Fidelity: Fund update - Emerging Markets

Key points

• Russia’s effective exclusion from the investable universe has resulted in us recalibrating parts of the portfolio. We have been increasingly seeking new opportunities in areas such as Brazil and the Middle East.
• Among sectors, we have been reducing our exposure to consumer discretionary since late last year as it started to become apparent that inflationary pressures were growing globally.
• We are now seeing opportunities in China. Valuations have fallen significantly across the market and certain areas now look very attractive.

Performance review

2022 has been a been a challenging year for financial markets and a particularly tough period for the portfolio. The main factor has of course been Russia’s invasion of Ukraine and its subsequent impact on global commodity markets, soft commodities, energy and a raft of commodities.

Going into the conflict, the portfolio was overweight Russia and underweight the Middle East, which was a natural beneficiary of the crisis as investors rushed into other oil-based safe havens following the invasion.

The second-order effect of the conflict has been the cost-of-living crisis among consumers, impacting their propensity to buy electronic goods, for example. This has had a knock-on impact in areas such as hardware technology where there are worries about demand for new mobile phones and laptops. Concerns about the consumer have also had an impact on memory and semi-conductors, impacting some of the stocks we own in this space such as Samsung Electronics and TSMC.

Recent portfolio moves

It is important to highlight why we were overweight Russia at the start of year. Back in 2021, it was clear that energy markets were tightening, and this was without the Russian-Ukraine crisis. Looking back over the past decade, there has been huge under-investment in capex by most of the oil companies, so Russia is a natural beneficiary of high energy prices. Russian stocks also offered high dividend yields - the yield on the index was approximately 11% and the portfolio would have had a yield estimated north of 15%. These stocks also ticked the value category as it became clear that interest rates were moving higher.

Given Russia’s effective exclusion from the investable universe, we have had to recalibrate parts of the portfolio. We have been seeking new opportunities in areas such as Brazil and the Middle East, spending time on the ground to meet with companies to enable us to make changes on a highly selective basis.

We are also making sure that the new names we are adding fit into the value criteria to some extent to ensure that the portfolio is balanced. We have been cautiously adding into areas like oil and gas and although we are still around three percentage points underweight this sector in aggregate, we have been adding across a number of diversified positions. In addition, China has been a market that's underperformed dramatically over the last 18 to 24 months. We see a lot of value in China and, as a result, we have increased our China positioning by around 400 basis points over the course of the last six months.

Another market that is interesting is Brazil, where we recently concluded a week-long research trip. We have seen value emerging in Brazil - for example, Banco Bradesco is currently trading at 5-6 times price to earnings multiple, with an attractive dividend yield. The overall feedback from this trip was that the macro conditions in Brazil have improved - the current account picture has improved and we expect to see a pickup in lending through the course of 2023. This should drive some volume growth among the larger banks.

If you compare and contrast Brazil to the Middle East, the latter has a very positive backdrop due to the high commodity price environment. However, the region remains expensive. By way of example, the leading bank in Saudi currently trades north of 20 times earnings, and while it does have positive fundamentals, you are still paying significantly more than you are for a Brazilian bank. The Middle East now constitutes about 7-8% of the broader EM index - it has clearly become bigger and more relevant, but it is expensive, with prudence required.

Sector views

Among sectors, we have been reducing our exposure to consumer discretionary since the end of last year as it became apparent that inflationary pressures were growing globally. Most of our consumer discretionary exposure is in China where inflation is less of an issue relative to the Western world.

In technology, memory stocks are trading to the bottom quartile of their very long price to book ranges and it's a segment that has seen a lot of consolidation. We expect a strong demand backdrop as the world becomes more digitised, creating more and more data. While at the margin consumers may not be looking to buy as many consumer-related electronic products, valuations are still attractive. It’s a similar theme among semi-conductor stocks. This space has also been hit by lower demand from consumers and the blow-up in the crypto industry. However, the long-term trends underpinning the stocks we own in the portfolio remain strong, in our view.

Areas of opportunity in China

China has had a litany of negative news over the past 18-24 months which has dragged the market down: the debt-crisis at property developer Evergrande, the tighter regulation which wiped out parts of certain sectors such as education, the halting of Ant Group’s IPO and the ongoing concerns about the ability of ADRs to remain listed in the US. Most recently, we have had China’s zero-Covid policy which has resulted in the lockdown of around 350 million people which is similar to the size of Western Europe.

Valuations in China have fallen a long way. The market is now trading at an 8-9 price to earnings multiple, which is the cheapest it’s been in a decade. For instance, property developers have come under pressure. There are a lot of developers with weak balance sheets, but that provides the strongest players with a good backdrop. For instance, China Overseas Land is a stock we own in the portfolio. It has a very resilient balance sheet and is currently trading below book value, with a dividend yield of over 6%.

Looking ahead, I expect to see more consolidation in this sector. There will be less competition for buying land from local governments, boosting the prospects of companies like China Overseas Land. I also expect the Chinese government to relax some of its property regulations over the coming months. This could spark a revival in some of the demand drivers in property over 2023.

The other notable area where I see value in China is the internet space, where we have seen a huge fall in stock prices. For instance, Alibaba, the poster child of China’s tech industry, has fallen by around 60% from its 2020 highs. Notably, when you take into account its cloud business and Ant Financial, there is still a lot of value in the company. Moreover, it is currently buying back US$25bn worth of shares and cutting costs as well. We believe this backdrop sets up an attractive risk-reward profile and after a challenging couple of years, we could see a marked improvement in performance from here.

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. Investments in small or emerging markets may be more volatile than other more developed markets. Changes in currency exchange rates may affect the value of investments in overseas markets. Fidelity’s EM equities funds have, or are likely to have, high volatility owing to their portfolio composition or portfolio management techniques. They can use financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The shares in investment trusts are listed on the London Stock Exchange and their price is affected by supply and demand. Investment trusts can gain additional exposure to the market, known as gearing, potentially increasing volatility. 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.