Waddell & Reed

Portfolio Perspectives


A Closer Look at Emerging Markets

Story Highlights

  • We think there are significant potential opportunities, despite uneven economic growth among emerging markets in recent years.
  • New technologies often penetrate emerging markets more quickly than in the developed world. Many emerging markets still face headwinds from inflation and from interest rates above historical averages.
  • Infrastructure, volatility, food and technology are key investment themes for the Fund now.
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Investment Team

Frederick Jiang, CFA, CPA

Portfolio Manager

Jonas Krumblys, CFA

Portfolio Manager

Emerging market countries have been growing faster than developed markets for the last decade.1 Billions of new consumers continue to enter the global economy, driving demand for goods and services. Frederick Jiang and Jonas Krumplys, portfolio managers of Ivy Emerging Markets Equity Fund, review the case for an allocation to emerging markets now.

An evolution in global economy

The term “emerging markets” was coined in 1981 to change the perception of economies and markets in developing countries, which now make up 80% of the world’s population and 75% of its geographic area. 2 Emerging markets also represent four of the top 10 countries in gross domestic product. In fact, the International Monetary Fund projects a growth rate of about 5% for these countries in the next few years, which is more than twice the projected U.S. growth rate. We think there are significant potential opportunities in these markets, despite the uneven economic growth among individual countries in recent years.

In general, we think there are four main features in emerging markets that differentiate them from developed economies:

  1. low household incomes,
  2. ongoing structural changes, such as modernization of infrastructure
  3. progress in economic development reforms,
  4. markets are less mature in terms of regulation and liquidity.

As household incomes rise, more people are moving into the middle class in emerging markets. Their spending patterns tend to change with the rising income, going beyond subsistence into discretionary goods. Over the next two decades, there could be 5 billion consumers in the world with the majority in emerging markets.3 Those consumers are likely to have a significant impact on global consumption and the demand for energy, technology, housing, health care, education and more.

Why emerging markets now?

We think there are several reasons for investors to consider an allocation to emerging markets, including equities valuations that now are low when compared with developed markets. For example, the price/earnings (P/E) ratio on average for emerging market securities this year has been about 11. By comparison, stocks in the U.S. and Japan have an average P/E this year of about 16 and stocks in Europe average about 15.4

A general lack of infrastructure in emerging markets provides another reason for considering emerging markets now. New technologies often can penetrate those societies more quickly than in the developed world. That may present opportunities for companies and their investors. For example, houses in many countries in Asia, Africa and Latin America often lack fixed-line telephones. But mobile phones can be purchased less expensively and their use can grow quickly as supporting infrastructure becomes available. In China, which does not yet have major retailers such as Wal-Mart or Target in many cities, online shopping and e-commerce are growing faster than in the U.S.

During the first decade of the century, China’s massive build-out in infrastructure created tremendous demand for commodities, including iron, copper, coal and energy. In the last 30 years, China has grown about 10% a year, mainly driven by that rapid infrastructure expansion and through export growth. China now is slowing to a growth rate closer to 7% a year as it moves to diversify toward a consumption-driven, service sector-driven economy. This transition has presented problems because of the economic rebalancing required. But we believe these generally are manageable issues and think China can continue to grow as it reforms its economic structure and moves to a consumption-driven economy.

We also think that many emerging market countries still have headwinds from inflation rates above developed markets and interest rates above their historical averages.

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A closer look at the Fund

Our process uses a balanced approach of both top-down and bottom-up analysis. The top-down analysis seeks to identify what we think will be the best countries and sectors for growth. This analysis includes research on growth and liquidity in the markets, identifying any systemic changes, measuring the political climate and considering any other factors that could affect a region or sector. We then use bottom-up analysis to identify specific companies that meet our screening requirements.

We are pursuing several key themes as we research and select securities for the Fund now, including:

  • infrastructure – growing economies and populations need water and sewer systems, roads, airports, railways, ports and more;
  • volatility – many emerging markets are political “hotspots” or are in regions undergoing rapid change;
  • food – the growing middle class in many emerging markets is seeking a better diet and access to improved agricultural products, more meat and dairy, and other foods;
  • technology – the internet, smartphones, e-commerce and other new technology is helping the growth of emerging markets consumers and businesses, even when there is a lack of supporting infrastructure.

The Fund is currently underweight when compared to its benchmark index in certain parts of the world that are very commodity-focused, such as the combination of Europe, the Middle East and Africa. We also are underweight in Russia for several reasons, including its recent moves in the Ukraine and the economic sanctions that followed from the U.S. and European Union.

The Fund is currently underweight versus the index in Latin America, which is about 20% of the index but about 15% of the Fund. We have holdings in Brazil, one of the 10 largest economies in the world. However, the country is suffering from a severe drought that is affecting its people, businesses and economy. About 80% of Brazil’s electricity comes from hydroelectric dams, which means there is strong potential for economic impact from brownouts or blackouts during the drought. Brazil also is hosting the 2014 FIFA World Cup of soccer, which has the potential to cause both benefits and problems. The costs of preparing facilities for such an event are drawing significant protest from many citizens across the country, despite what the government hopes will be an economic boon. Brazil will hold presidential elections in October and we think a change in leadership is likely. Many in Brazil are dissatisfied with the direction of the economy and high tax rates.

We also have some exposure to Mexico, the other big economy in Latin America. We think energy reform is likely in Mexico, which could open that sector to outside investment.

The Fund is currently overweight in India, reaching about double the weight in the index. Recent elections brought Narendra Modi to power as prime minister. He previously was governor of the state of Gujarat, which had strong economic growth during his tenure. We think he can do the same with the national economy, including instituting reforms and reducing inflation and interest rates. In general, we have a positive outlook about India. We also are overweight in general in Southeast Asia, which comprises a group of countries with about 600 million in population. It includes the stronger economies of Indonesia, Thailand, the Philippines, Malaysia and Singapore, which are growing at 5 to 7%. We think there is significant potential for further growth in the region and, in particular, are overweight Indonesia and the Philippines. It’s worth noting that the Fund is currently underweight in South Korea, in part because of a currency war between Japan and the rest of the world. South Korea is an export-driven economy and, while exports are running at a solid pace now, many investors worry that Japan may take market share.

Top 10 Equity Holdings
as a % of net assets as of 5/31/2014
Taiwan Semiconductor Manufacturing Co. Ltd. 3.2%
Larsen & Toubro Ltd. 3.0%
Galaxy Entertainment Group

2.8%

JD.com, Inc. ADR

2.6%

SK hynix, Inc.

2.3%

Chicago Bridge & Iron Co. N.V., NY Shares

2.2%

Fosun International Ltd.

2.2%

MediaTek, Inc.

2.1%

Hyundai Motor Co.

2.0%

Petroleo Brasileiro S.A.

1.8%


1 Source: IMF World Economic Outlook 2013
2 Sources: International Finance Corporation ”IFC History”; CIA World Factbook; IMF World Economic Outlook 2013
3 Source: Brookings Institution Press, “China’s Emerging Middle Class: Beyond Economic Transformation,” 2010
4 Source: Bloomberg.com market data

 

Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s portfolio managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through June 9, 2014, and are subject to change due to market conditions or other factors.

Investment return and principal value will fluctuate, and it is possible to lose money by investing.

Risk factors: As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investments in countries with emerging economies or securities markets may carry greater risk than investments in more developed countries. Political and economic structures in many such countries may be undergoing significant evolution and rapid development, and such countries may lack the social, political and economic stability characteristics of more developed countries. Investments in securities issued in these countries may be more volatile and less liquid than securities issued in more developed countries. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

On Feb. 11, 2014, Ivy Pacific Opportunities Fund was changed to Ivy Emerging Markets Equity Fund and its strategy was changed to reflect a concentration in emerging market equity securities. Performance prior to such time in part reflects the Ivy Pacific Opportunities Fund’s former strategy to invest primarily in Pacific region equity securities, and the Fund’s performance may have differed if the current strategy had been in place.

On March 17, 2014, Ivy Asset Strategy New Opportunities Fund merged into Ivy Emerging Markets Equity Fund.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for the Ivy Funds, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.

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