Guest Author: Clive Corcoran provides private client wealth management services, as well as being a financial educator/mentor and an independent trader. Formerly he was active for 20 years in the entertainment industry as a producer/manager/agent for several musical artists. Longer bio available at the end of this article.
Some intriguing, and potentially unsettling, shifts have been taking place in macro asset allocation decisions over the last few weeks which have been somewhat overshadowed by the relative strength of US equity markets, and perhaps more recently obscured by developments in Egypt, Tunisia and Yemen.
The striking observation that needs to be made is that global investors are losing their appetite for the BRIC economies, indeed there are cracks in the BRIC’s which are beginning to point to a potential hard landing for such previously buoyant markets as China, Brazil and India.
First of all we need to state in simple terms the extraordinary growth that these last three economies have shown in the last several years.
Martin Wolf, the respected FT columnist included the following helpful illustration of how, despite the financial crisis of 2008, the BRIC economies have surged ahead in recent years, especially in relation to the “advanced” economies. He demonstrated this with reference to a notional GDP index for several key economies here
If one were to set GDP at 100 in 2005, it was 105 in the US in 2010, 104 in the Eurozone and 102 in Japan and the UK. But in Brazil it was 125, in India 147 and in China 169.
As Wolf remarks for policy makers in the BRIC nations there is a temptation to ask laconically “Crisis? What crisis?”
However, the cracks which are now appearing in the BRIC’s and three of the equity markets referenced in the acronym are revealing that despite, perhaps even because of the remarkable growth rates which have been seen in these super economies of the future, all is not well. Global asset allocators and other investors are exiting these markets in a hurry now and this is confirmed by data published in a report from Emerging Portfolio Data Research (EPFR) and which is referenced in this recent article also from the Financial Times. Note: A companion article discusses investment strategy options is detail.
Has U.S. QE Ended its Magic?
However, as with most sudden rushes for the exits, there were early warning signs of a retreat in the BRIC’s and these have been evident for some time. In fact, the case will be made that the tide turned for these markets in November of last year and that two related events could be behind the shift away from the stellar performers during most of 2010. The two events are – on the one hand – the persistence of the elevation in commodity prices which has been associated with an unwillingness of, indeed need for, the BRIC monetary authorities to take measures to address troublesome inflation, particularly in food prices – and on the other hand – the decision by the US Federal Reserve to continue with its policy of QE. Somewhat counter-intuitively the US dollar also registered a multi-year low in November 2010 which adds further credence to the notion that FX traders in particular decided to sell on the rumor (of QE prolongation) and buy on the fact i.e. when Bernanke officially confirmed the QE2 program at the beginning of November.
The chart below shows the trajectory taken by the US dollar index, as reflected in the price of the exchange traded fund, UUP, over the last year.
Evident on the chart is the low seen in early November which was also accompanied by a positive technical divergence in momentum. One could argue that the last move down in early November was the final thrust by FX traders keen to set up better levels for taking long positions on all of the key dollar cross rates as the implications of further QE became the focal point in markets. Adding to the notable bounce in the dollar was also the fact that Chairman Bernanke limited himself to only $600 billion, rather than the $1 trillion or more which some had been projecting.
China, Currency and Political Stability
Even though the US dollar registered a significant low the continued appetite from investors and traders for most commodities, and the accusations by the Chinese that QE2 was in effect a deliberate debasement of the US currency and attempt to trigger inflation, added further impetus to the incipient currency war which moved to center stage in late 2010. The events in the Eurozone, with Ireland’s need for a rescue operation, also deflected some attention away from the fact that the Chinese authorities were becoming more than just a little concerned about the fact that their own equity market was showing signs of fatigue. Mounting concerns about rising food prices and commodity pressures in general, in the wake of too much global liquidity – at least that is the view of the PBOC – and the possibility that this might lead to civil unrest is an alarming prospect for the second largest economy in the world, which is now responsible for 10% of global GDP. As China morphs even more into an urban economy where the acquiescence of the working classes toward rising food prices, rents and their willingness to accept evidence of blatant social inequality, cannot be taken for granted.
India and Inflation
There is a real concern about the accelerating rise in food inflation which is now above 17% on an annualized basis, and this is putting increasing pressure on New Delhi to take tougher steps to keep food prices in check in India. It is worth noting that in an economy where 80% of the 1.2 billion population lives on less than $2 a day, the impact of higher prices for basic foodstuffs is far more profound than it is in a more heterogeneous market where consumers have more discretionary income.
The following comments from the Indian government which were reported recently by BBC News, highlight the risk that the Sensex index, precariously poised at 18,000, may come under further pressure as India’s central bank seems destined to keep raising rates.
India’s prime minister has warned that the country’s rapid economic growth is under “serious threat” from inflation. Manmohan Singh said getting inflation under control was a matter of urgency, raising the prospect of an eighth interest rate rise in under 12 months. Emerging markets like India, where GDP growth is running at 8.5%, are helping to drive global economic recovery. But Mr Singh said India’s inflation rate of 8.4% – and food price inflation of 17% – was unsustainable. “Inflation poses a serious threat to the growth momentum. Whatever be the cause, the fact remains that inflation is something which needs to be tackled with great urgency,” he said.
Analysts believe that surging food and oil prices mean that India’s central bank may have to raise interest rates before its next policy meeting, which is scheduled for 17 March. India’s stock market has fallen this year on fears that high inflation will scare off foreign investors.
The key macro-financial question has to be asked – how likely is it that the Indian government will be able to contain the damage being done by increasing food prices simply by base rate increases in its domestic financial markets? A compelling argument can be made that global liquidity – driven mainly by easy money and ZIRP policies in many “advanced” economies – is the principal dynamic, along with weather related and geo-political unrest, behind the relentless increase in the cost of basic agricultural and industrial commodities. To imagine that the Indian government can counter these dynamics by local interest rate increases is analogous to the notion that one can tame a King Kong like gorilla by administering a mild sedative.
Can Global De-Coupling Continue?
The more positive outcome for investors would be that one would expect, on the assumption that asset allocators remain optimistic about the continued economic out-performance of the BRIC’s in contrast to the sclerotic growth in the mature economies, that equity market rebounds are most likely. Moreover if one subscribes to the view that global de-coupling is valid, and that there is a long term macro negative correlation between the appetite for the dollar and BRIC/EM assets then one would have to remain skeptical regarding the US dollar’s appearance of forming a base at present (i.e. in early February 2011).
If on the other hand the attrition in the BRIC markets continues and risk appetite for BRIC assets is in retreat one must be tempted to reach the conclusion that there are the beginnings of a real aversion by investors to the inflation genie. Not only is it out of the bottle but fund managers may suspect that containing the damage arising from mounting agricultural and other strategic commodity prices, will be a painful affair for the BRIC’s and perhaps too eventually for the “advanced” economies.
The question then becomes one of de-coupling again but under a different guise this time than that usually depicted. If the most dynamic economies of the world – where final demand is increasing more rapidly than in North America, Japan and most of Europe – are being forced to tighten monetary policy to preserve purchasing power of their currencies, and to avoid the political and social fallout of higher food costs, then for how much longer is it safe for the USA, UK and Eurozone to maintain the confidence trick that ZIRP is not a hazardous policy which will eventually lead to troubling and ubiquitous global inflation?
The question of how these emerging economy factors will affect investors in 2011 will be discussed in a companion article coming tomorrow at the GEI Investing Blog.
As an author he has written “Long/Short Market Dynamics: Trading Strategies for Today’s Markets” (Wiley, 2007) and two textbooks, “Financial Markets, and Portfolio Construction Theory” and “Wealth Management” (both published in 2010), which are foundation items for those seeking the Master’s qualification from the Chartered Institute for Securities and Investment, where he is an Associate.He is also a director of Morphology Management Inc. which has developed a systematic trading platform which includes pattern recognition technologies and implements inter-market strategies in the global equities and foreign currency markets. He has been a regular analyst/contributor to CNBC Europe and other broadcast outlets, runs executive education workshops in conjunction with ICMA and Thomson Reuters, and has been a featured speaker at international trading expos.Previously he was the founder and CEO of a personal and business management company for entertainment professionals that operated in Los Angeles, London, Munich and Toronto, where clients that he represented included several multi-platinum recording/touring artists.