Monday, May 23, 2011

Emerging Markets' Biggest Threat is Deflation - Not Inflation

Brazil and other emerging markets are also leveraged in another way - to the dollar. The commodities trade in particular for exporters is prone to violent swings. Oil and many agricultural products are tied to benchmark rates set on the CME and CBOT in the USA b/c futures contracts continue to be priced in dollars. Recent margin hikes on oil and precious metals are warning signs to me to contain volatility. For Brazil, agricultural commodities are capped w/lock limit prices on the Chicago exchanges so volatility won't come from that corner. Instead it will come from base metals traded on the LME like copper (see prior article about China and copper for a more reasoned explanation).

The long term fundamentals of supply and demand for agriculture are expected to remain strong for the next several years -supportive of continued inflation of land, inputs and machinery.

But what comes up must come down. Demand destruction is real - the world cannot survive for long on oil >$100/barrel and oil is considered a leading industrial indicator. The velocity and supply of money has turned from a stream into a river in many developing countries. Some of this can be attributed to Western investors but a lot more is sourced from the native governments.

The biggest culprit I see now is China - M2 has jumped despite efforts by the PBOC to play games ( M2 is STILL up b/c the Politburo has focused its efforts on blaming Western foreigners (US and British investors) instead of looking in the mirror - the explosion in money supply is due to FORCED domestic lending by banks from the 2009 stimulus effort. Simply put, loans are being made to people who should not be receiving them - all in the effort to keep employment high.

China's leaders are following this policy b/c they value social stability above all. But the policy is ruinous and leading to a credit bubble. Already we are seeing signs of a coming deflation in wage growth. I was reading in the Financial Times where the reporter stated China and India are leading the world in wage inflation by repeatedly raising minimum wages . In the short term that is a good policy to have - but the 2 countries are already losing their competitive advantages to smaller, cheaper players like Vietnam, Philippines, and Indonesia.

Conclusion: Emerging markets' biggest threat now is deflation - NOT inflation. The current runup in inflation is due to a massive increase in credit since the Lehman bubble popped in 2008. But this rise in inflation is only short term - it will pop as over-capacity in capital stock comes downstream. Politicians are stuck between choosing growth or choosing inflation. Instead the choice will be made for them by the markets. I predict a hard landing for many markets w/in the next 9-15 months, 2013 by the latest.
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