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Manoj Pradhan’s thought provoking FT piece touches on some of the very themes and factors I’m attempting to articulate and quantify per my ongoing “contagion” score model now featured as part of the weekly macro analysis at Alterio Research and in fact expounds on the nature of my analysis hitherto via an ‘original sin’ metric, i.e. “the amount of short-term external debt relative to the total external debt burden as well as the amount of FX reserves held” as well as the consideration of those countries with current account deficits that concurrently run credit growth in excess of nominal GDP growth. Moreover, as Pradhan aptly points out, local authorities with balance of payments issues do have some mitigating mettle in their arsenal to combat relatively sudden capital inflow shocks–“when an economy is no longer able to roll over its gross liabilities (usually private sector liabilities), it may well use its [gross] assets,” he writes. Finally, while Pradhan correctly dismisses the notion that emerging markets have decoupled from developed ones (“the shock that triggers a sudden stop [in portfolio flows] is likely to come from developed markets”), frontier market asset managers are quick to point out that frontier equities are least historically correlated–.64 versus .86 (BRIC) and .92 (Emerging Markets) to global stocks, per Silk Invest’s 2012 outlook. That said the effects of developed-derived shocks remains real as the EU remains a major trading partner with certain African economies in particular. To this end, in line with its downward revision of global growth the IMF also revised Sub-Saharan Africa’s 2012 growth down by 0.3 percentage points to 5.5% (4.9% in 2011) and 0.2 percentage points in 2013 to 5.3%. Yet certain countries look comparatively insulated per the Alterio model; Ghana, for instance, features a diversified export basket, improving current account dynamic and benign inflationary environment such that its reserves to output ratio should remain healthy and growth relatively robust in 2012. We feel this is of particular importance to bond investors, though as future research of ours will highlight there are also ramifications on the cost of capital and thus equity valuations which may be overlooked.
I’ll be providing macroeconomic analysis going forward through Alterio Research, an independent research firm founded last year by Fabrice Yanou.
Last week I focused on Nigeria and this week’s concentration shifted to Kenya, where a number of dynamics have been in play since the summer, testing central bankers and causing a currency flux. My hope going forward is to continue to evolve the sophistication of commentary while offering institutional and retail investors alike a top-down view of the primary economic catalysts inherent to a given Sub-Saharan sovereign, a shifting paradigm and backdrop against which equity valuations are continuously refined. Last week’s macro report follows:
Against the backdrop of rising developed market equity correlation and volatility, in conjunction with ongoing liquidity contraction (i.e. what the IMF deems the absence of “financial lubrication”) stemming not only from the post-Lehman deleveraging paradigm but also from the (best case) renovation or (worst case) deterioration and ultimate destruction of the EU’s monetary union, Sub-Saharan exchange rates have largely come under pressure in the second half of 2011, perpetuating a vicious cycle whereby both currency and inflationary pressures demand fiscal and monetary (policy rates) tightening that in turn tends to impede output (GDP) expansion.
From an overall macro fundamental perspective, therefore, we remain attracted to those countries wherein net reserve coverage (defined as foreign-exchange (FX) reserves plus current account (CA) surplus, less short-term external debt) provide monetary authorities with ample artillery by which to stem depreciation pressures through increased FX sales. This ability, or lack thereof, we believe to be of the utmost importance in terms of stabilizing real rates of return that external capital demands in both the short and long run—investment flow that, if depended on to finance a CA deficit, for instance, is not merely valuable but in fact wholly vital to the state’s operations. Moreover, strong coverage allows a given central bank the luxury of easing rates should global conditions require it, a further fillip to growth that in theory should also pad domestic equity valuations relative to peers given, all else equal, a less onerous cost of capital.
Nigeria, for instance, despite relatively strong reserves (albeit currently static and within a continual annual downtrend) has seen its inflation worries persist as the recently devalued naira, coupled with ominously high fiscal spending and next year’s proposed fuel subsidy removal (which is likely to push inflation up if implementation is phased in) indicate consumer price expectations will stay wedded to the upside. That said, supportive bond yields keep inflation-adjusted real rates in a comfortably positive territory such that further downside currency risks are negligible going forward, in our view. Yet the country’s CA surplus, at an estimated 9% of GDP for 2011, remains highly dependent on oil revenues and moreover, much like reserve, has decreased steadily over the past four years (~16.8% of GDP in 2007). As demand side dynamics continue to underpin import growth, underwhelming FX reserve trends could deteriorate and further restrict fiscal and monetary options in 2012, acting as a headwind on both GDP and equity markets.
 Singh, Manmohan. Velocity of Pledged Collateral: Analysis and Implications. IMF WP/11/256. Nov. 2011.
Emerging markets collectively remain “high beta coupled”, so to speak, with their developed brethren per Wednesday’s Lex column, the implication being that an eventual price-to-book convergence and ultimately out-performance (per their relative fiscal fundamentals alone) are in the cards for those investors steely enough to latch on. Yet while anticipating this homecoming of sorts, now may be the perfect time to finally take a more discerning eye towards EMs instead of lumping them all-together, given that our premise remains that the strong fiscal balance sheets and still largely dormant, demographic dividends upon which much of their stories rest can all-too-easily be undone by an uncouth central bank (not to mention shoddy governance). Moreover not every economy is equally poised at the same moment to prosper equally, even from the loosest of monetary policies. Martin Sandbu’s Monday FT piece on Chile and the “middle income trap” is case in point as it underscores the importance of total factor productivity (TFP)—i.e. how efficiently capital and labor are combined–in helping to ease a given population’s transition from developing to developed as its PPP adjusted, GDP/capita invariably rises (in fact, a World Bank report from 2008, “Unleashing Prosperity” demonstrates that TFP is the fundamental driver of real output among developing nations). With this in mind Sandu notes that “Chile’s record is disappointing”, a mild understatement given that until only recently the figure has been negative. Even a recent estimate of around 1% sits well beneath the average emerging market annual rate of 2.4% from 2005-2008 (compared to 0.2% in advanced economies for that same period), a number which has admittedly declined per The Conference Board “as transitional productivity effects appear to [be abating] in some of the major emerging economies.” Thus, as the BCCH (Chile’s central bank) soon embarks on what the consensus now expects to be a 100bp easing cycle delivered in four consecutive 25bp cuts to help combat what analysts expect are downside risks to the 3.9% q/q saar GDP forecast for Q3 11, realize that while the monetary catalyst may be coming, the results could be underwhelming.
While mainstream financial commentators continue to grasp onto the Sub-Saharan (SSA) growth story in their arguably fruitless short term, safe-haven search, the IMF’s recent World Economic Outlook (WEO) report was a bit more circumspect in its nuanced observation that despite relatively strong fiscal and current account balances (versus advanced economies), growing cash reserve liquidity and the fact that it is “one of the few places in the world with a rising labor force”, the premise of contagion across many African frontier markets remains palpable. To that end, the IMF noted, “a faltering U.S. or European recovery could undermine prospects for exports, remittances, official aid and private capital flows.” That said, emerging markets in general and select frontier ones should benefit from an expected paradigm shift–at least for the near term–of collective, central bank dogma away from rigid inflation targeting towards a more dovish, holistic approach to rate setting that would theoretically embrace more fluid inflation targets, especially to the degree that fiscal policy remains conservative. Admittedly, this sort of monetary policy makeover across EM/FM central banks would likely need the initial support of their more developed brethren. Moreover, not all markets are equally immune to temporary bouts of price elasticity; while U.S. core PCE inflation (the Fed’s preferred gauge) hovers just under 2% y/y, the IMF expects SSA inflation to average 8.4% and 8.3% in 2011 and 2012, respectively (versus 7.5% in 2010), testament to a stickier and hence greater vulnerability to enhanced energy and food commodity volatility. Yet to the extent that central banks choose to overlook breached inflation target ceilings, growth should be smoother across more emerging and frontier markets than not, a phenomenon displayed nearly by The Economist’s graph, inset.
South Africa’s monetary policy committee (SARB) harped on the receding global backdrop in its recent dovish decision to maintain the benchmark rate at a 30-year low; yet coupled with continued albeit slowed growth in output in demand-led sectors (i.e. retail trade, financial and personal services) as well as in discretionary spending (in a bit of warning sign, on a 3m/3m seasonally adjusted and annualized basis sales growth turned negative for the first time since October 2009) and discretionary credit (last up 20.2% YTD in Q2), the SARB’s general theme underscored a mantra of growth support (it downgraded its GDP forecasts to 3.2% for 2011 and 3.6% for 2012, from 3.7% and 3.9%, respectively, previously) compared with concern over inflation (though a weakening rand, per our somewhat prescient forecast from this spring, complicates matters), and we suggest studying other markets to ferret out similar dynamics whereby dovish policy could provide a fillip to aggregate domestic demand. Moreover, certain economies like Ghana (and other key commodity exporters) could be set to see the best of both worlds, i.e. lingering accommodative policy together with hitherto low inflation. While not “safe”-havens per se, these are the kinds of economies to key in on when discerning among emerging and frontier economies and while developed growth sputters.
As ratings agency reports go, Fitch’s latest Sub-Saharan write-up wasn’t so much controversial as it was cautionary; specifically, its point relating to inadequate infrastructure is one common to most if not all emerging and frontier economies (outside of Asia, at least), a discouraging and productivity/growth-stunting phenomenon The Economist duly noted last week while concluding that “most [Latin American] countries neither save nor invest enough [and] do not use their resources efficiently” due at least in part to an over-dependence on monetary tightening whereby “low savings, high interest rates and protective tariffs on inputs make investing unusually costly.” Ultimately, moreover, ever burgeoning consumption in said economies–and by extension the hitherto elusive global re-balance fundamental to PIMCO’s ‘new normal’ paradigm–may be heavily correlated with just how efficiently this investment deficiency corrects. To this end, McKinsey theorized last winter that the glaring disconnect between savings and the pragmatic need for more emerging and frontier-sponsored capital investment is destined to usher in a new secular shift away from equities and towards bonds over the next decade (as incentives align) meaning that this month’s drastic global equity dip may be more harbinger than herring. That said, it may also invite an awkward limbo period for central banks as efforts to moderate inflation are tested by increased fiscal outlays which could augment borrowing costs even more if deficit to growth rates become overly stretched. Nigeria’s current inflation picture is a perfect case in point: while July’s core inflation, which excludes farm produce items from the CPI, was unchanged from the previous month at 11.5% y/y, Barclays opined earlier this summer that “CBN Governor Sanusi has been very outspoken about government’s excessive spending” even though some it at least looks geared towards addressing a woefully underdeveloped electricity sector and oil revenues should be long-term sticky. Yet the lion’s share of spending excess, per some pundits, stems not only from steep, public sector wage increases but also a patronage-driven political system.
Several recent mainstream media pieces (including The Wall Street Journal linked herein), picking up on a research paper from the African Development Bank, underline a common point, though it’s one that frontier savvy mangers and investors have been harping on for quite some time now–namely that the growth rate of Africa’s middle class continues to accelerate, while consumption expenditures in turn continue to converge with developing countries (a phenomenon we’ve highlighted previously vis a vis Morocco and Tunisia, specifically, with Europe. That said, the study in question–which delineates middle class by purchasing power parity and daily per capita expenditures (as well as the fact that it is “likely not to derive its income from agricultural and rural economic activities [but rather from] salaried jobs or small businesses), and further subdivides it into “floating”, “lower” and “upper” regions, admits there exists a “high concentration in the lower ranks” vulnerable to exogenous shocks (to that end, the percentage of the continent’s middle class without said wobbly “floating” class has actually dipped slightly in the past thirty years). As the authors point out this applies most notably to the three most populous countries in Africa, Nigeria, Ethiopia and Egypt “where more than half of the middle class is in the floating category, living on less than $4 per day.” Not surprisingly, the paper concludes that going forward “Africa’s middle class [will be] strongest in countries that have a robust and growing private sector,” while pointing out that statistically “enhancement of a country’s human resources through greater access to education and improved healthcare shows [the highest] positive correlation” with the size of a respective, middle class.” So what’s an investor to do? We continue to look for the most robust countries that offer exposure not only to these specific paradigm shifts relating to sustainable middle class composition as well as continual improvements to the ease of private sector wealth creation and the renovation and nurturing of physical (and social) infrastructure, education and health care, but also natural resources–wealth from which will [theoretically] help hasten a given economy’s transition away from commodity export reliance, encourage foreign investment and thus fuel the development and maturation of local sovereign and ultimately corporate debt markets–the true crucible and/or vanguard of enduring political, social and economic change to the continent, in our opinion. The ever-mobile Mark Mobius, for example, hit on these same points recently, highlighting Nigeria, Ghana and Kenya in particular.
Caravan Capital Management’s recent paper on frontier equity markets makes several salient points. For starters, in reference to the S&P Frontier BMI Index and the MSCI Frontier Markets Index the fund notes:
“Commodity prices tend to drive corporate earnings indirectly through overall GDP growth, as well as the relative strength of many frontier currencies. As a result, the returns of the frontier market indices are heavily correlated with crude oil and copper spot price returns. In a regression the individual correlation coefficients between the annualized returns of the MSCI Frontier Index and the annualized spot price returns of West Texas Instrument Crude Oil and London Metals Exchange Copper were 0.51 and 0.32 respectively for the 10 years ending 11/30/2009. While investing in the frontier markets can provide an indirect hedge against inflation for investors based in the developed world, commodity price fluctuations are also a cause of return volatility.”
Per liquidity, one of the chief characteristics used to classify stock markets within emerging and frontier economies, the fund writes:
“While over $560 billion of securities traded per month for the emerging markets, only $33.7 billion traded for the frontier markets. However, even this large disparity is deceiving as most of that volume came from the much more liquid Gulf countries. When these countries are removed from the frontiers, total monthly volume decreases substantially to $7.4 billion. More dramatically, the monthly volume of all exotic [i.e. those countries not included by either of the two aforementioned indices] frontier markets was a mere $520 million per month over this period.”
On a per trade basis, this relative lack of flow translates into a per trade cost 5-18x (bp) that of emerging markets, the piece calculates. Finally, as to expected returns the paper highlights the fact that while the simple average of trailing P/E ratios for members of the MSCI Frontier Index vs. the country members of the MSCI Emerging Markets Index as of 4/30/2010 was 11.8 compared with 14.8 for the latter, “these lower valuations may not be wholly justified by this perception of risk, based on one important observation; many frontier equity markets are still dominated by local market participants who rationally demand higher returns to compensate for the country specific risk they experience. However, from the perspective of global investors, much of this country specific risk should be effectively reduced through diversification within a global portfolio.”
To that end, against the backdrop of lower volatility, not only do frontier markets exhibit “significantly lower correlations to the developed markets than do the emerging markets,” but even strictly among frontier markets diversification is more easily attainable than it is among emerging countries given that “in the five years ending 4/30/2010, the emerging markets averaged a cross correlation of 0.64, while the standard frontiers averaged 0.28, and the exotic frontiers averaged a mere 0.07.”
To a contrarian investor, articles like this one–documenting the fact that frontier market equity funds so far this year have received more than $1 billion in inflows, easily eclipsing their hitherto record in 2007 of $442 million–signal that–in Chuck Prince lingo–the music may have indeed stopped. This would run contrary to the conventional feeling following the confirmation of QE2 that the yield-seeking ‘risk trade’ was still ‘on’, though the natural rebuttal to that would be that markets have essentially been pricing in QE2 to their risky asset valuations ever since Ben Bernanke all but revealed his hand in Jackson Hole on August 27th. That said, as the true ‘tail end’ of the risk curve, frontier markets have historically lagged their emerging brethren in terms of timing and breadth (their higher volatility also suggest that even core ‘believers’ are somewhat fickle). The MSCI BRIC index, for instance, has risen nearly 150 percent since March 2009, while the MSCI frontiers index has ‘only’ returned 65 percent over that same period (see chart, left). This suggests that the claustrophobia felt by some emerging market investors could naturally be a boon for less crowded, frontier trades, per Nouriel Roubini’s latest musing.
Additionally, for at least one fund manager, QE2 is a curse given its inflationary implications. “I would view the impact of QE2 as being mostly negative,” argued Ahmed Heikal, chairman of Cairo-based private equity firm Citadel Capital. “QE1 has caused a substantial rise in food prices, QE2 is a continuation of that. There is no sign of food prices abating anytime soon, and that is going to put inflationary pressures on many parts of Africa.” This echoes our argument that inflation in countries like Nigeria, where food is such a relatively large portion of headline CPI compared with developing nations–will be especially rampant all else equal going forward. This effect would be muted to a large degree if frontier currencies also rose. To Razia Khan, head of Africa research at Standard Chartered, the rub is in the timing of it all. “The danger for African countries is if you see oil prices going a lot higher–or food prices–before you see African currencies rising,” Khan said.
Yesterday we relayed Imara Asset Management CEO John Legat’s theory that a flat tax rate would be a boon for Zimbabwe and ultimately erode corruption while underpinning the country’s competitiveness (against the likes of South Africa, for instance) and moreover augment its moribund tax base. The Economist’s latest piece on business and bureacracy (“Snipping of the shackles”) touches upon some of these same themes, noting [in regards to the World Bank’s latest “(Ease of) Doing Business Survey 2011”] that “wherever the red tape is thickest, the result is widespread informality. Many small firms operate under the radar of officialdom, dodging taxes and ignoring rules [in order] to survive. But they have to stay small, and thus contribute much less than they might otherwise do to a country’s prosperity.” Cutting said tape, the theory goes, propels a positive feedback loop that–given how low a base some countries are coming from–can quickly translate into fairly remarkable results. The state of Lagos for example, home of Nigeria’s business capital by the same name, “has been improving its tax collection . . . encouraging formerly chaotic companies to keep proper accounts, which in turn makes it easier for them to do business with each other. The extra tax revenue is being used to improve services such as public transport, which among other benefits makes it a better place to do business.” Among other countries making recent gains in the rankings, Mexico (“the most straightforward country in Latin America”) and Kazakhstan (year’s most improved economy) were frontier stand outs.
Another, Saudi Arabia, is ranked higher than both Germany and Japan, which might cause some cynics to question the data’s veracity. On a similar note we switch gears to a project recently published by two MIT economists which used the internet to provide a daily gauge of consumer price inflation (see graph, inset) among various countries and which also calls into question the rosey conclusions offered up by some governments–namely Argentina’s:
“In countries where the apparatus for collecting prices is limited, or where officials have manipulated inflation data, the economists’ indexes might give a clearer view. In Argentina, for example, the government has been widely accused of massaging price figures to let it pay less interest to holders of inflation-indexed bonds. President Cristina Fernández has defended the government data. For September, the government’s measure of prices rose 11.1% from a year earlier. The economists’ measure in that period: up 19.7%.”