Looking for countries that have their financial acts together? Look to emerging markets like Peru and Indonesia

01/12/2010 10:09 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

As far as I know, there's no financial-markets law saying that if some countries get a credit-rating downgrade, then others must get a credit-rating upgrade to keep the system in balance.

But right now it seems to be working that way.

The past year has brought credit-rating downgrades to Portugal, Spain, Ireland and Greece, and credit-watch warnings to the United Kingdom and Mexico.

And it has brought credit-rating upgrades to Brazil, Peru, Turkey and Indonesia, and credit-outlook improvements to Russia and India.

See a pattern here?

Some of the world's developed economies are getting downgrades. If you included the U.K. and Mexico, I'd change my language slightly to say that many of the financial markets that U.S. investors know best are in trouble with the credit-rating agencies.

(For more on the chances that the United Kingdom will get a credit-rating downgrade http://jubakpicks.com/2010/01/08/the-next-financial-crisis-has-a-name-and-its-the-united-kingdom/ .For a look at Japan's financial problems, see my post http://jubakpicks.com/2010/01/07/is-japan-betting-its-future-on-a-new-weak-yen-policy/ .)

Meanwhile, countries that have been off the radar screen for decades are getting upgrades. When Brazil got its upgrade from Moody's in September, it marked the first time that the country had an investment-grade rating from all three of the big U.S. credit rating companies.

Frankly, I don't know what's more shocking: the prospect that the United Kingdom could lose its AAA rating in 2010 or that Peru earned an investment-grade rating in December.

You might scoff at the source of these ratings. These are the same companies -- Moody's, Standard & Poor’s , and Fitch Ratings -- that missed the deterioration in credit quality in the run-up to the U.S. mortgage-backed-securities bust.

You certainly should question whether bond investors have let some of these ratings go straight to their heads, resulting in some questionable pricing based on turning current events into long-term trends. For example, the five-year credit default swaps that are a way to insure against a default by Indonesia are priced just 0.01 percentage point above those for Greece, even though Greece has a current credit rating four notches higher than Indonesia's.

And credit-rating companies do tend to grade on a scale. If the United States and the United Kingdom are still AAA-rated risks these days, how can Brazil's investment-grade status even be a question?

But there's enough reality to these upgrades and downgrades that I think we're looking at a long-term trend. It may not be the world turned upside down, but it's close enough that investors need to re-engineer their portfolios to take it into account.

After I expend a few words in an attempt to convince you that there's more here than Wall Street hyping another investment strategy, I'll give you some suggestions on how to incorporate this new world into your portfolio.

Peru is a great example -- and probably a story that you don't yet know by heart -- of the reality that lies behind these changes in credit ratings. On Dec. 15, Moody's became the last of the big three credit-rating companies to raise Peru's sovereign debt to investment-grade. Luis Carranza, Peru's finance minister, announced the upgrade at a news conference that essentially boiled down to "What took you so long, Moody's?" Fitch Ratings and Standard & Poor's had upgraded Peru in 2008.

Certainly Moody's had plenty of evidence to work with, Carranza noted. At the start of the decade, Peru's national debt equaled 50% of the country's gross domestic product. It now stands at just 25%. (The United States is on track to finish fiscal 2011, ending Sept. 30, 2011, with a debt equal to 98% of GDP, according to the International Monetary Fund.

About 40% of Peru's debt is denominated in the national currency, the sol. A decade ago, almost all of the country's debt was denominated in dollars. With debt denominated in its own currency, Peru is a lot less susceptible to a financial crisis caused by U.S. dollars fleeing the country. Economic growth, which had dropped to 1% in 2009 from 10% in 2008, will climb to 5% in 2010, Goldman Sachs projects. Inflation, which ran at 0.25% in 2009, should pick up modestly this year.

Certainly Moody's had plenty of evidence to work with, Carranza noted. At the start of the decade, Peru's national debt equaled 50% of the country's gross domestic product. It now stands at just 25%. (The United States is on track to finish fiscal 2011, ending Sept. 30, 2011, with a debt equal to 98% of GDP, according to the International Monetary Fund.

About 40% of Peru's debt is denominated in the national currency, the nuevo sol. A decade ago, almost all of the country's debt was denominated in dollars. With debt denominated in its own currency, Peru is a lot less susceptible to a financial crisis caused by U.S. dollars fleeing the country. Economic growth, which had dropped to 1% in 2009 from 10% in 2008, will climb to 5% in 2010, Goldman Sachs projects. Inflation, which ran at 0.25% in 2009, should pick up modestly this year.

Not that Peru's perfect now. The economy is still heavily concentrated in mining, timber and oil and gas production, industries known for their boom-and-bust cycles. Development is highly uneven; the bulk of the wealth is going to the coastal region at the expense of the much poorer interior. The poverty rate has plunged from 50% in 2003 but still stands near 35%. Conflicts between indigenous groups -- half the people in Peru identify themselves as members of an indigenous group -- and the central government over control of development in the interior, and resulting profits, haven't gone away.

(Peru, I want to note, is the only country in Latin America to sign on to the Blair. The goal of the project is to make it easier to monitor cash flows from energy and mining companies to local and national governments.)

Like Indonesia and Brazil, Peru is a country that didn't appear on the global financial map for decades. And now it does.

What does this mean to you, if you're an investor in the United States or one of the other developed economies of the world? Three things:

  • You need to expand your world map. Peru didn't used to count. Its economy couldn't put two good years together. Its debt wasn't anything you wanted to own. It didn't matter if you couldn't name a single Peruvian company. Your portfolio wasn't missing anything. And that was true of countries such as Brazil and Indonesia that have much bigger populations and take up an even bigger chunk of global real estate than Peru does. You could afford to ignore them. I don't think that's true any longer.



  • You need to put a dollop -- a modest spoonful to start -- of emerging-market debt into your portfolio. Include it as part of whatever you allocate to bonds and fixed income assets now. Emerging-market bonds pay higher yields than developed-country bonds, and these countries are earning credit-quality upgrades instead of facing capital-destroying downgrades. Don't go overboard, and don't go crazy trying to analyze this paper for yourself. Use a mutual fund or an exchange-traded fund. Two funds to consider are Fidelity New Markets Income (FNMIX)) and Pimco Emerging Markets Bond D (PEMDX). For an ETF, take a look at iShares JPMorgan USD Emerging Markets Bond (EMB ).



  • Think about the effect of a rising credit rating on not just a country's bonds but on its stock market, too. A higher credit rating means lower interest rates -- by and large positive for a national stock market. It means easier access to capital and lower capital costs for a country's companies -- which makes expansion easier and, by cutting interest payments, increases earnings. And an improved credit rating is shorthand for a government budget that's under control and doesn't require tax increases and/or rising interest rates that damp economic growth. An improving credit rating should put a country's equities, as well as its bonds, on your investing radar screen. Again, I think a good first step, if you're new to emerging-market investing, is an ETF such as the iShares MSCI Emerging Markets Index (EEM).


But an emerging-market equity index has some drawbacks that you should consider as you gain experience in this part of the global equity market. Because the index is weighted by market capitalization, a buyer gets a very heavy dose of the biggest names in each emerging market. And because those big-cap stocks tend to be concentrated in a few industries -- mining and telecommunications services, for example -- buying the index gives you more concentration in a few industries than you might like, or more than your portfolio will appreciate if the cycle turns against a heavily cyclical industry such as mining. You'll also wind up light on smaller and more-innovative companies in these emerging economies.

I'll be writing about some of those smaller, harder-to-find -- and often less expensive -- companies in the weeks to come.

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