For the quarter ending March 31, 2023, the Matthews Emerging Markets Small Companies Fund returned 5.50% (Investor Class) and 5.56% (Institutional Class), while its benchmark, the MSCI Emerging Markets Small Cap Index, returned 3.94%.

Market Environment:

2023 started where 2022 ended with the market closely following inflation data releases and trying to assess U.S. Federal Reserve’s reaction function to them. After doing well in the first few weeks of 2023 on account of a belief that inflation might be softening, the markets had a reality check in February after a worse than expected inflation data print. Silicon Valley Bank’s collapse, followed by troubles at Signature Bank and First Republic Bank, led to a bout of risk-off sentiment and challenges for equity markets in addition to tightening financial conditions toward the end of the quarter.

Select Latin American currencies did well again against the U.S. dollar after a strong 2022 performance. The Mexican peso, Chilean peso, Colombian peso and Brazilian real appreciated the most among emerging markets currencies alongside the Hungarian forint during the quarter. The Argentine peso and Turkish lira, 2022’s worst performers, continued to depreciate against the U.S. dollar as did the Russian ruble and South African rand.

For the quarter, Hungary, Mexico, Taiwan and South Korea were the best-performing small-cap emerging markets. Turkey, Egypt and Colombia were the worst performing markets. A number of the poor performers in 2022 turned in strong performances during the quarter, including Taiwan and South Korea. From a sector perspective, information technology (IT) and materials were the best performers while energy and consumer discretionary were the worst performers.               

Performance Contributors and Detractors: 

On a country basis, our stock selection in South Korea was the biggest contributor to relative performance during the quarter, followed by our stock selection and underweight in Turkey and our lack of exposure to South Africa. Our holdings in Taiwan were the second-biggest contributor by stock selection. On the other hand, our overweight allocation to China and underweight allocation to Taiwan detracted from performance.

From a sector perspective, our stock selection and overweight in industrials was the biggest contributor to relative performance. Stock selection in IT also contributed positively. On the flip side, stock selection and overweight in financials, alongside stock selection in real estate detracted from relative performance.

At the stock level, South Korean battery supply names in the portfolio including Ecopro BM contributed positively to performance. After having underperformed toward the end of 2022 on worries over weak demand and oversupply concerns, many of these names rebounded strongly in the first quarter on the back of positive news flow over the potential impact on electric vehicle (EV) demand and customer eligibility for IRA subsidy payments of the U.S. Inflation Reduction Act. Strong new customer order wins, especially from U.S. automakers alongside capacity addition announcements, also contributed to strong performance by these stocks.

In contrast, Indian financials such as Bandhan Bank and Shriram Finance detracted from performance amid a general decline in Indian equities, after their strong performance in recent years left relative valuations very expensive, especially compared with China. Indian financials also got caught up in the global financials selloff in the aftermath of turbulence in the U.S. financial system following Silicon Valley Bank’s demise.

Notable Portfolio Changes:

In the last quarter we initiated a new position in Eugene Technology, a South Korean semiconductor fabrication-equipment maker that specializes in deposition gear. In addition to its core expertise in low pressure chemical vapor deposition equipment, Eugene is making strong inroads into atomic layer deposition equipment thereby increasing its addressable market. While the company’s products have largely been used in manufacturing memory products, it is also making progress in the semiconductor foundry manufacturing process as well which presents an attractive growth opportunity in the future.

During the quarter we exited India-based GMR Airports Infrastructure to take profit and we also exited Marico, a health and wellness products company also based in India, to redeploy capital elsewhere.

Outlook:

The Fed’s interest rate strategy and the market’s expectation of its evolution remain the most important variables impacting the near-term performance in emerging markets. That said, we expect the impact of the Fed’s actions this year to be less than it was in 2022 as the tightening cycle enters the late stages.

Our other key focus will be how China’s economic recovery and growth plays out and how it affects the dynamics of other emerging markets. And Russia’s invasion of Ukraine and its effect on energy prices— alongside OPEC’s efforts to keep the prices high—will need ongoing, careful monitoring.

Over the coming years, we expect the emerging markets gross domestic product (GDP) growth-differential with developed markets to improve from a 23-year low reached in 2022. This development, alongside relatively attractive valuations, should potentially lend support to better equity performance against developed markets compared with the last decade.

As the global economy wades through a tricky 2023, we believe small companies in emerging markets offer long-term growth opportunities given their innovation and domestic consumption orientation. We continue to find quality businesses at attractive valuations in this asset class.

Top 10 holdings as of March 31, 2023. Current and future holdings are subject to change and risk.

Average Annual Total Returns - MSMLX as of 03/31/2023