Abney Associates Financial Advisory: Confidence key to emerging markets

Abney Associates Financial Advisory: Confidence key to emerging markets
At the beginning of the year, there were three potential areas of asset allocation that very
few global portfolio managers wanted to consider seriously. As I travelled around the
United States and elsewhere in the world, almost none of our clients wanted to hear
about Japan, commodities or emerging markets, Ameriprise Financial Abney Associates
Team.
So far they have been wrong about commodities, which are a part of my radical asset
allocation and have broken out of their trading range and headed higher. The standard
of living continues to improve in the developing world, and one of the first things
consumers do when their income increases is start to eat better. This means more meat
and poultry where grains are used for feed as well as more consumption of grains by
individuals. As a result of continuing growth in the developing world and flat to uneven
agricultural production because of variable weather, prices for corn, wheat and soybeans
have risen.
As for the other two areas of investor disinterest – Japan and emerging markets (both
also in my radical asset allocation) – performance this year has been poor. Japan has
been hurt by the increase in its sales tax to 8 per cent from 5 per cent in April as well as
concern about a weakening Chinese economy.
During March, I travelled to Chile and Colombia in Latin America. In April, I flew to
Sydney and Melbourne and Kuala Lumpur, Singapore, Hong Kong, Beijing, Seoul and
Tokyo. I talked to our clients and knowledgeable observers in these areas. While each
region faces challenges, I believe the emerging markets generally present opportunities
but it is unclear when investors will start to appreciate them.
Emerging markets have suffered for two reasons. The first is the belief that continued
Federal Reserve tapering will cause interest rates in the US to rise and the dollar to
strengthen. This would be bad for those whose assets are in emerging market
currencies. As a result there has been selling of equities in Asia and Latin America by
local and global investors in spite of the fact that growth in those areas is considerably
above that in the developed world.
The Russia/Ukraine situation has also had a broad influence in the emerging markets
because it has highlighted the second reason for investor concern, the issue of political
risk. The governments in many of these countries have only a tenuous hold on the power
to influence the future course of economic growth. While Ukraine was never an area of
investor interest, Russia’s action there caused concern throughout the developing world.
KOREAN UNIFICATION
At this point, I do not believe Putin will move further toward strong military action,
although there is much informed opinion on the other side. The new presence in
Ukraine of armed gunmen in unmarked uniforms occupying government buildings
replicates the situation in Crimea prior to the referendum. If Putin moves to take over

eastern Ukraine, I think it would be a strategic mistake for him. The response from the
West would be a strong, and the sanctions already imposed have had a negative impact
on Russia.
He would be much better off waiting until later or moving very slowly now. Some of
Putin’s closest advisors are for cooling the situation down but Russia’s leader is both
ambitious and unpredictable. One would be wrong to be complacent about the situation.
Ukraine has revived concerns about political instability in the developing world hurting
emerging market equities across the board.
During my trip I had an email exchange with my former Morgan Stanley colleague Steve
Roach, who was in Asia discussing his book on the rebalancing of the Chinese economy.
He and I have been in a dialogue over the last few months about how much the Chinese
economy will slow down if the consumer segment becomes the dominant driver of
growth rather than credit-driven spending on state-owned enterprises and
infrastructure.
Roach believes the economy may not weaken as much as I fear because the service
sector is becoming more important and each service sector percentage point of growth
generates 30 per cent more jobs than a point of growth in the manufacturing sector. He
thinks growth will moderate very gradually and a considerable number of new jobs will
still be created each year, reducing the likelihood of social unrest.
One investor I discussed this with pointed out that it may be true that a percentage point
of service sector growth produces more jobs than one in manufacturing, but many pay
low wages and may not do a lot to increase the importance of the consumer in the
economy.
CHINA’S POLLUTION PROBLEM
Several discussions in Beijing yielded insights worth passing on. One investor was
concerned about similarities between China now and Japan in the 1980s. During the
1980s numerous books were written about how Japan was doing everything right, with
robotics increasing productivity, very strong export growth and soaring real estate
values. Japanese technology and consumer electronics stocks were US sharemarket
favorites back then. Suddenly it was all over and the Nikkei 225 declined 75 per cent,
and today it is trading at 35 per cent of its peak level.
I pointed out some significant differences. China has a population 10 times that of
Japan. Its per capita income is one-tenth of that of the US, and by improving its
standard of living, China can hope to see its economy grow for a long time, especially if
it is successful in shifting the components of growth toward the consumer. Also, China
has a centralised government structure that can make decisions quickly and implement
them without delay. This is in sharp contrast to the Japanese Diet, where the legislative
process can drag on endlessly in a manner similar to the US Congress.

What China must do is deal with its enormous pollution problem. My eyes burned and
my throat was sore while I was in Beijing. It was worse on this trip than in previous
years. There are reports that 280 million people do not have access to safe drinking
water, resulting in high cancer rates. Ground pollution from industrial waste is also a
serious problem. The pollution condition must be faced if China expects to have an
increasingly important role in the world economy and geopolitics.
Another investor asked me what I would do to get Chinese consumers to spend more. I
told him that improving the social safety net would help. The Chinese save for the afterschool
education of their children, healthcare and their retirement. If the government
played a greater role in providing services in these areas, perhaps the Chinese would
spend more time at the malls.
That change is not likely to come quickly. Some investors are also concerned that the
economy is slowing because of a lack of both domestic and export demand, which could
reduce job creation, causing problems for the authoritarian government. Most Chinese
would want to have a lot of cash on hand if that happened.
WIDE-RANGING GEOPOLITICAL CONCERNS
Everywhere I went in Asia, investors were sceptical about their home markets, but
Japan was extreme in this respect. Perhaps it was because the Nikkei 225 had a difficult
first quarter and is down 14 per cent in yen and 11 per cent in dollars so far this year. In
the longer term, the ageing population will cause the work force to peak in the next few
years and this would make growth difficult. The country has initiated a guest worker
program to mitigate this.
Prime Minister Shinzo Abe’s first two arrows, fiscal and monetary expansion, have
produced growth of 1.5 per cent and inflation approaching 2 per cent, achieving two of
his objectives. The third arrow, regulatory reform and sustainable growth, requires
legislative action and that will be harder to achieve.
Investors wondered why my asset allocation had a 5 per cent position in Japan in the
face of all of these problems. My response was Japan was clearly out of favour, few
institutions held positions, the economy was finally growing and recent data was quite
positive. Finally, there were a number of reasonably valued stocks available. I thought
the risk of a further decline was low and there was an opportunity to make money from
these levels if and when investors turned constructive.
While monetary growth and bank loans have slowed recently, and this may have
dampened the enthusiasm of some investors, I believe there is no chance that Prime
Minister Abe will let the country slip back into a deflationary recession and another
round of stimulus is ahead if it is needed.
In discussions with Asian investors, I addressed their geopolitical concerns, which
focused on Russia and Ukraine, Israel and Palestine, the Iran nuclear threat and,
particularly, the disputes between Japan and China over islands and fishing rights in the

South China Sea. The thrust of their questions was whether the world is on the brink of
armed conflict in a number of different places and this would destabilise the markets.
My views on Russia/Ukraine were described earlier. Regarding Iran, I think the
sanctions are working and I probably would have demanded that Iran dismantle its
centrifuges before offering any relief, but that may have been diplomatically impossible.
Now we have to hope that Iran is serious about reducing its nuclear effort; we should
have the answer to that in a few months.
Everyone I talk to who is close to the situation is sceptical and reluctant to trust the
Iranian government’s commitment, but the people of Iran feel they have been repressed
for too long. They want the sanctions lifted so they can participate in the economic
opportunity that should emanate from their vast oil resources. The new government in
Iran appears ready to respond to the demands of its constituents.
REASONABLE VALUATIONS
The Israel/Palestine conflict seems unresolvable. Neither a one-state nor a two-state
solution appears possible. The Arab world refuses to acknowledge Israel’s right to exist
and Israel refuses to reduce the settlements in territory it feels is legitimately part of
Israel. Even US Secretary of State John Kerry is frustrated by his inability to make
progress there.
As for the South China Sea, which is so important to that region, I am hopeful that a
diplomatic solution can be reached. China is very proud of its military progress, but is
more concerned with the growth of its economy and not anxious to be distracted by
armed conflict with anyone at this time, in my opinion. Perhaps I am naïve in thinking
hostilities are not going to take place in any of the major trouble spots in the near term,
but over the past decade I think everyone has learned how little has been gained by
going to war.
Investors were concerned that the recent sharp decline in the technology, social media
and biotechnology stocks signaled the end of the bull market or even the bursting of a
bubble in equity prices that began with the market’s rise in 2009. After all, they
reasoned, stocks have been rising for most of the past five years and that is the usual
duration of a positive cycle. I pointed out that valuations were still reasonable at 16
times forward operating earnings and the US economy was expected to pick up
momentum after the brutal weather of the first quarter.
The present multiple of the market is about equal to the long-term median. The previous
bull market that ended in 2007 reached a multiple in excess of 20 times and the frothy
dot.com market which ended in 1999 had a peak multiple in excess of 30 times.
I still believe the US economy will move toward real growth of 3 per cent and the S&P
500 will turn in a strong performance before year-end. The stocks that have been hit
hardest are the big winners of the past year where investors did not want to see their
profits melt away. This has been true of the exchange-traded funds of the favoured

sectors where selling has been particularly furious, resulting in sharp liquidation of the
underlying stocks.
Asian investors were focused on the tapering by the Federal Reserve, which has hurt the
emerging markets and many wonder if it will continue. My response was that it will as
long as the US economy is growing above 2 per cent, but it might be suspended for a
while if the pace falters. As for Europe, there was concern about deflation, but I said that
it looked like growth in the euro zone would be 1 per cent in 2014 and that diminished
the deflation threat.
The mood in Asia was clearly subdued even though the economies there seem to be
doing reasonably well. The International Monetary Fund estimates world growth for
2014 at 3.6 per cent, the US at 2.8 per cent, the euro zone at 1.2 per cent and emerging
markets at 4.8 per cent. With the developing world growing so much faster than its
mature brethren, you would think there would be opportunities there.
What is needed is renewed confidence on the part of local investors and a willingness to
put money into their home market. Right now they are pulling money out. One
attitudinal difference between Asian investors I talked with and their American
counterparts is their fear that a geopolitical event will send equities tumbling
everywhere. American investors are more complacent. I certainly hope the Asians are
wrong.