Author: jvande

Which Emerging Markets are actually Emerging?

Why some countries prosper and others don’t is one of the most contentious debates that concerns economists, political scientists and policy makers. After W.W. II and during the Cold War wealthy countries embraced the notion that good institutions (rule of law, education, free markets) teamed up with technology and savings would allow poor countries (called “latecomers”) to catch up. These theories were famously promoted by economists like Walt Rostow and pursued through foreign aid and institutions like the World Bank. The results 50 years later are surprising. With a few exceptions — East Asia,  Singapore and, more recently, China and Eastern Europe — there has been very little catching up by the poor. Most gains have been achieved by the already relatively prosperous; for example, the country that has had the largest relative increase in per capita income has been Norway.

The data from the World Bank measuring per capita income relative to the United States, though not comprehensive,  is revealing: “catching up” is a reality for the few; most stagnate; and many actually lose ground.

Measuring GDP/capita of countries as a percentage of the GDP per capital of the United States for the past 50 years, what we discover from the data (which covers 78 countries over this time-frame)  is that the greatest gains were achieved by countries that had already secured relatively high income levels 50 years ago. In the chart below, which shows the countries that increased their ratio by more than 10%, we see Norway as the top gainer, increasing by 90 percentage points from 56.5% of the GDP/capita of the U.S. to 145.5% (145.5-56.5=90).  Singapore, Hong Kong, Korea and are the non-European highlights; all of these started from low levels of GDP/capita, particularly China and Korea. Korea, which now has reached the level of Spain, in 1967 had income per capita which was only 3% of the U.S. level, half of Brazil’s level and in line with the poorest African countries.  Uruguay, Trinidad and Tobago and Malaysia also appear with more moderate gains, just above 10%. (Note: the data is in current dollars, so currency movements impact the data)

 

The Biggest Gainers, 50 years

The vast majority of countries of interest to emerging market investors made very moderate gains over this period, in essence proving unable to make progress in bridging the gap with the U.S. The chart below shows those countries that have achieved between zero and ten percent gains in relative GDP/capita compared to the U.S. over the 50-year period. This includes the middle-income countries of Latin America, Turkey and Thailand, examples of economies that have fallen into the “middle income trap.” India, the Philippines and Nigeria are examples of lower income countries that have also made very little progress in bridging the income gap, despite enormous potential for productivity improvements.

The Stagnant Countries, 50 years

Perplexingly, it is the poorer countries that make the least progress, including many very low-income countries of Africa.  But this list of serious under-achievers also includes South Africa, Argentina, Zimbabwe and Venezuela, countries that are moving from middle-income status downwards.

 

The Losing Countries, 50 years

Taking a look over shorter periods, we can see some interesting trends developing. 30 Years coincides with the beginning of modernization reforms in China (1980) and in India  (1991),  the fall of the Berlin Wall (1989) and accelerated European integration. The chart below shows the past 30 years, including 123 countries.  Of note is the rise of Ireland (“the Celtic Tiger”), New Zealand , Australia and Israel, and the generalized strength of a European region benefitting from economic integration which drive improvements in incomes in Spain, Portugal and Turkey.  The absence of emerging market countries, except for the Asian Tigers and China, is striking, though the good performance of Uruguay (the “Switzerland of Latin America”) and reform-minded Chile are significant exceptions.

The Winners over the past 30 years

Looking at the past 15 years, we see very interesting new trends. The World Bank has new increased their data set to 164 countries over this period, adding Russia and its former Iron Curtain comrades, among others.  The chart below shows these very interesting developments, with, for the first time, as slew of emerging markets appearing.  Of the 27 names on the chart, ten, including China, are former communist, centrally-planned economies, that have undergone profound economic reforms.

The Winners over the past 15 years

 

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Putin’s Embrace of “One Belt, One Road”

The national identity of Russia is intrinsically tied to the mastery  of the Eurasian steppes, the grassland plains that  stretch from Hungary to Northern China. The territorial expansion of Moscow, from the 16th century onward, required  wresting control of the steppes away from the Mongols and securing the fertile black earth plains of modern-day Ukraine and Central Russia. The eventual collapse of the Mongol empire in the 17th century allowed the extension of the Russian empire to the pacific. Russian geo-political control over the steppes, Siberia and the Pacific coast has been largely uncontested for centuries.

However, the economic rise of China over the past decades and its increasingly outward-looking pretensions, as highlighted by President Xi Jinping’s ambitious “One Belt, One Road Initiative” (OBOR) changes everything for Russia.  While Russia has seen the steppes mainly for their value in securing geopolitical control of the Eurasian center, Xi envisions a return to the commercial dynamism of the historical Silk Road, which united the Far East with the Middle East and Europe for centuries, until the collapse of the Mongol empire. The Chinese have been aggressively executing Xi’s vision, building infrastructure to connect China with the West and becoming the largest investor in the natural resources of the former Soviet Republics.

Surprisingly, perhaps because of pragmatism and acceptance of Xi’s promise that the OBOR is aimed at benefiting all participants equally, so far there appears to be little resistance on the part of Russia to Xi’s grand and transformative plan. To the contrary, there has been a rapprochement between Putin and Xi, who have met on frequent occasions over the past several years. In a recent state visit to Moscow, Xi announced $10 billion in agreements for OBOR-related infrastructure investments and told the media that relations between the two countries were currently at their “best time in history” and that Russia and China were each other’s “most trustworthy strategic partners.”

Russia’s cuddling up with China is probably its best strategic option at this time. First, neither China nor Russia have to worry about business relations being undermined by volatile domestic politics or high-minded demands for human rights, and, in that sense, they see themselves as reliable partners. Second, both parties have an interest in weakening what they consider to be the arbitrary and hegemonic power of the United States. For example, both would like to see a weakening of dominance of the U.S. dollar and America’s discretionary control of the global financial system, so it is no surprise that Russia is accepting payment in yuan for commodities and that China is setting up a Petro-yuan-gold trading infrastructure in Shanghai and Hong Kong to facilitate non-dollar transactions.

Most importantly, however, is the fact that Asia will be the driving force of global growth and that its center of activity will be in China and its Far East neighbors. Driven by China, Asia’s share of world GDP will grow to 35% by 2022 (IMF forecast), and almost all of global growth in marginal output will come from Asia.  With its abundant energy, mineral and farm resources, Russia is best positioned to meet growing demand for natural resources in Asia.

A remarkable essay written by President Putin this week clearly states Russia’s current state of mind regarding Asia, and the seemingly total embrace of Xi’s OBOR vision. In a remarkable turn of events, Putin and Xi have become the defenders of open markets and predictable rules of commerce, in stark contrast to Donald Trumps “America First” ideology.

Putin writes: (excerpts, full note available here.)

“As a major Eurasian power with vast Far Eastern territories that boast significant potential, Russia has a stake in the successful future of the Asia-Pacific region, and in promoting sustainable and comprehensive growth throughout its territory. We believe that effective economic integration based on the principles of openness, mutual benefit and the universal rules of the World Trade Organization is the primary means of achieving this goal.

We support the idea of forming an Asia-Pacific free-trade area. We believe this is in our practical interest and represents an opportunity to strengthen our positions in the region’s rapidly growing markets. Indeed, over the past five years, the share of APEC economies in Russia’s foreign trade has increased from 23 percent to 31 percent, and from 17 percent to 24 percent in exports. We have no intention of stopping there…

On a related note, I would like to mention our idea to create the Greater Eurasian Partnership. We suggested forming it on the basis of the Eurasian Economic Union and China’s Belt and Road initiative. To reiterate, this is a flexible modern project open to other participants.

Comprehensive development of infrastructure, including transportation, telecommunications and energy, will serve as the basis for effective integration. Today, Russia is modernizing its sea and air ports in the Russian Far East, developing transcontinental rail routes, and building new gas and oil pipelines. We are committed to bilateral and multilateral infrastructure projects that will link our economies and markets — such as the Energy Super Ring that unites Russia, China, Japan and the Republic of Korea, and the Sakhalin-Hokkaido transport link.

We are particularly focused on integrating Russia’s Siberian and Far Eastern territories into this broader network. This includes a range of measures to enhance the investment appeal of our regions and to integrate Russian enterprises into international production chains.

For Russia, the development of our Far East is a national priority for the 21st century. We are talking about creating territories of advanced economic growth in that region, pursuing large-scale development of natural resources and supporting advanced high-tech industries, as well as investing in human capital, education and health care, and forming competitive research centers…

We intend to engage in substantive discussions on all these topics at the 25th APEC Economic Leaders’ Meeting this week. I am confident that, acting together, we will find solutions to the challenge of supporting the steady, balanced and harmonious growth of our shared region, and securing its prosperity. Russia is ready for such a collaborative effort.”

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India’s Star Rises in the World Bank’s Doing Business 2018 Survey

The World Bank has conducted its “Ease of Doing Business” survey for fifteen years, providing a comparative view of business regulation around the world over an extended period of time. The survey is aimed at providing a comparative basis to help policy makers address issues that impact entrepreneurial activity. The rankings resulting from the survey are an important indication of how business-friendly countries are and how successful they can be in attracting the entrepreneurial capital to succeed in an increasingly competitive global environment. The survey ranks 190 countries. The top thirty can be considered an elite in terms of providing a regulatory environment amenable to business. A top 50 ranking is good. A ranking above 100 indicates that a country’s business community is crippled by bureaucracy and rent-seeking agents. A poor ranking is particularly debilitating for a small country that does not have the market scale and diversity to attract capital that large countries like Brazil, China and India have.

There were several important revelations from the 2018 survey published this week.

  • India improved its ranking from 130th to 100th, which is a significant improvement. This confirms a recent trend and lends credence to the government’s very ambitious objective of improving the country’s ranking to 50 during the current Modi Administration.
  • India’s improvement highlights Brazil’s sorry performance. Brazil and India have long been competing for the position of lowest ranked of the major emerging market economies. Brazil fell two points in the latest ranking, to 125th and now has a secure hold on the bottom rung.
  • Indonesia, the third of the large emerging markets economies with consistently poor scores over the history of the survey, has been steadily improving its performance for the past six years, and reached 72nd in 2018, which compares to 129th in 2012.
  • Asia, by and large, provides good business regulation and is improving. In addition to India and Indonesia, Vietnam is showing steady improvements and now has a ranking of 68, compared to 99 in 2014. China also is gradually improving. Taiwan, Malaysia, Thailand and South Korea are all elite in terms of business regulation.
  • The Philippines provide somewhat of a glaring exception in Asia. Though the country has improved significantly from the very low ranking of 2011, it has significantly deteriorated over the past four years, and it obtained a ranking of 113th in the 2018 survey. Given how competitive the Asian region is and the improving trends, the Philippines appear to be at a growing disadvantage.
  • In Europe, the remarkable trend is the surge of Russia and much of Eastern Europe. At a 2018 ranking of 35th, Russia is approaching the “elite” countries in terms of the quality of business regulation. Russia has improved every year since 2012, when it ranked at 123rd. Poland’s ranking at 27th secures an “elite” standing. Moreover, the improvements in Eastern Europe are much more profound. Georgia, Macedonia, Estonia, Lithuania and Latvia all rank in the top twenty, ahead of most Western European countries, including Germany, and are well ahead of the Mediterranean countries, France, Spain, Italy, Greece and Turkey.
  • South Africa appears to be on a ruinous path. Its ranking has fallen steadily for nine years, taking the country from elite status to 82nd.
  • Latin America is also on a steady decline, losing competitiveness to the other regions of the world. Mexico is the only bright spot, just because it has maintained its decent ranking around the 50th level. Chile, Peru and Colombia have all seen consistent and worrisome declines in recent years. Argentina and Brazil are secure in their abysmal rankings, near the bottom for economies of this relative importance. Not to mention, Venezuela which is essentially closed for business. With a wave of business-friendly governments now rising to power in Latin America, it will be interesting to see if these negative trends can be reverted in upcoming surveys.

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China’s Awakening is Shaking the World

In his address to the 19th Communist Party Congress this week, Chinese President Xi Jinping humbly downplayed China’s global standing and stated that much work is still needed to achieve the “China Dream of Rejuvenation”  and become  “a mighty force” that could lead the world on political, economic, military and environmental issues. Particularly noteworthy was Xi’s comment that China would not have a world-class military until 2050.

On many measures China clearly does trail the US by a large margin. For  example, in 2016 the per capita GDP of the United States was still over six times that of China.  Nevertheless, in a growing number of economic areas the weight of China is already the primary source of marginal demand and the major driver of performance. Moreover, Chinese influence on markets will be felt more and more over the next decade, as the world evolves towards multi-polarity and the center of gravity of the global economy shifts to East Asia. To paraphrase Napoleon, during this continued awakening, China will shake the world.

Though the U.S. GDP will remain larger than China’s until around 2027, China’s marginal contribution to global GDP is already higher than that of the U.S. According to IMF forecasts, China will add $7.15 billion trillion to global GDP by 2022 compare to $4.88 trillion for the U.S. From 2016 to 2022, China’s GDP  will go from 60% to 80% of the U.S. GDP.

In terms of GDP calculated on the basis of purchasing power parity, China’s economy is already 14% larger than America’s and will be nearly 50% larger by 2022.

Over the past fifteen years, Chinese infrastructure and real estate investments already shook the commodity world, driving a frenzy in the markets for copper, iron ore and other materials.  Astonishingly, China consumed 50% more cement over three years (2011-2013) than the U.S. consumed in the entire 20th century.

As the Chinese middle class has grown, China also became the primary driver of soft commodity markets. For example, for the past ten years China has provided essentially all the growth in demand for market pulp used for consumer goods like tissue paper.

China  is also becoming the driving force in many consumer industries. China’s cinema box office is expected to pass the United States this year; and, increasingly, the success of Hollywood blockbusters depend on the response of the Chinese public. China’s cinema ticket sales are expected to grow 5-6% annually while ticket volumes  in the U.S. decline by 1-2% a year. China now has more movie theatres than the U.S. (stuck at 40,000 since 2013) and is adding 7,500 annually. IMAX has 750 screens in China, twice as many as in the United States.

More and more, the success of global brands will rely on sales in China. On this week’s quarterly results call with investors, NIKE’s CEO Mark Parker noted that “the target population of China for NIKE is really moving towards ten times what it is in the United States, and the appetite for  Nike in China as the number one brand is incredibly strong.”

The focus of the global auto industry has also shifted to China for both traditional and electric vehicles. Auto vehicle unit sales in China surpassed those of the United States in 2010. Expectations are for volumes in China to reach 28 million units in 2017, vs less than 18 million in the U.S. Unit sales in mature markets (the U.S., Japan and Western Europe) are at the same level as over a decade ago and are expected to experience no growth over the next five years. Meanwhile, auto sales in China are growing steadily and may reach double the level of U.S. volumes by 2023.

 

The situation is similar for electric vehicles, which are being heavily promoted in China by government policy.  EV sales in 2016 in China were double the level of those in the U.S, and they are expected to ramp up in coming years.

Finally, according to government statistics, China is estimated to have 750 million internet users, compared to 300 million in the United States. Growing access to smartphones has resulted in a boom in mobile e-commerce, so that mobile e-commerce in China now dwarfs that in the U.S. The growth in internet mobility in China, places China at the forefront of many new data-driven technologies such as the “internet-of-things,” e-commerce, artificial intelligence, robotics and self-driving vehicles.

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China Watch:

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Energy Disruption Will Benefit Emerging Markets

The ongoing technological disruption of the energy sector is a net positive for emerging markets. The economic importance and market weight of those countries negatively affected by low oil prices (Russia, Mexico, Indonesia, Venezuela) is dwarfed by those that stand to benefit (India, China, Turkey). The rapidly declining cost of wind and solar power as well as the batteries needed to store it will provide huge opportunities for many emerging markets to improve their balance of payments, optimize electric grid efficiency and also make it easier to provide cheap power for hundreds of millions of poor people living in remote areas.

The latest report from the International Energy Agency  (IEA)  makes it clear that we have entered the age of renewable power. According to the IEA, in 2016 two thirds of new net power capacity added around the world came from renewable sources of energy.  In 2016, record-low auction prices were recorded for solar in India, the Middle East, Chile and Mexico, with prices reaching below USD 3 cents per KW. The IEA sees another 920 GW of renewable capacity added by 2022, with solar for the first time contributing more than hydro and wind. The main drivers of future growth continue to be technology-induced cost reductions and China’s policy initiatives, but India has also become a primary source of growth. India is expected to add more capacity than Europe and is on track to pass the United States as the second largest contributor to growth in capacity.

By 2021, according to forecasts from Bloomberg New Energy Finance, wind and solar will have become cheaper than coal in both China and India, two countries that have an enormous incentive to reduce coal combustion to address horrific air pollution problems. As the cost of renewables continues to decline over the next two decades coal power will become increasingly uneconomical.

The growth of solar will accelerate even more if battery costs continue to decline as they have over the past decade. Tony Seba, an expert on energy disruption who teaches at Stanford University, believes that an enormous wave of mega-investments in battery plants currently being made by Samsung SDI, LG Chem, BYD, Tesla, Foxconn and others, will drive down battery costs by over 20% annually for the next five years, to below $100/KW by 2022-23. At this price point, disruption will accelerate and battery storage will become prevalent across all points of the electricity grid (from the plant to the home). Seba believes cheap battery capacity will mean that the electricity grids in most countries will have to convert from the current “just-in-time” framework to one based “on demand,” which will eliminate the need for very expensive “peak” capacity. The average American home will spend less than a dollar a day to store energy for use in peak hours, resulting in much lower electricity bills.

Chile provides a prime example of the transformational impact renewables are having have on a developing economy. Chile has been dubbed “the solar Saudi Arabia,” because of the extraordinary potential for generating solar power in the Atacama Desert situated in the north of the country. Because of ideal direct normal sun irradiation and the dryness of the air, the Atacama is considered the best place on the planet to generate solar energy.

With scarce hydrocarbon resources, Chile has always depended on imports for most of its energy needs, and has suffered acutely from surges in oil prices. As recently as 2007, the country went through a severe crisis when Argentina reneged on contracts to pipe natural gas across the Andes, which forced massive investments in costly emergency diesel generators and LNG plants.

Compounding Chile ‘s energy woes, in recent years it has become increasingly difficult and time-consuming to build hydroelectric dams or coal-fired plants, as these face opposition from local communities and environmentalists.  However, the Atacama now promises a future of abundant and cheap energy.

In contrast to the difficulties faced in building “dirty” capacity, in the uninhabited Atacama desert environmentally-friendly  solar investments can be brought to market in less than a year, and recent advances in technology have made these projects very attractive to private investors.

Benefitting from clear regulation and investment rules, solar production has taken off over the past four years, putting Chile near the top in global tables. Solar producers have come to dominate public auctions,  offering to supply electricity at less than half the cost of coal-fired plants. In recent auctions in Chile, concentrated solar power (CSP) plants also have underbid gas plants. CSP technology combines solar generation with giant molten salt battery towers, allowing the plant to dispatch during the night. In Chile’s last auction for power, Solar Reserve, a U.S. firm,  bid a world-record-breaking low price at just 6.3 cents per kWh ($63/MWh) for dispatchable 24-hour solar.

The speed with which Chile has developed its solar potential is reflected in the generation of over 850 MW from solar panels in 2015, up from 11 MW in 2013. Current investments will bring installed capacity to 1,800 MW.

Solar also improves the potential optimization of the national electricity grid, as solar can be maximized during the day, allowing water accumulation at the hydroelectric dams in the Andes. As the cost of storage batteries decrease in coming years, it will make more and more sense to maximize production in the Atacama.

India is another country that stands to be a major beneficiary of disruptive energy technologies. First, India is a large importer of oil, which makes the economy vulnerable to surges in prices; second, it generates most of its electricity with dirty coal, which contributes greatly to horrendous pollution; and third, solar panels combined with batteries will provide the most cost-effective way to provide power to the nearly 250 million Indians, mainly in remote areas, that do not have access to power.

Prime minister Modi has announced bold plans to promote solar energy. The government aims to add 175 GW of renewable power by 2022, of which 100 GW would come from solar. As the cost of solar goes below coal generation over the next five years and battery storage becomes cheap, India’s is likely to rely on clean solar power for more and more of its needs.

Fed Watch:

India Watch:

  • India on the wings of digitization (Wisdom Tree)
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China Watch:

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EM Investor Watch:

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Energy Market Disruption and Global Multi-polarity

 

Around the world, energy markets are being disrupted by a combination of technology and geopolitics. On the one hand, technology is having a huge impact on supply, with shale production exploding in the United States and alternative energies (solar and wind) becoming increasingly competitive everywhere. On the other hand, growing energy self-sufficiency in the U.S. is occurring at a time when demand for oil imports is still growing quickly in emerging markets, particularly in China. As the major importer of oil in the world, China’s future economic stability will depend on secure supplies, which is forcing it to become much more pro-active in global diplomacy. China also will become uncomfortable paying for oil imports in U.S. dollars, as has been the global custom for the past 50 years. China will increasingly insist on being paid in Chinese yuan, a trend that will slowly undermine the “petrodollar system” and U.S. financial hegemony.

Over the past decade, technological innovation has permitted the exploitation of enormous U.S. shale oil and gas deposits, leading to a renaissance for the American oil industry. This, jointly with growing output of renewable energy and higher fuel efficiency, is driving the U.S. towards energy self-sufficiency. BP in its BP 2017 Energy Outlook estimates this will happen in 2023.  U.S. net imports of oil have already fallen from 13 million b/d in 2007 to 3.7 million today.

The decline in U.S. oil imports will have important consequences for global financial markets, because the U.S. pays for imported oil in dollars and the trade receipts accumulate in the world’s Central Banks and sovereign funds and is redistributed into T-bills, bank loans and other investments. Since the 1970s the global economy has been frequently buffeted by violent changes in the price of oil, leading each time to financial instability and a sharp redistribution of wealth between exporters and importers.

U.S. oil production peaked in 1970 at 10 million barrels per day and then began a precipitous decline, reaching a low of 5 million b/d in 2008. The decline in U.S. production, coming at a time of steady increases in global demand, strengthened the hand of OPEC and led to price surges in 1974 and 1980, causing stagflation in the U.S. and eventually the emerging market debt crisis of 1981. The rise of Chinese demand during the past decade created another huge surge in oil prices, with a peak in 2008 and a rebound in 2011, with enormous consequences on global liquidity and financial markets.

Oil imports have been the primary component of chronic U.S. current account deficits, representing 40.5% of cumulative deficits between 2000 and 2012, and 55% in 2012 alone. In the early 1970’s, as the major importer of oil and the global hegemon, the United States was able to convince the Saudis to price their oil in dollars, which they have done along with other OPEC members since the early 1970s. This created the “petrodollar system” as a partial substitute for the gold standard abandoned by President Nixon in 1971, guaranteeing that the dollar would remain dominant in global trade and finance.

 

However, the conditions that led to the replacement of the gold standard by the petrodollar system no longer exist in 2017. The U.S. is approaching energy self-sufficiency, while China is now the dominant oil importer in the world, with demand for imports expected to reach nearly 10 million b/d in 2018.

This is happening at a time when U.S. hegemony is on the decline, and the world is seeing multi-polar leadership, with growing Chinese and European importance.

One of the Chinese government’s expressed objectives is to increase the international influence of the yuan. In a direct challenge to American economic hegemony, China has already started using oil imports to propagate the yuan. Breaking ranks with OPEC, Nigeria in 2011 and Iran in 2012,  both started accepting yuan for oil and gas payments and accumulating yuan Central Bank reserves. Russia did the same in 2015. For both Russia and Iran, the yuan payments allow them to skirt U.S. sanctions, and for Russia this also achieves the objective of undermining U.S. dollar hegemony. Moreover, last month, Venezuela, which owes China $60 billion, announced it will price its oil in yuan.

Also, in September the Nikkei Asian Review reported that China is on the verge of launching a crude oil futures contract denominated in yuan and linked to gold. This contract would be settled in Hong Kong and Shanghai and allow Asian importers to bypass USD denominated benchmarks and could greatly strengthen the financial infrastructure necessary to promote the yuan in Asian trade.

In another interesting development, China appears to be intent on solidifying diplomatic ties with Saudi Arabia. This is of critical importance, given the crucial role the Saudi’s have in maintaining the petrodollar system. As reported by Bloomberg,  the Saudi’s are looking to tighten energy ties with China by investing $2 billion in Chinese refinery assets in exchange for China taking a major stake in the upcoming ARAMCO IPO.

All of this oil diplomacy, comes at a time when China is already achieving success in expanding the role of the yuan in global financial markets. One years ago, the International Monetary Fund agreed to a long-standing Chinese request to give the yuan official Special Drawing Rights status, joining the U.S. dollar, euro, yen, and British pound in the SDR basket. China has also successfully lobbied the MSCI to increase the weighting of Chinese stocks in its Emerging Market Index by including locally traded “A” shares, a first step towards a major integration of China’s financial market into global financial markets which will further the propagation of yuan assets in global portfolios.

Fed Watch:

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India Watch:

  • Tencent wants its share in India (Caixing)
  • India’s electrical vehicle dreams (CSIS)

China Watch:

  • 7 things we learned from China in September (WEF)
  • Buffett’s bet on BYD is working (QZ)
  • Meet China’s evolving car buyer (McKinsey)

China Technology Watch:

  • China’s airplane delivery drones (China Daily)
  • China, from imitator to innovator (Forbes)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

Technology Watch:

  • Adidas robots (Wired)
  • Acemoglu on robots (AEI)
  • Germany has more robots and stable jobs (VOX EU

Commodity Watch:

Investor Watch:

 

 

 

 

 

 

 

 

Global Competitiveness In Emerging Markets

The Global Competitiveness Index (GCI) ranks countries according to how hospitable they are to promoting economic growth and prosperity. The rankings have been published by the World Economic Forum since 2004, allowing for a measure of how countries are progressing in terms of their relative competitiveness in the global economy.

The GCI seeks to evaluate 12 different factors in three main areas: the quality of physical infrastructure and institutions; the ease of doing business (macro-economic stability, and open and flexible markets for goods, labor and capital); and the quality of education and ability to innovate.

The GCI 2017 report (WEF) and an analysis of the trends of the past five years provide some interesting insights on prospects for different emerging market countries. The chart below shows the 2017 rankings for most of the significant emerging market countries and the evolution over the past five years.

  • Several important countries are secure in the top quartile segment of the ranking. Taiwan, Malaysia and South Korea all have reached elite status and are stable.
  • China continues to gradually improve its ranking, from 29 in 2013 to 27 in 2017, and is likely to secure its place in the top quartile. China has followed in the path of its East-Asian neighbors, making this region one of the most competitive in the world and increasingly the center of gravity of the global economy. China’s continuous positive evolution is driven by improvements in education and innovation, which is in line with the country’s strategy to move up the industrial value chain.
  • Both Thailand and Indonesia have shown impressive progress over the past five years, moving into the top quartile.
  • India, on the back of Prime Minister Marendra Modi’s reforms, has improved its ranking dramatically, from 59 to 40. The areas of greatest improvement have been confidence in public institutions, infrastructure and macroeconomic stability.
  • In the EMEA region (Europe, Middle East and Africa), Russia is a surprising positive highlight. Russia has moved from 67 to 38 over five years, approaching the top quartile, as President Putin’s “order and progress” regime has gained traction, reflected in improved infrastructure and public services. On the other hand, South Africa has taken a spill, moving from 52 to 61, as declining public services and corruption have impacted business confidence. Turkey has also suffered an alarming decline, from 43 to 53, the result of political instability and a growing estrangement from Europe.
  • Latin America can be singled out for its relative decline, particularly compared to comparable middle-income economies in Asia and Eastern Europe. Though Chile has secured its ranking as a top quartile “elite” economy,” Brazil has had the worst collapse of any country, moving from 48 to 80. The rest of the region is stable in its mediocrity, with Argentina the worst and Mexico the least bad. Peru has seen a concerning decline from a ranking of 61 to 72. The region of late has been severely impacted by recession and corruption scandals, resulting in declining public trust in institutions and low business confidence.

India Watch:

  • India’s electrical vehicle dreams (CSIS)
  • India’s Industrial policy (Live Mint)
  • India’s imminent economic crisis (Live Mint)

China Watch:

  • Buffett’s bet on BYD is working (QZ)
  • Meet China’s evolving car buyer (McKinsey)
  • Beijing praises patriotic entrepreneurs (SCMP)
  • Reconnecting Asia (CSIS)

China Technology Watch:

  • FT has lunch with JD.com’s Liu Qiangdong (FT)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

  • Gazprom knocks Exxon off its pedestal Forbes

Technology Watch:

Investor Watch:

Ray Dalio on market valuation:

Do you see a disconnect between the U.S. stock markets being at an all-time high, while at the same time the economy continues to grow slowly?

No, I don’t. Markets, in general, are driven by the interest rate. As interest rates go down, as they have, that’s helped. Second, the purchases of financial assets by central banks have pushed asset prices up. Third, the expected returns of bonds and equities going forward are at relatively normal premiums to the existing short-term interest rate.

What are the implications of all that?

People buy profits, not the economy. So if the corporate tax rate is cut, a company is worth more even though the economy might or might not pick up on that. If regulation is reduced, that stimulates business. It might have other consequences, but it causes profits to rise.

Any other critical reason for what’s happening in the economy and market?

Technology, which is improving profitability, is also worsening [employment]. That worsens the economy because technology is replacing people [in jobs]. Improving profitability [through technology] is good for companies but not good for the economy as a whole because the people losing jobs are also the people who are more inclined to spend income. I call that group the lower 60%. So technology helps profits but hurts employment and helps to cause a slower economy at the same time it has caused companies to be worth more.

Has the U.S. ever been in a situation like that before?

We had a similar one between 1935 and 1940. I would say that 1937 [during the Great Depression, two years before the start of World War II] is most like the year today. We had the same sort of debt crisis; interest rates went to zero and the central banks printed a lot of money and bought financial assets, which went up in price. We had the same sort of wealth gap and the same sort of populism around the world.

So is there a lesson from 1937?

It’s very important that the Federal Reserve be very cautious and slow to tighten monetary and fiscal policy because we have asymmetrical risks: many more risks on the downside than on the upside. And be cautious about how political and social conflict is handled. Can we work together, or are we going to be split? Even though the stock market is at its peak and the unemployment rate is at a low, for the bottom 60% it’s a bad economy. We must not have an economic downturn.

What’s your take on the long-running debate about active vs. passive management and the move toward ETFs and other passive investments?

The question is: How much alpha can I buy by going to [a manager]? That alpha game is a zero-sum game. So don’t expect, on average, to get alpha because when somebody buys, somebody else has to sell. It’s like at a poker table: somebody will take money from somebody else — and there will be better players. There will always be smart people who will be able to make better decisions and pursue alpha. The challenge is to find them because those who are good at it are largely closed to new investors.

Business Corruption in Emerging Markets

It is obvious to the casual observer that many successful entrepreneurs in the United States and Europe are immigrants from countries known for their corrupt business practices. Turks in Germany, Indians and Nigerians in England and Mexicans and Brazilians in the U.S., to name a few examples, make enormous contributions to the entrepreneurial dynamism of their adopted countries while upholding the highest business ethics.

Why do immigrants change their behavior when they leave their home country? A Nigerian or Indian businessman in his home country might dedicate a significant part of his time and resources to corrupt practices but when in England apply all his efforts to making his business more innovative and efficient. The very recent case of the Batista brothers in Brazil highlights this phenomenon. Joesley and Wesley Batista, over a period of 15 years, grew their company, JBS, from a small regional meat-packing business in Brazil into the largest meat-processing firm in the world, with dominant operations in Brazil, the U.S., Europe and Australia. There is no doubt that the Batista brothers were very astute and visionary businessman, and they ran their operations very efficiently and professionally. However, it has been revealed in recent months that one of the brothers, Joesley, dedicated essentially all of his time to greasing the hands of politicians in Brazil to secure cheap financing from public banks and other favors.  While Joesley acted with total impunity in Brazil and is reported to have paid more than $150 million in bribes to over 1,800 politicians, there is no evidence of any illegal acts by the Batista’s or their employees outside of Brazil where by all accounts they acted as upright corporate citizens.

The case of the Batista brothers illustrates perfectly a theory proposed by the American economist William Baumol. In a seminal 1990 paper, “Entrepreneurship; Productive, Unproductive and Destructive behavior,” Baumol argued that though some societies or cultures may have more entrepreneurial dynamism than others what matters more is how that entrepreneurial spirit is allocated. Business people can apply their entrepreneurial spirit towards productive activities such as innovation or to non-productive activities such as rent-seeking, or, in a worse-case scenario, to destructive activities such as organized crime.  According to Baumol, the actual supply of entrepreneurship does not vary as much as its allocation to productive or non-productive activities. Entrepreneurs react rationally to the different payoffs society offers and will dedicate themselves to non-productive activities if that is where they find the highest returns. As the theory predicts, when in Brazil the Batista’s applied themselves assiduously to rent-seeking behavior because payoffs were high, but outside of Brazil they stuck to a strict legal path and focused on management and innovation.

The case of the Batista’s is not at all unique. Brazilian’s have long quipped that “businessmen work when the government goes to sleep at night.” The CEOs and CFOs of Brazil’s leading companies, even when they espouse the highest ethical standards, are required to spend an inordinate amount of time courting politicians and are expected to travel frequently to Brasilia at a moment’s notice.

Baumal’s theory links well with the argument of the “institutionalists” like Daron Acemoglu (Why Nations Fail) who argue that strong institutions (e.g., the judiciary) underpin development.  Clearly, an efficient bureaucracy and effective judiciary would reduce the opportunities and greatly increase the cost of corruption in Brazil and motivate entrepreneurs to direct their energies to legal activities.

In any case, the implications for policy makers are clear. Countries like Brazil, Argentina, India and Nigeria have huge repressed entrepreneurial spirit that could be unleashed if the business environment was less conducive to corruption.  Reducing bureaucracy, regulations and taxes should be at the top of the list. It is not a coincidence that the countries that rank poorly in the World Bank’s Ease of Doing Business survey tend to be the same where corruption is most prevalent. Straight-forward bureaucratic reforms can make a large difference. For example, in many countries, something very basic like opening or closing a business can require large expenses and months of time, pushing small businesses to take the path of informality. Privatizing state-owned firms also must be pursued, as time and time again we see these entities at the center of political influence-peddling and rent-seeking behavior.

As Baumal concludes, “the overall moral, then, is that we do not have to wait patiently for slow cultural change in order to find measures to redirect the flow of entrepreneurial activity toward more productive goals… It may be possible to change the rules in ways that help to offset undesired institutional influences or that supplement other influences that are taken to work in beneficial directions.”

 

India Watch:

China Watch:

  • Meet China’s evolving car buyer (McKinsey)
  • Beijing praises patriotic entrepreneurs (SCMP)
  • Reconnecting Asia (CSIS)

China Technology Watch:

  • FT has lunch with JD.com’s Liu Qiangdong (FT)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

  • The collapse of Venezuela (Vox)
  • Chile’s energy transformation (NYT)
  • Reconnecting Asia (CSIS)
  • Sam Zell is back in Brazil (CFA Institute)
  • Corruption in Latin America (IMF)

Technology Watch:

Investor Watch:

Notable Quotes:

Opportunity for Growth and Scale in Emerging Markets: In the 1990s, Zell and his team were intrigued by the opportunities in emerging market real estate platforms and other types of emerging market companies and started investing. Even though the potential for strong returns was much higher, Zell’s team wasn’t deluded about the trade-offs. “Investing in emerging markets is a bet on growth,” he said. “But what’s being given up is the rule of law.” That compromise is one he never takes lightly.  Sam Zell (CFA Institute)

Before I begin telling you what I think, I want to establish that I’m a “dumb shit” who doesn’t know much relative to what I need to know. Whatever success I’ve had in life has had more to do with my knowing how to deal with my not knowing than anything I know. The most important thing I learned is an approach to life based on principles that helps me find out what’s true and what to do about it.  Ray Dalio, Bridgewater

 

 

Caution Is Merited For India’s Stock Market

The stock market of India today is probably the most hyped and loved by emerging markets investors. Investor enthusiasm is rooted in the assumption that the country’s high growth rate can be sustained by structural reforms aimed at boosting productivity and modernizing the economy.

As a low-income economy, India has considerable potential for boosting economic growth simply by narrowing the productivity gap that it has with more developed economies. Though India has many world class companies in sectors such as information technology, pharma, manufacturing and banking, much of the economy, particularly small-scale informal manufacturing and farming, suffers from abysmal levels of productivity. Stifling bureaucracy and corruption make operating a business very difficult in India and promote informality. India ranks 130th in The World Bank’s 2017 Ease of Doing Business survey, the worst of any large economy.

Since market-oriented reforms were first introduced in 1991, India has entered into an accelerated catch-up phase, enjoying GDP growth of 6-7%.  For the 2014-2018 period, GDP growth will average about 7% annually, making India the fastest growing large economy in the world. Moreover, in recent years India’s trade accounts and inflation have benefitted from low commodity prices.

In principle, higher GDP growth should justify higher stock market valuations. In many countries, there is a well-established and logical correlation between GDP growth and corporate earnings growth. A generally optimistic view of the potential for long-term growth in earnings has resulted in high multiples for Indian stocks. Moreover, the relatively high valuations in India may be validated by the corporate structure of the Indian market which is dominated by well-managed and profitable private companies operating in industries with stable growth characteristics, in contrast to the much higher concentration of cyclical businesses and mismanaged state-owned firms in the stock markets of Russia, China and Brazil.  We can see this in the chart below, which shows cyclically adjusted, 10-year average price earnings ratios (CAPE) for major emerging markets. India has traded at the highest PE multiples for this group of countries for the past 15 years, as the market has priced in high expected earnings growth and low expectations for future volatility. The market sees India as a “high quality” stock market, with high earnings and low volatility, in contrast to markets like Turkey, Brazil or Russia which are seen as low-growth and high volatility. The only other market currently held in such high esteem by investors is the Philippines.

However, investor enthusiasm for India’s stock market may be misplaced.

India, with its bouts of uncontrolled inflation, high fiscal deficits and elevated public debt levels, recurring balance of payments crises, currency volatility, extreme inequality,  complex democratic politics, and highly inefficient and corrupt bureaucracy, resembles Latin America more than it does East Asia. East Asia has benefited from strong commitments to competitive currencies, a financial system geared to support manufacturing, trade and small-scale farming, and widespread education, none of which are the reality in India or Latin America. Consequently, though India’s GDP growth may be relatively high, it is likely to be volatile, leading to choppy earnings growth for its listed companies.

Furthermore, high GDP growth may be more a curse than a blessing for many of India’s blue chips as it promotes more competition. In recent years, India is seeing many new entrants in sectors like consumer goods and banking. IT powerhouses like TCS and Infosys are threatened by disruption from cloud-based providers. India’s high growth and looser regulations are bringing more foreign competition in many industries (e.g., motor vehicles), potentially disrupting powerful incumbents over time.

In general, stock markets that are very popular with investors because of attractive growth prospects do not tend to perform well in the future. Nevertheless, though expensive relative to other emerging markets, the Indian stock market may continue to do well. It trades today at a CAPE valuation which is below its long-term average and about in the middle of its long-term range, which does not seem prohibitive at a time of very high asset prices around the world.

Still, from a relative performance point of view, there is a high probability that over the next 3-5 years, India will not perform as well as cyclically depressed markets such as Turkey, Russia and Brazil.

One of the ironies of investing in emerging markets is that high GDP growth most often results in excess investment and low future returns. The best stock market returns are often found in depressed cyclical markets which have seen a period of low investment and where companies stand to benefit from operating leverage during powerful cyclical rebounds.

India Watch:

China Watch:

China Technology Watch:

  • FT has lunch with JD.com’s Liu Qiangdong (FT)
  • How Baidu will win the global AI race (Wired)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

Technology Watch:

Investor Watch:

 

 

 

 

 

 

Venezuela’s Tragic Collapse

 

Venezuela’s catastrophic social and economic collapse, the result of two decades of authoritarian populism, shows the precariousness of development for countries with weak institutions. Similar forces in recent times have brought misery to Zimbabwe and threaten both South Africa and Brazil.

Once Latin America’s richest nation, a thriving middle-income democracy which attracted immigrants and capital investments from around the world, Venezuela fell prey to Hugo Chavez, a charismatic “caudillo,” who promised a “Bolivarian Revolution” to bring social justice and prosperity for all.

Chavez cleverly exploited a serious economic downturn in 1998 in Venezuela caused by a collapse in oil prices, and he also tapped into popular disenchantment with a democratic regime marred by corruption, mismanagement and by a failure to renew its leadership. At year-end 1998, Chavez was elected president on a populist, anti-establishment, “drain-the-swamp” platform.

Chavez faced severe opposition in his early years. His efforts to concentrate power in the presidency and weaken the judiciary were rebuked by an anxious middle class, the media and the business community, and he was almost ousted by a military revolt in 2002.

But then, the winds of fortune changed for Chavez. Just as he was doubling down on his Bolivarian Revolution by purging the military and the national oil company PDVSA of “anti-revolutionaries” and accelerating the nationalization of industry and the socialization of farming, oil prices began to rise because of the China-fueled global commodity boom (2003-2012). At the same time, the global capital markets opened for Venezuela, and the country began a massive credit-binge. Accompanied by price controls, all of this created an enormous temporary illusion of prosperity.

Though the George W. Bush Administration initially took a strong stand against Chavez, once Chavez was able to use the oil bonanza and foreign credit to fund social programs the apologists for the regime started to dominate the discourse. Perhaps swayed by a parade of intellectuals and Hollywood figures who fell for the Chavez charisma and sang the praises of his Cuban-designed social programs, the Obama Administration sought to normalize relations with Venezuela. President Obama also heaped praise on Brazil’s President Lula (“That’s my man right here… Love this guy. He’s the most popular politician on earth.”) whose popularity also increased in line with commodity-boom-fueled economic growth and ample global liquidity. Eminent economists like Joseph Stiglitz, Noam Chomsky and Paul Krugman and institutions like the World Bank also fell in line and lauded Lula and Chavez for improving wealth distribution and giving the poor access to public services. Hollywood director Oliver Stone released a fawning documentary on Chavez in 2009 (South of the Border) acclaiming “a triumph for Venezuelan democracy” and an “alternative to capitalism.”

Washington abdicated its traditional strong influence on Venezuelan affairs in deference to South American sensibilities on non-intervention and in response to a vigorous defense of the Chavez regime led by the leftist governments of Brazil and Argentina. A policy of appeasement was taken as Venezuela pursued its course towards dictatorship and economic collapse.

The plummeting of oil prices in 2014 brought Venezuela’s dream of an alternative capitalism to a brutal end. Chavez had the good luck of dying just before the global capital markets shut down for Venezuela (2013) and oil prices collapsed (2014). He left the country and his successor, Nicolas Maduro, with gargantuan deficits and rampant inflation. Over the past three years, Venezuela has suffered what is perhaps the worst economic collapse of any country in modern history. Harvard Professor Ricardo Haussmann, a Venezuelan who served as planning minister in 1992-93, has documented the extent of the collapse (Venezuelan Tragedy, FT AlphaChat):

  • Output from the productive sector of the economy has fallen by 55% since 2013.
  • The median household wage at the black-market rate is $20/month, and buys 7,000 calories/day compared to 55,000 in 2012.
  • Collapse in public services and health standards are “beyond belief,” and Caracas is the murder capital of the world.
  • Assets of the financial system have fallen by over 90% since 2012 and the banking system has essentially ceased to exist.
  • Public external debt rose from $24 billion in 2004 to $178 billion today, of which $56 billion is owed to China. Haussmann questions the ethics of this lending which served only to prop-up the regime, and he is particularly critical of a recent $850 million “odious” transaction with Goldman Sachs carried out with an expected yield of over 50% annually.
  • To remain current on the servicing of the foreign debt the government has cut imports by over 80%.
  • The productive capacity of PDVSA has been compromised, with oil output falling from 3.7 million barrels/day in 1998 to 2 million today. PDVSA has become the funder and administrator of social programs and the primary locus of corruption.
  • Nationalized firms have been decimated. For example, the steel company, SIDOR, now produces 200,000 tons/year with 22,000 workers, compared to 4.5 million tons with 5,000 employees before.
  • The private sector has been destroyed by expropriations and price and currency controls.

The damage done is irreparable and Venezuela will take decades to recover. The country has become one of the most hostile places to run a business in the world, ranked 187th out of 190 countries in the World Bank’s Ease of Doing Business 2017 survey, surpassed only by Libya, Eritrea and Somalia. An enormous brain-drain of educated Venezuelans working in the oil sector and the private economy and the closure of thousands of businesses can only be reverted over time. Haussmann points to Albania, the former basket case of Eastern Europe that has started a recovery process over the past twenty years, as a source of hope.

Hopefully, the United States and the global community will orchestrate a massive humanitarian and financial effort to help Venezuela recover once the Bolivarian Revolution dies.

Why has Venezuela’s tragic collapse happened?  It took a coincidental combination of a charismatic demagogue and discredited institutions for the process to be triggered and a pliable and easily hijackable political system for it to flourish. Fortunately, in Brazil, at least for the time being, the judiciary, the press and the political establishment have been able to thwart Lula’s project.

Us Fed watch:

China Watch:

China Technology Watch:

  • How Baidu will win the global AI race (Wired)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

  • Russia is becoming a food superpower (Bloomberg)
  • Norway’s sovereign fund drops EM bonds (Bloomberg)
  • Emerging Markets look undervalued (Seeking Alpha)
  • No crisis in Venezuela (Al Jazeera)
  • How Western capital colonized Eastern Europe (Bloomberg)
  • From Soviets to oligarchs (NBR Working Papers)
  • Emerging Markets are turning the corner (Seeking Alpha)
  • Understanding the Russian mind-set (Spiegel)

Technology Watch:

  • Pandit says 30% of bank jobs will disappear in next 5 years (Bloomberg)
  • Nike’s Static-Electricity robots (Bloomberg)
  • Government Investment was key to US success (Teasri)

Investor Watch:

The EVP of Johnson and Johnson’s consumer products  did a great job of summarizing the immense challenges facing the industry and features heavily in this week’s post. He argues that historical barriers to entry are crumbling and that data is the new barrier to entry. It’s an interesting thesis, and only time will tell if it’s the right one, but it explains why companies are scrambling to use machine learning to make sense of the data that they have access to. One might wonder though, if old-line companies are leveraging tech companies’ cloud and engineers to unlock insights into their data, who’s data is it anyways? (Avondale)

Consumer:

The head of J&J’s consumer division laid out the problems facing consumer products companies:

Competitive advantages are being dismantled

“the reality is that the pace of change in our industry is truly accelerating…If you look at our last few decades in this industry, there were a series of barriers for entry or sources of competitive advantage that were well established but those are becoming less and less unique.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

It’s hard to have a monopoly on talent

“It used to be that companies like ours would acquire the best talent through our recruiting human resources mechanism, but it’s never been easier for you to source great talent across the world on demand.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

It’s never been easier to build a brand

“Our ability to build and nurture brands, brand building competencies used to be again a source of competitive advantage but the reality is it’s very easy for you to start building a business, building a brand from scratch and you really don’t need a ton of money to get a community of active users that support you.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

It’s not hard to access global manufacturing expertise

“Large scale manufacturing assets used also to be a source of competitive advantage. But the reality is if you want to compete in this industry, you can access high quality contract manufacturing work any place in the world.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

Retailer relationships are no longer a moat

“Retailer relationships used to be also a source of advantage and a barrier for entry, but as you all know, new companies can now sell directly to consumers profitably in most markets. And then financial firepower for companies like J&J is not as critical as it used to be because new startup entrants can access capital relatively easy through VCs.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

The disruption is digitally enabled

“So this disruption that is happening is digitally enabled and is changing the face of our industry. You see these new players coming into our category and at the heart of this disruption, there is a new consumer centric paradigm and that’s challenging completely the cost of goods scale and the value scale as we know it and its forcing a change in both the retail and the media landscape.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

Small companies are succeeding because they stay close to the consumer and have digital DNA

“small players are the ones that are gaining share and majority of large companies are losing market share…they are really committed to breakthrough innovation by staying really close to consumers and customers and staying on top of consumer trend. They see where the product is going and they are designing to what that emerging consumer need is. They are focused on building digital first brands that have a clear purpose and a reason for being that resonates with millennial consumers. They capitalize on the rise of emerging channels. They don’t just play in the legacy channels but they figure out what are the new shopping behaviors, new emerging channel trends and they disproportionately drive growth in those channels. They are hyper efficient. Normally have very lean cost structures, flat organizations, no bureaucracy and as a result they move very fast. Speed is a great currency for them.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

Big companies are becoming value added VCs

“the innovators are launching hundreds of new products every year. But once they’re successful, they all have the same kind of issues, issues like buying, procurement, like selling, distributing, manufacturing and capital. And so, we have a venture group that we started about ten years ago and, basically, it goes out to all the entrepreneurs and says, instead of going to private equity to get money, why don’t we work with you, we’ll invest in you and we’ll help you. And we’ll help you take your idea, solve some of the issues you might have, and we can see how you can be a part of what we’re doing and we can help you achieve your dreams as an entrepreneur…All of that allowing us to kind of source external innovation, so that when you take a healthy core, build strong, new businesses, and then bring all the next businesses in, it gives you a sustainable top line.” —Coca Cola EVP Sandy Douglas (Beverage)

Data is the new barrier to entry

“And what we’re seeing now is there is a new playbook emerging, a new how-to-win playbook that is really characterized by an asset light infrastructure. And the control of the consumer relationship, via the acquisition of the…data that allows for you to have a highly personalized iterative on demand consumer experience. And the ownership of this relationship with consumers and associated ecosystem that comes with it is now the new playbook. It is now the greatest new source of competitive advantage.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

The Rise of Robots in Emerging Markets

 

The relentless rise of robotics in manufacturing around the world that is expected for the next decade will affect the development of emerging market economies in different ways. The “East-Asian Tigers,” including China, are embracing robotics full-heartedly as the way to preserve the manufacturing intensity of their economies and build global market share in medium and high-value added industries, like automobiles, electronics, semiconductors and batteries. Germany and Japan are also manufacturing powers determined to maintain their manufacturing base through innovative engineering.

Most middle-income countries throughout South-east Asia and Latin America are lagging seriously behind in the robotics race and may find it increasingly difficult to move up the value chain to compete for market share in many highly-automated industries. These middle-income countries also face rising competition in low-value-added manufacturing from the new wave of industrializing countries with significantly lower labor costs, such as Vietnam, Bangladesh, India, Pakistan  and Indonesia.

Until today, robot deployment has been highly concentrated in a few industries, namely motor vehicles, electronics and metal-working.

However, accelerating trends in robotics technology is changing this focus in important ways. For example, robot suppliers are beginning to offer automation solutions for clothing and shoe manufacturing, industries that today are highly dominated by low-income economies. This trend may allow for the preservation of these industries in current high-cost producers like China, and even relocation to Europe and North America, in a process dubbed “robot-shoring.”  Moreover,  teamed with computer-aided-design (CAD) and 3D printing, which dramatically accelerate product design, automated manufacturing in developed countries will permit much shorter production chains and give producers  greater ability to react quickly to consumer trends. This is particularly true for high fashion-content clothing and shoe-wear, so it should not be a surprise that Nike and Adidas are leading the “robot-shoring” trend.

Both Nike and Adidas are working with tech partners on solutions for automating the most labor-intensive part of the sneaker manufacturing process, the fusion of the many parts and layers that make up the upper part of the sneaker. Nike invested in 2013 in a company called Grabit that uses a process called eletroadhesion to use static electricity to manipulate soft materials like leather and cloth, and this year Grabit commissioned upper-assembling robots in Nike plants in Mexico and China that work at 20 times the pace of human workers. This is a significant step towards bringing back production closer to consumers in developed markets.

Adidas’s Speedfactory in Ansbach, Germany is another experiment towards using 3D Printing and robotics to bring back sneaker production home. Adidas has partnered with Oechsler Motion, a German machinery supplier, and plans to produce 500,000 units a year in 2018. A second plant is under construction in Atlanta. Adidas believes technology can solve a huge mismatch between the typical 18-month production chain with Asia and the 12-month “fashion-life” of a sneaker.

Another company, Softwear Automation of Atlanta, Georgia, is intent on using its “Sewbot” technology to disrupt the world apparel-making process and the lives of millions of $5/day sweatshop employees scattered around South-East Asia and Central America.. Sewbot has solved the difficult task of robot manipulation of fabric, and Softwear Automation claims to have dominated the automated production of T-shirts and denim bluejeans. The company estimates that its process is 17 times more productive than human labor. Tianyuan Garments, a large Chinese firm that supplies Adidas, is building a plant in Arkansas that will have 20 Sewbot production lines and aims to produce 1.2 million T-shirts a year. Tianyuan estimates human labor will amount to $0.33/shirt on its completely automated production line, which compares to about $0.33/shirt in Bangladesh, the current low-cost producer.

China has made robotics a key part of its government supported “Made in China 2025” plan, both in terms of usage and domestic supply. The goal is to make China one of the world’s top 10 most intensively automated nations by 2020, with 150 industrial robots per 10,000 employees, which compares to today’s leader South Korea, with 531 robot units, the USA with 176 robot units and Germany with 301 robot units.

In 2016 China led the world in terms of both the amount of new robots installed (87,000 units, of which 27,000 came from Chinese firms) and for the total stock of operational robots (340,000, +33% over 2015).

The deployment of manufacturing robots around the world is extreme in its geographic concentration. As the data from the International Federation of Robotics shows,  the great majority of robots are being deployed in East Asia, North America and Germany. Middle-income countries with significant manufacturing bases, such as Brazil, Thailand, Malaysia, Turkey and South Africa, and European powers like France and the U.K, are being left far behind. The positive exceptions are Italy and  Eastern Europe, perhaps because of the latter’s close integration with the German supply chain.

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • China’s  Anyuang to make T-shirts with robots in Arkansas (Bloomberg)
  • China’ luxury consumer opportunity (McKinsey)
  • China bans ICOs (Bloomberg)
  • Seven reasons China banned ICOs (Fortune)
  • Michael Pettis on China’s slowing growth (Carnegie)
  • China bear turns bullish (Bloomberg)
  • The coming collapse of China’s Ponzi scheme  economy (SCMP)
  • China is going to hit a wall (FUW)
  • The global economy’s new rule maker (Project Syndicate)
  • Chinese millenials will drive global growth (SCMP)

China Technology Watch:

  • How Baidu will win the global AI race (Wired)
  • China leads the world in digital economy (McKinsey)
  • Chinese firms eyeing passenger drones (WIC)
  • Alibaba wants to bring big data to 1 million small shops (Caixing)
  • China’s  Anyuang to make T-shirts with robots in Arkansas (Bloomberg)

EM Investor Watch:

Technology Watch:

  • Nike’s Static-Electricity robots (Bloomberg)
  • Government Investment was key to US success (Teasri)

Investor Watch:

 

 

 

 

 

 

Russia is becoming a food superpower (Bloomberg)

Norway’s sovereign fund drops EM bonds (Bloomberg)

Bull and bear markets and capital allocation (Absolute Returns)

Profit margins and mean reversion (Philosophical Econ)

The Bullish Case for Brazilian Stocks

Brazil is coming out of one of the worst economic slumps in its history, after having lost more than 7% of its GDP over the past three years. A huge binge caused by a boom in commodity prices (2004-2011) which led to hot-money capital inflows and excessive credit and consumption was followed by a large hangover, made much worse by a political crisis and a draconian monetary policy of extremely high real interest rates. But all downturns come to an end, and Brazil is now poised to start a new growth cycle on solid ground. Corporates now have very lean cost structures, and they will see significant margin leverage as sales recover. Profits are very depressed; in 2016 they were at 2005 levels. At the same time, the market is inexpensive relative to its history and one of the cheapest in the world, so there are good prospects for both vigorous profits growth and multiple expansion over the coming years.

It can be argued that the past 10-15 years were wasted by Brazil. The Workers Party (PT) governments of Presidents Lula and Rousseff coasted on the reforms passed by the previous administration and sat back to enjoy high commodity prices and ample foreign capital inflows.  Several important achievements of the previous government, such as depoliticized regulatory agencies and the professionalization of public companies, were discarded, and new reforms were taken off the agenda. The PT focused mainly on a multitude of poorly-designed social welfare programs and corporate subsidies, without consideration for the fiscal consequences. When commodity prices retreated and the mismanagement and corruption of the public sector was revealed, the party came to an end.

The interim president Michel Temer, who replaced Rousseff after her impeachment, has made good progress towards putting Brazil’s economy back on the right track. For the first time in nearly twenty years, Brazil now has a reform agenda and a real opportunity to break out of economic stagnation (Brazil’s Economic Stagnation). An inbred love for experimental developmental economics and a complacency facilitated by the commodity boom and Petrobras’s oil finds, seem to finally have been replaced by a new realism and a desire to follow market economics. The country has woken up to the evidence that Argentina and Venezuela are not better models to follow than Chile and Mexico, and that wholesale antagonization of the U.S. leads nowhere.

Temer has already secured passage of a “fiscal responsibility law” which limits public spending increases to inflation and provides a possible anchor to a future of fiscal rectitude.

Temer has also brought competent management back to the state-owned national oil company  Petrobras, the electricity-holding Eletrobras and other public entities. Petrobras has started a process of selling non-core distribution and refinery assets, to focus on managing the development of its prodigious deep-water oil reserves. Temer has also proposed privatizing Eletrobras, a state electricity conglomerate that has long been a hotbed of patronage for politicians. Moreover, additional privatizations and infrastructure concessions once again are being advanced. It appears that these will be done in a manner to promote investment and efficiency, not for the convenience of corrupt construction companies and their political friends, as was the case during the Lula and Rousseff governments.

The good news for the stock market is that there are plenty of low-hanging fruits for Brazil to collect.

First, after this dire 3-year economic recession Brazil will enjoy a natural rebound. That alone should guarantee moderate growth in coming years. The negative effects of low commodity prices have already been felt and these are likely to stabilize from now on.

Second, important reforms of social security and labor are likely to pass. Consensus appears to have evolved in favor of these fundamental reforms. Social security reform is vital to stabilize fiscal spending. A labor reform could create enormous opportunities to create jobs in the formal economy.

Third, productivity is very low (at about a quarter of US levels) and productivity growth has been abysmal. Brazil has huge potential to increase productivity by pursuing two tracks:

  • Lower tariff and non-tariff barriers to open the economy. Brazil can take advantage of the enormous presence of mutinationals and the scale of their Brazilian businesses to promote integration into global supply chains and increase exports. For example, the auto industry currently has very low productivity and is mainly domestic focused.
  • Brazil has a pathetically low rank in the World Banks’s “ease of doing business survey”, and has seen no progress over the past decade. It has the worse ranking in Latin America and one of the worse for the main emerging markets. A methodical approach towards deregulation and tax-simplification would quickly yield high dividends.

World Bank’s Cost of Doing Business Country Rankings

Fourth the stocks market is inexpensive relative to both its history and other stock markets.

  • Dollarized earnings rebounded strongly in 2016 and will rise another 20% this year, but they remain below the level of 2005 and at about half the level of 2010-11. With very lean cost structures, companies will see better margins and earnings as the recovery progresses.
  • Cyclically adjusted price earnings (CAPE) ratios on a dollarized basis are cheap relative to Brazil’s stock market history as well as compared to other markets. In a world of very high assets prices caused by the impact of monetary policies on the pricing curve for capital duration and risk, emerging markets equities in general and Brazilian equities  in particular still trade below long term averages. Though CAPE ratios in general are not a good timing tool, they are very predictive of market performance on a 7-10 year basis in developed markets and a 3-5 year basis in emerging markets where cycles tend to be shorter and more abrupt.

There are sufficient risks in Brazil so that the market will face a wall of worry. At the top of the list is the outcome of next year’s presidential election. A successful run by Lula, a low probability at this time because of his legal problems, would certainly unsettle the markets.

Longer term, Brazil faces two fundamental issues.

  • A chronically overvalued currency. It is an absurdity that Brazil has the sixth  most expensive BigMac in the world, a reflection of the very high costs of doing business and an over-valued currency. Policymakers need to constantly remind themselves of former Finance Minister Mario Simonsen’s dictum, “A inflação incomoda, mas o câmbio mata. (Inflation is a nuisance but the foreign exchange rate kills.“ )

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  • Pro-cyclical policies. Every cycle, Brazil ‘s politicians increase spending during the boom times and then are forced to retrench during the busts. As John Maynard Keynes wisely noted, “The boom, not the slump, is the right time for austerity at the Treasury.”

 

Us Fed watch:

India Watch:

  • India’s rural distress puzzle (livemint)
  • The battle for India’s gold market (Bloomberg)
  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The coming clash of empires, Gavekal  (Zero Hedge)
  • The global economy’s new rule maker (Project Syndicate)
  • Chinese millenials will drive global growth (SCMP)
  • China’s booming pet-care industry (WIC)
  • Hyundai feels the wrath of China (Caixing)

China Technology Watch:

  • Chinese firms eyeing passinger drones (WIC)
  • China military focuses on drone swarms (FT)
  • Big data war in China (WIC)
  • Qualcomm plays the China tech game (WIC)
  • Alibaba wants to bring big data to 1 million small shops (Caixing)

EM Investor Watch:

Technology Watch:

  • Nike’s Static-Electricity robots (Bloomberg)
  • Government Investment was key to US success (Teasri)

Investor Watch:

China’s “Inevitable” Rise Through Protectionism

 

China’s rise as an economic power increasingly threatens the Asian and global geopolitical balance of power.  The growing realization in Washington that China’s ascent may be inevitable is based on the acknowledgement that Chinese policy makers are on a coherent and proven path of development, previously followed by the United States itself and later by Japan and the newly minted Asian tigers (Taiwan, South Korea, Hong Kong and Singapore). Japan and the Asian tigers were politically aligned with and militarily dependent on the United States and did not have the scale to upset the global order, but a resurgent China is a different matter.

The uniqueness of China’s rise cannot be over-emphasized. Every other country that has successfully broken out of the “middle-income trap” during the post-war period (the Asian tigers, Israel and today several eastern European countries) (China, the middle income trap and beyond) has done so with strong political, military and financial support from the United States. Most countries are not successful at building the institutions and executing the policies required to graduate beyond middle-income status, and many formerly “miracle economies,” face stagnation. Brazil is a case in point. Despite great natural resources and a vibrant entrepreneurial class, incoherent populist policies, an expansive state bureaucracy and oppressive taxes and regulations on business have caused stagnation since the early 1980’s. The result of Brazil’s stagnation at a time of great dynamism for China is an astonishing reversal in the relative importance of both countries to the global economy.

Source: World Bank

The Chinese model follows the well-worn protectionist path, embraced by the United States in the 19th century.  Once Great Britain had been well-established as the global hegemon, it espoused free-trade to facilitate the dissemination of its industrial production. The liberated Americans would have none of it. Alexander Hamilton’s Report on Manufacturers, submitted to Congress in 1791, which called for imports tariff and non-tariff barriers and subsidies for infant industries and innovation, provides a blueprint for the policies now followed by China. On the other hand, the U.S. as the new hegemon, has now assumed the role of the promoter of free trade.

China, with its huge market and high growth, has the same ability to attract capital and technology on its own terms that the U.S. had in the 19th Century. The Chinese have studied history and are simply following the path taken by the U.S. and the Asian Tigers. The Chinese know that to continue their rise they must now dominate high-value-added and technology-intensive industries, and they are determined to provide the protection and subsidies to facilitate this. In 2015, the government announced its Made in China 2025 and Internet Plus initiatives which aim to transform the country into a high-tech superpower by integrating artificial intelligence, robotics and social media. The plans are unabashedly protectionist and aim to substitute high tech imports by using the full regulatory and financial power of the state. This strategy of state supported industrial planning follows what Japan and Korea have assiduously done in the past, most recently with Korea’s full-fledged effort since 2001 to dominate robotics.

China’s plans have alarmed the world’s leading technology providers, such as the U.S., Japan, Germany and South Korea, and led to protests. President Trump last week signed an executive order asking his trade office to investigate China for theft of American technology and intellectual property.  But it is unlikely that China will change its path because it has history on its side and it believes that rival nations and corporations will cooperate to gain access to its markets. Moreover, there is no denying that the results of the policy so far are encouraging.

Many leading industries in the world today, from airplanes to internet search engines, have winner-take-all characteristics because of enormous capital intensity and/or network effects. China’s decision to restrict the freedom of American internet and ecommerce firms has promoted a vibrant domestic environment for tech start-ups unique in the world outside of Silicon Valley, and it has greatly facilitated the success of companies like Baidu, Tencent and Alibaba which are today the only global rivals to America’s tech hegemons.

The enormous amount of mobile phone and internet users, 751 million at last count, and the massive amounts of data they generate positions Chinese companies to become dominant players in the “internet of things,” artificial intelligence , data mining and related services. Neil Shen of Sequoia China, a leading venture capital investor in technology firms in China, succinctly states the bull case for the sector:

“I’m very optimistic about the prospects of the Artificial Intelligence industry in China, probably more so than back 20 years ago when china started with the online internet. The reasons being two: one is you need data for AI development and we have tons of data whether its Alibaba’s transaction data, social network data from Wechat, etc. And on top of that when you are looking at the researchers and experts in that space many are Chinese and if you are looking at quotations in research papers the Chinese AI research in the world has a very decent market share. And so, with that I think we have a very good chance to take a lead. In fact, fundamentally what is AI in the whole science field: its mathematics and statistics and China has very strong talent in these two areas.” Sequoia China’s Neil Shen (Bloomberg Interview).

China’s support of leading-edge practical technologies through subsidies, financing, R&D support, import protection and the leveraging of its huge market and the state’s purchasing power has led to significant breakthroughs. For example:

  • High-speed trains – Fuxing, the latest generation of Chinese bullet trains, with a maximum speed of 400 km/hour, was recently launched on the Shanghai-Beijing route, cutting travel time to 4 ½ hours. Fuxing is said to be 84% home-made standardized design, in contrast to previous generations which relied heavily on Japanese and French technology. The name, Fuxing, which means “revival,” is politically-loaded.(Caixin)
  • Over the past ten years, China has become the global leader in all aspects of the use and manufacturing of solar power. China is the world’s largest producer of photovoltaic power, and on track to add 40 gigawatts of capacity this year in its domestic market.
  • China also leads the world in the production and use of wind power and smart grid technologies.
  • China has become the global leader in the use and manufacturing of electric vehicles, selling 507,000 units in 2016, compared to 222,000 in Europe and 157,130 in the U.S.
  • China owns 70% of the world’s commercial drone market. For drones with communication-ability selling above $500/unit, Shenzen’s DJI is estimated to have around 70% of the U.S. market. DJI has become so dominant that competitors are abandoning hardware manufacturing to focus on software applications exclusively. Chinese military drones, with similar range and effectiveness as the U.S. military’s Predator and Reaper drones but selling at a fraction of the cost, have been gaining significant foreign market share, at the expense of the U.S. (WSJ).
  • Surveillance technology – Shenzen’s Hikvision, a subsidiary of CETC, a state conglomerate with close ties to the military, has become a global leader in internet-based digital surveillance systems which are being widely deployed in China and other countries through CCTV, ATMs and mobile phone applications. The company has become a leader in facial recognition and data harvesting.
  • Facial recognition – Beijing-based Megvii’s Face++ is the world’s largest face-recognition technology platform, currently used by more than 300,000 developers in 150 countries to identify faces, images, text and documents, such as government IDs. Baidu and SenseTime are also important players in this space.
  • Mobile Telephony – Chinese firms control over half the global market for mobile phones, with growing domination in emerging markets. China aims to be a leader in 5G mobile networks, and plans to spend $250 billion to have an operative system over the next five years.
  • Quantum Telecommunications – China appears to have the lead in the development of the new technology, “hackproof” quantum communications . China is said to be near completion of a 2,000 km “unhackable” fiber network linking Shanghai and Beijing. Moreover, Chinese researchers recently announced a breakthrough in successfully teleporting “entangled” photons from a quantum satellite 480 km above the earth to two terrestrial stations 1,200 km apart, and the government plans the deployment of a fleet of quantum-enabled satellites linking China nationwide and with Asia and Europe by 2020. The idea is to control a Chinese-centric hack-proof, cybersecure global network.

There are two new priority areas were the Chinese state is committed to deploying its financial and protectionist might:

  • Semiconductors – China has made it a national security priority to control the semiconductor supply chain. The government is lavishing money on the country’s chip makers, including $22 billion on state-owned Tsinghua Unigroup. Some 20 fabs are currently under construction in China. (WSJ)
  • Artificial Intelligence – China’s State Council in June announced a plan to provide tax benefits and state support to make China a global leader in AI by 2025 and Chinese companies major players in self-driving cars, smart robotics, wearable devices and virtual reality.

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

EM Investor Watch:

Investor Watch:

The Growing Role of the ETF in Emerging Markets Investing

ETFs, exchange-traded funds that track indices and are traded like common stocks on stock exchanges, have become enormously popular over the past decade and are an increasingly disruptive influence on the traditional asset management industry. Global ETF assets surpassed $4 trillion in 2017, growing 36% year-on-year, and 2,034 ETFs trade in the U.S. alone. Cost and liquidity are the primary attraction of ETFs, with the largest S&P500 trackers charging fees as low as 0.04% per year.  ETFs have become increasingly important as allocation instruments used by financial advisors and individual investors. Moreover, they are now commonly used by active institutional investors and traders.

Emerging Markets have seen an onslaught of ETF products. In the U.S. alone there are currently 195 EM ETFs being actively traded, representing nearly $200 billion in assets. The category is amply dominated by Global Emerging Markets (GEM) funds, with 70% of the assets. Specific country ETFs, which are widely used by active macro investors, are the second largest group, with 21% of assets. Fundamental strategies, also known as “smart beta,” make up 8% of assets. There has been a proliferation of these products, many launched by traditional active managers, which seek to exploit a specific factor (eg, value, quality, dividends, low volatility…etc.) These products are attractive to issuers because they still command relatively high fees compared to standard GEM ETSs.  The remaining categories are surprisingly insignificant. Regional funds, which used to be a fundamental part of the EM asset class, represent only 3.3% of ETFs, and are highly dominated by Asia. In contrast to the U.S., sector funds play almost no role in EM ETFs. EM sub-categories (frontier and BRIC, mainly) also are of little importance.

The EM ETF category is very dominated by four massive and growing GEM funds: Vanguard’s VWO, Blackrock’s IEMG and EEM and Schwab’s SCHE.  Fees have consistently declined for the big funds, with Schwab at the current low of 13 basis points per year. Ishares’s EEM is a complete outlier in terms of fees in this group, charging  0.72% of assets. As the first GEM fund to be launched (2003), EEM probably has legacy cost issues. For the time being, EEM can sustain this situation because its huge daily volume makes it the vehicle of choice for large hedge funds and institutional traders and investors seeking exposure to emerging markets. To compensate for the inevitable decline of EEM, Blackrock launched IEMG in 2012, with fees in-line with the competition.

Specific country funds are dominated by Blackrock’s MSCI-based ishare funds. These products maintain relatively high fees because their liquidity makes them the vehicle of choice for macro-investors, traders and allocators. Outside of the ishare products, almost all the activity of significance is in Asia where a panoply of country specific “smart beta” and sector products have been developed for China and India.

Fundamental smart beta products have also prospered in the GEM space and sustain high fees. These funds are aimed mainly at individual investors and financial advisors. Product sponsors offer “alpha-generating” factor tilts and other characteristics considered attractive to investor, such as high dividends, “quality,” low volatility, currency hedging, environmental consciousness (ESG) and leverage. The category is dominated by multi-factor funds that tilt stock allocation in favor of a combination of the value, momentum, quality and low volatility factors. The largest fundamental ETFs are listed below.

 

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The geopolitical landscape of Asia Pacific is changing (WEF)
  • China’s ascent is slowing (Bloomberg)
  • China needs more reform to progress (Caixing)
  • Trump on the verge of trade war with China (Brookings)
  • Foreign tourists are shunning China (SCMP)

China Technology Watch:

  • New China Maglev train moves ahead (China Daily)
  • China now has 751 million internet users (Caixing)
  • China is the next tech superpower (Diamandis)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch:

Investor Watch:

Notable Quotes:

“I’m very optimistic about the prospects of the Artificial Intelligence industry in China, probably more so than back 20 years ago when china started with the online internet. The reason being two: one is you need data for AI development and we have tons of data whether its Alibaba’s transaction data, social network data from Wechat, etc. And on top of that when you are looking at the researchers and experts in that space many are Chinese and if you are looking at quotations in research papers the Chinese AI research in the world has a very decent market share. And so, with that I think we have a very good chance to take a lead. In fact, fundamentally what is AI in the whole science field: its mathematics and statistics and China has very strong talent in these two areas.” Sequoia China’s Neil Shen (The Economist)

“When it comes to assessing political matters (especially global geopolitics like the North Korea matter), we are very humble. We know that we don’t have a unique insight that we’d choose to bet on … We can also say that if the above things go badly, it would seem that gold (more than other safe haven assets like the dollar, yen, and treasuries) would benefit, so if you don’t have 5-10% of your assets in gold as a hedge, we’d suggest you relook at this. Don’t let traditional biases, rather than an excellent analysis, stand in the way of you doing this (and if you do have an excellent analysis of why you shouldn’t have such an allocation to gold, we’d appreciate you sharing it with us.)” Ray Dalio, Bridgewater

Notable Charts:

 

 

Emerging Markets Valuations in a Global Context

 

Successful investors are never shy to avoid expensive markets, preferring to build cash reserves to deploy when other investors are less greedy and more fearful. Much of the success of investors like Warren Buffett or Seth Klarman (Baupost) has come from having plenty of cash on hand when markets suffer cyclical downturns, like in 2000 and 2008. Klarman was once asked by a client why he should be paid his high fees for holding very large amounts of cash (sometimes well above 50%). His answer: “You are paying us to decide when to hold onto cash and when to invest.”

Well, it appears it may be happening again. It was revealed this week that Buffett’s Berkshire Hathaway holds over $100 billion in cash, and Klarman also has well over a quarter of his fund in cash.  Meanwhile individual investors have reduced cash to the lowest levels since the peak of the 2000 bubble.

Buffett and Klarman are not alone. It is commonly accepted by market historians, though certainly not by technicians and momentum traders, that the U.S. market is at very high levels. This view is based on the premise that market valuations mean-revert over time in a somewhat predictable fashion. Though valuations are by no means a timing instrument, they do have a good track record of predicting long-term (5-10 years) future returns. For example, Robert Schiller’s CAPE ratio (Shiller), which measures valuations based on 10-years of inflation-adjusted earnings, currently shows extraordinarily high levels, which at least in the past have been highly predictive of  low prospective returns.

Shiller CAPE Ratio

Crestmont Capital’s extremely thorough analysis of U.S. valuation (1926-2017) history points to a near certainty of lower than normal returns from current levels. Historical U.S stock market returns of 10.0%, came from nominal earnings growth (5.1%), price-earnings multiple expansion (0.6% annually, starting from a low level of 10.2 in 1926) and dividend yield (4.3%).  Annual Real GDP growth and inflation over the period averaged 3.3% and 2.9%, respectively, both of which are currently expected to be lower over the next ten years. The table below shows Crestmont’s absolute best case forecast for market returns for the next ten years to be in the order of 7.1%, well below historical levels. Earnings growth is optimistically assumed to grow 5.1%, in line with history, even though GDP growth and inflation are both likely to be lower. Price-earnings ratios are assumed to remain at the current very high levels. Dividend yield is determined by current valuations. Any contraction of PE levels or lower than historical earnings growth would result in lower returns.

The logic of Shiller’s CAPE and Crestmont’s analysis leads to forecasts of low expected returns for U.S. equities, and all other asset classes impacted by similar factors. For example, relying on historical analysis and reversion-to-the-mean assumptions, Jeremy Grantham’s GMO  (GMO) predicts abysmally low returns for almost all of the asset classes it follows.

Similar analysis produced by Research Affiliates points to equally poor results for the next decade: near zero real returns for U.S. stocks, 2%+ returns for international stocks and 6%+ stocks for emerging markets:

Both GMO and Research Affiliates highlight the relative attractiveness of emerging markets equities in a very low return world. An extended period of under-performance of emerging markets relative to the U.S. market in particular has created a significant gap for investors to exploit. Not only are emerging markets cheap relative to the U.S. and other developed markets, they also are inexpensive relative to their own history. On a cyclically adjusted basis (CAPE EM), valuations in EM are still below average and very far from historical peaks, in contrast to the U.S. which is well above average and near historical peaks. Price earnings ratios  for EM, are near historical averages, in a world where most asset prices are well above historical levels.

To conclude, a further comment on U.S. valuations is in order. It can be argued that current U.S. valuations reflect the reality of extraordinarily low interest rates. The puzzle lies in determining the cause of these low rates; is it Federal Reserve manipulation?; is it deflation caused by globalization and technology?; or does it point to low real growth in real GDP and earnings  in the future caused by demographics and low productivity? The answer to this puzzle will likely explain the short term course of the U.S. market.

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The geopolitical landscape of Asia Pacific is changing (WEF)
  • China’s ascent is slowing (Bloomberg)
  • China needs more reform to progress (Caixing)
  • Trump on the verge of trade war with China (Brookings)
  • Foreign tourists are shunning China (SCMP)

China Technology Watch:

  • China now has 751 million internet users (Caixing)
  • China is the next tech superpower (Diamandis)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch

  • Bangladesh’s rise to manufacturing powerhouse (FT)
  • Venezuela’s total collapse (Project Syndicate)
  • Venezuela was once Latin America’s richest country (WEFORUM)
  • Military unrest on the rise in Venezuela (Geopolitical Futures)
  • In Brazil highway robbery is a growth industry (Bloomberg)

Investor Watch:

Notable Quotes: (Avondale)

It’s a low return high risk world

  • “Markets normally respond to elevated uncertainty with lower asset prices and compensatorily higher returns. But that’s not what we are encountering today. We are living in a low-return, high risk world and an environment where most investors are happy to bear risk.” —Oaktree CEO Jay Steven Wintrob (Investment Management)

China is likely to lead the world in electrification

  • “China’s forecasted to lead the global trend in Powertrain electrification, representing over 50% of unit production in 2025, reflecting a 40 fold increase over today’s levels. We remain optimistic about the China market as a result of the underlying macro trends which include increased government focus on emissions regulations, which are increasing demand for China’s new energy vehicles” —Delphi CEO Kevin Clark (Auto Parts)

Australian Iron Ore is being sold to traders, not users

  • “what these guys are doing, these guys mean, for abundance of clarity, Fortescue, BHP and Rio Tinto, Vale and even the midget, Roy Hill, they sell to traders. And these traders do not have blast furnaces. They buy because it’s cheap to borrow money in Chinese banks. Then they put that iron ore in the ground, not in a blast furnace, at the port. And then they go back to the banks, and say, hey, I have collateral, can I borrow more? And the banker say, yes, and they borrow more, and they buy more for the same idiots…That’s my problem with the business in Australia. Then comes the question, will this be happening forever? Yes or no? Of course, the answer is no. One day, this bubble will burst. And on that day, people will say, oh, we are surprised that we are not seeing iron ore inventories going up.” —Cliffs Natural Resources CEO Lourenco Goncalves (Iron Ore)

Notable Charts:

The Lottery of Stock Picking

Academic research has highlighted the high risk of investing in individual stocks. Stock-specific risk, in contrast to market risk, can be diversified away, so investors are not compensated for taking it. One study by Blackstar Funds  (The Capitalism Distribution), for example, showed that for the period 1983-2006 the 3,000 largest U.S. stocks had an average return of -1.1% compared to a 12.8% return for the Russell 3000 Index. 39% of stocks lost money during this 25-year period and all of the market return could be attributed to 25% of the stocks. Like most indices used by investors the Russell 3000 is market-capitalization-weighted, which means that the losers have increasingly smaller weights in the index while the winners constantly increase their weight. The indices follow mechanically the trend-following rule of cutting losses and sticking with rising stocks.

Another study by Hendrik Bessembinder (Do Stocks Outperform Treasury Bills) provides more recent data. Bessembinder covered all U.S stocks for the 1926-2015 period. According to the study, only 42% of stocks beat the returns of 1-month Treasury bills and less than half of stocks achieve positive nominal returns over their lifetimes. Over this 90-year period, only 86 stocks accounted for 50% of returns and an incredible 96% of stocks did not surpass the returns of 1-month treasury bills. Bessembinder compares stock-picking by individuals as “lotterylike” behavior; the hope of picking an Amazon and seeing it appreciate by thousands of percent.

What can be said  about the experience of emerging markets? Our data history is short and complicated by frequent changes in the indices, including the addition and exclusion of entire countries. Nevertheless, looking at Ishares Emerging Markets (EEM), which is based on the MSCI EM Index, for the period starting at year-end 2016 until mid-year 2017, we can draw some interesting parallels.

  • Of the 274 stocks in the index in 2006 only 148 (54%) remained in July 2017. These 148 remaining stocks provided a nominal return of -46.1% over the period, compared to a 7.5% return (before dividends) of EEM.
  • Of the top 10 stocks in 2006 (Gazprom, Samsung, TSMC, Posco, Kookmin Bank, Lukoil, UMC. KEPCO, Chunghwa and Silicon Precision) all except for Samsung, TSMC and Chunghwa have underperformed, dramatically in the case of the commodity stocks, Kookmin and UMC.
  • Of the original stocks only a handful have had good performance: Naspers, TSMC, Samsung Electronics, Ambev and Steinhoff.
  • Positive returns can be attributed to a few stocks, mainly East Asian tech stocks: Tencent-Naspers, Alibaba, TSMC, Samsung Electronics, Hynix, Netease, JD.Com, Naver, CTRIP and Largan.

The case of South Africa’s NASPERS is an interesting illustration of the “lotterylike” nature of investing. NASPERS has long been Africa’s most important and valuable media company. Like almost all South African corporates it began reducing its domestic exposure some twenty years ago. Adopting a incubator-venture capital model, it adopted a shotgun strategy, investing in a multitude of media and e.commerce ventures around the world,  including a stake in China’s Tencent in 2001. NASPERS’s business in Africa has stagnated and most of its foreign investments have floundered, except for Tencent where it hit the jackpot. Naspers’s original $34 million investment in Tencent in now worth $120 billion. Interestingly, the entire market value of Naspers is only $88 billion, so the market gives little real or optional value for the remaining assets.

Most individuals and professionals alike don’t have an identifiable edge in picking stocks and are compelled to the exercise for the lottery-like thrill of hoping to pick a winner. Picking a winner and holding on to it can be hugely profitable and make a career.

Us Fed watch:

India Watch:

  • Outsourcers are returning to the U.S. (NYT)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

China Consumer Watch:

  • Starbucks bullish on China growth Caixing
  • China’s Wanda slims down (NY Times)

China Technology Watch:

  • China’s surveillance giant, Hikvision, is worth $55 billion (WIC)
  • China’s phones growing share in EM (SCMP)
  • Chinese cellphone brands account for half of global sales (SCMP)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch:

  • South Africa’s great reconciliation is coming apart (WSJ)
  • Brazilian billionaires swap assets (bloomberg)
  • EM Valuations strong buy signal (Wisdom Tree)
  • Revisiting Allocation decisions in EM (GMO)
  • EM ETFs don’t all track the same index (ETF.com)

Technology Watch:

  • Summer of Samsung (Bloomberg)
  • TVs are disappearing from American homes (Recode)

Investor Watch:

Notable Quotes: (Avondale)

This quarter may have been more challenging than advertised

“this indeed was another challenging quarter and as I think we all know, the industry continues to face global market volatility and we have seen a further slowdown in consumer demand in several key markets, most especially the U.S. Southeast Asia and South Pacific.” —Colgate CEO Ian Cook (Packaged Goods)

Healthcare: Birthrates around the world have been disappointing

“So we had kind of projected 2016 was going to be a flat birthrate year. In the second quarter, we got the final fourth quarter numbers that showed it down 2% for the fourth quarter, which brought the full year down 1%…Korea’s birthrate…was down 7%, which is a pretty big, big drop…we don’t really understand it at a deep enough consumer insight level…But a broad trend is that Millennials are having their children a little later.” —Kimberly Clark CEO Thomas Falk (Packaged Goods)

There’s a lot of capital sloshing around the world

“there is a lot of capital that’s being raised and has been raised. And in general, there is just a whole lot capital sloshing around the world, looking for returns. ” —Blackstone COO Tony James (Private Equity)

“In the vast majority of asset classes, prospective returns are just about the lowest they have ever been,” Howard Marks (Oaktree Capital).

Notable Charts:

 

 

 

 

 

 

 

 

 

 

 

Emerging Market Portfolio Managers Against the ETFs

In the world of emerging markets it has generally been presumed that managers can justify higher fees for this asset class because they add more value. It is argued that emerging markets are less efficient because they are complex and under-followed by professional investors.  The relatively scarce qualified portfolio managers and analysts with the skills and experience to navigate the territory should command higher compensation.

While low-cost indexed products have increasingly disrupted the asset management industry, the arguments in favor of active management for the emerging markets asset class have persisted: (Bloomberg)

  • Market inefficiency – More complexity and less professional analysis gives a tangible advantage to managers capable of conducting in-depth research.
  • Benchmark composition – The index benchmark is full of unattractive countries, sectors and companies, that can be avoided by skilled managers. For example, heavy index weightings in poorly managed state enterprises and commodity producers can be avoided to outperform.

Moreover, EM managers may have the advantage that because of its relatively short history as an asset class less academic research has been conducted on performance factors. While in the U.S. academic research has identified the performance “anomalies” caused by tilting portfolios for value, size, quality and momentum, these factors are less well understood in EM and may be easier to exploit by managers.

The evidence partially supports the argument that professional managers of emerging markets funds add value, at least in comparison to managers of U.S. domestic and international funds.

For example, the table below shows the latest results of Morningstar’s Active/Passive Barometer (Morningstar ). Active EM managers, despite higher fees, are seen to perform better than their peers in U.S. and International asset classes, with particularly impressive results over the three and five year periods. On an asset weighted basis, which gives greater consideration to the larger funds, performance is even better. (Note, the data does not consider the greater tax efficiency and lower acquisition costs for ETFs).

The SPIVA Scorecard published annually by S&P Dow Jones Indices (S&P Indices)  shows much less impressive results for EM active managers. SPIVA claims to have a more rigorous approach, adjusting results for survivor bias and for style (e.g., growth vs. value). The SPIVA scorecard shows EM active funds under-performing indices over all periods, largely in a fashion similar to U.S. and International funds. As with Morningstar, SPIVA shows larger managers with better results.

Part of the discrepancy between SPIVA and Morningstar can be explained by the significantly stronger performance of the S&P/IFCI EM Index used by SPIVA compared to the ETF composite used by Morningstar. This causes confusion as both ETFs and active funds use various indices, and neither study adjusts for this. In any case, both reports agree on several points. First, active managers have not created value over the long term; second, larger asset managers create more value. The better performance of the larger funds may show that larger managers with greater analytical resources can add more value.

The Morningstar report also points out that the primary source of outperformance relative to peers for active managers is lower fees. This may also explain the better performance of the larger managers, assuming that they are passing on the benefits of scale economies to clients.

Certainly, the disruptive influence of EM indexed products will not go away and may worsen. It may be that EM active managers have benefited of late from the bear market of the past five years for several reasons. First, during down markets active managers benefit from holding cash. This becomes a source of performance drag during bull markets, and we may have already seen this effect during 2016. Furthermore, assuming positive performance for EM equities, indexed products are likely to be more formidable competitors in coming years, as they tend to outperform in bull markets.

Index products should be easier to beat in a five-year bear market for EM like the one we saw between 2011-2016. The benchmarks which most active managers as well as ETFs observe are market cap-weighted indices, which makes them classic trend-following instruments. When markets are rising and flows are abundant, the index keeps on increasing position sizes in winners and reducing positions in laggards. This led to huge positions in commodity stocks in 2006-2007 and to very high weightings in tech companies today. During bull markets, most active investors become nervous about valuations and the size of positions and retreat ahead of the indices. In a bear market the process reverses. The index pressures prices by selling its largest most overvalued positions. The collapse of commodity stocks during 2012-2014 created “easy alpha” for managers who were comfortable in stepping aside and waiting for valuations to return to normal levels.

The dilemma for EM managers is the same faced by managers in all asset classes disrupted by low-cost index funds. To justify their existence managers have to take much more risk than they are comfortable with. The vast majority of professionally managed funds can be considered “closet index funds” in the sense that they manage around the index. The difference between the portfolio and the index is known as the “active risk.”  Many actively managed funds will have around 15% of active risk, the remainder of the portfolio mimicking the benchmark. The problem is that an ETF like Vanguard’s VWO, charges a management fee of only 14 basis points (0.14%), while the active manager charges, on average, 1.5%  even though  85% of his assets only mimic the benchmark. Clearly identifying this issue, a firm like Blackrock, which manages both ETFs and active funds, is moving aggressively into highly concentrated actively managed portfolios with very high levels of active risk.

However, moving to highly concentrated portfolios with high active risk is something that very few managers can countenance. AS GMO’s Jeremy Grantham  never tires of saying, the primary behavior driver of asset managers is career risk ( GMO ). Unfortunately, the proliferation of low-cost alternatives is undermining the economics of the asset management industry and decreasing job security just at the time that managers need to embrace risk.

Us Fed watch:

India Watch:

  •  Indian market can triple over the next five years (Wisdom Tree)

China Watch:

China Technology Watch:

  • China outlines plans to be world leader in AI (Caixing Global)
  • Lenovo announces big push into AI (SCMP)

Technology Watch:

  • The return of basic sewing manufacuring to the U.S. ((FT)
  • Are robots the future of global finance (UBS)

EM Investor Watch:

  • Emerging Markets rally has “legs” (Van Eck)
  • Revisiting Allocation decisions in EM (GMO)
  • EM  breaks 10-year downtrend (The Reformed Broker)
  • The bullish case for EM (Mark Dow)
  • EM ETFs don’t all track the same index (ETF.com)

Investor Watch:

Notable Quotes: (Avondale)

 

Emerging markets have been weak for a long time: “since the financial crises, interest rates, currencies etcetera, we’ve had a prolonged period of about eight, nine years now where we have seen significant weakening of emerging market currencies…you actually see the volume component of these emerging markets continuing to be very, very low, while historically it was all volume-driven growth. I am convinced that that is coming back now.” —Unilever CEO Paul Polman (Packaged Goods)

China may be stabilizing: “China for example is actually much more stable than the last 12 to 18 months. I like what I’m seeing in China right now.” —Abbott CEO Miles White (Medical Device)

Chinese are still buying international assets: “we’re still seeing the trend of Chinese buying and international assets. ” —Goldman Sachs CFO Martin Chavez (Investment Bank)

“In the vast majority of asset classes, prospective returns are just about the lowest they have ever been,” Howard Marks (Oaktree Capital).

Notable Chart:

In Emerging Markets The Only Constant is Change

Antoine van Agtmael, the man who coined the term “emerging markets,” was a pioneer. His firm Emerging Markets Management was founded in 1988 to provide institutions access to what was at that time a very small emerging markets asset class, with fewer than 20 companies with revenues over $1 billion, almost all of them either banks or commodity producers. In his book, The Emerging Markets Century (2007), van Agtmael stressed the violent pace of change for the asset class. Fifteen years after launching the fund, 80% of the largest 100 companies had disappeared from the list. Not one of the top ten most valuable stocks remained 15 years later. Several factors drove this revolution, according to van Agtmael.

  • The move of China, Russia and Eastern Europe from centrally-planned to market-oriented economies and their integration into the global economy through trade and investments.
  • A neo-liberal wave of privatizations across emerging markets, leading to private investment in energy, telephone and power companies and a wave of public listings.
  • Improved economic policies and lower tariffs (The Washington Consensus), resulting in the control of hyperinflation in Argentina and Brazil, fiscal discipline and deleveraging in Asia and trade expansion.

The chart below  lists the top ten most valuable emerging market stocks in 1990 and 2005, taken from van Agtmael’s book. I have added the current standings, as of July 2017.

 

These lists give us several valuable insights on emerging markets investing.

  • Change is constant. The “revolution” continues. The 1990 list was dominated by Taiwan which was at the top of an epic stock market bubble. The 2005 list is dominated by commodity stocks, propped up by the China-induced commodity bubble. The current list is all China and tech. Emerging markets have their own version of FANG (Facebook, Apple, Netflix, Google), which is BATS (Baidu, Alibaba, Tencent, Samsung).
  • The drivers cited by van Agtmael have lost traction. We are seeing a backlash against neo-liberal reforms and globalization, and few privatizations. Countries with large domestic markets to protect and exploit are now seen to have the advantage.
  • Bubbles in specific geographies or segments can have a huge impact on performance. The 1990 list coincides with the peak of the great Taiwan bubble. Bubbles in Mexico (1992), Malaysia (1996), Brazil (1997), Korea (2005) had similar distortionary effects on the rankings. Same for the  commodity bubble (2005-2010), which rules the 2005 list. The 2017 list is greatly impacted by the current boom in tech stocks. There seems to always be a major bubble brewing somewhere in emerging markets.
  • There are fewer changes between the 2017 list and the 2005 list than there were between 2005 and 1990, with four stocks remaining on the list. All of the surviving stocks are either China or tech related, which may indicate we are seeing long-term secular shifts happening.
  • The expansion of China in general and China and tech in particular seem inexorable. Or are they? Only time will tell. Of the 2017 top ten, eight are essentially Chinese stocks, as Naspers’s value is mainly in its holdings in Tencent and Hon Hai’s operations are mainly based in China. Only Samsung and TSMC are independent of China. China’s market weight is likely to grow further, as its economy grows above the global average and benchmark indices include more Chinese stocks.
  • India’s absence is noteworthy. If the current hype on India is justified, ten years from now we will likely see a few Indian names on the list.

 

Us Fed watch:

Brazil Watch :

India Watch:

  • The Indian economy; a tale of two narratives (Livemint)
  •  Indian market can triple over the next five years (Wisdom Tree)

China Watch:

  • China broad credit growth slows to zero (Variant Perception)
  • Making sense of China’s foreign M&A (McKinsey)
  • Zombies are dragging down China’s productivity (Bloomberg)
  • The CEO guide to China (McKinsey)
  • The Chinese bought $32 billion in U.S. residential real estate in 2016 (WSJ)
  • Xi’s Tiger Hunt (Sinocism)

China Technology Watch:

  • Chinese military drones gaining foreign markets at U.S. expense (WSJ)
  • JD.COM invests in drone delivery (China Daily)

China Consumer Watch:

  • Chinese have all the appliances they need (SCMP)
  • China’s Hisense wins sponsorship for FIFA 2018 (China Daily)

Eastern Europe Watch:

  • Poland is breaking out of the Middle-Income Trap (NY Times)

Technology Watch:

  • The return of basic sewing manufacuring to the U.S. ((FT)
  • Are robots the future of global finance (UBS)

EM Investor Watch:

Investor Watch:

Notable Charts:

 

Learning to Love Volatility in Emerging Markets

Though economic and currency volatility may reduce the long-term sustainable GDP growth of countries like Brazil ( Brazil’s Economic Stagnation), paradoxically,  volatility is also the primary source of returns for the emerging markets investor. Economic booms, with rising stock markets and strengthening currencies, are invariably followed by busts, with collapsing markets and weaker currencies. For the investor who measures returns in dollar terms, the more volatile emerging markets provide turbo-charged results both on the way up and the way down. Learning to love that volatility is often the key to success.

Brazil is one stock market that is marked by enormous swings. Since 1990 Brazil has seen three market collapses; -88% in 1997, -76% in 2008, and -88% in 2011 (all measured in USD terms). Brazil also had a 80% collapse in the seventies and an 88% drawdown concluding in 1990. It seems that about once a decade, a period that should be well within a reasonable time horizon for most investors,  an investor in Brazil suffers  losses of between 80-90% in terms of U.S. dollars.. But Brazil is far from being unique in emerging markets in this regard. Since 1990, there have been 41 cases of a stock markets losing more than 50% of their value, with an average drawdown of 72%. Over this period, Turkey and Argentina are the champs, each experiencing six drawdowns of over 50%.

On the positive side, drawdowns are followed by bull markets, like day follows night. Over the next two and half years following the 41 market bottoms, investor see average returns of over 500%. Every Brazilian collapse has been followed by a extraordinary bull market:

  • 1983 bottom (-80%), followed by 14x return of capital
  • 1991 bottom (-87%), followed by 24x return of capital
  • 2002 bottom (-83%), followed by 17x return of capital

For the value investor, the brutality and frequency of emerging market drawdowns creates a dilemma. Value investors, indoctrinated by Warren Buffett’s consistent wisdom, believe in investing for the long-term. For example, two commonly cited quotes from Buffett are:

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 year;”

And “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”

An emerging markets investor could follow Buffet’s advice, patiently sitting through the drawdowns. By sticking with only the highest quality companies, the drawdowns can be minimized. The astute investor can also improve returns by trimming positions when valuations are high and taking advantage of market meltdowns to add to positions.

However, an alternative and often more productive better way to invest in emerging markets is to learn to love the volatility and skillfully harness it as the major source of returns.  Emerging markets, like commodities, often experience extreme cyclicality with predictable patterns. Investors that are aware of the patterns, can exploit them repeatedly. As commodity markets investor Martin Katusa says, investors in markets characterized by extreme cyclicality can best be “be approached with a ‘rent, don’t own” mentality.”

A strategy which may be anathema to value investors but is very effective in emerging markets and commodity investing is to marry a valuation process with basic trend-following techniques. An investor can patiently wait for a market to meltdown and then watch like a hawk for an entry point to ride the inevitable bounce-back. Typically, good entry points are created when a market has reached extraordinarily low valuations and is showing signs of trending up. Market bottom valuations, in my view, are often signaled by cyclically adjusted price/earnings ratios (like the CAPE Schiller ratio), which should be dollarized to fully measure the volatility of the markets. Timing decisions can be influenced by simple trend-following indicators, like the 50-day or 200-day moving average.

The advantage of patiently waiting for markets to bounce back before deploying capital is that the investor does not experience massive losses of capital on the downside. The absolute investor without concern for benchmarks is in a better position to do this than most institutional investors who are not willing or permitted to stray from their benchmarks for long periods of time.

Us Fed watch:

Brazil Watch :

  • China’s Fosun looking at Brazil Healthcare (SCMP)
  • IMF On Latin America Currency Flexibility ( IMF)

Mexico Watch:

  • WEF Tourism Competitiveness Report shows Mexico’s Rise (WEFORUM)
  • Mexico’s surprising oil finds (NY Times)

India Watch:

China Watch:

  • Mark Mobius on China  (Templeton)
  • Beijing’s New Airport (Caixing)
  • Xi Jinping’s War on Financial Crocodiles (FT)

China Technology Watch:

  • Chinese train maker expands U.S. market  (China Daily) 
  • China Launches new generation bullet train (WIC)
  • Beijing Subway Blocks ApplePay WIC
  • JD.COM invests in drone delivery (China Daily)
  • China plans $108 BB investments in chips (WSJ)

China Consumer Watch:

  • China’s Hisense wins sponsorship for FIFA 2018 (China Daily)
  • China rises in global tourism competitiveness (China Daily)

Korea Watch:

Eastern Europe Watch:

  • Poland is breaking out of the Middle-Income Trap (NY Times)

Commodity Watch:

  • Oil’s Game of Chicken; Can OPEC Finally Bankrupt U.S. Production (Seeking Alpha)

Anti-Globalization Watch:

Emerging Markets Investor Watch:

Guru Watch:

  • An Interview with Peter Bernstein (Jason Zweig)
  • Chano’s sees weak U.S. economy (Inetenomics)Notable Charts:
  • China Inverted yield Curve signals slowdown
  • Commodities at record low valuations relative to the S&P 500

Notable Quotes:

  • When markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.” (Bob Rodriguez – We are witnessing the development of a “perfect storm”(seeking alpha)

“Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepted theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.” (Robert Schiller)

 

 

 

 

 

 

 

 

 

 

 

 

Brazil’s Economic Stagnation

Brazil is a poster child for the “middle-income trap,” the phenomenon that keeps developing economies from narrowing the wealth gap with wealthy countries once they have reached a moderate level of prosperity. As is typical for many emerging market countries which are over-dependent on commodity exports and foreign capital inflows, the Brazilian economy experiences frequent boom-to-bust cycles, the latest being the commodity/liquidity/credit-fueled consumption boom of 2003- 2013 which was followed by a deep recession in 2014-2017. The overall result is mediocre growth. Brazil’s GPD per capita relative to the high-income economies is at the same level as in 1960, and actually has deteriorated significantly since the late 1970s.

A recent paper by Jorge Arbache and Sarquis J. B. Sarquis, Growth Volatility and Economic Growth in Brazil (Arbache-Sarquis) argues that Brazil’s poor performance is tied to the high volatility of the economy which in turn is caused by uncertain commodity prices and capital flows and their effects on currency valuation. It makes intuitive sense that volatility would hurt growth; boom-to-bust cycles are inefficient, as economic agents over-indulge in good times and retreat in bad times. Volatility also makes it difficult for both the public and private sector to plan and budget long term investments.

Brazil’s economic volatility is caused by well-known factors:

  • Chronic low savings and high current account deficits financed by fickle foreign capital flows.
  • Exports dominated by commodities, and the current account highly impacted by commodity prices. High commodity prices improve the current account which lowers country risk premia and leads to higher foreign financial and investment When commodity prices fall, the process unwinds.
  • Pro-cyclical currency valuation. The currency appreciates during good times and weakens during busts. During currency appreciations manufacturers lose export competitiveness and focus on growing domestic consumption.
  • Monetary policies dictated by the U.S. Fed. The deep recession of 1981-83 was triggered by U.S. Fed Volcker’s high interest rates imposed to wage his war on inflation. The boom of the last decade was fueled by Fed-fueled global liquidity.
  • Pro-cyclical fiscal and monetary policies; fiscal expansion during booms and retraction during busts. During the current deep recession in Brazil, the authorities have both increased real interest rates and tightened fiscal spending.
  • Chronic fiscal imbalances cause uncertainty and high country risk premia.

The current boom-bust cycle has been particularly destructive for Brazil. The china-induced commodity boom caused excessive currency appreciation, a credit-fueled consumption surge and severe deindustrialization.  In sharp contrast to successful Asian economies that have promoted the exports of manufactured goods, Brazil has evolved prematurely into a service economy. 76% of jobs in the Brazilian economy are now generated by the service sector, and the great majority of these jobs are low-skill, low wage jobs. Manufacturing’s share of GDP has fallen from 34% in 1980 to 10% in 2015, and Brazil has become increasingly dependent on commodity exports.

Brazil’s Central Bank has pursued inflation-targeting, the latest fashion for global monetary authorities, with abandon. During the past decade and especially the past three years of deep recession, Brazil has consistently had the highest real interest rates in the world. The famous dictum voiced by former Finance Minister Mario Henrique Simonsen  — “A inflação incomoda, mas o câmbio mata (Inflation bothers but the foreign exchange rate kills.“ ) has been entirely forgotten.

How can Brazil avoid boom-bust cycles in the future? As Arbache and Sarquis state in their paper, given Brazil’s history it is better to aim to grow in a stable and sustained manner than to seek high rates of growth. Solving chronic fiscal and foreign account imbalances are at the center of any reduction in volatility. On the foreign account side, it would be imperative for Brazil to maintain a competitive currency to promote domestic manufacturing and gradually diversify from commodities.

However, Brazil’s poor economic performance is only partially explained by volatility. More importantly, Brazil does poorly in human capital development and in providing a good environment for business. Steady improvement in both these areas would boost sustainable growth. Unfortunately, Brazil has shown no progress in these areas. Its ranking in the United Nations Human Development Index has fallen from 69 to 79 over the past 15 years. Ditto for the World Bank’s Doing Business survey which ranks countries in terms of the quality of the regulatory and institutional framework for business and where Brazil has shown no progress whatsoever.  Brazil ranks a miserable 123rd on the list, lower than 119 in 2006, and the worst performing of the major emerging markets except for India.

 

Us Fed watch:

Brazil Watch :

India Watch :

China Watch:

  • Beijing’s New Airport (Caixing)
  • Xi Jinping’s War on Financial Crocodiles (FT)

China Technology Watch:

  • China aims to be a leader in 5G  technology (WIC)
  • China Shows off New Generation of High-Speed Trains (Caixin)
  • CRRC Wins Train Supply Deal in Montreal (Caixin)
  • Chinese Phones Take over Indian Market (SCMP)

China Consumer Watch:

  • China’s aging (Bloomberg)
  • P&G Refocuses Strategy on Premiumisation ( SCMP)

Eastern Europe Watch:

Poland is breaking out of the Middle-Income Trap (NY Times)

Commodity Watch:

  • Oil’s Game of Chicken; Can OPEC Finally Bankrupt U.S. Production (Seeking Alpha)
  • Will U.S. Drillers Drive Oil Prices Into the Ground (Fed Up)
  • Temasek on Chinese Overinvestment (CNBC.com)
  •  China’s Steel Overcapacity (Peterson Institute)

Technology Disruption Watch:

Anti-Globalization Watch:

Emerging Markets Investor Watch:

Notable Blogs:

Notable Quotes:

“The biggest unknowable is that you have the illusion of liquidity. You have people who promise overnight liquidity that have taken quite illiquid positions, particularly lending to various entities. As long as the party continues that’s fine, but should this liquidity be tested it’s not going to be as deep as people think.” – Mohamed El-Erian

“When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.” (Bob Rodriguez – We are witnessing the development of a “perfect storm”(seeking alpha)

“Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepte theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.” (Robert Schiller)