Vitally important for being a successful investor is the ability to look beyond ‘buzzwords’, acknowledge that a wobble can be more dangerous when the training wheels come off and understand the nature of those that hold the future of the company / country / financial market in their hands.
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1. Catchy titles do not tell the full story (more…)
From the world’s best performing index in the first three months of this year, to a laggard this quarter, the Russian index has offered dramatic returns as well as downside risk. What has driven investor sentiment and what are many investors missing?
The World Leader Slips to World Laggard
Russia’s RTS Index was the world’s best performing index in the first three months of this year but has now fallen by around 11% in value so far this quarter (Source: Bloomberg). Moves in this market are often attributed to sentiment over the oil price due to the significant revenues generated by the country exporting this commodity. Therefore speculation over economic growth (read: oil demand) is highly influential. This year has been no different. Turmoil in the Middle East can be attributed as one of the main drivers of a strong rally in oil in the first quarter and concerns over economic growth has caused a reversal since that time. However, is this too simplistic a view and aren’t there other factors to which an investor in Russia should be paying attention?
It is clear to see why investors play so much emphasis on the oil price as a dictator of Russia’s financial health. Supplying some 11.4% of the world’s oil supply last year, Russia is the “biggest single source outside the opec cartel”. Although official figures calculate its contribution to Russia’s GDP at 9%, it is important to be aware that speculation over tax avoidance suggests the value may be nearer to 25%. Nevertheless, what is often overlooked is the specific oil price factored into their budget. For this year, a price above $75/barrel will produce a deficit reduction. With Brent currently standing at $115/barrel, a fall in the Russian Index in reaction to a fall in the oil price to anything above $75/barrel may be missing the point.
Boosting Ties with Iraq
With Russian oil fields maturing and production growth resting heavily on foreign investment, the country is looking externally for new sources. Iraq offers potential opportunities and TNK-BP, Russia’s 3rd largest oil producer and BP Plc’s 50-50 joint venture, isn’t holding back. The relationship between the two countries dates back many years and in 2008 Russia wrote off most of their $12.9bn debt mainly generated pre-gulf war from the Saddam Hussein government purchases of Soviet weapons. Interestingly, last October the Russian President, Dmitry Medvedev announced his country was ready to strengthen co-operation with Iraq, the same month TNK-BP gained the right to bid for 3 natural gas areas in the region.
Mediating the Exit of Qaddafi
Within the political arena, Russia has been just as active. In addition to fighting for a stronger developing market influence at the IMF, Russia has offered its services to facilitate the exit of Qaddafi from rule in Libya. This is the first time it has shown support for the NATO-led military campaign after abstaining from UN Security council vote in March which authorised the intervention and accusing NATO of violating the resolution by backing anti-Qaddafi rebels and causing civilian casualties from air raids. Due to the belief that Qaddafi has “forfeited legitimacy”, they are willing to negotiate his fate with members of his entourage. Evidence of the country’s powerful network, the value of their political clout has been highlighted.
Driving the Agriculture Market
Back to commodities but from a different angle, the Russian weather is an influencer to watch for investing in the agriculture markets. Fine weather has prompted an upward revision of Russian grain production with the Federal Hydrometerological Center reporting the warmer weather has improved the prospect for crops. This has led to speculation that Russia’s ban on grain exports may be lifted on 1 July. Wheat future prices saw double digit losses.
The Chinese Buyer
One particular potential buyer of Russia’s resources is China, state media reported last Monday. China Investment Corp (CIC), the country’s $300bn sovereign wealth fund, was set up in 2007 to invest some of the country’s massive foreign exchange reserves. With the world’s largest foreign capital resource, at $3.0tn, they are keen to find better sources of return and commodities to fuel their rapid economic growth.
G-8 Bullishness Boosting Appetite for Risk
Despite these many factors which may influence Russia’s outlook, financially, economically and politically; its index continues to exhibit a strong correlation to the oil price. This week we’ve seen oil (and Russian equities) respond positively to the declaration by the Group of Eight that the global recovery is strengthening.
Nevertheless, to differentiate between short-term over-reaction and more logical fundamental moves, being aware of all the issues will equip you with the insight to navigate this volatile but potentially profitable market.
As “super-injunctions” are labelled “pointless” by the rise of ‘new’ social media sites, the world seems a smaller place for those wanting to hide potential transgressions. Indeed, such accusations can have broad ramifications as the head of the International Monetary Fund this week steps down from his leadership position. Could this trigger the end of European dominance at the IMF and even pave the way for Emerging Market leaders to acquire a more appropriate size of the power pie?
Jurisdiction Arbitrage: The Super-Injunction Flaw
Last week, an anonymous twitter user exploited a ‘jurisdiction arbitrage’ to name celebrities whose identities are being protected by a series of ‘gagging-orders’. The Twitter site is based in the US and therefore “outside the jurisdiction of the British courts”. Furthermore, not only would the user himself be “difficult to trace” but the number of other users who forwarded on the names and could be charged represented a “mass defiance” and “unlikely” any of them would be pursued. Therefore potential wrong-doers can, for the moment at least, be named and shamed in some form of media. Just how dangerous can these revelations be?
Revelations at The IMF
This week legalities are once again in the headlines as Dominique Strauss-Kahn, (now the former) head of the International Monetary Fund, stands accused of politically damaging indiscretions. Regardless of the outcome of the case, the political impact has been made and focus is on identifying his potential successor.
The European Bias
Historically the IMF Managing Director has been European and the World Bank President American but nowhere in the “Articles of Agreement’ is this mentioned. So where did this bias come from? It dates back to the Bretton Woods conference, where the fund was formed and this informal agreement struck. In the aftermath of World War II, European economic stability played a large part in the health of the world’s economy and voting power reflected the balance of power. The US has a 16.7% share, Germany 5.9% and the UK & France 4.9% each; leaving the ‘door open’ for ‘behind the scenes’ negotiations. Unsurprisingly, since this time, there have been 10 Managing Directors, all of them European.
Flaws of a European Successor
Proponents of a continuation of European dominance point to the IMF’s crucial role in stemming the European Sovereign Debt crisis. A German government spokesman, Christoph Steegmans, maintains that the leader needs to understand “Europe’s particularities”. Interesting then that there has been no talk of electing an official from the Middle East as Egypt requests a $4bn loan to ‘fill its budget gap’. With all the turmoil, doesn’t a leader need to understand the ‘particularities’ of this region too? Instead, focus is on German candidates (including Axel Weber, the former head of the Central Bank who recently withdrew from the race to succeed Trichet as head of the ECB). A favourite amongst pundits is French finance Minister Christine Lagarde. Bank of Canada Governor, Mark Carney has even been given odds of 10-to-1 by a British bookmaker. Gordon Brown’s name has even been thrown into the ring but was quickly opposed by our PM Cameron due to the record budget deficit which continued to build during his tenure. Here lies the crux of the issue, since the EU and ECB have yet to solve the debt crisis, is it time for someone else to have a go?
Opportunity for Developing Markets
The economic balance of power is changing. China has overtaken Japan as the second largest economy and it has been argued that it will surpass the US’s share of global GDP in a decade. Back in 1973, the developing nations asserted more of their power as a group led by Indonesia and Iran vetoed the nomination of a Dutch candidate (seen as too closely aligned to the interests of wealthy nations). With this in mind, candidates from South Africa, Turkey, Singapore, Indonesia, Mexico and a Chinese official who advises the IMF already have been mentioned in the press. Brazil too has contributed to the discussion, as their Finance Minister argues for a “new criteria”. Indeed changes to IMF governance were decided in 2008 and last year, shifting 5.3% of the voting share to emerging markets. Although nothing has yet taken effect. However, with the increased contribution of funding coming from these regions and the negativity within these countries expressed against too much focus on the developed world, change is warranted.
As ever, economic issues can often lie opposed to equity market movement. But changes (or continuation) of dominance could affect short-term sentiment for various country’s financial markets. Exploit any over-reaction in the short-term whilst remaining focused on quality in the longer-term. The shift of economic power is well underway, let’s see if the political powers play catch up….
Follow this link to read the article, as published in The Huffington Post.
What Investor Excitement Is Ignoring….
Inflation is like sin; every government denounces it and every government practices it – Frederick Leith-Ross
One of the most interesting market moves in 2010 was the significant outperformance of US equities over Chinese, despite far weaker GDP growth numbers. What many missed is the fact that it is not absolute values but relative figures / surprises which move markets. With this in mind, is it worrying that the consensus for China’s long term earnings growth is forecasted at 18%? Not much room is left for upside surprises, but there’s plenty of space for disappointment!
Therefore, it is important to be aware of the issues and risks associated with the region to be able to decide not only what to invest in but how to size the investment accordingly, inline with risk / return targets. As expressed above, it is crucial to judge what you believe is already priced into the markets and what pose as upside or downside potential.
Short-Term EM Risks
Short-term cyclical factors can overshadow long-term structural trends
INFLATION: the index used to calculate inflation in EM has double the exposure to food prices than in the G10 (developed countries). Using the price of wheat as an example – an all time high was reached at the beginning of this month, highlighting the magnified pressure felt in the region which may spook investors. From another angle, fiscal policy in China led to a 30% growth in the money supply (M2) in 2009, increased by almost as much again last year, stoking inflationary fears (since with more money around, it becomes worth less and more of it is required to buy goods i.e. goods become more expensive)
ALLOCATIONS: a record percentage of portfolio managers are overweight Emerging Market equities. The combined net assets of the two largest EM ETFs are now above that for the S&P 500, despite the US equity market being ~4 times the size of the investable EM universe.
Long-Term EM Risks
Long-term demographics may negatively affect the working population
AGE TRENDS: the biggest drop in the young working age population is “set to take place in China,” a result of its one-child policy.
ACCESS TO EDUCATION: Of the top 50 universities, only 3 are based in emerging market countries and the highest stay rate is among Chinese students. This means that in order to get a top quality education, the youth of Emerging Markets may have to study abroad and if they do so, may end up staying, greatly limiting the young, well-educated working class of their homeland.
EM Stock Risks
Do due diligence on the companies you pick – you may not be getting the exposure you want
EXPOSURE: just 14% of EM market cap is represented by domestic-facing sectors (i.e. not all EM stocks give investors exposure to the rise of the Consumer and the “Domestic Demand” growth story, a main reason for investment)
GOVERNMENT INTERVENTION: Within the EM stock markets, government ownership of companies is significant. For the Chinese market, 67% of its market cap is government owned (35% in Russia, 29% in India and 14% in Brazil). Putting this in context, in the US, at the height of the financial crisis, government ownership was about 3.7% of market cap. The importance of this should not be underestimated. It means that at times, within EM, a majority government owned entity may not be acting entirely in the interests of the investors.
STOCK EXAMPLE: Petrobras (PBR): Brazilian government and its affiliates own about 64% of common voting shares. The offering documents state that “the government, as our principal shareholder, has and may pursue in the future, certain of its macroeconomic and social objectives through us.”
Therefore, in conclusion: Be aware –
Short-term cyclical factors can overshadow long-term structural trends
Long-term demographics may negatively affect the EM working population
Do due diligence on the companies you pick – you may not be getting the exposure you want
“Risk of acronym over-exuberance – a pithy abbreviation does not necessarily equate to a profitable investment!” (Me!)
Click the image below to here my views on Emerging Markets (and the global economic outlook). It was broadcasted just the other week on “The N@ked Short Club” on Resonance FM – (2m+ listeners and growing!). Follow-on comment from Mike Gasior, CEO of AFS.
The Long-Term Case Summarised
- Strength of balance sheets (10% D / GDP vs. 400% in UK)
- High levels of savings to deploy rather than build (33% vs 17% of GDP)
- FX reserves (75% of global forex)
- Wider range of policy tools available
- The growth of emerging consumer class: an estimated 1bn are to join by 2030 , with the Chinese middle class to exceed the US population within a few yrs
- We have seen resolve: Industrial Production is above its pre-crisis peaks in emerging Asia and there are increasing levels of intra-regional trade (see chart below) – leading to countries becoming more insulated from pullbacks in demand from developed markets
- From export-led to domestic-demand (and neighbor-demand) led
Although valuation and reputation concerns remain
A word of warning
- As ever, DIFFERENTIATE between markets – they aren’t all as strong.
- And market RISK OF CONTAGION remains – if international investors get spooked, they will take risk off the table across the board regardless of fundamentals
- INVEST IN QUALITY – should add value over longer-term.
We have had the “BRICs” (Brazil, Russia, India and China) and the calls just keep coming. Now the term “Chindonesia” (China, India and Indonesia) has been coined or even the “Civets” (not just cat-like mammals from Africa and Asia but Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa). But as my above quote states, there is a risk of acronym over-exuberance – a pithy abbreviation does not necessarily equate to a profitable investment! Often there are discrepancies between international investor excitement and the fundamentals of the economy and sentiment on the ground.
Specific Stock Example
Avoid anything with “Chinese Consumer” in the name, a beneficiary of this “over-exuberance” and have potentially, in some cases, become over-priced. Instead look for more indirect access to value and growth.
One such example – to be taken within the context of an admission of having spent little time evaluating the fundamentals sufficiently, is Want Want China Holdings, listed on the Hong Kong Stock Exchange – maker of rice cakes and flavoured milk in China as well as snack foods. Has rallied 24% YTD to a PE, according to Reuters, of around 33x, above that of its sector. A different angle is Olam International, listed in Singapore, – global leader in supply chain management of agriculture products and food ingredients, which has underperformed Want Want by almost 7% YTD and cheaper than the sector average (PE 19x).
Back from a business trip to South Africa. I was flown over to present my investment ideas and during my time being the key note speaker and from the conversations with investors, I noted a recurring question – “what data should I watch?”. Now I always maintain one must not focus too heavily on one data point or information from one source / point of view. Nevertheless, to help give some clarity, I’ve managed to boil down global economic insights into just a handful of key points. Starting with the UK… Short term growth restrained, drivers of growth later on uncertain…
In terms of the three stages required for a self-sustaining recovery…
1. Stimulus – yes, we’ve seen quantitative easing but are we seeing LENDING (to businesses, consumers etc – remember consumption still accounts for a large % of GDP)?
2. Inventory Rebuilding – yes we’ve seen temporary re-stocking but are we seeing consumers SPENDING?
3. Job Creation – are jobs no longer at risk i.e. a SELF-SUSTAINING recovery?
Conclusion: The UK “aint there yet!”
1. Versus stimulus we are to see – THE LARGEST FISCAL SQUEEZE SINCE WW2…
And lending remains muted:
“Despite various forms of support from the Bank of England and from Government, it is clear that the lending capacity of the banking system, in the UK and elsewhere, is impaired and will take some years yet to recover. Some banks need to continue de-risking and de-leveraging.” Paul Fisher – Executive Director Markets and member of the Monetary Policy Committee
2. Instead of spending, governments, households and companies are DE-LEVERAGING, CONFIDENCE IS LOW, household spending restrained
In Rebecca Wilder’s article in her blog Household leverage: what does the US have that the UK does not? in News N Economics (her answer: they still have expansionary fiscal policy) the chart featured below highlights the extent to which households still need to de-lever (and a comparison of the heightened problem in the UK vs. the US)
3. Job creation? Following on from the government’s public spending review – 750k public sector jobs are at risk
INVESTMENT INSIGHT – Conditions for a sustainable, strong recovery are “still not there yet”
Returns are to be generated opportunistically – in a lower growth environment, index moves may be range bound – capture alpha from the volatility – quality stocks that are over-punished during pullbacks. Instead of investing in companies focusing on UK sales, invest in those more internationally focused (especially EM).
Stock example – RR/ LN: Rolls Royce Group PLC (more on the car manufacturer next), the global power systems company, “signs agreement with STX Engine Company to further strengthen position in Asia” October 2010 (Rolls Royce Announcement)
“STX Engine, based in Korea, will become a packager of Rolls-Royce industrial gas turbine generating sets in the Asia Pacific region to better serve the growing demand for electrical power generation technology and will further strengthen our position in important Asian markets such as Bangladesh, Philippines, Taiwan, Vietnam and also Korea”.
“American households have shifted their cash flows from illiquid real estate and consumer durables to paying down mortgages and consumer debt…It is this rapid rise in aversion to illiquid risk that explains a large part of the anaemic recovery in the US.” Greenspan
DRIVER OF REVIVAL: The US consumer has historically been a crucial driver of economic renewal
PRECARIOUS POSITION: Many worried about employment, have under-saved for retirement
STIFFLED STIMULUS: The propensity to spend (and boost the economy) will be limited
The importance of the consumer and the concerns surrounding the structural headwinds they face are undeniable. Consumer spending accounts for approximately 70% of US GDP (although I’ve read an interesting piece by Darren Marron arguing this figure is actually nearer 60% when spending on imports are dealt with more appropriately but nevertheless, this is still a significant percentage). The magnitude of the problem has been well described by John Maudlin who pointed out that versus the last recession, we have seen “double the asset deflation, triple the job loss, coupled with a collapse in credit.” It doesn’t look likely that the consumer will be bouncing straight back!
On the subject of unemployment, although it is universally monitored, what has been missed by many is what the rate does not take into account. Salaries have been cut and working hours reduced. This adds to the misery of many consumers. Furthermore, it is these people who are working part-time that will be hired back into full-time employment before companies reach out to the many unemployed. This must be assessed within the context of an expanding labour force where a substantial amount of new jobs are needed every month in the US.
Looking forward, another key limiting factor on the consumers’ propensity to spend is the move to save instead, as they look to fund their retirement / non-wage earning years. The “Baby Boom” generation is expected to account for nearly 60% of net US wealth by 2015, according to a study by McKinsey, and their turnaround from spending to focus on saving will be magnified by the fact that they have historically under-saved. The aforementioned report identified that as low as only 25% are “financially prepared for retirement”, thus the decrease in the spending habits of the vast majority will be significant. Inside Europe the story isn’t much brighter and the UK pension gap (the difference between the income needed to live a comfortable retirement and the actual income individuals can expect from their current pensions) has been heralded as the “biggest in Europe” by national papers. The OECD sets an average pension at around 59% of the earnings built during a full working career, a stark comparison with the UK’s 31%. With relatively small public pension, an individual will need to make extra savings to ensure their standard of living does not drop dramatically as they move into retirement. This is not an outlook that will encourage the spending that will boost or even support the economy. (For a deeper insight into the ageing populations of the developed world see What is a \”Structural limitation to growth\”? How can I exploit it?)
ECONOMIC IMPACT: This points to a muted recovery instead of a “V” shaped bounce-back.
INVESTMENT INSIGHT: Look at companies which aren’t as heavily reliant on the Developed Consumer but with an international reach and operations within Emerging Markets. To exploit the ageing of the “Baby Boomers” within Developed Markets, see What is a \”structural limitation to growth\”? How can I exploit it? and invest in companies positioned to benefit from an increased reliance on healthcare, nursing homes etc.