Author: jvande

Emerging market stocks have persistently underperformed the S&P 500 for the past decade, leading to renewed faith in American exceptionalism and consistent international flows into the perceived soundness and reliability of U.S. assets. Nevertheless, if we look at the data, we can conclude that there are good reasons for the run in U.S. stocks but also evidence to believe it will not last for ever.

The performance of EM stocks relative to the S&P 500 can be seen as a tale of two decades. As the chart below shows, EM stocks dominated for the first ten years while the S&P 500 won handily in the second decade, through June 2023.

Most of this performance can be explained by  changes in valuation as measured by price-earnings and CAPE ratios (CAPE, cyclically adjusted PE), as shown below.  U.S. ratios started high in 2002 and fell during the next decade and then rebounded in the 2012-2023 period. The exact opposite occurred for EM:  ratios were at very low levels in 2012, rose during the decade and now have fallen back to low levels.

The chart below digs deeper to further explain the disparate performances of EM and S&P 500 stocks over the past two decades, by showing annualized earnings growth and currency effects for both assets. The chart breaks down annualized index performance for both decades in terms of earnings and PE multiple expansion, and also provides the contribution from currency exchange  rate movements for emerging markets. The S&P suffered from significant multiple contraction in the first decade and benefited from a large multiple expansion in the second decade. EM benefitted from strong earnings growth boosted by currency appreciation in the first decade and suffered from negative earnings growth pushed down by  currency depreciation in the second decade. CAPE ratio for the S&P 500 fell slightly between 2002 and  2012 and then expanded massively in the second decade, while CAPE ratios for EM rose sharply between 2002 and 2012 and then collapsed from 2012 to 2023.

The drivers of S&P relative performance over the past decade have been primarily multiple expansion and dollar appreciations, two factors that have proven to be cyclical in the past and highly prone to reversion.

We can also point to other extraordinary events that have provided a one- time boost to the S&P 500 index.   Recent work from Michael Smolyansky at the Federal Reserve ((link) and Minje Kwun at Verdad Capital (link)  highlight the importance that reductions in corporate taxes and low interest rates have had in driving earnings growth over the past decade. The chart below shows the remarkably favorable circumstances that American corporations have had since the late 1980s, and the sharp fall in interest rates and taxes over the 2012-2022 period. The recent rise in interest rates and the prospect of rising U.S. debt and fiscal deficits point to a cyclical reversion of these trends in the coming decade.

None of the factors boosting U.S. stocks have benefitted emerging market stocks over the past ten years, which may leave EM stocks better positioned to outperform.

During my freshman year in college in 1976, I took a class on development of the “Third World” which highlighted Brazil’s “economic miracle” and its rise as a leading economic power. That same year, the renowned MIT economic historian Charles Kindleberger, mulling over what country might assume global leadership from a waning United States, suggested Germany, Japan “or some country of energy and wealth, like Brazil, which has yet to make its presence felt on the world scene.”

By the early 1980s, Japan was considered by many to be the most dynamic economy in the world and on the way to surpassing the U.S.  This “miracle” economy was accompanied by a huge asset bubble, with real estate prices in Tokyo peaking in 1989 at 300 times the level of equivalent space in Manhattan.

China, the latest “economic miracle,” is now expected to become the largest economy in the world by the middle of this decade. The debates of the 1970s on global leadership have resurfaced, as the U.S.  shows signs of fatigue from shouldering the burdens of a benevolent hegemon, and China aims to reshape the world economic order into something new.

However, history shows us that economic “miracles” end in excesses of debt and speculation, and are followed by long periods of stagnation.  The Brazilian and Japanese booms are distant memories, and these economies have struggled to work out the large imbalances built up during the good years.  China’s rise also came with massive debt accumulation and an enormous real estate bubble, and it too faces a difficult transition.

At least, this is the view of the Beijing-based economist Michael Pettis, a Professor at Peking University’s Guanghua School of Management, and a keen observer of China’s developmental challenges. Pettis argues that China’s economic miracle peaked many years ago, and the drivers of growth – labor growth, investment, and exports – are now all severely constrained. Given its level of development and these constraints, Pettis argues, China now should promote consumption to sustain growth, but this path is blocked by vested interests (the beneficiaries of the previous model: provincial governments, exporters, business elites). Pettis sees a clear parallel with what has happened in Brazil and Japan, where reactionary political, business, and financial elites blocked the reforms necessary to secure sustained economic expansion.

The imbalances of China are well known and long dated. Early in 2007, Wen Jiabao (溫家寶), premier of China at the time, declared that the country’s economic growth trajectory was “unstable, unbalanced, uncoordinated and unsustainable.” Since Wen Jiabao expressed his concern, China’s debt to GDP ratio has doubled, and the real estate sector’s share of GDP grew by 50% to unprecedented heights. We can see the rise in debt levels in the chart below from the Bank for International Settlements. Given that most economist believe that China’s GDP is overstated by at least 20%, actual debt ratios may be considerably higher.

The following chart from  Rogoff and Yang (2020) shows the disproportionate share of China’s GDP related to real estate, surpassing greatly the levels reached in other countries affected by real estate bubbles.

The Chinese “economic miracle,” Pettis argues, petered out over a decade ago as productivity growth and returns on investment collapsed. GDP growth has slowed sharply, and the quality of that growth is dubious, as it comes increasingly from unproductive investments related to infrastructure and real estate. We can see this in the three charts below. The first shows the path of GDP growth, both based on official data and on the basis of an alternative methodology which aims to align China’s numbers with those of other countries. The second and third chart  show the composition of that growth for both GDP data sets. Over the past ten years, GDP growth has been cut by more than half, from the low teens to below 5%.  Meanwhile, the quality of the growth has deteriorated dramatically, coming now primarily from investment capital instead of labor growth and productivity. We can see this deterioration more starkly in the alternative data. This data comes from The Conference Board and has been developed in a partnership with the Groningen Growth and Development Centre (University of Groningen, The Netherlands) (Link).

China’s over-dependence on capital investment is in line with the experience of other Asian “tiger” economies, as described by Paul Krugman in his 1994 article “The Myth of Asia’s Miracle.” Both the Brazilian “miracle” of the 1960s and 1970s and the Japanese “miracle” of the 1980s followed a similar pattern of investment-led growth hitting a wall when returns on capital declined and debt levels reached high levels.

The Brazilian Miracle

 Brazil experienced very high growth from the 1950s to the end of the 1970s. Much of the growth in the 1950s was driven by multinational firms bringing mass production manufacturing to the country, in a process very similar to what China went through in the 1990s and 2000s. Mature technologies and business models were easily assimilated and had the advantage of being highly labor intensive. In the 1960s, more FDI came to meet Brazil’s growing consumer market, and “Asian-like” public policies were introduced to promote domestic savings and investment. During the 1970s, Brazil, benefited from a commodity boom but debt levels rose sharply (especially external debt), and investment quality and returns plummeted (increasingly pharaonic projects, roads to nowhere, as in China). The boom came to an end in 1980, and since then Brazil has stagnated, achieving growth of GDP 2.1% per year and GDP per capita growth of 0.8% annually. The mass production paradigm that benefitted Brazil so much in the 1960s and 1970s was exhausted by 1980. Since then, Brazil has been unable to grow its consumer market, leading MNCs to focus on better opportunities elsewhere (Asia, Mexico). Brazil became the poster-child for the “middle-income trap” – a middle-income economy unable to build the institutions required to sustain growth.

The first chart shows the path of GDP growth, and the second shows the enormous debt accumulation and fiscal deficits towards the end of the “miracle” in the 1970s. The third chart shows the composition of growth from 1952-2023. Remarkably, total factor productivity declined from 1.6% annually between 1952 and 1979) to negative 0.9% annually from 1980 to 2023. TFP declined sharply in the second half of the 1970s as investment-led growth lost traction.  Since 1980, Brazil has deindustrialized dramatically, and today the economy has returned to the commodity-dependence levels experienced before the industrialization process took off in the early 1950s.

Japan’s “Economic Miracle”

Japan enjoyed very high GDP growth during the 1950s and 1960s. This growth was briefly interrupted by the 1973 oil crisis, but then resumed in the second half of the 1970s and into the 1980s. This later phase of growth was characterized by real estate and stock market speculative bubbles. The asset bubble popped in 1989, and since then annual GDP growth has averaged 0.9%.

The chart below shows the contribution of labor, capital, and total factor productivity to Japan’s GDP growth. We can see broad contributions from all these factors from the 1950s until 1989, with a sharp increase of reliance on capital in the 1980s. As in Brazil in the 1970s and China over the past decade, declining returns on capital during the 1980s asset speculative boom marked the end of the Japanese miracle. From 1951 to 1989 TFP contributed 2.4% to annual GDP growth, but from 1990 until 2023, this contribution has been -0.9% annually.

Conclusion

Unfortunately, “economic miracles” are more chimerical than miraculous. This is most true in the last phase of the boom when excesses and speculation generate mainly malinvestment.

The post-boom periods tend to be painful and drawn-out because the beneficiaries of the past resist the reforms necessary to achieve a rapid transition to a more sustainable growth model. The U.S came out of the Great Recession of the 1930s because radical “anti-elite” measures implemented by President Roosevelt became consensual in the post-war boom. Brazil’s political and financial elites have resisted the reforms needed to improve income distribution and create a broader consumer market. The political process in Japan also has failed to change the investment and export-focused economic model. China appears to be following Japan’s example, as it continues to focus on the exhausted drivers of past growth instead of actively pushing for policies that would build the purchasing power of households in a consumption-driven economy.

As the world moves away from the globalization of manufacturing value chains and finance, the protection of domestic markets is back in favor with policy makers. However, the new mercantilists will have to overcome high costs, including overvalued currencies.

The case of TSMC’s investment in a new $40 BB semiconductor  plant is illustrative. The Taiwanese chipmaker gave in to pressure from the Biden Administration  and agreed to build a “fab’ in Arizona, but it does not seem to be happy about it. Recent press reports say the Taiwanese chipmaker’s management is dismayed by “exorbitant costs and unmanageable workers.”

TSMC’s preference for manufacturing at home is not surprising. Taiwan is a model of successful mercantilist policies (repression of wages, directed credit and competitive currency) that create a haven for manufacturing exports. Taiwan, and other Asian “tigers”, have carefully managed their currencies to assure export competitiveness. The U.S., on the other hand, has long favored consumers over manufacturers, and has an overvalued currency, which serves as the safe haven asset for the rest of the world.

We can see the challenges faced by the new mercantilists by looking at relative exchange rates. Below, we shows the Big Mac Index rankings and Real Effective Exchange rates. The Economist’s Big Mac index is a good measure of the overall cost for  businesses to operate in an economy, as the product being compared incorporates farm, manufacturing, and services, including taxes and regulations. Countries with an established vocation for manufacturing exports are labeled in green, while commodity producers that rely more on imports are labeled in bold black. The chart compares three data points — today, 2020 pre-covid and 2010. We can see that across these periods exporters have cheap Big Macs and importers have expensive Big Macs. There are some exceptions for importers, explained by excessive political instability and capital flight (South Africa, Argentina in 2010, Peru and Brazil in 2023).

Brazil and the United States, two countries now enthusiastically pursuing neo-mercantilist agendas, are interesting and similar cases. They both are  countries that have severely deindustrialized, while at the same time expanding energy production aggressively. Both went from large importers of oil to self-sufficient since 2010, which, all else being equal, means  stronger currencies. The implication is that neo-mercantilist policies will be pursued at a high cost, without the luxury of a weak currency.

Real Effective Exchange Rates (REER) tell the same story. The exporters are all close or below long-term averages, with Thailand the possible exception. Vietnam is an interesting case of an aspiring Asian “Tiger” that may be undermined by an appreciating currency, the result of diplomatic pressure from the U.S.

The irony is that commodity prices are likely to remain high in the 2020s because of a more inflationary environment and production bottlenecks. This would mean stronger currencies for commodity producers and even higher costs to implement reindustrialization policies. The “commodity curse” is difficult to shed.

After a brutal decade for emerging markets stocks marked by poor absolute returns and dismal performance relative to the S&P 500, it is timely to review how the asset class fits into a global allocation process.

Any investor in emerging market bonds or stocks, unless he or she is a dedicated portfolio manager with a mandate to outperform an EM index on a short term basis (1-3years), should operate under the following assumptions.

1.“Buy-and-hold” does not work in EM.

2. Risk always trumps valuation in EM stocks and bonds.

3. EM stocks are liquidity-driven trending assets.

4. The U.S. dollar drives returns and is negatively correlated to EM stocks and bonds.

The first premise – “Buy-and-hold” does not work in EM – is derived from the other premises. Emerging markets are too subject to “sudden stops” of liquidity to provide reliable returns for investors over meaningful periods, say over a decade. Empirical evidence clearly guides investors to avoid “sudden stops” by focusing more on risk than on valuation. Risky market conditions, measured by macro vulnerability (debt, deficits, overvalued currencies), domestic politics and geopolitics (e.g., Russia), will almost always trump low valuations. Low valuations and low risk provide the best conditions, but you are better off owning expensive stocks in a low-risk country than cheap stocks in a risky country. Of course investors tend to do the opposite,  as we last saw in 2008-2012 when EM bulls courted disaster by buying extreme valuations at a time of extreme risk.

If buy-and-hold is a losing strategy, the question is how to time allocation exposure to EM markets. The answer lies in premise three and four. History shows us that EM assets are trending assets, and this is for good reasons. Therefore the job of the allocator is to identify the trends and ride them  until they exhaust themselves. The first chart below shows the performance of the MSCI EM stock index relative to the S&P 500  over its 35-year history. We can clearly see two periods when allocations to EM stocks paid off handsomely for investors: 1987-1994 and 2001-2012. Unfortunately, all this relative outperformance was wiped out in the past ten years. The second chart, from BOFA’s recent 2023 Market Outlook, shows the relative performance over a much longer 72-year period. Though it is problematic to come up with a realistic EM index over this period, BOFA’s data shows a third massive cycle of outperformance for EM stocks lasting from 1970-1980.

There are two fundamental causes behind these long trends: valuations and the U.S. dollar. Three of the peaks in U.S. performance (1970, 2000, 2022) are characterized by very high valuations in the U.S. (the Nifty Fifty bubble in 1970, the TMT bubble in 2000 and the Everything Bubble of 2022) and an overvalued dollar. All the periods of EM outperformance start with low relative valuations and an expensive dollar. This insight is confirmed by the DXY dollar index, shown in the next chart. Every spike in the DXY (dollar strength) is accompanied by strong relative performance of U.S. assets.

This relationship between the USD and EM stocks is further illustrated in the chart below. We can see the obvious negative correlation between EM stock prices and the DXY.

Another chart from the BOFA 2023 Outlook points to another fundamental correlation with important consequences for EM investing. This chart shows how growth stocks (tech and healthcare ) are negatively correlated to value/cyclical stocks (energy and financials).

This is a critical insight with important implication for EM allocation. EM stocks can be considered value stocks with a dominance of cyclical exposure in commodities and industrials.

We can see this insight confirmed by the chart below which shows the correlation between the S&P Industrial Metals Index (GSCI) and the DXY. The chart looks almost the same as the chart above that showed the relationship between EM stocks and the DXY.

As we can deduce from the following chart, EM stocks are a leveraged play on the prices of industrial metals.

This relationship leads to a further important insight for EM allocation. On both a global or a country basis, the simplest and most cost-effective manner to gain exposure to EM stocks is through commodity stocks. This is shown in the next two charts, which show first the performance of mining companies relative to the EM index and the performance of Vale relative to the Brazilian index. These stocks outperform massively on the uptrend and underperform on the downtrend.

Therefore, for a global allocator investing in emerging markets can be simplified to owning blue-chip mining firms during upcycles and unloading them when the cycle turns. However, we still have to identify the cycles. To do this the allocator must follow the trends and valuations.

A simple method to gauge the condition of the long-term trend is to look at the one-year relative performance of the S&P 500 relative to EM stocks and the U.S. dollar relative to other currencies.

The chart below shows that the S&P 500 continued to outperform EM stocks (with and without China) over the past year.

The DXY also is still in an upward trend on a 1-year, 3-year and 5-year basis, as shown below.

Valuation is also an important element in determining turning points. We know that U.S. stocks and the U.S. dollar both are very expensive relative to history. As shown below, we also can be confident that EM stocks are cheap relative to their own histories and compared to U.S. stocks.

A sign that a new trend may be forming is that value, cyclicals and the cheapest EM stocks (e.g., Turkey) all have been outperforming this year, while U.S. tech is faltering.

“A second marriage is the triumph of hope over experience.” Samuel Johnson

Brazilian voters have the sorry task of choosing between two deeply flawed political figures in a runoff presidential election on October 30. The frustration is increased in that the two candidates already have proven their incompetence for the job, so the choice can only be grounded in hope over experience.

The alternative is between Luiz Inacio Lula da Silva, the caudillo who has run the Workers Party (PT) for decades, including a 14-year stretch (2002-2016) marked by rampant corruption, and Jair Bolsonaro, a right-wing evangelical populist with a truculent manner, an unsavory environmental record, and a deep nostalgia for the “order and progress” of military dictatorship (1964-1985). Most voters are motivated by fear and rancor and resigned to choosing the least-worse option; either “a corrupt thief” (Lula) or “a genocidal fascist” (Bolsonaro), as the candidates defined each other in a recent public debate.

The political, media and business elites in Brazil mainly have sided with Lula, if with a pronounced lack of enthusiasm. The rationale is that Lula is “more democratic,” though this overlooks his fervent admiration of Cuba’s Castros and other Latin American dictators and his antagonism towards Brazil’s vibrant free press.   Bolsonaro is lambasted for adulating Trump and siding with right-wing strong-men around the world. Bolsonaro also is accused of plotting to bring back a military dictatorship to Brazil, though there is no evidence that the military would countenance this unless social order declined precipitously, and the middle classes took to the streets clamoring for an intervention.

Lula’s key campaign promise is that he will bring back the consumption boom experienced during his presidency (2002-2010) which resulted from a surge in commodity prices and a massive positive terms-of-trade shock. This was a period of prosperity when purchasing power expanded greatly for low-skill workers and investment bankers alike. As Lula tirelessly repeats: “They know that never in the history of this country they made so much money as when I was president. Bankers made money, businessmen made money, farmers made money.”

However, Lula grossly mismanaged the commodity boom, and it was followed by a severe case of “Dutch Disease’ (the natural resource curse) from which Brazil still has not recovered.

“Dutch Disease,” named after the economic instability caused by the discovery of gas fields in the Netherlands in the 1960s, is well documented, and responsible natural resource producers (e.g., Norway, UAE) have learned to avoid it by taking preventive measures e.g., offshore sovereign funds.  The discovery of the huge pre-salt offshore deposits by Petrobras in 2005 and the China-induced commodity super-cycle (2002-2012) caused a massive terms-of-trade shock for Brazil.  Unfortunately, Lula fell right into the trap, and Brazil followed the classic course of Dutch Disease as outlined by academics.

1. Currency overvaluation, resulting in the decline of the trade sector and deindustrialization, followed by devaluation.
2. A credit-fueled consumption boom, followed by lower growth and reduced living standards.
3. Monetary expansion and asset bubbles followed by crashes.
4. Increase in corruption and rent seeking, undermining confidence in judicial and political institutions.

Corruption scandals marred the 14 years of PT rule. Moreover, Lula undid important administrative and economic reforms that had been achieved under his predecessor, Fernando Henrique Cardoso.

 Since the end of the PT’s rule in 2016, Brazil’s economy has been in a depressionary state. But slowly the foundations of growth have been restored by competent monetary and fiscal policies and a series of important reforms. These include pension, labor and bankruptcy law reforms, and laws setting a ceiling on fiscal spending, guaranteeing Central Bank Independence and for the regulation of water and sewage utilities. Since 2016, Brazil has also seen its most important wave of privatizations since the 1990s. This includes the spectacular privatization of Eletrobras, the national electricity utility, which for decades had been a bountiful source of graft for politicians. Next on the list of privatizations is Petrobras, which was at the core of the corruption scandals of the PT years. These reforms aim to make the economy more competitive and productive. Lula opposes them all and aims to overturn them.

The choice is a tortuous one for the Brazilian voter. If character is the determining factor, many will stay home or nullify their votes. If voters understand the benefits that may accrue from the current course of economic reforms, the choice may be easier.

Emerging market stocks have continued to underperform the S&P500 over the past year and the past quarter,  as global capital flows to the safety of U.S. assets in a world of rising economic instability and risk aversion. However, below the surface  interesting trends are emerging that point to better days ahead.

After a decade of poor returns, value investing (contrarian investing in cheap stocks in cyclical industries with little growth) is working again in emerging markets. The MSCI EM value index has outperformed the MSCI EM core index by 3% over the year, and, more importantly, the cheapest countries in the EM index are now by far the best performers. This is in stark contrast to the past five years when cheap only became cheaper and rich only became richer.  We can see this in the chart below which shows the performance of the four cheapest markets in EM relative to the MSCI EM index. Turkey (TUR), Brazil  (EWZ) and Chile (ECH) have beaten the EM index by huge margins over this period.  Colombia (GXG), which recently elected a leftist anti-business president, has still managed to perform in line with the market.

This trend should boost the confidence of EM investors. Emerging markets are by nature a value asset (highly weighted to cyclical businesses) and should not be performing well in an environment of rising risk aversion.  But investors are now betting that these markets are too cheap to avoid because low valuations promise high expected returns that more than compensate short-term risks.

The chart below shows the current expected returns for EM markets and for the S&P500 based on a CAPE ratio analysis. The Cyclically Adjusted Price Earnings Ratio (CAPE)  takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful tool for highly cyclical assets like EM stocks.  We use dollarized data to capture currency trends. This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University.

As we have seen in recent years, CAPE is not a good timing tool, but it does tend to work well over time, particularly at extreme valuations.  CAPEs below five, such as Turkey today, have historically been a failsafe indicator of high future returns. CAPE ratios that are completely out of sync with historical averages for the country are also powerful predictors of future returns. Aside from Turkey, Colombia, Philippines and Korea look very cheap on this basis. On the other hand, India , the most popular market with investors today, is an absolute outlier on the expensive side.

That cheap markets are now performing well in a risky environment is very encouraging for EM investors. If value continues to do well, EM stocks will likely do very well when the coming synchronized global and U.S. recessions  hit bottom.