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16 October 2017

Over the past week Australian shares were up 1.8% while small company shares rose 2.8%. Shares in developed countries were up 0.7% with the US market up 0.2%. Shares in emerging markets rose 2.1%. The Australian dollar moved up 1.5% to 78.77 US cents. The Australian 10 year bond yield fell slightly to 2.79% with the US 10 year bond also falling to 2.27%. The oil price rose 4.4% to 51.45 US dollars per barrel.

Venezuela

In the last update, Patterns in Prosperous Economies, we linked several factors with the degree of economic prosperity, gross domestic product (GDP) per capita, we see around the world. These factors include low levels of corruption (good governance, good institutions and secure property rights) and free international trade. This week we turn our attention to the challenges of Venezuela’s high price inflation and explain its puzzling stock market returns.

Venezuela is a country in crisis, with anti government protests, queues for food and queues for hospitals making the news. A reduction in free trade and foreign investment along with high levels of corruption have impacted negatively on GDP growth, estimated to have fallen by around 35% over the last four years. Unemployment is forecast to be at 30% next year, yet the major stock index has risen by about 1,575% this year. Why?

The answer to this riddle involves three parts and begins with inflation or more precisely hyper-inflation. Inflation in Venezuela is thought to be running at around 800% to 1000% (the government stopped publishing official numbers in 2015). Expectations are that this will get a lot worse before it gets better. Last week the International Monetary Fund (IMF) said that it expects inflation to reach 2,300% in 2018. The local currency, the Bolívar, has become essentially useless as a method of payment. Many shop owners prefer to sell (exchange) their goods for other goods, back to the barter system.

Hyper-inflation means that the real return for Venezuela’s IBC equity index, denominated in Bolívars, is much lower. The real return of an asset is simply its nominal return adjusted for inflation. An asset returning 5% per annum when inflation is 2% per annum has a real return of 3% per annum. Hyper-inflation means that the real return for the equity index is near 675%. This is still high but may reflect much higher current and expected inflation.

The second part of the answer is that Venezuelan investors know that placing cash on deposit in a Venezuelan bank is a sure loss, in real terms, and may be a complete loss if banks collapse. So, the wealthier Venezuelans have bought shares instead, which has driven prices up.

The final part of the explanation is that the Venezuelan dollar (although only traded on the black market) has fallen against all other currencies, it’s worth about 15% of what it was a year ago. Venezuelan stock prices are denominated in Bolívars and this means that companies holding foreign assets, or local production that can be sold overseas, will see higher stock prices.

Is there a solution to the economic problems? With President Maduro in a war of words with President Trump there is reluctance to adopt the US dollar (dollarization is a possible path out). The President’s wavering political support has benefitted from anti US rhetoric. A new government committed to free trade and good governance would be a positive start.

The situation in Venezuela is extreme and unusual; however, inflation and real returns are a concern in developing countries too, but for entirely different reasons. In most of the developed world, including Australia, inflation is low, wages growth is slow, interest rates are low and GDP growth is only now beginning to show signs of improvement. At Mine we’re conscious of the impact of inflation on the returns we generate for our members.

Signing off

Sean Anthonisz | Senior Quantitative Analyst – Asset Allocation

Past performance isn't necessarily an indicator of future performance.

All data sourced from Bloomberg.

Sources include CNN Money, Trading economics, Bloomberg Markets and US Department of State, Business insiderBloomberg and News.com.au