Economic drivers are things related to the macroeconomic environment. This could include monetary policy, interest rates, lending activity, yield curve analysis, relative GDP growth analysis, and myriad others. What economic forces are likely to drive GDP growth throughout countries in the world? What is the outlook for interest rates and how would that impact sectors? What is the outlook for technology and infrastructure spending among countries?

Economic drivers pertain not only to the fundamental outlook of the economy (GDP growth, interest rates, inflation), but also to the stock market (valuations, M&A activity, share buybacks). As an investor, it's your job to identify these drivers and determine how they'll impact your overall portfolio and each of its segments.

Important economic drivers include:

Political drivers can be country-specific, pertain to regions (Asia, Latin America), or affect interaction between countries or regions (such as trade policies). These drivers are more concerned with categories such as taxation, government stability, fiscal policy, and political turnover. Which countries are experiencing a change in government that could have a meaningful impact on their economies? Which sectors could be at risk from new taxation or legislation? Which countries are undergoing pro-growth reforms?

Political drivers will help determine the relative attractiveness of market segments and countries. Be warned, however: Most investors suffer from "home country bias," where they ascribe too much emphasis on the politics of their own country. Always keep in mind it's a big, interconnected world, and geopolitical developments everywhere can have implications.

Political drivers also tend to be exaggerated in emerging markets. Big changes often occur rapidly; even entire governments can be overthrown in days. Thailand, for example, has witnessed 10 coup d'états since 1971.^[170] Given the potential for surprise, politics is an especially powerful driver in emerging markets. Some of the most important aspects:

Sentiment drivers attempt to measure consensus thinking about investment categories. In the quest to know something others don't or interpret widely held information differently, sentiment drivers are vital inputs—they reflect expectations and what the market is discounting. Surprises move markets, so use these drivers to help you find areas where sentiment is different than reality. For example, let's say you observe most investors currently expect a recession in the next year. But you disagree and believe GDP growth will be strong. This presents an excellent opportunity for excess returns. You can load up on stocks that will benefit from an economic boom and watch your portfolio rise as the rest of the market realizes it later and prices in the result.

Since the market is a discounter of all known information, it's important to try and identify what the market is pricing in. Looking forward, which sectors are investors most bullish about and why? What countries or sectors are widely discussed in the media? What market segments have been bid up recently based on something other than fundamentals? If the market's perception is different than fundamentals in the short term, stocks will eventually correct themselves to reflect reality in the long term. Key sentiment drivers include:

In 2002, Brazil prepared for a new president—the second term of President Fernando Cardoso's administration was coming to an end. Elections are one of the most important political drivers, as they represent the greatest probability of change. As such, investors tend to view them cautiously, and this one was no different.

The outgoing president, Fernando Cardoso, was a firm proponent of fiscal responsibility. As finance minister, he helped lead the country out from hyperinflation with his "Real Plan" in 1994.^[173] In his second term, Cardoso passed several landmark laws, including the Fiscal Responsibility Law in 2000, which imposed greater controls on government spending. Given Brazil's historical lack of fiscal discipline, this was a welcome change.

Cardoso also introduced additional sound reform. Presidential Decree 3088, issued in January 1999, established inflation targeting as the official monetary regime for the Brazilian central bank. Brazil's long history of hyperinflation wreaked havoc on economic and financial stability; the sheer scale of price changes and its violently unpredictable nature continuously frightened away investors. While the Real Plan successfully brought inflation down from the heady levels of previous administrations, Cardoso's decision to institute inflation targeting helped keep it under control. These reforms represented positive political drivers—much rested on their continuation in the next administration.

But Cardoso's successor potentially threatened this progress. A former metalworker and union leader, Luiz Inacio Lula da Silva (known commonly as Lula) gained popularity by leading strikes against the Brazilian military dictatorships of the 1970s and 1980s. He also helped found the Worker's Party, the dominant left-wing party of Brazilian politics.

Given his background and Brazil's history of populist-leaning leaders, Lula frightened investors. He had a history of fiery anti-capitalist rhetoric, promoting such causes as intentional debt default and the renationalization of state-owned enterprises. At best, investors feared he would ditch the market-friendly policies introduced under Cardoso's regime. At worst, he represented a return to the country's populist ways. Investors held their collective breaths and the uncertainty weighed on markets—Brazilian stocks sold off in the run-up to elections. This was a political driver at work.

Investors were also suspicious of the economy. Crises in Argentina and Uruguay erupted into fears of contagion across the region. Even though Brazil was financially separated from these trouble spots, it was still viewed by investors as Latin American. Contagion represents both a sentiment and an economic driver. It is based mostly on fear (sentiment) but is also in response to the visible deterioration of some corner of the market (economic). In either case, traders thrashed the Brazilian real to historic lows, interest rates and inflation spiked, and major credit rating agencies began questioning the country's ability to service its $250 billion in debt.^[174] Taking stock at the end of 2002, uncertainty remained high. Investors were unsure what elections might bring, and the economic outlook appeared murky.

Lula took office in 2003 and quickly assuaged investors' fears. Upon assuming office, the 35th president of Brazil hardly resembled the leader suggested by his past. He toned down his populist rhetoric and adopted many of Cardoso's key policies on fiscal responsibility and inflation targeting.

The fear of change soon morphed into optimism of further change. Lula didn't just keep the market-friendly policies of his predecessor, he built on them. For example, the pension system was bloated from the populist handouts of previous administrations—pensions cost the government nearly $20 billion, or 4 percent of GDP at the time.^[175] One of Lula's first actions as president involved reforming this system. He passed laws limiting the size of public-sector pensions and made them taxable. These moves were very unpopular; Brazil's politicians had long cemented their hold on power through the support of the masses. But markets welcomed the structural reform. They represented a break from Brazil's damaging populist past.

But the administration wasn't done yet. Brazilian consumers and businesses had long starved for credit. Not only were interest rates prohibitively high, but structural inefficiencies deterred banks from lending more. For example, Brazilian reserve-to-deposit requirements were among the highest in the world. This manifested itself in a generally low level of credit across the economy, even by emerging market standards. Credit availability is a crucial variable to the efficient functioning of markets, a key economic driver.

Lula focused on structural reforms to increase the overall availability of credit. A series of measures, such as changes to bankruptcy law and the framework for securitization, coaxed banks to take more risk and increase lending. With interest rates and inflation already heading downward, banks were now more apt to extend loans after reform. And lend they did. Bank lending rose from 25 percent of GDP in 2003 to just over 40 percent in 2008. This had clear positive economic ramifications: During this period, capital goods production consistently grew over 20 percent year-over-year, and retail sales, which were declining in 2003, began to grow at double-digit rates.^[176] In this case, positive political drivers (structural reform) helped shape economic drivers (increased lending).

Continued reform boosted investor confidence and led to other enticing economic drivers. Inflation, long the country's nemesis, remained steady and predictable, encouraging investment, consumption, and ultimately higher economic growth (see Figure 6.1). Capital goods production consistently grew over 20 percent year-over-year, and retail sales, which were declining in 2003, began to grow at double-digit rates. Not surprisingly, Brazilian Financials performed extremely well due to the windfall of credit reform, returning 69 percent annualized from 2003 to 2007.^[177]

In addition to positive domestic drivers, there were larger, more powerful trends brewing outside Brazil's borders. In the developed world, we often take for granted the electricity lighting our homes, the roads facilitating easy transport, or the clean water systems providing one of our most basic human needs. But this infrastructure is generally inferior or non-existent in emerging markets. Rapid economic growth and industrialization in recent years only exacerbated the strain on existing resources.

Figure 6.1. Brazil Inflation and Interest Rates Since Inflation TargetingSource: Thomson Datastream.

In response, governments deployed enormous amounts of capital to upgrade the emerging world at the turn of the twenty-first century. At the same time, cracks began to form in the developed world, much of which was industrialized 100 years ago. Its infrastructure began to deteriorate and, in some cases, fail completely. The developed world needed a refresh. Together, these trends unleashed an investment boom seen only a few times in history (an economic driver). And because of its resource-heavy market composition, Brazil was one of its biggest beneficiaries.

Infrastructure requires two key inputs—raw materials and energy. You can't build a skyscraper without steel beams or a road without concrete, and the surge in infrastructure spending dramatically increased demand for basic materials. From 1980 to 2000, global crude steel production, a metal required for manufacturing and construction, grew 18 percent. In the seven years from 2000 to 2006, however, production increased 58 percent.^[178] Increased demand for steel in turn led to demand for iron ore, its main ingredient (see Figure 6.2). In addition, the wave of industrialization dramatically increased demand for oil and its derivatives, pushing up oil prices more than five-fold.^[179]

Figure 6.2. Iron Ore Benchmark PricesSource: International Monetary Fund.

This was a powerful economic driver for Brazil, as the country was the world's second-largest producer of iron ore and also home to a large energy sector.^[180] Together, the Energy and Materials sectors account for nearly 50 percent of the country's weight. Both clearly benefited from the global thirst for commodities, returning an annualized 73 percent and 82 percent from 2003 to 2007, respectively (see Table 6.3).

The commodities boom presents a few key takeaways. First, investors cannot ignore the structural composition of each country's market. One of the first steps to evaluating a country should be an understanding of its sector composition. Here, recognition of the larger infrastructure theme would have likely led you to Brazilian Materials and Energy regardless of your view on the country. Second, don't forget to think globally. In today's globalized world, not every reason for a country's relative market performance lays within its borders. A broader global trend can be just as impactful to a country if it provides a key input or is in some way connected.

No evaluation of portfolio drivers is complete without an in-depth analysis of risk. An underappreciated negative can sometimes outweigh an otherwise rosy outlook. Investors should therefore spend just as much time evaluating what could go wrong as what may go right.

And despite the ongoing positive developments, risks remained. Economically, Brazil as a country remained sensitive to market turbulence due to its reliance on foreign capital. Red tape still entangled businesses, fostering inefficiencies. And although interest rates were substantially lower than historical levels, they remained high on an absolute basis.

Politically, a series of scandals plagued much of Lula's first term and threatened progress on reform. Corruption is commonplace in emerging markets due to weak institutions and often poorly developed legal and regulatory frameworks. Lula was also going against the weight of historical trends; it takes a strong politician to consistently challenge the status quo. At any given point in time, Brazil's fragmented political process threatened to undo the progress made.

Figure 6.3. Weighing Portfolio Drivers

The evaluation of portfolio drivers doesn't occur in a vacuum. In this case, a similar analysis of other countries in the benchmark would need to be conducted before determining the appropriate allocation to Brazil. After you've gone through the relevant markets, stack up countries (or sectors) relative to each other. Clearly, there were a number of positive drivers in Brazil. But how did they stack up against other emerging markets? We like to think of this process like a scale, with the heavier category represented as an overweight. Put one country (or sector) on each side. Which side would weigh more? By how much?

Figure 6.3 illustrates a very simple example of this idea, comparing Brazil to South Africa in the early 2000s. Like Brazil, South Africa also benefited from increased commodities demand because of its vast mineral resources. But while interest rates and inflation were falling in Brazil, they were rising in South Africa. And the political environment in South Africa was fraught with risk. Therefore, an overweight to Brazil relative to South Africa was justified. Utilizing this approach with each segment will help guide you in determining what areas of the market to over- and underweight.

Emerging markets tend to have higher economic growth rates than developed markets. This is part of their allure to investors. But does stronger economic growth translate into stock outperformance?

The evidence suggests so—at least through its relatively short history. Using the 24 official countries in emerging markets today, the average annual GDP growth for the category since 1988 is 4.3 percent. The same number for developed markets is 2.8 percent.^[182] Stock market performance over the same period is also in emerging markets' favor, with the MSCI Emerging Market Index returning an annualized average 11.4 percent versus 6.2 percent for the MSCI World Index.^[183]

Taken at face value, these data suggest holding a constant overweight to emerging markets. After all, they offer stronger economic growth and higher stock market returns. However, this is dangerous logic in the short term. No category of stocks outperforms at all times, and emerging markets stocks are often subject to large swings in performance. In any given year, such a belief can lead to disappointing and unexpected negative returns. For example, the MSCI Emerging Markets Index fell an average annualized 9 percent from 1994 through 1998, while the MSCI World Index rose 16.2 percent a year over the same period.^[184]

In addition, much of emerging markets' outperformance in the past two decades represents their arrival on the world stage. Growth was disproportionate in this beginning stage and, as it invariably slows, emerging markets may begin to perform more like their developed market peers over time. In the very long term, most equity indexes finish with roughly the same return.

Upon closer inspection, the connection between economic growth and stock market performance appears less straightforward. At the country level, for instance, there is little relationship between the two. In Chapter 2, we told the story of China's vicious 2001 to 2005 bear market, a time when the Chinese economy averaged double-digit growth. Investors indiscriminately following the country with the best economic growth would have seen their portfolio wilt. To be sure, the two are not mutually exclusive—a strong economy can certainly be one driver behind market outperformance. But solely using economic growth as a guide for portfolio allocation may just as often lead to trouble.

A better approach is to take a step back and consider emerging markets' role in the global economy. Economic development happens in several stages. Most societies are agrarian to start, largely for means of self-sustenance. Eventually, productivity increases enough for a society to specialize and trade for goods it has neither the skills nor the resources to produce. Over time, the country moves up the value-chain, developing a manufacturing base to produce more sophisticated goods.

This happened in the developed world at various stages throughout the eighteenth and nineteenth centuries—think of the US' humble progression from Pilgrim farmers to railroad magnates. The continuous fight for progress rarely slows, and many societies move further toward high-margin and knowledge-based services, such as banking or engineering.

Emerging markets are predominantly in the early stages of this development cycle. While many still cling to their agricultural past, most have recently industrialized, replacing the developed world as the source for lower-end manufacturing. This means emerging markets represent the beginning phases of the global economic production cycle and tend to be more sensitive to expectations of world economic growth.

The lesson for investors: Emerging markets tend to perform well when expectations of global economic growth are strong and underperform during downturns. So your expectations for emerging markets as a category should invariably include some evaluation of global growth expectations.

How does an investor possibly begin to evaluate something so broad? First, consider (though not necessarily heed) the consensus. Various organizations, such as the IMF and big brokerage houses, publish growth expectations. Get a feel for what they're saying and why. Ask yourself if you agree and why, and then brainstorm alternative scenarios. What do you think would surprise markets or cause an economy to deviate from the consensus? Feel free to be as creative as you like. Think aliens might invade Russia? Go ahead and jot it down.

Once you've thoroughly exhausted every conceivable option, go back and assign a probability to each of your scenarios. Don't feel pressured to be overly precise. Remember, investing isn't a certainties business—you're simply trying to objectively evaluate a range of possibilities. Do this often enough, and you'll notice your conclusions differ in some ways from the consensus. Even if it's a subtle difference, it can have important allocation implications. Imagine the consensus believes the global economy will grow like gangbusters, but you see it growing positively at an average pace. In this case, maybe you underweight emerging markets slightly because you believe there is a greater probability of downside surprise.

Beyond economic growth, the overall risk environment is another important driver for the emerging markets. Investors perceive emerging markets to be risky investments. This is warranted—returns are volatile and the political, economic, and social environments are often chaotic. Because of this added risk perception, emerging markets tend to perform in line with the overall risk environment—when investors are fearful, emerging markets underperform; when optimistic, they outperform. In other words, emerging markets act like high beta plays on global equities.

To see this at work, consider a recent example: The global bear market beginning November 2007. A full explanation of the events surrounding this period is beyond the scope of this book, but, broadly, the crisis began in the developed markets and emerging markets played little to no part. Unfortunately, that doesn't mean they were left unscathed—investors pummeled the category in tandem with developed markets from the start. This was an interesting phenomenon at the time, defying emerging markets' historic role as riskier, higher-beta plays on global equities (one would expect emerging markets to decline more). But strong fundamentals justified their relative resiliency: Economic growth remained robust, government officials built up war chests of foreign currency reserves in the preceding years, and monetary and fiscal policy was increasingly stimulative.

Figure 6.4. Emerging Market Relative PerformanceSource: Thomson Datastream, MSCI Inc.^[5]

Yet, as economic data from developed markets continued to darken, investors' overall perception of risk continued to follow suit. Even though fundamentals for many emerging market countries and securities remained solid, the overall risk environment deteriorated, and the category paid the price simply for what they generally were: risky assets. Figure 6.4 shows the marked turn in emerging markets' relative performance to developed markets at the beginning of 2008. Note how emerging markets traded sideways relative to developed markets at the start of the bear market (i.e., both categories were declining at roughly the same rate). By May 2008, emerging markets began to underperform considerably.

A related concept introduced in earlier chapters is worth reiterating. Contagion describes the transmission of a crisis across many countries, including those with no apparent fundamental link to its cause. Emerging markets are especially vulnerable to this behavior. As such, negative events in only a small handful of countries can weigh on the entire asset class.

Structural differences also drive performance for the emerging markets category. Table 6.4 illustrates the differences in sector weights between the developed and emerging markets. Aside from Information Technology, they are notably different.

Clearly, if you expected Health Care to lead the market in the period ahead, you'd also expect emerging markets to underperform. Likewise, if you were particularly bullish on global Telecommunication Services, you would expect emerging markets to outperform. Emerging markets are also more associated with commodities, as they have over 10 percent more weight devoted to the Energy and Materials sectors. If you are interested in learning about the drivers behind individual sectors, see the Fisher Investments On series.

In its formative years in the late 1980s and early 1990s, emerging markets was an esoteric asset class. A small group of early adopters sought exposure to an untapped segment of the equity universe and the low correlations and diversification that came with it. This is less true today. Emerging markets are increasingly integrated into the global economy and beginning to converge with developed markets. A dedicated allocation to emerging markets has become increasingly necessary for proper international equity exposure.

While the diversification benefits of emerging markets have decreased, the increased demand has made the asset class more accessible to investors. The introduction of American Depositary Receipts (ADRs) gave the average US investor access to securities previously only available to institutional investors with contacts in local markets. More recently, the increasing availability of exchange-traded funds (ETFs) has given retail investors the ability to acquire exposure to the entire category with one security. Financial innovation will surely persist, and the further lowering of barriers to investment will continue to contribute to emerging market demand relative to other categories.

Often, a trend across several countries can drive performance for the broader category. In the early 2000s, for instance, emerging markets on balance enacted pro-growth reforms and reduced tax burdens. In 2002, South Korea offered tax breaks and other incentives to investors in an effort to attract capital—companies investing more than $50 million in the country received exemptions from corporate and income taxes for an extended period.^[186] Many other countries introduced similar investor-friendly measures, and, taken together, this trend represented a driver for the category as a whole.

Most economic data come from government sources and are often publicly available for free on the Internet. These websites offer information from interest rates to banking statistics to gross domestic product figures. Because not every organization produces the same set of figures across all countries, you may have to do a little bit of digging. For instance, Malaysia's inflation rate comes from the Department of Statistics Malaysia (www.statistics.gov.my/eng/), while Mexico's inflation rate is tracked by the country's central bank, Banco de Mexico (www.banxico.org.mx/sitioIngles/index.html).

If you don't know which government agency produces the data, look for a press release or newswire story on the subject. Most articles cite what source the data came from, as in "Mexico's consumer prices rose in February, according to the central bank," or something similar. Data can often be easily downloaded too, allowing you to track them over time or plot them out on a graph. And no need to fret language barriers—virtually every website these days offers an English-language version.

Data don't just come directly from the government. There are myriad third-party sources that either compile their own data or reinterpret figures from national sources. Two great resources, which are used extensively throughout this book, are the International Monetary Fund (IMF) and World Bank. The data may not be as timely as some of the figures offered by the government, but they can be invaluable when evaluating history or attempting to quickly glean high-level trends.

The IMF's World Economic Outlook Database (www.imf.org/external/data.htm), updated a few times a year, offers annual data on important figures, such as inflation, gross domestic product, and the current account balance. The World Bank complements these data with other statistics such as external debt and population growth (www.worldbank.org, see "Key Development Data & Statistics"). In addition to hard data, these sources also offer topical research papers and in-depth studies for those particularly inclined to get their hands dirty.

We'll touch on this a bit more in Chapter 7 when discussing security analysis, but a company's filings can also offer insight into a country's investment environment. Unfortunately, reporting standards are quite a bit more lax in emerging markets compared to the developed world. But many emerging market companies are increasingly becoming big, global players with secondary listings or ADRs on developed market exchanges, subjecting them to the higher regulatory and reporting standards of developed markets.

Staying on top of day-to-day news is critical to the proper monitoring and development of portfolio drivers. If you don't pay attention to what's going on in the world, you can't possibly know if your drivers remain valid and risk new drivers passing by unnoticed.

Luckily, remaining informed is easier than ever before—there are almost too many choices. We suggest spreading your time across several different news sources to get different points of view. For general financial developments, a major daily such as the Wall Street Journal or Financial Times is highly recommended. Longer-dated periodicals such as the Economist or BusinessWeek are also worth occasional perusal. A variety of other sources provide a mix of commentary and just-the-facts reporting, such as Bloomberg.com, Reuters, BBC (British Broadcasting Company), and the like. And most emerging countries have a major daily rag in English that can offer a unique perspective, such as South Africa's Mail & Guardian or China's China Daily. Read through as many different sites as you can until you get a feel for the ones that offer the best content for your purposes. And change it up! Too many investors become habituated to the same columnists and editors; your job as an investor is to ascertain the right information and what the consensus believes.

A common concern when investing in emerging markets is the credibility of published information. Because of weaker reporting standards and lower levels of ethical conduct, the data from emerging market nations often need to be taken with a liberal shaking of salt.

This highlights the value of diversifying your information sources. First, if the data are suspect, you're likely to read about it in the press. For example, it is widely understood that Argentine inflation figures are fudged by the government.^[188] Second, third-party providers will often adjust their estimates for such inconsistencies.

Certainly, data credibility issues make it more difficult to objectively assess emerging markets. Unfortunately, there is no way to completely circumvent potential issues—it remains an inherent risk to investing in the category. But remaining diligent and inquisitive in your information gathering should help you stay ahead.

Chapter Recap

• Identifying portfolio drivers begins with an analysis of three broad categories of factors: economics, politics, and sentiment.

• These factors work across all categories of stocks, but the drivers within them will vary considerably depending on both place and time. (See the questions provided in this chapter to get a better understanding of what to look for in emerging markets.)

• This framework can also be applied to emerging markets as a category, although several key factors play particularly important roles at this level (like economic growth and the overall risk environment).

• Obtaining the required information to develop drivers is easier than ever. Investors can access a variety of websites—from government data sources to third-party newswires—with a simple Internet connection.

• Data quality issues remain, but diligent investors can navigate with little trouble.