A New Era of Protest Against the Political Elite?
2016 was a year of many twists and turns in global macroeconomics and politics. We started the year with intense speculative pressure about the vulnerability of the Chinese economy and currency. The mid-year June 23 U.K. Brexit vote to leave the European Union was a shock to most, and this combined with the unexpected U.S. election results, is evidence that we might be entering a new era of popular protest against the political elite.
While there were several quite important emerging markets events in the fourth quarter of 2016 in India, Turkey and South Africa, for example, none of these events were as significant to the quarter's performance of global risk assets as the historic outcome of the U.S. presidential election, which had significant reverberations in currencies and rates.
Market Response to Election Tough on Emerging Markets
Since Trump's win on November 8, U.S. Treasury yields, the U.S. stock market and the U.S. dollar have all risen sharply. Most of this market response has been unhelpful to emerging markets. Since November, exporters of goods from emerging markets sold off hard (and then recovered somewhat). Emerging markets currencies also depreciated quite sharply against the stronger U.S. dollar, wiping out most of the emerging markets' pre-election outperformance over the U.S. and other developed markets. Ultimately, however, at VanEck we invest in emerging markets businesses that face and benefit from long-term structural trends. Share prices may be affected by short-term volatility and strategy flows, but in the longer term we have always believed that exceptional businesses that enjoy a strong competitive advantage and that are managed by smart, competent men and women will be winners.
Recent Period Favored Large-Cap Value, Rather Than Smaller-Cap, High-Quality Growth
We have a distinct approach to emerging markets investing, which has generally served long-term investors well over a sustained period of time. Nevertheless, from time to time, there can be periods where our approach is not in favor, and large-cap (often state-owned) cyclicals take the lead in emerging markets. We have just moved through such a period, and underperformance in this period is naturally inherent in our philosophy, style, and process. Large-cap value which, in many cases, crosses over with cyclical sectors (materials and energy) will always have periods of outperformance over growth. Our sense is that we are far closer to the end of this transitional period than the beginning, and we have focused over the past year on positioning in emerging markets companies that will benefit when regime change means investors once again favor high-quality growth over low-quality, large-cap cyclicals.
4Q'16 Emerging Markets Equity Strategy Review and Positioning
At a country level, stock selection in Peru, the Philippines and Thailand helped the relative performance of our emerging markets strategy in 2016. Conversely, exposures in Brazil, China and Russia, hurt the strategy's relative performance most. In the case of Russia, we are typically underweight this very cyclical and generally poor quality equity market which rallied strongly post-U.S. election, and on the back of stronger commodity prices. China was a poor relative performer throughout 2016, although the doomsday scenario forecast by many did not materialize. In fact, China's growth has turned out to be a little better, rather than worse than expectations, and many forward indicators are predicting at least a stable outlook. However, multiples remain depressed, and this leads us to believe that China is likely to do better for our strategy in 2017.
In terms of industry sectors, our stock selection in consumer sectors in emerging markets helped the strategy in 2016 despite weakening performance at year-end from sectors impacted by the uncertainties over the future of global trade that followed the U.S. election. On the other hand, our exposure to financials in emerging markets, in addition to the strategy's structural underweight in energy and materials led to poor relative performance in terms of asset allocation, as both sectors (energy and materials) continued to do well. Touching a little on energy and materials, we would posit that much of the outperformance has probably taken place. We do see supply discipline in the shorter term but we continue to believe that in the medium and longer term, not being exposed to these sectors is advantageous.
A Distinct Improvement in Global Growth and Sentiment
Entering 2017, emerging markets face a significant degree of uncertainty, with some clearly identifiable risks, both positive and negative. The complicated, and uncertain, interplay of reflationary policies, interest rates and the U.S. dollar, is difficult to predict. Likewise, the policy actions of the new U.S. administration, although potentially very different from campaign rhetoric, will influence outcomes for emerging markets. Reflation stagflation, and the return of deflation are all plausible. We are tending to view the global macro environment favorably. We see a distinct improvement in global growth, with better sentiment indicators and improving analyst earnings revisions. We need to carefully monitor further U.S. dollar strength, which is generally a negative for emerging markets investors. Disruptive trade and tax policies also have the potential to be significant headwinds.
India's Temporary Dislocations
Turning to some country specifics: In India, the market struggled in the fourth quarter as investors came to grips with some significant government moves, including "demonetization." This is the process whereby certain local currency notes (1,000 rupees and 500 rupees) were invalidated overnight, and replaced with new notes. One of the intentions behind this move was a push to formalize more of the economy. This ought to have a long-term positive impact on the economy, but it has certainly created some temporary dislocations. We have used this period of investor disfavor to reposition and optimize the strategy's portfolio for where we believe the opportunities will be in the future, rather than where short-term sentiment is currently.
China Offers Mispriced Opportunities in Specific Sectors
The outsized performance of value (which has become the momentum trade in emerging markets), has meant that the valuations of our consistent growers have become relatively more attractive. In addition, as they steadily compound earnings, their absolute valuations are clearly improving as well. We are finding tremendous value in currently out of favor markets such as Indonesia, the Philippines and China and will continue to allocate capital to structural growth businesses that are most attractively priced. We expect 2017 yet again to be a year where the outsized predictions of "perma-bears" in China prove to be wrong. This does not mean that there are not significant challenges, but we are confident that there are also significantly mispriced opportunities in specific sectors. We are not in the camp of a disorderly depreciation of the Chinese currency.
Work Still Needs to Be Done in Brazil
Brazil's outlook improved post-impeachment. However, we believe that, in general, Brazil's equity market is fully discounting that improvement while there remains some very significant work to be done in terms of the social security and pension systems. Meanwhile, real activity indicators are sluggish, to say the least.
Vulnerability in certain emerging markets countries has been reflected in some very weak currencies. Mexico certainly bore the brunt of that in 2016, being particularly impacted by the shifting political winds in the U.S. The fear is, of course, that foreign direct investment is significantly impacted. In Turkey, the lira has also been very weak. In this case, it also reflects concern about domestic and regional politics. Turkey has vulnerability to a weaker currency through heightened inflation and elevated foreign currency debt. Our stock selection in Turkey reflects our medium-term anticipation of further currency weakness.
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Please note that Van Eck Securities Corporation offers investment portfolios that invest in the asset class(es) mentioned in this commentary. The Emerging Markets Equity strategy is subject to the risks associated with its investments in emerging markets securities, which tend to be more volatile and less liquid than securities traded in developed countries. The Emerging Markets Equity strategy's investments in foreign securities involve risks related to adverse political and economic developments unique to a country or a region, currency fluctuations or controls, and the possibility of arbitrary action by foreign governments, including the takeover of property without adequate compensation or imposition of prohibitive taxation. The Emerging Markets Equity strategy is subject to risks associated with investments in derivatives, illiquid securities, and small or mid-cap companies. The Emerging Markets Equity strategy is also subject to inflation risk, market risk, non-diversification risk, and leverage risk. Investing involves risk, including possible loss of principal. An investor should consider investment objectives, risks, charges and expenses of the investment company carefully before investing. The prospectus and summary prospectus contain this and other information. Please read them carefully before investing.
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