Key factors are contributing to potential for emerging markets:
- Attractive valuations
- Rebound in energy and commodity prices
- Surge in innovation
- Depressed currencies
We think several factors are contributing to the potential for emerging market equities to perform well in 2017. Overall, we believe global economic growth is going to be stronger this year. We recognize that geopolitical uncertainty remains high with the Trump administration now in office, especially as it relates to the potential for changes in trade policies. While the U.S. may attempt to renegotiate many existing trade agreements over time with a goal of providing benefits to U.S. manufacturing, we do not expect significant headwinds for overall global trade. In addition, we think oil prices are likely to at least remain stable and believe it is more likely they will continue their gradual rise this year. We believe countries, currencies and companies that benefit from firm oil prices now are likely to maintain solid performance this year.
We believe the macro fundamentals for emerging markets are much healthier than in previous periods of weakening currencies. Few emerging market currencies are pegged to the value of the U.S. dollar and current account balances generally are either in surplus or near a zero deficit. High current account deficits typically mean a country needs external funding or investment to run its economy, so a surplus or no deficit is an indicator of strong internal funding and a healthy economy. We are also in a period in which more than 80% of global Purchasing Manager Index readings are above 50%, which is an indication of positive economic trends and a healthy global economy overall. We think these factors are positive indicators for continued expansion in global trade (exports of manufactured goods and services as well as commodities), which in turn is likely to be good news for emerging markets.
Brazil, Russia recovering
We believe the economic growth gap between emerging markets and developed markets is likely to expand this year. We already have seen two of the world’s largest emerging economies, Brazil and Russia, move ahead after multi-year recessions. The inflation rates in both countries have dropped significantly from their peak levels, with Brazil falling to 5.4% from 11% and Russia to 5% from a massive 16.9%.1 There are indications the inflation rates in both countries will continue this downward trend. We expect more expansionary monetary policies from the central banks in both countries and think favorable reactions are likely to continue in both stock markets. If reforms continue in Brazil this year, we believe there is the potential for the economy to begin a slow return to growth and offer longer term investment opportunities.
An agreement by the Organization of Petroleum Exporting Countries (OPEC) in November 2016 to reduce oil production quotas is likely to help the Russian economy since the majority of the country’s revenues come from the domestic energy sector. A major wild card, however, relates to the U.S. and European Union sanctions because of Russia’s annexation of Crimea and aggressive moves in Ukraine. Even the rumor of the sanctions being lifted has caused Russia’s stocks and currency to spike higher. However, there does not seem to be widespread support now for any change to the sanctions. The Fund now is overweight Brazil and Russia compared to the benchmark MSCI Emerging Markets Index.
China maintains growth push
China, the world’s second-largest economy after the U.S., faces leadership changes later this year. The ruling Chinese Communist Party meets every five years and changes the membership of the powerful Politburo Standing Committee, which historically has five to nine members. Typically, committee members who have served two terms or are over age 67 will stand down. That would mean replacing five members this year. Only Hu Jintao, China’s top leader in 2002–2012, has ever broken this guideline.
Current President Xi Jinping is keen to keep his hold on power and push his long-term vision for the Communist Party and China. One issue to watch in the future is whether he will try to repeat Hu Jintao’s move and seek a third term on the Politburo Standing Committee in 2022. In any case, we think there will continue to be a high premium on keeping social unrest to a minimum and maintaining steady economic growth.
Last year’s rally in hard commodities surprised many investors. The mining sector benefited from the unexpected restructuring of China’s steel and coal sectors, where capacity and production cuts actually were implemented. The drivers behind these actions included increasing profitability for producers and addressing China’s serious pollution problems. We think China will seek to address overcapacity in other “smokestack” sectors this year.
The recovery in the Chinese property sector and a renewed push on infrastructure spending also are likely to be tailwinds this year. We believe forecasts in these areas are too gloomy and think there will be improvement in free cash flows and continued balance sheet repair among metal producers and the mining sector.
In general, we think stability in China helps global stability, and in turn can benefit commodity-producing countries and emerging markets equities. The Fund recently closed its longstanding underweight in China by adding to holdings in the financials, property and autos sectors as well as via futures contracts based on the Hang Seng China Enterprises Index in Hong Kong.
India pursues reforms
India in November 2016 unexpectedly announced it would "demonetize" and eliminate the two most widely used bank notes, taking more than 85% of the country’s currency out of circulation. The intent was to eliminate the underground economy, reduce counterfeit currency and curb corruption and criminal activity that often relied on the 500- and 1,000-rupee notes. The immediate impact caused severe economic disruption and led to a sharp selloff of local equities. Despite the initial turmoil, we think most of India’s citizens will benefit from this action in the intermediate term.
The action was only the first of several reforms promised by Prime Minister Norendra Modi. For example, demonetization is to be followed later this year by the implementation of a good and services tax. In general, Modi seeks to advance a digitized economy, reduce corruption, increase tax revenues, improve supply chain and logistics efficiencies, and boost both foreign direct investment and domestic investment. We think these goals all are positive for the immediate term. The Fund now is overweight India versus the benchmark index.
Focus on technology leaders
Leading-edge technologies and entrepreneurs do not reside just in Silicon Valley. Information technology companies make up the largest sector of emerging markets. We believe there are investment opportunities in some of the technology giants of Asia such as Samsung, Tencent and Alibaba,2 as well as small and mid-capitalization companies focused on visual recognition, security systems, and advanced driver assistance systems. We also think there is potential in internet, gaming and hardware companies in technology. In addition, Asia is home to the majority of leading global camera and lens companies used in smartphones, virtual reality, augmented reality, self-driving cars, digital medical imaging and high-tech industrial manufacturing firms.
About two-thirds of the Fund’s portfolio is focused on these “new economy” stocks (including internet, technology-focused hardware, health care and “biosimilar” pharmaceuticals, education, cameras, and more). The remainder is in cyclical recovery stocks (mostly based in commodity-related countries such as Brazil and Russia).
Assessing potential opportunities
There is a tendency to think of emerging markets as a single potential investment option, but there are many variations among these countries. We think it’s critical to analyze each country’s fundamentals and idiosyncratic risks, and to analyze it sector by sector in order to make an investment decision.
We think potential opportunities may continue in the near term from current oil prices and ongoing reform programs in many emerging market countries. Given the variations and volatility of each individual market, we believe an active management approach is the best way to invest in equities in these markets.
Analyzing impact of oil prices, reform programs
Source: Ivy Investment Management Co.; fund data as of 12/31/2016; selected emerging market countries; country allocations can and do change frequently. "Other" includes allocations to Netherlands, Chile, Thailand, Macau, U.S. and Malasia.
1 Source: Trading Economics; inflation rates as of January 2017.
2Samsung Electronics Co. Ltd., 6.16%; Alibaba Group Holdings Ltd., 3.29%; Tencent Holdings Ltd., 2.54% of net assets as of 01/31/2017.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s 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 February 2017, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Risk factors: The value of the Fund's shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. 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. 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.
The MSCI Emerging Markets Index is an unmanaged index comprised of securities that represent large and mid-cap companies within emerging market countries. The Hang Seng China Enterprises Index tracks the performance of companies incorporated in China and listed on the Hong Kong Stock Exchange. It is not possible to invest directly in an index.
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