U.S. Stocks in Sweet Spot as Emerging Markets Tighten
Price pressures are pushing emerging-market central banks from Russia to China to raise interest rates this year, tarnishing the appeal of their stocks and increasing investor interest in the U.S.
Tighter monetary policy means officials in developing nations will break further with Federal Reserve Chairman Ben S. Bernanke. He has pledged to keep rates near zero for an extended period and continue stimulus plans to power a recovery now gathering momentum.
The shift is causing Goldman Sachs Group Inc. -- which coined the term BRIC to highlight the power of Brazil, Russia, India and China -- to dilute its support for stocks of emerging countries, saying it no longer expects them to outperform the Standard & Poor’s 500 Index. JPMorgan Chase & Co. also has reversed a bias toward these equities.
Developing “markets are on the frontline of the inflation fight,” said Eric Fine, a portfolio manager in New York who helps Van Eck Associates Corp. oversee $3 billion in emerging- market assets. “This is the year when the trade-off between inflation and growth becomes even harder.”
The combination of accelerating growth in economies such as the U.S. with little pressure for tighter policy may be creating a “sweet spot” for their asset markets, Dominic Wilson, head of Goldman Sachs global-markets research in New York, wrote in a Jan. 5 report to clients. The firm’s strategists estimate the S&P 500 will end 2011 at 1,500, up from 1,283.76 at 4 p.m. in New York yesterday. They aren’t alone in their confidence.
Robert Doll, BlackRock Inc.’s chief equity strategist, predicts stocks in the U.S. will gain more on a relative basis this year as its growth runs closer to that of emerging countries. The U.S. expanded 2.8 percent in 2010, according to the median estimate of 84 economists surveyed by Bloomberg News. That would be the strongest annual pace since 2005.
“People will move away” from developing nations, and “America will do better than the rest of the world,” billionaire investor Kenneth Fisher said Jan. 10 on Bloomberg Television’s “Surveillance Midday” with Tom Keene.
China and its counterparts limited interest-rate increases for much of 2010 to safeguard expansion and avoid surging exchange rates, helping the MSCI Emerging Markets Index gain 16 percent last year. Now investors are in retreat, with that index up 3 percent since China announced Christmas Day that it would raise its key one-year lending and deposit rates by 25 basis points, the second move since mid-October.
Chinese Stocks Tumble
China’s stocks tumbled today on concern stricter monetary policy may hurt growth and, in another attempt to rein in liquidity, the authorities told banks to set aside more deposits for a fourth time in two months.
Thailand boosted its benchmark rate on Jan. 12 by a quarter percentage point to 2.25 percent. South Korea followed yesterday with a matching increase to 2.75 percent. Brazil’s central bankers convene next week, with investors anticipating higher rates there, too.
The need for more-restrictive monetary policy in developing countries is a “key reason” why Goldman Sachs analysts decided in November to revoke a bet that their stocks would outperform the S&P 500, according to Wilson. JPMorgan Chase analysts said last week they have “tactically” reversed their so-called overweight position in these equities compared with those of developed economies, partly because of the likelihood that higher inflation will require rate increases.
Wilson’s research shows that emerging-market stocks underperform when China is tightening policy. Also driving the global split is the biggest difference in 16 years between output gaps in advanced and emerging nations, Wilson calculates. An output gap is the spread between current expansion in gross domestic product and the pace of growth that ignites inflation.
“Inflation pressure and a tightening response in parts of the emerging-market world are likely to continue to be features of the landscape,” Wilson wrote in the report. He estimates price increases will accelerate this year to 5.8 percent in developing countries from 5.6 percent, compared with 1.8 percent in advanced economies from 1.6 percent.
Win Thin, global head of emerging-market strategy at Brown Brothers Harriman & Co. in New York, says the currencies of developing countries also will strengthen as policy makers realize they can’t restrain both exchange rates and inflation.
Having raised its benchmark rate by 200 basis points last year to 10.75 percent, Brazil’s officials have made three attempts since October to hold back a 35 percent rally in the real since the end of 2008. Their goal is reducing the threat of asset bubbles and currency gains driven by foreign capital seeking higher yields. Last week, they set reserve requirements on short dollar positions held by local lenders.
Almost a month after Chile raised its benchmark a quarter point to 3.25 percent, it is buying $12 billion in the foreign- exchange market to weaken the peso.
“Attempts to target both inflation and the exchange rate are basically impossible and will eventually break down,” Thin said. “Inflation-targeting warrants higher interest rates, which in turn leads to a stronger currency.”
China, India, South Africa, Indonesia, Singapore and Thailand will be “more open to a combination of monetary tightening and currency strength,” while more-limited inflation threats in Malaysia, the Philippines and Taiwan will allow them to resist increases in rates and currencies, Thin predicted. Reports last week showed inflation picking up in Indonesia and Thailand.
Thin also forecasts more stringent monetary policy in Latin America after Peru last week unexpectedly raised its interest rate by a quarter point to 3.25 percent and data showed inflation running faster than economists predicted in Brazil, Colombia, Chile and Mexico.
Central banks in developing countries are changing tack as the global recovery builds and economists warn that food and commodity prices risk spilling into broader inflation. The United Nations reported last week that world food prices rose to a record in December, while the Standard & Poor’s GSCI Spot Index of 24 commodities touched 645.72 on Jan. 12, the highest since Sept. 26, 2008. The measure has rallied 21 percent in the past year.
That contrasts with advanced economies, where the need to cement the recovery from the worst recession since World War II will force the Fed and Bank of Japan to hold rates near zero through year-end and the European Central Bank to boost its benchmark from 1 percent only in the final quarter, says Ethan Harris, head of developed-markets economic research at Bank of America Merrill Lynch in New York.
Neither the ECB nor the Bank of England announced increases when their policy makers gathered yesterday, although ECB President Jean-Claude Trichet signaled he’s prepared to boost rates if needed.
Harris predicts his measure of emerging-market rates will rise to 6.27 percent this year from about 5.66 percent at the end of 2010, while his advanced-nation gauge will increase 19 basis points to 0.77 percent.
Developing nations will find it easier to raise rates this year because, unlike in 2010, slack in their economies is evaporating, said Manoj Pradhan, an economist at Morgan Stanley in London. That removes a counterbalance to the higher raw- material costs just as growth in key export markets is improving, led by the U.S., he said.
Seventeen of the 23 emerging markets that Morgan Stanley monitors will raise rates this year, and most of them likely will allow their currencies to appreciate, Pradhan and his colleagues predict. China will lift its key rate to 6.56 percent from 5.81 percent, Brazil will increase by 1.75 percentage points to 12.50 percent and India will add 100 basis points to its 6.25 percent repurchase rate.
They say it also is likely that China, South Korea, Mexico and South Africa will allow their currencies to appreciate, making exports more expensive and imports cheaper. By contrast, Brazil, India and Thailand are unlikely to allow their exchange rates to rise, they say.
“The risk of not doing anything now is faster inflation later; and if that happens, they’d have to step on the brakes harder and slow growth right down,” Pradhan said.
Stephen King, chief global economist at HSBC Holdings Plc in London, is betting authorities will lean toward measures other than interest-rate increases to deflate their economies so as not to spark currency surges that hurt their trade positions.
Recent examples of this strategy, which King calls “quantitative tightening,” include last month’s announcement by South Korea that it will apply a levy on banks’ foreign- exchange borrowings and Taiwan’s decisions to step up curbs on the use of exchange-rate derivatives and on second-home mortgages. Exports account for about 40 percent of South Korea’s economy and two thirds of Taiwan’s.
The greatest risk is that policy makers won’t act fast enough and their economies will overheat, said David Hensley, director of global economic coordination at JPMorgan Chase in New York. He estimates emerging-market interest rates are now about 2 percentage points below their pre-credit-crisis average.
Hensley likens the current economic environment to 2006-07, when monetary policy in developing economies was too loose. The result was a commodity-price boom and accelerating inflation that were reversed only when the credit crisis in rich nations dragged emerging countries down.
Fast forward to 2011, and developing nations are “playing with fire,” Hensley said. Failure to act soon risks “setting the stage for a more aggressive, and possibly threatening, policy adjustment in 2012.”
His interest-rate measure for emerging markets shows an increase of less than 1 percentage point this year to 6.08 percent, even as he calculates inflation will end the year still above 5 percent.
“They’ll tighten this year but not enough,” Hensley said. “There is a real problem building here.”
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