Investment Commentary: International Developed And Emerging Markets
Investment Commentary: International Developed and Emerging Markets
By Riad Younes
R Squared Capital Management
Since late first quarter, a sudden and steady rotation has been taking place in international markets, sharply reversing a trend established for more than two years. Emerging market assets and energy stocks have been rallying sharply, while Europe financials have been heavily sold. In addition, the benign economic outlook has put selling pressure on cyclically sensitive stocks in favor of those with characteristics more defensive to the economic cycle.
Also since earlier this year, a sudden and steady rotation has been taking place in the market, sharply reversing a trend that has been established for more than two years. Emerging market assets and energy stocks have been rallying sharply, while Europe financials have been heavily sold. In addition, the benign economic outlook has put selling pressure on cyclically sensitive stocks in favor of those with characteristics more defensive to the economic cycle.
The rotation in the second half of the second quarter started in reaction to macroeconomic data coming from the U.S. as well as Europe and to statements made by their respective central bankers. As a result of reactions to both factors, rates in Europe are heading lower and will remain low longer than expected, and though U.S. interest rates may rise sometime next year, they will do so at a pace that is slower and peak at a level that is lower than previously expected.
The message is simple: The developed world’s high leverage and its reliance on high asset prices for mending stretched balance sheets make low interest rates an essential part of our daily lives. Growth in the developed world will be scarce and challenged. The “easy money era” has gotten a life extension.
Our thesis for overweighting European banks remains intact despite recent heavy selling that occurred in the industry.
China’s struggle to rebalance its economy away from fixed asset investment towards consumption continues. The adjustment and rebalancing of China’s economy is not likely to occur smoothly.
Our prognosis is that commodity prices will decline steadily this decade as the belated supply to China’s demand shock brings the market closer to equilibrium.
The energy sector outperformed as the continued instability in the Middle East led the market to price in these conflicts as quasi-permanent. As a result, long-dated oil future contracts rose significantly because instability is no longer perceived as transitory. We have been underweight the energy sector for a variety of reasons; however, given the improved outlook for oil prices, we are reviewing our current bias and exposure.
Given our strong convictions, as reflected in our portfolio construction versus the benchmark, periods of underperformance are to be expected. While our portfolio is built with a three-to-five-year horizon, we are periodically adjusting the portfolio to reflect changes in our theses or the investment environment.
We continue to view the appeal in growth stocks as limited and challenging. Growth opportunities tend to be overly concentrated in the technology sector and in emerging countries. While valuation seems to be the main challenge in many internet/high-tech names, domestic imbalances and structural reforms are the main challenges in the structurally attractive emerging markets.
Despite these challenges, we are always searching for investment opportunities (in both technology and emerging markets) that we believe are rightly positioned to grow into their valuation or overcome the current macro challenges. At the same time, we are monitoring reform progress in key emerging markets and the rebalancing efforts in China -- looking for tipping points.
We are increasing our portfolio exposure further towards value and income because we believe the best opportunities currently lie there. Despite the recent setback, we continue to believe that European banks are great bargains -- they are dominant franchises in their local markets, yet they trade around or below tangible book value. Patience may be a well-rewarded virtue in this sector.
All investments involve risk, including possible loss of principal. Foreign securities generally pose greater risks than domestic securities, including greater price fluctuations and higher transaction costs. Foreign investments also may be affected by changes in currency rates or currency controls. With respect to certain foreign countries there is a possibility of naturalization, expropriation or confiscatory taxation, imposition of withholding or other taxes and political or social instability that could affect investments in those countries. These risks can be greater in the case of emerging country securities.
A significant portion of the information used by R Squared is received from external sources and has been adapted for use in R Squared's analytical and risk management systems framework. This report has been created using information believed to be reliable, but we do not warrant its accuracy or completeness. While every effort is made to insure the validity of the information received, R Squared cannot be responsible for any inaccuracies that may occur. The material may contain forward-or backward-looking statements regarding intent or beliefs on current or past expectations. Readers are cautioned that such statements are not a guarantee of future performance, involve risks and uncertainties, and actual results may differ materially from those statements as a result of various factors. The views expressed are also subject to change based on market and other conditions. Furthermore, the opinions expressed do not constitute investment advice or recommendation by R Squared Capital Management, L.P. (“R Squared”).
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