At the end of 2016, we commented that we were entering 2017 with a significant number of risks, both positive and negative. We came to the conclusion that on balance we viewed the global macro environment favorably, while identifying the specific risks of a stronger U.S. dollar, higher interest rates, and the further evolution of protectionist and nationalistic trade policies as some of the major negatives to monitor.
As we reflect on the first quarter of 2017, most, if not all, of these presumed deleterious factors have receded. The U.S. dollar has declined. The Federal Reserve has hiked rates, and this was almost unanimously expected. The more febrile fears of fresh trade sanctions have faded for now. Meanwhile, the solid underpinning of improved global economic momentum, which is especially helpful to the emerging markets asset class, has continued.
Emerging Markets Equities Resume Outperformance Trend
In the first quarter of 2017, the emerging markets equities asset class resumed its outperformance "spell" over global equities markets. This run of outperformance began a year ago and accelerated in the summer of 2016, but then was interrupted abruptly last November following the unexpected result of the U.S. presidential election.
It is interesting to note that 2017 so far looks to be demonstrating a style rotation. We wrote last quarter that we thought that we were close to the end of the brief but sharp period of outperformance of the heavily cyclical part of emerging markets. We thought then, and continue to believe, that the environment this year will be much more conducive to our emerging markets equity investment philosophy, which emphasizes high-quality growth over lower-quality, large-cap cyclicals.
A Style Rotation that Favors High-Quality Growth and Smaller-Cap
With one quarter completed, the evidence appears to support our style rotation contention with a much more balanced pattern of performance within the asset class. Growth stocks (MSCI EM Growth) outperformed value stocks (MSCI EM Value) by 274 basis points in 1Q 2017, while small-capitalization stocks led large caps by 144 basis points. On a sector level, the energy sector, a top performer in 2016, paused during the first quarter of 2017 and ended March at the bottom of the list. The information technology, industrials, and consumer sectors, on the other hand, performed best. Argentina, the sole representative of Latin America in the top performing countries, led country performers, followed by Poland and India. China performed in line with the overall asset class, while Russia performed worst.
1Q'17 Emerging Markets Equity Strategy Review and Positioning
Our emerging markets equity strategy is driven by bottom-up stock selection. This past quarter, we found it particularly hard to make generalizations about country weightings and were able to find good opportunities in several countries without any one geography standing out.
The strategy's strong stock selection in the consumer discretionary sector and its lack of exposure to the energy sector helped relative performance the most, while stock selection in the industrials and consumer staples sectors disappointed the most. On a country level, selection in China, Russia, and Brazil added most value on a relative basis during the quarter, helped by good performance from Internet companies in China and Russia, and strong performance from most of our Brazilian stocks. Stock selection in Turkey, which is currently highly politically charged, and the strategy's under allocation to Korean companies, disappointed on a relative basis.
Our biases by sector, driven by our philosophy, remain. We typically have very limited exposure to energy and materials due to their cyclical characteristics. We tend to be "underweight" in telecoms and utilities due to unattractive growth rates. On the other hand, areas like consumption, healthcare, and specialized financials are natural places for us to find opportunities, if valuations make sense.
Top Strategy Performers Hail from China and India
Top performing companies in 1Q'17 came from China and India. As a group, our main investments in Chinese companies in the Internet sector performed well, including Tencent Holdings (OTCPK:TCEHY), Alibaba Group (NYSE:BABA), and JD.com (NASDAQ:JD). All three reported strong operations and very visible growth. TAL Education Group (NYSE:TAL) provides K-12 after school education programs in China and also performed well, reporting strong numbers, leveraging the demand for educational achievement with innovative delivery models. In India, our banking sector exposure, Yes Bank Limited (OTC:YYBKY) and HDFC Bank Limited (NYSE:HDB), did well, in part as a result of a more realistic appraisal of the effects of the aforementioned "demonetization".
The strategy's bottom performers came from a variety of countries. Kenya's dominant mobile telecom operator, Safaricom, struggled given concerns about Safaricom's dominance, with some advocating a split up. Korean-based Soulbrain, a Samsung supplier of specialty semiconductor chemicals, was hurt by market fears and lumpy revenue recognition. Wizz Air Holdings (OTCPK:WZZAF), a leading low-cost airline company in Eastern Europe, was impacted by higher jet fuel prices despite good operational numbers. South Africa's Rhodes Food Group Holdings (OTC:RHDFF) was challenged by the strength of the South African rand. Finally, waste water treatment company Beijing OriginWater Technology was a poor performer, but we remain confident that its numbers should improve as the year progresses.
Improved Earnings Reflect Firm Underpinning of Better Economic Growth
Most importantly for the asset class, we are pleased to see vindication of our stance on improved earnings for emerging markets corporates. Over the last few years, corporations have failed to deliver meaningful earnings growth, both in absolute terms and relative to expectations. From the interim reporting period last year, we had been "banging the drum" on signs of a substantively improved earnings outcome. As we move through the tail end of annual reporting, we are pleased to report that earnings have been satisfactory, and even more than satisfactory for the companies that fall into our structural growth philosophy. It is not just a mark-to-market for cyclical, often commodity based, value stocks, but rather a more broad based, more efficient reflection of a firm underpinning of better economic growth.
Upward Revision to 12-Month Forward Earnings Estimates for Emerging Markets
Source: BAML, HSBC, Data as of March 2017. Past performance is not indicative of future results.
The actionable agenda of the new Trump administration remains fairly uncertain. Thankfully, the prospect of unilateral, harmful moves to increase trade barriers and tariffs seems to have receded recently. Whether this is due more to political realities or a more sober reflection on the cost certainly can be debated, but it is to be welcomed.
Rising Interest Rates are Generally Good for Emerging Markets
A word on rates: Rising short-term rates in the U.S. are typically an indicator of better growth and, in our view, should not be feared. As emerging markets are generally operationally leveraged, meaning that they have a higher capital stock to revenue ratio, a stronger nominal growth environment is generally positive compared to a disinflationary one. Listed emerging markets companies may be operationally geared, but are certainly not financially leveraged compared to their developed markets brethren. In fact, it is useful to note that as capex declines rapidly in many emerging markets, and revenue pick up, free cash flow is increasingly very positive, and that in the context of "arguably" under-geared balance sheets. The prospects of a more substantive return of capital to shareholders has rarely looked brighter.
With China, no news is good news. While we have never sought to downplay the challenges that exist in China as the economy evolves, we stick to our view, expressed frequently, that there was very little danger of some kind of imminent implosion in the financial system and/or the currency, as espoused by many "talking heads". China's economy is actually doing very nicely. The variable timing of the Lunar New Year celebrations can complicate economic analysis, but as the dust settles, it appears that growth is fine, and that capital outflow pressure is less. Nominal growth has substantially improved, leading to strong profitability in the industrial sector. We tend to invest in areas of the corporate landscape which are loosely called the "New China" - healthcare, education, Internet, for example. And in those areas growth simply remains strong.
For India, the fourth quarter of 2016 was challenging 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 to be replaced with new notes. We said that we were taking advantage of the temporary dislocations to increase investment. We did so, and it bore fruit, as India was one of the better performing markets in the first quarter of 2017.
Mexican equities and the currency were clearly weighed down by that country's position as one of the main potential victims of a harsher trade environment. Again, we took the view that market sentiment was overwrought, and our enhanced weighting in that country stood us in good stead in the first quarter, as it, too, has performed very well in 2017, particularly in U.S. dollar adjusted terms.
Turning to last year's strongest country performers, Brazil's outlook improved post-impeachment, but we continue to believe that, in general, the equity market is fully discounting that improvement. However, there remains some very significant work to be done in terms of the social security and pension systems. In the meantime, real activity indicators are sluggish, to say the least.
Another of last year's winners, Russia, had a difficult first quarter of 2017. As the so-called reflation trade has deflated and crude prices retreated, Russia has suffered. Economic management has been positive, but the country's stocks remain fairly strongly correlated to the price of commodities, with a significant overlay of geopolitical risk.
For a complete listing of the holdings in VanEck Emerging Markets Fund (MUTF:GBFAX) as of 3/31/17, please click on this PDF. Please note that these are not recommendations to buy or sell any security.
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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.
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