Author: Andy Djordjalian
Disclaimer: Andy owns ESD in his Covestor South America Model.
October 4, 2010: September was an excellent month for equity, particularly in emerging markets. Brazilian large-caps did exceedingly well. The largest Brazil fund, iShares MSCI Brazil Index (EWZ), advanced from 66.90 at the close on August 30th, to 76.95 on September 30th, which means a 15% gain for the month (http://www.google.com/finance?q=ewz), while another popular Brazil ETF, Market Vectors Brazil Small-Cap (BRF), gained nicely from August 30 through September 30 (http://www.google.com/finance?q=brf). Benchmarks for other segments of this portfolio did well too. For example, iShares MSCI Chile Investable Mkt Index ETF (ECH) advanced from August 30 through September 30 (http://www.google.com/finance?q=ech) and Market Vectors Junior Gold Miners ETF (GDXJ) had a nice increase from August 30 through September 30 (http://www.google.com/finance?q=gdxj).
I am satisfied with this model’s result, which was in line with those numbers, because its major component belongs to a more-conservative asset class – I am talking about the closed-end fund Western Asset Emerging Markets Debt (ESD) – and because the portfolio had avoided much of the downturn suffered by heavyweight Brazil earlier this year (EWZ had ended 2009 at 74.61 dollars per share (http://www.google.com/finance?q=ewz)), thus the two-digit return for September can be taken as a sign that the previous outperformance was not due to an excess of conservatism.
My strategy is to try to capture much of the good performance during bullish periods and avoid as much loss as I can during downturns. That intent is being accomplished so far, September’s results included, even though I wish this portfolio had a more-spectacular month given the strength of the regional securities.
To my understanding, the main drivers behind this excellent month for emerging markets were:
1) The recovery of equity that had suffered earlier this year even though the fundamentals were good, and still are.
2) An anticipation of more quantitative easing in the U.S. and U.K., after signs of weakness in the recovery of their economies.
The second item seems to involve a paradox. One of the aims of quantitative easing in the developed world is to regain local jobs, which have been lost, in part, because of the intense competition from emerging economies. Nevertheless, much of that liquidity ends up in emerging economies, not only through the financial markets but also via multinationals that direct to other countries much of the capital that was meant for local small-and-medium enterprises that can create new jobs. This constitutes a limitation of quantitative easing, but I do not think it renders it useless, because not all of the money drifts to other countries and the portion that does is not augmenting the problem but, on the contrary, it increases wages in the emerging economies, alleviating the demand-and-supply disbalance between these and the developed world (https://www.nytimes.com/2010/06/08/business/global/08wages.html?_r=2).
I believe we are witnessing a shift in the main driver for growth in the emerging economies. During the last decade, it was exports propelled by low-cost labor. That model is losing momentum, as developed economies are not able to ‘export’ labor as they used to. Moreover, emerging nations do not depend on positive trade balances as in the past, when they needed to build up monetary reserves. That stage is already accomplished and they have won the confidence of the markets, up to the point that the Chinese renminbi has the opportunity to become the third international currency alongside the dollar and the euro (or fourth if we count the yen) if the Chinese government takes the necessary measures (http://english.caing.com/2010-05-06/100141783.html).
China has a centralized economy that makes it reluctant to change, but this new scenario offers opportunities that I do not think its high powers will want to miss. Specifically, to sophisticate their financial institutions and receive high levels of investment for durable goods and infrastructure. Moreover, their society will probably pressure for them, through their demand for better access to urban housing and consumer goods. I believe this will be the driver for growth in the emerging world now that the previous model is coming to an end, while the developed world recovers its jobs and puts its economy in order. Therefore, it is not surprising that quantitative easing seems to be more welcome elsewhere that in the originating countries, but I do not think it is a reason for suspending it.
South America is playing an important role in this new scenario. China will take long to grow its domestic consumer base, but South America has a considerable middle class that very much welcomes products from the developed nations. On the other hand, the strong buildup of infrastructure and other durable goods will demand materials and energy that are produced in South America, to add to the appetite for precious metals that I have discussed in previous months and for food for the rising Chinese and Indian middle class. Therefore, I believe South America will act as intermediary for the attainment of a future balance of trade, as it will export raw materials to Asia to import products from developed economies. The importance of this role should offer economic opportunity and political leverage.
I think this is a secular trend that we are experiencing, which drives many of my investment decisions. Not only the selection among regional assets, but also my desire to be invested in emerging economies, materials and precious metals. There surely will be bumps on the road, which may offer opportunity if we have the stomach to stand them and are capable of taking advantage, but I believe the secular trend will persist.
On a different note, I am writing this on October 4th, right after the first round of the presidential elections in Brazil. Lula’s candidate Dilma Rousseff is winning, as it was expected, but the news is that she is not obtaining enough votes to avoid a ballotage (this is, a second round of voting with only the top-two candidates competing) although she most probably will win there, given today’s results and the fact that the voters for the candidate that is coming third with almost a 20% of the votes, charismatic Marina da Silva, are ideologically closer to Dilma than to runner-up Serra.
When the markets open tomorrow, they may show dislike about Dilma not earning 50% of the votes today, because it rather empowers some of her allies that are not seen as ‘market friendly’ as the nucleus around her and Lula, and because Marina’s good result implies social approval for the statement that she was making via her candidacy. Da Silva was Lula’s Environment Minister until 2008 when she resigned on disagreement with Lula’s policy, which she saw as too inclined towards economic interests in detriment of environmental considerations – Marina is an environmentalist whose first political activity was working for activist Chico Mendes, who you may remember from a very good movie with Raul Julia called The Burning Season (http://www.imdb.com/title/tt0109351/). Her discourse has not been harsh towards Lula, but she positioned herself as an option for people liking the current administration but wanting to limit its power (mostly relative to environmental issues according to her platform, but voters may have extended that idea to other spheres).
Therefore, the markets might transitorily unwelcome this result, but another possibility is that the bulls ‘tromp’ on those concerned about it and keep pushing the markets higher, stimulated by the reasons I gave before. According to my view, the Brazilian potential is not at risk by this small distribution of power away from Dilma and Lula. On the contrary, I welcome the effect it may have for keeping corruption in check. But I would understand it if the markets are doubtful, and would try to capitalize by buying more cheaply with the proceeds from my recent sale of Embraer (ERJ). I think this is a great company and would like to purchase it again in the future, but these days its profitability will probably be damaged by the appreciation of the real caused by the current strong flow of capital into Brazil, so I see better opportunity elsewhere.
Thanks for your interest in this model, I wish you have a very pleasant October.
