Deflation Mania Peaks as Oil Freefall Ends…

Eurozone and German inflation has surprised to the upside recently against the backdrop of oil (and those euro parity forecasts) defying the consensus. We’ve seen some brutal portfolio repositioning, particularly in German bunds – the sudden burst of volatility reflects an upward shift in implied inflation expectations in recent weeks and some very crowded positioning unwinding. After the Wall Street analyst herd panicked back in February with forecasts as low as $20-30 a barrel, we suggested taking advantage of consensus bearishness to opportunistically add credit and equity E&P weightings ahead of a rally in prices and a likely M&A boom. In fact, we thought that global energy, alongside Japanese and Eurozone equities and the MSCI China, ranked among the best risk adjusted return profiles for 2015 back in December.

Oil majors having failed to book significant new reserves had been slashing capex since 2013 and have little choice but to acquire them – the Shell/BG deal will be the first of many. It looks like demand was up about 1.7m bpd y/y in Q1 versus consensus estimates of less than 1m bpd and the market is beginning to tighten even before US output growth now inevitably slows in coming months. Global output is still outrunning demand by about 1.5m bpd and record US inventories are still growing, albeit at a slowing pace.

The rally is capped by the ability of the US shale sector as the new global ‘swing producer’ to access funding at prices much above about $70/bl (at which level it would be profitable on a marginal cost basis but net cash negative and reliant on external funding) on WTI and restore output growth. We’re certainly not going to re-test last year’s highs for the foreseeable future and huge volumes stored to take advantage of what was in Q1 a very lucrative contango price curve is an overhang, but nonetheless, the end of oil’s freefall phase will change market perceptions far beyond the (outperforming) energy sector.

A resurgence in US auto mileage and recent monetary easing across emerging economies (not least China, where energy intensive fixed investment is likely bottoming near term led by Tier-1 housing) supports ongoing demand upside in coming months as US output growth slows. We expected Brent oil to reach a $70-80 trading range by year end, and the only surprise is the speed of the rally  – if sustained through this summer, it has significant asset allocation implications. Our non-consensus call in December was for the US 10-year yield to breach 2% in Q1 and 3% by Q4 (and the S&P 500 to consistently underperform the MSCI World ex US). We could see a sustained period of bond market volatility through the rest of this year, as the CPI impact of last year’s oil crash begins to drop out, as well as a shift in emerging market FX risk profiles undermining the until now highly profitable short EM commodity exporter/long importer strategy.

The broad CRB index bears watching, because the rally in oil is being joined by other industrial commodities such as copper (which has seen its longest rally in a decade) and industrial input costs and producer price inflation (or rather deflation in many major economies) are now likely bottoming…

Does History Risk Repeating for Indonesia?

I’ve been cautious on Indonesia since late 2012, terming the country a ‘macro accident waiting to happen’ and moving underweight local equities in late Q1, but a late 1990s style capital flight crisis looks very unlikely unless local policymakers again display remarkable incompetence. So far, despite several missteps, they have retained credibility. Back in the 11th December weekly looking at Indonesia’s generous minimum wage hikes, I noted that: In 2013, there is a growing risk that either inflation lets rip or the trade deficit turns ugly. In either case, BI would be forced to hike rates to defend the IDR. Brazil offers a cautionary tale of excessive domestic consumption growth gone horribly wrong, in the absence of structural reform and infrastructure investment, with a crashing currency as the solution.’ 

And that just about sums up the past few months; the country’s GDP growth fell to 5.8% in Q2, and with a surge in inflation to 8.6% last month, sustained IDR weakness and overall a broad stagflation trend, echoing the pattern from India to Brazil in recent years. This is partly the result of the ‘terms of trade shock’ for commodity exporters, a key macro investment theme which is the flipside of China’s new lower trend growth rate.

Rising consumer spending has been a key pillar of Indonesia’s growth acceleration in recent years, alongside burgeoning natural resource exports, but the latter has been badly affected by the slowdown in China. The impact of this slump alongside the recent 75bps BI rate hikes is beginning to damage broader confidence in the economy and will dampen growth in domestic private consumption, the crux of the bull case. The IMF has recently estimated that each percentage point fall in Chinese trend GDP growth could cut as much as half a percentage points from Indonesian growth, via the commodity export impact.

International financing costs for local corporates are rising as markets anticipate a tightening of US monetary policy reflected in 10-year sovereign yields breaking 8%, a level at which as highlighted in recent notes inflation risks are fully priced in and which has attracted opportunistic foreign buying. Import costs, notably for capital goods, have been pushed up by the rupiah’s depreciation of nearly 9% against the dollar over the past year while business leaders also fear growing political interference in the economy ahead of the presidential election next year. Both factors are capping investment growth, critical to avoid an Indian stagflation style outcome.

Private consumption is still strong, boosted by those minimum wage hikes, expanding 5.1% y/y in Q2. However, investment growth slowed to 4.7% y/y from 5.8% in Q1, accounting for most of the overall slowdown and has now fallen for four consecutive quarters in an echo of India’s structural growth slowdown/supply side inflation crisis. Base-year effects skewed investment, which slowed in y/y terms to 4.7%, but bounced 3.1% q/q seasonally adjusted following a flat quarter in Q1. Policy makers have indeed now given up on supporting the IDR, which has broken decisively through 10,000 versus the USD and saw its worst monthly performance since 2009 in July, adding to inflation upside risks.

Are there echoes of the 1997/8 backdrop in Indonesia’s current outlook? Yes, to the extent there are also echoes of that period across much of Emerging Asia, after a period of rapid credit/GDP, real estate and wage growth with record carry trade driven foreign capital inflows across the region and wider GEM starting to reverse. Global funds pulled $3.6 billion from Indonesian stocks and bonds in the three months through July, amid a general GEM rout on USD strength; globally, this has been a year for a ‘barbell’ strategy of developed and frontier equity markets, with the BRICs a horror story and ASEAN markets turning volatile, with the JSE struggling to rebound from the Q2 selloff.

Longer term, like say Mexico, Indonesia offers a compelling secular consumer income EM growth story, but while Mexico has begun radical structural reforms and an ambitious multiyear investment program under its new government and is attracting a surge in manufacturing FDI, any sustained equity re-rating seems unlikely until the commodity/China growth cycle bottoms out and we have clarity on whether post-election policy making will continue along the recent haphazard but on-going reformist path. A 15x current year forward JSE multiple looks full until at least some of the macro uncertainties clear.