Emerging market equities have outperformed the S&P 500 index and the flagship asset class index fund (symbol EEM) is up 12.5% in 2017. The US dollar and the ten-year US Treasury bond yield have both fallen since the March 14 FOMC rate hike, the ideal macro tailwind for emerging markets such as China and India. Not even the latest 10% hit in crude oil prices, revelations of Russian cyber-espionage in the US Presidential elections, a money market liquidity squeeze in Shanghai, Trump’s tirades against Mexico and China and the arrest of South Korean Park Geun-hye has derailed the asset class’s bullish momentum.
The fact remains that the US Dollar Index’s spectacular 30% rise in the past five years has made many emerging market currencies grossly undervalued in the global foreign exchange market. The Malaysian ringgit trades at 1998 Asian flu lows. The Russian rouble is half its exchange rate against the US dollar when the Kremlin ordered its troops to invade Georgia in 2008. Brazil offers the world’s highest inflation adjusted interest rates. The Egyptian pound was deeply undervalued at 19. The Federal Reserve has hinted that it will not choke the global liquidity cycle with draconian rate hikes even as both global earnings growth rates and industrial production improve. Emerging markets are a hedge against the nosebleed valuations in US equities and Donald Trump’s legislative woes in Congress.
The best money making opportunity in 2017 has been to invest in Hong Kong property developer shares, who have all hugely benefited from a tsunami of Mainland Chinese money that has led to a spectacular bull market in Hong Kong residential and commercial property. Wharf Holdings, Kerry Properties and Wheelock are all up 30 – 40% in the past three months alone. Hong Kong may no longer be a Crown Colony of the British Empire but its capitalist elite still know how to mint money in brick and mortar! The Hong Kong dollar peg enables local asset prices to benefit from the lower Uncle Sam bond yields. Apart from Hong Kong, the most profitable country funds to own in the past three months have been Poland, Argentina, South Korea and Mexico, all up 18 – 24%. Russia has not performed in 2017 due to the oil crash, nor has Saudi Arabia. Nigeria, as in 2016, is a nightmare.
I concede there are pocket of froth and overvaluation in specific emerging markets. India’s Nifty is far too expensive for my taste at 17 times forward earnings, two sigma above its ten year mean valuation. Despite Trump’s Obamacare debacle, I would not rule out the Republican Party’s obsessive interest in lowering the 35% US corporate income tax and the Federal Reserve’s determination not to fall behind the “inflation curve”. This means King Dollar may be down but is definitely not out – not yet. The financial markets have dramatically scaled back their expectations of tight money from the Yellen Fed in 2017. My tactical emerging market bets for April? Thailand, Argentina, Chile and China. The best short? The South African rand as Zuma reshuffles his Cabinet on the eve of the another ANC leadership change that will reshape the Rainbow Nation. Nkosi sikelel’ iAfrika!
“Things fall apart, the center cannot hold, mere anarchy is loosened upon the world” William Butler Yeats’s poetry could well described the psychological zeitgeist in Europe on the eve of the Dutch, French and German elections. Yet the worst of all possible worlds, Dr. Pangloss’s nightmare scenario, did not happen in Hollande. The political center held in the Dutch election and will hold in both Paris and Berlin. This means the Euro is burdened with an excessive risk premium that will fade as 2017 progresses. The real story in Europe is that inflation expectations have bottomed and the ECB has successfully reflated the Eurozone with its “shock and awe” bond purchases. Purchasing manager indices (PMI) new orders have begun to rise in both France and Germany. This is the reason even Marine Le Pen has toned down her Frexit threats. This means German Bund yields can and will move higher once Macron wins the Élysée Palace and I celebrate the Treaty of Rome in my own way by owning the Italian country index fund at book value! In any case, European equities offer an attractive risk/reward calculus at a valuation of 14.9 times earnings and 1.8 times book value.
Market View – Time to accumulate oil and gas shares?
Crude oil prices have fallen 10% from their 2017 peaks despite a lower US dollar after the March Fed rate hike and lower US Treasury bond yields. This has happened because the world oil market has concluded that Saudi Arabian brokered OPEC and non OPEC output cuts since December have not been deep or sufficient to offset the rise in US inventories and US shale oil output. There is also evidence of friction between Saudi Arabia and Russia on the Kremlin’s failure to cut its promised 100,000 Urals barrels in February as well as Iraq’s ambition to expand production to 5 MBD. Baghdad argues that its 220,000 output cut is unfair because the Iraqi Army is engaged in a battle to defeat Daesh terrorists in Mosul while the Kurdish regional government in Erbil exports 600,000 barrels to global markets via land routes to the Turkish oil terminal at Ceyhan on the Mediterranean coast.
The fall in Brent crude below the psychological level of $50 and US inventories above 528 million barrels gives Saudi Arabia the political cover to roll over the OPEC cuts at the next meeting in Vienna on May 25. The last thing the kingdom wants or needs at a time of fiscal austerity, Eurobond new issuance, economic restructuring and the endgame to Saudi Aramco’s floatation is a new 2015 style collapse in oil prices below $30 or lower. Russian President Vladimir Putin and Iraqi Prime Minister Haider Abadi have no strategic choice but to boost compliance with last November’s output deal if they want Saudi Arabia, UAE, Kuwait and Qatar to continue to act as the “swing producers” of OPEC in 2017. Despite Saudi Oil Minister Khalid Al Falih’s complaints about Russia and Iraq at the CERA energy conference in Houston, the royal court in Riyadh has issued successive statements that reaffirm the kingdom’s commitment to last November’s OPEC agreement and affirmed the logic of a May 25 roll over.
French bank Societe Generale revised its oil prices forecast for front month ICE Brent to $60 and $65 in the third and fourth quarter of 2017 after Deputy Crown Prince Mohammed bin Salman’s state visit to President Trump in Washington. Goldman Sachs rightly argues that oil demand will surpass supply in the second half of 2017 and that OPEC will roll over the Vienna pact on May 25 for six more months to normalize global inventories and rebalance the oil market.
Goldman Sachs has flagged both Exxon Mobil and Chevron as among the 19 large cap US companies must shorted by long/short hedge funds and most shunned by US mutual funds. After all, energy was the worst performing S&P sector in the first three months of 2017. Goldman Sachs also demonstrates that the gap between crude oil prices and energy stock performance is the widest in five years, as many overweight long only funds dumped the sector in the last three months. Positioning now creates another classic asymmetric risk trade opportunity.
Chevron (CVX) is my preferred US supermajor, ideally at a buy price of $104 when the dividend yield would be 4.25%. I read its recent Analyst Day transcripts literally twice to ensure that management is commited to its 4% dividend while not sacrificing its “fortress balance sheet”. As CEO John Watson pointed out, Chevron, whose geologists discovered the Damman salt dome gusher in 1937 that changed the history of Saudi Arabia and the Arab world forever, has increased its dividend for 29 successive years. As megaprojects like the Wheatstone/Gorgon LNG plants in Australia and offshore Angola come on line, Chevron can grow output by 6 – 8% and its growth investment focus has now shifted to the Texan Permian Basin. The valuation is at an attractive discount to both Exxon and the S&P 500 index. My buy/sell level in Chevron remains 104 – 120.