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Darius McDermott: China fears should not shroud attractive EM valuations

darius mcdermottFirms are unloved but could be set to change

An easing of trade concerns between the US and China and the dovish shift by central banks has led to a strong rebound in emerging markets in the first few months of 2019, with the MSCI Emerging Markets index rising by more than 10 per cent. It comes after a challenging 2018, which saw the index fall by 11.39 per cent, as weak fundamentals and political instability in countries like Turkey, Argentina and South Africa played a major role in dragging down performance – as did the strength of the US dollar.

You could even argue EM valuations were at one point approaching crisis levels due to substantially weaker performance and confidence, despite cashflows and earnings remaining fairly resilient. Fast-forward a few months and while there has been a recovery, we believe valuations are still cheap both historically and relative to most developed markets. The truth is, EM companies have been unloved for some time.

China’s role

It does not take a genius to know China plays a key role in the success of the asset class. A truce – albeit an uneasy one – with the US over trade negotiations, as well as Chinese authorities implementing monetary and fiscal measures to support the slowing economy have added some conservative optimism to the market.

For example, the International Monetary Fund slightly increased its projected growth estimate for China to 6.3 per cent in 2019, although the unprecedented levels of debt still loom heavily. MSCI incorporating China’s A-shares into its EM equity benchmarks also opens a new opportunity to investors. It says quadrupling the weighting to the index may draw more than $80bn (£61bn) of fresh foreign inflows to the world’s second-biggest economy.

Wider Asia

It has been a mixed story for a number of other Asian countries. In the midst of a general election, Indian equities have rallied  on the back of the momentum generated by prime minister Narendra Modi, such as the response to the ongoing tensions with Pakistan, as well as more support for rural India. The current coalition government is now expected to stay in power in some shape or form.

Taiwan stocks also advanced in the first quarter, although South Korean stocks underperformed following the unwelcome end to the US-North Korea summit and worries over corporate earnings. We believe South Korea, despite having concerns over how companies are generally run and demographics, has a number of interesting opportunities. It is also making strides to tackle corporate governance issues.

One fund we believe is ideal for the current scenario is Fidelity Asia Pacific Opportunities, managed by Anthony Srom. It is a concentrated portfolio of 25 to 35 stocks with the sole focus of finding the best companies, rather than focusing on an industry or theme. Srom also aims to lower potential volatility by making sure the portfolio is diversified, while correlations of underlying stocks are monitored closely, with the fund performing well in down markets.

The Schroder Asian Alpha Plus fund is another with consistent performance. Manager Matthew Dobbs’s investment process is bottom-up with a top-down overlay, with weightings reflecting whether he sees stocks demonstrating visible earnings growth, sustainable returns, or if they are attractively valued.

Pro-business Latin America

There are positives also for Latin America, where five out of six governments are now actively pro-business, although there are still issues with Argentina and Venezuela, with the latter facing both economic contraction and political unrest. Brazil, which accounts for more than 7 per cent of the MSCI Emerging Markets index, is emerging from one of its longest periods of recession with solid balance sheets and more efficient cost bases.

This is reflected in a solid outlook for earnings per share growth going into 2019 and 2020, when compared with other regions.

For those looking specifically at Latin America, I would recommend the Aberdeen Latin American fund, which currently has the majority of its allocation in Brazil and Mexico. From a top-down perspective, the team managing the fund believes the region presents strong fundamentals.

A more generalist option would be Lazard Emerging Markets, whose team aims to identify the global brands of tomorrow in developing regions. It has a preference for emerging Asia, with a 59 per cent allocation to the region.

But it also has almost 14 per cent in emerging Europe, 12.7 per cent in Latin America and 8.8 per cent in Africa.

Darius McDermott is managing director of Chelsea Financial Services and FundCalibre

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  1. “An easing of trade concerns between the US and China…”

    It`s tough being a commentator at the moment.

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