Episode Transcript
The Finance Ghost: Welcome to episode 290 of Magic Markets. Today we are talking El Niño.
Moe will be talking about why a strengthening El Niño can matter for inflation and growth, as well as why the same event can be positive for some countries, regions and companies for that matter, and damaging for others.
And I'll be digging into some of the sectors that you might want to consider in this space and where some of the risks and maybe the opportunities lie as well.
So, welcome to Magic Markets.
Mohammed Nalla: Yeah, Ghost, I thought it was quite relevant to be jumping into a topic like El Niño.
Last week I was mentioning to you offline how we just suffered through a 1-in-100-year storm up here in Toronto. It was quite bad. We had downed power lines, we had floods in certain areas, massive disruption to travel.
I was concerned because it looked as though we were maybe going to get a tornado in areas close to me. And so, we had the family down in the basement over that time of the very intense storm activity. But thankfully, all okay.
And again, it's thus very relevant to look at weather because weather doesn't just impact our lives; it also impacts markets, it impacts inflation. And I'm going to look to unpack that.
So, let's jump right in because I think the key point for me is that El Niño is this global macro shock. It comes through every two-to-seven years, and it's a cycle. So, you get El Niño and then you get La Nina, which is effectively the opposite of that. But the important thing to discuss today is that it's not the same shock everywhere. There's a very different impact in different countries.
At the moment, very quickly, the current event of El Niño is strengthening. The weather services globally say that there's now a near 100% probability that it not just exists right now, but that it persists through to February next year and that it could also become one of the strongest El Niño events on record.
What is El Niño, if people are not familiar with this term? I think some of our listeners in South Africa might be familiar with that. But it's effectively unusual warm water in the central and eastern Pacific that then changes the atmospheric circulation. That's the textbook explanation out there. And the important impact for ordinary people like you and I is that it impacts rainfall, it impacts temperatures, and that then filters through into agriculture, markets, into energy. So, there are clear economic winners and losers. And I'm going to unpack that.
Firstly, maybe looking at who some of the losers are. And this is based on IMF research, it's not my own research, where they looked at El Niño events between 1979 and 2013. So these are historical estimates, but it's not really a reference point in terms of what's definitely going to happen in this season. It is, however, quite important to look at this.
And the first countries or regions that are more vulnerable would be in Asia Pacific, the clearest negative effects tend to come through in countries like Australia, India, Indonesia, New Zealand and then South Africa.
So starting off with Australia, El Niño means hotter, drier conditions and that hits their wheat output. It raises the risk of wildfires and significantly reduces agricultural exports. And in Australia, it roughly works out to around a 0.4 percentage point drag on their GDP growth, obviously with a knock-on impact through the agriculture value chain.
Indonesia, they are quite vulnerable. The drought there affects agriculture and the products would be palm oil, coffee, cocoa. But it also impacts them on the electricity side - they are quite reliant on hydropower. And the GDP impact there was negative 1 percentage point over 4 quarters.
Then moving on, we've got India. They tend to get a weaker monsoon and this effectively hits agriculture. But the bigger macro issue in India would be food inflation, because historically food has represented a very large portion of their CPI basket. Even a relatively modest crop disruption there can quickly become a central bank problem.
And now let's bring it back home to South Africa for our listeners because it is very important here. El Niño here typically creates a probability of a much drier summer rainfall season and that filters very directly into that agriculture value chain. Referencing the IMF research that I mentioned, it roughly equates to around a 0.7 percentage point drag on growth over the year from a typical shock. And the channels are effectively agriculture, food production, you get rural incomes and food inflation that start to come through. So in South Africa, I'd be watching rainfall very, very closely and how that filters through into dam levels, crop estimates as well.
Now, I mentioned there are winners and losers and mostly we've just discussed the losers. So let's go into the winners, because I sit up here in North America and in the Americas in general, north as well as south, it's a much more mixed impact that comes through.
The biggest beneficiary here on this side would be Argentina. El Niño effectively brings them more rain and that effectively boosts soybean and grain production. And the IMF estimate there is a 1.1 percentage point positive impact to their GDP. Argentina might be the wild card here, keep an eye on them.
The US is slightly more mixed. It brings wetter conditions to California and the south, warmer winters in the Northeast, fewer tornadoes, which certainly is good news for people like myself there. And on balance, it brings around a half a percentage point boost to US growth.
Canada, where I currently live, the impact is around 0.85 percentage points on the positive side. Mexico, even stronger, around 1.5 percentage points.
Europe, we haven't covered. And that's because there's much less of an impact coming through in Europe. So I think there it would really be through transmission, through trade. Does global inflation rise on the back of food inflation, does that filter through to Europe? Not too much to focus on there.
So if we wrap this up and we bring it back to the inflation story, because that's quite topical with what we've discussed recently on the show, it does vary quite a bit from country to country.
The IMF on a global level says that it adds around 0.1 percentage point to 1 percentage point to inflation, depending on where you are. I’ve mentioned how India is certainly a lot harder hit than other geographies, where South Africa, I would say, comes through around the middle to the upper end of that particular basket of countries that are vulnerable.
What does it mean from a macro perspective? What am I actually watching? Like I say, watch rainfall data, how that filters through into crop forecasts and estimates. What does that actually mean from an inflation perspective, given the fact that we currently have upside inflation risks coming through from energy and other geopolitical risks globally?
And then for South Africa, I mean, South Africa produces a lot of its own food, so maybe the food impact would be mitigated. But I still think there may be some sort of tail risk coming through on the inflation front there. That might just keep the central bank down there slightly more cautious.
Ghost, I'm very keen to hear what you can actually unpack in terms of those sector exposures and where investors can either manage risk or take opportunities.
The Finance Ghost: Yeah, so the point that I think has come through really well in your sections there, Moe, is that there are really mixed impacts from this thing. Some areas potentially win, others potentially lose. All of this is just weather forecasting at the end of the day, and no one is entirely sure how it might play out.
So It's something that could come, probably will come, but to what degree we don't know yet. You might see downstream benefits in unusual places, for example in food retailers. Grocery stores actually like it when there's a little bit of inflation because it helps them deal with their own inflationary pressures.
And we've seen this play out in South Africa recently with retailers like Shoprite, for example, keeping everyone honest and leading to a scenario where inefficient retailers really struggle because there hasn't been much food inflation recently due to what's happening in soft commodities and various other factors.
A little bit of inflation can actually help some of the weaker retailers survive, provided their volumes hold up. So that's an interesting point.
Another thing that's worth keeping in mind is that even in the Agri space – I'll get to that just now – you can have a scenario where some companies actually do really badly out of this, perhaps because volumes are down if there's drought conditions and farmers aren't planting as much. But conversely, you can have high-tech companies that actually do quite well if they're helping farmers maximise yield.
Obviously primary agriculture is front of mind here. And this sector is underrepresented in global capital markets, even though it has a huge bearing on economies.
Because farms are generally privately owned, farming operations don't necessarily scale very easily. There’s lots and lots of risk, especially at individual farm level - this makes it really hard to attract high valuations, just doesn't make them a great fit for public markets.
Now one of the exceptions, obviously not the only one, but one exception, is fishing. It's more commercialised, it's built around scalable concepts like the number of vessels, genuine moats like fishing quotas, for example. No one has a maize quota!
And these businesses tend to be vertically integrated. That creates a lot more value by controlling the value chain. You don't see that as much in land-based primary agriculture with its concept of a “farm gate” being the kind of handover in the chain.
So fishing is one area where we might see some action on markets. And the South African market has a few fishing names actually. Question is, is that part of the chain, or part of the market, more sheltered from the effects of an El Niño? So I went and dug through the history books a bit and the answer is that it's quite the opposite, actually.
We've seen some rather shocking stuff in history around fish populations collapsing as a result of these weather patterns, while other parts of the world can actually do better because the ocean is just such a complex ecosystem.
So that goes back to your point, Moe, about how the effect can vary so much across regions.
Another important point here is that a significant reduction in volumes of catch can affect the prices of things like fish meal, which in turn then affects the aquaculture market. So you have a crazy situation where a fish that you may not be able to catch as effectively in one part of the world completely changes the cost of raising fish in a controlled environment somewhere else in the world. So lots of layers of risks in these businesses.
Then if we head back to the land, there's a recent Reuters report that highlights companies talking about El Niño and how they tend to be quite regionally focused.
This makes sense obviously, because the weather is going to be regional.
So if you look at a market where there's lots of worries about what could happen from an Agri perspective, India is a name that does tend to come up quite a lot. And it's not just primary agriculture in that market, it's concepts like rural consumption as well. You've touched on some of these points.
So you can have a scenario where the financial sector may well be the highest exposure in the MSCI India Index, for example, but that doesn't actually tell you the full story about the downstream exposure of what could happen if the weather changes.
What would that mean for the credit books of these banks, for example?
And if you have a look at the Nifty50 index in India, which had a fantastic run from COVID until late 2024, it then stalled and it's been range bound for a couple of years. It got quite expensive. So personally, for me at least, between the effect of AI on services outsourcing plus all these Agri risks as well, India feels to me like a market where the risk-reward setup is maybe not great right now.
Mohammed Nalla: Yeah, Ghost. I mean, I just want to jump in here because it's very much shaping out to be a divergence between emerging markets and then developed markets up here in North America where arguably there could be some sectors that benefit.
I mean, if you look at US agriculture, we know there are certain structural issues at the moment. We know their beef prices have been rising. They're looking at importing beef. I would say maybe there are still some opportunities, but maybe on a macro expression it starts to look as though this trend tends to favor certain developed markets over a basket of emerging markets that seem to have a lot of underlying vulnerabilities.
The Finance Ghost: 100%, Moe, and that's a really good time then for me to maybe take us a bit further up the value chain to talk about the picks and shovels approach to the farming sector.
Perfect example here, chemicals and fertilisers. So if farmers are planting less in drought conditions, then that will affect overall volumes. But here's the really interesting thing - it can create pockets of growth for firms that have, for example, higher-tech seeds.
You've got a bunch of names in the US that you can look at. For example, this would include the likes of FMC, Corteva, Nutrien. And on a year-to-date basis, Corteva is up 31%, Nutrien up 29% and FMC down 6.5%.
The FMC drop is not because of El Niño, but rather because of issues specific to that firm. Corteva is more of a seeds business actually, with the market buying the technology story versus the more competitive chemical space that the likes of FMC is playing in. And then Nutrien, that's a potash and fertiliser company enjoying strong prices for its products at the moment.
Three names in the US, three completely different business models here and no one-size-fits-all answer. Because on top of the differences in business model, there's also the geographical exposure that varies in terms of US versus rest of world. Maybe a few names for us to dig into there in Magic Markets Premium.
One that we have looked at before is Deere and Co. - obviously the purveyors of fine tractors. The thing to understand here is that farmers can of course delay the purchases of new equipment, particularly in times of strife. So this will be less defensive than, for example, seeds and fertiliser.
But they've also been pushing into the underlying tech in their products and creating this recurring revenue model, almost a SaaS-style earnings profile, to actually create revenue off the existing fleet of vehicles out there. So for those who are Premium subs, go and check out our work on Deere and Co. if you want to understand that better, and that would certainly help in a downturn.
So I guess key takeouts from my side, Moe, as I bring my section to a close.
First point, no one really knows what could happen here. Lots of talk about El Niño, but no one knows.
Second point, the impact will likely be regional. Some areas will win, some will lose. Watch out for exposed emerging and especially frontier markets that are very, very dependent on agriculture. Lots of good examples of these in Africa. And you've got to really just be a little bit scared there because if El Niño does go against them, then that can get very ugly very quickly. Obviously more developed markets will be somewhat buffered.
Third point, risks and opportunities will emerge throughout value chains, not just in one layer.
And then my last point is that the companies supplying Agri markets are not blind to what's going on here. Obviously, if people like us have heard about El Niño, then Agri executives are all over this thing and they will have plans in the background, even if they're not talking about it publicly yet.
But I will say that it's probably not a great time going into next year to own weaker names in the Agri value chain, turnaround stories or inefficient businesses. When you see a crisis, if it turns into one, then you want to ideally own the stronger names.
And even better, in a perfect world, you want to wait until the stronger names suffer a correction due to negative sentiment and you can pick up great businesses at much more appealing prices.
Mohammed Nalla: One more additional macro point I'd like to maybe just land on is the fact that if this is something that is cyclical, that recurs every two to seven years, and if the frequency of the recurrence of El Niño is something that picks up, as per the experts out there in the field, then countries that are vulnerable, like South Africa from a macro perspective, should really look at how they deepen their value chains, how they mitigate some of these risks. And again, I think that is a much bigger question for policymakers to address.
Because if you start running into things like food security, which certainly isn't an issue down in South Africa, but might be in certain other countries, maybe even India, if you start running into food security issues, that becomes a much more important social aspect to address because it then introduces political uncertainty and that comes with a whole new stack of risks that you've got to layer on top of that emerging market versus developed market divide.
That's where we're going to leave the show this week. We hope you, as our listeners, have enjoyed this. Let us know what you thought of the show. Hit us up on social media. It's at @MagicMarketspod, one word, @Finance Ghost and @MohammedNalla, all on X. Or go find us on LinkedIn. Pop us a note on there. We hope you've enjoyed this. Until next week, same time, same place. Thanks and cheers.
The Finance Ghost: Ciao.
