During October, the fund outperformed the MSCI Emerging Markets Index by 0.2%.
While markets were pressured by rising US rates and events in the Middle East, our portfolio was helped by continued strength among our Taiwanese holdings. This was partly offset by stocks in the UAE that participated in a regional selloff as well as Brazil where the cost of capital was dragged up by the US Treasury selloff.
During the month we added back to exposure in Poland following a defeat of the populist government which should unlock EU funds and restore central bank independence.
We have always maintained that Emerging Market equities should trade at discounts to developed counterparts. The primary reason was that they faced a significantly higher cost of capital. In the year 2000, not a single country in the MSCI Emerging Markets index had a lower domestic bond yield than the United States. The weighted average 10 year bond yield for the index was a full 6% points higher than the US equivalent.
Domestic investors in Emerging Markets had the option of generating high levels of income by lending to their own government. This alternative meant equities needed to be cheap – certainly cheaper than US equities needed to be given lower available yields. Broadly speaking this has been the case over the years.
Today, a full 60% of the MSCI Emerging Markets universe is made up of countries that have lower domestic currency bond yields than the United States. The weighted average 10 year bond yield on the countries that make up our portfolio is also lower than the US, despite including some high interest rate countries in Latin America.
From the perspective of domestic savers in Taiwan, Korea, China but also Thailand and Greece, domestic bond markets offer relatively low yields. If they want to save in their currency, equity markets are the obvious alternative – often even when looking purely at dividend yield.
There are other reasons why Emerging Markets may trade at a discount, such as poor governance, composition of indices or even weak macro situations. Nonetheless, the reversal of the cost of capital differential should give investors pause. Lower discount rates should support Emerging Market equity valuations relative to the US, if only due to domestic savers taking advantage of this disconnect.
