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Unravelling the BRIC market meltdown

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By Vishal Teckchandani
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14 minute read

Many financial advisers have been seduced by the rising economic prosperity in Brazil, Russia, India and China (BRIC). However, BRIC nation equities have endured a horror run so far this year, burning many financial advisers and investors caught up in the emerging market hype. Vishal Teckchandani reports.

Many investment experts have painted a rosy economic outlook for Brazil, Russia, India and China (BRIC) amid the United States sub-prime devastation.

Despite this, BRIC stock markets have tumbled this year and underperformed their global counterparts, including US and Australian equities.

Many financial advisers and their clients with BRIC investments have undoubtedly been baffled and burnt by the experience after being caught up in the emerging markets hype, especially last year.

So why have their equities underperformed if their economies have had robust economic growth figures in 2008 - and are expected to only cool only slightly in 2009?

One reason is that BRIC stocks have gone up so much in value in the past five years, according to Colonial First State Global Asset Management (CFSGAM) deputy head of global emerging markets Jonathan Asante.

"[Emerging markets] have provided investors with very positive returns over the last five years, so there are substantial profits to be taken," Asante says.

Before the BRIC stock markets shed over a quarter of their value this year, Brazil's Bovespa Index had surged more than 300 per cent, India's BSE Sensex Index had quadrupled, and China's CSI 300 Index and Russia's RTS Index more than quintupled at one stage.

In comparison, the MSCI World Index of developed markets, including the US, Japan and Germany, only added around 40 per cent.

Valuations for many BRIC stocks have also cooled off from price-to-earnings ratios around 40 before their big correction to below 20.

The MSCI BRIC Index fell 37 per cent between January and September 12, while the MSCI Emerging Markets Index dropped by 31 per cent.

But now the attention is turning to the possibility of slower economic expansion, and how much of that is yet to be priced into BRIC stock markets is anybody's guess.

The International Monetary Fund in April projected the world economy would grow by 3.7 per cent in 2008 and added there was a 25 per cent chance of a world recession.

Asante says institutional and retail investors generally pull out of emerging markets when there is global uncertainty.

"Rising aversion encourages investors to switch from risky assets, such as emerging market equities, into lower risk ones such as government bonds," he says.

Soaring food and fuel prices in emerging markets have also caused nervousness among investors, he says.

The S&P GSCI Index of 24 commodities, including oil, corn and soybeans, touched a record 507 points in July, more than doubling from a year ago.

The benchmark has tumbled 29 per cent from its peak until September 12 on reports of falling demand.

However, prices are still much higher than a year ago and the BRIC economies have had to hike interest rates while companies deal with higher input costs, which may dent profits and sting economic growth.

"Rapidly rising input costs will make life much more difficult for managers of companies in the emerging world, but fortunately some of them are well accustomed to operating in an inflationary environment," Asante says.

For example, companies such as oil titan PetroChina and utility Shanghai Electric Power cannot pass on higher costs due to government controls. So even amid record oil prices and higher operational expenses, those companies have actually lost money.

"The combination of rising inflation and slowing growth is not good for emerging economies, although the growth of consumer markets across the asset class makes them less vulnerable than they were in the past," Asante says.

So this begs the question: how are the BRIC economies dealing with these problems and which one is best positioned for growth in the next five years?

The China story
"What financial advisers are now looking to find is where is the best place to invest and we all know markets go up and down," Premium China Funds Management head of distribution and operations Jonathan Wu, who helps look after the $315 million Premium China Fund, says.

"If I was going to put my money somewhere, I am going to try and find the best place that has the best growth potential and right now that is Asia."

He says inflation in the country of 1.3 billion people has probably peaked after the central bank raised interest rates to 7.47 per cent and ordered banks to cool lending by boosting their reserve requirements to 17.5 per cent.

The cost of living in China climbed 4.9 per cent for the year to August, weaker than a 6.3 per cent surge in July, figures from China's National Bureau of Statistics show.

Besides, Wu adds, China's Government, with US$1.68 trillion in foreign reserves, is absorbing the bulk of high oil and food prices.

"Note that China is actually a net grain exporter, they actually have the ability to feed their entire population without an issue," he says.

China's CSI 300 Index has swapped its mantle as the world's best major stock market (in 2006 and 2007) to the world's worst in 2008.

The benchmark has fallen from a record 5885 points set last November, to 2077 points at September 12, a 65 per cent rout.

"It's just sheer panic," Wu says.

He says the magnitude of the fall is puzzling and partly blames US and European investment banks - which have taken the bulk of the $620 billion in mortgage losses - for China's woes.

Institutions from those countries have heavily sold off Chinese stocks to help shore up their own balance sheets, he says.

"US and European banks are suffering to keep themselves afloat [amid the sub-prime crisis]," he says.

"What we have seen is that they are selling holdings in Chinese companies because Chinese stocks have been most profitable [for investors]."

But nonetheless, Premium China Funds Management's underlying fund manager, Value Partners, is finding plenty of quality opportunities as the sell-off flattens PE ratios for Chinese stocks from about 40 last year, to around 14 in September.

Wu says Value Partners likes and holds companies including Industrial and Commercial Bank of China (ICBC), the world's biggest and most profitable bank.

The lender posted a 57 per cent surge in first-half net income to US$9.42 billion and trades on a PE multiple of just 13.

ICBC has $160 billion of cash in its arsenal, enough to buy Commonwealth Bank of Australia, Westpac Banking, ANZ Banking Group and St George Bank together.

Value Partners also likes Gome Electronics, a retail franchise similar to Australia's Harvey Norman. Retail sales in China soared 23.3 per cent in July as people rushed to buy TV's before the Beijing Olympics.

Wu says that figure alone shows China relies on internal consumer spending - and not exports - to grow.

"China's growth is all based on consumer demand and right now you have a got a middle class of 300 million, an urban population of 600 million and these people . their income per capita has increased 14 per cent this year," he says.

"A lot of these people haven't experienced watching a plasma TV, a lot of people haven't experienced driving a Mercedes Benz, and going into the future, China is going to be able to experience these things for a much larger set of population.

"For China now, it's the same as what happened to America after their revolution."

There can no telling when China's CSI 300 will regain its fiery bullish streak, but Wu says investors certainly won't be waiting for a US recovery to pump cash into Chinese equities.

"[Investors] may lose another 10 per cent, they may lose another 15 per cent," Wu says.

"But on a long-term trend, because of the fact that we are just buying these value stocks that have such good fundamentals behind them, once there is that confidence restored in the market, stocks will fly."

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Brazil's commodities slump and Russian tensions
Brazil's Bovespa Index fell from 62,891 points to 52,392 points between January and September 12, a 15 per cent decline. The index topped 73,000 points in May.

Slumping resource prices have hurt the profit outlook for companies, including the world's largest iron ore exporter, Cia Vale do Rio Doce, state-owned oil titan Petroleo Brasileiro SA and the world's biggest sugarcane processor, Cosan.

"We have migrated from inflation fears to growth fears [in emerging markets] and those growth fears will not change if the US doesn't recover," Globalis Investments managing partner and portfolio manager Dave Dali, who looks after the Macquarie-Global BRIC Advantage Fund, says.

"Frankly there is not a whole lot of light at the end of the tunnel even though valuations are certainly getting attractive," Dali says.

"Until this [credit crisis] clears up, the emerging markets will suffer and the recovery will be slow."

He says he is waiting on the sidelines, as depicted by his fund (both hedged and unhedged) having only 40 per cent of its $150 million invested.

"[We structured] the fund for exactly the circumstance to allow the fund to hold significant amounts of cash in times of uncertainty," he says.
Brazil's economy grew by 6.1 per cent in the 12 months to June 30, beating the Government's own expectations.

The country recently achieved an investment-grade debt rating from research house Standard and Poor's, giving it access to large pools of institutional capital.

However, Dali, a macro investor, is also concerned about how the BRIC nations - except for Brazil - are handling inflation.

Brazil hiked its so-called Seilic rate to 13.75 per cent in September to control inflation running at 6.17 per cent - which is above the central bank's comfort zone of under 4.5 per cent.

The interest rate being higher than inflation (real interest rates) is a good sign and is showing Brazil, a country of 187 million people, is the best out of the BRICs to deal with rising cost of living pressures, Dali says.

This is the exact opposite to Russia, where interest rates are 11 per cent, according to the Central Bank of the Russian Federation's website - while inflation is running at 15 per cent, data from the country's Federal Statistics Service shows.

Dali says the rate hikes in Russia this year are becoming a problem for the country's local assets.

Russia's RTS Index was gaining in value this year amid the sub-prime crisis and tensions over US missile defence systems.

The benchmark was up from 2296 points in January to nearly 2500 points in May. It started falling dramatically in August when Russia invaded Georgia.

The RTS Index was worth 1341 points on September 12, extending its decline to over 45 per cent since its peak this year.

Foreign funds and institutional investors pulled US$4.6 billion from Russian equities, currencies and bonds, central bank estimates show.

"Certainly not all emerging markets are equal and they don't all contain the same political risk that Russia currently contains and alternatively, Russian fundamentals are fantastic other than the fact we are seeing some geopolitical risk into the equation," Dali says.

The instability has probably peaked in Russia, which has US$400 billion in foreign currency reserves, he says. But now tumbling commodity prices remain an issue for Russia and Brazil.

"I would like to see commodity prices stabilise, not necessarily at lower levels but even at these levels. Stable commodity markets will support emerging markets and support US financial markets," Dali says.

Dali's BRIC Advantage Fund is looking to invest more in India and Brazil but also likes the even-better valuations being offered by Russia and China after their stock markets have tumbled.

The fund also invests in other emerging markets, including Mexico, South Korea, Hungary, Poland and the Czech Republic, through index contracts and iShares exchange-traded funds.

Dali says the only wildcard that could dent BRIC growth severely is a sharp G-7 slowdown, which would dampen demand for exports.

But he agrees with Wu that it is domestic consumer demand that is driving the bulk of BRIC GDP growth and "recession is not a word that comes close to the vocabulary of the BRIC economies".

India's vision
India's Government has said it wants GDP to exceed 10 per cent for the next five years, as three-quarters of its 1 billion residents look to move from rural areas to cities.

That vision has been hurt by mismanaged inflation and its GDP climbed by 7.9 per cent for the year to June 30, the slowest growth since 2004, according to India's Central Statistical Organisation

The cost of living in India tripled to 12.4 per cent in 2008, and economists say the Reserve Bank of India's interest rates of 9 per cent have so far been ineffective.

The Government has boosted salaries for workers in state-owned enterprises by over 20 per cent to compensate. Analysts expect that move to hurt company earnings.

But nonetheless, economic expansion is still expected to remain robust as the Government invests US$45 billion in infrastructure projects for 250 areas in order to support urbanisation and energy demand for manufacturers, government data shows.

India has nearly US$300 billion in foreign currency reserves.

A big advantage India has is that it is a democracy - where many people speak English - and its rules are based on the British legal system, Fiducian manager of investment projects Jai Singh, who helps look after the $20 million Fiducian India Fund, says.

That is enticing massive international investment from firms including US giant Citigroup and French bank BNP Paribas, which are setting up local offices to tap into the wealth of the country's over 1 billion people.

The investment is allowing India to diversify its economy away from just manufacturing, information technology services and agriculture by adding a financial services hub.

Yet India's key Bombay Stock Exchange Sensitive Index (BSE), declined 32 per cent to 14564 points between January 2008 and August 31.

"Share market volatility is exacerbated by the fact that 30 per cent of capital inflows are [from] foreign institutions and if pressure builds from redemptions at home, usually emerging markets see an outflow as capital is repatriated to the domestic economy," Singh says.

"Another contributor to volatility is the fact there is no capital gains tax and with four times the daily turnover [compared] to the Australian share market, we suspect there is a section of the investment community involved in day trading."

Singh says India's growth has decades to go as the country implements important reforms to curb inflation and stimulate growth, while the country's middle class strives to have the luxuries many in the West take for granted.

"Just to give a simple example, there are more cars in Australian than there are in India," he says.

So is investing in BRIC nations worth it?
BRIC markets have tumbled dramatically, but attractive valuations have re-emerged and growth is still expected to be robust even if the sub-prime crisis plunges the US and Europe into a recession.

Although that may not help inflows into BRIC assets, the experts IFA interviewed agree that at some point emerging markets stocks will have to revert to fair value and when they do, it will be at lightning speed.

The BRIC foreign ministers have held an exclusive meeting in Yekaterinburg, Russia, in what was seen as a healthy sign of cooperation and a forum for energy and climate change debate.

Unfortunately, most of the ministers got sidetracked when US President George W Bush complained about increasing prosperity in the BRIC economies was leading to higher food and fuel prices for Americans.

BRIC economies may surpass the collective economic might of the G-7 countries by 2035, according to Goldman Sachs Group's London-based chief economist, Jim O'Neill, who coined the term in 2001.

The nations made up 12 per cent of global GDP last year, up form 8 per cent in 2000.

Macquarie recently launched its Gateway Trust to offer advisers' clients and self-managed superannuation fund (SMSF) trustees exposure to Asia, with capital protection.

Barclays Global Investors also launched its newly-listed BRIC and S&P Asia 50 iShares exchange-traded funds (ETF), aimed at attracting retail investors and SMSFs with a lower fee value proposition than managed funds.

But Morningstar head of adviser and research Anthony Serhan says planners are better served by investing in a broad emerging markets portfolio, rather than just limiting themselves to the BRIC theme.

"If you invest in a BRIC fund, you are immediately locking yourself into some specific markets regardless of whether or not those markets are deemed relatively more expensive than other markets," Serhan says.

"We find the funds that do well are typically those that have skilled managers who have a wider canvas on which to paint."