July 2022 – The Emerging Markets Investor

The Big Mac Index, REER and Competitiveness in Emerging Markets

Since the imposition of a dollar-centric fiat currency global monetary system by President Richard Nixon in 1971 countries have had to carefully manage their foreign accounts or suffer the consequences. Without the discipline imposed by the golden fetters of the Bretton Woods System (1946-1971), countries that run large current account deficit, accumulate foreign debt and welcome “hot money” flows often have been at the mercy of fickle financial markets and an erratic U.S. Federal Reserve concerned only with the effect of its policies on the U.S. economy. These countries generally have had poor growth and volatile economies and have suffered from low investment, deindustrialization and capital flight. On the other hand, countries which have carefully managed foreign accounts, repressed short-term financial flows and “managed ” their currencies have stabler currencies, grow faster, invest more and successfully move up the industrial value chains.

In emerging markets there has been a clear divergence in economic performance between countries with stable and competitive currencies and those with volatile currencies , with a pronounced advantage for the former. We can separate countries into three groups:

Convergers are high growth, industrializing countries which follow mercantilist policies and financial repression (China, Taiwan, South Korea, Poland, Vietnam). These countries have successfully converged with developed countries in terms of GDP per capita. They all carefully manipulate their currencies and support industries to achieve competitiveness for their manufacturing exports. These countries have been the great beneficiaries of the dollar-centric monetary system as they have exploited the U.S. current account deficits inherent to the system to their great advantage.

Erratic Convergers are countries have maintained a commitment to manufacturing exports but without the discipline, governance and quality of execution of the “Convergers”(Malaysia, Thailand, Indonesia, Turkey, Mexico). These countries have erratic growth and moderate convergence at best. Their economies and currencies are too volatile to sustain high export growth and move up value chains, and they are typically “sandwiched” between the highly competitive “convergers” and lower-cost newcomers (e.g. Vietnam, Bangladesh).

Middle-Income Trappers are countries without the institutional governance to manage growth (Brazil, Chile, Argentina). These countries experience low growth, high economic and currency volatility and rapid deindustrialization. They are often commodity rich countries that periodically go through boom-to-bust cycles and bouts of “Dutch Disease” Suffering from similar problems are the “Basket Cases” commodity producers that verge on the border of failed states (South Africa, Nigeria).

Low Income Convergers: Poor countries in a high-growth catch-up phase driven by urbanization and basic manufacturing (India, Philippines, Bangladesh). These countries experience high growth and convergence, and they will eventually hit the middle-income trap unless they can improve institutional governance and develop competitive manufacturing exports and move up value chains.

We can see the disparate circumstance of these groups in the charts below. The first chart shows the 30-year volatility of the Real Effective Exchange Rate (REER) for each country. (The REER measures the value of a currency against the country’s trading partners). The following charts show the 22-year implied valuations relative to the USD for each country organized by the groups define above, using data from the Economist’s Big Mac Index. This index measures the cost of manufacturing a basic commodity product (the Big Mac Sandwich) in a service industry and has proven to be a good measure of a country’s general competitiveness.

Convergers (China, Taiwan, South Korea, Poland, Vietnam). All these countries have low volatility in the REER, meaning they preserve currency stability, a sine qua non to incentivize investment and export growth. (Vietnam’s high level is distorted by early data but its REER has been more stable over the past 20 years as it has embraced the “China Model” and has become a dynamic exporter. The Big Mac Index data below confirms this low volatility and, more importantly, persistently high competitiveness.

Big Mac Implied Valuation relative to the USD

Erratic Convergers (Malaysia, Thailand, Indonesia, Turkey, Mexico). Malaysia, Thailand and Mexico have low REER volatility while Turkey and Indonesia are at relatively high levels. All of these countries have experienced at least one severe economic shock accompanied by maxi-devaluations over this 30-year period. The Big Mac data below confirms that Malaysia, Thailand, Indonesia and Mexico have learned from their past mistakes and have sustained high levels of currency competitiveness in support of manufacturing. Turkey, however, is a different story . Though the lira is currently competitive, it has gone through multiple cycles over the past twenty years, mainly caused by “hot money” flows tied to domestic credit cycles. It is remarkable that Turkish manufacturing has remained as competitive as it has given these difficult circumstances.

Big Mac Implied Valuation relative to the USD

Middle-Income Trappers: (Brazil, Chile, Argentina). Both Argentina and Brazil experience high levels of currency volatility caused by commodity cycles, “hot money” flows and periodic capital flight. Chile was previously considered a “converger” but in recent years has looked more like its neighbors, with institutional instability and severe capital flight. The data from the Big Mac Index highlights the difficult circumstances faced by exporters of manufactured goods in these countries. In addition to high volatility, these currencies are always expensive relative to Asia, Mexico and Turkey. A decade ago, Brazil had the third most expensive Big Mac in the world, and even today it has the most expensive in emerging markets, even though Brazil is the largest exporter of beef in the world.

Low Income Convergers: (India, Philippines) These countries can achieve high growth because they start from a very low level of GDP per capita and can boost productivity easily by adopting technologies and by boosting the productivity of labor by migrating workers from subsistence farms to modern industries in urban settings. Neither country is following the North-Asian model of growth led by exports of manufactured goods, though they have specialized in the export of niche services (I.T. outsourcing for India and call centers for the Philippines). These exports added to remittances from workers abroad are important sources of dollars.

In conclusion, we look at what the REER and Big Mac Index tell us about current currency values.

The first chart shows current currency valuations on a Real Effective Exchange Rate (REER) basis for both major emerging market countries and developed economies, using data for the past 30 years. This measures a country’s currency relative to its trading partners. The main outliers at the current time are Turkey and Argentina on the cheap side and Russia on the expensive side. Also, on the expensive side we find India, Vietnam, Nigeria, the U.S. and the Philippines. With the exception of Vietnam which may be statistically insignificant because of its short history as a trading nation, all the other countries give low importance to their export manufacturing sectors. Not by coincidence, most dedicated manufacturers (Mexico, Malaysia, Europe, South Korea Taiwan, Poland, China and Thailand are towards the middle of the chart.

The currency values derived from the Big Mac Index largely confirm the REER analysis. The dedicated exporters all have cheap currencies. Low-income growers (India, Philippines) are shown to be appreciating in terms of REER but remain structurally cheap in terms of the Big Mac Index. Middle-income trapped countries (Brazil) are depreciating in terms of REER but remain fundamentally uncompetitive in terms of the Big Mac Index

Emerging Markets Expected Returns, 2Q2022

For over a decade earnings and earnings multiples have declined for emerging market stocks, leading to very poor returns both in absolute terms and relative to the S&P 500. Over this period, these markets went from “bubble” conditions in 2010-2013, fueled by the commodity super-cycle and the rise of China, to the current depressed state which reflects slowing growth, Covid, geopolitical risk and global financial instability caused by high debt levels and a rising USD.

We can see this evolution in the following tables. On the left, Cyclically Adjusted Price Earnings (CAPE) multiples are shown for the S&P500, EM stocks (MSCI) and a sample of emerging market countries. Note the contrast between the sharp rise in the U.S. and the decline in most emerging markets, with the exception of the tech-centric Taiwan. On the right, dollarized MSCI EM earnings are rebased to 100 in 2010. Here we see the striking contrast between surging earnings in the U.S. market and the flat to negative earnings in EM, once again except for Taiwan (TSMC). Even China, with its supposedly high GDP growth, strong RMB and enormously successful tech stocks, has seen no earnings growth over this period.

Predicting the future evolution of geopolitics, Fed policies and the other myriad factors that impact economies, capital flows and stock markets is always a daunting challenge for investors. For this reason, it is often best and easiest to assume that historical patterns of valuation and mean reversion will persist. In this regard, we can use CAPE analysis to provide a basis for valuation parameters. Though CAPE is not a short-term timing tool, it has proven effective in predicting long term returns. This is particularly true at market extremes, like 2010-2012 when CAPE was screaming “bubble” across EM.

The CAPE takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful tool for highly cyclical assets like EM stocks. We use dollarized data to capture currency trends. This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University.

The chart below shows CAPE ratios for 16 EM countries, global emerging markets (GEM, MSCI) and the S&P500 relative to each country’s history. This gives a general idea of where valuations are on a historical basis for each country. Extreme discrepancies from historical patterns are currently evident in the U.S. and India on the overvalued side. Most emerging markets appear to be very undervalued; Turkey, Korea, Colombia, Philippines and Chile are at extremes.

In the table below we show the results of our adjusted CAPE methodology for estimating future expected returns. The expected returns of markets depend on valuation (CAPE ratio) and earnings growth (largely a function of GDP growth). No consideration is given here to possible multiple expansion or the liquidity factors that may have a major influence on market returns. The two columns on the far right show (1) the expected nominal return for each index and (2) the real (inflation adjusted) expected return for each index with the addition of expected dividends.

The methodology derives expected returns by setting a long-term price objective based on the expected CAPE earnings of the target year, which in this case is 2028. The CAPE earnings of the target year are multiplied by the historical median CAPE for each country. The underlying assumption of the model is that over time markets tend to revert to their historical median valuations.

The countries with very low expected returns (Indonesia, U.S., Thailand and India) each have their specific issues. Given the stretched valuation, Indian firms will have to surprise the markets with better than expected earnings growth. The U.S. faces the challenge of high CAPE multiples, record corporate operating margins and declining potential GDP growth. Thailand and Indonesia are reasonably priced and could enjoy higher returns if GDP growth surprises on the upside. This would require a boost in productivity to break out of the current trap these countries face, stuck between new low-cost competitors (e.g. Vietnam) and China’s industrial might.

The five markets with the highest expected returns (Turkey, Brazil Colombia, Chile and Peru) are all in countries with significant economic and political concerns. In the case of Turkey, the destitution of President Erdogan is probably necessary for these returns to materialize. As for the Latin American countries, political stability and high commodity prices would make these returns likely.

Taiwan’s high expected returns require a recovery of the semiconductor cycle, which is likely. Also, investors have to be comfortable with rising geopolitical risk in the Taiwan Strait.

Winter is Here for Emerging Markets

The first half of 2022 has been another big disappointment for investors in emerging markets as EM stocks fell 17%. On the positive side, EM stocks did better than the S&P 500, which fell by 20% during this period. Unfortunately, the rest of the year does not look better. The environment is simply not positive for EM assets. I wrote in February that Winter was coming (link) ; now we can say that we are in the thick of winter.

All the indicators that we look at to mark the investment climate point firmly to more trouble ahead. Let’s look at these one by one.

King dollar – EM assets usually do poorly when the dollar strengthens, mainly because most EM countries are short dollars and because commodity prices tend to do poorly during these times. The dollar has been strong since 2012, and this has been an awful period for EM investors. The recent surge in the dollar caused by high global risk aversion and flight of capital into U.S. assets, is a huge headwind for EM. The charts below show first the DXY (heavily weighed towards the euro and the yen) and second the MSCI EM currency index, both of which show the sustained run the dollar has had for 10 years.

2. Global dollar Liquidity – Risky assets like EM stocks and bonds do well when dollar liquidity is ample and poorly when it dries up. After the money printing orgy of 2021, the tide has ebbed. The charts below show: first, one measure of global liquidity (U.S. M2 plus central bank reserves held at the Fed); and second, central bank reserves held a the Fed. Liquidity is now in free fall. Foreign reserves held at the Fed are also plummeting, as countries like China and Russia have dramatically reduced their positions for geopolitical reasons and other countries are fleeing the negative real yields of Treasury notes.

3. Yield spreads – The spread between the yield of U.S. high yield bonds and Treasury bonds is one of the best indicators of risk aversion and recession risk. Historically, rising spreads point to problems for EM. We can see in the next chart the recent rise in the spread. Moreover, the rise in the spread has been tempered by the benefit of high oil prices for oil companies. Stripping these out the spreads would be much higher.

4. The CRB Industrial Index – Commodity prices and in particular industrial commodity prices are a tried and true indicator ofmarket trends for EM assets. This has been even more so since the rise of China twenty years ago because China is the primary consumer of industrial commodities, and any slowdown in China now spreads rapidly to the rest of EM. The CRB index, shown in the chart below from Yardeni.com, has turned down since February and now appears in free fall. The combination of high oil prices and low industrial metal prices is a very bad one for EM.

5. Copper price – Finally, the price of copper is a good indicator of global economic activity, as Dr. Copper is known to sniff out recessions earlier than most economists. Unfortunately, copper also appears in free fall now.

So, all the relevant indicators tells us we are in a winter storm. It is best to sit be the fire with cash in hand and wait for calmer times.