Month: July 2018

Emerging Markets’ Innovation Problem

The Global Innovation Index ( GII)  measures how countries compare in their ability to innovate. Presumably, innovation drives productivity and development, and, therefore, the most innovative economies are also those enjoying the best growth in living standards. Today we face revolutionary breakthroughs in artificial intelligence and automation technologies which promise to radically change  for the better the way we work and live. However, these changes present a heavy challenge for many emerging markets as new technologies eliminate the rote manufacturing jobs traditionally off-shored to labor-abundant developing countries.

Sponsored by Cornell University, INSEAD and WIPO (World Intellectual Property Organization),  since 2007 GII ranks countries in terms of their innovation potential. This gives us a decade of observation to gauge how different countries are progressing. Unfortunately for emerging markets, the evidence is disappointing, with a few important exceptions. By and large, emerging markets appear to be falling behind in their innovation capacity.

The chart below shows the rankings of the top 25 most innovative countries in both 2007 and 2017, with arrows pointing to the change in position.

 

The rise of small European countries is highly significant. Switzerland, the Netherlands, Ireland and the Nordic countries have all progressed very positively. This contrasts to the relative decline of France, Germany and Italy. In any case, eight  of the top 10 innovators in the ranking are European countries, which belies the prevalent market pessimism on the prospects for Europe. Italy, India, UAE and Belgium fell out of the “elite “top 25, replaced by China, Czech, Estonia and New Zealand.

In relation to emerging markets, the chart highlights the radical divergence of India and China. China has had a steady rise up the rankings from 29th in 2007 to 25th in 2016 and 22nd  in 2017. South Korea has also had an impressive escalation, from 19th to 11th; and, remarkably, it has surpassed Japan which has fallen from 4th to 14th. However, the most concerning performance has come from India which has seen its ranking fall from 23rd to 59th.  This result raises serious questions about the quality of Indian growth.

India’s decline is emblematic of a wider problem in emerging markets, as the below chart highlights

 

The chart highlights how the GII rankings have changed for the 18 most important countries for investors in emerging markets.  Of these 18, two-thirds have had significant declines in their rankings and only one-third has experienced improvement. Of these EM countries, only eight rank in the top 50 for innovation, compared to eleven in 2007. Aside from China and Korea mentioned above, Vietnam, Poland and Russia have risen in the rankings. The rise of Vietnam is impressive and gives credence to its claim as the rising star of “frontier markets.”

On the negative side,  India, Brazil, Mexico, South Africa, Thailand, Colombia and Indonesia are evolving very poorly, raising questions about how they can compete effectively in an increasingly competitive, technology-driven global economy. Also in this camp, the Philippines and Argentina are in dire situations. These countries do not seem able to nurture the institutions and make the public investments required for investment and productive innovation to take place. Consequently, their best minds are deserting, immigrating to more hospitable places.

Macro Watch:

India Watch:

  • India pushes coal (SCMP)
  • Samsung opens world’s largest smartphone factory in India (Bloomberg)
  • Scarsity of visas is shaking up Silicon Valley (SF Chronicle)

China Watch:

  • Why was the 20th Century not Chinese (Brad Delong)
  • The Chinese view Trump as cunning strategist (FT)
  • US-China Trade War – How we got here (CFR)
  • China will not reflate this time (Marcopolo)
  • Xi’s vision for China global leadership (Project Syndicate) (Kevin Rudd)

China Technology Watch

 

  • China’s BOE targets Apple screens (WSJ)
  • Tsinghua Unigroup bids for French tech firm Linxens (SCMP)
  • Interview with AI expert Kai-Fu Lee (McKinsey)
  • JD.com is driving commerce in rural china (Newyorker)

EM Investor Watch

  • Can Iran by-pass sanctions (Oil Price.com)
  • Brazil’s military strides into politics (NYtimes)
  • An update to the big mac index (Economist)
  • Interview with Kissinger (FT)
  • Erdogan’s “New Turkey” (CSIS)

Tech Watch

  • Seven reasons why the internal combustion engine is dead (Tomraftery)

Investing

 

 

 

 

The Impact of Trade Wars on Emerging Markets

The main goal of American diplomacy now appears to be to disrupt the post-war rules-based global economic order. President Trump viscerally believes that the status quo is rigged against the United States and in favor of America’s most important trading partners. In this scheme of things, traditional allies like Canada, Mexico and Germany are “ foes” and a rising economic power like China becomes an existential threat to American hegemony. On the other hand, countries do not export large amounts to the U.S are irrelevant (e.g. South America) or potential friends (e.g. North Korea, Russia)

According to the Trump Doctrine, global trade and investment are zero-sum games which should naturally be dominated by the U.S. because of its heft and competitive advantages. Trump believes that the U.S. is entitled to dictate terms to those countries that seek access to its markets, capital and technology. Central to this view, the U.S. has only two real rivals that challenge its hegemony: Germany and China.

Germany is seen as having taken control of Europe through the European Union, exploiting divisions to its own benefit, in order to further its global mercantilistic ambitions. Trump fervently supports Brexit because a divided Europe weakens Germany. Brexit would allow the U.S. to impose its own terms on a bilateral U.S.-U.K. trade deal.

China is seen by Trump to be a highly disloyal competitor which exploits the current global order to its own advantage. Allowing China into the WTO was “the worst deal ever,” and caused enormous damage to the U.S. economy. According to Trump, China’s business practices are utterly unfair for the following reasons:

  • Currency manipulation.
  • High tariff and non-tariff trade barriers.
  • Violation of intellectual property rights.
  • Highly restricted access for foreign investment, and imposition of JV requirements and technology transfer agreements.
  • State control of the economy, with huge subsidies provided to both state-controlled and private Chinese firms.

Moreover, as China steadily moves up manufacturing value chains, the U.S. has become obsessed with potential  future competition in high-technology goods. The focus of Washington’s anger is President Xi’s “Made in China 2025” plan to promote Chinese competency in key industrial technologies. Trump’s recent tariffs imposed on China are heavily targeted on the sectors that Xi has determined to be strategic, as shown in the chart below.

Consequences of the Trump Doctrine

As the U.S. questions the transatlantic alliance and the post W.W. II global institutional framework it will abdicate its role as the leader of the project. Without U.S. leadership new alliances will form in unpredictable ways. Though the current situation is highly dynamic and the future is unpredictable, some thoughts are in order:

  • The Trump Doctrine is isolationist for America. As Henry Kissinger has pointed out, the U.S. stands to become a “geopolitical island… without a rules-based order to uphold.” Nevertheless, as the largest and most diverse economy, the U.S. may have the least to lose.
  • America’s neighbors Mexico, and Canada will have no choice but to begrudgingly cave-in to U.S. bullying and accept Trump’s terms. Any deal will be better than no deal.
  • As it undermines the Western Alliance, The Trump Doctrine furthers the interests of both Russia and China. Ironically, both these dictatorships are more comfortable  dealing on a bi-lateral transactional basis than the U.S. with its checks and balances and elections. China is in a good position to trade access to its growing consumer economy on a transactional basis.
  • American isolationism and unilateralism also strengthens China’s hand in its One Belt one Road (OBOR) initiative which has as its primary objective the control of the Eurasian steppes (the old Silk Road, linking China with Europe and the Middle East.) Russia and China are enjoying the warmest diplomatic ties since the 1950s as they see eye-to-eye on this Eurasian strategy; for the Chinese it secures its borders and opens up commerce; for Russia it extends its geo-political reach. As Kissinger has noted,  Europe may become “an appendage of Eurasia.” Key targets here are Iran and Turkey, both of whom are currently at odds with American policy.  China has become Iran’s main trading partner and investor and is committed to buying its oil.
  • Both China and Russia see American “sanctions diplomacy” as a fundamental violation of the global rules-based economic order. U.S. imposed restrictions on Russia, Iran and other countries on the use of the SWIFT global financial transfer system and recent sanctions on Chinese telecom firm ZTE on the import of U.S. components have highlighted the urgency for reducing dependence on the U.S.  This will strengthen China’s resolve to achieve competence in key technologies and further efforts to develop alternatives to the U.S. dollar.  India is also dismayed by American strong-arm tactics, as sanctions are interfering with its commercial ties to Iran and the Middle East and its strong ties with Russia.
  • American antagonism towards the E.U. may also push Germany towards China. Germany may increasingly play its cards in Asia, which is increasingly the center of gravity of the global economy. It is probably not a coincidence that as Trump has launched his trade war against Beijing there has been a sudden rapprochement between Germany and China, and the announcement of a slew of important business transactions. First, BASF was given the go-ahead on a $10 billion fully-owned petrochemical plant, an unprecedented concession by the Chinese in a sector where Germany and the U.S are chief rivals. Second, German companies are securing preferential treatment in the auto sector, now by far the largest in the world and the focus of activity for electric vehicles and, increasingly, autonomous vehicles. In recent weeks, Daimler was awarded a permit to test driver-less cars In Beijing, a first for a foreign firm. Daimler is partnering with Baidu Apollo, a leader in mapping and artificial intelligence applications in China. Also last week Chinese Premier Li Keqiang said BMW may get control of its JV with Brilliance by 2022. BMW, which already has China as its largest market producing about 25% of global profits, has committed to a large increase in capacity and a partnership with Baidu. BMW also secured the right to take an equity stake in CATL, the world’s largest electric vehicle battery producer by sales, after the carmaker agreed to purchase $4.7bn worth of battery cells from the Chinese company. Finally, Volkswagen announced a partnership with FAW for electric vehicles and autonomous cars.
  • The announcement by Tesla last week that it would build its cars in a fully-owned plant in Shanghai is another sign of how companies are adapting to the Trump Doctrine. Chinese tariffs on American cars have increased the price of Teslas in China at a time when dozens of very well-financed local start-ups are coming on stream. Though the move is a significant market opening benefit for an American firm, it can also be seen for Tesla as a desperate attempt to remain relevant in China’s EV market at a time when sales are expected to ramp up dramatically. Still, it may be too late for Tesla, as its plant will not come on stream until 2020.
  • Access to the Chinese market is of great importance to multinationals. In a transactional world, the Chinese can provide access judiciously to secure powerful allies in developed countries. In the case of the U.S., China continues to offer incremental access to financial services, a long-standing demand of American firms.
  • “Winners” in the age of the “Trump Doctrine” are large countries with strategic importance. China is likely to come ahead, as it has strategic importance, a huge market and leadership with long-term objectives. India is not considered a rival by the U.S. and has high strategic value, so it also is in a good position to secure favorable terms. Brazil, though of no strategic value for the U.S., is not considered a rival by Trump and is also in a good position to negotiate.
  • “Losers” are small countries with no strategic value for the U.S.. As global value chains are disrupted by American unilateralism, those countries most dependent on exports to the U.S. are the most vulnerable. The chart below from Pictet Bank gives a good idea of which countries face the most downside: Mexico, Korea, Vietnam, Thailand, Taiwan, Indonesia and Malaysia. They will face unclear rules which will hurt investment. At the same time, the two largest economies in the world,  the U.S. and China will become more insular and self-sufficient.

Fed Watch:

India Watch:

  • Samsung opens world’s largest smartphone factory in India (Bloomberg)
  • Scarsity of visas is shaking up Silicon Valley (SF Chronicle)

China Watch:

China Technology Watch

  • Interview with AI expert Kai-Fu Lee (McKinsey)
  • JD.com is driving commerce in rural china (Newyorker)
  • Tesla-foe Xpeng’s $4 billion valuation (SCMP)
  • China’s tech lag highlighted (SCMP)
  • Tesla’s move to Shanghai (FT)
  • Tesla’s China plan (NYtimes)
  • BMW enters China’s fast lane (WSJ)
  • Daimler and Baidu get ahead on driverless cars in China (Reuters)
  • China wants high-tech cars with German help  (NYT)

EM Investor Watch

  • An update to the big mac index (Economist)
  • Interview with Kissinger (FT)
  • Erdogan’s “New Turkey” (CSIS)
  • Why Bolsonaro is leading Brazil’s polls (Foreign affairs)
  • Pundits are down on EM (Research Affiliates)
  • Indonesia takes control of mega copper mine (WSJ)

Tech Watch

  • Seven reasons why the internal combustion engine is dead (Tomraftery)

 

 

 

 

 

 

 

 

Valuations in Emerging Markets

The current environment appears unattractive for emerging market equities (The Outlook for 2018). Nevertheless, for those disposed to stand pat and allow time to deliver the long-term returns and diversification benefits of investing in emerging markets current valuations are compelling enough to remain invested.

Over the short-term (1-2 years) valuations are not he main driver of stock performance. Liquidity, driven by monetary policy and human psychology are much more important over the short term. This is well expressed in this  quote from the legendary investor Stan Druckemiller:

“Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”

However, over the long term valuations do matter. As Ben Graham once said: ““In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Valuations do matter and they are the key driver of long-term performance. So, where are we now with vauations in emerging markets?

At the end of June, emerging market equities remained inexpensive relative to their own history and very cheap compared to the S&P 500. As the table below details, EM equities trade at about half the level of the U.S. market on a price-to-earnings basis and are even much cheaper on the basis of a cyclically adjusted price-to-earnings ratio (CAPE; price divided by 10-year average inflation-adjusted earnings).  While the S&P500 CAPE is priced at one standard deviation above its recent 15-year average, the EM CAPE is well below its 15-year average. Compared to their own history, EM equities are relatively cheap while the U.S. stock market is very elevated.

 

 

The work of two prominent firms that recommend allocation strategies — GMO and Research Associates – points to the same conclusion.  GMO, in its most recent 7-year forecast recommends EM for its relative attractiveness. As shown in the chart below, GMO sees real (after inflation) annual returns of 2.4% for the next seven years for EM and -4.4% for the S&P500.

Research Affiliates projects similar outperformance for EM, with 6.7% real annual returns for the next ten years from EM, compared to 0.3% for the S&P500.

These attempts at projecting future returns are, to a large degree, based on the assumption  that valuations revert to historical means over the long term (7-12 years).

Country-specific Valuations

Emerging markets are a very broad asset class, so it is not surprising that valuations vary greatly  across the markets. One of the main reasons for differences in valuations is that sectorial composition  is not consistent across markets. Because of this, it is generally more useful to compare valuations to a country’s own history rather than to other countries or EM as a whole. This works for most markets but not all. For example, historical comparisons are largely irrelevant in China which has a short trading history and a rapidly changing market structure (10 years ago industrial state companies dominated the market; today private tech firms stand out).

In any case, the charts below rank key emerging market countries in terms of valuation. The first group consists of markets that are valued well below their own history and therefore stand to offer high upside for the future. The second group have low valuations and can be expected to provide above average long-term returns. The third group of countries have relatively high valuation and should provide more modest returns in the next 7-10 years.

The markets with low valuations include several countries – Turkey, Russia and Brazil – that have recently experienced turbulent political disruptions which have caused economic distress and a loss of investor confidence. Argentina is in a similar situation. These markets may require a break with the past through elections or transformational reforms for market recovery to occur. For example, if a reformist leader is elected in Brazil this year, this could provide a trigger for the market to recover strongly.  On the other hand, Colombia, Chile, Malaysia and Indonesia already appear poised for stock market appreciation.

 

 

One-Year Positioning    

 To rank markets in terms of attractiveness for the next twelve months we look at valuations,  and macro and liquidity factors.  Each factor is scored from 2 to -2 for each country. The macro factor measures where a country is in its business cycle; and the liquidity factor looks at credit and flows. Results are shown below. Scores of three and above indicate relatively positive prospects.

 

 

Fed Watch:

India Watch:

  • Samsung opens world’s largest smartphone factory in India (Bloomberg)
  • Scarsity of visas is shaking up Silicon Valley (SF Chronicle)
  • India’s national strategy for artificial intelligence (NITI.Gov)
  • A look at the value factor in the Indian stock market (Indexology)

China Watch:

China Technology Watch

  • Tesla’s move to Shanghai (FT)
  • Tesla’s China plan (NYtimes)
  • Daimler and Baidu get ahead on driverless cars in China (Reuters)
  • China wants high-tech cars with German help  (NYT)
  • The battle to build the next super-computer (Tech Review)
  • America’s war on China tech (FT)
  • China tech start-ups lead VC funding (SCMP)
  • Shanghai aims to raise $15 billion for AI investments (SCMP)

EM Investor Watch

Tech Watch

  • Seven reasons why the internal combustion engine is dead (Tomraftery)

 

 

 

 

The Outlook for Emerging Markets in 2018

Investors in emerging markets stocks started the year upbeat, expecting a two-year rally to continue. Market conditions appeared favorable. Valuations were low relative to the U.S. and other developed markets; and the global economy appeared strong, marked by “synchronized” growth across the developed world, China and emerging markets. Emerging markets also were expected to continue to benefit from rising commodity prices and a weakening dollar, both of which tend to occur during the later stages of the U.S. business cycle.

Unfortunately, by late-January the bullish thesis began to unravel.. The first sign of changes in the market environment was the sudden increase in volatility in the U.S. stock market. After the exceptionally low stock market volatility of 2017, the surge in volatility signaled a new regime of higher market risk. This was confirmed by a sudden appreciation of the U.S. dollar, a tell-tale sign of rising investor risk aversion.  The first chart below from Credit Suisse show the remarkable increase in risk aversion that has occurred since late January. In the second chart , the JP Morgan EM Currency Index highlights the concurrent break in the two-year trend of dollar appreciation.

 

 

 

Concurrently with the return of volatility, during February economic indicators began pointing to unexpected slowdowns in economic activity in both Europe and China. This undermined the thesis of global synchronized growth. Worse, U.S. growth, fueled by enormous fiscal deficits in a late cycle economy operating at full employment, now appeared to be growing at a higher rate than the global economy. The chart below shows the worrisome slowdown experienced by China.

 

Also, early this year we saw an important radicalization of Trump’s “America First” agenda., with a strong rejection of traditional American diplomacy. In particular, his threats of engaging in trade wars with foes and allies alike has significantly increased risks to the global economy.

Finally, early this year markets have started to accept that the U.S. Fed is serious about the normalization of monetary policy. A new, less-dovish Fed governor and the inflationary impact of fiscal expansion and trade wars has convinced investors that monetary tightening is for real.

The new environment that has existed since February – relatively strong U.S. growth, Fed tightening and rising risk aversion – has triggered a strengthening of the U.S. dollar and a downtrend for EM equities. As the following chart from Ed Yardeni Research shows, as usually happens, emerging market stocks started to trend down at the same time that the dollar began to appreciate. The negative correlation of EM stocks with the US dollar (ie. EM stocks fall in local currency terms as the USD appreciates) significantly increases the volatility of the asset class.

 

 

The value of the dollar relative to EM currencies is a key indicator for EM equities, a rising dollar pointing to a move from investors way from high- risk EM securities to the safe haven of U.S. treasury bills. On the other hand,  the two other key indicators to watch for emerging market equities – commodity prices and the spreads on high-yield bonds (U.S. and emerging markets) did not show initial signs of deterioration. In fact, as the charts below show both commodity prices and bond spreads have been stable since late January. It is only in recent weeks that both commodity prices and high-yield spreads appear to have started negative trends. The first chart, the Bloomberg Commodity Index, shows that commodity prices remained resilient through May, but have drifted down slowly since then. The second chart, from the Federal Reserve Bank of St.Louis, shows the difference in yield between high yield bonds and treasure bonds. This spread is a reliable indicator of aversion for risky assets and very negatively correlated to EM equities (as the spread goes up, EM equities fall).

 

 

Conclusion

For the time being, the trend does not favor EM equities, and a cautious stance is in order. If anything, the recent weakness in commodity prices and the rise in high yield spreads points to further troubles for EM equities. Nevertheless, for the medium term a more bullish stance is justified.

First, after the recent correction valuations are once again very compelling.

Second, by the end of this year a series of events weighing on the markets will have passed. The Chinese economy, which has been weighed down by official measures to deleverage corporations , is likely to see a rebound before the end of the year. In addition, the completion of a wave of elections in Turkey, Colombia, Mexico and Brazil will soon bring more clarity to policies for important EM markets.

Third, and perhaps most importantly, next year the U.S. economy is likely to slow down considerably, so that U.S. growth will no longer be higher than that of the global economy. As concerns rise with U.S deficits and the ageing business cycle, dollar weakness may resume.

In conclusion, keep your powder dry as 2019 may be a much better year for EM equities.

Fed Watch:

  • Don’t blame Trump for the decline of globalization (SCMP)
  • The rising USD and EM (WSJ)

India Watch:

  • Scarsity of visas is shaking up Silicon Valley (SF Chronicle)
  • India’s national strategy for artificial intelligence (NITI.Gov)
  • A look at the value factor in the Indian stock market (Indexology)

China Watch:

  • Beijing completes its seventh ring road (WIC)
  • The demonization of China (Foreign Policy)
  • A look at Chinese ETFs (ETF.com)
  • Xi tells CEOs he will strike back at the U.S. (WSJ)

China Technology Watch

  • America’s war on China tech (FT)
  • China tech start-ups lead VC funding (SCMP)
  • Shanghai aims to raise $15 billion for AI investments (SCMP)
  • China plans to leapfrog ahead in key technologies (SCMP)
  • China extends lead in most powerful computers (NYtimes)
  • Google invests in JD.com (CNBC)

EM Investor Watch

Tech Watch

  • Seven reasons why the internal combustion engine is dead (Tomraftery)