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									                           Emerging Markets
    Curtis
Mewbourne                  Watch
                                                                                                                                                       August 2009




                                                                  Emerging Markets
                                                                 in the New Normal
                           At PIMCO’s most recent secular forum we                                     review the critical mass of this transforma-
                           analyzed the significant changes to the                                     tion and the implications this has for the
                           global economy and concluded we were                                        valuation of the U.S. dollar and its role as
                           entering a New Normal. This New Normal                                      the global reserve currency.
                           will mean lower potential growth for the
                           global economy overall and especially so                                    Voting or Weighing Machine?
                           for the highly levered developed economies.                                 Whether financial markets are voting
                           For the emerging economies this presents a                                  machines or weighing machines2 the chart
                           challenging environment, with lower export                                  below is eye opening. China’s stock market
                           demand and a reversal of leverage induced                                   capitalization is now larger than that of
                           global capital flows. But it also presents sig-                             Japan, the second largest economy in the
                           nificant opportunities, not only to shift from                              world. Just three years ago, in 2006, Japan’s
                           export led growth to domestic demand but
                           also to strengthen their position within the                                                   Stock Market Capitalization
                                                                                                             6
                           new economic order.
                                                                                                                                            Jan-2008
                           We believe that several key emerging econ-                                        5

                           omies are well advanced in the process
                                                                                                             4
                           of making that transition. While the U.S.,                                                                                    Jul-2009
                                                                                            U.S.$ Trillion




                           Europe, and Japan are still economically the
                                                                                                             3
                           largest and most dominant economies, these
                           economies are reaching the tipping point1                                         2
                           of global economic impact. This article will
                                                                                                             1
                                                                                                                                                       Japan
                                   Emerging Economies Becoming                                                                                         China
                                   “Locomotive” of Global Growth                                             0
                           10                                                                                    Jan-06        Jan-07         Jan-08   Jan-09
                                                        Advanced Economies GDP Growth
                                                                                                                   Source: PIMCO
                            8                           Emerging and Developing Economies                                               Chart 2
                                                        GDP Growth
                            6                                                                           market capitalization was 12 times the size of
                            4                                                                           China’s. In retrospect a buy China/sell Japan
             Percent (%)




                            2
                                                                                                        trade was about as close to a “no brainer” as
                                                                                                        financial markets offer. Four trillion dollars
                            0
                                                                                                        of profits were available for investors who
                           -2                                                                           stuck with this simple theme.
                           -4
                                                                                                        Some readers may perhaps fear that yet
                           -6                                                                           another asset bubble is forming, and that
                                     2007            2008           2009F         2010F
                                                                                                        the growth in the Chinese market has come
                                Source: IMF World Economic Outlook 2009                                 too far too fast, which of course is pos-
                                                       Chart 1                                          sible. At 25 times forward earnings and
          Emerging Markets Watch


          3.8 times price-to-book, the Shanghai Stock            Projections of Global
          Exchange Composite Index is far from cheap             Consumption Growth
          by traditional measures, and thus financial
          markets are likely reflecting more of a “voting        One analogous way to think of an economy
          machine” aspect of future expectations than a          is as a company with four major divisions,
          “weighing machine” measure of current value.           namely, consumer, business (investment),
          But the fact is that we are witnessing real            government, and international (net exports).
          time indicators of significant changes in the          For a company with limited domestic
          global economy, with China clearly continuing          customers (consumer, business, or govern-
          its meteoric rise in terms of global economic          ment), a winning strategy can be to initially
          importance. It is not surprising China’s market        produce goods for the export markets,
          capitalization is larger than Japan’s, given that      and look to grow the other divisions over
          the Chinese economy will probably surpass              time as demand picks up. As shown in the
          Japan to become the second largest economy             graph below, that domestic demand is now
          in the world next year, measured in current            starting to pick up, with enabling condi-
          exchange rates.3                                       tions in place following years of structural
                                                                 reforms and balance sheet improvement.7
          China is clearly the largest emerging econ-
          omy, but by no means is the phenomenon                 Following this simple construct, economies
          limited to China. Indeed in terms of GDP,              with large domestic consumer and business
          emerging market (EM) economies account for             (investment) sectors – like in China and India
          seven of the top twenty countries4, and repre-         with 30% of the world’s population – may
          sent the component that is growing the fastest.        have a key advantage. Take for example the
          The rest of the BRICs5 share some of the same          auto industry: Chinese auto sales are poised to
          characteristics that are significant comparative
          advantages in the New Normal, for example,                         Global Share of Consumption
          low labor costs and extremely low levels of           (% share of global
                                                                                     2007E   2008F   2009F   2010F   2015F   2020F
                                                                consumption)
          consumer debt. They also have large popula-
                                                                U.S.                 30.2    29.3    28.3    27.4    23.5    20.8
          tions, so domestic demand can truly move the
          needle on a global scale.                             Non-Japan Asia       12.1    13.6    15.5    17.1    25.8    32.3

                                                                China                 5.3     6.4     8.0     9.3    16.4    21.1
          For countries to become and remain domi-
          nant in the global economy they must reduce           Japan                 8.2     7.9     7.7     7.4     6.5     5.8

          their dependency on others (export demand)            Germany               5.6     5.5     5.3     5.1    4..3     3.8
          and develop their own sources of sustainable          U.K.                  5.0     4.9     4.8     4.6     4.0     3.7
          demand (particularly domestic consumption).
                                                                France                4.2     4.1     3.9     3.8     3.2     2.9
          Thus for large systemically important econo-
          mies, export led growth is a means rather than        Italy                 3.6     3.4     3.3     3.2     2.7     2.3

          an end, and the transition to domestic demand         NIE 4*                2.9     3.0     3.0     3.0     3.1     3.1
          is underway. The large (~$580 bn) government          India                 2.0     2.2     2.4     2.6     3.9     5.3
          stimulus program in China has been a contrib-
                                                                Spain                 2.4     2.3     2.2     2.2     1.9     1.8
          uting factor, keeping GDP above 6%. But India
          too has been able to maintain growth around           ASEAN 4**             1.8     2.0    21.1     2.1     2.5     2.7

          5%, without such a large program. A recent            Canada                2.3     2.3     2.2     2.1     1.9     1.7

          analysis by Credit Suisse6 shows that Chinese
                                                               Source: Credit Suisse
          consumption is already the second largest con-       Note: Data sorted by year 2010
          tributor to global consumption, and that China      *Includes Hong Kong, Korea, Taiwan and Singapore
          and India will be the first and fourth largest      **Includes Indonesia, Malaysia, the Philippines and Thailand

          contributors by 2020.                                                               Chart 3




August 2009                                                                                                           Page 2
                exceed U.S. sales (chart below). The BRICs have   are freely convertible. Each of these coun-
                10 times the population of the U.S. and less      tries has some system of capital controls that
                than 3% of the population own automobiles, so     significantly limit foreign exchange trans-
                the potential for growth is simply huge.          actions. Governments use capital controls
                                                                  to keep control of their currencies by not
                One of the most powerful and poten-
                tially profitable investment implications         allowing currency to leave the country9 freely
                likely to result from emerging economies          and by requiring foreign entities to exchange
                reaching critical mass is the future value of     only with the central bank or its agents. On
                the U.S. dollar, which has been the undis-        the trading floors of the large international
                puted global reserve currency since the end       banks you can trade U.S. dollars, Japanese
                of WWII. Many thoughtful and influential          yen, euros, British pounds, Mexican pesos
                market participants expect the U.S. dollar        and Polish zlotys and dozens of other curren-
                to continue to play that role, if for no other    cies for delivery into your bank account, but
                reason that there are no viable alternatives.     if you want to buy or sell Chinese renminbi,
                They will likely point to the euro (€)8 as suf-   Brazilian real, Indian rupees or Russian
                fering from a lack of political union among       rubles you can only do so in the “offshore”
                member states and the significant finan-          derivative market, where buyers and sellers
                cial crises among peripheral countries. The       pair up with no physical currency changing
                British pound, notwithstanding the fact that      hand, and all gains or losses are settled in a
                it was the global reserve currency for most of    different agreed currency.10
                the 18th and 19th centuries, is not a realistic
                contender given the small size of the U.K.        So while it is true that no emerging curren-
                economy. Nor is the yen, with the dimin-          cies have yet reached critical mass as a viable
                ishing economic status of Japan, following        replacement, there are many reasons to expect
                two decades of economic stagnation.               a secular decline in the value of the U.S. dollar.

                Notably absent from the list of alternatives      As seen in the following chart, emerging
                above are the currencies of the BRIC coun-        countries hold the lion’s share of international
                tries. Why? Because none of these currencies      reserves, mainly in the form of U.S. dollars
                                                                  and to a lesser extent euros. They appear to
                                                                  be increasingly concerned that the weak-
                                       U.S. and China             ening U.S. economy and banking system, the
                                      Automobile Sales            increase in money supply and other factors
             20,000
                                                                  may reduce the value of the dollar over time.
             18,000
                                                                  Notably, they have been voicing concerns in
             16,000
                                                                  international forums like recent G8 meetings,
             14,000
                                                                  and they have taken some (perhaps small)
             12,000
                                                                  steps to reduce dependency on the U.S. dollar.
000s Units




             10,000

              8,000
                                                                  China for example has entered currency swap
              6,000
                                                                  arrangements with a number of countries11 so
                                                                  that trade financing can be negotiated in ren-
              4,000
                                                         China
                                                         U.S.
                                                                  minbi as opposed to dollar terms. In addition,
              2,000
                                                                  several countries have signed up to replace
                  0
                                                                  part of their foreign currency reserves with
               D l-08
               M -08
                         9
               Fe -07
                 Ju 08
               Ju -06
               N -06
               Ap -06
               Se -07
               M -04
               Au r-05
               Ja 05
               O 04
               Fe -02
                Ju 03

               M -03
               Se -02
               Ju -01
               N -01
               Ap 01




               D -03




                      -0
                   b-
                   g-
                     -
                   b-
                     -




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                      Source: PIMCO                               nated in SDRs (Special Drawing Rights), a
                                         Chart 4                  basket of currencies.




                Page 3
                                                                                                                                                                           Facebook…
                                        It May Be Our Currency,                                the absence of a single viable alternative. In                          Stay up to date on
                                         But It’s Your Problem12                               combination with other factors, that likely                        PIMCO with Facebook.
                         65                                                                    means a continuing devaluing of the U.S.                                Search “PIMCO.”
                                                                                               dollars versus other currencies, especially
                         60                                                                    the EM currencies. Accordingly investors                                        twitter…
                                                                                               should consider whether it makes sense to                                     Stay in touch
% of World FX Reserves




                         55
                                                                                               take advantage of any periods of U.S. dollar                                  with PIMCO.
                                                                                               strength to diversify their currency exposure.                           Search “PIMCO”
                                       EM Economies
                         50
                                       Advanced Countries

                         45
                                                                                               Curtis Mewbourne
                                                                                               Managing Director, Portfolio Manager
                         40


                         35
                                 97        99       01         03      05       07             1
                                                                                                    In his book of the same name, Malcolm Gladwell says
                              Source: PIMCO, as of June 2009                                        a “Tipping Point is the moment of critical mass, the
                                                         Chart 5                                    threshold, the boiling point.”
                                                                                               2
                                                                                                    To paraphrase, in the short term, the stock market behaves
                         Capital must flow somewhere, and recent                                    like a voting machine, but in the long term it acts like a
                         data suggest that the patterns of the pre-                                 weighing machine, Graham and Dodd, Security Analysis
                                                                                                    (McGraw-Hill, 1934), page 23.
                         vious decades, when capital flowed out                                3
                                                                                                    IMF forecasts of nominal GDP measured in $U.S. at
                         of emerging countries and back into core                                   current exchange rates, World Economic Outlook April
                         countries has to some degree reversed.                                     2009. China became the second largest economy in the
                         Clearly the U.S. dollar benefitted from                                    world in purchase power parity (PPP) terms in 2001
                                                                                                    according to IMF data.
                         a strong flight to quality bid during the                             4
                                                                                                    China, Russia, Brazil, India, Mexico, Korea, Turkey per
                         global banking crisis. However, recently                                   IMF World Economic Outlook 2009.
                         we have witnessed a reversal of those                                 5
                                                                                                   BRICs include Brazil, Russia, India, and China.
                         flows, arguably at least in part due to con-                          6
                                                                                                    Credit Suisse, “China’s Economic Outlook,” Dong Tao,
                         cerns that the massive amounts of U.S.                                     Chief Economist, Non-Japan Asia Economics Research,
                         dollar liquidity produced in response to the                               July 16, 2009.

                         crisis. Indeed, in emerging countries we are
                                                                                               7
                                                                                                    See previous EM Watch articles for analysis of structural
                                                                                                    and institutional reforms across EM countries at http://
                         seeing some central banks intervening to                                   www.pimco.com/LeftNav/ContentArchive/Default.htm
                         limit appreciation of their currencies as cap-                        8
                                                                                                    The € was introduced as an accounting currency
                         ital flows back into their economies. These                                on 1/1/1999 with coins and bills entering circulation
                         preliminary signs of a reversal in the tra-                                1/1/2002.

                         ditional pattern of capital flows during
                                                                                               9
                                                                                                    Small amounts of notes and coins are tolerated but
                                                                                                    foreign individuals and companies cannot, for example,
                         a deleveraging cycle may well mark an                                      exchange those currencies or deposit them into a
                         important shift in currency preferences.                                   bank account.
                                                                                               10
                                                                                                     The Non Deliverable Forward (NDF) market under
                         And while we have not yet reached the point                                ISDA agreements.
                         where a new global reserve currency will                              11
                                                                                                    Brazil, Hong Kong, Indonesia, Korea, Malaysia, Belarus
                         arise, we are clearly seeing a loss of status                              and Argentina.
                         for the U.S. dollar as a store of value even in                       12
                                                                                                    John Connally, Treasury Secretary under Nixon.




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                         curities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in              840 Newport Center Drive
                         emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio.
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                         Newport Beach, CA 92660, 800-387-4626. ©2009, PIMCO. EMW048-081309

								
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