighting virtual battles with, say, an Australian gaming counterpart named Beaglerush. We grapple with how social media has degraded civil discourse and how black market economies thrive on the Dark Web. But despite its challenges, the technology revolution has created one extraordinarily positive phenomenon. Since the onset of that revolution in 1966, the population of the planet has rocketed from 3.3 billion to 7.7 billion. In that same time, the number of people living in extreme poverty has been cut in half. This represents a stunning milestone for humanity. It also presents meaningful economic opportunity.
In this mid-quarter issue, CWC portfolio manager, Mike Hubbert, writes about why we believe the Emerging Markets and their growing middle class creates significant opportunity for investors.
Our View on Emerging Markets
by Michael Hubbert, CIMA® CWC Portfolio Manager
We think we’ve seen this before
A few days ago, not unlike any other typical day in my life, I was thinking about all the positive demographic shifts that are happening across the globe. I was trying to figure out the inflection point for when those positive trends might start filtering through to the equity markets, and to the investment accounts of our clients. (Yes, that is a typical day in my life.)
Modern demographics are better than you think
Technological innovation has changed the fortunes of billions of people who might otherwise have lived in extreme poverty, and continues to create tangible positive change for the world’s growing middle class. The citizens of the world are considerably better off than they were in the recent past, as measured in increased life expectancies, reduced poverty levels, access to electricity and water, higher immunization rates, less violence, fewer deaths from natural disasters, higher literacy rates, better child mortality rates, better access to education, and improved women’s rights. While there are still many problems to solve, on whole, the world’s children are better educated and healthier than in any time in human history. Consider the following statistics on extreme poverty. In 1966, 50% of the world’s population lived in extreme poverty. That number dropped to 30% in 1980, and sits at 9% today.(1) Billions of people are better off today than their parents were. That is a very good thing for the long-term health of the global economy.
Pop Quiz: What percentage of girls in the world have access to, and attend grade school? Take a guess. I’ll give you the answer at the end.
As evidence of the world’s rapidly expanding middle class, in 2017, 100 million Asians took their first ever commercial airplane trip.(2) While 100 million is a relatively small percentage of Asians, in absolute numbers it is hugely meaningful. In American terms, that would be as if a third of the country elevated their socioeconomic status sufficiently to afford to do something all 33% of them had never been able to afford to do before. The technological revolution isn’t only changing the economic demographics of poor and middle class people. Presently, 60% of the richest people in the world are living in “western society.” The “rest of the world” represents the other 40%. In approximately 20 years, those numbers are estimated to flip. Sixty percent of the people living at the highest tier of society will live outside the “western world.”(3) With about four billion people living in Asia, that’s a huge addressable market and a lot of potential new consumers.
The “non-western” world is catching up
Some people may be concerned with how rising levels of Nationalism and Protectionism, both domestically and abroad, might affect trade with Emerging Markets. Tariffs are one hallmark of protectionist ideology. An all-out trade war is not something equity markets respond to positively, and it would be cavalier to scoff at the possible effects of one. But at the same time, our traditional beliefs need to catch up with the new facts. There is an old adage on Wall Street that goes, “when the United States sneezes, the rest of the world catches a cold.” This may no longer be as true as it once was. World Bank statistics indicate that emerging economies are less dependent on the United States than ever before. Take China for instance. In 2006, China exported $200 billion in goods to the United States. In 11 short years, that number has ballooned to $430 billion (per 2017 World bank statistics). While that sounds like more dependency on U.S. markets, it isn’t when you compare China’s exports to the United States as a percentage of their total GDP. In 2006, China’s GDP was about $2.75 trillion and today it is about $12.25 trillion. In 2006, exports to the U.S. accounted for roughly 7.25% ($200B/$2.75T) of China’s GDP. Today exports to the U.S. account for roughly 3.50% of their GDP ($430B/$12.25T).(4) So things have changed. We aren’t quite there yet but we believe someday soon, when America sneezes, Asia will politely pass us a box of tissues.
The economies of countries in the Emerging Markets are getting healthier
The “financial houses” of the developing economies are in the best shape they have ever been. There are always ebbs and flows, but overall the average foreign exchange reserves of developing economies are nearly 25% of GDP, triple what they were when the World Bank started tracking this data in the 1960s. This makes them more resistant to currency fluctuations that might otherwise have affected their debt. The largest components of the Emerging Markets indices all have low external debt-to-GDP levels, and most are currently running an account surplus, which makes them more resistant to business cycle fluctuations: a big positive. On a side note, the United States is currently in the top 10% of countries worldwide with the highest debt-to-GDP, on both a gross and a net basis.(5)
A few thoughts on valuation
As investors, we assess risk relative to prospective returns. We feel that markets that have a high price-to-earnings ratio (among a few other ratios like market-cap-to-GDP, better known as the Warren Buffet indicator(6)) are generally pricing in “future good news.” By most measures, Emerging Markets are now at a 31% discount. So, if valuations still matter, and we think they do, Emerging Markets could be returning considerably higher compounded returns for the next decade. (For a much more detailed explanation of Valuations, see the Valuations Addendum at the bottom of this newsletter.)
Where we think we’ve seen this before
As a quick recap, when it comes to Emerging Markets, we like the demographics, we like the financial viability, we like the valuations. But as far as the stock markets go, Emerging Markets have gone nowhere for a decade. Actually, worse than nowhere. They’ve declined 25% since the highs achieved in October of 2007. What gives?
I began this article with the headline “We think we’ve seen this before …”. In the CWC portfolio management department, we strongly suspect that the last fifteen years in Emerging Markets equities is analogous to the Nasdaq in the late ‘90s and the subsequent decade. The Nasdaq rose at least 400% between late1995 and early-2000. The markets knew that the internet revolution would likely create a huge leap forward in many of the world’s economies. Speculation got overheated and valuations reflected “irrational exuberance” resulting in a significant market adjustment in mid-2000. But fundamentally, the market got the phenomenon right. The internet has changed the world in more ways than just ‘liking’ someone’s photo on your Facestagram or watching politicians make public policy in 280 characters or less. The internet has changed the way information flows for companies and for healthcare professionals. It has decreased latency times and allowed seamless transfer of data on a worldwide basis. Utterly life-changing for the majority of the people living on the planet.
From 2002 to 2007, while the U.S. markets were enjoying an unfolding housing boom, and celebrating a 100% market recovery, the emerging economies (lead by Asia and Latin America) rocketed up 400% (see chart below).
Like the Nasdaq, Emerging Markets got the secular trend right, but got the valuations, time frame and return structure wrong. People around the world are the healthiest, and most well-educated they’ve ever been. They are rising out of poverty at record levels. But in 2007, Emerging Markets stocks traded at a massive valuation premium relative to the S&P 500, and what the market told us was that 400% in five years was just “too-far-too-fast.”
In the subsequent decade, the Nasdaq struggled, but during that time, technology got better and better. Since the market lows in 2009 (roughly 15 years after the start of the powerful move in 1995), the Nasdaq has been the leading domestic index. In our opinion, as evidenced by the chart above, the Emerging Markets started moving out of a long sideways period in the middle of last year. And now, roughly fifteen years after their big move started in 2002, we think they’re ready to take the baton. We see a lot of similarities between Emerging Markets and the Nasdaq when evaluating whole market cycles. Additionally, I would like to note that this is not unlike many other times the S&P 500 has been in long basing periods, followed by periods of impressive market returns (eg: 1998 -2012, 1968 -1982, 1930 -1950). (7)
None of the phenomena I mention matter when viewed individually. We need to be able to put all these pieces together for the odds to be ever in our favor. In a perfect future world, fifteen years from now we would be able to say “Yes, it WAS almost exactly like the Nasdaq.” Obviously, we can’t predict the future, but we like what we’re seeing on many levels.
And the answer to the pop quiz is …
Ninety percent (90%) of girls around the world are enrolled in a grade school accessible by local transportation. Don’t feel bad if you got it wrong. My guess was so much more pessimistic, it’s staggering. I recommend the book “Factfulness” by renowned TED-talker, doctor, and UNICEF and WHO advisor, Hans Rosling. It is an interesting read that reminds us that life on this planet is making rapid changes, and facts (and attitudes) need continuous updating. We need to continue perfecting the practice of filtering out the noise and keeping our eyes on the big picture.
Valuations Addendum
As investors, we assess risk relative to prospective returns. We feel that markets that have a high Price-to-Earnings ratio (among a few other ratios like Market-Cap-to-GDP, better known as the Warren Buffet indicator(6)) are generally pricing in “future good news.” The overwhelming evidence points to higher P/E ratios being a bad thing for future returns. In short time periods, it’s difficult to predict market returns based on valuations, but over the long term it’s quite useful. Below is one example from Nobel Laureate Bob Shillers’ work, the CAPE ratio, and what forward returns look like in those scenarios. The CAPE ratio is a Price-to-Earnings ratio, but it is adjusted for a full “economic cycle.”
By most measures, Emerging Markets stocks (which in the past have traded at a premium to the S&P 500) are now at a 31% discount. The S&P 500’s P/E ratio for this past year is roughly 16.38x while the Emerging Markets are 11x. If you use Robert Shiller’s CAPE ratio, that’s about a 50% (plus) discount. The first data set (Table 1) gives an idea of expected forward returns over a 10 year period, when stocks are in a certain CAPE range.(7) The floating bar chart (Table 2) shows where current CAPE ratios are for certain stock markets (the circle being where the asset class is currently, the grey or orange bars being the median range over time). Emerging Markets are at a 12 CAPE, while the U.S. is at about a 28 -30. So, if valuations still matter, and we think they do, Emerging Markets could be returning considerably higher compounded returns for the next decade, while the passive U.S. instruments could be around 2% -4%.
Table 1
Table 2
References
Rosling, Hans. Factfulness. London: Hodder & Stoughton Ltd., 2018
Rosling, Hans. Factfulness. London: Hodder & Stoughton Ltd., 2018
https://wits.worldbank.org/CountryProfile/en/Country/CHN/StartYear/1992/EndYear/2016/Trade Flow/Export/Indicator/XPRT-TRD-VL/Partner/USA/Product/Total https://wits.worldbank.org/CountryProfile/en/Country/CHN/StartYear/1992/EndYear/2016/TradeFlow/Export/Indicator/XPRT-TRD-VL/Partner/WLD/Product/Total https://data.worldbank.org/country/china
Bloomberg showing multiple 15-20 year periods in American history when the S&P 500 had zero return over the time-period (other than dividends) – (1998 -2012, 1968 -1982, 1930 -1950)
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