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Plotting the bottom for emerging market stocks
05/10/2011 11:01 am EST
Emerging market stocks have had the “emerging” beaten out of them in the last month. Brazil’s Bovespa index is down 7.8% from the April 5 local high to the close on May 6. India’s Sensex 30 index is down 6% from its April 4 local high to the close on May 6. China’s Shanghai Composite index is down 6.3% from its local high on April 18 to the close on May 6.
But this recent drop is just an accelerated version of the decline that most of these markets have suffered since they peaked back in the first half of November. From those November highs the Bovespa is down 10.4%; the Sensex is down 11.2%, and the Shanghai Composite is down 9.0%.
Since the beginning of the year I’ve been saying that the U.S. market will be the best performing stock market in the world in the first half of 2011. And it has been with the Standard & Poor’s 500 index up 5.3% even after the carnage of the last week.
But I’ve also been saying that investors should rotate into emerging market stocks, beginning slowly in May or so, because they would outperform in the second half. On current performance you’re entitled to ask “Oh, yeah? When?”
In the last few weeks I’ve been writing that “May or so” should definitely emphasize the “or so.” Today’s post is my attempt to explain why the timetable for rotating into emerging markets has slipped but remains fundamentally intact. And to give you some concrete guidelines for planning your rotation into emerging market stocks.
First, a quick summary of everything that was going to fall into place to make emerging markets outperform.
- Emerging market central banks, which began fighting inflation before any of the Big Three developed economies started to raise interest rates, would have ended the chance of runaway inflation and be close to ending the current cycle of interest rate increases from Delhi to Brasilia.
- Developed economies would be just starting a round of interest rate increases designed to fight inflation, yes, but just as importantly to normalize currently negative real interest rates somewhere above zero.
- As emerging economy central banks stopped raising interest rates, economic growth rates in those countries would start to move higher.
- Rising interest rates in the Eurozone and the United States would start to strengthen the euro and the dollar against emerging market currencies, reducing the hot money cash flows into these currencies and at least slowing the rate at which they appreciate against the dollar and euro.
- The end of worries about emerging economy growth that comes with the end of the interest rate tightening cycle would stabilize commodity prices in an upward trend but that move is moderated by gains in the dollar. Commodity-driven emerging markets show less volatility.
Nothing ever works out as perfectly and orderly as that scenario. It’s just a question whether the changes are so great that you need to junk the whole thing and go back to the scenario board or if they are just modifications in a structure that still hangs together. I believe that the second is the case in this emerging market scenario. The timing certainly needs modification but the trend does still run in the direction I’ve described.
- Emerging economy central banks have blinked when it came time to really stomp on inflation. For example in Brazil, the Banco Central do Brasil imposed a 0.25 percentage point increase in interest rates when the financial markets were thinking that 0.5 percentage points were necessary. That just undermined the bank’s credibility on inflation and stretched out the rate increase cycle.
- Some emerging economy central banks remain convinced that they can get away with fewer interest rate increases or none at all by supplementing (as in the case of China) or replacing rate increases with higher bank reserve requirements (Turkey), credit restrictions, and price controls (China again). Nobody is sure if these measures will work but the financial markets have doubts. This too drags out the interest rate cycle.
- U.S. fiscal policy has been so irresponsible that it has delayed any move by the Federal Reserve—except the politically necessary one to end quantitative easing in June—that might slow the U.S. economy. The U.S. central bank is doing everything it can—reminding Wall Street that it will keep buying Treasuries when current investments mature, for example—to convince financial markets that it will continue to a pro-growth monetary policy. Of course, the financial markets aren’t convinced; they know how little wiggle room the Fed has left with interest rates at 0%. But you can’t say the Fed isn’t trying. And it has managed to convince investors that the beginning of U.S. interest rate increases are further out than anticipated at the beginning of 2011.
- Nobody expected a wave of revolutions in the Arab world that would remind commodity markets of exactly how little spare capacity oil producers have. The rise in oil prices helped lead commodity prices in general higher and that has fed into global inflation and inflation expectations.
- The European Central Bank is trying desperately to live up to the inflation-fighting image of the old Bundesbank, but the euro crisis keeps getting in the way. The bank would be a lot further down the rate-increase road if Portugal and Greece didn’t keep getting in the way. And if the European Central Bank had already raised rates two or three times by now, instead of just once, who knows if the U.S. Federal Reserve could have resisted the pressure—or the plunge in the dollar—to follow and put an interest rate increase on the books for 2011.
What we’re left with after reality has so rudely dealt with my ideal scenario is a combination that I’d call splintering delay: all the emerging markets are going to take longer to reach their interest rate cycle turning points and some are going to take far longer than others.
Brazil, for example, which looked at one point to see the current interest rate cycle top out at 12% perhaps as early as this fall, now looks headed for a top benchmark interest rate of 13% or even 13.25% by the end of 2011. The central bank is still predicting that month to month inflation growth will start to slow in May and that 12% is a likely top. But that forecast is widely seen as part of the problem: The central bank is too optimistic and therefore moving too slowly, the financial markets concluded after the bank raised rates just 0.25 percentage points in April.
But Brazil seems to be on the inflation/interest rate cycle fast track when compared to China. Beijing seems to have moved in recent months from fighting inflation to fighting the perception of inflation—see Friday’s fine of 2 million yuan ($308,000) against Unilever for talking about plans to raise prices. Panic buying hit Shanghai, Beijing and other cities when government media announced that the four companies that dominate the detergent market—Procter & Gamble, Guangzhou Liby Enterprise Group, Nice Group, and Unilever were planning to raise prices by as much as 15%. So far only Unilever has been hit with a fine.
As politically popular as price controls, government-run low-price grocery stores, ad-hoc reversals of transportation fees and surcharges, and the public humiliation of companies that dare even think about raising prices may be, all these measures are really just delaying tactics. They postpone the day when inflation hits home, but they don’t themselves reduce the causes of inflation. They’re worth implementing if they buy time while the government tackles the root causes of inflation—in the case of China such thorny problems as an under-valued currency and negative interest rates for bank depositors. They’re actually harmful, however, if they wind up being regarded as substitutes for hard choices that might actually slow the economy and throw Chinese workers out of work. In that case these policies actually make inflation worse by delaying significant action and lead to the need for more drastic policies in the future.
In China’s case I can actually see real but very painful steps that the country could implement to fight inflation. I have a much harder time imagining what India could do. The country’s inflation seems undiminished by fairly aggressive interest rate increases by the Reserve Bank of India because the huge inefficiencies in the Indian economy multiply the effects of global inflationary trends. True, food prices are going up around the world, but they’re going up faster than trend in India because the country’s chaotic transportation and distribution systems can’t get food from producers to consumers without vast waste. The bottlenecks in the country’s roads, railroads, and ports impose a kind of tax on the economy that makes itself felt when domestic demand strains against those limits. Fixing these kinds of problems isn’t impossible—after all New York is finally building a Second Avenue subway line a mere 75 years after planning started—but it is much more complicated and takes far longer than fixing a currency exchange rate.
I’d divide the world’s emerging economies into four groups—the slightly delayed group (modeled on Brazil), the in denial-group (modeled on China but including Turkey and Indonesia), the really long-term problems group (modeled on India), and a very small group that seem on top of the problem (modeled on ‘Chile)—based on their inflation-fighting policies and their place in the interest rate cycle.
Trying to put an investment strategy together that fits this splintered picture isn’t easy.
So much depends on not just domestic policy decisions but on the way global trends break. And in the sensitivity of individual emerging economies to these global trends,
Chile is a great example. In April inflation in Chile moved up only 0.3% from March. That’s a huge retreat from the 0.8% monthly inflation rate in March. Chile’s central bank, which has been one of the world’s most vigilant on inflation, had raised interest rates by 0.5 percentage points in each of the last two months trying to get ahead of inflation that threatened to accelerate above the bank’s 4% annual target. The bank will almost certainly not declare victory on one month’s data.
Chile imports about 99% of its fuel and that makes the country’s inflation extremely sensitive to fluctuations in the price of oil. Looking at domestic data alone the bank is probably feeling hopeful that it has inflation under control. Looking at the global economy and the possibility for a return to oil price inflation, I suspect the bank is worried. I think that the domestic news has increased the odds that the central bank will opt for a 0.25 percentage point increase rather than 0.5 percentage points when it meets on May 12. But it’s worry about the global picture that makes the bank likely to raise rates despite domestic good news.
Brazil is less sensitive to global oil prices than Chile, since under normal conditions it produces all its own fuel from oil and sugar cane. (Currently Brazil is importing some fuel because of a poor sugar crop and rising sugar prices.) But Brazil’s domestic inflation rate is very sensitive to inflows of U.S. dollars. For Brazil getting inflation under control would be a whole lot easier if more U.S. dollars stayed at home. They have in recent weeks—one reason, perhaps, that Brazil’s most recent inflation data looked promising. But Brazil’s central bankers have a similar worry to that troubling their Chilean counterparts: Are the trends that are sending dollars out of Brazil likely to last for long?
To my way of thinking, currently, the domestic trends—inflation and interest rates—are more important to investors than the global trends. The domestic trends on inflation and interest rate cycles take longer to play out than the swoons and rallies of currencies or booms and panics in commodity prices set off by changes in margin requirements in Chicago. And the effects of these domestic trends are fundamental in ways that a rally in the dollar or a correction in oil prices aren’t. Trends in interest rates and inflation can starve a company of capital or destroy markets entirely because customers don’t have access to cash.
Think of it this way—the global trends are creating really scary short-term volatility but while frightening, this volatility doesn’t have much to do with the fundamental value—to investors—of a Brazilian fast food franchisor such as Arcos Dorados (ARCO) or a Chinese hotel company such as Home Inns and Hotels Management (HMIN) or a Chilean airline such as LAN Airlines (LFL). Tell me how, for example, the rise or fall of copper, the gyrations of the U.S. dollar, and the risk on/risk off sloshing of cash around the globe change the fundamentals for this year and the next and the next for a company like Arcos Dorado’s, the biggest McDonald’s franchisor in Latin America?
From this perspective, the very scary drop in stock markets in the last week are important for emerging market stocks only to the degree that they stretch out the inflation/interest rate cycle in individual emerging markets. Aside from that, they’re noise—scary like thunder but ultimately powerless.
Right now I’d be looking for bargains in companies with domestic franchises (or brands or market share leaders—however you want to define the edge you’re looking for) created by that volatility in the domestic economies of the countries of what I’ve called the Chile group, a group that may be limited to Chile, Poland, and Singapore. These are small economies so that doesn’t give you a whole lot of stocks to pick from. Chile offers LAN and Cencosud (CSUDF.US or CENCOSUD.CI in Chile), an operator of supermarkets, hypermarkets, home improvement stores, and shopping centers in Chile and Argentina. Poland offers Powszechny Zaklad Ubezpieczen (PZU in Warsaw), the country’s leading insurance company. In Singapore there’s Keppel (KPELY.US or KEP.SP in Singapore), a builder of oil rigs and desalination plants.
Right now I’d be watching and waiting on similar domestic companies in the economies of the Brazil Group. Names that come to mind that you can actually buy on U.S. markets include Arcos Dorados and AmBev. I think you can start buying these about six months before you think the interest rate cycle will peak. If you project December, for example, that means June or July. (Or as I said earlier “May or so.”) I’d hold off of Brazilian banks until a bit later to see if the consumer credit “problem” in Brazil” is going to become a “bubble.”
And on the China group I’d wait even longer. A 10% drop in Shanghai stocks isn’t a huge correction. That market so regularly delivers 20% drops that only a retreat of that magnitude constitutes a buying opportunity. Absent one of those, I’d wait until we have a better idea of how fast and far inflation is going to run, and how hard the People’s Bank is going push interest rates higher. August comes to mind as a potential timeline but that’s nothing more than a guess on my part based on previous August swoons in Shanghai.
This scenario is subject to revision with events—an outbreak of fiscal sanity in Washington, a Greek default, peace in Libya or …some surprise that’s not even on the radar screen at the moment.
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 Home Inns and Hotels Management, LAN Airlines, Keppel, Natura Cosmeticos, and Powszechny Zaklad Ubezpieczen as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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