Real Estate in the Energy Capital of the World

Much has been made of the dramatic movements in oil prices and the potential effects both domestically and internationally. Here, we narrow in on oil’s impact on Houston, the self-proclaimed “Energy Capital of the World” and, specifically, on real estate in Houston.

The crude oil price collapse of 1986—where prices fell 58% in just over seven months—devastated the Houston economy. The negative impact was magnified by the “double-whammy” that included massive over-building in the oil patch triggering the Savings & Loan crisis. It took nearly ten years for Houston to recover.

In more recent years, Texas led the charge coming out of the Great Financial Crisis in large part due to its ties to the energy sector, creating 25% of all net new jobs in the U.S. since 2009. Houston, specifically, boasts a 4.1% unemployment rate (as of 12/2014), well below the 5.6% national average.1 The addition of healthcare and higher education sectors has made for a more diversified local economy, yet Houston remains heavily energy-dependent. Although nearly half of the figure from the 1980s, roughly 38% of Houston’s economy is tied directly to energy.2

Real Estate Houses Houston’s Economy
And the mood in Houston has changed. Houston’s real estate “houses” its economy; there is a clear connection between the energy sector boom and real estate market strength. With oil prices now down by over 50% since July 2014, a cloud is hanging over the metro’s real estate markets, as much because of uncertainty associated with oil price volatility as the actual drop itself. Until prices stabilize, both buyers and lenders will perceive the Houston market as a riskier trade, which will lead to higher return requirements and lower prices. Many firms are hitting the pause button on moves and expansions, especially in Houston’s Central Business District (“CBD”) and the Energy Corridor. Moreover, media reaction to the oil price decline has been intense and is influencing the tone of landlord/tenant conversations. Near-term this will negatively impact rents, perhaps in the range of 5% to 10%.

Submarket Exposure to Energy is Key
Within the Houston metro, the submarkets differ in their exposure to energy. For example, office tenancy in the Galleria submarket is only 34% directly linked to energy, compared to 50% and 80% of office tenants in the CBD and Energy Corridor, respectively.3 As such, markets like the Galleria will be cushioned by its diverse tenancy and will fare better in a downturn than others.Houston Real Estate Oil Prices Submarket Exposure

Looking Forward
The ultimate impact of cheaper oil on the Houston economy and its real estate markets depends largely upon two things: 1) How low will oil prices go? and 2) How long will they stay there? Should lower oil prices persist, it is expected that merger and acquisition activity will increase. This will likely result in more layoffs from redundancies and consolidation of space, dampening the demand for space. And, especially when mixed with the spate of new construction, this, in turn, should lead to a decrease in rents as landlords scramble to attract and retain tenants.

Houston’s diversified economy, pro-business government and tax structure, and entrepreneurial culture will help the city continue to grow. On the other hand, if lower oil prices persist, they will dampen that growth such that it will feel as though Houston is in recession. This will put the brakes on new development projects in the pipeline and also slow down the lease-up of recently completed projects and properties currently under-construction.

It would be highly speculative to attempt to divine an immediate impact. Hard data for evaluating the current environment is scant, as it takes time for completed transactions to substantiate market movement. Anecdotes on buyer “re-trades” point to slightly higher capitalization rates and modestly lower prices across property sectors. The magnitude of these moves is heavily dependent upon asset-specific factors like location, quality and tenancy. Only once oil prices settle will it be possible to make well-reasoned forecasts on either the near-term or medium-term impact to Houston’s real estate market.

1 Bureau of Labor Statistics.
2 Greater Houston Partnership based upon U.S. Bureau of Economic Analysis Statistics.
3 Colvill Office Properties.


This communication is for informational purposes only and is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. This communication does not take into account the particular investment objectives, financial situations or needs of individual clients. References to specific stocks are for illustrative purposes only and are not intended to represent any past, present or future investment recommendations. Charts and performance information provided in this presentation are not indicative of the past or future performance of any Bailard product, strategy or account. All investments have the risk of loss. In addition to the normal risks associated with investing, international investments in a single country may involve risk of capital loss from fluctuations in currency values, from differences in generally accepted accounting principles, from country specific risks and from economic or political instability in other nations. Emerging markets involve heightened risk related to the same factors, as well as increased volatility and lower trading volume. There is no assurance that Bailard or any of its investment strategies can achieve their investment objectives. Past performance is no guarantee of future results. This communication contains the current opinion of its author and such opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Bailard cannot provide investment advice in any jurisdiction where it is prohibited from doing so.

Abenomics: One Arrow or Three?

Abenomics Japan Investing One Arrow or ThreeWhat is Abenomics, really?
Twenty one months ago, the term Abenomics was born with the election of Japan Prime Minister Shinzo Abe and his appointment of Haruhiko Kuroda as head of the Bank of Japan. It was then that we were introduced by Abe to the Japanese parable of three arrows. The old parable says that any individual arrow can be easily broken, but that together three arrows are unbreakable – in fact, almost unbendable. The parable has worn thin for Japan.

First Arrow: Monetary Policy
First came some great rhetoric and aggressive quantitative easing, Kuroda swore he would “break the back of deflation.” And so, a new and colossal buyer emerged to buy the ever-expanding debt issued by the Japanese: the Bank of Japan. We all know the trope: Japan has the highest debt-to-GDP of any nation on earth, the level is growing fast and, at some point in the future, when interest rates rise due to irresponsible money creation, the mountain of debt will come down on Japan like Godzilla out of Tokyo Bay.

Second Arrow: Fiscal Policy
Abe quickly began to take steps to energize the economy from the fiscal side. The steps were at best tepid, and now, a year and a half later, mostly forgotten. This Spring’s increase in the consumption tax, a worthy attempt to shore up the nation’s finances, seems like 1997 redux: pushing the nation to the brink of recession yet again. The Prime Minister’s recent choice to delay next year’s second round of tax increases and to call a snap election while his popularity remains high enough to reaffirm his coalition are just reactions to weak economic data, not actions reflective of strong leadership.

Third Arrow: Structural Reform
Finally, the third arrow – structural reform – is the one investors were most intrigued by: could one man alter Japanese business culture entrenched since the Meiji Restoration in 1868? If Abenomics meant a new mindset of creating a more efficient business culture with greater focus on returns to shareholders, if it meant creating a new culture of spending in relatively parsimonious Japan, if it meant a new, younger invigorated workforce to replace the swelling band of pensioners, well, the results are, so far, less than inspiring.

The Bar for Abenomics Set Low
But that doesn’t seem to be what Abenomics has become shorthand for. These days it seems like success will simply be measured by having “no chance” of seeing 1% inflation again, ending the “deflation mindset”, etc. It seems that everything but monetary policy has become just too hard. In contrast, the tools to work for reflation are common to the central banker albeit never used in such magnitude.

Abenomics is simply weakening the yen with two goals: one, making imports more expensive so the nation can “import inflation” (note that it’s important to consider here energy, which has become a larger proportion of imports since the shutdown of all of Japan’s nuclear generators after the Fukushima disaster); and two, making Japan’s exports cheaper to foreigners.

exports-of-goods-and-services-as-of-gdpNow, remember that Japan doesn’t export as much as many imagine: recent data show exports adding only 14% to the nation’s GDP, about on par with the relatively light-trading U.S. and a far cry from its export-intensive neighbor, South Korea, for which exports makeup almost half of GDP. The magnitude of the benefits of a weaker currency is therefore less as well.

The Silver Lining – For Now
As we consider Abenomics, we must remember that while a modest bit of inflation could rekindle Japan’s animal spirits, what the nation really needs is higher nominal GDP growth to work down the nation’s debt load…especially as the nation ages and its savers (owners of the debt) begin to sell.

All that said, for investors, Japanese companies have been turning in strong earnings for six quarters now, and while they may slow a bit, the near-term picture isn’t as gloomy as my frustrations over Abenomics may suggest.


This communication is for informational purposes only and is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. This communication does not take into account the particular investment objectives, financial situations or needs of individual clients. References to specific stocks are for illustrative purposes only and are not intended to represent any past, present or future investment recommendations. Charts and performance information provided in this presentation are not indicative of the past or future performance of any Bailard product, strategy or account. All investments have the risk of loss. In addition to the normal risks associated with investing, international investments in a single country may involve risk of capital loss from fluctuations in currency values, from differences in generally accepted accounting principles, from country specific risks and from economic or political instability in other nations. Emerging markets involve heightened risk related to the same factors, as well as increased volatility and lower trading volume. There is no assurance that Bailard or any of its investment strategies can achieve their investment objectives. Past performance is no guarantee of future results. This communication contains the current opinion of its author and such opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Bailard cannot provide investment advice in any jurisdiction where it is prohibited from doing so.

Qatar and UAE May Bring Heat to the Emerging Markets

Image: UAE & Qatar

Welcome to the Big Leagues, guys. Well, hey, to AAA ball anyway. And you very well may be the all-stars there. You’re different than everybody else. In some ways you’re definitely the veterans with a lot to teach some of those with raw skills (or materials). You’re getting called up mid-season, but the rest of the guys have been hitting below their weight for more than a year now.

Welcome to the ranks of emerging markets, Qatar and UAE. Many investors will have trouble knowing what to make of you. You’re like the Dodgers’ Yasiel Puig, five-tool players but with other (positive and negative) intangibles. On a per capita basis you’re two of the wealthiest nations on earth. You have political stability that even some developed countries might envy (think France, Italy, and until recently Greece). That political stability isn’t unvarnished though; it comes in the form of absolute monarchies which confer few rights on the majority of their populations (who aren’t citizens but foreign workers primarily from South and East Asia).

At the same time, being an Emirati or Qatari provides social welfare benefits unequaled even in Western Europe: in Dubai primary and secondary education is free, ditto health care…and ditto HOUSING! And the price of these benefits to the nations’ citizens? Zilch. Nada. No income tax, no sales tax, no property tax. While great for the pocketbook, the reality is that such systems make the government unaccountable to the citizenry, progress to democracy rare and can allow the function of government to overwhelm other productive enterprises. So long as the majority of citizens feel like they’re getting their fair share of the nation’s natural resource bounty, stability reigns. When it is perceived that the spoils aren’t filtering down sufficiently, you end up with failed rentier states like Venezuela or many in Central Africa.

For now Qatar is the largest natural gas exporter in the world and the fruits from that are remarkable. The UAE’s flag carrier, Emirates, is the largest international airline; both Emirates and Qatar Air are consistently measured as among the best airlines in the world. The Dubai airport is on the verge of usurping the title of busiest international passenger airport from London’s Heathrow airport. The most recent Global Competitiveness Index produced by the World Economic Forum placed Qatar 13th and UAE 19th in the world (sandwiching the very developed markets of Canada, Denmark, Austria, Belgium and New Zealand in the 14th to 18th spots).

For investors, the question is “what are you buying when investing in Qatar or UAE?” You’re not looking for social change (there won’t be any). You’re not investing in a growing middle class (they’re already rich). If UAE/Qatar were a major leaguer, maybe they’d be Ichiro; he had a hall of fame quality career in Japan before crossing the Pacific to see how his skills matched against the world’s best. In his case, the answer was: his game was revolutionary and adapted well to the Majors (who’d have thought that George Sisler’s single season hits record would ever be broken?). In the case of UAE and Qatar we’re not getting what we’d expect—oil and gas—since those are primarily state monopolies. What we are getting are the companies that have been created with that wealth to diversify the nations’ economies. The UAE Index is made up entirely of financial firms (banks and property financing companies) and industrials (builders and port operators). Qatar adds a little diversity to that mix with the country’s major telecommunications companies and a bit of utility exposure. Going outside the index names, there are some mid-size gas transmission companies as well as more industrials, including a local budget air carrier.

For investors, these new emerging markets offer access to growth in a region that has huge reserves of natural resources to support their aims to become the financial capital of the Middle East, a top vacation destination, one of the world’s major transportation hubs and, with some of the best engineering know-how in the region, the chance to become the builder of the Middle East (think a combination of Singapore and Korea).

They’re both priced like bonus babies right now, with price-to-earnings ratios above the emerging market average. That said, they’re producing some pretty solid earnings as well, better in fact than many other emerging markets.

Time to start thinking like a manager and figuring out where these two markets fit in your line-up…. 

 

This communication is for informational purposes only and is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. This communication does not take into account the particular investment objectives, financial situations or needs of individual clients. References to specific stocks are for illustrative purposes only and are not intended to represent any past, present or future investment recommendations. Charts and performance information provided in this presentation are not indicative of the past or future performance of any Bailard product, strategy or account. All investments have the risk of loss. In addition to the normal risks associated with investing, international investments in a single country may involve risk of capital loss from fluctuations in currency values, from differences in generally accepted accounting principles, from country specific risks and from economic or political instability in other nations. Emerging markets involve heightened risk related to the same factors, as well as increased volatility and lower trading volume. There is no assurance that Bailard or any of its investment strategies can achieve their investment objectives. Past performance is no guarantee of future results. This communication contains the current opinion of its author and such opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Bailard cannot provide investment advice in any jurisdiction where it is prohibited from doing so.

Would Russia Risk its Golden Goose?

Photo courtesy of Greg Westfall, http://flic.kr/p/cxK6pGIt is the job of investment managers to generate conviction through analysis and interpretation. As an investment opportunity, Russia may be looked back upon as one of the most obvious value traps in the past 20 years, a market dripping with political risk and declining toward the kind of pariah status held by Venezuela and Iran.

I just don’t believe it.

I think the economic interests of various players actually coincide in such a way to overwhelm Putin’s maniacal dreams. Here’s a BIG disclaimer: such bets don’t always work. While commentators enjoy describing the globalization of the past 30 years, we didn’t invent it; we rediscovered it. Global trade as a percentage of GDP didn’t regain its pre-WWI level until the 1970s. Europe prior to WWI was so highly integrated that no one thought war was possible. Same can be said to a lesser extent for 1930’s Europe. Those didn’t work out so well for the optimists of economics over politics.

There are a lot of positives I hear cited that don’t hold a lot of water. Yes, Russia has vast foreign currency reserves (5th highest in the world at about $450 billion). And that makes sense. It has had a balance of payments surplus on the order of $150 to $200 billion annually due to its extensive exports of gas and oil. But such big numbers can evaporate quickly in times of crisis. Last year saw capital outflows of $63 billion. The current estimate for the first quarter of this year is $63.7 billion. At this rate the piggy bank doesn’t look quite so stuffed.

Russia’s failure to adequately diversify its economy beyond defense and energy has left it largely bereft of infrastructure and, more importantly, a broader range of industries from which to generate economic growth. And so we get to the real kernel here: if Russia’s balance of payments is so dependent on the energy sector, can it afford to risk its golden goose? Russia spends a fortune on a social safety net to offset the lack of economic opportunity in Russia. This is expensive. Less than ten years ago, an oil price of $30 to $40 per barrel was sufficient to balance the national budget. Today, the estimate is something closer to $115 per barrel. Losing the revenue that its biggest customers (Western Europe) pay for oil and gas would disrupt that social contract. Further, the cost of supporting its expanding empire, including Crimea but potentially with other portions of Eastern Ukraine (which are also poorer than Russia as a whole), would exacerbate Russia’s ability to keep the masses satisfied. While the social contract between the government and the citizenry in Russia has never been strong, the history of uprisings against the government is.

So where does that leave Russia?

It needs Europe. But Europe also needs it. For Western Europe, the starting point is pretty good. After a mild winter, natural gas reserves are high and the demand for them during the temperate spring and summer is modest. But come winter, the need for Russian gas will be undeniable. Unlike other forms of fuel that are more easily transported, getting substitutes for gas over the short-term (i.e., several years) is almost impossible. The minimal sanctions employed thus far and the surprisingly conciliatory tack Angela Merkel is taking are indicative of this reality for Western Europe.

With prices roughly at five times current earnings, investors are discounting a tremendous amount of bad news in Russian stocks. Those who are avoiding the market may actually be the ones who get burned.

 

 

Photo: Gazprom facility on the Moscow River. Courtesy of Greg Westfall, flic.kr/p/cxK6pG.

This communication is for informational purposes only and is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. This communication does not take into account the particular investment objectives, financial situations or needs of individual clients. Charts and performance information provided in this presentation are not indicative of the past or future performance of any Bailard product, strategy or account. All investments have the risk of loss. In addition to the normal risks associated with investing, international investments in a single country may involve risk of capital loss from fluctuations in currency values, from differences in generally accepted accounting principles, from country specific risks and from economic or political instability in other nations. There is no assurance that Bailard or any of its investment strategies can achieve their investment objectives. Past performance is no guarantee of future results. This communication contains the current opinion of its author and such opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Bailard cannot provide investment advice in any jurisdiction where it is prohibited from doing so.

Rising interest rates may not adversely impact commercial real estate

What happens to commercial real estate values in a rising interest rate environment? When interest rates are trending downward, real estate yields tend to follow suit. However, in a rising interest rate environment, the story is quite different. As the table below illustrates, sometimes real estate yields (cap rates) rise, sometimes they remain flat, and sometimes real estate yields actually decline!

Chart: Effect of Interest Rates on Real Estate

Impact of Rising Rates
In today’s environment, it is possible that rising rates may not mean a corresponding rise in commercial real estate yields (a decline in property values). According to Real Capital Analytics, the spread premium between commercial real estate yields and the ten-year U.S. Treasury bond is 32 basis points (0.32%) wider than the historical average since 2001 of 355 basis points (3.55%). This means there is room for the spread premium to contract as rates rise, leaving overall cap rates relatively unchanged. It also seems likely that investors have some room in their underwriting to accommodate a rise in yields; in fact, the average cap rate for commercial real estate has actually declined since May of 2013 when interest rates began their upward march.

In the event that cap rates do begin to increase, it is possible the effect on property valuations may be at least partially offset by growth in net operating incomes (NOI) as well. A continued economic expansion should result in higher rents and occupancies flowing through to the bottom line, increasing the numerator in the property valuation equation (NOI/cap rate = property value).

While rising rates mean higher borrowing costs for leveraged investors, higher interest rates would also serve as a governor on new supply, making it more difficult for developers to obtain construction financing and thus further aiding the recovery in property market fundamentals.

Outlook for Real Estate
There are a number of reasons to remain optimistic about the prospects for commercial real estate. Property market fundamentals (rents and occupancies) continue their upward trajectory. New construction remains fairly muted, in part due to a somewhat sluggish economic recovery. And interest rates, despite the recent rise, remain low in an absolute sense. Although all investments have risks, we continue to believe that the prospects for the asset class are bright.

 

 

This communication is for informational purposes only and is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. This communication does not take into account the particular investment objectives, financial situations or needs of individual clients. Any references to specific securities are included solely as general market commentary and were selected based on criteria unrelated to Bailard’s portfolio recommendations or past performance of any security held in any Bailard account or fund. Unless otherwise indicated, charts and performance information provided in this presentation are not indicative of the past or future performance of any Bailard product, strategy or account. All investments have risks, including the risk that they may lose money. In addition to the normal risks associated with investing, real estate has additional risks unique to the asset class. There is no assurance that Bailard or any of its investment strategies can achieve their investment objectives. Past performance is no guarantee of future results. This communication contains the current opinion of its author and such opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Bailard cannot provide investment advice in any jurisdiction where it is prohibited from doing so.

Global Commodities Trading: Think Beyond China

IMAGE: Globe with Arrows

Every subtle change in Chinese GDP has a dramatic effect on the Chiles, Australias and Brazils of the world. Investors have come to perceive that only the giant maw of China’s raw materials demand can support the equities of export-intensive nations. But while China may be the biggest beast in the room, it isn’t alone. With incipient Japanese growth and manufacturing returning to the U.S., it is becoming equally important for investors to focus on the fortunes of these (and other developed) economies when considering the fate of companies in traditionally commodity-exporting countries.

But first off, the news of China’s demise is a bit exaggerated. Even with slightly weaker headline GDP, China’s imports have risen dramatically this year compared to 2011 with many partners: Australia has enjoyed 16.3% growth over the past year, for example. Many of the countries that have suffered from China’s (relative) slowdown have been those providing finished goods; Japan’s exports to China, for instance, have declined more than 10% over the same period.

In terms of the broader global picture, much of the critical building of infrastructure (which has been dominated by China for the past two decades) is likely to shift to the developed world. Over the past decade, Chinese municipalities have taken on large amounts of debt to execute infrastructure projects directed by the national government. While the building will continue, it will slow as their infrastructure deficit has shrunk and their debt burdens have grown. The story is quite different in Japan, the U.S. and Europe, all of which experienced major infrastructure build-outs in the 1950s and 1960s. Here, existing projects are reaching the end of their projected lives. Bridges, tunnels, gas pipelines and electrical grids are being pushed beyond their capacities and are in dire need of replacement. This will be a critical theme in the developed markets in coming years.

As China endeavors to shift the focus of GDP growth away from the government-sponsored infrastructure projects to a stronger contribution from consumer demand, their dependence on raw materials will, at the margin, diminish. With the dependence on raw materials increasing elsewhere, it is likely that the sensitivities of commodity-exporting countries, currencies and companies to announcements of Chinese growth will decrease, while the correlation between growth in the developed markets and commodity producers will rise.

 

 

This communication is for informational purposes only and is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. This communication does not take into account the particular investment objectives, financial situations or needs of individual clients. Any references to specific securities are included solely as general market commentary and were selected based on criteria unrelated to Bailard’s portfolio recommendations or past performance of any security held in any Bailard account or fund. Unless otherwise indicated, charts and performance information provided in this presentation are not indicative of the past or future performance of any Bailard product, strategy or account. All investments have risks, including the risk that they may lose money. In addition to the normal risks associated with investing, international investments in a single country may involve risk of capital loss from fluctuations in currency values, from differences in generally accepted accounting principles, from country specific risks and from economic or political instability in other nations. There is no assurance that Bailard or any of its investment strategies can achieve their investment objectives. Past performance is no guarantee of future results. This communication contains the current opinion of its author and such opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Bailard cannot provide investment advice in any jurisdiction where it is prohibited from doing so.

Emerging Market Debt vs. Equity: Where is the Opportunity Now?

Photo courtesy of Tim Evanson, http://flic.kr/p/ddw5TM.The Fed giveth, and the Fed taketh away. Global stocks and bonds—rallying nicely against a backdrop of ultra-easy monetary policy on the part of central bankers in the U.S., Europe and Japan—have fallen sharply over the past month, pulling many markets into losses for the year. We can see the turning point on May 22, following congressional testimony from Ben Bernanke. What he said then, and restated on June 19, seems fairly reasonable: that Fed policy will change in response to improvements in the economy and unemployment. But investors were in no mood to contemplate a balanced macroeconomic diet; they wanted only to continue guzzling the high-fructose corn syrup of open-ended quantitative easing. They threw a fit.

Among the asset areas hit hardest in this correction are stocks and bonds in the emerging markets. Outside capital has fled from risk, as the hot money often does when fear takes hold. In addition to the Fed Chairman musing publicly about tighter conditions down the road, China’s central bank is apparently clamping down on credit growth, causing spikes in the overnight lending rate (SHIBOR). Although there are obvious good reasons for China to come to grips with its mounting internal debts, the action has unnerved markets nonetheless. Adding to the tension are ongoing anti-government demonstrations in Turkey and Brazil.

An investment manager sees a 15% drop in emerging market (EM) stocks and a 10% drop in EM bonds (as measured by the MSCI Emerging Markets (EM) index and the Citi Emerging Market Sovereign Bond Index, respectively), and asks: now that prices are lower on assets that are fundamentally unchanged, is there a good opportunity here? My answer to this is: yes and no.

Yes to emerging market stocks, no to EM bonds.

Why favor one and not the other? It comes down to entry point (valuation), potential upside (reward for risk taken on) and diversification benefit (how the asset mixes with other elements of an investment portfolio).

ENTRY POINT (VALUATION)

For better or worse (better if you are a potential buyer, worse if you were already an owner), EM stocks have been laggards all year, even prior to May 22, as concerns over slower growth in China weighed on commodity prices and Japan’s dramatic yen-weakening measures put pressure on other exporters in Asia. While the U.S. and other developed markets (measured by the MSCI EAFE index) were racking up double-digit gains, the MSCI EM index returned… zero. With the recent correction, emerging markets find themselves down 15% for the year, while developed non-U.S. markets hang on to small gains and the U.S. remains up over 10%, as measured by the S&P 500 index. As a result, the forward price/earnings ratio (price to next 12 months earnings) on the EM index is well under 10x, versus EAFE at more than 12x and the U.S. market at 14x. This gives the investor in emerging markets a margin of safety should corporate profit forecasts change for the worse.

By contrast, investors in EM bonds continued to pour money in right up to May of this year, pushing prices higher and yields lower. As 10-year U.S. Treasury yields sat at historical lows around 1.5% (less than the rate of inflation), EM government yield spreads over treasuries sat at a historically narrow 2.5%. In the pursuit of incremental income, lenders bid up the price of bonds so that going-in yield was a paltry 4%. Meanwhile EM stocks offered a dividend yield of nearly 3%. In the words of PIMCO bond titan Bill Gross (applying to bonds generally and EM debt specifically): “Never have investors reached so high in price for so low a return. Never have investors stooped so low for so much risk.” Fundamental improvements in countries’ budget balances, inflation rates, and economic policies had been fully priced in. Now that yields have risen back up closer to 5.5%, emerging market bonds are certainly cheaper today than they were a month ago. But does this mean that the asset represents good value? An assessment of the potential risks and rewards suggests not.

POTENTIAL UPSIDE (REWARD FOR RISK)

Though both assets come with risks inherent to emerging markets (more political instability, fewer legal and regulatory protections, wider currency swings, an arguably higher propensity for default or corporate bankruptcy), equities are admittedly riskier: meaning more price volatility and greater risk of loss compared to bonds. The potential reward on the stock side, however, is large enough to justify the risks, while the potential reward for bond holders is severely limited. Emerging economies are in a cyclical slowdown, not a secular decline. EM stocks will recover and eventually push past their all-time highs, on the back of a growing, consuming, investing, aspiring middle class—wealth creation on a scale to make the Industrial Revolution look like a pilot program. As time goes on, emerging markets are set to make up an ever larger share of world GDP, market capitalization and corporate profits. If these trends play out, even partially or fitfully, the stock investor—with an ownership stake in the emerging countries’ productive assets and a claim on their corporate cash flows—stands to benefit.

On the other hand, the bond investor stands to gain very little from emerging markets’ continued emergence. The upside scenario is that yields go back down to where they were in early May, and then to fresh all-time lows, and then… stay there. For how much lower could they possibly go? In the future will investors be lending money to EM companies and governments at 2%? (Currency appreciation could be a source of return but that would similarly benefit stock holders.) What odd combination of economic stagnation, price deflation, and eerie calm on the part of creditors would have to be in place for this to happen? The monetary authorities won’t by themselves be able to engineer low yields indefinitely; and in any case, their purpose is not an extended era of low yield for its own sake but the creation of more “normal” economic conditions under which GDP and interest rates may someday rise again. If anything, the last month of market action indicates that rates could normalize sooner than people expect, which would mark an end to the multi-decade bull market in bonds.

DIVERSIFICATION BENEFIT (ROLE IN A PORTFOLIO)

Taking on equity risk for equity return is what grows an investor’s portfolio over the years and decades. Higher-risk equities such as emerging market stocks can and should play an important role in that growth as one piece of the allocation puzzle. Looking back over the past ten years—a period encompassing commodity and housing bubbles, global financial crisises and central bank-led recoveries—it was a very good period indeed for EM equities, and EM bonds also show up rather well. The key distinction is that the attractive returns enjoyed by EM stocks over the past ten years, or 20, could conceivably be seen again over the next ten or 20 years. For bonds, though, the returns recorded over an era of declining yield are one-time-only. Common sense puts a floor on yields (people won’t lend at less than 0%), and arithmetic turns that into a cap on prices.

An asset with low expected return can still play a role in a portfolio, provided it offers a diversification benefit: that is, a price that moves differently than other asset prices. U.S. treasury bonds, for instance, have low or negative correlation with equities and also act as an insurance policy in the case of financial panic (return was positive in 2008 while stock markets crashed). The combination of treasury bonds and equities results in a smoother portfolio return series, which results in a portfolio owner who sleeps better at night. Unfortunately, the correlation between EM debt and equity return is much higher, especially in down markets (EM bond return was negative in 2008 along with stocks). So, having both in a portfolio does little for diversification. Simply put, an investor who believes in the merits of emerging market stocks can forego the addition of EM bonds.

 

 

Photo courtesy of Tim Evanson, http://flic.kr/p/ddw5TM.

The MSCI EAFE Index and the MSCI EM Index are free float-adjusted market capitalization indexes that are designed to measure equity market performance of global developed and emerging markets, respectively. The Citi Emerging Market Sovereign Bond Index includes Brady bonds and US dollar-denominated emerging market sovereign debt issued in the global, Yankee, and Eurodollar markets, excluding loans. The S&P 500 Index is a nationally recognized large-cap stock index. All indices are unmanaged, uninvestable, presented on a total return basis with dividends reinvested in U.S. dollars, and do not reflect transaction costs.

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