Morningstar Advisor - Summer 2008 - 53

economies. At a profits level, particularly in the developed world, we are absolutely going down a profits recession. This is where profits are down year over year in aggregate. We already had it in the U.S. in Q1, but it’s going to spread. A profits recession is really troubling. Offsetting that is the fact that stocks from Oct. 16, when they peaked, to March were off almost 20% globally, because everybody knows what I just said. So in a weird sense, risk premiums are high, but risk premiums will come down—since the Bear Stearns event or Northern Rock or whatever event you want to say. But earnings power is absolutely coming down. The whole developed world was making, quite frankly, excess returns because of dynamic growth. That concerns me a lot. You’ll remember, when risk premiums come down, markets want to go up, because things are optically cheap. But today, earnings power is coming down. This is where I spend all my time, trying to find the individual names that have excess risk premium, because it’s going to come down, but that we believe have earnings power, even if it’s impaired, that is still durable or good, or not even impaired at all. That’s a hard thing to do. In the emerging world, the concern’s slightly different but very troubling. The global inflation picture has picked up, especially in the emerging world. The most important inflation that matters is not oil, gas, coal, iron ore, or other commodities; it’s food, which is important because it affects economies and social welfare, but also labor inflation. Labor inflation is just rampant. In most countries in the emerging world outside of Latin America—China, Russia, India, all of the Persian Gulf—real interest rates are negative, and real inflation is rising. Stated inflation—I’m telling you, I travel a lot. I don’t know who’s making those numbers up, but they’re too low. You’ve got a situation where they have to raise interest rates just to get ahead of this—growth has been so dynamic. We got lucky. Inflation was benign because of globalization, but inflation’s picked up hard, and the funny thing is, the question mark on 2008 is the developed world and does the U.S. housing crisis spread. 30000 But the question mark for the stock markets in 25000 and 2010 is the emerging world. How do 2009 they 20000 stay ahead of inflation without doing an old-style slowdown or mini-recession? 15000 T. Rowe Price Global Stock PRGSX $30K 25 MSCI EAFE TR 20 15 03 04 05 06 07 08 KK: 10000 How do they do that? RG: Every country’s different. Take just China and India; they’re so dramatically different. In India, they’re doing it in a very traditional, classic economic way. They’re just raising interest rates and hoping to slow the band and doing some foreign direct investment controls. Whether they’ll be able to stay ahead of it, I don’t know. They’re doing all the right things at the central banks that I know. China’s handling things completely differently. It’s a centrally planned economy—very similar to Japan and Korea that way, with their centrally planned industrial policy. China is doing things to try to change the rules of engagement. They have price controls, allocation of resources. That worries me. They make unanticipated mistakes. Post-Olympics, how will they deal with the massive structural imbalances? I don’t know. In Russia, they’re going to just let the good times roll, and they got massive inflation. In the Persian Gulf, it’s more about unpegging the currency and how much they’ll let the currency appreciate. In an investing context, it’s an odd thing. You’ve got inflation, interest rates going up, but when the currency’s unpegged and you revalue currencies, you get a lot of asset revaluation. There can be money made. KK: How are these emerging-markets concerns affecting your portfolios? RG: I’ve got to take almost every country separately because they’re all different in their concerns. I’ll take my top three, Brazil, China, and India. Category World Stock Morningstar Rating QQQQQ Minimum Investment $2,500 Expense Ratio (%) 0.87 Data as of June 30, 2008. 3-Yr Anl Total Rtn (%) 16.9 3-Yr. Rtn Rank Category (%) 4 Stewardship Grade Z Jan-03 is my largest weight in emerging markets Brazil Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Feb-03Nov-03Jul-04Mar-05 Feb-06Nov-06Jul-07Mar-08 Mar-03Dec-03Sep-04 Jun-05 Mar-06 Mar-07 Feb-08 Apr-03 Feb-04Nov-04Jul-05 Apr-06 Apr-07 Apr-08 May-03 Mar-04Dec-04Sep-05 Jun-06 May-07 May-08 Jun-03 Apr-04 Feb-05Nov-05Jul-06 Jun-07 Jun-08 Jul-03 May-04 Apr-05 May-06 Aug-03 Jun-04 May-05 Sep-03 Aug-04 Aug-05 Aug-06 Aug-07 Oct-03 Oct-04 Oct-05 Sep-06 Sep-07 Oct-06 Oct-07 Nov-07 some Dec-02 might find odd. You’ve got much better Dec-05 Dec-06 Dec-07 Feb-07 and has been for quite some time, which growth in Asia, but you’ve had much better valuations in Brazil. You’ve had a situation where the 4.5% real GDP growth was accelerating at a time when real interest rates were declining, mainly because the country was going investment-grade, so the risk premium could come down. Brazil is commodity wealthy and very broad-based—oil, minerals, agriculture, blessed with the nice sun, and the Amazon. It has a central government that’s fiscally responsible. That’s the backdrop in Brazil. We own Petrobras PZE, which is really a publicly traded national oil company with great reserves. We also own Banco Itau, which is one of the large universal banks. We own Vale, the iron ore-nickel company, and we also own an e-tailer, B2W, which is an Amazon. com look alike. The beauty in Brazil—it’s a little bit of a Latin thing—is that they allow oligopolies. The number one and two e-tailers merged, and they become B2W. The industry structure is amazing there. I am becoming more concerned in Brazil MorningstarAdvisor.com 53

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Morningstar Advisor - Summer 2008

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