Baron Emerging Markets Fund | Q1 2025
Outlook
April 2, 2025 was deemed “Liberation Day” by U.S. President Donald Trump, though it may represent liberation only from free trade and economic optimization. The U.S. initiated a trade war against the rest of the world (ROW), while, when viewed in conjunction with recent foreign policy moves, may perhaps more significantly be signaling America’s withdrawal from the longstanding global trade and security compact that it inspired in the aftermath of World War II, having ascended to unilateral hegemon after the fall of the Iron Curtain in November 1989. We believe the market reaction to “Liberation Day” is reasonable given the uncertainties, and suggests that contrary to the spin, the U.S. was actually the disproportionate beneficiary of this global trade and security equilibrium. It is of course possible that a negotiated course-correct plays out which we would view as positive for investors, but as we alluded in our prior letter, the emperor of U.S. exceptionalism appears to have little clothing right now. On the other hand, should the paradigm of economic nationalism and foreign policy isolationism gain momentum and take hold for good, we believe such a new world order would initially elevate risk premium, and it could take considerable time to establish a new equilibrium. The silver lining for those reading this letter: if such a paradigm shift were to take place, we would anticipate outperformance of non-dollar assets as likely. The unprecedented recent weakness of the U.S. dollar in the face of rising recession odds in our view suggests rising likelihood of a paradigm shift and better times ahead for the relative returns of non-U.S. equities. U.S. economic nationalism, isolationism, and a willingness to declare economic war on the ROW, whether for real or just as negotiating leverage, is proving a unifying event for Europe as well as for ROW consumers and corporates, and in our view, a wake-up call for global investors currently underweight non-U.S. assets.
What’s at stake in this potential withdrawal? The U.S. is currently on course to cede its role as white knight hegemon, a role that has worked out pretty well for America in the post-World War II era, despite the blemishes and costs. Certainly U.S. manufacturers and the related working class have been adversely impacted, but to us this is likely more due the relatively high cost of U.S. labor, land, and environmental regulations when compared to countries with far lesser per capita income, than to foreigners “ripping us off.” While foreign trade barriers can and should be lowered, the U.S. is by far the wealthiest nation in the world, and with a consumer-led economy, it should naturally have a current account deficit. The U.S. has failed over decades to establish policies and programs to adequately retrain workers that have been disadvantaged by the “middle-income trap” afflicting low value-added manufacturing, but we believe historic levels of tariffs are unlikely to represent a silver bullet. The administration on the surface seeks not only to shrink or eliminate the current account deficit but to also abruptly diminish 40 years of globalization, economic optimization, and capital efficiency. In our opinion, success would likely come at least partially at the expense of corporate profit margins and U.S. consumers’ real income. Forcing the private sector to reshore low value-added manufacturing plants may or may not improve manufacturing wages (we suspect it may also speed the development of automation, AI and humanoid robots, etc.), but we do not believe it will be beneficial to corporate profit margins.
One reason EM equities trade at a discount to the U.S. is because many such countries function at least in part as patronage systems with a weak or unpredictable rule of law. In such systems, political affiliation or favor, rather than free market competitive advantage, often divide the spoils, leading to heightened volatility and a lack of duration, reflected in lower equity multiples. It is premature to declare the U.S. economy as such a system, but this appears the direction of travel, in our view unsettling the tectonic plates of relative earnings growth, risk premium and valuation on U.S. versus non-U.S. assets. Patronage and national service usurp the private sector’s freedom to allocate capital to its most efficient use, while also often capping corporate profitability and/or investor confidence in longer-term earnings growth. In our view, this, rather than near-term economic/earnings momentum, is the greater risk of a paradigm shift in the global trade equilibrium.
As the issuer of the world’s reserve currency, the U.S. has benefitted for decades as the safe haven in a storm; a rising currency in turbulent times affords the Federal Reserve incremental cushion to ease monetary policy to combat financial or economic stress – particularly relative to foreign central banks that must contend with weaker currencies and by association more challenging inflation risks. Further, the world’s reserve currency, particularly during the global hegemon phase of the past 35 years, accrues a material funding cost advantage as it ensures stable demand for sovereign bonds and, by definition, a dominant liquidity advantage. The mirror image of a large current account deficit is a massive capital/financial account surplus, which in our view has been a key contributor to perceived U.S. exceptionalism when measured by demand for U.S. assets and relative valuation. Thus, a significant reduction in the U.S. current account deficit would also diminish foreign demand for U.S. financial assets and erode the global liquidity, funding cost advantage, and safe haven status endemic to the world’s reserve currency. The extraordinary U.S. tariff regime as proposed represents a short-term inflation and growth shock to the U.S., while outside the U.S., it represents a deflationary impulse and growth shock, this time affording foreign central banks greater room to maneuver. A goal of onshoring manufacturing at a high marginal cost, while encouraging the ROW to coalesce in protest of U.S. protectionism via new trade pacts and boycotts, would likely reprogram global capital flows and further erode the net benefits that have accrued to the U.S. over the 30-plus year period of expanding global trade. Further, roughly 40% of S&P 500 Index revenues are generated in foreign countries – certainly some portion of this is at risk, which in our view again would shift the forward-looking relative earnings growth dynamic in the direction of non-U.S., as U.S. goods and services are increasingly replaced by alternative sources.
With regard to the Fund, we highlight our large overweight position in India as a likely anchor in the current global trade storm. Having absorbed a fairly steep correction in our India holdings in the fourth quarter of 2024 and through much of the recent quarter, Indian equities began to recover and outperform just as global equities and volatility started sending warning signals in early March. In our view, India is a big “relative winner” as the country is one of the least impacted from a trade war, given that it is primarily a domestic consumer driven economy with a low share of global trade. With goods exported to the U.S. accounting for only 2% of India’s GDP, the impact of announced tariffs will only modesty impact it’s world-leading real GDP growth of roughly 6%. Further, we anticipate the final impact could be far less, as the U.S. and India are currently in active discussions to sign a Bilateral Trade Agreement (BTA) with a lofty goal to more than double trade to $500 billion by 2030. In our view, India will likely increase purchases of U.S. oil and gas, as well as defense equipment, to narrow the current $46 billion trade surplus with the U.S. We are closely monitoring developments on this front as the execution of a BTA should trigger a meaningful reduction in tariffs and set the stage for increased bilateral trade, benefitting both countries and confirming our longstanding view that India represents an increasingly important ally of the U.S., particularly as a counterweight to a rising China within Asia. In addition, a global slowdown will have a deflationary impact on key oil and commodity imports for India, often viewed as the country’s Achilles heel, thereby acting as a fiscal boost given that India imports roughly 80% of its energy needs. More generally, and across the Fund, from a bottom-up perspective we have always emphasized quality domestic growth companies rather than global-facing and export driven businesses, which should further temper our direct exposure to earnings disruption related to rising trade protectionism.
Current U.S. economic and trade policy is turning economic orthodoxy on its head. While the U.S. dishonors this orthodoxy, capital is migrating offshore. It appears that the U.S. may no longer be the protector of global security and democracy, free trade, and free markets; rather, it recently appears a principal source of disruption with an agenda to unwind decades of disinflation and capital efficiency. While we look for signs that the U.S. Congress can begin to reclaim its mandate over U.S. trade and tariff policy and slow the protectionist momentum, we suggest that to some extent, and in the eyes of our traditional trading and geopolitical allies, the genie is out of the bottle, and the catalyst we have been waiting for is finally now in view. Our suggestion in our previous letter, that the horse of U.S. exceptionalism has left the barn, and that looking forward from here there is likely more upside than downside in ex-U.S. equity relative performance, now appears prescient. We believe it is time to rebalance in favor of non-U.S. assets. We continue to anticipate a volatile year that we suspect will offer attractive opportunities for long-term investors.
Thank you for investing in Baron Emerging Markets Fund.
Sincerely,
Featured Fund
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