Neither. The emerging markets equity managers that we respect and follow closely have not become meaningfully more aggressive; however, many have used the volatile market conditions to do some bargain hunting, upgrade portfolios, and modestly shrink their cash balances.
The recent turmoil has, in many ways, been a classic case of the scenarios that tend to disadvantage emerging markets. USD strength is generally bad for emerging markets. Emerging markets typically have weaker institutions, and corruption can negatively impact local economies, delay needed reforms, and promote imbalances. Examples of these problems abound in Brazil, South Africa, and Turkey. Weak institutions can also increase investor sensitivity to political leadership changes, evidenced by the peso sell-off preceding Mexico’s July election of fiery leftist Andrés Manuel López Obrador as president. Add to this concoction of 2018 EM disruptions a dash of potential sanctions in Russia and trade war risk in China, and it is not surprising that EM equities, a classic risk asset, are struggling.
Many investors might look at these developments and be wary of drinking the potion that emerging markets have served up this year. However, seasoned managers (that we respect) have weathered turmoil before and, through their experience, have arrived at strong views about which ill-tasting potions improve long-term returns and which will bring unrewarded pain. For them, this environment has largely been one of “business as usual.” They have mostly kept, rather than cut, their exposure to higher headline risk countries—including Brazil, Mexico, Russia, and South Africa—and marginally increased their weights to China and India. China and India have deeper opportunity sets; China’s accessible market has continued to expand, and India’s headwinds are seen as more transient than those in Brazil or South Africa. In addition, though portfolio cash levels increased marginally and briefly around the second quarter, several managers have been redeploying that capital in recent months amid the market’s retreat.
Notably, some style trends are evident within managers’ choices. For example, value and value-leaning quantitative strategies were more likely to increase, rather than just maintain, their Brazil exposure. Quality growth and quality GARP (growth at a reasonable price) strategies were more likely to boost India exposure than pure value strategies.
Furthermore, even in portfolios where country weights did not shift much, we saw some individual stock rotation within the country positioning. Companies that held up well were replaced by oversold peers, and companies with newly elevated exposure to risks, such as sanctions, have been sold in favor of ones less likely to fall in the crosshairs (e.g., a GARP manager sold a Russian metals producer and reallocated the proceeds to positions in a rail freight firm and a state-affiliated bank). In fact, our conversations with managers revealed that many of the marginal country shifts were more the result of company-specific decisions, rather than a means of implementing overarching negative views on specific emerging markets. Managers’ decisions on whether and how to adjust their Brazil exposure hinged on whether they viewed the resignation of Petrobras’ chief executive as a sign of government meddling after the trucker strike, and whether they believed the stock’s risk/reward compensated for these questions, given that it had already rallied. Value managers tended to hold on, while growth managers looking for a stronger earnings and revenue growth trajectory to hold on tended to sell, particularly those with a quality bias. Similarly, managers’ South Africa weight has tended to have more to do with how they feel about Naspers (30% of the MSCI South Africa Index, and a major holder of shares of Chinese media firm Tencent), than how they feel about South Africa’s domestic situation.
Overall, and despite the noise, conversations with these managers reflect the mood of business as usual. Managers we speak with have largely remained constructive on EM fundamentals. While they may have briefly paused mid-year to digest near-term risks and not rushed to redeploy capital at that time, since then they have been picking up opportunities, rather than shying away from risk.
Dorota Spaulding, Senior Investment Director on Cambridge Associates’ Global Investment Research Team