Guild Investment Management, Executive Summary, Apr. 20, 2017

Executive Summary

 

1.  Are emerging markets, long out of favor, regaining their mojo?  Over the last year, in spite of economic fears and geopolitical surprises, developed markets have moved steadily ahead, buoyed by rising profits and an improving fundamental global economic backdrop.  Although market anxieties and further geopolitical worries are visible in the rest of 2017, that fundamentally positive backdrop will likely remain and strengthen.  Emerging-market stocks could be key beneficiaries — partly because the fundamentals support them, but primarily because they have been relative laggards for years, spurned by global investors.  At this writing, the premium enjoyed by the U.S. S&P 500 in its next-12-months price-to-earnings ratio stands a full standard deviation above the average of the last decade.  That gap can narrow — and if it does, emerging-market manufacturers, especially those leveraged to tech, could benefit.  We also like India, where Prime Minister Modi is making steady progress in implementing reforms to increase India’s manufacturing prowess.

2.  Market summary.  In the last few weeks, U.S. and world equity markets have exhibited the greatest period of weakness since January because of concerns that President Trump’s tax cuts and infrastructure spending will be delayed or abandoned — and at the same time, the arrival of fears due to rising geopolitical risks.  Have these events caused the buying opportunity that investors have wanted?  Within three days, the first phase of the French elections will have occurred; the final round will conclude on May 7.  The U.K. has scheduled an election, but they have already agreed on Brexit, and this election will just be about the strengthening of the Tory majority in Parliament.  Syrian, Korean, and Russian issues remain on the table, but historically, concerns like these have not disrupted stock prices unless they become decidedly more aggravated.  Meanwhile, the global economic recovery continues.  U.S. corporate profits for the first calendar quarter are now being reported, and thus far they are exceeding estimates.  We anticipate that corporate profits will be up on average 9–10% for the first quarter, with revenues up by 7–8%.  These are strong results, and will continue to create investor interest and encourage higher stock prices.  Currently, several indices of global risk aversion show a degree of fear close to that after the Brexit vote and the recent U.S. presidential election.  Such fear, when combined with current skepticism that the Trump administration can achieve its tax cut and infrastructure goals, is an indicator that the market could be close to a point at which it reverses course and moves up.  We continue to believe that the U.S. has the potential to move higher over coming months.  The current period of fear and concern may be a good time to add to positions.  We are also optimistic that the developed countries of Europe will move higher in coming months.  We are bullish on the economic prospects of India and, if fighting can be avoided (which we believe is possible), South Korea.  Gold has been moving steadily upward.  It is being propelled by a lower/stable U.S. dollar and by geopolitical concerns.  In our view, gold will continue to move higher if the dollar maintains its current level.

 Emerging Markets Rally, Defying Political Fears:  Longer-Term, Emerging Markets Are Attractive Because They Have Been Out Of Favor For Years

The surprising result of the U.S. presidential election confounded many investors who had positioned themselves for a different outcome.  The incoming administration had won on an “America first” platform and had emphasized its intention to renegotiate trade agreements with many of the U.S.’ trading partners, particularly China and Mexico.  The instinctive, fearful reaction of many market participants was to imagine the arrival of a global trade war in which the new administration’s anti-globalist campaign rhetoric would rapidly translate into a curtailing of global commerce.

The stocks of many emerging-market economies had begun to rally earlier in 2016 with the reacceleration of global growth that followed the passing of the dollar and oil shocks that we have written about often in recent months.  In November, they declined sharply as nervous investors discounted the policies of a new administration that they assumed would be hostile to free trade.  But lo and behold: after two months of volatility, emerging markets continued their rally even more strongly.  They are now correcting part of that move.

Source: Bloomberg

Source: Bloomberg


This performance is not out of touch with the performance of the U.S. stock market in the period following the post-election lows.  However, another perspective appears when we examine the performance of emerging markets since the financial crisis, and compare it to the U.S.

In a seven-year snapshot, the U.S. is up substantially, and emerging markets are down 5%.  Increased demand for raw materials was met with increased supply, so emerging markets did not fully benefit.  In the manufacturing sector, profits grew; but not at the rate that was projected.  Part of this was due to increased conservativism on the part of consumers in the developed world, who are more price-conscious and somewhat more averse to conspicuous consumption than in years past.

This observation brings us to our main point.  Over the past year, we have seen market sentiment fluctuate sharply according to prevailing perceptions of risky events, and prevailing sentiment about nebulous future risks to the global post-crisis economic recovery.  We could mention the panic that surrounded the Brexit vote; or the consternation and uncertainty that accompanied the election upset in the U.S.; or fears of secular stagnation among some members of the U.S. Federal Reserve Board of Governors.

All of these events caused or accompanied significant market volatility.  Yet underneath the news flow was a swell of positive financial and economic progress which ultimately lifted corporate profits and stock prices…  and showed that prophecies of doom were premature.  “You can’t stump the Trump” was a rallying cry for the new president’s supporters at his more raucous campaign events last summer… but perhaps what you really couldn’t stump was the next up-leg in the global recovery from the Great Financial Crisis.  And eventually, that translated into corporate profits and higher stock prices in the developed world.

S&P 500 Earnings Went Sideways and the Market Stagnated…

But When They Resumed Growth, So Did the Market’s Rally

Chart shows S&P 500 monthly price data.
Source:  Bloomberg, Guild Investment Management

What This Means For Emerging Markets:  After Underperforming for Years, Are They Ready To Catch Up?

Last year, negative news-flow and worrisome geopolitical events caused market volatility, even while the real underlying economic and financial fundamentals strengthened.  Emerging markets still face plenty of potentially destabilizing events.  The new U.S. administration has begun to project a more engaged military stance, first in Syria, now in the Korean peninsula; isolationist rhetoric is giving way to a more recognizably mainstream Republican view.  While that may be reassuring to some on the basis of its greater predictability, it presents the prospect of market volatility arising from military action.

Also, since both commodity-exporting and manufacturing-centered emerging market economies depend on the vitality of growth and trade in the developed world, developed-market volatility has the prospect of spreading to emerging markets as well.  For example, we have the upcoming French elections, and now the snap elections called for June by U.K. Prime Minister Teresa May.

We believe, however, that the fundamental story for emerging markets is deeper than these surface disruptions will prove to be.  A relatively minor part of that story is the new up-leg in the post-crisis global economic recovery, particularly in Europe.  The main part of that story, though, is the relative underperformance of emerging markets for the past decade.

Earnings, and earnings expectations, have risen in developed markets, as they have been relatively stronger performers.  The gap in 12-month forward price-to-earnings ratios between the S&P 500 Index and the MSCI Emerging Markets Index has grown wider than usual.

Source:  Bloomberg

On average, since 2006, the S&P 500 has enjoyed a 22% premium to emerging markets in its 12-month forward price-to-earnings ratio.  Currently, that premium is at 32% — nearly a full standard deviation higher.  With basic positive global growth and trade data supportive, a few of the best emerging markets have the potential to narrow that valuation gap.  

We note that we are not equally enthusiastic about all emerging markets; we continue to favor manufacturers over commodity exporters, and particularly manufacturers leveraged to technology, such as South Korea.  We also favor India, where electoral results are supporting the rational and growth-oriented policies of Prime Minister Modi.  We note further that the positive global growth backdrop should still be watched closely, and that if the real fundamentals falter, EMs will face tough sledding.  Over the longer term, we expect the undervaluation to correct itself, and continue to support a catch-up in the best-growing emerging market stocks.

Investment implications:  At the current juncture, we are particularly interested in India and South Korea.  ETFs exist for both countries.

Market Summary
 
In the last few weeks, U.S. and world equity markets have exhibited the greatest period of weakness since January because of concerns that President Trump’s tax cuts and infrastructure spending will be delayed or abandoned — and at the same time, the arrival of fears due to rising geopolitical risks.

Have these events caused the buying opportunity that investors have wanted?  Within three days, the first phase of the French elections will have occurred; the final round will conclude on May 7.  The U.K. has scheduled an election, but they have already agreed on Brexit, and this election will just be about the strengthening of the Tory majority in Parliament.  Syrian, Korean, and Russian issues remain on the table, but historically, concerns like these have not disrupted stock prices unless they become decidedly more aggravated.
Source:  Morgan Stanley Research


Meanwhile, the global economic recovery continues.  U.S. corporate profits for the first calendar quarter are now being reported, and thus far they are exceeding estimates.  We anticipate that corporate profits will be up on average 9–10% for the first quarter, with revenues up by 7–8%.  These are strong results, and will continue to create investor interest and encourage higher stock prices.

Currently, several indices of global risk aversion show a degree of fear close to that after the Brexit vote and the recent U.S. presidential election.  Such fear, when combined with current skepticism that the Trump administration can achieve its tax cut and infrastructure goals, is an indicator that the market could be close to a point at which it reverses course and moves up.
 
The U.S. Market

We continue to believe that the U.S. has the potential to move higher over coming months.  The current period of fear and concern may be a good time to add to positions.

Europe

We are optimistic that the developed countries of Europe will move higher in coming months.

Emerging World

We are bullish on the economic prospects of India and, if fighting can be avoided (which we believe is possible), South Korea.

Gold

Gold has been moving steadily upward.  It is being propelled by a lower/stable U.S. dollar and by geopolitical concerns.  In our view, gold will continue to move higher if the dollar maintains its current level.

Thanks for listening; we welcome your calls and questions.
Tim Shirata
Executive Vice President
Guild Investment Management, Inc.

12400 Wilshire Blvd. Suite 1080
Los Angeles, CA 90025
Tel: (310) 826-8600 Fax: (310)826-8611
email: tshirata@guildinvestment.com
http://www.guildinvestment.com

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NOTICE TO RECIPIENT: This email is meant for only the intended recipient of the transmission, and may be a communication privileged by law. If you received this email in error, any review, use, dissemination, distribution, or copying of this email is strictly prohibited. Please notify us immediately of the error by return email and please delete this message from your system. Although this email and any attachments are believed to be free of any virus or other defect that might affect any computer system into which it is received and opened it is the responsibility of the recipient to ensure that it is virus free and no responsibility is accepted by Guild Investment Management for any loss or damage arising in any way from its use.Guild Investment Management, Executive Summary, Apr. 20, 2017

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