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The New Frontiers of Global Investing

Dear Subscribers,

According to a recent Associated Press article, the Indian IT industry is once again experiencing growing pains, as the country is quickly running out of qualified workers to fill the necessary jobs in the IT industry. Sure, Indian schools currently graduate as many as 400,000 engineers every year, but according to experts such as Mohandas Pai, human resources chief for Infosys Technologies, only about 100,000 or so are ready to join the IT workforce. Quoting James Friedman, an analyst at Susquehanna Financial Group that has studied the issue: ""When we first started covering the industry, in 2000, there were maybe 50,000 jobs and 500,000 applicants. Now there are perhaps 180,000 annual openings, but only between 100,000 and 200,000 qualified candidates." In order to combat this shortage, many companies in India (such as Infosys and IBM) are building "finishing schools" or programs to help Indian graduate brush up their jobs skills - and while they are having initial successes, things are getting more uncertain as time goes on. For this year, the Indian IT industry will most probably hold up - but if the Indian IT labor pool does not see an improvement as early as next year, we could potentially see skyrocketing wages and a shift towards other overseas markets, such as the Philippines, Ireland, and so forth.

At the same time, however, this is no time to be resting on your laurels. Because while the cost of operating call centers and software companies may be rising in India, this is not the case just yet for "front-office work" such as investment banking, drugs development, aircraft design, and so forth. For example, Cisco has now mandated that as many as 20% of its "top talent" should be located in India within five years. IBM has shrunk its U.S. workforce by 31,000 since 1992 and increased its Indian workforce from 0 to 52,000 during the same time period. Meanwhile, 600 of Citigroup's stock analysts were hired in India. For folks that have PhD or MBA aspirations at a top 50 school, this is now the time to get one.

Before we begin our commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,227.13 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,107.13 points

In our mid-week commentary, I discussed the highlights of the IMF's latest Global Financial Stability Report - namely, what the IMF sees in terms of short to intermediate term risks (these were all covered in Chapter 1 of the document), such as the deteriorating conditions in the U.S. housing market, the increasing leverage and complacency in the global LBO industry, global "imbalances" such as the U.S. current account deficit and the Yen carry trade, and so forth. What I did not discuss, however, was the potential risks in the emerging markets countries as seen by the IMF. Make no mistake: Emerging market countries as a whole have increased their shares of their global pie over the last five years - and any "hiccup" in those countries will also have a significant impact on the U.S. and other developing countries as well - whether it is in decreased sales of Fortune 500 companies, investor losses, or just an increase in the general aversion of risk. Fortunately for the bulls, the risks - as evaluated by the IMF - in emerging market countries as a whole have "broadly declined" since the release of the last Global Financial Stability report last September. Quoting the IMF:

[This view is] supported by the benign global economic outlook, improved macroeconomic performance, and improving sovereign debt profiles. Investor flows to EMs have increased and demand has broadened, not just for external debt, but for local-currency denominated assets ... The positive global outlook, including generally high levels of commodity prices in recent years, continues to provide a supportive backdrop for emerging markets and should allow for continued export-led growth. In addition, EM vulnerabilities have broadly continued to decline.

The decline in these "vulnerabilities" can be witnessed in the following graph showing: 1) the decrease in gross public debt since 2002, 2) the increase in reserve cover since records have been kept, and 3) the improvement in the fiscal balance (as a percentage of GDP) since 2002:

Indicators of External Vulnerability in Emerging Markets

Moreover, with the exception of countries such as Ecuador, Thailand, and Venezuela, government and local central bank policies have generally been constructive on improving the credibility of emerging market countries. This was evident in countries such as Turkey, South Africa, and Hungary. Quoting the IMF report:

Policy credibility continued to recover in Turkey following the central bank's sharp tightening of monetary policy in June and July 2006, and efforts to improve policy communications. In South Africa, the Reserve Bank's steady tightening of monetary policy helped consolidate market stability. In Hungary, market perceptions that fiscal policy was becoming increasingly credible helped restore investor confidence, leading to record levels of nonresident holdings of forint-denominated assets in late 2006.

More importantly - unlike investors' reactions and perceptions during the 1990s and into the Argentine Crisis of 2002, much of the negative reactions have been confined to the countries concerned (such as Thailand). This was not surprising, as EM sovereigns aggressively retired external debt in 2006 - and sovereign external debt flows, including coupon payments, are expected to be negative during 2007. Together, this resulted in a further rise in EM credit ratings to just slightly below BB+, representing a one-notch increase since the end of 2004. Finally, sovereign credit rating upgrades by Moody's and S&P outpaced downgrades in 2006 for the 5th year in a row, with 38 upgrades vs. only two downgrades. The improvement in EM credit quality is illustrated in the following chart from the IMF report:

Emerging Market Credit Quality Index

Not everything is perfect, however. The purpose of the "Global Financial Stability" publication is to illustrate potential systematic risks - so the IMF will go to any lengths to "dig up" any potential trouble spots. Again, quoting the IMF:

However, as investors move further out along the risk spectrum, such [foreign] flows pose new challenges for policymakers, requiring concomitant advances in financial market development and regulation. Two recent developments highlight the need for these advances. First, a rapid expansion of corporate debt issuance in emerging Europe, led by domestic banks, is contributing to rapidly expanding credit in some countries. Second, as investors seek out "new frontiers" in EMs, recent inflows into local government securities of some countries in sub-Saharan Africa have exposed those markets to risks of reversal.

In discussing the rapid corporate debt issuance in emerging Europe, the IMF specifically brings up the examples of Kazakhstan and Russia, where corporate bond issuance (mainly from banks) is supporting rapid growth in loans to the private sector. Moreover, the majority of these loans are only BB rated - and both capital adequacy in these two countries are either low or declining. Another issue is that the majority of these loans are not denominated in the local currency - thus increasing foreign currency exposure (remain when many Thai companies found out that they were up to their eyeballs in debt simply because the Thai Baht crashed in the midst of the Asian Crisis in 1997?). However, much of these risks may be offset by the continuing economic growth in these two respective countries and generally low leverage ratios. Given that banks account for a significant proportion of this new EM corporate debt issuance, the IMF is currently mainly concerned with the adequacy of bank regulation and supervision in these countries.

Meanwhile, the second concern of the IMF is most probably not "systematic" in nature from a global standpoint, but it is definitely of concern to those countries that can be classified as the "new frontiers" - or in other words, many of the countries that are currently booming in sub-Saharan Africa, with the exception of South Africa. This is the main topic of our commentary today (yes, finally).

Ever since the proposal of the "Multilateral Debt Relief Initiative" in June 2006 by the G-8 countries, investors have come to recognize that many of the countries who initially qualify for this relief (March 2007) will receive significant one-time boosts to both fiscal and political stability. Indeed, two countries that initially qualified - Zambia and Ghana - have also benefited hugely from high commodity prices. Combined with the fact that many of these markets remain uncorrelated with the more liquid emerging markets, there is no doubt that they have now become very attractive places to invest. As stated in the IMF report:

Portfolio investors have become increasingly active, especially in local currency debt markets, led by dedicated EM hedge funds and institutional investors. A trading volume survey by the Emerging Market Traders Association (EMTA) shows sub-Saharan debt trading volume reached $12.7 billion in 2006, nearly double the volume in 2005 ... Meanwhile, the ability of foreign investors to access the region's markets has improved as an increasing number of the region's assets can now be settled via Euroclear, lowering transaction costs. Prior to 2006, only the South African rand among sub-Saharan African currencies was a settlement currency within Euroclear. In 2006, seven additional sub-Saharan currencies were added.

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