Global Investing

When will Brazil’s central bank admit it has an inflation problem? Markets will be watching today’s rate-setting meeting for clues.

There is no doubt about the outcome of today’s meeting at the Banco Central do Brasil (BCB) — no one expects it to do anything but leave interest rates steady at the current 7.25 percent. But the BCB has been focused on growth for 18 months and has cut interest rates by 525 basis points in this time, its actions helping to drive the real 10 percent lower last year versus the dollar. The government meanwhile has unleashed huge doses of fiscal stimulus. The result, rather than a growth recovery, is a steady rise in inflation.

Goldman Sachs’ Latin America economist Alberto Ramos points out that Brazilian inflation came in above the 4.5 percent target for the third straight year in 2012 and the balance of inflation risks has deteriorated. Gasoline prices are to rise from next week and drought is making hydro-power generation more costly. Analysts polled by Reuters expect 2013 price growth at 5.53 percent. Ramos writes:

We are of the view that at a certain point the central bank needs to own the inflation problem and acknowledge that just remaining on automatic pilot may not be enough to drive inflation to the 4.5% target by year-end 2013.  

The bank will not raise interest rates any time soon and is sticking to a 4.8 percent inflation forecast for 2013 . Ramos says the bank must at least change its post-meeting message in which it has referred to “a stable/unchanged monetary stance for a prolonged period of time”.

All eyes on Poland’s central bank this week to see if it will finally join the monetary easing trend underway in emerging markets. Chances are it will, with analysts polled by  Reuters unanimous in predicting a 25 basis point rate cut when the central bank meets on Wednesday. Data has been weak of late and signs are Poland will struggle even to achieve 2 percent GDP growth in 2013.

How far Polish rates will fall during this cycle is another matter altogether. Markets are betting on 100 basis points over the next 6 months but central bank board members will probably be cautious. Inflation is one reason  along with the  the danger of excessive zloty weakness that could hit holders of foreign currency mortgages. One source close the bank tells Reuters that 75 or even 50 bps would be appropriate, while another said:

“The council is very cautious and current market expectations for rate cuts are premature and excessive.”

The Olympic medals have all been handed out and the athletes are on their way home.  Which countries surpassed expectations and which ones did worse than expected? And did this have anything to do with the state of their economies?

An extensive Goldman Sachs report entitled Olympics and Economics  (a regular feature before each Olympic Games) predicted before the Games kicked off that the United States would top the tally with 36 gold medals. It also said the top 10 would include five G7 countries (the United States, Great Britain, France, Germany and Italy), two BRICs (China and Russia), one of the developing countries it dubs Next-11  (South Korea), and one additional developed and emerging market. These would be Australia and Ukraine, it said.

Close enough, except that Hungary took the place of Ukraine as the emerging economy in the Top 10 and the United States actually took 46 gold medals — more than Goldman had predicted.

Could the Turkish central bank surprise markets again today?

Given its track record, few will dare to place firm bets on the outcome of today’s meeting but the general reckoning for now is that the bank will keep borrowing and lending rates steady and signal no immediate change to its weekly repo rate of 5.75 percent. With year-on-year inflation in the double digits, logic would dictate there is no scope for an easier monetary policy.

But there are reasons to believe the Turkish central bank, whose mindset is essentially dovish, is letting its thoughts stray towards rate cuts. Consider the following:

a) Governor Erdem Basci has already said he does not see the need for further policy tightening  b)The lira has strengthened  9 percent this year against the dollar and is back at levels last seen in early September, thanks to almost one billion dollars in foreign flows to the Turkish stock market and well-subscribed bond issues. And crucially c) Global factors are supportive (developed central banks are continuing to pump liquidity and a bailout  has finally been agreed for Greece) .

Emerging market bonds denominated in local currencies enjoyed a record January last month with JP Morgan’s GBI-EM Global index returning around 8 percent in dollar terms. Year-to-date, returns are over 9.5 percent.

This is mainly down to spectacular gains on emerging currencies such as the Mexican peso and Turkish lira which have surged 7-10 percent against the dollar and euro this year.  Analysts say the currency component of this year’s returns has been around 7 percent, meaning any portfolio hedged for currency risk would have garnered returns of just 2.5 percent.

The gains come as good news to investors licking their wounds after the index ended 2011 in negative territory. A mid-year rout on emerging markets pushed up local bond yields, often by hundreds of basis points and sent many currencies to multi-year lows.

Anyone worried about Greece and the potential impact of the euro debt crisis on the world economy should have a chat with Jim O’Neill. O’Neill, the head of Goldman Sachs Asset Management ten years ago coined the BRIC acronym to describe the four biggest emerging economies and perhaps understandably, he is not too perturbed by the outcome of the Greek crisis. Speaking at a recent conference, the man who is often called Mr BRIC, pointed out that China’s economy is growing by $1 trillion a year  and that means it is adding the equivalent of a Greece every 4 months. And what if the market turns its guns on Italy, a far larger economy than Greece?  Italy’s economy was surpassed in size last year by Brazil, another of the BRICs, O’Neill counters, adding:

“How Italy plays out will be important but people should not exaggerate its global importance.  In the next 12 months the four BRICs will create the equivalent of another Italy.”

Emerging economies are cooling now after years of turbo-charged growth. But according to O’Neill, even then they are growing enough to allow the global economy to expand at 4-4.5 percent,  a faster clip than much of the past 30 years. Trade data for last year will soon show that Germany for the first time exported more goods to the four BRICs than to neighbouring France, he said.

BRIC is Brazil, Russia, India, China — the acronym coined by Goldman Sachs banker Jim O’Neill 10 years back to describe the world’s biggest, fastest-growing and most important emerging markets.  But according to Albert Edwards, Societe Generale‘s uber-bearish strategist, it also stands for Bloody Ridiculous Investment Concept. Some investors, licking their wounds due to BRIC markets’ underperformance in 2011 and 2010, might be inclined to agree — stocks in all four countries have performed worse this year than the broader emerging markets equity index, to say nothing of developed world equities.

For years, money has chased BRIC investments, tempted by the countries’ fast growth, huge populations and explosive consumer hunger for goods and services. But Edwards cites research showing little correlation between growth and investment returns. He points out that Chinese nominal GDP growth may have averaged 15.6 percent  since 1993 but the compounded  return on equity investments was minus 3.3 percent.

But economic growth — the BRIC holy grail – is also now slowing. Data showed this week that Brazil posted zero growth in the third quarter of 2011 compared to last year’s 7.5 percent. Indian growth is  at the weakest in over two years. In Russia, rising discontent with the Kremlin — reflected in post-election protests — carries the risk of hitting the broader economy. And China, facing falling exports to a moribund Western world,  is also bound to slow. Edwards goes a step further and flags a hard landing in China as the biggest potential investment shock of 2012.  “Yet investors persist in the BRIC superior growth fantasy…If growth does matter to investors, they should be worried that
things seem to be slowing sharply in the BRIC universe,” he writes.

China moved to ease policy this week via a reserve ratio cut for banks, effectively starting to reverse a tightening cycle that’s been in place since last January. Later the same day, Brazil’s central bank cut interest rates by 50 basis points for the third time in a row. Both countries are expected to continue easing policy as the global economic downturn bites. And last week Russia signalled that rate cuts could be on the way.

That makes three of the four members of the so-called BRIC group of the biggest emerging economies. Indonesia, the country some believe should be included in the BRIC group, has also been cutting rates. That leaves India, the fourth leg of the BRICs, the quartet whose name was coined by Goldman Sachs banker Jim O’Neill ten years ago this week. India could use a rate cut for sure. Data this week showed growth slowing to 6.9 percent in the three months to September — the slowest since September 2009. Factory output slowed to a 32-month low last month, feeling the effects of the global malaise as well as 375 basis points in rate increases since last spring. No wonder Indian stocks, down 20 percent this year, are the worst performing of the four BRIC markets.

But unlike the other BRICs, a rate cut is a luxury India cannot afford now — inflation is still running close to double digits.  “The Reserve Bank of India (RBI) is the odd guy out due to stubbornly high inflation of near 10 percent,” writes Commerzbank analyst Charlie Lay.

Goldman Sachs researchers have been hitting the history books again, trying to divine what happens to currencies when economies stagnate. Answer:  Not as much as you might think

Looking at exchange rates for years before and during "stagnation", Goldman found that year-to-year FX volatility in such periods is lower than in normal periods. But a lot of it depends on the type of stagnation.

First, an average stagnation -- a period of sub-par economic growth lasting for at least six years:

Could the dreaded R word come back to haunt the developing world? A study by Goldman Sachs shows how differently financial markets and surveys are assessing the possibility of a recession in emerging markets.
One part of the Goldman study comprising survey-based leading indicators saw the probability of recession as very low across central and eastern Europe, Middle East and Africa. These give a picture of where each economy currently stands in the cycle. This model found risks to be highest in Turkey and South Africa, with a 38-40 percent possibility of recession in these countries.
On the other hand, financial markets, which have sold off sharply over the past month, signalled a more pessimistic outcome. Goldman says these indicators forecast a 67 percent probability of recession in the Czech Republic and 58 percent in Israel, followed by Poland and Turkey. Unlike the survey, financial data were more positive on South Africa than the others, seeing a relatively low 32 percent recession risk.
Goldman analysts say the recession probabilities signalled by the survey-based indicator jell with its own forecasts of a soft patch followed by a broad sustained recovery for CEEMEA economies.
"The slowdown signalled by the financial indicators appears to go beyond the ‘soft patch’ that we are currently forecasting," Goldman says, adding: "The key question now is whether or not the market has gone too far in pricing in a more serious economic downturn."