November 2020 – The Emerging Markets Investor

If you Like Emerging Markets, Buy Mining Stocks

Emerging market assets have always experienced good performance during times when commodity prices are rising. These periods are characterized by strong economic performance of the global economy relative to the that of the United states and they are normally accompanied by a weak U.S. dollar. This combination of relatively strong growth and a weak dollar and the stimulative effect of higher commodity prices on commodity-dependent economies typically underpins bullish stock markets in EM.

The persistent relationship between commodities and emerging market stocks is illustrated in the chart below which tracks the prices of copper (black), EM (red) and the copper mining giant Freeport-McMoRan (blue). (Copper is used as a surrogate for economically sensitive commodities). The chart shows that the prices of these three assets are directionally linked. Arguably, copper is a leveraged play on emerging markets and copper mining stocks provide further leverage on copper itself. This illustrates clearly the cyclical nature and economic sensitivity of emerging markets. It also raises an interesting and perhaps disturbing question for emerging market portfolio managers: why not obtain your general exposure to EM by simply timing the cycle and piling into a few mining stocks?

The viability of this strategy is shown in the next two charts. The first chart shows the performance of emerging market stocks (VEIEX) and of several of the most prominent mining stocks (Vale, Freeport-McMoRan, Vale, SQM and Southern Copper). These mining stocks all dramatically outperformed during the four cycles under consideration (2000-2008, 2009-2012, 2016-2018, and 2020-). Using a very simple 200 day moving average to trigger buys and sells, an investor could have enjoyed most of the upside and very little downside. The investor could have either shifted into cash or stayed invested by owning the EM index whenever the copper price moved below the 200-day moving average. The entry point this year would have been the first week of June. As the second chart shows, since that time the mining stocks have ramped up and left the EM index behind. This outperformance has occurred even though tech stocks in Asia have become much more important in recent years. Moreover, the performance is even much better compared to the EM ex-China index or a commodity-heavy index like Latin America.

Historically, reflation trades trend for long periods. If this one gets traction during the next six months, this trade may be only beginning.

The CAPE Ratio and Emerging Market Stock Returns

The cyclically adjusted price earnings (CAPE) ratio augurs low perspective returns for U.S. stocks and improved performance for the battered and unpopular emerging markets equities. After a decade of very poor returns in emerging markets compared to the S&P500, relative valuations now favor emerging stocks to the same degree as in 2000. The following decade (2000-2010) saw strong emerging market outperformance.

The CAPE smooths out earnings by taking an inflation-adjusted average of the past ten years. It has been a popular measure with fundamental investors since the 1950s, and has been a reliable tool for forecasting long-term stock market returns. High valuations both in absolute terms and relative to a market’s history normally point to low returns in the future.

The S&P500 CAPE ratio is now the second most expensive it has ever been, only surpassed at the peak of the telecom, media and tech bubble in 2000. In line with the logic behind CAPE, in the decade after the TMT bubble the S&P500 produced negative returns for investors. During the 2000-2010 period, the CAPE ratio for the S&P 500 plummeted from 37 to 23, bringing it back to slightly below the historical average.

On the other hand, at the end of 2000 the MSCI Emerging Markets index was valued at a CAPE of 10, which was slightly below its historical mean. Over the net decade, the EM CAPE more than doubled to 20.4 and the MSCI EM index more than tripled in value.

Today, we appear to have gone full circle back to where we were in 2000. The S&P500 CAPE is once again at very high levels and the EM CAPE has returned to depressed levels. Both are near where they were in 2000.

The current condition of CAPE ratios is shown in the two charts below. The first chart shows both the present and the historical average levels of the CAPE for the EM index and most individual emerging markets and also for the S&P 500. The second chart illustrates the difference between the current levels and historical norms. Positive numbers indicate high valuations relative to history and probable low future returns.

The S&P500 is expensive in both absolute and relative terms. The S&P500 CAPE is 33% above its historical mean, which is similar to where it was at the end of 2000.

The CAPE for Emerging markets is slightly below the historical average.

In EM only Taiwan and India look expensive relative to historical CAPE norms. Of the 19 EM markets in the charts, nine are valued at 30% or more below normal.

The predictive power of CAPE ratios relies entirely on markets remaining structurally similar over time and on valuations regressing to the mean. Neither of these requirements will necessarily prevail. Market structures may change abruptly, as we have seen over the past decade in China where the index has gone from heavy in state-owned industrials to dominated by private technology companies. Also, mean regression may not occur because fundamentals (economics, politics, etc…) have changed either for the better or for the worse. Furthermore, we should expect CAPE ratios to gradually move higher because of declining transaction costs and rising liquidity.

Determining which countries deserve to be upgraded or downgraded is complicated and subjective because there are many moving parts. For example, in the case of China we can argue that slowing growth and high debt warrant lower valuations but also that the structural change of the market in favor of “growthier” private companies argues for higher valuations.

Relatively few countries have had a clearly delineated change in their fundamentals in recent years. I think a good case can be made for declining fundamentals in the following countries: South Africa, Thailand, Chile, Brazil and Turkey. These countries have had fundamental deterioration in growth prospects because of the evolution of political and economic trends, and, therefore, may not offer the upside that the CAPE framework assumes.

Bitcoin is Digital Gold for Emerging Markets

The price of the bitcoin blockchain currency has more than doubled since the beginning of the year and has appreciated by 450% since the bottom of the most recent financial meltdown in March. The financial crisis and Covid epidemic have been brutal for many emerging market currencies and financial assets and, not surprisingly have provoked a wave of capital flight from EM. For the first time, bitcoin appears to have had a significant role in this movement of capital, a testament to growing trust in its value for both cross-border transactions and the preservation of wealth. What initially had been mainly of interest to financial and tech geeks and criminals seeking anonymity, now appears to have gained mainstream status with EM elites seeking paths to preserve wealth in a world of growing financial instability and currency debasement.

Not surprisingly, Bitcoin is finding more early adopters in countries which have a combination of financial instability and governments with weak deterrence ability. Therefore, as expected, Bitcoin adoption is more prevalent in a country like Nigeria than it is in China. The following chart from CoinDesk Research, a media outlet that focuses on blockchain and bitcoin news, confirms this. In the case of Nigeria, bitcoin “cryptowallet” payment systems, which bypass banks and regulators, have become prevalent for conducting all sorts of international transactions, ranging from receiving remittances to paying for imports to facilitating capital flight. Though not appearing in CoinDesk’s survey, Russia, Argentina and Brazil have also become big bitcoin adopters. These three countries all have precarious financial systems and poor prospects of economic growth and highly sophisticated elites with a penchant for seeking offshore havens to preserve financial wealth. A network of specialized broker dealers/asset managers/fintech platforms has been set up mainly in London and Zurich to service the needs of this clientele.

The rising prominence of bitcoin is a response to the high costs and increased monitoring of more traditional channels, especially private banks. Governments have become more effective at monitoring cross-border financial flows through regulated financial institutions.

With currency debasement and unorthodox monetary policies reaching ever higher levels, EM investors are being proactive in anticipating the probable consequence of these policies (capital controls and confiscatory tax policies) sometime in the near future. In this context, bitcoin’s attractiveness is enhanced by its “digital-gold” status in a world of inflated fiat currencies.

At the same time, bitcoin is slowly but surely gaining status with institutional investors in developed markets as a legitimate asset with valuable diversification benefits. This year, for the first time, prominent investors in the investment world have touted bitcoin, and some large conservative institutional funds have started to nibble. So what started as a currency for geeks and criminals is now moving into the mainstream led by emerging market flight capital.