Developing world equities have largely struggled compared with the likes of the UK and US over recent years as issues such as slowing economic growth in China, current account deficits and the impact of tighter monetary policy in the US have all weighed heavily on investors’ minds.
Though there were signs that emerging markets had bottomed earlier this year, they were one of the worst hit during the sharp correction in October. It means that, according to FE Analytics, the MSCI Emerging Markets index has returned less than half the amount of the MSCI Developed World index so far this year.
Performance of indices in 2014
Source: FE Analytics
That being said, investors seem to be growing more bullish on the developing world as the annual Schroder Adviser Survey showed advisers are planning to up their clients’ exposure to emerging market funds over the coming year.
However, Gutteridge says investors need to be very selective in terms of their fund choices as there will be some clear-cut winners and losers next year.
“Emerging markets are a difficult equity space to shed light upon as it not a homogenous asset class, however, it is of our opinion that Latin American generalist funds and Brazilian funds are unappealing,” Gutteridge (pictured) said.
“Our primary concern within Latin America is the fortunes for the Brazilian economy and its stock market. Having frequently commented on the negative outlook for Brazil, and successfully predicting the nation would fall into recession, we see no catalyst for a turnaround and expect continued malaise and disappointing equity returns.”
Gutteridge’s major worry with Brazil is its exposure to commodities, and with Chinese demand expected to slow over the coming years as its authorities try to move the economy to a consumer driven model, he warns that the outlook is very bleak.
“Looming large in the commodities market is decreasing demand as well as a large excess in supply, with China’s recent announcement of an industrial slowing and oil flooding the market,” he said.
“Although only forming about 25 per cent of the Brazilian benchmark, this understates the importance of fiscal redistribution from these assets. As a significant part of the Brazilian government agenda, falling prices will weaken their ability to stimulate.”
“The alternative is to raise taxes but this would simply choke of profitability for large portions of the market.”
He is also concerned that Brazil is in desperate need for economic reform as productivity gains have been stifled and the country is now very uncompetitive as a manufacturer.
According to FE Analytics, the MSCI Brazil index has materially underperformed the wider market over recent years, losing 20 per cent over three years while the MSCI Emerging Markets index is up 11 per cent.
Performance of indices over 3yrs
Source: FE Analytics
Despite that, there are a number of funds in the IMA Global Emerging Markets sector which are overweight Brazilian equities relative to the MSCI Emerging Markets index.
The list includes Baillie Gifford Emerging Markets, Charlemagne Magna Emerging Markets Dividend, Polar Capital Emerging Markets Income, M&G Global Emerging Markets and the multi-billion Aberdeen Global Emerging Markets Equity fund.
Gutteridge warns those who think Brazil now offers good value following its poor performance are making a mistake.
“As is the case with many emerging markets, aggregate valuations are dragged down by the large and inefficient state owned (influenced) enterprises such as Vale and Petrobras. The outlook for these companies is poor and their lowly valuations are well merited,” he said.
“Away from these companies and the financial sector, the index is not particularly cheap. Brazil, therefore, is a classic value trap.”
While Gutteridge thinks Brazil will be a loser next year, he believes India will be a winner.
“We have a positive outlook for the Indian market, given the ambitious reform programme the country is embarking on,” he said.
“It was not so long ago that India was lumped together with Brazil and others under the moniker the ‘fragile five’. What’s changed since then to make us so positive? Well, in short, a lot!”
He points to the decisive election victory of Narendra Modi in May this year as a major turning point and says Raghuram Rajan, the central bank governor of the RBI, is working hard to revive the economy by tackling the main issues of inflation, its current account deficit and fiscal account.
India has been one of the best performing markets this year, with its equities returning more than 30 per cent year to date. Though those strong gains over such a short period of time might be a turn off for some investors, Gutteridge expects more of the same over the longer term.
“With such a structural tailwind in place of genuine reform, India’s potential growth rate must rise. Given this, we believe the moderate premium currently afforded the market is justified,” he said.
“Indeed in conversations with [lauded economist] Nouriel Roubini just recently, it was proclaimed that India would be growing faster than China in 2016.”
He added: “We have long derided the ‘supposed’ correlation between economic growth and stock market returns.”
“However, when you observe above trend growth, and it is combined with government and monetary policy that renders such growth as sustainable, we believe this is a powerful cocktail for long-term equity gains.”
Gutteridge’s favoured fund for this market is the Ocean Dial Gateway to India fund, which is domiciled in Ireland and sits in the offshore universe.
The portfolio, which is headed up by David Cornell, is relatively concentrated as it is made up of just 42 holdings. Its top 10 holdings account for close to a third of the total portfolio.
Cornell is currently overweight cyclical areas such as materials and industrials but is underweight defensives like consumer staples.
Since its launch in September 2012, it has returned 69.75 per cent beating the FO Equity India sector by more than 25 percentage points. As a point of comparison, the MSCI India index is up 55.05 per cent over that time.
Performance of fund vs sector and index since Sep 2012
Source: FE Analytics
The $80m fund has an annual management charge of 1.5 per cent.
Other direct India funds include JPM India, Jupiter India and Invesco India Equity. Emerging market funds which are overweight India relative to the index include Somerset Global Emerging Markets, First State Global Emerging Markets and Skagen Kon Tiki.
Our data shows there are 38 funds in the IMA Asia Pacific ex Japan funds which are over overweight India, including the likes of Fidelity Emerging Asia, First State Asia Pacific Leaders and JOHCM Asia ex Japan.
