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Emerging markets whitepaper in October 2010

Whitepaper article article published in 2010 discussing the emerging market.

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Emerging markets whitepaper in October 2010

  1. 1. Interested in the Emerging Markets?The Emergence of the Middle Class Makes Brazil a Top ChoicePerhaps the most dangerous four words in the investment lexicon are – It’s different thistime. That simple phrase cajoled millions in the late 1990s into believing that real worldvaluations no longer applied to high-flying technology stocks. Those same words mostrecently convinced buyers to overpay in an inflated housing market because they figuredhome prices would skyrocket forever. Rather than adopt “It’s different this time” as yourinvesting mantra, it’s a lot safer to equate it to your children’s immature rationale,“Everyone has one.” In that light, we’re more likely to avoid making blind justificationsfor investments, and take the time to scrutinize whether there really is something differentabout the market and why.Lately, we’re beginning to hear “It’s different this time” as justification to load up onemerging markets. Everyone wants some emerging markets exposure. After all, theMSCI EMERGING MARKETS Index returned 8.58 percent last year, besting the S&P500 Index’s 6.04 percent. Even more impressive, as of December 31, 2009, the ten-yearreturn for the MSCI EMERGING MARKETS Index was 10.11% versus a 1.58% returnfor international developed markets (MSCI EAFE Index) and a -0.95% return for USmarkets (S&P 500 Index).Index 1 3 5 7 10 year years years years years % % % % %S&P 6.04 26.46 -5.63 0.42 5.52 -0.95500®IndexMSCI 2.22 32.46 -5.57 4.02 10.76 1.58EAFE®indexMSCI 8.58 79.02 5.42 15.89 22.39 10.11EMERGINGMARKETS(EM)index
  2. 2. Source: Zephyr StyleADVISOR, SSgA Strategy &Research, as of 12/31/2009.Generally, emerging markets are defined as countries that are experiencing rapideconomic growth and financial and economic liberalization, prompted by policy reforms.Typically, they have immature capital markets and partially developed institutions.Frequently, these countries also are undergoing economic, political, or socialtransformation.Significantly, the per capita incomes and gross national income (GNI) of emergingmarkets are just a fraction of those of developed world economies. According to theWorld Bank’s classification of countries into four income categories, a majority ofemerging countries fall within the bottom three categories and have a GNI per capitaincome of below $11,905. By comparison, the United States 2008 GNI per capita wasabout $47,580.Countries Classified as “Emerging”Brazil Chile China ColombiaCzech Egypt Hungary IndiaRepublicIndonesia Israel Korea MalaysiaMexico Morocco Peru PhillipinesPoland Russia South Africa TaiwanThailand TurkeySource: MSCI International Equity Indices, as of 12/31/2009.While emerging markets have posted impressive returns, there’s no such thing as a freelunch. Historically, emerging markets have been more volatile than developed markets,with increased potential for losses. In fact, investors have witnessed tremendous portfolioswings during the past decade.However, while risk is certainly omnipresent in the emerging markets, there is something“different” going on that, over the long term, could temper the boom and bust cycle. Thatsomething different is the major international investment theme I’ve embraced for the lastfive years -- the emergence of the Middle Class. Today, standard of living improvementsthat range from incorporating protein into once grain-heavy diets to moving from areliance on public transportation to buying a first car are fueling the ascent of the middleclass. And, the fact that once people have a taste of improving their lifestyle, they don’twant to go back lends some sustaining power to emerging markets growth.Brazil has a lot of wind in their salesNo where is the emerging middle class story stronger than in Brazil. Brazil’s middle classhas grown steadily since 2003, when President Luiz Inacio Lula da Silva took office, and
  3. 3. accounts today for nearly 50 percent of the population, according to a recent report by theGetulio Vargas Foundation.The nearly 91 million people in the South American country’s middle class represent49.22 percent of the population and account for 46 percent of national income. In 2003,according to the report, the middle class included 64.1 million people who represented37.56 percent of the population and accounted for 37 percent of national income.1Although Brazil’s 192 million population is dwarfed by China’s 1.3 billion people, itlikely will be decades before China experiences the burgeoning consumerism on displaytoday in Brazil. Interestingly, economists point to a cultural characteristics drivingconsumerism in Brazil. While the Chinese are notorious savers, Brazilians enjoyspending. In fact, Illan Goldfajn, Chief Economist at Brazilian bank, Itaú, recentlyquipped, “If the world is looking for savers, Brazil is not much good… But if it’s lookingfor consumers, then we might be able to help.”2A number of additional factors make investing in Brazil more attractive than China. First,Brazil is a democratic nation, not a communist one. Current programs reflect theBrazilian government’s ongoing commitment to improve the country’s infrastructureto alleviate the strains the increasing middle class puts on it.Brazilian President Luiz Inacio Lula da Silva announced 886 billion US dollarsinfrastructure investment plan that would be carried out by his chosen successor, CabinetChief Dilma Rousseff, should she win the presidential election next October.Specifically, the government plans to invest 105 billion Reais in transportationinfrastructure such as new roads and ports, according to the document. Investments inrailroads are slated at 46 billion Reais, and include studies for three new high- speedtrains connecting the cities of Sao Paulo, Curitiba and Belo Horizonte.The second stage of Lula da Silva’s Growth Acceleration Program, PAC, is expected tohelp Brazil expand an average 5.5 percent a year through 2014.3In addition to its political stability, Brazil is far less reliant on exports; only 14 percent ofBrazil’s GDP comes from exports, compared to 35 percent from China. Also, Brazilalready possesses all the natural resources necessary to support its booming economywhereas China needs foreign assets to feed its economic machine.In addition, the level of sophistication in Brazil’s financial markets is impressive. Havingto deal with hyper inflation, they have become very apt in terms of trading skills and risk1
  4. 4. control. Similarly, their efforts to improve fiscal and monetary policies have beencomprehensive. For example, Brazil’s banks are required to keep 30 percent of alldeposits with the central bank, plus capital reserves of at least 11 percent of total assets,when most financials outside the country maintain capital ratios of 16 percent or more.And while hedge funds are unregistered in US, Brazil treats hedge funds like US mutualfunds that must offer daily liquidity investors. The same fiscal strictness applies toconsumers. For example, those applying for a mortgage must put one third down andplace one third in escrow before being allowed to borrow the last third.In addition to resulting in lowering inflation, a reduction of net debt to 40 percent ofGDP, and an investment grade rating for the country’s debt, Brazil was also the firstcountry in Latin America to stage a recovery in the second quarter of 2009. In fact, onstrong footing coming out of the financial crisis, the Brazilian economy is on track togrow more than 5 percent in 2010, according to the Central Bank of Brazil. In the view ofCentral Bank Governor Henrique Meirelles, sound macroeconomic policies adoptedduring the last years, including firm regulatory controls, inflation targeting, a floatingexchange rate regime and a fiscal policy that enabled the public debt-to-GDP ratio todecline during the period enabled Brazil to navigate successfully through the 2009 globalfinancial crisis and put the country on the road to strong growth prospects.4Finally, the fact that Brazil will play host to the world’s two biggest sporting events in thecoming years – the 2014 soccer World Cup and 2016 Summer Olympics – should alsogive a major boost to the economy.How to Invest?As already mentioned, emerging markets present unique and increased risks. Like allasset classes, they carry market risk. However, they also involve additional risksassociated with a lack of sound information, currency depreciations against the US dollar,and political risk.Because we are looking to make a beta play in emerging markets like Brazil, ExchangeTraded Funds (ETFs) with their low cost, transparency, and liquidity are often ourinvestment vehicles of choice. Invest any other way and you will overpay for investmentbeta. We’re particularly interested in two broad-based ETFs: iShares MSCI Brazil Index (NYSE: EWZ): This invests in mostly large-cap financials and commodity stocks such as Petrobras (NYSE: PBR) and Vale (NYSE: VALE). With the large-cap emphasis, comes a more global focus, not strictly th emergence of the middle class in Brazil. Van Eck Market Vectors Brazil Small-Cap (NYSE: BRF): This fund offers exposure to Brazilian small-cap stocks from dental providers to insurance and technology companies, all with big potential. BRF is an ideal way to play Brazil’s rising middle-class population and higher consumer consumption rates.4
  5. 5. However, our affinity for ETFs doesn’t preclude portfolios having some active managers.Large family offices have access to large institutional fund managers who provide on theground surveillance necessary for us to feel comfortable investing in individual names. Ihave, for instance, held Vale for some time to take advantage of the secular trend incommodities.To capitalize on the opportunity in emerging markets, last year I constructed a barbellapproach for clients. At one end, I focused on income generation with mortgage-backedsecurities and bank debt providing healthy yields. On the other end, I held a fairlyaggressive, 10 to 15 percent, in emerging markets with an overweighting in Brazil.While that portfolio worked out well for investors, we do not limit our investments toBrazil. India, for example, a world leader in business process outsourcing, enjoys ahighly educated work force and a large, increasingly affluent population. What Iparticularly appreciate about India is that multinational outplacement companiesunderstood from the beginning that their competition was not Indian companies, butglobal companies. Accordingly, they accepted that they had to adhere to global standards– not only with accounting, but corporate governance. This global perspective forcedthem and investors to apply more of a global multiple in terms of their earnings.China, too, offers significant opportunity. It’s projected that China to become the world’ssecond largest economy in the next two years. In fact, the World Bank recently raised itsprojection for China’s 2010 GDP growth from 6.5 percent to 7.2 percent. With nearly $2trillion in reserves, a low level of debt-to-GDP, and additional stimulus funding available,China maintains policy flexibility to deal with recovering global markets. To takeadvantage of that growth potential, we’ve invested and iShares FTSE/Xinhua China 25ETF (FXI) that invests in the 25 largest companies I China. We also have interest insome closed end funds.The bottom line is that investing in emerging markets is “different” today. That is,although volatility, the boom and bust cycle, will always be a part of emerging marketsinvesting, building on what was learned in the 1990s, these countries continue to institutenew economic policies and structural reforms to increase financial transparency andimprove their fiscal health.Invest vehicles themselves have also improved. Today, ETFs offer investors a better wayto control emerging markets risk through greater transparency and lower costs. Equallyimportant, the increasingly wide range of ETFs means you can target a particularinvestment interest – like the emergence of the middle class in Brazil.Yours sincerely,Michael S. Finer ©