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Jubak's Journal
Recent articles:
• 5 stocks inflation will help, 5/19/2004
• Why the Fed needs to hike rates soon, 5/18/2004
• My formula for buying stocks in a rocky market, 5/14/2004
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2 rules for investing in edgy emerging markets
The Federal Reserves low-rate policy helped boost stock prices in many global markets. Now, the possibility of higher rates makes them vulnerable. That creates buying opportunities -- if you follow these two rules.
By Jim Jubak
Just when the global economy started to party, they took the punch bowl away.
They, of course, is the U.S. Federal Reserve. Any investor looking to offset the sell-off in U.S. stocks and bonds by buying foreign assets has been disappointed to discover that the prospect of rising interest rates in the United States is enough to lower boats in all the worlds markets.
And when it comes to the stocks and bonds of emerging markets, such as India, China, and Brazil, the Feds potential shift in policy has been enough to make these markets crater. Clearly, the recent declines are a sign that the old rule for when to buy emerging-market stocks and bonds needs a major revision.
Let me sketch an updated rule for deciding when to buy in these volatile but potentially very rewarding emerging markets.
But first, lets step back and look at first-quarter growth numbers for the worlds major economies. Japans GDP is up an annualized 5.6%, the United States 4.2%, China 9.8% and India 10%.
Even the Europeans, not exactly party animals in recent years, looked ready to get down. GDP grew at an annualized rate of 3.2% in France, 2.4% in the United Kingdom and 1.6% in Germany.
All the countries that dominate the global economy looked were about to boogey together. Youd think the worlds stock markets would be ready for a bull run of historic proportions.
But instead investors get treated to a day like May 17, when the Dow Jones Industrial Average ($INDU) fell 106 points, or 1.1%, and the Nasdaq Composite ($COMPX) retreated 28 points, or 1.5%.
And that was the good news. In India, the stock market fell 11.1%. South Korea fell 5.1%, Japan 3.2%, Hong Kong 2.7%, Brazil 2.6%, Mexico 1.9%, France 1.4% and Germany 1.3%.
Certainly there are country-specific reasons for these markets to tumble: political uncertainty in India and yet more big bank losses in Japan. The suicide bombing in Iraq that took the life of the president of the Iraqi Governing Council and eight others certainly was unsettling enough to put pressure on financial markets across the globe.
The Fed shuts the party down
But to understand why the party that these great economic numbers promised has turned into a bust -- and why the worst of the hangover is being felt in what are called the emerging stock markets -- youve got to start with that global party pooper, the U.S. Fed.
Its the end of Alan Greenspans guarantee of cheap money (i.e., money you can borrow at 1% a year) that is putting an end to financial partying around the world.
It works like this. Hedge funds and other big U.S. institutional investors have been able to borrow at 1% at the short end of the U.S. debt market. Much of that money went into U.S. Treasury bonds. The returns there were just too tempting to resist: An investor could borrow at 1%, buy a bond with a 3.5% yield and, while the Fed was still in the process of cutting rates on the way to 1%, collect a capital gain, too. Hedge funds and other institutional investors are now unwinding these positions by selling bonds and using the proceeds to repay those loans. This unwinding is a major reason that interest rates in the U.S. bond market have started to climb even before the Fed actually does anything.
But not all that borrowed money went into the U.S. bond market. Hedge funds that were long Treasurys (meaning they owned a lot of them) often bought foreign securities as another way to profit from the Feds 1% rate target. (As a bonus, buying foreign stocks and bonds also hedged the investor against losses in the U.S. markets, as unlikely as they might be as long as the Fed kept its promises.) You see, the currency of a country running a huge trade deficit (as the U.S. does) and a huge government budget deficit (as the U.S. does) is likely to fall in value. A falling dollar means profits for U.S. investors who own investments denominated in yen or baht or won or euros. The non-dollar interest payments from those investments and the non-dollar principle amounts translated back into more dollars as the U.S. dollar fell in value.
The Fed boosted emerging markets, too
Buying non-dollar financial assets was even more attractive since some of these foreign markets exploded this year. Indias Senex Index, for example, was up more than 70% last year in dollars.
The Fed played a role in emerging-market stock performance, too. Low interest rates in the United States let countries like China and India attract foreign investment capital at lower rates and keep their own domestic interest rates relatively lower as well. The low rates, of course, helped push economic growth higher.
Now, just as hedge funds and others are unwinding their positions in the U.S. bond market, investors are unwinding their positions in India, Brazil, Korea, Thailand and China.
Sellers are bailing out because, with U.S. interest rates set to rise, the dollar is likely to strengthen in the short term. So these investors who used to prefer non-dollar denominated financial assets now prefer dollar-denominated instruments. At least until the dollar starts to weaken again. These investors realize that higher U.S. interest rates can hurt the economies of these emerging countries -- by making investment capital more expensive and by increasing domestic interest rates -- just as lower U.S. interest rates helped these economies.
Other investors are pulling out of these emerging markets because:- Theyre worried about the effect of slower growth in China.
- They're worried about the effect of rising oil prices or the effect of higher U.S. interest rates.
- Theyre seeing prices in these markets start to go down, and they want to protect their profits.
According to AMG Data Services, which tracks cash flows into and out of U.S. mutual funds, more than $464 million flowed out of emerging-market stock funds last week -- the largest outflow on record.
Brazil shows why investor fears are real
Look at the plight of Brazil to see why these investors worries are real -- and why these worries tend to become self-fulfilling prophecies. Brazils government has issued about 760 billion reals in debt to investors worldwide. (It now takes about 3.1 reals to equal a dollar.) Like the U.S. Treasury, the Brazilian Treasury must constantly sell new notes and bonds to finance any increases in that debt but also to refinance any bonds and notes that mature.
To get investors to buy Brazils debt, the government has had to keep its target interest rate at 16%. Thats considerably above what investors get in interest on U.S. Treasurys. It is, however, what investors have demanded to compensate for the risk that the real will sink in value or that the price of Brazilian bonds will fall or that the government of Brazil will decide to write off some of its debt. Right now, Brazils debt is a stunning 58% of the countrys gross domestic product.
The government of President Luiz Incio Lula da Silva would love to lower interest rates to spur growth in the Brazilian economy, but thats almost certainly not in the cards if U.S. interest rates go up. Investors who demand 16% yields from Brazil when the U.S. 10-year note pays 4.8% wont ask for less than 16% if the yield on the U.S. note goes up to 5%. So Brazilian interest rates, rather than falling, may have to rise. And that would put a crimp in Brazils economy.
Investors who fear this scenario either can pull their money out of Brazilian financial assets or demand higher rates. That, in turn, will create problems when Brazil tries to roll over maturing debt. The Brazilian Treasury had to cancel its regular auction last week, and its now been three weeks and counting since Brazil has sold any fixed-rate debt at all.
This week, the Treasury did manage to sell about 3 billion reals worth of floating-rate debt, but thats well short of the 32 billion reals that mature this week. (Brazil does have about $50 billion in reserves that it can use to finance the maturing debt, so the country is certainly not in any immediate danger of default.)
Investors who sold Brazilian assets over worries about just this kind of development now see their decision validated. That just makes it harder for Brazil to sell its debt, to lower interest rates or to set its economy on the path of faster growth.
Its the effect of likely increases in U.S. interest rates that has changed, for the moment, the rules for when to buy stocks and bonds of an emerging-market country.
Buy when things look worst and Fed panic is biggest
The conventional advice is to buy when things look blackest for the market in question. The usual phrase is when blood runs in the streets. So the time to buy Indian stocks, for example, was Friday. Thats when it looked like the Congress Party was going to have to buy the support of the Communist and Marxist parties it needed to form a majority coalition in the new Indian parliament by promising to undo some of the reforms that been so critical to Indias recent growth.
Add in the outgoing governments threat to boycott Congress Party head Sonia Gandhis inauguration as prime minister on grounds of her birth in Italy, and not India, and it looked like the country was headed toward a full-blown political crisis.
That was the low point. Indian stocks rallied sharply Tuesday and Wednesday after Gandhi said she would turn down the job of prime minister, and on hopes that economist Manmohan Singh would be the next prime minister. Singh is the ex-finance minister credited with saving the country in the fiscal crisis of the early 1990s and is seen as the father of the current economic reform program.
The solution to the political problem, if thats what this turns out to be, doesnt do a thing to change the dynamics of the problem that all emerging markets face as a result of rising U.S. interest rates. Investors can expect to see the pressure on emerging-market stocks and bonds continue as long as investors are uncertain about how far and fast the Fed will push up U.S. interest rates. U.S. interest rates are a global dynamic that is acting to reset prices on all emerging-market assets.
Investors in this situation need to add a second rule. Buy emerging-market assets when things look blackest in that market and when worries about the pace of Fed rate hikes is highest. The timing of those blackest periods will vary from emerging market to emerging market. But the peak of worry about the Fed will be a global one.
My best guess is that the period of greatest worry for all emerging markets about Fed policy may still be ahead of us. It may take an actual June or August interest-rate hike here in the United States to bring that fear to a climax.
Until then, Id anticipate extreme volatility and heavy trading volumes in emerging-market stocks (and in their U.S.-traded ADRs) to continue, and for downward pressure from potential U.S. rate hikes to continue no matter what crises and crises solutions may come and go in individual emerging markets.
New developments on past columns
Why the Fed needs to hike rates soon
Martin Fridson offers one of the best explanations that Ive seen of why this isnt 1994 and investors shouldnt worry that the Federal Reserve is about to hike interest rates six times as they did that year.
Once the high-yield bond guru at Merrill Lynch and now the editor of Leverage World, Fridson argues that this time the bond market has anticipated the Feds hikes by pushing bond prices lower and boosting yields. In 1993, before the Fed started to raise rates, the yield on the 10-year Treasury note actually fell by 70 basis points as bond traders thought rates were headed lower. (100 basis points equal one percentage point.) But in the 12 months after February 3, 1994, when the Fed began to push rates higher, the yield on the 10-year Treasury climbed by 184 basis points. The price of the bond fell with a very loud thud.
Compare that with the last 12 months: The yield on the 10-year Treasury has climbed by 117 basis points, and the Fed hasnt yet moved on rates. Fridson notes that the consensus among economists right now is that the Fed funds rate will climb to 2.5% in the next 12 months from the current 1%. If thats true, the 117 basis point increase weve seen in the 10-year note yield is equal to 78% of the projected total Fed rate increase.
3 growth stocks with room to grow
The global soybean market is a mess, thanks to the financial troubles at Chinese soybean processors and the small U.S. crop due to last years drought.
Chinese banks have refused to issue letters of credit to Chinese soybean crushers, leaving cargoes of soybeans stuck in port. Apparently, one result of the recent government pressure on Chinese banks to think before they lend is that the banks have noticed that the countrys soybean crushers lose almost $40 for every ton of beans they crush at current prices.
Adding to the woes of Chinese crushers, they bought much of their supply at peak prices and now are looking to delay or cancel delivery. This plus the small U.S. harvest has made soybean prices on the Chicago Board of Trade extremely volatile lately. Prices for July delivery of soybeans fell to their 50 cents-a-bushel limit at the Board of Trade on May 14. I dont think any of this will have a serious effect on shares of Bunge Ltd. (BG, news, msgs). Judging from the companys first quarter results, Bunge locked in low soybean prices last fall, and the companys huge Brazilian presence gives it ready access to Latin American soybean crops.
A safer way to play higher oil prices
Demand for oil from China and increased Saudi Arabian production are keeping oil tanker charter rates higher than expected during the seasonally-weak second quarter of the year. That is leading Wall Street analysts to raise their earnings estimates for tanker companies. On May 17, Jefferies & Co. raised its second-quarter estimate for TeeKay Shipping (TK, news, msgs) to $1.99 a share from the previous $1.77 a share. For all of 2004, Jefferies & Co. raised its earnings projections to $9.79 from the earlier $9.17 a share.
My hell-in-a-handbasket portfolio
Good news and bad news in an annual review issued by ICICI Bank (IBN, news, msgs) on April 30. First, the good news from the Indian banking giant. Earnings were up 33% year over year for the fiscal year that ended in March 2004. The bank continued to reduce its credit risk problem with non-performing assets falling by 23%. And the company continued to show huge market share in the consumer retail market with a 28% share of mortgages, 36% of auto loans, and 23% of credit cards issued.
Raymond James estimates that the bank has 30% of the retail loan market in India and that retail loans account for 54% of the banks loan portfolio. Thats the kind of progress in making the transition from a commercial to a retail lender that I was looking for when I added the stock to Jubaks Picks. Retail banks command higher price-to-earnings ratios than commercial banks.
Now, the bad news. Its clear that a large percentage of the banks earnings are coming from its trading operations in the stock market. The banks disclosure on this and from its income on selling loans is inadequate. The bank will only say that selling of loans makes up about 20% of net income. The reliance on stock market profits and loan sale earnings is likely to make this a very volatile stock on the currently very volatile Indian stock market. As of May 21, Im keeping my December 2004 target price at $21 a share. (Full disclosure: I own shares of ICICI Bank.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned shares in the following equities mentioned in this column: ICICI Bank. He does not own short positions in any stock mentioned in this column.
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