The main investment themes of 2017 have extended strongly into 2018. In particular, the positive messages about the ongoing recovery of the global economy have continued with upbeat activity indicators being recorded across both developed and developing economies.
China’s influence on the world economy and global investor risk sentiment remains powerful and importantly, its outlook continues to be positive. Equity markets have had a rougher ride this year but remain generally well supported. The main driving theme for equity markets has been the strength of ‘growth’ stocks (which tend to reinvest earnings rather than pay dividends), and tech- related stocks in particular which very much fit into this category.
This theme leans strongly into the high- tech exposed markets of the Emerging Markets and the US. Both these markets strongly outperformed Eurozone and the UK last year and, despite the volatility in tech stocks this year, have continued to do so during 2018.
Decades ago, equity exposure in emerging markets was dominated by industrials and commodity- related stocks, but now tech is an increasingly important part of both developed and developing economies. By way of example, the five largest stocks in the S&P 500 are tech-related - Apple, Microsoft, Alphabet (Google), Facebook and Amazon collectively make up around 13% of the index, and the four largest companies in the MSCI Emerging Markets Index, Tencent, Samsung, Alibaba and TSMC (Taiwan Semiconductor Manufacturing) are also tech-related giants which together account for 16% of that index.
In contrast to the strength of the emerging markets, Europe’s main equity markets (both the UK and Eurozone) continue to struggle. The Italian election result will not have helped investor optimism for Eurozone equity.
The overwhelming vote for anti- establishment parties, wary of the Euro, represents a warning for the future stability of the single currency and there has to be a higher probability now that the next downswing in economic growth could drive these parties to support a referendum on Italy’s membership of the Euro – something which would threaten the Eurozone with a period of chaotic risk aversion.
Accordingly, the result has made us a little more nervous about exposure to this region and, indeed, the UK. The greater the political risk to the Eurozone, the less generous the European Union is likely to be with respect to the terms of the UK’s departure from the EU.
Given the elevated political risk across Europe, we remain cautious about equity exposure in this region and we are strongly of the view that investors should be extending their investment focus into the growing markets of less well developed economies in Latin America and Asia, the so-called ‘emerging markets’.
Of course, the risks in these markets for investors are higher than developed economies, partly because the economic growth dynamic is less stable, and both political and structural economic foundations are less secure. And we are very aware of this. But at the same time there are extremely powerful fundamentals working in these economies which the more open, market embracing, global economic architecture is allowing to thrive.
Demographic factors, in particular, are especially powerful - across the emerging markets landscape, a huge population is now rising into the middle class and driving growth in consumer spending.
While we are strongly persuaded by the return potential of the emerging markets, it is important to ensure that the risks associated with this exposure are lowered as much as possible. Hence we avoid country specific exposure and look for experienced Third Party Fund managers that have widely diversified funds across the region (often including both Latin American and South East Asian exposure), together with excellent track records at delivering returns on a sustainable basis.
One of the things we pay especially close attention to is how funds are managed when investment conditions become more challenging as invariably they do in emerging markets. We speak to the fund managers on a regular basis to understand their positioning and ensure that it fits our investment outlook.
Overall, we take a somewhat measured approach and, in particular, avoid exposure to the ‘frontier market’ funds which invest in smaller, higher risk emerging markets (for example, many African economies fall into this ‘frontier market’ classification).
Key to our investment philosophy is the importance of protecting client capital and generating sustainable returns. The higher risks related to emerging markets means that it is especially important to pay attention to portfolio risk management techniques that lower risk as much as possible.
Don Smith, Chief Investment Officer
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