Month: November 2021

A Tale of Two Decades For Emerging Markets

For investors in emerging markets, the past decade has been a mirror image of the previous one. The S&P500 treaded water between 2001-2010, at first held back by the hangover of the technology-media-telecom bubble and then crashing with the Great Financial Crisis. Emerging markets, on the other hand, benefited from the peak growth years of the Chinese economic miracle and the commodity super-cycle that it engendered, and sailed through the GFC thanks to the extraordinary stimulus measures adopted by China. Over the past ten years, the opposite has happened. Emerging markets have languished as the U.S. dollar went from weak to strong, commodity prices collapsed and the pace and quality of China’s growth worsened. U.S. stocks, on the other hand, were turbocharged by waves of Quantitative Easing, which channeled liquidity into financial assets,  deflationary forces and the remarkable maturation of America’s tech monoliths into cash-generating machines.

We can see this evolution clearly in the following chart, which includes the EAFE index (Europe, Asia, Far East developed markets) and the Dow Index, in addition to the FTSE EM Index and the S&P500. The EAFE index is the biggest loser over the combined period, as it was hit hard by the GFC and lagged in the recovery. These two periods can also be explained in terms of the performance of the dollar and the nature of the components of the different indices. Non-U.S. developed market currencies appreciated nearly 40% over the first period and lost 20% over the second period, while EM currencies appreciated by 33% and then fell by 30%.

In terms of index components, EM and EAFE (and the Dow) are weighted towards cyclical stocks (industry, commodities and banks) much more than the tech heavy S&P500. This means that, to a significant degree, the relative performance of these indices can be considered in terms of the  value-growth style factors. Traditional value stocks performed well in the first period and miserably in the second.

 

How can we explain the poor performance of cyclical stocks over the past decade?  Probably the answer lies in several coincident developments in the world economy that have resulted in excess capacity and low demand for commodities and industrial goods:

  • The great financialization of the global economy, which peaked with the Great Financial Crisis, has sapped investment and growth at a time when rich countries are ageing and losing dynamism. Debt-to-GDP ratios are at peak historical levels in most developed and EM countries with not much to show in terms of productive investments.
  • The end of China’s economic miracle. Since the GFC, China’s authorities have mainly concerned themselves, with little success, with correcting growing economic imbalances. Efforts to boost consumption and reduce dependence on non-productive investments have not been successful.
  • The 2001-2011 decade left many industries and commodity producers with excess capacity. The commodity super-cycle turned out to be much more of a bane then a boom for commodity dependent economies which subsequently have suffered from a heavy dose of “Dutch Disease.” (Brazil, South Africa, Chile, Indonesia)
  • Technological disruption is hitting many of the traditional cyclical industries (banking, autos).

The combination of these factors have led to a state of quasi-depression for most emerging markets over the past decade. We can see this in earnings growth over the two decades, as shown in the following charts.

The 2001-2011 decade was outstanding for corporate earnings, particularly for countries highly engaged in the China trade (Chile, South Africa, Indonesia, Korea). The U.S. lagged considerably, worse than appears on the chart because the base for the U.S. is the trough of the 2001 U.S. recession.

The chart for the 2011-2021 period paints a very different picture. The beneficiaries of the China trade of the previous decade all suffer deeply from a combination of “Dutch Disease,” terms-of-trade shocks and global excess capacity. Almost all the countries show low to negative earnings growth over the decade, the exceptions being the U.S. (strong dollar and tech stocks) and Taiwan (TSMC).

The past decade has seen a revival of “American exceptionalism,” premised on the relative strength of U.S. capitalism and economic dynamism compared to the rest of the world. The unique capacity of American venture capitalism, Washington’s pro-business and pro-Wall Street stance, the ocean of liquidity provided by the Federal Reserve and its perceived commitment to backstop equity markets, and corporate America’s keen focus on shareholder value have made America’s stock market the magnet for international capital looking for safety in a turbulent world.

Chile’s Constitutional Trap

Latin America’s persistent economic decline relative to other emerging markets over the past 40 years can largely be attributed to poor governance. The region has become the main example for the “Middle-Income Trap” which results when rent-seeking interest groups institutionalize policies that make reforms nearly impossible in the future. Typically, these policies are introduced at times when social turmoil leads to “regime changes,” often through constitutional reforms. Brazil went through this process in the 1980s. Chile is going through a similar experience today.

Over the past thirty years, Chile has been the only successful major economy in Latin America. Until recently,  it was considered a serious candidate to join the club of high income and developed economies. However, inconsistent economic policies over the past decade and an explosion of social turmoil in 2019 appear to have brought about a regime change, which would reverse most of the pro-investment policies introduced during the military regime by its free-market “Chicago Boys.” A Constitutional Convention, firmly dominated by progressive and parochial interests, is now in session to define the rules of this new regime.

The example of Brazil should make Chileans very nervous. Brazil’s military regime (1965-1985) collapsed during the Latin American debt crisis of the early 1980s, a period  of increased political and social protest. Amidst this popular demand for change, progressive politicians filled the political vacuum left by the military. A Constitutional Assembly dominated by progressives came up with the “People’s Constitution,” which, according to its President, Ulysses de Guimaraes, would protect Brazil’s “suffering poor, massacred, humiliated and abused throughout history.” The new Constitution was a full rejection of the Military Regime’s trickle-down, investment-led approach in favor of one focused on securing social rights and economic safety nets.  Important interest groups with political influence, particularly civil servants, captured for themselves juicy windfalls. (One lone dissident voice at the convention, Senator Roberto Campos, a leading figure in economic policy during the military regime, decried the new constitution as “a mix of panaceas and passions…a catalogue of utopias… a civic Carnival… a hodgepodge of pettiness, xenophobia, irrational economics, corporativism, pseudo-nationalism and other foul “isms.”)

Very soon following its approval in 1988, more sober economists and policy makers began arguing that the Constitution – particularly its extremely generous provisions for civil servants–would prove a fiscal straitjacket and a severe burden on public policy.  For the past thirty years, successive governments have sought, with little success, to reform the Constitution to allow more flexibility in fiscal spending

One of the first critics was Raul Velloso, an expert on public finances with a PhD from Yale University. From day one, Velloso warned that the fixed expenditures mandated by the  Constitution  would prove catastrophic for economic growth. This week Velloso published an article in the Estado de Sao Paulo newspaper (Link) summarizing the consequences  of Brazil’s “Citizens Constitution.”

Since 1988 fiscal expenditures in Brazil have become dominated by mandated disbursements for social welfare benefits and civil servant salaries and pensions. We can see this in the chart below, based on Velloso’s data. Government expenditures have become increasingly channeled into constitutionally mandated social spending and civil servant benefits, leaving  scarce resources for anything else. The biggest victim has been investments, which according to Velloso, fell from 16% of the budget to 3%. Public sector investments in infrastructure have fallen from 5.1% of GDP to 0.7% over this period.

The lessons of Brazil are clear. Idealistic social mandates written into Constitutions during times of social upheaval have predictably nefarious long-term consequences. Once granted, benefits are extremely difficult to withdraw. Economic growth and prosperity lose. For Chile, Brazil provides a roadmap for what to avoid.

Emerging Markets Should not be Complacent About Debt

The  monetary and fiscal policies pursued since the Great Financial Crisis and greatly expanded during the COVID pandemic have repressed interest rates and flooded the global economy with liquidity. Low interest rates have promoted debt accumulation and stimulated a global yield chase. This environment has supported the widespread complacency of policy makers and investors who assume that these conditions are here to stay.

The fundamental argument of those who argue that the current mix of policies is sustainable is that low nominal interest rates and negative real rates make the burden of debt low by historical standards. The data series published quarterly by the Bank for International Settlements (BIS) allow us to evaluate this claim. What the BIS data shows is that some important qualifications are in order. Though low debt servicing costs may persist in  the U.S., it seems stretched for many other countries to believe they will be so fortunate.

The chart below shows the latest  non-financial private sector debt service ratios for emerging markets as well as for several key developed markets. Private sector ratios are important as they are very sensitive to credit cycles and the private sector in all these countries is the driver of productivity and growth. The data for China may be less meaningful because of the dominant role of the state in the economy and the difficulty in distinguishing between public and private companies.

What we see is that these ratios vary tremendously across the world and within regions. The United States is in the middle of the pack, a comfortable position for the issuer of the global reserve currency and also the deepest market for “safe” assets. The countries on the left of the chart appear in good shape. On the other hand, on the right side of the chart there are obvious vulnerabilities. France is probably the weakest link among developed countries (twice the level of Germany though below Canada). In emerging markets, Brazil, Turkey and Korea are around the critical 20% level.

These debt service coverage ratios must be seen in the context of the recent wave of Central Bank tightening cycles that have been initiated  to confront rising inflation and capital flight. The chart below from Charlie Billelo details the recent wave of tightening measures. Both Brazil and South Korea are now in tightening mode but still have negative real central bank rates.

We should also be aware of the historical context. We can see the historical trends for each individual country in the three regional charts below. First, in Asia it is noteworthy that Korea may soon be back to the record-high debt service ratios experienced after the Asian financial crisis.

In EMEA (Europe, Middle East and Africa), the very high and persistently rising ratios of France and Turkey are noteworthy.

Finally, in the Americas the contrast is striking. Both the United States and Mexico have relatively low ratios which are very consistent over time. The U.S. is in a privileged situation as the recipient of global capital flight, and the Federal Reserve may be in a position to maintain negative real interest rates for the foreseeable future. Mexico’s private sector is underleveraged and poised to take advantage of growth opportunities. The situation is very different in Brazil.  Brazil has a history of high and volatile debt ratios. Corporate debt is at record-high levels at a time when the Central Bank may have to tighten sharply,  the economy is slowing to a crawl and capital flight is high.

The BIS data is a warning to not make global generalizations about debt sustainability. Arguments for Modern Monetary Theory, unrestrained fiscal expansion and financial repression may be justified for the U.S., but inapplicable for most countries.