M&G Emerging Market Equities

Transcription

1 M&G Emerging Market Equities 2019: Opportunities amid uncertainty Michael Bourke FOR INVESTMENT PROFESSIONALS ONLY December 2018 Trade tensions and higher interest rates in the US weighed on emerging market equities in 2018 Macroeconomic concerns are likely to continue to influence markets in 2019 Valuations are attractive, particularly among cheaper, value stocks Michael Bourke was appointed manager of the M&G (Lux) Global Emerging Markets Fund* from launch in October He joined M&G s Emerging Markets Equities team in 2015 and has managed the M&G (Lux) Emerging Markets Income Opportunities Fund, an income-focused fund investing in emerging market equities and corporate bonds, since its launch in May Michael previously worked at Legg Mason and Deutsche Bank and has more than a decade s experience in emerging markets investing. In this introductory Q&A, Michael explains his investment approach, looks back at what has driven emerging markets in 2018 and shares his views on the current opportunities and challenges for emerging market investors. Investment approach What is your investment philosophy and process? Just like my predecessor Matthew Vaight (who managed the M&G Global Emerging Markets Fund, the UK-authorised OEIC, between its launch in February 2009 and October 2018), I believe that company fundamentals, especially value creation, are the primary driver of stockmarkets. My approach focuses on return on capital I believe the level of returns that companies generate has strong explanatory power for their share price performance. Trust is another important element of my approach. I want to invest in companies where there is alignment between the interests of management teams and shareholders. Management should be focused on using capital efficiently, to create long-term value for shareholders. It may sound obvious, but it is important to remember that the price you pay for a stock is a significant determinant of returns. In emerging markets, it is easy to overpay for future growth. As a value-oriented investor, I look for stocks whose long-term returns are being undervalued. My process is bottom-up I select stocks on their individual merits, rather than according to my views on particular countries or sectors. I consider the wider macroeconomic backdrop, but this is mainly to help me understand the environment in which firms operate. Please note that the value of investments and the income from them will rise and fall. This will cause the fund price, as well as any income paid by the fund, to fall as well as rise. Emerging markets can be volatile, so we try to build a diversified portfolio with different types of stocks or baskets. We combine companies that have low, but improving, levels of returns on capital with higher-quality businesses that have high and sustainable levels of returns. Each basket has different risk/reward characteristics and combining them helps create a balanced portfolio that has the potential to cope in varied market conditions. Is it possible to mitigate some of the risks associated with emerging market investing? Emerging market equities are generally considered to be a higher-risk asset class, as they can experience more volatility than developed markets. But investors with a longterm investment horizon, such as pension funds, should be able to cope with short-lived periods of short-term volatility and enjoy the long-term capital growth they offer. Many investors, particularly those with an income focus, have adopted an absolute-return mindset lately focusing on the return on the particular asset, rather than looking at it in comparison with another asset or a benchmark. In recognition of this development, with the M&G (Lux) Emerging Market Income Opportunities Fund we have developed a strategy that aims to deliver an annual income of 4-6% from investing in emerging market assets. Please note there is no guarantee the fund will achieve its objective, and you may not get back the amount you originally invested. The M&G (Lux) Emerging Market Income Opportunities Fund combines the best ideas from across the emerging market corporate bond and equity markets. We look for bonds with attractive yields and higher-quality equities that * On 26 October 2018, the non-sterling assets of the M&G Global Emerging Markets Fund, a UK-authorised OEIC, which launched on 5 February 2009, merged into the M&G (Lux) Global Emerging Markets Fund, a Luxembourg-authorised SICAV, which launched on 26 October The SICAV is run to the same investment strategy as the UK-authorised OEIC.

2 offer the prospect of income and capital growth. By blending these two types of assets, we believe we can deliver a relatively stable level of income from the corporate bonds as well as potential capital growth from the equities. With the bonds typically denominated in US dollars and equities in local currencies, the fund should have lower levels of currency risk than an emerging market equity fund. However, changes in currency exchange rates will affect the value of your investment. You should also be aware that the value of the fund may fall if the issuer of a fixed income security held is unable to pay income payments or repay its debt (known as a default). Given the breadth of the combined emerging market corporate bond and equity universe, the fund is well diversified. In our view, this product is an interesting new approach to emerging market investing that could potentially appeal to a wide range of investors. However, investors are reminded that emerging markets are generally less liquid and more sensitive to economic and political factors. In exceptional circumstances, the fund may encounter difficulties when selling or collecting income from these investments, which could cause the fund to incur a loss. In extreme circumstances, it could lead to the temporary suspension of dealing in shares in the fund. Review of 2018 How have emerging markets performed in 2018? Investors have become increasingly cautious about emerging markets this year. After an impressive rally in 2017 emerging market equities have fallen steeply in 2018 as concerns about rising interest rates in the US, trade tensions between the US and China and a potential slowdown in global economic growth have dampened investor confidence. They have also significantly underperformed developed markets. Investors worries about the macroeconomic situation have been expressed most clearly through emerging market currencies, which have weakened against the US dollar this year. The decline in the Turkish lira, driven by concerns about the country s financial position, was particularly notable. The Indonesian rupiah has fallen steeply to levels more typically associated with crisis periods. In our view, some of these declines are excessive, and selective currencies look good value. Currency movements have also distorted the performance of several stockmarkets. For instance, Brazil s stockmarket is in positive territory this year, but the depreciation of the Brazilian real against the dollar means the returns for overseas investors are much more modest. This suggests to us that investors have focused on the macroeconomic environment and issues such as US monetary policy, rather than fundamentals. Views on markets and sectors Where have you been finding opportunities recently? As value-focused investors, we are drawn to cheaper, outof-favour areas of the market. We believe that volatility can present opportunities to buy mispriced stocks, and over the summer we took advantage of the sell-off in Turkish assets. We have had concerns about Turkey s macroeconomic situation: the country has a large current account deficit and recent economic growth has been fuelled by debt. However, in the crisis Turkish stocks screened up as cheap, and we started a position in Koc, a large, diversified conglomerate. Koc s businesses include finance, energy and automotive services. Around 50% of the company s revenues come from exports, which could, in our view, benefit from the weakness in the lira. The company also has a good record of capital allocation and creating value. While there are concerns that currency depreciation might lead to rising levels of bad debts in Turkey, we believe Koc is a strong company with sound finances and is very attractively valued. More recently, we have taken advantage of macroeconomicrelated weakness in Brazil and the Philippines to invest in Brazilian private education company Kroton Educacional and GT Capital, a conglomerate from the Philippines. Broadly speaking, we currently see value in China and Latin America. However, given our valuation-focus, we struggle to find interesting opportunities in the more expensive markets such as India and Indonesia. The pace of reforms under way in India is impressive and reminiscent of China a decade ago. Despite the potential benefits of these changes, we think the valuations of Indian equities are too high and investors are being asked to pay too much for future returns. What is your view about the outlook for China? We think US tariffs represent a real threat to the Chinese economy. In the past, China did not face such a hostile US president, who appears determined to change the trading relationship between the two countries. If the tariffs on US$200 billion worth of Chinese goods rise to 25% from 10% next year, as proposed, and other duties are introduced, it could have a significant impact on China.

3 We expect the Chinese government to respond to the challenge with some kind of stimulus to support the economy. The issue is that the government is already trying to tackle the problems caused by previous debt-fuelling stimulus measures. Deleveraging and supply-side reforms (reducing excess capacity in industries such as steel) have taken place to try and stabilise the economy. We expect to see some non-performing loans, but we don t believe this will result in a financial crisis. Debts are being written off and restructured, which should help the situation, even if it is not great for investors. The government s current focus is on the quality of growth, rather than simply the rate of growth. For investors, this shift to a more sustainable, efficient growth model could be a positive development. As China s economy is increasingly driven by consumption and services, there could be plenty of interesting investment opportunities. Do you see opportunities in China A shares? With the inclusion of mainland shares in the MSCI Emerging Markets Index, China is becoming increasingly prominent for investors. We may see more China-focused funds in future. At present, we have no China A shares in our portfolios. While there are some exciting opportunities available, they tend to have high valuations and generally do not meet our requirements on corporate governance and capital allocation. There are changes happening, however. Businesses and management teams in China are becoming higher quality and there is greater understanding of the needs of overseas investors. We are at the start of a journey that will arguably lead to overseas investors having a greater allocation to A shares in future. The M&G (Lux) Emerging Market Income Opportunities Fund may invest in China A shares. Please note that investments in assets from the People's Republic of China are subject to changeable political, regulatory and economic conditions, which may cause difficulties when selling or collecting income from these investments. In addition, such investment is made via the 'Stock Connects' systems, which may be more susceptible to clearing, settlement and counterparty risk. These factors could cause the fund to incur a loss. What is your view on the energy sector? The oil price has been volatile this year. After climbing to the highest level in four years, it has experienced a steep decline in recent months amid concerns about oversupply and slowing global growth. As many emerging markets are net importers of oil, they are sensitive to changes in the oil price. India and Turkey are notable examples where lower oil prices certainly help their economies. In the equity portfolio, we are overweight energy, which has been helpful this year as the sector has been one of the best performers. Chinese energy firms CNOOC and Sinopec have benefited from higher oil prices. Counterintuitively, we don t want oil prices to go up too much. Rising prices lead to cost inflation and we want companies to keep their costs stable. When oil prices are at US$70 a barrel, companies are generally more profitable. Management teams typically think about projects based on a low oil price, which helps ensure their returns are more resilient. Outlook What should we expect in 2019? We believe uncertainty about the macroeconomic situation is likely to weigh on markets in the coming months. The trade dispute between the US and China remains a key risk. Additional US tariffs on Chinese goods could lead to a fullblown global trade war. Meanwhile, continued monetary tightening in the US and further appreciation of the US dollar are also potential headwinds for the asset class. Despite these concerns, we are optimistic about the potential long-term returns from emerging market assets. Valuations are the main reason for our positive view. After recent declines, emerging market stocks currently trade at a significant discount to their historical average and relative to developed markets. In particular, we think that cheap value stocks are very attractive. In recent years, investors globally as well as in emerging markets have favoured growth stocks, notably fast-growing technology firms, propelling these stocks to ever higher valuations. In contrast, value stocks have largely been overlooked and trade on much more attractive valuations, in our view. We recognise that many growth stocks, such as Chinese internet companies Alibaba and Tencent, are great businesses with exciting prospects, but we think investors have been paying too high a price for their future growth. Encouragingly, during the recent market sell-off the share prices of these companies have fallen steeply, whereas value stocks have been relatively resilient. Investors seem to be starting to question the elevated valuations of growth stocks and their prospects. At the same, time they appear to be looking more favourably on value stocks. What are the challenges for emerging markets?

4 On the whole, we think investor sentiment towards emerging markets is too pessimistic. In our view, fundamentals and underlying corporate performance broadly remain robust. However, there are a number of macroeconomic headwinds that could curb investors enthusiasm for the asset class. One of the challenges is that higher interest rates in the US and the appreciation of the dollar make US assets, including cash, attractive to risk-averse investors. December 2018 In the past, rising rates have tended to be good for emerging markets as they have been a sign of robust economic growth. In this cycle, the pace of rate hikes is key. The Fed has raised rates gradually over the past few years and policymakers appear to recognise the risks of tightening policy too fast. Given the combination of attractive valuations and robust fundamentals today, we believe there are currently attractive opportunities for contrarian, long-term emerging market investors. M&G Michael Bourke The M&G (Lux) Global Emerging Markets Fund invests mainly in company shares and is therefore likely to experience larger price fluctuations than funds that invest in bonds and/or cash. The M&G (Lux) Emerging Markets Income Opportunities Fund allows for the extensive use of derivatives. Further risks associated with the funds can be found in their Key Investor Information Document. For Investment Professionals, Institutional Investors, Accredited Investors and Professional Investors only. Not for onward distribution. No other persons should rely on any information contained within. Distribution of this document in or from Switzerland is not permissible with the exception of the distribution to Qualified Investors according to the Swiss Collective Investment Schemes Act, the Swiss Collective Investment Schemes Ordinance and the respective Circular issued by the Swiss supervisory authority ("Qualified Investors"). Supplied for the use by the initial recipient (provided it is a Qualified Investor) only. In Spain the M&G Investment Funds are registered for public distribution under Art. 15 of Act 35/2003 on Collective Investment Schemes as follows: M&G Investment Funds (1) reg. no 390, M&G Investment Funds (2) reg. no 601, M&G Investment Funds (3) reg. no 391, M&G Investment Funds (5) reg. no 972, M&G Investment Funds (7) reg. no 541, M&G Investment Funds (9) reg. no 930, M&G Investment Funds (12) reg. no 1415, M&G Investment Funds (14) reg. no 1243, M&G Global Dividend Fund reg. no 713, M&G Global Macro Bond Fund reg. no 1056 and M&G Optimal Income Fund reg. no 522, M&G (Lux) Investment Funds 1 reg. no The collective investment schemes referred to in this document (the "Schemes") are open-ended investment companies with variable capital, incorporated in England and Wales in respect of M&G Investment Funds and in Luxembourg in respect of M&G (Lux) Investment Funds. In the Netherlands, all funds referred to are UCITS and registered with the Dutch regulator, the AFM. For Hong Kong only: The contents of this document have not been reviewed by any regulatory authority in Hong Kong. You are advised to exercise caution in relation to the offer of any funds mentioned in it. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. Shares, units or other interests in the funds mentioned in this document may only be offered or sold in Hong Kong to persons who are professional investors as defined in the Securities and Futures Ordinance ( Ordinance ) and any rules made under the Ordinance or in circumstances which are permitted under the Companies (Winding Up and Miscellaneous Provisions) Ordinance. In addition, distribution of this document in Hong Kong is restricted. It may not be issued or possessed for the purposes of issue, whether in Hong Kong or elsewhere, and shares, units or other

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