Equity markets in most emerging markets are lagging the US and Europe significantly this year. The reason for this is the stricter rules for listed companies in China and the continuing impact of the coronavirus. While the former is an ongoing source of uncertainty for investors, the latter creates buying opportunities, particularly in Southeast Asia.
This is the view of Tom Wilson, head of emerging markets at Schroders, in conversation with our sister publication Fondsnieuws talking about the Emerging Markets Equity Alpha Fund. “In the Asean region [Southeast Asia], some banks have upside price potential of up to 40 percent,” Wilson says. “The prices of those banks have fallen sharply this year, and those price declines are entirely due to risks around Covid.”
In most emerging countries, at most 15-20 percent of the population has been vaccinated. Wilson: “Emerging markets are lagging behind enormously, particularly in terms of second vaccinations. This is true for almost all countries in the index, with the exception of countries in the European union, such as Poland, the Czech Republic and Greece.” That makes emerging markets vulnerable to the highly contagious Delta variant. “The current acceleration of infection rates in many countries is problematic and has a negative impact on short-term growth and equity markets.”
But when vaccination rates have risen sufficiently, the epidemic will eventually be able to be brought back under control, Wilson expects, and the earlier share price losses will be recouped. “The only question is when that will happen.” Anticipating the eventual recovery, Wilson’s fund has already increased its positions in some Southeast Asian banks. “And we are thinking about increasing those allocations even further.” He does not want to say which banks are involved, because he does not want to talk about individual stocks.
Furthermore, Wilson does not see too many opportunities in cyclical stocks anymore. We have largely passed the reflation trade. Many cyclical stocks have already risen sharply. The period of making easy money is now largely over.
According to Wilson, the investment process of the Schroders Emerging Markets Equity Alpha Fund, one of the funds the team manages, cannot be captured by growth or value. It has, certainly compared to many other emerging markets funds, a relatively large allocation to financials (25.4 percent, compared to 17.7 percent for the benchmark) but growth stocks are also well represented in the portfolio. For example, the fund’s top-four offers a familiar sight with Samsung, TSMC, Alibaba and Tencent.
Uncertainty around Chinese tech
The latter two companies in particular have been under fire lately, as the Chinese regulator has been targeting them. Earlier this year, the IPO of Alibaba’s fintech branch Alibaba was blocked, and the regulator is also investigating abuse of their market position by Alibaba and Tencent, among others. Alibaba has already been penalized with a billion-dollar fine for this. The most recent victim is cab company Didi, this time for alleged misuse of data.
Albert Kwok, manager of the PGIM Jennison Emerging Markets Equity Fund, resigned from Alibaba earlier this year because of the company’s problems with the regulator, but Wilson sees no reason to do so as yet. “Increasing regulation may be appropriate because it addresses problems such as limited competition, inequality or systemic risk,” Wilson believes. “But markets don’t like regulatory uncertainty. Tighter supervision can put pressure on profits, and we anticipate a period of significant changes in Chinese regulation,” Wilson signals.
Another concern that has hit the Chinese market in recent days is the fear that so-called Variable Interest Entity (VIE) holding structures will be reviewed. Wilson: “These structures have been used to circumvent restrictions on foreign ownership. They are contractual agreements that give access to the economic benefit of a company without owning the underlying assets”. Wilson believes that U.S.-listed entities using VIE structures (including Alibaba) will continue to be listed in Hong Kong, but the extent and impact of any revision is uncertain and has led to a higher risk premium for such stocks, he believes.
‘Volatility is now normal”
It remains to be seen how long the current uncertainty surrounding supervision in China will persist. “In the short term, such uncertainty leads to lower valuations in the stock market, because the operational consequences of any stricter rules are unclear. Volatility in stock prices is normal during such periods.”
Wilson’s fund is down more than 7 percent in the past month, and that is mainly due to the market correction in China. The stock markets in Shanghai and Hong Kong are already almost 20 percent in the red this month. The question is to what extent “the new normal” of permanently lower corporate profits due to stricter regulations has now been priced in.
“The key question now is whether the regulatory environment is stabilizing after new rules are enacted or whether the business environment in China has become less predictable,” Wilson said. The answer to that question will determine whether the Chinese tech sector remains attractive to (foreign) investors, or whether they would be better off looking elsewhere. For the time being, the market will not get the opportunity to calm down. After the Chinese regulator also announced strict new rules for private education providers on Monday, stock markets fell further.
Key facts:
- Fund returns after expenses (YTD, 1, 3 years) (+4 percent, +26 percent, +40 percent)
- Manager experience: Head of emerging markets equities Tom Wilson (20 years’ experience, including 20 years at Schroders)
- Schroders EM Equity Alpha portfolio manager Waj Hashmi (28 years’ experience, including 16 years at Schroders), Robert Davy (38 years’ experience, including 35 years at Schroders)
- Assets under management EM fund range 36 billion euros
- Assets under management fund range 641.7 billion euros / 785.1 billion dollars by 31/7/2020