Latin Lessons
Receiving investment grade status is supposed to make you more attractive to investors, not less. But over the last few weeks institutional investors have been reducing their exposure to Brazil, with the Latin American indices giving up all their gains since the start of the year.
Patrice Lemonnier, head of emerging markets at CAAM, believes the sell off is linked to general risk aversion and inflationary concerns: “Flows are drying up everywhere in emerging markets – the environment is not too good for equities.” He points out that Asian valuations have halved over the last six months so their overvaluation problems have disappeared, whereas the valuations for Latin America have come off a bit but relative to developed markets they are still the same.
Will Landers, who manages BlackRock’s family of Latin American equity funds, believes profit-taking may also have something to do with it. “There was a very short sharp move upwards following the investment grade rating from S&P at the end of April, and as people were looking to raise cash they decided to take advantage of this. If you’ve been invested in Latin America for a while this is definitely an area where you would have had profits to realise.”
Inflationary pressures
Medium term, he believes investment grade status will help attract more conservative institutional investors to the region, but right now, inflationary pressures are making the region less appealing. “We do see a weakening in bank lending, and possibly some increase in non-performing loans, and as interest rates increase some of the real estate opportunities look less attractive,” says Stephen McCarthy, senior portfolio manager for emerging markets at SSgA.
He believes that Brazil’s central bank has been the most successful in signalling to the market that it will keep inflation down, but many countries have begun to tighten, including Mexico, Peru and Colombia. “Chile is lagging a bit behind the curve but it has been trying to offset the inflows of currency from the very strong copper price,” he says.
Indeed, many of these markets have benefited from strong commodity prices. Mexico has enjoyed a windfall as the price for Mexican crude is twice the amount it budgeted for. “Both Brazil and Mexico have programmes to promote infrastructure investment so ports and the transportation of goods and services should improve,” says McCarthy. “In the long run this should reduce inflation as this will lower the costs of production and make their goods more competitive.”
SSgA views Chinese demand for commodities as a long-term trend despite the fear of short-term pull-backs. McCarthy also doesn’t see the same huge systemic risks of the 1990s, as the LatAm economies are more integrated into global trading networks and fiscal and monetary policies have improved, with the exception of Argentina. “Rising inflation is a concern and loan growth to some of the lower income groups is excessive – there could be some set-backs there. But there is less risk of a foreign exchange crisis than in the past,” he says.
However, this remains a very narrow market, with the same stocks appearing in managers’ top 10 holdings again and again. Everybody loves Petrobras, CVRD (Vale), Banco Bradesco, and America Movil. Hexam Capital’s Bryan Collings, a global emerging markets manager, says he recently bought some of the latter, which he sees as a well-run, safe cash flow generator in the mobile space.
“It is not as exciting as some of the other mobile operators in India, Russia or Nigeria, but as the money comes into Latin America, this will be a beneficiary,” he says. “And it is probably one of the safest, most predictable earnings defensive plays, as so much of Mexico is dependent on what happens in the US, particularly the growth of the southern states.”
Don’t cry – there’s always Tenaris
Argentine pipe manufacturer Tenaris also turns up regularly, liked because it is a global player in the oil services segment, deriving few of its revenues from its troubled home market. Lemonnier says that it remains difficult to get access to markets like Colombia, whilst Chile is expensive due to the participation of local pension funds. Meanwhile Venezuela has disappeared from the investable map following a series of nationalisations – most recently those of its cement and steel industries.
“Latin America is basically Brazil and a handful of other stocks,” says Collings. “Of all the regions it is the smallest and it is shrinking in many ways, in contrast to EMEA where you’ve got other markets coming through. I don’t really think it’s necessary to have a Latin America fund – you can pick the eyes out of it and get exposure to other stocks elsewhere in the world.”
Currently he prefers China, arguing that investors have missed opportunities by not being there. “People think that China has completely blown itself up. But if you look at it, it is only down 13 percent relative to the emerging market index this year, and the banking sector is up some 17 percent.”
He says that Bank of China is up 11 percent and China Construction Bank is up 12 percent relative to emerging markets, so these stocks are doing as well as, if not better than, Brazilian banking stocks. “In fact they have outperformed, year to date, one of the best iron ore producers in the world – CVRD.”
Disappearing act
Collings argues that investors need to dig a bit deeper and look for the inconsistencies in what people are saying: “There is no better example than the amazing Houdini-like disappearance of those people who last year said that when the China A-share market falls, which it has done massively, the China story and the commodities story will be badly affected. Well that just hasn’t happened, has it? But where are these people?”
He argues that the reason why both have been unaffected is because the size of the equity market in China is so small relative to the economy: “It wouldn’t make a difference if it fell 90 percent, in contrast to the size of the equity markets in developed economies, where it does affect your wealth. The Chinese still have well over a trillion dollars sitting in retail bank deposits.”
Collings believes that Brazil’s investment grade status overestimates its capacity for growth, and fails to take into account potentially negative surprises for investors. “Brazil is simply not as robust as people think, not as robust as emerging market funds’ positioning suggests and certainly not as robust as in recent years.”
If you want to read more about how regional specialists are trying to protect their portfolios against a backdrop of rising inflation, please go to:
A Frontier Too Far?
The African markets are still considered a frontier too far for many, but over the last 12 months a number of managers have entered the space, on the back of roaring commodity prices and capital inflows from China and India.
“There are 200 corporates in Africa but these are under-researched opportunities,” says Stuart Culverhouse, chief economist at Exotix, a securities dealer in frontier markets. “Some markets have had reasonably good runs like Kenya and Ghana, and Zambia’s index doubled last year. Nigeria has also had three years of relatively good growth. But new funds are being set up to invest in this area every week, which helps explain why the performance has been so good.”
Mark Mobius, manager of the Templeton Emerging Markets Investment Trust, is cautious about many of the Sub-Saharan African markets, but is upbeat about their future prospects. “The growth potential in Sub-Saharan Africa is very great so we will be doing more there as we go forward, but it is going to take time,” he says. He warns that within each market there is an incredible variation in valuation and liquidity, whilst in many cases local investors still dominate.
Infrastructure push
Despite a mixed political backdrop, he sees Nigeria, Kenya and Ghana as amongst the most interesting markets. “Kenya has a pretty good history of capital market development, but we’ll have to live with political problems for a while in this region. The good news is that it is attracting a lot more investment than it has before, particularly with the Chinese, Russians and Indians moving in. And whenever you have that kind of push, you start to get infrastructure working.”
But he adds that markets like Namibia are still too small to be of interest: “When I first went there, the stock exchange was in a shopping centre,” he recalls. “And when I first went to Botswana, I walked into a broker’s office and said: ‘Where’s the stock exchange?’ And he said: ‘Turn around, you’re in it!’ I turned around and there was a list of stocks. This is the kind if thing you have.”
By contrast, Nigeria has attracted a lot of the initial interest from foreign investors because of a healthier financial sector. “Banking and insurance reforms are encouraging institutional domestic investment in Nigeria,” says Culverhouse. “The market has been led up by banks, but 8 percent non-oil GDP growth is helping the stock-market.”
Stephane Bwakira, manager of the Standard Africa Equity Fund, which invests across the continent and now has some $330 million under management, says that the recapitalisation programme in Nigeria has led to a lot of consolidation, with the number of banks in Nigeria falling from 89 to 23. “Most of them now have at least $1 billion in capital which has made them stronger and able to take on big transactions in the oil and gas sector, and the big infrastructure projects,” he says. “Historically these have gone to foreign investment banks, but the local content requirement has helped.” This says that a percentage of any business undertaken by the big conglomerates must be transacted through the local banks.
Credit expansion
The banks have also ramped up their businesses following debt write-downs, and are now taking on real risk. “The banks are competing for the same corporate business so their margins are thinning out, and therefore they are now starting to lend to retail customers,” explains Bwakira. “We are seeing mortgages, car loans and credit cards creep up. There are still some legal issues to be sorted out but the banks are expanding their footprints by opening more branches to get more clients onto their books.”
He adds that it is a similar picture in Morocco for mortgage lending, and property developers are seeing a big increase in business due to government-sponsored low income housing programmes which offer developers tax incentives. Meanwhile, the growth of housing in Egypt for the young professional classes is also supporting the expansion of real estate and mortgage lending.
Bwakira’s fund is not untypical in spreading its net wide, including stocks listed on other exchanges that transact the majority of their business in Africa, as well as MNCs with local listings. Despite the high risk associated with these small, illiquid markets, Bwakira argues that diversification across the continent offers a natural hedge. This means that when Kenya experienced violence following the disputed election earlier this year, this had no ripple effect on Zambia, and a positive effect on Mauritius, which inherited some of the tourists that might otherwise have gone to Kenya: “There is very little correlation between markets and currencies.”
He too is upbeat about the future for this region: “We have seen a lot of interest and flows, whereas three years ago it was very difficult to get anyone to even look at it, but the perception is quite different now. Africa is the last frontier market, but people are buying the long-term growth story.”
If you want to read more about how managers are tapping African investment opportunities, please visit:
http://www.thomsonimnews.com/story.asp?storycode=43910
No Way Out
Comedian Rob Newman used to do a routine about the world’s dwindling supplies of oil, the essentially doomed nature of the petrochemical economy, and the increasingly desperate attempts governments and oil companies would employ to keep the lights on. But whichever way they turned, however hard they tried to escape from the inevitable, eventually they would have to face up to the fact that there was no way out – fossil fuels would run dry. In the routine, this sobering fact was epitomised by a cackling Baron Samedi figure in a gloomy stairwell.
It is still possible to find people who cite the supply argument in favour of a decline in the oil price – perhaps they’re banking on those Canadian tar sands coming up trumps. Others argue that even if a recession reduces demand in the West, any fall in price is likely to be modest and short-lived, as India and China keep industrialising.
The historical oil consumption per capita charts certainly make for grim reading. Whilst India and China are still at the usage level of the US in 1904, the experiences of Japan and South Korea are instructive. The charts show that whilst consumption is low in the early years of industrialisation, the following decades see a sudden exponential increase per capita. For Japan it happened in the 1960s, for South Korea, in the 1990s. It will be interesting to see how such a spike in usage by China and India will affect the market for oil in the next 20 years.
Energy crisis
Newton Investment Management, for one, is worried. In a recent research note it commented: “Unlike previous oil price spikes, there appear now to be few options to ‘get out of jail free’. We are witnessing not simply an ‘oil problem’, but rather the first stages of what could become a global energy crisis. The challenge now is the dearth of inexpensive, available energy sources to permit the reduction of oil demand through fuel switching.”
Ah yes, if only we had started investing in alternative energy back in the 1980s, then perhaps we wouldn’t be in this fix. Unfortunately, election cycles are too short to incentivise governments to take the tough decisions that are necessary to deal with such issues. And the longer we delay, the more expensive the bill when it finally falls due – which discourages subsequent governments from making themselves unpopular by stepping up investment.
“Failing to take tough decisions will lead to an extended period of energy inflation,” warned Newton. “This will prevent OECD economies from stimulating growth through monetary policy, while developing economies, burdened with subsidies, will be forced into trade controls and commodity hoarding.”
It suggested that governments should consider adopting mandatory investment in hydrogen networks, carbon sequestration and the development of second generation bio-fuels that do not compete with the food chain: “The real cost and impact of energy prices must be tackled, or the lights really will start to go out.”
Unfortunately, such Cassandra-like cries are rarely welcomed. Demand will fall in the West, the oil bears insist, and supply will start to come through, then the oil price will tumble. The bulls respond that once the industrialisation genie is out of the bottle, it can be hard to stuff it back in again.
Although most analysts have tended to be behind the curve in predicting the oil price, insisting that it must come down because that’s how it behaved in previous cycles – you remember, when the two most populous nations in the world weren’t industrialising – Global Insight recently revised its forecasts. It now believes that oil, food and raw materials costs will keep rising throughout the first half of 2009, and expects the price of West Texas Intermediate crude oil to peak at $160 a barrel in December 2008, up from $124 in its previous forecast.
“Growth in both real GDP and energy demand in emerging markets is likely to remain strong for some time,” said Nariman Behravesh, Global Insight’s chief economist, and Sara Johnson, economist, in a forecast alert. They pointed to a combination of stimulative monetary policies and fuel subsidies, which weaken the incentive to conserve energy.
“While some countries are beginning to tighten monetary policy and some are cutting fuel subsidies, these moves have been modest and are unlikely to have any significant impact until late 2009 or 2010,” they said. “In the meantime, strong energy demand growth in emerging markets will outstrip additions to non-OPEC supply and will offset the declines in demand that have already occurred in the US and Europe.”
Fuel subsidies
The question now is how long non-oil producing nations can afford to maintain fuel subsidies. India is already facing a ballooning fiscal deficit, but Vinay Gairola, manager of the Atlantis India Opportunities Fund, doesn’t see fuel subsidies being ditched in an election year. “There are 500 million poor voters who won’t allow this subsidy to be cut – the government doesn’t dare tinker with this,” he said. Instead, he sees the possibility of a windfall tax on Reliance Industries and Cairn Energy to help plug the gap. And Tata’s plans for an affordable runabout are likely to keep oil demand ticking along for a while yet.
Meanwhile, countries like Russia and the Middle East are simply using the receipts from their oil revenues to fund domestic fuel subsidies. Newton points out that in previous crises, natural gas has taken up the slack, but recently liquefied natural gas prices have risen faster than crude prices. “In the Middle East, a shortage of natural gas is having a direct impact on the oil supply: first because oil products are being burned instead of natural gas, and secondly, because reduced gas injection into oil reservoirs is curbing the production of crude oil.”
But isn’t it just the activities of those naughty speculators that have pushed up the price, say the oil bears. Well, Newton believes that the rise in price to $135 per barrel in May owed much to capitulation by commercial buyers, such as airlines, who had been waiting for the price to fall – as had been forecast by most commodity specialists in light of an impending slowdown in global economic activity: “Even the bullish, and widely-followed Goldman Sachs commodity team suggested a near-term correction in the oil price.”
Buying the curve
So when Goldman Sachs increased its forecast for the end of 2008 oil price from $115 to $149 a barrel, commercial buyers scrambled to ‘buy the curve’. “The rise in the oil price was exaggerated by the actions of hedge funds, which as the true speculative buyers, reversed the time spreads, which had entailed their betting on the short end of the curve, against the long end,” said Newton.
Even if the oil price does eventually roll back, it is likely to do so to a price well above previous plateaus. Global Insight is now predicting a fall in the oil price by the end of 2009, to $130, compared with $111 in its prior forecast, and to $105 by the end of 2010. But it warned that geopolitical events, such as conflict between Israel and Iran and more supply disruptions by rebels in Nigeria, could easily push prices higher.
If you want to read more about oil demand and supply dynamics and how the oil price is impacting earnings at energy companies, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=3&storycode=43565
Into The Woods
July 11, 2008 at 1:08 pm (Macroeconomic commentary, UK equity markets) (banks, Bear market, Commodities, energy, financials, Japan equities, mining, monolines, UK equities)
Careful there! Tread quietly! We are now in official bear territory. Who knows what dangers lurk in these woods?
Yes, the FTSE finally succumbed to the inevitable and crashed through the technical bear barrier this week, following the S&P 500’s ignominious tumble into the badlands earlier this month. On Tuesday the FTSE All-Share fell 20% off its October high of 3,467, whilst this morning the FTSE 100 ventured into bear territory by crashing to 5,333.9, well below the 5,385 bear threshold.
“The news that we have officially entered a bear market comes as no surprise to many investors whose shareholdings have halved in value,” said Angus Campbell, head of sales at Capital Spreads, on Tuesday. “The 20% rule simply confirms what we have long suspected since the beginning of the year – we are well and truly in the grip of a grizzly bear market.”
Manoj Ladwa, a senior trader from TradIndex, said that financial stocks, including RBS and HBOS, had fallen further in response to losses in New York, while house-builders had had another bad morning following a predictably weak trading update from Persimmon. “Mining stocks, which have been a mainstay of the index this year, started to weaken, as analysts lose faith in BHP Billiton’s takeover of Rio Tinto happening any time soon.”
Danger – loose bears
Campbell said that it is a clear danger signal when there is a 100 point rally in a market that is trending lower, followed by a large sell-off to test new lows. “That is exactly what we have seen [this week] with financial stocks yet again leading the way. The outlook for pretty much every stock though is truly dire at the moment and if it was not for the energy and mining sectors keeping us afloat, we would have been testing the 5,000 level months ago.”
He added that if investors now pull out of the energy and mining sectors, it is anyone’s guess where global indices will bottom out. The FTSE 100 currently contains 10 mining companies, and seven oil and gas companies. By market cap, there are four mining, and three oil and gas stocks in the top 10 alone, and these companies collectively account for 50% of the FTSE 100’s total market cap. This is creating some concern amongst the trackers, which are now heavily exposed to what tend to be very cyclical industries.
Meanwhile, the outlook for financials worsens day by day. As the economy grinds to a halt, credit defaults are finally starting to come through, threatening to turn what was a liquidity crisis into a solvency crisis – witness Bradford & Bingley’s increasingly desperate attempts to raise cash. All those blank cheques written by merry banks in the consumer spending boom are now falling due. The UK banks are staring into a black hole of buy-to-let mortgages and worthless credit card debt.
This is reflected starkly by the sector’s performance since the credit crunch began. According to Bert Veldman, senior investment manager, global equity, at ING Investment Management, share prices of financials have dropped by an average of 43 percent since the peak in April 2007. And in the second quarter, global financial equities fell by an average of 12 percent.
Eaten by bears
House-builders are also feeling the pinch, with Capital Economics now predicting a 15 percent fall in UK house prices this year, and a fall of 35 percent over three years. Not surprisingly, house-builders have received a thorough mauling by the bears and are desperately trying to raise capital.
Back at sub-prime’s ground zero, the investment banks are still announcing new write-downs following the long-anticipated monolines downgrades last month. After many warnings, Moody’s finally downgraded Ambac and MBIA – the former by three notches and the latter by five notches. S&P had already downgraded both, suggesting that we will see further fire sales by those investors and conduits who can only hold Triple A-rated securities. Investment banks must also increase their risk-weighted capital to offset these downgrades.
For example, Merrill Lynch holds some $18 billion in collateralised debt obligations and asset-backed securities, of which the majority is insured via monolines. Now that these insurers have been downgraded, the risk for Merrill Lynch has increased. The worry is that this will lead to fresh, substantial write-offs and that banks will be forced to liquidate positions, says Caspar van Grafhorst, head of investment grade credits at ING Investment Management. The market is expecting Merrill to write off about $5 billion for the second quarter.
But Guy de Blonay, manager of the New Star Global Financials Fund, says that the key issue for investment banks is not necessarily whether more write-downs will be revealed but whether they can write new business over the next few years. “There has been a fundamental shift in institutions’ desire to embrace risk. Some profitable business lines may, therefore, be closed for months and perhaps years,” he says.
The worsening economic outlook does not rule out the possibility of bear market rallies, however, and this morning the FTSE 100 obliged with a rebound. This followed reports that the US government was mulling a bail out of its hapless Fannie Mae and Freddie Mac mortgage agencies, which Lehman says will have to write off another $75 billion.
This rally was short-lived, however, as the market then charged headlong into bear territory, perhaps after realising that the fundamentals in the UK hadn’t changed. The question now is whether the combined strength of energy and miners will be able to prevent the FTSE falling further. State Street’s latest fund flows note reported that institutional investors are becoming increasingly sceptical about the commodities boom, with selling already underway in the materials sector.
Bear traps
Joost van Leenders of Fortis Investments points out that bear markets usually end with a final sharp fall as the last bulls capitulate. The average decline during bear markets after recessions is 28 percent, but this includes some very large drops, such as the 50 percent fall after 2001. “These large drops started with overvalued equity markets, which was not the case this time,” he adds. However, earnings have been high, and have only just fallen back to trend. He also believes that economic and profit forecasts for the second half of 2008 look unrealistically high.
Fortis is now adding to Japanese equities – still leading the field as the least loved market around – followed by US and emerging market equities. “We have not suddenly become Japan optimists but we think that a lot of the bad news is priced in,” Leenders says. Certainly the Japanese economy is looking in better shape than the UK’s for once. And those bulls have got to find somewhere else to chew grass, right?
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