Monday, November 18, 2013

Caisse Betting Big on Emerging Markets?

I will translate the main message for those who do not speak French. Michel Munger of Le Journal de Montréal reports, La Caisse investira plus dans les pays émergents:
La Caisse de dépôt et placement du Québec investira jusqu'à 10% de son actif dans les pays émergents, faisant presque doubler la mise à 20 milliards$ d'ici la fin de 2014. Elle aura besoin d'un coup de main pour le faire.

L'intention de la Caisse a été exprimée par Roland Lescure, chef des placements, jeudi matin lors d'un colloque de l'Institut de la gouvernance des organisations publiques et privées (IGOPP).

Pour expliquer cet intérêt, M. Lescure a dit qu'il se méfie des consensus. Il croit que les investisseurs se trompent en pensant que la vague est terminée, notamment en Asie, où les placements sont peu coûteux.

«Dans les 25 années qui viennent, avec des pays émergents qui vont contribuer à environ 70% de la croissance économique mondiale, on va voir un véritable déplacement du centre de gravité. C'est une tendance lourde», a-t-il ajouté.

Le chef des placements a toutefois admis que la Caisse connaît peu cette partie du monde. Elle devra conclure des partenariats avec des entreprises «qui connaissent le pays dans lequel elles investissent aussi bien que nous connaissons le Québec et le Canada».

Roland Lescure dit aussi nager à contre-courant en voyant une renaissance aux États-Unis. Leurs marchés boursiers ont beaucoup monté grâce au soutien des banques centrales. Plus de volatilité est attendue, mais il n'y aurait pas de bulle.

La découverte de pétrole et de gaz donne un regain de vie aux voisins du Sud. La fabrication a le vent dans les voiles et le secteur automobile américain est redevenu exportateur.

«La révolution énergétique est une réalité, a dit M. Lescure. On estime à deux millions les emplois qui en découlent depuis cinq ans et à plus de trois millions le nombre d'emplois qui seront créés.»

«Nous souhaitons y être exposés en étant plus investis dans des entreprises canadiennes qui exportent, a-t-il expliqué. Je pense à Gildan, à Magna, au Canadien National et à quelques autres. Nous souhaitons également accroître notre présence en immobilier, notamment dans les bureaux dans quelques grandes villes.»

La Caisse a aussi les projets américains d'infrastructures dans sa mire.

M. Lescure est moins optimiste sur les perspectives de l'Europe, qu'il ne croit pas sortie du bourbier. La zone euro a encore des pays insolvables, des banques en manque de capital, une devise trop forte et un chômage élevé. Celui-ci dépasse 50% chez les jeunes en Espagne.

La page tournée sur les PCAA

M. Lescure n'a pas esquivé les questions concernant la crise du papier commercial adossé à des actifs (PCAA). Il n'est plus question de miser des milliards de dollars sur des placements exotiques. «Nous n'investissons dans les produits que nous ne maîtrisons pas. C'est terminé», a-t-il précisé.

«Les dérivés ne sont pas morts, a-t-il ajouté. Certains dérivés simples sont utiles, notamment pour se couvrir contre les risques extrêmes.»
Let me begin from the end of the article. Roland Lescure, the Caisse's CIO, referring to the ABCP scandal, stated they will no longer invest in exotic products they do not fully understand. That's a relief given the Caisse's previous management really bungled it up in their delusional thirst for exotic products that offered a nice spread over their benchmarks.

By the way, I added a postscript to my last comment on the media covering up the Caisse's ABCP scandal. Diane Urqhart, an independent financial analyst who represented thousands of retail investors that got hammered by the ABCP meltdown, shared this with me:
The Caisse made a huge mistake in owning too high a percentage of its total portfolio in ABCP given its exceptionally high risk relative to the marginal incremental return. Also, according to the evidence presented in the OSC hearing on Coventree misrepresentations, the Caisse then engaged in activities compounding its problem: bought more ABCP to keep the market rolling; co-operated with Coventree to move US subprime mortgages out of the trusts it owned to trusts other investors owned; did massive selling of CIBC bankers acceptances to create financial distress on this bank in order to force its co-operation to keep ABCP in its inventories and to make the ABCP market look healthy; and, finally, is rumored to have been the confidential funding source for 60% of the $177 M settlement with the Canaccord and Credential retail customers ($188 M settlement with interest paid from the ABCP trusts) even though it was not responsible for the losses of these people.

Overall, the Caisse did inadequate due diligence and was duped by Deutsche Bank AG, who was the biggest winner from this and who, in my opinion, committed alleged fraud in respect to the design of the paper. There has been no evidence of any specific kick-backs paid to the Caisse managers to buy the ABCP. However, the Caisse's actions to artificially keep the market rolling, move US subprime mortgages out of the paper it owned, force financial distress on the CIBC and then generally cover-up what it did post the ABCP crisis are unsavoury actions, that might reach the level of fraud, even though its own exposure to ABCP was simply gross negligence.
I thank Diane for sharing her insights on this important topic. I received a few comments from people telling me that brokers made off like bandits and there likely were bribes involved. The brokers did make off like bandits in this ABCP scandal and the banks got away with a slap on the wrist. I will leave it up to the police and regulators to determine whether anyone received kickbacks in this sordid affair (it wouldn't shock me).

Now, back to the Caisse investing more in emerging markets. The irony in all this is that Richard

Emerging markets or submerging markets?:
Long-time readers of mine know that I have been keeping a close eye on emerging markets since they began meaningfully underperforming the S&P 500 toward the tail end of the first quarter. Using inter-market trend analysis, context and valuation, I went so far as to continually call the trade the "next fat pitch."

Yes, the fat pitch has taken much longer than I thought to materialize. No, I will not back down on the idea. Extreme momentum went first to Japan (DXJ), then to the U.S. (IWM), and most recently to Europe (VGK). It is illogical to think emerging markets are not the next bucket to absorb money.

The argument all along for emerging-market equities has been that the spread differential between the BRICs (Brazil, Russia, India, and China) relative to the S&P 500 is too large to make sense. At one point in the year, emerging markets on average were lagging the U.S. by north of 30%, a level not seen since 1998. Yet, in 1998 there was an actual emerging-markets crisis to explain that differential. No such crisis exists as is extremely clear now.

And don't assume the spread can be explained with QE alone. After all, Europe has no QE, and yet those countries are now significantly ahead of emerging-market stocks on a year-to-date basis as well. Valuation as a reason to keep buying developed markets relative to emerging markets? Not a likely explanation either since many emerging markets are considerably cheaper.

So what explains the big spread, and will it ever close? Take a look below at the price ratio of the iShares MSCI Emerging Markets ETF (EEM) relative to the S&P 500 (SPY). As a reminder, a rising price ratio means the numerator/EEM is outperforming (up more/down less) the denominator/SPY (click on image below).

Note that the trend in weakness has been persistent (again, despite no crisis), to the point where the law of one price has been violated, with investors pricing in a Lehman event as if one already took place overseas. The ratio bottomed in early June, went sideways, had a powerful run of strength, and has for the past several weeks turned down relatively hard. Remember that at the core, everything is about relative momentum within an asset class. In this case, I focused heavily on watching this ratio for signs of a big move to come, but admittedly leadership has been fleeting.

So what happens next? I maintain my thesis — a major trade will come in emerging-market equities, but I may have been early in bringing attention to this idea given relative ratio momentum which has failed to turn up convincingly. However, when it does, mean reversion can be swift and aggressive. Those who recall how emerging markets performed in 2005 know just how powerful momentum can be in smaller-country indicies when it takes hold, which can overwhelm developed market gains seen in 2013.

Buy low, sell high? Emerging markets have been submerging all year. That does not mean you should remove them from your watch list, especially if inflation expectations rise.
So is the next big trade going to be in emerging markets? That's a complicated question. Michael Gayed is right, on a relative basis, they are under-valued and oversold relative to developed markets but there are reasons to be concerned. Below, I list a few things to keep in mind:
  • China's investment boom is over. As China moves from an investment economy to a consumer economy, there will be less investments to fund major infrastructure projects. The ramifications of this will be felt throughout the world, especially in commodity producing countries like Australia, Canada and other BRICs like Brazil and Russia. China will still keep growing but nowhere near the rate of the last ten years.
  • An emerging market crisis looms large. Several prominent investors, including Bridgewater's Ray Dalio, have sounded the alarm on an emerging markets. Of course, Bridgewater still holds a ton of emerging market shares in their portfolio so take his dire warnings with a grain of salt. However, if interest rates start rising again, then this could unleash hell in emerging markets. The Fed knows this which is likely the reason why it didn't taper back in September and won't taper anytime soon. Nonetheless, more QE also means lower U.S. dollar and lower commodity prices, which hurts many BRIC economies like Brazil exporting commodities.
  • U.S. manufacturing renaissance. Despite the sluggish recovery, the U.S. economy remains a global powerhouse. It's still the dog that wags the tail of the global economy. I never bought the myth of decoupling and think investors are deluding themselves thinking the U.S. is going to underperform the rest of the world over the next 30 years. In fact, lower energy prices will bring manufacturing back to the U.S. and help boost its exports, but apart from that, the U.S. will always remain the leader of the world because as imperfect as its economy is, it's still the most innovative and productive economy in the world. 
Let me end by stating there are plenty of ways to invest in emerging markets through the U.S. and Canadian stock market. Last December, I recommended a lump of coal for Christmas, explaining why coal, copper, and steel stocks were way oversold and should be bought. I've since tempered my enthusiasm but like the price action in these industries. I haven't seen a significant breakout yet but keep an eye on these shares (take the time to go over the holdings of top funds during Q3 to gain more insights on where you should be focusing your attention).

As far as the Caisse and other Canadian funds buying the Brazilian boom story, increasing their holdings of emerging markets, maybe they are right but the lack of transparency and liquidity in these markets remains a cause for concern. In my opinion, there is a lot of potential to make money in public and private markets in emerging markets but I still prefer the liquidity and transparency in US and Canadian stocks to play this theme. In this environment, tread carefully when it comes to emerging markets (just ask Ontario Teachers who almost got burned by Ike Batista and is now cautious on China).

Below, Mark Mobius, chairman of Templeton Emerging Markets Group, talks about the impact of Federal Reserve policies on emerging markets, investment in Ukraine debt and the outlook for China. He spoke with Bloomberg Television's Angie Lau in Hong Kong on Nov. 11.

And Byron Wien, vice chairman of the advisory services unit at Blackstone Group LP, talks about corporate earnings, the U.S. economy, stock prices, and the Federal Reserve's policies. He also talks about China and Japan's economies, and emerging-market stocks. He speaks in Hong Kong with Mia Saini and Rishaad Salamat on Bloomberg Television's "Asia Edge."