Navigating volatility has always been a priority for the MCP investment team, not just to mitigate risks but also to proactively capitalise on the opportunities that market fluctuations present. Given the recent spike in volatility this summer, we thought it was an opportune time to share our insights on navigating market turbulence, drawing on Carlos Hardenberg’s 25+ years of experience. Beginning his career during the Asian financial crisis, Carlos has navigated the dotcom bubble, the global financial crash, the Covid-19 pandemic and numerous other market disruptions. His experience as a long-only equities investor has only reinforced the idea that volatility can be your friend if you use it effectively.
Understanding Volatility
Managing market volatility starts with understanding its causes — asking why investors buy one day and sell the next, often without any significant change in fundamentals. This behaviour is rooted in the fear of the unknown, a human characteristic to which investors are not immune.
Uncertainty leads to nervousness, causing a risk-averse instinct which, in investing, often leads to sell-offs. The herd mentality exacerbates the situation — as everyone else sells, the fear of being left behind and suffering greater losses grows stronger, pushing more investors to follow suit. The widespread use of algorithmic trading, most of which trades on the same set of predefined conditions that mirror market movements, compounds the effects of sell-offs and thus increases volatility further. In 2018, Select USA estimated that algorithms now dominate 60-75% of trading in major US, European and Asian markets.
Leveraging Volatility
In times of volatility, we believe it is important to remain calm and focus on fundamentals and the long-term. We seek high-quality companies with excellent management teams, strong moats, positive cashflows and little to no debt. These companies are more likely to prove resilient and maintain a positive outlook. Nevertheless, we always monitor macro developments and their potential impact on our investment case very closely. Timing is critical in responding to changing macro and micro conditions — selling too early or too late can have significant consequences. Yet 25 years of investment experience has taught Carlos that selling on volatility alone usually leads to poor investment decisions. During the 2008 global financial crisis, many investors fled risk assets such as emerging markets, resulting in a vast pool of undervalued EM stocks despite their strong fundamentals and sound business models. Rather than following the herd, Carlos leveraged the volatility as a source of additional alpha generation. By staying disciplined, closely monitoring his investments and adjusting his strategy when needed, he was well positioned to capitalise on these mispriced assets during the subsequent recovery, thereby leveraging uncertainty as a friend. Similarly, during the Covid-19 pandemic, the team swiftly repositioned the portfolio, seizing the opportunity to add high-quality companies from our watch list. These companies were being unfairly dragged down by market sentiment. This timely and strategic response, we believe, contributed significantly to the fund’s strong outperformance.
Interestingly, over the past decade, US equities have been more volatile than emerging markets in local currency terms. One reason could be the high concentration of the US market. Since 2014, big tech companies have rapidly increased their market dominance, with the ‘Magnificent 7’ now accounting for around 30% of the S&P500. In a highly concentrated market, sell-offs can become more severe as many investors rush to offload the same stocks, leading to outsized losses for those who remain invested. Historical examples have showcased the risks inherent in highly concentrated markets. For example, the dotcom bubble era was dominated by five tech stocks, which were quickly sold off when the bubble burst, contributing to the 78% loss in the Nasdaq index from its peak in March 2000 to its low in October 20021.
Market Concentration and Volatility
While the high concentration of the US market is widely recognised, many investors do not realise that the situation is similar in emerging markets. In the MSCI EM Index, the top 10 companies account for approximately 25% of the total index weight, despite there being around 1,300 constituents in total. In addition, many of the bulge-bracket EM funds’ portfolios are similarly concentrated in these top 10 names, potentially increasing their vulnerability to significant drawdowns during market sell-offs. This highlights the importance of portfolio diversification. We prefer smaller, lesser-known innovative companies in emerging markets, particularly in sectors like AI and the semiconductor supply chain, which we believe have a strong potential to deliver alpha.
Monetary Policy, Volatility and Emerging Markets
One of the main sources of volatility this year has been the Federal Reserve’s decisions regarding interest rate cuts. While the pace of future cuts and any unexpected employment or inflation data may continue to cause market fluctuations, the direction is now clear with the first cut behind us. Our focus, however, remains on the impact of these rate cuts on emerging markets rather than the short-term volatility around Fed meetings. With rates trending lower, as demonstrated by the Fed’s half-point cut on 18 September, we believe emerging markets are poised to benefit. Lower interest rates in advanced economies typically weaken the dollar, which in turn supports EM currencies and eases the burden of dollar-denominated debt.
Since 1988, EM equities have, on average, outperformed DM equities in 4/5 Fed rate-cutting cycles returning 29% in the 24 months following the last Fed rate hike2. Moreover, while many LatAm countries are ahead in the rate cutting cycle, Asian countries have been more cautious. Fed cuts now give many of them more room to begin their respective cutting cycles, thereby enabling cheaper borrowing, improving consumer sentiment and corporate spending, and stimulating growth.
In addition, lower US interest rates can benefit emerging markets by reducing the attractiveness of safer, lower-yielding assets in developed markets, encouraging investors to seek higher yields in EM, increasing FDI flows and supporting EM asset prices. However, this impact varies across emerging markets as increased risk appetite and lower US yields cannot offset poor macroconditions or weak corporate fundamentals. For example, in the rate-cutting environment of 2019, Taiwan saw strong FDI inflows of $8.2bn, up 16% from 2018, while Argentina, with weaker fundamentals saw a 43% drop in FDI to $6.7bn3. Therefore, maintaining a robust macroeconomic overlay, combined with diligent stock selection, remains essential. This approach focuses on companies with strong fundamentals and resilient business models that can capitalise on a lower interest rate environment.
Volatility around Elections
The global election year, seeing more than 60 countries and two billion people participating in elections4, has provided an additional source of volatility as uncertainty over new governments and policy directions incites investors’ fear of the unknown. However, most of the elections in emerging markets this year have not led to significant long-term spikes in volatility as the results have largely maintained the status quo in government policy. While initial declines in equity markets were mostly brief and quickly reversed (Mexico being one exception) some elections have even reduced local market volatility, with South Africa being a good example.
The US election remains a major source of uncertainty, more so than local EM elections, and will probably cause short-term market fluctuations in the lead up. However, historically, volatility tends to decline after the election announcement as uncertainty is reduced and, in fact, the MSCI EM Index often shows positive performance in the 100 days following the election announcement. The long-term impact of the new government’s policy direction, particularly on the strength of the USD and foreign policy, is what is most crucial for emerging markets. Donald Trump has perhaps been a more vocal proponent of protectionism, proposing extreme measures, including minimum tariffs of 60% on Chinese goods, 10% tariffs on global imports and, most recently, 100% tariffs on countries that turn from the US dollar. However, Joe Biden has retained and expanded many of the tariffs implemented by Trump during his presidency, reflecting a rare area of agreement between the two adversaries and a broader US shift towards de-globalisation and protectionism. Given Kamala Harris’s role as Vice President in implementing and expanding key protectionist policies such as the Inflation Reduction Act (2022) and the CHIPS and Science Act (2022), significant changes in trade policy may not be expected if she takes office.
As a result, we expect friend shoring and nearshoring to continue driving capital into regions like Mexico and ASEAN, particularly in their manufacturing sectors. Additionally, the US’s decoupling from China is likely to strengthen ties with allies such as Taiwan and South Korea for semiconductor chips, and with South American and Eastern European countries for raw materials such as lithium, benefiting these emerging markets’ respective industries.
Geopolitics and Volatility
Geopolitics has long been, and is likely to remain, a significant source of volatility in global equity markets. No market, whether developed or emerging, is immune to the impacts of geopolitical events such as trade wars, ongoing conflicts or rising regional tensions. We believe the key to navigating these shocks, much like economic crises, is to stay disciplined by continuously monitoring the situation, staying informed and revisiting and reconfirming every single investment case as circumstances evolve. A disciplined macro-overlay is essential in emerging market investing, even for bottom-up stock pickers like ourselves. This approach has allowed us to effectively navigate and mitigate risks associated with major geopolitical events. For instance, we had no exposure to Russia during its invasion of Ukraine, driven by concerns over governance issues and the regulatory environment.
We closely monitor the relationship between China and Taiwan and believe that China will continue to focus on its own economic priorities in the near future, such as the overcapacity in the property market and high unemployment levels, and the recent measures to boost the economy seem to confirm this. Meanwhile, our exposure to Taiwanese companies is limited to asset-light businesses or those with a well-diversified global production base, providing some downside protection in the event of an escalation.
Conclusion: Stay Calm and Carry On
The bottom line is to stay disciplined and maintain a long-term perspective as markets tend to mean revert. Therefore, we believe by focusing on quality fundamentals rather than short term trends, volatility can be more effectively managed and even leveraged. In addition, falling interest rates have put EM back on the table as an attractive investment case for many, but we believe it is important to optimise EM investments via under-covered and mispriced small and mid-cap companies that will benefit from growing trends, such as AI, renewables and the growing consumer and middle classes, as well as diversifying your portfolio beyond the most concentrated stocks.