Month: December 2020

Global Liquidity, For Now, is Flooding Emerging Markets

The extraordinary policies implemented this year by the the U.S. Fed and fellow central bankers around the world have flooded the global economy with liquidity. In addition to jacking up asset prices and enriching the holders of financial assets around the world, extremely loose financial conditions may have triggered a change in global economic conditions towards a weaker U.S. dollar and, consequently, higher commodity prices and better prospects for emerging markets asset prices.

Global U.S. dollar liquidity, as measured by U.S. money supply (M2) added to  foreign reserves held in custody at the Federal Reserve, has risen at the fastest pace ever recorded over the past year.  This indicator in the past has been a very good measure of global financial conditions and is strongly correlated to economic and financial conditions in the typically “dollar short” emerging markets. The chart below shows the evolution of this indicator over time, measured in terms of year-on-year real growth. The indicator  shows clearly the loose conditions during the 2002-2012 commodity supercycle which was a period of very robust performance for EM assets. On the other hand,  liquidity has been tight since 2012 (when the commodity-supercycle ended), only interrupted by brief expansions in 2014 and 2016. This period of tight global dollar liquidity resulted in very poor conditions for emerging markets, particularly for those cyclical economies outside of NE Asia .  Interestingly,  during this long downtrend emerging market stocks had two brief periods of strength, in 2014 and 2016. Not surprisingly, the outperformance of EM stocks since April of this year has happened concurrently with a massive expansion of global liquidity.

Increased U.S. money supply, particularly at times of low growth and gaping fiscal and current account deficits, tends to be associated with a weak USD. In the past we have seen that during these periods major emerging markets, either because they practice persistent mercantilistic policies (Korea, Taiwan, China) or because they introduce “defensive” anti-cyclical measures aimed at avoiding the negative effects of “hot money”  (Brazil), have accumulated foreign reserves which they hold in Treasuries at the U.S. Fed. The effects on domestic monetary policies that these efforts to manipulate currencies bring about are very difficult to neutralize and have invariably led to strong expansions in money and credit in domestic economies. This occurred  intensively in the 2005-2012  period and was the primary cause of the great EM stock bubble. The opposite has taken place since 2012, with foreign reserves declining and tight credit conditions existing  in most EM countries. The charts below show : 1, the progression in foreign reserves held in custody at the U.S. Fed; and 2, the year-on-year growth in these reserves.

Note the recent uptick in the second chart which indicates a recent turn in the trend of foreign reserve accumulation. This upturn has been caused by the large current account deficits that the U.S. has had with Asia this year while it has sustained consumption of imported goods through fiscal and monetary policies while both the consumption of domestic goods (services) and manufacturing were stifled by Covid.

Is a Repeat of the 2000s in the Cards for Emerging Markets?

The current expansion of global liquidity and the weakening USD are unquestionably bullish for emerging markets. However, there are several  reasons to believe that the conditions do not exist for an emerging market super-boom like we saw in the 2000s.

First, the U.S. has clearly evolved in its awareness of the negative effects that unfettered globalization has had on its working class. This means it now has much less tolerance for the mercantilistic currency manipulation practiced by allies (e.g., Korea, Taiwan) and zero tolerance for those practiced by strategic rivals (China).  This reality is shown by the increasing attention given to the U.S. Treasury’s bi-annual Currency Manipulator Watchlist Report which this week added India and Vietnam, in addition to China, Japan, Korea, Germany, Italy, Singapore, Malaysia, Taiwan, Thailand, and India. Most of these countries are close strategic allies of the U.S. that in the past had been given a free-pass, but that is not likely to be the case in the future. Until now, the U.S. has not used the Watchlist to impose sanctions on trading partners,  but the mood in Washington has changed and we will see what attitude the Biden Administration assumes.

This means that countries may no longer be allowed to run large current account surpluses and accumulate foreign reserves. It may also mean that countries that are subject to highly cyclical inflow of hot money will  be restricted in accumulating reserves, like Brazil did in the 2000s.  In that case, they will have to turn to some sort of capital controls to regulate flows.

Second, emerging markets are much more indebted than they were 15-20 years ago when the previous cycle started. This means that even if countries were allowed to manipulate their currencies, the domestic economies have much less room to absorb credit expansion without creating instability.

Finally, though valuations in EM are lower than for the bubbly U.S. market, they are much higher than they were in the early 2000s.

In conclusion, the 2020s will probably not look much like the 2000s. The U.S. is likely to be a much more cantankerous partner, and one much less willing to assume the costs of globalization.

 

 

 

The Next Commodity Cycle and Emerging Markets

 

The stars may be aligned for a new cycle of rising prices for industrial and agricultural commodities. It has been nine years since the 2002-2011 “supercycle” peaked, and the malinvestment and overcapacity from that period has been largely washed out. Over the past several months, despite economic recession around the world, commodity prices have started to rise in response to supply disruptions and the anticipation of a strong global synchronized recovery in 2021. Moreover, in recent weeks the victory of Joe Biden in the U.S. elections has raised the prospect of a combination of loose monetary policy and robust fiscal policy, with the added benefit that a good part of the fiscal largess will be directed to infrastructure and “green” targets which will increase demand for key commodities. Finally, global demographics are once again becoming supportive of demand.

The chart below shows 25 years of price history for the CRB Raw Industrials Spot Index and the Copper Spot Index. Not surprisingly, these indices follow the same path. Interestingly, they are also closely linked with emerging markets stocks. This is is shown in the second chart. (VEIEX, FTSE EM Index). This is clear evidence of the highly cyclical nature of EM investing, and it is the explanation for why EM stocks outperform mainly when global growth is strong,  commodity prices are rising and the USD is declining.

Since the early 2000s, China has been the force driving global growth and the cyclical dynamic. Since that time China has been responsible for generating most of the incremental demand for commodities. Starting in 1994, China embarked on a twenty-year stretch of very high and stable GDP growth which took its GDP per capita from $746 to $7,784. In 1994, China’s GDP/capita was in line with Sudan and only 15% of Brazil’s. By 1994, China’s GDP/capita reached 65% of Brazil’s. By 2018, China had surpassed Brazil.

By the turn of the century, China’s coastal regions which dominate economic activity had already reached the transformation point when consumption and demand for infrastructure and housing result in a surge of demand for commodities. This transformation point typically occurs  around when GDP/capita surpasses $2,000, which happened for Brazil in 1968 and in Korea in 1973. In 2005 China’s overall GDP/capita reached $2,000 and the commodity super-cycle was well under way. (All GDP/capita figures cited are from the World Bank database and based on 2015 constant dollars.)

Moreover, China was not the only significant country to enter this commodity-intensive phase of growth during the 2000s. The chart below shows the list of new entrants to the $2,000/capita club since the late 1960s. During the 2000s, three large EM countries, Indonesia, the Philippines and Egypt,  also broke the barrier. These three countries added fuel to the commodity boom created by China’s hyper-growth and infrastructure buildout, generating the commodity “supercycle.”

The historical link between rising commodity prices, a falling dollar and the incorporation of large amounts of new consumers into the world economy can be seen in the following three charts which cover the 1970-2020 period.. The first chart shows the rolling three-year average of the total annual increase in the population of global citizens with an annual income above $2,000. The second chart shows the  increase in commodity prices relative to the S&P 500; and the third chart shows the evolution of the nominal effective U.S. dollar. The connection between the three charts is clear: every period of rapid growth in new developing world consumers coincides with both rising commodity prices and a weaker USD. Not surprisingly, every bull market in EM stocks (1969-1975, 1987-92, 2002-2010) also follows this pattern.

 

The bull case for emerging markets investors today is that we are on the verge of entering a new cycle as five more countries pass the $2,000/capita barrier.  Already this year, Kenya and Ghana will reach this level. These two countries in themselves are not that significant but they point to the importance of Africa for the future. Then in 2021 India (pop. 1.4 billion) reaches the benchmark, followed by Bangladesh (pop. 170 million) in 2022. The following chart shows the evolution of the total global population with per capita GDP above $2,000 and the annual increases for the past 50 years and the next five years. The potential significance of India and Bangladesh are clear.

India will likely have an  impact on a different set of commodities  than China had. India is unlikely to achieve the pace of infrastructure growth that China had, and has significant iron ore resources. This means the impact on iron ore and other building materials will not be as great. On the other hand, India imports most of its oil and will have an increasing impact on the oil markets. India also faces great urgency to electrify the country and to do this with clean energy. This points to growing demand for copper , cobalt and silver, three markets that already appear to be undersupplied in coming years.