Tuesday, September 29, 2015
The fourth quarter is a good time to start thinking about the outlook for the global economy and markets not just for rest of the year but for the following year and for the following year as well. The independent and well regarded research firm BCA produces a quarterly strategy update which covers the global economy and markets (US, Europe, Japan, China, EM) as well as specific investment ideas, and given their remarkable track-record (turning cautious on global markets in June after being bullish since 2009, bearish on EM currencies and commodities since last year, ending of the US dollar bull run earlier in March) it is advisable to pay due heed to their research. To summarise:
-The global economy is expected to muddle along a below trend pace this year, but should pick-up some steam next year driven by successful efforts by China to reflate their economy and the resulting recovery in EM economies. However, the shortfall in aggregate demand will keep inflation subdued and will keep rates low for years to come.
-US growth is currently averaging 2.3% for the year, which is in line with growth over the previous five years, and looking ahead it is unlikely to deviate much from the 2% rate. While some developing tailwinds should provide support - like the positive impact of lower oil prices on consumption, a normalization of the 30% drop in energy capex spending, and a diminished fiscal drag which has subtracted 0.50% from GDP growth over the last five years (assuming no government shut down later this year). They are likely to be offset by fading tailwinds from loosening in lending standards, improving business and consumer confidence, rapidly rising asset values, zero rates, and finally a normalization of the recession induced pent-up demand (i.e. auto sales).
-The remarkable feature of the US recovery has been that a meager 2% growth rate has reduced the unemployment growth rate from 10% in late 2009 to 5.1% , which based on the pre-crisis relationship should have kept unemployment at around 10%. This is due to the exceptional decline in labour productivity (see chart below) driven by both structural factors (flattening out in the rate of educational achievement, disappointing gains from the latest technologies) and cyclical factors (low levels of business investment, misallocation of labour).
-An enduring feature of the sub-par recovery since the crisis has been the shortfall in demand. While the adverse impact of deleveraging on demand has been well documented, what has been missing is a new re-leveraging cycle to bring demand back to pre-crisis levels. For example, residential investment is currently 3.4% of GDP, and while it may go back to 4%, it is very unlikely to go the pre-crisis level of 6% which means that 2% of GDP has just vanished.
-This fall in demand is unlikely to be replaced by increased consumption (as savings are higher), increased investment (as labour force growth is falling implying less demand for building capacity), increased exports (due to a stronger dollar) or higher government spending (political considerations).
-The possible way out is that rates remain low for an extended period (the above analysis assumes rates move back to pre-crisis levels) which could spur consumption, increase investment in marginally profitable projects made possible by low rates, stronger exports due to a weaker dollar and higher fiscal spending due to low borrowing costs.
-How low should rates be? With short-term real rates averaging only 1% during the previous business cycle (see chart below) when all the above factors were major tailwinds, it is safe to assume that real rates should stay at zero or even negative for the foreseeable future.
-By contrast, Europe with is poorer demographic profile and dysfunctional institutions, will need continued zero or even negative nominal rates to support the economy and the risk is that it may not be able to ease financial conditions sufficiently to prevent a Japanese style deflationary spiral.
-While official forecasts (IMF, European Commission) expect a rebound in the peripheral economies to support European growth, the signs are that this may prove to be difficult. For example, the IMF expects Italian growth to pick-up driven by increased investment by the private sector to offset the increase in government austerity (thereby reducing the debt/GDP ratio) , but this is unlikely given their shrinking labour force and lack of competitiveness, forcing the government to increase spending (and therefore increase the debt/GDP ratio) or face stagnant growth.
-Therefore, the longer term prognosis for Europe implies a resurfacing of the debt crisis at some point, though over the next 12 months we are likely to see a surprise on the upside driven by lower oil prices, a weaker euro, improving credit markets (see chart below which shows the almost perfect correlation between credit growth and GDP) and pent-up demand from the recession.
-Moving to Japan, while the economy faces numerous challenges like a declining working-age population, disappointing productivity growth (output per hour remains 36% below US levels), a high government debt level limiting fiscal stimulus , and a relatively higher vulnerability to EM economies, it is important to note that falling property prices and corporate deleveraging have largely run their course. In addition, Abenomics seems to be working with inflation expectations rising sharply and pushing down real rates by almost 2% (see chart below), and the prime age employment-to-population ratio has risen by 3% and is now 5% higher than in the US.
-EM economies have suffered greatly from an outflow of liquidity this year, a reversal of the massive inflows which took place until a few years ago. A lack of structural reforms during the boom years led to a significant fall in productivity outside of Asia (see chart below) and the credit deleveraging cycle is still in its early stages with Turkey, South Africa and Brazil being most vulnerable.
-Growth in China is slowing down driven by a slowdown in demand for its exports, the government’s anti-corruption drive which has reduced consumption of luxury goods, and as it transitions from a capital intensive export-oriented economy to more focus on consumption and services (see chart below).
-However, policy makers have the tools in place to ensure that the transition does not disrupt economic growth in a significant way. The cuts in rates and reserves seem to have caused a rebound in the housing market with both sales and prices accelerating recently (see chart below). In addition, the fiscal measures to boost infrastructure spending announced recently should add 1% to annual GDP growth over the next three years. On the negative side, the recent mini-devaluation of the yuan was botched as the move was not meaningful enough resulting in capital outflows which offset some of their easing measures. Expect the yuan to depreciate by another 5-8% against the dollar.
-China is likely to avoid a hard landing – firstly, their debt is mainly from state owned banks to local governments and SOEs and arguably these could be netted out as its one part of the government lending to another. Secondly, the housing market has very low debt levels with mortgage debt at 19% of GDP (versus 74% in the US) and loans to developers at 10% of GDP versus 30% in pre-crisis Spain. Even if housing prices fall sharply, the correct analogy would be Hong Kong, which despite suffering precipitous price declines during the Asian financial crisis, saw only a marginal increase in mortgage default rates compared to the US and Spain.
-Claims that China overinvests are also somewhat misleading, as despite the capital-to-output ratio moving higher in recent years it is still lower than it was in the late 70s (see chart below) . This is because the optimal level of investment depends on the growth rate – while China has invested heavily its economy has also grown substantially keeping the capital-to-output ratio in check and well within the range of other countries (see second chart below).
-China is expected to maintain a relatively strong growth rate for years to come driven by its exceptionally high educational attainment level for its stage of development (see chart below). For example, if China’s output per worker were to converge with the level of South Korea by mid-century(currently at 30%), it implies a growth still averaging 7% over the next decade.
-Remain tactically cautious on equities (since June 12, 2015) given the fragility in emerging markets, the uncertainty surrounding a Fed rate hike in December and the collapse in global earnings (see chart below).
-However, remain cyclically bullish (have been since October 2009) using the late 90s as the template, when every major sell-off proved to be a buying opportunity. While some factors differ from the late 90s – i.e. EM are a bigger part of the global economy and DM central banks have less room to cut rates, valuations are much more attractive now with global equities at a forward P/E of 16 (compared with 25 in the late 90s) and at 2 times book (versus 4 times in the late 90s). Europe and Japan are preferred over the US given their more attractive valuations and favourable liquidity conditions. So remain cautious for now and use a 10% or more pullback to increase exposure.
-Remain cautious on EM over the near term and use a further sell-off of 15-20% to add risk. While EM stocks have got cheaper, and trade at a low 12 P/E, this reflects depressed valuations in a few heavy weight sectors like energy, materials and financials, and they still trade at a relatively high median 19 P/E (same for price-to-book).However, the Chinese stimulus should provide a boost to global growth in 2016 which would support the cyclical sectors in EM, and in particular, China H-shares which trade at record low valuations despite earnings and dividend growth which have far exceeded the US over the past decade (see chart below). They represent the single best current trade idea over the long haul.
-US treasuries remain cheap given 10-years at a fair value of 1.5% (with Fed funds remaining in a 1-2% range for reasons outlined earlier and other fundamental reasons), though in the near term they are vulnerable to a sell-off. Typically during past tightening cycles, long rates sell-off during the months preceding the first tightening, then stabilise and actually decline over the cycle. Long treasuries also provide a good hedge against stock market risk, as evidenced by the negative correlation in place since the 2000s which is in sharp contrast to the previous three decades (see chart below).
-The dollar is expected to continue to be range bound against the Euro and Yen while appreciating against commodity and EM currencies for the balance of the year.
Fascinating insights which I broadly agree with. As detailed in last weeks letter, the current uncertainty surrounding the flow of liquidity warrants a cautious approach and the need to raise cash if we do get a rally into year-end, to be redeployed if we get the 10% plus correction in DM equities (and more in EM). Over the longer haul, EM equities (in particular China and India) and currencies provide superior expected returns implying that core portfolios should continue to favour EM assets. The continued Chinese stimulus should also provide good upside to Russian and Brazilian assets in 2016. Perhaps the single most important variable to keep a close eye on in the coming months is the monthly Chinese M2 growth number as it encapsulates the net effect of all the Chinese easing measures (besides being more reliable than other economic variables) which have a significant impact on global markets. As the chart below illustrates clearly, monthly M2 growth dipped to 10% in the summer, the lowest level in more than 17 years, but since then has moved up sharply in the past three months in response to policy measures. Please also note the relationship between falling money supply growth since its peak in 2010, and the slowdown in EM economies (with the US escaping the slowdown due to its QE policy implemented in late 2010). Chinese money supply growth is key - equivalent to $21 trillion versus $12 trillion for the US!
Monday, September 28, 2015
Aluminum giant Alcoa is splitting itself into to two public companies: Upstream Company and Value-Add Company.
The names of the companies speak for themselves. Upstream Co. will be involved in getting the stuff out of the ground. Value-Add Co. will turn that stuff into a workable product for its customers.
"The globally competitive Upstream Company will comprise five strong business units that today make up Global Primary Products - Bauxite, Alumina, Aluminum, Casting and Energy," management explained. "The innovation and technology-driven Value-Add Company will include Global Rolled Products, Engineered Products and Solutions, and Transportation and Construction Solutions."
Management expects the action to be completed in the second half of 2016.
“In the last few years, we have successfully transformed Alcoa to create two strong value engines that are now ready to pursue their own distinctive strategic directions,” CEO Klaus Kleinfeld said. “After steering the Company through the deep downturn of 2008, we immediately went to work reshaping the portfolio."
"We have repositioned the upstream business; we have an enviable bauxite position and are unrivalled in Alumina, we have optimized Aluminum, flexed our energy assets, and turned our casthouses into a commercial success story," Kleinfeld continued. "The upstream business is now built to win throughout the cycle. Our multi-material value-add business is a leader in attractive growth markets. We have intensified innovation, made successful acquisitions, shed businesses without product differentiation, invested in smart organic growth, expanded our multi-materials profile and brought key technologies to market; all while significantly increasing profitability.”
Saudi Arabia has withdrawn tens of billions of dollars from global asset managers as the oil-rich kingdom seeks to cut its widening deficit and reduce exposure to volatile equities markets amid the sustained slump in oil prices.
The Saudi Arabian Monetary Agency’s foreign reserves have slumped by nearly $73bn since oil prices started to decline last year as the kingdom keeps spending to sustain the economy and fund its military campaign in Yemen.
This month, several managers were hit by a new wave of redemptions, which came on top of an initial round of withdrawals this year, people aware of the matter said.The central bank is also turning to domestic banks to finance a bond programme to offset the rapid decline in reserves.
“It was our Black Monday,” said one fund manager, referring to the large number of assets withdrawn by Saudi Arabia last week.
Institutions benefited from years of rising assets under management from oil-rich Gulf states, but are now feeling the pinch after oil prices collapsed last year.
Nigel Sillitoe, chief executive of financial services market intelligence company Insight Discovery, said fund managers estimate that Sama has pulled out $50bn-$70bn over the past six months.
“The big question is when will they come back, because managers have been really quite reliant on Sama for business in recent years,” he said.
Since the third quarter of 2014, Sama’s reserves held in foreign securities have declined by $71bn, accounting for almost all of the $72.8bn reduction in overall overseas assets.
Other industry executives estimate that Sama has withdrawn even more than $70bn from existing managers.
While some of this cash has been used to fund the deficit, these executives say the central bank is also seeking to reinvest into less risky, more liquid products.
“They are not comfortable with their exposure to global equities,” said another manager.
Fund managers with strong ties to Gulf sovereign wealth funds, such as BlackRock, Franklin Templeton and Legal & General, have received redemption notices, according to people aware of the matter.
Some fund managers have seen several billions of dollars of withdrawals, or the equivalent of a fifth to a quarter of their Saudi assets under management, the people aware of the matter said.
Institutions such as State Street, Northern Trust and BNY Mellon have large amount of assets under management and are therefore also likely to have been hit hard by the Gulf governments’ cash grab, the people added.
“We are not that surprised,” said another fund manager. “Sama has been on high risk for a while and we were prepared for this.”
Sama has over the years built up a broad range of institutions handling its funds, including other names such as Aberdeen Asset Management, Fidelity, Invesco and Goldman Sachs.
BlackRock, which bankers describe as the manager handling the largest amount of Gulf funds, has already reported net outflows from Europe, the Middle East and Africa.
Its second-quarter financial results reported a net outflow of $24.1bn from Emea, as opposed to an inflow of $17.7bn in the first quarter.
Market participants say the outflow is in part explained by redemptions from Saudi Arabia and other Gulf sovereign funds, such as Abu Dhabi.
Saturday, September 26, 2015
As the stock price of China’s online retail giant Alibaba Group plunges on account of slowing growth and question marks over the company’s accounting policies and business model, investors fear a ripple effect on valuations of e-commerce companies in India.
The funding boom in India of the past 20 months was at least partly driven by the success of Alibaba’s initial public offering (IPO), which was the largest ever share sale and valued the company at more than $230 billion. It spurred hope that India, the next big online retail market after China, could also produce valuable e-commerce companies. Eager investors pumped more than $8 billion into Indian start-ups. Tech investors in the US, Europe and Asia, who either missed out on Alibaba’s IPO or were enriched by it, queued up to invest in India’s e-commerce companies.
It’s a different matter that, time and again, investors and companies attracted by comparisons of India’s consumption potential with that of China’s market reality have inevitably been disappointed.
Now that question marks have emerged over Alibaba’s perpetual motion engine, venture capital (VC) firms and other investors said they will be more cautious on late-stage deals in India, conduct stricter due diligence and demand higher transparency and disclosure from current and potential portfolio companies.
Since Alibaba went public last September, the company’s market value has plunged to less than $160 billion from a peak of more than $250 billion. In an article published earlier this month, Barron’s, a US-based financial weekly, predicted Alibaba’s stock may fall by up to 50% and criticized the company’s accounting and corporate governance and said its claims of high user numbers and spending were inflated.
Alibaba fired back and said the Barron’s article contains “factual inaccuracies and selective use of information, and the conclusions (it) draws are misleading”.
Whatever happens to the Alibaba stock, e-commerce investors are already turning cautious on emerging markets, especially India.
“Clearly, the sheen has been taken off (Alibaba’s IPO); the IPO was a major event in the funding boom of the past year or so,” said an investor in Flipkart, speaking on condition of anonymity. “In India, late-stage valuations are already showing signs of plateauing and it’s clear they will not increase with the ease they did in the past year. Now, when new investors are evaluating Indian companies, they are doing more due diligence and asking about structures and corporate governance because they’re seeing the scrutiny Alibaba is being subjected to. These kinds of questions weren’t asked with such seriousness earlier.”
Executives at five other venture capital firms confirmed that they were doing this.
There are some close connections between Alibaba and India’s e-commerce business.
SoftBank, Tiger Global and DST Global, all three of which are currently writing the largest cheques for Indian e-commerce firms, backed Alibaba. Another shareholder in Alibaba, Temasek Holdings Pte. Ltd, which is Singapore’s state-run investment firm, is an investor in Indian e-commerce as well as a limited partner (LP) in some VCs. LPs put their money into VCs, which in turn back start-ups.
Japan’s SoftBank, in particular, has taken a direct hit from the drop in Alibaba shares as it owns roughly a third of the Chinese company. Alibaba itself is an investor in Snapdeal (owned by Jasper Infotech Pvt Ltd) and its affiliate Ant Financial backs One97 Communications Ltd-owned Paytm.
These linkages pose a threat to the funding rush into Indian start-ups that is already showing signs of ebbing as profits and viable business models still elude e-commerce companies, Mint reported on 24 August . Alibaba’s declining stock price played some part in the slight but sure shift in investor perception toward Indian start-ups and any further hit to Alibaba’s image may make a funding slowdown worse, investors said.
LPs are already asking VCs to go slower on deals because of the controversy surrounding Alibaba, a prolific early stage investor said on condition of anonymity.
There will be some negative impact on valuations, particularly for late-stage companies because of the controversy surrounding Alibaba, but that is not a “bad thing”, said Amit Anand, managing partner at Singapore-based VC firm Jungle Ventures.
“Such a correction is healthy and it will eventually build confidence among investors. While some fly-by-night investors will exit or avoid India because of the Alibaba impact, people who are serious about investing in India will continue to put in money because of the massive potential,” Anand said.
For the best part of a decade the popularity of premium brands has been one of the most striking features of Latin America’s rapidly growing consumer economy.
But in the last couple of years, a different trend has started to emerge. With economies slowing, unemployment and debt burdens rising, many households are under financial pressure and shoppers are starting to rein in spending.
“More and more people are worried for their jobs, and are economising,” says Luciana Hope, a 43-year-old housewife who lives in an upmarket district of Salvador in Brazil’s north-east.Families that may have freely spent on an Apple iPhone or L’Oréal face cream are looking at cheaper alternatives.
In the past few months, she has swapped her tried and tested Omo washing powder for discounted Ariel, used Ypê fabric conditioner instead of Comfort and Seda shampoo rather than the more costly TRESemmé.
When Ms Hope’s friends and neighbours go out, they are choosing cheaper trendy Skol beer rather than the more expensive spirits or cocktails they might recently have preferred.
The trend is particularly strong in Brazil’s economy which is expected to contract by about 2 per cent in 2015. However, the region as a whole is set to stagnate this year, so confidence is subdued elsewhere too. Regular surveys of 6,500 consumers in six Latin American countries conducted in recent months by FT Confidential Research, show confidence edging lower even in countries such as Colombia and Peru that are expected to grow by more than 3 per cent this year.
Across the region, the research shows a steady increase in the number of consumers who are attaching more importance to price than to quality. In June 2015, for example, 19 per cent of respondents said price was the most important consideration when buying food compared with 16.4 per cent nine months previously. Price was also a more influential factor when it came to buying clothes and personal care products, becoming the main concern for 41.5 per cent (up from 38.8 per cent) and 34.4 per cent (up from 31.1 per cent) of respondents respectively.
“We are seeing depremiumisation as Latin America passes through a moment of crisis,” says Eduardo Tomiya, managing director for South America at Millward Brown Vermeer, a marketing consultancy in São Paulo.
In the group’s latest compilation of the top 50 most valuable Latin American brands, five relatively cheaper beers, four of which are made by AB InBev, the beer giant of which Brazil’s AmBev forms a significant part, are in the top 10. Skol heads the table for the first time, taking over top position from Corona, which was the region’s most valuable brand in 2013 and 2014.
The calculations — based on the difference between an estimated market value and a brand’s tangible assets — shows economy products gaining ground in other areas too.
In the food sector, growing numbers of consumers are preferring to shop at cash and carry outlets or discount supermarkets. Bodega Aurrerá and Lider, respectively the Mexican and Chilean discount operations of the US supermarket group Walmart, both rank highly in the Millward table, with Bodega up six places to 14th and Lider up eight to 17th.
“Cash and carry has been expanding very aggressively,” says Mr Tomiya. The local operations of two international groups: Brazil’s Atacadão, owned by France’s Carrefour, and the Argentine and Brazilian operations of Spain’s El Día, illustrate the same tendency.
Many Brazilians still put a priority on upmarket shampoos, face creams and other personal care items and cosmetics, but recent research by FT Confidential showed that economy brands have been doing well this year.
Brands doing well in its most recent survey include Bic of France’s cheap disposable razors and Risque, a mainstream nail varnish made by Hypermarcas, a Brazilian consumer group known for its slick marketing campaigns.
This trend has also been very clear in the electronics sector, where the upmarket mobile phones, tablets and laptops of international manufacturers such as Apple and Samsung are still hugely popular, but less so than in recent years.
Latin Americans remain big fans of the smartphone and enthusiastic participants in social media but they are less likely to splash out on the most expensive equipment.
In June 2015, only 41.8 per cent of the 1,500 Brazilian respondents in the Confidential survey said they intended to buy an Apple or Samsung tablet over the next six months. When the survey was first conducted in December 2012, 59.7 per cent of respondents said they planned to do so.
The Millward Brown BrandZ survey, part of the broader group’s global survey, illustrates more general points.
First, Latin American brands are relatively small compared with the largest global brands. None of the leading Latin American brands is big enough to figure in Millward Brown’s table of the top 100 global brands. Skol’s brand value is estimated at $8.5bn in the research. By contrast, Scotiabank, the 100th largest global brand, is judged to be worth $11.04bn.
Second, some of the most successful brands in the Latin American table are only partly Latin American. Ambev is part of the giant AB InBev combine, formed first by the 2004 merger of Belgium’s Interbrew and Brazil’s Ambev into InBev and then by Inbev’s 2008 takeover of Anheuser-Busch of the US. Aguila, the Colombian beer brand judged ninth most valuable, is owned by another drinks giant, SABMiller.
Third, with the partial exception of beers, Latin American brands remain locally or regionally focused. Bradesco (number four in the Millward survey) and Itaú (number seven), Brazil’s two biggest banks, are minor players outside their home country. Retailers such as Chile’s Falabella (number five) have extended their business abroad but only into relatively small regional markets such as Colombia and Peru.
In the telecoms sector Mexico’s Telcel and Telmex are ranked third and 11th, but largely by virtue of their dominance of the highly concentrated local market. The same is true in the media sector of Televisa, the media company.
Experience suggests caution is advisable in assessing the global potential of Latin American brands. Brazil’s Petrobras, the state controlled oil company that was judged the most valuable Latin American brand in 2012, has dropped out of the regional top 50.