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Russell Hoss, CFAManaging Partner

Richard Hoss Managing Partner January 13, 2014 Neil Dorrel, CAIA Managing Director

SELECTIVELY OPTIMISTIC: 2014 OUTLOOK The Year of the Taper History may view May 22’s Federal Reserve testimony as the defining moment of 2013 for emerging market economies. This is when Chairman Bernanke stated that the Fed “could take a step down in our pace of purchase,” referring to the beginning of the end of quantitative easing1. A step down in treasury purchases led to more expensive debt, which in turn led to weakness in emerging market. Importantly, more expensive debt plays an integral role in our 2014 outlook. The search for yield A decade of historically low interest rates was conducive to a broad-based economic boom for emerging markets. These countries saw capital inflows from developed markets as low interest rates in the US implied unattractive returns on cash. This global search for yield resulted in high emerging market country and security correlation. In other words, emerging equity markets and currencies generally rose in lockstep, despite significant differences in economic merit. The beginning of taper = the reversal of broad-based flows While a reduction of QE from $85B to $75B sounds small in the grand scheme of things, it’s the change at the margin that is important. Chairman Bernanke has instituted three quantitative easing programs: QE1, QE2, and QE3 (commonly referred to as QE∞). If QE∞ is reduced to $75B, then ∞ minus $75B is a staggering number. Either way, a material reduction in treasury purchases and the resulting higher U.S. yields encourage a reversal of the broad-based flows to emerging markets of recent years. The natural consequence is weakness in these markets and currencies as witnessed over the summer of 2013. Increased country dispersion and a return to fundamentals Our expectation is for emerging markets to return to fundamentals in 2014. A lack of differentiation in past years has now opened up opportunity as well as risks for the world’s developing countries. As the large exodus of less durable capital flows has likely finished, we expect the next evolution to be substantial country dispersion within the emerging market category. There will be winners and there will be losers; we expect 2014 to mark this turning point.

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What to look for in 2014 The countries that demonstrate favorable economic balance, implement meaningful reforms, and continue to invest in production and infrastructure will likely be the winners of 2014. The last decade was a rare opportunity for emerging regions to use accommodating external conditions in order to make real economic and political progress. Some countries have started the process while others have taken the era of easy funding for granted and remain stagnant, squandering the opportunity to effect structural change with the surpluses of the commodity boom years. We believe the winners of tomorrow will be those countries that understand the implications of higher external funding costs and can adjust accordingly. Integral to our investment process, our 2014 country outlook is based on our scorecard system, which ranks countries on a -3 to +3 scale. For 2014, our scorecard overweights the following three categories: economic balance, reforms, and investment. Please contact us for more detailed discussion of our current scorecard pertaining to emerging market countries.

REGIONAL OUTLOOK: ASIA Our 2014 outlook for Asia is mixed. Developed Asia is well positioned to benefit from strengthening exports to developed markets while emerging Asia faces structural headwinds including unbalanced economies that need to be addressed through policy and fiscal reforms. China has the most ambitious reform package, but many investors seem convinced that implementation will be slow. Elections in Thailand and Indonesia may prove to be positive catalysts if the newly elected leaders are able to navigate an environment of weaker currencies and rising rates. We expect wider economic and equity market dispersion in 2014, requiring investors to be selective and prudent in building equity portfolios. Economic balance Those countries with well-balanced economies and strong export sectors – notably South Korea and Taiwan – outperformed less developed peers as the U.S. and European economies recovered in 2013. Meanwhile, emerging Asia (excluding the Philippines), struggled as currencies weakened, sovereign rates rose, and growth slowed. While each country faces its own set of challenges, the way in which a government reacts to a global economy led by a stronger US dollar and tighter global liquidity will be a central theme to equity market returns in 2014. South Korea and Taiwan are benefiting from recovering export sectors primarily due to economic strength of the U.S. and Europe. Stronger exports result in a current account surplus which acts as a buffer to a rising U.S. dollar. Furthermore, capital flows that were attracted to high growth in emerging Asia have now reversed and are headed to the region’s more mature economies. Thus equity market returns of South Korea and Taiwan, when currency adjusted, significantly outperformed Indonesia and Thailand last year. We expect this trend to continue, at least in the early part of 2014.

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The key to stronger returns in 2014 will be whether or not Thailand and Indonesia can right the ship. The countries each face different challenges – unbalanced economic growth in Indonesia where the current account deficit ran 3.8% of GDP in Q31, and a cyclical slowdown in Thailand that is exacerbated by political turmoil. The potential positive catalyst is the same, however – elections in 2014. If newly elected governments can regain confidence and focus on reforms that rebalance the economies, we may see meaningful upside risk for equity investors. Reforms Reforms will play a key role in determining equity market performance in 2014. Undoubtedly, China has introduced the most comprehensive and ambitious reform package in Asia. However, there is plenty of skepticism as the timing and priority of the reform package remains unclear. Making the situation more challenging, economic growth in China is slowing again after a brief pick up in the summer of 2013. Investors are now weighing the benefits of potentially positive growth enhancing reforms versus an economy that continues to slow. We feel more optimistic than most investors, as we see valuations as discounting the negative growth story, while not fully discounting the positives from the reform package. In emerging Asia, the Philippine government has been the most successful in implementing needed change over the past several years. As a result, the Philippine economy was the strongest in emerging Asia in 2013, with a growth rate of 7.0% in the third quarter2. While we see some deceleration in 2014, the investment cycle is in full swing and should provide a buffer against its weaker neighbors. In Thailand and Indonesia, we don’t expect much progress due to pending elections in 2014. However, investors would likely cheer loudly if a blueprint emerges for future reforms from the new governments, which we expect in the second half of 2014. As for India, we remain dissuaded given a terrible track record over the last decade, stubborn inflation of 7.52%3, and balance of payments challenges. Investment There is no universal prescription for investment spending in Asia. Historically, China has overinvested in infrastructure while emerging Asia underinvested for many years post Asian Financial Crisis of 1998. Our view is that countries matching investment requirements with expenditures are likely to benefit in 2014. In China, investment is not required in infrastructure, but instead is sorely needed to improve global competitiveness of its exporters and to offset rising costs of its domestically oriented companies. As wages and other costs have increased significantly over the past several years, operating margins at Chinese companies have been negatively impacted. We foresee needed investment in productivity-enhancing areas – such as automation in manufacturing and supply chain software in retail -- to be a predominant focus of companies in China. Those companies that can demonstrate

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productivity improvements through rising operating margins are likely to be rewarded by investors. Then there is the allure of Chinese consumer spending, which is perhaps the single most tantalizing inducement to invest: more than half of all Chinese urban households, for example, will be solidly middle class by 2020, up from 6 percent in 2010.4 In South East Asia, investment is required in basic infrastructure including transportation, energy, telecom, and housing. We expect broader infrastructure spending in Thailand and Indonesia to slow in the first half of 2014, but reaccelerate after the elections. Thailand has a meaningful infrastructure plan in place, but without a government to approve projects, spending is likely to slow until after the election. Indonesia sorely needs to jump-start its infrastructure plan, which may also happen after its elections. Our baseline case is a slow first half of 2014, but accelerating infrastructure spending in Thailand and Indonesia in the second half, a scenario which may reward equity investors.

REGIONAL OUTLOOK: LATIN AMERICA Our 2014 outlook considers a lower growth profile for the region when compared with the last decade. A beneficiary of the commodity super-cycle, Latin America is now facing flat to falling commodity prices, revealing economic imbalances. While not insurmountable, 2014 will demonstrate that economic growth models need to be revised through reforms and investment. Some countries, however, have already gotten started. Economic balance Commodity cycles can be considered both a blessing and a curse. During high and rising commodity prices, the country of supply finds itself with high demand for its resources, driving foreign inflows, a strengthening currency, and the likely extension of leverage to its population. Once commodity prices decline, the country faces an economy too dependent on resources that are falling in value, its currency too strong for other exports to be competitive, and its citizens overleveraged. This generally describes our outlook on Latin America and is particularly applicable to economies with significant dependence on mining, such as Chile, Peru, and Brazil.

Mexico, on the other hand, did not enjoy the tidings of the commodity super-cycle to the same degree as the rest of Latin America. While still rich with natural resources, Mexico’s economy is mostly driven by value-added processes, such as manufacturing. Furthermore, Mexican manufacturing has recently become more competitive due to rising labor costs in China. Coupled with low debt and a small current account deficit, Mexico has among the best economic balance in the region. This is not to imply that Brazil and the Andean region are headed for crisis. Instead, we expect the currencies of these countries to weaken; restoring balance to these

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economies. With a weaker currency, Brazilian and Andean consumers will lose some purchasing power, but exports should gain some global competitiveness. We fear the situation in Argentina. Recently, the administration has moderated on certain issues – such as the YPF nationalization and the ongoing negotiation with holdouts from its 2001 sovereign debt restructure -- and combined with expectations for a new administration in 2015, this has contributed to the largest equity rally in Latin America. However, our view is that the moderation is forced by the severe economic imbalances in Argentina, rather than an administration that admits to mishandling national issues and commits to making changes. Reforms Mexico has led the way with positive policy changes in 2013 – 2014. President Peña Nieto masterfully handled a long list of insightful reforms, passing them with minimal disruption and maximum impact. While all are meaningful, the most significant is the inclusion of concessions in the Energy Bill that allow private sector investment for the first time since 1938. While we certainly don’t expect the same progress in 2014, we expect the positive sentiment surrounding the reforms to remain. Brazil, on the other hand, desperately needs reforms. The cost of doing business in Brazil continues to be high, rated 116th out of 189 economies by the World Bank.5 Its infrastructure is decrepit, its tax system dizzying, and the government’s influence in markets unnerving. But with 2014 being an election year, we do not expect unpopular but necessary reforms to gain any traction. As for the rest of Latin America, we are not expecting substantial progress on positive needed change. In Chile, there may be some populist-oriented reforms by newly elected President Bachelet, but nothing that we see as either significantly favorable or detrimental. Investment A key driver to future emerging market dispersion is investment in productivity. Investment can take place in myriad ways, be it infrastructure, education, technology, or country-unique sectors. Those countries that develop and diversify competitive advantages should fare better in a future world of tighter liquidity and lower growth. With Mexico’s reform agenda, we expect to see significant investment in infrastructure, manufacturing, and energy. Government estimates for the country to increase crude production from 2.5 million to 4 million barrels per day will require a meaningful investment cycle, with current estimates that the energy sector will add 1% to GDP by 2018 6. Oil revenues of 2% of GDP per year are estimated by the government, which will drive both energy and non-energy related investment spending.

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Brazil’s outlook for investment remains clouded. Both positive and negative headline news for the 2014 World Cup and 2016 Olympics forces the government’s hand in infrastructure investment. Brazil has auctioned airports to private consortiums, which we consider a positive move. The country has also incented exporting companies through favorable tax treatment and local content requirements. Lastly, the government has encouraged higher education by providing advantageous funding programs. However, one-step forward seems to be followed by one-step back in Brazil, as the government’s other investment programs are counter-productive, such as the large social housing support, consumption tax breaks, and onerous business taxes. The Andean region generally has a favorable outlook for investment with a history of >20% investment to GDP7. Colombia and Peru currently have ambitious infrastructure programs in place that should improve each country’s productivity. Chile requires less infrastructure, but could use more diversification of its economy. Conclusion As emerging market investors, our goal is to invest in those countries that will one day be developed markets while avoiding those countries that are chronically emerging. When one looks at the landscape for investing, there is reason to be selectively optimistic in 2014. It must be mentioned in the same breath that pitfalls exist, and that emerging markets investing can also be fraught with peril. Now more than ever, it is crucial to begin with a keen eye toward specific country factors at a macro level. We believe that volatility in currencies and great dispersion between countries is part of the new normal in emerging markets investing. With that perspective, one can understand that an approach based upon an index rather than an informed view of the world is fundamentally flawed. Investing in the BRIC economies was a formula that worked for much of the century’s first decade, but we believe the growth drivers have changed and will continue to do so. We remain bearish on Brazil and India, and wouldn’t even consider an investment in Russia. We are long term believers that the China growth story is intact, albeit with an evolution that is taking a new path. We are also quite bullish on Mexico, believing that they are moving toward fulfilling the promise that was always there. And we believe that certain of the Southeast Asian economies are poised to be great investments, though timing is less certain here. In summary, we believe that the case for emerging market investing is strong, but that care must be taken in execution. God is in the details, as the saying goes. In the short term, we are at an inflection point. Change is in the air, with few clearly compelling themes. We may be at the end of major commodity cycle that has driven growth for so long, though industrialization across Asia rather than a mass export boom will see stead but moderate demand for fuel and raw materials. Over the next decade, two themes will reshape the developing world: the emergence of the consumer class in these

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countries, and a rise in productivity. Those countries that understand this and wisely enact policies to attract foreign investment will be the winners in this game, while others will continue to be mired in the same fragile predicament that has stunted their prosperity. The biggest companies won’t be the best way to access the promise of the developing world. And great stock picking alone won’t be enough either, as the stiff headwind presented by negative macro factors will be hard to overcome if the country allocation is wrong. But to those who can manage to get the country, sector, and stock elements mostly right, the reward can be compelling. 1. U.S. Federal Reserve, FOMC, 2013 2. Bank Indonesia, Current Account, November 2013 3. Republic of the Phillipines Statistics Authority, Press Release, Philippine Economy posts 7.0 percent GDP growth in Q3 2013, November 2013 4. Indian Ministry of Commerce and Industry, Wholesale Price Index Third Quarter 2013, November 2013 5. McKinsey & Co, Winning the $30 Trillion Decathalon, July 2012 6. The World Bank, Doing Business 2014, January 2014 7. World Economic Forum, Global Energy Architecture Performance Index Report 2014, December 2013 8. BNAmericas, 3rd Andean Infrastructure Summit, March 14, 2013