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.
