Month: February 2022

High Commodity Prices for Brazil Probably Mean Another Wave of Dutch Disease

It is an unfortunate reality that for most countries natural resource wealth is counterproductive. This phenomenon is known in economics as “Dutch Disease,” in reference to the Dutch natural gas boom in the 1960s which resulted in currency overvaluation, declining manufacturing exports ,  higher unemployment and lower GDP growth.

In the Post W.W. II period, which has been marked by declining trade transaction costs and more open borders, few countries have avoided the resource curse. Norway, having learned from the Dutch experience, carefully managed the windfall from its oil boom in the 1970s by creating a Sovereign Wealth Fund to distribute benefits over generations. The United Arab Emirates has also squirreled away oil income into Sovereign Funds which make long-term investments to reduce dependence on finite oil resources.

In emerging markets it is difficult to exercise this discipline because of weak institutions and the pressing needs of the poor. Rent-seeking elites, crony capitalists and corrupt politicians inevitably take advantage of this institutional fragility to appropriate a disproportionate share of the resource windfall.

Brazil is perhaps the best recent example of the curse at work. A discovery of very large offshore oil reserves in 2006 was expected to be transformational for a country with a history oil deficiency. Predictions were made for an expansion of oil production from 2 million b/d to over 7 million over the next decade. The discovery sparked a euphoric mood, and  investors and policy makers projected positive effects on GDP growth, fiscal accounts and the balance of payments.

Brazil’s oil discovery  turbo-charged the commodity super-cycle (2002-2010),  which was already underway,  causing  a positive terms of trade shock, currency appreciation, and a massive credit boom. Instead of saving for the future, the government dramatically increased spending on social welfare programs and public sector benefits.

Unfortunately, the commodity boom brought all the negative consequences which are associated with “Dutch disease.”

  1. Worsening governance and corruption

The commodity boom brought forth the worse tendencies of  Brazilian governance,  well described by former Central Bank president Gustavo Franco as “An obese state  fully captured  by parasites and opportunists always  fixated on protecting their turf.”  We can see how governance (government effectiveness), as measured by the World Bank, deteriorated in the following chart.

Corruption also reached unprecedented levels over this period, as measured by the World Bank.

  1.  Currency appreciation followed by eventual depreciation.  Instead of squirrelling away the commodity windfall, Brazil allowed the currency to sharply appreciate. International reserves were also increased significantly, but without sterilizing the impact on domestic supply, which fueled credit growth.

 

  1. Deindustrialization

The huge appreciation of the BRL caused an accelerated loss of competitiveness of the manufacturing sector, which we can see in the fall of manufacturing share of GDP and an accelerated decline in manufacturing complexity. The first chart below shows the evolution of manufacturing value-added  as a share of GDP for resource-rich economies  compared with resource-poor economies, highlighting that Dutch Disease impacted all commodity exporters. The next two charts also show the evolution of manufacturing by comparing economic complexity in Latin America and  Asia.

  1. Lower Potential Growth. The erosion of manufacturing capacity led to massive replacement of “quality” industry jobs with low valued-added service jobs, and, consequently, a collapse in productivity. Potential GDP growth was about 2.5% annually before the commodity boom and has now fallen to less than 1.5%. As shown below, over the past decade total factor productivity has collapsed in Brazil.

 

 

As a result of this aggravated case of Dutch Disease, Brazil is more than ever dependent on its world class natural resource sectors: export-oriented farming, and export-oriented mining. Both of these sectors are highly competitive globally but very technology and capital intensive , providing  few jobs (Vale’s enormous iron ore operations generate only 40,000 jobs in Brazil.) Paradoxically, Brazil’s  farm sector has similarities with South-East Asia’s “Tiger” economies. Like in Taiwan, Korea and China, Brazilian farmers have benefited from ample credit,  state R&D support and export subsidies.

Ironically, current prospects for rising commodity prices are not necessarily  good news for Brazil as there  is no evidence that lessons have been learned from the past.

Value is Dead; Long Live Value!

Growth stocks, defined as those with underlying businesses growing much faster than GDP, flourished over the past decade. Tepid global growth, marked by aging work forces and declining productivity growth, put a high premium on those few sectors and companies with high secular growth, mostly in the tech driven digital economy. At the same time, extraordinarily loose monetary policies which drove real interest rates to negative levels around the world , sparked a speculative stock market frenzy, directed mainly to the most speculative “pie-in-the-sky” stories of  technological disruption.

For value investors the environment of the past decade was devasting, and believers in the old “Graham and Dodd” mindset of fundamental investing became an endangered species. In recent years, business publications and academic journals were full of declarations on “The Death of Value.”

Metrics from Google’s search engine give an idea of the narrative that dominated the scene, as shown below.

Of course, we know that this kind of media attention is a contrary indicator. For example, we can be confident that any business publication cover declaring the certainty of any investment trend is good evidence for the end of that trend (e.g. The Economist has marked multiple peaks and troughs in the Brazilian stock market with its covers.)

So, it really should not be a surprise with regards to value investing that, as Mark Twain once quipped: “The reports of my death are greatly exaggerated.”

Lo and behold, over the past year value has made an impressive comeback.

Warren Buffett, the doyen of “Graham-and-Dodd’s-Ville, who had underperformed the S&P500 for over ten years, made a big comeback over the past year, outperforming the index by 16%, as we can see below. A simple value strategy of weighing the index by fundamentals (sales and profits)  instead of market capitalizations also outperformed neatly.

The same has happened in emerging markets where, over the past year, EM value has had one of its best years ever relative to EM growth, leaving the vast majority of portfolio managers (today, almost all fully-declared growth investors or really “closet” growth investors) licking their wounds. We can see below that in every region  of EM (except for the GCC, for classification reasons) value has beaten growth by a huge margin.

As in the case of the U.S., a simple strategy based on fundamentals instead of market capitalization also beat the index by a huge margin and outperformed 90% of active managers in emerging markets.

What the future brings, we don’t know. But, historically, regime changes in favor of value can last for many years. If we have really moved into a more inflationary environment, which is typically good for value, then perhaps value has a ways to go.

 

The Cycle is Turning; Winter is Coming

Since the outset of the pandemic the global economic cycle has been in accelerated mode. We witnessed one of the shortest downcycles ever and the quickest recovery of employment for any recession in decades. By the middle of last year, the U.S. economy showed clear signs of mid-to-late  cycle behavior, with low employment and rising prices. Now, we are clearly late cycle, with Central Banks having to tighten monetary policy and yield curves flattening underway.

Asset prices have behaved as expected both on the way down and the way up: risk assets (value, small caps, cyclicals) did very poorly on the way down and then very well on the way up. Defensive assets such as quality growth held up on the way down, underperformed on the way up and have proved resilient in the current late phase. Increasing volatility in asset prices and the collapse of speculative bubbles are also signs of a cycle end.

We are now seeing the cycle go full circle, with the typical signs of contraction appearing.

Leading Economic Indicators are pointing down, as shown in the charts below. The first chart is the OECD’s global LEI; the second chart shows LEIs for the U.S. and Korea, the two most important bellwethers of the global growth cycle.

Dr. Copper, also famous for his ability to predict global cycles, also is signaling problems ahead.

The implication is that we are entering a risk-off phase when investors will shun value, small caps and cyclicals. Of course, this includes emerging markets, particularly non-China assets. This will create the next good buying opportunity.