2018 Q3 Legacy Group Commentary

Global Trade – Keeping It Brief

The last two commentaries were largely focused on the developing global trade war…which country has said what, who’s threatened who with which tariffs, etc. Trade continues to be the dominating geo-political event moving financial markets, but quite frankly, writing about it is starting to feel like writing the gossip column for a junior high school newspaper (do those even exist anymore?).  If we are tired of writing about it, you are probably tired  of reading about it. So, a quick update, and then we’ll look elsewhere for this commentary: some things have been resolved (Europe and, most recently, Mexico and Canada); others have digressed (China) and will likely deteriorate further. There is your official trade war update from we at Legacy  Advisory Group. And now for something completely different….

Emerging Markets

After two years of strong returns, emerging markets have been on a steady decline since January 26th of this year. Like domestic markets, emerging markets started the year with very strong gains, but then experienced volatility towards the end of January. Emerging markets have continued to be pressured throughout the year by global trade fears (we just can’t get away from it, can we?), a strengthening dollar and rising US interest rates.

While these factors do weigh on emerging markets, we believe their ultimate impact will be small.  For one, US trade pressure has been focused on  China. This is not necessarily bad for other countries’ economies,  especially in  Asia.  As the world’s largest exporter,  China is as much of a competitor to those countries as they are to us, if not more so. The world’s largest consumer placing tariffs specifically on imports from the world’s largest exporter may open opportunities to other countries.

As to the other concerns, a strengthening dollar and rising interest rates (which are highly correlated) have been the cause of volatility in emerging
markets for 20 years now. Emerging markets are one of the few asset classes where investors have a long memory. Whenever interest rates start rising and the dollar begins strengthening, investors’ minds go back to the Asian Financial Crisis in 1997/98. Leading up to the crisis, Asian countries and corporations had acquired large amounts of debt denominated in US Dollars. In order to pay this debt, these countries would first need to convert their currency into dollars. This works out ok, so long as their currency doesn’t weaken relative to  the US dollar.  Towards  the beginning of 1997 that’s  exactly what started happening… their currency weakened relative to the dollar and it became more difficult to pay this debt. As  their  currency weakened, more investors sold the troubled currencies, which only accelerated and accentuated the problem. By the end of 1997 the International Monetary Fund had provided emergency loans to the Philippines, Thailand, Indonesia and South Korea  to  the tune of $1  billion, $17  billion,  $40 billion and $57 billion, respectively.

Not wanting a repeat of that disaster, those countries (and others) made significant adjustments that have made them far more resilient  to  currency market changes. They have since built up large financial reserves denominated mostly in US dollars. Of the four countries listed above, the Philippines has the smallest reserve account, at $77 billion. South Korea’s reserve account is north of $400 billion. These funds can be used  to support  their  currency and provide emergency financing to corporations, if needed. Another adjustment was that these countries now finance more of their debt domestically and denominate it in their currency. A much smaller percentage of their total debt is in US Dollars than it was in  the Asian  Financial  Crisis. Because of these changes, these countries are much better prepared to deal with currency fluctuations.

The health of many emerging market economies is often ignored by investors due to ontology. Ontology is the study of the nature of being, and more specifically, the development of categories within a subject area. Take food groups for example. Somebody somewhere at sometime considered all the properties of various foods, found commonalities among them, came up  with  the groupings  and  then  built  that  food  pyramid  we are all  familiar with. That is ontology, and it is very useful for analysis. The process of categorizing helps us better understand an object as we consider  the properties and characteristics of that object. Once categorized, we can deepen our understanding by looking at one category’s  relationship  to another.  However,  the categorization of an object can have shortfalls that can hurt analysis as well. Going back to our food example, some apparently would argue that by stuffing the breadbasket of the original food pyramid with all things grain, it failed to distinguish that whole grains are healthier than refined grains (I don’t like it either, but it’s true: https://www.hsph.harvard.edu/nutritionsource/mypyramid-problems/ ). Through an inappropriate broadening of application, the pyramid implied that all bread was created equal.

A similar broad application has arguably created the same result in emerging market economies. The “Emerging Markets” moniker was coined in the  early 1980’s by economist Antoine von Agtmael, who worked at the then  International  Finance  Corporation,  an arm of the World  Bank.  His  intent was to encourage investment in countries that were between  poor and  rich and that had  publicly listed securities.  Now there’s a broad  definition for you. And that broad definition continues today.  It is used  to describe  both Kenya, with an average GDP  of $350  per person, and China, with an  average GDP of $5,000 per person, and everything between. There are huge disparities across these countries, but this broad categorization causes investors to generally view all these markets the same. When something goes wrong in one or two emerging market economies, investors act like the canary in the coal mine just dropped dead, and they go rushing for the exits.

This year’s dead canary award goes to Turkey and Argentina (Venezuela gets honorable mention). Both countries  have serious  problems.  They each have inflation in the double digits. Argentina’s inflation  is over of 40%.  Unlike many of the Asian countries listed above, Argentina has continued  to take on large amounts of debt in US Dollars and does not have the reserve funds to combat a weakening currency. This has resulted a massive budget deficit. They recently secured an emergency loan of $57 billion from the IMF to help cover their shortfall. This will only calm fears some, as Argentina has a history of default and restructuring (5 times in the last 50 years). Turkey is only two years removed from a good ol’fashioned military coup d’etat attempt. President Erdogan responded by consolidating power and just recently passed a new constitution  that  basically makes  him king.  He  has bullied their central bank to take an unorthodox approach to monetary policy, which  is arguably causing damage  to the economy.  As these countries have suffered, they have stoked the fear of contagion across emerging market and have driven the whole sector lower.

These two countries are not representative of many of the emerging market economies; rather many of them are far more stable both politically and economically. Plus, the long-term fundamentals have not changed. Virtually every estimate of GDP  growth has emerging markets growing at a faster  rate than developed markets. Emerging markets generally have far less debt than developed markets. Furthermore, almost every developed country has an aging population, which creates a drag on economic growth. At its most basic calculation, GDP growth is workforce  growth  plus  productivity growth. In short, you need more people being more productive. With a shrinking working age population, developed countries will have to rely on productivity growth to grow their economies.

Emerging economies, for the most part, do not face the same headwinds. With growing populations (China being the major exception here… their one child policy was short-sited and will cause a huge demographic drag on the economy starting in the next 15-20 years) and ample opportunities  to  improve productivity, their long-term growth perspectives are better than their developed country counterparts. Lastly, on a more philosophical note, countries classified as emerging markets represent roughly 85% of the world’s population. Many of these people are looking for the exact same thing as the developed world … higher quality of life. I recently ran across a quote from Adam Butler of ReSolve Asset Management that rings accurate: An investment in emerging markets is a bet is on tbe expanding prosperity and innovation of our species.

These markets will continue to have their ups and downs. They will continue to face challenges. They are far from risk free  but  our long-term  conviction in emerging markets remains the same. We have carefully selected funds for our portfolio that will invest consistent with the thoughts above. We believe the long-term opportunity is worth living through the ups and downs. We will diligently continue to look for opportunities to invest capital with an acceptable level of risk.

Blake

Past performance is not a guarantee of future earnings. Asset a/location does not assure a profit or protect against loss in a declining market. Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

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