Emerging Markets: Proceed with Caution (Gibley)

Thursday, April 4th, 2013

April 3, 2013

by Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key points

• 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.

Investment implications

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.

***

Important Disclosures

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.

Tags: Brazil, BRIC, BRICs, China, Emerging Markets, India, Russia
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Emerging Markets Radar (February 11, 2013)

Monday, February 11th, 2013

Emerging Markets Radar (February 11, 2013)

Strengths

• China January money supply (M2) was up 15.9 percent year-over-year, beating the market estimate of 14 percent. New January bank loans were Rmb1.07 trillion, or 15.4 percent year-over-year, better than the market expectation of Rmb1 trillion. Total Social Financing increased Rmb2.54 trillion versus Rmb1.63 trillion in December last year.
• China January exports were up 25 percent year-over-year, better than the market estimate of 17.5 percent; imports were up 28.8 percent, also beating the market expectation of 23.5 percent. In spite of belated January base effect last year, the number showed a positive trade trend which can drive up shipping rates and port throughput.
• China January Consumer Price Index was in line with the market expectation at 2 percent year-over-year, and the Producer Price Index was also in line with market expectation down 1.6 percent, which was improved from negative 1.9 percent in December, showing the demand recovery.
• China January passenger vehicle sales were up 49 percent year-over-year, primarily due to a lower base last year and higher demand prior to Chinese New Year which falls on February 10.
• Hong Kong loan and deposit (ex-Rmb) grew 9.6 and 8.8 percent in 2012. Annualized fourth quarter loan and deposit growth rose to 11.2 and 18 percent respectively, supporting a robust property market.
• China January HSBC service Purchasing Managers Index was 56.7 percent versus 51.7 percent in December, driving a strong service sector performance in H shares.
• Chilean exports surged 7.4 percent to $6.94 billion in January year-over-year on the back of increased demand for copper exports to China. The resulting $244 million trade surplus crushed analyst expectations for a $120 million trade deficit.

Weaknesses

• Increasing fears of government intervention in curbing the housing market had caused negative sentiment for developer stocks in Hong Kong listed H shares in spite of robust January sales and price increase.
• Indonesia 2012 GDP growth slowed to 6.2 percent versus 6.5 percent in 2011, primarily due to business unfriendly regulations and weak global commodity demand over the past year which dampened investment and consumption growth, though the economy is still robust.
• The Colombian government has suspended Drummond’s coal port operating license as it investigates the company’s responsibility in the dumping of a coal load into the ocean earlier this year. This added to the work stoppage at Cerrejon Mine, Colombia’s largest coal producer by output, has brought 80 percent of the country’s coal production to a halt. Colombia is the fourth largest coal exporter in the world with an annual output of 91 million tons.

Opportunities

• The chart above shows China January total social financing increased to a record high, indicating China’s investment demand is in momentum. Recent data also showed M1/M2 ratio is turning up after being on the down trend for most of 2012. This indicates that faster deposit growth allows the banks to lend more to the economy, confirmed by better-than expected January bank loans.
• Peru’s Central Bank President Julio Velarde has encouraged pension funds to increase their investments abroad in an attempt to devalue the sol from a 16-year high. The Finance Minister of Colombia has vowed to decrease U.S dollar borrowing in favor of local currency borrowing and to narrow the fiscal deficit in an attempt to prevent further Colombia peso revaluation.
• An almost 10 percent correction in Turkish stocks since the recent high presents a buying opportunity, according to J.P. Morgan. There has been no change in the macro outlook, as evidenced by the practically unchanged bond yields and lira exchange rate.

Threats

• The People’s Bank of China (PBOC), the central bank, warned of inflation pressure as global central banks are increasing money supply through quantitative easing. Though there probably is no immediate inflation threat in 6 to 9 months, the price increase for energy, materials and food (please refer to the natural resources section of this report) year-to-date are indeed at relatively fast pace and threatens China as the country’s investment demand is recovering.
• Brazil has vowed to allow the Brazilian real to appreciate a further 5 percent before resuming its currency intervention policy amid stagflation concerns. The expansive monetary policy pursued over much of last year accelerated inflation to 6.15 percent while GDP growth remained around the 1 percent level.
• Regulatory action, competitive pressure, and austerity measures are impacting revenue recovery of Eastern European telecom companies, making it difficult for them to maintain current high dividend yields.

Tags: BRICs, Emerging Markets
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Morgan Stanley’s 17 Macro Surprises for 2013

Wednesday, December 19th, 2012

Via Morgan Stanley:

Just When You Thought it Was Dead, Inflation Returns (Joachim Fels/Charles Goodhart)
A strong economic rebound in China and the US, adverse supply shocks in agriculture and worries about swelling central bank balance sheets lead to a sharp rise in actual and expected global inflation. Central banks don’t dare to respond, given high debt levels and financial fragilities, and either continue to ignore or abandon their inflation targets. Rising wheat prices lead to bread riots. In the UK, Chancellor Osborne advises the British to eat oatcakes instead.

Debt Cancellation (Spyros Andreopoulos)
The US Treasury, Japan’s Ministry of Finance and Her Majesty’s Treasury jointly announce that the Treasury debt held by the Federal Reserve, Bank of Japan and Bank of England respectively as a consequence of QE purchases are cancelled, and that these central banks will operate with negative equity until further notice. As a consequence, government debt/GDP ratios are brought down by 11pp, 18pp and 25pp, respectively. Ratings agencies love it, as does the bond market – until it realizes that large-scale debt monetization has just taken place, and sells off sharply.

US Over the Cliff and Likes it (Vincent Reinhart)
The US goes over the fiscal cliff and likes it. A deal delayed to early 2013 in which politicians compromise because of concerns about financial markets would resolve uncertainty more assuredly than the baseline of stop-gap legislation followed by a plan later in the year. As a consequence, confidence gets a boost, pent-up business investment kicks in and the labour market improves more rapidly.

US Housing Stalls Out (David Greenlaw)
The burgeoning housing recovery in the US begins to stall due to credit tightening. There is still no private mortgage market at this point and financial problems are brewing at the FHA which could lead to a dramatic reduction in credit availability for first-time homebuyers. Meanwhile, putback risk continues to cause originators to increase scrutiny for conforming loans.

BoJ Leads World in Adopting Rule-Based Monetary Policy, but Exit from Deflation Lags (Robert Feldman/Takeshi Yamaguchi)
Following a change in its leadership, the Bank of Japan switches to target the ex-food ex-energy CPI, adopts price level targeting to make up for past deflation, and implements a base money growth rule based on deviations of the actual CPI from the desired path. However, the targeted CPI measure remains negative year on year in December 2013, and the BoJ maintains aggressive policy into 2014 and beyond.

BoJ First to Buy Euro Area Bonds, ECB Left Watching and Waiting (Elga Bartsch)
The Bank of Japan, as part of its more aggressive policy stance to fight deflation (see above), starts to acquire euro area government bonds in order to push down the yen before the ECB is able to activate its OMT program. While the BoJ acts, the ECB waits in vain for the Spanish government to apply for an ESM credit line and OMT bond purchases. The BoJ focuses its purchases on ESM/EFSF bonds as well as higher-yielding core and large peripheral markets and thus effectively becomes a lender of last resort for the euro area.

Italian Politics Revives the CRIC Cycle and Triggers OMT (Elga Bartsch/Daniele Antonucci)
A lively anti-austerity campaign in the run-up to the early elections causes investors to seriously worry as to whether Italy could be contemplating an exit from the euro. The convertibility risk, which the ECB’s OMT announcement had reduced, returns and Italy is forced to seek an ESM credit line and becomes the first country to trigger the OMT. Unfortunately, the damage has been done as markets now believe that the convertibility risk is political rather than monetary. Investors sell the euro and peripheral assets and stock up on tinned food and mood-boosting pills.

From ‘Grexit’ to ‘Brixit’ (Elga Bartsch)
Financial markets come round to the idea that Greece will stay in the euro for the foreseeable future. Instead, investors are getting increasingly concerned about the UK’s political stance on Europe, especially in view of a possible referendum on EU membership. Polls during 1H13 start to suggest that an exit of the UK from the EU is now seen as more likely than an exit of Greece from the euro. The London property market wobbles as financial institutions start making contingency plans for moving employees to Frankfurt and Paris.

The UK Formally Gives Up the Fight Against Inflation (Melanie Baker)
As inflation looks set to remain well above 2% for yet another year, the government begins to fear that targeting inflation at the 2% level will mean an abrupt end to very low interest rates in the not-too-distant future…or a sharp loss of Bank of England credibility. MPs increasingly argue that embedding a bit more inflation might be a good thing for helping the UK economy out of its difficulties. The government raises the MPC’s inflation target and, for good measure, it merges the Monetary Policy Committee and Financial Policy Committee together.

Recession Returns to Australia (Gerard Minack)
Australia hasn’t had a recession for 21 years – arguably, one is overdue. Markets view the risk as low: fixed income markets are pricing in only 1-2 more rate cuts, and equities have re-rated through 2012.

Not the Right Green Shoots in EM (Manoj Pradhan)
EM green shoots develop further, but from the ‘wrong’ sources of growth. Better DM growth and/or an unwinding of the shock to global exports stabilizes EM exports and hence production. Complacency sets in and structural reforms to move away from the broken, export-investment-led model are put on the back-burner. The result? EM growth deteriorates shortly after.

China’s Shocking Tightening (Helen Qiao)
The Chinese government inadvertently tightens financial conditions aggressively by applying a ‘shock therapy’ during the early stage of the recovery. Off-balance sheet lending activities are banned and forced to roll back onto commercial banks’ balance sheets, causing a major liquidity freeze in the system. More credit defaults occur, giving rise to higher systemic risks. The economic recovery unravels.

The AXJ Productivity Booster (Chetan Ahya)
Policy-makers in Asia ex-Japan move aggressively to implement policy reforms, boosting the region’s productivity dynamic. China accelerates the move up the value chain and boosts consumption growth; India unveils more measures to lift investment in the economy; and Indonesia initiates reforms which improve the competitiveness of the non-commodity sectors. This raises productivity growth in the region, which has slowed significantly since the crisis, and results in higher corporate profitability.

Mexico’s Moment Arrives in its Long-Troubled Oil and Gas Industry (Gray Newman/Luis Arcentales)
Newly inaugurated President Enrique Peña Nieto surprises with a passage of aggressive constitutional change in Mexico’s oil and gas industry – he gains the political upper hand in energy and fiscal reform by starting his six-year term with a big boost in social programs and promises that energy/fiscal reform will provide even more revenues for social spending. MXN rallies on the prospects of a new FDI wave and the sovereign sees an upgrade.

Brazilian Policy Shifts from Stimulating Demand to Boosting Supply, with Ambitious Infrastructure Program (Gray Newman/Arthur Carvalho)
President Dilma Rousseff surprises most Brazil watchers as she follows through on her promise of an ambitious infrastructure program, lifting the globe’s sixth-largest economy from near the bottom of the globe’s infrastructure rankings. The technical details show attractive IRR triggering large investment inflows from abroad. BRL rallies more than expected on the news.

Turkey Goes Boringly Orthodox in Rates (Tevfik Aksoy)
The Central Bank of Turkey switches back to a conventional, orthodox and less exciting monetary policy in 2013. It removes the non-standard and creative tools designed to achieve inflation and financial stability goals at the same time. As a consequence, it faces new challenges of currency appreciation, currency volatility and no meaningful decline in the current account deficit. The experiment fails and policy switches back to non-conventional measures later in the year in an attempt to recoup the loss of credibility.

Back in the USSR (Jacob Nell)
Putin is successful in enticing Ukraine into the Eurasian Customs Union in return for energy subsidies which reduce its balance of payments financing need to a level which requires neither painful policy adjustment nor a sharp FX adjustment. This closes the door on EU entry for Ukraine, since you can’t be a member of two customs unions at once, and leads to economic reintegration of the main post-Soviet states – Russia, Ukraine, Kazakhstan and Belarus. The removal of trade and investment barriers – particularly if accompanied by a pro-investment, pro-market set of Russian-led policies – triggers higher growth across the region, while Russian energy subsidies would stabilize the hyrvnia and ruble.

Tags: BRICs
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More Un-Predictions: Deutsche’s 13 Outliers For ’13

Wednesday, December 19th, 2012

Following on the heels of Byron Wien, Morgan Stanley’s Surprises, and Saxo’s Outrageous Predictions, Deutsche Bank’s FX strategy team has created a who’s who of 13 outliers for 2013. Quite frankly, given the extreme nature of monetary (and now fiscal) policy, asset allocation decisions, and bankers’ and politicians’ willingness to go into the media and lie directly to our faces, the comprehension of the possible (no matter how improbable) is far more important for risk management than the faith in the centrally-planned unreality our markets (and therefore ourselves) currently find themselves in. As they note, all too often, the tendency to not stray too far from a self-anchoring recent-history-extrapolated consensus (while apparently highly profitable for some for a microcosm of time) leads to unrecoverable drawdowns exactly when career-risk was the limiting factor. From Malaysian elections and EM bubbles bursting to Fed monetizing equities and South China Sea escalation, these outliers seem all to ‘normal’ in our brave new world.

Via Deutsche Bank:

When thinking about the year ahead, it is tempting to extrapolate the recent past whether looking at risks or one’s base case. Moreover, there is a tendency not to deviate too far from consensus, perhaps seeing safety in being part of the herd. From a statistical perspective, this is very similar to assuming markets follow a normal or Gaussian distribution. That is, markets are well behaved and extreme outcomes are rare. The financial crisis of 2008 taught us otherwise, yet it is very difficult to shrug off the bias to assume normality in markets. We have therefore conducted an exercise within our team to think up 13 outliers or extreme events that could unfold over 2013. These are not simply the commonly cited risks to views, but events and occurrences that would genuinely surprise market participants; we underscore that these scenarios do not represent the DB base case. What we are trying to do is highlight outliers that are in the tails of the distribution. Our ability to predict outliers, by very definition, is limited, yet we hope the approach of assuming extreme events will be more common than we might think should provide the right mindset as we enter 2013.

1. Fed finances the purchases of equities

The Fed has consistently taken a more aggressive approach to easing since the 2008 crisis. Indeed, the most recent FOMC meeting introduced QE4 and quantitative thresholds for future policy – steps that were more than many had expected. The question is, what could the Fed do next? Finance the purchase of equities could be the answer. Indeed, one of the strongest market reactions to past QEs has been stock market rallies, yet that effect appears to have faded since QE3 in mid-September, as equities have not rallied in the same way. With the US housing sector apparently turning the corner, stronger equities may be the necessary tonic to further increase household wealth, and also to boost investment. Moreover, it is not unprecedented amongst developed-world central banks. The Bank of Japan under its current Asset Purchase Programme buys corporate bonds, ETFs and REITS. While the Fed does have restrictions on what assets it can buy, it can invoke Section 13(3) of the Federal Reserve Act that allows more extreme actions in “unusual and exigent circumstances”. One only needs to recall that the Fed created the Maiden Lane vehicle in 2008 to hold the risky assets of Bear Stearns that JPMorgan was not willing to hold to see what powers the Fed has.

Should this happen, growth and risk-sensitive currencies such as EM FX, dollar bloc and SEK should perform well.

Bilal Hafeez, London

2. Greece discovers gas reserves valued more than total debt

Greece has sizeable undersea terrain in the Mediterranean, and several Mediterranean countries have already discovered and are exploiting undersea natural resources, most notably the Levantine gas field between Israel and Cyprus. A number of studies that have looked at similar gas finds in the Mediterranean as a basis of comparison put the potential size of gas fields to the South of Crete as high as $600bn. These are not based on hard geological evidence, and the government has recently commissioned a seismic survey company to determine the potential magnitude of reserves. Preliminary outcomes are expected in mid-2013, with a potential positive find generating a rare positive surprise for the debt-stricken country.

Should this happen, EUR should perform well.
*’Greece looks out to sea for gas and wealth salvation,’ Reuters Newswires, 3rd October 2012

George Saravelos, London

3. Sweden, Turkey and Brazil work together to bring peace to the Middle East

In September, at the 67th UN General Assembly meetings in New York, Sweden, Brazil and Turkey launched a new initiative called the “Three soft powers from three continents”. The first goal will be to prevent assaults on sacred values. However, the foreign ministers of each country, Carl Bildt of Sweden, Ahmet Davutoglu of Turkey and Antonio Patriota of Brazil, have talked about their interest in helping solve challenges facing the international community based on their common values of dialogue, multilateralism and democracy. In the past, Brazil and Turkey have attempted to resolve the nuclear issues in Iran, while Turkey and Sweden have worked together on issues in the Balkans. As the three countries work more closely together on international issues, their attention could once again turn to the Middle East. Syria is the most pressing issue, but their focus could expand to other countries in the region. The foreign ministers next meet in Turkey in January.

Should this happen, ILS and EGP should benefit and oil exporters CAD and RUB suffer at the expense of importers INR, TRY

Bilal Hafeez

4. UK coalition government breaks up – election called

It is not widely anticipated by political analysts that the coalition government will hold until the end of the parliament term in 2015. Both the Liberal Democrat and Conservative parties will likely wish to have some time before the next election to distance themselves from the policies of their partners in the eyes of the electorate. This split could potentially occur as early as next year, with divisions over energy policy, parliamentary boundary changes, House of Lords reform and most importantly economic policy leading prominent party members to agitate for a split. Given that the parliamentary term is fixed, it seems the most likely outcome of a breakup would be a minority Conservative government that relies on informal Lib Dem support to pass legislation. However, if this were to prove unworkable, a vote of confidence could be called, which would lead to new elections.

Should this happen, GBP should depreciate.

Oliver Harvey, London

5. A 2013 race to negative depo rates and every major stock market in the world is up

It started in Denmark and Switzerland, with Japan following, and to avoid excessive currency appreciation, EUR and then the US could follow suit with negative rates. But there is another investment vehicle. Currently only Spain and China’s major equity indices are down in 2012. In 2005, China and Italy were the exceptions and were down, while in 2006 and 2009 there were no exceptions, with all 47 of the most liquid equity markets ending up on the year. With China widely seen as cheap, and EUR periphery risks dissipating, 2013 could be another year where every major equity market is up, aided and abetted by negative rates.

Should this happen, carry currencies should outperform.

Alan Ruskin, New York

6. North Korea opening/detente

Unconfirmed reports this year suggested new North Korean leader Kim Jong-un planned to push ahead with reforms, enabling capitalistic agricultural and industry reform per China in the 1970s and 80s. The start date was reportedly slated for October 1, but was pushed back by food shortages until after the one-year anniversary of Kim’s father’s death on December 17. China’s new leadership is also likely to push for more specific, tangible reforms, and they have plenty of leverage as North Korea’s trade dependency on China has risen from 52% in 2005 to 84% last year. Incoming president Xi Jinping has close ties with the North, and Kim Jong-un is expected to visit China and meet Xi as soon as January. Meanwhile, Xi has expressed hopes that China’s ‘strategic cooperative partnership’ with South Korea will develop further in ‘new political circumstances.’

Should this happen, KRW should appreciate.

James Malcolm, London

7. Iran turns less hawkish or more volatile

The Iranian presidential election is scheduled to take place on June 14th 2013 to choose a successor to Mahmood Ahmadinejad. While the list of candidates is pre-screened by the Iranian Council and the selection process is currently being tightened via changes to the electoral law, the election outcome still has potential to surprise. Indeed, Ahmadinejad himself was viewed as a political outsider when he announced his presidential bid as Mayor of Tehran in 2005, subsequently taking a hard-line stance on Iran’s nuclear program. Somewhat ironically, the changes to the electoral law are mainly opposed by the current president, who reportedly views them as negatively affecting a potential candidacy bid of his close ally Esfandiar Rahim Mashaei. Other potential candidates mentioned in the press include Tehran’s mayor Mohammad-Bagher Ghalibaf, the chief nuclear negotiator and a close ally of Khamenei, Saeed Jalili, and Ali Larijani, the parliamentary speaker. Some are viewed as more pragmatic on Iran’s nuclear program generating the potential for a softer foreign policy following the election, easing geopolitical risk in the Middle East next year. In the meantime, broader political and social uncertainty around the election cannot be ruled out, with Ahmadinejad’s 2005 re-election causing a wave of protests and riots that lasted into 2010.

Should this happen, ILS would likely be most sensitive, along with oil betas (CAD and RUB in particular).

George Saravelos

8. Breakdown of FX/equity correlation

The spike in correlation between G10 FX and equities beginning in 2008 and lasting through the present is unprecedented in the free float era. Next year may finally see the breakdown in this correlation for three reasons.

1. Global yield compression and light positioning has unwound carry trades: FX positioning has been reduced in large part because carry-to-vol ratios were not compelling; currencies such as EUR and CAD were still behaving like risky assets, with high betas to the S&P 500, even though carry in these pairs had long disappeared. Volatility is finally falling in these pairs to match the low carry as there are fewer G10 positions to unwind and hence the beta (if not yet the correlation) to the S&P 500 is falling.

2. Real activity data is less correlated as recovery proceeds at different speeds: The fundamental driver of FX/Equity correlation is likely global synchronization of business cycles, most prominently in 2008-09. This correlation has been falling for several years as the US economy outperforms an austerity-led European recession and Asian growth increasingly drives $-bloc and Scandinavian economies.

3. Volatility and correlation are falling in other asset classes: Falling S&P 500 single stock correlation, historically closely related to FX/equity correlation, points to the declining influence of global risk factors on individual asset prices. A correlation breakdown would have positive implications for currency investors. They would regain access to a diversified basket of instruments, useful and effective in expressing views on relative monetary policy, independent of the global growth landscape. The elimination of high beta volatility stemming from global macro risks would reduce currency portfolio volatility and potentially improve returns as fundamental and momentum investors get stopped out of trades less often. Finally, reduced equity correlation would likely rekindle interest in FX as an asset class, now seen by many macro investors as little more than a trendless proxy for equity volatility.

Should this happen, FX should become more diversified.

Daniel Brehon, New York

9. South China Sea territorial tensions escalate

An increasingly assertive China, the US foreign policy pivot towards Asia, an ocean bed of potentially vast mineral reserves surrounded by fast-growing resource-hungry nations, disputed maritime boundaries, and fishing boats with tendencies to stray, all make for a combustible situation in the South China Sea. While a full-blown military conflict remains unlikely, a series of naval skirmishes in 2012 and creeping militarization in the region have bred suspicion and heightened tensions. Further provocation could begin to strain trade relationships in a region with highly integrated supply chains, dampening the exports recovery. It could also decrease (the potential for) intra-regional FDI at a time when the overseas investment push from Asia is increasing, and may also detract from the credit re-rating story underway in certain markets (i.e. Philippines).

Should this happen, all Asia FX including JPY should suffer.

Mallika Sachdeva, Singapore

10. Europe gets powered by solar

In theory, an area of the Saharan desert the size of Wales could harness enough solar energy to power the whole of Europe. The theory may eventually turn into reality thanks to initiatives like Desertec, a consortium set up in 2009 to harness solar energy from the Sahara. Desertec aims to provide 15% of Europe’s electricity by 2050. Solar and wind power projects have already started in Morocco. Importantly, in November of this year, Morocco, Germany France, Italy, Malta, and Luxembourg reached an understanding for the first joint project between Europe and Morocco. Spain’s absence from the agreement has so far prevented the agreement from being formally executed, but expectations are that Spain will sign. Admittedly, there are issues of funding and partners for the overall project, but meaningful advances on the project over 2013 could result in one of the more positive surprises of the year.

Should this happen, EUR should benefit.

Bilal Hafeez

11. Climate change risks begin to get priced

In March the Intergovernmental Panel on Climate Change (IPCC) published a report warning that global warming is already resulting in such extreme weather that governments should prepare themselves for a higher incidence of natural disasters. This admonition was brought home most recently by the devastation caused on the US East Coast by Hurricane Sandy. Accelerating climate change has a number of implications for financial markets and FX. For example, if the droughts in the US, Russia and Brazil continue next year as forecast, this could lead to knock-on effects for global food prices, one result of which may be pressure on central banks to tighten policy (our Asia strategists already identified SGD’s high beta to food prices for this reason in July). Natural disasters such as typhoons and hurricanes can have significant negative impacts on GDP and may weigh on the economic recovery. Finally, if markets begin to rerate potential future economic growth, or the longevity of certain energy sources, this could result in structural shifts in asset valuations.

Should this happen, FX vol should rise.

Oliver Harvey

12. EM bond bubble bursts

The past few years have seen non-resident investors build up their positions in EM local debt markets to new record levels, driven by a broader global search for yield, monetary policy easing across major Emerging Markets and the healthy state of EM fiscal balance sheets. With few exceptions markets expect this trend to carry over into the new year. However, with output gaps typically limited, real rates at cyclical lows, and global liquidity abundant, EM economies will be sensitive to higher inflation, which could undermine the attractiveness of EM debt given that it is already unattractive vs. inflation expectations. Supply shocks, with higher food prices and/or crude triggering higher inflation would be particularly negative, and/or EM FX continuing to underperform would not only add to inflationary pressures but also undermine total returns of EM local debt. South Africa, Turkey, Russia, Brazil and Peru have the highest pass-through from food and oil prices to CPI and could end up yielding negative real rates in this scenario, which in turn could trigger substantial outflows.

Should this happen, EM FX should suffer and FX vol should rise.

Henrik Gullberg, London
Siddharth Kapoor, London

13. Malaysia government loses election

In Malaysia, elections must be called within the first half of 2013. Barisah National, the ruling coalition, lost its super-majority (two-thirds) for the first time in Malaysia’s modern history in 2008, and there has been a growing popular movement for electoral reform since. An upset by the opposition – although very unlikely by all public indications – could have a significant impact on economic policy (fate of the government’s flagship Economic Transformation Plan, tax policies) and would likely hurt the equity market with government-linked companies taking a hit. In India, while national elections are not due until 2014, the government – currently operating as a minority coalition – is dependent on drawing shaky support from a diverse group of regionalist, populist, and pro-/anti-reform parties. Support from the latter could slip amidst a series of state elections next year, prompting early elections. The ensuing policy vacuum and a dimmer/deferred outlook for reforms would likely drive off much-needed portfolio flows.

Should this happen, MYR should depreciate.

Mallika Sachdeva

Source: Deutsche Bank

Tags: BRICs
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5 Amazing Global Consumer Trends

Monday, November 26th, 2012

5 Amazing Global Consumer Trends

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors

This weekend marks the official start of the holiday shopping season in the U.S., so for the next month, consumers will be enticed with daily deals on the latest fads, such as one-cup coffee makers, tablets, flat screens and cashmere sweaters.

According to the latest survey from the Consumer Electronic Association, about 60 percent of adults plan to shop in stores or online this holiday weekend, with the average person indicating they’ll fork over $218 for gifts and merchandise from Thanksgiving through Cyber Monday. This is a sharp increase from 2011, where shoppers said they’d spend $159.

For the ultimate gold lover on your shopping list, one amazing purchase you can nab is a Christmas tree complete with Disney characters and gold leaf ribbons made of 88 pounds of pure gold from a jewelry store in Tokyo, according to Reuters. The ornamental tree will set you back $4.2 million, but there’s also a smaller version available for $243,000.

Here are 5 other amazing consumer trends that are happening around the world.

1. Fifth Avenue no longer the world’s most expensive retail location

The New York strip boasting high-end shopping, including Tiffany’s, Louis Vuitton, Hugo Boss and Fendi, has been knocked from its No. 1 position as the retail area with the top rental rates around the world. Hong Kong’s Causeway Bay area commands more per square foot than any other place on the globe, according to a report from Cushman & Wakefield, a real estate firm.

Tourists and mainland China residents have been flocking to Causeway Bay to shop at places including Burberry, Coach and Gucci that are among its Times Square’s 230 shops located on 16 floors. Shoppers can also head to Causeway Bay’s Fashion Walk, which features local fashion designers and trends catering to a young and fashionable crowd.

2. China set to be the second largest luxury market by 2017

With sales of luxury goods including designer handbags, clothes, jewelry, fine wine and spirits growing 18 percent every year in China, the country is on track to surpass Japan, Italy and France as the biggest luxury market in the world. While the U.S. is still projected to remain the top country in luxury-goods sales, consumers in Brazil, Russia, India and China (BRIC) have been closing the gap. Luxury sales in BRIC countries made up only 4 percent of the total in 2007, but at the end of 2012, it’s expected to be 11 percent.

3. Viva Macau is gaming capital of the world

The city of Macau, which is the only Chinese territory where casino gambling is legal, is the world’s largest gambling town. In 2011, casinos took in $33.5 billion, five times more than the establishments in Las Vegas.

With a population of 500,000, the city’s average citizen makes more than the average person in Europe. Over the last decade, Macau has grown by 19 percent a year—twice as fast as mainland China. It continues to see a whole lot of money that’s ready to burn, to quote Elvis Presley, and American casino companies have been clamoring for a piece of the action. Steve Wynn opened a casino in Macau in 2006 and now makes most of his profits there, says The New Yorker. Sheldon Adelson built Sands Macau in 2004, and later opened a $2.4 billion Venetian Macau which houses the largest casino floor in the world. In September 2012, Adelson unveiled plans for The Parisian, which will have 3,000 rooms and a 50 percent scale replica of the Eiffel Tower.

4. Inexpensive Indian Aakash 2 could revolutionize tablet industry

A 7-inch Android tablet developed in India may present stiff competition to the more expensive counterparts made by Apple and Google, potentially making all tablets a little less expensive in the future.

Datawind’s Aakash 2, with 512MB of RAM and 800 x 480 pixel resolution, was developed as an affordable way to get technology, especially e-books and the Internet, into the hands of students in India. Deployed by the government in post-secondary schools, the Indian Ministry of Human Resource Development subsidizes some of the cost, making the tablet available to college students for $35. To help students access the Internet on the tablets, the government has been working to connect 600 universities and 1,200 colleges with broadband and Wi-Fi.

5. Emerging market residents don’t need a bank account to pay with their mobile wallet

A lack of financial infrastructure is making phone-based payment systems attractive in some emerging markets around the world. Due to the growing number of cell phones in the Philippines along with overseas Filipinos who send money back to their families, the mobile money payment business offered by Smart Communications and Globe Telecom has been consistently growing in recent years.

M-Pesa has been successful in Kenya, allowing people without bank accounts to move funds quickly via mobile money transfers. Increased security and convenient access to money are among the biggest benefits, especially for those living in rural areas

U.S. firms are making sure they aren’t left out of this growing business: In 2011, San Francisco-based Visa purchased South African firm Fundamo, which provides mobile phone-based payment services in the underbanked emerging markets in Africa, Asia and Latin America.

Just as the love of gold is intertwined throughout the East and the West these days, globalization is making the world more connected than ever. Soon, “keeping up with the Joneses” may no longer refer to only the neighbors who live on our block. In emerging markets, supportive government policies, rising wealth and access to innovative technology may be an influential source for future Black Friday purchases in the U.S.

All of us at U.S. Global Investors are thankful for our shareholders’ confidence and trust. We hope our readers enjoy their Thanksgiving weekend traditions safely and peacefully, whether it involves spending time with friends and family shopping, watching football, or eating turkey casserole.

Tags: BRICs
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Emerging Markets Radar (October 29, 2012)

Sunday, October 28th, 2012

Emerging Markets Radar (October 28, 2012)

Strengths

• The HSBC China October flash manufacturing Purchasing Manager’s Index (PMI) improved 1.2 percent to 49.1 from 47.9 in September. The breakdown of the index shows some positive signs, such as the running down of inventories and improving new orders. The market was encouraged by the improving PMI, though it is still below 50, indicating that industrial activities are in contraction.
• Data from the China Banking Regulatory Commission (CBRC) showed that for the first nine months, loan balances for social security housing constructions at banking institutions went up 47.6 percent on a year-over-year basis, which should benefit construction companies.
• The Philippines cut interest rates by a quarter of a percentage point to a record-low 3.5 percent in the week. This was the fourth time this year to spur growth and dampen currency gains as U.S. monetary stimulus threatens to boost capital inflows.
• Thailand’s September exports were slightly up by 0.2 percent on a year-over-year basis, beating the market consensus which had predicted a contraction.

Weaknesses

• Korea’s GDP decelerated to 1.6 percent in the third quarter this year, below the consensus forecast of 1.7 percent.  This was the slowest growth in three years since the third quarter of 2009 due to weak capital spending and destocking, but economists said it could be the bottom of the cycle.
• Out of 935 companies listed in the Shanghai Composite, 161 have reported third-quarter earnings with profits falling an average 4.5 percent from a year earlier, but analysts encouraged investors to look beyond reported earnings, rather than paying attention to earning revisions in the reporting season.
• In spite of the market consensus that The People’s Bank of China (PBOC), the central bank, would cut interest rates at least once and cut the bank reserve ratio one to two times before year-end, that hope has diminished lately due to increasing reverse repo operations by the central bank. Similarly, the market may have overestimated the probability of a large stimulus package around the national congress on November 8.
• In its recent research report, JP Morgan predicts Korea’s economically active population to peak in 2012/2013, tracking Japan closely in its economic and population dynamics.

Opportunities

• The graph above shows that money flows into Association of Southeast Asian Nations (ASEAN) countries went up in the third quarter due to the U.S. QE3 program. The increasing inflow of money should help inflate asset prices in these countries, particularly benefiting the equity and property markets.
• HSBC makes an ongoing case for Turkey, even after its very strong run, up 45 percent year-to-date in U.S. dollar terms. The chart below shows that foreign ownership is still low by historical standards.

• Turkish corporations improved their competitive position dramatically over the past five years. Net profit margins expanded as unit labor costs have fallen, the opposite of all the BRIC (Brazil, Russia, India and China) countries.

Threats

• Indonesia’s current account (CA) balance turned into a deficit this year due to reduced demand from China for its commodities and lower coal and rubber prices. CLSA forecasts Indonesia’s CA could be worse than India next year, reaching 3 percent of GDP. This widened CA deficit is mostly due to a weak external market, with strong domestic demand for external consumer and industrial goods. A number of economic forces can act to dampen or reduce the impact of the CA deficit, including continuing FDI (foreign direct investment) inflow, global recovery, and productivity-enhancing domestic policies.
• Mark Mobius expressed his concern to the Russian business paper Vedomosti about the fate of minority investors in TNK-BP Holding following its acquisition by the state company Rosneft. Despite consolidation, Rosneft CEO Igor Sechin said that there are no plans for a minority share buyout.  Mobius declined to comment how the deal reflects on the investment climate in Russia.
• A BCA Research valuation ranking shows that currencies of commodity-producing nations, such as Brazil, Chile, Indonesia and Russia, are the most expensive, which makes them particularly vulnerable if commodity prices head lower. BCA ranks emerging markets currencies based on an average of two valuation measures: the deviation of the real effective exchange rate from its 10-year mean and purchasing power parity.  On the other hand, the Indian rupee has the most upside by this measure.

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Food Inflation To Surge, Goldman Warns

Thursday, October 11th, 2012

We have been very active in our discussions of the impact of the pending rise in food prices around the world (from central bank largesse to weather-related chaos). As Goldman notes, food inflation has been one of the most significant sources of headline inflation variation in emerging markets (EM) over the past few years. Since June, international prices for agricultural commodities have risen almost 30%, increasing the risk of fresh, food-related increases to EM headline inflation. We, like Goldman, expect EM headline inflation to start to reflect the relevant pressures more broadly in the October prints at the latest. While the effects, for now, are expected to be less extreme than the 2010-2011 episode, the timing as the US enters its fiscal-cliff-prone malaise, could mean a further round of easing will reignite this critical inflationary concern.

Via Goldman Sachs, Food prices: A key driver of EM inflation

Swings in food prices have important implications for overall inflation in emerging markets. Since 2007, we have observed substantial shifts in food inflation, which in turn have triggered significant contemporaneous volatility in EM headline inflation (see Exhibit 1).

Food inflation has a strong impact on overall EM inflation for two reasons:

• In lower per-capita GDP economies, households necessarily dedicate a larger portion of their disposable income to inelastic goods such as food. As such, food makes up a larger share of the consumer basket. The average inflation share for food items in EMs is generally larger than that for the G10 countries (25% vs 15% respectively, on average). In order to capture the joint effect of the weight, the relative variation of food vs non-food inflation and the potential correlation between food and non-food items, we run univariate regressions of food on headline inflation. The R-squareds are typically higher on average for EMs (42%) than for G10 economies (33% respectively, Exhibit 2).

• Food prices have been highly volatile since 2007 globally. We have observed very large spikes in international prices for agricultural commodities (proxied by the S&P GSCI® Agricultural Index) in 2008, 2011 and more recently in June 2012. Such global price shifts typically also tend to be reflected in local food inflation. Exhibit 3 shows the co-movement between international food prices and an equally weighted average of food inflation rates across emerging markets. International food prices have tended to lead local food inflation by a few months (approximately four months on average).

Following a significant increase in 2010, aggregate EM food inflation peaked in 2011 and has contributed to an overall moderation in EM headline inflation since. But EM food inflation has recently shown tentative signs of a trough and, at the country level, there is variation in the recent path of food inflation. China, Korea and Indonesia have seen the largest falls in food inflation from their 2011 peak. However, in countries such as Taiwan, Mexico and the Czech Republic, yoy food inflation has picked up and is currently hovering at higher levels than in 2011.

This bottoming-out of EM food inflation has coincided with a significant spike in international agricultural commodity prices. In June and July this year, the S&P GSCI® Agricultural Index rose almost 40%, to levels last seen in August 2011, and roughly speaking has remained there since. Should this spike persist, we would expect to see food inflation pick up across EM once again.

Here we argue that food price pressures will boost EM headline inflation by October at the latest. However, we do not expect EM CPI to exceed 2011 levels (in yoy terms). This is because we expect the increase in food prices to be smaller and less broad-based, and because non-food inflation is running at a slower pace currently. Moreover, we find evidence that the pass-through from international to local food prices has declined, something that first became visible in 2010.

Food price outlook – new highs expected

Agricultural commodity prices have exhibited substantial swings in the past few years. On the demand side, rapid income growth in EM economies has supported overall demand for agricultural products. Along with the broader increase in agricultural commodity demand, increased consumption of meat products has led to higher meat production and, in turn, higher demand for livestock feed. Lastly, high energy prices also boost food demand via the substitution process between conventional fuel and biofuel.

Given this backdrop of elevated demand for agricultural commodities, the response in food supply conditions becomes the key to analysing price movements. Volatility in weather patterns and crops has helped trigger substantial inventory shortages and price spikes such as those experienced in 2008, 2011 and more recently in June 2012.

The current spike has come in response to the summer drought in the US Midwest, which was one of the worst in the past century. In addition, a wide set of agricultural commodity producing countries have experienced adverse weather conditions (such as Brazil and Argentina in the past winter, and Russia, Ukraine, Kazakhstan and India). Damien Courvalin from our Commodities Strategy Team points out that these disruptions have caused substantial losses in global food supply (see Agriculture Update: ‘Severe US Drought to Push Corn and Soybean Prices to New Highs’, July 23, 2012).

The supply loss is concentrated in wheat, corn and soybeans, which jointly account for 70% of world agricultural production. In contrast, rice remains largely unaffected.

Despite the resulting 40% spike in the S&P GSCI® Agricultural Index between mid-June and mid-July, demand for agricultural commodities has remained robust. The net result has been a decline in inventories, with the USDA’s September 1 stocks of corn and wheat well below expectations, as Damien highlights in Agriculture Update: ‘Crop prices to recover on tight supplies with corn outperforming’, September 30, 2012.

Our Commodities Strategy team expect demand to remain resilient and supply to remain binding, leading soybean and corn prices to new highs in the coming months. Higher prices will eventually be followed by a supply response, and if weather returns to normal, we should expect a large crop in South America (harvested next spring) and in the US (harvested next autumn). In the interim, prices are likely to remain high.

However, there is a clear weather dependency to this assessment; further weather adversity is likely to pose further upside risks to food prices. To address the binary nature of the food price outlook, our Commodities Strategy team provided us with two scenarios:

• The ‘favourable’ weather scenario, in which larger harvests in South America and the US serve to moderate agricultural prices following the initial increase. In this scenario, a basket of corn, wheat and soybeans sees year-on-year price changes of 46%, 16% and -21% in 3, 6 and 12 months respectively.
• The ‘moderately adverse’ weather scenario, in which supply tightness intensifies due to less favourable weather in South America, pushing prices to a higher peak over the coming months. In this scenario, the basket of corn, wheat and soybeans increases 65%, 41% and 1% in 3, 6 and 12 months respectively.

Exhibit 4 shows the equivalent paths corresponding to each of the two scenarios of price developments in the corn, wheat and soy basket. In both scenarios, the S&P GSCI® Agricultural Index reaches new highs in the months ahead and declines one year out. The peak is, of course, higher in the adverse scenario, as is the trough 12 months out. The decline following the initial spike is also more gradual in the adverse scenario, while the final levels remain very close to the previous (2011) highs. It is worth pointing out that this scenario analysis is only meant as an illustration of the broader argument, rather than a precise forecasting exercise.

Evidence of a moderation in the pass-through to EM inflation

To translate our scenarios for international food prices into local food price trends for emerging markets, we need an estimate of the relationship between the two variables. As mentioned earlier, large shifts in global food prices have tended to show up systematically in local food inflation. Moreover, local food prices are typically stickier and slower to respond to shocks in global agricultural prices, which creates a lag between the two.

To map international food prices onto local food prices, we follow the framework we introduced in Global Economics Weekly 11/13, June 6, 2011. We regress changes in the S&P GSCI® Agricultural Index on changes in an equally weighted average of food CPI components from key EMs. To avoid issues of seasonality and excessive near-term volatility, we look at year-over-year percentage changes in the two variables. Lastly, we examine different lags in international food prices to find the type of structure that offers the highest explanatory power. As in our previous analysis, we find a strong correlation between international and local food prices (an R-squared of 40%), with international food prices feeding through to local food prices with the highest explanatory power at a four-month lag (with a five-month lag a very close second).

We estimate the historical sensitivity of local to international food prices at around 0.058, which implies that a 10ppt increase in international food prices would tend to raise our proxy of EM local food inflation by 58bp. Interestingly, this is 20% lower than our estimate from one year ago, of 0.073. This is further evidence for our suggestion from last year that EM CPIs appear to be displaying a lower sensitivity to global food price shocks. This could be due to a number of reasons, such as the temporary nature of the shocks, the softening in global demand dynamics leading to less broad-based price pressures, or the larger capacity of EM authorities to respond to food price volatility and smooth such shocks. It will be interesting to observe whether the pass-through declines further this time too.

In our previous analysis, we also examined two alternative scenarios for food prices: one that assumed that normal weather conditions persist and one that assumed that adverse weather conditions push food items significantly higher. Based on those scenarios (combined with our pass-through estimates), we projected ranges of outcomes for the forward path of our EM food inflation aggregate. Finally, we translated those paths into EM headline inflation projections by keeping the rate of inflation for non-food CPI in EM economies constant.

To check whether this approach is robust using out-of-sample data, we contrast the actual path of EM inflation with the scenarios developed in April 2011. We see that over the last year EM headline inflation has hovered between our moderate and our adverse scenario (see Exhibit 5). This confirms our ex ante assumption that food inflation would remain the most important determinant of EM headline inflation, and also provides a level of comfort that our estimation approach and results are fairly sensible. It broadly confirmed our estimates for a lag of about four months in international food prices feeding through to EM inflation rates on aggregate.

EM inflation set to increase more moderately than in 2010-11

With our two scenarios for international food prices, and our updated pass-through coefficient, we can now calculate two potential paths for EM food inflation. Using these, we then turn to estimating the impact of EM food inflation to EM headline inflation. To do this, we use the relevant food weights to split EM headline inflation into a food and an ex-food component. We then assume that EM inflation ex-food continues to grow at the current pace and we add the weighted path of food inflation to project the headline rate. We find:

• Relative to the latest available inflation data (August), there may be further downside to aggregate EM headline inflation due to food contributions. The impact of base effects and the relevant lags between international and local food prices imply that we may need to wait until the full set of October inflation prints are out to fully confirm the beginning of the systematic pick-up in EM food inflation.
• From October onwards inflation starts to rise and peaks, on a year-over-year basis, in March 2013, i.e., 40-60bp above current levels and 80bp-100bp above the projected trough. After March 2013, inflation starts to decline. The pace of the decline will depend on future weather conditions. A moderate weather environment would lead to a quicker and deeper normalisation in EM inflation.
• Our projections suggest the peak in headline inflation will be lower than the 2011 food price spike episode, at between 4.6% and 4.8%yoy depending on weather conditions, compared with 5.1% in mid 2011. This is mostly because the food price increase itself is projected to be somewhat smaller for international food prices on aggregate and in annual terms, and to be less broad-based (focused on wheat, corn and soy). In addition, non-food inflation rates in the first half of 2011, when EM headline inflation peaked, were slightly higher (about 20bp on average) relative to the current annual pace of non-food inflation.

There are three key risks around these conclusions.

• Timing appears to be more uncertain this time around. As mentioned earlier, there are signs across a number of EMs that food inflation is already picking up. This may mean that the lag estimate of four months in the pass-through from international to local food prices may be too lengthy this time around. In turn, this means that EM food inflation is likely to pick up sooner than October.
• Relative to the last food price spike in 2011, this analysis may be less applicable to Asian economies. This is chiefly because of the much more stable price developments in rice. To some extent our analysis takes this into account; as mentioned earlier, we map the corresponding shifts in the corn, wheat and soy basket on broader shifts in the S&P GSCI® Agricultural Index. And this is, in part, the reason why the size of the shock in aggregate international prices is smaller. However, we are conscious that we run our exercise on a high level of aggregation, which does not allow for more precise adjustments along those lines.
• The uncertainty in non-food inflation may be high in the months ahead. Oil prices are expected to recover from current lows but a lot will depend on the pace of global demand and developments in geopolitical risks. Moreover, there is a degree of co-movement between food inflation and core inflation across several EMs, which may pose upside risks to our stable current non-food inflation assumption. Finally, core inflation may exhibit a high degree of variation across emerging markets. We are coming out of a period of softening growth in EM economies which could dampen headline inflation prospects. That said, many EM economies continue to run at high rates of capacity utilisation and experience persistent inflation inertia.

Note that these assessments do not constitute an inflation forecasting exercise but rather an illustration of likely paths for food-driven EM inflation on aggregate. There are, of course, local particularities that may create deviations from such assessments on a regional or country level. Our Asia and CEEMEA Economics research team have also done quantitative work projecting the likely impact of higher food prices on local CPIs. Reassuringly, their findings are broadly consistent with ours; in CEEMEA, our economists expect a 50bp-100bp upside contribution to headline inflation, mostly due to higher food prices but also accounting for the impact of energy prices. In Asia, our economists expect food inflation to add 100bp to local inflation.

EM currencies to benefit

Given the significance of food inflation for overall headline inflation levels and the linkages between food and non-food inflation recorded in the past, EM central banks are unlikely to fully dismiss food price volatility as a temporary and mean reverting phenomenon. Instead, they are likely to respond by tightening monetary conditions either via guidance (a more hawkish stance) or via currency strength (to curtail price pressures on imported food items), or even via higher policy rates. As international food prices are available in high frequency, markets are likely to anticipate these shifts to some extent. Given, however, that ex ante market assessments are conditioned on a number of underlying macro developments, shifts are likely to be priced only partially.

Therefore, it is reasonable to expect market shifts to occur as EM food inflation pushes headline inflation up and EM policy makers react proportionally. Overall, higher headline inflation in EMs is broadly consistent with higher front-end rates (or rate expectations), flatter EM curves and currency strength. To confirm this intuition, we run a simple cross-asset event study of the last three food inflation spikes: 2004, 2007-08 and 2010-11 (Exhibit 7). We examine the average impact of food-driven headline inflation on EM curves and currencies, and also look at equity market behaviour.

More specifically, to proxy for shifts in near-term interest rate expectations, we look at the change in 1-year rates 1-year forward relative to the US (to account for global shifts in fixed income markets). We also look at shifts in the spread between 5-year and 2-year EM rates relative to the US to proxy for shifts in the broader shape of the curve. Lastly, we examine average EM FX returns vs the USD and average EM equity performance vs the SPX. Arguably, it is hard to rely on such small sample assessments and cross-EM averages, but it is interesting that our results generally confirm our macro intuition:

• Typically, 1-year 1-year forwards tend to increase on average, albeit by a small amount, while EM curves flatten significantly in only two of the three episodes.
• EM currencies appreciated strongly vis à vis the USD during the last two food inflation spike episodes and were flat in the first episode under study.
• Interestingly, EM equities outperformed the SPX in all three episodes. It is hard to argue that such a negative supply shock can be linked to benign equity market trends. Indeed, in absolute terms, equities fell in two of the three spikes. The relative outperformance may be due to stronger EM growth vs G10 in our sample.

Hard as it may be to draw firm conclusions from a limited sample, EM FX vs USD strength appears to be the clearer tradable result of EM food inflation pressures. Forward rate expectations have also tended to pick up, albeit to a small extent, while curve flattening is less obvious. Lastly, it is not clear if we will observe a repeat of the relative EM equity strength we saw in the past given the current mixed cyclical backdrop across different EMs.

Source: Goldman Sachs

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The BRICs Are in Trouble (FT)

Tuesday, October 9th, 2012

by Gideon Rachman, FT.com

Over the past three years, conventional wisdom divided the world’s major economies into two basic groups – the Brics and the sicks. The US and the EU were sick – struggling with high unemployment, low growth and frightening debts. By contrast the Brics (Brazil, Russia, India, China and, by some reckonings, South Africa) were much more dynamic. Investors, businessmen and western politicians made regular pilgrimages there, to gaze at the future.

But now something odd is happening. The Brics are in trouble. The nature of the problem in each nation is different. But there are also some broad difficulties that link them. First, for all the hopeful talk of “decoupling”, the Brics are all affected by weak western economies. Second, all five nations are finding that endemic corruption is eroding faith in their political systems, and imposing a tax on their economies.

China remains the daddy of the rising powers. It is the second-largest economy in the world – and easily still the fastest growing Bric. And yet the country feels more uncertain about its economic and political future than in many years. As a Chinese friend put it recently: “Our economy is slowing sharply, our next leader has disappeared, and we are sending ships towards Japan.” Xi Jinping has since reappeared – as mysteriously as he disappeared in the first place. But political tensions remain high, with the trial of Bo Xilai about to start and a crucial party congress approaching.

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Growing Pains in the BRICs

Tuesday, September 25th, 2012

September 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.

Separate Paths
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

Source: FactSet

Brazil: Reaccelerating?
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.

India 2.0
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.

Tags: Brazil, BRICs, China, Commodities, energy, India, Natural Gas, oil, Russia
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Emerging Markets Weakening

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.

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Tags: Brazil, BRICs, Emerging Markets, India, Russia
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