August 2020 – The Emerging Markets Investor

The Yuan’s Run has Legs

It has been an interesting year in global currency markets. Early in the year, the U.S. dollars spiked, as the combination of the pandemic and fears of discord within the European Union triggered a trade to “safe haven” assets. However, since May, following a friendly resolution of tensions in the EU, the euro rallied strongly, taking with it the DXY index, which is the market bell-whether for the relative value of the USD. The significant weakening of the dollar against the euro, and to a lesser degree against the Japanese yen, has raised hopes for international investors that the strong-dollar cycle started in 2011 may have ended, which would be supportive of better performance for non-U.S. assets. The chart below shows the DXY’s evolution for the past twenty years: a sharp downcycle for the dollar from 2001 to 2011, followed by a persistent dollar upcycle from 2011 to this year until the recent sharp correction.

Unfortunately for EM investors, when looked at on a broader basis the USD is not as weak as it is against the euro-heavy DXY index. For example, on a trade-weighted basis, as shown below, the dollar has strengthened by 2.1% since the beginning of the year.

In the case of a currency index based on the country component weights in the MSCI EM equity index, the USD has appreciated by 4.2% this year. The yuan has appreciated by about 1% against the USD over this period, while the rest of EM has experienced currency losses of 6.2%.The evolution of the MSCI EM currency index is shown in the chart below from Yardeni.com. We can see that EM as a whole still appears to be in a downtrend relative to the dollar, and both the EMEA and Latin American regions have currencies which are persistently weak relative to the USD.

So, the important question is why is the yuan strengthening at this time and is its rise sustainable? This is what matters to EM investors as China is now 42% of the MSCI index. The answer is in the two charts below. The first chart shows the yuan on the left side and the interest rate differential between China and the U.S. for 2-year government notes on the right side. In a world of negative real rates in both developed and emerging markets, China now has real rates and a growing differential in its favor. The second chart shows China’s trade surplus back at record levels (at a time when both tourism and capital outflows have come down sharply).

It is logical that a combination of high rates and strengthening trade and current accounts would lead to currency yuan strengthening. Given trade tensions with the U.S. (and the rest of the world) and a clear commitment to boosting consumption and moving up the manufacturing value-added chain, it is likely in Beijing’s interest to let the yuan move higher.

A New Development Model for Brazil

Over the past fifty years, very few countries have successfully progressed from lower-income status to developed status. This very short list includes Korea, Taiwan, and the island city-states of Hong Kong and Singapore. We can also add coastal China, the extraordinary case of the past decades. These countries all have followed the model pursued by the United States, Germany and northern Europe, which was prescribed by the first Treasury Secretary of the United States in his seminal “Report on Manufacturers.”

Hamilton asserted that no country would prosper without a strong manufacturing sector, and noted that case for free-markets made by Great Britain was self-serving, to preserve its hegemony.”

In defense of trade tariffs, Hamilton argued that:

“There is no purpose to which public money can be more beneficially applied, than to the acquisition of a new and useful branch of industry; no consideration more valuable, than a permanent addition to the general stock of productive labor.”

Every successful country has followed this mantra. The “Asian Model” espoused by Japan, Korea, Taiwan and China, has relied intensively on manufacturing. The “ China 2025” industrial policy, which has annoyed the current hegemon, the United States, takes to heart Hamilton’s focus on “new and useful branch of industry” by focusing government support on frontier industries. In addition to targeting subsidies for industry the “Asian Model” prescribes the following:

· The promotion of competition in manufacturing, with prioritization of exports.

· Competitive currencies. (This has always been important but now more than ever in a world of low-cost container shipping and erratic capital flows.)

· Create conditions for small farmers to thrive.

· Channel agricultural surpluses and savings into productive investments by regulating lending by financial institutions.

The resilience of manufacturing promoted by the Asian Model is in sharp contrast to the “Latin American Model.” The result can be seen in the following chart. Brazil has essentially abandoned its manufacturing sector and faces a crippling state of premature deindustrialization. Mexico has done much better than Brazil, but has focused, almost exclusively, on serving as a “workshop assembly line” for the U.S. market, with little value added.

Brazil gave up on its industrial model in the 1980s. Since then, it has essentially followed policies that are the antithesis to the “Asian Model.” Unlike in Asia, where export-competitiveness was stipulated, Brazilian industry lost support because of a reputation for high costs and poor quality. Brazil’s foreign currency management has also been incongruous, leading to extreme volatility in the exchange rate and a persistent tendency for overvaluation, conditions that are unbearable for the manufacturing sector.

Furthermore, the Brazilian policy framework has promoted an oversized financial system which thrives on speculation, and serves almost no purpose in funneling savings into productive activities. The past ten years have seen the logical culmination of this process, as debt levels have exploded at a time of extremely low investments in productive activities.

The current conditions in Brazil don’t look propitious for a major change of course. For the short term investors can hope only for some progress in terms of current government initiatives to reduce the excessive cost of government bureaucracy, simplify the tax system and deregulate several industries to encourage more investment. None of this can solve the structural issues that the country faces, particularly the excessive debt levels

If the current Brazilian model has run its course, what lies in the future? What could a new Brazilian development model look like?

1. First, the country will have to address excessive debt levels. Current debt levels asphyxiate growth, so some form of financial repression is inevitable to brings levels back to sustainable levels.

2. Second, Brazil will have to stabilize its currency at a competitive level and convince markets of a long-term commitment to currency competitiveness.

3. Third, Brazil needs to credibly commit itself to a new industrial policy. This is a huge challenge because of a lack of confidence in policy makers, but it is imperative. Legislation should be passed to provide long-term support or several “frontier industries,” while encouraging a competitive environment and a priority for exports. I suggest three candidates:

Renewable energy – Brazil is well-positioned to be a global leader in solar, wind, and bio energy. It has ample resources, a large market and already a solid industrial base.
“Green” farming – Agriculture is the one sector where Brazil has maintained global competitiveness, and it is well positioned to meet global demand for ecologically-sound farmed products.
Deep-water oil production – Brazil has huge deep-water oil fields that will provide demand for capital goods for decades to come. However, the poorly structured policies and inconsistency of previous efforts have undoubtedly left a bitter taste.

Expected Returns in Emerging Markets

The global Covid-19 pandemic has had a grave impact on emerging markets. As has happened broadly across the world, the pandemic has accelerated existing trends and highlighted the strengths and weaknesses of countries and companies. It has also grievously exacerbated income and wealth inequality in most countries, increasing the divide between the tech-connected “haves” and the disconnected “have-nots.” We can group emerging market countries in terms of how well they have dealt with the virus and the impact that the pandemic will have on GDP growth and public finances. Also, we should differentiate those markets with ebullient tech sectors from those with little presence of tech companies. All these factors have had important ramifications for market performance so far this year and are likely to continue to do so for the foreseeable future.

Taking into account the highly uncertain evolution of the pandemic and its economic and corporate consequences, we live in times when making forecasts is a thankless task.

It may also be senseless when the objective is to identify probable long-term returns in the context of extraordinary monetary and fiscal policies and major shifts in the global trading system.

Nevertheless, we plod on with this exercise in the hope of identifying extreme valuation discrepancies. As in past efforts (Link ), we assume that valuations will mean-revert to historical levels over a 7-10 year time-frame; also, we expect that GDP growth and corporate earnings will return to trend over the forecast period; finally, after deriving a long-term earnings forecast, we apply a “normalized Cyclically-Adjusted Price Earnings (CAPE) ratio to determine a price target and expected return. We assume, perhaps naively, that historical valuation parameters still have some validity in a world characterized by Central Bank hyper-activism and financial repression. The methodology has negligible forecasting accuracy over the short-term (1-3 years) but, at least in the past, has had significant success over the long-term (7-10 years), particularly at market extremes.

The chart below shows the result of this exercise. The first thing to note is that, by-and-large, returns are muted, which is not surprising in a world of declining growth and negative real interest rates. Global emerging markets (GEM) are expected to provide total returns (including dividends) of 6.7% annually in real terms (net of inflation) over the next seven years. This is below historical returns and disappointing in light of the poor results of the past decade. These returns, however, are attractive compared to the dismal prospects for U.S. stocks. The U.S. is trading a near record-high valuations while emerging markets are priced at large discounts to historical valuations.

To secure more attractive expected returns the investor needs to venture into the riskier and cheaper markets. Colombia, Turkey, Chile, Philippines, Mexico and South Africa all trade at very sharp discounts to historical valuations and will provide high returns if mean-reversion occurs. The markets currently are pricing in difficult economic prospects for these markets. However, narratives change quickly. For example, South Africa, Chile, Mexico and Colombia would all benefit from rising commodity prices., and the recent decline of the U.S. dollar and the sharp rise in gold may portend a reflationary trend for the global economy.

There is no hiding from the reality that most assets are priced richly, and investors should not be counting on high returns.

GMO, an asset manager based in Boston, (Link) expresses this clearly in their most recent 7-year forecast for the expected real returns of different asset classes. As shown below, GMO expects negative real returns for most asset classes and a meager 1.6% annually for emerging markets. To garner high returns, GMO recommends investors venture into “value” stocks in emerging markets. This “active” position may be promising because it is diametrically opposed to the positioning of the great majority of “active” investors who are extremely concentrated in “growth” stocks, especially the e.commerce and internet platforms around the world.

This view is also echoed by Research Affiliates (Link), as shown below. RA’s methodology is similar to the one highlighted above, relying on mean-reversion to historical valuation parameters to forecast expected returns. However, RA is more optimistic on EM stocks, where it expects real annual returns of 7.7%

Our forecasts reflect both the views of GMO and RA. We expect decent, if not stellar, returns for EM stocks, with the possibility of much higher returns if a global reflation trade allows deeply discounted stocks to outperform.

The U.S. Dollar and Emerging Markets

The recent weakening of the U.S. dollar has raised hopes that international stocks, including those of emerging markets, may be ready for a period of superior performance compared to those of the United States. This is because, in the past, foreign stocks have enjoyed strong results during periods of dollar weakness. The dollar cycle has tended to last about a decade and a half, with some eight years of dollar strength followed by some eight years of dollar weakness. The dollar has been strong relative to foreign currencies since 2012, so perhaps the recent weakness of the greenback may indicate the cycle is now turning.

The strength of the dollar tends to be associated with periods of U.S. “exceptionalism:” times when the U.S. is growing more and creating more wealth than the rest of the world and, consequently, attracting more capital to its shores. The U.S. is also often seen as the primary safe haven for capital, given its deep capital markets, rule of law and friendly attitude to foreign capital inflows. During times of global political or financial stress this “safe-haven” status of the U.S. is especially important. This has certainly been the case for the past eight years which have seen negative interest rates in Europe and Japan and massive capital flight from many emerging markets, including China and Latin America.

The U.S. safe haven status diminishes in importance when the prospects for economic growth and returns on capital appear to be relatively better in foreign markets. This may be the case today given the complicated circumstances of U.S. in terms of politics and the economy in the wake of the disastrous management of the Covid-19 pandemic. The U.S. is now committed to negative real interest rates for the foreseeable future and is likely to turn to financial repression to face growing debt and social liabilities. Ten-year Treasury bills now yield 0.5%, which points to a combination of low growth and deflation for the foreseeable future. Moreover, high U.S stock prices also point to very low forward returns.

On the other hand, growth prospects now look relatively more attractive in Europe, Asia and emerging markets, and the valuation differential between U.S. and foreign stocks are near record highs. This has set the stage for the current weak performance of the U.S. dollar. As shown in the chart below, The U.S Dollar Index (DXY) has fallen sharply, by about 10% since its March high and is now trading well below its 200-day moving average.

However, it is important to note that the DXY, though the most watched indicator of the USD, is weighed heavily to the Euro and the Japanese Yen. To get an idea of the trends for emerging markets we have to look at the MSCI emerging markets currency ratio which shows the weighed relative performance for all of the countries included in the MSCI EM index. The following chart, from Yardeni Research shows this ratio. We can see here that there has been so far only a slight uptick in this ratio, not enough to indicate a trend.

Furthermore, the previous chart obfuscates the continued poor performance of the majority of EM currencies. Aside from China and a few other Asian currencies, all the major EM currencies continue to lose value. We can see this in the chart below. Not surprisingly, the worse performing currencies belong to those countries that have poorly controlled the pandemic and suffer from financial and political instability.

In conclusion, it is still early to bring out the champagne. Though the USD is weakening relative to the Euro and the Yen, and especially gold, emerging markets are not yet participating because fundamentals are in many cases still deteriorating.