May 31st, 2011
Guest Author: MacroTides. See About the Author at end of the article.
Coming into 2011 we suggested there were three major themes that would play out in the course of this year. We have already discussed U.S. macroeconomic issues and investment outlook in two previous articles. Here we will address our concerns about the BIC part of the BRICs. A future article will address the situation in Europe. Follow up:
In the January letter, we discussed the tightening of monetary policy in Brazil, China, and India which would raise doubts about second half growth in those countries, and cause a sharp shake out in commodities. After reviewing the rate increases initiated by the central banks in these countries in the February letter, we noted,
"At some point in this year’s first half, it is going to dawn on investors that the cumulative impact of all these rate increases in the countries that have been growing the fastest will cause a second half slowdown in each of these countries."
The Reserve Bank of Brazil's central bank increased its Selicrate to 12.0% on April 20, making it the highest in the world. Overnight on May 2, India hiked their repo rate from 6.75% to 7.25%, a larger than expected increase. The rate increase was the ninth since March 2010. On May 12, the People's Bank of China increased its reserve ratio for the 15th time in the last eighteen months to 21%. In early 2010, the reserve ratio was 15%. The Chinese Central Bank is attempting to curb lending by forcing banks to set aside $.21 of each $1.00 lent. In the U.S., the reserve ratio is about 10%.
Silver has been the poster child of the surge in commodity prices and for good reason. Shortly after the Federal Reserve announced its intentions to launch QE2 in November on August 10, silver soared from $18.00 an ounce to a closing high of $48.60 on Friday, April 29. On Monday, May 2, silver dropped to $42.20. Four days later silver traded down to $33.04 (July contract). Silver was not the only commodity to be hit hard. Crude oil fell from $114.83 on May 2 to $94.63 on May 6. Gold dropped to $1462.50 on May 5, from a high of $1577.40 on May 2. There is no question that a significant increase in margin requirements for these commodities played a large role in contributing to the wave of liquidation that swept through commodities in the first week of May. We think the targeted increase in margins was a stroke of genius, since it dampened speculation. The cumulative rate increases in Brazil, China, and India also diminished the notion that demand from these countries for raw materials is infinite, which has been a big part of the fundamental story supporting the run up in commodities in general.
Inflation is likely to remain a concern for each of these countries. Brazil's Central Bank has an inflation target of 4.8%. In mid-May, consumer prices were up 6.51% from last year. This suggests the Brazilian Central Bank won't be lowering rates soon, and may tack on one or two .25% rate increases in coming months
In China, inflation dipped to 5.3% in April from March's 5.4% rate, but is still above the official inflation target of 4%. Signs of slowing are beginning to emerge. Industrial output, retail sales, and money supply growth have all slowed in recent months. M2 money supply growth of 15.3% was the slowest in 29 months, and a clear indication that the increase in reserve requirements is having an impact on lending. If these trends persist through the summer, China may lower rates before the end of 2011.
India faces a more challenging environment than Brazil or China. The wholesale price index was up 8.66% in April from a year ago. India has cut fuel subsidies, which will boost energy inflation, and industrial production was up 7.3% in March from last year. Commercial credit has grown by 22% over the last year. This suggests the Reserve Bank of India may nudge rates higher in coming months.
All central banks are forced to drive monetary policy looking through the rear view mirror. This usually means they tighten, or hold policy too tight, until economic growth slows more than expected. This is possible in China as household spending as a percent of GDP has fallen to 35%, while fixed investment has climbed to 45% of GDP. This is the ideal prescription for an excess capacity problem, which could be significant. During the last two years, bank lending has amounted to 40% of China's $5 trillion in GDP.
Our attempts to play in the BIC sandbox have been stopped out by our risk control process. As mentioned in Overview of the Markets, a Special Update was sent to subscribers of MACRO TIDES on March 29 recommending the purchase of four ETFs. Here are the opening prices for the recommended ETFs on March 30, and the prices they were sold: Brazil (EWZ) $76.04, stopped May 3 at $76.18, Korea (EWY) $63.68, stopped out on May 17 at $63.95, Australia (EWA) $26.44, half sold on April 27 at $28.25 and half stopped on May 4 at $26.90.
Our macroeconomic concerns indicate that caution for investing in the BIC area is advisable for the rest of 2011. See an analysis just posted by Michael Pettis that discusses some of the same concerns (first Related Article, below).
China: Unsustainable Rise in Debt? by Michael Pettis
Follow up:As we started the year we felt the tightening of monetary policy by Brazil, China, and India would continue, and lead to a second half slowing in these high growth economies. The slowdown in these countries would likely dampen export growth from the developed countries in Europe and the U.S., which had previously been a source of strength. The recognition of the coming slowdown in the high growth economies would cause a sharp break in commodity prices, especially since China is a huge source of demand for "stuff".
China: Will Increasing Wages Lead to Rebalancing? by Michael Pettis
U.S. Macroeconomic Overview by MacroTides
Overview of the Markets by MacroTides
Secular Cycles for Stocks by Ed Easterling
Using Forward Earnings Estimates by Jeff Miller
Profiting from Forward Earnings Estimates by Jeff Miller
Market Valuations and Longer Term Perspective by Doug Short and John Lounsbury
Consensus: A Groundhog Decade for Stocks by Ed Easterling
What Happens if Chinese Growth Slows? by Michael Pettis
About the Author
Macrotides is a monthly subscription newsletter written by a wealth manager associated with a major Wall Street investment bank. The author’s firm has requested that he not use his name to avoid any incorrect implication that his views might reflect those of the bank. The author has written investment advisory subscription newsletters based on macroeconomic analysis and market technicals for more than 20 years. Enquiries can be made at MacroTides@firstname.lastname@example.org