Thursday, April 4th, 2013
April 3, 2013
by Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research
• Emerging markets have great promise—but we see constraints on future growth in large EM economies, and stocks have underperformed recently.
• Meanwhile, inflation is stubbornly high in several large countries, which could result in monetary tightening that further slows growth.
• We are cautious on emerging markets as an asset class, and see better opportunities in developed markets such as Europe and Japan.
The large emerging-market economies of Brazil, China and India have run into growth, inflation, and structural challenges. Combine that with a potential peak in commodity prices that could damage heavy commodity exporters such as Brazil, South Africa, Russia, Indonesia and Chile, and we see reason to be cautious on emerging markets (EM) as an asset class.
High economic growth doesn’t assure strong stock performance
Just five years ago, emerging markets, including the BRIC sub-group (Brazil, Russia, India and China) showed great promise. Chinese and Indian incomes were growing; Brazil and Russia boasted abundant and valuable natural resources; and low government debt and high levels of foreign exchange reserves in many emerging markets seemed to pave the way for rapid growth.
Emerging-market growth steps down
Source: FactSet, IMF. Estimates used after vertical line are as of Oct. 2012, World Economic Report database.
Unfortunately, growth rates have taken a noticeable step down, and emerging-market stocks have underperformed over the past two years. Some investors have held on to emerging-market allocations on the premise that the growth outlook for these countries remains above that in the developed world.
Paradoxically, higher economic growth doesn’t always equate to the best investment returns—academic research suggests no clear correlation. While stronger economic growth creates the potential for greater sales growth, high earnings per share and dividend growth don’t necessarily follow. Profits can suffer if wages rise faster than productivity increases. Weak corporate governance can reduce returns when profits are expropriated rather than passed along to shareholders. Additional capital can be needed to sustain high growth, which can reduce shareholder returns.
The role of expectations and valuations is also very important. High growth expectations can be accompanied by high valuations, resulting in future underperformance—the good news is priced in. We believe that missed growth expectations in emerging markets are the likely culprit for the underperformance over the past two years.
Emerging market growth may have difficulty improving
So are expectations now low enough to get in? We view valuation as an important basis for future performance, but not the only factor. We are cautious on emerging markets (EM) as an asset class due to growth constraints for 60% of the weight in the universe, as defined by the MSCI Emerging Market Index. We believe addressing these constraints could involve difficult transformations or decisions by policymakers in the largest countries.
• A combination of stagflation and structural issues in the large emerging market economies of Brazil, China and India, which represent 40% of the MSCI Emerging Market Index.
• Commodities are potentially peaking, which represents roughly 20% of the MSCI Emerging Market Index, excluding Brazil (included above).
China: Still growing, but sources are suspect
Construction spending has been the primary driver of China’s economic growth in recent years, but it was fueled by a massive issuance of debt, which grew at 30% of GDP for four straight years. That rate of growth can’t continue forever, so we think property and infrastructure construction will likely slow from the rapid pace of the past. Additionally, the overhang of debt could result in a credit crunch that reduces growth for the overall economy.
China’s government is trying to transition to a more consumer-led economy, which will likely be an eventual positive for consumer spending—but we could see policy mistakes and uneven economic progress along the way. It’s much harder for a government to control consumer spending than it is to order new infrastructure construction or command a state-owned company to build another factory. Wages are rising, which benefits consumers, but sales and labor productivity are slowing, constraining corporate profits. Corporations have had difficulty with pricing power.
Additionally, China has a host of challenges related to the growth of its shadow banking sector. See more in “China’s Hidden Risks: Shadow Banking and US Delisting” and “Avoid China – Subprime-Like Bubble Brewing.”
China’s debt-fuelled growth potentially unsustainable
Source: FactSet, People’s Bank of China, Bloomberg. In current dollars using the December 31, 2012 exchange rate. Total credit as measured by total social financing. As of January 29, 2013.
Brazil: Stressed consumers and government bureaucracy
Brazil’s economy relies heavily on consumers, who represent 60% of GDP—and right now, consumers are challenged by inflation and high levels of household debt.
Inflation in Brazil accelerated to 6.3% in February and has exceeded the central bank’s 4.5% target for more than two years. The country’s tight labor market could further propel inflation. With flagging productivity gains and low unemployment, employers won’t find it easy to get more productivity out of the existing workforce or hire lower-wage workers—which means that rising wages may be next. This is good for workers, but often leads to accelerating inflation.
Additionally, the rapid growth in consumer credit that helped to fuel Brazil’s economy in recent years may now be waning. Brazil’s households spend roughly 20% of their disposable income servicing debt, compared to 14% at the peak for the US consumer in 2007, according to Capital Economics. With consumers spending so much money servicing debt, there’s little disposable income left over for new consumption.
Brazil’s consumers are tapped out on credit
Source: FactSet, Banco Central do Brasil, Bloomberg. As of March 15, 2013. *Household debt is the sum of consumer loans outstanding and housing loans outstanding.
On the business side, government bureaucracy and increased interference in the private sector has created a difficult operating environment—particularly for the two largest stocks in the Bovespa Index, as well as utilities and banks. For example, the government limited the price Petrobras could charge for petrol fuel in order to dampen inflation—but this reduced profits for the oil company. Meanwhile, Brazil’s central bank has pursued a somewhat volatile monetary policy. It has overshot at times, creating volatility in both growth and inflation, and has instituted controls that limit foreign investment.
India: Reforms needed, but hopes fading
Economic growth in India has roughly halved from the 9-10% range in the late 2000s to a 4.5% annualized rate as 2012 ended, well below the country’s 8% growth goal. From a funding perspective, India suffers from both a large fiscal deficit and the need for foreign investment due to low savings rates. Therefore, reforms to reduce fiscal spending and attract investment are important to reinvigorate growth.
India’s fiscal deficit expected to worsen before it improves
Source: FactSet, Bloomberg, India Central Statistical Organization. Estimates used after vertical line are provided by India Central Statistical Organization. As of March 15, 2013.
The fiscal budget released in February 2013 was a disappointment for investors hoping for reforms. The budget projected optimistic revenue increases and placed a greater tax burden on corporations, but lacked reforms to spending, preserving populist measures such as costly fuel, food and fertilizer subsidies. Reforms to open the economy to competition announced in 2012 were a positive first step, but momentum has stalled and the possibility of progress ahead of elections in April 2014 is fading.
Meanwhile, inflation is stubbornly high due to swings in food prices, which constitute a large portion of consumer spending. This volatility is the result of supply bottlenecks that stem from insufficient power and warehouse facilities, low agriculture yields, an inefficient public food-distribution system and dependence on the unpredictable monsoon season for irrigation.
Commodity prices may be peaking
As emerging-market economies continue to build out infrastructure and housing, they’ll support demand for commodities such as industrial metals and construction materials. However, the pace of demand growth is likely to slow. China constitutes 40% of demand for many commodities right now, and we expect slower growth in future demand from China as construction of infrastructure and property slow. We don’t see any countries that could replace China as a major commodities consumer—both Brazil and India are potential candidates, since they appear to need large investments in infrastructure, but government bureaucracies and lack of funding are barriers to progress.
Revenues for commodity producers are a function of both demand (where we expect slower volume gains) and prices. Prices of some commodities may have difficulty increasing, as demand growth in the past was met with significant increases in supply. Stagnant commodity revenues could be a challenge to economic growth for the commodity-oriented emerging economies of Brazil, South Africa, Russia, Indonesia and Chile.
Commodity prices have yet to gain traction
Source: FactSet, Commodity Research Bureau. As of March 15, 2013.
Monetary policy may tighten
In Brazil, central bank chief Alexandre Tombini said in February that he was “uncomfortable” with current inflation levels and that the bank will not hesitate to raise rates. At its March 6 meeting, the central bank removed the language (used since October) that it would maintain monetary policy for a “prolonged period of time,” suggesting it has shifted its priority from encouraging growth to fighting inflation. Brazil was the first major emerging-market country to ease in August of 2011, and its moves could be reflective of broader trends.
Inflation still a concern in Brazil and India
Source: FactSet, IBGE, Indian Ministry of Labor. As of March 15, 2013.
In China, Governor Zhou of the People’s Bank of China (PBoC) noted in March that China should be on “high alert” as inflation could accelerate later this year. As a result, monetary policy in China is now in “neutral” territory, and the next move for the PBoC is more likely to be tightening than easing.
Attractive valuations, but disappointing earnings
In a fourth straight quarter of disappointing results, more than 59% of companies in the MSCI BRIC Index reported quarterly earnings that trailed analyst estimates, while profits rose less than 1%, according to Bloomberg. Earnings estimates for emerging markets may still be overly optimistic, as economic growth continues to come in below expectations.
Consumers in some countries (such as Brazil) and other borrowers (such as local governments in China) appear tapped out on credit, and without credit to help fuel consumption we may see slower economic growth. Additionally, rising labor costs in many emerging markets could put a damper on corporate profits. While valuations appear attractive relative to historical averages, lower growth and potentially unmet estimates will likely necessitate lower valuations until these trends turn around.
As long as China’s economic reacceleration continues, emerging-market investments could benefit in the short term. However, we believe longer-term investors may want to consider re-orienting international exposure away from China and emerging markets and toward developed international markets. Earnings in non-US developed markets such as Europe and Japan have been cut quite dramatically, and economic data has shown steady (albeit modest) improvement. Additionally, valuations in Europe and Japan look low relative to historical averages, so stocks in these markets could be a relative bargain.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers are obtained from what are considered reliable sources. However, accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
The MSCI BRIC Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the following four emerging market country indices: Brazil, Russia, India and China.
The Bovespa Indexis comprised of the most liquid stocks traded on the Sao Paulo Stock Exchange, and serves as the main indicator of the Brazilian stock market’s average performance.
Copyright © Charles Schwab and Co.
Tuesday, September 25th, 2012
by Neuberger Berman Investment Strategy Group
The “BRIC” countries have been a focal point of investor interest since the early 2000s. Brazil, Russia, India and China account for about half of the world’s population, boast vast natural resources and are among the fastest-growing economies in the world. That said, progress at times has been uneven. Since 2010, the MSCI BRIC Index has largely underperformed the S&P 500 as economic growth flagged. In this edition of Strategic Spotlight, we discuss current conditions and the outlook for these markets.
Following the global financial crisis of 2008–2009, the BRIC countries enjoyed a strong economic rebound as forceful policy measures reignited growth. However, a surge in capital inflows stoked inflation and led to tightening measures in 2010 and 2011. Currently, the BRICs are experiencing varying stages of easing as growth and inflation decline. Unlike the synchronous rebound we saw in 2009, progress in the BRIC countries is diverging due in part to idiosyncratic policy initiatives aimed at managing structural changes within their specific economies.
BRIC GROWTH RATES HAVE SLOWED
Brazil’s real GDP growth declined from 9.3% in the first quarter of 2010 to 0.5% in the second quarter of 2012—a number that disappointed investors looking for 3.5% GDP growth for all of 2012. The slowdown is partly a function of so-called macro-prudential measures—meant to fight inflation and control the appreciation of the real currency due to capital inflows—as well as a slowdown in exports. The tightening measures have had the desired impact of reducing inflation from 7.2% from last September to 4.1% in August 2012, but have also caused investment spending to plummet as the outlook for commodities (a key sector for Brazil) deteriorated. Domestic consumption, which accounts for about 60% of Brazilian GDP, has held up surprisingly well, supported by the country’s still-low unemployment rate.
Since the end of 2011, the Brazilian central bank has reduced interest rates, complementing the government’s recent accommodative fiscal measures such as payroll tax cuts. The OECD expects growth to pick up gradually in the third quarter as these measures work through the system.
Russia: The Limitations of Oil
The Russian economy has held up reasonably well in the past few years despite turmoil in Europe. Since the end of June 2012, real GDP has grown at around 4% annually, which is close to the post-crisis peak of around 5% in 2010. This good fortune is mainly due to relatively high oil prices and, most recently, fiscal spending ahead of the presidential elections in March 2012. Unlike Brazil, Russia is grappling with rising inflation as record-low unemployment has supported wage growth. In September, the country’s central bank surprised investors by hiking interest rates as inflation had come in above the bank’s target range of 5%–6%.
For the most part, Russia’s domestic consumption has been strong but the impact of declining oil demands from key trading partners such as Europe and China could have spillover effects—weakening the outlook for budget and current account balances. Concerns about an overheating economy have led to predictions that further tightening measures could be introduced, marginally reducing growth in 2013.
PERFORMANCE AND VALUATIONS
Source: FactSet as of Sept 17, 2012.
Despite a year-to-date equity market return of about 20% (see display), India’s real GDP growth continuously slowed to about 4% in the second quarter—a level last seen during the crisis of 2008–2009. Declining global growth, reductions in foreign investments and monetary tightening measures have contributed to a slowdown in manufacturing and services. In June, government agencies reported that foreign direct investments had decreased by as much as 67% from a year ago, as economic reforms stalled and business conditions were increasingly viewed as being biased against foreigners.
In addition, India is dealing with rising consumer price inflation, as recent cuts in government fuel subsidies and the effects of the monsoon season feed through the system. Consumer price inflation ramped up to 10% in August, reducing the scope for further rate cuts by the Reserve Bank of India. Moreover, warnings of a downgrade have been issued by rating agencies, given that India’s government finances are weaker than other BRIC countries. Investors are closely watching reform measures designed to promote competition and improve market efficiency following the decision last week to expand foreign companies’ access to the retail and airline industries.
China: Political Transitions
Recent data indicate that China continues to slow from tightening measures enacted in 2010–2011 and a decline in exports. Investors have been somewhat surprised by the government’s passivity toward this slowdown. Following small cuts in interest rates and reserve requirement ratios earlier in the year, the People’s Bank of China (PBoC) has not done more despite inflation dipping below its 3%–4% target. And while most analysts did not expect a repeat of the 2008–2009 RMB 4.0T fiscal stimulus, the government has acted less forcefully than expected.
The failure to act could be a result of widely reported complications in the current once-in-a-decade change to the country’s political leadership. Moreover, the PBoC could be concerned about magnifying the inflationary impact of loose monetary policy in developed countries. The political transition is expected to conclude by March 2013, potentially paving the way for better policy engagement. Regardless, the IMF expects China’s growth to reaccelerate next year.
A More Nuanced Progression
In the past decade, the BRIC countries have experienced rapid growth, but are now showing signs of slowing down as cheap labor and abundant resources are beginning to yield a diminishing impact on their economies. As such, investors should consider looking towards the rising middle class to lead the charge in driving growth.
Before we reach that point, however, we believe some structural reforms will need to be made. Investors should remain vigilant of the various policy prescriptions during this period to avoid potential speed bumps. Not every policy change will be successful, but if imbalances are adequately addressed, the BRIC countries should continue to offer investment opportunity.
This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. The views expressed herein are generally those of Neuberger Berman’s Investment Strategy Group (ISG), which analyzes market and economic indicators to develop asset allocation strategies. ISG consists of five investment professionals who consult regularly with portfolio managers and investment officers across the firm. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. This material may include estimates, outlooks, projections and other “forward-looking statements.” Due to a variety of factors, actual events may differ significantly from those presented. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
Monday, September 24th, 2012
Submitted by John Aziz of Azizonomics
The Next Industrial Revolution
Large, centrally-directed systems are inherently fragile. Think of the human body; a spontaneous, unexpected blow to the head can kill an otherwise healthy creature; all the healthy cells and tissue in the legs, arms, torso and so forth killed through dependency on the brain’s functionality. Interdependent systems are only ever as strong as their weakest critical link, and very often a critical link can fail through nothing more than bad luck.
Yet the human body does not exist in isolation. Humans as a species are a decentralised network. Each individual may be in himself or herself a fragile, interdependent system, but the wider network of humanity is a robust independent system. One group of humans may die in an avalanche or drown at sea, but their death does not affect the survival of the wider population. The human genome has survived plagues, volcanoes, hurricanes, asteroid impacts and so on through its decentralisation.
In economics, such principles are also applicable. Modern, high-technology civilisation is very centralised and homogenised. Prices and availability are affected by events half way around the world; a war in the middle east, the closure of the Suez Canal or Strait of Hormuz, an earthquake in China, flooding in Thailand, or a tidal wave in Indonesia all have ramifications to global markets, simply because of the interconnectedness of globalisation. The computer I am typing this into is a complex mixture — the cumulative culmination of millions of hours of work, as well as resources and manufacturing processes across the globe. It incorporates tellurium, indium, cobalt, gallium, and manganese mined in Africa. Neodymium mined in China. Plastics forged out of Saudi Crude. Bauxite mined in Brazil. Memory manufactured in Korea, semiconductors forged in Germany, glass made in the United States. And gallons and gallons of oil to ship all the resources and components around the world, ’til they are finally assembled in China, and shipped once again around the world to the consumer. And that manufacturing process stands upon the shoulders of centuries of scientific research, and years of product development, testing, and marketing. It is a huge mesh of interdependent processes. And the disruption of any one of these processes can mean disruption for the system as a whole. The fragility of interconnection is the great hidden danger underlying our modern economic and technological paradigms.
And even if the risks of global trade disruptions do not materialise in the near-term, as the finite supply of oil dwindles in coming years, the costs of constantly shipping so much around and around the world may prove unsustainable.
It is my view that the reality of costlier oil is set over the coming years to spur a new industrial revolution — a very welcome side-effect of which will be increased social and industrial decentralisation. Looming on the horizon are technologies which can decentralise the means of production and the means of energy generation.
3D printers — machines that can assemble molecules into larger pre-designed objects are pioneering a whole new way of making things. This could well rewrite the rules of manufacturing in much the same way as the rise of personal computing discombobulated the traditional world of computing.
3D printers have existed in large-scale industry for years. But at a cost of $100,000 to $1m, few individuals could ever afford one. Fortunately, improved technology and lowered costs are making such machines more viable for home use. Industrial 3D printers now cost from just $15,000, and home versions for little more than $1,000. Obviously, there are still significant hurdles. 3D printing is still a relatively crude technology, so far incapable of producing complex finished goods. And molecular assembly still requires resources to run on — at least until the technology of molecular disassembly becomes viable, allowing for 3D printers to run on, for example, waste. But the potential for more and more individuals to gain the capacity to manufacture at home — thereby reducing dependency on oil and the global trade grid — is a huge incentive to further development. The next Apple or Microsoft could well be the company that develops and brings home-based 3D printing to the wider marketplace by making it simple and accessible and cheap.
Decentralised manufacturing goes hand-in-hand with decentralised energy generation, because manufacturing requires energy input. Microgrids are localised groupings of energy generation that can vary from city-size to individual-size. The latter is gradually becoming more and more economically viable as the costs of solar panels, wind turbines (etc) for energy generation, and lithium and graphene batteries (etc) for home energy storage fall, and efficiencies rise. Although generally connected to a larger national electricity grid, the connection can be disconnected, and a microgrid can function autonomously if the national grid were to fail (for example) as a result of natural disaster or war.
Having access to a robust and independent energy supply and home-manufacturing facilities would be very empowering for individuals and local communities and allow a higher degree of independence from governments and corporations. Home-based microgrids can allow the autonomous and decentralised powering and recharging of not just home appliances like cooking equipment, computers, 3D printers, lights, and food growing equipment, but also electric vehicles and mobile communications equipment. Home-based 3D printing can allow for autonomous and decentralised design and manufacturing of useful tools and equipment.
The choice that we face as individuals and organisations is whether or not we choose to continue to live with the costs and risks of the modern globalised mode of production, or whether we decide to invest in insulating ourselves from some of the dangers. The more individuals and organisations that invest in these technologies that allow us to create robust decentralised energy generation and production systems, the more costs should fall.
Decentralisation has allowed our species to survive and flourish through millions of years of turbulent and unpredictable history. I believe that decentralisation can allow our young civilisation to survive and flourish in the same manner.
Tuesday, September 18th, 2012
The last two quarters we have seen quite a deceleration in S&P 500 earnings – in fact the S&P 499 has been flatlining. But Apple has a massive out sized effect on earnings (and hence supporting S&P 500 earnings growth). The NYT has a piece out this morning where they extrapolate a potential negative growth rate on said earnings, even with Apple. With export revenues hurt by Europe and to a lesser degree “emerging markets” (China, India, Brazil, et al) and profit margins falling from record highs, this is definitely an issue. That said stock prices are part earnings and part multiples – multiples are always an unknown; we saw how high they could get in 1999 when Uncle Alan flooded the world with liquidity ahead of Y2K.
- Wall Street analysts expect earnings for the typical company in the S.& P. 500 to decline 2.2 percent in the third quarter from the same period a year ago, according to Thomson Reuters, the first such drop since the third quarter of 2009. Earnings are expected slide 3 percent from the second quarter of 2012.
- “A lot of the profit gain you had in the last few years was a bounce from the recession and a result of very aggressive cost-cutting,” said Ethan Harris, chief United States economist at Bank of America Merrill Lynch. “Those factors are going to be very hard to replicate.”
- What is more, 88 companies have already said that results will come in below expectations; 21 that have signaled a positive outlook, said Greg Harrison, corporate earnings research analyst at Thomson Reuters. “That’s much more pessimistic than normal,” said Mr. Harrison, who added that the third quarter of 2001 was the last time that earnings guidance leaned so heavily to the downside.
- After rising steadily in the wake of the recession, profit margins for S.& P. 500 companies peaked at 8.9 percent in late 2011, said David Kostin, chief United States equity strategist at Goldman Sachs. Margins are expected to fall to 8.7 percent in 2012. (still a great figure)
- While profit margins have plateaued in corporate America, productivity gains in the overall economy have ebbed as well. After rising at an annual rate of 2.9 percent in 2009, and a 3.1 percent pace in 2010, productivity inched up 0.7 percent in 2011, according to the Bureau of Labor Statistics. “There’s only so much you can cut,” said Chad Moutray, chief economist at the National Association of Manufacturers.
Saturday, September 8th, 2012
The Economy and Bond Market Radar (September 10, 2012)
Treasury yields rose this week, largely in anticipation that the employment report released on Friday would be good news. The employment report showed non-farm payrolls growing a meager 96,000 and payrolls for the prior two months were revised down by 41,000. This was a poor report and well below analysts estimates, which improves the odds that the Fed takes action next week with another round of quantitative easing but Treasuries couldn’t recoup the loses suffered earlier in the week. Another factor at work was the ECB’s decision to implement unlimited European Union sovereign bond purchases out to three years. This action follows more than a month of building expectations and the ECB was able to follow through on its commitment to save the euro. This policy will give European governments more time to fix their fiscal situation.
- The ECB announced a sovereign bond purchase program this week which continues to solidify the reputation of the ECB as finally truly doing what it takes to adequately address the current crisis.
- U.S. auto sales rose by nearly 20 percent from a year ago with broad-based gains among most of the global auto makers. Auto production in Brazil rose 10.6 percent in August vs. July and sales rose 15.3 percent to a record 400,000 units, driven by tax cuts and lower borrowing costs.
- The ISM Non-Manufacturing Index rose and beat expectations for August, indicating expansion.
- The August employment report was weak and it is difficult to identify a near-term catalyst that will change that situation.
- The August ISM Manufacturing Index remained in contraction territory for the third straight month.
- Eurozone retail sales fell 1.7 percent in July and economic data coming out of Europe has been very weak.
- The ECB acted this week to address liquidity and confidence issues in the marketplace and the Fed appears likely to act next week on an additional round of quantitative easing.
- With further weak economic data out of China, odds of additional easing measures continue to move higher.
- Interest rates are likely to remain very low for the foreseeable future.
- Europe remains a wildcard with the markets shifting focus on a weekly basis.
- China also remains somewhat of a wildcard as the economy has slowed and officials appear in no hurry to take decisive action.
Saturday, September 1st, 2012
Energy and Natural Resources Market Radar (September 2, 2012)
- The U.S. oil-rig count rose for the first time in three weeks as crude futures breached $95 a barrel. The oil count increased by 11 to 1,419 rigs.
- International oil companies and sovereign wealth funds continue to see opportunities in the North American oil patch. The Globe and Mail reported that the Kuwait Petroleum Corporation may invest as much as C$4 billion for a joint venture to develop Athabasca Oil’s assets in Alberta.
- Despite a sluggish domestic economy, the Department of Energy’s latest report showed that June 2012 implied demand for gasoline and distillate were revised up 1.3 percent and 1.2 percent, respectively.
- Rusal announced it would be cutting 150,000 metric tons of capacity in light of continued pressure on aluminum prices and company performance. The cut represents roughly 4 percent of expected 2012 output and comes as part of a larger review of 275,000 metric tons of high-cost capacity. Further cuts could potentially be made in stages over the next several years and replaced with lower-cost capacity currently under construction in Siberia.
- Returns for very large crude carriers (VLCC) for the industry’s busiest trade route stayed negative for an eighth week as a lack of cargoes continues to persist. VLCCs are losing $6,389 daily from the Middle East to Asia route. Returns have now been negative since July 5.
- Iron ore prices fell to their lowest levels since 2009 on Thursday as a slowdown from top-consumer China dampens demand for the steel-making ingredient.
- Increased activity in the exploration and production (E&P) sector will be the primary driver in pushing oil and gas capital expenditure (capex) to an enormous $1,039 billion for 2012, states the latest report by GlobalData. The new report predicts that the total oil and gas capex will increase by 13.4 percent this year over the 2011 total of $916 billion, as oil companies intensify upstream operations across locations as diverse as offshore Brazil, the Gulf of Mexico and the Arctic Circle.
- Royal Dutch Shell will be allowed to begin some “limited” drilling in Alaska’s Chukchi Sea, the U.S. government said on Thursday, a move the company hailed as a step forward in its long-delayed effort to tap Arctic oil.
- Morgan Stanley says iron ore could decline as much as 16 percent from its lowest price in more than 2 years on slowing demand and rising stockpiles. Iron ore with 62 percent iron content was at $99.40 per ton on August 24.
- Downgrades to Chinese economic growth may bias oil demand growth prospects to the downside, which could weigh on crude oil prices.
Friday, August 31st, 2012
by Mark Hanna, Market Montage
I wrote about a week ago that China was acting quite poorly relative to what was happening in European and U.S. markets. I guess yesterday a brokerage report hit that said the same thing and now a host of pundits are waving it around as a bearish signal. It shows how quickly group think is created on Wall Street as long as it originates from a major brokerage house. Whatever the case, while the U.S. is in some form of strange holding pattern with holiday type volume and an extremely narrow range post August 3rd spike up, some key overseas markets are weakening along with China. Now some of these are resource focused (Russia, Brazil, even Chile) so as a lot of commodity plays sell off after their early month reversion to mean spike, the sector rotation seems to be creating a big tailwind for those countries.
India has been relatively stronger among the BRICs, although it too has had a rough week.
If anything it seems the U.S. continues to benefit from the best house in a bad block syndrome. However without semiconductors, transports, or commodities it will be hard for the other parts of the market to continue to levitate on their own. A lot of the steel, coal, et al stocks that surged post Draghi comments in late July have given up most of their gains already, as has the transports index. Here is an example of what I speak of – a massive rally which in hindsight seems to be short covering, and now giving up the ghost.
As for Jackson Hole tomorrow there seems to be a concentrated effort this week to “talk down” expectations for Bernanke’s speech. If that is in the market or not at this point, who knows but the focus seems to be switching to Draghi at the end of next week instead. The first week of the month is also the one with a heavy data set (PMIs, ISMs, employment report) so one assumes the current zombie like state of the market should finally change. Futures are pressured some this morning but again since the August 3rd jump and ensuing Monday follow through rally, the S&P 500 has gone nowhere – there has been rotation under the surface from one group to another week to week but little change at all on the top line indexes.
Copyright © Market Montage
Thursday, August 30th, 2012
The BRIC trade was one of the hottest trends of the mid-2000s, but it has been especially weak over the past few years. Today, the BRIC (Brazil, Russia, India, China) ETF broke below its 50-day moving average, so we have charted the year-to-date performance of the four countries that make up the ETF in the second chart below.
As shown, India is the only market that is outperforming the S&P 500 in 2012. India’s Sensex is up 13.17% vs. the S&P 500′s gain of 12.13%. Both Brazil (Bovespa) and Russia (RTSI) are barely in the green for the year, while China’s Shanghai Composite is down 6.65%.
Copyright © Bespoke Investment Group
Tuesday, August 28th, 2012
The impact of unsustainable production in Chinese Steel-making plants, to avoid the inevitable employment consequences, has created a ‘glut’. This excess inventory will need to be worked through before spot Iron Ore (and Coking Coal) prices can stabilize.
Morgan Stanley believes the sharp raw material price declines since mid-July followed a collapse in Chinese steel prices and aggressive margin compression. This was the result of continued weakness in demand and the over-production of crude steel, reflected in rising producer inventories. This is in turn has resulted in aggressive thrifting of raw material purchases. More recently, the price declines have accelerated with Chinese re-bar and HRC prices reaching 33-month lows.
In their view, prices of steel making raw materials can recover in 4Q 2012 and in 2013, but spot prices for both iron ore and coking coal first have to fall below the marginal cost of seaborne (not Chinese) production to drive out the short-term supply overhang. In addition, Chinese steel mills have to complete finished product and raw material de-stocking to stabilize both steel and raw material prices (if they are ever allowed to). Iron Ore prices could fall 17% further before this ‘stabilization’ and spot coking coal over 8% from current levels.
Spot Iron Ore and metallurgical coal prices…
Where will prices stabilize?
Our best estimate of where spot prices for iron ore and hard coking coal might bottom-out in this environment is one in which prices reflect levels that are below the marginal cash cost of the true seaborne market, not sellers of distressed or displaced cargoes in this environment, the price has to reflect a level that drives the seaborne sellers out of the market, albeit temporarily. At the same time, as the spreads between domestic and international prices widen (especially in the iron ore market), prices at levels below true seaborne marginal cost should also become sufficiently attractive to beleaguered Chinese mills to finally entice them back to the market, albeit on a small scale until steel prices stabilize. At the time of writing, with spot prices for 62% Fe fines CFR into North China at US$99.40/dmt, Australian net back prices on the IODEX platform for a capesize cargo, with an 8.03% moisture adjustment, are US$94.32/t, while Brazilian net backs are at US$82.60/t with a 9.0% moisture adjustment.
The global seaborne iron ore cost curve (ex-China), 2012
Worst case scenario – prices could overshoot below the seaborne marginal costs of around US$92/t DMT CFR. We think the true seaborne market (which excludes China domestic production) is driving current prices. Given that there could be as much 4Mt of displaced cargoes trying to find immediate buyers in this environment, we believe there is a possibility prices could overshoot on the downside.
Based on data from CRU Consultants, we estimate that on a business or cash equivalent basis, the 90th percentile of seaborne suppliers (ex-China) as a proxy for marginal cost is US$79/t on a FOB wet metric tonnes basis for two small Australian producers. At current spot freight rates and an average moisture content of 8%, this equates to an implied CFR price of US$92/t, some 7.7% below the current spot.
To highlight the very short-term risk of prices overshooting even below this level, we have assumed a potential further downside risk of 10% below this indicated price level, suggesting a possible floor in the price around US$82-83/t cfr North China for 62% Fe fines. At this level, prices would have fallen to the 86th percentile of current true seaborne costs, a level 16.9% below the current spot price.
Interestingly, at today’s spot price, the 4Q 2012 midpoint price is at US$93.25/dmt CFR DMT North China, slightly above the estimated level of the seaborne marginal cost. On the same basis of a potential overshoot 10% below estimated seaborne marginal cost, spot hard coking coal prices could fall as low as US$150-155/t fob North Queensland, indicating further potential downside of 5.2-8.3%.
Source: Morgan Stanley
Tuesday, August 28th, 2012
by Mark Hanna, Market Montage
It seems the only topic that currently matters to the market is central bank actions. The end of the week brings us the Jackson Hole, WY gathering of global financial policy makers at which Bernanke famously laid the groundwork for QE2 in 2010. Markets began one of their strongest runs since the March 2009 bottom, essentially running from September 2010 to February 2011 with only a break during November. However, as Bloomberg points out, the actual “easing” action didn’t come until after elections that year – in November. To further complicate things, we have Europe’s central bank in what seems to be a far more aggressive mode with Draghi at the helm versus Trichet. Both men have implicitly signaled something is coming with jawboning. The market has bought into it, and as I have stated in the past have almost backed the banks into a corner – i.e. “there is no turning back”. So it’s really about when, as much as what. And what is already “priced in”. Bloomberg has a bit of a less hopeful tone than Mr. Hilsenrath at the WSJ in terms of the potential for immediate gratification.
- Federal Reserve Chairman Ben S. Bernanke — returning this week to the scene of a 2010 speech that foreshadowed a second round of quantitative easing –probably will disappoint investors looking for him to signal new stimulus. Bernanke probably won’t use his Aug. 31 speech at the Fed’s annual symposium in Jackson Hole, Wyoming, to suggest a third round of bond buying is at hand, according to economists including Michael Feroli and James O’Sullivan.
- Two years ago, Bernanke said in his speech that the FOMC “is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly.” The committee didn’t announce a second round of quantitative easing at its September meeting, though; it waited instead until November 3 of that year. Markets rallied in the weeks after Bernanke’s 2010 remarks; “on the day, however, the speech was generally read as inconclusive,” O’Sullivan said. “Nor do we expect Mr. Bernanke to send a definitive signal this year.”
- “The Fed chairman’s Jackson Hole address has traditionallybeen used more for laying out broad themes than for sending specific policy signals,” said O’Sullivan, chief U.S. economist for Valhalla, New York-based High Frequency Economics, in an Aug. 27 report.
- “You can’t find a trader who doesn’t think Ben Bernanke is going to signal QE3 at Jackson Hole,” said Dan Greenhaus, chief global strategist for broker dealer BTIG LLC in New York. “But to have traders so convinced that this is a sure thing kind of screams there’s room for a letdown here.”
- Policy makers at the central bank have said they are prepared to provide new stimulus “fairly soon” unless they’re convinced the economy is poised to rebound, according to the minutes of the FOMC’s July 31-Aug. 1 meeting released last week. Bernanke sees “scope for further action,” he wrote in an Aug. 22 letter to California Republican Darrell Issa, chairman of the House Oversight and Government Reform Committee.
- Given the division among policy makers and mixed economic data, Eric Green, a former economist at the New York Fed, said Bernanke will want to use the symposium to clarify his views. The minutes from the last FOMC meeting “make Jackson Hole even more relevant because it will help resolve the tension between the Aug. 1 period, which preceded firmer data, and how the Fed is looking at things now,” said Green, now global head of rates and foreign-exchange research at TD Securities Inc. in New York. “The burden of proof is to see a sustained pickup in growth, and I don’t think we’re going to get that,” he said, predicting expansion in the third quarter will come in below 2 percent again. “The world will be looking for something very clear, and the odds are that he will deliver.”
- Bernanke isn’t alone in considering fresh aid for his economy. Joachim Fels, Morgan Stanley’s London-based chief economist, predicts central banks in the U.K., euro area, Sweden and Australia will ease monetary policy further, as will those in about 10 emerging markets, including China and Brazil.
- Mario Draghi, in his first year as president of theEuropean Central Bank, will participate in a Jackson Hole panel on Sept. 1, five days before he chairs a meeting of his Governing Council at which investors seek details of a plan to defend the euro region from surging bond yields. Draghi’s Aug. 2 pledge to craft the plan and declaration that the euro is “irreversible” were enough to drive a rally in Spanish and Italian bonds as investors bet the central bank will be able to quell the region’s debt crisis, now in its third year. The yield on 10-year Spanish government bonds fell to 6.42 percent on August 24 from a peak of 7.62 percent on July 24. Ten-year Italian bond yields were 5.71 percent compared with 6.6 percent in July.
- While Der Spiegel magazine this month reported the ECB is considering yield caps, economists at Goldman Sachs Group Inc. predict it will eschew explicit goals and instead intervene to keep market rates within a wide range. Draghi might wait until Germany’s Constitutional Court rules on the legality of Europe’s permanent bailout fund on Sept. 12 before unveiling full details of his plan, two central bank officials said last week.
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