Review and Outlook
Emerging market equities declined significantly in the third quarter in response to diminishing growth prospects, widening credit spreads, and a broad increase in risk premium. In our view, a key catalyst was a volatile progression of policy moves in China; first a failed attempt to stabilize the local A Share equity markets, and subsequently a modest, but meaningful, devaluation of the RMB. Such measures resulted in rising uncertainty over economic and financial stability and political leadership in China, an undisputed driver of global investment and growth over the past decade. The other major catalyst of market activity was the shifting anticipation over a rate hike by the U.S. Federal Reserve. Although expectations of such an event have been pushed out for now, a significant tightening of conditions has been priced into the high-yield and EM sovereign bond markets. While we believe we have progressed into late stages of the EM absolute and relative bear market, we note that such tightening conditions have increased the likelihood of a related credit event, which in our view could mark the “ninth inning” and perhaps set up a solid reversal.
What is the way forward from here? To answer we must first analyze the root cause. We believe the strong headwinds emerging markets face today stem largely from aggressive quantitative easing by developed world central banks in recent years. After the 2008 financial crisis, U.S. QE led to a decline in global interest rates and expectations for sustained dollar weakness. As leverage rose in the emerging markets, the U.S. economy slowly healed, and the Fed passed the monetary baton to Japan and the ECB. This easing in Japan and Europe in the context of Fed tapering represented a tightening for most EM countries, particularly China, whose competitive position is directly impacted as the RMB remains largely pegged to the dollar. Many other EM countries have commodity sensitive revenue streams and currencies and/or had previously aggressively borrowed in dollars, and as such, local currency and commodity weakness also represents a tightening of conditions. We were not entirely surprised by China’s depreciation of the RMB; we see no reason to expect China to unilaterally absorb the deflationary pressure resulting from a rising dollar as their neighbors devalue.
We see three possible scenarios for emerging markets in the near term. First, the global economic indicators could sustainably improve of their own accord in response to months of developed world easing in the pipeline. We suggest this is possible but unlikely. Second, China could engage in aggressive stimulus and/or devalue materially – also possible but unlikely given recent official statements. Third, the Fed could indefinitely defer rate hikes and perhaps even signal possible further easing, an outcome we would tend to expect if the market-based tightening referenced above were to result in a credit event. We believe any of the above could create an important bottom in global markets, and would likely trigger a reversal in the relative performance of hard hit asset classes such as EM and commodities.
Top Contributors/Detractors to Performance
Quarterly Attribution Analysis
When reviewing performance attribution on our portfolio, please be aware that we construct the portfolio from the bottom up, one stock at a time. Each stock is included in the portfolio if it meets our rigorous investment criteria. To help manage risk, we are aware of our sector and security weights, but we do not include a holding to achieve a target sector allocation or to approximate an index. Our exposure to any given sector is purely a result of our stock selection process.
Baron Emerging Markets Fund declined 14.26% in the third quarter, yet outperformed the MSCI EM IMI Growth Index by 241 basis points, mainly due to stock selection and its average cash exposure of 10.4% in a down market.
During the quarter, emerging market equities declined significantly in response to diminishing growth prospects. Excluding Hungary, all emerging market countries in the benchmark registered declines ranging from -1.74% (Czech Republic) to -27.42% (Brazil). Outperformance of the Fund’s Indian investments and meaningfully larger exposure to this country, which outpaced the broader index by 11.2% in the quarter, added the most value. Investments in Mexico, Korea, the Philippines, and Taiwan, while down for the quarter, also outperformed their counterparts in the index. These positive relative results were somewhat offset by the sharp decline of the Fund’s only U.S. holding, TerraForm Global, Inc., a renewable energy company focused on emerging markets. Underperformance of investments in Brazil and China also weighed on relative results.
On a sector basis, the Fund’s Consumer Discretionary, Health Care, and Consumer Staples investments were the largest contributors to relative results. Within Consumer Discretionary, outperformance of the Fund’s Indian media holdings, led by PVR Ltd., Dish TV India Ltd., Zee Entertainment Enterprises Ltd., and Sun TV Network Ltd., added value. Further, within this sector, investments in sophisticated textile manufacturers, including Makalot Industrial Co., Ltd. and Eclat Textile Co., Ltd. of Taiwan and Shenzhou International Group Holdings Ltd. of China, also noticeably contributed to relative performance. Strength in Health Care was mostly attributable to outperformance of the Fund’s Indian pharmaceuticals holdings, comprised of Torrent Pharmaceuticals Ltd., Divi’s Laboratories Ltd., Lupin Ltd. and Glenmark Pharmaceuticals Ltd. Larger exposure to the better performing pharmaceuticals sub-industry and outperformance of Chinese holding Wuxi PharmaTech (Cayman) Inc. also aided relative performance. The Fund’s Consumer Staples holdings declined in the quarter, yet outperformed their index counterparts by 840 basis points, helped by gains from Grupo Lala, S.A.B. de C.V. and Fomento Económico Mexicano, S.A.B. de C.V. of Mexico. These and other consumer-oriented stocks in Mexico benefited from lower input costs along with improving consumer spend during the quarter.
Underperformance of the Fund’s Information Technology (IT) investments detracted the most from relative results. Weakness in the sector was largely due to underperformance of several holdings in the hard hit markets of China and Brazil, led by Kingdee International Software Group Co. Ltd. and TOTVS SA.
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