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 If, however,  GDP growth is going to surprise on the upside quite so dramatically, then QE will be withdrawn much faster than I am currently anticipating and the Fed will be forced to reconsider its rate stance.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!