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PERSPECTIVES JANUARY 2017 FIDELITY EMERGING MARKETS FUND This is for investment professionals only and should not be relied upon by private investors Emerging markets in 2017 Emerging market equities rallied in 2016: Local politics, a recovery in commodity prices, and the hunt for yield were amongst the key drivers of a fast rising market. In large part, the rally was indiscriminate and, in our view, longer term fundamentals were overlooked. This Perspective looks at some of the factors set to influence emerging market assets in 2017 and sets out the rationale for current portfolio positioning. HOW DOES 2016 FRAME YOUR THINKING FOR THE YEAR AHEAD? There were aspects of 2016 which were very challenging; there is no doubt that Brazil was a tough market in terms of the very strong price moves. Fuelled by a more positive political backdrop, Petrobras was up in the region of 220% from the January lows to October high, despite being one of the world’s most indebted companies. Looking back over my tenure, we have experienced these periods before and maintain that you always have to think medium to longer term in investing. We continue to focus on buying great businesses that compound over time; an approach which underpins a strong long-term track record. In 2016, we saw such businesses de-rate which impacted performance. I would remind investors that changes such as demonetisation in India or concerns about remittances of money provide an opportunity in general, although sentiment can have a marked impact on valuation in the short term. One such example is HDFC, one of the largest holdings, which was hit by demonetisation but as the market begins to refocus on results there should be re-rating as the Indian economy moves to a more formal structure. Broadly speaking, earnings have not disappointed and our target prices have not changed so that means, by definition, we see more upside in the portfolio. I am hopeful that 2017 will be a better year. IS THE REFLATIONARY TRADE SET TO CONTINUE? There has been much comment on the reflationary trade, something we would argue commenced before Trump’s victory. Whilst future US infrastructure plans bolster sentiment towards commodities, they pale into insignificance when set against Chinese demand and supply side response. Our estimations are for the push on infrastructure spend in China to last another 18 months. Our analysts base their earnings estimates on long-term commodity price assumptions rather than spot prices to better gauge through-the-cycle earnings potential. Whilst we see a healthier backdrop for commodities, currently our work points to iron ore prices, in particular, being too high. NICK PRICE is the team leader of Fidelity’s Global Emerging Markets equity team. Nick has led the development of Fidelity International’s EM equity investment team since 2005, and draws on Fidelity’s extensive emerging market equity resources, which includes specialist portfolio managers and 51 research analysts. Nick has a Bachelor of Commerce & Accounting from the University of Natal and is a Member of the South African Institute of Chartered Accountants. He is also a CFA charterholder. Top Active Positions Overweight % Under-weight % AIA Group 5.3 Samsung -4.3 Sberbank 4.7 Tencent -3.5 HDFC Bank 4.7 Alibaba -2.5 Naspers 4.0 China Mobile -1.7 Steinhoff 3.6 China Const. Bank -1.6 TSMC 2.8 Indl. & Coml. Bank China -1.1 NLMK 2.4 Hon Hai -1.0 Tectronic 2.4 Bank China -0.9 SK Hynix 2.3 Itau -0.9 Cognizant 2.3 Petrobras -0.8 Source: Fidelity International, as at 31 December 2016. Within our universe, Brazil’s Vale continues to trace a strong iron ore price, regardless of capacity cuts in China’s steel industry. This is an important observation given that iron ore is used to produce steel. Elsewhere, we have good exposure to a broad range of businesses in the materials sector resulting in a modest overweight versus the benchmark. Our investments remain focused on low-cost producers with strong balance sheets that have the ability to generate free cash flow and pay dividends to shareholders through the market cycle. IS THERE ANY CASE FOR INVESTING IN VALUE AREAS OF THE MARKET SUCH AS CHINESE BANKS? Value stocks had a strong run in 2016 and as such multiples have moved up towards the long-term average. Conversely, quality and growth stocks have de-rated sharply. If we look at the investable universe there are examples of companies that on the face of it, look cheap. Chinese Banks trade at around 0.8x book value. However, there are reasons to be sceptical. We have concerns on the quality of the loan book; our research analysts estimate that 10-12% of Chinese loan books in aggregate are bad, potentially wiping out any equity value. Whilst we don’t see any near-term catalyst, we think there is a very real risk in the medium term that there is an enormous recapitalisation of these banks and we see them as ‘value traps’. Whilst we remain cautious of these so-called ‘value traps’ an attractive valuation remains a critical component of what we seek, given our unwavering focus on identifying companies that can offer attractive levels of Total Shareholder Return. Sberbank was added to the fund last year because the business has been trading on about 1.1x price-to-book, with a 20% Return on equity. This compares with a Brazilian bank where Return on Equity is running in the late teens, and you’re paying about 1.7x price-to-book, so you can see there is a huge difference in terms of the multiple that’s being ascribed across different markets. HAVING MENTIONED SBERBANK, HOW DO YOU BALANCE THE IMPROVEMENTS IN THE RUSSIAN ECONOMY WITH THE RISKS AS AN INVESTOR? I’ve been looking at the Russian market for 15 years and it’s important to acknowledge that it is an extremely corrupt economy and that brings with it issues. I would also underline that none of my thought process is predicated on a reduction in sanctions or a closer relationship between Putin and Trump. However, there are signs of improvement in the economic backdrop in Russia which can drive benefits for companies available to us as investors. We continue to believe that the oil price should trade up to a level of $60-65/barrel, and that’s more than discounted into the oil stocks. Therefore, we are not chasing those names. For me, Sberbank’s appeal is that it dominates the landscape in Russia in a way in which most banks across other developing countries do not. Market dominance provides access to a huge profit pool share and share of deposits. The materials sector is an area where we also have a few positions: NLMK is the world’s lowest-cost steel producer, benefiting from vertical integration (i.e. captive iron ore & coal) which provides a cost advantage. Generally, the Russian steel companies came out of the global financial crisis incredibly indebted and in many cases bankrupt. They engaged in enormous cost cutting and, as a result, have created a far higher sustainable profit pool. Management teams of businesses like this have realised that it is pointless to direct more capital into expansion and so we are getting very nice dividend returns out of these companies. HOW DO YOU FACTOR FUTURE US POLICY UNDER DONALD TRUMP INTO YOUR THINKING? Whilst there is still uncertainty regarding how far Trump’s protectionism will go, we have been reducing some positions so that we are not overly exposed. Indian IT outsourcers Cognizant and Infosys are companies that benefit from the growth in digitisation and labour cost arbitrage, but they may be vulnerable in the event that Trump imposes significant visa restrictions. We have also reduced the exposure to Mexican conglomerate FEMSA, contributing to the reduction in the fund’s overweight to consumer staples. Although it has one of the most attractive food retail formats globally, the risk/reward balance has shifted given Trump’s stance on Mexico and the knock-on effect of a weak peso. The fund remains overweight Mexico due to the position in Grupo Mexico, which is an exporter of copper with costs in pesos and revenue in dollars. This company is unlikely to get impacted by Trump walls, both physical or in tariff format. PERSPECTIVES | Emerging markets in 2017 2 Chart 1 Sector positioning 30% Fund Index 25% 20% 15% 10% 5% 0% Cons. Disc. Cons. Stap. Financials Materials Health Care IT Real Estate Industrials Utilities Telecoms Energy 31.12.2016 14.5 3.1 1.2 0.3 -0.5 -0.7 -2.6 -2.6 -2.9 -5.9 -7.9 30.11.2016 14.3 4.2 0.4 -0.4 -0.6 -1.9 -2.5 -2.4 -2.8 -5.9 -7.5 31.10.2016 14.8 7.3 1.0 -3.2 -0.9 -0.9 -2.6 -2.1 -2.9 -6.0 -7.3 Relative Source: Fidelity International, as at 31 December 2016. Index: MSCI Emerging Markets Index. Cash = 4.0%. WHAT COMMENTS WOULD YOU MAKE ABOUT CURRENT POSITIONING? Broadly speaking, a number of areas of the portfolio remain unchanged. We remain underweight the energy sector as we see limited value in the oil sector at current share prices. We also have no exposure to the telecoms sector, which we view as a declining returns sector, and no exposure to the utilities which will be impacted by higher discount rates and the higher cost of fuel that goes into producing energy. The real estate sector is dominated by Chinese names and we do not own anything given our negative views on the property market resulting from the restrictions on sales of properties in certain Tier 1 cities. There remains a risk that bond yields move higher and we have reduced exposure to some of the more defensive names in the portfolio. Where we do maintain exposure, the businesses we own are all capable of generating low to mid-teens earnings growth and generally pay good dividends. We have recently moved to a modest overweight position in the materials sector. I have already alluded to the fact that we are very directed in our approach towards the lowest cost producers. The investments include a position in Phosagro (the lowest-cost phosphate producer), NLMK (the lowest cost steel producer) and Grupo Mexico (owner of the best quality copper assets). OUTLOOK In general, valuations in EM remain very attractive which supports the case for the asset class. Our approach to investing remains very much about identifying good quality businesses positioned to deliver high returns on a sustainable basis over the medium to long term at a reasonable valuation. We remain cautious on companies with large state ownership, where capex is potentially misdirected by the government and results in a permanent destruction of capital. We are also wary of businesses like Petrobras where the debt burden subsumes all equity value. In 2016 many stocks like this were bid up purely as a function of being large constituents in the index or cheap on the face of it. As the market begins to refocus on results, a number of the portfolio’s holdings are showing strong upside for the year ahead. PERSPECTIVES | Emerging markets in 2017 3 Important Information This information is for Investment Professionals only and should not be relied upon by private investors. It must not be reproduced or circulated without prior permission . This communication is not directed at, and must not be acted upon by persons inside the United States and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required. Fidelity International refers to the group of companies which form the global investment management organisation that provides information on products and services in designated jurisdictions outside of North America. Fidelity International does not offer investment advice based on individual circumstances. Any service, security, investment, fund or product mentioned or outlined in this document may not be suitable for you and may not be available in your jurisdiction. It is your responsibility to ensure that any service, security, investment, fund or product outlined is available in your jurisdiction before any approach is made to Fidelity International. This document may not be reproduced or circulated without prior permission. Past performance is not a reliable indicator of future results. Unless otherwise stated all products are provided by Fidelity International, and all views expressed are those of Fidelity International. Top security holdings are those companies in which the largest percentages of the fund’s total net assets are effectively invested. Positions in other funds - including ETFs (Exchange Traded Funds) – can appear in this table, but index derivatives form part of an 'Other Index / Unclassified' category which will not appear. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The research and analysis used in this documentation is gathered by Fidelity for its use as an investment manager and may have already been acted upon for its own purposes. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. Fidelity only offers information on products and services and does not provide investment advice based on an individual's circumstances. The value of investments can go down as well as up and investors may not get back the amount invested. For funds that invest in overseas markets, changes in currency exchange rates may affect the value of an investment. Foreign exchange transactions may be effected on an arm's length basis by or through Fidelity companies from which a benefit may be derived by such companies. The Authorised Corporate Director of Fidelity Investment Funds and Fidelity Investment Funds IV OEIC, and the Manager of Fidelity Unit Trusts is FIL Investment Services (UK) Limited. Please note Fidelity Unit Trusts are not registered for sale in Jersey or Guernsey. Investments in small and emerging markets can be more volatile than other more developed markets. Due to the lack of liquidity in many smaller stock markets, certain country select funds may be volatile and redemption rights may be restricted in extreme circumstances. In certain countries, and for certain types of investments, transaction costs are higher and liquidity is lower than elsewhere. There may also be limited opportunities to find alternative ways of managing cash flows especially where the focus of investment is on small- and medium-sized firms. For funds specialising in such countries and investment types, transactions, particularly large ones, are likely to have a greater impact on the costs of running a fund than similar transactions in larger funds. Prospective investors should bear this in mind when selecting funds. Issued by FIL Investments International (FCA registered number 122170) a firm authorised and regulated by the Financial Conduct Authority. FIL Investments International is a member of the Fidelity International group of companies and is registered in England and Wales under the company number 1448245. The registered office of the company is Oakhill House, 130 Tonbridge Road, Hildenborough, Tonbridge, Kent TN11 9DZ, United Kingdom. Fidelity International’s VAT identification number is 395 3090 35. GEMS0787 PERSPECTIVES | Emerging markets in 2017 4