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2013 Emerging markets’ structural growth story remains intact Dara White, Senior Portfolio Manager The 2008 global financial crisis spurred a rapid response from policymakers in emerging markets (EM) as swift and large fiscal and monetary stimulus occurred from central banks throughout the EM universe. With looser monetary policy, credit boomed, consumer spending surged and infrastructure projects pulled forward. As a result, with the onset of 2011, we saw a return of domestic inflation and deterioration in asset quality at many banks, particularly in the larger EM countries such as China, Brazil and India. Policymakers responded accordingly and tightened policy across the EM universe throughout 2011, causing the economies to slow considerably. This proved too large a headwind for EM equity markets, which underperformed versus developed markets in 2011. The cycle slowly started to turn at the beginning of 2012 and policymakers once again loosened monetary policy, albeit gradually. The magnitude of the easing, while disappointing to some market observers, was intentional as policymakers were wary to prevent a return of inflation and asset quality concerns. In that regard they have been successful; we have seen a slow stabilization in the major EM economies without the return of inflation. However, because growth has stabilized rather than rebounded strongly, there are some who believe the slowdown is more structural (long lasting) than cyclical — we are not in that camp. We believe the structural advantages for EMs are still intact. And, while the growth rate may not return to what it was during the last decade, it may very well be growth of higher quality, i.e., more consumption-led growth driven by a strong sustainable middle class, rather than growth driven by fixed asset investment. Moreover, it is important to remember that approximately 70% of the world’s incremental global growth is coming from emerging markets — even with the big markets of China and Brazil slowing down materially. Competitive advantages are still in place Emerging markets suffered through crisis after crisis from the 1980s until the early 2000s. In the process of recovering from these crises and attempting to set up a system that would prevent them from recurring, many countries imposed new regulations and fiscal disciplines that have left them in a much healthier place today. And the factors that launched them on their growth trajectory are still in place today, including: > A manufacturing cost advantage, although now perhaps in different countries and certainly different industries. > Healthy corporate balance sheets that allow EM companies to take on greater capacity. Companies have continued to de-lever after learning many of the painful lessons of carrying too much debt. This is also true at the government and household levels. Exhibit 1: Government debt levels remain under control Global emerging markets (GEM) government debt-to-GDP 60 EM demographics are also a very powerful driver of economies and markets over time. Due to the long lead times, demographics are actually very easy to analyze and predict. Having a young, growing workforce certainly increases the potential gross domestic product (GDP) of a country. Overall demographics in emerging markets are much healthier than in the developed world, which will continue to act as a tailwind over time. 50 Exhibit 3: Healthy demographics are a plus for EMs 110 100 90 80 70 40 Developed vs. emerging economy working age population Working age population (ages 15-64) as a % total population (%) 100 80 60 40 20 Sources: Ned Davis Research 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012e 0 Developed economies 12/31/50 = 58.4% 2050 120 2045 140 2040 Exhibit 2: Corporate net debt-to-equity remains low Emerging economies 12/31/50 = 63.7% 2035 The percentage of debt-to-GDP in non-Japan Asia and the global emerging markets remains well below that of the United States and other developed nations. 2030 Sources: Thomson Reuters, Credit Suisse research Data as of 6/30/11 2025 U.S. 2020 Global emerging markets Peaking later and then declining at slower pace 2015 Non-Japan Asia 67.99 67.60 67.21 66.83 66.45 66.07 65.69 65.32 64.95 64.58 64.21 63.84 63.48 63.12 62.76 62.40 62.04 61.69 61.34 60.99 60.64 60.29 59.95 59.61 59.27 58.93 58.59 2010 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2005 30 2000 (%) Demographic trends are another positive Latin America Asia EMEA Sources: USB GEM Inc., UBS World Inc. Emerging market corporations have brought debt levels down considerably in recent years, including those in Latin America and Asia as well as Europe, Middle East and Africa (EMEA). The working age population will peak much later in emerging markets than in developed markets, and will subsequently decline at a slower pace. A young, growing workforce increases the economic growth potential of the region. 67.99 67.60 67.21 66.83 66.45 66.07 65.69 65.32 64.95 64.58 64.21 63.84 63.48 63.12 62.76 62.40 62.04 61.69 61.34 60.99 60.64 60.29 59.95 59.61 59.27 58.93 58.59 It is important to note that within EMs, there are stark differences between countries that help guide our country allocations. When a country has both a strong demographic profile and an economy that allows for social mobility that country can truly capture the demographic dividend. In our 2012 Perspectives, we published “The demographic winners and losers in emerging markets.” That story is still relevant today. Our favored countries with good demographics include Indonesia, the Philippines, Turkey and Brazil. We also add India, where J.P. Morgan estimates that 250 million people will enter the working age population between 2005 and 2025. This is a staggering number and could turn out to be extremely powerful. Headlining the losers in terms of demographics are the large markets of Russia and China. The one child policy, in place since the 1970s, has had a very serious impact on Chinese demographics. It looks like the Chinese workforce will peak sometime in the next few years in terms of sheer size. The Chinese government is well aware of this phenomenon, and perhaps that is one of the reasons they have dedicated significant resources to improving education levels and moving up the value chain. Other areas where we have concerns about demographics are South Africa and parts of the Middle East, where the populations are young but the lack of social mobility caused by poor education and structural unemployment may prove to be a recipe for social unrest. Addressing China The macroeconomic data in China has stabilized and continues to point to a soft landing. We don’t expect an immediate change in policy with the new leadership in China. We believe the new leaders, like the previous ones, view the magnitude of the 2009 stimulus as a mistake and many industries are still feeling the ensuing overcapacity. We believe that employment remains the government’s primary focus. As long as employment stays strong, we do not expect another round of big stimulus, but rather a continuation along a gradual transformation to a more consumption-led economy. At the same time, we do have some concern that China is becoming less competitive, particularly on the low end of the value chain. The cost of doing business has been rising rapidly due to the peaking of the workforce and the steady increase in wages, which has hurt the return on invested capital of the export sector. Over the long term, we believe they will be successful in moving up the value chain, but it may be a bumpy transition due to weak demand, particularly from the developed markets. Our other concern on China has been the deterioration in the return on invested capital and earnings of the listed companies. Many sectors are in a state of overcapacity and the earnings downgrades have felt much more like a hard landing than the macro numbers indicate. Part of the problem is that Chinese companies have historically managed for maximum growth in output. Managing in a constrained environment has been a new experience for many management teams, and the stress is showing. One silver lining is the housing market. Since the policy restrictions were lifted last March there has been a significant pickup in transaction volumes, hence inventories have started to come down and new starts have begun to pick up. The gains in investment will have a good effect on the economy. China is a complex market, and it is important to keep in mind the positive and negative crosscurrents when evaluating it. Our expectation from here is that the macro numbers will muddle along as we continue to look for opportunities at the individual stock level. Beyond the BRIC The emerging markets are not just about the big four countries of Brazil, Russia, India and China. It is true that all four have faced some type of cyclical or even structural issue in the last 24 months, which has held back the overall performance of the broader EM index. However, that has masked the stellar performance of some of the smaller index constituents. Through October 31, 2012, markets such as the Philippines (up 36% in USD terms), Thailand (up 25% in USD), Turkey (up 53.84% in USD), and Mexico (up 21.94% in USD) have continued to post very strong returns supported by solid fundamentals. Investing in emerging markets requires the flexibility to position around an often-inefficient index to take advantage of these opportunities. As of the end of October 2012, constituents of the energy, financials and materials sector made up a little bit more than 50% of the weight of the overall index. This is why the index behaves in such a cyclical manner and does not truly capture the secular opportunity associated with the EM universe. Consumer and services sectors have been leading the market’s performance over the past few years. Given the secular trends with strong middle class formation in many of these countries, we feel they should continue to do so. The same point can be made on the stock level, where the top end of the index is dominated by state-owned enterprises, whose primary purpose is to provide employment for the people of the nation rather than to maximize shareholder value. Over time, a distinct focus on companies that create shareholder value should also add to returns. During this economic slowdown it has been hard to separate the cyclical versus the secular issues, but the long-term drivers for EM growth are still in place. Analysts have consistently revised earnings estimates downward and multiples have compressed. Expectations for emerging market equities are low, but with the help of accommodative monetary policy, growth seems to have stabilized. In the current environment, one may need to dig a little deeper and work a little harder to find great investment opportunities — but they are there. Investments in emerging markets present greater risk of loss than a typical foreign security investment. Because of the less developed markets and economics and less mature governments and governmental institutions, the risks of investing in foreign securities can be intensified in the case of investments in issuers organized, domiciled or doing business in emerging markets. Important disclosures The views expressed are as of January 2013, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate. Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC. Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value. © 2013 Columbia Management Investment Advisers, LLC. 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