Month: April 2018

Exploiting Boom-to-Bust Cycles in Emerging Markets

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

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

 

 

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

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

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

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

Fed Watch:

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

India Watch:

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

China Watch:

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

China Technology Watch:

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

Technolgy Watch

  • Taiwan is falling behind Korea (SCMP)

EM Investor Watch

Investor Watch:

 

 

 

 

Financial Bubbles in Emerging Markets – The Case of Brazil

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

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

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

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

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

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

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

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

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

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

We now look in detail at the Brazilian experience.

The Case of Brazil

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

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

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

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

Fed Watch:

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

India Watch:

  • India’s demographic dividend (Livemint)
  • Modi’s make-in-India strategy (NYT)
  • Infosys to sacrifice margins for growth (Bloomberg)
  • Reset with China is a grand illusion (Livemint)
  • Gujarat plans world’s largest 5GW solar park (India Express)
  • Alstom and GE’s made-in-India locomotives (Swarajya)
  • Xiaomi’s made-in-India phones (Caixing)
  • India’s biometric data program growing pain (NYT)
  • Mohnish Pabrai on the Indian market (Youtube)
  • Half a billion mobile internet users in India (Quint)
  • Digital streaming is taking over cinema (Quint)

China Watch:

  • China’s big plans for Hainan include gambling (WIC)
  • China grants visa-free travel to Hainan (SCMP)
  • China’s economy is closing not opening (SCMP)
  • Qingdao Haier to list in Germany (Caixing)
  • JPM China stock investment strategy (SCMP)
  • Trade war ominous implications (George Magnus)
  • China airline threatens move to Airbus (SCMP)

China Technology Watch:

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

Technolgy Watch

EM Investor Watch

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

Investor Watch:

 

 

Trends in Emerging Markets ETFs

 

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

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

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

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

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

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

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

Source: ETF.Com

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

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

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

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

Fed Watch:

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

India Watch:

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

China Watch:

  • China airline threatens move to Airbus (SCMP)

China Technology Watch:

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

Technology Watch

EM Investor Watch

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

Investor Watch: