SUMMER 2009
(Q2-2009 Data)
Volume 19, Number 3

merging markets equities rose 34.8% during the second quarter as global investors snapped up shares at a record pace. Year to date, the MSCI EM Index has gained 36.2%, significantly outpacing the MSCI All World and all other developed markets indexes. Newgate’s Portfolio gained 27.2% during the quarter and up 27.5% year to date.

Market Review. The total value of emerging market equities reached an all time high relative to the global markets by the end of the second quarter. Collectively, emerging markets now comprise 24% of global market capitalization, up from 18% at the beginning of the year.

Since there has been very little IPO activity this year, relative outperformance of emerging markets has been the primary driver of this increase in market share. This outperformance, combined with attractive valuations and growth prospects, spurred over $26 billion in fund flows into emerging market equities during the quarter. Overall, emerging market economies are relatively healthier than most of the developed markets. Forecasts of a major recession in China have proven false, and the Chinese economy is reaccelerating. Economies from Brazil to South Korea and Indonesia also appear to be heading out of recession.

The US dollar is also a significant factor in emerging market psychology. Developed market central banks have cut interest rates to essentially zero and have engaged in some form of quantitative easing. Any single country instituting these policies would see its currency weaken. But when all developed nations do it, the results are unclear. Since emerging market countries have stabilized interest rates, their currencies have generally appreciated against all those in the developed markets. Emerging markets (equities, debt and currencies) have become a hedge against US dollar weakness, and are likely to remain so even if the dollar rises against other developed market currencies.

Every emerging market had positive returns during the quarter. In Asia, India had the best performance, up 60%. May elections resulted in a strong coalition dominated by the Congress Party and its allies and reduced participation by the far left. It is expected that this realignment in government will allow the implementation of much needed economic and political reforms. Chinese equities gained 36% as the economy continued to expand at a better than expected pace. Korean equities rose 25% despite increased tensions with North Korea. The Korean won, which declined dramatically last year, rose almost 10% during the quarter on rising interest rate expectations.

In Latin America, Brazil rose 41%, bolstered by higher commodity prices. Mexico, that had been lagging due to its strong economic ties to the US, rose 36% during the quarter. At the end of May, Argentina was removed from the MSCI Emerging Market Index due to capital restrictions imposed by the Fernandez de Kirchner government.

Eastern Europe also experienced a rebound during the quarter. Russia rose 38%, aided by a stronger ruble and higher energy prices. Poland, hit hard by the global credit crunch, was up 37%, though it remains the only country with negative returns year to date. Smaller countries tended to do well in all regions. Indonesia, Colombia, Thailand and Turkey each rose more than 50%. It is not unusual for markets with less depth and liquidity to have extreme swings in price, both positive and negative.

Portfolio Review. China remains one of the dominant themes in the Portfolio. Not only is the economy one of the most vibrant in our universe, but it continues to have a significant positive impact across most of its key trading partners. We ended the quarter with a 26% allocation to the country, modestly reduced by profit taking in Hong Kong. China was also the single largest contributor to last quarter’s returns, followed closely by Brazil. We remain underallocated to Taiwan and India. Although the recent political developments are promising, valuations in those markets are not compelling enough and we are looking for more attractive entry points.

Outlook. The Portfolio is invested in larger capitalization stocks that offer a higher degree of safety warranted in the current economic climate. While globally things are better, and better than the worst case expectations so commonly forecast, there are still risks to the global economy. Most emerging markets seem clearly in a superior position, with less debt and a simpler financial structure. At 13x earnings, valuations in emerging markets are still attractive, but are approaching historically average levels. What is not average is the growth rate differential between the developed and developing world, which should continue to attract capital into emerging market economies and reward investors with favorable returns.