Are Emerging Markets Turning A Corner?

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Includes: ADRE, DBEM, EDBI, EDC, EDZ, EEM, EET, EEV, EMEM, EMF, EMLB, ESGE, EUM, EWEM, FEM, FLQE, HEEM, IEMG, ISEM, KEMP, MFEM, MSF, PPEM, RFEM, ROAM, SCHE, SPEM, VWO, XSOE
by: Invesco US
Summary

The fourth quarter of 2018 was negative for both emerging and developed markets.

However, we saw emerging market headwinds start to ease toward the end.

In fact, EM stocks rebounded strongly in January, yet valuations have remained at a discount to developed markets.

A tough fourth quarter led to a solid January, and valuations remain compelling

By Steve Cao, Senior Portfolio Manager in Equities

Are emerging markets turning a corner?

The fourth quarter of 2018 was negative for both emerging and developed markets. However, we saw emerging market headwinds start to ease toward the end of the year, thanks to stabilizing currencies, lower oil prices, lower inflation pressures and progress in the US-China trade conflict. In fact, EM stocks rebounded strongly in January, yet valuations have remained at a discount to developed markets. All told, we believe there are compelling opportunities to be found in emerging markets.

Recent outperformance of emerging markets

In the fourth quarter, emerging markets were in negative territory, yet still outperformed developed markets. The MSCI Emerging Market Index returned -7.47 while the developed market MSCI EAFE Index returned -12.54. In January, the emerging market index bounded back to return 8.77%, while the developed market index returned 6.57%. From a valuation perspective, the MSCI Emerging Market Index has been trading at 11.9x, while the MSCI EAFE Index has been trading at 12.7x.1

Three areas of opportunity in EM

In the fourth quarter, our team's emerging market activity was concentrated in three regions: China, Brazil and Mexico.

China. The Chinese stock market (as measured by the Shanghai Stock Exchange Composite Index) was down 11% in the fourth quarter on concerns that economic growth has slowed.2 The latest domestic activity indicators pointed to a softening in retail sales, exports and industrial activity. The concerns about slower growth and escalating trade tensions caused a large market correction - we took advantage of lower valuations by adding to our existing positions and buying a new position, New Oriental Education (NYSE:EDU) (0.86% of Invesco Developing Markets Fund as of Dec. 31, 2018).

New Oriental Education is the largest private education provider in China, with services including English language courses, college admission test preparation, K-12 after-school tutoring and more. The company has been experiencing short-term pressures from new regulations and increased investment in online services, which triggered a stock derating. We initiated a position in the fourth quarter as the valuation significantly improved. (New Oriental Education's stock price was above $100 in June 2018, and the company was trading at 30x earnings after stripping out the net cash. The stock subsequently fell into the $50s with valuation improving to a more reasonable 15x ex-cash.3) Meanwhile, the company generates strong free cash flow, a return on equity in the mid-teens, and has a net cash balance sheet.

Mexico. Another volatile area, the Mexican stock market (as measured by the Bolsa Mexicana de Valores) declined 19% in the fourth quarter.2 Following its 2018 presidential election, there have been concerns about the new government's policies. Some of them were announced during the fourth quarter, including the cancellation of the planned Mexico City airport and the decision to halt new oil auctions for at least three years. These policies raised uncertainties for private and foreign investments and may have eroded confidence. Financial conditions also deteriorated as Mexico's central bank hiked its policy rates again.

As the market corrected in response to the uncertainty, we took the opportunity to add to our existing positions. We added to airport operator Grupo Aeroportuario del Centro Norte (NASDAQ:OMAB) and consumer staples company Kimberly-Clarke (NYSE:KMB) (1.13% and 1.45% of Invesco Developing Markets Fund as of Dec. 31, 2018).

Brazil. Brazil was a strong performer in the quarter, up 12%.2 The results of the 2018 election were positive, in our view, as they ushered in a market-friendly government with a strong commitment to Social Security reform, privatization of government-owned companies, and reduction of trade barriers - all of which are critical to bringing the Brazilian economy back to a path of sustainable growth, in our view. At the same time, the economy continued to recover, evidenced by a decline in the unemployment rate, improvement in consumption, and a rebound in credit growth and private investment.

Brazilian stocks rallied in the quarter, and the fund benefited from our overweight position there. Given the strong performance and less-attractive valuation, we took some profits by trimming our positions in Brazil.

1 P/E (NTM) as of Jan. 31, 2019. Source: Invesco, FactSet Research Systems, Inc.

2 Source: Merrill Lynch Global Performance Monitor, Jan. 2, 2019

3 Sources: Bloomberg L.P., FactSet, data as of Jan. 16, 2019

Important information

Blog header image: cittadinodelmondo/Shutterstock

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Holdings are subject to change and are not buy/sell recommendations.

The fund is subject to certain other risks. Please see the prospectus for more information regarding the risks associated with an investment in the fund.

The MSCI EAFE Index is an unmanaged index designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.

The MSCI Emerging Markets Index is an unmanaged index considered representative of stocks of developing countries.

The Shanghai Stock Exchange Composite Index is a capitalization-weighted index that tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange.

The Bolsa Mexicana de Valores is the Mexican Stock Exchange, commonly known as Mexican Bolsa, Mexbol, or BMV, is one of two stock exchanges in Mexico.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.'s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.

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Are emerging markets turning a corner? by Invesco US

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.