In the time since Russia directly attacked Ukraine on February 24, the war has escalated and Western powers have responded with aid to Ukraine and sanctions against Russia. The human cost of war is obvious and heartbreaking. Nevertheless, at Wasatch Global Investors, we need to focus on the economic and market consequences for clients and shareholders.
To begin, it’s important to note that even before war broke out, the main emerging markets indexes had very small weights in Russia. For example, as of December 31, 2021, Russia represented under 4% of the MSCI Emerging Markets Index and a mere 1% of the MSCI Emerging Markets Small Cap Index.
More recently, MSCI has announced plans to remove Russia from these indexes—and Russian stocks have mostly been halted from trading on major exchanges. As a result, many institutions—including Wasatch—now consider Russia to be “uninvestable” for the time being.
- Even before war broke out, Russia was a small component of the MSCI Emerging Markets and Emerging Markets Small Cap indexes. MSCI has since announced plans to remove Russian stocks from these indexes, and Russia has become “uninvestable” for the time being.
- The war may exacerbate inflationary pressures. Russia is a large exporter of natural gas, oil and coal. Russia and Ukraine also supply raw materials vital to semiconductor manufacturing.
- Nations heavily dependent on energy imports saw their stocks hit particularly hard. This affected Indian equities, which are a large percentage of the Wasatch Emerging Markets strategies.
- India is in a much better position to withstand rising commodity prices than the last time oil exceeded $100 per barrel. The Indian companies we own have been posting solid earnings, have enviable market positions and have been experiencing strong momentum in their businesses.
- Our holdings in Mexico, Brazil and South Africa provide diversification to the commodity–related vulnerabilities of our Indian names.
- Despite volatility in the equities of our Taiwanese semiconductor companies, we think diversified procurement and stockpiling of materials may limit disruptions in chip manufacturing.
- We’ve thoroughly reviewed our holdings across the firm to look for relevant changes in underlying fundamentals. We want to ensure—to the extent possible—that our analysis correctly includes all relevant risk factors.
RUSSIAN EQUITIES AND RISK ASSESSMENT AT WASATCH
When we invest in any company, we must consider the operating environment in addition to business–specific fundamentals. If we perceive the environment to carry greater risk, we want to see more potential upside in our holdings. Wasatch held two Russian companies at the time of the attack on Ukraine. Unfortunately, the repercussions of the attack overwhelmed what we had believed to be strong business fundamentals. Stocks in Russia fell sharply after Western sanctions on the country’s central bank impacted Russia’s entire financial system.
Trading on the Moscow Exchange was suspended after President Putin announced the military operation against Ukraine. While our two Russian companies were listed in the U.S. and London, within the week, trading of Russian ADRs (American depositary receipts) was halted and trading of Russian GDRs (global depositary receipts) was suspended before we could fully divest our shares. We currently hold small positions in the two Russian companies, and Wasatch’s Pricing Committee will be fair valuing the securities in accordance with the Wasatch Pricing Policy until trading resumes.
EMERGING MARKETS IN THE AFTERMATH OF RUSSIAN AGGRESSION AND RISING COMMODITY PRICES
At the present time, the Wasatch Emerging Markets strategies have de minimis direct exposure to Russia. However, we must still consider how the war has changed the economic and market environment by exacerbating commodity inflation in a world still grappling with the effects of the Covid–19 pandemic. Prices have been rising as Russia is the globe’s biggest exporter of natural gas, wheat and fertilizer and the third–largest exporter of crude oil and coal.
Russia and Ukraine together account for more than a quarter of world–wide trade in wheat and one–fifth of corn sales. These countries also supply key raw materials such as neon and palladium, both of which are vital to semiconductor–chip manufacturing—an industry already dealing with backlogs due to strong global demand.
Nations heavily dependent on imports of energy have seen their stocks hit particularly hard—with India, for example, showing especially disappointing performance recently. India is the world’s third–largest consumer of oil, 85% of which is purchased on the global market.
THOUGHTS REGARDING INDIA
India is the biggest country weight in our Emerging Markets strategies. On the ground, we’ve been hearing from the management teams of our Indian companies that business conditions have been especially strong.
Still, we’re keeping an eye on overall economic growth and inflation. According to data released by the Statistics Ministry on the last day of February, India’s gross domestic product (GDP) grew 5.4% in the fourth quarter of 2021—missing expectations for a 5.9% expansion and down from 8.4% growth in the previous quarter. Meanwhile, retail inflation breached the central bank’s tolerance limit of 6% for the first time in seven months as consumer prices rose 6.01% in January from a year earlier.
We view these factors as moderate headwinds of the type India has encountered before. Yes, inflation may tick up and force the Reserve Bank of India to raise interest rates. Yes, growth may slow a bit. However, the Indian companies we own have tended not to be particularly sensitive to temporary economic swings. For the most part, the companies have been posting solid earnings, have enviable market positions and have been experiencing strong momentum in their businesses.
It’s also important to note that the backdrop in India is very different from what it was the last time oil exceeded $100 per barrel. In October 2014, India had approximately $360 billion in foreign–exchange reserves available to defend its currency. Currently, forex reserves stand at $633 billion. And while India’s current account deficit is now roughly the same size as then, it’s much lower as a percentage of GDP. Moreover, India’s booming IT–services and pharmaceutical industries have stabilized the current account situation compared to past periods of spiking global commodity prices. We have carefully reviewed our Indian holdings and are comfortable with our overweighted allocation in the country.
BALANCING OUR PORTFOLIOS WITH EXPOSURE TO MEXICO, BRAZIL AND SOUTH AFRICA
While we’ve long held a positive outlook for India, we’ve recently become more constructive regarding Mexico, Brazil and South Africa. Beyond company fundamentals, our Mexican, Brazilian and South African holdings provide some diversification to the commodity–related vulnerabilities of our Indian names.
In Mexico, declining Covid–19 caseloads have boosted airport traffic and tariff revenue—and the government plans to more than double the country’s crude–processing capacity. This bodes well for Mexico and its trading partners in an environment of higher oil prices. We’ve seen similar signs of strength in Brazil, where the central bank has already implemented necessary rate increases, money has flowed into the country from overseas and the currency has appreciated meaningfully. In South Africa, investor sentiment has improved with indications that the Omicron variant is less deadly than previous strains of the virus.
CHINA’S ECONOMY AND TAIWAN’S SEMICONDUCTOR-MANUFACTURING INDUSTRY
As for China, the central bank cut interest rates in January to spur economic growth—even while policymakers in the U.S. and Europe eyed more restrictive monetary actions to combat inflation. Slowed by onerous virus–containment measures and a slumping real–estate market, the Chinese economy grew just 4% in the fourth quarter of 2021 from a year ago—its weakest pace since early 2020.
The People’s Bank of China has pledged to use additional tools to drive credit expansion and shore up domestic demand. With inflation low on a relative basis and additional monetary easing likely, we think the market environment for Chinese stocks may improve. Nonetheless,
we believe our underweighted allocation in China is appropriate due to regulatory and geopolitical challenges in several sectors.
Turning to Taiwan, the Wasatch Emerging Markets strategies have been hurt recently by our exposure to Taiwanese semiconductor companies. The stocks of some of these companies have been down on supply chain worries following reports that the White House’s National Security Council had warned U.S. manufacturers of semiconductor chips to find alternative sources of neon and palladium.
Neon, which is critical for lasers used to make chips, is a byproduct of steel manufacturing—much of which is done in Russia. The purification of neon is largely performed in specialized Ukrainian facilities. Palladium is used in sensors, memory circuits and other devices.
Despite volatility in the equities of semiconductor companies, we think diversified procurement and stockpiling of materials may limit disruptions in chip manufacturing for now. Moreover, we believe increases in production costs can likely be passed along to customers. At Wasatch, our Taiwanese semiconductor companies had been significant sources of strong performance during the past several years—and we continue to have confidence in the companies’ excellent fundamentals over the long term.
OUTLOOK AND POSITIONING
To put the current environment in context, it’s important to note that prior to the war, most financial markets had already moved down. The U.S. Federal Reserve’s hawkish turn in January was viewed negatively for stocks and bonds—including those in emerging markets. Rising interest rates in the U.S. can be perceived as making riskier assets in developing nations less attractive to international investors.
Higher rates sometimes have outsized impacts on long–duration growth stocks of the type Wasatch favors. Because the cash flows of growth companies are expected to occur further into the future, higher rates can make the companies’ income streams less valuable in the present. Moreover, stocks tied to e–commerce, digital consulting and other areas that had previously benefited from the pandemic tended to pull back after previous gains.
We think the characteristics of our companies will eventually offset these short–term challenges. In general, we seek to own high–quality businesses with unique products and services, market leadership, pricing power, significant margins, and operations that aren’t overly capital–intensive. Such businesses are typically better able to manage supply chains and cope with rising costs of labor and materials. Moreover, these businesses are usually less vulnerable to a revenue disruption because they tend to have healthy balance sheets with relatively low debt levels.
Despite recent underperformance compared to our benchmarks, we’re comfortable with the companies owned in the Wasatch Emerging Markets strategies. We’ve thoroughly reviewed our holdings, revisiting our investment theses, double–checking our revenue and earnings models and looking for relevant changes in underlying fundamentals. We’ve also spoken with management teams to ensure—to the extent possible—that our analysis correctly includes all relevant factors.
Going forward, we’ll attempt to take advantage of market volatility—buying companies when they’re unfairly punished and selling companies whose stock prices get too far ahead of fundamentals. In this sense, volatility isn’t something we can see in our crystal ball but it is something we can use to enhance portfolio positioning.
Thank you for the opportunity to manage your assets.
RISKS AND DISCLOSURES
This commentary is intended to provide you with information about factors affecting the performance of your Wasatch strategy. Portfolio holdings are subject to change at any time. Current and future holdings are subject to risk. Wasatch analysts closely monitor the companies held in the strategy. If a company’s underlying fundamentals or valuation measures change, Wasatch will reevaluate its position and may sell part or all of its holdings. Past performance is not indicative of future results. Information in this commentary regarding market or economic trends or the factors influencing historical or future performance reflects the opinions of management as of the date of this commentary. This commentary should not be relied upon for any other purpose.
Mutual-fund investing involves risks, and the loss of principal is possible. Investing in small cap funds will be more volatile and loss of principal could be greater than investing in large cap or more diversified funds. Investing in foreign securities, especially in emerging markets, entails special risks, such as unstable currencies, highly volatile securities markets and political and social instability, which are described in more detail in the prospectus.
An investor should consider investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus, containing this and other information, visit wasatchglobal.com or call 800.551.1700. Please read the prospectus carefully before investing.
Wasatch Advisors, Inc., doing business as Wasatch Global Investors, is the investment advisor to Wasatch Funds.
Wasatch Funds are distributed by ALPS Distributors, Inc. (ADI).
ADI is not affiliated with Wasatch Global Investors.
Wasatch Advisors, Inc., trading as Wasatch Global Investors ARBN 605 031 909, is regulated by the U.S. Securities and Exchange Commission under U.S. laws which differ from Australian laws. Wasatch Global Investors is exempt from the requirement to hold an Australian financial services licence in accordance with class order 03/1100 in respect of the provision of financial services to wholesale clients in Australia.
The MSCI Emerging Markets Index is a free float adjusted market capitalization index designed to measure the equity market performance of emerging markets.
The MSCI Emerging Markets Small Cap Index includes small-cap representation across 25 emerging-market countries. The index covers approximately 14% of the free float adjusted market capitalization in each country. The small-cap segment tends to capture more local economic and sector characteristics relative to larger emerging markets capitalization segments.
You cannot invest directly in these or any indexes.
Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indexes. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties or originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)
Diversification does not eliminate the risk of experiencing investment losses.
Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year.