July 2016. For professional investors only. Compared to more established economies, the value of investments in emerging markets may be subject
to greater volatility due to differences in generally accepted accounting principles or from economic or political instability. Please read the important
disclosure at the end of this article.
Rob Marshall-Lee
Investment Leader
Emerging and Asian equity team
The UK’s vote to leave the European Union: a
boost to emerging markets and Asia?
Introduction
The UK’s vote to leave the European Union is likely, we think, to put an end to expectations of rising
US interest rates, as global recession and deflationary fears increase. In Europe, the risk of knock-on
fragmentation of the peripheral countries is likely to put pressure on the euro and further paralyse
already weak economic activity, compounding structural impediments, such as weak demographics
and unaffordable pension promises for the baby-boomer generation. For emerging markets, the
change in interest-rate expectations is a boon, removing the fear of reduced rate differentials, and
hence the reversing of capital flows required by growing economies.
A number of emerging economies are driven by internal growth, including India, the Philippines, and
even China and Mexico, which are less export-dependent than historically, instead led by economic
reforms and the development of the middle-class consumer. That said, we need to be aware that the
more export-dependent companies and regions will see some headwinds, although this is more of a
continuation than something new.
As European markets become a less attractive destination for capital, owing to political and economic
risks to the currency and profit growth, and bearing in mind long investor positioning in Europe, we see
this as focusing attention on the more robust emerging markets as more attractive and undervalued
alternatives. Consider that the US dollar has had a long run of strong performance, as have US equity
prices, despite profits showing contraction. We believe this leaves US equities also looking very
expensive in relation to emerging-market equities for the long-term investor. The big drag for emerging
markets has been currency depreciation, but, with commodity prices stabilising and internal consumer
demand correction well progressed where necessary, most current accounts have inflected where
they had been in significant deficit, indicating that these currencies are cheaper than they should be.
In markets such as India, we are seeing positive earnings inflection, and we expect this to manifest
itself in real hard-currency terms as attractive investment returns.
The outlook remains highly differentiated, so we would not endorse investing much in Brazil or Russia
for now, but we believe that economies that did not ride solely on the commodity boom are broadly
attractive. With through-the-cycle valuations at levels we do not see as demanding, good profit growth
prospects, depressed currencies and an obvious source of cash looking for a new home, we think this
is an opportune time to consider an allocation to a well-considered emerging-market or Asian equity
strategy.
The pre-referendum backdrop
We have not made any knee-jerk decisions following the surprise UK referendum outcome. Instead,
we have been thinking about the way the global economy and markets are likely to look over the
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coming years and which securities are going to be the best investments to protect and grow your
purchasing power. It is worth remembering that much of the recent economic growth in the developed
world has been a function of zero rates, quantitative easing and similar artificial policy support
measures forcing up asset prices via lower discount rates. This has led to house-price appreciation
and strong bond and equity markets with trickle-down growth effects. Some deleveraging has
happened in places, but it has largely been offset by increased leverage elsewhere – both government
and private. US equity earnings have benefited from massive buy-backs, for example, while
companies have used cheap debt to buy earnings through acquisitions, even if we deem such moves
value-dilutive (using a sensible cost of capital).
What has been noticeably absent is productivity growth. There has been little productive investment
by companies or governments, as capital has been misallocated to assets such as property and
financial engineering, attracted by lower bond yields. In large swathes of the developed world,
population growth continues to decline, and high debt levels and pension liabilities suggest growth and
wealth have already been appropriated from future generations. Structurally, greater levels of
automation and cloud computing (as identified by our smart revolution theme) are likely to keep
developed-world wage growth and employment below historic trend levels; combined with high debt
dependency, this suggests to us that looser monetary policy is likely to be here to stay in the medium
term.
And now…
We think the UK referendum vote is significant for many reasons, and that the implications are wideranging.
First, we have to recognise that there are many uncertainties, which is part of the problem in terms of
near-term activity freezing. Likely ramifications include a weaker euro, weaker economic growth,
higher risk premiums on equities and corporate bonds, and spreads widening in the more peripheral
European countries (such as Italy) versus core European countries (such as Germany); Greek and
Italian 10-year yields have risen even as those in core Europe have fallen since the results of the vote.
Exhibit 1:
Italian vs German generic 10-year government bond yields and the spread between them
8
7
Yield (%)
6
5
4
3
2
1
0
-1
Jul-11
Apr-12
Italian bond yield
Source:
Feb-13
German bond yield
Dec-13
Oct-14
Aug-15
Jun-16
Spread (Italian bond yield minus German bond yield)
Bloomberg, 29 June 2016
Hence we believe we can pretty much forget any threat of rising interest rates anywhere in Europe,
North America, Japan or other major markets outside Asia in the near future. This takes the pressure
off many emerging-market and Asian currencies and bond yields, which suffered in 2013 from the
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‘taper tantrum’ as the market moved to price US rate rises that have since failed to materialise, apart
from a meagre 25bp rise in December 2015. The charts below illustrate some of the thinking behind
this perspective.
Exhibit 2:
US 2-year generic government bond yield, effectively showing future rate expectations. Note
the surge from mid-2013, which rocked emerging and Asian markets
1.2
1.0
Yield (%)
0.8
0.6
0.4
0.2
0.0
Jul-11
Source:
Apr-12
Feb-13
Dec-13
Oct-14
Aug-15
Jun-16
Bloomberg, 29 June 2016
Exhibit 3:
Indonesia 10-year generic government bond yield – spot the taper tantrum! This is typical of
Asian bond markets over the period and precipitated a sharp currency devaluation and equity
market sell-off
10
Yield (%)
9
8
7
6
5
4
Jul-11
Source:
Apr-12
Feb-13
Dec-13
Oct-14
Aug-15
Jun-16
Bloomberg, 29 June 2016
The currency collapse and interest-rate increase in Indonesia in 2013 (from 5.75% to 7.5%) led to a
correction in imports, driven partly by reduced consumption, which offset lost exports from
commodities, leading to a rebound in the current account (see exhibit 4 below). Essentially, we think
this tells us that the currency got too cheap. We are using Indonesia as an example to illustrate what
has been taking place across many emerging-market bond and currency markets, with knock-on
effects on economies and equities.
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Exhibit 4:
Indonesia current account balance (% of GDP)
1.0
0.5
% of GDP
0.0
-0.5
-1.0
-1.5
-2.0
-2.5
-3.0
-3.5
Source:
Mar-16
Jan-16
Nov-15
Sep-15
Jul-15
May-15
Mar-15
Jan-15
Nov-14
Sep-14
Jul-14
May-14
Mar-14
Jan-14
Nov-13
Sep-13
Jul-13
May-13
Mar-13
Jan-13
Nov-12
Sep-12
Jul-12
May-12
Jan-12
Mar-12
Nov-11
Sep-11
-4.0
Bloomberg, March 2016
These charts are intended as representative examples to illustrate that the interest-rate environment
has been painful for emerging and Asian markets, but that this is likely to reverse in their favour, with
the tough correction already behind us for most, though not all.
The Mexican peso has been particularly hard hit, down c.40% over the last two years against the US
dollar, which is particularly surprising to us given that the trade balance has been rebounding and
foreign worker remittances have been rising sharply. We believe that this is likely to have been
because the country was hit by negative ‘hot money’ capital flows that have driven down the highly
liquid peso as a risk proxy, and put the currency out of kilter with the more positive fundamentals on
which we focus. This makes the equities that we invest in cheap when we consider them in real hardcurrency terms. We find plenty of attractive stocks in Mexico in this context.
As an active equity manager, we can aim to pick the best companies with an awareness of these
developments, as well as many more structural industry factors and stock-specific aspects such as
brand strength, sustainable return on capital, corporate governance and valuation. We do not have to
slavishly look like the index plus or minus a bit. We simply seek the best balance of reward for the risk
that we are taking within a well-diversified portfolio.
In many markets, the underlying growth drivers of superior population dynamics, the potential for a
catch-up in productivity, and low levels of credit penetration remain. Such a backdrop is typified by the
Philippines, which went through a credit cycle and saw a decade of balance-sheet repair following the
Asian crisis in which debts were paid down, in sharp contrast to most developed markets. This leaves
room for credit expansion to drive growth, in addition to other drivers of economic activity, including
fast growth in the labour force and strong productivity trends. The recent acceleration in private credit
growth (shown in the chart below) is indicative of this growth recovery.
The latest Philippine private credit ratio of 39% compares with 139% for the UK, while the government
debt ratio of 45% compares with the UK’s 91%. In simple terms, we believe the UK has appropriated
growth from the future, whereas the Philippines is running a far more sustainable growth path. This
shapes our confidence in future growth potential for particular companies and influences our large
overweight to this country, but ultimately we remain stock-pickers and are guided by our investment
themes and the resultant macroeconomic interpretation they give us.
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Exhibit 5:
Philippines domestic private sector credit to GDP and Government debt to GDP ratios
80
70
60
50
Private credit (% GDP)
40
Govt debt (% GDP)
30
01/12/1996
01/01/1998
01/02/1999
01/03/2000
01/04/2001
01/05/2002
01/06/2003
01/07/2004
01/08/2005
01/09/2006
01/10/2007
01/11/2008
01/12/2009
01/01/2011
01/02/2012
01/03/2013
01/04/2014
01/05/2015
20
Source:
World Bank, December 2014, CIA, December 2015. For illustrative purposes only.
Summary
We believe that now is a good time to consider increasing allocations to emerging-market and Asian
equities.
We regard valuations as attractive versus history, using through-cycle measures such as the Shiller
price-to-earnings ratio (10-year cycle-adjusted); there has been a bear market in emerging-market and
Asian equities for the last few years, unlike in the run-up to 2008. This is less apparent in short-term
measures, which hide the fact that margins are broadly depressed, even in markets such as India
where GDP is already accelerating, in stark contrast to elevated margins in the US, a market which is
being capitalised at very high multiples in a currency we see as expensive. For the long-term investor,
the chance to buy attractive growth potential at depressed multiples on depressed margins in a
depressed currency means that many drivers of future financial returns are stacked in one’s favour,
with the potential for attractive returns. As stock-pickers, our team seeks to separate the ‘wheat’ from
the ‘chaff’, and hence try to drive strong returns with reduced risk and an absolute mindset, but with an
aim of substantial outperformance of the comparative index over a five-year time horizon.
We believe the outlook is positive for both growth and income strategies in emerging markets – the
latter benefiting more from the reversal of Asian bond yields, but the former having greater structural
growth opportunities in the likes of India, which has little scope for yield.
5
Exhibit 6:
Emerging markets have de-rated substantially, evidenced by the Shiller P/E ratio
Shiller P/E ratio: Institutional Brokers' Estimate System (IBES) MSCI EM vs IBES MSCI World
40x
35x
Shiller P/E ratio
30x
25x
20x
17.0x
15x
10.2x
10x
5x
0x
1997
Source:
1999
2001
2003
2005
IBES MSCI Emerging Markets
2007
2009
2011
2013
IBES MSCI World
2015
Newton, Thomson Reuters DataStream, 30 April 2016
Shiller P/E: a cyclically adjusted price/earnings ratio, otherwise known as the CAPE, or Shiller P/E, measures the real price of a company's stock
relative to real average earnings over the past 10 years. The Shiller P/E aims to smooth out the economic and profit cycles to give a more
informed view of a company's price than the traditional price earnings ratio, which uses only one year of profits.
Exhibit 7:
Newton Global Emerging Markets strategy – themes drive stocks and hence sector positioning
Note: 1 The MSCI Emerging Markets Index is used as a comparative index for this strategy. The strategy does not aim to replicate either the
composition or the performance of the comparative index.
This data is from a representative portfolio and is for illustrative purposes only.
Source:
Newton, 31 May 2016
We have a portfolio positioned to try to harness future growth, both by industry (see exhibit 6) and by
country, investing in what we believe to be the most attractive future growth areas, such as Indian
consumer companies and Chinese internet and health-care companies. We use our themes to try to
6
help understand the macroeconomic risks and rewards ahead of time, and to aid stock selection over
a time horizon of five years and beyond.
Exhibit 8:
Newton Global Emerging Markets strategy – some markets are far more attractive than others
Note: 1 The MSCI Emerging Markets index is used as a comparative index for this strategy. The strategy does not aim to replicate either the
composition or the performance of the comparative index
This data is from a representative portfolio and is for illustrative purposes only
Source: Newton, as at 31 May 2016
Exhibit 9:
Cumulative return of Newton Global Emerging Markets strategy since inception¹ vs
comparative index
30
22.39
20
Growth (%)
10
0
-10
-10.18
-20
-30
Jun-11
Jan-12
Aug-12
Apr-13
Nov-13
Jul-14
Newton Emerging Markets (GBP) Composite, gross of fees²
Feb-15
Oct-15
May-16
MSCI Emerging Market Index³
Notes:
1
Inception date: 31 May 2011
2
Strategy performance calculated as total return (including reinvested income gross of UK tax) and charges. All figures are in GBP terms. The
impact of an initial charge (currently not applied) can be material on the performance of your investment. Further information is available upon
request.
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3
The MSCI Emerging Market index is used as a comparative index for this strategy. The strategy does not aim to replicate either the composition
or the performance of the comparative index
Source: Newton Global Emerging Market Composite in GBP terms. Periods to 31 May 2016. This data is from a representative portfolio and is
for illustrative purposes only.
The strategy’s performance has been a result of seeking strong compounding companies (high growth
with high returns on capital reinvested) in the most attractive parts of emerging markets, while avoiding
the riskiest areas. For example, there are still no state-owned entities held in the strategy. To date (29
June 2016), the Newton Global Emerging Markets Fund has outperformed the MSCI Europe and
1
FTSE UK All Share indices comfortably over 1, 3 and 5 years, despite the prevailing wisdom that this
has been a bear market for emerging markets. Exhibit 9 above is only to 31 May 2016, so does not
include the more recent sterling devaluation, which has further boosted performance in sterling terms.
As we expect the emerging-market and Asian currency headwinds to ease, we believe the underlying
earnings growth in the strategy’s holdings should be progressively seen.
What we are trying to achieve for our clients is illustrated well by the below chart of compounding
returns in the Newton Asian Income strategy. We are looking for companies that are able to
compound cash flow returns over a multi-year horizon to generate attractive investment returns, be
they from capital or income, with an appropriate risk profile, not least in terms of environmental, social
and governance (ESG) analysis, which is integrated in our investment process. We are confident that
we can replicate this across all of our emerging-market and Asian strategies.
Exhibit 10: Compounding of returns since inception in Newton Asian Income Fund vs index
1
Index
200
200
180
180
160
160
140
140
120
120
40
Newton Asian Income Fund - Inst W Acc (total
return)
Newton Asian Income Fund - Inst W Acc (income
contribution) GBP
May-16
Oct-14
Jul-15
Dec-13
-20
Nov-05
0
-20
May-12
Feb-13
20
0
Jul-11
20
60
Feb-09
40
80
Dec-09
Sep-10
60
2
100
Jul-07
Apr-08
80
Sep-06
% of total return
100
Nov-05
Sep-06
Jul-07
May-08
Feb-09
Dec-09
Oct-10
Jul-11
May-12
Mar-13
Dec-13
Oct-14
Aug-15
May-16
% of total return
Fund
FTSE AW Asia Pacific ex Japan (total return) GBP
FTSE AW Asia Pacific ex Japan (income
contribution) GBP
Notes:
1 Inception date: 30 November 2005
2 The FTSE AW Asia Pacific ex Japan GBP Index is used as a comparative index for this Fund. The Fund does not aim to replicate either the
composition or the performance of the comparative index
Source:
1
Lipper, 31 May 2016
Source: Newton, 29 June 2016
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For more information please contact:
Julian Lyne, Head of Distribution
020 7163 4234
julian_lyne@newton.co.uk
Important information
This is a financial promotion. This document is for professional investors only. The opinions expressed in this document are
those of Newton and should not be construed as investment advice or any other advice and are subject to change. This
document is for information purposes only and does not constitute an offer or solicitation to invest. Your capital may be at risk.
Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as
rise and investors may not get back the original amount invested. Strategy holdings are subject to change at any time without
notice and should not be construed as investment recommendations. Past or current yields are not indicative of future yields.
Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell this security,
country or sector. The value of overseas securities will be influenced by fluctuations in exchange rates. Compared to more
established economies, the value of investments in emerging markets may be subject to greater volatility due to differences in
generally accepted accounting principles or from economic or political instability. Your capital may be at risk. The value of
investments and the income from them can fall as well as rise and investors may not get back the original amount invested.
Except where specifically noted, performance is stated gross of management fees. The impact of management fees can be
material. A fee schedule providing further detail is available on request. Newton claims compliance with the Global Investment
Performance Standards (GIPS®). Newton, the firm, includes all the assets managed by Newton Investment Management
Limited, Newton Investment Management (North America) Limited and Newton Investment Management (North America) LLC,
which are wholly owned subsidiaries of The Bank of New York Mellon Corporation. To receive a complete list and description of
Newton composites and a presentation that adheres to GIPS standards, please contact Newton via telephone on +44 (0)20
7163 9000 or via email to contact@newton.co.uk. You should read the Prospectus and the Key Investor Information Document
(KIID) for each fund in which you want to invest. The Prospectus and KIID can be found at www.bnymellonim.com. The MSCI
Emerging Markets Index is used as a comparative index for the Newton Global Emerging Markets strategy. The MSCI Emerging
Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of
emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indices: Brazil,
Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines,
Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates. The FTSE AW Asia Pacific ex Japan
Index is used as a comparative index for the Newton Asian Income strategy. The strategies do not aim to replicate either the
composition or the performance of their comparative indices. The FTSE World Asia Pacific ex Japan Index is part of the FTSE
Global Equity Index series. It includes constituents from only countries classified as developed and advanced emerging, such as
Australia, Hong Kong, Korea, New Zealand, Singapore and Taiwan. The Newton Global Emerging Markets Fund (‘NGEMF Unit
Trust’), an authorised unit trust with the same investment objectives, polices and strategy was merged into the Newton Global
Emerging Markets Fund, a sub-fund of BNY Mellon Investment Funds on 25 July 2015. Newton Investment Management
Limited, the investment manager of the Newton Global Emerging Markets Fund, was also the investment manager of the
NGEMF Unit Trust. The NGEMF Unit Trust was closed for winding up on 25 July 2015, and all of the NGEMF Unit Trust’s
assets were transferred to the Newton Global Emerging Markets Fund at its launch on 25 July 2015. The NGEMF Unit Trust
was one out of three funds included in the composite of this strategy which was launched on 13 May 2011. Composite
performance of the strategy is therefore used to illustrate the longer track record of the NGEMF. However, there may be
material differences between this composite performance and how the Newton Global Emerging Markets Fund will perform and
should not necessarily be relied upon. Issued in the UK by Newton Investment Management Limited, The Bank of New York
Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment
Management is authorised and regulated by the Financial Conduct Authority.
9