Category: Global Emerging Markets

Top-down Allocation and Country Selection in Emerging Markets

The first quarter of 2018 has been a wild ride for emerging markets investors.  An early January surge was followed by a 10% correction in February, as EM stocks reacted to the return of volatility in the U.S. markets. In recent weeks, concerns with global trade wars and slowing growth in China and Europe have dampened enthusiasm. Signs of rising risk aversion can be seen in the strengthening dollar and falling commodity prices. Any confirmation of this trend would be worrisome for emerging markets investors.

Nevertheless, the odds still appear to favor an extension of the rally in emerging markets which has resulted in over two and half years of strong outperformance for EM.

First, the assumption continues to be that Trump’s trade-war talk is largely posturing and that common sense will prevail. Recent evidence that NAFTA talks are making good progress points in that direction.

Second, as confirmed by Fed Chairman Powell this week, U.S. growth prospects are strong while inflation continues to be tame. In fact, as the IMF stated in its most recent forecast, the global growth outlook continues to be healthy, and inflationary pressures mild. The combination of (1) a vigorous late-cycle U.S. economy fueled by fiscal deficits and declining private savings and (2) solid global growth is very supportive of a weakening dollar, rising commodity prices and buoyant asset prices in emerging markets.

Third, in a world of high asset prices, emerging markets are reasonably priced both relative to their own history and relative to other markets such as U.S. equities. The chart below compares EM valuations to the S&P500. While cyclically-adjusted price-earnings ratios (10-year average of inflation-adjusted earnings) for the S&P500 are 30% above both the historical average and the average for the past 15 years, EM is in line with the historical average and 8% below the average of the past 15 years. The 12-month forward looking PE for EM is an undemanding 12.2, vs a relatively high 17.5 for the U.S. Bear in mind that many EM countries are in early stages of their business cycles and can expect cyclical improvements in margins and profits, while the U.S. is in the later stages of its business cycle and can expect the opposite.

Given the diversity of countries in the emerging markets equities asset class, the investor taking a top-down point of view can improve returns by concentrating investments in the markets displaying cheap valuations, improving economic conditions and liquidity-driven momentum. This can be achieved at low cost and effort through ETF country-index products. More ambitious investors can further enhance returns by tilting the portfolio to additional factors (e.g., value, quality, etc…) and also by picking stocks with extraordinary upside potential.

The results of a top-down analytical process is shown in the chart below. Though considered a Frontier Market, Argentina is included because it is widely believed that it will be soon included in the EM indices. Countries are ranked based on three criteria:

  • Valuation – Current CAPE valuation relative to history and to the past 15-years, plus a mean-reversion factor.
  • Macro – A measure of where the country lies in its business cycle.
  • Liquidity – A measure of liquidity factors driving upside momentum in asset prices.

 

The results show that today in emerging markets the vast majority of countries show good characteristics. At the top of the list (3-ranking) are countries that trade at low valuations and appear to have both the business cycle and liquidity flows in their favor. These are mainly commodity producers like Chile and Brazil that were hit by the sharp downturn in commodity prices in 2014-2015.

Indonesia, Colombia and Mexico all sport attractive valuations and macro-characteristics, but are burdened by week flows. These can change quickly, so investors should keep a close eye on these markets.

Both Taiwan and Korea have benefitted handsomely from the strong tech cycle and may be set to take a breather.

At the bottom of the rankings, the Philippines, with high valuations and late in the business cycle, and Argentina, with valuations ahead of fundamentals, are vulnerable.

Investors should concentrate their emerging market holdings in those countries with rankings of two and three and stay clear of those with negative rankings.

 

Fed Watch:

India Watch:

China Watch:

  • What the West doesn’t get about Xi  (NYtimes)
  • Interview with CEO of Mengniu, China’s leading dairy firm (McKinsey)
  • The complex ties between China and Australia (WIC)
  • The turning point for land-reform (Caixing)
  • Chinese firms dominate video-streaming in China (SCMP)
  • Hillhouse capital raises record PE fund for China (FT)

China Technology Watch:

  • China wants to set the standards for AI (Technology Review)
  • Watch China to see the future of digital innovation (AllianceBernstein)
  • Naspers to sell $10.6 billion of Tencent stock (SCMP)
  • China drives AI into healthcare diagnostics (Tech Review)
  • Geely’s Global Rise (WSJ)
  • Kuka’s rise in China with Medea (SCMP)

EM Investor Watch

  • Thailand’s economic transformation (Opengovasia)
  • Wisdom Tree’s SOE-free EM fund shines (Wisdom Tree)
  • The future of manufacturing in Africa (SET)
  • Insider trading in the Mexican market (bloomberg)
  • In Brazil nostalgia grows for law and order (Washington Post)

Investor Watch:

  • James Donald of Lazard on Emerging Markets (bloomberg)
  • EM stocks are still relatively cheap (SCMP)
  • Blackrock’s quant strategy (FT)
  • Soros-Rogers interview (Twitter)
  • Li Ka Shing call it a day (SCMP)
  • Electric vehicles will be cheaper than regular cars in 7 years (Bloomberg)
  • Will China out-innovate the West (Project Syndicate)
  • Momentum Investing is Easy – So Why Does it Work (Behavioral Investment)

 

 

 

Demographics and Slowing Growth

The next decade is likely to be one of extraordinary change for the developing world with unpredictable outcomes. Countries will struggle to adapt to massive technological change as robotics and artificial intelligence transform supply chains as dictated by spatial economics, while the international policy framework is made uncertain by anti-globalization forces in a multi-polar world. All of this will happen as ageing populations weigh on GDP growth.  

 A new order is being driven by these trends. While over the past two decades success for emerging markets was largely secured by those committed to export-led industrialization, the winners of the future are likely to be different.

  On the more predictable side, demographics point to slower growth and dampened consumer demand in all of the developed world and in many key emerging markets. Much of the developing world, including China, Russia, Brazil, Taiwan and Korea will experience declining work-forces and ageing populations. In a world of lower growth and declining demand, those countries with attractive demographics – enjoying the so-called “demographic-dividend” of an increase in the working population relative to children and retirees – will be few. Of the important emerging markets for investors, India, Indonesia and Mexico stand out as the few  still receiving benefits from demographics. Compare the two charts below, which show the extremes of India and Japan. In Japan, the ratio of active workers supporting dependents (children and retirees) has increased from high single-digits in the 1950-1980 period to a current level of 2.1 (2015) and is expected to fall to 1.7 in 2030. On the other hand, in India there are currently over 10 workers per dependent and this will fall only to 7.4 in 1930.

 

Japan, dependency ratio

 

India, dependency ratio

 

The chart below from the U.S. Federal Reserve’s research department (Fed Paper) shows an estimate of the effect of the ageing population on U.S. GDP growth. According to the Fed’s model, the ageing of the U.S. population has stripped 1.25% from potential GDP growth since 1980. By 2030, real potential annual GDP growth could fall to below 0.5%.

 

 By 2010, Russia, China, Korea, Argentina and most of Eastern Europe had joined the developed world and passed the point of transition from a “demographic dividend” to a “demographic tax.” By 2020, Brazil and Chile will have joined this group, and by 2030, Mexico, Colombia, Malaysia, Thailand, Vietnam and Indonesia will also have graduated, leaving only India and the Philippines and most of Africa in the “demographic dividend” camp. The table below shows estimates made by  Research Affiliates, based on United Nations population predictions . The table shows the increase in the dependency ratio by country between 2015 and 2030 and the potential negative effect on per capita GDP growth. Of course, this effect may be neutralized by unexpected changes in the working population resulting from immigration, delayed retirement and other factors, and the impact on growth could theoretically be entirely compensated by technology-induced productivity increases.

 

 

With the end of the demographic dividend some countries are up for a serious reckoning. Unfortunately, relatively few emerging markets were successful in exploiting the bonanza years to prepare for the future. Instead of investing in public infrastructure and education, which could sustain higher growth in the future, resources were captured by special interests and squandered on consumption. At one end of the spectrum, Latin American countries, with the exception of Chile, lost any capacity to invest in public goods, while blandishing privileges on chronies and influential narrow interests. At the other extreme, China has had remarkable success in setting a foundation for future growth by directing scarce resources to basic infrastructure and leading-edge industrial development.

 Can any of those countries still enjoying the tail-wind of demographics      (e.g., India, Philippines, Indonesia, South Africa, Nigeria) follow China’s path? Investors are hopeful that India is moving in the right direction, with Prime Minister Modi as a strong visionary leader. However, India has not yet found a way to urbanize with job creation in a way that allows it to accumulate capital and direct it to investment in in public goods, and the politicians seem more inclined to commit scarce resources to hand-outs for constituents than to investing in the future.

Fed Watch:

India Watch:

China Watch:

China Technology Watch:

  • Geely’s Global Rise (WSJ)
  • Kuka’s rise in China with Medea (SCMP)
  • Fear China’s tech armory (The Times)
  • Alibaba’s AI challenge (TR)

EM Investor Watch:

  • Nigeria, IMF Country Report (IMF)
  • Mexico’s leading candidate promises state investment in refining (WSJ)
  • Russia’s Growth Challenge (bloomberg)
  • Latin America needs an infrastructure upgrade (Economist)
  • A bumby road ahead for Sebastian   Pinera (The Economist)

Investor Watch:

 

 

 

The Case for Value in Emerging Markets

 

Over the long term, stocks that trade at low multiples of earnings or net worth (book equity) have consistently outperformed the general market. This is known in investing as the “value premium,” and it is explained by the general public’s tendency to overvalue high profile, “growthy” stories. Simply put, investors prefer the glamorous stocks in the news, which gives an opportunity for contrarian investors to buy obscure and unpopular stocks at big discounts. However, now for over a decade value has performed poorly relative to the market, and this inevitably has raised the question of whether the value premium no longer exists.

The chart below, from Causeway Capital’s recent paper “The Compelling Case for Value” (Causeway) shows the long-term outperformance of value over growth stocks for the MSCI World Index. Similar results can be shown for the U.S. market and emerging markets.

However, over the past ten years the results have been very different, with growth more than doubling the returns of value across most markets.

MSCI, 10-year Annualized Return

There are two main arguments that are made to explain the recent underperformance of value.

  • The increasing prevalence of companies with little need for capital. If a company like Amazon can grow its business entirely with third-party capital (eg suppliers), then surely a price-to-book multiple becomes irrelevant. Warren Buffett, the most famous value investor of them all, recognized this at his shareholder assembly last year when he heaped praise on tech hegemons. Buffett said these companies were the “ideal business,” because they get very high returns for little capital. “I believe that probably the five largest American companies by market cap…if you take those five companies, essentially you could run them with no equity capital at all. None,”  said Buffett.  This is a remarkable statement from someone who, to this day, focuses much of his activity on capital-intensive businesses like railroads, utilities and manufacturers.
  • Low growth and low interest rates. Growth companies have benefited from  an unusually favorable environment. As the rate of GDP growth has fallen sharply over the past decade, it is plausible that those few companies able to achieve high growth could command higher premiums. This has happened at a time when interest rates have been at record lows, which means that this growth is discounted at record low rates.

Of course, we can’t know if these arguments will make sense in the future. Particularly in the case of low interests, it is likely that we will look back on recent years as exceptional, not a new normal.

Part of the issue with “value,” has to do with the definition of the term. Most value benchmarks rely exclusively on the price-to-book ratio. However, many successful  “value” investors have long migrated to different indicators. Buffett, for example, since the 1970s has focused on “relative value,” looking for  “wonderful companies at reasonable prices.”  Similalry, Joel Greenblatt’s “magic formula” picks quality companies (high returns on capital) at relatively low prices. Dimensional Fund Advisors (DFA), a prominent “quant”  value manager, introduces several indicators in its rules-based quant model to improve on the price-to-book metric. By doing this DFA has achieved much better performance in its “smart-beta” EM value fund (3.33% annualized for the past ten years vs -1.3% for the price-to-book based MSCI EM).

However, seeking explanations for value’s underperformance may be an exercise in futility. Paradoxically, it is exactly the long periods of anomalous underperformance that allows for any investment factor to perform over time. If any strategy was easy to pursue, it would quickly be arbitraged away. For example, Joel Greenblatt points to long periods of underperformance for his “magic formula” as the primary reason for why it continues to sustain results. Hugely successful value investors such as Seth Klarman of Baupost and Buffett himself,  have had long periods of underperformance, which might well have ended their careers at typical investment firms.

One of the most difficult challenges any investor faces during the allocation process is determining whether long-term parameters for valuations are still valid. The fear always lurks that the world has changed. The investor always struggles between accepting the usefulness of real historical data and being flexible enough to appreciate that valuation paradigms may evolve in compex adaptive systems like stock markers.

In the case of emerging markets today, I think it is reasonable to at least tilt portfolios towards value. I prefer relative value, but there is also a good case to be made for also owning low-price-to-book stocks. As the following chart from Pictet Asset Management shows, EM Value relative to EM Growth is approaching historical lows, and this at a time when GDP growth in emerging market economies is accelerating. This is not surprising, given that recent EM performance has been driven by Chinese tech stocks.

In a related topic, a recent paper by Michael Kepler and Peter Encinosa of Kepler Asset Management provides a detailed look at the “value” experience in emerging markets for the  MSCI Emerging Markets Index since 1988    (The Journal of Investing). To begin with, the authors note that the MSCI EM index has outperformed the MSCI World Index by more than 3% annually over the period (9.63% vs. 6.38%). However, this outperformance is achieved with much higher volatility (standard deviation of monthly returns of 6.71% for EM vs. 4.31% for the World). Volatility is a huge problem for most investors because it leads to emotionally adverse behavior, essentially panic selling at the bottom and buying at the top.

In their article, Kepler and Encinosa plot the relationship between price-to-book and future 4-year stock returns for both the MSCI World and MSCI EM. The plots shown below give a valuable perspective on the relative opportunities.

 

First for MSCI World, the regression analysis  using data between 1969-2016 shows an expected return of 8.5% annually for a price to book of 2.14, with a range of possible outcomes from -2.1% to +20.1%. At current valuations of 2.4 time book (February 2018), the expected return declines to below 7% annually, and possible downside of 8% and upside of 18%.

For MSCI EM, the regression analysis using more limited data  between 1988-2016 shows an expected return of 12% annually for the next four years for a price-to-book value of 1.56, with a range of possible outcomes of -8.8% annually to +36.9% annually. At current valuations of 1.81x book, expected returns are closer to 9% with a range of outcomes of -12% to +30%.

 

Fed Watch:

India Watch:

China Watch:

China Technology Watch:

  • Ten Chinese firms vying to beat Tesla (SCMP)
  • Shanghai give go-ahead for driverless car road tests (SCMP)
  • China on the leading edge of science (The Guardian)

EM Investor Watch:

  • No one is listening to Jeremy Grantham (Institutional Invstor)
  • The compelling case for value in global stocks (Causeway)
  • The fall of the Gupta’s in South Africa (FT)
  • Unlocking Indonesia’s digital opportunity (McKinsey)

 

Investor Watch:

  • Interview with Paul Tudor Jones (Zero Hedge)
  • A Criticism of CAPE ratios (FT)
  • Credit Suisse Global Investment Report (Credit Suiss)

 

 

 

 

 

 

Geopolitics and Asia’s growing role in the Oil Markets

British Petroleum’s annual energy outlook published this week (BP -energy-outlook-2018.pdf) highlights the enormous shifts taking place in the supply and demand for oil and other fuels. Energy consumption drives development and higher living standards, and, over the past 100 years, oil politics have heavily influenced international relations. Much of Post WW II geopolitics has been influenced by the growing dependence of the industrialized world on unstable sources of oil supplies from the Middle East. But the future is now starting to look very different, as dependence on the Persian Gulf oil  is moving from the U.S. and Europe to China and India.

Long the dominant oil importer, the U.S. will soon be self-sufficient, because of rising shale oil production. As shown in the charts below, U.S. oil output is returning to levels last seen in the early 1970s, and imports are approaching zero compared to a peak of 12.5 million barrels per day 15 years ago.

On the other hand, Asian demand, mainly from China and India, is ramping up.  China started to have a significant impact on oil markets in the early 2000s, and now  it is India’s turn. Asia’s growing share of global imports is shown below in a chart from the BP report.

I

As I discussed in a previous blog ( India-urbanization-and-a-new-commodity-bull-market), India is having  growing impact on commodity markets. Indian oil consumption has increased by nearly 5% a year since 1990, growing from 1.2 million barrels/day to 4.2 million b/d. In 2016, India surpassed China has the largest contributor to marginal global demand for oil. India’s production meanwhile it around 700,000 b/d, and not expected to grow much, so India’s impact on the oil market will only increase with time. China and India are expected to import 9.5 million  and 3.7 million b/d in 2018, respectively.

Over the next twenty years, according to BP, demand for oil will start to decline in the OECD countries. As shown in the chart below, almost all demand growth will come from Asia.

The global oil market over the next decade will become almost completely Asia-centric. With its geographical proximity to the Persian Gulf and its historical and cultural ties, it is highly likely that India will become increasingly influential in the region. Both India and China will step into the vacuum left by the U.S. as it loses interest in the region, and this may lead to fascinating developments in our increasingly multi-polar world.

Fed Watch:

India Watch:

China Watch:

China Technology Watch:

  • China on the leading edge of science (The Guardian)
  • China’s Uber killer ((Wired)
  • How China became a tech superpower (Wired)
  • China shows of tech in Spring Festival Gala (SCMP)

EM Investor Watch:

  • Unlocking Indonesia’s digital opportunity (McKinsey)
  • Transparency International 2017 Corruption Index (Transparency)
  • Turkey’s challenges in the Black Sea (CSIS)
  • The future of economic convergence (Project Syndicate)
  • The decline of governance in Turkey  (The Economist)

Investor Watch:

 

 

 

Where are we in the Emerging Market Cycle?

 

The increase in volatility in global financial markets over the past several weeks has raised concerns that the rally in emerging markets equities may come to an end. The market uncertainty is caused by the conflicting stances of U.S. monetary and fiscal policy; while the Federal Reserve is intent on tightening monetary policy, the Republican Administration has embarked on massive fiscal expansion. The fear is that fiscal pump-priming in an economy near full-capacity will boost inflation and compel the Fed to accelerate interest rate hikes, which could impact demand for riskier asset classes such as EM equities.

There is no question that the fiscal expansion being engineered by Washington is unusual policy this late in the business cycle. The current U.S. economic expansion, now in its ninth year, looks mature, given low unemployment and scarce idle capacity in the economy.  The Republicans hope to trigger a sustainable boost in U.S. GDP growth, to 3% or above. However, given expected labor force expansion of 0.5% and recent annual productivity growth of 1%, any growth above 2% will be ephemeral. Unless higher growth does materialize, the policy is expected to engender huge fiscal deficits in the years to come. This will happen at a time when private savings have collapsed to record low levels. This means that fiscal deficits will have to be financed by foreign savings, resulting from higher trade and current account deficits. U.S. personal savings and expected fiscal deficits are shown below.

In the past, rising current account deficits in the U.S. have been favorable for  emerging market asset prices. Large U.S. deficits signify a strong, late-cycle U.S. economy. This is typically accompanied by a weakening dollar and increased global liquidity,  which is  very beneficial for emerging markets. The last time we saw this was between 2003-2008 when twin deficits in the U.S. led to a weak dollar and booming asset prices in emerging markets. The reason that this happens is the following: 1. The overheated U.S. economy results in large current account deficits; 2. Surpluses accumulate in foreign central banks which intervene in currency markets to avoid accelerated appreciation; 3. These surpluses are very difficult to sterilize and stimulate credit and economic activity;4. As investors see currencies and markets appreciate they pile into the markets, causing additional upside pressure on asset prices.

As the U.S. economy strengthened over the past two years and the output gap was closed, this process already started. EM currencies and asset prices had reached very low levels in 2015. Now, after outperforming developed markets for two years, EM equities are no longer dirt cheap, but they are still very inexpensive relative to U.S. equities. We are probably about mid-cycle for EM. Economies are starting to gain some traction and equities are reasonably priced, at about historical averages. If the cycle progresses normally, we should see increasing liquidity push asset prices considerably higher for at least the next twelve months.

In contrast to the U.S., most EM economies are in the early or mid-stages of their business cycles, and the commodity-rich economies are just exiting from the deep slump caused by low commodity prices in recent years. Commodities also benefit from the overheated U.S. economy and the weak dollar, adding fuel to the emerging market cycle. The chart below shows were EM countries lie in the business cycle.

Of course, there are risks to this scenario. What could abort the global liquidity cycle?

  • An acceleration in U.S. inflation, triggering more aggressive Fed policy is a possibility. If U.S. inflation where to spike above 3%, the Fed would likely respond aggressively and could provoke a recession.
  • Trade Wars. U.S. tariffs and subsequent retaliations, would be inflationary and create uncertainty.

The most benign scenario for emerging markets is for a continuation of the trends of the past several years; this is a “Goldilocks” scenario of disappointing GDP growth and stubbornly low inflation, which allows the Fed to pursue its gradualist, “asset-friendly,” strategy. This is probably the most likely scenario at this time, and it could mean the extension of the business cycle for another year or two, in an environment of ample global liquidity.

Higher volatility in financial markets could also be a positive new element, to the extent that it caps enthusiasm for U.S. equities and allows emerging market equities to attract more flows and continue to outperform.

Fed Watch:

India Watch:

  • India is starting to move the oil markets (Oil price)
  • India needs to create salaried jobs (Livemint
  • RBI warns on Modi’s budget (QZ)
  • India’s protectionist budget (Swarajyamag)
  • India launches Modicare (Swarajyama)

China Watch:

  • China’s shadow banking system (BIS)
  • Shandong Ruyi textile group buys Bally luxury shoes (SCMP)
  • Cruise ship industry is booming (WSJ)
  • China and free trade (NYtimes)

China Technology Watch:

  • China is winning the battery war (WSJ)
  • China and the AI war (Science Mag)
  • Interview with JD.com’s Richard Liu (Youtube)

EM Investor Watch:

  • The enlightenment is working (WSJ)
  • Costa Rica runs 300 days on renewables (VT)
  • Inflation stalks Macri in Argentina (WSJ)
  • Why South Africa matters (FT)
  • Which emerging market is emerging (Seeking Alpha)
  • PDVSA’s workforce is jumping ship (Oil Price)
  • Traders warn EM rally is ending (Bloomberg)
  • Brazil’s hedge-funds boom again (Bloomberg)
  • Reasons for Brazil’s credit dysfunction (AQ)
  • Brazil’s PagSeguro IPOs on NYSE (Bloomberg)

Technology Watch:

  • Renewable power costs in 2017 (Irena)
  • Apple’s share of smartphone profits is falling (SCMP)

Investor Watch:

  • The decline of buy and hold (Seeking Alpha)
  • Munger says bitcoin is noxious poison (FT)
  • On the future of active investing (Forbes)

 

 

Big Macs and Emerging Markets

The Economist’s Big Mac Index looks at the dollar cost of a hamburger sold by McDonald’s restaurants in some 60 countries. The index shows a remarkable range of prices around the world. In the latest survey, the most expensive burger was found in Switzerland ($6.80) and the cheapest could be bought in Ukraine ($1.60). Presumably, these hamburgers are identical, with the same combination of bread, beef patty, lettuce and sauce in every unit. The price in each country should reflect the cost of the materials, labor and rent, as well as profit margins and taxes. The index pretends to shed some light on the relative costs of doing business in different countries, and, given that it has been measured for some 30 years, it can also provide an indication of the evolution of business costs. Moreover, it can be used as a proxy to  measure the relative competitiveness of currencies around the world.

The results of the January 2018 survey are shown below.

A Few observations:

  • No surprise to see Switzerland and Scandinavian countries at the top, where they have been for a long time. This makes sense, given high labor costs and value added taxes in these highly productive economies.
  • The high ranking of the United States is relatively new. The U.S. had ranked in the third and fourth decile, until 2016. This is the consequence of U.S. dollar strength, and a very surprising 4.1% annual increase in prices, more than twice U.S. inflation.
  • Brazil is back in the top decile, and it secures its place as the most expensive burger in emerging markets. Brazil is a complete anomaly, the only EM country in the top 20, and this in spite of being an extremely competitive producer of beef and other agricultural product. The high ranking is caused by the chronic overvaluation of the real, excessive business regulations and very high taxes. It will be interesting to see whether the recent labor reform can result in lower costs and if a significant fall in interest rates over the past year will lead to a weaker currency.
  • Turkey has fallen to the bottom decile for the first time in over a decade, the result of a weak economy and currency devaluation.
  • The traditional export-focused countries all maintain competitive currencies and cheap burgers. Of the Asian countries, only South Korea appears in the top half. In Latin America, Mexico remains very competitive.

The charts below show Big Mac prices relative to the U.S. price over the past twenty years, by region.

Asia is characterized by consistently stable and low prices. Chin has seen the most appreciation, caused by the appreciation of the yuan.

Latin America is characterized by unstable prices, with episodes of high overvaluation. Mexico is the exception, maintaining a more stable and competitive peso which is essential for its export-driven economy.

In Europe and Africa, Turkey behaves more like a Latin American market. After several decades of abusing with current account deficits, Turkey has had to devalue the lira to regain competitiveness. Russia, on the other hand, has managed its currency relatively well in spite of the volatility of oil prices.

For comparative purposes, the table below shows the REER (Real effective exchange rate), since 1995.

  • High volatility in Brazil and Turkey.
  • Gradually appreciating currencies China and Indonesia.

Fed Watch:

  • Gray Shilling on the Fed (Shilling)
  • World Finance in peril (Telegraph)
  • China is the leading candidate for the next financial crisis (FUW)
  • The coming melt-up in stocks (GMO)

India Watch:

  • RBI warns on Modi’s budget (QZ)
  • India’s protectionist budget (Swarajyamag)
  • India launches Modicare (Swarajyama)

China Watch:

  • China and free trade (NYtimes)
  • China mulls gambling on Hainan (SMH)
  • When will China become the biggest consumer economy (WIC)
  • Xi ally highlights financial risks (SCMP)

China Technology Watch:

  • China and the AI war (Science Mag)
  • Interview with JD.com’s Richard Liu (Youtube)
  • China and the U.S. wage the battle for AI on the cloud (Technology Review)
  • Hong Kong-mainland bullet-train links ready (Caixing)

EM Investor Watch:

Technology Watch:

  • Renewable power costs in 2017 (Irena)
  • Apple’s share of smartphone profits is falling (SCMP)

Investor Watch:

The Next Ten Years in Emerging Markets

 

Emerging markets have come out of a period of considerable underperformance relative to both the U.S. market and international developed markets. They have now outperformed for over two years, recovering some lost ground.

Valuations in emerging markets remain in line with historical norms, which is an aberration in a world of generally extreme asset prices. Strangely, while a very large growth premium is paid for growth assets in the U.S. market, that view has not benefited emerging markets, even though on average they have much higher GDP growth than developed markets.

EM’s poor performance over the past decade can largely be attributed to multiple contraction (The Past Ten Years in Emerging Markets). The graph below shows the evolution of the cyclically adjusted price to earnings (CAPE) ratio over this period. The average historical CAPE ratio for EM has been 14.4, which is exactly in line with the current level. After peaking in 2007, the CAPE for EM bottomed out in 2011-2013, at 10 times trailing earnings. We have already seen considerable multiple expansion since then, a consequence of the past two years of strong performance. Nevertheless, we can expect that, as always, valuations will peak this cycle well above the historical average, so additional multiple expansion is likely.

On a country-by-country basis, however, greater opportunities exist, and the investor can weigh his allocations accordingly.  The chart below shows how valuations have evolved over the past ten years for the primary EM countries. The first two columns on the left show the CAPE ratios at year-end 2007 and 2017, respectively. While the U.S. saw multiple expansion, every EM country saw multiple contraction over this period.  The next to last column on the right shows the country’s average CAPE for the past twenty years, and the last column shows how far the 2017 ratio is above or below the average.

Several conclusions can be drawn from this table.

  • The U.S market is priced for perfection, and should be expected to provide very low returns for the next 7-10 years.
  • “Risky” countries (commodity producers and those dependent on erratic foreign flows) offer significant upside to get back to average valuations. These “boom-to-bust” markets now stand to benefit from late-cycle effects of the U.S. economy, the weak dollar and strengthening commodity prices and will eventually trade at multiples above the historical average. This means high potential upside for stock prices in Russia, Brazil, Turkey, Malaysia , Chile and Colombia.
  • Mexico has been overly punished because of concerns with President Trump and the 2018 presidential election, and it could rebound strongly.
  • Indonesia and India are near normal valuations, and will need strong earnings growth and higher multiples to continue to outperform.
  • Philippines is at a very high level of valuation. This “FIRE” (finance-insurance-real estate) economy/market has benefited from liquidity and low interest rates, as these activities are all highly leveraged. Of course, the opposite will occur on the downside.

Valuations, in general, and CAPE in particular, are not good timing tools. However, historical observation and the academic research done by Professor Robert Shiller and others show a high correlation between CAPE and future returns. In EM, investors are fickle and nervous and things tend to happen quicker than in developed markets, so CAPE is probably a good allocation tool for 3-5 year investment cycles.

India Watch:

China Watch:

  • Couples not delivering on babies (Caixing)
  • The world’s most valuable luxury good company (WIC)
  • Making China Great Again (The New Yorker)

China Technology Watch:

  • China now top producer of scientific articles (Nature)
  • Tencent’s Wechat: an app and an app-store  at the same time (SCMP)
  • China to test new Maglev train (Caixing)
  • JD’s Liu goes to Davos (SCMP
  • Smartphone sales fall in China for the first time (SCMP)
  • Xiaomi gains top smartphone spot in India (SCMP)EM Investor Watch:

Technology Watch:

  • Amazon’s new Go store (Stratechery)
  • Renewable power costs in 2017 (Irena)
  • Apple’s share of smartphone profits is falling (SCMP)

Investor Watch:

 

 

 

 

 

 

 

 

 

 

The Past Ten Years in Emerging Markets

 

 

Ben Carslon ( Wealth of Common Sense blog) every year publishes a chart reviewing the performance of 10 asset classes over the past decade. It is a good reminder of how erratic annual returns can be. As shown in the chart below, even though emerging markets performed very poorly over the decade, the asset class was the best performer in three of the years and in the top half of the chart 50% of the time. Commodities were the worst performing asset class, which partially explains weak EM. This chart is U.S.-centric and expressed in US dollar terms, so the strength of the USD  over the period goes a long way to explaining the weak results for EM, commodities and international stocks.

A similar review of emerging markets organized by country is shown below. The returns are not strictly comparable to the previous chart, as these do not include dividends as part of the return. As in the previous chart, the annual returns are erratic and highly unpredictable. However, over the 10-year period, which is long enough to represent two normal 5-year investment cycles or a long 10-year cycle, the results are much less arbitrary.

Valuations do Matter

Though over the short-term valuations are a poor timing instrument, over ten-year periods they are very effective allocation tools. Looking at the Cyclically Adjusted Price Earnings Ratio (CAPE), which averages  inflation-adjusted earnings over the ten-year period, we can see that much of the performance differences can be attributed to the starting and ending points of valuations. The CAPE ratios for 2007 and 2017 are shown below. It must be noted that 2007 ended with very high valuations in most emerging markets, as this was the peak of U.S. Fed-induced “easy money” and commodity prices.

In  our sample, only the USA  (S&P 500) had an expansion in its CAPE ratio, and this explains almost all of its absolute and relative returns for the period. The best performing emerging market, Thailand, had a flat CAPE ratio, while every other market had a contraction in its CAPE ratio. The better performers had smaller contractions in their ratios, with the exception of Indonesia. The worst performers – Russia, Brazil, Turkey, Malaysia — had huge contractions in their CAPE ratios. Though India experienced a period of very high GDP growth and political stability, it could not overcome the anchor from its extreme valuations at the start of the period.

Commodities and Currencies Matter in Emerging Markets

The past ten years was a period of dollar strength and commodity weakness, both of which are correlated to poor performance for the EM asset class. With the exceptions of Indonesia, Peru and South Africa, all commodity-sensitive countries did poorly. Indonesia and Peru were supported by the large size of financials in their indexes, and South Africa is an anomaly because its market has become more correlated to China technology (Naspers-Tencent) than to the domestic economy.

And so do Politics and Governance

Russia, Brazil and Turkey all suffered from severe political instability during the period. Russia’s war with Ukraine and the following economic sanctions, Erdogan’s radicalization of Turkish politics, and Brazil’s economic mismanagement and corruption scandals, were all self-inflicted disasters that could not have been anticipated at the end of 2007.

 

Fed Watch:

India Watch:

China Watch:

  • The world’s most valuable luxury good company (WIC)
  • US politics gets in the way of Ant Financial’s US plans (SCMP)
  • Making China Great Again (The New Yorker)

China Technology Watch:

  • Chinese tech workers are flocking home  (Bloomberg)
  • How China went from made in to created in (SCMP)

EM Investor Watch:

 

  • Venezuela’s oil production collapse (Bloomberg)
  • World Economic Forum, Manufacturing Report, 2018 (WEF)
  • Pakistan ditches the dollar for China trade (CNBC)

Technology Watch:

  • Renewable power costs in 2017 (Irena)
  • Apple’s share of smartphone profits is falling (SCMP)

Investor Watch:

India, Urbanization and a New Commodity Bull Market

Around the turn of the century, China’s economy entered in a phase of very high growth which was fueled by investments in infrastructure and heavy industry and was extremely intensive in the use of hard commodities. A surge of demand from China caught producers by surprise and drove prices  for commodities, such as iron ore and copper, to very high levels for an extended period of time (2003-2011).  A typical boom-to-bust cycle ensued, with overinvestment by producers eventually resulting in over-capacity and a return to low prices.

Commodity markets have been depressed for the past five years and valuations for the stocks of the producer firms have reached record lows relative to stocks in other sectors.

China’s impact on commodity prices, though extraordinary, was not atypical. Historically, countries have entered periods of commodity-intensive growth when they reach a certain level of wealth and experience high urbanization rates: for example, the U.S. in the 1920s, Japan in the 1950s, Brazil in the 1960s and Korea in the 1970s. All these countries saw a period of massive growth in commodity consumption, which eventually leveled off. U.S steel consumption today is at the same level as in 1950, while the Japanese consume steel at 1975 levels.

We can see in the following chart the recurring pattern, when countries suddenly ramp up urbanization rates. High income nations have largely stabilized urbanization levels, while China, India and  all lower-income developing countries still have several decades ahead.

 

If we can identify the next countries experiencing high growth and urbanization, we can go a long way towards understanding the next upcycle in commodities. From looking at historical data, it is the case that urbanization rates ramp up when countries reach a level of wealth around $2,000 per capita (2016, constant USD). The table below shows the progression by decade of new countries entering this wealth level, according to IMF and World Bank data. During the decade ending in 1980, Korea, Poland and Thailand entered into this group; none entered in the 1980s; Russia (and other Eastern European state) appear in the 1990s; and China, Nigeria, Ukraine and Indonesia enter in the 2000s. In this current decade only Vietnam has appeared, so far; but if we look through 2022, we see a massive swell led by India but also including Uzbekistan, Myanmar and Kenya.

It is not the number of countries that matter, of course, but rather the population impact that they represent. The chart below shows the population impact by period, in terms of new entrants as a percentage of global population. We can see a huge surge representing 21.8% of the global population (23%, including Vietnam), surpassed only by the China-led surge of the 2000s.

Equally important, the upcoming surge will happen at a time when China sustains relatively high growth and increasing urbanization, so that we will have both China and India sustaining demand at the same time.

A new upcycle in commodity prices is obviously bullish for emerging market producers, such as Chile, Brazil, Indonesia, Russia and South Africa. It also likely points to a weak dollar and good performance for emerging market stocks in general.

Fed Watch:

India Watch:

China Watch:

 

  • US politics gets in the way of Ant Financial’s US plans (SCMP)
  • Making China Great Again (The New Yorker)
  • Geely invests in AB Volvo trucks (SCMP)
  • China’s commodity demand (Treasury)
  • Ground broken on China-Thai railroad (Caixing)

China Technology Watch:

EM Investor Watch:

 

  • France seeks closer ties with Russia and China (WSJ)
  • Latin America’s rejection of the left (Project Syndicate)
  • Indonesia’s bullet-train project stalls (Asia Times)
  • Boeing’s bid for Embraer (Bloomberg)

Technology Watch:

  • Apple’s share of smartphone profits is falling (SCMP)
  • Fanuc’s robots are changing the world (Bloomberg)
  • Battery costs coming down (Bloomberg)

Investor Watch:

 

 

 

 

Deglobalization and Technological Disruption

Deglobalization and rapid technological change are likely to be the two main drivers of economic and stock market performance in emerging markets for the next five years. Every country faces different combinations of challenges and opportunities and how they deal with these will make a big difference in whether they prosper in our rapidly changing world.

Deglobalization

The intense globalization of the past decades, which had not been seen since the last decades of the 19th century, was a boon to the global economy, while at the same time dramatically redistributing relative income: to the poorer countries and away from the developed ones; and to super-wealthy individuals and away from everyone else. The political effects of this redistribution have become evident in recent years, leading to a dramatic corruption crack-down in China and the rise of populism in the West in the shape of Brexit and Donald Trump.

The clear beneficiaries of globalization were those manufacturing countries that integrated themselves in global value chains. These were mainly in Asia, though countries like Mexico and Turkey also participated. Some small, highly competitive countries also benefitted from better access for their exported goods. And, of course, consumers in developed economies benefitted from cheaper imports.

The relative losers were those countries that fought the trend (Brazil, India, South Africa, Venezuela, Indonesia, Russia) or were too small or uncompetitive to participate.

Unfortunately, those countries that did everything right during this cycle and participated fully in the upside of globalization may now have more to lose. Those countries highly integrated into global value chains and highly dependent on exports may now suffer relative underperformance unless they can find other sources of growth.

On the other hand, those countries that never embraced globalization –Brazil and India for example — may now be well positioned. Given the size of their domestic markets and ample growth opportunities that are unlinked to the global economy, they could still attract investments and thrive in a world where country-to-country trade deals based on reciprocal market access become more the norm.

China also seems well positioned. Given the size of its economy, further export-led growth was never going to be plausible. Moreover, the Chinese economy is coincidentally entering into a phase where it will be driven by domestic consumption and improvements to the “quality” of life.

Developed economies also are generally well positioned. Protectionism may lead initially to a welcomed increase in wages. Over time, it will trigger investments in automation technologies and accelerate the opportunities for “on-shoring,” the relocation of manufacturing closer to the customer in the developed countries. Two examples of this are: Adidas operating highly automated sneaker plants in Germany, and cloud computing and artificial intelligence undermining the low-value-added services of the Indian information technology industry.

Technology

There are two main thrusts of technological innovation that will dramatically impact emerging markets in coming years: 1. Artificial intelligence and robotics; and 2. Renewable energy.

With regards to technology, there are two factors to consider; whether a country can benefit as a developer of new technologies; and whether a country can successfully embrace the adoption of new technologies.

In terms of participating in the benefits of the development and commercialization of new technologies, it seems today that only East-Asian emerging markets (China, Korea, Taiwan) are well positioned to do so. China, following the path of its East-Asian neighbors and committing huge government support, is already becoming a leader in many technologies (internet, mobile telephony/5g, drones, high-speed trains, electric vehicles, solar and wind, among others).

In terms of the potential for countries to embrace new technologies, the path is much less clear.

New technologies offer enormous opportunities for emerging markets to leapfrog to state-of-the art conditions with much lower costs and vastly better productivity. For example, China has built a world class telecommunications network based on mobile technology without having had to make huge investments in fixed telephony networks. In Brazil, fixed lines are likely to become nothing more than a bad memory for people over 50 years of age. In Vietnam and India, the average person will have never experienced a fixed line. The potential for leap-frogging is the greatest in the poorer countries which have no attachment to legacy technologies, such as Africa, India and China.

A multitude of new technologies now being deployed will ramp-up dramatically in coming years, including cloud computing, artificial intelligence, drones, electric and autonomous vehicles, e.commerce, fintech, and battery-centric renewable energy. Many of these technologies will be very disruptive to businesses, that will lobby hard to protect legacy markets. Every country will deal differently with these disruptive forces, depending on the vision of policy makers and the power of entrenched interests to block change.

China has embraced technology for idiosyncratic reasons. China started from so low a level of economic development and the pace of change has been so fast that entrenched interests did not oppose new technologies. But that is not the case in most places, particularly the stagnant middle-income countries with powerful entrenched interests and rent-seeking politicians.

Take a country like Brazil. New technologies may face a phalanx of opposition from manufacturers, unions and local politicians, aimed at discouraging entrepreneurs. While in China, multinational automobile firms have quickly toed the Party line and committed to electricity vehicle investments, in Brazil they are likely to resist for as long as possible.

India is probably the country with most to gain from disruptive changes. It has a tech-savvy elite which has been instrumental in pushing for digitalization, such as the recently implemented AADHAAR national biometric digital identification program, which opens huge opportunities for digital commerce and fintech. With a very large proportion of its population with no access to basic public, financial and commercial services, AADHAAR provides significant opportunities for the Indian masses to gain access to state-of-the art technologies. This is now happening with smart-phones and will soon ramp up with battery-centric renewable energy and fintech services, giving countless isolated villagers access to modernity for the first time. Also, with only a fraction of the population currently with access to automobiles, in India there is no legacy infrastructure standing in the way of electric vehicles.

Though it is difficult to predict how things will play out, the following chart attempts to map-out how de-globalization and technological disruption may affect the major countries in emerging markets.

 

 

Fed Watch:

India Watch:

China Watch:

  • China’s commodity demand (Treasury)
  • Ground broken on China-Thai railroad (Caixing)
  • China’s new winter sports resort ( WIC)
  • China cannot be a global leader (China File)

China Technology Watch:

EM Investor Watch:

Technology Watch:

Investor Watch:

 

Picking Stocks

Many active portfolio managers describe themselves as “bottom up” investors, by which they mean that their process begins with picking individual stocks that are fundamentally mispriced. However, the evidence shows that successful investing does not start with stock picking, but rather with a firm set of principles and exploitable factors. For example, Warren Buffet, considered by many the best stock picker of his generation, has been known to buy a stock after only a brief conversation because he can quickly fit the idea into his very defined philosophical framework.

The investors first task should be to define an investment policy and a process which is simple and replicable. The second task, refered to as asset allocation, is to construct a portfolio of assets that matches risk appetite and tolerance for drawdowns by diversifying into non-correlated cash flow streams. The third task is to identify the securities, including stocks, to implement the strategy. It is at this point that stock picking acumen comes into play, giving the investor the opportunity to use skill to garner excess return (“alpha”) beyond what is available through indexing strategies.

Quant strategies are already very good at exploiting at very low cost the market return (beta) and factors such as value, size, momentum and quality. Therefore, the successful stock picker needs to focus on segments of the market that are “inefficient” because of the behavioral biases of both institutional and individual investors. Computers are not particularly adept at reading human emotions, judging human character and seeing the future, so in these matters portfolio managers still have a significant advantage.

The behavioral biases that can be exploited are:

  • Short-termism – the great majority of institutional investors and all of the Wall Street “sell side” brokerages are focused on the next 3-6 months. Enormous resources are spent on this time frame, so the market is extremely efficient and alpha is scarce. But if the investor can look forward, the competition for alpha declines precipitously as duration increases. Time-horizon arbitrage is a lonely occupation in the investing world, so there is alpha to collect.
  • Herding – Investors like to move in herds. As Keynes once noted, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to success unconventionally.” Contrarians are rare in the investing world, so they can harvest alpha through mean-reversion strategies, which go against the herd.

The independent investor should also narrow his focus to segments of the market that are richer with alpha. Buffett, for example, says that from the start he eliminates 90% of the stocks in the market, the “too difficult” pile. He focuses all his attention on the remaining 10%. This pool of stocks, which he names his “circle of competence,” are companies that have simple business models and returns that are both high and sustainable. The sustainability of high returns exists because of a “moat” that defends against competitive pressure.

While most investors have portfolios heavily laden with market risk (beta) and factors that can be easily replicated by quants, the skilled stock-picker should focus on high-return prospects; “fishing where the fish are,” so to speak.

The key to alpha generation is to exploit human foibles in areas of the market that offer high potential, following strategies that cannot be easily replicated by the quants and their computers.

The first step is to define the “circle of competence.” In my emerging markets investments I initially reduce the universe to the 10% of profitable companies (historical basis). These companies, which have shown the ability to makes good returns on capital over the past 5-10 years , can be called the “Legacy Moat.”

The second step is to run a value screen on the Legacy Moat, and eliminate the more expensive stocks. This can be done simply with something like Greenblatt’s “magic formula,” or, for example, by eliminating high PE ratio or high price-to-book stocks. The list of stocks, narrowed to 5% of the universe, already should provide significant alpha based on the value and quality factors. Unfortunately, up to now the process can also be easily replicated by a computer.

The third step is to subjectively review the stocks on qualitative grounds, entering into issues where computers provide little insight.

The questions to be asked are highly subjective in nature:

  1. Is the moat sustainable?
  2. How much can the business grow and for how long can capital be redeployed at high rates?
  3. What is the “character” of managers/owners? Do they have integrity? Will they make good capital allocation decisions?

None of these questions is easy to answer, but this is where the portfolio manager can add  value.

The third step will narrow the list to 1% of the total stock universe. These businesses which have high returns, sustainable moats and the ability to reinvest can be called “moat compounders.”  These are the most extraordinary businesses if they have long runways (e.g. Walmart in 1970, Indian banks today.) Particularly in the medium-cap world and in emerging markets, these opportunities are not well followed and can be very under-priced. Typically these businesses have one of three moats: network effects (e.g. Facebook, Tencent); scale advantage (E.g. Amazon, Alibaba, Ambev); or valuable intangible assets  like brands (e.g. Coca Cola, Banco Itau).

Identifying moat compounders is not easy, but skillful investors do have an edge. First, by being exclusively focused on this “fishing ground,” they improve their chances from the start. Second, by  studying the nature of moats they become experts at identifying them. Third, they can take a long-term view, allowing for compounding effects to materialize. Fourth, they can exploit the moods of the market, as the herd moves on the “fear and greed” spectrum.

There is one additional segment worth mentioning that can provide significant alpha for the stock picker.  This is the “legacy moats” that do not have reinvestment opportunities but do have exceptional capital allocators. These legacy moats can be great investments if capital is redistributed to investors or redeployed effectively in M&A. This is the model followed over three decades by Brazil’s Jorge Paulo Lehman, as he buys mature businesses (e.g. beer) and redeploys cash flow into M&A opportunities.

Fed Watch:

India Watch:

China Watch

  • China’s new winter sports resort ( WIC)
  • China cannot be a global leader (China File)
  • China forms a Cement giant with eye on Silk Road (SCMP
  • Starbucks opens its largest store in Shanghai (FT)
  • China and India lead in growth in parcels shipped (Business Wire)

China Technology Watch:

  • China’s two largest trucking aggregators merge (WIC)
  • The battle between Alibaba and Tencent (WIC)
  • China-U.S. competition for AI (AXIOS)
  • China’s AI Awakening (MIT Tech Review)

EM Investor Watch:

 

  • GMO goes all-in on EM (GMO)
  • The end of globalization as we know it (Barclays)
  • Demographics will reverse major trends (BIS)
  • Venezuela’s farming disaster (Bloomberg)

Technology Watch:

 

 

 

 

Using Momentum in Emerging Markets

 

Momentum investing relies on inertia: the directional tendency of investment performance. What has been doing well will tend to continue doing well; what is doing badly will tend to continue doing badly.  Momentum investors seek to catch long rising trends, and quit losing trades. The famous classical economist, David Ricardo, summed it up well in 1838 when he said what has become a mantra for momentum investors: “Cut your losses; let your profits run on.”

An elite cohort of investors have embraced this style of investing, including Richard Driehaus, Paul Tudor Jones, George Soros and Stanley Druckenmiller, some working purely on a technical basis, others combining momentum with fundamentals.

Like all anomalies in efficient markets, the momentum factor creates excess returns because of behavioral reasons. Successful investors learn to exploit systematic and predictable irrational human behavior. A typical trend evolves as follows:

Phase 1- Anchoring and under-reaction- Prices initially lag fundamentals, allowing early movers to position themselves well ahead of the crowd.

Phase2- Herding  and over-reaction – As prices start moving higher, investors join the heard, eventually over-reacting.

In an effort to show how common investors, without the trading smarts or resources of a Soros, could successfully use momentum to enhance returns, Gary Antonacci proposed  “Dual Momentum Investing,” in an article and subsequently a book.

Antonacci’s Global Equities Momentum (GEM) portfolio builds a portfolio with three assets: U.S. stocks, international stocks and U.S. bonds. For the retail investor he recommends using low-cost ETFs: for example, VOO for U.S. stocks; VEU for non-U.S. stocks and AGG for U.S. aggregate bonds.

Antonacci named his system “Dual Momentum” because he uses both relative momentum (the measure of the performance of an asset relative to another asset) and absolute momentum ( the measure of performance relative to the risk-free rate – absolute excess return.)

To keep the process very simple to implement, he used a 12-month look-back period and an easy to execute buy and sell system.

  • Every month the investor places all funds in the equity ETF that has the best 12-month performance relative to the other equity ETFs, unless the absolute performance is worse than the return of six-month U.S. Treasuries (as measured by BIL ETF).
  • If absolute performance is below the BIL ETF, then the investor places all funds in AGG, the aggregate bond index.

The simple process aims to position the investor to benefit from long rising trends while avoiding drawdowns. The process is fully automated, eliminating human behavioral reactions.

Antonacci looks at results from 1974 to October 2013. During this period, the portfolio was invested 41% of the time in U.S. stocks, 29% in international stocks and 30% in U.S. bonds. The portfolio was switched 1.3 times per year.

The portfolio outperformed the global benchmark (MSCI All Country World Index – ACWI) by 7.6% annually for the period, with consistent outperformance every decade. It accomplished this with much lower volatility (standard deviation of GEM is 12.64% vs. 15.56%.) More importantly, the maximum drawdown (decline in the value of the fund) was 17.8%, vs. 60% for ACWI.

Antonacci does not recommend using emerging markets in his GEM portfolio, beyond what is already included in the ACWI. He claims that emerging markets have become more correlated in recent years and do not add value.

To evaluate this claim, I ran Antonocci’s system, including emerging markets as a third asset class in addition to U.S. stocks and the MSCI developed market Index. I suspected that Antonacci’s view on the high correlation was influenced by the very high down-side correlation during the 2008-09 financial crisis. Historically, correlations have been relatively low, particularly on the upside, and the high volatility of emerging markets should be exploitable by the GEM process.

From 1999 to October 2017 (admittedly a short period) the GEM Plus EM portfolio produced impressive results, as shown below. The investments are implemented using the SPY ETF (S&P), VTMGX (EAFE), and VEIEX (EM).

  • The expanded GEM portfolio generated significant excess return by riding long dominant upswings for EM and the S&P and avoiding downturns by  reallocating to U.S. bonds. By doing this it avoided massive drawdowns in the early 2000s and during the financial crisis of 2008-09. Given the very high correlation that markets have shown during downturns, the option of holding U.S. bonds for 18% of the time-period reduced the funds maximum drawdown dramatically.
  • Switches from one asset to another occured 1.49 times per year, compared to 1.3 times per year for Antonacci’s portfolio. This is because of the addition of a third asset.

These momentum strategies seem well suited for the market environment of the past decades which has been marked by large drawdowns and sustained trends. They also provide downside protection from the very high current asset prices around the world.  For tax-shielded investors, the advantages are clearly compelling, somewhat less so for taxed investors. The strategy would work poorly if market leadership were to change frequently, creating false signals.

Fed Watch:

India Watch:

China Watch:

  • China’s Transsion leads mobile phone sales in Africa (FT)
  • China transforms the trucking business (Bloomberg)
  • China needs centrally controlled deleveraging (Bloomberg)
  • World Bank, China 2030 (World Bank)
  • The coming China trade war (IRA)

 

China Technology Watch:

  • Chinese Surveillance camera’s are found on U.S. army bases (WSj)
  • Hisense buys Toshiba’s TV business (Caixing)

EM Investor Watch:

Technology Watch:

  • Fanuc’s robots are changing the world (Bloomberg)

Commodity Watch:

  • There is more farmland then previously thought (Bloomberg)
  • Australia’s economy is a house of cards (Linkedin)

Investor Watch:

 

 

 

 

 

 

 

 

 

 

 

Which Emerging Markets are actually Emerging?

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

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

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

 

The Biggest Gainers, 50 years

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

The Stagnant Countries, 50 years

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

 

The Losing Countries, 50 years

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

The Winners over the past 30 years

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

The Winners over the past 15 years

 

Fed Watch:

India Watch:

China Watch:

China Technology Watch:

  • Chinese Surveillance camera’s are found on U.S. army bases (WSj)
  • Hisense buys Toshiba’s TV business (Caixing)
  • VW to invest $12 billion in EV in China ( WSJ)
  • Google tries to enter China again with AI Bloomberg)

EM Investor Watch:

 

Technology Watch:

  • The road to cheap ubiquitous energy (The Economist)
  • The power plant of the future is your home  (WEF)
  • The Future of the car, Bob Lutz (Auto News)

Commodity Watch:

  • There is more farmland then previously thought (Bloomberg)
  • Australia’s economy is a house of cards (Linkedin)

Investor Watch:

  • ETFs are no bonanza for Wall Street (WSJ)
  • Jeremy Grantham, why this time is different (WSJ)

 

 

 

 

 

 

 

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

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

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

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

Fed Watch:

India Watch:

China Watch:

China Technology Watch:

  • How China will rate its citizens with AI technology (Wired)
  • China’s focus on practical AI application (Arxiv.org)
  • China and Russia invest in face-recognition start-up (Bloomberg)
  • Automaker Changan to go 100% electric (Caixing)

EM Investor Watch:

Technology Watch:

Commodity Watch:

 

 

 

 

 

 

 

 

 

 

 

China’s Awakening is Shaking the World

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

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

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

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

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

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

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

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

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

 

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

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

Fed Watch:

India Watch:

China Watch:

  • Xi’s glittering solutions for China (Geopolitical Futures)
  • Xi’s plan for state-sponsored quality growth (Bloomberg)
  • Xi’s bureaucratic shake-up (CSIS)
  • Xi’s conservative, greener speech (CSIS)
  • Five things to know on Xi’s speech (The Guardian)
  • Spence on China’s challenge (Project Syndicate)
  • Asia now has more billionaires than the U.S. (Caixing)
  • The internationalization of China’s capital markets (Bloomberg)
  • Why the renminbi won’t rule (Project Syndicate)
  • China’s influence on global markets grows (Bloomberg
  • China’s economy is already the biggest and growing fast (Bloomberg)

China Technology Watch:

EM Investor Watch:

Technology Watch:

Commodity Watch:

 

Energy Disruption Will Benefit Emerging Markets

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

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

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

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

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

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

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

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

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

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

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

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

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

Fed Watch:

India Watch:

  • India on the wings of digitization (Wisdom Tree)
  • India’s electrical vehicle dreams (CSIS)

China Watch:

  • The internationalization of China’s capital markets (Bloomberg)
  • Xi’s conservative, greener speech (CSIS)
  • China’s influence on global markets grows (Bloomberg
  • China’s economy is already the biggest and growing fast (Bloomberg)
  • Riding China’s huge high-flying car market (Mckinsey)
  • China, a strategy born of weakness (Geopolitical Futures)
  • 7 things we learned from China in September (WEF)
  • Buffett’s bet on BYD is working (QZ)
  • Meet China’s evolving car buyer (McKinsey)

China Technology Watch:

EM Investor Watch:

  • Five books on globalization and inequality (Five Books)
  • Investment anomalies (Wisdom Tree)
  • Anchoring Value Investing in EM (Eastspring)
  • EM Index without SOEs (Wisdom Tree)
  • Asia leading in (KKR)
  • Latin America’s slow recovery is on track (IMF)
  • Amazon expands in Brazil (Bloomberg)
  • Increasing pressure on Venezuela’s dictatorship (CSISAsia leads global recovery (IMF)
  • EM; doom to boom (Seeking Alpha)
  • Why you should care about Brazil’s stock market (Seeking Alpha)
  • Gazprom knocks Exxon off its pedestal (Forbes)

Technology Watch:

Commodity Watch:

Investor Watch:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Energy Market Disruption and Global Multi-polarity

 

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

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

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

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

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

 

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

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

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

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

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

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

Fed Watch:

  • Rajan’s view on unconventional monetary policy (Chicago Booth)
  • Low returns expected long term for U.S. stocks (Macrovoices)

India Watch:

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

China Watch:

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

China Technology Watch:

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

EM Investor Watch:

Technology Watch:

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

Commodity Watch:

Investor Watch:

 

 

 

 

 

 

 

 

Global Competitiveness In Emerging Markets

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

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

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

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

India Watch:

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

China Watch:

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

China Technology Watch:

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

EM Investor Watch:

  • Gazprom knocks Exxon off its pedestal Forbes

Technology Watch:

Investor Watch:

Ray Dalio on market valuation:

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

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

What are the implications of all that?

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

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

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

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

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

So is there a lesson from 1937?

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

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

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

Business Corruption in Emerging Markets

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

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

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

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

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

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

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

 

India Watch:

China Watch:

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

China Technology Watch:

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

EM Investor Watch:

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

Technology Watch:

Investor Watch:

Notable Quotes:

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

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

 

 

Caution Is Merited For India’s Stock Market

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

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

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

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

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

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

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

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

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

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

India Watch:

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China Technology Watch:

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EM Investor Watch:

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