Three Extraordinary Years in Emerging Markets. Part 3
Portfolio manager John Paul Lech explores the defining changes of the last three years. Here he explains how he is navigating the new era of rising interest rates and financial tightening.Subscribe
- The exuberance of the pandemic rally favored companies that lacked profitability, cash flow or a pathway to it. Liquidity can keep things going but it doesn’t generate a self-sustaining business model.
- The war in Ukraine altered the dialogue around energy and indelibly changed the risk profile of companies whose states are known for pursuing kinetic action. These changes are likely to be long lasting.
- Interest rates don’t matter until they do. As rates rise, companies with high leverage have to roll over or replace existing debt with higher yielding instruments, challenging margins.
On April 30, 2020, we launched the Matthews Emerging Markets Equity Fund (MEGMX). The ensuing three years saw more changes in emerging markets than the whole of the previous decade. It tested our approach and our processes. I’d like to reflect on those changes and on the market environments that dominated, how our process guided us through and on the lessons we’ve learned.
Three distinct narratives unfolded that, in our view, impacted—and in some cases upended—many approaches to investing in emerging markets and equities generally. At the outset there was COVID-19, the first pandemic in 100 years; second was the war in Ukraine, the biggest ground conflict in Europe since World War II; and third was the rise in interest rates after almost two decades of close-to-zero borrowing costs. The types of companies that succeeded or collapsed during each of these narratives were very different.
Rising interest rates: financial leverage and ballast
Rates don’t matter until they do. Our thought process as the Federal Reserve entered a tightening phase was in line with that of many market participants. Higher interest rates make the prospect of future cash flows less appealing than those that can be realized in the short term. Profitless companies seemed likely to suffer and high multiples seemed likely to contract. Companies that lacked growth and just distributed earnings—often called bond proxies—also seemed vulnerable as their income streams would compete with ever higher-yielding fixed income options.
“We proactively positioned in a few companies that meet our investment criteria and which will benefit from a topping out or even a decline in interest rates.”
Our investment framework tends to lead us to companies with low levels of financial leverage. Companies with high leverage need to roll over or replace existing debt with higher yielding instruments, challenging margins. We also proactively positioned in a few companies that meet our investment criteria and which will benefit from a topping out—or even a decline—in interest rates.
What we didn’t see coming was the collapse of Silicon Valley Bank which, in retrospect, is easy to understand as a simple case of asset/liability mismatch. Most emerging markets banks have high levels of capital, lack currency mismatches and, in the case of the ones we own, have broad and diverse deposit franchises.
Higher interest rates have changed the composition of the portfolio but we’ve avoided making moves that will wrap the portfolio too tightly to one outcome. Consequently, we have holdings that won’t fall apart with higher rates but aren’t nurtured by them either. This ballast and diversity should serve us well when the global tightening cycle peaks.
The surest way to generate positive returns is to make bold predictions that turn out to be correct. But often the best-performing fund in a particular market is tightly wound around a factor and history teaches us that markets are full of surprises. Guessing the big picture of what’s next rarely works over the long term.
Our approach is to focus on great companies. We seek diversity in what will work, with the commonality that great companies tend to survive and thrive in the long term. Our aim is to perform through a variety of market environments and doing so requires tempering a desire to predict what’s next and then fitting the portfolio to that narrative. We try to provide resilience from holding a diverse set of underlying companies and we will bring to the next three years what we have learned over the last three extraordinary years.
John Paul Lech
You should carefully consider the investment objectives, risks, charges and expenses of the Matthews Asia Funds before making an investment decision. A prospectus or summary prospectus with this and other information about the Funds may be obtained by visiting matthewsasia.com. Please read the prospectus carefully before investing as it explains the risks associated with investing in international and emerging markets.
The value of an investment in the Fund can go down as well as up and possible loss of principal is a risk of investing. Investments in international, emerging and frontier markets involve risks such as economic, social and political instability, market illiquidity, currency fluctuations, high levels of volatility, and limited regulation. Additionally, investing in emerging and frontier securities involves greater risks than investing in securities of developed markets, as issuers in these countries generally disclose less financial and other information publicly or restrict access to certain information from review by non-domestic authorities. Emerging and frontier markets tend to have less stringent and less uniform accounting, auditing and financial reporting standards, limited regulatory or governmental oversight, and limited investor protection or rights to take action against issuers, resulting in potential material risks to investors. Investing in small- and mid-size companies is more risky than investing in larger companies as they may be more volatile and less liquid than large companies. In addition, single-country and sector funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific industry, sector or geographic location. Pandemics and other public health emergencies can result in market volatility and disruption.