3Q18 Wasatch Market Scout: Clear Skies in the U.S. Brought More Storm Clouds to Emerging Markets



American mathematician and meteorologist Edward Norton Lorenz coined the term “butterfly effect” in 1969 after he discovered that small changes in the initial conditions of his weather model could produce vastly different outcomes. Although a butterfly doesn’t directly create a hurricane, its fluttering wings can theoretically alter initial conditions just enough to affect the weather in other parts of the world.

The interconnectedness of world financial markets is more intuitive than that of the weather but similarly complex. Like air flowing from areas of high pressure to areas of low pressure, money tends to flow toward countries offering investors the highest returns. The Tax Cuts and Jobs Act of 2017 set in motion a series of events that pulled investment assets away from emerging markets toward the U.S.—and especially into small-company stocks.

By lowering corporate and individual tax rates, the new tax law boosted economic activity and improved the earnings of U.S. companies. Because small companies tend to have more exposure to the U.S. and higher effective tax rates than larger peers, small-company stocks stood to gain the most. The greater domestic focus of smaller firms was an added bonus in 2018, as newly imposed tariffs on steel and other imports threatened to disrupt the businesses of large U.S. companies and multinationals. The dollar strengthened against other currencies as capital flowed to America’s shores.

The surging greenback made riskier investments in emerging markets less attractive to international investors. It also raised the cost of servicing dollar-denominated debt taken on by developing nations in the years following the global financial crisis. Emerging-market equities came under additional pressure on worries that the trade dispute between the U.S. and China might develop into a full-scale global trade war. Rising U.S. interest rates further underpinned support for the dollar, adding to the woes of emerging markets.

While this outline of recent events may sound like a case for pessimism regarding the future of emerging-market stocks and a case for unbridled confidence regarding U.S. equities, especially small caps, we believe both views should be tempered. In fact, market dislocations—such as those we’ve seen in emerging countries—have a way of creating opportunities for astute investors.

Moreover, investors should keep in mind that a large portion of the poor performance in emerging-market stocks was due to currency effects rather than company fundamentals. As for U.S. small caps, while some stocks likely got ahead of themselves, others saw increases that were in fact justified by improvements in the underlying companies’ revenues and earnings.


Regarding the economic news, let’s start in the U.S. The government’s Bureau of Economic Analysis upwardly revised its estimate of second-quarter gross domestic product (GDP) growth to 4.2% thanks to healthy consumer spending on durable goods. And although economic growth will likely moderate from that pace, government data suggests the U.S. economy will continue to expand at a healthy clip.

Consistent with robust economic growth, the U.S. unemployment rate—which is hovering at its lowest level since 2000—has continued to fall as the labor market has tightened. Job openings continue to exceed the number of unemployed workers. And these conditions have likely contributed to accelerating wage growth, a key factor in U.S. families’ inflation-adjusted incomes—which rose in 2017 for the third straight year.

Not surprisingly, consumer sentiment among individuals hit an 18-year high in September. Similarly—amid tax cuts, deregulation and a warm view toward business—U.S. corporate earnings, which already look set to extend a streak of double-digit percentage gains in the third quarter, are projected to grow at double-digit rates for the next two quarters.

For its part, the U.S. Federal Reserve (Fed) characterized economic conditions as “strong,” which was an improvement from its previously “solid” assessment. And Fed policy makers voted unanimously on September 26th to raise the benchmark federal-funds rate by a quarter of a percentage point to a range between 2% and 2.25%. Policy makers expect to raise the rate again later this year and through 2019 to keep the strong economy on an even keel.

While the U.S. economic conditions described above are positive, they could set the stage for accelerating inflation—particularly with oil prices at their highest levels since 2014, and with tax cuts putting more money into the hands of businesses and individuals. According to Fed Chairman Jerome Powell, however, there’s little to indicate that inflation will surprise to the upside in the near future. It’s possible that inflation is also being contained by the strong U.S. dollar. But with tariffs adding to the cost of imported goods and labor markets tight, we’re keeping a watchful eye for early signs of prices getting out of control.

In addition to the Fed raising short-term interest rates, just a few days after quarter-end the 10-year U.S. Treasury yield jumped to its highest level in seven years. While this may simply reflect the strong economy, higher U.S. interest rates could put some upward pressure on rates overseas.

This brings us to a discussion of international economies. While the eurozone is still growing, the pace of growth has slowed from a year ago. Compared to the U.S. economy, eurozone economies seem more susceptible to the repercussions of global trade tensions, Brexit, political uncertainty, and growing risk aversion among businesses and consumers. Having said that, the European Central Bank—in a show of confidence—still plans to follow the U.S. Fed and gradually withdraw monetary stimulus over the next year or so.

In Japan—which seems somewhat less involved in trade disputes—Prime Minister Shinzo Abe’s policies appear to be working, and the country has achieved its highest rate of GDP growth in over a year. Like the U.S., both the eurozone and Japan are experiencing some labor shortages and rising wages. For us as investors looking ahead, we have to be aware of the potential for wages to cut into corporate profits—especially if we start to see erosion in the ability of companies to raise prices.

On the subject of global trade, tensions between the United States and the rest of the world remain a top-of-mind concern. Although we received good news regarding the renegotiation of the North American Free Trade Agreement (NAFTA) on September 30th, earlier in the quarter President Trump rejected a European Union proposal to remove auto tariffs. Moreover, the administration moved forward with new tariffs on $200 billion worth of Chinese imports into the United States, and China retaliated by announcing new tariffs of its own.

In addition to U.S. political drama, emerging markets—especially China—have been mainstays in the headlines. China’s $12 trillion economy has faced fresh challenges. Two separate measures of Chinese factory activity came in weaker than expected in September, reflecting China’s economic slowdown and the impact of tariffs on the country’s export manufacturers.

With little hope for a quick resolution on trade, China’s economic outlook now depends largely on the government’s ability to implement appropriate stimulus measures. A key importer of raw materials, components and finished goods from other countries, China functions as a locomotive of growth for other emerging markets. So while the stakes are high and the risks are significant, we think the Chinese government has an abundance of policy levers at its disposal and has demonstrated an uncanny ability to pull just the right ones at just the right time.

Although the impacts of the storm clouds over emerging markets are difficult to predict, we expect a resolution similar to the one in the aftermath of the so-called “Taper Tantrum” of 2013. Back then, investors feared that as the Fed curtailed (tapered) bond purchases, U.S. interest rates would rise substantially and cause money to flow out of emerging markets into the U.S. These fears never materialized in an overwhelming way. And emerging markets are generally in even better shape today than they were in 2013. Current-account deficits are much lower. Foreign-exchange reserves are generally higher. And fiscal-budget balances are better too.

More specifically, among emerging markets, we’re most optimistic regarding India. The Indian economy is largely driven by domestic demand and is tied less to exports and global supply chains. With tariffs on Chinese exports to the U.S. posing threats for China and its trading partners, we think India’s relatively closed economy offers attractive opportunities for international investors seeking to reduce exposure to global risks.


While economic news doesn’t always drive global financial-market performance, returns during the third quarter were consistent with the headlines.

Stocks in the U.S. mostly traded up. The large-cap S&P 500® Index advanced 7.71%. The technology-heavy Nasdaq Composite Index gained 7.41%. The Russell 2000® Index of small caps rose 3.58%. And similar to the previous quarter, growth-oriented small caps performed very well too, with the Russell 2000 Growth Index up 5.52% (which marked the tenth consecutive quarter of positive returns for the Index). Value-oriented small caps in the Russell 2000 Value Index were relative laggards at 1.60%, as value stocks—including those across larger market capitalizations—generally trailed growth stocks.

Along with somewhat higher interest rates during the third quarter, longer-term U.S. government bonds felt moderate price declines—which was consistent with the Bloomberg Barclays US 20+ Year Treasury Bond Index being down -3.00%. But shorter-term and higher-yielding bonds held up better, as indicated by the Bloomberg Barclays US Aggregate Bond Index being relatively flat with a gain of just 0.02%. Going forward, despite some recent price declines, we’re not necessarily bearish on U.S. bonds because we think extremely low interest rates overseas may help keep U.S. rates from rising too dramatically.

For the most part, like the previous quarter, international stock markets didn’t fare as well as those in the U.S. The MSCI World ex USA Index rose a relatively modest 1.31% and the MSCI Emerging Markets Index fell -1.09% for the third quarter.


Based on the quarterly returns presented above—and considering the past year’s returns, many of which were even more favorable for American companies—some investors may be tempted to ask whether or not it makes sense to venture outside the U.S. To help answer this question, take a look at the Dow Jones Industrial Average (DJIA) graph shown above—which we’ve repurposed from one of our shareholder commentaries. We chose the DJIA because it’s been in existence much longer than many other U.S. and international indexes.

What the graph shows is that there were long periods of time in which stocks were in a rising trend and periods in which stocks moved sideways overall. Moreover, within these periods, there were shorter-term bull and bear markets. Interestingly, these long-term and short-term market cycles don’t correlate perfectly with economic conditions and companies’ operating performance. In other words, stock prices can outrun or lag behind the fundamental conditions of the economy and of the companies themselves.

It’s important to note that the long-term and short-term market cycles displayed by the DJIA also occur in developed markets and emerging markets overseas. The difference is that cycles overseas tend not to coincide exactly with the cycles in the U.S. For example, U.S. stocks generally underperformed international stocks in the decades of the 1970s, 1980s and 2000s. Moreover, it’s impossible to predict how market cycles in the U.S. and overseas will unfold or how long they will last. For these reasons, among others, we believe it’s important to invest both at home and abroad.

Another important point is that although U.S. stocks have been setting records recently, we don’t know when the next period of flat or down performance will arrive. What we do know, however, is that the current rising trend hasn’t yet lasted as long as the previous two—and it may still have legs. So rather than paying too much attention to market cycles, we focus on finding high-quality growth companies that we believe will help us take advantage of favorable conditions, and hopefully help us navigate more-difficult environments as well.


During the third quarter, most of Wasatch’s U.S. funds benefited from steady business conditions and subdued inflation, which favored the stocks of growth-oriented small companies—including many that were somewhat insulated from tariffs and global trade concerns. Beyond the tailwind of a favorable environment for our investment style, we were pleased to see that most of our companies continued to boost revenues and deliver outstanding earnings growth that wasn’t simply related to tax cuts. In fact, we’ve been hearing from company management teams that the business environment is the best it’s been in a decade.

As company-focused investors, we believe earnings drive stock prices over the long term. But in the short term, stock prices can sometimes get ahead of company fundamentals. Therefore, as prices rose during the quarter, we sought to control risk by trimming positions (e.g., some Software-as-a-Service names) that we felt had moved up too dramatically. And we reinvested the proceeds in what we saw as more-reasonably valued issues.

Among emerging markets, pockets of concern flared up with greater intensity during the quarter. There’s no question that investors were generally more comfortable with what they perceived as the safer—and still fast-growing—U.S. stock market. But we remain optimistic about the prospects for our current emerging-market holdings, particularly those in India, for reasons already described.

Moreover, we continue to see solid opportunities for new investments. For example, with recent declines in Chinese stocks having brought valuations to more-attractive levels, our research has identified approximately 200 Chinese companies that we think merit further evaluation. Toward that end, analysts from the Wasatch international team recently returned from a trip to China that included visits to 65 companies. This was the first of a series of trips designed to cover our list of candidates for investment in China. The targeted securities span China’s A-share market as well as the H-shares.

While we wouldn’t minimize the negative effects of trade conflicts, we believe these conflicts will ultimately be resolved on reasonable terms—perhaps along the lines of the recent settlement regarding NAFTA. We also believe that the recent rise in the value of the U.S. dollar won’t continue much further; and it may actually reverse, which would ease the fiscal pressures on emerging markets and provide a performance tailwind for nonresidents who invest in those countries.

In the meantime, we’re pleased that the emerging-market companies we own have generally delivered strong earnings growth despite the recent underperformance of their stocks. As fundamental, bottom-up investors, we believe earnings-driven market environments will eventually provide beneficial conditions for our investment approach to outperform.

Again, while it’s impossible to predict the timing of market cycles, the “butterfly effect” could easily work in the opposite direction without warning. At Wasatch, it’s our job to find the best companies we can no matter where they are in the world. And we think it’s a good idea for individual investors to have a long-term perspective and portfolios that are geographically diversified too, because when you’ve got the world covered it doesn’t matter as much what the butterflies do.

With sincere thanks for your continuing investment and for your trust,

Ajay Krishnan and John Malooly



Portfolio Manager Bios

Ajay Krishnan, CFA—Portfolio Manager

Mr. Krishnan is the Lead Portfolio Manager for the Wasatch Emerging Markets Select and Emerging India Funds. He is also a Portfolio Manager for the Wasatch Global Opportunities Fund. He was a Portfolio Manager for the Ultra Growth Fund from 2000 to 2013. In addition, he was a Portfolio Manager for the World Innovators Fund from 2000 to 2007. He joined Wasatch Advisors as a Research Analyst in 1994. He was a Research Analyst on the Ultra Growth Fund prior to becoming a Portfolio Manager.

Mr. Krishnan earned a Master of Business Administration from Utah State University, where he also worked as a graduate assistant. He completed his undergraduate degree at Bombay University, earning a Bachelor of Science in Physics with a Minor in Mathematics.

Mr. Krishnan is a CFA charterholder and a member of the Salt Lake City Society of Financial Analysts. He specializes in analyzing the investment potential of fast-growing companies.

Ajay is a native of Mumbai, India and speaks Hindi and Malayalam. He enjoys traveling, reading, playing squash and road biking.

John Malooly, CFA—Portfolio Manager

Mr. Malooly has been a Portfolio Manager for the Wasatch Ultra Growth Fund since 2012. He was previously a Portfolio Manager for the Wasatch Micro Cap Value Fund. He joined Wasatch Advisors in 1997 as a Research Analyst on the Small Cap Growth Fund. From 1999 to 2003, he worked as a Senior Research Analyst on the Micro Cap Fund.

Prior to joining Wasatch Advisors, Mr. Malooly was an investment specialist at UMB Fund Services (formerly Sunstone Financial Group), the transfer agent for Wasatch Funds.

Mr. Malooly graduated from Marquette University, earning a Bachelor of Science in Business Administration. He is also a CFA charterholder.

John is a Wisconsin native who enjoys the outdoors and spending time with his family.

CFA® is a trademark owned by CFA Institute.


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China A-shares, along with B-shares, are sold on mainland China’s two stock exchanges, which are in Shanghai and Shenzhen. The key difference between A-shares and B-shares is that A-shares are denominated in mainland China’s currency, the renminbi, and B-shares are denominated in foreign currency (U.S. dollars in Shanghai and Hong Kong dollars in Shenzhen).

A bear market is generally defined as a drop of 20% or more in stock prices over at least a two-month period.

Someone who is “bearish” or “a bear” is pessimistic with regard to the prospects of a market or asset.

Brexit is an abbreviation for “British exit,” which refers to the June 23, 2016 referendum whereby British citizens voted to exit the European Union. The referendum roiled global markets, including currencies, causing the British pound to fall to its lowest level in decades.

A bull market is defined as a prolonged period in which investment prices rise faster than their historical average. Bull markets can happen as the result of an economic recovery, an economic boom, or investor psychology.

The Bureau of Economic Analysis (BEA) is an agency in the United States Department of Commerce that provides important economic statistics including the gross domestic product of the United States. BEA is a principal agency of the U.S. Federal Statistical System.

The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ. Charles Dow invented the DJIA in 1896.

Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.

The federal-funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. It is the interest rate banks charge each other for loans.

The global financial crisis, also known as the financial crisis of 2007-09 and 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.

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.

H-shares refer to the shares of companies incorporated in mainland China that are traded on the Hong Kong Stock Exchange. Many companies float their shares simultaneously on the Hong Kong market and one of the two mainland Chinese stock exchanges in Shanghai or Shenzhen. Such companies are known as A+H companies.

The North American Free Trade Agreement (NAFTA) is a treaty entered into by the United States, Canada and Mexico. In accordance with the terms of the agreement, the three nations phased out numerous tariffs between January 1, 1994 and January 1, 2008. NAFTA’s purpose is to encourage economic activity between the United States, Canada and Mexico.

Valuation is the process of determining the current worth of an asset or company.

The Russell 2000 Index is an unmanaged total-return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small-company stocks.

The Russell 2000 Growth Index measures the performance of Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values.

The Russell 2000 Value Index measures the performance of Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values.

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The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged and is a commonly used measure of common stock total return performance.

The MSCI Emerging Markets Index captures large- and mid-cap representation across 24 emerging market countries. With 1,151 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI World ex USA Index captures large- and mid-cap representation across 22 of 23 developed market countries—excluding the United States. With 1,015 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

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The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (MBS) (agency fixed-rate and hybrid adjustable-rate mortgage [ARM] pass-throughs), asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) (agency and non-agency).

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