The Double-Edged Sword

January 13, 2014 FF Journal

Cambridge analyst, Chris Morris, describes emerging market risks for metal industry

December 2013

By Chris Morris

U.S. Fed tapering and uncertainty in emerging markets offer opportunities and challenges for the metal industry

December 2013 – American enterprises have long held tremendous faith in emerging markets as an environment to source labor and materials and in more recent years, have even viewed them as fertile markets to sell their finished goods with the expansion of the middle class. These regions have thus experienced a tremendous swell in GDP, in particular India, Asia and South America, however, we’re now seeing a staggering decline in their economies as U.S. companies have pulled back manufacturing onshore. In fact many of their economies are suffering, their currency a reflection of this loss, take for example, the Indian Rupee and the Brazilian Real, which have plummeted 20 percent this year against the dollar. These losses were described in articles in The Guardian andBloomberg News.

The promise of opportunity in these regions is weighed against complex political and economic issues, as well as energy woes that drive up the cost of export transportation, creating a volatile mix of economic drivers hindering the value of emerging market currencies within the global market. It seems at this point many currencies are over-valued and the bubble in demand for their exports has now popped. The metal production industry, integral to all types of manufacturing, has been hit especially hard as demand has fallen sharply through the global economic downturn.

U.S. policy and market volatility

Emerging economies depend greatly on the U.S. due to their reliance on American capital investment and assistance in alleviating account deficits, thus any major events for the U.S. economy may in turn impact their markets. One such event on everyone’s minds is the Federal Reserve’s plan to taper its quantitative easing (QE) program, which was announced on Dec. 18, 2013.

QE, in which the Fed purchases Treasury Notes and Mortgage Backed Securities from its member banks, has kept interest rates and the U.S. dollar low since 2008, providing stimulus to a hurting economy. Beginning in January, the Fed will be lowering its $85-billion a month in bond purchases by $10-billion and since the announcement markets have already begun reacting dramatically. A sizeable correction has occurred in the value of emerging market currencies versus hard currencies like the dollar, leaving many emerging economies and their citizens panicked and searching for answers. Countries with the largest account deficits, for example, Turkey, South Africa, India, Chile, Peru, Egypt, Poland and the Czech Republic, are facing the largest risk as predicted by this September article in the Financial Times.

China, with its enormous FX reserves, is not likely to feel the same impact, but it is not immune. To avoid instability, some are taking steps to actively manage their exchange rates with a strategy sometimes referred to in markets as a “dirty float.” For example, Brazil in August injected $60 billion into its FX market in an effort aimed at stemming the selling pressure on the Real. Unfortunately, no one has a crystal ball, and while we can anticipate most challenges, there is no definite way to avoid them.

Opportunities for on-shoring

There’s a ray of hope for America’s manufacturers and their metal suppliers. Many businesses that have spread their operations overseas to emerging economies are finding enormous challenges. The markets are difficult to navigate, for example the web of rules and regulations in China. There are also political implications; we’ve seen this with the recent upheaval in Brazil and Turkey. But more importantly, market fluctuations play a significant role in the ultimate success of these operations. At the end of the day, if a company is gaining substantial revenues, but their profits are sliced by the currency losses after their conversion back to USD, the effect can take a toll economically and psychologically as in many cases, the model comes into question.

In 2013 markets have experienced tremendous volatility across the asset class spectrum, and with events like the end of America’s QE program, the trend is expected to carry into next year. This is all cause to deter U.S. businesses from expanding their geographic footprints and even installing their plants in these regions. In fact, some foreign companies are opening factories in the U.S. to avoid FX losses by building their cost base in domestic currency terms. Recent data points to this, as for the first time in more than a decade, the deficit on trade of manufactured goods shrank by $2 billion in the first half of 2013, as reported in August in the Wall Street Journal. While it isn’t a giant leap in progress, it’s certainly a significant step in the right direction.

Challenges for imports/exports

With the current state of metal product prices, maintaining margins can be a difficult proposition. No matter the size of the business, as a producer, processor or manufacturer, profitability remains on the defensive. Currency fluctuations are one risk factor that companies should be able to avoid. Unfortunately, most of the raw metals imported by the U.S. come from overseas and from many emerging markets, where volatility, if not already felt, will likely incur losses for non-USD transactions, bruising bottom line expenses. In addition, companies paying suppliers in U.S. dollars may actually be paying more, as many foreign producers in these regions embed costs to their invoices to deflect against their own exposure and volatile market conditions.

For exports, the pain point is squarely focused on top line revenue. Take for example, Steel Warehouse, a large private steel processor based in South Bend, Ind. The company has a global network of customers including those within South America and Asia, and with the volatility seen in the past six to nine months, they have not taken any chances. To hedge against currency volatility, Lewis Hicks, general manger for the company’s International Division, uses a variety of currency risk mitigation instruments such as forward contracts in widely traded currencies and non-deliverable forward (NDF) contracts in illiquid currencies, a tool recommended by global payments and risk management company Cambridge Mercantile Group. Thanks to this strategy, Steel Warehouse has successfully hedged in recent months against drops in the Rupee, Singapore Dollar, Chilean Peso, Peruvian Sole and Australian Dollar. NDF’s are a preferred tool in emerging markets because they allow a business to hedge its exposure without the need to actually exchange currency in the local market. The tool is purely a hedging vehicle as there is no exchange of principal amounts at expiry, only a cash-based settlement of profit or loss calculated by taking the difference between the agreed upon exchange rate and the spot rate at expiry. The result is typically an image of what the company has forecasted to maintain its budget. Some companies won’t hedge, and take confidence in the logic of what goes up must come down. But once a major event in our markets happens, it’s done, and recovery is not always quick or easy. FFJ