CIO REPORTS
The Monthly LetterThe Chief Investment Officer Team • JULY 2013
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Emerging Markets—Time for a CHANGEEver since the creation of the BRIC (Brazil, Russia, India, and China) acronym, investors have been aware of the opportunities inherent in investing in Emerging Markets (EM). However, the meteoric performance of BRIC markets between 1999 and 2007 (see Exhibit 1) and the subsequent realization that many EM have already “emerged” now has investors looking for new go-to buzzwords to invest in. We believe the most important buzzword investors should take into account when considering the next phase of EM investment is CHANGE.
In this CIO Monthly Letter, we discuss the fundamental change in many EM from a decade ago and explain why this
reduces the likelihood of a repeat of the 500 percentage
point outperformance of EM relative to the developed world
seen from 2000 to 2007. We explain our preference for
allocating to smaller EM (as well as frontier markets) within
portfolios. We discuss our economic and market views for
the four BRIC countries and explore where opportunities
lie within the BRICs. Last, we show how the investment vehicles have also changed, demonstrating how passively
allocating to broad Emerging Market vehicles now over-
allocates to large, in our view worse-performing economies
and under-allocates to smaller, better-performing and under-
owned ones, and why actively managed funds represent a
more effective strategy going forward.
Our bottom line is that investors should consider an allocation to smaller emerging and frontier markets as these countries have better return prospects when compared to BRIC or larger EM, in our view. Implementation-wise, we believe investors should focus on non-benchmark constrained, flexible active managers that have an allocation to smaller EM and frontier markets as part of their exposure to EM growth.
How EM has CHANGED over the last decadeIn response to ongoing demographic pressures, many large
emerging economies, especially China, are undertaking
an economic transformation, shifting from exports and
infrastructure to consumption as the principal driver of
growth. We believed investors would generally tolerate
such a change. Following two years of underperformance
by EM from 2011 to 2012, we were becoming more
optimistic about the prospect of a rebound in Chinese and
EM equities toward the end of the first quarter this year,
advising investors to re-focus on opportunities that we
expected to develop around the middle of 2013. Instead,
as Chinese and EM economic data further disappointed,
monetary and fiscal policy remained tighter than
BRIC Markets Developed Markets
0
100
200
300
400
500
600
700
800
1999 2000 2001 2002 2003 2004 2005 2006 2007
Exhibit 1: BRIC markets significantly outperformed between 1999-2007...
Source: Bloomberg, IMG
CIO REPORTS • The Monthly Letter 2
anticipated, political risks rose and profit margins fell, EM (and in
particular Chinese) equities have performed far worse than we had
hoped (see Exhibit 2).
The change in the fundamental growth outlook and collapse in
profit margins has pushed us to revisit the medium-term outlook
for EM, which has been downgraded in recent quarters, reflecting
weaker domestic conditions and tighter financial conditions
following the rise in U.S. interest rates (see Exhibit 3). Questions
are being raised as to how much of this slowdown is cyclical or
structural in nature. We believe that it is a combination of both
cyclical (e.g., lower exports and tighter monetary policy) and
structural factors (e.g., lower productivity growth and less favorable
demographics). Even as cyclical factors begin to improve into 2014,
such as a pick-up in global trade, the growth rates of many larger
emerging economies will be lower due to the structural changes
underway. Overall, the potential growth rates in many of the larger
EM are on a downward trend (see Exhibit 4) from their heights, and
we don’t see this trend reversing anytime soon.
As a result, we do not believe there will be a repeat of the 2000-
2007 outperformance in the coming years. Essentially, this
outperformance was a combination of a rising share of global
gross domestic product (GDP), high corporate profitability and
improving corporate balance sheets, extremely favorable starting
valuations, and improving fundamentals throughout the emerging
block. Some of these fundamentals included reduced external
debt, rising foreign reserves, a build-up of current account
surpluses (see Exhibit 5), and declining and negative real interest
rates (largely driven by falling real interest rates in the U.S., see
Exhibit 6 on the next page).
BRIC Markets Developed Markets China
75
80
85
90
95
100
105
110
Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13
Exhibit 2: ...but have been disappointing year to date
Source: Bloomberg, IMG. Data as of July 2013
Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Exhibit 3: Financial conditions in EM have tightened
Source: BofA Merrill Lynch Global Research, IMG. Data as of July 2013.
2003200119991997 2005 2007 2009 2011 2013
KoreaChina
South AfricaIndiaMexico
PolandGEM-10Turkey
IndonesiaBrazilRussia
-5-3-113579
111315
Exhibit 4: Potential growth rates for big EM have peaked
Source: BofA ML Global Research, IMG
Current Account Balance (% of GDP) External Debt (% of GDP, Right)
20
25
30
35
40
45
-4 -3 -2 -1 0 1 2 3 4 5 6
1999 2002 2005 2008 2011
Exhibit 5: EM external debt and current account positions improved in early 2000s
Source: IMF, IMG. Data as of end 2012.
CIO REPORTS • The Monthly Letter 3
EM companies benefited during the boom as well. Profit margins
grew, corporate leverage was declining, and return on equity (ROE)
was rising (see Exhibit 7). With EM equities trading on attractive
absolute and relative valuations to the developed world in 2000,
the improvement in economic and corporate fundamentals drove a
relative re-rating of the EM bloc (see Exhibit 8).
The structural advantages noted above have to a large degree
been exhausted by emerging economies. As can be seen in Exhibit
9, GDP growth rates are lower post-crisis, and fiscal positions have
begun to reverse. As Exhibit 5 on the previous page shows, current
account surpluses are now declining, too.
Furthermore, as U.S. real Treasury yields begin to rise as the
U.S. Federal Reserve (Fed) unwinds its unconventional monetary
policies and eventually raises interest rates, EM real interest rates
are likely to follow. On the corporate side, profitability and ROE
has been on a declining trend since the financial crisis as excess
capital has flowed to less productive investments.
With some of the previous supports turning into potential
headwinds, doomsayers argue that the disappointing returns from
EM assets over the past two years are set to continue. We see
merit in some of the arguments made. However, not all of the tail
winds will turn into headwinds. For example, lower credit creation
and higher real interest rates should allow for higher future ROE
as unprofitable companies go bust. External debt positions and
reserves should continue to remain strong, which should mitigate
the likelihood of a balance of payments crisis in turn potentially
reducing the volatility of emerging economies’ foreign exchange
(FX) rates.
Emerging Markets U.S.
-1
0
1
2
3
4
5
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Exhibit 6: Declining real interest rates spurred economic growth
Source: BofA ML Global Research, IMG. Data as of July 2013.
EM Margins EM Return on Equity EM Leverage
35%
40%
45%
50%
55%
60%
65%
70%
75%
4
6
8
10
12
14
16
18
20
2000 2002 2004 2006 2008
Exhibit 7: EM corporate fundamentals improved between 2000-2007
Source: Datastream, BofA ML Global Research, IMG
Emerging Markets Developed Markets EM relative to DM (Right)
0.4
0.5
0.6
0.7
0.8
0.9
1.0
5
7
9
11
13
15
17
19
21
23
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Exhibit 8: EM benefited from starting low absolute and relative valuations (12m forward PE)
Source: Factset, IMG. Data as of June 2013.
Change in Debt/GDP ratio
GDP
Grow
th R
ate
%
0
2
4
6
8
10
-20 -15 -10 -5 0 5 10
2009-20121999-2008
Lower GDP
Worse debt/GDP
EM
Asia
CEE* Latam^
Exhibit 9: Post financial crisis, EM growth rates have declined and debt-to-GDP worsened
Source: IMF, IMG. *CEE = Central and Eastern Europe; ^Latam=Latin America
CIO REPORTS • The Monthly Letter 4
Therefore, we think that writing off the entire emerging bloc disregards many opportunities that still exist. As we have highlighted in our “A Transforming World” communications, the growth of EM, especially the middle class, is one of the largest economic shifts ever experienced. EM already account for more than half of GDP growth and 40% of investment worldwide. Ignoring EM means missing considerable investment opportunities in the world, and in many cases there is still plenty of upside.
Instead of aggregating the bloc as a single investment, focusing individually on country- or sector-specific trends within EM will, in our opinion, provide better returns over the coming years. In our opinion, the days of significant broad re-rating of EM relative to the developed world are behind us as the structural drivers of this re-rating fade, but plenty days of still-healthy returns lie ahead. This will, however, require investors to be more selective and flexible, to not limit investment opportunities to outdated benchmarks, and to focus less on large BRIC markets and more on smaller emerging and frontier markets.
A CHANGE beyond BRICs from an investment perspectiveThe term Emerging Markets covers a broad set of developing countries. Of these, the most
economically and capital-advanced have been classified together to capture the performance of
the whole. (Currently, 21 countries led by the BRICs, Korea and Taiwan are classified as emerging
within the MSCI Emerging Markets Index.) Most Emerging Market fund managers invest within
this grouping of countries. Frontier markets are a subset of smaller emerging economies with less
developed capital markets. These countries are typically not included in EM index funds and are often
not invested in by broad benchmark constrained Emerging Market active managers (see Appendix on
page 12 for country classification between EM and frontier markets).
However, we think many of these smaller emerging and frontier countries represent some of today’s best investment opportunities within the developing world. Many of these economies have high prospective growth rates, large current account and fiscal surpluses and lower public debt than their larger cousins. They trade on undemanding valuations and have improving and deepening capital markets. In many ways, you might say they are in a similar position as EM countries were around 2000.
As Exhibit 10 shows, over the next five years non-BRIC EM are
forecast by the International Monetary Fund (IMF) to grow at the
same rate as their pre-crisis levels while BRIC growth is expected
to go lower than the pre-crisis trend. Additionally, many smaller
emerging economies are under-owned by investors, have relatively
stronger domestic economies, are less vulnerable to foreign
capital outflows, and may also have greater monetary policy
flexibility.
For example, Indonesia and Peru have both seen their average
growth rates since the financial crisis remain above pre-crisis
levels, at the same time their government-debt-to-GDP ratio has
declined. For Indonesia, removing expensive subsidies could free
up public funds to further support growth. Growth in Chile and the Philippines has not been any lower
post-financial crisis and the IMF forecasts both these countries to grow at roughly 5% per year over
BRIC Non-BRIC EM 0
1
2
3
4
5
6
7
8
2000-2008 2009-Present 2013-2018
Exhibit 10: Non-BRIC EM to return to pre-crisis growth rates, unlike BRIC
Source: IMF, IMG. Data as of April 2013.
CIO REPORTS • The Monthly Letter 5
the next five years at the same time their fiscal positions are forecast to improve. A similar story
exists for Colombia. Malaysia has increased investment as a percentage of GDP, which should lead to
an even higher growth rate. Meanwhile, our colleagues in Bank of America Merrill Lynch (BofA ML)
Global Research have highlighted Mexico and Turkey for their potential to become significantly bigger
contributors to global growth. Mexico is also highly integrated into the U.S. economic cycle (mainly
through labor income repatriation and trade), so it should benefit from the ongoing recovery in the U.S.
Better profit opportunities can also be found in non-BRIC economies. Indonesia, the Philippines and
Thailand all have higher ROE than China, although there have been significant fund flows into these
regions, which have caused some re-rating. Many of these regions continue to have strong domestic
consumption stories, selected countries are less vulnerable to foreign capital outflows, and many haven’t
experienced anything like the domestic credit surge seen in China. Mexico, too, has a ROE above 15% and
a low representation in the MSCI EM Index that makes significant fund outflows less likely.
One of our Top 10 Portfolio Actions for 2013 is focused on
frontier markets, the even less-developed economies that
encompass such countries as Qatar, Kuwait and Nigeria. The
universe of frontier markets, as measured by the MSCI Frontier
Emerging Markets Index, is small—less than twice the size of
Apple. This has often deterred investors. But in fact, six (Saudi
Arabia, Qatar, Kuwait, Oman, Nigeria and Peru) of the top 10 of
most resilient economies in the BofA ML Global Research ranking
(which measures important economic indicators such as fiscal
position and current account balance) are frontier markets or
smaller emerging countries (see Exhibit 11). Many of the high-
ranked frontier markets have high prospective growth rates,
favorable demographics, large current account, fiscal surpluses
and lower public debt, trade on undemanding valuations (many trade on discounts to larger EM when
compared to their own history) and have improving and deepening capital markets. Most private
clients are unlikely to have investment exposure to many of those top ranked economies. Again,
though, as can be seen by the fact that several of the lowest-ranked countries are frontier markets,
too, there is a requirement to differentiate within these market classifications, as well.
While most individual investors remain underexposed to these
frontier markets, the global investment community is becoming
more comfortable with allocating to the space as recognition rises
of the relatively stronger growth story there. Year-to-date, global
frontier funds have seen inflows exceeding 40% of their assets
under management, a trend we expect to continue (see Exhibit
12). Within a low-but-improving growth world, opportunities for
higher growth should still prevail, leading the case for frontier
markets. Furthermore, we believe sufficient global liquidity and
the reduction of tail-risks (primarily in Europe and with regards
to the U.S. fiscal cliff) will cause investors to take opportunities
within markets they have previously perceived as being too risky.
Two additional factors, in our view, support the ongoing attraction
0 10 20 30 40 50
Top 10
Bottom 10
LebanonSerbia
UkraineGhana
MoroccoEgypt
SloveniaSouth Africa
JordanCroatia
GabonPeruIraq
NigeriaTaiwanChinaOman
KuwaitQatar
Saudi Arabia
Aver
age
Exhibit 11: Top 10 most resilient economies are dominated by frontier markets
Source: BofA Merrill Lynch Global Research, IMG. Data as of June 2013.
Global frontier �ows, 10-wk ch. (US$m)MSCI Frontier perf. vs. MSCI EM (Right)
Mar-12 Jul-12 Nov-12 Mar-13-50
50
150
250
350
450
550
650
750
98102106110114118122126130134138
Exhibit 12: Investors attracted to frontier markets as performance impresses
Source: EPFR, Datastream, BofA ML Global Research, IMG. Data as of July 2013.
CIO REPORTS • The Monthly Letter 6
of frontier markets. First, several frontier markets will over the next few years be upgraded toward
EM status, leading to significant fund inflows. Second, a growing recognition that frontier markets
are not just commodity dependent or an oil play but actually a good way to get exposure to the
growth of consumers within the developing world should reduce a perceived risk of the region. As
BofA ML Global Research has shown, while the degree to which
commodities drive the economy varies across countries, overall
they are less significant to market performance than people might
realize, with many frontier markets actually outperforming larger
EM during oil price declines.
As Exhibit 13 shows, frontier markets (as measured by the
MSCI Frontier Emerging Market Index) have performed much
stronger than the larger country Emerging Market Index since
the beginning of 2013. Our colleague Michael Harris, EEMEA
Investment Strategist for BofA ML Global Research, currently
recommends an overweight to frontier markets within Emerging
Europe, Middle East and Africa (EEMEA).
BRIC markets outlookChina“ In our discussions with the authorities, they emphasized their intention to embark on a comprehensive
reform agenda that will ensure more balanced, inclusive and environmentally friendly growth going
forward. While China still has significant policy space and financial capacity to maintain stability even
in the face of adverse shocks, the margins of safety are narrowing and a decisive impetus to reforms is
needed to contain vulnerabilities and move the economy to a more sustainable growth path.”1
In previous episodes of economic slowdown, the de-facto policy response of Chinese leaders was
to ease monetary and fiscal policy. This time, however, Chinese officials have broken from tradition.
Under the leadership of new Premier Li Keqiang, financial and monetary conditions have been
tightening so as to reign in the growing shadow banking system and deliver a less credit-fueled
longer-term growth rate. The new policymakers appear to have been more willing to let the economy
slow, focusing instead on reform to support medium-term growth. In retrospect, this tighter policy
stance was more than we had expected. Premier Li has emphasized the need to maintain GDP
growth above a minimum threshold (likely 7.5%), but the tightening in financial conditions and the
clampdown on shadow banking have reduced private sector demand, reducing the likelihood of a
sharp rebound in the economy.
Frontier Markets Emerging Markets Developed Markets
80
85
90
95
100
105
110
115
120
Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13
Exhibit 13: Frontier markets have outperformed EM so far this year
Source: Bloomberg, IMG. Data as of July 2013.
Portfolio Strategy: We believe investors should look beyond BRICs when allocating to EM.
Select, smaller, non-BRIC EM should benefit more from an improving U.S. economy and may
prove less vulnerable to higher U.S. interest rates. Furthermore, we think a focus on frontier
markets, which have performed better than larger EM equities this year, should be included. We
prefer flexible, active managers that are not constrained by BRIC and EM benchmarks.
1 IMF 2013 Article IV Consultation Discussions with China, May 28, 2013
CIO REPORTS • The Monthly Letter 7
As such, expectations for 2013 Chinese GDP have been
persistently downgraded by economists (see Exhibit 14). Ting Lu,
BofA ML Global Research Chief China economist, recently reduced
his forecast for Chinese GDP growth in 2013 and 2014 to 7.6%
each year, from 8.0% and 7.7%, respectively, on the expectation of
weaker exports and slower inventory restocking.
Focusing on equity markets, Chinese equities have had a horrid
2013, down 7% year-to-date in total return U.S. dollar terms
(as measured by the MSCI China Index), underperforming the
S&P 500 Index by over 20 percentage points. Corporate profit
margins too have fallen significantly in recent years (see Exhibit
15) and earnings have trended downwards. The slower earnings
growth can be largely attributed to weaker domestic and global
economies and tighter domestic credit conditions.
Sentiment on Chinese equities has fallen to very low levels (see
Exhibit 16). The good news is low equity valuations (see Exhibit
17) should limit significantly further relative underperformance
from here, in our view. The re-affirmation of Premier Li to not
let growth go below a minimum level and the stabilization in
interbank funding markets has calmed investors and led to a
tactical bounce. As highlighted by our colleague BofAML Global
Research Chief Global Investment Strategist Michael Hartnett,
tactical trading indicators show this bounce may continue over the
short term (see Exhibit 18 on the next page).
For the bounce to turn into a more sustainable uptrend in
China, however, we think we need to see evidence of stronger
profitability from Chinese companies, higher corporate ROE, an
easing in financial conditions and a bottom in the earnings revision
cycle. These indications, combined with attractive valuations,
China Consensus 2013 GDP Growth (%)
7.5
7.7
7.9
8.1
8.3
8.5
Jul-12 Oct-12 Jan-13 Apr-13 Jul-13
Exhibit 14: Expectations of 2013 China growth have been revised markedly lower
Source: Bloomberg, IMG. Data as of July 2013.
China Pro�t Margins (%)2006 2007 2008 2009 2010 2011 2012 2013 9
10
11
12
13
14
15
Exhibit 15: China profit margins have declined in recent years
Source: Datastream, BofA ML Global Research, IMG. Data as of June 2013.
China 12m forward PE
7
9
11
13
15
17
19
21
23
25
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Exhibit 17: Chinese equity valuations almost back to levels of the financial crisis
Source: Factset, IMG. Data as of June 2013.
0 5 10 15 20 25 30 35 40 45 50 55 60Jun-13 Jul-13
In�ation
US �scal tightening
Other* (*please specify)
Failure of “Abenomics”
Geopolitical crisis
EU sovereign/banking crisis
China hard landing & commodity collapse
Exhibit 16: Sentiment on China has declined as investors become more concerned with a hard landing
Source: BofA ML Global Research, IMG
CIO REPORTS • The Monthly Letter 8
would give us comfort that investors have sufficiently discounted
the new growth model at a time when fundamentals are again
improving, but we are not there yet.
BrazilIn Brazil, economic activity continues to weaken. Domestic
household indicators remain soft, with the retail sector particularly
disappointing. As such, BofA ML Global Research Brazil Economist
David Beker believes that the Brazilian economy may grow as
slowly as 2% in 2013, with only a slow pickup to 2.6% in 2014
(see Exhibit 19). The combination of high inflation and rising
inflation expectations, tighter monetary policy, slow economic
growth and concerns over higher unemployment have all led to a
huge decline in President Dilma Rousseff’s approval rating. Greater
political instability has also weighed on markets.
Focusing on equities, the Brazilian market has declined by 17%
year to date. Our colleagues in BofA ML Global Research acknowledge that risks to Brazilian equities
remain to the downside. The combination of a negative macro environment combined with declining
profit margins could see earnings expectations further under pressure. But it is clear that investor
sentiment on Brazil has collapsed, which could lead to a rebound from the bottom. Still, within Brazil,
the focus should be on sector- and company-specific opportunities, in our opinion, rather than allocating
to the broad index. The combination of slowing growth and still-high inflation indicates to us the nation
is under-invested, a feeling shared by the IMF in its recent economic outlook press conference. We
believe there will be better investment trends in the years ahead that companies can benefit from. As
highlighted by BofA ML Latin America Equity Strategist Felipe Hirai, there are segments of the market
that remain attractive, such as capital goods, large-cap banks and sectors linked to increasing education
levels. Further, moving away from allocating solely to the index reduces the concentration in some
heavily represented materials and energy companies, which may struggle more.
Portfolio Strategy: Further significant short-term downside
in Chinese equities is limited, in our view, given current
valuations. Deeply negative sentiment may allow this current
rebound to continue short-term but the ride will likely be
bumpy. Yet, a catalyst for a significant re-rating is still some
time away as investors get used to a new growth model with
tighter credit conditions. We do not think investors should
run head-long toward Chinese equities at present. Where
allocated, focus on the winners of the new growth model—
investments linked to the growth of the Chinese consumer,
the aging population, companies with higher earnings quality,
and those focused on higher value added production. Active
managers can identify structural winners as China’s economy
rebalances toward private sector spending.
5/10 9/10 1/11 5/11 9/11 1/12 5/12 9/12 9/131/13 5/1330
35
40
45
50
55
Soft buy-signal
Dec'12 sell-signal
Sell-signalSell-signal
Sell-signal
Soft buy-signal
Sell-signal
EEMPrice Performance
Exhibit 18: BofA ML Global Research trading rule signals short-term upside for EM
Source: BofA ML Global Research, IMG. Data as of July 2013.
4Q12 1Q13 2Q13F 3Q13F 4Q13F Averages (2012and 2013F)YoY % change QoQ % change
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
Exhibit 19: Brazilian GDP to remain low through 2013
Source: BofA ML Global Research, IMG
CIO REPORTS • The Monthly Letter 9
IndiaThe Indian economy has slowed meaningfully from a peak rate of
nearly 12% year-on-year in first quarter of 2010 to a low of 4.7%
year-on-year at the end of 2012 due to tightening by the Reserve
Bank of India (RBI), a slower global economy, weak domestic
investment, poor rains, and limited structural reform adopted by a
challenged government. The good news for the Indian economy is
that, as highlighted by BofA ML Global Research India economist
Indranil Sen Gupta, the worst is likely now passed (see Table 1).
However, that does not necessarily equate to a surging recovery.
Rather, the economy is likely to remain stagnating around the
5-6% annual growth rate, well below the potential capacity. Much
like Brazil, the economy faces far too high an inflation rate given
the recent cooling in growth.
The equity market has proved particularly resilient in local currency
terms, yet the currency has weakened substantially. With the Indian economy running twin current
account and budget deficits, the bias for the currency is to weaken on bouts of global investor
risk aversion or any further disappointment in the Indian economy. Corporate earnings could be
downgraded further, although there is more positive news on margins, which are expected to show
a year-on-year improvement. At 13.1 times the 12-month forward price to earnings ratio, the Indian
market is starting to offer value, especially if we have passed the peak in the tightening cycle as
inflation moderates in the second half of 2013 and the election next year allows for more reform and
investment. We would look to start dipping our toes back into the Indian market on expectation of
monetary easing, a healthy monsoon season, support to margins, and a pick-up in reforms in 2014.
Investors mindful of adding too much risk should manage the currency exposure by hedging the
rupee to mitigate against the risk of further investor apprehension.
Portfolio Strategy: The market is beginning to offer value, especially if we have passed the
worst of the economic and earnings cycle. This may prove early as much will depend on the
run up to the election yet within the BRIC markets, the outlook is relatively better, although
we note that India has remained a destination of choice for EM investors so far this year. To
reduce risk, our preference is for defensive companies and to hedge the currency.
Sector Jan-10 Dec-11 Apr-12 Current
Real cash demand Positive Negative Positive Positive
Industrial production Industry Positive Negative Negative Negative
Credit Industry, services Neutral Neutral Negative Negative
Capex Industry Positive Negative Negative Negative
Business Confidence Index Industry, services Positive Negative Neutral Neutral
Earnings Industry, services Positive Negative Neutral Neutral
Construction Industry, services Positive Neutral Neutral Neutral
Traffic Industry Positive Neutral Neutral Neutral
Telecom subscribers Services Neutral Neutral Neutral Neutral
OECD lead indicator Industry, services Positive Negative Neutral Neutral
Table 1: India’s indicators pointing to stabilization, yet improvement from H1 2013
Source: BofA ML Global Research, IMG
Portfolio Strategy: The combination of higher inflation, weak activity, a tightening central
bank, falling profit margins and under pressure earnings warrants a cautious view on Brazilian
equities. Within the headline index, there are attractively valued opportunities linked to the
need to increase investment spending and supply side reform. We think investors should focus
on these instead of broad Brazilian equities, which are overly concentrated on few stocks.
CIO REPORTS • The Monthly Letter 10
RussiaOur colleagues in BofA ML Global Research forecast the Russian economy to grow by 2.9% in
2013, before accelerating modestly to 3.1% next year. The IMF forecasts an average annual
growth rate between 2013 and 2016 to be 3.6%, down from an average of nearly 7% between
2000 and 2008. The principal driver in pre-crisis economic growth was the rise in productivity, but
this has now reduced substantially. With Russian demographics unfavorable over the medium term,
Russia needs increased capital investment. The government appears to be taking very modest
steps toward that end, yet the fiscal position remains at risk should oil prices begin to falter. In
regards to monetary policy, the CRB (Central Bank of the Russian
Federation) could ease policy through year end as inflation
pressures remain low in the face of the economy’s overcapacity
and negative output gap.
Focusing on equities, the Russian market trades on exceptionally
cheap valuations (see Exhibit 20). This has been true for several
years, though, and is not necessarily a catalyst for considerable
future performance. Still, the combination of the low valuations,
high and presently rising oil prices, the possibility of central bank
monetary easing and more favorable investment could lead to
Russia outperforming some other BRIC markets over the coming
quarters. (Historically, Russia is less vulnerable to rising nominal
U.S. bond yields, too). Harris currently prefers to be overweight
Russia on the possibility of outperformance through the third
quarter, with a preference for consumer and banking stocks.
We stress, however, our belief in more active management when
considering Russian equities. Passive vehicles that track either the
MSCI Russia Index or the local Micex Index have incredibly high
stock concentrations. For example, half the index consists of just
three stocks.
A CHANGE in HOW we investOver the recent quarters, we have written frequently about the way we believe clients should be
investing in EM. Last September, we discussed the need to rethink how to invest in EM (CIO Monthly
Letter, Rethinking Emerging Market Portfolios, September 2012), acknowledging four key elements: 1)
the role of multinational companies, 2) the role of local winners, 3) the bigger role for countries and
sectors over homogenous “regions” and 4) a preference for active management over passive exposure.
In discussing the new growth models of many EM, we re-affirm the need to be more granulated when
Portfolio Strategy: Russian equities trade on exceptionally low relative valuations which,
combined with easier monetary conditions, low investor positioning and high oil prices, could
lead to tactical outperformance to other BRIC markets in third quarter. We believe Russian
equities are best allocated to active investment vehicles as part of a broader Emerging Market
allocation, given worryingly high stock concentration with passive investments.
Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12-60%
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
Russia, 12m fwd P/E rel. to EM
+1 std dev
-1 std dev
Exhibit 20: Russian equities trade on very cheap relative valuations
Source: BofA ML Global Research, IMG. Data as of July 2013.
Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12-70%
Russia, 12m fwd P/E rel. to EM
-60%
-50%
-40%
-30%
-20%
-10%
0%
10%
+1 std dev
-1 std dev
CIO REPORTS • The Monthly Letter 11
investing, stressing the need to focus on country and sector themes tied to local growth stories, rather
than broad allocation to EM as a region, and to favor active over passive exposure.
When looking at passive investments replicating EM, we believe
the index composition reflects the historic stories of EM rather
than the best positioning for the future ones. This can be shown
when breaking down the index by countries and sectors. Focusing
on countries, the EM Index has a very large allocation to BRIC
markets (see Exhibit 21), which, as we have argued above,
are not currently the best opportunities. Looking at a country
concentration, it can be seen that almost two thirds of the index
weighting comes from just the five largest countries.
Instead, for example, allocating an equal amount to each EM
country within the MSCI Emerging Market Index, rather than
allocating to the EM Index, would have been a more beneficial
strategy (see Exhibit 22).
The reason for this is because the eight best-performing EM
countries since 2003 (Colombia, Peru, Egypt, Indonesia, Brazil,
Turkey, Chile, and Thailand) have less than a 25% allocation in
passive funds replicating the EM Index, while the eight worst-
performing countries have a 55% allocation. It’s clear then how an
active approach to country allocation would have better captured
the performance of the best-performing markets.
A similar story can be seen when looking at a sector breakdown
of passive investments. These are often over concentrated in
materials and energy, which benefited most from the largest
drivers of growth from the last decade. The largest drivers of
the next decade—the consumption and reform cycle benefiting
the consumer-related sectors such as consumer staples, discretionary and healthcare—are far less
represented in the index. Furthermore, unlike in the developed world where the largest companies in
the index owe their place to persistent, successful, profitable growth, the largest companies in the
EM index are often state-driven, static, conglomerate companies with low profitability. The use of
active management with local knowledge can therefore avoid less profitable companies and sectors.
So, while exchange-traded funds (ETFs) that track national or regional stock indexes can be a useful
way to take advantage of global growth, in the current environment actively managed funds may be a
more effective way to help investors navigate markets that may not be as familiar to them—such as
EM and frontier markets.
Equal Weighted Emerging Market IndexMSCI Emerging Market Index
0
100
200
300
400
500
600
700
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Exhibit 22: Higher allocation to smaller EM has historically outperformed
Source: Factset, IMG. Data as of end 2012.
5 largest countries (Right)BRIC concentration
50
52
54
56
58
60
62
64
66
68
0 5
10 15 20 25 30 35 40 45 50
2005 2006 2007 2008 2009 2010 2011 2012
Exhibit 21: Index funds have high concentration to few countries (% of total EM Index)
Source: Factset, IMG. Data as of end 2012.
Portfolio Strategy: We believe investors need to CHANGE the way they invest within EM.
Instead of large allocations to passive investments representing EM indices that are over
allocated to large and in our view weaker performing EM countries, flexible active managers can
avail of the country and sector specific trends that better represent the growth prospects of the
future, including smaller EM and frontier markets.
CIO REPORTS • The Monthly Letter 12
APPENDIX
Contributing Author: Chris Wolfe
Emerging Markets vs. Frontier Markets
EMERGING MARKETS FRONTIER MARKETS
AmericasEurope, Middle
East & Africa Asia Americas Europe & CIS Africa Middle East Asia
BrazilChile
ColombiaMexico
Peru
Czech RepublicEgypt
Greece3
HungaryPolandQatar4
RussiaSouth Africa
TurkeyUnited Arab Emirates4
ChinaIndia
IndonesiaKorea
MalaysiaPhilippines
TaiwanThailand
ArgentinaJamaica1
Trinidad & Tobago1
Bosnia Herzegovina1
BulgariaCroatiaEstonia
LithuaniaKazakhstanRomaniaSerbia
SloveniaUkraine
Botswana1
Ghana1
KenyaMorocco3
MauritiusNigeriaTunisia
Zimbabwe1
BahrainJordanKuwait
LebanonOman
Saudi Arabia2
Palestine1
BangladeshPakistanSri LankaVietnam
1 The MSCI Bosnia Herzegovina Index, the MCSI Botswana Index, the MSCI Ghana Index, the MSCI Jamaica Index, the MSCI Trinidad & Tobago Index, the MSCI Zimbabwe Index, the MSCI Palestine IMI are currently stand-alone country indices and are not included in the MSCI Frontier Markets Index. The addition of these country indices to the MSCI Frontier Markets Index is under consideration.
2 The MSCI Saudi Arabia Index is currently not included in the MSCI Frontier Markets Index but is part of the MSCI Gulf Cooperation Council (GCC) Countries Index.
3 Effective November 2013, Greece is reclassified from Developed Markets to Emerging Markets, and Morocco is reclassified from Emerging Markets to Frontier Markets.
4 Effective May 2014, Qatar and the United Arab Emirates are classified from Frontier Markets to Emerging Markets.
Source: MSCI, IMG.
Spencer Boggess, CIO, Alternative Investments212-448-2043
Anil Suri, CIO, Multi-Asset Class Modeled Solutions212-449-3385
Chris Wolfe, CIO, PBIG and Ultra-High Net Worth Customized Solutions212-236-3159
Jim Russell, CIO, Portfolio Construction and Multi-Manager Solutions201-557-0079
Mary Ann Bartels, CIO, Portfolio Strategies646-855-0206
Victoria Ip, Chief Investment Strategist, Asia-Pacific Rim852-3508-5305
Johannes Jooste,Chief Investment Strategist, EMEA44-207-9964686
ThE CIO TEam
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