Hot money and cold comfort

Follow the money into cyclical emerging markets or hunker down with some steady defensive stalwarts? The MoneyLetter’s regular investment strategy columnist John Stephenson recommends a combination of two emerging market exchange traded funds and three global blue chip stocks as the steadiest way to handle this vacillating market.

The most recent weekly data are showing more and more money chasing returns in emerging markets as investors seek return while downplaying the risk in a world where $13.4 trillion in bonds yield less than zero.  Inflows into emerging market equity funds recently hit a 58-week high with $5.1 billion arriving in a single week.  Emerging market equities have climbed to their highest level since July 2015, with the MSCI (Morgan Stanley Capital International) Emerging Markets index up 15.4 percent so far this year.

Expectations that the U.S. Federal Reserve will remain on the sidelines have weighed on the U.S. dollar and bolstered oil prices.  These assumptions were put to the test recently at the annual gathering of central bankers in Jackson Hole, Wyoming.  Investors initially viewed Fed chair Janet Yellen’s rather hawkish comments with enthusiasm sending the stock market higher.  But later when vice chairman Stanley Fischer spoke with CNBC saying that “the U.S. economy had strengthened, with strong jobs data in the last three months,” the market took his comments as evidence that the Fed was seriously considering a September rate increase sending stocks lower.  Not for the first time, there is a divergence between the hawkish chatter of some Fed officials and a bond market that thinks there is little chance of an interest rate tightening in December, let alone next month.

Top emerging market equity funds

As expectations have risen that the Fed will remain accommodating, inflows to emerging market funds have steadily increased as investors have been lured by the promise of high returns. Nowhere has this promise been more rewarding than with Peru’s S&P Lima General Index which has topped all global emerging markets in local currency terms in 2016, romping to a 58 per cent gain and far outpacing Argentina’s Merval and the 37 per cent jump for Brazil’s Bovespa over the same period.

In currency-adjusted terms, Peru is the world’s No. 2 market after Brazil, which has benefited from a big rally in its currency, according to an MSCI ranking.

The 58 per cent appreciation in the Lima General Index this year is only the fourth-largest rally in the last decade.  The index rose by 168 per cent in 2006, 101 per cent in 2009 and 65 per cent in 2010.  And the market is still well below its peak, touched in April 2012 at 24,095.29.  The index has benefited from a pro-reform president, Mr. Pedro Pablo Kuczynski, a former World Bank official and Wall Street banker and the index’s relatively small size.

While Peruvian companies are no longer cheap after the rally, they remain fairly valued.  The Lima General Index trades at 14.26 times earnings, well below the S&P 500’s 20.00, even though it has dwarfed the S&P 500’s seven per cent 2016 return.

Despite the heady gains from a handful of Latin American bourses, Bloomberg’s Stock Correlation Tracker shows that in the age of globalization, diversity is harder to come by.  In contrasting the benchmark equity indices of 84 countries with the S&P 500 index over a ten-year period, Bloomberg found that 88 per cent of them were positively correlated with the U.S. market in the first half of this year—a complete reversal from a decade ago.  The reason? Most markets are experiencing slower growth and their performance is much more closely aligned with that of the S&P 500, including several Middle Eastern indices that used to move in the opposite direction to the S&P.  Today they are now moving more in lockstep.

The one exception to the stronger correlations with the S&P 500 is the falling correlations between the U.S. benchmark and those in Latin America’s largest economies.  In part, this is because of the construction of the benchmark indices in some of these economies.  In the cases of Brazil and Chile, their benchmark indices have actually become less representative of their economies since 2006, shedding more than 30 per cent of gross domestic product from their respective market capitalizations.

For investors considering the possibilities of jumping into the emerging markets it might be prudent to wait until the Fed meeting in September.  Any evidence that a rate rise is in the offing in the near-term could send the U.S. dollar higher and send emerging markets lower.

Two emerging market equity funds to buy

The very fact that various Fed officials are signaling that a rate rise may be in the offing highlights the relative strength of the American economy from other developed economies. Already there is some preliminary market evidence from August that investors in the U.S. think the worst may be behind them as investors have been rotating back into out-of-favour stocks that tend to do well when the economy is stronger. In August the sole sector to hit a new market top was the consumer discretionary, made up of companies such as McDonald’s Corp., Inc. and Starbucks Corp. that consumers can live without.

The absence of any repercussions from the June U.K. vote to leave the European Union and two strong U.S. jobs reports have helped these cyclical sectors to rebound, after being shunned earlier in the year in favor if safer bond-like stocks. The best-performing sectors in August were information technology stocks, financial stocks and energy stocks, which have given the market a significant boost since they started beating the S&P 500 this summer.

The U.S. stock market may well be setting up for a decent run into the end of the year.  Investors who look at the concentration of gainers and losers in the market usually worry that as bull markets near their end, investor interest becomes excessively focused on a small number of fashionable stocks. But even as the number of sectors setting highs has narrowed, the market has remained broad on other measures.  The most-watched gauges are the “advance-decline” line, which is the number of gainers minus losers, and the percentage of companies hitting 12-month highs, neither of which is raising a red flag.

The very strong returns from the emerging markets should not be ignored but they are in part a function of currency moves.  If the U.S. Fed remains accommodating and leaves rates alone, an investment in either the iShares MSCI All Peru Capped ETF (NYSE—EPU) or the iShares MSCI Brazil Capped ETF (NYSE—EWZ) makes sense as their respective currencies will likely rally against a weakening U.S. dollar.

Three global blue chip stocks to buy

Fed policy moves have been anything but predictable. Given that the Fed is just as likely to keep rates on hold as it is to raise rates suggests that there is an opportunity to buy some of your favorite dividend paying stocks at discount.  Pairing a number of solid dividend-payers with some cyclical names could help hedge your portfolio against whatever the Fed or other central banks send your way.

One company that I like for the dividend yield and solid upside potential is Vodafone Group PLC (NASDAQ—VOD). Vodafone is a multinational, and predominantly mobile, telecommunications stock with over 444 million customers worldwide. While the company is headquartered in the UK, the country contributes less than 10 per cent to the firm’s bottom line.  Vodafone has recently completed a major capital investment phase which should help boost revenue and EBITDA growth. The current dividend yield on the stock is 6.7 per cent and I have a ‘Buy’ rating and a twelve-month price target of $38.25 per share on Vodafone Group PLC.

Another company that I really like, particularly in a recovering economy, is Medtronic PLC (NYSE—MDT). Medtronic is a leading worldwide medical technology stock engaged in manufacturing and selling device-based medical therapies. Medtronic will likely achieve sustainable double-digit EPS growth over the next five years, with multiple levers to drive upside.  The company should also be able to drive about $1 billion plus back towards shareholders over the next few years in the form of share buybacks and dividend increases. I have a ‘Buy’ rating and a twelve-month price target of $98 per share on Medtronic PLC.

Another name that I really like is Lloyds Banking Group PLC (LSE—LLOY), a major UK bank formed from the merger of Lloyds TSB and HBOS in January 2009.  Lloyds is one of the best capitalized European bank stocks which is a testament to its low risk, high capital generative business model.  I believe it will follow other European retail banks and distribute a significant percentage of its earnings such that the dividend becomes the focus for investors and the driver of the share price. The company also has a current dividend yield of 4.0 per cent which further supports the stock price.  I have a ‘Buy’ rating and a twelve-month price target of £70 per share on Lloyds.

The market has switched its focus from cyclical names to defensive names and then back again all throughout the year, and the remainder of the year will likely be no different.  By having some positions in both the cyclical and defensive camps, investors should have the best shot of handling whatever the market throws your way.

John Stephenson is an award-winning portfolio manager and the President and CEO of Stephenson & Company Capital Management Inc. in Toronto.  He is the author of “The Little Book of Commodity Investing” and “Shell Shocked: How Canadians Can Invest After the Collapse”.


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