Category: Global Emerging Markets

4Q 2022 Expected Returns for Emerging Market Stocks

Emerging market stocks once again lagged U.S. stocks in 2022, as they have consistently over the past decade.  A rising dollar and persistent economic instability and risk aversion all have contributed to making emerging market stocks a poor asset class over the past year and the last decade. However, there are signs that the environment may be changing. EM stocks are now very cheap relative to the S&P 500, the dollar shows signs of having peaked and, most importantly, investors are looking for real assets that may perform better in a more inflationary environment. EM stocks, which have a high concentration of commodities and cyclical businesses , may be better positioned in the future than they have been in the “growth”-dominant investment world of the past decade.  Moreover, after a decade of poor returns, value investing (contrarian investing in cheap stocks in cyclical industries with little growth) is working again in emerging markets.

The MSCI EM value index outperformed the MSCI EM core index by 5% over the year, and, more importantly, the cheapest countries in the EM index were the best performers. This is in stark contrast to the past five years when cheap only became cheaper and rich only became richer.

The chart below shows the 2022 returns for all the countries in the MSCI EM index. On the right margin countries in the index are shown ranked in terms of a CAPE valuation based expected returns analysis at year-end 2021, with the cheapest on the top and the most expensive on the bottom. We can see that the cheapest countries (Chile, Turkey and Brazil) were the best performers in 2022 while expensive countries (India, Russia, USA, Taiwan) generally did poorly. The Philippines are one important exception to this trend, having started the year as “cheap” and ended even “cheaper.”

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

The chart below shows the current expected returns for EM markets and for the S&P500 based on a CAPE ratio analysis. The Cyclically Adjusted Price Earnings Ratio (CAPE)  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.  We use dollarized data to capture currency trends. This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University.

As we have seen in recent years, CAPE is not a good timing tool, but it does tend to work well over time, particularly at extreme valuations.  CAPEs below five, such as Turkey ‘s at the end of 2021, historically have been a failsafe indicator of high future returns. CAPE ratios that are completely out of sync with historical averages for the country are also powerful predictors of future returns.

The table above points to significant opportunities in EM. Global EM (GEM) on its own is cheap relative to the U.S., but more attractive opportunities exist at the top of the chart, particularly in Colombia, Brazil Chile, Taiwan, Peru, South Africa, the Philippines, Mexico, Turkey and Korea, which all promise high returns. Moreover, these countries offer significant, geographical, geopolitical and business cycle diversification opportunities. Colombia, Chile, Philippines and Korea are all extremely cheap relative to their valuation history and are well positioned for business cycle recovery in 2023. On the other hand, India , the most popular market with investors today, is an absolute outlier on the expensive side.

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

Latin America’s Pink Wave Faces Investor Skepticism

A pink wave of leftist governments has swept across Latin America. In recent years, first Mexico, then Argentina, Peru, Chile and Colombia and finally Brazil, have all elected governments with ambitious social agendas and plans for bringing back the state as the agent of economic development. Unfortunately for them, investors, both local and foreign, are not sticking around to see how this will work out.

The left in Latin America has a dismal record with its style of developmental activism centered around state companies, private firm “champions” and protectionism. Recent experience with Peronist Argentina, Bolivarian Venezuela and Brazil’s PT party have ended in economic collapse, inflation, currency devaluation, soaring debt and increased misery. The result has been a decade of severe capital and human flight.

The return of Lula and his PT party to power in Brazil promises more of the same big plans for state-led growth promoted by government agencies, state companies and public banks. It doesn’t matter that these policies previously ended in enormous losses caused by mismanagement and rampant corruption.

Unlike a decade ago, when Latin America’s left was going against the neoliberalism of the Washington Consensus, today state activism is back in favor in Western capitals. Partially as a response to Chinese policies but also because of a new concern for the many domestic losers of globalization, the Biden Administration has pushed through the country’s biggest-ever piece of climate legislation (The Inflation Reduction Act) which will provide lucrative tax incentives to companies that develop mines, processing facilities, battery plants and EV factories in the US. In addition, with bipartisan support, new laws have been passed to promote infrastructure and semiconductor investments. Moreover, these new programs now have strong intellectual support from academicians (Mariana Mazzucato and Carlota Perez are prominent examples) who argue that history points to the importance of government policies to induce investment, particularly at times of enormous technological disruption like the ones we are now living.

Chile’s president Gabriel Boric has sought the counsel of Carlota Perez, a Venezuelan economist who studies the interplay of long-term technology and financial cycles,  to understand how Chile fits into the current process of global technological transformation engendered by the Information and Telecommunications Technology (ICT) revolution. According to Perez, Latin America has been a major loser of this technology cycle which has crippled the mass production “Fordism” model (manufacturing jobs that pay enough for a worker to acquire middle class consumer goods) that was the foundation of the post WW II Latin American modern economy. These jobs have been destroyed across South America and replaced by low-pay/low-skills service jobs. Nevertheless, Perez actually sees a brighter future, as we have now entered the period of massive diffusion of ICT technologies, a “golden age of full deployment.” During the second half of long technology cycles, typically the productive sector replaces the financial sector as the driver of the economy. Perez sees a vital role for the state at this stage of the cycle to “tilt the playing field” through public policies (credit, taxes, subsidies, etc…) to support productive activities and “smart, green, healthy global growth.” She recommends that a country like Chile  promote  ICT diffusion by inducing investments into socially critical areas (e.g., the democratization of access to education and information) and into priority frontier industries (e.g., alternative energy technologies and supply chains).  Perez argues that those countries with political dynamics that allow for proactive public policies will  have a big advantage in coming years. Without these policies, ICT investments have primarily financed “escapist undertakings” such as computer games, social networks, parallel universes and delivery services for the rich, Perez says.

In line with the ideological shift towards state activism, Brazil’s Andre Lara Resende, a MIT trained economist who has joined president-elect Lula’s economic transition team, argues in favor of “alternative policies of public investment” to kick-start capital deployment in infrastructure, decarbonization, electrification and industrial revitalization. According to Lara Resende, these investments are productive and profitable and would  boost economic activity , and, therefore, would have a positive impact on fiscal accounts. His rationale relies on a proposed radical change in Brazil’s monetary policy from the current Fed-centric model to an independent one based on ‘’Modern Monetary Theory,” which assumes that public debt does not matter as long as rates are below nominal GDP growth.  Lara Resende would achieve this through financial repression (artificially low interest rates and directed lending), at the expense of what he sees as an over-sized financial sector divorced from the productive sector of the economy and at the service of the rentier class.

Though Lara Resende doesn’t say this, the logical consequence of his plan is a return to the strict capital controls that Brazil had until the 1990s. Of course, investors will try to anticipate this change. Boric faces the same issue in Chile which as seen huge levels of capital flight in expectation of structural changes to economic policy.

The president of Brazil’s Bradesco, Bank, Octavio de Lazari, this week warned president-elect, Lula that, given “an extremely challenging” 2023, there is no room for “tests and experiments,” and he suggested the government focus on reducing inflation and controlling fiscal deficits. From within Lula’s economic transition team, the sole orthodox member, the economist Persio Arida, echoed these thoughts, advising his colleagues to stick to the basic objectives —  ‘Opening the economy, making the state more efficient and reforming the tax system” — which have been pursued by  Brazilian economic policy makers, unsuccessfully, for the past 40 years.

Latin America faces a stark dilemma. The neoliberal polices of the Washington Consensus are deeply out of favor and blamed for currents ills, and the rich countries are moving away from these policies and are increasingly prone to fiscal and monetary experimentation and state activism. This could in theory provide an opening for policy changes in Latin America. However, investors believe that today’s Latin American states do not have the ability to implement state-led growth without the corruption and incompetence of the past. In a world of free capital flows, investors will prefer to move  their capital outside the country rather then risk it at home.

Long Technology Waves and Emerging Markets

The poor performance of many developing economies in recent decades has many explanations. Thought leaders such as prominent mainstream economists, the World Bank and the IMF tend to attribute failure to weak “institutions” which engender corruption, bureaucracy, lawlessness and poor human capital formation, and, consequently, result in a difficult environment for productive investments and capital accumulation to occur. In the countries themselves structural reasons often are preferred which tend to blame external forces: the legacy of colonialism and foreign oppression or the inequitable dependency of the “periphery” (developing countries) on the “center”  (rich countries). A third approach, put forward by experts on historical technological cycles, gives significant incremental insights on the question, and, more importantly, guidance on a path to better performance in the future.

The Russian Nikolai Kondratiev and the Austrian Joseph Schumpeter developed the idea during the 1920s that  long technological waves drive  the course of economic growth. Both of these “political economists” sought to understand the miraculous growth created by the industrial revolution over the previous century to better explain the post W.W. I  environment.

Schumpeter is best remembered for the idea that “creative destruction” is fundamental for progress and occurs in a recurring process: innovations made by scientists and tinkerers are turned into inventions by profit seeking entrepreneurs; eventually, the wide diffusion of disruptive technologies lead to widespread creative destruction as entire industries and sectors are transformed.

The chart below, from Visual Capitalist, summarizes the long-term technological cycles defined by Kondratiev and Schumpeter. Though the precise dates are debated by historians, the chart seeks to cover the entire era of the “Industrial Revolution.”  Five distinct “long waves of innovation” are described, each one of which was deeply transformative, not only for the firms and industries involved but also for the socio-political fabric of society. This framework puts us today in the fifth wave of technological progress, the Information and Communication Technologies Age (ICT).

Following  in the path of Schumpeter, the Venezuelan economist Carlota Perez and others have advanced the discussion of technological waves by incorporating the role of capital markets and exploring the implications for the development of “periphery” countries. Perez’s book, Technological Revolutions and Financial Capital (2001), has been hugely influential and is required reading in Silicon Valley boardrooms and venture capital firms.

Perez talks about technological revolutions as “great surges of development” which cause structural changes to the economy and profound qualitative changes to society, and she sees capital markets at the core of the process. Her “revolutionary waves,” as shown in the chart below are in line with Schumpeter’s, but she increases the scope to show the broad reach of these technologies on communications and infrastructure and, consequently, trade and commerce and society as a whole.

Perez’s technological cycles are divided into three distinct phases, which are determined by the diffusion rate of technologies.

During the initial phase – Installation – new innovations are slowly adopted by entrepreneurs with disruptive business models. As the kinks are worked out and the technologies become cost effective more entrepreneurs adopt the technologies with the backing of financiers (e.g. venture capital) who seek the high potential payoff of backing a future champion. This leads to a frenzy of capital markets speculation, which invariably results in overinvestment, hype, financial bubbles and financial crisis.

As shown below, every Installation phase has ended in a bubble, followed by a financial crisis, which Perez call the Turning Point. The canal mania of the British industrial revolution, the British railway mania of the Age of Steam, the global infrastructure mania (sometimes called the Barings mania) of the Age of Steel, the roaring twenties stock market bubbles of the age of mass production and the  Telecom, Media and Technology (TMT) bubble of  the ICT revolution all ended in financial crises.

For illustration purposes, the chart below shows Perez’s process at work for the current Information and Communications Technologies (ICT) revolution that we are currently living. The cycle is a typical S-curve which has a long incubation period of slow growth, followed by a sharp ramp up and an eventual flattening.  The current cycle can be said to have started in 1971 with the launch of the first commercial micro-processor chip by Intel, but this was only possible because of a prior decades-long incubation period of scientific research and tinkering. Financial speculation built up between 1995-1999 led to the great TMT bubble and the crash in 2000-2001. Following the crash, the Deployment Phase has caused the rise of the major winners through a consolidation process (FAANGS). (These consolidations are normal, according to Perez. For example, hundreds of auto companies engaged in brutal competition before consolidating into the three majors in the 1920s).

The Deployment Periods, which Perez calls the “Golden Ages”, is when the technologies become cheap and ubiquitous, and their benefits are widely diffused through business and society. Perez argues that we are on the verge of another “golden age” today, as we approach broad access to smartphones and the internet and massively powerful micro-chips are becoming almost ubiquitous in basic consumer products (the chip in an Iphone has a trillion times the computing power of those used by IBM’s mainframe computers in 1965.)

If it doesn’t feel now like we are entering another “Golden Age” it is because we are still experiencing the after-shocks of the previous phase of financial frenzy and economic collapse and its consequences: high inequality and populism. Perez argues that the successful countries of the next decades will be those that have governments that understand the moment and can actively promote the diffusion of ICT technologies to achieve broad societal goals (e.g. “green” technologies).

Technology Cycles and Emerging Markets

Looking back at history, one can see how this process has played out before for developing countries. We will focus on the last three technology cycles: The age of steel and mass engineering, the age of oil and mass production and the current ICT revolution.

The age of steel and mass engineering (1875-1908): This was the age of the wide diffusion of the steam engine and steel through mass engineering to provide the infrastructure for the first wave of trade globalization. The rise of Japan (the first of the Asian Tigers) occurred over this period as it methodically diffused all of the technologies developed in the West.  Latin America experienced its own “Belle Epoque,” as steamships and railroads made its commodities competitive in global markets. During this time, Argentina and Brazil were considered at the level of development of most European countries and attracted millions of European immigrants.

The age of oil and mass production (1908-1971) – Interrupted by two devasting world wars and marked by profound socio-political change, this age still generated wide-spread prosperity, though China, India and Eastern Europe did not participate. Initiated by the launch of Henry Ford’s Model T automobile in 1908, it saw the diffusion of the internal combustion engine, electrification, and chemicals under the structure of the modern corporation. Following the Second World War, broad diffusion of these technologies led to a “Golden Age” of capitalism throughout the Western World. This was also a period  of “miraculous” growth throughout Latin America as the wide diffusion of the mass production process, supported by import substitution policies and foreign multinationals, created abundant quality jobs in manufacturing and the rise of the middle class consumer.

The  Information and Communication Technologies  (ICT) Revolution (1971-today): All phases of technological revolutions overlap with their predecessor and follower as the diffusion process plays out. In the case of the ICT revolution the overlap has been particularly important and has created unexpected winners and losers. China’s economic reforms (1982) and the fall of the Berlin Wall (1989) had the effect of radically expanding the length and scope of the Mass Production Age at a time when the “creative destruction” of the ICT Age should have been undermining it. Instead of increasing productivity German corporations moved mass production to Eastern Europe and American corporations outsourced to China, to exploit cheap labor. Companies also were able to avoid expensive environmental costs by offshoring carbon-intensive, heavily polluting industries to China and the Middle East, delaying the diffusion of “green” technologies for decades. The Mass Production Age, with its high environmental costs, was extended to the enormous benefit of China and a few countries in Eastern Europe, at the expense of workers in Europe and America who were pushed into low-productivity service jobs, and the “Golden Age” of the ICT revolution has been delayed. ( U.S. productivity and growth have declined and inequality has risen sharply while Amazon makes it ever easier to buy Chinese-made goods.)

The slow diffusion of the ICT age and the extension of the mass production age has had very uneven consequences for emerging market countries. The winners of the ICT age have been those countries that were late comers to the mass production paradigm and understood that the ICT revolution would lead to massive reductions in communication and transport costs and a new wave of globalization. The Asian Tigers (Korea, Taiwan, China, Vietnam) and to a lesser degree Eastern European countries (Poland, Czech, Hungary) have been the champions by integrating themselves in global mass production value chains and assiduously working to add value. South-East Asian countries (Indonesia, Thailand, Malaysia) initially did well but increasingly find themselves sandwiched between newcomers like Vietnam and Bangladesh, which are competitive in low value-added products, and China for higher value-added products. Both India and the Philippines almost completely missed out on the mass production age revival but have made small niches for themselves in the ICT world with Business Process Outsourcing (BPO) and IT Services Outsourcing.

The big loser of the ICT age has been Latin America, which has undergone severe deindustrialization and has become mired in the middle-income trap. Mexico has suffered the greatest frustration. This country, led by its brilliant technocrats, did everything right to position itself for the mass production to ICT transition, entering into the groundbreaking NAFTA trade agreement with the U.S. and Canada. The thinking behind NAFTA was brilliant. It would facilitate a smooth transition out of mass production to ICT for U.S. firms while extending the benefits of the mass production age to a friendly neighbor operating under controlled conditions (labor, local content, subsidies, environmental, etc…). Unfortunately for Mexico, the dramatic rise of China as the factory of the world undermined all of these objectives, as China successfully dominated global value supply chains without having to meet any of the conditions Mexico had to comply with.

South America has not fared better. As high-cost producers with very volatile currencies and economies, these countries were unprepared to compete with China. These disadvantages were compounded by (1) the false hope created by the commodity boom  (2002-2012) which resulted in a typical boom-to-bust cycle and a vicious case of Dutch Disease (natural resource curse) that these countries have yet to recover from and (2) the adoption of “Washington Consensus” financial opening dogma (free movement of capital) which increased volatile flows of hot money and destabilized currencies.

The following chart shows economic convergence since 1980 (in terms of USD GDP/Capita) for a sample of developed and emerging market countries, which is illustrative of the winners and losers of the ICT Revolution.

The Golden Age of ICT

If Perez is correct and we are on the verge of a Golden Age of  extensive diffusion of ICT technologies through all segments and geographies what should countries be doing?

Perez and Raphael Kablinsky in his recent book, Sustainable Futures, An Agenda for Action, argue for activist government using its resources to incentivize private investment to achieve desirable societal goals (e.g., environmental sustainability, equal opportunity). The Biden Administration’s recent Inflation Reduction Act (IRA) and the Chips and Science Act are both in that spirit, aiming to promote investment in clean energy and energy efficiency and the re-shoring of  semiconductor production away from the Asian mass production value chain. These initiatives, as well as President Xi’s Made in China 2025 Plan, all assume that the great Mass Production Age extension through China-centric global value chains has run its course, and that ICT diffusion will now result in, without excess short-term costs, a return to more local/regional manufacturing and a more autarkic or segmented global trade system. Through massive state subsidies China already has taken a commanding lead in the production of “green” products such as electric vehicles and batteries and solar panels.

The return of activist government, coming after a 40-year period of neo-liberalism and government retrenchment, raises the question of what policies countries should pursue to fully reap the benefits of this final phase of the ICT Revolution.

Perez recommends two basic courses of action that many emerging economies and developing countries can pursue. First, governments should be active in promoting ICT diffusion in industries where competitive advantages are evident. For example, commodity rich countries like Brazil, Argentina and Chile can increase productivity by being at the forefront of ICT innovations applicable to farming and mining and, at the same time, aggressively move up value chains for these products. (Brazil, with its low carbon-dependent economy and enormous potential in solar, wind and biofuel energies, is well positioned to become a global leader in “green” farming and mining).  Second, Perez sees large opportunities for countries or regional groups to capitalize on climate change initiatives by deploying alternative energy sources and capturing their value chains through localized production. (Once again, Brazil with its large local market opportunity can achieve leadership).

The consulting firm McKinsey provides a roadmap for the future in a recent article, “Accelerating Toward Net-Zero; The Green Business-Building Opportunity” (Link). The following chart from McKinsey maps out the sectors expected to have the largest economic importance in a “greening” economy and, consequently, where governments and firms are advised to focus their efforts.

Investment Factors in Emerging Markets

Since the 1970s when quantitative analysis began to dominate investing financial academics have looked for the drivers of investment returns. Initially, the focus was on explaining stock market returns in excess of risk free Treasury Bills in terms of compensation for higher risk. Then it was found that this market risk premia could be decomposed into the value and size factors, as empirical evidence showed that cheap stocks and small capitalization stocks provided their own excess returns beyond the market premia. Over time, academics have come up with a multitude of additional factors, of which quality (high profitability and low capital requirements) and momentum (rising stocks continue to outperform) are the most important.

Over the past twenty years these investment factors have become staples of the investment industry sponsored by index providers and investment firms. One of the benefits of this proliferation of new products and data is that it provides significant explanatory evidence for market developments. Emerging markets are no exception to this, and we can explain much of recent market developments in terms of factors.

The chart below  shows the evolution of the primary investment factors in emerging market stocks for the past ten years. The data is from Professor Kenneth French’s website (link ) of Dartmouth College. The factors are small caps (SMB), value (HML), profitability (RMW), momentum (MOM) and low capital intensity (CMA).  We can see that the past decade has been entirely dominated by the momentum factor. This was particularly true from the Spring of 2017 through the summer of 2020 which was the period of the great tech boom in both the U.S. and China. In a world of low growth (emerging markets  and most of the global economy were in a state of semi-depression during the past ten years) and exceptionally low interest rates, long-duration “growthy” assets experienced significant expansions in their price to earnings multiples.  Value and small caps stocks, on the other hand, are highly sensitive to economic conditions and, consequently, languished over this period. Not surprisingly, over this period  “growth” investors came to completely dominate performance and asset accumulation, while “value” funds had a horrible decade. Note that value has had a big comeback since November of 2020, a move that has left most EM portfolio managers poorly positioned and with poor performance. This is shown in more detail in the second chart.

Investment factors, like most things in finance and investing, go through cycles of strength and weakness, with mean reversion periodically bringing them back to long term trends. The graph below shows the Fama-French data for emerging markets from 1989 until June 2022.  We can see that over this 32 year period, the momentum  (MOM) and value (HML) factors have generated large premia while small caps (SMB), profitability (RMW) and low capital intensity (CMA) have provided more modest premia.   Both momentum and value have had long periods of superior performance, and  since 2014 momentum has taken off dramatically.

The following chart provides more detail with a decade by decade breakdown for MSCI EM from 1992-2022  and for the S&P500 from 1962 to 1992.  We can see that in both the U.S. and EM factor performance is inconsistent, varying significantly from one decade to another. The fact that factors can lag for extended periods of time (a decade is an eternity in the life of a portfolio manager) means that these trends determine the trends of the investment industry. For example, the phenomenal success of Warren Buffett, considered the leading investor of the past forty years, was driven by the huge premia provided by the value factor between 1972 and 1992. If Buffett had launched his fund in 2002, he surely would have gone out of business very quickly.

 

In EM, though all factors under consideration provide premia, for small caps (SMB) almost all the outperformance was secured in the 1992-2002 decade, and for value (HML) most of the premia was accumulated during 1992-2012. The poor performance of small caps explains why this market segment is neglected in the EM fund industry. The very strong performance of EM value in the 1992-2012 period made this style of investing very popular with fund managers and fund marketers. However, the poor performance of value between 2012-2020 nearly decimated this style of investing and led to the closure of many funds. With EM value bouncing  back over the past two years, catching almost  all fund managers off guard, it will be interesting to see if value investing makes a comeback.

 

Emerging Markets Expected Returns, 2Q2022

For over a decade earnings and earnings multiples have declined for emerging market stocks, leading to very poor returns both in absolute terms and relative to the S&P 500. Over this period, these markets went from “bubble” conditions in 2010-2013, fueled by the commodity super-cycle and the rise of China, to the current depressed state which reflects slowing growth, Covid, geopolitical risk and  global financial instability caused by high debt levels and a rising USD.

We can see this evolution in the following tables. On the left, Cyclically Adjusted Price Earnings (CAPE) multiples are shown for the S&P500, EM stocks (MSCI) and a sample of emerging market countries. Note the contrast between the sharp rise in the U.S. and the decline in most emerging markets, with the exception of the tech-centric Taiwan. On the right, dollarized MSCI EM earnings are rebased to 100 in 2010. Here we see the striking contrast between surging earnings in the U.S. market and the flat to negative earnings in EM, once again except for Taiwan (TSMC). Even China, with its supposedly high GDP growth, strong RMB and enormously successful tech stocks, has seen no earnings growth over this period.

Predicting the future evolution of geopolitics, Fed policies and the other myriad factors that impact economies, capital flows and stock markets is always a daunting challenge for investors. For this reason, it is often best and easiest to assume that historical patterns of valuation and mean reversion will persist. In this regard, we can use CAPE analysis to provide a basis for valuation parameters. Though CAPE is not a short-term timing tool, it has proven effective in predicting long term returns. This is particularly true at market extremes, like 2010-2012 when CAPE was screaming “bubble” across EM.

The CAPE  takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful tool for highly cyclical assets like EM stocks.  We use dollarized data to capture currency trends. This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University.

The chart below shows CAPE ratios for 16 EM countries, global emerging markets (GEM, MSCI) and the S&P500 relative to each country’s history. This gives a general idea of where valuations are on a historical basis for each country. Extreme discrepancies from historical patterns are currently evident in the U.S. and India on the overvalued side. Most emerging markets appear to be very undervalued; Turkey, Korea, Colombia, Philippines and Chile are at extremes.

In the table below we show the results of our adjusted CAPE methodology for estimating future expected returns. The expected returns of markets depend on valuation (CAPE ratio) and earnings growth (largely a function of GDP growth). No consideration is given here to possible multiple expansion or the liquidity factors that may have a major influence on market returns. The two columns on the far right show (1) the expected nominal return for  each index and (2) the real (inflation adjusted) expected return for each index with the addition of expected dividends.

 

The methodology derives expected returns by setting a long-term price objective based on the expected CAPE earnings of the target year, which in this case is 2028. The CAPE earnings of the target year are multiplied by the historical median CAPE for each country. The underlying assumption of the model is that over time markets tend to revert to their historical median valuations.

The countries with very low expected returns (Indonesia, U.S., Thailand and India)  each have their specific issues. Given the stretched valuation, Indian firms will have to surprise the markets with better than expected earnings growth.  The U.S. faces the challenge of high CAPE multiples, record corporate operating margins and declining  potential GDP growth.  Thailand and Indonesia are reasonably priced  and could enjoy higher returns if GDP growth surprises on the upside. This would require a boost in productivity to break out of the current trap these countries face, stuck between new low-cost competitors (e.g. Vietnam) and China’s industrial might.

The five markets with the highest expected returns (Turkey, Brazil Colombia, Chile and Peru) are all in countries with significant economic and political concerns. In the case of Turkey, the destitution  of President Erdogan is probably necessary for these returns to materialize. As for the Latin American countries, political stability and high commodity prices would make these returns likely.

Taiwan’s high expected returns require a recovery of the semiconductor cycle, which is likely. Also, investors have to be comfortable with rising geopolitical risk in the Taiwan Strait.

 

Winter is Here for Emerging Markets

The first half of 2022 has been another big disappointment for investors in emerging markets as EM stocks fell 17%. On the positive side, EM stocks did better than the S&P 500, which fell by 20% during this period. Unfortunately, the rest of the year does not look better. The environment is simply not positive for EM assets. I wrote in February that Winter was  coming  (link)   ; now we can say that we are in the thick of winter.

All the indicators that we look at to mark the investment climate point firmly to more trouble ahead. Let’s look at these one by one.

  1. King dollar – EM assets usually do poorly when the dollar strengthens, mainly because most EM countries are short dollars and because commodity prices tend to do poorly during these times. The dollar has been strong since 2012, and this has been an awful period for EM investors. The recent surge in the dollar caused by high global risk aversion and flight of capital into U.S. assets, is a huge headwind for EM. The charts below show  first the DXY (heavily weighed towards the euro and the yen) and second the MSCI EM currency index, both of which show the sustained run the dollar has had for 10 years.

2. Global dollar Liquidity – Risky assets like EM stocks and bonds do well when dollar liquidity is ample and poorly when it dries up. After the money printing orgy of 2021, the tide has ebbed. The charts below show: first, one measure of global liquidity (U.S. M2 plus central bank reserves held at the Fed);  and second, central bank reserves held a the Fed. Liquidity is now in free fall. Foreign reserves held at the Fed are also plummeting, as countries like China and Russia have dramatically reduced their positions for geopolitical reasons and other countries are fleeing the negative real yields of Treasury notes.

3. Yield spreads – The spread between the yield of U.S. high yield bonds and Treasury bonds is one of the best indicators of risk aversion and recession risk. Historically, rising spreads point to problems for EM. We can see in the next chart the recent rise in the spread. Moreover, the rise in the spread has been tempered by the benefit of high oil prices for oil companies. Stripping these out the spreads would be much higher.

 

4. The CRB Industrial Index – Commodity prices and in particular industrial commodity prices are a tried and true indicator ofmarket trends for EM assets. This has been even more so since the rise of China twenty years ago because China is the primary consumer of industrial commodities, and any slowdown in China now spreads rapidly to the rest of EM. The CRB index, shown in the chart below from Yardeni.com,  has turned down since February and now appears in free fall. The combination of high oil prices and low industrial metal prices is a very bad one for EM.

5. Copper price – Finally, the price of copper is a good indicator of global economic activity, as Dr. Copper is known to sniff out recessions earlier than most economists. Unfortunately, copper also appears in free fall now.

So, all the relevant indicators tells us we are in a winter storm. It is best to sit be the fire with cash in hand and wait for calmer times.

The Great Inflation Debate

The great investment debate of today is about the future course of inflation. Economists and investors are divided into the “inflationistas” and “deflationistas.” The former, “Team Permanent,” see the recent surge in inflation as indicative of a regime change towards a world of supply scarcity and higher prices.; the latter, “Team Transitory,” believe we are stuck in a low growth and demand-constrained environment where prices always fall unless monetary authorities intervene.

Until recently, the “deflationistas” were triumphant. Fears that the money printing and fiscal expansion that followed the Great Financial Crisis would spark inflation never materialized. The past ten years have been marked by low inflation and a strong dollar despite zero bound nominal interest rates. The core argument of the “Deflationistas,” as expressed by economist luminaries such as Paul Krugman and former Fed Chair Ben Bernanke, is that inflation is repressed by declining growth in the working age population. This phenomenon, sometimes called “secular stagnation” or also “the global savings glut” has supposedly  brought down the “natural rate of interest” which preserves price stability.

Deflation has been the norm for so long that it is understandable that most people assume that it  will persist.

Since the U.S. Consumer Price Index (CPI) peaked at 15% in the spring of 1980 it has been on a persistent downward trajectory. This has been dubbed “The Great Moderation” by Bernanke  who attributed this result to the masterful management of the Fed and  its 400 economists.

The contribution of the Fed to the deflation process is difficult to confirm because of the various other factors that have concurrently impacted prices over the period. These are well known, but we list them below:

  1. The collapse in commodity prices. Energy prices fell by 80% during the 1980s and remained low until 2002. Following the GFC, the U.S. shale revolution drove energy costs in the U.S. to near record lows.
  2. The baby boom labor expansion which was magnified by a huge increase of the female participation rate in the labor force, and also by record levels of legal and illegal immigration.
  3. The rise of China under Deng (1982) and the fall of the Berlin Wall (1989), which added nearly a billion low-cost workers to the global economy. China’s debt-fueled mercantilist industrial promotion policies also dramatically increased global production capacity for a wide variety of industrial goods.
  4. Hyper-globalization, driven by declining transportation and communication costs and chronic U.S. current account deficits. Outsourcing has been highly deflationary, lowering labor costs of goods and putting downward pressure on domestic wages.
  5. Hyper-financialization, driven by the Washington Consensus for open global capital and labor markets.
  6. The Reagan-Thatcher Neoliberal Revolution which drove prices down through deregulation, the defenestration of labor unions and lower taxes.
  7. Lax anti-trust policy which incentivized corporate concentration . This was further accentuated by the emergence of  “winner-take-all” network-driven technology business models.
  8. Digitalization of consumption through technology.

Over this long 40-year deflationary period, different forces have dominated at different times. For example, in the 80s declining commodity prices, deregulation and abundant labor were the dominating forces. However, in the 00s, the “China supply shock” (including cheap Chinese labor) and hyper-financialization were the dominant forces, overwhelming the temporary surge in commodity prices.

Some of these deflationary forces are still operative today. Foremost, technology continues to be deflationary as digitalization spreads wider (entertainment, office work, medicine, etc…) and communications facilitate offshoring (eg. IT in Bangalore). Supposedly accelerating technological disruption is now the key argument of many deflationistas (e.g. Cathie Wood of Ark Investments), even though over the past decades this was probably of secondary importance to the overall deflationary trend.

There is also a major new source of deflation, which is the high levels of debt accumulated around the world and, consequently, the collapse in “money velocity” (the creation of money through commercial bank lending). Though this is a controversial topic with economists, there are reasons to believe that the very high levels of debt around the world repress future economic growth. This is manifested by the decline in the money expansion created by bank lending over the past decades, and it explains why quantitative easing has had little impact on consumer prices. It may well be that debt levels are so high that any effort to raise real interest rates by central banks will tank economies. This view, pushed by the investor Ray Dalio, assumes that we have reached the peak of a long-term debt cycle.

On the other hand, there are new inflationary forces and some of the powerful deflationary forces of recent decades may have lost steam. These inflationary  factors can be listed as follows:

  • Commodity prices have surged recently and may continue to rise because of underinvestment caused by regulations and ESG lobbying. The shale revolution in the U.S. may have peaked out and may no longer provide a source of low-cost marginal production.
  • Labor in developed countries is now tight because of ageing populations, a decline in female participation rates and anti-immigration policies. The working age populations in most developed countries and in China are now in steep decline which should increase the cost of labor if productivity does not compensate.
  • Hyperglobalization may be under threat as reliance on China and other Asian manufacturing hubs is increasingly seen as irresponsible in an increasingly fraught geopolitical environment.
  • Hyperfinancialization is under question as unfettered capital flows have proven to be highly disruptive for both the United States and most emerging markets. Over this long deflationary period, chronic current account deficits have made the U.S. a net debtor to the world with a Net International Financial position going from positive 10% of GDP in 1981 to negative 86% of GDP in 2021.
  • The neoliberal revolution may have exhausted itself. Labor unions are showing signs of making a comeback and tax cuts have resulted in chronic deficits and record debt levels. Also, there is a growing realization that without government interference the U.S stands to lose jobs and stature to countries which actively support industries through subsidies and mercantilist policies (e.g. semiconductor manufacturing which may soon disappear from the U.S. unless the government supports it). Moreover, there are some signs of a resurgence in anti-trust efforts from Washington.

The debate between the “deflationistas” and the “inflationistas” will not be settled anytime soon. There are simply too many moving pieces and competitive forces at work to have high conviction now. Nevertheless, for the first time in decades the Fed may no longer have the wind at its back and the luxury to print trillions of dollars to support economic activity and financial markets. If the Fed is faced  with the choice between supporting the economy and financial markets or controlling inflation, political pressures will guide its decisions. In a world of populist politics this may mean higher prices in exchange for more government spending and higher wages.

The charts below show the inflation story in pictures.

Deflation has been a global trend since the 1980s.

But has also recently has been on the rise everywhere.

 

Commodity prices (relative to inflation) were extremely deflationary between 1980-2000 and 2012-2020, but are also rising sharply now.

 

The impact of deregulation on freight rail  rates.

The defenestration of labor unions.

 

Outsourcing has shifted share of GDP from workers to corporations.

The rate of growth of the working age population has collapsed.

Money velocity has collapsed as debt levels increase.

 

 

 

Another Emerging Markets Debt Crisis?

After ten years of extraordinary accommodative monetary policy, marked by a 2020 peak of $19 trillion in negative yielding debt, it is understandable that debt levels have grown to record high levels. Markets have been complacent about this accumulation of debt because of low servicing costs and persistent deflationary trends. However, recent developments that point to resurging inflation are now forcing central banks to seriously consider restrictive monetary policies, including positive real rates, that would lead to much higher servicing costs for highly leveraged governments, households and corporations. This is worrisome for emerging markets which do not tend to fare well during tightening cycles occurring after long periods of debt accumulation.

As the following chart from the Financial Times shows, developing countries debt levels are at record levels and have grown precipitously since the Great Financial Crisis. The total debt to GDP ratio for developing markets has more than doubled since the GFC.

 

The following chart shows the evolution since the GFC in more detail for EM countries. Debt  to GDP ratios  have nearly doubled for total debt as well as for government, household and corporate debt. These ratios would be even worse if not for the extraordinary policies of financial repression and negative real interest rates pursued in 2021, as central banks allowed inflation to surge.

 

Debt levels of many key EM countries, shown in the chart below, are now at levels which leave them highly vulnerable to economic stagnation and financial crisis. Asian EM countries (with the exception of Indonesia) and Chile and Brazil are all at very high levels in absolute terms and relative to their histories. China (considering SOE debt and overstatement of GDP), India (considering overstatement of GDP),  Brazil and Argentina all have levels of government debt close to 100%, a level which is considered highly debilitating by students of debt dynamics. China, given its capital controls and state-controlled banking system, may have the means to avoid financial disruptions but that is less true for the others, particularly for Latin American countries which have a history of rapid and profound shifts in capital flows and currently face strong capital flight from their own citizens.

 

The pace of increase in debt levels in recent years is also cause for concern. The chart below shows the increase in debt to GDP ratios over the past five years and during 2021.  Historical precedents point to countries facing high risk of debt-related crisis following a surge of their debt to GDP ratio  of 20% or more over a 5-year period. Last year was a year of acute financial repression by most central banks, so it is no surprise that debt levels came down for most countries. We can see the positive impact that this had for Brazil, in the next chart which shows how interest rates lagged inflation. Unfortunately, as the Scotiabank chart projection below shows, this effect will reverse in 2023, leading to high real rates.

Below, we focus on several key EM countries, each with its own vulnerabilities.

China

Debt levels have more than doubled since the GFC. If we assume that GDP figures need to be adjusted downwards by 20-25% to make them comparable to other countries, then debt ratios could be approaching 350%. Government debt has more than doubled over this period, and if we consider that almost all corporate debt is held by SOEs, then government debt would be well above 100%. The issue in China is not government solvency as the state has all the tools to keep the financial system operating smoothly. Rather, the vulnerability is that very high debt levels are choking the economy, and that the economy relies on unproductive debt-fueled growth to sustain growth. The consequence is that future growth levels can be expected to be low.

Brazil

Brazil’s debt levels are much too high for the economy to function properly and condemn the economy to low growth unless a serious fiscal reform or a productivity miracle occurs. Brazilian debt levels are at record high levels and they have risen by 60%  since the GFC, a period during which growth and investments have been very poor. The government debt ratio has risen by 50%, to finance current spending, while corporate debt  has risen by 70% and household debt has doubled. Government debt will likely reach 100% over the next year, which is much too high for a country with a structural deficit and which suffers from capital flight and political turmoil. Unlike in China, Brazil’s banks are private and managed very conservatively.

Korea

Kore’s debt ratio has risen by 50% since the GFC and is now one of the highest in the world. The government debt ratio has doubled over this period but remains at reasonable levels, and corporate debt has risen by 30%. Household debt has risen by 50% to 107% of GDP, an exceptional level, even higher than that of the consumption-happy United States. These very high debt levels would become a significant burden for the economy if interest rates rise, and could be a source of popular unrest with political consequences.

The Fed’s decade-long experiment in free money now may be at its end, leaving behind mountains of debt everywhere. Already weakened by the pandemic, political tensions and slowing growth, many emerging markets will add higher interest bills to their woes.

Global Growth Prospects

The World Bank has significantly reduced its growth outlook for 2022 and is  concerned that we may be facing “global stagflation.”  The World Bank’s “Global Economic Prospects June 2022″ report   highlights  the vulnerability of lower income economies in the current environment of lower growth and rising food and energy prices. Nevertheless, the bank  retains a relatively sanguine view, as it sees a persistently vibrant U.S. economy and declining commodity prices in both 2023 and 2024.

The chart below resumes the World Bank’s latest real GDP forecasts for emerging market economies  and several  important frontier markets (Nigeria, Pakistan, Bangladesh and Vietnam.) The bank’s forecast provides growth estimates through 2024. The chart ranks countries in terms of their 3-year average real GDP growth for the 2022-2024 period. The two columns on the right show the changes since the bank’s prior forecast six months ago which was made prior to the Ukraine invasion and the COVID lockdowns in China. Given its mandate, the bank tends to be “politically correct” in its forecasts. Historically, this has resulted in the bank usually accepting China’s official targets, and in this case it may explain the optimistic forecast for the U.S.  The relatively low economic cost to Russia  for the invasion of Ukraine (well below most other estimates) is difficult to explain.

As we have come to expect, most of the world’s growth will come from Asia where the bank expects stellar GDP growth in India, Bangladesh, Vietnam, the Philippines and Indonesia. This kind of growth is probably not priced in for the stock markets of Indonesia and the Philippines.  Egypt’s high expected growth is also surprising good news for this normally struggling economy and should be supportive of  higher asset prices. Though Malaysia’s expected growth is not as stellar, stock prices there are very low and also provide good prospects.

Also, in what has become the  “new normal,” growth prospects in Latin America and South Africa are dismal. Chile and Brazil are at the bottom of the chart, and would be last if not for the dramatic woes inflicted by Putin on Russia. In the case of both Chile and Brazil these GDP forecasts are likely optimistic if Chile’s new constitution is approved as currently expected and if Lula wins the election in Brazil as is also the most likely scenario. The one  Latin American exception — Colombia — is a big if, as the World Bank’s forecast is certainly wildly optimistic should the former guerilla fighter Gustavo Petro win the election on June 19. As in the case of Chile, Colombia faces capital flight and low investments for the foreseeable future.

The yuan’s Long Road To Hegemony

Talk of the yuan replacing the U.S. dollar as the global reserve currency is mostly idle because China neither provides the conditions for this to occur nor appears to desire this outcome over the short term. Nevertheless, over time, the U.S. dollar’s hegemony is fraying, leaving a vacuum which will be filled by alternative currencies.

The conditions for a currency to establish itself as the dominant global instrument for trade transactions and storing wealth are shown by history. First, reserve currency status is a function of a country’s dominance of economic output (GDP), trade and net creditor status. Second, certain arduous requirements need to be met:

  • Trustworthiness
  • Institutional strength (rule of law, property rights)
  • Large economy and reliable trading partner
  • Free movement of capital and strong banking system
  • Large and liquid sovereign bond issuance providing safe assets
  • Willingness to provide global currency liquidity

 

No previous reserve currency has had the scale or scope that the U.S. dollar has had over the past seventy years, being generally limited by the country’s geographic hegemony. For example, the British pound was the leading reserve currency for a century (aprox. 1814-1914) because of its global empire and naval domination but it still left much of the world uncovered and faced competition from European rivals (France, Germany).

Post W.W. II U.S. dollar hegemony was secured because of America’s near total economic dominance. However, over time this has changed dramatically. The following chart from the IMF, which measures GDP, trade and net creditor status, shows the evolution over time: the U.S. goes from absolute dominance in the 1950s to a much weaker position today. By this measure, China has already surged and is poised to assume more influence.

 

 

The following three charts show this in detail: 1. Share of global GDP; 2. Share of global trade; 3. Net creditor status. The first two are shown for both the U.S. and China; the third shows the evolution of the U.S. net creditor position, from 20% positive in 1950 to over 80% negative in 2022 (China’s positive net creditor position is estimated to be about 15% of GDP, similar to the U.S. position in the 1950s).

 

On the other hand, with regards to the “institutional” and policy characteristics required to establish reserve status China lags far behind.

  • Trustworthiness – Though trust in the U.S. has declined in recent years because of the heavy-handed use of “sanctions diplomacy” it retains considerable advantages over China. China has antagonized a great many potential partners by engaging in provocative “wolf warrior” diplomacy. Moreover, China is even more prone to sanctions diplomacy than the U.S., as shown recently by retaliations against Korea, Australia and Lithuania for criticizing China’s policies.
  • Rule of Law – China’s lack of due process and judicial independence makes it a poor safe haven. Though the recent freeze on Russian assets held abroad by the U.S. and other western countries have created a terrible precedent, by and large investors still expect to be treated fairly by U.S. courts.
  • Large economy and reliable trading partner – This is China’s strong point and where it can increasingly contend with the U.S..
  • Free movement of capital and strong banking system – China fails on both counts. It has strict capital controls, mainly to keep domestic capital from fleeing. Also, it remains fully committed to managing its currency to preserve export competitiveness. Its banks are agents of the state and can be considered “highly liquid but insolvent.”
  • Large and liquid sovereign bond issuance providing safe assets – China is improving quickly on this count, but is still way behind the U.S., and the lack of rule of law and the presence of strict capital controls will impede progress.
  • Willingness to provide global currency liquidity – This is the biggest impediment for China to move forward on reserve currency status. The global economy needs a constant and predictable increase in the volume of the reserve currency. Under the British Gold Standard gold output increased by over 2% a year to keep the system liquid. Under the U.S. fiat currency system, the U.S. has run persistent current account deficits to feed dollars into the global economy. Since 1980, the U.S. has run annual current account deficits of on average -2.7%. This global liquidity is the counterpart to the growth in the U.S.’s negative net creditor position. Meanwhile, since 1980 China has run current account surpluses of 2% of GDP, allowing it to build its net creditor position. There is no evidence at this time that China would  change the mercantilist policies that support its export competitiveness and sustain current account surpluses, and until it does the yuan cannot increase its global hegemony.

Conclusion

Over the past twenty years China has become the primary buyer of global commodities. For example, China has replaced the U.S. as the biggest importer of oil. This raises the possibility that the dollar’s stranglehold on the pricing of most commodities may not persist. U.S. sanctions diplomacy against major oil producers such as Iran and Russia have already thrown these countries into the arms of China and reportedly have resulted in a significant amount of Chinese imports being invoiced in yuan. At the same time, China has established close diplomatic ties with Saudi Arabia which may be considering similar arrangements. A deal with the Saudis would be a watershed event, given how important the U.S.’s deal with the Saudis in 1974 was in securing the dollar’s hegemony  in the 1970s. However, unlike the Iranians and the Russians, the Saudis have options. In the end, the Chinese will need to convince the Saudis to invest in the Chinese capital markets which brings us back to the inadequacy of the yuan as a reserve currency for the reasons listed previously.

King dollar Will Rise Before it Falls

The U.S. dollar’s role as the global reserve currency has been questioned repeatedly during the 7o years since it was established at the Bretton Woods conference in  1944. Current opposition to the U.S. monetary order and calls for its replacement are nothing new and echo past critics who have complained that the U.S. abuses the system to favor its own interests.  Yet, the dollar system today in many ways is stronger than ever, and  there are currently no viable alternatives.

At the Bretton Woods conference strong opposition to a U.S. centric monetary order  was voiced by Maynard Keynes who argued instead for a decentralized system which would prevent countries from running persistent current account imbalances.  Keynes’s fears proved well-founded,  and by the late 1960’s persistent U.S. current account deficits led France to denounce what it called America’s “exorbitant privilege” (i.e., the ability to pay for imports with printed fiat money).  First France and then several more countries demanded to move their gold reserves back home, which left U.S. dollar reserves depleted and undermined the implicit U.S. dollar-gold connection that had been a key feature of the Bretton Woods agreement. In August 1971, Richard Nixon announced the end to the convertibility of dollars into gold, which gave birth to the current U.S. fiat currency monetary system.

The current dollar reserve system has been unique in both its nature and scope. It is the first major currency  reserve system in 700 years of Western financial  history which is not linked to a metal and relies exclusively on the creditworthiness of the issuer. Second, the U.S. dollar can be considered the first truly global currency, as no previous reserve currency has had its geographical reach.

Nixon’s decision was momentous. It had been assumed that a stable monetary order would require a link to gold. England had been able to maintain a stable gold price for nearly 200 years. The U.S. has secured a stable gold price around $20/ounce since 1792, with the only exception being FDR’s devaluation in 1934, to $35/ounce.  FDR’s decision had been seen to be an adjustment within the system, while Nixon’s was perceived as its full repudiation. The chart below shows the evolution of the USD/gold price from 1931 (before FDR’s decision) until 1980.

Not surprisingly, Nixon’s decision was not well received by global capital.  It led to the first genuine dollar crisis  (chart below) and to a long period of dollar weakness,  high inflation and economic “malaise,” as described by Jimmy Carter. During the 1970s talk of the rise of the Deutsche mark and the Japanese yen as viable reserve currencies was prevalent and both currencies appreciated by more than 40% against the USD.

Two separate events were instrumental in recovering the dollar’s credibility. First, behind the scenes, in 1974 a secret deal was reached between Treasury Secretary William Simon and Saudi Arabia’s King Faisal for the Saudis to agree to invoice all oil exports in USD in exchange for U.S. weaponry and protection. This deal, in essence, defined the terms of the new fiat monetary system, providing a mechanism for recycling persistent U.S. current account deficits back into U.S. financial assets. The new “petrodollar system” allowed for the “neutralization” of the high commodity prices of the 1970s by channeling windfall OPEC oil profits into Wall Street banks, which, in turn, flooded the world with dollar loans.

The second event that established the dollar’s supremacy was the appointment of  Paul Volcker to head the U.S. Treasury in 1979 . He  proceeded to raise  the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981.  Volcker’s super-hawkish policy coincided with the election of Ronal Reagan in November 1980,  and the combination of tight monetary policy with the promise of economic rejuvenation through “supply-side” economics led to a massive dollar rally, lasting t0 1985.

The twenty years between 1980 and 2000 can be considered the golden age of the dollar.  The “Petrodollar System” for recycling U.S. current account deficits back into the U.S. financial system worked smoothly over this period of relative economic and price stability. One of the assumptions of the system was that the U.S. would manage its economy to maintain general price stability and the purchasing power of commodities. We can see in the following chart that this was largely achieved  during this time, as oil prices were kept stable in both nominal and real terms (and at acceptably high prices for OPEC).

This period of faith in dollar supremacy led global central banks to sell  long-held gold reserves in exchange for treasury notes and other U.S. assets. The following chart from Ray Dalio shows clearly why the 1980-2000 can be considered the dollar’s heyday.  We can see that Central Banks aggressively  sold dollars for gold and Deutsche marks during the 1970s, only to about-face when Volcker hiked rates. Central Banks then proceeded to dump gold reserves  for the next twenty years. By 2000, the dollar’s share of central bank reserves was at its all-time high while gold reserves were at all-time lows.

This golden period for the USD unleashed two powerful trends: first, deflation (closely linked to hyper-globalization and the rise of China); second, hyper-financialization and chronic financial bubbles (directly linked to asymmetric policies pursued by an emboldened Fed convinced that modern macro economists had discovered the key to the “Great Moderation.” Naturally, these two trends are interdependent. Hyper-globalization could never have occurred without  a financial system able to absorb enormous inflows of foreign dollar reserves and also systematically increase credit to the U.S. consumer. At the same time, hyper-financialization relied on deflation  persistently repressing interest rates which enabled the Fed “put” to be activated anytime the system was perturbed.

Since its peak around 2000, the dollar fiat system has been under stress. The unwinding of the great TMT bubble in 2000 , the Great Financial crisis in 2008 and then a long period of extraordinary “experimental” Fed policy from 2008 until today are manifestations of an unanchored monetary policy. Going back to the previous chart showing historical WTI prices, we can see that the the assumption of price stability which was part of the “Petrodollar anchor” has come completely unglued since 2000, with enormous volatility on both the up and downside.

The only thing left from the Petrodollar regime are enormous current account deficits , now no longer driven by energy imports but rather by Asian consumer manufactured goods (the U.S. is now a net exporter of energy and commodities).  Keynes’s imbalances and France’s “exorbitant privilege” are greater than ever, remaining the essence of the U.S. centric monetary system.

But, as the eminent economist Joseph Stiglitz has noted ,”The system in which the dollar is the reserve currency is a system that has long recognized to be unsustainable in the long run.”  This is because, over time, structural current account deficits erode a country’s manufacturing base and competitiveness. This is even more true when, as has been the case for decades, prominent competitors pursue mercantilistic policies to promote their industrial exports (e.g., China, East Asia, Germany). The two charts below illustrate the essence of these circumstances: first, the persistent U.S.  current account deficits over the past 40 years; second, the U.S. role in absorbing the impact of trade surpluses generated by mercantilist competitors).

As shown below, not only has the U.S. lost competitiveness, it has also sold off  a significant part of its industrial base and corporations to foreign creditors, moving from a positive  international investment position to a highly negative one since 1980. This deterioration in net creditor status has accelerated in the past decade, and foreign creditors have increasingly shunned treasury bills in favor of direct investments, stocks and real estate.

If the current system is untenable, what can replace it?   Talk of a new monetary order built around China is idle,  as the RMB does not meet the basic requirements of a  reserve currency (rule of law, property rights, deep and liquid capital markets, free movement of capital).  Moreover,  a formidable mercantilist  China could never assume the responsibility of providing liquidity to the global market. Most likely, eventually Keynes’s old proposal from Bretton Woods will be resurrected.

Meanwhile, the USD remains king. Ironically,  the system’s  probable slow death will create intense havoc and uncertainty, conditions that favor USD strength not weakness. We have seen this clearly in recent years as the dollar has been strengthening, driven by massive capital flows out of international and emerging markets.

 

 

 

 

 

 

 

 

 

 

Don’t Fight the Rising Dollar!

Periods of dollar strength are deflationary in the context of the current dollar-centric global monetary system. A strong dollar is generally associated with global inflows into the U.S. either because the U.S. provides superior returns on capital relative to international markets or because high levels of risk aversion drive global capital into the “safe-haven” U.S. capital markets (liquidity, transparency and rule of law).

Periods of dollar strength are the two corners of the “dollar smile” as previously discussed  (Link ) and as shown below.

 

Dollar strength saps liquidity out of international markets, especially in emerging markets where governments and companies  are overly reliant on dollar funding because of shallow domestic capital markets. The combination of higher funding costs for these borrowers and flight capital often results in emerging market financial crisis, 1980, 1997  and 2008 being some of the most painful episodes.  Because of the ongoing surge in the dollar in 2022, we should expect that emerging market economies and asset prices will be under significant stress for the time being.

Because most commodities and a significant amount of global debt are  priced in dollars, a rising dollar depresses global demand and economic growth. This impacts global corporate margins and profitability , including American exporters and domestic industries that compete against foreign imports.

The deflationary nature of dollar strength has a strong impact on global stock market returns because it depresses the earnings of cyclical companies, particularly commodity and industrial companies and banks. Global stock markets in general and emerging markets in particular have much greater exposure to cyclical industries and therefore suffer more during these periods. In the U.S. market, industrials and multinationals with heavy foreign exposure also suffer from a strong dollar. The chart below shows how this phenomenon plays out in the U.S. stock market. During periods of dollar strength (1997-2000) and 2012-2021), the Nasdaq index dramatically outperformed the Dow Industrials Index because the Nasdaq is composed mainly of growthy, long-duration stocks while the Dow includes mainly cyclical businesses such as industrial and banks.

The chart below shows the impact on Dow Index earnings  caused by strong dollar deflationary periods. The three periods of dollar strength since the inception of the fiat dollar regime in 1971 are highlighted by the dark bars.  We can see flat to negative earnings in the first two periods and very choppy earnings in the current third period despite the Trump corporate tax cuts and huge stock buy-backs (the final leg up in earning was driven by the recovery in commodity prices in 2021.)

The charts below show the strongly negative effect that a strong dollar has on corporate earnings in emerging markets. The first chart shows that earnings  (in nominal dollar terms) for Global Emerging Markets (MSCI EM Index) were highly depressed during the last two phases of dollar strength (1997-2002) and 2012-2021.  The following chart shows the poor earnings performance of Chinese stocks, over the past decade despite  the RMB’s appreciation over the period, which is a testament to the poor governance and the deflationary effects of overinvestment in industrial capacity and debt expansion. Next, we see the same for Brazilian corporate earnings which by the end of 2021 have still not returned to 2012 levels in nominal dollar terms, despite very strong earnings growth for commodity producers in 2021. Same for India, which barely returned to 2012 earnings level in nominal terms in 2021 even though the Indian economy has enjoyed high rates of GDP growth. Mexico and Korea show a similar story. The one outstanding exception is Taiwan, which has seen good earnings growth because of strong links to the  global technology sector.

The history of emerging markets shows that practically all earnings growth comes in periods when the dollar is depreciating. The current dollar upcycle will eventually turn, bringing better prospects for investing in EM assets. Rising inflationary pressures and buoyant commodity prices may portend that a change is coming.

 

 

The “dollar Smile” does not favor Emerging Markets

The U.S. dollar’s recent surge against both developed and emerging market currencies has extended the current dollar upcycle into its tenth year. Since the end of the Bretton Woods gold-anchored monetary system in 1971, the dollar’s viability as a fiat reserve currency  has relied on the credibility of the Federal Reserve and the willingness of foreigners to own U.S. assets. Since 1971, a relatively predictable 16-18 year cycle has occurred, with 8-9 years of dollar strength followed by 8-9 years of dollar weakness.

Given the short life of the current dollar fiat-global reserve currency system and its absolute uniqueness in historical terms,   it is difficult to generalize and define trends. However, we can say that we are currently in a third upcycle for the USD in what appears to be a declining trend. This is highlighted in the charts below. The second chart details the current dollar upcycle, which started in early 2011. The current upcycle is now in its eleventh year, and, with the recent surge of the DXY to the 103 level, we are now at the long-term downward sloping trendline. We are currently seeing a triple top for the DXY as it has returned to peaks previously reached in 2017 and 2020.

The prolongation of the current dollar upcycle  may have several explanations. Both in 2017 and in 2020 the dollar experienced significant weakness which seemed to indicate the beginning of a downtrend. However, both these downtrends were aborted by market -shaking events that drove investors into U.S. assets: In 2017-2018, Brexit, the Trump tax cut and the  Powell pivot from hawk to dove; in 2021, the extraordinary combination of U.S. fiscal and monetary stimulus and surprisingly strong U.S. economy. Furthermore, the 2017-2022 period has been marked by the strong returns of U.S. equity markets driven by the phenomenal operational performance during the pandemic of America’s “winner-take-all” tech hegemons. Finally, the Russian invasion of Ukraine and China’s economic problems (bursting of the real estate bubble and mismanagement of COVID) have accentuated flows into  U.S. safe haven assets, mainly stocks and real estate.

The current strength of the dollar relies on the notion of American exceptionalism. The U.S. goes through periods of “exceptionalism” and “malaise” which have influence on investor appetite for U.S. dollar assets and set the course for the dollar. Despite all of its stark deficiencies, relative to the rest of the world today the U.S. looks very stable and attractive for investors and it is sucking up excess capital which drives dollar strength.

The chart below schematically describes a framework for understanding the drivers of the U.S. dollar. This so-called “Dollar Smile” framework , which is built on the insights of macro traders like George Soros and others, pinpoints how the dollar behaves in diverse economic environments.

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At the two corners of the mouth, conditions exist for a strong dollar. The right corner represents periods of U.S. exceptionalism when the U.S. leads the world in economic growth and attracts global savings. The left corner represents periods of global crisis when capital flows to the safety of financial havens, especially the U.S. with its large and liquid capital market. The current dollar upcycle over the past eleven years has been supported by one or both  corners of the smile at different times.

At the bottom of the smile, conditions exist for a weak dollar. These are periods of synchronized global growth when the rest of the world is relatively stronger than the U.S. and is attracting capital (e.g. the 1970s in Europe and developed Asia; emerging markets, 2000-2012).

At the present time, the dollar is supported by high levels of economic uncertainty arising from geostrategic conflict and the consequences of an extended period of global fiscal and monetary adventurism. The left corner of the smile is likely to dominate currency movements for the foreseeable future, which portends a strong dollar. Under these conditions, emerging market countries will continue to see persistent capital flight and their assets are not likely to offer attractive returns.

Expected Returns for Emerging Markets, 1Q 2022

After a dismal decade of slowing GDP growth and stagnant earnings, emerging stock markets are showing signs of life. Overall returns are dampened by the value destruction of private company stocks which has been engineered by China’s government over the past year, but returns for EM ex-China have been much better. Most importantly, some of the cheaper markets in EM have started to take off, which is catching the attention of trend followers and bringing new capital into play. This is happening partially because of a more favorable environment for value stocks, cyclicals and commodities, but also because a rotation out of  long-duration tech “dreamer” stocks has been triggered by rising interest rates. All of this is good, but, unfortunately, EM is not yet out of the woods because storm clouds are staying put; these are, specifically ,the rising USD,  the tightening of U.S. monetary policy and the explosion of food and energy prices. This is a lethal combination for emerging markets.

Looking beyond the turbulence of the short term, the market action should be a major comfort to long run investors. For the first time in a while, the cheap markets are performing much better than the expensive markets, and investors are taking notice.

We turn to our CAPE methodology as a contribution to taking long term allocation decisions in emerging markets. CAPE provides insight on where valuations stand relative to historical trends and can help to structure mean reversion trades which have a good chance of working over  a 3-5 year time horizon. We combine CAPE with macro-economic conditions and market technicals  to determine entry and exit points in the context of a long term allocation strategy. The CAPE (cyclically adjusted price earnings) takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful tool for highly cyclical assets like EM  stocks. At extreme valuations, the tool has had very good predictive capacity in the past.  We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized more recently by professor Robert Shiller of Yale University.

The methodology sets a long-term price objective based on the expected CAPE earnings of the target year, which in this case is seven years (2028). The CAPE earnings of the target year are multiplied by the historical median CAPE for each market. The underlying assumption of the model is that over time markets tend to revert back to their historical median valuations.

The table below summarizes the results of our calculations for 17 EM countries, global emerging markets (GEM, MSCI) and the S&P500. The expected returns of markets depend on valuation (CAPE ratio) and earnings growth (largely a function of GDP growth). No consideration is given here to possible multiple expansion or the liquidity factors that may have a major influence on market returns.

Not surprisingly, all the  markets with the lowest valuations and highest expected returns are currently facing difficult economic and/or political prospects  Investing in these countries requires a leap of faith that “normalization” is possible. For example, it assumes that the current crisis in Turkey will be resolved adequately, that Chile’s constitutional reform will not structurally impair growth prospects and that China’s absurd vendetta against its most innovative and dynamic private firms will come to an end.  Until recently, none of these trades has worked. Still today, Chinese stocks are sliding, but the other cheap markets — Turkey, Brazil, Chile  and South Africa — are all doing much better, which is heartening.

 

High Commodity Prices for Brazil Probably Mean Another Wave of Dutch Disease

It is an unfortunate reality that for most countries natural resource wealth is counterproductive. This phenomenon is known in economics as “Dutch Disease,” in reference to the Dutch natural gas boom in the 1960s which resulted in currency overvaluation, declining manufacturing exports ,  higher unemployment and lower GDP growth.

In the Post W.W. II period, which has been marked by declining trade transaction costs and more open borders, few countries have avoided the resource curse. Norway, having learned from the Dutch experience, carefully managed the windfall from its oil boom in the 1970s by creating a Sovereign Wealth Fund to distribute benefits over generations. The United Arab Emirates has also squirreled away oil income into Sovereign Funds which make long-term investments to reduce dependence on finite oil resources.

In emerging markets it is difficult to exercise this discipline because of weak institutions and the pressing needs of the poor. Rent-seeking elites, crony capitalists and corrupt politicians inevitably take advantage of this institutional fragility to appropriate a disproportionate share of the resource windfall.

Brazil is perhaps the best recent example of the curse at work. A discovery of very large offshore oil reserves in 2006 was expected to be transformational for a country with a history oil deficiency. Predictions were made for an expansion of oil production from 2 million b/d to over 7 million over the next decade. The discovery sparked a euphoric mood, and  investors and policy makers projected positive effects on GDP growth, fiscal accounts and the balance of payments.

Brazil’s oil discovery  turbo-charged the commodity super-cycle (2002-2010),  which was already underway,  causing  a positive terms of trade shock, currency appreciation, and a massive credit boom. Instead of saving for the future, the government dramatically increased spending on social welfare programs and public sector benefits.

Unfortunately, the commodity boom brought all the negative consequences which are associated with “Dutch disease.”

  1. Worsening governance and corruption

The commodity boom brought forth the worse tendencies of  Brazilian governance,  well described by former Central Bank president Gustavo Franco as “An obese state  fully captured  by parasites and opportunists always  fixated on protecting their turf.”  We can see how governance (government effectiveness), as measured by the World Bank, deteriorated in the following chart.

Corruption also reached unprecedented levels over this period, as measured by the World Bank.

  1.  Currency appreciation followed by eventual depreciation.  Instead of squirrelling away the commodity windfall, Brazil allowed the currency to sharply appreciate. International reserves were also increased significantly, but without sterilizing the impact on domestic supply, which fueled credit growth.

 

  1. Deindustrialization

The huge appreciation of the BRL caused an accelerated loss of competitiveness of the manufacturing sector, which we can see in the fall of manufacturing share of GDP and an accelerated decline in manufacturing complexity. The first chart below shows the evolution of manufacturing value-added  as a share of GDP for resource-rich economies  compared with resource-poor economies, highlighting that Dutch Disease impacted all commodity exporters. The next two charts also show the evolution of manufacturing by comparing economic complexity in Latin America and  Asia.

  1. Lower Potential Growth. The erosion of manufacturing capacity led to massive replacement of “quality” industry jobs with low valued-added service jobs, and, consequently, a collapse in productivity. Potential GDP growth was about 2.5% annually before the commodity boom and has now fallen to less than 1.5%. As shown below, over the past decade total factor productivity has collapsed in Brazil.

 

 

As a result of this aggravated case of Dutch Disease, Brazil is more than ever dependent on its world class natural resource sectors: export-oriented farming, and export-oriented mining. Both of these sectors are highly competitive globally but very technology and capital intensive , providing  few jobs (Vale’s enormous iron ore operations generate only 40,000 jobs in Brazil.) Paradoxically, Brazil’s  farm sector has similarities with South-East Asia’s “Tiger” economies. Like in Taiwan, Korea and China, Brazilian farmers have benefited from ample credit,  state R&D support and export subsidies.

Ironically, current prospects for rising commodity prices are not necessarily  good news for Brazil as there  is no evidence that lessons have been learned from the past.

The Cycle is Turning; Winter is Coming

Since the outset of the pandemic the global economic cycle has been in accelerated mode. We witnessed one of the shortest downcycles ever and the quickest recovery of employment for any recession in decades. By the middle of last year, the U.S. economy showed clear signs of mid-to-late  cycle behavior, with low employment and rising prices. Now, we are clearly late cycle, with Central Banks having to tighten monetary policy and yield curves flattening underway.

Asset prices have behaved as expected both on the way down and the way up: risk assets (value, small caps, cyclicals) did very poorly on the way down and then very well on the way up. Defensive assets such as quality growth held up on the way down, underperformed on the way up and have proved resilient in the current late phase. Increasing volatility in asset prices and the collapse of speculative bubbles are also signs of a cycle end.

We are now seeing the cycle go full circle, with the typical signs of contraction appearing.

Leading Economic Indicators are pointing down, as shown in the charts below. The first chart is the OECD’s global LEI; the second chart shows LEIs for the U.S. and Korea, the two most important bellwethers of the global growth cycle.

Dr. Copper, also famous for his ability to predict global cycles, also is signaling problems ahead.

The implication is that we are entering a risk-off phase when investors will shun value, small caps and cyclicals. Of course, this includes emerging markets, particularly non-China assets. This will create the next good buying opportunity.

Does CAPE Work For 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 usually 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 and the CAPE has proven effective in highlighting them.

The CAPE (Cyclically adjusted price earnings) 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.

The charts below illustrate the relationship between stock market total nominal returns and the level of the CAPE ratio for Global Emerging Markets, the S&P500 and 18 emerging markets. 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 data is more significant because the CAPE ratios capture better the evolution of the single asset.

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

  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 2021 was 39.3, the second highest in history.

2. All date points, including GEM and 18 countries: This is a very noisy graph  but the trend is clear. All 10 year periods with returns at least 15% annually started with CAPE below 25.

3. Global Emerging Markets: Clear trend.  GEM has never returned less than 10% annually with cape below 10; returns have never been above 5% with CAPE above 20. GEM CAPE ended 2021 at 14.4.

 

4. China: All high return years started at CAPE below 10; all low returns started at CAPE above 20. China end 2021 at 13.3.

 

5. India: India performs best with CAPE below 20 and really struggles above 25. 2021 ended at 31.1 which should weigh heavily on future returns.

6. Korea: Clear trendline but slightly more dispersion than in most other markets. Current CAPE is 9.6.

7. Taiwan; All high return decades have started with CAPE  below 15; low returns have started above 20. The current level is 27.1, the highest since the Taiwan bubbles of the 1990s.

8. Brazil: Brazil is a good example of a highly cyclical economy prone to boom-bust cycles and unstable liquidity flows. A CAPE of 15 seems to be the dividing line for returns, with equity booms starting with CAPES in the low teens and the market struggling with CAPES in the high teens.  At the current CAPE of 10.9, the market is priced to provide high returns.

9. Turkey: Annual returns have been very high when CAPE has approached the five level, and very poor when CAPE reaches the high teens. The current CAPE of 4.1 is the lowest since the early 1990s. This is the fourth time that CAPEs have been below five and on every occasion very high returns have followed.

10. Mexico. Current CAPE is 18.2

 

11. Philippines

12. Thailand

13. Russia

14. Malaysia

15. South Africa

16. Indonesia

17. Peru

18. Chile

19. Colombia

20. Argentina

CAPE and Expected Returns in Emerging Markets, 2022-2028

The past decade in emerging markets has been one of slowing GDP growth, low earnings and poor returns. By and large, today valuations have come down enough from the lofty levels of 10 years ago to make the markets attractive, particularly compared to the high valuations of the U.S. market. Emerging markets are under-owned and certain segments of the market are extraordinarily cheap. If “value” segments of the market (industrial cyclicals, banks, commodities) continue to rally like they did in 2021, then prospects may be quite good. However, at the same time, the markets face a Fed monetary tightening process that may broadly challenge asset prices and, if history repeats itself, be particularly troublesome for emerging markets.

We turn to our CAPE methodology periodically to shed some light on relative valuations and derive estimates of “probable” future returns. The CAPE (Cyclically adjusted price earnings) takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful too lfor highly cyclical assets like EM  stocks. At extreme valuations, the tool has had very good predictive capacity in the past.  We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized more recently by professor Robert Shiller of Yale University.

The methodology sets a long-term price objective based on the expected CAPE earnings of the target year, which in this case is seven years (2028). The CAPE earnings of the target year are multiplied by the historical median CAPE for each market. The underlying assumption of the model is that over time markets tend to revert back to their historical median valuations.

The table below summarizes the results of our calculations for 17 EM countries, global emerging markets (GEM, MSCI) and the S&P500. The expected returns of markets depend on valuation (CAPE ratio) and earnings growth (largely a function of GDP growth). No consideration is given here to possible multiple expansion or the liquidity factors that may have a major influence on market returns.

Not surprisingly, the markets with the lowest valuations and highest expected returns are currently facing difficult economic and/or political prospects and, consequently, have been abandoned by investors. Investing in these countries requires a leap of faith that “normalization” is possible. For example, it assumes that the current crisis in Turkey will be resolved adequately and that Chile’s constitutional reform will not structurally impair growth prospects.

The CAPE methodology is a poor predictor of short-term results. For example, the cheap markets at year-end 2021 all did poorly over the past year while the expensive markets (USA, India) just got more expensive.

A Tale of Two Decades For Emerging Markets

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

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

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

 

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

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

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

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

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

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

Chile’s Constitutional Trap

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

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

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

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

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

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

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