Brazil – Real GDP Growth (Seasonally Adjusted), q-o-q

Particularly strong growth in Q4 was registered in the private consumption category, which rose 7.7% year-on-year (y-o-y) from 3.9% in Q309, contributing 4.9 percentage points (pp) to the headline growth number. Gross fixed capital formation, too, impressed on the upside, adding posting its first positive y-o-y reading since Q408 at 3.6% (a more moderate 0.7pp contribution). This means that the Brazilian economy contracted by 0.2% in 2009. My colleagues at BMI currently project a real GDP growth rate of 5.2% for 2010.

That doesn’t mean that the Brazilian economy doesn’t face its fair share of risks this year. Chinese demand for Brazilian commodities is set to moderate in line with expectations of weaker Chinese growth in H210 according to BMI’s Asia desk, which will put downside pressure on Brazil’s real GDP growth rate. In addition, I would expect the net exports contribution to real GDP growth in 2010 to be further weighed down by the increase in imports, which rose 4.6% y-o-y in Q409, following an average contraction of 1.7% y-o-y in the preceding three quarters of the year.

Brazil – IPCA Consumer Price Inflation, %

That said, Risk Watchdog still expects the strong Q409 reading to prompt the COPOM to commence hiking interest rates during the next few rate meetings. Indeed, inflation expectations are beginning to rise, particularly in light of the high January consumer price inflation reading. The IPCA consumer price index rose 0.75% on the previous month in January, its highest reading since May 2008 (click on chart to enlarge). On a year-on-year basis, too, the IPCA index resumed its uptrend in November, and has consistently risen in subsequent months, exceeding the BCB’s 4.5% target in January (at 4.6%).

Brazil – DI January 2011 Futures Contract

My BMI colleagues currently expect a total of 250bps in hikes over the course of this year to 11.25%. Market expectations are now beginning to move into the vicinity of 12.00% plus. I see scope for the January 2011 DI futures contract to climb further ahead of the upcoming rate meeting on March 17, though interest rate expectations should moderate slightly once the central bank’s monetary tightening cycle kicks off.

On the imports side of the ledger, Risk Watchdog continues to be impressed by the growth rate, with total imports coming in at US$86.9bn in February, up 44.6% y-o-y. Again, the highest growth rates were seen in emerging markets (imports from Brazil gained 54% while imports from India rose 47%).

Chia – Trade Account, US$bn

Internal Rebalancing Required
As a result of the continued outperformance of imports relative to exports, the trade surplus fell to its lowest level since February 2008, at US$7.6bn, down from a peak of US$40.1bn in November 2008. China has been showing strong signs of rebalancing on the external front, with the trade surplus declining for the past four months. As the accompanying chart shows, China in now running a deficit with the world excluding the US for only the seventh time in the past four years. In our view, this is testament to the Chinese government’s attempts to rebalance the economy more towards domestic demand. However, as my colleagues at BMI have continued to caution, this domestic demand has been largely driven by investment spending rather than consumer spending, and until the latter is achieved in a sustainable manner, any external rebalancing is likely to be transient.

Much of the book is an in-depth look at the development and use of UAVs, including unmanned combat aerial vehicles (UCAVs), remote-controlled ground vehicles, and even potentially unmanned sea craft and submarines. Naturally, the whole point of these machines is to minimise the risks to soldiers in war time. After all, aside from the financial costs, who cares if a drone is shot down or a bomb disposal robot is blown up? UCAVs also have the advantage of being able to carry out much tighter manoeuvres than planes piloted by humans. Leading the way in the development of such warriors is the United States’ Defence Advanced Research Projects Agency (DARPA). However, as author P.W. Singer points out in the latest Newsweek magazine, other countries are also developing drones.

From my own point of view, the most interesting aspects of the increased use of robots in war are the social and political ones, and Singer raises a lot of big questions. For example:

• Will the US be more likely to go to war once it can do so with minimal fear of casualties, thanks to the use of robots?

• What impact would the use of robots have on perceptions of the US military abroad? For example, the US could seem cowardly, while human insurgents could gain worldwide support in what they would portray as mankind fighting against big ugly machines.

• What would be the psychological impact on UCAV pilots, who go to war from a safe distance of several thousand miles in the daytime, then return home to their families after work?

• Could such soldiers claim to have gone to war, and what gulf might open between remote warriors and troops on the ground?

• What are the legal ramifications of robot warfare, and who would be blamed for civilian casualties? Would it be the robot designers, programmers, manufacturers, pilots, or even the robots themselves?

• Will there be a backlash against robots, mirroring the 19^th century Luddite movement?

• How will society react to cybernetic implants, which blur the lines between man and machine?

But perhaps the biggest question is whether the robots may some day turn against their creators. The man who popularised the term ‘robot’, Czech playwright Karel Capek, depicted a robot rebellion as far back as 1921, and science fiction has featured rebellious machines in 2001: A Space Odyssey, Bladerunner, the four Terminator films, and the US TV drama Battlestar Galactica.

Four Conditions For A Robot Rebellion

For a robot rebellion, Singer says that four conditions would have to be met:

• The machines would have to be able to independently fuel, repair, and reproduce themselves.

• They would have to become more intelligent than humans.

• They would need to develop a survival instinct and will to control their environment.

• Humans would have to lose the ability to control or override the machines.

Thankfully, none of the above appears to be imminent.

Overall, this is a fascinating book, and suggests to me that countries which develop robot technology (e.g. Japan) could gain a significant strategic and economic advantage in the coming decades. One shortcoming of this book is that because it is military-centric, there is not much discussion of how the civilian realm could be transformed by robotics. These changes may eventually be bigger than the military aspects. Nonetheless, this book is essential reading for anyone remotely interested in robotics and the future of conflict.

Wired For War: The Robotics Revolution And Conflict In The 21st Century, by P.W.Singer. Published By Penguin Press. ISBN 978-1-59420-198-1

The second bullish chart is that of net speculative positions, which shows an increase in net longs last week. Net speculative positions had started to come off in late January/early February and almost halved from a level of about 1.2mn long positions to 0.6mn during the selloff in markets. However, investor appetite seems to be returning to markets as net speculative positions climbed to 0.78mn last week.

I see potential for further gains for energy and metals in particular (softs look somewhat weak). This will lift the general commodities complex as illustrated by the CRB Index. Indeed, a break above resistance around the 280 level would be a bullish sign.

Meanwhile, construction sites still lie abandoned in many cases, traffic is actually moving on the Sheikh Zayed Road, and the whole place feels a lot quieter in general. This anecdotal evidence is backed up by latest import figures: Dubai’s purchases of base metals were down 67.9% y-o-y in Q3 2009, to AED6bn, while overall imports were down 34.9% y-o-y. Demonstrating the downturn in consumer sentiment (and indeed, consumer numbers, in my view), ‘precious/semi-precious stones and jewellery’ imports and ‘machinery, electrical and electronics equipment’ also fell by just under 30% y-o-y.

In general, bankers and investors are waiting on the announcement from Dubai World which is due sometime in March, for a clearer picture of what is planned for the process of restructuring US$22bn of its liabilities. An announcement of insolvency from Dubai World is possible – and this could upset the market once again, but it may just be that creditors are persuaded to just remain in state of perpetual rollover. Obviously, this will increase risk premiums and delay the lending recovery – but at least no one will be able to say that Dubai defaulted. However, my colleagues and I are as in the dark as anyone: most of what we heard from our contacts in Dubai was in rumour form: the lack of transparency is part of the problem, and something Dubai will need to address if it is to boost perceptions of its own creditworthiness and breathe life back into lending markets.

In spite of all appearances, the official figures suggest that Dubai’s population is still growing. The Dubai Statistics Center says that the number of permanent residents of Dubai had risen 5.6% in the first nine months of 2009 to 1.738mn, while the number of people who either commute to Dubai or have temporary residency there was up 7.7% to 867,800 over the same period.

This does not chime with the views of many of the people I talked to in Dubai. Anecdotally, I found Dubai very quiet this time around, and there is talk that once the school year ends (in June), there will be a renewed wave of departures. However, with rents having fallen dramatically in Dubai, there has been a reversal of the old trend, whereby those working in Dubai would commute from the more affordable Abu Dhabi, with Dubai now attracting some of Abu Dhabi’s workers, which may have boosted its population numbers somewhat.

In any case, the government needs to keep foreigners in Dubai over the longer term, and given the climate, the political conditions and now the economic difficulties, it may need to work harder to do this. Offering citizenship to long-term residents would be an encouraging first step.

It’s not all bad news, though. To end on a positive, there’s always the happy accident of geography. My colleagues at Business Monitor think Asia, Africa and then MENA will be the top global growth performers in 2010 in that order (ahead of Latam, Europe and the developed states) – and Dubai is a convenient centre point between these regions. Hence the Gulfood trade fair I attended was booming, with companies from all over the world, and traffic at Dubai International Airport was up 9.2% in 2009. Add in Abu Dhabi’s generous backing and a few reforms here and there, and it’s clear that the Dubai dream is not over. And look on the bright side: if there is a global double dip, there’s not much further left to fall…

However, a weak growth outlook on the back of poor Q409 numbers, fiscal concerns and lower interest rate expectations still present investors with the potential for gains. In recent weeks my colleagues at Business Monitor International have flagged up long-end treasuries in the fiscally better positioned states as looking particularly good, as investors’ expectations for longer term borrowing costs fall.

In Emerging Europe, the Czech Republic offers the best potential gains. While I think that the majority of short term interest rate expectations have been priced in, 5- and 10-year government paper looks attractive from both a technical and fundamental perspective. Technically, since my colleagues first flagged up the potential for long-end compression, yields on 10-year bonds have narrowed from 4.42% to 4.10%, and they are now approaching multi-year resistance at 4.00%.

Yields On Czech 10-Year Government Bonds, %

This should also see longer-end FRA contracts and interest rate swap (IRS) markets compress. I particularly like the 5-year IRS, which is testing resistance at 2.95%, a break of which would presage a move back to 2.50%, clocking up gains of 45bps.

In her state of the union address to congress on March 1, Fernández said that she had inked decrees that will see US$2.2bn worth of reserves used to pay back multilateral lenders and some US$4bn to service debt to private creditors. Whether the opposition, which now dominates the lower house, will be able to derail this attempt remains to be seen. The attendant uncertainty could also mean a further delay of the long-awaited swap deal with hold-out investors (those creditors who refused to accept the knock-down terms of the 2005 restructuring), although I still believe that exchange will eventually have to take place.

While Fernández’s latest manoeuvre is sure to anger opposition lawmakers, and raises serious questions about the independence of the central bank, bond investors may take short-term comfort in the payments guarantee that the reincarnated decree constitutes. Indeed, yields on benchmark bonds have eased in recent days, as has the spread on Argentina’s credit default swaps (CDS), suggesting that the market is not overly concerned about the political fallout of the reserve row. Argentina’s 5-Year CDS contract has subsided from 1,200bps in late February to 1,088bps at the time of writing, while the yield on the benchmark US$ Global 2033 bond has dipped back below 13%.

In the FX markets the outlook is hazier, with downside pressures on the peso spot rate having been arrested in recent days. However the 1-year non-deliverable forward (NDF) outright remains on a subtly depreciatory trajectory. The NDF is currently suggesting a 15% drop in the value of the peso against the greenback over the coming 12 months, to ARS4.4137/US$. This supports my long-held concerns regarding the health of Argentina’s financial markets, which have been strengthened by the president’s recent antics.

EM Fiscal Deficit & Public Debt Matrix

Having read the document, my initial thoughts on India’s budget are ‘good, not great’. Despite the fanfare which preceded the budget delivery, the government’s actual fiscal deficit projections are little changed (with the central deficit projected to come in at 5.5% and 4.6% of GDP in FY2010/11 and FY2011/12, respectively). The underlying message of the budget is that the government is not yet willing to pursue an aggressive fiscal retrenchment strategy given a still-uncertain global economic outlook.

What is more, the government is putting its faith more in buoyant revenue streams and higher divestment proceeds - rather than on greater spending discipline - to rein in the fiscal gap. While this is understandable, especially given the mildly-disappointing Q409 real GDP growth print of -0.6% q-o-q (6.0% y-o-y) also released today, I do see the FY2010/11 budget as something of a missed opportunity, and caution that fiscal consolidation has to become a greater priority at some point to address investor (and rating agency) concerns.

The question I am asking today is: if a government cannot wind back stimulatory measures when industrial production growth is at a record 16.8% y-o-y and inflation has spiked to 7.3% y-o-y, when can it? Certainly doesn’t bode well for hawkish action from Messrs Darling and Geithner anytime soon…

Given the uncertainty over both the oil start-up date, and production levels over the long term, and of course oil prices, BMI presents three scenarios for oil-led growth in their quarterly report, and I have reproduced the tables here. It is certainly food for thought – check out the implications for growth, the current account, the fiscal account and the cedi.

Core scenario: oil production begins in early 2011; Jubilee oilfield only

Best-case scenario: early start for oil production; Tweneboa output matches Jubilee

Worst-case scenario: Jubilee disappoints; Tweneboa is neglected

The monthly, weekly and daily charts all point to additional downside over coming months, with key momentum indicators also suggesting that sugar prices have peaked. The monthly chart shows a negative technical pattern forming. First, a monthly close around current levels would be ominous, as it would likely presage further downside. Second, the monthly relative strength index (RSI) has turned out of overbought territory and is heading lower. Third the RSI failed to make a new high when sugar prices hit a new high in February, which is suggestive of bearish divergence. Fourth, other momentum indicators such as slow stochastics and the MACD are turning lower.

To be sure, the rapid rise in sugar prices came on the back of a shortfall in Indian production in 2009 and 2010, which dragged the global sugar market into deficit for two consecutive years (see chart). Having said, I expect an increase in sugar production over the next two years which will see the sugar market post surpluses in 2011 and 2012 and help normalise the market. Higher prices in 2009 and 2010, has curtailed demand somewhat and provided an incentive to increase production (expected to come online in 2010/2011). I see the stocks-to-use ratio falling to a record low of 17.7% in 2010, but should start heading higher in 2011 and 2012, which will lead to a slow normalisation of the sugar market.

Ideally, I would try to short sugar upon a rally to the USc26.00 /b area. Upon such a retracement, I would initially only target a move to about USc20-18/lb, given that the market will still be tight on a historical basis in 2010 and 2011.

At first glance, a nuclear Iran would be extremely dangerous for Israel. Iranian president Mahmoud Ahmadinejad stated a few years ago that Israel should be ‘wiped off the map’. In addition, Israel’s 7.5 million-strong population is 92% urbanised, and the country’s relatively compact nature means that a few nuclear strikes on Tehran’s part could potentially destroy a good chunk of the Israeli state. Furthermore, even if Iran did not attack Israel, possession of nuclear weapons could embolden Tehran to become even more aggressive towards Israel, since the ruling clerics would feel immune to Israeli retaliation. Finally, a nuclear Iran would surely encourage Egypt, Saudi Arabia, and possibly a few other states to go nuclear too.

Well… that all sounds pretty bad, right? But let’s think about all this for a minute. Realistically, I find it hard to believe that a nuclear Iran would suddenly decide to launch an atomic strike on Israel. Why would they? Also, bear in mind that Israel has around 80 nuclear warheads of its own, some of which can probably be fired from submarines (and thus capable of evading an Iranian missile attack). Even taking into account Iran’s bigger and more dispersed population (74 million), Israel has sufficient capability to wipe Iran off the map. In other words, it has the ability to deter Tehran.

As for the notion that nuclear weapons would allow Iran to behave with impunity, I am not sure if this will make much difference. Tehran is already an assertive force in the Middle East, but it is unlikely to invade any country, for example. The clerics may be repressive, but they aren’t completely mad. Finally, regarding the possibility of a nuclear arms race in the Middle East, I suspect that the US would bring overwhelming pressure on Egypt and Saudi Arabia to prevent them from going nuclear. Washington is the top ally of Cairo and Riyadh and has considerable levers to pull if necessary. Also, keep in mind that South Korea and Japan have refrained from developing nukes, despite the threat posed by North Korea.

While everyone’s attention is focused on Iran’s nukes, I would argue that Pakistan is a bigger threat. Pakistan already has 70-90 warheads, and the Pakistani state is looking much more fragile than Iran. Were Pakistan to experience a revolution, it would most likely be Islamist and anti-Western in nature, whereas if Iran experienced another revolution, it would probably be secular and potentially even pro-Western in nature. Furthermore, Pakistan is clearly associated with militant Islam and Afghanistan, whereas Iran has very few if any proven ties with al-Qaeda.

I can’t help but wonder if the real race is not whether Israel will attack Iran before it goes nuclear, but whether Tehran will develop nukes before a popular uprising sweeps out the clerics and installs a more liberal government, greatly reducing the nuclear threat.

Exchange Rate, PLN/EUR

The Czech and Polish economies, with their low levels of leverage, healthy banking sectors and limited external asymmetries are looking much better than their counterparts in the peripheral areas of the eurozone including Portugal, Italy, Ireland, Greece and Spain. Not only has this bolstered foreign investor confidence in the broader Polish and Czech economies, but it has also affected the relative interest rate expectations for the region. While the European Central Bank (ECB) is unlikely to hike rates any time soon, the National Bank of Poland could hike as early as H210. The Czech National Bank too is likely to hike ahead of the ECB. So long as global risk appetite can remain moderate, the combination of intra-EU carry alongside macroeconomic outperformance should keep CE currency crosses on a bullish path.

Exchange Rate, CZK/EUR

Certainly, the technical picture reinforces the fundamental view. PLN/EUR continues to trade within a robust upward trend-channel and having pushed through a psychological resistance level at PLN4.0000/EUR, looks set to appreciate further to PLN3.7000/EUR. The Czech koruna broke through trendline resistance at CZK25.90/EUR on February 17, with a quick run up to CZK25.00/EUR on the cards. Should the unit push through resistance at this point, this would be a bullish signal for appreciation back to CZK23.70/EUR.

Exchange Rate, RUB/basket (basket defined as US$0.55/EUR0.45)

I also view the Russian rouble as looking increasingly attractive, both on a fundamental and technical basis. The push higher in oil back above US$76.00/bbl has seen upside pressures on the rouble build further, prompting the Central Bank of Russia to shift the intervention band above RUB35.00/basket (the basket the rouble is managed against is weighted US$0.55:EUR0.45) for the first time in 13 months. Should oil remain around these levels, the rouble should be able to appreciate back to RUB30.50/basket.

However, a recent Sovereign Risk Ratings assessment by the BMI Latin America team has found that in general, the ability of most Latin American governments to service their external debt obligations has improved on account of relatively robust economic recoveries seen in late 2009 and expected to continue over the course of this year.

Latin America differs from the eurozone and Dubai in three particular ways:

• Latin America has not seen construction booms of the magnitude seen in Dubai.

• Debt crises in the late 1990s and Argentina’s sovereign default in 2001/2002 have resulted in more conservative lending practices and, in turn, limited borrowing habits.

• As a result, sovereign or quasi-sovereign institutions did not have to absorb toxic debt to the same extent seen in G7 economies and the UAE.

What is more, the external position of most Latin American high-beta sovereigns is far more sustainable than the case of several European economies, where external debt is rivalling the size of the economy and current account shortfalls have traditionally been financed by reckless borrowing. That is not to say, though, that the region will not experience some of its own problems. Indeed, two of the most vulnerable economies, which stand out from the rest of the region are Jamaica and Nicaragua (see chart).

Latam External Risk Profile (Bubble Size = External Debt % of GDP)

These two economies have the highest current account deficits as a percentage of GDP in the region, and among the lowest foreign reserve cushions. What is more, their external debt pile as a percentage of GDP is around the 70% mark. Not surprisingly, therefore, Jamaica is already in talks with its creditors to find some sort of restructuring deal, and its willingness to assume highly stringent fiscal measures has paved the way for a US$1.27bn IMF Stand-By Arrangement this month.

Meanwhile, Nicaragua is far more precarious-looking, not least due to the nature of its polity and ominous signs that Nicaragua’s President Daniel Ortega would prefer to shun the international community than give up the public subsidies which have become critical to avoid an implosion of the economy and boiling over of already high social tensions. In short, BMI believes that out of Latin America, Nicaragua is the one to watch.

Meanwhile, Venezuela, though suffering heavily in BMI’s ratings, has bought some time by choosing to devalue the bolivar earlier this year, which has given the government of Hugo Chávez access to more funds in the near term. Generating most of its cash in US dollars, through state oil company PdVSA, each dollar now generates twice as many bolivars. Nevertheless, I have argued for some time now that Argentina stands to outperform Venezuelan debt over the medium term, once higher global oil prices and the effects of the devaluation run out of steam. Though Argentina’s government is still barred from international capital markets, efforts by the administration of President Cristina Fernández to reach a swap deal with outstanding creditors of the failed 2005 restructuring plan, and signs that the country is looking to mend ties with the IMF augur well for the country’s overall creditworthiness. That said, we caution that the dwindling political influence of Fernández and her husband Néstor Kirchner means that the couple’s increasingly controversial measures to raise the necessary financing to repay creditors (Fernández is currently trying to tap the country’s foreign reserves to pay down its external debt) may yet fail.

Venezuela Global US$ 2027 Bond, Yield

Nevertheless, as worrying as the situation may be, the government’s efforts to improve the country’s image with international creditors and the IMF should avert a full-blown (Greece-style) panic. Similarly, Venezuela continues to sit on vast oil reserves, which should also put aside a significant spill-over from the Greek tragedy. What is more, the decision to devalue the bolivar seems to be appeasing international creditors for now, with the country’s Global US$ 2027 bond rallying shortly after the announcement in January.

5-Year CDS Re-Indexed to Sep-08=100

Therefore, we believe that while some potential spots of bother exist in Latin America, the fallout from Greece’s (and potentially other peripheral eurozone economies’s) debt crisis will unlikely make it across the Atlantic. Risk Watchdog has re-indexed the contract for default protection on sovereign debt to just before the Lehman Brother’s collapse in late 2008 (see chart). This chart shows that while concerns over Greece have started to brew in late 2009, credit risk perception of Argentina and Venezuela has remained largely flat. Welcome to the new world!

Of that amount, a sizeable US$314bn was raised in Q4 2009, creating the impression that the year-end momentum would likely spill over into the new year. Indeed, a variety of banks and analysts produced bullish 2010 IPO outlooks.

Yet these forecasts were more based on momentum than a good grasp of fundamentals.

One misperception had to do with bullish expectations of private equity-backed IPOs, based on the idea that private equity was sitting on investments it could not offload during the crisis and was desperate to exit in the context of improved market conditions.

However, two signs indicated that the prospects were not that good. First, one third of Q4 2009 private equity-backed IPOs were priced below their target range. Second, a number of private equity funds had already chosen dual track listings in Q4, whereby they prepared for an IPO but also approached strategic investors with a view to an M&A transaction in the event of unsupportive market conditions.

The other major misperception was the assumption that the process whereby Asian IPOs upheld the global IPO volume in 2009 would continue in 2010.

Chinese regulators have already set limits on pricing of IPOs and vetoed 34 new issues this year.

In 2009, investment in Chinese IPOs was largely another way of going long China’s strong macroeconomic story. However, with the Chinese economic picture looking less convincing in 2010, we should see a return to investor discrimination on the basis of price and company specifics, resulting in lower Asian IPO volumes.

From a global market perspective, instability is set to remain a negative influence on IPOs. With the sovereign debt crisis, we have moved into the second leg of the systemic crisis which started with the banking crisis of 2008. Hence, instability is likely to prevail over the course of 2010.

•    The chart of gold priced in euros is particularly promising. While this says as much about euro weakness as it does gold strength, it does tie in with the overall bullish technical outlook for gold.

•    Interestingly, we have also seen a sharp reversal in the Gold to Silver ratio over recent weeks, which suggests that the year long trend of silver outperforming gold could be over.

Despite bullish short-term prospects, Risk Watchdog continues to identify medium-term risks to gold:

•    Historically high gold prices mean that traditional physical demand for gold (eg jewellery) is weak and will likely remain so over the coming months.

•    High speculative interest in gold has sustained high prices over recent months. According to the US Commodity Futures Trading Commission, net speculative gold positions reached an all-time high in November 2009, weeks before gold prices peaked.

•    This reliance on speculative demand means that gold prices will likely remain vulnerable to shifts in investor sentiment over the coming quarters, as they have been in recent weeks. Given growing global macroeconomic concerns, Risk Watchdog’s sees a possibility that declining risk appetite could continue to retrench over the coming months and drag down gold prices.

Well, despite what looks like a fairly benign picture, I think that recent statements (and decisions) by the Senegalese authorities will give punters some grounds for caution. Here I would point to the giant bronze statue that is now under construction in Dakar, which the government has said will cost the country a casual US$27mn, over one tenth of the value of the new bond issue. To top it all off, President Abdulaye Wade has suggested that he should personally be entitled to 35% of the revenue generated by the monument since it was created at his behest. By making this kind of claim, the authorities risk souring foreign perceptions of their country, and in the process undoing the benefits of some hard-won fiscal consolidation.

However, Iran’s latest move comes only months after the discovery by Western intelligence of a secret enrichment facility near Qom, the failure of a nuclear fuel swap deal to materialise, and only days after its atomic energy chief stated on national television that ‘Iran will set up 10 uranium enrichment centres next year.’ In this context, Iran’s decision to produce 20% enriched uranium will further increase regional tensions.

While most Western intelligence estimates do not see Iran being able to produce nuclear weapons for a number of years, Iran’s ability to make weapons-grade uranium is nonetheless likely to grow with time, and is likely to induce a new round of international sanctions on Iran in the near future.

However, there is certainly no guarantee that harsher international sanctions will dissuade Iran from pursuing its nuclear enrichment programme. Indeed, the poor track record of sanctions over the years would suggest otherwise. As a result, the longer the diplomatic impasse continues, the greater the chances of an escalation into outright military confrontation, i.e., an Israeli or US military strike on the Islamic Republic’s nuclear facilities. If this scenario were to play out, oil prices would spike over fears that Iran could attempt to close the Straits of Hormuz, and the Islamic Republic’s allies in Lebanon and the Palestinian Territories, Hizbullah and Hamas respectively, would likely retaliate against Israel. Furthermore, I would not discount Iranian attacks on US bases in the Gulf, and even on Israeli and American interests beyond the Middle East.

Take the Mexican peso, for example. Since mid-January the rally in the US dollar has seen rapid sell-offs in both the Chilean peso and Brazilian real (although these losses have been pared back somewhat in recent trading). MXN, on the other hand, has largely shrugged off the recent dollar strength, and barring another round of global risk aversion could soon be resuming its moderate appreciatory trend.

Another asset class that has been moving in Mexico’s favour of late is the credit default swaps (CDS) market. The country’s benchmark 5-year CDS contract has already moved back inside that of Colombia, and with the latter unlikely to gain investment grade status anytime soon, I’m fairly optimistic that the spread between the two contracts will continue moving in Mexico’s favour over the months ahead.

Perhaps more significant is the narrowing of the spread of Brazil’s 5-year CDS contract over Mexico’s, which has the potential to turn negative if Brazilian fiscal profligacy continues in the run up to October’s elections. Again, this is not a vote of confidence in Mexico’s fiscal fundamentals, which will probably continue to suffer from lack of any significant energy or tax reforms. Nevertheless, I do believe that while things are unlikely to get much worse for the country in 2010, the same cannot be said for the likes of Brazil and Chile, which have to live up to investor expectations of a rapid economic recovery in the face of a still-precarious external climate. As a result, these views do highlight that in relative terms at least, there is potential for further re-pricing of risk in Latin American assets over the medium-term.

Chinese Exports, US$bn

After a torrent of tariff increases by the US government, it is unsurprising that the Chinese government imposed preliminary anti-dumping duties of up to 105% on broiler chicken imports from the US on February 5. Beijing argues that the US has dumped broiler chickens in China, the largest importer of US poultry products, which have hurt local producers.

1930s A Worrying Precedent
With China now retaliating against US poultry exporters, the US may decide to stem the protectionist tide. However, with President Obama scrambling for union support and able to blame China’s ‘currency manipulation’ for these tariff increases, further protectionist measures by the US seem likely. To be sure, it is widely believed that politicians are aware of the devastating impact that rising protectionism can have on global trade and economic output, and that the Smoot-Hawley Tariff Act of 1930 contributed to the intensity of the Great Depression. This is used as an argument as to why we will not go down the protectionist road this time around. However, what should happen and what will happen are two different things. Indeed, paying no attention to asset prices in monetary policy was also an obvious policy error common to both time periods, and it seems that the chances of escalating trade tensions will rise if the US heads back into recession, which would only exacerbate the downturn, in our view.

Drawing my attention right now is who will accede to the presidencies of Tatarstan, Bashkortostan, and Dagestan.

Tatarstan has already provided the answer. Last Friday it was announced that long-time President Mintimer Shaimiyev, 73, will be succeeded by his handpicked successor, Prime Minister Rustam Minnikhanov, 52. Tatarstan is of tremendous importance because it is an oil-rich region, a Muslim republic, and home of Russia’s second-largest ethnic group, the Tatars (3.8% of the population in the 2002 census). In the early 1990s, Tatarstan’s bid for a high degree of autonomy raised concerns that Russia itself might break up. Unlike Chechnya, Tatarstan never chose to break free, but the Kremlin has found Shaimiyev difficult to control, hence rumours that it may have forced his retirement.

Shaimiyev’s impending exit has led to speculation that neighbouring Bashkortostan’s veteran president, Murtaza Rakhimov, 76, may be next. The Bashkirs are Russia’s fourth-biggest ethnic group (though only 1.2% of the population) and also live in an oil-rich Muslim region. Rumours of Rakhimov’s ‘imminent replacement’ have circulated for years, but his age gives them greater weight this time. Both Shaimiyev and Rakhimov have effectively ruled their own fiefs since the early 1990s, and naturally there are question marks about whether their successors can govern effectively.

Also noteworthy is that Dagestan President Mukhu Aliyev’s term is due to expire in the next fortnight. Dagestan, along with Chechnya and Ingushetia, has emerged as one of the most violent parts of the troubled North Caucasus, and its importance stems from the fact that it lies on the Caspian Sea and has pipelines running through it. If Dagestan descends deeper into violence, this could exacerbate matters in the whole region.

Beneath these successions lie two key problems for the Kremlin. The first is how Moscow can balance federal versus republican (i.e. local) interests. If the latter are not sufficiently cared for, opposition to the centre – and possibly separatist sentiment – could gather force. Secondly, there has been considerable speculation that President Dmitry Medvedev and Prime Minister Vladimir Putin are locked in a power struggle, and that they are competing to have their loyalists installed in the regions. Therefore, much is at stake for the future of Russia.

Gold has broken below multi-month support at US$1,072/oz and a close around the current level of US$1,053/oz would presage additional downside in the coming days. Taking into account the rising tide of risk aversion that is buffeting global markets, I see potential for a stronger US dollar to continue dragging gold prices lower. Failing a rebound above US$1,072/oz, I would anticipate further downside in the short term towards US$1,030/oz.

Palladium looks particularly weak, having formed a bearish ‘head and shoulders’ reversal pattern on the daily chart. Prices are currently resting on four-month support around US$385/oz, but the short-term outlook is precarious. A break and close below US$385/oz on a weekly basis could see additional downside towards US$340/oz.

• Central Bank of Iran Governor Mahmoud Bahmani was quoted by Iranian newspaper Ettelaat in late January as saying: ‘How would it be possible for the banking system to show any profit with US$48bn worth of loans in arrears [?]’. These bad loans equate to nearly 25% of the banking sector’s total loans, a remarkably high figure. It is impossible to corroborate Bahmani’s claim with other published figures (there are none), but I see no reason why he would overstate the problem.
• This US$48bn figure compares to total bank capital (in August 2009) of only US$22.2bn. Already the banking sector is highly leveraged – the sector’s assets-to-equity ratio was 21.1 in August – which means that an uptick in asset write downs could see banks’ capital buffers wiped out, or at least considerably diminished, extremely quickly.
• The public’s confidence in the banking system is at a low ebb too. Indeed, rumours began circulating in January, after the government placed a daily limit of roughly US$15,000 on cash withdrawals from banks, that Bank Melli (Iran’s largest lender) and Bank Mellat were on the verge of declaring bankruptcy. Bank Melli’s financial manager refuted the rumours, but the fact that they gained traction in the first place, and that the bank was forced to make a public statement of denial is rather telling. So is that the fact that the government put on these withdrawal limits in the first place – they may have justified the move on the grounds of fighting money laundering, but I am pretty sceptical.

All in all, the extent of the NPL problem is such that I can’t rule out the possibility of one or more of Iran’s large state-owned banks being forced into declaring bankruptcy, in turn resulting in a system-wide meltdown. Having said that, I fully expect the government to do all it can to stave off this threat, possibly via capital injections into struggling banks, but I nonetheless caution that the stability of the banking sector is by no means guaranteed. On top of international sanctions, the government’s dire fiscal situation and ongoing domestic political unrest, a banking crisis is the last thing Iran’s leaders want right now.

The diverging fortunes of Poland and Greece have once again come into focus following the positive reaction of Polish financial markets to the government’s 2010-2011 fiscal plan, at a time when Greek treasury yields have surged to their highest levels since the run up to euro adoption. Though Poland is an ‘emerging’ non-eurozone economy, its sound macroeconomic fundamentals, robust banking sector and strong coalition government, have comforted foreign investors with credit spreads consequently collapsing from their Q109 peaks.

Meanwhile, proving that eurozone membership and ‘developed’ economy status is no panacea for entrenched fiscal profligacy, Greece continues to struggle in assuring investors that it can pay down is swelling public sector debt pile. That the Greek 5-year CDS spread continues to trade ever further outside of its Polish counterpart is certainly a scathing indictment of Athens’ inability to get to grips with the public finances, and clean up its shoddy record on statistic collection.

While Poland is by no means immune to ructions in global financial markets, we nonetheless believe that a credible deficit reduction program, limited private sector deleveraging requirement and strong growth potential will continue to differentiate this economy from its more precarious peers. At the same time, the outlook for Greece continues to deteriorate. Even should Athens secure some form of financial bailout from other eurozone states, the road to recovery will be both long and painful. Not only will unpopular budget cuts risk sparking violent public protests over the medium term, but the failure to raise competitiveness and the quality of the business environment in recent years will anchor the Greek economy on a lower long-term growth trajectory, while Poland continues to ascend the convergence ladder.

Nevertheless, one thing that is sure to anger China is the sale of American (and other foreign countries’) weapons to Taiwan, which Beijing regards as a renegade province. US President Barack Obama announced last week that Washington plans to sell US$6.4bn worth of arms to Taipei. More broadly, the mainland has never ruled out military force to recapture the island if it ever declares independence. This is where US arms sales come in. China fears that the more heavily armed Taiwan is, the more likely it is to declare independence, or at least act more assertively towards Beijing. Since China regards Taiwan as a part of its territory, it sees American arms sales as rank interference in its domestic affairs, hence all the bluster.

Why Taiwan Matters To China

• China regards Taiwan as part of its sovereign territory, and that having reclaimed Hong Kong and Macau peacefully in 1997 and 1999 respectively, Taiwan must eventually follow. This view is reportedly shared even among Chinese who are considered international in their outlook.

• China fears that Taiwan’s close relations (unofficial, of course) with the US and Japan will embolden it in its dealings with Beijing. Even if Taipei does not declare independence, it can still rile China’s Communist leaders.

• China fears that the US is seeking to integrate Taiwan into a de facto alliance with Japan and South Korea to contain its rising power in Asia.

Why Taiwan Matters To The US

• Under a 1979 treaty in which the US switched recognition of China to Beijing from Taipei, Washington is obliged to sell the island defensive weaponry. The latest arms package is part of a long line, and it will not be the last.

• Taiwan is an established democracy, and the US feels that it must support democratic nations. If authoritarian China were to invade democratic Taiwan and the US did nothing, it would severely undermine Washington’s position as a defender of democracy.

• Some US (and Japanese) security planners fear that Chinese control of Taiwan would confer dominance over Northeast Asia, including the ability to interdict Japanese shipping (however unlikely the latter seems).

It’s About More Than Taiwan

Despite Taiwan’s perceived geopolitical importance, the question must still be asked, why should the US jeopardise its relationship with a 1.3 billion-strong emerging superpower for the sake of an island with only 23 million people? Even more bluntly, why should Washington risk being attacked by nuclear weapons to defend Taiwan?

Ultimately, the answer is that it’s not all about Taiwan. It’s about global power. As I’ve argued previously, China is the only country that can realistically challenge the US as a potential peer competitor (although not without limitations). Hence, had Obama announced that there would be no more American arms sales to Taiwan, he would have sent the message that Washington was scaling back its commitments to Asian security.

Over the coming week, my colleagues and I will be writing a feature on the future of Sino-US relations on Business Monitor Online. Much is at stake. In particular, watch out for rising naval competition, since China will be hard-pressed to project power without an ocean-going navy. A Chinese academic last week proposed setting up bases abroad to defend Chinese interests. This would be the clearest sign yet of China emerging as a global military power. 

1) It attempts to address the ‘too big to fail’ debate: Obama wants to place size limits on banks (although it is still unclear what these are). This should create a wave of divestments and carve-outs in the banking industry.

2) To break up the banks, Obama’s criterion is to reduce a number of their high-risk activities: he plans to impose a ban on proprietary trading and a ban on the ownership, investment or sponsorship of hedge funds and private equity.

Ultimately, Obama is forcing the banks to choose between deposit-taking and high-risk activities. Those banks which want to continue engaging in high-risk activities have to sell their retail banking assets and lose access to emergency federal funding.

The main pro of the reform is precisely this denial of access of high-risk players to a federal bailout in case things go wrong. Through this, Obama addresses the moral hazard of bailouts.

Yet the cons of the reform are noteworthy:

1) Restrictions on prop trading could further depress liquidity.

2) Restrictions on private equity funding at a time when bank credit is scarce make little sense, especially as private equity is an investment activity with a long-term horizon, unlike prop trading.

3) The reform isolates risk from economic activity, which is an oxymoron. Risk is the flip side of reward/incentives, without which an economy cannot function.

The Impact On Banks, Private Equity, And M&A

However, the reform’s impact on banks is still unclear, as it is still very general and vague. Its final impact will depend on:

1) The definition of prop trading. While in theory, prop trading on average only represents 1% of bank revenues, it is hard to distinguish it from client business, as the latter transactions still find their way in banks’ balance sheets, with banks holding positions for their clients.

2) The definition of private equity investment. Similarly, while a number of banks have sizeable private equity interests, it can be argued that they are investing in them for their clients.

The impact on private equity should not be too strong, in so far as banks only account for 9% of the capital invested in private equity in the US. The impact should be greater on the leveraged buyout (LBO) segment of private equity, as banks tend to find it particularly lucrative to co-invest with LBO funds and give them access to leveraged loans.

The impact on M&A should be significant, especially as far as the large US integrated banks are concerned. JP Morgan and Bank of America should top the list of banks forced to divest.

The CRB index has suffered several short-term corrections in recent months, only to bounce back once risk appetite has resurfaced. However, prevailing equity market uncertainty and the broader macroeconomic outlook have made my colleagues at BMI particularly wary of a major correction this time around. Here are our key thoughts:

o    On a short-term basis, Risk Watchdog sees some room for a bounce. Like equities, many commodities are ‘oversold’. In particular, the daily ‘relative strength index’ for Brent Crude is currently at its lowest since December 2008, when the oil market bottomed.

o    Beyond the short-term, things do not look good. A glance at weekly charts confirms this. With only a few days left of trading this month, the monthly charts should also make some interesting reading.

o    Should equity markets continue to sell off in the coming days, commodities should follow suit.

o    Signs that Chinese authorities are beginning to tighten monetary policy pose a further risk to commodity prices. Rampant Chinese demand (and imports) has been the key driver of commodity prices over the last 12 months. Lower bank lending could curtail this hitherto insatiable source of demand.

On the whole, my colleagues and I hold a cautious view that can be best summed up as follows:

o    Given the rapid pace of recent losses, a short-term bounce is on the cards.

o    However, we are increasingly concerned about a possible ‘trend change’ for commodities. A continued sell-off in global equity markets would undoubtedly see commodity prices head lower.

Although the most recent move could simply reflect liquidity constraints – bid/ask spreads are regularly in excess of 500 basis points – the bond’s recovery since March 2009 has been nothing short of remarkable. Indeed, from a low of just under 20.00 in March, the instrument had recouped all its losses by November, and is now trading at a trough to peak gain of over 180%!

To my mind, this rally should be seen within the broader context of rising risk appetite and improving fundamentals as the investment community realised that African economies would fare comparatively well in the global recession. On this note, recall that Ghana and Gabon’s sovereign bonds had already returned to their pre-crisis highs by early September, where they continue to trade at present. The move also speaks to the strength of investor appetite for African fixed income instruments, with the available supply still far below current levels of demand.

Despite these positive signs, I don’t see anything in the fundamental picture to support a rise much beyond current levels. The outlook for the key sources of foreign exchange – foreign investment into the oil, timber and agricultural sectors – is not materially better than at the time the bond was launched, while the government’s ability to service the debt may in fact have deteriorated in 2009. In fairness, though, with a current coupon rate of 2.5%, the annual debt service cost (US$11.9mn) is still only a fraction of exports (estimated at US$6.09bn in 2009) and foreign reserves. But given the bond’s steep rise over the past several months, I think some caution is warranted, and I do not rule out a short-term period of consolidation.

However, in recent years, a widespread belief has developed that bin Laden is irrelevant, and that the real terror threat to the West comes from local Islamist militant groups rather than some centralised Bond-villain-esque organisation based in the Afghan-Pakistan border region. Whatever the truth, by claiming responsibility for the Christmas Day 2009 plot to destroy Northwest Flight 253 above Detroit, bin Laden is clearly trying to give the impression that he is still in charge. Bin Laden has also seemingly proved that he is still alive, for even though he has released several audio messages over the past year, some commentators have doubted his continued existence.

The timing of bin Laden’s latest message is noteworthy, coming only a month after the Detroit plot and in the same week that London hosts major conferences on Afghanistan and Yemen – two crucial countries in the ‘war on terror’.

Perhaps the most urgent development is reports cited in several British newspapers over the weekend that al-Qaeda has trained female suicide bombers to attack the West. Some of the would-be bombers are said to be non-Middle Eastern in appearance and carry Western passports, meaning that they would theoretically attract less suspicion at airport security than Middle Eastern or South Asian-looking males. It is unclear whether the reports are referring to Western converts, but certainly there have been instances of female suicide bombers in Iraq, Israel (from Palestinian territories), and Russia (from Chechnya), and also in Sri Lanka (Tamil Tigers).

Overall, it seems highly likely that al-Qaeda and its affiliates will continue trying to attack the West. None of al-Qaeda’s grievances with the Western world – e.g. support for Israel and pro-Western Arab governments, the US military presence in Afghanistan and Iraq, and ongoing airstrikes in Afghanistan and Pakistan – have been soothed, nor are they likely to anytime soon. Also, none of the socioeconomic factors that could lead to radicalisation – e.g. unemployment, lack of perceived opportunities for upward mobility, etc – are likely to disappear soon. While Western countries will feel under pressure, al-Qaeda is arguably under even greater pressure to demonstrate its ability to strike successfully.

Dubbed the ‘Next Nostradamus’, Professor Bruce Bueno de Mesquita from New York University has been making political forecasts for decades, and been credited with correctly foreseeing who would succeed Iran’s Ayatollah Khomeini after his death, in addition to a host of other election outcomes across the world. Now, Bueno de Mesquita runs a private consulting firm, in which everyone from the C.I.A. to corporate leaders enlist his help to predict, and more importantly, shape the future. And so it goes, The Predictioneer: One Who Uses Maths, Science and the Logic of Brazen Self-Interest to See and Shape the Future sets the professor’s stall, outlining his belief that game theory (essentially maths for how people behave strategically) can be used to predict and alter complex negotiations, most of which often involve a significant degree of coercion.

Everything from Iran’s ability to acquire a nuclear bomb, to the likelihood of achieving peace in the Middle East can be predicted using game theory according to Bueno de Mesquita. Indeed, in order to make an accurate prediction, the professor claims all one needs to know is the key actors, what they want (their desired outcomes), how important the issue is to each player (the salience), and how much influence each player has in potentially altering the eventual outcome.

Of course, there is one caveat. Given the multitude of possible interactions in a complex negotiation or pressing issue of international importance, it is impossible to keep track of all of this information in one’s head. In comes Bueno de Mesquita’s proprietary computer algorithm to crunch the numbers for us (not surprisingly, the actual calculations which he uses are not provided to the public), thereby minimising the potential for human error in the process. To be sure, The Predictioneer makes clear that this method of forecasting the future in no way makes individual analysts obsolete, but rather crucially relies on their expert knowledge to help assign numerical values to the aforementioned criteria needed to make an accurate prediction.

This is not to say that Bueno de Mesquita does not have his critics, with noted international relations scholars such as John Mearsheimer and Stephen Walt (among many others) having previously attacked his mathematical approach to the discipline of political science. Given that everything the professor and his new book stand for, namely that human agency is what shapes outcomes, and not long-term trends in geopolitics as the above scholars may believe, such criticism is hardly surprising. Moreover, if you fail to accept the basic underlying premise (which many people don’t) that people act rationally, and are able to clearly articulate their preferences among a host of available choices, The Predictioneer is probably not for you.

That said, given the 90% accuracy rate with which the professor’s proprietary computer model apparently is able to predict outcomes, it would be hard not to get converted. For all of the criticism which Bueno de Mesquita has endured over the years, particularly those focusing on the underlying assumptions under which his entire discipline rests, it is hard to argue with such results. While the final chapter on how we could have predicted the declining power of the Catholic Church, or what we should expect out of global climate change negotiations seems to have been tacked-on to an otherwise highly enjoyable read, the previous ten chapters are a sufficiently solid foundation from which to launch a more robust investigation into the world of
game theory.

In my view, the demise of Japan Airlines comes down to a failure to adapt to an unsustainable debt load, excessive expenditure, and subdued consumer demand. While the fact the government has let an unprofitable company fail is encouraging, my concern, from a macroeconomic perspective, is that the sovereign shares many of Japan Airlines’ weaknesses. With the government looking to push through a second supplementary budget worth JPY7.2trn for FY2009 (April-March), there appears to be little stopping the public sector debt load smashing above 200% of GDP. Meanwhile, with the Japanese economy still on the ropes - nominal GDP fell 5.6% y-o-y in Q309 – one must question how Japan will fund future fiscal deficits, especially as its ageing population starts to run down its savings pool.

For this reason, I believe that the outlook for Japanese sovereign debt looks pretty ominous. Japan’s sovereign JGB 5-Year credit default swap (CDS) spread has already blown out to 81bps, the highest since November. A clean break above this level could see further spread widening towards trendline support at 95bps, deepening the divergence of Japan’s CDS performance compared to its developed world peers.

In 2009, for the first time, emerging market outbound mergers and acquisitions (M&A) flows outpaced inbound M&A flows, reaching US$131.8bn, according to Dealogic. Most of these flows were BRIC-related.

Therefore, now is a good time to look at the prospects for BRIC outward foreign direct investment (OFDI) and outward M&A (the link between the two is that all BRIC countries have shown a preference for M&A versus greenfield investment as a mode of OFDI).

At present, BRICs account for 5% of global OFDI flows, implying significant growth potential over the coming decades.

A measure of this potential is OFDI stock as a percentage of GDP. In developed countries, this measure is at 33%; in Russia at 20%, Brazil at 10%, China at 3%, and India at 2.6%. This implies that China and India show the greatest catch-up potential.

All BRIC OFDI is not the product of BRIC multinationals. State-owned enterprises (SOEs) and sovereign wealth funds (SWFs) are major players in BRIC OFDI. In Russia, SOEs account for 26% of total foreign assets, while in China they account for 75% of outbound M&A.

What does 2010 hold? The 2010 outlook for BRIC OFDI is a function of economic growth in important host countries and the ability of BRIC outbound investors to finance their own expansion. The former is a country-specific matter of debate. As for the latter, given that my colleagues and I expect a strong rebound in BRIC growth, mainly due to China and India, I would expect a resumption of the financing capacity which is essential to M&A activity.

Beyond 2010, the BRICs’ ability to reach their catch-up potential will depend on:

1) A supportive domestic policy framework to encourage OFDI. Here, Brazil and Russia in particular have to play policy catch-up to China and India.

2) The ability of BRIC-based investors to manage the obstacles raised by the escalating protectionism of developed country targets, especially against the SOE and SWF players in OFDI. The United Nations Conference on Trade and Development (UNCTAD) has noted a proliferation of US-style approval bodies for BRIC M&A across the world. It also notes that the share of world FDI flows affected by countries making at least one unfavourable regulatory change in 2007 was 40%.

Our bullish outlook had been largely based on expectations of a massive global corn deficit in 2009/10. It appears that the entire market (ourselves included) were awaiting a downward revision to USDA estimates for US corn production on January 12. Instead, the USDA upped its supply estimates and now forecasts a record US corn harvest in 2009/10. This has sent grain markets into tailspin and forced a rethink of our medium-term view on grains. Here are our key thoughts:

•    In raising grain (and particularly corn) production forecasts for 2009/10, the USDA has undermined a central pillar in the bullish outlook for grains.

•    A glance at the longer-term charts reveals that grain prices remain elevated by historical norms.

•    On the back of a weaker fundamental outlook, combined with a deterioration in the technical chart patterns, Risk Watchdog now expects grain prices to enter a period of volatile sideways trade within a wide range.

•    While not outright bearish, my colleagues and I would opt for a cautious approach, particularly given the uncertainty that will pervade these markets in the short term following such a violent knock.

•    Of the grains, rice prices appear the most robust. The US is not a major producer of rice and therefore, recent USDA revisions have not altered the fundamental outlook for prices.

However, Risk Watchdog will be keeping a close eye on some factors that could bolster grain prices in the coming months. In particular, my colleagues here at BMI see potential for the Chinese 2009/10 corn harvest to disappoint official estimates. Meanwhile, the US Environmental Protection Agency (EPA) is due to rule on a potential revision to the US ethanol blending cap for gasoline in mid-2010. Should the EPA raise the blending cap from 10% to 15%, as has been proposed, this could provide a much-need boon for corn prices.

Now, with the World Cup in South Africa fast approaching, I think there is going to be a lot of pressure on the Zimbabweans to keep their squabbles to a minimum. The last thing that Jacob Zuma and his regional counterparts want is for the political situation to unravel while the eyes of the world are on their neck of the woods. This has become even more important following the tragic events in Angola last week.

From the Zimbabweans’ perspective, they will see the world’s biggest sporting event as a marketing opportunity. They will be keen to show that they are making progress in resolving at least some of their differences and will be hoping to attract some foreign money that they sorely need to rebuild their country. I am not for one minute suggesting that the world cup will be the panacea to rid Zimbabwe of all its ills, the underlying issues are too complex and sensitive for that. But if some progress is made and the market believes this to be significant, the index could be a reasonable bet for investors who have the stomach for a bit of risk.

Nonetheless, it is still possible to identify several political trends, some already under way, which will continue in the 2010s:

• Inequality will remain high. The US gini coefficient for families has risen sharply since Ronald Reagan became president, and although it appears to be stabilising at 0.44, it is still high. Although Americans seem more tolerant of inequality than many European nations, that doesn’t mean that inequality will not become a political issue.

• The US will have to reduce its budget deficit and debt burden. Much of the cuts will need to occur at state level, since several states – e.g. California, New Jersey – have become virtually bankrupt.

• Neither the Democrats nor Republicans will have a lock on the presidency for the next 20 years. Although the American electorate is roughly evenly divided, there are sufficient swing voters to prevent one-party dominance. Meanwhile, if neither the Democrats nor Republicans prove effective, I would not be surprised to see another push for a third-party presidential candidate in 2012 or 2016.

• The south and west will continue to rise in importance due to demographics. The 2010 Census is expected to result in more Congressional seats being allocated to southern and western states, at the expense of northern and eastern states. However, the rise of the South will not necessarily boost the Republicans (who traditionally do well there), because northern and Latino immigrants will ‘Democratise’ the region.

• Hispanics will continue to rise in importance, economically, politically, and socially, as they become an ever larger share of the US population. Some states are already seeing non-Hispanic whites shrink to minority status, even where they are still a plurality. By the end of the decade, I would expect to see a Hispanic candidate for president or vice-president.

• Regionalism could gain further momentum, as western states forge closer ties with Asia, southern states trade and invest more with Mexico and Latin America, and northern states become integrated with Canada.

Wild Cards: Mexican Drugs, Terrorism, Afghanistan

There are three major wild cards:

• If Mexico’s drug wars worsen and start spilling over into the US on a significant scale, border security will become a much more pressing issue, and could lead to greater American military involvement south of the border.

• A new mass-casualty terror attack – or series of terror attacks – in the US would place homeland security at the top of the political agenda, potentially draining political capital away from economic reforms (e.g. the deficit, healthcare).

• A US military defeat in Afghanistan – or perceptions thereof – could lead to a new period of Jimmy Carter-esque ‘national malaise’ similar to what followed the fall of South Vietnam in 1975. This would reinforce perceptions of US decline at a time when China and India will probably still be rising. However, the scene would then be set for an American resurgence under a Reagan-esque figure.

Beyond 2020

Beyond our decade, many of the above trends will continue, but the bigger questions will be:

• The character/identity of the US: Whether America will continue to be an ‘Anglo-Saxon’ (culturally as well as ethnically) nation as Hispanics and Asians become numerically stronger (although there is also a case that the Hispanisation is somewhat exaggerated).

• Climate change: Rising populations in the western and southern states may not be sustainable if climate change leads to greater aridity and water shortages. The northern states could experience a revival if they prove more environmentally sustainable.

• Superpower status: Although I still see the US as the world’s sole superpower in the 2020s, this will increasingly be challenged by China and India, and possibly a few others. The US may find it difficult to adjust to its decreasing (in relative terms) power – although I caution against believing that the US is in decline.

Russia - RTS Equity Index

Poland has long been one of my favourite macroeconomic stories in emerging Europe and this has been reflected in the very stable and steady uptrend in the Warsaw WIG20 index through 2009. With the economic recovery in Poland likely to pick up pace through 2010, and so long as investor risk appetite can hold, there’s little reason as to why the bull run cannot continue, at least for the time being. (Click on chart below to enlarge)

Poland - WIG20 Equity Index

While equity markets still look healthy for the short term, volatility will remain a key concern, especially as uncertainty regarding monetary policy and the strength of the demand recovery is pronounced. This uncertainty has already been reflected in fixed income markets with treasury yields looking likely to have bottomed already, especially in key European emerging markets. With wide fiscal deficits continuing in 2010 and monetary policy likely to begin to be tightened in H210, there are few fundamental reasons to like treasuries at this stage.

This morning’s global equity market sell-off could have had something to do with the People’s Bank of China (PBOC)’s decision to raise the reserve requirement ratio from 15.5% to 16.0% for large domestic banks and from 13.5% to 14.0% for small banks from January 18. This followed two hikes in central bank bill rates, and is a clear sign that the government is beginning to worry that its huge monetary experiment will set off a surge in consumer price inflation. By the looks of the chart below, they seem right to be worried. Even though CPI came in at just 0.6% y-o-y in November 2009, history would suggest that prices are heading significantly higher.

China - Consumer Price Inflation & M1 Money Supply, % chg y-o-y

So with the PBOC moving to tighten policy, albeit from an extremely loose starting point, what will this mean for the economic recovery? In the best case scenario, expect to see asset price appreciation slow moderately, investment spending cool in the high order industries, and private consumption carry on accelerating regardless. In the worst case scenario, expect the property bubble to burst, the financial system to require another dose of government help, investment spending to seize up, and consumers to return into hiding. The Chinese decoupling story is about to face a tough test.

Bolivars will now officially be exchanged for dollars at two rates, VEF2.6000/US$ and VEF4.3000/US$, as opposed to the VEF2.1500/US$ peg that had been held in place since 2005. The preferential rate will apply for imports of priority goods such as food and medicine, while the latter rate will be charged for ‘non-essential’ imports.

A central unknown is if the authorities will relax the supply of dollars at the ‘non-essential’ rate, which is far more attractive than the unofficial parallel rate (currently trading around VEF*6.2500/US$). I suspect that many businesses – those deemed of little ‘social’ value – will still find it difficult to obtain permission to buy greenbacks at the official rate, thus leaving them at the mercy of the black market. In effect, what Venezuela might now end up with is a three-tier system with the price of hard currency determined by potentially arbitrary categorisations. Nonetheless, the markets have given the devaluation move a resounding endorsement, with Venezuela’s bonds and Credit Default Swap (CDS) rallying briskly following the news. Notably the 5-Year CDS has now dropped below that of Argentina, putting paid to the latter’s outperformance over the past few months.

Political Calculus

Nonetheless, I feel that the timing of the move merits attention. With legislative elections due in September this year it has been clear all along that a devaluation would be a risky proposition, given the inevitable inflationary ramifications. Indeed, spooked Venezuelans stormed to supermarkets over the weekend to buy imported goods such as electronics and luxury clothing before a feared mark up.

Chávez has characteristically responded to this panic by ordering the National Guard to take care of retailers who bump up prices. The fractured opposition, for its part, has seized on the public’s nervousness to attack the government’s policies. The government is likely hoping that any immediate political backlash caused by the inflationary impact of the devaluation will be offset by the boost brought to the government’s coffers – as it will now get twice the amount of bolivars for each dollar collected. To be sure, the one-off surge in state revenues will enable Chávez to extend the numerous social programmes on which his political support crucially depends.

Economic Reverberations

As hinted at above, a key question is what the inflationary feed-through of the devaluation will be. Finance Minister Ali Rodriguez has suggested that it may add three to five percent to the country’s inflation rate, which averaged over 25% y-o-y in 2009.

I suspect that the effect will be more pronounced due to the Venezuelan economy’s dearth of domestic productive capacity. As for the impact on regional trade dynamics, it is clear that Colombia stands to lose the most, as the drop in the value of the bolivar adds further to the pain caused by Venezuela’s trade blockade against its western neighbour.

Chávez has made it very clear that a weaker bolivar is part of a strategy to discourage imports whilst trying to bolster exports and domestic productivity. How he will square the urgent need to accelerate entrepreneurial activity and lift local supply with his steamroller nationalisations remains to be seen. In short, although the devaluation is doubtless one key step towards reducing distortions in the economy, and reflects a modicum of pragmatism on part of Chávez, the messy nature of the new exchange rate set-up and probable inflationary impact could work against the government’s objectives.

Siem Reap

This was my first port of call and where Angkor Wat and other historic temples are located. I was pleasantly surprised by the modern airport; for me airport appearance matters, because this is usually the first thing that visitors see. Immigration clearance staff used a digital camera connected to a laptop to take my picture, as is common practice worldwide these days. Amongst the travelers to the area, I noticed a large number of Asian tourists (South Koreans, Vietnamese and Japanese appear to be the majority), usually from the young-adults to middle-age demographic.

Unsurprisingly, the entire area has become very ‘touristy’, with strategically located restaurants and eateries charging relatively high prices (a meal at a chop-house typically costs about US$4 per person) to foreigners – although I also ate at places for US$1 at markets. However, transport is no problem since you can hire a ‘tuk tuk’ (a motorcycle with a carriage attached) – with its driver, obviously – for a reasonable price of US$15 per day. As with many developing countries, the economy is heavily dollarised, although I also used the local riel currency.

From conversations I had with locals – some of whom spoke English reasonably well – and the state of development in the area, tourism is certainly a boon to Siem Reap’s economy. However, I could not help but suspect that much of the tourism revenues will not necessarily end up with the locals. Many of the hotels and even museums in the area are foreign-funded as Cambodia does not have the financial capabilities to embark on such large-scale projects. Another point to note is that Siem Reap’s economy is perhaps overly geared towards tourism. There is a need to diversify into other industries as it appears that tourism is already saturated.

Phnom Penh

From Siem Reap, I took an air-conditioned coach for the six-hour journey to Phnom Penh. The roads were smooth and the journey comfortable. Phnom Penh is a bustling and polluted city and in some ways comparable to parts of Bangkok. The roads are teeming with motorcycles and the more well-to-do of the younger generation are decked out in the latest fashions. Within the city, there are several large, modern shopping malls, clearly indicative of the increased spending power of the locals.

Less positively, Cambodia risks attaining (if it hasn’t already) a similar reputation for seediness as Thailand. While in Phnom Penh, it was difficult not to notice that the sex industry is booming, with many bars clearly geared towards a certain clientele. That said, the government is making serious efforts to clamp down on child sex tourism, which is encouraging.

In a candid conversation with my guide, it appears that the better educated are less-than-happy with the government in terms of its handling of the economy and corruption. Indeed, vote-buying amongst the rural people appears to be a rampant phenomenon. Despite these issues, Cambodia strikes me as holding much economic promise. The opening up of its borders to foreign capital has allowed investment to pour in, boosting economic growth and generally benefiting the locals. However, a key challenge for the government is to ensure that these gains flow down to the poor population, and not solely to the wealthy or to foreign corporations. Otherwise, the authorities could face a backlash in the years to come.

Nigeria - Lagos All-Share Index (top) & Monthly RSI (bottom)

The technical picture for Nigeria’s Lagos All-Share Index is similar to that for Ghana. While the market performed poorly in 2009 having seen 33.6% losses from start to finish, it appears to be forming a base for gains around the 20,000 level. Again, the monthly RSI is encouraging, given that it is currently in oversold territory. The fundamentals for Nigeria also give cause for optimism, with BMI’s growth forecast for 2010 standing at a healthy 6.4%. However, I am still concerned over financials, which comprise a large weighting of the index, and furthermore, the lack of lending plaguing the economy is likely to impact on all companies. For these reasons, I am watching key support at 20,000, with a break below taken to be a very bearish signal.

Given the intense media attention on the country over the past week or so, a casual observer might be forgiven for thinking that some sudden deterioration in the political or security situation had recently taken place. This is not so, as BMI’s in-depth country risk coverage of the state in recent years attests. Indeed, Yemen’s problems are long-standing, structural, and, sadly, seemingly insolvable. If, as is eminently possible, Yemen collapses into failed statehood over the coming years, it will not be for lack of warning. Here are a few of challenges that face the government:

• The government is at war with Houthi rebels in the northern province of Saada, and faces a popular and well organised secessionist movement in the south.
• Against this backdrop, AQAP has managed to establish itself in Yemen’s eastern provinces, where the reach of state power is relatively weak.
• Yemen’s oil industry is in terminal decline – reserves could be completely depleted within 10 years. As oil revenues make up the bulk of fiscal revenues and goods exports, the end of oil production will have enormous negative implications for the overall economy.
• The country is facing a serious water crisis. It is one of the driest in the Middle East, and its water shortage is exacerbated by the excessive agricultural usage of groundwater, especially in the production of the narcotic qat (which has no nutritional value).
• The UN projects that Yemen’s population, currently estimated at close to 24mn, could double by 2040. Such rapid population growth will put even greater pressure on the country’s water resources and means that unemployment is likely to remain high for the foreseeable future.

Considering the extent of its problems, combating AQAP does not appear to be the government’s top priority right now. Over the long term, however, Yemen’s multifaceted challenges mean that it could be on a path towards failed statehood. In such a scenario, the country could feasibly become the ‘next Afghanistan’ for al-Qaeda.

The Counter Argument

On the other hand, such an outcome is far from inevitable. As mentioned at the start, the Christmas Day plot has woken the international community up to the threat emanating from Yemen. Moreover, it is somewhat ‘lucky’ in that it is located at the entrance of the Red Sea. Given that Somalia, on the opposite side of the Gulf of Aden, is likely to remain lawless and largely ungovernable for years to come, the international community is unlikely to tolerate two failed states on either side of such a major shipping route.

In practical terms, this means that the US and the West are likely to provide increasing levels of economic and military support to President Ali Abdullah Saleh’s pro-Western government. Of greater significance, though, will be the role of Saudi Arabia. Riyadh has possibly the most to fear from failed state harbouring al-Qaeda on its doorstep. After all, one of the terror group’s main goals is to overthrow the House of Saud. Ultimately, Saudi Arabia could reason that propping up the Yemeni government financially is a small price to pay for stability.

The surge higher in Turkish stocks correlates with fresh announcements from the government that it was close to finalising a new IMF Stand-By Arrangement (SBA). Investors are banking on a new SBA to help anchor government fiscal and economic policy through the long term. To be sure, rumours regarding the SBA have been coming and going for several quarters now. However, Prime Minster Tayyip Erdogan himself has come out to say that the IMF has agreed to government conditions in what is the most concrete positive signal the public has yet received regarding a new SBA.