00:00 Intro
This is the EPFR Exchange Podcast. All opinions expressed by Cam, Kirsten, or our podcast guests are solely their own opinions and do not reflect the opinion of EPFR. This podcast is for informational purposes only and should not be relied upon for investment decisions.
00:18 Kirsten Longbottom
Hello everyone. I'm Kirsten Longbottom from EPFR's research team, and I'm joined on today's Exchange Podcast by EPFR Research Director Cameron Brandt and R. Burns McKinney from NFJ Investment Group. Welcome!
Emerging markets will be the focus of today's discussion. It has been another eventful year for this asset class as interest rates in the developed world continued to climb, globalization continues to fall out of favor with many electorates and China's much anticipated rebound from the anti-COVID lockdowns continues to underwhelm. Before we dive in, I'd like to welcome Burns and ask him to give us a snapshot of his background and his interest in emerging markets as well.
01:08 Burns McKinney
Sure thing, thanks Kirsten. And thanks for having me. I work at NFJ Investment Group. I'm a portfolio manager here and we're based down here in Dallas, Texas. Among the roles I play here, I'm a co-lead manager of the NFJ International Value Fund, which is a strategy that has nearly a 20-year track record as a “really go anywhere” ex-U.S. fund. We let valuations dictate where we go, looking for companies that trade at a relative discount to their peers, and specifically those that have a track record of returning cash to shareholders via dividends and repurchases. Specifically, because it's a go anywhere strategy, we've had wide leeway to invest in the emerging markets for that entire nearly two-decade span.
One of the things I like to point out that's exciting to us about the space is the area of dividend payers and growers within the emerging markets, which we believe to this day is a largely ignored and underexploited universe. Investors have this tendency to categorize and group investments into nice, neat little buckets. You might have your dividend bucket over here and your emerging markets bucket over here but if you think in terms of circles, that small area where the circles overlap, it's really an exciting space. I like to think of it if you look back in time at those old Reese's commercials where they talk about, you got your chocolate and my peanut butter and my peanut butter and my chocolate and you try it out, and they work great together.
And that's the way we feel about dividend payers in the developing world because of the fact that, if you want to get that developing world growth exposure, doing it within dividend stocks and yielding stocks, is perhaps a little more conservative way of getting that. Because if you're looking at names that they paid dividends, it means within that space, you're talking about stocks that are perhaps a little bit more mature in their lifecycle. It means that they're obviously producing free cash flow to support those dividends. I think probably one of the most valuable things is it gives investors earnings transparency. We've seen going back over the last couple of decades, it doesn't matter whether you're in Taiwan, or if you're in Houston, Texas, it's easy for companies to manipulate reported earnings, but you can't manipulate a dividend.
Down here in Dallas, we call that train ride money. It's something tangible. You can touch it, feel it, put it in your pocket. To an extent the portion of earnings that are paid out as a dividend you know that’s real, and you know that management views it as being sustainable. So that's a little bit of a snapshot as far as how we end up looking at the space.
03:55 Kirsten Longbottom
That's great, thank you. We'll dive into a bit of each of those areas you focused on. Cam, to set the scene for our discussion, can you tell us what picture has emerged from the flows so far this year that we've seen on the emerging market side?
04:13 Cameron Brandt
It's certainly so far been a year where investors who viewed emerging markets as the glass half full despite a lot of fairly alarming headlines from many of the key actors. The universe of Emerging Markets Equity Funds we track have collectively pulled in $90 billion so far this year, while their Developed Markets counterparts have seen $83 billion flow out, so the needle has definitely swung in direction of EM funds. However, as ever, that headline number often conceals some less compelling things and one of them is that China and India funds between them account for 75% of the headline number. So other markets and regions have been getting 25% of that nice sounding $90 billion slice.
In addition to India and China, we have seen a pickup in interest in Latin American funds. Interestingly tied not so much, as historically been the case, to hopes for Chinese demand, though that is certainly there, but more because of a realization that a lot of the sustainable and clean energy infrastructure that especially in developed markets governments are pushing for, require an awful lot of copper, zinc, lithium and a lot of that will of necessity have to come from Latin America.
In the past few weeks, we've noticed diminished interest and actually this has been true since mid-second quarter in diversified exposure, which is not necessarily a bullish sign for emerging markets. But GEM Equity Bonds have struggled to attract fresh money now, for at least four months. And the EMEA universe, since it took that tremendous shot in the shins from Russia's incursion into Ukraine last year, really has struggled to capture investor interest and money.
06:32 Kirsten Longbottom
Burns, we'll jump back over to you. Why don't we start with the 800-pound gorilla in the EM room? Do you think China is an investable stance?
06:43 Burns McKinney
Well, first of all, the fact that people are asking that already tells me that you're going to find value opportunities there because it is so out of favor. One of the things that we look at we say, yeah, I think in large part you do need to start looking there, because a number of the headwinds that investors have been talking about or focused on over the last couple of years, are either poised to become tailwinds, or they're already doing that. I think, specifically speaking, policymakers have pivoted away from a lot of the attacks, the regulatory attacks on some of the internet platforms, the restrictions related to COVID, those have largely opened up. Now, no one ever said that was going to be a smooth process but that's opening up.
One other thing is that because I think one of the areas you really do have to, probably the biggest real area of concern, is the housing sector in China. And you have seen policymakers really shift towards trying to offer some sort of support for developers in the housing sector. And the biggest thing is that China, as a result of some of these recent headwinds, is trading at historically cheap, steep discounts to the rest of the world. Right now, the MSCI China index is trading around half of where it was two or three years ago. The risk premium that investors get compensated with for investing, it's over three times that for Chinese equities of what it is for US stocks right now. But at the same time, investors should prepare for volatility. That sharp turns towards reopening is something that it's not going to go super smoothly in the near term. But, for longer term investors, we do feel that the growth story in China it is maturing, it's not dying.
I think investors, if you think in terms of having a broad globally diversified portfolio, China's share of the global economy, if you look at it on purchasing power parity basis, has now surpassed that of the United States. If you look at manufacturing, China has nearly a third of global manufacturing which is I think the US is maybe a fifth or something like that. It's a major trading partner to a lot of countries. They have the ability to move very quickly to build infrastructure faster than we can, 5Gs really far along. There's certainly a lot to like in the longer term, but as I noted in the near term, investors should expect volatility, and that actually really takes us back to the point I was making a few minutes ago. What's one of the best ways to mute volatility? And that's to look at companies that are paying growing dividends, which is a way of keeping up with inflation and, again, the dividend portion of your return. Capital gains can be positive or negative, but dividends paid, they're always positive. You can't pay a negative dividend. And so that's one way of going about it.
09:27 Kirsten Longbottom
Just to halt on the sector fund portion of your discussion there. I think when we're looking at our EPFR tracked sector funds, specifically China technology and utilities, those seem to be areas investors are definitely focusing in and putting money into. China Utilities Sector Funds last year, saw their total net assets grow by 15,000%, which was quite incredible for that group, it's that huge upshot and kind of technology again, seems to be a consistent breadwinner in that space. This year, I believe they're up to $14.8 billion so far this year. Last year, they attracted $24 billion so right on track for a similar level there, kind of interesting. What do you think the story is behind China Technology and Utilities sector funds?
10:29 Burns McKinney
Although within those, I think the utility space is a really interesting way to go about getting that exposure in China. It's not one that gets really talked about as much I think a lot of the focus has been on more of the communications area. But an example, again, I like to talk to examples because it really gives a snapshot as far as how we think of the world would be a name like ENN energy, which is a Chinese gas utility. Right now, that's a name that's trading at about a 20% discount to where it has over the last 15 years or so. They have a three plus percent dividend yield. And what we especially like about it is those dividends grown by over 20% per year, over the last five years. What you're getting there in the name is China's gas consumption has been growing at double digit rates, which is really central to Chinese policymakers’ admissions cut goals, which in many ways makes it an ESG leader. They've had-- The ESG momentum has been very strong there. They've been MSCI has upgraded their ESG score in 2021, as well as 2022. And you just overall, you have China trying to make a real policy driven move from coal towards natural gas. In many ways I like to think of as a great example of a name whereby you're getting a low valuation and solid fundamentals, as well as a play on sustainable energy, I think which can also act as a tailwind from the investment side going forward.
11:51 Kirsten Longbottom
We touched on India earlier as well as an alternative to China. Do we think it's a credible alternative to China? Cam, Burns, either one?
12:02 Cameron Brandt
There's a certain Groundhog Day quality to the expectation that India will break free and start to realize its potential, and certainly its equities reflect a great deal of optimism. Average valuations are running at nearly double China's at the moment, which may be another reason to pay more attention to China given the relative cheapness. And certainly it has a history of finding ways to short circuit periods of momentum with policy missteps. But that said, I should know better than to say words like this time, it's different, but there are definitely some elements of it that are different this time.
There's a lot more top-notch infrastructure being laid down, which means that surges and growth are not going to sort of hit the buffers literally and figuratively, as hard as they have in previous moves forward. And I've been sort of paying some attention to the fact that India for a long time was a market that gave you protection against the emerging markets export story because it was very much a domestic demand story with a relatively low exposure to global trade. That's changing quickly. A lot of certainly regional leaders are moving to take advantage of China's relative unpopularity as a destination for offshoring. There's much more openness now to global manufacturing. So, I definitely think in a selective way that it is worth paying some attention to, I don't know if you agree, Burns.
13:48 Burns McKinney
I think investors do have to pick their points. India is definitely more of a growth story than a value story. But, as you noted, for longer term investors, there is a lot to like. One thing that we really agree with that you pointed out was the that they're finally getting their act together as far as upgrading the infrastructure with respect to the highways, power and water. You've got a great demographic story as a result of the better demographic and population growth. India recently overtook China as the world's most populous country. So, there's that. Bureaucracy, government bureaucracy as far as permitting for investments is slowly reforming. And you have a hugely growing middle class, for which digitization has really started to increasingly connect a lot of the population to banking. So we’ve got China's working age population is shrinking. In India, it's growing. But valuations are rich, if you look at the market as a whole, the overall forward P multiple of India is at least half of that of China. And so you had to pick your points to take advantage of some of those trends.
An example of something that has been kind of interesting to us if you want to see that growing population would be something like an HDFC Bank, which is again, we're looking for a lot of those stable premier names over there. It's a name that still trades at a discount to some of its Indian banking peers. What they are is they're the top mortgage financial institution in India, they have a strong asset quality, a good funding base. If you look at mortgages, default rates tend to be fairly low in India. I think that people really place a lot of priority on their home is their castle, so to speak. Earnings have been growing and a lot of that has to do with the growing middle class and they've been growing branches to take advantage of that, they have good living standards as examples like that, where if you're going to go there, by the best house in the neighborhood if you can, so to speak.
15:49 Kirsten Longbottom
Burns, do you share the enthusiasm we've been seeing for Latin America? Do you see it as a green story as well?
15:57 Burns McKinney
I don't 100% know about the green story, but you definitely do have the fact that a lot of the minerals and materials that are needed for green energy and batteries, that the mining sector in Latin America is certainly poised to benefit. I think that's one of the reasons why Latin America was a really good performer last year relative to the other emerging markets. Another thing that I think that Latin America is probably poised to gain from would be deglobalization. You think about nearshoring and safe shoring of both trade and supply chains. They can be poised to benefit. I think one thing is that we at least always have pause in some areas is that, in a lot of countries in Latin America, there's always been call it an on and off again relationship with inflation. And so, between that as well as certain areas where you might have leaders’ kind of shifting the other direction undermining democracy. There certainly are geopolitical risks that investors have to be aware of and sidestep. So, we don't have a lot of exposure in Latin America today.
17:03 Kirsten Longbottom
It's been over 18 months since Russia invaded Ukraine. A lot longer than some of us might have expected, but along the way, they've dealt a heavy blow to investor appetite for EMEA exposure. Cam, Burns, is there any hope for this corner of the EMEA universe?
17:23 Cameron Brandt
Well, I think before we sort of look at hope and hopefully Burns, will come up, pull a rabbit out of that hat. I think it's important to note that while Russia's incursion into Ukraine in some ways crystallized all the issues that dog that particular part of the EM universe, it has plenty of supporting actors in terms of making it an uncomfortable pool for investors to swim in. You have Turkey's dogged pursuit of an anti-inflationary policy that consisted of cutting interest rates, you have the breakdown of South African governance and institutions, you have an increasingly nationalist statist political philosophy spreading across emerging Europe and a lot of Africa's classic problems with weak institutions grout, post-colonial problems are still with us. So, there is an awful lot there that the headwinds are multiple and blowing strong. So the usual approach there is, again to think at the company level and to be ultra selective but EPFR does not sort of advise. But were we in that position, I would not be advising anyone to really wade into that corner. Burns and his team do advise, I think, and I'm interested to hear what he makes of that particular part of the emerging markets universe.
19:14 Burns McKinney
That's an area where really a lot of our risk controls make us a bit hesitant to make geopolitical bets right now. Going back to 2022, you had transactions a lot of areas at least in Russia that were blocked by the Biden administration, you had the global OTC suspended trading and a lot of names there. Whenever you're starting to deal with that sort of thing, you're not necessarily talking about market fundamentals. You're not talking about revenue growth; you're not talking about margins. You're talking about regulators stepping in and oftentimes, in many cases, you have names that just cease to offer the corporate governance that would make them investable. Between that as well as just really challenging price momentum, we kind of operate by the mindset in some cases as value investors, we're value investors but we don't want to bottom, don't try to attack or nail the bottom. We'd rather be six months too late to a story rather than six months too early to story.
20:08 Kirsten Longbottom
So, we just started this discussion by focusing on one 800-pound gorilla in the EM room and that was China. To wrap up, what about the other one and by that, I mean, the Fed and the impact its tightening has had on EM markets? Burns, do you expect anything? Do you have expectations for this?
20:29 Burns McKinney
In many ways, that's another case of a headwind turning into a tailwind. I think the bond market is finally buying in and finally believes that the Fed is either done or near done raising rates, but also that they're probably going to keep rates unchanged for an extended period. Jay Powell has been very consistent in his statements of there being asymmetric risk of a stop and start policy that the Fed or undertook per se in the 1970s when it came to fighting inflation. But if you look at well, okay, what's the impact of that fed policy for overseas investors? We look at the dollar, the dollar started 2022 or actually 2023, rather as overvalued on a trade weighted basis as it had been in 30 or 40 years, it was really significantly overvalued. With the Fed finishing their tightening cycle, with risk sentiment easing from say where it was last year. Last year you had risk factors like the Russian invasion, like the debt earlier in the year, the debt ceiling issues, a lot of that is easing and so, as a result, you do have a little bit more of a flight risk on trade should mean the dollar would be weaker. And overall, that's usually a positive for emerging market stocks, especially many of which tend to hold debt denominated in dollars. And so that easing dollar probably, again does lead to a bit more of a risk on environment which would be a positive for investors overseas. But again, we always like to caution that if you're doing that, you'll find a safer way to do it. Look at companies that have clean balance sheets, that have stable and recurring earnings, and that are returning capital to shareholders, are buying back shares and they're paying out cash to shareholders.
22:13 Kirsten Longbottom
Well, thank you both so much for your insight today and giving perspective on the EM universe. Whether that was from China to India to EMEA, we covered quite a bit. Fr future podcasts, we invite EPFR and industry experts to discuss timely trends driving financial markets aimed at arming global investors with a deeper understanding of where money is moving and why. If you have a topic you would like to discuss or are interested in joining us for an episode, please don't hesitate to reach out to Cam or myself. Thank you Burns. Thank you, Cam.
22:53 Cameron Brandt
Thank you, Kirsten, thank you Burns.
22:55 Burns McKinney
Thanks Cam. Thanks Kirsten.
22:57 Outro: Thanks for listening to the EPFR Exchange Podcast. For more information, visit epfr.com or epfr.buzzsprout.com. Interested in joining Cam and Kirsten to talk fund flows and allocation data or have a suggestion for the topic of a future podcast? Email us directly at podcast@epfr.com