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Broyhill Letter (Q1-09)

Broyhill Letter (Q1-09)

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Published by: Broyhill Asset Management on Nov 21, 2009
Copyright:Attribution Non-commercial


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\u201cOne dog barks because it sees something; a hundred dogs bark because they heard the\ufb01 rst dog bark.\u201d
\u2013 Chinese Proverb
Executive Summary

The Federal Reserve engineered a housing and mortgage bubble in order to mask the side-effects from the collapse of the technology bubble. It is now painfully clear that this boom severely distorted economic activity and created a massive expansion of non-productive credit. The U.S. dependence on credit may have undermined the foundation of the Ameri- can economy, just as the Spanish economy in the 16th century was weakened by its growing reliance on South American gold. The resulting low level of U.S. manufacturing investment in recent years compares with an unprecedented capital expenditure boom in China. In this respect, despite its much vaunted\ufb02 exibility, the world\u2019s most respected economy is beginning to resemble that of Britain after WWII.

It is possible that the history books may look upon this period in time, and identify the credit bubble as the catalyst for a
fundamental shift in the balance of economic power to the East.
The Death of Decoupling

Decoupling, the industry\u2019s favorite buzz word some months ago, described the prospect for continued emerging market growth despite faltering developed world economies. Like most other Wall Street consensus concepts, this one too died in the ass. In 2008 emerging market equities fell considerably more than those in the rich world, and\ufb01 nancial woes forced many countries to go cap in hand to the IMF. But is this the end of the emerging market boom?

Short term pain is only to be expected, yet emerging economies\u2019 reliance on America is often exaggerated. True, exports as a share of emerging economies\u2019 GDP have surged this decade, but their dependence on exports to developed countries has barely budged. Most of the growth in exports has been within the developing world itself as the internal components of aggregate demand continue to develop in a gradual and robust manner, offsetting reduced exports to the rich world (Chart 1).

There are good reasons to believe that emerging economies will continue to have a growing in\ufb02 uence on the global economy\u2019s rate of growth, the level and direction of trade, the price formation process, and the stability of cross-border capital\ufb02 ows. In fact, they are already the most important contributor to global growth and they have captured a large and growing share of world trade (Chart 2). Most emerging economies are not plagued by America\u2019s deep structural problems, such as an overhang of debt which will cramp growth for years. On many measures, such as government and external


balances, emerging economies look much sounder than the developed world. Current account surpluses and modest do- mestic debt in emerging Asia mean that most of the region is much less exposed to the credit crunch. The majority of Asian governments are in a good position to \u201cturn Keynesian\u201d should they wish to offset the impact of lower U.S. growth. The robust nature of many of these countries balance sheets \u2013 historically unusual \u2013 gives them the ability to stimulate internal consumption and investment.

In the meantime, the Latin American economies, though slowing, are showing incredible resilience. Unlike prior\ufb01 nancial crises, Latin American economies are structurally sound with much reduced foreign debt levels and only modest current account imbalances. Brazil and Chile are doing particularly better as they are commodity heavy and the recent resilience of commodity markets is probably a re\ufb02ection that major economies in the emerging market world are beginning to sta- bilize

Pumping Up the Panda

Although the global economy continues to deteriorate, China is showing early signs of recovery. As a result, the world\u2019s third largest economy is using its position as an opportunity to gain a seat at the head of the global table. In recent weeks, China has been negotiating deals to double a development fund in Venezuela to $12 billion, lend Ecuador at least $1 billion to build a hydroelectric plant, provide Argentina with access to more than $10 billion in Chinese currency and lend Brazil\u2019s

national oil company $10 billion. These deals largely focus on China locking in natural resources like oil for years to come. China is rapidly increasing its lending in Latin America as it pursues not only long-term ac- cess to commodities like soy- beans and iron ore, but also an alternative to investing in United States Treasury notes, of which they are the world\u2019s larg- est holder (left).

The story in China is fairly simple. It is the only country that has actually implemented a broad based and large scale stim- ulus program, and the impact is beginning to show. The sheer size of the investment, relative to the size of the economy, is approximately twice as large as the U.S.\ufb01 scal stimulus program. They are in the fortunate situa- tion of having ample resources

to do this. The Chinese economy operates in an authoritarian regime where political power is\ufb01 rmly controlled from the top allowing the Chinese government to implement its policy initiatives very effectively. This is a rare moment where an authoritarian regime has its advantages. A recovery in the Chinese economy that will likely lead the global economy will be distinctly bullish for Chinese equities as well as for stocks in markets closely related to the Chinese economy, including a number of China\u2019s neighbors in Asia and commodity producers around the globe. The massive resource requirements of the Chinese economy imply a compelling long-term case for the commodities asset class as the economy recovers.

The Emerging Emerging Bubble

From its low in 2002 to its recent peak, emerging market equity indices soared almost 500% against a mere double for the S&P 500 Index taking the price-to-earnings ratio on emerging market equities above that of U.S. equities. But emerging markets have not escaped the downward pressure on asset prices brought about by the credit crunch, resulting in many valuation metrics again reaching new highs relative to developed markets and their historical means. Earnings yields, divi- dend yields, and cash-\ufb02 ow yields have all reached record highs resulting in emerging markets again selling at a discount. But what interests us most is the potential for further gains, and perhaps the emergence of a full-\ufb02edged bubble.

The prospect of slowing developed world growth should not come as a surprise to inves- tors today. But what we are approaching now is the unthinkable: that the U.S. is past its prime. All bubbles need an underlying strong funda- mental case (or at least one that looks like it for a while). And the case for an emerging market boom is really understood by the consensus. Over the long term, the net creditor status of emerging markets leaves them less vulnerable than net debtor U.S. And as the debtors save more and the creditors pick up their spending with increased consumption, the secular con- trasts will likely continue, especially given the demographic trends. Demographics point to future growth and rising stock prices in China,

Brazil and other emerging economies, while pointing to increased savings and more subdued performance in the U.S. and

This simple story appears far more rationale than prior manias. Recall internet stocks with no likelihood of ever earning a pro\ufb01 t turning college drop-outs into millionaires overnight? Or the Japanese real estate bubble which ended with the Imperial Palace in Tokyo worth more than the entire state of California? The fascination with growth propelled the median Nasdaq 100 stock to over 100x earnings and the entire Japanese stock market to 65x earnings - 3x the valuation of the rest of the world! Surely, it is not unreasonable to conclude that as investors increasingly recognize that \u201ceasy money\u201d is in emerging markets and developed countries are a tired old story that emerging market equities selling at twice the multiple of developed markets is not outside the realm of possibility.

Bottom Line

To date, the recent bear market can be divided in three distinct stages. During the initial phase, which concluded during the\ufb01 rst half of last year, emerging markets performed well while the bear market was concentrated in the global\ufb01nancial sector. The second and most destructive phase, leading up to the collapse of Lehman Brothers and the resulting down- ward spiral in economic activity, once again proved that the only thing that rises in times of crisis is correlation. Global equities, commodities, corporate bonds and all asset classes beyond government debt crashed in tandem, while emerging markets fell considerably further. But during the current and likely\ufb01 nal stage of this bear market, emerging market relative performance has again demonstrated strength and resilience. We believe this is a major departure from the past and likely indicates future leadership when global share prices ultimately bottom. Historically, outperformers in bear markets become market leaders in the ensuing upturn.


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