Quarterly Investment Commentary
Continuing the strong momentum established earlier in the year, US markets reached new highs during the second quarter only to pull back a bit in the last few weeks before June 30. Federal Reserve Board comments coupled with liquidity concerns in China caused a broad based equity sell-off. Despite this, US large companies managed to retain an overall gain of 2.7% for the quarter, while small company stocks were up 3.1%.
Bond market performance dominated the news, as sharply rising yields caused negative returns. The sell-off started in May and was further exasperated by comments in June from Federal Reserve chairman Ben Bernanke, who spooked markets after providing details around reducing bond purchases. The broad based bond market index declined -2.3%, while corporate, municipal, and high yield bonds finished down -3.3%, – 3.1% and -1.4%, respectively. 10-year and 30-year Treasuries declined even more, down -4.6% and -6.1%.
Under normal circumstances, the Fed’s action of reducing stimulus indicates an improving economy via low inflation, declining unemployment, and rising corporate profits. However, investors’ knee jerk reaction indicates their emotional reliance on the stimulus. Going forward the Fed will not only have to manage the economic realities but also investors’ emotional state, which is a hard task indeed. The bottom line though is that economic conditions are improving, which is very positive news. US corporations reported solid quarterly earnings as they continue to improve profitability, and household sentiment also continued to improve.
In very sharp contrast to US market results, emerging markets declined -8.0%. These declines were driven by significant declines for Brazil (-17.2%), Russia (-8.3%), and China (- 6.5%). Weakness started in May when China announced slower growth and reduced manufacturing activity. The sell-off picked up steam in June when China released information about liquidity challenges amongst its banks. Investors responded by pulling money out of emerging market equities.
Given the environment over the last few weeks of the quarter, the second half of the year may shape up to be eventful. Keep an eye on the Fed and economic news coming out of China. Also, remember that global risks remain via turmoil in the Middle East and the ongoing European sovereign debt crisis.
Q2 2013: Emerging Markets Exposure
In recent months emerging markets have not kept pace with other equity markets as many investors reacted irrationally by selling into a declining market. Our experience is that this type of knee-jerk reaction is based on short-term thinking and does not lend itself to long-term success. This quarter we would like to revisit our long-term thesis for investing in emerging markets and our conviction for the level of emerging markets exposure in our portfolio.
What’s going on now and should I be worried?
To date, there are two main causes for the underperformance of emerging markets relative to their developed market counterparts. First, reported corporate earnings have not been as robust as analysts thought they would be. Second, there has been news coming out of China about slower economic growth and credit concerns. Although much of the information is ambiguous (as much information from China tends to be), it caused anxious investors to rapidly pull money out of the entire emerging markets asset class. While both of these factors are concerning in the short run, they do not damage our longterm thesis for the asset class. At current prices, emerging market equities are cheap relative to their developed market counterparts and relative to history.
Why own Emerging Market Equity?
We expect emerging market equities to be more volatile than other equity markets, so one might naturally ask the question: Why own these stocks in the first place? We own emerging market equities for diversification and growth. Emerging markets offer unique characteristics that are often not as readily available in developed equity markets, so they are a better diversifier to US stocks than developed foreign markets. Additionally, the growth characteristics for emerging market stocks are extremely favorable, which can be expected to result in higher long-term performance for these stocks versus other equity markets. We have written about our thesis for investing in emerging markets in prior newsletters, but it is likely useful to revisit a brief summary. Our investment rationale includes the following:
- Emerging markets represent a meaningful and growing portion of global stock market capitalization.
- Emerging markets are expected to continue demonstrating favorable economic growth trends.
- There are high quality companies available for investment in emerging markets.
- Superior currency diversification is available in emerging markets relative to non-US equities.
- Investing in products that emerging market consumers purchase provides diversification because their purchasing habits are different than developed market consumers.
- Emerging market consumers, businesses, and governments carry less debt than their developed market counterparts.
These long-term trends form the basis for including emerging market equities in our Global Equity Portfolio. As you can see from the chart at right, since 1988 emerging markets have steadily increased their share of global market capitalization. Despite some periods where they lost ground, the overall long-term trend has been quite positive. At the same time, emerging market economies have experienced faster economic growth than developed markets, and recent projections from the International Monetary Fund in April 2013 suggest that emerging market economies will grow at 6.4% versus 1.6% for their developed counterparts. (See second chart at right.)
Despite the recent downturn in emerging market stock prices, the emerging market growth story remains very much intact. While we know that economic growth alone does not necessarily lead to stronger earnings growth and higher stock prices, it certainly doesn’t hurt. Taken with other favorable factors like smaller public and consumer debt burdens, strong trade balances, and fewer demographic challenges, emerging markets should provide a ripe environment for companies to generate strong profits over time. Additionally, investment managers operating in this space report better corporate management and focus on long-term profitability (versus quarterly results) among emerging market companies.
How much is too much?
Paracle’s emerging markets allocation is 15% of our Global Equity portfolio. To evaluate the reasonableness of this, let’s compare to two other sources. Emerging markets share of the global equity market is 11%. If one believes that the financial markets are perfectly wise and efficient allocators of financial capital and resources, then one should invest exactly 11%. (We don’t think too many people firmly believe that financial markets are perfectly efficient after experiencing the tech, real estate, and financial sector bubbles of the last 13 years.) Surprisingly, according to a 2010 asset allocation survey by the Council of Institutional Investors, U.S. corporate, public and union funds have an average emerging markets allocation of just 4%. So is 15% too much? We don’t think so for a few reasons, which we will explain.
Reason #1: Paracle’s unique integration of detailed financial planning with investment strategy allows greater flexibility to seek out areas with higher potential return in the equity portfolio. Our solid planning process helps determine reasonable allocations to different types of assets that are each intended to accomplish different goals (e.g. protection, income, appreciation). Because we help clients plan well, we are confident that the assets that they have invested in emerging markets will not be needed for at least 10 – 15 years, which is long enough to ride through the volatility cycles and achieve growth. We don’t need to zig when the markets zag.
Reason #2: Portfolio volatility increases slightly with a 15% emerging markets exposure, but long-term return increases quite meaningfully. Remember, there is no free lunch in the markets, so to achieve a higher rate of return requires taking on additional risk. Notwithstanding, we certainly don’t want to go overboard. Consider two portfolios, one with 5% emerging markets and one with 15%. Since 1988 the portfolio with 15% emerging markets does have a bit higher variability from year to year, but not as much as one would expect. On a $1 million equity portfolio invested from 1988 to 2013, you would have experienced annual price swings that were .42% higher or lower than the portfolio that had only 5% emerging markets exposure. Some years you were a hero, and others you were a goat. However, spread out over the entire time period, your returns would have been .77% higher on average. The compounding effect of .77% higher average returns over this long of a time period would have resulted in $1,905,000 higher growth in the equity portfolio that had 15% emerging markets exposure versus the equity portfolio with only a 5% emerging markets allocation (i.e. $11MM total ending portfolio value versus $9MM). Historically, it would have been well worth enduring slightly higher short-term variability in exchange for better compound returns. Of course, no one knows if the past will repeat itself exactly, but as a wise person once said, “The past may not repeat, but it often rhymes.”
Reason #3: Paracle’s emerging markets portfolio is designed to help control risk in a historically volatile asset class. We select and combine managers in a thoughtful way in order to achieve broad exposures that are diversified by country, sector, and company size. Our core emerging markets manager has around 1,400 positions compared to 820 in the index. Paracle’s country exposure is not only more balanced than a capitalization-weighted index, but it also includes a higher total number of countries than the index. Expected benefits of this approach are to avoid bubbles and enhance currency diversification.
In conclusion, short term events in emerging market equity returns do not dampen our conviction that this asset class will provide strong growth benefits over time. We are comfortable with the risks that exist in allocating to this asset class because we are confident that our clients will not need to access these assets for 10+ years, over which time they should achieve higher returns as a reward for riding through volatile quarters like the last one. With a thoughtful allocation and a wellconstructed portfolio, time is on your side, and these temporary and cyclical elements will work themselves out.
We hope that you find these perspectives helpful and are eager to discuss any aspects that you would like to cover in greater detail.
Sources: JP Morgan, IMF