Ongoing events in the Middle East and North Africa have reminded investors of some of the risks associated with investing in emerging markets, while MENA developments as well as Japan’s disaster have likely fuelled the shift in focus back towards developed world equity. To discuss these global trends and investigate whether the emerging market story remains in tact or whether the BRICs, for one, have seen their heyday, I recently talked to Nick Smith, Director at Allianz Global Investors.
Emerging markets have been all the rage over the past year or so and though the consensus remains that their economic growth will continue to outstrip that of the developed economies, there’s less of a clear consensus as to whether the GEMs still offer as much value as they have in recent years or if the region has become somewhat overheated. What’s your take?
Clearly you’re right. The consensus at the moment is that if you’re looking for value there’s value arguably to be found in the developed markets as much as in the emerging markets. I think where we would diverge is that we’d say maybe that’s true in the short term but actually people shouldn’t lose sight of the fact that generally when one’s talking about investing, you’re talking about medium- to long-term investing, i.e. not necessarily over the next 3-6 months but over the next 3-6 years and beyond.
We remain genuinely very bullish on the GEM story. In terms specifically of valuations, interestingly last year the non-BRIC emerging markets outperformed the BRIC markets. That was down to a number of reasons, but arguably at the beginning of last year the BRIC markets had had a fantastic run over several years, bar 2008, and in a sense there was a pause for breath as the smaller markets caught up with how the BRIC markets had performed. But what you’ve ended up with now is a situation in which the BRICs relative to others emerging markets actually look very good value. If you look at 2011 P/Es, the BRICs on average are all quite different—you’ve got China and Brazil on roughly 11x, Russia right down at 7x, and India is relatively expensive at 13x-14x—but you’ve got other smaller markets actually trading at significantly higher P/Es, reflecting their very strong year last year. If you look at corporate earnings estimates for this year, the forecasts for BRICs companies are actually as high or greater than those of the other emerging markets, so we would actually say that the BRICs look better value than the other emerging markets when you look out over the rest of 2011. Last year was very different, this year we think the BRICs could reinstate themselves as the emerging market leaders.
You mentioned India as being relatively expensive compared to the other BRICs and that was certainly a criticism that we heard over the past year. Do you think that remains the case or is your stance likely to change on the region?
Basically we’re still underweight India. Obviously a lot has been happening there recently but I don’t believe Michael Konstantinov’s [fund manager of the Allianz RCM BRIC Stars fund] immediate view will have changed as he doesn’t tend to react to the immediacy of events. We’ve actually seen India fall quite significantly this year so it’s become better value, as it were, but essentially within BRIC markets we prefer and are overweight Brazil and Russia over China and India. These are fairly modest over- and underweights, however, so though we are underweight India we’re not massively so. The events that are affecting India now and other factors affecting the region—putting interest rates up, for example, I suspect will make Michael revisit the India valuation story sooner rather than later.
One of the big things about India at the moment is inflation, driven mainly by food price inflation and how quickly that is going to abate—that’s one of the big overhangs on the market. But actually on a recent trip to India, the managers found that the feeling on a corporate level was that all of the companies [held in the BRIC Stars portfolio] were operating at full capacity and demand is huge, and resilient, and still there. So all the companies they spoke to are actually producing more goods than they’ve produced before and can hardly keep up with demand, so this is an economy that’s still growing strongly at a corporate level. All the fundamentals remain very much in place as far as we’re concerned.
Turning to the B in BRIC, Brazil, it’s actually had a bit of a rough ride so far in 2011 and the Allianz RCM Brazil fund has suffered in the first few months of the year. What’s the story there and how does manager Michael Konstantinov propose to generate returns for investors going forward?
There’s been a number of overhangs with Brazil and one is the political uncertainty leading up to the elections last year. There was also Petrobras having what was effectively a massive rights issue into the market, which dampened down the equity market. Those two factors are now obviously resolved. While you’ve got a completely stable changeover from one government to the other—something that we take for granted now, which is great, but it didn’t used to be the case—you’ve also seen the central bank actually show that it’s not going to follow what the government might want, in that it’s actually been raising rates to a certain degree, which has dampened the market in the short term. We believe in the longer term this is a good thing as it shows the central bank is independent and wants to follow prudent macroeconomic policy.
We are very happy with the medium-term outlook. Again, we’ve got a situation where there are potential inflationary problems, but we like Brazil, we think all of the main things are in place. It’s got multiple dimensions to the story: one is the domestic consumption story, which is very strong; one is the commodity story, and we’re looking at what’s happening around us now in terms of Japan’s rebuild and potential commodity demand from there, plus all the other emerging markets where demand for commodities is in a long-term ascent. You’ve got the soft commodities story, the mineral and iron ore story, plus the domestic demand story, plus a stable government and a reasonably robust central bank.
Maybe in the short term over the immediate months it might not be the best performing market but certainly over the medium term we’re very confident. In fact that’s why we launched the Brazil fund, because out of all the BRIC markets we particularly like Brazil on a medium- to long-term view.
Given the inflation risk in these markets, how are you able to insulate holdings from concerns about rising inflation, particularly commodity inflation?
RCM is a bottom up, stock-picking company so implicitly there’s no hedging that takes place as such, but what they do is look for companies that have the pricing power to pass inflationary pressures on to their customers. Another part of the success story of investing in the BRICs is that it’s about investing in commodities, so actually a large portion of the portfolio tends to benefit when commodity prices rise and that’s why Russia has been one of the strongest performing markets so far this year with the rise of the oil price. One benefits by investing in those markets as they tend to be the commodity producers. Brazil, for example, is one of the world’s largest exporters in terms of food commodities.
The BRIC that we haven’t touched on yet is China and obviously inflation is one of the key stories there as well, with the People’s Bank of China having taken several recent moves to curb that. What’s your view of the investing environment there?
Our view is that [the inflation outlook] is slightly more benign for China than perhaps other people believe. Michael Konstantinov’s view is that Chinese authorities in the past have been pretty good at taking action to contain inflation and stopping it taking off in a furious way, and actually the action they’ve been taking recently is fairly preemptive, so he’s fairly bullish in terms of the second half of 2011. We’re likely to see more issues with inflation over the next quarter but in the second half we could see fears about rising inflation abate and a more favourable outlook from an equity market perspective. That could offer the opportunity for the equity markets to perform quite well. So I think in the second half of this year we could actually have a very different view on China from the consensus at present, which is modestly bearish. Having said that, on investing in China in general, I think there’s a lot of choice but also lots of companies that aren’t particularly high quality. It’s all about having resources on the ground who can look at it on a company-by-company basis rather than just generally being optimistic or bullish on the region in general, as there are plenty of companies that aren’t particularly profitable or high quality. The key is to be a discerning investor.
Looking at a broader level rather than just at emerging markets, it seems that over the past year there have been at least three distinct trends as to the flow of investor assets: into fixed income, into global emerging markets, and now seemingly the focus is turning back to developed world equity. What overriding trends are you observing at Allianz?
With my European hat on as well as my UK hat, what we’ve seen—and I know PIMCO would confirm this—is very, very strong flows into PIMCO [fixed income] products last year and that’s continuing into this year. You’re right about the emerging markets; those flows have dampened down this year but, having said that, we haven’t seen particularly significant redemptions, but rather lower sales and slightly higher redemptions. It’s not a massive change but clearly investors have been stepping back from emerging markets and BRICs for the last three to four months now.
On the other side we have seen very strong flows into two product areas. One is into US equities, both into our domestic US equity fund, which has now gone through the £100 million mark having been at less than £20 million less than a year ago, and also on a pan-European perspective. The other product where people are beginning to focus on and discretionary managers are beginning to want to overweight is Europe. If you’d asked six months ago, people would have said that in developed market terms they were definitely looking at US equities and Europe was an area they weren’t looking at. Now I think there’s been a shift and they’re thinking some of the opportunities in German equities, for example, where clearly the German economy is doing very well, are actually quite interesting and arguably undervalued. Our product in that area has been collecting a lot of money recently across Europe.
What do you see as the main challenges that investors face going forward?
I think we live in a world of greater volatility and that’s the greatest challenge really. I think all of us who manage money are also looking at products that can help dampen that volatility and make things more predictable. Volatility and managing risk are twinned and occupy all of our time.
I think events that we’re seeing at the moment emphasise how things can come unexpectedly and markets tend to react in uniform, whether they’re emerging markets or developed markets. What we’ve seen in Japan is that though [the earthquake] wasn’t anything to do with emerging markets, markets right around the world fell together in unison. People then have pause to think about the consequences and you then see very different outcomes—some markets recover very quickly and start strengthening, others fall further as people work out the wider context of what, for example, Japan means for the world economy.
A final thing I'd say is that RCM isn’t a trading type of business, we’re not going to be making massive changes to portfolios based on the latest news story, but what we will be doing is thinking what are the medium-term implications and how should portfolios be positioned irrespective of what might happen tomorrow.
