FIRST Q U A RT E R 2 0 0 9

THE BROYHILL LETTER

“One dog barks because it sees something; a hundred dogs bark because they heard the first dog bark.”
– Chinese Proverb

Executive Summary

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

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

The Death of Decoupling

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

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

There are good reasons to believe that emerging economies will continue to have a growing influence on the global
economy’s rate of growth, the level and direction of trade, the price formation process, and the stability of cross-border
capital flows. In fact, they are already the most important contributor to global growth and they have captured a large and
growing share of world trade (Chart 2). Most emerging economies are not plagued by America’s deep structural problems,
such as an overhang of debt which will cramp growth for years. On many measures, such as government and external
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balances, emerging economies look much sounder than the developed world. Current account surpluses and modest do-
mestic debt in emerging Asia mean that most of the region is much less exposed to the credit crunch. The majority of
Asian governments are in a good position to “turn Keynesian” should they wish to offset the impact of lower U.S. growth.
The robust nature of many of these countries balance sheets – historically unusual – gives them the ability to stimulate
internal consumption and investment.

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

Pumping Up the Panda

Although the global economy continues to deteriorate, China is showing early signs of recovery. As a result, the world’s
third largest economy is using its position as an opportunity to gain a seat at the head of the global table. In recent weeks,
China has been negotiating deals to double a development fund in Venezuela to $12 billion, lend Ecuador at least $1 billion
to build a hydroelectric plant, provide Argentina with access to more than $10 billion in Chinese currency and lend Brazil’s
national oil company $10 billion. These deals largely focus on China locking in natural resources like oil for years to come.
China is rapidly increasing its
lending in Latin America as it
pursues not only long-term ac-
cess to commodities like soy-
beans and iron ore, but also
an alternative to investing in
United States Treasury notes, of
which they are the world’s larg-
est holder (left).

The story in China is fairly

simple. It is the only country
that has actually implemented a
broad based and large scale stim-
ulus program, and the impact is
beginning to show. The sheer
size of the investment, relative
to the size of the economy, is
approximately twice as large as
the U.S. fiscal stimulus program.
They are in the fortunate situa-
tion of having ample resources
to do this. The Chinese economy operates in an authoritarian regime where political power is firmly controlled from the
top allowing the Chinese government to implement its policy initiatives very effectively. This is a rare moment where an
authoritarian regime has its advantages. A recovery in the Chinese economy that will likely lead the global economy will be
distinctly bullish for Chinese equities as well as for stocks in markets closely related to the Chinese economy, including a
number of China’s neighbors in Asia and commodity producers around the globe. The massive resource requirements of
the Chinese economy imply a compelling long-term case for the commodities asset class as the economy recovers.
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The Emerging Emerging Bubble

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

The prospect of slowing developed world

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

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

Bottom Line

To date, the recent bear market can be divided in three distinct stages. During the initial phase, which concluded during
the first half of last year, emerging markets performed well while the bear market was concentrated in the global financial
sector. The second and most destructive phase, leading up to the collapse of Lehman Brothers and the resulting down-
ward spiral in economic activity, once again proved that the only thing that rises in times of crisis is correlation. Global
equities, commodities, corporate bonds and all asset classes beyond government debt crashed in tandem, while emerging
markets fell considerably further. But during the current and likely final stage of this bear market, emerging market relative
performance has again demonstrated strength and resilience. We believe this is a major departure from the past and likely
indicates future leadership when global share prices ultimately bottom. Historically, outperformers in bear markets become
market leaders in the ensuing upturn.
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PIMCO’s Mohamed El-Erian offers a highly lucid and well articulated assessment of how the vast societal, economic and
governmental changes are reshaping the world as we know it in his recent book, When Markets Collide. We are impressed
enough by his work to cite some of his key points below (emphasis added), to conclude this quarter’s Broyhill Letter.

The Markets are headed toward a secular destination involving consequential changes for investors. The engine of economic growth worldwide will
no longer be so highly dependent on the United States; instead, emerging markets will increasingly constitute a consequential and independent
driver for growth. This evolution has the potential to facilitate the much-needed and long-delayed adjustment in a U.S. economy that has been
overly dependent on debt-financed consumption.

For investors, these changes alter the configuration of risk and returns. Given the nature and depth of these structural changes, market partici-
pants need to adjust if they wish to remain successful in this new age. Ongoing transformations alter in previously unthinkable ways the configu-
rations of risk and return. They necessitate adjustments on the part of market participants that, counter-intuitively, may also involve deviating
even further from what was previously deemed conventional wisdom. At the heart of all this is the gradual unfolding of an economic, financial and
technical realignment of the global system. The main drivers include the emergence of a new set of systemically important countries and a significant
cross-border transfer of wealth. A faltering U.S. engine of global growth will be replaced by several emerging market engines.

Most investors still show a very high degree of “home bias” in their capital allocations. If our secular destination of more balanced growth mate-
rializes, investors will wish to be exposed to a globally diversified set of stocks. Global exposure is also justified by the secular growth hand-off
that will result in less reliance on the dynamism of the U.S. economy and more on the expansion in economic activity throughout the rest of the
world (and particularly emerging economies).

- Christopher R. Pavese, CFA