David Riedel: Emerging Markets Entering the Third Phase

David Riedel: Emerging Markets Entering the Third Phase The First Phase was led by manufacturing exporters and the Asian Tigers. The Second Phase was led by commodity producers, easy money and China. The Third Phase is being led by infrastructure and consumer markets, youthful demographics, and strong domestic fundamentals. www.riedelresearch.com 1 Copyright All Rights Reserved.

Historical Perspective: The Three Phases of Emerging Markets Investing The fallout from the collapse of the US and G10 financial markets and the ensuing economic recession of 2009 will result in a tepid and uneven recovery in developed economies and consumption patterns. This slow recovery will provide negative headwinds for developing economies that remain overly-reliant on export growth or on narrow commodity bases. The global recovery will, however, be strong enough to allow for strong investment returns and out-performance by developing countries with strong fiscal positions, growing domestic consumer markets, low leverage, positive demographics, and scale. We believe that the Emerging Markets have moved through two discrete investment phases and are now entering a third. The first was led by manufacturing exporters and the Asian Tigers. The second was led by commodity producers, easy money and China. The Third Phase is being led by infrastructure and consumer markets, youthful demographics, and strong domestic fundamentals. What makes the Third Phase different and especially intriguing from an investment viewpoint is our belief that Third Phase Emerging Markets will out-perform both Developed equity markets and other Emerging Markets. Index-based ETF s and other traditional investment vehicles remain grounded in Second Phase approaches and may not be well-positioned to capture this new out-performance. Country and index funds are too heavily weighted to mega-caps and can be overly weighted towards one commodity sector (Russia and oil and gas) or companies that rely on trade with G10 economies or sectors (India and US I.T. spending). These funds do not properly reflect the Third Phase domestic growth of emerging economies and their consumer markets. Artificial and overly simplistic regional investment themes, such as the BRIC concept, lump together widely disparate economies with widely diverse fundamentals and growth drivers. These also fail to capture the essence of the Third Phase consumer, infrastructure and demographic story. 2

Historical Perspective: The Three Phases of Emerging Markets Investing (cont d) Choosing winners and losers in these sectors now requires indepth fundamental research grounded in local intelligence and deep company insight, rather than overly-broad index, regional or country approaches. As an example, the Van Kampen Emerging Markets Unit Investment Trust, for which Riedel Research acts a paid advisor, uniquely combines Riedel s proprietary, independent, on-the-ground company and sector intelligence with strategic macro analysis. Starting with local intelligence, we factor in relative growth, trade, currency and market risk, to create the optimal portfolio for the Third Phase of Emerging Markets investments. Phase One: 1980 s late 90 s: Manufactured Exports Phase One of investment in Emerging Markets was driven by the boom in manufactured exports and exporters, led by what became known as The Asian Tigers. The successful transition by Taiwan and Korea from low-value-add to high-value-add exports (the move from Toys to Computer Chips) focused attention on other countries Thailand, Malaysia, Indonesia - as the next phase of Tigers. From 1985-1995, in fact, the fastest growing economy in the world was Thailand, with a Compounded Annual GDP Growth Rate of 10%. Overinvestment predictably led to a bubble in capacity and real estate which led to the collapse of the Thai baht in 1997 and the Asian crisis of 1997-1998. Phase Two 2000 s: Commodity Boom As China s economy started to grow quickly and dominate global manufacturing, demand for raw materials and commodities exploded. Growing populations, an emerging consumer class, changing diets, and an infrastructure and real estate boom all contributed to increased agricultural, energy, and materials demand. Oil, iron ore, steel, coal -- in short, all commodities -- boomed in the 2000 s. A flood of easy money and leverage fueled a synchronized global economic and asset price boom. Emerging Market beneficiaries included oil producers and commodity producing frontier countries, despite limited infrastructure and markets. EM Indexes (like Brazil) that tend to be very heavy on commodities did exceptionally well. The collapse of the US credit market and economy brought Phase Two to an end. Phase Three 2010s: Domestic Demand and Consumer Demographics After the crash of 2008 investors questioned the advice they had been given about international and Emerging Markets investing. Indices that were supposed to reflect budding, resilient emerging economies collapsed along with G10 assets and commodity prices. Indices, however, are based on models, and in the case of Emerging Markets we believe that most do not accurately reflect Third Phase economies. As investors began to feel less panicked about the global financial system, Emerging Markets were the first to recover. In fact, the IMF now forecasts Developing and Emerging Economies to rebound from a 1.5% GDP growth rate this year to 4.7% in 2010, with Asia clipping along at 7%, as opposed to a slim 0.6% for the mature, Advanced Economies. The beneficiaries of this Third Phase will be countries with diverse and dynamic domestic economies, less reliance on G10 trade and commodity exports, and strong internal demographics, with economic systems that can fuel strong infrastructure and consumer spending. The beneficiaries of this Third Phase will be countries with diverse and dynamic domestic economies, less reliance on G10 trade and commodity exports, and strong internal demographics, with economic systems that can fuel strong infrastructure and consumer spending. We expect developing markets that have demographic characteristics closer to mature markets (e.g. Eastern Europe), to under-perform those with more classic Emerging Markets consumer demographics (India, Indonesia, Brazil). We expect infrastructure and domestic consumer sectors to outperform export-oriented companies and sectors, with commodity sectors falling in between, as commodities continue to rise due to long-term supply and demand fundamentals, but at a slower rate than last decade s liquidity-fueled run up. 3

Emerging Markets: The Third Phase The Aftermath: Ongoing Challenges for Developed Markets In Developed Markets, the most significant changes will include: A more risk-averse consumer with higher savings rates A larger public sector with greater social security cost to the economy resulting from an aging population Large fiscal deficits that will require continued higher tax rates A more regulated, less leveraged, and less productive financial sector A less profitable, higher taxed corporate sector that will be slower to re-hire The second half of 2008 witnessed a massive sell-off in Emerging Markets, dragged down by the global financial markets crisis, de-leveraging, economic recession, and a collapse in US and G10 markets. The severity and global extent of that sell-off disproved many over-simplified theses of a total decoupling of emerging economies from developed markets, and reinforced the continued vital significance of global trade, credit, and capital market linkages. Yet contrary to the crisis of 1997-8, which resulted from the effects of developing countries imbalances, irrational currency regimes, and too much capital flow being diverted to the US and G10, the crisis of 2007-8 resulted from a very different perfect storm : the massive bubbles, imbalances, and lax regulatory regimes in the US and the developed world, spreading out to infect an overstretched but still reasonably healthy global economy. The US, UK, and to a lesser extent the Eurozone have thus had to embark on massive, unorthodox quantitative easing policies to save their financial sectors, and are looking at major overhauls to their regulatory systems to curtail excess risk-taking. That will impact their economies and financial health for years to come. We are firm believers in the resilience and strength of the largest economy in the world, the US economy. Yet we believe that the impact and the responses to the extreme boom and crash of the last decade that is being rightly or wrongly - compared in magnitude to the seismic shock of the Great Depression of the 1930s, will leave the US with an economy and markets that are closer to the slower-performing mature economies of Europe and Japan than to the fasterpaced economies of the rest of the world. And while there may be new areas of technology and growth that emanate from this cycle (alternative energy, for example), given the strides in global education and the young and growing populations around the world, the sources and benefits of even such innovation will likely be more dispersed, spreading more rapidly than in the past. 4

Emerging Markets: The Third Phase The Aftermath: Emerging Markets Enter the THIRD PHASE Having learned their own painful lessons from the 1997-98 crisis, the major emerging countries, with the possible exception of some newly opened eastern European economies, find themselves with less risky public and private sector balance sheets, huge accumulated reserves, and a consumer sector and capital markets that are substantially less leveraged to the US mortgage and derivatives meltdowns than many so-called developed economies. They thus require far less drastic adjustments. Nevertheless, because of the severity of the correction in global markets and the severity of the credit crisis that shocked many of these economies, Emerging Market policy makers do need to focus on the factors that they can control domestic activity and demand. While policy makers around the world could not control Lehman Brothers or Bear Stearns, they can institute policies that will impact demand within their own borders. The Chinese stimulus plan is one way this has been put into practice. As compared with the US style of blanket fiscal spending, the Chinese stimulus has sought to encourage spending through a targeted campaign to convince people that their social safety net is in place and solid. This will allow them to be more confident in spending rather than saving for retirement, health care and so on, and will keep the spending focus in the consumer sector rather than shifting the burden inordinately to the public sector. Other ways these consumer stimulus policies have been implemented include adjustments in taxes and tariffs on certain goods (white goods, for example, in Brazil recently, and adjustments to taxes on auto sales in India and China). Healthcare, education, internal commerce and productivity are all sectors that Emerging Markets policy makers can positively impact and stimulate. Not every country, however, is going to be impacted in the same fashion by domestic consumer stimulus measures. What We LIKE: Large, young, growing populations & markets Diverse, dynamic domestic economies that can accommodate investment in infrastructure and have low-hanging fruit for productivity enhancements Less reliance on external funds & trade Healthy country balance sheets What We DON T LIKE Aging populations Dependence on one commodity or product Heavy reliance on external trade, especially with G10 Unhealthy country balance sheets 5

Emerging Markets: The Third Phase Van Kampen Emerging Markets UIT: Portfolio Structure Beyond BRIC Investors have been badly served by so much focus on BRIC countries. Not only are they not homogeneous, but they are not the only places to get good Emerging Markets exposure. Indonesia, Turkey, Poland and South Africa are among the countries outside the BRICs which present extremely interesting investment opportunities. Russia is a classic example of what we DON T like: Dependence on one product oil / gas Aging, shrinking population Index totally dominated by oil / gas Considerable politicization of business (Yukos, BP, Gazprom) China, India and Brazil are good examples of what we DO like. Investors have been badly served by so much focus on BRIC countries. China s large population means that even a small improvement in consumer spending can have a huge impact in offsetting their relatively heavy reliance on exports. On the negative side, China s population is aging rapidly. India has a large, young and growing population with an established consumer culture. On the negative side they do not have a large tax base and therefore find it difficult to fund the investments needed to improve their economy. Brazil has a large population, a strong country balance sheet and low-hanging fruit for productivity enhancements (improved infrastructure and greater integration of the various regions of the country) 6

Emerging Markets: The Third Phase Putting it All Together While far from immune to the enormous recent downdraft in global wealth, confidence, consumption, and trade triggered by the collapse of the US credit market and economy, the emerging equity markets have been, with good fundamental reason, both later to fall and earlier to recover than developed markets. This out-performance, along with active currency markets, reflects a rebalancing of capital flows from developing to Emerging Markets that captures a new reality in fundamental and longer-term relative growth. We firmly believe that due to changes in infrastructure, capital markets, economics, and demographics, the out-performance by Emerging Markets will continue, even in down-to-sideways markets. We believe that the Third Phase of Emerging Markets investment will look substantially different from the first two. Out-performance by Emerging Markets will continue, even in downto-sideways markets. Investment strategies will need to be more selective and more heavily researched from macro, sector and company levels, to be successful. Third Phase strategies cannot rely on simple country, sector or index asset allocations that, in the final analysis, lump together investments with widely divergent profit potential, exposures and risk profiles. The Riedel Approach: PHASE THREE INVESTING 1. Pick strong stocks with good macro tailwinds not indexes 2. Focus on local consumer and local infrastructure 3. Follow government announcements and policies, combined with onthe-ground company and sector intelligence ABOUT RIEDEL RESEARCH Founded and managed by David Riedel, we provide portfolio advisory and management services, independent equity research, and country intelligence on Emerging Markets. Riedel professionals operate both at a macro level and on the ground, creating company reports, analyses, earnings models and projections. Contact us at www.riedelresearch.com. 7