Review and Outlook
The third quarter of 2016, "post-Brexit" rally suggests there are few signs of political change or contagion strong enough to disrupt the market equilibrium in place for many years. Sovereign bond markets initially moved aggressively to discount likely global policy support, a stimulative catalyst, particularly for the emerging markets. From our vantage point, while we may question the fundamental underpinnings, we must respect that such a significant decline in cost of capital is likely to spark an earnings recovery, particularly in the developing world where previous pressures suggest pent-up demand and trough corporate profit margins. As such, we remain confident that EM equities can maintain a leadership position for the time being.
A key question in the past year has been whether imbalances and strong credit growth in China will ultimately lead to a credit contraction and/or a marked RMB devaluation. While we have previously noted cause for concern, financial and economic conditions now appear to be stable and improving, with economic growth, consumption, and commodity prices holding up well in the face of moderating stimulus measures and increased scrutiny over non-traditional bank lending. We view this as a sign that structural reforms, improved policy coordination and communication, and progress on capital market liberalization, financial reform, and bank non-performing loan recognition, seem to be achieving desired goals. As an important contributor to global demand, we believe stability in China is a key variable in the outlook for global growth and corporate earnings, and are encouraged by recent progress.
Looking forward, we remain optimistic, though as always, we are monitoring several key variables. We believe EM economies and equities have reached a favorable inflection point, where the cyclical earnings recovery seems to be coalescing with longer-term structural reforms across many EM countries, driving outperformance and potentially a sustainable bull market. Such reforms are in direct response to deteriorating economic and financial conditions suffered over the past several years, and often take time to take effect. In particular, we note China, India, Indonesia, Mexico, Brazil, and Argentina as countries where we have invested in companies likely to benefit from economic, financial or labor reforms, or significant political change. More recently, our enthusiasm is balanced by early signs that we may be passing through an important secular bottom in sovereign bond yields. Developing political realities, likely fiscal expansion, signs of rising wage and rent inflation, and comments by the U.S. Federal Reserve and Bank of Japan suggest the central bankers appear to be encouraging inflation expectations to rise, and perhaps “run hot” for the time being. This important shift is occurring after an historic decline in global yields that leaves investor sentiment and positioning vulnerable to “inflation sightings.” We suspect bond market volatility is likely to rise, although it remains an open question as to whether this would be favorable or unfavorable for equities, and we suspect we will have more to report on this at year end.
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Quarterly Attribution Analysis
The Quarterly Attribution Analysis for period ending September 30, 2016 is not yet available
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