structural

Emerging Markets – Crucial Points to be Aware of When Investing in the “Region”

What Investor Excitement Is Ignoring….

Inflation is like sin; every government denounces it and every government practices it – Frederick Leith-Ross

One of the most interesting market moves in 2010 was the significant outperformance of US equities over Chinese, despite far weaker GDP growth numbers. What many missed is the fact that it is not absolute values but relative figures / surprises which move markets. With this in mind, is it worrying that the consensus for China’s long term earnings growth is forecasted at 18%? Not much room is left for upside surprises, but there’s plenty of space for disappointment!

Source: "The Surprising truth about Investing in the BRICs" on Nicholas Vardy's The Global Guru, http://www.theglobalguru.com/article.php?id=340&offer=GURU001.

Therefore, it is important to be aware of the issues and risks associated with the region to be able to decide not only what to invest in but how to size the investment accordingly, inline with risk / return targets. As expressed above, it is crucial to judge what you believe is already priced into the markets and what pose as upside or downside potential.

Short-Term EM Risks

Short-term cyclical factors can overshadow long-term structural trends

INFLATION: the index used to calculate inflation in EM has double the exposure to food prices than in the G10 (developed countries). Using the price of wheat as an example – an all time high was reached at the beginning of this month, highlighting the magnified pressure felt in the region which may spook investors. From another angle, fiscal policy in China led to a 30% growth in the money supply (M2) in 2009, increased by almost as much again last year, stoking inflationary fears (since with more money around, it becomes worth less and more of it is required to buy goods i.e. goods become more expensive)

ALLOCATIONS: a record percentage of portfolio managers are overweight Emerging Market equities. The combined net assets of the two largest EM ETFs are now above that for the S&P 500, despite the US equity market being ~4 times the size of the investable EM universe.

Long-Term EM Risks

Long-term demographics may negatively affect the working population

AGE TRENDS: the biggest drop in the young working age population is “set to take place in China,” a result of its one-child policy.

ACCESS TO EDUCATION: Of the top 50 universities, only 3 are based in emerging market countries and the highest stay rate is among Chinese students. This means that in order to get a top quality education, the youth of Emerging Markets may have to study abroad and if they do so, may end up staying, greatly limiting the young, well-educated working class of their homeland.

EM Stock Risks

Do due diligence on the companies you pick – you may not be getting the exposure you want

EXPOSURE: just 14% of EM market cap is represented by domestic-facing sectors (i.e. not all EM stocks give investors exposure to the rise of the Consumer and the “Domestic Demand” growth story, a main reason for investment)

GOVERNMENT INTERVENTION: Within the EM stock markets, government ownership of companies is significant. For the Chinese market, 67% of its market cap is government owned (35% in Russia, 29% in India and 14% in Brazil). Putting this in context, in the US, at the height of the financial crisis, government ownership was about 3.7% of market cap. The importance of this should not be underestimated. It means that at times, within EM, a majority government owned entity may not be acting entirely in the interests of the investors.

STOCK EXAMPLE: Petrobras (PBR):  Brazilian government and its affiliates own about 64% of common voting shares. The offering documents state that “the government, as our principal shareholder, has and may pursue in the future, certain of its macroeconomic and social objectives through us.”

INVESTMENT INSIGHT

Therefore, in conclusion: Be aware –

Short-term cyclical factors can overshadow long-term structural trends

Long-term demographics may negatively affect the EM working population

Do due diligence on the companies you pick – you may not be getting the exposure you want

EU Differentiation… The Key Points you should know…

“United we stand; divided we fall” Aesop (Ancient Greek Fabulist and Author of a collection of Greek fables. 620 BC-560 BC)

The problem with the “EU” banner is that it links together economies that are quite different from each other. Much press has been dedicated to the fate of the PIIGS – Portugal, Italy, Ireland, Greece and Spain but it is interesting to compare journalistic exposure with economic impact. Greece Ireland and Portugal account for less than 5% of EU GDP. To save you shifting through pages of research – here are the key pertinent points for each economy… The structure follows that of my earlier assessment of the futility of EU bailout mechanisms–

  1. FLAWED LOGIC – what are the real issues?
  2. NOT SOLVING THE PROBLEM – will the economy in question be able to grow enough / will the debt burden be manageable enough so that it will fall as a % of GDP?
  3. UNCERTAINTY – what are the political issues?

Source: "Belgium Joins The PIIGS: And Then They Were Six" - Gavan Nolan, Econotwist The Swapper - learning and understanding the increasingly complex financial world.

Portugal – A Disappointing Deficit, Dipping Back Into Recession

  1. DISAPPOINTING DEFICIT and FOREIGN PRESSURE – Disappointed the market with its deficit reduction plan for this year, amounting to a value for the first 10 months of 2010 which was than for the whole of 2009 and forecasted to exceed the EU limit until at least 2012. Exposed to more foreign pressure with around 70% of its debt is held abroad
  2. LOW GROWTH – estimated to only amount to 1.3% for 2010 for an economy expected to fall into recession next yr
  3. POTENTIAL SOCIAL UNREST – planning to reduce its public workforce

Italy – Saved by its Savings, Economic Exposure but Debt Isolation

  1. TOO BIG TO BAIL OUT – second largest debt burden after Greece (public debt equates to 120% of GDP)
  2. LOW GROWTH

  • HOWEVER: High savings rate, exposure to German and Emerging Market economies, less dependant on foreign creditors and therefore more flexible

Ireland – The Public Prefers a Default

  1. HUGE BAILOUT – amounting to 60% of GDP vs. “only” 47% for Greece
  2. POTENTIAL FOR DEFAULT – 57% of the public believe the country will not be able to support the annual interest payments involved with this debt burden (€5bn over 9 years) and would prefer the government to DEFAULT on its commitments
  3. PROTEST and INTERNATIONAL IMPACT – 50,000 took to streets to protest against the Government’s plan to cut the budget deficit. The UK has £140bn exposure to Irish banks

Greece – Flirting with Insolvency

  1. STRUCTURAL LIMITATIONS“overblown state sector”, “uncompetitive and relatively closed economy”
  2. SOLVENCY – It has been argued that the bailout package will only prevent Greece from insolvency for ~a year
  3. CIVIL UNREST – has been seen in response to social program cutbacks

Spain – Pulling a “Sickie”

  1. UNEMPLOYMENT and a potential for DEFAULT – the highest in the EU at around 20% of the population. A third of private sector debt (€0.6tn) was generated from the housing boom and liable to default.
  2. INTEREST PAYMENTS HAVE JUMPED – Since Oct, yields have jumped from 4% to 5% leading to a larger debt burden as a percentage of GDP
  3. SOCIAL UNREST – Just the other week we saw one of the largest “sickies” thrown by their air traffic workers

Hungary – The Government Can’t Win

Although not within the PIIGS acronym – it is important nonetheless to mention this economy at this point and a great example of the potential impacts to investment. It’s a case that highlights the Government can’t win – if it decides that instead of implementing austerity programs eliciting social unrest, it will instead employ more crowd-pleasing reforms, it will get punished nonetheless….

  • DOWNGRADED – Moody’s has downgraded its debt to the lowest investment grade status. One more downgrade and it changes classification and those restricted to investing in Investment Grade debt only will be forced to sell, regardless of any other factors. Great opportunity to pick up dent at a discount (whilst watching the quality of the issuer!)
  • REASON – Short term (less antagonistic) measures are not sustainable – special taxes and utilising private pension schemes to fill holes! The Government is relying on future growth to afford its pension liability in the future and anyone not transferring to a state pension by end Jan may lose 70% of their pension value.

Contrast with the Core

Just to contast these economies with the one seeming to be driving force behind the union – Germany’s deficit could potentially fall to the 3% EU limit next year

INVESTMENT INSIGHT: When investing in the EU – differentiate between countries!