Month: April 2021

Internationalization and Economic Convergence

Very few countries in emerging markets have sustained high GDP growth levels long enough to  aspire to convergence with  the developed world. These include the members of the club of Asian “tigers ,” originally formed by Taiwan, Korea and Singapore,  and now being joined by China, Vietnam, Thailand and Malaysia. Outside of Asia, Poland, Hungary and other formerly Comecon states have made huge strides towards catching up.  One thing all of these success stories have in common is openness to trade and integration into international supply chains.

The chart below shows the internationalization rate for the primary emerging markets.

The successful convergers have a high level of internationalization of their economies, as measured by total trade (imports plus exports) divided by GDP  minus net trade.  Asian countries have followed  a mercantilistic framework of  industrial planning and subsidies supported by  currency manipulation to maintain export competitiveness. Eastern Europe and Mexico have relied more on integration into regional trade networks. The focus on international trade has required that these countries focus on comparative advantages and market-based decisions, and this process has facilitated an accumulation of knowledge and skills which can lead to gradual moves up the industrial value chain.

This path of convergence is obviously not easy to follow or else more countries would do it. It requires long-term planning and economic stability, including a stable and competitive currency. Countries that experience frequent boom-to-bust cycles because of economic instability or commodity cycles will not succeed in this path. Moreover, many countries fall into the “middle-income trap”  which is caused by  dominant interest groups lobbying against open-market policies and other reforms.

Latin America is where the middle-income trap has become most prevalent.  The region suffers from a high dependence on commodities and repeated  phases of “Dutch Disease,”  the destructive aftermath of commodity busts, such as the one the region has experienced since the end of the 2002-2012 commodity super-cycle. The region also bought into the wrong elements of the neo-liberal “Washington Consensus.”  It adopted financial liberalization while failing  on fiscal reforms.

Brazil has become the poster child of the middle-income trap. Its gross mismanagement of the commodity boom (overvalued currency, corruption) left behind increased de-industrialization, debt and financialization of the economy. Ironically, while developmentalist policies are back in favor in Biden’s Washington, they are totally out of favor in Brazil where the finance minister espouses 1970s style Chicago School economics.

 

Update on Expected Returns For Emerging Market Stocks

The first quarter for emerging market stocks can be characterized as more of the same. EM equities once again underperformed U.S. stocks, as they have consistently for the past decade. The year started with a spurt of optimism, but then the cold reality of the pandemic sobered investor spirits. Meanwhile, the U.S. surprised with competent delivery of vaccines and an  extraordinary blend of fiscal largesse and monetary expansion.  The combination of vaccines and stimulus convinced markets that the U.S. might achieve a rapid return to trend growth, and this triggered a strengthening of the dollar. By quarter-end it looked like the long-awaited EM recovery was on hold again, until markets  begin to consider the aftermath of the the U.S. extravaganza.

For the long-term investor hoping for mean-reversion to cause cheap markets to outperform pricy ones, the first quarter was another disappointment.  As the chart below shows, by and large, the least expensive markets were the worst performers for the quarter, as investors  continued to focus on the reasons that made these markets cheap to begin with. Leading the way was Turkey, where Erdogan doubled up on his quarrel with economic sanity. Brazil was close behind, as Bolsonaro continued to demonstrate remarkable incompetence at managing public policy.   South Africa and Chile were exceptions, both benefitting from rising prices for industrial minerals, and, at least in the case of Chile, a proficient job with delivering vaccines.  On the other hand, the expensive markets all outperformed. Ironically, the two most expensive markets in the table were also the best outperformers, which is a good reminder that , over the short-to-medium term , momentum is a more powerful force than mean reversion.

Unfortunately,  some of the worst performing markets may have fallen for good reasons. The pandemic  and general government incompetence will have left a devastating impact on countries like Brazil, resulting in diminished growth prospects.  We can see this in the chart below which shows the IMF’s latest World Economic Outlook forecasts. Few emerging market countries  are expected to experience high growth, and they are all in Asia. Some of these like Indonesia, the Philippines and Malaysia also appear inexpensive in the previous chart, and therefore should be the best ponds to fish in. In Latin America, Colombia looks attractive.

Investors should focus on the inexpensive markets with good growth prospects. In addition, assuming that recent commodity price increases can be sustained, markets like Chile and South Africa may surprise to the upside. The remaining inexpensive markets — Brazil and Turkey — need some sort of a trigger (e.g. economic reform, political transition) to bring them back to life. Mexico is an interesting outlier. It is so extraordinarily  well positioned in terms of the current incentives for multinational firms to near-shore production and  reorganize supply chains, that even the best efforts of AMLO may not get in the way of success.