Category: Investing

Market seers look at various indicators to predict future returns for stocks. By looking at the historical relationship between the indicator and the value of the stock market analysts seek to establish a statistical pattern that if repeated in the future can provide an indication of probable prospective returns for stocks from current levels. Several popular indicators used by forecasters include the following: market value to sales; market value to inflation-adjusted average ten-year earnings (CAPE); and market value to Gross National Product (GNP). This last one is known as the “Buffett Indicator” because Warren Buffett noted in 2001 that it is “probably the best single measure of where valuations stand at any given moment.” The underlying premise of the “Buffett Indicator” is that over the long-term corporate earnings remain constant in proportion to GDP. Though this is not true over the short term (e.g. corporate earnings have risen much more than GNP over the past decade), the assumption is that eventually they revert.

Let us look at the Buffett Indicator; first for the U.S. market, and then for several emerging markets. The chart below graphs both U.S. GDP and the U.S. stock market for the past sixty years. It is interesting to look at the graph in the context of Buffett’s investment career, which coincidentally extends for the sixty years of data. First, the period from 1960 to 1970 was one of consternation for value investors like Buffett who felt that valuations were extremely high. Buffett closed his initial partnership in 1969, partially because he felt valuations were too high to remain invested. Second, the period 1974 to 1997 which were Buffett’s most successful years. He thrived in the 1970s, an environment of very low valuations caused by high inflation. Third, 1998 to 2001 was a period of serious underperformance for Buffett, as he was out of the high-flying technology stocks. Fourth, from 2001 until today, Buffett has not performed as well as in the past, only outperforming the market during the large drawdowns of 2002 and 2008. The “Buffett Indicator” today points to very high valuations, and probably to a big opportunity for Buffett to capture alpha (relative market performance) in the next downturn.

It is easy to see why Buffett would like this indicator. When the market line is below the GNP line the investment environment is favorable to value investors like Buffett. When the market line is above the GNP line, the environment is favorable to “growth” investors who prefer leading-edge companies with rosy prospects.

In the case of emerging markets, we look at three countries: Brazil, Turkey and India (charts below). These three markets all have enough historical data to identify patterns, which is less true for markets with short histories like China and Russia. Brazil and Turkey are very volatile “trading” markets. India is a less volatile market with more extended trends. Our data is all dollarized because we are dollar-centric investors, but consequently both GNP data and market data are greatly accentuated by currency effects. The GNP data is from The World Bank.

Brazil

Following the “economic miracle” (1968-71), Brazil entered an extended period of rising inflation and malinvestment (1972-1980). During this period of high economic growth, the stock market greatly underperformed GNP, leading to exceptionally low valuations. During the period of “re-democratization”  (1982-1990), the market initially rallied strongly but then entered  into a long period of extreme volatility driven by various failed plans to bring economic stability. Since the economic stabilization brought by the Plano Real (1994) the stock market has followed GNP more closely, falling in periods of recession and rising during periods of economic growth and optimism. After the liquidity and credit driven boom of 2002-2010 economic recession and currency weakness has brought the market down. Since 2016 the market has rallied on the hope of new reforms and economic recovery. If this hope fades, the market is likely to resume its decline.

Turkey

Like Brazil, Turkey is a market of great stock market volatility cause by repeated economic instability and long periods of economic stagnation. Also, like Brazil, this volatility makes Turkey a great “trading” market. Though the market over time follows the course of GNP, over the shorter-term it constantly veers above and below the GNP trend line creating trading opportunities. Since the market collapse in 2008, the market has significantly disconnected from GNP. Unlike Brazil, where the market is pricing in economic recovery, the Turkish market is in deep value territory. Based on its history of sharp stock market recoveries, the current position well below the GNP trend line positions it for a sharp rally.

India

The Indian market has closely followed the GNP trend line. The chart below covers essentially the period since the economic “opening” launched by Finance Minister Manmohan Singh in 1991. This period, from 1991 to today, has been one of relative stability and rising economic growth, conditions which are highly favorable for stock market appreciation. Different to China or Brazil in the 1970s, the Indian market is dominated by profit-oriented private companies. The contrast with Turkey and Brazil is also obvious: the Indian market is much less volatile and has followed the course of a rising GNP more closely. Periods of relative pessimism, when the market has traded below the GNP trend line, have been valuable buying opportunities for the long-term investor, while the dramatic overshooting in 2008, in retrospect, was an obvious time to reduce positions. The market offered its last good buying opportunity in 2017 and today looks only slightly undervalued relative to the GNP trendline.

Problems with the Buffett Indicator

There are potential issues with the Buffett Indicator.

First, the underlying assumption of stable corporate earnings relative to economic activity may be wrong. Or it may be correct for the United States but not for other markets.

Second, there are many measurement issues. These relate to the accuracy of GNP measurements and accounting issues. Both GNP calculation methodology and accounting standards evolve over time, and this may undermine historical comparisons.

Macro Watch:

• The US trade deficit is not caused by low savings (Carnegie Pettis)
• We were pirates too; trade rivals steal secrets (Foreign Policy)
• The double standard of Trump’s trade policy (Project Syndicate)

India Watch:

• India’s strong economy leads global growth (IMF)
• (King coal rules India (Economist)
• Apple is struggling in India (Bloomberg)

China Watch:

• China and Russia’s dangerous liaison (FT)
• China thoughts (Base Hit Investing)
• Australia’s complicated China ties (The Monthly)
• Tianjin suffers a slowdown (Economist)
• China’s summer of discontent (Asian Times)
• Protecting American tech from China (Foreign affairs)

China Technology Watch

• China’s rise in bio-tech (WSJ)
• Berlin blocks Chinese acquisition (Caixing)
• The man behind Pinduoduo (WIC)
• Wake up call for China’s chip industry (Caixing)

EM Investor Watch

• Brazil’s populist temptation (Project Syndicate)
• Turkey’s rejection of the West (FT)
• Thailand’s economic challenge (Cogitasia)
• GMO makes the case for EM

Tech Watch

• The future of batteries (Wired)
• The world’s largest solar farm in Egypt (LA Times)

Investing

• Li Lu’s lecture at Beijing University (Himalaya Capital)
• Charlie Munger and Li Lu Interview (Guru Focus)
• Interview with Bill Nygren (Youtube)
• The 8 best predictors of market returns (WSJ)

Over the short-term stock prices are mainly driven by liquidity and human emotions, but over the long-term fundamental valuation is the key variable.  This leads to mean reversion being one of the few constant rules of investing, as both liquidity and human behavioral cycles normalize over time. Over a ten-year period (approximately two investment cycles), one should expect mean reversion to run its course, and the evidence is strong that it does in emerging markets.

The past ten years in emerging markets have been dismal for investors, largely because the previous had been very good. As the chart below shows, emerging markets outperformed dramatically for the ten years leading to July-end 2008 and now have underperformed for the past ten years. By year -end 2017 the two indices were even, though during the first half of this year the S&P500 has once gain taken a small lead.

Over the long term there are only two drivers of stock performance: (1) Earnings growth, which is closely linked to GDP growth; and (2) the price-to earnings multiple, which is tied to liquidity and human emotions as well as interest rates and inflation. Current projections by the IMF and others anticipate that GDP growth for emerging markets as a whole will average about 5% for the next 5-10 years, compared to around 2% for the United States and other developed markets. This means that earnings growth in emerging markets should be significantly higher than in the United States. At the same time, P/E multiples in emerging markets are nearly half those in the United States (13.0 vs. 24.1). The combination of higher earnings growth and much lower starting multiples, all else being equal, points to relatively good prospects for emerging market equities over the next 5-10 years.

Another manifestation of mean reversion can be seen in stock leadership Every decade seems to have a few defining themes.  In emerging markets the decade ending in July 2008 was very driven by high prices for commodities. For the past ten years, the main themes have been the rise of both China as an economic power and technology as ia disruptive force. The charts below show the top ten stocks over the past three decades for both emerging markets and the U.S., with those stocks remaining on the list from one period to another highlighted in red. What we see in both cases is that market leadership constantly changes as investors shift their attention to the countries, companies and sectors experiencing the most positive narratives and best profit cycles. We can see how difficult it is for stocks to remain on the list. In both emerging markets and the United States between 80-90% of the ten most highly valued companies underperform the index for the next ten-year period as investors move on to new darlings. For the past ten-year period, of the leaders in 2008 only Microsoft outperformed the index in the United States and only TSMC and Samsung outperformed in emerging markets.

The current ten most valuable stocks in emerging markets reflect both the rise of China and the technology sector. Remarkably, seven out of ten stocks are Chinese  compared to only one ten years ago  (though Naspers is based in South Africa all of its value can be attributed to its Tencent stake) . This Chinese domination of the index occurs at a time when China faces a slowing economy, a credit bubble and unprecedented animosity from its main trading and investment partners. Last month Reliance Industries of India entered the list, replacing Ping Ang Insurance of China. Perhaps this is a harbinger of the next wave in emerging markets.

Macro Watch:

• We were pirates too; trade rivals steal secrets (Foreign Policy)
• The double standard of Trump’s trade policy (Project Syndicate)
• Stiglitz on trade wars (Project Syndicate)
• Michael Pettis on tariffs (China Financial Markets)

India Watch:

• India’s internet shut-down problem (QZ))
• India pushes coal (SCMP)
• Samsung opens world’s largest smartphone factory in India (Bloomberg)

China Watch:

• Protecting American tech from China (Foreign affairs)
• Regrets on giving China entry to WTO (WSJ)
• Foreign CEO’s on a tight leash in China (Foreign Policy)
• The door is closing on Chinese investments abroad (FT)
• China’s matchmakers (Spiegel)
• China is losing the trade war (WSJ)
• China’s New Silk Road (The Economist)
• Why was the 20th Century not Chinese (Brad Delong)
• The Chinese view Trump as cunning strategist (FT)

China Technology Watch

• Berlin blocks Chinese acquisition (Caixing)
• The man behind Pinduoduo (WIC)
• Wake up call for China’s chip industry (Caixing)
• China leads the way with electric vehicles  (McKinsey)
• A global look on Chinese robotics (ZDNET)
• Germany impedes China tech m&a (WSJ)
• China is leading in the robot wars (QZ)
• China’s BOE targets Apple screens (WSJ)
• Tsinghua Unigroup bids for French tech firm Linxens (SCMP)

EM Investor Watch

• Sec. Pompeo’s remarks on the Indo-Pacific (State)
• Can Iran by-pass sanctions (Oil Price.com)
• Can Brazil fix its democracy ? (FT)
• Brazil’s military strides into politics (NYtimes)
• Interview with Kissinger (FT)
• Erdogan’s “New Turkey” (CSIS)

Tech Watch

• The world’s largest solar farm in Egypt (LA Times)
• Seven reasons why the internal combustion engine is dead (Tomraftery)

Investing

• Bob Farrell’s ten investment rules (seeking alpha)

The current environment appears unattractive for emerging market equities (The Outlook for 2018). Nevertheless, for those disposed to stand pat and allow time to deliver the long-term returns and diversification benefits of investing in emerging markets current valuations are compelling enough to remain invested.

Over the short-term (1-2 years) valuations are not he main driver of stock performance. Liquidity, driven by monetary policy and human psychology are much more important over the short term. This is well expressed in this  quote from the legendary investor Stan Druckemiller:

“Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”

However, over the long term valuations do matter. As Ben Graham once said: ““In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Valuations do matter and they are the key driver of long-term performance. So, where are we now with vauations in emerging markets?

At the end of June, emerging market equities remained inexpensive relative to their own history and very cheap compared to the S&P 500. As the table below details, EM equities trade at about half the level of the U.S. market on a price-to-earnings basis and are even much cheaper on the basis of a cyclically adjusted price-to-earnings ratio (CAPE; price divided by 10-year average inflation-adjusted earnings).  While the S&P500 CAPE is priced at one standard deviation above its recent 15-year average, the EM CAPE is well below its 15-year average. Compared to their own history, EM equities are relatively cheap while the U.S. stock market is very elevated.

The work of two prominent firms that recommend allocation strategies — GMO and Research Associates – points to the same conclusion.  GMO, in its most recent 7-year forecast recommends EM for its relative attractiveness. As shown in the chart below, GMO sees real (after inflation) annual returns of 2.4% for the next seven years for EM and -4.4% for the S&P500.

Research Affiliates projects similar outperformance for EM, with 6.7% real annual returns for the next ten years from EM, compared to 0.3% for the S&P500.

These attempts at projecting future returns are, to a large degree, based on the assumption  that valuations revert to historical means over the long term (7-12 years).

Country-specific Valuations

Emerging markets are a very broad asset class, so it is not surprising that valuations vary greatly  across the markets. One of the main reasons for differences in valuations is that sectorial composition  is not consistent across markets. Because of this, it is generally more useful to compare valuations to a country’s own history rather than to other countries or EM as a whole. This works for most markets but not all. For example, historical comparisons are largely irrelevant in China which has a short trading history and a rapidly changing market structure (10 years ago industrial state companies dominated the market; today private tech firms stand out).

In any case, the charts below rank key emerging market countries in terms of valuation. The first group consists of markets that are valued well below their own history and therefore stand to offer high upside for the future. The second group have low valuations and can be expected to provide above average long-term returns. The third group of countries have relatively high valuation and should provide more modest returns in the next 7-10 years.

The markets with low valuations include several countries – Turkey, Russia and Brazil – that have recently experienced turbulent political disruptions which have caused economic distress and a loss of investor confidence. Argentina is in a similar situation. These markets may require a break with the past through elections or transformational reforms for market recovery to occur. For example, if a reformist leader is elected in Brazil this year, this could provide a trigger for the market to recover strongly.  On the other hand, Colombia, Chile, Malaysia and Indonesia already appear poised for stock market appreciation.

One-Year Positioning    

 To rank markets in terms of attractiveness for the next twelve months we look at valuations,  and macro and liquidity factors.  Each factor is scored from 2 to -2 for each country. The macro factor measures where a country is in its business cycle; and the liquidity factor looks at credit and flows. Results are shown below. Scores of three and above indicate relatively positive prospects.

Fed Watch:

• Michael Pettis on tariffs China Financial Markets)
• Don’t blame Trump for the decline of globalization (SCMP)
• The rising USD and EM (WSJ)

India Watch:

• Samsung opens world’s largest smartphone factory in India (Bloomberg)
• Scarsity of visas is shaking up Silicon Valley (SF Chronicle)
• India’s national strategy for artificial intelligence (NITI.Gov)
• A look at the value factor in the Indian stock market (Indexology)

China Watch:

• Trump’s trade war (Politico)
• Trade war will not stop China ( Project Syndicate)
• China loosens credit controls (WSJ)
• Beijing completes its seventh ring road (WIC)
• The demonization of China (Foreign Policy)

China Technology Watch

• Tesla’s move to Shanghai (FT)
• Tesla’s China plan (NYtimes)
• Daimler and Baidu get ahead on driverless cars in China (Reuters)
• China wants high-tech cars with German help  (NYT)
• The battle to build the next super-computer (Tech Review)
• America’s war on China tech (FT)
• China tech start-ups lead VC funding (SCMP)
• Shanghai aims to raise $15 billion for AI investments (SCMP)

EM Investor Watch

• Why Bolsonaro is leading Brazil’s polls (Foreign affairs)
• Pundits are down on EM (Research Affiliates)
• Indonesia takes control of mega copper mine (WSJ)
• A look at Frontier Markets (ETF.com)
• The performance of US based EM Funds (Emerald Insights)
• Frontier markets facing oblivion (FT)

Tech Watch

• Seven reasons why the internal combustion engine is dead (Tomraftery)

Investors in emerging markets stocks started the year upbeat, expecting a two-year rally to continue. Market conditions appeared favorable. Valuations were low relative to the U.S. and other developed markets; and the global economy appeared strong, marked by “synchronized” growth across the developed world, China and emerging markets. Emerging markets also were expected to continue to benefit from rising commodity prices and a weakening dollar, both of which tend to occur during the later stages of the U.S. business cycle.

Unfortunately, by late-January the bullish thesis began to unravel.. The first sign of changes in the market environment was the sudden increase in volatility in the U.S. stock market. After the exceptionally low stock market volatility of 2017, the surge in volatility signaled a new regime of higher market risk. This was confirmed by a sudden appreciation of the U.S. dollar, a tell-tale sign of rising investor risk aversion.  The first chart below from Credit Suisse show the remarkable increase in risk aversion that has occurred since late January. In the second chart , the JP Morgan EM Currency Index highlights the concurrent break in the two-year trend of dollar appreciation.

Concurrently with the return of volatility, during February economic indicators began pointing to unexpected slowdowns in economic activity in both Europe and China. This undermined the thesis of global synchronized growth. Worse, U.S. growth, fueled by enormous fiscal deficits in a late cycle economy operating at full employment, now appeared to be growing at a higher rate than the global economy. The chart below shows the worrisome slowdown experienced by China.

Also, early this year we saw an important radicalization of Trump’s “America First” agenda., with a strong rejection of traditional American diplomacy. In particular, his threats of engaging in trade wars with foes and allies alike has significantly increased risks to the global economy.

Finally, early this year markets have started to accept that the U.S. Fed is serious about the normalization of monetary policy. A new, less-dovish Fed governor and the inflationary impact of fiscal expansion and trade wars has convinced investors that monetary tightening is for real.

The new environment that has existed since February – relatively strong U.S. growth, Fed tightening and rising risk aversion – has triggered a strengthening of the U.S. dollar and a downtrend for EM equities. As the following chart from Ed Yardeni Research shows, as usually happens, emerging market stocks started to trend down at the same time that the dollar began to appreciate. The negative correlation of EM stocks with the US dollar (ie. EM stocks fall in local currency terms as the USD appreciates) significantly increases the volatility of the asset class.

The value of the dollar relative to EM currencies is a key indicator for EM equities, a rising dollar pointing to a move from investors way from high- risk EM securities to the safe haven of U.S. treasury bills. On the other hand,  the two other key indicators to watch for emerging market equities – commodity prices and the spreads on high-yield bonds (U.S. and emerging markets) did not show initial signs of deterioration. In fact, as the charts below show both commodity prices and bond spreads have been stable since late January. It is only in recent weeks that both commodity prices and high-yield spreads appear to have started negative trends. The first chart, the Bloomberg Commodity Index, shows that commodity prices remained resilient through May, but have drifted down slowly since then. The second chart, from the Federal Reserve Bank of St.Louis, shows the difference in yield between high yield bonds and treasure bonds. This spread is a reliable indicator of aversion for risky assets and very negatively correlated to EM equities (as the spread goes up, EM equities fall).

Conclusion

For the time being, the trend does not favor EM equities, and a cautious stance is in order. If anything, the recent weakness in commodity prices and the rise in high yield spreads points to further troubles for EM equities. Nevertheless, for the medium term a more bullish stance is justified.

First, after the recent correction valuations are once again very compelling.

Second, by the end of this year a series of events weighing on the markets will have passed. The Chinese economy, which has been weighed down by official measures to deleverage corporations , is likely to see a rebound before the end of the year. In addition, the completion of a wave of elections in Turkey, Colombia, Mexico and Brazil will soon bring more clarity to policies for important EM markets.

Third, and perhaps most importantly, next year the U.S. economy is likely to slow down considerably, so that U.S. growth will no longer be higher than that of the global economy. As concerns rise with U.S deficits and the ageing business cycle, dollar weakness may resume.

In conclusion, keep your powder dry as 2019 may be a much better year for EM equities.

Fed Watch:

• Don’t blame Trump for the decline of globalization (SCMP)
• The rising USD and EM (WSJ)

India Watch:

• Scarsity of visas is shaking up Silicon Valley (SF Chronicle)
• India’s national strategy for artificial intelligence (NITI.Gov)
• A look at the value factor in the Indian stock market (Indexology)

China Watch:

• Beijing completes its seventh ring road (WIC)
• The demonization of China (Foreign Policy)
• A look at Chinese ETFs (ETF.com)
• Xi tells CEOs he will strike back at the U.S. (WSJ)

China Technology Watch

• America’s war on China tech (FT)
• China tech start-ups lead VC funding (SCMP)
• Shanghai aims to raise $15 billion for AI investments (SCMP)
• China plans to leapfrog ahead in key technologies (SCMP)
• China extends lead in most powerful computers (NYtimes)
• Google invests in JD.com (CNBC)

EM Investor Watch

• Pundits are down on EM (Research Affiliates)
• Frontier markets facing oblivion (FT)
• The Erdogan Supremacy (NYtimes)
• Erdogan’s   bet pays off  (Brookings)
• India’s shaky reforms (FT)

Tech Watch

• Seven reasons why the internal combustion engine is dead (Tomraftery)

Donald Trump’s “America First” ideology is one of many manifestations of a break in the process of globalization. The incremental increase in open markets for trade, capital and labor which for decades was promoted by the U.S. now faces opposition from domestic interest groups that have been left behind. Politicians are exploiting the built-up resentment of “silent majorities” which feel that they have been exploited by a darwinian system that combines market fundamentalism with meritocracy to promote the interests of a self-serving elite. At the same time, this new global elite, a “noisy minority”  with highly progressive views on social issues, has clashed with a “silent majority” which identifies with traditional conservative social values. Trump has masterfully played upon this resentment, by espousing anti-globalization positions on trade, immigration and climate change, and by touting “politically incorrect” views on foreigners, immigrants and minority groups.

The resentment is not only a U.S. phenomenon, but also obvious in Brexit, Italian and German political instability, the rise of strongmen in Turkey, Poland and the Philippines, etc… The consolidation of Xi’s power in China also is rooted in the same soil, as the Communist Party recognized that the enormous rise in wealth concentration in China would inevitably cause political chaos without the re-imposition of order by strong reins. The process continues around the world with or without the democratic process; Erdogan’s supremacy was confirmed in Turkey last Sunday, and both Mexico and Brazil are headed for controversial elections which are likely to mean decisive breaks with the past.

These powerful domestic political forces can play out in unexpected ways. In France, disruption has produced Macron and a shift to the right. Something similar may happen in Brazil, where the current leader in the polls, Jair Bolsonaro, promises a sharp turn to the right.  Brazil has been a reluctant participant in trade liberalization, choosing to pursue long-standing protectionist policies. On the other hand, for decades it has fully embraced financial liberalization and a highly orthodox (i.e. U.S. determined) monetary framework. The result has been an over-sized financial sector, a rapid process of premature de-industrialization, wealth concentration and economic stagnation. Several generations of the best students from Brazilian universities have flocked to banks (Brazil’s leading bank, Itau, prides itself on its engineering culture.) Into this mess has stepped Bolsonaro, with a message of “Law and Order” and support for traditional “family values” which appeals to a “silent majority” heavily influenced by evangelical churches. Ironically, in highly bureaucratized, statist, leftist Brazil, change means a move to entrepreneurial freedom, and Bolsonaro, so far, has espoused a very pro-business, economic-freedom agenda.

The new resistance to globalization has several important consequences.

First, over the short-term it may favor the U.S.. This is certainly Trump’s political calculus. As the largest economy in the world, the U.S. relies less on trade than almost any other country, and it can move to self-sufficiency more quickly than others can. As the largest consumer market in the world and the prominent importer, it can largely impose its own terms on those seeking access  to its market.

The opposite goes for small countries with export-oriented economies. The big losers are countries like Taiwan, Korea, Thailand and Mexico, all of which are key players in global value chains. For example, those most hurt by Trump’s proposed tariffs against Chinese imports, aside from the American consumer, will be the Taiwanese and Korean producers of electronic parts. Ironically, as more countries favor nationalistic approaches over global connectivity, large protectionist economies such as Brazil and India may now gain a significant edge in attracting investment.

Second, Trump’s policies are inflationary. They will push wages up, which will benefit Trump politically. The Federal Reserve is likely to be compliant and allow inflation to rise, as it is in the interest of the U.S. to see nominal GDP higher than nominal interest rates.  However, higher nominal rates and a rising dollar will be a heavy burden on EM countries that have borrowed heavily in U.S. dollars and on those that need foreign funds to finance current account and fiscal deficits.

Third, higher wages will accelerate the trend towards robotization in developed countries. This is already happening in an accelerated fashion in Japan with its declining work-force, and it will spread quickly to the U.S. Trump’s “America First” protectionism is happening exactly at a time when automation technology is making it increasingly practical to “reshore” supply chains and final-stage manufacturing back to the U.S. Interestingly, this week Foxconn, the world’s largest electronics contract manufacturer, broke ground on a $10 billion investment to manufacture flat-screen liquid crystal display panels in Wisconsin, its first investment outside of Asia.

The disruption in supply chains  will be extremely disruptive to those EM countries that actively participated in them. Once again, the small export-led economies will suffer the most. However, large EM economies with big domestic markets like Brazil and India have the least to lose. China will combine automation with a rapid move up manufacturing value chains in order to increase the in-sourcing of intermediate goods, creating more pressure on small export-led economies.

Fourth, as the U.S. increasingly flaunts the rules of global trade to promote ”America First,” it will seek to impose bilateral deals on exporters wanting to access the its market. Other large economies will do the same, reluctant to export consumer demand. Regional blocks will increase in importance, with China determined to dominate an Asian trading block. If the U.S. pursues its popular “cold war” against Chinese technology companies it will force Beijing to double-down on its efforts to dominate frontier technologies. The result may be a strange new tech world which revolves around two separate ecosystems, one dominated by Silicon Valley, the other by Beijing. The current structure of the technology venture capital system which now invests with equal eagerness in both countries may be completely disrupted. We may see the same happening in the auto sector, with the industry revolving around the two largest markets China and the U.S., with separate supply chains.

Fifth, as regional trading blocks gain traction, U.S. dollar supremacy is likely to decline. In particular, the Chinese yuan will gradually gain space as China becomes the key player in Asian trade. China has already replaced the U.S. has the largest importer of hydrocarbons and will increasingly insist on having contracts priced in yuan. The U.S.’s heavy handed implementation of trade and financial sanctions, such as those on Iran, Russia and North Korea, also will accelerate the acceptance of yuan-based contracts.

Fed Watch:

• Don’t blame Trump for the decline of globalization (SCMP)
• The rising USD and EM (WSJ)

India Watch:

• India’s national strategy for artificial intelligence (NITI.Gov)
• A look at the value factor in the Indian stock market (Indexology)

China Watch:

• A look at Chinese ETFs (ETF.com)
• Xi tells CEOs he will strike back at the U.S. (WSJ)
• Beijing’s big idea for southern China (SCMP)
• How China secured a port in Sri Lanka (NYtimes)
• JPMorgan on MSCI A share inclusion (SCMP)

China Technology Watch

• China extends lead in most powerful computers (NYtimes)
• Google invests in JD.com (CNBC)
• U.S. faces unprecedented threat from China tech (bloomberg)
• CATL, the rise of China’s new EV battery champion (Technology Review)
• Competition in energy storage markets (McKinsey)
• The disruption of battery storage technology (McKinsey)

EM Investor Watch

• The Erdogan Supremacy (NYtimes)
• Erdogan’s   bet pays off  (Brookings)
• India’s shaky reforms (FT)
• Now Erdogan faces his economic mess (NYtimes)
• The roots of Argentina’s surprise crisis (Project Syndicate)
• The rise of strongmen in global politics (Time)

Tech Watch

Seven reasons why the internal combustion engine is dead (Tomraftery)

The emerging markets asset class is said to provide better opportunities for skilled investors because stocks are supposed to be priced more inefficiently than those in developed markets like the United States. However, important markets such as Brazil and Mexico have come to be dominated by highly sophisticated local and foreign institutional investors and are now probably nearly as efficiently priced as developed markets. Nevertheless, there are still significant pockets of inefficiency in markets where short-term traders and retail investors have a dominant presence and in large markets with many smaller stocks which are not on the radars of institutional investors. The Chinese A-share market and India are arguably the two markets which perhaps best display these characteristics and therefore offer the best opportunities for skilled investors to profit.

The SPIVA Scorecard, which is compiled bi-annually by S&P Dow Jones Indices, provides regular comparative data on the relative performance of actively and passively managed portfolios in different markets around the world. As previously discussed (active-vs-passive-in-emerging-markets), the data shows that emerging markets in general are somewhat less efficient than developed markets and provide some opportunities for skilled asset managers to outperform indices. This is particularly true for the larger asset managers, presumably because they have more and better resources to conduct fundamental research. SPIVA also provides detailed analysis on specific countries which provides an interesting view on which markets may provide the best opportunities for skilled managers to harvest alpha (i.e. outperformance relative to the market).

The table below shows the percentage of managers able to outperform indices over five and ten year periods in representative U.S. and emerging markets for the period ending at year-end 2017. The figures refer to managers in each country investing in their own domestic markets (i.e. Brazilian managers investing in Brazilian equities.) SPIVA uses its own indices for each market, and these are constructed to represent a market universe of easy accessible to the standard international investor. Domestic managers in each country may be measuring their performance in comparison to other benchmarks, which may be significantly different than the index used by SPIVA.

The first thing to note is that, by and large, markets are efficient.  U.S. large caps are exceptionally efficient, with only 10% of funds able to outperform over the long-term (10 years). Though smaller companies with less market capitalization are much less followed by Wall Street research firms and are deemed to be less efficiently priced, the evidence from SPIVA shows that only 4% of managers can beat the small-cap index over the long-term. The same is true in Europe where less than 15% of managers beat the index over the long-term.

Outside of the U.S., however, there appears to be large differences in the degree of market efficiency. Latin American markets, which are increasingly institutionalized and have a large participation of foreign institutional investors, appear highly efficient. SPIVA provides results net of fees, so in Latin America where fees can be exceptionally onerous, the numbers may be partially explained by high expenses. South Africa is another market highly dominated by institutional investors, which helps to explain why the market appears very efficient.

In addition to the high participation of institutional investors, the opportunity-set of investable stocks is another factor that determines market efficiency. Mexico, Chile and South Africa are very shallow markets dominated by very few stocks, so these are very well followed by investors. Brazil’s equity market has more depth, but still the very large and competent institutional investor base focuses mainly on a few dozen securities.

In the SPIVA data-base, India stands out as a particularly good environment for active investors. Well over half of managers outperform the index over five year periods, and almost half over ten years, despite relatively high fee structures. This high level of inefficiency points to a market where institutions still have a weak presence. This is particularly true in small and mid-caps, where foreigners are largely absent.

Though not yet covered by SPIVA, the other large and inefficient market is China. The China  A-share market (stocks listed in Shenzhen and Shanghai) is a very deep and growing market dominated by local traders and retail investors and with very little participation from institutional investors. Chinese A-shares were recently included for the first time  in both the FTSE and MSCI emerging markets indices followed by foreign investors and will become increasingly important in coming years.

In addition to having the highest -growth economies and the largest and most dynamic stock markets, China and India also provide the best opportunities for investors to outperform their competitors by engaging in thorough fundamental research.

Fed Watch:

• Don’t blame Trump for the decline of globalization (SCMP)
• The rising USD and EM (WSJ)

India Watch:

• India’s national strategy for artificial intelligence (NITI.Gov)
• A look at the value factor in the Indian stock market (Indexology)

China Watch:

• JPMorgan on MSCI A share inclusion (SCMP)

China Technology Watch

• CATL, the rise of China’s new EV battery champion (Technology Review)
• Competition in energy storage markets (McKinsey)
• The disruption of battery storage technology (McKinsey)

EM Investor Watch

• The roots of Argentina’s surprise crisis (Project Syndicate)
• The rise of strongmen in global politics (Time)

Stormy waters are putting on hold the two-year bull market in emerging market equities, leading cautious investors back to port.

Emerging market securities – both stocks and bonds – are relatively risky assets that attract investors when the global economic scene is benign and potential returns for investments are better in international markets than in the United States. This has been the case for the past two years, and, as usually happens during these periods, the U.S. dollar has weakened, serving to further enhance returns outside the U.S.

The recent break-out of the dollar after a 3-month consolidation, points to an important change in the trend.  Yield-chasing investors have started moving back to safety, abandoning “carry trade” currencies that were attractive for the past several years because high interest rates were enhanced by appreciating currencies. The major “carry trade” currencies – Indonesia, Turkey, Brazil, Argentina – have all seen their stocks, bonds and currencies trashed in recent weeks.

The move in the dollar is probably related to an incipient deterioration in the global economic environment. The market narrative since late last year was of a strong “global synchronous recovery,” but signs of slowdowns in Europe, China, Japan and Brazil have thrown some cold water on this.    Very contentious and possibly calamitous upcoming elections in Brazil and Mexico are also cause for concern.

However, the most important development is the dramatic attack on global trade being carried out by President Trump. The anti-trade zealots in the U.S. Administration, who now have the upper hand in the White House, stepped-up their hostile stance towards China in this week’s meetings in Beijing. At the same time, Washington has started a full-scale war against Chinese tech companies, Huawei and ZTE. Also, hopes of reaching a NAFTA settlement before the Mexican elections are fading, as the U.S. insists on industry-by-industry micro-management.

The intransigent, “take it or leave it attitude” of U.S. negotiators is causing enormous ill-will with America’s allies and major trading partners. The imposition of steel and aluminum quotas on Brazil last week stunned Brazilian negotiators. The spokesman for Brazil’s aluminum firms, Milton Rego, described U.S. tactics as “Al Capone-like,” and added: “You get better results by pointing a gun to the head.”

On the positive side, emerging markets are still well positioned in terms of very low valuations relative to the U.S. and the recovery in commodity prices. Oil prices, in particular, continue their rising trend. Increasing investments in oil producing countries and reducing positions in oil importers may be one of the few attractive trades in these turbulent waters, but in general it is probably best to stay closer to shore.

Fed Watch:

• The rising USD and EM (WSJ)

India Watch:

• Stock fever grips India retail  (WSJ)
• Ray Dalio is bullish on India (IB Times)
• The strategic importance of India’s rise (CSIS)

China Watch:

• JPMorgan on MSCI A share inclusion (SCMP)
• Korean cosmetics lose their edge in China (WIC)
• Samsung’s sales collapse in China (WIC)
• Thoughts from China’s elites (FT)

China Technology Watch:

• China’s response to US on tech (Axios)
• DJI is shaking up China private equity (WIC)
• China installed 10 GW of solar in Q1 (Tech Review)

Technolgy Watch

• Taiwan is falling behind Korea (SCMP)

EM Investor Watch

• Turkey’s finances spiraling out of control (Heisenberg)
• Morocco’s solar ambitions (WEForum)
• Populism is back in Indonesia  (The Malaysian Reserve)

Investor Watch:

• Buffett’s secret sauce no longer adds value (Advisor Perspectives)
• Buffett’s Edge (Master Invest)

Emerging market stocks are highly prone to recurring bubble-like cycles caused by economic and currency volatility and erratic “hot money” flows. As I discussed last week (link), recent experience over the past five years indicates that this high degree of volatility very much continues to be a defining characteristic of emerging market equities. If anything, with rising debt levels and newly forming markets in the frontier world such as Vietnam, everything points to more volatility in the future.

The chart below from a recent article from value investors GMO Asset Management (Link) shows the incredible economic volatility suffered by emerging markets compared to the S&P 500. Focusing on the grey bar of the chart, which represents the three worst performing EM markets, the chart shows the probability of declining earnings per share for any given year.  For the 1995-2017 period,  there was a 30% probability for the bottom three EM countries to have EPS growth of -50%. Given the very high correlation between EPS growth and market returns, this, in essence, means that an investor can expect about one 50% plus drawdown (market correction) for at least one country in the emerging markets universe in any given year.

The chart below confirms this with data on 46 market drawdowns of over 50% since 1990. This period of 28 years covers pretty much the entire period of institutional investor participation in emerging markets. Therefore, on average  1.7 specific country drawdowns of over 50%  occur every year. Since 2015, seven such drawdowns have occurred, right in sync with the trend of the past 28 years.

The huge price corrections that emerging markets consistently experience raises the question of whether these markets are suited for the buy-and-hold passive investor. Nevertheless, almost all of the flows invested in EM today are participating through passive indexed instruments like ETFs, and the majority of active investors also tend to track the indices closely, so that most investors are subjected to these violent drawdowns.

On the other hand, the active investor with a systematic methodology for avoiding drawdowns stands to have a very significant advantage in these markets, following a few basic rules:

1. Focus on countries having recently experienced severe drawdowns, and which are valued significantly below long-term average multiples of cyclically-adjusted earnings.
2. Identify a turning point; usually a political change or economic reforms which trigger recovery.
3. Increase positions as a positive trend develops.
4. Increase caution as markets gain momentum and valuations reach levels well above long-term averages.

Fed Watch:

• Trade and Globalization in EM (Voxdev)
• Gavekal view on the cycle, China, commodities and EM (CMG Wealth)

India Watch:

• Ray Dalio is bullish on India (IB Times)
• The strategic importance of India’s rise (CSIS)
• Walmart prepares bid for Flipkart (Bloomberg)
• India’s demographic dividend (Livemint)
• Modi’s make-in-India strategy (NYT)
• Infosys to sacrifice margins for growth (Bloomberg)

China Watch:

• Starbuck’s has a new competitor in China (WIC)
• The craft beer war in China (supchina)
• Police nab bandit at concert using facial recognition tech (WIC)
• China plays it cool (Mauldin)
• Brookfield is bullish on China real estate (Forbes)
• Trump’s weak case against China (Project Syndicate)
• Anbang’s political connections worked until they didn’t (Caixing)

China Technology Watch:

• DJI is shaking up China private equity (WIC)
• China installed 10 GW of solar in Q1 (Tech Review)
• China to double-down on chip development (Reuters)
• Didi launches in Mexico (Recode)

Technolgy Watch

• Taiwan is falling behind Korea (SCMP)

EM Investor Watch

• Bangladesh’s remarkable economic growth (Project Syndicate)
• Saudi’s privatization program (Arabian Business)
• Applying Ben Graham to EM (GMO)
• EM stocks and the China yield curve (Bloomberg)
• Vietnam’s booming stock market (FT)
• Vietnam’s socialist dream hits hard times (Asian Times)

Investor Watch:

• Buffett’s secret sauce no longer adds value (Advisor Perspectives)
• Buffett’s Edge (Master Invest)
• Research Affiliates on Bubbles (Research Affiliates)
• Scott Galloway’s advice to students (L2)

The rise of the Exchange Traded Fund (ETF) over the past decade has been a huge benefit for the investor in emerging market. ETFs give investors access to the broad asset class with low fees and significant tax advantages. Increasingly, these same benefits are provided to investors looking for exposure to specific countries and various investment factors. All of these products together provide the tools for the both the passive and active investor to develop intelligent and cost-efficient strategies for investing in emerging markets.

ETF emerging market assets are highly concentrated, with the ten largest funds gathering 81% of the $240 billion invested in U.S. listed ETFs.  These include the mammoth core emerging markets ETFs that follow the primary EM benchmarks provided by FTSE-Russell  (Vanguard) and MSCI (Blackrock-iShares). Fees for these funds have been consistently reduced and are now about 0.14% of assets. A clear indication of the relentless downside pressure on fees is that in 2012 Blackrock had to launch a new lower-fee core emerging markets fund, IEMG, to compete with its own original EEM fund. EEM continues to charge its legacy fees of 0.69%, but gradually is losing ground. Newcomers, Charles Schwab, and State Street, have secured market share by taking fees even lower.  Schwab’s FTSE-based core EM ETF, SCHE, currently has a 0.13% fee, and State Street’s SPEM ETF, benchmarked to the S&P BMI Emerging Markets Index has lowered its fee to 0.11%.

A similar story is unfolding with country-specific ETFs, a category until today largely dominated by Blackrocks’s MSCI-based iShares. The big funds in this space are iShares Brazil (EWZ), iShares India (INDA), iShares Taiwan (EWT), iShares China Large Cap (FXI, iShares China MSCI (MCHI) and iShares Latin America (ILF). All of the iShares country-specific products have maintained fees above 0.60%. So far, Ishares, with its first-mover advantage and the superior liquidity of its shares, has felt limited competition in this space, but that may be changing. This year Franklin Templeton launched a family of FTSE-based country funds under the Franklin LibertyShares label with 0.09% a fee for developed markets and a 0.19% fee for emerging markets. Brazil, China, Taiwan, Russia and Mexico have already been launched with good traction.

Another interesting trend in emerging markets ETFs are “Smart Beta” funds. This is a vague term that has come to include a category of products that feature a quantitative tilt towards specific valuation attributes (factors) or portfolio structures that aim to enhance returns. Most of these funds seek to exploit the “investment factors” —  value, size, momentum, and quality – that have been shown by long-standing academic research to improve portfolio returns over the long term. These techniques, commonly espoused by active managers, tilt portfolios towards stocks with low price-to-book ratios (value), smaller stocks (size), rising stocks (momentum) and stocks with strong balance sheets and steady returns (quality). Moreover, academic research supports the idea that portfolio returns can also be enhanced by changing the weights of stocks in a portfolio from one based on market capitalization to one based on equal weights or one based on fundamental factors, like sales, cash flows or book values.

Smart Beta funds were initially launched with higher fees, in the 0.7% range. However, fee compression is affecting these products as well, and recent launches are charging fees closer to 0.3%.

Some ETFs following the Smart Beta  track include Goldman Sachs Active Beta Emerging Markets (GEM) (value, momentum, quality, low volatility); Invesco, whose Powershares FTSE RAFI EM (PXH) weighs its portfolio positions based on book value, cash flow, sales and dividends,  a fundamental value strategy; Northern Trust EM Factor Tilt (TLTE) (small caps and value); FirstTrust EM AlphaDEX (FEM) (value and quality); SPDR EM Small Caps (EWX); and JPMorgan’s Diversified Return EM Equity (JPEM) (value, quality, momentum).

The chart below shows the twenty largest EM ETFs, with factor tilts listed on the far right. The top twenty ETFs represent nearly 90% of the EM ETF assets in the U.S. market.

Source: ETF.Com

A very successful player in the “factor” space is Wisdom Tree (WT), which has its academic credibility supported by having Wharton’s Jeremy Siegel as its senior investment strategy advisor.  WT has funds tilted towards high dividend stocks; high dividends serving as a proxy for value, quality and corporate governance. These include a core EM ETF (DEM)  and a small cap EM ETF (DGS). WT also has an India ETF (EPI), with factor-tilts towards small caps, value and quality. Moreover, WT has launched both an EM ETF and a China ETF which avoid state-run companies. This seeks to tilt the portfolio towards higher quality companies with better corporate governance, under the assumption that very few state-run companies care about creating value for minority shareholders.

WT  has the advantage that it cuts expenses by creating its own indices. This strategy has also been followed by Van Eck Funds and Cambria, among others, and this is adding pressure on the leading index providers  (FTSE and MSCI) to further reduce fees.

In conclusion, this plethora of core EM funds, country and regional funds and factor-tilted smart beta ETFs means it has never been easier and cheaper to build intelligent EM strategies. The investor has the opportunity to generate significant alpha in emerging markets by strategically tilting portfolios towards countries and factors. Once this has been accomplished, 80-90% of the task is done. The remaining 10-20% —  capturing stock-specific alpha – is both the most difficult and the least important. For those investors with the skill, free-time and patience to do this, I recommend a portfolio overlay of one or a combination of the two following strategies:

• Invest with an active manager with a highly concentrated, long-term oriented portfolio.
• Invest in a 15-30 high quality EM blue chips which have very long investment runways, and hold for the very long-term.

Fed Watch:

• The Fed’s ammunition ran out (Zerohedge)
• High Wages and high savings in a globalized world (Carnegie)

India Watch:

• Mohnish Pabrai on the Indian market (Youtube)
• Half a billion mobile internet users in India (Quint)
• Digital streaming is taking over cinema (Quint)

China Watch:

• China airline threatens move to Airbus (SCMP)

China Technology Watch:

• China 2017 tech strides (Youtube)
• Transsion is the leading cel-phone in Africa (bloomberg)
• China moves up the value chain (bloomberg)

Technology Watch

• Waymo driverless cars ambitious plans (The Atlantic)
• Electric vehicle trends (McKinsey)

EM Investor Watch

• Russia and China’s uneasy Far-East partnership (Carnegie)
• Thailand is he next Japan (The Economist)
• Korean millenials  feeling the Bitcoin pain (The Verge)
• Sam Zell is back in Buenos Aires (WSJ)
• EM countries getting old; the case of Brazil (WSJ)

Investor Watch:

• The value premium is not dead (ETF.com)
• What new ETF would you like to invest in? (Abonrmal Returns)

The debate over active versus passive portfolio management has been raging for many years.  In emerging markets, it is frequently argued that greater market inefficiencies can be exploited by the skilled manager. Though active managers have been losing assets to passively managed indexed products, an important place remains for managers who offer idiosyncratic strategies which can create alpha over the long-term. In fact, the proliferation of low-cost indexed products should benefit the active managers that are able to differentiate themselves and generate value.

Active managers with genuine alpha-generating skill (the ability to consistently outperform their benchmarks over time) could theoretically benefit from the current environment for several reasons.

First, passive products are a continuing menace to the marketing-driven closet-indexers that have largely dominated the industry. As these products are being replaced by passively-managed funds, competition for well crafted active products with skillful managers should decrease.

Second, it is increasingly evident that the flows into passive products that are almost always based on market -capitalization-weighted indexes are creating significant market distortions. By design, cap-weighted indexes are driven by absolute momentum, as money flows into the best performing stocks and out of the laggards. This tends to happen gradually in a bull-market like we have seen in recent years but could reverse more abruptly if we were to suffer a market drawdown caused by a recession or another reason. Skilled active managers might well be adept at exploiting these market distortions at that time.

A good reminder of the travails facing active managers is the annual report by SPIVA Scorecard of U.S. -managed mutual funds which is produced by S&P Dow Jones Indices, one of the largest providers of indices in the U.S. market. The latest report was published last week (SPIVA). The SPIVA Scorecard is considered the best measure of active performance because it compares a funds performance to its style category (ie., a U.S. small cap manager to the S&P500 Small Cap Index) and it adjusts for survivorship bias. This latter adjustment is particularly important for measuring long-term performance since for long periods (10-15 years) it is the case in many of the investment categories followed by SPIVA that close to half the funds have disappeared, presumably because of poor performance.

The chart below shows the results from the 2017 SPIVA scorecard. The data shows the percentage of funds that under-perform their indices. Though the 1-year numbers are relatively positive for active managers, 3-years and beyond show much worse results.the US market, where nearly 90% of managers underperform over 10 years. The U.S. numbers are very relevant because the S&P 500 index is by far the most followed benchmark in the U.S. market. In international markets, however, the MSCI benchmarks are the most commonly used by managers, so that certain distortions may exist in the SPIVA analysis.

This is particularly true in emerging markets, where the S&P/IFCI Composite Index used by SPIVA for comparative purposes is not at all commonly used as a benchmark by investors, the MSCI EM and FTSE-Russell EM being highly dominant. For an unexplained reason, the S&P/IFCI Composite Index performance numbers have been consistently higher than either the MSCI EM or FTSE, which results in the SPIVA Scorecard making EM managers look worse than they really are.

Comparing active returns to the more appropriate MSCI EM benchmark paints a slightly different story.

As shown below, EM funds do on average underperform the MSCI Index. However, on an asset weighted basis, funds actually manage to beat the index over the past five years and nearly track the benchmark  on a 10-year basis. Given the high concentration of assets in the hands of relatively few managers, this is probably a fairer basis of analysis. It indicates that those firms with more assets may have two advantages. First, they may have superior resources to support the large cost-base necessary to hire highly-skilled managers and conduct serious fundamental analysis around the EM world. Second, they may also pass on their scale benefit to clients by lowering fees.

Several observations can be made on these results.

• The numbers show that there is alpha-generating capacity in the emerging market asset class, probably to a significantly higher degree than in the U.S. market. Before fees, most managers are generating significant levels of value-added. The larger managers show significant skill in exploiting what may be greater inefficiencies in emerging markets. However, most of this alpha-generation is kept in house to compensate portfolio managers and analyst and costly marketing organizations, so that the mutual fund investor does not reap the benefits. Despite pressure from ETFs, fees remain high, ranging from 1% to well over 2%. Of course, this is true only for mutual fund investors. Large institutional clients can negotiate much lower fees, and therefore capture a lot more of the alpha-generation.
• EM ETF’s are getting cheaper. Franklin Templeton’s recently launched EM country ETFs have net fees of 0.19%. S&P500 tracking ETFs are approaching zero cost, and surely fees will continue to fall for EM funds, as well.
• Moreover, the tax advantages of ETFs relative to mutual funds are still poorly understood by investors. Mutual funds are required to pay out all capital gains on an annual basis. Given the high average turnover of managed funds, capital gains can be significant. Not only, do ETFs normally have very low turnover but investors are not liable for capital gains taxes, and these can add up to significant amounts. This advantage for ETF’s translates into around an additional 1.0% annual return advantage for the ETF compared with the mutual fund. Again, this is an issue of little relevance to many institutional investors.
• In the future, successful mutual fund products will have to continue to lower expenses by reducing fees and turnover. They will also have to concentrate portfolios and make them markedly different from the indices.
• The investor should look for highly idiosyncratic funds (dissimilar from the benchmark) that follow a simple and understandable strategy that can be consistently followed over time to produce replicable results. These funds should also have a fee-structure, that aligns the interest of the manager and the investor, and that allows a significant portion of the alpha to be captured by the investor.

Fed Watch:

• US focus on trade gap misses the target (WSJ)
• The end of the liberal world order (Project Syndicate)

India Watch:

• India eases sugar exports (Reuters)
• India illustrates EM opportunities (Blackrock)

China Watch:

• Blackrock expects China’s market opening (Caixing)
• Yuan oil futures start trading in Shanghai (SCMP)
• China will tighten financial regulation (Caixing)
• Asset Management supervision rules tightened (Caixing)
• China cuts business taxes (Caixing)
• China’s oversupply of shared-bikes (The Atlantic)
• Facial recognition tools China’s surveillance state (The Atlantic)
• US aims to block China industrial policy (NYtimes)
• China term-limits and leadership quality (Project Syndicate)
• US tariffs aim at China’s industrial policy (FT)
• How to avoid a trade war (Project Syndicate)
• Trump will lose his trade war with China (SCMP)

China Technology Watch:

• China moves up the value chain (bloomberg)
• Qudian’s CEO joins $1 salary club (WIC)
• FCC wants to block China tech titans (Bloomberg)
• US FCC seeks to shut out Huawei (NYtimes)
• Huawei plans $20 billion in R&D in 2018 (FT)
• China wants its own chips in driverless cars (bloomberg)

Technology Watch

• Waymo driverless cars ambitious plans (The Atlantic)
• Electric vehicle trends (McKinsey)

EM Investor Watch

• The history of Singapore, the miracle of Asia (Youtube)
• Saudi Arabia will enter FTSE EM Index (FT
• Vietnam to promote private sector (FT)
• Trade wars in a tri-polar world (FT)
• Thailand’s economic transformation (Opengovasia)

Investor Watch:

• James Donald of Lazard on Emerging Markets (bloomberg)
• EM stocks are still relatively cheap (SCMP)

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:

• Global growth accelerates (Bloomberg)
• Explaining the weak dollar (Project Syndicate)

India Watch:

• India illustrates EM opportunities (Blackrock)
• India needs growth (Livemint)
• Tata launches new electric sedan (Economic Times)

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)

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:

• The myth of sound U.S. fundametals (Project Syndicate)

India Watch:

• An Indian nightmare (Foreign Affairs)
• The fraud at Punjab Bank (Bloomberg)
• India’s digital revolution (13D)

China Watch:

• Herding Grey Rhinos (Geopolitical Futures)
• Xi’s digital dictatorship (Project Syndicate)
• China has already won the global trade war (SCMP)
• China breaks record for monthy cinema billings (SCMP)
• China detains oil firm founder (SCMP)

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)

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:

• Dalio on the business cycle (Linkedin)
• There will be no economic boom (Seeking Alpha)
• The U.S. business cycle (Seeking Alpha)
• Gary Shilling on the Fed (Shilling)
• World Finance in peril (Telegraph)

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)

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:

• India’s manufacturing challenge (India Times)
• Modi at Davos (Economic Times)

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:

• Ben Carson on market drawdowns (Wealth of Common Sense)
• An interview with Ed Thorpe (http://AQR)
• Tech will revolutionize institutional investment (Institutional Investor)
• Shiller on CAPE ratios (Project Syndicate)
• Shiller on narrative (Chicago Booth)
• My favorite performance chart  (Wealth of Common Sense)
• U.S. future equity returns (Philosophical Economics)
• The Seven deadly sins (Mauldin Economics)