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Goldman Sachs’ Don Gervais on N-11’s Potential to Rival G-7: Weekend Interview

By Janet Levaux

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don gervaisTo gauge the various factors influencing international markets today and where the best investing opportunities are today, AdvisorOne spoke recently with several experts, including Don Gervais, global head of the fundamental equity product management for Goldman Sachs Asset Management.

What are the most important global-investing themes or issues today for you and your organization?

Gervais: One theme we are discussing with clients and see as an investing opportunity is emerging markets. When you look at how the world has been transformed over the last decade, a lot of these countries are in the process of evolving out of emerging-market status and are moving much closer to what has historically been called developed-market status.

We see a number of these countries as growth markets, and not surprisingly, this includes the BRICs – Brazil, Russia, India and China.  With China now the second-largest economy in the world, it’s important – given the economic landscape – to look at how these countries are represented in client portfolios, so investors have exposure to the growth in these emerging markets. 

The BRICs have been talked about for a number of years, and we still very much believe that we are in the early days in terms of their impact on the global economy. When we look at opportunities in global investing, we are very excited about the BRICs. Looking at their evolution, when the concept was first coined by Jim O’Neill of Goldman Sachs, it met with a lot of suspect and skepticism.

Today, BRICs are now acknowledged to be a very important part of the global economy, which has prompted some to ask what other economies could also influence and have an equally sizeable impact on worldwide growth. Thus, we’ve looked at the economic landscape and are now discussing a term we’re very excited about – Next 11 or N-11. This is a group of nations that with their growth over the next 40 years can potentially rival the G-7 in economic importance. 

The four most-advanced N-11 nations are South Korea, Mexico, Indonesia and Turkey, with the other seven in the group being the Philippines, Vietnam, Bangladesh, Nigeria, Egypt , Pakistan and Iran. (We do not directly invest in Iran as part of our strategy, but it is an important economy in terms of growth.)

What positive investment opportunities do you see based on the trends you described earlier?

Gervais: These N-11 markets are becoming very interesting.  The International Monetary Fund says that there are approximately 150 non-developed economies worldwide, and we believe that there are 15 that really matter and that investors should focus on: The BRICs and the N-11. There are three key things that make them interesting as investment opportunities. One is the tremendous gross domestic product, or GDP, growth taking place in these markets, which has been quite strong and should be even more robust in the future. Our projections show that over the coming decade, the BRIC and N-11 countries could account for over 60% of global growth.

Second is population, namely that 20 percent of the world’s population reside in the N-11. That represents about 1.3 billion people, and the median age is in the mid-20s. In the BRICs, which accounts for over 40 percent of world population, the median age is 31, and the developed economies, of course, have a median age that is much higher particularly in Japan.

Third, we are seeing the tremendous development of the middle class, which totals about 300 million people in the N-11 countries. This means that there is a large number of people with increasing income levels that will be able to boost their spending.. Think about the demand for goods and services and the impact of that on commodities, such as food, petroleum and other materials. This helps the N-11 economies in terms of domestic growth and it helps outside economies, as well. 

It is also important to note that N-11 offers diverse exposure – economically and geographically speaking.  There are economies like South Korea that are much further along in development, and then you have countries like Bangladesh and Pakistan, which are what investors have historically thought of as frontier markets. Some of these are proven economies that are growing rapidly, while others do face challenges.  But this represents some significant opportunities as they continue to get their monetary and fiscal policies right, to mature their rule of law and develop in other ways. These are all important issues.

This group has done reasonably well in their performance in dollar terms recently, especially South Korea, which has been especially robust, and is up just under 8 percent so far this year. Their diversification is a huge benefit to investors, since some of these markets – like Egypt – have seen a lot of geopolitical issues. With diversification, of course, you limit exposure to any one particular market.

As we talk with our clients, we speak about the emerging markets as one large group in the aggregate, which includes approximately 150 markets. Given these opportunities, we suggest they position themselves to take advantage of growth not across the group, but particularly in the BRICs and N-11 countries. This is where the growth should be concentrated.

The BRICs and N-11 represent about 25% global GDP today. But over the next two decades, the BRICs should grow to account for over 35% of global GDP, and the N-11 could account for over 10%, according to our estimates.  These 15 nations are expected to represent two-thirds of global GDP growth in the next 10 years.

What about other areas of potential opportunities and/or risks?   

Gervais: In terms of high commodity prices, this trend does benefit some of these [BRIC and N-11] economies, since they are rich in resources. Thus, some rise in income is expected, and overall commodity-prices increases have not been particularly disadvantageous to emerging markets. But, of course, another trend has been food inflation tied to floods and drought in China and India, especially. This trend, though, is short, and another growing season can get going soon – generally speaking. And this means the impact can be shortened, and we should see some easing of this pressure in the coming months.

Also, if you look at the financial crisis that we just experienced, this was the first time that major economies outside of the developed world were able to cut interest rates to stimulate growth during a crisis. In the past, they’ve always had to raise rates to keep capital in their markets. This is the first time they had such monetary tools at their disposal.

Brazil cut by 500 basis points during the crisis. China, India and Russia all cut by a couple hundred basis points. While we’ve had lots of headlines about Brazil raising rates recently and China, too, what is being forgotten is that they are raising rates while coming off of a

much lower base then where they’d been before. They were able to cut rates to stimulate growth during the crisis – which was the appropriate thing to do – and are now trying to cool inflation by raising rates and are moving to cool down their economies a bit.

Thus, there’s a need to re-evaluate historic norms and risks surrounding rampant inflation and other risks – geopolitical risks, liquidity risks, etc. — which did make sense in the past and have been important to investors. As markets mature and grow, however, these countries are getting more access to better tools to help them manage these risks. Consequently, while these risks do still exist, they’re changing. We no longer need the old perceptions of them.

Inflation management is one example. Fiscally, these countries are in a much better position than they were decades ago when they faced these same pressures. If we think about where the recent fiscal, public balance-sheet discussions have taken place, it hasn’t been in the BRICs or in the emerging economies, it’s been in Europe and in the United States.  Sovereign-debt discussions haven’t focused in the developing economies, which are running a huge surplus, it’s been in the developed economies. We are seeing the early signs of a lot of these changes happening, and the surpluses give these nations much more monetary flexibility and enable them to manage inflation and other pressures much more effectively than in the past.

Would you like to comment on other global dynamics affecting international investing at this time?

Gervais: We see two ways to take advantage of the growth happening in the [BRIC and N-11] markets. First, the average U.S. investor has about a 5-percent exposure to the emerging markets on a direct-equity basis via equities, funds, etc., which are domiciled in emerging markets. We think this is too low. 

The emerging markets represent approximately one third of total global market capitalization today. Do investors want to be this much underexposed to the world’s fastest-growing markets? Or do you want to be better positioned for the 10-, 20-, 30- and 40-year growth we expect in these countries?

We think most investors want to take advantage of this growth and should re-examine how much exposure they have. We recognize that there are risks involved, but we think these risks are changing and evolving. We also think that an increasing allocation to emerging markets should focus on these 15 economies – the BRICs and N-11.

Valuations now look reasonable to attractive across these markets. We advise clients to start making an allocation, do dollar-cost averaging and use market pullbacks to increase exposure. We see this as a long-term investment that will involve volatility but will also be an important source of returns.

Investors can also tap into this growth through the more developed stock markets, since there are a lot of U.S., European and Japanese companies that are able to take advantage of this growth as well. Urbanization in the developing economies is leading to greater demand for health-care services and pharmaceutical products, and these industries are not highly developed in these maturing economies. This means great demand for global pharmaceuticals. And there’s also a strong need for heavy equipment manufactured by global companies such as John Deere, Siemens and other firms.