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Bob von Rekowsky: Be wary of value trap

Emerging-market equities experienced another round of “taper tumult” in early 2014, as investors negatively assessed both the U.S. Federal Reserve’s (Fed’s) efforts to scale down large asset purchases and a tepid global growth outlook. However, after declining approximately 9% in the first five weeks of this year, the MSCI Emerging Markets Index staged an impressive rally through quarter end, paring back its absolute and relative losses versus the U.S. and developed markets. Of particular note is that several of the “fragile five” economies (Brazil, South Africa, India, Indonesia, and Turkey, some of 2013’s worst performers) rallied back the strongest. This factors into our assessment of how their economic adjustment has developed over the past 12 months and how these markets may progress in the coming 12 months. Meanwhile, although geopolitical risk is weighing heavily on Russia’s performance, its equity market and the ruble have rallied off their mid-March lows.

With EM currencies being significantly pressured by the Fed’s tapering program—particularly in those countries with the most acute current-account deficits—our concern is that weaker currencies would pressure central banks to raise domestic interest rates to stem inflationary expectations, at a time when their economies may already be prone to a cyclical slowdown. This risk is perhaps best exemplified by Brazil. Elsewhere, what is slowly becoming apparent in the data is that economic adjustment is occurring instead in the form of muted import demand, while exports gradually stabilize. This has moderated current-account funding fears and put a floor under currency weakness. Indonesia is a good example. The country suffered a substantial correction last summer. Since then, however, Indonesian goods exports have staged a steady comeback while its imports have weakened further, allowing the overall balance of payments to stabilize and improve. Relatedly, the Indonesian rupiah has recently appreciated since its February 2014 lows.

On a sector basis, cyclically exposed consumer discretionary stocks have handily outperformed their more expensive consumer staples peers since last autumn. We expect this reversal to continue. On the other hand, though they have rallied from their mid-March lows, the emerging-market energy and materials sectors continued to languish versus the broader market, reinforcing our view that much of the constituency is a classic value trap: Companies that appear cheap because their stock prices have fallen may still be prone to further earnings downgrades. There are exceptions in each sector, reiterating that active management may help investors take advantage of stock-specific opportunities that could outperform both their respective sectors and the broader market.

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Sammy Simnegar: Widest valuation discount since 2005

Against a volatile backdrop, EM equities posted modestly negative returns in Q1 with relative strength in Latin America, where appreciating currencies—specifically the Brazilian real and Mexican peso—boosted U.S. dollar (USD) returns in that region. Elsewhere, emerging Asia declined as credit conditions hit new cycle lows, while emerging Europe, Middle East, and Africa (EMEA) also fell as the crisis in Ukraine amplified geopolitical risk.

EM equity valuations remain depressed. Earnings have declined since 2010 and stock returns have been lackluster as well. EM economies in general have transitioned to a slower pace of growth, while cyclical improvement in advanced economies has helped developed markets generate more favorable returns. The current price-to-earnings (P/E) ratio for EM stocks is 12.2 on a weighted-average basis, compared with 16.3 for developed markets—the widest discount since 2005. However, the median P/E, which adjusts for the cyclically depressed P/Es of large state-owned entities in the index, is a loftier 17.2. This aligns EM valuations more closely with their historical average (see chart, below) and, in our view, substantiates the need for an active approach to stock picking to help differentiate the potential winners from the losers.

On a price-to-book (P/B) basis, the MSCI EM Index trades at roughly 1.5x.2 Historically, P/Bs below 1.5 have often resulted in positive returns for EM equities in the subsequent 12 months. From Oct. 1995 to March 2014, there were 38 months when the MSCI EM Index had a P/B ratio below 1.5x. In 33 of those months, the index had a subsequent positive 12-month absolute return.3 

In terms of specific countries, GDP in China is supposedly growing at an annualized rate of 7% to 8%,4 but it has not translated into profits. Meanwhile, the growth of the Chinese labor pool is slowing, which should cause wages to increase. In Latin America, Mexico has made some tough economic decisions and appears to be better positioned than in 2013. Contrast that with Brazil, where I’m less optimistic. Wages have risen in the high single digits annually on average in the past decade, but manufacturing productivity has declined slightly. This ratio is not sustainable, so I am focused on companies in Brazil that sell low-priced staples (phones, toothpaste) rather than automobiles or other high-priced discretionary items. I’m positive on the Southeast Asia region, particularly the Philippines and Indonesia. These countries tend to have relatively large domestic economies, high savings rates, low loan-to-GDP ratios, strong real economic growth, and relatively modest levels of inflation. Sub-Saharan Africa is another potential growth area. For example, many South African companies are well run with good corporate governance, have a track record of operating in tough environments, and stand to benefit from growth in the region.

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  • Sammy Simnegar manages Fidelity® International Capital Appreciation Fund (FIVFX) and Fidelity® Emerging Markets Fund (FEMKX).
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  • Find emerging market mutual funds, ETFs, and stocks.

John Carlson: After a strong Q1, opportunity remains.

Emerging-market debt (EMD) had a strong Q1 in 2014, gaining roughly 2% for unhedged local currency debt and 3.5% for sovereign bonds (USD). Falling interest rates in January, followed by two months of relative yield stability, proved favorable on balance. Returns across EMD sovereigns are being driven mostly by U.S. Treasury movements and coupon income. Local currency yields were largely unchanged, meaning most of the return was coming from interest payments. This puts yields in the hard currency market (both corporates and sovereigns) around 5.5% (see chart, below), and in local currency debt around 6.9%. Yields in both these markets remain attractive relative to other fixed-income opportunities. As of Mar. 31, 2014, the BofA Merrill Lynch U.S. High Yield Master II Index offered about 6.1%, while the investment-grade Barclays U.S. Aggregate Index yield is just shy of 2.5%. On the whole, EM debt has lower credit quality and longer duration than the Aggregate Index, and higher credit quality/longer duration than the high-yield benchmark. These can be attractive attributes in a stable or declining interest rate environment.

Interest rates in emerging markets have generally risen alongside interest rates in the U.S., which is resulting in lower growth expectations. Importantly, macro adjustments are occurring—such as improved current-account balances in India and Indonesia—and for the first time in a while there is the potential for more synchronized global economic growth. With inflation expectations muted in the developed world, interest rates will likely stay on the low side in a historical context.

We see this as an environment where credit differentiation matters and relative value opportunities will be more prevalent. At quarter end in the hard currency sovereign market, high-yield sovereigns offered a sizable yield advantage over investment-grade constituents—more than 400 basis points, a level last seen in the depths of the 2008 crisis. While fundamentals are admittedly challenged among a number of these issuers, this could present compelling relative value opportunities.

Many investors have left EM for developed-market assets over the past year. It is this broad-brush approach that helps to create these relative value opportunities. Sentiment toward EM is more improved now than in Q1, though it’s too soon to call this a trend. But seeking to take advantage of market dislocations may be a good way to benefit from the long-term structural story in EM debt.

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Bob von Rekowsky: Can elections benefit EM equity performance?

A heavy EM election calendar in 2014 (see chart, below) could be a key driver of EM equity returns this year. With that in mind, we studied how elections affected EM equity performance over the past 25 years, and the findings broadened our previous assessment of this dynamic (Read the study methodology).

We sought to answer four broad questions:

1. Is there a correlation between the elections and EM equity market performance?
Yes.

2. Was the impact of elections dependent upon market performance leading up to elections?
Post-election outperformance versus the broader EM index was particularly pronounced in countries that lagged the index leading into an election.

3. Did the impact of elections on equity market performance depend on whether the incumbent party won or lost?
We found that post-election outperformance came almost entirely from countries where the opposition was victorious. When an incumbent was returned to office, markets appeared to perform roughly in line with the EM Index.

4. What effect did elections have on equity market volatility?
We were surprised to learn that market volatility appeared to be minimally impacted by elections. We found no sustained increase in volatility either before or after elections.

Post-election outperformance

Our research indicates countries have often significantly outperformed the MSCI EM Index after elections. Relative performance was a total of +15% for the two-year period after an election event, with a strong statistical significance in our sample size. This suggests markets price in election risks and, in fact, tend to overestimate that risk. This jibes with a study we conducted in the early 1990s, which included both developed and emerging countries. This study revealed the election “event” itself was the driver of uncertainty, and that uncertainty diminished no matter the outcome, once the event passed. Our current study let us delve deeper into the data set and establish if it matters whether the incumbent or challenger wins.

Pre-election outperformance

It also turns out that, broadly speaking, emerging countries did not lag heading into elections. We found the relative performance was effectively zero in the six-month, one-year, and two-year periods prior to an election. We also discovered that nearly all examples of outperformance came from countries where the opposition won the election. In these cases, equity markets outperformed the broad EM Index by a total of 23% two years after the election, with statistical significance. Similarly, countries that lagged two years leading into an election subsequently outperformed by 20% in the two-year post-election period. Data further suggest countries that outperformed ahead of an election also experienced a post-event bounce, but the margin was much smaller—around 8%—and we were not as confident the results were as compelling statistically. For countries that underperformed heading into elections, we found that when the opposition won, that country’s stock market had the highest relative return two years out from that event—at a total of 30% outperformance with high statistical significance. In markets where incumbents won, relative performance was mixed, depending on the time period, and two years out we failed to find any statistical significance.

Case study: 2002 election in Brazil

One classic outperformance example we analyzed was Luiz Inácio “Lula” da Silva’s electoral victory in Brazil in 2002. In the two years prior to the election, Brazilian equities underperformed the EM Index by 44% (USD), as measured by the MSCI Brazil Index. Two years after the election, Brazilian stocks more than tripled, delivering a staggering 150% outperformance versus the broader market.

We are cognizant that other macroeconomic factors may have significantly boosted Brazilian equity returns two years after the election, for which we did not set out to control. Specifically, we recognize that the China “story” boomed onto the world stage in 2003-04, with a voracious appetite for all things mined, milled, and smelted (soybeans, iron ore, oil), which Brazilian excess capacity was well-poised to deliver. That said, we also recall the near-apocalyptic prognosis from many Brazilian private-sector companies in 2002–03 with the prospect of Lula’s candidacy and his expected nonmarket-friendly policies. The fact that da Silva enacted credible fiscal and monetary policies during his first term helped solidify the enhanced external demand Brazil experienced. The combination of these post-election factors helped reduce the elevated political risk priced into the market, thus propelling Brazilian equities to 10-year highs by the end of 2005.

These results bolster our previous belief that elections impact the market, and we also came away with beneficial conclusions regarding pending elections across the EM world. We were heartened by the fact that there was significant outperformance to potentially capture when the opposition party wins. But considering those same markets underperformed by a total of nearly 11% heading into elections smacked of market timing to us. Also, we found that post-election outperformance accrued progressively over the ensuing two-year period, and that it often took a full 12 months following the election to recoup the negative six months of underperformance leading into elections. Of course, as with any market indicators, past performance is no guarantee of future results.

Case study: 2004 election in India

An excellent example of this dynamic was the Indian elections of 2004, where the MSCI India Index fell nearly 27% (USD) from late April (pre-election) to mid-May (post-election) following the surprise loss of the ruling party and win by the opposition. From that mid-May nadir, however, Indian equities staged an impressive 55% return by year-end 2004. And by the end of 2005, Indian equities posted an additional 35% return in U.S. dollars.

Investment implications

The overall findings of the study reinforce our belief that elections do have an impact on market performance, with the greatest significance being seen two years out from the event. We were pleasantly surprised to learn that significant outperformance opportunities may present themselves around specific elections, bolstering the case for active management. The study also supports the view that an opposition win, particularly when coupled with incumbent-induced market underperformance going into elections, may result in enhanced equity results in the ensuing two-year period. We take it to suggest that a self-correcting or “healing” impact from policy changes exists in emerging markets.

What we may not conclude from our study, which we also anticipated previously, is the existence of a risk/reward payoff of an early “bet” on policy reform. In fact, the risk/reward was poor. Therefore, we will continue to focus on stock- and sector-selection processes where fundamentals are the most compelling driver of results.

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Fidelity Institutional Portfolio Manager Brian Drainville and Investment Capability Director Andy Rubin also contributed to this report. Fidelity Portfolio Manager Greg Lee and Equity Research Sector Specialist Aliasgar Bharmal contributed to the Election Effect report. Fidelity Vice President and Senior Investment Writer Matt Bennett provided editorial direction.
Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information.  Read it carefully.

Views expressed are as of the date indicated and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments.

Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.

Past performance is no guarantee of future results.

Neither asset allocation nor diversification ensures a profit or guarantees against a loss. Information presented is for informational purposes only and is not intended as investment advice or an offer of any particular security. This information must not be relied upon in making any investment decision. Fidelity cannot be held responsible for any type of loss incurred by applying any of the information presented.

Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market, or economic developments, all of which are magnified in emerging markets. These risks are particularly significant for investments that focus on a single country or region.

In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.)  Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

1. For government debt, emerging markets are represented by JPMorgan Emerging Markets Bond Index (EMBI) Global; U.S. debt by Barclays U.S. Aggregate Bond Index; and developed markets by Citigroup Non-U.S. G-7 Index. For equity, emerging markets are represented by MSCI® Emerging Markets (EM) Index; U.S. stocks by Standard & Poor’s 500 Index; and developed markets by MSCI® Europe, Australasia, Far East (EAFE) Index. The index performance includes the reinvestment of dividends and interest income. Securities indices are not subject to fees and expenses typically associated with managed accounts or investment funds.
2. FactSet, as of Mar. 31, 2014.
3. FactSet, as of Mar. 31, 2014.
4. FactSet, as of Mar. 31, 2014.
Barclays Global Treasury Index tracks fixed-rate local currency government debt of investment-grade countries in developed and EM markets.
JPM® EMBI Global Index, and its country sub-indices, tracks total returns for traded external debt instruments issued by emerging-market sovereign and quasi-sovereign entities.
Barclay’s U.S. Government Bond Index is a market value-weighted index of U.S. gov’t fixed-rate debt issues with maturities of one year or more.
Barclays U.S. Aggregate Bond Index is an unmanaged, market value-weighted performance benchmark for investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities with maturities of at least one year.
Citigroup Non-USD Group-of-Seven (G7) Index is designed to measure the unhedged performance of the government bond markets of the G7 excluding the U.S., which are Japan, Germany, France, United Kingdom, Italy, and Canada. Issues included in the index have fixed-rate coupons and maturities of one year or more.
MSCI® Emerging Markets (EM) Index is an unmanaged market capitalization- weighted index of over 850 stocks traded in 21 world markets.
MSCI Brazil Index is designed to measure the performance of the large- and mid-cap segments of the Brazilian market. The index has 75 constituents and covers about 85% of the Brazilian equity universe.
MSCI India Index is designed to measure the performance of the large- and mid-cap segments of the Indian market. With 69 constituents, the index covers approximately 85% of the Indian equity universe.
MSCI Europe, Australasia, Far East (EAFE) Index is an unmanaged market capitalization-weighted index designed to represent the performance of developed stock markets outside the U.S. and Canada.
BofA Merrill Lynch U.S. High Yield Master II Index tracks the performance of below-investment-grade, but not in default, U.S. dollar-denominated corporate bonds publicly issued in the U.S. market, and includes issues with a credit rating of BBB or below, as rated by Moody’s and S&P.
Standard & Poor’s 500 Index (S&P 500®) is an unmanaged market capitalization-weighted index of 500 widely held U.S. stocks and includes reinvestment of dividends.

The third-party trademarks appearing herein are the property of their respective owners.

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Study methodology

We considered the national-level elections of 19 major EM countries based on the current composition of the MSCI EM Index (China was excluded since it has no democratic elections). We included all those elections where these countries were part of the MSCI EM index for three to six months prior to the time of the election and remained part of the index for the entirety of the subsequent two-year period. This gave us a total of 98 elections from 1988 (when the MSCI EM Index was formed) through the end of 2013 from 19 countries on which our statistical observations are based. We used country-specific MSCI indexes when measuring individual countries against the broader MSCI EM Index.

Key points

  1. We considered only national-level elections and not local elections.
  2. We removed a few elections, which, while they were national elections, were not important for our analysis (for instance, we removed the elections for the President’s post in India since it is a ceremonial post).
  3. All returns are in U.S. dollars.
  4. We included only those elections where the market was a part of the MSCI EM index at the time and remained an index component for the entire subsequent two years. This resulted in the elimination of the following elections from the data set:
  • Greece: Apr. 9, 2000
  • Greece: Mar. 7, 2004
  • Greece: Sep. 16, 2007
  • Greece: Oct. 4, 2009
  • Greece: May 6, 2012
  • Greece: Jun. 17, 2012
  • Israel: Feb. 10, 2009
  • Israel: Jan. 22, 2013
  • Poland: Sep. 19, 1993
  • Russia: Jun. 16, 1996
  • South Africa: Apr. 27, 1994
  • Taiwan: Dec. 21, 1992
  • Taiwan: Dec. 2, 1995