Investment Adventures in Emerging Markets

Perspective

Not All Emerging Markets Are Equal

Trade talks, country-specific concerns and a stronger US dollar created a challenging backdrop for emerging markets in the third quarter, but Manraj Sekhon, CIO of Franklin Templeton Emerging Markets Equity, and Chetan Sehgal, senior managing director and director of portfolio management, are looking beyond the noise of negative headlines. They highlight the effects of a growing disconnect between the negative sentiment permeating the market and positive emerging-market equity fundamentals, and present the team’s overview of the emerging-markets universe in the third quarter of 2018.

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Three Things We’re Thinking About Today

  1. The US Federal Reserve (Fed) raised its key interest rate by 25 basis points in September, its third increase in 2018, and in line with market expectations. The Fed is widely expected to raise the rate again in December and another three times in 2019. While some investors worry that rising US interest rates could hurt emerging markets, we found that previous tightening cycles did not lead to a long-term downward trend. In fact, since rates were first raised in December 2015, emerging-market (EM) stocks, as represented by the MSCI Emerging Markets Index, have risen over 40% cumulatively in US-dollar terms.1
  2. An escalation in the trade dispute between the United States and China resulted in several rounds of tit-for-tat tariffs in recent months. Trade tariffs upon China have come at a challenging time, when its labor-cost advantage is fading and it is embarking upon the process of deleveraging. However, we believe supply-side reforms and deleveraging could help ease structural risks. Meanwhile, a shift towards innovation, technology and consumption as primary drivers of growth supports improved earnings sustainability. Corporate results have also been encouraging, with many companies not just reporting improved operating and financial performance, but also proposing to pay out a higher portion of earnings to shareholders.
  3. The passage of two key laws required for the 2019 general elections and a solid macroeconomic environment made Thailand one of the best-performing emerging markets over the quarter. The economy grew by a faster-than-expected 4.6% year-on-year in the second quarter,2 inflation remained well under control despite the rise in oil prices, and interest rates are close to record lows. A current account surplus and large foreign reserves supported the Thai baht. While Thailand’s market trades at a premium to its EM peers, we can still find stocks at attractive valuations. We believe major domestic banks are key beneficiaries of Thailand’s economic recovery and appear attractively valued to us. Retail companies are another area of interest as they stand to benefit from the rise in consumption ahead of the elections.

Outlook

In the last decade, China has surpassed the United States to become a far more important export market for most large emerging economies, mainly due to its burgeoning consumer market. Thus, trade growth now predominantly comes from intra-EM demand. Rising protectionism in the West may further pivot focus towards regional agreements. Indeed, China appears eager to replace US trade leadership in Asia.

In emerging markets in general, we continue to like themes such as the structural growth in the technology sector, rising consumption and economic reforms. Technology is reshaping the global economy. While emerging markets were once disadvantaged by poor infrastructure, digitalization and new technologies have enabled emerging markets to address development challenges and leapfrog technological change.

We aim to look beyond the “noise” of negative news headlines and instead focus on the underlying fundamentals of the EM asset class. We find a disconnect between the negative sentiment permeating the market and positive EM equity fundamentals, including rising cash flows, improving capital-allocation discipline, corporate deleveraging, healthy earnings and discounted valuations.

Not all emerging markets will be hurt by the same factors, and performances of individual emerging markets vary considerably. As stock pickers, we can choose among the varied opportunities that emerging markets offer to build well-diversified portfolios that seek to avoid excessive risks.

Emerging Markets Key Trends and Developments

EM equities began the third quarter on a strong footing but ended the period lower. Mixed news on trade talks, country-specific concerns and a stronger US dollar created a challenging backdrop for emerging markets. Conversely, developed-market stocks advanced. The MSCI Emerging Markets Index fell 0.9% over the quarter, compared with a 5.1% gain in the MSCI World Index,3 both in US dollars.

The Most Important Moves in Emerging Markets This Quarter

  • Asian equities fell amid a raft of economic concerns, led lower by China, Pakistan and India. China’s deleveraging campaign and deepening trade row with the United States weighed on the outlook for its economy. Pakistan struggled with its growing current account deficit and shrinking foreign exchange reserves. India was hobbled by a decline in the rupee, a wider current account deficit and troubles in the non-bank lending industry. In contrast, stocks in Thailand, Taiwan and Malaysia were the top gainers. Thailand’s economy grew faster than expected in the second quarter and the military government took steps towards holding a general election by May next year. Taiwan benefitted from an advance in technology stocks, especially index heavyweight Taiwan Semiconductor Manufacturing Company.
  • Latin America was the best-performing region over the quarter, driven by strength in Brazil and Mexico. Brazil’s market benefitted from the growing popularity of a more market-friendly candidate in electoral polls ahead of the October elections, coupled with resilient corporate earnings, higher commodity prices and reasonable valuations. Market sentiment in Mexico was supported by easing political uncertainty following Andrés Manuel López Obrador’s victory in July’s presidential elections and a conclusion on the revised North American Free Trade Agreement (NAFTA). Canada reached an agreement late in the period to join the revised trade deal between the United States and Mexico. The accord, renamed United States-Mexico-Canada Agreement (USMCA), is expected to be signed in November. Colombia, Peru and Chile, however, recorded declines.
  • Emerging European markets, as a group, gained during the quarter, supported by a surge in September. Poland’s equities rose ahead of FTSE’s reclassification of the market from EM to developed-market status in September. Higher oil prices and attractive valuations drove stock prices in Russia. Despite a strong rebound in September, following appreciation in the lira and a sharp increase in interest rates, Turkey’s market ended the three-month period with a double-digit decline. A strong dollar and worries about a proposed land reform weighed on investor sentiment in South Africa. On the positive side, some of the more controversial requisites of the proposed reform were eased in the country’s Mining Charter.
  • Frontier markets declined, lagging their EM peers, partly due to asset class outflows. Lebanon, Nigeria and Sri Lanka were among the weakest markets, ending the quarter with double-digit declines. Nigeria was dragged down by slowing economic growth, high inflation and a decline in foreign direct investment, coupled with uncertainty ahead of the general elections in February 2019. Equity prices in Sri Lanka were impacted by a devaluation in the rupee and external debt funding concerns. Bahrain, Oman and Kuwait, however, fared better, ending the quarter with positive returns. The FTSE upgrade later this year and hopes of inclusion in the MSCI Emerging Markets Index in the future continued to drive positive sentiment in Kuwait.


Outlook

As of September 30, 2018

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The comments, opinions and analyses expressed herein are solely the views of the author(s), are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

Important Legal Information

All investments involve risks, including the possible loss of principal. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.

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1. Source: FactSet, as of September 30, 2018.The MSCI Emerging Markets Index captures large- and mid-cap representation across 24 emerging-market countries. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com. Past performance is not an indicator or guarantee of future performance.

2. Thailand’s National Economic and Social Development Board, August 2018.

3. Source: Factset. The MSCI Emerging Markets Index captures large- and mid-cap representation across 24 emerging-market countries. The MSCI World Index captures large- and mid-cap performance across 23 developed markets. Indexes are unmanaged and one cannot directly invest in them. Past performance is not an indicator or guarantee of future performance. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com.

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