Learning to Love Volatility in Emerging Markets

Though economic and currency volatility may reduce the long-term sustainable GDP growth of countries like Brazil ( Brazil’s Economic Stagnation), paradoxically,  volatility is also the primary source of returns for the emerging markets investor. Economic booms, with rising stock markets and strengthening currencies, are invariably followed by busts, with collapsing markets and weaker currencies. For the investor who measures returns in dollar terms, the more volatile emerging markets provide turbo-charged results both on the way up and the way down. Learning to love that volatility is often the key to success.

Brazil is one stock market that is marked by enormous swings. Since 1990 Brazil has seen three market collapses; -88% in 1997, -76% in 2008, and -88% in 2011 (all measured in USD terms). Brazil also had a 80% collapse in the seventies and an 88% drawdown concluding in 1990. It seems that about once a decade, a period that should be well within a reasonable time horizon for most investors,  an investor in Brazil suffers  losses of between 80-90% in terms of U.S. dollars.. But Brazil is far from being unique in emerging markets in this regard. Since 1990, there have been 41 cases of a stock markets losing more than 50% of their value, with an average drawdown of 72%. Over this period, Turkey and Argentina are the champs, each experiencing six drawdowns of over 50%.

On the positive side, drawdowns are followed by bull markets, like day follows night. Over the next two and half years following the 41 market bottoms, investor see average returns of over 500%. Every Brazilian collapse has been followed by a extraordinary bull market:

  • 1983 bottom (-80%), followed by 14x return of capital
  • 1991 bottom (-87%), followed by 24x return of capital
  • 2002 bottom (-83%), followed by 17x return of capital

For the value investor, the brutality and frequency of emerging market drawdowns creates a dilemma. Value investors, indoctrinated by Warren Buffett’s consistent wisdom, believe in investing for the long-term. For example, two commonly cited quotes from Buffett are:

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 year;”

And “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”

An emerging markets investor could follow Buffet’s advice, patiently sitting through the drawdowns. By sticking with only the highest quality companies, the drawdowns can be minimized. The astute investor can also improve returns by trimming positions when valuations are high and taking advantage of market meltdowns to add to positions.

However, an alternative and often more productive better way to invest in emerging markets is to learn to love the volatility and skillfully harness it as the major source of returns.  Emerging markets, like commodities, often experience extreme cyclicality with predictable patterns. Investors that are aware of the patterns, can exploit them repeatedly. As commodity markets investor Martin Katusa says, investors in markets characterized by extreme cyclicality can best be “be approached with a ‘rent, don’t own” mentality.”

A strategy which may be anathema to value investors but is very effective in emerging markets and commodity investing is to marry a valuation process with basic trend-following techniques. An investor can patiently wait for a market to meltdown and then watch like a hawk for an entry point to ride the inevitable bounce-back. Typically, good entry points are created when a market has reached extraordinarily low valuations and is showing signs of trending up. Market bottom valuations, in my view, are often signaled by cyclically adjusted price/earnings ratios (like the CAPE Schiller ratio), which should be dollarized to fully measure the volatility of the markets. Timing decisions can be influenced by simple trend-following indicators, like the 50-day or 200-day moving average.

The advantage of patiently waiting for markets to bounce back before deploying capital is that the investor does not experience massive losses of capital on the downside. The absolute investor without concern for benchmarks is in a better position to do this than most institutional investors who are not willing or permitted to stray from their benchmarks for long periods of time.

Us Fed watch:

Brazil Watch :

  • China’s Fosun looking at Brazil Healthcare (SCMP)
  • IMF On Latin America Currency Flexibility ( IMF)

Mexico Watch:

  • WEF Tourism Competitiveness Report shows Mexico’s Rise (WEFORUM)
  • Mexico’s surprising oil finds (NY Times)

India Watch:

China Watch:

  • Mark Mobius on China  (Templeton)
  • Beijing’s New Airport (Caixing)
  • Xi Jinping’s War on Financial Crocodiles (FT)

China Technology Watch:

  • Chinese train maker expands U.S. market  (China Daily) 
  • China Launches new generation bullet train (WIC)
  • Beijing Subway Blocks ApplePay WIC
  • JD.COM invests in drone delivery (China Daily)
  • China plans $108 BB investments in chips (WSJ)

China Consumer Watch:

  • China’s Hisense wins sponsorship for FIFA 2018 (China Daily)
  • China rises in global tourism competitiveness (China Daily)

Korea Watch:

Eastern Europe Watch:

  • Poland is breaking out of the Middle-Income Trap (NY Times)

Commodity Watch:

  • Oil’s Game of Chicken; Can OPEC Finally Bankrupt U.S. Production (Seeking Alpha)

Anti-Globalization Watch:

Emerging Markets Investor Watch:

Guru Watch:

  • An Interview with Peter Bernstein (Jason Zweig)
  • Chano’s sees weak U.S. economy (Inetenomics)Notable Charts:
  • China Inverted yield Curve signals slowdown
  • Commodities at record low valuations relative to the S&P 500

Notable Quotes:

  • When markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.” (Bob Rodriguez – We are witnessing the development of a “perfect storm”(seeking alpha)

“Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepted theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.” (Robert Schiller)

 

 

 

 

 

 

 

 

 

 

 

 

Brazil’s Economic Stagnation

Brazil is a poster child for the “middle-income trap,” the phenomenon that keeps developing economies from narrowing the wealth gap with wealthy countries once they have reached a moderate level of prosperity. As is typical for many emerging market countries which are over-dependent on commodity exports and foreign capital inflows, the Brazilian economy experiences frequent boom-to-bust cycles, the latest being the commodity/liquidity/credit-fueled consumption boom of 2003- 2013 which was followed by a deep recession in 2014-2017. The overall result is mediocre growth. Brazil’s GPD per capita relative to the high-income economies is at the same level as in 1960, and actually has deteriorated significantly since the late 1970s.

A recent paper by Jorge Arbache and Sarquis J. B. Sarquis, Growth Volatility and Economic Growth in Brazil (Arbache-Sarquis) argues that Brazil’s poor performance is tied to the high volatility of the economy which in turn is caused by uncertain commodity prices and capital flows and their effects on currency valuation. It makes intuitive sense that volatility would hurt growth; boom-to-bust cycles are inefficient, as economic agents over-indulge in good times and retreat in bad times. Volatility also makes it difficult for both the public and private sector to plan and budget long term investments.

Brazil’s economic volatility is caused by well-known factors:

  • Chronic low savings and high current account deficits financed by fickle foreign capital flows.
  • Exports dominated by commodities, and the current account highly impacted by commodity prices. High commodity prices improve the current account which lowers country risk premia and leads to higher foreign financial and investment When commodity prices fall, the process unwinds.
  • Pro-cyclical currency valuation. The currency appreciates during good times and weakens during busts. During currency appreciations manufacturers lose export competitiveness and focus on growing domestic consumption.
  • Monetary policies dictated by the U.S. Fed. The deep recession of 1981-83 was triggered by U.S. Fed Volcker’s high interest rates imposed to wage his war on inflation. The boom of the last decade was fueled by Fed-fueled global liquidity.
  • Pro-cyclical fiscal and monetary policies; fiscal expansion during booms and retraction during busts. During the current deep recession in Brazil, the authorities have both increased real interest rates and tightened fiscal spending.
  • Chronic fiscal imbalances cause uncertainty and high country risk premia.

The current boom-bust cycle has been particularly destructive for Brazil. The china-induced commodity boom caused excessive currency appreciation, a credit-fueled consumption surge and severe deindustrialization.  In sharp contrast to successful Asian economies that have promoted the exports of manufactured goods, Brazil has evolved prematurely into a service economy. 76% of jobs in the Brazilian economy are now generated by the service sector, and the great majority of these jobs are low-skill, low wage jobs. Manufacturing’s share of GDP has fallen from 34% in 1980 to 10% in 2015, and Brazil has become increasingly dependent on commodity exports.

Brazil’s Central Bank has pursued inflation-targeting, the latest fashion for global monetary authorities, with abandon. During the past decade and especially the past three years of deep recession, Brazil has consistently had the highest real interest rates in the world. The famous dictum voiced by former Finance Minister Mario Henrique Simonsen  — “A inflação incomoda, mas o câmbio mata (Inflation bothers but the foreign exchange rate kills.“ ) has been entirely forgotten.

How can Brazil avoid boom-bust cycles in the future? As Arbache and Sarquis state in their paper, given Brazil’s history it is better to aim to grow in a stable and sustained manner than to seek high rates of growth. Solving chronic fiscal and foreign account imbalances are at the center of any reduction in volatility. On the foreign account side, it would be imperative for Brazil to maintain a competitive currency to promote domestic manufacturing and gradually diversify from commodities.

However, Brazil’s poor economic performance is only partially explained by volatility. More importantly, Brazil does poorly in human capital development and in providing a good environment for business. Steady improvement in both these areas would boost sustainable growth. Unfortunately, Brazil has shown no progress in these areas. Its ranking in the United Nations Human Development Index has fallen from 69 to 79 over the past 15 years. Ditto for the World Bank’s Doing Business survey which ranks countries in terms of the quality of the regulatory and institutional framework for business and where Brazil has shown no progress whatsoever.  Brazil ranks a miserable 123rd on the list, lower than 119 in 2006, and the worst performing of the major emerging markets except for India.

 

Us Fed watch:

Brazil Watch :

India Watch :

China Watch:

  • Beijing’s New Airport (Caixing)
  • Xi Jinping’s War on Financial Crocodiles (FT)

China Technology Watch:

  • China aims to be a leader in 5G  technology (WIC)
  • China Shows off New Generation of High-Speed Trains (Caixin)
  • CRRC Wins Train Supply Deal in Montreal (Caixin)
  • Chinese Phones Take over Indian Market (SCMP)

China Consumer Watch:

  • China’s aging (Bloomberg)
  • P&G Refocuses Strategy on Premiumisation ( SCMP)

Eastern Europe Watch:

Poland is breaking out of the Middle-Income Trap (NY Times)

Commodity Watch:

  • Oil’s Game of Chicken; Can OPEC Finally Bankrupt U.S. Production (Seeking Alpha)
  • Will U.S. Drillers Drive Oil Prices Into the Ground (Fed Up)
  • Temasek on Chinese Overinvestment (CNBC.com)
  •  China’s Steel Overcapacity (Peterson Institute)

Technology Disruption Watch:

Anti-Globalization Watch:

Emerging Markets Investor Watch:

Notable Blogs:

Notable Quotes:

“The biggest unknowable is that you have the illusion of liquidity. You have people who promise overnight liquidity that have taken quite illiquid positions, particularly lending to various entities. As long as the party continues that’s fine, but should this liquidity be tested it’s not going to be as deep as people think.” – Mohamed El-Erian

“When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.” (Bob Rodriguez – We are witnessing the development of a “perfect storm”(seeking alpha)

“Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepte theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.” (Robert Schiller)

China, the Middle Income Trap and Beyond

Emerging market countries can be categorized according to the level of prosperity achieved by their populations.  Generally, poor countries, with lower GDP per capita, should grow faster than richer countries, as they adopt well-known technologies to boost productivity. Assuming a stable social and political environment and basic legal and economic conditions, high growth, driven by urbanization and basic manufacturing, can be achieved for long periods. India and Indonesia, for example, today are in this “catch-up” phase, growing their GDP at well above average global rates. China has achieved phenomenal growth since it launched economic reforms in the late 1970s, following the path previously taken by its neighbors South Korea, Taiwan and Japan.

However, once middle-income status has been achieved most countries are unable to further reduce the gap with the United States and the other highly developed countries. This is called the “middle-income trap.” Aside for a few city-states (Singapore and Hong Kong) and oil-rich sheikdoms,  few  have broken the trap.  The exceptions may be Taiwan, South Korea and Israel. These three have benefited from a special relationship with the U.S. hegemon and successfully pursued education-intensive, high-tech strategies. On the other hand, some countries regress after reaching middle-income level; Argentina, Venezuela and South Africa are examples of this. Brazil is another worry; it has grown GDP/capita at less than 0.9% per year since its “miracle” came to an end in the late 1970s.

China clearly sees itself following the path of Taiwan and South Korea. Though it will not enjoy U.S. support, some indicators point to good prospects.

For  a middle-income country to sustain high growth it needs to move up the value chain which means higher innovation and productivity, which requires a highly educated workforce. The Global Innovation Index ranks countries in terms of their innovative capacity and has been doing this for 10 years using the same methodology. In its 2017 report, GII highlights the stagnation of middle-income countries in bridging the gap with rich countries, but singles out China as the exception. GII ranks China as the 22nd most innovative economy, closing in on the elite. This compares to its 37th ranking in the 2008 GII report

China’s growing capacity to innovate is confirmed by its increase in patent filings. In fact, according to the World Intellectual Property Organization (WIPO),  in 2016 China filed for over 38% of international patents, surpassing the  United States with 20.4%.

The OECD Program for International Student Assessment (PISA)  evaluations point to China’s spectacular rise in science and technology and give credence to its ambitions. According to the 2015 PISA report, the most developed parts of China, as represented by Beijing-Shanghai-Jiangsu-Guangdong, already score in line with the best Asian performers and well above the United States and European levels, particularly in mathematics.

Chinese policy makers are well aware of the “middle-income trap,” and are determined to avoid it. The legitimacy of the authoritarian political regime to a degree rests on its ability to sustain growth and rising living standards. That is why promoting innovation was given the highest priority in the governments 13th Five-Year Plan for Economic and Social Development, 2016-2020, and a commitment was made to harness resources to achieve breakthroughs in key technologies. The 13th plan goes so far as to specify the technologies that China must dominate and makes an explicit commitment to provide the financial and institutional support to promote success.

 

Us Fed watch:

 

Brazil Watch :

India Watch :

China Watch:

Xi Jinping’s War on Financial Crocodiles (FT)

China and Africa (Mckinsey)

China Technology Watch:

China Shows off New Generation of High-Speed Trains (Caixin)

CRRC Wins Train Supply Deal in Montreal (Caixin)

Chinese Phones Take over Indian Market (SCMP)

Tech Titans in China Take Battle to a New Frontier (Bloomberg)

 

China Consumer Watch:

  • P&G Refocuses Strategy on Premiumisation ( SCMP)

 

Commodity Watch:

  • China Scap Metal Exports Balloon (Caixin)
  • “The mining methods of the past have changed. And where we’re controlling mines from for the future from pit support is located in office buildings instead of the mine sites…I was talking to a customer last week about autonomy and they have a goal to be fully autonomous on every mine site by 2025. And they have thousands of pieces of equipment. So, you’ve got these bold goals being placed out there. So, clearly, the momentum is moving.” —Caterpillar Resource Industries President Denise Johnson (Mining)
  • And this chart from Martin Katusa shows how weak demand and declining production costs lead to low prices, and commodity prices at all-time lows relative to the S&P 500.

  • The Collapse of South Africa’s Mining Sector Valuewalk

Technology Disruption Watch:

Anti-Globalization Watch:

 

Notable Blogs:

 

Notable Quotes:
• “Xi’an only has a little over 40 Starbucks at the moment. This is definitely not enough. I think 400 would be more appropriate.” Wang Yongkank, Party Secretary of Xi’an, as reported by Week in China.
• “The reality is that as a planned economy and with the government having control of the major banks and large companies, a financial crisis is simply not in the cards.” Mark Mobius, Templeton Investments on China.

The Case for Emerging Markets

Warren Buffett and Jorge Paulo Lehman, two of the best investors of the past decades, recently met with students at a conference at the Harvard Business School organized by Brazilian business students. Asked for their opinion on opportunities for investing in emerging markets, both Buffett and Lehman deflected the question, preferring to highlight a preference for the depth and wealth of opportunities available in the United States. “If we’re going to prospect,” Buffett said, “this is a huge, huge market, and if there is something modestly better where I don’t understand the culture that well or the laws of have an acquaintance with the business people and were missing that that doesn’t bother me at all.” “America”, he added, “is a pretty darn good place to invest.”
Should the individual investor follow the advice of the Sage of Omaha? Surely there is wisdom in investing in things that one understands, and the dynamism and diversity of the American capital markets are unsurpassed. Yet, there is a good case for allocating some capital outside the United States.
When Buffett started investing in the 1950s and 1960s the U.S. was a global hegemon with a preponderant economy and matchless capital markets, but today the global economy is increasingly driven by Asia. Aging populations, low productivity growth and high levels of debt in the U.S. and other developed countries point to slower growth than in the past. Younger populations and more opportunities for increasing productivity mean that emerging markets can count on relatively higher economic growth and expanding capital markets. Most of the wealth creation in the world today is being generated in Asia. Many traditional industries, such as oil and electricity, face declining volumes in developed markets, and will rely entirely on emerging markets to sustain any growth.
In addition to providing investors the opportunity to tap into the faster growing economies of the world, Emerging markets provides the investor with some diversification, the only “free lunch” in the investing world.
Notwithstanding Jorge Paulo Lehman’s appreciation for the depth and scale of the U.S. capital markets which he now finds indispensable to deploy the fire-power of 3G Capital, his partnership continues to treasure its Brazilian roots. The beer and food empire which now includes Budweiser and Kraft all started from nothing some 30 years ago in Brazil, and even today the group harnesses the best of Brazilian entrepreneurial creativity and dynamism. After the recent merger of ABInBev and SABMiller, Lehman’s beer juggernaut will have more than half of sales and practically all of its growth generated by its breweries in emerging markets. As Lehman told the Harvard students, though “America is wonderful compared to the rest of the world,” beer is not growing in developed markets, so ABInbev has gone to Africa in “a big way” where “there is a hot climate, young population” that will double from 1 billion to 2 billion in the next thirty years. AbInBev now has six of the top ten best-selling beer brands in China, the largest potential source of earnings growth for the global beer industry in the coming decade, and near-monopolistic positions in the African and Latin American continents.
This blog will explore the opportunities for investing in emerging markets created by entrepreneurs like Jorge Paulo Lehman. It will seek to educate the common investor about the main trends in these markets and explore the controversial issues that affect the investor in emerging markets.

Us Fed watch:
• Ady Barkan sees changes coming at the Fed (Fed Rethink Coming ).
• Ben Hunt on who is master of the FED( Tell My Horse).
• Larry Summers on Why the Fed is making a mistake(Larry Summers)
• Unprecedented valuations of financial assets (The Felder Report).

Emerging Markets Watch :
Bloomberg says BRICS are back in favor. (Bloomberg)

Brazil Watch :
• Brazil’s Argentina Moment Project Syndicate

India Watch :
• A New Emphasis on Gainful Employment In India McKinsey

• India’s PayTM said to seek license to offer money market fund. Bloomberg

China Technology Watch:

• China Shatters “Spooky Action at a Distance” Record, Preps for Quantum Internet  Scientific American

Commodity Watch:
• “The mining methods of the past have changed. And where we’re controlling mines from for the future from pit support is located in office buildings instead of the mine sites…I was talking to a customer last week about autonomy and they have a goal to be fully autonomous on every mine site by 2025. And they have thousands of pieces of equipment. So, you’ve got these bold goals being placed out there. So, clearly, the momentum is moving.” —Caterpillar Resource Industries President Denise Johnson (Mining)
• And this chart from Martin Katusa shows how weak demand and declining production costs lead to low prices, and commodity prices at all-time lows relative to the S&P 500.

• Fear is What Changed Saudi Arabia (WSJ)
• “You go to Asia. You go to Europe. You go to the Middle East. They realize the position of the U.S. in the world is different today because of this change in our energy position. Among other things, the sanctions on Iran would not have worked had it not been for shale, because you could not have replaced the Iranian oil that was taken off the market. And so now instead of just OPEC and non-OPEC, you have the big three. You have Saudi Arabia, you have Russia, and you have a country called the United States.”— Daniel Yergin, vice chairman, IHS Markit (WSJ)
• Measuring Labor Productivity in the Gold Mining Industry S&P Global Market Intelligence
• The Collapse of South Africa’s Mining Sector Valuewalk

Technology Disruption Watch:
• Amazon’s New Customer  Stratechery
• Why Amazon Bought WholeFoods L2

Anti-Globalization Watch:
• Commerce Secretary Wilbur Ross Talks Trade  WSJ

Notable Blogs:
• On My Radar: Investment Ideas — Notes from the 2017 Strategic Investment Conference   CMGwealth
• Peak Stimulus has Passed  CreditBubbleBulletin
• Yardeni on tech valuations Yardeni
• On momentum investing and buying all-time highs. Of dollars and data

Notable Quotes:
• “Xi’an only has a little over 40 Starbucks at the moment. This is definitely not enough. I think 400 would be more appropriate.” Wang Yongkank, Party Secretary of Xi’an, as reported by Week in China.
• “The reality is that as a planned economy and with the government having control of the major banks and large companies, a financial crisis is simply not in the cards.” Mark Mobius, Templeton Investments on China.

Notable Chart from Gavekal Research