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Curtis A. Mewbourne
At our most recent quarterly Economic Forum, PIMCO investment professionals concluded that we are living in a multi-speed world, with a stark and widening divergence between the outlook for growth in the developed world and the emerging markets (EM).
In fact, as a group, we expect real GDP growth of 1% to 2% for the developed world vs. 4% to 8% for the EM (represented by China, Brazil, Russia, India and Mexico). And the divergence will likely be even larger in nominal terms, since the U.S., Europe and Japan are teetering on the edge of deflation, while inflation across the EM will likely average 3% to 4%.
Readers of previous EM Watch columns will be familiar with our view that many emerging economies are undergoing a secular move to greater economic importance and increasing wealth. While many questions remain about the nature of that journey – including the degree to which slowdowns in the developed economies will affect emerging economies and to what extent the EM consumer can replace the U.S. consumer as a source of global aggregate demand – PIMCO believes the investment opportunities in the EM are among the most attractive in an uncertain, New Normal world.
Witness the case of General Motors. For the first time ever, in the first quarter of this year the company sold more vehicles in China than in the U.S. But far from being just a China story, roughly 50% of GM’s sales so far this year are outside of the traditional American and European markets. So for one major global manufacturer, the EM consumer is indeed ascendant.
More broadly, private consumption continues to grow in the EM. As shown in Chart 1, the EM component has been increasing as a percentage contribution to global growth. The U.S. consumer, shown in the dark blue bars, was a larger contributor for much of the 1990s, but by the latter part of the decade was contributing less than consumers in the EM.
The rise of the EM consumer is the result of a combination of factors. After many years of faster growth rates, the EM economies as a group are now large enough to matter relative to the developed economies. China, for example, is now the second largest economy in the world. Another way of looking at the size advantage can be seen in the chart from Morgan Stanley, which estimates that there are now roughly as many households in the BRIC (Brazil, Russia, India, China) countries with disposable income over $10,000 as in either the U.S. or Europe. Further, within five years there will be more households with more than $10,000 in disposable income in the BRICs than in the U.S. and Europe combined.
Lower interest rates are another positive factor supporting the EM consumer. Lower interest rates and increasing availability of credit are enabling an increase in consumption. For example, in Brazil, the decline in interest rates means that a person paying 25% of monthly income for debt service can now purchase three to four times the amount of durable goods that he or she could a decade ago.
How Should Investors Approach EM? With zero or near-zero returns on cash in the U.S., Europe and Japan, low interest rates on government bonds and the prospect of continued losses in those equity markets, shifting investments to the emerging economies stands out as one of the more attractive risk/reward opportunities.
Historically, many EM investors have used an “all in one” strategy, namely purchasing EM equities to get regional/country exposure, currency exposure and exposure to the private sector. This strategy has had mixed results at best, with lengthy periods where little or no excess returns were produced while volatility was high. We would suggest that investors would be better served to use a “menu” type approach, choosing the optimal investment strategy for each component of the exposure.
One way for investors to get exposure to EM-based companies is through U.S.-dollar-denominated emerging market corporate bonds. In many cases the companies are benefitting from the increase in domestic demand discussed above. Further, many of the EM companies once seen as national champions have now become global champions. Take for example the five largest companies in the J.P. Morgan Corporate Emerging Market Bond Broad Index (CEMBI). Russia’s Gazprom is the largest domestic and regional supplier of natural gas, and it also supplies roughly 30% of Europe’s natural gas. Hong Kong–based Hutchison Whampoa is the largest port operator in the world, with 50 ports across 25 countries. Brazil’s Petrobras is the second largest company in the world by market capitalization.1 Brazil’s Vale is the second largest mining company in the world. America Movil is the largest telecom company in Latin America, with operations in 18 countries and over 200 million wireless subscribers.2 While these are just examples, many of the 100+ companies in the CEMBI index are benefitting from the increases in disposable income and the growing customer base. Valuations also remain relatively attractive, with the yield on the JPM CEMBI Broad index around 5.5% at the end of September 2010, the latest full month for which data are available, while the yield on the Barclays credit index was around 3.6%.
For investors looking for government exposure as opposed to private companies, there are two alternatives, namely local currency and dollar-denominated government bonds. The regionally diversified J.P. Morgan GBI index was yielding around 6.25% at the end of September, which is about three times the yield of similar maturity government bonds from developed markets. And while historically higher interest rates in EM countries were thought to be compensation for currency weakening, given current conditions we think the highest probability is that EM currencies will appreciate vs. the U.S. dollar. Thus, investors may benefit from both higher interest rates and currency appreciation. Interestingly, in the aftermath of the global financial crisis, local government bonds as represented by the JPM GBI index have behaved more like developed country interest rates, posting more than 16% returns this year through September, while global equity markets overall (as represented by the MSCI World Index) have gained 3.5%. Of course, all investments involve some degree of risk, and for EM investors those risks would include political risk, policy risks and, in some cases, liquidity risks. But on balance we think the balance of potential risks and returns looks compelling.
As the world economy follows the bumpy journey to a New Normal, investors face an uncertain future and unsettling choices. We view EM as particularly attractive from a risk/return perspective, and in that sense they truly stand out in an otherwise bleak investing landscape. For the many investors who are underexposed to emerging markets, we would recommend using the inevitable bumps we will see along the New Normal journey as an opportunity to increase allocations to those countries and companies that are rapidly becoming the dominant global economic forces.
Curtis MewbourneManaging Director, Portfolio Manager
1 Exxon Mobil is the largest company in the world by market capitalization.2 More subscribers than AT&T and Verizon combined.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value.
References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. PIMCO may or may not own the securities referenced and, if such securities are owned, no representation is being made that such securities will continue to be held. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.
Barclays Capital U.S. Aggregate Index (BCAG) represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The JPMorgan Emerging Markets Bond Index (EMBI) Global is an unmanaged index which tracks the total return of U.S.-dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady Bonds, loans, Eurobonds, and local market instruments. The JPMorgan Corporate Emerging Markets Bond Index (CEMBI) is a global, liquid corporate emerging markets benchmark that tracks U.S.-denominated corporate bonds issued by emerging markets entities. The JPMorgan Government Bond Index is an unmanaged market index that currently comprises the local currency, fixed rate coupon issues of 13 markets greater than 1-year in maturity. JPMorgan Emerging Local Markets Index Plus (ELMI+) (Unhedged) tracks total returns for local currency-denominated money market instruments in 23 emerging markets countries with at least U.S. $10 billion of external trade. The Morgan Stanley Capital International (MSCI) Emerging Markets Free Index (EMF) is a market capitalization weighted index composed of over 800 companies representative of the market structure of emerging countries in Europe, Latin America, Africa, Middle East and Asia. The MSCI EMF Index excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The index is calculated separately; without dividends, with gross dividends reinvested and estimated tax withheld, and with gross dividends reinvested, in both U.S. Dollars and local currency. MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. Since June 2007 the MSCI World Index consisted of the following 23 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The index represents the unhedged performance of the constituent stocks, in US dollars. It is not possible to invest directly in an unmanaged index.
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