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Plant a tree

DOUG By Guest Blogger Doug Rowat

There’s an old Chinese proverb (I guess they’re all old) that says “if you plan for one year, plant rice. If you plan for 10 years, plant trees.” Well, after this disastrous year, emerging market investors are probably pretty tempted to plant nothing. In other words, give up on the region entirely.

And how painful has it been for emerging market investors this year? Well, the MSCI Emerging Market Index is down 16% and the CSI 300, the benchmark for China A-share equities, which has taken the brunt of the punishment, is down 21%.

With commodity prices plunging, Donald “the Tariff Man” Trump taunting China continuously, rising US interest rates and a strong US dollar, both of which are negative for emerging market economies because of their significant amounts of dollar-denominated debt, and an overall risk-off market sentiment at the moment, emerging market equities are easy to hate. But extreme bearish sentiment presents opportunities.

The long-term thesis for investing in emerging markets is well-known but worth repeating. Emerging market populations are young, emigrating rapidly to urban areas and voraciously adopting developed-world technology. For instance, about 58% of China’s population has Internet access, up from only 23% 10 years ago, according to CNNIC. And China has already surpassed the US in total retail sales. Think of what China’s retail sales numbers will look like when it reaches the US’s 89% Internet adoption rate in the coming decade.

As China accounts for roughly 30% of the MSCI Emerging Market Index, it’s also worth focusing on this country’s mind-boggling urbanization rate. In the 1970s, the percentage of China’s population living in urban centres hovered at only the mid-teens. Now it sits at 58%. Yet, with more than 40% of China’s population still living in rural areas, the ‘citification’ trend still has plenty of room to run.

And China urbanization has an incredible trajectory, with rates likely to approach developed-world levels within the next 10 years. The below chart compares China’s historical pace of urbanization to Canada and the US’s—in this race, developed countries have the lead, but China is, effectively, Usain Bolt. The economic advantages of more urbanization are significant: more jobs are created, salaries can ramp-up five-fold, and demand for material goods and housing both rise dramatically.

Urban population (% of total)

Source: United Nations Population Report

So, to think emerging markets are simply going to disappear under the weight of their short-term economic problems is naïve and overly pessimistic. When the MSCI launched its first comprehensive emerging markets index back in 1988 only 10 countries were worthy of representation and encompassed only 1% of the world’s market cap. Today this index includes 24 countries and 11% of the world’s market cap. Emerging market investing is here to stay.

But, from a timing perspective, should investors buy now? Well, valuation is a notoriously poor predictor of entry points, particularly for short-term investors, but regardless, I would still argue that current valuations are compelling. For example, the price-to-book (P/B) differential between the MSCI Emerging Market Index and the S&P 500 is as wide as it’s been in 10 years.

MSCI Emerging Market Index P/B discount to S&P500 continues to widen

Source: Bloomberg

And let’s take a closer look at this spread. Naturally, emerging market equities historically trade at a P/B discount to US equities given their higher risk profile. However, the discount widened to more than DOUBLE its 10-year average (white line below) before contracting in recent months. Given the still-considerable spread, I wouldn’t be surprised to see the discount continue to contract. But if your investment horizon is 10 years or more, then whether to invest now or later amounts to splitting hairs. Emerging markets, simply put, are cheap.

MSCI Emerging Market Index P/B minus S&P500 P/B

Source: Bloomberg. White line = 10-year average

Relatively speaking, emerging markets have had a sub-par past 10 years with the MSCI Emerging Market Index returning 8.7% annually (total return) versus the MSCI World Index up 11.1%. However, a 20-year time frame paints a different picture, with the MSCI Emerging Market Index returning 8.9% annually versus the MSCI World Index returning only 5.4%. If you believe in long-term cycles of under- and outperformance, the next decade could belong to emerging markets.

And, if you had to choose an area to invest in for the next 10 years, given its impressive economic and demographic fundamentals, long-term outperformance and inexpensive valuation, you could do worse than to pick emerging markets. As it stands now, emerging market equities are not being fairly represented in MSCI indices based on their corresponding share of world GDP. It could be argued, in other words, that the market is not giving emerging market equities their proper due based on their global economic contribution:

GDP share and market share for EM

Source: MSCI, IMF

Eventually, emerging markets will rally, likely strongly. And if you’ve decided to abandon this area of the market entirely because of a few threatening Trump tweets, you’ll miss out on the recovery. And you’ll have no one but yourself to blame.

You’ll be reminded of another Chinese proverb: “if your face is ugly, don’t blame the mirror.”

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.


The tree police

SHRUB modified

Cindy thought it would be a cool idea to carpet her lawn. So she did. Astroturf. Synthetic grass. Always green, forever clipped, no lawnmower, no trimmer, never a squirrel hole and no watering. Just green, crisp and neat.

Besides, on her Toronto street the green space in front of most homes is barely 15 feet across, once the parking pad is factored in. The urban soil is dodgy, and sunshine rarely gets through the canopy of boulevard trees. Growing healthy grass is almost a lost cause.

“So screw it,” she said. “We went for the plastic.”

A year later Cindy and Toby had another kid and decided to add to the back of the house. Fine. Drawings, permits, committee of adjustment approval – it all got done, but the project would mean the removal of a tree. Not that great a tree, either. And a private one – owned by them, in their back yard.

Enter the tree police.

The city sent a couple of guys to look at it, and determine if the slaughter could occur. In the course of that visit, every piece of vegetation on the lot became subject to inspection. Including the rubber lawn. And while it passed, the small amount of synthetic grass Cindy had installed around the boulevard tree on city property in front of their home did not.

As a condition of securing their building permit, she was ordered to remove the carpet, replace the dirt beneath and sod it, at her own expense. “I can live with that,” she says, “but not the tree tax.” Cindy and Toby were required to write a cheque for $4,000 as a ‘security deposit’ on the boulevard tree which sits on land they don’t own. If it croaks, they lose the money. If it lives for a few years, they get it back.

“This is disgusting,” she says. “Worse, it’s extortion. Where am I supposed to get an extra four thousand?”

People without houses lament the fact they can’t paint the walls chartreuse, plant a medical marijuana garden or ‘make the place my own.’ They often have absolutely no idea of the financial burden of home ownership, or the straitjacket most urban owners live inside of. On Cindy’s street, for example, old mutual driveways are too narrow to pilot the SUV down, but the city controls who can turn a lawn into parking. You can’t move an interior wall or finish your basement, let alone plant a single support for a new back deck, without a permit and a fee.

Wood-burning fireplaces are essentially banned. Fences must be three metres in height, and no shrubs can poke above them. If a garage falls down, it cannot be replaced. Of course, any city employee can come and spray paint instructions on your grass, along with the gas and hydro guys. In a country where citizens have no constitutional right to own property,  you can even have your whole house seized for an on-ramp or a park.

By the way, the people on Cindy’s street (where unremarkable houses on 30-foot lots cost a million) pay about $500 a month in property tax. They pay the city a garbage tax, as well, plus a water bill. Electricity charges are slated to rise by about 40% over the next few years, and if anyone decides to move, there’s double land transfer tax in Toronto. The average moving tax on this street is about $35,000.

Homeowners pay considerably more for insurance than renters, which is to be expected. New policies routinely come with a home inspection these days, and that normally results in a list of defects. No repairs, no insurance. No insurance, no mortgage.

Of course, houses have to be heated and cooled, which requires a furnace and air conditioning unit, which need regular maintenance, filters and duct-cleaning, lest your kids like inhaling carpet fibres and tasty dust mites. By the way, if the furnace is over four years of age, it’s probably an energy pig – which is consequential, given the increases in oil and gas prices. Outside, the garden needs attention, because the city can order you to remove any noxious weeds. Fail, and they’ll send some guys in brown shorts to do that job, and send you a bill. Don’t pay, and it goes on your property tax.

Same with the sidewalk out front. If you don’t clear the ice and snow within twelve hours of a storm, the fine is $100, plus a $25 surtax. Each time. And bugs. Watch the little suckers. Whole swaths of trendy, in-demand areas of Toronto, for example, packed with those slanty semis that hipsters love to bid for, are laced with termites. Getting rid of them can easily cost a few thousand bucks when trenching is involved. And there’s no point even starting if your infested neighbour refuses to spend the dough.

Did I mention the bed bugs? Or the white grubs in the lawn that are caviar to raccoons? The cute little guys have sharp snouts and can turn your turf into a miniature version of France during World War One in a single night. Of course, you can always come home one evening to see the bungalow next door has been demolished and a giant, smelly yellow machine is sitting on top of the bricks. Then you have a pleasant year ahead of listening to construction workers talk about boobs.

For this you hand over all your money, then shoulder gobs of debt. And pity the renters.