Month: October 2022

“A second marriage is the triumph of hope over experience.” Samuel Johnson

Brazilian voters have the sorry task of choosing between two deeply flawed political figures in a runoff presidential election on October 30. The frustration is increased in that the two candidates already have proven their incompetence for the job, so the choice can only be grounded in hope over experience.

The alternative is between Luiz Inacio Lula da Silva, the caudillo who has run the Workers Party (PT) for decades, including a 14-year stretch (2002-2016) marked by rampant corruption, and Jair Bolsonaro, a right-wing evangelical populist with a truculent manner, an unsavory environmental record, and a deep nostalgia for the “order and progress” of military dictatorship (1964-1985). Most voters are motivated by fear and rancor and resigned to choosing the least-worse option; either “a corrupt thief” (Lula) or “a genocidal fascist” (Bolsonaro), as the candidates defined each other in a recent public debate.

The political, media and business elites in Brazil mainly have sided with Lula, if with a pronounced lack of enthusiasm. The rationale is that Lula is “more democratic,” though this overlooks his fervent admiration of Cuba’s Castros and other Latin American dictators and his antagonism towards Brazil’s vibrant free press.   Bolsonaro is lambasted for adulating Trump and siding with right-wing strong-men around the world. Bolsonaro also is accused of plotting to bring back a military dictatorship to Brazil, though there is no evidence that the military would countenance this unless social order declined precipitously, and the middle classes took to the streets clamoring for an intervention.

Lula’s key campaign promise is that he will bring back the consumption boom experienced during his presidency (2002-2010) which resulted from a surge in commodity prices and a massive positive terms-of-trade shock. This was a period of prosperity when purchasing power expanded greatly for low-skill workers and investment bankers alike. As Lula tirelessly repeats: “They know that never in the history of this country they made so much money as when I was president. Bankers made money, businessmen made money, farmers made money.”

However, Lula grossly mismanaged the commodity boom, and it was followed by a severe case of “Dutch Disease’ (the natural resource curse) from which Brazil still has not recovered.

“Dutch Disease,” named after the economic instability caused by the discovery of gas fields in the Netherlands in the 1960s, is well documented, and responsible natural resource producers (e.g., Norway, UAE) have learned to avoid it by taking preventive measures e.g., offshore sovereign funds.  The discovery of the huge pre-salt offshore deposits by Petrobras in 2005 and the China-induced commodity super-cycle (2002-2012) caused a massive terms-of-trade shock for Brazil.  Unfortunately, Lula fell right into the trap, and Brazil followed the classic course of Dutch Disease as outlined by academics.

1. Currency overvaluation, resulting in the decline of the trade sector and deindustrialization, followed by devaluation.
2. A credit-fueled consumption boom, followed by lower growth and reduced living standards.
3. Monetary expansion and asset bubbles followed by crashes.
4. Increase in corruption and rent seeking, undermining confidence in judicial and political institutions.

Corruption scandals marred the 14 years of PT rule. Moreover, Lula undid important administrative and economic reforms that had been achieved under his predecessor, Fernando Henrique Cardoso.

 Since the end of the PT’s rule in 2016, Brazil’s economy has been in a depressionary state. But slowly the foundations of growth have been restored by competent monetary and fiscal policies and a series of important reforms. These include pension, labor and bankruptcy law reforms, and laws setting a ceiling on fiscal spending, guaranteeing Central Bank Independence and for the regulation of water and sewage utilities. Since 2016, Brazil has also seen its most important wave of privatizations since the 1990s. This includes the spectacular privatization of Eletrobras, the national electricity utility, which for decades had been a bountiful source of graft for politicians. Next on the list of privatizations is Petrobras, which was at the core of the corruption scandals of the PT years. These reforms aim to make the economy more competitive and productive. Lula opposes them all and aims to overturn them.

The choice is a tortuous one for the Brazilian voter. If character is the determining factor, many will stay home or nullify their votes. If voters understand the benefits that may accrue from the current course of economic reforms, the choice may be easier.

Emerging market stocks have continued to underperform the S&P500 over the past year and the past quarter,  as global capital flows to the safety of U.S. assets in a world of rising economic instability and risk aversion. However, below the surface  interesting trends are emerging that point to better days ahead.

After a decade of poor returns, value investing (contrarian investing in cheap stocks in cyclical industries with little growth) is working again in emerging markets. The MSCI EM value index has outperformed the MSCI EM core index by 3% over the year, and, more importantly, the cheapest countries in the EM index are now by far the best performers. This is in stark contrast to the past five years when cheap only became cheaper and rich only became richer.  We can see this in the chart below which shows the performance of the four cheapest markets in EM relative to the MSCI EM index. Turkey (TUR), Brazil  (EWZ) and Chile (ECH) have beaten the EM index by huge margins over this period.  Colombia (GXG), which recently elected a leftist anti-business president, has still managed to perform in line with the market.

This trend should boost the confidence of EM investors. Emerging markets are by nature a value asset (highly weighted to cyclical businesses) and should not be performing well in an environment of rising risk aversion.  But investors are now betting that these markets are too cheap to avoid because low valuations promise high expected returns that more than compensate short-term risks.

The chart below shows the current expected returns for EM markets and for the S&P500 based on a CAPE ratio analysis. The Cyclically Adjusted Price Earnings Ratio (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.

As we have seen in recent years, CAPE is not a good timing tool, but it does tend to work well over time, particularly at extreme valuations.  CAPEs below five, such as Turkey today, have historically been a failsafe indicator of high future returns. CAPE ratios that are completely out of sync with historical averages for the country are also powerful predictors of future returns. Aside from Turkey, Colombia, Philippines and Korea look very cheap on this basis. On the other hand, India , the most popular market with investors today, is an absolute outlier on the expensive side.

That cheap markets are now performing well in a risky environment is very encouraging for EM investors. If value continues to do well, EM stocks will likely do very well when the coming synchronized global and U.S. recessions  hit bottom.