April 2019 – The Emerging Markets Investor

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

A primer on India’s elections (Chatham House)
India’s digital transformation (McKinsey)

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

Can the gold industry come back (McKinsey)
Ruchir Sharma is bullish on EM (Barrons)
Why trust is the gold standard in EM entrepreneurship (Wharton)
Peak Profit Margins (Bridgewater)
When will value outperform growth? (Barrons)
The man who cracked the horse-betting code (keanchan)
Trading lessons from Michael Marcus (Macro-ops)
KKR Insights on the investing environment (KKR McVey)
Why capitalism has to be reformed (Ray Dalio)
Ten advantages of the amateur investor (Behavioural Investment)
Why does momentum investing work? (Behaviouralinvestment)
Two centuries of momentum investing (Thinknew found)
Research Affiliates Presentation (RA)
Popularity : a bridge between classical and begavioral finance (CFA)
Ray Dalio’s view on the global economic cycle (Linkedin)
Interview with Norbert Lou (Tao Value)
Credit Suisse annual Investment Report (Credit Suisse)
Who is on the other side? (Mauboussin)
Factors and business cycles (Papers ssrn)
50 reasons not to invest for the long-term (Abnormal returns )

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)