Emerging markets continue to feel the impact of uncertainty about international trade and tariffs, a strong U.S. dollar, sanctions on Russia and more. Most of these headwinds are idiosyncratic risks and they have led to negative year-to-date returns in the benchmark emerging markets index. We believe the fundamental basis for investing in emerging markets is intact; however, until there is more clarity around the risks, market volatility is likely to persist.
Emerging markets gained nearly 35% in 2017, based on the MSCI Emerging Markets Index, and started 2018 with a gain of more than 8% in January. However, as discussions of tariffs, Russia sanctions and the Brazilian trucker strike littered the headlines early in the year, the market began to peel back those gains and was down more than 9% through Sept. 14, 2018.
Investor sentiment in general about emerging markets still is under pressure, given these headline risks and in the face of the strong U.S. dollar. It’s worth noting that there has been a wide dispersion of returns in emerging markets, especially when you look at the U.S. dollar returns versus the localcurrency returns. While many markets have had negative returns in terms of the dollar, a few of the local market returns have been positive.
It does not appear that there is a systemic or fundamental deterioration in many of these markets. As shown in the chart below, the majority of the pain has been from currencies. In aggregate, U.S investors have seen a drag of about 5.5% on returns from the weakening of emerging market currencies.
Comparing performance in U.S. dollar and local currency terms
country returns based on
MSCI Emerging Markets Index,
U.S. dollar and local currency.
Past performance is not a guarantee of future results.
Impact on performance, positioning
The Fund had a strong 2017 and outpaced both peers and the index. However, it has trailed the benchmark this year. The Fund began 2018 with overweight allocations to China, Russia and Brazil – each of which has since been hit by headline risk or the strength of the U.S. dollar.
The largest relative detractors to performance on a year-to-date basis have been:
- China (-1.80% relative detractor); the main detractors to performance have been stock selections in Geely Automobile Holdings Ltd., Hangzhou Hikvision Digital Technology Co. Ltd. and Baidu.com, Inc.
- Brazil (-1.12% relative detractor); the main detractors have been a combination of stock selection (Petrobras, Raia Drogasil S.A. and Banco do Brasil S.A.) and the negative currency effect from the depreciation of the Brazilian real.
- Taiwan (-0.54% relative detractor); the main detractor has been an underweight allocation to this market, as it has been one of the better performers.
We have steadily reduced the Fund’s overweight position relative to the benchmark index in shares broadly related to China – including Hong Kong H shares, China A shares and the Taiwan market – and now have an underweight to these countries in aggregate. We still believe that China’s economy can show solid growth while trade negotiations with the U.S. continue, but we want to see more clarity around the situation before we increase our allocation to the region.
India is the Fund’s largest overweight. The market in India has held up well in our view, as it largely is sheltered from global trade disputes. We believe India’s greatest challenges stem from the potential for further increases in energy prices and the uncertainty about next year’s elections there.
Russia is the Fund’s second-largest overweight. We believe the country’s fiscal position remains strong, supported by high energy prices. The largest headwind to performance in Russia is the risk of additional economic sanctions. For example, the Trump administration recently issued an executive order that could impose sanctions on any country that interferes with U.S. elections – a topic that already includes Russia.
Brazil is another overweight for the Fund. Despite the headline risk around the elections occurring there next month, we feel that the valuations and the risk/reward tradeoff is a positive for the allocation.
Valuations, earnings growth offer potential
Despite concerns about some emerging markets, we think valuations and earnings growth overall remain attractive and we still believe there are potential opportunities for investors who can weather occasional volatility. The largest individual security overweight positions in the Fund now are in high-conviction stocks related to internet technology, energy and materials.
It has been particularly difficult in recent months to predict how far the Trump administration will go in its attempts to improve trade terms for the U.S. with China, partners in the North America Free Trade Agreement (NAFTA) and the European Union. Resolution of the NAFTA discussions appear to be nearing completion, which may allow for a more focused effort on tackling the trade dispute with China. However, the visibility of the trade disputes may affect U.S. midterm elections and further cloud the timing of any progress on a deal with Beijing.
We recognize that a full-blown U.S. trade war with China and the rest of the world would damage global growth and global trade, with a significant impact on emerging market countries. But we still do not think that scenario is likely since the U.S. also benefits from the steadily growing global economy.
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