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Improving emerging markets equity cycle

Archie Hart, Portfolio Manager
Volatility in the asset class is likely to be particularly high, but we believe there are now reasons to be cautiously optimistic

Volatile, but improving

Emerging market equities can be highly volatile and tend to move in deep cycles. This means there are times when they will pay and times when they don’t. In retrospect, these cycles are easy to identify, but tough to forecast in advance. However, we believe there is increasing evidence that many emerging market countries, governments and companies are now beginning to respond to the challenges facing them, with evident improvements coming through.


Understanding EM cyclicality

Global markets and economies are cyclical – emerging markets are more cyclical still. One way to understand emerging market cyclicality is Morgan Stanley’s CRIC theory (Crisis-Response-Improvement-Complacency, see Figure 1).

The CRIC cycle in action:

  • Point A: Investors, governments, corporates and investors have become complacent. Growth is very strong, accompanied by euphoria and little reform (the y-axis). However, at some point the music stops and a crisis ensues, leading to point B.
  • Point B: Government, regulatory and corporate discipline has broken down and a crisis has emerged, invariably accompanied by weak economic growth, soaring indebtedness, deficits, rising unemployment, rating downgrades and political crisis. In response, regulators wake up and tighten oversight, while governments and corporates tighten their belts and reform and renewal begins, and the situation travels up the reform scale to point C.
  • Point C: After a strong period of reform and humility, things begin to improve, leading almost inevitably to complacence once again, until the next crisis strikes.

Figure 1: The CRIC Cycle in action
The CRIC cylce: Crisis - Response - Improvement - Complacency


Source: Morgan Stanley, 2000.

 

Reasons to be upbeat

The CRIC cycle has historically been more cyclical and a bit wilder in nature among emerging markets, as weaker institutions tend to result in more exaggerated ‘overshoots’ and ‘undershoots’. While this may sound a little bleak for emerging market investors, we are in fact more upbeat on emerging markets than we have been for some time. We believe there are many strong indications that we are in the ‘Response-Improvement’ part of the cycle. Some of the changes we are seeing indicate real efforts to improve the longer-term institutional framework of many key emerging markets, resulting in a more promising investment environment.


Optimism is legitimate

We would illustrate our optimism by focusing on a few countries where we believe policymakers are beginning to drive significant positive change: Brazil, China, Hungary, India and South Korea. These five countries together account for almost 60% of the portfolio at the time of writing. However, we are selective, bottom-up investors, which means that we are currently underweight three of the countries where we believe policymakers are beginning to implement positive reforms.

Across these countries we observe that a number of our positions in banks are experiencing recoveries from extended bad debt cycles, or seeing a more risk-aware/returns-focused management. We also have some positions in basic materials stocks, which are beginning to benefit from China’s more proactive stance in closing surplus capacity. In India, we are primarily positioned in stocks which will benefit from rising consumption and incomes in that country, while in eastern Asia we have a number of positions in China’s high-growth internet stocks and an overweight position in Samsung Electronics.


Figure 2: Emerging Markets Equity Strategy
Country relative weights


The example of the holdings is intended to reflect the typical sector and geography that could be deployed by the Strategy to generate the target returns. There is no assurance that Investec will be able to identify or secure investments in securities substantially like those discussed and the above is not intended to represent a summary of buy, sell or hold recommendations. The portfolio may change significantly over a short period of time. Source: Investec Asset Management, portfolio stock weights relative to MSCI Emerging Markets NR Index, 31.01.17. Numbers are unaudited. Data is based on a pooled vehicle within the Strategy. For further information on indices and investment process, please see the important information section.

Archie’s recent extended 14-page review


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Important Information
The information may discuss general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. The economic and market views presented herein reflect Investec Asset Management’s (‘Investec’) judgment as at the date shown and are subject to change without notice. The value of investments, and any income generated from them, can go down as well as up and will be affected by changes in interest rates, exchange rates, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets invested in.

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References to particular investment or strategies are for illustrative purposes only. Unless stated otherwise, the specific companies listed or discussed are included as representative of the Strategy or Strategies. Such references are not a complete list and other positions, strategies, or vehicles may experience results which differ, perhaps materially, from those presented herein due to different investment objectives, guidelines or market conditions. The securities or investment products mentioned in this document may not have been registered in any jurisdiction. More information is available upon request.

Indices
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