Timely market analysis and portfolio positioning in the face of volatilityPractical Perspectives
Distilling the Fallout From Ukraine
Peter Cadaret:
Thank you for joining us for Oppenheimer's Practical Perspectives investment series. I'm your host, Peter Cadaret, Head of Sales and Marketing for Oppenheimer Asset Management. This series was developed to provide timely market analysis and to give insights on how our partners, some of the most respected and experienced investors in the industry, are responding to the market gyrations and positioning their portfolios in the face of this volatility. Today, I'm pleased to be joined by Chad Cleaver, the lead portfolio manager of the Driehaus Emerging Markets Small Cap Equity Strategy and a portfolio manager for the Driehaus Emerging Markets Opportunities strategies.
Peter Cadaret:
His idea generation, security selection, portfolio construction, and risk management responsibilities, along with his macro level analysis, are leveraged across all three strategies managed by Driehaus. Given the focus on Russia, China, and many of the emerging markets around the world. We thought it was a great a time to check in with Chad, get his thoughts and get an insight into how he's navigating this unusual market. So thank you for joining us, Chad, and let's jump right into the questions if we can. As you were looking at these set of facts that were developing in January, February, which really included troops amassing on the border, the potential of a very disruptive situation in Europe, both economically, and for the citizens of Europe, how were you and your team preparing for the situation and preparing your portfolio for this environment we find ourselves?
Chad Cleaver:
Well, thank you, Peter, for the opportunity to provide our perspectives today. Is we saw the events unfolding early in the second half of last year and into January. We knew that this was a possibility of a full-fledged invasion. However, we did not think that the, calculus made a lot of sense for Russia to go this route. And so when we thought about our exposure across the strategies, we did neutralize our previously overweight position in Russia in the EM Growth strategy, and we exited Russian positions in the EM Small Cap strategy. So we came into Russia and we came into the year with an equal weight to no exposure in one of our strategies. Having known that this was a potential outcome, we reacted very swiftly when we saw the invasion actually take place and exited the remaining Russia positions in our EM Growth strategy.
Peter Cadaret:
One of the interesting things that you've written about in a few of your commentaries is that, despite the short term volatility and concern, there's sort of a larger trend in play here, which is really the creation of what you describe as a sort of a multi-polar world, and you have a great quote in your commentary that said, "we're likely to see divergent policies, risk premium, and economic developments across various regions. Financial markets may be more prone to volatility, but this goes hand in hand with widening dispersion". And that's really also making a case for active management, selective stock picking. Talk a little bit about that divergence you see developing in different parts of the globe and in different regions.
Chad Cleaver:
Yeah, I think, really to approach the emerging markets, one really needs an element of creativity and open-mindedness. In the past several years, we've seen multiple trends that suggest to us that the world is really moving towards this multi-polar environments, in which China is wielding greater influence, specifically as its economy has grown in size and influence. Certainly Russia or Europe remains an important regional block and of course the US as the world's largest economy and largest proportion of global FX reserves in the dollar. We continue to see this trend unfold in a number of ways and I think it creates additional opportunities for active management, really thinking about how these spheres of influence can, not only impact local markets and economies, but also have important spillover effects across various regions.
Chad Cleaver:
So, this is particularly important in Asia, where many of the local economies are key suppliers to China. We've seen an increase in foreign direct investments in places like Vietnam and Indonesia, and that's increasingly to satisfy Chinese demand for various types of end products. So these shifts, really imply think the need for active and nimble approach to these markets in order to capture these opportunities.
Peter Cadaret:
One of the sort of subtopics going on in the news outside of the military conflict that's occurring is the spillover effect largely into the commodities market. One of the strong considerations when investing in the emerging markets is some of the commodity complex and their exposure to those areas. Talk for just a moment, if you would, how you foresee this environment playing out and what the implications are on the commodity side for the potential of a Russian economy collapsing and those types of things.
Chad Cleaver:
Yeah. Russia is certainly an important supplier of commodities and really when I think about the commodity market implications, it breaks down into three buckets, so to speak, energy, food, and metals. Certainly Russia is a meaningful supplier of oil and gas and as we look at the current situation, there have been some self-imposed embargoes of oil by various trading houses, and certainly the US and UK have banned Russian oil. But this is not a worldwide ban on Russian oil and I think the most palpable impacts that we're seeing in terms of the economics spillover are actually in natural gas and Russia supplies about 28% of Europe's gas. Europe has already indicated that they wish to wean itself from Russian gas over time. This may require considerable investment in areas like LNG and renewables. And in fact, Russia itself is supposed to be one of the largest suppliers of LNG in the coming 10 years.
Chad Cleaver:
So, there may be much needed exploration on this front to meet that demand. Certainly the spillover effect in terms of gas also leads into other industries. So fertilizer companies in Europe tend to be heavy users of natural gas, aluminum smelters use gas-fired power. So this has additional implications in what is already a very tight commodity markets. If we look at the agricultural commodities, Russia and Ukraine combined, are roughly 25% of the global wheat output. This has meaningful considerations for importers of grains across the emerging world. And again, with the fertilizer input costs going up, this adds another inflationary consideration. Lastly, on metals.... Peter Cadaret: To that point, could I just ask one question about the agricultural commodity complex? I've read a lot about the potential given the large percentage of agricultural production that's done in Russian and Ukraine of the potential of food shortages and other things in Europe. What percentage or probability do you ascribe to that scenario where the disruption in the food supply becomes significant?
Chad Cleaver:
Well, I think one of the biggest considerations on that point is the state of Ukraine's planting of grains moving forward were highly likely because of the war to see a disruption to seasonal planting. That may mean that there's a persistence of high food prices. Certainly the spillover effect to a number of economies is going to be felt in terms of a persistent inflationary impact.
Peter Cadaret:
Thank you. Sorry to interrupt you there.
Chad Cleaver:
No, absolutely, and then lastly, I would just say that metals is an area where Russia is broadly a significant producer accounting for nearly 44% of the world's palladium supply, 6% of the world's aluminum supply, and 6% of the world's nickel supply. This is again, coming at a time in which commodity markets for all these metals are extremely tight relative to historical standards. We've seen quite a wave of demand coming from the renewables and electric vehicles trend for these base metals that go into many of these applications. With these already tight conditions likely to be exacerbated in the aftermath of this invasion. We see this as another persistent source of inflationary pressure on the commodity side.
Chad Cleaver:
A couple things I'd like to mention as it relates to commodities and kind of connecting the dots here. First, unlike the 1970s, we would see this crisis as being mostly Eurocentric, but much more global in nature than the 70s oil shock. This is much more far-reaching than the 70s oil shock as I mentioned, it includes not only energy, but also agricultural commodities and metals. Then lastly, I think an important consideration is that while there's certainly no good time for war to occur, these shocks are coming at a particularly bad time because inflationary pressures are already significantly impactful across the globe. So as compared to past occasions of macroeconomic shocks, the FED simply lacks the space to provide monetary stimulus in this backdrop.
Peter Cadaret:
Interesting, let's continue with the conversation of the spillover implications, and we've certainly discussed it on the commodity side. But one of the other major players in and around the emerging market is obviously China and with a lot of attention going on in Europe, China has been very active, there's been tremendous volatility in the equity markets in China. There has been lots of changes in policy direction by the government of China over the last several months. Share your perspective on the state of the investment environment in China right now, and how you are viewing that opportunity set.
Chad Cleaver:
Well, China's been under considerable pressure over the past year and a half, mostly due to a heightened regulatory regime that was undertaken last year. Moving into this year, we've seen particular weakness in property sales and property new starts, which is an important area for the overall economic health of the country. There have been some considerations that potentially China could show an acceleration and its growth rate this year. This is a very important year for China as later this year at the party Congress in October, Xi Jinping is set to potentially become president for life. So, there's a view that China would want to create a more conducive growth backdrop to move through this in a position of strength, certainly after the shock to growth last year, through both the policy reforms, the property market weakness, as well as an energy crunch faced in the second half of last year. The authorities have sent a clear message that they want to normalize growth conditions into this year.
Chad Cleaver:
In fact, in a recent government work report, the phrase, "economic stability" was mentioned 81 times. So this is a key focus for policy makers. A few things have constrained that, first, we've continued to see weakness across the property sector year to date, new starts and sales are down in excess of 20% to 30%. We have seen resurgence of COVID and relative to much of the rest of the world, China lacks a credible mRNA vaccine. In fact, just this week, we saw a lockdown of one of the largest cities Changchun, which in terms of its economic size would be on par with Israel. So these are meaningful questions as we look at the growth outlook for China, that being said, there are some continued, source of relative optimism for the country. China is one of the few places, just because of its command economy, that they can implement growth measures in a fairly swift manner.
Chad Cleaver:
So we do expect to see investments in infrastructure, in particular in the renewable power space, where we actually have seen some extremely large scale projects being rolled out. Also, China is perhaps somewhat insulated from the commodities shock relative to the rest of the world. Some recent analysis suggests that China holds some 85% of global copper inventories, 70% of corn inventories and 25% of crude oil inventories. So, this may offer some sort of a buffer. Then lastly, I do think that over time we will see a similar sort of reopening story on the consumer side, as what we've seen in much of the rest of the world, or what we may be on the cusp of seeing in the rest of the world. China has been out of sync with the rest of the global economy with respect to its growth trajectory since COVID. We do believe that it remains one of the few economies that can show incremental growth throughout the year.
Peter Cadaret:
So Chad, when commenting about China, you use the term relative optimism on certain data points or pieces of scenario. Let's take that scope and expand it. What is the case for relative optimism more broadly in the emerging market, as you look out the next three years or five years? What are the positive developments that you see coming online and what are the underpinnings of the case to make for this asset class for a long term investor?
Chad Cleaver:
Well, I really want to start with just the starting point itself. If you look at valuations of emerging market equities, there are two standard deviations below their long term average, relative to developed markets. Historically, sometimes one has to look into the eye of the storm in emerging markets and be willing to buy when others are not willing to take risk. I think that is one of the central parts of the case today is just that starting point itself. Secondly, we continue to see emerging market economies, being leaders in some of the newer technologies. Specifically I would point to the development of the renewables and electric vehicle supply chain, some 75% of which is controlled by Chinese companies.
Chad Cleaver:
Then third, we haven't talked much about India yet, but India is a standout economic story in our view. It's a relatively, closed economy versus many of the other emerging economies and there are some meaningful changes occurring in the tech sector, as well as in local manufacturing that we think could drive economic growth, drive wages, and new household formation, and lead to a robust consumer backdrop. So when we're thinking about our optimism on emerging markets, I think it's a combination of the starting point, the trends toward innovation, and the strength of some of the larger economies, namely China and India.
Peter Cadaret:
Chad, what I was going to say is we're right up about the 10 or 15 minute mark. So, I want to thank you for joining us and sharing your thoughts. I want to conclude maybe with just one final question that I think is an overriding question across the emerging markets, which is really what maybe your view of the US dollar is as we move forward. That's obviously very much a part of the data set that you focus on. So maybe you can conclude with a few thoughts on the dollar.
Chad Cleaver:
Yeah, the dollar has exhibited persistent strength over the past several years. There have been many calls for de-dollarization or a pronounced period of dollar weakness that has yet to materialize. I think it is a bit more nuanced of the situation, however, in that we have seen certain emerging market currencies exhibit particular strength versus a dollar. Namely, I point to the Chinese Yuan and some of the other north Asian currencies. We've also seen economies such as Brazil and South Africa exhibit stronger, in terms of trade with respect to their commodity-linked export baskets that has helped their currencies sustain through challenging macroeconomic environments. So when we look at the dollars position, vis-à-vis emerging currencies, it's somewhat different than what we see in the broad dollar basket. As it pertains to the concept of de-dollarization, it's a very interesting topic and it's one that's been particularly top of mind for a lot of people in the aftermath of the recent invasion as the US has frozen Russia's foreign exchange reserves.
Chad Cleaver:
Not only has the US participated in this, but all of the G7 economies have frozen the FX reserves of Russia that are denominated in their currencies. So countries tend to hold foreign exchange reserves for two reasons. First is to defend their currencies in times of macroeconomic shocks and the second is to act as war chest in times like this. For Russia, while they had $640 billion worth of FX reserves, the fact that the G7 economies have frozen a large proportion of that, has really nullified the war chest aspect of the FX reserves. Over time, we've seen the dollar share in FX reserves come down from about 70% at its peak to 59% today. But I think that the real question, which is really quite frankly, lacking a clear answer right now, is what supplants the US dollar? There's no logical answer to that, it's unlikely to be the Yuan and it's unlikely to be the Euro or gold. So, the dollar is likely to remain an influential part of trade and FX reserve mix moving forward. However, I think as we've seen this week, particularly with Saudi Arabia's discussions to sell oil to China, denominated Yuan, that there will be certain bilateral deals or arrangements that may chip away at the US dollar over time.
Peter Cadaret:
Chad that's excellent perspective. We really appreciate you again, taking the time to join us and share your thoughts on the emerging markets, on the developments in Russia and Ukraine, the dollar, the energy markets, and all of the great points you shared. So again, thank you and your team from Driehaus for your partnership and for making the time to join us and we'll go ahead and conclude the call here.
Chad Cleaver:
Thank you, Peter. Appreciate the opportunity.