Author: Andy Djordjalian
Covestor models: South America, Emerging Market Sector Focus
Macro view
It has been quite a ride since my last report. Adding to losses in July, the markets retreated in early August, presumably responding to concerns regarding sovereign debt in Europe as well as to the way in which the U.S. debt-ceiling debate took place and ended. The S&P 500 then showed some support near the 1,120 level, exhibiting a double (or rather, triple) bottom, to recover some lost ground by the end of the month.
Emerging markets followed the route of the U.S. large-cap universe, but emerging market indexes generally lost a few percentage points more in August as a probable result of a mild flight to quality favoring non-cyclical stocks in mature economies.
Many commentators include the S&P downgrade of US debt among the reasons for the early-August losses, but actually I doubt that is a relevant factor. U.S. Treasuries are a unique benchmark for global investors, who do not need the simplified summary of a credit agency to assess their reliability. Early this year, Paul Krugman cited the uneventful downgrade of Japanese bonds in 2002 [1].
Still, the U.S. debt downgrade was the result of a political process that spread doubt among investors. To continue healing, the U.S. economy would very much benefit from increasing confidence from consumers about their spending possibilities and from the business community regarding the capacity of politicians to lay out more-effective spending, tax collection and financial regulation. The tone and method of the debt-ceiling debate did not help in this respect.
The markets priced in this factor and the price decrease of sovereign bonds of some European countries, on top of all the structural macroeconomic problems that were already considered in stock prices. Though stocks have recovered much of what they lost since the 2008 subprime crisis, companies increased their efficiency in the meantime and there was good growth in emerging markets as well as a significant injection of money into the global economy. These developments drove earnings higher and decreased the yield of alternative investments.
Normally, this would justify a higher valuation for stocks, as suggested by the relation between stock prices and earnings, sales, book value, etc. Nevertheless, current stock prices are evidently the result of severe concerns about the future, as investors evaluate the possibility of global recession or the rest of the recovery being extremely slow.
My investment policy
I do not rule out those unfortunate scenarios, but better ones have to be considered too. If risk aversion recedes and a portion of what investors have allocated in cash and treasuries is moved into equity, there is much potential for stock prices to grow. Investors disregarding this possibility assume a speculative position, because in the event of prices increasing, they would be left only with the option of re-positioning by buying at higher prices or doubling the bet by keeping away from stocks for a longer time. In other words, chasing performance or trying to time the markets – both of which I want to avoid as drivers of poor performance.
Staying out of the stock market today is not the logical conclusion of believing that there may be tough times ahead for the economy, but rather of believing that the markets have not priced in that possibility sufficiently. I do not see grounds for such a belief and, if I did, I would not tie most of my portfolio to it because it would mean trying to time the markets, a pointless strategy.
Instead, I aim to carefully assess my risk tolerance and keep an amount of low-volatility investments while I also invest in the higher-risk space, where I believe opportunity may be more present than before due to increased risk aversion. My portfolios at Covestor are part of this strategy.
Performance of emerging markets and the South America model
The South America model performed somewhat better than its benchmarks during August, as can be seen in the graph provided by Covestor on its profile. This outperformance was caused mostly by its positions in precious-metals mining.
A recent development in the region was the reduction of interest rates by the Brazilian central bank, which media commentary regarded as a surprise measure. I am working with the thesis of the authorities not prioritizing a small probability of high inflation over growth. I invested in monetary-policy-sensitive companies such as banks Itau (ITUB), Bradesco (BDD) and home maker Gafisa (GFA) partly because they were affected by expectations of severe tightening.
One of the reasons for the rate decrease was that, during the second quarter of the year, Brazilian growth has slowed. According to finance minister Guido Mantega, it was due to the markets responding to the tightening measures that were enforced to control inflation. [2]
During these last months, I did not see signs of the markets punishing Brazilian stocks particularly, which indicates that markets discounted this amount of slowdown, acting in anticipation. After all, the Brazilian large-cap universe has had lackluster performance in the last two years and current valuation multiples are low.
There was good news from emerging markets regarding the control of inflation, so I find it reasonable to expect more dismantling of tightening measures. A further reason for this is the increasing possibility of a relaxation of monetary policy in developed economies by the end of the year. The markets will move according to the expectations about the future, be that dismantling or whatever other outcomes are most probable according to investors.
I bear in mind that growth in Brazil is still at positive levels and due to increase in 2012, and that the relaxation of monetary policy normally lifts asset prices.
However important these local factors are, the recent performances of Brazil and the rest of the emerging markets were dominated by fears of contagion, from Europe particularly. Fund managers were selling probably because many of their customers decided to tilt their allocations towards cash and high-grade fixed income. Many fund investors are unsophisticated, so this move should not be considered as one based on skill and experience.
Managers also needed to modify their portfolios in an attempt to control risk, despite the current high volatility. These processes provide an explanation for emerging markets being highly correlated to developed markets over the past couple months, which hides their diversification potential. But investments of different quality and dependencies cannot be forever treated equally.
South America is more than commodities
Last month I had another chance to confirm that the South American story is more than mining and agriculture, as I had business at two interesting locations.
First, I visited the Itaipu Dam, the most powerful power plant in the world, located in the frontier between Brazil and Paraguay. South America has vast potential for hydroelectric power generation, a significant portion of which is currently utilized, but much remains unexploited. This is an important asset in a world of increasing costs of energy. Moreover, the high liquidity in the global economy facilitates the expansion of this infrastructure, but let us hope that they do it with sufficient care for the environment and indigenous populations.
My other business trip was to Invap, an Argentine company that designs small nuclear reactors for research and medicine, as well as radar systems and a recently-launched instrumentation satellite built in collaboration with NASA and the Argentine space agency.
Both locations are near touristic attractions, as the amazing Iguazu Falls are close to Itaipu and Invap is in the lovely city of Bariloche, one of the most important ski destinations of the southern hemisphere. Ski fans from the US, Europe and Japan flock to it during their summer, though last week it was packed with Brazilians, as it is their winter-holiday season.
My new Emerging Market Sector Focus model
