Review and Outlook
The first quarter or 2016 witnessed a sharp selloff and recovery across the emerging and global capital markets. We believe this market behavior reflects the fragility of confidence in forward-looking economic and financial conditions in an era of increasing policy intervention. The global markets have exhibited a high correlation, often reacting in unison to events in the U.S., Europe, Japan, and particularly China. We believe the interconnectedness of global markets is likely to remain high while global growth remains subpar and stimulative policy intervention in one jurisdiction often triggers unintended consequences in another.
While we were pleased to see the equity, credit and commodities markets strengthen through the end of the first quarter, we would prefer to see convincing evidence of underlying fundamental strength and an improvement in global imbalances rather than what appears to be ongoing aggressive monetary and fiscal policy tweaks. In our opinion, the most important such tweak was the shift in rhetoric suggesting the deferral of interest rate hikes by the U.S. Federal Reserve. The good news here is that if the Fed can deliver on recent communications, we are likely seeing a re-synchronization of global monetary policy, which would significantly reduce the short-term pressure on the Chinese currency, commodity prices, and the emerging markets. Indeed, the commodity and emerging markets took a leadership role in the rally which began in mid-February. In addition to the revised Fed communique, the European Central Bank, Bank of Japan and People’s Bank of China, as well as Chinese fiscal policymakers, all appeared to accelerate easing measures during the quarter. While measures of coincident and leading economic indicators have recently responded in kind with fairly broad-based improvement, it is difficult to distinguish cause and effect. Are improving economic indicators driving the rally in capital and commodities markets, or are policy-driven markets leading to improved economic indicators via the channels of rising confidence and recovering financial conditions? We believe that fundamental, lasting confidence in the global economy and global and emerging markets would be inspired by a successful normalization of interest rates, while confidence driven by ever more unconventional measures, such as the recently launched negative interest rate policies in Europe and Japan, will likely remain fragile.
We reiterate the view expressed last quarter that we are likely in the late stages of a relative and absolute bear market in the emerging markets, where much damage and currency adjustment has already occurred. We believe recent emerging market leadership confirms our view that a bottoming process is underway, and while we would not be surprised by a return of volatility later this year, we would likely view such an event as an opportunity to increase our exposure to high quality growth businesses in industries and countries where risk premium has been high and investor sentiment weak. We sense substantial investment opportunities ahead, and believe we are strategically and tactically prepared to take advantage.
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 rose 0.85% in the first quarter, yet underperformed the MSCI EM IMI Growth Index by 212 basis points, mostly due to a combination of sector stock selection and relative country weights.
On a country basis, outperformance of investments in China, Korea, South Africa, and Panama and lower exposure to lagging Korean equities added the most value. These positive relative results were overshadowed by underperformance of investments in Taiwan, India, and the U.S. Larger exposure to lagging Indian equities, which fell 5.3% in the quarter, lack of exposure to outperforming Turkish and Malaysian equities, and lower exposure to strong performing Taiwanese equities also hurt relative results.
On a sector basis, outperformance of Financials and Industrials investments contributed the most to relative results. Strength in Financials was mainly due to the outperformance of Brazilian financial exchange operators BM&FBOVESPA SA and Cetip SA - Mercados Organizados. BM&FBOVESPA’s bid to acquire Cetip, which would create a unified financial clearinghouse for the Brazilian capital markets, drove shares of both companies sharply higher. Metro Pacific Investments Corp. of the Philippines and Bangkok Bank Public Co. Ltd. of Thailand also aided relative performance. Within Industrials, outperformance of Latin American airline Copa Holdings, S.A. and South African holding company Bidvest Group Ltd. added the most value. Declining airline capacity in Latin America, lower fuel prices, and more stable ticket pricing helped drive up shares of Copa, while shares of Bidvest increased on solid earnings results and announced plans to spin off its international foods business.
Health Care, Consumer Discretionary, and Utilities investments were the largest detractors from relative performance. Within Health Care, underperformance of Ginko International Co., Ltd. of Taiwan and Divi's Laboratories Ltd. of India detracted the most from relative results. Ginko was the third largest detractor on an absolute basis, while Divi's shares fell due to below-consensus earnings performance. Pharmaceutical holdings also weighed on relative performance, falling 10.7%, with Sihuan Pharmaceutical Holdings Group Ltd. of China and Lupin Ltd. of India leading the decline. Weakness in Consumer Discretionary was partly attributable to the underperformance of Indian cable & satellite and broadcasting holdings, whose share prices were pressured by delays in the implementation of Phase III cable TV digitization in India. Underperformance of apparel, accessories & luxury goods holdings Makalot Industrial Co., Ltd. of Taiwan and Shenzhou International Group Holdings Ltd. of China and larger exposure to this lagging sub-industry also hampered relative results. Within Utilities, underperformance of TerraForm Global, Inc., a U.S.-based renewable energy company focused on emerging markets, detracted the most from relative performance. TerraForm Global was the second largest detractor from absolute performance.
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