Where Falling Inflation Means Rising Valuations (Koesterich)

Thursday, December 29th, 2011

by Russ Koesterich, Chief Investment Strategist, iShares

One silver lining of the current slow growth environment is that inflation in emerging markets appears to have hit an inflection point.

In recent months, for instance, inflation in both China and Brazil has come down. In China, consumer prices rose 4.2% in November from a year earlier, a 14-month low. Similarly, in Brazil, annual inflation fell to 6.64% in November, close to the 6.5% upper limit of the Brazilian central bank’s target range.

Emerging market inflation should decelerate further in 2012 thanks to a combination of continuing slower global growth and the lagged impact of monetary tightening. Brazil’s central bank has said it expects inflation to “fall sharply” by the second quarter of next year.

With the outlook for emerging market inflation improving, my team recently ran an analysis to determine which developing countries are likely to see their valuations benefit the most from falling inflation.

Here is the list, with each country ranked in order of how much they should benefit.

1.      Brazil

2.      India

3.      Egypt

4.      South Africa

5.      Russia

6.      Turkey

To develop the list, we looked at the relationship over the last five years between valuations (as measured by price-to-book values) and inflation levels for various emerging markets. For some countries, the relationship is positive — modest inflation is better for growth and translates into higher valuations during periods of inflation.

However, for other countries, the relationship is negative and higher inflation means lower valuations. This is especially true for countries that have gone through hyperinflation in the past, where investors are particularly sensitive to inflation readings and where valuations should benefit from decreasing inflation.

For our ranking, we focused on countries with a negative relationship that also still have high levels of inflation. For instance, Mexico and Indonesia would benefit from declining inflation. But they didn’t make our list because their inflation has already come down to a good range, which has already helped their valuations.

So how much should our top six countries benefit from falling inflation? Historically, every percentage point increase of inflation in Brazil is associated with Brazil’s price-to-book value decreasing by 0.3. I would expect the opposite to hold if Brazil’s inflation decreases.

At the bottom of the list, every percentage point increase of inflation in Turkey is associated with Turkey’s price-to-book value decreasing by 0.03. The other countries on the list fall somewhere in between.

But keep in mind that emerging market inflation is likely to stay above the comfort zone of many central bankers. In addition, inflation is not necessarily slowing in all emerging markets on our list. In Turkey, for instance, inflation has accelerated since February due to a combination of an overheating domestic economy and very unconventional monetary policy.

(Potential iShares solutions: EWZ and ERUS)

Disclosure: Author is long EWZ and ERUS

Source: Bloomberg

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.

Copyright © iShares

Tags: Book Values, Brazilian Central Bank, Chief Investment Strategist, Developing Countries, Egypt, Emerging Market, Emerging Markets, Global Growth, Growth Environment, Hyperinflation, inflation, Inflection Point, Negative Relationship, Periods, Russ, S Central, Second Quarter, South Africa, Target Range, Valuations
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An Opening for the Bears?

Thursday, February 24th, 2011

by Trader Mark, Fund My Mutual Fund

I have long said this is the unshortable market.  The strength has been so unyielding, even breaking the 13 day moving average (not to mention something more serious) was impossible.  In a normal market, the falling to the 20 day moving average is very normal, even in an uptrend.  But those moments have been extremely rare the past 6 months.   What I was looking for a month ago when the market broke down due to Egypt was a fall through the 20 day moving average – that did happen, and the market closed on the lows of the day (and week).  In normal times that is a very bad development for the technical structure of the market.  But I was wary.  Why?  Because it happened on a Friday, and since March 2009 almost all gains have come on (a) premarket surges Monday morning or (b) the first day of the month.  And after the Friday Egypt was roiled came Monday + the first day of the month (Tuesday).  Like clockwork the market gapped up Monday and was at yearly highs by Tuesday.  So much for the technical condition.

This time around, Monday is still a few days away, as is the first day of the month.  So the bears might have a small window of opportunity.  Now neither of these days should really mean anything but the psychological impact of seeing those type of days always work for the bulls, feeds on itself.  What would be truly striking would be a poor Monday premarket and/or a poor first day of the month – talk about a change in character.

Yesterday I said I’d like to see the 20 day moving average pierced, and then to close below it another day or two.  Thus far today in the early going, the bears finally have some mojo.  Of course the close is more important than intraday so we’ll see what happens at 4 PM, but for the first time since November shorts actually have a level to play against.  Once can short the index versus the 20 day moving average – if a burst of buying occurs the trade is over, and back to the unshortable market we go.  But at least there is some downside opportunity now and perhaps a move to the 50 day moving average on the S&P 500  (1286).  That would still be a shallow correction if it happened versus last Friday’s highs, but at least a bone for the long suffering bears.

One thing to note – EVERYONE thinks this dip is a buying opportunity.  In normal times, that would have be thinking it is not going to be so neat and easy.  A nice 3-5% dip that can be bought, and we can all live happily after.  The market *should* be messing with as many people as possible, so a nice cute short lived correction should not be what happens.  But this has not been a normal market in a long time.   Just in case there is any inkling of normalcy, a few out of the money puts 4-5 months out, would be an interesting insurance policy that could play out if we get something more serious – such as a break of the 50 day moving average, that really shakes some confidence.

Copyright (c) Trader Mark, Fund My Mutual Fund

Tags: Bears, Bulls, Burst, Egypt, Few Days, Intraday, Lows, Mojo, Monday Morning, Mutual Fund, oil, Premarket, Psychological Impact, Technical Structure, Uptrend, Window Of Opportunity
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Is the Fed to Blame for Unrest in Arab World?

Tuesday, February 8th, 2011

Bill Fleckenstein (hedge fund manager) and Dylan Ratigan explain the Fed’s role (Quantitative Easing) in the food price ignited revolutions (Tunisia, Egypt) in the Arab world.

Visit msnbc.com for breaking news, world news, and news about the economy

Tags: Arab World, Bill Fleckenstein, Breaking News, Economy, Egypt, Food Price, Hedge Fund Manager, Msnbc, Msnbc News, News World, Quantitative Easing, Revolutions, Tunisia, Unrest, World News
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Pickens: Egypt is Another Wake-up Call on Oil

Tuesday, February 1st, 2011

T. Boone Pickens, billionaire energy investor, on the unrest in Egypt and the possibility of it spreading to other nations.

Click here or on the image below to watch the video.

Source: Fox Business, January 31, 2011.

Tags: Billionaire, Egypt, energy, Fox, Foxbusiness, Image, Investor, Oil Energy, T Boone Pickens, Unrest, Wake Up Call
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Gold bullion – Is a Cycle Low Imminent?

Monday, January 31st, 2011

In what is probably an overdue correction after a stellar performance (+29.6%) during 2010, gold bullion has declined by 6.0% since the turn of the year. However, with the turmoil in Egypt as catalyst, the yellow metal sharply reversed course on Friday from an intraday low of $1,308.10 to close the week at $1,335.40.

The question that invariably comes to mind is whether we have seen the worst of gold’s decline. A few comments from Richard Russell, author of the Dow Theory Letters, regarding cycles are of particular interest.

“Analysts are talking about gold correcting down to 1,200 or even 1,000. However, I believe that the more important picture is that the gold bull market has much further to go on the upside. I’ve been reading the McClellan Market report for years. McClellan does a good deal of research on cycles, and I must say some of its cycle studies work out quite well.

“McClellan has discovered that a cycle low appears for gold roughly every 12.5 months. The cycle lows have run as follows: Jan 6, ‘06, Jan 8, ‘07, Jan 7, ‘08, Jan 5, ‘09, Jan. 4, ‘10, Jan. 8, ‘11. McClellan puts the next cycle bottom for gold at February 8, 2011 which means it should arrive at any time between now and February 8, give or take a few weeks before or after that date.

“Interestingly, the McClellan cycle bottom for gold is due to arrive amid a good deal of professional bearishness regarding gold. Thus many traders have traded out of their gold positions, just as we near the date for the McClellan cycle bottom.”

The red arrows in the chart below mark the McClellan cycle lows.

Source: StockCharts.com

Separately, Adam Hewison (INO.com) also provided a brief video analysis on the technical outlook for gold, arguing that a buy signal has not been given but that gold see a pop to the upside. Click here to access the presentation.

Although it is difficult to pinpoint short-term bottoms, I am of the opinion that the gold bull market remains intact, especially with inflation blowing up all around the world. Meanwhile, China and a number of other Asian countries keep adding gold to their reserves. These purchases should provide a floor to price declines – an “Asian put” so to speak.

Tags: 5 Months, Bottoms, Catalyst, China, Decline, Dow Theory Letters, Egypt, Gold, Gold Bullion, Gold Market, Ino, Jan 7, Lows, Mcclellan, Pop, Red Arrows, Richard Russell, Separately, Stellar Performance, Technical Outlook, Turmoil, Video Analysis
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Obama’s Honeymoon Faces Daunting Tasks

Wednesday, January 21st, 2009

The following paragraphs from Nouriel Roubini’s RGE Monitor provide an insightful look at the daunting economic and geo-political challenges facing President Obama.

Now that Barack Obama has taken the oath and become the 44th President of the United States, he faces great expectations at home and abroad to steer the U.S. and global economy out of the greatest post-war recession and financial crisis, to re-align the U.S. foreign policy stance and global standing on issues like financial sector regulation, climate change, trade talks and nuclear proliferation. He – and his team – enters with large amounts of political capital.

Obama’s public acknowledgment that the country’s economic woes will remain challenging in the near-term and will involve great adjustments, and his choice of a strong economic team are signs of optimism that the administration will be quick with policy measures. While the domestic economy (especially passing a fiscal stimulus package) will take most of his time in the short-term, the Israel-Gaza offensive indicates foreign policy concerns – especially in the Middle East and South Asia will also demand attention from the beginning of the Obama presidency.

Fiscal Stimulus
Significant growth contraction in Q4 2008 and Q1 2009 along with mounting job losses, declining asset incomes, corporate bankruptcies and tight credit conditions, mean Obama’s first priority will be to pass the fiscal stimulus package by February 2009. The payroll tax relief, extension of unemployment insurance and food stamps for low-income households included in the package will cushion vulnerable groups from the recession and boost consumer spending. However, these policies may do little to boost growth in the short-term. With only about US$100bn of around US$500bn in planned infrastructure spending expected to kick in within the first three months, the initiative may not be timely in spite of being potentially effective in boosting the economy during late 2009 and 2010.

While tax cuts will be timely, households facing financial pressure will save the proceeds rather than boost spending just as they did during Q2 2008, limiting effectiveness. Similarly, tax credits for businesses to hire workers and invest in new equipment will be ineffective in stimulating investment since firms forecasting a prolonged slump in domestic and export demand and high credit costs will cut capex plans.

However, given that state and local governments support greater spending and jobs than the federal government, grants for the recession- and budget-deficit hit states will be more effective in preventing cut backs in public services, infrastructure projects and jobs, and also partly offset declining tax revenues and slump in debt financing.

But given our estimated contraction in private demand of around US$700bn in just 2009 alone, the US$800bn-plus stimulus package distributed over two years (2009-10) might not be enough to offset the contraction in GDP in 2009. Also, the extent of job creation via the stimulus might be limited as infrastructure projects will, at best, absorb workers from real estate construction and low-end manufacturing while services and manufacturing in general will continue to witness hiring freezes due to low demand. Moreover, investment in infrastructure, renewable energy and R&D will simulate the economy and create jobs only in the medium to long run.

Hence, the prolonged slump and a very sluggish economic recovery might actually necessitate a second stimulus package. More importantly, unless the government addresses problems of bank capitalization and mortgage crisis, any fiscal stimulus will be ineffective in steering the economy out of this crisis.

Continued bank bailouts have signaled to the administration that further bank writedowns are imminent and the banking system as a whole might be insolvent. Capital injection on an ad-hoc basis, or even after banks write down bad debt to establish asset values, might only delay a broader solution for toxic assets while making inefficient use of the TARP funds. One possible solution would be the creation of a ‘bad bank’ that can buy toxic assets from banks to ease pressure on their balance sheets and help stimulate lending to the private sector.

An alternative might be to use the remaining TARP funds to extend government insurance to banks’ toxic assets. Obama’s economic team also has voiced concerns that the TARP funds have been inefficiently used by banks so far in order to absorb losses on their balance sheets, fund acquisitions and pay for compensation rather than fuel credit growth in the economy. The new administration will likely direct the remaining funds towards unclogging credit markets and renewing lending to households and firms by targeting consumers and municipalities – credit cards, mortgages, auto loans, students loans and muni bonds. Total loan losses are expected to hit US$1.6 trillion and additional negative feedbacks on MBSs and other ABSs are imminent, especially as the recession raises default by households and corporates.

Tight credit conditions and financial headwinds for households will continue to raise foreclosures and mortgage defaults. Increase in the excess home supply now poses the risk of over-correction in home prices thus leading to further bank losses and contraction in consumer spending. As a result, Congressional Democrats and the Obama administration will have to work on modifying the troubled mortgages and refinancing them into longer term low interest loans. But given the limited effectiveness of past government programs, the new government needs to reduce the mortgage principal to fix the problem of homeowners’ insolvency rather than just extending the maturity period or reducing the interest rate.

To encourage greater lender participation, the government will have to share the cost of modifying the loans and offer lenders a share in future home appreciation and share any losses from default on the modified loans. While Democrats favor using some of the remaining TARP funds for this purpose, estimates suggest that the cost of such a program might be as much as US$600bn to US$1 trillion, especially as home prices overcorrect downward, more homes fall into negative equity and defaults on the refinanced mortgages continue. To contain fiscal costs, the government should be the senior debt holder in the modified mortgages to benefit from future home appreciation.

Continued bank bailouts, fiscal stimulus packages and refinancing at-risk mortgages will likely push up the fiscal deficit to over US$1.3 trillion in FY2009. While these counter-cyclical spending measures are warranted to address the crisis and Obama might also delay his plan to raise taxes, the U.S. will have to consider fiscal consolidation during the recovery phase. Unless the government reforms the tax system, reduces health care costs and finances Social Security and defense needs, a structural budget deficit will continue to pose risks to the U.S. debt financing needs and the dollar for many years to come.

Trade
Global trade talks might take a backseat in 2009 as the U.S. and other economies remain occupied with domestic counter-cyclical fiscal and monetary policies. However amid slumping exports, more and more governments might impose import restrictions, offer trade distorting fiscal stimulus to domestic firms, prevent stimulus leakages via imports, bail out national champions and favor undervalued currencies. Escalating trade protectionism during the Great Depression actually worsened the global economic crisis. In such a scenario, the U.S. would need to take the lead to renew global trade talks and establish WTO guidelines to prevent countries from pursuing protectionist measures. However, this will be a longer term objective.

Meanwhile the discussion on NAFTA is likely to re-emerge in light of the President’s visit to Canada, reportedly his first foreign trip. While policy on trade agreements, the Chinese reminbi and inward-investment by foreign governments might take a backseat in the initial days of the new administration, China’s bias for an undervalued currency to support exports and the need for investments from foreign governments in the face of U.S. bank and corporate bankruptcies might rekindle these issues. Moreover, as imports and exports shrink for deficit and surplus countries respectively, U.S. will lead the world in the painful unwinding of global imbalances.

Energy and Climate Change
Although climate change is a major priority and the new members of Obama’s energy team are focused on increasing energy efficiency and the share of alternative fuels in the U.S. energy mix, coming to consensus on these issues may be difficult – and comprehensive climate change legislation might not come to the fore until 2010. In the short-term, the most significant policies to support alternative fuels may come through other economic packages – the fiscal stimulus, the terms of the support to the auto sector are some examples.

President Obama has emphasized that the fiscal stimulus will include support for ‘green jobs’ – jobs that support alternative energy and help to wean the U.S. from fossil fuels that are increasingly sourced abroad from unstable countries, but these will take time to have effect. However, political momentum globally may build as the next climate change conference approaches at the end of 2009. Steven Chu and other members of Obama’s energy team are expected to push for significant energy policy changes towards renewable and federal climate change legislation, including an economy-wide cap-and-trade program however the severity of the economic recession may make a gas tax unpalatable even if it is matched by offsetting payroll tax cuts.

Despite the fall in demand as global output contracts, there are obstacles in diversifying both the source of energy supplies and the type will be difficult, particularly in the short-term. Not only do the costs of alternative energy remain high, particularly as technologies are still being developed. Government policies might offset this gap.

The reduction in oil prices may deter some of the demand for drilling off the U.S. coastline even as it deters investment in alternative technologies. Similarly, environmentally costly fuel from Canada’s oil sands may find U.S. markets less welcoming, even if it spurs investment in carbon sequestration in the long-term. Already the fall in gasoline prices has deterred the purchases of hybrid vehicles, possibly reversing some of the behavioral changes that led to lower petroleum consumption in mid-2008.

Foreign Policy
Despite the administration’s focus on passing a fiscal stimulus and domestic policy issues, President Obama has inherited a complex set of foreign policy issues from President Bush that will occupy him, his Secretary of State Hilary Clinton and their teams. Political and security issues in the Middle East and South Asia are particularly urgent. Obama comes to power with significant political capital and a set of experienced officials determined to increase diplomatic efforts to counter global threats given the limitations of hard power to solve global issues.

The Gaza crisis pushed the Middle East and especially the Israeli-Palestinian conflict to the top of the President Barack Obama’s agenda. In particular the focus will be on trying to prevent a precarious ceasefire from contributing to regional instability. The cease-fire in Gaza could present a fresh opportunity for mediating a peace process, but Obama will be faced with a set of challenges nevertheless that may absorb a lot of U.S. political capital in the region.

The conflict had deepened a rift between the Palestinian rival political factions – Hamas and Fatah – and the lack of national unity may continue to impede the serious advancement of the Israeli-Palestinian peace process, as will divisions between Arab states. Furthermore, Israel holds parliamentary elections on Feb 10 and the commitment of the Israeli government to the peace process will vary. Finally, brokering a successful Middle East peace process involves a broad regional approach and an effort to address regional players, such as Syria and Iran and involving both tradition power brokers like Egypt, Jordan and Saudi Arabia and newer entrants like Qatar.

A set of elections in the Middle East, especially in Israel, Iraq and Iran in the first half of 2009 may provide testing times. The reduction of U.S. troops in Iraq and transfer of power to Iraqi authorities is already well under way but more details are yet to emerge regarding the exit of U.S. troops. While Obama pledged to withdraw troops from Iraq with 16 months of taking office, they might remain for some time. The President has emphasized a new approach to deal with Iran including the possibility of lower-level diplomatic engagement, but the country’s emphasis on nuclear proliferation may be difficult to shake. With the fall in the price of oil, Iran’s abilities to fund its proxies in Iraq, Lebanon and Palestine may be reduced as maintaining domestic support becomes paramount.

Regional security continues to deteriorate in South Asia with the resurgence of the Taliban in Afghanistan, growing hostilities between India and Pakistan, and a weakening alliance with Pakistan against the war on terror. Obama has regularly echoed the need for more troops to be deployed and the Senate has agreed to send additional troops almost doubling American troops on the ground. However, the daunting task of constructing a comprehensive new strategy for a region defined by endemic corruption and the lack of basic amenities remains – and the economic crisis might make it more difficult to convince fellow NATO members to also increase their military presence. By contrast, despite the persistence of North Korea’s nuclear program, East Asia is unlikely to grab as much attention. Economics will likely continue to dominate the U.S. China relationship particularly now that China’s exports are contracting and China, like the U.S. faces a hard landing.

President Obama will seek to strengthen transatlantic ties that have weakened following the Iraq war. Washington will work together with EU closely together to respond to the financial and economic crises, peace and security issues, and to stop and reverse climate change. But convincing NATO allies to increase military presence in Afghanistan may be difficult. U.S.-Russia relations have been strained by NATO’s eastward expansion, war in Georgia, gas politics, Kosovo’s independence to name a few. Despite a warning that Russia might deploy short-range missiles in the Baltic region if Washington proceeded with its missile defense shield in Eastern Europe, Moscow has signaled its willingness to reexamine relations with the U.S. under the new administration.

The U.S. and Russia may be able to make common cause regarding the nuclear threat from Iran, helped perhaps by Obama’s ambivalence about the missile defense and ruling out of a speedy NATO membership track for Ukraine and Georgia. Yet neither country will be willing to compromise on its core interests, and a divided Europe may make responding to a poorer, but still determined, Russia more difficult.

Source: RGE Monitor, January 21, 2009.

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