Sector Watch: Looking past the volatility

For the nine months ended Sept. 30, the MSCI emerging markets index was down by 4.8% (in Canadian dollar [C$] terms), a weak performance after a remarkably strong gain of 28.3% for all of 2017. In contrast, the S&P 500 composite index rose by 13.6% in C$ terms in the same nine-month period.

Emerging-market funds’ portfolio managers are optimistic about many of these markets’ superior long-term growth potential. Many stocks traded in these markets are viewed as being better valued than stocks in the U.S., where markets have been propelled by President Donald Trump’s tax cuts, robust economic growth and strong employment numbers.

U.S. stocks – as measured by the S&P 500 – have been trading at price/earnings multiples well above the index’s 10-year average recently, in contrast to stocks in the MSCI emerging markets index, which are trading well below 10-year average P/E multiples. In addition, the average dividend yield of emerging markets’ stocks recently has been roughly double the yield of U.S. stocks – another measure of better value in emerging markets.

Although the long-term picture is bright for emerging markets due to young populations, growing middle classes and the development of new businesses leading to greater economic growth, the headwinds blowing against emerging markets may continue for a while longer.

The U.S. Federal Reserve Board raised its leading interest rate three times this year and is expected to do so one more time in 2018 and at least three times in 2019. Rising interest rates in the U.S. have the effect of strengthening the US$ relative to emerging markets’ currencies.

At the same time, rising interest rates can be problematic for emerging markets’ governments and corporations that have borrowed money in US$ and may not have the means to repay as their own currencies sink. Among the more vulnerable borrowers are Argentina, Turkey, Ukraine and Venezuela.

For example, the Argentine peso declined by 30% and the Turkish lira fell by 24% in the third quarter of 2018 relative to the US$. Such dramatic declines in foreign currencies can be devastating for the portfolio returns of investors in these markets.

In addition, there are no signs of a truce in the trade conflict between China and the U.S. The escalating tariff dispute is related to Trump’s rivalry with China in trade, technology and innovation, portfolio managers say. Trump wants to maintain the U.S.’s economic and military superiority; however, China, with its annual gross domestic product (GDP) growth rate of more than 6%, is the largest emerging markets country and is catching up rapidly to the slower-growing U.S. and thus threatens the latter’s global dominance.

“The trade war is a longer-term event,” says Louis Lau, director, investment group, who sits on the emerging markets committee at Brandes Investment Partners LP in San Diego and is a member of the team managing Brandes Emerging Markets Value Fund. “The goal of the Trump administration is to contain the rise of China – economically, technologically and militarily. China is not in a hurry to negotiate a trade deal. [China] wants trade, but doesn’t want to lose face.”

The trade war could drag GDP growth in China downward to 5.5% annually from its current rate of roughly 6.5%, Lau says: “China is trying to promote domestic consumption and infrastructure spending to keep [GDP] growth going. There could be a hit of 0.5% to 1% on annual growth [as a result of] the trade war.”

China is the highest geographical weighting in the Brandes fund, at 9% of assets under management (AUM). Nevertheless, China is underweighted in the fund relative to the country’s much larger, 33% weighting in the benchmark MSCI emerging markets index, Lau says. Geographically, Brazil, Russia and Mexico are the most overweighted countries vs the benchmark index’s weightings.

Geographical and industry weightings are not based on top-down considerations, Lau says; rather, the weightings are a function of finding attractive opportunities, and the team at Brandes doesn’t see much value in China at present.

Meanwhile, uncertainty about the outcome of the Oct. 28 presidential election in Brazil, which resulted in the election of far-right candidate Jair Bolsonaro, put stock prices under pressure in that country and created buying opportunities. The Brandes fund’s allocations to Brazil and Russia are roughly triple their weightings in the benchmark index.

The top holding in the Brandes fund is China-based telecommunications service provider China Mobile Communications Corp., which is a beneficiary of the rapid penetration of cellphones. China Mobile is the world’s largest mobile network operator, with 902 million subscribers, and controls 70% of China’s cellphone market. Another China-based company among the Brandes fund’s top 10 holdings is Dongfeng Motor Group Co., a manufacturer of commercial and consumer vehicles and autoparts.

In Brazil, one of the Brandes fund’s top holdings is the preferred shares of Companhia Brasileira de Distribuição, a food and staples retailer. Another top holding in Brazil is Embraer SA, an aerospace conglomerate that produces commercial, military, executive and agricultural aircraft, and provides aeronautical services.

A smaller holding in Brazil is Petróleo Brasileiro SA (a.k.a. Petrobras), an oil and gas producer that benefits from strong oil prices.

But while rising oil prices have benefited oil-producing countries such as Brazil and Russia, the rise in price has been costly for India and China, which are net importers of oil.

“Higher oil prices have been a net negative for emerging markets,” Lau says, “based on the large size of the economies that consume imported oil.”

The Brandes fund has two significant investments in South Korea: Hyundai Mobis Co. Ltd., an autoparts company; and Korea Tobacco & Ginseng Corp. (KT&G), the country’s dominant tobacco company. Last year, KT&G launched an electronic cigarette-style device that emits nicotine-infused vapour and is rapidly gaining a share of this new market.

Fidelity emerging markets Fund similarly is underexposed to China relative to the benchmark MSCI emerging markets index. However, the opposite is true for India, in which the fund is overweighted vs the index. India is less reliant on exports and therefore less vulnerable to trade wars. India accounts for 12% of the fund’s AUM vs 8% in the index, says lead fund manager Sammy Simnegar, portfolio manager with Fidelity Investments Canada ULC in Boston.

“India is promising,” Simnegar says. “It has a well-managed economy with a young and dynamic population. India’s [annual GDP] growth rate of 7% is higher than that of China, and good companies can capitalize on [India’s] growing middle class.”

A key holding of the Fidelity fund in India is HDFC Bank Ltd., which Simnegar calls a rare “20/20/20” investment, meaning the stock has achieved 20% annual growth with a 20% return on equity for 20 years.

On a sector basis, the Fidelity fund’s biggest weighting is in the technology sector (about 30% of AUM), followed by financial services (19%). In the tech sector, the fund’s biggest holding is Tencent Holdings Ltd., a China-based company with interests in social networking, online games and entertainment, artificial intelligence and online payment systems. Other China-based holdings are Alibaba Group Holding Ltd., which focuses on e-commerce and cloud technology; and Baidu Inc., a tech giant that specializes in Internet products and services.

“The emerging markets’ middle-class consumer is buying and paying for more products online,” Simnegar says.

Financial services companies also benefit from the growing middle class, as people earn, spend, save and borrow more money, Simnegar adds: “Countries where consumers still are relatively underleveraged are good places to own bank [stocks]. There’s a lot of potential for loan growth as these economies grow.”

Aside from HDFC Bank in India, the Fidelity fund holds Sberbank of Russia, the dominant and most profitable bank in that country; and Bank Rakyat, a well-managed bank in Malaysia. Another of the Fidelity fund’s top 10 holdings is Ping An Insurance Group Co. of China Ltd., which also is in the financial services sector and offers life insurance and other financial services.

“As the Chinese become wealthier, they have more wealth to manage and protect,” Simnegar says.

With uncertainty and volatility expected to continue in emerging markets as they fight the effects of rising U.S. interest rates, a strong US$ and robust U.S. economic growth, the Fidelity fund holds about 10% of its AUM in non-emerging market-domiciled multinational companies that sell products such as luxury consumer goods, cosmetics and automobiles to emerging markets.