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Orthodoxy Behind Revival In Emerging Markets

Devan Kaloo, Head of Global Emerging Markets, Equities

The orthodox monetary policy of emerging markets stands in stark contrast to the intractable mess in which the developed markets find themselves. And it's beginning to pay off.

Having raised interest rates and endured austerity to tame inflation, emerging market central banks positioned themselves to cut rates again and restart growth, which has led bond prices to rally. As yields have fallen, equities are also rallying, driving fund inflows and leading currencies to rally too. Additionally, economic growth is returning to emerging markets. After working through recessions, both Brazil and Russia are forecast to deliver positive gross domestic product (NYSEMKT:GDP) growth in 2017 for the first time in years.

Importantly, the trigger for this resurgence in emerging markets is not a rebound in commodity prices, but rather rate cuts in response to falling inflation. It underlines the sustainability of this recovery trend.

Moreover, even as the U.S. Federal Reserve (Fed) stands ready to embark on a series of interest- rate hikes - traditionally a source of painful volatility for emerging markets - this cycle is widely expected to be gradual and controlled. The June 23 vote by the British public to leave the European Union increased political and economic risks, which suggests that global monetary policy will be loose for longer. This has weakened the case for U.S. rate rises and should be supportive of emerging-markets equities and currencies.

Developing nations are better positioned to cope with U.S. rate hikes and a strengthening dollar than in previous years.

Certainly, we don't expect the European Central Bank (ECB), the Bank of Japan (BOJ), the Bank of England (NYSE:BOE) and the People's Bank of China (PBoC) to raise rates anytime soon. But we strongly believe countries such as Brazil, India, Indonesia and Mexico will continue to cut rates. Underscoring this decoupling, developing nations are better positioned to cope with U.S. rate hikes and a strengthening dollar than in previous years, given that most now have flexible exchange rates and ample foreign exchange reserves.

The markets where we are seeing compelling opportunities include Hong Kong, India, Mexico and Brazil. Hong Kong offers diversified, regional businesses, particularly those providing exposure to mainland China, with the added advantage of better standards of accounting and transparency. India's new tax bill is expected to boost investor sentiment and export competitiveness. The country is home to high-quality companies with good, long-term prospects.

Mexico also offers many well-run firms at attractive valuations that are in line to benefit from the government's reform agenda. It is a similar story in Brazil, where the new government is restoring confidence and seeking to accelerate the liberalization of various industries.

We are still watching developments in China, as there are still reservations about its substantial and growing debt burden, which may contribute to a continued decline in corporate profitability there. Many Chinese companies still fall short on quality and corporate governance.

Looking towards South Korea, the domination of chaebol, or sprawling conglomerates, can make the business landscape less competitive, and moves to prevent hostile domestic takeovers have also raised concerns. Additionally, while Taiwan is home to several interesting businesses, the bulk of them are in lower-quality cyclical industries and corporate transparency is generally poor.

From a sector perspective, we see fewer opportunities in technology, which is due largely to characteristics such as cyclicality, constantly evolving business models and increasingly shorter product lifespans.

We are also less enthusiastic about industrial companies because they tend to be more aggressive in balance-sheet management, and in utility companies because of regulatory risk.

As for the companies we do hold, we are positive about what we are seeing on the ground. They have reported decent results, particularly those outside of the commodities sector. We are seeing evidence of margin expansion and growth in earnings denominated in local currencies, with scope for significant earnings in dollar terms to come in the year ahead.

Emerging markets have come a long way in a relatively short amount of time, and we are optimistic about the changes taking place in this dynamic asset class.

Additional disclosure: Important Information

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.