What next for emerging markets?

SPONSORED BY : Fidelity International

By Fidelity International

Added 27th September 2016

Following strong performance so far this year, is the rally in emerging market equities sustainable in its current form?

What next for emerging markets?

2016 has seen a significant rebound in emerging market (EM) performance, with the MSCI Emerging Markets index posting year-to-date returns of 28.7% (GBP, 31 August 2016).  One of the primary performance drivers in recent months has been a significant rotation of passively-managed assets into emerging markets as negative rates push investors higher up the risk spectrum.

One of the effects has been an indiscriminate price increase in large index names. Nick Price, portfolio manager of the Fidelity Emerging Markets Fund, does not believe in buying index names unless there is a solid investment thesis for the business.  His view is that fundamentals reassert over time, and at that point good quality businesses will come back to the fore. 

Another important contributor to market performance has been a bottoming out of the negative economic spirals that have been affecting leading EM countries like Brazil, Russia and South Africa. The Brazilian stock market in particular has enjoyed an impressive bull run this year. Economic projections suggest Brazilian GDP should still contract by -3% in 2016, but the expectation for next year is GDP growth of 2%.

There have been some political developments in Brazil too – even putting aside the Dilma Rousseff impeachment – with President Temer pushing to increase the state retirement age to over 65, which would be a vital reform in a country where many civil servants currently retire in their 50s on generous state pensions. Equally ground-breaking  is the move to impose a legislative cap on national spending, which would be an important step towards bringing the ballooning budget deficit under control. Whilst on the face of it these would be encouraging steps forward if implemented, the likelihood is that their effectiveness will be diluted as they go through the legislative process.

Nick Price considers Brazilian stocks to be largely fairly valued following the rally and, whilst he has selectively added exposure to Brazil, maintains an underweight relative to the index overall.    

Focus on EM consumers

From a sector perspective, Nick and his team maintain their conviction in consumer-related stocks. Whilst the long-term consumer growth story in emerging markets is well understood, some companies are clearly better placed to benefit than others. When it comes to finding the key beneficiaries, the team favour market leaders which operate in under-penetrated areas with significant structural growth potential.

Oil stocks have been good performers in 2016. However, looking at the valuation levels of stocks in the sector, investment opportunities are limited. This suggests an apparent disconnect from fundamentals.  For example, oil stocks have been discounting a price of US$75 per barrel. However, Fidelity’s internal research suggests oil should peak around US$65 per barrel, at which stage additional supply from US shale should provide a cap.

Clearly, the improved sentiment surrounding the asset class is good news. Whilst positive data and structural reform have been catalysts for some of the market returns, a large proportion of the rally has been sentiment-driven. As market conditions normalise and fundamentals come to the fore, Nick Price believes his team’s focus on owning quality stocks with the potential to deliver solid and sustainable returns on equity should prove rewarding in the medium to long term.

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