The Good, the Bad and the Ugly

I don’t think anyone would have predicted that 2016 would be quite as eventful as it turned out to be but while a lot happened not a lot actually changed.  To my mind, investing, particularly in emerging markets (EM), always requires a patient, judicious approach and 2016 was no different. The list of issues to worry about is a long one: Exchange rates, interest rates,  growth rates, political uncertainty - my developed market peers have a lot on their plate! If nothing else 2016 reminded markets that the issues above are not just the preserve of emerging markets. Globalisation has driven ever greater linkages across geographies and asset classes, any perceived interference therefore creates volatility which is immediately transmitted across the investment universe. With that in mind, there are a couple of things I did want to comment on.

1) The Fund remains underweight Energy

Robust corporate governance and prudent capital allocation are two of my most important considerations when it comes to stock selection. Historically the majority of the state owned EM energy sector (which includes Russia but also China and elsewhere) have made incredibly bad capital allocation decisions. Overtime this tends to result in a significant impairment of shareholder value which is in my experience not a price worth paying for the odd period of cyclical improvement. For this reason, I continue to be discerning when it comes to stock selection focusing on minimising the risk of a permanent loss of capital before cyclical valuation expansion.  

2) Indian demonetisation a long-term positive

The Indian Government’s controversial decision late last year to  demonetise its 500 and 100 rupee notes to curb ‘black money’ may be an incredibly positive development long-term , given the limitations which informality imposes on the ability of an economy to continue to develop.

Bringing black money back into the formal banking system will, in theory, lead to a reduction in long-term funding costs and lower the cost of capital for infrastructure and investment project.  Factors badly needed in order for India to maintain the current rate of economic growth, generate jobs for its large population and avoid the inflationary pressures which fast consumer growth without a commensurate increase in fixed asset investment will create. 

In the short-term however such draconian measures have created sizable problems and there will likely be a significant contraction in near-term demand as the demonetisation process works its way through. The inability to transact and problems accessing cash is obvious in terms of how consumer demand and purchasing has declined since the demonetisation measures were announced.

Yours truly can testify to the very real impact of such measures on a recent trip to Northern India when I was forced to purchase a $3 lunch with a $30 note, only to receive my change in 10 rupee notes - all 180 of them! 

The demand air pocket needs to be carefully considered when looking at the valuation multiples of a number of stocks, particularly those in the consumer sector which rely on the cash economy for end demand.

3) Trumponomics: A little overdone

This is the most difficult topic for me as whilst one can rationalise to an extent the improvement in commodity prices, it does look overdone in light of the actual impact that the USA has on global commodity demand. Additionally, the disconnect between EM exchange rates and commodity prices is a phenomenon which typically hasn’t persisted for long in the past i.e. either EM foreign exchange will strengthen or commodity prices will pull back. In all likelihood we will see a combination of both and from this starting point it may be a little late to blanket buy resource stocks. As ever, I do think that there are some selective opportunities in this area: Grupo Mexico, African Rainbow Minerals to name a few.