In a bubble, Day and Night

Is it Bust or is it Boom

That frames thy fearful asymmetry?*

 (click on pictures to enlarge)

Can you feel it? That calm and soothing feeling of low volatility and heaven bound risky assets driven by green shoots and second derivatives. Well, if you can't you are excused since neither can yours truly, or more precisely; he has a distinctly difficult time seeing from where people get the idea that we are headed for a broad based global recovery. However, beauty as always lies in the eye of the beholder and whichever way you look at it would be difficult to completely deny that the three key ingredients for a global recovery (and a resurgence of carry trade) in the form of low volatility, steadily climbing risky assets, and benign credit wholesale market credit conditions certainly seem to be present in ample quantities.

Now, while it is true that the level of volatility is still higher now than it was pre Q4-2008 and indeed pre August 2007 the trend so far this year has been inexorably down which reflects the perception that the worst may be over as well as the discourse of second derivatives and green shoots which has been with us throughout Q2 2009. With respect to equities they have equally begun to nudge up and are up some 5-10% from the beginning of the year in relation to Europe and the US. If you count from the trough reach some time during the first quarter this year, the increase would of course be bigger. The strength of the recovery discourse has taken many by surprise or perhaps more precisely, it has frustrated many. For example, I take note of the fact that two of the most astute macro traders (at least in my book) are feeling decidedly puzzled by the way the market is behaving at the moment. I cannot say that I blame them. For someone who take pride in being up to date in terms of macroeconomic data and analysis one would find it difficult to track the amount of bullishness which currently appear to have taken hold.

Now, I should immediately point out that I am not blind to the existence of the second derivative. I mean, I took calculus and I can also eyeball a graph in changes when I see one. My only gripe is that it only takes the faintest of scratch in the surface of the second derivative/green shoot glamour image to see that the fundamentals have not changed and moreover that the crisis has now moved its locus away from the US and right smack into the mainland of Europe in the form of significant downside risks in relation to Southern Europe and the ongoing mess in the CEE.

Yet, who is listening to a Danish student of economics anyway?

Consider consequently that the past couple of weeks brought us Bernanke's "exit talk" testimony to congress, news that a certain Mervyn residing at Threadneedle street would beat Bernanke to the exit, news that Russia is actually seriously considering issuing (and expecting foreign investors to bite) debt to cover its 2010 deficit, news that Hungary actually lowered interest rates despite, one could easily infer, an abyss of downside in the form of a plunging forint and a liability side denominated in Swiss francs, and finally Timmy's trip to China where it seems that the main message carried was one of reassurance that the US most certainly intend to vigilant towards the rising deficit.

We could add the Q2 GDP print in the US (preliminary) put up a much better figure, - 1% annualised, than expected which has so far been interpreted as a sign of recover although yet again I think that narrating this as a sign of an impending recovery is somewhat of a stretch. Meanwhile, Europe is heading straight for deflation and although I know that some economists, especially those of the old academic guard, consistently have been pointing to the benign effects of rigidness on the downside it is very important to remember that those same prices will need to adjust in key Eurozone countries absent a currency to bear some of the burden and thus price/wage rigidity may turn out to be a curse rather than a blessing.

Where is the Recovery?

The easiest way to approach this question is perhaps to point out where the recovery isn't and here I am talking about the OECD in general. Surely, we may succeed to avoid future cataclysmic events but the something has changed and new fundamentals are taking over. For example, I seriously doubt that many people have considered what it means for the global economy that the US economy will need to run an external surplus and I also think that most people have not yet realized the consequences of the unfolding mess in Europe and the Eurozone. On the other hand I have also stressed before how I am not, after all, a permabear in the sense that I do indeed see positive signs in emerging economies such as for example Brazil, India, Chile, Turkey, and China (although the latter is different for a number of reasons). I won't call this decoupling because evidently it isn't. To stay in the jargon I would rather call it re-coupling since this is essentially what it is and one key issue is the extent to which the new global economic system will help to even out the present imbalances and what consequences this, in some sense, inevitable rebalancing will have on surplus and deficit economies respectively. In this context and although one should always be careful in quoting onself, the following from an entry back in May still sums up quite well how I see the world at the moment;

We are very much still stuck in the mire and especially so in the context of the so-called developed OECD economies where it is difficult to see where any speedy recovery is going to come from. On the other hand the world is not made up entirely by the OECD edifice and it is exactly the potential for an asymmetric "recovery" and how global monetary policy might serve to transmit such a recovery which is the topic of this entry.

For the specifics of how I see the role of global monetary policy and global liquidity I recommend you to visit the actual post. However, it is worth noting that in a world where major global central banks are destined to keep rates low for an extended period it does not take much creativity to imagine the dynamics by which the global economy may potentially move forward driven by carry trade flows financed in the developed world seeking yield in whatever economies that might be able (and willing) to absorb the tide which is coming.

As I have stressed on several occasions it is exactly this reshuffling of the global economy on the back of the financial crisis which is at the heart of the matter. One obvious consequence is thus that the global economy, at one and the same time, increasingly will be populated by an increasing amount of economies with the need (and desire) to deleverage as well as an increasing amount of economies dependent on exports to achieve economic growth. In wonkish terms, global economies will tend to move towards the same intertemporal preference for consumption and saving and since global intertemporal smoothing, by definition, occurs through current account imbalances it is not difficult to see how there is a constraint on many economies’ ability to smooth their consumption and saving decisions optimally in the case of a process of crowding in one end of the spectrum.

An obvious question here becomes; who, if any, will be the economies tilting the scale in the other direction through their ability to provide capacity (return) for other nations' desire to save more?

How are things in Emerming Market Land then?

Personally, I have tended to put my focus elsewhere than China most prominently because I think that the old narrative of the BRIC economies taking over the helm is not an adequate way to look at it. Essentially, I would put Brazil and India one one side and Russia and China on the other side since in the case of the latter they are about to grow old much before they become the economies so many people expect to become. Apart from Brazil and India I also see a fairly wide batch of emerging economies with the potential to do the heavy lifting as we move forward and I would include here economies such as Chile, Indonesia, Turkey, Morroco and a number of others. Much more than quibbling about the actual candidates here I want to emphasise the importance in realizing how this global realignment won't take place with the emergence of one single economy taking over from the US, but rather with a "basket" of economies/currencies driving the realignment.

Having said all this, it is pretty difficult to get around the fact that everything seems to be revolving around China at the moment. More specifically fears are growing that in an effort the counter the global recession and in a world where 6-8% growth rates are, in general, difficult to come by Chinese authorities as well as foreign investors are fuelling a bubble in China which may look like the one currently unravelling in e.g. the Baltics look minuscule [quote from Bloomberg and the FT]. Thus and even though I would argue that the analysis should have a different fundamental focus it is still cast in the perspective of, first China and then the BRICs in general.

The BRIC nations, which also include India and Russia, have the four best performing stock markets in dollar terms this year among the world’s 20 biggest, according to data compiled by Bloomberg. China’s Shanghai Composite Index has soared 85 percent in dollars while Brazil’s Bovespa Index rose 77 percent. India’s Sensitive Index, or Sensex, climbed 61 percent and Russia’s RTS Index gained 60 percent. The Standard & Poor’s 500 Index in the U.S., by comparison, is up 8.4 percent while Japan’s Nikkei 225 Stock Average rose 7.5 percent.

Investor appetite for emerging-market assets is building on speculation that countries such as China and Brazil will be among the first to recover from the worst global recession since World War II, said Vinicius Silva, New York-based emerging markets strategist for Morgan Stanley. “It highlights the fact that demand for emerging-market assets remain strong and that companies, particularly in the BRIC markets, are using the improvements in capital markets to raise capital,” Silva said.

(FT)

Shares in Shanghai and Hong Kong tumbled on Wednesday as investors snapped up two newly listed mainland construction groups while selling down the rest of the market after reports that China’s central bank might rein in bank lending. Shares in China State Construction Engineering rose by as much as 90 per cent on their debut before closing 56 per cent stronger in Shanghai. China’s largest house-builder had last week raised Rmb50.2bn ($7.34bn) in the world’s biggest initial public offering since Visa raised $19bn in March 2008.

It is way beyond the scope of this post to open the box on what is really going on China. In terms of that topic I reserve the right to deal with it later and refer, thus far, to my styling on Blake above. However, I did like the recent analysis by Morgan Stanley's Qing Wang in which he talks about whether China is over-investing or over saving as well as the very relevant question of where the money would be spent were it not being used to finance the massive infrastructure investment program. Or, what is the opportunity cost of China's fixed asset investment program?

Given China's high national savings rate, from the perspective of the economy as a whole, there are only three forms in which China can deploy its savings: 1) onshore physical assets; 2) offshore physical assets; and 3) offshore financial assets. Since China maintains tight controls over outbound capital flows, about 70% of China's total offshore assets are in the form of official FX reserve assets as a result of investment made by a single-largest investor - the central bank. Moreover, we estimate that about 65-70% of China's official FX reserves are invested in US dollar assets, the bulk of which are US government bonds.

In response to this I ask the simple question. What is actually the capacity in China to create return on current and future investment of the magnitudes we are talking about both in the context of money supplied by domestic stimulus packages as well as foreign money thirsty for yield? Wang touches exactly upon this question as he questions just how much China can suck up. I would put it much more bluntly. China's capacity is declining and will continue to do so as we move forward as a result of the ageing which the one child policy is set to produce. This is really the missing story on China at the moment I feel and one story which could go a long way to differentiate the story. In this respect I do agree wholeheartedly with Michael Pettis when he says;

I have warned for a long time that it would be very difficult for China to make the necessary transition to a consumption-led economy quickly enough to accommodate the global adjustment taking place. Unless it is willing to see its economy collapse, there is simply no way China can reduce its negative net demand quickly enough to match the contraction in US demand and so avoid squeezing the hell out of the global tradable goods sectors. That is why policy coordination is so important, especially between China and the USD, and of course that is why I continue to be a pessimist. I do not think this policy coordination is taking place. I will write about this more later this week.

The only thing I would add is that this is not simply a question of correcting US-China imbalances, but a more more deep rooted issue in terms of fundamental drivers of international capital flows and the future supply of net capacity.

Moving on to safer ground I recently did a lengthy analysis on Chile in which I concluded that the economy was one of to watch for relative good news in relation to the financial crisis. Recently, we learned how Chilean banks booked a healthy US 959 million profit in the first half of 2009 and although this number is useless in itself I think that it is pretty obvious from digging into the specifics (see article) that although Chile financial sector has seen its share of losses, the picture is a lot less dire than elsewhere. In fact, if we look at one of graphs that I showed in my analysis of Chile, we see that financial services have held up remarkably well during the financial crisis (see also here), no doubt due to strong underlying fundamentals as well as a very aggressive policy reaction from the central bank. 

Generally, analysts and local observers in Chile are beginning to notice green shoots with increasing regularity and unlike the ones observed in Europe or elsewhere in the OECD I am more confident that the ones in Chile are going to be long lived although 2009, in all likelihood, will be a tough year when the chapter is closed. The following quote is from Bloomberg;

Chile’s economy may be starting to recover from its slump as extra government spending spurs growth, Finance Minister Andres Velasco said today. Velasco has spent more than $4 billion this year on tax cuts and extra outlays. He will pull $8 billion from Chile’s offshore savings funds in 2009 to help pay for the stimulus as well as to plug the budget deficit caused by slowing growth and lower receipts from mining.

Chile is facing the deepest recession since 1999 after revenue from exports declined and a virus ravaged its salmon farming industry. The economy shrank faster than forecast in the first half and probably contracted in the second quarter from the first, the central bank said on July 8.

“These policies have effects, but they don’t occur overnight, they don’t happen in one month or one quarter,” Velasco said. “We have to continue working, we have to keep a cool head and at the same time be prudently optimistic.”

Now, Velasco has a distinct interest, of course, in spinning the story in a certain way but until evidence surfaces to the contrary I am willing to buy this story. More generally, the influence of China also pops up in the context of copper prices where many suggest that a large part of the recent increase in Copper prices (and indeed commodities) owes itself exactly to the stimulus money from China. As a side note on this, it seems that the link between rising Copper (and commodities in general) is being increasingly linked to a story of stockpiling in China and then of course, what will happen when China decides that it has had enough. This was a story I picked up on in my analysis of Chile (picked off from Macro Man) and it appears to be gaining traction as an actual analytical explanation.

Elsewhere in Latin America, Morgan Stanley's Latam analyst on Brazil Marcelo Carvalho simply throws in the towel, as it were, devotes an entire note to the link between Brazil and China and what this means for the economic growth of the former. As will come as no surprise Carvalho notes the strong link between Brazil's economic performance and commodity prices and since China certainly seems to be driving the latter, if not directly, then through its effect on overall global sentiment then the rampant growth in China may add positively to the outlook in Brazil.

Moving the perspective up a further notch and as a concluding remark on my, admittedly, selective tour of the emerging market edifice I will leave you with the recent general statement from Morgan Stanley's Manoj Pradhan;

The strong worldwide rally in risky assets since March reflects not just the relief that the worst is likely behind us, but also anticipation of a return to growth for most economies. Much is expected from Emerging Markets, particularly from Asia ex-Japan, which is expected to outperform the rest of the world. Markets and investors realize, however, that not all EM economies are alike, and some will show output growth that is lower than the 1.3% growth our global team expects from the G10 economies in 2010.

Thanks for nothing might be your immediate response here and although I agree that this is extremely general it does sum up the main discourse at the moment whether you agree or not.

Bottomline - What to Watch?

The answer to this question depends on your perspective of course but it seems abundantly clear that if the locus of the financial and economic crisis has moved from the US to the shores of Europe and in particular Eastern and Southern Europe, the corresponding locus of the recovery has moved to Asia (ex-Japan) and most forcefully China. I think it is important to understand how and why these two discourses may co-exist as we move forward.

I believe it is obviously clear that the global economy is not heading for a quick rebound here, but it is equally as clear that some economies will be able to post growth rates that are much above the mean of what the OECD is able to. In this way, one key theme to watch is how this difference is transmitted through to the global economy e.g. in the form of carry trade flows but also in the form of an evolving process by which some economies begin, and go through, their inevitable adjustment and rebalancing phase.

In this specific context I have to be more than a little bit skeptical about the capabilities of China. This is not out of an inherent disdain towards the country but, on the contrary, because I fear that China may ultimately succumb to all those hopes and subsequent load pinned on her shoulders. In this sense I think, although I acknowledge that I have presented no formal analysis to back it up, that the recovery is some way to really materialize and that it may just ultimately be bust and not boom that frames China's economy.

---

* Apologies to William Blake; and of course to Macro Man for encroaching on his territory.

Chicago, IL - April 23, 2009 - Zacks Equity Research picks Gafisa S.A. (GFA) as Bull of the Day and Johnson Controls, Inc. (JCI) as Bear of the Day. In addition, the analysts at Zacks Equity Research discuss the latest on Nabors Industries (NBR), BJ Services (BJS) and Halliburton (HAL).

Full analysis of all these stocks is available at: http://at.zacks.com/?id=2678

Bull of the Day

We are reiterating our Buy recommendation on Gafisa S.A. (GFA). We have been encouraged by the stimulus package and the new value-added tax relief recently announced by the Brazilian government.

Fourth quarter 2008 results were lower than expected, which is a clear indication that the international crisis has reached Brazil's construction sector. The recent acquisition of Tenda will enhance the company's presence in the low-income segment, which will be the focus of the Brazilian government. Thus, we expect Gafisa to benefit from the announced program in the following quarters.

Currently, Gafisa is trading at 7.7x 2009 revised EPS estimate. We reiterate our Buy recommendation on Gafisa, with a target price of US$16.25, representing a valuation between 9x and 10x our 2009 P/E, closer to the Bovespa benchmark for Brazilian stocks.

Bear of the Day

Johnson Controls, Inc. (JCI) is suffering from a weakness in its North American business, high inventory levels at the OEMs, weakening product mix, and raw material/ price squeeze. Rapid deterioration in automotive production coupled with a worsening residential market raise concerns.

As foreseen, Johnson reported losses in the second quarter of fiscal 2009. The company expects a return to profitability in the second half of fiscal 2009. These lead us to rate the stock a Sell with a target of $12.00.

Currently, Johnson Controls shares are trading at approximately 15.8x our 2010 estimate of $1.11. Our target price is 10.8x our 2010 EPS estimate.

Recent Analysis from the Analyst Blog

Nabors Beats, but Be Cautious 

Bermuda-based land drilling powerhouse Nabors Industries (NBR) beat earnings expectations in its first quarter report, released after the market's close yesterday. We would caution investors against viewing the outperformance as an early sign of land drilling revival. Historically, the land drillers lead the rest of the oilfield service/drilling space in cyclical turnarounds. We do not think that we at such a stage yet.

The North American rig count is still falling, though management did note that the rate of decline of their rig count has slowed. We have a Sell rating on Nabors shares and continue to stay wary of land drillers and other U.S. natural gas centric oilfield operators such as BJ Services (BJS) and Halliburton (HAL).

Get the most recent insight from Zacks Equity Research with the free Profit from the Pros newsletter: http://at.zacks.com/?id=2649.

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Fourth quarter 2008 results were lower than expected, which is a clear indication that the international crisis has reached Brazil's construction sector. The recent acquisition of Tenda will enhance the company's presence in the low-income segment, which will be the focus of the Brazilian government. Thus, we expect Gafisa to benefit from the announced program in the following quarters.

Currently, Gafisa is trading at 7.7x 2009 revised EPS estimate. We reiterate our Buy recommendation on Gafisa, with a target price of US$16.25, representing a valuation between 9x and 10x our 2009 P/E, closer to the Bovespa benchmark for Brazilian stocks.Zacks Investment Research

Starting off, the S&P 500 (SPX) is a long way down since October 2007.

S&P 500 (Jan 2007 to Mar 2009)

On the other hand, if we analyze the Shanghai Composite divided by the S&P500, we can see that this relation reached a peak in the beginning of 2008 when the S&P500 was already falling. More recently, in the beginning of 2009, the Shanghai Composite started to outperform the U.S. benchmark again, as it did until January 2008.

Shanghai Composite/S&P 500 (Jan 2007 to Mar 2009)

Analyzing the Brazilian benchmark Bovespa is not that different. The Brazilian index continued to climb up against the S&P until mid 2008 and started to outperform the U.S. benchmark in the end of 2008 and reached a new relative peak in March 2009.

It seems that the crisis had three different moments: in the beginning of the crisis the U.S. market was falling but emerging market were still up. In the second moment the U.S. market collapsed and so did emerging markets . In fact during the worst days between Aug 2 and Nov 2008 emerging markets under performed the U.S. benchmark.

More recently, emerging economies begun to outperform the U.S. market again. We believe this movement will be even more apparent in the following months as the U.S. dollar begin to lose ground against emerging currencies.

Bovespa/S&P500 (Jan 2007 to Mar 2009)

We understand that the outperforming trend should continue in the short-term. Even more, it is hard to have a positive view on the dollar for the foreseeable future, mainly considering the weak banking system in the U.S., extremely low interest rates, record budget deficit and rampant economic recession.

It is very likely that we will witness a rebound of some emerging markets currencies. Particularly attractive are the Brazilian Real and the Chinese RMB, since both countries have above average interest rates (particularly Brazil), a more solid fiscal situation, huge international reserves and a healthy banking system. We believe that the first movement in the local stocks will be followed by a movement in the currency and, in the particular case of Brazil, a strong reduction in domestic interest rates.

In such a scenario we continue to recommend Brazilian stocks focused in the local markets, away from the international economic cycle, with strong balance sheets and high dividend yields, which are expected to fall following domestic rates. We like Telesp (TSP), Telemig (TMB), Copel (ELP), Ultrapar (UGP) and Oi Participacoes (TNE).

Barclays PLC launched three exchange-traded funds in Brazil on Dec. 2, the first ETFs from the world's biggest ETF manager for the Brazilian market. 

The Brazilian iShares tracks three indexes: 1) the Bovespa Index, which holds the 66 most-traded stocks on the main Brazilian stock exchange; 2) the BM&F Bovespa Mid-Large Cap Index, which holds 69 stocks representing the top 85% of the market capitalization on the Sao Paolo exchange (adjusted for liquidity); and 3) the BM&F Small Cap index, which holds 71 companies representing the bottom 15% of the exchange's market cap.

Brazil is one of Latin America's biggest fund markets, and the Bovespa's profile as a major global exchange, the largest in South America, has been raised in recent years. Barclays Global Investors has plans to significantly expand its ETF staff in its Sao Paolo office over the next few years as part of its major push into South America (see story here).

Brazil's wealth soared on commodities market gains in recent years, and some of its top companies, including mining giant Vale and oil company Petrobras, had huge earnings relative to global competitors. Brazil has taken a tumble this year as the commodities markets dropped and the U.S. dollar surged, buts its long-term prospects are still positive for ETFs, as its trading volumes are already higher than those on the Mexican Bolsa de Valores. Bovespa officials said that investor demand will lead to the creation of additional ETFs and indexes before year-end.

In particular, Brazil's Multimercado fund market, essentially hedge funds of funds, are expected to be big users of ETFs. These funds are not allowed to invest a greater percentage of their assets in foreign investments. Barclays executives said the ETFs should initially attract Brazilian institutional investors and then, gradually, individual investors. Brazil still tightly controls the extent to which individual investors can invest in foreign securities, but there has been a regulatory push of late to liberalize the government policies.

BGI said the three ETFs have initial portfolios totaling about 100 million Brazilian reals (U.S. $41 million) in assets.

In the U.S., the iShares MSCI Brazil Index Fund (NYSE Arca: EWZ) has daily volume of about $1 billion, making it among the most traded ETFs, according to BGI.

More from Money Morning:

Like most other markets, Brazil has been battered by the credit crisis – the BOVESPA index is currently down 28% in October alone and no less than 52% from its peak as recently as May. It now appears to represent excellent value, with a historic Price/Earnings (P/E) ratio of only7.0.

But are Brazil’s prospects good enough to justify investing there?

Brazil was included in the “BRIC” (Brazil, Russia, India and China) group of rapidly…

Plunging oil prices and currencies, combined with tight credit markets, have formed a fiscal hurricane sweeping through Mexico, Venezuela, Brazil and Argentina.

Although oil prices rebounded 17% yesterday, a barrel of crude is down 45% from its record high of $147.27 in July.

Many Latin American countries prospered with rising oil prices. They are now in the throes of a crisis that obliterates any oil-premium safeguards for investors -- at least for the near-term.

Petro-fascist Hugo Chavez of Venezuela lost some of his bluster.

Venezuela is one of the biggest oil exporters to the US. However, American consumption has been sliding along with the overall U.S economy. The January-April 2008 numbers show a 2.5% drop to 140,000 barrels from all of 2007.

Chavez has cut oil export deals with China and Russia. But it’s too soon to tell how much is flowing to those countries.

Still, if you were in Venezuela’s Caracas stock market you probably didn’t do too horrible compared with the rest of Latin America. It’s down 5.17% over the past three months.

Investors in Brazil’s Bovespa stock market, however, did much worse. It’s down nearly 41% during the past three months -- perhaps one of the biggest surprises in Latin American economies.

Fitch Ratings forecast Brazil's economy to grow by 3.3% next year, down from an earlier prediction of 5.1 percent.

With its rapid drop, the Bovespa certainly did some severe damage to investors caught in the downdraft. But the real question to ask is whether or not it’s time to get back in at today’s discounted prices.

Brazil is among the top energy independent countries in the world, both of fossil fuels and bio-fuels. This shields it from some of the inflationary pressures racking more import-dependent countries.

Also, Brazil’s banks haven’t been ravaged by the mortgage meltdown.

The Bovespa took a hit for two reasons: 1) an overall flight to safety and 2) a related loss of confidence in an oil-producing economy.

How much lower the Bovespa will drop is anyone’s guess. But if you have guts, it may be worth a look.

When it comes to Argentina, investors can still hear the screams from the massive default of 2001. Argentina needs about $12 billion in cash to make it through next year and no one is quite sure where that money will come from.

At least, until recently, Argentina could bank on rising oil prices.

The general lack of confidence in Argentina is clearly reflected it’s stock market, the Argmerv, which is down 37.2% in three months.

Meanwhile, Mexico is getting a double-whammy with big hits to the peso and oil. The Mexican IPC index slumped 28.6% during the last three months. It seems that many investors came up on the wrong side of currency trades.

Of all the Latin American oil producers, Mexico is in pretty good shape. It has low debt and big reserves. Given its trade status with the US, it could be one of the earliest beneficiaries of a US turnaround.

On Monday, authorities halted trading on Brazil's Bovespa for 30 minutes after it tumbled 10%. Trading in Russia was frozen on several occasions in the last two weeks to prevent an all-out collapse of the market. And China's CSI Index has lost 58% of its value so far this year.

Despite recent setbacks, however, Andrew Gordon reckons Brazil is the most likely of the pack to weather the current financial storm

This from Investor's Daily Edge:

Are BRICs going to suffer the same as the U.S. and Europe? Or are they going to forge their own path and avoid the worst of the economic meltdown we are going through? Here’s what I believe...

1. Putin Painted into a Corner. The Russian economy has grown for nine straight years on the back of soaring oil and gas prices. But things have gotten so out-of-hand that Russia had to shut down trading a couple of weeks ago and pump $100 billion into its faltering banks.

Now oil prices and gas prices are down. Inflation is running at 15 percent. Its little incursion into Georgia helped spur over $55 billion of capital to flee its equity markets.

The verdict. Russia came back strong when it defaulted on its national debt in 1998. But where’s the growth to come from now? Oil output falling along with prices will prove a tough combination for Russia to overcome.

2. Chinese Leaders Hope Slowdown Is Temporary. Manufacturers in China are increasing profits at about half the pace as last year. And this is the fourth quarter in a row that economic growth has slowed. The government is now pushing growth over fighting inflation. It’s making it easier for banks to lend. And it won’t hesitate to make use of its $1.8 trillion dollar cash reserve to finance infrastructure projects – including a slew of them in western Sichuan Province where the earthquake hit last May. Is it enough to reignite growth?

Metal traders (not the speculators – these are the folks who trade the physical metals) tell me that demand for nickel has slipped but demand for other metals like copper and manganese is still running high.

The verdict. Every time you shop at Wal-Mart, you help pay for the salary of a Chinese factory worker. China has the means and motivation to keep economic growth around its current pace of 10.1 percent. But if you stop shopping, Chinese factories will go on a firing binge. And China’s economic growth spree could come to a screeching halt.

3. The Raj’s Rough Year. The Indian government has been treading a fine line between controlling inflation and keeping growth going. Inflation has slowed. But so has the economy which will be lucky to reach a rate of eight percent when the year is finished. It was expected to grow a half-to-a-percentage point faster.

With commodity prices falling and inflation at its lowest rate in five weeks, the government is once again throwing its weight behind growth. It’s expected to soon lower its prime interest rate. And that should help consumers buy cars and other big items.

The verdict. India’s high-tech low-wage English-speaking work force has a lot going for it. But its economy is closely tied to Western economies. Even though Indian banks aren’t in trouble like they are in the U.S., tight credit is squeezing a lot of growth out of the economy. Don’t be surprised to see India pulling up the rear among the BRICs.

4. Brazil Still Blazing. The government is looking at current-account deficits for the first time in several years. But that’s not the worst news. President Lula da Silva may be going soft on economic reform. It looks like labor, taxes, and social security are no longer on top of his agenda.

The economy is still going strong. Last quarter it grew over six percent. For the past 12 months it has grown 5.8 percent. For Brazil that’s fast. And unlike India and China, Brazil continues to raise interest rates to cool off inflation.

The verdict. Brazil’s vast offshore oil reserves should keep its economy going strong for the next ten years. But only if its state-controlled oil company - Petrobras - has access to global capital. The bailout could help Brazil almost as much as the U.S.

With all the hype on BRICs being the wave of the future, only Brazil could withstand the economic slowdown in the U.S. and Europe. As I said, it’s hard to talk about the BRICs as a whole. But this one thing is true. They’re not immune to the world’s economic problems. And even Brazil will suffer if the U.S. can’t solve the credit crisis.

Source: BRICs or Straw?

It was a brutally down day on Wall Street by just about any measure on Monday. And exchange-traded funds were not spared any of the punishment.

With the Dow Jones Industrial Average suffering its biggest single-day drop ever (777 points, or a loss of 6.98%), all the broad market equity ETFs received a complementary backlash, and the beating was no longer focused on financial ETFs.

The SPDR Trust (AMEX: SPY) hit a 52-week low mark of 110.97, before closing at 111.38, a 9.47% drop for the day. The S&P 500 Index was down 8.79% for the day, and the Nasdaq Composite was down 9.14%. The Dow's massive loss was not among its 10-biggest drops ever on a percentage basis, but avoiding placement in that infamous group provided little reason to celebrate.

The Diamonds Trust (AMEX: DIA) closed at a 52-week low of 104.75, down 6.40% for the day. ETFs pegged to Russell indexes also showed serious bruising.

Among the 10-largest ETFs as ranked by assets, the iShares Russell 2000 Index (NYSE Arca: IWM) was down 5.58%, and finished just short of its 52-week low of 64.10. The iShares Russell 1000 Growth Index (NYSE Arca: IWF) was down 3.68% for the day.

Outside of the equities market, but among the top 10 ETFs by assets, the iShares Lehman Aggregate Bond Index (NYSE Arca: AGG) was down 0.45%; while SPDR Gold Shares (NYSE Arca: GLD) finished the day up 2.93%, and really gained in the late afternoon after news of the bailout plan's defeat in Congress was announced. Among sector ETF giants, PowerShares QQQ (NASDAQ: QQQQ) was down 3.26%, also hitting a 52-week low water mark of 37.82.

The overseas markets fared no better than the U.S. equities fiasco. Brazil had to shut down its stock exchange, the Bovespa, after it dropped near 10%, its largest loss in a decade. The MSCI World Index dropped 6.8%, its largest drop in its 38-year history. And international ETFs shared in the bleeding.

The iShares MSCI EAFE (NYSE Arca: EFA) was down 6.67%, hitting a 52-week low of 53.08. The iShares MSCI Emerging Markets (NYSE Arca: EEM) dropped more than 4% and came close to its 52-week low of 31.21, ending the day at 31.61. At least it beat something. The Vanguard FTSE All World (NYSE Arca: VEU) was down 4.63%, falling to a 52-week low of 40.50.

The good news? Well, investors in the ELEMENTS Australian Dollar exchange-trade note saw a day during which their fund was up 9.5%, or an intra-day change of 88.95%, finishing the day just short of a 52-week high. And inverse international ETFs had a good day as well.

ProShares Ultrashort FTSE/Xinhua China ended that day up 26.59%, and the same hefty intra-day return profile was achieved by ProShares inverse MSCI EAFE and emerging markets ETFs, not surprisingly. When Asian markets open tomorrow morning, one does not need to have a fanciful imagination to hazard a guess as to which direction ETFs with significant concentrations in Asia will trend.

To what extent do you feel the U.S. economic slowdown has affected foreign banks in Europe at this time?

The US economic slowdown has hurt European banks immensely, for a couple of reasons. First, many European banks conduct a significant portion of their business in the US. Second, the slowdown in the US is spreading to Europe and the UK, and these countries are experiencing the same types of problems as in the US.

For example, Britain, Ireland, and Spain are witnessing a substantial contraction in their housing markets, which has pushed both sales and pricing into negative territory. This is particularly problematic for Spain and Ireland, where residential investment accounts for 9% and 12% of their economies, respectively, compared to 5% in Britain and 4% in the United States. This is now spreading to other parts of the economy, with the result that GDP is expected to slow.

The European Commission (EC) recently announced that Germany, Spain, and the UK economies would fall into recession this year. The German economy, the largest in euro zone, contracted 0.5% in the second quarter and the EC forecast negative growth of 0.2% for the third quarter. Spain is forecast to record negative growths of 0.1% and 0.3% in the third and fourth quarters, respectively. The UK economy is also expected to experience contractions of 0.2% each in the third and fourth quarters of 2008.

From a broader perspective, the EC forecast gross domestic product growth of 1.3% for this year in the Euro Zone, down from 1.7% previously when the EC saw no risk of recession in Europe. The EC forecast growth of 1.4% for the broader EU, which includes Britain, Sweden, Denmark and several countries in the formerly communist eastern Europe, down from 2.0% before.

This has been reflected in stock prices. For non-US banks in the Zacks universe, the median price decline year to date is 26.7% compared to a 14.9% decrease for the S&P 500. For European and UK banks only in the Zacks universe, the price drop is even worse at 38.0%.

Asia of course is boasting continually strong economic growth. Of the Asian banks under your coverage, which are benefiting most from this?

While it is true that certain Asian economies continue to grow at a reasonable pace, they are still experiencing slowdowns relative to recent growth in their economies. Others are not growing at all. For example, the Reserve Bank of India, expects GDP growth in India to fall to around 8% in fiscal 2009 (ending March) from 9% in fiscal 2008.

In Japan, the economy contracted 0.7% in the 2008 April-June quarter, translating into an annualized drop of 3.0%. This decline reflected sluggish exports and slowing corporate capital spending.

As to stock performance, Asian banks in the Zacks universe experienced a median year-to-date 26.5% decrease, with banks in India down 42.0% year to date and the banks in Japan down 16.3%.

Another strong growth area is Latin America. Do you see banks strengthening following Brazil’s upgrade to investment-level status?

Ironically, since Brazil was upgraded to investment grade by Standard & Poor’s on April 30, 2008 (followed by Fitch on May 30, 2008), the stock market has tanked. The BOVESPA index in Brazil has slumped 24.5% since April 30, while the S&P 500 is down only 9.9% over the same period. This reflects declining commodity prices, risk aversion to emerging markets in general, and global economic slowing.

For Latin American banks in the Zacks universe, the median stock price decline year to date is 21.4%, compared to 14.9% for the S&P 500.

In time, we believe that the upgrade to investment grade will be helpful to Brazil and Brazilian banks. However, this is currently being overshadowed by events on the global stage.

Overall, which are your top Buys/Sells these days?

I have two Buys: Banco Santander Central Hispano, S.A. (STD) and Unibanco - Uniao de Bancos Brasileiros S.A. (UBB).

Banco Santander Central Hispano, S.A. is the largest bank in the euro zone and the fifth largest in the world, based upon profit. Santander had total assets of €913 billion (US$1.3 trillion) in assets as of December 31, 2007, and is among the highest-rated banks in the world following recent credit rating upgrades. Banco Santander’s long-term credit ratings are AA by S&P and Fitch and Aa1 by Moody’s. We believe that Santander’s valuation is lower than it should be given its strong growth prospects relative to global peers.

Unibanco - Uniao de Bancos Brasileiros S.A. is Brazil’s fourth largest private bank, with total assets of R$150 billion (US$84 billion) at December 31, 2007. The bank offers a diverse array of products and services. Unibanco’s long-term credit ratings are Baa3 by Moody’s, BBB- by Standard & Poor’s, and BBB- by Fitch. UBB represents a good value relative to its strong growth prospects and also vis-à-vis Brazilian peers, Banco Itau (ITU) and Banco Bradesco (BBD).

Ann Heffron, CFA is a senior analyst covering foreign financial institutions for Zacks Equity Research.
"UBB" Free Stock Analysis: Buy? Sell? Hold?
Zacks Investment Research

In addition, the Brazilian business environment remains encouraging; the energy consumption in Brazil is still heated; and the short-to-medium-term outlook for energy consumption in Brazil is very encouraging. Moreover, becoming a part of the São Paulo Stock Exchange's Level 1 of Corporate Governance will enhance the positive aspects of the company. Finally, COPEL shares are trading at an attractive valuation.

COPEL's second quarter net revenue reached US$820.6 million. During the quarter, total power consumption billed by COPEL grew 5.5%. The company has a strong balance sheet with a net debt of US$206.4 million.

Presently, COPEL is trading at a P/E of 6.9x our 2008 estimated earnings. We believe the company's valuation looks highly attractive when compared to other international electric utilities and the industry mean of 16.1x, mainly considering that the outlook for the Brazilian economic growth is positive for the following quarters and the positive tariff correction in 2009. Also, the Brazilian economic plans for increasing investments in the electric energy sector are both positive signs for COPEL.

All considered, we still think there is a huge upside potential for the stock in the short term, and the company should trade closer to the BOVESPA's average. Our target price assumes a P/E of 10x 2008 EPADR estimate, close to the company's historical standards and the BOVESPA's average. Our target price is US$26.50.

Read the full analyst report on ELP

It is important to note that 2007 earnings were highly affected by the infrastructure crisis in the Brazilian airports, a problem that showed a slightly improvement in the first half of 2008. Additionally, 2008 results are now affected by high oil prices. Gol remains one of the fastest growing airlines in the world and with the acquisition of VRG the short-term growth outlook seems positive.

We were very encouraged to see that oil prices have begun to move down from the US$150 per barrel peak recently. The reaction in the airline industry was prompt. This was great news for GOL; nevertheless it is too early to be convinced that the oil problem is over.

However, we do not consider the current valuation particularly attractive, even considering that earnings will be more reasonable in 2009 since it is likely that the situation in the Brazilian airports will improve.

Second quarter 2008 results were negative and it is important to consider the short-term problems after the July disaster in the Congonhas airport, the still high oil prices and the difficult economic environment throughout the world. Currently, Gol is trading at 11.6x our 2009 estimated EPS. We set a target price of US$10.00, representing a valuation between 12x and 12.5x our 2009 P/E, in line with the valuation of the Brazilian benchmark Bovespa.

Read the full analyst report on GOL

One notable recent development has been the decision by ratings agency Standard & Poor’s to award Brazil investment grade, with the foreign currency debt rating being raised to BBB- from BB+. This decision has produced considerable debate as many long term Brazil watchers believe that the upgrade comes at a time when Brazil has all the cyclical winds blowing in her favour, and ask the not unreasonable question what happens when the weather shifts? It is clear however that Brazil has made tremendous improvements over the past decade in terms of central bank independence, reigning in inflation and setting public debt on a sound footing, so whatever the fine print details, Standard and Poor’s decision can surely not be considered an imprudent one.

As regards its external balance Brazil is rather different from many other large emerging economies since while the central bank (which has a high level of independence from government) does intervene in the spot market to try to keep a lid on the Real’s rise and to built up a “war chest” of international reserves the bank has allowed the currency to rise substantially against the US dollar (as of July the Real had appreciated by some 13% against the dollar in 2008) and Brazil has also recently opened a small but quite manageable deficit on its current account, which means that Brazil as it develops is becoming a net consumer of excess capacity in the global economy. A break-down of the current account position reveals that Brazil continues to retain a surplus on the goods balance due to the importance of commodities and food but that services and in particular a negative income account are now gradually pulling the overall balance into negative territory. This is really what one could reasonably expect in the context of an emerging economy at Brazil's stage of development.



On the monetary policy front the central bank is rapidly earning a reputation for itself as Latin America’s new Bundesbank, and governor Henrique Meirelles delivered a decisively hawkish message during the last monetary council meeting to accompany the decision to hoist rates by 75 basis points to the current 13% level. Brazil's interest rate is now the the second-highest inflation-adjusted one in the world after Turkey's. Brazil's real interest rate, or the benchmark 13 percent rate minus annual inflation of 6.06 percent, is 6.94 percent. Turkey currently has the world's highest so-called real interest rate at 7.55 percent.

This decision is the continuation of a hiking campaign set in motion in order to establish strong credentials for the central bank as an inflation fighter, and to prevent generalised inflation expectations from taking a hold among the population. The central bank is attempting to keep inflation within the the official target of 4.5% and with inflation forecast to be somewhat above that figure in 2009 the central bank is simply acting accordingly.



Such aggressive tightening is, however, not without its problems, and policy makers now face a serious dilemma. Predictably, given the state of the current global environment, the central bank's larger than expected interest hike was rapidly translated into an appreciation of the Real – pushing it to its strongest level since 1999. So far, the 13% rise against the USD this year puts the real in the pole position amongst emerging market currencies versus the USD. This position is reasonably comprehensible taking into account the recent decision to award Brazil investment grade status; this coupled with a nominal yield on 10 year government notes at about 15% and a benchmark stock index – the Bovespa – which is up approximately 10% from its January level, implying a 20% gain in US dollar term, basically mean that international investors are finding it hard not to put money into Brazil at this point in time.

Consequently, with a global credit crisis far from over, a hawkish central bank, and a hard currency making exports more difficult one could only reasonably expect the economy to slow in line with weaking global momentum. The key point with respect to the Real would be that a continuing rise will push the external balance further into negative territory. Moreover, in a likely scenario where global commodity prices somewhat pare-back their recent impressive upward movement Brazil’s external bookkeeping will further come under pressure.

Outlook on Key indicators

• 
  Following the most recent rate hike market expectations have now solidified towards further interest rate increases in the pipeline. The driving orce here will, as ever, be inflation running above the central bank's nominal target. Here at Emerginvest we see the Central Bank of Brazil aiming for a nominal rate of 15% which should be reached over the course of the next three meetings.
• 
  The Real is likely to continue to be supported by a hawkish central bank but as the external balance moves steadily into negative territory macro-fundamentals may take over, and as the economy slows and inflation comes into the target zone the central bank will once more move into loosening mode pushing the Real down in the process. A violent correction however is not expected.
• 
  GDP growth is expected to moderate in 2008 compared to the levels seen in 2007 but at this point growth projections remain solid, and we certainly see Brazil’s mid term sustainable growth rate as being above the consensus 3%-5% rate once inflation is firmly under control.

2007 Data

GDP (2007) - 5.4%
Inflation (2007) - 3.6%
Current Account Deficit -0.27% of GDP
Fiscal Deficit - 2.27% GDP
Debt to GDP ratio - 42.8%


Debt Ratings (local currency, long term)

Fitch - BBB-
S&P - BBB+
Moody- Ba1


2008 Central Bank Inflation Target - 4.5% (+ or – 2pp)

Population Median Age -29 years
Total Fertility Rate (2007) -1.88 child per women
Male Life Expectancy - 68.57 years

Development Indicators Rank (131 economies in total)

Global Competitiveness (World Economic Forum)
72/131 (2007-08)
Business Competitiveness (World Economic Forum)
59/131 (2007-08)


Selected Sub-components

Institutions - 104/131
Infrastructure - 78/131
Macroeconomic Stability - 126/131
Health and Primary Education -84/131

Short Term Data

Retail Sales Growth (May, y-o-y, volume index) - 10.5%
Industrial Output (May, y-o-y) - 2.4%
Inflation (July 2008) - 6.3%
Central Bank Interest Rate (SELIC Rate) - 13.0%

One notable recent development has been the decision by ratings agency Standard & Poor’s to award Brazil investment grade, with the foreign currency debt rating being raised to BBB- from BB+. This decision has produced considerable debate as many long term Brazil watchers believe that the upgrade comes at a time when Brazil has all the cyclical winds blowing in her favour, and ask the not unreasonable question what happens when the weather shifts? It is clear however that Brazil has made tremendous improvements over the past decade in terms of central bank independence, reigning in inflation and setting public debt on a sound footing, so whatever the fine print details, Standard and Poor’s decision can surely not be considered an imprudent one.

As regards its external balance Brazil is rather different from many other large emerging economies since while the central bank (which has a high level of independence from government) does intervene in the spot market to try to keep a lid on the Real’s rise and to built up a “war chest” of international reserves the bank has allowed the currency to rise substantially against the US dollar (as of July the Real had appreciated by some 13% against the dollar in 2008) and Brazil has also recently opened a small but quite manageable deficit on its current account, which means that Brazil as it develops is becoming a net consumer of excess capacity in the global economy. A break-down of the current account position reveals that Brazil continues to retain a surplus on the goods balance due to the importance of commodities and food but that services and in particular a negative income account are now gradually pulling the overall balance into negative territory. This is really what one could reasonably expect in the context of an emerging economy at Brazil's stage of development.



On the monetary policy front the central bank is rapidly earning a reputation for itself as Latin America’s new Bundesbank, and governor Henrique Meirelles delivered a decisively hawkish message during the last monetary council meeting to accompany the decision to hoist rates by 75 basis points to the current 13% level. Brazil's interest rate is now the the second-highest inflation-adjusted one in the world after Turkey's. Brazil's real interest rate, or the benchmark 13 percent rate minus annual inflation of 6.06 percent, is 6.94 percent. Turkey currently has the world's highest so-called real interest rate at 7.55 percent.

This decision is the continuation of a hiking campaign set in motion in order to establish strong credentials for the central bank as an inflation fighter, and to prevent generalised inflation expectations from taking a hold among the population. The central bank is attempting to keep inflation within the the official target of 4.5% and with inflation forecast to be somewhat above that figure in 2009 the central bank is simply acting accordingly.



Such aggressive tightening is, however, not without its problems, and policy makers now face a serious dilemma. Predictably, given the state of the current global environment, the central bank's larger than expected interest hike was rapidly translated into an appreciation of the Real – pushing it to its strongest level since 1999. So far, the 13% rise against the USD this year puts the real in the pole position amongst emerging market currencies versus the USD. This position is reasonably comprehensible taking into account the recent decision to award Brazil investment grade status; this coupled with a nominal yield on 10 year government notes at about 15% and a benchmark stock index – the Bovespa – which is up approximately 10% from its January level, implying a 20% gain in US dollar term, basically mean that international investors are finding it hard not to put money into Brazil at this point in time.

Consequently, with a global credit crisis far from over, a hawkish central bank, and a hard currency making exports more difficult one could only reasonably expect the economy to slow in line with weaking global momentum. The key point with respect to the Real would be that a continuing rise will push the external balance further into negative territory. Moreover, in a likely scenario where global commodity prices somewhat pare-back their recent impressive upward movement Brazil’s external bookkeeping will further come under pressure.

Outlook on Key indicators

• 
  Following the most recent rate hike market expectations have now solidified towards further interest rate increases in the pipeline. The driving orce here will, as ever, be inflation running above the central bank's nominal target. Here at Emerginvest we see the Central Bank of Brazil aiming for a nominal rate of 15% which should be reached over the course of the next three meetings.
• 
  The Real is likely to continue to be supported by a hawkish central bank but as the external balance moves steadily into negative territory macro-fundamentals may take over, and as the economy slows and inflation comes into the target zone the central bank will once more move into loosening mode pushing the Real down in the process. A violent correction however is not expected.
• 
  GDP growth is expected to moderate in 2008 compared to the levels seen in 2007 but at this point growth projections remain solid, and we certainly see Brazil’s mid term sustainable growth rate as being above the consensus 3%-5% rate once inflation is firmly under control.

2007 Data

GDP (2007) - 5.4%
Inflation (2007) - 3.6%
Current Account Deficit -0.27% of GDP
Fiscal Deficit - 2.27% GDP
Debt to GDP ratio - 42.8%


Debt Ratings (local currency, long term)

Fitch - BBB-
S&P - BBB+
Moody- Ba1


2008 Central Bank Inflation Target - 4.5% (+ or – 2pp)

Population Median Age -29 years
Total Fertility Rate (2007) -1.88 child per women
Male Life Expectancy - 68.57 years

Development Indicators Rank (131 economies in total)

Global Competitiveness (World Economic Forum)
72/131 (2007-08)
Business Competitiveness (World Economic Forum)
59/131 (2007-08)


Selected Sub-components

Institutions - 104/131
Infrastructure - 78/131
Macroeconomic Stability - 126/131
Health and Primary Education -84/131

Short Term Data

Retail Sales Growth (May, y-o-y, volume index) - 10.5%
Industrial Output (May, y-o-y) - 2.4%
Inflation (July 2008) - 6.3%
Central Bank Interest Rate (SELIC Rate) - 13.0%

Exxon’s overall oil and gas production fell 5.6 per cent from the year-earlier quarter. Production in Africa, a key new area of investment, fell 20 per cent as high oil prices and contract stipulations forced it to hand over more of its production to host country governments. Venezuela’s nationalisation of its oil fields also hurt the group’s volumes, as did declines at Canadian gas fields. Unlike Royal Dutch Shell, which is stressing its research in second generation biofuels, and is a leader in making natural gas into transport fuels, Exxon has long argued that traditional alternatives, such as wind power, have proved uneconomic. But it says it is researching future fuels that it is less ready to talk about publicly. The figures are likely to increase pressure from investors for Exxon to raise dividends. It devoted $8bn to buying back its own shares and $1.9bn to dividends while adding another $6.9bn to its now $40.9bn cash pile.

High government spending and public debt remains Brazil's ``foremost credit weaknesses," S&P said. Net government debt reached 47 percent of the country's gross domestic product in 2007, ``higher than in similarly rated credits and above 20 percent for the BBB median,"

Brazil is still a long way from the top-notch triple A ratings of the developed economies, such as the US, Britain and Germany, but its rise out of junk or speculative grade is important as it allows some of the biggest pension and insurance funds to invest in the country. Many of these big institutions are not allowed to channel funds into countries rated below investment grade because of the dangers that these economies will default, losing their clients vast sums of money.

``There are two elements that are important when you move a rating -- you need all the support behind the improvement of fundamentals, and those elements are there in Brazil,'' according to Mauro Leos, vice president and senior credit officer at Moody's in New York. ``You also need a serious reduction of liabilities.''