Are the Rate Cuts Nearly Over? EM Equities and Slick Oil
The concern over an oil-related early upturn in Emerging Markets inflation and end to monetary easing is slightly overdone. Citi Investment Research & Analysis expects a further 15%+ upside to EM equities over the rest of 2012
One of our major themes for 2012 has been the benefit to EM equities from the declining trend of inflation and interest rates within the emerging markets themselves; this has presented a very different picture from the inflation “panic” of early-2011. However, nearly three months into the year, there is some concern that this support for higher equity markets may already be fading. Recent more hawkish commentary from certain EM central banks (such as Brazil, Chile, India and Indonesia) has contributed to a stalling-out of this year’s rally in EM equities.
Indeed, concern is building that current conditions may not be so different to 2011 – a bad year – after all. This is partly because of the uncanny resemblance (see Fig. 1) between the current equity market rally beginning in early-October 2011 (since when MSCI GEMs is up 26%) and that which began in late-May 2010 (which led to a 41% rally until early-May 2011 when last summer’s bear market began).
The other fairly close similarity with last year is the high oil price (Fig. 2). So far in 2012, the price of Brent oil has risen by 14% since the end of 2011 (from $108.3/barrel to $123 at the time of writing); over exactly the same period last year, Brent rose by 25% from $92.8/barrel to $116.
The Base Case: Inflation and Interest Rates
We argued last December (“2012 Outlook – The End of Dear Money”, Global Emerging Markets Strategy, Geoffrey Dennis) that the “key support for emerging market equities in 2012 is, in our view, the prospect of a much more benign interest rate outlook than in 2011”.
A new monetary easing cycle in emerging markets was in prospect for this year for several reasons:
i) low/negative real interest rates (or “financial repression”) in developed economies, such that, without lower EM rates in also, emerging market currencies would become uncomfortably strong; ii) weak global growth with, in the limit, fears of a return to recession in the world economy;
iii) lower inflation in the emerging markets. In certain countries (such as, to date in this cycle, China and India), easier monetary policy has implied lower reserve requirements rather than actual cuts in policy interest rates.
The anticipated downturn in inflation in emerging markets is well underway. Average EM inflation has fallen from a peak of 5.5% in June 2011 to 4.0% in February, falling from well above trend back towards its recent historical average (Fig. 3). The prior increase in inflation (from below 4% in late-2010) and the subsequent decline has been largely a BRIC phenomenon. BRIC inflation surged from 5.0% in late-2010 to a 2011 peak of 7.4%, and has now fallen back to 4.7% (also February). By contrast, non-BRIC inflation did not rise as much last year and so has not fallen back in the same way either.
There have, accordingly, been plenty of excuses for EM central banks to adopt easier monetary policies in recent months, in sharp contrast to early-2011. The trend of short-term interest rates is typically an important driver of EM equities. Lower rates tend to boost equity markets and high rates are typically a negative (although the former trend can be overridden if economies are extremely weak).
This theme – lower rates, higher equities – is shown clearly in Fig. 4, where we found the best correlation (-0.75) between the two series with a five-month lag.
Fig. 5 below updates our familiar monetary policy grid. It shows that:
• Asian and Latin American countries have eased monetary policy more widely in the current cycle, starting in late-2011; there has been little easing in CEEMEA so far due, in part, to weaker fundamentals, including pressure on exchange rates;
• interest rates have been cut in the current cycle in six countries – Indonesia, the Philippines, Thailand, Russia, Brazil and Chile. Adding in RRR cuts in China and India, 8 of the 21 MSCI GEMs countries have eased monetary policy since late-2011;
• there is also a group of countries that did not raise interest rates in the prior cycle and have not yet cut in this cycle either. In these cases, rates have been on hold at current levels for several quarters: Mexico (remarkably, since July 2009), Czech Rep (since May 2010) and South Africa (November 2010);
• the only countries to go against the EM trend by raising interest rates recently have been Hungary (weak fundamentals) and Colombia (resilient inflation);
• monetary policy in Turkey is both unorthodox and an outlier versus the EM trend. The Turkish central bank cut rates, against market expectations, last August
• the only countries that raised interest rates in the last cycle but have not yet cut in this cycle are Korea, Malaysia, Taiwan, Poland and Peru – not a long list.
Where Do We Go from Here?
The question investors are now beginning to ask is whether all the rate cutting/easing is already over? The answer seems to be clearly no, according to our macro forecasts – both rates and inflation. Further rate cuts are expected in the current cycle in Russia, Brazil and Chile while a new rate-cutting cycle is still expected to begin over the next few months in India (50-75bp), Hungary (25bp) and Poland (50bp). In addition, our Chinese economists still expect a further 3-4 cuts in reserve requirements (RRR) in China over the next few months, reducing the RRR to 18.5-19% from a recent peak of 21.5%.
One obvious theme from this set of forecasts is that BRIC central banks, where inflation rose sharply last year and still has further to fall this year, have further easing to go, while many of the smaller EM countries have completed their easing (such as in Asia) or have little scope to do so anyway.
To achieve another read on the outlook for further monetary easing, Fig. 6 lays out the profile of our economists’ forecasts for EM inflation, by country, on a quarterly basis into 2013. Even though base effects naturally come into come play, given that these are annual inflation forecasts (and the base effects are generally favourable in the first half of 2012, before turning less helpful after midyear), it is useful to identify when inflation will trough in each country – a trough in inflation may signal an end to monetary easing.
In terms of the big countries, inflation is expected to bottom out in the current quarter in Russia (at 3.6%, and then it rebounds sharply by year-end), South Africa and Korea while the second quarter signals the trough in inflation in Brazil and China (two important countries in this easing process) as well as Taiwan. Inflation is not expected to hit bottom until the fourth quarter in India and Mexico, and not until 2013 in Hungary and Turkey. Overall, our current forecasts suggest that average inflation for the emerging markets as a whole will trough at 4% in Q2, a significant drop from average inflation of 5% in 2011 and a recent peak of 5.5% last June.
Another exercise which could provide some clues as to why market expectations over the timing of the end to monetary easing have deteriorated is to look at the direction of changes to our inflation forecasts since late-2011. However, this also does not explain why investors are worrying about an early end to monetary easing:
• for GEMs as a whole, our current inflation forecasts are lower today at 5.2% for both 2012 and 2013, compared to 5.3% for both years, than in late-2011;
• for 2012, there have been inflation forecast downgrades in eight of the twenty-one emerging markets since last November (including, amongst the big countries Brazil, Russia, China and India). For the major EMs, the inflation forecast has risen only for South Africa (5.8% to 6.0%) with unchanged forecasts in Korea (3.3%) and Taiwan (1.4%);
• for 2013, there have again been forecast downgrades for seven of the twenty-one emerging markets, including India, China and South Africa. Higher inflation is now forecast for next year in Brazil (to 5.5% from 5.2%), Russia (to 6.8% from 6.1%) and Korea (3.3% from 3.2%).
In summary, on the evidence of Citi’s interest rate and inflation forecasts, it would seem that concern over an early end to the monetary easing cycle in emerging markets may be premature. Therefore, the main reason why concerns have developed that the end of the easing cycle may be approaching sooner than we had expected is, in our view, down to one major exogenous factor – the price of oil.
Citi Investment Research & Analysis