“We believe emerging markets are a cycle not a trend. Their complexity, volatility and dispersion are fertile ground for active investing and generating alpha,” Gordon Fraser, managing director, global emerging markets equities at Blackrock said at a media briefing in Hong Kong this week.
Fraser is on a mission to dispel the notion, common among investors, that the asset class is simply a structural growth play.
Instead, he argues that emerging markets are cyclical and mean-reverting, with their macroeconomic condition going through four stages of decline, recovery, liquidity inflows and a surge in activity.
Blackrock’s portfolio managers, supported by a team of 37 analysts, aim “to capture the turning points, buying early cycle countries that are improving and selling late cycle countries that are deteriorating,” he said.
Capturing the turning points is especially important because of the volatility and dispersion in emerging markets – the same features that offer alpha generating opportunities can also lead to underperformance.
Fraser pointed out that in 19 of the last 20 years, emerging markets had a drawdown of at least 18% from their peak, and that during the same period 75% of stocks within the MSCI Emerging Market index have moved by more than 40% per year.
The inference is that there are almost always opportunities in emerging market equities: they are not a homogenous asset class, instead each country travels though its cycle at its own pace.
That belief is reflected in Fraser’s strategic allocations. The $1bn Blackrock GF Emerging Market Fund, which he manages, has its largest overweight positions in Mexico and Russia.
“Both countries are enjoying the benefits of reform measures that will improve their macro conditions and are therefore set for market upturns,” he said.
In contrast, Fraser is underweight India which is “vulnerable to a credit crunch and whose domestically-driven market is on a downward trend,” he said, while South Africa and Taiwan are in the “sell-off” stage of weakening economic activity.
Fraser is “style-flexible”, alternating between a growth and value bias. For most of 2018, his portfolio had a value tilt, and switched to a growth emphasis last year, which he currently maintains.
In terms of sectors, this translates into overweight positions in healthcare, information technology and consumer discretionary stocks, and underweights in materials and financials.
However, his negative view on the latter is buttressed by his belief in a secular trend of rival fintech firms putting pressure on banks’ fees, as well as the cyclical phase of flat yield curves, (particularly) in Asia, reducing interest income.
The Blackrock version of a top-down strategy seems to have rewarded investors. Its Emerging Market Fund has generated a 53.53% cumulative return (in US dollars) during the past three years, placing it fourth among 64 emerging market equity funds authorised for sale in Hong Kong and/or Singapore, according to FE Fundinfo data.
Its annualised volatility of 14.04% is higher than the sector average (11.96%), but lower than its MSCI Emerging Markets index benchmark (14.27%).
Fraser reckons the biggest risk to market performance are companies that have benefited most from a decade of low interest rates by increasing leverage and investing in high-risk projects.
However, perhaps, the fund’s greatest vulnerability is that other investors do not share the Blackrock strategy of defining individual emerging market countries by their “turning point” phases.
Instead, index tracking, bottom-up stock picking or fluctuating sentiment about the “structural case” for emerging markets in general might prevail.
Blackrock GF Emerging Markets Fund country and sector weightings vs MSCI Emerging Market Index
Source: Fund Fact Sheet (30 November 2019)
Generic case for emerging markets
However, despite the selectivity, finessing and timing that characterises Blackrock’s approach, Fraser also made the more familiar case for emerging market equities as a whole.
Supportive factors include improving liquidity in many countries, beneficial effects of reforms, slowing negative revisions to earnings per share, cheap valuations (price-to-earnings at a 20% discount to developed markets), negative emerging market outflows last year and underweight positions among global mutual funds.
In fact, in December, the Apac strategist at the Blackrock Investment Institute, Ben Powell told media that higher global growth and easy financial conditions should support emerging market asset prices in general, and especially in Latin America.
Even Sean Taylor, chief investment officer for Asia-Pacific at DWS, who had maintained a cautious stance throughout most of last year, enthused in December that “emerging markets…should be the engine of global growth” in 2020. The German asset manager has now made overweight bets on Brazil, China, India, Russia and Thailand.
In the same month, Patrick Brenner, head of multi-asset investments in Asia at Schroder Investment Management, argued that emerging markets are in a “sweet spot”, pointing to the low multiple of the the MSCI Emerging Markets index compared with European markets. He was also encouraged by the prospect of a phase one trade deal which could prompt a rebound in Asian assets, in particular Chinese equities and other export-oriented markets such as Korea and Taiwan.
However, this week Robert Horrocks, veteran chief investment officer of Matthews Asia, lamented both the failure of Asia policy makers to take advantage of a great opportunity to stimulate their economies through monetary and fiscal policies, and the reluctance of investors to appreciate the value available in Asian stock markets.
Blackrock GF Emerging Markets Fund vs MSCI Emerging Markets index and sector average