Coastline Trust | NEWSLETTER

Emerging markets are the success story of a crisis that has left much of the developed world struggling with slow growth and heavy debt. Sam Finkelstein, GSAM’s global head of Macro strategies, discusses the sustainability of growth in emerging markets, and the resulting investment opportunities in their local debt and currencies.

Emerging markets have come out of the financial crisis relatively unscathed. What does this say about the attractiveness of investments in the developing versus the developed world?

The recent financial crisis marked a turning point in the modern history of global markets. In the past, trouble emanated from the emerging markets. This crisis was different – the problem began with too much debt in the developed world. Not only were emerging markets not the problem; in our view, they have become the solution, as the source of the world’s growth.

Emerging economies grew by 1.7% in 2009, while developed markets contracted by 3.4%, according to the IMF. Their estimates also suggest emerging economies will almost quadruple the sluggish pace of G7 growth in 2010. This decoupling1 is driven by debt whereby a heavy debt burden in the developed world contrasts the far lighter loads in emerging markets. Debt is effectively a tax on future consumption, where today’s spending is paid for in the future.

Debt ratios are a critical measure of credit quality for investors. Many bearish views on the global economy are based on unsustainable debt in the world’s major economies, where debt-to-GDP is rising fast, and in some cases piercing the 100% level within the next few years. By contrast, IMF estimates show the percentage of debt to GDP is stable in the emerging world, in the mid-30s.

This low debt, combined with higher growth, amounts to a virtuous cycle that can benefit all emerging market assets. If debt remains static, the ratio of debt-to-GDP will fall in an environment of strong economic expansion. Growth will result in higher revenue and less pressure to spend. Growth is good for currencies, as capital flows toward higher rates of return.

We’ve seen emerging markets take off in the past, only to crash further down the track. What evidence do we have that today’s improvements are sustainable?

All past crises can be explained by at least one of the following three pitfalls: Excessive government spending, an overvalued currency and/or a weak or vulnerable banking sector. When you look across the emerging markets in aggregate today, none of these problems are evident.

First, emerging markets offer some striking examples of fiscal discipline that contrast with the loose policies seen in the most developed countries today. China’s fiscal deficit last year was 2.8% of GDP, according to the World Bank, compared with percentages in double figures for the US and UK. One of the most striking examples of political will to take unpopular austerity measures was Mexico’s tax reform in 2008. We believe that the government’s value-added tax hike, while unpopular, should help narrow the country’s fiscal defi cit to 2% of GDP, averting a ratings downgrade.

Secondly, we do not believe that emerging market currencies are overvalued in aggregate. Most developing countries have switched from fixed pegs to floating regimes, allowing exchange rates to absorb market shocks. And where strong growth has drawn strong capital inflows, particularly in Asia, central banks have tended to intervene to prevent currency appreciation that could harm the competitiveness of their domestic exports.

And to the third point, even before this crisis, banks in many emerging market countries were in better shape than their peers in the world’s biggest financial centers. Given the infancy of the banking sector in many emerging markets, lending is modest, and so their institutions aren’t as levered as many in the developed world.

These three fundamental strengths underpin a major policy improvement that has helped set many emerging market countries on a course for sustainable long-term growth: countercyclical monetary policy. To preserve economic stability, a central bank should hike interest rates as economic activity speeds up, and cut rates as the economy decelerates. In previous shocks to the global financial system, emerging market central banks did the opposite, hiking rates to prevent capital outflows in emergency action that actually intensified the damage to their economies. But this time was different. From 2008 on, countries across the developing world cut rates as the global economy faltered and inflationary pressures subsided. Turkey’s central bank was the most aggressive, cutting rates by 10.25%, though its target interest rate remains well above the global median.

Chinese policy is attracting a lot of attention at the moment. Should investors be concerned about tighter lending and fiscal conditions, given the global economy’s increased dependence on Chinese growth?

China’s policy tightening could be seen as a threat to growth. Withdrawing stimulus as an economy accelerates is prudent monetary policy to prevent overheating. But China is growth hungry, and officials won’t want to risk a collapse by tightening too much. So far this year policymakers have used a subtle combination of measures to tighten: hiking reserve requirements, allowing yields to rise on one-year bill auctions, and there’s anecdotal evidence to suggest they are regulating lending. We think Chinese officials are most comfortable with growth around the 8% to 10% range, but maintaining the policy balance to preserve that growth will be challenging.

If growth in emerging markets has found a sustainable path, does that mean concerns about asset bubbles are exaggerated?

We see little evidence of bubbles in emerging markets debt and currency markets, where improving fundamentals have driven solid returns for much of the past decade. We believe that these strong economic features and sound policies should persist.

In many cases, these improvements have outpaced the market pricing, and holders of emerging market bonds are still getting attractive yields relative to the risk involved. We do not think that such persistently healthy premiums suggest a bubble. As of March 29, JP Morgan’s index of local-currency government bonds in emerging markets, the JP Morgan GBI-EM Global Diversified Index, paid 7.2%, which is generous for countries characterized by low levels of debt and healthy growth, and well above the 2.8% paid on the index of developed countries’ government bonds. That compensation for risk of default in local emerging markets is ample given the fundamental health across these economies and their ability to pay their debt.

In emerging currency markets, the widespread central bank interventions discussed earlier have made bubbles even more unlikely. Real exchange rates in many emerging markets have changed little over the past decade, as intervention has kept many currencies artificially cheap. This price suppression is inconsistent with the inflated valuations symptomatic of bubbles. Investors concerned about bubbles might find more worrying trends in developed markets, where quantitative easing has artificially lifted prices of assets, including government bonds and mortgage-backed securities.

In addition, central bank interventions have helped many emerging markets establish buffers against future shocks in global financial markets. When central banks intervene, they accumulate reserves that can be used to help stabilize their domestic markets in times of stress.

Given this positive outlook, where do you see the best opportunities in emerging markets?

Emerging market local debt offer investors an attractive combination of currency diversification, credit quality and yield.

We think Brazil is a good example. As of March 29, a 10-year local-currency bond paid a 12.75% nominal yield, well above the country’s stated 4.5% inflation target. So Brazil offers investors one of the highest real yields in the world, despite very strong fundamentals.

We also believe Brazil’s yield curve is amply steep to deliver investors positive return potential. We estimate that the market is pricing in around 300 basis points of rate hikes this year, more than we think is likely. As a result, we believe investors can potentially earn a good return in Brazil’s local markets even in a rising interest rate environment.

Investors considering the merits of a local debt versus an external debt allocation in emerging markets should be aware that liquidity has been improving in local markets, as more developing countries shift their borrowing to local currency to replace their external debt. This shift is another positive for fundamentals: the greater the proportion of local currency debt, the less exposed the country is to exchange-rate fluctuations that may cause a spike in its debt service.

Not only has liquidity in emerging markets improved; it withstood a major test in 2008. In the peak of the financial crisis, liquidity deteriorated across all markets. But the diversity of buyers and local liquidity providers helped support emerging local markets, despite paralysis across credit markets globally, as major dealers pulled capital commitments to clients.

How do you address currency risk?

Of course, emerging market currencies fluctuate, but we think the trend is for appreciation, as stronger fundamentals and improved monetary and fiscal discipline continue to attract capital inflows.

By contrast, the combination of loose monetary and fiscal policies now common among developed markets is not generally a good recipe for currency appreciation. So for investors in the developed world with a home bias, emerging market currencies offer diversification.

To identify the best opportunities in emerging local markets, we believe active managers must consider two key sources of alpha: duration and currency. Does a local bond offer value, or does the currency offer a better risk/return? A thorough assessment of fundamentals and instruments is at the heart of our investment strategy in emerging markets. If we don’t think the bond has an attractive risk/return, we may just own the currency, and if we have concerns about the exchange rate, we may buy the bond at the optimal point in the yield curve and hedge the currency risk.

What do you consider to be the main risks to this highly positive outlook for emerging markets assets?

There are always risks, but emerging markets have already withstood a major challenge to the global financial system and remained strong.

One concern in terms of local debt is its concentration. Not all of the roughly 39 developing countries with active external debt markets also have local markets in which foreign investors can buy and settle. Of the active local markets, only 14 countries are included in the index, so buying JPMorgan GBI EM Global Diversified Index focuses roughly 85% of your investment in fewer than 10 countries. One of the advantages of an active manager is the flexibility to allocate to countries outside the benchmark, having thoroughly researched the full universe of emerging market countries.

As discussed earlier, though, we believe the most prominent risks at the moment are in the developed world, where some countries are only starting to tackle unsustainable debt and fiscal problems. Yields on bonds in peripheral Eurozone countries now exceed those in much of the emerging markets universe, so the lens through which we distinguish developing from developed markets is blurred.

Sam is the global head of Macro strategies within the Global Fixed Income team at Goldman Sachs Asset Management (GSAM). In this role, he is responsible for overseeing the Global Rates, Fundamental Currency, Emerging Market Debt and Commodities teams. He joined the firm in 1997 and became a managing director in 2005.

For more information on the Goldman Sachs Emerging Markets Debt and Goldman Sachs Local Emerging Markets Debt Funds, please contact your Investment Professional.

IRS Circular 230 Disclosure Goldman Sachs does not provide legal, tax or accounting advice. Any statement contained in this communication (including any attachments) concerning U.S. tax matters is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties imposed on the relevant taxpayer. Clients of Goldman Sachs should obtain their own independent tax advice based on their particular circumstances.

Risk Considerations

Foreign securities may be more volatile than investments in U.S. securities and will be subject to a number of additional risks, including but not limited to currency fluctuations and political developments.

Investments in fixed income securities are subject to the risks associated with debt securities including credit and interest rate risk. Emerging markets may have sovereign ratings that are below investment grade or are unrated. High yield, lower rated securities involve greater price volatility and present greater risks than higher rated fixed income securities. Fixed income securities of emerging countries are less liquid and are subject to greater price volatility and will be subject to the risks of currency fluctuations and sudden economic or political developments. The securities markets of emerging countries have less government regulation and are subject to less extensive accounting and financial reporting requirements than the markets of more developed countries. Emerging markets are also subject to the risk that the issuers of sovereign debt or the government authorities that control the payment of debt may be unable or unwilling to repay principal or interest when due.

Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or its securities. A complete list of recommendations is available upon request. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures.

Additional Disclosures Economic and market forecasts presented herein reflect our judgment as of the date of this presentation and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts. Case studies and examples are for illustrative purposes only. Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without Goldman Sachs Asset Management’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 authorized agent of the recipient. 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. Traditionally, decoupling would suggest that developing economies would follow the growth patterns of developed economies. This publication discusses decoupling where developing economies are moving in the opposite direction of developed nations/economies. JPMorgan Government Bond Index – Emerging Markets Global Diversified Index is an unmanaged index of debt instruments of 14 Emerging Countries. The Index fi gures do not reflect any deduction for fees, expenses or taxes. It is not possible to invest directly in an unmanaged index. This material has been prepared by GSAM and is not a product of the Goldman Sachs Global Investment Research (GIR) Department. The views and opinions expressed may differ from those of the GIR Department 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. Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.

INVESTMENT TIPS

TODAY'S MARKET

NEWSLETTER

News For Investors

May 2010

COASTLINE TRUST IS MOVING

Emerging Markets: Sustainable Growth Drives Opportunities in Local Markets

Weekly Market Monitor

Investment Outlook