In The Art of War, Sun Tzu discusses the concept of the oblique. In his opinion, warfare had two basic concepts: the direct approach and the oblique (the inconspicuous). If a general understands the use of the oblique, an inexhaustible source of tactics is available to him. “There are only five basic notes in music, but their variations are infinite. There are only five primary colours, but when blended, their shades and hues are limitless.” When tasked with devising an investment strategy, people often pursue the direct approach – the one most widely used – and often with a home bias. However, by considering the oblique, we have the opportunity to find that sought-after alpha (excess returns over the benchmark).
Despite much of the world being in lockdown for the better part of 2020 (and now into 2021 as well), North American markets have rallied. Most investors took the direct approach, continuously bidding up technology and work-from-home darlings, but this concentration does not come without risk and frothy valuations. One must ask, does the current economic environment support such valuations, and how long can it continue? The COVID-19 pandemic and other geopolitical issues have set the stage for a much different economic reality, and perhaps one that requires a different approach – the oblique.
Studying the terrain
Strained American foreign relations, particularly with China, were only exacerbated with the impact of the pandemic. There’s hope that a Biden presidency will achieve more stability and predictability in global trade. However, populism has permeated much of the globe, putting a focus on the home country. As governments seek to keep their people happy, they may look more closely at protectionist policies.
China’s new five-year plan discusses a desire to reduce dependence on U.S. technology. In the U.S., Biden has signed the Buy American executive order. If future economic growth becomes domestically focussed and relies on relatively shorter supply chains, perhaps a focus on areas with larger populations and more growth potential is warranted. International and emerging markets (EM) make up more than 75% of global GDP and 96% of the population.
Governments had to respond to the pandemic with extreme levels of fiscal stimulus and maintain accommodative monetary policy. The U.S. deficit has grown significantly, and many believe the dollar will fall further as the U.S. recovers from the economic recession. Figure 1 below shows the significant decline.
Citigroup strategists believe that the dollar could see an additional 20% drop, and Goldman Sachs analysts see a 6% decline over the next 12 months. In opposition, EM maintained lower debt levels which will help their economies and support the local currency. Much has changed over the past year which begs the question, should your investment strategy change too?
Figure 1: Bloomberg Dollar Spot Index
Deliberations – laying plans
It may be difficult to consider investing in international and EM because the market underperformance of these areas from 2010 to 2020 may still linger. However, with a declining U.S. dollar, a better response to the pandemic, and low interest rates, the conditions may be ripe for another bull market like 2002 to 2007. Figure 2 below displays the outsized returns for the World ex U.S. vs U.S. during this time frame.
A declining U.S. dollar is an appealing tailwind when foreign equities are purchased, because they are bought in the domestic currency and later sold and converted to U.S. dollars. This creates a translation benefit if the dollar declines even further during the hold period.
Many EM countries, such as China, have had a better response to the pandemic and, as a result, their economies are expected to recover to pre-pandemic levels more quickly. Recent PMI data (Purchasing Manager’s Index), a forward-looking indicator of economic growth, supports this recovery thesis. EM also benefit from low interest rates and a comparatively low U.S. dollar because their debt is often denominated in USD, and the combination makes repayment less onerous for them. In addition, a low interest rate is a catalyst as it helps stimulate key industries and promote innovation.
Figure 2: World ex U.S. vs U.S. stock performance 2003-2007
Innovation may appear to be predominantly in the U.S., but it’s flourishing abroad. For example, the pandemic has ameliorated the use of contactless transactions resulting in the accelerated use of mobile payments globally.
In some EM, many people did not have bank accounts but did have mobile phones, which led to an improved adoption of mobile payments. Alipay, an Alibaba affiliate, is a dominant actor in the mobile payments space. In China, it’s not uncommon to pay for everything you need daily using a single smartphone app. Will this be adopted in North America? Perhaps this, along with many other inventions, is one of the reasons why more venture capital is finding its way outside of the U.S., as can be seen on Figure 3.
Figure 3: Percent of global venture capital funding
Tactical dispositions - understanding the advantage
At CWB McLean & Partners, we understand the benefit of exploring and capturing the alpha in the oblique. Our International Equity Pool portfolio managers have uncovered intrinsic valuation gaps in several innovative or misunderstood companies that have proven profitable for our clients.
The International Equity Pool has 19% direct exposure to EM via companies that are domiciled in those markets such as Alibaba but it also has significant indirect exposure of 44% through companies that realize sales in excess of 25% in the EM such as LVMH, Sony and Daimler. Daimler AG, a 2.6% weighting in the pool, sells almost 30% of its vehicles in China, which is even more than in Germany. EM are highly populated and as they mature, this will be a significant contributor to growth for many companies.
Comparatively better equity valuations, thriving innovation, and a better foundation for economic growth are key reasons why we believe it is important to add international and emerging market exposure to your portfolio and find that alpha.