Emerging Markets: Lessons Learned and Marching Forward

A GLANCE BACK

As we look at 2013, we see it was not an ideal year to invest in developing markets. Bonds, stocks and other financial instruments suffered, while developed markets rose sharply, driven primarily by the U.S. macro environment. Many investors unwound positions in emerging bonds to buy American and European bonds, resulting in a loss of value in respective currencies versus the U.S. Dollar and Euro.

As mid-year approached, the yield on the benchmark 10-year U.S. Treasury note jumped more than 100 basis points from 1.60%, then reaching 3% by year-end. This movement had a snowball effect on institutional investors fearing significant capital outflows from countries of lower quality, seeking refuge in the dollar and other major currencies in developed economies. The three principal U.S. equity markets climbed 30% on average, while Latin America closed with negative returns. Latam’s two largest markets, Brazil and Mexico, saw losses of 15 and 2 percent, respectively.

Reducing stimulus via bond purchases – “tapering” – by the U.S. Federal Reserve, sent a message to markets that the U.S. economy was on track for growth and the support measures that were in place for the prior three years, would no longer be needed. This held open the possibility that interest rates could increase further in the not too distant future.

PROCEEDING WITH CAUTION

Despite all this, factors that have led us to believe strongly in emerging markets in the past have not disappeared. However, unlike previous years, there is a need to be more selective and differentiate those emerging markets that are most vulnerable to capital outflows – i.e. they are more reliant on foreign funding to cover current account deficits and keep their economies growing – vs. those with stronger balance sheets.

That said, there are positive factors that exist in many such countries, and also risks. Growth rates are still much higher than those of developed countries. Additionally, there is a burgeoning middle class, with growing consumption, which is also helping to replace external demand with domestic demand. We must also take into account demographics are on their side, populations are much younger, which will help in the future. Other positive factors include less debt in their economies relative to the size of their GDPs. Also, many have a much higher level of foreign exchange reserves than they did before the financial crisis. In fact, when the criteria used in the Maastricht Treaty that analyzed the ability of various European countries to join the euro zone are applied to many of those same countries today, most of them do not meet the criteria, unlike most Latin American and Southeast Asia countries that do.

Productivity levels are improving. We have seen situations of American companies that were previously producing goods in China moving their plants to Mexico and Central America for more competitive pricing, better quality and closer proximity to the North American market. In addition – some multi-national companies are even returning manufacturing to the USA due to minimal price differences and quality benefits.

One final advantage is the difference in valuation of shares and bonds in emerging markets compared to developed countries, with multiples that are far lower than in the U.S. and Europe.

However, risks remain. The first is the devaluation of some currencies that could lead to inflationary spirals, which would reduce their competitiveness. Political instability could also be a factor. In the next 12 months, we will see elections in many of these countries that could bring to power leaders less open to free market policies. Finally the great impact of the Chinese economy and its slowdown in recent years may send a signal of concern affecting other emerging markets.

In our opinion, there is a clear opportunity for profit in the medium and long term. But unlike before, not all markets will evolve in the same way. There are countries, especially the BRICs, that may be best to avoid. There are however, companies and sectors that benefit more from increased consumption, and markets where domestic reforms are taking place.

We continue to look for investment opportunities that will take advantage of these trends, yielding positive returns over a reasonable timeframe.

Disclosure
This communication contains our current opinions and commentary, and does not represent a recommendation of any particular security, strategy, investment product or manager. The views expressed here are subject to change without notice. This commentary is distributed for educational purposes only and should not be considered as investment advice or an offer of any security or service for sale. Information contained herein has been obtained from sources we believe to be reliable, but we do not guarantee its completeness or accuracy. No part of this letter may be reproduced in any form, or referred to in any other publication, without WE’s written permission.