Pendal MidCap (BTA0313AU) Report & Performance

July 2023 was a strong month for emerging market equities. The MSCI EM index returned 4.9% in AUD terms, with strong gains from some major groups of stocks. Chinese internet names performed well, including some key portfolio holdings; some emerging market banks rose strongly, including portfolio holdings in Mexico and South Africa. Turkish (not held) stocks rose strongly on hopes for more orthodox economic policies.

By far, the most substantial gains, though, were in parts of the broader technology sector, particularly stocks with exposure to electric vehicles/batteries and stocks that are possible artificial intelligence beneficiaries. We see multiple signs that there may be excessive optimism in some of these groups of stocks. We are neither taking a view on particular companies/business models nor saying that these upward moves are finished, but we are highlighting some of the market dynamics we see:

1. Huge volumes and parabolic price moves driven by retail investors: this has particularly been the case with the Korean EV/battery sector. EV/battery stocks represented nearly half of the total Korean stock market turnover on some days in July, driven by retail investor leverage rising to a record KRW (South Korean won) 10trn. The key to stock selection has been the Korean YouTube presenter Park Soon-hyeok, better known as ‘Mr. Battery’. Six of his eight recommended names rose over 40% in the month, with the strongest of them, Ecopro (not held), up 1,059% year-to-date. There has also been a raft of new issuance of Korean EV/battery ETFs in recent weeks.

2. Strongest moves in names that might have quality challenges: Strongest moves in names that might have quality challenges: New Oriental Education (China, online education, not held) has previously been the subject of both short-seller allegations of dishonesty and also of the crackdown on online education by the Chinese government. The stock returned 49.8% in July. NIO (China, EV, not held) is forecast by consensus estimates to have a net loss of USD 2bn on USD 8.9bn of sales this year but rose 58% in July, underperforming XPeng (China, EV, not held), expected to lose USD 1.2bn on USD 4.5bn of sales, and up 74% in July. In May of this year, Lee Dong-chae, the chairman and largest shareholder of Ecopro, was sentenced to two years in prison for violating South Korean capital market laws.

3. Parabolic moves in stocks that aren’t pure play tech names: Posco Holdings (Korea, steel, not held) is one of Asia’s largest steel producers, with thirty thousand employees producing 32 million tons of steel every year. The company has made some smart investments in green steel technology and has ongoing investments in EV battery components, which it provided an update on in July. That update was material in driving the market cap of Posco Holdings from USD 24.9bn to USD 42.5bn in the month. Similarly, strong monthly gains (+50%) were seen in some Taiwanese PC and laptop producers that have been reporting declining PC, laptop and server volumes this year, on the hope that AI server orders (volumes and margins at this point unclear) are about to follow.

4. Crucially, the high-quality large-cap companies with proven track records and technologies were laggards in the month. TSMC (Taiwan, tech hardware, held) is widely recognised as the world’s dominant producer of high-performance semiconductors that are key to AI; the stock fell 2.8% in July. Samsung Electronics (Korea, tech hardware, held) is TSMC’s nearest challenger in highend semiconductors and a major producer of computer memory, including the HBM type used in AI servers; the stock fell -0.4% in July. The technological revolutions in AI and EV are changing the world, but equity markets will not price that opportunity with perfect efficiency. We are concerned that some parts of the EM equity space look particularly inefficient right now.

One of the strongest arguments for employing a top-down, country-level approach to EM equity investing (as we do) is the role of currencies in returns and the variance of returns. Emerging market currencies are typically more volatile than developed market currencies, but in addition, currency moves in emerging markets are typically correlated with equity market moves and with economic conditions.

This approach has worked well in the first half of 2023, with some major emerging markets (from the higher beta, more US dollarsensitive end of the spectrum) seeing strong returns in both currencies and equities. For example, MSCI Mexico returned 11.6% in MXN terms, while the Mexican peso appreciated by 13.9% against the US dollar, lifting USD returns for the index to 27.1%. Brazil and Indonesia enjoyed similar return patterns in the first half of the year.

There have been a number of drivers of this currency support for equity returns, and we believe that these are likely to persist in the second half of 2023, lifting our confidence in the markets our portfolio is overweight.

Firstly, conditions for the US dollar. Exchange rates are just ratios, and the fundamentals of the US dollar have not been supportive this year. 2021 and 2022 saw dramatic strength in the US dollar relative to key trade-partner currencies, lifting the real effective exchange rate to a thirty-year high. This represented an overshoot relative to the commodity terms of trade, which turned into negative momentum in late 2022 and the first half of 2023. With a more uncertain outlook, the Federal Reserve may be hiking or cutting interest rates in the second half of 2023 in H2, but the interest rate outlook seems less hawkish than other global central banks.

Secondly, and following on from that, many emerging market central banks, including in Mexico and Brazil, had hiked much earlier and far more aggressively than developed market central banks. Policymakers in these countries have remained cautious despite clear disinflation in their economies – ex-ante real interest rates in Brazil are approaching 9%. Other central banks, for example, in India and Indonesia, have chosen to deploy excess foreign exchange reserves to support their currencies but have avoided the accommodation of inflation that we have seen in many developed markets.

Combining these, we have seen strong conditions for carry trade investors funding in US dollars and investing in emerging market rates and bond markets. As those flows have stabilised currency volatility, risk-adjusted carry returns have steadily improved. A JP Morgan index of one month volatility in emerging market currencies peaked at 20% during the Covid sell-off, averaged 11.3% in 2022, but declined to 8% in June 2023. Volatility adjusted carry still looks attractive relative to history.

Lastly, the trade fundamentals, both in terms of prices (terms of trade) and goods flows (trade balances), look extremely supportive. Trade balances and current account balances look strong relative to history in Brazil, India and Indonesia, while the Mexican trade deficit is offset by inbound remittances from overseas Mexican workers. In all four countries, strong economic and domestic demand growth will inevitably lead to rising imports, but the starting position remains attractive after weak domestic demand growth in the 2010s and the powerful sell-off in real effective exchange rates in 2020.

For these emerging economies, we see attractive economic conditions and strong commitments to monetary orthodoxy attracting increasing capital flows from global carry-trade investors. Those flows further drive liquidity and growth while stabilising and strengthening currencies, all of which are highly supportive for equity investors. We remain highly positive on the outlook for these markets in the second half of the year.

This Fund is designed for investors who want the potential for long term capital growth and tax effective income from a portfolio of primarily 40-60 Australian mid cap shares and are prepared to accept higher variability of returns.

Pendal defines the mid cap universe to include companies ranked between 51 and 150 of the S&P/ASX 200 Index. The Fund may also invest in equivalent companies listed on the New Zealand Stock Exchange, hold cash and may use derivatives. Pendal’s investment process for Australian shares is based on our core investment style and aims to add value through active stock selection and fundamental company research. Pendal’s core investment style is to select stocks based on our assessment of their long term worth and ability to outperform the market, without being restricted by a growth or value bias. Our fundamental company research focuses on valuation, franchise, management quality and risk factors (both financial and non-financial risk).

This Fund is designed for investors who want the potential for long term capital growth and tax effective income from a portfolio of primarily 40-60 Australian mid cap shares and are prepared to accept higher variability of returns. Pendal defines the mid cap universe to include companies ranked between 51 and 150 of the S&P/ASX 200 Index. The Fund may also invest in equivalent companies listed on the New Zealand Stock Exchange, hold cash and may use derivatives. Pendal’s investment process for Australian shares is based on our core investment style and aims to add value through active stock selection and fundamental company research. Pendal’s core investment style is to select stocks based on our assessment of their long term worth and ability to outperform the market, without being restricted by a growth or value bias. Our fundamental company research focuses on valuation, franchise, management quality and risk factors (both financial and non-financial risk).

This Fund is designed for investors who want the potential for long term capital growth and tax effective income from a portfolio of primarily 40-60 Australian mid cap shares and are prepared to accept higher variability of returns. Pendal defines the mid cap universe to include companies ranked between 51 and 150 of the S&P/ASX 200 Index. The Fund may also invest in equivalent companies listed on the New Zealand Stock Exchange, hold cash and may use derivatives. Pendal’s investment process for Australian shares is based on our core investment style and aims to add value through active stock selection and fundamental company research. Pendal’s core investment style is to select stocks based on our assessment of their long term worth and ability to outperform the market, without being restricted by a growth or value bias. Our fundamental company research focuses on valuation, franchise, management quality and risk factors (both financial and non-financial risk)

This Fund is designed for investors who want the potential for long term capital growth and tax effective income from a portfolio of primarily 40-60 Australian mid cap shares and are prepared to accept higher variability of returns.

Pendal defines the mid cap universe to include companies ranked between 51 and 150 of the S&P/ASX 200 Index. The Fund may also invest in equivalent companies listed on the New Zealand Stock Exchange, hold cash and may use derivatives. Pendal’s investment process for Australian shares is based on our core investment style and aims to add value through active stock selection and fundamental company research. Pendal’s core investment style is to select stocks based on our assessment of their long term worth and ability to outperform the market, without being restricted by a growth or value bias. Our fundamental company research focuses on valuation, franchise, management quality and risk factors (both financial and non-financial risk).