China & Commodity Countries

Nick Ferres Vantage Point Articles

One of my favourite behavioural case studies from a macro perspective is the rise and fall of Brazil. The currency and the stock market went from complete crisis and revulsion levels of valuation in 2001, to an economic miracle according to the Economist magazine by late 2009. It then proceeded to de-rate again over the following decade until the current episode where the currency has once again depreciated to a 41% discount on a real effective basis and the equity market near to the 2001 level in relative price terms. To be fair, the equity market valuation is less extreme today (chart 1).

From a big picture perspective it was not a coincidence that the rise and fall of Brazilian assets coincided with the commodity super cycle after China joined the WTO in 2001. As a producer of key commodities like iron ore, the relative performance of the stock market was correlated to the terms of trade, which in turn had an influence on corporate profits, national income and the domestic business cycle (chart 2).

The critical point was that the entire boom and bust was cyclical, not structural, as some had claimed. Indeed, the windfall from the commodity super cycle was consumed. Once China’s trend growth rate slowed, particularly in steel production, infrastructure and real estate, it had a material second order impact on Brazil and exposed the structural weaknesses in the economy.

There are three interesting points to note from a forward looking tactical perspective. First, valuation of the currency is episodic on a fundamental real effective basis. Second, there has actually been a modest improvement in the terms of trade, Brazil’s share of global exports and external position. Third, the key driver of demand for commodity prices – Chinese credit, investment and real estate – has been accelerating. That is also evident in both industrial commodity prices like copper and bulk commodities such as iron ore. It is also evident in the performance of other commodity currencies like the Australian dollar (chart 3).

On the negative side, Brazil has been a poster child for how not to manage the current crisis. Like other crises in history it has exposed the structural weaknesses in Brazil’s economy and institutions. On the positive side, (valuation of the currency is episodic. Our only quarrel is that the real yield or risk compensation in both the interest rates and the equity market is modest by Brazilian standards. Therefore, any risk exposure probably ought to be taken in real assets.

In conclusion, Brazil and some of the other commodity linked markets have tactical upside based on the acceleration in credit growth in China. Although it is important to note that each successive credit cycle since 2008 has had a lower peak as China has attempted to moderate excessive leverage and re-orientate the economy toward services. Of course, credit or liquidity is fungible. It will seek the highest return and has also probably been just as important for Chinese internet stocks which are inexpensive relative to US technology peers (chart 4).

About the Author:

Nick Ferres is CIO of Vantage Point Asset Management. Prior to this, Nicholas was at Eastspring Investments, the Asian asset management business of Prudential plc, as Investment Director, in September 2007. Nicholas was Head of the Multi Asset Solutions team and was responsible for managing the global tactical asset allocation of funds for external institutional and retail clients. Before joining Eastspring Investments, Nicholas worked for Goldman Sachs Asset Management as Investment Strategist & Portfolio Manager. He has more than 20 years of financial industry experience. Nicholas holds a B.A. (Hons) in Economic History and Politics from Monash University, Australia, a Graduate Diploma in Economics and a Graduate Diploma in Applied Finance.