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Anthony Ward, founder of London-based commodity hedge fund Armajaro Holdings, not only gave new meaning to the phrase ‘putting your money where your mouth is’ last week when he took physical delivery of 240,000 tons of cocoa beans following a $1b bet in London’s NYSE Liffe (limitless) futures market on July contracts the fund then held to expiration–but also, per John C. Thomas over at Diary of a Mad Hedge Fund Trader, evoked memories of “fabled economist John Maynard Keynes, [who] once rented all the available warehouse space in London to avoid taking delivery of a bad position in copper.”
So what’s on Ward’s mind precisely? Prices following the stunt hit a 33-year high of £2,732 per ton, and moreover have been on an upwards tear the past two years in particular (see chart, above) on the back of poor harvests and what Ward sees as increasingly diminishing production quality in Ghana and moreover the Ivory Coast, which is accountable for approximately 40 percent of a given year’s annual crop is grown (see chart, below). And while manufacturers have hitherto responded to this market dilemma by raising prices, manipulating portion sizes and altering recipes, such measures are surely just a stopgap, especially given the increasing demand from relatively newfound and ever-burgeoning consumption in countries like China.
Per an exceptional and indepth FT article from late May, for instance:
“Cocoa trees are getting old and sick, and a byzantine world of smallholder farmers, corrupt politicians and travelling middlemen is resistant to change . . . unlike almost every other major agricultural commodity – corn, coffee, palm oil, sugar – the world’s cocoa is still grown overwhelmingly by smallholders, each owning less than four hectares of land. The task of increasing production does not lie with the managers of big agribusiness plantations, but in the individual actions of thousands of mainly poor west African farmers.”
The piece lays out in the depth the incredible challenge facing the cocoa industry going forward, from Nestle’s aim to replant 12 million trees over the next decade which will be more impervious to disease and able to yield quicker, to efforts by trading houses to go out into the country to improve farming and fermentation methods, and finally to the volatile political backdrop–where onerous cocoa levies line coffers but also dissuade production. Thus, while the long-term looks opaque, the present price trend is clear, according to Jürgen Steinemann, chief executive of Barry Callebaut, the chocolatier supplying many of the world’s top foods groups: “At this moment, cocoa is a scarce material: demand has been rising, supply has been stable, so prices have gone up. [And] there’s no fundamental reason why cocoa should become cheaper.”
Saudi Arabia’s impending “mortgage law”, which has been in the planning stages for nearly a decade, was further delayed earlier this month when the Shoura Council, Saudi Arabia’s principal advisory body appointed by King Abdullah, announced that it would not vote on the measure until late September following the holy month of Ramadan and then the Eid al-Fitr holiday.
Per a Deutche Bank research note from April, total outstanding home finance provided by the private sector in Saudi Arabia aggregates to less than 1% of GDP, compared with well over 50% in most developed countries, and approximately 6% in Kuwait and 7% in the UAE. Furthermore, the Bank estimates that Saudi Arabia will need 1.2 million additional housing units by 2015, and that based on market assumptions, when the new mortgage law is ultimately enacted it will contribute to incremental demand of approximately 55,000 additional units per year.
Against the backdrop of a rapidly rising population that is set to exceed 26 million within the next three years, analysts forecast that long-term residential housing demand in Saudi Arabia will remain strong going forward, as almost 40 percent of the population is under the age of 14, and personal disposable income is projected to grow at a compound annual growth rate of 6.5 percent (reaching approximately SR659b, or $176b, by 2013). And since it’s estimated that upwards of 30% of all consumer spending in rich economies is home-related, estimates published by BMI, a consultancy, earlier this year forecasting average annual private consumption growth of 7.92% between 2011 and 2014 that will outperform the average GDP growth over the same period (see graph, below) could be understated.
Either way, it seems daft to continue to write-off Saudi Arabia’s overall economic well-being as wholly-dependent on exported commodities. Moreover, if the Kingdom ever chose to address its chronic unemployment and income inequality issues, consumer figures would truly accelerate.
It was only a matter of time before an asset manager like New York-based Van Eck Global launched a local currency debt fund; thankfully for investors seeking such exposure they now have a relatively low cost (0.49% net expenses ratio) vehicle to do it with (NYSEArca: EMLC; Market Vectors Emerging Markets Local Currency Bond ETF) before certain developing market currencies really start to appreciate against debt-ridden, developed ones. Per the FT:
“Most emerging market governments issue debt in both ‘hard currencies’ like the US dollar and euro and in their own local currencies,” notes Kevin Gardiner, head of global investment strategy at Barclays Wealth. “Generally, the local currency debt trades with a higher yield to compensate investors for the additional foreign exchange risk they are incurring by holding the bonds.” But Mr Gardiner said that as many emerging market economies and fiscal positions were in much better shape than their counterparts in the developed world, this is currently a risk he was happy to take. “Local currency bonds in Asia, in particular, seem to us likely to outperform in all but the very worst investment environment,” said Mr Gardiner.
Van Eck reports that EMCL will focus on issues with an average years to maturity of 6.6, while only 21.6% of the fund is currently allocated to bonds that mature more than 10 years from now. The relatively low duration thus means less price sensitivity to interest rate movements. As to individual country exposure, Brazil, Malaysia, Mexico, Poland, South Africa, and Thailand are each weighted at 10% of the fund’s total assets, the maximum any one sovereign can hold under the fund. Finally, all of the countries in the fund are rated investment grade by S&P with four countries achieving ‘A’ status or better and only two countries, Hungary and Egypt, hitting the lower rung of the investment grade spectrum at BBB-. The underlying benchmark for the Van Eck ETF is the JPMorgan Government Bond Index – Emerging Markets Global Core Index, which has 171 constituents and is yielding roughly 6.8 percent.
Interesting special report in this week’s Economist on Egypt, ranging from the country’s “natural advantages” to speculation regarding the eventual Presidential successor to the 82 year old and “visibly ailing” Hosni Mubarak. In regards to the former, aside from fertile land (though desert takes up 95% of it) that it has used to grow its agriculture, mineral and hydrocarbon industries, Egypt’s “Suez Canal has provided a steady stream of revenue, against little outlay, by providing the shortest shipping route between Europe and Asia. Constantly widened to accommodate the growing size of vessels, the canal can now handle all but fully laden supertankers and giant bulk carriers. Revenues doubled in the boom from 2002 to 2008, hitting a record $5 billion that year. After a slump in 2009 they have started to climb again and look set once again to exceed $5 billion this year.”
Moreover as the above charts indicate, Egypt’s economy–once the victim of high taxes and state managed, central planning–continues to mature while public debt has fallen and foreign investment rises. Additionally, robust domestic demand cushioned the effects of the global credit crunch, a promising sign if developed economies in fact embark on a prolonged flirtation with slow inflation. And with roughly 40% of the 83m plus of its burgeoning population under the age of 18, the seeds for Egypt’s continued growth and consumption are in place, assuming policies to remove a startling number out of poverty are achieved.
One particularly enticing industry for investors is cement, of which Egypt is one of the world’s bigger producers. Earlier this week Egypt’s Suez Cement group, the country’s largest listed cement maker by market value and a unit of the Italcementi group, reported a 4.8 percent increase in net sales to 3.4 billion pounds. The firm supplies approximately 26 percent of Egypt’s market for grey cement and 42 percent for white cement.
Ex-Economist writer-turned money manager and market commentator Vivian Lewis of Global Investing cited a recent quote from former CNN journalist Frida Ghitis to highlight the investment potential of Colombia:
“Colombia, where I was born, is slowly emerging from a drug-fueled war that lasted decades. The future looks bright. Dodging a regional trend, Colombia’s democratic institutions survived a hyper-popular president who could have held on to power. Its just-completed elections were won by a competent technocrat against a flashier charismatic challenger. President-elect Juan Manuel Santos, who studied economics at Harvard and the London School of Economics (no guarantee of anything) will continue Uribe’s business and security focused policies. Colombians are repatriating their cash. And foreign investment that might have gone next door to Venezuela, spooked by Chavez will head to Colombia. Santos will be good for the economy and investors.”
Per the performance of GXG (above), the ETF based on the FTSE Colombia 20 Index, there have been far worse places to have been invested in the past 10 months. As eager investors continue to rush to the peso (see USD/COP, below) domestic borrowers are getting in on the act. Earlier this week Bancolombia, the country’s largest lender, sold $620 million of subordinated bonds after boosting the size of the offering by $20 million. The 10-year notes pay a spread of 337.5 basis points, per Bloomberg.
As The Economist hinted in late June, there can be renewed optimism about Colombia’s future if for no other reason that commentators are now far more focused on its economy than the once-bustling drug trade (see graph, inset) and the once-thriving contingents of FARC and ELN guerillas terrorizing at will.
However, that isn’t to say that the underlying economy isn’t without its own host of problems:
“At home Mr Santos faces a bankrupt health system, a persistent budget deficit and an unemployment rate of 12%, one of the highest in the region. He promises to balance the budget by 2014 without raising taxes, and to cut unemployment to single digits. He says this can be done by reforming health care and reducing transfers of oil and mining royalties to the provinces. He has been cagey about reforming archaic labour laws that condemn most Colombians to the informal economy.”
Last August The Economist published an interesting piece on Africa’s population transition; while still an outlier compared with the developing world, the continent’s total fertility rate, which was over six in 1990 compared with two in East Asia, is expected by the U.N. to halve in sub-Saharan Africa by 2030 and then fall below 2.5 by 2050. The article poses the question whether or not Africa will be able to capitalize on what it labels the “demographic dividend”:
As societies grow richer, and start to move from high fertility to low, the size of their working-age population increases. The effect is a mechanical one: they have fewer children; the grandparents’ generation has already died off; so they have disproportionately large numbers of working-age adults. According to a study by the Harvard Initiative for Global Health, the share of the working-age population will rise in 27 of 32 African countries between 2005 and 2015.
The result is a “demographic dividend”, which can be cashed in to produce a virtuous cycle of growth. A fast-growing, economically active population provides the initial impetus to industrial production; then a supply of new workers coming from villages can, if handled properly, enable a country to become more productive. China and East Asia are the models. On some calculations, demography accounted for about a third of East Asia’s phenomenal growth over the past 30 years.
One nation explicitly predicted to benefit from said dividend is Mozambique, a country still suffering the effects of a brutal civil war following its independence from Portugal in 1975. Yet per last week’s Economist, much has changed since the peace deal officially ending the carnage:
At the end of the civil war in 1992, Mozambique was arguably the world’s poorest country. Its transport, education and health systems were in ruins. Many Mozambicans with marketable skills had fled. But now its economy is one of the fastest-growing in the world. In the past 15 years it has swelled by an average of 8% a year, dipping slightly to 6% during last year’s global meltdown, with nearly 7% expected this year, well above the 4% the World Bank forecast for southern Africa as a whole.
After South Africa, which imports electricity from the continent’s most powerful hydroelectric plant, China and India continue to be the country’s biggest foreign investors, keen to feed their voracious resource appetites and specifically their supplies of quality, coking coal (although India is one of the world’s biggest producers of coal, it produces only limited quantities of the coking coal needed by its steel plants). In late June, China announced that it had agreed to invest $1bn in a coal project in Mozambique’s Tete province, and India sent yet another trade delegation two weeks ago to “consolidate friendly relations between the two countries.”
Coking coal could indeed be a feather in Mozambique’s macro cap, though the extent to which the country can profit from an expected continual surge in demand will be dependent on improved infrastructure, noted a recent research piece from MF Global which concluded that the coking coal market had better long-term fundamentals than the iron ore market, and furthermore that Mozambique and Mongolia have the potential to be “potential game changers” on the supply side – but only from 2015 and “conditional on infrastructure”. At present however, it noted, Mozambique suffered “severe limitations on its rail and port infrastructure.” While critics of the BRICs’ resource romp in Africa contend that the rents gained from commodity-rich governments are often inadequate and/or squandered by opaque political elite decision making, one byproduct of foreign investment is generally an immediate upgrade in infrastructure. And if coking coal can be the impetus for the above-related demographic dividend to take shape, then the commodity loss can indeed be seen as pie-expanding instead of zero-sum.
Further confirmation of the gradual manufacturing shift away from China and towards regional frontier markets in an Economist piece this week (“Culture Shock”) about how the rising number of labor disputes in China (largely revolving around wage increases) is beginning to intensify the country’s “shift from being the world’s workshop to its shopping mall: as employees demand and get higher incomes, the country’s attractiveness as a manufacturing base ebbs but its appeal as a consumer market grows.” While companies’ collective response has to some degree been in part to mollify the wage demands, “firms with labor-intensive work have been shifting it to cheaper Asian countries like Vietnam, Thailand and Cambodia. Uniqlo, a clothier, plans to reduce its proportion of Chinese-made garments from 90% to 65% in the next three to five years.” Of course, foward-looking investors are already contemplating the next logical step. Per Paul Collier, a professor of economics at Oxford, “over the past three decades, offshoring shifted labor-intensive manufacturing from the OECD countries to Asia. In the next decade, expect the same process to begin shifting these activities from Asia to Africa.”
Bill Gross’ July Investment Outlook from PIMCO succinctly summarizes the dearth of ‘global aggregate demand’ that must ultimately be ironed out and will underpin “inexplicable low total returns on investment portfolios” until it is.
It is this lack of global aggregate demand – resulting from too much debt in parts of the global economy and not enough in others – that is the essence of the problem . . . If policymakers could act in unison and smoothly transition maxed-out indebted consumer nations into future producers, while simultaneously convincing lightly indebted developing nations to consume more, then our predicament would be manageable. They cannot. G-20 Toronto meetings aside, the world is caught up as it usually is in an “every nation for itself” mentality, with China taking its measured time to consume and the U.S. refusing to acknowledge its necessity to invest in goods for export . . . Consumption when brought forward must be financed, and that financing is a two-way bargain between borrower and creditor. When debt levels become too high, lenders balk and even lenders of last resort – the sovereigns, the central banks, the supranational agencies – approach limits beyond which private enterprise’s productivity itself is threatened.
Moreover, on the lack of debt in developing markets:
There are 6.5 billion people in the world and will soon be 1 billion more. Many of them are debt-free and have never used a credit card or assumed a home mortgage. Why can’t lenders like PIMCO lend to them, allowing developing nations to bring their consumption forward, developed nations to supply the goods and services, and the world to resume its “old normal” path toward future profits, prosperity and increasing standard of living? To a certain extent that is what should gradually happen, promoting more rapid growth in the emerging nations and a subdued semblance of it in the G-7 – a “new normal.”
But they – the developing nations – are not growing fast enough, at least internally, to return global growth to its old standards. Their financial systems are immature and reminiscent of a spindly-legged baby giraffe, having lots of upward potential but still striving for balance after a series of missteps, the most recent of which was the Asian crisis over a decade ago. And so they produce for export, not internal consumption, and in the process leave a gaping hole in what is known as global aggregate demand. Developed nation consumers are maxed out because of too much debt, and developing nations don’t trust themselves to stretch their necks for the delicious leaves of domestic consumption just above.
Only six markets worldwide are trading above their 2007 highs, and all of them can be classified as “frontier,” per a recent piece from the Wall Street Journal:
Tunisia, the tiny African nation south of Italy, has been the best performing stock market since 2007. The Tunindex, a 12-year-old index of 45 stocks, is trading 81% above its high for that year, and is up 15% for 2010. Sri Lanka is up 53% since 2007 and 36% this year. The other four comprise Venezuela, Colombia and Chile— Latin American countries benefiting from a rush to commodity-rich emerging markets—and Indonesia.
The tally of performances demonstrates just how much investors have been favoring emerging markets, and the extent to which they have been willing to delve into frontier markets.
Emerging market mutual and hedge funds saw inflows of $17.3 billion in the first half of 2010, while frontier markets saw $780 million incoming. Fund managers, the theory goes, are increasingly turning their attention to such markets if for no other reason that growth rates there are expected to vastly outperform those in developed countries.
The true test, of course, will be the viability of any long-term paradigm shift. Are money managers merely opportunistically seeking short term alpha, or are these shifts the beginning stages of a more concerted, long-term effort at mirroring what many observers predict will be a fundamental change and rebalancing in global finance whereby the relative fiscal strength of developing markets is reflected in higher exchange rates and greater consumption and foreign investment, fueling in turn a virtuous cycle and greater liquidity in their risky assets?
In a recent interview with Reuters (video linked herein), Timothy Drinkall, a portfolio manager for Morgan Stanley’s Frontier Emerging Markets Fund (NYSE:FFD) touts investing in Bangladesh, a country Drinkall’s fund has had exposure to for over two years, while the MSCI just added it to their Frontier Markets Index (at 1.8%) this past May. Drinkall opines that Bangaldesh is at “the very early stages of an investment boom” and is thus the anti-Vietnam, an economy he feels will struggle to grow in the near-term like it has for the past decade. While Bangladesh’s economy is roughly the same size as Vietnam’s, its FDI/capita is strongly lagging at $95 versus 6.5. Moreover, Drinkall argues, its banking system in particular is vastly “underpenetrated,” with total loans/GDP in the 40-45% range, versus Vietnam’s 2009 reading of 142%, and most firms are correspondingly underleveraged. A quick look at FFD’s makeup finds Bangladesh’s Brac Bank, in its Top 25 holdings. Aside from being overweight Bangaldesh, Drinkall is also bullish on Saudi Arabia, Nigeria, Kenya, Lebanon and Argentina from an overall, top-down standpoint.
JGW
Frontier Markets 