During Q2 24, the fund lagged the MSCI Emerging Markets index by 4.5%. Most of this difference accrued during June when we saw a series of elections generate significant volatility in markets.
The quarter’s underperformance was driven by four distinct geographies. In China we saw an unfavourable stock selection effect as the highly discounted internet stocks that we owned reversed earlier gains. In contrast, some of the more expensive and growth-oriented names continued to perform well and created a major disconnect. The Brazilian market as a whole was hit hard by a reversal in Fed rate cut expectations. This impacted domestic cost of capital and caused a currency sell-off, which in turn hurt our smaller and mid-sized stocks disproportionately. In Mexico, the emphatic win by the incumbent Morena party’s candidate has raised fears of excessive concentration of power and led to a market and currency selloff. Finally, elections in India where we are underweight have led to a market rally despite an unfavourable outcome for the reformist government.
Our positions in Taiwan and Korea have continued with a positive contribution but this was not sufficient to offset the other areas. It has been an unusual quarter in the sense that this time our portfolio diversification was overwhelmed by multiple unrelated unfavourable developments.
We have been active in response to these developments, both in reassessing some existing positions and in taking the opportunity to enter new ones. Our overall exposure to domestic Brazil has fallen in response to the higher for longer rate environment but we have also been buying US$ earners in the energy space that have been unfairly discounted. A similar shift is taking place in our Mexican portfolio where we are more concerned about the upcoming US election than the incoming presidency of Claudia Sheinbaum. We have added a new highly discounted internet stock in China and some new ideas in Korea and the UAE. Finally, we are building up some exposure to South Africa where the new centrist unity government may help reduce the cost of capital. Combined with a gradual improvement in the energy supply situation, this could allow some resumption of growth in the country.
At the half-way point in the year, EM markets have diverged significantly in performance, especially when taking account of currency moves. The strong US dollar has disproportionately hurt returns in Brazil but also affected most Asian markets. The latter currencies seem to have largely moved in sympathy with the volatile Japanese Yen.
We don’t believe that it is possible to consistently forecast near- or mid-term currency movements. Over time however, we expect these to inversely correlate to the yield premium that local bond markets offer to the dollar. Countries with insufficient domestic savings rely on foreign portfolio flows for domestic investment and need to offer high yields. When these flows dry up, the currencies depreciate as we have witnessed in Brazil this year.
Looking at inflation adjusted exchange rates, we note that the Turkish Lira, Brazilian Real and South African Rand have been the weakest major EM currencies since 2010 although during that time they also enjoyed periods of stability thanks to their carry trade status.
While the Korean Won and Taiwan dollar have also dropped over the past three years, this is a only a recent phenomenon and unlikely to be due to structural issues. These countries continue to enjoy cheaper financing terms than the US thanks to plentiful domestic savings. Given their export oriented corporate sectors, such a depreciation is a tailwind for earnings even though translating into dollars affects returns for foreign equity investors.
Given the US$ strength over the past few years there is at least room for some reversal, especially against fundamentally strong currencies. How this actually plays out may depend on policies implemented by the next White House occupants. Among the big macro moves, there are bound to be opportunities to pick up fundamentally sound companies whose valuations have been buffeted by global dislocations.
