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Rethinking emerging markets after Libya? Who isn't? Here's how that violence has changed my thinking.
02/25/2011 8:30 am EST
I certainly think that the big drops in emerging market stock markets are leading some investors to abandon markets that they never felt all that comfortable with in the first place.
For those of us—and I do mean us—who do believe in the long-term emerging markets story (and I wouldn’t have started a global mutual fund if I didn’t), it is still important to acknowledge that what we can call the Libya crisis for short has increased the medium term—say the next six to nine months--risk of these markets.
How come? Higher oil prices are a big problem.
Yes, I know that Saudi Arabia has lots of excess oil capacity and has pledged to pump to meet any losses from Libya. I know that it’s likely that once the Libyan crisis is over oil prices will retreat from current levels so that the world is probably not looking at $110 a barrel oil as the new base price. (I argued all this in my post http://jubakpicks.com/2011/02/23/its-still-a-little-early-in-the-libya-crisis-for-bargain-hunting/ )
And I know that the worries of the moment have concentrated on the world’s developed economies, especially Europe, which is very dependent on oil and gas supplies from Libya. The worry here is that higher oil prices—and Brent crude traded at $111 a barrel on February 23—will stall the weakest economies in the European Union. (A rule of thumb among economists is that every $10 increase in the price of a barrel of oil cuts GDP growth by half a percentage point within two years.)
But higher oil prices, even modestly higher oil prices, couldn’t come at a much worse time for emerging economies where governments are waging a tough battle to control inflation without tipping their economies into a big slowdown.
That balancing act, already difficult, got much, much harder with Libya. The danger of a policy mistake—too much inflation fighting leading to too little growth or too little inflation fighting leading to too much inflation—has gone way up, even if post-Libya, the price of oil comes back down to $95 or so.
To understand the risks play central banker with me for a moment. Pretend that you’re the head of the People’s Bank of China, the Reserve Bank of India, or the Banco Central do Brasil and that you’re engaged in a tough battle to control inflation and to preserve as much economic growth as possible.
In Brazil, for example, inflation roared ahead to a 5.99% annual rate in January and then climbed further to a 6.05% rate in February. (Brazil measures inflation from mid-month to mid-month.) That’s despite an interest rate increase from the central bank to 11.25% in January. The Banco Central is expected to raise its Selic benchmark interest rate again when it meets next in early March.
Economists don’t think a March increase will be the last either. The consensus is that the Selic interest benchmark will hit 12.5% by the end of 2011 before falling back to 11.25%, the current rate, by the end of 2012. Even with those rate increases economists are expecting inflation to be a still high 5.75% by the end of 2011.
To get inflation down in 2012, the bank has to slow the economy now. Which does seem to be happening. Economists now project that the economy will grow by 4.5% in 2011. That’s down from an earlier projection of 4.6% growth and from 2010 growth of 7.8%. It’s also below the government’s official projection of 5% growth.
Threading this policy needle already looked tough enough. Thanks to that 7.8% growth rate—GDP growth averaged a much lower 3.24% from 1991 to 2010--unemployment in Brazil in hit a record low 5.3% in 2010. Unemployment averaged 9.95% from 2001 to 2010. A slowdown to 4.5% growth won’t raise unemployment but it’s sure going to raise anxiety in a country coming off annual growth of 7.8%.
Into this growth/inflation mix add rising commodity prices. Higher commodity prices are good news for growth in an economy that exports commodities, such as Brazil, but it is still bad news for inflation. If iron ore, and sugar, and coffee prices all go up—and prices for Arabica coffee beans are up more than 100% since June 2010 to a 30-year high—that means good times for Brazilian companies such as Vale (VALE) and Cosan (CZZ)—but also higher consumer prices for everything from cars to soda to coffee. And bigger inflation worries for the Banco Central do Brasil.
And now along come higher oil prices thanks to the turmoil in Libya. Brazil is an oil exporter—an estimated 570,000 barrels a day in 2010—which is good for Brazilian oil companies and their partners. But an increase in global oil prices still means an increase in the price that Brazilian companies have to pay for fuel and petroleum feed stocks. Brazilian airline Gol Linhas Aereas Inteligentes (GOL), for example, modeled its 2011 guidance for investment analysts in early January using a range of $82 to $93 a barrel for oil (West Texas Intermediate). That benchmark closed at $99 a barrel on February 23, substantially worse than Gol’s worst-case scenario.
Brazilian regulations don’t allow airlines to charge a fuel surcharge to domestic passengers—ouch for Gol—but you can bet that any company paying extra for oil will do its best to pass on all the costs it can to consumers. And that means higher inflation.
Before the Tunisia/Egypt/Libya crisis commodity prices looked like they might be moderating as a result of attempts to slow growth in emerging economies. Central banks looked like they might get lucky and some either took a break from interest rate increases or talked about giving rate increases a rest. But the spike in oil prices from the crisis has removed that potential positive feedback from the system. Since the rise in oil prices doesn’t (so far at least) have anything to do with demand, central banks are left looking at a scenario in which their efforts to slow their economies have almost no effect on oil prices. And the inflation created by oil prices.
In this way oil prices act very similarly to food prices. Lowering demand by slowing economic growth so that consumers have less to spend on food (Isn’t that an exciting policy choice?) would have little effect on rising prices for corn, wheat, soybeans, etc., which, in the short-term that we’re talking about, are driven by the effects of drought, floods, cold, etc.
Many central banks in both the developed and emerging economies have decided to deal with the problems of rising food and energy inflation, even before Libya, by ignoring them. The U.S. Federal Reserve, for example, follows a core inflation measure that excludes food and energy prices. The People’s Bank of China seems to be pursuing a de facto policy of treating food price inflation as a temporary problem.
In the short-term I don’t think it’s possible statistically to ignore all the inflationary impact of higher energy and food prices. I’m pretty sure that in the long-term it doesn’t work as central bank policy because food and energy inflation filter through to the rest of the economy.
And as they do central banks that are now ignoring this kind of inflation will have to join the ranks of those central banks that include these prices in their inflation measures and figure out how much higher interest rates should go to take account of this inflationary effect.
Central banks such as the U.S. Federal Reserve that seem likely to fight including these prices to the very end will pay a price in a weaker currency, which might require higher interest rates if the country in question needs to get overseas investors to buy its debt. (Sound like any country you know?) That was one explanation offered by currency traders on February 23 to explain why the dollar was falling against the euro. (The European Central Bank includes food and energy in its inflation measures and was therefore thought more likely to raise interest rates before the Fed does.)
Central banks that include food and energy in their inflation measures and decide they need to raise interest rates to combat inflation from those sources too risk stunting the growth of their economies. That’s a real danger in the European Union, where even the German economy has slowed lately. And it’s just as much a danger in emerging economies where the policy response to inflation has already put multiple interest rates into the economic system.
Interest rate increases operate with a lag. So central banks that have raised rates aggressively, such as India or Brazil—or more moderately—such as China—are looking at economies that are already set to slow by an unknown amount on an unknown schedule.
Should the Banco Central or the Reserve Bank of India or the People’s Bank raise rates on the schedule they developed before the Libyan crisis raised oil prices to near $100 a barrel? That might be insufficient to effectively fight inflation with a bigger contribution from oil prices. Should the central bank get more aggressive? That risks slowing the economy more than expected at a time when higher oil prices are already acting as a drag on growth. Already some economists in Brazil are warning that current policy could send growth below 4% in 2011.
For investors the risks are that central banks will raise interest rates for longer and to higher levels than the financial markets now expect. Expectations are that the rate increases in Brazil will stop at 12.5% at the end of 2011. Expectations are now that the People’s Bank of China will raise benchmark interest rates one more time this spring (two at the outside), and then take a break to see what happens to food prices over the summer. If those expectations turn out to be too optimistic, then emerging financial markets will fall further and for longer than the 15% to 20% by June that I’ve been using as my worst-case scenario. (That’s a total decline of 15% to 20% from the highs, mind you, and not from current prices. India’s Sensex 30 index, for example, is already down 13.5% from its November 5, 2010 high.)
The real quandary is that there won’t be any way to tell until later in the year what the central banks in emerging economies have decided to do. We’ll have to wait until April or May to see what the central banks might do for the rest of the year. And even then there’s a very real possibility that we won’t be able to tell with any certainty.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Cosan, Gol, and Vale as of the end of January. For a full list of the stocks in the fund as of the end of January see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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