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  • Emerging Markets Equity

    Growth Expectations Driving Emerging Markets

    David Semple, Portfolio Manager
    July 18, 2017
     

    Emerging Markets Equities Post Notable Gains in 1H2017

    After a very creditable first quarter, emerging markets equities ― as represented by the benchmark MSCI Emerging Markets Investable Markets Index (MSCI EM IMI)1 ― consolidated and built upon that period to achieve a gain of 18.27% for the first half of 2017. For the asset class as a whole, stronger performance can be traced to both the dissipation of a number of potentially negative factors and a solid underpinning of better earnings growth and significantly better free cash flow generation.

    We have witnessed a radical shift away from the outperformance of cyclicals which was so marked in 2016. To date, the 2016 winners and losers by country and sector have been turned on their heads. In particular many large, cyclical, often commodity-based companies, having experienced a banner year in 2016, have performed poorly thus far in 2017 ― as they had done for a number of years prior to 2016. We maintain a disciplined focus on structural growth, largely eschewing cyclicality. This focus has clearly served our emerging markets equity investment strategy well in 2017.

    Growth Continued to Outpace Value

    Growth stocks continued to outperform value stocks in the second quarter of 2017, while small caps continued to lag large caps extending their underperformance "spell" to 18 months. Information technology sector led by the benchmark's top holdings performed best during the quarter followed by consumer related stocks. The energy, utilities, and materials sectors all registered negative returns. On a country level, stocks in Turkey, Hungary, and Poland performed well while stocks in Russia and Brazil did not, mainly driven by macroeconomic and political factors.

    Positive Outlook Progresses in 2017, Replacing Yearend 2016 Negativity

    At the start of the year, the possibility of U.S. dollar strength, unanticipated rate increases, China issues, and protectionism were all cited as significant reasons for antipathy towards emerging markets equities. In each case, the negative scenario failed to develop. The U.S. dollar actually weakened. This tends to be positive for emerging markets as long as the decline is not rapid. Short-term interest rates increased in the United States. This was well anticipated and, in our view, not something to be feared as it tends to evidence better economic growth in developed markets. Traditionally, this has had a positive impact on emerging markets. China exhibited stronger than expected growth in the first quarter and again was well able to control the potential negative implications of imbalances in its economy. We do expect economic growth in China to be weaker for the rest of the year, but to remain resilient. The worst fears of protectionist measures emanating from the U.S.'s new Trump administration proved to be misguided. For whatever combination of reasons, wholesale tariffs as described in the stump speeches appear unlikely to be implemented.

    On the positive side for the asset class, earnings expectations, which held up well at the end of 2016 (in stark contrast to the previous four years), have been positive in 2017. We believe that there continues to be an underappreciated and significant increase in free cash flow among emerging markets corporates. Stronger revenues allied to less capex spend means that, in contrast to prior years, many companies have significant "free cash".

    EM Rally has Firm Underpinning of Earnings and Cash Flow

    Balance sheets for listed emerging markets companies are already significantly stronger than their developed markets counterparts. This begs the question about the use of this excess cash. Whether capital investment activities pick up again, corporate M&A becomes more popular, or capital is returned to shareholders, most uses of cash should be positive for equity markets. There is significantly more pressure on corporates to avoid adding further cash to their balance sheets since it depresses their return on equity.

    While fears have dissipated, we think that this firm underpinning of earnings and cash flow is what gives the emerging markets rally some "legs".

    2Q'17 Emerging Markets Equity Strategy Review and Positioning

    The strong performance of growth stocks in Q2 worked well for the emerging markets equity strategy's relative performance, while the weakness in small-caps hurt. On a sector level, exposures to consumer discretionary and financials sectors helped the strategy's relative performance vis-à-vis the benchmark, whereas underexposure to utilities and an overweight position in the healthcare sector detracted. On a country level, China was the largest contributor to the strategy's relative performance. China's solid contribution is complemented by positive contributions from countries such as Brazil and Russia; Taiwan and Greece detracted from performance.

    Top Strategy Performers/Detractors in Q2

    The best performing stocks for the quarter were quite an eclectic group. Our top performing stocks were dominated by four companies from China (including Hong Kong). The other company came from South Korea. Samsung Electronics Co., Ltd., based in South Korea, manufactures a wide range of consumer electronics, information technology, and mobile communication products. Its semiconductor business manufactures a wide range of memory chips. Supply in that industry is becoming more concentrated, while the uses are becoming more broad-based, significantly reducing cyclicality. The company benefited from significant earnings upgrades, with expectations for 2017 earnings increasing by over 25% over the first six months of the year.

    Two of the Chinese investments are involved in the Internet sector. Tencent Holdings Ltd and Alibaba Group Holding Ltd. both reported strong operations, maintained very visible growth (despite their scale) and continued to offer exciting earnings growth prospects as their quasi-monopolistic positions broadened and deepened.

    The biggest detractors from the strategy's performance during the period were from around the globe. Russia's dominant bank, Sberbank of Russia OJSC, suffered from a correction in the Russian market driven potentially by a drop in crude oil prices. The performance of Syngene International Limited, a small, but fast growing pharmaceutical company in India, suffered from a fire at its facility in December. Strides Shasun, an Indian pharmaceutical company, also had a difficult quarter due to disappointing results.

    Strong Earnings Support Positive Outlook for Second Half of 2017

    Looking at the asset class as a whole, the macroeconomic vulnerability of emerging markets is currently at very low levels compared to what it has been in the past and certainly compared to even just the "Taper Tantrum" in 2013. Nearly every country is in better shape, whether in terms of current account deficits, fiscal deficits, and short-term debt versus total external debt, or PMIs.

    On the microeconomic or corporate level, we have over the last year seen better earnings results. For 12 consecutive months emerging markets corporate earnings have been upgraded (see chart below). We have seen this happen a handful of times in the last 20 years or so. And each time it has been positive for the market. However these upgrades have not related just to commodities, they have been broad based.

    In addition, and importantly, operating cash flow is strong and increasing, and capex is declining, which is leading to not only increasing but also historically high free cash flow. Since there is low leverage in emerging markets, this ought to result in more cash being available for companies to pay out to shareholders either by way of dividends or through share buybacks.

    MSCI EM Index: % Change in Price and EPS Growth (Quarter over Quarter)
    June 2007 - June 2017

    MSCI EM Index: % Change in Price and EPS Growth (Quarter over Quarter) Chart

    Source: Bloomberg. Past performance is not indicative of future results.

    China

    Looking at individual countries, while China's economy may have had a good first quarter in macro terms, our expectations for the rest of 2017 are that the economy will be slightly weaker. We do not believe, however, that there is anything to worry about. There has been some prudential tightening in an attempt to try to clean up some of the balance sheet issues that exist. But these affect only certain aspects of China's economy.

    India

    In India, while reforms may be progressing, the concern is that there is still a reasonably large bad debt issue in the banking sector which is not evenly recognized among India's banks. We believe there has to be some recapitalization among banks, and probably some mergers and acquisitions. But, ab initio, everything needs to be done on a level basis. The Central Bank of India is enforcing normalization of bad debt recognition and some issues may arise in this respect. However, once banks have been recapitalized, then both a credit and capex cycle can be started. Each has been noticeably absent.

    Mexico

    Mexico bounced back very strongly in the first quarter following concerns in the last quarter of 2016. We believe Mexico's economy is, effectively, normalizing. Although there are challenges going forward, the economy seems to be on reasonably firm footing.

    Brazil

    In Brazil, as the economics continue to be challenging and the tentacles of corruption spread further, the prospects for reform appear to recede. However, what the strategy is exposed to in Brazil is not too economically sensitive.

    South Africa

    Confidence in South Africa remains depressed because of political uncertainty and an administration that appears not to be business friendly. We believe, however, that corporate management in the country continues to be among the best in the emerging markets. We can still find companies that, while based in South Africa, derive a significant portion of their revenues and/or earnings overseas, thereby providing something of a hedge for rand weakness.

    Download Commentary PDF with Fund specific information and performance.
    For a complete listing of the holdings in VanEck Emerging Markets Fund (GBFAX) as of 6/30/17, please click on this PDF. Please note that these are not recommendations to buy or sell any security.