This note was originally published January 14, 2011 at 14:31 in Macro
Conclusion: Accelerating inflation globally has been a key factor in our bearish outlook for emerging market bonds and equities over the past three months. Despite our cautious stance, there are several key, non-consensus ways to play this theme on the long and short side over the intermediate-term TREND and long-term TAIL.
This morning, we came across an article that highlighted some key broker sentiment regarding emerging market investments. The article points out how Goldman Sachs and JPMorgan have been reneging on their bullish EM bets over the past few weeks and months as a result of hawkish monetary policy, instead opting for predicting outperformance by US equities.
Their retreat from emerging markets offers a tactical backboard for alpha-generating investment opportunities. Below, we’ll highlight some of the ideas we’ve been fond of on both the long and short side over the intermediate-term TREND and long-term TAIL.
For the sake of keeping this note short, we’ll be brief; simply email us if you’d like to see the research reports behind the ideas below:
COMMODITIES: FOOD – As we last saw in summer of ’08, deadly riots are breaking out globally in protest of rising food prices, currently at all-time highs. Perpetuated by global supply shortages, we anticipate a meaningful increase in import demand for many food products throughout the course of the year as developing nations look to rebuild domestic stockpiles.
- Long Sugar: Between flooding and droughts, adverse weather is causing key producers and exporters to revise down their production and export estimates (Brazil, Australia, Thailand, etc.). Further, we think market expectations of Indian stockpile rebuilding have gotten too hopeful. India is shortly removed from a major supply shock; if domestic production falters in any way, expect India to act quickly and resume imports as a way of alleviating any potential scarcity within its domestic market.
- Long Corn: Current prices – at a two-year high – are supported by a global supply/demand imbalance. Domestic stockpiles are at a four-year low and demand for the grain, which is more inelastic than supply, is sticky in the US and the rest of the world. We anticipate accelerated import demand from China in the coming months in an effort to help ease domestic food inflation, currently trending at a 28-month high of 11.7% YoY.
COMMODITIES: OTHER – Severe weather is adversely affecting many key agricultural-producing regions globally (flooding in Australia, mudslides in Brazil, etc.). Getting ahead of growing supply/demand imbalances is key, as agencies like the USDA tend to be rather hopeful with their production estimates, leading to downward revisions to their forecasts in subsequent reporting.
- Long Cotton: Because of severe supply-side issues, cotton prices have gone parabolic. Our best-in-class Retail/Apparel/Footwear Team tells us management teams have been delaying purchases of new inventory, citing high cotton prices. Last we checked, retailers need stuff to sell, so we anticipate an acceleration of corporate demand over the coming quarters as, which will only add to the current supply/demand imbalance.
CURRENCIES – As monetary policy tightens globally, several countries will see their currencies move as a result of: a) slowing global growth; b) the direction of global interest rates and rate differentials; and c) key moves in their basket of counterparts.
- Long Chinese yuan: The last time China experienced a food-price shock, it revalued its currency roughly +20% over the next three years. We look to history to remind us that nothing gets Chinese officials more nervous than food inflation/food shortages. China’s desire to curb food inflation and prevent domestic riots and famine far exceeds their desire to support exporters with an undervalued currency. China has been adverse to hiking interest rates to fight inflation of late, but should prices get further out of hand, we expect them to implement a more forceful tightening cycle. Lastly, as China revalues the yuan upward, it gives them more purchasing power of things priced in US dollars, so expect all commodities to act accordingly and appreciate, lest China soak up the world’s supplies.
- Long US dollar: Rising Treasury yields, which are being dragged higher by rising global bond yields and heightened inflation expectations are supportive of a stronger US dollar. In addition, the combination of a growing fear of emerging market tightening mentioned above and an illusion of accelerating US growth has many investors opting for US equities instead. Further, the dollar receives incremental bids as investors cash out of EM investments and into US stocks.
- Short Gold: With real interest rates trekking steadily upward and the US dollar following close behind, gold prices come under pressure as this commodity is forced to join the competition for yield. Further, sober fiscal policy in the US (or at least the talk thereof) keeps a lid on the “Fear of Government” trade – at least for now.
- Short the Japanese yen: After being trapped in a deflationary spiral since the early 90’s, Japan might be the only country in the world that welcomes inflation with such earnest. In fact, Japan may opt for additional monetary easing over the next three months if domestic growth comes in at the low end of our estimates. Japan, an economy leveraged to manufacturing and exports, will feel the brunt of a slowdown in global growth which is being perpetuated by global tightening. Lastly, as a key constituent in the yen basket, a strong US dollar lends support to this thesis.
EQUITIES – As we have seen many times in financial market history, inflation can erode returns on equities by reducing company earnings via margin squeezes or by investors discounting slowdowns in growth as central banks tighten monetary policy. Despite this, there are ways to play this on the long and short side depending on the type of tightening measures implemented.
- Long Brazilian Infrastructure (BRXX): Like many countries globally, Brazil has been struggling with its own catch-22 in trying to balance the tightening of monetary policy with their desire for a weak(er) currency. Given, Brazil, like China, has been “cute” with its tightening measures, opting for fiscal conservatism among other things. This push has led newly-elected President Dilma Rousseff to loosen Brazil’s public sector hold on infrastructure development and opt for private sector involvement. The current mudslides in Rio present a major opportunity for her to prove she’ll let capitalism take hold in this burgeoning industry. Key long-term catalysts are Brazil hosting the World Cup in 2014 and the Summer Olympics in 2016.
- Short Indian equities: Simply put, India is way behind the ball with fighting inflation. As we called for back in November, WPI inflected and accelerated in December to +8.43% YoY. The central bank’s recent efforts to add liquidity to its banking sector only exacerbate this headwind. Of all the countries we monitor, India is likely to have to tighten monetary policy the most in 2011, crimping domestic growth alongside a compression in corporate margins from higher input costs.
- Short Japanese equities: As mentioned prior, Japan is an economy leveraged to manufacturing and exports, so it will disproportionately feel the brunt of a slowdown in global growth which is being perpetuated by global tightening. Many think a weak yen is beneficial to Japanese exporters, and it is – to a point. When commodity inflation takes off globally, input costs rise because of Japan's propensity to import inflation via a weak(er) yen. This compresses margins in Japan because neither Japanese retailers nor exporters are willing to take up price as a result of their deflationary mindsets.
Please keep in mind that these are merely ideas to have on your screens and do not represent tactical calls to run out get long/short right this minute. When Keith returns from recovering from achilles surgery next week, we’ll be able to provide quantitative levels should you look to get involved with any of these ideas.
Have a great long weekend,