Domestic Drivers in Tariff Headwinds

It was a strange first quarter. Overall, emerging markets performed positively, delivering a return of around 3%.¹ That was something of a surprise. Many investors had expected a weaker performance amid a stronger U.S. dollar and a stronger U.S. market heading into 2025. But that’s not how it unfolded.

For most of the quarter, the dollar was weaker, partly because it had surged after Donald Trump won the U.S. presidential election. We had an environment where yields on U.S. 10-year bonds declined, which benefited emerging markets. And while interest rates stayed on a slow-cutting trajectory, inflation looked relatively contained. The performance of emerging markets and markets in Europe also improved while the U.S. market weakened. In our view, there were two catalysts: In Europe, there was Germany’s election and policy decision to ramp up fiscal spending, and progress toward a resolution to the Russia-Ukraine conflict; and there was China’s DeepSeek ‘Sputnik’ moment, along with more visible signs of proactive support for business by China’s leadership. The surprise success of China’s open-source AI platform challenged assumptions about the high-CapEx dominance of U.S. based-AI services and renewed confidence in China’s innovation capability. Xi Jinping’s public support for the private sector and tech firms also bolstered China’s equity markets. Consequently, the mismatch in valuations between large U.S. tech firms and large Asia tech firms came more into focus for investors in our view.

The other major external factor was “Trump 2.0” tariffs. However, new import quotas didn’t charge out of the blocks at the start of the year. Their introduction was fragmented and wide ranging, without one particular market in the crosshairs. As such, they were a lesser headwind than expected, though the threat of tariffs continued to weigh on markets generally.

Key Markets

India

Indian equities declined in the first quarter as earnings disappointed and economic growth softened. The market was weak as corporate growth fell short, leading to multiple negative earnings revisions, while valuations only belatedly declined. Poor earnings can be attributed to two factors: first, a decline in government fiscal spending since the formation of the coalition government last year, which has diluted Prime Minister Modi’s supply side growth agenda; and second, relatively tight monetary policy, particularly regarding unsecured credit. However, we see the impact of these factors receding over the next six months or so.

There has also been a significant differentiation in terms of where the earnings revisions have been. Larger financials and telecommunications companies held up well while the pain was felt acutely in infrastructure and consumer discretionary areas. Additionally, the rural economy showed no signs of recovery, so consumer staples were weak, as were sectors related to government spending. Negative sentiment has increased across the board in Indian equities, even among quality large-cap stocks, resulting in lower valuations. While this rebalancing is to be welcomed, we think there is more downside for mid- and small-cap stocks as they were trading on very high valuations.

North Asia

North Asia is more correlated to the rest of the world, and particularly the U.S., than most other large open markets. However, there was a clear contrast with how South Korea performed compared with Taiwan, which posted a large loss. Taiwan is almost a direct play in a very narrow area of technology driven by AI, by the Apple trade and by large CapEx spending by big U.S. tech firms like NVIDIA.² And sentiment turned as expectations for U.S. stocks deteriorated while valuations remained expensive. While we haven't seen a marked weakening in earnings yet, we believe prices are reflecting the anticipation of such declines.

On the other hand, South Korea posted a respectable gain. The impeachment of the president has been an overhang on the market and its industries have suffered from a cyclical slowdown. However, valuations have decreased and there are opportunities that are not tied to the global cycle. There is also the slow burning “value up” trade, with South Korean firms gradually improving capital efficiency and generating value for investors in the form of stock buybacks and increased dividends.

China

China was the best-performing major equity market in the first quarter of 2025, according to MSCI index data¹. The offshore markets performed well, due in part to the DeepSeek break-through that has shown that innovation and technological advancement in China is still world class, despite trade restrictions and investment curbs with the U.S. Valuations have also been compelling and we saw a big rally which has been justified by earnings revisions. We would also say that the catalysts to the rally were broader than AI and tech—there are many well-run electric vehicle (EV) and e-commerce companies in the consumer discretionary sector that have been cutting costs, generating earnings and buying back stock.

But it was still a narrow rally and the reason it hasn't expanded into more main-street sectors is the lack of a pickup in growth in China’s domestic economy. Mainland investors also surged into the offshore markets, shifting momentum away from domestic markets. In the period, southbound investment was around $56 billion, the highest quarterly purchase since the channel was launched in 2014.³

Looking more closely at the mainland or A-shares market, while many smaller companies’ earnings might come from exports, larger stocks are driven by domestic consumption, which has been weak. Property prices are mixed and there's still no evidence of a recovery. In order to see consumer sentiment strengthen, we believe more labor creation is needed and that will be a long road ahead. But we would also say the government’s increasingly visible pro-business posture may be signaling the start of a long-term cycle of private entrepreneurs gaining confidence to invest in the China's economy, which should in turn create jobs.

Japan

Japan posted a small gain in the quarter. Earnings were supportive and a slower but steady stream of share buybacks continued—an important contributor for total returns in Japan’s market. Dividends, another important contributor as Japan is not a high earnings growth market, were healthy. On the macro side, rates are rising and the yen has been strong and in such conditions many investors still tend to sell down their exposure to Japan equities. It’s important to note that Japan is a global cyclical economy, with many of its companies having production hubs across Southeast Asia. It is also reliant on the autos industry. As such, a potential slowdown in the U.S. and the impact of tariffs will be a pressure on Japan’s companies and equities.

Southeast Asia and Latin America

Southeast Asia stood to benefit from a weakening U.S. dollar in the quarter but political concerns, particularly in Indonesia, the Philippines and Thailand, impacted investor confidence. As a result, these markets are undervalued but are lacking a catalyst to attract renewed investment. Other markets fared well. Singapore held up due to its strong defensive sectors and the country’s banks and financial services are robust. Elsewhere, Vietnam has undertaken significant reforms which we view positively and expect the benefits to materialize over time.

In Latin America, the contrast couldn’t be greater. The region posted double-digit gains in the quarter and Brazil and Mexico delivered high single-digit returns. Brazil benefited from an improving macro environment and in Mexico there was a more supportive political backdrop as President Claudia Sheinbaum astutely managed challenging trade relations with the U.S., in our view. Over the next 18 months, as elections take place in Chile, Peru and Brazil, we may see increasingly supportive political landscapes emerging which will be positive for these economies and equity markets.

Our Outlook

Tariffs

Central to our outlook for the second quarter and beyond is the impact of U.S. tariffs—particularly the escalation of duties with the broad introduction of, and then temporary pause in, elevated reciprocal tariffs across many markets. It’s too early to assess the impact of reciprocal tariffs and the Trump administration’s tariff policy is also fluid. As we have seen so far this year, it is often characterized by negotiated exemptions. Thus, new tariffs may be rolled back and a very different picture may come into focus in the coming weeks and months.

At this point, we can conclude that, from a U.S. perspective, the administration’s tariff policy is growth negative and inflation positive—reflected in recent market concerns. While we don’t think it will lead to stagflation in the U.S., growth will be lower, inflation will likely stay around 3% and that has implications for the Federal Reserve’s policy. Does the Fed start to worry about lack of growth, or does it worry about inflation?

Domestic Drivers and the Longer Term

When the global economy is under pressure, we believe domestic drivers are more important than global drivers. For Asia, this environment calls for caution in markets that are correlated to the U.S. and in companies that are selling into the U.S. While valuations are attractive in markets such as Taiwan we remain cautious, and we are being selective in South Korea. Conversely, domestic demand-driven markets like India and China, which rely less on the global economy, will likely be more resilient. While China still faces a tariff rate of more than 100% on its exports to the U.S., pro-business policy changes and public support for its private sector are encouraging.

Looking ahead, we believe emerging markets will be supported by a recovery in earnings on valuations that are still cheap. This serves as a counterbalance to the headwinds from tariffs. And trade within Asia is also increasing.

For now, volatility and uncertainty remain. However, domestically driven markets can do well despite global challenges, provided the right political environment and the right fiscal policies are in place. We believe there are opportunities that experienced active managers can identify and focus on fundamentals, and we remain attuned to these developments.

Sources: ¹ MSCI, ² As of March 31, 2025, portfolios managed by Matthews did not hold positions in Apple and NVIDIA, ³ Reuters

Sean Taylor
Chief Investment Officer