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  • Emerging Markets Equity

    Strong Earnings Fuel Emerging Markets Rally

    David Semple, Portfolio Manager
    October 13, 2017

    Strong Performance Continues in 3Q'17

    The third quarter of 2017 was another strong quarter for emerging markets. Emerging markets equities ― as represented by the benchmark MSCI Emerging Markets Investable Markets Index (MSCI EM IMI)1 ― gained 7.74% in the third quarter of 2017. Most of the gains took place in the first two months in anticipation and appreciation of strong corporate earnings.

    In September, emerging markets, as an asset class, actually underperformed developed markets, driven by a stronger U.S. dollar and higher U.S. bond yields with consequent weaker emerging markets currencies. In addition, with strong gains year-to-date for the asset class, there may have been an element of consolidation or digestion of gains. Capital market activity has picked up, particularly in Latin America, and especially Brazil, with a long parade of deals that were waiting for a better stock market environment. However, flows into the asset class remained positive.

    By country, the top performing markets included Brazil, Argentina, and Russia. China also outperformed in the third quarter, while India lagged. On a sector level, energy and materials staged a comeback and technology companies also did well, driven by Internet companies. The worst performers were consumer staples and industrials. Healthcare, also, continued to struggle.

    Emerging Markets Equity Strategy Review and Positioning

    Growth stocks continued to outperform value stocks and large caps continued to outperform small caps, helping in the process the emerging markets equity strategy's relative performance versus the benchmark. China, South Korea, and Taiwan added value in third quarter due to favorable allocation and stock selection. In the cases of South Korea and Taiwan, being underweight helped, whereas an overweight position in China worked well for the emerging markets equity strategy. On a sector level, consumer discretionary and technology stocks continued to lead the way. The strategy's underweight position in energy hurt modestly.

    Top Strategy Performers/Detractors

    Aside from the usual suspects such as Alibaba Group Holding Limited and Tencent Holdings Limited, the list of top performing stocks for the quarter included another Chinese duo of TAL Education Group and China Lodging Group Limited. These are stocks that fit squarely into structural growth for us, leveraging on increased consumption expenditure in China in areas such as private education and travel. In both cases, better than expected revenue this year has led to much better than expected earnings driven by good operating leverage.

    In the negative column for the quarter, there is no strong commonality. Rhodes Food Group Holdings Limited, a food manufacturer in South Africa, was a poor performer. Operationally, the company did not deliver as expected. As a beneficiary of a weak rand, it has suffered in times of rand strength. Luxoft Holding, Inc, an Eastern Europe-based provider of software and IT development services, appears to be in a transitional year as its core clients, principally in the financial services sector, have proven to be weaker than expected in terms of their IT spend. Both positions are, though, relatively small for the strategy.

    Macro Environment and Strong Free Cash Flow Expectations Support Positive Outlook

    The emerging markets macro environment is currently in good shape ― in general the traditional triggers for macro concerns in emerging markets, such as current account deficits, fiscal deficits, and elevated credit cycle indicators remain, in aggregate, remarkably benign. Inflation, in emerging markets terms, is pretty much missing in action. Real rates are still relatively high. China concerns have faded as a more realistic understanding has developed about China's capacity to control the effects of imbalances in the economy.

    The most exciting story for us as unrepentant stock pickers, is that corporates continue to deliver. In particular, we expect strong free cash flow to become increasingly apparent over the next year, with enhanced agitation from shareholders for increased pay back in the form of enhanced dividends and share buy backs. Leverage is not a general issue in emerging markets, with listed non-financial balance sheets in emerging markets being significantly less levered than in the developed markets. Valuations for emerging markets are close to historical averages, but relative to developed markets, look very attractive. Notwithstanding net inflows this year, almost all the indicators that we see suggest that positioning in the asset class remains relatively light. In short, while we could never pencil in a continuation of the performance of the asset class that we have seen so far this year, we remain optimistic, albeit with gains at a more measured pace.

    There was little significant change to country or sector allocation in the quarter. We have a larger allocation to Brazil. A decision to reduce our exposure to India earlier in the year, due to stretched stock valuations, has been vindicated by the significant underperformance of Indian stocks since then.

    China remains a lucrative place for us to find good, structurally growing investments, and like many of our peers, we will spend significant time further exploring the A-share (or domestic) market in the coming months and quarters. In summary, we are happy to report a solid quarter with reasonably good prospects ahead.

    Download Commentary PDF with Fund specific information and performance.
    For a complete listing of the holdings in VanEck Emerging Markets Fund (GBFAX) as of 9/30/17, please click on this PDF. Please note that these are not recommendations to buy or sell any security.