Month: October 2021

Economic Freedom in Emerging Markets

It is widely acknowledged by development economists that a country’s wealth is correlated to the economic freedom enjoyed by its citizens. The history of Europe supports this idea. From the Italian and Flemish city-states of the 15th century to the United Provinces of the Netherlands in the 17th century and finally England’s Glorious Revolution and the take-off of the industrial revolution in the 18th century, every great surge of prosperity in Europe occurred when republican ideals, open markets and tolerance for new ideas were allowed to flourish and overcome centralized, absolute rule. Moreover, these Anglo-Dutch ideals were the philosophical foundation of the American Revolution and instrumental to the United States’ rise as the world’s most dynamic economy in the 19th century.

The rise of the Soviet Union as an economic power in the 1960s raised doubts about “economic freedom”  being the only path to prosperity. Famously, the economist Paul Samuelson included the chart below in his widely read college textbook between 1961 and 1980, showing the Soviet economy on the path to overtake the United States. Samuelson’s basic argument was that the Soviets would grow faster because investment rates were higher and potential for efficiency gains were greater. Similar arguments were made in favor of the Japanese economy in the 1980s and have returned with even more vigor in relation to China in recent years.

The confidence in China’s ability to sustain high rates of GDP growth in the future is grounded in a belief that  the government is able to successfully steer investments into sectors of the economy with high growth potential. This thinking is rooted in the extraordinary success of the “East Asia Development Model” pursued by Japan, Taiwan, Korea and China which relies on  state support (tariffs, fiscal subsidies, credit subsidies) to corral investments into “frontier” industries with high export potential. It is also supported by arguments, back in favor in Western economic academia (e.g. Mariana Mazzucato, Carlota Perez), which proffer a key role for the state as an inducer of investment in vital industries.

Though it can be debated what the exact role of the state should be as an inducer of economic activity there are a series of objective criteria that can be identified as necessary to provide the appropriate institutional conditions for human and financial capital to be deployed in entrepreneurial activities. These basic conditions can be said then to provide the institutional framework for “economic freedom.”

Several institutions (e.g., The World Bank, The Fraser Institute, The Heritage Institute) have developed methodologies to rank countries in terms of economic freedom over time.

All of these look at a combination of the following factors:

  1. Rule of Law (property rights, government integrity, judicial effectiveness)
  2. Government Size (government spending, tax burden, fiscal health)
  3. Regulatory Efficiency (business freedom, labor freedom, monetary freedom)
  4. Open Markets (trade freedom, investment freedom, financial freedom)

 

The table below is from The Fraser Institute’s 2021 report which is based on 2019 data. The countries are ranked and separated into four quartiles, the top quartile being the countries with the highest level of economic freedom. These rankings are available for the past 40 years to provide a history for evaluating progress or regression over time.

 

The following maps show the Fraser Ranking in both 1980 and 2019. Note the tragic fall of Venezuela from one of the most economically free countries in the world to the bottom.

The following graph looks at the relationship between economic freedom and wealth, using Fraser’s country data and the World Bank’s  2019 GDP per capita as a proxy for wealth. We can see a strong correlation between economic freedom and wealth. Two noteworthy outliers are petro-states (UAE, Quatar, Brunei) and tax havens (Luxembourg) which are considerably above the trend line and Eastern European “reformers” (Lithuania, Lativia, Estonia, Georgia, Poland) which are well below the trendline. Presumably, the Eastern Europeans will experience a period of catching up as they enjoy the benefits of the reforms that have been implemented since the 1990s.

The table below narrows the Fraser Institute’s data for the primary emerging markets of interest to investors. The table shows the four quartiles, the country’s overall rank and the change in the quartile since 1980.

In conclusion, there are several interesting facts to note about the table.

  • Overall, EM has had a small improvement over the past 40 years.
  • In terms of the importance of countries relative to their weight in benchmarks, the rankings are not auspicious. India, Brazil and China, which are really the core of emerging markets as an asset class, are all in the bottom of the Third Quartile. Vietnam, considered by many the most promising frontier market, is in the Fourth Quartile.
  • Those countries in the Second Quartile may offer the best opportunities. I would highlight the Philippines and Indonesia which are on the right path and continue to enjoy high potential growth.
  • The three countries in the top quartile – Taiwan, Chile and Peru — are new entrants to this elite, with Peru coming all the way from the Fourth Quartile. In 1980 EM  had these three countries in the First Quartile, Venezuela, Malaysia and the UAE. Venezuela went from the First Quartile with a highly ranked 16th overall in 1980 to absolute bottom ranking in 2019. Peru’s rise and Venezuela’s collapse are a testament to the institutional precariousness of Latin American institutions.

 

Emerging Markets Stocks Expected Returns, 3Q2021

If forecasting is foolhardy in the most stable of times, trying to make predictions under current circumstances is risible. For the time being, financial markets are driven by the extraordinary policies of U.S. monetary and fiscal authorities which support consumption and provide liquidity to backstop asset prices. The limits of these policies are unknown, but, for now, investors from around the world are willing to engage in this lucrative scheme.

Predictions for the short term are always haphazard. Most market participants simply assume that current trends will continue. They are usually right because trends are persistent while mean reversion occurs over the long-term horizon. The current trends favor investing in U.S. stocks. These have outperformed for over a decade and the biggest and most dominant tech stocks have metamorphized into the new global “safe” asset of choice, replacing return-less U.S. Treasury bonds. Investors have concluded that these quasi-monopolies in winner-take-all growing sectors of the economy are pillars of stability in a turbulent world. The assumptions that underlie this investment thesis are that: 1.  the Federal Reserve is fully committed to sustaining the stock market because it believes that a market correction from the current high levels would cause  a negative “wealth effect” that would precipitate an economic depression; and 2. The Fed desires sustained higher inflation to erode the value of the Federal debt.

The COVID pandemic in a perverse way facilitated the work of the Fed and consolidated what could be called the “FAANG Monetary Standard.”  COVID justified unprecedented levels of monetary intervention and fiscal expansion and drove the stock market to record prices. The exceptional efforts of U.S. authorities made the 2021 recession one of the shortest ever and allowed the U.S. economy to outperform the global economy by a wide margin. Rising asset prices in the U.S. sucked in global capital and pushed up the value of the USD.

Unfortunately, none of this was beneficial for emerging markets. With the exception of China which managed the pandemic well and benefited from the surge of U.S. imports of consumer goods, emerging markets suffered profoundly from COVID, both in terms of short-term growth and long-term growth potential. COVID only accentuated what has been a state of semi-depression in emerging markets for the past decade, as a strong USD and U.S. financial markets have drained them of capital resources.

Ironically, the accelerated nature of the COVID recession in the U.S. will now play against emerging markets as we enter 2022. The United States and China, the two main drivers of the global economy, are now in the process of slowing dramatically as the effects of the COVID stimulus wear off. This means that the expected late recovery of most EM countries will be muted.

In fact, 2022 is likely going to be the year when the markets fully appreciate the devastating long-term consequences of COVID. The enormous increases in government debt incurred by the United States, China and most EM countries in 2021 will weigh on growth for years to come. U.S potential real GDP growth, which was considered to be around 2% before the pandemic, can now be assumed to be considerably lower. Many emerging market countries, including China and Brazil, are facing poor growth prospects as they deal with high levels of unproductive debt.

Ironically, the coming slowdown in the U.S. may continue to favor U.S. stocks and the USD. As the economy slows in coming months, the Fed will have to provide more liquidity to the markets to avoid a correction in asset prices. This may well lead to a further expansion in valuation levels for the tech stocks and final blow off for the S&P500.

The two charts below show the current debt levels in emerging markets and the five-year increase in the level of the debt to GDP ratio for these countries and the United States. The countries with high debt levels and very high recent accumulation of debt generally face difficult challenges ahead. These include, China, Brazil, Chile and Korea.

The next chart shows expected long term stock market returns for EM countries and the United States. The annual returns are for the next seven years but would be similar for 10 years. These returns are in USD terms and assume that EM currencies maintain current valuations relative to the USD over the period. If EM currencies were to appreciate over the period (likely in my view) then returns would be higher.

The details are shown in the next table. Turkey tops the chart and probably provides the best bet for high returns. CAPE ratios below 5 have been in the past fail-safe as an indicator of high future returns. Turkey is well underway in its economic adjustment, with a very competitive currency and export sector and rising business confidence. The Philippines are also well positioned, but do have a challenge to return to the very high historical CAPE, particularly given the lofty weight of financials and real estate in the index. Brazil is cheap but faces high debt and a weak economy as it enters a complicated election year. This is a reminder that CAPE ratios are not helpful for short- term predictions. Moreover, valuation is never enough. Markets always need a trigger.

On the negative side, Taiwan and India both stand out for their very high CAPE ratios. For these valuations to be justified, earnings will have to be much higher than currently anticipated. This means a major ramping up of margins and corporate profitability in India and an extension of the semi-conductor super-cycle in Taiwan.

CAPE Ratios Relative to History and Real Expected Returns, September 2021
Current Cape Historical AVG CAPE Difference Earnings Cycle Expected 7-Year Total Real Annual Return
Turkey 4.4 8.6 -48.84% Early 12.0%
Philippines 15.8 22.8 -30.70% Early 10.3%
Brazil 11.5 12.3 -6.50% Late 9.2%
Malaysia 11.9 15.6 -23.72% Early 7.7%
S. Africa 13 14.5 -10.34% Early 7.6%
Colombia 9.2 14.2 -35.21% Early 7.0%
Peru 16.5 16.9 -2.37% Early 6.4%
China 13.5 15 -10.00% Late 6.3%
Indonesia 13.5 16.1 -16.15% Early 5.4%
Thailand 13.7 14.7 -6.80% Early 4.9%
Mexico 17 17.4 -2.30% Early 4.7%
GEM 14.6 14.3 2.10% Early 4.4%
Chile 14.6 17.9 -18.44% Early 4.3%
Korea 11.6 13.2 -12.12% Early 4.2%
Taiwan 24.9 18.5 34.59% Mid 4.0%
USA 37.9 24.8 52.82% Late 3.3%
Russia 7.9 6.8 16.18% Early 0.8%
India 30.4 20.8 46.15% Early 0.6%
Argentina 9.5 8.5 11.76% Early -7.9%

The methodology used to determine expected returns is the following:

  1. Forecasted earnings for 2022-2028 assume earnings growth of nominal GDP, making adjustments for each country’s place in the business cycle.
  2. A cyclically-adjusted earnings value for 2028 is calculated as an average of inflation-adjusted earnings for the 10-year period ending in 2028.
  3. Each country’s historical cyclically adjusted price earnings ratio (CAPE) is calculated as an average of CAPE ratios for the country since its inclusion in the MSCI index, with an increased weight given to the past 15 years.
  4. The historical CAPE ratio is applied to 2028 earnings to determine the expected level of the country index in 2028.