Emerging markets have potential for brighter 2019

Ivy Emerging Markets Equity Fund

We still believe that the main headwinds for emerging markets in 2019 are idiosyncratic risks and will affect relatively few countries. While market volatility is likely to persist, we believe the fundamental basis for investing in emerging markets still is intact.

Emerging markets started 2018 with a gain of more than 8% in January, based on the MSCI Emerging Markets Index, after gaining nearly 35% in 2017. The largest issues were in Asia (China, South Korea and Taiwan), where the U.S.-China trade war led to a technology sell-off in a variety of industry segments. The strength of the U.S. dollar also was a drag across the board. The index closed 2018 down 14.6% and the Morningstar Diversified Emerging Markets category was down more than 16%.

But there was a wide dispersion of returns among emerging markets — especially considering U.S. dollar returns versus local-currency returns. While many markets have had negative returns in U.S. dollar terms, a few of the local market returns have been positive.

China (-19%), South Korea (-21%) and South Africa (-25%) were among the worst-performing emerging markets for the year. By contrast, markets in Brazil (-0.5%), Russia (-0.7%) and India (-7%) held up relatively well.

We don’t see a systemic or fundamental deterioration in many of these markets. As shown in the chart, the strength of the U.S. dollar affected countries in different magnitudes. In aggregate, U.S. investors had about a 4.5% drag on returns from the weakening of emerging market currencies.

Comparing 2018 performance in U.S dollar and local currency terms (%)
Chart Comparing 2018 performance in U.S dollar and local currency terms (%)

Source: Morningstar Direct; country returns in % based on MSCI Emerging Markets Index, 01/01/2018–12/31/2018, in U.S. dollar and local currency. Past performance is not a guarantee of future results.

Impact on fund and positioning

After the challenges of 2018, the Fund closed down 19.48% (Class I) for the year.

The Fund opened 2018 with overweight allocations to China, Russia and Brazil — each of which were later hit by headline risk or the strength of the U.S. dollar.

The largest detractors to the Fund’s performance relative to the index for the year were:

  • An overweight allocation the consumer discretionary sector, which turned out to be the worst-performing sector in the index. Exposure in particular to Automobiles and Internet/Direct Marketing stocks in the sector hurt performance, as these industries were in the crosshairs of the trade war rhetoric.
  • Holdings in the materials (Metals & Mining) and information technology (Electronic Equipment) sectors.
  • Stock selections in general in China and South Korea.

The Fund had positive contributions from holdings in the financials and real estate sectors. In addition, the overweight allocations to Brazil and India were top contributors.

A brighter outlook for 2019

We think valuations remain a supportive theme for emerging markets. While not at extreme discounts in both absolute and relative terms when compared to developed markets, they are below historical median levels.

Overall, emerging market equities ended 2018 trading at 10 times the 2019 consensus estimates of projected earnings, a 27% discount to developed markets. We think this relative valuation level still offers potential opportunities for emerging markets investors.

We also believe positive secular themes continue to propel companies in fields related to technology, the internet, biotechnology, financial services and middle-class consumption, and these remain an integral part of the Fund.

As we open 2019, here are our views on a few of the top country allocations in the Fund:

  • Brazil — After a record-setting recession, Brazil is in the early stages of a recovery. We think valuations there remain attractive and we believe interest rates will stay lower for longer because inflation is under control. A new government in Brazil in 2019 also offers the promise of fiscal reforms.
  • India — We believe India adds an attractive risk profile to the Fund by being relatively immune to the trade-related headwinds elsewhere in Asia. We continue to find what we believe are attractive secular growth stories in financial services, energy and the consumer space.
  • China — While it appears there may be a thaw in the ongoing trade tensions between the U.S. and China, there is no resolution yet. That leads us to cautious positioning because this is a critical issue for China and its Asian trading counterparts. We believe China has started loosening domestic policy and we expect an easing of regulatory, monetary and fiscal policies. We think such a move will support its economy. We already see early measures that are benefitting China’s private sector, personal consumption and infrastructure spending and we think more such measures are likely.

There are challenging issues facing many emerging markets — including slowing growth in the global economy, ongoing trade dispute and elections scheduled in several key countries — but we believe a variety of factors can combine to create a brighter outlook for 2019.

Fund Performance

Past performance is no 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 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-capitalization companies within emerging market countries. It is not possible to invest directly in an index.