Unpacking Morgan Stanley ContaigEM report with local chief Chris Meyer
Wall Street investment bank Morgan Stanley has been blamed for sparking an Emerging Market currency crisis with a research report it headlined The Fragile Five – with South Africa as one of the unfortunates. Another report entitled ContaigEM is now creating waves. It focuses on the likely fallout in the stalling of Emerging Market growth on First World stock markets. We asked Chris Meyer, head of the local RMB Morgan Stanley joint venture business to come into the CNBC Africa Power Lunch studio and unpack the report for us. – AH
ALEC HOGG: Joining us now for some investment insights as we take a look at South African equities, the U.S. and Europe versus emerging markets and how the sell-off is going to affect us, is Chris Meyer, Chief Executive or RMB Morgan Stanley. Perhaps before we look at the broader basis of the South African equities and the valuations thereof, this report that Morgan Stanley's brought out.
CHRIS MEYER: Look, it's actually not, although to some extent it's talking about what could happen if the so-called Fragile Five (we call them the double-deficit countries now), have a sudden stop. If there's an emerging market crisis that becomes much worse, what could it mean for developed markets? It's not our base case if that happens, but investors are quite interest in 'so…okay, emerging markets are looking a bit vulnerable here. If the emerging market crisis of today – and it's not a crisis yet – but if it turns into a crisis like '97 or '98, what could it mean for the U.S. or Europe?' It's quite a provocative thought. I don't think it's in anyone's base case of assumptions, but it's quite a provocative thought.
ALEC HOGG: Is it a Black Swan possibility – a very small percentage?
CHRIS MEYER: Yes, I wouldn't say it's a Black Swan because it will probably be something that would happen over time. Obviously, you think about a Black Swan as a financial…the Lehman Brothers was a black swan. Emerging market crisis is not going to happen collectively, as an asset class, all at the same time. I don't think so, anyway. Countries would fall over one-by-one and it would create a growth slowdown in developed markets. That's really the core here. If emerging markets have a crisis, they are much more intertwined with developed markets today than they were '97 or '98. For example, emerging markets make up something like 50 percent of the world's GDP at the moment, whereas back in 1997, it was 30 percent, most of it China – admittedly – but it's also Brazil, Russia, Eastern Europe, and parts of Africa. Therefore, there is much more GDP contribution to the world, coming from emerging markets so obviously, if it slows it's going to have an impact on global GDP, including that of the U.S. and Europe. We think Europe is the most affected, so something like 60 to 80 percent of the growth in European GDP, has come from emerging markets in the last few years. Since domestic demand in Europe has been so poor, most of the companies that operate out of Europe are getting all of their earnings growth from emerging markets. The reason why it's interesting for South Africa or South African investors is that companies like SA Breweries, Anglo American, Richmont, and British American Tobacco have two-thirds of their earnings coming from emerging markets. If there is an emerging market crisis, it is going to affect the earnings of those companies.
ALEC HOGG: Hence, the JSE.
CHRIS MEYER: Yes, therefore the share price. What's quite interesting for us when you say 'where should you put your money': you want to hide in non-mining Rand hedge stock at the moment. We are therefore saying to clients 'stay in the Richemont's" or maybe not so much Richemont – we think it's quite expensive – but in the British American Tobacco's and the South African Breweries. However, if this scenario were to arise, that might not actually be the place to put your money.
GUGULETHU MFUPHI: Talk to us about the debate regarding South African equities and the valuation thereof.
CHRIS MEYER: I think the key debate for South Africa at the moment, is when do you rotate out of the mining shares back into those interest rate-sensitive stocks? For most of the first half of last year, the financial and industrial shares were doing were doing very well. Mining shares were doing very poorly. This year, there's been a significant rotation into gold, platinum, and even the mining house shares, out of retailers, and even to some extent, banks. It has been dramatic. We're talking a 40 to 50 percent differential between those sectors. The key debate in South Africa is when and if do you buy the retailers? We all know the consumer is going through a tough time and chances are interest rates might go up. However, at what point do they start to offer value? I think much of that debate hinges upon how severe could this interest rate cycle be. We started with 50 basis points. If it's another 200 as the market is predicting, that could be a significant event.
ALEC HOGG: Are they predicting 200 now – two percentage points?
GUGULETHU MFUPHI: I heard 150 this morning.
ALEC HOGG: So it's gone up in the last…
CHRIS MEYER: Yes, maybe it's 150.
ALEC HOGG: It's still significant.
CHRIS MEYER: It's the start of a real increase in rate cycle. It's not a one off, just to defend the currency. If that happens, what happens to the consumer? I think much of it revolves around this whole tapering conversation. If the U.S. does taper very quickly and U.S. interest rates rise, money pours out of emerging markets – including South Africa – goes back into the U.S. bond market or back into developed markets. Could it create this cycle in South Africa where we have to raise rates significantly to protect the currency or to defend inflation? If so, could the consumer collapse? In that scenario, you wouldn't want to buy retail shares today because even though they look cheap, their earnings are going to be bad.
ALEC HOGG: Is that what they're discounting? Are they discounting that Armageddon-type situation?
CHRIS MEYER: No, I don't think they're discounting Armageddon.
ALEC HOGG: That's an Armageddon-type situation – the one, which you've described now.
CHRIS MEYER: Yes, I think so. I think you would not want to own retailers in that scenario, because you're going to get significant cuts to future earnings in that sector. However, if we have a situation where we don't raise interest rates by 200 basis points because maybe the developed market isn't that fast… Maybe inflation isn't that big a deal in developed markets. They don't taper all that quickly, and the South African bond market and the currency do not sell off much further than where we are today. Perhaps the consumer can muddle through. In that case, the retailers won't have the kind of earnings growth they've seen in the last five years, but there are good companies and maybe its decent earnings growth. In that scenario, maybe you would start looking at Shoprite, Woolworths, and Tiger Brands. Good companies, but they're just having a real anxiety attack by investors in those shares at the moment, because they worry that the Armageddon situation might happen the way – frankly – it happened with African Bank where very clearly, bad consumer equals difficult time for your business model.