Emerging markets still deserve attention

Ivy Emerging Markets Equity Fund
02.28.18

Investors kept a bullish view on emerging markets in 2017, resulting in strong positive returns for those equities at levels that outperformed developed markets. But do those gains indicate a turning point? We believe corporate revenue and earnings growth is likely to continue in most key emerging market sectors in 2018 and provide ongoing investment potential.

After a year of solid gains, the valuation levels of emerging market equities have become a question for many investors. While valuations levels did increase modestly, returns in 2017 in those equities were driven primarily by strong earnings revisions and earnings growth.

The estimated price/earnings (P/E) ratio for companies across emerging markets put stock prices at about 12 times (12x) the level of earnings per share as 2017 began. Despite the strong performance in 2017, consensus estimates still put the P/E at only 12.5x based on strong earnings estimates. As we entered 2018, emerging markets were trading at about two-thirds the level of developed markets, as shown in the chart below.

The weak U.S. dollar for most of 2017 also was a tailwind for emerging markets returns. The accompanying strength in commodity and energy prices helped the economies of resource-rich countries like Russia and Brazil. We think these trends will continue in 2018. The synchronized global recovery in economic activity and trade also is likely to provide support for emerging market currencies and commodity prices.

Emerging market valuations VS. Developed markets still below historical average

Source: Morningstar Direct; relative price/earnings (P/E) ratio, January 2006-December 2017, of MSCI Emerging Market Index for emerging markets and S&P 500 Index for developed markets. It is not possible to invest directly in an index. Past performance is not a guarantee of future results.

Focus on key sectors

The Fund ended 2017 with a very different weighting in key sectors compared with the start of the year. The changes in weightings are detailed in the chart on the next page.

The year began with a significant overweight in technology, which was about one-quarter of the index at that time, and an underweight in financials, materials and energy. By the end of the year, we had reduced the overweight in technology and increased positions in financials, materials and energy, as we saw increased economic strength across the globe.

In our view, supply-side reform originating in China to curb pollution and decrease financial risk also provided a favorable backdrop for commodity prices.

The technology situation in emerging markets was similar to that of the U.S., where the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) and the technology sector led the market. The Fund’s overweight position includes key holdings in internet-related stocks, semiconductors and smartphone component companies in China, South Korea, Taiwan, Russia and in Latin America.

We anticipate an important political year in 2018, and the potential changes may give rise to challenges and opportunities across market sectors. Elections are scheduled in several emerging market countries, including Brazil, Mexico, India and Russia. We already have seen major changes in South Africa, where long time President Jacob Zuma recently resigned under pressure and was replaced as president by Cyril Ramaphosa.

We think our increased focus on financials is likely to benefit from higher rates and an improving business cycle. Technology and innovation continue to be areas of focus for the Fund, with electric vehicles, biosimilars (biological medical products that are demonstrated to be interchangeable with an approved product) and financial technology becoming important secular themes.

Fund allocations VS. Benchmark index reflect changing focus on key market sectors

Source: FactSet; Ivy Emerging Markets Equity Fund allocations to key sectors in December 2016 and December 2017, compared to the allocations in the benchmark MSCI Emerging Markets Index. It is not possible to invest directly in an index.

Role of BRIC countries

In managing the Fund, we have an ongoing focus on the BRIC countries — Brazil, Russia, India and China — and have overweight positions in those countries compared with the benchmark index. Several factors drive our investment views on those countries.

China is the Fund’s biggest overweight and is a major part of the benchmark. The economy in China, which started improving in 2016, remains strong and the Fund had some benefit from exposure to the property market, financial services, domestic consumption in consumer staples and autos. China also has begun reducing excess capacity in steel, cement and coal, and we believe there are opportunities for greater exposure to commodities. The Fund invests in names globally because these basically are global commodities. If China — which is both a major consumer and producer of commodities — is restricting utilization, we believe there will be opportunities for growth that can extend to supporting industries and other commodity producing countries.

The Chinese Communist Party in late 2017 held a People’s Congress — which it does every five years — where it named the membership of the powerful Politburo Standing Committee and announced its latest five-year plan. President Xi Jinping remained in office and strengthened his position. The current five-year plan shows China’s intent to be a powerhouse in artificial intelligence, electric vehicles, industrial automation, health care innovation, new materials, alternative energy technology and environmental controls.

Both Brazil and Russia exited severe recessions last year, and equity valuations remain at low levels. The Fund is about 5% overweight in each, with sector overweights in those markets in financial services and energy. In addition, the Fund invests in some of the leading internet platforms in those countries.

We have maintained an overweight to India in the Fund. We think structural reforms there will be challenging in the near term, and India is dealing with two major changes instituted by Prime Minister Narendra Modi: the demonetization program and the introduction of the goods and services tax. We think these represent two key changes targeted at formalizing India’s economy and decreasing the associated frictions and corruption in the country.

Our key sector overweight in India is in financials, which we think can benefit from increased penetration of financial services and an improving credit cycle. We also are able to identify what we consider to be attractive stocks in that sector with differentiated earnings power, strong competitive positions and management teams that we think can create shareholder value.

We also continue to find what we believe are attractive companies that serve “new economy” themes. These include those involved in the internet, research and production of biosimilars and those serving the growing middle class of consumers in areas such as education, travel, entertainment and real estate.

An eye on geopolitics

Elections in 2018 again are likely to be market factors that we will watch closely in managing the Fund:

  • The U.S. faces midterm elections that could change the makeup and control of the House of Representatives.
  • In Russia, a presidential election in March will almost certainly keep President Vladimir Putin in office. However, many will be watching the voter turnout as a test of the popularity of many of his economic programs and policies.
  • A presidential election is scheduled at midyear in Mexico, which is in renewed negotiations with the U.S. and Canada about the North American Free Trade Agreement (NAFTA). If those negotiations still are under way, a new president might have different views on what NAFTA should look like from Mexico’s perspective.
  • Brazil will hold elections in October, including for its President. After years of scandal trials and the impeachment of a sitting president, many investors are hoping for a new president that can lead Brazil back to economic strength.

A selective, active approach

There is a tendency among many investors to think of emerging markets as a single potential investment option — which can lead to allocations that are out of sync with the situation in each country. While emerging markets collectively represent about 80% of the world’s population and land mass, we think it is important to remember that there are many variations among individual countries. We reiterate our belief that it is critical to analyze each country’s fundamentals and idiosyncratic risks, and to analyze it sector by sector in order to make an investment decision. Given the variations and volatility of individual markets, we believe the consistent application of our active investment process is the best way to invest in equities in these markets.


FIVE FORCES DRIVING EMERGING MARKETS NOW

Attractive valuations

Emerging market equity valuations trading at significant discount, and below historical averages, to developed markets.

Energy prices

Importing countries are benefitting from “lower-for-longer” energy price scenario and lower relative input cost; range-bound prices have reduced volatility and offered some downside protection for exporting countries.

Surging innovation

Many leading technology companies are based in emerging markets, especially in Asia; cover wide spectrum, including e-commerce, technology related to visual recognition, security systems, advanced driver assistance systems, self-driving cars, gaming, smartphones, virtual reality, digital medical imaging and more.

Geopolitical factors

Elections are scheduled in the U.S., Russia, Mexico, Brazil, plus tensions continue on Korean Peninsula and in Middle East; South Africa has a new president after the sitting president resigned; political reform is a key driver for growth and market recoveries, and may offer selected emerging market opportunities.

Trump agenda

Global trade among emerging markets remains strong and recent U.S. tax reform likely to be positive for emerging markets; missteps by U.S. administration could result in geopolitical turmoil, increasing volatility.

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 2018, 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 S&P 500 Index is a float-adjusted market capitalization weighted index that measures the large-cap U.S. equity market. The index includes 500 of the top companies in leading industries of the U.S. economy.