This week’s note will begin by reiterating our bullish theme on the Natural Gas market. We hav...
Libya Crisis Confounds Investing
02/25/2011 5:30 am EST
A spike in oil prices means higher inflation, which makes it much harder for governments to slow growth without tanking their economies.
Is the violence in Libya the last straw for the world's emerging economies? Or at least for investors in those markets?
I think the big stock drops of developing nations are leading some investors to abandon markets they never felt all that comfortable with in the first place.
For those of us who believe in the long-term emerging markets story (and I do mean us—I wouldn't have started a global mutual fund if I didn't), it is important to acknowledge that risk associated with the Libya crisis has increased sharply. What initially looked like a short-term crisis has now widened to the medium term—say the next six to nine months.
That, in turn, makes higher oil prices the big problem.
Yes, I know that Saudi Arabia has lots of excess oil capacity and has pledged to pump more petroleum to meet any losses from Libya. It's likely that once the Libya crisis is over, oil prices will retreat from current levels. The world is probably not looking at $110 a barrel as the new base price for oil. (I argued this in a recent blog post.)
I also know that the worries of the moment are concentrated in the world's developed economies, especially Europe, which is highly dependent on oil and gas supplies from Libya. Many fret that higher oil prices—Brent crude for April traded as high as $120 a barrel on Feb. 24—could stall the weakest economies in the European Union.
A Tougher Balancing Act
Higher oil prices, even modestly higher oil prices, couldn't come at a much worse time for many emerging nations, where governments are waging a tough battle to control inflation without tipping their economies into a slowdown.
That balancing act, already difficult, got much, much harder with Libya's unrest. 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. This remains true, even if 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 Banco Central do Brasil. You're engaged in a tough battle to control inflation while preserving 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 6.05%, in February. (Brazil measures inflation from mid-month to mid-month.) That increase came despite an interest-rate hike from the central bank to 11.25% in January. Banco Central is expected to raise its Selic benchmark interest rate again when it meets again in early March.
Economists don't think that the March increase will be the last. The consensus is that the Selic rate 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 increases, economists are expecting inflation to remain at or above 5.75% by the end of 2011.
To reduce inflation in 2012, Brazil has to slow its economy, which appears to be happening. Economists now project the economy to grow by 4.5% in 2011. That's down from an earlier projection of 4.6% growth and well off 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 (gross domestic product growth averaged a much lower 3.24% from 1991 to 2010), unemployment in Brazil hit a record low of 5.3% in 2010. Unemployment averaged 9.95% from 2001 to 2010.
A slowdown to 4.5% growth won't increase unemployment, but it is sure going to stir anxiety in a country coming off annual growth of 7.8%.
NEXT: Double Trouble|pagebreak|
Into this tricky growth-inflation mix, we now add rising commodity prices. Higher commodity prices are good news for growth in an economy that exports commodities, such as Brazil, but such a trend is still bad news for inflation.
If iron ore, 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 (NYSE: VALE) and Cosan (NYSE: CZZ). But it also means higher consumer prices for everything from cars to soda and coffee—and bigger inflation worries for the Banco Central do Brasil.
Of course, we now have spiking 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 the petroleum feedstock used to make everything from plastic gadgets to hand lotion.
Brazilian airline Gol Linhas Aereas Inteligentes (NYSE: 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 Feb. 23, substantially above 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 crises, 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. Some took a break from interest-rate increases, while others at least talked about giving rate increases a rest.
But the spike in oil prices from the turmoil has removed that potential positive 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 or the inflation created by oil prices.
Rising Oil, Rising Food
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?—has little effect on rising prices for corn, wheat and soybeans, which are driven mainly by the weather effects like drought, floods and cold.
Many central banks have, so far, decided to deal with the problems of food and energy inflation by ignoring them. The US 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 policy of treating food-price inflation as a temporary problem.
In the short term, I don't think it's possible to ignore the inflationary impact of higher energy and food prices. It doesn't work as central-bank policy because food and energy inflation filter through the rest of the economy. Central banks that ignore this kind of inflation will eventually be forced to join the central banks that include these prices in their inflation measures. They will all have to figure out how much they need to raise interest rates to account for these inflationary effects.
Central banks such as the US Federal Reserve, which seem likely to fight including these prices in inflation measures, will pay the price of a weaker currency. That might require higher interest rates if the country in question needs to get overseas investors to buy its debt.
That was one explanation offered by currency traders on Feb. 23 to explain why the dollar was falling against the euro. The European Central Bank includes food and energy in its inflation measures; the ECB was therefore thought likely to raise interest rates before the Fed does.
Yet 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, risk stunting the growth of their economies. That's a real danger in the European Union, where even Germany's economy has recently slowed. And it's just as much a danger in emerging economies, where the policy response to inflation has already put multiple interest-rate increases into the economic system.
Interest-rate increases operate with a lag. So central banks that have raised rates aggressively, such as India or Brazil, and those that have raised more moderately, such as China, are both dealing with economies that will slow by an unknown amount on an unknown schedule.
Should Banco Central or the Reserve Bank of India or the People's Bank raise rates on the schedule they developed before the Libyan crisis pushed oil prices to more than $100 a barrel? That might be insufficient to effectively fight inflation now that higher oil is a contributing factor.
Should the central banks get more aggressive? That risks slowing the economy more than expected at a time when higher oil prices have begun acting as a drag on growth. Already, some economists in Brazil are warning that current policy could send growth below 4% in 2011.
What's the Worst That Could Happen?
For investors, the risks are that central banks will now raise interest rates for longer and to higher levels than the financial markets expect. Expectations are that the rate increases in Brazil will stop at 12.5% at the end of 2011. The People's Bank of China is expected to 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, emerging financial markets will fall further and for longer than the 15% to 20% drop 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 Nov. 5 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 know that. Even then there's a very real possibility that we won't be able to tell with any certainty.
At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. The fund did own shares of Oasis Petroleum, Schlumberger, and Weatherford International as of the end of December. Find a full list of the stocks in the fund as of the end of January here.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.
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