Financial Bubbles in Emerging Markets – The Case of Brazil

The modern era of the emerging markets asset class began with the creation of benchmarks by the World Bank-IFC and Morgan Stanley Capital International (MSCI) in the late 1980s, which in turn led to gradual  participation first by institutional investors and later by retail investors. This brief period of 30 years for the asset class coincided with a period during which developed markets have experienced serial financial market bubbles,  including  the Japanese stock  and real estate markets (1990), the dot-com bubble (2000), the U.S. stock and real estate bubbles in 2007, and currently the Canadian and Australian real estate markets. Consequently, emerging market assets, which already have to contend with more volatile economies and fickle foreign capital flows, have also had to deal with the winding and unwinding of bubbles happening far from their own shores.

Bubbles are not always easy to identify and are only confirmed post-facto by a crash. So, for example, though Bitcoin may be a “crazy bubble,” we will know that for sure only if it eventually collapses.

Nevertheless, financial bubbles tend to have some common sources. They seem to originate in circumstances of technological breakthroughs (e.g.,19th century British railroads, the internet, bitcoin)  which engender great expectations of future profits. Also, they are often linked to periods of financial innovation/deregulation which lead to credit expansions and a sustained rise in asset prices (e.g. real estate, art, stocks).

Additionally, many bubbles are marked by opaque fundamentals. The more difficult it is to value an asset, the higher the propensity for prices to be determines by unfettered human imagination.

Emerging markets are subject to bubbles for all of these reasons. However,  several additional factors further increase the propensity for bubbles to develop  These include:

  • As many markets have short histories (eg., China, Vietnam) historical empirical data is lacking. Combining this with a high participation rate of new investors, the foundations for price discovery are poor.
  • Given the higher economic and currency volatility of many emerging markets and frequent boom-to-bust cycles, it is difficult for investors to maintain a firm grasp of “normal” valuations. This is further complicated by elevated currency volatility.
  • In many markets the marginal investor is often an opportunistic foreigner with low tolerance for losses; this results in few “firm hands,” and greatly enhanced volatility both on the up and downside caused by changes in the direction of liquidity flows. This is especially true in frontier markets (the second-tier of emerging markets), an asset class with a shorter existence and poorly-followed securities.

In a recent research paper from the Swiss Finance Institute, (Link) the authors studied 40 bubbles of the past 30 years, of which 19 occurred in emerging markets. The paper sought to establish increasing volatility as a predictor for the imminent collapse of a bubble but found no significant correlation. Also, the authors found that credit conditions varied considerably and that credit growth was not a necessary pre-condition for a bubble to develop.

Even if every bubble has its own particular characteristics, there do seem to be a few things necessary for a bubble to develop. Almost all bubbles in emerging markets seem to have been associated with a strong rise in expectations of future profits caused by either: 1. Political or Economic Reforms; or 2. financial deregulation (privatizations, bank reform, elimination of exchange controls). In turn, these changes in the domestic environment have usually caused large inflows of foreign capital and currency appreciation., both of which add fuel to the trend of rising asset prices.

The paper unfortunately covers only a minority of the stock market bubbles that have occurred in emerging market in recent decades. By my count, over the past 30 years there have been in the order of 45 single-country stock market bubble experiences, ending, on average, with a peak-to-bottom drawdown of -71.5% (in US$ terms). Three countries  – Brazil, Argentina and Turkey – have been the most prone to powerful boom-to-bust equity cycles. Over this period, Argentina and Turkey have each had six drawdowns of over 50%, the worst being 94% for Turkey in 2000.

These emerging market stock market cycles  can be characterized as bubbles because they are of enormous scale in terms of stock price movements and are generally triggered by a large, though ephemeral, increase in investor expectations. However, to a degree they are also simply the manifestation of the response of investors to boom-to-bust economic cycles in environments of fickle capital flows and high interest rates.

We now look in detail at the Brazilian experience.

The Case of Brazil

Brazil has experienced five enormous stock market “bubbles” since the 1970s, which amounts to one per decade.

  1. December 1967 – May, 1971.
    • Cause: enthusiasm for economic reforms leading to the “Brazilian Economic Miracle.”
    • 1,120.3% appreciation.
    • Subsequent correction of -77.61%
    • 4 years required to reach new highs.
  2. August 1983 – May 1986
    • Enthusiasm for political and economic reform.
    • 1,141.23% appreciation.
    • Subsequent correction of -88.1%
    • 6 years required to reach new highs.
  3. December 1987- October 1989
    • Temporary recovery, mini-bubble
    • 550% appreciation.
    • Subsequent correction of -87%
    • 2 years required to reach new highs.
  4. December 1990 – July 1997
    • Enthusiasm for economic reform.
    • 2,812.8% appreciation.
    • Subsequent correction of -88.1%
    • 1 years required to reach new highs.
  5. September 2002 – May 2008
    • Commodity boom and credit expansion
    • 1,912.6% appreciation.
    • Subsequent correction of -77.6%
    • Years required to reach new highs: unknown
  6. January 2016 – ?

What can we say about this recurrent pattern of “bubbles” in Brazil.

  • These great stock market surges are founded in Brazil’s volatile, boom-to-bust economic business cycle.
  • Brazil’s stock market has provided good returns over the past 50 years (compound annualized returns of 11.6% in US$), but with very high volatility. The market rarely trades on its trend line, but rather lurches from one side to the other. (See chart below).
  • Stock market cycles have been mainly caused by changes in economic policies, often triggered by political shifts.
  • Foreign capital inflows have certainly abetted stock prices moves both to the upside and downside, to one degree or another. Surges in stock prices are typically concurrent with large foreign capital inflows, which lead to currency appreciation and reinforcing positive feedback loops on the upside. The opposite occurs on the downside.
  • The last bubble cycle (2002-2008) was highly unusual, as it was not associated with political or economic reform. Quite the opposite, the boom defied a serious deterioration in both economic policy and political governance. This bubble seems to have been caused mainly by an expansion of credit and an appreciation of the currency brought about by the China-induced commodity boom and massive foreign capital inflows into Brazilian financial securities,
  • For the current surge in the stock market initiated in January 2016 to continue a new wave of political and economic reform will be necessary, since credit expansion and currency appreciation are already near their limits.

Fed Watch:

  • Gavekal view on the cycle, China, commodities and EM (CMG Wealth)
  • The Fed’s ammunition ran out (Zerohedge)
  • High Wages and high savings in a globalized world (Carnegie)

India Watch:

  • India’s demographic dividend (Livemint)
  • Modi’s make-in-India strategy (NYT)
  • Infosys to sacrifice margins for growth (Bloomberg)
  • Reset with China is a grand illusion (Livemint)
  • Gujarat plans world’s largest 5GW solar park (India Express)
  • Alstom and GE’s made-in-India locomotives (Swarajya)
  • Xiaomi’s made-in-India phones (Caixing)
  • India’s biometric data program growing pain (NYT)
  • 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’s big plans for Hainan include gambling (WIC)
  • China grants visa-free travel to Hainan (SCMP)
  • China’s economy is closing not opening (SCMP)
  • Qingdao Haier to list in Germany (Caixing)
  • JPM China stock investment strategy (SCMP)
  • Trade war ominous implications (George Magnus)
  • China airline threatens move to Airbus (SCMP)

China Technology Watch:

  • The O2O wars intensify (WIC)
  • US likely to block China tech M&A (Bloomberg)
  • The next Alibaba?(WIC)
  • Alibaba’s new Tencent-backed challenger (Seeking Alpha)
  • US moves to block China’s telecom hardware firms (NYtimes)
  • China is increasing state-oversight of tech firms (bloomberg)
  • Xiaomi’s internet strategy (SCMP)
  • What China wants to win is the computing war (SCMP)

Technolgy Watch

EM Investor Watch

  • Vietnam’s booming stock market (FT)
  • Vietnam’s socialist dream hits hard times (Asian Times)
  • Swedroe, don’t exclude EM (ETF.com)
  • EM markets are getting bumpier (bloomberg)
  • Van Eck’s EM strategy (Van Eck)
  • Saudi’s inclusion in EM funds (FT)
  • The case for Russian stocks (GMO)
  • Jeremy Grantham is still bullish on EM (Economist)

Investor Watch: