Could Lower Commodity Prices Pave the Way to Steady Interest Rates?

Interest-Rates / US Interest Rates Aug 11, 2008 - 07:36 AM

William Patalon III writes: With oil trading near a three-month low (and corn now at a four-month low), U.S. Federal Reserve policymakers may have just the ammunition they need to hold the line on interest rates for the foreseeable future - or at least until their Sept. 16 policymaking meeting.

On the other hand, threats of hurricanes in the Gulf of Mexico and geopolitical turmoil in Iraq, Turkey, Nigeria - and now the fireworks between Russia and Georgia - could spark a dramatic reversal in sentiment and renew fears of supply disruptions.

That's why we here at Money Morning developed “The BRIC Report,” a new feature in which we'll periodically update you on the latest developments in each of the BRIC economies and stock markets, and highlight some BRIC-related companies you might want to look at.
In Part I of this report, we analyzed Brazil and Russia. Here in Part II, we examine India and China.

India Intrigue

Given that its stock market is down 23% this year, you're probably surprised to hear that India is my favorite of the BRIC economies . Even worse: India's torrid economic growth is throttling back a bit, and there are signs of a credit crunch.

But investors need to hear the proverbial “rest of the story.” You see: If India had no problems, its stock market would be trading at 40 times earnings – and not 18 times earnings, as it is now. In other words, India could well represent a “double” for investors with the courage to buy in now and stay the course.

Without a doubt India remains one of the world's great long-term growth plays, and investors today are likely getting in on the ground floor of a major long-term bull market .

India's economic growth was 9% in 2007, and will be around 8% in 2008, so the overall market seems reasonably valued at the current multiple of 18. If India can get its political and economic houses in order, it has some very real prospects for a couple of generations of rapid growth before living standards start to approach the West and growth rates slow.

In the short-run, however, there are some potential pitfalls to be aware of. The current Indian government, in office since 2004, is a coalition between the Congress Party, which had ruled India for most of the period since independence without any great success, and the anti-market Communists. Although Prime Minister Manmohan Singh is a moderate, the government has seen India's economic emergence as an opportunity to fund favorite projects and social programs.

The budget for the current fiscal year (ending next March) proposes an 18% spending increase, and that's after spending rose 24% last year. The state budget deficit (federal plus local) is around 7% of gross domestic product; in any kind of recession, that could easily spike to the 10% of GDP level at which deficits become difficult to finance.

There is hope on the horizon: An election is due in May 2009, at latest, and the center-right opposition is currently leading in the opinion polls. But wise investors know better than to base their investment plan on something as uncertain as that.

India's other big problem is inflation, currently running at 8% per annum, which is higher than short-term interest rates. Higher commodity and energy prices have affected India as they have other countries; India's position is made more difficult by the poverty of much of the population.

The Indian government has restricted exports of rice and has subsidized other foods and gasoline (the latter makes no sense socially since automobiles are largely owned by the middle classes).

Needless to say, these subsidies and restrictions make the budget deficit worse, and will pose an additional problem when they are lifted and newly unfettered consumer prices soar in response.

Growth has now acquired huge momentum, and any conceivable Indian government will do no more than slow it temporarily. Furthermore, the economics of the contracted-out customer support and manufacturing services that India has built into a national mainstay – in the era of globalization and the Internet – is so compelling that it will inevitably continue to produce huge profits for decades to come. The question is not:
“Should I invest in India?” It's actually: “How can I afford to ignore India?”

And the answer is: You can't.

Stocks to consider would include Infosys Technologies Ltd . (ADR: INFY ), the Bangalore-based software giant, which seems pretty invulnerable to Indian or global recession and is selling at a fairly reasonable 19 times current earnings and 20 times next year's earnings.

Another possibility is the pharmaceutical company Dr. Reddy's Laboratories Ltd. (ADR: RDY ), a major generic drugs manufacturer that can expect to benefit from the expiration of many U.S. pharmaceutical patents in the next five years, and carries a fairly reasonable forward P/E ratio of 23.

Finally, you might consider India carmaker Tata Motors Ltd. (ADR: TTM ), whose shares currently trade at about 8.5 times earnings. In the luxury end of the market, Tata recently bought Jaguar and Land Rover from Ford Motor Co. ( F ). And at the bottom end, Tata has grabbed global headlines with its $2,500 Nano , a car that's 40% cheaper than anything else on the world market.

Charged Up Over China

As we've pointed out repeatedly, China is a huge opportunity: It's already the third-largest economy in the world after the United States and Japan, and it quite possibly could be the world's largest by 2025. Its stated growth rate is even higher than India's, although Chinese economic statistics are pretty suspect. Nevertheless, apart from the qualms raised by the Chinese market's six-fold increase in 2006-07, and current high valuations, there are significant weaknesses that should not be ignored.

The two biggest: China's banking system and its high rate of inflation.

China's banks were for years used as a piggy bank for state-operated industries, many of them major money-losers and some that were technically bankrupt. Instead of the state recording budget deficits by subsidizing rubbish, the banks would lend the money to the bad companies, recording them as current loans. The result was a mountain of bad debt in the Chinese banking system. Back in May 2006, Ernst & Young estimated the bad debt had reached $911 billion (an estimate Ernst and Young was forced to withdraw; after all, they do have a substantial auditing business in that country!).

Encouragingly, Chinese authorities are beginning to attack this problem: An estimated $130 billion of the country's $200 billion sovereign wealth fund has been used to recapitalize parts of the banking system. Since China has $1.68 trillion of foreign exchange reserves, and the bad debts are presumably still only $1 trillion or so, China does have the financial wherewithal to solve the problem. However, using FX reserves to recapitalize the banks would be highly inflationary, providing an almost 50% increase in the money supply.

That brings us to the next problem: Inflation, which is rising sharply. China's official inflation rate for the year ending in May is 8.3%, but the actual inflation rate is believed to be much higher.

China's yuan has been allowed to appreciate against the dollar to combat this, but the real need is for higher interest rates, which are still below the inflation rate. It seems inevitable that China will suffer some kind of tight money crisis, in which the banking system is recapitalized and inflation conquered, while the real economy suffers accordingly. However, such a crisis has appeared inevitable for several years now, and it hasn't happened yet.

Whether or not China suffers a short-term crunch, its long-term prospects are excellent. Its stock market remains highly illiquid, since much of the market capitalization represents state controlled companies, of which only a small portion are publicly traded. Given the problems in the banking system, financial services should be avoided, while P/E ratios in many other sectors are far above what would be considered appropriate in the West. Nevertheless, with the 30% fall in the Chinese market since last November, there are now some bargains to be found.

CNOOC Ltd. (ADR: CEO ), China's major international oil company, is selling at a P/E ratio of about 15. Most of its exploration activity is concentrated in China's offshore region, but it also has operations in Australia, Indonesia and Africa. CNOOC is central to China' search for oil resources, and critical to its future growth.
Yanzhou Coal Mining Co . (ADR: YZC ), China's largest coal miner, is rapidly ramping up production to meet soaring worldwide demand for coal: China alone is commissioning one new coal-fired power station per week. Selling at 17 times current earnings but only 12 times forward earnings, Yanzhou is benefiting from soaring coal prices, as well as rocketing demand.

Both CNOOC and Yanzhou are major, state-controlled behemoths. For a venture into China's true private sector, consider a look at a medium-sized company that is active in generic pharmaceuticals in what is potentially a huge market in China for such products. That company is Simcere Pharmaceutical Group ( SCR ). Its shares are currently trading at about 15 times current earnings.

[ Editor's Note : Part I of this “Special Report” ran both on Friday and yesterday .]

News and Related Story Links :

Money Morning Special Investment Report: Special Report: Hit the BRICs for a Global-Investing Double Play .
Money Morning Market Analysis : With the New Russian President Vowing to Steer a Steady Ship, U.S. Investors Can Look to Profit .
Money Morning Investment Analysis : China Gets the Buzz, but India Gets the Cash, and Leads in Private Equity Infrastructure Investment .
Money Morning Special Investment Report : With Strong Growth Prospects at Home and Increasing Influence Abroad, India is a Profit Play Investors Need to Make Now
Money Morning News Analysis: Tata Targets Jaguar and Land Rover for Long-Term Returns .
Tata Motors . The Nano .
Wikipedia : BRIC .

By Martin Hutchinson
Contributing Editor

Money Morning/The Money Map Report

©2008 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

Signs That the Credit Crisis Has Yet to Hit Bottom

Credit Crisis Continues as Banks Sell Assets to Cover Losses

Best Financial Markets Analysis Article Keith Fitz-Gerald writes: "Have we seen the worst from the financial sector?"

The question - a very good one - came from an audience member following my global investing presentation at the Agora Wealth Symposium in Vancouver, British Columbia. During my entire time there, the interest in the ongoing credit crisis was intense.

I took a deep breath and launched into my three-point response.

First, I'm encouraged by what I see lately but still believe there is a fair distance to travel before all the skeletons are cleaned out of the financial sector's closet .

There is a growing body of data that suggests banks have recognized only a fraction of the overall potential losses - approximately $50 billion to $75 billion so far on subprime debt alone. And a variety of estimates suggest that total subprime losses may be more than $300 billion before we're through.

And that figure, incidentally, doesn't include the additional losses from secondary-prime mortgage loans, auto loans, credit card balances, student loans and the other credit-related flotsam and jetsam floating around in the debt markets.

That suggests that the hundreds of billions of dollars in emergency capital infusions from the world's central bankers we've seen to date may only be a fraction of what's ultimately needed by the time fully leveraged figures are thrown into the mix.

Second, liquidity conditions now may actually be worse than when the entire credit-crisis mess began to unravel this time last year . For example, the benchmark London Interbank Offered Rate (LIBOR) remains higher than so-called "policy rates" and U.S. Treasuries of comparable maturities (Please see accompanying chart).

This suggests that banks still don't trust each other and therefore are keeping so-called "Interbank" borrowing rates high in order to reflect what they perceive to be the added risk of doing business. We've been warning investors to watch out for this since as far back as April , and have generally been preaching caution since the credit crisis began last year.

In other words, the fact that Libor-Treasury spreads are wider today than they were a year ago suggests that the banks really don't know who continues to hold the toxic debt instruments the entire world has come to fear - despite a recent earnings parade of CEOs making claims to the contrary.

The upshot: Many institutions are hoarding cash - something you'd hardly expect to see if the credit crisis were really on the mend.

Third, judging from recent reports, it's beginning to dawn on financial regulators that this crisis was never about a lack of liquidity in the first place , which is something I suggested in an open letter to U.S. Federal Reserve Chairman Ben S. Bernanke some time ago.

Instead, this crisis is about three things:

Too much liquidity.
Fundamental structural problems in the credit industry, including the almost-total lack of regulation.
And the lack of transparency of complex financial instruments for which there is no public market, making them tough to value and nearly impossible to trade.

It is becoming clearer by the day that - partly because of these three factors - a good deal of money has been made fraudulently, if not illegally.

Granted recent changes surrounding the " mark-to-market" accounting of so-called "Level 3" assets are a step in the right direction. But what few people realize is that, in the short-term, these new requirements could involve the immediate recognition of even larger losses than we've seen to date.

The reason is that many of the firms involved - think Merrill Lynch & Co. Inc. ( MER ), Lehman Brothers Holdings Inc. ( LEH ) and Citigroup Inc. ( C ), for example - will no longer be able to hide their losses in Level 3 assets, as they have in the past.

As you might expect, there's a counterargument to this, and it's a highly popular one on Wall Street - especially inside the CEO set, whose members desperately want to stop the financial hemorrhaging their firms are enduring. They claim they're "selling" risky assets and "de-leveraging" their balance sheets.

But here's what they are not telling you.

Even though these folks are technically "selling" assets - particularly the distressed "Level 3" assets I mentioned a bit earlier - what they are really doing is assigning the upside to hedge funds, private equity firms, and sovereign wealth funds in exchange for cash.

But here's the kicker: The banks actually are holding onto the downside liability in the event the underlying securities go bad. That brings us back to the start of this commentary, when I said that I expect more securities to go bad.

No matter how you look at it, these financial institutions are playing a vicious shell game, hoping all the while that they're not the loser who is taken to the cleaners when he picks up the wrong shell.

Where this goes from bad to worse is that at the same time they're playing more fancy accounting tricks, these firms continue to pony up to the Fed's private backdoor lending window for sweetheart financing. After all, they can't get the financing anywhere else.

That means that every taxpayer in this country is involuntarily being put in the bailout business.

As for whether or not we're near the end of the credit crisis as a whole, it depends on whom you ask.

When this crisis started a year ago, I was asked a similar question and answered it by saying that we would not even begin to approach the end of the line until the total losses exceeded $1 trillion.

My audience chuckled politely.

Fast-forward 12 months, and nobody's laughing anymore - especially when I say that I'm now raising my industry loss estimate to nearly $2 trillion.

Increasingly, other analysts are embracing a similar viewpoint. UBS AG ( UBS ) raised it's estimate of the total cost of the credit crisis to $600 billion, while noted hedge fund manager John Paulson suggested $1.3 trillion is not unthinkable. Meanwhile, in a report issued last May, the International Monetary Fund (IMF) projected the bailout costs at $1 trillion.

All of this leads us to a single conclusion: At least for now, this is a "recovery" in name only.

News and Related Story Links :