Are Emerging Markets Just Getting Started?

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1 Are Emerging Markets Just Getting Started? September 27, 2016 by Robert Sharpe of Heartland Advisors Talking Points: Despite recent strength, emerging markets (EM) appear to have room to run. Stable currencies should boost growth. EM economies are diverse and no longer driven by commodities. In our opinion, valuations continue to create opportunities in the near and long term. Enduring Markets Potential rate hikes in the U.S., tepid growth of developed economies, and a fragile energy market have led to doubts about the staying power of this year s surge by EM equities. We believe this view overlooks stabilizing local currencies, differentiation among national economies, the long term potential of developing regions, and continued attractive valuations. A look at the recent past may explain why some are hesitant to embrace the recent strong returns among EM names. Much of 2015 s poor performance was tied to weakening local currencies. Among the hardest hit were energy producing countries that faced a one two punch of lower crude prices and higher debt servicing costs. Brazil highlights the challenge. During 2015, the Real was off more than 45% versus the U.S. dollar. At the same time, oil, the country s third largest export, remained well below historic averages. The combination was painful for investors with the major Brazilian market down 13.3% in local terms and nearly 42% on a dollar denominated basis. The country appears to have turned a corner and the free fall has abated even as crude prices remain volatile. Brazil s steady currency has been a boon for investors. The Real has firmed and many investors also sense that its Finance Minister has room to step in to quell inflation. The benign situation has led to greater interest in the region and the Bovespa Brazil s primary stock exchange is up 37% in local denomination and 67% in U.S. dollar returns through the first eight months of the year. We believe other emerging countries will continue to benefit from a similar dynamic. Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 Stabilization is a growing theme in developing markets and has shown signs of resiliency. As the chart shows, EM currencies weakened significantly in 2015 on fears of U.S. rate tightening. However, when expectations of higher rates ticked up in spring, the reaction was muted. Stronger local currencies can keep inflation in check and provide more flexibility for policy makers to spur growth domestically. Beyond the BRICs Skeptics of current EM strength note that mature markets are laboring under a low or no growth environment. As a result, commodity demand could remain sluggish and upside potential for exporters may be limited. We acknowledge growth in developed markets is tepid, yet believe the strength of local consumers in budding regions is being overlooked. Exporters Brazil, Russia, India, and China (BRIC) remain dominant among emerging economies, but opportunities are widespread and less driven by commodity producers. For example, Stock Spirits Group PLC (STCK LN), a leading branded spirits player in Eastern and Central Europe, is a top 10 holding in our portfolio and has been a significant contributor as it has been able to maintain margins in a highly competitive space. The company is indicative of our EM exposure, which is diversified among sectors and lacks direct Energy exposure. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 As currency erosion subsides, the chart illustrates how consumers from Thailand to Indonesia are showing early signs of opening their wallets. While the uptick in spending may not make a meaningful impact to economic data, the increased sales can be significant at the company level and should benefit active stock pickers. A Long Term Case Recent strength aside, we have long been constructive on emerging markets due to a combination of population growth and improved standards of living. In developing economies, the middle class is growing rapidly. More young adults are moving to cities, entering the industrial work force, earning higher wages and enjoying access to an array of consumer goods and services. The world s middle class population numbered 1.8 billion in 2009.* By 2030, it s estimated to rise to almost 4.9 billion a 160% increase in just 21 years.* As this development progresses, the number of middle class consumers will expand dramatically, increasing their share of total global spending. The expanded purchasing power of more people earning higher wages can drive growth. This trend is benefiting companies in a number of industries where valuations are reasonable, including automotive, aerospace, and rail stocks. Auto manufacturers and parts suppliers stand to gain as more consumers can afford to purchase cars. In China size and population are creating opportunities for airplane manufacturers, particularly those making aircraft that are suited to the country s domestic travel market. Similarly, less affluent residents are contributing to stronger rail passenger traffic, and rising volumes of goods being produced and shipped are increasing freight traffic levels. Selling at a Discount Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 While we believe the recovery in emerging markets has staying power, for prudent investors, the group only represents an opportunity if stocks are trading at compelling multiples. As the chart shows, valuations are attractive even when adjusted for cyclicality of the business environment. At less than 10x on a cyclically adjusted Price/Earnings ratio, the group is trading at levels not seen since the tech crisis of the early 2000s. The valuations are noteworthy, because in the years following the last time these diminished levels were reached, emerging markets had a sustained run. Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

5 Disclosure: *Kharas, H. (2010), "The Emerging Middle Class in Developing Countries," OECD Development Centre Working Papers, No. 285, OECD Publishing, Paris. DOI: Past performance does not guarantee future results. The statements and opinions expressed in this article are those of the presenter(s). Any discussion of investments and investment strategies represents the presenter s views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change. Investing involves risk, including the potential loss of principal. There is no guarantee that a particular investment strategy will be successful. Value investments are subject to the risk their intrinsic value may not be recognized by the broad market. Foreign investing involves special risks such as currency fluctuations and political uncertainty. Sector and Industry classifications as determined by Heartland Advisors may reference data from sources such as FactSet Research Systems, Inc. or the Global Industry Classification Codes (GICS) developed by Standard & Poor s and Morgan Stanley Capital International. As of 6/30/2016, Stock Spirits Group PLC represented 3.04% of the International Value Fund s net adjusted assets. Portfolio holdings are subject to change. Current and future holdings are subject to risk. Robert C. Sharpe is a registered representative of ALPS Distributors, Inc. The Heartland Funds are distributed by ALPS Distributors, Inc. Definitions: CRB Commodity Index (Thomson Reuters Core Commodity CRB Index): is a commodity futures price index consisting of 19 commodities using an arithmetic average with monthly rebalancing. Consumer Price Index (CPI) is the most widely used measure of consumer price inflation. The CPI measures the average change over time in the prices paid by urban consumers for goods and services. The Bureau of Labor Statistics (BLS) of the U.S. Department of Labor collects the CPI price information and calculates the CPI statistics. Cyclically Adjusted Price/Earnings Ratio (CAPE): of a stock is calculated by dividing the current price of the stock by its real per share earnings over a 10- year period to eliminate fluctuations in net income caused by variations in profit margins over a typical business cycle. Real Rate of Return: is the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects Heartland Advisors heartlandadvisors.com Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.

6 HLF5445/0917 Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.