Global Investing

Battered India rupee lacks a warchest

The Indian rupee’s plunge this week to record lows will have surprised no one. After all, the currency has been inching towards this for weeks, propelled by the government’s paralysis on vital reforms and tax wrangles with big foreign investors. These are leading to a drying up of FDI and accelerating the exodus from stock markets. Industrial production and exports have been falling.  High oil prices have added a nasty twist to that cocktail. If the euro zone noise gets louder, a balance of payments crisis may loom. The rupee could fall further to 56 per dollar, most analysts predict.

True, the rupee is not the only emerging currency that is taking a hit. But the Reserve Bank of India looks especially powerless to stem the decline. (See here for an article by my colleagues in Mumbai) .  One reason  the RBI’s hands are  effectively tied is that  India is one of the few emerging economies that has failed to build up its hard currency reserves since the 2008 crisis and so is unable to spend in the currency’s defence. Usable FX reserves stand now around $260 bilion, down from $300 billion just before the 2008 crisis.  See the following graphic from UBS which shows that relative to GDP, India’s reserve loss has been the greatest in emerging markets.

But there is worse. The relative decline in reserves since 2008 coincides with a ballooning in India’s external debt, both private and public. Comprising mostly of corporate borrowing and trade credit, the debt stands at $350  billion, up from $225 billion four years back.

No wonder investors have upped their bearish bets on the rupee: a Reuters poll of Asian fund managers shows these at a six-month high and significantly higher than any other Asian currency. For now, the trade  looks worryingly like a one-way street.

Not everyone is “risk off”

Who would have thought it. As fears over the euro zone’s fate, Chinese economic growth and Middle Eastern politics drive investors toward safe-haven U.S. and German bonds, some have apparently been going the other way.  According to JPMorgan, bonds from so-called frontier economies such as Pakistan, Belarus and Jordan (usually considered high-risk assets) have performed exceptionally well, doing far better in fact than their peers from mainstream emerging markets.  The following graphic from JPM which runs the NEXGEM sub-index of frontier debt, shows that returns on many of these bonds are running well into the double digits.

NEXGEM returns of 8.4 percent  are on par with the S&P 500, writes JPMorgan and outstrip all other emerging bond categories. Clearly one reason is the lack of correlation with the mainstream asset classes, many of which have been selling off for weeks amid growth fears and in the run up to French and Greek elections.  Second, investors who tend to buy these bonds usually have a pretty high risk-tolerance anyway as they keep their eyes on the double-digit yields they offer.

So year-to-date returns on Ivory Coast’s defaulted debt are running at over 40 percent on hopes that the country will resume payments on its $2.3 billion bond after June. The underperformer is Belize whose bonds suffered from a default scare at the start of the year.

South African bond rush

It’s been a great year so far for South African bonds. But can it get better?

Ever since Citi announced on April 16 that South African government bonds would join its World Government Bond Index (WGBI),  almost 20 billion rand (over $2.5 billion ) in foreign cash has flooded to the local debt markets in Johannesburg, bringing year-to-date inflows to over 37 billion rand. Last year’s total was 48 billion. Michael Grobler, bond analyst at Johannesburg-based brokerage Afrifocus Securities predicts total 2012 inflows at over 60 billion rand, surpassing the previous 56 billion rand record set in 2o1o:

The assumption..is based on the fact that South Africa will have a much larger and diversified investor base following inclusion in the WGBI expanding beyond the EM debt asset class

Big Fish, Small Pond?

It’s the scenario that Bank of England economist Andrew Haldane last year termed the Big Fish Small Pond problem — the prospect of rising global investor allocations swamping the relatively small emerging markets asset class.

But as of now, the picture is better described as a Small Fish in a Big Pond, Morgan Stanley says in a recent study, because emerging markets still receive a tiny share of asset allocations from the giant investment funds in the developed world.

These currently stand at under 10% of diversified portfolios from G4 countries even though emerging markets make up almost a fifth of the market capitalisation of world equity and debt capital markets.  In the case of Japan, just 4% of cross-border investments are in emerging markets, MS estimates.

For luxury, all that glitters is gold

The year has certainly got off to a good start for luxury companies, with firms like LVMH, home to Louis Vuitton, reporting stellar results for the first quarter. No wonder – according to CLSA Asia-Pacific Markets analyst Aaron Fischer, resurgent emerging market consumers are fuelling a strong growth in the global luxury goods market. Growth in the sector was  double its long-term average last year, Fischer says.  He has updated his bullish 2011 report “Dipped in Gold” and is particularly optimistic on established brands, predicting global growth of 10% in 2012, slowing slightly from last year’s 14% rise:

However, we expect leading brands to continue to outperform, rising 15%, compared with the street’s estimate of 12%, which seems far too low.

We look for emerging market consumers, especially when travelling, to drive robust sector growth in the medium term, posting a 15% demand compound annual growth rate in the next 10 years.

In India, no longer just who you know

It’s not what you know but who you know. There are few places where this tenet applies more than in India but of late being close to the powers in New Delhi does not seem to be paying off for many company bosses.

Look at this chart from specialist India-focused investor Ocean Dial. It shows that since mid-2011 companies perceived as politically well-connected have significantly underperformed the broader Mumbai index. The underperformance has intensified this year.

According to David Cornell, portfolio manager at the fund, this is down to several factors such as The Right to Information Act which has helped curb unfettered corruption as well as shifting political power away from the centre towards provincial governments.  He says:

In defence of co-investing with the state

It’s hard to avoid state-run companies if you are investing in emerging markets — after all they make up a third of the main EM equity index, run by MSCI. But should one be avoiding shares in these firms?

Absolutely yes, says John-Paul Smith at Deutsche Bank. Smith sees state influence as the biggest factor dragging down emerging equity performance in the longer term. They will underperform, he says, not just because governments run companies such as Gazprom or the State Bank of India in their own interests (rather than to benefit shareholders)  but also because of their habit of interfering in the broader economy.  Shares in state-owned companies performed well during the crisis, Smith acknowledges, but attributes emerging markets’ underperformance since mid-2010 to fears over the state’s increasing influence in developing economies. (t

Jonathan Garner at Morgan Stanley has a diametrically opposing view, favouring what he calls “co-investing with the state”.  Garner estimates a basket of 122 MSCI-listed companies that were over 30 percent state-owned outperformed the emerging markets index by 260 percent since 2001 and by 33 percent after the 2008 financial crisis on a weighted average basis. The outperformance persisted even when adjusted for sectors, he says (state-run companies tend to be predominantly in the commodity sector).

Trading the new normal in India

After a ghastly 2011, Indian stock markets have’t done too badly this year despite the almost constant stream of bad news from India. They are up 12 percent, slightly outperforming other emerging markets, thanks to  fairly cheap valuations (by India’s normally expensive standards)  and hopes the central bank might cut rates. But foreign  inflows, running at $3 billion a month in the first quarter, have tapered off and the underlying mood is pessimistic. Above all, the worry is how much will India’s once turbo-charged economy slow? With the government seemingly in policy stupor, growth is likely to fall under 7 percent this year. News today added to the gloom — exports fell in March for the first time since the 2009 global crisis.

So how are fund managers to play India now? According to David Cornell, who runs an India portfolio at specialist investor Ocean Dial, they must simply get used to the “new normal” — subpar growth and high cost of capital. In this shift, Cornell points out, return on assets in India has fallen from a peak of almost 14 percent in 2007 to less than 10 percent now. While that is still higher than the broader emerging asset class, the advantage has dwindled to less than 1 percent as companies suffer from margin compression and falling turnover. Check out these two graphs from Ocean Dial:

Cornell is playing the new normal by focusing on three sectors — consumer goods, banks and pharmaceuticals. These companies, he says, have pricing power and structural barriers to entry (banks); provide access to still-buoyant demand for services such as mobile phones (consumer goods) and are well-run and profitable (pharmaceuticals). And the export-oriented pharma sector is also an effective hedge against the weakening rupee.

Emerging bond defaults on the rise, no surprise

As may be expected, the crisis has increased the risk of default by emerging market borrowers. According to estimates by ING Bank’s emerging bond guru David Spegel, the default rate on EM bonds is running at over $6 billion in the first four months of 2012, already surpassing the 2011 total of $4.3 billion. He  predicts another $1.3 billion of emerging defaults to come this year.

Spegel expects the default rate for speculative grade emerging corporates to rise to 3.25 percent by September, up from 3 percent at present.  That doesn’t look too bad, given defaults ran at 13 percent after the 2008 crisis and hit a record of over 30 percent in the 2001-2003 period. But ING data shows some $120 billion worth of corporate bonds trading at “distressed” or “stressed” levels, i.e. at spreads upwards of 700 basis points. The longer such wide spreads persist, the higher the probability of default. A worst case scenario  would see a 12.9 percent default rate by end-2012, Spegel says.

Many companies are having trouble rolling over maturing bonds (selling debt to pay off existing creditors). One reason might be the explosion in bond issuance this year. Data from Bank of America/Merrill Lynch shows bond sales by emerging borrowers, sovereign and corporate, totalled 14 billion in the first three months of the year, a quarter more than the same 2011 period.  Clearly everyone is rushing to raise cash before U.S. Treasury yields rise further. (see what we wrote on this a few months ago)

Where will the FDI flow?

For years the four mighty BRIC nations have grabbed increasing shares of world investment flows. But the coming years may not be so kind.  These countries bring up the bottom of the Economic Freedom Index (EFI) for 2012. Compiled by Washington D.C.-based think-tank The Heritage Foundation the EFI measures 10 freedoms —  from property rights to entrepreneurship – and according to a note out today from RBS economists, there is a strong positive link between a country’s EFI score and the amount of FDI (foreign direct investment) it can secure. So the more “free” a country, the more FDI inflows it can expect to receive — that’s what an RBS analysis of 2002-2008 investment flows shows.

So back to the BRICs. Or BRICS if you add in South Africa (part of the political grouping though not yet included in the BRIC investment concept used by fund managers). The following graphic shows Russia languishing at the bottom of the EFI, China just above Russia and India third from bottom.  Brazil is sixth from bottom while South Africa ranks two places higher.

At the other end of the spectrum is tiny Singapore. Its EFI score is double that of Russia and between 2002-2008 it attracted FDI equivalent to 50 percent of its economy. Russia in contrast saw negative net FDI (outflows exceeded inflows)