Category: Uncategorized

The Big Mac Index and EM Currencies

 

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 ($6.62) and the cheapest could be bought in Russia ($1.65).  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 latest January 2019 Big Mac Index data confirms that the U.S. dollar is very overvalued. The two charts below show the evolution of Big Mac prices for countries in both developed economies (Left) and Emerging economies (Right), with the dashed lines showing the averages. In both cases, the dollar shows the most strength in nearly 30 years.

The two charts below, from Yardeni.com, confirm this dollar overvaluation trend for both developed and EM countries.  These charts measure the currency evolution of MSCI Indices (MSCI All Coubtry World ex U.S. for developed markets and MSCI EM fr Emerging Markets) relative to the USD. The overvaluation of the U.S. dollar relative to EM is key to the EM investment thesis, as when this trend turns it will provide a powerful boost for EM assets.

The next two charts show, first, the top twenty most overvalued currencies according to the Big Mac Index and, second, the cheapest 20 currencies (the numbers refer to the price in each country relative to the U.S. price).  Noteworthy overvalued Big Mac currencies for EM countries are Brazil, Colombia and Chile, all in Latin America. On the cheap side, India, Mexico, Indonesia, South Africa, Taiwan, Malaysia, Argentina, Turkey and Russia stand out.

The data is detailed below for the primary EM countries of interest to investors.

It is important to view the data in a country-specific historical context to understand what the data means. We look below at several specific cases.

Brazil

The two charts below show The Economist data since 2000 (left) and the Real Broad Effective Exchange-RBEE (right) as measured by the Bank for International Settlements  (BIS). The first thing to note is that the current relatively high valuation of the Brazilian real is not an anomaly. Except for a brief period in 2015, one has to go back to 2000-2004 to find a “cheap” real. The current “weakness” of the real appears largely explained by the strength of the dollar, which has appreciated against almost all currencies over the past eight years. The data is confirmed by the BIS RBEE data which shows the BRL to be about in line with its 25-year average. The BRL probably has some moderate potential for appreciation only if the economy experiences a robust economic recovery.

South Korea

South Korea appears as the second most expensive EM currency relative to the USD in Big Mac terms. The history shows that the USD price of the South Korea Big Mac has been stable over the past ten years, so the overvaluation of the won is due largely to other currencies becoming cheaper relative to the dollar. This is confirmed by the BIS RBEE which shows the won having appreciated significantly over the past decade. The strength of the won should present a headwind for investors in coming years.

Turkey

By any measure, the Turkish Lira is very undervalued.  The Big Mac Index shows Turkey at record-lows both relative to its history and compared to other countries. The is confirms by the RBEE which shows Turkey starting to rebound from near record-low levels. For an investor in Turkish assets, the very cheap lira should provide a strong boost to total dollar returns when the economy recovers over 2020-2022.

Russia

Russia provides an interesting contrast to Turkey. Though the Russia Big Mac is very cheap, it is only marginally cheaper than it has been for the past 20 years both relative to the USD and to other countries. The BIS RBEE shows that the ruble is only cheap relative to the peek of the 2008-2012 commodity boom but not relative to history. This points to relatively poor upside for the ruble, unless, of course, oil prices rally strongly.

India

India shows a significant relative appreciation in the Big Mac data for the past ten years, and its Big Mac has been increasing in price relative to other countries. This is confirmed by the BIS RBEE data which shows the rupee at a moderately high level on a historical basis. The rupee is likely to trade increasingly in line with oil prices as the country has become the biggest importer of oil in the world. Currency strength is not likely to be a boost to investor performance from current levels, unless oil prices collapse.

China

China’s place in the Big Mac Index has been gradually rising, and the price of a Big Mac in China relative to other countries has increased significantly over the past ten years. This is confirmed by the BIS RBEE which shows the consistent appreciation of the yuan over the past 15 years. The yuan has stabilized over the past 4-5 years and the future path of the yuan is not clear.

 

Trade Wars

India Watch

  • India looks to China to shape mobile internet (WSJ)
  • Amazon adapts to India (WSJ)
  • India’s love of mobile video (WSJ)
  • India’s potential in passive investing (S&P)
  • India’s food-delivery startup, Swiggy, backed by Tencent (SCMP)
  • Modi’s election troubles (WSJ)

China Watch:

  • Will China fail without political reform? (Project Syndicate)
  • S&P gets go-ahead to issue China debt ratings (WIC)
  • Stable growth expected for China’s Economy (AMP Capital)
  • China’s infrastructure spending to boost economy (SCMP)
  • The new Beijing-Moscow axis (WSJ)
  • Russia-China entente worries Washington (WSJ)
  • What next for China’s development model (Project Syndicate)
  • An entrepreneur’s tale of adaptation (NYT)
  • China boosts new airport spending (Caixing)
  • An analysis of nightlight points to overstated Chinese GDP (JHU)
  • China’s slowdown (CFE)
  • China’s GDP (Carnegie Pettis)

China Technology Watch

  • CTrip’s strategy (Mckinsey)
  • DJI’s rise (SCMP)
  • China’s decade-long Bullet-train revolution (WIC)
  • China’s lead in EVs and EV infrastructure (Columbia)
  • China’s high-flying car market (McKinsey )
  • China’s place in the autonomous vehicle revolution (McKinsey)
  • Can China become a scientific superpower? (The Economist)
  • The quantum arms race (tech review)
  • Baidu CEO says winter is coming (SCMP)
  • Zoomlion’s international ambitions (FT)
  • Ping An goes digital (Mckinsey)
  • China’s bet on AI chips (Tech Review)
  • China’s 5G push (tech review)

Brazil Watch

  • John Bolton’s Troika of Tyranny (The Hill)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

  • Globalization in Transition (mckinsey)
  • World Bank Report, Global Economic Prospects (World Bank)  
  • Indonesia’s economic populism (The Economist)
  • EM’s Corporate debt bomb (FT)
  • Holding’s digital transformation (Mckinsey)
  • Lowy Institute Asia Power Index (Lowy
  • In pursuit of prosperity (Mckinsey)
  • What drives the Russian state? (Carnegie)
  • Russia’s big infrastructure bet (WSJ)

Tech Watch

Investing

 

 

 

 

 

 

 

 

 

 

The Next Ten Years in Emerging Market Stocks

  Investors in emerging markets had very poor returns in 2018, experiencing losses of 14.5%. Nevertheless, over the past decade, EM total annualized returns in USD (including dividends) have been a reasonable 8.4%. However, retruns in EM stocks have been dismal compared to those of U.S.  equities.As the chart below shows, during the past decade EM equities returned a total of 90% which compares to a 240% return enjoyed by investors in the S&P 500. . We can look at relative valuations to explain this relative performance. The chart below looks at Cyclicaly Adjusted Price-earnings (CAPE) ratios for both EM and the S&P 500. (The CAPE takes an average of ten-year  inflation-adjusted earnings to smooth out cyclicality). This poor EM performance occurred because at the beginning of the period valuations in EM were relatively high and U.S. valuations were relatively low. The chart shows that a year-end 2008 EM was trading at a CAPE multiple 0f 14.7, in line with its 15-year average. Meanwhile, the U.S. market was valued at a CAPE mulitple of 15x, compared to its 15-year average of 26x.  By the end of the 10-year period, EM CAPE multiples had declined and were well below historical averages while U.S. multiples were well above the historical average. This largely explains the relatively strong returns of the S&P 500 for the 2008-2018 decade. As a reminder, the previous decade 1998-2008 had been an entirely different story, with EM vastly outperforming the stagnant U.S. market.  During the 1998-2008 period, EM CAPE multiples expanded and U.S. mulitples contracted. In fact, if we look at the past twenty years EM stock market performance is far ahead , providing returns of 444% vs. 204% for the S&P 500, as shown in the gaph below. So, what can current valuations tell us about probable future returns? In short, the prospects look good for EM.  EM is now relatively cheap, trading at a CAPE valuation of 11.7 vs. a 15-year average of 16. Meanwhile, U.S. stocks trade at a CAPE of 28.4 times vs. an average of 24.7x. The U.S. dollar has also been strengthening for years against EM currencies, a trend that is likely to revert in the future. Though, in the words of baseball legend Yogi Berra, “it is difficult to make predictions, especially about the future”, we can use the historical context to make some guesses about probable future returns. We make three assumptions: 1. Valuations will move back to the historical CAPE average over the next five years; 2. Earnings return to historical trend; and 3. Normalized earnings grow by nominal GDP. To determine the historical earning trend we take a view of where we are in the business-earnings  cycle. In the case of EM we consider that at this time earning are about 10% below trend and we assume 6.5% nonimal GDP Growth (vs. 4% for developed markets). Based on this simple framework and assumptions we project annualized returns for EM stocks for the next five years of 9.8% (9.3% for ten years).   Adding dividends, we project total annualized returns of 12.1% (10.5% for ten years.)  The U.S. ,by contrast, is likely to experience multiple contraction and is at peak earnings, so that returns can be expected to be low single-digits. Two outside opinions shown below arrive at similar results: first GMO (on the left) projects 4.4% real annualized returns for EM (7.9% for EM value) for its seven-year forecast period; Research Affiliates (link) arrives at at 9.6% annualized nominal return for its 10-year forecast. On a country-by-country basis, as one would expect, great differences appear. Countries find themselves at different points in the business-earnings cycle and their valuations may vary greatly depending on the mood and perceptions of investors. The chart below shows where country-specific valuations stand relative to the 15-year CAPE average for the primary EM markets. The third column shows the difference between the current CAPE and the historical average. For example, Turkey’s valuation, in accordance with CAPE, is 60% below normal. The markets in the chart are ranked in terms of probable long-term returns (5-10 years), with the last two columns to the right  estimating annualized total returns (including dividends) for the next five and ten years. The table also shows where markets are currently in their business-earnings cycle and expected annualized earnings growth for the next five years. What does this table tell us? First, we can see that valuations are generally low.  The majority of markets in EM trade at very deep discounts. India, Peru and Thailand, the most expensive markets, are valued only slightly above historical valuations and are not abnormally high in absolute terms. Second, most markets stand  in the early-to-mid part of the earnings cycle. This provides the opportunity for concurrent earnings growth and multiple expansion for Brazil, China, Chile, Mexico, Malaysia, Colombia and Turkey. What does the table not tell us? First, this methodology serves best as a long-term allocation tool, not as a timing tool. Market timing is difficult because short-term stock movements are determined much more by liquidity considerations and the mood of investors than by valuation. So, for example, timing a stock market recovery in Turkey is not easy. The market may fall much further before it starts a recovery. Eventually, a new more constructive narrative will gain traction in Turkey and catch the  attention of investors, starting a new cycle. Second, the assumptions of the model may be wrong.

  • Historical CAPE valuations may be a poor guide, either too high or too low. Only the future will tell.
  • Earnings projections also may be wrong. Earnings may or may not return to trend, and can err in either direction. For example, the return forecast for Brazil assumes a return to the earnings trend and 5% annual nominal earnings growth between 2019-2023. This could be much too conservative if the new government achieves its planned ambitious free-market reforms; on the other hand, it may be too optimistic if the reforms are not introduced and the fiscal situation gets out of hand.

 Trade Wars

India Watch

  • India’s potential in passive investing (S&P)
  • India’s food-delivery startup, Swiggy, backed by Tencent (SCMP)
  • Modi’s election troubles (WSJ)

China Watch:

  • Zero growth in car sales expected for 2019 (Caixing)
  • Looking back on 40 years (Ray Dalio)
  • China steps up bullet train spending (scmp
  • On sector investing in China (Globalx)
  • The Future Might Not Belong to China (FT)
  • Will China reject capitalism (SCMP
  • The rise of China’s steel industry (WSJ)
  • Nobel economists comment on Chinese model (ECNS
  • Learning from China’s development model (scmp)
  • China debates economic policy (FT)
  • China is stepping-up infrastructure investments again (Caixing)
  • China’s radical experiment (Project Syndicate)

China Technology Watch

Brazil Watch

  • John Bolton’s Troika of Tyranny (The Hill)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

  • Koc Holding’s digital transformation (Mckinsey)
  • Lowy Institute Asia Power Index (Lowy
  • In pursuit of prosperity (Mckinsey)
  • What drives the Russian state? (Carnegie)
  • Russia’s big infrastructure bet (WSJ)

Tech Watch

Investing

 

The Last Ten Years in Emerging Markets

 

 

Around the world asset prices performed poorly in 2018, and  U.S. dollar cash had the best returns of any major asset class. Emerging markets, as all international assets, suffered from the combination of a slowing global economy, falling commodity prices and a rising dollar. Global Emerging Markets (GEM), according to the MSCI EM index, fell by 16.6% in 2018, of which 4.4% can be attributed to the USD’s rise against EM currencies.

The Table below shows returns for the primary EM countries and U.S. stocks for the past ten years. 2018 was the second time over the last ten years when every country provided negative returns, though 2011 was also painful because only Indonesia gave positive returns that year.

Brazil and Peru were the best performing EM markets in 2018. These two countries are also the best EM performers over the past three years. Brazil has now appreciated 120% since it bottomed in January 2016. This compares to a 30% return for the S&P 500. This is a good reminder that markets should be bought at the point of maximum pessimism, particularly if, like Brazil, they are large and diversified and the country has stable institutions. Of course, this is difficult to do, especially for large institutional investors.

Returns across the asset class are volatile and unpredictable. For example, over the period, Brazil has been a top-2 performer three times and also in the bottom-2 three times. Russia also has careened from top to bottom regularly.

The table also shows returns for the past decade, a period marked by unorthodox monetary policies and Quantitative Easing.  It has been a tough slog for EM, as investors have achieved only 5.5% annual returns compared to the 10.8% annual returns in the U.S. stock market. Nevertheless, three EM markets – Thailand, Philippines and Indonesia – did better than the U.S. The USD has been strengthening relative to EM currencies since 2012. This has reduced returns in EM by 1.5% annually over the decade, from 7% to 5.5%.

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Looking Back: what explains performance?

Currency

Currencies had major impacts on performance for Global Emerging Markets and individual countries. Currencies tend to trend over multi-year periods and the past seven years have seen a persistent strengthening dollar. Many EM commodity producers saw currency appreciation until 2012, but when commodity prices reverted the currencies also turned down. The chart below shows annual returns for EM countries in both USD and local currency. Of the eight EM markets with the highest annual returns, six – Thailand, Philippines, Peru, Korea, Taiwan and China – has stable currencies relative to the USD.  The bottom eight, with the exception of Chile all had very weak currencies.

EM Countries Annualized Returns

  
 

USD

Local Currency

Difference

Thailand

12.6%

11.9%

0.7%

Philippines

11.5%

12.6%

-1.1%

Indonesia

10.9%

14.1%

-3.2%

USA

10.8%

    

India

9.1%

13.1%

-4.0%

Peru

8.7%

8.5%

0.2%

Korea

8.3%

7.0%

1.3%

Taiwan

8.2%

7.5%

0.7%

China

5.6%

5.7%

-0.1%

GEM

5.5%

7.0%

-1.5%

Malaysia

4.2%

6.1%

-1.9%

S. Africa

3.8%

8.5%

-4.7%

Russia

3.7%

9.9%

-6.2%

Chile

3.5%

4.4%

-0.9%

Mexico

2.7%

6.4%

-3.7%

Colombia

2.0%

5.9%

-3.9%

Brazil

1.7%

7.0%

-5.3%

Turkey

-1.4%

11.6%

-13.0%

Earnings and Multiple Expansion

The chart below looks at the evolution of Cyclically Adjusted Price Earnings Ratios (CAPE)  and earnings over the last ten years. The seven best performers all saw expansion in the CAPE multiple, which means investors are now paying more for stocks relative to their earnings power than they did ten years ago. The top nine performers also experienced healthy annualized earnings growth, so that by the end of the period investors were paying higher multiples on a significantly higher earnings base.

The opposite is true for the bottom eight, the laggards. These all saw multiple contraction (except Mexico) and flat to negative earnings growth.

 

CAPE as a Predictor of Future Returns

Though over the short-term valuation is a poor timing instrument, over ten-year periods it should have some forecasting value and/or at least serve as an allocation tool. Unlike in 2007, when valuations in many EM countries had reached extremely high levels both in absolute terms and relative to history, at year-end 2008 valuations in EM were closer to the historical norm (based on a 15-year trailing average of CAPE ratios).The following two tables below show the situation at the end of 2017 and then a year-end 2018. Note the remarkable contraction in CAPE multiples that occured between 2007 and 2017 and led to very poor returns over that ten-year period.

Nevertheless, five of the countries with better returns over the 2008-2018 period, started with CAPE ratios below average and saw multiple expansion (Thailand, Indonesia Korea, Taiwan). Two of the worst performers started with CAPE ratios above average and saw multiple contraction (Brazil, Colombia).

Using CAPE as an allocation tool is probably most effective at the extremes. At the end of 2008 this was clearest with the S&P 500 with a CAPE of 15.2 compared to a 15-year average of 27.8, which pointed to a significant opportunity to buy.  Also, Colombia, with a CAPE of 23.6 compared to an average of 16.8 was notably out of line, and this was a strong argument to sell.

Trade Wars

  • Seven issues will drive the trade talks (Caixing)
  • King dollar? (Kupy)
  • Europe is wary of Chinese M&A (SCMP)
  • Obama administration view on China issues (Caixing)
  • China’s tantrum diplomacy   (Lowy)
  • Making sense of the war on Huawei  (Wharton)
  • The war on Huawei (Project Syndicate)

India Watch

  • India’s potential in passive investing (S&P)
  • India’s food-delivery startup, Swiggy, backed by Tencent (SCMP)
  • Modi’s election troubles (WSJ)

China Watch:

  •  
  • Looking back on 40 years (Ray Dalio)
  • China steps up bullet train spending (scmp
  • On sector investing in China (Globalx)
  • The Future Might Not Belong to China (FT)
  • Will China reject capitalism (SCMP
  • The rise of China’s steel industry (WSJ)
  • Nobel economists comment on Chinese model (ECNS
  • Learning from China’s development model (scmp)
  • China debates economic policy (FT)
  • China is stepping-up infrastructure investments again (Caixing)
  • China’s radical experiment (Project Syndicate)

China Technology Watch

Brazil Watch

  • John Bolton’s Troika of Tyranny (The Hill)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

  • Koc Holding’s digital transformation (Mckinsey)
  • Lowy Institute Asia Power Index (Lowy
  • In pursuit of prosperity (Mckinsey)
  • What drives the Russian state? (Carnegie)
  • Russia’s big infrastructure bet (WSJ)

Tech Watch

Investing

China’s Slowdown

 

Washington’s growing hostility is complicating China’s efforts to gradually move away from the debt-driven investment model of the past decades to a more consumer-driven service economy. Weaning the economy from the previous growth-model was never going to be easy, but growing U.S. antagonism may be hurting confidence and affecting growth prospects. In any case, signs of slowing growth are everywhere and will increasingly impact the domestic political process.

The Chinese growth model has been based on exports, urbanization and infrastructure development. On the one hand, the export growth model has reached its limits because of resistance from trading partners and the rising cost of manufacturing in China. Foreign investors that played a major role in exports are now relocating to cheaper sites such as Vietnam and Mexico. On the other hand, urbanization and infrastructure development, are well advanced and will not have the same impact on growth as in the past. Moreover, these sources of growth were debt-funded, and China is probably close to the end of a cycle of debt accumulation. The chart below shows the remarkable increase in borrowing that has fueled growth since 2008. China responded to the Great Financial Crisis with a huge debt-financed fiscal expansion, largely aimed at supporting infrastructure and urbanization projects. At the same time, household lending, primarily for real estate, took off.

 

The lending boom led to a surge in real estate prices and enormous fortunes for developers.

However, in recent years the government has grown increasingly weary of both debt levels and real estate speculation. Starting in 2016, measures were introduced to restrain lending. The chart below shows the year-on-year growth of lending according to China’s “total social lending” concept. This lending growth is now a th lowest level in 15 years and barely above nominal GDP.

China’s lending restrictions were aimed mainly at “shadow bank lending,” which are creative vehicles that banks used to channel credit to private borrowers at higher rates. This source of lending, which was vital for private businesses and speculation, is now in sharp decline, as the chart below shows.

Construction spending, which has been the main driver of Chinese growth for decades, is very closely tied to bank lending, as shown below. As bank lending growth declines, it is no surprise that construction activity is also stabilizing.

These tighter financial conditions are starting to have a broad impact on the economy.  Housing prices have now stopped rising in China’s main cities; car sales are falling for the first time in years; and retail sales are soft. We can see this in the three following charts:

China’s slowing growth is structural in nature. Given the size of the economy now, it is no longer possible to run large current account surpluses. China’s population is ageing very fast, more like a developed nation than an emerging market, and the labor force has been declining for several years.

The government’s strategy to manage slowing growth is three-pronged: continued urbanization of second and third-tier cities and rural development; increasing the share of household consumption in the economy; and promotion of initiatives to dominate frontier technologies, the so-called “Made in China 2025” industrial policy.

This is a reasonable policy but for it to work it requires a stable transition. This is occurring at a time when domestic politics appear to have become tense, with a debate raging between hardline “big state” authoritarians and “free market” reformers. Growing U.S. hostility will not help, and managing slowing growth and high debt levels will be a challenge.

 

Macro Watch:

  • The emergence of the petro-yuan (APJIF)  
  • A users guide to future QE (PIIE)
  • Economic brake-lights (Mauldin)

Trade Wars

  • China’s tantrum diplomacy   (Lowy)
  • Making sense of the war on Huawei  (Wharton)
  • The war on Huawei (Project Syndicate)
  • Trump pushes China to self-sufficiency (SCMP)
  • The road to confrontation (NYT)
  • The real China challenge (NYT)

India Watch

  • Modi’s election troubles (WSJ)
  • India’s air pollution problem (FT)
  • India’s mutual fund industry (CRISIL)
  • Election uncertainty clouds Indian stock market (FT)

China Watch:

  • China’s radical experiment (Project Syndicate)
  • China picks tobacco taxes above public health (WIC)
  • How free is China’s internet? (MERICS)

China Technology Watch

  • Will China cheat U.S. investors in tech stocks (WSJ)
  • The Huawei security threat (Tech Review)
  • China’s Big Tech Conglomerates (IIF)
  • How China raised the stakes for EV  (WEF)
  • A profile of Bytedance, China’s short-video app (The Info)

Brazil Watch

  • John Bolton’s Troika of Tyranny (The Hill)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

  • In pursuit of prosperity (Mckinsey)
  • What drives the Russian state? (Carnegie)
  • Russia’s big infrastructure bet (WSJ)
  • Russia’s new pipeline (Business Week)
  • Indonesia’s elections (Lowy)
  • Chile’s renewable energy boom (Wiley)

Tech Watch

  • Bloomberg energy finance, 2018 report (Climatescope)
  • Fast-tracking zero-carbon growth (Ambition loop)
  • Why have solar energy costs fallen so quickly (VOX)
  • Asia leads in robot adoption (QZ)
  • The new industrial revolution (WSJ)

Investing

 

 

 

The U.S.-China “Cold War”

 

Until recently, China and the United States had a convenient symbiotic relationship whereby China supplied cheap consumer goods to the U.S. consumer in exchange for dollars which it then invested in U.S. treasury bills. The relationship was perceived to be largely benign and mutually beneficial. For China, access to the U.S. market allowed it to follow the path followed in the past by its Northeast Asia neighbors (Japan, Korea and Taiwan), gradually moving up the value chain from toys, to textiles to electronics…etc. For the U.S., cheap Chinese goods increased consumer purchasing power at a time of stagnant wages. Geo-political strategists in Washington imagined that as China prospered it would start to act more like a Western liberal democracy.

However, since the arrival of Trump the relationship has frayed, and the two countries are now on the verge of a full-fledged “cold war.” Though Trump’s  anti-globalization and protectionist rhetoric may have galvanized opposition to China, the change in Washington is deep-rooted and largely consensual. Today, China-bashing is one of the few things that unite republicans and democrats, and the Washington establishment has made a remarkable about-face and now actively demonizes China. What was once seen as a “win-win” relationship is now perceived to be heavily skewed in favor of Beijing.

The current line of thinking in Washington is that China has abused American goodwill. While the U.S. opened its markets for Chinese exports and investments, China gamed WTO rules, restricted access to its market for trade and investments and sponsored the theft of intellectual property. Moreover, it has suddenly dawned on the Washington intelligentsia that China does not intend to become a liberal democracy. This makes China very different from previous beneficiaries of the “Pax Americana,” such as Germany, Japan and the Asian tigers. China is also different because of its huge scale and a growing economy that may, if it follows its current growth path, surpass the U.S. economy over the next decade. For the first time ever, China is now seen as a potential hegemonic rival that must be thwarted.

Washington’s new-found condemnation of China grew in tandem with the ascendency of Xi Xinping, his consolidation of power and his “coronation” in October, 2017 as “leader for life.”  Prior to Xi, Chinese leaders had projected  diffidence and humility. This was best expressed by Deng Xiaoping who advised: “Observe calmly; secure our position; cope with affairs calmly; hide our capacities and bide our time; be good at maintaining a low profile; and never claim leadership.”  However, Xi has come to symbolize a new more militant, arrogant and ambitious China, with pretentions of global leadership. Most emblematic of this are Xi’s two core policy initiatives: One-Belt-One-Road, which seeks to project Chinese influence and investments outside of China, particularly along the old “Silk Road” and international shipping routes; and the “Made in China 2025” industrial planning policy which aims to move Chinese manufacturing up the value chain into frontier technologies.

The U.S. is critical of both of these initiatives because they are seen as anti-market products of a command economy, made possible by state subsidies and state companies. These policies and Xi’s stated objective of strengthening state capitalism and the role of the Communist Party are seen by Washington as indicative that China is a non-market economy that operates by different rules than Western economies. Topping off Washington’s grievances is the perception that Xi is taking China down a new path of military expansionism which threatens Asian stability.

With Trump at the helm, there is a very high probability of further deterioration in the relationship with China. As JPMorgan strategists wrote last week  “a full-blown trade war becomes our new base case scenario for 2019.” It is increasingly likely that a 25% tariff will be imposed on all Chinese goods early next year.

Currently, the two countries are at an impasse. Trump believes that the Chinese will surrender on his terms as the Chinese economy deteriorates. Xi believes the state-run Chinese economy is resilient, and China can wait patiently for changes in the U.S. political and economic cycles. China is convinced that the U.S. is now undermining the post-war economic order because it is determined to thwart China’s economic rise. Its response has been to act as a responsible member of the rules-based international community, gradually adapting to the legitimate demands of its commercial partners. An example of this is China’s recent elimination of joint-venture requirements in the auto sector (this week BMW announced it is taking full control of its JV with Brilliance China).

The two countries are probably underestimating each other’s resolve, which means that the quarrel with have long-term consequences. What may be these be?

  • Tariffs and disruption of supply chains will boost inflation in the U.S. and bring the late-cycle U.S. economy closer to recession. Over the short term, little can be done to substitute Chinese imports, and tariffs will act as a large tax on consumers. Over the medium term, countries like Vietnam, Bangladesh, and Mexico can replace China as manufacturing bases for the U.S. consumer. Over the long-term robotics may change everything and allow a contraction of manufacturing supply chains.
  • European and Asian firms will take advantage of the trade war to take market share from U.S. firms in the Chinese market.
  • As indicated by the poor performance of the stock market, the Chinese economy may become less stable. China already faces big challenges dealing with high debt levels and malinvestment, while it moves from an investment and export driven economy to one based on consumption. A trade war with the U.S. can only make this transition more difficult, and this may have significant negative consequences for the global economy. Given that EM stocks are mainly driven by events in China and the U.S., the disruption of the China-U.S. relationship will surely have very serious consequences.
  • Over the medium term, there may be a retrenchment in globalization and an acceleration of regional blocs and multipolarity. Firms will have to think about operating in increasingly separate ecosystems, each with its own supply chains and technological platforms: one supply chain will serve the U.S. market; another will be structured for the Chinese market. This process is in full acceleration: Huawei and ZTE have been banned from the U.S.; the U.S. is accusing China of hacking supply-chain components sourced in China; China is determined to become self-reliant in key components for the high-tech sector.
  • Initially, one of the few clear winners of this “Cold War” may be Mexico. The Mexican government smartly outmaneuvered Trump and secured the basics of NAFTA in exchange for a new name (USMCA). The deal allowed Trump to say that “the worst trade deal ever” has now become “a great deal, the most important trade deal we have ever made.” The new deal may make Mexico the manufacturing base of choice for firms seeking the combination of easy access to the U.S. market and cheap labor.

Macro Watch:

  • The weak fundamentals of the global economy (Project Syndicate)
  • Trump’s poison pill for China (Yardeni)
  • U.S. tariffs on China are not short term strategy (WSJ)
  • The decline of the dollar standard (Project Syndicate)
  • The U.S. will win this trade war (Gary Shilling)
  • New NAFTA is a relief (The Economist)
  • Brazilian democracy on the brink (Project)
  • The Tyranny of the US dollar (Bloomberg)
  • Trump’s rebranded NAFTA (Bloomberg
  • New NAFTA shows limits of “America First” (WSJ)
  • NAFTA to USMCA – What in a name? (Lowy)

India Watch

  • India’s Russia arm deal (WSJ)
  • India’s game-changing healthcare plan (Lowy)
  • Measuring Indian equities (S&P)
  • Modi is no populist (Foreign Policy)

 

China Watch:

  • Chinese actress to pay $129 million tax-evasion fine (WIC)
  • A strategy for dealing with China (PIIE)
  • China and Islam ( Hoover)
  • Gloves off in China-US conflict (Axios)
  • The garlic war (AXIOS)
  • Chinese U.S. investments plummet (SCMP)
  • China-U.S. ties now driven by conflict and containment (CSIS)
  • VP Pence’s cold war China speech (NYtimes)
  • U.S.-China trade relations forever broken (SCMP)
  • The U.S. will lose its trade war with China   (Project Syndicate)
  • Hong Kong mainland bullet-train link opens (WIC)
  • China’s embracement of Russia (SCMP)

China Technology Watch

  • BMW takes control of China venture (WSJ
  • China aircraft sector slow take-off (SCMP)
  • How the US halted China cyber-attacks (Wired)
  • Huawei’s new chips (WSJ) and (Tech Review)
  • Most Chinese patents are worthless (Bloomberg)
  • Chinese provinces keen to attract EV investments (Caixing)
  • How China sustematically steals technology (WSJ)

Brazil Watch

  • Brazil’s Bolsonaro (New Yorker)
  • In Brazil, campaign promises but no money (WSJ)
  • Emerging markets’ lost decade (Blackrock)
  • Brazil’s gene-edited angus cow (WSJ)
  • Brazil’s social media election (FT)
  • How to fix Brazil’s economy (Project Syndicate)

EM Investor Watch

  • Indonesia’s bullet-train is stalled (Caixing)
  • Russia’s missed tech opportunity (Hoover)
  • Emerging markets’ lost decade (Blackrock)
  • SPIVA Latin American Scorecard (S&P)

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

Investing

 

 

 

 

A Reading List for Emerging Markets

Here is a list of books that I think are useful and interesting for any investor seeking to understand investing in emerging markets. The list reflects my bias for long-term investing rooted in knowledge of history and business cycles. I have included only books published in English, which is a big restriction. Also, I have not included basic investing books, which is an entirely sparate list.

The list is divided into three sections.

  • Macro Economics and Business Cycles
  • Development and Economic Convergence
  • Regions and Countries

The books in each section are listed in no particular order.

1 Macro-economics, business-cycles and financial bubbles

 The Volatility Machine by Michael Pettis

This Time is Different by Reinhart and Rogoff

The Bubble Economy by Chris Wood

Inflation and Monetary Regimes by Peter Bernholz

Money and Capital in Economic Development by Ronald McKinnon

How to Make Money with Global Macro by Javier Gonzalez

Business cycles: history, theory and investment reality by Lars Tvede

Emerging market portfolio strategies, investment performance, transaction cost and liquidity risk by Roberto Violi and  Enrico Camerini II (Link)

Against the Gods by Peter Bernstein

 Alchemy of Finance by George Soros

The Fourth Turning: What the Cycles of History Tell Us About America’s Next Rendezvous with Destiny by William Strauss, Neil Howe

Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages by Carlota Perez

Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay

Manias, Panics, and Crashes: A History of Financial Crises, by  Charles P. Kindleberger and Robert Z. Aliber

Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor

 

2 Development and Economic Convergence

 

 

Civilization and Capitalism, 15th-18th Century, Vol. I: The Structure of Everyday Life by Fernand Braudel

The  Pursuit of Power: Technology, Armed Force, and Society since A.D. 1000  by William H. McNeill

The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor by David S. Landes

Energy and Civilization: A History  by Vaclav Smil

Barriers to Riches (Walras-Pareto Lectures) by Stephen L. Parente, Edward C. Prescott

The Great Convergence: Information Technology and the New Globalization

by Richard Baldwin

A Discussion of Modernization Li Lu (Link)

Slouching Towards Utopia?: AnEconomic History of the Long 20th Century, Brad Delong

Breakout Nations. In Pursuit of the Next Economic Miracles by Rushir Sharma

Why Nations Fail: The Origins of Power, Prosperity, and Poverty  by Daron Acemoglu and James A. Robinson

The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor by David S. Landes

The Birth of Plenty : How the Prosperity of the Modern World was Created by William J. Bernstein

Why Did Europe Conquer the World?    by Philip T. Hoffman

Empire of Cotton: A Global History  by Sven Beckert

The Pursuit of Power: Technology, Armed Force, and Society since A.D. 1000 by William H. McNeil

The White Tiger by Aravind Adiga

How to get Filthy Rich in a Rising Asia by Mohsin Hamid

AI Superpowers: China, Silicon Valley, and the New World Order by Kai-Fu Lee

Growth and Interaction in the World Economy by Angus Maddison

 

 

3 Regions and Countries

 

Latin America

 

Guide to the Perfect Latin American Idiot by Plinio Apuleyo Mendoza, Carlos Alberto Montaner, Alvaro Vargas Llosa

Left Behind: Latin America and the False Promise of Populism by Sebastian Edwards

 

 

Brazil

 

Brazil: A Biography by Lilia M. Schwarcz and Heloisa M. Starling

The Military in Politics: Changing Patterns in Brazil by Alfred C. Stepan

Brazillionaires: Wealth, Power, Decadence, and Hope in an American Country 

by Alex Cuadros

Brazil: The Troubled Rise of a Global Power by Michael Reid

Lanterna na Popa by Roberto Campos

A Concise History of Brazil by  Boris Fausto

A History of Brazil by E. Bradford Burns

 

Mexico

 

The Course of Mexican History by Michael C. Meyer and William L. Sherman

Mexico: Biography of Power. A History of Modern Mexico, 1810-1996 by Enrique  Krauze

 

Turkey and the Middle East

 The Political Economy of Turkey by Zulkuf Aydin

Midnight at the Pera Palace. The Birth of Modern Instanbul, by Charles King

The Prize: The Epic Quest for Oil, Money & Power by Daniel Yergin

The Yacoubian Building by  Alaa Al Aswany

 

Russia

 

Wheel of Fortune. The Battle for Oil and Power in Russia by Thane Gustafson 2012

Red Notice: A True Story of High Finance, Murder, and One Man’s Fight for Justice by Bill Browder

The Future Is History: How Totalitarianism Reclaimed Russia  by Masha Gessen

 

 

 

Asia

 

Asian Godfathers: Money and Power in Hong Kong and Southeast Asia by Joe Studwell

How Asia Works: Success and Failure in the World’s Most Dynamic Region

by Joe Studwell

Lords of the Rim by Sterling Seagrave

 

 

China

 

Factions and Finance in China by Victor C. Shih

Capitalism with Chinese Characteristics. Entrepreneurship and the State by Yasheng Huang

China’s Crony Capitalism: The Dynamics of Regime Decay  by Minxin Pei

CEO, China: The Rise of Xi Jinping by Kerry Brown

Factory Girls: From Village to City in a Changing China by Leslie T. Chang

Avoiding the Fall. China’s Economic Restructuring by  Michael Pettis

The River at the Center of the World by Simon Winchester

Mr. China by Tim Clissold

The China Strategy by Edward Tse

River Town  by Peter Hessler

The Economic History of China: From Antiquity to the Nineteenth Century

by Richard von Glahn

Understanding China: A Guide to China’s Economy, History, and Political Culture 

by John Bryan Starr

China’s Economy: What Everyone Needs to Know  by  Arthur R. Kroeber

Modern China by Jonathan Fenby

The Chinese Economy: Transitions and Growth by Barry Naughton

Wealth and Power. China’s Long March to the 20th Century by David Schell and John Delury

China’s New Confucianism by Daniel Bell

China Fireworks: How to Make Dramatic Wealth from the Fastest-Growing Economy in the World by Robert Hsu

Cracking the China Conundrum: Why Conventional Economic Wisdom Is Wrong

by Yukon Huang

Little Rice: Smartphones, Xiaomi, and the Chinese Dream  by Clay Shirky

Alibaba: The House That Jack Ma Built  by Duncan Clark

 

India

 

India – A Wounded Civilization by by V. S. Naipaul

Behind the Beautiful Forevers by Katherine Boo

 India’s Long Road: The Search for Prosperity by Vijay Joshi

The Billionaire Raj: A Journey Through India’s New Gilded Age by James Crabtree 

Capital: The Eruption of Delhi by Rana Dasgupta

Investing in India: A Value Investor’s Guide to the Biggest Untapped Opportunity in the World by Rahul Saraogi

 

Macro Watch:

India Watch:

  • India’s strong economy leads global growth (IMF)
  • (King coal rules India (Economist)

China Watch:

  • China vs. the U.S.: the other deficits (Caixing)
  • Media warns to avoid Japan’s mistakes (SCMP)
  • China needs to get its house in order (SCMP)
  • China resumes urban rail incestments (Caixing)
  • Chinese firm will take over Iran gas project (Bloomberg)

China Technology Watch

  • How WeChat conquered China (SCMP)
  • Why do Western digital tech firms fail in China (AOM)
  • Hayden Capital on China tech investments (HaydenCapital)
  • A deep look into Alibaba’s 20F (Deep Throat)
  • China’s rise in bio-tech (WSJ)

EM Investor Watch

  • Turkey could be worse than Greece (dlacalle)
  • The West’s broken relationsip with Turkey (Project Syndicate)
  • Africa cannot count on growth dividend (FT)

Tech Watch

  • Drones in mining (Youtube)
  • The future of batteries (Wired)

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)

The Impact of Trade Wars on Emerging Markets

The main goal of American diplomacy now appears to be to disrupt the post-war rules-based global economic order. President Trump viscerally believes that the status quo is rigged against the United States and in favor of America’s most important trading partners. In this scheme of things, traditional allies like Canada, Mexico and Germany are “ foes” and a rising economic power like China becomes an existential threat to American hegemony. On the other hand, countries do not export large amounts to the U.S are irrelevant (e.g. South America) or potential friends (e.g. North Korea, Russia)

According to the Trump Doctrine, global trade and investment are zero-sum games which should naturally be dominated by the U.S. because of its heft and competitive advantages. Trump believes that the U.S. is entitled to dictate terms to those countries that seek access to its markets, capital and technology. Central to this view, the U.S. has only two real rivals that challenge its hegemony: Germany and China.

Germany is seen as having taken control of Europe through the European Union, exploiting divisions to its own benefit, in order to further its global mercantilistic ambitions. Trump fervently supports Brexit because a divided Europe weakens Germany. Brexit would allow the U.S. to impose its own terms on a bilateral U.S.-U.K. trade deal.

China is seen by Trump to be a highly disloyal competitor which exploits the current global order to its own advantage. Allowing China into the WTO was “the worst deal ever,” and caused enormous damage to the U.S. economy. According to Trump, China’s business practices are utterly unfair for the following reasons:

  • Currency manipulation.
  • High tariff and non-tariff trade barriers.
  • Violation of intellectual property rights.
  • Highly restricted access for foreign investment, and imposition of JV requirements and technology transfer agreements.
  • State control of the economy, with huge subsidies provided to both state-controlled and private Chinese firms.

Moreover, as China steadily moves up manufacturing value chains, the U.S. has become obsessed with potential  future competition in high-technology goods. The focus of Washington’s anger is President Xi’s “Made in China 2025” plan to promote Chinese competency in key industrial technologies. Trump’s recent tariffs imposed on China are heavily targeted on the sectors that Xi has determined to be strategic, as shown in the chart below.

Consequences of the Trump Doctrine

As the U.S. questions the transatlantic alliance and the post W.W. II global institutional framework it will abdicate its role as the leader of the project. Without U.S. leadership new alliances will form in unpredictable ways. Though the current situation is highly dynamic and the future is unpredictable, some thoughts are in order:

  • The Trump Doctrine is isolationist for America. As Henry Kissinger has pointed out, the U.S. stands to become a “geopolitical island… without a rules-based order to uphold.” Nevertheless, as the largest and most diverse economy, the U.S. may have the least to lose.
  • America’s neighbors Mexico, and Canada will have no choice but to begrudgingly cave-in to U.S. bullying and accept Trump’s terms. Any deal will be better than no deal.
  • As it undermines the Western Alliance, The Trump Doctrine furthers the interests of both Russia and China. Ironically, both these dictatorships are more comfortable  dealing on a bi-lateral transactional basis than the U.S. with its checks and balances and elections. China is in a good position to trade access to its growing consumer economy on a transactional basis.
  • American isolationism and unilateralism also strengthens China’s hand in its One Belt one Road (OBOR) initiative which has as its primary objective the control of the Eurasian steppes (the old Silk Road, linking China with Europe and the Middle East.) Russia and China are enjoying the warmest diplomatic ties since the 1950s as they see eye-to-eye on this Eurasian strategy; for the Chinese it secures its borders and opens up commerce; for Russia it extends its geo-political reach. As Kissinger has noted,  Europe may become “an appendage of Eurasia.” Key targets here are Iran and Turkey, both of whom are currently at odds with American policy.  China has become Iran’s main trading partner and investor and is committed to buying its oil.
  • Both China and Russia see American “sanctions diplomacy” as a fundamental violation of the global rules-based economic order. U.S. imposed restrictions on Russia, Iran and other countries on the use of the SWIFT global financial transfer system and recent sanctions on Chinese telecom firm ZTE on the import of U.S. components have highlighted the urgency for reducing dependence on the U.S.  This will strengthen China’s resolve to achieve competence in key technologies and further efforts to develop alternatives to the U.S. dollar.  India is also dismayed by American strong-arm tactics, as sanctions are interfering with its commercial ties to Iran and the Middle East and its strong ties with Russia.
  • American antagonism towards the E.U. may also push Germany towards China. Germany may increasingly play its cards in Asia, which is increasingly the center of gravity of the global economy. It is probably not a coincidence that as Trump has launched his trade war against Beijing there has been a sudden rapprochement between Germany and China, and the announcement of a slew of important business transactions. First, BASF was given the go-ahead on a $10 billion fully-owned petrochemical plant, an unprecedented concession by the Chinese in a sector where Germany and the U.S are chief rivals. Second, German companies are securing preferential treatment in the auto sector, now by far the largest in the world and the focus of activity for electric vehicles and, increasingly, autonomous vehicles. In recent weeks, Daimler was awarded a permit to test driver-less cars In Beijing, a first for a foreign firm. Daimler is partnering with Baidu Apollo, a leader in mapping and artificial intelligence applications in China. Also last week Chinese Premier Li Keqiang said BMW may get control of its JV with Brilliance by 2022. BMW, which already has China as its largest market producing about 25% of global profits, has committed to a large increase in capacity and a partnership with Baidu. BMW also secured the right to take an equity stake in CATL, the world’s largest electric vehicle battery producer by sales, after the carmaker agreed to purchase $4.7bn worth of battery cells from the Chinese company. Finally, Volkswagen announced a partnership with FAW for electric vehicles and autonomous cars.
  • The announcement by Tesla last week that it would build its cars in a fully-owned plant in Shanghai is another sign of how companies are adapting to the Trump Doctrine. Chinese tariffs on American cars have increased the price of Teslas in China at a time when dozens of very well-financed local start-ups are coming on stream. Though the move is a significant market opening benefit for an American firm, it can also be seen for Tesla as a desperate attempt to remain relevant in China’s EV market at a time when sales are expected to ramp up dramatically. Still, it may be too late for Tesla, as its plant will not come on stream until 2020.
  • Access to the Chinese market is of great importance to multinationals. In a transactional world, the Chinese can provide access judiciously to secure powerful allies in developed countries. In the case of the U.S., China continues to offer incremental access to financial services, a long-standing demand of American firms.
  • “Winners” in the age of the “Trump Doctrine” are large countries with strategic importance. China is likely to come ahead, as it has strategic importance, a huge market and leadership with long-term objectives. India is not considered a rival by the U.S. and has high strategic value, so it also is in a good position to secure favorable terms. Brazil, though of no strategic value for the U.S., is not considered a rival by Trump and is also in a good position to negotiate.
  • “Losers” are small countries with no strategic value for the U.S.. As global value chains are disrupted by American unilateralism, those countries most dependent on exports to the U.S. are the most vulnerable. The chart below from Pictet Bank gives a good idea of which countries face the most downside: Mexico, Korea, Vietnam, Thailand, Taiwan, Indonesia and Malaysia. They will face unclear rules which will hurt investment. At the same time, the two largest economies in the world,  the U.S. and China will become more insular and self-sufficient.

Fed Watch:

India Watch:

  • Samsung opens world’s largest smartphone factory in India (Bloomberg)
  • Scarsity of visas is shaking up Silicon Valley (SF Chronicle)

China Watch:

China Technology Watch

  • Interview with AI expert Kai-Fu Lee (McKinsey)
  • JD.com is driving commerce in rural china (Newyorker)
  • Tesla-foe Xpeng’s $4 billion valuation (SCMP)
  • China’s tech lag highlighted (SCMP)
  • Tesla’s move to Shanghai (FT)
  • Tesla’s China plan (NYtimes)
  • BMW enters China’s fast lane (WSJ)
  • Daimler and Baidu get ahead on driverless cars in China (Reuters)
  • China wants high-tech cars with German help  (NYT)

EM Investor Watch

  • An update to the big mac index (Economist)
  • Interview with Kissinger (FT)
  • Erdogan’s “New Turkey” (CSIS)
  • Why Bolsonaro is leading Brazil’s polls (Foreign affairs)
  • Pundits are down on EM (Research Affiliates)
  • Indonesia takes control of mega copper mine (WSJ)

Tech Watch

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

 

 

 

 

 

 

 

 

Valuations in Emerging Markets

Valuation of equities is a relatively simple matter, as long as one is disposed to believe that prices fluctuate as a function of the “greed-fear” cycle of investors but eventually mean-revert to historical parameters. However, over the short-term, the forward-looking period of 3-12 months of almost exclusive concern to Wall Street, the media and the majority of investors, valuation parameters can seem largely irrelevant, as it is difficult to predict when trends will change or what may trigger a drawdown. Typically, market corrections are caused by economic recessions, which bring stocks back to lower levels and create opportunities for investors to buy equities with prospects for reasonable returns.

Having said that, there are two reasons for believing that valuations may be drifting higher with time, which would require long-term forecasters to make some adjustments to their models. First, there is no doubt that the cost of buying and holding equities has fallen dramatically over time. For example, I remember buying the closed-end , NYSE-traded The Mexico Fund in the mid-1990s. Trading commissions were in the order of ten times the $5/trade many brokers charge today, the fund manager charged a management fee well above 2% for what was essentially an index fund. To top it off, the fund traded at very large discounts to Net Asset Value, sometimes as great as 30%. Compare that to the emerging market country funds now trading in ETF form with annual fees of as low as 14 basis points (0.14%), and it is clear that investing in emerging market equities, as in other asset classes, has never been cheaper than today. It would make sense that valuations would at least partially reflect the lower transaction costs.

Another often-cited, though less plausible, explanation for higher valuations is that risk has been permanently reduced by lower economic volatility. This theory was advanced as a possibility already in the late 1950s by no less than the legendary investor and teacher Ben Graham, who was searching for a reason to explain why U.S. stocks had appreciated so much during the post-war period. If one believes Ben Bernanke’s theory that improvements in the science of monetary economics has resulted in a “great moderation,” or smoothing of economic cycles, than this could point to higher-for-ever valuations. Of course, one would have to explain the Great Financial Crisis of 2008-2009 as a “Five Sigma” event not likely to happen for another thousand years. This is the view that has been publicly expressed rather unconvincingly, in my view, by Bernanke and Janet Yellen, and which justifies the extremely low volatility and high valuations of the current investment environment.

What does history tell us about current valuations? The work of GMO, Research Affiliates, and Haussman all agree that most assets priced at levels that point to very low expected returns for most asset classes.

First, let’s look at the work of John Hussman (Hussman Funds), which back-tests historical data to forecast future returns. Hussman’s model predicts negative 2% nominal (including inflation) returns for the next 12 years.

Second, let’s look at GMO, which has made these forecasts for decade with a high degree of predictive success. The table below shows GMO 7-year forecast for real (inflation-adjusted) returns. GMO sees negative returns for stocks, partuclarly U.S. large cap stocks with negative 4.6% annual real returns (in line with Hussman’s number). Emerging markets stocks are the exception,  priced to give a 2.2% real annual return. Jeremy Grantham, GMO Chief Strategist, recently advised his clients to load-up as much as they can on emerging market equities.

Third, we look at Research Affiliates, with the results of their latest exercise below. RA forecasts real returns and volatility for the next ten years. RA’s model points to generally higher returns for all asset classes compared to GMO’s, but still U.S. equities are expected to provide near zero return for the period. International returns (EAFE, Europe, Asia, ar-East) are slated at slightly above 4%, and emerging markets are expected to provide real returns of 6% per year.

These three approaches point to relatively high expected returns for emerging markets. These can be explained by three factors: 1.relative under-performance over the past five years; 2.Valuations in line with history, and quite low relative to U.S. equities; 3. the earnings cycle; and 4. the currency cycle.

  1. Relative Underperformance (S&P 500 vs. MSCI Emerging Markets Index)

  1. Valuations (Cyclically Adjusted PE ratio), S&P500 vs. EM

3.Earnings are on the rebound in EM.

4.Competitive Currencies

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)

China Technology Watch:

 

 

EM Investor Watch:

 

 

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:

 

 

 

 

 

 

 

 

“The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority ‘go with the flow,’ either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in ‘fair value’ for the stock market.”  ~ Jeremy Grantham

Factor Investing in Emerging Markets

Over the past fifty years, financial economists in academia have built mathematical models to explain how excess returns can be obtained by investors in “efficient” markets. The Capital Asset Pricing Model (CAPM), developed during the 1960s, was the first formal model that sought to explain asset prices as a function of risk and return. According to this simple model, the equity market as a whole has a systemic return which is the excess return over a risk-free asset (i.e Treasury Bills) that an investor needs to assume the greater risk of the stock market. Market risk is called BETA in the model, with the risk free asset having a BETA of zero, the  market a BETA of one and riskier assets a BETA above one. BETA itself is  measured in terms of the correlation of an asset to the market and how volatile it is relative to the market.

Though the CAPM model remains the pillar of modern finance, academics have punched many holes in its one-factor (BETA) structure. A generation of finance PHDs have come up with “anomalies” in CAPM, which are additional factors that explain excess returns in a persistent manner over time, sectors and geographies. Initially small-capitalization stocks and value stocks (low price-to-book-value or low price-to-earnings relative to the market) where identified as generating a return premium. Then momentum (the tendency of rising stocks to keep rising and falling stocks to keep falling) gained acceptance, followed by quality and profitability. In recent years, academics have gone wild identifying multitudes of new factors, but most of these seem redundant, and the focus by investors is on the initial five.

The excess return premiums over the risk-free rate which investors expect from these factors (based on historical empirical evidence) are the following (Source, Your Complete guide to Factor-based Investing, Berkin&Swedroe):

Not only do the factors provide excess return premiums (for example, smalls caps add 3.3% of excess return), they also show negative correlations to the market excess return (BETA). This means that by tilting a portfolio to a specific factor the investor can expect to have both higher returns or lower volatility.

Given that the validity of these factors assumes prevalence over geographies, an investor should expect to find them in emerging markets. What is the evidence?;

The most recent academic research –”Size, Value, and Momentum in Emerging Market Stock Returns: Integrated or Segmented Pricing?”(SSN) , by Matthias X. Hanauer, Martin Linhart ( February 2015), analyzed the July 1996 to June 2012 period and found strong  value and momentum effects. However, they identified only a weaker size effect, and that only in Asia.

Lazard Asset Management, a prominent value manager, studied a similar time period (December 1999 to September 2015) and reached essentially the same conclusion (LAM). Lazard found a large value premium, best exploited through low PE and high dividend stocks (not low price/book). Lazard also found lower but still high momentum and quality premiums. Interestingly, these styles are negatively correlated to value in EM: momentum and quality perform strongly in rising markets, while value is resilient in down markets. Therefore, combining these factors can provide diversification benefits.

The absence of a premium for small-cap stocks in emerging markets would be surprising as this factor is highly prevalent over time in both the U.S. and international markets. Dimensional Fund Advisors (DFA) Management, a quant manager with exceptional academic credentials, has had a small cap EM fund (DEMSX) since 1998 that has performed poorly compared to its emerging market product (DFETX), as shown below:

Source: Yahoo Finance

However, emerging markets small caps have had very good relative performance since 2010, as shown below with DFA’s funds. Given the lack of long-term data for emerging markets, it is certainly plausible that a small-cap premium will materialize over time.

 

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:

EM Investor Watch:

Technology Watch:

Investor Watch:

 

 

Putin’s Embrace of “One Belt, One Road”

The national identity of Russia is intrinsically tied to the mastery  of the Eurasian steppes, the grassland plains that  stretch from Hungary to Northern China. The territorial expansion of Moscow, from the 16th century onward, required  wresting control of the steppes away from the Mongols and securing the fertile black earth plains of modern-day Ukraine and Central Russia. The eventual collapse of the Mongol empire in the 17th century allowed the extension of the Russian empire to the pacific. Russian geo-political control over the steppes, Siberia and the Pacific coast has been largely uncontested for centuries.

However, the economic rise of China over the past decades and its increasingly outward-looking pretensions, as highlighted by President Xi Jinping’s ambitious “One Belt, One Road Initiative” (OBOR) changes everything for Russia.  While Russia has seen the steppes mainly for their value in securing geopolitical control of the Eurasian center, Xi envisions a return to the commercial dynamism of the historical Silk Road, which united the Far East with the Middle East and Europe for centuries, until the collapse of the Mongol empire. The Chinese have been aggressively executing Xi’s vision, building infrastructure to connect China with the West and becoming the largest investor in the natural resources of the former Soviet Republics.

Surprisingly, perhaps because of pragmatism and acceptance of Xi’s promise that the OBOR is aimed at benefiting all participants equally, so far there appears to be little resistance on the part of Russia to Xi’s grand and transformative plan. To the contrary, there has been a rapprochement between Putin and Xi, who have met on frequent occasions over the past several years. In a recent state visit to Moscow, Xi announced $10 billion in agreements for OBOR-related infrastructure investments and told the media that relations between the two countries were currently at their “best time in history” and that Russia and China were each other’s “most trustworthy strategic partners.”

Russia’s cuddling up with China is probably its best strategic option at this time. First, neither China nor Russia have to worry about business relations being undermined by volatile domestic politics or high-minded demands for human rights, and, in that sense, they see themselves as reliable partners. Second, both parties have an interest in weakening what they consider to be the arbitrary and hegemonic power of the United States. For example, both would like to see a weakening of dominance of the U.S. dollar and America’s discretionary control of the global financial system, so it is no surprise that Russia is accepting payment in yuan for commodities and that China is setting up a Petro-yuan-gold trading infrastructure in Shanghai and Hong Kong to facilitate non-dollar transactions.

Most importantly, however, is the fact that Asia will be the driving force of global growth and that its center of activity will be in China and its Far East neighbors. Driven by China, Asia’s share of world GDP will grow to 35% by 2022 (IMF forecast), and almost all of global growth in marginal output will come from Asia.  With its abundant energy, mineral and farm resources, Russia is best positioned to meet growing demand for natural resources in Asia.

A remarkable essay written by President Putin this week clearly states Russia’s current state of mind regarding Asia, and the seemingly total embrace of Xi’s OBOR vision. In a remarkable turn of events, Putin and Xi have become the defenders of open markets and predictable rules of commerce, in stark contrast to Donald Trumps “America First” ideology.

Putin writes: (excerpts, full note available here.)

“As a major Eurasian power with vast Far Eastern territories that boast significant potential, Russia has a stake in the successful future of the Asia-Pacific region, and in promoting sustainable and comprehensive growth throughout its territory. We believe that effective economic integration based on the principles of openness, mutual benefit and the universal rules of the World Trade Organization is the primary means of achieving this goal.

We support the idea of forming an Asia-Pacific free-trade area. We believe this is in our practical interest and represents an opportunity to strengthen our positions in the region’s rapidly growing markets. Indeed, over the past five years, the share of APEC economies in Russia’s foreign trade has increased from 23 percent to 31 percent, and from 17 percent to 24 percent in exports. We have no intention of stopping there…

On a related note, I would like to mention our idea to create the Greater Eurasian Partnership. We suggested forming it on the basis of the Eurasian Economic Union and China’s Belt and Road initiative. To reiterate, this is a flexible modern project open to other participants.

Comprehensive development of infrastructure, including transportation, telecommunications and energy, will serve as the basis for effective integration. Today, Russia is modernizing its sea and air ports in the Russian Far East, developing transcontinental rail routes, and building new gas and oil pipelines. We are committed to bilateral and multilateral infrastructure projects that will link our economies and markets — such as the Energy Super Ring that unites Russia, China, Japan and the Republic of Korea, and the Sakhalin-Hokkaido transport link.

We are particularly focused on integrating Russia’s Siberian and Far Eastern territories into this broader network. This includes a range of measures to enhance the investment appeal of our regions and to integrate Russian enterprises into international production chains.

For Russia, the development of our Far East is a national priority for the 21st century. We are talking about creating territories of advanced economic growth in that region, pursuing large-scale development of natural resources and supporting advanced high-tech industries, as well as investing in human capital, education and health care, and forming competitive research centers…

We intend to engage in substantive discussions on all these topics at the 25th APEC Economic Leaders’ Meeting this week. I am confident that, acting together, we will find solutions to the challenge of supporting the steady, balanced and harmonious growth of our shared region, and securing its prosperity. Russia is ready for such a collaborative effort.”

Fed Watch:

India Watch:

China Watch:

China Technology Watch:

  • Google tries to enter China again with AI Bloomberg)
  • How China will rate its citizens with AI technology (Wired)
  • China’s focus on practical AI application (Arxiv.org)

EM Investor Watch:

Technology Watch:

  • The power plant of the future is your home  (WEF)
  • The Future of the car, Bob Lutz (Auto News)

Commodity Watch:

Investor Watch:

  • ETFs are no bonanza for Wall Street (WSJ)
  • Jeremy Grantham, why this time is different (WSJ)
  • Isaac Newton’s lesson on financial gravity (WSJ)
  • Caxton Partners on macro investing (Bruce Kovner)
  • The frustrating law of active management (Thinknewfound)
  • Fees on active share eat up returns (Thinknewfound)
  • What makes a great investor (Macro-ops)
  • Buffett and the power of compounding (Collaborative Fund)

 

 

 

 

 

 

 

 

 

 

 

 

Emerging Markets Valuations in a Global Context

 

Successful investors are never shy to avoid expensive markets, preferring to build cash reserves to deploy when other investors are less greedy and more fearful. Much of the success of investors like Warren Buffett or Seth Klarman (Baupost) has come from having plenty of cash on hand when markets suffer cyclical downturns, like in 2000 and 2008. Klarman was once asked by a client why he should be paid his high fees for holding very large amounts of cash (sometimes well above 50%). His answer: “You are paying us to decide when to hold onto cash and when to invest.”

Well, it appears it may be happening again. It was revealed this week that Buffett’s Berkshire Hathaway holds over $100 billion in cash, and Klarman also has well over a quarter of his fund in cash.  Meanwhile individual investors have reduced cash to the lowest levels since the peak of the 2000 bubble.

Buffett and Klarman are not alone. It is commonly accepted by market historians, though certainly not by technicians and momentum traders, that the U.S. market is at very high levels. This view is based on the premise that market valuations mean-revert over time in a somewhat predictable fashion. Though valuations are by no means a timing instrument, they do have a good track record of predicting long-term (5-10 years) future returns. For example, Robert Schiller’s CAPE ratio (Shiller), which measures valuations based on 10-years of inflation-adjusted earnings, currently shows extraordinarily high levels, which at least in the past have been highly predictive of  low prospective returns.

Shiller CAPE Ratio

Crestmont Capital’s extremely thorough analysis of U.S. valuation (1926-2017) history points to a near certainty of lower than normal returns from current levels. Historical U.S stock market returns of 10.0%, came from nominal earnings growth (5.1%), price-earnings multiple expansion (0.6% annually, starting from a low level of 10.2 in 1926) and dividend yield (4.3%).  Annual Real GDP growth and inflation over the period averaged 3.3% and 2.9%, respectively, both of which are currently expected to be lower over the next ten years. The table below shows Crestmont’s absolute best case forecast for market returns for the next ten years to be in the order of 7.1%, well below historical levels. Earnings growth is optimistically assumed to grow 5.1%, in line with history, even though GDP growth and inflation are both likely to be lower. Price-earnings ratios are assumed to remain at the current very high levels. Dividend yield is determined by current valuations. Any contraction of PE levels or lower than historical earnings growth would result in lower returns.

The logic of Shiller’s CAPE and Crestmont’s analysis leads to forecasts of low expected returns for U.S. equities, and all other asset classes impacted by similar factors. For example, relying on historical analysis and reversion-to-the-mean assumptions, Jeremy Grantham’s GMO  (GMO) predicts abysmally low returns for almost all of the asset classes it follows.

Similar analysis produced by Research Affiliates points to equally poor results for the next decade: near zero real returns for U.S. stocks, 2%+ returns for international stocks and 6%+ stocks for emerging markets:

Both GMO and Research Affiliates highlight the relative attractiveness of emerging markets equities in a very low return world. An extended period of under-performance of emerging markets relative to the U.S. market in particular has created a significant gap for investors to exploit. Not only are emerging markets cheap relative to the U.S. and other developed markets, they also are inexpensive relative to their own history. On a cyclically adjusted basis (CAPE EM), valuations in EM are still below average and very far from historical peaks, in contrast to the U.S. which is well above average and near historical peaks. Price earnings ratios  for EM, are near historical averages, in a world where most asset prices are well above historical levels.

To conclude, a further comment on U.S. valuations is in order. It can be argued that current U.S. valuations reflect the reality of extraordinarily low interest rates. The puzzle lies in determining the cause of these low rates; is it Federal Reserve manipulation?; is it deflation caused by globalization and technology?; or does it point to low real growth in real GDP and earnings  in the future caused by demographics and low productivity? The answer to this puzzle will likely explain the short term course of the U.S. market.

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The geopolitical landscape of Asia Pacific is changing (WEF)
  • China’s ascent is slowing (Bloomberg)
  • China needs more reform to progress (Caixing)
  • Trump on the verge of trade war with China (Brookings)
  • Foreign tourists are shunning China (SCMP)

China Technology Watch:

  • China now has 751 million internet users (Caixing)
  • China is the next tech superpower (Diamandis)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch

  • Bangladesh’s rise to manufacturing powerhouse (FT)
  • Venezuela’s total collapse (Project Syndicate)
  • Venezuela was once Latin America’s richest country (WEFORUM)
  • Military unrest on the rise in Venezuela (Geopolitical Futures)
  • In Brazil highway robbery is a growth industry (Bloomberg)

Investor Watch:

Notable Quotes: (Avondale)

It’s a low return high risk world

  • “Markets normally respond to elevated uncertainty with lower asset prices and compensatorily higher returns. But that’s not what we are encountering today. We are living in a low-return, high risk world and an environment where most investors are happy to bear risk.” —Oaktree CEO Jay Steven Wintrob (Investment Management)

China is likely to lead the world in electrification

  • “China’s forecasted to lead the global trend in Powertrain electrification, representing over 50% of unit production in 2025, reflecting a 40 fold increase over today’s levels. We remain optimistic about the China market as a result of the underlying macro trends which include increased government focus on emissions regulations, which are increasing demand for China’s new energy vehicles” —Delphi CEO Kevin Clark (Auto Parts)

Australian Iron Ore is being sold to traders, not users

  • “what these guys are doing, these guys mean, for abundance of clarity, Fortescue, BHP and Rio Tinto, Vale and even the midget, Roy Hill, they sell to traders. And these traders do not have blast furnaces. They buy because it’s cheap to borrow money in Chinese banks. Then they put that iron ore in the ground, not in a blast furnace, at the port. And then they go back to the banks, and say, hey, I have collateral, can I borrow more? And the banker say, yes, and they borrow more, and they buy more for the same idiots…That’s my problem with the business in Australia. Then comes the question, will this be happening forever? Yes or no? Of course, the answer is no. One day, this bubble will burst. And on that day, people will say, oh, we are surprised that we are not seeing iron ore inventories going up.” —Cliffs Natural Resources CEO Lourenco Goncalves (Iron Ore)

Notable Charts: