Since bottoming at the end of October, the MSCI Emerging Market Index (MXEA) and MSCI Asia Ex-Japan ...
Reset the Clock on Emerging Markets
05/10/2011 9:00 am EST
The timeline for buying stocks in developing countries has splintered. Buy Chile first, then Brazil, and later (maybe much later), China.
So where's the bottom in emerging-market stocks? Or, if picking the absolute bottom is too hard (and it is most of the time), when is enough risk out of these stocks to justify some serious bargain hunting?
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 high to the close on May 6.
- And China's Shanghai Composite index is down 6.3% from its 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 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 US market will be the best-performing stock market in the world in the first half of 2011. And it has been, with the S&P 500 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 those equities 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 column 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.
What I Thought Would Happen
First, a quick summary of everything I thought would soon 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 just be starting a round of interest hikes—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, growth rates in those economies would start to move higher.
- Rising interest rates in the Euro zone and the United States would start to strengthen the euro and the dollar against emerging-market currencies, reducing the flows of hot money into these currencies, and at least slowing the rate at which they appreciate against the dollar and the 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 the move would be moderated by gains in the dollar. Commodity-driven emerging markets would show less volatility.
Nothing ever works out as perfectly and in such an orderly way as that scenario. It's just a question of whether the deviations are so great that we need to junk the whole scenario and go back to the drawing board—or if we just need to make some modifications in a structure that still hangs together.
I believe the latter is the case in this emerging-market scenario. The timing certainly needs modification, but the trends still run in the direction I've described.
NEXT: Now, What’s Changed?|pagebreak|
Now, What's Changed?
- Emerging-economy central banks blinked when the time came 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 an increase of 0.5 percentage points was necessary. That 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 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.
- US 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 US economy. The US 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 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 US 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 US Federal Reserve could have resisted the pressure—or the even greater plunge in the dollar—to follow and put a 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.
A Closer Look at Brazil, China, and India
Brazil, which looked at one point like its current rate cycle would 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 fast track when compared with China. Beijing seems to have moved in recent months from fighting inflation to fighting the perception of inflation—see last Friday's fine of 2 million yuan ($308,000) against Unilever (UL) 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 (PG), 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 reversal 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 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 undervalued 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 slow the economy and throw some Chinese 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 the global 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 system of roads and ports impose a kind of tax on the economy that makes itself felt when domestic demand strains against those limits.
Fixing such infrastructure 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.
NEXT: A Splintered Picture|pagebreak|
A Splintered Picture
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 of nations 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 piece together an investment strategy that fits this splintered picture isn't easy.
So much depends not just on 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 almost certainly will not declare victory based 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 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 the worry about the global picture that makes the bank likely to raise rates despite that 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, it 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 US dollars.
For Brazil, getting inflation under control would be a whole lot easier if more US 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 the one 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 are the global trends. The domestic trends will last longer. 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 isn'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 franchiser such as Arcos Dorados (ARCO), or a Chinese hotel company such as Home Inns & Hotels Management (HMIN), or a Chilean airline such as LAN Airlines (LFL).
Can anyone tell me, for example, how the rise or fall of copper, the gyrations of the US dollar, and the risk-on/risk-off sloshing of cash around the globe change the fundamentals for this year and next for a company like Arcos Dorados, the biggest McDonald's franchiser in Latin America?
From this perspective, the very scary drop in stock markets in the last week is important for emerging-market stocks only to the degree that it stretches out the inflation/interest-rate cycle in individual emerging markets. Aside from that, it's all 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—but you want to define the edge you're looking for) created by that volatility in the domestic economies of the countries in what I've called the Chile group, a group that may be limited to Chile, Poland, and Singapore.
These are small economies, so they don't give you a whole lot of stocks to pick from:
- Chile offers LAN and Cencosud (CSUDF), an operator of South American supermarkets, hypermarkets, home improvement stores, and shopping centers.
- Poland offers Powszechny Zaklad Ubezpieczen (which trades as PZU in Warsaw), the country's leading insurance company.
- In Singapore, there's Keppel (KPELY), 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 US markets include Arcos Dorados and Ambev (ABV).
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 on 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 a much larger correction, I'd wait until we have a better idea of how fast and how far inflation is going to run, and how hard the People's Bank is going to push interest rates higher. August comes to mind as a potential timeline, but that's nothing more than a guess, based on previous August swoons in Shanghai.
This scenario is subject to revision depending on events—an outbreak of fiscal sanity in Washington, a Greek default, peace in Libya, or some other 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 column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own shares of Home Inns & Hotels Management, LAN Airlines, Keppel 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 here.
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