Author: jvande

Valuations in Emerging Markets

Valuation of equities is a relatively simple matter, as long as one is disposed to believe that prices fluctuate as a function of the “greed-fear” cycle of investors but eventually mean-revert to historical parameters. However, over the short-term, the forward-looking period of 3-12 months of almost exclusive concern to Wall Street, the media and the majority of investors, valuation parameters can seem largely irrelevant, as it is difficult to predict when trends will change or what may trigger a drawdown. Typically, market corrections are caused by economic recessions, which bring stocks back to lower levels and create opportunities for investors to buy equities with prospects for reasonable returns.

Having said that, there are two reasons for believing that valuations may be drifting higher with time, which would require long-term forecasters to make some adjustments to their models. First, there is no doubt that the cost of buying and holding equities has fallen dramatically over time. For example, I remember buying the closed-end , NYSE-traded The Mexico Fund in the mid-1990s. Trading commissions were in the order of ten times the $5/trade many brokers charge today, the fund manager charged a management fee well above 2% for what was essentially an index fund. To top it off, the fund traded at very large discounts to Net Asset Value, sometimes as great as 30%. Compare that to the emerging market country funds now trading in ETF form with annual fees of as low as 14 basis points (0.14%), and it is clear that investing in emerging market equities, as in other asset classes, has never been cheaper than today. It would make sense that valuations would at least partially reflect the lower transaction costs.

Another often-cited, though less plausible, explanation for higher valuations is that risk has been permanently reduced by lower economic volatility. This theory was advanced as a possibility already in the late 1950s by no less than the legendary investor and teacher Ben Graham, who was searching for a reason to explain why U.S. stocks had appreciated so much during the post-war period. If one believes Ben Bernanke’s theory that improvements in the science of monetary economics has resulted in a “great moderation,” or smoothing of economic cycles, than this could point to higher-for-ever valuations. Of course, one would have to explain the Great Financial Crisis of 2008-2009 as a “Five Sigma” event not likely to happen for another thousand years. This is the view that has been publicly expressed rather unconvincingly, in my view, by Bernanke and Janet Yellen, and which justifies the extremely low volatility and high valuations of the current investment environment.

What does history tell us about current valuations? The work of GMO, Research Affiliates, and Haussman all agree that most assets priced at levels that point to very low expected returns for most asset classes.

First, let’s look at the work of John Hussman (Hussman Funds), which back-tests historical data to forecast future returns. Hussman’s model predicts negative 2% nominal (including inflation) returns for the next 12 years.

Second, let’s look at GMO, which has made these forecasts for decade with a high degree of predictive success. The table below shows GMO 7-year forecast for real (inflation-adjusted) returns. GMO sees negative returns for stocks, partuclarly U.S. large cap stocks with negative 4.6% annual real returns (in line with Hussman’s number). Emerging markets stocks are the exception,  priced to give a 2.2% real annual return. Jeremy Grantham, GMO Chief Strategist, recently advised his clients to load-up as much as they can on emerging market equities.

Third, we look at Research Affiliates, with the results of their latest exercise below. RA forecasts real returns and volatility for the next ten years. RA’s model points to generally higher returns for all asset classes compared to GMO’s, but still U.S. equities are expected to provide near zero return for the period. International returns (EAFE, Europe, Asia, ar-East) are slated at slightly above 4%, and emerging markets are expected to provide real returns of 6% per year.

These three approaches point to relatively high expected returns for emerging markets. These can be explained by three factors: 1.relative under-performance over the past five years; 2.Valuations in line with history, and quite low relative to U.S. equities; 3. the earnings cycle; and 4. the currency cycle.

  1. Relative Underperformance (S&P 500 vs. MSCI Emerging Markets Index)

  1. Valuations (Cyclically Adjusted PE ratio), S&P500 vs. EM

3.Earnings are on the rebound in EM.

4.Competitive Currencies

Fed Watch:

India Watch:

China Watch:

  • US politics gets in the way of Ant Financial’s US plans (SCMP)
  • Making China Great Again (The New Yorker)

China Technology Watch:

 

 

EM Investor Watch:

 

 

Technology Watch:

  • Apple’s share of smartphone profits is falling (SCMP)
  • Fanuc’s robots are changing the world (Bloomberg)
  • Battery costs coming down (Bloomberg)

Investor Watch:

 

 

 

 

 

 

 

 

“The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority ‘go with the flow,’ either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in ‘fair value’ for the stock market.”  ~ Jeremy Grantham

India, Urbanization and a New Commodity Bull Market

Around the turn of the century, China’s economy entered in a phase of very high growth which was fueled by investments in infrastructure and heavy industry and was extremely intensive in the use of hard commodities. A surge of demand from China caught producers by surprise and drove prices  for commodities, such as iron ore and copper, to very high levels for an extended period of time (2003-2011).  A typical boom-to-bust cycle ensued, with overinvestment by producers eventually resulting in over-capacity and a return to low prices.

Commodity markets have been depressed for the past five years and valuations for the stocks of the producer firms have reached record lows relative to stocks in other sectors.

China’s impact on commodity prices, though extraordinary, was not atypical. Historically, countries have entered periods of commodity-intensive growth when they reach a certain level of wealth and experience high urbanization rates: for example, the U.S. in the 1920s, Japan in the 1950s, Brazil in the 1960s and Korea in the 1970s. All these countries saw a period of massive growth in commodity consumption, which eventually leveled off. U.S steel consumption today is at the same level as in 1950, while the Japanese consume steel at 1975 levels.

We can see in the following chart the recurring pattern, when countries suddenly ramp up urbanization rates. High income nations have largely stabilized urbanization levels, while China, India and  all lower-income developing countries still have several decades ahead.

 

If we can identify the next countries experiencing high growth and urbanization, we can go a long way towards understanding the next upcycle in commodities. From looking at historical data, it is the case that urbanization rates ramp up when countries reach a level of wealth around $2,000 per capita (2016, constant USD). The table below shows the progression by decade of new countries entering this wealth level, according to IMF and World Bank data. During the decade ending in 1980, Korea, Poland and Thailand entered into this group; none entered in the 1980s; Russia (and other Eastern European state) appear in the 1990s; and China, Nigeria, Ukraine and Indonesia enter in the 2000s. In this current decade only Vietnam has appeared, so far; but if we look through 2022, we see a massive swell led by India but also including Uzbekistan, Myanmar and Kenya.

It is not the number of countries that matter, of course, but rather the population impact that they represent. The chart below shows the population impact by period, in terms of new entrants as a percentage of global population. We can see a huge surge representing 21.8% of the global population (23%, including Vietnam), surpassed only by the China-led surge of the 2000s.

Equally important, the upcoming surge will happen at a time when China sustains relatively high growth and increasing urbanization, so that we will have both China and India sustaining demand at the same time.

A new upcycle in commodity prices is obviously bullish for emerging market producers, such as Chile, Brazil, Indonesia, Russia and South Africa. It also likely points to a weak dollar and good performance for emerging market stocks in general.

Fed Watch:

India Watch:

China Watch:

 

  • US politics gets in the way of Ant Financial’s US plans (SCMP)
  • Making China Great Again (The New Yorker)
  • Geely invests in AB Volvo trucks (SCMP)
  • China’s commodity demand (Treasury)
  • Ground broken on China-Thai railroad (Caixing)

China Technology Watch:

EM Investor Watch:

 

  • France seeks closer ties with Russia and China (WSJ)
  • Latin America’s rejection of the left (Project Syndicate)
  • Indonesia’s bullet-train project stalls (Asia Times)
  • Boeing’s bid for Embraer (Bloomberg)

Technology Watch:

  • Apple’s share of smartphone profits is falling (SCMP)
  • Fanuc’s robots are changing the world (Bloomberg)
  • Battery costs coming down (Bloomberg)

Investor Watch:

 

 

 

 

Deglobalization and Technological Disruption

Deglobalization and rapid technological change are likely to be the two main drivers of economic and stock market performance in emerging markets for the next five years. Every country faces different combinations of challenges and opportunities and how they deal with these will make a big difference in whether they prosper in our rapidly changing world.

Deglobalization

The intense globalization of the past decades, which had not been seen since the last decades of the 19th century, was a boon to the global economy, while at the same time dramatically redistributing relative income: to the poorer countries and away from the developed ones; and to super-wealthy individuals and away from everyone else. The political effects of this redistribution have become evident in recent years, leading to a dramatic corruption crack-down in China and the rise of populism in the West in the shape of Brexit and Donald Trump.

The clear beneficiaries of globalization were those manufacturing countries that integrated themselves in global value chains. These were mainly in Asia, though countries like Mexico and Turkey also participated. Some small, highly competitive countries also benefitted from better access for their exported goods. And, of course, consumers in developed economies benefitted from cheaper imports.

The relative losers were those countries that fought the trend (Brazil, India, South Africa, Venezuela, Indonesia, Russia) or were too small or uncompetitive to participate.

Unfortunately, those countries that did everything right during this cycle and participated fully in the upside of globalization may now have more to lose. Those countries highly integrated into global value chains and highly dependent on exports may now suffer relative underperformance unless they can find other sources of growth.

On the other hand, those countries that never embraced globalization –Brazil and India for example — may now be well positioned. Given the size of their domestic markets and ample growth opportunities that are unlinked to the global economy, they could still attract investments and thrive in a world where country-to-country trade deals based on reciprocal market access become more the norm.

China also seems well positioned. Given the size of its economy, further export-led growth was never going to be plausible. Moreover, the Chinese economy is coincidentally entering into a phase where it will be driven by domestic consumption and improvements to the “quality” of life.

Developed economies also are generally well positioned. Protectionism may lead initially to a welcomed increase in wages. Over time, it will trigger investments in automation technologies and accelerate the opportunities for “on-shoring,” the relocation of manufacturing closer to the customer in the developed countries. Two examples of this are: Adidas operating highly automated sneaker plants in Germany, and cloud computing and artificial intelligence undermining the low-value-added services of the Indian information technology industry.

Technology

There are two main thrusts of technological innovation that will dramatically impact emerging markets in coming years: 1. Artificial intelligence and robotics; and 2. Renewable energy.

With regards to technology, there are two factors to consider; whether a country can benefit as a developer of new technologies; and whether a country can successfully embrace the adoption of new technologies.

In terms of participating in the benefits of the development and commercialization of new technologies, it seems today that only East-Asian emerging markets (China, Korea, Taiwan) are well positioned to do so. China, following the path of its East-Asian neighbors and committing huge government support, is already becoming a leader in many technologies (internet, mobile telephony/5g, drones, high-speed trains, electric vehicles, solar and wind, among others).

In terms of the potential for countries to embrace new technologies, the path is much less clear.

New technologies offer enormous opportunities for emerging markets to leapfrog to state-of-the art conditions with much lower costs and vastly better productivity. For example, China has built a world class telecommunications network based on mobile technology without having had to make huge investments in fixed telephony networks. In Brazil, fixed lines are likely to become nothing more than a bad memory for people over 50 years of age. In Vietnam and India, the average person will have never experienced a fixed line. The potential for leap-frogging is the greatest in the poorer countries which have no attachment to legacy technologies, such as Africa, India and China.

A multitude of new technologies now being deployed will ramp-up dramatically in coming years, including cloud computing, artificial intelligence, drones, electric and autonomous vehicles, e.commerce, fintech, and battery-centric renewable energy. Many of these technologies will be very disruptive to businesses, that will lobby hard to protect legacy markets. Every country will deal differently with these disruptive forces, depending on the vision of policy makers and the power of entrenched interests to block change.

China has embraced technology for idiosyncratic reasons. China started from so low a level of economic development and the pace of change has been so fast that entrenched interests did not oppose new technologies. But that is not the case in most places, particularly the stagnant middle-income countries with powerful entrenched interests and rent-seeking politicians.

Take a country like Brazil. New technologies may face a phalanx of opposition from manufacturers, unions and local politicians, aimed at discouraging entrepreneurs. While in China, multinational automobile firms have quickly toed the Party line and committed to electricity vehicle investments, in Brazil they are likely to resist for as long as possible.

India is probably the country with most to gain from disruptive changes. It has a tech-savvy elite which has been instrumental in pushing for digitalization, such as the recently implemented AADHAAR national biometric digital identification program, which opens huge opportunities for digital commerce and fintech. With a very large proportion of its population with no access to basic public, financial and commercial services, AADHAAR provides significant opportunities for the Indian masses to gain access to state-of-the art technologies. This is now happening with smart-phones and will soon ramp up with battery-centric renewable energy and fintech services, giving countless isolated villagers access to modernity for the first time. Also, with only a fraction of the population currently with access to automobiles, in India there is no legacy infrastructure standing in the way of electric vehicles.

Though it is difficult to predict how things will play out, the following chart attempts to map-out how de-globalization and technological disruption may affect the major countries in emerging markets.

 

 

Fed Watch:

India Watch:

China Watch:

  • China’s commodity demand (Treasury)
  • Ground broken on China-Thai railroad (Caixing)
  • China’s new winter sports resort ( WIC)
  • China cannot be a global leader (China File)

China Technology Watch:

EM Investor Watch:

Technology Watch:

Investor Watch:

 

Picking Stocks

Many active portfolio managers describe themselves as “bottom up” investors, by which they mean that their process begins with picking individual stocks that are fundamentally mispriced. However, the evidence shows that successful investing does not start with stock picking, but rather with a firm set of principles and exploitable factors. For example, Warren Buffet, considered by many the best stock picker of his generation, has been known to buy a stock after only a brief conversation because he can quickly fit the idea into his very defined philosophical framework.

The investors first task should be to define an investment policy and a process which is simple and replicable. The second task, refered to as asset allocation, is to construct a portfolio of assets that matches risk appetite and tolerance for drawdowns by diversifying into non-correlated cash flow streams. The third task is to identify the securities, including stocks, to implement the strategy. It is at this point that stock picking acumen comes into play, giving the investor the opportunity to use skill to garner excess return (“alpha”) beyond what is available through indexing strategies.

Quant strategies are already very good at exploiting at very low cost the market return (beta) and factors such as value, size, momentum and quality. Therefore, the successful stock picker needs to focus on segments of the market that are “inefficient” because of the behavioral biases of both institutional and individual investors. Computers are not particularly adept at reading human emotions, judging human character and seeing the future, so in these matters portfolio managers still have a significant advantage.

The behavioral biases that can be exploited are:

  • Short-termism – the great majority of institutional investors and all of the Wall Street “sell side” brokerages are focused on the next 3-6 months. Enormous resources are spent on this time frame, so the market is extremely efficient and alpha is scarce. But if the investor can look forward, the competition for alpha declines precipitously as duration increases. Time-horizon arbitrage is a lonely occupation in the investing world, so there is alpha to collect.
  • Herding – Investors like to move in herds. As Keynes once noted, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to success unconventionally.” Contrarians are rare in the investing world, so they can harvest alpha through mean-reversion strategies, which go against the herd.

The independent investor should also narrow his focus to segments of the market that are richer with alpha. Buffett, for example, says that from the start he eliminates 90% of the stocks in the market, the “too difficult” pile. He focuses all his attention on the remaining 10%. This pool of stocks, which he names his “circle of competence,” are companies that have simple business models and returns that are both high and sustainable. The sustainability of high returns exists because of a “moat” that defends against competitive pressure.

While most investors have portfolios heavily laden with market risk (beta) and factors that can be easily replicated by quants, the skilled stock-picker should focus on high-return prospects; “fishing where the fish are,” so to speak.

The key to alpha generation is to exploit human foibles in areas of the market that offer high potential, following strategies that cannot be easily replicated by the quants and their computers.

The first step is to define the “circle of competence.” In my emerging markets investments I initially reduce the universe to the 10% of profitable companies (historical basis). These companies, which have shown the ability to makes good returns on capital over the past 5-10 years , can be called the “Legacy Moat.”

The second step is to run a value screen on the Legacy Moat, and eliminate the more expensive stocks. This can be done simply with something like Greenblatt’s “magic formula,” or, for example, by eliminating high PE ratio or high price-to-book stocks. The list of stocks, narrowed to 5% of the universe, already should provide significant alpha based on the value and quality factors. Unfortunately, up to now the process can also be easily replicated by a computer.

The third step is to subjectively review the stocks on qualitative grounds, entering into issues where computers provide little insight.

The questions to be asked are highly subjective in nature:

  1. Is the moat sustainable?
  2. How much can the business grow and for how long can capital be redeployed at high rates?
  3. What is the “character” of managers/owners? Do they have integrity? Will they make good capital allocation decisions?

None of these questions is easy to answer, but this is where the portfolio manager can add  value.

The third step will narrow the list to 1% of the total stock universe. These businesses which have high returns, sustainable moats and the ability to reinvest can be called “moat compounders.”  These are the most extraordinary businesses if they have long runways (e.g. Walmart in 1970, Indian banks today.) Particularly in the medium-cap world and in emerging markets, these opportunities are not well followed and can be very under-priced. Typically these businesses have one of three moats: network effects (e.g. Facebook, Tencent); scale advantage (E.g. Amazon, Alibaba, Ambev); or valuable intangible assets  like brands (e.g. Coca Cola, Banco Itau).

Identifying moat compounders is not easy, but skillful investors do have an edge. First, by being exclusively focused on this “fishing ground,” they improve their chances from the start. Second, by  studying the nature of moats they become experts at identifying them. Third, they can take a long-term view, allowing for compounding effects to materialize. Fourth, they can exploit the moods of the market, as the herd moves on the “fear and greed” spectrum.

There is one additional segment worth mentioning that can provide significant alpha for the stock picker.  This is the “legacy moats” that do not have reinvestment opportunities but do have exceptional capital allocators. These legacy moats can be great investments if capital is redistributed to investors or redeployed effectively in M&A. This is the model followed over three decades by Brazil’s Jorge Paulo Lehman, as he buys mature businesses (e.g. beer) and redeploys cash flow into M&A opportunities.

Fed Watch:

India Watch:

China Watch

  • China’s new winter sports resort ( WIC)
  • China cannot be a global leader (China File)
  • China forms a Cement giant with eye on Silk Road (SCMP
  • Starbucks opens its largest store in Shanghai (FT)
  • China and India lead in growth in parcels shipped (Business Wire)

China Technology Watch:

  • China’s two largest trucking aggregators merge (WIC)
  • The battle between Alibaba and Tencent (WIC)
  • China-U.S. competition for AI (AXIOS)
  • China’s AI Awakening (MIT Tech Review)

EM Investor Watch:

 

  • GMO goes all-in on EM (GMO)
  • The end of globalization as we know it (Barclays)
  • Demographics will reverse major trends (BIS)
  • Venezuela’s farming disaster (Bloomberg)

Technology Watch:

 

 

 

 

Factor Investing in Emerging Markets

Over the past fifty years, financial economists in academia have built mathematical models to explain how excess returns can be obtained by investors in “efficient” markets. The Capital Asset Pricing Model (CAPM), developed during the 1960s, was the first formal model that sought to explain asset prices as a function of risk and return. According to this simple model, the equity market as a whole has a systemic return which is the excess return over a risk-free asset (i.e Treasury Bills) that an investor needs to assume the greater risk of the stock market. Market risk is called BETA in the model, with the risk free asset having a BETA of zero, the  market a BETA of one and riskier assets a BETA above one. BETA itself is  measured in terms of the correlation of an asset to the market and how volatile it is relative to the market.

Though the CAPM model remains the pillar of modern finance, academics have punched many holes in its one-factor (BETA) structure. A generation of finance PHDs have come up with “anomalies” in CAPM, which are additional factors that explain excess returns in a persistent manner over time, sectors and geographies. Initially small-capitalization stocks and value stocks (low price-to-book-value or low price-to-earnings relative to the market) where identified as generating a return premium. Then momentum (the tendency of rising stocks to keep rising and falling stocks to keep falling) gained acceptance, followed by quality and profitability. In recent years, academics have gone wild identifying multitudes of new factors, but most of these seem redundant, and the focus by investors is on the initial five.

The excess return premiums over the risk-free rate which investors expect from these factors (based on historical empirical evidence) are the following (Source, Your Complete guide to Factor-based Investing, Berkin&Swedroe):

Not only do the factors provide excess return premiums (for example, smalls caps add 3.3% of excess return), they also show negative correlations to the market excess return (BETA). This means that by tilting a portfolio to a specific factor the investor can expect to have both higher returns or lower volatility.

Given that the validity of these factors assumes prevalence over geographies, an investor should expect to find them in emerging markets. What is the evidence?;

The most recent academic research –”Size, Value, and Momentum in Emerging Market Stock Returns: Integrated or Segmented Pricing?”(SSN) , by Matthias X. Hanauer, Martin Linhart ( February 2015), analyzed the July 1996 to June 2012 period and found strong  value and momentum effects. However, they identified only a weaker size effect, and that only in Asia.

Lazard Asset Management, a prominent value manager, studied a similar time period (December 1999 to September 2015) and reached essentially the same conclusion (LAM). Lazard found a large value premium, best exploited through low PE and high dividend stocks (not low price/book). Lazard also found lower but still high momentum and quality premiums. Interestingly, these styles are negatively correlated to value in EM: momentum and quality perform strongly in rising markets, while value is resilient in down markets. Therefore, combining these factors can provide diversification benefits.

The absence of a premium for small-cap stocks in emerging markets would be surprising as this factor is highly prevalent over time in both the U.S. and international markets. Dimensional Fund Advisors (DFA) Management, a quant manager with exceptional academic credentials, has had a small cap EM fund (DEMSX) since 1998 that has performed poorly compared to its emerging market product (DFETX), as shown below:

Source: Yahoo Finance

However, emerging markets small caps have had very good relative performance since 2010, as shown below with DFA’s funds. Given the lack of long-term data for emerging markets, it is certainly plausible that a small-cap premium will materialize over time.

 

Fed Watch:

India Watch:

China Watch:

  • China’s new winter sports resort ( WIC)
  • China cannot be a global leader (China File)
  • China forms a Cement giant with eye on Silk Road (SCMP
  • Starbucks opens its largest store in Shanghai (FT)
  • China and India lead in growth in parcels shipped (Business Wire)

China Technology Watch:

EM Investor Watch:

Technology Watch:

Investor Watch:

 

 

Using Momentum in Emerging Markets

 

Momentum investing relies on inertia: the directional tendency of investment performance. What has been doing well will tend to continue doing well; what is doing badly will tend to continue doing badly.  Momentum investors seek to catch long rising trends, and quit losing trades. The famous classical economist, David Ricardo, summed it up well in 1838 when he said what has become a mantra for momentum investors: “Cut your losses; let your profits run on.”

An elite cohort of investors have embraced this style of investing, including Richard Driehaus, Paul Tudor Jones, George Soros and Stanley Druckenmiller, some working purely on a technical basis, others combining momentum with fundamentals.

Like all anomalies in efficient markets, the momentum factor creates excess returns because of behavioral reasons. Successful investors learn to exploit systematic and predictable irrational human behavior. A typical trend evolves as follows:

Phase 1- Anchoring and under-reaction- Prices initially lag fundamentals, allowing early movers to position themselves well ahead of the crowd.

Phase2- Herding  and over-reaction – As prices start moving higher, investors join the heard, eventually over-reacting.

In an effort to show how common investors, without the trading smarts or resources of a Soros, could successfully use momentum to enhance returns, Gary Antonacci proposed  “Dual Momentum Investing,” in an article and subsequently a book.

Antonacci’s Global Equities Momentum (GEM) portfolio builds a portfolio with three assets: U.S. stocks, international stocks and U.S. bonds. For the retail investor he recommends using low-cost ETFs: for example, VOO for U.S. stocks; VEU for non-U.S. stocks and AGG for U.S. aggregate bonds.

Antonacci named his system “Dual Momentum” because he uses both relative momentum (the measure of the performance of an asset relative to another asset) and absolute momentum ( the measure of performance relative to the risk-free rate – absolute excess return.)

To keep the process very simple to implement, he used a 12-month look-back period and an easy to execute buy and sell system.

  • Every month the investor places all funds in the equity ETF that has the best 12-month performance relative to the other equity ETFs, unless the absolute performance is worse than the return of six-month U.S. Treasuries (as measured by BIL ETF).
  • If absolute performance is below the BIL ETF, then the investor places all funds in AGG, the aggregate bond index.

The simple process aims to position the investor to benefit from long rising trends while avoiding drawdowns. The process is fully automated, eliminating human behavioral reactions.

Antonacci looks at results from 1974 to October 2013. During this period, the portfolio was invested 41% of the time in U.S. stocks, 29% in international stocks and 30% in U.S. bonds. The portfolio was switched 1.3 times per year.

The portfolio outperformed the global benchmark (MSCI All Country World Index – ACWI) by 7.6% annually for the period, with consistent outperformance every decade. It accomplished this with much lower volatility (standard deviation of GEM is 12.64% vs. 15.56%.) More importantly, the maximum drawdown (decline in the value of the fund) was 17.8%, vs. 60% for ACWI.

Antonacci does not recommend using emerging markets in his GEM portfolio, beyond what is already included in the ACWI. He claims that emerging markets have become more correlated in recent years and do not add value.

To evaluate this claim, I ran Antonocci’s system, including emerging markets as a third asset class in addition to U.S. stocks and the MSCI developed market Index. I suspected that Antonacci’s view on the high correlation was influenced by the very high down-side correlation during the 2008-09 financial crisis. Historically, correlations have been relatively low, particularly on the upside, and the high volatility of emerging markets should be exploitable by the GEM process.

From 1999 to October 2017 (admittedly a short period) the GEM Plus EM portfolio produced impressive results, as shown below. The investments are implemented using the SPY ETF (S&P), VTMGX (EAFE), and VEIEX (EM).

  • The expanded GEM portfolio generated significant excess return by riding long dominant upswings for EM and the S&P and avoiding downturns by  reallocating to U.S. bonds. By doing this it avoided massive drawdowns in the early 2000s and during the financial crisis of 2008-09. Given the very high correlation that markets have shown during downturns, the option of holding U.S. bonds for 18% of the time-period reduced the funds maximum drawdown dramatically.
  • Switches from one asset to another occured 1.49 times per year, compared to 1.3 times per year for Antonacci’s portfolio. This is because of the addition of a third asset.

These momentum strategies seem well suited for the market environment of the past decades which has been marked by large drawdowns and sustained trends. They also provide downside protection from the very high current asset prices around the world.  For tax-shielded investors, the advantages are clearly compelling, somewhat less so for taxed investors. The strategy would work poorly if market leadership were to change frequently, creating false signals.

Fed Watch:

India Watch:

China Watch:

  • China’s Transsion leads mobile phone sales in Africa (FT)
  • China transforms the trucking business (Bloomberg)
  • China needs centrally controlled deleveraging (Bloomberg)
  • World Bank, China 2030 (World Bank)
  • The coming China trade war (IRA)

 

China Technology Watch:

  • Chinese Surveillance camera’s are found on U.S. army bases (WSj)
  • Hisense buys Toshiba’s TV business (Caixing)

EM Investor Watch:

Technology Watch:

  • Fanuc’s robots are changing the world (Bloomberg)

Commodity Watch:

  • There is more farmland then previously thought (Bloomberg)
  • Australia’s economy is a house of cards (Linkedin)

Investor Watch:

 

 

 

 

 

 

 

 

 

 

 

Which Emerging Markets are actually Emerging?

Why some countries prosper and others don’t is one of the most contentious debates that concerns economists, political scientists and policy makers. After W.W. II and during the Cold War wealthy countries embraced the notion that good institutions (rule of law, education, free markets) teamed up with technology and savings would allow poor countries (called “latecomers”) to catch up. These theories were famously promoted by economists like Walt Rostow and pursued through foreign aid and institutions like the World Bank. The results 50 years later are surprising. With a few exceptions — East Asia,  Singapore and, more recently, China and Eastern Europe — there has been very little catching up by the poor. Most gains have been achieved by the already relatively prosperous; for example, the country that has had the largest relative increase in per capita income has been Norway.

The data from the World Bank measuring per capita income relative to the United States, though not comprehensive,  is revealing: “catching up” is a reality for the few; most stagnate; and many actually lose ground.

Measuring GDP/capita of countries as a percentage of the GDP per capital of the United States for the past 50 years, what we discover from the data (which covers 78 countries over this time-frame)  is that the greatest gains were achieved by countries that had already secured relatively high income levels 50 years ago. In the chart below, which shows the countries that increased their ratio by more than 10%, we see Norway as the top gainer, increasing by 90 percentage points from 56.5% of the GDP/capita of the U.S. to 145.5% (145.5-56.5=90).  Singapore, Hong Kong, Korea and are the non-European highlights; all of these started from low levels of GDP/capita, particularly China and Korea. Korea, which now has reached the level of Spain, in 1967 had income per capita which was only 3% of the U.S. level, half of Brazil’s level and in line with the poorest African countries.  Uruguay, Trinidad and Tobago and Malaysia also appear with more moderate gains, just above 10%. (Note: the data is in current dollars, so currency movements impact the data)

 

The Biggest Gainers, 50 years

The vast majority of countries of interest to emerging market investors made very moderate gains over this period, in essence proving unable to make progress in bridging the gap with the U.S. The chart below shows those countries that have achieved between zero and ten percent gains in relative GDP/capita compared to the U.S. over the 50-year period. This includes the middle-income countries of Latin America, Turkey and Thailand, examples of economies that have fallen into the “middle income trap.” India, the Philippines and Nigeria are examples of lower income countries that have also made very little progress in bridging the income gap, despite enormous potential for productivity improvements.

The Stagnant Countries, 50 years

Perplexingly, it is the poorer countries that make the least progress, including many very low-income countries of Africa.  But this list of serious under-achievers also includes South Africa, Argentina, Zimbabwe and Venezuela, countries that are moving from middle-income status downwards.

 

The Losing Countries, 50 years

Taking a look over shorter periods, we can see some interesting trends developing. 30 Years coincides with the beginning of modernization reforms in China (1980) and in India  (1991),  the fall of the Berlin Wall (1989) and accelerated European integration. The chart below shows the past 30 years, including 123 countries.  Of note is the rise of Ireland (“the Celtic Tiger”), New Zealand , Australia and Israel, and the generalized strength of a European region benefitting from economic integration which drive improvements in incomes in Spain, Portugal and Turkey.  The absence of emerging market countries, except for the Asian Tigers and China, is striking, though the good performance of Uruguay (the “Switzerland of Latin America”) and reform-minded Chile are significant exceptions.

The Winners over the past 30 years

Looking at the past 15 years, we see very interesting new trends. The World Bank has new increased their data set to 164 countries over this period, adding Russia and its former Iron Curtain comrades, among others.  The chart below shows these very interesting developments, with, for the first time, as slew of emerging markets appearing.  Of the 27 names on the chart, ten, including China, are former communist, centrally-planned economies, that have undergone profound economic reforms.

The Winners over the past 15 years

 

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India Watch:

China Watch:

China Technology Watch:

  • Chinese Surveillance camera’s are found on U.S. army bases (WSj)
  • Hisense buys Toshiba’s TV business (Caixing)
  • VW to invest $12 billion in EV in China ( WSJ)
  • Google tries to enter China again with AI Bloomberg)

EM Investor Watch:

 

Technology Watch:

  • The road to cheap ubiquitous energy (The Economist)
  • The power plant of the future is your home  (WEF)
  • The Future of the car, Bob Lutz (Auto News)

Commodity Watch:

  • There is more farmland then previously thought (Bloomberg)
  • Australia’s economy is a house of cards (Linkedin)

Investor Watch:

  • ETFs are no bonanza for Wall Street (WSJ)
  • Jeremy Grantham, why this time is different (WSJ)

 

 

 

 

 

 

 

Putin’s Embrace of “One Belt, One Road”

The national identity of Russia is intrinsically tied to the mastery  of the Eurasian steppes, the grassland plains that  stretch from Hungary to Northern China. The territorial expansion of Moscow, from the 16th century onward, required  wresting control of the steppes away from the Mongols and securing the fertile black earth plains of modern-day Ukraine and Central Russia. The eventual collapse of the Mongol empire in the 17th century allowed the extension of the Russian empire to the pacific. Russian geo-political control over the steppes, Siberia and the Pacific coast has been largely uncontested for centuries.

However, the economic rise of China over the past decades and its increasingly outward-looking pretensions, as highlighted by President Xi Jinping’s ambitious “One Belt, One Road Initiative” (OBOR) changes everything for Russia.  While Russia has seen the steppes mainly for their value in securing geopolitical control of the Eurasian center, Xi envisions a return to the commercial dynamism of the historical Silk Road, which united the Far East with the Middle East and Europe for centuries, until the collapse of the Mongol empire. The Chinese have been aggressively executing Xi’s vision, building infrastructure to connect China with the West and becoming the largest investor in the natural resources of the former Soviet Republics.

Surprisingly, perhaps because of pragmatism and acceptance of Xi’s promise that the OBOR is aimed at benefiting all participants equally, so far there appears to be little resistance on the part of Russia to Xi’s grand and transformative plan. To the contrary, there has been a rapprochement between Putin and Xi, who have met on frequent occasions over the past several years. In a recent state visit to Moscow, Xi announced $10 billion in agreements for OBOR-related infrastructure investments and told the media that relations between the two countries were currently at their “best time in history” and that Russia and China were each other’s “most trustworthy strategic partners.”

Russia’s cuddling up with China is probably its best strategic option at this time. First, neither China nor Russia have to worry about business relations being undermined by volatile domestic politics or high-minded demands for human rights, and, in that sense, they see themselves as reliable partners. Second, both parties have an interest in weakening what they consider to be the arbitrary and hegemonic power of the United States. For example, both would like to see a weakening of dominance of the U.S. dollar and America’s discretionary control of the global financial system, so it is no surprise that Russia is accepting payment in yuan for commodities and that China is setting up a Petro-yuan-gold trading infrastructure in Shanghai and Hong Kong to facilitate non-dollar transactions.

Most importantly, however, is the fact that Asia will be the driving force of global growth and that its center of activity will be in China and its Far East neighbors. Driven by China, Asia’s share of world GDP will grow to 35% by 2022 (IMF forecast), and almost all of global growth in marginal output will come from Asia.  With its abundant energy, mineral and farm resources, Russia is best positioned to meet growing demand for natural resources in Asia.

A remarkable essay written by President Putin this week clearly states Russia’s current state of mind regarding Asia, and the seemingly total embrace of Xi’s OBOR vision. In a remarkable turn of events, Putin and Xi have become the defenders of open markets and predictable rules of commerce, in stark contrast to Donald Trumps “America First” ideology.

Putin writes: (excerpts, full note available here.)

“As a major Eurasian power with vast Far Eastern territories that boast significant potential, Russia has a stake in the successful future of the Asia-Pacific region, and in promoting sustainable and comprehensive growth throughout its territory. We believe that effective economic integration based on the principles of openness, mutual benefit and the universal rules of the World Trade Organization is the primary means of achieving this goal.

We support the idea of forming an Asia-Pacific free-trade area. We believe this is in our practical interest and represents an opportunity to strengthen our positions in the region’s rapidly growing markets. Indeed, over the past five years, the share of APEC economies in Russia’s foreign trade has increased from 23 percent to 31 percent, and from 17 percent to 24 percent in exports. We have no intention of stopping there…

On a related note, I would like to mention our idea to create the Greater Eurasian Partnership. We suggested forming it on the basis of the Eurasian Economic Union and China’s Belt and Road initiative. To reiterate, this is a flexible modern project open to other participants.

Comprehensive development of infrastructure, including transportation, telecommunications and energy, will serve as the basis for effective integration. Today, Russia is modernizing its sea and air ports in the Russian Far East, developing transcontinental rail routes, and building new gas and oil pipelines. We are committed to bilateral and multilateral infrastructure projects that will link our economies and markets — such as the Energy Super Ring that unites Russia, China, Japan and the Republic of Korea, and the Sakhalin-Hokkaido transport link.

We are particularly focused on integrating Russia’s Siberian and Far Eastern territories into this broader network. This includes a range of measures to enhance the investment appeal of our regions and to integrate Russian enterprises into international production chains.

For Russia, the development of our Far East is a national priority for the 21st century. We are talking about creating territories of advanced economic growth in that region, pursuing large-scale development of natural resources and supporting advanced high-tech industries, as well as investing in human capital, education and health care, and forming competitive research centers…

We intend to engage in substantive discussions on all these topics at the 25th APEC Economic Leaders’ Meeting this week. I am confident that, acting together, we will find solutions to the challenge of supporting the steady, balanced and harmonious growth of our shared region, and securing its prosperity. Russia is ready for such a collaborative effort.”

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China Watch:

China Technology Watch:

  • Google tries to enter China again with AI Bloomberg)
  • How China will rate its citizens with AI technology (Wired)
  • China’s focus on practical AI application (Arxiv.org)

EM Investor Watch:

Technology Watch:

  • The power plant of the future is your home  (WEF)
  • The Future of the car, Bob Lutz (Auto News)

Commodity Watch:

Investor Watch:

  • ETFs are no bonanza for Wall Street (WSJ)
  • Jeremy Grantham, why this time is different (WSJ)
  • Isaac Newton’s lesson on financial gravity (WSJ)
  • Caxton Partners on macro investing (Bruce Kovner)
  • The frustrating law of active management (Thinknewfound)
  • Fees on active share eat up returns (Thinknewfound)
  • What makes a great investor (Macro-ops)
  • Buffett and the power of compounding (Collaborative Fund)

 

 

 

 

 

 

 

 

 

 

 

 

India’s Star Rises in the World Bank’s Doing Business 2018 Survey

The World Bank has conducted its “Ease of Doing Business” survey for fifteen years, providing a comparative view of business regulation around the world over an extended period of time. The survey is aimed at providing a comparative basis to help policy makers address issues that impact entrepreneurial activity. The rankings resulting from the survey are an important indication of how business-friendly countries are and how successful they can be in attracting the entrepreneurial capital to succeed in an increasingly competitive global environment. The survey ranks 190 countries. The top thirty can be considered an elite in terms of providing a regulatory environment amenable to business. A top 50 ranking is good. A ranking above 100 indicates that a country’s business community is crippled by bureaucracy and rent-seeking agents. A poor ranking is particularly debilitating for a small country that does not have the market scale and diversity to attract capital that large countries like Brazil, China and India have.

There were several important revelations from the 2018 survey published this week.

  • India improved its ranking from 130th to 100th, which is a significant improvement. This confirms a recent trend and lends credence to the government’s very ambitious objective of improving the country’s ranking to 50 during the current Modi Administration.
  • India’s improvement highlights Brazil’s sorry performance. Brazil and India have long been competing for the position of lowest ranked of the major emerging market economies. Brazil fell two points in the latest ranking, to 125th and now has a secure hold on the bottom rung.
  • Indonesia, the third of the large emerging markets economies with consistently poor scores over the history of the survey, has been steadily improving its performance for the past six years, and reached 72nd in 2018, which compares to 129th in 2012.
  • Asia, by and large, provides good business regulation and is improving. In addition to India and Indonesia, Vietnam is showing steady improvements and now has a ranking of 68, compared to 99 in 2014. China also is gradually improving. Taiwan, Malaysia, Thailand and South Korea are all elite in terms of business regulation.
  • The Philippines provide somewhat of a glaring exception in Asia. Though the country has improved significantly from the very low ranking of 2011, it has significantly deteriorated over the past four years, and it obtained a ranking of 113th in the 2018 survey. Given how competitive the Asian region is and the improving trends, the Philippines appear to be at a growing disadvantage.
  • In Europe, the remarkable trend is the surge of Russia and much of Eastern Europe. At a 2018 ranking of 35th, Russia is approaching the “elite” countries in terms of the quality of business regulation. Russia has improved every year since 2012, when it ranked at 123rd. Poland’s ranking at 27th secures an “elite” standing. Moreover, the improvements in Eastern Europe are much more profound. Georgia, Macedonia, Estonia, Lithuania and Latvia all rank in the top twenty, ahead of most Western European countries, including Germany, and are well ahead of the Mediterranean countries, France, Spain, Italy, Greece and Turkey.
  • South Africa appears to be on a ruinous path. Its ranking has fallen steadily for nine years, taking the country from elite status to 82nd.
  • Latin America is also on a steady decline, losing competitiveness to the other regions of the world. Mexico is the only bright spot, just because it has maintained its decent ranking around the 50th level. Chile, Peru and Colombia have all seen consistent and worrisome declines in recent years. Argentina and Brazil are secure in their abysmal rankings, near the bottom for economies of this relative importance. Not to mention, Venezuela which is essentially closed for business. With a wave of business-friendly governments now rising to power in Latin America, it will be interesting to see if these negative trends can be reverted in upcoming surveys.

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China Watch:

China Technology Watch:

  • How China will rate its citizens with AI technology (Wired)
  • China’s focus on practical AI application (Arxiv.org)
  • China and Russia invest in face-recognition start-up (Bloomberg)
  • Automaker Changan to go 100% electric (Caixing)

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China’s Awakening is Shaking the World

In his address to the 19th Communist Party Congress this week, Chinese President Xi Jinping humbly downplayed China’s global standing and stated that much work is still needed to achieve the “China Dream of Rejuvenation”  and become  “a mighty force” that could lead the world on political, economic, military and environmental issues. Particularly noteworthy was Xi’s comment that China would not have a world-class military until 2050.

On many measures China clearly does trail the US by a large margin. For  example, in 2016 the per capita GDP of the United States was still over six times that of China.  Nevertheless, in a growing number of economic areas the weight of China is already the primary source of marginal demand and the major driver of performance. Moreover, Chinese influence on markets will be felt more and more over the next decade, as the world evolves towards multi-polarity and the center of gravity of the global economy shifts to East Asia. To paraphrase Napoleon, during this continued awakening, China will shake the world.

Though the U.S. GDP will remain larger than China’s until around 2027, China’s marginal contribution to global GDP is already higher than that of the U.S. According to IMF forecasts, China will add $7.15 billion trillion to global GDP by 2022 compare to $4.88 trillion for the U.S. From 2016 to 2022, China’s GDP  will go from 60% to 80% of the U.S. GDP.

In terms of GDP calculated on the basis of purchasing power parity, China’s economy is already 14% larger than America’s and will be nearly 50% larger by 2022.

Over the past fifteen years, Chinese infrastructure and real estate investments already shook the commodity world, driving a frenzy in the markets for copper, iron ore and other materials.  Astonishingly, China consumed 50% more cement over three years (2011-2013) than the U.S. consumed in the entire 20th century.

As the Chinese middle class has grown, China also became the primary driver of soft commodity markets. For example, for the past ten years China has provided essentially all the growth in demand for market pulp used for consumer goods like tissue paper.

China  is also becoming the driving force in many consumer industries. China’s cinema box office is expected to pass the United States this year; and, increasingly, the success of Hollywood blockbusters depend on the response of the Chinese public. China’s cinema ticket sales are expected to grow 5-6% annually while ticket volumes  in the U.S. decline by 1-2% a year. China now has more movie theatres than the U.S. (stuck at 40,000 since 2013) and is adding 7,500 annually. IMAX has 750 screens in China, twice as many as in the United States.

More and more, the success of global brands will rely on sales in China. On this week’s quarterly results call with investors, NIKE’s CEO Mark Parker noted that “the target population of China for NIKE is really moving towards ten times what it is in the United States, and the appetite for  Nike in China as the number one brand is incredibly strong.”

The focus of the global auto industry has also shifted to China for both traditional and electric vehicles. Auto vehicle unit sales in China surpassed those of the United States in 2010. Expectations are for volumes in China to reach 28 million units in 2017, vs less than 18 million in the U.S. Unit sales in mature markets (the U.S., Japan and Western Europe) are at the same level as over a decade ago and are expected to experience no growth over the next five years. Meanwhile, auto sales in China are growing steadily and may reach double the level of U.S. volumes by 2023.

 

The situation is similar for electric vehicles, which are being heavily promoted in China by government policy.  EV sales in 2016 in China were double the level of those in the U.S, and they are expected to ramp up in coming years.

Finally, according to government statistics, China is estimated to have 750 million internet users, compared to 300 million in the United States. Growing access to smartphones has resulted in a boom in mobile e-commerce, so that mobile e-commerce in China now dwarfs that in the U.S. The growth in internet mobility in China, places China at the forefront of many new data-driven technologies such as the “internet-of-things,” e-commerce, artificial intelligence, robotics and self-driving vehicles.

Fed Watch:

India Watch:

China Watch:

  • Xi’s glittering solutions for China (Geopolitical Futures)
  • Xi’s plan for state-sponsored quality growth (Bloomberg)
  • Xi’s bureaucratic shake-up (CSIS)
  • Xi’s conservative, greener speech (CSIS)
  • Five things to know on Xi’s speech (The Guardian)
  • Spence on China’s challenge (Project Syndicate)
  • Asia now has more billionaires than the U.S. (Caixing)
  • The internationalization of China’s capital markets (Bloomberg)
  • Why the renminbi won’t rule (Project Syndicate)
  • China’s influence on global markets grows (Bloomberg
  • China’s economy is already the biggest and growing fast (Bloomberg)

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Technology Watch:

Commodity Watch:

 

Energy Disruption Will Benefit Emerging Markets

The ongoing technological disruption of the energy sector is a net positive for emerging markets. The economic importance and market weight of those countries negatively affected by low oil prices (Russia, Mexico, Indonesia, Venezuela) is dwarfed by those that stand to benefit (India, China, Turkey). The rapidly declining cost of wind and solar power as well as the batteries needed to store it will provide huge opportunities for many emerging markets to improve their balance of payments, optimize electric grid efficiency and also make it easier to provide cheap power for hundreds of millions of poor people living in remote areas.

The latest report from the International Energy Agency  (IEA)  makes it clear that we have entered the age of renewable power. According to the IEA, in 2016 two thirds of new net power capacity added around the world came from renewable sources of energy.  In 2016, record-low auction prices were recorded for solar in India, the Middle East, Chile and Mexico, with prices reaching below USD 3 cents per KW. The IEA sees another 920 GW of renewable capacity added by 2022, with solar for the first time contributing more than hydro and wind. The main drivers of future growth continue to be technology-induced cost reductions and China’s policy initiatives, but India has also become a primary source of growth. India is expected to add more capacity than Europe and is on track to pass the United States as the second largest contributor to growth in capacity.

By 2021, according to forecasts from Bloomberg New Energy Finance, wind and solar will have become cheaper than coal in both China and India, two countries that have an enormous incentive to reduce coal combustion to address horrific air pollution problems. As the cost of renewables continues to decline over the next two decades coal power will become increasingly uneconomical.

The growth of solar will accelerate even more if battery costs continue to decline as they have over the past decade. Tony Seba, an expert on energy disruption who teaches at Stanford University, believes that an enormous wave of mega-investments in battery plants currently being made by Samsung SDI, LG Chem, BYD, Tesla, Foxconn and others, will drive down battery costs by over 20% annually for the next five years, to below $100/KW by 2022-23. At this price point, disruption will accelerate and battery storage will become prevalent across all points of the electricity grid (from the plant to the home). Seba believes cheap battery capacity will mean that the electricity grids in most countries will have to convert from the current “just-in-time” framework to one based “on demand,” which will eliminate the need for very expensive “peak” capacity. The average American home will spend less than a dollar a day to store energy for use in peak hours, resulting in much lower electricity bills.

Chile provides a prime example of the transformational impact renewables are having have on a developing economy. Chile has been dubbed “the solar Saudi Arabia,” because of the extraordinary potential for generating solar power in the Atacama Desert situated in the north of the country. Because of ideal direct normal sun irradiation and the dryness of the air, the Atacama is considered the best place on the planet to generate solar energy.

With scarce hydrocarbon resources, Chile has always depended on imports for most of its energy needs, and has suffered acutely from surges in oil prices. As recently as 2007, the country went through a severe crisis when Argentina reneged on contracts to pipe natural gas across the Andes, which forced massive investments in costly emergency diesel generators and LNG plants.

Compounding Chile ‘s energy woes, in recent years it has become increasingly difficult and time-consuming to build hydroelectric dams or coal-fired plants, as these face opposition from local communities and environmentalists.  However, the Atacama now promises a future of abundant and cheap energy.

In contrast to the difficulties faced in building “dirty” capacity, in the uninhabited Atacama desert environmentally-friendly  solar investments can be brought to market in less than a year, and recent advances in technology have made these projects very attractive to private investors.

Benefitting from clear regulation and investment rules, solar production has taken off over the past four years, putting Chile near the top in global tables. Solar producers have come to dominate public auctions,  offering to supply electricity at less than half the cost of coal-fired plants. In recent auctions in Chile, concentrated solar power (CSP) plants also have underbid gas plants. CSP technology combines solar generation with giant molten salt battery towers, allowing the plant to dispatch during the night. In Chile’s last auction for power, Solar Reserve, a U.S. firm,  bid a world-record-breaking low price at just 6.3 cents per kWh ($63/MWh) for dispatchable 24-hour solar.

The speed with which Chile has developed its solar potential is reflected in the generation of over 850 MW from solar panels in 2015, up from 11 MW in 2013. Current investments will bring installed capacity to 1,800 MW.

Solar also improves the potential optimization of the national electricity grid, as solar can be maximized during the day, allowing water accumulation at the hydroelectric dams in the Andes. As the cost of storage batteries decrease in coming years, it will make more and more sense to maximize production in the Atacama.

India is another country that stands to be a major beneficiary of disruptive energy technologies. First, India is a large importer of oil, which makes the economy vulnerable to surges in prices; second, it generates most of its electricity with dirty coal, which contributes greatly to horrendous pollution; and third, solar panels combined with batteries will provide the most cost-effective way to provide power to the nearly 250 million Indians, mainly in remote areas, that do not have access to power.

Prime minister Modi has announced bold plans to promote solar energy. The government aims to add 175 GW of renewable power by 2022, of which 100 GW would come from solar. As the cost of solar goes below coal generation over the next five years and battery storage becomes cheap, India’s is likely to rely on clean solar power for more and more of its needs.

Fed Watch:

India Watch:

  • India on the wings of digitization (Wisdom Tree)
  • India’s electrical vehicle dreams (CSIS)

China Watch:

  • The internationalization of China’s capital markets (Bloomberg)
  • Xi’s conservative, greener speech (CSIS)
  • China’s influence on global markets grows (Bloomberg
  • China’s economy is already the biggest and growing fast (Bloomberg)
  • Riding China’s huge high-flying car market (Mckinsey)
  • China, a strategy born of weakness (Geopolitical Futures)
  • 7 things we learned from China in September (WEF)
  • Buffett’s bet on BYD is working (QZ)
  • Meet China’s evolving car buyer (McKinsey)

China Technology Watch:

EM Investor Watch:

  • Five books on globalization and inequality (Five Books)
  • Investment anomalies (Wisdom Tree)
  • Anchoring Value Investing in EM (Eastspring)
  • EM Index without SOEs (Wisdom Tree)
  • Asia leading in (KKR)
  • Latin America’s slow recovery is on track (IMF)
  • Amazon expands in Brazil (Bloomberg)
  • Increasing pressure on Venezuela’s dictatorship (CSISAsia leads global recovery (IMF)
  • EM; doom to boom (Seeking Alpha)
  • Why you should care about Brazil’s stock market (Seeking Alpha)
  • Gazprom knocks Exxon off its pedestal (Forbes)

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Commodity Watch:

Investor Watch:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Energy Market Disruption and Global Multi-polarity

 

Around the world, energy markets are being disrupted by a combination of technology and geopolitics. On the one hand, technology is having a huge impact on supply, with shale production exploding in the United States and alternative energies (solar and wind) becoming increasingly competitive everywhere. On the other hand, growing energy self-sufficiency in the U.S. is occurring at a time when demand for oil imports is still growing quickly in emerging markets, particularly in China. As the major importer of oil in the world, China’s future economic stability will depend on secure supplies, which is forcing it to become much more pro-active in global diplomacy. China also will become uncomfortable paying for oil imports in U.S. dollars, as has been the global custom for the past 50 years. China will increasingly insist on being paid in Chinese yuan, a trend that will slowly undermine the “petrodollar system” and U.S. financial hegemony.

Over the past decade, technological innovation has permitted the exploitation of enormous U.S. shale oil and gas deposits, leading to a renaissance for the American oil industry. This, jointly with growing output of renewable energy and higher fuel efficiency, is driving the U.S. towards energy self-sufficiency. BP in its BP 2017 Energy Outlook estimates this will happen in 2023.  U.S. net imports of oil have already fallen from 13 million b/d in 2007 to 3.7 million today.

The decline in U.S. oil imports will have important consequences for global financial markets, because the U.S. pays for imported oil in dollars and the trade receipts accumulate in the world’s Central Banks and sovereign funds and is redistributed into T-bills, bank loans and other investments. Since the 1970s the global economy has been frequently buffeted by violent changes in the price of oil, leading each time to financial instability and a sharp redistribution of wealth between exporters and importers.

U.S. oil production peaked in 1970 at 10 million barrels per day and then began a precipitous decline, reaching a low of 5 million b/d in 2008. The decline in U.S. production, coming at a time of steady increases in global demand, strengthened the hand of OPEC and led to price surges in 1974 and 1980, causing stagflation in the U.S. and eventually the emerging market debt crisis of 1981. The rise of Chinese demand during the past decade created another huge surge in oil prices, with a peak in 2008 and a rebound in 2011, with enormous consequences on global liquidity and financial markets.

Oil imports have been the primary component of chronic U.S. current account deficits, representing 40.5% of cumulative deficits between 2000 and 2012, and 55% in 2012 alone. In the early 1970’s, as the major importer of oil and the global hegemon, the United States was able to convince the Saudis to price their oil in dollars, which they have done along with other OPEC members since the early 1970s. This created the “petrodollar system” as a partial substitute for the gold standard abandoned by President Nixon in 1971, guaranteeing that the dollar would remain dominant in global trade and finance.

 

However, the conditions that led to the replacement of the gold standard by the petrodollar system no longer exist in 2017. The U.S. is approaching energy self-sufficiency, while China is now the dominant oil importer in the world, with demand for imports expected to reach nearly 10 million b/d in 2018.

This is happening at a time when U.S. hegemony is on the decline, and the world is seeing multi-polar leadership, with growing Chinese and European importance.

One of the Chinese government’s expressed objectives is to increase the international influence of the yuan. In a direct challenge to American economic hegemony, China has already started using oil imports to propagate the yuan. Breaking ranks with OPEC, Nigeria in 2011 and Iran in 2012,  both started accepting yuan for oil and gas payments and accumulating yuan Central Bank reserves. Russia did the same in 2015. For both Russia and Iran, the yuan payments allow them to skirt U.S. sanctions, and for Russia this also achieves the objective of undermining U.S. dollar hegemony. Moreover, last month, Venezuela, which owes China $60 billion, announced it will price its oil in yuan.

Also, in September the Nikkei Asian Review reported that China is on the verge of launching a crude oil futures contract denominated in yuan and linked to gold. This contract would be settled in Hong Kong and Shanghai and allow Asian importers to bypass USD denominated benchmarks and could greatly strengthen the financial infrastructure necessary to promote the yuan in Asian trade.

In another interesting development, China appears to be intent on solidifying diplomatic ties with Saudi Arabia. This is of critical importance, given the crucial role the Saudi’s have in maintaining the petrodollar system. As reported by Bloomberg,  the Saudi’s are looking to tighten energy ties with China by investing $2 billion in Chinese refinery assets in exchange for China taking a major stake in the upcoming ARAMCO IPO.

All of this oil diplomacy, comes at a time when China is already achieving success in expanding the role of the yuan in global financial markets. One years ago, the International Monetary Fund agreed to a long-standing Chinese request to give the yuan official Special Drawing Rights status, joining the U.S. dollar, euro, yen, and British pound in the SDR basket. China has also successfully lobbied the MSCI to increase the weighting of Chinese stocks in its Emerging Market Index by including locally traded “A” shares, a first step towards a major integration of China’s financial market into global financial markets which will further the propagation of yuan assets in global portfolios.

Fed Watch:

  • Rajan’s view on unconventional monetary policy (Chicago Booth)
  • Low returns expected long term for U.S. stocks (Macrovoices)

India Watch:

  • Tencent wants its share in India (Caixing)
  • India’s electrical vehicle dreams (CSIS)

China Watch:

  • 7 things we learned from China in September (WEF)
  • Buffett’s bet on BYD is working (QZ)
  • Meet China’s evolving car buyer (McKinsey)

China Technology Watch:

  • China’s airplane delivery drones (China Daily)
  • China, from imitator to innovator (Forbes)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

Technology Watch:

  • Adidas robots (Wired)
  • Acemoglu on robots (AEI)
  • Germany has more robots and stable jobs (VOX EU

Commodity Watch:

Investor Watch:

 

 

 

 

 

 

 

 

Global Competitiveness In Emerging Markets

The Global Competitiveness Index (GCI) ranks countries according to how hospitable they are to promoting economic growth and prosperity. The rankings have been published by the World Economic Forum since 2004, allowing for a measure of how countries are progressing in terms of their relative competitiveness in the global economy.

The GCI seeks to evaluate 12 different factors in three main areas: the quality of physical infrastructure and institutions; the ease of doing business (macro-economic stability, and open and flexible markets for goods, labor and capital); and the quality of education and ability to innovate.

The GCI 2017 report (WEF) and an analysis of the trends of the past five years provide some interesting insights on prospects for different emerging market countries. The chart below shows the 2017 rankings for most of the significant emerging market countries and the evolution over the past five years.

  • Several important countries are secure in the top quartile segment of the ranking. Taiwan, Malaysia and South Korea all have reached elite status and are stable.
  • China continues to gradually improve its ranking, from 29 in 2013 to 27 in 2017, and is likely to secure its place in the top quartile. China has followed in the path of its East-Asian neighbors, making this region one of the most competitive in the world and increasingly the center of gravity of the global economy. China’s continuous positive evolution is driven by improvements in education and innovation, which is in line with the country’s strategy to move up the industrial value chain.
  • Both Thailand and Indonesia have shown impressive progress over the past five years, moving into the top quartile.
  • India, on the back of Prime Minister Marendra Modi’s reforms, has improved its ranking dramatically, from 59 to 40. The areas of greatest improvement have been confidence in public institutions, infrastructure and macroeconomic stability.
  • In the EMEA region (Europe, Middle East and Africa), Russia is a surprising positive highlight. Russia has moved from 67 to 38 over five years, approaching the top quartile, as President Putin’s “order and progress” regime has gained traction, reflected in improved infrastructure and public services. On the other hand, South Africa has taken a spill, moving from 52 to 61, as declining public services and corruption have impacted business confidence. Turkey has also suffered an alarming decline, from 43 to 53, the result of political instability and a growing estrangement from Europe.
  • Latin America can be singled out for its relative decline, particularly compared to comparable middle-income economies in Asia and Eastern Europe. Though Chile has secured its ranking as a top quartile “elite” economy,” Brazil has had the worst collapse of any country, moving from 48 to 80. The rest of the region is stable in its mediocrity, with Argentina the worst and Mexico the least bad. Peru has seen a concerning decline from a ranking of 61 to 72. The region of late has been severely impacted by recession and corruption scandals, resulting in declining public trust in institutions and low business confidence.

India Watch:

  • India’s electrical vehicle dreams (CSIS)
  • India’s Industrial policy (Live Mint)
  • India’s imminent economic crisis (Live Mint)

China Watch:

  • Buffett’s bet on BYD is working (QZ)
  • Meet China’s evolving car buyer (McKinsey)
  • Beijing praises patriotic entrepreneurs (SCMP)
  • Reconnecting Asia (CSIS)

China Technology Watch:

  • FT has lunch with JD.com’s Liu Qiangdong (FT)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

  • Gazprom knocks Exxon off its pedestal Forbes

Technology Watch:

Investor Watch:

Ray Dalio on market valuation:

Do you see a disconnect between the U.S. stock markets being at an all-time high, while at the same time the economy continues to grow slowly?

No, I don’t. Markets, in general, are driven by the interest rate. As interest rates go down, as they have, that’s helped. Second, the purchases of financial assets by central banks have pushed asset prices up. Third, the expected returns of bonds and equities going forward are at relatively normal premiums to the existing short-term interest rate.

What are the implications of all that?

People buy profits, not the economy. So if the corporate tax rate is cut, a company is worth more even though the economy might or might not pick up on that. If regulation is reduced, that stimulates business. It might have other consequences, but it causes profits to rise.

Any other critical reason for what’s happening in the economy and market?

Technology, which is improving profitability, is also worsening [employment]. That worsens the economy because technology is replacing people [in jobs]. Improving profitability [through technology] is good for companies but not good for the economy as a whole because the people losing jobs are also the people who are more inclined to spend income. I call that group the lower 60%. So technology helps profits but hurts employment and helps to cause a slower economy at the same time it has caused companies to be worth more.

Has the U.S. ever been in a situation like that before?

We had a similar one between 1935 and 1940. I would say that 1937 [during the Great Depression, two years before the start of World War II] is most like the year today. We had the same sort of debt crisis; interest rates went to zero and the central banks printed a lot of money and bought financial assets, which went up in price. We had the same sort of wealth gap and the same sort of populism around the world.

So is there a lesson from 1937?

It’s very important that the Federal Reserve be very cautious and slow to tighten monetary and fiscal policy because we have asymmetrical risks: many more risks on the downside than on the upside. And be cautious about how political and social conflict is handled. Can we work together, or are we going to be split? Even though the stock market is at its peak and the unemployment rate is at a low, for the bottom 60% it’s a bad economy. We must not have an economic downturn.

What’s your take on the long-running debate about active vs. passive management and the move toward ETFs and other passive investments?

The question is: How much alpha can I buy by going to [a manager]? That alpha game is a zero-sum game. So don’t expect, on average, to get alpha because when somebody buys, somebody else has to sell. It’s like at a poker table: somebody will take money from somebody else — and there will be better players. There will always be smart people who will be able to make better decisions and pursue alpha. The challenge is to find them because those who are good at it are largely closed to new investors.

Business Corruption in Emerging Markets

It is obvious to the casual observer that many successful entrepreneurs in the United States and Europe are immigrants from countries known for their corrupt business practices. Turks in Germany, Indians and Nigerians in England and Mexicans and Brazilians in the U.S., to name a few examples, make enormous contributions to the entrepreneurial dynamism of their adopted countries while upholding the highest business ethics.

Why do immigrants change their behavior when they leave their home country? A Nigerian or Indian businessman in his home country might dedicate a significant part of his time and resources to corrupt practices but when in England apply all his efforts to making his business more innovative and efficient. The very recent case of the Batista brothers in Brazil highlights this phenomenon. Joesley and Wesley Batista, over a period of 15 years, grew their company, JBS, from a small regional meat-packing business in Brazil into the largest meat-processing firm in the world, with dominant operations in Brazil, the U.S., Europe and Australia. There is no doubt that the Batista brothers were very astute and visionary businessman, and they ran their operations very efficiently and professionally. However, it has been revealed in recent months that one of the brothers, Joesley, dedicated essentially all of his time to greasing the hands of politicians in Brazil to secure cheap financing from public banks and other favors.  While Joesley acted with total impunity in Brazil and is reported to have paid more than $150 million in bribes to over 1,800 politicians, there is no evidence of any illegal acts by the Batista’s or their employees outside of Brazil where by all accounts they acted as upright corporate citizens.

The case of the Batista brothers illustrates perfectly a theory proposed by the American economist William Baumol. In a seminal 1990 paper, “Entrepreneurship; Productive, Unproductive and Destructive behavior,” Baumol argued that though some societies or cultures may have more entrepreneurial dynamism than others what matters more is how that entrepreneurial spirit is allocated. Business people can apply their entrepreneurial spirit towards productive activities such as innovation or to non-productive activities such as rent-seeking, or, in a worse-case scenario, to destructive activities such as organized crime.  According to Baumol, the actual supply of entrepreneurship does not vary as much as its allocation to productive or non-productive activities. Entrepreneurs react rationally to the different payoffs society offers and will dedicate themselves to non-productive activities if that is where they find the highest returns. As the theory predicts, when in Brazil the Batista’s applied themselves assiduously to rent-seeking behavior because payoffs were high, but outside of Brazil they stuck to a strict legal path and focused on management and innovation.

The case of the Batista’s is not at all unique. Brazilian’s have long quipped that “businessmen work when the government goes to sleep at night.” The CEOs and CFOs of Brazil’s leading companies, even when they espouse the highest ethical standards, are required to spend an inordinate amount of time courting politicians and are expected to travel frequently to Brasilia at a moment’s notice.

Baumal’s theory links well with the argument of the “institutionalists” like Daron Acemoglu (Why Nations Fail) who argue that strong institutions (e.g., the judiciary) underpin development.  Clearly, an efficient bureaucracy and effective judiciary would reduce the opportunities and greatly increase the cost of corruption in Brazil and motivate entrepreneurs to direct their energies to legal activities.

In any case, the implications for policy makers are clear. Countries like Brazil, Argentina, India and Nigeria have huge repressed entrepreneurial spirit that could be unleashed if the business environment was less conducive to corruption.  Reducing bureaucracy, regulations and taxes should be at the top of the list. It is not a coincidence that the countries that rank poorly in the World Bank’s Ease of Doing Business survey tend to be the same where corruption is most prevalent. Straight-forward bureaucratic reforms can make a large difference. For example, in many countries, something very basic like opening or closing a business can require large expenses and months of time, pushing small businesses to take the path of informality. Privatizing state-owned firms also must be pursued, as time and time again we see these entities at the center of political influence-peddling and rent-seeking behavior.

As Baumal concludes, “the overall moral, then, is that we do not have to wait patiently for slow cultural change in order to find measures to redirect the flow of entrepreneurial activity toward more productive goals… It may be possible to change the rules in ways that help to offset undesired institutional influences or that supplement other influences that are taken to work in beneficial directions.”

 

India Watch:

China Watch:

  • Meet China’s evolving car buyer (McKinsey)
  • Beijing praises patriotic entrepreneurs (SCMP)
  • Reconnecting Asia (CSIS)

China Technology Watch:

  • FT has lunch with JD.com’s Liu Qiangdong (FT)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

  • The collapse of Venezuela (Vox)
  • Chile’s energy transformation (NYT)
  • Reconnecting Asia (CSIS)
  • Sam Zell is back in Brazil (CFA Institute)
  • Corruption in Latin America (IMF)

Technology Watch:

Investor Watch:

Notable Quotes:

Opportunity for Growth and Scale in Emerging Markets: In the 1990s, Zell and his team were intrigued by the opportunities in emerging market real estate platforms and other types of emerging market companies and started investing. Even though the potential for strong returns was much higher, Zell’s team wasn’t deluded about the trade-offs. “Investing in emerging markets is a bet on growth,” he said. “But what’s being given up is the rule of law.” That compromise is one he never takes lightly.  Sam Zell (CFA Institute)

Before I begin telling you what I think, I want to establish that I’m a “dumb shit” who doesn’t know much relative to what I need to know. Whatever success I’ve had in life has had more to do with my knowing how to deal with my not knowing than anything I know. The most important thing I learned is an approach to life based on principles that helps me find out what’s true and what to do about it.  Ray Dalio, Bridgewater

 

 

Caution Is Merited For India’s Stock Market

The stock market of India today is probably the most hyped and loved by emerging markets investors. Investor enthusiasm is rooted in the assumption that the country’s high growth rate can be sustained by structural reforms aimed at boosting productivity and modernizing the economy.

As a low-income economy, India has considerable potential for boosting economic growth simply by narrowing the productivity gap that it has with more developed economies. Though India has many world class companies in sectors such as information technology, pharma, manufacturing and banking, much of the economy, particularly small-scale informal manufacturing and farming, suffers from abysmal levels of productivity. Stifling bureaucracy and corruption make operating a business very difficult in India and promote informality. India ranks 130th in The World Bank’s 2017 Ease of Doing Business survey, the worst of any large economy.

Since market-oriented reforms were first introduced in 1991, India has entered into an accelerated catch-up phase, enjoying GDP growth of 6-7%.  For the 2014-2018 period, GDP growth will average about 7% annually, making India the fastest growing large economy in the world. Moreover, in recent years India’s trade accounts and inflation have benefitted from low commodity prices.

In principle, higher GDP growth should justify higher stock market valuations. In many countries, there is a well-established and logical correlation between GDP growth and corporate earnings growth. A generally optimistic view of the potential for long-term growth in earnings has resulted in high multiples for Indian stocks. Moreover, the relatively high valuations in India may be validated by the corporate structure of the Indian market which is dominated by well-managed and profitable private companies operating in industries with stable growth characteristics, in contrast to the much higher concentration of cyclical businesses and mismanaged state-owned firms in the stock markets of Russia, China and Brazil.  We can see this in the chart below, which shows cyclically adjusted, 10-year average price earnings ratios (CAPE) for major emerging markets. India has traded at the highest PE multiples for this group of countries for the past 15 years, as the market has priced in high expected earnings growth and low expectations for future volatility. The market sees India as a “high quality” stock market, with high earnings and low volatility, in contrast to markets like Turkey, Brazil or Russia which are seen as low-growth and high volatility. The only other market currently held in such high esteem by investors is the Philippines.

However, investor enthusiasm for India’s stock market may be misplaced.

India, with its bouts of uncontrolled inflation, high fiscal deficits and elevated public debt levels, recurring balance of payments crises, currency volatility, extreme inequality,  complex democratic politics, and highly inefficient and corrupt bureaucracy, resembles Latin America more than it does East Asia. East Asia has benefited from strong commitments to competitive currencies, a financial system geared to support manufacturing, trade and small-scale farming, and widespread education, none of which are the reality in India or Latin America. Consequently, though India’s GDP growth may be relatively high, it is likely to be volatile, leading to choppy earnings growth for its listed companies.

Furthermore, high GDP growth may be more a curse than a blessing for many of India’s blue chips as it promotes more competition. In recent years, India is seeing many new entrants in sectors like consumer goods and banking. IT powerhouses like TCS and Infosys are threatened by disruption from cloud-based providers. India’s high growth and looser regulations are bringing more foreign competition in many industries (e.g., motor vehicles), potentially disrupting powerful incumbents over time.

In general, stock markets that are very popular with investors because of attractive growth prospects do not tend to perform well in the future. Nevertheless, though expensive relative to other emerging markets, the Indian stock market may continue to do well. It trades today at a CAPE valuation which is below its long-term average and about in the middle of its long-term range, which does not seem prohibitive at a time of very high asset prices around the world.

Still, from a relative performance point of view, there is a high probability that over the next 3-5 years, India will not perform as well as cyclically depressed markets such as Turkey, Russia and Brazil.

One of the ironies of investing in emerging markets is that high GDP growth most often results in excess investment and low future returns. The best stock market returns are often found in depressed cyclical markets which have seen a period of low investment and where companies stand to benefit from operating leverage during powerful cyclical rebounds.

India Watch:

China Watch:

China Technology Watch:

  • FT has lunch with JD.com’s Liu Qiangdong (FT)
  • How Baidu will win the global AI race (Wired)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

Technology Watch:

Investor Watch:

 

 

 

 

 

 

Venezuela’s Tragic Collapse

 

Venezuela’s catastrophic social and economic collapse, the result of two decades of authoritarian populism, shows the precariousness of development for countries with weak institutions. Similar forces in recent times have brought misery to Zimbabwe and threaten both South Africa and Brazil.

Once Latin America’s richest nation, a thriving middle-income democracy which attracted immigrants and capital investments from around the world, Venezuela fell prey to Hugo Chavez, a charismatic “caudillo,” who promised a “Bolivarian Revolution” to bring social justice and prosperity for all.

Chavez cleverly exploited a serious economic downturn in 1998 in Venezuela caused by a collapse in oil prices, and he also tapped into popular disenchantment with a democratic regime marred by corruption, mismanagement and by a failure to renew its leadership. At year-end 1998, Chavez was elected president on a populist, anti-establishment, “drain-the-swamp” platform.

Chavez faced severe opposition in his early years. His efforts to concentrate power in the presidency and weaken the judiciary were rebuked by an anxious middle class, the media and the business community, and he was almost ousted by a military revolt in 2002.

But then, the winds of fortune changed for Chavez. Just as he was doubling down on his Bolivarian Revolution by purging the military and the national oil company PDVSA of “anti-revolutionaries” and accelerating the nationalization of industry and the socialization of farming, oil prices began to rise because of the China-fueled global commodity boom (2003-2012). At the same time, the global capital markets opened for Venezuela, and the country began a massive credit-binge. Accompanied by price controls, all of this created an enormous temporary illusion of prosperity.

Though the George W. Bush Administration initially took a strong stand against Chavez, once Chavez was able to use the oil bonanza and foreign credit to fund social programs the apologists for the regime started to dominate the discourse. Perhaps swayed by a parade of intellectuals and Hollywood figures who fell for the Chavez charisma and sang the praises of his Cuban-designed social programs, the Obama Administration sought to normalize relations with Venezuela. President Obama also heaped praise on Brazil’s President Lula (“That’s my man right here… Love this guy. He’s the most popular politician on earth.”) whose popularity also increased in line with commodity-boom-fueled economic growth and ample global liquidity. Eminent economists like Joseph Stiglitz, Noam Chomsky and Paul Krugman and institutions like the World Bank also fell in line and lauded Lula and Chavez for improving wealth distribution and giving the poor access to public services. Hollywood director Oliver Stone released a fawning documentary on Chavez in 2009 (South of the Border) acclaiming “a triumph for Venezuelan democracy” and an “alternative to capitalism.”

Washington abdicated its traditional strong influence on Venezuelan affairs in deference to South American sensibilities on non-intervention and in response to a vigorous defense of the Chavez regime led by the leftist governments of Brazil and Argentina. A policy of appeasement was taken as Venezuela pursued its course towards dictatorship and economic collapse.

The plummeting of oil prices in 2014 brought Venezuela’s dream of an alternative capitalism to a brutal end. Chavez had the good luck of dying just before the global capital markets shut down for Venezuela (2013) and oil prices collapsed (2014). He left the country and his successor, Nicolas Maduro, with gargantuan deficits and rampant inflation. Over the past three years, Venezuela has suffered what is perhaps the worst economic collapse of any country in modern history. Harvard Professor Ricardo Haussmann, a Venezuelan who served as planning minister in 1992-93, has documented the extent of the collapse (Venezuelan Tragedy, FT AlphaChat):

  • Output from the productive sector of the economy has fallen by 55% since 2013.
  • The median household wage at the black-market rate is $20/month, and buys 7,000 calories/day compared to 55,000 in 2012.
  • Collapse in public services and health standards are “beyond belief,” and Caracas is the murder capital of the world.
  • Assets of the financial system have fallen by over 90% since 2012 and the banking system has essentially ceased to exist.
  • Public external debt rose from $24 billion in 2004 to $178 billion today, of which $56 billion is owed to China. Haussmann questions the ethics of this lending which served only to prop-up the regime, and he is particularly critical of a recent $850 million “odious” transaction with Goldman Sachs carried out with an expected yield of over 50% annually.
  • To remain current on the servicing of the foreign debt the government has cut imports by over 80%.
  • The productive capacity of PDVSA has been compromised, with oil output falling from 3.7 million barrels/day in 1998 to 2 million today. PDVSA has become the funder and administrator of social programs and the primary locus of corruption.
  • Nationalized firms have been decimated. For example, the steel company, SIDOR, now produces 200,000 tons/year with 22,000 workers, compared to 4.5 million tons with 5,000 employees before.
  • The private sector has been destroyed by expropriations and price and currency controls.

The damage done is irreparable and Venezuela will take decades to recover. The country has become one of the most hostile places to run a business in the world, ranked 187th out of 190 countries in the World Bank’s Ease of Doing Business 2017 survey, surpassed only by Libya, Eritrea and Somalia. An enormous brain-drain of educated Venezuelans working in the oil sector and the private economy and the closure of thousands of businesses can only be reverted over time. Haussmann points to Albania, the former basket case of Eastern Europe that has started a recovery process over the past twenty years, as a source of hope.

Hopefully, the United States and the global community will orchestrate a massive humanitarian and financial effort to help Venezuela recover once the Bolivarian Revolution dies.

Why has Venezuela’s tragic collapse happened?  It took a coincidental combination of a charismatic demagogue and discredited institutions for the process to be triggered and a pliable and easily hijackable political system for it to flourish. Fortunately, in Brazil, at least for the time being, the judiciary, the press and the political establishment have been able to thwart Lula’s project.

Us Fed watch:

China Watch:

China Technology Watch:

  • How Baidu will win the global AI race (Wired)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

  • Russia is becoming a food superpower (Bloomberg)
  • Norway’s sovereign fund drops EM bonds (Bloomberg)
  • Emerging Markets look undervalued (Seeking Alpha)
  • No crisis in Venezuela (Al Jazeera)
  • How Western capital colonized Eastern Europe (Bloomberg)
  • From Soviets to oligarchs (NBR Working Papers)
  • Emerging Markets are turning the corner (Seeking Alpha)
  • Understanding the Russian mind-set (Spiegel)

Technology Watch:

  • Pandit says 30% of bank jobs will disappear in next 5 years (Bloomberg)
  • Nike’s Static-Electricity robots (Bloomberg)
  • Government Investment was key to US success (Teasri)

Investor Watch:

The EVP of Johnson and Johnson’s consumer products  did a great job of summarizing the immense challenges facing the industry and features heavily in this week’s post. He argues that historical barriers to entry are crumbling and that data is the new barrier to entry. It’s an interesting thesis, and only time will tell if it’s the right one, but it explains why companies are scrambling to use machine learning to make sense of the data that they have access to. One might wonder though, if old-line companies are leveraging tech companies’ cloud and engineers to unlock insights into their data, who’s data is it anyways? (Avondale)

Consumer:

The head of J&J’s consumer division laid out the problems facing consumer products companies:

Competitive advantages are being dismantled

“the reality is that the pace of change in our industry is truly accelerating…If you look at our last few decades in this industry, there were a series of barriers for entry or sources of competitive advantage that were well established but those are becoming less and less unique.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

It’s hard to have a monopoly on talent

“It used to be that companies like ours would acquire the best talent through our recruiting human resources mechanism, but it’s never been easier for you to source great talent across the world on demand.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

It’s never been easier to build a brand

“Our ability to build and nurture brands, brand building competencies used to be again a source of competitive advantage but the reality is it’s very easy for you to start building a business, building a brand from scratch and you really don’t need a ton of money to get a community of active users that support you.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

It’s not hard to access global manufacturing expertise

“Large scale manufacturing assets used also to be a source of competitive advantage. But the reality is if you want to compete in this industry, you can access high quality contract manufacturing work any place in the world.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

Retailer relationships are no longer a moat

“Retailer relationships used to be also a source of advantage and a barrier for entry, but as you all know, new companies can now sell directly to consumers profitably in most markets. And then financial firepower for companies like J&J is not as critical as it used to be because new startup entrants can access capital relatively easy through VCs.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

The disruption is digitally enabled

“So this disruption that is happening is digitally enabled and is changing the face of our industry. You see these new players coming into our category and at the heart of this disruption, there is a new consumer centric paradigm and that’s challenging completely the cost of goods scale and the value scale as we know it and its forcing a change in both the retail and the media landscape.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

Small companies are succeeding because they stay close to the consumer and have digital DNA

“small players are the ones that are gaining share and majority of large companies are losing market share…they are really committed to breakthrough innovation by staying really close to consumers and customers and staying on top of consumer trend. They see where the product is going and they are designing to what that emerging consumer need is. They are focused on building digital first brands that have a clear purpose and a reason for being that resonates with millennial consumers. They capitalize on the rise of emerging channels. They don’t just play in the legacy channels but they figure out what are the new shopping behaviors, new emerging channel trends and they disproportionately drive growth in those channels. They are hyper efficient. Normally have very lean cost structures, flat organizations, no bureaucracy and as a result they move very fast. Speed is a great currency for them.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

Big companies are becoming value added VCs

“the innovators are launching hundreds of new products every year. But once they’re successful, they all have the same kind of issues, issues like buying, procurement, like selling, distributing, manufacturing and capital. And so, we have a venture group that we started about ten years ago and, basically, it goes out to all the entrepreneurs and says, instead of going to private equity to get money, why don’t we work with you, we’ll invest in you and we’ll help you. And we’ll help you take your idea, solve some of the issues you might have, and we can see how you can be a part of what we’re doing and we can help you achieve your dreams as an entrepreneur…All of that allowing us to kind of source external innovation, so that when you take a healthy core, build strong, new businesses, and then bring all the next businesses in, it gives you a sustainable top line.” —Coca Cola EVP Sandy Douglas (Beverage)

Data is the new barrier to entry

“And what we’re seeing now is there is a new playbook emerging, a new how-to-win playbook that is really characterized by an asset light infrastructure. And the control of the consumer relationship, via the acquisition of the…data that allows for you to have a highly personalized iterative on demand consumer experience. And the ownership of this relationship with consumers and associated ecosystem that comes with it is now the new playbook. It is now the greatest new source of competitive advantage.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

The Rise of Robots in Emerging Markets

 

The relentless rise of robotics in manufacturing around the world that is expected for the next decade will affect the development of emerging market economies in different ways. The “East-Asian Tigers,” including China, are embracing robotics full-heartedly as the way to preserve the manufacturing intensity of their economies and build global market share in medium and high-value added industries, like automobiles, electronics, semiconductors and batteries. Germany and Japan are also manufacturing powers determined to maintain their manufacturing base through innovative engineering.

Most middle-income countries throughout South-east Asia and Latin America are lagging seriously behind in the robotics race and may find it increasingly difficult to move up the value chain to compete for market share in many highly-automated industries. These middle-income countries also face rising competition in low-value-added manufacturing from the new wave of industrializing countries with significantly lower labor costs, such as Vietnam, Bangladesh, India, Pakistan  and Indonesia.

Until today, robot deployment has been highly concentrated in a few industries, namely motor vehicles, electronics and metal-working.

However, accelerating trends in robotics technology is changing this focus in important ways. For example, robot suppliers are beginning to offer automation solutions for clothing and shoe manufacturing, industries that today are highly dominated by low-income economies. This trend may allow for the preservation of these industries in current high-cost producers like China, and even relocation to Europe and North America, in a process dubbed “robot-shoring.”  Moreover,  teamed with computer-aided-design (CAD) and 3D printing, which dramatically accelerate product design, automated manufacturing in developed countries will permit much shorter production chains and give producers  greater ability to react quickly to consumer trends. This is particularly true for high fashion-content clothing and shoe-wear, so it should not be a surprise that Nike and Adidas are leading the “robot-shoring” trend.

Both Nike and Adidas are working with tech partners on solutions for automating the most labor-intensive part of the sneaker manufacturing process, the fusion of the many parts and layers that make up the upper part of the sneaker. Nike invested in 2013 in a company called Grabit that uses a process called eletroadhesion to use static electricity to manipulate soft materials like leather and cloth, and this year Grabit commissioned upper-assembling robots in Nike plants in Mexico and China that work at 20 times the pace of human workers. This is a significant step towards bringing back production closer to consumers in developed markets.

Adidas’s Speedfactory in Ansbach, Germany is another experiment towards using 3D Printing and robotics to bring back sneaker production home. Adidas has partnered with Oechsler Motion, a German machinery supplier, and plans to produce 500,000 units a year in 2018. A second plant is under construction in Atlanta. Adidas believes technology can solve a huge mismatch between the typical 18-month production chain with Asia and the 12-month “fashion-life” of a sneaker.

Another company, Softwear Automation of Atlanta, Georgia, is intent on using its “Sewbot” technology to disrupt the world apparel-making process and the lives of millions of $5/day sweatshop employees scattered around South-East Asia and Central America.. Sewbot has solved the difficult task of robot manipulation of fabric, and Softwear Automation claims to have dominated the automated production of T-shirts and denim bluejeans. The company estimates that its process is 17 times more productive than human labor. Tianyuan Garments, a large Chinese firm that supplies Adidas, is building a plant in Arkansas that will have 20 Sewbot production lines and aims to produce 1.2 million T-shirts a year. Tianyuan estimates human labor will amount to $0.33/shirt on its completely automated production line, which compares to about $0.33/shirt in Bangladesh, the current low-cost producer.

China has made robotics a key part of its government supported “Made in China 2025” plan, both in terms of usage and domestic supply. The goal is to make China one of the world’s top 10 most intensively automated nations by 2020, with 150 industrial robots per 10,000 employees, which compares to today’s leader South Korea, with 531 robot units, the USA with 176 robot units and Germany with 301 robot units.

In 2016 China led the world in terms of both the amount of new robots installed (87,000 units, of which 27,000 came from Chinese firms) and for the total stock of operational robots (340,000, +33% over 2015).

The deployment of manufacturing robots around the world is extreme in its geographic concentration. As the data from the International Federation of Robotics shows,  the great majority of robots are being deployed in East Asia, North America and Germany. Middle-income countries with significant manufacturing bases, such as Brazil, Thailand, Malaysia, Turkey and South Africa, and European powers like France and the U.K, are being left far behind. The positive exceptions are Italy and  Eastern Europe, perhaps because of the latter’s close integration with the German supply chain.

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • China’s  Anyuang to make T-shirts with robots in Arkansas (Bloomberg)
  • China’ luxury consumer opportunity (McKinsey)
  • China bans ICOs (Bloomberg)
  • Seven reasons China banned ICOs (Fortune)
  • Michael Pettis on China’s slowing growth (Carnegie)
  • China bear turns bullish (Bloomberg)
  • The coming collapse of China’s Ponzi scheme  economy (SCMP)
  • China is going to hit a wall (FUW)
  • The global economy’s new rule maker (Project Syndicate)
  • Chinese millenials will drive global growth (SCMP)

China Technology Watch:

  • How Baidu will win the global AI race (Wired)
  • China leads the world in digital economy (McKinsey)
  • Chinese firms eyeing passenger drones (WIC)
  • Alibaba wants to bring big data to 1 million small shops (Caixing)
  • China’s  Anyuang to make T-shirts with robots in Arkansas (Bloomberg)

EM Investor Watch:

Technology Watch:

  • Nike’s Static-Electricity robots (Bloomberg)
  • Government Investment was key to US success (Teasri)

Investor Watch:

 

 

 

 

 

 

Russia is becoming a food superpower (Bloomberg)

Norway’s sovereign fund drops EM bonds (Bloomberg)

Bull and bear markets and capital allocation (Absolute Returns)

Profit margins and mean reversion (Philosophical Econ)

The Bullish Case for Brazilian Stocks

Brazil is coming out of one of the worst economic slumps in its history, after having lost more than 7% of its GDP over the past three years. A huge binge caused by a boom in commodity prices (2004-2011) which led to hot-money capital inflows and excessive credit and consumption was followed by a large hangover, made much worse by a political crisis and a draconian monetary policy of extremely high real interest rates. But all downturns come to an end, and Brazil is now poised to start a new growth cycle on solid ground. Corporates now have very lean cost structures, and they will see significant margin leverage as sales recover. Profits are very depressed; in 2016 they were at 2005 levels. At the same time, the market is inexpensive relative to its history and one of the cheapest in the world, so there are good prospects for both vigorous profits growth and multiple expansion over the coming years.

It can be argued that the past 10-15 years were wasted by Brazil. The Workers Party (PT) governments of Presidents Lula and Rousseff coasted on the reforms passed by the previous administration and sat back to enjoy high commodity prices and ample foreign capital inflows.  Several important achievements of the previous government, such as depoliticized regulatory agencies and the professionalization of public companies, were discarded, and new reforms were taken off the agenda. The PT focused mainly on a multitude of poorly-designed social welfare programs and corporate subsidies, without consideration for the fiscal consequences. When commodity prices retreated and the mismanagement and corruption of the public sector was revealed, the party came to an end.

The interim president Michel Temer, who replaced Rousseff after her impeachment, has made good progress towards putting Brazil’s economy back on the right track. For the first time in nearly twenty years, Brazil now has a reform agenda and a real opportunity to break out of economic stagnation (Brazil’s Economic Stagnation). An inbred love for experimental developmental economics and a complacency facilitated by the commodity boom and Petrobras’s oil finds, seem to finally have been replaced by a new realism and a desire to follow market economics. The country has woken up to the evidence that Argentina and Venezuela are not better models to follow than Chile and Mexico, and that wholesale antagonization of the U.S. leads nowhere.

Temer has already secured passage of a “fiscal responsibility law” which limits public spending increases to inflation and provides a possible anchor to a future of fiscal rectitude.

Temer has also brought competent management back to the state-owned national oil company  Petrobras, the electricity-holding Eletrobras and other public entities. Petrobras has started a process of selling non-core distribution and refinery assets, to focus on managing the development of its prodigious deep-water oil reserves. Temer has also proposed privatizing Eletrobras, a state electricity conglomerate that has long been a hotbed of patronage for politicians. Moreover, additional privatizations and infrastructure concessions once again are being advanced. It appears that these will be done in a manner to promote investment and efficiency, not for the convenience of corrupt construction companies and their political friends, as was the case during the Lula and Rousseff governments.

The good news for the stock market is that there are plenty of low-hanging fruits for Brazil to collect.

First, after this dire 3-year economic recession Brazil will enjoy a natural rebound. That alone should guarantee moderate growth in coming years. The negative effects of low commodity prices have already been felt and these are likely to stabilize from now on.

Second, important reforms of social security and labor are likely to pass. Consensus appears to have evolved in favor of these fundamental reforms. Social security reform is vital to stabilize fiscal spending. A labor reform could create enormous opportunities to create jobs in the formal economy.

Third, productivity is very low (at about a quarter of US levels) and productivity growth has been abysmal. Brazil has huge potential to increase productivity by pursuing two tracks:

  • Lower tariff and non-tariff barriers to open the economy. Brazil can take advantage of the enormous presence of mutinationals and the scale of their Brazilian businesses to promote integration into global supply chains and increase exports. For example, the auto industry currently has very low productivity and is mainly domestic focused.
  • Brazil has a pathetically low rank in the World Banks’s “ease of doing business survey”, and has seen no progress over the past decade. It has the worse ranking in Latin America and one of the worse for the main emerging markets. A methodical approach towards deregulation and tax-simplification would quickly yield high dividends.

World Bank’s Cost of Doing Business Country Rankings

Fourth the stocks market is inexpensive relative to both its history and other stock markets.

  • Dollarized earnings rebounded strongly in 2016 and will rise another 20% this year, but they remain below the level of 2005 and at about half the level of 2010-11. With very lean cost structures, companies will see better margins and earnings as the recovery progresses.
  • Cyclically adjusted price earnings (CAPE) ratios on a dollarized basis are cheap relative to Brazil’s stock market history as well as compared to other markets. In a world of very high assets prices caused by the impact of monetary policies on the pricing curve for capital duration and risk, emerging markets equities in general and Brazilian equities  in particular still trade below long term averages. Though CAPE ratios in general are not a good timing tool, they are very predictive of market performance on a 7-10 year basis in developed markets and a 3-5 year basis in emerging markets where cycles tend to be shorter and more abrupt.

There are sufficient risks in Brazil so that the market will face a wall of worry. At the top of the list is the outcome of next year’s presidential election. A successful run by Lula, a low probability at this time because of his legal problems, would certainly unsettle the markets.

Longer term, Brazil faces two fundamental issues.

  • A chronically overvalued currency. It is an absurdity that Brazil has the sixth  most expensive BigMac in the world, a reflection of the very high costs of doing business and an over-valued currency. Policymakers need to constantly remind themselves of former Finance Minister Mario Simonsen’s dictum, “A inflação incomoda, mas o câmbio mata. (Inflation is a nuisance but the foreign exchange rate kills.“ )

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  • Pro-cyclical policies. Every cycle, Brazil ‘s politicians increase spending during the boom times and then are forced to retrench during the busts. As John Maynard Keynes wisely noted, “The boom, not the slump, is the right time for austerity at the Treasury.”

 

Us Fed watch:

India Watch:

  • India’s rural distress puzzle (livemint)
  • The battle for India’s gold market (Bloomberg)
  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The coming clash of empires, Gavekal  (Zero Hedge)
  • The global economy’s new rule maker (Project Syndicate)
  • Chinese millenials will drive global growth (SCMP)
  • China’s booming pet-care industry (WIC)
  • Hyundai feels the wrath of China (Caixing)

China Technology Watch:

  • Chinese firms eyeing passinger drones (WIC)
  • China military focuses on drone swarms (FT)
  • Big data war in China (WIC)
  • Qualcomm plays the China tech game (WIC)
  • Alibaba wants to bring big data to 1 million small shops (Caixing)

EM Investor Watch:

Technology Watch:

  • Nike’s Static-Electricity robots (Bloomberg)
  • Government Investment was key to US success (Teasri)

Investor Watch:

China’s “Inevitable” Rise Through Protectionism

 

China’s rise as an economic power increasingly threatens the Asian and global geopolitical balance of power.  The growing realization in Washington that China’s ascent may be inevitable is based on the acknowledgement that Chinese policy makers are on a coherent and proven path of development, previously followed by the United States itself and later by Japan and the newly minted Asian tigers (Taiwan, South Korea, Hong Kong and Singapore). Japan and the Asian tigers were politically aligned with and militarily dependent on the United States and did not have the scale to upset the global order, but a resurgent China is a different matter.

The uniqueness of China’s rise cannot be over-emphasized. Every other country that has successfully broken out of the “middle-income trap” during the post-war period (the Asian tigers, Israel and today several eastern European countries) (China, the middle income trap and beyond) has done so with strong political, military and financial support from the United States. Most countries are not successful at building the institutions and executing the policies required to graduate beyond middle-income status, and many formerly “miracle economies,” face stagnation. Brazil is a case in point. Despite great natural resources and a vibrant entrepreneurial class, incoherent populist policies, an expansive state bureaucracy and oppressive taxes and regulations on business have caused stagnation since the early 1980’s. The result of Brazil’s stagnation at a time of great dynamism for China is an astonishing reversal in the relative importance of both countries to the global economy.

Source: World Bank

The Chinese model follows the well-worn protectionist path, embraced by the United States in the 19th century.  Once Great Britain had been well-established as the global hegemon, it espoused free-trade to facilitate the dissemination of its industrial production. The liberated Americans would have none of it. Alexander Hamilton’s Report on Manufacturers, submitted to Congress in 1791, which called for imports tariff and non-tariff barriers and subsidies for infant industries and innovation, provides a blueprint for the policies now followed by China. On the other hand, the U.S. as the new hegemon, has now assumed the role of the promoter of free trade.

China, with its huge market and high growth, has the same ability to attract capital and technology on its own terms that the U.S. had in the 19th Century. The Chinese have studied history and are simply following the path taken by the U.S. and the Asian Tigers. The Chinese know that to continue their rise they must now dominate high-value-added and technology-intensive industries, and they are determined to provide the protection and subsidies to facilitate this. In 2015, the government announced its Made in China 2025 and Internet Plus initiatives which aim to transform the country into a high-tech superpower by integrating artificial intelligence, robotics and social media. The plans are unabashedly protectionist and aim to substitute high tech imports by using the full regulatory and financial power of the state. This strategy of state supported industrial planning follows what Japan and Korea have assiduously done in the past, most recently with Korea’s full-fledged effort since 2001 to dominate robotics.

China’s plans have alarmed the world’s leading technology providers, such as the U.S., Japan, Germany and South Korea, and led to protests. President Trump last week signed an executive order asking his trade office to investigate China for theft of American technology and intellectual property.  But it is unlikely that China will change its path because it has history on its side and it believes that rival nations and corporations will cooperate to gain access to its markets. Moreover, there is no denying that the results of the policy so far are encouraging.

Many leading industries in the world today, from airplanes to internet search engines, have winner-take-all characteristics because of enormous capital intensity and/or network effects. China’s decision to restrict the freedom of American internet and ecommerce firms has promoted a vibrant domestic environment for tech start-ups unique in the world outside of Silicon Valley, and it has greatly facilitated the success of companies like Baidu, Tencent and Alibaba which are today the only global rivals to America’s tech hegemons.

The enormous amount of mobile phone and internet users, 751 million at last count, and the massive amounts of data they generate positions Chinese companies to become dominant players in the “internet of things,” artificial intelligence , data mining and related services. Neil Shen of Sequoia China, a leading venture capital investor in technology firms in China, succinctly states the bull case for the sector:

“I’m very optimistic about the prospects of the Artificial Intelligence industry in China, probably more so than back 20 years ago when china started with the online internet. The reasons being two: one is you need data for AI development and we have tons of data whether its Alibaba’s transaction data, social network data from Wechat, etc. And on top of that when you are looking at the researchers and experts in that space many are Chinese and if you are looking at quotations in research papers the Chinese AI research in the world has a very decent market share. And so, with that I think we have a very good chance to take a lead. In fact, fundamentally what is AI in the whole science field: its mathematics and statistics and China has very strong talent in these two areas.” Sequoia China’s Neil Shen (Bloomberg Interview).

China’s support of leading-edge practical technologies through subsidies, financing, R&D support, import protection and the leveraging of its huge market and the state’s purchasing power has led to significant breakthroughs. For example:

  • High-speed trains – Fuxing, the latest generation of Chinese bullet trains, with a maximum speed of 400 km/hour, was recently launched on the Shanghai-Beijing route, cutting travel time to 4 ½ hours. Fuxing is said to be 84% home-made standardized design, in contrast to previous generations which relied heavily on Japanese and French technology. The name, Fuxing, which means “revival,” is politically-loaded.(Caixin)
  • Over the past ten years, China has become the global leader in all aspects of the use and manufacturing of solar power. China is the world’s largest producer of photovoltaic power, and on track to add 40 gigawatts of capacity this year in its domestic market.
  • China also leads the world in the production and use of wind power and smart grid technologies.
  • China has become the global leader in the use and manufacturing of electric vehicles, selling 507,000 units in 2016, compared to 222,000 in Europe and 157,130 in the U.S.
  • China owns 70% of the world’s commercial drone market. For drones with communication-ability selling above $500/unit, Shenzen’s DJI is estimated to have around 70% of the U.S. market. DJI has become so dominant that competitors are abandoning hardware manufacturing to focus on software applications exclusively. Chinese military drones, with similar range and effectiveness as the U.S. military’s Predator and Reaper drones but selling at a fraction of the cost, have been gaining significant foreign market share, at the expense of the U.S. (WSJ).
  • Surveillance technology – Shenzen’s Hikvision, a subsidiary of CETC, a state conglomerate with close ties to the military, has become a global leader in internet-based digital surveillance systems which are being widely deployed in China and other countries through CCTV, ATMs and mobile phone applications. The company has become a leader in facial recognition and data harvesting.
  • Facial recognition – Beijing-based Megvii’s Face++ is the world’s largest face-recognition technology platform, currently used by more than 300,000 developers in 150 countries to identify faces, images, text and documents, such as government IDs. Baidu and SenseTime are also important players in this space.
  • Mobile Telephony – Chinese firms control over half the global market for mobile phones, with growing domination in emerging markets. China aims to be a leader in 5G mobile networks, and plans to spend $250 billion to have an operative system over the next five years.
  • Quantum Telecommunications – China appears to have the lead in the development of the new technology, “hackproof” quantum communications . China is said to be near completion of a 2,000 km “unhackable” fiber network linking Shanghai and Beijing. Moreover, Chinese researchers recently announced a breakthrough in successfully teleporting “entangled” photons from a quantum satellite 480 km above the earth to two terrestrial stations 1,200 km apart, and the government plans the deployment of a fleet of quantum-enabled satellites linking China nationwide and with Asia and Europe by 2020. The idea is to control a Chinese-centric hack-proof, cybersecure global network.

There are two new priority areas were the Chinese state is committed to deploying its financial and protectionist might:

  • Semiconductors – China has made it a national security priority to control the semiconductor supply chain. The government is lavishing money on the country’s chip makers, including $22 billion on state-owned Tsinghua Unigroup. Some 20 fabs are currently under construction in China. (WSJ)
  • Artificial Intelligence – China’s State Council in June announced a plan to provide tax benefits and state support to make China a global leader in AI by 2025 and Chinese companies major players in self-driving cars, smart robotics, wearable devices and virtual reality.

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

EM Investor Watch:

Investor Watch:

The Growing Role of the ETF in Emerging Markets Investing

ETFs, exchange-traded funds that track indices and are traded like common stocks on stock exchanges, have become enormously popular over the past decade and are an increasingly disruptive influence on the traditional asset management industry. Global ETF assets surpassed $4 trillion in 2017, growing 36% year-on-year, and 2,034 ETFs trade in the U.S. alone. Cost and liquidity are the primary attraction of ETFs, with the largest S&P500 trackers charging fees as low as 0.04% per year.  ETFs have become increasingly important as allocation instruments used by financial advisors and individual investors. Moreover, they are now commonly used by active institutional investors and traders.

Emerging Markets have seen an onslaught of ETF products. In the U.S. alone there are currently 195 EM ETFs being actively traded, representing nearly $200 billion in assets. The category is amply dominated by Global Emerging Markets (GEM) funds, with 70% of the assets. Specific country ETFs, which are widely used by active macro investors, are the second largest group, with 21% of assets. Fundamental strategies, also known as “smart beta,” make up 8% of assets. There has been a proliferation of these products, many launched by traditional active managers, which seek to exploit a specific factor (eg, value, quality, dividends, low volatility…etc.) These products are attractive to issuers because they still command relatively high fees compared to standard GEM ETSs.  The remaining categories are surprisingly insignificant. Regional funds, which used to be a fundamental part of the EM asset class, represent only 3.3% of ETFs, and are highly dominated by Asia. In contrast to the U.S., sector funds play almost no role in EM ETFs. EM sub-categories (frontier and BRIC, mainly) also are of little importance.

The EM ETF category is very dominated by four massive and growing GEM funds: Vanguard’s VWO, Blackrock’s IEMG and EEM and Schwab’s SCHE.  Fees have consistently declined for the big funds, with Schwab at the current low of 13 basis points per year. Ishares’s EEM is a complete outlier in terms of fees in this group, charging  0.72% of assets. As the first GEM fund to be launched (2003), EEM probably has legacy cost issues. For the time being, EEM can sustain this situation because its huge daily volume makes it the vehicle of choice for large hedge funds and institutional traders and investors seeking exposure to emerging markets. To compensate for the inevitable decline of EEM, Blackrock launched IEMG in 2012, with fees in-line with the competition.

Specific country funds are dominated by Blackrock’s MSCI-based ishare funds. These products maintain relatively high fees because their liquidity makes them the vehicle of choice for macro-investors, traders and allocators. Outside of the ishare products, almost all the activity of significance is in Asia where a panoply of country specific “smart beta” and sector products have been developed for China and India.

Fundamental smart beta products have also prospered in the GEM space and sustain high fees. These funds are aimed mainly at individual investors and financial advisors. Product sponsors offer “alpha-generating” factor tilts and other characteristics considered attractive to investor, such as high dividends, “quality,” low volatility, currency hedging, environmental consciousness (ESG) and leverage. The category is dominated by multi-factor funds that tilt stock allocation in favor of a combination of the value, momentum, quality and low volatility factors. The largest fundamental ETFs are listed below.

 

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The geopolitical landscape of Asia Pacific is changing (WEF)
  • China’s ascent is slowing (Bloomberg)
  • China needs more reform to progress (Caixing)
  • Trump on the verge of trade war with China (Brookings)
  • Foreign tourists are shunning China (SCMP)

China Technology Watch:

  • New China Maglev train moves ahead (China Daily)
  • China now has 751 million internet users (Caixing)
  • China is the next tech superpower (Diamandis)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch:

Investor Watch:

Notable Quotes:

“I’m very optimistic about the prospects of the Artificial Intelligence industry in China, probably more so than back 20 years ago when china started with the online internet. The reason being two: one is you need data for AI development and we have tons of data whether its Alibaba’s transaction data, social network data from Wechat, etc. And on top of that when you are looking at the researchers and experts in that space many are Chinese and if you are looking at quotations in research papers the Chinese AI research in the world has a very decent market share. And so, with that I think we have a very good chance to take a lead. In fact, fundamentally what is AI in the whole science field: its mathematics and statistics and China has very strong talent in these two areas.” Sequoia China’s Neil Shen (The Economist)

“When it comes to assessing political matters (especially global geopolitics like the North Korea matter), we are very humble. We know that we don’t have a unique insight that we’d choose to bet on … We can also say that if the above things go badly, it would seem that gold (more than other safe haven assets like the dollar, yen, and treasuries) would benefit, so if you don’t have 5-10% of your assets in gold as a hedge, we’d suggest you relook at this. Don’t let traditional biases, rather than an excellent analysis, stand in the way of you doing this (and if you do have an excellent analysis of why you shouldn’t have such an allocation to gold, we’d appreciate you sharing it with us.)” Ray Dalio, Bridgewater

Notable Charts: