During the first quarter of 2016, the Seafarer Overseas Growth and Income Fund gained 8.58%.1 The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, rose 5.75%. By way of broader comparison, the S&P 500 Index gained 1.35%.
The Fund began the quarter with a net asset value of $10.37 per share. The Fund paid no distributions during the quarter, and it finished the period with a value of $11.26 per share.2
During the first quarter, stocks in the emerging markets once again exhibited pronounced volatility, following a sharp “V-shaped” pattern.
Equities began the year by falling immediately and sharply in January. Chinese stocks led the plunge. At the time, pundits speculated that China’s markets were collapsing due to accumulated fears over the country’s currency. The popular view was that the renminbi was unstable, and would potentially come unglued; it was suggested that this instability was somehow instigating losses among Chinese equities. That explanation was widespread, but lacked merit. The renminbi was nowhere near as unstable as the pundits then suggested, and the fluctuations that it did exhibit did not provide a satisfactory explanation for the substantial decline in stocks. Simply put, this was not a case where the tail was wagging the dog.
In my portfolio review for the fourth quarter 2015, I discussed two possible causes for the swoon in Chinese stocks. First, I suggested that the behaviors of China’s currency and stocks were consistent with deteriorating domestic liquidity conditions. I suggested that the behaviors of both might herald future distress within China’s financial sector. Second, I suggested that perceptions of instability and schisms within the senior leadership of the Chinese government might have destabilized markets. The two alternatives remain speculation for the time being. However, as events unfold, I believe both scenarios hold a degree of truth.
By the third week of January, China’s slump overwhelmed the emerging markets. The Fund declined -9.7%, whereas the benchmark index fell -13.3%. However, that moment proved to be the near-term nadir, as stocks rose sharply from that point until the end of the quarter, led by the Brazilian market.
In mid January, a long-developing graft scandal in Brazil came to a head. Leaders of the country, including the country’s former President Lula da Silva, were implicated directly in the scandal. Lula’s implication was particularly stunning, as most observers believed that his political status would render him “untouchable.” As the investigation proceeded apace, it eventually culminated in an impeachment vote by the lower house of the Brazilian government. Brazilian stocks and the currency moved swiftly higher in response, on the speculative hope that a new government might arrest the country’s economic decline. The benchmark index rallied sharply in response, finishing the quarter in positive territory, as Brazil and most other emerging markets – including China – climbed from the lows of January.
The Fund’s outperformance within the period was driven primarily by its substantial exposure to Brazilian stocks. For the past two years, the Fund sustained a meaningful allocation to the country, despite the market’s very weak performance, particularly as measured in dollars. The Fund’s goal was to accumulate shares of profitable companies, capable of generating reasonable profits and dividends even amid the country’s economic crisis. My idea was that such companies would likely survive the current mess; and if they did, our analysis suggested they might once again expand their profits and resume growth. Accordingly, the Fund’s allocation was predicated on the idea that an eventual recovery in profits and growth would allow the companies’ shares to recover a substantial portion of their lost value, particularly when measured in dollars.
This Fund’s persistent holdings in Brazilian stocks amid the country’s decline meant the Fund began 2016 with an outsized allocation to the country as a whole. In aggregate, that allocation was not intended to function as a means to speculate on the country’s politics, but rather to take advantage of the basic cheapness prevalent in the market amid the nation’s chaos. While I could not (and cannot) prove that Brazil would turn itself around anytime soon, I was nonetheless confident that the capitalization of companies in the Fund reflected little hope of progress. Accordingly, I was drawn to companies that could survive the current malaise, but whose capitalizations might recover if events improved beyond the market’s dire view.
In a basic sense, that is what happened during the quarter: Brazilian stocks reacted swiftly and positively to the mere idea that the country’s economic distress might diminish. The market’s sharp recovery seemed to confirm the basic cheapness that I thought was present in the market.
However, the political events that spurred the market’s recovery were unpredictable and haphazard. No economic recovery has taken place, as I had speculated might eventually occur. All evidence suggests that Brazil’s output continues to shrink. The Fund’s allocation to Brazil was no accident, but the timing and the magnitude of the resultant gains (and therefore the Fund’s outperformance during the quarter) were the product of luck.
Given that the Fund’s recent returns were due to chance, I thought it prudent to reduce the portfolio’s allocation to Brazil, thereby booking a portion of those fortunate gains permanently. I did so to avoid a portfolio construction in which a large and growing portion of the assets were “held hostage” to the vacillating sentiment associated with Brazilian politics. Also, some of the basic cheapness that motivated the initial investment was diminished. Accordingly, the Fund’s large allocation Brazil (well over 15% after the market’s surge) was trimmed at the margin, in late March and early April. The proceeds were distributed broadly throughout the remainder of the portfolio.
Apart from this shift away from Brazil, the Fund also undertook a number of small changes during the quarter.
First, the Fund added two corporate bonds. The first bond was issued by America Movil, the Mexican telecommunications company, in pesos. This new bond is similar in duration and quality to another Movil bond, already held by the Fund (see comments from the portfolio review from the third quarter 2015). Cielo, a Brazilian payments processing firm, issued the second bond. Cielo is one of the dominant transaction processing firms in Brazil. In late 2012, Cielo issued bonds totaling $875 million to fund an acquisition of an American financial technology firm based in Silicon Valley. In my view, the merits of that transaction are in doubt; however, our research suggests that transaction should not prevent Cielo from servicing its dollar-based obligations effectively – despite the economic crisis in Brazil, and despite the recent downgrade of Brazil’s sovereign debt.
Next, the Fund deleted a small position in Iochpe-Maxion, a Brazilian auto parts manufacturer. In my view, Iochpe remains a well-run company with impressive market share for its products in the global auto industry. Iochpe’s global breadth was established only recently, unfortunately via debt-financed acquisition. I believe that Iochpe may struggle to service such debts. The risk of financial strain has weighed on the company’s shares from time to time. While such risk was always evident, it allowed the Fund to accumulate shares in the company at prices I believed advantageous. However, in light of volatile financial conditions within Brazil, I grew concerned that Iochpe’s debts would ultimately prove difficult to service or refinance, and thus the Fund exited the shares out of caution.
Lastly, the Fund initiated a holding in the shares of a small engineering company domiciled in India. As the Fund continues to accumulate its initial position at this juncture, I will decline to discuss it further in this review. I may re-introduce it in a future commentary.
From my perspective, there are two competing tensions within the emerging markets, each of which is vying to shape the investment outlook for the next 12 to 24 months. The first tension is that economic conditions generally favor lower interest rates, and the resulting cuts might stimulate growth. The second tension is that regardless of whether rates are headed lower, growth is very sluggish at present, so much so that monetary stimulus might prove useless.
Regarding the first point: in previous commentaries, I have suggested that there was some evidence that the monetary policies of the emerging markets were diverging from that of the U.S. Federal Reserve (the “Fed”). This is a big deal. Throughout my career, the Fed’s interest rate decisions have dictated the course of action for most central banks in the developing world. This has meant that the emerging markets were obliged to adopt U.S. monetary policy (tighter or looser, higher or lower rates) regardless of whether such policy suited domestic interests. However, in my view, the evidence is now conclusive that the historic link is broken. Most central banks in the developing world are now cutting rates, or keeping them stable, even as the Fed has embarked on a course to raise rates. This constitutes a form of decoupling, in my view.
The central banks of the emerging markets are decoupling because inflation is tepid or below target, and growth is weak. It does not make much sense for the developing world to raise rates as growth decelerates, even as it was sometimes forced to do so in the past. This time, it appears monetary policy is poised to ease, counter-cyclically, to offset anemic growth conditions.
While the rationale for the decoupling might be clear, the reasons why it is possible now, and not before, are complicated. In my view, the situation can be summarized in the fact that the developing world is far less indebted in dollars than it once was (measured in proportional terms, not absolute). The developing world continues to borrow a great deal from the developed world; but the vast majority of that debt is now denominated in local currencies – not dollars, euro or yen. As the proportion of dollar debt has grown small, the central banks of the developing world are no longer obligated to defend their currency’s values against the dollar the way they once were. They are correspondingly free to select a monetary policy suited to their domestic interests, rather than reflexively “following the Fed.” Ultimately, the newfound independence of the central banks is a form of decoupling that constitutes an important hallmark (but not a sufficient condition) of financial independence and development.
Normally, when inflation is low and growth is weak, I would suggest that cutting rates is probably a decent course of action to stimulate nominal growth (naturally, one can have a long debate about the merits and practices associated with modern monetary policy). However, even as I would generally be in favor of such policy, I am concerned it might not work well in the current environment. The reason is that growth is exceptionally sluggish.
I have long understood that the developing world was traversing an economic cycle, one that is now mired in low growth. I have been bracing for the financial results from the current quarter under the assumption that corporate profits would reflect difficult conditions. Indeed, I had hoped that late 2015 or early 2016 might be the nadir of the cycle, particularly given that central banks were acting (albeit modestly) to stimulate nominal growth. Unfortunately, my reading of the results for the fourth quarter of 2015 and the first quarter of 2016 is not encouraging.
Even as I braced for weak financial performance, the results have been even worse (with some notable exceptions). Some of the companies in the Fund, and many more that I follow otherwise, are reporting results that range from poor to awful. I had hoped to see some indication that the monetary stimulus was counteracting the weak economic environment, but no signs are present as yet. I am therefore concerned that the developing world has not yet passed through the nadir of the current cycle. I still hope that the aforementioned monetary stimulus might prompt a recovery – it is certainly possible. Yet I would admit that ordinary stimulus might not be sufficient this time around. Central banks may be prompted to adopt aggressive or unorthodox methods. I would not cheer if they did so. Among many other consequences, I imagine such methods would have negative ramifications for the stability of financial markets, particularly emerging currencies. This threat is one that I will watch carefully on behalf of the Fund, and I urge shareholders to do the same.
Thank you for entrusting us with your capital. We are honored to serve as your investment adviser in the developing world.Andrew Foster,
- 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 March 31, 2016, America Movil SAB Corporate Bond 6.45% 12/05/22 MXN comprised 0.5% of the Seafarer Overseas Growth and Income Fund, America Movil SAB Corporate Bond 7.125% 12/09/24 MXN comprised 0.8% of the Fund, and Cielo Corporate Bond 3.75% 11/16/22 USD comprised 0.7% of the Fund. The Fund had no economic interest in Iochpe-Maxion SA. 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) gained 8.50% during the quarter.
- The Fund’s Investor share class began the quarter with a net asset value of $10.35 per share. It paid no distributions during the quarter, and finished the quarter with a value of $11.23 per share.