December February 2011

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Kellie McKinney
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December 2010 February 2011 Food price risks: Who s vulnerable?

2010, due to bad weather, seems unlikely to end soon.

supply situation is uncertain; demand pressures in emerging markets are

which raises the risk of contagion from food prices to the rest of the CPI.

apparent in the summer, in the form of rising energy prices.

1 December 2010 February 2011 Food price risks: Who s vulnerable? The food price shock that kicked off in the northern hemisphere s summer of 2010, due to bad weather, seems unlikely to end soon. Other factors create additional risks, in Citi analysts view: the food supply situation is uncertain; demand pressures in emerging markets are strong; and monetary conditions in many countries are relatively loose, which raises the risk of contagion from food prices to the rest of the CPI. On top of that, there is now an additional threat to food prices that wasn t apparent in the summer, in the form of rising energy prices. Here we try to give some substance to the threats emerging economies might face over the next few months, and what the policy response might be.

2 Food price risks: Who s vulnerable? The good news so far is that the food price shock of 2010 did not produce a huge wave of inflation surprises, although we have seen a few important emerging economies (China, Brazil, Korea, Poland and India) record upside surprises in recent months. Still, the experience of the 2007/08 food price shock shows that rising food inflation can be associated with some big changes in monetary policy. Back then, we saw some dramatic monetary tightening in the first six months of 2008, when interest rates across 22 emerging economies rose in net terms by 1,375 bps. There are 2 good reasons why Citi analysts think that pressure on food price inflation is likely to remain a big headache in 2011: i) the dynamics of the food market; and ii) the effect of rising energy prices. It is not easy to be definitive about the state of world food supply, but the assessment of the UN Food and Agricultural Organisation (FAO) is not uniformly encouraging. While the FAO does suggest that wheat plantings for 2011 are marginally higher than a year ago, its overall view is that crop conditions are mixed. What this means, on balance, is that any increase in cereals output this year remains critically subject to the weather. Yet the effective global availability of wheat may be more constrained than this, particularly by policy. In Russia for example which is responsible for 6.5% of global wheat production and 14% of global wheat exports the government banned cereals exports in August through to the end of 2010, and subsequently extended the ban for the first half of Whether this can be offset by liberalised wheat exports from Argentina remains to be seen. But probably the most important part of the FAO s analysis of the world food situation is what it all means for stocks. The stock-to-utilisation ratio for world cereals has been falling pretty consistently since at least the late 1990s. In fact, the stock ratio fell to a 30-year low in 2007/08, and this was an important cause of that year s food price shock. Although the FAO does not expect the stock ratio to fall back to that level, there is little room for comfort, since stocks of cereals are likely to remain low by historical standards. So the food supply picture may not help stabilise prices, and it appears that the demand story is unlikely to either as demand pressures remain strong. Food consumption seems to be on the increase as the global population grows and as incomes rise in the developing economies. There is something structural about the increasing demand for food by households in emerging economies; it is part of the development process. And that trend gets reinforced at times of strong growth, as we are seeing now. Yet food-related demand for cereals is only part of the story since bio-fuels production is becoming a more important source of pressure on food prices. One of the many ingredients in the 2008 food price spike was that demand for corn, sugar and oilseeds received an unusually large boost from rising bio-fuels output. For example: ethanol production, which accounts for around 8 of total bio-fuels output, rose by 35% in 2008, a much sharper increase than in previous years. Altogether, the production of ethanol and biodiesel rose by over 4 in Bio-fuels become commercially viable at oil prices above US$70/bbl, and price increases much above this level will, naturally, boost investment in bio-fuels capacity: some US$15 billion was spent globally in 2008 on bio-fuels refineries. With energy prices now at elevated levels, Citi analysts believe that bio-fuels output is particularly at risk of staging a large increase. Moreover, the International Food Policy Research Institute (IFPRI) reckons that if governments around the world were to implement the plans they have announced to raise bio-fuels output by 2020, that alone could potentially raise corn prices by between 23% and 72%; oilseeds prices by between 18% and 76%; wheat prices by 8% to 3; and sugar prices by between 12% and 66%. All in all, food prices are worth worrying about in 2011, Citi analysts believe. If there are upside risks to inflation, then the monetary policy dilemma facing many emerging market policymakers how to raise rates without sucking in unwelcome capital inflows? is likely to grow. In any case, Citi analysts expect interest rates to go up in a number of countries this year, and their FX forecasts for emerging markets are almost universally bullish. If food inflation stays on the radar, the risks to these interest rate forecasts at least are likely to be to the upside, and that might make policymakers more inclined to pursue non-conventional means of managing unwelcome capital flows: more FX intervention, more experimentation with capital controls. At the extreme, food inflation might cause a capital outflow from emerging markets, causing yield curves to shift upwards. A more likely result, Citi analysts think, is a bear-flattening of many yield curves: long-ends remain anchored by inflows, while the impact of rising policy rates is felt primarily at the shorter end.

3 Chart 1: S&P 500 Index Chart 2: Dow Jones Stoxx 600 Index % % 1.54% 2.26% 2.26% % United States Moderate economic expansion expected in 2011 Growth has slowed recently as fiscal policy s thrust has ended and the mid-year flare-up of sovereign debt concerns triggered a widespread reduction in risk appetite that undermined financial support to activity. However, concerns that recovery might falter altogether have been assuaged somewhat by more recent evidence of moderate spending and job growth, and the Federal Reserve s (Fed) reenergized effort to buoy financial conditions through purchases of longer-dated Treasuries. In Citi s view, moderate recovery is likely to continue but with subpar contributions from the consumer sector and especially housing, where downside risks linger. Until officials can be more confident of positive feedback loops between economic and financial activity, monetary policy is expected to remain highly accommodative through all of Citi s base case is for exit strategies, including initial policy rate hikes, to remain on hold until later in Euro-Area Sovereign debt crisis may continue in 2011 and beyond The sovereign debt crisis looks likely to remain at the top of the agenda and could affect economic and market developments in the Euro Area over the next few years. In order to bring government budgets back on a sustainable path, all Euro Area countries but particularly the periphery ones will need to tighten fiscal policy in Citi analysts expect the austerity measures to have a negative impact on economic growth for the Euro Area on average, and believe that it is likely to contribute to a large divergence in growth in 2011 and 2012 between the fiscally-strained periphery countries and the healthier core countries. In an environment of weak domestic demand, Citi analysts expect inflation to stay low over the forecast horizon. While the European Central Bank (ECB) is likely to reduce its non-standard measures further in the near term, policy rates are likely to remain on hold until But, the ECB could potentially act earlier should there be signs of higher money or credit growth, or increasing inflation expectations. From an equity perspective, in spite of all the angst surrounding the consumer sector, a near 14% gain in the S&P 500 in the past six months is noteworthy given the traditional relationship between changes in stock market wealth and core retail sales activity. Such a development alongside modestly higher employment does not appear to imply a challenged holiday sales season but rather a decent outcome which might surprise investors to the upside. However, having said that, Citi analysts note that their primary sentiment indicator, the proprietary Panic/Euphoria Model has reclaimed complacency territory. This was last seen in April 2010 before markets backed off, and suggests that hopes for a late 2010 rally may very well be in jeopardy. This macro economic back drop coupled with corporate earnings trends leads Citi analysts to maintain their preference for Northern over Southern European equity markets. They also reiterate their long-held preference for companies with strong balance sheets and international exposure. They note that equity markets in the North (Germany, France and the UK) have posted stronger performance versus the South (Italy, Spain, Portugal, Ireland and Greece). In the North, Germany proved slightly more resilient during this latest Irish led selloff; up over 13% since end-june, reversing its underperformance from 1H10. In the South, Ireland has been the worst performer since end-june, down 13%.

4 Chart 3: MSCI Asia Pacific Chart 4: MSCI Emerging Markets Index % % 12.88% % -0.78% % % mth YTD 1 Year 3 Years* - Japan Deflation likely to persist at least into 2012 Citi analysts expect the cyclical mechanism in which export growth drives Japan s economic activity to return in Exports are likely to resume increasing at a moderate pace early this year after a temporary stall in the second half of 2010, thanks to a sustained expansion of the global economy. Emerging Markets CEEMEA and Latam currencies remain supported CEEMEA 1 seems to have entered 2011 with more momentum from 2010 than expected, but foundations remain wobbly. Citi analysts have as such maintained their forecast for a slower pace of growth this year (3.9%) compared to a likely 4.3% in Stubborn deflation is likely to persist at least into 2012, according to Citi analysts, reflecting shrinking but still large economic slack, and continued declines in unit labour costs. As a result, Citi analysts expect the Bank of Japan (BoJ) to maintain the current policy rates until at least 4Q13. Meanwhile, the BoJ may expand the size of the asset purchase program introduced last autumn, depending on developments in the economy and financial markets. Asia Pacific Risk of rising inflation Inflation concerns are at the forefront with Citi s Asia inflation surprise index turning positive and at its highest level since March, coinciding with a surge in commodity prices. There are growing signs that strong demand is facilitating the pass through of headline into core inflation. As such, Citi analysts expect Central Banks in Asia to hike policy rates by about bps this year on average, though they are only calling for 50 bps hikes in Malaysia and Taiwan. There are also increasing odds that the Monetary Authority of Singapore may tighten its monetary policy via the SGD NEER band as early as April. Citi analysts continue to expect most Asian currencies, particularly the Chinese Yuan (CNY), Singapore Dollar (SGD) and Korean Won (KRW) to strengthen versus the USD over the medium term, given strong regional growth and tighter monetary policy. However, appreciation Meanwhile, Citi analysts believe Latin America's growth rate could stand at 4.7% in 2011 after an expected 5.9% rate in In 2011, inflation could accelerate to 8.1%, up from 7.6% in They consider higher marginal reserve requirements an effective tool to curb excessive growth in credit to the private sector, and its resulting adverse impact on external accounts and inflation. In CEEMEA, risks to the Hungarian Forint (HUF) and Turkish Lira (TRY) loom, but a search for yield could continue to drive most other currencies in the region higher. These factors, plus strong commodity prices, are also likely to continue supporting Latam currencies. Healthy corporate earnings growth and reasonable valuations are expected to continue supporting Latin American equities, though Citi analysts caution that mounting inflationary pressures remain a concern in the near term. Nevertheless, their 2011 year end target for the MSCI Latin America now stands at 5,700, up from 5,300 previously. Within Latin America, they are overweight Brazil. As for CEEMEA equities, the region has moved up on corporate earnings momentum, while the interest rate path in the region remains more benign than elsewhere. Key regional risks however remain proximity to any intensification of the European debt crisis, slower economic growth and weaker fiscal/current account fundamentals. Within CEEMEA, Citi analysts are overweight Russia and Poland trends are expected to be disrupted occasionally by intervention measures in the region.

5 Currencies Chart 5: Currencies (vs US Dollar on 1 month) Euro GBP Yen Currencies Positive on High-grade and High-yield corporate debt US Treasury Bonds A slow and protracted economic recovery, the second round of quantitative easing (QE2), sluggish job growth, and concerns about the Euro zone periphery, are expected to keep Treasury rates low. Corporate Bonds Dollar denominated corporate spreads could compress further, though the current low level of absolute yields suggests that they are unlikely to move significantly tighter. Meanwhile, high-yield spreads are anticipated to continue grinding tighter over time as positive technical factors and improving fundamentals support performance. Short term USD gains are likely to give way to continued trend weakness over 6-12 months, absent a major reduction in risk appetite or a new HIA (fiscal policy aiming at promoting domestic investment by allowing corporate tax breaks to repatriate profits) in the US AUD may suffer from short term negatives, including flooding costs, and could under perform CAD over 0-3 months. But post-flood reconstruction is a huge potential positive and AUD will likely be the G10 out performer over 6-12 months. Euro Bonds Although two bailout programs have been put in place to alleviate liquidity concerns, uncertainty over longer-term fiscal sustainability is likely to be a drag on spreads. Citi analysts maintain a long duration bias on the highest quality AAA core Euro zone nations. Emerging Market Debt Inflation concerns warrant caution. Though mostly concerned about localcurrency bonds, foreign debt is also likely to suffer short term. A more hawkish ECB may offset ongoing periphery sovereign concerns and allow a recovery in EUR/USD to 1.40 over 6-12 months. GBP seems set to outperform a bit in Europe, CHF seems hugely overvalued. Scandi currencies have had a great run and further gains will likely be more limited. In the emerging world, we expect broad appreciation vs. forwards in The main drivers continue to be a search for yield, strong macro fundamentals and, for some, higher commodity prices. In EM Asia, CNY appreciation against the USD is likely to continue helped by an evident need to contain rising inflation. High G3 liquidity and a stronger CNY should support appreciation in EM Asia, despite policy attempts to resist it. In CEEMEA, risks to HUF and TRY loom, but a search for yield should continue driving most other currencies in the region higher. General Disclosure Citi analysts refers to investment professionals within Citi Investment Research and Analysis, Citi Global Markets (CGM) and voting members of the Global Investment Strategy Committee. Citibank N.A. and its affiliates / subsidiaries provide no independent research or analysis in the substance or preparation of this document. The information in this document has been obtained from reports issued by CGM. Such information is based on sources CGM believes to be reliable. CGM, however, does not guarantee its accuracy and it may be incomplete or condensed. All opinions and estimates constitute CGM's judgment as of the date of the report and are subject to change without notice. Opinions expressed herein may differ from the opinions expressed by other businesses or affiliates of Citibank N.A. This document is for general information purposes only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or currency. 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Market volatility to continue

Market volatility to continue How much more? Renewed speculation that financial institutions may report increased US subprime-related losses has sent equity markets tumbling. How much more bad news can investors expect going forward?