Market outlook: Global Emerging Markets

Date: 09. Apr. 2019 Time 10:25

A solution to the trade conflict will be of crucial importance for emerging market shares.

Return developments in Q1 
The fund recorded a return of 12.68% in Q1 2019 whereas its benchmark, MSCI Emerging + Frontier Markets, returned 11.89%.

Developed markets (+14.17%) outperformed emerging markets (+11.8%). The extremely positive return of Chinese shares was propelled by expectations of a solution to the trade conflict, economic stimulus in China and a more dovish rhetoric by the Fed. Overall the picture in Q1 2019 was turned upside down compared to the scenario that took place in Q4 2018, which is also reflected in returns for the region.

India continued its upward trend from Q4 2018 even though oil prices, which often move in the opposite direction of Indian shares, gained more than 27% in Q1 2019. The main reasons were a new central bank governor with a more dovish stance, populist measures adopted by the government and expectations of the current government being re-elected. 

The fund’s return was positively influenced by its overweights in Mexico and Brazil and its underweight in Chile. The fund’s underweight in Colombia was a drag on relative performance.

The positive contributions from Brazil and Mexico were primarily driven by our equity picks. In Brazil especially our exposure to energy benefited from the sharp rises in oil prices during the quarter but also our equity picks in consumer names added to relative performance. In Mexico we profited in particular from our equity picks in the industrial sector as well as our overweight in financials and underweight in the telecom sector.

Our underweight in Colombia was adversely impacted by higher oil prices. 

The contribution to return from the EMEA region was positively affected by our overweight in South African company Naspers but our underweights in Poland and Qatar also added to performance after the two countries slipped slightly after a strong finish to 2018. The equity picks in Russia detracted however from overall performance. 

Country review
US President Donald Trump had proclaimed that import duties on Chinese goods would be raised from 10% to 25% on 1 March 2019. But after intense negotiations between China and the US during the first two months of the year Trump decided to postpone the increase in duties. Throughout the first quarter expectations of an impending agreement with a positive outcome influenced the equity market. However the US is looking for further concessions regarding China’s use of state support and its theft of patents and intellectual property. These issues clearly represent the greatest challenges. China has adopted a new law governing foreign investment that will come into effect on 1 January 2020. The law reflects some of the demands made by the US during the trade talks. 

China has recorded double-digit growth rates for many years but growth prospects for the years ahead do not match those of earlier years even though they are still high. Consequently the government has relaxed its lending terms for banks, introduced tax cuts, lowered the VAT rate, etc. After including local Chinese shares in May 2018, MSCI will raise the weighting of Chinese A shares further in its emerging market index  during 2019. This will result in significant inflows to local Chinese shares. At present the percentage of A shares is very small compared to their real market value. 

India’s government party, BJP, was a disappointment at the state elections in December. The election outcome put pressure on the Modi government ahead of the elections to be held from 11 April to 19 May. India’s share market dropped as a result but Modi shifted to a more populist policy to increase the likelihood of re-election. In February the Pakistani military shot down two Indian military aircraft over Pakistani airspace. This provided Modi with an opportunity to take a more nationalist position and use it in his campaign. Modi criticised the opposition for not being ready to use the means necessary and for delaying the procurement of new fighter jets. As a result Modi was once again the odds-on favourite ahead of the election.

In Brazil the reform programme dominated the headlines. The overriding focus continued to be the major overhaul of the pension system. Brazil’s pension rules have long been extremely favourable for Brazilians including a very low retirement age and generous payouts. But if the system is not changed Brazil’s public debt will grow to unstable levels in the years to come. This is also why equity markets are focusing so strongly on this reform.

President Bolsonaro’s government surprised the market already in late January when he scrapped the former government’s pension proposal and replaced it with a completely new proposal. The previous agreement had already been passed by the lower house. This caused considerable jitters as the new agreement will have to go through the political process again and therefore it cannot be adopted until later this year. 

Former president Temer was held in custody on corruption charges, an addition to the proposed savings concerning the military in Brazil disappointed and there was a public disagreement regarding the overall political process between President Bolsonaro, Lower House President Rodrigo Maia and Economy Minister Paulo Guedes. The latter two politicians are seen as being crucial to the implementation of reforms and the market’s reaction was a sharp sell-off of Brazilian shares, which fell by around 10% in a week in the middle of March. These three key political figures have since settled, in varying degrees, some of their differences and the market has stabilised. 

In EMEA we have changed our positions in South Africa from consumer shares to materials shares and industrial shares. 

Most important portfolio decisions and positioning 
During the quarter we raised our exposure to local Chinese A shares. During 2019 MSCI will increase the weighting of A shares in the EM index from around 0.7% to around 3.3 % in three steps. As a result foreign investors are expected to invest an additional DKK  400-600bn in local Chinese shares.

Apart from the growing interest in Chinese A shares, other factors could be supportive of the market. China is in the process of implementing tax cuts and other measures to boost the economy. In addition the pricing of Chinese shares is reasonable. And if there is also a favourable solution to the trade war between USA and China, A shares will be interesting. 

The portfolio’s exposure to A shares was increased during the quarter. We also added to life insurance company Ping An and purchased 1.5% of Hong Kong Exchanges & Clearing as we believe that both will benefit from the increasing focus on A shares.

Apart from the overweight in China of just under 2 percentage points, India remains our preferred country to invest in. The overweight in India is unchanged at 4 percentage points. In the short term Indian shares may experience tailwinds in connection with the election in May as the likelihood of an election victory to Prime Minister Modi is growing stronger. Our largest overweight is currently in Indian financials (overweight position of 4.3 percentage points). The liquidity challenges in the sector have grown smaller, interest rates may be on their way down and down the road long-term earnings growth for private banks in India will exceed 20% a year. 
At sector level the most important change is that we are now more positive on IT shares. We have shifted from a small underweight to a small overweight position. Many IT shares struggled in 2018 but are now interesting again. As mentioned above we see a potential for manufacturers of camera lenses for mobile phones, which is why we bought Largan. However the shares went up considerably during the quarter and therefore we are keeping an eye on pricing. 

Apart from the IT sector we have added in consumer discretionary and consumer staples. In the wake of the sharp gains during the quarter we have purchased stable shares such as CP All, KT&G and Gudang Garam. 

In Latin America Brazil was the main contributor with our exposure to energy.  Return was driven in particular by our overweight in major oil company Petrobras and our investment in oil company QGEP Participacoes, which gained more than 77% during the quarter. In contrast the decent return in energy was pulled down by our underweight in materials. Especially small steelmaker Cia Siderurgica, which gained 86% during the quarter, detracted from performance. We have not selected the company due to its high level of debt but a high operating leverage greatly exposes the company to rising steel prices, which we saw during the quarter. One of the reasons for the sharp increase in iron ore prices and subsequently steel prices was the tragic rupture of a dam owned by major iron ore producer Vale. 

The Brazilian authorities have closed several of the company’s dams for the time being but due to Vale’s size the closures have resulted in such sharp increases in iron ore prices that the company’s share price is almost the same as before the catastrophe. 

Market outlook
A solution to the trade conflict will be of crucial importance for emerging market shares. It is still likely that any rollback of tariffs will occur in stages as the two parties reach agreement on more issues. We expect that an agreement will be reached. 

Economic stimulus measures by the Chinese government are anticipated to take effect in the period ahead, which will influence the mood and expectations among investors. 

If Modi wins the election by a large margin it will have a very positive effect on the share market. Furthermore it is likely that the central bank in India will introduce new rate cuts. Overall, looser fiscal and monetary policies will create a decent domestic framework for Indian shares in the short term. 

We continue to project a volatile equity market in Latin America in the second quarter of 2019. 

Even though recent major political decisions in Mexico have been positive from a share market perspective we do not expect to see a unified political agenda. On the one hand we have seen that AMLO often ends up making pragmatic decisions but that the road leading up to them is often filled with populist propaganda and related share market volatility. We do not project that Mexico will return to the high valuations of former times. This is based on greater uncertainty as well as lower growth prospects but we still see good potential in many Mexican shares. 

We project that Brazil will continue to be steered by the political scene. The working relationship between President Bolsonaro, Lower House President Rodrigo Maia and Economy Minister Paulo Guedes will be crucial for the reform process. Maia has shown that he has the support of congress and President Bolsonaro has behaved in a slightly more humble manner after the latest drops in share prices, which we see as positive. 

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