Saturday, 5 February 2011

Will the BRICS and US decouple, or are cracks in the BRIC's a taste of things ahead?

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 Reseach (EPFR) and which is referenced in this recent article also from the Financial Times

Investors have pulled more than $7bn from emerging market equity funds in the past week, the biggest withdrawal in more than three years….
Violence on the streets of Egypt and a jump in oil prices to more than $100 a barrel set off a wave of anxiety across developing markets.
But the fund outflows also reflected deeper unease about economic overheating in China, India, Brazil and other big emerging economies.
Emerging markets attracted record investor inflows of $95bn last year as they became a defining investment theme in the wake of the financial crisis. The latest figures have raised concern that the bull run may be about to end as investors look for value in beaten-down markets in the west.
“Since the fourth quarter, the perception of where the value lies in the equity markets has shifted pretty decisively toward the developed markets,” said Cameron Brandt, global markets analyst at EPFR, which tracks the fund movements.

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.

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.

The chart below for the Shanghai Composite index shows that this key BRIC index topped out around 3200 in early November 2010. Since this most recent peak the index has retreated by almost 600 points, touching an intraday low of 2661 on January 25th of this year.

The decline in the Shanghai index has been, from a technical perspective, remarkably in conformity with certain key fibonacci levels. The move down from the top in November to the low seen on January 25th was almost exactly 62% of the range between the high and low values seen on the chart. The recovery back towards the 38% level will be especially critical for this index as this level is also an area of technical resistance. The 50 day moving average (exponential) has intersected with the 200 day average, and if, in fact, the index fails to maintain its recovery mode and there is a crossing of the shorter term average below the longer term average, this would actually constitute a so called death cross which, as the name suggests, is not a healthy development in technical terms.

The way in which prices develop on this index in the coming weeks will be vital to monitor as the trend line up from the lows seen in the summer of 2010 has clearly been violated, and the risk is that if the index fails to regain the levels seen in mid December a succession of lower highs would suggest that the correction has further to run.

The relatively weak performance of Chinese equities sets the backdrop for the remainder of this discussion which will focus on two other BRIC markets.

Recently I presented charts showing the negative reaction in two of the other key BRIC markets in a televised slot for Reuters Insider which can be seen here.

The first chart to consider is that for the Mumbai Sensex index which has fallen by more than 15% since reaching a high above 21,000 on November 5th (recall that this was almost exactly to the day that the US dollar index turned upwards after the QE2 ratification).

The key factors with regard to the Mumbai index are the notable failure in mid January - shown as B on the chart - for the index to reach back to its November peak - marked A on the chart. Also evident is the recent price action which has brought the index to the somewhat critical 18,000 level. The index closed on Friday (Feb 4th) just above this level which also is a 62% retracement of the entire high/low range seen on the chart.

Moving beyond the technical patterns there are undoubtedly some key concerns that are undermining the confidence of global and local investors in Indian equities. 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 analagous to the notion that one can tame a King Kong like gorilla by administering a mild sedative.

The final market to consider in this overview of unsettling developments in the BRIC's is Brazil. The extent of food price inflation in Brazil, according to the official government statistics, is far less alarming than the 17% figure seen in India, and is currently estimated to be around 6% on an annual basis; but there are unofficial estimates that place the figure considerably above this level.

The losses seen on the Bovespa index have so far been less than 10% but the potential exists for a further slide in this index. The inflation-targeting program established by the Brazilian government requires that above target inflation has to be held in check and this will almost certainly lead to further interest rate hikes.

The base rate in Brazil is already at 11.25%, and in a recently released central bank survey, Brazilian economists have projected a rise to 12.50% by the end of 2011.

The usefulness of fibonacci retracement targets in forecasting potential price targets and support/resistance levels is well illustrated in relation to the weekly close for Brazil’s Bovespa Index. On February 4th the index closed at 65,269 which was almost exactly the level indicated in the broadcast slot above and in my daily commentary which was published early on February 3rd and which is available here.

The thesis being proposed is that the three BRIC economies examined in this piece have all reached key retracement levels where there are two contrasting outcomes.

The more positive outcome 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?

There are several ETF’s that enable investors to have exposure to some key emerging markets and these include EWZ, which tracks the MSCI Brazil index; INP, which tracks the MSCI India Index; IDX, which tracks the MSCI Indonesian market; ILF, a fund which tracks the Top 40 Latin American equities, and which provides exposure to Brazil as well as Mexico. These are all relatively large and liquid exchange traded funds and there are also inverse funds for taking a short position with respect to BRIC and emerging markets in general.

BZQ ProShares UltraShort MSCI Brazil
EDZ Direxion Daily Emrg Mkts Bear 3X Shares
EEV ProShares UltraShort MSCI Emerging Mkts
FXI iShares FTSE China 25 Index Fund

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