Outlook 2021: Fixed Income Boutique
Some capital markets, in particular in emerging markets, are inefficient and enable active investment managers to generate superior risk-adjusted returns, be it in the fixed income or equity space. One advantage in their favor: Their ability to build high conviction portfolios driven by disciplined bottom-up security selection, not a broad market benchmark. Standard benchmarks are only a subset of the investment universe and often the best opportunities are found outside the benchmark, not least during market gyrations. This is when skillful active managers become your ally.
Luc D’hooge: As a deeply contrarian manager, we seek stories which other managers avoid, and we exploit the situations that they sometimes even provoke. Emerging market investors can be a jittery lot and, when risk materializes, outflows tend to be sudden. These risk-off moments are often short lived and, as prices attempt to adjust to the new reality, there is a tendency to overreact. In an inefficient asset class such as emerging market debt, this is precisely the time when opportunities appear and value can be generated for clients.
Roger Merz: From an equity market perspective, exploiting attractive price inefficiencies is at the core of active management. Valuation is key here. It’s all about identifying the biggest inefficiency at the lowest possible price. Finding these opportunities is challenging since often they don’t occur for obvious, analytical reasons. Rather, they are created by short-term market thinking, misunderstanding of a situation and a mismatch between market perception and reality. Such instances lead to fleeting windows of opportunity that a skillful active manager can fully exploit.
"It’s all about identifying the biggest inefficiency at the lowest possible price."
Luc D’hooge: Apart from the event-driven inefficiencies mentioned earlier, there are also systematic mispricings that can generate recurring, low risk/high return opportunities. An example are bonds from the same issuer with a similar maturity, but issued in different currencies, which can have significant differences in spreads, even after hedging currency risk. These differences are often the result of mandate, currency, behavioral and legal constraints faced by investors. One example would be when only one of the two bonds is included in an index, which results in benchmark-hugging managers pushing up the price of one bond while ignoring the other.
Roger Merz: We observe a number of inefficiencies in equity markets and in particular in emerging markets. An example where inefficiencies can arise is when a stock gets sold down on macro fears. Just because a company is located in a specific country where the economic data starts to deteriorate does not necessarily mean a leading business needs to deteriorate to the same extent. It may or it may not. If it does, it may be the right decision to sell. However, it might operate in a segment of the market that is much less affected by a slowing GDP, thus potentially offering a good buying opportunity if the share price gets pushed down to a level where the valuation is low relative to the price, and the upside is high relative to the risk the investment incorporates. In this example, one can observe several inefficiencies playing out at the same time: short-termism, fear, a mismatch between perception and reality, and top-down versus bottom-up induced inefficiencies. All or some of these inefficiencies can potentially be exploited by an active manager.
Luc D’hooge: Emerging markets remain attractive and are now the largest contributor to global economic growth. In fact, in purchasing power parity (PPP) terms, over half of the world’s gross domestic product (GDP) is generated from these thriving economies. However, emerging markets are moving from a world in which beta alone will not deliver returns so investors need to generate alpha through bond selection. In this type of environment, characterized by less correlation and greater dispersion of returns in the financial markets overall, bottom-up selection of securities should prove beneficial for investors.
By finding quality bonds outside the benchmark and keeping a cool head, investors will be able to catch bonds on the cheap. So remember: when it comes to emerging market bonds, the benchmark is not your buddy, but active investing is your ally.
Roger Merz: We build portfolios on the basis of pure bottom-up stock selection so it’s all about finding leading companies that generate strong, market-beating returns on their invested capital. Interestingly, the market tends to underestimate emerging markets companies’ ability to sustain their profitability and thus future cash flow growth which ultimately drives equity performance. Buying these companies at a discount reinforces the opportunity you are presented with.
“By finding quality bonds outside the benchmark and keeping a cool head, investors will be able to catch bonds on the cheap.”
Luc D’hooge: Has the tide turned? We believe not. Fundamentals remain strong and valuations attractive. Technicals are somewhat more volatile and we may not see a repeat of last year’s heady returns, but for investors who are not tied to a benchmark, the segmented and often inefficient emerging bond markets continue to offer high return and low volatility opportunities. These opportunities are indeed enhanced by the volatile technical environment including US rates and USD. Regulatory and behavioral constraints, as well as rating agency inertia, are exacerbated and result in mispricings which experienced emerging market investors can exploit. Political risk is a constant presence in emerging markets, but in the recent past, political risk has also infested developed markets (Brexit, Trump, Germany, Italy and France). At least in emerging markets, investors are compensated for taking on that risk. Not investing for the remainder of 2018 because of political risk would, in our view, be a mistake. Money left on the table does not deliver yield and carry; being in the market does.
Roger Merz: Many investors still worry about China. We beg to differ. Even in times of pressure due to the ongoing trade row between the U.S. and China, we remain constructive in our outlook for Chinese equities and the Chinese economy. Mind you, we expect China’s GDP growth to slow down on the back of ongoing supply side reforms, enforcements in environmental standards, as well as reforms in the financial sector. However, in our view, these reforms should lead to a reduction in overall risks and thus improvements in corporate profitability, offsetting the slightly lower growth rate. The broad recovery of returns on invested capital across most sectors and regions in emerging markets substantially expands the opportunity set for us. Looking at companies, we are finding more businesses with the characteristics that we look for: expanding returns on invested capital (ROIC) at attractive valuations.
Technology is one area where we keep finding leading businesses at attractive valuations that will continue expanding their ROIC. In India though, where most emerging market managers are overweight, finding attractive entry points is problematic in our view. Many leading businesses unfortunately often come at sky-high valuation levels.