Transcript Client Name Topic Date

State Association of
County Retirement Systems
Fall Conference
November 13-16, 2007
Cynthia Steer
Chief Research Strategist
Managing Director, Fixed Income Research
Telephone: 203-656-6716
[email protected]
Table of Contents
 Section I
The Case for Emerging Markets in 2004
 Section II
The Case for Emerging Market Debt in 2007
 Section III
Understanding Emerging Market Countries
as the New, Powerful Institutional Investor
2
Section I
The Case for Emerging Markets in 2004
3
Cartography and Investment Topography
4
Cartography and Investment Topography
 In 2004, two definitions were useful in dividing the
world and setting investment strategies and asset
allocation targets:
 Developed Markets
 Emerging Markets
5
What is a Developed Market?
The implication is:
 A nation that is industrialized (e.g., a well-developed
manufacturing sector), has substantive infrastructure,
and a well-developed service sector
 A nation that has a per capita income higher than
$9,655
 A nation that has universal education and significant
health indicators on infant mortality, life expectancy,
and literacy
6
What is an Emerging Market?
The official definition:
 An economy with low-to-middle per capita income as
defined by the World Bank (i.e., less than $9,656
minimum GNP per capita)
 Investable market cap is low relative to its most recent
Gross Domestic Product (GDP)
7
What is an Emerging Market?
The implication is:
 It is a nation that is in rapid transition, increasing in
size, activity, or level of sophistication
 It is a nation that is making an effort to change and
improve its economy, as well as provide an
infrastructure in order to become a developed nation
8
Cartography and Investment Topography (2004)
 Like nature, nations gradually or glacially evolve from
emerging to developed
 And a few move back
 What contributes to a successful evolution is a complex
question as tectonic plates shift slowly
 Why does it matter from an investment perspective?
9
History of World GDP Share
35.0
Opium and Tea Trades
% of World GDP
30.0
25.0
20.0
15.0
10.0
5.0
0.0
1500
1600
1700
UK
1820
USA
1870
Japan
1913
1950
China
1973
1998
India
Surprise! India and China were the leaders in terms of GDP market
share until surpassed by the U.S. in the early 20th century.
Source: Angus Maddison (2001) the World Economy:
A Millennial Perspective, Table B-20
10
Rates of Growth of World GDP Per Capita
Annual Average Compound
Growth Rates
10.0
8.0
6.0
4.0
2.0
0.0
-2.0
1500-1820 1820-1870 1870-1913 1913-1950 1950-1973 1973-1998
Historical Year Periods
UK
USA
Japan
China
India
So why are they just surpassing their prior per capita
growth in the 20th century?
Source: Angus Maddison (2001) the World Economy:
A Millennial Perspective, Table B-22
11
Rates of Growth of World GDP Per Capita
Annual Average Compound
Growth Rates
10.0
8.0
6.0
4.0
2.0
0.0
-2.0
1500-1820 1820-1870 1870-1913 1913-1950 1950-1973 1973-1998 1998-2007
UK
Historical Year Periods
USA
Japan
China
India
…and now racing ahead at an unprecedented pace
Source: Angus Maddison (2001) the World Economy:
A Millennial Perspective, Table B-22
12
Developed, Emerging, or Hegemon?
 A highly evolved nation with overwhelming
demographics does not always graduate to a developed
nation
Nation
Time Period
Source of Power or Wealth
Portugal
1494 – 1580
Dominance in navigation
Holland
1580 – 1688
Control of credit and money
Britain
1688 – 1792
Textiles and command of the sea
Britain
1815 – 1914
Industrial Supremacy and railroads
United States
1945 – 1971
Petroleum and internal combustion engine
13
Cartography and Investment Topography (2004)
 Economists and investors are always seeking to develop
a set of metrics to identify a country’s future status
 That is, which countries will move from:
 Emerging to Developed to something else
 However, there is no defined set of rules to determine
who will and will not evolve
 Are there catalysts?
14
Benchmarks as Investment Topography
 Current industry practice is to construct portfolios
using benchmarks as maps or guides
 Are our current maps pre-Columbus, seismic sensors,
or GPS?
15
A View of Our World in the Pre-Columbus Era
 Fortunately, early investors did not use maps for guides
or they might not have gotten there
16
A View of Our World from the English Colonies
 Where would the U.S. be
if our forefathers only
focused on investing in
the original 13 colonies
and didn’t think about
the frontier?
17
A View of Our World After the Louisiana Purchase
 Or called it quits after Napoleon sold us the Louisiana
Purchase?
18
So, What is the Lesson?
 Historically, the most successful investors have sought
future rather than past growth
 Would you have invested in the Erie Canal?
 If you are the typical institutional investor, probably not!
19
Cartography and Investment Topography
 State of the art today…very Americentric
 Very benchmark-aware
 Average U.S. plan sponsor holds the following portfolio:
 40 – 50% U.S. Equity
 15 – 20% Non-U.S. Equity
 15 – 30% Fixed Income
 0 – 15% Alternatives
20
Market Capitalization Weights As Maps
Select Developed and Emerging Markets as of 2004
Capitalization Weights within
the MSCI ACWI Free
60%
52.6%
50%
40%
30%
20%
10%
10.1%
9.7%
0%
United
Kingdom
Japan
USA
0.2%
0.4%
0.2%
India
China
Russia
 Constructing an investment map for tomorrow and today’s
portfolio based on benchmarks is investing in the
rearview mirror
Source: RIMES Online
21
2004 Outlook
Five Year Projected Growth Rates of Select Developed
and Emerging Markets
5 Year Cumulative Projected
Real GDP Growth
50%
46.7%
40.1%
40%
30.9%
30%
20%
12.5%
10%
9.3%
9.7%
Japan
USA
0%
United
Kingdom
India
China
Russia
 As an investor seeking to grow assets, wouldn’t you seek
future rather than historical growth?
Source: National Governments, Consensus Economics,
Economist Intelligence Unit, Datastream
22
Benchmarks as Investment Maps
60%
52.6%
50%
40%
30%
20%
10%
10.1%
9.7%
0%
United
Kingdom
Japan
USA
0.2%
0.4%
0.2%
India
China
Russia
50%
46.7%
40.1%
40%
30.9%
30%
20%
12.5%
10%
9.3%
9.7%
Japan
USA
0%
United
Kingdom
RIMES Online
National Governments, Consensus Economics, Economist
Intelligence Unit, Datastream
India
1Source:
2Source:
23
China
Russia
S&P 500 Index
Dec-02
Dec-00
Dec-98
Dec-96
Dec-94
Dec-92
Dec-90
Dec-88
Dec-86
Dec-84
Dec-82
Dec-80
Dec-78
Dec-76
Dec-74
Dec-72
Dec-70
Dec-68
Dec-66
Dec-64
Dec-62
Dec-60
Dec-58
Dec-56
Dec-54
Dec-52
Dec-50
12
11
10
9
8
7
6
5
4
3
2
1
0
Dec-48
Cumulative Log-Adjusted Return
S&P 500 Index vs. Nominal GDP Growth
Nominal GDP Growth
 Developed markets are positively correlated with
domestic GDP growth but emerging markets may not be
Source: Nominal GDP Growth data provided courtesy of
Bureau of Economic Analysis (BEA)
24
Section II
The Case for Emerging Market Debt in 2007
25
Cartography and Investment Topography
26
Asset Allocation with Possibly the Wrong Map
Public Plans Anticipating an Increase/Decrease in
Strategic Allocations
% anticipating an
increase in allocations
31%
28%
22%
By Asset Class
9%
2%
-2%
0%
0%
-15%
% anticipating a
decrease in allocations
Equities
Source: JPMorgan Asset Management
-28%
Fixed Income
Real Estate
27
Private Equity
Hedge Funds
Emerging Market Metamorphosis
FX Reserves of Major EM Countries
200
170
$ Billion
140
110
80
50
20
-10
1997
1998
1999
Brazil
2000
Mexico
2001
2002
Malaysia
2003
2004
Russia
2005
2006
Turkey
 We all read about global liquidity and its sources but
generally don’t ponder its implications
Source: JPMorgan
28
Emerging or Developed?
France
Thailand
29
Emerging or Developed?
London
Morocco
30
Emerging Market Metamorphosis
Trivia
 Approximately 25% of the total number of world cranes is situated
in one single city. Which city is it?
 Up until 1998, the trophy for the tallest building has been in
developed countries, mainly the United States. Currently how
many of the top ten tallest buildings are in developed countries?
 True or False. In 2005, more space missions have been launched
by developed countries than emerging countries?
 Of the top 40 countries by growth in manufacturing output, how
many are emerging markets?
 How many of the world’s top five billionaires are EM country
nationals and who currently leads that list?
31
Emerging Market Debt Metamorphosis
1996 Average
2005 Average
1996 – 2005
Change in Average
Current Account
-1.8
1.7
3.5
External Debt
32.2
28.8
-3.4
Reserves / Short Term Debt
145.9
400.1
254.1
Fiscal Balance
-3.1
-2.4
0.8
GDP Growth
7.5
5.2
-2.2
Inflation
23.5
5.9
-17.6
 Emerging markets have witnessed a major transformation
as evidenced by key economic variables
Source: Goldman Sachs, IMF
32
Emerging Market Debt Metamorphosis
Current Account Balances
400
300
200
100
0
-100
1998
1999
Em Asia
2000
2001
2002
EMEA
2003
2004
Latin America
2005
2006
2007F
EM Total
 Current accounts have transformed from deficits to
strong surpluses in the last decade
Source: JPMorgan, Bloomberg, PIMCO
33
Emerging Market Debt Metamorphosis
FX Reserves of Major EM Countries
200
170
$ Billion
140
110
80
50
20
-10
1997
1998
1999
Brazil
2000
Mexico
2001
2002
Malaysia
2003
2004
Russia
2005
2006
Turkey
 Substantial foreign reserves make emerging market
countries less vulnerable to external shocks
Source: JPMorgan
34
Emerging Market Debt Metamorphosis
Year/Year Inflation as of July 2007
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
U.S.
Japan
U.K.
France
Argentina
Brazil
Chile
Colombia
Mexico
Poland
South
Africa
 Inflation rates in emerging economies are converging
toward those of developed economies
Source: PIMCO
35
Emerging Market Debt Metamorphosis
Currency Regimes
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1996
1999
Pegged or Dollarized
2003
Managed Floating
2006
Floating
 The majority of emerging market countries have moved
toward a floating exchange rate
Source: JPMorgan, PIMCO
36
Emerging Market Debt Metamorphosis
Emerging Market Universe Credit Quality Composition
100%
90%
80%
70%
60%
Russia
Upgrades
50%
40%
México
Upgrades
30%
05
20
02
01
03
20
B
20
BB
20
00
99
20
Investment Grade
19
98
19
97
19
96
19
95
19
94
19
19
93
0%
20
10%
04
Korea
graduates
out of the
index
20%
NR, CCC, and Below
 Structural reforms and fundamental improvements are
reflected in credit ratings
Source: JPMorgan
37
Emerging Market Debt Metamorphosis
Sovereign Ratings Action
45%
35
Number of rating actions
30
35%
25
30%
20
25%
20%
15
15%
10
10%
5
70%
250
40%
Downgrade ratio
60%
200
50%
40%
150
30%
100
20%
50
10%
5%
Downgrades
Upgrades
Downgrades
Downgard Ratio
Upgrades
D
20
06
YT
20
05
20
04
20
03
20
02
20
01
YT
D
06
05
20
20
04
20
03
20
02
20
01
20
20
0%
0
0%
00
0
20
00
Number of rating actions
80%
300
50%
Downgrade Ratio
Source: S&P, JPMorgan
Source: S&P, JPMorgan
 Favorable rating trends have extended beyond sovereign
debt
38
Downgrade ratio
40
EM Corporate Ratings Action
Emerging Market Debt Metamorphosis
2007 Growth Forecast
9
8
YoY Growth (%)
7
6
5
4
3
2
1
0
Latin America
EM Asia
2005 Actual
Emerging
Europe
U.S.
2006 Actual
Japan
Euroland
2007 Forecast
 Growth prospects for emerging markets remain strong
Source: JPMorgan, Goldman Sachs, PIMCO
39
Emerging Market Metamorphosis
Relationship of G7 Growth to World Growth
6
5
4
3
2
1
0
-1 1980
1985
World Real GDP Growth
1990
1995
G7 Real GDP Growth
2000
2005
Correlation of G7 growth to World Growth
 The correlation between economic activity in the large
developed economies and total global growth has fallen, as
emerging countries have become more important growth
engines of the global economy
Source: IMF, PIMCO
40
Implications for the Investment Opportunity
Comparative Performance 1-Month
as of August 31, 1998
%
Comparative Performance 2-Months
as of August 31, 2007
5
3
0
2
-5
1
-10
%
-15
-20
0
-1
-2
-25
-3
-30
JPM EMBI Global
Citigroup HY
Credit Suisse
-4
LB Aggregate
JPM GBI-EM
(LC)
Leveraged Loan
JPM EMBI
Global
Citigroup HY
Credit Suisse
Leveraged
Loan
 Is emerging market debt the new “safe haven” as
opposed to U.S. credit? How much is too much in
emerging markets? What is true growth?
41
LB Aggregate
Section III
Understanding Emerging Market Countries as the
New, Powerful Institutional Investor
42
Cartography and Investment Topography
43
Cartography and Investment Topography
 Western financial markets create acronyms based on:
 Economics
 Liquidity and capital flows
 Organizational structures
 In era of vast change in size and influence of liquidity pools,
important and instructional to reconsider basic assumptions
 EMEA (Europe, Middle East and Africa) and MENA (Middle East,
North Africa) are examples of this
 Context of discussion centered on changing missions of World
Bank, IMF, IFC (e.g., in North/South dialogues migrating to
South/South investment)
44
Our Investment Topography
 Definition:
 Europe, the Middle East, and Africa, usually abbreviated to
EMEA, is a regional designation used for government,
marketing, and business purposes. It is particularly common
amongst North American based companies, who often divide
their international operations into the following regions:
– The Americas, being North and South America (AMER)
– North America (NORAM)
– Europe, the Middle East, and Africa (EMEA)
– Asia Pacific and Japan (APAC or APJ)
– Brazil, Russia, India, and China (BRIC)
 Increasingly, companies are separating their Eastern European
business from the rest of Europe, and refer to the EEMEA
(Emerging Europe, Middle East, and Africa) region as separate
from the European region
45
New Investment Topography
 Definition:
 The term MENA, for Middle East and North Africa
– An acronym often used in academic and business writing
– Generally covers an extensive region, extending from
Morocco in northwest Africa, to Iran in southwest Asia
– Generally includes all the Arab Middle East and North Africa
countries, including Iran but not Turkey
46
Our Investment Topography
EMEA GDP (as % of world GDP) and
Market Capitalization (as % of MSCI AC World Index Free)
1998 - 2007*
5.0
4.5
4.0
3.5
3.0
(%) 2.5
2.0
1.5
1.0
0.5
0.0
1998
1999
2000
2001
2002
GDP
2004
Market Cap
* 2007 data is for the year to September.
Source: MSCI and U.S. Department of Agriculture
2003
47
2005
2006
2007
Changing Investment Topography
EMEA Country GDP and Market Capitalization Growth (%)
2003 - 2007
Country
Cumulative
GDP
Annualized
GDP
Cumulative
Market Cap
Annualized
Market Cap
Czech Republic
Hungary
Poland
Russia
Turkey
Israel
Jordon
Egypt
Morocco
South Africa
27.9
20.0
28.0
39.4
38.3
23.2
33.2
28.3
23.1
22.3
5.6
4.0
5.6
7.9
7.7
4.6
6.6
5.7
4.6
4.5
898
430
895
1198
924
337
257
2131
658
272
180
86
179
240
185
67
51
426
132
54
Total EMEA
30.9
6.2
552
110
Source: MSCI and U.S. Department of Agriculture
48
Size and Shape of Capital Flows in Rapid Evolution
49
Changing Destination of Capital Flows
50
Changing Rapidly from EMEA to MENA
51
External Assets not Going to U.S.
52
And Increasingly Finding Local Homes
53
With Local Structures
54
And Local Connotations
 The keystone to Islamic finance is the idea that investments must be
made in a manner that is compliant with Shariah, a set of rules and
laws, collectively governing economic, social, political, and cultural
aspects of Islamic society.
 Shariah prohibits riba, or the charging of interest, thus introducing a
challenge to traditional investment mechanisms such as bonds or
mortgages.
 Most interpretations of Shariah state that in any investment
arrangement, risks must be shared by all parties and equal riskreward profiles must exist. Therefore, a predetermined interest
rate is considered unacceptable (haram).
 Sukuk – similar to an asset-backed bond, Sukuk pays investors over
the life of the “bond” directly from leases, profits, or sales of
tangible assets, such as property, infrastructure, equipment, or
business ventures.
55
Sound Bytes About Islamic Finance
 Up until this point, Islamic financial innovations have captured the
attention of the clientele interested in Shariah compliant products.
Going forward, these instruments will likely have a broader appeal.
 In the near future, we will likely witness the creation of a much
broader spectrum of Shariah compliant financial instruments,
including structured products, hedging tools with features similar to
the conventional derivatives markets, an increase in short-term
liquidity products, and a wider variety of asset classes.
 Shariah compliant securities will also attract attention from socially
conscious investors across the globe. Shariah prohibits investment
in any business that is deemed unethical, such as gambling, alcohol,
and casinos.
 Islamic finance offers a unique opportunity for bridging
financial/cultural differences between Islamic and Western nations.
56
Implications for U.S. Pension Funds
 Rapid redistribution of capital flows implies the following:
 Mispricing of risk and return - old versus new thinking
 Inappropriate weightings of region
 Information inefficiency
 Premium for early movers
 BUT…old style analysis not as relevant
 MENA investment dominated by real estate, infrastructure, plus
hedge funds and private equity, not necessarily public equity
 NECESSITY to consider new structures, including Shariah compliant
bonds and investment vehicles
 FEWER traditional managers (even hedge funds) able to take
advantage, so finding regional capabilities will probably be important
 IMPORTANT to know what you don’t know and to update frequently
57
Changing Investment Topography: Old Style
Analyses Don’t Tell Story
10%
100%
8%
80%
6%
60%
GDP Growth
4%
2%
40%
0%
20%
-2%
0%
-4%
-20%
-6%
-40%
-8%
-10%
1998
1999
2000
2001
2002
2003
GDP Gro wth
* 2007 data is for the year to September.
Source: MSCI and U.S. Department of Agriculture
2004
2005
2006
M arket Cap Gro wth
58
-60%
2007
Market Cap Growth
EMEA GDP and Market Capitalization Annual Growth
1998 - 2007*
Changing Investment Topography
MSCI Emerging Markets Index Regional Breakdown
September 2002
Market Cap: $475 Billion
EMEA Country Breakdown
September 2002
Market Cap: $124 Billion
Czech Republic
2%
EMEA
Hungary
5%
Israel
13%
26%
Jordan
1%
Poland
4%
South Africa
50%
Asia
58%
Latin America
16%
Morocco
1%
Source: MSCI
59
Egypt
1%
Turkey
4%
Russia
19%
Changing Investment Topography
MSCI Emerging Markets Index Regional Breakdown
September 2007
Market Cap: $3,354 Billion
EMEA Country Breakdown
September 2007
Market Cap: $812 Billion
Czech Republic Hungary
3%
4%
EMEA
24%
South Africa
28%
Israel
9%
Jordan
0%
Poland
7%
Morocco
1%
Asia
58%
Egypt
3%
Latin America
16%
Turkey
7%
Source: MSCI
60
Russia
37%
Changing Investment Topography
EMEA Country Breakdown by GDP
2007*
Total GDP: $1,538 Billion
EMEA Country Breakdown by GDP
2002
Total GDP: $1,174 Billion
Czech Republic
South Africa
Morocco
12%
3%
5%
Czech Republic
South Africa
Hungary
Morocco
4%
5%
Hungary
11%
4%
3%
Israel
Israel
9%
10%
Egypt
9%
Jordan
Egypt
1%
9%
Jordan
1%
Poland
Poland
14%
15%
Turkey
Turkey
18%
17%
Russia
Russia
37%
37%
* 2007 data is for the year to September.
Source: U.S. Department of Agriculture
61
Old Versus New Topography
 Growth in MENA lost in rapid growth in Asia and
investor focus
 Current index reflects public market capitalization but
not true GDP growth and flows to private equity and
new wealth
 Country representation is limited
 Plan sponsors lack time and focus to reposition
portfolio
 Alternatives include GDP/flow weighted indices and
regional mandates for infrastructure, hedge funds,
currency, and private equity as well as public equity
62
Old Versus New Topography
 Facts:
 0.3% of global equity markets but young
demographics of 700 million
 Resource provider to Europe and U.S.
 Rapidly expanding and NEW infrastructure
 Home to innovation in biotech and technology
 Deep and liquid stock markets with over 200 global
companies
 Fast growing sovereign wealth funds (SWFs)
63
Aging Demographics but MENA is Young
Source: UN (2005)
64
With New Buildings and New Infrastructure…
Source: Factset, UBS
65
And an Identity as Africa – the Supplier to Asia
Source: African Analyst Journal 2006
66
So is this Risky?
Source: Factset
67
There is More to the Region than Just Oil…
Source: JPMorgan, Merrill Lynch estimates
68
Other Changing Topographies: Asia
69
Cartography and Investment Topography: Asia
 Asia also growing rapidly
 Surpluses are growing rapidly
 Sovereign Wealth Funds have been created
 Investment policy and governance are slowly being
considered
 Asian topography more centered on debt culture and
ASEAN Plus 6
70
But Its Tectonic Plates Are Different
71
Investment Topography Changing but Slowly
72
Changing Investment Topography: Old Style
Analyses Don’t Tell Story
10%
100%
8%
80%
6%
60%
4%
40%
2%
20%
0%
0%
-2%
-20%
-4%
-40%
-6%
-60%
-8%
-80%
-10%
1998
1999
2000
2001
2003
2002
2005
M arket Cap Growth
GDP Growth
* 2007 data is for the year to September.
Source: MSCI and U.S. Department of Agriculture
2004
73
2006
-100%
2007
Market Cap Growth
GDP Growth
ASEAN Plus 6 (Ex. U.S.) Plus New Zealand
GDP and Market Capitalization Annual Growth
1998 - 2007*
Changing Investment Topography
MSCI AC World Index (Ex. U.S.)
Regional Breakdown, September 2002
Market Cap: $5,697 Billion
ASEAN Plus 6 (Ex. U.S.) Plus New Zealand
Country Breakdown, September 2002
Market Cap: $1,745 Billion
New Zealand
0%
Indonesia
0%
South Korea
6%
ASEAN +6 (Ex. USA) +
New Zealand
31%
Malaysia
2%
Phillipines
Singapore
0%
3%
Thailand
0%
Australia
14%
China
2%
Hong Kong
5%
Developed Europe
60%
EMEA
2%
Latin America
1%
EM Asia Ex. Asean +6
1%
Source: MSCI
Japan
68%
North America, 5%
74
Changing Investment Topography
MSCI AC World Index (Ex. U.S.)
Regional Breakdown, September 2007
Market Cap: $18,756 Billion
ASEAN Plus 6 (Ex. U.S.) Plus New Zealand
Country Breakdown, September 2007
Market Cap: $5,610 Billion
New Zeland
0%
ASEAN +6 (Ex. USA)
+ New Zealand
Indonesia
1%
South Korea
9%
30%
Malaysia
1%
Phillipines
0%
Singapore
3%
Thailand
1%
Australia
17%
Developed Europe
53%
China
10%
EMEA
4%
Japan
52%
Latin America
4%
EM Asia Ex. Asean +6
3%
Source: MSCI
North America, 6%
75
Hong Kong
5%
Implications for U.S. Pension Plans
 Central bank reserves and sovereign wealth funds will be managed
differently than petrodollar neighbors
 Slow, cautious intra-region cooperation will be the norm
 Asset allocation and SWF governance will evolve over time
 ASEAN accords shed light on process (first steps, interlocking swap
agreements to provide members liquidity relative to 1998 and
purchases of regional sovereign debt)
 ASEAN nations still engaging China, Japan, India, and Australasia
 Policy focused on capital preservation and liquidity
 Culture of debt and real estate rather than public and private
equity
76
Summary
 Surpluses of emerging markets are transforming to
powerful investors
 Risk/return appetites and perspectives differ from U.S.
pension plans
 Looking forward, it is imperative not to make
assumptions viewing the world from our
perspective…the consequences could be significant
77
Thank You for Your Time!
78