Frontier Life

When the stock market turns ugly, the quest for “non-correlated assets” intensifies. A non-correlated asset is fancy Wall Street talk for something that doesn’t move lock-step with the overall market. When the market falls, a non-correlated asset might actually rise, or at least hold its own better than the market.

Gold is a classic example. Its price tends to rise during times of stock market distress. But very few investments can rival gold’s long history of non-correlation. Imposters abound. The imposters might move independently of the overall market for months or years at a time, thereby creating the impression that they are non-correlated. But when the markets really turn nasty, investors often learn that their “non-correlated” asset tumbles just as sharply as an S&P 500 Index fund.

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However, some investors think they’ve found a reliable new non-correlated asset: “frontier markets.” Merrill Lynch recently created an index not only to track them, but for investors to buy and sell them.

Frontier markets include Pakistan, Kuwait, the United Arab Emirates (UAE) and other markets throughout Africa and the Middle East. They also include Vietnam, Kazakhstan, Cyprus and others. They are individually too small for institutions to invest in, but cobble them together in a new index that allows you to buy and sell the basket and… well, then you have something.

Merrill Lynch’s new Frontier Index tracks the 50 largest companies in 17 frontier markets. Even so, the market value of all these companies combined is only about $330 billion – or about that of General Electric. Right now, the index heavily tilts toward the Middle East, with 50% of the index in the region. Asia is the second largest component, with 23%, followed by Europe at 14% and Africa at 13%.

As for industry groups, banks usually are among the biggest companies in any emerging market. So banks and financial service companies represent about 65% of the index. Oil and gas is the next largest sector, weighing in at 13%. As far as countries go, the top three are the UAE (23%), Kuwait (18%) and Pakistan (14%).

So far, these frontier markets have lived up to their advance billing of not following the broader markets. Since Sept. 30, for example, the frontier markets actually gained 31% while the broader market lost ground. Merrill Lynch backtested the index several years and found that between February 2000-December 2007, the index return’s correlation with the S&P 500 was only 32%. Basically, that means that about two-thirds of the time, the frontier markets zigged while the S&P 500 zagged.

I love the idea of frontier investing, because I’m an optimist when it comes to global trade and booming overseas markets. Maybe it’s my globe-trotting that’s skewed my view. But when I travel overseas, I see great opportunity. I see people building businesses. I see the impact of global market forces on local energy, food and resource markets. I see the world getting smaller.

I’m long-term bullish on markets such as the UAE, Kuwait, Vietnam and others. But I also realize that the ride in some of these markets will be absolutely gut-wrenching. Just look at Vietnam.

The Vietnamese economy is growing somewhere between 7-9% per year. It is a cheaper place to do business than many other parts of Asia. Hence, Vietnam continues to attract a strong flow of investment.

While I liked what I saw going on there, I found no direct investment ideas for us. The market is just too small and illiquid. Heck, before March 2002, the market traded only on alternate days. Moreover, as with most of these frontier markets, Vietnam suffers from poor disclosures and low transparency. When you invest here, you’re really not sure what you’re getting.

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I remember listening to Carlo Cannell, a very good investor at Cannell Capital, talk about his trip to Vietnam and his investments there. This was back in May 2007. The theme was investing in the dark. In Vietnam, he basically made many blind bets on lots of companies, figuring enough of them would work out.

But the market has tanked since then.

Perspective, though, is everything in markets. That chart looks nasty, with a near 50% drop from the high in less than a year. But as recently as July 2005, the index was only 250. You’d still have more than doubled your money in less than three years. In 2000, it was only 100. Investors are still up sixfold from 2000, which is a lot better than an investment in the S&P 500 Index. And that’s really the key to the whole frontier market idea. As an investor, what’s most important is what happens over the years.

I’m skeptical of the idea of frontier markets as an “non-correlated asset” for all seasons. Links between these small markets and their bigger brothers are probably stronger now than in the past. Vietnam, for example, depends heavily on foreign investment. Vietnam’s currency, the dong, is still linked with the dollar. So we have to be careful in taking the past and saying the future will work the same way.

Rising raw material prices, in particular rising food prices, are now causing real hardship and what represents a cause for shoppers in developed economies to grumble is a matter nothing short of life and death for the millions less fortunate around the world. This note considers what many emerging countries are doing and why their actions, far from alleviating the problem, are actually making matters worse.

Lord Mark Malloch Brown is a junior minister in the current Labour administration. He has a reputation for being forthright and often puts his colleagues’ hackles up. He is also the former deputy secretary general at the United Nations and an acknowledged authority on global issues of critical concern. His recent comments regarding the growing food crisis are significant both because he has identified some of the root causes and because he has taken steps to raise the matter where some of his more craven colleagues dare not.

Lord Malloch Brown describes, somewhat unoriginally, the confluence of factors he sees as serving to cause food prices to rise as a “perfect storm”. These factors are: a series of poor harvests in Australia, the incremental demand for improved diet caused by the newly prosperous parts of China and India, coupled with the now wide-spread process of biofuel “flag planting” on land previously devoted to the production of food stuffs. We would add a few additional factors, on which more below.

Bang on cue, the United Nations secretary general Mr Ban Ki-moon has warned that, if allowed to escalate, permanently higher food prices could not only damage global growth but also, possibly, global security too.

Rightly, the secretary general has stuck to the UN’s remit by indicating that an environment that has seen wheat prices double and the price of rice explode higher could seriously put back the process of global poverty elimination. “If not handled properly, this crisis could result in a cascade of others (including the imposition of quotas and the banning of exports) and become a multi-dimensional problem affecting economic growth, social progress and even political security around the world”.

The biofuels debate is interesting from a number of angles. Firstly, it is not absolutely true to say that the commitment of land to the production of biofuels automatically reduces food production everywhere (although that hardly makes the European Union’s full-on encouragement of plant-derived fuel right).

Supporters of biofuels tend to use the Brazilian experience as justification for the dash to plant-derived fuel alternatives, not that that country’s success should detract from the fact that there are a lot of other places where land which would otherwise have been used to grow food for human consumption has now been given over to the production of biofuel to feed machinery!

The EU could, for example, call a halt to its pre-announced intention to derive 5.75% of petrol and diesel to be manufactured from plants, although we understand the EU’s difficulties given growing stresses in the oil market too.

The developed world has hardly covered itself in glory on this matter either. In particular legitimate questions might be asked of Western countries’ commitment to what has become known as the “Washington Consensus”. Part of the reason why a number of African countries are now back on the verge of starvation is that developed nations, through their International Monetary Fund (IMF) conduit, actively encouraged many African governments to cut farming subsidies and focus instead on producing cash crops for export and by so doing, open up their previously closed economies.

That the plan has backfired is made obvious by the fact that many countries are now struggling to grow sufficient to meet basic levels of domestic demand. Whilst the UN falls back on its World Food Programme to raise sufficient funds to feed starvation zones, what is really required is greater research and development, improved credit facilities and ultimately a “green revolution” similar to that which took place in parts of Asia, not that the Asian experience is without its own pressure right now.

From the point of view of global economics there has always been a gulf between the “haves” and the “have-nots”. Generally speaking, the larger a country is, the greater the likelihood that it will be richly endowed with natural resources. The fact that not even the largest countries are so well endowed in every scarce resource is reflected in the fact that imported inflationary pressure has become a global issue. Indeed, some of the world’s largest and most populous countries are those with the greatest dependency on imported raw materials.

Estimated top global countries by resource production

The chart shows resource wealth, calculated using the most recent production data for energy, basic resources and agricultural products using average prices achieved over the previous quarter. Against this is plotted a countries’ wealth on a per capita basis, to show that some countries are likely to benefit significantly more than others. On this basis, Saudi Arabia, Canada, Australia and Russia stand out. The second chart (below) compares the global share of a country’s estimated resource wealth against its share of global population.

“This lasted until the boys showed up for work in New York where things really got serious to the up-side. But once the London p.m. fix was in, the boys wasted no time in getting things cooled down in both metals. The stocks did well too” says Ed Steer.

Of course all this activity in the precious metals was on the back of a fairly significant fall in the US peso. It will be interesting to see if there’s any follow-through today in either the precious metals to the upside…or the US$ to the downside.

Open interest numbers for Tuesday were up once again, with gold up 3,190 contracts and silver up another 1,175. Nothing too big in these numbers, but it’s a given that the open interest numbers for Wednesday will be on the large side.

A couple of stories today. The first has to do with the alarming situation with world grain supplies and government’s reactions to it. As I said yesterday, Haiti’s government fell over this issue, and the latest story is from the Financial Times out of London, where one of the world’s largest grain exporters, Kazakhstan, just announced it was halting all foreign sales. The story is headlined “Biggest Grain Exporters Halt Foreign Sales”. This is serious stuff, folks. The story is linked here.

The other story is from John Embry over at Sprott Asset Management out of Toronto. His April missive is courtesy of Investor’s Digest of Canada and is entitled “Credit-Creation Mechanism Appears to be Broken” and is linked here.

I argued then…and would argue now, that the idea of a “strong dollar policy” is a vacuous notion. – Former Treasury Secretary Paul O’Neil (Bloomberg: 16 April 2008)

It was another “Alice in Wonderland” day on Wall Street yesterday…with the boys making another silk purse out of a sow’s ear. Let’s see what they can manufacture today, and all of us at Casey’s Daily Resource Plus will be here tomorrow to discuss it with you.