The coming surge in food prices

- "The surge in commodity prices in 2003-08 was the largest, longest and most broad-based of any commodity boom since 1900. The prices of energy and metals surged the most, but it was the agricultural market that saw the most fundamental change. It may not take much of a disruption in food supply to trigger another surge in prices given that the dynamics have become a whole lot more uncertain as a result of new and some increasingly powerful influences acting on both sides of the food supply-demand equation. Indeed, droughts this year in Russia and Kazakhstan and severe flooding in Pakistan and China have sent global wheat prices higher, while meat and sugar prices have hit 20-year highs, despite lacklustre growth in many of the advanced economies."
- "We expect another multi-year food price rise, partly because of burgeoning demand from the world’s rapidly developing – and most populated – economies, where diets are changing towards a higher calorie intake. We believe that most models significantly underestimate future food demand as they fail to take into account the wide income inequality in developing economies. The supply side of the food equation is being constrained by diminishing agricultural productivity gains and competing use of available land due to rising trends of urbanization and industrialization, while supply has also become more uncertain due to greater use of biofuels, global warming and increasing water scarcity. Feedback loops also seem to have become more powerful: the increasing dual causation between energy prices and food prices, and at least some evidence that the 2007-08 food price boom was exacerbated by trade protectionism and market speculation."
- "We assess how a steep secular rise in food prices can affect the macro economy and financial market prices, and we explain how the impact could be devastating for poor countries that import most of their food and spend a large share of personal incomes on food. Such countries may experience: a sharp decline in GDP growth, a surge in CPI inflation, worsening fiscal finances, higher interest rates, a depreciating currency and widening credit spreads. On the other hand, rich countries that are large net exporters of food could benefit."
- "We construct the Nomura Food Vulnerability Index (NFVI), providing a summary ranking of each of the world’s 80 largest economies, in terms of their exposure to another food price surge. NFVI identifies Bangladesh, Morocco, Algeria, Nigeria, Lebanon, Egypt and Sri Lanka as the most vulnerable to high food prices, while at the other extreme are New Zealand, Uruguay and Argentina. We use NFVI to quantify the impact of the 2007-08 food price surge, by comparing the 25 most vulnerable and 25 least vulnerable economies. We find that the most vulnerable group would indeed experience relatively weaker GDP growth, significantly higher CPI inflation, worsening fiscal positions, higher policy rates, widening credit spreads and widening government bond spreads to US Treasuries."
- "In terms of fixed-income strategy, we recommend using a combination of structured products – to buy a basket of agricultural commodities – and relative basket trades – in rates, FX and CDS spreads. We recommend paying 2y interest rate swaps of the 10 countries with the highest exposure to food in their CPI basket against receiving the 10 with the lowest. The impact on FX is more clouded, but we expect owning a basket of currencies selected from those with the lowest exposure to food in the CPI basket and most likely to experience an improvement in terms of trade against a basket of the opposite to be profitable. We use the NFVI in combination with a starting debt-to-GDP threshold to buy CDS protection on those sovereigns most likely to see fiscal deterioration against those least likely to. Trades in the inflation-linked space are limited, but we believe there is value in buying European inflation breakevens against US BEIs."
- "In the equity space, the total market capitalisation of the food sector is tiny compared to that of, for example, financials or property. However, while the investment universe may appear limited, investors ought also to consider companies involved in the shipping and storage of soft commodities, seed and fertilizer producers, and those that produce farm machinery, tractors and irrigation systems. Equally, we would suggest investors consider timber and other industrial soft commodities. We highlight four companies that we believe stand to benefit the most from rising food prices within the Asia ex-Japan region: China Agri-Industries (606HK Buy), China Yurun Food (1068 HK, Buy), United Phosphorous (UNTP IN, Buy) and Wilmar (WIL SP, Buy)."

The Widening Growth Gap

- Emerging Markets and the Global Economy in the Month Ahead "Fears of a double-dip recession and the risk of deflation in the US have risen appreciably in past couple of months. Although our own baseline forecast has not yet moved that far after accommodating recent economic data releases, the downside risks have clearly increased. However, we have been of the view that the main threat to EM decoupling is a credit-crunch-driven sharp growth deceleration and that EM growth (and assets) would continue to outperform otherwise. Recent asset price performance reinforces our view. Since valuations are now less compelling, however, we have narrowed long positions in selected Rates, FX and Credit markets"
- EM Rates -- The Last Drop "We examine whether EM rates have become more sensitive to global drivers and identify those curves which could still benefit from US rates falling further. While most curves would benefit under this baseline scenario, not all will fare equally under risk scenarios. We examine behavior under "double dip" and a mean-reverting "old normal" highlighting the risks in (long-end) Brazil and Turkey. On the other hand, while many of the other curves are similar in terms of exposure to USTs, individual factors lead us to favor curves where further cuts cannot be ruled out (Mexico and South Africa) or risk-adjusted carry still appears high (Poland)."
- EMFX: Protection in Risk Reversals "The combination of unusually low betas and flat risk-reversals (RRs) suggests that we could see a double-whammy of overshooting in both spot and skews should macro data deteriorate. We hence look at defensive risk-reversals in EMFX in currencies where the hedges have highest payout ratios and the currency betas retraced the most."
- Opportunities in Sovereign Credits "We remain constructive on the performance of EM sovereign credit despite our baseline scenario of lower UST yields, as we believe strong inflows will continue to more than offset the negative impact of lower UST yields on credit spreads. We also present our country-specific views on the major sovereign credits and discuss trading opportunities within each of them."
- Revisiting Financial Condition Indices in Latin America "We update our estimates of financial conditions indices in Latin America. The indices include not only real interest rates but also other financial indicators. Our findings suggest that financial conditions in Colombia and Mexico are rather loose, while those of Argentina, Brazil, Chile and Peru are closer to neutrality."
- The Local Markets Analytics Package (LMAP) Expands to Asia "Two years ago we launched our Local Markets Analytics Package (LMAP), covering six local markets in EMEA and two in Latam. We are delighted to now announce the biggest enhancement to the package, with the inclusion of ten Asian local markets, taking the total tally of markets covered to 21. In this article we present an updated guide to the LMAP, building on the original guide from 2008, but with additional material to address some of the questions we have received from readers over the past two years."

Countervailing Forces

- "The latest growth scare appears to be running its course, despite lingering obstacles to a strong rebound. Although financial conditions are providing uneven support for recovery, at present they do not signal further downgrading in recovery’s prospects, especially at its core in consumer spending."
- "Recent signs that consumer spending is on a 2% growth track reflect key tensions in the outlook. Cyclical support from pent-up needs and reviving income are pitted against structural drags associated with balance sheet rebuilding and limited credit access."
- "A flurry of new fiscal policy proposals to support recovery underscores an element of uncertainty weighing on economic decision making. In the current environment, expensing of certain business investments would not likely alter the outlook much. Nonetheless, the new focus on tax policy could be an early sign that an undesirable fiscal drag on 2011 may yet be headed off."

Scenario for 2010-2011: a slowdown is not a meltdown

- "Our scenario rules out the eventuality of a double-dip recession in the US. But while we have always defended the idea of sluggish post-bubble growth, the 3% growth that has been forecast for the US seems over-optimistic. Featuring a downward revision to 2% over the next two years, our new scenario sticks closer to the idea of a sluggish growth rate."
- "It to see how Europe will be able to repeat its fine growth performance achieved in the first half of the year. Against a backdrop of a global slowdown, a soft landing is more likely for the second semester of 2010. We are forecasting annual growth of around 1.5% for the eurozone this year and next."
- "As part of the changed US scenario, we have shifted the timetable for the Fed’s first rate hike to Q1 2012. With growth topping out at 2%, unemployment should prove sticky, which may prompt the Fed to bide its time."
- "The ECB, however, could make its move earlier, as it is in a hurry to normalise liquidity conditions and return to key rates that are more in line with this forecast recovery, however sluggish it may be. We are forecasting a target 1.5% for the minimum bid rate by year-end, with a first move coming in September 2011."
- "There is also talk of normalisation in the bond markets once fears of a new US downturn recede. We are still forecasting a rise in the risk-free rate (from 2.75% for the German Bund and 3.10% for US 10-year paper to respectively 4.0% and 3.80% in December 2011), but the lacklustre recovery and absence of inflation are likely to restrict this upward trend."
- "Once the markets have factored in the idea that the US will see a smooth slowdown, the dollar is likely to regain some of its lost ground. EUR/USD parity should return to its equilibrium level of around 1.22 by end-2010 moving to 1.15 by December 2011."

The outlook for US government debt

- "US net debt has risen fast during the recent recession, to more than 60% of GDP from 36% in 2007. Compared with other OECD countries however, this level is not alarming. Rather, it is the outlook for US debt over the next decade and beyond that is worrying." 
- "Under the President’s current budget proposal the budget will be in continuing deficit throughout the next decade. This will push net debt to 90% of GDP by 2020. Additional fiscal tightening is thus needed to stabilise debt." 
- "The scope for additional fiscal tightening is limited in the short term and largest beyond 2014. A broadly growth-neutral fiscal policy from 2014 onwards would be enough to bring net debt to 60% of GDP by 2020."

Making credit beta work for real: Scaling index risk to information

- "Credit beta – long-only index exposure – appears to deliver little in the long term. What we think works far better is adjusting index exposure between long, short or flat based on slow-moving changes in macro-credit conditions. This is because index returns in the future are semi-predictable based on information available in the present. Nomura’s Credit Scorecard offers a mechanism to benefit from this predictability. The Scorecard has not outperformed a long-only index in every period of time and will not in the future. But it has offered compelling outperformance in the medium term."

Trading Places X

- "The notion of trading markets can last well over a decade. Markets are typically range bound following major economic booms and busts as was seen in the US during the 1930s and 1970s or in Japan in the 1990s. Thus, this past decade’s post tech bubble bursting market and economic phenomenon should not be surprising nor considered unusual and is not necessarily part of a new normal construct, but rather a very old normal repeating itself. Indeed, such patterns can last longer than many investors want them to and it may be more critical to consider the catalysts for change in the future."
- "Several conditions may need to be met for a renewed secular bull market. After the 1930s equity market debacle and the Great Depression, people became so disenchanted with stocks and the financial system that it took high dividend yields to entice investors back into equities. While possibly shocking to some who are unaware of market history, dividend yields fell below Treasury bond yields only after the late-1950s such that stocks were viewed as income producing assets and were not purchased for capital gains. The clear discomfort with equities currently may demand the rise of the dividend again though tax treatment is uncertain."
- "Budget deficit reduction plans and evidence of their implementation are required. Given the explosion of the US debt burden without even considering the demographic pressures that will drive health care spending higher in coming years, it would seem that the investment community may insist on some real proof that the government will deal with these issues in a responsible manner. Since such approaches may prove politically unpopular, it could take another couple of election cycles to convince a wary populace."
- "Technological innovation often has generated opportunity. Throughout US history, a strong entrepreneurial spirit matched with the profit incentive inherent in capitalism, enforced legal protections and personal liberty has provided the fodder for invention and innovation which then blossomed into growth opportunity. The most obvious potential can be detected via the need for a much larger mobile broadband network given the likely penetration of smart wireless devices by 2013 and their insatiable consumption of bandwidth, which is already being strained presently."
- "A growing group of baby boom echo Americans will enter their saving years by 2013. While many pundits focus on aging baby boomers and their desire to supposedly shift assets away from volatile equities into allegedly safer fixed income vehicles, they ignore the baby boomers’ children whose population growth (albeit at a slower pace than witnessed for their parents) suggest a new segment of society that will be saving for retirement beginning in roughly three years. This crucial dynamic is often left out of the demographic debate."

Trend Growth Trending Down

- "We conclude our analysis of trend growth determinants in a selection of euro area countries and find that, beyond a likely lower contribution from labour input, capital accumulation growth is also likely to slow down in coming years in those countries most badly hit by the financial crisis."
- "With major improvements in total factor productivity growth unlikely, the growth decomposition analysis suggests trend GDP growth is likely to significantly decelerate in all peripheral euro area countries in coming years."

Basel III – A government bond friendly latest and potentially final draft

- "Over the weekend the Basel Committee on Banking Supervision released its latest – and potentially final – draft proposal for the forthcoming Basel III solvency and liquidity framework. Both the solvency and liquidity frameworks have been watered down from the original proposals released last December, but are stricter than many had expected. From an interest rate market perspective, the overall conclusion is that the latest Basel III proposals are highly positive for government bonds: i) Banks are still required to accumulate a liquidity buffer primarily comprising government bonds; ii) While banks now face less immediate pressure to reduce short-term wholesale funding, the trend towards higher funding costs, wider lending rate spreads and lower “neutral” policy rates remains intact; iii) The decision to delay the implementation of the Leverage Ratio removes one potential constraint on the current asset allocation into government bonds by OECD banking systems."

Credit Shows Some Improvement but Challenges Remain

- "As with the economy in general, improvement in the credit environment continues, but credit indicators are mixed and the situation remains challenging. The overall loan delinquency rate fell in the second quarter, with all loan types seeing declines from the prior quarter. Some delinquency rates are even down from the prior year, most notably for credit cards. While residential delinquency rates remain far above year-ago levels, the year-over-year difference has come down markedly. Even the much beleaguered commercial real estate sector saw a decline in delinquency rates."
- "Mortgage rates are at all-time lows. While this has led to a resurgence in refinancing, applications to purchase a home remain very low. Thus, while those who are refinancing their mortgages are benefiting from reduced mortgage payments and huge interest savings, those who want to buy a home are either not taking advantage due to concerns about further price declines, or cannot take advantage due to tighter credit standards, lack of a job or lack of equity in their homes."
- "While banks have become more willing to lend, terms and conditions are still tight, and there are differences between large and small banks. Large banks have eased many terms and conditions, while small banks continue to tighten. Standards for prime mortgages have loosened, but banks are still reporting weaker demand for consumer loans, albeit at a lower rate."
- "Consumer credit outstanding at commercial banks finally expanded slightly in the second quarter from the first, but remains below year-ago levels as some consumers have paid down debts and others remain hesitant to take on new debt amid persistently high unemployment and continued weakness in the housing market. Another important factor in the year-over-year contraction is the surge in bank charge-offs, which have quadrupled over the last four years."
- "In the second quarter, the upward trend in personal bankruptcies continued amid high unemployment and the ongoing housing malaise, but business bankruptcies, after a few quarters of declines, edged up as well. Business bankruptcies had declined recently as firms shored up their balance sheets and reported stellar profits. But the rebound in business bankruptcies suggests the business environment remains challenging, which does not bode well for strong job growth in the near future."
- "Although the stabilization in housing has helped to restart consumer spending, the pace of spending growth remains historically sluggish. We believe the housing market will remain moribund which, along with the decline in credit and lack of job growth, suggests consumer spending will not provide much fuel for near-term economic growth. Further adding to our weak spending outlook are historically low consumer purchasing plans. Plans to buy an auto, a home or a major appliance remain in the doldrums. The brief improvement in the spring was largely due to the optimism created by the homebuyer tax credit. However, we were skeptical that the pace of spending seen in the spring was sustainable in part because purchasing plans and income expectations remained severely depressed."
- "The mixed signals emanating from the credit environment suggests we still have a ways to go."

How can we explain the fact that some OECD countries are returning to their pre-crisis growth?

- "Most OECD countries will post far lower growth in 2010-2011 than before the crisis, due to deleveraging, deindustrialisation, the slowdown in wages, etc. But in 2010-2011, some countries are returning to a level of growth that is similar to their pre-crisis growth: Canada, Sweden, Australia."
- "How can this be explained? At first sight, we can think of:
• the fact that some countries benefit from being commodity-exporting countries;
• the fact that in some countries, the maximum indebtedness constraints have not been reached, and that credit can continue to increase;
• some countries’ capacity to generate substantial exports to highgrowth countries, without, for all that, weakening domestic demand; this may possibly be associated with an exchange-rate depreciation
• the lack of a need for a sharp reduction in fiscal deficits;
• keeping a large manufacturing sector."
- "We show that the following factors are significant:
• the size of commodity exports;
• households’ capacity to continue to run up debt;
• for Australia, the size of exports to emerging countries;
• exchange rate depreciation;
• the lack of a need for a sharp reduction in fiscal deficits"

European sovereign debt concerns back in spotlights

- "As concerns about a US ‘double-dip’ have eased somewhat, European sovereign debt concerns started to attract attention again last week (p.2, p.3 & p.4)."
- "This week’s focus is on US retail sales tomorrow and CPI inflation on Friday, on the German ZEW index tomorrow, and on UK CPI inflation tomorrow and the labour market report on Wednesday (p.2, p.3 & p.4)."
- "The Chart of the Week shows government bond yields of Portugal, Ireland, Greece and Spain. Many names have been used to describe the crisis that already started more than 3(!) years ago. At first, the term subprime crisis was used, but quite rapidly it was called a liquidity, credit and/or bank crisis. Since late last year/early this year, the term sovereign debt crisis has often hit the headlines. Clearly, these are all different kinds of crises, but at least they all appear to be caused by too much debt. As such, concerns about the fiscal situation of the so-called euro zone periphery countries will probably not really fade as long as debt/GDP ratios are high and even increasing, despite the European rescue packages. In fact, the rise of government bond yields of especially Portugal, Greece and Ireland over the last weeks reminds us somewhat of the start of this crisis in 2007 when subprime RMBS spreads widened, thereafter tightened as markets thought that the worst was over, but unfortunately widened again to even higher levels etc. Also over the last few months, yields continued to drift higher, but this remained more or less out of the spotlights as (mainly US) ‘double-dip’ fears dominated. Let’s hope that history will not repeat itself, but we are not convinced that the euro zone periphery countries are out of the woods yet."

What prospects for balance sheet adjustments?

- "The deterioration in the balance sheet situation of households as well as companies is the principal cause of the crisis. As long as the balance sheet adjustments (rebalancing of debts and assets) are not over, we cannot hope for a return to normal in the economies."
- "We look at the state of the balance sheets and to what extent they have been adjusted in the United States, the euro zone and the United Kingdom."
- "The correction in excess debt relative to assets can be done either passively via a fall in real interest rates or via a rise in asset prices, or actively via a rise in savings used to deleverage and rebuild wealth, and by a decline in investment."
- "We can see that the balance sheet adjustment is mainly carried out via a rise in savings and a fall in investment in all countries. It is only in the United Kingdom that real interest rates are low."
- "This adjustment is therefore costly in terms of growth, and also slow (2 - 3 years or even more in the euro zone)."

China appears to be regaining strength

- "On Saturday China released economic data for August which exceeded expectations across the board. While GDP growth could still slow to below 7% q/q AR in Q3, the data released on Saturday suggest the Chinese economy is now bottoming out and is poised to improve in Q4."
- "In Q2 and Q3 growth has been pulled lower mainly by weaker construction activity and inventory cuts. We expect construction activity growth to remain substantially below trend well into 2011 as fiscal stimulus gradually unwinds. Private consumption increasingly looks like China’s new growth engine, although demand for consumer durables has temporarily slowed following the explosive growth last year. Inventory cuts are easing and this should add to growth in the coming quarters." 
- "Export growth has so far been resilient and China’s trade surplus has again improved above USD20bn on a monthly basis. However, we expect the trade surplus to decline in the coming quarters as exports to Europe and the US lose some momentum and China’s import growth improves." 
- "The impact on the property market from the government’s regulatory tightening now seems to have been less than expected. House sales started to recover in August and the expected large drop in property prices has so far failed to materialize." 
- "We do not find the increase in inflation in August from 3.3% y/y to 3.5% y/y alarming. With GDP growth currently below trend, inflationary pressure is easing; we expect inflation to peak in September and decline close to the government’s 3% target by the end of the year." 
- "The Chinese economy currently appears to be very close to where the Chinese government wants it. Hence, we do not expect any major policy adjustments this year. However, we still believe China is in a tightening cycle and, while interest rate hikes are probably off the table for the rest of this year, further regulatory tightening targeting the property sector looks increasingly likely." 
- "This latest economic news has made us more confident that China remains in a tightening cycle. In addition, exports have remained resilient, the trade surplus has improved and the effective CNY exchange rate has actually depreciated since China formally abolished the USD peg in July. With the political focus in the US returning to China’s exchange rate policy, we still expect CNY to appreciate." 
- "While, alone, signs of a soft landing in China should be reassuring for commodity markets, it is important to stress that the composition of Chinese growth now is less commodity friendly, because construction (and temporarily durable consumer goods) is growing below trend."