Sunday Night Insight August 13, 2012

Lights Out on the BRICs? Sharmin Mossavar-Rahmani Neeti Bhalla Maziar Minovi Brett Nelson Matthew Weir Paul Swartz William Carter Kent Troutman Chief Investment Officer Managing Director Managing Director Managing Director Vice President Associate Analyst Analyst

While Olympians were breaking records in London, another record was being broken in emerging markets: a world-record power outage in India that left well over 600 million people without electricity. The blackout prompted some attention grabbing headlines: Would the Last Investor to Leave India Please Turn Off the Lights,1 Powerless to Act ,2 and Indias Dark Night.3 The blackout has also prompted extensive commentary on the structural problems in India: everything from politics, to infrastructure, to the undernourishment of nearly half its children. At the same time, investors are questioning whether Chinas growth actually bottomed in the second quarter given the recent weakness in industrial production, retails sales, the trade balance, and both the manufacturing and non-manufacturing purchasing managers indexes. Adding to the worries, loan growth in China also dropped from Rmb 920 billion in June to Rmb 540 billion in July. Nowadays, some of the commentary regarding China also reads less positively than before, including: China Faces a Profitless Recovery,4 China is in the middle of a decoupling of the worst kind for investors,5 and Accounting fraud and China have become synonymous for many investors. 6 The current more dour EM sentiment marks a significant shift from what prevailed in the mid- to late2000s, when the floodlights on emerging markets blinded investors and pundits alike, clearly evidenced in the reverent book titles of the period such as: India Rising: Emergence of a New World Power,7 When China Rules the World: The End of the Western World and the Birth of a New World Order,8 Russia: A superpower rises again,9 and Brazil: An economic superpower, and now oil too.10 And more broadly, The Emerging Markets Century: How a New Breed of World-Class Companies are Taking Over the World.11 At the same time, the US is regaining its perch as the undisputed economic superpower of the world. The Boston Consulting Group has published numerous studies on the return of manufacturing to the US. Observers such as Niall Ferguson of Harvard University, who wrote about the world In Chinas Orbit, now express optimism about the US. Meanwhile, Nicholas Bloom and John Van Reenen of Stanford University and London School of Economics, respectively, have written about the preeminence of US corporate management. Moreover, the dollar remains the reserve currency of the world, with calls for its replacement by the euro or Special Drawing Rights from the International Monetary Fund having receded into the background. Outside the financial realm, the recent landing of the one-ton Curiosity on Mars--some 350 million miles away from Earthstands as a testament to
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the USs enduring innovation. And on a lighter note, lets not forget that the US ranks number one in gold medals, as well as total medals in the Olympics. But lest we get too carried away with American exceptionalism, we note that the US had a blackout of its own recently, in none other than Greenwich, CT, when 99% of Connecticut Light and Power customers lost electricity on August 6th. This despite the fact that Greenwich is the hedge fund capital of the world, with nearly triple the income per capita of the US! The recent shift in EM sentiment has not been lost on the capital markets. Since the trough of the relative performance between US and emerging market equities on October 2010, US equities have outperformed by 14.3% annualized in local currency terms and by 17.3% annualized for dollar-based investors. During this period, the US dollar has rallied about 9% relative to the basket of emerging market currencies in the JPMorgan Emerging Market Local Debt index. In addition, recent economic data in the US has also been more favorable with moderate improvement in the labor market and the trade balance. In fact, the Citi Economic Surprise Index for the US has bounced nicely off its trough. This sentiment shift reminds us of one of the most important insights in investing provided by Benjamin Graham and David Dodd in their seminal 1934 book on investing Security Analysis: Many shall be restored that are now fallen and many shall fall that are now in honor. This adaptation from the lyrics of Roman poet, Horace, (b.65 BC) is a critical tenet of all great investors, as it illustrates the extent to which the investing pendulum swings from euphoria and greed to fear and despair. It is, therefore, our responsibility to provide clients with a more balanced view, so as to protect their portfolios from these swings in market sentiment. With that balanced view in mind, lets look at emerging markets in search of investment opportunities. In this Sunday Night Insight, we will first review the recent performance data and put the market returns in perspective. We will then look at current valuations to see if emerging market equities warrant a tactical overweight at this time. Finally, we will conclude with the rationale for why we recommend our clients have a strategic allocation to emerging markets.

The Total Return Facts

Facts are facts and will not disappear on account of your likes--Jawaharlal Nehru (Indian Prime Minister 1947-64).

We think it is very important to provide perspective when talking about emerging market returns. True to Horaces lyrics above, emerging markets have gone through periods of strong outperformance and strong underperformance, as shown below in Exhibit 1. During Period I, from 1994 through the end of September 1998, emerging markets underperformed US equities by 35% annualized and 185% cumulatively. This underperformance increases to 45% on an annualized basis if one includes the weakening of emerging market currencies during that time. Subsequently, during Period II from late 1998 through early October 2010, emerging markets outperformed US equities by 17% annualized and 495% cumulatively through October 2010. As mentioned above, in Period III since late 2010, EM has underperformed the US by 14% annualized and 28% cumulatively. We think it is important to look at the longer period for three reasons: First, it is imperative to understand the extent to which emerging markets rise and fall relative to US equities over long periods of time; such understanding will enable clients to stay away from the fear and greed that pervades the capital markets and not be unduly influenced by recent performance or dazzling headlines. Second, since most investors chase performance and hence typically miss the turns in the market, one has to invest in emerging markets with a long investment horizon to capture the
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expected outperformance. On this point, we note that since 2002, during a period of EM outperformance, about $210 billion of assets flowed into emerging markets equities, according to EPFR.12 Yet, although this period covers more than a decade, 73% of this inflow occurred in just the last 2 years (2009-2010) with 40% in 2010 alone, a year where emerging markets barely outperformed US equities (by 0.7%). Thus while a minority of investors assets benefitted from the entire outperformance in Period II, the bulk of those assets only participated in the outperformance of the last two years. Third, given the inherent volatility in data over short periods of time, it is always prudent to look at the longest period possible for which there is reasonable data, even though we recognize that these emerging market countries and their respective equity market benchmarks have evolved significantly over the last two decades. Nevertheless, we also recognize that limiting ones perspective to just the EM bull market of the last 10 years could mislead investors into making the wrong decisions.
1. EM vs. US Relative Return in Local Currency
0.15

0.13

US vs. EM Relative Total Return (Local)

9/23/1998 0.11 US Outperforms EM by 185% (35% Ann.)

0.09

0.07

EM Outperforms US by 495% (17% Ann.)

0.05

US Outperforms EM by 28% (14% Ann.) 10/6/1994

0.03 10/4/2010

0.01

-0.01 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Source: Investment Strategy Group, Datastream.

Is there a Tactical Investment Opportunity in Emerging Market Equities?

The key question now is whether the recent bout of underperformance has created a tactical tilt opportunity in emerging market equities. We address this question on an absolute basis and relative to other investment opportunities. We have looked across a range of measures and have found that price to cash flow and price to peak earnings tend to have the highest correlation with EM returns over the following 12 months. If we look at emerging markets compared to their own history, we can see that the the 10-year average and the long-term average valuations are nearly identical (as shown below in Exhibit 2). If we assume valuations revert to their 10-year average, emerging market equities would generate a midteens expected return. On this basis, one can argue for a small tactical overweight to emerging markets. However, looking at valuation more comprehensively, by also comparing the relative valuation of
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emerging market equities to US equities, yields a very different conclusion. If we assume mean reversion to the 10-year average of relative valuations (as shown in Exhibit 3), emerging markets would have a slightly negative return. Moreover, if we assume mean reversion to the long-term average, emerging markets would generate a negative 10% return. As we look at expected returns across various scenarios, we think that emerging markets equities do not yet offer a compelling risk and return profile, especially in light of the significant structural fault lines that exist across the key emerging market countries. In the parlance of Graham and Dodd, there is not much margin of safety in a tactical tilt towards emerging market equities at this time, especially compared to the margin of safety in our current tactical tilts in other equity markets: Eurostoxx, US banks, and Japanese equities.
2. EM Price to Cash Flow Multiple Through August 2012
14 EM P/CF Historical Average 10 Year Average

12

10 8.6 8.5 8

7.4 6

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

10

11

3. EM vs. US Price to Cash Flow Premium/Discount Through August 2012

EM vs. US PCF Premium/Discount 10% Historical Average 10 Year Average

EM vs. US Price to Cash Flow Premium/Discount

0%

-10%

-20%

-20.6% -22.0% -28.8%

-30%

-40%

-50%

-60%

-70% 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Investment Strategy Group, Datastream.

Obviously, we are watching valuations carefully, both in emerging markets in aggregate as well as across the key BRICs countries, should an investment opportunity present itself.
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What are the Key Structural Fault Lines

In a July/August article in Foreign Affairs, How India Stumbled, the author points out that the recent disappointment with India is overdone partly because the economy has been troubled all along: all the hype in 2009 disguised a number of real weaknesses. 13 In our view, the real weaknesses in the key emerging market countries which we call structural fault lines have existed all along; many have been identified for years, and policy makers have made some attempts to address them. We will provide a very brief overview of these fault lines. Our purpose is two-fold: first, in spite of these fault lines, we still recommend a strategic asset allocation to emerging markets; and second, because of these fault lines, we believe that emerging market equities should trade a discount to developed market equities. CHINA: We start with China, given its position as the largest economy in the emerging markets and second largest in the world. Chinas leaders have summarized Chinas structural fault lines better than anyone has: in 2007, Premier Wen Jiabo stated that Chinas economic growth is unsteady, imbalanced, uncoordinated, and unsustainable. More recently in 2011, President Hu Jintao stated that imbalanced, uncoordinated, and unsustainable problems with Chinas development have emerged.14 The biggest imbalance in China comes from what is termed financial repression whereby interest rates are kept artificially low. As a result, households earned a -0.5% real return since 2004, compared to an average real return of 3% from 1997 through 2003. 15 In this environment, savers earn less on their deposits, which in turn hinders household consumption, while corporate borrowers, including property developers, commercial banks, exporters, and state owned enterprises, benefit from the low cost of capital. This leads to an economy that is too dependent on exports and investment, but does not have sufficient domestic consumption. Along with financial repression, there is an absence of viable investment alternatives, forcing savers to invest even further in the property sector. According to Nicholas Lardy of the Peterson Institute for International Economics, residential investment in China in 2011 as a percent of GDP exceeded the peaks reached in both Spain and the United States (as shown in Exhibit 4). Needless to say, the Spanish and US experiences do not bode well for the Chinese property sector and the Chinese economy.

4. Residential Investment as a Share of GDP at its Peak by Country

12 10.7

10
8

9.5

% GDP

6
4 2 0

5.2 4.3

China (2011) Spain (2007) United States India (2008) Taiwan (1980) (2005)
Source: Investment Strategy Group, Peterson Institute for International Economics.

BRAZIL: In Brazil, the key fault line is the role of the government. The government accounts for about 40% of GDP, which is the highest among the BRICs. This large government role crowds out private sector investments as the private sector has to compete with the government for the same pool of capital, resulting in very high real interest rates. In fact, real interest rates as measured by the prime lending rate in Brazil are among the highest in the world. The government also tends to exert influence directly on various businesses in the energy, commodity, and banking sectors. Petrobras and Vale are both good examples of government involvement in specific companies. Brazil has also grown quite dependent on the commodity boom. Commodities and raw materials account for about two-thirds of total goods exported while commodity-related companies account for more than 40% of the Brazilian equity market. As shown in Exhibit 5, the year-on-year change in investments is highly correlated with the changes in commodity prices.
5. Brazil Commodity Prices vs. Investment
120.0 Investment (RHS) 100.0 80.0 60.0 40.0 10.0 20.0
5.0

35.0 Export price - fuel (LHS)

Export price - Basic goods (LHS)

30.0 25.0 20.0 15.0

0.0 0.0 -20.0 -40.0 -60.0 -80.0 3/1/2001 -5.0 -10.0

-15.0

-20.0 10/1/2002 5/1/2004 12/1/2005 7/1/2007 2/1/2009 9/1/2010

Source: Investment Strategy Group, CEIC. 6

RUSSIA: In Russia, the dependence on the energy sector is even starker, as the sector accounts for about 25% of GDP and 30% of government revenues. Energy alone accounts for nearly 60% of the equity market capitalization, while other commodities account for another 11%. Since oil production in Russia is not growing as fast as GDP, Russia is not only dependent on commodities in general but also on rising oil prices to sustain its growth. Without rising oil prices, Russia may face a bigger budget deficit going forward. Russia is also hindered by its political system where there is considerable uncertainty with respect to the rule of law and private sector property rights. This has led to large scale capital outflows that stand in sharp contrast to that of the other BRICs. As shown in Exhibit 6, Russia in the only member of the BRICS to face steady capital outflows since 2008the total since then stands at $356 billion!! And no end is in sight. Less that two weeks ago, a high profile oligarch, Aleksander Lebedev, announced that he would sell all his Russia-based assets. Earlier this year, the Central Bank of Russia provided data that showed that Russians spent $12 billion on foreign property alone in 2011.
6. BRIC Cumulative Net Capital Flows
5.0% Russia Brazil China
Global Financial Crisis

India

4.0%

3.0%

2.0%
Percent of GDP
Moscow Disputed mayor/oligarch parliamentary sacked elections

1.0%

0.0%

-1.0%

-2.0% Putin wins presidential election

05 06 07 08 09 10 11 12

-3.0%

Source: Investment Strategy Group, CEIC, Dastastream, Bloomberg.

INDIA: The biggest fault line in India is also one of its strengths. While it is a thriving democracy, its political system has led to a burgeoning bureaucracy, lack of strong leadership at the state level, and a very decentralized government that has hindered structural reformsbe it in the electricity sector, the agriculture sector, or education.16 In addition, a series of scandals involving the sale of telecommunication licenses have heightened investor concerns regarding corruption throughout the political and judicial system. As pointed out by the Eurasia Group when the headlines first appeared, multiple accusations put the spotlight on large-scale corruption in India, tarnishing the Congress Party.17 No doubt, poor infrastructure will be a drag on Indias long-term growth potential. A recent World Bank report on the Energy Intensive Sectors of the Indian Economy concluded that Indias electricity supply would need to be increased fivefold or more to support annual growth of 9% through 2031. Obviously, such expansion would require substantial investment. On this point, the head of Infrastructure Development Finance Company in Mumbai estimates that India will need $400-$500 billion to invest in the power sector, but it is not clear where the money will come from when the
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banks are already heavily exposed to the energy companies. 18 India is also burdened by a very poor education system. Only 23% of Indians have received secondary education. And a 2011 survey of government schools revealed that half of the countrys 5th graders, who are typically 10 years old, could not read text that was suitable for children three years younger.19

Why a Strategic Allocation

With such fundamental and somewhat immutable looking structural faults, why do we recommend a strategic allocation to equities, local debt, and private equity in emerging markets, totaling 9% for a moderate risk investor and as much as 13% for an aggressive investor? There are two keys reasons for such an allocation, namely diversification and an attractive long-term risk/return profile. The diversification benefits are probably best exemplified by the exposure of emerging market local debt (EMLD) to various risk premia. As shown below, EMLD provides some exposure to all of the six risk premia that we have identified as part of our new strategic asset allocation tools. In fact, this asset class has one of the most balanced exposures to these risk premia among all the other asset classes. Therefore, the overall risk/return profile of any clients strategic portfolio is enhanced by some exposure to EMLD.
7. Factor Decomposition of EM Local Debt Risk Premium
2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

Equity

Term

Funding

Liquidity

Exchange Rate

Emerging Market

Source: Investment Strategy Group.

With respect to emerging market equities, they also provide some diversification benefits and this is best observed when we compared the risk premia exposures of emerging market equities with that of the S&P 500. As shown in Exhibit 8, while half the expected returns of both markets derive from the exposure to global developed market equity returns, emerging market equities actually have a more diversified exposure to the other factors.

8. Factor Decomposition of EM vs. US Equity Risk Premium

6% Equity Term Funding Liquidity Exchange Rate Emerging Market
5.1%

5%

4% 3.5% 3.2% 3%
2.5% 2%

1%
0.5% 0.3%

0.8% 0.2% 0.0% 0.3%

0% -0.4%
-1%

-0.4% Emerging Market Equity

S&P 500

Source: Investment Strategy Group.

Finally, private equity in emerging markets provides exposure to some of the fastest growing sectors in these countries, such as the consumer discretionary and healthcare sectors. Moreover, private equity allows clients to reduce some of the risks associated with emerging market investing, by limiting investment in sectors with heavy government involvement, by providing greater due diligence and better control, and by affording investors a greater margin of safety, given the typical purchase price discount of private companies relative to public market valuation. For these reasons, we estimate that private equity in emerging markets has one of the most attractive risk/return profiles across all asset classes, being just a little lower than that of EMLD.

Conclusion
In conclusion, we think that our clients will benefit from maintaining a balanced view of emerging markets. We neither agree with those who suggest investors allocate at least 34% of their investments in emerging markets,20 nor do we agree with those who think that one should only capture emerging market growth through developed market equities. Instead, our balanced view suggests a measured allocation in line with ones risk tolerance. On this point, in spite of recent emerging market underperformance, we are not yet ready to tactically overweight EM equities, as we believe a greater discount is warranted at this time. Indeed, we are arguably headed into a period of greater uncertainty in September, including the forthcoming ruling of the constitutional court in Germany regarding the European Stability Mechanism, the meeting of the European Central Bank, the FOMC meeting and their updated economic projections for the US, audit results of Spanish banks, and the Troika decision (EC, ECB, and the IMF) regarding the Greek bailout program, not to mention the intensification of the US election campaign. Such uncertainty will contribute to further volatility in the financial markets and emerging market equities will no doubt be among the most volatile. At the same time, many of the concerns mentioned above are policy-related or political in nature,
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creating somewhat binary outcomes. As such, if sufficient political will materializes, risk assets could react very positively, making an equity underweight costly. Against these competing tensions of several sources of downside risk on the one hand, and the potential for market-friendly policy responses on the other, we have recently recommended a portfolio hedge consisting of attractively priced at the money S&P 500 puts. Notably, this hedge allows upside participation in each of our tactical tilts, which we continue to believe offer attractive risk/reward, while also insulating a portion of our YTD gains, thereby dampening downside risk. This stands in contrast to last years tail risk hedge, which was compromised of deeply out of the money puts geared toward protecting the portfolio against low probability but truly adverse outcomes. Sources: Investment Strategy Group, Datastream, Bloomberg, Goldman Sachs Global Investment Research, CEIC, Eurasia Group, Peterson Institute for International Economics, The Wall Street Journal, Foreign Affairs, The Financial Times. 1 Would the Last Investor to Leave India Please Turn Off the Lights. GaveKal Research, August 1, 2012, 2 Powerless to Act. The Financial Times. August 5, 2012. 3 Indias Dark Night. Foreign Affairs. August 8, 2012. 4 China Faces a Profitless Recovery The Wall Street Journal, August 10, 2012. 5 China is in the middle of a decoupling of the worst kind for investors The Financial Times, July 30, 2012. 6 Accounting fraud and China have become synonymous for many investors The Wall Street Journal, August 8, 2012. 7 Collette Mathur, et al. India Rising: Emergence of a New World Power. Marshall Cavendish Business, 2005. 8 Martin Jacques. When China Rules the World: The End of the Western World and the Birth of a New World Order. The Penguin Press, 2009. 9 Russia: A superpower rises again. Cnn.com, December 13, 2006. 10 Brazil: An economic superpower, and now oil too The Economist, April 18, 2008. 11 Antoine van Agtmael. The Emerging Markets Century: How a New Breed of World-Class Companies are Taking Over the World. Free Press, 12 EPFR Global provides fund flows and asset allocation data to financial institutions around the world. 13 Pratap Bhanu Mehta. How India Stumbled: Can New Delhi Get Its Groove Back? Foreign Affairs. July/August 2012. 14 Calculating the Coming Slowdown in China. The New York Times, May 23, 2011 15 Nicholas Lardy. Rebalancing Economic Growth in China: Presentation to Goldman Sachs. The Peterson Institute for International Economics. August 7, 2012. 16 India: State-Assembly elections and parliamentary deadlock will weaken reform momentum Foreign Affairs, January 26, 2011; and India: Government Slow to cope with structural problems in agricultural sector. Eurasia Group Note, February 12, 2011. 17 Seema Desai. INDIA/POLITICS: Multiple accusations put the spotlight on large-scale corruption in India, tarnishing the Congress party. Eurasia Group Note. December 2, 2010.
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18 Powerless to Act. The Financial Times, August 5, 2012. 19 India Inc Will Never Catch up with China. The Financial Times, August 8, 2012. 20 Mark Mobius, EMs Safest Bet; Commodities Will Trend Upward. Economic Times India, August 29, 2011.
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