Outlook 2018: Where to for emerging markets?

2017 was a robust year for Emerging Market (EM) equities with the continuation of a number of appreciating trends which commenced early in 2016. Broad drivers of the market included:

• The stabilisation of commodity prices,
• A softening of the US Dollar versus its major trading currencies,
• Synchronised global GDP expansion, and
• Attractive absolute and relative starting valuations.

Looking into 2018, I expect the majority of these tailwinds to remain in place, though to a lesser extent than we’ve seen over the past 18 months. Global monetary conditions remain supportive for equities generally and that coupled with the benign inflationary backdrop, will likely result in a continuation of current conditions.

Equity valuations have rebounded from the lows seen in 2016 and, as a consequence, a large part of the cyclical recovery looks to have already played out. Future gains are likely to be derived from those companies with the ability to defend the underlying profitability of their businesses and deploy excess capital at attractive incremental rates of return. This will lead to a greater discrepancy of positive returns within EM equities and investors will need to focus on stock selection and valuation discipline to generate consistent absolute returns.

The most compelling opportunities

We are positioned to benefit from increasing penetration and consumption of both discretionary and staple items across multiple end markets most notably China via domestic A share holdings.  

I expect Foshan Haitian and Shanghai Flyco to continue to deliver attractive reinvestment returns as they move up their respective value chains. I expect them to increase market share due the competitiveness of their production processes. This will enable both businesses to deliver a high-quality product at an extremely attractive price point to the end customer.

Our portfolio also heavily features financial companies such as HDFC Bank, Bank Central Asia and AIA Insurance. These firms have dominant market positions, which affords a cost of funding and credit risk advantage versus their peers.  

A dangerous consensus

Technology stocks within the Chinese internet space have been material absolute and relative outperformers during 2017. The mega-cap names in this space have benefited from exceptionally strong revenue growth, but also the significant inflow of passive investors into Asia and Technology exchange traded portfolios.

Although many of these businesses are exceptionally robust franchises, market extrapolation of current revenue growth rates is leading to valuation multiples pricing at unattainable levels or further accelerating rates which are already elevated.

These high prices and revenues growth could create an environment where valuation multiples compress from current levels, resulting in stocks that exhibit a high level of valuation risk for absolute investors despite delivering robust fundamental results.

An overlooked opportunity

The strength of domestic demand in China and its potential implications for the rest of Emerging Markets in being slightly overlooked.

There is a certain degree of pessimism concerning the outlook for Chinese industrial demand given that the industrial sector has recovered somewhat over the last 12 months or so. This ignores the fact that industrial demand in China was exceptionally weak for a 3-4-year period prior to the second half of 2016 and there is therefore potential for current demand run rates to be maintained. This would be a positive surprise relative to the broader markets expectations for cash flows and returns for the sector.

Consequently, the market is less focused on the potential for improvement in domestic demand levels in countries such as Indonesia which has seen sluggish economic activity for the past 36-48 months. Should demand recover in Indonesia, there is significant potential for consensus earnings forecasts to be upgraded, particularly in the Indonesia banking sector.

A high conviction stock for 2018

Hong Kong-listed AIA Insurance is my highest conviction stock for 2018 on a risk adjusted return basis.

The business has a dominant position in all its end markets, an unparalleled agency platform and a robust balance sheet with a substantial amount of excess capital. Furthermore, it operates in end markets which are extremely under penetrated from an insurance and financial protection point of view. These factors combine to create an environment where AIA can deploy significant amounts of excess capital at extremely attractive incremental rates of return which creates the opportunity for long term accretive compounding of returns for shareholders.

For further insights from Alex Duffy or to find out more about the Fidelity Emerging Markets Fund, please visit our website.