Taper Tantrum

John Authers at the FT had a great video on when to Buy BRICs this week.


Given how all the research presented showed that Emerging Markets are very cheap relative to Developed Markets, it was surprising to see Andrew Pease sitting so firmly on the fence. No wonder people have such a dim view of consultants these days.

I did, however, take some comfort from him being as wrong as I was with regards to the onset of Fed Tapering; I was convinced it would not start until q1 2014.

Given the strength of US GDP revisions on Friday, in hindsight it is clear why the Fed moved when it did. Having said recently that I expect GDP estimates to get revised up in both the UK and the US in early-mid 2014, I confess I am now a little thrown that we are seeing that so soon.

Both inflation and unemployment remain below the Fed's targets, which is why the Fed has made it so clear that they do not intend to raise rates anytime soon. If, however,  GDP growth is going to surprise on the upside quite so dramatically, then QE will be withdrawn much faster than I am currently anticipating and the Fed will be forced to reconsider its rate stance. This is the biggest visible threat to my base case scenario, and with it the risk of a "melt up" in Emerging Markets.

If the risk is increasingly that of a "Melt up", the risk is not that higher interest rates depress EM valuations, but that the stronger growth in the US, UK, and Germany drags up EM earnings estimates. Merrill recently published an excellent piece outlining their thoughts for next year in Emerging Markets. They point out that bottom up earnings expectations for EMs are usually too high at the start of the year, and they generally fall as the year progresses. Expectations for 2014 are unusually low on this basis, whilst the economic outlook appears to have upside surprises.

Is this the year analysts start too pessimistic?

As the FT makes clear, we have seen massive redemptions from retail investors out of Emerging Market Bond funds ahead of Fed tapering, whilst I had previously posted a video from an RBC Portfolio Manager showing how there had been a lot of late selling by Hedge Funds who had been weak holders of EM debt. Long-term Institutional money had basically sat still. To me this says that institutions are now more firmly committed to EM markets, both debt and equity. During the Asian crisis the question was often if institutions should hold EM Assets, whilst now it is more a question how much they should hold. Andrew Pease's fence sitting was therefore more appropriate for the old way of thinking, whilst  I would advocate a bolder stance more fitting to the "modern' thinking; buy the cheap assets, but put on a hedge if you are nervous. I believe we are now at the "sell on the rumour, buy on the news" stage. The cheap parts of EM equities are now very cheap according to Merrill, with a lot of bad news built into the price; How much cheaper can they get, barring a crisis? You just need to pick the right stocks.

Getting a lucky break - follow up to my post on Petrobras pricing

Having talked about Petrobras's failure to establish a meaningful pricing policy,  I was fortunate enough to discuss with Sinopec (386 HK) their approach, especially in light of the liberalization of prices following the 3rd Plenum.

As I had posted earlier, the pricing adjustments announced at the 3rd Plenum were not as far reaching as the headlines suggested, as several firms had already moved to more transparent policies. In the case of Sinopec, they actually moved to an improved formula as of March 26th, including publishing the changes to their website. These changes were the 5th round of improvements to pricing since 1998.

The two key points this year were;
1) Import parity is now calculated on a 10 day moving average, down from 22 days
2) The automatic trigger was lowered from a 4% price move to RMB50/ tonne. At around 7.3 barrels/tonne and $100/ barrel, that equates to a readjustment for every 1% change in the price of oil currently.

Frankly, even if Petrobras adopted Sinopec's old formula, it would still be a huge improvement.

I also caught another break on Monday when Clément Gignac published a commentary in Canada's Globe and Mail of the end of QE and its affect on the US 10 year bond. Read the article for his methodology, but the final passage says it all,

"In a nutshell, when the Fed finally puts an end to QE, which should happen by the end of 2014, long-term rates should march up toward about 3.5 to 3.6 per cent, a rise of 75 basis points from current levels. But 10-year rates should only return to a more “normal” level of around 4.5 per cent when the Fed brings its monetary policy back to neutral, which would be in line with a Fed funds rate of about 2.5 per cent to 2.75 per cent."

Although he is slightly more "bearish" than I am (I see QE ending in 2015), I would still describe a rise in the 10 year yield to 3.5% as modest and accommodative. It is certainly not enough to derail long-term funding for Emerging Markets.

Ordem E Progresso

Brazil, as always, continues to fascinate and excite. This week they took several steps forwards and several steps backwards; to be honest I am still trying to count how many in each direction.

Petrobras, the State owned Oil Company held a board meeting where they raised gasoline and diesel prices 4% and 8% respectively. This is good, as far as it goes. These changes should add $3.7Bn to EBITDA and $2.3Bn to net income according to Merrill Lynch.

Unfortunately they didn’t bring the domestic prices up to international parity, so the large amounts of fuel Brazil imports is still being sold at a discount – about an other 8% for gasoline and 15% for diesel, again according to Merrill.

Apart from the direct effect this has on Company and Government revenues, it has serious knock on effects to other industries, such as the domestic ethanol industry - Brazilian cars are able to run on any mixture of ethanol or gasoline.

Ethanol for fuel is a genuine green industry in Brazil, since it uses sugar cane rather than corn. Sugar cane requires basically no fertilizer (derived from oil) to grow, and can yield multiple harvests a year. Brazil has established itself a world leader not only in the production of ethanol, but also the technology that allows vehicles to be so flexible. Having encouraged huge amounts of private capital into the industry, the Government is now pulling the rug out from underneath them by crushing profitability. As a result, Private Investors are going to demand even bigger subsidies from the state development bank (BNDES) to invest in Brazil in future – hence the heavy participation of BNDES in the recent airport auctions.

Net-net, the Government is handicapping its own financing abilities AND discouraging investments at the margin, hindering economic growth.

The board also failed to specify how and when farther adjustments would be made, only that they hoped to do it over the next 24 months. This was a great opportunity for the Government to show that they were in control of the situation, and they blew it.

Petrobras was recently downgraded, and S&P has the country on negative watch. I would argue that these failures to take decisive action make a Sovereign downgrade inevitable, possibly as soon as the next review in early 2014. Should the Government continue to run such incoherent policy, a second downgrade after the elections cannot be ruled out.

I, however, still think that a second downgrade would be unlikely and a serious over reaction. As much as the Government’s policies are incoherent, they are in no ways a return to the idiocy of the pre-Real Plan days. Losing investment grade would be a major blow to national prestige and seriously undermine the Government’s credibility. When push comes to shove, I believe that the Government will do just enough to stop things getting out of control.

They have also made it clear that they recognize the effect their policies are having on Petrobras’s Balance Sheet, and its ability to fund its huge investment program. Out have gone the platitudes that Petrobras is fine, in has come the recognition of the speed with which debt is now rising and the rapid deterioration of debt metrics; The company is talking more seriously of Net Debt/ EBITDA below 2.5X, whilst it is currently over 3.1X and set to rise farther.

Barring a Sovereign crisis, and there are absolutely no rational reasons why Brazil should have one even under the current mismanagement, we are probably approaching the point of maximum pessimism. My guess, and I emphasize guess, is that it should occur during the first half of 2014. Once the World Cup starts, things will coincidently get better slowly, as the competition proves not to be a disaster, and any back up in US 10 year yields due to Fed Tapering proves to be muted; Current 10 year yields are 2.82, up from 1.62% a year ago. That is already quite a significant de facto tightening, so it's hard to see Janet Yellen trying to push rates up much farther.

There was an other development that got much less attention, but which could be very significant in the long run, if it is followed up; Brazil actually jailed corrupt Senators!

One of the causes of this summer’s riots was frustration with the politicians who had been found guilty of bribery and corruption but were able to keep themselves out of jail through complex legal wrangling. The cynical view on the street was that it would “all end in pizza”, a Brazilian term meaning the bad guys would get away with it again. Now it seems the Supreme Court has had enough too, and has sent the most visible and important members to prison – José Dirceu and Jose Genoino – along with several others.

This may be just a one-off sop to appease the rioters, and once they get bored it will be back to business as usual, but there is a very strong movement to increase transparency in Government that appears to be having an effect. I am under no illusion that Brazil will suddenly become as corruption free as Canada, but every journey starts with a single step.

Such is Progresso!

Up, Up, and Away!

Having criticized Brazil for the mishandling of the recent auction of Pre-Salt oil fields, it is only fair that I give them credit for the success of their latest auction of airport concessions.

As the FT reports,  Singapore’s Changi Airport, together with Brazil’s Oderbrecht group, paid $8.3BN to run Rio’s Galeão airport, whilst a consortium of Zurich and Munich Airports teamed with CCR to win the Belo Horizonte Airport concession with a bid of $790M.

This comes after similarly successful auctions last year for concessions to operate São Paulo’s Guarulhos, Viracopos in Campinas and Brasilia’s airport.

All the concessions were contested by a variety of consortia, comprising local and international players, and in contrast to the oil auction went for multiples of the minimum bid price. Current airport operator, Infraero, will remain as minority partner of all the projects ostensibly for investment purposes.

The success of these auctions shows just how profitable for the country well constructed concessions can be. The $9bn investment for the latest auction will help to close some of the budget deficit; the international portion will boost the Capital Account, whilst future expansion and improved efficiency will boost economic growth. All this comes at a time when people are worried about slowing growth and a widening current account.

Meanwhile Infraero, a pretty poor airport operator, is going to get instruction from some of the world’s best airports on how to do things better, and will have a strong financial incentive to follow that advice.

What are the opportunities that the winning bidders are buying?

The concession for Guarulhos last year stipulated increasing aircraft movements from 46 an hour to 56 an hour. Heathrow operates at 54 on a daily average, but operations are restricted between 23:00 and 07:00, so obviously operates at a much higher rate during the day. I assume the concession for Galeão stipulates similar increases.

Increased plane movements are not the only source for increased traffic. I am embarrassed to say, but I do not know if either airport is capable of handling the new A380. Having said that, my various journeys through both suggest not, as they struggled to handle even midsize jets. If carriers are able to use the newer bigger jets, passenger traffic would increase dramatically, yet the investment necessary to accommodate these jets adequately was way beyond Infraero’s capabilities.

Anyone who has travelled through Changi, Heathrow, or even Cancun will tell you that the opportunities for shopping at these airports is tremendous. From the ability to buy a decent meal before boarding the flight, through to buying an iconic last minute gift, you have a captive audience that is looking for something to help while away the time.

Some airports, like Heathrow, set a maximum return so shopping profits offset landing and parking fees, whilst others, such as Cancun allow the operator to keep both revenue streams. At first sight it looks like these Brazilian concessions fall into the later category, making them more valuable.

Finally, these airports suffer from the same poor reputation that all Brazilian ports do for freight handling, the famous gasto do Brazil. More efficient handling will allow for greater transportation of high value cargos; Heathrow handles about 1.5 Million tons of cargo a year.

So that’s the opportunity.

More recently several of the Canadian Pension funds (CPPIB and AIMCo),  have expressed doubts about the valuations that Alternative Investments including infrastructure deals are currently going for. They didn’t specifically mention these deals, but it would be reasonable to assume that they looked at them long and hard given their track records not only in infrastructure but also Brazil.

It would also be good to know how much these bids are dependent on BNDES funding, rather than commercial rates. The size and composition of the consortia means they should have no problem getting long-term funding rather than depending on the National Development bank.  Subsidized funding should be directed to projects that do not enjoy such access to long-term funds, whilst projects like this would be invaluable for helping develop and deepen local bond markets.

Finally, returning to one of the themes from my opening post, these deals show that the slow money that measures deal success over decades rather than months isn’t put off by short-term variations in exchange rates or the threat of QE tapering, to them that is just noise.

China’s 3rd Plenum Follow up

It seems appropriate that I should follow up on last week’s comments about the 3^rd Plenum in China, but first here is a nice short little video I found about this year’s correction in Emerging Markets.

RBC's Laurence Bensafi

I have never met the young lady, but I like her simple explanation – I find a lot of people try to make things too complicated just to justify there own existence, where as the simplest answer is often the best.

And on to China...

First of all I like the fact the FT put implementation risk front and center of its coverage. As I hope I made clear last week, implementation often goes counter to the intent of these meetings. I was particularly struck by the phrase “In Chinese policy circles, the 2002-2012 rule of President Hu Jintao is now referred to as a “lost decade” because of this striking disconnect between state policy goals and actual outcomes.”

Ironically it appears to be the follow up document released on Friday, rather than the official document from the meeting released on Tuesday that has attracted the most attention, not only for the speed with which it came out but also for the fact it appeared more direct. Sadly, I have yet to see a good reason as to why they followed up in this manner.

It is good that they have started to ease the one child policy. Urban Chinese of relatively modest means can afford the fines associated with having more than one child, but the brutal enforcement of this policy in rural communities and especially its warping of the gender ratio is a staple of Western tabloid newspapers and is a serious cause for concern for demographers. It has now been confirmed that China’s workforce is shrining and the population is starting to age. As policies go, I suspect this will be one of the easiest to implement quickly.

Improved property rights for farmers, even those who move to the cities, and improved residency rights for those who move to smaller cities sounds very encouraging, but again enforcement is going to be the key. Officials in these areas make good money by ignoring even the existing rules, whilst the calls for an extended phase-in suggest implementation wont be easy.

I was certainly happy to see talk of State owned Enterprises handing over 30% of their profits by 2020. Unfortunately, as we have seen with the likes of Gazprom in Russia, a lot of SOEs will simply hide profits by ramping up the capex spending. I do not doubt that we will see many of these companies opening lavish offices in London or New York. China is already losing huge amounts through capital flight and the slow phase in might actually encourage more of this in the short and medium term. Needless to say, I wont be holding my breath until I actually see some real change take place.

A move to more market based price setting makes sense, and if it is allowed to curb some of the SOEs at the same time, so much the better.

For me, I think it was important that they didn’t promise too much. Between the two communiqués there was sufficient for a determined Government to focus on without over promising, and enough to be ambitious if they can implement it.

Over all, if they can implement enough of these measures to reduce official corruption and its corrosive effects, that has to be a good thing.

If…

China Tea Leaves

When I was a child in the Industrial Midlands of the UK, my parents used to take us out for a Chinese meal as an occasional treat. At the end of the meal, my Mother would “read” the tea leaves at the bottom of our cups, inevitably predicting all sorts of exciting events in our futures.

I was reminded of this because today is the 3^rd Plenum of the 18^th Chinese Communist Party Congress taking place from the 9^th to 12^th in Beijing. I can already see pots of tea leaves being “read” with regards to its outcome; The FT is full of guest posts predicting all sorts of momentous things.

It is apparently during the 3^rd Plenum that the new leadership lays the groundwork for any reforms that they are planning for their 5-10 years in power. Favourable comparisons are being drawn to the 3^rd Plenum of Deng Xiaoping in 1978 where he established the reform agenda that launched China on its current growth path, and Jiang Zemin’s 3^rd Plenum in 1993 that push those reforms even farther.

Other leaders have been less bold, and missed the opportunity to advance reforms, even if they made grandiose announcements at their own 3^rd plena.

And there in lies the problem; whether in China or elsewhere, it is very easy to announced grand plans, but much harder to implement them. There is an old Chinese proverb, “The Mountains are high, and the Emperor is far away”, recognizing this.

It is also unfair of these commentators to cite any reforms by Deng as a precedent since he was such an extraordinary leader by both local and international standards. That would be like asking David Cameron to emulate Mrs. Thatcher, or President Obama to be another Kennedy.

Needless to say, I think the outcomes have been over hyped and I will be a lot more interested in any implementation of policy.

Last week when talking about Petrobras, I attempted to describe how the Government’s fortunes, actual and metaphorical, were intimately linked to its handling of the company. Since then, despite pronouncements that it has plenty of room to add more debt and is in fine shape to meet its capital expenditure commitments, the Government has introduced plans to reform the petrol subsidy that should easily add $4BN to the bottom line. Just the talk of this has reversed the slide in Petrobras’s share price, and if implemented, may go some way to preventing a possible Sovereign ratings downgrade next year.

China’s problems are arguably larger than Brazil’s, and will thus require a greater effort to change them. There is no single company in China where one can say, “if they mess that one up, they mess everything up”, so we will need to see a collection of policies rather than one single one.

Having said that, one reform that I would like to see would be to change the way State Owned Enterprises pay dividends. Currently they are too low and go to SASAC, the State Owned Assets Supervision and Administration Commission who then reinvests that money back into the companies it controls. It would be better to see that money go to the central treasury to fund many of the much needed improvements to the social safety net. Frankly, I am not that hopeful.

Either way, I will be taking any “major” announcements with a large pinch of salt.

I have a feeling that the old trader’s adage “Buy on the rumour, sell on the news!” could well be in order, followed by a nice cup of tea.