Part 2: Why EM Private Markets.
In Part 1 of this blog-post, we discussed the liquidity curse in developed markets (DM). Investors can be trapped by following accepted norms of asset allocation. The liquidity curse is particularly difficult to escape if one further suffers from Core/Periphery Disease and considers emerging markets (EM) as somehow ineligible for major allocations.
The potential for high correlations across all DM asset classes leads to nervousness about leaving the perceived safety of assets with most liquidity. In a major macro crisis not only are short-term valuations likely to be impacted across the board, but there could be major negative economic implications across all DM assets, both liquid and illiquid. Hence the correlations and losses could be more than short term.
This is far less of a problem with allocations to EM. Moreover, within EM, allocations to illiquid markets have a major role to play meeting longer duration liabilities and in side-stepping the expected short-term turbulence in liquid markets.
Following the 2008 financial crisis, capital was withdrawn from EM rapidly and this effected business cycle dynamics. These economies have now readjusted and are healthier as a result. Globally, growth is coming back, but it is not apparent to those with Core/Periphery Disease that this is a recovery being led by EM nations, which are economically both stronger and a lot more robust than their DM counterparts. Interest rates are also rising in EM, faster than in the developed world, and in response to local economic conditions.
Following the 2016 turn in US interest rates, 2017 saw the start of a return of capital to EM – about a fifth of the previous outflow has now returned. EM assets are thus set for a strong 2018 as these economies’ growth levels edge up, and as institutional investors continue their rebalancing away from bubble developed markets. DM equities and bonds, in contrast, are likely to fall in 2018, and the dollar will continue to weaken. Substitution within the developed world is likely from the dollar and US equities to the Euro and Eurozone equities, and from EU bonds to Treasuries. But the main DM currencies may all fall against EM currencies, and most DM asset classes will likely underperform their EM equivalents.
But How Much?
So institutional investors would be well advised to recognise a much greater role in allocations to the two thirds of the global economy traditionally seen as peripheral. But how much should institutional investors allocate to emerging markets and to illiquid asset classes (mostly infrastructure and real estate) within them?
One way to use our knowledge of macroeconomic imbalances, politics, demographics and history is to use scenario planning. Top of the list of scenarios to consider, and have a response strategy for, is another global financial crisis (possibly much worse than 2008). Such a strategy should feature major allocations to non-levered economies (EM), assets which are non-tradeable and otherwise relatively immune from external shocks, and illiquid assets least likely to face massive and correlated investor outflows in a crisis. EM real estate and infrastructure meet all these requirements and can help to reduce risk away from currently highly concentrated allocations to developed markets.
Typical investment indices are highly distorted and wholly unfit for determining global allocation weights. Purchasing Power Parity (PPP) is arguably the best available long-term measure of global economic weights and hence the investment universe. EMs are currently about 58% of global GDP using PPP and expected to grow to about 72-73% over the next 15 years (a typical institutional investor liability duration). However, not all goods are tradeable (those subject to international competition and price setting). For a relatively open economy like the UK, some 50% of exposure could remain domestic to cover liabilities not determined by global supply and demand.
So that moves us from say 72% to 36% allocation to EM. This would be a neutral weighting, though, seeing as it compensates neither for the relative misperception of EM versus DM risk, nor does it make any allowance for the possibility of high-impact negative scenarios. You can also expect higher returns in EM, over both the short and long run. Taking these into account would argue for pretty much the whole non-domestic exposure to be in EM – let’s say 46% up from 36% – and more if the home economy is also in trouble (like the UK). So that could, prudently, push us up to a 56% EM allocation.
The next question is, within EM how much should be in illiquid markets. Within developed markets, allocations to just real estate can be 15%, often more, but we can double this to 30% in EM given the scale of the opportunities relative to liquid markets (a far greater proportion of economic activity is unlisted in EM), relative value, and the protective role we are seeking from illiquid assets. And 30% of 56% is 17%.
So 17% is the sort of number we should see as a typical institutional allocation to EM Private Markets, depending on the assumptions above. This will be a shockingly large number for many, and represents radical change from the present. But it is a defensive and prudent allocation. There will be those who object that it is simply not possible to deploy that much capital. However, whilst it may be difficult and take time, it is not impossible. Investors do not have to do it all at once and they will benefit from the very long time it will take their peers to join them.
Even if it may seem a lot now, it may not in a decade. For we should not confuse being conservative with being prudent. And sometimes we should choose ambitious targets, as JFK said, “not because they are easy, but because they are hard”.
Dr. Jerome Booth in London