Excess liquidity in the world economy is at the highest level since the end of the Global Financial Crisis. This is expected to drive a strong economic rebound as pandemic containment measures are eased, suggesting outperformance of cyclical assets, including emerging market equities.
We believe that the use of liquidity indicators and an emphasis on political risk in conjunction with more traditional economic analysis allows us to get ahead of moves in the risk premium – to which emerging markets are very sensitive. Liquidity can move markets significantly away from ‘fair value’ as suggested by Efficient Markets Theory. Analysing money trends can improve forecasting ability around turning points in economic growth.
Annual growth of broad money supply in the G7 economies rose to 13% in April this year, the fastest since 1976. Money growth has also picked up in China and is surging in other emerging economies, including Korea, Russia and Brazil. We estimate that a double-digit percentage gap has opened up between the global stock of money and the demand to hold money by households and firms – the largest since 2009:
Liquidity trend analysis is a cornerstone of our alpha-generating proposition. Fundamental macroeconomic analysis provides the framework for portfolio construction. Interpreting liquidity trends is paramount to country, sector and thematic views. Liquidity analysis dictates risk appetite at regional, sector and total portfolio levels. We systematically screen emerging market countries and some frontier markets based on changes in macro and liquidity indicators; notably narrow money growth, which can provide insights into whether there is excess liquidity in an economy and if economic growth will accelerate or slow.
This is important because excess liquidity can flow into the economy, boosting activity, or asset markets, thereby boosting prices. Both are likely right now. Assuming virus containment via a proven vaccine or effective test and trace programmes, we expect 2021 to be a boom year for the global economy with GDP more than reversing crisis losses. A strong bounce-back would result in money flow into markets being directed towards cyclical assets. This puts emerging markets at an advantage, especially given their more favourable current valuations:
We suspect that, contrary to post-GFC experience, broad money growth will be sustained at a high level, reflecting central bank financing of fiscal deficits and a relaxation of regulatory constraints on commercial banks to encourage them to lend to support the economy. This would suggest an extended economic boom and medium-term upswing in inflation.
We are optimistic because in addition to plentiful liquidity, improving economic prospects and the relatively cheap EM valuations mentioned above, earnings estimates are holding up better than in developed markets and commodity prices are showing signs of recovery:
Federal Reserve policy, meanwhile, is supportive, with US annual broad money growth reaching 25% in early May, a post WW2 high. Faster money growth in the US than elsewhere is relieving the US dollar shortage and raising the possibility of a decline in the US currency – icing on the cake of a bullish EM scenario:
Our investment process seeks to capture returns by identifying market inefficiencies arising from the failure to discount the impacts of economic liquidity (especially monetary conditions) and structural change, and the under-pricing of sustainable competitive advantage in companies that are generating high and improving ROIC. The purpose is to identify the best combination of stock and country allocation to meet our relative return targets within acceptable risk tolerance levels:
We generate a rating for each market taking into account a range of factors including sensitivity to the global economic cycle and global liquidity and domestic monetary trends. These ratings form the basis for our country allocation decisions. The country rating process incorporates a qualitative assessment of the economic outlook, earnings trends, valuations, structural liquidity – and, importantly – politics.
Our seven-factor checklist for assessing the relative attraction of EM equities is giving the most promising message since 2016:
As a result, we are adjusting our strategy, increasing previously-low exposure to cyclical markets, sectors and stocks while maintaining an emphasis on solid balance sheets and sustainable earnings growth. We focus on companies with a distinct competitive advantage that generate a high or improving return on invested capital with good earnings momentum.
We maintain a strategic bias towards those companies, industries and countries that have superior long-term growth potential. Our overall objective is to maximize exposure to the best market opportunities while keeping the portfolio within acceptable risk tolerance levels and ensuring proper diversification of investment ideas.
The focus on economic profit analysis allows us to avoid companies that are destroying shareholder value – we have generally found that these stocks underperform the market over the long term. This philosophy has been consistently applied in managing our emerging markets equity strategy since inception in 1996 and has resulted in strong outperformance relative to the peer group and the MSCI EM Index. We have every reason to believe that the same philosophy will provide competitive performance results in both up- and down-market environments going forward.
We continue to monitor global money data closely – a medium-term return of inflation implied by continued strength would have profound investment implications. Where would investors find their inflation hedges and income generating assets? EM equities should in fact do very well in this scenario. The unprecedented nature of the supply vs demand shocks and monetary and fiscal policy response suggests that economic and market volatility will remain much higher than in recent years, increasing the importance of portfolio diversification and appropriate hedging of macro risks – all of which suits our approach.