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Bram de Haas
Bram de Haas
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GMO Doubles Down on Emerging Markets

A review of the firm's latest quarterly letter and its asset allocation policies

August 16, 2018 | About:

The GMO Asset Allocation team has a great reputation for accurately predicting market returns. They are known for being somewhat bearish, but perhaps everyone else is just overly optimistic. Ben Inker just wrote a quarterly letter focusing on the firm's call to move into emerging markets, which really hurt last quarter. It contained several very interesting observations, which I'll highlight. Let's start off with a bang:

"Emerging value stocks represent the most attractive asset we can find by a large margin."

It appears GMO isn't backing off its emerging markets bet, but doubling down. The managers rationalize this primarily by claiming valuation is much more predictive of returns compared to momentum. Momentum, of course, would suggest getting out of emerging markets.

The team at GMO believes the quarter wasn't highly unusual for emerging markets. These markets are known to be volatile at times, and they were. The pain was primarily caused by the surge in the U.S. dollar. Many emerging markets need to issue debt denominated in dollars because investors don't trust them to keep inflation in check in the local currency. If they can borrow in the local currency, it is at much higher interest rates. In good times, these nations favor borrowing in U.S. dollars, but this practice can backfire.

GMO presented a very interesting graph to show why they prefer value over momentum as an indicator of future returns by asset class:

In their words (emphasis mine):

"Over three months, the momentum move should matter more, and the expected impact is slightly negative. As the period gets longer, it wouldn’t even be a contest, as the power of valuation continues to grow while momentum completely dissipates. In a world of zero transaction costs it might be tempting to trade on momentum, although the returns wouldn’t be extraordinary. In the real world, where trading costs real money, it seems very difficult to argue for selling any emerging equities today. Emerging equities are cheaper than they were three months ago, and history shows that when these assets are cheaper, they perform better over time."

GuruFocus has a market tool that isn't calibrated exactly with GMO's return forecasts, but it shows a similar profile since it is also based on valuation:

GMO put a little bit more work into its forecast and arrived at a more granular conclusion:

"But how has emerging been doing fundamentally? A more important question to our minds is about how the fundamentals of emerging have been doing. Our forecasts, which are more involved than a simple cyclically-adjusted P/E, assume that the underlying fundamentals for emerging stocks will grow solidly over time. Specifically, we assume that the sum of dividends and per share growth in capital should be approximately 6% real, as those two pieces make up the long-term return to stocks. "

There is one huge caveat, though; trade wars. These aren't factored into GMO's base model, but the firm does observe the potential of a trade war already has an effect on markets:

"That doesn’t mean that there couldn’t be problems in future. In particular, the looming prospect of a broad trade war weighs very heavily on emerging market countries. We can see that directly in their performance over the past 18 months."

GMO's John Pease actually put together a pretty awesome chart showing the relationship between Google searches for “trade war” and the performance of emerging markets.

It turns out that when the searches for "trade war" double, emerging markets go down 0.8% for the week.

That sounds a bit worrisome, but GMO has an interesting perspective (emphasis mine):

"From a fundamental perspective, emerging countries really do have a lot to lose if the world were to retreat from global trade. Trade is a large percentage of GDP for many emerging countries, but even beyond that, the industries that produce exports are the industries that are capable of the strong productivity growth that is necessary for emerging economies to get richer."

It gets worse:

"Many emerging companies are parts of the supply chain for global multinationals. Without a strong brand or differentiated intellectual property of their own, they can be particularly vulnerable should tariffs or quotas change the attractiveness of doing business in a particular country. It is appropriate, therefore, to be concerned about escalating trade tensions."

It feels very much like we are entering a trade wars, but, as GMO points out, it is mostly a "war" between the U.S. and the world. That is very different from an environment where every country is slapping tarriffs on every other country. They illustrate this further with some figures:

"While the U.S. is the world’s largest economy at about 25% of global GDP as of 2016, it is one of the most closed economies in the world, such that U.S. exports are only about 12% of the global total and imports about 15% of the global total. If the U.S. were to actually follow all the way down the current path and put tariffs on 100% of all U.S. imports, with the rest of the world responding with tariffs of their own, the result would impact 12% to 15% of trade for the rest of the world and 100% of trade for the U.S. While 15% of trade isn’t immaterial, it’s hard to see how it fundamentally alters a lot of the calculus of who builds what where."

GMO also believes the tarriffs are already affecting U.S. businesses, especially users of steel and aluminum. On one hand, that's bad for those companies, but it may also serve as a wake-up call to the administration that this isn't a desirable outcome. Especially for the U.S.

This leads the firm to say:

"Price action so far makes the US look like a haven from trade war fears, whereas emerging countries look like the major victims. But it seems likely the reality of a trade war, should it occur, will prove otherwise."

A sobering thought.

To leave you on a more upbeat note, GMO continues to prefer emerging market value stocks. It likes them so much, the margin is much bigger compared to other asset classes.

GMO remains alert for important events that could truly derail emerging markets, but prefer these value stocks over anything else. It is an interesting and out-of-the-box position for any asset manager.

Disclosure: No positions.

About the author:

Bram de Haas
Bram de Haas is the managing editor of The Black Swan Portfolio.

Visit Bram de Haas's Website

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