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VIDEO: Emerging markets stocks well-placed to ride out inflation risk

October 29, 2021

A country-by-country approach to asset allocation is the best approach for Emerging Markets investors right now as inflation risks play out, says Pendal’s James Syme.

Watch a short video interview below with Pendal senior fund manager James Syme and portfolio specialist Chris Adams. Scroll down for a transcript.

Subtitles are available: Please click “CC” in the video player.

TRANSCRIPT

Chris Adams, Pendal portfolio specialist: Hello and welcome. I’m joined today by James Syme, senior fund manager for the Pendal Global Emerging Markets Opportunities Fund.

James, I wanted to start with something more macro in nature that investors are grappling with internationally. That’s the risk of stagflation. Talk us through your take on the risks of stagflation and potential implications for emerging markets.

James Syme, senior fund manager, Pendal Global Emerging Markets Opportunities Fund:

If we take a step back and look at the nature of Emerging Markets (EM) equity as an asset class, EM equity is a growth asset. It does well when growth is strong, both through the more manufacturing export side of emerging markets (perhaps some of the Asian markets) and also through demand for commodities (perhaps from Latin America, South Africa, Russia, Middle East).

So EM is a growth asset. It tends to do well when the global cycle is strong and the slow growth with stagnation would definitely be more challenging for EM equity.

Then assuming on the inflation side you get a traditional developed market, central bank reaction function where they put rates up in response to the inflation part of stagflation, that would be a difficult environment for Emerging Markets.

Stagflation is in a sense, the worst of both worlds.

So were you to see sustained inflation, and world and central banks hiking rates to deal with that, that would be difficult for EM, because you would see capital flow from Emerging Markets back to the developed world, which would be a drag on economic performance and on market returns.

However, I think firstly, we are clearly in a slightly different developed market, central bank reaction function for now.

You’ve seen much more willingness to accommodate inflation on the upside, whether it’s the Federal Reserve, the ECB, the Bank of England.

So if you do get short-term stagflation, you don’t necessarily get the penalising policy interest rates in the developed world as a response.

Secondly, part of the beauty of EM equity as an asset class is that it is very differentiated at country level. There will always be parts of EM doing well and parts doing badly.

There will always be opportunity within the asset class.

The reason our process works like it is, is to identify which of those countries have the better prospects at that point in time.

So within any stagflation environment, there will be some countries that can do better.

It really depends on which part of the basket of goods and services is driving the inflation.

High oil prices are good for some EMs, not for others. High food prices are good for some and not others.

So there will be winners within the asset class in almost any situation. And that’s part of the beauty of the asset class, and why our process works like it does.

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Chris Adams: You’ve got a position in the portfolio in Brazil. Brazil is one of those countries that we have seen hiking interest rates up in the last couple of months in response to inflation. Does this have an impact on your positive thesis around Brazil? Has it changed your view of the country at all?

James Syme: I’d say two things about what we own in Brazil. Firstly, our overweight position is one of the smaller ones in our portfolio, partly because we were concerned about these risks.

We were also cognisant of political risk there.

Secondly, we have a very US dollar revenue / export type portfolio. So we do have some domestic exposure. We have some consumer and transport and travel names. But the bulk of what we own is oil and gas and pulp and paper. So we are less exposed to the domestic economy and more exposed to the global cycle and commodity prices there.

So we haven’t really built a portfolio of very domestic cyclical assets in things like real estate or banking like we have perhaps in some other markets.

Brazil is working exactly as our thesis for how this type of Emerging Market works. Where you have these markets that tend to be higher risk and tend to be more dependent on foreign capital, you get these positive and negative cycles that occur.

So when you get a positive cycle, which is where India is – we also have an overweight in India which is working very well – you’ve seen strong economic recovery in over the last 12 months. And with it, you’ve seen capital flowing in, which strengthens the currency, which depresses inflation and enables interest rates to be kept low, which supports growth. That’s how the cycle works.

So CPI inflation in India is 5.3% [after this interview it fell to 4.35% for September] and is expected to fall in the next couple of months. So India is in a very good place right now.

Brazil has ended up at the moment on the other path. So capital growth is slightly weak, and inflation is slightly higher, capital flows out, that weakens the currency and the weaker currency feeds through to inflation which causes rates to go up — and you’re on the other half of that.

Now we don’t see in Brazil, structural conditions around things like capacity utilisation and unemployment to cause sustained inflationary pressures.

We think when the inflation numbers start to improve, then you’ll start to see capital flowing back in.

(And this is far more about fixed income capital flows, than equity market capital flows.)

But when the capital flows back in, and the Real starts strengthening again, those inflation numbers could come down pretty quickly. Then we may well transition our portfolio from a more external / export-based one to a more domestic one.

So we’ve held off waiting for that to occur. But there’s nothing in Brazil we think at the moment to suggest there’s a sustained inflationary pressure.

So if you’ll permit me to add another EM to my answer, Turkey has inflationary pressures because for the last four or five years, they’ve had this big credit fuel boom, a lot of credit in the economy, big increase in house prices, a lot of consumption, and now they’re feeing the effects of that.

Brazil hasn’t had that as a problem. We fundamentally don’t see the conditions in Brazil of having been in a boom, of having high capacity utilisation and low unemployment that can cause structurally sustained inflation.

So we’ve been cautious within Brazil. What we’re waiting for is that turn. We do believe that the conditions are there for it.

Chris Adams: If we perhaps move from Latin America, go around the globe to Asia, there’s a lot happening in China. Obviously a very large part of the market and plenty going on there. Maybe if we just hone in on one specific aspect, obviously there’s been a lot of headlines around Evergrande, commentary about this being China’s Lehman brothers moment. It’d be great to get your take on Evergrande. Does this present that systemic risk to the Chinese economy?

James Syme: We really don’t think that it does. Firstly, we’ve seen the comparisons in investment commentary in the media with Lehman brothers.

The problem with Lehman was it was so interlinked with everything else. All the other investment banks back in ’08 were all dependent on each other. That’s not really how the property market works.

Evergrande will undoubtedly cause some significant defaults on some parts of debt and there will be pain where those are owned. But those debts aren’t owned, for example, by other property developers.

And where you’ve got domestic debts within the Chinese financial system, firstly, we think there should be easily the capacity to bear it.

The entire Chinese financial system is so big and Evergrande is not hugely material in it.

Secondly, we’re very sure there will be state support or workouts required to protect the domestic financial system. We’re very sure that will be the case.

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What we think we’re seeing with Evergrande is really… A lot of the focus on Evergrande is the fact that it’s a real estate business. But we think really the pressure is on leverage.

There’s been a very significant tightening in the last 12 months of monetary policy in China. We had the latest set of credit monthly data in the last 24 hours. Once again we’re even lower than we were before.

So they’ve really trodden on the brakes in terms of monetary policy. They’ve been very clear with some of their specific policies and some of the statements that highly leveraged groups are going to be in trouble. And they are happy I think to let that happen.

What’s happened to Evergrande isn’t a surprise to Chinese policy makers. It’s very clear from the way they had structured their policies – the three red red lines about additional borrowing in real estate developers – that they were saying to these companies, either you recapitalise yourselves and de-lever or you’re going to face trouble.

We think this is a deliberate policy choice. It’s kind of euthanasia for highly leveraged firms. And we are very sure there will be whatever support or workaround to prevent any kind of contagion.

Now that all said about the fact that we’re not about to go into a Chinese version of 2008, the credit money supply data we’ve seen over the last six months or the last year, does suggest a further slow-down Chinese economy.

We think that has implications for what one wants to own in China. We remain very defensively positioned in things like utilities, consumer staples – and in the very quality end of areas like real estate.

It also has significant implications for some global commodities — I’m thinking particularly about metals. Even if you see stronger demand in the developed world, a big continued slow-down in China, we think has to be bad for thgins like iron ore and copper and we have no exposure to those things in the portfolio at al.

Chris Adams: Thank you for that, James. It might be nice to finish up with a brief overview of any changes you’ve made in the portfolio recently, any adjustments in your positions.

James Syme: We’ve mostly been making small changes within some of the names we own. With the big dislocation in China, we have found opportunities to add the names we already own, that we like. That includes one of the real estate names we believe is very much the highest quality, private-sector real estate company in China.

We took the opportuity a couple of months ago to add to that really at what we believe is the lows and it’s made a recovery since.

We have found some consumer names in China as well, which have come down with the market, where we don’t see a justification for that.

I’d say what has been a lot of our workflow over the last couple of months has been looking at some of the developing Covid data and economic data and looking for where there’s potential opportunity.

We’ve been out of Southeast Asia for quite a long time – markets like Indonesia, Thailand, The Philippines.

Those markets are quite dependent on tourism and as we start seeing vaccinations rates increase around the world, including in those countries, there may well be some interesting opportunities there.

So we’ve been preparing to potentially make some changes there.

Chris Adams: Thank you very much for your insights and your time from London this morning James, we really do appreciate it.

James Syme: Great. Thanks Chris.

Chris Adams: Thank you all for joining us. If you have any other questions around the Pendal Global Emerging Markets Opportunities Fund, please don’t hesitate to reach out to your account manager and we will be more than happy to help you.

Thanks for your time. Goodbye.


About James Syme and Pendal Global Emerging Markets Opportunities Fund

James Syme is a senior portfolio manager of Pendal’s Global Emerging Markets Opportunities Fund with Paul Wimborne.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

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This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at October 28, 2021.

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