Cullen Emerging Markets High Dividend: Q2 2018 Commentary

Fund Update
June 2018Print article
Rahul SharmaFund Manager

Summary Comments:

The second quarter of 2018 proved turbulent for emerging markets (EM) equities, particularly after the dramatic rise in the asset class in 2017 and through January 2018. Increased volatility was evident globally amid escalating trade tensions, and EM stocks and currencies posted their weakest quarter since 2015. As a result, EM stocks (MSCI EM Index) more than gave back their gains from January and 1Q, and closed the second quarter down 7.96%. This compared to a decline in the Developed Markets (MSCI EAFE) index of ‐0.97%, whereas the United States (S&P 500) index rose +3.43% during the quarter. Market‐moving events in the second quarter of the year included mounting tariff threats and threatened retaliation, a hawkish Fed and a rally in the USD, ongoing strength in the oil price amid OPEC discipline, and electoral news out of several major countries. Although EM equity funds saw outflows in June, the asset class remains net inflow positive at almost $30bn for the year1. Asian stocks (‐5.82%, MSCI EM Asia Index) outperformed those in Latin America (‐17.68%, MSCI EM Latin America Index) and EMEA (‐10.00%, MSCI EM Europe, Middle East and Africa Index). Within EM, value stocks (‐8.87%, MSCI EM Value Index) lagged growth stocks (‐6.96%, MSCI EM Growth Index). Commodities were mixed during the quarter. WTI crude rallied more than fourteen percent amid new Iranian sanctions in May, plus OPEC’s extended supply agreement, and closed in June at $74.15, hitting a new high since late 2014’s price slump2. Conversely, the S&P Industrial Metals index was up just 0.90%, with particular weakness in iron ore and copper offset by a rally in nickel and aluminum, as tariff rhetoric and trade war tensions were headwinds. The US dollar strengthened in the second quarter and the Dollar Index (DXY) closed the quarter up 5.00%, amid particular weakness across markets with higher USD exposure, such as Turkey and Argentina. Additional key geopolitical events in the second quarter included the Trump‐Kim summit in Singapore, the US refusal to endorse the G7 communique and threat to impose auto tariffs, a Fed rate hike June, and a truckers’ strike which disrupted commerce in Brazil.

The top EM country performers in the second quarter of 2018 were Qatar, India and Greece. Qatar benefited from the rally in the oil price, which represents a boost to the country’s GDP. In India, exporting sectors such as Health Care and IT Services led the market higher, aided by a weakening currency. Greece saw the continuation of structural improvements in the economy, an improvement in economic sentiment, and an expansion in GDP growth. The bottom EM country performers were Brazil, Turkey, and Thailand. Brazilian truck drivers successfully ground the country to a halt to protest rising fuel prices and subsequently negotiated a new government fuel subsidy. Turkey saw its currency swoon on the strength of the USD given the country’s reliance on external funding. This combined with populist electoral rhetoric ahead of the country’s June presidential election, which incumbent Erdogan handily won. The top EM sectors in the second quarter of 2018 were Energy, Health Care and Information Technology. The bottom performers were Financials, Industrials and Real Estate.


The fund depreciated 9.79% in the second quarter of 2018, underperforming the benchmark (MSCI EM Index, ‐7.96%) by 1.83%. Over the long‐term, we expect the fund to participate meaningfully in up markets while outperforming in down months. However, short‐term deviations from this performance pattern are possible, such as we observed during the strong drawdown of the EM equity asset class in June.

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Portfolio Attribution:

Sector Attribution

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On a sector basis, the fund’s top contributor was Real Estate, where overweight positioning contributed to performance in addition to positive stock selection. The fund’s underweight to the Financials and Industrials sectors, which both lagged, were also contributors to performance. Conversely, sector weighting to Information Technology, where the fund is underweight, was the top detractor. Although the technology sector was a relative outperformer in the second quarter, technology stocks depreciated 5.09% on an absolute basis and were bolstered by the performance of the internet subsector, which was down just 1.60% for the period. Hence, the fund’s lack of exposure to these stocks on valuation and dividend grounds was a material driver of relative performance. Consumer Staples and Utilities, where the fund is under‐ and over‐weight, respectively, were also detractors from relative performance.

Country Attribution:

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On a country basis, the fund’s overweight positioning in Brazil was the top contributor on account of beneficial stock selection. The fund’s stock selection in Greece and South Korea were also contributors to performance. The top country detractors were Taiwan and India. In Taiwan, where the fund is slightly overweight, stock selection was a detractor, particularly within Information Technology. In India, which underperformed the broader EM market during the period, the fund’s stock selection also detracted. Top contributors in the quarter were AIA Group (China/ HK, Financials), Sinopec (China/ HK, Energy), Mondi (South Africa, Materials), and Times Property (China/ HK, Real Estate). Top detractors were Sberbank (Russia, Financials), Sabesp (Brazil, Utilities) and Asian Pay TV (Taiwan, Consumer Discretionary).

Market Outlook:

As a reminder to our investors, the long‐term time horizon we utilize in assessing investment opportunities leads to few substantive changes to our outlook on a short‐term basis. So while we have been surprised by the magnitude of the relative YTD underperformance of emerging market equities and recognize the emergence of risks tied to the uptick in trade tensions, we remain constructive on their long‐term performance potential. Our constructive outlook continues to be underpinned by EM stocks’ attractive valuations and the long term structural drivers they continue to enjoy. While it is true that select EM countries such as Turkey and Argentina have seen a material deterioration in their macroeconomic positions in recent months, EM countries as a whole remain much better positioned compared to their long‐term history. In particular, current account deficits and inflation are near multi‐decade historical lows across much of the EM universe, and particularly in countries which are large constituents of the EM equity index. Valuations are attractive on an absolute and relative basis with the MSCI EM Index trading at 12.4x forward P/E, which represents a 20% discount to developed markets stocks. The valuation of the index is even more compelling in the context of its constituent outliers, as the P/E of the top 20% of stocks is a whopping 37.8x. The compelling valuation of the majority of EM stocks beyond the top 20% in the index is certainly reflected in our portfolio, with our portfolio P/E of 10.3x and our portfolio dividend yield of 5.5% both meaningfully more attractive than the benchmark. Indeed, our portfolio valuation levels are near the most attractive levels we have witnessed since strategy inception in 2005.

The notably attractive dividend yield that our portfolio offers should be of interest to income‐focused EM investors who most often invest in EM bond strategies. This may be especially top of mind recently, given that the selloff in EM bonds has pushed bond yields higher. EM bond investors are likely unaware of the income opportunity in dividend‐paying EM stocks, as well as several key differences between the EM equity and bond asset classes, which are not widely publicized. Investors seeking EM exposure combined with a current income stream should be aware of these differences in order to avoid potentially unforeseen risks and take advantage of opportunities. First, the country composition of the most popular EM sovereign bond index, the JP Morgan Emerging Markets Bond Index, is strikingly different than that of the MSCI Emerging Markets equity index. For purposes of this exercise, we consider the corresponding ETF instruments, since investors cannot purchase indices directly (EMB, iShares J.P. Morgan USD Emerging Markets Bond ETF; EEM, iShares MSCI Emerging Markets ETF). The country representation differences are due to divergent index weighting mechanisms; the EM equity index is weighted by free float‐adjusted equity market capitalization, whereas the EM bond index is weighted by total hard currency sovereign debt balance outstanding. This results in surprising key country and regional differences. For example, Mexico is the largest constituent by weight in the EM bond index at 6.1%, which compares to the largest equity constituent, China, with a weight of 32.6%. The weighting differences are particularly salient in Asia overall, as the pie charts below demonstrate. The EM bond index has only a 13.4% exposure to Asia Pacific versus 66.0% for the MSCI EM Equity Index. The largest Asian markets, including China, South Korea and Taiwan, have materially better sovereign debt ratings than the index overall, but are barely represented in EMB. Furthermore, the EM equity index has no exposure to riskier countries with weak sovereign credit ratings such as Ukraine, Venezuela, Azerbaijan, Angola and Ecuador that are outside even the frontier universe yet constitute a meaningful weight in the EM bond index.3 The divergence between the exposures of the EM equity and bond indexes is likely to widen in the future as several Middle Eastern countries are currently under consideration for inclusion in the bond index.

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While the fiscal condition of many EM countries has materially improved in recent years and compares favorably to developed markets, this is not equally true across the universe. Average EM government debt loads stand at 48% of GDP, compared with 110% in developed markets. The percentage of this debt denominated in local currencies now stands at an all‐time high 93%4, which reduces these countries’ exposure to exchange rate volatility. As discussed above, however, the regions with the largest improvements in fiscal position are underrepresented in the EM sovereign bond indices. As the table above shows, the weighted average sovereign bond yield of the countries represented in EMB, the EM bond ETF, is four full notches below the weighted average sovereign bond yield of the countries constituting EEM, the EM equity ETF. Hence, investors looking for exposure to the strengthening sovereign balance sheets may not find as much of this exposure in the EM bond index as they expect.

An additional distinction to be of aware of when investing in EM debt is that the condition of EM corporates has not improved as consistently as that of the corresponding sovereigns. EM corporate debt levels have risen to more than 94% of GDP, up from 63% a decade ago, and now exceed corporate debt levels in developed markets which are below 90%5. Over‐leveraged EM corporates may be particularly risky, especially if rates continue to rise in the United States and potentially exacerbate balance sheet weaknesses. By contrast, the Cullen EM High Dividend fund is not exposed to companies with risky debt levels, and we see these risks as a further indication of the importance of taking an active approach versus passive approach to EM equities, as well as the benefits of following a disciplined strategy. In addition to the highly disparate country composition and leverage in sovereign versus corporate EM debt markets, liquidity is much higher in the EM equity markets versus in the EM bond markets. Again using EMB and EEM as proxies, we see that daily USD trading volumes are nearly 100x higher in the equity ETF. The total market capitalization of the members of the MSCI EM index is 20x higher than those same countries’ outstanding hard currency sovereign debt balances. Even in the corporate debt market, as overall debt balances have recently grown, market conditions have tightened and trading turnover has actually declined.4 Of even greater concern than the relative illiquidity of the EMB relative to the EEM ETF is the even more meaningful illiquidity of the underlying bonds that the EMB owns compared to the liquidity of the stocks in the EEM ETF. The potential advantage of EM dividend‐paying equities versus EM bonds in light of these meaningful differences, namely country composition, sovereign versus corporate leverage and liquidity, is even more apparent when comparing the distribution yield of the EMB ETF of 5.1% to the portfolio dividend yield of the Cullen EM High Dividend fund of 5.5%. This is especially true since our fund offers exposure to the countries and companies we see as best‐positioned within the emerging markets universe. For these reasons and given current market conditions, now may be an ideal time for investors to consider reallocating EM exposure from bonds to dividend‐paying EM equities. 

Notwithstanding the increased concerns which have negatively impacted EM equities year to date, we continue to be excited about our portfolio exposure and positioning. Three primary concerns that have weighed on EM equities are (a) trade war concerns, (b) worsening external vulnerabilities of a few emerging market countries, and (c) the weakening of the Chinese Renminbi (RMB). While it is impossible to avoid the uncertainty created by these concerns nor completely avoid exposure to them, we continue to find our portfolio to be largely insulated from these risks from a fundamental perspective. Furthermore, the extremely attractive valuations of the portfolio arguably discount the limited exposure we have to these concerns should they worsen. With regard to trade war concerns, we have miniscule revenue exposure to the products that are or may be subject to tariffs since our exposure to China tends to be either domestically oriented or focused on exporters of products primarily outside the scope of U.S. tariffs. As mentioned above, we are meaningfully underweight countries with weak external vulnerabilities and the exposures we do have are insulated from these country risks since portfolio companies in these countries tend to be export‐oriented and/or do not have meaningful levels of debt. Therefore, most portfolio companies in weaker countries either benefit from or are not meaningfully impacted by the currency weakness that is often precipitated by their country’s weak external positions. With regards to the weakening Renminbi, we expect further weakness to be limited and we do not have exposure to relatively indebted companies that become riskier in such an environment. Furthermore, we would also expect any negative impact on the Chinese consumer from a weaker RMB to be limited and offset by the relatively strong household wealth and incomes particularly of the Chinese middle class who continue to show a huge propensity to consume. So to the extent that our portfolio weakens along with emerging markets as a whole due to a worsening of these risks, we would see this as a great long‐term buying opportunity since the weakness would not be fundamentally driven. 

In addition to the fact that consensus EM risks may already be discounted by our attractive portfolio valuations, we also see better opportunities for many of our portfolio companies that are largely insulated from these risks. For example, EM companies outside of China like Taiwanese or South Korean technology companies may benefit from stronger demand trends for their products and less risk from increasing competition from Chinese tech companies who may be targeted by U.S. tariffs. Similarly, EM multinational companies may benefit from reduced competition from U.S. companies who may find it harder to compete in international markets where they are subject to retaliatory tariffs. From a bigger picture perspective, it is likely to be a major positive if rational and limited new trade policies do improve the most unsustainable global trade relationships that do exist. One should also not exclude the likelihood that the trade wars will be averted in large part if rationale thinking indeed prevails. Averting trade wars would certainly be a major catalyst for global markets, especially emerging markets, allowing them to climb the wall of worry that has been built by these very concerns. Finally, the currency deprecations from countries with external vulnerabilities or from Asian currencies as a result of the weakening Renminbi have made asset prices in these countries far more attractive. We find that to be particularly true in Asia, where equity markets have corrected markedly in recent months. We continue to find very much to like about the geopolitical and macroeconomic environment in Asia, as well as the meaningful policy reforms which should herald lasting improvement in the region in the years to come. Asia is also the region which is most obviously and positively impacted by long term EM structural drivers owing to its sizeable demographics, strong fiscal positions and, perhaps most importantly, rising consumer incomes, corporate earnings and sovereign GDPs. These factors are all accompanied by a large propensity to consume off of notably underpenetrated consumption and ownership levels as seen across a broad and diversified array of products and services. Accordingly, we continue to retain large exposure to Asia and consider the recent pullback in regional equities to be an excellent long‐term buying opportunity in countries that we expect to become increasingly important contributors to global earnings and earnings growth for the foreseeable future.

Thank you for your continued support and please do not hesitate to contact us with any questions.
Best regards,
Cullen Capital Management LLC