January 2020 – The Emerging Markets Investor

Increasing Debt Levels Raise Risks for Emerging Markets

Increasing debt levels are a major source of vulnerability for boom-to-bust prone emerging markets. In its latest Global Financial Stability, the IMF highlighted its concerns for rising debt levels in emerging markets, particularly for corporations seeking cheap dollar financing. (Link)

The IMF report points out that external debt ratios have deteriorated to levels that in the past have signaled high risk, as shown in the two charts below. The IMF’s concern is that this funding will dry up when there occurs a shift in global liquidity conditions.

An important measure of vulnerability for emerging market debtors is the recent rate of debt accumulation. The charts below show the five and ten-year increase in debt-to-GDP ratios for the primary emerging markets. The first chart shows total debt (public and private), while the second chart shows only private debt. Any increase in total debt/GDP ratios of 5-10% during a mere five years can be considered to be excessive and a considerable source of risk. As we can see in the first chart below, China and most of Latin America have been the worst abusers in the past five years. This accumulation of debt is bad in itself but made even worse by the use of the debt: in China, mainly for sustaining low-return investments by state firms; in Latin America, to sustain public sector current expenditures and capital flight.

The accumulation of private debt, shown in the second chart, points to several critical stress points: China, Turkey, Korea and Chile. Chile, which is currently undergoing a severe political crisis that will have an impact on confidence and growth, should be an area of particular concern.

30 Years after the Caracazo

Last year millions of ordinary citizens took to the streets in Chile in what was the most disruptive and violent popular protest in Latin America since the “Caracazo” in Venezuela thirty years earlier. As we reflect on these unsettling events, we should not forget that the “big thing in Caracas” led to Hugo Chavez and his catastrophic Bolivarian Revolution.

There are some similarities between the Chile of 2019 and the Caracas of 1989. Both were seemingly “successful” economies with “stable” democracies, and both had recently benefited from a cycle of high commodity prices that had raised the economic expectations of their citizens. When the inevitable bust occurred and the belt tightening followed, expectations were crushed. The popular narrative suddenly shifted to a viral rejection of what was now seen as a “rigged” system promoted by corrupt politicians and their crony business elites.

In the Spring of 1989, the “Caracazo” street riots erupted in response to prices increases for gasoline and public transport, a situation similar to the 2019 chaos in Santiago. After oil prices collapsed in 1986, Venezuela’s economy tumbled and investors deserted. In February 1989, a newly-elected president, Carlos Andres Perez (CAP), took office. Though during the campaign CAP had denounced the IMF as “a neutron bomb that kills people, but leaves buildings standing,” he now requested the organization’s support, agreeing to a traditional belt-tightening program. The Caracazo upheaval paralyzed the country and resulted in hundreds of deaths. More protests persisted into 1990. They were followed by two coup attempts in 1992 and, shortly after, the rise of Colonel Hugo Chavez and his “Bolivarian Revolution.”

I lived in Caracas from 1980-1984, working as a journalist and business consultant. This was the tail end of the “OPEC oil boom” and the beginning of the debt crisis that was to result in a “lost decade” for all Latin America. When I lived in Venezuela it appeared to be a stable and functional democracy, with regular alternation of power between the left and the right. Despite its problems (traffic, corruption of all sorts, and poor public services), Caracas was a delightful place to live and work. Venezuela was a prosperous country with a large and thriving middle class, and it attracted legions of immigrants from Latin America and the rest of the world. It had a world class oil industry and was a magnet for multinational investments. In the early 1980s, Caracas was the most cosmopolitan city in Latin America, with the best restaurants and lifestyle. Its airport hosted a daily Concord flight to Paris and six daily flights to Miami.

After 25 years of misrule by Chavez and his lieutenant Nicolas Maduro, Venezuela today can only be characterized as a failed state. Its collapsed economy serves only the interests of a small group of kleptocrats.

Venezuela is now ranked 188^th in the World Bank’s “Ease of Doing Business” survey, with only Eritrea and Somalia considered to be worse.

GDP per Capita has fallen by half since Chavez took power, as the World Bank’s data shows below.

I left Venezuela in 1984 to pursue an MBA. I returned periodically, including in 1996 when Chavez was the leader of the opposition and in 1999 and 2002 when he had already been elected president. On each visit, I made the rounds of business leaders and friends. The message was one of complacent resignation. Most Venezuelans saw Chavez as a temporary problem. This complacency was all that Chavez, with the assistance of his Cuban mentors, needed to entrench himself by gradually undermining democratic institutions and the rule of law. Chavez was very fortunate that oil prices rose sharply between 2002-2007 which allowed him to fund his nationalizations and social programs and cement his control of the military, the courts and the legislature. By the time Venezuelans realized that Chavez had secured power, it was too late to do anything about it. Millions of Venezuelans, including the most educated and productive, since then have left the country, resettling in Colombia, Chile, Brazil, Miami and Madrid. It is ironic that in the 1970s and early 1980s, Colombians, Chileans and Spaniards had all flocked to Venezuela. Isabel Allende spent her formative years in Caracas, an exile from Chile.

Chavez was clever in securing international support for his experiment, including from prominent foreign leaders and intellectuals. To deceive and disarm his opponents, he tightened the screw in steps, gradually eroding property and democratic rights. The charts below, which come from the World Bank’s Government Indicators, show how freedoms were taken away step-by-step during the course of the Bolivarian Revolution. Today, Rule of Law is near zero on the World Bank’s scale.

Lessons for Chile and Others

What are the lessons to be learned from the Venezuelan catastrophe? Perhaps the only obvious one is that success and stability are precarious. This means that no effort should be spared to strengthen institutions and governance. Also, it should be recognized that in the present environment of slow growth stability will be difficult to maintain unless societies are able to generate more equitable distributions of incomes. Latin America currently fails miserably in providing equal opportunities to all. Entrenched interest groups fight tooth and nail to preserve their privileges. Matters are complicated by the fact that capital is mostly in the hands of a highly globalized elite which is risk-averse and prefers “safe” assets in the U.S. or Europe. During the slow burn of the Chavez regime, domestic capital deserted, to never return.

Expected Returns in Emerging Markets

After a decade of poor returns in emerging market stocks, the asset class suffers a crisis of credibility. But, cheer up; prospects for future returns have improved. As we enter the new decade, we may be diametrically opposed to where we stood a decade ago when EM stocks were expensive and U.S. stocks were cheap.

Investors in emerging market stocks had total returns of 18.5% in 2019, ending a dismal decade on a positive note. Total returns (including dividends) over the past ten years have been just 4% per year, which is well below the historical average of 10.3%. EM net returns also have paled in comparison to those of the mighty S&P 500. As the chart below shows, over the decade the S&P 500 provided total returns of 253% compared to 33% for the MSCI EM.

The chart below provides some perspective by showing performance for the S&P500 and the MSCI EM Index by decade.

Investors suffer deeply from “recency bias,” the tendency to believe that market trends will continue. This means that today there is a strong bullish consensus on the rising U.S. market and pessimism on the relatively weak emerging markets. However, if we are patient and can take a longer term view, we can expect that valuation fundamentals will weigh heavily on stock prices, triggering a process of mean reversion. Because of this, rational investors take a long-term probabilistic view of capital allocation, assuming that over an extended time-frame (e.g., 7-15 years) mean reversion is likely to play out. While Wall Street enthralls the public with bold annual forecasts, long term investors should develop a humble and long-term view on the probability of future outcomes.

Any analysis of historical returns shows that, over the long-term, stock prices have two drivers: earnings and the multiple on earnings that investors will pay. Earnings are generally driven by GDP growth, though over the short to mid-term they are affected by business cycles and corporate margins. The relationship between earnings and GDP is the basis for Warren Buffet’s favorite stock market valuation indicator (S&P500/GDP). Multiples vary depending on the mood and risk-taking appetite of the investment public and also on the level of interest rates (lower interest rates lead to higher multiples). Multiples also are sensitive to inflation. The low inflation and negative real interest rates of recent years are the main reason for the high multiples that we see for U.S. growth stocks.

Capital allocators estimating long-term probable returns generally must take a simplistic view. In terms of earnings they will try to establish a normalized level which adjusts for business cycle effects. Future multiples are assumed to revert to historical levels, or at least move in that direction. There is no standard way of doing this, and each practitioner may do it slightly differently, but in general results tend to be similar. In the charts below we look at the current expected return forecasts made by two prominent asset managers/allocators: GMO (Link) and Research Affiliates (Link).

Both GMO and Research Affiliates expect emerging markets stocks to be the star performers over the forecast. GMO expects 4.5% real annual returns for EM and 9.3% for EM value and negative 4.4% for U.S. large cap stocks. Research affiliates sees 6.8% real annual returns for EM and o.3% real annual returns for U.S. large caps over the next ten years. Star Capital, a European asset manager, reaches similar conclusions, estimating expected real returns for the next 10-15 years to be 7.6% for EM and 2.8% for the U.S (Link).

We conduct a similar exercise with a focus on emerging markets. Our forecast is for 6.2% real annual returns over the next seven-year period and 0.8% real annual returns for the S&P 500.

We make three assumptions: 1. Valuations will move back to the historical CAPE average over the next seven years; 2. Earnings return to the historical cycle-adjusted 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. We calculate the historical average CAPE by taking a weighted-average of the CAPE-ratio for the past 15 years (75%) and the CAPE-ratio over the entire period that data is available (25%)

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 CAPE average for the primary EM markets. The third column shows the difference between the current CAPE and the historical average CAPE. For example, Turkey’s valuation, in accordance with CAPE, is 40.5% below normal. The markets in the chart are ranked in terms of probable long-term returns (7 years). The table also shows where markets are currently in their business/earnings cycle.

We can see that valuations are generally low in emerging markets. The majority of markets in EM trade at CAPE ratios which are below average, and Turkey, Malaysia, Chile and Argentina are heavily discounted. On the expensive side, only Thailand stands out. The contrast with the U.S, is striking. While 10 years ago the CAPE ratio in the U.S. was well below normal, today it is more than one standard deviation above normal.

The methodology assumes a stable dollar, meaning the dollar will neither appreciate nor lose value relative to the basket of currencies represented in the MSCI EM Index. The actual trajectory of the dollar will have a big impact. The experience in emerging markets is that a weak dollar generates liquidity and higher earnings growth, as well as higher multiples. If the dollar were to lose relative value over the forecast period it is probable that returns in EM would be significantly higher. This is particularly true for commodity-exporting countries like Brazil which would experience liquidity windfalls.

Furthermore, we can expect markets to overshoot both on the up and downside. Forecasts assume a return to normalized historical statistical trends, but markets can be expected to surpass those levels as enthusiasm builds momentum.

In conclusion, allocators should consider increasing positions in emerging markets where returns will probably be relatively strong in coming years.

What to Expect for the 2020s in Emerging Markets

A decade seems like a long time but in investing it should be considered a reasonable period for evaluating results. Ten years covers several economic/business cycles and allows both valuation anomalies and secular trends to play out. Moreover, it gives time for the fundamental investor to show skill. Though over the short-term – the months and quarters that the great majority of investors concern themselves with – the stock market is a “voting machine,” over the long-term the market becomes a “weighing machine” which rewards the patience and foresight of the astute investor.

When we look at the evolution of markets over a decade we can clearly see how these big long-term trends play out. The chart below shows the evolution of the top holdings in the MSCI Emerging Markets Index over the past three decades. We can appreciate how constant and dramatic change has been in the twenty years since 1999, and we should recognize that the next decade will be no different.

The top holdings at the end of each decade reflect the stocks and countries that have been favored by investors and, presumably, bid up to high valuations.

At the end of 1999, countries in favor were Taiwan, Korea, Mexico and Greece, and the hot sectors were telecommunications and utilities.

By year-end 2009, the new craze was for anything commodity related, and Brazil was the new craze. Banks, which benefited from a global liquidity boom also came into favor.

By year-end 2019, telecom/utility stocks and commodities were all deeply out of favor. The high-flying markets of the previous decade (eg. Brazil) suffered negative total stock market returns for the whole period. The past decade has been all about the rise of China and the internet-e.commerce platforms and the chips and storage (the cloud) required to make it all work.

What will the next ten years bring. Only one thing is certain: the pace of change and disruption will accelerate. Whether this will benefit the current champions or create new ones is anyone’s guess.

One difference from ten years ago is that emerging markets are not expensive. Unlike in 1999, the market leaders don’t seem to be at unsustainable valuations. On the other hand, there a few markets that sport very low valuations. These are mainly either commodity producers (Colombia, Chile, Brazil, Russia) or markets that have been through tough economic/political cycles (Argentina, Turkey, India).

Good luck to all!