Emerging Markets Review 2011

PI P R E V I E W S p r i va t e & i n s t i t u t i o n a l p o r t f o l i o

2012 Emerging Markets

We are delighted to feature a host of co-published articles from a series of seasoned managers in this edition of our 2012 Emerging Markets Review. In an uncertain global economic climate where investors face great challenges in implementing positive asset allocation strategies for capital preservation. This publication will provide timely themes and insights into one of the few investment areas that is able to potentially provide returns across asset classes and time horizons.

We sincerely hope you enjoy reading this edition as it has been a pleasure to compile for a wider audience.

Sunil Maya Managing Director PIP Reviews IBPC 153 Fenchurch Street London EC3M 6BB info@ibpcmedia.com Tel: +44 207 220 0440 Fax: +44 207 220 0445 Although every effort has been made to ensure the accuracy of the information contained in this book the publishers can accept no liability for inaccuracies that may appear.

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The material in this publication has been prepared solely for the distribution to professional and qualified investors.

The information in this publication you are about to read is intended for Professional and Qualified Investors. Including regulated financial intermediaries such as banks and securities brokers, regulated insurance companies, government or public authorities, corporate treasurers and financial advisers.

The information contained in this publication should not be considered as an offer, or solicitation, to deal in any of the investments or funds mentioned herein, by anyone in any jurisdiction in which such offer or solicitation would be unlawful or in which the person making such offer or solicitation is not qualified to do so or to anyone to whom it is unlawful to make such offer or solicitation.

The market commentaries represent an assessment of the market environment at a specific point in time and are not intended to be a forecast of future events, or a guarantee of future results. This publication is not prepared for any particular investment objectives, financial situation or requirements of any specific investor and does not constitute a representation that any investment strategy is suitable or appropriate to an investor’s individual circumstances or otherwise constitute a personal recommendation. The information in this publication is being provided strictly for informational purposes only and does not constitute an advertisement.

The commentaries should not be regarded by investors as a substitute for independent financial advice or the exercise of their own judgment.

IBPC does not warrant the accuracy, adequacy or completeness of the information and materials contained in the publication and expressly disclaims liability for errors or omissions in such information and materials. Accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the reader, the investor, any person or group of persons acting on any information, opinion or estimate contained in the website. IBPC reserves the right to make changes and corrections to any information on this publication at any time, without notice.

Past performance is not a guide to the future. Market and exchange rate movements may cause the capital value of investments and the income from them, to go down as well as up and the investor may not get back the amount originally invested. Investments involve risks. Before making any investment decision, you should read the relevant offering documents and in particular the investment policies and the risk factors. You should ensure you fully understand the risks associated with the investment and should also consider your own investment objective and risk tolerance level. Remember, you are responsible for your investment decision. If in doubt, please get independent financial professional advice.

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Contents

01 02 03 04 05

Lloyd George Management - The Strategic Case for Investing inFrontier Equity Markets Goldman Sachs Asset Management International Redefining Emerging Markets Carmignac Gestion - Why are we long-term believers in Emerging Markets?

Kaltchuga Capital Management - Re-developing Russia, the next European superpower AllianceBernstein - The Advantages of Multi-Asset Investing in Emerging Markets

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06 07

7 11

08 09

ACPI - Monthly Viewpoint: Trick or Treat Pictet Asset Management - Reshuffle of Chinese regulators points to policy continuity Charlemagne Capital - The Passing of the Baton Lipper - Best Performing Global Emerging Markets Funds

18 21 22 25

12 16

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Lloyd George Management

The Strategic Case for Investing in Frontier Equity Markets We believe that frontier markets currently offer equity investors the prospect of compelling long term returns, and represent an opportunity set within which robust active management can achieve significant alpha generation. As such, investors seeking the next emergent asset class may find frontier markets to be worthy of attention.

Founded in 1991, Lloyd George Management “(LGM)” has consistently invested with a strategic conviction that the world economy is undergoing a structural transformation, with the economic centre of gravity shifting steadily from developed to emerging countries, and from West to East.

Since then, investors have experienced two decades of dramatic change in the economic world order - first as Japan’s rise gave way to that of the dynamic Asian Tigers, and, more recently, as the re-emergence of India and China as economic powerhouses fundamentally reshaped the global landscape. As a result, LGM’s early conviction about the growth prospects of Asian economies has rewarded our clients.

We are now embarking on a further global transformation, namely the rise of key periphery countries—frontier nations. Frontier economies are developing rapidly by leveraging a variety of advantages, including abundant natural resources, favourable demographic trends and rising domestic consumption.

Frontier stock markets, which receive very limited coverage from sell-side research departments, offer rich pickings for active management to add value.

Against this background, therefore, a compelling long-term investment case can be made for an investment in frontier markets—the next emerging markets.

The Next Emerging Markets In 1990, emerging markets were often considered to be risky places to invest, and constituted, at most, a marginal weighting in investors’ portfolios. Twenty years later, they have become the prime drivers of global economic growth, and, having achieved recognition as a well-established asset class, are well-analysed, arguably leaving relatively few ‘undiscovered’ investment opportunities remaining.

Today, while the long term fundamental picture for emerging markets remains attractive, the opportunity for significant alpha generation has expanded to encompass previously more obscure countries across Africa, Eastern Europe, the Balkans, the Baltic States, the Middle East, Latin America, the Caribbean, and Asia. As a group, these countries have become known as the ‘frontier markets’.

The following map outlines LGM’s frontier market universe of 61 countries. In addition to the 25 countries included in the MSCI Frontier Markets index, this also encompasses five smaller emerging market countries (including Colombia and the Philippines), and also countries that index providers exclude from frontier indices for reasons including low liquidity, or a scarcity of investible companies, but which may still present attractive individual investment opportunities.

Economic Strengths On the economic front, while the prospects of individual countries vary significantly, frontier markets as a group offer strong GDP growth prospects; an abundance of natural resources; and the demographic advantages conferred by the possession of young, growing populations.

The IMF currently forecasts a five year growth rate for frontier economies of 5.3% p.a., which compares favourably with the forecast of 2.9% p.a. for developed economies, is a rare bright spot in the global economic picture as developed economies wrestle with the burdens of fiscal reform, deleveraging and slower growth.

This growth in frontier markets is supported by abundant reserves of various natural resources (including around 45% of global oil reserves, and 25% of arable land) and demographic advantages including young and growing populations.

Strikingly, while the UN population division predicts that the ratio of working age population to dependent population will worsen for emerging markets from 2017, the picture will continue to improve for frontier countries until 2045.

Frontier balance sheets at the sovereign, corporate and household level are also healthy. The following chart, for example, indicates both the low level of indebtedness demonstrated by frontier markets relative to their emerging and developed market counterparts, and also reveals the extent to which Frontier markets have accumulated a healthy cushion of foreign exchange reserves:

Widely regarded as the natural successors to the initial group of emerging markets, frontier markets display many of the characteristics emerging markets offered 20 years ago, including low equity market capitalisations relative to both population and economic output.

In short, several factors suggest that frontier markets as a whole represent fertile ground for the generation of attractive long term investment returns. These can be broadly separated into two categories – economic, and equity market drivers.

The absence of the extreme levels of indebtedness with which developed nations are currently burdened is a strong positive for frontier countries at the macro, corporate and household levels.

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Lloyd George Management

The Strategic Case for Investing in Frontier Equity Markets Frontier Equity Markets

Valuations and Dividend Yields

Positive drivers relating to equity markets include the prospect for expansion and liberalization of frontier stock markets; diversification benefits to be gained from owning a less-correlated asset class; stock market inefficiencies that create alpha-generation opportunities; and, finally, attractive equity valuations and dividend yields.

Frontier market equity valuations currently look reasonably attractive relative to both their emerging and developed counterparts, and their own history. The MSCI Frontier Index currently trades at around 1.4x trailing book value. This is significantly below the average observed across its history, and also below MSCI Emerging Markets (1.6x currently) .

The following chart shows clearly the extent to which equity market capitalisation-to-GDP ratios for frontier markets have lagged those of their emerging and developed counterparts in recent years:

On a forward PE basis, frontier stocks currently trade broadly in line with emerging markets at 10x forward earnings, but if we ally to these numbers the substantially larger dividend yield offered by Frontier Stocks (4.8% vs 3.4% for EM) , the case for frontier appears rather compelling.

The Frontier Market Opportunity Set The formalisation of the frontier market asset class is a relatively recent development. The term itself was first used in 1996 by the International Finance Corporation (IFC) to connote the group of small stock markets that made up its ‘frontier composite’ of 21 countries. Having acquired this dataset in 1999, Standard & Poors (S&P) then launched the first investible frontier index in October 2007.

Morgan Stanley Capital International (MSCI) followed suit with its own frontier index later the same year, initially including 19 countries, and later expanded this to cover the current 25.

*LGM Frontier Markets Universe as described previously **MSCI Emerging Markets Index constituents excluding countries already in LGM Frontier Markets Universe (Colombia, Peru, Philippines, Morocco, Egypt)

Index providers, including MSCI, FTSE and Standard & Poors, require each market to meet specific criteria before it can join the investible universe. Such criteria typically include: minimum standards of capital mobility; efficient clearing and settlement of trades; independence of the market from state government.

There are also qualifying criteria at the individual stock level, which include minimum levels of liquidity and market capitalisation.

***MSCI World (Developed Markets) Index constituents

The gradual process of convergence that will occur as frontier markets follow the growth path of their emerging markets counterparts – one which for many frontier countries will be driven by a transition to the sort of manufacturing exportbased economy that drove the first group of emerging countries to a higher tier of development – is likely to bring benefits to long-term frontier investors.

Risk Diversification Despite equity market correlations having risen somewhat recently, correlations between frontier markets and other equity asset classes remain relatively low. The following matrix outlines weekly correlations over a nine-year period (30.06.2002-30.06.2011):

Historically frontier markets have been one the few equity asset classes with low correlations and have offered a significant diversification benefits. While correlations have increased recently, the diversification benefits offered by an allocation to frontier remain substantial.

Portfolio Management Team Lloyd George Management’s Frontier Markets investment team is led by Thomas Vester Nielsen, CFA, who managed Frontier Market portfolios at BankInvest in Copenhagen from September 2007:

Thomas, who is based in London, is supported by a team of two experienced frontier analysts, and specialist Advisors including Dr. Greg Mills, head of the Johannesburg based Brenthurst Foundation and a leading advisor to governments in a number of frontier countries.

The team places a strong emphasis on the importance of primary research including on-the ground company meetings. The importance of such meetings can hardly be overstated, given a lack in certain cases of consistently presented accounting information (sometimes a com-

pany’s financial statements are only available to be viewed in person at their premises), and a scarcity of quality sell-side investment research. These inefficiencies do however often the existence of attractively mispriced investments opportunities.

Inefficiencies also permeate the market trading environment where volumes can be thin, and, as a consequence, bid-ask spreads are often large. Local connections and deep market knowledge, such as those possessed by Lloyd George Management’s experienced trading team, can help provide a further edge.

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Lloyd George Management

The Strategic Case for Investing in Frontier Equity Markets Choice of Index

tions, and will be benchmarked against a composite index comprising 50% MSCI Frontier Markets index and 50% MSCI Frontier Markets ex-GCC index.

The concentration of standard frontier indices in country terms - 3 oil-rich GCC countries (Kuwait, Qatar and UAE) make up in excess of 50% of the capitalisation of the MSCI Frontier Index - could skew the portfolio’s weighting toward GCC stocks and mean that attractive opportunities from elsewhere in the frontier universe are sacrificed.

Please email info@uk.lloydgeorge.com for further details.

Lloyd George Management believes that, in order to offer clients a better balance of attractive opportunities across the range of smaller frontier countries, that a blended index consisting of 50% MSCI Frontier Markets Index, and 50% MSCI Frontier Market (ex-GCC) Index, is more appropriate.

Lloyd George Management info@uk.lloydgeorge.com

LG Frontier Markets Fund The Investment Approach Our investment philosophy is predicated on the view that financial markets are inefficient and that pricing anomalies may persist for prolonged periods of time, particularly in frontier markets. In the long term we believe that market pricing will reflect corporate fundamentals, and reward companies with structurally attractive business models stewarded by skilful, prudent management teams which apply a strong capital discipline to generate cash returns above their cost of capital across the business cycle.

We aim to exploit these inefficiencies with our long term fundamental investment approach, which is primarily bottom up and focussed on intensive company research. This fundamental research is complemented by a macroeconomic framework which helps to set the context for analysis of corporate prospects, and also to maximise the quality of our research efforts by identifying countries and sectors on which to focus, and in some cases, to avoid.

Thorough due diligence is then undertaken in order to understand the dynamics driving a company’s business model. We only invest in strong franchises and in assets which have the ability to generate returns in excess of the cost of capital across the business cycle. We look to management teams with the integrity, vision and intelligence to capitalise on these business opportunities and foremost management which shows a strong capital discipline. Furthermore, we prefer companies with a net cash position or very limited financial obligations. Dividend yield is also an important criteria for us and we favour companies with a long history of rewarding shareholders with dividends, believing that a consistent dividend pay-out is likely to be a positive indicator of both corporate governance standards and cash generation.

Full assessment of a company requires first hand meetings with the management, often occurring over a period of years. Regular visits to frontier countries are essential to understand the local dynamics, not only of the corporate sector but also of the local financial and macro-economic environment. Our detailed company analysis extends to our own modelling and typically comprehensive company notes, when we consider companies are potentially worthy of purchase.

We assess the fair value of companies using DCF, and cross check with other metrics. To initiate a position in a stock, we generally require a minimum upside of 20% between the current share price and our estimate of fair value.

Our objective is to build a portfolio of 40-60 holdings with considerable performance potential and to be non-benchmark driven in our portfolio composition.

We aim for low turnover, typically anticipating a holding period of at least 5 years and to add alpha across the market cycle.

Lloyd George Management has recently established a Dublin-domiciled Frontier Markets Fund to be managed by Thomas Vester Nielsen and the team. The Fund, a UCITS IV vehicle, will offer daily subscriptions and at least fortnightly redemp-

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Disclaimer The material in this publication has been prepared solely for the distribution to professional and qualified investors.

The information in this publication you are about to read is intended for Professional and Qualified Investors. Including regulated financial intermediaries such as banks and securities brokers, regulated insurance companies, government or public authorities, corporate treasurers and financial advisers.

The information contained in this publication should not be considered as an offer, or solicitation, to deal in any of the investments or funds mentioned herein, by anyone in any jurisdiction in which such offer or solicitation would be unlawful or in which the person making such offer or solicitation is not qualified to do so or to anyone to whom it is unlawful to make such offer or solicitation.

The market commentaries represent an assessment of the market environment at a specific point in time and are not intended to be a forecast of future events, or a guarantee of future results. This publication is not prepared for any particular investment objectives, financial situation or requirements of any specific investor and does not constitute a representation that any investment strategy is suitable or appropriate to an investor’s individual circumstances or otherwise constitute a personal recommendation. The information in this publication is being provided strictly for informational purposes only and does not constitute an advertisement.

The commentaries should not be regarded by investors as a substitute for independent financial advice or the exercise of their own judgment.

IBPC does not warrant the accuracy, adequacy or completeness of the information and materials contained in the publication and expressly disclaims liability for errors or omissions in such information and materials. Accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the reader, the investor, any person or group of persons acting on any information, opinion or estimate contained in the website. IBPC reserves the right to make changes and corrections to any information on this publication at any time, without notice.

Past performance is not a guide to the future. Market and exchange rate movements may cause the capital value of investments and the income from them, to go down as well as up and the investor may not get back the amount originally invested. Investments involve risks.

Before making any investment decision, you should read the relevant offering documents and in particular the investment policies and the risk factors. You should ensure you fully understand the risks associated with the investment and should also consider your own investment objective and risk tolerance level. Remember, you are responsible for your investment decision.

If in doubt, please get independent financial professional advice.

Goldman Sachs Asset Management International

Redefining Emerging Markets Foreword Would you call markets with these characteristics ‘emerging’?

1

Home to almost 20% of Fortune 5001 companies and 30% of the world’s billionaires

2 3

Average investment grade rating on sovereign debt.

4

Six out of the 15 largest economies, including the world’s second largest economy.

5

Eight out of the top 10 predicted contributors to global growth over the coming decade.

Home to 15 of the world’s 20 largest cities.

Neither would we. Given the rising importance of some of these economies, we no longer think the traditional developed/emerging divide is appropriate.

At Goldman Sachs Asset Management (GSAM) there are eight countries that we now refer to as ‘Growth Markets’ because we believe their current size and macroeconomic conditions offer the potential for transformational growth in the coming decades. The Growth Markets include each of the BRIC countries (Brazil, Russia, India and China) as well as the four largest ‘Next 11’ (N-11) countries: Mexico, South Korea, Turkey and Indonesia. These are the countries that we believe are most likely to experience rising productivity coupled with favourable demographics, and therefore, a faster growth rate than the world average going forward.

Over the next few pages, we will explain our thinking behind our Growth Markets concept and examine the rise of the growth markets consumer, which we believe will be a key driver behind world economic growth in the future. We will also explore how this framework can be useful in identifying exciting investment opportunities.

Jim O’Neill Chairman, Goldman Sachs Asset Management

Introducing Growth Markets What happens when emerging markets have emerged? The answer is to redefine the pack leaders and adjust your investment strategies accordingly. The biggest emerging market economies are now growth markets.

Since the term ‘BRIC’ was coined one decade ago, many of Goldman Sachs’ projections about the economic clout of this grouping of Brazil, Russia, India and China have been realised earlier than expected.

China is already the world’s second largest economy. The BRIC nations plus Mexico, South Korea, Turkey and Indonesia account for six of the world’s 15 largest economies as measured by US dollar equivalent GDP.1 They are no longer emerging – they are genuine growth markets of substance.

GSAM’s chairman, Jim O’Neill believes: ‘These countries are home to 20% of the Fortune 500 companies and 30% of the world’s billionaires. Their sovereign debt is investment grade. The group will provide eight of the top 10 predicted contributors to global growth over the coming decade.’

Since the 1980s, the wider grouping of emerging economies has developed global scale and its share of global equity market capitalisations has risen from 1% to 13%.2 Yet, there are still marked differences in market size, macroeconomic improvement and growth rates for each country. Emerging markets are not homogenous.

To accommodate the phenomenal emerging market growth of the past 20 years and its expected potential, GSAM has divided the economies of 180 countries

into three groups – developed, growth and emerging.

Developed markets are countries with a high average income per capita. They have reached advanced stages of economic development and offer open and transparent financial markets. The US, Japan, Germany and other G7 nations fit this description. There are eight non-developed markets with a share of global GDP greater than 1%, which are grouped as growth markets. The BRIC nations and Mexico, South Korea, Turkey and Indonesia have the potential for transformational growth. They are now growth markets in their own right.

Other nations each contribute less than 1% to global GDP. The term emerging market is still appropriate for these economies, which typically have low GDP and low income per capita.

O’Neill says: ‘Many offer scope for improvement in their investment environments as GDP rapidly increases. Nigeria, Vietnam, the Philippines, Iran, Egypt and others are those we continue to view as emerging markets.’

But it is the eight growth market economies that now have the likely impact and scale to outshine many developed market economies.

Their size and potential are large enough to affect the world economy. The 1% of global GDP threshold equates to a market economy of at least $600 billion.

Many of the BRIC nations are far larger than the cut-off point.

‘Growth Market economies now have the scale to outshine many developed market economies.’

Together, the growth markets are already big and will get bigger. They have a 23% share of global GDP, against a 65% share for developed markets and 12% for emerging markets. Their potential for growth is far greater than for most developed and emerging market economies. O’Neill says: ‘We believe economies of this size allow for business operations and investment similar to that in developed market countries. In the coming decade, the eight will be among the top 10 predicted contributors to growth, accounting for 60% of global GDP growth.’

They share other characteristics. All have growing populations and substantial equity markets. The average-weighted capitalisations for each run from approximately $12 billion for Indonesia to $70 billion for Russia, whereas most emerging market capitalisations are below $5 billion. The choice of growth market stocks is also increasing. Turkey has the fewest number of listed stocks at just 19, whereas China has 141. O’Neill says: ‘By virtue of their size, these markets offer the depth and liquidity investors need and they have the most potential for growth.’

Broadly the growth markets have favourable demographics, which is their key advantage for economic expansion. Their young, large and growing populations will fuel this on both a country and a global scale. They are already home to half the world’s population and could add over 300 million people to their labour forces over the next two decades.

Improving conditions for growth also play a part in developing economic and investment potential. GSAM considers macroeconomic factors such as inflation, open economies and the use of technology, as well as human factors such as educational levels and political conditions, before it assigns growth market status.

The changing line-up of economic powers and the emergence of growth markets leave investors with a number of equity investment strategy options.

Growth market, N-111 and emerging market allocations can be used as separate investments or in combination.

The BRIC nations are already the largest economies within the growth market set and have Introducing Growth Markets strong potential to provide the most compelling long-term growth prospects.

The N-11 accounts for 8% of global GDP, about half the size of the BRIC economies. The four biggest nations of N-11, South Korea, Mexico, Indonesia and Turkey represent the majority of the N-11’s economic clout, accounting for three

Emerging Markets

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Goldman Sachs Asset Management International

Redefining Emerging Markets quarters of N-11 GDP and of the N-11 portfolio. A combined BRIC and N-11 exposure covers 23% of global equity market capitalisations and that share could double by 2030. The markets will continue to see more participants in that time, potentially increasing the number of investible opportunities.

Exhibit 1 - BRICs’ real consumption could quadruple in the next 15 years

BRIC and N-11 indices have outperformed over the last 10 years. N-11 posted gains at 20.3% and MSCI BRIC at 16.5%, against 14.1% for the MSCI EM and 2.3% for the MSCI World Index.2 Combining investments in the two aims to provide broad exposure to the growth markets and some future, potential growth markets.

The resulting investment also benefits from diversification by country and sector, covering 14 countries (as Iran is subject to investment restrictions) and 10 business sectors. Compared with a traditional emerging markets portfolio, a BRIC and N-11 line-up apportions greater exposure to growth markets, with the N-11 longerterm potential. The N-11 countries may some day have the scale, growth trajectory and aspirations to become growth markets themselves.

All data and quotes are sourced from GSAM Strategy Series: Redefining Emerging Markets, 31 January 2011, unless sourced otherwise.

The Rise of the Growth Markets Consumer In the post-crisis world economy, the power of the US consumer has become questionable. Many fear it will be difficult for the world to cope without this key player, which has been the dynamic driver of global growth over the past several decades. It is fortunate, therefore, that the BRIC and so-called Next 11 (N-11) countries are likely to be able to compensate for any sluggishness in US consumption going forward. It is perhaps because of the challenges faced by the US and the global crisis that we are entering a period when other consumers will take up the lead and drive the world’s growth. While the US still consumes much more than the BRICs, the developed world cannot compete with these four countries in terms of potential for growth and incremental consumption opportunities - both today and in the future.

We expect that the BRICs consumer could become as large as the US consumer by the end of this decade – both in real and nominal terms, as Exhibit 1 illustrates. In terms of incremental changes, the BRICs together could add up to $1 trillion of additional real consumption on average per year to 2025.

Within the BRICs, China, in particular, will likely remain the main marginal influence to global consumption – its consumers could exceed Japan’s before 2013.

In terms of incremental consumption, China could potentially add almost $500 billion a year on average to world consumption to 2025.

Moreover, if China succeeds in raising its consumption-to-GDP ratio over the next few years and the US ratio falls to its historical average, the Chinese consumer alone could challenge the US in the first half of the next decade. Among the other BRICs, India could overtake Brazil to become the second largest country in the group in terms of consumption by 2019.

While the BRICs will undoubtedly dominate consumption, today’s other growth markets – South Korea, Indonesia, Mexico and Turkey – might also gain substantial weight as major consumption stories. As Exhibit 2 shows, Mexico’s consumers will lead the latter group.

Consumption in Turkey and Indonesia is likely to overtake South Korea by the beginning of the next decade. In fact, Indonesia could have the fastest growth across all N-11 economies, relative to its current position.

Mexico, Indonesia and Turkey could also each add on average in the region of $40 billion-$50 billion in consumption per year to 2025.

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Implications for Goods and Services A dramatic expansion of the middle and high income classes in the BRICs and the N-11 will be the main driver behind the rise in consumption over the next decade and beyond (see Exhibit 3). As people move through different income brackets, the relative composition of their expenditure switches from predominantly necessities to predominantly discretionary consumer goods and services as well as luxuries. As various goods and services suddenly become affordable, demand for them accelerates. Sectors that are particularly well positioned to benefit from rising incomes are consumer durables (in particular, autos), travel and tourism (in particular, aviation) and luxury goods. We believe the next 10-15 years could see the start of the BRIC’s dominance in the global markets, in terms of both growth and absolute size. In 2009, China became the biggest car market by sales. By 2020, BRIC consumers could be buying half of all cars sold globally.

Within other growth markets, the auto sectors in Mexico and Turkey are likely to provide sizeable opportunities in the decade ahead. Travel and tourism – both domestic and international – could also see a significant change in its demand and supply dynamics over the next decade and beyond. The different beneficiaries from this shift will include service industries such as transport, particularly aviation, hotels, tour operators, as well as retailers of travel items and others.

Specifically, the BRICs’ share of global air travel could rise to 35% by 2020 and to over 50% by 2050.

Annual growth in BRICs air passengers over the next decade is expected to be in double digits, mainly driven by China and India. By 2019, China could become the largest aviation market in the world. Another product category that benefits from rising incomes is luxury goods, such as spirits and champagne, fragrances and cosmetics, jewellery, ready to wear, leather goods and watches. By 2025, the BRICs could represent half of the global luxury goods market. By the same year, China could become the largest luxury goods market. The Rising Consumer: Opportunities and Risks The remarkable transformations in global consumption patterns will undoubtedly continue to create plenty of opportunities for investors, companies, governments and economies in general. But together with positive implications come associated risks and pressures. Among the benefits, we would highlight enormous supply-side opportunities and associated prospects for capital markets development. In addition, the ensuing rebalancing towards domestic consumption and sector diversification could also benefit the domestic economies by ensuring that their growth models are more sustainable. Among the potential risks, we would identify demand induced fluctuations, environmental concerns, as well as the uncertainty surrounding our projections.

While the opportunities and risks are numerous and highly complex, we believe the rise of the BRICs and N-11 consumers over the decades ahead will underpin the most important investment themes in all markets, both directly and indirectly. To benefit from this changing landscape, we believe investment managers should consider gradually giving more weight in their portfolios to the growth markets. Given their size, these countries have the capacity to generate a number of major investment opportunities going forward – and thus deserve special

Goldman Sachs Asset Management International

Redefining Emerging Markets attention from investors.

‘By 2020, BRIC consumers could be buying half of all cars sold globally’ Exhibit 2 - While the BRICs will dominate, other growth markets might also gain gravity as major consumption stories

tutes an emerging market. Dow Jones counts 35 countries in its broad global index, Standard & Poor’s 19, while MSCI counts 21. Which of the index providers is right? GSAM encourages investors to think outside the constraints indexes may pose, adopt a robust macroeconomic framework to identify the most important part of the opportunity set, and allocate capital accordingly.

In GSAM’s view, the BRICs and N-11 offer the most compelling opportunities in terms of potential long term growth and equity returns over the coming decade. GSAM believes investors should consider actively managed BRIC and N-11 portfolios to access this opportunity. In combining BRIC and N-11 portfolios, investors can look to achieve good country diversification, as well as meaningful sector diversification.

BRIC is traditionally quite heavy in commodities as they form a large part of the equity market in Brazil and in Russia. N-11 markets have only 15% commodity exposure so can offer a great complement to BRIC that should serve investors well. For example, in the recent sell-off, the N-11 strategy held up well compared with BRIC indices.

Exhibit 3 - BRICs and N-11 middle class expansion will drive consumption

GSAM’s analysis suggests that over the next two decades BRICs and N-11 market capitalization could increase substantially in absolute terms and overtake developed markets. The primary drivers are rapid economic growth and capital market deepening, or new issuance that will be skewed to these countries.

GSAM believes the BRIC and N-11 markets will move from the periphery to the core. As these economies increasingly drive most of the important things in the world, whether that is growth or equity markets, investing in these countries may not be optional for investors who want to build truly global portfolios.

However, economic growth and equity growth are not perfectly correlated.

There will be periods, months or even years, when the link between the two may be tenuous. Over the long term, GSAM believes that investors will be rewarded for anticipating these dramatic structural shifts in the global economy and the global equity markets. This has certainly been the case over the last decade and GSAM believes that it can be repeated over the next 10 years.

Investing in a Growth Markets World It has been almost 10 years since Jim O’Neill of Goldman Sachs created the BRIC acronym to identify Brazil, Russia, India and China as engines of global growth with the potential of ranking among the world’s largest economies. Since that time, China has created the equivalent of three UK economies, Brazil has generated more GDP than Japan and the equity markets have quintupled. Goldman Sachs Asset Management believes the next 10 years will be dominated by the continued rise of what we term the Growth Markets. The Growth Markets include each of the BRIC countries (Brazil, Russia, India and China) as well as the four largest ‘Next 11’ (N-11) countries: Mexico, South Korea, Turkey and Indonesia. These are the countries that are most likely to experience rising productivity and a faster growth rate than the world average going forward. The other N-11 countries (Bangladesh, Vietnam, Pakistan, Nigeria, Egypt, Iran and the Philippines), should still be considered as traditional emerging markets, but if they work on improving their growth environments, some may be able to transition to Growth Markets.

While ‘emerging markets’ may offer exciting investment opportunities – GSAM thinks it is critical for investors to be selective about where to allocate capital within the 150 countries that are currently classified as non-developed markets [7]. GSAM further believes that the Growth Markets framework can be helpful to investors in deciding where to focus in this diverse opportunity set. In our view, emerging markets can no longer be seen as all offering the same potential.

Even index investors must be careful as there is little consensus on what consti-

Seeking out under-appreciated or unknown stocks in the Growth Markets requires significant resources. GSAM has been building its local capabilities and now boasts 31 investment professionals based in eight offices across the globe, including São Paolo, Mumbai, Shanghai and Seoul. GSAM believes selectivity is important and local expertise is instrumental in the decision making process.

Understanding local customs and languages, accessing management teams and real-time access to local capital markets and news flow provide the edge.

Currently, the GSAM portfolio management team continues to have a preference for companies that are expectedto benefit from the rise in the domestic consumer. For example, the team has identified the largest brewing company in Nigeria, which has approximately 60% market share. Nigeria has the second largest beer market in Africa but is underpenetrated relative to global beer markets. GSAM believes Nigeria’s young, large and increasing population, rising per capita incomes and changing consumption and cultural trends should drive demand for such products.

Another example is a Korean company, which makes plastic food containers.

With a lot of Asian food being liquid-based, their products have continued to gain popularity, given their leak-proof and water-proof characteristics and affordable prices. The company has great brand recognition across Asia, particularly in China, given their high quality and reliable products and GSAM expect demand for their products to grow in line with consumer demand.

[1] Source: Fortune Magazine, 2010 Global Fortune 500 [2] Source: Forbes Magazine, 2010 World Billionaires [3] Source: S&P, Moody’s, Fitch, as at January 1, 2011 [4] Source: http://www.citypopulation.de/world/Agglomerations.html [5] Source: IMF World Economic Outlook 2010, as at October 2010

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Goldman Sachs Asset Management International

Redefining Emerging Markets [6] Source: GSAM, “It is Time to Re-Define Emerging Markets”, January 31, 2011 [7[Source: IMF World Economic Outlook Database, April 2011

Disclaimer THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORISED OR UNLAWFUL TO DO SO. Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant.

Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. Future returns are not guaranteed, and a loss of principal may occur.

This material has been approved in the United Kingdom solely for the purposes of Section 21 of the Financial Services and Markets Act 2000 by Goldman Sachs Asset Management International, which is authorised and regulated by the Financial Services Authority (FSA). In Germany and Austria this document is presented to you by Goldman Sachs & Co oHG, regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin). In France this document is presented to you by Goldman Sachs Paris Inc. et Cie, regulated by the Autorité de Marchés Financiers (AMF). In Switzerland this document is presented to you by Goldman Sachs Bank AG, regulated by the Eidgenössische Finanzmarktaufsicht (FINMA). In Ireland this document is presented to you by Goldman Sachs Bank (Europe) plc, regulated by the Irish Financial Services Regulatory Authority (IFSRA). In Italy this document is presented to you by Goldman Sachs International, Italian Branch, regulated by the Commissione Nazionale per le Società e la Borsa (CONSOB).

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Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without GSAM’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient.

The economic and market forecasts presented herein have been generated by GSAM for informational purposes as of the date of this material. They are based on proprietary models and there can be no assurance that the forecasts will be achieved.

Views and opinions expressed are for informational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security. Views and opinions are current as of the date of this material and may be subject to change, they should not be construed as investment advice.

Political and economic structures in countries with emerging economies or stock markets may be undergoing significant evolution and rapid development, and such countries may lack the social, political and economic stability characteristics of more developed countries including a significant risk of currency value fluctuation. Such instability may result from, among other things, authoritarian governments, or military involvement in political and economic decisionmaking, including changes or attempted changes in governments through extra-constitutional means; popular unrest associated with demands for improved political, economic or social conditions; internal insurgencies; hostile relations with neighboring countries; and ethnic, religious and racial disaffections or conflict. Certain countries may have in the past failed to recognise private property rights and have at times nationalised or expropriated the assets of private companies. As a result, the risks from investing in those countries, including the risks of nationalisation or expropriation of assets, may be heightened. In addition, unanticipated political or social developments may affect the values of investments in those countries and the availability of investments in those countries. The small size and inexperience of the securities markets in certain countries and the limited volume of trading in securities may make investments illiquid and more volatile than investments in more established markets. There may be little financial or accounting information available with respect to local issuers, and it may be difficult as a result to assess the value or prospects of an investment. In addition, the settlement systems may be less developed than in more established markets, which could impede ability to effect transactions and may result in investments being settled through a more limited range of counterparties with an accompanying enhanced credit risk. Certain countries may also operate margining or pre-payment systems whereby margin or the entire settlement proceeds for a transaction need to be posted prior to the settlement date which can give rise to credit and operational risks as well as potentially borrowing costs. In certain markets, local regulations may limit investment into local securities to certain qualifying foreign institutions and investors through licensing requirements and may also limit investment through quotas granted by local authorities.

This material has been prepared by GSAM and is not a product of the Goldman Sachs Global Investment Research Division. The views and opinions expressed may differ from those of the Global Investment Research Division or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and GSAM has no obligation to provide any updates or changes.

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Emerging Markets

Pascal Mischler +41(22)816-6786 / Pascal.Mischler@gs.com

Alain Barthel +41(44)224-1342 / Alain.Barthel@gs.com

Carmignac Gestion

Why are we long-term believers in Emerging Markets?

Growing businesses, strong balance sheets and attractive valuations…

Despite short term concerns, we are long term believers in Emerging markets.

Thanks to their growing businesses, their strong balance sheets and their attractive valuation, emerging markets should once again show their resilience in a context of global economic slowdown.

but our proprietary work indicates that inflationary pressures should weaken considerably in the coming few months. It seems perfectly possible, thus, to us that going into mid-2012 investors could find that emerging markets are able to ease monetary policy substantially as inflation falls and real rates become positive. This would be particularly true of those economies which have seen the most aggressive monetary tightening in the past few quarters – such as India, Brazil and China (although China has tightened more by non-monetary measures such as attempting to control house prices).

Clearly, the sell-off in emerging markets as witnessed since the start of August cannot be disassociated from events in the developed world, but as in 2008 emerging markets have underperformed developed markets despite not being at the root of the world’s problems. The main reason for this underperformance is that emerging markets remain very vulnerable to contractions of global liquidity associated with the recent rise in the US dollar and the withdrawal of credit from the distressed Western banking system. This effect has been particularly marked in economies with high-yielding currencies which have hitherto attracted substantial capital inflows, such as Brazil, South Africa and Indonesia, but has been common across the entire emerging world.

In these circumstances, emerging markets would quite possibly enter into an easing cycle which is normally synonymous with rising equity prices. A final reason for optimism is that emerging market equities have become attractively valued as a result of the sell-off. Most markets trade on single-digit price/earnings multiples, and even traditionally expensive India looks attractively valued for the first time for more than two years. What is particularly interesting is that, due to strong profit growth in the last two years, the valuation of emerging markets stands at a noticeable discount to that of developed markets, at a time when, as explained above, we continue to expect faster profit growth in the emerging world.

Whilst it is true that emerging market equities have seen net outflows for at least the last twelve months, fixed income markets continued to see strong inflows right up to August. The sudden drop in emerging currencies during September is surely associated with a partial reversal of this phenomenon. Apart from this problem of flow, some markets may become stressed by this sudden contraction in US dollar funding, as has happened previously in episodes such as 1997 and 2008. It appears to us that foreign-currency denominated debt is far less prevalent in emerging markets than even three years ago; and thus far there is little sign of stress in local banking systems. Nevertheless we are concerned by recent rumors of distress in, for example, the Chinese property sector which has been a big borrower in US dollars. We are also monitoring markets like Turkey which are dependent on foreign portfolio flows to plug their current account deficits. Allied to these liquidity concerns is the impact of a slowdown in the global economy. As we saw in 2008, countries such as Korea, Taiwan, Singapore and Mexico are particularly vulnerable to dips in world trade; and we can expect these economies to slow in the next few quarters at least. However, the larger domestic economies are not totally immune. Brazil’s real GDP growth has already slowed to around 3% annualized, whilst recent Indian industrial production numbers presage a slowdown to perhaps 7%. Perhaps the biggest concern today is China, however. Recent industrial surveys and hard data like electricity consumption and housing sales show an economy which is slowing towards the 8% growth rate. This is far from disastrous; however, it is questionable whether the amount of leverage added to the economy since the reflationary effort of 2008 will allow the Chinese authorities to react in a similar fashion in the event of a further slowdown below that rate.

Marco Fiorini, Head of Country – Switzerland mfiorini@carmignac.com / 00 352 46 70 60 61

Disclaimer This document does not constitute investment advice or financial analysis. None of the information contained in this document should be interpreted as having contractual value of any kind. This document is produced for indicative purposes only. Carmignac Gestion may not be held responsible for any decision taken on the basis of information contained in this document, or for its use by a third party. This document may not be used for any purpose other than that for which it was intended and may not be reproduced, distributed or sent to third parties, either in whole or in part, without prior written permission from Carmignac Gestion.

Nevertheless, reasons for longer-term optimism remain intact. Indeed, whilst acknowledging that emerging markets are unlikely to outperform developed markets in the short-term, we do feel strongly that there are many reasons for optimism that the decade-long outperformance of emerging markets will resume in the medium-term. Despite its probable slow-down, emerging market growth is still set to outperform that of developed markets by a substantial margin which will if anything be increased by deflation in the West. Again, in comparison to developed markets, both public and private-sector balance sheets remain very strong. Whilst leverage has undoubtedly been added in economies like China and Brazil, absolute numbers remain reasonably low compared to developed markets. More importantly, most emerging markets retain the potential to grow their way out of stretched balance sheets – an advantage which is lacking for the developed world. Moreover, the global slowdown should help emerging markets deal with the inflationary problem which has concerned the market since mid-2010. Not only should domestic liquidity be lessened by a reduction in currency appreciation pressure, but it seems reasonable to assume that commodity prices should fall in the coming quarters. We admit to having been disappointed with the persistence of inflation throughout the emerging world in recent months, a persistence linked principally to the stickiness of agricultural prices,

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Kaltchuga Capital Management

Re-developing Russia, the next European superpower Views and investment opportunities Russia is not a true emerging country. Prior to collapse in 1991, the USSR had largely achieved the transformation of an old rural nation into a modern urban society with developed education, infrastructure, and strong manufacturing capacities. After Russia’s economic and geopolitical power vanished in the early 1990s, the country was forced to move on the path towards post-Soviet institutions and economic transition. Twenty years after the USSR ceased to exist, Russia remains a country in transition, making up for its lost decades and progressively converging towards its secular European destiny. Although the path is not quite a straight line, the vision for the country for the next couple of decades is clear and simple. Russia aims to be a top 5 global economic power, the world’s leading energy supplier and a truly developed and integrated European state. Good investment opportunities are and will be available and we are committed to assisting investors in navigating between value and growth, Soviet legacy and modern Russia, export and domestic markets, leverage and inflation, Europe and Asia, democracy and authoritarianism, etc. Russia is a very specific investment case among so-called emerging markets, and quite a fascinating story indeed.

Emerging, developed or re-developing country Following the collapse of the Soviet Union, Russia saw a dramatic and brutal reduction of its economic output, with most parameters such as its real GDP, agricultural output or oil production falling by 40-50% within a couple of years.

Inflation flared up to 3000% in 1992, wiping out the savings of the population.

Russia was suddenly downgraded from the status of developed superpower having sent the first man in the outer space to the rather humiliating qualification of ‘emerging’ country. But Russia is not a true emerging country. It does not face today an issue of moving hundreds of millions people from rural areas to the cities. Thanks to its Soviet legacy, it also does not need to build an infrastructure from scratch. Within the Soviet Union, Russia was a developed country, which at some point dropped out of the race with the West, and is now more likely on a path to catch up with the rest of Europe, to re-develop, than to run a growth race with India or Brazil.

The end of the Soviet Union also opened two decades of radical changes. The first phase under the presidency of Boris Eltsin was one of liberalization and ended with the 1998 ‘Asian’ crisis; the second phase that just stopped with the global financial crisis was one of active development of Russia’s consumer society.

1991-1998: liberalization Between 1991 and 1998 Russia saw the formation of a market economy via massive privatization of its economy (raising the share of private sector from almost zero to about two thirds of the GDP), the introduction of free market prices (a process still ongoing as of today in the utilities sector), the organization of the necessary legal and tax infrastructure, and the formation of capital markets. A banking sector was able to emerge, alongside with the resurrection of a middle class. 80% of the Russian population received property rights on the dwellings they were living in and, helped by a legacy of mass education in Soviet schools and universities, most were able to walk their way out of survival mode and to lay the foundations of a consumer society. All this ended in the turmoil of the 1998 Asian crisis, as Russia defaulted on its domestic bonds, forcing the rouble to devaluate by 85%.

1998-2008: all about oil After 1998, Russia was blessed by a decade of strong global growth led by the accommodative monetary policy of the Federal Reserve in the US, by globalization and by strong demand for commodities in booming emerging markets. As the oil price was growing from $10 up to $147 per barrel, Russia was awash with cash inflows generated by commodity exports (mostly oil and gas). Via taxation

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of profits from oil&gas companies, the Russian state led by President Vladimir Putin found itself in a capacity to reallocate this bonanza among itself, the Russian corporate sector and the Russian people. The State could at the same time reduce its external debt to almost nothing (less than 10% of GDP), build $600bn of foreign currency reserves, and increase its budget year after year, at the same time boasting fiscal surpluses up until 2008. Budget increases translated into higher pensions, salaries and social spending. The number of civil servants grew by 50% and their salaries grew by 20% per year (from an average of $60 in 1999 to over $700 in 2008). Pensions were multiplied fivefold between 2003 and 2010, from under $50 to over $250 per month. Again, the middle class was able to expand, amounting in 2008 to 80-90 million people (two thirds of the population), with an improving purchasing power and virtually no debt. Russia has thus become the largest consumer market in Europe for a number of goods and items.

For example, the Russian car market reached 3 million vehicles in 2008, as much as Germany. The surge in household spending, as high as 50% of Russia’s GDP, gave a strong push to the economy. Russia’s GDP surged from less than $200bn in 1998 to $1666bn in 2008 (growing by 27% per annum in nominal terms), propelling Russia back among the ten largest global economies. Demography also benefited sensibly from budget increases in health infrastructure and social spending, as better sanitary conditions positively added to better psychological and material conditions among the population, including better and larger housing. Nevertheless, a major consequence of such developments was the subsistence of strong inflation (around 10%). High inflation induced high interest rates that made investment unadvisable (safe for investment in real estate) and pushed Russian companies enjoying hard currency revenues (exporters) to obtain cheaper credit in Europe where banks were just happy to play the carry trade.

2008-2010: Russia in the global financial crisis In 2008, unlike 1998, the crisis came from the West. Developed countries and banks were forced to deleverage, and Russia could realize how dependent it was on foreign capital. On one side, corporate credit had soared to $500bn (30% of GDP), mostly short term (12-24 months). On the other side, happily, the State had no debt and held $600bn in FX reserves, of which $100bn were used to supply liquidity in the banking system and prevent a run on the banks. Another $100bn were used to support the economy and control a smooth devaluation of the rouble. Therefore, Russian banks could restructure corporate debt and no major bankruptcies nor nationalization occurred during the crisis. It is also important to notice that Russia did not introduce any stop to capital flows. We see it as a very convincing stress test with regard to the credibility of Russia as an open economy attached to liberal principles. Often depicted by critics as a predator ready to grab private assets, the Russian state rather bailed out the private sector in its entirety and let the economy adjust to the global environment (rouble devaluation of 30% and strong GDP correction of -25% in nominal terms) without increasing its balance sheet.

2011-2020: reinventing Russia’s growth model A positive outcome from the 2008-10 financial crisis is that it flashed a bright light on the necessity for Russia to do whatever necessary to free itself from its dependence on oil prices. As the oil price fell down to $30 the fiscal balance had turned negative and the momentum of the period between 1998 and 2008 had broken down. In a way, after inflating its social obligations (health, pensions, salaries) during ten years, Russia now faces the same issues as most rich countries, hence it cannot anymore balance its budget with an oil price of less than $100.

Too dependent on the oil price, too dependent on foreign capital, too primitive (it still creates little value added and produces mostly commodities), the Russian economy needs some reengineering. Although we trust exports and household spending will remain the first two principal engines of growth, we also believe investment enabled by lower interest rates will give additional boost to Russia’s economic growth in the 2011-2020 period.

Kaltchuga Capital Management

Re-developing Russia, the next European superpower 1.

Primary source of growth - Exports

Commodity exports, particularly energy, must remain the primary source of capital to the Russian economy and we trust the source is not likely to run dry in the next 10 years. Europe still needs Russian gas, accounting for 25% of its supply today, as much as Russia needs European customers, who represent 30% of its sales in volume and as much as 60% of Gazprom revenues. Obviously the relationship between Russia and Europe with regard to gas supplies is much more balanced than the common western view of a Russian evil empire blackmailing European consumers! However, while Europeans constantly look at diversifying their supplies, Russia is actively looking for new customers in Asia. The construction of the ESPO pipeline to ship oil from Siberia to the Pacific Coast, with a link to the Chinese border, was completed at the end of 2010. Russia and China are in negotiations on a project to build a 2800 km pipeline to transport 30 bcm of gas from Siberia and 38 bcm from Sakhalin to China under the Altai mountains (planned for 2015-2018). Today China is still a relatively small consumer of gas (100 bcm per year) and it prefers LNG because demand so far has mostly developed in the Southern coastal areas, which are easily accessible by sea. But Turkmen gas has already made its way to the North-Western regions and by 2030 Chinese gas consumption is expected to grow from 100 bcm to 330 bcm per annum.

2.

We already mentioned the role of foreigners, who intensified their investment activity in Russia starting from the mid 2000s. The growing size of Russia’s economy and GDP raised the appetite of European companies for a large solvent market in the neighbourhood of their traditional playground. While issues remain, like corruption, property rights, red tape, weak legal system and poor law enforcement, or even the quality of infrastructure, foreign entrepreneurs have massively overcome the perception reported in the western media that Russia is such a bad place for business. What they actually experience is that Russia puts no more barriers than many developed countries do, no capital control unlike most emerging markets, and we quite believe it is less difficult and more profitable to operate a business in Russia than in most emerging countries. All major car manufacturers now operate manufacturing capacities in Russia and Soviet automotive champions have been taken over by Renault, Daimler or Nissan. In every sector of the economy you can be pretty sure to find a foreign company among the top three leaders. Such densification and modernization of the Russian industry thanks to foreign strategic investment is a huge motivation for Russian entrepreneurs to plug into it.

4.

Lower inflation, lower rates, more confidence – the propellant Russia needs to grow further

Second stage of the rocket - Spending

Consumer spending, the principal growth driver over the last decade, will likely remain strong. Thanks to a reasonable amount of State support to the economy and to the banking system, and despite a rouble devaluation and a brisk drop in nominal GDP, Russian consumers have not been crushed by the recent crisis, as it had been the case in 1998. Russia’s middle class keeps expanding and it is virtually debt free. Outstanding mortgage is still less than 2% of Russia’s GDP and credit expansion has a long way to go from where it starts. Taxation is low, with a 13% flat rate on all household revenues, enabling Russians to spend around $600 PPP and to save 10% of their revenue every month. As the gap between living standards in Russia and those in other European countries remains quite wide, we trust the appetite for buying more goods will not fade any day soon.

3.

private partnership (PPP) programs.

Third stage of the rocket - Investment

Investment has been subdued in Russia for the past thirty or forty years. Although the potential of Soviet legacy infrastructure and manufacturing capacity is now quite exhausted, the new prosperity brought by oil windfalls over the past decade has not enabled investment to pick up dramatically, mostly because of Russia’s scarcity of long-term capital, demand-pushed inflation and subsequent high interest rates. Some progress could be made in areas where either foreigners or Russian entrepreneurs enjoying access to cheaper European credit could invest into their business. Russian steel mills, for instance, have enjoyed major enhancements to enable them to compete on the global arena.

Modern format retail has expanded at a very fast pace and transformed the urban landscape across Russian regions. Infrastructure was not totally left aside either. The power generation and grid transmission monopoly were privatized and reshaped into more efficient private companies, some of which controlled by foreign strategic investors like E.On or Enel, and power and grid capacities increase and get upgraded every year. Russian travelers transit more and more often through brand new rail stations and airports, although roads and rail remain obvious weak points.

Infrastructure needs massive investment, and we are now confident things are about to happen. One particular reason for such enthusiasm is that Russians just cannot imagine being ashamed in face of the whole world, would they fail to deliver the promised city infrastructure, high speed rail and road connections by 2014 for the Winter Olympics in Sochi and 2018 for the FIFA World Cup. Another reason is that lower interest rates today provide for better funding conditions, and the Russian state has very little debt (less than 10% of GDP). In addition, WTO access is now very close and will be a nice additional trigger to improve conditions for foreign capital to play the carry trade and be invested in public

We earlier mentioned interest rates were too high for Russian entrepreneurs or the Russian state to borrow locally and contemplate long term investment in Russia. Lower rates are necessary for credit expansion to foster domestic investment and spending. Since the global financial crisis has hit Russia, we have been witnessing several facts, which tend to comfort us into the view that Russia has entered a new stage of its development, where interest rates progressively converge towards those of its European neighboirs. Indeed, convergence is happening even faster than we would have expected. Rates of Russia’s sovereign 10Y bonds are now just over 4%, which compares with the average cost of debt in the Eurozone today.

The first parameter inducing lower interest rates in Russia is the global need for deleveraging which forces governments and central banks in developed economies to keep interest rates at lower figures for an extended period. With the resumption of the carry trade towards higher growth economies, ‘cheap money’ will again find its way into emerging countries, including Russia.

The second factor is the switch that occurred in Russia during the crisis from a fiscal surplus to a budget deficit. While before the crisis, fiscal surplus roubles were used as a resource to fight rouble appreciation and sterilize dollar inflows into foreign exchange reserves, today inflowing dollars are used to finance the budget deficit. Not willing to inflate the monetary base, the Central Bank of Russia, instead of printing roubles, needs to draw roubles from the market and has therefore a strong motivation to keep the price of its rouble purchases – e.g. of interest rates – as low as possible. Given the need for the Russian state to increase its spending oninfrastructure development and pension payments, we believe this trend is a sustainable one.

The third and very important parameter is inflation, which has been declining from nearly 15% at the peak of the crisis to a historical low of 6-7% in the summer of 2010 and a tad above 7% in 2011. True, inflation can go up again. If the oil price flares up, we may see the resumption of double digit annual revenue inflation (including salaries and pensions), on the same pattern as observed in 1998-2008. It is not a bad scenario for capital markets (the IRR of Russian stocks was above 20% in 1998-2008) but it is not our base scenario. We would rather assume the oil price to stabilize around $100 or grow more or less in line with global inflation. In such case, we do not think inflation shall be a structural issue in the longer run as Russia is naturally hedged against commodity inflation due to the vast stock of natural resources in its soil, and also thanks to large manpower resources available at its Asian borders. Although in many sectors productivity is still low, investment shall help the redevelopment of a powerful agriculture so that Russian consumers are less vulnerable to imported global food inflation. In

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Kaltchuga Capital Management

Re-developing Russia, the next European superpower 2008, the land farmed in Russia was still only 60% of what it was in 1991, while crop yields grew from 0.8 to 1.2 tons /ha, still a very low indicator. There is big room for improvement.

To close this chapter on the macro outlook of Russia, it is important to remind that Russia being now a true capitalist country, where consumers have taken a leading role in the economy, it is now a vital necessity that those consumers put more trust in their own country. This starts with being more confident in their national currency, in order to build the long term capital base necessary to fund long term development. To achieve this goal, the Russian population needs to have a clear vision of the country’s future. To tame inflation is a priority towards restoring confidence, and as we have just discussed earlier this stands loud and clear among the state’s priority issues, and the CBR is targeting CPI under 5% in 2014. After more than a decade accumulating foreign reserves, Russia’s current leadership has proved much more anxious to prevent social unrest than anything else. Their track record clearly tells us their priority is political stability over development, modernization and diversification of the economy. This is why inflation, still the number one worry of the population is as much a political challenge as an economic challenge and will be addressed before other issues like unemployment, security or corruption for instance.

Investment opportunities With new times come new opportunities, particularly in countries like Russia still in their transition process. Whereas until the mid-2000s Russia could be contemplated as a pure value market, stock prices have since largely rerated and some arbitrage is now possible between value and growth stocks. High interest rates have been a reason why few industrial projects originated in Russia over the past decade, hence our investment universe suffering from a lack of diversification out of the oil and commodity sectors. Following our view that lower interest rates from now on are going to boost domestic investment and support local household spending, we now expect more and more new companies to appear on our radar screens. Investment and country modernization shall give us the stock picking opportunities we have been expecting for the past twenty years.

Qualitative on top of quantitive growth.

Value For the major part of our investment universe, buying Russia is buying real stuff.

Because Russia is the world’s largest bank of natural resources, investing in Russia gives you primary and tangible exposure to booming commodity demand created by the secular growth of Asian economies. Looking at the book value of Russian assets, we would bring particular attention to two sectors – electricity and oil.

Thermal power generation companies are still valued between $200 and $300 per kW of installed capacity, to compare with $900 in average in emerging countries and $1200 in developed countries. There is a wide spread between the best managed assets and the most obsolete ones. Among the best assets, the Russian subsidiary of E.On with an EBITDA margin of 35% now trades at $500 per kW of installed capacity and about 4x 2012E EBITDA and 6x 2012E earnings. It has benefited from cash investments for upgrading and enhancing its generation capacity on one hand, and from electricity tariff liberalization and demand growth on the other hand. At the other side of the spectrum, a company like OGK6, controlled by Gazprom, which is not in a hurry to upgrade its capacity and to improve profitability, has an EBITDA margin just over 10% and trades at $200 per kW of installed capacity.

Russian integrated oil companies trade at $5 per barrel of 1P SEC resources, compared with $15 in other emerging and developing markets. Most are today valued at 2-3 times their 2011E EBITDA and 3-4 times their 2011E earnings. For a long time the discount of Russian oil companies could be justified by the Russian taxation system, which confiscates a large part of the profits, but today the rest of the world has come in line with Russian standards. Moreover, thanks to

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their deep vertical integration and downstream exposure in refining, retail and other activities, Russian oil companies are still very profitable. Lukoil, priced 2.3x 2011E EBITDA and 3x 2011E PER, made about $7bn in free cash flow in 2010 and on current oil prices it generates between $2bn and $2.5bn of free cash flow every quarter (over 20% FCF yield). Within the energy sector, a couple of oil field service companies (Catoil, Integra) are also worth some attention, because they capture a large part of the cash flows used by Russian oil extraction companies to develop into new fields, and also because they may be attractive takeover targets for such international players as Schlumberger or Halliburton for example.

Growth / convergence The beauty of Russia’s investment case is in its simplicity. Convergence towards standards of neighbouring European countries is easy to quantify by a sample of numeric indicators. Investors can base their assumptions by measuring the gap to be filled by Russia so that for example its GDP per capita ($12500 in 2011) rises up to that of Poland ($20 000), and then France or Germany ($40 000). Same applies for instance for household spending per capita, which amounted $5684 in Russia in 2008, compared with $8479 in Poland and about $25000 in France or Germany. The list is not exhaustive and depending on which sector you look at, you will be interested in tariff convergence for cellcos, advertisement, utilities or in spending per capita on drugs, steel, advertising, food, not to mention salaries or square meters of living space per capita. We just need to assume it is Russia who rises up to current European standards, instead of European standards collapsing to the level of Russian ones… Among the sectors where we can pick some growth stocks we emphasize retailers and banks.

Russia was the fifth largest food retail markets in Europe, amounting to $145bn in 2010, behind France ($270bn), Germany ($220bn), the UK ($195bn) and Italy ($160bn), with one of the lowest penetration rate by modern retail formats (35%), compared with an average of 80% in Western Europe. The top 5 players still share only 14% of the market and we believe they still have a minimum of three years ahead of them before they start to compete with each other. The density of hypermarkets remains low (2 per 1 mln population in Russia, although already 15 in Saint Petersburg), compared with 15 in France or Germany.

Although they may look a bit pricey at first sight 2012E PER around 20x), they display strong growth potential for the coming years (PEG of 0.5x). Such companies as X5, Magnit, O’Key, M-Video and Dixy are rather easy to monitor, as they publish either monthly or quarterly trading updates and quarterly IFRS accounts with detailed reports on their operations including expansion of selling area, LFL sales and margins. It is also quite easy to meet with their management teams and get some feeling of their capacity to keep growth and profitability on track.

The banking sector is still under penetrated, with the ratio of loans to GDP a meager 39%, whereas the loan-to-deposit ratio has dropped below 100% during the crisis. In the wake of higher oil prices in 2011, loan growth rate is accelerating after NPLs have obviously turned the corner, with an stable outlook for margins. Lower interest rates make credit more accessible to the population and to corporate clients, while the state, having virtually no debt, shall also inflate its balance sheet in the coming years. The average credit portfolio of a Russian bank is quite reflective of the still primitive nature of the economy. It displays mostly real estate, contruction and commodities. Outstanding mortgage assets is less than 2% of GDP. In other words, Russian banks are quite immune to the derivative and other CDS frenziness that has transformed banks into hedge funds in most western economies. We feel comfortable buying Russian banks for a price of 0.8-1.0x their book value, with expectations of a 20%+ asset growth per annum.

Modernization / stock picking It is time new companies start replacing soviet legacy stocks. Modernization is the ubiquitous word in every political address. We would just point out here that convergence towards European standards shall not be just quantitative. There is a quality component too and the gap is just as wide. In Russia SMEs account for only 15-20% of GDP and jobs versus 50-70% in developed economies. Small

Kaltchuga Capital Management

Re-developing Russia, the next European superpower innovative companies account for only 1% of GDP. In 2008 Russian companies altogether spent only $800m in R&D versus $8bn for General Motors alone. The State’s commitment to innovation via such initiative as Rusnano or Skolkovo may bring some fruit, but above all the State must do its best efforts to ensure a benign financial and administrative environment in favour of entrepreneurs and for improving the level of education. The role of foreign investors is also instrumental in modernizing the Russian corporate sector. One just needs to take a look back at the transformation undergone by such sectors as retail, telecom or construction for instance to understand how foreign investment has impacted the country and to foresee what is going to happen in other sectors like the automotive industry for example. In 2008 Vladimir Putin has set a target of multiplying productivity four times by 2020. Before Renault-Nissan took over Avtovaz in 2008, a worker in Togliatti made 7 cars per annum compared with 30 at General Motors, not mentioning that a GM car is worth 3-3.5 times more than a Lada, which means a GM employee would be 15 times more productive than his peer at Avtovaz. Even in sectors where Russia has a strong experience and knowledge like the oil sector, it happens that a Lukoil employee still extracts twice less crude oil (4700 bbl) than a BP employee (9400 bbl). We have seen a first wave of new companies in the telecom, food and retail sector emerge in the 1990-2000s. We now look forward for the next generation of Russian jewels to hit the market in the wake of the modernization wave currently in process. The recent introduction of such companies as as Mail.ru, O’Key and Yandex in the past recent months gave us a good foretaste of what we make be expecting for our stock picking activity of tomorrow.

Risks Obviously since the middle of the 2000’s, external risks have been more significant for the Russian stock market than domestic factors. Key external risks are essentially a possible correction in commodity prices, renewed risk aversion among global investors or geopolitical factors. We have gone through the stress test of 2008, so we now know there is no such thing as a safe haven in a recessing global economy, while capital flows in and out of the Russian market are still predominantly dominated by foreigner investors. We thus do not have any illusion of the domestic capital base soon in a capacity to support the price of Russian stocks, would the world collapse again, and for risk adverse global investors, high beta Russian stocks still do clearly not represent an alternative to US T Bills.

As far as domestic risks are concerned, we think inflation comes in number one.

Higher inflation may be triggered both by higher commodity prices and strong capital inflows. We see Russia quite well positioned to bumper an outbreak of inflation by letting the rouble appreciate from its current levels against the bicurrency basket. This would not hurt exports, which are mostly commodity shipments denominated in US dollars, but would harm the profitability of Russian commodity exporters. With a strong rouble, the country just gets richer, and convergence speeds up. Besides, as we already mentioned, Russia is structurally hedged against inflation, because of the vast stock of commodities it holds underground.

Social unrest is another source of concern. Growing social consciousness makes people less and less tolerant towards the incompetence and backwardness of its plethoric and corrupted administration. So far, we see just exasperated passengers shouting at Aeroflot staff members when forced to spend part of their winter holidays in Moscow airports due to poor management of weather conditions by the airline’s representatives. Are we close or far from a May 1968 of Russia? It is difficult to say, but in a developing economy, the population who gets wealthier year after year certainly grows more and more expectations from its ruling administration. Mr Medvedev was not only the depositary of Mr Putin’s legacy. He had also committed to bringing more virtue into a system still marred with heavy corruption, poor law observance and weak institutions. It is a pity his performance in this task has been so fruitless, and we are for the time being left with our cynical selves, hoping that for a while Russia’s fast growing consumer society can continue to accommodate private vices of their ruling elite into public benefits, as with corrupted bees in Mandeville’s Grumbling Hive.

Conclusion – From convergence to integration We think the Russian investment case looks attractive compared with Asian bubble economies on one hand and heavily indebted western countries on the other hand. Russia’s economic recovery in 2010-11 may look pale compared with that of Asian emerging economies, and even compared with that of western countries, because Russia has not been spending as much cash on stimulating domestic demand. The choice made by Russian officials during the crisis was to stay plugged on external demand. So by opting for the passive way, Russia is about to be the biggest beneficiary from inflating monetary base in Asia and ever rising debt in the developed world. And instead of stimulating inner demand and inflating its monetary base, Russia used cash flows to enhance its balance sheet. Global investors regularly rekindle their appetite towards Russia because of its humongous bank of natural resources. Oil, gas, metals, ores, coal and land are synonym of hard assets, and investment in Russian stocks is still contemplated essentially as a value investment as opposed to seeking growth and development in Asian emerging economies for instance. We believe it is wrong.

Investors still underestimate the growth potential of the Russian economy, as they pay low attention to Russia’s hidden resource – its balance sheet. Growth on an unleveraged basis and a protection against bubbles and inflation, who else?

We trust the scenario of Russia’s European convergence is a very strong driver.

We also have a strong conviction on the next step, which is European integration. We are strong advocates of a secular move towards full integration of Russia into Europe and we stick to the opinion that it makes great historical and economical sense to combine the resources of both parts of Europe - technological edge and cheap long term capital on the western side, and a large unleveraged consumer market with vast material resources on the eastern side.

Russian leaders have been increasingly aware of the limits of the development model Russia has been implementing over the past ten years. To modernize Russia, European technology and cheap capital are more than ever welcomed in Russia. In the keynote speech he delivered in Davos last spring, President Medvedev set very explicitly as a goal for Russia its full economic integration with the EU. But the most prolix on the topic was Vladimir Putin. In a article for German newspaper Süddeutsche Zeitung (25 November 2010), Premier Putin expressed his vision of a programme to bring Russia and the European Union closer together and build a strong competitive alliance. As Europe is less and less afraid of Russia and more and more in need of a new perspective, we believe bureaucratic and political headwinds shall be subsiding faster now. Entrepreneurs have already made the step towards integration, and we suspect that after they have designed some solution to stabilize the situation with their sovereign debt, Europeans will find the theme of integration with their unleveraged Eastern neighbors all the more compelling.

Jean Michel Febvey - Head of Sales jean-michel.febvey@kaltchuga.com / +352 26 26 24 161

Emerging Markets

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Alliance Bernstein

The Advantages of Multi-Asset Investing in Emerging Markets What is the best way for investors to benefit from the expected long-term growth of emerging markets? Historically, stocks provide the best way for investors to participate in long-term economic growth. Yet many investors hesitate to increase their emerging-markets stock exposure because of the volatility of returns. Despite their maturing economies, emerging-market stock volatility remains much higher than in developed markets (Display 1) Volatility can erode investments’ value over the long term because of “risk drag”, the corrosive effect that volatility-driven declines have on compounding.

global investors’ tendency to treat emerging-markets stocks and bonds as one “risk asset”. However, at the country level, there is still substantial variation in correlations (Display 2).

For stock/bond correlation, much depends on the country. (Display 2)

The good news is that investors don’t have to limit themselves to stocks when seeking to profit from emerging-markets growth. There are multiple potential beneficiaries of emerging-markets growth, including bonds and currencies— and even developed-market stocks (because some developed-market companies sell into emerging markets). These asset classes benefit from emerging-markets growth in different ways and can provide investors with greater diversification potential to reduce volatility.

An investor could invest in these asset classes separately, but we believe that integrating them in one dynamically managed portfolio can generate much better risk/return potential than a stock-only strategy. An unconstrained, holistic and integrated approach to an emerging markets multi-asset portfolio provides at least three primary benefits:

1

First, it provides utmost flexibility to seek higher risk-adjusted returns, by broadening the opportunity set to include more and different asset classes, countries, currencies and securities than a stand-alone debt or equity portfolio could access.

2

Second, it provides greater diversification potential to reduce portfolio volatility.

3

Third, it opens up a wider range of hedging opportunities to reduce undesired exposures and focus on what is most essentially attractive.

Emerging - Market Stocks Are More Volatile. (Display 1)

Correlation relates to the coincidence of direction, but not of magnitude, so even though emerging bonds in aggregate may fall with emerging stocks, they generally don’t fall nearly as far. Thus, the quality improvement in emerging bonds means that they can provide very significant downside protection and volatility reduction, but the downside protection is less powerful than in traditional developed-market portfolios. On the other hand, their correlation with emerging stocks and meaningful return potential imply that combining emerging stocks and bonds doesn’t constrain upside potential as it would in developed-market portfolios (Display 3).

Bonds Dampen Stock Risk and Provide Return Potential. (Display 3)

Dampening Stock Volatility with Bonds

The Case for Active Management

Using bonds to offset the volatility of stocks is one of the most basic risk management strategies in developed-markets portfolios, but only recently has it become a broadly viable strategy in emerging markets. The emerging-market bond universe is growing and maturing. It includes both sovereign and corporate bonds, denominated in either US dollars or local currency, and these sectors all have different risk/return profiles, thus adding multiple sources of diversification.

The variation in correlation between different countries’ stocks and bonds points to the value of an active management strategy in the emerging markets. Whereas a passive strategy might dictate increasing bond exposure at a time when risk aversion is growing, an active strategy can choose among emerging-market bonds to find those with least correlation to the emerging-market stocks.

The universe of emerging-market bonds includes not only countries with a wide range of credit ratings, but also different types of bonds, including dollardenominated sovereign bonds, local currency sovereign bonds and corporate bonds.

A key difference between a strategy combining emerging stocks and bonds and one combining developed stocks and bonds is that the correlation in emerging markets is more highly variable. At an aggregate level, emerging stocks and bonds exhibit greater correlation than developed stocks and bonds, because of

16

Emerging Markets

Active management has other strong potential advantages in emerging markets, especially regarding security selection. Even if one believes strongly in pas-

Alliance Bernstein

The Advantages of Multi-Asset Investing in Emerging Markets sive management for developed markets, emerging markets are different in key ways. Developed markets are highly liquid, and information flows so efficiently that mis-pricings of individual stocks and among stocks may be arbitraged away quickly. Yet emerging markets are less liquid and information flows less freely, providing potential advantages for active managers.

An active strategy that is unconstrained across asset classes has more opportunity to find mis-pricings that arise from other investors failing to “connect the dots”. Whereas news about a change in an emerging-markets company’s strategy or financial condition may be slow to be captured in its share price, the implications of such news for the sector, the currency or the government’s creditworthiness are even slower to make their way through the capital markets.

Using Currency to Improve Risk-Adjusted Returns

risk in the shares. Yet the bond market perceives credit risk as very low, because of the country’s strong fiscal health. Therefore insurance against extreme downside risk can be purchased in the credit markets at a much cheaper price. It is only possible to take advantage of such an approach in a strategy that is truly unconstrained and holistic. And, equally important, a simplistic “bolting together” of an emerging stocks portfolio with an emerging bonds portfolio would fail to capture such an anomaly.

Overall, the ability to look across asset classes for the most attractive investments should allow investors to earn the returns they expect from emergingmarkets stocks with a lower level of market risk. For those interested in total returns rather than consistency in tracking a benchmark, this should be a better approach, and should be reflected in a higher Sharpe ratio. Both approaches can deliver alpha, but a multi-asset approach should deliver that alpha at a lower level of risk (Display 4).

Active currency management is the third “lever” for seeking better risk-adjusted returns in a multi-asset strategy. While many international stock managers use currency to hedge the local currency exposure of their holdings in general, disaggregating currency from stock and bond investments creates new opportunities to seek return or manage risk.

A multi-asset strategy seeks alpha with lower risk. (Display 4)

For example, a manager could use currency in a stock-specific strategy: perhaps investing in a Turkish exporting company in expectation that the company’s competitiveness will improve from a weaker Turkish lira, while at the same time shorting the lira so that the currency’s depreciation will not impact the principal value of the stock. In a truly integrated approach, this can be more than a simplistic currency “overlay”: the awareness of the ability to hedge undesired currency exposure should change the stocks that a manager would buy, and affect their weight in a portfolio. Without the ability to hedge currency risk, certain stocks would appear less attractive and not be included in a truly integrated portfolio.

Further, a manager who can invest in currencies as investments, not just hedging instruments, can gain exposure to currency more effectively than a bond-only or stock-only manager. For example, one might believe the Chinese renminbi will appreciate against the US dollar because of China’s large external surplus and a desire by authorities to shift their economy away from exports and toward greater domestic consumption. But at a particular moment in time, one may not find sufficient stock or bond investments to reach the ideal level of exposure to the currency, so the currency exposure can simply be taken directly.

Cheaper Tail Risk Hedging The multi-asset approach can also find better priced “tail risk” protection strategies than those available to managers confined to a single asset class. For example, consider a very wealthy Middle Eastern country where economic development has outpaced most wealthy developed nations: its sovereign debt is rated high investment grade in the credit markets, yet the country is labeled “frontier emerging” by the leading stock market index provider, MSCI, because it has too few listed large-cap companies to qualify as a full-fledged emerging market.

These anomalies in emerging-markets indices are not unusual, especially across asset classes.

Two opportunities arise here: first, the “frontier” designation puts the country’s companies off limits for institutional investors that restrict themselves from owning such presumably risky investments. This artificially suppresses potential demand for shares and creates opportunity for unconstrained investors to get in at better prices for the upside potential of earnings growth. Second, the country’s stocks have downside risk, as any stocks do, and because they are based in the Middle East, they carry the risk of geopolitical events that are difficult to forecast. If one were to purchase downside protection in the stock options market, it would be very costly because these instruments are priced off the perceived

Integrated Markets; Integrated Portfolio The debate on how best to integrate emerging markets into global portfolios is ongoing, but an actively managed, integrated, multi-asset approach offers clear benefits and potential advantages over a single-asset or otherwise constrained strategy. These advantages may be summed up in three themes—more opportunities, greater flexibility and enhanced diversification potential:

1

2

Freedom from investments dictated by benchmark indices, which may limit an investor’s opportunity set, or include risk positions that aren’t appropriate to an investor’s objective.

3

Enhanced risk management, thanks to the flexibility of more hedging sources.

4

Greater diversification potential from more sources of returns.

5

An ability to arbitrage mis-pricings between stocks and bonds in one country or between separate countries.

A larger universe of investments opportunities.

An ability to invest opportunistically in situations unavailable to traditional single-asset class strategies.

Peter Stiefel - Director – Switzerland +41 22 3109082 / peter.stiefel@alliancebernstein.com

Emerging Markets

17

ACPI, Chief Investment Officer Marco E Pabst

Monthly Viewpoint: Trick or Treat If you have kids you know the situation: You put them in their room because you want to read the gory details of the latest Global rescue summit in the newspaper or watch your favourite TV episode you recorded last week. Usually, the rascals spend the first fifteen minutes fighting and shouting and then suddenly all turns calm and quiet. You have a brief look at the situation again to make sure none of them is injured and return to your favourite pastime. When you are finished after an hour you come back only to find their room in a state of total devastation with toys spread all over the floor.

This is what the political situation in Europe reminded me of in the wake of the EU summit at the end of October; the only difference being that in the latter case rumours kept being leaked that gave you some idea of the sorry state of affairs inside the room.

Exhibit 1: Performance of different markets year-to-date

A EUR3bn bond issue was postponed and a new EUR10bn issue is priced 20bps higher than expected.

Result: June 2012 deadline for banks to reach a core tier 1 capital ratio of 9% after writing down their sovereign bond holdings to market value. EBA estimates capital requirements to be EUR106bn in total (Greece: 30bn, Spanish banks 26bn, Italian banks: 15bn, French banks: 9bn, German banks: 5bn). Banks have until December to present fund raising plans. Banks that fail to provide such a plan first tap national governments. EFSF rescue is the option of last resort.

Comment: I am curiously looking forward to the fund raising plans of all these banks. EUR109bn in nine months with many hundreds of billions of existing debt to roll on top?

The bigger challenge seems to be the mark-to-market treatment of Italian and French bonds as their yields are blowing out.

Result: The ECB broadly managed to remain independent and not being dragged into the mess. However, the new head Draghi indicated that he is willing to support the markets with unconventional measures, most likely the purchase of bonds in secondary markets, something Germany was opposed to earlier.

Comment: Unfortunately, the ECB will probably gradually be weakened: TARPlike asset purchase programmes, if not sterilised (no comments made on this crucial point), will kick-start the European version of QE at some point.

After cutting rates in Europe, Draghi seems to want to correct past mistakes by being accommodating but, at the same time, talks hawkishly.

Meanwhile, Merkel suggested that changes to the Maastricht treaty will be necessary. However, this issue was pushed out way into next year, so nothing tangible on that front.

I am still somewhat surprised that the market rallied that hard after the announcement of the summit results. After all, most of the “news” leaked out days before and appeared to be well expected by the market. And while the results are a move in the right direction, they are hardly the Bazooka everyone was hoping for but rather a “small pea shooter” as Willem Buiter, ex BoE MPC member, put it.

The statement addressed a number of key issues but, unfortunately, was massively short on detail. This is my quick take: Result: EU leaders agreed on a 50% Greek debt haircut for private investors.

Comment: How voluntary is this haircut (bond prospectuses do not contain collective action clauses)?

How can an individual bondholder be forced to accept?

Will it avoid a credit event? (Fitch says it would be considered a default) What happens to the CDS? What happens to positions that are supposedly hedged via CDS where the hedge turns out to be worthless?

Is the 50% haircut based on NPV or notional (hard haircut)?

Furthermore, the numbers don’t stack up: There is EUR350bn of Greek debt outstanding, ~150bn of which is held by the ECB/Troika. Only the privately held EUR200bn are being haircut and a significant portion of this is owned by Greek banks and pension funds. Presumably the 150bn have to be serviced in full; therefore the overall haircut is much less than 50% (100/350=28%) Result: Leverage the EFSF several-fold up to EUR1trn using ~250bn of the 440bn EFSF as “equity”. The fund will be used to insure government bonds (20% first loss) and allow, via a SPIV (Special Purpose Investment Vehicle – EU leaders: next time please check your use of language) outside investors, i.e. China et al, to invest. China’s counter-rhetoric has already started (“we may consider investing once Europe becomes a market economy”) Comment: Lack of detail. They are expected to be presented in November. In the meantime, EFSF bond sales are proving difficult as the market is closing down.

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Emerging Markets

In a surprise move last week, Greek’s “G Pap”, for reasons that are beyond us, decided to stir a little mess in demanding a referendum on the austerity measures that threatened to torpedo the EU rescue plans. He quickly backtracked on this idea after a raft of criticism, not least from the very people who were willing to keep writing the cheques; although “Merkozy” briefly hinted at the possibility of an outright Greek default. Historians will certainly be able to tell us whether Papandreou had just lost his marbles or tried to execute a strategic Machiavellian master stroke. As it stands it seems that his political career is now over.

Certainly, at this critical juncture in Greek politics a referendum was a calculated bet that backfired. Given the wave of further unpopular measures to hit the streets soon, had he lost the referendum he would have been spared the painful route of implementation and also saved his party, PASOK, from falling into the abyss in the process. If people were to vote for the measures, however, he would have been perfectly legitimised to execute what was on the table.

At a time when Greece’s economy is contracting at more than 5% with numerous austerity measures still to be deployed next year, it seems the best solution would be a government of national salvation with a prime minister who is internationally respected, who does not come with the baggage of a political dynasty that has been dominating Greek politics for so long and who does not crave power as much as Papandreou.

Markets remain newsflow driven to an extent that I cannot remember ever having seen before. Implied correlations for S&P 500 options reached and exceeded 100% a few days ago.

Merkel, Sarkozy, the EU Commission and IMF decided in an emergency meeting last week to put the latest €8bn aid instalment for Greece on hold until the political situation in Greece was resolved. We note that the recent EFSF bond sale was postponed due to “unfavourable” market conditions, a euphemism for the market not being interested in buying EFSF paper. Also, the Chinese appetite for European paper will remain rather subdued as long as Europe does not grant China more access to its end markets. The continent is China’s largest trading counterparty, so this is a legitimate request, at least in the eyes of the Chinese.

ACPI, Chief Investment Officer Marco E Pabst

Monthly Viewpoint: Trick or Treat

Exhibit 4: Monthly flows of funds into long-term mutual funds in US$bn, January 2007 until 26 October 2011

It is a widely held view that the Japanese Yen would be massively overvalued.

While the Yen might be overvalued versus the US Dollar to some extent it does not appear that this overvaluation is very large in the context of financial markets. The key is the inflation differential. Japan is struggling to ignite inflation while the US keeps inflating its debt and the Dollar away. In the FX world, the currency with less inflation will always be worth more than the currency with more inflation like any other asset that keeps its value. Therefore, it makes perfect sense that, ceteris paribus, as long as inflation in the US is higher than in Japan, the Yen will appreciate against the Greenback. It can also be gleaned from the chart that the trade-weighted Yen has not appreciated as much as the Yen versus the Dollar. Bottom-line: The Yen is overvalued but not as much as people believe it is.

Dampening Stock Volatility with Bonds Individual and professional sentiment towards equities was very negative at the end of September before it started improving as the rally unfolded in October.

Yale’s “Crash Confidence Index” reached multi-year lows in September. The index measures the confidence that there will be no stock market crash in the succeeding six months. The index reached its all-time low in early 2009 just months after the Lehman default.

Exhibit 5: Yale Crash Confidence Index measuring the confidence that there will be no stock market crash

For many years now US administrations have demanded an aggressive revaluation of the Renminbi (RMB) from China. The request is aiming at a reduction of the trade deficit that the US is piling up with its Asian trading partner. This would make US exports more competitive compared to the Chinese. So far, the government in Beijing has only allowed a rather gradual increase in the value of the RMB and only when it saw fit. During the financial crisis the revaluation was put on hold in order to protect the local industry and was resumed in mid 2010.

Over the past five years the RMB has appreciated by approximately 4.5% pa. This compares to a rate of appreciation of nearly 7% in 2007.

While the ‘Polit Bureau’ has showed the usual resilience in the past vis-à-vis demands from Western politicians to let the RMB appreciate to a level that would better represent its “fair” value, the government this time appears to be taking significant steps that ultimately may lead to a free-floating currency probably sooner than many observers would expect.

To be clear: we are still talking years here but we are of the view that the RMB is an interesting investment vehicle in that it exhibits an asymmetric risk/return profile. As long as the Chinese economy does not hit the dire straits of some peripheral European countries, the upward revaluation pressure on the RMB will make sure that the secular trend is a one-way bet. While there may be some episodes of a weaker Yuan depending on the path of growth that China will take, overall, the risk is expected to be limited while upside is probably in the mid single-digits. This makes the RMB an attractive investment target. The only problem left to solve is how to best get access to this market.

CHINA: Recent news out of the Chinese property markets is not encouraging.

The country’s biggest developer Vanke reported year-on-year sales down 33% and month-on-month down 17%. Home prices in second tier cities are beginning to see price drops of between 20% and 40%. China’s economy is at an inflection point. Manufacturing and new order PMI figures are only marginally above 50 (and much worse than expectations), the level below which contraction ensues. The input price PMI signals disinflationary tendencies. The gap between order books and inventories has reached an all-time high. From a macro point of view, China is slowing down fast, sending ripple effects through Asia and the rest of the World.

THE YEN: While not fully unexpected, the recent intervention of the Bank of Japan in the currency market in order to weaken the Yen was a record for a single day. According to the Wall Street Journal it is believed that Japan sold around JPY7trn or the equivalent of USD90bn, which is significantly higher than the JPY4.5trn sold in the last intervention on the 4th of August. As a result, the currency dropped nearly 5% before recovering somewhat. Unilateral interventions usually have no lasting effect and the diminished credibility of the Japanese Finance Ministry (the Ministry orders the BoJ to intervene) is not helping to lend support. In comparison, in Switzerland the market appears to have much more respect for the SNB as the CHF never even came close to the new peg levels against the Euro.

The local (onshore) market for RMB, or CNY as it is called, is not really accessible for foreigners. Today, the main avenue into RMB trading is via non-deliverable forwards (NDF) that are still the best option for large positions with a daily trading volume in this market of USD3bn. Local Chinese deposit rates are between 2% and 4% for maturities ranging from one to five years.

Historically, the RMB market began to open up in 2003 when the People’s Bank of China (PBOC) and the Hongkong Monetary Authority (HKMA) signed an agreement that would allow Hongkong-based banks to conduct RMB business for individuals, basically addressing the travel-related business between China and Hongkong. This regulatory framework was broadened in 2005 with the raise of the cap for individual transactions to RMB20,000.

In 2007, another major step followed that would allow the issuance of RMB-denominated bonds in Hongkong, which laid the foundation for the so called “Dim Sum Bond” market. While in the beginning only Chinese financial institutions were allowed to issue RMB bonds in Hongkong, since 2010 this market is also open for foreign corporate issuers. So far, a few dozen bonds have been issued and are attracting a large investor base that is keen to invest in Chinese currency. Besides the large Chinese companies and a host of smaller issuers we also find some Western businesses such as Caterpillar and McDonald’s, the latter was the first Western issuer raising a mere RMB200m. Typical issue sizes are between RMB1bn and RMB5bn with an average tenor of around two to three years. Yields

Emerging Markets

19

ACPI, Chief Investment Officer Marco E Pabst

Monthly Viewpoint: Trick or Treat

are low at around 2%, which makes this an attractive market to raise funds that will be invested in China.

Even European issuers are now entering the scene. In May, carmaker Volkswagen AG issued an RMB1.5bn (USD231m) bond in Hongkong. The choice makes sense: it would have been significantly more expensive for the company to take out a loan than issuing a Dim Sum bond carrying a 2.15% coupon. Also, quasi sovereign institutions such as the KfW are planning to issue paper soon in order to finance their projects in China.

The Dim Sum market is still small at circa USD13bn in outstanding issues as it is not very widely known yet and potential issuers are just getting to grips with it.

However, it is growing fast and we will certainly see a huge number of US and European issuers refinancing their Chinese onshore operations going forward.

The new marketplace will most certainly help to open the RMB up for non-Chinese investors and elevate the currency higher up in the ranks of Global reserve currencies.

Another step that is expected to be implemented this year is the opportunity for overseas companies to settle their inward foreign direct investment into China in RMB. This will not only mean more lending business for Hongkong banks but also incentivise foreign companies to accumulate RMB. In our view, the efforts by the Chinese government to gradually open their markets for foreigners cannot be underestimated as they will ultimately lead to an end of the ring-fence around the Renminbi.

Three month outlook Asset class

Equities

Sovereign Bonds

Corporate Bonds

Similar instruments for foreigners are also available in Hongkong, the main market for offshore RMB desposits. This has created an offshore RMB market with a separate exchange rate, the CNH, which is close but not necessarily identical to the RMB/CNY. Strictly speaking there are four different markets today for RMB: (1) the onshore CNY market, (2) the offshore CNH market, (3) the NDF market and (4) the CNT market that serves offshore corporates for trade settlements. By design and through regulation, all these markets trade separately from each other.

Exhibit 1: Performance of different markets year-to-date

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Emerging Markets

Commodities

Emerging Markets Asia is beginning to price in a significant Global slowdown as well as lower growth in China. This leads to earnings revisions as a result. Foreign investors repatriate money, selling stocks and the currencies.

We prefer to be positioned defensively in high-quality Global companies that generate stable cash flows and provide sustainable income via dividends.

We prefer DM equities with exposure into emerging markets. EM equities have just started to correct and the commodity markets would suggest a deeper recession.

Difficult risk/reward due to the inflationary threat, the end of QE2 and a renewed economic slowdown. Choppy moves provide trading opportunities but yield levels are too low considering the fiscal and debt situation of most developed market economies.

We see attractive spreads in selected markets like India but watch capital flows and central bank action.

Rebounding commodity prices could cause another inflationary wave in EM that would create further upward rate pressure.

The deteriorating economic environment will keep rates lower for longer. This would support current DM sovereign bond price levels.

We like the exposure as we expect looser monetary policy in the future on the back of stalling/reversing inflation provided commodity prices remain under control. Weakening economies (such as China and Brazil) could also enact lower policy rates.

Corporate bond spreads widened a lot during the Sept/Oct correction as Global growth is faltering but have now reached levels that appear to be attractive considering long term fundamentals, i.e. expected vs. realistic default and recovery rates. The market dislikes any European periphery issues as well as financial exposure. Liquidity in the market is more problematic to source than earlier in the year.

EM corporates offer more upside as they are not widely discovered yet, but most spreads could widen further under a recessionary scenario. Additional risks are in the area of transparency, reporting standards and legal systems. We would only invest in very liquid issues as aftermarket liquidity will dry up and spreads widen immediately when risk aversion returns.

While we pick up some yield in high quality names we wait for further market weakness to increase our exposure. We focus on strong names with solid balance sheets and business models. The number of distressed bonds is close to long-term low levels.

We have select exposure to some large emerging market issuers with strong cash flow generation and solid balance sheets. We avoid venturing into less liquid names for the time being.

EUR and USD are exhibiting very high news-flow driven volatility. It appears difficult to imagine that the EUR could move much higher from here considering the expected slowdown in Europe and further rate cuts.

We generally prefer emerging market Asian currencies over developed market counterparts, favouring India, Malaysia and Singapore. In the short to medium, however, EM currencies may suffer from a stronger Dollar.

The Euro has performed well as the European debt crisis ran its course. Key for the four large currencies will be inflation expectations and interest rate differentials as well as the course of political action in Europe and the US.

We add exposure to these markets even if yield pick-ups are not high but we would like to get exposure to the currencies that we expect to appreciate in the long run.

Currencies

Alongside the relaxation of rules governing the corporate bond issuance an even more important venue was opened for foreign investors: the possibility for individuals outside China to open bank accounts in RMB. In January the Bank of China announced without much fanfare a new bank account that would be available to US citizens. Americans now have the opportunity to swap their constantly debasing home currency into Chinese Renminbi at a branch next door. The minimum deposit is USD500 which will be converted into RMB. For the time being this is all you can do with this account as you cannot write checks or get debit or credit cards and obviously not withdraw money at the cash machine but the odds are good that it will beat the average US money market fund or USD based cash deposit.

Developed Markets Following significant corrections in August and September, markets are still in medium term downtrends. Markets are beginning to establish a broader consolidation range. Trapped between seemingly attractive valuations and fundamental headwinds, markets are now entirely newsflow-driven.

All commodities benefitted strongly from monetary easing, increasing demand and inelastic supply. After strong gains in 2010 we would expect more volatility, especially in the soft commodity sector as supply will ultimately be able to react.

The commodity market is particularly sensitive in terms of a change in the Global growth picture. While we don’t expect a recession in China, a significant slowdown seems very likely following in the footsteps of the US and Europe. Also, the China periphery is suffering from high inflation and falling growth, all of which will put a lid on demand for commodities.

Energy and base metals are under pressure from what appears to be the onslaught of a new recession in Europe and the US. It is too early to buy back into these markets now. The only commodity-related asset class we prefer are precious metals, Gold in particular, as they protect against further monetary debasement.

Meeta Misra - Director - Product Specialist & Investor Relations Meeta.Misra@acpi.com

Pictet Asset Management

Reshuffle of Chinese regulators points to policy continuity At first sight there is little connection between the reshuffle of three of China’s top regulators and the decision by Shenguan Holdings, a manufacturer of edible sausage casings, to upgrade its product range. But the two developments highlight some key and interlinked trends in the Chinese economy. Shenguan’s move to make tastier and more digestible skins reflects changing consumption patterns as the new urban middle class seeks a richer diet in which better-quality sausages play a part. And the identities of the new heads of the banking, securities and insurance commissions, all drawn from Communist Party officials with backgrounds running large state-owned banks, point to a deep continuity in policy, even as the authorities adapt to slowing growth and a changing economic structure. These moves kick off a series of appointments that will culminate in the replacement in late 2012 of President Hu Jintao and Premier Wen Jiabao by Vice-President Xi Jinping and First Vice-Premier Li Keqiang respectively.

The new head of the banking commission – a key body given the importance in China of state-owned banks in allocating capital and implementing monetary policy – is Shang Fulin, who in his previous role running the securities commission, China’s SEC, saw through a number of important market changes. Since 2002 he has pushed the big financial reform that made it possible to trade the massive amount of shares in previously untradeable state-owned companies listed in Shanghai, effectively creating a real stock market in China. At the time of his promotion he was working on a reform to enable Shanghai to list shares in foreign companies and “red chips” – those Chinese companies incorporated or listed abroad – to boost Shanghai as a financial centre.

It’s important to understand that such reforms represent a desire to try out market mechanisms to make the economy more efficient. They do not amount to liberalisation, because the Communist Party is not ceding control of the economy; it is building state capitalism.

That is why the current round of personnel changes is so important. In a command economy, policy-making is critical and hence so is knowing who the policy-makers are. The Communist Party draws its legitimacy not from ideology but from delivering growth and jobs. Economic stability and growth are essential.

The messy attempts to solve the euro zone crisis in Europe or U.S. fiscal problems in Congress, playing according to democratic rules, are observed with a mixture of horror and bemusement in Beijing. Party leaders are keenly aware of outbreaks of social unrest in China, often triggered by dissatisfaction over wages, land use or prices. After all, the Tienanmen Square protest of 1989 – a traumatic event for the leadership – was triggered as much by soaring inflation as anything else.

China’s explosive growth in recent years that made it the number two world economy and put it on course for first place (in fact simply returning it to the position it held for centuries before the temporary shock of European colonialism) has been accompanied by inflationary pressures. The leadership faced the dilemma of curbing the overheating economy while ensuring growth continued sufficiently to generate jobs for the millions of people in the countryside, where half the 1.3 billion population still lives. So news that inflation slowed in October to 5.5 per cent, a sharp drop from July’s three-year peak, while industrial output grew at its slowest rate for a year, reinforces the view that policy-makers will now tilt their focus to stabilize and support growth rather than slowing an overheating economy.

Rebalancing Act Why rebalance? Demographic factors such as an ageing population and the one-child policy, plus growing shortages of unskilled workers, are putting pressure on wages. The widespread view that China’s economy is based on exports is misplaced. Over the last decade, exports have contributed less than 10 per cent to growth, whose main driver is investment. But there is a growing view that infrastructure projects just for the sake of growth are no longer desirable.

Instead, resources must be spent more efficiently, hence the appeal of market mechanisms to allocate capital, such as more flexible interest rates. Chinese consumers are already emerging as significant players on world markets. If growth is not to be powered by exports or investment, then it is time to give the middle classes and lower paid a bigger slice of prosperity, by improving consumption.

That would involve improving pensions and healthcare, so that Chinese people felt able to spend some of the high savings they now hold against ill health or old age. The new five-year plan talks explicitly about improving the social safety net, although the results will take some years to materialise.

U.S. politicians have called on China to rebalance its economy by allowing its undervalued exchange rate to appreciate sharply. But such a simple and drastic step would not appeal to the cautious Chinese. Zhou Xiaochuan, the governor of the People’s Bank of China, the central bank (whose own replacement in the coming months will be closely watched), likes to draw an analogy from healthcare. Western medicine typically has one active ingredient and aims for a quick result. Traditional Chinese medicine has various elements, and the doctor will try different combinations and strengths to see how the patient responds over time. That pragmatic trial-and-error approach is how the Chinese authorities will handle the economy.

These changes have important implications for investors. Chinese manufacturers based on the eastern seaboard, faced with growing labour constraints, can either relocate operations inland to where the workforce is still cheap and plentiful, or improve productivity through automation. Companies involved in the infrastructure of new inland and western urban centres, or in automation, stand to benefit. Similarly a whole range of sectors will benefit from growing consumer power, from education, entertainment and Internet retailing, to sausage-making.

François Pirrello - Head of Sales - CH Romande & Ticino Direct line +41 (058) 323 2445

The motors of that growth are already changing, as the economy matures and those seeming infinite resources of cheap labour start to dry up. Much western media coverage of the 12th Five-Year Plan, approved this year and running to 2015, focused on the military budget. The real story in the plan was China’s efforts to rebalance its economy increasingly towards quality growth

Emerging Markets

21

Charlemagne Capital

The Passing of the Baton The end of 150 years of western domination and the rise in emerging markets At the start of the 19th century, the world economy was dominated by the two Eastern giants. In the early 1800s, China accounted for 30% of the world economy and was by far the world’s largest economy. A century earlier, India was probably the biggest economy on the planet, with about a quarter of global GDP. World GDP

World GDP

100% United States

80%

This development was in no small part due to inward-looking policies by the Asian powers, broadly from 1950 to 1980, that verged on the suicidal. A group of countries, the “West”, with a combined population today of less than a billion, have for the last 150 years controlled the destiny of a planet whose population has now surpassed seven billion.

It is clear that this control has come at an increasing economic cost. As shown below, the US national debt has increased almost 40-fold over the last 40 years, from less than 40% of GDP to more than 100% this year. Japan’s national debt is more than 200% of GDP, up from nearer 50% in 1980, Germany’s is around 80%, up from 30% in 1980. For some countries hanging on to the coat-tails of greater powers, such as Greece, the level of debt has become unsustainable.

China

A huge increase in public debt

Western Europe

60%

Latin America

40%

Japan

A huge increase in public debt . . .

USD billions

% GDP

15000

India

20%

Others

0% 1500

1600

1700

1800

1900

120%

US Gross Federal Debt, USD billions, LHA % GDP, RHA

10000

80%

5000

40%

2000

In the middle of the 19th century, in the wake of the Industrial Revolution, there followed a series of events within a mere two decades that gave rise to the western-dominated world that we have known for the last century and a half.

0 1970

0% 1975

1980

1985

1990

1995

2000

2005

2010

These were:

Up to 1853

Westward expansion of the US (Texas 1845, Oregon 1846,

Mexican Cession 1848, 1853) and the completion of the contiguous USA

1854

Convention of Kanagawa followed in 1868 by the Meiji

Restoration – the opening up of Japan to outside influ ences

1858

The end of the Opium wars and the treaty of Tianjing,

which led to the emasculation of China

1858

Formalisation of the British Raj in India

1871

Unification of Germany

Following these seismic changes, an increasingly globalised economy was now in the hands of a small number of countries – the great western powers plus Japan. By contrast, giants such as China and India were rapidly reduced to shadows of their former selves, at least in relative terms. By 1900, Western European economies were already 50% larger than the combined size of the two eastern powers. This gap then widened to the extent that by the 1980s, Western Europe was almost three times the size of India and China together, in terms of GDP.

22

Emerging Markets

At the same time, levels of private sector debt, in the US and elsewhere in the West, have risen markedly. Put simply, people, as well as nations, are increasingly living beyond their means. The personal debt/income ratio in the US hit 130% in 2007, having almost doubled over the past 20 years. In these terms, the euro zone sovereign debt crisis can be seen as the culmination of pre-existing trends.

Debt is theoretically supported by ability to pay, (i.e. by current income) and by expectations of future income. A rise in the ratio is sustainable only for as long as asset prices rise. In reality, this means the prices of houses and, to a lesser extent, other financial assets such as equities. And we know where they have gone since their recent respective peaks: for US homes, down 30%, for US equities, down 20%, having been down 60% at their worst.

The flip side of this whole dynamic has been an export boom and the amassing of reserves by emerging markets countries. And it’s these countries to whom the West has become increasingly indebted. Principal of these is China, but the list includes those other emerging markets countries which have run current account surpluses over the last decade or so.

The countries with the cash: International Reserves

The countries with the cash: International reserves

USD billions

3000 2500 2000 1500 1000 500 0 China

Russia

Taiwan

South Korea

Brazil

India

Charlemagne Capital

The Passing of the Baton The great deleveraging in the West has been underway for a good couple of years now. The cost of all this will be paid for by western taxpayers over the years ahead as the government’s role in the economy grows. To see what is likely to happen in most of the West, just look at what has already happened in Japan and Italy. In the 1990s, they were the two most indebted major economies in the world. It is no surprise that these have been among the world’s slowest economies in the last decade and more. Would you have wanted to invest in Japan over the last decade? This is a sign of things to come for the US and Europe. In addition, what little growth there has been in Japan in the last decade and more has been due entirely to export growth, a prop that is unlikely to be as supportive in the coming years.

The price of indebtedness: 12 years of the Nikkei Index level

The price of indebtedness: 12 years of the Nikkei

25000 20000 15000 10000

Emerging Markets as a percentage of the World Emerging markets

Developed markets

9

91

MSCI Market cap (full market)

20

80

GDP at PPP

49

51

Foreign exchange reserves

73

27

Population

87

13

MSCI Market cap (float adjusted)

Sources: Merrill Lynch; BP; CIA World Factbook; IMF World Economic Outlook; MSCI

One of the consequences of the global financial crisis of 2008 and the euro zone sovereign debt crisis of 2011 has been a reduction of risk appetite. This has led to an underperformance of emerging markets relative to developed markets during periods of market dislocation when share prices are tumbling. While this may be logical in the short term, longer term it makes no sense at all. In our view, investors need a totally different approach to what is meant by ‘risk’. To us, risk is investing in low growth countries with increasing state intervention, the inevitability of rising taxation and currencies being eroded by the printing presses. At the very least, most investors should look to have a substantially greater allocation to emerging markets equities than they do at present. The falls in emerging markets post the 2008 crisis presented a very attractive entry point, with PE multiples at record lows; current valuations are almost equally attractive.

GEMs trailing PER: Cheap by historic standards GEMs trailing PER: Cheap by historic standards

5000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

So what does this imply for investors? Firstly, developed markets are destined for a period of low growth. People and governments will spend years rebuilding their balance sheets. Policies aimed at stimulating consumption are destined to fail. It’s easy to overlook quite how bad the state is at allocating capital – just look at those economic decisions made by China and India in the mid-to-late 20th century referred to above. More government involvement will mean poorer capital allocation and less innovation, which means lower productivity growth, lower economic growth and increasingly debased currencies. This means that their imports will stagnate or fall, which in turn means that exports in emerging markets, and therefore the latter countries’ growth in foreign reserves, will slow or be reversed. This in turn is bearish for the long term recipients of FX reserves such as the US Treasury bill market. In addition, emerging economies will increasingly use their substantial reserve cushion to fund domestic economic activity. This in turn puts a floor on commodity prices in the long term – has anyone else noticed how no-one is talking about Indian demand for commodities, as if over a billion people have simply disappeared off the map?

The second implication is this: the slowdown in emerging markets is temporary, in contrast to that of developed markets. The ‘decoupling’ argument – the view that emerging markets can perform while their more mature cousins stagnate - has been shown to be at best premature, at worst wrong. This time, however, emerging markets are now of such significance – almost 50% of global GDP on a ‘purchasing power parity’ basis – and their economic ammunition is such that they can increasingly lead the world economy and not follow. And this is the heart of the argument. Emerging markets, led by China and India, are set to resume their leadership of the world economy after a hiatus of 150 years. This growth will not be a matter of fuelling western consumption: it’s the domestic consumer who will take up the baton. Implications for investors are massive.

Currently, 80-90% of the value of the world’s stock markets (depending on one’s definitions) are in developed markets such as the US, Western Europe and Japan.

Using a benchmarking approach, it therefore follows that 80-90% of an investor’s equity investments should be in developed markets – even though these countries represent only 50%, and shrinking, of the world economy. Does this really make sense?

40

Dashed lines show mean and standard deviation

30 20 10 Aug 1998

0 1996

Sep 2001

12.5

1998

Feb 2009

10.8

2000

2002

Sep 2011

7.9

2004

2006

2008

10.2

2010

2012

The conclusion is both opaque and clear. What happens in the near term is, as ever, impossible to predict. Inevitably economic growth everywhere has taken a hit. But as developed economies flirt once again with recession, the argument in emerging economies is whether growth will be 8% or 5%. But it’s still 5%. And once markets return to anything resembling stability, the picture is very clear.

Current market volatility surely offers a remarkable opportunity to position portfolios to take advantage of this.

Decoupling has happened before, to dramatic effect. The last great market to emerge was Japan. This coincided with massive outperformance of the Japanese market during the 1960s and 1970s. In the decade from 1971, the US market went sideways for ten years, while Japan rose sixfold!

Emerging Markets

23

Charlemagne Capital

The Passing of the Baton A world dominated once again by China and India, with Europe and the US in important, but secondary roles, will be a different, and for some, an unsettling place. But perhaps not a bad one in which, instead of the West selling Asians opium, they are selling us toys, software and running shoes.

Neither Charlemagne Capital (UK) Limited nor its third party content provider shall be liable for any errors, inaccuracy, delay or updating of the published content of the provided document.

Charlemagne Capital (UK) Limited expressly disclaims all warranties as to the accuracy of the content provided, or as to the use of the information for any purpose, as far as legally possible.

This material is for the use of intended recipients only and neither the whole nor any part of this material may be duplicated in any form or by any means. Neither should any of this material be redistributed or disclosed to anyone without the prior consent of Charlemagne Capital (UK) Limited.

A massive divergence between Japan and the US in the 1970’s

A massive divergence between Japan and the US in the 1970s

Rebased Jan 1971 = 100

600 500 400 300

Nikkei

200

Dow Jones

100 0 1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

Marketing & Sales Department Tel: + 44 (0)20 7518 2100 Fax: + 44 (0)20 7518 2199 Email: marketing@charlemagnecapital.com Website: www.charlemagnecapital.com Issued by Charlemagne Capital (UK) Limited, 39 St James’s Street, London SW1A 1JD A company authorised and regulated by the Financial Services Authority

Disclaimer This document has been issued by Charlemagne Capital (UK) Limited for information purposes only and is not to be construed as a solicitation or an offer to purchase or sell any security or other financial instrument. Although the material in this report is based on information that Charlemagne Capital (UK) Limited considers reliable, Charlemagne Capital (UK) Limited does not make any warranty or representation (express or implied) in relation to the accuracy, completeness or reliability of the information contained herein. Any opinions expressed herein reflect a judgment at the date of publication and are subject to change. Charlemagne Capital (UK) Limited accepts no liability whatsoever for any direct, indirect or consequential loss or damage of any kind arising out of the use of all or any of this material.

Where Charlemagne Capital (UK) Limited provides information in the document, it is provided exclusively for information purposes. The information does not constitute any form of recommendation related to the personal circumstances of investors or otherwise, nor does it constitute any specific or general recommendation to buy, hold, or sell financial instruments and does not thus create any relationship between Charlemagne Capital (UK) Limited and any investor. The document may not include all the up-to-date information required to make investment decisions. Other more accurate and relevant sources of information may exist.

Investors should thus diligently inform themselves about the chances and risks of the investments prior to taking investment decisions. In addition to the financial aspects, this should include, in particular, the legal and tax aspects of the investments. It is strongly recommended that any potential investor should contact a financial adviser and, where required, a lawyer or tax adviser. Furthermore, it should also be considered that the future performance of financial

24

Emerging Markets

instruments and their return cannot be inferred from their past performance. The value of investments may go down as well as up and investors in financial instruments should be capable of bearing a total loss of investment.

Lipper

Best Performing Global Emerging Markets Funds Best Performing Global Emerging Markets Funds Source: Lipper, a Thomson Reuters company Report date: 18 November 2011 Based on universe of active, primary, mutual funds, domiciled in Europe Universe is Lipper Global Classifications: Bond Emerging Markets Global & Equity Emerging Mkts Global TR ExD LC = Total Return, Gross of any tax, in Local Currency, Dividends reinvested on Ex date

Top 10 Bond funds over 1 year Lipper ID 65116901 65098018 68048424 65082041 68038983 68093129 65107437 60059017 65027933 68021989 11000447

Name OTP EMDA Szarmaztatott Alap AEGON Kozep-Europai Kotveny ba GE Money Feltorekvo Piaci Devizakotveny a ESPA BOND BRIK CORPORATE T Aviva Investors EM Inflation Linked Bond USD BNP Paribas Flexi III Bd World Em Adv X Stone Harbor Emerging Markets Debt M USD Acc Aberdeen Global - Emerging Markets Bond A2 Acc Sydinvest Engros Emerging Markets Bonds BlueBay Emerging Market Corporate Bond USD R Acc JP Morgan EMBI+

Fund Management Company OTP Alapkezelo Zrt AEGON Magyarorszag Befektetesi Alapkezelo Rt BUDAPEST Alapkezelo Zrt Erste Sparinvest Kapitalanlagesellschaft mbH Aviva Investors Luxembourg SA BNP Paribas Investment Partners Luxembourg SA Stone Harbor Investment Funds plc Aberdeen Global Services S.A. Investeringsforeningen Sydinvest International AS BlueBay Funds Management Company S.A

Domicile Hungary Hungary Hungary Austria Luxembourg Luxembourg Ireland Luxembourg Denmark Luxembourg

Lipper Global Classification Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global

% Growth TR ExD LC 1Y 31/10/2010 to 31/10/2011 23.07 8.67 6.16 6.1 6.09 5.9 4.92 4.55 4.15 4.11 3.96

Institutional Fund?

TRUE

Top 10 Bond funds over 3 years Lipper ID 60038115 60055693 65094112 65116901 65082041 65107416 65107437 65011320 60093533 60059017 11000447

Name Amundi Oblig Emergents P C Amundi Fds Bond Global Emerging - AU (C) SICAV II (Lux) Aberdeen Emerging Mkts Bd B OTP EMDA Szarmaztatott Alap ESPA BOND BRIK CORPORATE T AB.LV High Yield CIS Bond Fund Stone Harbor Emerging Markets Debt M USD Acc Danske Invest Emerging Markets Debt Kasvu SEI SGMF Emerging Markets Debt USD Inst Aberdeen Global - Emerging Markets Bond A2 Acc JP Morgan EMBI+

Fund Management Company Amundi SA Amundi Luxembourg SA Credit Suisse Fund Services (Lux) OTP Alapkezelo Zrt Erste Sparinvest Kapitalanlagesellschaft mbH IPAS AB.LV Asset Management Stone Harbor Investment Funds plc Danske Invest Rahastoyhtio Oy SEI Investments Global Limited Aberdeen Global Services S.A.

Domicile France Luxembourg Luxembourg Hungary Austria Latvia Ireland Finland Ireland Luxembourg

Lipper Global Classification Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global

% Growth TR ExD LC 3Y 31/10/2008 to 31/10/2011 148.89 128.86 120.29 116.64 103.49 102.91 101.78 96.33 95.17 92.47 68.53

Institutional Fund?

Top 10 Bond funds over 10 years Lipper ID 60067772 60000478 60059017 60013289 65116216 60076350 60091000 65058506 60005216 60050618 11000447

Name ZZ1 Ashmore Emerging Markets Liquid Investment Ptf Aberdeen Global - Emerging Markets Bond A2 Acc Franklin Templeton Emerging Market Debt Opps USD DekaLuxTeam-EM Bond CF MFS Meridian Funds Emerging Markets Debt A1 USD PIMCO GIS Emerging Mkts Bd Inst USD Acc LGT Multi Manager Bond Emerging Markets (USD) B WIP Emerging Markets Fixed Income Fund A USD HSBC GIF Global Emerging Markets Bond PD USD JP Morgan EMBI+

Fund Management Company Semper Constantia Invest GmbH Ashmore Management Company Limited Aberdeen Global Services S.A. Franklin Templeton Investment Management Ltd Deka International SA MFS Meridian Funds SICAV PIMCO Global Advisors (Ireland) Ltd LGT Capital Management AG Oppenheim Asset Management Services Sarl HSBC Investment Funds (Luxembourg) SA

Domicile Austria Guernsey Luxembourg Ireland Luxembourg Luxembourg Ireland Liechtenstein Luxembourg Luxembourg

Lipper Global Classification Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global Bond Emerging Markets Global

% Growth TR ExD LC 10Y 31/10/2001 to 31/10/2011 478.1 262.1 254.47 229.48 224.03 221.66 218.66 208.24 203.28 197.94 197.37

Institutional Fund?

TRUE

TRUE

Top 10 Equity funds over 1 year Lipper ID 68043824 68046184 65020476 65117680 68121171 68028766 60090074 60036473 68048907 68056414 11000559

Name First State Global Emerging Markets Select III St James's Place Global Emerging Markets Acc First State Global Emerging Markets Leaders I SAMPENSION INVEST GEM II RIC Acadian Global Equity Wellington Opportunistic EM Debt USD A Cap First State Global Emerging Markets Leaders A GBP Vontobel Fund Emerging Markets Eq B USD Akbank Franklin Templeton BRIC Quoniam SICAV - EM Equities MinRisk MSCI EM (Emerging Markets) TR USD

Fund Management Company First State Investments (Hong Kong) Ltd St James’s Place Wealth Management First State Investments (Hong Kong) Ltd SAMPENSION INVEST Russell Investments (Ireland) Ltd Wellington Management Portfolios (Ireland) Plc First State Investments (UK) Limited Vontobel Management SA Ak Asset Management Inc Union Investment Luxembourg SA

Domicile Ireland UK Ireland Denmark Ireland Ireland UK Luxembourg Turkey Luxembourg

Lipper Global Classification Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global

% Growth TR ExD LC 1Y 31/10/2010 to 31/10/2011 9.64 6.07 4.02 3.64 3.32 3.12 2.65 2.62 2.27 1.33 -7.44

Institutional Fund?

TRUE

TRUE

Top 10 Equity funds over 3 years Lipper ID 65098608 65093609 65094176 65071396 65029740 65121303 65090601 65075785 60081345 60001614 11000559

Name JPM Emerging Markets Small Cap A Acc USD Global Emerging Mrkt Small Cap UBAM Equity BRIC + A C Aberdeen Global - Emrg Markets Smaller Cos A2 Acc Danske Invest Nye Markeder Small Cap McInroy & Wood Emerging Markets Aviva Investors Emerging Markets Eq Sm Cap A USD Dimensional Emerging Markets Targeted Value A USD Genesis Emerging Mkts Investment Company SICAV Danske Invest Global Emerging Markets A MSCI EM (Emerging Markets) TR USD

Fund Management Company JPMorgan Asset Management (Europe) Sarl Danske Invest Management Company SA Union Bancaire Privee SA Aberdeen Global Services S.A. Danske Invest Investeringsforeningen McInroy & Wood Portfolios Ltd Aviva Investors Luxembourg SA Dimensional Funds II plc Genesis Emerging Markets Investment Company SICAV Danske Invest Management Company SA

Domicile Luxembourg Luxembourg Luxembourg Luxembourg Denmark UK Luxembourg Ireland Luxembourg Luxembourg

Lipper Global Classification Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global

% Growth TR ExD LC 3Y 31/10/2008 to 31/10/2011 158.95 150.88 147.5 141.06 137.77 135.24 118.72 117.75 116.31 114.13 88.79

Institutional Fund?

TRUE

Top 10 Equity funds over 10 years Lipper ID 60008639 60081345 60002590 60036473 60011561 60049285 60049329 60010267 60003731 60044173 11000559

Name Aberdeen Emerging Markets A Acc Genesis Emerging Mkts Investment Company SICAV Genesis Emerging Markets Fund Ltd (NAV) Vontobel Fund Emerging Markets Eq B USD First State Global Emerging Markets A GBP Acc City of London Emerging World USD Retail A Russell IC Emerg Mkts Eq A Lazard Emerging Markets Ret Inc Lazard Emerging World Bolux International MSCI EM (Emerging Markets) TR USD

Fund Management Company Aberdeen Unit Trust Managers Limited Genesis Emerging Markets Investment Company SICAV Genesis Fund Managers LLP Vontobel Management SA First State Investments (UK) Limited City of London Investment Management Co Ltd Russell Investment Company PLC Lazard Fund Managers Ltd Lazard Fund Managers (Ireland) Limited Victory Asset Management S.A

Domicile UK Luxembourg Guernsey Luxembourg UK Ireland Ireland UK Ireland Luxembourg

Lipper Global Classification Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global Equity Emerging Mkts Global

% Growth TR ExD LC 10Y 31/10/2001 to 31/10/2011 548.4 532.03 440.73 436.15 404.25 397.12 394.78 392.16 391.15 379.79 387.49

Institutional Fund?

TRUE

Emerging Markets

25

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