Our investment expert views: Emerging markets

Global emerging markets (EM) as an asset class is an under penetrated market structure which leads to increasing levels of investment, job creation at a local economic level, a rising wealth effect and ultimately growth in consumption. The structural back drop provides numerous attractive reinvestment opportunities in an otherwise relatively low return global investment landscape. The challenge for investors however is that whilst the structural opportunities are widely understood there is also a cyclical overlay to the asset class which can lead to substantial equity market volatility. 

Navigating this volatility is a critical element to preserving the long term compounding of returns which the structural back drop provides. A key factor impacting the cyclicality of the asset class today is the direction of US interest rates and more specifically what a rising interest rate environment means for funding costs across the asset class and the implications for the exchange rates. For the most part, emerging markets are in a far better place than they were in previous cycles to weather rising global interest rates. 

The exchange rate volatility caused by the global interest rate environment is further exacerbated by a busy election year particularly within Latin America where by the key markets of Brazil and Mexico are due to go to the polls in H2. Brazil in particular is an economy which, from an equity market perspective needs a stable and effective Government in order to push ahead with the social reforms. These are desperately needed in order to arrest the fiscal position of the country, attract foreign direct investment, structurally lower interest rates and ultimately stabilize the currency. Whilst we remain positively disposed to a handful of individual companies within Brazil, we did reduce our exposure earlier this year due to the valuations of equities not necessarily reflecting the balance of risks as we saw them at the time.

Outside of politics and currency, another area where we have been increasingly cautious over the last 6 to 9 months has been general valuation levels in EM equities. Rising global interest rates have a direct impact on the discount rate used to value equities and it has been our view for some time that certain pockets of the equity market are not reflecting the true cross cycle discount rates which should be applied. This gives rise to the potential for a moderate de-rating of such stocks and the portfolio took steps to address this issue from a positioning point of view as we exited 2017. Should such a de-rating occur it will likely provide an opportunity for us to acquire good businesses at better prices. Staying close to such companies and being alive to the opportunities as they present themselves will be a key area of focus throughout the second half of 2018 and into 2019.

A final key area of focus worthy of mention is the rate of innovation we are currently witnessing across Emerging Markets, but particularly in China. Investment in education and research & development is critical to improving the long term growth rates and structural health of an economy and more specifically creates reinvestment opportunities and intrinsic value for investors. Over the last 10 years China has moved from being a ‘fast follower’ of technology to a genuine leading edge innovator as is demonstrated by the increase in R&D as a % of GDP from 1.2% in 2007 to 2.1% today (a growth rate off 6.8% p.a.) or China’s global leadership in AI related scientific filings. Such investment an innovation is creating multiple new growth opportunities for Chinese companies be it in factory process automation, security & surveillance or even the use of facial recognition technology in dynamic advertising.

Within all industries across Global Emerging Markets technology is being embraced at a significant rate and is leading to true differentiation in the growth outlook and financial prospects of many businesses. Perhaps most excitingly, this isn’t confined to the technology titian alone. Rather the technological intensity of all industries is increasing which is creating new leading companies and attractive investment opportunities within the asset class. A core focus of our work over the coming months will be in identifying where the winners and losers are within this evolution and seeking to take advantage of any market volatility to increase our ownership of the long term winners at attractive valuations.

Visit the Fidelity Global Emerging Markets Fund page