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Examining the Growth Potential of Coffee in India and China

Posted on May 17, 2013

By Mayank Tripathi, Strategic Services

China and India, the two most populous countries in the world, have traditionally been tea drinkers. In 2011, their per capita annual coffee consumption was a mere 25 and 80 grams, compared to 12.3 kg in the largest European nation and the United States (4.2 kg)[1]. However, of late, both China and India have witnessed a slow, albeit steady growth, in coffee consumption.  Based on current market trends, if all goes well with current players in the market, these two countries will likely become among the top five markets for coffee consumption.

This trend has not gone unnoticed by investors and global coffee houses that are looking to grow beyond their traditional markets in the western hemisphere. Increase in coffee consumption in these countries has attracted major global brands. Stores ranging from Starbucks to Nestle to local players have all been busy trying to tap into the potential of these markets. Three key questions companies and investors need to ask are:

  • What are the demand drivers?
  • How are current coffee franchises responding and is there room for further growth and expansion?
  • Is the demand widespread among other fast-moving consumer products as well?

What is Driving Demand?

Over the past decade, the appeal of coffee has grown across India, particularly in urban areas. Factors such as globalization, an expanding middle class, rising disposable incomes, and changing lifestyle have all contributed to the increase in coffee consumption in the country. A rising café culture also favors coffee’s uptake. Industry participants estimate the Indian coffee market to be worth $200 million as of 2012, with café and coffee sales expected to grow 25% annually. As per market estimates, the coffee-drinking population is likely to increase by at least 100 million in the near future.

Traditionally, a tea drinking nation, China is enjoying coffee as well! Retail market for packaged coffee grew by an 18% CAGR during 2007–2012. By 2017, the Chinese market for packaged coffee is estimated to reach $2.5 billion. However, the growth in China is driven by the adoption of coffee culture, rather than its taste. Companies such as Nestle and Starbucks are preparing to tap the growth potential in the world’s most populous country. Per capita coffee consumption in China is only 3–4 cups a year, as opposed to almost 600 cups in France, and 400 cups in Japan. These companies see potential in cities such as Shanghai, where rising income levels are laying the foundation for adoption of western culture, including drinking coffee.

Increasing Presence of Global Coffee Giants in China and India

Starbucks
In China, Starbucks started operations in 1999, and currently has about 767 outlets across the country. By 2015, it plans to nearly double the existing number of stores in the country. This would make China its second-largest market after the United States—superseding Canada. The Seattle-based coffee retailer opened its first outlet in India in 2012. Since then, the company has opened eight other outlets (as of March 2013) across Mumbai and New Delhi. In 2013, the company also opened a coffee roasting unit in India.

Nestle
Nestle, a Switzerland-based company, is the dominant player in the Chinese coffee market. Its instant coffee brand, Nescafe, accounts for two-thirds of total sales. The country is expected to become its second largest market after the United States. The company is heavily promoting Nespresso, its single-serve coffee machines, in the country. It plans to spend about $16 million to develop a coffee center in China as part of its efforts to boost coffee consumption in the country in the near future.

Barista Lavazza
Italy-based Barista Lavazza started its Indian operations in 2007. It currently operates about 318 stores across India, making it the second-largest coffee retail chain. Once considered to be a serious threat to Café Coffee Day (CCD), the company has, of late, decided to shut down some of its outlets amid restructuring moves—it plans to reduce the number of stores to 110 in 2013.

Café Coffee Day
Bangalore-based Café Coffee Day, or CCD as it is popularly known, is the leader in the Indian coffee retail market and the company accounts for 66% of the cafes within the country. Launched in the mid-90s, the company operates about 2,000 retail stores currently, with plans to increase the number to 5,000 by 2018.

Other Players
Costa Coffee (UK), Mocha (India), Gloria Jean’s (Australia), Coffee Bean & Tea Leaf (US), and Dunkin Donuts (US) are the other prominent players in the Indian coffee retail market. They operate about 100, 18, 17, 17, and 5 outlets, respectively, in the country. Costa Coffee and Gloria Jean’s plan to increase their stores to 300 and 100, respectively, by 2017.

The key takeaway here is that while the “David’s” of the international coffee market step up efforts to gain a foothold in China and India, they will have to face tough competition  from local “Goliath’s” who have no intention to forego their home-turf advantage.

Impact on the Global Coffee Market

The increased consumption of coffee in China and India is likely to be a boon for coffee production as well. As a result, more area will likely be brought under coffee cultivation. Indian coffee exports are likely to witness a dramatic fall between 2013 and 2022, on account of rising domestic consumption. Further, demand for coffee dispensing machines is expected to rise in these countries, which would be a boon for global coffee machine and pod manufacturers.

What do you think?

  • Will India and China overtake the United States and other European nations in becoming two of the largest coffee consumers?
  • Have you assessed the Indian and Chinese markets’ attractiveness for your respective categories?

[1] International Coffee Organization, 2011

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Japan, Methane Gas, and Energy Independence

Posted on May 9, 2013

By Sanchita Arora, Strategic Services

Overview

In Q1 2013, the world’s energy landscape witnessed a potential game-changing development. Japan extracted methane gas from deep-sea deposits of methane hydrate in the Nankai Trough, 50 miles south of Atsumi Peninsula.

The discovery of these methane hydrate deposits dates back to 2001, when state-owned Japan Oil, Gas and Metals National Corporation (JOGMEC) started phase one of the ‘Methane Hydrate R&D Program’. Between 2001 and 2008, seismic surveys and exploitation drillings were conducted, and presence of a considerable amount of methane hydrate deposits was confirmed. Phase two started in 2009, with an aim to develop a technology that could extract methane gas from methane hydrate. Onshore tests were conducted in partnership with Canada, and the depressurization method was found to be efficient. This method was also chosen to conduct offshore production tests. Finally, the offshore production test ended in March 2013, when gas production was confirmed. This was the first time in history that methane gas was extracted from undersea deposits.

These methane hydrate deposits are estimated to contain more than 7 trillion m3 of methane (250 tcf). According to JOGMEC, methane hydrates available within Japan’s territorial waters are likely to be enough to cater to the nation’s natural gas needs for a century. Japan is expected to enable commercial extraction and use by 2018.

What does this mean for Japan?

“Methane hydrate may start a revolution in Japan as shale gas did in the U.S., but there are still a lot of challenges ahead.” – Yuji Morita, Senior Researcher, Institute of Energy Economics, Japan, March 2013

Source: U.S. EIA

In 2011, only 14% of the country’s energy demand was met through domestic production. Japan has traditionally been heavily reliant on imports to meet its energy requirements.

Source: U.S. EIA

Japan is the:

  • Third-largest importer of Oil
  • Second-largest importer of Coal
  • Largest importer of LNG

With the discovery of methane gas reserves, Japan is likely to substantially reduce its energy imports and even perhaps become self-reliant. This trend will be driven by the need to alter the country’s fuel mix (to reduce dependence on nuclear energy) after the closure of nuclear facilities post the Fukushima disaster.

In the long term, as the country starts commercial production, LNG imports are expected to decline. In 2011, Malaysia (19%), Australia (18%), Qatar (15%), Indonesia (12%), and Russia (9%) were the key LNG suppliers to Japan. As Japan becomes self-sufficient for its natural gas needs, these countries’ LNG exports are expected to take a hit. At the same time, these countries will also face competition from Japan, as the latter is likely to emerge as a natural gas exporting nation. This development is likely to create investment and employment opportunities in the country, as commercial players enter the market in the long term. Overall, the Japanese economy is set to witness robust growth, driven by improved trade balance in the long term.

What are the key roadblocks?

Economics and Cost Effectiveness
Perhaps the biggest challenge for Japan’s energy authorities will be to extract methane gas economically. The cost of extracting natural gas from undersea methane hydrate is estimated at $50 per million BTUs, as against $3 per million BTUs for shale gas extraction in the US and $15 per million BTUs for gas imports.

Environmental Challenges
Safe extraction from this seabed will be a concern for companies, as Nankai Trough is prone to seismic activity. Leakage of methane gas from hydrates is also a possible threat as it is an extremely potent greenhouse gas. Global warming of the earth’s surface can also lead to melting of the permafrost layer, and cause bubbling of hydrates. Extraction activities without adequate research and precautionary measures are likely to exacerbate this problem.

What Next?

Canada, Norway, China, and the US are also exploring hydrates!
In March 2013, the US announced the discovery of methane hydrate reserves along the Pacific and Atlantic coasts. The US Bureau of Ocean Energy Management reported that methane hydrate deposits in the country contained 51,338 tcf of gas (in 2011, the US consumed 24.4 tcf of natural gas). Deposits are mostly concentrated along the continental shelf from Rhode Island to North Carolina.

There are several research projects dedicated to methane hydrate exploration on Alaska’s North Slope. Large energy companies are monitoring such developments for future commercialization. As Japan and other countries explore commercial methane gas extraction possibilities, the world energy markets are set to register dynamic changes in the near and long term, and witness trade balance shifts. With multiple market forces at play, interesting times lie ahead for various participants in the global energy supply chain.

Looking for more insights about Japan and its economy?

Monetary Transmission: The Bank of Japan’s Weakest Link

Betting on Abe-nomics?

Are Uranium Prices at a Critical Tipping Point?

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Monetary Transmission: The Bank of Japan’s Weakest Link

Posted on May 2, 2013
By Ankit Mittal, Quantitative Research
 

This is our second post on Japan’s new economic project.

The newly appointed Bank of Japan (BOJ) Governor Haruhiko Kuroda shocked the market by announcing the “massive” monetary easing at his first policy meeting on April 4, 2013. Consensus expectations before the BOJ policy meet was that Kuroda would under deliver, demonstrated by the appreciation of the Japanese yen before the announcement. However, Kuroda over delivered, announcing a new policy package, including the following:

  • Doubling the monetary base in two years (also changing operating target from call rate to monetary base1)
  • Increasing the average maturity of the BOJ’s Japanese Government Bond (JGB) holdings and extending the maturity of bonds, eligible for purchase, from 3 years to 40 years
  • Increasing the purchase of risky assets (ETFs & REITs)
  • Continuing easing until a 2% inflation target is achieved

Following the announcement, the yen lost more than 5% of its value in just two days.

A return to monetary aggregates and Bernanke’s prescience
The BOJ has somewhat turned back the clock by abandoning interest rate in favor of monetary base as its operating target. None of the central banks of major advanced economies has used monetary aggregates as policy tools since the 1980s. Another interesting aspect of the BOJ’s new measures is their similarity to Ben Bernanke’s suggestion in a famous speech delivered in 1999. His suggestions—higher inflation target, weaker yen, significant increase in money supply and JGB purchases—are now part of Japan’s new economic policy.

Monetary stimulus in major economies since crisis
What has caught the imagination of the market is the BOJ’s commitment to double the monetary base in two years. Surprisingly, this is not very different from what central banks in the United States, the United Kingdom, and the eurozone have done since the 2008 financial crisis. The balance sheets (close proxy for monetary base) of the Bank of England, the Federal Reserve and European Central Bank are now about 5.1, 3.7, and 2.3 times their pre-crisis levels, respectively. The BOJ’s new policy, along with other relatively small bouts of QE undertaken since 2008, will bring its balance sheet to 2.5 times the pre-crisis level. Based on this matrix, the BOJ’s policy is hardly earth shattering. As a percentage of the GDP, however, the BOJ’s actions seem more audacious. While the balance sheet of central banks in the United States, the United Kingdom, and the eurozone stand between 20% and 28% of the GDP, the same figure will rise to about 58% for Japan (from the current 35%) by the end of 2014. The discrepancy arises because the BOJ’s balance sheet still carries the asset accumulated during the unsuccessful policy interventions from the late 1990s to 2006. To highlight the scale of the current policy again, the BOJ will likely purchase assets worth ¥60–70 trillion ($70–$80 billion) per month in 2013, not much less than the U.S. Fed purchase of $85 billion per month at present, in an economy that is one-third of the U.S. economy.

Sources: Bloomberg, IMF

The repercussions of such easing in the United States, the United Kingdom, and the eurozone have not been very dramatic. While their currencies have depreciated, they haven’t exactly fallen off the cliff. Inflation too, barring the United Kingdom, has been below the target in these economies for most of this period. Inflation in the United Kingdom (2–5% since the crisis) has been higher on account of higher VAT and energy prices. This has primarily happened because demand continues to be weak and inflationary expectations are well anchored due to the credibility of central banks in these economies. This experience, combined with the deeply entrenched deflationary expectations in Japan, suggests that the new policy package is not a recipe for hyperinflation or large scale currency debasement, as suggested by a few commentators.

Monetary transmission in Japan – historically
The increasing supply of money cannot create inflation on its own, unless there is a demand for those funds. Deleveraging and risk aversion have ensured that the channels of monetary transmission remain clogged. Balance sheet recession from the 1990s to the early 2000s has sapped any appetite to borrow from the Japanese households and businesses. Deflationary expectations ensure that money is hoarded rather than spent. Thus, broad money2 has not grown despite the rapid expansion of monetary base. This is important, because the prices will rise only when base money circulates in the economy and becomes broad money. The evidence on these relationships over the last three decades (1981–2012) in Japan is presented below.

Source: Bloomberg

As we can see, there is no observable relationship between base money and inflation in Japan over the last three decades, even after we account for a one year lag for transmission. We do, however, find a positive association between broad money and inflation. Finally, we can see that there is no apparent relationship between base money and monetary base. Therefore, unless monetary transmission starts working again, inflation is unlikely to respond to the monetary base expansion.

Monetary transmission in Japan – today
This puts the BOJ’s actions in context. The BOJ’s ‘shock and awe’ policy aims “to drastically change expectations of markets and economic entities” conditioned by years of deflation. However, the economy will need to deliver rather quickly over the next one or two years in terms of positive inflation and better growth for expectations to be sustainably changed. Otherwise, the ‘shock and awe’ too will fizzle out, once people do not see any impact on the ground.

Apart from a weak yen and rising market expectations of inflation, exports, consumer sentiment, and domestic lending look slightly positive this year, perhaps showing early signs of the new policies making an impact. Moreover, there have also been some reports of wage increases. On the other hand, an air of pessimism, fed by two decades of deflation and balance sheet corrections, seems to hang over businesses. This is reflected in low credit offtake and a preference for overseas expansion rather than domestic, despite a weaker yen. The sentiment was reinforced days before the BOJ’s announcement of the new policy, when Shinzo Abe admitted, quite uncharacteristically, that the inflation target may not be met in the next two years.

There is concern that monetary transmission may work only via a weaker exchange rate, while private domestic borrowing remains sluggish. This would create a divide between the tradable sectors and the rest of the economy and is, therefore, unlikely to lead to broad-based growth and inflation. Moreover, reliance on a weaker currency to boost exports will limit incentives for innovation, diminishing the long-term prospects of the export sector. The fate of former market leaders such as Sony is illustrative. Therefore, if sluggishness continues in the private sector and monetary transmission via commercial banks does not work, deficit spending by the government would only be able to raise broad money and therefore, increase growth and inflation.

Fiscal vulnerability
This puts Japan’s precarious public finance situation in the spotlight. The BOJ-engineered higher inflationary expectations can potentially raise JGB yields, limiting fiscal space. While both the United States and the United Kingdom have been able to keep yields low, and, at the same time, keep the inflationary expectations significantly positive, recent volatility in JGB is a cause of concern. George Soros recently lamented that the current policy would have been great if it was implemented 15 years ago, when the public debt figure was not so high. While the taboo associated with downgrades has certainly reduced, S&P’s recent downgrade warning reflects the risks associated with the Japanese economic project. If the volatility gives way to higher yields, it would not only signal a failure of the BOJ policy, but would also endanger Japan’s fiscal stability. It would also be catastrophic for large holders of government bonds like banks, insurers and pension funds. Recent anecdotal evidence suggests that Japanese investors are looking to move out of JGBs to the United States, or the Antipodes, or eurozone sovereign debt to escape near-zero yields. JGBs attractiveness to foreign buyers has also diminished due to a depreciating yen. Therefore, it is very important to keep an eye on the performance of JGBs, lest the mother of all monetary stimuli gives way to the mother of all fiscal crises.

__________________________

1Monetary Base/Base Money (M0): This is the currency supplied by the Bank of Japan. It is defined as Monetary Base = Bank notes in circulation + Coins in circulation + Current account balances in the Bank of Japan.

2Broad Money (M3): This includes currency in circulation, deposit money, quasi-money, and certificate of deposits (CDs) issued by depository institutions. It represents the broadly defined liquidity in the Japanese economy.

——————————————————————————————————

This is our second post on Japan’s new economic project and a lot has changed since our first post at the beginning of this year. The international community has largely countenanced the yen’s depreciation; self-imposed restrictions (banknote principle and maturity) have been done away with; institutional reluctance seems to have been overcome; and unlike previous instances, the markets, not BOJ interventions, have driven the depreciation. These developments could now see the yen stabilize at a lower than anticipated level.

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Five Game-changing Factors of the Palm Oil Industry in 2013

Posted on April 24, 2013

Palm oil, the most popular vegetable oil globally, is used in a wide range of food (such as margarine and ice cream), non-food products (such as shampoos, soaps, and cosmetics), and biofuel production.

In late 2012, palm oil prices slumped following a bumper crop in major producing regions—Malaysia and Indonesia. However, prices revived at the beginning of Q2 2013 as production in Indonesia and Malaysia entered a low output cycle.

In April 2013, palm oil prices increased to $750–770 per MT in these regions, reviving from its biggest slump of about $670–680 per MT in November 2012. Prices are likely to remain high at $755–820 per MT until April end; however, elections in Malaysia and increase in soybean export from South America are anticipated to reduce prices to $720 per MT after April. Prices are expected to further decline after August and futures are likely to drop below $656 per MT once the low output cycle is over.

Source: Bloomberg

Production is, however, likely to remain strong between 2013 and 2015 with output expected to reach 18.9 million MT and 30 million MT in Malaysia and Indonesia, respectively, in 2013. As of Q2 2013, production is slightly outpacing demand by 1–2%, and, therefore, stock inventory is expected to remain high at about 2 million MT in 2013, impacting prices negatively. CPO production is set to register a strong growth of 8–10% in 2013, taking the world output to 57–58 million MT with Indonesia (30 million MT) and Malaysia (18.9 million MT) accounting for about 85% of the total production in 2013.

As a result, five underlying factors that are likely to impact palm oil prices in 2013 have been assessed below:

1.) Elections in Malaysia: Palm oil prices are expected to be volatile during the upcoming elections in Malaysia. In April 2013, palm oil stocks in Malaysia dropped the lowest over eight weeks and Malaysian Ringgit began to slide after Prime Minister Najib Razak dissolved the parliament. With elections in June 2013 and speculation over the ruling coalition losing support and derailing reforms, contract prices for June have already dropped to about $761 per MT.

“With the elections approaching, investors may avoid holding Ringgit-denominated assets on fear of political risks. Production is picking up in Malaysia but gaining exports may cushion prices.” – Chung Yang Ker, Analyst, Phillip Futures Pte. (April 2013)

2.) Bumper harvest of soybean in South America: Prices of soybean oil, an alternative to palm oil, are expected to decline as bumper harvests are expected in South American countries—Brazil, and Argentina. According to the USDA, a record 83.5 million MT and 53 million MT of soybean crops are likely to be harvested in Brazil and Argentina, respectively, in 2013. This is expected to put further pressure on the already dwindling palm oil prices.

“Bumper soybean crop from South America is expected to pressure soybean oil prices and indirectly, CPO prices as well. In addition, the high palm oil inventory globally should cap CPO prices on the upside to below $920 per MT in the near term.” – Lim Cheong Sun, Analyst, Kenanga Research (March 2013)

3.) European debt crisis: According to the median of analysts’ forecast compiled by Bloomberg, the economy of Europe, the third-largest buyer of palm oil after India and China, is expected to contract for a second consecutive year in 2013 owing to the debt crisis. According to the Societe Generale de Surveillance, shipments to EU countries by Malaysia dipped 18% M-o-M in March to 155,870 MT, while the total exports fell 7% to 1.1 million MT. Declining demand from Europe is likely to inhibit the rise in palm oil prices in the near future.

4.) China’s slowing economy: In 2012, China’s largest cities, including Beijing and Shanghai, tightened rules on home purchases after the center asked local governments to pacify the property market. Restrictions on property and investments in China are expected to slow the economy and decrease the demand for palm oil. Inventories in China, which were at a record level at the beginning of March, fell 60,000 MT to 1.19 million MT toward the end of the month due to a decline in imports.

 “European debt crisis and China’s economy will remain the key to palm oil price outlook. There are concerns that property and investment curbs in China might slow the economy more than necessary and dampen the demand outlook for palm oil.” – A report by Phillip Futures Pte (April 2013)

5.) Decline in global biodiesel demand: The demand for palm oil in the biodiesel sector is experiencing a structural slowdown driven by the lack of new mandates and increased constraints of substitution with CPO. Experts state that CPO is nearing demand saturation in the biodiesel sector. The global biodiesel demand is projected to rise by a mere 1 million MT during 2012–2013, down from 2–4 MT in recent years. License and quotas as well as threat of anti-dumping duties are also likely to impede growth in 2013. Further, at least 1 million MT of used cooking oil is reused as a raw material for biodiesel, which reduces the demand for palm oil.

“The booming United States mineral oil production will have a direct impact on the palm-based biodiesel initiatives led by the respective governments. Last year alone, the world demand for biodiesel had shrunk by 2 million MT. At the same time, many Western countries are starting to cut back on their biofuel subsidies and targets. Some European nations are already backtracking on their biodiesel mandates, while in the US there is an issue over the withdrawal of the Blenders Credit at $1 per gallon.” – Dorab Mistry, Director of Godrej International Ltd (March 2013)

The palm oil industry is going through a period of transition. Palm oil prices are expected to be volatile in H2 2013 and this entails an interesting period for buyers to observe the probable changes in the market.

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Iron Ore – Prices Losing the Sheen of Yore

Posted on April 18, 2013

Iron ore, the second most traded commodity in the market after crude oil, is the primary source of iron for the world’s iron and steel industries. Between June and September 2012, spot prices for iron ore declined from around $140/MT to about $99/MT—a three-year low. These price fluctuations in a span of few months have compelled downstream industries to contemplate the consequences of these variations on their bottom line.

A volatile future

Barring September 2012, iron ore prices have remained above $100/MT since December 2009, driven by sustained demand from China. In February 2011, the prices hit an all-time high of $187/MT, after which the prices started easing out.

In 2012, iron ore prices recorded a downward trend, reaching nadir at $99/MT in September. The declining prices were in consonance with China’s economic condition, which grew at a lesser rate in 2012, vis-à-vis 2011. Further, supply from the leading producers grew 7.4% in H1 2012, compared with H1 2011, which also exacerbated the supply-demand situation.

Analysts predict that iron ore prices will decline between 2013 and 2015, driven by a situation of excess supply and an expected slowdown in steel output in China. Goldman Sachs has lowered the price forecast for iron ore to $139, $115, and $80/MT for 2013, 2014, and 2015, respectively.

As The Economist says, “The heady days of sky-high rewards for moving earth around the planet could well be at an end, but an era of volatile prices beckons.”

Source: Bloomberg

Market forces and speculation driving the prices

Iron ore prices are not only driven by the market forces of demand and supply but also, increasingly, speculative activity from market participants.

Huge demand from China and other developing countries

The demand for iron ore is primarily driven by steel manufacturers. An insignificant volume is also used in other applications such as cosmetics, paints, inks, and dyes. Over the recent past, iron ore demand has been influenced by the following factors:

  • China investing heavily in developing infrastructure and steel industries: Over the last decade, the Chinese government made massive investments in developing the country’s infrastructure and it is continuing to make significant investments. Currently, huge investments (about $270 billion) in building about 20,000 kilometers of rail network between 2013 and 2015 will provide a momentum to steel consumption and consequently boost the demand for iron ore in the country.
  • Demand from India and Brazil: It is estimated that between 2012 and 2017, India will seek to invest $1 trillion to develop its infrastructure. Further, the upcoming sporting events in Brazil—Football World Cup (2014) and Olympics (2016)—will help upgrade the country’s infrastructure and consequently drive the demand for iron ore.

Indian ban on iron ore exports coupled with a switchover to quarterly contracts will affect supply immensely

Between 2013 and 2014, iron ore is likely to face supply bottlenecks. The following factors are expected to have an impact on short-term iron ore prices:

  • Restricted iron ore supply from India: In a bid to curb illegal mining, India’s apex court—the Supreme Court—halted the mining of iron ore in the mineral-rich states of Goa and Karnataka. This ban has dented India’s image in the global arena as a credible supplier. Further, to protect the domestic steel industry, the Indian government has imposed a higher export duty of 30% on all grades of ores and increased the freight charges on export-destined iron ore.
  • Change in contract terms: Over the recent past, the iron ore industry has replaced annual contracts, which were in practice for decades, with quarterly contracts. In 2007, BHP Billiton, an Australian mining giant, became the first company to insist on short-term quarterly contracts benchmarked against movements in the spot market. This was necessitated because annual contracts made iron ore prices predictable for buyers.

Impact of speculation

Iron ore spot prices have been increasingly influenced by the speculators and derivative markets that are burgeoning around it, such as swap contracts or steel futures. For instance, some of these derivatives rose dramatically in the first two months of 2013 on the assumption that China’s recovery would occur more broadly and the demand for iron ore would again exert pressure on supply. Also, speculation in end-use sectors, such as tighter control over the domestic property market, also adds to the volatility in commodity price.

Industry participants facing the brunt

The medium-term (between 2013 and 2015) outlook for iron ore producers appears to be bleak and prices are likely to decline progressively on account of developments in the Chinese real estate sector. Tightening government controls over the real estate sector are likely to dampen the uptake of steel, which will have a ripple effect on iron ore prices. Additionally, quarterly price mechanism and linkage to spot-market prices imply that price volatility will become a characteristic of this market.

European countries are heavily dependent on iron ore imports for steel production, which is why steel prices in Europe move in tandem with global iron ore prices. This implies that the costs of automobiles, heavy machinery, and electronics manufactured in Europe are exposed to the effects of volatile iron ore prices.

The US would be relatively less affected to varying iron ore prices, as iron ore is used as a feedstock in only about 38% of the total steel produced in the country.

Given the prevalent volatile and uncertain global economic environment, iron ore consumers can look to:

  • Keep a close eye on steel derivatives—its movement will serve as an indicator for iron ore price fluctuations; track the various developments happening within the steel industry
  • Evaluate long-term strategies involving forming a strategic partnership with suppliers and, if feasible, backward integration (obtaining a stake in iron ore mines)
  • Study cost-benefit assessment involved in short versus long-term contracts

More insights about the steel industry and its association with the iron ore industry can be accessed here (Changing Dynamics in the Global Steel Industry).

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Regression: The Backbone of Econometrics

Posted on April 16, 2013

In the current business environment, decision-making relies more than ever on data analytics. Although this is typical in the data analytics area, it is now more common across all business functions. A trader, for example, will want to develop a relation between oil prices and inflation, or perhaps with another instrument, to execute an informed trade.  Similarly, a manufacturing company will look to see how its inventory is linked to market sentiments, or consumption during a festive season.

All such relationships can be explained by regression analysis, a statistical-based method. Regression analysis is widely used in all major industries—from commodity trading firms and large investment banks to toy manufacturing companies and major corporations—to analyze relationships between price and demand/supply, or to establish macroeconomic relationships of the effect of foreign exchange on a country’s economic growth or a particular sector.

The question is how does regression analysis aid in decision making? The analysis involves creating a mathematical relationship based on historical data. This relation can be used for the following:

  1. Inference: To assess how a variable is affected by certain variables (or “drivers”) on which it is dependent(e.g., understanding how each dollar spent on advertising leads to sales of a particular product)
  2. Forecasting: To predict value(e.g., predict the housing prices based on the current economic trends)

Let’s look at the basics first, before delving into further details.

What is regression?

Regression is a statistical measure that attempts to determine the strength of the relationship between one variable (called dependent) and another single/group of variable(s) known as independent variable(s). More specifically, it helps one understand how the value of the dependent variable (referred to as Y) changes when independent variables (referred to as X) change.

Regression is a simple and easy-to-implement methodology and is accepted globally. It is widely used for forecasting and analyzing relationships between variables.

For example, regression analysis will be adopted if one wants to see how gold prices react to an increase or decrease in oil prices. Firstly, you would identify the dependent variable, which is gold price (y) in this case, and the independent variable, which is oil price (x1), and then collate data on a daily basis for a considerable period of time. On running a regression analysis on the data points, the following mathematical regression equation can be generated:

y=β1+β2X1+error term

In this case, we have also created a scatter plot, wherein the dependent variable oil is plotted on the X axis and the independent variable gold price is plotted on the Y axis. We obtain a constant (β1=692.99 and a coefficient (β2=7.281 as shown in Fig. 1. The coefficient (β2 explains that if oil prices increase by 1 unit, the gold price changes by β2 units. The figure also indicates the direction of movement of the dependent variable with respect to the independent variable. In this case, oil and gold prices move in the same direction as denoted by the positive sign of β2. The black line shows the best fit line between the oil and gold prices.

Once the relationship is established, you can forecast the dependent variable based on values of independent variables. What is interesting about regression analysis is that it provides forecasts with a specified confidence level and error expectation.

 Figure 1. Regression of Gold Prices on Oil Prices

Regression of Gold Prices on Oil Prices

Source: Bloomberg

One of the most popular parameters to analyze regression result is R-square, which identifies what proportion of variation in the dependent variable is explained by the independent variable(s). In simple words, it tells us the goodness of the fitted line. This R-square lies between 0% and 100%; the closer it is to 100%, the better is the fit.

Naive users beware! The seemingly simple technique that can even run on Microsoft Excel has more to it. For building a robust model, one needs to carry out certain checks.

Higher R-square is not the only thing

While a high R-square is a prerequisite to a good model, it should not be followed blindly. Decisions based solely on R-square tend to be biased. Hence, it is critical to check the logical sense of the independent variables (or drivers) chosen in the model.  For example, oil price cannot be predicted by bread prices or vice versa. Adding such variables could result in a high R-square for the model and such a relationship may not provide any meaningful information or estimates.

Further, we should test for variable significance using the t-statistics test (t-test), which will ascertain whether the individual independent variables have significant explanatory power in the regression model. It is also necessary to validate the basic assumptions of regression, such as autocorrelation[1], multicollinearity[2], and hetroskedasticity[3], while constructing the model.

Another critical issue is the under/over specification[4] of the model. The example of gold prices is underspecified. For simplicity, only one independent variable (oil prices) was used. However, an ideal model would contain all relevant variables, which could influence gold prices.

Regression, if used properly, can go a long way in aiding key decision making and forecasting. The above example, however, provides a rather simple picture. To carry out more complex analyses, one would be required to employ advanced techniques—co-integration, error correction models, panel data regression, etc.  With multiple forces at play in a given market, it is important to determine which technique is to be used before jumping into regression!

Despite all the challenges of a robust regression model, it is still the backbone of an econometric analysis, and it offers quick and easy interpretation.

To learn more,  email info@thesmartcube.com

 


[1] Autocorrelation tests are used to determine if serial correlation exists in error term series, which could lead to estimates that are no longer efficient and hence corrective measures need to be taken.

[2] Multicollinearity test is used to determine if there exist high linear relationships among the independent variables which could lead to wrong interpretation of results.

[3] Hetroskedasticity test is used to determine if variance of the error terms varies with time. which could lead to estimates that are no longer efficient and hence corrective measures need to be taken.

[4] It means one should correctly select an appropriate functional form of the model along with choosing all relevant variables that can affect the dependent variables in order to obtain a correct relationship with good predictive power, i.e., higher R-square.

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Is Social Class Segmentation the Perfect Score for Marketers?

Posted on April 11, 2013

According to a recent study carried out by BBC Lab UK in cooperation with, amongst others, Manchester University and the London School of Economics, the social class system in the UK has grown from three to seven. The traditional working middle and upper class are now defined as elite (6%), established middle class (25%), technical middle class (6%), new affluent workers (15%), traditional working class (14%), emergent service workers (19%) and precariat (15%). As a result of the analyzed personal surveys, which took each individual 25 minutes to complete, the researchers could determine a person’s social, cultural capital, and economic score.

This should come as fantastic news for businesses that are targeting the UK market. The value of such a personalized score is mouth-watering for any marketer, especially those in B2C. Knowing that an individual’s privacy is strongly enforced, this new research is of little value, but begs the following question:

What would happen if these kinds of scores could be determined on a much larger scale?

As Location-Based Marketing (LBM) and Big Data (see our previous blog) continue to have a dramatic impact on personalized product offers and messaging, the combination with an individuals social, cultural or economic lifestyle traits would be close to perfect (from a marketing perspective, of course).

Although it is prohibited to ask anyone to complete a similar survey for commercial purposes—and rightfully so—there are a number of other data sources available. For example, the kind of language that is used in social media can be linked to a group of individuals who occupy a similar position in a pre-defined economic system. Combine this with LBM, e-mail traffic, SMS, etc., and it becomes possible to fine-tune product offerings and messaging to a much higher degree—a degree that finds its roots in a subculture.

There are a number of examples of how a group of cultural equals found eachother on the Web and had a tremendous influence on governments and/or private organizations. What if it was the other way round?

The current often-mislabelled behavioral segmentation techniques based on purchase behavior will become just a single element in a much more detailed profile. Although a debate on the impact of culture on buying behavior could be long, and sometimes probably philosophical, individual targeting based on hard and soft data will give marketers plenty to do in the very near future.

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Diverging Trends – Risk Appetite and Commodity Markets

Posted on April 9, 2013
This is the seventh installment of The Smart Cube’s monthly Risk Appetite Index (TSC RAI) blog series.
 

A curious phenomenon is currently playing out in the global markets. Improving macroeconomic outlook and continuation of QE by the Fed ideally support assets across classes. This had indeed been the pattern since the onset of the financial crisis, which saw a significant increase in cross asset correlation. However, since late 2012, commodities have been diverging from the broader market trend, especially equities. As risk appetite has reached its post-Lehman high and S&P 500 is treading at all-time highs, commodities have been declining (see Figure 1). Current speculative positioning—as measured by CFTC net non-commercial futures positions—is net short for commodities, such as wheat and copper. Therefore, a turnaround is not being anticipated by hedge funds. What does this say about the current state of the economy? Some might argue that commodities are portraying a more accurate picture, as they represent a demand for real goods, unlike financial assets, such as equities. However, others might counter that the current risk rally is supported by improving growth prospects.

Figure 1

Source: Bloomberg

Impact of dollar

The decline in commodity prices has been pervasive, led by copper, wheat and corn, and to a lesser extent by crude oil. Since all commodity prices are quoted (or denominated) in terms of dollars, the recent strengthening of the dollar can be seen to be an important factor exerting downward pressure on prices. In Figure 2, we can see a high correlation between the inverted dollar index and the commodity index.

Figure 2

Source: Bloomberg

The strengthening of the dollar, however, is clearly not enough to explain the decline, as we also see a change in the shape of the term structure of these commodities in the forwards market. As is evident from Figure 3, both wheat and copper have moved from ‘backwardation’ six months ago to ‘contango’ at the present*, as a result of adverse fundamentals.

Figure 3

Source: Bloomberg

Fundamentals behind weakness

Recent news flow suggests that multiple factors have been at play in depressing commodity prices – increased supply (hence inventory build up), weaker demand and appreciation of the dollar. Global copper inventories are estimated to be at a nine-year high. On the demand side, excluding China’s copper consumption, global demand for copper actually contracted in 2012. The supply outlook of copper is considerably better for 2013; hence, weakness is likely to persist.

The US Department of Agriculture’s report on the build up of grain inventories and a better supply outlook has been behind the recent weakness in agriculture commodities such as wheat and corn. Crude has also been hit by demand substitution towards gas. As a result, natural gas has bucked the trend and the Henry Hub benchmark is up about 80% Y-o-Y. This shift towards gas has become more prominent due to the shale gas boom. All of these factors lend more credibility to commodity prices versus financial assets (such as equity), as unlike commodities, there are no physical demand and supply fundamentals in equities.

Economic prospects

What is important to look at is – what this divergence between equities and commodities says about the state of economy? Recent US economic data has been a mixed bag. Optimism borne out by the positive housing and consumer data has been tempered by weaker PMIs and employment, which, along with sequester, have led to lower Q2 growth expectations. Chinese data has also been uneven. Despite this, it is quite evident that the US economy is on a much stronger footing than it has been since the recession, which may justify the performance of equity markets. Also, events in Cyprus notwithstanding, the situation in the Eurozone, is far away from the dire prospects predicted during 2011–2012.

Commodities such as copper are seen as leading economic indicators due to their multiple uses in different industries, e.g., construction and electronics. However, the divergence between the broader market risk appetite and price trends of commodities is sending mixed signals about the state of the economy. So, do we have the spectre of another downturn looming large on the horizon or is copper in danger of losing its sheen as the bellwether of the global economy? Perhaps growth and employment numbers in the coming months will be able to answer this better.

*Technically contango (backwardation) refers to a situation where future prices are above (below) expected spot prices. However, in practice current spot prices are generally used instead of expected spot prices.

For more on TSC’s RAI performance and outlook, view our recent update.

_______________________________________________

More about TSC’s RAI 

For a methodology brief of TSC’s RAI, request our white paper.

Current values of TSC’s RAI will be available in future blog posts along with thought-provoking insights. If you would like to receive current values more  frequently or would like the historical series, email insights@thesmartcube.com or contact your local Smart Cube office.

Previous Posts

Sixth Installment – Credit Spurs Optimism After 2012

Fifth Installment – Laggards Take a Leap

Fourth Installment – Preparing for the Equity Turnaround

Third Installment – The Tale of Two Asset Classes: Equity and Fixed Income

Second Installment – Tactical Investing

First Installment – Introducing The Smart Cube RAI

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Location-Based Marketing and Big Data: Are Marketers Ready?

Posted on March 26, 2013

The rise of social media and the inclination to share one’s location provides a unique opportunity for marketers to drive brand engagement and consumption. In fact, the next few years might witness exponential growth in location-based marketing (LBM) and allied services.

The LBM ecosystem is expanding fast. According to Pyramid Research, global market revenue for mobile location-based services and location-enabled mobile apps should reach more than $10.3 billion by 2015. The Yankee Group anticipates 70 million mobile coupons worth $2.4 billion to be redeemed in 2013. More potential consumers “checking in” means more opportunity for consumers to “check out” when offers are presented at the right place and at the right time.

Some recent examples of LBM include brands such as American Express and Starbucks that recently began incorporating Facebook check-ins into their loyalty programs. In the UK, Nestle “hid” GPS trackers in some of its chocolate bar wrappers such as KitKat and Yorkie. A team tracked the users after they opened the wrapper and contacted them within 24 hours to deliver a cash prize.

Data from SMSs, emails, videos, social networking messages, image and graphics uploads, and cloud computing is inundating the web every minute. And all of this can be tracked right to the exact street from where it originated. Big Data analytics can help analyze data from social media to detect new market trends and change in demand, and send tailored recommendations to mobile devices at just the right time—when customers are at the right location to take advantage of offers.

Advertising rules may also witness a complete overhaul, with abundant data and tracking capabilities coming into the ecosystem. Digital and mobile advertising is easier to track; hence, we might experience a huge shift in how media plans take shape—integrating LBM to deliver maximum impact, aiding higher purchase conversion and brand engagement.

As other social networking sites launch ‘location-aware applications’, the adoption of LBM by marketers will no doubt continue to evolve. However, with so much data around consumer location and transaction behavior, brands will need to invest in analytical capabilities that provide actionable insight. It is now up to the marketers and their agencies to leverage this technology to create truly innovative marketing campaigns, with targeted messaging and personalized product offers.

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The Smart Cube Risk Appetite Index – Credit Spurs Optimism After 2012

Posted on March 20, 2013
This is the sixth installment of The Smart Cube’s monthly Risk Appetite Index (TSC RAI) blog series.
 
 

A few days back, news of George Soros reducing his stake in the biggest gold exchange-traded products[1] (ETP) by 55% in Q4 2012, was making the rounds. Bloomberg data confirmed that investors sold 106.2 tons of gold, valued at $5.4 billion, from ETP in February 2013. This is estimated to be the highest since the launch of gold ETF in 2003. All investment banks have already reduced their forecasts for gold for 2013–2014.

John Toohey, Vice President of Equity Investments at USAA Investments (a financial service provider), who manages more than $54 billion of assets, says, “There is a belief that the world economy is improving.” Investors have started shifting base from safe havens such as gold and DM sovereign debt to EM sovereign debt or equity. What would be interesting to see is that if there is any definite pattern that exists in this cross-asset spillover, i.e., movement/change in one asset leads to a move in one or more assets.

Testing for causality

To test this, TSC used an econometric technique—Granger Causality[2]. This test helps identify whether series X precedes series Y, Y precedes X, or if the movements are contemporaneous. It does not imply ‘true causality’, but identifies whether one variable precedes another.

To effectively understand the implications, TSC considered the period from 2004 to date and divided it into different periods—pre-crisis, crisis, and recovery phase. During the pre-crisis period (from June 2004 to September 2007), the economy witnessed a boom, with equity indices, commodities, EM currency, and fixed income markets recording new highs every day. The test results showed credit to be ‘Granger causing’ equity, commodity, currency and fixed income [3] (Fig-1).

During the crisis and up to July 2012, TSC did not find any causality in the markets, which could determine that a movement in one asset could cause movement in another. From August 2012, to date,  this period registered a return to the pre-crisis, cross-asset relationship, with Granger tests showing ‘credit’ to be leading the movements in the FX, equity, and fixed income markets (Fig-1).

Fig-1: Granger causality result

Results quite intuitive

Results of credit leading the herd fall in line with the conventional wisdom. These credit spreads represent the spread over some benchmark index (either treasury or others) and give a sense of the extra premium over the benchmark for the additional risk. Credit spreads widen during financial stress, but fall back at normal times. Since TSC’s RAI credit basket has both sovereign as well as corporate credit spreads, it is natural that any improvement in risk sentiment would lead to a reduction in the credit spread and a consequent pick up in further risk on activity.

From mid-2012, as fears of a breakup of the Eurozone abated, the markets started improving, with investors moving to emerging markets in search of better yields. Optimism of a recovery in the US economy over the last couple of months led to a further boost in confidence.  TSC’s RAI has been increasing ever since, having recently crossed the 1.5 level, suggesting a continued increase in investors’ risk appetite (Fig.2).

Fig-2: TSC RAI Vs TSC RAI Credit Basket[4]

Likewise credit spreads have lowered from the highs of June 2012 (as seen in Fig.2), boosting the confidence of corporate houses and private equity firms that have excess cash and that look for strategic buyouts within or outside their operating territories. Some of them are also looking to increase their global presence or diversify their businesses.

Big buyouts infuse confidence

A look at the M&A space shows deals increased in Q4 2012, over Q4 2011. This acceleration has infused optimism for the remaining part of 2013. This is backed by good economic news, particularly in the United States, where there is improved corporate confidence and a relatively healthy debt market. Some major deals in Q4 2012—Intercontinental Exchange Inc.’s $8.2-billion purchase of NYSE Euronext, Tokyo-based Softbank’s acquisition of a 70%-stake in Sprint for about $20 billion, Deutsche Telekom AG’s T-Mobile USA’s partnership with Metro PCS Communications Inc. for $29 billion—underline this optimism. Moreover, private equity firms will also be looking out for strategic acquisitions similar to the takeover of Dell Inc. by Silver Lake Partners and HJ Heinz’s buyout by Berkshire Hathaway and 3G Capital.

Lower credit spreads, better US economic data and increase in M&A activities should continue to provide impetus to the world economy going forward unless the EU puts a wrench in the works.

For more on TSC’s RAI performance and outlook, view our recent update.

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[1] An ETP is a derivatively priced security that trades intraday on a national stock exchange. ETP is benchmarked to indices, stocks, commodities, etc.

[2] Granger causality: if a signal X1 ”Granger-causes” (or “G-causes”) a signal X2, then the past values of X1 should contain information that helps predict X2 above and beyond the information contained in past values of X2 alone.

[3]For this analysis, TSC used data for different buckets–equity, credit, currency, commodity and fixed income from TSC’s RAI. For further details on these buckets, please refer to our white paper.

[4]TSC’s credit index is composed of JP EMBI+  Sovereign spreads, spread of AAA and BBB securities, spread of US Treasury and AAA securities, ITRAXX EU and CDX NA.

More about TSC’s RAI 

For a methodology brief of TSC’s RAI, request our white paper.

Current values of TSC’s RAI will be available in future blog posts along with thought-provoking insights. If you would like to receive current values more  frequently or would like the historical series, email insights@thesmartcube.com or contact your local Smart Cube office.

Previous Posts

Fifth Installment – Laggards Take a Leap

Fourth Installment – Preparing for the Equity Turnaround

Third Installment – The Tale of Two Asset Classes: Equity and Fixed Income

Second Installment – Tactical Investing

First Installment – Introducing The Smart Cube RAI

[4] TSC Credit index is composed of JP EMBI+  Sovereign Spreads, Spread of AAA and BBB securities, Spread of US Treasury and AAA securities, ITRAXX EU and CDX NA

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Is Plastic Electronics the Next Game Changer for the Consumer Electronics Industry?

Posted on March 10, 2013

The electronics industry has come a long way since the invention of transistors, semiconductors, and integrated circuits. Early inventions in the second-half of the 20th century revolutionized the manner in which electronic products were manufactured and paved the way for next-generation products, which were previously inconceivable.

The electronics industry is yet again at a technological tipping point. Advancements made in substances used in manufacturing electronic components are set to heavily influence the electronics industry. By all accounts, plastic (or organic) materials are likely to replace organic materials, such as silicon, in these components. The Smart Cube’s latest white paper looks at the recent developments in this arena and assesses the potential impact on the consumer electronics companies, end consumer and the overall supply chain.

What does this mean for the electronics industry?

Judging by the manner consumer electronics companies’ are focusing their energies on plastic electronics, it could well be argued that the industry is bracing for a massive technological shift in this decade. Although estimates for the market’s size differ, industry observers and companies operating in this segment agree that it is likely to grow exponentially over the next decade.

Large international players, such as Samsung, LG, Sony, and Philips, have started making inroads and have made large investments in research and development (R&D). This growth is expected to influence industry players in numerous ways—greater collaborations to gain a competitive advantage over bigger rivals, even greater spend on R&D, effective patent protection methodologies, enhanced government regulations, and innovative sourcing strategies.

What is in store for consumers?

Future advancements in this area may soon turn fiction into reality. Products once only seen in science fiction movies will eventually dominate the market. Owning flexible, mobile handsets will become a real possibility. Other benefits to consumers will include greater availability of low-power consuming devices and less expensive products with efficient lighting.

To read more on this topic, request our complementary white paper.

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Are Uranium Prices at a Critical Tipping Point?

Posted on March 7, 2013

Uranium, a radioactive material, is used as a fuel by nuclear power plant operators. It currently produces 18% of the world’s electricity. Known to be an efficient energy source (a kilogram of uranium produces 50,000 kwh of energy compared to 3 kwh produced by a kilogram of coal), and also a source of clean energy,  this share is expected to increase over the long term. In this blog post, TSC analyzes the price behavior of uranium and its likely impact on different stakeholders.

Price Trends

Uranium spot prices are likely to recover from a consecutive annual decline in 2013. The recovery is expected on the back of Japan’s plans to gradually restart its nuclear power plants (almost two years after the Fukushima disaster) and as China moves ahead with developing 29 nuclear plants by 2020.

Uranium spot prices recovered from its lowest level of $40.6 per pound since November 2010 (over the last two years) to reach $43.9 per pound on January 28, 2013. Earlier, uranium prices had significantly risen to as high as $73 per pound in 2011 from about $40 per pound in 2009 (post the global economic recession), driven by the rise in demand for nuclear energy.

Analysts predict that uranium spot prices are expected to continue rising in 2013. According to Bloomberg analysts, uranium spot prices are expected to reach an average of $55 per pound in 2013, while a J P Morgan analyst estimates uranium spot prices to reach an average of $70 and $85 per pound in 2013 and 2014, respectively.

 

What is driving uranium prices?

Prices in most industries are governed by market forces, and uranium is no exception. A complex interplay of various supply–demand factors influenced uranium prices in the recent past.

Demand drivers

The demand for uranium is primarily driven by nuclear power plant operators who use it as a key input to generate electricity. A small volume of uranium is also consumed by state-owned defense establishments that use it to develop nuclear weapons. Currently, uranium demand is positively influenced by the following factors:

  • Japan reevaluating its nuclear power strategy: After the twin disaster—earthquake and tsunami—that struck the Fukushima nuclear power plant in March 2011, the erstwhile Japanese government decided to phase out nuclear power by 2040. However, the recently elected Japanese Prime Minister, Shinzo Abe, has promised to rethink over the previous government’s decision. If the government opts in favor of nuclear power (after the reactors are reviewed for safety norms by the Nuclear Regulation Authority), uranium demand from Japan is expected to rise to pre-Fukushima levels of about 20 million pounds annually.
  • Nuclear power demand from developing nations: Developing countries such as China, India, and Russia are at the forefront of nuclear power adoption. Over the next two decades, the number of Chinese nuclear reactors could increase to 100 from 15 currently. Similarly, India is also making slow, but steady progress in increasing the share of nuclear energy in its overall energy mix. Currently, the country operates 20 nuclear reactors, while 7 are under construction. Russia operates 33 nuclear reactors and has 10 reactors in the construction stage. Globally, 65 nuclear power plants are under construction, another 160 new reactors are currently in the planning stage, and 340 more have been proposed.

These factors mentioned above, indicate a strong demand for uranium between 2013 and 2014, which is likely to drive prices upward.

Supply drivers

Between 2013 and 2014, uranium is likely to face a supply crunch, which is expected to further strain the supply–demand scenario. The following are expected to have an impact on short-term uranium prices:

  • Constrained production: According to the World Nuclear Association, in 2011, global consumption of uranium was 176.7 million pounds, while total production stood at 135 million pounds, which indicates a supply gap of about 40 million pounds. Further, uranium miners claim that the average production cost is about $85 per pound, while current spot prices are in the range of $42–45 per pound. This does not offer a strong incentive to miners to increase production. Hence, until uranium selling prices support production cost, supply of the commodity is likely to be under pressure.
  • End of the Megatons to Megawatts program: Under this program, in 1993, the United States and Russia decided to convert high-enriched uranium (HEU) from Russia’s dismantled nuclear weapons into low-enriched uranium (LEU). This led to an available capacity of 24 million tons of uranium for US-based utilities. However, the program is likely to end towards the end of 2013, which will lead to a steep decline in global uranium supply.

Impact on industry participants

The short-term outlook of both uranium and nuclear energy producers is likely to improve on the back of the expected revival of the Japanese nuclear plants and new demand from developing countries, such as China, India, and Russia. The re-election of the pro-nuclear Japanese government (that has promised to rethink over the previous government’s decision to phase out nuclear power by 2040), drove the shares of Japan’s Kansai Electric and Tokyo Electric by 18% and 33%, respectively, on December 17, 2012. Concurrently, a short-term spike in uranium spot prices between December 17 and 18, 2012, raised the shares of leading Australia-based uranium suppliers—Paladin Energy and Energy Resources of Australia—by 22% and 13%, respectively.

Positive outlook in the demand for uranium has led to the recent signing of several new supply contracts. In October 2012, Paladin Energy signed a long-term contract with France’s EDF Group to supply 13.7 million pounds of uranium from 2019 to 2024. In September 2012, Areva, a France-based uranium producer, signed a supply contract of about 66 million pounds of uranium 308 with the EDF Group for the next 60 years. In August 2012, six uranium producers, including Russia’s Tenex, Rio Tinto, France’s Areva, and US-based Uranium Energy Corporation, signed a $3 billion nuclear fuel supply contract with the UAE for four planned nuclear reactors in the country.

Additionally, Canada-based Cameco, the world’s third-largest uranium miner, announced plans to begin its Kintyre Uranium project in Australia’s Great Sandy Desert as soon as uranium spot prices reach $67 per pound.

Liquefied natural gas exporters, including Qatar and Australia, who had helped plug Japan’s power shortage since the Fukushima disaster in March 2011, were significantly hit due to the recovery in uranium demand.

Given the prevailing supply demand dynamics, what is the best course of action for Uranium buyers in 2013?

  • Should they focus on containing price rise impact in the short-term?
  • Should buyers wait till the prices stabilize? What would be that stable price?
  • What would be the ideal course of action for suppliers? What sort of contracts they should try to enter with buyers that would maximize their returns?
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The Digital Evolution Among the BRIC Countries

Posted on February 28, 2013

With surging broadband penetration and rising consumer demand for smartphones and tablets, the music industry stands at a critical crossroad—deal with declining physical format sales and different forms of online piracy.

The digital music industry includes Internet music downloads, online music streaming, and ringback tones, and is broadly segmented under two consumption models—access and ownership—depending on user preferences. Users can either download (ownership) or view/listen to songs through online streaming (access) on devices such as PCs, laptops, mobile phones, and tablets. With Internet traffic set to quadruple by 2015, digital music is becoming a key driver for global music sales. The global digital music industry was worth $5.23 billion in 2011, an 8% increase over 2010. Between 2012 and 2017, the market is expected to grow at a 15% CAGR to $22.5 billion. The increase in digital sales showcases a tectonic shift in the music industry, from physical platforms such as CDs to digital platforms such as the Internet.

The digital music industry in BRIC nations presents an interesting case in point, with three of these countries (India, China, and Brazil) registering an average YoY growth of 21%, way above the global average of 8%, in 2011. Notwithstanding rampant piracy and insufficient government regulations to check illegal downloading, these three countries experienced phenomenal growth in the digital music sales, owing to a rise in middle class population, ease of Internet access, affordability of digital devices, and the rise in popularity of foreign artists. Russia, on the other hand, happens to have the dubious distinction of being one of the nine countries globally to have recorded a contraction in its digital music market in 2011. This was due to an untamed, piracy-rife digital music marketplace and easy availability of free music on Russia’s version of Facebook, VKontakte.

Sources: Chinadaily; Paidcontent.org; The Brazil Business; The Economist; ZDNet; Internet World Stats

India

In 2011, India had the largest share (in terms of size) in the digital music pie among the BRIC countries. Valued at about $95 million, the Indian digital music market grew 22% YoY in 2011. Accounting for almost 58% of the overall Indian music industry’s revenue in 2011, digital music is emerging as a high-growth outfit in the country, affirmed by label companies such as Sony Music, which expects sales at a CAGR of 36% between 2011 and 2014.

Before 2012, pirate sites accounted for a staggering 97% of music downloads in the country. However, with anti-piracy regulations kicking in, the scenario is expected to improve. India also happens to be the fifth largest smartphone market in the world, with 44 million smartphone users as of Q4 2012. With the Internet penetration rate touted to increase at approximately 35% CAGR between 2011 and 2016, to 400 million active connections, India provides an exciting proposition for e-music stores and music labels.

China

China, albeit possessing a market size of $63 million, which is smaller than India, experienced the highest YoY growth among BRIC countries in 2011. With a growth of approximately 29% over 2010, the Chinese digital music market is driven by its large netizen population of more than 500 million (the largest in the world), with over 72% of these users using mobile devices for surfing.

However, the market is plagued by an extremely high music download piracy of approximately 99%. Music labels rely on an operating model that provides mobile network operators with content to develop subscription-based platforms, so that a portion of the fee income earned from end users is shared with the label. This is contrary to the model adopted by Internet companies who take advantage of weak copyright-protection laws in their respective countries and provide free music labels on their sites. However, with popular Web portals such as Baidu Music and QQ Music set to replace free downloads with monthly subscriptions, major Internet platforms in China are showcasing an act of solidarity against piracy, with a vision to eradicate illegal downloads in the country.

Digital content accounts for about 73% of the Chinese music industry’s sales, making it the largest contribution among the BRIC countries. Despite the prevalence of piracy, China is projected to account for the largest share in digital music retail sales among the BRIC countries, owing to its high net-using population and youth-driven demand for easily available digital music.

Brazil

Brazil, with a high Internet penetration of about 48%, offers an easier digital market for music companies due to a relatively lower piracy rate and high Internet usage. With a market size of about $30 million, digital music accounted for only 16% of the Brazilian music industry’s sales in 2011, suggesting high growth avenues for the segment in the future. According to Universal Music Group, mobiles account for 70% of the revenue, while online content contributes the remaining, suggesting that the market favors mobile-based platforms over the Internet for digital sales.

What does this mean for the global music industry?

Among the BRIC nations, China, given its high digital music sales growth and large netizen population, can compete with the current market leaders, such as the US, if suitable measures are undertaken to curb its high online piracy. It is common knowledge that the overall piracy in developed regions, such as the US and Western Europe, hovers between 20% and 35% (which is considerably lower than developing countries), as a result of relatively lower CD and DVD prices (physical format media) and stringent anti-piracy regulations. India, another high-growth market, in spite of its low Internet penetration, can leverage its huge market size to attract more players to invest in the digital music market. Brazil, with the lowest piracy rate among the four, is a relatively untapped market for investment, while Russia showcases unfavorable market conditions marked by high piracy and low music sales.

The global music industry is at a stage where digital evolution is an eventuality it will have to deal with. Finding a piracy-proof business model, optimizing online distribution platforms, and determining the best emerging market to tap into are some of the key questions that players need to ask themselves at this juncture.

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Stem Cell Research – Unleashed Potential for Pharmaceutical Companies

Posted on February 25, 2013

Despite scientists’ best efforts to utilize technologies to uncover treatments for life-threatening diseases, such as leukemia, heart diseases and neurogenerative disorders, cures have yet to be found. However, in recent years, stem cell research, where primitive cells can be developed into different varieties of desired functional cells, has evolved as a ray of hope. Upon being transplanted, stem cells—which can be derived from various sources, including bone marrow, peripheral blood, and umbilical-cord blood—have the capability of developing into different types of specialized cells and replacing damaged cells.

In October 2012, John Gordon (UK) and Shinya Yamanaka (Japan) received the Nobel Prize for their work on changing adult cells into stem cells that are capable of being transformed into the desired type of cell in the body. This recognition has led to increased global interest in stem cell technology and, in turn, opportunities for pharmaceutical companies.

Stem cell products poised for growth

The global market for stem cell products was $3.8 billion in 2011, which is expected to reach nearly $4.3 billion in 2012, and $6.6 billion by 2016.

Where is the growth coming from? The US has been a pioneer of stem cell research since the early 2000s. In 2004, the California Institute for Regenerative Medicine (CIRM)—the state stem cell agency—provided $3.0 billion in grants over 10 years, giving priority to human embryonic stem cell (hESC) research. Since April 2006, the agency has awarded 485 grants, valued at $1.3 billion, and as of February 2012, it has committed another $586.0 million, providing an impetus to stem cell research. Other countries also support and have made generous commitments to stem cell research. The ministry of health and welfare of South Korea plans to invest $29.0 million, focused on stem cell research; while European and Nordic countries encourage stem cell research institutions and companies. Favorable government regulations and an increase in investments have also triggered the growth of stem cell research in recent times.

With growth comes opportunity for pharmaceutical companies

Over the last five years, several academic institutions, research centers, and stem cell companies have started collaborating with biotechnology and pharmaceutical companies, commonly referred to an academia–commercial company partnership model. These partnerships have led to the emergence of new findings. As a result, major pharmaceutical companies have begun to enter into strategic partnerships with stem cell research-based companies to increase the pace of research for novel drug molecules. Together, these organizations are exploring ways to utilize stem cells in the drug discovery process. Companies, including Novartis, Pfizer, GlaxoSmithKline, Novo Nordisk, Teva Pharmaceuticals, and Roche are actively involved in such partnerships.

In most partnerships, the pharmaceutical company funds the research and benefits from its outcome. However, the trend in recent years has shifted from collaboration to acquisition as show in the table below.

 Key Deals in the Stem Cell Research Markets During 2007–2011

Source: American Association of Blood Banks (AABB), April 2012

Source: American Association of Blood Banks (AABB), April 2012

 Could stem cell research be the cure for the impending patent cliff?

Despite the increased focus and interest in stem cell research, it is still at a nascent stage. Further, substantial results are required over the long term to prove its efficacy and in turn attract investments. However, the potential of the technology is such that it could provide a sure-shot cure for diseases such as AIDS and cancer. These immense possibilities and profit-generating capabilities of stem cell research are factors that will continue to lure pharmaceutical and biotechnology companies toward this technology in the future.

The question then becomes, with an increasing number of patents going offline in 2013, will pharmaceutical companies turn their focus towards stem cell research?

 

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Currency Wars – A New Paradigm in the Global Economy

Posted on February 19, 2013

Recent efforts by the Japanese government to weaken the Yen, in order to revive the domestic economy have led authorities in South Korea, Russia, Norway, China, Chile, Australia, New Zealand, the United Kingdom, Sweden and some Eurozone countries to raise concerns over a global currency war, prompting a statement from the G7 and making it the main talking point at the recent G20 meeting. However, the G7 and G20 statements—by avoiding any criticism of the policy-engineered depreciation of JPY— have done little to assuage the fears of competitive devaluation. In fact, the JPY depreciated even further in response to the statements. Perhaps the only major implication of the G20 statement is that ‘talking down’ currencies or verbal intervention may become a taboo. On the whole, global policy coordination notwithstanding, a global currency war is well underway.

Currency War

The term ‘currency war’ was coined by the Brazilian Finance Minister, Guido Mantega, in 2010, as quantitative easing induced capital, flooded Brazil and caused its currency to sharply rise against the USD. With developed markets continuing to grapple with the near-zero interest rate and slow domestic demand, external devaluation appears to be an attractive growth avenue. Since it comes at the expense of the growth of other economies, such policies are labelled as ‘beggar thy neighbour’ policies. Over recent decades, China has been considered to be the most successful proponent of this type of strategy. Emerging markets (EM), especially those that rely on exports, have been historically reluctant to accept a nominal appreciation of their currencies, and are expected to counter any significant strengthening.

Source: Bloomberg

The depreciation of the JPY, though seen as a big positive for the Japanese economy (see Figure 1), has been especially problematic for South Korea and Taiwan, as they compete against Japanese products in international markets. This year, the KOSPI has fallen on account of worries over the impact an appreciating currency will have on the export sector. Expectations of retaliation from Korean and Taiwanese authorities have led to the depreciation of their respective currencies against the USD.  Korean authorities are planning to impose taxes to rein in capital inflows and expectations are rising that the Bank of Korea may intervene in the foreign exchange markets. China also seems to have taken the cue, with the People’s Bank of China recently setting the RMB at weaker levels  However, given the apparent desire to rebalance the Chinese economy away from exports, the RMB may not be allowed to fall drastically or even depreciate at all in the medium term.

Changing Policy Paradigm

In the widely accepted ‘Impossible Trinity’ of monetary policies, an economy can hope to have only two of the following three simultaneously:  independent monetary policy, fixed exchange rate, free capital flows. Over the last two decades, the favoured policy prescription has been—independent monetary policy and free capital flows; leaving the exchange rate to be determined by the markets. A prolonged worldwide currency war will change this, with countries looking to manage the exchange rate by direct intervention in the foreign exchange markets, or a looser monetary policy, or by restricting capital flows. IMF’s recent institutional acceptance of limited, conditional capital controls can be seen to be lending legitimacy to such policies.

Direct interventions, most likely unsterilized, could add to inflationary pressures on the already ‘stagflated’ economies (a topic we will cover in our forthcoming blogs) and also create grounds for asset bubbles. Inflation pass-through from a weaker currency would also be an important consequence to be considered.

Brazil has been active in imposing taxes on capital inflows and has also intervened in foreign exchange markets in an effort to manage its currency’s movement. The Brazilian government has tinkered with these taxes as its focus has oscillated between growth and inflation. In this sense, it exemplifies the dilemma that economies face, especially emerging ones, which experience high inflation and slowing growth, while participating in the currency war. This period has seen the BRL trade as high as 1.53 against the USD in 2011 and as low as 2.13 by the end of 2012.

Rising tolerance of looser monetary conditions and lower interest rates, aimed at weakening the currencies is also being observed. Despite still high inflationary expectations, the Turkish central bank recently slashed its overnight rates to restrict capital inflow and in turn prevent the appreciation of the TRY. In Sweden, though the deflation in recent months was reason enough, the central bank cited the strengthening of the SEK as “yet another reason” for a rate cut. Denmark has already experimented with negative interest rates to limit the appreciation of its currency vis-à-vis the EUR. As the currency wars continue, we may see more and more central banks giving higher weightage to currency movements in their rate setting considerations.

Consequences

Similar to Brazil, many emerging markets are likely to face the difficult choice between protecting growth and suppressing inflation or even between preserving the newly earned free market credentials and the stigma associated with managed exchange rates (admittedly diminishing recently). This would, however, increase policy uncertainty and lead to a rise in volatility, as the markets will hang on to every action by the authorities for guidance on the next move of the exchange rate. The recent spike in the volatility of KRW as uncertainty over policy action looms, is a typical case which could be experienced in other countries as the ‘war’ plays out.

A major consequence of the currency war would be the realignment of trade among countries, with those that are more successful at playing the game, gaining a bigger chunk of the global trade pie. Countries unable to participate, perhaps due to high foreign debt or reliance on imports for food/energy, will come out as poorer neighbours in the world of ‘beggar thy neighbour’ policies.

We have had two major worldwide currency wars—1930s and 1970s—until now. The 1930s war was characterised by protectionist trade barriers, which led to a significant decline in world trade, and is not a very relevant guide for the current currency wars. High inflation that followed the 1970s episode though, is an important consequence that needs to be monitored. This time around, the primary consequences could be the realignment of trade and therefore growth, higher volatility in the foreign exchange markets, rising inflation and the possibility of asset bubbles in emerging economies.

Trading Opportunity

A positive interest rate differential, along with the Balassa-Samuelson effect*, leads to a natural tendency for the currencies of growing emerging market countries appreciate, a ‘problem’ compounded by the currency war. Willing and able countries may be able to prevent such an appreciation and their currencies can be good short bets in a hypothetical exchange trade basket. On the other hand, currencies of unwilling or unable participants may turn out to be good long bets.

 *Rising productivity in an economy leads to an appreciation of its currency.

 

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The Smart Cube Risk Appetite Index – Laggards Take a Leap

Posted on February 12, 2013
This is the fifth installment of The Smart Cube’s monthly Risk Appetite Index (TSC RAI) blog series.
 
 

Something is stirring in the markets!  There are steady though cautious movements taking place. People have now started talking about the “great rotation”—moving from safe bonds, such as government bonds, to equity, which we had captured in one of our previous blogs. However, this time around, we would like to draw your attention to another space, i.e., currency.

Through TSC’s RAI, we have the benefit of looking at not only fixed income and equity, but also FX, commodities and volatility baskets, which makes up the complete RAI. Also, we had been wondering when currencies would pick up. Now, we see a very clear steep upward movement in the currency space, which so far had been lagging behind (refer to Figure 1). Fixed income and equity appear to have moved up the risk appetite curve quite early.

As is evident from the TSC RAI, risk appetite appears to be at one of its highest points. Thus far this year, the global economic outlook has improved. Furthermore, returns on bond markets look increasingly hard to sustain, since interest rates have fallen to historic lows in 2012. Similarly, safe haven currencies are also falling out of favor.

Figure 1 – Risk appetite surges powered by Currencies, Fixed Income and Equities

Currencies back in action

With low volumes, FX was not a very attractive asset class in 2012. However, it has seen resurgence in risk appetite (Figure 1), with the Currency RAI touching the zero (or neutral) level for the first time since 2010. Banks are now reporting record trades in FX.

The recovery in currency could mainly  be ributed to the increased risk appetite leading to rotation out of havens, which has led to the weakening of the CHF (Swiss franc) and the GBP, and perhaps a small bit of the AUD and CAD as well. The EUR has appreciated as the EU risk sentiments improve and as the ECB turns slightly hawkish. But, by far, the main contributor is the Japanese Yen. With the full backing of the Japanese government and the BOJ, the yen’s depreciation has become a one way game. This definitely will be a game changer in carry trades, of which, Japan has been the dominant funding currency for several years.

Carry trade

Carry trade is a strategy in which a trader borrows a low-yielding currency (e.g., Yen or even EUR in the past year) to invest in a higher-yielding currency (e.g., AUD and NZD) and benefit from the higher interest rates. For carry trades to be successful, currency markets need to be relatively stable, as any sharp swings could adversely impact investors.

The so-called yen carry trade was last in fashion during 2004–2008; however, the global financial crisis sent investors scurrying for safe-haven assets and appreciation in yen caused many a heartbreak.

The EUR and USD were also favored as funding currencies owing to the low interest rates last year, but as a result of the appreciating EUR, carry trades in the currency have again reversed.

Currently, volatility in Japan is quite high, but we believe that it will subside in the medium term. Thereafter, we expect carry trade to pick up and investors to start funding higher yielding assets, which might add to the depreciating pressure on Japanese currency

Currency risk outlook for the rest of the year

In the short term, we expect the overall risk appetite to remain at similar levels, as even though downside risks have been reduced by government activism, no substantial positive news exists on the horizon. We believe that a realignment of the risk appetite in equity and currency will be the dominant theme.

While risk appetite in currencies is mostly expected to be neutral, reemergence of Euro crisis may play spoilsport. Further, fear exists that Japan’s currency tactics might not work and the crowding could result in a sudden appreciation (Betting on Abe-nomics?) and volatility may continue to be higher. Additionally as governments take a stronger view on capital inflows and look to weaken their currencies to protect the economy, prospects of a currency war loom large. We plan to cover this topic in greater detail, in our future publications.

For more on TSC’s RAI performance and outlook, view our recent update.

TSC RAI

TSC RAI is an index developed by The Smart Cube to measure the risk appetite of the global financial system. TSC’s RAI is a basket of differently weighted inputs that are adjusted to regularly track the market. This can be used to aid investment decisionmaking, to generate trading signals, and for financial analytics.

RAI comprises six sub-indices of volatility, commodity, equity, fixed income, currency, and credit. Each sub-index represents the prevailing risk appetite in that asset class.

More about TSC’s RAI 

For a methodology brief of TSC RAI, request our white paper.

Current values of TSC’s RAI will be available in future blog posts along with thought-provoking insights. If you would like to receive current values more  frequently or would like the historical series, email insights@thesmartcube.com or contact your local Smart Cube office.

Previous Posts

Fourth Installment – Preparing for the Equity Turnaround

Third Installment – The Tale of Two Asset Classes: Equity and Fixed Income

Second Installment – Tactical Investing

First Installment – Introducing The Smart Cube RAI

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An Apple® Smart TV?

Posted on February 1, 2013

While the current wave of innovations in the smartphone and tablet market keep the market buzzing, many are wondering what’s next for the high-tech industry. One recent trend that many manufacturers and retailers are counting on is the smart TV—the technological convergence of television (TV) sets and computers. With rumors swirling of a possible Apple® smart TV, it will be interesting to see if the technology innovator will once again disrupt the technology ecosystem as it did with the iPod®, iPhone®, and iPad®—and give a push to a maturing market. It also will be interesting to see how TV manufacturers, media broadcasters, content providers, and telecom operators respond.

Looking at Apple’s past innovations, it might again set the market ablaze with a product that redefines the TV market and allows it to garner a large share of the smart TV market.

Current market scenario

DisplaySearch Quarterly, in Q1 2012, reported that approximately 27% of TV sets that shipped worldwide had Internet connectivity. Japan was the highest, with 46% of all sets having networking capability. Western Europe had 36%. Gartner reported that 69 million units were shipped in 2012. That number is expected to reach 198 million units by 2016. Furthermore, as much as 85% of all flat-panel TVs manufactured in 2016, will be smart TVs.

The flat TV market is primarily occupied by global players such as Samsung, LG Electronics, Sony, Panasonic, and Sharp. All these players offer a variety of TVs (including smart TVs), with low product differentiation.  They are expected to pose strong competition for Apple in terms of product offerings, pricing, and distribution.

In an attempt to gain the early mover advantage, Samsung has started showcasing products with voice and motion control. LG has forged alliances with players in the IT industry to work on a smart TV ecosystem. To reduce the risk of obsolescence, manufacturers are providing evolution kits (which address software and hardware updates) to ‘future proof’ their TVs.

Smart TV manufacturers believe that these new initiatives will incentivize consumers to replace their old TV sets and provide new  revenue streams beyond the product, by adding Internet-enabled, value-added services, such as music apps, social networking, news, and on-demand movies and TV shows.

Smart TV usage

A McKinsey study—conducted in France and the UK in 2012—showed that only 10% of households have a smart TV and only 3% of those households use the technology—despite an active push from manufacturers. Users and critics cite complexity, a confusing interface, and lack of premium content.

However, with the possible  launch of an Apple Smart TV, which would aim to address these issues and add greater value for consumers, it is expected that the market size will expand. As a result, the race to capture market share will also heat up. To adequately compete, manufacturers operating in this space must find ways to address current issues.

Likely impact of the Apple Smart TV: key considerations for other smart TV manufacturers

Attention to design and detail is something Apple is known for and a main reason the corporation has such a huge fan following. This could be a cue for manufacturers to partner with top-of-the-line design agencies or assemble their own teams as well as partner with software providers to match the highly capable iOS.

Manufacturers also will need to invest in R&D and strengthen their patents to avoid litigations and lawsuits currently gripping the smartphone and tablet industry.

Although Apple currently sells either directly or through its resellers, it will be interesting to see if it adopts a different approach when it comes to smart TV. Logistically, manufacturers should consider streamlining their operations and reaffirming relationships with distributors.

Lastly, pricing models and product positioning will be key factors that manufacturers will have to focus on in the near future.

How this could impact stakeholders

Broadcasters and Content Providers – Players in this space should strategize the best way to leverage this opportunity. Traditional broadcasters should follow the way Disney partnered with Apple when it launched video on iPod. Rather than resisting inevitable change, the entertainment enterprise embraced the opportunity.  Additionally, tailoring content to specific audiences through the tracking of Internet protocol id’s could help grow advertising revenue as well as help marketers better identify and market to specific audiences, thereby resulting in higher marketing ROI.

Unconventional Competitors – Microsoft Xbox, Netflix, Skype, and many others will also benefit from the many Internet-enabled, motion-controlled, value-added services, becoming available on TV screens around the world. This may trigger a “tech war,” putting some companies out of business and while others thrive.  These companies should start re-evaluating their value propositions and plan accordingly to stay competitive.

Consumers – Those who have been exposed to Apple’s earlier products have shown that existing theories of rational buying can be challenged and consumer behavior can radically change if there’s a revolutionary product in the market. The introduction of an Apple Smart TV will increase available options and competitors may be forced to reduce prices to attract consumers.

It is difficult to gauge what will eventually tip the scales and lead consumers to discard their old TV for a premium product with a larger life cycle. According to a survey of 1,568 US households conducted by AlphaWise and Morgan Stanley in 2012, consumers who already access the Internet on TV were willing to pay up to 20% more than their current TV for an Apple TV. However, before investing in design changes and prior to product pricing and distribution, manufacturers should analyze and understand consumer attitudes toward and usage of connected devices.

 While Apple keeps everyone guessing about the look of its Smart TV and its release, stakeholders should prepare to be part of the race. Identifying the right content partners, hardware and software vendors; investing in design capabilities; and understanding the consumer better will go a long way toward being a competitive player in this new market.

The Smart Cube blog is an independent publication and has not been authorized, sponsored, or otherwise approved by Apple Inc.
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Rising Prevalence of Diabetes in Emerging Countries: Implications for Pharmaceutical Companies

Posted on January 29, 2013

The increasing prevalence of lifestyle diseases, such as diabetes and cardiovascular disease (CVD), has been a cause of concern for emerging countries on account of a combination of genetic, social and economic factors. Diabetic patients have been consistently growing despite the attempts of respective governments to spread awareness and provide adequate treatment.

In November 2012, the International Diabetes Federation (IDF) published a report on diabetes prevalence in various countries. According to the report, countries from the developing world constitute 8 of the top 10 countries with the highest number of diabetics. Globally, the prevalence of diabetes has been increasing in epidemic proportions, with the most notable rise registered in densely populated countries. In 2012, China had the highest number of diabetic patients (92.3 million) followed by India (63.0 Million), Brazil (24.1 million) ranked fourth, and Mexico (13.4 million) was at the sixth position. By 2030, the diabetic population in India and China is expected to increase 63.5% and 44%, respectively.

Source: IDF (November 2012)

Key issues and challenges for pharmaceutical companies

The rising prevalence of diabetes has resulted in an increase in the demand for diabetes drugs and the entry of a number of pharmaceutical majors in these markets. Despite the increasing demand and huge business potential, companies have struggled to make profits in these markets.

The problem can be traced to the low affordability to health-care treatment in these countries. For example, the annual average spend on a diabetic patient in China is $194 per year, which is significantly less than the global average of approximately $1,274. Further, a lower per capita income in these countries has a direct bearing on affordability, which limits their expenditure on drugs.

These markets are also very price-sensitive due to high share of out-of-pocket payments in health care spending. With, Indian, Brazilian, and Chinese governments looking to impose strict pricing control on essential medicines, pricing strategies of pharmaceutical companies are likely to be impacted. As pharmaceutical companies do not have the liberty to sell their branded products at low prices due to high R&D costs, they are likely to shift their focus to generic products and curb their R&D expenses on diabetes care. This might impact the overall quality of health-care services and lead to reduced innovation in this disease segment.

Further, as rural population constitutes a major part of the total population in these developing countries, lack of product knowledge and low access to new drugs (specially related to insulin and diabetes type I) are other major constraints. This section of the population is not only largely unaware of new diabetes treatments and drugs, but live in areas where availing treatment and drugs is immensely difficult.

Other key challenges in these markets include—counterfeit drugs, extensive competition from domestic players and an intricate drug approval process.

What strategies can be adopted by pharmaceutical companies to overcome these challenges?

To seize the opportunities in the emerging countries, pharmaceutical companies must overcome the above mentioned hurdles, execute successful product launches and boost their revenue growth. Maintaining profitability will be a huge task for pharmaceutical companies in these low-margin markets, in the coming years. A few strategies that can be adopted by these companies include the introduction of innovative products, rapid penetration into vast rural markets, partnerships with health insurers to provide financing on diabetes care, and low-cost manufacturing.

In most developing countries, consumers’ insurance reimbursement schemes exclude high-cost drugs for chronic diseases. To overcome this challenge, pharmaceutical companies could consider partnering with insurers (to include branded chronic disease drugs in insurance terms) to increase and sustain margins. Recently, Roche, a global pharmaceutical major, partnered with Swiss Re (a re-insurance firm) to sell private insurance in China (that will supplement a patient’s existing insurance policy) to cover its expensive drugs under the reimbursement plan. The company is also in talks with leading health insurers of the country to provide this exclusive service to their existing customers. A positive outcome of this venture may result in other companies adopting the same approach.

Companies also need to develop and launch low-cost, innovative products in emerging countries. This will help them gain competitive advantage over other companies (who rely on traditional products). In October 2012, Sanofi launched a low-cost, reusable insulin pen called AllStar in India, priced at approximately $12, which is manufactured at a new facility in Gujarat, India. The product is almost 20% less expensive than the average cost of competitors’ products. The company also has plans to export this product in other geographies as well.

A product localization strategy through local partners should also be considered. Companies would need to understand the importance of local market knowledge, as it will allow them to customize the product according to demography and needs of local patients.

For example, in 2008, Novartis joined forces with a local partner, USV, to co-promote Galvus (non-insulin dependent diabetes drug) in India. Local branding of the product as ‘Jalra’ and the employment of a large sales force translated into a high market penetration in a very little time. Realizing the benefits, Merck also partnered with Sun Pharma to market its diabetes drugs ‘Januvia’, which was re-launched in India as ‘Istamet’. Later, inspired with its success, Merck adopted the same strategy in China and Brazil as well.

Development of sales and marketing infrastructure in rural areas is another essential element of pharmaceutical marketing strategies in emerging countries. Some companies have already started building their product counsellor and educator teams to create awareness about their products and different types of treatments for diabetes. In 2011, Eli Lilly announced plans to set up a team of about 70 diabetes educators to provide counselling services to patients and health-care providers in India. On the same lines, Novartis launched a campaign to raise awareness about the diabetes condition and its pharmaceutical offering in Brazil. The company provided comprehensive clinical data and product samples to key opinion leaders and physicians. It also invited medical professionals to attend the American Diabetes Association congress in the US, to learn more about treatment and establish close relations with them. This has resulted in a strong brand image for the company in the country.

Way forward

Companies need to identify and implement the right strategy mix of cost optimization and innovation to penetrate these markets to sustain and boost their top and bottom lines. Moreover, strategizing becomes more relevant now, as governments are increasingly becoming concerned about making cost-efficient, health-care services available to their citizens. In line with this, companies will need to explore viable options, such as low-cost manufacturing or outsourcing the sales functions while entering into these markets, to lower their op-ex and in turn their product cost.

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The ‘Mature Consumer’—How Can Brands Engage with Them?

Posted on January 24, 2013

In the coming years, the world is expected to witness a tectonic demographic shift. The number of people aged 60 and above is expected to reach two billion by 2047—a change that is likely to have a long-term impact on business-to-consumer organizations worldwide.

Most developed countries today are well into the third stage of demographic transition, characterized by low birth and death rates, and increased longevity aided by improved healthcare. Healthy people who are living longer want to live as well in their retirement years as they did during their working years. More importantly, they have the means to do so. For example, in October 2011, 23% of the Japanese population was in the senior citizen age bracket and accounted for 44% of the country’s consumption expenditure. This figure is growing not just in Japan, but also across Europe and North America among the baby boomer population.

Mature Consumer Buying Behaviors
This generation of consumers is quite different from the previous one, both in the social and the economic sense. As globalization makes the world a smaller place and as an increasing number of people move out of their hometowns in search of education or work, senior members are left alone at home. This geographical separation from family has made them more comfortable with the use of technology. To stay connected with families and find friends over the Internet, use of smartphones and tablet computers has become a common phenomenon, making online shopping a growing trend.

However, while online shopping is a convenient medium for people with mobility constraints, there are still a number of mature consumers who prefer to visit brick and mortar stores. They consider shopping a means of physical activity and an opportunity to socialize—a welcome break from their otherwise lonely lives. Yet, while many of them would prefer to shop for items at a brick and mortar store, the store outlay can be a constraining factor.

As an example, grocery stores, they feel, are designed for young consumers, with products placed on shelves that are either too high to reach or too low to bend. Also, the fine print on product packages makes it difficult for elders with weak eyesight to read the price or ingredients. Other problems they face are slippery floors, non-user friendly packaging, deep and heavy trolleys, long, narrow aisles with no resting places, and unfriendly staff.

Steps to Engage with the Mature Consumer
Businesses have realized that in the coming years, the mature consumer will account for a major chunk of the consumption pie. Following are some steps that companies can take to engage with them.

Design senior-friendly products and services
Hospitals and pharmacies, which are expected to have maximum engagement with mature consumers, can provide special services such as senior citizens discounts, home delivery of medicines, complimentary health checkups, and easy access to physiotherapy centers.

The banking industry can introduce ‘senior’ special services, such as easy insurance claims, and easy credit card and bill payments. Banks stand to benefit a lot, as if they manage to convince a customer to keep his funds with them, there is a high probability that the customer shall stick with them for the rest of his life.

Several mobile phone companies across North America, Europe, and Asia have already launched special ‘senior-friendly’ phones, with easy-to-use features, such as big buttons, pre-programmed numbers, and emergency call button.

Make shopping easier
A recent article on NPR’s website reported that several retailers had introduced magnifiers hanging by the shelves, allowing elders to read the fine print.  Making minor changes to the store format can also help brick and mortar stores attract and retain mature consumers, who are often more loyal than younger adults. Some retailers have carpeted their shop so that elders can walk comfortably, without the fear of slipping.

Following are some other measures that retailers can take:

  • Placing products at a convenient height (neither too high nor low)
  • Installing easy-to-open doors
  • Offering lightweight and easy-to-operate trolleys
  • Providing adequate seating facilities wherever feasible
  • Ensuring that store staff is sensitive to their needs

Design senior-friendly packaging
Irrespective of whether a customer shops online or otherwise, a major hurdle that most elderly people face is that of product packaging. For an elderly person, product packaging can be a significant determining factor in deciding his or her loyalty to a brand.

Considering that most elderly people live alone and will not always have younger hands around to open a tightly packed product, manufacturers need to design senior-friendly, and easy-to-open packaging.

Create targeted marketing and advertising
Many mature consumers believe that television commercials focus more on younger adults, making them feel unwanted. Companies on the other hand feel that airing senior-oriented advertising might dilute the brand’s image. However, in the future, this obsession with youth holds the potential risk of alienating a significant portion of their consumption base. Businesses and marketers need to align their marketing strategies and invest in building relationships with this segment.

Focusing on mature consumer should become an important corporate strategy. Generally, older adults rely on referrals and personal interaction, which can go a long way in determining their loyalty toward a particular brand. If targeted in the right manner, older consumers can become a loyal segment that meets or exceeds its younger counterparts.

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The Smart Cube Risk Appetite Index – Preparing for the Equity Turnaround

Posted on January 15, 2013
This is the fourth installment of The Smart Cube’s monthly Risk Appetite Index (TSC RAI) blog series.
 

2012 was the year of fixed income. Global bond fund sales were close to the €200 billion mark and the European bond fund managers had recorded their best year in the last decade. In fact, so dominant were the net sales of fixed income funds, that other investments were of no more than marginal interest (quote FT).

However, by the end of 2012, flows into fixed income started decreasing. December 2012, proved to be a good month, as many equity funds reached breakeven. We seem to be at a turning point (as discussed in our previous blog) that could pose well for equities in 2013.

 Investing in equities based on its risk perception

For fund managers who would want to make this transition through stock picking, tough times lie ahead. This is attributable to the fact that fundamentals are not the sole differentiators during periods of risk-on, risk-off, as market dynamics become totally altered. Further, the correlation among stocks have remained consistently elevated—partly due to the rise of global macro/relative value hedge funds and exacerbated by the growth of exchange-traded funds.

The effect of these technicals has given us a new dimension to identify risky stocks, apart from the traditional definition of cyclical and defensives. If we could hold equities on the basis of the market perception of risk associated with them, we could gain, as less-risky stocks would not be highly susceptible to large movements in market risk appetite. This will help investors to ride over the volatility of the uncertain times ahead.

A rather simple, yet effective way to measure market risk perception of a particular asset is by the correlation of its price movement to the changes in its corresponding TSC RAI(details at the end of the blog). That is, if an asset falls/rises in line with market risk sentiment, we believe that the market perceives the asset to be risky. The higher the correlation, the more the market perceives the asset to be risky.

Investment in equity on the basis of TSC’s RAI

To assess the viability of this idea, we tested it on the universe of stocks in the S&P 500 Index. Based on the correlation of each stock with the Equity RAI over the last three years, we divided the stock universe equally into two buckets—‘Risky Bucket’ (with high correlation) and ‘Safe Bucket’ (with less correlation). Equi-weighted (all stocks have equal weight) baskets of these two buckets were then constructed for analysis purposes. Every year these baskets were reconstructed on the basis of the correlation over the last three years.

Click to enlarge image

 As can be seen in the chart above, investing in equities with a low correlation to risk (‘Safe Bucket’) pays off well, which is evident even historically (except in 2003). The difference in portfolio returns shows the effectiveness of investment in the safe bucket. As per the above chart, the ‘Safe Bucket’ yield stands at 17.5%, while that of the ‘Risky Bucket’ stands at 7.5%—which is an overperformance of 10%.

Screening and allocation of portfolios

The example above demonstrates how investment in equities can be refined by looking at the correlation of the asset price and the market risk sentiment (TSC RAI). In the current state of the financial markets, looking at the correlation of assets with the TSC’s RAI can further aid fund managers in their investment decisions.

This type of screening can also be extended to other asset classes, such as FX and fxed income. In the current uncertain environment, it becomes even more important to consider the prevailing risk sentiment in the market.

For more on TSC’s RAI performance and outlook, view our recent update.

TSC RAI

TSC RAI is an index developed by The Smart Cube to measure the risk appetite of the global financial system. TSC’s RAI is a basket of differently weighted inputs that are adjusted to regularly track the market. This can be used to aid investment decisionmaking, to generate trading signals, and for financial analytics.

RAI comprises six sub-indices of volatility, commodity, equity, fixed income, currency, and credit. Each sub-index represents the prevailing risk appetite in that asset class.

More about TSC’s RAI 

For a methodology brief of TSC RAI, request our white paper.

Current values of TSC’s RAI will be available in future blog posts along with thought-provoking insights. If you would like to receive current values more  frequently or would like the historical series, email insights@thesmartcube.com or contact your local Smart Cube office.

Previous Posts

Third Installment – The Tale of Two Asset Classes: Equity and Fixed Income

Second Installment – Tactical Investing

First Installment – Introducing The Smart Cube RAI

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