Brazil Drags Down Emerging Market Performance

Emerging markets equities continue to be negatively affected by heightened investor concern over the likely direction of interest rates and weak economic news flow out of China

Lena Tsymbaluk 7 December, 2015 | 7:29AM
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Emerging markets have significantly underperformed the developed markets over the last three and five years. For the year-to-date to the end of October, the MSCI Emerging Markets index has fallen 9.5% in US dollar terms, while the MSCI World index for developed-country stocks has returned 0.3%.

Russia, despite being in recession, has been among the largest outperformers in 2015

Emerging markets equities continue to be negatively affected by heightened investor concern over the likely direction of interest rates and weak economic news flow out of China. The Fed’s signal that US interest rates would likely rise this year, despite its decision to keep them on hold at its September meeting, added to widespread uncertainty.

China, the largest constituent in the MSCI Emerging Markets index at 24%, has remained highly volatile in 2015. Following a strong rally in April-May driven by hopes of monetary easing, Chinese data pointed to a deepening slowdown in the economy and caused weakness in the equity market. Measures introduced by the Chinese authorities, such as encouraging banks to buy shares and banning the sale of equities by leading shareholders, somewhat stabilised the market. However, the unexpected devaluation of the yuan on August 11 raised uncertainty over Chinese economic policy and triggered a collapse in the Chinese market.

Brazil has been among the worst performing emerging-market countries, with the MSCI Brazil index falling 36% year-to-date. The country’s continued economic underperformance, deterioration of fiscal accounts, high unemployment, and even higher inflation have all added to asset volatility. In addition, low commodity prices and a slowdown in China, which has been a key source of demand for Brazil’s natural resources, have negatively affected Brazilian exports of iron ore and other raw materials.

Russia Provides Unexpected Bright Spot

Russia, despite being in recession, has been among the largest outperformers in 2015, with the MSCI Russia index returning 15.5% year-to-date. Following the worst sell-off among the world’s biggest equity markets in 2014, the market rebounded in the first half of 2015 as the oil price recovered and the crisis in eastern Ukraine eased. In addition, while the currency devaluation towards the end of last year was painful for consumers, it has delivered a boost to the competitiveness of Russian exporters.

In terms of outlook, Morningstar Head of UK Investment Strategy Andy Brunner believes emerging markets remain a difficult call having been a serial underperformer for some considerable time. Those of a bearish persuasion still see sizeable problems ahead. Economic slowdown, capital outflows from China, high levels of emerging markets corporate USD debt, further currency devaluations and more profit declines have rekindled memories of prior serious bouts of emerging-markets stress.

The main issue is the extent to which the Chinese economy slows; there is no doubt it is slowing and longer term it will continue to do so, but, even so, the economy is gradually undergoing a transformation, consumption is now 60% of the economy, retail sales volumes continue to rise in excess of 10% annually and job and wage growth remain strong. Most commentators believe a so-called economic “soft landing” may not be deliverable, but expect a “bumpy” rather than a “hard landing” as policymakers add to both monetary and fiscal easing measures. Consensus forecasts for the full year 2015 and for 2016 have all been revised lower and downside risks still predominate. 

Elsewhere, many emerging-market economies are considerably better positioned relative to past crises. Most no longer have pegged exchange rates, currencies have already depreciated substantially and in aggregate emerging markets run a current account surplus.

Funds to Consider for Emerging Market Exposure

Obvious contenders for emerging-market equity exposure are Morningstar Silver-rated Aberdeen and First State, which focus on large quality growth companies. Their expertise at running emerging-market mandates has led them to consistently deliver strong performance over most time periods, resulting in concerns over capacity and soft closures.  In terms of investment strategy, Aberdeen focuses on quality, sustainable, competitive business models with high returns on assets and capital, while First State favours firms with sustainable drivers of earnings growth and high standards of corporate governance.

There are a number of other strategies available for investors looking for emerging markets equities exposure. We have a high regard for Bronze-rated Fidelity Emerging Markets, which is managed by Nick Price and his team of four portfolio managers. The focus is on quality companies with proven track records of superior profitability and high returns on equity, which are able to fund growth using free cash flows. Another strong choice is Bronze-rated JOHCM Global Emerging Markets Opportunities fund, managed by James Syme and Paul Wimborne.

Unlike many peers, the investment approach is driven by top-down analysis of the 23 countries making up the MSCI Emerging Market index. At the stock level, the managers evaluate companies for their value and growth appeal. We also like PFS Somerset Global Emerging Markets, which is rated Bronze by Morningstar and benefits from an experienced manager Edward Robertson and the firm’s close-knit team. Somerset is a London-based boutique asset manager specialising in emerging-markets equities and was founded in 2007. There is a shared investment philosophy at Somerset that emphasises valuation and balance sheet strength.

The emerging-market small-cap sector is still relatively limited. Morningstar Bronze-rated Templeton Emerging Markets Smaller Companies is managed by the Templeton Research Team, whose experience in emerging market equities dates back to 1987. The strategy targets small-cap growth stocks trading at significant discounts and generally has two thirds of net assets in small-caps.

Increasingly, there are a number of emerging-market income funds available. The managers of these funds believe that a dividend discipline tends to lead to companies with stronger corporate governance and better capital allocation. Morningstar has some Bronze-rated emerging-market income funds, including PFS Somerset Emerging Markets Dividend Growth, Polar Capital Emerging Markets Income, and JPMorgan Emerging Markets Income.

This article was written by Morningstar fund analysts for Money Marketing magazine

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Lena Tsymbaluk