May 2018 – The Emerging Markets Investor

The pace of change in emerging markets is accelerating. Unfortunately, in most countries the political class and policy makers are entirely oblivious of the future trends.

The enormous changes come on three fronts.

The End of Bretton Woods

President Trump’s “America First” dogma is emblematic of a change in mood both in America’s heartland and Washington thinktanks. Americans increasingly don’t see the value in paying for the “Pax Americana” announced at the Bretton Woods Conference in 1949; an American promise to pay for the security of its allies and provide open, rules-based markets. The model worked incredibly well for over six decades bringing peace and growing prosperity for most of the world and exceptional success to those countries, not only in Europe, but also in Japan, Singapore, Taiwan, and Korea, which exploited its full potential. With the entry of China into the picture, America is reconsidering Bretton Woods. China rocked the boat in two ways: first it is too big and has become too powerful economically to be allowed to play the same game; second, it is considered not an ally but an adversary. For Donald Trump it does not make sense to pay for a system that promotes the rise of a potential rival.

“Re-shoring

The end of the Bretton Woods model likely means a much less secure world with less trade. Trump’s comment this week about reducing the U.S. troop count in Korea is a sign of things to come, which will result in Japan, Korea and Europe having to foot more of the bill for their security. It also means companies will be much more reluctant to rely on value chains stretching around the globe. This will accelerate the existing trend towards so-called “re-shoring,” where companies bring production back closer to the final consumer. We see this already in “fast-retail” where Zara is the new model of success, with almost all its production in northern Iberia. Also, as Adidas is showing, robotic automation and 3D printing is bringing the manufacturing of sneakers and basic clothing back to Germany and the United States.

For small countries running apparel sweatshops for export (e.g., Mauritius or even Bangladesh), the future looks bleak. For large economies, like Brazil, India or China there is an opportunity to keep production at home instead of exporting demand. The Chinese have clearly understood this, and they are leading the way to automating basic industries. For Brazil, a country undergoing a dramatic case of what Harvard professor Dani Rodrick has dubbed “premature de-industrialization”, there may be a golden opportunity to revive once vibrant shoe and apparel industries.

Energy is another area where “reshoring” and its effect on global trade is occurring before our eyes. Breakthroughs in technology for the production of shale oil and gas and the declining cost of wind and solar energy have made North America fully self-sufficient in energy, undermining the U.S. commitment to the security of Middle-Eastern oil producers. This is another area where policy makers in emerging market countries need to act to secure cheap and decentralized energy for the future. Chile is the example to follow, with its ambitious plans to dramatically reduce its dependence on imported fossil fuels by developing its world class potential in solar, wind and geo-thermal resources.

A World of Scarce Capital

Finally, unavoidable demographic trends will increase the cost of capital. Capital has been super-abundant for the past two decades because of the peak saving years of the baby-boom generation, but boomers are now retiring and moving from savers to pensioners. The increasing scarcity of capital and rising interest rates will be a huge challenge to most emerging market economies, as markets will become much less forgiving of highly indebted countries and those that provide hostile conditions for business.

Fed Watch:

The rising USD and EM (WSJ)

India Watch:

Stock fever grips India retail (WSJ)
Ray Dalio is bullish on India (IB Times)
The strategic importance of India’s rise (CSIS)

China Watch:

JPMorgan on MSCI A share inclusion (SCMP)
Korean cosmetics lose their edge in China (WIC)
Samsung’s sales collapse in China (WIC)
Thoughts from China’s elites (FT)

China Technology Watch:

China’s response to US on tech (Axios)
DJI is shaking up China private equity (WIC)
China installed 10 GW of solar in Q1 (Tech Review)

Technolgy Watch

Taiwan is falling behind Korea (SCMP)

EM Investor Watch

The rise of strongmen in global politics (Time)
Turkey’s finances spiraling out of control (Heisenberg)
Morocco’s solar ambitions (WEForum)
Populism is back in Indonesia (The Malaysian Reserve)

Investor Watch:

Buffett’s secret sauce no longer adds value (Advisor Perspectives)
Buffett’s Edge (Master Invest)

Stormy waters are putting on hold the two-year bull market in emerging market equities, leading cautious investors back to port.

Emerging market securities – both stocks and bonds – are relatively risky assets that attract investors when the global economic scene is benign and potential returns for investments are better in international markets than in the United States. This has been the case for the past two years, and, as usually happens during these periods, the U.S. dollar has weakened, serving to further enhance returns outside the U.S.

The recent break-out of the dollar after a 3-month consolidation, points to an important change in the trend. Yield-chasing investors have started moving back to safety, abandoning “carry trade” currencies that were attractive for the past several years because high interest rates were enhanced by appreciating currencies. The major “carry trade” currencies – Indonesia, Turkey, Brazil, Argentina – have all seen their stocks, bonds and currencies trashed in recent weeks.

The move in the dollar is probably related to an incipient deterioration in the global economic environment. The market narrative since late last year was of a strong “global synchronous recovery,” but signs of slowdowns in Europe, China, Japan and Brazil have thrown some cold water on this. Very contentious and possibly calamitous upcoming elections in Brazil and Mexico are also cause for concern.

However, the most important development is the dramatic attack on global trade being carried out by President Trump. The anti-trade zealots in the U.S. Administration, who now have the upper hand in the White House, stepped-up their hostile stance towards China in this week’s meetings in Beijing. At the same time, Washington has started a full-scale war against Chinese tech companies, Huawei and ZTE. Also, hopes of reaching a NAFTA settlement before the Mexican elections are fading, as the U.S. insists on industry-by-industry micro-management.

The intransigent, “take it or leave it attitude” of U.S. negotiators is causing enormous ill-will with America’s allies and major trading partners. The imposition of steel and aluminum quotas on Brazil last week stunned Brazilian negotiators. The spokesman for Brazil’s aluminum firms, Milton Rego, described U.S. tactics as “Al Capone-like,” and added: “You get better results by pointing a gun to the head.”

On the positive side, emerging markets are still well positioned in terms of very low valuations relative to the U.S. and the recovery in commodity prices. Oil prices, in particular, continue their rising trend. Increasing investments in oil producing countries and reducing positions in oil importers may be one of the few attractive trades in these turbulent waters, but in general it is probably best to stay closer to shore.