Emerging markets rallied in the first half of 2016 after several down years. Where will they go from here?
Viewpoints reached out to Sammy Simnegar and Will Pruett, manager of Fidelity International Capital Appreciation (FIVFX) and Fidelity Latin America (FEMKX), respectively, to ask why emerging markets (EM) rallied, can the recovery last, and where the managers are finding attractive investments these days.
They told us that the EM bounce may prove temporary—but some lower income markets offer appealing opportunities. The highlights:
Q: Why did emerging markets struggle so much in the years leading up to 2016?
Sammy Simnegar: They were dealing with the hangover from the Chinese infrastructure boom, and still are. The scale of that boom was staggering. For example, two-thirds of all the elevators built in the world in the last 10 years went into China. China and India have roughly the same population, but China consumes 10 times as much cement. A lot of capacity was built to supply that level of demand; but now, in my view, that boom is over, and we’re dealing with the problems that come with excess supply: lower profitability, deflation, and nonperforming loans.
Will Pruett: The 10-year commodities boom also caused many emerging market currencies to appreciate, while the use of leverage increased in these countries. Those trends gave consumers in many emerging markets greater purchasing power. Now those consumers have less credit and weaker currencies, dampening economic growth and corporate profits.
Q: In that case, why have emerging markets rallied so much in the first half of this year?
Simnegar: Investors came into the year with very low expectations for emerging markets. Then commodity prices recovered somewhat, and investors facing exceptionally low interest rates in the developed world prioritized yield, which they found in emerging markets. Then the Fed went on hold, which was very positive for the emerging world.
Q: How big was the impact of Fed monetary policy on the emerging markets complex?
Simnegar: It was very important. The markets were expecting the Fed to raise rates. When the Fed raises rates, dollar assets become more attractive compared to non-dollar assets and this sucks money out of emerging markets, strengthening the dollar against those currencies. Consequently, a stronger dollar typically depresses consumption in emerging markets; it also weakens commodity prices, because most global commodities are traded in dollars. All of this means that emerging markets that export commodities become less wealthy, and/or their purchasing power declines. So when the Fed declined to raise rates, emerging markets stocks benefited.
That said, emerging markets have a long way to go before they work off the excess supply built up during the China-led commodities super-cycle. So while a few factors have helped these markets rally this year, the outlook remains challenging for the EM complex as a whole.
Q: Do some emerging markets look attractive despite the broadly negative outlook?
Simnegar: People tend to talk about emerging markets as if they’re one homogeneous category, but they’re not. The drivers of stock market performance in Mexico are very different than they are in Brazil, the Philippines, Indonesia, and so on.
I’m generally unenthusiastic about the larger emerging markets. The best analogy for China right now is Japan in the 1990s: You have a lot of banks with bad loans that they are not willing to recognize. Rather than addressing the root issues, they’re just extending the debts.This is why the Chinese banks are some of the cheapest in the world. In Russia, Putin is consolidating power, and the country has done close to nothing to diversify away from oil. Turkey had been moving toward making beneficial structural reforms for many years, but more recently it’s moved to manage its economy more like Russia does.
In contrast, I find the lower-income emerging markets—such as India, Indonesia and the Philippines—to be more interesting. They tend to be relatively well managed economies, have emerging middle classes, and many are not dependent on commodity exports. In my view, they should have room to sustain GDP growth between 6% and 7% for many years.
Pruett: My fund is overweight in Peru and Argentina relative to its benchmark. Peru has a great banking system, with very profitable banks, low banking penetration—meaning room for growth—and low valuations. In Argentina, President Macri has vastly exceeded my expectations, and the country is finally putting its economy back on track from a very low base.
I’m underweight in Mexico and Brazil relative to the fund’s index, but I’m finding interesting opportunities in each. In Brazil, my investments have focused on consumer discretionary stocks and the non-bank financial space, where a lot of quality businesses are trading cheaply. In Mexico, I think some of the niche small- and mid-cap financials are particularly interesting.
It sounds like this is a good environment for active management.
Simnegar: If we assume that commodity prices remain stable for the next few years, then a relatively stable macro environment would favor companies that are well run and can grow earnings. An active manager who can identify those companies should fare well relative to an index.
Pruett: The first quarter of this year had big inflows into EM, with most of the money going into the largest stocks—many of which were the big resource-based companies at risk from the excess capacity we discussed earlier. In the second quarter, those stocks did less well; the ones that did a lot better were the small- and mid-cap stocks with interesting idiosyncratic drivers, suggesting greater opportunities for fundamental company research and active portfolio management.
Q: What impact is the run-up to the U.S. election having on emerging markets?
Simnegar: The Mexican peso continues to devalue, and is one of the only currencies in the EM that’s down year-to-date against the dollar. One explanation that seems plausible is that this is stemming from the uncertainty about the future of NAFTA and from the contentious rhetoric about immigration policies.
Pruett: The Mexico peso has underperformed the Brazilian real this year by 30%. For a national currency, that’s a huge amount. The real effective exchange rate shows that the peso is at its weakest point since the low point of the 90’s. From now until the election, I think many Mexican businesses are going to be in a wait-and-see mode because exporting to the United States is such an integral part of their country’s business models and any changes to NAFTA could have big implications.
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