More Underweight Russia; Increased Turkey

• Russia remains the largest absolute position within the fund, although we continued to be net sellers over the quarter, deepening our relative underweight position.
• Our second-largest absolute position is in Turkey. We were net buyers during the quarter, and our relative position is increasingly overweight.
• We continue to be underweight in Central and Eastern Europe where economic growth remains mostly on track. The region is less tied to oil or the slowdown in China and more closely aligned with brightening prospects in the eurozone.
• We have a few investments in peripheral countries such as Ukraine, Kazakhstan, Georgia, and Romania. While these countries are not represented in our benchmark, they offer select long-term growth opportunities and help us diversify the portfolio.

Exposure to Russian Financials, Energy Cut

International sanctions, which were extended in late December, and the weakness in oil, one of Russia's main exports, continue to pressure the country's economy. However, fears that Russia's recession would last a second year were partly assuaged by a strengthening in oil prices over the quarter and the consequent appreciation of the ruble, following three years of annual declines. Industrial output beat expectations and rose in February; auto sales rose strongly, snapping a sharp five-month decline; and inflation slowed sharply. The purchasing managers' index for services unexpectedly rose above the 50-level denoting expansion. The central bank also left its key rate unchanged in March, signaling a reduced probability of rate cuts in the coming months. Despite the challenging conditions, we continue to believe that leaders in many industries, such as food retailing, will use the downturn to reinforce their market-leading positions, as foreign competition should remain limited and service penetration has room to increase.

• We further reduced our exposure to the financials and energy sectors. We sold out of Gazprom to raise funds for investments elsewhere. The company announced its latest strategy of going after market share in Europe and an increase in large capital expenditure plans, meaning negative free cash flow for at least the next couple of years.
• We trimmed our holdings in Bank Saint Petersburg and the country's largest retail bank, Sberbank, holding around 30% of total banking assets and 45% of retail deposits in the country.
• However, we increased our exposure to the consumer sector, opening a position in a Swedish-listed investment company, Vostok New Ventures. The company owns Avito, Russia's leading online classifieds business. We added to food retailer X5 Retail Group, which has seen strong revenue growth in the past year. We further added to a position in agricultural company Ros Agro, which has been a rare beneficiary of the sanctions regime.

Added to Turkish Banks, Automobiles

As an energy importer, Turkey is reaping the benefits of low oil prices and healthy domestic consumer demand. Sentiment has also been propped since last year when the ruling AK party won elections with an outright majority, dissipating worries about political instability. Despite negative factors including escalating political violence blamed on Kurdish separatists, the ongoing civil war and terrorism in Syria, and a general capital flight from emerging markets, the economy in Turkey is surprisingly resilient. The lira appreciated over the quarter as the U.S. dollar weakened, and the stock market was the best performer in the region. GDP expanded 5.7% on the year in the fourth quarter, which gave full-year growth of 4.0% in 2015. Private and public consumption also showed healthy growth. The central bank cut is overnight lending rate by a quarter point in March, surprising the market and fueling speculation it was preparing to shift its bias toward monetary easing.

• Financials remains our largest absolute sector exposure in the country as we believe banks stand to benefit from the long-term growth of a consumer economy. We continued to add to our bank holdings over the quarter. We topped up our second-biggest holding, Turkiye Halk Bankasi, a well-run state-owned bank that benefits from a low cost of funding and high penetration in the retail and SME sector, and opened a position in Akbank TAS, the country's fourth-largest lender by total assets and one of the most profitable. We sold out of Yapi Credit Bankasi, a lower-quality bank, to fund our positions in higher-quality Turkish banks.
• We hold a number of consumer names that include Bim Birlesik Magazalar, the country's largest discount food retailer with over 4,000 stores domestically and stores in Morocco and Egypt, and Coca Cola Icecek. We believe that domestic consumption demand is rising in importance across the region.
• Our bet in Turkish autos is increasing. We opened a position in Tofas Turk Otomobil, whose new products have had good takeup at the start of a new production cycle, and we added to vehicle manufacturer Ford Otomotiv Sanayi. We have continued to build up our recently acquired position in food products company Ulker Biskuvi Sanay, now one of our biggest bets in Turkey.

Hungary Focus in Central and Eastern Europe

Prospects for Hungary's economic growth remain robust. We maintain some exposure to the retail market through our position in footwear retailer CCC, which we believe has strong revenue growth potential due to its expansion plans, which also include Romania and Bulgaria.

We continue to build our position in Hungary's OTP Bank, as Russia and Ukraine have become small parts of its business, while its core Hungarian segment is continuing to recover. The central bank unexpectedly reduced interest rates after an eight-month pause, and taking its overnight deposit rate into negative territory to combat deflation was favorable.

The October election win of the right-wing, nationalistic Law and Justice (PiS) party clouds the outlook in Poland, with implications on regulation and taxation on several sectors that is helping drive our underweight position in the country. We avoided companies in the Czech Republic, where the economy is growing but valuations are unattractive.

Added to Romania in Frontier Markets

We retained our overweight position in Romania, where the economy is growing at a strong pace and a big anti-corruption drive is sweeping through the government and private sector. We added to our holding in commercial bank Banca Transilvania, which was one of the largest buys during the previous quarter, and added again to Fondul Proprietatea, an investment fund with general exposure to the Romanian economy.

Within Ukraine, we maintain a position in poultry producer MHP.

Within Kazakhstan, we entered the quarter with two positions in Halyk Savings Bank and telecommunications name Kcell. The banking sector has gone through much restructuring since the global economic crisis, and we feel Halyk Savings Bank is well positioned to take market share. A devaluation of the tenge that had been widely expected failed to materialize. The central bank instead kept its main policy rate unchanged at 17% and said the need to support the tenge after its sharp depreciation overweighed concerns about an economic slowdown. The government in February downgraded its 2016 economic growth outlook to 0.5% from a previous forecast of 2.1%.