A Positive Start to the Second Half of 2018 for Emerging Markets
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- Randell Greer
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1 Investment Team Update 31 July 2018 A Positive Start to the Second Half of 2018 for Emerging Markets EMERGING MARKETS INSIGHTS Three Things We re Thinking About Today 1. The left-wing coalition headed by Andrés Manuel López Obrador (AMLO) won by a landslide in Mexico s general election. We do not expect a radical change in terms of Mexico s fiscal or central bank policy as a result of AMLO s win. Overall, we continue to have a positive outlook for the country. High consumer confidence, combined with a gradual disinflation process, a healthy labor market and credit availability, should help support private consumption this year. If the new administration can deliver on its promises and still preserve solid economic fundamentals, we could see healthy growth in Mexico this year and in The recent market correction across emerging markets has made valuations even more attractive, helping us find interesting opportunities related to secular technological trends. Growth in the e-commerce sector, for example, continues to accelerate, gaining an increasing share of the retail market in countries such as China and India. We believe the long-term growth of e- commerce companies hinges on their ability to scale and increase their market penetration. More importantly, these companies are using innovation to their advantage to disrupt traditional business models in other industries such as transportation and health care to pursue new revenue streams. 3. We believe China s deleveraging process has been more orderly than may appear at first glance. The fact that regulators allow banks to report non-performing loans reflects their confidence in the system s ability to bear those losses. We remain positive on China s overall growth trajectory. Some observers estimate that the trade war and other issues could shave up to 100 basis Market Performance (MSCI EM Index, USD) Cumulative Return +Brazil (11.8%) -Turkey (-7.2%) +Qatar (11.6%) -Egypt (-3.3%) +Poland (11.4%) -China (-2.4%) Sector Performance (MSCI EM Index, USD) Cumulative Return +Energy (7.1%) -Health Care (-6.1%) +Materials (6.1%) -Consumer Discretionary (-2.3%) +Utilities (5.5%) -Information Technology (0.0%) Currency Performance (vs. USD) % Change +Mexico (5.3%) -Turkey (-6.7%) +South Africa (4.6%) -China (-2.9%) +Hungary (2.9%) -Pakistan (-1.9%) Source: FactSet, one-month period ending 31/07/18. points off China s gross domestic product (GDP) growth, but this is not much considering that growth is still expected to exceed 6%. We continue to favor companies that stand to benefit from structural trends like e-commerce, growing affluence and premiumization. Outlook Rising trade tensions, particularly between the United States and China, have prompted a cautious investor outlook, affecting emerging markets over the short term. However, we believe the market correction was overdone, and we could see a widespread recovery in the second half of the year. In our opinion, what has been hurting sentiment is not trade policy itself, but continual trade tensions and uncertainty. We believe businesses can adapt and develop long-term strategies around trade policies once there is greater clarity. We consider fears regarding US dollar strength to be overblown. While a few countries such as Argentina and Turkey may have skewed overall perceptions, we believe that many emerging-market (EM) currencies are attractively valued and well-supported after recent downward moves. On the US dollar, short-term risk aversion and a slight upward move in the interest rate trajectory have contributed to strength, but we do not expect these drivers to be sustained over the long term. EM equity fundamentals remain strong, a factor largely ignored by the market. Cash flow generation has accelerated considerably, which, when paired with better capital allocation discipline, improves returns to shareholders and results in corporate balance sheet deleveraging. Similarly, earnings growth has been resilient, supported by technological advances and domestic drivers such consumerism. Moreover, valuations have become even cheaper despite this good news. A note to our readers: Given the rapid changes that can take place in global markets, it is often difficult to provide up-to-date materials that address the most current situations. The following update is valid only as of 31 July 2018.
2 Our investment philosophy remains centered on three tenets: value, patience and a bottom-up approach. We take a holistic view of value to also assess sustainability, quality and growth. Emerging Markets Key Trends and Developments EM equities rebounded in July but trailed their developed-market counterparts. Constructive trade talks between the United States and European Union eased fears of a global trade war and lifted investor sentiment. EM stocks recorded their first monthly gain since January this year, aided by local currency strength against the US dollar. The MSCI Emerging Markets Index returned 2.3% over the month, compared with a 3.1% gain in the MSCI World Index, both in US dollars. E-Commerce Penetration Rates: U.S. vs. China ( E) 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% e Ecommerce penetration as % of total retail sales - China Ecommerce penetration as % of total retail sales - USA Sources: JP Morgan Equity Research via FactSet (January 9, 2018 China Consumer Sector 2018 Outlook ); iresearch; National Bureau of Labor Statistics. Telsey Advisory Group Research via Factset (May 7, 2018 AMZN Initiating OP Still AMaZING Growth Ahead); US Census Bureau; TAG Estimates. The Most Important Moves in Emerging Markets This Month Asia recovered amidst hopes for a respite in global trade tensions. Thailand, the Philippines and India advanced the most. Thailand's economic activity continued to accelerate, and the government raised its outlook for export growth this year. India rallied on a string of positive news, including strong corporate earnings and lower goods and services taxes on a range of consumer products. Conversely, China and South Korea declined. China was held back by ongoing trade tensions with the United States and the yuan's fall against the US dollar. South Korea trimmed its economic growth forecast for 2018, citing weakness in investments and the labor market. Positive political developments and stronger domestic currencies propelled Latin American markets in July. Brazil and Mexico were among the top markets. Equity prices in Brazil were driven by favorable election news, strong earnings results and appreciation in the real. In Mexico, despite some initial fears of a less business-friendly administration, the peso and financial markets largely rallied in July, as the new government vowed to uphold fiscal discipline, maintain an independent central bank and indicated that implemented reforms, including the privatization of the energy sector, would not be reversed. Colombia, in contrast, declined, largely due to a fall in oil prices. Easing concerns about a trade war between the United States and the European Union in July bolstered emerging European markets. Poland and the Czech Republic were among the top-performing markets in the region. Undemanding valuations continued to attract investors to the Russian market, despite declining oil prices in July. Turkey, however, significantly lagged its peers. Higher-than-expected inflation, inaction from the central bank and a devaluation in the lira weighed on equity prices. South Africa's market was supported by growing reform expectations under President Ramaphosa, improved business and consumer confidence, and an appreciation in the rand. Frontier markets rebounded in July, faring better than their EM and developed-market peers. Argentina, Bahrain and Kuwait led performances. The Argentine market bounced back with a double-digit return after a weak first half, supported by an appreciation in the peso. Positive sentiment in Kuwait continued to be driven by the expected FTSE upgrade later this year and hopes of inclusion in the MSCI Emerging Markets Index in the future. At the other end of the spectrum, Bangladesh, Jordan and Oman ended the month with declines. A Positive Start to the Second Half of 2018 for Emerging Markets 2
3 Regional Outlook Three-Month Period Ended 30 June 2018 Market ( ) N (+) Investment Thesis Asia China India Indonesia South Korea Pakistan Taiwan Thailand Vietnam Europe Czech Republic Hungary Russia Turkey Strong macro fundamentals, but trade and geopolitical concerns might affect some markets. The overall outlook for China remains stable but we are cautious as uncertainties are rising. Supply side reforms and deleveraging could help ease structural risks but rising trade tensions could offset the benefits of stronger global growth. The RMB is at risk from a stronger US dollar driven by increases in US interest rates. Strong macro fundamentals, under-penetration, formalisation of economy and a stable government, but near-term earnings challenges lead us to maintain a neutral view on the market. Economic growth has been recovering slowly. However, politics will likely heat up in 2018 with the presidential election in April Macro indicators remain sound. The geopolitical situation warrants close attention, while concerns about government regulations are growing. Uncertainty remains with concerns on a political reshuffle and high current account deficit. Cross-strait geopolitical risk has always existed and is well-known. Macroeconomic data remain healthy but inflation may start to rise, pressuring interest rates. While a strong Taiwanese dollar weighed on corporate earnings, recent weakness should ease concerns. Overall outlook is positive. Economic stability remains strong with continued improvement in economic growth. The upcoming general election could further boost sentiment. Steady outlook. GDP above 6%, underpinned by resilient domestic demand, rebounding agricultural production, and strong export-oriented manufacturing. Solid economies with attractive valuations, but political uncertainty may weigh on some markets. The recent business survey data were positive and inflation has moderated recently. The central bank s latest assessment signals a modest deceleration of real GDP growth to 3.4%, from its earlier forecast of 3.9%. Economic data generally remain strong in recent months, with high industrial and construction confidence, but consumer sentiment normalising back to previous high levels from the exceptionally large jump in April. The central bank remains committed to a loose monetary stance. In a stable oil price/ruble environment, domestic names should benefit due to earnings revisions and increased demand. The political situation should remain stable with the next presidential election scheduled for However, macro risks remain high due to volatile commodity prices and the possibility of additional US/EU sanctions. Turkey currently employs a tight monetary policy and slightly expansionary fiscal policy with an expected GDP growth of 3%. If the economy cools down and inflation normalises, Turkey could offer significant upside in view of its undemanding valuations. cont d. The graphic reflects the views of Franklin Templeton Emerging Markets Equity regarding each region. All viewpoints reflect solely the views and opinions of Franklin Templeton Emerging Markets Equity. Not representative of an actual account or portfolio. A Positive Start to the Second Half of 2018 for Emerging Markets 3
4 Regional Outlook, continued Three-Month Period Ended 30 June 2018 Market Latin America Argentina Brazil Mexico Peru Middle East Kuwait Qatar Saudi Arabia United Arab Emirates Africa Egypt Kenya Nigeria South Africa ( ) N (+) Investment Thesis Solid economic situation but political elections in 2018 may result in increased volatility in some markets. Portfolio outflows have resulted in a run on the currency, higher inflation, lower GDP growth and a change in the political outlook. The presidential campaign has already started and public confidence in the government has been negatively impacted by events in late April / early May. The IMF agreement could support asset valuations but it is far from clear that a sustainable recovery in sight. The near-term outlook is challenging in view of 2018 presidential elections, which could bring higher volatility, although a favorable outcome is expected. Our long-term outlook is positive with a new president likely to continue promoting reforms. Macroeconomic outlook is stable and equity valuations are below historical averages. We believe Mexico s risk profile has increased with the ongoing NAFTA renegotiation and the 2018 presidential election. Peru witnessed a peaceful political transition amidst a supportive international economic environment. Peru s economic and debt indicators stand favorably versus its regional peers. The resignation of the Finance Minister (signaling the challenges that the new president has in terms of building political consensus with the opposition) could indicate that the implementation of infrastructure projects, vital for economic growth recovery, could decelerate. We expect political noise but believe that it should not deviate Peru from its sustained long-term growth trend. Varied outcomes in different markets some affected by macro and political factors, others benefiting from reforms and FTSE/MSCI upgrades. Potential FTSE upgrade could be a positive catalyst for the market. This market s fiscal position appears stronger than its regional peers and hence more defensive. A persistent risk is political deadlock, which often leads to slower fiscal reforms and investments. Risks include slowing economic growth, political conflict and deadlock, and continued weak investor appetite. FTSE and MSCI EM upgrades could be strong catalysts for the market. The country continues to have stable economic growth, while the National Transformation plan and Vision 2030 is being redrafted to reflect more realistic targets. Within the region, the UAE is least dependent on oil revenues. Fiscal reforms such as the recent VAT implementation have been successful. The economy boasts a robust service sector, and positive current account and fiscal balances. The strong property sector, however, needs to be monitored closely. Strong potential for improvement going forward, encouraging political and macro signs. Egypt has made a committed step toward economic reforms. It is witnessing receding inflation and a strengthening currency. GDP growth could pick up after stalling last year. The government's interest rate cap on bank lending could be relaxed or lifted, further supporting growth. The market is improving from a macro perspective with higher oil production, higher oil prices, steadying inflation, and foreign exchange liquidity. The political change has significantly improved the country's prospects. The implementation of reforms and job creation could drive growth. The graphic reflects the views of Franklin Templeton Emerging Markets Equity regarding each region. All viewpoints reflect solely the views and opinions of Franklin Templeton Emerging Markets Equity. Not representative of an actual account or portfolio. FRANKLIN TEMPLETON EMERGING MARKETS EQUITY LOCAL KNOWLEDGE, GLOBAL REACH In a sea of overlooked and under-researched companies, there s no substitute for local market knowledge. Our on-the-ground investment team of over 80 portfolio managers and analysts across 20 countries distinguishes Franklin Templeton Emerging Markets Equity from the crowd. Investors benefit from our networks of local business contacts, access to in-person company visits and real time response to local market events. Our global reach through Franklin Templeton Investments provides access to sophisticated risk management and trading resources. Portfolio management collaborates closely with the Investment Risk Management Group, which provides detailed risk analytics to complement the team s assessment of risk exposures. 80+ portfolio managers and research analysts 15 years on average of industry experience 10 years on average with Franklin Templeton Manraj Sekhon, CFA Chetan Sehgal, CFA A Positive Start to the Second Half of 2018 for Emerging Markets 4
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