Addressing Concerns about a Two-Track World
January 21, 2011

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I recently had a conference call with our investors around the world. Depending on where they were from, some of them were concerned about inflation while others were worried about sovereign debt problems. Here are a few topics that we discussed.

What are the factors that might impact global growth?

Inflation: Inflation is a problem faced by countries around the world, not just emerging markets. But it is an important and acute question for emerging markets because it hits lower-income groups especially hard, which represent a larger proportion of the total population in emerging markets. Some emerging countries are raising interest rates, but that presents a problem in itself because it draws in more speculators for their currencies. Emerging market currencies have already appreciated substantially during the last two years, and I think many of them are over-valued on a price-parity basis. These countries are in a dilemma, because they want to export but their currencies are appreciating. Thus, some countries have introduced various capital controls to prevent their currencies from rising further. For instance, Brazil has put a tax on incoming money for fixed income instruments while China actively controls its currency. Inflation is a big challenge, and I believe it will probably be very important going forward.

Sovereign Debt:  Another factor is the possibility of sovereign debt defaults in Europe, and what that may imply for other countries around the world. Greece, Spain, Portugal and Ireland continue to have problems managing their debt. While they obviously do not want to default, in looking at the numbers, I think it may be quite difficult for them to avoid it. The question now is how they can instill confidence back into the markets and how they might restructure their debt or raise more debt to repay the old debt. That said, I believe the governments in these countries continue to be very focused on coming up with a constructive approach to restructuring their debt obligations and in working with the European Union to try and avoid large scale problems.

How are you positioning your portfolios in the face of uncertainty regarding European debt?

Stocks run ahead of reality on the ground and that certainly is what happened in Eastern Europe. However, we are still looking very closely at the region; we are finding opportunities in Russia, but we are not ignoring other markets like Poland, Hungary, and the Czech Republic. As you may know, we also recently began a large operation in Romania. It is still early, but I think there will be a time when the stock prices of companies in those countries are going to look attractive despite the possible debt problems of their governments. We are not counting Eastern Europe out completely because we believe there could be an opportunity to go in and invest for the long-term.

With rising inflation, should investors be investing in commodities and agriculture?

While we select stocks using a bottom-up investment approach, in general the commodities space continues to be attractive to us. Food prices have gone up and are likely to stay up for some time. To some extent, bad weather has been a cause for the rise in prices, but from a longer-term perspective, increasing demand for food, particularly from India and China, means we may have to live with higher food prices unless farm productivity increases dramatically. This is one of the reasons we are looking very closely at investments in Ukraine, a country that is famous for agriculture and its fertile “black earth”. Operations there are not limited to wheat, corn and other crops but also extend to dairy and meat production. Meanwhile in Brazil, we are looking at food processing businesses.

Are emerging market valuations reaching bubble territory?

In general, according to the International Monetary Fund, emerging markets are expected to grow an average of three times faster than developed markets in 2011.[1] At these growth rates, I believe the opportunities could be outstanding. While valuations don’t appear to be as cheap as they were, they are still not as expensive as they were at the very height of bull markets we’ve seen in the past, such as prior to the Asian crisis in 1997.

The rise in emerging market equity prices has been substantiated by a correspondingly large increase in the earnings growth of emerging market companies. While there may be cases where stock prices have run ahead of fundamentals, our analysis leads us to believe that on average, prices are in the middle of their historical range. This of course, does not mean that all emerging markets equities will move similarly. 2010 was a good example of this.  If you look purely at the indices, Thailand’s equity market returned about 56%, while Brazil returned 7% in 2010.[2] This is why I think our stock-picking approach is so important. In times like this, we have to differentiate between stocks that are expensive and those that are not; that takes a great deal of work. We are able to leverage our experienced investment team around the globe to do the extensive research and to pick what we think are the best stock bargains that we can hold for a five-year investment time-frame.

[1] Source: International Monetary Fund, World Economic Outlook, October 2010.

[2] Source: Morningstar Direct, MSCI Brazil Index and MSCI Thailand Index, as of December 31, 2010, based on USD currency.

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