Emerging market stocks were battered in 2022. Many emerging market funds reached highs in February 2021, about the same time cryptocurrencies and speculative technology funds such as ARK Innovation (ARKK) were peaking. Unlike speculative growth stocks, most emerging market funds, including Fidelity Emerging Markets (FEMKX), have gained little on an annualized basis since 2007. Fidelity Hong Kong and China (FHKCX) has risen about 30 percent in 15 years, an annualized return of about 1.8 percent.
Weakness in emerging markets stems from several factors. First, the 2008 financial crisis wasn’t only about the U.S. housing market and the related financial assets. It was also the peak of a commodities bull market. China was the main driver of commodity demand. Its economy started slowing significantly in the 2010s and has continued slowing with a policy of lockdowns for the coronavirus. Many developing countries export commodities to China, making a slowdown bad news for the entire asset class. China also dominates many emerging market funds.
From the perspective of bullish investors, emerging markets are undervalued. The index funds such as MSCI Emerging Markets trade near a forward P/E of 10 that marked the low for most of the past 15 years. Only the lows in 2008 pierced that level. With many country funds flat since the 1990s or 2000s, they are much cheaper than they’ve been in years. Cycles are also lining up in their favor. The late 1990s and early 2000s also saw a strong U.S. dollar, a bottom in commodities such as oil and a bear market in technology stocks.
The biggest risk for emerging markets in the near term is currency risk. The Chinese yuan is overvalued and can probably fall another 10 percent. This seems highly likely if currencies such as the yen, euro and Korean won resume their weakness. Emerging market currencies will likely underperform the Chinese currency, perhaps moving lower by 15 percent to 20 percent.
Over the next 12 months or so, currency risk is highly relevant for investors. A surge in the U.S. dollar could force emerging markets lower and provide a major low that won’t be seen again for a decade or longer. In the longer term, valuations will be more important. Emerging markets have underperformed uninterrupted for almost 12 years. The longest stretch of outperformance was a two-year run from the market low in January 2016 until early 2018. Going back to the relative performance peak in 2010, FHKCX and FEMKX have risen 52.67 percent and 31.59 percent, respectively, versus the 330.02 percent rally in SPDR S&P 500 (SPY).
Looking forward, emerging markets may provide aggressive investors a solid value opportunity.
Fidelity Emerging Markets (FEMKX)
FEMKX seeks capital appreciation from superior asset selection. Emerging markets are more complex investments because there are currency and economic risks that differ from those in U.S. markets. The fund seeks strong, stable companies that are undervalued by the market.
FEMKX has been managed by John Dance since February 2019. He previously managed Pacific Basin (FPBFX) and Emerging Asia (FSEAX) before leading this fund. Under his tenure, FEMKX gained more from Chinese technology exposure than it has given back, making for outperformance over his thus far brief tenure.
The fund has an expense ratio of 0.88 percent and a turnover rate of 36 percent, plus 5-star and Bronze ratings from Morningstar.
The portfolio leans toward higher-quality, large-cap stocks as compared with the category and plain vanilla passive emerging market indexes. China makes up 28 percent of assets, India 19 percent, Taiwan 12 percent, Saudi Arabia 5 percent and South Korea 5 percent. The largest currency exposures are the Indian rupee at 19 percent, Hong Kong dollar 17 percent, U.S. dollar 16 percent, Taiwan dollar 12 percent and Chinese yuan 8 percent.
The top holdings have been Taiwan Semiconductor at 7.82 percent, Tencent 5.59 percent, Samsung 3.76 percent, Reliance Industries 3.29 percent and Kweichow Moutai 2.99 percent.
FEMKX has a beta of 0.92 versus 0.98 for the category and 0.95 for the emerging markets index. It has a standard deviation of 19.41 percent versus the 20.53 percent of the category and the 19.21 percent of the index. Lower volatility comes from the larger average market capitalization in the fund.
Fidelity Hong Kong and China Region (FHKCX)
FHKCX has been managed by Ivan Xie since April 2018 and co-manager Peifang Sun since January 2021. Both previously worked as analysts covering the Greater China region. The fund mainly searches for growth at a reasonable price along with turnaround plays in cyclically depressed industries.
The expense ratio is 0.91 percent. Turnover is 60 percent. FHKCX has a 4-star and Neutral rating from Morningstar.
Like FEMKX, this fund has a higher average market cap than the China category and the China index. Technology leads with 24 percent of assets, followed by consumer discretionary with 24 percent, financials 16 percent, communication services 10 percent and consumer staples 5 percent. Geographically, China leads with 62 percent of assets. Taiwan has 23 percent and Hong Kong 9 percent.
There is some overlap with FEMKX in the top holdings. Taiwan Semiconductor has 16.38 percent of assets, Tencent 8.29 percent, Alibaba 5.82 percent, AIA Group 5.11 percent, Meituan 4.51 percent, Industrial & Commercial Bank of China 2.82 percent, China Construction Bank 2.54 percent, Pinduoduo 2.42 percent, Kweichow Moutai 2.04 percent and Media Tek 1.92 percent.
FEMKX has a beta of 0.70 versus 0.61 for the China category and 0.53 for the MSCI ACWI ex-USA Index. The standard deviation is 20.77, below the 23.57 of the China category and higher than the 20.44 of the MSCI ACWI ex-USA Index. The lower volatility and correlation as compared with the category are explained in large part by its larger market capitalization, while the higher beta and standard deviation versus the index are explained by the country concentration.
Emerging market indexes have gone nowhere since 2007. Chinese indexes are also below levels seen in 2007. The long stretch of underperformance was a combination of cyclical factors such as the commodities cycle, the currency cycles favoring the U.S. dollar, excessive optimism in the 2000s giving way to the reality of slower Chinese growth in the 2010s, and now high volatility in the wake of the coronavirus pandemic, deglobalization, trade tensions and rising geopolitical risk.
Valuations have largely priced in these risks, and the remaining risk will stem from currencies and China’s coronavirus policy. Currency risk will follow the U.S. dollar. If its rapid rise continues, volatility in the currency markets will intensify. If emerging markets are forced into significant devaluations, that will be the absolute best time to buy. For this reason, we would not go “all-in” on emerging markets here, but instead, start small and build on weakness moving forward.
China will also be key for emerging markets. FHKCX is a much riskier fund because it is concentrated in China, but investors who want emerging markets exposure won’t see good returns until the Greater China region moves higher. The risk in China is political, plus it has the same currency risk as elsewhere. The government is still shutting down entire cities as part of its zero-COVID strategy. This has greatly slowed the economy. China analysts who don’t trust the government data believe the country could already be on the brink of a recession.
Investors love to say they’re contrarian, but real contrarian investing comes from buying when nobody else wants the assets. We still see potential risk in emerging markets that should keep conservative investors on the sidelines for now, but younger investors with long time horizons can start building a small starter position if they’re planning on holding for five or more years. Conservative investors would be better served by patience. That could mean missing some of the gains if a low is already in, but it avoids potential double-digit losses if there is one more downswing for these markets.
We recommend avoiding FHKCX. China will have more upside potential at the low, but until it reopens, risk is elevated. FHKCX has outperformed, but it still lost 16 percent from high to low in October versus 24 percent for iShares China Large Cap (FXI). The accelerating decline in Chinese shares looks like the type of drop that precedes a major low, but conservative investors should be wary of catching the proverbial falling knife.