During the first quarter of 2014, the Seafarer Overseas Growth and Income Fund gained 0.62% and 0.70% for the Investor and Institutional share classes, respectively. The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, fell by -0.37%. By way of broader comparison, the S&P 500 Index rose 1.81%.

The Investor and Institutional classes both began the quarter with net asset values of $11.35 per share. No distributions were paid during the quarter. The Investor and Institutional classes finished the period with net asset values of $11.42 and $11.43, respectively.

Performance

A casual glance at the benchmark’s performance might give rise to the false impression that the first quarter passed by quietly. It was not so. From the moment the year began, emerging market equities were in decline; by February 5^th – only five weeks into the quarter – the Fund’s benchmark had already fallen -8.4%.¹ However, the final weeks of the quarter brought a sharp reversal in fortune: stocks lurched upwards, and the benchmark recovered nearly all its losses. Rarely have I seen such volatility or so many shifts in sentiment occur in such a short span of time.

January made for a tough beginning to the year. During the final months of 2013, emerging market currencies declined as investors wrestled with vague (and mostly exaggerated) fears about macroeconomic imbalances in the developing world. Some investors believed that a specific set of countries suffered from fiscal and trade deficits – deficits that would become untenable if global interest rates were to rise. This cluster of countries came to be known as “the fragile five.”² The five had supposedly grown too dependent on foreign capital flows and were therefore susceptible to currency weakness. The financial media stoked fears over “the five” and over emerging markets in general, and what began as a modest sell-off swiftly became a panicked rout. The ensuing decline spilled over into January, and spread from emerging currencies to all other asset classes, including equities. Markets fed on their own panic, and the benchmark fell sharply in response.

China was not among “the five,” but Chinese equities were still weak, mainly because of mounting evidence that the country’s growth is decelerating. The Chinese government has set an official target of 7.5% expansion for 2014. However, the country’s leadership has acknowledged that growth may fall short, particularly if the country pursues its economic reform agenda in earnest.³ (Some economists believe the country will struggle to achieve 7.0% growth. Seafarer does not produce detailed economic forecasts, but I think the country will be very fortunate if it produces average growth of 5% to 6% between now and the end of the decade.) Fears over the rickety state of China’s financial system also escalated, as the country experienced a number of public bankruptcies – including the first default ever recorded in the country’s corporate bond market. The imperative for China to develop a new economic model was increasingly evident during the quarter.

Even as Chinese equities were depressed, Russian stocks came under even greater pressure due to events in Ukraine. Ukraine’s former government was allied to Russia; however it was ousted by a wave of populist protest in February. An interim, pro-Western government was installed in Kiev, but this triggered immediate retaliation from its former ally. Russia sent troops into the Crimean peninsula, ostensibly to protect people of Russian origin, but with the underlying intent to secure its economic and military interests within the peninsula. Russia then sought to legitimize its occupation by orchestrating a snap referendum regarding Crimea’s willingness to split from Ukraine and join Russia as a federal subject. Though the rest of the world questioned the legality of the referendum, the motion to join Russia won an overwhelming majority, and Russia moved to annex the peninsula. Ukraine’s woes were compounded when Russia enacted a massive increase in the price of gas that it sells to Ukraine. Many suspect that Russia is also fomenting unrest in other Ukrainian states that might be tempted to break away and follow Crimea’s example. At the time of this report, Ukraine’s status was unstable, without any resolution in sight. The only thing known with certainty is that Ukraine’s fiscal position is in disarray, and that the country is teetering on the edge of bankruptcy. For reference, the Fund does not invest in either Russia or Ukraine.

Between the “fragile five,” China and Russia, emerging markets were beset by a number of difficulties during the quarter, and it was not surprising that equities slumped in response. What was surprising was their subsequent recovery. In March, fears over China’s deceleration and financial distress were sufficiently advanced as to prompt contrary speculation: investors began to believe that China would soon introduce fiscal and monetary stimulus to offset the slowdown. This speculation proved correct, but more importantly it prompted Chinese stocks to surge higher before the quarter’s end. Meanwhile, Brazil’s stock market also rose based on speculation that the country might undergo political change that could beget better economic performance. As China and Brazil performed better in tandem, the Fund’s benchmark surged forward, recovering most of its losses for the quarter.

Over the past 18 months or so, the performance of the core emerging markets was lackluster, especially within the BRICs (Brazil, Russia, India and China). Consequently, several of the best-performing strategies emphasized investments in the peripheral components of the emerging markets, such as small capitalization stocks, or perhaps developed market stocks that had some marginal profit contribution from the developing world. Standard emerging market strategies, particularly those that emphasized large capitalization stocks held within the benchmark index, fared less well. Yet all of this changed in dramatic fashion during the final weeks of the quarter. The index surged forward, led by China and Brazil; the benchmark quickly overtook many of the strategies that had emphasized peripheral exposure to the emerging markets.

Amid such volatility and such pronounced shifts in the market’s leadership, I am pleased to report the Fund fared well. My aim is to create a well-diversified, “all weather” portfolio that is not overly dependent on any geography, sector or investment theme. Consequently, I was pleased to see the Fund maintain its outperformance versus its benchmark both before and after the March rally – especially given that the rally seemed to correspond to a strategic shift in the market itself.

Allocation

The market’s pronounced volatility has generated a number of investment opportunities, and consequently I made a number of revisions to the Fund’s construct in the past quarter.

One major change is that the Fund has taken up a small basket of long-dated, foreign currency-denominated government bonds (three positions, four percentage points of weighting). I believe the recent decline in the fixed income markets smacked of panic, and I intend for the Fund to take advantage. All three of the Fund’s new bond positions were issued by governments counted among the “fragile five.”

Since its inception, I have kept the Fund near “full investment,” which in my mind means carrying cash levels ranging between 0% and 5% of the portfolio.⁴ However, in order to manage the Fund’s liquidity appropriately amid volatile conditions, I have generally steered the Fund toward the higher end of that range, typically carrying 3% or more in cash. However, during the recent market volatility, I found the yields on several long-term bonds to be too attractive to pass up. Consequently, I chose to utilize a portion of the cash on hand (held predominately for liquidity management) to purchase these seemingly distressed bonds. In my opinion, the bonds offered excellent coupons, good long-term value, and little diminishment in liquidity versus the prior alternative (i.e. holding cash). In the future, I intend to manage the Fund with lower average cash levels, roughly 1% to 2%; the liquidity buffer the extra cash afforded will instead be satisfied by the new sovereign bond holdings.

In the very short run, the Fund’s timing with respect to these bonds has been good: the bonds’ prices have each risen between 2.1% and 9.4% since purchase, and the underlying currencies have gained between 3.5% and 5.1% in the same short interval.⁵ Yet I assume these securities will remain risky and susceptible to the same conditions that were associated with the turmoil of the past few months. Indeed, the bonds’ recent performance may represent less of a “bottom” and more of a “dead cat bounce.” Yet I am confident that the underlying yields are attractive within the context of the Fund’s strategy, that the securities will offer plentiful liquidity, and that while the bonds carry more risk than cash, they present substantially less risk than the portfolio’s core holdings in foreign currency equities.

As these bonds are denominated in the local currencies of the issuing governments, I perceive little risk of default. The main risk is that the underlying currencies depreciate against the dollar over time. This may occur, but I have little doubt that the Fund will still earn attractive dollar-equivalent yields, provided these bonds are held to maturity – certainly better than the zero yield associated with holding cash. Ultimately, I know the Fund is better off to buy these bonds now, when prices are lower and the underlying currencies are beaten up, than it was to do so 24 months ago when local currency emerging strategies were “hot.” I look forward to holding these bonds for the next 9 to 13 years as they mature.

On a separate note, the Fund has increased its exposure to Brazil over the past several quarters. This shift was not the result of a “macro allocation” or a deliberate decision to “boost the Fund’s exposure to Brazil” – I do not make “macro” investment decisions based on country or sector themes. Instead, Seafarer’s research there continues to turn up worthwhile companies, and valuations have fallen over the past two years, especially when measured in dollars. This conjunction gave us more reason to invest in the country, on a “bottom-up” basis. However, having done so, I would note that Brazil’s performance, as that market surged late in the quarter, helped lift the Fund’s returns into positive territory in March.

I think this is notable, as the general sentiment I see associated with the country is quite negative. There is good reason for this negativity: the current administration’s maladroit handling of economic policy, the ongoing youth riots, the public outcry over the excessive spending associated with the World Cup and Olympics, the fiscal stress that may yet take a toll on the country’s bond rating. Yet I think this list of woes misses the bigger picture: Brazil is generally in better shape than its major emerging market peers (i.e. China, Russia or India). This is for the simple reason that most of Brazil’s current woes can be addressed by reasonable modifications in economic policy.

The other three BRICs face challenges that are less tractable. China appears to be undertaking an impressive and necessary set of economic reforms, but it will be several years before any reforms bear meaningful fruit. Given the Chinese government’s apparent commitment to reform, I would counsel against an overly pessimistic view; still, the immediate economic outlook for the country is not encouraging. Meanwhile, Russia’s aggression in Crimea has already incurred international condemnation and sanctions. Even if the Ukrainian situation is resolved peacefully, Russia’s economy will likely remain a pariah. Lastly, India’s markets have fared well in anticipation of change in government following from upcoming elections. The BJP (“Indian People’s Party”) – the presumptive winner of the election – is friendlier toward business than its predecessor. However, India’s economy remains burdened with deep-seated structural inefficiencies, and thus any excitement over the election may prove misplaced and short-lived.

Brazil therefore stands out in comparison: it may suffer from sub-par growth, but the root cause is nothing that cannot be fixed. Meanwhile, stock prices are down and the currency is cheaper, both of which contribute to better valuations among equities. All of this, when combined with our bottom-up research on individual companies, has led the Fund to boost its exposure to Brazil. That decision was fruitful in the short run, and we intend to maintain the allocation for the foreseeable future.

Thank you for entrusting us with your capital – we do appreciate it, not least because this past quarter’s volatility required more trust and more patience than usual. We are, as ever, honored to serve as your investment adviser.

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.

1. Source: Bloomberg, as of 5 February 2014.
2. The “fragile five” term was coined in the summer of 2013 by a currency analyst at Morgan Stanley. The five consist of Brazil, India, Indonesia, South Africa, and Turkey. Personally, I discount its actual relevance: I believe the term is yet another catchy but misguided bit of jargon, coined by an investment bank seeking to over-simplify a complex condition.
3. South China Morning Post, "GDP growth target flexible as jobs take priority, says Premier Li Keqiang,” 13 March 2014.
4. For more information, please see this Ask Seafarer discussion of the role of cash in the Fund’s portfolio.
5. Source: Bloomberg, as of 31 March 2014.