The Case for Emerging Markets

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1 The Case for Emerging Markets Economic recovery, low inflation, weak currencies, and reasonable valuations bode well for emerging markets Present The Future Weakening Global Trade China Slowing Improving Growth Outsized Percentage of World GDP Growth Commodities Falling Currencies Falling Commodity Stabilization Urbanization % Inflation Rising Fed Tightening Currency Stabilization, Benign Inflation Favorable Demographics

2 OppenheimerFunds Krishna Memani Chief Investment Officer Executive Summary EM growth has bottomed out and is improving. Real yields are positive as inflation has come down. Emerging market currencies are undervalued against the U.S. dollar. Flows into EM still relatively weak, valuations remain attractive compared to developed markets. Historically, emerging markets have performed well during rate tightening cycles. In the first 13 years of this century, emerging market equities outperformed U.S. equities by over 7% per year. That s almost 2% of cumulative outperformance. The following three years were not as kind to emerging market investors. Emerging market assets suffered from a series of macro headwinds including weaker global growth, sharp declines in emerging market exports, a collapse in commodity prices, falling currencies, rising inflation, and capital flight as U.S. monetary policy conditions normalized. The cyclical downturn notwithstanding, the death of emerging markets has been greatly exaggerated. Growth rates in many of the largest emerging market economies have stabilized and are now trending higher, commodity prices have bottomed, and currencies have steadied, bringing inflationary pressures under control. Meanwhile, favorable demographics and the prospect of further productivity gains in emerging economies should support growth. The cyclical emerging market economic backdrop, combined with still-relatively cheap valuations, suggests that emerging market equities are poised to outperform the developed world over the next market cycle. 2

3 The Right Way to Invest Emerging Markets Had Been Underperforming Since 213 MSCI Emerging Market Index vs. MSCI World Index (12/31/7 = 1) 13 Index Level (based to 1 at 12/31/7) Taper Tantrum First Fed Interest Rate Hike MSCI World (Developed) Index MSCI Emerging Market Index Prior to 217, emerging market equities experienced a prolonged period of underperformance relative to developed market equities. A confluence of factors weighed on emerging market performance including weaker global demand for exports, a slowdown in Chinese growth, the end of the multi-year commodity and credit-driven boom, and tighter U.S. monetary policy. In particular, the onset of monetary normalization in the United States, beginning in earnest with the tapering of U.S. Federal Reserve (Fed) asset purchases in 213 and continuing with the first Fed interest rate hike in December 215, resulted in a massive flight of capital out of the emerging markets and into U.S. dollar-denominated assets. The tide now appears to be turning. The cyclical case for emerging market equities is supported by the following: 1. Economic growth is improving (in some instances, such as in Russia and Brazil, off of recession lows) and exceeding expectations. 2. Inflation has fallen rapidly. Real interest rates are now positive in emerging markets suggesting that, this time, modest U.S. interest rate hikes will not result in significant capital flight. In addition, policymakers are better positioned to support economic growth. 3. Emerging market equities are trading at attractive valuations compared to developed market equities. 4. The U.S. dollar is unlikely to be a headwind for U.S.-domiciled international investors. Many of the emerging market currencies are already trading at steep discounts. 5. The likelihood that a series of Fed rate hikes will derail the nascent emerging markets economic recovery is small. Source: Bloomberg, 2/28/17. Past performance does not guarantee future results. 3

4 OppenheimerFunds EM Growth Has Bottomed Out and Is Improving China Russia EM Composite PMI vs. EM Equity Returns Year-over-Year % Change 1% India Diffusion Index CRB Raw Commodity Index (Right) China Imports (Left) Expansion Contraction 216 9% India Manufacturing Purchasing Managers Index Year-over-Year % Change Year-over-Year % Change 8% Brazil Diffusion Index Russia Exports Expansion 211 Contraction Brazil Manufacturing Purchasing Managers Index 217 Diffusion Index (%) Correlation Coefficient =.81 EM Composite PMI (Left) MSCI EM (Right) Year-over-Year % Change Emerging market growth bottomed in 216 and has since exceeded expectations. In China, massive policy support helped drive increases in internal and external demand for goods and services by corporations and households. China s recovery also boosted demand globally for commodities, providing a tailwind and a path out of recession for Russia and Brazil. India s economy has also bottomed following the decline in activity resulting from the government s move to demonetize and replace its largest bank notes. Along with Brazil, Russia, India and China, many other emerging economies, including South Africa and Indonesia, have experienced significant improvements in current account balances over the past three years. Leading indicators, as represented by the Purchasing Managers Index, continue to point higher in emerging markets, providing a potential tailwind for the financial markets. Sources: Bloomberg, Haver Analytics and Markit, 2/28/17. 4

5 The Right Way to Invest China Is Not Collapsing as the Naysayers Feared It Would Share of Nominal GDP by Sector % Services Cell Phone Users 756 million 1.32 billion Manufacturing Online Shoppers 1 million 52 million Services Manufacturing Vehicle Sales 11.9 million 21. million There has been a widely held view, sowed by a skeptical Western press, that the Chinese economy has been on the verge of imminent collapse. The reality is very different. China has successfully transitioned from a heavy industries and manufacturing economy to a service-oriented economy. China s policymakers have initiated a series of reforms aimed at spurring higher-value exports and promoting consumption-led growth driven by rising middle-class income. Over the past 1 years, the average annual salary in China has more than doubled, leading to massive increases in discretionary spending in areas such as smartphones, online shopping and vehicle sales. The private sector in China is vibrant and growing. State-owned enterprises now represent less than one-fifth of industrial output, down from nearly 8% in the late 197s. Select Chinese companies are among the most innovative and rapidly growing companies in the world. China s rising debt levels do continue to raise concerns as real estate developers and local governments borrow heavily to finance infrastructure projects. However, we believe that these fears are likely overstated. China s construction spending per capita is generally in line with that of South Korea and Taiwan during their economic booms. Further, the Chinese government retains the financial flexibility to respond to any potential crisis, both at the local level or within the financial system, as total debt at the federal and state level stand well below that of most advanced economies. Source: Bloomberg, 2/28/17. 5

6 OppenheimerFunds Real Yields Are Positive as Inflation Has Come Down Consumer Price Index by Country 9% Average Real Yields of EM 1-Year Bonds Year-over-Year % Change Year-over-Year % Change India China Russia Brazil Indonesia Taper Tantrum Average ( ) Current Inflation has fallen across most emerging market economies due to the combination of a weak economic backdrop in 214 and 215 and a sharp decline in energy prices. Energy inflation is now accelerating off of a weak base but, in most countries, core inflation (excluding food and energy) remains subdued. This relatively benign inflation backdrop provides central bankers in most emerging market countries with the flexibility to provide monetary policy support to the promising economic recoveries. Importantly, as inflationary pressures have moderated, average real yields in emerging markets have approached cyclical highs. Given the attractive real yields in emerging markets, the potential for another taper tantrum (i.e., capital flight out of the emerging markets as the Fed raises U.S. interest rates) is unlikely. Source: Bloomberg, 2/28/17. Countries included in the average real yield calculations are India, Russia, China, Mexico, Indonesia, Turkey and Brazil. Real yields are the nominal yield of a country s sovereign bond minus the year-over-year change in their respective consumer price index. Past performance does not guarantee future results. 6

7 The Right Way to Invest Emerging Market Currencies Are Undervalued Against the U.S. Dollar Currency Over/Undervaluation vs. USD on Purchasing Power Parity Percent Under (-) / Overvalued (+) 7% South Africa 62.7% Russia 57.5% Mexico 55.9% Indonesia 54.% India 5.8% Turkey China Cheap vs. USD 45.7% 44.1% Brazil 1 1.1% Expensive vs. USD For U.S. investors, a prolonged period of U.S. dollar strength has created a headwind to emerging market equity returns. Emerging market currencies had previously weakened as global economic growth slowed and the prospects of protectionist policies from the Trump Administration and Fed interest rate hikes loomed. We believe that U.S. dollar strength is unlikely to hurt investors in emerging market equities over the next cycle. Many emerging market currencies are now trading at deep discounts versus the U.S. dollar on a purchasing power parity basis. Fundamentals are improving, including significant improvements in the capital accounts in countries such as India, Brazil, Indonesia and China. Relatively benign inflation in the emerging markets and positive real yields on sovereign bonds are generally supportive for currencies. Source: The Economist Big Mac Index, 1/12/17. Index is unadjusted and is based on the theory of purchasing power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries. Past performance does not guarantee future results. 7

8 OppenheimerFunds Strengthening Currencies, Growth Accelerating, Current Account Balances Improving Currencies and Growth Tend to Move in the Same Direction MSCI EM Currency vs. Emerging Market Manufacturing PMI Index Current Account Balance 3 2 Expansion India South Africa Year-over-Year % Change Contraction Diffusion Index Turkey Brazil Indonesia China Russia Mexico MSCI EM Currency (USD, Left) Emerging Markets Manufacturing Purchasing Managers Index (Right) Yr. Current Account Balance Change in % of GDP Since Q2 213 For U.S. investors, there is a silver lining to the emerging market currency declines in 214 and 215. The currency weakness has made imports more expensive and helped restore emerging market competitiveness, resulting in improved current account balances since 213. The dollar value of exports from emerging market countries is forecasted to rise for the first time since 214. Leading indicators of emerging market economies, as represented by the Purchasing Managers Index, began to reaccelerate as currencies were bottoming. The improvements in emerging market fundamentals (economic growth and the current account balances) make the emerging market economies significantly less vulnerable than in 213 and 215 to capital flight as the Fed raises interest rates. Source: Haver Analytics, 2/28/17. 8

9 The Right Way to Invest Flows into EM Still Relatively Weak, Valuations Remain Attractive Compared to Developed Markets Morningstar Estimated Monthly Net Flows into Emerging Markets 23-Present $154B 1B Price to Sales MSCI Emerging Markets Index/MSCI World Index EM Expensive DM Cheap Billions of Dollars Price to Sales EM Cheap DM Expensive Shaded Areas Represent Recessions Sentiment for emerging market equities is improving off of very weak levels. After experiencing massive inflows between 29 and 213, funds flowed out of emerging market equities for much of 215 and 216. Flows turned positive again in early 217, but remain relatively weak. Emerging market valuations also appear attractive and, on almost any valuation metric including price to sales, are trading as cheap to developed markets as they have since 21. At that time, emerging market economies represented 21% of global GDP. Today, they represent 35% of world GDP and that number is climbing. The last time emerging market equities traded this cheap relative to the developed world, they outperformed the S&P 5 Index significantly over the next 12 years. Source: Morningstar, 3/1/17. Note: U.S. open-end funds and ETFs excluding money market funds, fund of funds and obsolete funds. 9

10 OppenheimerFunds Historically, Emerging Markets Have Performed Well During Rate Tightening Cycles MSCI EM Index vs. Fed Funds Rate Fed Funds: +3.5% 6, MSCI EM: +31.6% Fed Funds: +4.25% MSCI EM: % 215? Fed Funds: +.75% MSCI EM: +13.1% 12 Index Level 5,, 3, 2, 1, Federal Reserve Benchmark Interest Rates MSCI EM Index (left axis) Fed Funds Target Rate (right axis) Historically, emerging market equities have performed well during Fed rate-tightening cycles. Emerging market equity underperformance during the 213 taper tantrum and in the lead up and aftermath of the December 215 interest rate hike is more of a historical anomaly than the norm. In fact, emerging market equities returned a cumulative 123% during the rate-tightening cycle. As described earlier, macro conditions in the emerging markets are different today than they were in 213 and 215. The likelihood that a series of Fed rate hikes will derail the nascent emerging markets economic recovery is small. Source: FactSet, 2/28/17. Past performance does not guarantee future results. 1

11 The Right Way to Invest The Long-Term Trends Still Favor Emerging Markets Germany 5% Italy 3% UK 3% Canada 3% 217 Estimate (E) EM 38% of World Economy Other Dev 9% Japan 8% France 4% U.S. 28% Russia 3% Brazil 3% India 3% China 11% Other EM 18% India Other Brazil Dev 8% 9% 5% Japan Russia 8% 4% Japan 4% France 3% Germany 4% Italy 2% UK 4% Canada 2% 235 Estimate (E) EM 6% of World Economy U.S. 21% China 28% Other EM 15% Working Age Population Population Size 5,,, 4,,, 3,,, 2,,, 1,,, 6.8% Developed World Population in 216 Population in % Emerging Markets Finally, the long-term emerging market macro story is still intact. Growth in developed economies is forecasted to stagnate in the coming years while emerging market growth is expected to accelerate. By 235, it is estimated that emerging market countries such as Russia, Brazil, India, China and others will represent 6% of world economic activity, up from 37% today. A coming surge of labor-force age emerging market citizens will drive much of that growth. The working-age population in the developed world is forecasted to decline 6.8%, from 411 million people in 216 to 383 million people in 25. By way of comparison, the working-age population in the emerging markets is poised to surge 135%, from 1.8 billion people today to 4. billion people by 235! In our view, this massive inflow of productive people in the labor force will ultimately represent one of the great investment opportunities of our lifetime. Sources: The U.S. Census Bureau and World Bank Forecasts, as of 1/31/17. Forecasts may not be achieved. Past performance does not guarantee future results. 11

12 OppenheimerFunds Contributors Brian Levitt Senior Investment Strategist Talley Léger Investment Strategist Timothy Horsburgh, CFA Investment Strategist 12

13 The Right Way to Invest Index Definitions The S&P 5 Index is a market-capitalization-weighted index of the 5 largest domestic U.S. stocks. The MSCI World Index is designed to measure the equity market performance of developed markets and includes the U.S., Eurozone area, Japan and Canada. The MSCI Emerging Market Index is designed to measure the equity market performance of the emerging markets. The Commodity Research Bureau (CRB) Raw Commodity Index is designed to measure the price performance of raw input commodities and includes the prices of various metals, textiles and fibers. Markit India Manufacturing Purchasing Managers Index is designed to measure the relative optimism of purchasing managers in the manufacturing sector in India and indicates the economic conditions of an economy. Markit Brazil Manufacturing Purchasing Managers Index is designed to measure the relative optimism of purchasing managers in the manufacturing sector in Brazil and indicates the economic conditions of an economy. Markit/HSBC Composite Emerging Market Purchasing Managers Index is designed to measure the relative optimism of purchasing managers in both the manufacturing and services sector across all emerging markets and indicates the economic conditions of an economy. Gross Domestic Product (GDP) is a measure of all of the goods and services produced within an economy during a year. The Economist Big Mac Index is based on the theory of purchasing power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries therefore identifying whether a currency is over or undervalued. MSCI EM Currency Index is a measure of a basket of emerging market currencies against the United States dollar. Markit Emerging Markets Manufacturing Purchasing Managers Index is designed to measure the relative optimism of purchasing managers in the manufacturing sector across all emerging markets and indicates the economic conditions of an economy. Current account balances are a measure of a country s savings and investment including the sum of the balance of trade (exports minus imports) and net income from abroad along with current transfers The Fed Funds Rate is the benchmark short-term interest rate level set by the Federal Open Market Committee. Working age population is defined by the number of people between the ages of in a given country at a certain time. Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results. 13

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16 Visit Us oppenheimerfunds.com Call Us Follow Us These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the close of business on March 31, 217, and are subject to change based on subsequent developments. Equities are subject to market risk and volatility; they may gain or lose value. Fixed-income investing entails credit and interest rate risks. Bonds are exposed to credit and interest rate risk. When interest rates rise, bond prices generally fall, and a fund s share prices can fall. Investments in securities of growth companies may be especially volatile. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and geopolitical risks. Emerging and developing markets may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues. The mention of specific countries, regions, or sectors does not constitute a recommendation by any particular fund or by OppenheimerFunds, Inc. Shares of Oppenheimer funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. Before investing in any of the Oppenheimer funds, investors should carefully consider a fund s investment objectives, risks, charges and expenses. Fund prospectuses and summary prospectuses contain this and other information about the funds, and may be obtained by asking your financial advisor, visiting oppenheimerfunds.com or calling 1 8 CALL OPP ( ). Read prospectuses and summary prospectuses carefully before investing. Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc., 225 Liberty Street, New York, NY OppenheimerFunds Distributor, Inc. All rights reserved. TH April 5, 217