Contrary to popular belief, a strengthening dollar and the election of Donald Trump as US president could actually work in the favour of emerging market equities this year, according to Somerset’s Edward Lam (pictured). 
The FE Alpha Manager, who heads up the five crown-rated Somerset Emerging Markets Dividend Growth fund, also believes rallying Indian equities are not in a bubble and that Russian banks are more attractive than many investors realise.
While he acknowledges that these views are somewhat contrarian, Lam says playing these themes in his portfolio should stand his £1.3bn fund in good stead over the long term.
Being unafraid to break with consensus has indeed fared well for Somerset Emerging Markets Dividend Growth’s performance in the past (although this is of course no guide to future returns).
Since Lam launched the fund in March 2010, it has almost doubled the performance of its average peer with a 64.85 per cent total return, which was achieved with a top-decile maximum drawdown (which measures the most money lost if bought and sold at the worst possible times), annualised volatility and Sharpe ratio (which measures risk-adjusted returns). It also would have earned investors £1,782.44 in income alone based on an initial £10,000 investment.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
In the below article, the manager discusses the perceived headwinds that emerging market equities are facing in 2017 and how they could bolster the market area.
The election of Donald Trump as US president will hinder EM
Since the controversial Republican candidate won the US election last November, the MSCI Emerging markets index has struggled to keep up with developed market indices. This is partially due to Trump’s plans to implement hefty trade barriers on the likes of China and Mexico in a bid to revive the US industrial and manufacturing sectors.
“Even before the election happened, I was of the view that, regardless of whether Clinton or Trump got in, it would be positive for emerging markets,” Lam said. “The basic reason for that – and obviously it was speculative – was that both candidates were fiscally dovish.
“Trump doesn’t break that mould and, fundamentally, any increase in spending by developed markets is very positive for emerging markets.
“In fact, there’s a dirty correlation between austerity post-crisis and the slowdown in global trade, the slowdown in global capital flows and the bear market in emerging markets.”
As such, the manager now believes we are at an inflection point and that Trump is simply another symptom of a changing global climate, rather than an actual pivot.
“The issue of protectionism is very interesting. That is what makes is much more interesting than what would have been the very simple story,” he continued.
“But, all I’d say about that is that it changes our stance from being generally bullish on emerging markets to being selectively bullish.
“Trump wants to spend more like everyone else but he doesn’t want to spend on everything and he wants to cut out certain countries. So he may try to cut out Mexico and he may try to cut out China, but if he cuts out China he probably will probably have better relations with Taiwan, for instance, and spend more there.”
A strengthening US dollar will mean EM equities struggle
Given that many emerging market regions have high amount of dollar-denominated debt on their balance sheets, investors are fearful that Trump’s fiscal loosening will boost the strength of the US dollar and therefore act as a major headwind for emerging market equities.
Performance of indices over 10yrs
Source: FE Analytics
“Again, I’m not concerned about that at this stage in the cycle,” Lam said. “We’ve been consistent on the view that a strong dollar is not always a negative for emerging markets.
“Strong dollar is negative for emerging markets in the early stage and the middle stage of dollar strength but, at the late stage of dollar strength – which is probably where we are now – I think it’s actually positive for emerging markets.
“When you think the Brazilian real has gone from 1.50/1.60 real to the dollar to now touching 4, if there were any dollar debt problems, they would have already been flushed out. Any further increase in the dollar is not going to cause any more companies to look like they’re going bankrupt.”
In fact, he says that a weakening of local currencies relative to the US dollar means assets look very cheap and are easier to bail out.
“It’s fair to say there are some countries where this dynamic has not played itself out, so there’s still risk, but what I would say is we’ve already had a lot of dollar strength and that’s now positive for emerging markets,” he added.
Indian equities are ‘in a bubble’
The benefits of buying Indian equities for 2017 have been well-publicised by numerous industry commentators, given the ongoing implementation of Modi’s reforms and improved corporate governance in the country.
However, this is reflected through market movements year-to-date, given that the MSCI India index is already up 13.46 per cent in sterling terms.
Performance of indices in 2017
Source: FE Analytics
Lam doesn’t believe Indian equities are in a bubble and says the country still yields attractive investment opportunities.
“I think India is a great market to be involved in. It’s fair to say that India is not an easy market for stock-pickers because, in general, valuations are higher,” he reasoned.
“Having said that, it’s not a reason not to be involved in India. I think you have to accept that some premium has to be paid.
“Part of this is based on my experience of the previous Indian bull market in 2004 to 2007 in which, again, there was always the complaint through that market. ‘Isn’t India just overvalued? Shouldn’t we be selling?’
“In reality, you’d have done a lot worse by selling out of that market. It was never a bubble and I think it’s fair to say the same is true now. There are one or two stocks that might be in a bubble or irrationally priced but, as a market overall, I don’t think it’s anywhere near close to that.”
EM financials are untrustworthy and often state-owned
“There are quite large misconceptions when it comes to emerging market banks and that’s what we often look for. One of the big surprises, even to me over the last two years, has been Russia,” Lam said.
“If you talk to the average person on the street or even the average global investor, I think you’ll come back with a very dim view of the Russian banking system and the Russian banking sector. People still have 1998 in their minds. Even if you asked me three years ago, I would have said the Russian banking sector is a bit of a basket case.”
The manager explains that, for more than a decade up until 2015, the Russian banking system was in liquidity deficit.
Now, however, he says the Russian banking system has moved into a liquidity surplus, which has been the result of a change in sentiment from the Russian central bank.
“Prior to the change in liquidity situation, the central bank has essentially shifted – as of 2013 and 2014 – to a relatively strong inflation-fighting mandate,” Lam explained.
“I’ve been following Russian central banking statements since 2007 or so. This is the first time I have seen them remaining consistent with actually tackling inflation as opposed to being relatively soft on inflation and effectively focusing on the nominal growth of the economy, unemployment and other things that might be the issue.
“That is a large part of the explanation behind the excess liquidity in the banking system. I think it is going to really help the economy, because the banks now have surplus funds to invest and that will help both the consumers looking for loans and also any infrastructure projects or capital spending that people want to do.”
The fund’s weighting in Russian equities has increased from zero per cent at the start of last year to more than 4 per cent now. The fund’s largest sector weighting is in financials at 33.1 per cent.