Month: July 2020

Global Macro Outlook for Emerging Markets

Emerging market economies and assets are sensitive to global U.S. dollar liquidity, the global economic cycle and the fluctuations of investor appetite for risk. The past decade has been one of relative strength for the U.S. economy in an environment of declining global growth. Relatively high returns on capital in the U.S. on both risk-free assets and stocks have sucked in capital from around the world and caused a prolonged cycle of appreciation of the U.S. dollar. These circumstances have been negative for emerging market asset prices and caused a decade of poor performance for stocks. Periodically, it behooves us to evaluate market conditions to ascertain whether circumstances are changing, and we do this by following a simple framework which considers:  Global U.S. dollar liquidity; currency trends; commodity prices; and risk aversion.

Global U.S. Dollar Liquidity

The chart below shows a measure of global U.S. dollar liquidity based on the evolution of  the combined values of (1) global central bank dollar reserves and (2) the U.S. M2 monetary base, data provided weekly by the U.S. Fed. The second chart shows separately global central bank reserves.  We can see from these charts the extraordinary nature of the times we are in.  The unprecedented increase in USD liquidity has been driven exclusively by massive money printing by the Federal Reserve, and this liquidity is finding its way into markets through fiscal spending and mandatory lending programs. This is in sharp contrast to the 2008-2009 (GFC) crisis when most of the increase in global dollar liquidity was caused by China’s infrastructure stimulus, which boosted commodity prices and underpinned international trade. In the current situation, international reserves have seen only a slight increase, but only because of some $700 billion in emergency swap lines provided to U.S. allies by the U.S. Fed.

 The U.S Dollar Cycle

The Fed’s unprecedented interventions made in concert with Treasury,  as well as gargantuan fiscal deficits, steep increases in U.S. government debt and the prospects of a sustained period of high fiscal deficits underpinned by financial repression (forced lending and negative real interest rates) may be unsettling the U.S. dollar. Debt levels in the U.S. are rising precipitously at a time when, for the first time in a decade, interest rates in the U.S. are no longer higher than in Japan or Europe and may no longer attract foreign capital.  Interestingly, the spread in favor of Chinese government bonds vs. U.S treasuries has been rising and is now at near record levels. The charts below show the DXY index, which measures the evolution of the U.S dollar primarily vs. the euro and the yen, and also the MSCI Emerging Markets Currency Index, which measures the value of EM currencies relative to the USD. The DXY has fallen from its March high of 103.5 to 95, breaking through the 50-day, 200-day and 18 month moving averages. This has happened concurrently with a sharp rise in the price of gold, which is further evidence that the confidence in the USD may be breaking. Nevertheless, for emerging market currencies, the breakdown of the USD is much less pronounced. Still, the recent weakness of the USD is certainly heartening for EM investors.

Commodity Prices

Commodity prices reflect both the value of the USD and global economic activity. At the same time, in recent decades they have been a key factor in determining global liquidity because major commodity producers typically sharply increase dollar reserves when prices rise. Rising commodity prices lead to significant increases in both global liquidity and domestic liquidity for many emerging markets, and they are generally necessary for asset appreciation throughout EM. The chart below, from Yardeni.com, shows the Commodity Research Bureau (CRB) Industrials Index, which historically has been highly correlated to emerging market asset prices.  We also show the chart for the spot price of copper, which has rallied strongly over the past two months. We can see from these charts – particularly the CRB Metals and copper – that industrial metals are on the rise. The likely explanation is the current surge in infrastructure spending by the Chinese government in a mini-version of the great 2008-2009 stimulus. These are bullish trends which further should improve investor appetite for EM assets.

 

Risk Aversion

Emerging market assets are considered high-risk investments that require a large risk premium.  In times of market turbulence, these premiums tend to expand dramatically. Emerging market premiums for both stocks and bonds are closely linked in their trading patterns to U.S. high yield bonds. The chart below, from Yardeni.com, shows the spread between U.S. Treasuries and U.S. high yield bonds. This is a very good measure of risk aversion, which serves for EM. We can see that these spreads have come down steadily since March. They remain at relatively high levels, but mainly because Treasury yields have collapsed. The question that investors have to ask themselves is whether market prices reflect reality at a time of unprecedented intervention by monetary authorities.

Conclusion

Though it may be early to call for the beginning of a new cycle of strong performance for emerging market stocks,  several signs are supportive of this thesis.  The recent weakness of the USD and the growing challenges for the U.S. economy may point to an extended period of  relative strength for emerging markets. Further USD weakness and commodity strength would support increasing exposure to EM assets.

Ten-Year U.S. Treasury Rates and the Reflation Trade

The ten-year U.S. Treasury bond rate is the most important parameter in investing, used by investors of all types to establish relative return metrics. Ten years encompasses about two regular business cycles and is a practical time-frame for investors to work with: it avoids both counterproductive “shortermism” as well as the unfathomable long term. Therefore, investors estimate cash flows ten years in advance and discount these by the risk-free treasury rate added to a premium which measures the specific risk of the investment.

So, what happens when 10-year rates approach zero or even negative rates, as they now have across Europe and Japan? U.S. rates, currently around 0.60%, are at historical lows in nominal terms and well into negative territory in real (inflation adjusted) terms, as shown in the graph below.

 

What do these historically low interest rates tell us?  In the past, the nominal ten-year rate has been a relatively good predictor of nominal GDP growth. This relationship has been reliable over the 1970-2020 period when both nominal GDP and the 10-year Treasury rate have averaged a little over 6% per year. The current low rates, then, may point to a combination of deflation and low GDP growth in coming years, unless an argument can be made that rates are being artificially repressed by the Fed (and elsewhere).

If valuations for stocks are determined by discount rates linked to the 10-year rate, what are the investment implications of the current circumstances? On the one hand, very low rates imply high valuations, as long-term cash flows increase in value as discount rates decline; on the other hand, tepid economic growth pushes down valuations, as cash flows for most company are closely linked to economic output. In summary, what the investor gains from low valuations he losses from low cash flow growth.

The current state of the global economy is depressive with low growth prospects. Most countries face poor demographics and excess debt. Concurrently, most industries are being brutally disrupted by an eruption of practical innovations spawned by the “information and communications” revolution. In this environment of low growth and disruption, one would expect that, in general, corporate profit growth would be weak, but that those few companies enjoying growth and benefiting from disruption would be rewarded with high valuations. The current Covid-19 environment has starkly heightened these trends, as most companies  have been devastated by the crisis while for a few disruptors it has been a boon.

Of course, most of these winning companies are U.S. based, and that explains the high valuations for tech companies in Silicon Valley and other frontier industries. These companies either have predictable long-term growth (eg. Amazon, Microsoft) or exceptional market opportunities (eg., biotech). These sectors benefit from long-duration cash flows which discounted at today’s low rates result in very high values. When found outside the U.S. — tech in China, Korea and Taiwan, e.commerce in Latin America (Mercado Libre) or South-East (SEA) — these firms are also highly valued.

In both the U.S. and international markets, “growth” stocks have performed much better than “value” stocks over the past decade. This is because growth has been scarce and low discount rates have boosted the value of long-duration cash flows. The problem for international and emerging markets is that “growthier” sectors (information technology, fintech, e.commerce and bio-pharma) have much less weight than they do in the tech-heavy U.S. stock indexes. This is particularly true in emerging markets where financials, industrials and commodities dominate the indexes. To make matters worse for emerging markets, at the beginning of this period of low growth and great disruption, around 2010-2012, these sectors had extremely high valuations.

Take the case of financials. In the past in emerging markets highly profitable banks with dominant market positions were favorites of investors. 10 years ago, financials in EM represented 24% of the index, led by the Chinese and Brazilian banks. Today, financials in EM represent only 18.5 of the MSCI index and they are suffering from a combination of low growth, historically low interest rates and attacks from tech-enabled disruptors which are often abetted by regulators. Technology only represents 16.5% of the EM index (most of which is in China) compared to about 45% of the S&P 500, while financials have fallen to only 10% of the U.S. index.

So, what could change the current paradigm of the market and make emerging markets attractive again?

Well, obviously a rise in inflation and interest rates would be beneficial, since this would reverse the cause of high valuations for growth stocks. A spike in the ten-year treasury rate would have a large impact on the valuation of companies with long-duration cash flows and cause a major shift in valuations, allowing “value” stocks to outperform in relative terms. However, this does not appear to be imminent. On the contrary, rates continue to be on a strong downtrend.

Nevertheless, we may be seeing some  “green shoots” of a reflation trade. These can be listed as follows:

  • High valuations for growth stocks are causing a rotation into underperforming segments of the market, including emerging markets.
  • China stimulus is pushing up commodity prices. Industrial commodities, led by copper and iron ore, have rebounded strongly.
  • Potential inflationary shifts in U.S. public policy: forced reshoring of manufacturing, boosts in minimum wages and union influence, universal income and expansive monetary and fiscal policy.
  • A weakening dollar and concurrent rise in alternative currencies (gold, bitcoin).

The USD has weakened significantly from the March high, and an extension of this trend would be important evidence supporting a regime change towards higher inflation

Capital Flight Into U.S. Residential Real Estate

Over the past decade (2010-2019) foreigners have invested more than a trillion dollars  in American residential real estate. This inflow of “flight capital” into U.S. homes reflects financial and political unease around the world and is a testament to the continued safe-haven status enjoyed by the U.S. These inflows have contributed to the persistent strength in the U.S. dollar over this period.

The National Association of Realtors (NAR)  in the U.S. publishes an annual report on foreign participation in the U.S. residential real estate (Profile of international activity in U.S. Residential Real Estate  Link.)  The chart below details the data for the past decade. According to the NAR, foreigners bought $934 billion in residential properties over the period. Because buyers may frequently not reveal their nationality or/and carry out purchases through legal entities, the NAR figures significantly understate reality. Also, these figures do not include commercial real estate transactions which also were pronounced over the period. Nevertheless, the data can provide some color on the scale and trends of the activity and who the buyers are .

Canada and the UK represent mainly buyers of vacation and retirement homes. The remainder of the primary buyers and the majority of the “others” category represent “flight capital” from a wide variety of emerging markets. These buyers have as their primary objective s to diversify their financial holdings away from their home country and to secure a “safe haven” residence for their families. Chinese buyers have been prominent over the period, particularly between 2014-2018, when capital flight from China was elevated. 2019 saw a large decline in purchases in general and from Chinese buyers in particular. This may be explained by the sharp appreciation of the dollar, the U.S.-China trade tensions and tighter capital controls in China.  The election of the anti-business populist AMLO in Mexico, has triggered a sharp increase in Mexican capital flight into residential properties across the northern border.

The top four destinations for foreign buyers are Florida, California, Texas and Arizona. Canadian “snowbirds”  flock mainly to Florida and Arizona, while the Chinese prefer California, and Mexicans go to Texas and California. Aside from the Mexicans, Latin Americans largely prefer Florida, where they are the dominant buyers in the Miami and Orlando areas and up the eastern coast.

The NRA’s Profile of International Real Estate Investing in Florida 2019 (Link) details Latin American flight capital into Florida. The chart below shows the total purchases by foreigners in the Florida market over the past 10 years in both units and values. Latin Americans represent about 45% of the foreign buyers in Florida, led by Brazil, Venezuela, Argentina and Colombia. Mexico and smaller Latin American countries represent about 40% of the “others” line. Mexicans  represent only about 2% of foreign buyers in Florida.

Foreign Buyers of Florida Homes, 2010-2019

The table below details the value of purchases by year. The past decade was turbulent in Latin America with political chaos and economic collapse in Venezuela and stagnation or deep recessions in most countries. The decade also started out with overvalued currencies in most Latin American countries and a depressed real estate market in Florida, which was a combination that favored inflows into Florida’s market. The scale of the flight capital from these savings-poor countries is very concerning, and a clear indication that elites are increasingly estranged and disassociated from the fortunes of their home countries.

Tech Drives EM stocks, Leaving Value Behind

Emerging Markets stocks have traditionally been an asset class closely tied to the global economic cycle. When the global economy was strong relative to the U.S. economy, the dollar would depreciate, commodity prices would rise and emerging markets would enjoy a period of ample liquidity and rising asset prices.

We can see this clearly in the chart below: since the 1980s, there have been two downcycles for the USD (1985-1997 and 2002-2012) which have coincided with bull markets in EM equities. We are now in the ninth year of a dollar upcycle, which has resulted in very poor returns for emerging markets investors.

It is not happenstance that emerging market stocks and “value” stocks are strongly correlated. The periods of strong performance for “value” (stocks with low prices relative to book value, earnings or sales compared to the overall market) have been largely concurrent with those for EM stocks, and the past ten years have been terrible for both. This is because both the value and EM universes are heavily weighted to cyclical and mature industries and sectors that are vulnerable to technological disruption. The chart below shows the performance of both the value and core indexes for U.S. and EM stocks for the past 10 years.

If we look at the performance data for EM in more detail we can see that regional disparaties are pronounced. The chart below highlight the enormous transformation that the asset class is undergoing, both in terms of the growing weight of China and Asia but also in terms of the surge of the technology sector. While 10-years ago the index was dominated by commodity producers, today almost every stock in the list is driven by the smart-phone/e.commerce revolution. Every single stock, except for Reliance of India operates in North Eastern Asia.

 

The charts below detail total annual returns by region and by style (value) year-to-date, 1-year, 5-years, and 10-years. A cursory glance at these numbers makes one thing clear: over the past ten years, in emerging markets it has always paid to be in Asia and out of value stocks.

The outperformance of Asia is explained by growing importance of the tech sector, both traditional players (TSMC, Samsung) and a plethora of newcomers in e.commerce.  The lack of tech in Latin America can be seen in the poor performance relative to Asia and in the similar returns between the Latin America core index and its value index. Just like in the U.S., emerging markets are now driven by tech, as shown in the chart below.

Even within regions or countries, owning tech has been the correct  strategy. Value has underperformed in every region. Within China, owning tech and avoiding value (state companies, banks) has been the trade.

In Indonesia, buying SEA Ltd, the country’s largest e.commerce company, has been the trade.

 

In Latin America, the one thing to do has been to buy Mercado Libre, the leading e.commerce site in Brazil and Argentina.

What the future will bring is anyone’s guess. Another downcycle  for the USD is likely to start over the next several years, providing support for EM value stocks. On the other hand, low global growth and intensive technology disruption should continue to boost the valuations of scarce growth opportunities.