The collapse of the United States-centered global financial system in 2008 made clear the fragility of the post-industrial model of capitalism built on increasing debt and financial complexity. Since the Great Financial Crisis awareness of the system’s fragility has dominated global investor behavior, causing a long period of global semi-depression, U.S. dollar appreciation and investor preference for the liquid and safe assets available in the U.S. capital markets. Periodic Fed interventions through QE aimed at sustaining asset prices have eliminated downside risk and encouraged this hoard of capital to find its way to Wall Street, causing interest rates on U.S. treasuries to fall to record low levels and the appreciation of all financial assets. Furthermore, it has brought about the extraordinary conversion of the leading technology growth stocks, with their supposed fail-safe winner-take-all business models, into the new global safe-haven liquid asset of choice.
This series of events has brought on a new period of American “exceptionalism.” As shown in the chart below, these are phases in the global economy when through a combination of superior growth, dollar appreciation and risk aversion global capital flows into the United States and U.S. asset prices enjoy an extended period of outperformance. We can see that since President Nixon abandoned the gold standard 50 years ago, the U.S. has had three periods when it has grown more than the global economy: 1980-86 when the combination of Volcker and Reagan boosted confidence in the USD and in the U.S. economy; 1994-2001, the Asian financial crisis and the Telecom-Tech-Media boom; and 2011-2021, QE, fiscal expansion and the new tech boom. Though the long-term trend is clearly for a sharp decline in the U.S. share of global GDP, each one of these upcycles in U.S. relative growth is accompanied by a strong dollar, large capital inflows and a booming stock market. The flip side of these periods of perceived American exceptionalism when the U.S. sucks up much of global capital is weak commodity prices, depressed growth and poorly performing stock prices in Emerging Markets. On the other hand, every downward swing in the chart (1971-1979, 1986-1994, 2001-2011) has seen strong growth and booming asset prices in EM.
The current period of American “exceptionalism” has been particularly painful for most emerging markets. Even before Covid, emerging markets had suffered a decade of low growth and low investment abetted by weakening currencies and persistent capital flight. Covid seriously worsened this trend, leaving most countries with more debt and worse growth prospects. Capital flight has only increased, much of it headed for “safe-haven” U.S. tech stocks.
The events of the past decade have led to extraordinary divergence between emerging markets and the United States in terms of corporate earnings and stock market performance. The charts below for the United States and major emerging markets seek to contrast the performance of the different markets in what has been an extraordinary era of superior returns for U.S. assets.
The first chart below seeks to provide the context of the long-term experience of the U.S. stock market since W.W. II , showing the annualized growth in stock prices, earnings and GDP.
We can see that stock prices, earnings and GDP tend to be tied together. This is because over time profit margins tend to revert to the mean and nominal earnings generally follow the path of nominal GDP. Stock prices should marginally rise more than both earnings and GDP over time because price-earnings multiples slowly move higher because of declining transaction costs. Therefore, though earnings rise by 5.8% over this period, compared to 6.0% for nominal GDP, the S&P500 index rises by 7.7% annually.
The second chart focuses on 1986-2021, the post-industrial era. when the pillar of the American economy became services – especially financial services. This has been a very good period for American corporations. This period, marked by hyper-globalization/offshoring, deregulation, lax anti-trust enforcement, declining taxes and interest rates, and ever-increasing financial engineering (leverage, buybacks) – all factors that boosted corporate profitability – has been very favorable for the profitability of U.S. corporations relative to non-U.S. ones. This period coincides with the modern era of emerging markets investing when institutional benchmarks (e.g., MSCI, IFC) became available. Over this period, we see an extraordinary disconnect between stock prices and earnings and GDP. The table below details the relative growth of the index, earnings and nominal GDP over distinct period. We can see that during periods of American exceptionalism, the U.S. stock market moves well above the long term trends for the market and GDP, with the current level at an extraordinary level of divergence.
The disconnect between index returns, earnings and GDP has been extraordinary. During 1986-2021, the S&P500 index has appreciated at nearly twice the rate of GDP growth while earnings have beaten GDP by about 35%. We can see this gap widening over the past 20 years as earnings grew at nearly twice the clip of GDP. Over the past ten years, the index’s gap over GDP has widened immensely, almost all due to multiple expansion. This multiple expansion can be explained by the “wealth effect” of the Fed’s QE policy, which has pushed up asset prices by eliminating downside risk and lowering discount rates.
A comparison of the U.S and Chinese stock markets reveals stark differences. First, China’s monetary policy has been much tighter and monetary interventions have been aimed exclusively at maintaining the stability of the real estate and banking sectors. While the U.S. Fed can be said to be fixated on stock prices, China’s central bank cares primarily about real estate prices. This makes sense because the Chinese have most of their wealth in residential properties. Second, while the focus of U.S corporate executives is shareholder returns, China’s companies are mostly controlled by the public sector and their executives are agents of the government. The exception has been venture-capital financed technology companies seeking to emulate the business models and corporate cultures of Silicon Valley, but, as recent events have shown, even these companies are on a tight leash with Beijing.
The nature of China’s listed companies is reflected in their historical performance which we can see in the charts below. The first thing to note is the relationship between the stock market and earnings and GDP. While this relationship in the U.S. has been constant over time (corporate margins and stock multiples revert to the mean and expand in line with GDP), in China they are unrelated. While China’s GDP has been on an unprecedented 30-year expansion, this is not reflected in stock prices or earnings. (However, over this period there has been an extraordinary appreciation in real estate prices). Remarkably, since 1992, China’s GDP has expanded at a rate of nearly 13% annually, while stock prices and earnings have declined. Even over the last decade which has been marked by the rise of China’s privately owned tech giants and yuan appreciation relative to the USD, earnings have been negative. This is a testament to global depression-like conditions, manufacturing oversupply, and misallocation of capital by state firms in China’s debt-driven economy. These conditions are likely to persist into the future as China’s government forces both public and private firms to invest in “strategic” frontier industries to secure independence from western suppliers.
Finally, we look below at three other EM countries: India, Brazil, and Taiwan.
India: The charts show that the long-term relationship between stock index appreciation, earnings and GDP has occurred in India as should be expected. Over the 1990-2021 period, Indian earnings and GDP growth are very similar. Stock prices have grown at a slightly higher rate which can be explained by multiple expansion and the current high level of the market. Over the 2001-2021 period the relationship between earnings and GDP holds tightly, while stock prices race ahead and experience two “bubbles,” in 2008 and at the present time. Over the past ten years, the global depression/strong dollar environment impacted GDP and especially earnings while the stock market disconnected as valuations returned to “bubble” levels (CAPE ratio at 28.1 which is the second highest ever, only below 30.6 in 2010).
In Brazil the relationship between GDP growth and stock price appreciation holds up as expected. However, earnings do not keep up. The 1986-2021 period in Brazil is marked by high economic volatility, boom-to-bust cycles and mismanagement of state companies, conditions which are detrimental to corporate investment and profits. Brazil missed out on the trade benefits of hyper-globalization and underwent a process of accelerated premature deindustrialization, leaving the economy and stock market highly vulnerable to commodity boom-to-bust cycles. Over the past decade, Brazil has been hit twofold by the collapse of the commodity supercycle and the global depression/strong dollar environment. Unlike EM countries in East Asia and India which have produced tech champions , Brazil has been largely “colonized” by Silicon Valley.
Taiwan provides an interesting contrast to Brazil, India and China. Over the 1986-2021 period stock price and earnings are closely tied but GDP lags behind. This is because Taiwan’s highly dynamic and increasingly profitable tech companies have a greater weight in the stock index than their share of GDP. Also, these numbers reflect the current “bubble” valuations and unusually high margins of tech companies, both of which should revert over the medium term. This effect has been particularly important over the past ten and twenty years, as TMSC has become one of the largest and most profitable global technology firms. In contrast to Brazil which exports commodities and China where exporters have a small weight in the stock index, Taiwan’s market-driven technology companies dominate the index. This has enabled Taiwan to sail through the global depression/strong dollar environment of the past decade.
What these charts show is how difficult it is for emerging markets to do well in periods of perceived American exceptionalism. Though Taiwan appears to be an exception, its performance is driven mainly by the enormous success of TSMC. In China, India and Brazil it has been a very poor past decade for corporate earnings. This is not likely to change until the current cycle of American exceptionalism ends. This is long overdue and will happen eventually, triggered by a new wave of optimism on global growth. However, for the time being, fear still dominates and the capital hoards will go to the “safety” of U.S. tech stocks.
