PIMCO recently hosted a conference call on emerging markets. Please see below for details on the call. Thanks to QES’s Nathan Dutzmann for the analyst coverage.
Investors are increasingly looking to emerging markets, because emerging markets are growing much faster than developed economies (“multi-speed growth”).
- BRIC countries have 13-14% nominal GDP growth, vs. 3-4% for developed world.
- PIMCO expects this to continue due to:
o Increasing domestic demand in emerging markets.
o Emerging markets starting from lower base, so more room to grow.
o Undergoing “middle income transition” -> changeover from low to middle class.
o Emerging markets can import technology from elsewhere and plug it into their economies.
For emerging market investments, macro views are vital.
- Country and currency selection account for about 50% of emerging market returns.
- Many reasons why macro factors may favor certain asset classes, sectors, etc.
o Multi-asset fund tilts among equities vs. fixed income, sovereign vs. corporate, long vs. short maturity, etc.
Emerging market equity has outperformed developed equity by 10% per year for a decade, but P/E ratios still look favorable.
- Are the high earnings inflated or sustainable? Based on comparison of margins, profits/GDP, and other measures, current earnings are on target by historical measures.
- Also, emerging market corporate leverage is lower than in developed countries, which is a potential source of future growth for emerging market companies.
- Technical measures are also supportive, and global capital is still under-allocated to emerging markets, although allocations are increasing as investors respond to higher returns.
- Ultimately, GDP growth rate drives growth.
PIMCO is more positive about emerging market sovereign debt than U.S. Treasurys.
- Emerging market sovereign debt has positive real yield, unlike much developed debt.
- Emerging market countries have been deleveraging over the past decade; emerging market debt/GDP around 50% vs. 100% for developed world. Credit quality actually favors emerging markets.
Everything about the emerging markets story (GDP growth, debt quality, capital flows) translates to stronger emerging market currencies in the long run.
How to extract the most value from emerging market investments? PIMCO’s method:
o Pitfalls to avoid: Ignoring macro outlook, not doing bottom-up analysis of securities, not protecting downside.
o PIMCO’s product is designed with these pitfalls in mind:
§ Unconstrained universe (no emerging market benchmarks).
§ Use of cyclical and secular macro analysis.
§ Tail-risk hedging (purchase large drawdown protection).
o Again, use top-down framework to show where to focus bottom-up analysis.
o Not all countries, currencies, or asset classes will benefit.
§ For example, Brazil’s fundamentals are very good, but not just any investment will work. This year, high GDP growth has led to inflation, which has led to high interest rates, so BRL fixed income is a good investment, but BRL equities have done poorly.
o Again, need to protect against tail risk. In short-term, many risks can hit emerging markets and cause disruptions, despite the long-term growth story.
Q: When will inflation pressure subside?
A: Inflation pressures are largely a result of GDP growth.
- GDP growth is commodity-intensive, so emerging market demand growth is partly driving commodity prices upward. At present, commodity prices may be pulling back from excessive levels.
- Still, inflation will be a consistent theme in the emerging market story.
Q: Is the multi-asset fund a balanced fund, or will it sometimes be almost completely in one asset class?
A: It is a balanced fund. Internal benchmark is 50% emerging market equities, 50% emerging market fixed income.
Q: How does PIMCO purchase protection?
A: Define “detachment point” (point at which protection becomes valuable): Around 30% for equity and 15% for multi-asset. Spend about 75-100 bps/yr on direct and indirect hedges. Indirect includes things like AUD puts or commodity puts. Indirect hedges are actively managed.
Q: Are the funds concentrated in the large “BRIC” countries?
A: No. Emerging market portfolios invest in around 45 EM countries, including “frontier” markets.
- Trying to take advantage of faster emerging market growth in smart risk-adjusted ways.
- For example, equities may have higher returns but much higher risks, so fixed income can improve overall portfolio. Same goes for “frontier” vs. “BRIC” investments.