David Semple, Portfolio Manager, Emerging Markets Equity Strategy
April 19, 2018
A Rollercoaster Start to 2018
The first quarter of 2018 was a true rollercoaster for global investors. Markets rose substantially in January, driven by optimism relating to both strong and synchronized global growth and the passage of tax reform in the United States. This was quickly shattered as investors began to worry about possible inflation and rising interest rates, and the announcement of tariffs by the U.S. on steel and aluminum and against Chinese imports further exacerbated market volatility. Investors felt torn between a reluctance to bid farewell to the bull market and the apparent risks emanating from tech, higher interest rates and a potential trade war between the globe’s two largest economies.
Consequently, country performance in emerging markets ranged between negative and positive 12%. Brazil, Pakistan, and Egypt led emerging markets in the first quarter of 2018, whereas the Philippines, Poland, and Indonesia lagged. On a sector level, healthcare, energy, and utilities performed best in emerging markets. Consumer discretionary and telecom both detracted from performance.
Areas to Watch
Early in the quarter, there was concern about the increase in U.S. interest rates and whether the U.S. Federal Reserve might be more aggressive in terms of rate increases. However, the emerging markets saw little impact. While the Fed is addressing a maturing business cycle, the emerging markets are, at best, mid-cycle.
The announcement of tariffs by the U.S. (and increasing protectionism) raised concerns around the form and extent of the reactions and the nature of any subsequent “tit for tat”. On the one hand, China and most developing markets do not play on a level playing field, and judging from the communist party’s agenda, as outlined in the party thought, this is going to be hard to change. On the other hand, the unilateral imposition of tariffs, such as the U.S. has done, is completely against World Trade Organization (WTO) rules.
The technology sector bore the brunt of the market shakeout globally due to regulatory risk in developed markets, the potential of a trade war, and profit taking, and it is an important sector in emerging markets. It is the largest sector in terms of weighting in the Morgan Stanley Capital International Emerging Markets Index (MSCI EM). We don’t believe much has changed in terms of the growth outlook for the sector, despite a slight negative revision in analysts’ earnings expectations during the quarter. However, we continue to watch carefully for any potential risks arising from a change in the regulatory framework in the countries they operate in. Unlike in developed markets, technology companies in emerging markets (especially in China) have been operating within strict guard rails since their inception, and therefore, in our opinion, face a lower risk of unforeseen regulatory events that might impact the sector meaningfully.
Strategy Review and Positioning
Large caps and value stocks slightly outperformed growth and small cap stocks, hurting the emerging markets equity strategy’s performance relative to the MSCI Emerging Markets Investable Market Index (MSCI EM IMI). Exposures in consumer discretionary and staples, and information technology added to the strategy’s relative performance, while lack of exposure to the energy sector and selection in materials detracted from performance. On a country level, exposures in Spain, India, and Mexico contributed positively whereas selections in China and Brazil detracted.
The top performing stock for the quarter was CIE Automotive, a Spanish company that manufactures a variety of car parts. Active in emerging markets countries, including Brazil, China, Mexico, and India, the company executed very well during the quarter. Chinese company Alibaba Group Holdings not only continued to execute well with a business model able to address changing opportunities, it also announced good results for 2017. CP All Public Co., which operates the 7-Eleven convenience store franchise in Thailand and its cash and carry subsidiary, produced good results. Finally, Chinese private education company TAL Education Group continued to execute well and announced much improved results for 2017.
The largest detractors included Chinese utility Beijing Enterprises Water Group, which suffered as a result of concerns about a slowdown in orders and construction as financing gets tighter for public/private partnerships in the waste water treatment area. Shares in South African based media giant Naspers fell on investor disappointment over capital allocation after the company, very profitably, reduced its holding in Chinese company Tencent Holdings by 2% at the end of March. Motilal Oswal Financial Services, an Indian financial services group suffered as the Indian market continued to underperform. Bharti Infratel, a provider of telecom tower and related infrastructure in India, experienced pressure on its stock as a result both of its parent having sold down its stake in the company and a disadvantageous change in its customer mix.
Tailwinds Overcome Headwinds to Support Strong Outlook
The outlook for emerging markets remains bright in our view. Global growth and actual trade are both good. Tariffs aside, right now, there are no real macroeconomic issues around emerging markets. In fact, macro has actually boost in some places, such as South Africa, where the election of Cyril Ramaphosa has helped boost sentiments towards its economy.
China’s Xi Jinping, also known as the President or Chairman of everything, has gotten a lot of people worked up by abolishing presidential term limits. However, this can mean a higher likelihood of policy continuation, including anti-corruption, supply-side measures and strengthening financial regulations, which are generally good for investors. In the long run, concentration of power is usually a bad thing, but for the average investor investment horizon, it should prove positive.
We continue to focus on uncovering and investing in structural growth opportunities across emerging markets. Our answer to all the current noise is our enhanced and disciplined due diligence process, which provides us with a higher degree of confidence and conviction when making investment decisions.
All indices listed are unmanaged indices and include the reinvestment of all dividends, but do not reflect the payment of transaction costs, advisory fees or expenses that are associated with an investment in the Fund. Certain indices may take into account withholding taxes. An index’s performance is not illustrative of the Fund’s performance. Indices are not securities in which investments can be made. The Morgan Stanley Capital International (MSCI) Emerging Markets Index captures large- and mid-cap representation across 24 Emerging Markets (EM) countries. With 836 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. The MSCI Emerging Markets Investable Market Index (IMI) captures large, mid and small cap representation across 24 Emerging Markets (EM) countries. With 2,628 constituents, the index covers approximately 99% of the free float-adjusted market capitalization in each country.
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Portfolio Manager, Emerging Markets Equity Strategy
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