Global themes for portfolio allocation
EM themes and investment ideas
Sector spotlight
Our next Strategy Monthly will appear on 10 June.
BRIC equities moved very much in tandem with commodity prices over the last six weeks, resulting in sizeable underperformance relative to developed equities. The performance patterns highlighted in Chart 1 below could have three possible explanations:
We think the third explanation is closest to the truth. With the exception of Russia whose market is heavily influenced by the oil price (through its impact on the fiscal deficit), the BRICs are not adversely affected by the commodity price weakness that roiled markets earlier this month. China and India are both large commodity importers, so lower prices for oil and copper are beneficial to them. Brazil is a major commodity exporter but prices of iron ore, its largest commodity export, actually rose over the past six weeks (see Chart 3 below).
We know that equity markets are moved as much by “animal spirits” as by fundamentals but we think that prospects for the emerging markets are improving even if this is not reflected in short-term market performance. Chart 2 below shows that Brazil and India closely followed Russia’s downward path even though neither country is in a remotely comparable situation with regard to oil. Indonesia, which is closest to Brazil in terms of dependence on commodity exports, emerged from the crash largely unscathed. Turkish equities fell after the commodity price crash even though it is the country most dependent on oil imports in our sample.
We do not believe commodities markets are on the verge of a price meltdown, nor do we think that continued commodity price volatility will be a major barrier to sustaining growth for most emerging economies. These countries face many economic policy challenges, especially strong inflationary pressures and the need to increase infrastructure investment. As we highlight below, they are all tackling these issues, some more successfully than others, but it would be a mistake to conclude that commodity prices play a dominant role in this process.
EM equities are poised for stronger performance during H2/11 after lagging developed market equities since last autumn.
Our call for the next six months is that EM equities will outperform developed market equities. This view rests on the following judgments:
Fears of an end to the secular trend of rising commodity prices are unwarranted. Global commodity prices will continue to rise in the medium and long terms.
Did the recent sell-off in commodities signal the end of the bull market?
The short answer is no. It was simply speculative money leaving what were very crowded, one-sided trades. This is most clear in the silver market, which led the decline with a 27 per cent plunge (see Chart 3 below). However, even more spectacular than this drop is the 35 per cent price increase since March. The bursting of this bubble was caused not by fundamentals but by speculative capital flows.
The story is similar for oil, though fundamentals have clearly capped the strong rally that began earlier this year. Although the price of oil dropped 10 per cent at the start of May, it is currently at the same level as at the start of March. One would have expected a number of speculators to take profits and exit the long oil trade once crude prices settled into a trading range, as happened before the crash. The violent correction that took place instead is more a testament to the volatility associated with the huge rise in speculative flows into commodities than a statement of rational expectations about future prices.
Commodities in which speculation is limited – such as coal and iron ore – were hardly affected by the sell-off. These commodities are typically traded on a spot basis rather than on exchanges, so speculators often have to take physical delivery in order to put on positions. Although we can expect to see continued volatility in commodities, the fundamentals of continued strong demand from India and China will support an upward trend in prices over the medium and long terms.
Attractive opportunities in local currency investments are few at the moment. Our top pick is Indonesia.
Chart 4 below highlights the strong performance of many EM currencies against the dollar over the past six weeks. Much of the appreciation was driven by the weakening dollar trend that now appears to have reversed with the rise of Eurozone turmoil surrounding Greece.
The sharp snapback in the ruble and the Real in the last two weeks makes us cautious about the near-term outlook for these currencies. By contrast, the Indonesian rupiah has continued on a slow, steady path of appreciation. Although Indonesian authorities have imposed minimum holding periods on short-term investments there is greater openness to letting the currency appreciate than in Brazil, for example. Real rupiah interest rates on local market government bonds are substantially lower in Indonesia than in Brazil but the latter's 6 per cent tax on fixed income inflows and the sharp appreciation of the country’s global Real bonds (which are tax exempt) make Brazil unattractive at the moment for new investment. Investors who were fortunate enough to get in before the taxes were imposed should continue rolling over their investments.
Brazil’s strategy for dealing with strong inflationary pressures remains in flux. After highlighting the potential for macroprudential measures to help rein in prices, Banco Central (BC) Governor Alexandre Tombini backtracked in a much publicized address to the National Congress on 5 May. Tombini downplayed the potential contribution of macroprudential measures and outlined a “sufficiently prolonged” tightening cycle that aims to bring inflation down from 6.5 per cent currently to 4.5 per cent − the midpoint of the bank’s inflation-targeting band − but only by the end of next year.
Tombini has had a rough time in the governor’s seat since his appointment last December. He is unable or unwilling to back up his tough talk with convincing policy actions. After emphasizing macroprudential measures for the first time in the COPOM minutes released in mid-March, the BC followed with restrictions on consumer credit that nobody in the market thought would have any effect on inflation. This action, together with the extended period he outlined for interest rate tightening, has seriously undermined the BC’s credibility as an inflation hawk. In what appears to be an effort at damage control President Dilma Rousseff said this week that Brazil would reach its inflation target “in the shortest time possible”.
The government has slowly begun making progress in tackling a daunting list of long-overdue reforms that are essential to get the country ready to host the 2014 World Cup and the 2016 Olympics. President Rousseff announced last month that five major airports would be opened to private management and investment. This move suggests that other initiatives will follow in the next two or three months to attract private investment into much needed infrastructure projects. While welcome, such an initiative is only a small step in the right direction and it comes too late to have any impact on inflation. More aggressive action is essential if the government is to resolve the policy confusion.
Although Dilma’s administration has displayed a willingness to address the country’s most pressing economic problems, our sense is that the economic team is adrift without a convincing strategy as to how to move forward. Part of the reason for this dilemma can be blamed on former President Lula, who increased spending to unsustainable levels ahead of last year’s election.
A larger problem, however, is that the government’s goals are inconsistent and no one appears prepared to set out clear priorities among them. In a speech to investors this week, for example, Dilma asserted that her government would “ensure growth at a fast pace, inflation that is under control” and investment “to overcome the limitations that still exist in the productive and social infrastructure”. Investors want to know how her government proposes to reach these goals and “what gives” if there are conflicts in meeting them. In the absence of a clear strategy, none of these commendable goals will be reached. In such an environment Brazilian equities will continue to face uncertain prospects.
Over the last two months consumer staples outperformed while energy and materials lagged. We think a similar pattern of performance is likely in the coming month. We recommend an underweight position in equities with a focus on defensive stocks.
Focus on inflation winners
The sectors best positioned to outperform in the current uncertain environment include:
The case for Russian equity outperformance has come into question following the recent meltdown in crude oil prices. We think the price collapse had to do with the inherent volatility of crowded long trading positions in oil; we do not anticipate a sustained decline in oil prices. We remain generally positive on the Russian outlook but recommend that investors look for outperformance via sector weightings away from oil.
Our base case is for steady but unspectacular growth of 3.5-4 per cent this year. We think oil prices will average somewhere in low triple digits, e.g., $100-115/bbl, and this will translate into a fiscal deficit for Russia of around 1 per cent of GDP. The oil price-related windfall will be spent partly on boosting incomes of pensioners and those in the military and partly on reducing the deficit. Inflation is now relatively high (9.6 per cent) but it appears to be peaking and looks likely to finish the year around 8 per cent or slightly below.
The major growth driver this year will be private consumption thanks to increases in pensions and to rising real wages (reflecting strong productivity gains in manufacturing). Investment has until recently been very much affected by a strong inventory investment cycle – a strong destocking in 2009 followed by restocking last year. We look for a gradual shift in spending into fixed investment led by construction and new projects launched by state firms later this year.
Uncertainties about the political transition in 2012 loom large in the outlook. We think the overriding concern of Russia’s top elite is to preserve stability. While some volatility is inevitable in the coming months, until details of the political transition are known − probably before the end of September − we do not anticipate a long-lasting negative influence of politics on equity valuations. Whether the eventual political transition will raise prospects for positive impacts, e.g., via commitments to root out corruption and to bear down on the state mafia, is less certain.
With the exception of the outperformance of the telecommunications sector, Russian equities moved in lock-step over the past two months. Our favourite sectors for the coming three months include natural gas, cyclical industrials and banks. We maintain our slight overweight recommendation.
Play the natural gas theme
Although the pure oil stocks will probably not outperform in the near term, further upside could be in store for gas-related plays including Rosneft and Novatek due to the expected rise in global demand for gas for power production.
Overweight cyclical industrial stocks
The investment case for cyclical stocks is based on the impressive results Russia’s manufacturing firms have achieved in labour cost control and productivity gains, which we highlighted in February. These should begin to show up in corporate earnings reports as we move into H2/11.
Overweight the major state-controlled banks
The major state-controlled banks have lagged their BRIC peers as well as the overall Russian market (see our Sector spotlight, below). These banks are a way to play the “recovering economy/falling inflation” theme. Prospects for partial privatization of VTB and further sales of Sberbank shares will also likely draw new investors.
India’s prospects are improving on both the inflation and the political fronts. The move on 3 May by the Reserve Bank of India (RBI) to a more aggressive monetary posture is welcome for several reasons. By tightening the repo rate by 50 bps the RBI effectively laid to rest market fears that it was hopelessly behind the curve on fighting inflation. More important than the rate move, however, was the RBI’s monetary policy statement issued on the same day that spelled out a revised view on inflation and in effect said that its past policies were wrong. While it would be too much to believe the RBI can counter the strong growth bias of many of the government’s ministers, the statement does at least underline that the RBI is serious and is moving in the right direction in dealing with inflation.
On the political front the Congress Party (CP) and its allies have put in a good showing in recent regional elections, winning three of four state assemblies. Perhaps the most exciting news is that voters in the eastern state of West Bengal have turned out its Communist-led government after 34 years of rule. This was the state that prevented Tata from opening its new factory to produce the Nano car. Our Indian economist Shumita Sharma recently visited the region and reports that the state is ready for much faster growth provided a stable government with the right policies (i.e. not Communist) takes power. As we go to print, poll tallies show that in addition to its major win in West Bengal, Congress and its partners are on track to garner majorities in Assam and Kerala. Congress and its local ally lost a bid to remain in power in the southern state of Tamil Nadu.
The political gains by the CP and its coalition partners imply that economic reform will gather pace. This prospect will not satisfy those who are sceptical of the Indian market but it is progress and it is in the right direction. This is enough for us to upgrade India to slight overweight from last month’s neutral weighting. Though we anticipate a short-term market bounce we remain concerned about progress in the government’s privatization programme; we may find ourselves reducing the recommendation before long if the scheduled privatizations fail to get off the ground.
Equities experienced a roller-coaster performance over the past two months – first a sharp upturn, followed by an equally sharp collapse in mid-April. We recommend a focus on consumer-related themes, especially in the agricultural supply chain where the entry of new firms is transforming a very traditional and backward sector.
Recent economic data confirm our expectation of strong growth and moderating inflation. Bank lending, the key variable for judging monetary policy, came in at Rmb740 billion in April, equivalent to an annual pace of expansion of 17.5 per cent. This was down from 19.9 per cent during calendar year 2010, but it was probably at the high end of the range the government finds acceptable.
We conclude that there is little prospect in the near term for a loosening of monetary policy. At the same time we do not see a need to tighten controls on bank lending either. Our expectation is that policy as regards bank lending will remain unchanged for the foreseeable future – further interest rate and reserve requirement hikes will continue but these will not have a significant impact on access to bank credit.
Inflation performance has been very much in the news, but in our view much media commentary misjudges what is really going on. Because inflation rose sharply during the course of 2010 the year-on-year data that are inevitably reported in the media are unreliable guides to inflation trends. For example, April’s year-on-year inflation was 5.3 per cent, which appears to be a small decline from March’s 5.4 per cent; but if measured on a month-on-month basis, the April number actually represented a 0.1 per cent increase. We expect the CPI in May and June to be 5.5-6 per cent but then to decline during the second half to end the year at around 4.5-5 per cent. The apparent rise and fall in the index will be almost wholly due to base effects rather than rising or falling trends in inflationary pressures. In our view this up-then-down trend will not lead to a tightening in controls on bank loans. Underlying inflation is running roughly at 4.5-5.5 per cent, a range which the government will accept even while expressing concern that it is too high.
The major uncertainties in the near-term outlook are associated with the spreading impact of severe drought. Prospects for China’s agricultural output this year are being revised downward due to difficulties in sowing crops and shortages of water for irrigation. China’s drought could fuel further increases in food commodity prices, given widespread global shortages of feed grain, especially corn and soybeans. The drought has also adversely affected river transport and hydroelectric production along the Yangtze. This is bullish for prices of coal, the only fuel that can substitute in the short run for reduced hydropower output. But there is also a risk that the inevitable power shortages will curtail industrial output later this year, particularly for energy-intensive industries.
The semi-annual US-China Strategic and Economic Dialogue concluded on 10 May with both sides lauding progress in developing bilateral ties. Translated into layman’s terms, this means that both sides made commitments to ambitious-sounding goals that they will “consider” while contentious issues such as solving global imbalances, China’s exchange rate policy or US plans for controlling its fiscal deficit continue to be ignored. In short, nothing of substance resulted from the meeting: each country will pursue self-interested policies without particular reference to the other.
Chinese equities outperformed other BRIC stocks during the past month (see Chart 2 above) though overall returns trailed both Indonesia and Turkey by a wide margin. Materials and consumer staples led the overall market, with industrials lagging significantly. We maintain our overweight recommendation on Chinese equities.
Overweight industrials, materials and logistics
The development of urban infrastructure will continue full steam ahead even without a loosening of monetary policy. The political imperative to complete major projects before the October 2012 political transition will ensure priority allocation to funding these projects even if cost overruns occur. Industrial stocks continue to lag the overall market. We still believe they can play catch-up in the next two or three months.
Continue to play the China story via commodities
As explained above, in our view the recent sharp sell-off of selected commodities was mostly driven by the sudden exit of speculative money from what were crowded trades in crude oil, silver, copper and several other exchange-traded commodities. By contrast, prices of iron ore and coal were little affected because they mostly trade in spot markets. Given continued relatively strong Chinese growth, we remain bullish on hard commodities prices over the medium term. In the short term markets will continue to be buffeted by volatility associated with speculative investment flows and the annual Chinese inventory cycle. (This cycle is typically front-loaded since the major state-owned firms receive their loan allocations at the beginning of the year and build up stocks that are then run down in the course of the year.)
Chinese imports of feed grain (especially corn) this year remain a wild card at this moment. All the information to date leads us to expect global supply constraints to be binding for feed grain. This suggests that prices will trend higher during the year and that China will be forced to import significantly higher volumes of corn, possibly as much as 5 million tonnes (vs last year’s 1.5 million tonnes).
Last week we initiated coverage of Indonesia with a detailed assessment of the country’s economic and investment outlook.
We concluded that Indonesia’s combination of high but contained inflation and stable growth is attractive for equity investors. Indonesia is a play on India and China because it has emerged as a major supplier of natural resources to both countries. It is also an attractive consumer play as its relatively high GDP growth (6-6.5 per cent) is driven by domestic consumption (unlike China where investment is the main growth driver).
Indonesian equities have substantially outperformed other EM equities over the past two months, rising approximately 15 per cent. Although Indonesia is a major commodities exporter, equities were little affected by the early May crash in hard commodities. This is because of continuing robust demand from India and China for the country’s leading resource exports, coal and palm oil. We recommend a strong overweight for Indonesian equities.
We initiated coverage of Turkey in April with an assessment of the Central Bank’s unorthodox monetary policies.
The near-term outlook for the Turkish market is complicated by two factors. One is the parliamentary elections scheduled for 12 June. The economic policies of the ruling Justice and Development Party (AKP) are not a major issue in the campaign but its expressed desire to move from a parliamentary to a presidential system of government could ultimately upset the market.
The second factor is mounting evidence that the economy is overheating and is in need of serious cooling off. The latest figures on the country’s current account show a record deficit of US$9.8 billion, more than double the figure for the same month last year. If these trends continue, the deficit will reach a record 8 per cent of GDP. Financing is not the problem; currently the country is awash in foreign capital. The problem is that economic growth is increasingly dependent on foreign capital rather than domestic savings to finance large increases in consumption and investment.
Turkey’s Central Bank has been implementing an unorthodox policy mix of sharp increases in banks’ reserve requirements together with interest rate reductions to dampen capital inflows. Although this policy mix may eventually be effective in slowing growth, the evidence so far is that there are long lags between policy implementation and impact.
Therefore much tougher tightening measures look likely once the elections are decided. This uncertainty is hanging over near-term prospects for the market. With the AKP expected to win a third term of single-party rule, a stock market rally would seem to be in order. However, with prospects of major new initiatives to cool the economy the rally could be short lived. We recommend an underweight position in Turkish equities.
Below we survey sector valuations in emerging markets (EM) both relative to developed markets (DM) and among the various emerging country markets.
The EM oil and gas sector is the favourite – cheap and higher yielding
Across all sectors over the past 12 months the EM oil and gas sector has been the cheapest and provided higher returns relative to DM, while utilities and industrials have lagged on both criteria. In Chart 11 below we show a grid with two separate valuation measures: price to cash flow and return on equity. The data are taken from the FTSE global sector indices calculated over the past 12 months.
Note: The position on the grid is determined by dividing the EM data by the DM data for each valuation measure. For example, a value of 1 means valuation measures for both EM and DM were identical.
As a first cut at identifying attractive sectors within EM, we are looking for valuations that meet the following criteria:
The oil and gas sector alone clearly meets both criteria, while four sectors have higher returns on equity with price to cash flow valuations that range from equal value (financials, basic materials) to “rich” (consumer goods and consumer services).
This exercise does not tell us which stocks to buy but it does point us in the right direction and suggest appropriate questions, e.g.: Why is EM healthcare so expensive? How do EM financials achieve such high returns on equity?
EM leaders and laggards in the consumer staples, financial and materials sectors
In Chart 12 we show MSCI performance indices for consumer staples stocks for six emerging markets over the past two months. Such stocks in China, Indonesia and Brazil have outperformed their EM peers while Russian and Indian stocks have lagged substantially. Stocks in Turkey also performed relatively well but now appear to be correcting sharply.
Chart 13 shows performance of financial stocks in the same six countries over the same period. Here Indonesia and Turkey are the clear outperformers relative to their EM peers, Russia is the laggard and the remaining three countries fall in the lower middle of the range.
The final chart shows the performance of stocks drawn from MSCI’s materials sector. Turkey, up 25 per cent since the beginning of March, is the major winner in this comparison. Brazil is the biggest loser, followed by Russia and India.
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