Japan's PAL Turns to Emerging Markets?
Japan’s public servants used to finance their retirements with equity investments limited to developed economies only, but they are now gaining exposure to places like Brazil, Colombia and South Korea.Investing in emerging markets is a hot topic these days. On Monday, I discussed nasty surprises that might lurk ahead, going over why Bridgewater's Ray Dalio thinks an emerging markets crisis is imminent. But Dalio also said that China's economy has bottomed and his fund has been ramping up its investments in emerging market ETFs, which doesn't exactly support his case against emerging markets.
The Pension Fund Association for Local Government Officials–known as PAL, a reserve fund for a number of government employee pension schemes–started to invest in emerging-market equities in the fiscal year that began April 1.
The fund declined to say how much money had been earmarked for emerging-market investments. PAL has an investment target of 11% of for all foreign equity, but the percentage can rise as high as 16% or as low as 6% before it has to buy or sell to bring its portfolio into line with its target.
Although Japanese pension funds have limited scope to diversify investments, contributors have done well thanks to the domestic stock market’s strong performance since November.
PAL decided to diversify “after considering the fact that emerging markets now make up a greater share of global GDP and, given their high growth, can be expected to give good returns,” said Tsukasa Kawashima, general manager of the fund management department. “We also discussed whether we might be missing out on profits by not putting money there.”
Though the 17 trillion yen ($170 billion) reserve fund is comparable in size with the Canadian Pension Plan Investment Board and the California State Teachers Retirement System, it lags behind its global peers in terms of diversity. Whereas other public pensions have put more retirement funds towards everything from gold to luxury department stores, PAL and Japan’s three other biggest public pensions have limited their investments to stocks and bonds.
The debate over Japan’s public pension money has raged for years, but the government has held firmly to the principle of maintaining a conservative approach to protect the world’s second-largest pool of retirement funds. Under Japanese law, public pensions don’t have a lot of scope to switch investments around, and they have certain investment obligations. For example, local government bonds, held obligatorily, accounted for a fifth of PAL’s portfolio at the end of March.
Mr. Kawashima said that the fund continues to study a number of other markets in addition to fixed-income and equities, but it isn’t yet at the point where it can decide whether or not to allocate more money to any other asset classes.
“There are a lot of challenges. For example, if you talk about real estate, there is the risk of a fall in prices, it’s hard to make a market valuation and we don’t have the know-how to assess such an investment,” he said. “But I believe there are also merits, so we’re studying those things.”
For the time being, Mr. Kawashima said the association’s members are in “a brighter mood” thanks to the pro-growth policies of Prime Minister Shinzo Abe, which have helped the Nikkei Stock Average to gain more than 60% since mid-November, boosting pension returns.
I also went over why Michael Gayed, CIO of Pension Partners, is bullish on emerging markets and bearish on U.S. stocks. Keith Porter, the former head of Emerging Market Equities at the Caisse, posted an interesting comment on LinkedIn after reading my post:
Back in June when I wrote on why fears of Fed tapering are overblown, I specifically mentioned the exact same point:I have to say I agree with Michael Gayed - especially when he says that the protests in Brazil are bullish longer term as the people start to demand sensible policies. My fundamental problem is that I can't see the Emerging World having the kind of crisis that many are predicting without that plunging the developed back into depression. At the same time, as the US and Europe recover they will tend to draw in more imports from the Emerging World. People are already talking about how the cheaper Real is good for Brazilian Agricultural exports.
Any tapering in the Fed’s $85 billion-a-month asset-purchasing program will hurt economies in Europe and Asia, where the focus remains on loose monetary policy, Stephen L. Jen and Joana Freire of London-based hedge fund SLJ Macro Partners LLP wrote in a June 10 report. This decoupling would particularly strike emerging markets, which previously served as magnets for capital as the Fed kept monetary policy looser than their central banks did.Keith and I spoke about Brazil and emerging markets. He rightly states that Eike Batista's downfall does not imply Brazil is doomed. "OGX was extremely over-leveraged and Batista was the consummate salesman. I once attended a conference in Brazil where he had everyone eating out of his hand."
Now think about what will happen if we get a crisis in emerging markets because the Fed starts tapering. It will only reinforce global deflationary headwinds, which is exactly the opposite of what the Fed and other central banks want.
For this and other reasons I've outlined above, I just do not see the Fed tapering any time soon. If they do, they will spark another global financial crisis at a time when the world is still dealing with the effects of the last crisis. Moreover, the spectre of deflation lingers, posing a real threat to the global financial system and to pensions preparing for inflation.
Keith also told me that he sees the protests in Brazil and Turkey as a good thing. "It shows you the middle class is rising and people want a better standard of living." [Note: Those of you looking for expertise in emerging markets can reach Keith Porter at keithporterqc@gmail.com]
I've been paying close attention to emerging market equities, especially iShares MSCI Brazil Capped (EWZ), iShares MSCI Emerging Markets (EEM), and iShares China Large-Cap (FXI). I've also been looking at companies like Vale (VALE) and many other companies in coal, copper, iron ore, steel and shipping, trying to gauge whether this is just another false breakout (many charts look the same which makes me nervous because I wonder whether this is just short covering or a real sustainable recovery).
One thing is for sure, emerging-market investors are getting picky with the Fed set to taper:
Investors bracing for the U.S. Federal Reserve to wind down its monetary stimulus have fled emerging markets in recent months, and while the impact of slow capital flows is likely to be felt for some time, some countries will fare much better than others.So what will happen in emerging markets and the rest of the world? So far, everything looks good. With the U.S. economy leading the way, Europe crawling back from its abyss and now China bottoming out, many leading economic indicators suggest that the world economy is finally recovering nicely.
The U.S. central bank is expected to begin trimming its massive $85 billion bond-buying program as early as next week. That will mean fewer Fed-created dollars sloshing around the global financial system.
Markets like Brazil and India, which must import capital to finance spending, will feel the squeeze. Mexico and South Korea, to name two, are less dependent and won't get hit as hard.
As a consequence investors hungry for the higher yields offered by emerging market stocks and bonds can no longer sink their money in the developing world indiscriminately, experts say. They will have to become much more selective.
For years, "many emerging markets have just had to sit back and watch the capital flow in. They haven't had to try very hard to attract it," said Morgan Stanley strategist James Lord. "Now they're going to have to work harder. That means reforms."
The MSCI Emerging Market Index fell some 12 percent between May and September. That was the worst four-month stretch in more than a year for the stock index, which did regain some ground in recent sessions. All told, investors have yanked $3.3 billion out of emerging bond funds since late May, according to Lipper, a Thomson Reuters company.
So far the pain has been most acute in places such as India, Turkey and Brazil. Those countries and others are also struggling with rising inflation and sluggish growth.
Other markets, while not untouched, have suffered less.
The Mexican peso and South Korean won have weakened about 2 percent each against the dollar this year, compared with 11 percent for Brazil's real and 18 percent for India's rupee.
Likewise, central banks in Indonesia, Turkey, Ukraine and India have seen the fastest erosion of foreign currency reserves since late May, according to Morgan Stanley calculations.
"When the hot money is gone, the tide will retreat and we will see who is naked on the beach," said Anjun Zhou, who helps manage $33 billion as head of asset allocation research at Mellon Capital Management.
"With less liquidity we will be more cognizant of which countries we pick, focusing more on their growth potential," she said, adding she favors Mexico, Russia and South Korea and is avoiding India and Brazil.
CRISIS CUSHION?
Ray Dalio, chairman and chief investment officer at Bridgewater Associates, one of the world's largest hedge funds, warned investors last week against wading into emerging markets in the near future. He said the sharp reduction in capital flows to countries such as India may lead to a crisis.
That's not to say investors will turn their backs on the developing world. While few emerging markets are growing at double-digit rates these days, they are still sure to outpace advanced markets for years to come. Some argue that most emerging countries are better prepared to weather the storm than they were during the emerging market crisis of 1997.
The International Monetary Fund still expects emerging market growth of 5 percent this year, about four times quicker than advanced economies, and 5.4 percent next year.
More flexible exchange rates and a larger stash of currency reserves - about $7.5 trillion as of March compared with about $600 billion in 1997 - also provides a cushion. Deficits and foreign currency debt, while worrisome, are not as large.
"The reality is things are going to be more challenging" for a lot of countries," added Andres Calderon, who helps oversee $4.4 billion in assets at Hansberger Global Investments. "But I would be very surprised if this turns into another crisis."
That said, simply muddling through by spending reserves and raising interest rates to prop up currencies won't be enough in the long run, especially for countries that need affordable access to foreign capital to service their deficits.
"These are temporary measures that can buy time," Lord said. "They're not a sustainable way of rebalancing the economy."
A better approach, investors said, is to get serious about long-term structural reforms.
Calderon said Brazil should focus on a more flexible labor market and major infrastructure reforms to attract foreign and local private capital.
Sean Lynch, global investment strategist at Wells Fargo Private Bank, said India could start helping itself by easing restrictions on foreign corporate ownership, a move that would attract stabilizing foreign direct investment.
MEXICAN EXAMPLE
Many investors urge policymakers to imitate Mexico, where the government has committed to sweeping reforms of the state-dominated energy sector, education and telecommunications.
While Mexico's IPC stock index .MXX has lost 6 percent this year, indexes are down by double digits in Brazil and Turkey, both current account deficit countries.
Still, it took a multi-year slump in the United States, Mexico's most important trading partner, to force action.
"Mexico felt a lot more pressure to tackle structural reform, and that put them ahead of the curve," said Calderon. "But I don't think they stand out as being uniquely enlightened. They just faced the pressure earlier."
Even so, it's all paying dividends now.
In Asia, capital is shifting from south to north, toward countries like China, South Korea and Taiwan, which could see trade gains as U.S. growth rebounds. Meanwhile commodity producers such as Indonesia and Malaysia have seen their finances worsen as metals prices have eased.
Peter Kohli, president of DMS Funds, said he launched two U.S.-listed mutual funds this year focused on Poland and the Baltic states - new European Union members with healthy finances and a commitment to reform.
"These markets are looking a lot more attractive," he said. "These countries seem to have their act together."
"A lot of countries have talked about reform but haven't delivered much," said Wells Fargo's Lynch, who helps oversees $170 billion in assets. "But I think the longer we see weakness in emerging markets, the more they will be forced to make meaningful reforms."
But remember what Michael Gayed said in his comment on nasty surprises that lurk ahead. The bond market matters and it's not about the level of rates but the speed at which they rise. If yields back up too fast, watch out, it will be a bloodbath in emerging markets and all risk assets, including U.S. stocks and corporate bonds.
Nevertheless, Verizon's record $49 billion bond deal suggests that investors aren't worried about nasty surprises that lurk ahead. Are they right? We shall see. All I now is that investors should remember Doug Pearce's words of wisdom: "the riskiest time in the market is when everyone thinks there is no risk at all."
Below, JP Morgan Head of Emerging Market Debt Pierre-Yves Bareau discusses which markets he's interested in investing in and which ones he think you should stay away from. He speaks with Mia Saini, John Dawson, David Ingles and Rishaad Salamat on Bloomberg Television's "Asia Edge."
Second, Jonathan Garner, head of Asia and emerging-market strategy at Morgan Stanley, talks about Japan and global emerging markets. He speaks in Hong Kong with John Dawson on Bloomberg Television's "First Up."
Finally, Russ Koesterich, chief investment strategist for BlackRock Inc., talks about the outlook for Federal Reserve monetary policy and global emerging markets. He speaks in Hong Kong with Rishaad Salamat on Bloomberg Television's "On the Move."