Emerging Markets Strategy October Commentary

Key Takeaways

• Infrastructure indices and global equities both traded down in October as expectations grew that interest rates would remain higher for longer than previously expected.

• Air traffic recovery in Asia helped airport holdings there, while an announced changed to the regulatory framework for Mexican airports caused some turbulence, though we expect the changes to be less negative than feared.

• We think utilities valuations, like infrastructure broadly, are attractive now, and, versus the more optimistic consensus narrative, our contrarian view is that the risks of a recession remain considerable.

Market Overview

Infrastructure indices and global equities both traded down in October as expectations grew that interest rates would remain higher for longer than previously expected.

Slowing inflation and reasonably strong economic data have led investors to reassess their expectations of a recession in 2023. China, meanwhile, is experiencing economic challenges as progress in its reopening is being disrupted by difficulties in the Chinese property sector.

Inflation continues to moderate, although concern remains around the level of wage inflation and more recently a surge in oil and gas prices, making it difficult for central banks to loosen policy quickly. As expectations for a higher-for-longer interest rate backdrop gain traction, financial conditions continue to tighten, placing further stress on economic growth. Consensus continues to moderate its expectations for a recession, with the possibility of a recession remaining the largest risk to investors.

Portfolio Performance

Chinese electric utility China Power International (+0.11%) was the top individual contributor to monthly performance. China Power International (CPI) is an independent power producer (IPP), operating ~30 GW of capacity in China, including 56% coal-fired, 20% hydro, and 23% wind, solar and others. Its holding company is State Power Investment Corporation, one of the top five Chinese state-owned power generator groups. Shares performed well as China Power’s parent company announced plans to increase shareholding in the coming months, signaling strengthening support and confidence.

Elsewhere in the Asia Pacific region, Malaysian airport operator Malaysia Airports (+0.10%) also performed well. Malaysia Airports is one of the world’s largest airport operators by passenger numbers. Based in Kuala Lumpur, it operates all but one airport in Malaysia and also has a 100% stake in Istanbul’s Sabiha Gokcen airport. Air travel across Asia continued to recover in October, helping Malaysia Airports shares.

Mexican airport operator Grupo Aeroportuario del Centro Norte (OMAB; -1.05%) and Indian energy infrastructure company Indraprastha Gas (-0.55%) were the largest detractors for the month. OMAB operates 13 airports in central and northern Mexico. Of Mexico’s three airport groups, OMAB is generally more focused on domestic/business travel as opposed to tourism. OMAB was an underperformer in October following the unexpected announcement that the Mexican government would be changing the regulatory framework for Mexican airports. This has resulted in a higher concession fees and lower tariffs. More details are yet to be released, but we expect the final result will be much better than originally feared.

Indraprastha Gas Limited is a city gas distribution business. It is one of India’s leading natural gas distribution companies, processing and distributing compressed natural gas and liquified petroleum gas to transport, domestic, commercial and industrial consumers. Indraprastha Gas shares fell on the back of fears of electric vehicle policy taking away market share from compressed natural gas vehicles.

There were no notable changes during the month.

All returns are in local currency.

Outlook

Despite recent volatility, we are maintaining our defensive positioning as we believe the impacts of tightened financial conditions will eventually affect the economy and ultimately corporate earnings (we are starting to see weakness in earnings from higher interest costs). The Fed and other central banks around the world have to maintain their hawkish position and have started to accept recessionary risks as increasingly likely but necessary to combat the stubbornly high inflation.

Our overarching view is that utilities can handle higher interest rates in the intermediate term. In a slowing growth environment, we believe their predictability of earnings makes utilities attractive compared to general equity sectors where earnings uncertainty results in less confidence among investors and higher volatility.

We think utilities valuations, like infrastructure broadly, are attractive now, and, versus the more optimistic consensus narrative, our contrarian view is that the risks of a recession remain considerable.