If you’ve been paying attention to emerging markets this year, you know it hasn’t been going well for investors. The third quarter wasn’t much better. Even your Motley Fool Emerging Markets Fund succumbed to gravity in the third quarter and underperformed the benchmark for the first time this year.
Our negative performance in the third quarter pulled our year-to-date numbers into the red. The fund continues to handily beat the benchmark for the year, but generating smaller losses than the benchmark only provides so much comfort.
Much of the pain in emerging markets this year has come from two items: a strong U.S. dollar and trade tensions.
The strength of the U.S. dollar, and the associated weakness of emerging-market currencies, has been a stone around the neck of emerging markets this year. The Indian rupee is at an all-time low against the dollar. The Brazilian real is testing multi-decade lows. The Indonesian rupiah is flashing back to its Asian Crisis lows from 20 years ago. And then there’s the Turkish lira. Oof. In all, currency weakness is responsible for roughly half of the benchmark’s losses this year.
A weak currency is bad news for an economy, for several reasons. For one, it makes imports more expensive, which can push up inflation and stall economic growth. For another, it makes dollar-denominated debt harder to service, and we know many emerging-market companies and governments have issued trillions in dollar-denominated debt over the past decade.
For U.S. investors, earnings in a weak currency are worth less in dollar terms. So even if the companies in your portfolio are executing well in their local markets, which is the case for nearly all the companies in your Emerging Markets Fund, that execution is currently less valuable to you. I say “currently” because currencies tend to fluctuate, so we could very well be looking at the other side of this equation in future years.
The ongoing (some would say escalating) trade conflict between the U.S. and China also isn’t helping emerging markets. This matter is less of a concern for the Emerging Markets Fund’s holdings, since we tend to invest in companies that have a more domestic bent, rather than in major exporters. It’s particularly true of our Chinese investments.
However, if the tariff back-and-forth slows the Chinese economy enough, our companies will feel the knock-on effects of lower consumer confidence and slower growth of household wealth. The negative sentiment over this possible outcome continues to weigh on Chinese markets.
Although it’s not the worst performer in the benchmark, the Chinese market has underperformed both the benchmark and the Emerging Asia-Pacific index so far this year. During the quarter, our investments in Tencent, Ctrip.com, and Alibaba were all meaningful contributors to our negative performance. Each declined at least 10% in the quarter, and we have above-average sized positions in all of them.
While the near term may be a bit bumpy for these holdings, we believe that rising wealth in China’s middle class and these companies’ competitive advantages should deliver strong returns for patient investors over the long term.
We did trim our position in Alibaba during the quarter, more for reasons of portfolio management than over any company-specific concerns. Similarly, we lightened up our MercadoLibre holdings. We didn’t do any buying during the quarter.
Our best performing positions during the quarter were Turkish airport operator TAV Havalimanlari Holdings (up 39%), Mexican airport operator Grupo Aeroportuario del Sureste (29%), Filipino port operator International Container Terminal Services Inc. (22%), and semiconductor manufacturer Taiwan Semiconductor Manufacturing Co (up 21%). Once again, we had far more laggards than winners, with Chinese online travel agent Ctrip.com falling the furthest (down 22%), along with Chinese tech firm Tencent (18%); our other port operator, Dubai-based DP World (17%); and Kenyan telecom Safaricom (17%).
Emerging-market investing isn’t for the faint of heart. It’s one of the more volatile asset classes out there. While our investing approach – selectively investing in the companies we feel have the highest quality businesses and management teams – can’t avoid these ups and downs, we do believe it will provide market-beating returns over the long term. In the meantime, keeping your eyes on the horizon tends to help settle the stomach.
Note: The Morningstar RatingTM for funds, or ‘star rating’, is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. As of 9/30/2018, the Motley Fool Emerging Markets Fund (Investor shares) was rated in the Diversified Emerging Markets Funds category, receiving a three-star rating among 7088 funds over a three-year period and a four-star rating among 508 funds over a five-year period.
Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product’s monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10- year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods. Past performance is no guarantee of future results.