Finweek English Edition - - FRONT PAGE - By Petri Redelinghuys

right in the mid­dle of the first quar­ter of the year, on 11 Fe­bru­ary, the MSCI All Coun­tries World In­dex dipped into bear mar­ket ter­ri­tory when it traded 20.2% down from its 21 May 2015 highs. The pic­ture looked dire, hope was dif­fi­cult to come by and many in­vestors and traders braced them­selves while fear firmly held its un­yield­ing grip on the mar­kets.

The mar­ket – be­ing the wild beast that it is – did of course not just roll over and die with­out putting up a fight. The sec­ond half of the first quar­ter saw a fierce rally in world eq­uity mar­kets, led higher by com­modi­ties such as oil and iron ore.

Does this mean that we have es­caped the dread­ful clutches of the bear mar­ket though? Per­haps we should re­visit some of the is­sues that were preva­lent at the time in or­der to un­der­stand what has changed and why.

The price of oil had been on a bit of a one-way trip to worth­less­ness and had traded be­low $30 a bar­rel for the first time since De­cem­ber 2003. Other hard com­modi­ties too had been trad­ing around their multi-year lows and the world was, and still is, wor­ried about China’s ever-de­creas­ing de­mand for com­modi­ties as it at­tempts to slowly turn it­self into a ser­vice-driven econ­omy. This down­turn in com­mod­ity prices led to de­vel­oped mar­kets find­ing it dif­fi­cult to at­tain any mean­ing­ful in­fla­tion, while emerg­ing mar­kets were strug­gling with per­va­sive in­fla­tion and se­vere cur­rency de­val­u­a­tion.

A dis­con­nect in global mone­tary pol­icy came about as de­vel­oped mar­kets loos­ened their reins while emerg­ing mar­kets tight­ened their belts. The US, how­ever, bucked the trend some­what and had taken a lik­ing to con­sis­tently talk­ing about in­creas­ing in­ter­est rates, so much so that they ac­tu­ally did it in De­cem­ber 2015. The steam seemed to be rush­ing out of a hole in the en­gine that could not be found and the mo­men­tum of the en­tire world mar­ket was start­ing to dwin­dle.

Will the bear or the bull come out on top?

In a fin­week ar­ti­cle pub­lished in the 25 Fe­bru­ary is­sue, we looked at the two pos­si­bil­i­ties that ex­isted in terms of how what was go­ing on at the time could turn out. The bear case was of course ob­vi­ous; the mar­ket had given two tech­ni­cal bear mar­ket sig­nals and China’s slow­down was the root cause of the de­clin­ing com­mod­ity prices.

The bull case re­lied on a num­ber of things that seemed some­what un­likely at the time, how­ever ap­pears to have come to pass (for now at least). These were a more ac­com­moda­tive mone­tary pol­icy stance from the US Fed­eral Re­serve, a rel­a­tively quick in­crease in Chi­nese de­mand for re­sources and some good old fash­ioned tech­ni­cal anal­y­sis as the MSCI All Coun­tries World In­dex tested a sup­port level it cre­ated in April 2011 (shown in graph 1 above).

The sup­port level held, the Fed stopped talk­ing about in­ter­est rate hikes as much and China has been re­port­ing some fairly de­cent eco­nomic data. So for now, the ever-rag­ing bat­tle of the mar­kets is be­ing won by the bulls. The ques­tion we are faced with now is that, given the cur­rent events and cir­cum­stances, have emerg­ing mar­kets come back into favour?

That’s not an easy ques­tion to an­swer as the an­swer is not sim­ply a “yes” or a “no”. There are a few things that are go­ing on and in or­der to at­tempt to an­swer the ques­tion of emerg­ing mar­kets be­com­ing the flavour of the week again, we must first un­der­stand the cur­rent sit­u­a­tion and hap­pen­ings. So let’s look at some of the facts.

Dur­ing the first quar­ter of 2016 we saw a re­mark­able turn­around in both emerg­ing and de­vel­oped mar­kets, al­though much more so in emerg­ing mar­kets. Emerg­ing-mar­ket economies have, on the whole, faster GDP growth rates than the economies in de­vel­oped mar­kets. The debt-to-GDP ra­tios in emerg­ing mar­kets are also bet­ter than those in de­vel­oped mar­kets (ex­cept for China), and emerg­ing mar­kets of­fer lower price-to-earn­ings ra­tios and bet­ter price-to-book ra­tios than as­sets in de­vel­oped mar­kets.

It is also no­table that emerg­ing mar­kets have an ex­pected growth rate of 4.3% ver­sus the 2.1% ex­pected growth rate of the de­vel­oped mar­kets for 2016. The fact that there is value to be found in emerg­ing mar­kets is made ev­i­dent when you con­sider that the MSCI Emerg­ing Mar­ket In­dex rose by 5.8% in the first quar­ter com­pared to a 0.2% de­cline in the MSCI All Coun­tries World In­dex. This was a re­mark­able turn­around in­deed for the emerg­ing world, and it was led by com­modi­ties.

Over­haul for cer­tain economies

The land­scape is chang­ing though as In­dia is try­ing to turn it­self into a man­u­fac­tur­ing des­ti­na­tion for in­ter­na­tional firms. While In­dia is by no means ri­valling China yet in terms of sheer vol­ume, it seems to be cop­ing a lit­tle bet­ter than China in some re­spects. Take for ex­am­ple its GDP growth rate. It eased to 7.3% from 7.7% year-on-year (y/y) ver­sus China’s GDP growth eas­ing to 6.8% from 6.9% y/y, both for the fi­nal quar­ter of 2015. So even though both are ex­pe­ri­enc­ing a slow­ing growth rate, In­dia is grow­ing faster. Then, y/y im­ports into In­dia de­clined by 5% while China’s fell by 13.8%, and y/y ex­ports out of In­dia de­clined by 5.7% while China’s ex­ports dropped by a mam­moth 25.4% (both y/y num­bers for the month of Fe­bru­ary 2016).

Sure, these are not nec­es­sar­ily pos­i­tive num­bers, al­though it in­di­cates that there might be a new kid on the block which, over time, may re­place China as the world’s pri­mary con­sumer of nat­u­ral re­sources. That is a long time away though and I di­gress, so let’s stick to the present. And the present in­volves re­sources.

The ques­tion of re­sources

So talk­ing about re­sources; we’ve not only seen a surge in eq­uity mar­kets, but in com­mod­ity prices as well over the last two months. Iron ore was the first to start lift­ing from its lows in De­cem­ber 2015 al­ready as talks of pos­si­ble stim­u­lus in China led to the an­tic­i­pa­tion of mas­sive in­fra­struc­ture and con­struc­tion spend­ing. This was fur­ther spurred on over the past few weeks by en­cour­ag­ing eco­nomic data that had been re­ported out of China, and of course, as an­tic­i­pated, stim­u­lus in the form of in­fra­struc­ture and con­struc­tion spend­ing com­mit­ments made by the Chi­nese gov­ern­ment. A ris­ing tide lifts all ships it is said, so other hard com­modi­ties such as cop­per are ben­e­fit­ting as well. Then of course there is oil, which has staged a sharp rally over the last two months on the back of the afore­men­tioned data out of China, and con­tin­u­ous ru­mours of a pos­si­ble oil pro­duc­tion freeze from not only the Or­ga­ni­za­tion of the Pe­tro­leum Ex­port­ing Coun­tries (Opec) mem­bers, but from non-Opec coun­tries as well.

This, com­bined with a weak­en­ing dol­lar – as the Fed has ap­par­ently re­alised that ris­ing in­ter­est rates in the cur­rent global eco­nomic en­vi­ron­ment might not be the bright­est idea they’ve ever had – has re­ally pro­vided some hope that com­mod­ity prices have found the bot­tom and have started turn­ing the cor­ner. This re­mains to be seen, al­though re­search from Cap­i­tal Eco­nomics sug­gests that it is rea­son­able to ex­pect com­mod­ity prices to con­tinue to edge higher for the rest of the year.

They also ex­pect that the de­cline in ex­ports that we are cur­rently see­ing across emerg­ing-mar­ket economies should start to ease, or slow down, in the com­ing quar­ters. Cap­i­tal Eco­nomics is also fore­cast­ing a re­cov­ery in the Chi­nese econ­omy. Ox­ford Eco­nomics, though, warns that the pos­i­tive bounce back in Chi­nese data that we have seen in the last few weeks is the re­sult of stim­u­lus and not real eco­nomic ac­tiv­ity.

What the Chi­nese do though, is in­clude hous­ing con­struc­tion spend into their GDP re­gard­less of whether these hous­ing de­vel­op­ments are then sub­se­quently sold to buy­ers, or merely stand va­cant in one of China’s many ghost cities. There­fore the real es­tate re­cov­ery is rel­a­tively un­likely to be sus­tain­able. This of course starts fu­elling the Chi­nese debt prob­lem fears again, and sug­gests that with­out the stim­u­lus be­ing pro­vided to the Chi­nese econ­omy that the house of cards will col­lapse.

How­ever, we are not here to spec­u­late on the Chi­nese econ­omy, but rather to un­der­stand what is driv­ing mar­kets and how that could po­ten­tially af­fect South Africa. Be­sides, China is not the only econ­omy to up the ante in terms of stim­u­lus. The Euro­pean Cen­tral Bank has re­cently in­creased its quan­ti­ta­tive eas­ing pro­gramme from €60bn per month to €80bn a month which, as you can imag­ine, added fuel to the rally we saw dur­ing the sec­ond half of the first quar­ter. So for now it is prob­a­bly safe to say that the world will re­main de­pen­dent on

It is also no­table that emerg­ing mar­kets have an ex­pected growth rate of 4.3% ver­sus the 2.1% ex­pected growth rate of the de­vel­oped mar­kets for 2016.

stim­u­lus in or­der to feign real eco­nomic growth and that there is re­ally no way of telling how long this for­mula will keep work­ing.

The im­pact of weak com­modi­ties

Now let’s look at the ef­fects that lower com­mod­ity prices have been hav­ing on emerg­ing mar­kets. In or­der to un­der­stand these im­pacts, we need to look at the dif­fer­ences be­tween those coun­tries and economies that are the net ex­porters of com­modi­ties and those that are the net im­porters of these raw ma­te­ri­als and nat­u­ral re­sources.

Look­ing at data com­piled by Cap­i­tal Eco­nomics, we can see a few things tak­ing place. Lower com­mod­ity prices have in­versely cor­re­lated ef­fects on coun­tries that are net ex­porters ver­sus those that are net im­porters of com­modi­ties. Coun­tries that are net im­porters of raw ma­te­ri­als and re­sources tend to see their cur­ren­cies strengthen and in­fla­tion sub­side.

Take, for ex­am­ple China, Thai­land, or Hun­gary. All these coun­tries are strug­gling with in­fla­tion that is less than 50% of what the mid-point of their re­spec­tive cen­tral banks’ in­fla­tion tar­get range is. China, as a more de­tailed ex­am­ple, has been at­tempt­ing – at a great cost – to de­value its cur­rency in or­der to re­main com­pet­i­tive in terms of the prod­ucts it man­u­fac­tures and sells in in­ter­na­tional mar­kets, and is try­ing to stim­u­late some in­fla­tion by cut­ting bench­mark rates in an at­tempt to get peo­ple and com­pa­nies spend­ing.

Coun­tries that are net im­porters of com­modi­ties are strug­gling to stim­u­late growth in their man­u­fac­tur­ing in­dus­tries on which com­mod­ity ex­porters rely for the de­mand and con­sump­tion for their prod­ucts. For net im­porters the prob­lem is a lack of growth com­bined with a lack of in­fla­tion and in some cases even de­fla­tion (see graphs 2 and 3).

On the flip side of the coin are coun­tries like Rus­sia, Brazil and SA who are net ex­porters of raw ma­te­ri­als and nat­u­ral re­sources. These coun­tries are strug­gling with weak­en­ing cur­ren­cies and in­fla­tion that is higher than the mid-point of their re­spec­tive cen­tral banks’ in­fla­tion tar­get ranges. For net ex­porters the prob­lem is a lack of growth com­bined with ram­pant in­fla­tion, or as it is of­ten fear­fully re­ferred to as, stagfla­tion.

In other words, a slow­ing econ­omy with high un­em­ploy­ment and high in­fla­tion, forced to in­crease in­ter­est rates in or­der to keep prices of every day goods and ser­vices from sky­rock­et­ing, yet suf­fers from a lack of eco­nomic growth that pretty much en­sures that in­di­vid­u­als’ dis­pos­able in­comes keep shrink­ing as the cost of fi­nanc­ing their debts keeps in­creas­ing. Not a pleas­ant sit­u­a­tion to be in. Summed up, for coun­tries like SA who are net ex­porters of com­modi­ties, lower com­mod­ity prices lead to tight­en­ing mone­tary pol­icy cy­cles as these coun­tries have to bat­tle higher in­fla­tion due to a weaker cur­rency, while si­mul­ta­ne­ously bat­tling a slow­ing econ­omy as de­mand for their prod­ucts, in

this case raw ma­te­ri­als and re­sources, dwin­dles.

Graph 4 be­low in­di­cates to us that Latin Amer­ica and the Mid­dle East and Africa are in tight­en­ing mone­tary pol­icy cy­cles as they are pre­dom­i­nantly net ex­porters of com­modi­ties, while emerg­ing Asia and emerg­ing Europe are in loos­en­ing mone­tary pol­icy cy­cles as they are pre­dom­i­nantly net im­porters of com­modi­ties.

What does it all mean?

Now I’ll be hon­est, I don’t know what hap­pens if this cur­rent di­ver­gence of global mone­tary pol­icy stays in place and com­mod­ity prices re­main as low as they are (or turn even lower). I would imag­ine though that a rather un­friendly gen­tle­man starts walk­ing around the room con­fis­cat­ing drinks while yelling, “Party’s over, folks!” But then, I re­ally don’t know.

Al­though worry not (for now), for the-mer­rygo-round keeps, well, go­ing around. The Fed has in­di­cated that it will take it easy in terms of in­ter­est rate hikes, China is stim­u­lat­ing its way to higher GDP growth – even though iron ore prices have rock­eted up in re­cent weeks on spec­u­la­tion that the stim­u­lus will lead to a re­stock­ing of sup­plies, and not the ac­tual re­stock­ing of sup­plies – and so far Saudi Ara­bia is win­ning its oil-based eco­nomic war against every­one else who pro­duces it.

All this is fos­ter­ing a bit of a risk-on feel­ing in the mar­ket and is weak­en­ing the dol­lar (which drives up com­mod­ity prices) as in­vestors seek higher yields out­side of the US.

The same can be said for Europe. There are neg­a­tive in­ter­est rates in many places there, so in­vestors are al­most forced to look else­where for in­vest­ment op­por­tu­ni­ties that of­fer at­trac­tive yield. There is only one place for this money to go, and that is emerg­ing mar­kets.

This in turn is un­do­ing some of the ef­fects that we wit­nessed in the first half of the first quar­ter of this year, which we ex­plored ear­lier, and pro­vides emerg­ing-mar­ket economies with much-needed relief. This is lead­ing to emerg­ing-mar­ket economies that con­tinue to out­pace de­vel­oped mar­kets, and thus an in­flow into our mar­ket from off­shore in­vestors. That, of course, pro­vided that the Chi­nese credit bub­ble doesn’t burst and that the stim­u­lus it’s sup­ply­ing to the econ­omy keeps work­ing. And of course that China doesn’t de­plete its for­eign ex­change re­serves in the process.

It’s a messy and con­fus­ing world out there at the mo­ment. One thing is cer­tain though, if com­mod­ity prices stay as low as they are, coun­tries like SA al­most cer­tainly can­not avoid a re­ces­sion.

That said, cen­tral banks around the world are fight­ing hard to avoid ex­actly that. We have en­tered into a very in­ter­est­ing time in fi­nan­cial mar­ket his­tory. A time dur­ing which fore­cast­ing what is likely to hap­pen is in­cred­i­bly dif­fi­cult.

So have emerg­ing mar­kets come back into favour? I think the an­swer, for now at least is, “Yes, for the time be­ing.”

It’s a messy and con­fus­ing world out there at the mo­ment. One thing is cer­tain though, if com­mod­ity prices stay as low as they are, coun­tries like SA al­most cer­tainly can­not avoid a re­ces­sion.

The head­quar­ters of the United States Fed­eral Re­serve in Wash­ing­ton, DC.

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