January 2013
Welcome to the January 2013 edition of Euro Pacific Capital's The Global Investor Newsletter. Our investment consultants are standing by to answer any questions you have. Call (800) 727-7922 today!
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The Hidden Truth of Higher Prices
By: Peter Schiff, CEO and Chief Global Strategist
Stimulus Could Continue to Drive Markets in 2013
By: Jim Nelson, Euro Pacific Asset Management
"RIGging" Country Selection for the Year Ahead
By: Russell E. Hoss, CFA, and Richard Hoss, Euro Pacific Funds
Telecom Offers A World Of Opportunity
By: David Echeverria, Investment Consultant
The Global Investor Newsletter - January 2013
March 21, 2013
The Hidden Truth of Higher Prices
By: Peter Schiff, CEO and Chief Global Strategist
In dismissing the inflationary warnings of Austrian School economists, the pro-stimulus Keynesians have largely refrained from attacking the roots of our logic. (Given that this involves defending the position that money printing does not lead to inflation, their reluctance is understandable). Instead they point to the lack of "evidence" that shows prices going up in step with money supply increases. Paul Krugman himself unpacked these arguments in a recent blog post designed to specifically discredit my views.
According to Krugman, the sub 2.5% increases in the Consumer Price Index (CPI) over the past few years are all that is needed to invalidate the fears of the inflationists.
However, there is plenty of evidence to suggest that the measurement tools used by Krugman and his cohorts to measure inflation are as deeply flawed as their arguments. And to conclude that inflation has been quelled requires a dismissal of the macroeconomic forces that have temporarily blunted the impact of an overly loose monetary policy.
Since the 1970’s the preferred government inflation metrics have changed so thoroughly that they bear scant resemblance to those used during the “malaise days” of the Carter years. Government and academia defend the integrity and accuracy of the modern methods while dismissing critics as tin hat conspiracy theorists. But given the huge stakes involved, it’s hard to believe that institutional bias plays no role. Government statisticians are responsible for coming up with the methodology and the numbers, and their bosses catch huge breaks if the inflation numbers come in low. Human behavior is always influenced by such incentives.
Beginning in the early 1980’s the methodologies were altered to compensate for a variety of consumer behavior. The new “chain weighted CPI” for instance incorporates changes in relative spending, substitution bias, and subjective improvements in product quality.
Essentially these measures report not just on price movements, but on spending patterns, consumer choices, and product changes. This is fine if the goal is to measure the cost of survival. But that is not the purpose for which these metrics are meant to be used. But if you simply focus on price, especially on those staple commodity goods and services that haven’t radically changed over the years, the underreporting of inflation becomes more apparent.
We randomly identified price changes of 10 everyday goods and services over two separate 10 year periods, and then compared those changes to the reported changes in the Consumer Price Index (CPI) over the same period. The 10 items, which we selected are: eggs, new cars, milk, gasoline, bread, rent of primary residence, coffee, dental services, potatoes, and electricity.
We know that people do not spend equal amounts on the above items, and we know their share of income devoted to them has changed over the decades. But as we are only interested in how these prices have changed relative to the CPI, those issues don’t really matter. We chose to look at the period between 1970 and 1980 and then again between 2002 and 2012, because these time frames both had big deficits and loose monetary policy. But they straddle the time in which the most significant changes to inflation measurement methodology took effect. And while nominal price increases rose much faster in the 1970’s, the degree to which the prices rose relative to the CPI was much, much higher more recently.
Between 1970 and 1980 the officially reported CPI rose a whopping 112%, and prices of our basket of goods and services rose by 121%, just 8% faster than the CPI. In contrast between 2002 and 2012 the CPI rose just 27.5%. But our basket rose by nearly double that rate – 52.1%! So the methods used in the 1970’s to calculate CPI effectively captured the price changes of our goods, but only got half of those movements more recently. How convenient.
Just to make sure, we ran the same experiment with 10 different goods and services. This time we chose: sugar, airline tickets, butter, store bought beer, apples, public transportation, cereal, tires, beef and veal, and prescription drugs. The results were notably similar. The basket increased 1% faster than the CPI between 1970 and 1980 and 32% faster between 2002 and 2012. In both cases we selected a random array of food and non-food items.
To be convinced that the CPI does a poor job in gauging the cost of living, all one needs to do is look at health insurance. According to the Kaiser Survey of Employer Sponsored Health Insurance, the average annual total cost for family health insurance in 2012 was $15,745, or more than one third of the median family income of $45,018 per year. Yet these costs are largely factored out of the CPI. In 2011, health insurance costs did not even merit a one percent weighting in the CPI. Furthermore, as far as the Bureau of Labor Statistics is concerned, health insurance costs are well contained. From 2008 through 2012, the BLS’ “Health Insurance Index” increased just 4.3% (total), which is far below the general rise of the CPI. In contrast, the Kaiser Survey showed family coverage rising 24.2% over that time.
A recent poll of likely voters conducted by Fox News in the weeks before the election, revealed that 41% of respondents identified “rising prices” as their top economic concern. This response beat out “unemployment” by nearly two to one.
The underreporting of price movements would explain why inflation is a concern on Main Street even while it’s not a concern on Pennsylvania Avenue. If these price changes in our experiments had been fully captured, CPI could currently be high enough to severely restrict Fed action to stimulate the economy.
But beyond arguments over the accuracy of our inflation yardsticks, there are solid reasons that prices are not rising as fast as they could be given the printing binge that has characterized the last few years. Economies no longer come in the neatly packagednational varieties. To a very large extent monetary conditions within the United States now are being influenced by activities of other countries.
Over the past years, unprecedented amounts of dollars have been created. But much of that money does not stay within the confines of the U.S. economy. A very large percentage of it winds up locked away inside the vaults of foreign central banks, particularly in the Far East. Countries like China and Japan, that run large trade surpluses with the U.S., need to warehouse these greenbacks so that they can keep their own currencies from appreciating against the dollar. The International Monetary Fund estimates that from first Quarter 2008 and second quarter 2012,U.S. dollars held in reserve by foreign central banks increased by $850 billion, or 31%.
When these countries decide that holding huge amounts of dollars is no longer in their interest, the money could come flooding back onto these shores, where it will exert upward pressure on domestic prices. In the meantime, the current flow of funds allows for a windfall for U.S. consumers. An artificially supported dollar means that we do not pay as much as we could for imported products. The low prices at Walmart are not the result of a sluggish U.S. economy, but by greater production abroad and dollar support from foreign central banks.
But in the meantime, it’s not as if those dollars have been neutered of their price raising power. Rather than being spent by U.S. consumers to push up domestic prices, they are creating inflation abroad and helping to push up the prices of U.S. Treasury Bonds, which foreign central banks buy with their excess dollars.
Given how weak the economy has been since the crash of 2008,it is surprising that domestic prices have risen at all. While there have been many similarities between the Great Depression and the Great Recession, one great difference was that the crash of the 1930’s was accompanied by significant deflation. By some estimates, prices fell by about a third. And so while consumers and businesses then struggled with unemployment and dropping share prices, at least they were cushioned by falling prices. Today we have no such support.
The Bureau of Economic Analysis reports that in December of 2008 food and energy spending, as a share of wages and salaries, had fallen to a low of 18.7%. Today that figure stands at 22.1%, an increase of more than 18% in just four years. This indicates that the stimuli of the past four years have failed to create the beneficial impact its architects had hoped. People who are spending a higher percentage of their incomes on necessities like food and energy are likely to be experiencing lower living standards.
Unlike Krugman and the Keynesians, I would argue that itis impossible to create something from nothing. I believe that printing a dollar diminishes the value of all existing dollars by an aggregate amount equal to the purchasing power of the new dollar. The other side takes the position that the new money creates tangible economic growth. I think that those making such absurd claims should bear the burden of proof. flation has been quelled requires a dismissal of the macroeconomic forces that have temporarily blunted the impact of an overly loose monetary policy.
Since the 1970's the preferred government inflation metrics have changed so thoroughly that they bear scant resemblance to those used during the "malaise days" of the Carter years. Government and academia defend the integrity and accuracy of the modern methods while dismissing critics as tin hat conspiracy theorists. But given the huge stakes involved, it's hard to believe that institutional bias plays no role. Government statisticians are responsible for coming up with the methodology and the numbers, and their bosses catch huge breaks if the inflation numbers come in low. Human behavior is always influenced by such incentives.
Beginning in the early 1980's the methodologies were altered to compensate for a variety of consumer behavior. The new "chain weighted CPI" for instance incorporates changes in relative spending, substitution bias, and subjective improvements in product quality. Essentially these measures report not just on price movements, but on spending patterns, consumer choices, and product changes. This is fine if the goal is to measure the cost of survival. But that is not the purpose for which these metrics are meant to be used. But if you simply focus on price, especially on those staple commodity goods and services that haven't radically changed over the years, the underreporting of inflation becomes more apparent.
We randomly identified price changes of 10 everyday goods and services over two separate 10 year periods, and then compared those changes to the reported changes in the Consumer Price Index (CPI) over the same period. The 10 items, which we selected are: eggs, new cars, milk, gasoline, bread, rent of primary residence, coffee, dental services, potatoes, and electricity.
We know that people do not spend equal amounts on the above items, and we know their share of income devoted to them has changed over the decades. But as we are only interested in how these prices have changed relative to the CPI, those issues don't really matter. We chose to look at the period between 1970 and 1980 and then again between 2002 and 2012, because these time frames both had big deficits and loose monetary policy. But they straddle the time in which the most significant changes to inflation measurement methodology took effect. And while nominal price increases rose much faster in the 1970's, the degree to which the prices rose relative to the CPI was much, much higher more recently.
Between 1970 and 1980 the officially reported CPI rose a whopping 112%, and our basket of goods and services rose by 121%, just 8% faster than the CPI. In contrast between 2002 and 2012 the CPI rose just 27.5%. But our basket rose by nearly double that rate - 52.1%! So the methods used in the 1970's to calculate CPI effectively captured the price changes our goods, but only got half of those movements more recently. How convenient.
Just to make sure, we ran the same experiment with 10 different goods and services. This time we chose: sugar, airline tickets, butter, store bought beer, apples, public transportation, cereal, tires, beef and veal, and prescription drugs. The results were notably similar. The basket increased 1% faster than the CPI between 1970 and 1980 and 32% faster between 2002 and 2012. In both cases we selected a random array of food and non food items.
A recent poll of likely voters conducted by Fox News in the weeks before the election, revealed that 41% of respondents identified "rising prices" as their top economic concern. This response beat out "unemployment" by nearly two to one. The underreporting of price movements would explain why inflation is a concern on Main Street even while it's not a concern on Pennsylvania Avenue. If these price changes in our experiments had been fully captured, CPI could currently be high enough to severely restrict Fed action to stimulate the economy.
But beyond arguments over the accuracy of our inflation yardsticks, there are solid reasons that prices are not rising as fast as they could be given the printing binge that has characterized the last few years. Economies no longer come in the neatly packed national varieties. To a very large extent monetary conditions within the United States now are being influenced by activities of other countries.
Over the past years, unprecedented amounts of dollars have been created. But much of that money does not stay within the confines of the U.S. economy. A very large percentage of it winds up locked away inside the vaults of foreign central banks, particularly in the Far East. Countries like China and Japan, that run large trade surpluses with the U.S., need to warehouse these greenbacks so that they can keep their own currencies from appreciating against the dollar. The International Monetary Fund estimates that from first Quarter 2008 and second quarter 2012 U.S. dollars held in reserve by foreign central banks increased by $850 billion, or 31%.
When these countries decide that holding huge amounts of dollars is no longer in their interest, the money could come flooding back onto these shores, where it will exert upward pressure on domestic prices. In the meantime, the current flow of funds allow for a windfall for U.S. consumers. An artificially supported dollar means that we do not pay as much as we could for imported products. The low prices at Walmart are not the result of a sluggish U.S. economy, but by greater production abroad and dollar support from foreign central banks.
But in the meantime, it's not as if those dollars have been neutered of their price raising power. Rather than being spent by U.S. consumers to push up domestic prices, they are creating inflation abroad and helping to push up the prices of U.S. Treasury Bonds, which foreign central banks buy with their excess dollars.
Given how weak the economy has been since the crash of 2008, it is surprising that domestic prices have risen at all. While there have been many similarities between the Great Depression and the Great Recession, one great difference was that the crash of the 1930's was accompanied by significant deflation. By some estimates prices fell by about a third. And so while consumers and businesses then struggled with unemployment and dropping share prices, at least they were cushioned by falling prices. Today we have no such support.
The Bureau of Economic Analysis reports that in December of 2008 food and energy spending, as a share of wages and salaries, had fallen to a low of 18.7%. Today that figure stands at 22.1%, and increase of more than 18% in just four years. This indicates that the stimuli of the past four years have failed to create the beneficial impact its architects had hoped. People who are spending a higher percentage of their incomes on necessities like food and energy are likely to be experiencing lower living standards.
Unlike Krugman and the Keynesians, I would argue that is impossible to create something from nothing. I believe that creating a dollar diminishes the value of all existing dollars by an aggregate amount equal to the purchasing power of the new dollar. The other side takes the position that the new money creates tangible economic growth. I think that those making such absurd claims should bear the burden of proof.
Peter Schiff is CEO and Chief Global Strategist of Euro Pacific Capital
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Stimulus Could Continue to Drive Markets in 2013
By: Jim Nelson, Euro Pacific Asset Management
Despite a generally moribund global economy in 2012, equity investors were treated to fairly positive results over the course of the year. But those trying to make the case that an improving economy underpinned the modest gains would be hard pressed to identify any such trend. In fact, throughout 2012, analysts continued to dial down their estimates for 2013 GDP growth for developed economies. The 5.5% earnings growth notched by the S&P 500 was significantly slower than the 14.5% seen in 2011 (a year which delivered much weaker market results). And in light of current economic developments, the consensus expectations for 10.5% earnings growth in 2013 could be at risk. In our opinion, 2012 equity markets rose due to unprecedented monetary stimulus. And although the impact of the stimulus will remain in the coming year we expect fundamentals to play a larger role than they did in the year just ended.
A Look Back at 2012
Although past performance is no guarantee for future results, most equity sectors handily outperformed bonds and commodities in 2012. See the chart below:
Figure 1. Asset Class Performance, January 1, 2012 through December 20, 2012 (in USD)
Source: Bloomberg, 2012
The first question to address is why the mining and energy sectors, in which many Euro Pacific investors are overweight, underperformed in relation to the broader markets. The poor performance of the gold miners can be traced to industry specific events, such as the increasing costs of production, strikes and protests in key mining regions such as South Africa and disappointing production numbers due to weather and low grades of ore. Energy stocks on the other hand have been buffeted by rising production costs, significant increase in supply and relatively weak pricing. Despite this, we did not expect commodity names to have underperformed other equities so drastically. In our opinion, commodities are slightly more sensitive to changes in economic growth than the broader equity market. And since the economy is weaker than many imagine, these stocks have faced headwinds. However, the sell off is creating opportunities.
A comparison of country results is always instructive (see chart below). Australia and Canada slightly underperformed due to their significant exposure to commodities. Japan underperformed due to an extremely strong Yen and the pressure the currency placed on exporters (although this looks to reverse as the new Prime Minister Abe has made a weaker yen an explicit policy priority). Brazil also faced growth headwinds due to a slowdown in their export markets and heavy-handed government intervention. In particular, investors punished Brazilian equities as a result Brazil’s renewal of energy concessions in 2012, which many viewed as hostile targeting of foreign investor capital.
Figure 2. Stock Market Performance, January 1, 2012 through December 20, 2012 (in USD)
Source: Bloomberg, 2012
2012 Market Performance Summary
Investors entered 2012 preoccupied with a number of risks that could have derailed the world economy: a deteriorating job market in the US, the potential breakup of the Eurozone, and fears of a “hard landing” in China. Growth expectations throughout 2012 continued to decline. Despite this, most markets turned in a solid performance. There can be little doubt that the massive monetary and fiscal interventions was the primary reason that investors were able to overcome these significant and substantive concerns.
In all, we counted twelve very significant policy actions that provided additional liquidity to the market. This translates into one significant policy action for each month in the year. With such a tailwind, it should have come as no major surprise that markets turned in good performances. Here’s a quick recap:
The European Central Bank (ECB) began the 2012 fireworks with its Long Term Refinancing Operation programs (LTRO) 1 and 2. The policy allowed European banks to draw on $1.2 trillion of liquidity, partially to finance Eurozone government deficit spending. Following the LTRO, the Eurozone and the International Monetary Fund rolled out the first $9.9 billion tranche of Greek bailout money, which prevented a likely Greek separation from the Eurozone. In June came the agreement of Eurozone members to lend Spain up to $120 billion in order to shore up its teetering banks. Later that month, European ministers agreed to an additional $150 billion in deficit spending by the European Investment Bank (EIB) in order to promote growth in the region. This was accompanied by additional coordination on bailout mechanisms designed to promote political and fiscal unity.
In July, investors were treated to the “Draghi Put,” in which the President of the ECB, Mario Draghi, hinted that the ECB was prepared to buy unlimited quantities of Eurozone government bonds in order to halt the crisis. Mr. Draghi was quoted as saying the Eurozone was “irreversible” and that the ECB was ready to “do whatever it takes to preserve the Euro. And believe me, it will be enough.” This blatantly open-ended statement helped set off a buying spree in European equities. Finally in December, Greece received its second bailout tranche of approximately $45 billion.
Policy gears were spinning just as energetically on the other side of the Atlantic. In June, the Federal Reserve extended its “Operation Twist” program that pledged to sell an additional $267 billion of short-term Treasuries and buy the same amount of long-term Treasuries in order to push longer term rates lower. In September, the Fed announced a third round of quantitative easing in which it pledged to buy $40 billion per month of mortgage backed securities (MBS) until the economy “showed signs of improvement.” Then, in December the Fed matched the open-ended tone of the ECB by pledging to buy an additional $45 billion per month in longer-maturity Treasury securities until unemployment improved. At the present time, it’s estimated the Fed’s purchases of Treasuries will be 100% of the total issuance in 2013.
Not to be outdone, the Bank of Japan (BoJ) increased its own asset purchase program by JPY 31 trillion in 2012. The newly elected Prime Minister Shinzo Abe has indicated he intends to pressure the BoJ into its own unlimited asset purchase program, targeting an inflation rate upwards of 2 percent. This level of seemingly permanent easing by major economies is unprecedented.
But what have we gotten in return for all this monetary activism? It’s evident to us that in 2012 these policies made a greater impact on asset prices than on the real economy. The United States, Western Europe and Japan have been mired in below trend growth and have flirted with contraction. In other words, asset prices are seemingly driven mostly by expectations for future inflation and a low cost of capital. On the other hand, despite all of the monetary intervention, expectations for growth in the real economy continued to be ratcheted down.
Economists modestly revised down their estimates for 2013 GDP growth for the United States and slashed their expectations for Europe – with many Eurozone nations already in recession. Needless to say, we believe estimates for the US can go significantly lower. These two economies represent 40.3% of world GDP (International Monetary Fund, 2011). Unemployment rates in the developed world remain elevated and production is barely expanding. We see no reason to believe that the latest round of stimuli will reverse these negative fundamental trends.
Monetary and fiscal stimuli are designed to incentivize the private sector to consume. However given the staggering debt levels, the private sector appears to have approached its maximum capacity. At the same time, these policies interfere with the market’s pricing mechanism, encourage unneeded investment and interfere with real wage and productivity growth. As a result, we believe that fiscal policy will be able to deliver more nominal results in the years ahead and will therefore play a much larger role than monetary policy. However, public debt levels have risen to such an alarming degree that this path is strewn with just as much danger.
In order to correct the current imbalances, it is our opinion that we need to see a healthy recession in the developed economies that clears up excess credit in the system, brings back market prices, encourages needed investment, and grows productivity. Reforms that encourage a more balanced economy raise the risks of such a recession and have therefore been rejected by policy makers. Unfortunately, the easy monetary and fiscal policies that developed nations are pursuing reduce near-term pain but delay the correction of these dangerous imbalances. Meanwhile, these persistent imbalances played a large part in constraining real GDP growth in 2012.
2013 Outlook
We see two possible scenarios for 2013. If both Europe and the United States make a real attempt to narrow their budget deficits (whether from higher taxes, spending cuts - or both), we think it likely that the world could slip into recession. While reducing debt is a healthy and necessary exercise, the realistic near term implications of this policy would be a short-term decline in commodity and stock prices (presenting a long-term buying opportunity, especially in hard assets). On the other hand, if both Europe and the United States continue to run large budget deficits and delay cuts in the name of growth, we believe that the world will likely avoid a recession, at least in 2013. In that scenario, stocks and commodities could perform moderately well. While the two outcomes seem very different, we believe we can position investors appropriately for both.
2013 Strategy
Given that so much of the 2013 market performance depends on policy decisions with respect to fiscal spending, and given that these outcomes are so hard to predict, we recommend constructing portfolios in two separate stages. The first is related to portfolio allocation, and utilizes a barbell type strategy. One end of the barbell will focus on commodities that we believe may perform well if the growth scenario plays out in 2013. The other end will focus on high quality, large, defensible businesses with strong balance sheets. We believe this strategy will allow our clients to participate in any further upside in markets if growth were to continue through 2013, yet also position them to take advantage of any pullback if policy in the developed world were to become more restrictive (which we think would be a short-term negative for risk assets).
The second stage of the strategy will focus on the approach that we’ve always used at Euro Pacific: investing in the countries and sectors that we think may perform well given current fundamentals. For 2013, we continue to favor the developed countries of Scandinavia, Switzerland, Singapore, Australia, New Zealand and Canada. Given their attractive valuations and relative underperformance in 2012, we also continue to favor China and Brazil, as well as some other targeted emerging markets (for more on this see Country Analysis: RIG 2013). A quick look at the tables below gives us confidence in our outlook for the markets in which we are positioning our clients in 2013.
Figure 3. Country Fundamentals
Source: International Monetary Fund, Bloomberg, Euro Pacific Asset Management, 2012
A successful strategy in 2013 will involve diversity and flexibility. The likelihood that policy decisions will continue to drive sentiment over the short-run is real. At Euro Pacific, we believe that a balanced strategy makes it possible to take advantage of opportunities created by these decisions, however fundamentally misguided they may be.
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"RIGging" Country Selection for the Year Ahead
By: Russell E. Hoss, CFA, and Richard Hoss, Euro Pacific Funds
With all the focus on how the meaningless political posturing in Washington is affecting the mood on Wall Street, many investors may be surprised to learn that there is a world of financial markets that function far from the gravitational pull of dysfunctional American politics. In fact, 2012 may be looked at as a year that many of the more vibrant emerging markets made tangible progress in blazing an economic path that was not as dependent on the overly indebted developed markets. In the years since the crash of 2008, emerging markets have had some difficulty in convincing investors that their financial markets will reflect the underlying growth of their economies. We believe that 2012 should provide some comfort on that front.
As we look forward to 2013 we have identified those international markets we expect to be well positioned for the year ahead. Our process focuses on two keys ideas: sustainability and relativism. Sustainability refers to an economy that increases aggregate revenue, margins and free cash flow at a somewhat constant rate over time. Relativism refers to the idea that an economy's performance can only be determined when compared to another economy. Generally, capital tends to flow to markets that are performing better, on a relative basis, than other analogous markets. Using this as a general framework, we have placed an emphasis in Asia on markets such as Indonesia, Thailand and the Philippines. For similar reasons we are focusing on Latin American attention markets such as Mexico, Chile and Peru.
Given the circumstances of today's investing environment, it is important to gauge where global equity markets have performed since the 2008 Global Financial Recession. After the credit bubble burst, governments provided fiscal and monetary stimulus that increased sovereign debt levels for just about every economy. The intent was for governments to support economies during the household deleveraging process. However in many developed economies debt levels are now at a critical stage as growth is being impeded by governments that are forced to raise taxes and cut spending simultaneously. With the developed West numbed by overly stimulative monetary policies and anti-business activist governments, export dependent, emerging economies understand that relying on developed markets for growth is not a sustainable model.
Fortunately, many of these economies have favorable demographics and minimal levels of debt as a starting point. Governments are accelerating various reforms that open markets, increasing the efficiency of capital allocation. In addition, after decades of underinvestment, many governments are launching major investment programs that have the potential to increase GDP growth rate. And unlike many indebted developed countries, these projects can be manageably paid for without incurring unsustainable debt. We refer to this trend in emerging markets as RIG (reforms, investment spending and growth) and view it as a key theme for 2013. RIG is helping support sustainable levels of economic growth that are relatively stronger than most developed markets.
Reforms: Mexico, India and China highlight the list of larger economies that we expect will announce significant reform packages. Government policies in these markets have historically relied on developed market demand to provide the fuel for their own economies. As a result they have taken steps to increase exports, often at the expense of their domestically focused industries. These policies have been a major impediment to sustainable economic progress. Understanding the uninspiring outlook for developed market demand, we expect substantial policy reforms to take place within Mexico, India, and China that will support a more sustainable economic model.
Smaller countries in Asia such as Indonesia have already announced important reforms. Unfortunately the moves have encountered considerable political headwinds that threaten to stall progress in 2013. After a relatively weak equity market performance in 2012, Malaysia could be the surprise outperformer, provided the elections scheduled for April produce no unwelcome surprises.
Investment: Investment spending accelerated in 2012 in the Philippines, Indonesia and Thailand, and we expect that these trends will continue in 2013 as governments there recognize the need for appropriate infrastructure to support economic growth. It is important to recognize that these governments have strong balance sheets that enable them to pay for such projects without incurring dangerous levels of debt. Many of the proposed projects may lead to significant improvements in business environment. Watch for progress in Brazil which could surprise investors if infrastructure projects that are long overdue are implemented smartly.
Growth: In all of the markets we cover, we expect earnings growth to be sustained in 2013. Brazil, India and China could see a moderate improvement as the economies in these countries rebound from a dismal six quarter stretch. We expect earnings growth in the more dynamic economies of the Philippines, Thailand, and Indonesia to be the strongest.
In Mexico, if newly elected President Nieto is successful in passing at least a portion of his ambitious reform package, economic growth there could accelerate further in 2013 and be the surprise pace setter in Latin America.
However, macro-economic factors are not the only determinant in portfolio success. The most important factor in driving our returns is our focus on finding growing companies that generate increasing amounts of free cash flow, demonstrate strong corporate governance, and that can be bought for an attractive valuation. Such companies do exist, in numbers that may surprise investors habituated to domestic options.
China
Although the Shanghai Composite is looking to be notching a narrow gain in 2012 (as of December 21, the index is up 2% year-to-date) the index is still suffering from a brutal six year bear market that has brought the index down 65% from its October 2007 highs. Despite the strong 9% rally over the past month, the Shanghai composite is still the worst performing market in Asia in 2012 (contrasted with Chinese shares traded in Hong Kong that are up nearly 20% this year). As a result, the world is littered with China bears. Nevertheless, we expect the Shanghai composite to finally hit some sort of stride in 2013. Although sentiment remains terrible and expectations remain low, valuations have become undeniably attractive.
We suspect the recovery in the Chinese economy will continue to moderately improve, although a 2013 GDP of +7.5%-8.0% will be lower than past periods. The likelihood that the rally that is closing out 2012 will continue into 2013 depends on two factors: Firstly, publicly traded corporations need to generate free cash flow and return that cash to shareholders (something that was lacking in 2012). Secondly, the new Chinese administration (which debuted last month) needs to tackle corruption and fraudulent corporate activity by introducing market friendly reforms. On both fronts, the early returns are promising. Accelerating economic data in the second half of 2012 has raised the outlook for free cash flow. Additionally, early signals from the new Chinese leaders on economic reform program appear to be encouraging.
India
We expect a gradual improvement in India's trade and budget deficits, lower inflation, looser monetary policy and a moderate rebound in economic activity to drive higher (but volatile) equity prices in 2013. Although dealing with the "twin deficits" will be a challenge, we believe that these issues have already been factored in by market participants
We believe that if current commodity price trends hold, then the trade deficit will improve even without policy changes. However, further improvements will need to be driven by government reforms. For example, opening the market to foreign companies in the oil & gas and coal sectors would be a first step in attacking the current account deficit.
Reducing the fiscal deficit however will require policy moves. For example, the government subsidizes many input prices in order to maintain lower prices for consumers. At the same time subsidies to targeted business partly contribute to stubbornly high inflation which then limits the ability to loosen monetary policy through lower interest rates. Recently the government has enacted legislation which will help modernize the economy, including allowing foreign companies to directly invest in the retail sector.
South Korea
We expect earnings growth of South Korean companies to remain slow in 2013, largely due to the dependency on exports to developed markets. The South Korean equity market is trading on 9x earnings with earnings expected to increase by 19% in 2013 compared to only a 7% in 2012. We suspect that consensus estimates for 2013 are too high and will be adjusted lower. Upside could result from a stronger recovery in exports to developed markets.
Taiwan
The Taiwanese equity markets are characterized by a disproportionate share of technology companies (~55% of the total market cap is in technology companies). As a result, stock performance there is highly influenced the developed economies who are the biggest buyers of technology products. And since we do not believe that the developed markets will see strong growth in 2013, we have concerns about Taiwanese earnings growth. Consensus estimates for 2013 earnings growth are projecting an optimistic +26% increase. Similar to South Korea, we expect these estimates to be adjusted lower throughout the year with upside from a stronger recovery in exports to developed markets. Taiwan would also benefit from a stronger than anticipated recovery in China.
Indonesia
Indonesia has been one of the best performing equity markets since the end of the 2008 global financial crisis. However, as a major exporter of raw materials, the market struggled somewhat in 2012 due to lower commodity prices. Headwinds were also supplied by currency weakness, political dithering over infrastructure reforms and high valuations. However we feel that there are reasons for long term optimism. Indonesia has an attractive demographic profile, rapidly rising real wages and a balanced economy. If commodity prices increase (which can be catalyzed by a moderate rebound in China and India), the Indonesian market may provide better returns in 2013. The market currently trades on a modest valuation of 14x earnings and consensus expectations are for earnings to grow by 15% in 2013.
Thailand
Although the Thai market saw strong returns in 2012, valuations relative to earnings growth rates remain attractive. The market currently trades on 12x 2013 earnings which are forecast to increase by16%. We expect strength from investment spending and consumption, combined with accommodative fiscal policies (corporate tax rates declining in 2013 from 23% to 20%, First Car Policy, First House Policy and farm price supports) to drive overall growth. The biggest risk to equities is a consumption slowdown as government policies end and/or a worse than anticipated slowdown in exports. With inflation subdued and accommodative fiscal and monetary policy in place, we anticipate another year of positive returns in Thailand.
Philippines
With a 33% increase year to date, the Philippines had the best returns for any Asian market in 2012. While many markets around the globe saw either GDP decelerations or actual economic contractions in 2012, the increase in year over year GDP growth achieved by The Philippines is notable. As we enter 2013, the Philippines equity market clearly has earnings momentum on its side, but at this point we feel that equity market valuations may be getting stretched. As a result, we feel that another 30%+, as seen in 2012, is unlikely for 2013. But given its attractive growth outlook, its domestic oriented economy, and low interest rates, we think it will be impossible for global investors to ignore this vibrant market. As a result, we expect that any weakness that emerges in the market will be seen as a buying opportunity.
Malaysia
The Malaysian equity market underperformed the region in 2012 due to rising debt-to-GDP levels, weaker exports, and political stasis. We believe that if the political situation there resolves, and if exports can improve, 2013 will likely be a better year. The outlook should be brought into sharper focus after the general election scheduled to be held in April. We expect to see a reacceleration of government investment spending after the election, which will provide a stimulus to the economy. Unlike the spending priorities that are proposed in many western economies, those under consideration in Malaysia are focused to support strategic industrial sectors. On a sector basis we are focusing on oil and gas sector, consumer discretionary/staples and construction. Malaysia trades on 14x 2013 earnings which are forecast to increase only 10%, which is light for the region. We believe that 2nd Half 2013 earnings growth will be adjusted upward.
Singapore
Of all the countries in Southeast Asian, the Singaporean economy is the most levered to global growth and generally the most volatile. As a result of the exposure to the developed economies, earnings are anticipated to increase only +3% in 2012 (after having declined in 2012). Given that the market trades on 13x those earnings, we see minimal upside to the Singapore market in 2013.
Brazil
The relatively disappointing economic growth in Brazil in 2012 has been one the top economic stories for the year just past. Growth had begun the year at well over 3%, but will likely end at less than half that when all the final numbers are tallied. Consensus expectations for 2013 growth remained north of 4% for most of 2012, but more recently have begun to fall into the 3.5% range. It appears as if those estimates will to continue to drift downward. While we expect 2013 growth to improve over 2012, a structurally lower potential growth rate will keep Brazilian GDP below long-term expectations as it struggles with the fallout of overinvestment in commodity production and underinvestment in productivity.
More importantly, we expect the administration of left-leaning President Dilma Rousseff to continue its highly decisive role in markets, awarding certain sectors and punishing others. Brazil's highly volatile 2012 will likely repeat in 2013, with a continued wide divergence between winner stocks and sectors and losing stocks and sectors.
As a result, we expect that our investments will remain aligned with Brazil's welfare-oriented policies. Although we don't have to agree with the philosophy of these policies, it would be foolish to not consider their investment ramifications. But given the activism, we approach the Brazilian market with a higher risk discount. At some point in the year ahead we expect the Brazilian market to look "cheap."
Mexico
We are optimistic about the reform outlook for Mexico in 2013. New President Enrique Pena Nieto is demonstrating political acumen by adroitly aligning the various political parties in the name of free market oriented reforms (a stark contrast with Brazil's approach). There are a multitude of catalysts to look forward to, such as labor reform, private investment in the Mexican oil and gas industry, accelerated infrastructure projects, and fostering competition within Mexico's oligopolies.
The Mexican market is certainly reflective of high hopes for 2013 and we acknowledge that failure to make progress on key reforms could result in investor disappointment and rough head winds. However, there are several other factors that support high valuation resiliency for Mexican equities in 2013, including scarcity of publicly traded equities, lack of country alternatives for Latin focused equity funds, and stable trade progress with Mexico's primary trading partner, the US.
Chile
Chile's economy has been an under-the-radar standout in 2012, and we expect market participants to take more notice in 2013. The country has consistently posted higher growth rates and lower inflation. Fundamentals for the Chilean economy remain strong, albeit still partially dependent on the price of copper. Historically, the Chilean market has traded at a warranted premium, due to its preferential position among Latin American peers. However, this premium has gradually eroded over the last two years, which we believe makes it a particularly attractive market heading into 2013.
Peru
We expect that that Peru will probably post the best economic results in Latin America in 2013. Peru has demonstrated rapidly accelerating growth in most industries, and its population has the most potential for upward social mobility. Debt is low, and the country is benefitting from high gold prices. The main challenge for investors is the lack of investible companies due to liquidity constraints. Peru's equity market is dominated by mining and mineral companies, but we note there are several non-Peruvian companies that are aggressively expanding in the country, providing alternatives for investment.
Russell Hoss and Richard Hoss, are co-portfolio managers of Euro Pacific Latin America Fund (EPLAX). Opinions expressed are those of the writers and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff. Russell Hoss and Richard Hoss are not affiliated with Euro Pacific Capital.
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Telecom Offers A World of Opportunity
By: David Echeverria, Investment Consultant
There can be little doubt that the smart phone is on the top of the current economic pyramid. Rarely in the history of commerce has a single product become so rapidly indispensable for so many people across the globe. For many, the act of forgetting one's phone at home renders a naked feeling of being disconnected from the outside world. These increasingly small devices are no longer just about phone calls. They connect us through word, picture, video and sound to everything. In this digital age, they are practically like another appendage.
For good or ill our growing thirst for ubiquitous information has taken global telecommunications on a wild ride of new frontiers and revenues. Every time that the electronics manufacturers dream up a new game changing device, the telecom companies need to provide bandwidth so the device can perform its miracles. What was once the stale territory of quasi-state utilities is now a vibrant investment sector. Most importantly, the telecom revolution is a truly global phenomenon. The United States is very far from the front of the pack in terms of digital penetration. And there are many developing countries that are making the leap directly from smoke signals to digital wireless connectivity. This creates a world of opportunity for discerning investors.
Telecom's initial growth in the last decade began with development of smart phones (and later tablets) that allowed mobile access to the internet. As a result, consumers now spend increasingly more time using telecom bandwidth and less time watching television or reading print media. The shift in advertising spending is a testament to this fact. Prior to the advent of the latest smart phones, total advertising dollars spent in print media was more than five times that spent online. Since then, the balance of advertising dollars has moved steadily towards online marketing. In fact, 2012 marked the first year that marketers spent more money advertising online than in print ($39.5 billion online advertising versus and $33.8 billion in print).
Easy mobile access to the internet has also resulted in an explosion of online content. With each passing day, the amount of content generated online and accessible by mobile phones, tablets, and notebooks grows exponentially: social networks, online games, online dating, YouTube, Twitter, Facebook, Instagram, television, magazines, blogs, podcasts, and untold other applications. Businesses are increasingly demanding access to cloud computing, mobile application platforms, and mobile payment platforms as it provides greater data storage, broader access to potential customers, and faster processing of transactions.
The question for investors is how to best capitalize on the trend. At the core, there are essentially three ways to tap into the information revolution: 1) invest in manufacturers of hardware (i.e. those who produce the cell phone, tablets, and computers we thrive on) 2) invest in manufacturers of content (i.e. those who produce the applications, social networks, games, websites) or 3) invest in the providers of service or connectivity (i.e. telecommunication services). There are certainly good options in each market segment, but I would argue that the connectivity providers offer one of the more stable and reliable means to gain exposure.
Both manufacturers of hardware and content must appeal to human sensibilities and taste. As a result, the market for devices and services can be difficult to gauge. Though the barriers to entry are significant, they do not shield companies from competition. Case in point is Apple and how quickly they were able to take over the mobile phone market at the expense of Research in Motion. Interestingly, Samsung has now emerged into an epic battle with Apple over mobile market share, while both Samsung and Microsoft are poised to challenge Apple in the tablet arena.
Not surprisingly, the market for content is even more fragmented than hardware. The amount of content online is endless, with barriers to entry extremely low. After all how much does it cost to start a website? Remember back in 2005 when Newscorp paid $580 million for social networking site MySpace. Despite the backing of one of the world's leading media conglomerates, MySpace has now almost completely disappeared from our collective consciousness. Newscorp resold MySpace for $35 million in 2011. Or more recently, consider Groupon, the daily deal website that had created so much buzz in 2010 and 2011. In the face of stiff competition from a plethora of copycat competitors the company's shares have lost 82% since its November 2011 initial public offering.
On the other hand, providers of connectivity are not held to the same whims of the marketplace. Buyers of bandwidth are not investing in a product, rather in a service. Consumers and businesses are interested solely in connectivity, network capacity, speed, and cloud based solutions. Providing these services is by no means a simple task and requires telecommunications companies to be constantly investing in and updating the infrastructure. However, this also means that barriers to entry are vast, ensuring less players and higher profit margins. Generally speaking there are only a few dominant players within each national market, and this is likely to contract further as many anticipate consolidation due to consistently high capital expenditures. As a result, telecoms are fast becoming virtual monopolies in many countries with dominant market shares and pricing power.
While the telecom industry expects continued growth within the United States, it will be much slower than growth internationally. According to Insight Research Corp's "2012 Telecommunications Industry Review: An Anthology of Market Facts and Forecasts," telecom service providers overseas are anticipated to have a combined revenue growth rate over the next five years that is 45% higher than North American providers. The report anticipates that the strongest growth will come from Asia and the Pacific Rim, Latin America, and the Caribbean.
Smart phone and internet penetration in developing markets is still behind that in the developed world and thus still has significantly more room to run. For this reason alone, exposure to telecoms in developing markets is worth considering for some investors. And while growth prospects for the industry look promising, it is also worth noting that the sector as a whole pays some of the highest aggregate dividend yields when compared to other industries.
According to Factset's December 2012 Dividend Quarterly, the aggregate dividend yield from Telecom companies in the S&P 500 was 4.7%, the highest among all sectors. A sample set of 15 foreign telecoms from earlier in the year had an average yield of 7.24%. The tremendous growth prospects and yields make telecom companies an attractive option for both growth and income oriented investment strategies.
In the end, owning telecommunication services is a long term play on the increasing reliance on the internet and mobile devices. With the information revolution still in its nascent phases, exposure to telecoms is something that many investors should consider. In fact, Euro Pacific Capital currently recommends a number of large non-dollar telecom stocks that offer high dividend yields and attractive valuations.
David Echeverria is an Investment Consultant in the Los Angeles, CA branch of Euro Pacific Capital.
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INTERNATIONAL INVESTING MAY NOT BE SUITABLE FOR ALL INVESTORS. TO SEE IF IT IS SUITABLE FOR YOUR INVESTMENT OBJECTIVES AND RISK TOLERANCE, <stro