Global Investing

Rate cuts are still coming thick and fast in emerging markets — in some cases because of falling inflation and in others to deter the gush of speculative international capital.

Arguably the biggest event in emerging markets is tomorrow’s Reserve Bank of India (RBI) meeting which is expected to yield an interest rate cut for the first time in nine months.

India’s inflation, while still sticky, eased last month to a three-year low of around 7 percent. And a quarter point rate cut to 7.75 percent will in effect be a nod from the RBI to the government’s recent reform efforts.  In anticipation of a rate cut, Indian 10-year bond yields have dropped 50 basis points since the start of the year.  But the RBI, probably the world’s most hawkish central bank at present, has warned that markets need not expect a 50 bps cut or even a sustained rate-cutting campaign. Governor Duvvuri Subbarao said last week inflation still remains too high for comfort, while on Monday the RBI said in a quarterly report that more reform was needed to make the central bank turn its focus on growth.

In Colombia, the  BanRep is likely to cut rates later today for the fifth time in seven months. Growth slowed to 2.1 percent in the third quarter, considerably below forecasts, while inflation in December was 2.4 percent, well below the midpoint of the target range.  Then there is the matter of the peso which has risen to the 1750 per dollar level that has triggered intervention in the past. Many analysts therefore reckon currency strength will be the main driver for the central bank’s decision later today. From that angle too, a cut looks logical.
According to Bank of America/Merrill Lynch:

We expect Banrep to compromise by cutting, and maintaining FX intervention unaltered, presenting the cut as a policy that tackles both deceleration and appreciation….another cut at Monday’s meeting would seem to be a safe bet.

What a varied bunch emerging markets have become. At last week’s monetary policy meetings, we saw one rate rise (Serbia) and differing messages from the rest. Mexico turned dovish while hitherto dovish Brazilian central bank finally mentioned the inflation problem. Russia meanwhile kept markets guessing, signalling it could either raise rates next month or cut them.

This week, a cut looks likely in Turkey while South Africa and the Philippines will almost certainly keep interest rates steady.

Turkey’s main policy rate – the one-week repo rate – and overnight lending rate are widely expected to stay on hold at 5.50 percent and 9 percent respectively on Tuesday. But some predict a cut in the overnight borrowing rate – the lower end of the interest rate corridor, motivated partly by the need to keep the currency in check.   The lira is trading near 10-month highs, thanks to buoyant inflows to Turkish capital markets.  That has helped lower inflation from last year’s double-digit levels.

Global markets have found themselves at an interesting juncture of underlying new year bullishness stalled by trepidation over several short-term headwinds (US debt debate, Q4 earnings, Italian elections etc etc) – the net result has been stalemate, something which has sunk volatility gauges even further. Not only did this week’s Merrill funds survey show investors overweight bank stocks for the first time since 2007, it also showed demand for protection against a sharp equity market drops over the next 3 months at lowest since at least 2008. The latter certainly tallies with the ever-ebbing VIX at its lowest since June 2007. Though some will of course now argue this is “cheap” – it’s a bit like comparing the cost of umbrellas even though you don’t think it’s going to rain.

Anyway, the year’s big investment theme – the prospect of a “Great Rotation” back into equity from bonds worldwide – has now even captured the sceptical eye of one of the market’s most persistent bears. SocGen’s Albert Edwards still assumes we’ll see carnage on biblical proportions first — of course — but even he says long-term investors with 10-year views would be mad not to pick up some of the best valuations in Europe and Japan they will likely ever see. “Unambiguously cheap” was his term – and that’s saying something from the forecaster of the New Ice Age.

For others, the very fact that Edwards has turned even mildly positive may be reason enough to get nervy! When the last bear turns bullish, and all that…

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:

Indonesia has just given the go-ahead for another leg down in the rupiah. It has cut its forecasts for the exchange rate to 9,700 per dollar compared to the 9,200 level at which the central bank used to step in. The currency has duly weakened and nervous foreigners have rushed to hedge exposure — 3-month NDFs price the rupiah at almost 10,000 to the dollar. The  rupiah last week hit a three-year low, its weakness coming on top of a dismal 2012 which saw it fall 6 percent as the current account deficit worsened. Traders in Jakarta are reporting dollar hoarding by exporters.

All that is spooking foreigners who own more than 30 percent of the domestic bond market. The currency weakness hit them hard last year as Indonesian bonds returned just 6 percent, a third of the sector’s 16 percent average (see graphic).

The central bank does not seem perturbed by the currency weakness. Luckily for it, inflation rates are still benign, which means a weak currency will probably remain in favour.

With Shinzo Abe’s new government intent on prodding the Bank of Japan into unlimited monetary easing, it is hardly surprising that the yen has slumped to two-year lows against the dollar. This could lead to even more flows into overseas markets from Japanese investors seeking higher-yield homes for their money.

Japanese mom-and-pop investors — known collectively as Mrs Watanabe -  have for years been canny players of currency and interest rate arbitrage. In recent years they have stepped away from old favourites, New Zealand and Australia, in favour of emerging markets such as Brazil, South Africa and Turkey. (See here  to read Global Investing’s take on Mrs Watanabe’s foray into Turkey). Flows from Japan stalled somewhat in the wake of the 2010 earthquake but EM-dedicated Japanese investment trusts, known as toshin, remain a mighty force, with estimated assets of over $64 billion.  Analysts at JP Morgan noted back in October that with the U.S. Fed’s QE3 in full swing, more Japanese cash had started to flow out.

That trickle shows signs of  becoming a flood. Nikko Asset Management, the country’s third  biggest money manager, said this week that retail investors had poured $2.3 billion into a mutual fund that invests in overseas shares — the biggest  subscription since October 2006. This fund’s model portfolio has a 64 percent weighting to U.S. shares, 14 percent to Mexico and 10 percent to Canada while the rest is split between Latin American countries.

A rate cut in Hungary is considered a done deal today. But a sharp downward move in the forint  is making future policy outlook a bit more interesting.

The forint fell 1.5 percent against the euro on Monday to the lowest level since July and has lost 2.6 percent this month. Monday’s loss was driven by a rumour that the central bank planned to stop accepting bids for two week T-bills. That would effectively have eliminated the main way investors buy into forint in the short term.   The rumour was denied but the forint continues to weaken.

Analysts are not too worried, attributing it to year-end position squaring. Benoit Anne, head of EM strategy at Societe Generale, points out the forint is the world’s best performing emerging currency of 2012 (up  11.3 percent against the dollar). Given the state of the economy (recession) and falling inflation, the forint move will not deter the central bank from a rate cut, he says.

A big week for central bank meetings looms and the doves are likely to be in full flight.

Take the Reserve Bank of India, the arch-hawk of emerging markets. It meets on Tuesday and some, such as Goldman Sachs, are predicting a rate cut as a nod to the government’s reform efforts. That call is a rare one, yet it may have gained some traction after data last week showed inflation at a 10-month low, while growth languishes at the lowest in a decade. Goldman’s Tushar Poddar tells clients:

With both growth and inflation surprising on the downside relative to the RBI’s forecast, there is a reason for the central bank to move earlier than its previous guidance.

Emerging market currencies have been a source of frustration for investors this year. With central banks overwhelmingly in rate-cutting mode and export growth slowing, most currencies have performed poorly. That has been a bit of a dampener for local currency debt –  while returns in dollar terms have been robust at 13 percent, currency appreciation has contributed just 1.5 percent of that, according to JP Morgan.

The picture could be changing though.  Fund managers at the Reuters 2013 investment outlook summit this week have been unanimously bullish on emerging debt, with many stating a preference for domestic debt. So far this year, dollar debt has taken in three-quarters of all inflows to emerging fixed income.

Andreas Uterman, CIO of Allianz Global Investors told the summit in London that many emerging currencies looked significantly undervalued, and that this anomaly would gradually resolve itself:

A mixed bag this week on emerging policy and one that shows the growing divergence between dovish central Europe and an increasingly hawkish (with some exceptions) Latin America.

Hungary cut rates this week by 25 basis points, a move that Morgan Stanley described as striking “while the iron is hot”, or cutting interest rates while investor appetite is still strong for emerging markets. The current backdrop is keeping the cash flowing even into riskier emerging markets of which Hungary is undeniably one. (On that theme, Budapest also on Wednesday announced plans for a Eurobond to take advantage of the strong appetite for high-risk assets, but that’s another story).

So despite 6 percent inflation, most analysts had predicted the rate cut to 6 percent. With the central bank board  dominated by government appointees, the  stage is now set for more easing as long as investors remain in a good mood.  Rates have already fallen 100 basis points during the current cycle and interest rate swaps are pricing another 100 basis points in the first half of 2013. Morgan Stanley analysts write: