Revisiting housing supply — Ku Swee Yong
January 07, 2011JAN 7 — It was a week before last Christmas when we celebrated the Housing and Development Board’s (HDB) completion of 1 million flats.
This is an awesome achievement. With 1 million flats averaging about 1,000 sq ft each, the HDB has within 50 years completed and handed over a billion sq ft of residential space. A billion sq ft. One, followed by nine zeros. That is more square footage than the above-ground portion of the Great Wall of China, which spans 6,500km.
Now, the actual number of HDB flats that exist today is just below 900,000. According to the HDB’s annual report, as of March 31, 2010, there were 890,212 flats under management. More than 100,000 flats have been demolished since the ‘70s, many of them rental flats. Older estates, such as Brickworks and Queenstown, have been upgraded.
Over the years, small individual estates have also been amalgamated into towns such as Bukit Merah Town, Clementi New Town, etc, under various estates renewal programmes, such as Selective En bloc Redevelopment Scheme (Sers).
The completion of an average of 20,000 flats per year in the HDB’s 50-year history was in tandem with the growth of Singapore’s population.
In the last 15 years, from 1995 to 2010, population growth (Singaporean citizens and permanent residents) averaged 50,000 per year, accommodated by the growth of public (additional 13,950 flats a year) and private housing (8,593 units a year). This is an average of one apartment for every two to three Singapore citizens and PRs. If we included non-residents (Work Permit and Employment Pass holders, for example), then this is an average of one new HDB or private home for every four new people added to the “headcount” in Singapore.
Table 1 shows the actual supply of physical units versus population growth. The 15-year data looks balanced.
However, within the 15 years, there were several tumultuous periods. Early on, a long queue of up to five years for HDB flats formed due to a perception of supply shortage and rising prices. Executive Condominiums were introduced.
The massive construction boom around 1995, with fuel added by en-bloc deals, led to a massive increase of 44,000 residential units per year in the period spanning 1998 to 2000. This is net additional physical supply; that is, demolitions from en-bloc deals have reduced the total count.
THE SCOURGE OF SARS
The economy dipped in 2001 after the dotcom crash, which was followed by 911, Gulf War II, the Bali bomb blast, and then Sars. The blip during the Sars crisis was the worst: A recession with a population exodus of 61,000 in 2003, during which there was an accumulated excess of residential units.
By March 2004, HDB announced it would stop building five-room flats because it had 10,000 units that were waiting to be taken up. At that time, three-bedroom private apartments could easily be had at S$500,000 and there was little demand from a population that shrank by 61,000.
The over-supply, apparent since 2001, brought on a revamp of the HDB and the introduction of the Build-To-Order (BTO) scheme. HDB flats will be constructed only when there are enough buyers, allowing the board to adjust supply based on demand from applicants.
In 2002, the registration for flats system was suspended and till today, the BTO scheme remains the main mode of HDB’s sales. The Design, Build and Sell Scheme (DBSS) was introduced in 2005 for private sector developers to participate in public housing projects. This scheme contributes about 10 per cent of total new HDB supply.
The period of 2004 to 2005 was one of slow growth as there was excess supply which had to be absorbed by new demand from the population growth before equilibrium could be reached. Government Land Sales slowed down, leading to the next squeeze.
MARKET RECOVERS AMID EN-BLOC FEVER
From 2006 to 2008, real estate prices recovered on a combination of factors, including: (a) rapid population growth on the back of strong jobs creation; (b) rosy economic outlook spurred by the promise of the integrated resorts; (c) developers replenishing freehold land bank through en bloc transactions and (d) small number of project starts in 2003 to 2005 leading to low completion numbers in 2006 to 2008.
Of the above factors, the en bloc phenomenon created the biggest squeeze because it (a) demolished physical housing units to make way for redevelopment, reducing total stock; (b) put millions of dollars of windfall into the hands of the en bloc sellers, amplifying purchasing power, and (c) en bloc sellers had to buy another property for their own stay at a time when net new supply was already low.
The average growth of population in the last five years - from 2006 to last year - was 162,000 per year. The demand for housing was way higher than the net supply growth of private residential at 5,780 units per year and the additional supply of 2,129 HDB flats per year, partly due to Sers rejuvenation of older estates. The timing could not have been better.
If we narrowed our analysis down to the numbers for 2006 to 2008, the shortage of space is even more pronounced. Vacancies dropped to a low of around 4 per cent as the average annual increase of 4,077 units of private residential stock (TOP completions minus en bloc demolitions) and 1,858 units of HDB stock were hardly enough for the influx of population at 191,200 a year! Assuming the new population agreed to squeeze into residential units 10 people at a time, we would need a supply of 19,100 units each year in 2006 to 2008. But the additional stock count was only 5,935. So naturally, rentals and capital values spiked.
SUPPLY OUTLOOK
We need to look at the planning for physical supply and not merely the real estate market based on launches and pre-sales. Some schools of thought favour the idea that, in land-scarce Singapore, property investors merely care about capital gains, not the steady rental income stream. For me, I stress the importance of long-term returns from real estate and therefore, I keep a close eye on physical supply and asset utilisation.
A property has real value only when it is well-used. Most hard, capital-intensive assets are like that: Ships, aeroplanes, machinery, satellites, ports, highways, and so on. If you leaned towards feng shui, you would also believe that the higher the human traffic and goods flow (especially for industrial, retail and commercial properties), the better the property.
An over-supply of completed residential properties, with insufficient end-users and poor utilisation, would naturally lead to price weakness.
Conversely, insufficient supply or too-rapid a population or demand growth will lead to sky-rocketing prices — similar to the situation in 2007. This would not go down well with our central planners. Despite being a top-notch economy, Singapore does not like to price itself out of the market. So, we can expect more supply to quench the fire of rising prices.
Since the middle of 2009, public housing demand has been robust and prices have moved up sharply. From Table 2, we see that HDB launches of BTOs were ramped up significantly last year.
According to the HDB: “The ramp-up of flat supply is part of a series of additional measures to reinforce the Government’s commitment to provide affordable and adequate public housing supply for first-timer households.” If demand remains strong, the HDB may launch up to 22,000 BTO flats and release land for 7,000 DBSS units this year. That’s a potential 29,000 HDB units. That’s huge.
However, the numbers do not indicate when the physical supply will be completed. The HDB supplies new flats based on various demand factors, such as new households formed from marriages, number of resale transactions, etc. To satisfy the strong demand and in order to shorten the waiting time for first-time buyers, Mah Bow Tan, the Minister for National Development, has announced that the HDB will endeavour to complete construction within two-and-a-half years, shorter than the previous average of three years, for all BTOs starting from September last year.
Based on the above information, public housing supply is estimated to be as shown in Table 3:
If we net out the number of HDB units that may be demolished for estate renewal, the supply looks comfortable, especially since most of the BTO flats have found owners before construction began.
However, if we look at the total supply of residential units (both HDB and private) as shown in Table 4, the numbers become somewhat scary.
If you recall from Table 1 above, the 15-year average annual supply is about 22,000 units of HDB and private housing. The recent record high Government Land Sales programme and the ramp up of HDB supply may lead to a supply of over 30,000 units in 2013 and 43,000 units in 2014.
The last time so many residential units were completed was during the period of 1998 to 2000, when an average 44,000 units were completed per year. That was a supply level that was challenging to absorb as new family formations through marriages tracked at around 25,000 per year and thepopulation increased at 70,000 per year. And not all newly-weds purchase homes or move out of their parents’ nests, while new population may come in the form of students or contract workers who occupy dormitories rather than residential units.
That period of over-supply led to a long period of indigestion from 2002 to 2005, when prices stagnated on the back of an economy hit by Sars and external turbulence. Vacancies of private residential units hovered above 8 per cent for most of 2002 to 2005, much higher than the 5 to 6 per cent of 2009-2010.
WHAT MIGHT BE THE LEVERS TO PULL?
Should the Urban Redevelopment Authority’s projections of residential completions be accurate and HDB supply remains high, we must brace ourselves for a deluge in 2013 and 2014. We are now in 2011, so that gives us over a year to prepare. There are, however, a few ways that may mitigate the over-supply threat:
- Speeding up estate renewal programmes
By 2015, there will be more than 200,000 flats that will be over 30 years old. Old flats could be torn down sooner. Current tenants will be given notice to move out into other HDB flats. However, HDB’s pace of renewal programmes is not entirely clear to market watchers, so I would not be able to take a stab here.
- Slowing down construction
The HDB can choose to slow down the supply of new flats. In the case of BTOs, the process of applications, queueing, balloting, selection, etc, and then contracting the construction companies to build are within the control of HDB. If physical supply is high and vacancies increase, the completion of construction could be delayed for the market to take up some slack.
- Embracing more foreigners
The demand side of the equation could be jacked up by welcoming more foreigners to our shores. This is especially so if the economic growth in the next five years can hold up at 5 per cent or higher, ensuring that jobs growth will be robust. If executed well, an increase in housing demand produces the best outcome for the whole market.
It remains to be seen if the large supply can be supported by demand. It is critical for stakeholders to make informed decisions, thinking through a comprehensive set of real estate data such as housing demolitions, population growth policies, public and private housing TOPs, etc, to the extent that such information is available. — Today
Monday 28 February 2011
Tuesday 22 February 2011
Monday 21 February 2011
Brace for poor returns as inflation rises
Published February 19, 2011
Show me the money
Brace for poor returns as inflation rises
Key macroeconomic challenge this year will not be growth, but dealing with emerging cost pressures
By TEH HOOI LING
SENIOR CORRESPONDENT
THE inflationary pressures are on! 'Government raises inflation forecast', screamed the headline in The Straits Times yesterday. 'New official projections have confirmed that rising prices will be the key economic issue this year and a major focus for today's Budget,' the news report said. 'The government yesterday raised its inflation forecast for the year by one percentage point to between 3 per cent and 4 per cent.'
The key macroeconomic challenge this year will not be growth, but dealing with emerging cost pressures, said Ravi Menon, Permanent Secretary for Trade and Industry.
Except for seven quarters between the second half of 2007 and the first quarter of 2009, Singapore has managed to keep the growth of its consumer price index (CPI) below 3 per cent since 1995. In Q3 2007, the CPI climbed to 3.17 per cent and rose to hit 7.5 per cent in Q2 of 2008.
But thanks to the global financial crisis, which effectively threw a soaking wet blanket on the overheated prices, the CPI eased to 0.17 per cent by Q2 2009. It was then followed by two quarters of negative growth.
But by Q2 2010, inflation reared its ugly head again as prices climbed more than 3 per cent year-on-year. It rose to just under 4 per cent by the final quarter of last year.
On Thursday, I received an e-mail from a reader asking if I could give him some insight/opinions regarding Singapore's record inflation rates in 2008 and which stocks outperformed during high interest rates and which did poorly.
I downloaded Singapore's inflation numbers since 1973, and the individual stocks' prices at various times when inflation was either rising and falling. I also downloaded the Straits Times Index (STI) as calculated by Datastream since 1973.
First up, I decided to look at how the general market performed during periods of high or low inflation.
Using the quarterly CPI numbers, I matched the quarterly returns of the STI with the CPIs for the corresponding quarters. For example, the CPI for Q1 2001 would be matched with the STI return for that quarter.
The assumption is that there would be monthly inflation numbers being released and the market would have an inkling of where the general price levels are headed. Stock market prices would then adjust accordingly as the quarter progressed.
The numbers that the data churned out showed clearly that inflation is bad for stock prices. I broke down the year-on- year change in CPI into eight groups: those below -1 per cent growth; from -1 to 0 per cent; 0-1; 1-2; 2-3; 3-5; 5-10; and those above 10 per cent.
As you can see from the first chart, the mean and median three-month returns of the STI in general get progressively smaller as inflation rises. For example, between 1973 and now, there were eight quarters when the CPI fell by more than one per cent from a year ago. The average and median return of those eight quarters were 11.2 per cent and 10.7 per cent respectively.
Meanwhile, there were 13 quarters when the CPI fell by between one and zero per cent. The average and median returns for those quarters were 9.9 per cent and 12.2 per cent respectively.
Recent examples of such quarters were the third and last quarter of 2009 when the CPI was -0.37 per cent and -0.73 per cent respectively. The returns for STI in those two quarters were 14.1 per cent and 7.6 per cent.
In Q1 2007, the CPI slid by 0.17 per cent. In that period, the stock market climbed by 8.3 per cent. Once the CPI climbed to the zero to one per cent range, the STI returns fell to about 5 per cent.
Between one and 10 per cent of inflation, market returns fell to between 0.5 and 3 per cent. And on the eight occasions when inflation surged beyond 10 per cent - that happened in the 70s - the average and median return for the STI were -10.3 per cent and -11.4 per cent respectively.
The third chart shows market valuations, as measured by the price-earnings (PE) ratio, getting lower the higher the CPI went. And we are now moving into the 3 to 5 per cent inflation range, when the market PE dropped rather significantly! But the thing is, current market PE wasn't high to begin with.
This phenomenon is observed in other markets as well, and financial economists find it surprising. After all, stocks, as claimed against real assets, should compensate for movements in inflation.
So given the negative relationship between short-term stock returns and inflation, the stock market is not even a partial hedge against inflation. A negative relationship implies that investors whose real wealth is diminished by inflation can expect this effect to be compounded by a lower than average return on the stock market.
The thing is inflation gets factored into nominal interest rates which are used to discount the future cash flows of companies to arrive at their current present value. All things being equal, the higher the discount rate, the lower the net present value of the company.
Of course, in an inflationary environment, companies would also have to contend with higher costs, be they manpower, raw materials or others. But what if the companies have the pricing power and are able to pass the higher costs to consumers?
Well, even if companies are able to maintain their margins, or in the optimistic scenario improve them, the higher discount rate would, in most likelihood, result in companies having lower net present value.
With that understanding, perhaps we can appreciate why funds are reversing out of fast growing Asia which are grappling with inflation, and heading toward the developed markets and to Japan.
Of course, inflation doesn't stay high forever. If prices increased sharply today, next year this time, we will measure the increase from today's higher base and the quantum may not be as high as a result.
And other studies have shown that over the long term, stocks do compensate for inflation. Studies in countries which suffered bouts of high inflation in Latin America also found stocks to yield real positive returns.
Now back to the reader's question: Which stocks did well in 2007/8 when inflation spiked up? Well, that coincided with the global financial crisis, and between end-September 2007 and end-September 2008, only 25 stocks out of 700- plus listed on the Singapore Exchange managed to chalk up positive returns.
The top performing companies during that period were from varied industries: RH Petrogas which deals in electrical equipment; Portek, which is in transport services; FDS Networks in computer services; Transcu in recreational services, ISDN Holdings in business support services; MAP Technology in computer hardware; Riverstone in medical supplies; and Metax Engineering in industrial machinery.
So it would seem that it was company specific news which drove the stock prices. But normally, it is accepted that resource providers would benefit more in an inflationary environment, so too technology and consumer products.
Meanwhile, utility and telecom companies typically are viewed as not having the pricing power to battle inflation and property developers don't generally do well when interest rates rise. Neither do real estate investment trusts which are raking it in now given the benign interest rates.
The writer is a CFA charterholder
Show me the money
Brace for poor returns as inflation rises
Key macroeconomic challenge this year will not be growth, but dealing with emerging cost pressures
By TEH HOOI LING
SENIOR CORRESPONDENT
THE inflationary pressures are on! 'Government raises inflation forecast', screamed the headline in The Straits Times yesterday. 'New official projections have confirmed that rising prices will be the key economic issue this year and a major focus for today's Budget,' the news report said. 'The government yesterday raised its inflation forecast for the year by one percentage point to between 3 per cent and 4 per cent.'
The key macroeconomic challenge this year will not be growth, but dealing with emerging cost pressures, said Ravi Menon, Permanent Secretary for Trade and Industry.
Except for seven quarters between the second half of 2007 and the first quarter of 2009, Singapore has managed to keep the growth of its consumer price index (CPI) below 3 per cent since 1995. In Q3 2007, the CPI climbed to 3.17 per cent and rose to hit 7.5 per cent in Q2 of 2008.
But thanks to the global financial crisis, which effectively threw a soaking wet blanket on the overheated prices, the CPI eased to 0.17 per cent by Q2 2009. It was then followed by two quarters of negative growth.
But by Q2 2010, inflation reared its ugly head again as prices climbed more than 3 per cent year-on-year. It rose to just under 4 per cent by the final quarter of last year.
On Thursday, I received an e-mail from a reader asking if I could give him some insight/opinions regarding Singapore's record inflation rates in 2008 and which stocks outperformed during high interest rates and which did poorly.
I downloaded Singapore's inflation numbers since 1973, and the individual stocks' prices at various times when inflation was either rising and falling. I also downloaded the Straits Times Index (STI) as calculated by Datastream since 1973.
First up, I decided to look at how the general market performed during periods of high or low inflation.
Using the quarterly CPI numbers, I matched the quarterly returns of the STI with the CPIs for the corresponding quarters. For example, the CPI for Q1 2001 would be matched with the STI return for that quarter.
The assumption is that there would be monthly inflation numbers being released and the market would have an inkling of where the general price levels are headed. Stock market prices would then adjust accordingly as the quarter progressed.
The numbers that the data churned out showed clearly that inflation is bad for stock prices. I broke down the year-on- year change in CPI into eight groups: those below -1 per cent growth; from -1 to 0 per cent; 0-1; 1-2; 2-3; 3-5; 5-10; and those above 10 per cent.
As you can see from the first chart, the mean and median three-month returns of the STI in general get progressively smaller as inflation rises. For example, between 1973 and now, there were eight quarters when the CPI fell by more than one per cent from a year ago. The average and median return of those eight quarters were 11.2 per cent and 10.7 per cent respectively.
Meanwhile, there were 13 quarters when the CPI fell by between one and zero per cent. The average and median returns for those quarters were 9.9 per cent and 12.2 per cent respectively.
Recent examples of such quarters were the third and last quarter of 2009 when the CPI was -0.37 per cent and -0.73 per cent respectively. The returns for STI in those two quarters were 14.1 per cent and 7.6 per cent.
In Q1 2007, the CPI slid by 0.17 per cent. In that period, the stock market climbed by 8.3 per cent. Once the CPI climbed to the zero to one per cent range, the STI returns fell to about 5 per cent.
Between one and 10 per cent of inflation, market returns fell to between 0.5 and 3 per cent. And on the eight occasions when inflation surged beyond 10 per cent - that happened in the 70s - the average and median return for the STI were -10.3 per cent and -11.4 per cent respectively.
The third chart shows market valuations, as measured by the price-earnings (PE) ratio, getting lower the higher the CPI went. And we are now moving into the 3 to 5 per cent inflation range, when the market PE dropped rather significantly! But the thing is, current market PE wasn't high to begin with.
This phenomenon is observed in other markets as well, and financial economists find it surprising. After all, stocks, as claimed against real assets, should compensate for movements in inflation.
So given the negative relationship between short-term stock returns and inflation, the stock market is not even a partial hedge against inflation. A negative relationship implies that investors whose real wealth is diminished by inflation can expect this effect to be compounded by a lower than average return on the stock market.
The thing is inflation gets factored into nominal interest rates which are used to discount the future cash flows of companies to arrive at their current present value. All things being equal, the higher the discount rate, the lower the net present value of the company.
Of course, in an inflationary environment, companies would also have to contend with higher costs, be they manpower, raw materials or others. But what if the companies have the pricing power and are able to pass the higher costs to consumers?
Well, even if companies are able to maintain their margins, or in the optimistic scenario improve them, the higher discount rate would, in most likelihood, result in companies having lower net present value.
With that understanding, perhaps we can appreciate why funds are reversing out of fast growing Asia which are grappling with inflation, and heading toward the developed markets and to Japan.
Of course, inflation doesn't stay high forever. If prices increased sharply today, next year this time, we will measure the increase from today's higher base and the quantum may not be as high as a result.
And other studies have shown that over the long term, stocks do compensate for inflation. Studies in countries which suffered bouts of high inflation in Latin America also found stocks to yield real positive returns.
Now back to the reader's question: Which stocks did well in 2007/8 when inflation spiked up? Well, that coincided with the global financial crisis, and between end-September 2007 and end-September 2008, only 25 stocks out of 700- plus listed on the Singapore Exchange managed to chalk up positive returns.
The top performing companies during that period were from varied industries: RH Petrogas which deals in electrical equipment; Portek, which is in transport services; FDS Networks in computer services; Transcu in recreational services, ISDN Holdings in business support services; MAP Technology in computer hardware; Riverstone in medical supplies; and Metax Engineering in industrial machinery.
So it would seem that it was company specific news which drove the stock prices. But normally, it is accepted that resource providers would benefit more in an inflationary environment, so too technology and consumer products.
Meanwhile, utility and telecom companies typically are viewed as not having the pricing power to battle inflation and property developers don't generally do well when interest rates rise. Neither do real estate investment trusts which are raking it in now given the benign interest rates.
The writer is a CFA charterholder
Saturday 19 February 2011
The Outlook is Dominated by Inflation and Uncertainty Over What to do About It
OUTLOOK IS DOMINATED BY INFLATION AND UNCERTAINTY OVER WHAT TO DO ABOUT IT
Global themes for portfolio allocation
•Inflation will lead to equity market underperformance in the BRICs other than Russia
•Rapid growth in food demand in China and India is driving global food price inflation
•Local fixed-income securities and BRIC currencies other than the ruble are unattractive at this time
BRIC themes and investment ideas
•Brazil - Uncertainty about how far the Banco Central's tightening cycle has to go in order to corral inflation will keep the equity market in the doldrums. Near-term underweight
•Russia - The combination of high global commodity prices and attractive valuations will continue to favour Russian equities. Overweight.
•India - The economic outlook has worsened because the government has been slow to respond to rising inflation and deterioration in fiscal performance. The Indian market will continue to lag. Stay on the sidelines for now
•China - Investors will likely stay away from the market until inflation peaks. Play the China story through commodities and look to increase equity allocations towards the end of Q2/11
Macro and sector spotlight
•India: Slippery slope for fiscal consolidation
•Russia's monetary crunch
•Why Brazilian ports will stay on the slow boat
Portfolio Strategy
Overview
Our top global theme last month has played out as we anticipated. As Charts 1 and 2 illustrate, BRIC equity markets other than Russia have lagged developed markets as well as East European emerging markets. The reason is inflation and uncertainty over how policymakers will deal with it.
Chart 1: MSCI Indices, December 2010 to date (US$ terms, three-day moving average)
The reasons for underperformance in Brazil, India and China (the BICs) reflect a combination of politics and uncertainty about whether the inflation remedies being implemented will actually work. We think BIC equity markets will underperform until there is tangible progress in curbing inflation.
In Brazil politics favours aggressive monetary tightening but markets are worried that current inflationary pressures need fiscal solutions. The recipe of more fiscal and less monetary tightening is a difficult one for Brazil's new President Dilma Rousseff to embrace because of her coalition of 12 mostly left-of-centre parties. Lacking clarity on the fiscal outlook, investors cannot judge how far the Banco Central will have to push up rates to control inflation.
Chart 2: Stock market performance, December 2010 to date (US$ terms, three day moving average)
In India policymakers appear unwilling to consider anything other than a very timid monetary tightening. Although Prime Minister Singh's Congress Party has a strong position in parliament there is little evidence of a willingness to push fiscal retrenchment. Instead, policy is biased towards higher spending on food subsidies, healthcare and education (for more details see the "Macro and sector spotlight" below).
Chinese policy also reflects the dominant influence of politics, in this case the scheduled transition to a new top leadership in October 2012. The government's Central Economic Work Conference in December failed to announce an expected tightening in monetary policy. Sources we consulted in Beijing told us this was because consensus could not be reached: finance officials pushed for tightening but were opposed by industry and provincial interest groups that argued against such cutbacks.
Russia's prospects are the exception among the BRICs. Although inflation is a problem Russia is a primary beneficiary of rising global commodity prices, especially oil. High oil prices reduce the country's fiscal deficit and its associated monetary financing. The prospect of a lower deficit combined with monetary tightening from the Central Bank of Russia (CBR) gives us reasonable confidence that today's 9.6 per cent inflation rate will be heading down later this year. Combine this with still attractive valuations and Russia stands out as an overweight allocation among the BRICs.
Among the three remaining BRICs we would single out China as the country most likely to convince markets that inflation is being contained. As we spellout in more detail below, we think China's inflation rate will peak at around 6 per cent in Q2/11 and then trend downward. It is still too early to call such a turnaround in either Brazil or India.
Looking ahead into 2011, we draw the following conclusions:
•Russian equities will likely extend their recent outperformance.
•Brazilian equities will likely underperform until the extent of the current monetary tightening cycle becomes clearer. We expect a minimum of 200 bps of tightening over the current cycle but we fear that Brazil's inflation rate could become stuck at an uncomfortably high level for structural reasons. Therefore we are less confident in calling a turning point in the inflation cycle at this time.
•China's inflation is moving onto a higher 4-6 per cent trend line but we think policy will contain inflation below the 6 per cent upper limit. Once markets perceive that inflation is peaking we anticipate a market rebound.
•We expect India's response to inflation to lag behind the curve, resulting in equity market underperformance for the foreseeable future.
Global themes for portfolio allocation
Inflation will lead to equity market underperformance in all BRICs other than Russia
Our leading global theme is unchanged from last month. Uncertainty about inflation and what policymakers will do about it will continue to dampen investors' enthusiasm for equities in Brazil, India and China. Although Russia has its own inflation problems high global oil prices and relatively attractive equity valuations set it apart, at least for now.
Two factors could elevate the BICs to outperformers:
1.Policymakers achieve success in controlling inflation, i.e. the monthly inflation results begin moving down.
2.Monetary authorities in developed countries announce strategies for exiting their current unprecedented monetary and fiscal stimulus programmes.
The main risk to Russia's outperformance is declining oil prices.
Our sense is that none of these possibilities is likely to emerge in the next two-three months. The earliest we are likely to see inflation turn down is towards the end of Q2/11 in China. Nor do we expect to see oil prices moving lower in the same time frame. Thus Russia will likely continue to outperform.
For the time being we recommend that investors play the emerging market theme through developed equities:
•Major US and EU multinationals with significant EM sales revenue will benefit from strong demand while being less affected by rising costs than purely local companies. Although these stocks have already had a good run we think there is still upside left on a two- or three-month view.
For pure BRIC plays, we recommend that investors stay away from crowded consumer trades since any inflation surprise will trigger an exit on the part of less dedicated investors. Instead we recommend that investors look at less popular large-cap industrials such as steel, cement and other infrastructure related firms. We would look first in China, then in Brazil.
Rapid growth in food demand in China and India is driving global food price inflation
In a recent TS View we argued that sustained food inflation in China will gradually move the country into the ranks of a major global importer of foods, especially feed grain, sugar and edible oils. The constraints on raising the efficiency of domestic food production are many:
•The lack of reform of land and labour markets will delay the consolidation of agricultural production units necessary to boost productivity.
•A steady decline in arable land and severe water management problems will thwart efforts to boost productivity.
•Priority in official policy to assuring domestic supply via subsidies in the face of a growing domestic food deficit will result in costs mounting through the supply chain.
India's domestic food economy shares many characteristics with China's, in particular supply bottlenecks, dependence on subsidies and growing shortages of water.
If we look at the demand side of the food equation we find the fastest growth in higherprotein foods such as meat, fish and dairy. Faced with limits on domestic food production, both China and India will turn to global markets to meet their food requirements. Both countries have the resources to buy what they need and there should be little doubt that they will do so.
Local fixed-income securities and currencies other than the ruble are unattractive at this time
The current economic environment in the BRICs is dominated by uncertainty about the prospects of policies to control inflation. This uncertainty weighs on prospects for equity markets, as has already been noted. Investors in local rates markets must judge whether local interest rate curves accurately reflect the future trend in interest rates.
We do not find the risk/reward equation attractive in any of the BRICs at this time for two primary reasons:
1.The risks are that global commodity prices for both hard and soft commodities will surprise on the upside due to political instability in Arab nations such as Egypt, shocks from adverse weather conditions and efforts by importing countries to bolster reserves in reaction to rising uncertainty about the security of supply.
2.We believe inflationary pressures in all the BRICs are poorly understood. Traditional policies of monetary tightening will prove to be less effective in attacking inflation than markets assume. This is because supply side bottlenecks are relatively more important.
Chart 3: Currency performance, January 2010 to date (US$, three-day moving average)
BRIC themes – Investment ideas
Brazil
President Dilma Rousseff has had a rocky first few weeks in office. Her initial message to the markets in early January was well received. To be sure, it was carefully crafted to reassure participants, but events quickly conspired to undermine confidence. Evidence of extremely tight labour markets - the country's 5.3 per cent unemployment rate for December is the lowest ever - has highlighted risks of cost-push wage pressures. Thus despite a promising debut the new economic team has failed so far to deliver a convincing second act detailing its policy for tackling inflation.
A resumption of monetary tightening by the Banco Central (BC) on 19 January has failed to restore confidence for the simple reason that nobody knows how high rates must go to dampen inflationary pressures. The fear is that rates will have to move substantially higher. Markets lack confidence that higher interest rates alone will solve what are, after all, supply-side bottlenecks. Meanwhile, markets are still waiting for details of fiscal cutbacks promised by the new economic team.
The BC's policy dilemma is that higher interest rates fuel new capital inflows that put upward pressure on the Real and undermine the competitiveness of domestic manufacturers. The BC has responded with large-scale interventions in spot and future currency markets with little effect: the Real has barely moved from a tight R$1.66-1.68/US$ range since a more active intervention policy was implemented in early January.
Part of the reason for the limited impact of the BC's interventions is that Brazilian corporations have been borrowing abroad as if there were no tomorrow. Although nonresident investors in domestic fixed-income securities face a 6 per cent up-front tax Brazilian borrowers can convert the proceeds of foreign bond issues without significant restrictions. The best way to discourage such foreign borrowing is by letting the currency appreciate. But any further Real appreciation is ruled out on political grounds.
The current mix of economic policies is therefore conspiring to erode confidence in the effectiveness of central bank policies. This is clearly a major negative for the outlook for equities.
Unsurprisingly, the MSCI Index was down last month though it did manage to outperform India, the worst-performing BRIC market. Energy, materials and telecommunication services led the markets (see Chart 4 below). We have a negative outlook for the broader market over the next two-three months.
Chart 4: MSCI Brazil Index, performance by sector, December 2010 to date
Focus on inflation winners
The sectors best positioned to outperform in the context of the current monetary tightening cycle include:
•Utilities whose tariffs are inflation-linked
•Consumer staples
•Metals and mining
•Energy (due to higher oil prices)
•Agricultural exporters.
Russia
Russia's economy surprised in Q4/10 by bringing full-year GDP growth to 4 per cent, higher than market expectations. Prospects for 2011 are for a continuation of steady, albeit unspectacular, expansion in the same range.
The overall picture for the year ahead can best be described as muddling through. On the positive side of the ledger, oil prices much higher than the US$75/bbl incorporated into the budget will lessen pressures from monetary financing of the deficit. This increases prospects that the monetary tightening that is bound to come before long will be successful in capping surging inflation, currently 9.6 per cent (for details see our overview of the outlook below in 'Macro and sector spotlight').
On the negative side should be counted the lack of any real effort on the part of the government to push needed structural reforms. Piecemeal progress on the programme of partial privatizations announced last autumn will likely move ahead slowly. But more far-reaching initiatives look unlikely. Deputy Prime Minister Alexei Kudrin recently highlighted what he called 'a difficult, complicated period' for the Russian economy, which has to modernize without the dividend from the oil sector that was available in previous years. Given current spending projections, any surplus for the budget from oil will not kick in until oil prices exceed US$110/bbl.
Investors have so far taken a more positive view of prospects for local markets than has the Finance Minister. Last month materials and energy led market outperformance, followed by finance and utilities (Chart 5). We remain positive on near-term prospects for Russian equities despite expectations that the CBR will begin raising interest rates in order to bring inflation down closer to its 7 per cent target. Commodity-related stocks will likely outperform in the near term, but we expect the most consistent performance from the banks over the course of 2011.
Chart 5: MSCI Russia Index, performance by sector, December 2010 to date
Commodity-related plays and state-controlled banks offer the best prospects
Russia's heavy industry sectors, especially steel, will be major beneficiaries of continued strength in hard commodity prices. The major state-controlled banks will likely attract foreign interest due to prospects for partial privatization of VTB and further sales of Sberbank shares.
India
The outlook for the Indian economy has turned from bad to worse. After a lacklustre response to major corruption scandals, Prime Minister Manmohan Singh's government appears to be running on autopilot, oblivious to worsening inflation and potential external shocks posed by rising oil and food prices.
Recent weekly figures put food inflation in the 15-20 per cent range with few signs of any easing in sight. Although last week's 130 per cent jump in onion prices will undoubtedly be reversed before long, prices of key food staples such as eggs and meat have been rising steadily at a 15 per cent clip over the past two months.
So far monetary policy has been the government's primary tool in fighting inflation. As highlighted below in our "Macro and sector spotlight", fiscal policy appears biased towards spending on food subsidies, healthcare and education. Meanwhile the Reserve Bank's timid response of a 25 bps hike in its intervention rates late last month suggests that monetary policy is seriously behind the curve.
The uncertainty created by high inflation and ineffective policy responses will continue to weigh on equity market prospects over the near and medium terms. And with a number of major companies failing to meet earning expectations capital will continue to exit the Indian market.
Last month the equity market lost over 10 per cent with finance and consumer discretionary stocks leading the decline. We have a negative outlook for Indian equities over the next three months.
Chart 6: MSCI India Index, performance by sector, December 2010 to date
China
Economic growth was surprisingly robust at 9.8 per cent in Q4/10. Like most analysts, we were expecting 8-9 per cent after the extremely strong results recorded earlier in 2010. As we explain below, we have raised our growth forecasts for 2011.
A recent visit to China convinced us that the economy will continue to be strong in the period up to the government transition in October 2012 and we have revised our 2011 GDP growth forecasts to 9-10 per cent as a result. Although the new leaders have already been anointed, they still need to be formally elected at next year's Communist Party conference and for this reason they need to keep all the regional Party cadres happy and well supplied with financing for their pet projects.
We came away from China with the impression that policymakers were relatively relaxed about current trends in inflation. Although inflation has moved up to a higher trend line of 4-6 per cent this level is viewed by policymakers as "normal" for an economy growing at nearly 10 per cent per annum. This view reflects a judgment that productivity differences between manufacturing and agriculture would inevitably result in rising food prices relative to manufactures. The bottom line for policymakers is that they should live with higher food inflation while administrative controls should be deployed to prevent price spikes from developing. Fuller details of our perspectives on Chinese inflation can be found in our latest TS View.
We have a positive view on prospects for Chinese equities this year, but we think there is still downside risk in the near term. Our sense is that most non-resident investors want to gain confidence that policymakers have a coherent plan to tackle inflation before stepping up allocations. This will be impossible in the near term, both because policy has become more opaque and because inflation will trend higher over the next two-three months. Monetary authorities will implement targeted administrative controls on individual banks rather than relying as in the past on an overall cap on bank loans. It will be difficult therefore for investors to become convinced that anti-inflation efforts are working until inflation begins trending down. We think this will happen towards midyear.
Investors should consider increasing allocations to Chinese stocks when inflation peaks, probably towards the end of Q2/11. In the meantime we favour industrial stocks such as steel and cement, given attractive valuations and prospects for positive earnings surprises. We view consumer and healthcare stocks as overvalued currently.
Chart 7: MSCI China Index, performance by sector, December 2010 to date
Play the China story via commodities
The combination of strong growth driven by continued investment in urban infrastructure and property is bullish
for hard commodities.
•Property and urban infrastructure investments will sustain demand for steel, cement and other hard commodities. These stocks have been out of favour in recent months and we expect them to outperform the overall market in the next two-three months.
We believe Chinese imports of feed grains, sugar and edible oils will continue to be strong during 2011.
•In order to meet rapid increases in domestic food demand we expect the government to let domestic traders increase food imports both to rebuild domestic stocks and to meet current demand.
Macro and sector spotlight
Below we highlight recent Trusted Sources research that identifies key macro and sectoral themes in BRIC markets. Our macro focus this month is on India and Russia. India will announce a new budget later this month, but we conclude that investors' expectations of either fiscal consolidation or a rollback of fiscal stimulus to tamp down inflationary pressures will not be met. Instead, inflation makes the likelihood of fiscal reform even more remote. In contrast, we expect to see a more proactive approach to inflation in Russia, with the CBR likely to overcome political obstacles in its campaign to further tighten monetary policy.
Our sectoral offering this month focuses on Brazil's port sector. Modernizing and building out port infrastructure is critical to the country's position as a leading exporter of agricultural commodities. Transport and logistics bottlenecks in Brazil will have an impact on prices of soft commodities and risk further spurring food inflation as demand from China and other emerging markets continues to outpace supply.
India: Slippery slope for fiscal consolidation
The government's justification for pursuing countercyclical fiscal expansionary policies cannot continue to be a pretext for liberal spending. Its feat of achieving, or even undershooting, its fiscal deficit target for FY11 is not a sustainable trend as the build-up of macro headwinds, particularly with regard to inflation, is making the already difficult political environment for subsidy and tax reform even tougher.
•Slow progress on expenditure and revenue reform is unlikely to gather pace in the near term, given resistance to tolerating any further inflationary pressures and the lack of political consensus.
•Tighter monetary policy to counter inflation and expansionary fiscal policy risk slowing the economy and, consequently, government revenue growth.
•Non-tax revenue sources such as minority stake sales in state-run companies including Indian Oil (IOCL:IN) and Hindustan Copper (HCP:IN) will not match the FY11 bonanza.
•Medium-term government policy appears biased towards higher expenditure on food subsidies, healthcare and education programmes. This will further increase the deficit and keep inflationary pressures high in the absence of an adequate supply-side response.
Russia's monetary crunch: Best of three
The monthly interest rate-setting meeting of the CBR Board on 31 January was an important test of the seriousness of Russia's post-crisis monetary policy, which has powerful implications for Russian asset valuations and investment strategies. The decision reached at that meeting - to leave interest rates on hold while hiking banks' compulsory reserve requirements - seems both strange and, in itself, negative. Final judgment, however, must be reserved for at least a couple of months. By the end of February or at the very latest the end of March, it will have become clear whether the CBR is capable of negotiating a politically viable path to a policy framework in which more than mere lip service is given to the fight against inflation.
•Russia's monetary policy crunch took one step forward with the December hike in deposit rates and then took a step back in January. The key test now is whether the CBR is able to hike rates by the end of Q1/11.
•The fact that January's hike in reserve requirements came into force with immediate effect, a departure from the previous practice of giving banks at least one month's notice, suggests that the CBR planned to raise rates across the board but ran into political resistance.
•CBR officials are ducking and weaving to find a way to pursue their stated inflation target and they aim to take advantage of growing evidence of rising core ("monetary") inflation to increase interest rates properly. If this happens, then the January decision will appear in a new, more positive and coherent light.
•We believe the CBR will make progress towards carrying out the mandate which it appears to have defined for itself: namely, pursuing (like the US Fed) the dual goals of price stability and growth while (unlike the Fed) setting an explicit inflation target (7 per cent for 2011).
Why Brazilian ports will stay on the slow boat
Brazil's notoriously backward port infrastructure has been justly criticized for its red tape, steep costs, constant delays and inaccessibility. Unfortunately, the Dilma administration's recent appointment of Leonidas Cristino to head the Ports Secretariat (SEP) seems unlikely to herald a new era of significant advances for the sector.Although Cristino has technical expertise as a civil road engineer, many in the port sector worry that the former mayor of a portless city located in northeast Ceara state - with no prior experience of port logistics - is unlikely to hit the ground running or be truly effective.
•Brazil requires US$30 billion in investments in port infrastructure (and a further US$20 billion in road and rail port access infrastructure) over the next 20 years to meet anticipated demand. Brazil in H1/10 had roughly R$15 billion (US$8.9 billion) in planned port investments up to 2013.
•Regulatory uncertainty - the top obstacle to more private investment in Brazilian port terminals - is likely to persist for the time being. This uncertainty is the result of an October 2008 decree issued by the SEP that changed the rules for third-party cargo in the country's private terminals, and consequently the profit potential of these investments.
•Port associations plan to heavily lobby the new administration to withdraw the 2008 decree, though this will likely be an uphill battle in view of Dilma's role as a prime architect of the Lula government's infrastructure programme.
•Irrespective of progress on the regulatory front, we expect the Dilma administration to make slow but steady progress with reducing red tape, streamlining intermodal transport and pushing ahead with oft-delayed but groundbreaking Lula administration initiatives. These include a R$1.6 billion (US$952 million) dredging programme for Brazil's principal public ports that is expected to help increase the dynamic operational capacity of these ports by up to 30 per cent.
•In the nearer term, new projected terminals at Santos (BTP, Embraport), noteworthy management changes at the country's second-largest port of Paranagua, and the purchase announced on 14 January by private equity firm Advent International of a 50 per cent stake in the country's thirdlargest container terminal, TCP, at Paranagua for an estimated US$500 million should all help port expansion plans, though most likely only by 2012-13.
•As overcrowded ports stay the norm this year, the country's exporters and importers will likely call increasingly on related logistics companies such as Log-In (LOGN3:BZ), Wilson Sons (WSON11:BZ) or Tegma (TGMA3:BZ) to help smooth the way.
Global themes for portfolio allocation
•Inflation will lead to equity market underperformance in the BRICs other than Russia
•Rapid growth in food demand in China and India is driving global food price inflation
•Local fixed-income securities and BRIC currencies other than the ruble are unattractive at this time
BRIC themes and investment ideas
•Brazil - Uncertainty about how far the Banco Central's tightening cycle has to go in order to corral inflation will keep the equity market in the doldrums. Near-term underweight
•Russia - The combination of high global commodity prices and attractive valuations will continue to favour Russian equities. Overweight.
•India - The economic outlook has worsened because the government has been slow to respond to rising inflation and deterioration in fiscal performance. The Indian market will continue to lag. Stay on the sidelines for now
•China - Investors will likely stay away from the market until inflation peaks. Play the China story through commodities and look to increase equity allocations towards the end of Q2/11
Macro and sector spotlight
•India: Slippery slope for fiscal consolidation
•Russia's monetary crunch
•Why Brazilian ports will stay on the slow boat
Portfolio Strategy
Overview
Our top global theme last month has played out as we anticipated. As Charts 1 and 2 illustrate, BRIC equity markets other than Russia have lagged developed markets as well as East European emerging markets. The reason is inflation and uncertainty over how policymakers will deal with it.
Chart 1: MSCI Indices, December 2010 to date (US$ terms, three-day moving average)
In Brazil politics favours aggressive monetary tightening but markets are worried that current inflationary pressures need fiscal solutions. The recipe of more fiscal and less monetary tightening is a difficult one for Brazil's new President Dilma Rousseff to embrace because of her coalition of 12 mostly left-of-centre parties. Lacking clarity on the fiscal outlook, investors cannot judge how far the Banco Central will have to push up rates to control inflation.
Chart 2: Stock market performance, December 2010 to date (US$ terms, three day moving average)
In India policymakers appear unwilling to consider anything other than a very timid monetary tightening. Although Prime Minister Singh's Congress Party has a strong position in parliament there is little evidence of a willingness to push fiscal retrenchment. Instead, policy is biased towards higher spending on food subsidies, healthcare and education (for more details see the "Macro and sector spotlight" below).
Chinese policy also reflects the dominant influence of politics, in this case the scheduled transition to a new top leadership in October 2012. The government's Central Economic Work Conference in December failed to announce an expected tightening in monetary policy. Sources we consulted in Beijing told us this was because consensus could not be reached: finance officials pushed for tightening but were opposed by industry and provincial interest groups that argued against such cutbacks.
Russia's prospects are the exception among the BRICs. Although inflation is a problem Russia is a primary beneficiary of rising global commodity prices, especially oil. High oil prices reduce the country's fiscal deficit and its associated monetary financing. The prospect of a lower deficit combined with monetary tightening from the Central Bank of Russia (CBR) gives us reasonable confidence that today's 9.6 per cent inflation rate will be heading down later this year. Combine this with still attractive valuations and Russia stands out as an overweight allocation among the BRICs.
Among the three remaining BRICs we would single out China as the country most likely to convince markets that inflation is being contained. As we spellout in more detail below, we think China's inflation rate will peak at around 6 per cent in Q2/11 and then trend downward. It is still too early to call such a turnaround in either Brazil or India.
Looking ahead into 2011, we draw the following conclusions:
•Russian equities will likely extend their recent outperformance.
•Brazilian equities will likely underperform until the extent of the current monetary tightening cycle becomes clearer. We expect a minimum of 200 bps of tightening over the current cycle but we fear that Brazil's inflation rate could become stuck at an uncomfortably high level for structural reasons. Therefore we are less confident in calling a turning point in the inflation cycle at this time.
•China's inflation is moving onto a higher 4-6 per cent trend line but we think policy will contain inflation below the 6 per cent upper limit. Once markets perceive that inflation is peaking we anticipate a market rebound.
•We expect India's response to inflation to lag behind the curve, resulting in equity market underperformance for the foreseeable future.
Global themes for portfolio allocation
Inflation will lead to equity market underperformance in all BRICs other than Russia
Our leading global theme is unchanged from last month. Uncertainty about inflation and what policymakers will do about it will continue to dampen investors' enthusiasm for equities in Brazil, India and China. Although Russia has its own inflation problems high global oil prices and relatively attractive equity valuations set it apart, at least for now.
Two factors could elevate the BICs to outperformers:
1.Policymakers achieve success in controlling inflation, i.e. the monthly inflation results begin moving down.
2.Monetary authorities in developed countries announce strategies for exiting their current unprecedented monetary and fiscal stimulus programmes.
The main risk to Russia's outperformance is declining oil prices.
Our sense is that none of these possibilities is likely to emerge in the next two-three months. The earliest we are likely to see inflation turn down is towards the end of Q2/11 in China. Nor do we expect to see oil prices moving lower in the same time frame. Thus Russia will likely continue to outperform.
For the time being we recommend that investors play the emerging market theme through developed equities:
•Major US and EU multinationals with significant EM sales revenue will benefit from strong demand while being less affected by rising costs than purely local companies. Although these stocks have already had a good run we think there is still upside left on a two- or three-month view.
For pure BRIC plays, we recommend that investors stay away from crowded consumer trades since any inflation surprise will trigger an exit on the part of less dedicated investors. Instead we recommend that investors look at less popular large-cap industrials such as steel, cement and other infrastructure related firms. We would look first in China, then in Brazil.
Rapid growth in food demand in China and India is driving global food price inflation
In a recent TS View we argued that sustained food inflation in China will gradually move the country into the ranks of a major global importer of foods, especially feed grain, sugar and edible oils. The constraints on raising the efficiency of domestic food production are many:
•The lack of reform of land and labour markets will delay the consolidation of agricultural production units necessary to boost productivity.
•A steady decline in arable land and severe water management problems will thwart efforts to boost productivity.
•Priority in official policy to assuring domestic supply via subsidies in the face of a growing domestic food deficit will result in costs mounting through the supply chain.
India's domestic food economy shares many characteristics with China's, in particular supply bottlenecks, dependence on subsidies and growing shortages of water.
If we look at the demand side of the food equation we find the fastest growth in higherprotein foods such as meat, fish and dairy. Faced with limits on domestic food production, both China and India will turn to global markets to meet their food requirements. Both countries have the resources to buy what they need and there should be little doubt that they will do so.
Local fixed-income securities and currencies other than the ruble are unattractive at this time
The current economic environment in the BRICs is dominated by uncertainty about the prospects of policies to control inflation. This uncertainty weighs on prospects for equity markets, as has already been noted. Investors in local rates markets must judge whether local interest rate curves accurately reflect the future trend in interest rates.
We do not find the risk/reward equation attractive in any of the BRICs at this time for two primary reasons:
1.The risks are that global commodity prices for both hard and soft commodities will surprise on the upside due to political instability in Arab nations such as Egypt, shocks from adverse weather conditions and efforts by importing countries to bolster reserves in reaction to rising uncertainty about the security of supply.
2.We believe inflationary pressures in all the BRICs are poorly understood. Traditional policies of monetary tightening will prove to be less effective in attacking inflation than markets assume. This is because supply side bottlenecks are relatively more important.
Chart 3: Currency performance, January 2010 to date (US$, three-day moving average)
BRIC themes – Investment ideas
Brazil
President Dilma Rousseff has had a rocky first few weeks in office. Her initial message to the markets in early January was well received. To be sure, it was carefully crafted to reassure participants, but events quickly conspired to undermine confidence. Evidence of extremely tight labour markets - the country's 5.3 per cent unemployment rate for December is the lowest ever - has highlighted risks of cost-push wage pressures. Thus despite a promising debut the new economic team has failed so far to deliver a convincing second act detailing its policy for tackling inflation.
A resumption of monetary tightening by the Banco Central (BC) on 19 January has failed to restore confidence for the simple reason that nobody knows how high rates must go to dampen inflationary pressures. The fear is that rates will have to move substantially higher. Markets lack confidence that higher interest rates alone will solve what are, after all, supply-side bottlenecks. Meanwhile, markets are still waiting for details of fiscal cutbacks promised by the new economic team.
The BC's policy dilemma is that higher interest rates fuel new capital inflows that put upward pressure on the Real and undermine the competitiveness of domestic manufacturers. The BC has responded with large-scale interventions in spot and future currency markets with little effect: the Real has barely moved from a tight R$1.66-1.68/US$ range since a more active intervention policy was implemented in early January.
Part of the reason for the limited impact of the BC's interventions is that Brazilian corporations have been borrowing abroad as if there were no tomorrow. Although nonresident investors in domestic fixed-income securities face a 6 per cent up-front tax Brazilian borrowers can convert the proceeds of foreign bond issues without significant restrictions. The best way to discourage such foreign borrowing is by letting the currency appreciate. But any further Real appreciation is ruled out on political grounds.
The current mix of economic policies is therefore conspiring to erode confidence in the effectiveness of central bank policies. This is clearly a major negative for the outlook for equities.
Unsurprisingly, the MSCI Index was down last month though it did manage to outperform India, the worst-performing BRIC market. Energy, materials and telecommunication services led the markets (see Chart 4 below). We have a negative outlook for the broader market over the next two-three months.
Chart 4: MSCI Brazil Index, performance by sector, December 2010 to date
Focus on inflation winners
The sectors best positioned to outperform in the context of the current monetary tightening cycle include:
•Utilities whose tariffs are inflation-linked
•Consumer staples
•Metals and mining
•Energy (due to higher oil prices)
•Agricultural exporters.
Russia
Russia's economy surprised in Q4/10 by bringing full-year GDP growth to 4 per cent, higher than market expectations. Prospects for 2011 are for a continuation of steady, albeit unspectacular, expansion in the same range.
The overall picture for the year ahead can best be described as muddling through. On the positive side of the ledger, oil prices much higher than the US$75/bbl incorporated into the budget will lessen pressures from monetary financing of the deficit. This increases prospects that the monetary tightening that is bound to come before long will be successful in capping surging inflation, currently 9.6 per cent (for details see our overview of the outlook below in 'Macro and sector spotlight').
On the negative side should be counted the lack of any real effort on the part of the government to push needed structural reforms. Piecemeal progress on the programme of partial privatizations announced last autumn will likely move ahead slowly. But more far-reaching initiatives look unlikely. Deputy Prime Minister Alexei Kudrin recently highlighted what he called 'a difficult, complicated period' for the Russian economy, which has to modernize without the dividend from the oil sector that was available in previous years. Given current spending projections, any surplus for the budget from oil will not kick in until oil prices exceed US$110/bbl.
Investors have so far taken a more positive view of prospects for local markets than has the Finance Minister. Last month materials and energy led market outperformance, followed by finance and utilities (Chart 5). We remain positive on near-term prospects for Russian equities despite expectations that the CBR will begin raising interest rates in order to bring inflation down closer to its 7 per cent target. Commodity-related stocks will likely outperform in the near term, but we expect the most consistent performance from the banks over the course of 2011.
Chart 5: MSCI Russia Index, performance by sector, December 2010 to date
Commodity-related plays and state-controlled banks offer the best prospects
Russia's heavy industry sectors, especially steel, will be major beneficiaries of continued strength in hard commodity prices. The major state-controlled banks will likely attract foreign interest due to prospects for partial privatization of VTB and further sales of Sberbank shares.
India
The outlook for the Indian economy has turned from bad to worse. After a lacklustre response to major corruption scandals, Prime Minister Manmohan Singh's government appears to be running on autopilot, oblivious to worsening inflation and potential external shocks posed by rising oil and food prices.
Recent weekly figures put food inflation in the 15-20 per cent range with few signs of any easing in sight. Although last week's 130 per cent jump in onion prices will undoubtedly be reversed before long, prices of key food staples such as eggs and meat have been rising steadily at a 15 per cent clip over the past two months.
So far monetary policy has been the government's primary tool in fighting inflation. As highlighted below in our "Macro and sector spotlight", fiscal policy appears biased towards spending on food subsidies, healthcare and education. Meanwhile the Reserve Bank's timid response of a 25 bps hike in its intervention rates late last month suggests that monetary policy is seriously behind the curve.
The uncertainty created by high inflation and ineffective policy responses will continue to weigh on equity market prospects over the near and medium terms. And with a number of major companies failing to meet earning expectations capital will continue to exit the Indian market.
Last month the equity market lost over 10 per cent with finance and consumer discretionary stocks leading the decline. We have a negative outlook for Indian equities over the next three months.
Chart 6: MSCI India Index, performance by sector, December 2010 to date
China
Economic growth was surprisingly robust at 9.8 per cent in Q4/10. Like most analysts, we were expecting 8-9 per cent after the extremely strong results recorded earlier in 2010. As we explain below, we have raised our growth forecasts for 2011.
A recent visit to China convinced us that the economy will continue to be strong in the period up to the government transition in October 2012 and we have revised our 2011 GDP growth forecasts to 9-10 per cent as a result. Although the new leaders have already been anointed, they still need to be formally elected at next year's Communist Party conference and for this reason they need to keep all the regional Party cadres happy and well supplied with financing for their pet projects.
We came away from China with the impression that policymakers were relatively relaxed about current trends in inflation. Although inflation has moved up to a higher trend line of 4-6 per cent this level is viewed by policymakers as "normal" for an economy growing at nearly 10 per cent per annum. This view reflects a judgment that productivity differences between manufacturing and agriculture would inevitably result in rising food prices relative to manufactures. The bottom line for policymakers is that they should live with higher food inflation while administrative controls should be deployed to prevent price spikes from developing. Fuller details of our perspectives on Chinese inflation can be found in our latest TS View.
We have a positive view on prospects for Chinese equities this year, but we think there is still downside risk in the near term. Our sense is that most non-resident investors want to gain confidence that policymakers have a coherent plan to tackle inflation before stepping up allocations. This will be impossible in the near term, both because policy has become more opaque and because inflation will trend higher over the next two-three months. Monetary authorities will implement targeted administrative controls on individual banks rather than relying as in the past on an overall cap on bank loans. It will be difficult therefore for investors to become convinced that anti-inflation efforts are working until inflation begins trending down. We think this will happen towards midyear.
Investors should consider increasing allocations to Chinese stocks when inflation peaks, probably towards the end of Q2/11. In the meantime we favour industrial stocks such as steel and cement, given attractive valuations and prospects for positive earnings surprises. We view consumer and healthcare stocks as overvalued currently.
Chart 7: MSCI China Index, performance by sector, December 2010 to date
Play the China story via commodities
The combination of strong growth driven by continued investment in urban infrastructure and property is bullish
for hard commodities.
•Property and urban infrastructure investments will sustain demand for steel, cement and other hard commodities. These stocks have been out of favour in recent months and we expect them to outperform the overall market in the next two-three months.
We believe Chinese imports of feed grains, sugar and edible oils will continue to be strong during 2011.
•In order to meet rapid increases in domestic food demand we expect the government to let domestic traders increase food imports both to rebuild domestic stocks and to meet current demand.
Macro and sector spotlight
Below we highlight recent Trusted Sources research that identifies key macro and sectoral themes in BRIC markets. Our macro focus this month is on India and Russia. India will announce a new budget later this month, but we conclude that investors' expectations of either fiscal consolidation or a rollback of fiscal stimulus to tamp down inflationary pressures will not be met. Instead, inflation makes the likelihood of fiscal reform even more remote. In contrast, we expect to see a more proactive approach to inflation in Russia, with the CBR likely to overcome political obstacles in its campaign to further tighten monetary policy.
Our sectoral offering this month focuses on Brazil's port sector. Modernizing and building out port infrastructure is critical to the country's position as a leading exporter of agricultural commodities. Transport and logistics bottlenecks in Brazil will have an impact on prices of soft commodities and risk further spurring food inflation as demand from China and other emerging markets continues to outpace supply.
India: Slippery slope for fiscal consolidation
The government's justification for pursuing countercyclical fiscal expansionary policies cannot continue to be a pretext for liberal spending. Its feat of achieving, or even undershooting, its fiscal deficit target for FY11 is not a sustainable trend as the build-up of macro headwinds, particularly with regard to inflation, is making the already difficult political environment for subsidy and tax reform even tougher.
•Slow progress on expenditure and revenue reform is unlikely to gather pace in the near term, given resistance to tolerating any further inflationary pressures and the lack of political consensus.
•Tighter monetary policy to counter inflation and expansionary fiscal policy risk slowing the economy and, consequently, government revenue growth.
•Non-tax revenue sources such as minority stake sales in state-run companies including Indian Oil (IOCL:IN) and Hindustan Copper (HCP:IN) will not match the FY11 bonanza.
•Medium-term government policy appears biased towards higher expenditure on food subsidies, healthcare and education programmes. This will further increase the deficit and keep inflationary pressures high in the absence of an adequate supply-side response.
Russia's monetary crunch: Best of three
The monthly interest rate-setting meeting of the CBR Board on 31 January was an important test of the seriousness of Russia's post-crisis monetary policy, which has powerful implications for Russian asset valuations and investment strategies. The decision reached at that meeting - to leave interest rates on hold while hiking banks' compulsory reserve requirements - seems both strange and, in itself, negative. Final judgment, however, must be reserved for at least a couple of months. By the end of February or at the very latest the end of March, it will have become clear whether the CBR is capable of negotiating a politically viable path to a policy framework in which more than mere lip service is given to the fight against inflation.
•Russia's monetary policy crunch took one step forward with the December hike in deposit rates and then took a step back in January. The key test now is whether the CBR is able to hike rates by the end of Q1/11.
•The fact that January's hike in reserve requirements came into force with immediate effect, a departure from the previous practice of giving banks at least one month's notice, suggests that the CBR planned to raise rates across the board but ran into political resistance.
•CBR officials are ducking and weaving to find a way to pursue their stated inflation target and they aim to take advantage of growing evidence of rising core ("monetary") inflation to increase interest rates properly. If this happens, then the January decision will appear in a new, more positive and coherent light.
•We believe the CBR will make progress towards carrying out the mandate which it appears to have defined for itself: namely, pursuing (like the US Fed) the dual goals of price stability and growth while (unlike the Fed) setting an explicit inflation target (7 per cent for 2011).
Why Brazilian ports will stay on the slow boat
Brazil's notoriously backward port infrastructure has been justly criticized for its red tape, steep costs, constant delays and inaccessibility. Unfortunately, the Dilma administration's recent appointment of Leonidas Cristino to head the Ports Secretariat (SEP) seems unlikely to herald a new era of significant advances for the sector.Although Cristino has technical expertise as a civil road engineer, many in the port sector worry that the former mayor of a portless city located in northeast Ceara state - with no prior experience of port logistics - is unlikely to hit the ground running or be truly effective.
•Brazil requires US$30 billion in investments in port infrastructure (and a further US$20 billion in road and rail port access infrastructure) over the next 20 years to meet anticipated demand. Brazil in H1/10 had roughly R$15 billion (US$8.9 billion) in planned port investments up to 2013.
•Regulatory uncertainty - the top obstacle to more private investment in Brazilian port terminals - is likely to persist for the time being. This uncertainty is the result of an October 2008 decree issued by the SEP that changed the rules for third-party cargo in the country's private terminals, and consequently the profit potential of these investments.
•Port associations plan to heavily lobby the new administration to withdraw the 2008 decree, though this will likely be an uphill battle in view of Dilma's role as a prime architect of the Lula government's infrastructure programme.
•Irrespective of progress on the regulatory front, we expect the Dilma administration to make slow but steady progress with reducing red tape, streamlining intermodal transport and pushing ahead with oft-delayed but groundbreaking Lula administration initiatives. These include a R$1.6 billion (US$952 million) dredging programme for Brazil's principal public ports that is expected to help increase the dynamic operational capacity of these ports by up to 30 per cent.
•In the nearer term, new projected terminals at Santos (BTP, Embraport), noteworthy management changes at the country's second-largest port of Paranagua, and the purchase announced on 14 January by private equity firm Advent International of a 50 per cent stake in the country's thirdlargest container terminal, TCP, at Paranagua for an estimated US$500 million should all help port expansion plans, though most likely only by 2012-13.
•As overcrowded ports stay the norm this year, the country's exporters and importers will likely call increasingly on related logistics companies such as Log-In (LOGN3:BZ), Wilson Sons (WSON11:BZ) or Tegma (TGMA3:BZ) to help smooth the way.
Wednesday 9 February 2011
Gathering My Thoughts Again...
I think we have entered another stage and will need some adjustments to our investment portfolios. I will contact you personally... Meanwhile, stay tuned...
Tuesday 8 February 2011
Funds Outflow From ASEAN Markets Slows, But Flows from Emerging Markets Back into Developed Markets Intensify
Business Times - 08 Feb 2011Funds outflow from Asean markets slows
But flows from emerging markets back into developed markets intensify
By TEH SHI NING
ASEAN markets saw a moderation in fund outflows last week, even as the reversal of fund flows back into developed markets from emerging ones intensified on shifting risk perceptions.
Foreign institutional investors withdrew a total of US$68 million from the Indonesian, Thai and Philippine stock markets, a Morgan Stanley Research report yesterday said. This was a moderation from total outflows of US$269 million the previous week.
In fact, Thailand saw a net inflow of US$18 million last week, after leading with US$308 million in fund outflows the week before. Volatility persisted though, with the Philippines and Indonesia posting fund withdrawals of US$65 million and US$21 million respectively last week, after marginal inflows the week before.
This means a cumulative US$1.7 billion in outflows from the three markets so far this year, compared with US$4.3 billion in inflows in 2010.
In the wider emerging market space, outflows swelled last week, as unrest in Egypt and Tunisia tried investors' nerves and concerns over inflation in emerging economies mounted, reversing the US$95 billion in fund inflows in 2010.
Fund-tracker EPFR Global said that investors pulled more than US$7 billion out of mutual funds and ETFs focused on emerging markets stocks last week, more than double the US$3 billion outflow in the previous week.
This was the third largest weekly outflow on record and of the emerging market funds, Asia-ex-Japan ones were hardest hit, a Citi equity strategy report last week said.
Funds flow weakness was widespread among Asia's individual country funds too. Outflows from China funds doubled from the previous week to US$455 million, overshadowing Hong Kong's net inflows. The only ones to see inflows last week were Japan and Korea funds, but even these were at sharply slowed rates, the Citi report added.
And the strong outflows from emerging markets continue to head developed markets' way. Global international funds recorded subscriptions in all the first five weeks of 2011, with cumulative inflows of US$9 billion thus far.
Further demonstrating the shift in investor sentiment, a Citi quantitative strategy report last week noted that while global equities have rallied, the Asia-Pacific regional index fell 0.74 per cent, 'underscoring the relative positive sentiment toward developed markets'. This compares with the benchmark MSCI AC World rising 1.6 per cent in January, while the European Monetary Union countries index rose 6.88 per cent and the US 2.39 per cent.
Meanwhile, yesterday's Morgan Stanley report also said that consensus earnings forecast for MSCI Asean was revised 14 basis points lower this week. Thailand and the Philippines were the main drivers of the downward revision, while Indonesia and Malaysia saw flat earnings.
Overall, MSCI Asean earnings are now forecast to grow 14 per cent this year, driven by 22.5 per cent growth from Indonesia. Singapore is now expected to see earnings growth of 11.6 per cent.
Copyright © 2010 Singapore Press Holdings Ltd. All rights reserved.
But flows from emerging markets back into developed markets intensify
By TEH SHI NING
ASEAN markets saw a moderation in fund outflows last week, even as the reversal of fund flows back into developed markets from emerging ones intensified on shifting risk perceptions.
Foreign institutional investors withdrew a total of US$68 million from the Indonesian, Thai and Philippine stock markets, a Morgan Stanley Research report yesterday said. This was a moderation from total outflows of US$269 million the previous week.
In fact, Thailand saw a net inflow of US$18 million last week, after leading with US$308 million in fund outflows the week before. Volatility persisted though, with the Philippines and Indonesia posting fund withdrawals of US$65 million and US$21 million respectively last week, after marginal inflows the week before.
This means a cumulative US$1.7 billion in outflows from the three markets so far this year, compared with US$4.3 billion in inflows in 2010.
In the wider emerging market space, outflows swelled last week, as unrest in Egypt and Tunisia tried investors' nerves and concerns over inflation in emerging economies mounted, reversing the US$95 billion in fund inflows in 2010.
Fund-tracker EPFR Global said that investors pulled more than US$7 billion out of mutual funds and ETFs focused on emerging markets stocks last week, more than double the US$3 billion outflow in the previous week.
This was the third largest weekly outflow on record and of the emerging market funds, Asia-ex-Japan ones were hardest hit, a Citi equity strategy report last week said.
Funds flow weakness was widespread among Asia's individual country funds too. Outflows from China funds doubled from the previous week to US$455 million, overshadowing Hong Kong's net inflows. The only ones to see inflows last week were Japan and Korea funds, but even these were at sharply slowed rates, the Citi report added.
And the strong outflows from emerging markets continue to head developed markets' way. Global international funds recorded subscriptions in all the first five weeks of 2011, with cumulative inflows of US$9 billion thus far.
Further demonstrating the shift in investor sentiment, a Citi quantitative strategy report last week noted that while global equities have rallied, the Asia-Pacific regional index fell 0.74 per cent, 'underscoring the relative positive sentiment toward developed markets'. This compares with the benchmark MSCI AC World rising 1.6 per cent in January, while the European Monetary Union countries index rose 6.88 per cent and the US 2.39 per cent.
Meanwhile, yesterday's Morgan Stanley report also said that consensus earnings forecast for MSCI Asean was revised 14 basis points lower this week. Thailand and the Philippines were the main drivers of the downward revision, while Indonesia and Malaysia saw flat earnings.
Overall, MSCI Asean earnings are now forecast to grow 14 per cent this year, driven by 22.5 per cent growth from Indonesia. Singapore is now expected to see earnings growth of 11.6 per cent.
Copyright © 2010 Singapore Press Holdings Ltd. All rights reserved.
Monday 7 February 2011
IQ & Global Inequality
What struck me is I have finally found evidence that northern climates are correlated to intelligence, better education, greater wealth. For every degree north, temperature falls by 0.885 degree celsius. National IQ rises by 0.677, quality of life as measured by QHC increases by 0.659, GNI per capita up 0.528, adult literacy rate up 0.482, tertiary enrollment ratio up 0.718, life expectancy at birth up 0.505.
http://en.wikipedia.org/wiki/IQ_and_Global_Inequality
http://en.wikipedia.org/wiki/IQ_and_Global_Inequality
Saturday 5 February 2011
We Need More Innovative Thinkers to Succeed
I've lived in Singapore for most of my life. I've lived in non-Asian countries for almost 5 years. What I miss most while in Singapore is mainly the weather. I love the 4 seasons, the cold wind that starts to blow against your face in September, culminating into a full blown winter in Janary. The snow that blankets the streets makes you want to walk out at times to feel the numbing sensation, and then hide into one of the corner cafes to bask in the warmth. In Spring, Summer and Autumn, one can sit outside the Cafe with a book in hand and wine glass in the other. I could finish several books in one day and feel very fulfilled. The beauty of Elfrescos is that you can watch people along the Boulevard, and people in turn watch you. It's a two-way thing that becomes a game. The air is much dryer in temperate climates as humidity is around 30 - 50%, unlike Singapore's 80 - 90%, which is causes profuse perspiration. If I feel cold, I can always put on a jacket and still stay outside. But in Singapore, I can't take off my T-shirt and be bare breasted. I have to go into the cafe which is hopefully air-conditioned enough to be comfortable.
But another perhaps more important thing lacking in Singapore is the creative, innovative thinking that leads to invention, innovation and success.While we more than match our ex colonial masters in terms of exams (our O and A Levels consistently beat the Brits), we fail to produce the same brilliance when we leave school. Perhaps it is our school system, forcing us to regurgitate knowledge, passing exams without really understanding what we study. In my CFA class, some of them are good at memorising formula. But when it comes to applying the knowledge on investments, they are not as sharp. There are of course brilliant ones in my class who can apply the knowledge. Perhaps it is the lack of passion in a subject we are studying. The need to pass exams to please our parents. Perhaps it is the need to conform, the fear of standing out apart from our peers. While the pressure to conform is not as great as in Japan, we still fear being singled out, to say things that may be out of the ordinary and not be understood, even if it sheds light on something.
The Chinese culture is still submerged in much myth. Everywhere we go during the Lunar New Year, we wish our friends and family, "good luck, health and wealth". I am ok with wishing one another good health and wealth, but why luck? Don't people know that luck is created? What we don't understand, we call it luck. Luck in business. Luck in investments. Luck in love life. But there are tonnes of research conducted to improve our investments, business and love life. Why not wish one another "better wisdom"? Go read books or something...
The western culture is more individualistic. They pen down their thoughts, monetise it by publishing books, research paper and applying it through investments / intellectual properties. They conduct research to prove or disprove something. They come up with innovative solutions to problems. They try to solve problems a little differently each time. Each little step, each improvement is recorded. Tonnes of literature is compiled about each tiny step. That is how society improves, advances.
We live in a little couped up world where we don't bother to reach out and understand things. It doesn't bother a lot of people why certain things happen. Why stocks rise and fall, what is happening to the world around us, how climate change may impact us some day, why we shouldn't eat sharks fin for example. A close relative of mine, whom I shall not name out of respect, still buys shares out of emotions. If he feels it is right, he will buy it. He doesn't know when to sell, but he will sell it when he feels the economy is falling. When I suggested to him why not read some books, he brushes it off and said that such books are not always accurate. How then, can one improve?
Or the subject of Feng Shui. It is surely a very controversial subject. Some people swear by it, stick golden coins on their calculators, thinking it will bring them luck. But has it been empirically studied? When I ask successful people if Feng Shui matters, most Chinese people said "yes" and most western people said "no". The Chinese believe in investing in houses with good Feng Shui. It could have been mis-attribution because in the first place, these people have a good eye for property investments. In any case, most of their claims of Feng Shui's accuracy is anecdotal.
The world is evolving. The one who can anticipate change ahead of the rest will emerge a winner. The one who sits snuggly on their cheese will one day find it removed. It is this simple. Smell the cheese everyday to find out if it has been reduced, moved slowly or added.
But another perhaps more important thing lacking in Singapore is the creative, innovative thinking that leads to invention, innovation and success.While we more than match our ex colonial masters in terms of exams (our O and A Levels consistently beat the Brits), we fail to produce the same brilliance when we leave school. Perhaps it is our school system, forcing us to regurgitate knowledge, passing exams without really understanding what we study. In my CFA class, some of them are good at memorising formula. But when it comes to applying the knowledge on investments, they are not as sharp. There are of course brilliant ones in my class who can apply the knowledge. Perhaps it is the lack of passion in a subject we are studying. The need to pass exams to please our parents. Perhaps it is the need to conform, the fear of standing out apart from our peers. While the pressure to conform is not as great as in Japan, we still fear being singled out, to say things that may be out of the ordinary and not be understood, even if it sheds light on something.
The Chinese culture is still submerged in much myth. Everywhere we go during the Lunar New Year, we wish our friends and family, "good luck, health and wealth". I am ok with wishing one another good health and wealth, but why luck? Don't people know that luck is created? What we don't understand, we call it luck. Luck in business. Luck in investments. Luck in love life. But there are tonnes of research conducted to improve our investments, business and love life. Why not wish one another "better wisdom"? Go read books or something...
The western culture is more individualistic. They pen down their thoughts, monetise it by publishing books, research paper and applying it through investments / intellectual properties. They conduct research to prove or disprove something. They come up with innovative solutions to problems. They try to solve problems a little differently each time. Each little step, each improvement is recorded. Tonnes of literature is compiled about each tiny step. That is how society improves, advances.
We live in a little couped up world where we don't bother to reach out and understand things. It doesn't bother a lot of people why certain things happen. Why stocks rise and fall, what is happening to the world around us, how climate change may impact us some day, why we shouldn't eat sharks fin for example. A close relative of mine, whom I shall not name out of respect, still buys shares out of emotions. If he feels it is right, he will buy it. He doesn't know when to sell, but he will sell it when he feels the economy is falling. When I suggested to him why not read some books, he brushes it off and said that such books are not always accurate. How then, can one improve?
Or the subject of Feng Shui. It is surely a very controversial subject. Some people swear by it, stick golden coins on their calculators, thinking it will bring them luck. But has it been empirically studied? When I ask successful people if Feng Shui matters, most Chinese people said "yes" and most western people said "no". The Chinese believe in investing in houses with good Feng Shui. It could have been mis-attribution because in the first place, these people have a good eye for property investments. In any case, most of their claims of Feng Shui's accuracy is anecdotal.
The world is evolving. The one who can anticipate change ahead of the rest will emerge a winner. The one who sits snuggly on their cheese will one day find it removed. It is this simple. Smell the cheese everyday to find out if it has been reduced, moved slowly or added.
Unemployment Drop May Not Deter Fed from Carrying Out Stimulus
Unemployment Drop May Not Deter Fed From Carrying Out Stimulus
By Joshua Zumbrun - Feb 5, 2011 3:47 AM GMT+0800
The unexpected drop in the U.S. jobless rate reported today probably won’t dissuade Federal Reserve policy makers from carrying out their program to pump $600 billion into the economy, economists said. (My comments: They will pump till inflation hits past 4%).
U.S. central bankers are deemphasizing the unemployment rate and are taking a broader look at the health of the labor market, said Vincent Reinhart, the Fed’s chief monetary policy strategist from 2001 until September 2007. That gives them flexibility to alter their easing program in response to changes in other indicators, including payroll growth, he said.
Chairman Ben S. Bernanke said yesterday he needs to see “a sustained period of stronger job creation” before he deems the recovery firmly established. The Fed’s Jan. 26 statement said the recovery “has been insufficient to bring about a significant improvement in labor market conditions,” expanding its focus beyond the jobless rate. (My comments: QE3 until 2012?)
“They shifted their rhetoric because they don’t want to be hung out on the unemployment rate,” Reinhart said.
Unemployment in January fell to 9 percent, the lowest level since April 2009, the Labor Department said today. The drop from November’s 9.8 percent rate represented the biggest two-month decline since 1958.
The drop in unemployment probably isn’t enough to satisfy Bernanke and most of his colleagues, said Roberto Perli, who until July was a member of the Fed Board’s Monetary Affairs Division staff.
Among the indicators that may give them pause: Employers added fewer than 100,000 workers to payrolls a month on average last year, the labor force participation rate has fallen to the lowest level since 1984, and 6.2 million people have been looking for a job for more than half a year.
Job Creation
“It seems to me that we’ve got at least 12 months ahead of us before the Fed feels comfortable in terms of a sustained period of job creation because that’s really what they require,” Bill Gross, manager of the world’s largest bond fund at Pacific Investment Management Co., said in an interview today on “Bloomberg Surveillance” with Tom Keene.
“Unless we see that sustained level, that virtuous circle that basically he spoke to, the Fed’s not going to raise interest rates,” he said.
Employment rose last month by 36,000 workers, the smallest gain in four months, after a 121,000 rise in December that was larger than initially reported.
“An employment report like this is a Rorschach test,” said Reinhart, now a resident scholar at the American Enterprise Institute in Washington.
Quantitative Easing
Fed officials who want to end the Fed’s program to buy $600 billion in Treasury securities through June will point to the unemployment rate as a justification, he said. Advocates of the program, called quantitative easing, will point to payrolls.
Joblessness rose above 9 percent in May 2009, beginning the longest period of unemployment at that level or higher since monthly records began in 1948.
Revisions to previous unemployment reports showed the economy lost 8.75 million jobs as a result of the recession. For all of 2010, the U.S. added about 909,000 jobs.
In November policy makers expected the unemployment rate to fall to 8.9 percent to 9.1 percent in the fourth quarter of 2011. Average hourly earnings rose 0.4 percent in January, the highest since November 2008.
Bernanke said yesterday in a speech in Washington that job gains at companies last year “were barely sufficient to accommodate the inflow of recent graduates and other new entrants to the labor force and, therefore, not enough to significantly reduce the overall unemployment rate.”
Several Years
“With output growth likely to be moderate for a while and with employers reportedly still reluctant to add to their payrolls, it will be several years before the unemployment rate has returned to a more normal level,” Bernanke said.
Central bankers likely remain wary about improvements in the jobless rate as other aspects of the employment report, such as the labor force participation rate, remain grim, James Glassman, senior U.S. economist at JPMorgan Chase & Co., said today on “Bloomberg Surveillance.”
“If you’re sitting at the Fed, you’re not going to be happy with this kind of trend because it’s yet another indirect sign that there’s not enough going on in the job market to keep people in or pull people in,” Glassman said.
-- With assistance from Bob Willis, Alex Kowalski and Shobhana Chandra in Washington and Tom Keene in New York. Editors: James Tyson, Christopher Wellisz
To contact the reporter on this story: Joshua Zumbrun in Washington at jzumbrun@bloomberg.net.
To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net .
By Joshua Zumbrun - Feb 5, 2011 3:47 AM GMT+0800
The unexpected drop in the U.S. jobless rate reported today probably won’t dissuade Federal Reserve policy makers from carrying out their program to pump $600 billion into the economy, economists said. (My comments: They will pump till inflation hits past 4%).
U.S. central bankers are deemphasizing the unemployment rate and are taking a broader look at the health of the labor market, said Vincent Reinhart, the Fed’s chief monetary policy strategist from 2001 until September 2007. That gives them flexibility to alter their easing program in response to changes in other indicators, including payroll growth, he said.
Chairman Ben S. Bernanke said yesterday he needs to see “a sustained period of stronger job creation” before he deems the recovery firmly established. The Fed’s Jan. 26 statement said the recovery “has been insufficient to bring about a significant improvement in labor market conditions,” expanding its focus beyond the jobless rate. (My comments: QE3 until 2012?)
“They shifted their rhetoric because they don’t want to be hung out on the unemployment rate,” Reinhart said.
Unemployment in January fell to 9 percent, the lowest level since April 2009, the Labor Department said today. The drop from November’s 9.8 percent rate represented the biggest two-month decline since 1958.
The drop in unemployment probably isn’t enough to satisfy Bernanke and most of his colleagues, said Roberto Perli, who until July was a member of the Fed Board’s Monetary Affairs Division staff.
Among the indicators that may give them pause: Employers added fewer than 100,000 workers to payrolls a month on average last year, the labor force participation rate has fallen to the lowest level since 1984, and 6.2 million people have been looking for a job for more than half a year.
Job Creation
“It seems to me that we’ve got at least 12 months ahead of us before the Fed feels comfortable in terms of a sustained period of job creation because that’s really what they require,” Bill Gross, manager of the world’s largest bond fund at Pacific Investment Management Co., said in an interview today on “Bloomberg Surveillance” with Tom Keene.
“Unless we see that sustained level, that virtuous circle that basically he spoke to, the Fed’s not going to raise interest rates,” he said.
Employment rose last month by 36,000 workers, the smallest gain in four months, after a 121,000 rise in December that was larger than initially reported.
“An employment report like this is a Rorschach test,” said Reinhart, now a resident scholar at the American Enterprise Institute in Washington.
Quantitative Easing
Fed officials who want to end the Fed’s program to buy $600 billion in Treasury securities through June will point to the unemployment rate as a justification, he said. Advocates of the program, called quantitative easing, will point to payrolls.
Joblessness rose above 9 percent in May 2009, beginning the longest period of unemployment at that level or higher since monthly records began in 1948.
Revisions to previous unemployment reports showed the economy lost 8.75 million jobs as a result of the recession. For all of 2010, the U.S. added about 909,000 jobs.
In November policy makers expected the unemployment rate to fall to 8.9 percent to 9.1 percent in the fourth quarter of 2011. Average hourly earnings rose 0.4 percent in January, the highest since November 2008.
Bernanke said yesterday in a speech in Washington that job gains at companies last year “were barely sufficient to accommodate the inflow of recent graduates and other new entrants to the labor force and, therefore, not enough to significantly reduce the overall unemployment rate.”
Several Years
“With output growth likely to be moderate for a while and with employers reportedly still reluctant to add to their payrolls, it will be several years before the unemployment rate has returned to a more normal level,” Bernanke said.
Central bankers likely remain wary about improvements in the jobless rate as other aspects of the employment report, such as the labor force participation rate, remain grim, James Glassman, senior U.S. economist at JPMorgan Chase & Co., said today on “Bloomberg Surveillance.”
“If you’re sitting at the Fed, you’re not going to be happy with this kind of trend because it’s yet another indirect sign that there’s not enough going on in the job market to keep people in or pull people in,” Glassman said.
-- With assistance from Bob Willis, Alex Kowalski and Shobhana Chandra in Washington and Tom Keene in New York. Editors: James Tyson, Christopher Wellisz
To contact the reporter on this story: Joshua Zumbrun in Washington at jzumbrun@bloomberg.net.
To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net .
Thursday 3 February 2011
Great Readings from John Paulson
Wednesday, February 2, 2011
John Paulson's Year-End Letter: Restructured Equities Will Drive Future Returns
John Paulson is out with his hedge fund firm's year-end letter and in it we learn that his funds have seen impressive compound annual growth rates ranging from 13.81% to 84.85% over their lifespan. Paulson & Co now has $35.9 billion in assets under management (AUM).
The bulk of Paulson's AUM can be found in his event funds (Paulson Advantage, Advantage Plus) as they collectively manage $18.6 billion. His original merger arbitrage funds garner just over $5 billion, his Credit Fund manages $8.6 billion, and his Recovery Fund manages $2.6 billion. Also, Paulson's gold fund (which we've covered in-depth) now manages just under $1 billion.
Focus on Restructuring Equities
Paulson's Recovery Fund, which is obviously betting on an economic recovery, primarily focuses on the financial sector but also takes stakes in industrials, hotels, and real estate. Interestingly enough, Paulson & Co's investment roadmap lays out the case for a focus on restructuring equities. We've detailed before how Dan Loeb's Third Point likes post-reorg equities as well. Paulson writes,
"In the midst of the credit bubble in 2006, we bought protection on our corporate and mortgage credit, which drove our returns in 2007. In 2008, we shifted our focus to shorting the equity of financial firms we thought could fail because of their exposure to credit losses, which was the main contributor to our gains in 2008. In late 2008 and early 2009, as credit markets bottomed, we switched to long distressed credit. From 4Q 2008 through 2Q 2009, we went from having no long exposure in credit to being $25 billion long. Long credit exposure drove our profitability in 2009.
As high yield bonds now trade at par and yields have plummeted, our focus has shifted to restructuring equities as the driver of future returns. While returns in our current-pay portfolio are still decent, we believe going forward the highest returns will be in restructured equities, mergers and acquisitions, and event arbitrage."
Paulson has essentially wagered over $20 billion in 40 different transactions. He feels that since these companies now have solid capital structures that their equity offers large upside potential. Paulson emphasizes that, "This is the part of the cycle where we want to have long event exposure and do not want to be under-invested."
Embedded below courtesy of ZeroHedge is Paulson & Co's year-end letter:
(Email readers need to come to the site to view the letter).
Finally, one other portion of Paulson's letter worth highlighting is his argument that his firm's large size will not be a detriment to finding opportunities and generating performance. So far, he is correct with Paulson's solid 2010 performance. We'll have to see if this holds true going forward as numerous hedge funds have struggled once they become asset gathering behemoths.
Read more: http://www.marketfolly.com/2011/02/john-paulsons-year-end-letter.html#ixzz1CrMsNm74
Monday, November 30, 2009
John Paulson's Gold Fund: Betting Against the US Dollar
By now you are undoubtedly aware that John Paulson's hedge fund firm Paulson & Co is set to launch a gold fund. We wanted to take a minute to investigate things on a deeper level and examine why he is doing so and why now. Simply put, Paulson & Co is betting on the devaluation of the US dollar. They see inflation in the cards for the future and are positioning themselves accordingly. The fund is set to launch in January and John Paulson will personally invest $250 million into the fund.
This is notable not for the wager on inflation, but for the vehicle they have selected to hedge their exposure. Many prominent hedge funds and market gurus have previously warned of inflation and have shorted long-term US treasuries. One of the original hedgies Michael Steinhardt himself has called treasuries foolish. Legendary investor and ex-Quantum fund manager Jim Rogers shares this sentiment and dislikes treasuries. Hedge fund legend Julian Robertson is betting on higher interest rates and is doing so via constant maturity swaps (CMS). We also note that John Paulson's former colleague Paolo Pellegrini has also taken an inflationary stance. Instead of playing gold, Pellegrini's hedge fund PSQR had previously been shorting treasuries and longing oil. We could go on and on but the main point is that there are some prominent and smart minds betting on inflation. While many of them share the same ideas on the topic of inflation, they've used a myriad of investment vehicles to execute their call. John Paulson has taken a slightly different approach to his inflationary bet and here's why.
The Introduction
Paulson's wager on gold is by no means new information. After all, Paulson's current hedge funds hold over $4.3 billion of gold related investments. And as we have pointed out in the past, this exposure is purely to hedge their US dollar exposure as one of their other hedge funds has a share class denominated in gold. Paulson's conviction in gold related investments has undoubtedly risen. After all, why else would he be launching a hedge fund dedicated to investing solely in gold related entities? The creation of Paulson's fund traces an eerily similar pattern to one of his prior hedge fund launches where he crafted an idea, launched a hedge fund based on that idea, and then made billions. (We're talking of course about his large bet against subprime). Paulson has made his next large bet and his new gold fund is the vehicle by which you can join him on the ride. His gold fund's objective "is to outperform gold price in a rising gold price environment." They will pursue this by investing in gold equities that are levered to the price of gold, as well as derivatives on the price of gold. Can Paulson be successful on two big bets back to back? We'll have to wait and see.
The Gold Thesis
According to recent presentations from Paulson & Co, their thesis for gold is threefold. Firstly, they believe that the printing presses of money that have been working overtime in America and other countries will cause depreciation in paper currency. Secondly, they believe that demand for gold will increase, particularly as a reserve currency. In fact, they think gold could become the primary reserve currency again as they have been looking at gold as currency, not a commodity. Thirdly, their belief is that demand for gold in general will be far greater than supply, causing prices to head higher. Overall, they see a very high probability of inflation in America's future and have selected gold related investments to hedge against this.
Ben Bernanke's Printing Presses
Looking further, Paulson & Co highlights that the monetary base has expanded to an absolutely exponential degree. According to the Federal Reserve, typical year over year changes in monetary base were under 20%. When the crisis occurred, that year over year change skyrocketed to 128%. Additionally, the correlation between the monetary base and money supply is very close, almost 1:1 as the monetary base finds its way to the money supply. In turn, unit money supply then is also highly correlated to the GDP price index, nearly a 1:1 correlation again. Paulson & Co's main argument here is that the monetary base has expanded dramatically, yet the money supply growth hasn't yet expanded. This is due to the fact that the velocity of money dropped furiously after the collapse of Lehman Brothers. Once money supply expands, look out for inflation.
Bolstering their argument, Paulson has also cited inflationary outlooks issued by the likes of former St. Louis Fed President William Poole, Harvard Professor of Economics and President Emeritus Dr. Martin Feldstein, and many more. Obviously they are not alone in their fears here. While America has taken center stage for their Central Bank balance sheet expansion, other countries' balance sheets have become just as bloated. From late 2008 until Q2 2009, the US Federal Reserve has expanded their balance sheet by 119%, the Bank of England's has expanded by 127%, the Swiss National Bank's has increased by 80%, and the European Central Bank's balance sheet has seen a 39% increase.
In the end, the crux of this part of their argument for inflation centers around money supply. Historically, inflation has lagged money supply growth by 2 to 3 years. So the lesson is that when you have money supply growth, inflation is just around the corner. And, gold has historically held its value and/or appreciated in times of inflation.
Rising Demand
To those pointing toward gold as a crowded trade or bubble, Paulson & Co argue that there has been vast appetite for gold, particularly in the popular exchange traded fund GLD. While the holdings of this ETF were only recently around $57 billion, the total pool of US money market reserves was a massive $3,850 billion. They imply that this leaves a vast amount of room for savers to shift away from paltry money market rates and into gold. Not to mention, Paulson's hedge fund actually expects central banks to turn into net buyers of gold in 2010. We've already seen signs of this as India's appetite for gold has heartily increased lately. It seems that the central banks have concluded they should not sell assets that are appreciating (gold) in order to buy assets that are depreciating (US dollar).
Gold has been on a rampage the past few months, breaking above the $1,000 technical and psychological level and heading even higher. The question now becomes, what's next for gold? Check out this video on gold to see logical pullback areas, price targets for gold's move higher, as well as where to place your stops. One thing's for certain: investors have definitely had more of an appetite for the precious metal as of late.
The Strategy
Curiously enough, it appears that Paulson's gold fund will actually not buy any physical gold. Instead, they will play inflation via gold equities as well as derivatives on the price of gold. The derivatives portion of their book has not been put on yet but they will target it to be slightly over 15% of their portfolio by using long-dated options. So, the vast majority of their gold fund will be comprised of gold equities. Some of Paulson & Co's other hedge funds already have large exposure to specific gold miners such as Anglogold Ashanti. They've selected this strategy for greater potential upside as they think gold equities will actually benefit most should gold prices stay flat or continue to rise.
Risks
As with any trade, there are always risks. Paulson's hedge fund has identified volatility, timing, price, and confiscation as potential risks to this play. In regards to timing, there is seemingly always a lag in when exactly inflation hits. It is usually a domino effect as the monetary base expands, then the money supply expands, and then you see inflation. The risk from their perspective is that it could take three to five years before we see any true signs of inflation. In regards to potential deflation in the price of gold, they identify the risks of a decline in industrial demand (jewelry etc), sales by central banks, and an increase in supply. Lastly, they identify confiscation by central banks as a threat. However, this scenario would essentially require the presence of hyperinflation and at that point the price of gold would be sky high.
A Winning Trade For Paulson
Regardless of gold's potential price appreciation, Paulson has already won on this trade. Why, you ask? Well, nowadays John Paulson is an investment icon and everyone wants to invest with him. He is already in the trade in some of his other hedge funds and soon will be with his gold fund. Not to mention, numerous other prominent hedgies are singing the praises of gold as of late. As others begin to filter into the trade and warm up to its potential, Paulson's play benefits. As our friend on Twitter mojakus puts it, Paulson can "ride the wave of wider recognition of the trade's merits. (It) doesn't really need to work out for him to mint it."
Paulson & Co don't necessarily need the trade to be realized, but rather they just need others to recognize the risk. They don't need gold prices to go higher, they only need others to recognize the potential for prices to head higher. After all, Paulson will charge a 1.5% management fee and a 20% performance fee in his gold fund with a $10 million minimum investment. As we posted on our Twitter, a massive rush of investors into gold funds could signify a top, but Paulson & Co obviously won't turn down receiving a nice set of fees for investing your cash into gold equities and derivatives.
This all comes on the heels of Paulson's huge bet against subprime over the past few years. Wall Street Journal columnist Gregory Zuckerman has detailed Paulson's amazing play in The Greatest Trade Ever, his new book (see our review here). Can Paulson do it again with his wager against the US dollar? It certainly would be quite the feat to nail two major trades in such a short span of time.
Hedgies Like Gold
As we've covered previously, hedge fund colleague David Einhorn of Greenlight Capital is positioning himself to benefit from the printing presses of the US and other governments. Einhorn is bullish on gold as well and has actually shifted from using the exchange traded fund GLD for his position to storing physical gold. So while Einhorn prefers physical gold instead of gold miners ala Paulson, the bottom line is they both have identified quantitative easing as a major inflationary threat going forward. As such, they are positioning themselves to benefit by what they deem to be the most beneficial way.
The Debate Continues
The inflation versus deflation argument rolls on and is shaping up to be quite the investment battlefield. With his gold hedge fund launch, John Paulson has planted himself firmly in the inflation camp. In the other corner, PIMCO's bond vigilante Bill Gross is betting on deflation. While the outcome could still be a few years away, it's interesting to see the wagers and investment vehicles selected by various notable investors. Slowly but surely the prominent names in the industry are placing their bets. Which side are you on?
John Paulson's Year-End Letter: Restructured Equities Will Drive Future Returns
John Paulson is out with his hedge fund firm's year-end letter and in it we learn that his funds have seen impressive compound annual growth rates ranging from 13.81% to 84.85% over their lifespan. Paulson & Co now has $35.9 billion in assets under management (AUM).
The bulk of Paulson's AUM can be found in his event funds (Paulson Advantage, Advantage Plus) as they collectively manage $18.6 billion. His original merger arbitrage funds garner just over $5 billion, his Credit Fund manages $8.6 billion, and his Recovery Fund manages $2.6 billion. Also, Paulson's gold fund (which we've covered in-depth) now manages just under $1 billion.
Focus on Restructuring Equities
Paulson's Recovery Fund, which is obviously betting on an economic recovery, primarily focuses on the financial sector but also takes stakes in industrials, hotels, and real estate. Interestingly enough, Paulson & Co's investment roadmap lays out the case for a focus on restructuring equities. We've detailed before how Dan Loeb's Third Point likes post-reorg equities as well. Paulson writes,
"In the midst of the credit bubble in 2006, we bought protection on our corporate and mortgage credit, which drove our returns in 2007. In 2008, we shifted our focus to shorting the equity of financial firms we thought could fail because of their exposure to credit losses, which was the main contributor to our gains in 2008. In late 2008 and early 2009, as credit markets bottomed, we switched to long distressed credit. From 4Q 2008 through 2Q 2009, we went from having no long exposure in credit to being $25 billion long. Long credit exposure drove our profitability in 2009.
As high yield bonds now trade at par and yields have plummeted, our focus has shifted to restructuring equities as the driver of future returns. While returns in our current-pay portfolio are still decent, we believe going forward the highest returns will be in restructured equities, mergers and acquisitions, and event arbitrage."
Paulson has essentially wagered over $20 billion in 40 different transactions. He feels that since these companies now have solid capital structures that their equity offers large upside potential. Paulson emphasizes that, "This is the part of the cycle where we want to have long event exposure and do not want to be under-invested."
Embedded below courtesy of ZeroHedge is Paulson & Co's year-end letter:
(Email readers need to come to the site to view the letter).
Finally, one other portion of Paulson's letter worth highlighting is his argument that his firm's large size will not be a detriment to finding opportunities and generating performance. So far, he is correct with Paulson's solid 2010 performance. We'll have to see if this holds true going forward as numerous hedge funds have struggled once they become asset gathering behemoths.
Read more: http://www.marketfolly.com/2011/02/john-paulsons-year-end-letter.html#ixzz1CrMsNm74
Monday, November 30, 2009
John Paulson's Gold Fund: Betting Against the US Dollar
By now you are undoubtedly aware that John Paulson's hedge fund firm Paulson & Co is set to launch a gold fund. We wanted to take a minute to investigate things on a deeper level and examine why he is doing so and why now. Simply put, Paulson & Co is betting on the devaluation of the US dollar. They see inflation in the cards for the future and are positioning themselves accordingly. The fund is set to launch in January and John Paulson will personally invest $250 million into the fund.
This is notable not for the wager on inflation, but for the vehicle they have selected to hedge their exposure. Many prominent hedge funds and market gurus have previously warned of inflation and have shorted long-term US treasuries. One of the original hedgies Michael Steinhardt himself has called treasuries foolish. Legendary investor and ex-Quantum fund manager Jim Rogers shares this sentiment and dislikes treasuries. Hedge fund legend Julian Robertson is betting on higher interest rates and is doing so via constant maturity swaps (CMS). We also note that John Paulson's former colleague Paolo Pellegrini has also taken an inflationary stance. Instead of playing gold, Pellegrini's hedge fund PSQR had previously been shorting treasuries and longing oil. We could go on and on but the main point is that there are some prominent and smart minds betting on inflation. While many of them share the same ideas on the topic of inflation, they've used a myriad of investment vehicles to execute their call. John Paulson has taken a slightly different approach to his inflationary bet and here's why.
The Introduction
Paulson's wager on gold is by no means new information. After all, Paulson's current hedge funds hold over $4.3 billion of gold related investments. And as we have pointed out in the past, this exposure is purely to hedge their US dollar exposure as one of their other hedge funds has a share class denominated in gold. Paulson's conviction in gold related investments has undoubtedly risen. After all, why else would he be launching a hedge fund dedicated to investing solely in gold related entities? The creation of Paulson's fund traces an eerily similar pattern to one of his prior hedge fund launches where he crafted an idea, launched a hedge fund based on that idea, and then made billions. (We're talking of course about his large bet against subprime). Paulson has made his next large bet and his new gold fund is the vehicle by which you can join him on the ride. His gold fund's objective "is to outperform gold price in a rising gold price environment." They will pursue this by investing in gold equities that are levered to the price of gold, as well as derivatives on the price of gold. Can Paulson be successful on two big bets back to back? We'll have to wait and see.
The Gold Thesis
According to recent presentations from Paulson & Co, their thesis for gold is threefold. Firstly, they believe that the printing presses of money that have been working overtime in America and other countries will cause depreciation in paper currency. Secondly, they believe that demand for gold will increase, particularly as a reserve currency. In fact, they think gold could become the primary reserve currency again as they have been looking at gold as currency, not a commodity. Thirdly, their belief is that demand for gold in general will be far greater than supply, causing prices to head higher. Overall, they see a very high probability of inflation in America's future and have selected gold related investments to hedge against this.
Ben Bernanke's Printing Presses
Looking further, Paulson & Co highlights that the monetary base has expanded to an absolutely exponential degree. According to the Federal Reserve, typical year over year changes in monetary base were under 20%. When the crisis occurred, that year over year change skyrocketed to 128%. Additionally, the correlation between the monetary base and money supply is very close, almost 1:1 as the monetary base finds its way to the money supply. In turn, unit money supply then is also highly correlated to the GDP price index, nearly a 1:1 correlation again. Paulson & Co's main argument here is that the monetary base has expanded dramatically, yet the money supply growth hasn't yet expanded. This is due to the fact that the velocity of money dropped furiously after the collapse of Lehman Brothers. Once money supply expands, look out for inflation.
Bolstering their argument, Paulson has also cited inflationary outlooks issued by the likes of former St. Louis Fed President William Poole, Harvard Professor of Economics and President Emeritus Dr. Martin Feldstein, and many more. Obviously they are not alone in their fears here. While America has taken center stage for their Central Bank balance sheet expansion, other countries' balance sheets have become just as bloated. From late 2008 until Q2 2009, the US Federal Reserve has expanded their balance sheet by 119%, the Bank of England's has expanded by 127%, the Swiss National Bank's has increased by 80%, and the European Central Bank's balance sheet has seen a 39% increase.
In the end, the crux of this part of their argument for inflation centers around money supply. Historically, inflation has lagged money supply growth by 2 to 3 years. So the lesson is that when you have money supply growth, inflation is just around the corner. And, gold has historically held its value and/or appreciated in times of inflation.
Rising Demand
To those pointing toward gold as a crowded trade or bubble, Paulson & Co argue that there has been vast appetite for gold, particularly in the popular exchange traded fund GLD. While the holdings of this ETF were only recently around $57 billion, the total pool of US money market reserves was a massive $3,850 billion. They imply that this leaves a vast amount of room for savers to shift away from paltry money market rates and into gold. Not to mention, Paulson's hedge fund actually expects central banks to turn into net buyers of gold in 2010. We've already seen signs of this as India's appetite for gold has heartily increased lately. It seems that the central banks have concluded they should not sell assets that are appreciating (gold) in order to buy assets that are depreciating (US dollar).
Gold has been on a rampage the past few months, breaking above the $1,000 technical and psychological level and heading even higher. The question now becomes, what's next for gold? Check out this video on gold to see logical pullback areas, price targets for gold's move higher, as well as where to place your stops. One thing's for certain: investors have definitely had more of an appetite for the precious metal as of late.
The Strategy
Curiously enough, it appears that Paulson's gold fund will actually not buy any physical gold. Instead, they will play inflation via gold equities as well as derivatives on the price of gold. The derivatives portion of their book has not been put on yet but they will target it to be slightly over 15% of their portfolio by using long-dated options. So, the vast majority of their gold fund will be comprised of gold equities. Some of Paulson & Co's other hedge funds already have large exposure to specific gold miners such as Anglogold Ashanti. They've selected this strategy for greater potential upside as they think gold equities will actually benefit most should gold prices stay flat or continue to rise.
Risks
As with any trade, there are always risks. Paulson's hedge fund has identified volatility, timing, price, and confiscation as potential risks to this play. In regards to timing, there is seemingly always a lag in when exactly inflation hits. It is usually a domino effect as the monetary base expands, then the money supply expands, and then you see inflation. The risk from their perspective is that it could take three to five years before we see any true signs of inflation. In regards to potential deflation in the price of gold, they identify the risks of a decline in industrial demand (jewelry etc), sales by central banks, and an increase in supply. Lastly, they identify confiscation by central banks as a threat. However, this scenario would essentially require the presence of hyperinflation and at that point the price of gold would be sky high.
A Winning Trade For Paulson
Regardless of gold's potential price appreciation, Paulson has already won on this trade. Why, you ask? Well, nowadays John Paulson is an investment icon and everyone wants to invest with him. He is already in the trade in some of his other hedge funds and soon will be with his gold fund. Not to mention, numerous other prominent hedgies are singing the praises of gold as of late. As others begin to filter into the trade and warm up to its potential, Paulson's play benefits. As our friend on Twitter mojakus puts it, Paulson can "ride the wave of wider recognition of the trade's merits. (It) doesn't really need to work out for him to mint it."
Paulson & Co don't necessarily need the trade to be realized, but rather they just need others to recognize the risk. They don't need gold prices to go higher, they only need others to recognize the potential for prices to head higher. After all, Paulson will charge a 1.5% management fee and a 20% performance fee in his gold fund with a $10 million minimum investment. As we posted on our Twitter, a massive rush of investors into gold funds could signify a top, but Paulson & Co obviously won't turn down receiving a nice set of fees for investing your cash into gold equities and derivatives.
This all comes on the heels of Paulson's huge bet against subprime over the past few years. Wall Street Journal columnist Gregory Zuckerman has detailed Paulson's amazing play in The Greatest Trade Ever, his new book (see our review here). Can Paulson do it again with his wager against the US dollar? It certainly would be quite the feat to nail two major trades in such a short span of time.
Hedgies Like Gold
As we've covered previously, hedge fund colleague David Einhorn of Greenlight Capital is positioning himself to benefit from the printing presses of the US and other governments. Einhorn is bullish on gold as well and has actually shifted from using the exchange traded fund GLD for his position to storing physical gold. So while Einhorn prefers physical gold instead of gold miners ala Paulson, the bottom line is they both have identified quantitative easing as a major inflationary threat going forward. As such, they are positioning themselves to benefit by what they deem to be the most beneficial way.
The Debate Continues
The inflation versus deflation argument rolls on and is shaping up to be quite the investment battlefield. With his gold hedge fund launch, John Paulson has planted himself firmly in the inflation camp. In the other corner, PIMCO's bond vigilante Bill Gross is betting on deflation. While the outcome could still be a few years away, it's interesting to see the wagers and investment vehicles selected by various notable investors. Slowly but surely the prominent names in the industry are placing their bets. Which side are you on?
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