Emerging markets: What you need to know about the selloff and potential opportunities | Capital Group Canada | Insights

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ARTICLES  |  SEPTEMBER 2018

Emerging markets: What you need to know about the selloff and potential opportunities

Featuring
Kent Chan, Equity Investment Specialist
Stephen Green, Economist
Jens Søndergaard, Currency Analyst

Although emerging markets have hit a rough patch, we see investment opportunities in companies in Asia-Pacific and India, which are benefiting from technological change and economic growth.

Key Takeaways

  • Emerging markets (EM) equities have been hurt by country-specific risks, U.S. dollar strength and global trade uncertainties.
  • Investors should expect continued volatility in EM as U.S. rates rise, trade tensions escalate and the political scene worsens in some countries.
  • Despite macro uncertainty, the outlook for corporate earnings remains strong with aggregate profits projected to grow by double-digits in 2019.
  • We see investment opportunities in companies in Asia-Pacific and India, which are benefiting from technological change and economic growth.


Emerging markets have hit a rough patch, with the MSCI Emerging Markets Index declining roughly 16% since hitting a two-year high on Jan. 26. The pullback is not a surprise, given the substantial 93% gain over a two-year period that stretched from January 2016 to January 2018. (All results in this article are in USD.)

Political uncertainty and economic turmoil in Brazil, Turkey and Argentina, which are large borrowers in international financial markets, have dragged markets lower at times. On the positive side, corporate profitability continues to be solid, especially for new economy companies in the technology and consumer discretionary segments. Nevertheless, volatility likely will continue as markets search for a new equilibrium.

Emerging markets: Old vs new


Even as we discuss the asset class broadly, it’s good to remember that emerging markets are a collection of very diverse countries at varying stages of economic maturity and political stability. We see two sides of emerging markets: one more defined by innovation and economic stability, and another that continues to be plagued by cyclical swings tied to commodity-related industries and political uncertainty.

The balance of power has shifted to Asian technology and consumer discretionary companies, some of which are now the biggest components of the MSCI EM Index. Mainland-listed Chinese companies, known as A-shares, are being added to the index. And India, now more business-friendly after a series of reforms, has surpassed China as the world’s fastest growing economy.

“Some of the risks we see in emerging markets have more to do with country-specific and macro-oriented issues and less to do with certain pockets of the Asia-Pacific and India, where our managers believe there are attractive, long-term opportunities to invest in companies benefiting from technological disruption and secular growth,” says Kent Chan, a Capital Group investment director and emerging markets specialist.

It’s also important to remember that this recent selloff comes after a long period of impressive gains, and it appears profit-taking is among the factors contributing to weaker sentiment.

Plenty of gains left from emerging markets rally

chart-em-return-since-2016-638x292

Sources: MSCI, RIMES. Returns in USD.

The EM-U.S. dollar relationship


A stronger U.S. dollar is making conditions difficult in emerging markets and has contributed to some capital flight. Historically, long periods of U.S. dollar strength have been a headwind for emerging markets, especially in cases where countries have relied on U.S. dollar-denominated debt for financing needs.

After weakening against several foreign currencies last year, the U.S. dollar’s rebound has been driven by the relative strength of the U.S. economy compared with Europe, expected U.S. rate hikes, stronger-than-expected earnings from U.S. corporations and increased uncertainty around trade tariffs.

Will emerging markets see any relief? Capital Group currency analyst Jens Søndergaard says further gains for the U.S. dollar may be hard to come by.

“For the U.S. dollar to rally further you need markets to start pricing even more Fed rate hikes than what’s already priced. That requires the current strong U.S. growth momentum to continue into 2019. It could happen but given the current trade war uncertainties, and signs of slower global growth ahead, I think we are now at peak U.S. growth,” says Søndergaard.

Emerging markets vs. U.S. dollar – still a strong relationship

chart-em-vs-usd-638x293

Source: U.S. Federal Reserve, MSCI, Thomson Reuters. As of 7/31/18. U.S. dollar index is represented by Trade-Weighted U.S. Dollar Index, a measure of the U.S. dollar relative to other world currencies.    

China’s slowdown


China’s economy in the second quarter grew at its slowest pace since 2016. Expect a gradual slowdown over the next six months and into next year, according to Capital Group’s China economist Stephen Green.

“Moves by the Chinese government to curb risks in the country’s financial system, and ongoing global trade tensions, should contribute to the deceleration,” Green says. “Deleveraging remains a priority in Beijing. While authorities are loosening up financing for infrastructure projects and encouraging banks to lend, I don’t think it changes the situation much in the near term. We may not see a stronger policy response in terms of stimulus until next year when more signs of the economic slowdown build up.”

Though it is slowing, China’s economy is still one of the fastest growing in the world: Its sheer size, growing tech centres and increasing wealth mean there will always be pockets of opportunity for investors.

EM fundamentals look attractive


Despite recent volatility, emerging markets could gain support from a combination of factors.

Corporate profitability and debt measures are stronger and improving. Valuations for emerging markets stocks are trading below their 10-year average on a price-to-earnings basis, and the discount has widened recently. At the same time, aggregate profits for companies in the MSCI Emerging Markets Index are estimated to rise by 16% this year and 11% in 2019 on a year-over-year basis, according to estimates by data aggregator FactSet.

Emerging markets discount widens

Emerging markets vs. developed markets relative valuation

chart-em-relative-valuations-638x281

Sources: MSCI, RIMES. As of 7/31/18. Relative valuation compares the forward 12-month price-earnings ratio of the MSCI World and MSCI Emerging Markets Indexes. Based in USD.

Selectivity is key, according to Chan.

“While we follow the macro developments closely, we invest bottom-up in companies that we believe can continue to grow despite geo-political uncertainty, risks of trade barriers and/or economic slowing, he says. “Furthermore, valuations, in some cases, have become even more compelling for companies that we believe have long growth runways as recent volatility is creating more opportunities to invest with our longer-term view.”

Emerging Markets Total Opportunities positioning


While maintaining adherence to the strategy’s objective, portfolio managers for Capital Group Emerging Markets Total OpportunitiesSM Fund (Canada) took advantage of the weakness in EM asset prices during the first half of the year to add incrementally to high conviction and oversold equity positions.

During the year-to-date period through August 31, 2018, the portfolio has increased its equity exposure from 44% to 50%, while reducing its fixed income exposure from 44% to 40% and its cash exposure from 12% to 10%. Within fixed income, a greater portion of the portfolio has shifted toward hard currency debt, as opposed to local currency debt.

Portfolio managers continue to focus on companies where they see attractive long-term upside potential, especially where our informational advantage gives us insight into something that we feel the marketplace may be missing. These include companies that the team feels are positioned to capitalize on unrecognized long-term growth trends, as well as potential turnarounds where they perceive the market to be overly pessimistic. Portfolio managers also continue to consider the potential volatility of their equity and debt holdings, as well as the correlation between them when constructing their portfolios.

About


Kent Chan

Kent Chan is an equity investment specialist at Capital Group. He has 26 years of investment industry experience and has been with Capital Group for two years. Prior to joining Capital, Kent spent over 20 years in Asia and most recently headed the Greater China equity research product at Barclays. Before that he was head of Asian technology equity research covering the hardware, wireless and Asian consumer sectors at Citigroup. He holds a bachelor’s degree in political economics from the University of California, Berkeley. Kent is based in Los Angeles.


Stephen Green

Stephen Green is an economist at Capital Group, responsible for covering Asia. He has 13 years of investment industry experience and has been with Capital Group for three years. Prior to joining Capital, he was head of economic research for Greater China at Standard Chartered Bank, in Beijing, Shanghai and Hong Kong. Before that he ran the Asia Programme at Chatham House, the U.K. think tank. He holds a PhD in government from the London School of Economics and a first-class honours degree in social and political sciences from Cambridge University. Stephen is based in Hong Kong.

Jens Søndergaard

Jens Søndergaard is a currency analyst at Capital Group. He has 12 years of investment industry experience and has been with Capital Group for five years. Earlier in his career at Capital, he worked as an economist covering the euro area and the U.K. Prior to joining Capital, he was a senior European economist at Nomura, a senior economist at the Bank of England and an assistant professor at The Johns Hopkins University. He holds a PhD in economics and a master’s degree in foreign service from Georgetown University. Jens is based in London.

 

 

 


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