Pursue Opportunities in Emerging Markets: SLI

With 2016 officially half over, global equity funds are reflecting a story of mixed performance. Some groups are up, while some are down and geographic location is driving market returns. To date, Asia and Europe are lagging, while North and South America are outperforming on a relative basis.

Latin American equity funds tracked by investment research firm Morningstar are ahead by almost 23% year to date and are leading all regions. Countries that comprise this group–such as Brazil, Mexico and Peru are part of the broader emerging markets group, which is also outperforming.

While many broadly diversified emerging market funds have lagged the developed markets over the past several years, the tide is now turning, according to Dr. Mark VIncent, portfolio manager overseeing emerging market equities at Standard Life Investments (SLI). “However, investors must use caution.”

“There are pockets of deterioration within emerging markets, with the commodity price slump badly affecting Brazil, political uncertainty in Eastern Europe and large behavioral shifts affecting the Chinese market.”

Vincent spoke exclusively to Emerging Market Views and discussed opportunities within emerging market equities, while noting that eastern European markets may be the ones to suffer the most from the United Kingdom’s recent “Brexit” vote in favor of leaving the European Union. Read on for more.

Emerging Market Views: Which emerging markets are the most volatile right now for investors? 

Dr. Mark Vincent: With the recent uncertainties around “Brexit” and its implications, it would not be surprising to see volatility in some of the emerging European markets, so that might be an area where we might think carefully about having a large overweight just now. That said, we believe there are alpha opportunities through stock picking in every market, particularly in global emerging markets (GEM) where the dispersion of returns between individual stocks is particularly high.

The right company-specific investment story can usually generate positive returns whatever the country or sector. Looking at the year-to- date China (the largest emerging market), has been an area of volatility with well-known concerns around indebtedness, credit quality, and the slowing economy. Many of those concerns are reflected in the price of stocks in the region.

However, over time we have found some of our best alpha opportunities in that market. The Chinese auto parts supplier Minth, for example, is a top quality player which is winning significant business both from the domestic Chinese carmakers and amongst the international OEMs. The stock is up more than 60% year to date in a weak Chinese market.

Would Latin America be a “safer bet” than say, sub-Saharan Africa?

Africa depends very much which market you are talking about. The Kenyan economy is performing reasonably well, for example, whereas Nigeria has struggled despite the reform agenda of new president Buhari because the country has been slow to re-align wits currency with the new economic realities of a lower oil price world. Generally speaking discount rates are high in Africa at the moment implying that significant risk is priced into those markets and that overseas investors are reluctant to get involved (whereas two years ago, for instance, investors as a whole were more optimistic).

Where are equities posting healthy returns so far this year, and why?

Brazil and Russia have been two standout markets this year, but both of those have come off low bases where lots of negativity was being priced in. Brazil has been driven both by the recovery in commodities and also (more particularly) the exit of President Dilma Roussef. There is now quite a lot of expectation of reform and economic improvement priced into the Brazilian market so it will be important to see progress being made.

In the case of Russia, the oil price recovery (and hence ruble recovery) has helped, plus the domestic economy, while weak, has performed better than feared.

Should investors be cautious of the so-called frontier markets or are these “fringe” markets a safe bet for the longer-term investor?

The long term potential of most of some of these markets is quite exciting, although short term there can be setbacks (Nigeria is a classic example here). Some of these markets can be very heavily impacted by commodities (Kazakhstan, Nigeria, Angola, for example), while the potential for political unrest can also be high – hence it is right for investors to use relatively high discount rates when discounting the cash flows they expect to receive from companies in these markets. There are some excellent companies, however – Safaricom in Kenya is one example which we hold in some of our strategies.

How has the downturn in global commodities impacted returns on emerging market investments?

Yes, and investors tend to discount the negative impacts on the commodity exporters (Brazil, Russia, etc) before they price in the benefits for those countries in EM which actually benefit from weaker commodities (India, Kenya, Turkey and much of Asia). In most markets the negative impacts of weaker commodities have now been discounted and it is a positive that commodity prices seem to have found some kind of a floor.

It is important to note, though, that some countries (India, Indonesia) are big beneficiaries of weaker commodities and inflation in these countries has significantly come down, enabling them to have looser monetary policy which can stimulate growth.