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Fidelity Equity Dividend Income (FEQTX) was one of many value-oriented funds that were outperformers in 2022. Diversified funds that had low technology exposure finished the year with small losses and even gains in many cases. Lack of exposure to mega-cap technology stocks along with avoiding speculative companies with little to no profits was half the battle. The other was having some positive exposure in the few sectors and subsectors that outperformed, such as energy and large-cap pharmaceuticals.

FEQTX’s current crop of top-10 holdings benefited most from the more than 80 percent rally in shares of Exxon Mobil (XOM). Higher oil prices and high inflation, plus low share prices coming out of the 2020 pandemic, helped power energy stocks last year. Consumer staples and healthcare were strong as well. Merck (MRK) was up 50 percent and Bristol-Myers (BMY) 20 percent. Johnson & Johnson (JNJ) had a small gain on the year, while Unilever (UL) saw only a small loss. These wins offset losses in holdings such as Cisco (CSCO) and Comcast (CMCSA).

Heading into 2023, the big debate is over economic growth. Inflation will fall because the first half of the year in 2022 contributed almost 5 percentage points of inflation. As long as inflation doesn’t suddenly reverse higher via geopolitical risk such as escalation in Ukraine, inflation should be far lower next year. Over the past six months (estimating December’s rate), the CPI increased 1.2 percent. If the trend carries into June, the CPI would fall to around 2.5 to 3.0 percent by then. This could dent holdings such as Exxon that rely on higher commodity prices, but the bulk of FEQTX’s portfolio is in dividend-paying blue-chip stocks. As inflation comes down, interest rates will stabilize or even decline.

The economy’s direction is more hotly debated. There are signs growth is slowing in areas such as manufacturing and housing, but overall economic growth remains solid. Surveys show employers report wage pressures and lack of skilled labor. Federal Reserve officials have singled out the surprisingly strong labor market as one reason why interest rates will remain higher for longer. Consumer spending has been robust. The yield curve is inverted, but it usually doesn’t steepen until the Federal Reserve starts cutting short-term interest rates. Finally, if we look at the stock market as a forward indicator, stocks such as Caterpillar (CAT) traded at new all-time highs in December. The market clearly thinks there will be rising demand for industrial products next year.

Funds such as FEQTX will do well in either of the most likely scenarios. A continuation of high inflation, higher interest rates and a strong economy will favor value stocks over growth. If all these trends reverse, investors will still favor dividend-paying stocks with strong financials over speculative growth stocks.

FEQTX is well positioned for variable outcomes because it has broad sector exposure. Financials is the largest sector at nearly 19 percent of assets but underweight relative to the benchmark Russell 3000 Value Index. Healthcare is next with 15 percent of assets. Blue-chip drug makers are a major subcomponent within the healthcare exposure. Along with Johnson & Johnson (JNJ), these stocks have earnings that are about as close to “recession proof” as companies get.

Technology is overweight at 13 percent of assets compared to the benchmark but still about half the exposure of the broader market. FEQTX also owns a different mix of technology stocks as represented by top holding Cisco. Energy is underweight at 6 percent of assets versus nearly 9 percent in the benchmark.

Overall, FEQTX leans toward the “growth” side of value with holdings such as pharma and tech stocks with high dividend yields. This makes it a good companion to more pure value funds that may overload the energy and materials sectors.

Management

John Sheehy has managed FEQTX since April 2017. He also manages Fidelity Stock Selector Large Cap Value (FSLVX).

FEQTX has an expense ratio of 0.58 percent. It has a turnover rate of 47 percent, down from 71 percent in the wake of the March 2020 market panic.

FEQTX paid a capital gain worth 5 percent of net asset value last year, 9 percent in 2021, 6 percent in 2019 and more than 11 percent in 2018. This fund should be held in a tax-advantaged account if minimizing taxes is part of your financial plan.

FEQTX earned a 3-star rating from Morningstar.

Portfolio

FEQTX has an average market capitalization of $54 billion, about half that of the Large Value category. It has fewer holdings in giant-caps and more in mid-caps. Compared to the average Large Value fund, FEQTX has about 14 percentage points less in giant-caps and 4 percentage points more in large-caps. Although only 5 percent of assets, the fund is also overweight small-caps relative to the category and index. Compared to the index, FEQTX has 20 percentage points lower exposure in giant- and large-cap holdings at 60 percent versus 80 percent for the index.

The top-10 holdings as of October 31, 2022 were Wells Fargo (WFC) 3.0 percent, Johnson & Johnson (JNJ) 2.9 percent, Unilever (UL) 2.9 percent, Exxon Mobil (XOM) 2.8 percent, Verizon (VZ) 2.4 percent, Sanofi (SNY) 2.2 percent, Bristol Myers Squibb (BMY) 2.2 percent, Cisco (CSCO) 2.1 percent, Merck (MRK) 2.1 percent and Comcast (CMCSA) 2.0 percent.

FEQTX is highly diversified, with its top-10 holdings accounting for only 24.6 percent of assets.

FEQTX has a beta and standard deviation slightly below that of the Large Value category.

Performance

As of December 27, FEQTX was down 0.91 percent in 2022. Over the past 1-, 3-, 5- and 10-year periods, it decreased an annualized 0.36 percent, then rose an annualized 6.95 percent, 6.99 percent and 10.30 percent, respectively.

FEQTX beat the Large Value category in all periods except the past 10 years, when it trailed by an annualized 0.10 percentage points. However, only about half of this period was managed by the current manager. Sheehy’s performance since taking over in 2017 has been excellent.

Outlook

Value funds outperformed greatly in 2022, and the conditions supporting their outperformance should continue. Fidelity Equity Dividend Income holds many “defensive” stocks that typically hold up better in bear markets. After a year in which some top holdings climbed more than 50 to 80 percent, another year of such strong performance is unlikely.

Economic and financial market conditions favor value stocks unless and until interest rates and inflation head back toward zero, something that won’t happen without further underperformance by growth stocks first. The best-case scenario for value stocks this year would be higher than expected inflation coupled with higher than forecast economic growth. Higher interest rates would trim growth stock valuations, while higher inflation and growth boost corporate earnings in the energy, materials and financial sectors.

Investors who want similar performance with a cheaper, more liquid fund can opt for Fidelity Stocks for Inflation (FCPI). The fund has a 0.29 percent expense ratio and 1.57 percent yield. FCPI outperformed FEQTX the past year as inflation took off because its portfolio is more fine- tuned for inflation. Since we expect inflation will drop at least in the first half of 2023, FCPI should have a smaller lead or even trail FEQTX in the first half of 2023. However, long-term investors who expect higher inflation in the coming decade may prefer building a position in FCPI for its inflation-oriented holdings.

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Emerging market stocks were battered in 2022. Many emerging market funds reached highs in February 2021, about the same time cryptocurrencies and speculative technology funds such as ARK Innovation (ARKK) were peaking. Unlike speculative growth stocks, most emerging market funds, including Fidelity Emerging Markets (FEMKX), have gained little on an annualized basis since 2007. Fidelity Hong Kong and China (FHKCX) has risen about 30 percent in 15 years, an annualized return of about 1.8 percent.

Weakness in emerging markets stems from several factors. First, the 2008 financial crisis wasn’t only about the U.S. housing market and the related financial assets. It was also the peak of a commodities bull market. China was the main driver of commodity demand. Its economy started slowing significantly in the 2010s and has continued slowing with a policy of lockdowns for the coronavirus. Many developing countries export commodities to China, making a slowdown bad news for the entire asset class. China also dominates many emerging market funds.

From the perspective of bullish investors, emerging markets are undervalued. The index funds such as MSCI Emerging Markets trade near a forward P/E of 10 that marked the low for most of the past 15 years. Only the lows in 2008 pierced that level. With many country funds flat since the 1990s or 2000s, they are much cheaper than they’ve been in years. Cycles are also lining up in their favor. The late 1990s and early 2000s also saw a strong U.S. dollar, a bottom in commodities such as oil and a bear market in technology stocks.

The biggest risk for emerging markets in the near term is currency risk. The Chinese yuan is overvalued and can probably fall another 10 percent. This seems highly likely if currencies such as the yen, euro and Korean won resume their weakness. Emerging market currencies will likely underperform the Chinese currency, perhaps moving lower by 15 percent to 20 percent.

Over the next 12 months or so, currency risk is highly relevant for investors. A surge in the U.S. dollar could force emerging markets lower and provide a major low that won’t be seen again for a decade or longer. In the longer term, valuations will be more important. Emerging markets have underperformed uninterrupted for almost 12 years. The longest stretch of outperformance was a two-year run from the market low in January 2016 until early 2018. Going back to the relative performance peak in 2010, FHKCX and FEMKX have risen 52.67 percent and 31.59 percent, respectively, versus the 330.02 percent rally in SPDR S&P 500 (SPY).

Looking forward, emerging markets may provide aggressive investors a solid value opportunity.

Fidelity Emerging Markets (FEMKX)

FEMKX seeks capital appreciation from superior asset selection. Emerging markets are more complex investments because there are currency and economic risks that differ from those in U.S. markets. The fund seeks strong, stable companies that are undervalued by the market.

FEMKX has been managed by John Dance since February 2019. He previously managed Pacific Basin (FPBFX) and Emerging Asia (FSEAX) before leading this fund. Under his tenure, FEMKX gained more from Chinese technology exposure than it has given back, making for outperformance over his thus far brief tenure.

The fund has an expense ratio of 0.88 percent and a turnover rate of 36 percent, plus 5-star and Bronze ratings from Morningstar.

Portfolio

The portfolio leans toward higher-quality, large-cap stocks as compared with the category and plain vanilla passive emerging market indexes. China makes up 28 percent of assets, India 19 percent, Taiwan 12 percent, Saudi Arabia 5 percent and South Korea 5 percent. The largest currency exposures are the Indian rupee at 19 percent, Hong Kong dollar 17 percent, U.S. dollar 16 percent, Taiwan dollar 12 percent and Chinese yuan 8 percent.

The top holdings have been Taiwan Semiconductor at 7.82 percent, Tencent 5.59 percent, Samsung 3.76 percent, Reliance Industries 3.29 percent and Kweichow Moutai 2.99 percent.

FEMKX has a beta of 0.92 versus 0.98 for the category and 0.95 for the emerging markets index. It has a standard deviation of 19.41 percent versus the 20.53 percent of the category and the 19.21 percent of the index. Lower volatility comes from the larger average market capitalization in the fund.

Fidelity Hong Kong and China Region (FHKCX)

FHKCX has been managed by Ivan Xie since April 2018 and co-manager Peifang Sun since January 2021. Both previously worked as analysts covering the Greater China region. The fund mainly searches for growth at a reasonable price along with turnaround plays in cyclically depressed industries.

The expense ratio is 0.91 percent. Turnover is 60 percent. FHKCX has a 4-star and Neutral rating from Morningstar.

Portfolio

Like FEMKX, this fund has a higher average market cap than the China category and the China index. Technology leads with 24 percent of assets, followed by consumer discretionary with 24 percent, financials 16 percent, communication services 10 percent and consumer staples 5 percent. Geographically, China leads with 62 percent of assets. Taiwan has 23 percent and Hong Kong 9 percent.

There is some overlap with FEMKX in the top holdings. Taiwan Semiconductor has 16.38 percent of assets, Tencent 8.29 percent, Alibaba 5.82 percent, AIA Group 5.11 percent, Meituan 4.51 percent, Industrial & Commercial Bank of China 2.82 percent, China Construction Bank 2.54 percent, Pinduoduo 2.42 percent, Kweichow Moutai 2.04 percent and Media Tek 1.92 percent.

FEMKX has a beta of 0.70 versus 0.61 for the China category and 0.53 for the MSCI ACWI ex-USA Index. The standard deviation is 20.77, below the 23.57 of the China category and higher than the 20.44 of the MSCI ACWI ex-USA Index. The lower volatility and correlation as compared with the category are explained in large part by its larger market capitalization, while the higher beta and standard deviation versus the index are explained by the country concentration.

Outlook

Emerging market indexes have gone nowhere since 2007. Chinese indexes are also below levels seen in 2007. The long stretch of underperformance was a combination of cyclical factors such as the commodities cycle, the currency cycles favoring the U.S. dollar, excessive optimism in the 2000s giving way to the reality of slower Chinese growth in the 2010s, and now high volatility in the wake of the coronavirus pandemic, deglobalization, trade tensions and rising geopolitical risk.

Valuations have largely priced in these risks, and the remaining risk will stem from currencies and China’s coronavirus policy. Currency risk will follow the U.S. dollar. If its rapid rise continues, volatility in the currency markets will intensify. If emerging markets are forced into significant devaluations, that will be the absolute best time to buy. For this reason, we would not go “all-in” on emerging markets here, but instead, start small and build on weakness moving forward.

China will also be key for emerging markets. FHKCX is a much riskier fund because it is concentrated in China, but investors who want emerging markets exposure won’t see good returns until the Greater China region moves higher. The risk in China is political, plus it has the same currency risk as elsewhere. The government is still shutting down entire cities as part of its zero-COVID strategy. This has greatly slowed the economy. China analysts who don’t trust the government data believe the country could already be on the brink of a recession.

Investors love to say they’re contrarian, but real contrarian investing comes from buying when nobody else wants the assets. We still see potential risk in emerging markets that should keep conservative investors on the sidelines for now, but younger investors with long time horizons can start building a small starter position if they’re planning on holding for five or more years. Conservative investors would be better served by patience. That could mean missing some of the gains if a low is already in, but it avoids potential double-digit losses if there is one more downswing for these markets.

We recommend avoiding FHKCX. China will have more upside potential at the low, but until it reopens, risk is elevated. FHKCX has outperformed, but it still lost 16 percent from high to low in October versus 24 percent for iShares China Large Cap (FXI). The accelerating decline in Chinese shares looks like the type of drop that precedes a major low, but conservative investors should be wary of catching the proverbial falling knife.