smif equity report emerging markets
TRANSCRIPT
2
Table of Contents
Macroeconomic Outlook 3 - 4
Credit 5
Inflation 6
SMIF’s Current Holdings 8
Recommendations 9 -
Indonesia ETF 9 – 10
Emerging Markets Equity Income ETF 11
MSCI Index Benchmark 12
Portfolio Repositioning 13
3
Macroeconomic Outlook
The global outlook through the end of Q4 2012 is bleak. After coming out of the 2008
financial crisis the global economy seems to have stalled. The small economic victories have
been overshadowed by the crisis in the Eurozone, stubbornly high unemployment in America,
and low to negative real growth in emerging economies. Developing markets, by and large, are
tied to the fate of developed nations, as they tend to be net exporters.
The major concern for the global economy is a slowdown in the global credit markets,
like the one witnessed after the collapse of Lehman Brothers. The European crisis is a cancer,
spreading through the global banking system. European corporations face both the risk of
currency fluctuations and the sovereign ceiling (the trend that corporations rarely have credit
ratings above their nation). The IMF has stated that they do not have enough capital to bail out
European banks, while Germany has committed a trivial amount of money to the Stabilization
Fund. Emerging nations such as China and Brazil and hesitant to invest in any bailout vehicle,
China has expressed interest in Italian bonds.
Under these conditions the majority of growth is coming from emerging economies.
The IMF’s revised forecast (as of September 2011) predicts that emerging economies will
outperform developed economies, though they do not see drivers of growth until the developed
world resolves their current debt crises.
5
Credit
China faces a 60 percent risk of a banking crisis
by mid-2013 according to Fitch Ratings. This default risk
stems from loose credit policies during the global
recession. China flooded its nations with capital to
continue to grow its economy amid the economic
slowdown, and the quality of these loans is questionable.
China has responded by being the first nation in the globe
to pull the reigns in on credit, unlike other nations China
sets lending quotas for banks.
The IMF’s recent report on Global Financial
Stability even raised the issue of solvency within the
Chinese banking system. As it is so tightly controlled by
the Communist Party reliable data is hard to find.
Credit in many other emerging nations has
remained relatively loose since 2008, with only a few
nations raising rates - due to inflationary worries. Credit
growth has been high in Brazil, Colombia, Hong Kong
SAR, India, Indonesia, Peru, and Turkey.
The increase in credit availability over the past
two years raises questions of credit quality. Emerging
markets are more susceptible to shocks than developed
nations. Since August the global stock market decline has
been led by EMs, as investors question the viability of
their growth in the current macro environment.
6
Inflation
Global inflationary pressures have been rising due to the increased money supply. While
inflation has been relatively modest in the United States, the emerging markets are especially
vulnerable to inflation – as a disproportionate part of income goes to food in developing nations.
This graphical representation of inflation, provided by the BLS, portrays the divergence between
core inflation, and inflation including food and energy. While many in the developed world have
barely felt the impact of inflationary pressure on food prices, developed nations have been hit
much harder. I expect the upward pressure on inflation to continue throughout the year, due to
the Federal Reserve’s liquidity drive.
Examining the stagflation witnessed in the 1970s, food prices increased much more
rapidly than energy. During the recent financial crisis we have felt the dramatic increase in
energy prices, but food prices have not suffered as much. While we are not in a stagflation
scenario, it is not a possibility to be ruled out completely.
8
Current Holdings
All of SMIF’s holdings in Emerging Markets have been liquidated due to their negative
performance. Emerging Markets have been hard hit in this environment, as investors flee these
regions for the relative safety of developed worlds. Prior to their liquidation we held:
iShares MSCI Brazil Index (EWZ)
o 1,200 shares, worth $42,324 when sold ($51,552 when bought)
iShares MSCI Emerging Market Index (EEM)
o 257 shares, worth $13,708 when sold ($17,134 when bought)
The emerging markets have underperformed the S&P 500 index during the current
market turbulence.
9
15%
13%
11% 33%
2%
6%
8% 9%
3%
EIDO Sector Breakdown3 Consumer Discretionary
Consumer Staples
Energy
Financials
Healthcare
Industirals
Materials
Telecom
Utilities
30%
16% 13%
12%
10%
9%
5%
4% 1%
IDX Sector Breakdown3 Financials
Energy
Consumer Staples
Consumer Discretionary
Materials
TelecommunicationServicesIndustrials
Utilities
Health Care
Recommendations
Indonesia has endured the financial crisis relatively well; this is due to its heavy reliance
on domestic consumption for economic growth. Its economy slowed down to 4.5% growth in
2009m from 6&-plus in 2007 and 2008, but it has rebounded to a 6% growth rate in 2010.
Unemployment is a modest 7.1% and the economy is based upon agriculture (15.3%), industry
(47%), and services: (37.6%). The debt to GDP ratio is 25.1%.1
2
Indonesia also has a young population, with a median age of 28.21. Indonesia’s
population is consuming more, which is why I propose the VanEck IDX ETF over the iShares
EIDO, as the iShares ETF is more heavily weighted towards financials (33%). The fees are
comparable, with iShares charging .61% and VanEck charging .6%.
_______________________
1. CIA World Fact Book
2. Australian Government Department of Foreign Affairs and Trade
3. ETF Prospectus
10
The S&P 500 has underperformed nearly all emerging indices since the end of the global
recession, though the emerging markets underperformed in the crisis. The Indonesian ETF was
not available until after the recession, but it has outperformed every emerging market thus far.
Emerging markets constitutes 7% of the funds gross exposure. I propose 2% of the fund be
invested in IDX.
11
26%
22%
13%
10%
9%
7%
5% 4% 4%
1. Financials
2. TelecommunicationServices3. Information Technology
4. Utilities
5. Materials
6. Consumer Staples
7. Industrials
8. Energy
9. Consumer Discretionary
22%
19%
9% 9%
5%
4%
4%
4%
4%
4%
3%
3% 3%
2%
2%
2% 1% 0%
0%
1. Taiwan2. Brazil3. South Africa4. Malaysia5. Chile6. South Korea7. Israel8. Turkey9. Thailand10. Czech Republic11. Mexico12. China13. Poland14. Philippines15. Argentina16. Indonesia17. Russia18. Hungary19. United States
As turmoil is expected over the coming months a defensive play on the emerging markets
in necessary. The WisdomTree Emerging Markets Equity Income ETF (DEM) yielded 7.66%
last year, and provides a geographical and sector diversification. With an expense ratio .63%, it
is within the standard range for ETF fees, though still costly.
DEM has outperformed both the MSCI world index and the S&P 500, not taking into
account the dividend payout. Going into a potentially inflationary environment the safety of a
dividend cushions the performance of any market index.
Given the safety of this play I propose a 3% allocation, to maximize our dividend payout.
12
9%
9%
2%
27%
1%
8%
14%
17%
9%
4% Consumer Discretionary
Consumer Staples
Energy
Financials
Health Care
Information Tech
Materials
Telecom
Utilities
The MSCI Emerging Market Index tracks the performance of emerging stock markets. It
is the benchmark by which the EM section of the portfolio is measured. Previously we held EEM,
the iShares MSCI Emerging Market ETF. I propose we change our holding to VWO, the
Vanguard MSCI Emerging Market ETF. The expense ratio on the Vanguard fund is .22% (as
opposed to .69% on EEM).
The two funds mimic one another almost identically – though the recent market volatility has
caused more of a divergence. This fund also holds 295 stocks, which gives us an increased
diversification.
The top holdings of the index are:
Petroleo Brasileiro SA 2.90%
Vale SA 2.50%
Samsung Electronics Co Ltd 2.40%
Gazprom OAO 2.00%
Taiwan Semiconductor Manufacturing Co 1.50%
China Mobile Ltd 1.40%
Itau Unibanco Holding SA 1.40%
America Movil SAB de CV 1.30%
Industrial & Commercial Bank of China 1.20%
CNOOC Ltd 1.10%
I propose that we hold 2% of the assets of the fund in VWO, so that we position
ourselves to capture any unforeseen market upside.
13
Portfolio Repositioning
In the difficult macroeconomic environment I propose that we allocate the 7% of the fund
allocated to the emerging markets in the following way:
Emerging Market Equity Income (DEM) 3%
VanEck Indonesia ETF (IDX) 2%
VanGuard MSCI Emerging Market ETF (VWO) 2%
This blend will provide us with a dividend protection, investment in one of the strongest
emerging markets, and exposure to our benchmark. This balance positions us for an upswing in
the global equities markets while providing us with downside protection during the expected
future turbulence.