During the fourth quarter of 2016, the Seafarer Overseas Growth and Income Fund lost -6.47%.1 The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, fell -4.08%. By way of broader comparison, the S&P 500 Index rose 3.82%.
The Fund began the quarter with a net asset value of $12.03 per share. During the quarter, the Fund paid a semi-annual distribution of approximately $0.110 per share. This payment brought the cumulative distribution, as measured from the Fund’s inception, to $1.370 per share.2 The Fund finished the quarter with a value of $11.14 per share.3
During the calendar year, the Fund returned 9.34%, whereas the benchmark index rose 11.60%.4
[Please note: this portfolio review encompasses only the fourth quarter of 2016, and does not offer a thorough discussion of the entire calendar year. The Fund operates on a fiscal year that concludes April 30; as such, Seafarer offers comprehensive performance reviews for the Fund’s annual and semi-annual periods, which are published in the Fund’s Shareholder Reports in late June and December, respectively. Previous Shareholder Reports are available in the Archives.]
At the outset of the fourth quarter, stock markets in the developing world were placid. Measured from September 30 to the evening of November 8, the benchmark index was perfectly flat. Yet thereafter, the calm was broken. The emerging markets – stocks, bonds and especially currencies – reacted sharply to the U.S. presidential election, the result of which appeared to take investors in the developing world by surprise. Most stock markets, save those of Russia and a handful of small markets in the Middle East, fell swiftly in the ensuing days. Some currencies, particularly the Mexican peso and the Brazilian real, swooned. The benchmark index declined such that it finished the fourth quarter with a loss of -4.08%, even as it rose 11.60% during the calendar year.
During this event, the Fund fared poorly. Heading into the election, I had no intention to embed any “political bet” within the portfolio’s construction. I never consciously invest on such premises: elections are too capricious, the immediate after-effects are short-lived and unpredictable, and the results rarely matter to the long-term fundamental success or failure of a given company. (Perhaps this election will prove different.) Yet in hindsight, I failed to recognize the portfolio’s holdings in Latin America (overweight positions in Brazil and Mexico) and its total lack of exposure to Russia (whose currency and stocks surged dramatically in the weeks after the election) constituted a serious political bet.
Frankly I am disappointed that I failed to perceive the risk posed by the election. I am also disappointed that markets reacted in the manner they did.
At the immediate moment, no one save the most senior members of the Trump administration know what lies in store for our country’s trade policies with foreign countries. Yet it is entirely rational that Mexico’s stocks and currency might collapse, speculatively, in the aftermath of the election: Mexico is incredibly dependent on the U.S. for both trade and cross-border finance. (As a brief aside: ironically, this characteristic is exactly what made the Mexican peso a darling for the many currency strategists who decried the “fragile five” three years ago. Those strategists cheered the peso without equivocation because of Mexico’s strong trade with the U.S., and the benefits flowing from geographical proximity. Now the peso is in tatters, easily as bad as any of the fragile five, and those same strategists are conveniently silent.)
By contrast, the reaction in Brazil was mystifying. Brazil’s economy has many shortcomings, including a paucity of international trade. The lack of trade is unambiguously detrimental to the economy’s growth potential, yet the irony of the moment is that Brazil has less to lose. Certainly, the country has some U.S. dollar-denominated borrowings; and perhaps refinancing those borrowings will become more difficult in the future. Yet Brazil’s net exposure to the dollar is not terribly large, as the nation is also sitting on substantial holdings of dollar reserves that can be used to repay its foreign currency debts. I am not a currency strategist, nor a macroeconomist, but Brazil’s reaction makes little sense to me. Yet the market delivered its verdict, and the Fund’s Brazilian holdings slumped.
None of the Fund’s holdings in the two countries are particularly dependent on international trade. The election result has shrunk the holdings’ capitalizations, but it has not as yet altered my intent to retain the positions.
The Fund’s performance across the year was stronger, though it lagged its benchmark by more than 2%. As discussed in the preceding portfolio review, if corporate earnings are accelerating from a cyclical low, the Fund’s absolute returns might improve, but its strategy will likely cause its relative returns to lag. Such conditions might exist now; see the Outlook section below.
During the course of the quarter, the Fund undertook several portfolio modifications. First, the Fund exited two long-standing holdings in Turkey: the common stock of Aselsan (a systems engineering company), and a smaller position in a Turkish sovereign bond. The Fund held shares in Aselsan for more than four years, during which time Seafarer observed the company transform from a military systems company highly dependent on one client – the Turkish army – to a diversified engineering firm, with some civilian and non-Turkish clients. The Fund exited the position largely on valuation grounds (the position generated gains despite the Turkish lira’s depreciation). The bond was exited predominantly due to heightened currency risks in Turkey.
Second, the Fund exited a very small position in Vietnam Reinsurance. The investment was successful for the Fund, but it was made at a time when the Fund’s asset base was smaller. Unfortunately, the position did not prove scalable. Thus, when the Fund’s assets under management grew, the holding in Vietnam Reinsurance shrank proportionately, and the positive impact on the Fund was muted. I sold the position because of its lack of scalability.
Third, the Fund accumulated two new holdings. The first is Delta Electronics, a Taiwan-based company that produces a wide range of technology products, from computer power supplies, to industrial fans, to automation systems for factory production lines. The second holding is Fuyao Glass, a producer of pane glass exclusively for autos. Fuyao is the leading supplier of such glass within China’s auto market, it has a global client base, it serves several high-end European automakers, and it recently opened a new factory in the U.S. to serve automakers in North America.
In the ensuing Outlook section, and in many preceding reports, I touch on the risks present in the Chinese economy. While I believe such risks are elevated, they are not manifest. In other words, there is a heightened risk of crisis, but it is not a foregone conclusion that one will occur. Until I detect that a crisis is imminent, I intend to remain invested in Chinese stocks, or even add them, as was the case with Fuyao. I am attempting to manage the resulting risk by constraining the aggregate exposure to Chinese stocks, and also by limiting the scale of any single investment in China, thereby lowering individual “position risk” in favor of enhanced diversification.
At this moment, investors harbor more doubt than ever about the relevance of the “emerging markets” as an asset class. I have discussed such doubts before, notably in the Letter to Shareholders for the period ended October 31, 2015. Yet given the sub-par performance of the emerging markets during the past five years, and especially given changing political sentiment in the U.S. and abroad, concerns about the asset class have intensified.
Bearing such doubts in mind, yet also looking forward, I believe investors should consider six critical aspects of the asset class: two structural, long-term merits; two cyclical, short-term factors; and two imminent risks.
Structural, Long-term Merits
The two structural, long-term merits are:
- Now the emerging markets can, for perhaps the first time, serve as an important diversification tool in growth-oriented investors’ portfolios, and
- The asset class could act as a meaningful hedge against the U.S. dollar.
Regarding the first point: during the past three decades, the economies of the developing world have grown in part due to the expansion of global trade. However, over the past five years, trade has stagnated. The current political cycle may exacerbate that downturn. The developing world can no longer assume that trade will bolster growth.
At the same time, many developing countries have already begun to transition their economies away from extensive reliance on exports. In order to advance their own development, and also to make their economies less dependent on external trade, such countries are placing greater emphasis on developing “domestic consumption.” Their aim is to stimulate households, small and medium-sized businesses, and large companies to consume and invest more within their domestic economies. If the intended transition is successful, it will necessarily mean that emerging economies become more domestic in nature, with an emphasis on the development of service sectors.
As such sectors grow and mature, they will present a different sort of investment opportunity than in the past. For much of the past three decades, investing in the emerging markets meant a near-exclusive focus on export-led industries. Those industries were dominated by global business cycles, and it meant that such companies’ financial performance – and stocks – were usually correlated with global markets.
By contrast, the future of the developing world will probably involve a greater degree of “decoupling.” The deliberate shift toward domestic consumption – especially the development of larger service sectors such as health care, media, insurance, software, and technology services – will likely make the emerging markets less susceptible to global business cycles. Further, as service sectors typically involve substantial regulation and local customization, typically they are the domain of local companies, and not that of large, multinational companies. For these reasons, I suspect that such sectors have the potential to provide a unique and less correlated source of growth to a global investor’s portfolio.
Regarding the second merit: a high-quality collection of income-producing emerging market securities could act as a meaningful hedge against U.S.-dollar currency risk.
Over the past five years, the U.S. dollar has appreciated substantially relative to nearly all other currencies and commodities around the world. To an extent that I imagine is difficult for most U.S.-based investors to perceive, the dollar’s strength has been instrumental to the recent out-performance of U.S. stock and bond markets. Whether the dollar’s strength has caused this performance, or whether it is merely correlated with it, is a complex and unanswerable question. Whatever the case, the link is unequivocal.
I know better than to make predictions about the future of emerging market currencies and the dollar. However, I would have investors note that prevailing narratives about what the dollar will or will not do have proven false at several critical junctures in the past five years. Most recently: since the U.S. began hiking interest rates in December of 2015, and through the date of this report, the dollar has weakened roughly 5% against a representative basket of emerging market currencies.5 For the past two years, the vast majority of pundits and strategists have confidently predicted the opposite: that emerging market currencies would continue – or even accelerate – their decline as the U.S. Federal Reserve (the “Fed”) raised rates. Thus far, they are wrong.
Personally, I have no inclination to predict what the dollar will do next. Yet I think cautious investors should consider placing at least a small portion of their portfolios in non-dollar denominated assets as a hedge against the dollar. In my own opinion, a basket of high-quality, income-producing securities from the emerging markets (dividend-paying stocks or coupon-paying bonds, or a combination thereof) could serve that purpose.
Cyclical, Short-term Factors
I also believe that investors should consider two shorter-term, cyclical factors within the emerging market asset class. Those opportunities are:
- Earnings growth in the developing world appears to be re-accelerating, and
- At the same time, valuations for emerging markets stocks are, in aggregate, at least one-fifth lower than those of U.S. stocks.
Regarding earnings growth: as discussed at length in the Growth and Income Fund’s third quarter 2016 portfolio review, 2016 represents the first year in five that corporate profits grew at a healthy rate. The preceding years were anemic, with little or no growth. The books are not closed on 2016 yet, but in aggregate, it appears that profits in the emerging markets will expand 8.5% (as measured in local currency terms).6 2016 is also the first year in five that profits met “consensus” expectations. Consensus called for 8.1% growth – and at this time, it appears to have been met, unlike the preceding five years of disappointment.6 This recovery is nascent, and thus I cannot gauge whether it will continue. Nonetheless, 2016 appears to have been the best year for the “fundamentals” in quite some time.
Regarding valuation: emerging market stocks are, in aggregate, at least one-fifth cheaper than stocks in the U.S. No single measure of aggregate valuation is perfect or comprehensive, but I believe these basic comparisons are illustrative: according to JP Morgan, emerging market stocks are priced at 13.4 times price-to-earnings for 2016, versus 19.6 for the U.S. (32% cheaper); 1.5 times price-to-book-value, versus 2.7 for the U.S. (44% cheaper); and they offer a 2.6% dividend yield versus 2.1% for the U.S. (19% cheaper).6
Taking these two shorter-term, cyclical factors together: it is notable that profits appear to be accelerating at a time when equities in the emerging markets are priced at a meaningful discount to U.S. stocks.
Unfortunately, the outlook for the developing world is not so simple. At present, there are two critical risks that hang over the markets – the prospect that:
- Currency-related risks worsen, and
- China may face some sort of economic shock because of poor and deteriorating liquidity conditions within its financial markets.
Regarding currency risk: I think day-to-day volatility for emerging market currencies will only rise versus the dollar. At the same time, I believe that the prospect of a currency crisis or shock (i.e., a sudden, surprise depreciation of 20% or more) is declining for nearly every country save China (more on China below).
For some time now, I have been convinced that the monetary and currency policies of the developing world have largely decoupled from the Fed. In the past, there was a great coupling: most developing countries pegged their currencies to the dollar at a fixed rate. Stable exchange rates meant that certain countries could borrow dollars cheaply from abroad – this seemed like a good deal, versus borrowing at higher rates in the home currency (it was not). It meant incurring a substantial mismatch between operating cash flows, denominated in the local currency, and debts, which were denominated in dollars. After the dollar debts piled up, propagated by an artificial sense of currency stability, central banks were obliged to maintain their pegs at nearly any cost, or face waves of debt defaults across their economies. This in turn forced the central banks to “follow the Fed” as it raised or lowered rates.
Much has now changed. Most developing nations now manage some sort of floating currency versus the dollar (save China). While many nations continue to incur dollar-denominated debts, their dependency on the dollar is much lower than it was two decades ago due to the maturation of their native currency bond markets. I believe such changes afford central banks in the developing world more freedom to set monetary policy (i.e. interest rates) based on domestic considerations, rather than a desperate need to maintain pegs – and they seem to be reveling in their freedom. By my count, only three of fourteen major central banks have increased rates in the past year, even as the Fed has increased rates twice.
I think the combination of floating currencies and reduced risk of dollar defaults lowers the risk of a sudden currency crisis (save China). As central banks also enjoy greater latitude to set rates based on domestic considerations rather than the Fed’s actions, this implies greater impunity regarding routine fluctuations of currencies versus the dollar. So while the risk of absolute crisis has receded (save China), investors must prepare for more “garden variety” volatility – small to moderate swings day-to-day, month-to-month.
Regarding China: I have commented a great deal about the deteriorating liquidity conditions in China in preceding communications (for example, see Seafarer’s Changes to Chinese Currency Policy – Update video), so I will not reiterate my arguments here. Suffice to say that I see additional evidence that liquidity conditions have worsened. Capital outflows and China’s multi-faceted efforts to restrict the capital account both suggest liquidity is strained. I do not know if China will face some sort of economic disruption soon, or ever; but I suggest that investors watch conditions there very carefully. China may yet manage its way out of the current predicament without a problem. If conditions escalate, China might attempt to avert crisis by closing the capital account outright; alternatively, it might seek to alleviate conditions by de-pegging from the dollar, and by re-fixing the yuan to a basket of commodities (e.g., gold or oil).
Thank you for your patience and your trust in us. We are honored to serve as your investment adviser in the emerging markets.Andrew Foster Seafarer Capital Partners, LLC
- The performance data quoted represents past performance and does not guarantee future results. Future returns may be lower or higher. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than the original cost. View the Fund’s most recent month-end performance.
- The MSCI Emerging Markets Total Return Index, Standard (Large+Mid Cap) Core, Gross (dividends reinvested), USD is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. Index code: GDUEEGF. It is not possible to invest directly in this or any index.
- The S&P 500 Total Return Index is a stock market index based on the market capitalizations of 500 large companies with common stock listed on the NYSE or NASDAQ. It is not possible to invest directly in this or any index.
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- As of December 31, 2016, Delta Electronics, Inc. comprised 2.9% of the Seafarer Overseas Growth and Income Fund, and Fuyao Glass Industry Group Co., Ltd. comprised 0.8% of the Fund. The Fund had no economic interest in Aselsan Elektronik Sanayi Ve Ticaret AS, Turkey Government Bond 8.8% 9/27/23 TRY, or Vietnam National Reinsurance Corp. View the Fund’s Top 10 Holdings. Holdings are subject to change.
- References to the “Fund” pertain to the Fund’s Institutional share class (ticker: SIGIX). The Investor share class (ticker: SFGIX) declined -6.46% during the quarter.
- The Fund’s inception date is February 15, 2012.
- The Fund’s Investor share class began the quarter with a net asset value of $12.00 per share; it paid a semi-annual distribution of approximately $0.104 per share during the quarter; and it finished the quarter with a value of $11.12 per share.
- The Fund’s Investor share class returned 9.28% during the calendar year.
- Source: MSCI Emerging Markets Currency Index (Bloomberg ticker code: MXEF0XC0).
- Source: J.P. Morgan, “Emerging Market Strategy Dashboard,” 2 January 2017.