Category: Global Emerging Markets

If forecasting is foolhardy in the most stable of times, trying to make predictions under current circumstances is risible. For the time being, financial markets are driven by the extraordinary policies of U.S. monetary and fiscal authorities which support consumption and provide liquidity to backstop asset prices. The limits of these policies are unknown, but, for now, investors from around the world are willing to engage in this lucrative scheme.

Predictions for the short term are always haphazard. Most market participants simply assume that current trends will continue. They are usually right because trends are persistent while mean reversion occurs over the long-term horizon. The current trends favor investing in U.S. stocks. These have outperformed for over a decade and the biggest and most dominant tech stocks have metamorphized into the new global “safe” asset of choice, replacing return-less U.S. Treasury bonds. Investors have concluded that these quasi-monopolies in winner-take-all growing sectors of the economy are pillars of stability in a turbulent world. The assumptions that underlie this investment thesis are that: 1.  the Federal Reserve is fully committed to sustaining the stock market because it believes that a market correction from the current high levels would cause  a negative “wealth effect” that would precipitate an economic depression; and 2. The Fed desires sustained higher inflation to erode the value of the Federal debt.

The COVID pandemic in a perverse way facilitated the work of the Fed and consolidated what could be called the “FAANG Monetary Standard.”  COVID justified unprecedented levels of monetary intervention and fiscal expansion and drove the stock market to record prices. The exceptional efforts of U.S. authorities made the 2021 recession one of the shortest ever and allowed the U.S. economy to outperform the global economy by a wide margin. Rising asset prices in the U.S. sucked in global capital and pushed up the value of the USD.

Unfortunately, none of this was beneficial for emerging markets. With the exception of China which managed the pandemic well and benefited from the surge of U.S. imports of consumer goods, emerging markets suffered profoundly from COVID, both in terms of short-term growth and long-term growth potential. COVID only accentuated what has been a state of semi-depression in emerging markets for the past decade, as a strong USD and U.S. financial markets have drained them of capital resources.

Ironically, the accelerated nature of the COVID recession in the U.S. will now play against emerging markets as we enter 2022. The United States and China, the two main drivers of the global economy, are now in the process of slowing dramatically as the effects of the COVID stimulus wear off. This means that the expected late recovery of most EM countries will be muted.

In fact, 2022 is likely going to be the year when the markets fully appreciate the devastating long-term consequences of COVID. The enormous increases in government debt incurred by the United States, China and most EM countries in 2021 will weigh on growth for years to come. U.S potential real GDP growth, which was considered to be around 2% before the pandemic, can now be assumed to be considerably lower. Many emerging market countries, including China and Brazil, are facing poor growth prospects as they deal with high levels of unproductive debt.

Ironically, the coming slowdown in the U.S. may continue to favor U.S. stocks and the USD. As the economy slows in coming months, the Fed will have to provide more liquidity to the markets to avoid a correction in asset prices. This may well lead to a further expansion in valuation levels for the tech stocks and final blow off for the S&P500.

The two charts below show the current debt levels in emerging markets and the five-year increase in the level of the debt to GDP ratio for these countries and the United States. The countries with high debt levels and very high recent accumulation of debt generally face difficult challenges ahead. These include, China, Brazil, Chile and Korea.

The next chart shows expected long term stock market returns for EM countries and the United States. The annual returns are for the next seven years but would be similar for 10 years. These returns are in USD terms and assume that EM currencies maintain current valuations relative to the USD over the period. If EM currencies were to appreciate over the period (likely in my view) then returns would be higher.

The details are shown in the next table. Turkey tops the chart and probably provides the best bet for high returns. CAPE ratios below 5 have been in the past fail-safe as an indicator of high future returns. Turkey is well underway in its economic adjustment, with a very competitive currency and export sector and rising business confidence. The Philippines are also well positioned, but do have a challenge to return to the very high historical CAPE, particularly given the lofty weight of financials and real estate in the index. Brazil is cheap but faces high debt and a weak economy as it enters a complicated election year. This is a reminder that CAPE ratios are not helpful for short- term predictions. Moreover, valuation is never enough. Markets always need a trigger.

On the negative side, Taiwan and India both stand out for their very high CAPE ratios. For these valuations to be justified, earnings will have to be much higher than currently anticipated. This means a major ramping up of margins and corporate profitability in India and an extension of the semi-conductor super-cycle in Taiwan.

The methodology used to determine expected returns is the following:

1. Forecasted earnings for 2022-2028 assume earnings growth of nominal GDP, making adjustments for each country’s place in the business cycle.
2. A cyclically-adjusted earnings value for 2028 is calculated as an average of inflation-adjusted earnings for the 10-year period ending in 2028.
3. Each country’s historical cyclically adjusted price earnings ratio (CAPE) is calculated as an average of CAPE ratios for the country since its inclusion in the MSCI index, with an increased weight given to the past 15 years.
4. The historical CAPE ratio is applied to 2028 earnings to determine the expected level of the country index in 2028.

The collapse of the United States-centered global financial system in 2008 made clear the fragility of the post-industrial model of capitalism built on increasing debt and financial complexity. Since the Great Financial Crisis awareness of the system’s fragility has dominated global investor behavior, causing a long period of global semi-depression, U.S. dollar appreciation and investor preference for the liquid and safe assets available in the U.S. capital markets. Periodic Fed interventions through QE aimed at sustaining asset prices have eliminated downside risk and encouraged this hoard of capital to find its way to Wall Street, causing interest rates on U.S. treasuries to fall to record low levels and the appreciation of all financial assets. Furthermore, it has brought about the extraordinary conversion of the leading technology growth stocks, with their supposed fail-safe winner-take-all business models, into the new global safe-haven liquid asset of choice.

This series of events has brought on a new period of American “exceptionalism.” As shown in the chart below, these are phases in the global economy when through a combination of superior growth, dollar appreciation and risk aversion global capital flows into the United States and U.S. asset prices enjoy an extended period of outperformance. We can see that since President Nixon abandoned the gold standard 50 years ago, the U.S. has had three periods when it has grown more than the global economy: 1980-86 when the combination of Volcker and Reagan boosted confidence in the USD and in the U.S. economy; 1994-2001, the Asian financial crisis and the Telecom-Tech-Media boom; and 2011-2021, QE, fiscal expansion and the new tech boom. Though the long-term trend is clearly for a sharp decline in the U.S. share of global GDP, each one of these upcycles in U.S. relative growth is accompanied by a strong dollar, large capital inflows and a booming stock market. The flip side of these periods of perceived American exceptionalism when the U.S. sucks up much of global capital is weak commodity prices, depressed growth and poorly performing stock prices in Emerging Markets. On the other hand, every downward swing in the chart (1971-1979, 1986-1994, 2001-2011) has seen strong growth and booming asset prices in EM.

The current period of  American “exceptionalism” has been particularly painful for most emerging markets.  Even before Covid, emerging markets had suffered a decade of low growth and low investment abetted by weakening currencies and persistent capital flight. Covid seriously worsened this trend, leaving most countries with more debt and worse growth prospects. Capital flight has only increased, much of it headed for “safe-haven” U.S. tech stocks.

The events of the past decade have led to extraordinary divergence between emerging markets and the United States in terms of corporate earnings and stock market performance. The charts below for the United States and major emerging markets seek to contrast the performance of the different markets in what has been an extraordinary era of superior returns for U.S. assets.

The first chart below seeks to provide the context of the long-term  experience of the U.S. stock market since W.W. II , showing the annualized growth in stock prices, earnings and GDP.

We can see that stock prices, earnings and GDP tend to be tied together. This is because over time profit margins tend to revert to the mean and nominal earnings generally follow the path of nominal GDP. Stock prices should marginally rise more than both earnings and GDP over time because price-earnings multiples slowly move higher because of declining transaction costs. Therefore, though earnings rise by 5.8% over this period, compared to 6.0% for nominal GDP, the S&P500 index rises by 7.7% annually.

The second chart focuses on 1986-2021, the post-industrial era. when the pillar of the American economy became services – especially financial services. This has been a very good period for American corporations. This period, marked by hyper-globalization/offshoring, deregulation, lax anti-trust enforcement, declining taxes and interest rates, and ever-increasing financial engineering (leverage, buybacks) – all factors that boosted corporate profitability – has been very favorable for the profitability of U.S. corporations relative to non-U.S. ones.  This period coincides with the modern era of emerging markets investing when institutional benchmarks (e.g., MSCI, IFC) became available. Over this period, we see an extraordinary disconnect between stock prices and earnings and GDP. The table below details the relative growth of the index, earnings and nominal GDP over distinct period. We can see that during periods of American exceptionalism, the U.S. stock market moves well above the long term trends for the market and GDP, with the current level at an extraordinary level of divergence.

The disconnect between index returns, earnings and GDP has been extraordinary. During 1986-2021, the S&P500 index has appreciated at nearly twice the rate of GDP growth while earnings have beaten GDP by about 35%. We can see this gap widening over the past 20 years as earnings grew at nearly twice the clip of GDP. Over the past ten years, the index’s gap over GDP has widened immensely, almost all due to multiple expansion. This multiple expansion can be explained by the “wealth effect” of the Fed’s QE policy, which has pushed up asset prices by eliminating downside risk and lowering discount rates.

A comparison of the U.S and Chinese stock markets reveals stark differences. First, China’s monetary policy has been much tighter and monetary interventions have been aimed exclusively at maintaining the stability of the real estate and banking sectors. While the U.S. Fed can be said to be fixated on stock prices, China’s central bank cares primarily  about real estate prices. This makes sense because the Chinese have most of their wealth in residential properties. Second, while the focus of U.S corporate executives is shareholder returns, China’s companies are mostly controlled by the public sector and their executives are agents of the government. The exception has been venture-capital financed technology companies seeking to emulate the business models and corporate cultures of Silicon Valley, but, as recent events have shown, even these companies are on a tight leash with Beijing.

The nature of China’s listed companies is reflected in their historical performance which we can see in the charts below. The first thing to note is the relationship between the stock market and earnings and GDP. While this relationship in the U.S. has been constant over time (corporate margins and stock multiples revert to the mean and expand in line with GDP), in China they are unrelated. While China’s GDP has been on an unprecedented 30-year expansion, this is not reflected in stock prices or earnings. (However, over this period there has been an extraordinary appreciation in real estate prices). Remarkably, since 1992, China’s GDP has expanded at a rate of nearly 13% annually, while stock prices and earnings have declined. Even over the last decade which has been marked by the rise of China’s privately owned tech giants and yuan appreciation relative to the USD, earnings have been negative. This is a testament to global depression-like conditions, manufacturing oversupply, and misallocation of capital by state firms in China’s debt-driven economy. These conditions are likely to persist into the future as China’s government forces both public and private firms to invest in “strategic” frontier industries to secure independence from western suppliers.

Finally, we look below at three other EM countries: India, Brazil, and Taiwan.

India: The charts show that the long-term relationship between stock index appreciation, earnings and GDP has occurred in India as should be expected. Over the 1990-2021 period, Indian earnings and GDP growth are very similar. Stock prices have grown at a slightly higher rate which can be explained by multiple expansion and the current high level of the market. Over the 2001-2021 period the relationship between earnings and GDP holds tightly, while stock prices race ahead and experience two “bubbles,” in 2008 and at the present time. Over the past ten years, the global depression/strong dollar environment impacted GDP and especially earnings while the stock market disconnected as valuations returned to “bubble” levels (CAPE ratio at 28.1 which is the second highest ever, only below 30.6 in 2010).

In Brazil the relationship between GDP growth and stock price appreciation holds up as expected. However, earnings do not keep up. The 1986-2021 period in Brazil is marked by high economic volatility, boom-to-bust cycles and mismanagement of state companies, conditions which are detrimental to corporate investment and profits. Brazil missed out on the trade benefits of hyper-globalization and underwent a process of accelerated premature deindustrialization, leaving the economy and stock market highly vulnerable to commodity boom-to-bust cycles. Over the past decade, Brazil has been hit twofold by the collapse of the commodity supercycle and the global depression/strong dollar environment. Unlike EM countries in East Asia and India which have produced tech champions , Brazil has been largely “colonized” by Silicon Valley.

Taiwan provides an interesting contrast to Brazil, India and China. Over the 1986-2021 period stock price and earnings are closely tied but GDP lags behind. This is because Taiwan’s highly dynamic and increasingly profitable tech companies have a greater weight in the stock index than their share of GDP. Also, these numbers reflect the current “bubble” valuations and unusually high margins of tech companies, both of which should revert over the medium term. This effect has been particularly important over the past ten and twenty years, as TMSC has become one of the largest and most profitable global technology firms.  In contrast to Brazil which exports commodities and China where exporters have a small weight in the stock index, Taiwan’s market-driven technology companies dominate the index. This has enabled Taiwan to sail through the global depression/strong dollar environment of the past decade.

What these charts show is how difficult it is for emerging markets to do well in periods of perceived American exceptionalism. Though Taiwan appears to be an exception, its performance is driven mainly by the enormous success of TSMC. In China, India and Brazil it has been a very poor past decade for corporate earnings. This is not likely to change until the current cycle of American exceptionalism ends. This is long overdue and will happen eventually,  triggered by a new wave of optimism on global growth. However, for the time being, fear still dominates and the capital hoards will go to the “safety” of U.S. tech stocks.

Emerging market stocks ended the second quarter badly underperforming the S&P500 and the MSCI All Country World Index (ACWI) year-to-date, as well as for the past one, three, five and ten years.  There had been some hope during the first quarter that rising inflation and interest rates would squash long duration assets like U.S. tech and give a chance for value stocks and emerging markets to outperform. However, this was short-lived. By the end of the second quarter, interest rates were collapsing, U.S. tech stocks were leading the way again and American exceptionalism was reaffirmed by the U.S. indexes hitting record levels at near-record valuations.

The second quarter and the year so far, therefore, brought more woes for emerging markets. Momentum has been the primary force for markets, driving the expensive stocks higher and the cheap stocks lower.  We can see this clearly in the charts below which show (1) country returns YTD for EM and (2) expected returns based on relative cyclically adjusted price earnings (CAPE) ratios.

With the exception of Brazil and South Africa, two countries benefitting from positive terms of trade shocks from rising commodity prices, the countries with the highest expected future returns (Turkey, Philippines, Peru, Colombia. Indonesia, Chile and Malaysia) are also the ones with the lowest returns for the period. On the other hand, the expensive countries with low expected future returns (India, Korea, Russia, Mexico, Taiwan) continue to outperform. Of course, the United States, the most expensive of any market around the world, provided stellar returns of 14.9% during the first half of the year.

Unfortunately, the countries with very inexpensive markets relative to their history are not helping themselves. Sadly, none of the “cheap” markets currently provide a positive narrative for investors. In addition to the pandemic which continues to wreak havoc across EM, many countries also face deteriorating political and economic fundamentals which would justify lower earnings multiples than a relative cape ratio methodology implies. We could argue that the growth prospects for Brazil, Chile, Colombia, Peru and South Africa have deteriorated enough over the past decade to justify lower CAPE multiples.  In many cases, historical CAPE multiples may have been distorted by the stratospheric-level valuations reached during the 2007-2012 EM bubble. It may be that some of these markets need to trade at much lower multiples to become attractive investments, say more in line with Turkey today (4.4 CAPE). Arguably, investors should be very cautious at deploying capital until a positive narrative can be developed in these countries.

This leaves us with very few markets to focus on. In Asia, which is where almost all the growth in GDP and consumption will occur over the next decade, Indonesia and Malaysia have good growth prospects and political stability.  Their CAPE ratios are cheap in both relative and absolute terms and promise good future returns. Moreover, we can see in the following chart that they both have competitive currencies and good economic fundamentals. The Philippines also appear attractive, given low valuations and a good growth profile, but have an overvalued currency and weaker fundamentals. In Latin America, Mexico also has a nice combination of an attractive CAPE valuation, competitive currency and good economic fundamentals.

The best opportunity in EM stocks today is in Turkey which has the compelling combination of very low CAPE valuation and undervalued currency. The patient investor would be well advised to build positions ahead of an eventual change in government or economic policy.

Investing in emerging market stocks and bonds is primarily driven by macro factors, such as liquidity, relative growth, politics and, most importantly, the mighty U.S. dollar. The importance of macro trends  is the reason that emerging market investing has traditionally been dominated by short-term oriented hedge funds and Wall Street trading desks. This has been true since the early 1980s when the liberalization of global financial capital flows allowed traders like George Soros to actively engage in EM equity and debt markets. More recently, firms like Ray Dalio’s Bridgewater have made EM a key part of their global diversification strategies.

In global macro, everything is in some sense a dollar trade, so it is imperative that investors have a view on the direction of the dollar.  In fact, the dollar’s trend clearly separates the world of financial assets into two camps: Long USD trades — risk tolerant and rate sensitive – which include bonds, growth stocks and other long-duration assets; Short USD trades – risk intolerant – which include value and small cap stocks, EM stocks and bonds and commodities.

Based on recent empirical evidence, investors have developed models to predict the future course of the dollar. Unfortunately, there is not a lot of historical data since the current USD regime is based on a fiat monetary system which has existed only since 1971.

George Soros is said to have come up with a visionary and innovative approach to currency trading in the early 1980s when he proposed that the dollar trend could be determined by the strength of the U.S. economy relative to the global economy. In periods of relative U.S. economic vigor, sometimes referred to as phases of “American Exceptionalism,” the U.S. attracts foreign flows into its capital markets and the dollar appreciates. Under these circumstances, the dollar can remain strong until the cycle exhausts itself because of rising macroeconomic imbalances. In periods of relative global economic vigor, capital flows out of the U.S. into more attractive international assets.

This dollar cycle as suggested by Soros is underpinned by reflexive investor behavior. As the USD appreciates the returns on U.S. assets increase for foreign investors which attracts more investment. When the USD begins a downward trend, then the opposite happens.

The empirical evidence for the Soros model is shown in the graph below. The top segment of the chart shows the evolution of the USD index (DXY) since the 1970s. We can see that there have been three major upswings of the USD over this period, in what appears to be a long-term downtrend. The cycles have lasted about 8-9 years on the uptrend and 8-9 years on the downtrend, for a total of 16-18 years. Given that the current dollar uptrend started in 2011, we would now expect a dollar downtrend to be under way. However, this remains to be confirmed, as currently the effects from the pandemic and extraordinary fiscal and monetary policies adopted around the world may be overwhelming long-term fundamentals.

The bottom segment of the chart shows the performance of the global economy relative to the U.S., with outperformance shown when the blue line is above the bar. One can see that Soros’s  insight is largely confirmed by the data: when U.S. growth is relatively strong, the USD tends to appreciate considerably.

The past several years have been extraordinary in the sense that official interventionism in financial markets has reached unprecedented levels.  First, we saw exceptional monetary policy adventurism with a novel focus on propping up asset prices in the name of “financial stability.” Second, we saw equally unheard of fiscal adventurism when Donald Trump slashed taxes at the tail end of a business cycle expansion with unemployment at record low levels. Third, the pandemic was met by enormous monetary and fiscal support which boosted the operations and valuations of America’s leading corporations in the tech sector. Fourth, we are now seeing new radical policies from the Fed (average inflation targeting) and the Biden Administration (fiscal expansionism to “Build America Back Better”). Finally, this year we saw the U.S. take the lead  in Covid-19 vaccinations which makes it likely that U.S GDP growth will outperform the global economy in 2021. All these factors have contributed to higher U.S. stock prices and a narrative of U.S. exceptionalism, and may have postponed the normal cyclical downtrend of the dollar.

In a recent interview, the investor Stan Druckenmiller made this point when he attributed the recent strength in the USD to foreign inflows into the U.S. tech stocks during the pandemic:

“It just so happened that the FAANG stocks, and many US companies like Zoom were better positioned to deal with COVID than any of our foreign counterparts, so we had a huge inflow into the equity market here. It made up for the change in the bond flow, but once valuations got high, that dissipated, and the dollar peaked out in July.”

Druckenmiller believes that the factors supportive of the dollar have run their course. The rest of the world will soon catch up in vaccinations and by 2022 the global economy will be in full recovery and outpacing the U.S. economy. Moreover, by next year, capital allocators are likely to begin to refocus  on the serious structural deficiencies of the U.S. economy: namely, the high and rising debt levels and the gigantic twin deficit (current account plus fiscal deficit.)

The U.S. will come out of the pandemic with historically high debt levels and deficits which are projected to remain at high levels for the foreseeable future. The first chart below shows the progression in U.S. debt levels as reported by the Bank for International Settlements (BIS). The next two charts show the U.S. fiscal and current account deficits and the twin deficit’s relationship with the USD. The twin deficit is projected to widen considerably during the decade as Social Security and Medicare outlays ramp up when the majority of baby-boomers retire. Also, any increase in interest rates from the current levels would worsen the fiscal accounts further.

We can see that the USD did not follow its normal reaction to gapping twin deficits during the pandemic. However, as these deficits persist in the future and the global economy recovers the USD this should change. The expectation that unsustainable  twin deficits will persist for the foreseeable future  is the primary argument for a weaker USD in coming years.

However, nothing may be so simple in our current macro world of extreme state interventionism and dysfunctional politics driven by populism.

First, for the dollar to fall other currencies must rise, but all the major trading partners of the U.S. appear determined to avoid this from happening  Most, like China, have adopted some sort of peg to a basket of currencies to protect their exporters. This means that it would require significant strong-arming from the U.S. to engineer an appreciation of foreign currencies, something that Washington has been reluctant to do.

This raises the scenario predicted by Raoul Pal (Real Vision ) of an orchestrated debasement of global currencies as all major economies seek to print themselves out of their fiscal and competitive dilemmas. The consequences of this would be a massive flight into any scarce real assets (gold, bitcoin, real estate, etc…). Pal argues we are already seeing this play out as most asset classes are trading at record highs.

The Raoul Pal scenario has interesting implications for emerging markets. The EM asset class is almost equally divided into commodity importers and exporters. Most importers of commodities (China, Korea, Taiwan, India) are not likely to tolerate currency appreciation, as long as Washington does not wage war against mercantilist policies. This leaves the commodity exporters to possibly allow their currencies to appreciate. We have seen this happen this year as the South African rand, the Russian rubble and the Brazilian real have appreciated. This process has been abetted by foreign hot money and welcomed by central banks for its deflationary effects.  Some other EM countries which have depressed currencies, (Mexico, Turkey) also have much room to allow appreciation and may be the best options for  investors to benefit in the coming currency wars.

The global Covid-19 pandemic has inflicted severe damage on emerging markets. Asia has fared relatively well and will bounce back quickly. However, Latin America and some EMEA countries (Turkey, South Africa) will take years to return to trend growth and are coming out structurally weaker in terms of debt, education and economic prospects.

Taking into account the highly uncertain evolution of the pandemic and its economic and corporate consequences,  making a forecast is more difficult than ever.  Nevertheless, we stick to our process and hope that it can provide some guidance for investment decisions.

Our main objective is to identify  extreme  valuation discrepancies. As in past efforts (Link ), we assume that valuations will mean-revert to historical levels over a 7-10 year time frame;  also, we expect that GDP growth and corporate earnings will return to trend over the forecast period; finally, after deriving a long term earnings forecast, we apply a “normalized Cyclically-Adjusted Price Earnings (CAPE) ratio to determine a price target and expected return. We assume that historical valuation parameters still have some validity in a world characterized by Central Bank hyper-activism and financial repression. The methodology has negligible forecasting accuracy over the short-term (1-3 years) but, at least in the past, has had significant success over the long term (7-10 years), particularly at market extremes.

The chart below shows the result of this exercise. The first thing to note is that, by-and-large,  current expected returns are muted. This is not  surprising in a world of declining growth and negative real interest rates.  Global emerging markets (GEM) are expected to provide total returns (including dividends) of  7.5% annually in nominal terms (including inflation) over the next seven years. This is below historical returns and disappointing in light of the poor results of the past decade. Nevertheless, these expected returns are attractive compared to the low prospects for U.S. stocks. The U.S. is trading in CAPE terms at the second highest levels ever  while emerging markets are priced slightly above historical averages.

To secure more attractive expected returns the investor needs to venture into cheaper markets. Brazil, South Africa, Colombia, Turkey, Chile, Philippines and Malaysia promise higher returns if mean-reversion occurs.

These expected returns do not assume a major recovery in cyclical and commodity stocks or other aspects of a reflation trade. Early signs of a weak dollar and rising commodity prices since March 2020 have pointed to the beginning of a reflation trade that could be beneficial to EM, particularly commodity producers. In these cycles, EM currencies appreciate and domestic economies benefit from expansion in liquidity and credit, and stock returns could be significantly higher in USD terms.

However, returns may be held back by the high debt levels in many countries and the reality that we are not at low valuations, compared to previous bottoms. The two following charts show the evolution of earnings multiples in EM and earnings, both on the basis of regular annual earnings and in terms of CAPE. CAPE ratios are not nearly as low as during the two previous good buying opportunities in 199-2001 and 2016. Moreover, in terms of CAPE earnings,  we are not as depressed relative to trend as during the 2000-2001 recession.

During the past ten years global stock markets experienced depression-like performance. The aftermath of the Global Financial Crisis was high debt and low growth and ineffective  monetary policy despite huge  money printing and zero interest rates.

The policies of Central Banks only benefited stocks in the  United States where technology and innovation sectors benefitted from low discount rates and earnings were pumped up by tax cuts and stock buybacks. The rest of the world by-and-large saw low earnings growth, declining multiples and weak currencies. Global stocks also started from relatively high valuations and margins, as ten years ago global growth had been highly stimulated by China’s investment boom.

We can see how this developed in the charts below. The first chart shows the performance of the S&P 500 vs the MSCI Emerging Markets stock index. The left side shows the evolution of earnings multiples, the price earnings ratio and the cyclically adjusted price earnings ratio (CAPE, average of 10-year inflation adjusted earnings).  Note the remarkable expansion of the U.S. CAPE from 25 to 34, which is the second highest level in history. At the same time the EM CAPE ratio fell from 20 to 15. The right side of the chart shows the evolution of the indexes and earnings. U.S. earnings were basically flat through 2015 and then took off, and, based on forward PE estimates for 2021, will end about double 2010 levels. EM earnings, based on forward PE estimates for 2021, will be at exactly the same level as 2010. Of course, the combination of the evolution of earnings and multiples explains the dramatic outperformance of U.S. stocks.

The following chart provides some granularity within emerging markets. The same charts as above are shown for three primary emerging markets, China, Brazil and Taiwan. Brazil in 2010 was a major beneficiary of the commodity bubble but since  then has suffered a vicious case of “Dutch Disease,” the natural resource curse. All other commodity producers (Chile, Peru, Indonesia, S. Africa, Indonesia) went through a similar process, though none as painfully as Brazil. Brazil’s CAPE ratio has fallen from 22 to 12 over the period and earnings in 2021 earnings are expected to still be 60% lower than in 2010.

China has seen a significant reduction in its CAPE ratio which went from 22 in 2010 to 11 in 2016 and 16.8 at year-end 2020. Over this period, the Chinese stock market has transformed itself from heavy with banks and industrials to one dominated by tech. These old economy sectors explain the flat evolution in earnings over the period, but in the future technology and innovation stocks will drive results.

Finally, Taiwan is shown as an example of an outlier. Taiwan, like Korea, is a stock market that is dominated by world-class technology companies. Not surprisingly, its CAPE multiple at year-end 2020 was higher that in 2010 and earnings are up over 50% during the period.