Are China and Brazil's stocks about to race away from slow growing developed markets?

09/09/2011 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Will the superior economic performance of developing economies such as China and Brazil translate into superior stock market returns over the next 12 months?

Or will the dismal performance of the world’s developed economies—as the United States and the European Union slide toward slow to no growth—drag all boats down to the bottom?

In other words will emerging stock markets decouple from developed stock markets in the last part of 2011 and in 2012?

I think that’s the most important question facing stock investors right now.

What’s decoupling? It’s when a stock market dances to its own tune rather than moving in lockstep with other markets or with the global market as a whole.

Decoupling is different—or maybe you can call it an extreme case--from relative out- and underperformance.

We’ve been through a good example of out- and under performance in the last part of 2010. In the fourth quarter of 2010, for example, the U.S. Standard & Poor’s 500 gained 10.8%. The Brazilian stock market, as tracked by the iShares MSCI Brazil Index Fund (EWZ), gained just 4%.

Sometimes the outperformance can be really extreme. From December 31, 2010 to its peak on April 29, 2011 the S&P 500 climbed to 1364 from 1258. That’s a gain of 8.4%. From December 31 to April 29 the MSCI Brazil Index Fund went from $76.23 to $76.55. That’s a gain of 0.4%.

But even then the two markets moved in the same direction—even if just barely.

Pure decoupling is different—and rarer. Like what happened in 2007. That year in the fourth quarter the S&P 500 went down by 3.6% while the Brazil Index Fund went up by 11.4%. For the year the S&P finished ahead a paltry 4.9% and the Brazil Index Fund was up 74.8%.

Could we see that kind of decoupling in the remainder of 2011 and in 2012? (Or even just extreme out performance?)

The economic growth trends give decoupling a good chance.

Leaks say that the International Monetary Fund will cut its forecasts for U.S. and Eurozone growth when it releases its next report on global growth on September 20.

For the United States, the forecast growth rate for 2011 will go to 1.6% from a forecast of 2.5% just two months ago. For 2012 the forecast will call for 2.0% growth, down from 2.7%.

For the EuroZone the drop will see a forecast of 1.9% growth in 2011 (down from 2.0%) and 1.4% growth in 2012 (down from a forecast of 1.7%).

In contrast the International Monetary Fund will forecast the global economy will grow by 4.2% in 2011 (down from a prior forecast of 4.3%) and by 4.3% in 2012 (down from a forecast of 4.5%).

That’s a big enough difference—roughly 2 times more growth for the global economy as a whole than for these two big developed economies.

But the gap gets even bigger if you look at the big developing economies of China and Brazil alone.

For Brazil the central bank’s most recent survey of economists showed a consensus forecast of 3.67% growth for 2011 and 3.84% in 2012. The government of President Dilma Rousseff is projecting 5% growth for 2012. (More later on who might be right.)

For China growth estimates have been falling as the global economy slows, but the consensus for 2011 still hovers just below 9% (Deutsche Bank, for example, forecasts 8.9% and UBS comes in with 9%), and for 2012 at 8.3% or so.

Economic growth rates alone don’t determine stock prices. Otherwise Chinese and Brazilian stocks would have outperformed the U.S. and European equity markets in the first half of 2011.

Expectations for the direction of economic growth rates are far more important, I’d argue, than absolute growth rates. In the first months of 2011, for example, the belief that the U.S. and EuroZone economies (Well, Germany and France, actually) were growing at better than expected—if still low rates—buoyed stocks in those markets. Fears that China and Brazil were slowing—even though the projected slowdown was to a growth rate two or three times higher than in the developed economies—weighed heavily on stocks in those markets.

And equally important to expectations, I’d say, is uncertainty over the direction and ultimate destination of economic growth rates. China’s financial markets have been a poor performer in 2011, falling 11.2% for the year as of September 7 and 17.6% from their April 13 high. And an even worse performer since they peaked on November 8, falling 27.7%--Big Bear Country—as of September 7. A good part of that has been because of uncertainty of how much growth Beijing’s fight against inflation would take out of the economy and fears that a long program of interest rate increases and additions to bank reserve requirements would send the economy crashing to a hard landing.

So where do China and Brazil stand on those two scales?

China looks like it is near a peak in inflation—6.5% in July—with economists calling for a dip to 6.1% for August in data to be released on Friday September 9. That wouldn’t put an immediate end to China’s round of higher interest rates and added bank reserve requirements but it would tell financial markets that the end of this cycle is near. Investors could start to take their worries about tighter monetary policies leading to an unexpected drop in growth off the table. China’s economy would most likely still slow as past monetary tightening and global economic slowing worked their way through the system but the likelihood is that current projections for 2012 growth rates of around 8.3% will to mark something like a low. If you follow the six –month rule (that the market anticipates news by about six months), then the end of 2011 and early 2012 would be time to build up China portfolio positions.

Brazil is much more complicated. The Banco Central do Brasil just staged a shocking cut in its benchmark Selic interest rate to 12% from 12.5% despite a lack of convincing evidence that inflation is under control. The central bank’s best argument was that Brazil’s inflation rate will come down with a slowing global economy and falling commodity prices.

This is wishful thinking, I’m afraid, and quite probably masks the bank’s cave in to political pressure from the Rousseff administration. At less than 4% growth, the economy was just generating too much pain for the president (after all growth in 2010, the last year under Rousseff’s predecessor Lula, had been 7.5%) and she put pressure on the bank to cut interest rates and get the economy moving at a faster rate.

I think you can find evidence for that in the rest of the Rousseff administration’s economic plan for 2012. The budget presented to Congress calls for a big increase in spending on pensions—indexed to the 13.6% increase in the minimum wage in 2011—big jumps of 15% and 33%, respectively, in spending on healthcare and education, and $1 billion in additional spending on airports and stadiums to prepare for the 2014 World Cup and the 2016 summer Olympics. The government’s budget shows a primary surplus for 2012—that’s a surplus before interest payments—but really only because it projects 5% growth instead of the 3.8% or so in the forecast of private economists.

If you want to say that this sounds like the typical budget-busting, government spending spree that will goose growth in the short-term and leave an inflationary hang over in the long term, I would say, Sure ‘nuff. But in the short-term, I think the government is going to spend its way to higher growth and keep enough pressure on the central bank to keep the inflation fighters on the sidelines until 2013 or later. (You want to stage a World Cup and an Olympics in the midst of a recession?)

In other words, I think Brazil is going to show more growth in the short-term than is now in the projections, that current projections mark a low point in expectations, and that domestic Brazilian companies are going to see big revenue jumps from this inflationary program.

That points me in the same direction as I look for Chinese and Brazilian stocks. I’d look for domestic companies rather than exporters since I think domestic growth will be stronger in both economies than will growth that depends on a slowing global economy. In China stocks that I’ve mentioned in recent months that fit this bill include Baidu (BIDU) and Tencent Holdings (TCEHY), and Home Inns and Hotels Management (HMIN). I’d also include two U.S. companies where China is a likely big driver of sales over the next 12 months: Coach (COH), and Apple (AAPL). In Brazil I’d include Gerdau (GGB) for its domestic infrastructure exposure, GOL (GOL) for an increase in air travel, Itau Unibanco (ITUB), and, if you can trade in Sao Paulo Natura Cosmeticos (NATU3.BZ) and Lojas Renner (LREN3.BZ).

I don’t think you have to rush out and buy any of these today. September is going to produce a lot more volatility. But slowly building positions here and through the end of 2011 makes sense to me now.

I’ll have more specific stocks to recommend in these two markets in coming weeks.

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 http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post.  The fund owned shares in Apple, Baidu, Coach, Gerdau, GOL, Home Inns and Hotels Management, Itau Unibanco, Lojas Renner, Natura Cosmeticos, and Tencent Holdings as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

 

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