2007 was the fifth consecutive year that emerging market stocks registered a double–digit advance. They significantly outperformed US and other advanced markets. The benchmark we use is the broad MSCI (Morgan Stanley Capital International) Emerging Markets Index; it increased by 39.4% in 2007.
Like last year, the same basic question applies: “Will the Boom Continue?” Our response is conditionally “yes”. The reason is that, as a group, emerging markets have become more mature. So far, they have demonstrated an impressive ability to weather the storms caused by the same credit crunch that adversely affected most advanced country’s markets. Market volatility has increased and country allocation among the emerging market universe is critical for portfolio performance.
The increased liquidity that major central banks are injecting into the global economy should help ensure that the current slowdown in the advanced economies is relatively short-lived. Cumberland does not believe it will deteriorate into a serious or global recession. Domestic liquidity conditions in most emerging market economies are healthy. Many emerging market countries are net creditors in the global markets. For them, domestic demand factors should underpin another year of solid economic growth.
While the large price advances in many of the major emerging markets this year had reduced their relative attractiveness, the market drawbacks in the last few months tempered their overheated nature. China and Hong Kong are examples.
China and Hong Kong
The Chinese economy continued to grow at a very rapid pace in 2007, 11% according to some preliminary estimates. Domestic Chinese investors piled into the stocks of Chinese firms. Prices in the Shanghai and Shenzhen markets rose to speculative bubble levels by mid-year (Shanghai was up by 85%), followed by a retrenchment of almost 20% in the second half.
Cumberland takes a conservative approach to participating in Chinese economic growth. We use up to eight ETFs to craft our China exposure. We will mention just two.
These two ETFs that track the shares of major Chinese firms that are listed on the Hong Kong market and/or the US market and hence meet the higher standards of these exchanges. The iShares FTSE/Xinhua China Index Fund (ticker FXI), tracks the corresponding index. It increased by 58.7% last year. The second of these ETFs, the Powershares Golden Dragon Halter USX China Fund (ticker PGJ) is comprised of the U.S. listed securities of companies that derive the majority of their revenue from the People’s Republic of China. This ETF rose by 59% last year.
The pace of economic activity in China, while decelerating, is still likely to be again in excess of 10% in 2008. Domestic Chinese investors, with growing incomes, are still largely a captive audience. They persist in flocking to China’s equity markets.
That said, Chinese equities may encounter some headwinds in 2008. A more rapid appreciation of the Chinese currency, the Yuan, perhaps as much as 10% over the year, is likely as the authorities seek to reduce inflationary pressures. This will hurt the earnings of Chinese exporters as well as the translation of equity returns into US dollars for dollar-based investors. Another importance risk facing Chinese exporters is the US presidential elections and the effect that will have on US-China trade relations. Also the plans of Chinese companies to raise another $100 billion on domestic and international equity markets next year could weigh on those markets.
On the positive side of the ledger, the Chinese authorities will likely take further measured steps in the coming months to lower the present regulatory barriers preventing most domestic Chinese citizens from investing in the Hong Kong and US markets. The Hong-Kong and US-listed shares of Chinese companies tracked by the two China ETFs mentioned above are now priced at a discount of 60% or more relative to the prices of the shares of the same companies in the China Mainland markets. The expected process of arbitrage between the markets as the so-called “through train to Hong Kong” gets underway in earnest should give a significant boost to these ETFs over the course of the year. Expecting further gains in 2008, we are maintaining an overweight position in China and Hong Kong.
The heightened risks mean that it will be important to monitor developments carefully. For some recent observations and personal travel notes on China by David Kotok, see http://www.cumber.com/four-commentaries-from-trip-to-china/ .
Increasing the ability of Mainland Chinese investors to invest in the Hong Kong market should also attract substantial new funds into the securities of domestic Hong Kong companies. Anticipation of this development already added to the Hong Kong markets performance in 2007. This factor and the close relationship between the Hong Kong and Chinese economies helped the iShares Hong Kong ETF (ticker EWH) advance by 40.5% this past year. The leading Hong Kong companies in this ETF are in the real estate and financial sectors. Both of these sectors are helped by the prevailing low interest rates, an ample supply of liquidity, and strong fundamentals for the economy.
Singapore’s economy and market are the most advanced of the markets Cumberland includes in our Emerging Market Portfolio. Singapore has a history of sound market-based economic policies and political stability. With few natural resources other than its people and its strategic location, the Singapore economy has demonstrated consistent strong performance, responding flexibly to changes in global markets. For example, it is now the world’s second largest inter-modal port. The iShares Singapore ETF (ticker EWS) increased by 27.8% last year, just a little less than its average annual increase of 29.9% over the past five years.
The Singapore market tends to outperform in periods of increased volatility in global markets as investors seek more stable investment opportunities. High volatility promises to be a characteristic of the emerging markets in the coming year.
The Malaysian economy is blessed with natural resources (particularly energy) a relatively stable government and currently a stimulative monetary policy. This year’s healthy economic growth of 6% should be followed by a similar advance in 2008. Like other emerging Asian economies, a modest weakening in the demand for Malaysia’s exports in 2008 is expected to be offset by stronger domestic demand. The iShares Malaysian ETF (ticker EWM) rose by 45.5% in 2007. Despite this advance, valuations are still attractive and the market appears poised for another good year in 2008.
Korea has a new, more pro-business President. However, there are a number of economic concerns that caution us from adding to our Korean position at this time. Domestic demand growth in Korea looks likely to be weaker than in other emerging market economies. Korean banks have experienced serious funding problems and interest rates have risen sharply. These high rates will hurt the heavily indebted Korean households. This does not bode well for Korean equities in the coming months. Later in the year the fiscal stimulus and market-friendly reforms planned by the new government should be important positive factors for equities. The iShares Korean ETF (ticker EWY) registered a strong increase of 32.1% last year but has underperformed in recent months.
The performance of Taiwanese stocks was considerably weaker than expected in 2007. The iShare Taiwan ETF (ticker EWT) increased by only 7.6% over the past 12 months. The big problem seems to be the negative sentiment of domestic Taiwanese investors towards their market. Perhaps this is due to uncertainties on the political front.
The positive factors which have encouraged us to retain our overweight for this market are the attractive valuations of Taiwanese companies and our global strategy of overweighting the technology sector which constitutes the major share of EWT. We also favor the increasingly close economic inter-relationships between Taiwan and China. Also, the upcoming elections in March may encourage Taiwanese investors to return to their domestic market.
Outside of Asia, Brazil is the other major center of growth among the emerging markets. Indeed, in 2007 Brazil registered the strongest performance among the markets in Cumberland’s equity market universe. The iShares Brazil ETF (ticker EWZ) rose by 76.6% last year. This outperformance continued through the recent market adjustment.
Brazil’s economic prospects continue to look benign with growth in excess of 4% expected in 2008. While Brazil is affected by developments in the global economy, it is not as directly tied to the US economy as are other Latin American countries, for example, Mexico. This currently is a plus as the US economy passes through a slow growth period. Another significant plus is the growing importance of Brazil’s energy sector. Despite the fact that Brazilian equity valuations are no longer cheap, we expect this market will maintain strong performance in 2008.
In contrast to Brazil, Mexico has limited ability to insulate itself from developments in the US. The housing slump and the credit crunch in the US have had a depressing effect on Mexican equities, which have declined during the latter half of 2007. As a result, the iShares Mexico ETF (ticker EWW) was up by only 12.3% for the year, in sharp contrast to Brazil’s 78% increase. Mexico’s interest rates remain among the highest in our Emerging Markets Portfolio, and its equity risk premium is negative. This situation may turn around later in 2008 when monetary policy is expected to ease and it becomes evident that the US has avoided a serious recession. For the time being, we are maintaining our underweight position.
South Africa faces rising inflationary pressures and an external deficit that equals almost 7% of its GDP. These conditions are forcing interest rate hikes by the South African Reserve Bank despite the growing evidence that domestic demand is faltering. We expect growth in South Africa’s economy to drop below this year’s 5% pace. An inflated housing market is at considerable risk. Adding to investors concerns is the election of Jacob Zuma as the leader of the ruling ANC party. Of greater concern than the populist economic policies he may wish to employ are the press reports that Zuma is being charged with racketeering, tax evasion, and corruption. A period of domestic political turmoil could prompt an exodus of foreign investors in the coming months. The iShares South African ETF (ticker EZA) advanced by 17.3% in 2007. We anticipate underperformance for this market in the coming year.
As I write this year-end review, there are violent riots in Pakistan, following the tragic assassination of Benazir Bhutto. So far there has been little effect on global equity markets or on spreads on Asian emerging market sovereign bonds. But the global struggle against terrorism has become more difficult with this testing of Pakistan’s political stability. This event is a reminder that we live in an uncertain world. Investing in emerging markets, despite the many advances that have been achieved, still involves a higher element of risk than is the case for the advanced market economies with their deeper, more liquid markets, stronger regulatory and legal systems, better corporate governance and more stable political structures.
At Cumberland in our active management of portfolios we seek to identify developing risks and rebalance portfolios accordingly. However, as not all developments can be foreseen, diversification of risks is an essential element of prudent portfolio management. A distinguishing feature of Cumberland’s risk management is our exclusive use of Exchange Traded Funds in our equity portfolios. These securities, which are traded like single stocks, provide broadly diversified investments in entire country markets, regions, sectors and/or styles. For example, the Korean ETF, ticker EWY, holds the shares of 100 Korean companies. One of our core holdings, the broad BLDRS Emerging Markets 50 ADR Index Fund (ticker ADRE), invests in 50 companies in eleven major emerging markets. The resulting diversification of risks together with a top-down approach to active portfolio management sums up our approach to investing in these markets.