by Ivan Martchev | October 10, 2012 7:30 am
A good rule of thumb is that whenever you use a properly spelled word that a spell-check program doesn’t recognize, you should probably go back and rewrite the sentence containing it.
This time, however, I decided to make an exception because the word “reductiveness” perfectly fits the economic state of affairs in the world’s largest emerging markets, famously dubbed BRICs. The editor who had pitched the story asked me if the BRIC term was “dangerously reductive” because I had something to say on the matter in June. My answer: “still hopelessly so.”
The BRIC economies are somewhat interconnected as the world economy gets more closely integrated after decades of globalization, but major differences remain among them.
Russia, with an estimated 2012 GDP per capita of $14,246, is a commodity-driven market, while China is an export powerhouse with a GDP per capita of $5,899. India is a domestic-demand story unlike the other BRICs, where exports of manufactured goods or commodities contribute a significantly smaller relative part of GDP. Finally, Brazil is more balanced than Russia with respect to its otherwise large soft and hard commodity exports. Also, Brazil is much more developed than India with estimated 2012 GDP per capita of $12,465, while India is at $1,455.
Let’s take a look at these four as the individual markets they really are.
While Russian equities have enjoyed a nice rebound since their June lows, their direction is still likely to be decided by oil prices, which have weakened somewhat in the past two weeks. The U.S. Energy Department reported that American crude production rose 11,000 barrels a day to 6.52 million last week — the most since December 1996 — while total fuel demand fell 0.3% to 18.3 million barrels a day in the four weeks ended Sept. 28. Falling demand and rising output generally is a recipe for lower prices.
Even though Russia is geared toward European and emerging market demand — where the Brent crude benchmark trades with a near $20 premium per barrel over the U.S. West Texas Intermediate benchmark — oil is fungible, and Brent and WTI affect each other. Since Chinese data have been weakening marginally all year and European economic data has been showing a more decisive similar trend, more oil price weakness is likely in a seasonally slow fourth quarter.
Russian large and small caps, investible via ETFs like Market Vectors Russia ETF (NYSE:RSX) and Market Vectors Russia Small-Cap ETF (NYSE:RSXJ), remain the cheapest in the BRIC universe, with P/Es of 6.5 and 5.4, respectively, and both trading at notable discounts to book value. Unless the oft-cited but slow-coming rebalancing of the Russian economy shifts it more toward services, I believe those depressed relative valuations to the rest of the BRICs will remain in place.
Some say the magnitude of the Chinese slowdown is better gauged via electricity or commodity demand because the data there are more reliable. On the commodities front, there was news that Australia — a major Chinese trading partner — had its worst trade numbers in more than four years in August. Australia’s trade deficit came in at A$2 billion, almost three times larger than consensus estimates, as weakening Asian demand for resources was a major factor.
Australia’s exports fell 3.3% in August to A$24.6 billion for a third consecutive month as iron ore exports fell by A$500 million and coal exports fell by A$400 million. Australian exports are 12% lower than last year, which is their worst annual decline since early 2010.
The iron ore issue will be big for Australia because Chinese demand is weakening as supply is increasing. Since 2004, China has spent an average 8% of GDP on steel, or 16 times higher than the average U.S. rate.
It’s typical for industrializing economies to have natural resource-intensive growth, yet an industrializing economy of such massive size relative to world GDP like China hasn’t shown a significant slowdown in a long time. The magnitude of the price decline in iron ore is yet unknowable. In this environment, one should be careful with more cyclical China-geared companies like iron ore and coal producers, both on and off the Mainland.
The Brazilian economy has decelerated to a near-crawl of 0.5% GDP annualized growth in the latest quarter, partially due to consumer spending fatigue and partially due to the slowdown in China and the situation in Europe.
This has caused the central bank to cut the policy SELIC rate to a record low of 7.5%, while the inflation rate is not at a low for the new “hard” version of the Brazilian currency, the reais. This has pressured the Brazilian currency somewhat because the country no longer enjoys the record adjusted-for-inflation interest rates that made the reais such a standout performer.
Brazilian consumer and corporate loan rates (which are multiples higher than the SELIC policy rate) are near a record low — consumer loans at 35.6% and corporate loans at 23.1% — while default rates are elevated at a three-year high. The consumer default rate in August was 7.9%, while the corporate loan default rate rose to 4.1% from 4% a month ago.
This looks like a situation where consumer spending fatigue is ongoing, and that may keep pressuring Brazilian banks, which trade at depressed book value multiples compared with a couple of years ago, despite the obvious fat interest rate margins.
Major financials like Itau Unibanco (NYSE:ITUB), Banco Bradesco (NYSE:BBD) and Banco Santander (Brazil) (NYSE:BSBR) trade at price/book multiples of 2, 1.8 and 0.9, respectively.
I believe India holds the most BRIC promise because it’s least developed on a GDP per capita basis and is the least exposed to shocks from developed markets. It’s also somewhat shielded from a potential shock from the bigger-than-anticipated slowdown in China, which is already affecting both Brazil and Russia via pressure on some commodity prices.
Not too many Indian ADRs are available for individual investors, but for long-term investors, the elevated valuation gap between small caps (cheap) and large caps (expensive) looks interesting. Indian small-caps investable via the Market Vectors India Small Cap Index ETF (NYSE:SCIF) trade at a fraction of the P/E and price/book multiple of Indian large caps, investable via the iShares India Nifty 50 Index Fund (NASDAQ:INDY).
Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates holds positions in Itau Unibanco for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the aforementioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.
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