At a Loss? Where to Look for Growth

09/09/2011 11:00 am EST

Focus:

Jim Jubak

Founder and Editor, JubakPicks.com

Economic growth forecasts are getting weaker in the US, but stronger in developing countries. Of those, 2 stand out as particularly promising for investors.

Will the superior economic performance of developing economies such as China and Brazil translate into superior stock market returns over the next 12 months?

Or, as the United States and the European Union slide toward slow to no growth, will the dismal performance of the world's developed economies drag all boats to the bottom?

In other words, will emerging stock markets decouple from developed stock markets in the last part of 2011 and in 2012? I think that's the most important question facing stock investors right now.

What's Decoupling?
Decoupling is when a stock market dances to its own tune, rather than moving in lockstep with other markets, or with the global market as a whole. Decoupling can lead to foreign markets that either outperform or underperform the US by extreme amounts.

We've been through a good example of underperformance of emerging markets in the last part of 2010—but it didn't quite meet the standard of real decoupling.

In the fourth quarter of 2010, the S&P 500 gained 10.8%. The Brazilian stock market, as tracked by the iShares MSCI Brazil Index Fund (EWZ) gained just 4%.

Then, from December 31, 2010 to its peak on April 29, the S&P 500 climbed to 1,364 from 1,258. That's a gain of 8.4%. Meanwhile, the Brazil Index Fund went from $76.23 to $76.55. That's a gain of 0.4%.

Clearly, Brazil underperformed the US. But even then, the two markets moved in the same direction—even if just barely.

Pure decoupling is different-and rarer. Let's look at what happened in 2007. In the fourth quarter that year, the S&P 500 went down by 3.6% while the Brazil Index Fund went up by 11.4%. For the year, the S&P finished ahead a paltry 4.9%, and the Brazil Index Fund was up 74.8%.

Could we see that kind of decoupling (or even just extreme outperformance) in the remainder of 2011 and in 2012? The economic growth trends give decoupling a good chance.

Why Decoupling Is Ahead
According to leaked information, the International Monetary Fund will cut its forecasts for US and Eurozone growth when it releases its next report on global growth September 20.

For the United States, the forecast growth rate for 2011 will go to 1.6% from a forecast of 2.5% just two months ago. For 2012, the forecast will call for 2% growth, down from 2.7%. For the Eurozone, the drop will mean a forecast of 1.9% growth in 2011 (down from 2%) and 1.4% growth in 2012 (down from 1.7%).

In contrast, the IMF forecasts the global economy will grow by 4.2% in 2011 (down from a prior forecast of 4.3%) and by 4.3% in 2012 (down from a forecast of 4.5%).

That's a big enough difference—roughly two times more growth for the global economy as a whole than for these two big developed economies. But the gap widens if you look at the economies of China and Brazil separate from those of the smaller nations.

For Brazil, the central bank's most recent survey of economists showed a consensus forecast of 3.67% growth for 2011 and 3.84% in 2012. The government of President Dilma Rousseff is projecting 5% growth for 2012. (More later on who might be right.)

For China, growth estimates have been falling as the global economy slows, but the consensus for 2011 still hovers just below 9%. (Deutsche Bank, for example, forecasts 8.9%, and UBS comes in with 9%.) For 2012, consensus growth is at 8.3% or so.

Economic growth rates alone don't determine stock prices. Otherwise, Chinese and Brazilian stocks would have outperformed the US and European equity markets in the first half of 2011.

Watch the Direction
Expectations for the direction of economic growth rates are far more important, I'd argue.

In the first months of 2011, for example, the belief that the US and Eurozone economies (those of Germany and France, actually), were growing at better than expected, if still low, rates, buoyed stocks in those markets. Fears that China and Brazil were slowing—even though the projected slowdown was to a growth rate two or three times higher than in the developed economies—weighed heavily on stocks in those markets.

Also important, I'd say, is uncertainty over the direction and ultimate destination of economic growth rates. China's financial markets have performed poorly this year, falling 11.2% as of September 7 and 17.6% from their April 13 high. They've performed even worse since they peaked on November 8, falling 27.7% since.

A good part of that decline has been because of uncertainty over how much growth Beijing's fight against inflation would take out of the economy, as well as fears that a long program of interest-rate increases and additions to bank reserve requirements would send the economy crashing to a hard landing.

So where do China and Brazil stand on those two scales?

China looks like it is near a peak in inflation—6.5% in July—with economists calling for a dip to 6.1% for August in data to be released on Friday. That wouldn't put an immediate end to China's rounds of higher interest rates and reserve requirements, but it would tell financial markets that the end of this cycle is near.

Time to Invest in China?
China's economy would most likely still slow, as past monetary tightening and global economic slowing worked their way through the system. But the likelihood is that current projections for 2012 growth rates of around 8.3% will mark something like a low.

If you follow the six-month rule (that the market anticipates news by about six months), then the end of 2011 and early 2012 would be time to build up China portfolio positions.

Brazil is more complicated. The Banco Central do Brasil just staged a shocking cut in its benchmark Selic interest rate, to 12% from 12.5%, despite a lack of convincing evidence that inflation is under control. The central bank's best argument was that Brazil's inflation rate will come down with a slowing global economy and falling commodity prices.

This is wishful thinking, I'm afraid, and it quite probably masks the bank's cave-in to political pressure from the Rousseff administration.

At less than 4% growth, the economy was generating just too much pain for the president (after all, growth in 2010—the last year under Rousseff's predecessor, Luiz Inácio Lula da Silva—had been 7.5%) and she put pressure on the bank to cut interest rates and get the economy moving faster.

I think you can find evidence of politics in the rest of the Rousseff administration's economic plan for 2012. The budget presented to Congress calls for a big increase in spending on pensions—indexed to the 13.6% increase in the minimum wage in 2011.

It also calls for big jumps (of 15% and 33%, respectively) in spending on health care and education. And it asks for $1 billion in additional spending on airports and stadiums to prepare for the 2014 World Cup and the 2016 Summer Olympics.

The government's budget shows a primary surplus for 2012—that's a surplus before interest payments—but only because it projects 5% growth instead of the 3.8% or so in the forecast of private economists.

How 'bout Brazil?
If you want to say that this sounds like the typical budget-busting, government spending spree that will goose growth in the short-term and leave an inflationary hangover in the long term, I would say, "Sure 'nuff."

But in the short term, I think the government is going to spend its way to higher growth and keep enough pressure on the central bank to keep the inflation fighters on the sidelines until 2013 or later. (You want to stage a World Cup and an Olympics in the midst of a recession?)

In other words, I think Brazil is going to show more growth in the short term than is in the current projections. I think that today's projections mark a low point in expectations, and that domestic Brazilian companies are going to see big revenue jumps from this inflationary program.

That points me in the same direction as I look for Chinese and Brazilian stocks. I'd look for domestic companies rather than exporters, because I think domestic growth will be stronger in both economies than will growth that depends on the global economy, which is slowing.

Stocks to Consider
In China, stocks that I've mentioned in recent months that fit this scenario include Baidu (BIDU), Tencent (TCEHY), and Home Inns & Hotels Management (HMIN).

I'd also include two US companies where China is a likely big driver of sales over the next 12 months: Coach (COH) and Apple (AAPL).

In Brazil, I'd include Gerdau (GGB) for its domestic infrastructure exposure, Gol Linhas Aéreas Inteligentes (GOL) for an increase in air travel, and Itau Unibanco (ITUB). If you happen to be able to trade in São Paulo, I also like Natura Cosmeticos (NATU3.BZ) and Lojas Renner (LREN3.BZ).

I don't think you need to rush out and buy any of these today. September is going to produce a lot more volatility. But slowly building positions here and through the end of 2011 makes sense to me.

I'll have more specific stocks to recommend in these two markets in coming weeks.

Full disclosure: I don’t own shares of any stock mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund owned shares in Apple, Baidu, Coach, Gerdau, Gol Linhas Aéreas Inteligentes, Home Inns & Hotels Management, Itau Unibanco, Lojas Renner, Natura Cosmeticos and Tencent as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.

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