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The onward march of economic globalization has been a key catalyst in the explosive growth of emerging markets. With the advent of the Global Financial Crisis ('GFC'), which shook developed economies and investment markets to the core, combined with the never ending fallout from the ongoing European financial crisis, these economies have gone on to become the drivers of global economic growth. These events have not only seen China become a dominant global economic power but also the emergence of Brazil as the world's sixth largest economy. It has also seen significant investor interest in emerging markets as they seek to maximize returns and escape the volatility sweeping developed markets. But now, as these markets adjust to the current global economic outlook and their economic development slow, many investors are finding themselves facing losses from what were once perceived as high return investment opportunities.

Many investors have found themselves in this position for a variety of reasons but the most prominent is a fundamental misunderstanding of the drivers of economic growth and investment returns in emerging markets. This has seen many investors, particularly those gravitating towards Brazil, to follow the herd and chase returns when making investment choices by only considering the net present value of projected returns, rather than taking into account future risk, investment fundamentals and macro-economic indicators.

Strong economic growth attracts investors to emerging markets

Investors have been increasingly attracted to Latin America and Brazil because over the last decade the region's government have sought to sweep away the debris of the lost decades of the 1980s and 1990s and actively participate in the global economy. For the last decade the region has experienced an average annual GDP growth rate of 4%, with many of the constituent countries such as Brazil, Chile, Argentina, Colombia and Peru having far greater rates of economic growth. These rates of growth as measured by GDP for the same period have eclipsed the developed economies of the U.S, Canada and Western Europe. The stunning rates of growth experienced by the region and in particular Brazil, Chile and Argentina were driven by a tremendous resources boom that swept across the region bringing wealth to countries once swept by severe poverty.

All of which saw the region, in particular Brazil, Mexico and to a lesser extent Argentina become popular with investors seeking exposure to markets with strong economic growth and high potential investment returns. Now however, growth in Brazil, the region's largest economy, has slowed dramatically. The country reported GDP growth of 2.73% at the end of 2011. Despite the Brazilian government embarking on an ambitious program to kick start economic growth, GDP growth has continued to decline, falling by almost 1% since the end of 2011 to 1.89% at the end of the first quarter 2012.This indicates that Brazil may be slipping into recession and it has seen dramatic falls in company valuations, as the government has pushed interest rates down causing the value of the real to depreciate.

When examining emerging markets it is apparent that much of this rapid economic development can be attribute to these countries growing from a lower economic and developmental base. In fact, as theories of economic convergence state, it is natural for less developed low income countries to grow faster economically than high income countries. This rapid growth then sees them narrow the income gap between themselves and developed countries in terms of per-capita income levels. The key catalysts for this rapid economic growth in poorer countries is the abundance of cheap labor coupled with inward flows of capital and advanced technology from developed countries, which drive rapid increases in productivity and industrial output.

However, many investors fall into the trap of believing that a country's economic performance is the main driver of returns in equities, yet this couldn't be further from reality and is one of several unfounded beliefs many investors have about the relative merits of investing in emerging markets. During 2011, emerging market share funds continued to experience strong inflows from investors despite the ongoing stock market volatility. It is this belief that helped fuel the surge of investment in emerging Brazilian companies particularly those listed as ADRs in the U.S by retail investors as well as strong inflows into emerging market share funds such as iShares MSCI Brazil Index (EWZ).

Growing GDP does not equal equity market gains

Economic growth and share market gains do not always go hand-in-hand. An example of this is Brazil, which since 2000 has averaged annual GDP growth of 3.6% and during this period an investor who had bought into the Brazilian broad equity index the Ibovespa and held it during this period would have had a return of 207%. But when looking at the annual performance over that period as set out in the chart below, a different story is revealed.

(click to enlarge)Source data: Yahoo Finance, BM&F Bovespa and Banco Central Do Brasil.

When examining 2007 the graph shows that Brazil's GDP grew by 6.1% and the Ibovespa rose in value by 44%. But when we consider 2008 the graph shows that Brazil's GDP grew by 5.2% yet the Ibovespa fell by 41%. The same can also be seen for 2010 where GDP growth was 7.5%, yet the Ibovespa grew by only 1% and 2011 where GDP grew at 2.7%, yet the Ibovespa fell by 18%. There are a number of reasons for this disparity including firstly the effects of innovation, which despite being an important catalyst for economic development typically drives higher incomes for consumers than share price appreciation. It can also be disruptive at an industry and company level, fueling competition, creating losers alongside winners.

Secondly, fast growth businesses may be financed by issuing additional equity which dilutes existing investors' holdings and caps share price growth. Thirdly, all companies that profit from a particular economy are not listed in that market, which for Brazil includes Chevron (NYSE:CVX), Siemens AG (SI), Shell (RDS.A) and General Motors (NYSE:GM), all of which have significant operations in the country. Finally, the extent to which the share market is driven by rational participants or herding behavior changes over time and investors moving as a group into high growth economies may actually overvalue share markets.

In the short-term it pays to be a catch-up economy

Provided other factors are equal, poorer less developed economies should grow more quickly than developed countries because they are coming from a lower economic and developmental base. Furthermore, they can rapidly close the gap with developed countries by following their lead through technology transfers and capital injections to achieve 'catch-up growth'. As a result of this catch-up growth three key drivers push these poorer economies towards becoming developed economies; industrialization, urbanization and consumption.

The physical capital of a country is a key component to catch-up growth. This is due to the technology embodied in physical machinery and its effect on improving productivity per worker and ultimately economic output. The ability of a country to access and mobilize resources to develop new productive assets and infrastructure significantly influences the pace of growth. An example of this is Brazil, which because of its large population and endowment with large quantities of natural resources has expanded to become the world's sixth largest economy.

Urbanization is also a result of rising industrialization and a rapid improvement in per capita income levels and as it grows it is expected that a significant number of people will shift from low social economic status to the middle-class. The economy will then require resources to build cities, transport, technology and logistics to connect them, as well as the energy to power them. As the graph below illustrates Brazil's urban population has grown substantially since 1950 and this can be attributed to the country's economic expansion.

(click to enlarge)Source data: Instituto Brasileiro de Geografica e Estatistica

As a population moves from country to city seeking higher salaries, consumption patterns will also begin to change. A higher income per person will in turn result in a large increase in demand for consumer goods, food, services and the raw materials required to produce them. This then leads to a growing middle-class, higher income levels and a surge in consumer demand. In a survey conducted by Banco Santander (STD) it was found that middle-class has grown in size by 10% since 2001, with more than 51% of all citizens in Latin America having now obtained middle-class status.

When this is considered in conjunction with rising urbanization and average per capita incomes which since 2001 are up on average by 64% across Latin America, it is clear that consumer demand will continue to grow. Traditionally, middle-class households have favored economic growth through aggressive capital accumulation by acquiring property, housing, education and investments. It is this dynamic that allows the middle-class to become the motor for domestic consumption and continue to fuel the growth in demand for consumer staples and discretionary products.

The transition to a higher income economy is not an easy endeavor

While many countries have been able to transition from being low income to middle income economies, very few have carried on to the high income levels of developed economies. There comes a point where a developing economy's growth slows markedly and per capita income levels stagnate, trapping the economy in the middle income category. This occurs despite the country still being endowed with the features that allowed it to grow rapidly initially including human capital, natural resources and access to technology. This point is known as the 'middle income trap' and there are many causes including a lack of innovation, poor economic policy and declining productivity gains.

The chart below from the World Bank's China 2030 report plots each country's income per person as adjusted for purchasing relative to that of the benchmark economy the U.S both in 1960 and in 2008. High income countries appear in the top row and from the chart it is possible to see that only 13 countries have moved from being low or middle income countries to high income countries since 1960. None of these are Latin American countries and as the chart illustrates two of Latin America's major economies, Brazil and Argentina remain firmly caught in the middle income trap.

(click to enlarge)Source: World Bank; 'China 2030: Building a Modern, Harmonious, and Creative High-Income Society.'

The causes of the middle income trap are debated but it is accepted that economic growth slows as the advantages of being a 'catch-up' economy decline. It is also believed that many of the policies adopted by the governments of emerging countries to promote economic growth decline in effectiveness as the economy develops and after reaching a particular point become ineffective. This point is where per capita income has risen significantly translating into higher production costs and driving a surge in consumer demand.

As a result economic growth transitions from investment driven growth to consumption driven growth and in many cases this transition is rapid and unbalanced, leading the developing economy to over-heat. This is a point that I believe the Brazilian economy has reached and much of that country's recent economic experiences certainly indicate that. This causes inflation to surge and the currency to appreciate in value.

This causes imports to rise as they become cheaper and exports to fall as they become more expensive. It also sees industry stop manufacturing and prefer to buy finished goods because they are cheaper thus leading to a de-industrialization effect in economies that have yet to fully industrialize. As a result these economies lack sufficiently developed tertiary and quaternary sectors which are able to fill the productive void.

In an attempt to control growing demand and dampen inflation these governments, like Brazil, raise interest rates to dampen demand and inflation. This only then serves to attract further foreign investment, particularly 'hot money' so as to benefit from the higher returns available. All of which causes the country's currency to surge in value as we have seen with Brazil's real. Unfortunately this investment predominantly doesn't go to productive assets such as the development of industry, further magnifying the de-industrialization effect as imports become cheaper and costs of production rise.

Early in economic development it is relatively easy for investors to pick winners. However, with time, the obviously productive investments become less plentiful and the investment path followed by governments becomes less clear. Several policies aimed at super-charging economic growth do so by subsidizing investment in mining, infrastructure and manufacturing at the expense of household savings. Unfortunately, strong household savings are necessary for a growing middle class and for developing a consumer society, vibrant service sector and robust domestic demand. These policies typically include government creating an undervalued currency, setting excessively low interest rates and repressing wage growth.

Rebalancing from investment to consumption-driven growth involves reversing these policies. The benefits are improved household income and savings (wealth) and lower current account surpluses. However, it may also expose the distortions accumulated in the economy such as uneconomic investments and non-performing loans, both of which may constrain growth, or even trigger a crisis.

In many cases, as we are seeing with Brazil and Argentina, the governments of these countries then resort to implementing policies that stimulate growth, reduce the costs of production and stimulate exports for low-tech produced goods, but dampen domestic consumption. This prevents the creation of a strong domestic consumer society, leaving these economies more susceptible to external macro-economic shocks and creating a classic boom and bust cycle revolving around demand for commodities, resources and low-tech manufactured goods.

I believe that Argentina represents a classic example of this and that Brazil is well on the path to becoming locked into this cycle in part because of the interventionist economic policies adopted by the current government. The current Brazilian government's ideological convictions have seen them seduced by the mirage of import substitution industrialization ('ISI') as a means of sustaining economic growth. This essentially means they are relying upon economic protectionism as a means of reducing imports to drive domestic production and industrialization through the exclusion of imports. The government has also embarked on an aggressive policy of reducing the value of the Brazilian currency to compensate for rising production costs as a means of making exports more appealing.

Good economic policy decisions can be bad for investors

The demand for additional productive assets and infrastructure, and changing consumption patterns are likely to drive increased prices for energy and food. These are typically the two largest categories of spending for the average consumer and have the greatest impact on inflation measures. Higher inflation means higher interest rates, which is typically bad news for equities.

Then as we have seen with Brazil, the government needs to rein in demand and inflation which only serves to increase the value of the currency repeating the de-industrialization cycle. When interest rates drop, this then leaves many domestic companies particularly those with dollar denominated debt with higher costs leading to cost cutting as well as pushing down their share prices. It also means that as the economy cools those companies reliant upon consumption for their revenues will experience reduced revenues as demand cools.

Opportunities for investors

Obviously the first conclusion that we can reach is investors should be aware of what developmental stage an emerging economy has reached. When looking at Brazil and the current economic climate it could be argued that the country's economic development has peaked and now it is firmly caught in the middle income trap. Unless Brazil can break through the middle income trap it implies there is a natural cap on the profitability of Brazilian companies dependent upon domestic consumption to drive profitability.

While those operating in the primary sector like Petrobras (NYSE:PBR) and Vale (NYSE:VALE) will become trapped in a boom and bust cycle driven primarily by external demand and macro-economic factors. This doesn't bode well for the performance of the multitude of Brazilian ETFs available to investors and will see them fall in value as the Brazilian economy cools. The broad based iShares MSCI Brazil Index is down by 14% so far for this year and because it mirrors the performance of the Ibovespa I believe for the reasons discussed there is some way to go before it bottoms.

Strategies for investing in emerging economies

There are a number of strategies available to investors to enhance the opportunity of future returns when investing in emerging markets and these include firstly and most importantly assessing the fundamentals of any potential investment to identify its valuation and potential investment returns. Secondly, investors should pinpoint the developmental stage of the country's economy and selecting investments in those industries that represent the greatest opportunities for growth at that stage. For example, during the early stages this includes mining and oil, in the middle stages consumer staples and transportation and for the later stages financials and consumer discretionary.

Thirdly, when selecting an emerging market investment investors can focus on those that are in the early stages of economic development. This is because as discussed earlier, economic convergence theory shows that lesser developed economies will grow faster increasing the likelihood of higher investment returns. In Latin America two economies that are still in the earlier stages of economic development are Colombia and Peru. Since 2000 Brazil's Ibovespa index has only risen by 207%, whereas Colombia's IGBC market index has risen by 1273% and Peru's IGBVL market index by 1033%. Investors considering making an investment in those emerging markets can do so through the Global X FTSE Colombia 20 ETF (NYSEARCA:GXG) or iShares MSCI All Peru Capped Index (NYSEARCA:EPU). Finally, it is essential that investors are fully aware of the risks including geo-political risk, economic risk, sovereign risk and currency risk and the impact they can have on their investment. These risks will also vary depending upon the stage of economic development that the country has reached.

Emerging markets provide a number of advantages for investors including portfolio diversification and the opportunity for enhanced returns. But as we are now seeing with Brazil, there may be setbacks and investors should not be entering these markets without a clear understanding of how these types of investments fit in to their investment portfolio. It is clear that a passive investment approach, with investors following the herd to invest in the next fast growing Latin American economy is unlikely to be effective. Instead, investors should be taking into account the country's stage of economic development, assessing valuation fundamentals, have a clear understanding of the risks as well as monitoring entry and exit points in combination with a clear investment strategy.

Source: Important Considerations When Investing In Latin America And Other Emerging Markets