Category: Global Emerging Markets

The Energy Transition in Emerging Markets. Part 2

 

Assuming current trends, the global annual growth rate of consumption of primary energy will nearly double this coming decade to 1.9%, compared to 1% over the past decade. This is solely because the slow-growing economies of the OECD, with high levels of per capita energy consumption but stagnant or declining growth in demand, are being supplanted by higher-growing emerging economies with very low per capita consumption levels.

A similar scenario can be painted for the growth of oil liquids oil and gas consumption. Since 2013, the emerging world, led by China and India, has consumed more oil and gas than the OECD countries. As shown in the chart below based on data from the Energy Institute Statistical Review, in 2022, non-OECD economies consumed 53% of global oil and gas production. Based on current trends,  this will reach nearly 60% over the next decade. Total demand for oil liquids can be expected to grow by 12 million barrels/day over the next decade to 112.5 million b/d. All of this increase will come from non-OECD economies, led by India, China, and Africa.

 

The transition to new forms of energy has always been slow and arduous, with the innovative fuel taking share by capturing marginal demand increases. We can see this in the chart below from Our World In Data. In all these transitions, the early adopters were the richest countries. Important transition fuels like hydropower and nuclear have stagnated because of high costs of adoption and political barriers. The same is happening today with coal and oil demand continuing to rise in developing countries where renewables are a costly alternative compared to coal and oil.

The scenario for coal consumption is worrisome, if CO2 emissions are the concern. Non-OECD countries already represent 82% of coal consumption. For leading consumers, China, India, and Indonesia, coal is by far the most abundant and cheapest fuel for generating electricity, and annual consumption is expected to continue growing at the trend of the past decade, 0.9%, 4%, and 9%, respectively.

The transition to green fuels in emerging countries is made difficult by the political commitment to industrialization. While in developed countries, about a third of primary energy consumption is committed to electricity generation and more room exists to substitute electricity for transportation and residential purposes, in Asia and the Middle-East, industry, much of it fueled by oil liquids, makes up half of primary demand. For example, India, following the path of China and the petro-states of the Middle-East, is becoming a major global player in petrochemicals, using Russian and Persian Gulf feedstocks.

The difficulty of reducing CO2 emissions to address concerns with global warming can be illustrated by the example of the United States. Despite conservation efforts and the deployment of wind and solar, the consumption of liquid hydrocarbons has grown its share of U.S. primary energy consumption over the past decade and is at the same level as in 1980. This is because gas has replaced coal for generating electricity. In terms of “clean” energies, nuclear output has been frozen since the mid-1990s while renewables have doubled their share to 13.5% since 2000. This evolution is shown in the chart below.

The exceptionally low cost of gas in the US and the low cost of capital, particularly over the past 15 years, has enabled a relatively smooth and affordable transition to cleaner fuels. Unfortunately, other countries don’t have this luxury. Except for France, which has embraced nuclear, in Europe, the transition is proving exceedingly costly and further undermining competitiveness. After decades of complacency, the cost of “green” politics has now become a big political issue in Germany.

Though China is highly committed to nuclear, it generates only 3% of its energy demand from this source. Also, despite massive political support for renewables, it meets only 13% of its demand from solar and wind, about the same as the US.

Other emerging markets do not have the financial or organizational capacity to follow China’s path because of much higher capital costs and the lack of local suppliers. These countries will find the transition to renewables prohibitively expensive unless prices for solar generation fall much further or the rich countries of the world hand out massive subsidies.

 

3Q 2023 Expected Returns for Emerging Market Stocks

Emerging market stocks are once again proving to be disappointing in 2023 due to increasing risk aversion. Geopolitical and domestic political factors, along with a strengthening dollar, are causing investors to seek the safety of U.S. blue-chip stocks and cash. Rising interest rates, concerns about a global recession, and weak earnings in many countries are all contributing to bleak short-term prospects. Investors can only find comfort in the expectation of longer-term returns.

The chart below illustrates the current expected returns for EM markets and the S&P500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings Ratio (CAPE) is calculated using the average of inflation-adjusted earnings for the past ten years, which helps to smooth out earnings’ cyclicality. This tool is particularly useful for highly cyclical assets like EM stocks and has a long history of use among investors, gaining popularity through Professor Robert Shiller at Yale University. We employ dollarized data to capture currency trends. The seven-year expected returns are calculated assuming that each country’s CAPE ratio will revert to its historical average over the period. Earnings are adjusted according to each country’s current position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (IMF WEO, October 2023).

As expected, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those considered “expensive” with CAPE ratios above their historical average. These expected returns are based on two significant assumptions: first, that the current level of CAPE relative to the historical level is not justified; second, that market forces will correct the current discrepancy.

Historical data strongly supports the second assumption when considering seven-to-ten-year periods but not in the short term (one to three years).

Nevertheless, during certain periods when “cheap” markets on a CAPE basis exhibit short-term outperformance, investors should take note, as the combination of value and momentum can be compelling. As shown in the chart below, we are currently in such a period. Over the past twelve months, holding the “cheapest markets” has generated alpha in an EM portfolio. Although Turkey is no longer “cheap,” it was clearly so a year ago and continues to enjoy that momentum. Nearly all the better performers are inexpensive markets. The one exception is India, which, despite very high valuations, continues to attract flows from investors enamored with EM’s “last growth story.” Chile is also an obvious anomaly, as it should be delivering better returns. It is very cheap relative to its history and, being the world’s leading copper producer, offers an excellent hedge against inflation.

The fact that cheap markets are now performing well is encouraging for EM investors. However, rising geopolitical tension and slow growth do not create a conducive investment environment. As always, a strengthening dollar signals the need to stay invested in dollar-denominated quality assets.

 

 

Emerging Markets Have An Earnings Problem

The past decade has been a disaster for investors in emerging markets because nominal earnings measured in dollars have not grown.

There are several reasons for this earnings stall:

First, the past 11 years have been a period of dollar appreciation. Due to its broad global use in invoicing and financing commercial flows, a strengthening dollar has had a depressing impact on most developing countries. Moreover, as typically occurs, a strong dollar has meant weak commodity prices and poor results for commodity producers (Latin America, Russia, South Africa, etc.).

Second, the fall in earnings and investor returns can be seen as a bearish cyclical adjustment after the prior decade of plenty. The weak dollar and commodity boom of the 2002-2012 decade provided outsized results for emerging markets, which were given back over the next ten years.

Third, profitless China has weighed down the asset class. China’s capital-intensive state-run economy has resulted in very low returns on capital and persistent dilution of investors in the stock market. This was a minor issue in 2000 when China was only a small part of the EM stock indices but became a huge burden over the past decade when Chinese stocks came to dominate the indices. The brief tech boom in China (e.g., Alibaba, Tencent, massive foreign private equity inflows) changed the perceptions of investors until it was crashed by Xi’s crackdown on the companies for their “socially destructive” behavior.

The following charts illustrate the evolution of nominal dollarized earnings over time for emerging market stocks. The first chart shows earnings data for the primary EM countries and the S&P 500 during the modern era heralded by the introduction of the MSCI EM index in 1986, including estimates for 2024. Over this long period, Mexico leads by a considerable margin, while India and Taiwan are neck-and-neck with the S&P 500. Before the S&P 500’s recent spurt (2020-2023), earnings growth in EM was broadly in line with the S&P 500.

The next chart shows earnings data starting in 1992 when China was included in the MSCI EM Index. Remarkably, China’s earnings in 2023 are below the level of 1992. Brazil leads the pack over this period, with the characteristic extreme cyclicality of commodity dependence, surging during the commodity supercycle (2002-2012), tanking during the commodity collapse (2012-2016), and recovering with the bounce in commodity prices starting in 2016. India stands out as the star performer over this period, as it has provided high earnings growth without the volatility of commodity producers. Also, unlike the capital-intensive, export-oriented businesses of China, Korea, and Taiwan, India’s mogul-controlled corporates enjoy strong market power, allowing for high and consistent returns. The S&P 500 experienced enormous volatility over this period marked by the combination of financialization of the Information and Communications Technology (ICT) cycle and monetary adventurism: two bubbles (tech, 1999-2001; real estate, 2003-2007), followed by crashes; an increasingly activist Federal Reserve, resulting in 15 years of negative real interest rates. Nevertheless, the enormously profitable tech giants supported the S&P 500.

The last chart shows the period after the Great Financial Crisis (GFC), 2010-2024. The post-GFC is characterized by “secular stagnation,” a period of low growth and low inflation which was met by the Federal Reserve with policies last seen in the Great Depression of the 1930s: massive money printing, negative interest rates (financial repression), and increasingly large interventions to support asset prices. This period also saw a persistent appreciation of the USD. The clear leader over this period has been the S&P 500, propelled not only by the rising USD but also by the remarkable expansion of profit margins for the monopolistic tech giants (FAANG) which saw profit margins rise from around 10% to the current 25%. Since 2019, earnings in both Taiwan and Mexico have recovered because of stellar results from TSMC in the former and a strengthening of the peso in the latter. Weighed down by China, EM nominal earnings have fallen over this long period. These years have been equally bad for commodity producers (low prices) and East Asian exporters (rising operating and financing costs and brutal competition from China). Even India, with its high GDP growth and booming asset prices, has seen no earnings growth over this period.

 

 

 

 

Chinese Auto Exports Threaten the Auto Industry Worldwide

Benefiting from technology transfers from multinationals and massive government subsidies, China has made itself the dominant force in the automotive industry over the past two decades. It has achieved this supremacy at a time when the industry is undergoing the most significant technological shift in 70 years: the transition from the internal combustion engine (ICE) to the electric motor. China had the foresight to anticipate this transition and leapfrog to the forefront of EV (Electric Vehicle) technology by harnessing subsidies and private capital. However, given the current reality of global geopolitical conflict and economic stagnation, China’s dominance of this critical industry may increasingly be seen by many countries as an unacceptable strategic and security threat.

Since the launch of Ford’s Model T in 1908, the automobile industry has been at the forefront of mass production manufacturing. By the 1950s, when the industry reached its peak impact on the American economy, the industry’s core technologies had been developed, and it entered its maturity stage. Since 1960, auto manufacturing has barely grown in the U.S., and the leading firms in the industry focused on disseminating their mass production skills around the world, a process that culminated with major multinational auto companies setting up plants in China between 1984 and 2004.

The chart below shows the auto industry’s annual growth rate since the 1950s. Global growth peaked in the 1960s, driven by Europe, Japan, and Latin America, and then has fallen every decade, except during the 2000s because of the precipitous rise in Chinese domestic demand. Growth for the twelve-year period ending in 2022 has been at a record-low 0.8% annually, despite a 50% increase in China’s output. U.S. production growth stalled much earlier, already in the 1950s, and only recovered in the 1980s and 1990s because protectionist policies were introduced to force foreign firms to make their cars in the U.S. There has been no increase in U.S. output since 1990.

The decline of the U.S. as a manufacturer of motor vehicles and the rise of China can be seen in the following chart (source: OICA, International Organization of Motor Vehicle Manufacturers). The U.S. emerged from World War II with nearly 80% of world output, was overtaken by Japan in the 1980s and 1990s, bottomed at a 10% share in 2010, and in 2022 had a 12% share. Since 1990, when the first joint-ventures with foreign firms began operating, China has grown its share of world output from 1% to 32%. The dominance of China in EV manufacturing is even more pronounced, reaching 59% of world output in 2022, compared to 19% for the United States. Germany, Japan, and South Korea followed, with shares of around 10%, 8%, and 6%, respectively (Canalys).

The following two charts show emerging market producers: first, mature players (Mexico, Brazil, Korea); and second, newcomers still enjoying growth (India, Indonesia, Thailand, Turkey, and Eastern Europe). Brazil’s share of global output peaked in 2010 but is now below 1980 levels. Mexico, despite NAFTA, is back to the level of 1990. Korea is also losing global share. In the case of countries growing their share of the global automotive pie, India and Eastern Europe stand out. Indian manufacturers benefit from trade protectionism (70% tariffs) and rapid economic growth. Eastern Europe has taken advantage of favorable EEU (Eurasian Economic Union) policies allowing firms to move production to places with lower wages.

The Market’s Reaction to the Inception of Chinese Vehicle Exports

The slowdown of China’s economy and low consumer confidence, combined with sustained investment in new production capacity, has caused excess manufacturing capacity and a surge in Chinese motor vehicle exports over the past two years. According to the China Association of Automobile Manufacturers, domestic sales of ICE (Internal Combustion Engine) vehicles peaked at 2.4 million monthly in 2018 and are now running at a monthly rate of 1.6 million, 36% lower. Exports of ICE cars have surged and are expected to reach 3.2 million units in 2023, an increase of 45% over 2022 levels. EV exports may reach 1 million units this year, a 60% increase. Remarkably, in three years, China has gone from almost no participation in auto exports to the leading position. China surpassed Korea in 2021, Germany in 2022, and long-time export leader Japan in 2023.

In the case of ICE cars, most of these exports are going to Russia, Eastern Europe, and developing countries in Asia and Latin America, undermining the competitiveness of manufacturers in those regions. EVs are mainly exported to more developed regions, such as Europe, which have high “climate change” incentives for EV sales, but this is also changing fast. For example, BYD has had enormous success exporting electrical buses to major emerging market metropolitan areas suffering from high pollution levels.

China’s increasing EV exports are creating a huge dilemma for traditional auto manufacturing countries around the world. In Europe, politicians are committed to promoting EVs but are also determined to support an important domestic industry that needs time to navigate the transition to EV technologies. This week the European Commission launched an anti-subsidy probe into EVs coming from China, aiming to protect European firms from “competitors benefiting from huge state subsidies.”

The situation today is different than in the 1980s when Japanese firms were required to build their cars in the U.S. At that time, the Japanese, a key strategic ally which had outcompeted U.S. firms with marginal improvements in manufacturing efficiency (just-in-time process) and better quality, were pressured into accepting a political concession. Today, Xi’s China is a strategic geopolitical adversary competing with “unfair” advantages and seeking dominion in a frontier technology of critical economic, social, and ecological importance.

Developing countries face, perhaps, even bigger challenges. Countries with long-established automotive industries cannot sustain competition from China’s ultra-competitive, modern, and highly subsidized auto sector, and, even in a best-case scenario, would lose regional customers in markets without the industrial base. For example, in Chile, a country that imports all of its cars, China has captured 40% of the market over the past few years. Half of the car models available for sale in Ecuador are Chinese, and these brands have captured nearly half the market since 2020. Also, China’s BYD has captured half of the bus markets of Santiago and Bogota with its electric buses over the past five years.

Moreover, any shift to EVs implies the importation of batteries and motors, which leaves only minimal value-added in final assembly. EVs also pose a mortal threat to local part suppliers that are an intrinsic part of the ICE value chain. The shift to EVs implies a transition from a mature industry with processes and technologies fully assimilated by countries like Brazil and Mexico to an industry on the technological frontier, which these countries have little hope of dominating.

 

If China’s Boom is Over, Where Will Demand for Commodities Come From?

China’s economy has experienced a multi-decade period of high growth, similar to “miracle” surges previously witnessed by other countries. Today’s wealthy nations once went through these surges as well: the U.K., the U.S., and Germany in the late 19th century; and Japan in the early 20th century and again in the 1960s. Various developing countries have also seen periods of so-called “miracle” growth, such as Brazil and Mexico in the 1960s, and Korea, Taiwan, and Malaysia since the 1970s, with China starting its own in the 1990s. A significant contributor to these periods of accelerated growth is a broad and powerful one-time build-out of physical infrastructure. This will be especially true in China, which has witnessed one of the greatest construction booms in history.

The amount of infrastructure investment undertaken by China is breathtaking. For example, Shanghai had four crossings of the Huangpu River in 1980 and now boasts 17. Shanghai did not possess a subway system in 1980, and now it encompasses over 800 kilometers of lines, making it the world’s longest. China claims eight of the top ten longest subway systems globally, with a total extension of 9,700 kilometers across 45 cities. In comparison, the U.S. has 1,400 km of subway lines in 16 cities. Since 2000, China has constructed 38,000 km of high-speed train lines, more than tripling the amount built by Europe since 1980. China’s National Trunk Highway System, primarily built over the past 20 years, now totals 160,000 km, compared to the 70,000 km of the U.S. Interstate Highway System.

China’s construction boom over the past decades can be measured by its share of the world’s production of basic building materials. For example, China consistently produced more than half of the total world cement output over the past decade, securing 56% in 2019. China also commands a similar share of the world’s steel output, reaching 57% in 2020, according to the American Iron and Steel Institute (AISI). The chart below illustrates China’s increasing share of world steel output, surpassing the level the U.S. had at the end of World War II.

The following chart displays steel output since 1950, with China’s ramp-up beginning in 2000.

Major infrastructure expansions do not need to be repeated. For instance, New York City’s infrastructure (bridges, tunnels, highways, subway system) was largely completed by the 1920s, and the bulk of the U.S. highway system was constructed between 1959 and 1972. The London Underground and the Paris Metro were built before the First World War, and France established most of Europe’s best high-speed train network between 1980 and 2000. The chart below illustrates this historical process and how it has impacted the production of steel in countries undergoing these surges in investment. Steel production surged in Europe in the late 19th century (railroads, steamboats, bridges, etc.) and again in the 1920s and 1930s (automobile infrastructure) and finally in the post-World War II “Golden Years.” The U.S. followed a similar path but also had a massive expansion of automobile infrastructure in the 1950-1970 period due to suburbanization and interstate highways. Brazil experienced an infrastructure boom in the 1960-1980 period, as did Korea in the 1970s. Invariably, these booms come to an end, and steel output plateaus, tapers, and eventually decreases.

The following table presents this data in percentage terms, with the total increase in steel output for the previous ten years. The data shows that multi-decade expansions in steel output are not uncommon: Europe and Japan (1970-1900); U.S. (1970-1940); Japan (1930-1970); Germany (1950-1980); Brazil (1950-1990); and Korea (1950-2010). China has been expanding steel output since the 1950s, which provided a high base for the mammoth expansion since 1980. India has been growing output at a swift rate even before reforms were launched in the 1980s, and it is already, with over 100 million in annual steel output, at a much higher level than China was when it started its “miracle” phase of economic growth.

Eighty-seven percent of the increase in world steel production over the past 22 years occurred in China, raising the question of which countries can pick up the slack if China’s construction boom is over. The hope is that India and emerging Southeast Asia can step up. Assuming China’s steel output remains flat, to maintain the 3.5% annual increase in global steel demand of the past twenty years, it will be necessary for India, Vietnam, Indonesia, and a few more high-growth economies to more than double their steel output every decade.

 

The Persistent Decline of Latin American Competitiveness

In a globalized world, capital will flow to the countries that provide the best conditions for businesses to operate. The IMD business school in Lausanne, Switzerland conducts a survey annually to measure how well governments  “provide an environment characterized by efficient infrastructures, institutions, and policies that encourage sustainable value creation by enterprises.” This survey is particularly significant because previous efforts by the World Bank (Doing Business) and the World Economic Forum (World Competitiveness Report) have been abandoned. The latest editition of the IMD World Competitiveness Report provides more damning evidence of the poor performance of many emerging markets, particulalry those in Latin America.

The IMD survey focuses on the 64 countries considered most relevant for multinational businesses. The latest rankings are shown in the chart below. Of the 15 largest countries in the MSCI Emerging Markets Index, only seven make it in the top half of the rankings (Taiwan, Saudi Arabia, UAE, China, Malaysia, Korea and Thailand). The two  in the top quintile (Taiwan and UAE) are rich countries, only included in the EM Index because of market access issues. On the other hand, in the bottom quintile, there are eight EM countries (Philippines, Peru, Mexico, Colombia, Brazil, South Africa, Argentina and Venezuela). Every Latin American country, except for Chile,  is in the bottom quintile, and four are in the bottom decile (Colombia, Brazil, Argentina and Venezuela. (Latin American countries are in bold and remaining EM countries in red)

The poor performance of Latin America has worsened over time. This can be seen in the following chart that shows IMD rankings since 1997 in decile form. There is a pronounced deterioration in the region’s rankings over this period, particularly after the commodity boom of the mid-2000s and the Great Financial Crisis. The decline of Argentina, Brazil and Chile, all commodity producers suffering from acute “Dutch Disease” (the commodity curse), is most pronounced, but even Mexico with the great advantage of NAFTA, has done poorly over the past ten years.

In addition to the devastating effects of the boom-to-bust commodity boom (2002-2012), the region suffers from multiple ills.

  • Political turbulence throughout the region, with the important exception of Mexico.
  • Poorly designed economic policies, often anti-business and generally poorly executed and unsustained.
  • Rampant capital flight, as elites and middle classes seek the security of Miami, Lisbon, Dallas, Punta del Este, etc…
  • The onslaught of Asian mercantilists, dumping manufactured goods in Latin American domestic markets.
  • Rising wealth inequality, as governments are unable to formulate and/or execute policies to provide employment or income to large segments of the population.

 

Stages of Development; Current Implications for Emerging Markets Part2

In a previous post (link) the stages of development were discussed in the context of the transition from a traditional rural society to a modern capitalistic consumer-driven economy.  Initially, abundant labor and high returns on capital  spark lengthy periods of “miraculous” growth. Later, as labor becomes scarce and the technology frontier is approached, returns on capital decline and GDP growth has to be driven by household consumption.  In this post, the factors of production (labor and capital) are looked at in detail.

The expenditure approach is commonly used in macroeconomics to describe economic output in terms of the money spent by consumers (households and government) and investors (private business and government). Net exports are added to measure whether an economy captures foreign consumer demand through exports  or relinquishes foreign demand through imports. For example, as a net exporter China is repressing domestic consumption to capture foreign consumer demand, while as a net importer, the United States is  stimulating domestic consumption and relying on foreign producers. Another approach to understand economic output is to measure the contribution to GDP growth coming from the  factors of production: labor and capital.

The Conference Board database on national accounts (link) provides a long-term view on productivity. The data illustrates what factors of production are driving the economy, and it is useful to measure the evolution of productivity over time.

As an economy begins to  modernize, labor productivity growth will be high and investors can deploy capital with high returns. As rural migration accelerates and more capital is deployed, countries experience stages of “miracle” growth when both labor and capital productivity are high. Eventually, a country achieves a significant degree of integration into the modern global capitalistic economy. At this time, labor becomes scarce and capital returns muted. Mature economies come to rely for growth mainly on the expansion of consumer services and hard-to-achieve technological innovation.

The charts below, based on the Conference Board data, aim to illustrate how the process plays out over time for countries at different stages of the development process. The first section looks at the United States and several mature emerging markets that have already experienced a one-time phase of “miracle” growth. The second section looks at India and Vietnam, two economies currently experiencing high growth

I. Mature Economies

The United States 

The United States has been a mature economy at the technology frontier since the early 2oth century. A broad expansion of consumption in the 1950s and 1960s drove high GDP growth. GDP Growth trended down from over 4% in the 1950s to below 2% in the 2020s, and has become  dependent on debt accumulation and Fed-driven asset appreciation. Contribution to GDP growth from labor has gradually declined over the period, despite high immigration, a huge one-time increase in female participation in the workforce, and steady improvements in the quality of labor. Growth in the working age population is projected to be near zero in the 2020s. Despite the United States’s dominant position in technological innovation, total factor productivity (the residual increase in growth that is not driven by capital and labor) has fallen from 1.5% in the 1950s to zero over the past decade.

 

Brazil

Brazil’s economy took off in the 1950s and experienced “miraculous”growth in the 1960s and 1970s, driven by high levels of investment and labor growth. Since the 1980s, Brazil has been mired in a “middle-income trap” caused by  a massive expansion of unproductive government spending, a stagnant consumer, a failure to promote innovation, and institutional breakdowns (i.e. corruption). Since 1980, GDP growth has averaged about 2%, falling to near zero over the past 12 years.

Labor quantity growth in Brazil is now near zero, though labor quality continues to improve.  Capital investment has not been driving growth, due to low returns on investment. Remarkably, total factor productivity, which was high in the 1950-1980 period, has now been negative over the past 40 years, and fell by 1.4% annually during the 2010s.

Korea

Korea’s economy took off in the 1970s and experienced its economic miracle between 1983 and 1997. Real GDP growth was very high for nearly three decades (1969-1997). As the economy  achieved advanced economy status, growth has slowed down over the past 20 years. GDP growth has fallen from 7% annually in the 1990s, to 4.5% in the 2000s and 2.5% over the pat 12 years. Over the past decade, labor quantity growth has been near zero, and though still positive, labor quality improvements are well below those of the miracle years. Total factor productivity has fallen from the 2.5% annually of the miracle years to 0.5% over the past decade. Korea is now a mature economy operating at the technology frontier. This means it competes directly in innovative products with developed nations, while facing strong competition from China on traditional products.

China

China’s economy took off in the 1970s, and then entered a 30-year period of “miraculous” growth with Deng Xiaoping’s reform in the 1980s. This extended period of growth allowed China’s coastal areas to reach a significant level of economic maturity, though much of the hinterlands remained isolated from the modern economy. China’s growth was driven by massive rural immigration and  high levels of investment by both the government and foreign enterprises, which converted China into the “workshop of the world.” The growth model followed closely what Paul Krugman described in his 1994 paper “The Myth of Asia’s Miracle,” which pointed out that growth in Korea, Thailand and Malaysia was driven by extraordinary growth in inputs like labor and capital rather than productivity.

China (Alternative)

China’s economic growth is considered by many economists to be overstated by the Chinese government. This is particularly valid over the past decade as the quality of growth has declined because of unproductive investments. The Conference Board provides an alternative measure of GDP which may be more realistic. According to the Conference Board’s alternative estimates, China’s GDP growth for the past twenty years was 7.1% compared to the 8.6% recognized by the government (and reported by institutions like the IMF and World Bank). If the alternative numbers are accepted, then China’s GDP output can be considered to be 30-40%  less than reported. Alarmingly, under the alternative analyst, investment drove almost all growth over the past twenty years, and the contribution to growth from total factor productivity has been negative over the period (-0.1 annually compared to 1.3% annually reported officially.)

Thailand

Thailand took off in the 1950-1970 period, with high GDP growth fueled by a healthy combination of labor, capital and total factor productivity. It enjoyed its “miracle” growth phase between 1980-1997, marked by slower labor growth, more moderate TFP growth, and, as Krugman pointed out, increasing reliance on the capital input. The “miracle” came to an end with the “Asian Financial Crisis” (1997-1990), and since then growth has moderated, with a decline in both labor and TFP growth. Since the financial crisis, TFP growth has averaged 0.6% annually and labor quantity growth has been a meager 0.1% annually, turning negative over the past decade. Apart from the high growth take-off period of 1950-1970, Thailand’s growth has relied heavily on capital inputs.

 

Malaysia

Malaysia, more than Thailand, fits Krugman’s observation that Asian growth is overly driven by capital.  Malaysia took off in the 1960s, and like Thailand, had a period of “miracle” growth in the 1980s and 1990s, ending with the 1997 Asian financial crisis. Growth recovered in the early 2000s, but since then has drifted down to moderate levels. Malaysia’s growth throughout this entire period has been driven by capital expansion, with only moderate contribution from labor and, remarkably, none from total factor productivity. Malaysia had some moderate growth in TFP during the 1960s take-off period, but since then TFP’s annual contribution to GDP growth has been negative every decade. Labor’s contribution has been healthier, providing a constant contribution of around 1% annually over the past five decades.

 

New “Miracle Economies”

India

India’s economy initiated a moderate take-off in the mid-1980s, with the launching of structural reforms. Growth accelerated in the 1990s, reaching high miracle-like levels in the 200os. Growth slowed to mid-single digit levels in the 2010s and is expected to remain at this level, which is high for current international parameters, but low in comparison to previous “miracle” economies. India has displayed Asian-style reliance on the capital input, with unusually low contribution to GDP from growth in labor inputs. India had a brief surge in labor in the 1970s, but this had fallen to 0.5% annually in the 200os and zero annually during the 2010s. This is an anomaly compared to other developing countries at this stage of growth when rural labor is very abundant. It can perhaps be explained by( 1)  scarce growth in mass production, labor-intensive manufacturing, (2) very low levels of female incorporation into the workforce, and (3) government initiatives to improve living conditions in rural villages. TFP was low to negative in the decades before structural reforms were implemented.  TFP’s contribution to annual GDP growth rose to 1.1% in the 1980s and 0.9% in the 1990s, 1.1% in the 2000s and 2.2% in the 2010s. For the miracle-like growth enjoyed by India in the decade prior to the pandemic to persist, it will be necessary for TFP contribution to remain high and for labor quantity growth to improve considerably.

Vietnam

Vietnam’s economy took off in the 1980s, supported by massive migration and capital deployment. Investment surged in the 1990s and has remained high since then, converting Vietnam into an alternative manufacturing  center for many multinationals. Labor growth remained high through the 2000s, but fell sharply in the 2010s. Vietnam fits squarely in Krugman’s description of a capital intensive Asian “tiger.” Total factor productivity has had negative contribution to GDP growth for most of postwar Vietnam’s economic history, turning positive only during the 2010s. A combination of high TFP growth, a resumption of labor growth and continued foreign direct investment will be needed for Vietnam to sustain high GDP growth levels. So far, Vietnam has closely followed the growth path of China. However, if its Communist Party  follows the ideological course taken by Xi’s China, foreign investors are likely to quickly move on.

 

 

 

Current Implications of the Development Process For Emerging Markets Part I

 

As countries develop, they follow a process of gradual absorption of both labor and capital into the “modern” economy. This model of development was described in Walter Rostow’s book The Stages of Development (1960), and the concept has influenced policy decisions since that time. Rostow’s five stages are outlined in the chart below.

The process is driven by the migration of labor from rural to urban locations, followed by the decline in fertility and family size. In Europe, it started in the late Medieval period (13th century) with the rise of city-states in Italy and the Netherlands, though serfdom persisted in Eastern Europe into the 19th century. The rise in urbanization allows for increased labor specialization and industrialization. Migration provides abundant labor which promotes investment and capital accumulation, until, eventually, as fertility declines wages rise, and consumption expands. The five stages are detailed below. It is important to stress that the stages are not clear cut either chronologically or geographically. For example, India’s current standing covers the first three stages; though the country is arguably on the verge of take-off, it has a large traditional rural population. Though China can be categorized as mature, one third of its population remains in a traditional rural condition. Brazil is also is a mature economy with a significant population of subsistence farmers.

Stage 1- Traditional Rural – Populations are rural and consist of subsistence farmers with minimal engagement in commerce. Much of sub-Saharan Africa, rural India and rural Indonesia are still at this stage today. At this stage, capital deployment and economic output are minimal.

Stage 2- Pre-take Off – Migration from farm to city provides cheap labor and initiates specialization and capital accumulation. The poor consume little, the rich consume luxury goods.

Stage 3- Take Off – The culmination of stage 2: super-abundant labor and rapid industrialization lead to high growth and capital accumulation and great fortunes (“robber barons”). This is the period of “economic miracles,” also called Golden Ages: England (1850-1870); United States (1870-1910); Argentina (1880-1900); Brazil (1950-1970); China (1980-2008), etc… Arguably, India is in this stage today, ruled by an alliance of robber barons and politicians.

Stage 4 – Maturity – Labor becomes scarcer, leading to pressure for higher wages and political conflict. Organized labor gains bargaining power, with the support of politicians. Wages rise, boosting consumption, but returns on capital decline:  Western Europe (starting in the 1870s), the United States starting in 1900, Brazil in the 1970s, China starting in 2015 (despite Xi’s efforts to stifle dissent). Mercantilist countries (Germany, the Asian Tigers, including China) seek to repress labor by capturing foreign demand.

Sometime between Stage 4 and Stage 5, the Lewis Turning Point occurs. This concept describes the moment when excess rural labor is fully absorbed into the manufacturing sector, causing unskilled industrial  wages to rise. Economists guesstimates for the turning point are:  England (1890), France (1900), the U.S. (1910), Japan (1965), Brazil (1975), Korea (1975), Mexico (2000) and China (2015). India, Indonesia and Vietnam are expected to reach the Lewis turning point in the next 15 to 20 years.

Stage 5  – Mass Consumption – Most developed countries now have economies dominated by the consumer. These countries are at or near the technological frontier and have highly developed physical infrastructure and costly labor, conditions that result in the share of GDP coming from consumption dominating that revived from investment. Mercantilist countries like Germany and Japan reduce consumption to some degree by repressing wages, allowing them to capture through exports some of the consumption demand from countries like the U.S., France and Spain. East Asian “Tigers” have delayed the mass consumption stage by implementing mercantilist policies which enable them to capture foreign demand through exports. Latin American countries have badly managed the transition from maturity to mass consumption, and they find themselves in the “Middle-income Trap,” with low returns on investment and insufficient consumer demand from most of their citizens.

Below, a few graphic examples of the different stages are shown. The data measures the components of GDP (World Development Indicators, World Bank)

Senegal (Traditional Rural, entering Pre-Take Off): Senegal is a low-income country with a large part of the population engaged in low-tech farming. Household consumption has dominated the economy but is now declining quickly as investment is ramping up. The current account is negative, as the country imports capital to finance investment.

 

 

Indonesia (Take-off): Indonesia entered the Pre-Take Off stage in the late 1960s, as migrants left subsistence farming to settle in urban areas. Take-off occurred in the 1980s (briefly interrupted by the Asian financial crisis). Rising capital accumulation and investment have brought high GDP growth and caused a reduction in the consumption share of GDP.  As Indonesia approaches the Lewis Turning Point in the 2030s, investment can be expected to start declining and consumption should rise.

India (Take-off): India entered the Pre-Take Off stage with economic reforms in the 1980s, leading to a long period of high GDP growth, rising investment contribution to GDP and declining consumption share of GDP. India is now in a typical Take-Off, with high capital accumulation and obscenely rich “robber barons” dominating the economy (like China in 2000).  India should reach the Lewis Turning Point over the next 20 years, at which time returns on investment will decline and the economy will become driven more by consumption.

China (Maturity):  China had its Pre-Take Off (with plenty of ups and downs) in the 1950s and 1960s. Take Off came with the economic reforms in 1980, resulting in very high GDP growth driven by investments and marked by enormous capital accumulation concentrated in few hands. The 1980-2005 “economic miracle” saw investments reach extremely high levels and plummeting of consumption’s share of GDP. The economy started losing steam in the 2000s because of high debt and declining returns on investments.  China reached the Lewis Turning Point around 2015. It now has approached the technology frontier and faces rising labor costs and low returns on investment. In this Maturity stage, investment share of GDP should decline, and consumption contribution should rise, but China is finding it difficult to abandon its debt-fueled investment model because of entrenched political interests. This raises the possibility of a long period of low growth and a “Middle-Income Trap.”

 

Korea (Maturity): Korea had its Pre- Take Off and Take Off stages in rapid succession in the 1960s. A twenty-year “Economic Miracle” was marked by high levels of investment and capital accumulation and a plummeting of the consumption share of GDP. The country reached the Maturity Stage in the 2000s, and now operates largely at the technology frontier. Korea, like China, is finding it difficult to move to a more consumer-driven economy. The country has been able to pursue mercantilist policies to secure demand from abroad for its exporters, so that it can delay increasing domestic consumption.

A Tales of Two Decades for Emerging Markets and the S&P 500 (Part 2)

Emerging market stocks have suffered a decade of dismal returns while American stocks have soared. In a previous post (link),  this divergence was  explained by valuations (high in EM and low in the U.S. in 2012) and the appreciation of the U.S. dollar over the past ten years. In addition, U.S. corporations have  benefited from historically low interest rates and tax cuts. All of the factors that benefitted U.S. stocks are likely to eventually revert, which  would lead to a new period of outperformance for international assets. In this post, we look  at this matter in further detail.

The chart below shows the twenty-year performance of the primary emerging market country MSCI indices, as well as the MSCI EM index and the S&P 500. During the 2002-2012 decade, the S&P500 underperformed the MSCI EM Index as well as every major country in the index. The opposite occurred from 2012-June 2023, as the S&P500 soarer while EM languished. Only tech-heavy Taiwan and India managed positive returns over this period.

Two Decades of Index Returns for Emerging Markets and the S&P500

In the chart below,  this divergence of returns is explained in detail by changes in valuation parameters (CAPE ratios, cyclically adjusted price earnings) and dollar-denominated earnings growth. There are two primary conclusion from this analysis. First, CAPE ratios have gone full circle.  S&P500 CAPE ratios started high in 2002, edged down through 2012 and then soared back to very high levels over the past decade. Global EM CAPE ratios started low, went up to high levels in 2012 and then went right back to where they started. As for earnings, for the S&P500, coming out of recession in 2002, earnings growth for the first decade was high and then moderate for the second decade (propped up by low interest rates and tax cuts). EM earnings were very high for the first decade and flat to negative for the second decade, with the exception of tech-heavy Taiwan. (Argentina should be taken with a grain of salt, as numbers are distorted by exchange controls)

The last column to the right in the chart above shows expected returns for the next seven years. The three countries with the highest expected return -Colombia, Chile and Turkey – have returned to the valuation levels they had in 2002 after reaching very high levels in both 2007 and 2012. Brazil’s CAPE ration went from 5.1 in 2002 to 12.9 in 2012 (after peaking at 32.1 in 2007!) and is now at 9.7. Similar to Brazil, the Philippines and Peru now have CAPE ratios well below 2012 but not nearly as low as in 2002. The two most expensive markets – the S&P500 and India – have CAPE ratios well above 2005 and 2012, both at near record levels.

Earnings growth in dollars for most EM countries was extraordinarily good between 2002 and 2012 and dismal in the 2012-June 2023 period, even considering the big surge in earnings in 2022 experienced by commodity producers (Chile and Brazil.)  Poor earnings growth is explained by a strong dollar, low commodity prices and intense competition for manufacturing nations  in a depressionary global environment. Surprisingly, despite an appreciating currency and a significant tech sector, China had negative 0.7%  annualized earnings growth during this period.

The expected returns displayed in the chart above assume that earnings will grow in line with nominal GDP growth for all countries. This also assumes that the currencies will be stable relative to the dollar. Given the current direction of China and its large weight in the MSCI Index, this may be an overly optimistic assumption which exaggerates potential returns for global emerging markets.

2Q 2023 Expected Returns for Emerging Markets

Emerging market stocks once again are lagging U.S. stocks in 2023, as they have consistently over the past decade, rising by 3.5% during the first semester compared to 16.8% for the U.S. market. The strength of U.S. stocks can be attributed to the resilient American economy and a return of speculative fervor for tech stocks, this time driven by the sudden discovery of the transformative power of “Artificial Intelligence.” Nevertheless, below the surface conditions are also positive for emerging market stocks. Almost all the underperformance of EM stocks can be attributed to China, while most other markets are not doing badly at all. Moreover, EM stocks are now very cheap compared to the U.S. market and value is being rewarded. Also, the U.S. dollar has been on a significant downtrend which, if sustained, will provide a significant tailwind for international assets, including emerging market stocks.

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) is based on 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.   This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University. We use dollarized data to capture currency trends. Seven-year expected returns are calculated assuming that each country’s CAPE ratio will revert to its historical average over the period.  Earnings are adjusted according to each country’s current place in the business cycle and then assumed to grow in line with nominal GDP projections taken from the IMF’s World Economic Outlook.

As expected, “cheap” countries (CAPE ratios below their historical average) tend to have higher expected returns than “expensive” ones (CAPE ratios above the historical average). These expected returns make two huge assumptions: first, that the current level of CAPE relative to the historical level is not justified; second, that market forces will correct the current discrepancy.

The second assumption is well supported by historical data if seven-to-ten-year periods are considered, but not over the short term (one to three years).

However, when during certain periods “cheap” markets on a CAPE basis are enjoying short-term outperformance investors should take note, as the combination of value and momentum can be compelling. As the chart below shows, we are currently in such a period. Over the past twelve months, holding the “cheapest markets” would have provided very high returns, even considering negative returns from Colombia. The chart shows Expected Return rankings from one year ago and, in the last column to the right, the total returns over the past year.

That cheap markets are now performing well is very encouraging for EM investors.  To cheap valuations, momentum, and a weakening U.S. dollar we can add the improvement in global business conditions. Almost all EM countries are now in the upswing of the business cycle, a time when they tend to outperform significantly. Moreover, the global economy is also recovering, and the U.S. is expected to achieve a soft landing later this year. This synchronized global recovery should be supportive of cyclical assets like commodities, value stocks and emerging markets.

The Beautiful Deleveraging From Financial Repression

Historically, the most effective manner to reduce excess debts held by the government and the public at large has been to inflate it away. This tool has been successfully implemented both by emerging markets and developing countries, most significantly by the U.S. during the 1950s. We see it at work once again today in a big way, with some countries making remarkable progress at reducing debt levels.

Financial repression consists of imposing negative real returns on the holders of fixed income securities by allowing inflation to be higher than interest rates. This can be done either through Central Bank monetary policy or by regulators forcing financial agents to hold unattractive securities. The winners in this game are the debtors at the expense of the creditors, which can lead to a significant redistribution of wealth.  For example, the archetypical old lady living off interest payments suffers badly, while the millennial with a fixed mortgage gains handsomely. Governments with high debt levels are big winners.

The chart below shows the one-year evolution of total debt to GDP (left side) and government debt to GDP (right side) for a broad group of emerging market and developed economies, based on Bank For International Settlements (BIS) data through December 2022. These numbers show the remarkable different paths countries have taken over this period. Most remarkably, highly indebted countries in Europe (UK, Spain, Italy) have achieved large reductions in total debt to GDP ratios through financial repression. For example, negative interest rates in the UK have brought the total debt to GDP ratio down by 52.4 percentage points, from 297.5% to 245.1%, and government debt to GDP, from 134.2% to 93.7%.  British monetary authorities must be delighted at the result of their policies, which they have continued to pursue through the first semester of 2023. China, on the other hand, with massive debt accumulating at a  furious pace, saw its total debt to GDP ratio rise from 285.1% to 297.2% and government debt to GDP rise from 71.7% to 77.7%, mainly because overcapacity and malinvestment have persistent deflationary effects.

In emerging markets, most countries have benefited from financial repression. In addition to China, Korea, South Africa and Argentina can be singled out as countries with rising debt ratios over the past year.

Unfortunately, this positive effect from financial repression may not persist for all. Continued winners in 2023 include the UK, the U.S. and the Euro area, all of which continue with negative interest rates while pretending to execute tight monetary policies. However, countries like Brazil now have very high real interest rates and are seeing renewed increases in debt ratios.

Brazil’s debt ratios increased in the 4th quarter of 2022 and will surge through 2023 unless the Central Bank  changes its current ultra-orthodox posture, repeating the policy mistake of the 2015-2019 period when high real rates led to a ramp up of debt levels, as shown below.

A New Path for Industrial Policy in Brazil

In recent decades, very few developing countries have reduced the income gap with rich nations, and those that have are either in East Asia or Eastern Europe. The successful “climbers” have prospered by integrating themselves into an increasingly globalized economy, gradually increasing the volumes and complexity of their exports. The “laggards” across the developing world have typically suffered from economic and political instability and shunned the competition of global markets. Brazil, the “poster child” for the laggards, has been stuck in a “middle-income trap” for over thirty years, caused by public policy errors resulting from political dynamics.

Since the 1980s “lost decade” Brazil’s politicians have pursued “distributional politics” aimed at correcting wealth disparities between regions and social classes. The previous model (like China’s current model), which for three decades (1950-1980) had been aimed at building mass production manufacturing and infrastructure, was largely discarded as inefficient and costly.

The new development model for Brazil, still very much extant today, has been driven by the “Welfare” Constitution of 1988 that imposed an extreme form of federalism which gives scarcely populated states enormously disproportionate representation in both chambers of Congress.

Unlike the successful economies of Asia and Easter Europe, since the 1980s Brazil’s industrial policy has been inward looking and aimed directly at achieving social objectives instead of economic results. The main goal of industrial policy has been to relocate industrial activity from rich states to poor states by providing abundant tax incentives to investors. The result has been the hugely wasteful Manaus Economic Free Zone and some uneconomic and nonproductive relocation of manufacturing facilities from the south to the north. Consequently, since 1980, Brazil has gone from being the prominent industrial nation in the developing world to a minor player undergoing large-scale deindustrialization.

The major winner from federal political dynamics has been the farm sector which is broadly diffused geographically in states with low population density. In this case the policies have led to massive increases in output and productivity.

In essence, Brazil’s farm sector is a disguised “Asian Tiger.”  Like in Asia, government support for Brazil’s farmers has been broad and extensive and consistent for decades. In addition to substantial fiscal, credit and export subsidies, the sector has benefitted greatly from the work of the national Brazilian Agricultural Research Corporation (Embrapa), which is widely recognized as a global leader in tropical agriculture research and has been instrumental in boosting crop productivity. Furthermore, the farm sector benefits from two more characteristics integral to the “East-Asian” development model. First, domestic competition is acute, therefore, even though state support is available to all, only the most productive farmers can thrive.  Second, because agricultural commodity markets are global in nature, the sector is export driven. This means that Brazilian farmers compete with American farmers and must remain at the forefront of technological innovation.

Unfortunately, the farm sector is not a good substitute for industry. In contrast to the job creation, work training and other multiplier effects that are integral to Asian industrial policy, the farm sector in Brazil is highly capital and technology intensive and does not generate many jobs or ancillary economic activity. Also, its success has significantly increased the commodity dependence of the Brazilian economy and led to a structural appreciation of the Brazilian real. Finally, this commodity dependence generates economic and currency instability which further undermines the competitiveness of the manufacturing sector.

The challenge for Brazil is to find new growth sectors which can secure sustainable political support and lead to productive investments that generate quality jobs. The markets are very skeptical that this can be done.

A brief effort at industrial policy during the first Lula Administration collapsed under mismanagement and corruption and was followed by an equally brief romance with neoliberal policies under Bolsonaro.

Lula’s return to power this year has revived talk of industrial policy in Brazil, abetted by a shift away from neoliberalism in the United States and China’s aggressive state-led push to achieve industrial self-sufficiency in all “strategic” industries. Unsurprisingly, given Lula’s track record, market skepticism is high. Initial signs from the new government do not give much hope. The best that the new administration has come up with so far is a hare-brained scheme to provide temporary subsidies for purchases of automobiles.

Any viable industrial policy will need broad and sustainable political support in Congress. This means that the benefits must be broadly distributed geographically. Unfortunately, Lula’s atavistic vision of development is rooted in the state-led, capital-intensive model of the 1970s (e.g. Petrobras leading investments in refining and infrastructure).

A better approach would be to focus on strategies that have been successful in other countries: tourism and “green” energy, for example. Building a national consensus with political support to provide long-term  incentives for private businesses to invest in tourism and alternative energy could set Brazil on a new growth path. Policies should be structured so that  investors face both domestic and foreign competition to weed out the weaker players.

These are two sectors that are labor intensive and with potential for broad geographical dispersion of benefits. Brazil’s woefully underdeveloped tourism industry can learn from countries like Mexico and the Dominican Republic. In the case of alternative energy, the policies pursued by the Biden Administration in the U.S., the roll out of wind and solar capacity in Texas and initiatives pursued in many other countries can be copied. The roll out of wind and solar energy in Texas is highly relevant, as Brazil has outstanding conditions  to do this, with many locations in poor states. 150,000 well-paid clean energy jobs have been created in Texas over the past eight years and the sector is growing fast.

Mexico’s Bull Run

Despite the antics, the atavistic fondness for state intervention and control, and the frequent attacks on both local and foreign business interests, Mexico’s populist leader Andres Manuel Lopes Obrador (AMLO) is presiding over the country’s best financial markets  in years.

AMLO can be credited for a sound fiscal policy and for letting the orthodox  Central Bank  do its job. This hasn’t resulted in better economic growth but it has allowed for a more stable economy than most of Mexico’s peers around emerging markets. However, the main cause for market enthusiasm seems to be the hope that Mexico will be a major beneficiary of  “friend-shoring” investments, as global manufacturers look for ways to diversify away from China.

The performance of Mexican assets has been remarkable. As shown below, the Mexican peso is the strongest currency in the world for the past one and three years,  periods marked by considerable chaos in currency markets in many other emerging markets

The Mexican stock market also has done exceptionally well, as shown in the chart below. The Bolsa is a top performer for both the past one and three years. For the past five years it is near the top, surpassed mainly by tech-heavy markets (U.S., Taiwan,  Netherlands, Denmark). This is impressive given that Mexico does not have a tech sector.

The current sectorial composition of the Mexican market relative to other markets is shown below.  A characteristic of the Mexican market is the high weight of defensive stocks, mainly consumer oriented telecom, food and retailing businesses. Unlike in most other emerging markets, the Bolsa is not dominated by state companies or mature cyclicals, but rather by well managed private concerns. The combination of a stable economy and well-managed private companies is a rarity in emerging markets.

The ten largest stocks in the MSCI Mexico index are listed below. With the possible exceptions of Banorte and Cemex, these are profitable world class companies with dominant market positions, all trading at near all-time high stock prices.

After this impressive bull run, what are the prospects for the Mexican market?

It should be noted that both the currency and stock prices started this run at low levels in both relative and absolute terms. As the chart below shows, Mexico’s Real Effective Exchange Rate was at historically low levels in 2019, and it remains competitive today. Over the past 20 years the peso has been managed like an Asian currency, for stability and export competitiveness. The Brazilian REER,  shown for contrast, is much more volatile, which causes havoc for managing the current account and promoting manufacturing exports.

 

The next chart shows that the cyclically-adjusted price earnings ratio (CAPE)  for Mexico was at historically low levels in 2019, and the PE ratio was well below trend. The CAPE ratio has now normalized but is still far from stretched.

Mexico’s CAPE ratio based on expected earnings for 2023 is currently at 17.2 which is in line with the country’s average for the past three decades. As shown below, based on historical returns, prospects for future seven- and ten-year returns are moderately positive.

 

Bull runs are not usually stopped by valuation concerns. Along with India, Mexico may continue to be one of the few large emerging market with a credible narrative and the capacity to absorb foreign capital. Nevertheless, in coming years, investors will need to see “Friend-shoring” capital flows go from hope to reality to sustain the Mexico story.

 

 

 

 

 

 

Growth and Economic Complexity

Rich countries have complex economies, and poor countries get richer by increasing the technological content of what they produce. This requires many things, such as good institutions (e.g., law and order, property rights) as well as an educated population and research institutions that drive innovation. The Atlas of Economic Complexity (AEC) , a joint project of the Massachusetts Institute of Technology and Harvard University, provides  insight into the progress countries around the world are making towards increasing their innovative capacity by measuring the degree of complexity and diversity of what they produce for global markets.

The work of the AEC was summarized in the 2011 book The Atlas Of Economic Complexity: Mapping Paths To Prosperity,  by Ricardo Haussman and Cesar Hidalgo, and it is  periodically updated by the Harvard Growth Lab (link) and the Observatory of Economic Complexity (link). The AEC solves the complex problem of measuring technological advancement by focusing on the degree of complexity and the diversity of a country’s exports and comparing this over time and with trading partners.

The chart below uses the AEI data to compare the top 25 most “complex” economies of 1995 to those of 2021. Not surprisingly, the leaders  of the Economic Complexity Index (ECI) are mainly the highest income countries. But this is less true in 2020 when compared to 1998, as Asian and Eastern European middle-income countries are moving up the ranking.

 

Although the list is relatively stable, there are five changes: five entrants, China, Malaysia, Mexico,  Taiwan and Romania,  replacing  Canada, Norway, Spain, Netherlands and Brazil.

All of the new entrants are countries well integrated into regional or global trade value chains that import almost all their commodity needs, while three of the departees (Canada, Brazil, Norway) are commodity producers.  This is interesting because the period saw the commodity super-cycle (2002-2012),  which greatly boosted the incomes and exports of commodity producers. The drop in the rankings of these countries is evidence of the “commodity curse” at work, whereby commodity boom-to-bust cycles create economic turbulence with long-term debilitating effects. In 2020 there are no commodity producers in this top 25 group, unless one counts the United States, which, in any case, saw its ranking fall from 9th to 13th.

The significant deterioration suffered by commodity producing countries is shown in detail below. These include the highly financialized Anglo-Saxon economies (Canada, Australia, New Zealand and the United States); and the traditional emerging market commodity exporters (Brazil, Chile, Argentina, Peru, Indonesia and South Africa). Brazil shares some of the characteristics of the Anglo Saxons, as it is also a highly financialized economy suffering rapid deindustrialization.

The change in the rankings from 1995 to 2020 for commodity producers is shown below. Indonesia is the only commodity exporter with an improved ranking, no doubt because it has been influenced by the mercantilist policies followed by its neighbors in South East Asia.

The contrast with the manufacturing-export-focused economies of Asia and Eastern Europe is shown below. These are all countries that have benefited from free trade and regional integration policies.

 

Finally, the following chart highlights the different paths taken by Brazil, Mexico and Turkey. Brazil has deindustrialized dramatically since 1995 and further  increased its dependence on commodities. Moreover, it has rejected globalization and regional integration.  On the other hand, Mexico and Turkey have embraced regional integration and successfully found their place in global value chains.

 

 

The Return of Deflation Raises Caution in Emerging Markets

All signs point to an imminent recession in the U.S. and the return of deflationary forces. The markets are pricing this in, forecasting that the Fed will begin to cut interest rates this summer. The debate is now between the soft-landing and hard-landing camps and on the length of the coming downturn, and on whether Jeremy Powel has the stomach for austerity or whether he will happily return to ZIRP and money printing.

In this environment, safety will trump risk. The recent surge in the infallible FAANG stocks — the current preferred safe haven for global investors — and the poor returns for value, small cap and cyclical stocks shows that we are in the very late stage of the business cycle or already in recession. Emerging market assets are not likely to do well at this time.

Commodity prices are leading the way in this deflationary push. As the chart below shows, oil and lumber, which are the two most significant economic indicators in the U.S. are down sharply relative to inflation (CPI). Oil is down 37% over the past year and natural gas is down 74%.  Lumber prices have fallen 50% more than the CPI. Even copper, which is supported by tight supplies and rising demand from “climate change” policies, is  still down 13% and supporting the deflationary push.

 

We also see broad deflationary forces in the broad commodity indices. forces. The S&P GSCI Commodity Index (GTX) and the S&P GSCI Industrial Metals Index are down 18% and 15%, respectively, over the past year, while the CPI has risen 6%.

The Industrial metals index is most significant for emerging markets because historically it has led the way for EM stocks. We can see this below.

Investors should keep their powder dry for the beginning of a new cycle in 2024.

Brazil’s Grievous Manufacturing Collapse

Brazil has become a posterchild for the Middle-Income Trap which hinders countries  no longer able to compete against low-wage countries but without the productivity growth to compete in the higher value added industries dominated by advanced economies. But little attention has been given to the related  economic phenomenon which strikes commodity producers – “Dutch Disease,” also known as the Natural Resource Curse. The combination of the two for Brazil  has caused crippling premature deindustrialization.

Brazil has suffered two severe bouts of “Dutch Disease.” The first during the commodity boom of the 1970s which was followed by the bust of the 1980s and a “lost decade” of economic stagnation. The second, during the 2001-2012 commodity super-cycle  driven by China’s “economic miracle, which was also followed by a long economic depression. These two commodity booms were marked by similar excesses — overvalued currencies, unsustainable consumer booms, excess fiscal spending and high levels of debt accumulation, a deterioration of governance and a rise in corruption. In their wakes, the booms left behind a debilitated manufacturing sector, high debt levels and lower growth prospects.

 

 

Brazil’s “Dutch Disease” has been worsened by the concurrent strong growth of the farming, mining and oil sectors — all productive and  capital intensive activities with a high degree of export competitiveness. The rapid growth of these sectors, and the discovery of the giant offshore pre-salt oil fields,  has strengthened the current account and caused a structural appreciation of the Brazilian real. The loss of competitiveness of Brazil’s manufacturing sector has been more than compensated by the increased production and dollar revenues of the growth sectors. Unfortunately, these successful sectors generate scarce jobs and lack the significant multiplier effects of the manufacturing sector.

The chart below shows manufacturing GDP as a percentage of GDP for both resource rich and resource poor countries in emerging markets. The declining trend for commodity exporters relative to commodity importers is notable, and Brazil stands out in particular.

 

In 1980, at the end of the 1970s commodity boom, Brazil was the dominant manufacturing power in emerging markets  (China surpassed Brazil’s production levels but was behind in terms of complexity and quality of manufacturing). The following chart from the World Bank shows manufacturing value added for the primary emerging markets (and France for comparative purposes) both for 1980 and 2021. The rise of China and the relative decline of Brazil are striking.

The same data is shown below with Brazil as the benchmark, to measure relative performance.  Over this period, China’s manufacturing value added went from two times Brazil’s to 31.3x, a relative increase of  15.7x. India went from 44% of Brazil’s level to 2.9x. Every single country in the chart has gained relative to Brazil. This includes commodity producers (highlighted in red) which also may have suffered Dutch Disease. Most striking are Indonesia and Malaysia which went from 15% of Brazil to 150%, and 8% to 56%, respectively, a testament to the Asian commitment to currency stability and manufacturing exports.

 

 

Finally, the following chart shows the decline in industrial employment in Brazil over the past decade. In 2019, according to World Bank data, only 20% of employment in Brazil was in industry, a decline from 23.4% in  1991. This places Brazil at a level similar to advanced rich countries with service-intensive economies. In Brazil these service jobs tend to be poorly paid and unproductive with very few opportunities for training and advancement.

Brazil’s manufacturing collapse has no easy solution. Brazil’s successful commodity exporters yield extensive political power, not the least with the oversized financial sector. Schemes like those adopted by Argentina, featuring  multi-tiered currencies and taxes on exporters are difficult to implement and have high costs. A return to high tariffs on imports would be highly unpopular. A mix of these policies is likely to be introduced by the new administration with elevated short-term costs and unclear long=term benefits.

Brazil and the Return of Neomercantilism

The principal challenge of emerging markets policy makers is to provide the business environment for private enterprise to invest in activities that generate sustainable and equitable growth.

When they fail to do this they face the crippling flight of both financial and human capital. The ease  of communications, travel and capital movements make it easier than ever for wealthy and cosmopolitan elites to move their families and capital abroad.

Human and financial  capital drain can be devastating for emerging markets. Some 4.5 million Indians,  generally well-educated, have immigrated to the U.S. and the U.K. since 1980, contributing greatly to these developed economies. Venezuela has lost most of its educated elite and middle class over the past 15 years, leaving the country with dire prospects of ever recovering the middle-income status it once enjoyed. The past decade of slow growth and political unrest in Latin America has caused massive  capital flight from historically more stable countries like Brazil and Chile.

Brazil, which in the past largely avoided the drain of human and financial capital, now faces an exodus, with Portugal and the U.S. as the favorite destinations. With the return to power of the leftist Lula — reenergized, more bitter and radical after his two-year prison confinement — this flight from Brazil is sure to accelerate.

Ironically, the policies proposed by Lula are no longer on the ideological extreme. On the contrary, the new government’s policy proposals – government support through subsidies and credit for industrial onshoring and green technologies, all justified under the banner of national security and sovereignty – are a carbon copy of those promoted by the Biden Administration in the U.S. Moreover, the quote below, which was made this week by President Biden, could have come out of Lula’s mouth

“What it’s about is giving working folks a chance. I’ve never been a big fan of trickledown economics. In the family I was raised in not a lot trickled down to our table. When the middle-class does well, everybody does well. I campaigned on build from the bottom and middle out and when that happens the poor have a chance up, the middle class does well, and the wealthy always do well.”

In many ways, Biden’s quote applies even more to Brazil than it does to the U.S., as Brazil’s has suffered more deindustrialization than the U.S., and its inequality is one of the worst in the world and worsening.

Brazil desperately needs a new policy framework which promotes investment in productive activities with jobs that provide a middle-class lifestyle, not the service jobs (e.g. food delivery) that have been the only source of jobs in recent years. Or else, it will continue deeper into a peripheral role as a  supplier of commodities, mainly to China. The core of any economic strategy has to be to improve the income of the mass of Brazilians that currently barely participate in the productive economy.

According to the World Inequality Database, the poorest 50% of Brazil’s populations have about 8% of the country’s income and none of its wealth.  The consequence of this is that Brazil is really two countries: one country of some 20 million people  who have the income level of southern Europeans and are genuine consumers; and another country of 200 million people – including  a large poor segment relying extensively on government handouts – that has little purchasing power. The charts below compares Brazil to other countries in this regard. With a little over 20% of its population able to consume, Brazil’s consumer market is small. Worse, it hasn’t grown much over the past twenty years, increasing only during commodity booms.

Given the size of its available market, Brazil does not underproduce. For example, production of motor vehicles per potential consumer is comparable to other countries. Given current circumstances opportunities for capturing foreign demand are scarce, so the only opportunity for growth would come from an increase in the population of consumers.

Brazil’s new government understands Brazil’s challenges and has ambitious plans to relaunch the economy through an active promoter-state. Unfortunately, it maintains its traditional penchant for doing this through state companies and a big-state mentality.

However, Lula’s main problem is that his Labor Party lacks credibility. Lula pretends that the rampant corruption and incompetent management of the last PT government (2002-2016) never happened, but for most Brazilians the memory of that period is still vivid. No one has forgotten that the previous PT government’s (2002-2016) efforts to implement similar policies were crippled by graft and poor execution, and expectations are high that the same will occur again.

The tragedy of Brazil is that it is likely to miss the boat again. It was a major loser of the past 40 years of neoliberalism and globalization (starting the process at its end with Finance Minister Paulo Guedes) and now, as the world turns to neomercantilism, it is unprepared to respond adequately.

 

 

 

 

 

China’s Existential Threat to Emerging Market Economies

The model of development followed by most developing countries has been to gradually move up the value chain of manufactured goods while at the same time establishing control of the production of the basic inputs of industrialization which are steel, cement, ammonia, and plastics.

This model of development worked well for many of the current middle income emerging market countries. Brazil and Mexico, for example, developed its steel, cement, ammonia and petrochemical industries in the 1950s and 1960s while it concurrently dominated the process of mass production of motor vehicles, capital goods and many other basic consumer goods. Those years were the golden years for these countries and were broadly perceived as economic “miracles.” Most middle-income Asian countries (Thailand, Malaysia, Indonesia) repeated this process in the 1960s, 1970s and 1980s with similar success, now followed by Vietnam.

This process of basic industrialization was achieved with foreign investment and the transfer of mature technologies from the U.S. and other developed countries. The technologies were easy to transplant to developing countries and had the advantage of being scalable to different markets and often  large generators of low-skill “quality” jobs. Generations of Brazilians were integrated into the modern economy and learned the skills of industrialization and the routines of modern enterprises by working in manufacturing, and they entered into the middle class and became consumers (e.g., Brazil’s current president, Lula, worked in an auto plant in Sao Paulo in the 1960s as a metalworker before becoming a union leader).

Two things happened to dramatically undermine this trend. First, the neoliberal revolution of the 1980s spawned the “Washington Consensus” for free trade and capital movements and the great wave of hyper-globalization of the past decades. Second, in the 1980s,  China entered the phase of rapid development, following the path set by Brazil and others: exploiting foreign investment and technology transfer to dominate the production of the basic inputs of industry (steel, cement, ammonia and plastics) and the mass production of consumer and capital goods.

While the mass production technological cycle (“Fordism”) was exhausting itself in both the industrialized world and middle-income emerging markets, giving way to the Information and Communication Technology revolution (ICT), China gave it new life. With abundant cheap labor and clever incentives, China became the dominant global producer of most basic industrial goods,  replacing production capacity in both developed and developing markets. In a neoliberal era of free markets, multinationals gladly offshored the mature mass production function to China, to gain access to cheap labor, subsidies and lax environmental rules. The combination of a large and growing domestic market and access to international markets gave China a scale advantage which previous fast-growing developing countries had never enjoyed during this period of learning to dominate the mass production process.

The degree to which China has taken over the mass production paradigm is shown in the following charts: 1. Global Primary Energy Consumption; 2. Global steel production; 3. Global cement production; 4. Global ammonia production; 5. Global plastics production. The growth of output that China has experienced in all of these areas is astonishing in a historical context. China consumed one third the primary energy consumed by the U.S. in 1980 and 1.7 times as much in 2021; it produced about the same amount of steel as the U.S. in 2000 and now produces 10 times more; China’s cement output in 2020 was 27 times the U.S.’s peak production year; China produced 2.5 times more ammonia than the U.S. did in 2021; and China now produces 1.5 times the plastics made by the U.S.

 

As China moves up the manufacturing value chains, it now seeks to dominate global markets for consumer durables, such as computers, televisions and cars. The charts below show the astronomical growth of China’s car production and its recent progress in tapping export markets. China’s growth in auto production over the past decade is greater than the entire growth of the industry on a global basis. And now, China’s auto firms, as the economist Brad Setser recently noted, are ramping up exports. In a few years’ time, Chinese passenger car exports have grown to surpass those of the U.S. and Korea and match those of Germany. Most of these highly subsidized exports are finding their way to developing countries.

The extension of the mass production technology cycle was an unequivocal boon for China but a mixed blessing for developed countries and the middle-income emerging markets. In exchange for cheap consumer goods and high corporate profits, manufacturing sectors were decimated, jobs were lost and income inequality and political rage increased. Moreover, while the mass production cycle was extended, with dire consequences for CO2 emissions, the potential benefits of the ICT revolution were delayed. Instead of focusing on making industry more productive and greener, Silicon Valley has channeled most of ICT investments into social networking, search, delivery and gaming applications.

For developing markets, China’s rise is an existential threat. Unless they can defend themselves with tariffs, they are condemned to handing over their consumer demand for manufactured goods to China in exchange for commodities.

Emerging Markets’ no Growth Decade

Emerging market stocks have performed poorly for more than a decade both in relative and absolute terms. This can be explained by a marked decline in price to earnings multiples since the very high levels achieved in 2008 and 2012 combined with poor growth in these earnings. In turn, low growth in earnings were caused by a significant deterioration in the GDP growth of most emerging markets.

We show the evolution of multiples and earnings in the following charts.  CAPE multiples are at a third of the level reached in 2008 while earnings have been flat in nominal USD terms.

 

This remarkable result can be explained by the unbalanced growth of the global economy. While emerging markets are said to be growing GDP at a higher rate than developed markets, the growth is highly concentrated in China (and to a degree India). Emerging markets ex China and India have languished over this period. We show this in the chart below.

 

Given the disappointing growth of emerging markets ex China since the GFC,  it is not surprising that earnings growth has been poor. What is stunning is the lack of earnings growth in both China and India, despite their high GDP growth, as shown below.

The explanation lies in the unbalanced nature of Chinese growth, which relies on the repression of the consumer to subsidize the export sector and unproductive state investments in infrastructure and industry. China’s excess capacity is increasingly dumped on emerging markets, leading to deindustrialization, low productivity and low growth.

Using CAPE Ratios in Emerging Markets

 

The CAPE methodology is well suited for volatile and cyclical markets such as those we find in Emerging Markets. Countries in the EM asset class are prone to boom-to-bust economic cycles which are accompanied by large liquidity inflows and outflows that have significant impact on asset prices. These cycles often lead to periods of extreme valuations both on the expensive and cheap side. The Cyclically Adjusted Price Earnings multiple (CAPE) has proven effective in highlighting them.

The CAPE takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings.  We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized recently by professor Robert Shiller of Yale University.

CAPE is best used as a long-term allocation tool. However, it is not effective  as  a timing tool. Market timers seeking short-term returns will be more successful using traditional technical analysis to identify trends and paying close attention to investor sentiment and liquidity flows.

CAPE works particularly well in markets with highly cyclical economies subject to volatile trade and currency flows (Latin America, Turkey, Indonesia);  it works less well for more stable economies (e.g., East Asia).

In recent years CAPE has  has been ineffective in predicting forward annual returns. This has occurred because momentum has been more important in determining stock performance than valuation indicators. Moreover, emerging markets started the past decade at very high valuations, and only recently have come to trade at cheap levels and, in some cases, extremely low valuations.

Since  October 2020, we have seen a marked change in the investment environment, with the value factor in both U.S. and international stocks starting to outperform “growth” stocks. Emerging market value stocks have outperformed the EM index by over 20% during 2021-2022. Also, by and large, “cheap” CAPE stocks have started to reward investors. The cheapest stocks on a CAPE basis at the end of 2021 (Turkey, Chile and Brazil) all performed exceptionally well in 2022.

In the charts below we see  what CAPE ratios are currently telling us about future returns based on historical precedents. We map index returns and CAPE ratios for the U.S., GEM (Global Emerging Markets) and the most important emerging market countries (China, India, Taiwan, Korea and Brazil) and also for several countries of interest (Turkey, Philippines and Mexico). The data covers the period since 1987 when the MSCI EM index was launched. The charts show a clear linear relationship between CAPE and returns with particular significance at extreme valuations. Country specific data is more significant because the CAPE ratios capture better the evolution of the single asset.

  1. S&P 500 :  The market has not provided 10-year annualized returns above ten percent when CAPE is above 25. Every time that the market has provided lower than 5% annualized return the CAPE has been above 30. The CAPE at year-end 2022 was at 27.3, a level which suggests moderate nominal returns in the low single digits for the next 7-10 years.

  1. Global Emerging Markets. At the current level (15.4) the GEM CAPE provides little insight. The probability of negative or high returns both appear to be low. GEM should be bought below 15 and sold above 20.

3. China’s short and turbulent stock market history provides few data points for CAPE analysis. Nevertheless, the current CAPE (9.5) has provided high returns in the past and points to low risk of negative returns. Chinese stocks should be bought below 12 and sold above 20.

 

4.India: The CAPE for India (25.6) is high both in absolute terms and relative to the country’s history, reflecting a good GDP growth profile in a world with scarce growth and investor enthusiasm. At this high level  return prospects are poor and negative returns are a distinct possibility. Indian stocks should be bought in the high teens and sold in the high twenties.

5. Brazil: At the current CAPE (9.4) history points to potentially high returns, but not without risk of disappointment. The ideal entry point for Brazil is below 8 and the market should be sold around 18.

  1. Korea: The CAPE for Korea (6.4) is low both in absolute terms and relative to the country’s history. At this CAPE level high returns are likely and negative returns are a low risk. Korean stocks should be bought below 10 and sold in the high teens.

5.Taiwan: The current CAPE for Taiwan (14.9) is cheap. Future returns appear attractive but Taiwan has a turbulent stock market history, a highly cyclical market and geopolitical risk, so caution is advised. Taiwan should be bought below 15 and sold above 20.

6.Mexico:The CAPE for Mexico (15.3) is in neutral territory, implying fair valuation. The market should be bought in the low teens and sold in the mid twenties.

7. Philippines: The current CAPE (13.1) is on the low side and offers the prospect of high returns with some risk. The market should be bought below 15 and sold above 25.

8.Turkey: The current CAPE (6.9) is low in absolute terms and relative to the country’s history and offers the prospect of high returns, made more likely by the recent momentum. Nevertheless, this is  always a very risky market with turbulent macroeconomics and politics and short cycles. This market should be bought below 10 and sold above 15.