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Market update: August 2011

Volatile markets: Emerging market and commodity update
This document represents our views as at August 2011 and may be subject to subsequent change

In the current period of volatility, our senior investors are providing a weekly update on the issues facing markets. This week, Neil Gregson and Austin Forey discuss the implications of the market uncertainty for investors in emerging market equities and commodity stocks stocks. How have the gold price and gold equity prices responded to the market turmoil? Neil Gregson: There has been a major change in the gold market since July. In the first half of the year, western investors were net sellers of gold ETFs, countered by strong buying from Asia. In July and August, this changed, with western investors becoming net purchasers as Asian investors continued to buy. In the past couple of weeks, weve also seen very strong g y g growth in the buying of g y g gold coins and small bars by European retail investors, while y p , central banks were net buyers for the first time in 21 years in 2010, and are continuing to be net buyers this year. As a result, the gold price has reached new highs in almost all currencies, with the exception of the Swiss franc, with gold also outperforming platinum and silver. So far, gold mining stocks have not fully participated in the strong performance of gold: over the year to date, the gold price is up USD 23/troy ounce, while shares in gold mining companies are down around 4%. However, this is now beginning to change. In the market turmoil of recent weeks, gold shares have been up strongly on several days when the broader equity market has been down. With g y q y gold mining stocks looking extraordinarily cheap, we g g y p, expect this outperformance versus other shares to continue and also for them to recover some underperformance versus the gold price. Exhibit 1: Gold equities have lagged the gold price
200 180 160 140 120 100 80 60 40 20 0
February 2010 February 2011 August 2009 November 2009 August 2010 November 2010 May 2010 May 2011

WORLD-DS Gold Mining PRICE INDEX Gold Bullion LBM U$/Troy Ounce

Source: Datastream 11/08/2011. For illustrative purposes only.

How much of the gold price rise has been driven by supply/demand fundamentals, and how much by speculation? NG: The gold price is always driven to some extent by speculation. Hedge fund activity remains noticeable in the market, but the dominant factor in recent weeks has been retail investors globally buying coins and bars, and these purchases are going to be much stickier. The large purchases we have seen from central banks may also be expected to make this price rise a more stable trend. At some point, the price will peak and overshoot, but for now, with US interest rates on hold close to zero for the next two years, this appears to be a fantastic environment for gold.

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Market update: August 2011 Volatile markets: Emerging market and commodity update
What has been the effect of the market volatility on commodity prices? NG: Commodity prices have been broadly resilient. Bulk commodities in general have held up, while metals have seen some selling, but buying interest now appears to be picking up at the cheaper prices. The copper price has fallen by around 10%; however, after destocking in the second quarter, China is now showing buying interest at these lower levels. Coal contract prices are still holding up, although we should note that they are down from their peak earlier in the year, which was driven by weather-related events, particularly in Australia. Iron ore prices, meanwhile, have actually risen in the turmoil of recent weeks, reflecting the view we expressed earlier in the year y g p y that long-term forecasts were too low given supply-side constraints. Exhibit 2: Commodity prices remain at elevated levels
Thermal coal Copper Met Coal Iron Ore

160 150 140 130 120 110 100 90 80

04/01/2011 1 18/01/2011 1 01/02/2011 1 15/02/2011 1 01/03/2011 1 15/03/2011 1 29/03/2011 1 12/04/2011 1 26/04/2011 1 10/05/2011 1 24/05/2011 1 07/06/2011 1 21/06/2011 1 05/07/2011 1 19/07/2011 1 02/08/2011 1
Source: Macquarie August 2011. For illustrative purposes only.

In this environment of flattish/only slightly weaker commodity prices for the year, commodity share prices are down by around 16% (or around 5% for the energy stocks), creating attractive value. What is your view on the oil price? NG: Our view has been unchanged since the beginning of the year, when we indicated that we expected the oil price to remain rangebound. In the short term, the upside appears limited by the demand destruction that emerges around the USD 130-140/barrel mark, while support on the downside comes from the ability of OPEC to intervene and cut supply if necessary. Oil prices are, of course, dependent on what happens to the global economy in the next year or two, but over the longer term, prices are likely to rise given the lack of growth in non-OPEC production.

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Market update: August 2011 Volatile markets: Emerging market and commodity update
Why have emerging markets fallen if this is a developed world crisis? Austin Forey: Inevitably, a rise in global risk aversion has a short-term effect on emerging market equities. However, the long-term background suggests a more sustainable trend at work in emerging markets. Exhibit 3: A self-sustaining economic force
Household disposable income over USD 10,000 p ,
No. of households in millions 400 BRICs 350 300 250 200 150 US Euro Area

Emerging economy exports by destination g g y p y

80 75 70 65 60 40 35 30 25 20 to Advanced Economies (LHS) to Emerging Economies (RHS) 15 10

100 50 0

55 50

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009E

2011E

2013E

2015E

2017E

2019E

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Source: Euromonitor, Morgan Stanley Research, May 2010. For illustrative purposes only.

Source: IMF Direction of Trade Statistics, 2010

Exports to the developed world are falling as a share of emerging market growth. Instead, intra-emerging market exports and domestic demand are playing an increasing role making emerging economies increasingly selfrole, sustaining. We therefore view problems in the developed world as buying opportunities, rather than as cause to reassess our views on emerging markets. With disposable incomes in emerging markets growing very rapidly compared with the rest of the world, we favour stocks with exposure to domestic demand. Are the very strong inflows into emerging markets in recent years now reversing? AF: Emerging markets bulls are very keen on using emerging market GDP as a percentage of global GDP to illustrate that emerging markets are under-owned. I am sometimes sceptical about this. Investors invest in corporate profits, not in GDP growth, so a better measure may be emerging market profitability as a share of global profitability. The rising share of global profits accruing to emerging economies demonstrates their growing economic weight. The market capitalisation share of emerging markets in global indices is now beginning to reflect their rising share of global profits, and we expect this balance shift to continue. Emerging market equity allocations in institutional portfolios remain well below market cap share, and investors are chasing an upwardly moving target, so we expect long-term flows to remain robust.

2008

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Market update: August 2011 Volatile markets: Emerging market and commodity update
What are your views on emerging market valuations? AF: Before the recent market falls, emerging market equities appeared fairly valued in price-to-book terms. Now, they are heading towards looking actively cheap. Exhibit 4: Emerging markets look attractively valued
GEM Price to Book: 1993 11th August 2011
4.0 3.5 3.0 2.5 25 2.0 1.5 1.0 0.5 0.0 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11
Source: Bloomberg. Data as at 11 August 2011

MSCI EM: 1993 11th August 2011

1,600 1,400

Euphoric Expensive E i Fair Cheap Crisis

1,200

1,000 1 000 800 600 400 200 0 Jan-93

Jan-96

Jan-99

Jan-02

Jan-05

Jan-08

Jan-11

Given th t we are a very l Gi that long way f from th wrenching economic adjustments th t emerging markets went th the hi i dj t t that i k t t through h in the 1990s, this appears to present buying opportunities. In our portfolios, we are responding by taking advantage of opportunities in high-quality financial and industrial stocks now trading at very attractive valuations. Brazil has underperformed significantly this year. What is your view on the market? AF: One of the surprising things when you visit Brazil is how expensive everything is. Brazil is coping with the consequences of a very strong currency, which is making the countrys export sectors uncompetitive. Over the past q y g y, g y p p p ten years, Brazil has been an enormous normalisation trade, as the exit from hyperinflation has resulted in huge increases in profits and valuations, as well as in the currency. From here on, it is going to be more difficult. The corporate sector, in particular the domestic sector, now needs to focus on disinflationary business models. We are therefore sceptical about Brazil, and particularly domestic Brazil, and remain underexposed. What is your view on China? AF: We AF W now h have th bi the biggest overweight i Chi th t weve ever h d t ki advantage of cheap valuations and t i ht in China that had, taking d t f h l ti d comforting economic fundamentals. We continue to expect China to grow, although perhaps not as fast as in recent years. However, the economy provides a strong contrast to those of many developed countries the government has no financial problems; the banking sector has a surplus of deposits not loans and the equity market has derated significantly, resulting in some very cheap prices for large cap stocks.

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Market update: August 2011 Volatile markets: Emerging market and commodity update
How are your portfolios positioned? NG: Around two-thirds of the JPM Natural Resources Fund is in commodities that are supply-side constrained or in gold stocks with the potential to benefit as miners begin to participate in the gold price rise. Given the lack of overall oil production growth, which will constrain supply in the long term, our energy allocation is weighted towards growth opportunities in production and exploration stocks. AF: It is important to note that we are stockpickers, not country allocators, therefore our country weightings arise as a result of which markets are offering the most attractive opportunities at the stock level With this in mind we are level. mind, currently overweight China, unusually, and India, which is more normal, as well as South Africa, where high quality stocks are trading at modest valuations. We are underweight the more mature Asian markets such as Korea and Taiwan, due to their greater export exposure. We are also cautious on Russia, given our views on the oil sector and the associated governance risks. More broadly, for a long time investors been able to make bigger returns from Latin America than from Asia, but now this balance looks to have shifted the other way, appearing more favourable for Asia than it has for some time. How should advisers persuade their clients to buy in the current volatility? NG: I have certainly been buying in the last week or so AF: as have I. We are both bullish on the long-term outlook for our markets, therefore it makes sense, where possible, to treat periods of volatility as an opportunity to pick up good quality stocks at cheap valuations.

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