Volatility

• Regarding the recent volatility in the Chinese equity markets and the impact it has had on global markets, we believe there is a significant disconnect between investor sentiment and the underlying fundamentals. Markets have reacted as if conditions are worse than the 2008 global financial crisis, or the Asian financial crisis of 1997 and 1998, yet several emerging market countries are in far better shape with larger foreign reserves and more diversified, growing economies. We continue to believe that conditions in China and across select emerging markets are fundamentally stronger than markets have been indicating.

Risk

• We view risk aversion across emerging markets as reaching a maximum state of unwarranted pessimism, which we believe provides compelling valuation opportunities. Not all emerging markets are attractive, in our assessment. Instead we are focused on two subsets of opportunities; (a) countries with solid fundamentals that are being priced as if they are in a crisis, such as Mexico, South Korea, Malaysia, Indonesia, and the Philippines, and (b) distressed special situations that are in crisis but have a clear path for exiting that crisis over the medium-term, such as Brazil.

Transformation

• Markets are currently in a state of transition from a period of high commodity prices to low prices, from zero interest rates in the US to rising rates, and from China growing at double digit rates to moderating and rebalancing its economy. This has caused volatility in the markets, but we believe much of the over-selling has been an overreaction. We believe that as commodity prices stabilize and the Fed continues to hike rates while China’s economy appropriately moderates, that markets will be in a better position to drive valuations back towards what the underlying fundamentals justify.

In our assessment

The markets fear of deflation are unwarranted. The decline in headline inflation was driven by the collapse in oil prices, yet core inflation has been positive and stable. We believe that the levels of underlying inflation appear underappreciated by markets and we anticipate a growing increase in the global output gap as emerging markets recover. In our view, there are more risks to inflation moving to the upside than to the downside, yet markets appear to be pricing in deflation and downside risks.

We believe the Fed risks losing credibility if it falls behind the curve in raising interest rates at a requisite pace. US labor markets remain close to full employment, economic growth continues to be good at 2% – 3%, and core inflation has remained stable. We expect wage pressures and an upward trend for core inflation during the year with a jump in headline inflation as oil prices stabilize and the year-over-year effects roll-off. If the Fed does not continue on its hiking path, it runs the risk of chasing inflation and losing credibility, as well as having no mechanism to reduce rates during an eventual downturn in the business cycle.