GLOBAL EMERGING MARKETS NOVEMBER 2016

FOR PROFESSIONAL CLIENTS ONLY

TALES FROM THE ROAD – ASIA

Asia is expected to deliver the bulk of emerging market growth over the next five years. However, at a time of global economic uncertainty, the outlook differs greatly from country to country. In a special focus on the region, Kim Catechis, Head of Global Emerging Markets, assesses how politics and individual governments’ success in implementing reforms and liberalisation programmes are key drivers, while portfolio managers Andrew Mathewson and Divya Mathur reflect on recent research trips to Korea and India.

Economic growth, trade and the impact of the US elections are now global preoccupations. These themes resonate particularly in Asia, especially as President-elect Trump has announced his plans to withdraw US support for the Trans-Pacific Partnership (TPP). The scheme would (it was hoped) have provided a significant economic boost to the region, promoting more orthodox policies and opening up previously inaccessible markets.

Kim CatechisHead of Global Emerging Markets

www.martincurrie.com

While clearly a negative for the region, Asian countries are close to concluding their own trade deal, the Regional Comprehensive Economic Partnership (RCEP) a simpler trade deal focusing on reducing tariffs.

Asia still includes some of the fastest-growing economies in the world and we find no shortage of highly attractive investment opportunities – across a variety of sectors.

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Malaysia, number of stocks: 1Prime Minister Najib Razak has focused on managing the fallout from politically unpopular fiscal reforms, including an end to fuel-price subsidies, a reduction in spending on sugar subsidies, and a new GST. Despite opposition, Najib has pushed forward his fiscal-consolidation agenda, a recalibrated and restricted budget with emphasis on fiscal discipline.

He faced criticism for his handling of the scandal surrounding government-owned investment fund 1Malaysian Development Berhad (1MDB). However, despite concerns over the government’s lack of transparency regarding the scandal, the business environment remains positive, with a predictable regulatory and legal backdrop.

Taiwan, number of stocks: 5Security has historically been considered a less significant variable, when set against larger factors like the effectiveness of economic policy, social stability and a cohesive government. However, the deterioration in the relationship between Taiwan and China could see that reversed. New President Tsai Ing-wen’s failure to explicitly endorse the ‘One China’ concept (instead indicating her government would seek a modernised framework for managing relations), demonstrated how sensitive and politically charged relations are, as China suspended direct government communications. This had previously been a meaningful channel to avoid or resolve conflicts and therefore could now mean less protection for Taiwanese companies operating in China.

This growing concern over relations with China will lead to a deterioration in the investment climate in the short term. The urgency behind trade and investment liberalisation initiatives is increasing, and the government’s inability to move forward with regards to any meaningful policy shifts will have growing downside

consequences for the economy.

China, number of stocks: 9 (including 1 Hong Kong holding)As the pace of economic growth slows, Beijing’s aims to cushion the blow via cautious relaxation of monetary and fiscal policy, but continues to push for reforms consistent with 6.5%–7% growth. This includes reducing industrial overcapacity, limiting debt financing, and combating environmental degradation. China is in the midst of overhauling its political and corporate governance, as it aims to put the economy on a more sustainable growth path.

President Xi Jinping’s attempts to engender greater transparency and responsible behaviour among government officials have included anti-corruption policies, which have had a negative impact on industries such as the luxury goods market, casinos and restaurants, as officials become more conscious about their spending.

Meanwhile, there is an increasing focus on national security, as the Chinese government looks to maximise state control over the internet and IT business environment. A new counterterrorism law, containing requirements for data localisation and encryption access, has already been passed. This has significant implications for companies active in e-commerce,

cloud, mobile technology and industrial internet.

Korea, number of stocks: 6Korea has historically been aided by its open economy. This helped exports and industrial production rebound sharply following the global financial crisis. However, global growth has turned increasingly sluggish and Korea has not been immune. The country is highly integrated within global value chains, with China a significant importer of intermediate goods in value-added terms. As a result, weakening Chinese growth puts pressure on Korean exports.

Foreign policy and security are naturally high on the agenda. In recent months an influence-peddling scandal has weakened President Park Geun-hye’s administration. These tensions will increase as the December 2017 presidential election approaches. Calls for monetary easing may help cyclical weakness but will not address more structural problems. If policymakers turn to unconventional easing to lift inflation expectations and keep real rates down, equities would seem to be significant beneficiaries. We continue to find great opportunities in the country.

Asia: a macroeconomic and political overview

Source: Martin Currie as at 31 October 2016. Data calculated for the Martin Currie Global Emerging Markets representative account.

India, number of stocks in Global Emerging Markets strategy: 6Until Prime Minister Narendra Modi’s Bharatiya Janata Party (BJP) gains more control in the upper house, more contentious prospective reforms, such as loosening labour laws to bolster manufacturing, are likely to proceed initially only at the state rather than central level. Long-awaited plans to replace existing indirect taxes with a unified goods-and-services tax (GST), which had been expected to pass in 2015, were delayed, but will now be implemented from April 2017.

In a move to tackle corruption and the black market, the Indian government has removed the 500 and 1,000 rupee banknotes from circulation. Representing around 85% of cash transactions, this has been a significant short-term negative for the economy. However, in the longer-term this will be positive for the country, with a potential windfall from deposited notes (and reduced liabilities from those that go undeposited).

Modi is attempting to foster a culture of accountability and responsibility among bureaucrats and politicians (both at a state and federal level). The very weak presence of the government in many rural areas will continue to make law enforcement in these areas a particular challenge. The business environment is notoriously difficult, something Modi is aware of and attempting to change. Investor interest is based on the market size and economic growth prospects. Democracy is entrenched (so political

risk centres on policy formulation rather than fundamental political stability).

Indonesia, number of stocks: 2President Joko Widodo is in a stronger political position than in previous years. However, he continues to face political and bureaucratic constraints. Joko reshuffled his cabinet in July, aiming to make it more efficient and press for more bureaucratic reforms. While incremental improvements to the business climate are likely through his drive for deregulation and liberalisation, the continued obstacles of corruption and inefficient bureaucracy mean the country remains a challenging place for businesses to operate in. The key positive development was the recent surge in tax revenue collection, as the government’s tax amnesty has completed its first phase, netting more than US$7 billion.

Thailand, number of stocks: 0The death of long-serving monarch King Bhumibol Adulyadej (seen as a unifying figure in Thailand) pulled the concerns around political instability in the country into sharp focus, as the question of his succession creates an uncertain environment. Discord between hardliners and moderates in the military-led government and among political stakeholders are never far from the surface.

The ruling administration maintains a constructive attitude toward foreign investment, but its decision-making process is partially driven by policies designed to please its nationalist allies, which will stall fiscal reforms and liberalisation, particularly in telecommunications and energy. The military’s main goal will be to remain in power during the royal succession process and closely monitor future governments.

Philippines, number of stocks: 1President Rodrigo Duterte’s new administration has pledged to increase welfare provisions (particularly social security and public healthcare insurance) and increase the regional distribution of economic resources. While falling commodity prices have reduced inflationary pressures (including food and consumer good prices), investors will be braced for a continued deterioration in the investment and business climate. Philippine institutions are stronger than they have ever been and robust enough to defend themselves from an attempt to grab power. Meanwhile, the latest GDP figures showed growth in the third quarter was 7.1%, and, the International Monetary Fund (IMF) has strongly endorsed the country’s economic policies and the business sector is enthused by the tax and investment reform and infrastructure plans.

Taiwan

South KoreaChina

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TALES FROM THE ROAD – KOREAWith a tech-savvy and well educated population, Korea has some of the most dynamic companies in the world. The country boasts a wealth of global brands and has forged a reputation for high-quality, value-added products. But there is still room for growth. On his recent research trip to the country, Andrew Mathewson explored how companies are demonstrating their ability to create larger addressable markets. Here, he looks at three different sectors where this was evident.

Autos – an industry evolvingThe autos subsector is already a global industry, with strong players based in both developed and emerging markets. Korea boasts a significant share of the global autos market and is home to some of the world’s most recognisable car brands. As research intensifies into the next generation of

Andrew MathewsonPortfolio Manager, Global Emerging Markets

motoring, two research and development (R&D) centre visits demonstrated how development of commercially viable electric vehicles and autonomous driving are allowing companies to expand their addressable market.

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Emergency braking/pedestrian detection/cruise control

Traffic sign recognition/lane departure warning

Cross traffic alert

Rear collision warning

Park assistance

Blind spotdetection

Blind spotdetection

360º Surround view360º Surround view

Adaptive cruise control

Radar Lidar (laser detection) Long range radar

Cameras Ultrasonics

Andrew MathewsonPortfolio Manager, Global Emerging Markets

Electric vehicles – the increasing demand for power

In 2015, the global threshold of 1 million electric cars on the road was exceeded for the first time and, although this is a tiny percentage of the total vehicles in deployment, governments and car manufacturers have increased targets for deployment*.

The first of the R&D visits, thermal-management company Hanon, a producer of air conditioning and cooling systems for vehicles, is an excellent example of how the shift from conventional to electric vehicles creates new opportunities. While the switch to electric power generation makes traditional cooling systems (such as radiator fans) unnecessary, electrification could lead to an increase in thermal-management requirements. New cooling solutions will be needed for larger batteries and computers with greater processing power. Design options for in-car air-conditioning (AC) systems are no longer constrained by a large combustion engine, but their high energy consumption dramatically reduces battery life (and therefore driving range). Therefore, more complex systems (using heat-pump technology, for example) are an integral part of the design process.

The cost of these requirements, compared with those of conventional engines, will clearly rise, with one estimation being a four to five times potential increase†. This will remain a relatively small proportion of the overall manufacturing cost of the car, but for companies like Hanon, its market looks set to expand, even without any particular growth in the overall industry. Requirements for more efficient AC systems will mean a larger addressable market and faster opportunities for growth.

Autonomous driving – a complex challenge for manufacturers

Developing advanced driver assistance systems (ADAS) is a further leap for the industry and the R&D centre visit to components supplier Mando provided important insight into how this industry is evolving. The company’s focus has shifted from supplying conventional steering, braking and suspension components – the car’s actuators – to developing an end-to-end integrated system. This involves developing sensors to pick up external factors (such as an object in front of the car), software to process the information and send a signal to the actuators, as well as the actuators themselves.

The ultimate aim is to enable completely autonomous driving, but the research visit gave useful insight into

the impediments to developing ADAS. For example, while keeping a car in the right lane and preventing it from crashing may be relatively straightforward, it is less clear what the most effective way to interpret traffic lights is. It could be a camera which detects a red light, or using 5G technology to pick up a signal which instructs the car to stop.

An industry ripe for disruption

There is again an opportunity for companies like Mando to significantly expand their addressable market (or the revenue per car they are exposed to) as auto-component suppliers (rather than manufacturers) are expected to deliver an increasingly larger proportion of the car. The research centre visits highlighted to me that, while there have been high-profile demonstrations of autonomous vehicles, mass production is still the challenge. Auto-parts firms are very likely to have an integral part to play in developing the new technology.

For us as investors, there are two areas to look at. Firstly, the implications for the original equipment manufacturers (OEMs) – specifically what becomes their differentiator as the industry develops. If a car company’s legacy is built on combustion engines, then its future might be simply as an assembler and marketer – people will still buy the brand. Secondly, where the balance of power lies as more-advanced technology is developed. It could be in the design of hardware, such as camera lenses used in advanced driving, or in developing software, which is essential to interpreting data.

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The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable. *Source: © OECD/IEA, Global EV Outlook 2016, IEA Publishing. Licence: www.iea.org/t&c †Source: Company meetings.

Autonomous driving technology

Source: Shutterstock, © monicaodo.

Convenience stores – changing habits, changing culturesExamples of companies increasing their addressable market were not limited to global outward-facing industries. It was also evident in more domestic-focused sectors, notably retail. While much of this sector in Korea has struggled in recent years, convenience stores (CVS) have seen growth*, posting improved sales and expanding store footprints. Convenience is increasingly prevalent as a key driver of consumer habits. This has been partly due to a shift in demographics (the number of single-person households has risen from 20% of the population in 2005 to 27% in 2015*) as well as changing cultural norms – dining alone, for example, is now viewed as more socially acceptable.

Innovating to increase margins

More than 30,000 convenience stores are now operating across the country with the largest, BGF Retail’s CU brand, opening its 10,000th in the first half of 2016. The breadth of what is available in store is also expanding. As the attitude to eating alone has changed, an important element has been the growth of ‘home-meal replacements’. CU and GS25 stores (owned by GS Group) offer ‘lunchboxes’, microwavable meals including the constituent parts of a traditional lunch. There is fierce competition to differentiate products, with GS featuring a famous soap actress on its products, while BGF’s example is endorsed by a celebrity chef. Along with more fresh food and, in particular, fresh coffee, convenience stores are including larger-ticket, higher-margin items. Stores are not just selling more, but these products are ‘own-label’, meaning the margins are higher than on branded items.. The CVS format has also expanded to include internet orders and payment services, which has aided the sector’s growth.

Room to move

Visiting Korean convenience stores, reinforced my view that the sector has many years of potential expansion ahead. A large proportion are quite small and the space within them dedicated to fresh food, or serving fresh coffee is still relatively limited. There is certainly scope for this to improve over time as new store openings continue. And expansion is not restricted to greenfield sites. Many of the new stores come from taking over single-operator ‘Mom and Pop’ stores, which are unable to compete with the larger franchises as the market becomes more complex. This presents a faster and cheaper alternative for companies looking for growth. For a sign of where the Korean CVS market can go from here, we can look at Japan’s convenience stores for an indication of its future trajectory. There has been a similar move to innovate and expand, serving fresh food (with its Bento boxes similar to the options being sold in Korea). However, in Japan, private label is now about 45% of sales, whereas in Korea this remains in the high single digits†. This, again, reinforces my view there is significant opportunity for growth in Korea’s stores.

The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable. *Source: Korean Statistical Information Service. †Source: Goldman Sachs.

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Internet platforms – capitalising on market dominanceAs active investors we are often looking for areas which are under-researched or mispriced. In the technology area, for example, while China dominates the headlines, Korean companies are given less attention by investors.

This is certainly evident in the development of online platforms. Emerging markets have led the way in this field. Companies in China in particular have succeeded in taking an online portal with a large number of active users, expanding it, introducing advertising and finding new ways of monetising the online world. A company like Tencent, for example, which began as a gaming and messenger business, is now ubiquitous in modern-day life, expanding into e-commerce, offering payment and becoming greater than the sum of its parts.

By comparison, Korea, already has a highly technology-literate population, and was the first country to pass 100% penetration for high-speed internet. It would therefore seem a logical area for this theme to be developed. The internet is well served by natural monopolies and so a company like Naver, which is a leading online portal in Korea with 42 million subscribers and 24 million daily unique visitors, has the potential to develop its existing market.

It has already introduced an online-shopping facility which has access to 600,000 products from 3,800 small and mid-sized offline shops, adopted a real-time communication channel to converse with shop managers and a payment function to e-commerce. Other services also include a video service added to live sports broadcasts on computer, allowing users to contact each other while watching*. The question for the business (and us as investors) is how does it make use of its status as the user’s destination point and can it take advantage of this as other companies have done elsewhere?

ConclusionIn times of little real growth, companies which can grow their addressable market are at a serious advantage. During the research visit there were many examples of firms which are well-positioned to do this. For Korean convenience stores, for example, I was able to reinforce my conviction of the sector’s growth potential.

Elsewhere, I was able to gain further insight into the varied opportunities across Korea coming from opposite ends of the spectrum. At one end, components manufacturers operating within a well-established global sector, growing their market as the industry evolves. On the other, the internet platform industry, still in the relatively early stages of development in comparison with other regions, and thus with plenty of room to grow for businesses.

Research trips like this are a vital aspect of our fundamental stock-driven approach. They give us a good sense of burgeoning industry trends and therefore enable us to gain early exposure to secular change in emerging markets.

The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable. *Source: Naver Annual Report 2016.

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TALES FROM THE ROAD – INDIAIndia is the second largest producer of cement in the world, but in recent years demand has disappointed – falling well below previous levels. Portfolio manager Divya Mathur used a research trip to India to explore the themes surrounding the cement industry and stress-test his conviction that a more positive picture for investors in the sector is emerging.

When I first started looking at this industry more than 20 years ago, almost every Indian manufacturing company had a side business involving cement supply (although none made it their sole focus). Since then much has changed, with many companies having either sold their interests or closed down.

Per capita cement consumption in India is now one of the lowest in emerging markets, but with roads, rail and sanitation in need of modernisation, the need for infrastructure is unequivocal. The government has an aggressive roadmap to achieve this, with plans to spend US$1.5 trillion. Cement capacity utilisation will increase at some stage in the future and between this and new supply eventually coming on stream there will be a sweet spot for investors in the cement cycle.

Divya MathurPortfolio Manager, Global Emerging Markets

To gauge the potential for recovery in demand and outlook for supply, my research trip included listed and unlisted companies and extended to cement producers – both large and small, domestically owned or with foreign parent firms. The visit also included equipment manufacturers and a range of consultants – including India’s only cement specialist.

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Divya MathurPortfolio Manager, Global Emerging Markets

Demand recoveryThe main driver for demand growth will come from the public sector. India’s cement demand is expected to reach 550–600 million tonnes per annum by 2025*. Housing will be the largest part of this, accounting for a significant proportion of total consumption. There is a focus on housing in both rural and urban areas at both a local and central government level. Government capital expenditure (capex) is also extending to other areas, such as roads and power projects and the push for large infrastructure projects is expected to accelerate demand in the next three to four years. Rural India is a key component to cement demand and so will be boosted by favourable policies as important state elections are held next year and a general election in 2019. The only area where we are not expecting any upside is in the private infrastructure sector. Here, capex is still weak (although this area has not historically been responsible for the bulk of demand).

Disciplined supplySupply has been slowing and an important condition for investing in this area is not just that it increases, but that this growth is disciplined. Incremental demand is expected to outstrip incremental supply after 2018†, which will be positive for eventual pricing. The groups we met on the research trip gave a number of insights into this area:

Low risk of disruption from imports

From a supply point of view, a key risk for India’s cement producers would be cheaper imports from places like China disrupting the domestic supply. There is, however, a low risk of cement coming in to India from overseas. Our conversations with consultants highlighted that there is no capacity at Indian ports, while logistics distribution across the country is also in a poor condition. Both these are essential for importing cement. Companies like HeidelbergCement, a German multinational with a presence in India, has capacity across Asia, but finds it difficult to export this into the country.

Capacity increasing, but slowly

Over time we expect to see cement capacity increasing, but this is happening at a slow pace. In particular, this is due to the lag associated with building new facilities. Estimations on how long this can take varied from somewhere between three and seven years. This is due to the number of licences required to set up; the process of connecting and organising plant infrastructure; and the availability of limestone. On this last point, restrictions on mining the country’s limestone reserves mean that producers expect competition between rivals to access assets close to their facilities. Earlier this year, Shree Cement was the highest bidder for deposits in Chhattisgarh, the first non-coal mining lease auction by the state government, as it plans to expand its cement plant at Raipur.

Few companies are announcing capacity increases. Ultratech, the largest cement producer, has worked around this lag for new facilities, by taking on capacity through mergers and acquisitions (M&A) activity. This has the added benefit that it can deliver cement immediately. In addition, the assets that it has purchased are underutilised, so there is huge restructuring potential. Meanwhile, the focus for HeidelbergCement, which is currently at around 85% capacity utilisation, is on debottlenecking (which it believes will increase future supply) as well as exploring M&A. Swiss-based LafargeHolcim, another of India’s larger players, is not expanding its Indian asset base but announced in November it has increased its investment in its Indian subsidiary holdings. While not increasing supply, this demonstrates its faith in long-term fundamentals and potential for further improvement in the industry.

For the smaller companies, however, the focus is on surviving until prices improve and avoiding the prohibitive costs of adding new capacity. This also means there are plenty of cement assets for sale by over-leveraged conglomerates looking for an exit.

The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable. *Source: CII-AT Kearney report – Cement Vision 2025: Scaling New Heights. †Source: Deutsche Bank.

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India’s demonetisation and its impact on cement demand

In early November the Indian government announced it was removing the 500 and 1,000 rupee banknotes from circulation, in an attempt to tackle the black market.

This move will be a long-term positive for the country, encouraging greater transparency, bank liquidity and putting the government in a better fiscal position. However, in the short term this has a significant impact on consumption, as the notes represent around 85% of cash transactions.

There are also negative implications for the cement industry, as many purchases of flats in urban areas have been paid in part-cash, part-mortgage. These are transitory impacts and, in any event, will not affect long-term demand from rural areas or infrastructure projects.

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Getting a more informed viewWithin Indian infrastructure there are a number of subsectors dealing with challenges, either with financial leverage or overcapacity in the power-equipment sector. The cement sector, however, is an attractive way to gain further exposure to a potential Indian infrastructure recovery, with better industry fundamentals.

One of the important benefits to the on-the-ground research conducted was the ability to pick up more detailed insight on a regional basis and, as a result, a stronger conviction in our investment thesis for the sector. Smaller (and unlisted) firms were able to give more specific and detailed guidance. These companies, being unlisted, have no particular motivation to meet investors and are therefore useful in highlighting where the real opportunities are.

One particular insight was from Wonder Cement, an unlisted company based in Rajasthan, where we built up a clearer picture on pricing. The firm highlighted that for smaller companies, the working capital cycle is a challenge, while the larger, listed firms have credit available to them. Another insight from various meetings was that, there are a large number of smaller and unlisted cement companies running at much lower profitability than listed firms and it was clear that this has been distorting the real industry profitability. This explains why pricing has not fallen, as the bulk of the industry cannot currently afford to cut prices.

Larger players Shree and Ultratech play an important role in determining the market pricing, with Shree often taking the initiative on price. When one company reduces the price others follow – meaning that reducing price is ineffective as a means of increasing growth.

My conviction in our investment thesis was strengthened by the visit to India. The recent demonetisation changes will have a significant impact on short-term consumption, including cement demand, but I believe the long-term drivers remain unaffected. Although views differed on when a recovery in demand would emerge, for us as long-term investors, this is less of an issue. In addition, as our research is driven by stocks and not top-down factors, we look for companies with self-help stories, which are able to optimise their capacity in order to benefit before the demand picture strengthens.

The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable.

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Important information

This information is issued and approved by Martin Currie Investment Management Limited (‘MCIM’). It does not constitute investment advice. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested.

The information contained has been compiled with considerable care to ensure its accuracy. But no representation or warranty, express or implied, is made to its accuracy or completeness. Martin Currie has procured any research or analysis contained for its own use. It is provided to you only incidentally, and any opinions expressed are subject to change without notice.

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The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable.

The opinions contained in this document are those of the named manager(s). They may not necessarily represent the views of other Martin Currie managers, strategies or funds.

Investors should also be aware of the following risk factors:

Investing in foreign markets introduces a risk where adverse movements in currency exchange rates could result in a decrease in the value of your investment.

Emerging markets or less developed countries may face more political, economic or structural challenges than developed countries. Accordingly, investment in emerging markets is generally characterised by higher levels of risk than investment in fully developed markets.

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