Is now the time to stop buying emerging market and commodity funds and to start taking profits? Why adopt this strategy in the face of a considerable argument in favour of these sectors?
Lately it seems the whole world has been piling into emerging markets and commodity funds on the back of some spectacular market gains, and that, if nothing else, should start alarm bells ringing with investors.
We have been wary of these sectors for a while now and we have been advising investors to reduce their weighting and take profits. Indeed, that is the strategy we have been following in our discretionary and model portfolios.
But why, I hear you ask, are we doing this at a time when there is so much talk about the potential of emerging markets – with many debates taking place in Davos last week concerning the shift in economic might from developed western markets to fast developing emerging markets – and respected organisations, such as the IMF, forecasting continued price rises in commodities throughout 2010?
The simple fact is we feel the sectors are to some extent enjoying a liquidity-led bull run and as such the markets are too expensive, with all the positive news already factored into the price. Hence, now is the time to review those investments and take some money off the table.
Emerging markets
Historically emerging markets are priced at a discount to Western markets. Apart from Brazil, the p/e of which is 14.3x, the majority of emerging markets have p/es of around 20x plus, or in the case of Taiwan, (which is over 10% of the MSCI Emerging Markets Index) nearly 30x.
The arguments being put forward for these higher values is that “it is different this time”: emerging markets have decoupled from western economies, they have a growth momentum of their own now, and so they should be priced at a higher p/e than western markets.
We disagree with those arguments. Here are a few reasons why:
1. Many emerging markets still need to sell exports to western economies to maintain strong growth after their stimulus packages expire. If we take the latest GDP figures from the UK, we can see the developed economies are not going to see demand anywhere near the strength they were experiencing before the financial crisis. The IMF has warned many economies are placing far too much emphasis on exports for their expansion.
2. The western banking system is basically on its knees. This is shown by the ongoing contraction in bank lending in the US and UK. We cannot stimulate more demand by increasing lending/borrowing. The US, UK and to a lesser extent Europe will have an anaemic ongoing recovery at best.
3. Corporate governance and the simple management of companies in many emerging market economies add to the counter arguments.
Many emerging market companies sacrifice profits for market share and also sacrifice shareholder value when they raise the new equity they want in order to grow.
While improvements in corporate governance have been made, it is far less advanced and stable than in many western markets. The argument the western banking crisis demonstrates that western corporate governance is poor as well, is like saying two wrongs make a right.
4. Politics is always a potential headache in some emerging markets. For example, how long can China maintain its suppression of the rights of individuals? The attempts to sensor Google illustrate the fear of the Chinese authorities. It makes for potentially volatile markets.
While these are stripped down views, they underline our opinion emerging markets should not be standing at a premium to their developed economies counterparts.
Commodities
If we turn to commodities, China is the biggest driver of commodity prices from an additional demand point of view. Much of the rise in commodity prices from early in 2009 has been attributed to China restocking its inventories while commodity prices were cheap.
But there is considerable over capacity being driven by the economic stimulus package. Take China’s steel industry as an example. Currently, around 70% of the steel industry’s capacity is being utilised. To demonstrate the sheer size of this overcapacity, at the end of 2008 the Chinese steel industry’s capacity was 660 million tonnes. Demand for steel in China was just 470 million tonnes. The difference between the two is pretty much equal to the EU’s total steel output. The EU Chambers of Commerce produced a report in November, which warns about Chinese overcapacity – noting there are currently a further 58 million tonnes of new capacity being built in China. Western demand for China’s steel output has diminished – a classic case of supply outstripping demand.
In addition, the Chinese are increasingly worried the aggressive stimulation of their economy will lead to a pick up in inflation. Before the western financial crisis China had inflation at 8.7% and rising. Inflation can cause unrest in the population and the authorities will want to ensure this does not happen.
There have already been initial attempts to dampen the economy, which grew at 10.7% last quarter. We expect the authorities will take further measures. This will put downward pressure on demand for commodities with corresponding impact on commodity prices over the coming months.
The omens
Along with a growing number of investment managers, we feel there is a period of correction in the markets on the way.
Certainly, from an economic viewpoint, the omens for the coming year are not looking good. While the UK saw its first growth figures in six consecutive quarters, indicating the UK was out of the recession, growth was just 0.1% and, from an investment perspective, we are expecting this year to be volatile, with considerably more movement in the stock markets than in 2009.
With this uncertainty in the markets, continual analysis of macro trends as well as ongoing research into individual funds is essential.
We have been running portfolios of unit trusts for clients of IFAs for over 25 years, during which time we have seen the herd mentality cost investors a lot of their hard earned savings.
You do not have to go too far back in history for examples. The continued rush into technology stocks at the peak of TMT boom is a good case in point.
This is not to say we believe the emerging markets and commodity sectors should not form part of an investor’s portfolio; simply that now is not the right time to be buying into them. Knowing when to sell a fund and take profit is just as important as buying a fund. Arguably it can be more important, as the signs can be obscured by over-zealous market sentiment.
Indeed, history has shown it is all too often the smaller investor who gets swept along with the positive sentiment in the markets and invests just when they should be selling.
We think now is the time to jump off the buying bandwagon.
Paul Warner, investment director, Minerva Fund Managers
