20 Jun 2023
Key points
We firmly believe that emerging markets (EM) are well-placed to provide superior returns over the medium to long-term. Medium-to-long term fundamentals are very reasonable today compared to the past. At a time when high inflation and interest rates are leading to a standard of living crisis in developed markets (DM), EM economies have been ahead of the curve in raising rates. They are now carrying positive real rates while inflation is plateauing. Whenever the US Fed pivots, EM central banks will have a lot of room to cut rates. Also, these economies have learned from their past and are now in a better position to absorb external shocks.
Similarly, the growth profile of EM is also superior. In India, for example, ongoing investment into infrastructure and manufacturing is supporting the country’s rate of growth. Technology companies in Korea and Taiwan have already gone through a deep inventory destocking cycle which is expected to normalise going forward. Meanwhile, EM valuations are much more reasonable, with regional equities trading at a discount to DM that is close to 20-year highs.
China caution
When the Chinese economy reopened, the expectation was for a broad-based 15-20% growth in sales on the back of pent-up demand. However, the actual recovery has been slower and patchier. Sectors that are the real beneficiaries of reopening, such as travel & hospitality, have held up well, but others, such as auto, grocery, ecommerce, have been weak. The market has become very short-term and choppy on the back of this - this indicates that investors are still concerned around regulatory risks and geopolitical risks. We continue to be cautious using a risk premium that’s 2% higher than earlier on Chinese companies.
In terms of recent portfolio moves, we have taken profits in ecommerce giant Meituan and drug-retailer Yifeng Pharmacy during the recent rally, using some of the funds to initiate a position in Focus Media Entertainment. It is the country’s leading outdoor advertising company that has 75% market share in ads on elevator screens. We were able to buy the stock at very reasonable price. It is a business with high operating leverage as they rent these screens and will benefit from reopening and recovery in advertising.
Opportunities in financials
Most EM countries have banks with very strong liability franchises and an industry that’s consolidated in favour of top four to five banks. As a result, their depositors are sticky and their cost of funds is low, which is then lent to the best quality customers.
This backdrop is informing a large financials overweight in the portfolio today. We own some of the biggest private sector banks in India and Indonesia, while we also recently initiated some positions in Brazil and Mexico. All these banks have very granular and sticky customer base. For example, Bank Central Asia, which is the largest private sector bank in Indonesia, has 27 million liability customers, against the country’s total population of 250 million. HDFC Bank in India has 70 million mid-to-high end liability customers versus the country’s total population of 1.4 billion and mid-to-high end population of 200 million. These banks do not have large exposure to bonds or treasuries - their retail-funded balance sheet is invested into real loans which are shorter in duration, rightly priced and provisioned.
In terms of risks, we might see some pull-back in net interest margins. These banks have benefited from rising interest rates as lending rates rose faster than deposit rates, but now cost of funds may increase due to tighter liquidity conditions. Having said this, we believe these banks are very reasonably priced and we remain positive on them from a medium to long term view.
Changing consumption patterns
A note should also be made on the consumer sector, where our positioning is quite differentiated versus the index. For example, we are interested in changes in Chinese consumption patterns and look for businesses aligned to this trend. For instance, we own one of the largest domestic sportswear brands, a dairy company, and a luxury car dealer in China. These are all very domestic-focused opportunities which are not impacted by geopolitical issues and are in areas that are less prone to regulatory risks.
In India, we focus on businesses that benefit from the country’s expanding middle class. As the country’s per capita income grows, Indians will move from buying essentials (like food, low-end housing, education) to buying more hygiene products and services (like automobiles, consumer electronics, mortgages, and credit cards). Despite being a hot country, India sold 7 million air-conditioners last year as compared to China which sold 100 million. As income levels grow consumers will leverage up and sales in some of these categories will grow manifold in the next few years.
Focusing on tech hardware
Elsewhere, we also have a large overweight position in technology, but again our positioning is very different. We are cautious on Chinese internet names as we think these companies are more susceptible to regulatory risks.
Instead, our focus is on hardware industry leaders such as TSMC, SK Hynix and MediaTek. Concerns around a global slowdown means that they trade at multi-year lows, but from our company interactions we are anticipating recovery in the second half of 2023. We are not sure about the pace of the recovery but we do not think current prices are pricing-in any sort of recovery. We believe these companies are critical and well ingrained in global technology supply chains and will continue to benefit from the long-term structural shift towards high-end computing products, electric vehicles, and artificial intelligence.
Navigating rising cost of capital
Rates can certainly move up from here which will impact emerging markets, but there is a higher likelihood of rates moving down from here. Compared to recent years, we are in a better situation today because the starting point of our assumptions is very reasonable.
I do not worry about interest rate and opportunity cost of capital now - my focus now is more related to fundamental analysis, where we need to understand and re-test the growth expectations on our businesses. These assumptions could be wrong if we go into a significant downturn, but we also believe the businesses we own are the most competitive in their sectors and will benefit in a downturn by gaining market share from weaker peers who go out of business.
Overall, if you consider fundamentals, or quality of underlying assets or valuations, we believe EM is in better shape, more resilient, and more attractively valued than in the past. This underpins our conviction that the asset class is well-placed to provide strong returns over the medium to long-term.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of an investment in overseas markets. Investments in emerging markets can be more volatile than other more developed markets. The Fidelity Sustainable Emerging Markets Equity Fund has the potential of having high volatility either due to its composition or portfolio management techniques. It can also use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. A focus on securities of companies which maintain strong environmental, social and governance ("ESG") credentials may result in a return that at times compares unfavourably to similar products without such focus. No representation nor warranty is made with respect to the fairness, accuracy or completeness of such credentials. The status of a security's ESG credentials can change over time. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes.