The “Value” Opportunity in Emerging Markets

Investors categorize themselves as either in the “value” or “growth” camps. The “value” followers focus on stocks that are overlooked by investors and judged to be temporarily mispriced: this is akin to finding $100 bills on the sidewalk or, as value guru Ben Graham described it, picking up  “cigar butts” with one puff left in them. The “growth” proponents, on the other hand, look for companies with bright long-term prospects and the potential for compounding cash flow streams.  While value investors find the future to be opaque, growth investors visualize huge bonanzas on the horizon. Because growth investors see the future as much better than the present, they are happy to pay higher multiples on current earnings and owner’s equity (book value). Because of this, the investment industry has generally categorized “growth” stocks as those with high valuation multiples (price-to-earnings and price-to-book) relative to the market.

Looking at the historical record, “value” stocks have provided better returns than “growth” stocks. This is known in academia as the “value premium” and is attributed to value stocks being underpriced because they are riskier and unpopular while “growth” stocks are overpriced because of their notoriety and bright prospects. Glamorous growth stocks are sometimes compared to “lottery tickets” as they can generate the excitement of a potential huge pay-off in the future. One of the main features of “growth” stocks is that they benefit from low interest rate environments, such as the one we are currently experiencing; this is because the huge future pay-offs investors are counting on can be discounted at lower rates and are therefore worth much more.

Though the value premium is well-documented by academics and is persistent over time and geographies, it will not prevail at all times.  In fact, any “factor premium,” or for that matter any investment strategy,  will go through valuation cycles, from cheap to expensive and back again. Over the past decade, value has been in a severe declining cycle, becoming gradually cheaper relative to the market, setting itself up for another opportunity for investors to harvest premia.  The cyclical evolution of value over the past forty years is well depicted in the chart below from the asset-manager GMO, which shows that currently in both developed and emerging markets “value” is priced at a deep discounts to the market.

Value stocks in the U.S. have underperformed 9 of the past twelve years for an average of 2% annually, one of the longest losing streaks ever recorded. Over the past ten years, in non-U.S. developed markets and in emerging markets annualized value returns have lagged the market by 1.6% and 1.1%, respectively.

Predictably,  as “value”  has become cheaper it has also become less popular with investors. Over this period, assets in value funds have declined sharply relative to the market. In emerging markets, the decline of value has been particularly severe.

Historically, value investors have had a big role in emerging markets. Particularly in the 1990s, stocks in emerging markets were very inexpensive and in a process of re-rating in response to market reforms, privatizations and capital inflows. However, since the 2008 financial crisis, low GDP growth, reform-fatigue and the rise of the tech sector in Asia has changed the dynamics in favor of growth, both in developed and emerging markets. This has resulted in a sharp decline in “value” funds, with many losing assets and shutting down. Interestingly, in the ETF space, which is where almost all marginal flows have gone to over this period, there is not one traditional value fund offered.  Instead, the vast majority of assets are flowing into capitalization-weighted indices (MSCI EM, FTSE). Taking the place of “value,” the industry has promoted RAFI and multi-factor “smart-beta” ETFs.  RAFI, which stands for Research Affiliates Fundamental Index, is a partial “value” substitute to the extent that position sizes are determined by fundamental factors (sales, cash flow, book value and dividends) in contrast to the capitalization-weighted method most commonly used.  Multi-factor “smart-beta” funds, on the other hand, use a mix of “factors” such as price-momentum, sales growth, “quality” and low-volatility in addition to traditional value measures.

Assuming that markets and valuations will continue their historical patterns of mean-reversion, the current opportunity for outsized returns in emerging markets “value” stocks is substantial. Emerging Markets by themselves are already very cheap relative to developed markets, so the deep discount of the value segment provides a significant opportunity for extraordinary returns. Those few remaining funds that still specialize in buying discounted “value” stocks are likely to enjoy a very good run as other investors and ETFs start chasing the return of the “value” premium.

However, a word of caution is warranted. Value stocks are usually cheap for a reason and this is tied to the more problematic and stressed nature of the companies (e.g., more debt, cyclical margins, vulnerability to economic downturns). Given the current global slow-down and the rising risk of U.S. recession, “value” may still have another leg of underperformance. The currently undergoing and expressive decline of global interest rates also continues to favor long-duration “growth” stocks. In short, value may have to wait a while longer, but this will only make the upcoming opportunity even greater.

Trade Wars

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

 

  • The rise of factors in the China A share market (MSCI)
  • How does factor investing work in China (Indexology)
  • How smart-beta strategies work in China (Savvy Investor)
  • China’s healthcare sector (globalx)
  • China’s Communication Services Sector (globalx)
  • China’s rare earths strategy (China File)
  • China-India relations are stressed (Carnegie)
  • China opens yuan commodity futures (SCMP)
  • China’s private firms struggle under Xi regime (PIIE)
  • Chinese quants (Bloomberg)
  • Oddities of the Chinese stock market (Bloomberg)
  • China’s quant Goddess (Bloomberg)
  • Guide to Quant Investing (Bloomberg)
  • China is a stock picker’s paradise (WSJ)
  • China’s middle-income consumer (WIC)

China Technology

  • Inside China’s biopharma market (McKinsey)
  • China’s food delivery war (Bloomberg)
  • How China took the lead in 5G technology (WP)
  • China’s MIC 2025 plans are roaring ahead (SCMP)
  • China’s EV future (The Econoist)
  • China’s EV bubble (Bloomberg)

Brazil Watch

 

EM Investor Watch

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Mary Meeker’s Internet Trends report (techcrunch)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

 

 

 

 

Are Emerging Markets Stocks a Viable Asset Class?

It is a basic fact of investing that stock market returns are determined by earnings growth and the multiple that investors will pay for them. Over time corporate earnings generally grow in line with GDP growth, while the multiple put on earnings varies depending on how fearful or optimistic investors may be. Stock valuations may also be impacted by the cost of capital, so that investors will pay higher multiples on earnings when interest rates are low and vice versa. These relationships apply across all geographies, including emerging markets.

Valuations in emerging markets have persistently been lower than in the U.S. and other developed markets even though emerging market economies grow at nearly three times the rate. Relatively low valuations and high GDP growth are the perennial selling points for investing in EM stocks. However, at least for the past decade, returns in EM have lagged well behind those for U.S. stocks, and, understandably, this has raised concerns about the viability of the EM asset class.

However, there are good reasons to believe that the poor performance of EM stocks is temporary. Explanations for weak EM returns point to cyclical and circumstantial causes that should eventually revert.

First, the valuation gap between emerging markets and the U.S, market has widened considerably over the past ten years because of structural issues which are probably temporary. While EM stock markets continue to be dominated by low-growth capital intensive sectors (e.g. banking, manufacturing and natural resources), the U.S. stock market has been driven by “growthy” capital-light companies (e.g. Facebook, Apple, Netflix, Google). “Growth” stocks are long-duration assets (i.e., The concentration of cash flow and dividend payments are in the distant future) and therefore they benefit from the low discount rates implied by the current low inflation and  low interest rate environment. Concurrently, the combination of low-growth/low investment with historically low interest rates in the U.S. has resulted in unprecedented stock buy-back activity by U.S. corporations over the past seven years. This structural cause of EM underperformance is largely the same that has led to the poor relative returns of “value” vs. “growth” investing in the U.S. and global markets, since value stocks are also “short-duration” investments.

This importance of buy-backs is highlighted in a recent paper from analysts at ADIA, the Abu Dhabi Investment Authority (“Net Buy-Backs and the Seven Dwarfs”, Link). The ADIA researchers looked at the MSCI All Country World Index (ACWI) for the 1997-2017 period and determined that the primary determinant of country-specific returns was net buy-back activity (NBB), a measure of the net increase in issued stock in a market (e.g., IPOs, delistings, corporate buy-backs, mergers and acquisitions). Depending on the nature of the NBB, it may enhance or take away from shareholder returns. Markets where companies constantly issue stock –  either because they are in low-return capital-intensive businesses or because they lack capital discipline and shareholder alignment – do poorly. In this regard, the data shows evidence that poor corporate governance manifested by undisciplined capital management has suppressed returns in EM, with the result that earnings have grown at a rate well below GDP growth.

Over the period covered by the study this has especially been the case in China where huge and overpriced initial public offerings (IPOs) of state-owned companies (SOEs) have severely  hurt shareholder returns. The Philippines, Indonesia, Chile, Russia and Thailand have also suffered from negative effects of NBB. The data on NBBs for emerging markets from the ADIA study is shown in the chart below. NBBs had a an average negative 3.4% impact on annualized returns, with less than a third of EM countries showing positive NBBs. Given that stock buy-backs are rare in EM, those countries showing positive NBBs had this as a result of M&A activity and delistings (e.g., ABInbev’s takeover of Modelo in Mexico). The study’s total sample of 41 countries had a negative 2.2% impact on annual returns, slightly above the U.S. market’s negative 1.8%. Interestingly, NBBs for the U.S. market become hugely positive over the 2009-2019 decade and are a major reason for U.S. stocks outperformance over this period.

The second reason for the underperformance of EM stocks over the past decade is the mean-reversion of both valuations and the U.S. dollar.  The charts below show (left) the relative performance of the FTSE EM Index (VEIEX) and the S&P 500 (SPY) over the past twenty years and (right) the EM MSCI Currency Ratio which is the performance of the currencies in the EM stock index relative to the USD. The twenty-year period is neatly divided into the first 10 years of EM stock outperfomance and dollar weakness and the following ten years of EM stock weakness and USD strength.

The strength of the dollar has been a major headwind for EM stocks over the past ten years, reducing returns by 3% annually, as shown below.

Over this period, valuations in EM and the U.S. market follow highly divergent paths. The chart below shows the evolution of valuations for both markets using cyclically inflation-adjusted price-earnings ratios (CAPE), a measure that smoothes out earnings and provides a better basis for comparison. EM started with a very low CAPE ratio of 9.2x in 1999, which rose sharply to 19.6x in 2009 (after reaching a peak of 30x in 1997) and then falls back to 11.5x in 2019. S&P500 valuations start at a bubble -level ratio of 42x  in 1999, fall by half to 20.5x in 2009 and are currently at 29x today.

Conclusion

The outperformance of the U.S. market over the past ten years can be attributed to circumstances that are probably temporary. U.S. returns were boosted by the relatively low level of initial valuations 10 years ago, historically low interest rates over the period, buy-backs and a strong dollar. On the other hand, EM returns have been hurt by relatively high initial valuations, a strong dollar and negative net buy-backs. Predicting the next ten years is a fool’s errand, but low valuations, a weakening dollar and relatively high GDP growth may put the odds in favor of EM stock outperformance.

Trade Wars

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

  • China’s rare earths strategy (China File)
  • China opens yuan commodity futures (SCMP)
  • China’s voracious appetite for Russia’stimber (NYT)
  • China’s  control of the lithium battery chain (FT)
  • Australia turns to China (NYT)
  • China’s private firms struggle under Xi regime (PIIE)
  • Chinese quants (Bloomberg)
  • Oddities of the Chinese stock market (Bloomberg)
  • China’s quant Goddess (Bloomberg)
  • Guide to Quant Investing (Bloomberg)
  • China is a stock picker’s paradise (WSJ)
  • China’s middle-income consumer (WIC)

China Technology

Brazil Watch

EM Investor Watch

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

 

 

 

 

Asset Management Fees are Moving Towards Zero

The individual investor in the United States has never had it easier, at least when it comes to the expenses incurred to get broad exposure to the global stock and bond markets. The common investor now pays fees which are a fraction of the cost paid a few decades ago, and every year fees fall further.  The collapse in fees has transformed the business of asset management in the United States, leading to a decline in active management and persistent concentration of assets in fewer firms. These trends are fast spreading to Europe and developed Asia. Inevitably, they will soon reach markets like India and Brazil, where powerful incumbents are still able to charge their clients 2-4% of assets under management .

The evolution of the industry is well described in The Investment Company Institute’s Factbook (2019 ICI Factbook), a compendium of data on the investment industry in the United States.

 

The Shift from Active to Passive

The primary shift in the asset management industry has been from high-cost actively managed products to low-cost indexed products in the form of both mutual funds and ETFs (exchange traded funds). As shown in the chart below, about 1.5 trillion dollars in actively-managed funds have been replaced by indexed-products.

Persistent Reduction in Fees

The expense incurred by investors in funds have fallen every year, from nearly 1% of assets in 2000 to 0.55% in 2018. The average fee charged by funds has fallen from 1.60% to 1.26%, but assets are increasingly  migrating  to low-cost providers like Vanguard and Charles Schwab. The industry is rapidly consolidating in fewer players. Many active managers are closing funds after milking their client-base for as long as possible. The final destination of this process is likely to be a few very large low-cost providers and a limited amount of highly skilled active managers still able to charge fees above 1% of assets under management.

The data is further broken down in the chart below. The key data point to focus on is the asset-weighted cost of indexed mutual funds which was 0.08% in 2018. These funds are weighted heavily towards  U.S. large capitalization stocks, a category which is seeing fees move to zero (made possible by stock-lending revenues received by the fund manager).

 

Chinese quants (Bloomberg)

Oddities of the Chinese stock market (Bloomberg)

China’s quant Goddess (Bloomberg)

Guide to Quant Investing (Bloomberg)

Trends Everywhere (AQR)

Ten bits of advice from Buffett (Seeking Alpha)

Value + Catalyst: the Gazprom case (Demonitized)

Latin America’s missing middle (McKinsey)

China’s  control of the lithium battery chain (FT)

 

Domestic Capital is Fleeing Emerging Markets

Plutocratic elites in emerging markets often “hedge” their bets by funneling financial assets out of their home countries into “safe havens” such as Switzerland and the United States. Maintaining bank accounts and second homes offshore and educating their children in foreign schools provides an insurance policy to protect against eventual political and economic turmoil at home.

In recent years this “keeping-one-foot-out-the-door” mentality seems to have spread dramatically since the great financial crisis. Slowing global growth and high risk-aversion have contributed to the strengthening of the U.S. dollar and the rise of dollar-denominated assets. This period has seen the rise of several very large new contributors, namely China, Turkey and Brazil, to the migration of wealth to safe-havens..

Not one of these countries played a big role in flight capital in the past. Rich Brazilians, for example, historically have had a preference for high-yielding domestic bonds and local real estate, unlike their fleet-footed Argentine neighbors who for decades have taken their assets offshore. But today, these countries are the primary drivers of capital migration. If you add the South Africans, who have been systematically moving both their assets and brain-power out of the country for decades, all of the BRICS (Brazil, Russia, India, China and South Africa), the supposed engines of emerging markets, are seeing persistent capital flight. India is possibly an exception, only because wealth creation is still greater than the funds leaving the country.

The anecdotal evidence on this is overwhelming. Chinese buyers are reported to have spent around $200 billion on foreign real estate in 2018 ($32 billion in Australia alone) and are the major drivers of real estate markets in popular destinations such as Sydney and Vancouver. Russian are known to favor Dubai, Cypress and London; and Brazilians love South Florida, Lisbon and New York. Realtor transaction data point to one-third of total real estate transactions in Lisbon and Vancouver being transacted by Brazilians and Chinese buyers, respectively.

Afrasia Bank’s “Global Wealth Migration Review 2019”( Link ) a compilation of data on the transaction flow of wealthy individuals around the world, provides some color on recent trends in capital flight. The report estimates that in 2018 108,000 High Net Worth Individuals (HNWI) with net assets above $1 million emigrated from their home countries, mainly emerging markets.

The map below, prepared by VisualCapitalist.com, graphically shows the origin and destination of migrant flight capital using Afrasia’s data.

More detailed data on the origin and destination of flows is shown below. A few destinations are highly preferred as safe-havens, with Australia, the U.S., Canada, Switzerland and the U.A.E. receiving most migrant flows. In the case of Australia, the inflows are enough to have a material impact on the total stock of HNWI. Though China and India are seeing significant outflows they also continue to generate many new HNWI. That is not the case in Brazil, Russia and Turkey where the outflows are resulting in a net decrease in the HNWI population. The situation is particularly dire in Russia and Turkey where outflows represent a large part of the home HNWI population and have been persistent in recent years. Other countries cited by the report as important sources of HNWI migrants are Venezuela, Nigeria and Egypt. In the case of Venezuela, HNWI’s have practically abandoned the country, resettling mainly in Spain and South Florida.

Though Afrasia’s data may be a good indication of trends, it probably understates the volume of migrants. This can be seen by looking in more detail at one segment: Brazilians in Florida.

The Case of Brazilians in South Florida

Every country’s HNWI migrants have distinct geographical preferences. As mentioned above, Brazilians have a strong affinity for South Florida. Realtor data for the Florida market indicates that the Afrasia Bank report significantly understates flight capital from Brazil.

A report from the National Association of Realtors on international real estate activity in Florida in 2018  (Link)  cites Brazilians as the most active foreign buyers in Florida in 2018. According to the report, Brazilians accounted for 17% of all real estate transaction in Miami-Dade County, equivalent to 2,400 residences for a disbursement of $1.5 billion.

Moreover, Brazilians are active buyers in other Florida markets, specifically Fort Lauderdale, Palm Beach and Orlando. According to the NAR report, Brazilians bought 2,280 homes outside of Miami-Dade County in 2018. This brings the total of Florida homes purchases by Brazilians last year to 4,680. Total disbursements in the Florida market in 2018 are estimated at $2.87 billion.

The chart below shows the persistent rise of Brazilian buyers in Florida since the great financial crisis. Over this period, Brazilian are estimated to have spent between $18-20 billion in Florida for a total of some 38,000 homes.

The chart below shows the strong presence of Brazilians  buyers in Miami and Orlando.

Interestingly, as the chart below shows, Brazilians are paying significantly more for Florida residence than other foreigners. This is probably an indication that purchases are meant to be primary residences and not vacation homes.

Trade Wars

India Watch

China Watch:

  • Chinese investors are inflating foreign real estate (Business Insider)
  • China’s voracious appetite for Russia’stimber (NYT)
  • China is a stock picker’s paradise (WSJ)
  • China’s middle-income consumer (WIC)
  • China’s tourism boom (WIC)
  • China commits to Russian LNG (SCMP)
  • America’s false narrative on China (Project Syndicate)
  • FBI Director Wray on China threat (CFR)
  • For the US to dismiss BRI is a mistake (Politico)
  • Time for a new approach towards Beijing (Der Spiegel)
  • China internet weekly (Seeking alpha)

China Technology

  • China’s food delivery war (Bloomberg)
  • How China took the lead in 5G technology (WP)
  • China’s MIC 2025 plans are roaring ahead (SCMP)
  • China’s EV future (The Econoist)
  • China’s EV bubble (Bloomberg)

Brazil Watch

EM Investor Watch

  • Why do investors keep on coming back to Argentina (FT)
  • Malaysia cuddles up with China (SCMP)
  • Erdogan’s new Turkey (Bloomberg)
  • Turkey will recapitalize state banks (FT)
  • Turkey’s bubble has popped (Forbes)
  • Istanbul’s new airport (The Economist)
  • Turkey’s key role in the Mediteranean gas market (GMFUS)
  • Malaysia restarts China rail project (SCMP)

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

China’s Temporary Stimulus

China’s stock market is leading the world this year, rising by 22% compared to 16% for U.S. stocks. China’s A-shares market, which represents a broader sample of mainland-listed stocks, is up a whopping 39% since the beginning of the year.  This bullish market has been propped up by confidence in a forthcoming trade deal with the U.S. and optimism that the economy is recovering from a recent lull.  This week’s announcement of  first quarter GDP growth at a sturdy 6.4% and a recent firming of manufacturing output data has provided support for the bulls. Moreover, news of record steel production and a ramp-up in iron ore prices have raised hopes of an old-style stimulus effort based on infrastructure spending which could translate into  a sustained move upwards for  commodities and emerging market stocks. This wishful thinking is most likely misplaced. Chinese policy makers are aware of the declining marginal returns on fixed capital formation investments and the lack of debt-capacity to fund them. Moreover, a return to the debt-fueled investment model of the past would go directly against the clear government policy of transitioning the economy from dependence on gross capital formation to greater reliance  on consumption. Furthermore, the government’s priority is to promote investment in the value-added frontier industries highlighted in its “China 2025” policy, which are considered of much greater strategic importance. So, what is going on and what can we expect for the future?  Most likely, we are seeing now a  coherent and moderate response by policy makers to the economy’s sharper than expected deterioration last year. Beijing was certainly surprised by the effectiveness of Trump’s trade war strategy and the broad support it has received from Europe and business interests. The tension and loss of confidence caused by the trade war came at a time when China’s economy was already feeling the pressure from the  difficult economic transition away from debt-fueled growth. In addition, a significant slowdown in the global economy did not help. In typical bureaucrat-central-planning mode, Beijing immediately responded with stimulus to maintain growth on its preordained path. Both fiscal and monetary measures were introduced throughout 2018 and they appear to have worked their magic. Though policy makers would have probably preferred to apply stimulus to the consumption side of the economy, several factors conspired against this. First, at the beginning of 2018 housing prices were  significantly above trend.  Beijing is very determined to maintain price stability in this crucial sector which represents  the core of private savings and was reluctant to fuel further housing inflation.  Second, the effectiveness of consumer stimulus is difficult to predict, as the consumer may save more instead of spending the boost in income. In any case, the stimulus has largely found its way to fixed asset investment in both infrastructure and real estate development, reverting the recent downward trend. These are areas where the government has great control over decisions and typically an abundance of shovel-ready projects, and they also immediately generate employment. This is shown clearly in the following chart from Gavekal. The chart shows clearly the downward trend in infrastructure and real estate development spending between 2012 and 2018. This has been an intrinsic element in Beijing’s effort to control debt levels and redirect spending towards consumption. In mid-2018 this trend was reverted, and further data points to a strong upsurge under way (shown in the chart below). However, this upsurge in fixed assets investing is most likely of an emergency nature. Once Xi and Trump sign their trade deal and a modicum of normality returns to China-U.S. relations confidence will return. At that time authorities will be able to recalibrate and adjust policies, and it is likely they will seek to return to the previous path of managing the transition to a more consumer and service-driven economy.

Trade Wars

  • After the deal “Cold War II” will continue (SCMP Stephen Roach)
  • The reemergence of a two-bloc world (FT)
  • The deepening U.S. China crisis (Carnegie)

India Watch

China Watch:

  • China’s economic Challenge (Barrons)
  • China’s bad debt problem (marcopolo)
  • Beijing’s new airport (Economist)
  • China’s laid-off optimists in Chongqing (NYT)
  • China’s economy increasingly pulls all of Asia (Nikkei)
  • China’s wig firm takes over Africa (WIC)
  • Does China have feet of clay (Project Syndicate)
  • Martin Wolf on China’s prospects (FT)
  • Chna stimulus is not what it used to be (FT)
  • Japanese firms are leaving China (WIC
  • China’s Gree going fully private (WIC)
  • The privatization of Gree (SCMP)
  • Shanghai consolidates position as global leader (SCMP)
  • Chinese students U.S. visa problems (WIC)
  • The debate on China’s BRI (Carnegie)
  • China’s voracious appetite for Russia’stimber (NYT) 

China Technology

  • The debate on China’s BRI (Carnegie)
  • China’s voracious appetite for Russia’stimber (NYT
  • China internet weekly (Seeking Alpha)
  • China’s food delivery war (Bloomberg)
  • How China took the lead in 5G technology (WP)
  • China’s MIC 2025 plans are roaring ahead (SCMP)
  • China’s EV future (The Econoist)
  • Chinna’s EV bubble (Bloomberg)

Brazil Watch

  • The bear case for Brazil (seeking alpha)
  • Business optimism returns to Brazil (FT)
  • Brazil digital report (McKinsey)
  • Brazil’s finance guru (FT)

EM Investor Watch

  • Erdogan’s new Turkey (Bloomberg)
  • Turkey will recapitalize state banks (FT)
  • Turkey’s bubble has popped (Forbes)
  • Istanbul’s new airport (The Economist)
  • Turkey’s key role in the Mediteranean gas market (GMFUS)
  • Malaysia restarts China rail project (SCMP)
  • Mexico’s back-to-the-past energy policy (NYT)
  • Nigeria’s urban time-bomb (Bloomberg)
  • Indonesia’s Economic slack (FT)
  • The strongmen strike back (Washington Post)

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

Expected Returns in Emerging Markets

Emerging market equities continue to perform poorly relative to U.S. stocks, a trend that now has persisted for nearly 8 years, since 2011. This poor relative performance is largely explained by the very high starting level of EM valuations, which may be considered to have reached “bubble” levels during the 2008-2012 period.  However, valuations are now back to attractive levels both in historical and relative terms, particularly compared to the richly valued U.S. market, so investors can expect returns in emerging markets to do considerably better over the next 5-10 years. Nevertheless, EM stocks continue to fare poorly, and they have underperformed the S&P 500 by a large margin over both the past quarter and the past year. Furthermore, short-term prospects appear muted, as macro factors provide significant challenges. IMF Manager Director Christine Lagarde reminded us of this this week in pointing out the “precarious” state of the global economy.

Experience tells us that EM assets perform well when there is strong global growth accompanied by a weakening U.S. dollar, the opposite of current conditions. What we have seen since 2012, pretty much on a persistent basis, is relatively weak global growth and a strengthening dollar. This has led to a condition of tight global dollar liquidity, marked by consistent flows into dollar assets. Ironically, this condition of the markets has allowed for massive amounts of issuance of dollar-denominated debts by EM corporates, which now may face severe difficulties in refinancing these loans if the trends of global weakness and dollar strength persist.

Nevertheless, the scenario is not all bad for EM assets. Several developments point to improving conditions going forward:  looser U.S. monetary policy; and a recovering Chinese economy which in turn is driving an increase in commodity prices.

The charts below illustrate current market conditions. The first chart shows global liquidity as measured by the U.S. monetary base (M2) and international dollar reserves. The recent surge can be attributed to the “Fed pivot,” and, if sustained, would be supportive of better global dollar liquidity. The second chart, from Yardeni.com, shows a different measure based on international trade surpluses and reserves, less supportive of an improvement in liquidity conditions. The third chart, also from Yardeni.com, shows the MSCI EM currency index, which represents the performance of the currencies in the benchmark relative to the USD. The recent uptick in the data is caused by the strengthening of the yuan and Indian rupee in recent weeks. On an equal weighted basis, the persistent strengthening of the dollar is still very obvious, and, overall, we can state that the dollar strengthening trend looks to be intact.  

Finally, the third macro factor which is highly correlated to positive EM performance – the price trend of commodities – is shown below. The chart shows the recent surge in the CRB Raw Industrials index, and especially the metals component. This is a clear sign that China’s stimulus is having an impact, and certainly a bullish sign for emerging market assets.

In conclusion, macro factors are a mixed-bag. Global growth is weak and the dollar is strong; on the other hand, there are some signs of improved dollar liquidity and commodity prices are acting well. The balance will tilt depending on China, with a recovery in the Chinese economy during the second half of this year supporting an improved environment for EM investors.

        Valuations are Compelling

The main reason to own emerging market equities is that after a long period of underperformance they are now inexpensive relative to their own history and compared to the U.S. market. For the investor with a long-term  view, current valuation strongly argue for increasing allocations to the asset class. The following table ranks the expected returns for the major EM countries as well as for the global emerging market benchmark and for the S&P 500. The dollarized nominal expected returns are derived by assuming that market Cyclically Adjusted Price Earnings(CAPE) ratios return to historical averages. Then this multiple is applied to “normalized earnings” which take into account where a country is in terms of its business-earnings cycle. Finally, normalized earnings are grown for the seven-year period by nominal USD-denominated GDP.

The table points to attractive returns for EM equities over the period, compared to very low returns in U.S. equities. An investor should seek to enhance EM returns by overweighting the highly discounted “riskier” markets such as Turkey, Colombia, Malaysia and Russia.

Similar exercises by GMO (Link) and Research Affiliates (Link) shown below reach slightly different conclusions but all point to significantly superior returns in EM relative to other asset classes.  

  • Trade Wars

  • After the deal “Cold War II” will continue (SCMP Stephen Roach)
  • The reemergence of a two-bloc world (FT)
  • The deepening U.S. China crisis (Carnegie)

 

India Watch

  • India’s internet users are addicted to these apps from China (WSJ)
  • India’s digital transformation (McKinsey)
  • The chinese are taking over smartphone apps in India (factordaily)
  • India ex-SOE Fund launched by Wisdom Tree (Wisdom Tree)
  •   A bullish view on India (Wisdom Tree)
  • How Youtube conquered India (FT)

China Watch:

  • China and its Western critics (Project Syndicate)
  • The chinese economy is stabilizing (FT)
  • China’s SOE reform (WIC)
  • Europe’s different take on China (SCMP)
  • A view on the Chinese economy (McKinsey)
  • Can outside pressure shift Beijing (Lowy)

China Technology

Brazil Watch

EM Investor Watch

  • AMLO’s first 100 days (Wilson Center)
  • The strongmen strike back (Washington Post)
  • Argentina’s downwards slide (FT)
  • What’s driving Turkey’s market wild (WSJ)
  • Turkey needs a better powerpoint (FT)
  • South Korea launches 5G network (Bloomberg)
  •  Malaysia’s four key challenges  (Lowy)
  • Turkey’s momentous election (Carnegie)

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

An Update on Active vs. Passive Investing in Emerging Markets

The  most under-rated aspect of investing is simplicity. Investors feel obliged to pursue complex methods to predict the future of the economy, the markets and corporate earnings and they then develop elaborate trading systems to leverage “superior” insights. This is often driven by clients who demand large teams of highly paid experts involved in complex strategies in order to justify paying management fees. If a process is too simple and transparent, the client may conclude that the manager is dispensable .

This dilemma is heightened  by the growing preponderance of passive indexing and “smart-beta” strategies, which offer market performance (“beta”) or the promise of factor-driven market outperformance (“alpha”) at ever-declining prices. These computer-driven quantitative strategies are the image of simplicity and transparency and can be manufactured cheaply.

These “passive “products increase the pressure on actively managed funds in two ways; first, they compress fees; second, they push managers to add skill and complexity which increases costs. This bad combination of lower fees and higher costs can only lead to a concentration of assets in those few active managers who can offer highly differentiated products.

These trends can be seen in the Year-end 2018 SPIVA Scorecard (Link, Link), which compares returns for U.S. mutual funds with their respective benchmarks. Here are some highlights from the report which concern emerging markets funds:

  • The number of available funds is declining, from 233 in 2015 to 210 a year-end 2018.
  • Larger funds perform better than smaller ones. This is seen in the higher returns on an asset-weighted basis than on an equal-weighted-by-fund basis. This advantage of larger funds over smaller funds is persistent over all time-periods and can be attributed to lower fees and higher skill.
  • 2018 was a difficult year for active managers, with 78% of managers underperforming their indices. The data for the past 15 years is shown below. Beyond, a one year time-frame, around 90% of managers underperform their indices.

Rolling three-year returns have also deteriorated, as shown in the following graph. This deterioration is also seen for global and  international funds.

     

  • Finally, SPIVA identifies low persistency in results for EM managers. While 41% of EM funds outperformed their indices for the 2012-2015 3-year period, only 7.5% of these funds continued to outperform the next year  (2016), 4.5% outperformed over the next two years (2016-2017) and zero outperformed for the next three years (2016-2018).

  Conclusion

The sobering data from the SPIVA scorecard highlights the challenges of active managers. To be successful, increasingly, active managers will need to focus on market niches where they can deploy unique skills and expertise, and/or pursue strategies that provide returns that are uncorrelated  to mainstream emerging market products. Some areas where active management may continue to be highly successful in “harvesting alpha” are the following:

  • Deep value contrarian investing. This strategy is highly out-of-favor because of a long period of underperformance of the value factor. Consequently, though it requires skillful fundamental research, it is under-researched because most managers have abandoned this discipline. This is the case at a time when opportunities are plentiful in the Indian and Brazilian markets, and particularly in the China A-share market.
  • Hedge Fund structures: Pure Alpha, shorting and trend following (CTA) strategies can provide returns uncorrelated to EM equities and valuable diversification.
  • Long-only, mainstream EM investors with low cost structures, long-term horizons and the ability to pursue strategies with high “tracking error” (the degree of  portfolio return uncorrelation with the benchmark). The problem is finding clients with long-term horizons and tolerance for “tracking error”.  The vast majority of both investors and clients prefer strategies that “hug” the benchmark, which makes alpha creation a remote possibility.

Trade Wars

  • Xi needs a trade deal (FT)
  • The reemergence of a two-bloc world (FT)
  • The deepening U.S. China crisis (Carnegie)
  • European Commission report on China relations (EC)
  • Should the U.S. run a trade surplus (Carnegie, Michael Pettis)
  • Why the U.S. debt must continue to rise (Carnegie, Pettis)
  • Turkey and India denied preferential U.S. trading status (FT)

India Watch  

  • India’s internet users are addicted to these apps from China (WSJ)
  • How India conquered youtube (FT)
  • Modi’s track record on the economy (The economist)
  • Increasing Indian demand for copper (Gorozen)
  • India’s growing share of oil imports (blog)
  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)

China Watch:

  • Quality will drive China A- share returns (FT)
  • Lessons from Li Keqiang’s report to Congress (SCMP)
  • China breaks world box office record (SCMP)
  • Why China supports North Korea (Lowy)
  • China’s PM frets about the economy (The Economist)
  • China has no choice (Alhambra)
  • China’s economy is bottoming (SCMP)

China Technology  

Brazil Watch

EM Investor Watch

  • AMLO’s first 100 days (Wilson Center)
  • South Africa’s electricity sector woes (FT)
  • OECD Report on Global Corporate Debt (OECD)
  • Russia’s global ambitions in perspective (Carnegie)
  • South Africa stagnates as confidence wanes  (Bloomberg)
  • Postcard from Malaysia (Foreign Policy Journal)

Tech Watch

Investing

 

Bond market risk and emerging markets

 One of the most salient concerns with the current state of the the global economy  is the very high level of corporate debt. This past week the OECD, the Dallas Federal Reserve and the Bank for International Settlements all warned that in an eventual economic downturn the solvency of corporate debt issuers  is likely to deteriorate quickly and deepen the contraction. 

The warning is highly relevant for emerging markets investors for two reasons; first, EM corporates have been active particants in the ramp up of debt, eagerly satisfying the chase for yield that lenders have pursued in response to quantitative easing policies; second, EM borrowers can be expected to suffer disproportionately if the lending cycle were to turn sour.

Rob Kaplan of the Dallas Federal Resrve did not mince his words this week (Link) in issuing a stark warning of the risk to the economy caused by the buildup of U.S. Corporate debt. Kaplan is concerned that the current high level of corporate debt will sharply deepen an eventual economic downturn. He points out that a preponderance of recent debt issuance has been used for non-productive and non-self-liquidating activities, mainly dividends, debt buy-backs and M&A activity. In addition, to an unprecedented degree, the debt has been rated BBB (barely one notch above high-yield, “junk”), and has come with more relaxed covenants. This is shown in the following chart two charts. The first shows the cyclical behavior of the corporate debt market and the current very high level relative to GDP, and the second shows the growing preponderance of lower quality issuers.

  Kaplan notes that “in the event of an economic downturn and some credit-quality deterioration, the reduction in bank broker-dealer inventories and market-making capability could mean that credit spreads might widen more significantly, and potentially in a more volatile manner, than they have historically.” As in past recessions, downgrades of BBB-rated debt may flood the relatively illiquid market for high-yield bonds and cause severe dislocations.

Unfortunately for investors in EM debt, the U.S. high-yield bond market and the market for EM debt are extremely correlated. Therefore, any disruption in the U.S. high-yield market will be felt immediately in an accentuated fashion in the EM debt market.

This is the view expressed in the recently published OECD study, “Corporate Bond Markets in a Time of Unconventional Monetary Policy.” The report  describes in ample detail a “prolonged decline in overall  bond quality…and  decrease in covenant  protection” and  predicts that many corporates issuers will suffer a downgrade to “junk” in an eventual economic downturn  and face amplified borrowing costs. The report repeats the concerns expressed by Kaplan with regards to the size and low quality of global corporate debt. In addition, it focuses on the specifics of the EM debt market.

The OECD points to an “extraordinary acceleration of corporate bond issuance in emerging markets,”  from$70 billion/year in 2007 to $711 billion in 2016. This is shown in the chart below.

  The rise in borrowing has been particularly acute in China, but also highly significant across the rest of the emerging markets. Total EM corporate debt reached $2.78 trillion in 2018, up 395% in ten years. 

 The OECD identifies an alarming decline of the overall quality of the global corporate bond market. According to OECD analysis, by historical standards the quality of bonds is exceptionally low for where we are in the economic cycle. This is shown in the chart below.

 The decline in quality is particularly severe for the overall quality of EM bonds, which just barely qualify as investment grade in 2018 after falling into junk status in 2017. The chart  below compares the quality of EM bonds to developed market bonds, according to the rating methodology ued by the OECD.

To make matters worse, the repayment profile for emrging markets is considerably worse than for DM, with 80% of loans due over the next five years.

 Interestingly, even though concerns of a global slowdown are growing, high yield bonds in general are  performing well, displaying very low premiums by historical standards to risk-free bonds. This is partially because of QE (especially in Europe) but also because of desperate efforts to secure yield in a low-return environment. Look, for example, at the chart below of the HYEM, the emerging markets high yield bond ETF, which has rallied strongly since last September.

Conclusion

 Investors in emerging markets should be aware of the considerable risks presented by the bond market. Any significant downturn in the global economy would likely lead to significant downgrades to high yield bonds and a strengthening of the U.S. dollar, and this may cause severe disruption of the high-yield market. The performance of emerging market equity markets, which are highly correlated to the EM high yield market, would suffer accordingly.

Trade Wars  

  • Xi needs a trade deal (FT)
  • Should the U.S. run a trade surplus (Carnegie, Michael Pettis)
  • Why the U.S. debt must continue to rise (Carnegie, Pettis)
  • Turkey and India denied preferential U.S. trading status (FT)
  • China, India and the rise of the civilisation state (FT)
  • When democracy is no longer the only path (WSJ)
  • The tremendous impact of the China-U.S. tech war (Lowy)
  • Huawei hits back at the U.S. (FT)

India Watch

  • Modi’s track record on the economy (The economist)
  • Increasing Indian demand for copper (Gorozen)
  • India’s growing share of oil imports (blog)
  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)

China Watch:

  • Quality will drive China A- share returns (FT)
  • China breaks world box office record (SCMP)
  • Why China supports North Korea (Lowy)
  • China’s PM frets about the economy (The Economist)
  • China has no choice (Alhambra)
  • China’s economy is bottoming (SCMP)
  • MBS in Beijing (WIC)
  • The story of the world’s biggest building (The Economist)
  • U.S. cars are strugling in China (NYT)
  • China’s tourist have political clout (The Economist)

China Technology

  • Huawei’s big AI ambitions (MIT Tech)
  • China’s EV startup Xpeng (WIC)
  • An interview with fintech Creditease CEO (Mcinsey)

Brazil Watch

EM Investor Watch

  • OECD Report on Global Corporate Debt (OECD)
  • Russia’s global ambitions in perspective (Carnegie)
  • South Africa stagnates as confidence wanes  (Bloomberg)
  • Postcard from Malaysia (Foreign Policy Journal)
  • South Africa slumps (Barrons) South Africa Innovation (FT)
  • Make hay while the sun shines in emerging markets (FT)
  • Globalization in Transition (mckinsey)

Tech Watch

Investing

 

 

 

 

 

Does China have a Debt Problem?

For many years concerns have been raised that imbalances in China’s financial system are a threat to economic stability.

Way back in 2007, Premier Wen Jiabao, asserted  that China’s economy was  “unstable, unbalanced, uncoordinated and unsustainable”. This idea was reiterated by a People’s Bank of China report this week that warned of an “arduous task to prevent and defuse financial risks.”

The sentiment is echoed by prominent U.S. hedge funds that for years have bet that the financial system’s fragility would cause a collapse of the yuan. Prominent China bear, Kyle Bass of Hayman Capital Management, recently repeated his case to CNBC, saying “China is running the largest financial experiment the world has ever seen. And the economic tides have turned negative for them.” Hedge Fund, Crescat Capital, echoed this sentiment last week, opining that”the Chinese banking asset bubble is currently the largest of any country ever with 400% on-balance-sheet banking asset growth relative to GDP in the last decade to $40 trillion.”

At the center of the concerns lies an unprecedented accumulation of total debt.  The chart below from the Bank for International Settlements (BIS) shows that China’s debt as a % of GDP  has more than doubled over the past decade. This is a high level of debt for a developing country like China, putting it at a level in line with many advanced economies. The concern is that the economy has become over-reliant on credit, of which much is mis-allocated to low-return activities. The risk is that at one point the debt could become an impediment to growth, leading to a “Japanification” of the economy, characterized by over-leveraged “zombie” companies.

Much of the criticism revolves around the nature of the Chinese financial system, which, in the tradition of the East-Asia developmental model, is much more driven by official policy goals than by the profit motive. In China the banks are seen as the instrument to channel household savings to the government’s priority activities.

Like Japan, the Chinese financial system is fully anchored in domestic savings, and, therefore not vulnerable to the mood-swings of foreign investors.

But, the Chinese may have additional advantages over Japan. Regulators are powerful and highly credible and have enormous flexibility to fix problems.  Their power and effectiveness is enhanced by the reality that the banks are owned by the state and can  rely on the government for capital injections. This means that bank liabilities – mainly loans to state entities – can be restructured at will.

Also, Beijing has the advantage of being exceptionally asset rich, because of the Communist legacy of state-ownership of productive assets.  The following chart from a recent IMF report, illustrates this clearly. Imagine if the United States government owned 80% of corporate America; concerns over the U.S. national debt would probably not exist. In any case, the Chinese authorities are well aware of market concerns with the high-rate of debt-accumulation and they are trying to manage them. Since the huge stimulus implemented during 2009-10 in the wake of the global financial crisis, China has consistently slowed down credit growth, as shown below in the chart from Goldman Sachs. Monetary authorities have sought to gradually slow credit growth, while at the same time using temporary stimulus to smoothen business cycles.  The following chart, from Macro-ops, shows how monetary authorities have eased on two occasions since 2010 but then returned to the credit- tightening trend. In late-2018, the PBOC initiated a third easing phase which continues to today. In addition to sharply reducing the rate of credit growth, the government has also redirected lending to households. As the BIS data shows in the first chart above, about half of credit growth has been funneled to households, mainly for mortgages. Since 2011, credit to households has risen from nearly zero to 58% of GDP. Credit for residential construction also makes up a large part of new loans. Adding these two items together, we see that a significant part of credit expansion has gone to support residential housing. The chart below shows the strong ties between Total Socal Lending — the Chinese term for total lending — and construction activity. In essence, since the great stimulus period after the GFC the Chinese financial system has become increasingly tied to residential real estate.  This is a natural development of the government’s efforts to transition the economy from dependence on infrastructure and exports to one that is driven by household consumption. While in the past  the  very high savings of the population had been channeled to state companies for nation-building investments, increasingly they are going to households in the form of mortgages and personal loans.

This is not exceptional by international standards. The quirk in the Chinese system, is that residential real estate also serves as a primary destination for long-term investments. This is also the case in many developing countries like Brazil and Turkey, where savers see residential investments as a safe harbor for long-term savings, but it may be going to extremes in China. We see this in reports of 65 million empty apartments.

The enormous amount of savings that the Chinese have in real estate means that the government is very concerned with maintaining consistent appreciation for housing and is careful to manage supply and demand for through financial measures. This can be seen in the chart below from Gavekal, which shows clearly how the monetary policy cycle is adjusted according to the trend of residential real estate prices, the objective being to engineer steady appreciation. It appears that, to a considerable degree, Chinese monetary policy is now aimed at guaranteeing stable returns for China’s owners of real estate. The current dilemma for monetary authorities is that, though the economy needs stimulus, the real estate market does not. In general, housing prices are relatively high at this time and are in no need of stimulus, as we see in the following chart.

However, the Chinese monetary authorities have many tools available. Given the current need for stimulus, the authorities are clearly rechanneling lending to SOE’s for recently announced large infrastructure investments. This means we are likely to see a temporary boost in total lending growth, with a focus on economic stimulus through traditional fixed asset investments, as the authorities try to steer through the current economic malaise.  

Trade Wars  

India Watch

  •  Increasing Indian demand for copper (Gorozen)
  • India’s growing share of oil imports (blog)
  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)
  • China is leading FDI in India (SCMP)
  • India curbs create chaos for Amazon and Walmart (Bloomberg)

China Watch:

  • China’s economy is bottoming (SCMP)
  • MBS in Beijing (WIC)
  • The story of the world’s biggest building (The Economist)
  • U.S. cars are strugling in China (NYT)
  • China’s tourist have political clout (The Economist)
  • MSCI boosts China A-share weight in EM index (WSJ)
  • Chinese consumers; your country needs you (FT)
  • China’s property market slowdown (WSJ)
  • Cracking China’s asset management business (Institutional Investor)
  • Haier’s turnaround of GE Appliances (Bloomberg)

China Technology

  • China will corner the 5G market (Wired)
  • CTrip’s strategy (Mckinsey)
  • DJI’s rise (SCMP)
  • China’s decade-long Bullet-train revolution (WIC)

Brazil Watch

  • Brazil’s crucial pension reform (Washington Post)
  • Brazil’s finance guru (FT)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

Tech Watch

Investing

India’s Growing Role in the Market for Oil Imports

Every year the oil company BP presents a twenty-year outlook (Link) for global energy markets. The latest report released last week points to  the  persistently rising importance of emerging markets in  the global market for imported oil. China has had the most impact on oil markets over the past two decades, increasing its imports from a little over one million barrels per day (b/d) at the turn of the century to over nine million today. China largely replaced the  market presence of the United States, which has seen its oil imports fall from 12 million b/d in 2007 to nearly zero today. But China’s growth in demand for oil is now slowing ,and India is now rising as the primary source of marginal demand for imported oil. Unlike China, which has had a large and growing domestic production of oil, India’s high demand growth is expected to be met almost exclusively by imports. The rise of India as a major actor in the oil markets comes at a time when the U.S. has become self-sufficient in oil and Europe’s demand for imported oil is declining. The result of this is that India is set to become the major buyer of Persian Gulf oil. The following chart from the BP report illustrates India’s growing role in the market. While combined demand from China and OECD countries is slated to remain flat, India and emerging Asia and other emerging markets will experience high demand growth. India’s oil demand is expected to rise by 3.1% per year through 2040, from 5 million barrels/day to 9 million b/d. BP expects India’s oil production to decline slightly from the current 1 million b/d of production, so that demand growth will have to be supplied by imports, which will rise from 4 million b/d to about 8.2 million b/d. BP expects total global demand for oil to fall from 96 million b/d to 82 million b/d between 2017 and 2040, which means that India’s share of global oil demand will double from 5% to 10%. China’s oil demand is expected to rise from 13 million b/d to 15 million b/d, while production stays around 4 million b/d. This means Chinese imports would rise by 2 million b/d, from 9 million b/d to 11 million b/d, half as much in volumes compared to India. As India and China come to dominate the market for imported oil, both the U.S. and Europe will become less significant. The U.S. is expected to export 5 million b/d in 2040. Over this period, according to BP’s estimates, Europe’s import would fall from 11 million b/d to 7 million b/d. Where will India and China source their oil? In the chart below, the BP data points to the same primary sources that have met demand for oil imports in the past decades: Russia and the Middle East. China is already cementing its energy ties with Russia, building a series of pipelines to Siberia and importing Russian Artic liquid natural gas (LNG). India, on the other hand, has as its traditional supplier the Persian Gulf, which makes sense from a logistical point of view. Certainly, as they always have in the past, the geopolitics of oil will require that both India and China become much more involved in international politics. With the U.S. no longer importing oil from the Middle East and, perhaps, entering a period of lesser foreign-policy engagement, China and India will increasingly have to  actively defend their strategic commercial interests. We have already seen this clearly wth regards to Indian imports of Iranian oil. India  has increased its imports of Iranian oil sharply in recent years, and China and India are today Iran’s two biggest clients. Interestingly, both received waivers from the U.S. Iran sanctions and continue to buy Iranian oil. India’s dependence on oil imports with their highly volatile prices also will create greater macro-economic challenges. Growing oil imports may pressure the trade and current accounts. Unlike China, which experienced huge trade surpluses during its decades of dependence on the importation of oil and other commodities, India runs chronic current account deficits. These are likely to become more difficult to manage, leading to increased currency volatility. Trade Wars  

India Watch

  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)
  • China is leading FDI in India (SCMP)
  • India curbs create chaos for Amazon and Walmart (Bloomberg)
  • India’s big upcoming election (Lowy)
  • India’s vote-buying budget (Project Syndicate)

China Watch:

  • China’s property market slowdown (WSJ)
  • Cracking China’s asset management business (Institutional Investor)
  • Haier’s turnaround of GE Appliances (Bloomberg)
  • China’s consumer is losing confidence (WSJ)
  • China real estate bubble (Nikkei)
  • Will China fail without political reform? (Project Syndicate)

China Technology  

  • China will corner the 5G market (Wired)
  • 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)

Brazil Watch

  • Brazil’s crucial pension reform (Washington Post)
  • Brazil’s finance guru (FT)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

  • Make hay while the sun shines in emerging markets (FT)
  •  
  • Globalization in Transition (mckinsey)
  • World Bank Report, Global Economic Prospects (World Bank)
  • Indonesia’s economic populism (The Economist)
  • EM’s Corporate debt bomb (FT)

Tech Watch

Investing

 

Caution Remains in Order For Emerging Markets

 

Financial markets have rallied strongly since the “Christmas Eve massacre.”  Since the December bottom, the S&P 500 has rallied 17% and emerging markets are 10% higher. Wall Street has put a positive spin on Fed Chairman Jay Powell’s sudden pivot to the dovish camp, and the bet is that a soft landing for the U.S. economy will be achieved. President Trump’s eagerness to sign a trade deal with China  also has lifted spirits.

For emerging markets, however, we have mixed signals and caution is still advised.

First, it may be that Wall Street,  for the time being, has interpreted the Fed in too optimistic a manner. The Fed’s pivot may be an indication that the interest rate cycle has peaked and that the next move in interest rates is down. This would not be bullish for EM equities, which tend to do well when the economy is over-heating and the Fed is raising rates (2016-2018) but then do poorly when the cycle turns. The Fed’s own recession probability indicator has shot upwards recently, even before the very poor December retail sales numbers released this week. This rising fear of a slowdown is seen also in Duke University’s CFO survey, which has 75% of CFO’s expecting a recession by 2020. This becomes a self-fulfilling prophesy, as CFO pessimism drives down investment and hiring plans.

Second, EM assets appear to be  in overbought territory. There has been a strong inflow of funds over the past two months into the three main EM asset classes: equities, local currency bonds and dollar-denominated bonds. Bonds started to rally before equities, an indication of increasing appetite for EM yield, as expectations for U.S. rate increases collapsed. Interestingly, according to Merrill Lynch’s survey of fund managers, EM equities have gone from the most shorted to the “most crowded trade” over a three-year period. The table below shows that today is the only time over the past five years that portfolio managers have been so keen on EM equities. Portfolio manager positioning tends to be a strong contra-indicator. In March 2016, at the lowest level since the great financial crisis and right at the beginning of a powerful rally for EM equities, Merrill’s survey identified being short EM equities as their highest conviction trade for portfolio managers.

Another indication that the markets may be overbought can be see in the following chart from Goldman Sachs. The chart shows a very unusual situation where EM assets have appreciated sharply in the face of deteriorating economic conditions.

In addition to the current overbought condition of EM, there are several additional indicators that merit investor attention. These are: dollar strength, commodity weakness and global liquidity.

Historically, EM assets sustain rallies when (1) the global supply of dollars is high, (2) the dollar is trending down (weakening relative to EM currencies) and commodities are appreciating.

Not one of these indicators is currently positive.

Global Liquidity

We can look at several indicators of the supply of dollar liquidity in international markets. These are shown below.

First, global dollar liquidity as measured by U.S. M2 plus international dollar reserves. This indicator moves up in December, but remain in depressed territory.

Second, International dollar reserves, which are still trending down.

Third, Ed Yardeni’s “Implied International Capital Flows,” which is in a sharp downtrend.

Fourth CrossBorder Capital’s “Emerging Markets Liquidity Cycle” which also is in a sharp downtrend.

The Dollar Trend

The dollar continues to strengthen relative to EM currencies.

First, the EM MSCI Currency Ratio, which continues in a major downtrend. The index has ticked up recently, only because it is heavily weighted in China, where the yuan has stabilized on trade-talks optimism.

Second, both the DXY dollar index (heavily weighted to developed currencies) and the equally weighted EM index show the dollar strengthening trend to be persistent.

 

Commodities

The CRB Raw Materials index measures prices for a broad variety of industrial inputs. Historically, this index has the highest correlation with EM equities. Following a strong rebound in 2016-2018, the index has resumed the downtrend started in 2012.

In conclusion, after the recent rally in EM assets, some caution is warranted. For investor optimism to be rewarded, it is important that the three pillars of EM asset prices (global liquidity, the dollar and commodities) turn favorably. Perhaps the greatest cause for bullishness would be a conviction that China’s efforts to stimulate its economy through fiscal and monetary measures will bare fruit during the course of the year. So, investors should focus keenly on the data coming out of China.

Trade Wars

  • A look at the future of Sino-U.S. relations (Li Lu Himalaya Capital)
  • The internet has become a battleground between the U.S. and China (WSJ)
  • Senator Rubio’s report on the China threat (U.S. Senate)
  • Is China or Russia are new rival (The Atlantic)
  • China, an existential threat for the 21st century (NYT)
  • New Zealand feels China’s anger (NYT)
  • The trade war is only about theft of technology (Project Syndicate)

India Watch

  • India curbs create chaos for Amazon and Walmart (Bloomberg)
  • India’s big upcoming election (Lowy)
  • India’s vote-buying budget (Project Syndicate)
  • 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:

  • Haier’s turnaround of GE Appliances (Bloomberg)
  • China’s consumer is losing confidence (WSJ)
  • China real estate bubble (Nikkei)
  • 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)

China Technology

  • 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)

Brazil Watch

  • Brazil’s finance guru (FT)
  • 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)

Tech Watch

Investing

 

 

 

 

 

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

 

 

 

 

 

 

 

 

 

 

Shedding Some Light on China’s GDP Data

China watchers have long debated the reliability of the country’s GDP numbers, and for many years the pessimists have argued that official figures are overstated. This is not a trivial debate anymore because China has become a major driver of global growth over the past decade, on par with the United States. Recent signs of slowing growth in China, blamed on trade wars and declining consumer confidence, have only heightened the debate.

The first thing to understand  about China’s GDP is that the concept of GDP targeting in China is very different from what investors are familiar with,  and this leads to confusion. One insightful  China watcher, Michael Pettis, who is  professor at Peking University’s Guanhua School of management, makes this argument in a recent article (What is GDP in China?). Pettis reminds us that the Chinese, with their deep tradition of economic planning, think of GDP as a pre-determined input figure not as a variable output. It is not a coincidence, therefore, that magically year after year the Chinese meet their GDP growth goal. Part of the reason for this may be some window-dressing for political reasons but much of it comes from active intervention. For instance, if the economy appears to be running below expectation, the authorities will respond quickly with increased spending and lending to set it back on target.

Unlike the U.S. Fed, which has only the blunt tool of monetary policy to achieve its pretentions of smoothing out the economic cycle (eg. Ben Bernanke’s “Great Moderation”), the Chinese authorities have an expanded toolkit of monetary policy, bank lending and fiscal spending which they have immediate access to.

Of course, achieving such fine tuning is easier said than done. The pessimists on China will argue that the Chinese authorities have exhausted the utility of these tools.  This may be because of a combination of excess debt and declining returns on fixed capital investments in real estate and infrastructure, and also because saturated foreign markets have become a much more volatile driver of growth. This state of affairs increasingly has raised the issue of the “quality” of China’s GDP growth. If the GDP numbers are being achieved by increasing debt that won’t be repaid – either for domestic investments or for ports in Pakistan – and the end-result is more empty real estate and under-used bullet trains, than the effort is counterproductive. The Chinese have long been aware of the unbalanced nature and the limits of their debt-driven fixed-asset investment model, but it is not easy to change behavior. China’s vice president, Wang Qishan, reiterated the government commitment to its GDP growth target this week in Davos. Wang pledged,   “There will be a lot of uncertainties in 2019, but something that is certain is that China’s economy, China’s growth, will continue and will be sustainable.” In other words, the authorities commit a-la-Draghi to do “whatever it takes” to meet the 6.5% annual growth target.

Nevertheless, foreign observers are always skeptical of China’s growth figures and seek alternative yardsticks to corroborate the official data. For example, electricity consumption is looked at in comparison to GDP growth. The recent numbers forelectricity consumption, shown below, at least have the merit of displaying year-to-year variability.

Along this line,  Barclay’s bank looks at a series of alternative indicators to provide a comparison to official figures. Based on this exercise, Barclay estimates that China’s economy has been performing well below targets for the past five years.

 A new paper by Yingya Hu and Jiaxiong Yao  of John Hopkins University  (“Illuminating China’s GDP Growth) uses a very innovative methodology and arrives at the same conclusion. Hu and Yao analyse  satellite-reported nighttime light over time to measure changes in economic activity. As shown below, they estimate that China’s GDP may be some 20% overstated. The authors have done this for a wide variety of markets and find the data in China to be one of the most overstated. As shown below, India is also slightly overstated while both Brazil and South Africa are actually understated. 

It is not clear what is causing this discrepancy in China. One theory is that a significant part of the real-estate stock remains dark, as properties are being bought for investment purposes and not occupied.

In any case, these theories of overstated GDP growth raise several worrisome questions. First, this may be evidence that the authorities may be pursuing unproductive policies as marginal returns from debt accumulation and fixed asset investments have declined.  Second, the country’s very high credit/GDP ratio of 300% may be significantly understated, and could be closer to 360%.

Trade Wars

India Watch

  • 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:

  • 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)
  • 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)

China Technology Watch

Brazil Watch

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

EM Investor Watch

  • 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%.

.

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

The Fed and EM Debt

 

Federal Reserve Chairman Jay Powell, unruffled by the bullying of President Trump and market commentators, raised interest rates this week and reaffirmed his commitment to unwind the extraordinarily loose monetary policies of the past decade. Suddenly, it is dawning on investors that the infamous Fed “put” – the firm commitment of the Federal Reserve to support the stock market in the name of financial stability and the “wealth effect” – can no longer be taken for granted. The Fed’s return to orthodoxy, if pursued, will not only unsettle the U.S stock market. It will have far-reaching consequences across financial markets, and certainly present a challenge for emerging markets.

The problem for emerging markets comes on two fronts. Tightened liquidity will lead to higher interest rates across global bond markets. As markets reprice the cost of credit, the “yield chase” which occurred in recent years will revert: investors will no longer have to pursue ever-more risky borrowers to achieve a modicum of returns. One of the best indicators of the changing market environment is the spread between the interest which high-yield lenders (“junk’) have to pay over the risk-free U.S. Treasury rate. As shown in the chart below, this spread has been surging. This is bad news for emerging markets because EM debt is a substitute for U.S. high yield debt.

Moreover, the higher cost of credit for emerging markets comes in the wake of a huge credit splurge. EM borrowers enthusiastically took advantage of the appetite of global yield-chasers over the past five years. As the tide now ebbs, borrowers will have to refinance at higher rates. Unfortunately, it appears that most of this lending did not go into productive investments and it did little to boost economic output. The chart below shows the increase in the total credit- to- GDP ratios for major EM countries, as reported in the data of the Bank for International Settlements (BIS).

The following chart shows the average GDP growth for the past five years compared to the past 20 years and also Fixed Capital Formation over the past five and 20 years.

 

These chart show that this debt accumulation has by-and-large not led to more investment or more growth. Quite the opposite, In many countries it appears that the marginal returns from debt are declining.

A few country-specific comments:

China’s debt load increase is unprecedented. Though it has financed increased capital formation it appears that a significant amount of investment has been in very low return infrastructure and real estate developments. Marginal returns from debt and investment are declining fast, and GDP growth is expected to fall below the current 6% annual rate.

Brazil’s debt load has increased at a very high rate and is now at very high levels for a country with high interest rates and prone to financial instability. The increase in debt of the past five years was used to finance current spending and interest expense.

Colombia’s debt increase is very large but absolute levels are moderately high and at least GDP growth has been sustained and capital formation has been boosted.

Chile’s debt ratio has increased sharply and debt levels are very high, but growth has sputtered. Though capital formation has increased, I suspect a significant amount of investment has been  in “glamour” real estate developments.

Turkey has seen a large increase in debt, much of it sourced in foreign currency. Debt levels are approaching high levels. The country has seen high growth in GDP and increasing capital formation, much of this in large infrastructure projects but also in glamour real estate. The crisis this year has thrown Turkey into what is likely to be a multi-year period of austerity and deleveraging.

Mexico’s debt has increased but remains at manageable levels. Growth and capital formation are steady at low levels.

India is the main outlier in EM. Debt is moderately high but it is has been declining. Both GDP growth and capital formation have increased. India appears well positioned for a new credit cycle.

 

Macro Watch:

  • The future of the dollar and U.S. diplomacy (Carnegie)
  • The emergence of the petro-yuan (APJIF)  
  • A users guide to future QE (PIIE)

Trade Wars

  • 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:

  • 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

 

 

 

Emerging Markets Debt Bomb

Business and investment cycles follow predictable patterns, starting out with pessimism and plenty of idle capacity and ending with optimism and the economy running above potential. But, every cycle also has its particularities. In the case of emerging markets, this current investment cycle is characterized by a very large accumulation of debt.

While emerging market stocks have performed very poorly compared to the U.S. market since 2012 and are now relatively undervalued, they are likely to be constrained by this debt accumulation. Typically, a new period of outperformance for emerging markets would be marked by new capital inflows and credit expansion, but given the rapid debt accumulation of recent years this may not happen this time. In fact, under current conditions of dollar strength, rising interest rates and weak commodity prices, this debt load is proving to be a heavy burden for many countries and causing stock markets to fall further.

Of course, the reason that this cycle is proving to be so different is the unprecedented and sustained Quantitative Easing (QE) programs pursued by the central banks of the world’s main financial centers since 2010. The long period of extraordinarily low interest rates motivated investors to “chase” for yield where ever they could find it and banks and corporations around the emerging market world were more than happy to oblige them. As QE is now being unwound and interest rates are rising, emerging market borrowers are having to refinance at much higher rates. This new trend of rising rates is being compounded by a rising dollar and the return of volatile financial markets.

The charts below, based on data from the Bank for International Settlements (BIS), shows the increase in total debt to GDP ratios for the primary emerging markets for the past 10 years, five years and three years. Note the extremely high increase in this ratio for many countries. These increases would be remarkable under any circumstances but are especially concerning in that this has been a period of relatively low growth. Look at the example of Brazil: the very large increase in the debt was not used at all for investment and therefore will in no way produce the cash flows to service interest.

What is remarkable is how generalized and sustained the trend has been over this entire period.

China’s course is unprecedented. Though marked by the dominant role of public sector corporates and therefore, arguably, quasi-fiscal in nature, the unsustainable increase and the high level of debt raises concerns about a Japan-like “zombification” of the economy. Chile’s path is also very concerning.

India is the outstanding exception. High GDP growth, tight control over state banks and a reluctance to tap cross-border flows are the explanation, and this positions India very well for the future.

Not only have debt ratios for EM countries increased at a very high pace they are also approaching high levels in absolute terms. The rise in EM debt levels has occurred while debt levels in developed economies have been somewhat stable, rising from 251% of GDP to 276% over the past ten years. As the table below shows, China and Korea are now at levels associated with developed economies and Malaysia is not far behind.

Finally, external debt levels have also risen consistently, as shown in the charts below. If we consider a level above 30% of external debt to GDP to mark vulnerability, most EM countries find themselves in this condition, at a time when the dollar is strengthening and U.S. interest rates are rising.

Macro Watch:

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

Trade Wars

  • Trump pushes China to self-sufficiency (SCMP)
  • The road to confrontation (NYT)
  • The real China challenge (NYT)

India Watch

  • Election uncertainty clouds Indian stock market (FT)

China Watch:

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

China Technology Watch

  • 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

What Caused Brazil’s Great Recession?

The debate continues on what caused Brazil’s most recent economic crisis, the deepest and longest the country has experienced since the Great Depression.

Nobel Laureate, Paul Krugman, gave his view in his New York Times column a few weeks ago (“What the Hell Happened to Brazil?”,  Link). Krugman points to “bad luck” in the form of a severe terms- of- trade shock caused by falling commodity prices, which in turn led to an unwinding of excessive household debt and a severe drop in domestic consumer spending. Brazil, according to Krugman, underwent a debt deflation process, not the typical “sudden stop” emerging market crisis where a build-up in foreign debt reverses when foreign capital abandons a country. The duration and depth of the recession, Krugman believes, were caused by bad policy mistakes: a combination of fiscal austerity and monetary tightening, at a time when Keynesian stimulus could have been effective.

Barron’s Magazine has also chimed into the debate with two articles by Mathew Klein (“Understanding Brazil’s Latest Depression” and “What Triggered Brazil’s Crisis,” Link).  Klein points to a massive increase in private debt between 2005-2015 which was accompanied by a large increase in foreign capital inflows, mainly into stocks and bonds. When the capital flows reversed in 2012-14 and the downturn began, the Brazilian authorities tightened both fiscal and monetary policies and deepened the fall, Klein writes echoing Krugman. Klein notes a fiscal adjustment of 5% between 2013 and 2016 (from a surplus of 2% to a deficit of 3%) but still agrees with Krugman that the authorities were too conservative on the fiscal front and focused largely on the tightening of monetary policy to stabilize financial markets.

Both the Krugman and Klein articles are insightful, but I take issue on several points. First, both Klein and Krugman make a glaring omission by not considering political factors. The reelection of President Dilma Rousseff  (October 2014) was a great disappointment for the business community and financial markets and probably triggered the start of the recession. At the same time, Brazil entered an enormous political crisis, with the explosion of the “Car Wash” graft probe (initiated in 2014, and still going on)) which implicated hundreds of businessmen and their political cronies.  This was soon followed by the impeachment of President Dilma (2015). These unsettling political events certainly played a big role in deepening and extending the downturn.

Second, both Klein and Krugman somewhat mischaracterize the crisis: Krugman, by arguing that Brazil’s woes were more akin to a developed market crisis and could have been alleviated through  stepped-up fiscal spending; and Klein, by stating that the commodity cycle (2003-2012) should be considered  largely irrelevant to the discussion.

I think the evidence does no support Krugman’s idea. In fact, the crisis should be seen as a garden-variety boom-to-bust emerging market crisis. This is clear if we put the event  in the context of the many EM crises of the past decades.  Ray Dalio’s book Principles for Navigating Big Debt Crises (Link) provides a good account of the record. Dalio’s “Economic Machine” concept is that financial crises are linked to debt cycles which evolve in predictable patterns and all go through three phases:  the bubble build-up, the depression  adjustment and the reflationary recovery.  Dalio looks at the specifics of 48 crises, 23 of which occured in major emerging markets and are summarized in the chart below. Brazil’s latest crisis is not included in Dalio’s book but I have added it for comparative purposes. The chart shows each country’s characteristics at the peak of the boom cycle in terms of the following criteria:

  • Expansion of the Debt to GDP Ratio of at least 5%
  • Foreign Debt to GDP of at Least 30%
  • Fiscal Deficit at least 2% of GDP
  • GDP Output Gap of at least 5% (GDP 5% over trend growth)
  • Currency at least 10% overvalued
  • Current Account Deficit over 3% of GDP

When a country meets most of these criteria its economy is considered very overheated and vulnerable to a serious downturn.

Not every crisis is the same. Every crisis has its own particularities, but by-and-large they follow the same pattern, meeting the criteria over 80% of the time. Russia, with its structural current account surplus, is the only anomaly, with both booms and busts dictated by oil-driven terms-of-trade shocks.

Brazil’s crisis fits like a glove, amply meeting all the criteria with the exception of “foreign debt to GDP.” But, even this exception is due only to nomenclature, because foreign capital inflows this time took the form of  direct investment in Brazil’s liquid bond markets instead of foreign debt. Brazil does in fact experience a pretty standard “sudden stop” when the end of the commodity boom leads to a reversal in capital flows.

In regard to Klein’s discounting of the relevance of commodities as a major factor, I think this is very unlikely. Brazil, with its historical dearth of domestic savings, has always been very sensitive to terms-of-trade shocks. This latest boom-to-bust cycle for Brazil starts with the China-driven boost in commodity prices in 2003 and comes to an end with the collapse in prices that begins in 2012. A glance at any commodity chart confirms this.

Though Brazil is not nearly as sensitive to commodity prices as Russia, they still do matter a lot in that they drive the current account; and when they rise  a solvency effect occurs which lowers country-risk perceptions and attracts foreign capital flows.

I think we can safely say that Brazil experienced an entirely traditional boom-to-bust cycle triggered by an increase in commodity prices.

However, the duration and depth of the crisis are more difficult to explain. In the past, Brazil’s economy always proved to be resilient and bounced back quickly from downturns, but this decline  has lasted longer and caused more pain.   So, what happened?

Why Did Brazil’s Recession Dragged on for so Long?

Both Krugman and Klein blame Brazilian policy-makers for the economy’s extraordinary downturn. But, in arguing that traditional Keynesian fiscal stimulus would have worked, Krugman shows a lack of sensitivity for the “curse” of emerging markets, which is precisely the difficulty of implementing counter-cyclical policies. This “curse,”  which is arguably the defining characteristic of EM, exists mainly because of “hot” and fickle  foreign capital flows, and this is especially true for a savings-defficient  economy like Brazil’s facing a term-of-trade shock.

Klein is closer to the mark by stating that policy makers obsessed over meeting inflation targets because of Brazil’s recent experience with hyper-inflation.

Dalio’s data-base is useful to determine how the recent Brazilian crisis may be unique in terms of how policy makers responded. In Dalio’s framework, the bubble is followed by a “depression,” typically resulting in a deleveraging which sets the base for an eventual reflation period and the start of a new cycle. The chart below looks how during past EM crises emerging market policy makers have typically “engineered,” willfully or not, this depression phase. We focus on the three main levers of adjustment: currency devaluation, current account adjustment and inflation.

What we see clearly is that adjustment periods are all essentially the same, and Brazil in 2012-2017 is no exception. Countries devalue to smoothen the adjustment in the current account and they allow inflation to ramp up. Both devaluations and inflation are taxes on consumption, which drive the adjustment.

But, policy makers in Brazil opted to “cushion” the adjustment. We can see this in the following three charts.

Devaluation – The Brazilian real was allowed to fall, but slowly and not nearly as much as in previous downturns, and not enough to adjust the current account. Brazil’s authorities probably felt that the huge foreign currency reserves accumulated during the commodity boom gave them the luxury to soften the BRL’s decline, and this was orchestrated in the name of financial stability.

Current Account –  The current account adjusted, but only after commodity prices staged a rally in 2016-2017.  The lack of a strong current account adjustment in the face of a terms-of-trade shock is very unusual.

 

Inflation –  Inflation rose briefly, but was then squashed by extremely tight monetary policy. Brazilian real rates (after inflation) rose to as high as 7% at a time when U.S. and European real rates were negative.

Why did policy makers choose this path? First, politics interfered, as Rousseff primed the economy to ensure her reelection in 2013-14. This served to  worsen conditions and delay the adjustment. Also, I agree with Klein that the the Central Bank’s obsession with inflation-targeting was  rooted in historical experience. Policy makers understood that inflation is a direct and exclusive tax on the poor because the owners of capital in Brazil have safeguards. But, at the same time, the Central Bank in Brazil, like elsewhere, being a  captive of financial markets may have seen its mandate to be to preserve financial stability at any cost. By allowing greater changes  in both the value of the BRL and the level of inflation, authorities could have imposed a greater cost on foreign holders of domestic debt and domestic dollar-indebted corporates but they were very reluctant to do this.

Ironically, though financial stability was well maintained in Brazil and inflation was contained, it was still the poor that bore the burden of the crisis. This time it was not through the inflation tax but rather through a long and brutal decline in employment and wages.

Also, the policies had two highly perverse effects (shown in the charts below).

  • Very high interest rates dramatically increased public debt levels, causing a new source of potential stress. Brazil failed to take advantage of the crisis to engineer a deleveraging of the economy and set a new base for a new reflationary debt cycle.  The debt-to-GDP ratio actually increased by nearly 30 points since 2012, and now public debt sits at precariously high levels.  We can contrast this with the significant deleveraging that occured in the 2002 recession, setting a base for the economic boom starting in 2004.
  • The relatively strong and stable BRL encouraged Brazilian corporates to borrow in international markets, also creating a new source of stress. External debt to GDP has risen from 18% of GDP in 2012 to 27% in 2017 (World Bank data), now approaching dangerous levels.

If every crisis creates opportunities, in this case Brazil failed. On the other hand, the crisis led to the rise of Bolsonaro and the prospect of liberal reforms, so maybe it was not a total loss.

External Debt Metrics

 

Macro Watch:

  • A users guide to future QE (PIIE)
  • Economic brake-lights (Mauldin)

Trade Wars

  • The road to confrontation (NYT)
  • The real China challenge (NYT)
  • China and the uS are on a collission course (brookings)
  • How Trump and Xi got into a trade war (WSJ)

India Watch

  • Election uncertainty clouds Indian stock market (FT)
  • India electrification to impact copper demand (Gorozen
  • Can the rupee become a hard currency? (Livemint)

China Watch:

  • China picks tobacco taxes above public health (WIC)
  • How free is China’s internet? (MERICS)
  • China extends its global influence (NYT)
  • How cheap labor drives China AI (NYT)
  • China’s property barons (SCMP)

China Technology Watch

  • A profile of Bytedance, Chna’s short-video ap (The Info)
  • Sense-time’s smart cameras (Bloomberg)
  • China’s Electric Vehicle push (Bloomberg)

Brazil Watch

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

EM Investor Watch

  • 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

  • Why have solar energy costs fallen so quickly (VOX
  • Asia leads in robot adoption (QZ)
  • The new industrial revolution (WSJ)

Investing

  • The top 100 asset managers in the world (Thinking Ahead)
  • An evolve or die momeent for the world’s great investors (Fortune)
  • Interview with William Eckhardt (Turtle Trader)
  • Why momentum inveting works (Anderson)

 

Billionaires in Emerging Markets

In April 2010 Brazil’s Eike Batista told the U.S. talk-show host Charlie Rose he would soon be the richest man in the world. As his vast oil discoveries came on stream, Batista said, his fortune would reach $100 billion, nearly double the $50 billion held by Bill Gates and Warren Buffet at the time. Three years later, after mostly dry wells, Batista’s oil company, OGX, filed for bankruptcy. Batista’s rise and fall is a good reminder of the ephemeral nature of great fortunes, particularly in the boom-to-bust conditions that characterize emerging markets. Huge wealth accumulation, particularly when it comes out of nowhere, is often a manifestation of extraordinary and temporary circumstances that have boosted asset prices to elevated levels. By looking at great wealth we can often identify where the greatest excesses are occurring in the markets. The chart below shows the ten-year evolution of the top ten richest individuals in the world, as compiled by Forbes magazine. Highlighted in red are the individuals who are based in emerging markets.

The first thing to note is the mercurial nature of the list. Only three names from 2008 remain on the list in 2018.

The changes in the list reflect economic and stock market cycles. Six out of the ten names in 2008 are from emerging markets, a consequence of the commodity-fueled liquidity boom that  greatly boosted asset prices in EM between 2002-2008.  India had an incredible four names on the list in 2008, the best possible indication of what has come to be known as the “billionaire Raj,” a process of enormous wealth accumulation and concentration based on “cozy” relations between business moguls and politicians.  Since 2012, India has disappeared from the top ten, as some of the excesses of the system have been curtailed.

Supported by the elevated commodity prices and global liquidity caused by China’s unprecedented credit-fueled construction boom, emerging markets remained active on the list until 2013. Eike Batista appears as the 8th name on the list in 2010, the year of the Charlie Rose interview, and peaks at seventh place in 2012.

After 2013, Carlos Slim has been the only representative of EM on the list, and his standing has been steadily declining because of the weakness of the Mexican peso and the very poor performance of his publicly-traded companies (since year-end 2012, Slim’s main asset, AMX, has lost 35% of its value while the S&P 500 has risen 110%.

Since 2012, the strength of the U.S. dollar, the remarkable outperformance of U.S. assets relative to the rest of the world and the surge of valuations for the FANG (Facebook, Amazon, Netflix and Alphabet-Google) and other tech stocks has led to the near-total domination of the top 10 ranking by Americans.  Bezos and Zuckerberg both appear on the list in 2016, and Bezos was crowned richest man in the world in 2018.

The most fascinating change of the past decade, the rise of China, is not done justice by the chart above. For this, we have to look at the top 100 names, as shown in the charts below.

 

There are many striking changes shown by these two charts, mainly driven by the end of the commodity/EM boom, the continued rise of China and the great rise of the QE-fueled U.S. bull market.

In 2018, China becomes the second largest contingent on the list with 19 names, compared to zero in 2008.

In 2018, 18 out of the top 30 are Americans and five are Chinese, compared to eight and zero, respectively, in 2008. Russia had seven names in the top 30  in 2008 but zero in 2018, and India goes from four to one.

The full list is shown below.

Macro Watch:

  • A users guide to future QE (PIIE)
  • Economic brake-lights (Mauldin)

Trade Wars

  • Henry Paulsen gets negative on China (WSJ)
  • U.S. accuses Cina firm of stealing Micron secrets (Wired)
  • Asia’s next trade agreement (Brookings

India Watch

  • India electrification to impact copper demand (Gorozen
  • Can the rupee become a hard currency? (Livemint)
  • Can India become the next $10 trillion economy ?(Wharton)
  • Apple is losing share in India to Chinese (Reuters)

China Watch:

  • China’s infrastructure investments in Latin America (The Dialogue)
  • China’s art-factory  town is evolving (Artsy)
  • China’s global infrastructure push (NYT)
  • Kevin Rudd on China reforms (Caixing)
  • 50 million empty homes in China (SCMP)
  • China and Myanmar approve port project (Caixing)
  • Four reasons to manage China’s rise  (Lowy)

China Technology Watch

  • China’s Electric Vehicle push (Bloomberg)
  • The rise of Asia’s research universities (The Economist)
  • China’s tech slowdown (Reuters)
  • China fights back on IP theft accusations (scmp
  • A graphic view on China’s tech progress (NYT)

Brazil Watch

  • The rise of evangelicals in Latin America (AQ)
  • Brazil’s new foreign minister says climate change is a marxist plot (The Guardian)
  • Brazil’s new finance tsar (Bloomberg)

EM Investor Watch

  • Russia’s new pipeline (Business Week)
  • Indonesia’s elections (Lowy)
  • Chile’s renewable energy boom (Wiley

Tech Watch

  • The new industrial revolution (WSJ)
  • Pathways for inclusive growth (BSG)
  • Paraguay is a bitcoin powerhouse (The Guardian)

Investing

  • The top 100 asset managers in the world (Thinking Ahead)
  • Interview with William Eckhardt (Turtle Trader)
  • Why momentum inveting works (Anderson)
  • Learning from investment history (Forbes)
  • The rise of “quantamentals” (FT
  • Monish Pabrai’s ten commandments (Youtube)
  • A profile of Paul Singer (New Yorker)