LATAM provides perhaps the prime example of weird behaviour by investors in recent weeks.
Listen carefully for the death knell for growth
By John Authers
Published: November 2 2007 17:04 | Last updated: November 2 2007 17:04
People do strange things at this time of year. Last Wednesday, children across North America and Europe dressed up as witches and ghosts, and went from door to door asking for sweets.
If Hallowe’en strikes you as a gauche American import, remember that on Monday, people across Britain will be attending bonfires where they will burn an effigy of a 17th century figure. In my home town of Lewes in Sussex, they will also burn an effigy of the Pope.
Remember these examples when considering the bizarre behaviour in a swathe of Latin America on Friday, as families staged night-long parties in cemeteries, complete with brass bands and lots of alcohol, to commemorate the Day of the Dead.
Latin America also provides perhaps the prime example of weird behaviour by investors in recent weeks. But those investors are not Latins – they come from countries where people go trick or treating.
I have noted before that the US Federal Reserve’s decision to cut its discount rate in mid-August, in response to what was then a deepening crisis in the money markets, prompted investors to put money into the emerging markets.
This was a twofold bet. First, they were betting that cheaper money from the Fed would be enough to stave off a crisis, which had started with problems for US housing.
Second, they thought that the unintended beneficiaries of the extra liquidity would be the emerging markets, which were believed to have the best growth prospects, and were not directly affected by the crisis.
There was a template for all of this in the Long-Term Capital Management crisis of 1998, when emergency rate cuts from the Fed led to the bubble in tech and internet stocks – which were as strongly favoured to produce long-term growth then as the emerging markets are now.
It might be unfair to call what has since happened in the emerging markets a “bubble”. But prices are no longer rational.
This is clearest in Brazil. It benefits from being one of the four “Brics” (Brazil, Russia, India and China) that Goldman Sachs identified some years ago as the world’s motors of growth. This helps it to attract money.
It is seen, rightly, as a prime beneficiary of the secular rise in commodity prices. In essence, Chinese industrial growth creates the demand, which Brazilian metals and agricultural products then satisfy.
Brazil, like other emerging markets, also benefits from historic undervaluation. It suffered a currency crisis in 1999, and from there until the election of president Lula in 2002, its benchmark Bovespa stock index lost almost 80 per cent in dollar terms. People feared Lula was a leftist demagogue.
Lula, we now know, is a pragmatist. The sell-off he inspired turned out to be a great buying opportunity. At one point in 2002, the price/earnings ratio of the Datastream Brazil index was 9. The p/e on the S&P 500 at the time was 45.6.
Five bull market years later, Brazil is up 1,600 per cent in dollar terms, and the value opportunity has gone. Brazil now trades at almost exactly the same p/e as the S&P 500: 17.8.
Not only the value case has gone. The strength of industrial metals prices – another cornerstone of the case for investing there – is also now in doubt. The Dow Jones-AIG industrial metals index peaked earlier this year. It has risen 5 per cent since the Fed’s rate cut in August, but is still down 20 per cent from its high.
Add to this that interest rates are above 11 per cent, that there are worries about inflation, and that the most optimistic forecasts do not see growth for the economy of much more than 5 per cent. This is not China, which is growing at more than 11 per cent.
Viewed in this context, Brazilian markets since the Fed cut rates on August 16 look as rational as a party in the cemetery.
CVRD, Brazil’s largest iron ore producer and a classic play on the global commodities story, is up 91 per cent since August 16. The Bovespa is up 33.4 per cent since then, but in dollar terms it is up 62.9 per cent, thanks to an 18.8 per cent appreciation of the real against the dollar.
Locals report that all this activity is being driven by foreign money. Nobody can work out how to use the flood of incoming capital.
The Bovespa itself floated last week, to become the first quoted exchange in Latin America. Its market capitalisation, after a heady debut, is now about £6.3bn. For comparison, the London Stock Exchange is worth £4.7bn.
Trading on the Bovespa tells its own story. Daily volume last year averaged about 2.5bn reals. This year, the average is about 4.5bn reals, while in recent weeks it is closer to 8bn reals.
These are all blatant signals that something irrational is afoot. For all its long-term positive outlook, nothing in Brazil itself can justify the faith that foreigners are putting in it.
Rather, they are making a two-part bet on the effect of cheaper money from the Fed. But that bet is looking ropey. The Fed signalled this week that it might not cut rates any further. Financial shares have tumbled, amid sharply rising fears for the financial health of credit insurers, who stand to bear the brunt of defaults, and of the big banks, who have already taken writedowns.
If the developed world’s financial sector continues to look this ugly, expect a rush for the exits in countries such as Brazil.
john.authers@ft.com |
