Author: jvande

Latin America’s Pink Wave Faces Investor Skepticism

A pink wave of leftist governments has swept across Latin America. In recent years, first Mexico, then Argentina, Peru, Chile and Colombia and finally Brazil, have all elected governments with ambitious social agendas and plans for bringing back the state as the agent of economic development. Unfortunately for them, investors, both local and foreign, are not sticking around to see how this will work out.

The left in Latin America has a dismal record with its style of developmental activism centered around state companies, private firm “champions” and protectionism. Recent experience with Peronist Argentina, Bolivarian Venezuela and Brazil’s PT party have ended in economic collapse, inflation, currency devaluation, soaring debt and increased misery. The result has been a decade of severe capital and human flight.

The return of Lula and his PT party to power in Brazil promises more of the same big plans for state-led growth promoted by government agencies, state companies and public banks. It doesn’t matter that these policies previously ended in enormous losses caused by mismanagement and rampant corruption.

Unlike a decade ago, when Latin America’s left was going against the neoliberalism of the Washington Consensus, today state activism is back in favor in Western capitals. Partially as a response to Chinese policies but also because of a new concern for the many domestic losers of globalization, the Biden Administration has pushed through the country’s biggest-ever piece of climate legislation (The Inflation Reduction Act) which will provide lucrative tax incentives to companies that develop mines, processing facilities, battery plants and EV factories in the US. In addition, with bipartisan support, new laws have been passed to promote infrastructure and semiconductor investments. Moreover, these new programs now have strong intellectual support from academicians (Mariana Mazzucato and Carlota Perez are prominent examples) who argue that history points to the importance of government policies to induce investment, particularly at times of enormous technological disruption like the ones we are now living.

Chile’s president Gabriel Boric has sought the counsel of Carlota Perez, a Venezuelan economist who studies the interplay of long-term technology and financial cycles,  to understand how Chile fits into the current process of global technological transformation engendered by the Information and Telecommunications Technology (ICT) revolution. According to Perez, Latin America has been a major loser of this technology cycle which has crippled the mass production “Fordism” model (manufacturing jobs that pay enough for a worker to acquire middle class consumer goods) that was the foundation of the post WW II Latin American modern economy. These jobs have been destroyed across South America and replaced by low-pay/low-skills service jobs. Nevertheless, Perez actually sees a brighter future, as we have now entered the period of massive diffusion of ICT technologies, a “golden age of full deployment.” During the second half of long technology cycles, typically the productive sector replaces the financial sector as the driver of the economy. Perez sees a vital role for the state at this stage of the cycle to “tilt the playing field” through public policies (credit, taxes, subsidies, etc…) to support productive activities and “smart, green, healthy global growth.” She recommends that a country like Chile  promote  ICT diffusion by inducing investments into socially critical areas (e.g., the democratization of access to education and information) and into priority frontier industries (e.g., alternative energy technologies and supply chains).  Perez argues that those countries with political dynamics that allow for proactive public policies will  have a big advantage in coming years. Without these policies, ICT investments have primarily financed “escapist undertakings” such as computer games, social networks, parallel universes and delivery services for the rich, Perez says.

In line with the ideological shift towards state activism, Brazil’s Andre Lara Resende, a MIT trained economist who has joined president-elect Lula’s economic transition team, argues in favor of “alternative policies of public investment” to kick-start capital deployment in infrastructure, decarbonization, electrification and industrial revitalization. According to Lara Resende, these investments are productive and profitable and would  boost economic activity , and, therefore, would have a positive impact on fiscal accounts. His rationale relies on a proposed radical change in Brazil’s monetary policy from the current Fed-centric model to an independent one based on ‘’Modern Monetary Theory,” which assumes that public debt does not matter as long as rates are below nominal GDP growth.  Lara Resende would achieve this through financial repression (artificially low interest rates and directed lending), at the expense of what he sees as an over-sized financial sector divorced from the productive sector of the economy and at the service of the rentier class.

Though Lara Resende doesn’t say this, the logical consequence of his plan is a return to the strict capital controls that Brazil had until the 1990s. Of course, investors will try to anticipate this change. Boric faces the same issue in Chile which as seen huge levels of capital flight in expectation of structural changes to economic policy.

The president of Brazil’s Bradesco, Bank, Octavio de Lazari, this week warned president-elect, Lula that, given “an extremely challenging” 2023, there is no room for “tests and experiments,” and he suggested the government focus on reducing inflation and controlling fiscal deficits. From within Lula’s economic transition team, the sole orthodox member, the economist Persio Arida, echoed these thoughts, advising his colleagues to stick to the basic objectives —  ‘Opening the economy, making the state more efficient and reforming the tax system” — which have been pursued by  Brazilian economic policy makers, unsuccessfully, for the past 40 years.

Latin America faces a stark dilemma. The neoliberal polices of the Washington Consensus are deeply out of favor and blamed for currents ills, and the rich countries are moving away from these policies and are increasingly prone to fiscal and monetary experimentation and state activism. This could in theory provide an opening for policy changes in Latin America. However, investors believe that today’s Latin American states do not have the ability to implement state-led growth without the corruption and incompetence of the past. In a world of free capital flows, investors will prefer to move  their capital outside the country rather then risk it at home.

The New Global Monetary Regime

The U.S. dollar has been the lynchpin of the global monetary system since the end of World War II, promoting the geopolitical strategic interests of the United States and serving as a “public good” to facilitate the globalization of trade and finance. However, today the rise of China and growing threats to globalization present significant challenges to the long-term hegemony of the dollar. At a time when China aims to change the present dollar-centric monetary order, the dynamics of economic and domestic political forces in the U.S. also put into question its usefulness.

The weight of the dollar in global central bank reserves peaked in 2000 and has been falling gradually since then (chart 1). Today, the global economy has returned to a state of multipolarity last seen prior to WW1 when both Germany and the United States threatened the hegemony of pound sterling. In terms of its share of global GDP and trade and its status as a primary creditor to the world, China’s desire to shape a less dollar-centric global monetary system is legitimate (chart 2). China today has become the largest trading partner of most countries around the world and is the dominant importer of most commodities, so it is not surprising, given growing tensions with the U.S., that it does not want to have to rely on dollars to transact foreign trade (chart 3)

Chart 1

Chart 2, Countries share of world GDP, trade and capital exports

Chart 3, The largest trading partner of countries around the world

The current dollar fiat global monetary order also has become a burden for the U.S. economy. Since the 1950s, the U.S. has gone from being the dominant manufacturing power and exporter of the world and its primary creditor to the present day hyper-financialized and speculative economy with net debts  of $30 trillion to the world. Moreover, the political mood in America has turned against the neoliberal policies of the past decades — anchored on the free flow of trade, capital and immigration and current account deficits  — which seriously undermined American labor.

The gradual strengthening of a multipolar global monetary order will add  instability and costs and further the geopolitical deterioration and rising inflation that we have seen so far in the 2020s. A world of less trade, more of it non-dollar centric, and declining global trade imbalances will be very different from the experience of past decades. Over the short-run, the  dollar’s strength is likely to continue, driven by its safe-haven status in unstable times and the diminished supply of dollars resulting from more balanced global trade. Over the longer term, the dollar could weaken considerably from its currently overvalued levels. A decline in dollar hegemony implies a weaker dollar over time, but it is good to remember that because of powerful network effects reserve currency regimes are very sticky (e.g.,  more reserves were still held in pound sterling than in dollars until 1963).

The 75-year U.S. dollar reserve currency system has been unique in terms of its global reach, but in myriad ways it appears to be following in the steps of the previous regimes centered around the pound sterling, the Dutch florin and others before it.  These currency regimes lasted for around a century going through distinct phases:

  1. Economic, trade and creditor dominance. Expansion of productive capacity and capital accumulation.
  2. Excess capital accumulation, leading to financialization and speculation at the expense of the productive sector.
  3. Economic decline, as new powers seek hegemony.

The  current dollar reserve currency regime has followed this pattern since its launch at the Bretton Woods Conference in 1944.

Bretton Woods I (1945-1971)

The U.S.  imposed a dollar-centric monetary system at the Bretton Woods Conference. Disregarding the argument made by John Maynard Keynes for a global bank that would resolve current account imbalances,  all currencies  were anchored to the dollar at a fixed price for gold. The U.S. came out of the war with by far the largest economy in the world, as a huge net creditor to the world and as the dominant manufacturing and trading nation, all of which secured reserve currency status for the dollar.

In the 1950s, the U.S. ran current account surpluses with its major global trading partners, which were largely rechanneled into aid and direct investments for the reconstruction of the war-torn economies of Europe and Asia. However, by the early 1960s, Japan and Europe had recovered and were running current account surpluses with the U.S., which were registered as increases in each country’s “gold” reserves held at the U.S Federal Reserve. Growing opposition to the system was best expressed by France’s finance minister Valerie Giscard D’Estaing who decried the “exorbitant privilege” enjoyed by the U.S. (the supposed advantage of paying for imports by printing dollars). The system showed its first crack when France sent a navy frigate to New York to repatriate its gold reserves. The depletion of U.S. gold reserves at a time of “American malaise” (e.g., political assassinations, racial riots, the Vietnam War fiasco), led President Richard Nixon to “close the gold window”  in 1971, putting an end to Bretton Woods I.

The Chaotic Interlude (1971-1980)

America’s insouciance with regards to unilaterally breaking the dollar’s tie to gold and imposing a pure fiat currency system was expressed by Treasury Secretary John Connally’s comment, “it’s our currency but it’s your problem.” The result was a collapse of confidence in American monetary stewardship and a flight to dollar alternatives. Dollars as a percentage of total central bank reserves fell from 50% in 1971 to 25% in 1980, replaced mainly by gold but also by Deutsche mark and Japanese yen.

The Petrodollar System and The Golden Age of the dollar (1980-2000)

An agreement between Saudi Arabia and the United States in 1974 (the U.S. Saudi Arabian Joint-Commission on Economic Cooperation) committed Saudi Arabia to invoice petroleum sales in U.S. dollars and hold current account surpluses in U.S. Treasuries in exchange for defense guarantees and economic support. The pact  guaranteed ample global demand for dollars and reinstated America’s  “exorbitant privilege”  of running perpetual current account deficits (chart 3).

Fed chairman Paul Volcker’s success in quelling inflation and President Ronal Reagan’s neoliberal pro-business agenda put an end to the 1970s malaise and set the stage for the golden age of the dollar. This period was characterized by a persistent decline in inflation and interest rates, underpinned by stable prices for oil and gold and deflationary forces from both domestic sources (deregulation, lower taxes, decline of unions, immigration) and international sources (globalization, lower tariffs, free flow of capital) (chart 4)

Confidence in the dollar returned and central banks increased the weight of dollar reserves, from a low of 25% in 1980 to a peak of 60% in 2000, while gold reserves fell from 60% in 1980 to 12% in 2000. Low and declining inflation gave birth to the Fed’s “great moderation” thesis and allowed it to promote the great financialization of the economy, all buttressed by growing current account deficits and foreign capital inflows. With Wall Street at the core of the process, this period saw the U.S. become a huge net debtor as foreign countries accumulated surpluses and became the financiers of U.S. debt and other assets. This period also saw the widespread elimination of capital controls around the world and the growing influence of “hot money” tourist capital flows into foreign assets (chart 5).

Chart 5

Bretton Woods II (2000-2012)

China’s “opening up” under Deng Xiaoping during the 1980s, the maxi-devaluation of the RMB in 1994 and accession to the WTO in 2000 drove China’s “economic miracle” and the commodity super-cycle (2002-2012). China’s rise inaugurated a new global monetary regime which has been dubbed Bretton Woods II. Like in Bretton Woods I, the U.S. promoted the growth of a potential rival through trade and investment (under the premise that China would become more democratic and market-oriented over time).  Once again imbalances emerged, as China’s mercantilist policies led to massive current account surpluses with the U.S. which were parked in U.S. Treasury bills.  “Chimerica,” as the symbiotic relationship came to be known, made China the factory floor for the U.S. consumer.  The China “trade shock” accentuated the deflationary forces of the 1990s. This enabled the Federal Reserve to pursue loose monetary policy despite soaring commodity prices, which broke the “petrodollar” anchor of price stability of the prior twenty years.

Without the stability of the price of oil and gold that was at the core of the “Petrodollar system” Bretton Woods II was an anchorless pure Fiat Reserve Currency Model relying entirely on the faith and credit of the Federal Reserve. Since 2000, recurring financial crises (2001, 2007, 2020) have been met by a desperate and increasingly unorthodox Federal Reserve determined to combat deflationary forces by supporting extremely high levels of debt and equity prices through quantitative easing and international swap lines.

Rising tensions between China and the U.S. since Xi Jinping took power in China in 2011 have undermined “Chimerica.” Since 2017, China has been reducing its holdings of Treasury bills, and no longer recycles its current account surpluses into Treasury bills.  The sanctions imposed on Russia after the invasion of Ukraine and acrimonious relations with Saudi Arabia have further undermined the appeal of recycling current account surpluses into Treasuries.

In Search of a New Regime: Bretton Woods III?

 As Nobel Laureate Joseph Stiglitz has said, “the system in which the dollar is the reserve currency is a system that has long  been recognized to be unsustainable in the long run.” Eventually the “exorbitant privilege” and its geopolitical benefits turn into an “exorbitant burden” of deindustrialization and foreign liabilities.  Moreover, for the first time since WWII, the world’s largest trading nation, China, does not support the  regime. This raises the question of what comes next?

China has declared its determination to move the current world monetary order towards a less U.S. centric model. Given the deterioration in China-U.S. relations and the prospect of economic decoupling, it is likely that China’s trade and current account surpluses with the U.S. will dwindle over the next decade.  Without a reliable substitute for the U.S. consumer, China now aspires to a symbiotic relationship with natural resource producers, whereby it ‘barters” manufactured goods in exchange for commodities. China’s rapprochement with Russia and its diplomatic advances in the Persian Gulf and the steppes of Central Asia are evidence of this focus on creating a new global payments system which focuses on commodities and bypasses the highly financialized dollar correspondent network promoted by the U.S. China aspires to do the same with large economies like Brazil and Indonesia. A Xi visit to Saudi Arabia, rumored to be scheduled for next month, would be of great concern to Washington.

Zolltan Pozsar of Credit Suisse has recently written about a new global commodity anchored reserve currency model which he calls Bretton Woods III. The idea is that in a world torn by geopolitics, sanctions and financial instability  countries will do more trade in other currencies than the dollar and prefer to hold reserves in commodities. Geopolitical tensions this year  — Russia’s invasion of Ukraine and the imposition of sanctions on its trade and foreign reserves, and growing tension in the Taiwan Strait which have resulted  in the  imposition of draconian controls by the U.S. on semiconductor exports  — may have been a watershed which will accelerate financial decoupling.

Does China want the renminbi to serve as a reserve currency?

China, at least in the short run, “wants to have its cake and eat it too.”

China would like to reduce its vulnerability to U.S. sanctions by promoting a new monetary order that is not dollar-centric and do this in a way that allows it to continue to expand its geopolitical influence on Asia and its primary trading partners, mainly commodity producers. However, facing a decade of low growth due to debt, a real estate crisis, poor demographics and plummeting productivity, it also wants to preserve the millions of jobs tied to exports of manufacturing goods. Like all Asian Tigers (Japan, Korea, Taiwan) it needs to pursue the mercantilist policies of the past: an undervalued currency and export subsidies. For now, these mercantilist tendencies imply current account surpluses, which would make it difficult for China to create the expansion of RMB liabilities required in a reserve currency system.

However, under the firm hand of Chairman Xi, China is now rapidly moving to a different economic model that is different from the one followed since the 1980s and at odds with the East Asian model. As it ages rapidly and faces a sharp decline in its workforce, China  will cease to be both the “factory of the world” and the major creditor to the world. This trend will accelerate this decade as China adopts widespread autarkic policies to reduce its vulnerability to potential sanctions from geopolitical adversaries. Over the next decade, China is likely to move to a less production-oriented and more consumer- and finance -oriented economy. This implies more balanced trade and more appropriate conditions for promoting the RMB as a reserve currency.

Conclusion

The move to a multipolar world and parallel monetary regimes will add instability to the global economy during the coming decade. Though declining global trade imbalances are positive in the medium run, the reduction in global dollar liquidity will support dollar strength at first but accelerate alternative reserve currency holdings over time. Commodities will probably play a more important role in future monetary regimes, which will benefit the major global commodity producers.

There is great uncertainty about the reshaping of a new monetary order, but certainty about one thing: more instability.  The quote from Stiglitz concludes: “The system in which the dollar is the reserve currency is a system that has long been recognized to be unsustainable in the long run. It’s a system that is fraying, but as it frays it can contribute a great deal to global instability, and the movement from a dollar to a two-currency or three-currency, a dollar – euro [sic], is a movement that will make things even more unstable.”

Brazil’s Bad Choices

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

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

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

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

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

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

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

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

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

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

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

EM Expected Returns, 3Q 2022. The Revenge of Value.

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

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

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

The chart below shows the current expected returns for EM markets and for the S&P500 based on a CAPE ratio analysis. The Cyclically Adjusted Price Earnings Ratio (CAPE)  takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful tool for highly cyclical assets like EM stocks.  We use dollarized data to capture currency trends. This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University.

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

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

Characteristics of Emerging Markets

The Emerging Markets asset class, for both bonds and equities, is made up of a smorgasbord of countries that don’t have much to do with one another. Very broadly, the index providers (MSCI, FTSE, Russell, etc.,)  differentiate between developed, emerging and frontier markets in terms of “investability”  criteria, such as market capitalization, liquidity and transparency. In this article, we provide a framework to further categorize  emerging markets. We look first at the basic economic structure of countries: the growth in the quantity of labor and the expected growth in the productivity of that labor. Second, we look at the capacity of countries to compete and move up value chains in a global economy.

1.Economic Structure

First, in the chart below, we look at GDP per capita, the most basic measure of a country’s relative development. We see that Taiwan, Korea and perhaps Poland are really closer to developed countries on this measure. Then , moving from left to right on the chart, we can somewhat arbitrarily group the other countries into middle-income (Chile to Thailand) and lower income (Peru to India).

Second, in the chart below, we distinguish between dynamic, stagnant and languid economies by measuring how GDP per capita for each country has evolved relative to the United States since 1980. Dynamic economies are converging with United States, the stagnant ones are “trapped” in relative terms and the languid ones are falling behind. The term “Middle-Income Trap” refers mainly to middle-income countries in Latin America that have stopped converging over this period, but there are also rich and poor countries that are neither outgrowing or growing less than the United States.

The following chart shows the long term effect of convergence for dynamic economies (Korea and China)  and a “trapped” country (Brazil). India has recently started a process of convergence, but it remains to be seen for how long it can be sustained.

GDP growth can be broken down into the growth of the supply of labor and the growth in the productivity of labor. The following three charts provide insight into labor growth for different EM countries: first, the expected annual growth in the working age population for the next decade; second, the degree of urbanization; and third, the female participation rate.  These charts show  radical extremes: On one end, a country like India ,with a growing population, very low urbanization and very low female participation, has potentially very large employment growth; at the other end, Korea ,  with negative growth in the working age population, a high degree of urbanization and a high rate of female participation, is likely to have very low employment growth.

In addition to the growth in the quantity of labor we need a notion of labor  productivity growth. The chart below shows annual labor productivity growth for the past ten years, which is a valid starting point for estimating future productivity growth.

Not surprisingly, labor productivity is linked to capital formation, as shown in the following chart.

Assuming that these rates of productivity growth persist in the future (admittedly a big assumption) and adding these to the working age population growth, we can derive a very general idea of potential future growth, which we show in the next chart.

2.Competitiveness

Another distinguishing characteristic of countries is the conditions they offer for private capital to unleash its entrepreneurial drive (“animal spirits) ,to boost productivity and innovation. These conditions —  Economic Freedom (The Heritage Foundation), or “Ease of Doing Business” (World Bank) — require  good governance and an efficient bureaucracy which provides rule of law, infrastructure and social services (education, healthcare). The result of good governance is a dynamic entrepreneurial sector which is innovative and globally competitive.

For countries to become increasingly competitive in the global economy they need 1. Human Capital; 2. Innovation and economic complexity; and 3. Growing participation in world trade for manufactured goods.

Human capital (education, health, etc.,) is measured by the World Bank’s Human Capital ranking. Also, the OECD’s  PISA (Program for International Student Assessment) provides an indication of the educational achievement levels of many countries. Both  of these are shown below.

Economic Freedom has been measured by the Heritage Foundation, the World Bank (Ease of Doing Business) and the World Economic Forum, among others, always with the objective of appraising the conditions for private investment and entrepreneurship. Below, we provide some of the findings of the Heritage Foundation’s Economic Freedom Index.

Innovation and Economic Complexity both are important indicators of a

country’s potential for moving from middle-income to higher-income status. Many EM countries, particularly those in Latin America, have not been able to innovate and move up industrial global value chains, falling into the “Middle-Income Trap.”

The Bloomberg Innovation Index ranks the major economies of the world in terms of innovation capacity. As usual, it is important to understand the historical trends of the indicator. The two charts below show the latest innovation rankings and the evolution of the rankings for the United States and China.

The Economic Complexity Index (ECI) measures the knowledge intensity of an economy. The first chart shows the rankings for a sample of major developed and EM economies. The second chart shows the evolution of the index since 1998 for three “converging” countries  (China, Korea and Poland) and two laggards (Brazil and the U.S.). Both the U.S. and Brazil are major commodity producers vulnerable to the “natural resource curse.”

 

Participation in World Trade is another critical indicator of competitiveness and growth potential. The evidence throughout history points to a clear connection between trade and prosperity. In the following two charts we contrast convergers with commodity producers. The convergers (China, Taiwan, Korea, Poland) have grown their participation in world trade while the commodity producers have low (and very volatile) participation.

Conclusion

From a macro viewpoint emerging markets include countries with very different profiles. In the chart below, we show which countries do well in growth and competitiveness. Hypothetically, the countries with growing economies that are competitive in a global economy should be attractive for investors. Unfortunately, many other factors come into play, the most important of which is the capacity for corporations to accumulate capital over long periods of time through high profitability and reinvestment opportunities. It is also important to understand financial stability and pay great attention to debt cycles, foreign flows and balance of payment dynamics.

 

 

 

 

 

Long Technology Waves and Emerging Markets

The poor performance of many developing economies in recent decades has many explanations. Thought leaders such as prominent mainstream economists, the World Bank and the IMF tend to attribute failure to weak “institutions” which engender corruption, bureaucracy, lawlessness and poor human capital formation, and, consequently, result in a difficult environment for productive investments and capital accumulation to occur. In the countries themselves structural reasons often are preferred which tend to blame external forces: the legacy of colonialism and foreign oppression or the inequitable dependency of the “periphery” (developing countries) on the “center”  (rich countries). A third approach, put forward by experts on historical technological cycles, gives significant incremental insights on the question, and, more importantly, guidance on a path to better performance in the future.

The Russian Nikolai Kondratiev and the Austrian Joseph Schumpeter developed the idea during the 1920s that  long technological waves drive  the course of economic growth. Both of these “political economists” sought to understand the miraculous growth created by the industrial revolution over the previous century to better explain the post W.W. I  environment.

Schumpeter is best remembered for the idea that “creative destruction” is fundamental for progress and occurs in a recurring process: innovations made by scientists and tinkerers are turned into inventions by profit seeking entrepreneurs; eventually, the wide diffusion of disruptive technologies lead to widespread creative destruction as entire industries and sectors are transformed.

The chart below, from Visual Capitalist, summarizes the long-term technological cycles defined by Kondratiev and Schumpeter. Though the precise dates are debated by historians, the chart seeks to cover the entire era of the “Industrial Revolution.”  Five distinct “long waves of innovation” are described, each one of which was deeply transformative, not only for the firms and industries involved but also for the socio-political fabric of society. This framework puts us today in the fifth wave of technological progress, the Information and Communication Technologies Age (ICT).

Following  in the path of Schumpeter, the Venezuelan economist Carlota Perez and others have advanced the discussion of technological waves by incorporating the role of capital markets and exploring the implications for the development of “periphery” countries. Perez’s book, Technological Revolutions and Financial Capital (2001), has been hugely influential and is required reading in Silicon Valley boardrooms and venture capital firms.

Perez talks about technological revolutions as “great surges of development” which cause structural changes to the economy and profound qualitative changes to society, and she sees capital markets at the core of the process. Her “revolutionary waves,” as shown in the chart below are in line with Schumpeter’s, but she increases the scope to show the broad reach of these technologies on communications and infrastructure and, consequently, trade and commerce and society as a whole.

Perez’s technological cycles are divided into three distinct phases, which are determined by the diffusion rate of technologies.

During the initial phase – Installation – new innovations are slowly adopted by entrepreneurs with disruptive business models. As the kinks are worked out and the technologies become cost effective more entrepreneurs adopt the technologies with the backing of financiers (e.g. venture capital) who seek the high potential payoff of backing a future champion. This leads to a frenzy of capital markets speculation, which invariably results in overinvestment, hype, financial bubbles and financial crisis.

As shown below, every Installation phase has ended in a bubble, followed by a financial crisis, which Perez call the Turning Point. The canal mania of the British industrial revolution, the British railway mania of the Age of Steam, the global infrastructure mania (sometimes called the Barings mania) of the Age of Steel, the roaring twenties stock market bubbles of the age of mass production and the  Telecom, Media and Technology (TMT) bubble of  the ICT revolution all ended in financial crises.

For illustration purposes, the chart below shows Perez’s process at work for the current Information and Communications Technologies (ICT) revolution that we are currently living. The cycle is a typical S-curve which has a long incubation period of slow growth, followed by a sharp ramp up and an eventual flattening.  The current cycle can be said to have started in 1971 with the launch of the first commercial micro-processor chip by Intel, but this was only possible because of a prior decades-long incubation period of scientific research and tinkering. Financial speculation built up between 1995-1999 led to the great TMT bubble and the crash in 2000-2001. Following the crash, the Deployment Phase has caused the rise of the major winners through a consolidation process (FAANGS). (These consolidations are normal, according to Perez. For example, hundreds of auto companies engaged in brutal competition before consolidating into the three majors in the 1920s).

The Deployment Periods, which Perez calls the “Golden Ages”, is when the technologies become cheap and ubiquitous, and their benefits are widely diffused through business and society. Perez argues that we are on the verge of another “golden age” today, as we approach broad access to smartphones and the internet and massively powerful micro-chips are becoming almost ubiquitous in basic consumer products (the chip in an Iphone has a trillion times the computing power of those used by IBM’s mainframe computers in 1965.)

If it doesn’t feel now like we are entering another “Golden Age” it is because we are still experiencing the after-shocks of the previous phase of financial frenzy and economic collapse and its consequences: high inequality and populism. Perez argues that the successful countries of the next decades will be those that have governments that understand the moment and can actively promote the diffusion of ICT technologies to achieve broad societal goals (e.g. “green” technologies).

Technology Cycles and Emerging Markets

Looking back at history, one can see how this process has played out before for developing countries. We will focus on the last three technology cycles: The age of steel and mass engineering, the age of oil and mass production and the current ICT revolution.

The age of steel and mass engineering (1875-1908): This was the age of the wide diffusion of the steam engine and steel through mass engineering to provide the infrastructure for the first wave of trade globalization. The rise of Japan (the first of the Asian Tigers) occurred over this period as it methodically diffused all of the technologies developed in the West.  Latin America experienced its own “Belle Epoque,” as steamships and railroads made its commodities competitive in global markets. During this time, Argentina and Brazil were considered at the level of development of most European countries and attracted millions of European immigrants.

The age of oil and mass production (1908-1971) – Interrupted by two devasting world wars and marked by profound socio-political change, this age still generated wide-spread prosperity, though China, India and Eastern Europe did not participate. Initiated by the launch of Henry Ford’s Model T automobile in 1908, it saw the diffusion of the internal combustion engine, electrification, and chemicals under the structure of the modern corporation. Following the Second World War, broad diffusion of these technologies led to a “Golden Age” of capitalism throughout the Western World. This was also a period  of “miraculous” growth throughout Latin America as the wide diffusion of the mass production process, supported by import substitution policies and foreign multinationals, created abundant quality jobs in manufacturing and the rise of the middle class consumer.

The  Information and Communication Technologies  (ICT) Revolution (1971-today): All phases of technological revolutions overlap with their predecessor and follower as the diffusion process plays out. In the case of the ICT revolution the overlap has been particularly important and has created unexpected winners and losers. China’s economic reforms (1982) and the fall of the Berlin Wall (1989) had the effect of radically expanding the length and scope of the Mass Production Age at a time when the “creative destruction” of the ICT Age should have been undermining it. Instead of increasing productivity German corporations moved mass production to Eastern Europe and American corporations outsourced to China, to exploit cheap labor. Companies also were able to avoid expensive environmental costs by offshoring carbon-intensive, heavily polluting industries to China and the Middle East, delaying the diffusion of “green” technologies for decades. The Mass Production Age, with its high environmental costs, was extended to the enormous benefit of China and a few countries in Eastern Europe, at the expense of workers in Europe and America who were pushed into low-productivity service jobs, and the “Golden Age” of the ICT revolution has been delayed. ( U.S. productivity and growth have declined and inequality has risen sharply while Amazon makes it ever easier to buy Chinese-made goods.)

The slow diffusion of the ICT age and the extension of the mass production age has had very uneven consequences for emerging market countries. The winners of the ICT age have been those countries that were late comers to the mass production paradigm and understood that the ICT revolution would lead to massive reductions in communication and transport costs and a new wave of globalization. The Asian Tigers (Korea, Taiwan, China, Vietnam) and to a lesser degree Eastern European countries (Poland, Czech, Hungary) have been the champions by integrating themselves in global mass production value chains and assiduously working to add value. South-East Asian countries (Indonesia, Thailand, Malaysia) initially did well but increasingly find themselves sandwiched between newcomers like Vietnam and Bangladesh, which are competitive in low value-added products, and China for higher value-added products. Both India and the Philippines almost completely missed out on the mass production age revival but have made small niches for themselves in the ICT world with Business Process Outsourcing (BPO) and IT Services Outsourcing.

The big loser of the ICT age has been Latin America, which has undergone severe deindustrialization and has become mired in the middle-income trap. Mexico has suffered the greatest frustration. This country, led by its brilliant technocrats, did everything right to position itself for the mass production to ICT transition, entering into the groundbreaking NAFTA trade agreement with the U.S. and Canada. The thinking behind NAFTA was brilliant. It would facilitate a smooth transition out of mass production to ICT for U.S. firms while extending the benefits of the mass production age to a friendly neighbor operating under controlled conditions (labor, local content, subsidies, environmental, etc…). Unfortunately for Mexico, the dramatic rise of China as the factory of the world undermined all of these objectives, as China successfully dominated global value supply chains without having to meet any of the conditions Mexico had to comply with.

South America has not fared better. As high-cost producers with very volatile currencies and economies, these countries were unprepared to compete with China. These disadvantages were compounded by (1) the false hope created by the commodity boom  (2002-2012) which resulted in a typical boom-to-bust cycle and a vicious case of Dutch Disease (natural resource curse) that these countries have yet to recover from and (2) the adoption of “Washington Consensus” financial opening dogma (free movement of capital) which increased volatile flows of hot money and destabilized currencies.

The following chart shows economic convergence since 1980 (in terms of USD GDP/Capita) for a sample of developed and emerging market countries, which is illustrative of the winners and losers of the ICT Revolution.

The Golden Age of ICT

If Perez is correct and we are on the verge of a Golden Age of  extensive diffusion of ICT technologies through all segments and geographies what should countries be doing?

Perez and Raphael Kablinsky in his recent book, Sustainable Futures, An Agenda for Action, argue for activist government using its resources to incentivize private investment to achieve desirable societal goals (e.g., environmental sustainability, equal opportunity). The Biden Administration’s recent Inflation Reduction Act (IRA) and the Chips and Science Act are both in that spirit, aiming to promote investment in clean energy and energy efficiency and the re-shoring of  semiconductor production away from the Asian mass production value chain. These initiatives, as well as President Xi’s Made in China 2025 Plan, all assume that the great Mass Production Age extension through China-centric global value chains has run its course, and that ICT diffusion will now result in, without excess short-term costs, a return to more local/regional manufacturing and a more autarkic or segmented global trade system. Through massive state subsidies China already has taken a commanding lead in the production of “green” products such as electric vehicles and batteries and solar panels.

The return of activist government, coming after a 40-year period of neo-liberalism and government retrenchment, raises the question of what policies countries should pursue to fully reap the benefits of this final phase of the ICT Revolution.

Perez recommends two basic courses of action that many emerging economies and developing countries can pursue. First, governments should be active in promoting ICT diffusion in industries where competitive advantages are evident. For example, commodity rich countries like Brazil, Argentina and Chile can increase productivity by being at the forefront of ICT innovations applicable to farming and mining and, at the same time, aggressively move up value chains for these products. (Brazil, with its low carbon-dependent economy and enormous potential in solar, wind and biofuel energies, is well positioned to become a global leader in “green” farming and mining).  Second, Perez sees large opportunities for countries or regional groups to capitalize on climate change initiatives by deploying alternative energy sources and capturing their value chains through localized production. (Once again, Brazil with its large local market opportunity can achieve leadership).

The consulting firm McKinsey provides a roadmap for the future in a recent article, “Accelerating Toward Net-Zero; The Green Business-Building Opportunity” (Link). The following chart from McKinsey maps out the sectors expected to have the largest economic importance in a “greening” economy and, consequently, where governments and firms are advised to focus their efforts.

Investment Factors in Emerging Markets

Since the 1970s when quantitative analysis began to dominate investing financial academics have looked for the drivers of investment returns. Initially, the focus was on explaining stock market returns in excess of risk free Treasury Bills in terms of compensation for higher risk. Then it was found that this market risk premia could be decomposed into the value and size factors, as empirical evidence showed that cheap stocks and small capitalization stocks provided their own excess returns beyond the market premia. Over time, academics have come up with a multitude of additional factors, of which quality (high profitability and low capital requirements) and momentum (rising stocks continue to outperform) are the most important.

Over the past twenty years these investment factors have become staples of the investment industry sponsored by index providers and investment firms. One of the benefits of this proliferation of new products and data is that it provides significant explanatory evidence for market developments. Emerging markets are no exception to this, and we can explain much of recent market developments in terms of factors.

The chart below  shows the evolution of the primary investment factors in emerging market stocks for the past ten years. The data is from Professor Kenneth French’s website (link ) of Dartmouth College. The factors are small caps (SMB), value (HML), profitability (RMW), momentum (MOM) and low capital intensity (CMA).  We can see that the past decade has been entirely dominated by the momentum factor. This was particularly true from the Spring of 2017 through the summer of 2020 which was the period of the great tech boom in both the U.S. and China. In a world of low growth (emerging markets  and most of the global economy were in a state of semi-depression during the past ten years) and exceptionally low interest rates, long-duration “growthy” assets experienced significant expansions in their price to earnings multiples.  Value and small caps stocks, on the other hand, are highly sensitive to economic conditions and, consequently, languished over this period. Not surprisingly, over this period  “growth” investors came to completely dominate performance and asset accumulation, while “value” funds had a horrible decade. Note that value has had a big comeback since November of 2020, a move that has left most EM portfolio managers poorly positioned and with poor performance. This is shown in more detail in the second chart.

Investment factors, like most things in finance and investing, go through cycles of strength and weakness, with mean reversion periodically bringing them back to long term trends. The graph below shows the Fama-French data for emerging markets from 1989 until June 2022.  We can see that over this 32 year period, the momentum  (MOM) and value (HML) factors have generated large premia while small caps (SMB), profitability (RMW) and low capital intensity (CMA) have provided more modest premia.   Both momentum and value have had long periods of superior performance, and  since 2014 momentum has taken off dramatically.

The following chart provides more detail with a decade by decade breakdown for MSCI EM from 1992-2022  and for the S&P500 from 1962 to 1992.  We can see that in both the U.S. and EM factor performance is inconsistent, varying significantly from one decade to another. The fact that factors can lag for extended periods of time (a decade is an eternity in the life of a portfolio manager) means that these trends determine the trends of the investment industry. For example, the phenomenal success of Warren Buffett, considered the leading investor of the past forty years, was driven by the huge premia provided by the value factor between 1972 and 1992. If Buffett had launched his fund in 2002, he surely would have gone out of business very quickly.

 

In EM, though all factors under consideration provide premia, for small caps (SMB) almost all the outperformance was secured in the 1992-2002 decade, and for value (HML) most of the premia was accumulated during 1992-2012. The poor performance of small caps explains why this market segment is neglected in the EM fund industry. The very strong performance of EM value in the 1992-2012 period made this style of investing very popular with fund managers and fund marketers. However, the poor performance of value between 2012-2020 nearly decimated this style of investing and led to the closure of many funds. With EM value bouncing  back over the past two years, catching almost  all fund managers off guard, it will be interesting to see if value investing makes a comeback.

 

The Big Mac Index, REER and Competitiveness in Emerging Markets

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

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

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

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

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

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

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

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

Big Mac Implied Valuation relative to the USD

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

Big Mac Implied Valuation relative to the USD

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

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

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

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

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

 

 

Emerging Markets Expected Returns, 2Q2022

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

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

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

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

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

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

 

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

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

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

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

 

Winter is Here for Emerging Markets

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

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

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

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

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

 

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

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

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

The Great Inflation Debate

The great investment debate of today is about the future course of inflation. Economists and investors are divided into the “inflationistas” and “deflationistas.” The former, “Team Permanent,” see the recent surge in inflation as indicative of a regime change towards a world of supply scarcity and higher prices.; the latter, “Team Transitory,” believe we are stuck in a low growth and demand-constrained environment where prices always fall unless monetary authorities intervene.

Until recently, the “deflationistas” were triumphant. Fears that the money printing and fiscal expansion that followed the Great Financial Crisis would spark inflation never materialized. The past ten years have been marked by low inflation and a strong dollar despite zero bound nominal interest rates. The core argument of the “Deflationistas,” as expressed by economist luminaries such as Paul Krugman and former Fed Chair Ben Bernanke, is that inflation is repressed by declining growth in the working age population. This phenomenon, sometimes called “secular stagnation” or also “the global savings glut” has supposedly  brought down the “natural rate of interest” which preserves price stability.

Deflation has been the norm for so long that it is understandable that most people assume that it  will persist.

Since the U.S. Consumer Price Index (CPI) peaked at 15% in the spring of 1980 it has been on a persistent downward trajectory. This has been dubbed “The Great Moderation” by Bernanke  who attributed this result to the masterful management of the Fed and  its 400 economists.

The contribution of the Fed to the deflation process is difficult to confirm because of the various other factors that have concurrently impacted prices over the period. These are well known, but we list them below:

  1. The collapse in commodity prices. Energy prices fell by 80% during the 1980s and remained low until 2002. Following the GFC, the U.S. shale revolution drove energy costs in the U.S. to near record lows.
  2. The baby boom labor expansion which was magnified by a huge increase of the female participation rate in the labor force, and also by record levels of legal and illegal immigration.
  3. The rise of China under Deng (1982) and the fall of the Berlin Wall (1989), which added nearly a billion low-cost workers to the global economy. China’s debt-fueled mercantilist industrial promotion policies also dramatically increased global production capacity for a wide variety of industrial goods.
  4. Hyper-globalization, driven by declining transportation and communication costs and chronic U.S. current account deficits. Outsourcing has been highly deflationary, lowering labor costs of goods and putting downward pressure on domestic wages.
  5. Hyper-financialization, driven by the Washington Consensus for open global capital and labor markets.
  6. The Reagan-Thatcher Neoliberal Revolution which drove prices down through deregulation, the defenestration of labor unions and lower taxes.
  7. Lax anti-trust policy which incentivized corporate concentration . This was further accentuated by the emergence of  “winner-take-all” network-driven technology business models.
  8. Digitalization of consumption through technology.

Over this long 40-year deflationary period, different forces have dominated at different times. For example, in the 80s declining commodity prices, deregulation and abundant labor were the dominating forces. However, in the 00s, the “China supply shock” (including cheap Chinese labor) and hyper-financialization were the dominant forces, overwhelming the temporary surge in commodity prices.

Some of these deflationary forces are still operative today. Foremost, technology continues to be deflationary as digitalization spreads wider (entertainment, office work, medicine, etc…) and communications facilitate offshoring (eg. IT in Bangalore). Supposedly accelerating technological disruption is now the key argument of many deflationistas (e.g. Cathie Wood of Ark Investments), even though over the past decades this was probably of secondary importance to the overall deflationary trend.

There is also a major new source of deflation, which is the high levels of debt accumulated around the world and, consequently, the collapse in “money velocity” (the creation of money through commercial bank lending). Though this is a controversial topic with economists, there are reasons to believe that the very high levels of debt around the world repress future economic growth. This is manifested by the decline in the money expansion created by bank lending over the past decades, and it explains why quantitative easing has had little impact on consumer prices. It may well be that debt levels are so high that any effort to raise real interest rates by central banks will tank economies. This view, pushed by the investor Ray Dalio, assumes that we have reached the peak of a long-term debt cycle.

On the other hand, there are new inflationary forces and some of the powerful deflationary forces of recent decades may have lost steam. These inflationary  factors can be listed as follows:

  • Commodity prices have surged recently and may continue to rise because of underinvestment caused by regulations and ESG lobbying. The shale revolution in the U.S. may have peaked out and may no longer provide a source of low-cost marginal production.
  • Labor in developed countries is now tight because of ageing populations, a decline in female participation rates and anti-immigration policies. The working age populations in most developed countries and in China are now in steep decline which should increase the cost of labor if productivity does not compensate.
  • Hyperglobalization may be under threat as reliance on China and other Asian manufacturing hubs is increasingly seen as irresponsible in an increasingly fraught geopolitical environment.
  • Hyperfinancialization is under question as unfettered capital flows have proven to be highly disruptive for both the United States and most emerging markets. Over this long deflationary period, chronic current account deficits have made the U.S. a net debtor to the world with a Net International Financial position going from positive 10% of GDP in 1981 to negative 86% of GDP in 2021.
  • The neoliberal revolution may have exhausted itself. Labor unions are showing signs of making a comeback and tax cuts have resulted in chronic deficits and record debt levels. Also, there is a growing realization that without government interference the U.S stands to lose jobs and stature to countries which actively support industries through subsidies and mercantilist policies (e.g. semiconductor manufacturing which may soon disappear from the U.S. unless the government supports it). Moreover, there are some signs of a resurgence in anti-trust efforts from Washington.

The debate between the “deflationistas” and the “inflationistas” will not be settled anytime soon. There are simply too many moving pieces and competitive forces at work to have high conviction now. Nevertheless, for the first time in decades the Fed may no longer have the wind at its back and the luxury to print trillions of dollars to support economic activity and financial markets. If the Fed is faced  with the choice between supporting the economy and financial markets or controlling inflation, political pressures will guide its decisions. In a world of populist politics this may mean higher prices in exchange for more government spending and higher wages.

The charts below show the inflation story in pictures.

Deflation has been a global trend since the 1980s.

But has also recently has been on the rise everywhere.

 

Commodity prices (relative to inflation) were extremely deflationary between 1980-2000 and 2012-2020, but are also rising sharply now.

 

The impact of deregulation on freight rail  rates.

The defenestration of labor unions.

 

Outsourcing has shifted share of GDP from workers to corporations.

The rate of growth of the working age population has collapsed.

Money velocity has collapsed as debt levels increase.

 

 

 

Another Emerging Markets Debt Crisis?

After ten years of extraordinary accommodative monetary policy, marked by a 2020 peak of $19 trillion in negative yielding debt, it is understandable that debt levels have grown to record high levels. Markets have been complacent about this accumulation of debt because of low servicing costs and persistent deflationary trends. However, recent developments that point to resurging inflation are now forcing central banks to seriously consider restrictive monetary policies, including positive real rates, that would lead to much higher servicing costs for highly leveraged governments, households and corporations. This is worrisome for emerging markets which do not tend to fare well during tightening cycles occurring after long periods of debt accumulation.

As the following chart from the Financial Times shows, developing countries debt levels are at record levels and have grown precipitously since the Great Financial Crisis. The total debt to GDP ratio for developing markets has more than doubled since the GFC.

 

The following chart shows the evolution since the GFC in more detail for EM countries. Debt  to GDP ratios  have nearly doubled for total debt as well as for government, household and corporate debt. These ratios would be even worse if not for the extraordinary policies of financial repression and negative real interest rates pursued in 2021, as central banks allowed inflation to surge.

 

Debt levels of many key EM countries, shown in the chart below, are now at levels which leave them highly vulnerable to economic stagnation and financial crisis. Asian EM countries (with the exception of Indonesia) and Chile and Brazil are all at very high levels in absolute terms and relative to their histories. China (considering SOE debt and overstatement of GDP), India (considering overstatement of GDP),  Brazil and Argentina all have levels of government debt close to 100%, a level which is considered highly debilitating by students of debt dynamics. China, given its capital controls and state-controlled banking system, may have the means to avoid financial disruptions but that is less true for the others, particularly for Latin American countries which have a history of rapid and profound shifts in capital flows and currently face strong capital flight from their own citizens.

 

The pace of increase in debt levels in recent years is also cause for concern. The chart below shows the increase in debt to GDP ratios over the past five years and during 2021.  Historical precedents point to countries facing high risk of debt-related crisis following a surge of their debt to GDP ratio  of 20% or more over a 5-year period. Last year was a year of acute financial repression by most central banks, so it is no surprise that debt levels came down for most countries. We can see the positive impact that this had for Brazil, in the next chart which shows how interest rates lagged inflation. Unfortunately, as the Scotiabank chart projection below shows, this effect will reverse in 2023, leading to high real rates.

Below, we focus on several key EM countries, each with its own vulnerabilities.

China

Debt levels have more than doubled since the GFC. If we assume that GDP figures need to be adjusted downwards by 20-25% to make them comparable to other countries, then debt ratios could be approaching 350%. Government debt has more than doubled over this period, and if we consider that almost all corporate debt is held by SOEs, then government debt would be well above 100%. The issue in China is not government solvency as the state has all the tools to keep the financial system operating smoothly. Rather, the vulnerability is that very high debt levels are choking the economy, and that the economy relies on unproductive debt-fueled growth to sustain growth. The consequence is that future growth levels can be expected to be low.

Brazil

Brazil’s debt levels are much too high for the economy to function properly and condemn the economy to low growth unless a serious fiscal reform or a productivity miracle occurs. Brazilian debt levels are at record high levels and they have risen by 60%  since the GFC, a period during which growth and investments have been very poor. The government debt ratio has risen by 50%, to finance current spending, while corporate debt  has risen by 70% and household debt has doubled. Government debt will likely reach 100% over the next year, which is much too high for a country with a structural deficit and which suffers from capital flight and political turmoil. Unlike in China, Brazil’s banks are private and managed very conservatively.

Korea

Kore’s debt ratio has risen by 50% since the GFC and is now one of the highest in the world. The government debt ratio has doubled over this period but remains at reasonable levels, and corporate debt has risen by 30%. Household debt has risen by 50% to 107% of GDP, an exceptional level, even higher than that of the consumption-happy United States. These very high debt levels would become a significant burden for the economy if interest rates rise, and could be a source of popular unrest with political consequences.

The Fed’s decade-long experiment in free money now may be at its end, leaving behind mountains of debt everywhere. Already weakened by the pandemic, political tensions and slowing growth, many emerging markets will add higher interest bills to their woes.

Global Growth Prospects

The World Bank has significantly reduced its growth outlook for 2022 and is  concerned that we may be facing “global stagflation.”  The World Bank’s “Global Economic Prospects June 2022″ report   highlights  the vulnerability of lower income economies in the current environment of lower growth and rising food and energy prices. Nevertheless, the bank  retains a relatively sanguine view, as it sees a persistently vibrant U.S. economy and declining commodity prices in both 2023 and 2024.

The chart below resumes the World Bank’s latest real GDP forecasts for emerging market economies  and several  important frontier markets (Nigeria, Pakistan, Bangladesh and Vietnam.) The bank’s forecast provides growth estimates through 2024. The chart ranks countries in terms of their 3-year average real GDP growth for the 2022-2024 period. The two columns on the right show the changes since the bank’s prior forecast six months ago which was made prior to the Ukraine invasion and the COVID lockdowns in China. Given its mandate, the bank tends to be “politically correct” in its forecasts. Historically, this has resulted in the bank usually accepting China’s official targets, and in this case it may explain the optimistic forecast for the U.S.  The relatively low economic cost to Russia  for the invasion of Ukraine (well below most other estimates) is difficult to explain.

As we have come to expect, most of the world’s growth will come from Asia where the bank expects stellar GDP growth in India, Bangladesh, Vietnam, the Philippines and Indonesia. This kind of growth is probably not priced in for the stock markets of Indonesia and the Philippines.  Egypt’s high expected growth is also surprising good news for this normally struggling economy and should be supportive of  higher asset prices. Though Malaysia’s expected growth is not as stellar, stock prices there are very low and also provide good prospects.

Also, in what has become the  “new normal,” growth prospects in Latin America and South Africa are dismal. Chile and Brazil are at the bottom of the chart, and would be last if not for the dramatic woes inflicted by Putin on Russia. In the case of both Chile and Brazil these GDP forecasts are likely optimistic if Chile’s new constitution is approved as currently expected and if Lula wins the election in Brazil as is also the most likely scenario. The one  Latin American exception — Colombia — is a big if, as the World Bank’s forecast is certainly wildly optimistic should the former guerilla fighter Gustavo Petro win the election on June 19. As in the case of Chile, Colombia faces capital flight and low investments for the foreseeable future.

O Fiasco Imobiliário do Conde de Ipanema

História da Família Ipanema de Moreira

Há duas ruas no Rio de Janeiro que comemoram a passagem de José Antonio Moreira. Uma é a Rua Barão de Ipanema no bairro da Praia de Copacabana e a outra, a Rua Conde de Ipanema na vizinha Praia de Ipanema. Pouco se escreveu sobre esse influente empresário e financista brasileiro da colônia portuguesa de Dom João VI e do império de Dom Pedro I e Dom Pedro II. Como ele é meu antepassado, montei uma biografia curta e resumida baseada em documentos públicos e arquivos familiares. Sua história reflete a modernização do Brasil no século 19 – de uma economia de plantação escravagista para uma nação moderna em industrialização. É também uma história da má fase de  especulação imobiliária e a dissipação de riqueza por descendentes ociosos.

A trilha da família Ipanema de Moreira começa na cidade de São Paulo, Brasil, no final do século XVIII. José Antonio Moreira, futuro Conde de Ipanema, nasceu em São Paulo, em 23 de outubro de 1797, filho de José Antonio Moreira (Pai) e D. Ana Joaquina de Jesus. A família era de origem nobre, do Distrito de Braga no norte de Portugal. Moreira era um nome comum em Portugal, com o significado de amoreira, por vezes associado à comunidade dos “conversos” (conversão forçada de judeus à igreja católica).

José Antonio Moreira (pai) era um próspero comerciante de São Paulo com ligações estreitas com a administração colonial. Desempenhou um papel fundamental no desenvolvimento do primeiro empreendimento industrial moderno do Brasil, a siderúrgica de Ipanema (Fundição Ipanema).

A invasão de Portugal por Napoleão fez com que a corte portuguesa de Dom João VI fugisse para o Rio de Janeiro em 1808. Dom João VI eliminou imediatamente todas as restrições mercantilistas existentes à manufatura domestica e apoiou ativamente a autossuficiência industrial. A fundição de ferro foi considerada de alta prioridade, e uma área com depósitos de ferro nas proximidades da cidade de  São Paulo foi escolhida como o local para o desenvolvimento.

A existência de jazidas de minério de ferro na Serra de Ipanema em uma área conhecida como Fazenda Ipanema, próxima à vila de Iperó, 125 km ao noroeste  da cidade de São Paulo, era conhecida desde os primórdios da colonização portuguesa. O local escolhido para a fundição de ferro localizava-se no rio Ipanema, afluente do rio Sorocaba, e era cercado por matas que poderiam ser usadas como combustível para a fundição. A área já havia sido habitada por índios tupis, que a batizaram de “Ipanema”, em referência a um rio que ali nasce. Ipanema significa “água estagnada ou estéril” em tupi-guarani.

A sociedade foi constituída por Carta Régia em 4 de dezembro de 1810 como sociedade  acionista  de economia mista, com 13 ações pertencentes à Coroa portuguesa e 47 a acionistas  privados, empresários com ligações à corte. José Antonio foi um investidor fundador, e provavelmente representava os interesses da coroa.  O projeto era de grande interesse para Dom João IV, que contou com o apoio técnico de especialistas suecos e alemães, e sabe-se que visitou a fábrica em várias ocasiões.

A Serralheria da Fazenda Ipanema, conhecida como Real Fábrica de Ferro de São João de Ipanema, fundiu seu primeiro ferro em 1816 e funcionou até 1895. Abaixo, uma foto de 1890.

 

O empreendimento, que pode ser considerado o primeiro empreendimento industrial moderno do Brasil, incluiu uma barragem e uma ferrovia de 4 km ligando as jazidas de minério de ferro à usina. A área é agora um parque nacional e uma atração turística popular. As estruturas do moinho estão intactas, como mostram as fotos abaixo, e podem ser visitadas pelo público.

A localização geográfica do local é mostrada nos mapas abaixo.

José Antonio Moreira, tanto o pai  como o filho, se envolveram ativamente na Fundação Ipanema. O futuro Conde de Ipanema, referido daqui em diante como José Antonio Moreira, se envolveu na  Fundação Ipanema desde cedo e permaneceria ligado aos empreendimentos industriais da metalurgia na primeira onda de industrialização do Brasil durante o regime imperial.

Desde a época da Fundação Ipanema, a família Moreira manteve-se intimamente ligada à corte imperial do Rio de Janeiro. No início da década de 1820, José Antonio Moreira estabeleceu-se no Rio de Janeiro, onde em 1823 casou-se com D. Laurinda Rosa Ferreira dos Santos, filha de um comerciante português do Porto. Ela nasceu no Rio de Janeiro em 1808 e faleceu em Bruxelas em 1881. Tiveram  seis filhos: José Antonio Moreira Filho, o futuro 2º Barão de Ipanema (1830-1899); João Antonio Moreira (1831-1900); Joaquim José Moreira (1832-?); Manoel Antônio Moreira (1833-?); Laurinda Rosa Moreira (1837-1920); Mariana Rosa Moreira (1842-?) e Francisco Antônio Moreira (1845-1930). Francisco Antonio Moreira é meu tataravô.

José Antonio casou-se com uma das famílias mais ricas do Rio de Janeiro imperial. Seu sogro era José Ferreira dos Santos, um comerciante de grande destaque. Uma pesquisa recente do professor de história da UCLA William Summerhill revela que José Ferreira dos Santos foi membro da Junta Administrativa da Caixa de Amortização de 1840 a 1846. Os membros desta comissão parlamentar – “capitalistas nacionais… e os maiores detentores da dívida nacional” – supervisionaram as operações do Tesouro para garantir o pagamento das obrigações da dívida soberana. O próprio José Antonio fez parte desta comissão de 1859-1869. Durante esse longo período de prosperidade sob o imperador Dom Pedro II, tanto José Antonio quanto seu sogro estavam entre os maiores detentores de títulos do governo, as chamadas “apólices”, no que era um mercado altamente concentrado. (Summerhill fornece um relato fascinante das finanças do Império em seu livro Revolução Inglória. Esse período prolongado é único na história brasileira pela credibilidade impecável do estado brasileiro.)

O sucesso de José Antonio como empresário e financista e seu serviço à Corte Imperial foram reconhecidos em inúmeras ocasiões com as mais altas condecorações : Comendador da Imperial Ordem de Cristo e Dignitário da Imperial Ordem da Rosa, 1845; Baronato de Ipanema,1847; Grandezas de Barão de Ipanema, 1849; Viscondado com Grandeza de Ipanema, 1854; e Conde de Ipanema, 1868. A associação de José Antonio com a Siderurgia e Metalurgia de Ipanema fica clara pela escolha do nome Ipanema. (Títulos imperiais de nobreza eram concedidos com base no mérito e serviço à coroa e, geralmente, não eram hereditários.)

Os escudos heráldicos dos Moreiras portugueses e dos Ipanemas brasileiros estão ilustrados abaixo. Repare que ambos os escudos têm a cruz florida, que em Portugal era o símbolo dos Cavaleiros de São Bento de Aviz, ordem de cavalaria fundada em 1146. O escudo de Ipanema também tem uma linha azul com cinco estrelas (representando o Rio Ipanema) e um Caduceu de Hermes (que representa a sabedoria).

Em 1844, durante o reinado de D. Pedro II (1831-89), o Brasil adotou políticas de promoção da industrialização e substituição de importações de produtos manufaturados, incluindo tarifas rígidas de até 60% sobre as importações. Antes dessa reforma, o país dependia amplamente de importações britânicas. A mudança de política resultou na primeira onda de industrialização do Brasil, que teve como principal empresário Irineu Evangelista de Sousa (Visconde de Mauá). José Antonio Moreira foi um dos primeiros sócios de investimentos e conselheiro do Visconde de Mauá. Evidentemente, José Antonio fez bom uso de suas conexões com a corte imperial  e seu expertise em metalurgia nesse período, e coinvestiu com o Visconde de Mauá em empreendimentos siderúrgicos, estaleiros, bancários, de barcos a vapor e ferroviários.

José Antonio Moreira foi o primeiro presidente do Banco do Brasil, um empreendimento de Visconde de Mauá, que foi crucialmente importante no financiamento da industrialização inicial do Brasil e que ainda hoje, desempenha um papel vital na economia brasileira. Curiosamente, nos documentos de afretamento da fundação do Banco do Brasil, José Antonio é descrito como um “empresário nacional envolvido no negócio de navios e generos nacionais”.

José Antonio também fez parcerias comerciais com investidores estrangeiros, incluindo empresas siderúrgicas na Bélgica. A partir de meados da década de 1850 José Antonio se envolveu com Bruxelas, e em 1860 sua esposa, D. Laurinda Rosa Ferreira dos Santos, passa a residir lá. A partir desta época, quatro de seus seis filhos se estabelecem em Bruxelas: Manoel Antonio, Mariana Rosa, Laurinda Rosa e Francisco Antonio Moreira. Manoel permanece em Bruxelas, onde serve como cônsul geral do Brasil, e seu filho, Alfredo de Barros Moreira, se torna o primeiro embaixador do Brasil na Bélgica.

Temos dois retratos de José Antonio. O primeira é um esboço dele quando jovem; o segundo, datada da década de 1860, mostra-o no auge.

Na fase final de sua vida na década de 1870, José Antonio Moreira compra uma propriedade localizada a cerca de 12 km ao sul do centro da cidade do Rio de Janeiro. Essa área com mais de 3 km de praia de frente para o Atlântico é hoje conhecida como o bairro da Praia de Ipanema.

A propriedade foi comprada em 1878 e inicialmente usada como casa de campo (chacara). Abaixo, uma representação artística da área na década de 1870 pelo pintor Eduardo Camões (n. 1955- ).

O mapa abaixo mostra a propriedade no contexto do Rio de Janeiro atual. A “chacara” se estendia da ponta sul da Praia de Copacabana (delineada pela atual Rua Barão de Ipanema) até o canal que liga o oceano à Lagoa Rodrigo das Freitas e cria a divisão entre os bairros de Ipanema e Leblon. A propriedade se estendia por partes do atual Leblon, incluindo o atual local do clube esportivo Monte-Libano.

O terreno adquirido por José Antonio Moreira era conhecido na época como “Praia de Fora de Copacabana”, que fazia parte de uma área maior chamada “Fazenda Copacabana”. A maior parte da propriedade foi comprada de um empresário francês, Charles Le Blond, dono de uma operação baleeira chamada “Alianca” que detinha o monopólio de abastecimento de óleo de baleia à cidade do Rio de Janeiro.  Le Blond faliu na década de 1860 quando o Visconde de Mauá introduziu iluminação a gás à cidade do Rio de Janeiro, e isso foi o provável motivo pela venda do imóvel. Os vestígios da operação baleeira de Le Blond incluem os nomes dos bairros da Praia do Leblon e da Praia do Arpoador, no ponto mais leste da Praia de Fora. O promontório rochoso que separa a Praia do Arpoador de Copacabana teve um papel importante na operação baleeira como um mirante ideal para detectar grupos de baleias migratórias.

A área era originalmente ocupada por índios tamoios e, brevemente, na década de 1550 o local de um posto militar francês. Conta a história que um antigo governador português erradicou a população indígena, fornecendo-lhes cobertores infectados com varíola (aparentemente uma prática comum no século XVI).

As partes sul e oeste da Fazenda Copacabana também foram amplamente utilizadas para grandes moendas de cana-de-açúcar e pastoreio de gado dos séculos XVI a XIX na área que se estende do Leblon ao Jardim Botânico. A parte leste da Fazenda Copacabana (atual Copacabana e Ipanema) era imprópria para a agricultura por causa do solo arenoso e ácido (restinga) e, no caso de Ipanema, inundações frequentes da lagoa. Uma das poucas construções na  região era a Igreja de Nossa Senhora de Copacabana,  um convento carmelita erguido no início do século XVI. O convento continha uma cópia de uma estátua da Virgem Maria da Igreja de Nossa Senhora de Copacabana às margens do Lago Titicaca, no Peru, que se dizia ter qualidades milagrosas; e daí o nome da praia.

Muito provavelmente, a compra da propriedade da Praia de Fora foi realizada como uma aposta especulativa imobiliária com grandes perspectivas futuras. Empresário de destaque, ligado ao Visconde de Mauá e à administração imperial, o Conde de Ipanema conhecia os planos de desenvolvimento urbano da cidade. No centro dessa visão estava a Companhia Ferro-Carril Jardim Botânico, empreendimento do Visconde de Mauá, que planejava expandir suas trilhas de bondes para as praias do sul do Rio de Janeiro. Com certeza, estava a par da moda europeia em meados do século XIX de frequentar resorts praianos, tornados possível pela expansão de ferrovias e por uma crescente valorização dos benefícios do mar à saúde. Infelizmente, o Conde faleceu em 1879, deixando o futuro desenvolvimento da área nas mãos de seu filho mais velho.

José Antonio Moreira Filho tinha 49 anos quando seu pai faleceu. Parece ter sido um empresário de sucesso por conta propria e muito estimado pela Corte Imperial, tendo sido condecorado em várias ocasiões: Comendador da Ordem Militar de Cristo e da Ordem de Nossa Senhora da Conceição de Vila Vicosa (o prêmio dado pelo soberano por serviços prestados à Casa Real). Recebeu  o baronato por decreto em 1885 e a grandeza por decreto em 1888. Em 1856 casou-se com D. Luiza Rudge (1838-1891), filha de George Rudge e Sofia Maxwell. Seu sogro era Joseph Maxwell (1772-1854), um dos homens mais ricos do Brasil, fundador da casa de corretagem Maxwell Wright, um estabelecimento comercial com fortes ligações aos mercados americano e britânico e um dos principais participantes do boom de exportação do café, assim como um facilitador do comércio do triângulo atlântico (importação de grãos e produtos manufaturados na América, exportação de café, e comércio de escravos da África). Os Rudges eram parceiros de negócios de Joseph Maxwell. As duas familias Rudge e Maxwell eram originalmente comerciantes de Gloucester, Inglaterra. José Antonio Filho e Luiza Rudge tiveram cinco filhos – Carlos, Luiza Sophia, José Jorge, Carlos Alfredo, Laurin Rosa e Sophia, Emília – todos assumiram o sobrenome Ipanema de Moreira e viveram suas vidas no Rio de Janeiro.

Abaixo, o único retrato que temos de José Antonio Filho  feito na década de 1870, antes de se tornar o Barão de Ipanema.

Temos também uma pintura dos dois filhos mais velhos, Carlos e Luiza, posando em uma rede em Ipanema com a Lagoa Rodrigo da Freitas e o Pico da Catacumba ao fundo.

Os planos de José Antonio Moreira Filho para a “Praia de Fora” dependiam da melhoria do acesso às praias do sul. Durante a década de 1880 o acesso à  região era feito por turistas ocasionais principalmente pelo mar. Isso mudou quando, em 1892, a Companhia Ferro-Carril Jardim Botânico inaugurou o Túnel de Copacabana (hoje Alaor Prata), ligando a Praia de Botafogo à Praia de Copacabana e fornecendo serviço de bonde entre o centro do Rio e as praias do sul. Uma linha de bonde cobrindo toda a extensão da praia de Copacabana foi concluída no início de 1894.

Antecipando a ampliação do serviço de bondes, foi oficialmente lançado  em abril de 1894 o projeto de incorporação imobiliária da Vila Ipanema. Os terrenos de Copacabana e Leblon não foram incluídos na Vila Ipanema, e não se sabe se foram doados à prefeitura ou incorporados a outros empreendimentos em promoção na época.

O layout da Vila Ipanema pode ser visto nos dois documentos abaixo. O primeiro, datado de 1894), é o projeto urbanístico original encomendado a Luiz Rafael Vieira Souto, engenheiro-chefe da Prefeitura do Rio de Janeiro. O segundo, de 1919, é de um folheto de marketing.

A Vila Ipanema dividiu a área em 45 blocos. Cada bloco padrão era dividido em 40 lotes, cada um medindo 10 metros por 50 metros. Foram lançados no mercado mais de um milhão de m2 de imóveis.

O lançamento inicial incluia 19 ruas e duas praças públicas (General Osório e Nossa Senhora da Paz). A maioria dos nomes das ruas homenageava parentes, associados e aliados políticos do Barão e seus parceiros. Por exemplo, a via principal na época do lançamento era a Rua 20 de Novembro (atual R. Visconde de Pirajá), que comemorava a data de nascimento de D. Luiza Rudge. Dos nomes originais restam poucos: R. Alberto Campos (cunhado) permanece; Avenida Vieira Souto, em homenagem ao urbanista, ainda enfeita a orla.

José Antonio Moreira Filho teve vários sócios na Vila Ipanema: Coronel Antonio José Silva, José Luis Guimarães Caipora e Constante Ramos. O Coronel incorporou o terreno que possuía na Praia de Fora ao projeto Vila Ipanema. Em 1901 os acionistas da Vila Ipanema eram os seguintes: a família Ipanema de Moreira, 90%; E. de Barros, 6,5%; Coronel Silva, 3,5%; Ulisses Vianna, 1,0%.

A sorte de José Antonio Moreira Filho parece ter se esgotado em seus últimos anos. Vila Ipanema foi lançada quando estava com 64 anos e com problemas de saúde. Dada sua intimidade com a corte imperial, a deposição de Pedro II em 1889 e seu exílio em Paris podem ter prejudicado seriamente seus negócios. Certamente, quando o conde adquiriu a propriedade, não havia previsto o fim do regime imperial. A proclamação da Primeira República em 1889 foi seguida de instabilidade política e crise econômica, e a fuga de capital humano e financeiro. Nos cinco anos após o golpe de Estado que derrubou D. Pedro II até o lançamento da Vila Ipanema em 1894, o real, a moeda brasileira, perdeu 60% de seu valor em relação ao dólar americano, e perderia outros 40% até se estabilizar em 1899. A década de 1890 também veria a ascensão de São Paulo como o centro econômico dinâmico do Brasil e o polo de atração para ondas de imigrantes italianos e japoneses.

Em meados da década de 1890 quase toda a família Ipanema de Moreira se instalou na Europa, mais especificamente em Paris ou Bruxelas. O Brasil, por sua vez, se tornou uma memória distante. Com o falecimento do Barão em 1899, o controle majoritário da Vila Ipanema passou para seu filho Francisco Antonio Moreira que residia em Paris, tendo se mudado do Brasil havia 40 anos.

O seguinte relato do filho de Francisco Antonio (sobrinho do barão), Alberto Jorge de Ipanema Moreira, dá um um pouco de cor à história:

“Na primavera de 1898 viajamos para o Rio, meu pai, minha tia e eu. Meu pai e minha tia foram tentar resgatar o que restava de uma fortuna brilhante.  Seu irmão e também procurador, o Barão de Ipanema, estava velho e doente e seus negócios haviam falido. A única coisa que restara eram as imensas terras em Copacabana e a “Praia do Arpoador” agora rebatizada de “Vila Ipanema”. Após a morte do Barão de Ipanema, foi feito um acordo entre seus herdeiros de um lado e meu pai e minha tia do outro, de que as terras que haviam sobrado para venda seriam divididas da seguinte forma: 35% para os herdeiros e 65% para meu pai e minha tia. Embora nascidos no Rio, meu pai, minha tia e minha mãe – ela de descendência inglesa, Rudge por parte de pai e Maxwell por parte de mãe –pouco conheciam o Rio, tendo sido enviados ainda muito jovens para estudar na Inglaterra.  Tinham pouca noção dos ativos que possuiam no Brasil.”

Franciso Antonio Moreira, meu tataravô, era um bon vivant que desfrutava da boa vida entre Paris e Nice. Era casado com D. Maria Tereza Rudge, a segunda filha de Joseph Maxwell. Pressupostamente, ambos eram herdeiros de grandes fortunas. No entanto, parece que eles viveram muito além de seus meios consideráveis. Seu filho Alberto Jorge conta mais:

“Era de se supor que esse acordo familiar seria muito favorável para meus pais. Não foi bem assim; muito pelo contrário, viveram os trinta anos seguintes recebendo apenas migalhas. Este grande capital foi se esvaindo e serviu apenas para cobrir as despesas mais básicas e indispensáveis. Os lotes de Ipanema vendiam mal, e meu pai queria vende-los a qualquer preço. Ele nasceu um grande senhor e não tinha noção de economia. Muito elegante e garboso, gostava muito de esportes, especialmente a cavalo; generoso, extremamente caridoso e de uma retidão incomum, não via o mal em nada e não havia sido educado para administrar uma fortuna”.

Francisco Antonio teve seis filhos: Alberto Jorge (diplomata brasileiro), Maria Luiza minha bisavó que se casou com Eugene Robyns de Schneidauer, diplomata belga, Leonora, Maria Thereza e José. Todos residiram e faleceram na Europa. A primeira foto mostra Francisco Antonio por volta de 1900 em trajes cerimoniais da corte. A segunda é um retrato da família feito em 1929, perto do final de sua vida, com ele sentado no meio, ao lado de sua esposa.

As fotos a seguir mostram a Praia de Ipanema na virada do século 19 e em 1930. Observe como ainda era pouco desenvolvida em 1930, ainda com paisagem de restinga.

As vendas dos lotes da Vila Ipanema ocorreram de forma muito lenta, pois ninguém queria investir naquele “fim de mundo”. Isso se deveu em parte à concorrência de desenvolvedores na Praia de Copacanana, onde haviam muitas ofertas com maior proximidade ao centro da cidade e do transporte público. Além disso, embora Ipanema e Copacabana fossem comercializados como “saudáveis ​​e higiênicos”, Ipanema era assolada por enxames de mosquitos quando a lagoa inundava periodicamente.

As vendas fracas também foram causadas pelo atraso na expansão do serviço de bondes, que chegou à Praça General Osório apenas em 1902. Até o final daquele ano, apenas 112 lotes haviam sido vendidos, o que representava apenas cerca de 6% do estoque disponível.

As despesas de desenvolvimento também sairam fora de controle. As despesas de capital, administrativas e de vendas ainda ocupavam mais de 60% das receitas no início de 1900. Devido aos altos custos de construção, em 1905 passou-se o trabalho de desenvolvimento para uma empreiteira, a Companhia Construtora de Ipanema, que havia feito trabalhos semelhantes em Copacabana e Leblon. Em 1906, esta empresa completou os taludes da lagoa, dando uma solução permanente às inundações.

A tabela abaixo mostra o fluxo de receita de vendas da Vila Ipanema de 1900 a 1930, época em que restavam poucos lotes. Esses números são apresentados em dólares americanos de 2020, ajustados pela inflação e pela depreciação da moeda. O real perdeu metade de seu valor nesse período. O pico das vendas ocorreu entre 1911-1915, período de pujança econômica e valorização do real. A evolução do real de 1984 a 1930 é mostrada no gráfico a seguir.

 

Nesse período de 30 anos, a receita bruta total da Vila Ipanema foi de US$ 15,1 milhões (USD constante em 2020). A receita líquida após todas as despesas foi de US$ 12 milhões, dos quais US$ 6,5 milhões foram para meu tataravô, Antonio Francisco Moreira. Na época de sua morte, em novembro de 1930, restava apenas uma pequena fração desse capital.

É claro que, em retrospecto, é fácil dizer que esse capital foi grosseira e irresponsavelmente dilapidado. Ipanema hoje é um bairro de luxo e um apartamento à beira-mar na Praia de Ipanema pode custar de 3 a 4 milhões de dólares. Inquestionavelmente, a melhor estratégia para um investidor de longo prazo teria sido construir um grande muro ao redor da propriedade e esperar.

No entanto, até as ultimas décadas mais recentes, a realidade é que Ipanema permaneceu um bairro pacato e distante, principalmente se comparado a Copacabana. Foi apenas na década de 1960 que começou a virar  um lugar de moda. Desde a década de 1960, o centro social e cultural do Rio de Janeiro deslocou-se rapidamente para as praias do sul, levando a uma grande valorização imobiliária.

Quando a família de Antônio Carlos (Tom) Jobim se mudou para Ipanema em 1933, foi porque sua mãe, recém divorciada, não tinha condições de morar em um bairro mais abastado. Por esse mesmo motivo, uma onda de imigrantes se estabeleceu ali depois da Segunda Guerra Mundial.

Na década de 1960, a geração de Antonio Carlos Jobim tornou Ipanema famosa com a Bossa Nova. Foi da esplanada do Bar Veloso na Avenida Prudente de Moraes que Jobim avistou a “menina de Ipanema”, Helô Pinheiro, voltando da praia para casa de biquíni, e o resto é história.

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The Count of Ipanema’s Real Estate Fiasco

History of the Ipanema de Moreira Family

There are two streets in Rio de Janeiro that commemorate the passage of Jose Antonio Moreira. One is the Rua Barao de Ipanema in the neighborhood of Copacabana Beach and the other the Rua Conde de Ipanema in the adjacent Ipanema Beach. Not much has been written about this influential Brazilian entrepreneur and financier of the Portuguese colony under Dom Joao VI and of the empire under Pedro I and Pedro II. Since he happens to be my ancestor, I have  put together a short and sketchy biography which relies on public documents and family archives. His story reflects the modernization of Brazil in the 19th century – from a slavery-manned plantation economy to a modern industrializing nation. It is also a tale of poor timing in real estate speculation and the dissipation of wealth by idle descendants.

The trail of the Ipanema de Moreira family starts in the city of Sao Paulo, Brazil in the late 18th century.  Jose Antonio Moreira, the future Count of Ipanema, was born in Sao Paulo, October 23, 1797, the son of Jose Antonio Moreira (Father) and Ana Joaquina de Jesus. The family was of noble origin, from the Braga District of northern Portugal. Moreira is a common name in Portugal, meaning mulberry tree, sometimes associated with the community of “conversos.” (Forced conversion of Jews to the Catholic faith)

Jose Antonio Moreira (father) was a prosperous merchant in Sao Paulo with close links to the colonial administration.  He had a key role in developing Brazil’s first modern industrial enterprise, the Ipanema iron works (Fundicao Ipanema).

Napoleon’s invasion of Portugal caused the Portuguese court of Dom Joao VI to flee to Rio de Janeiro in 1808. Dom Joao VI immediately eliminated all existing mercantilist restrictions on domestic manufacturing and actively supported industrial self-sufficiency. Iron smelting was considered a high priority and an area of with iron deposits in the vicinity of the city of Sao Paulo was chosen as a site for development.

The existence of iron ore deposits on the Ipanema Hills in an area known as the Fazenda Ipanema, nearby the village of Iperó, 125 km northwest of the city of Sao Paulo, had been known since the early days of the Portuguese colony. The site chosen for the iron smelter was located on the Ipanema River, a tributary of the Sorocaba River, and was surrounded by forests which could be used as fuel for smelting. The area had previously been inhabited by Tupi Indians, who had named it “Ipanema,” a reference to a river that has its source there. Ipanema means “stagnant or barren water” in Tupi-Guarani.

The company was established by Royal Charter in December 4, 1810 as a mixed capital shareholder company, with 13 shares belonging to the Portuguese Crown and 47 to private shareholders, businessmen with connections to the court. Jose Antonio probably represented the crown’s interests and was a founding investor. The project was of keen interest to Dom Joao IV who enlisted technical support from Swedish and German specialists, and he is s known to have visited the mill on multiple occasions.

The Fazenda Ipanema Ironworks, known as the Real Fábrica de Ferro de São João de Ipanema, smelted its first iron in 1816 and operated until 1895.  A picture from 1890 is shown below.

The enterprise, which can be considered Brazil’s first modern industrial undertaking, included a dam and a 4-km railroad connecting the iron ore deposits with the plant. The area is now a national park and a popular tourist attraction. The structures of the mill are intact, as shown in the pictures below, and can be visited by the public.

The geographical location of the site is shown in the maps below.

Jose Antonio Moreira, both father and son, were actively involved with the Fundicao Ipanema.  The future Count of Ipanema, who will be referred to as Jose Antonio Moreira from now on, was involved with the Ipanema Fundicao from an early age, and he would remain connected to industrial ventures in metallurgy and metal-working in Brazil’s first wave of industrialization during the imperial regime.

From the time of the Fundicao Ipanema, the Moreira family remained closely tied to the imperial court in Rio de Janeiro. By the early 1820s, Jose Antonio Moreira had settled in Rio De Janeiro where in 1823 he married Laurinda Rosa Ferreira dos Santos, the daughter of a Portuguese merchant from Porto.   She was born in Rio de Janeiro in 1808 and died in Brussels in 1881. They has six children: José Antonio Moreira Filho, the future 2 º Barão de Ipanema (1830-1899); João Antonio Moreira (1831-1900); Joaquim José Moreira (1832-?); Manoel Antônio Moreira (1833-?); Laurinda Rosa Moreira (1837-1920); Mariana Rosa Moreira (1842-?) and Francisco Antônio Moreira (1845-1930). (Francisco Antonio Moreira was my great-great-grandfather.)

Jose Antonio married into one of imperial Rio de Janeiro’s wealthiest families. His father-in-law was Jose Ferreira dos Santos, a highly prominent merchant. Recent research by UCLA history professor William Summerhill reveals that Jose Ferreira Dos Santos was a member of the Junta Administrativa da Caixa de Amortizacao from 1840-46. The members of this parliamentary commission — “national capitalists…and the largest holders of the national debt”  — oversaw the Treasury’s operations to ensure payment of sovereign debt obligations. Jose Antonio himself was to sit on this commission from 1959-1969. During this extended period of prosperity under Emperor Pedro II, both Jose Antonio and his father-in-law were among the largest holders of government bonds, so-called “apolices,” in what was a highly concentrated market. (Summerhill provides a fascinating account of the Empire’s finances in his book Inglorious Revolution. This extended period is unique in Brazilian history for the impeccable creditworthiness of the Brazilian state.)

Jose Antonio’s success as an entrepreneur and financier and his  service to the Imperial Court was recognized on numerous occasions with the highest honors:  Comendador da Imperial Ordem de Cristo and Dignitário da Imperial Ordem da Rosa (Commander of the Order of Christ and Officer of the Imperial Order of the Rose), 1845; Baronato  de Ipanema (Barony), 1847;  Grandezas de Barão de Ipanema (Barony Grandee), 1849; Viscondado com Grandeza  de Ipanema (Viscount Grandee), 1854; and Conde de Ipanema, 1868 (Count).  Jose Antonio’s association with the Ipanema Iron Works and metallurgy are made clear by the choice of the Ipanema name.  (Imperial titles of nobility were awarded on the basis of merit and service to the crown and, generally, were not hereditary.)

The heraldic shields of both the Portuguese Moreiras and the Brazilian Ipanemas are shown below. Notice that both shields have the flourished cross, which in Portugal was the symbol of the Knights of Saint Benedict of Aviz, an order of chivalry founded in 1146. The Ipanema shield also has a blue line with five stars (representing the Ipanema River) and a Caduceu of Hermes (wisdom).

 

In 1844, during the reign of Pedro II (1831-89), Brazil adopted policies to promote industrialization and the import-substitution of manufactured goods , including stiff tariffs of up to 60% on imports.  Prior to this reform, the country had relied extensively on British imports. The policy shift resulted in Brazil’s first wave of industrialization, which had as its leading entrepreneur Irineu Evangelista de Sousa (Visconde de Maua). Jose Antonio Moreira was an early investment partner and adviser to the Visconde de Maua.  It is clear that Jose Antonio put his court connections and expertise in metallurgy to good use over this period, and he coinvested with the Visconde de Maua in steel, shipyard, banking, steamboat and railroad ventures.

Jose Antonio Moreira was the first president of the Banco do Brasil, a Visconde de Maua venture that was crucially important in financing Brazil’s early industrialization and still plays a vital role in Brazil’s economy today.

Interestingly, in the Banco do Brasil’s founding charter documents Jose Antonio is described as a “national businessman involved in the business of ships and national goods” (comercio de navios e generos nacionais).

Jose Antonio also had business partnerships with foreign investors, including steel concerns in Belgium. From the mid-1850s Jose Antonio is connected to Brussels, and in 1860 his wife, Laurinda Rosa Ferreira dos Santos, takes up residence there. From this time, four of their six children are established in Brussels: Manoel Antonio, Marriana-Rosa, Laurinda Rosa and Francisco Antonio Moreira. Manoel remained in Brussels where he served a Brazil’s general consul, and his son, Alfredo de Barros Moreira, would serve as Brazil’s first ambassador to Belgium.

We have two portraits of Jose Antonio. The first is a sketch of him as a young man; the second, dating from the 1860s, shows him in his prime.

It was during the final phase of his life in the 1870s that Jose Antonio Moreira purchased an estate located some 12 km south of the center of the city of Rio de Janeiro. This area with more than 3 km of beaches facing the Atlantic is now known as the Ipanema Beach neighborhood.

The estate was purchased in 1878 and initially it was used as a country house (chacara). An artistic rendition of what the area may have looked like in the 1870s by the painter Eduardo Camoes  (b. 1955- ) is shown below.

The map below shows the estate in the context of today’s Rio de Janeiro. The “chacara” extended from  the southern tip of Copacabana Beach (delineated by the current Rua Barao de Ipanema) to the canal that connects the ocean with the Rodrigo das Freitas Lagoon and creates the division between the neighborhoods of Ipanema and Leblon. The property stretched into parts of modern-day Leblon, including the current site of the Monte-Libano sports club.

 

The land purchased by Jose Antonio Moreira was known at the time as “Praia de Fora de Copacabana,” which was part of a larger area called the “Fazenda Copacabana.” Most of the property was purchased from Charles Le Blond, a French entrepreneur who ran a whaling operation called “Alianca´ and had secured a monopoly on supplying Rio de Janeiro with whale oil. Le Blond went out of business in the 1860s when the Visconde de Maua introduced gas lighting to the city of Rio de Janeiro, and this may have provoked the sale of the property.  Vestiges of Le Blond’s whaling operation include the names of the Leblon Beach neighborhood as well as Arpoador  (Harpooner) Beach at the easternmost point of  Praia de Fora. The rocky promontory which separates Arpoador Beach from Copacabana  played an important part in the whaling operation as an ideal lookout to detect migrating pods of whales.

The area was originally occupied by Tamoia Indians, and, briefly, in the 1550s it was the site of a French military outpost. Reportedly, an early Portuguese governor eradicated the Indian population by furnishing them with blankets infected with smallpox (apparently a common practice in the 16th century).

The southern and western parts of the “Fazenda Copacabana” also were widely used for large sugar cane milling operations and cattle grazing from the 16th to the 19th centuries in the area which stretches from Leblon to the Jardim Botanico. The eastern part of the Fazenda Copacabana (modern day Copacabana and Ipanema) were inappropriate for farming because of sandy, acidic soil (restinga) and, in the case of Ipanema, frequent flooding from the lagoon.  One of the few structures in the area was the Igreja of Nossa Senhora de Copacabana, a Carmelite hermitage founded in the early 16th century. The hermitage had a copy of a statue of the Virgin Mary from the Church of Nossa Senora de Copacabana on the shores of Lake Titicaca in Peru which was said to have miraculous qualities, and that is the source of the name of the beach.

In all likelihood, the purchase of the Praia de Fora estate was made as a farsighted speculative real estate bet. As a prominent businessman with close ties to the Viscount of Maua and the imperial administration, the Count of Ipanema knew the city’s plans for urban development. Central to this vision was the Companhia Ferro-Carril Jardim Botanico, a Viscount of Maua venture, that was planning to expand its tramway coverage to the southern beaches of Rio de Janeiro. Moreover, he was certainly aware of the mid-19th century European boom in beach resorts made possible by railroads and by a newfound appreciation for the health benefits of the sea. Unfortunately, the Count passed away in 1879, leaving the future development of the area in the hands of his eldest son.

 

Jose Antonio Moreira Filho was 49 years old when his father passed away.  He appears to have been a successful businessman in his own right and highly regarded by the Imperial Court, and he was decorated on several occasions:  Commander of the Military Order of Christ and  the  Order of Our Lady of the Conception of Vila Vicosa (the paramount award given by the sovereign for services rendered to the Royal House). He received his baronage by decree in 1885, and the grandeeship by decree in 1888. In 1856 he married Luiza Rudge (1838-1891), daughter of George Rudge and Sofia Maxwell.  His father-in-law was Joseph Maxwell (1772-1854), one of Brazil’s richest men, founder of the Maxwell Wright commission house. This was a trading house with strong links to the American and British markets which was a leading participant in the coffee export boom and a facilitator of the Atlantic triangle trade (imports of grains and manufactured goods from America, exports of coffee and slave trading with Africa). The Rudges were business partners with Joseph Maxwell. Both the  Rudge and Maxwell families were originally merchants from Gloucester, England. Jose Antonio Filho and Luiza Rudge had five children — Carlos, Luiza Sophia, Jose Jorge, Carlos Alfredo, Laurin Rosa  and Sophia, Emilia – all of whom assumed the surname Ipanema de Moreira and lived their lives in Rio de Janeiro.

The only portrait we have of Jose Antonio Filho is the one shown below, made in the 1870s before he had become the Baron of Ipanema.

We also have a painting of the two eldest children Carlos and Luiza posing in a hamac in Ipanema with the  Rodrigo da Freitas Lagoon and the Catacumba Peak in the background.

Jose Antonio Moreira Filho’s plans for “Praia de Fora” depended on improved access to the southern beaches. During the 1880s the estate had been accessed primarily from the sea by occasional tourists. This changed when in 1892 the Companhia Ferro-Carril Jardim Botanico inaugurated the Copacabana Tunnel (today known as Alaor Prata), linking Botafogo Beach with Copacabana Beach, and providing tram service between the center of Rio and the southern beaches. A tram line covering the entire extension of Copacabana beach was completed by early 1894.

In anticipation of the further extension of the tram service, in April 1894 the Vila Ipanema real estate development project was officially launched. The land holdings owned in Copacabana and Leblon were not included in Vila Ipanema, and may have been donated to the city or incorporated into other developments being actively promoted at the time.

The layout of the Vila Ipanema can be seen in the two documents below. The first, dating from 1894, is the original urban design commissioned to Luiz Rafael Vieira Souto who was the Chief Engineer of the Municipality of Rio de Janeiro.  The second, dating from 1919, is from a marketing brochure.

Vila Ipanema divided the area into 45 blocks.  The standard block was broken into 40 lots, each measuring 10 meters by 50 meters. More than a million m2 of real estate were put on the market.

The initial launch included 19 streets and two public squares (General Osorio and Nossa Senhora da Paz). Most of the street names honored family members, associates and political allies of the Baron and his partners. For example, the main road at the time of launch was the Rua 20 de Novembro (Visconde de Piraja), which commemorated the date of birth of Luisa Rudge. Of the original names few remain: Alberto Campos (brother in law) remains; Avenida Vieira Souto, in honor of the urban planner, still graces the waterfront.

Jose Antonio Moreira Filho had several partners in Vila Ipanema: Coronel Antonio Jose Silva, Jose Luis Guimaraes Caipora and Constante Ramos.  The Coronel incorporated land he owned in Praia de Fora into the Vila Ipanema project. In 1901 the shareholders of Vila Ipanema were:  Ipanema de Moreira family, 90%; E. de Barros, 6.5%; Coronel Silva, 3.5%; Ulysses Vianna, 1.0%.

Jose Antonio Moreira Filho’s luck seems to have run out in his final years. He was 64 years old when Vila Ipanema was launched and in bad health. Given his intimacy with the imperial court, the deposition of Pedro II in 1889 and his exile to Paris may have seriously undermined his business affairs. Surely, when the Count acquired the estate he had not countenanced an end to the imperial regime. The proclamation of the First Republic in 1889 was followed by political instability and economic crisis, and the flight of both human and financial capital. In the five years from the time of the coup-d’etat which ousted Pedro II to the launch of Vila Ipanema in 1894, the real, the Brazilian currency, lost 60% of its value relative to the U.S, dollar, and it would lose another 40% before stabilizing in 1899. The 1890s would also see the rise of Sao Paulo as Brazil’s dynamic economic center and the magnet for waves of Italian and Japanese immigrants.

By the mid-1890s almost all of the Ipanema de Moreira family was settled in Europe, either in Paris or Brussels. Brazil was far away and becoming a distant memory. When the Baron passed away in 1899, the majority control of Villa Ipanema went to Francisco Antonio Morreira who resided in Paris and had not lived in Brazil in 40 years.

 

The following account from Francisco Antonio’s son (nephew of the baron), Alberto Jorge de Ipanema Moreira, gives some color:

“In the spring of 1898 we travelled to Rio, my father, my aunt and I. My father and my aunt went to try to salvage what was left of a brilliant fortune. Their brother, the Baron of Ipanema, who was their proxy, was old and sick and his business affairs had collapsed. The only thing left were the immense land holdings in Copacabana and the “Praia do Arpoador’” now renamed “Vila Ipanema.” Following the death of the Baron of Ipanema, an agreement was reached with his heirs on one side and my father and my aunt on the other, that the remaining land for sale would be divided  so that the heirs would keep 35% and my father and my aunt would receive 65%. Though born in Rio, my father,  my aunt and my mother – she of English descent, Rudge by her father and Maxwell by her mother – had spent little time in Rio, having been sent at a young age to study in England. They had little notion of the assets they had in Brazil.”

Franciso Antonio Moreira, my great-great grandfather, was a bon vivant living the high life between Paris and Nice. He was married to Maria Tereza Rudge, the second daughter of Joseph Maxwell, and, presumably they both had inherited large fortunes from their parents. However, it seems that they lived well beyond their considerable means. More on this from his son Alberto Jorge:

“It would seem that this family settlement had been very favorable for my parents. It didn’t turn out that way; quite the contrary, they lived for the next thirty years receiving only crumbs. This great capital withered away, used only to cover the most basic and indispensable expenses. The lots in Ipanema sold poorly, and my father wanted to sell at any price. He was born a great lord, and had no notion of thrift. Very elegant and handsome, he loved sport, especially horses; generous and extremely charitable, of an uncommon righteousness, he saw no evil and was not made to manage a fortune.”

Francisco Antonio had six children: Alberto Jorge (Brazilian diplomat), Maria Luiza (my great grandmother who married Eugene Robyns de Schneidauer who was a Belgian diplomat), Leonora, Maria Thereza and Jose. All of them resided and passed away in Europe. The first photo shows him around 1900 in ceremonial Court regalia. The second photo is a family portrait taken in 1929, near the end of his life, where he is seated next to his wife in the middle, up front.

The following pictures shows Ipanema Beach at the turn of the 19th century and in 1930. Notice how poorly developed it remained in 1930, still marked by the characteristics of the “restinga.”

The sales of the Vila Ipanema lots were painfully slow, as no one wanted to invest in that “fim do mundo.” This was in part because of competition from developers in Copacanana Beach which offered plenty of supply with closer proximity to the city and public transport. Moreover, though both Ipanema and Copacabana were marketed as “healthy and hygienic,” Ipanema was plagued by mosquito swarms when the lagoon periodically overflooded.

Poor sales also were caused by the delayed expansion of the tram service, which reached the General Osorio Square only in 1902. By the end of that year only 112 lots had been sold, which represented only about 6% of the available inventory.

Development expenses also ran out of control. Capital, administrative and selling expenses were still taking up over 60% of revenues in the early 1900s.  High construction costs led to the farming out of development work to a contractor in 1905, the Companhia Constructora de Ipanema, which did similar work in Copacabana and Leblon. In 1906, this company completed the embankments of the lagoon, providing a permanent solution to the flooding.

The table below shows the Vila Ipanema sales revenue stream from 1900 to 1930, by which time very few lots remained. These numbers are presented in 2020 U.S. dollars, adjusting for inflation and currency depreciation. The real lost half of its value over this period. The peak of sales occurred between 1911-1915, a period of economic strength and real appreciation. The evolution of the real from 1984 to 1930 is shown in the following chart.

Over this 30-year period, total Vila Ipanema gross revenues were $15.1 million (constant 2020 USD). Net revenues after all expenses amounted to $12 million, of which $6.5 million went to my great-great grandfather, Antonio Francisco Moreira. By the time of his death in November 1930, a small fraction of that capital remained.

Of course, in retrospect it is easy to say that this capital was grossly and irresponsibly dilapidated. Ipanema today is prime luxury real estate and a beachfront apartment on Ipanema Beach may cost 3 to 4 million dollars. Unquestionably, the best strategy for a long-term investor would have been to build a big wall around the property and wait.

However, the reality is that Ipanema remained a sleepy and distant neighborhood, particularly compared to Copacabana, until recent decades.  It was not until the 1960s that it received some notoriety as a fashionable destination. Since the 1960s, the social and cultural center of Rio de Janeiro has moved rapidly to the southern beaches, leading to huge appreciation in real estate.

When Antônio Carlos Jobim’s family moved to Ipanema in 1933 it was because his mother was recently divorced and could not afford to live in a nice neighborhood. For the same reason, a wave of immigrants settled there after W.W. II.  In the 1960s, Antonio Carlos (Tom) Jobim’s generation made Ipanema famous with the Bossa Nova.  It was from the terrace of the Bar Veloso on the Avenida Prudente de Moraes that Tom spied the “girl from Ipanema”, Helo Pinheiro, walking home bikini-clad from the beach, and the rest is history.

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The Girl From Ipanema

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The yuan’s Long Road To Hegemony

Talk of the yuan replacing the U.S. dollar as the global reserve currency is mostly idle because China neither provides the conditions for this to occur nor appears to desire this outcome over the short term. Nevertheless, over time, the U.S. dollar’s hegemony is fraying, leaving a vacuum which will be filled by alternative currencies.

The conditions for a currency to establish itself as the dominant global instrument for trade transactions and storing wealth are shown by history. First, reserve currency status is a function of a country’s dominance of economic output (GDP), trade and net creditor status. Second, certain arduous requirements need to be met:

  • Trustworthiness
  • Institutional strength (rule of law, property rights)
  • Large economy and reliable trading partner
  • Free movement of capital and strong banking system
  • Large and liquid sovereign bond issuance providing safe assets
  • Willingness to provide global currency liquidity

 

No previous reserve currency has had the scale or scope that the U.S. dollar has had over the past seventy years, being generally limited by the country’s geographic hegemony. For example, the British pound was the leading reserve currency for a century (aprox. 1814-1914) because of its global empire and naval domination but it still left much of the world uncovered and faced competition from European rivals (France, Germany).

Post W.W. II U.S. dollar hegemony was secured because of America’s near total economic dominance. However, over time this has changed dramatically. The following chart from the IMF, which measures GDP, trade and net creditor status, shows the evolution over time: the U.S. goes from absolute dominance in the 1950s to a much weaker position today. By this measure, China has already surged and is poised to assume more influence.

 

 

The following three charts show this in detail: 1. Share of global GDP; 2. Share of global trade; 3. Net creditor status. The first two are shown for both the U.S. and China; the third shows the evolution of the U.S. net creditor position, from 20% positive in 1950 to over 80% negative in 2022 (China’s positive net creditor position is estimated to be about 15% of GDP, similar to the U.S. position in the 1950s).

 

On the other hand, with regards to the “institutional” and policy characteristics required to establish reserve status China lags far behind.

  • Trustworthiness – Though trust in the U.S. has declined in recent years because of the heavy-handed use of “sanctions diplomacy” it retains considerable advantages over China. China has antagonized a great many potential partners by engaging in provocative “wolf warrior” diplomacy. Moreover, China is even more prone to sanctions diplomacy than the U.S., as shown recently by retaliations against Korea, Australia and Lithuania for criticizing China’s policies.
  • Rule of Law – China’s lack of due process and judicial independence makes it a poor safe haven. Though the recent freeze on Russian assets held abroad by the U.S. and other western countries have created a terrible precedent, by and large investors still expect to be treated fairly by U.S. courts.
  • Large economy and reliable trading partner – This is China’s strong point and where it can increasingly contend with the U.S..
  • Free movement of capital and strong banking system – China fails on both counts. It has strict capital controls, mainly to keep domestic capital from fleeing. Also, it remains fully committed to managing its currency to preserve export competitiveness. Its banks are agents of the state and can be considered “highly liquid but insolvent.”
  • Large and liquid sovereign bond issuance providing safe assets – China is improving quickly on this count, but is still way behind the U.S., and the lack of rule of law and the presence of strict capital controls will impede progress.
  • Willingness to provide global currency liquidity – This is the biggest impediment for China to move forward on reserve currency status. The global economy needs a constant and predictable increase in the volume of the reserve currency. Under the British Gold Standard gold output increased by over 2% a year to keep the system liquid. Under the U.S. fiat currency system, the U.S. has run persistent current account deficits to feed dollars into the global economy. Since 1980, the U.S. has run annual current account deficits of on average -2.7%. This global liquidity is the counterpart to the growth in the U.S.’s negative net creditor position. Meanwhile, since 1980 China has run current account surpluses of 2% of GDP, allowing it to build its net creditor position. There is no evidence at this time that China would  change the mercantilist policies that support its export competitiveness and sustain current account surpluses, and until it does the yuan cannot increase its global hegemony.

Conclusion

Over the past twenty years China has become the primary buyer of global commodities. For example, China has replaced the U.S. as the biggest importer of oil. This raises the possibility that the dollar’s stranglehold on the pricing of most commodities may not persist. U.S. sanctions diplomacy against major oil producers such as Iran and Russia have already thrown these countries into the arms of China and reportedly have resulted in a significant amount of Chinese imports being invoiced in yuan. At the same time, China has established close diplomatic ties with Saudi Arabia which may be considering similar arrangements. A deal with the Saudis would be a watershed event, given how important the U.S.’s deal with the Saudis in 1974 was in securing the dollar’s hegemony  in the 1970s. However, unlike the Iranians and the Russians, the Saudis have options. In the end, the Chinese will need to convince the Saudis to invest in the Chinese capital markets which brings us back to the inadequacy of the yuan as a reserve currency for the reasons listed previously.

King dollar Will Rise Before it Falls

The U.S. dollar’s role as the global reserve currency has been questioned repeatedly during the 7o years since it was established at the Bretton Woods conference in  1944. Current opposition to the U.S. monetary order and calls for its replacement are nothing new and echo past critics who have complained that the U.S. abuses the system to favor its own interests.  Yet, the dollar system today in many ways is stronger than ever, and  there are currently no viable alternatives.

At the Bretton Woods conference strong opposition to a U.S. centric monetary order  was voiced by Maynard Keynes who argued instead for a decentralized system which would prevent countries from running persistent current account imbalances.  Keynes’s fears proved well-founded,  and by the late 1960’s persistent U.S. current account deficits led France to denounce what it called America’s “exorbitant privilege” (i.e., the ability to pay for imports with printed fiat money).  First France and then several more countries demanded to move their gold reserves back home, which left U.S. dollar reserves depleted and undermined the implicit U.S. dollar-gold connection that had been a key feature of the Bretton Woods agreement. In August 1971, Richard Nixon announced the end to the convertibility of dollars into gold, which gave birth to the current U.S. fiat currency monetary system.

The current dollar reserve system has been unique in both its nature and scope. It is the first major currency  reserve system in 700 years of Western financial  history which is not linked to a metal and relies exclusively on the creditworthiness of the issuer. Second, the U.S. dollar can be considered the first truly global currency, as no previous reserve currency has had its geographical reach.

Nixon’s decision was momentous. It had been assumed that a stable monetary order would require a link to gold. England had been able to maintain a stable gold price for nearly 200 years. The U.S. has secured a stable gold price around $20/ounce since 1792, with the only exception being FDR’s devaluation in 1934, to $35/ounce.  FDR’s decision had been seen to be an adjustment within the system, while Nixon’s was perceived as its full repudiation. The chart below shows the evolution of the USD/gold price from 1931 (before FDR’s decision) until 1980.

Not surprisingly, Nixon’s decision was not well received by global capital.  It led to the first genuine dollar crisis  (chart below) and to a long period of dollar weakness,  high inflation and economic “malaise,” as described by Jimmy Carter. During the 1970s talk of the rise of the Deutsche mark and the Japanese yen as viable reserve currencies was prevalent and both currencies appreciated by more than 40% against the USD.

Two separate events were instrumental in recovering the dollar’s credibility. First, behind the scenes, in 1974 a secret deal was reached between Treasury Secretary William Simon and Saudi Arabia’s King Faisal for the Saudis to agree to invoice all oil exports in USD in exchange for U.S. weaponry and protection. This deal, in essence, defined the terms of the new fiat monetary system, providing a mechanism for recycling persistent U.S. current account deficits back into U.S. financial assets. The new “petrodollar system” allowed for the “neutralization” of the high commodity prices of the 1970s by channeling windfall OPEC oil profits into Wall Street banks, which, in turn, flooded the world with dollar loans.

The second event that established the dollar’s supremacy was the appointment of  Paul Volcker to head the U.S. Treasury in 1979 . He  proceeded to raise  the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981.  Volcker’s super-hawkish policy coincided with the election of Ronal Reagan in November 1980,  and the combination of tight monetary policy with the promise of economic rejuvenation through “supply-side” economics led to a massive dollar rally, lasting t0 1985.

The twenty years between 1980 and 2000 can be considered the golden age of the dollar.  The “Petrodollar System” for recycling U.S. current account deficits back into the U.S. financial system worked smoothly over this period of relative economic and price stability. One of the assumptions of the system was that the U.S. would manage its economy to maintain general price stability and the purchasing power of commodities. We can see in the following chart that this was largely achieved  during this time, as oil prices were kept stable in both nominal and real terms (and at acceptably high prices for OPEC).

This period of faith in dollar supremacy led global central banks to sell  long-held gold reserves in exchange for treasury notes and other U.S. assets. The following chart from Ray Dalio shows clearly why the 1980-2000 can be considered the dollar’s heyday.  We can see that Central Banks aggressively  sold dollars for gold and Deutsche marks during the 1970s, only to about-face when Volcker hiked rates. Central Banks then proceeded to dump gold reserves  for the next twenty years. By 2000, the dollar’s share of central bank reserves was at its all-time high while gold reserves were at all-time lows.

This golden period for the USD unleashed two powerful trends: first, deflation (closely linked to hyper-globalization and the rise of China); second, hyper-financialization and chronic financial bubbles (directly linked to asymmetric policies pursued by an emboldened Fed convinced that modern macro economists had discovered the key to the “Great Moderation.” Naturally, these two trends are interdependent. Hyper-globalization could never have occurred without  a financial system able to absorb enormous inflows of foreign dollar reserves and also systematically increase credit to the U.S. consumer. At the same time, hyper-financialization relied on deflation  persistently repressing interest rates which enabled the Fed “put” to be activated anytime the system was perturbed.

Since its peak around 2000, the dollar fiat system has been under stress. The unwinding of the great TMT bubble in 2000 , the Great Financial crisis in 2008 and then a long period of extraordinary “experimental” Fed policy from 2008 until today are manifestations of an unanchored monetary policy. Going back to the previous chart showing historical WTI prices, we can see that the the assumption of price stability which was part of the “Petrodollar anchor” has come completely unglued since 2000, with enormous volatility on both the up and downside.

The only thing left from the Petrodollar regime are enormous current account deficits , now no longer driven by energy imports but rather by Asian consumer manufactured goods (the U.S. is now a net exporter of energy and commodities).  Keynes’s imbalances and France’s “exorbitant privilege” are greater than ever, remaining the essence of the U.S. centric monetary system.

But, as the eminent economist Joseph Stiglitz has noted ,”The system in which the dollar is the reserve currency is a system that has long recognized to be unsustainable in the long run.”  This is because, over time, structural current account deficits erode a country’s manufacturing base and competitiveness. This is even more true when, as has been the case for decades, prominent competitors pursue mercantilistic policies to promote their industrial exports (e.g., China, East Asia, Germany). The two charts below illustrate the essence of these circumstances: first, the persistent U.S.  current account deficits over the past 40 years; second, the U.S. role in absorbing the impact of trade surpluses generated by mercantilist competitors).

As shown below, not only has the U.S. lost competitiveness, it has also sold off  a significant part of its industrial base and corporations to foreign creditors, moving from a positive  international investment position to a highly negative one since 1980. This deterioration in net creditor status has accelerated in the past decade, and foreign creditors have increasingly shunned treasury bills in favor of direct investments, stocks and real estate.

If the current system is untenable, what can replace it?   Talk of a new monetary order built around China is idle,  as the RMB does not meet the basic requirements of a  reserve currency (rule of law, property rights, deep and liquid capital markets, free movement of capital).  Moreover,  a formidable mercantilist  China could never assume the responsibility of providing liquidity to the global market. Most likely, eventually Keynes’s old proposal from Bretton Woods will be resurrected.

Meanwhile, the USD remains king. Ironically,  the system’s  probable slow death will create intense havoc and uncertainty, conditions that favor USD strength not weakness. We have seen this clearly in recent years as the dollar has been strengthening, driven by massive capital flows out of international and emerging markets.

 

 

 

 

 

 

 

 

 

 

Don’t Fight the Rising Dollar!

Periods of dollar strength are deflationary in the context of the current dollar-centric global monetary system. A strong dollar is generally associated with global inflows into the U.S. either because the U.S. provides superior returns on capital relative to international markets or because high levels of risk aversion drive global capital into the “safe-haven” U.S. capital markets (liquidity, transparency and rule of law).

Periods of dollar strength are the two corners of the “dollar smile” as previously discussed  (Link ) and as shown below.

 

Dollar strength saps liquidity out of international markets, especially in emerging markets where governments and companies  are overly reliant on dollar funding because of shallow domestic capital markets. The combination of higher funding costs for these borrowers and flight capital often results in emerging market financial crisis, 1980, 1997  and 2008 being some of the most painful episodes.  Because of the ongoing surge in the dollar in 2022, we should expect that emerging market economies and asset prices will be under significant stress for the time being.

Because most commodities and a significant amount of global debt are  priced in dollars, a rising dollar depresses global demand and economic growth. This impacts global corporate margins and profitability , including American exporters and domestic industries that compete against foreign imports.

The deflationary nature of dollar strength has a strong impact on global stock market returns because it depresses the earnings of cyclical companies, particularly commodity and industrial companies and banks. Global stock markets in general and emerging markets in particular have much greater exposure to cyclical industries and therefore suffer more during these periods. In the U.S. market, industrials and multinationals with heavy foreign exposure also suffer from a strong dollar. The chart below shows how this phenomenon plays out in the U.S. stock market. During periods of dollar strength (1997-2000) and 2012-2021), the Nasdaq index dramatically outperformed the Dow Industrials Index because the Nasdaq is composed mainly of growthy, long-duration stocks while the Dow includes mainly cyclical businesses such as industrial and banks.

The chart below shows the impact on Dow Index earnings  caused by strong dollar deflationary periods. The three periods of dollar strength since the inception of the fiat dollar regime in 1971 are highlighted by the dark bars.  We can see flat to negative earnings in the first two periods and very choppy earnings in the current third period despite the Trump corporate tax cuts and huge stock buy-backs (the final leg up in earning was driven by the recovery in commodity prices in 2021.)

The charts below show the strongly negative effect that a strong dollar has on corporate earnings in emerging markets. The first chart shows that earnings  (in nominal dollar terms) for Global Emerging Markets (MSCI EM Index) were highly depressed during the last two phases of dollar strength (1997-2002) and 2012-2021.  The following chart shows the poor earnings performance of Chinese stocks, over the past decade despite  the RMB’s appreciation over the period, which is a testament to the poor governance and the deflationary effects of overinvestment in industrial capacity and debt expansion. Next, we see the same for Brazilian corporate earnings which by the end of 2021 have still not returned to 2012 levels in nominal dollar terms, despite very strong earnings growth for commodity producers in 2021. Same for India, which barely returned to 2012 earnings level in nominal terms in 2021 even though the Indian economy has enjoyed high rates of GDP growth. Mexico and Korea show a similar story. The one outstanding exception is Taiwan, which has seen good earnings growth because of strong links to the  global technology sector.

The history of emerging markets shows that practically all earnings growth comes in periods when the dollar is depreciating. The current dollar upcycle will eventually turn, bringing better prospects for investing in EM assets. Rising inflationary pressures and buoyant commodity prices may portend that a change is coming.

 

 

The “dollar Smile” does not favor Emerging Markets

The U.S. dollar’s recent surge against both developed and emerging market currencies has extended the current dollar upcycle into its tenth year. Since the end of the Bretton Woods gold-anchored monetary system in 1971, the dollar’s viability as a fiat reserve currency  has relied on the credibility of the Federal Reserve and the willingness of foreigners to own U.S. assets. Since 1971, a relatively predictable 16-18 year cycle has occurred, with 8-9 years of dollar strength followed by 8-9 years of dollar weakness.

Given the short life of the current dollar fiat-global reserve currency system and its absolute uniqueness in historical terms,   it is difficult to generalize and define trends. However, we can say that we are currently in a third upcycle for the USD in what appears to be a declining trend. This is highlighted in the charts below. The second chart details the current dollar upcycle, which started in early 2011. The current upcycle is now in its eleventh year, and, with the recent surge of the DXY to the 103 level, we are now at the long-term downward sloping trendline. We are currently seeing a triple top for the DXY as it has returned to peaks previously reached in 2017 and 2020.

The prolongation of the current dollar upcycle  may have several explanations. Both in 2017 and in 2020 the dollar experienced significant weakness which seemed to indicate the beginning of a downtrend. However, both these downtrends were aborted by market -shaking events that drove investors into U.S. assets: In 2017-2018, Brexit, the Trump tax cut and the  Powell pivot from hawk to dove; in 2021, the extraordinary combination of U.S. fiscal and monetary stimulus and surprisingly strong U.S. economy. Furthermore, the 2017-2022 period has been marked by the strong returns of U.S. equity markets driven by the phenomenal operational performance during the pandemic of America’s “winner-take-all” tech hegemons. Finally, the Russian invasion of Ukraine and China’s economic problems (bursting of the real estate bubble and mismanagement of COVID) have accentuated flows into  U.S. safe haven assets, mainly stocks and real estate.

The current strength of the dollar relies on the notion of American exceptionalism. The U.S. goes through periods of “exceptionalism” and “malaise” which have influence on investor appetite for U.S. dollar assets and set the course for the dollar. Despite all of its stark deficiencies, relative to the rest of the world today the U.S. looks very stable and attractive for investors and it is sucking up excess capital which drives dollar strength.

The chart below schematically describes a framework for understanding the drivers of the U.S. dollar. This so-called “Dollar Smile” framework , which is built on the insights of macro traders like George Soros and others, pinpoints how the dollar behaves in diverse economic environments.

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At the two corners of the mouth, conditions exist for a strong dollar. The right corner represents periods of U.S. exceptionalism when the U.S. leads the world in economic growth and attracts global savings. The left corner represents periods of global crisis when capital flows to the safety of financial havens, especially the U.S. with its large and liquid capital market. The current dollar upcycle over the past eleven years has been supported by one or both  corners of the smile at different times.

At the bottom of the smile, conditions exist for a weak dollar. These are periods of synchronized global growth when the rest of the world is relatively stronger than the U.S. and is attracting capital (e.g. the 1970s in Europe and developed Asia; emerging markets, 2000-2012).

At the present time, the dollar is supported by high levels of economic uncertainty arising from geostrategic conflict and the consequences of an extended period of global fiscal and monetary adventurism. The left corner of the smile is likely to dominate currency movements for the foreseeable future, which portends a strong dollar. Under these conditions, emerging market countries will continue to see persistent capital flight and their assets are not likely to offer attractive returns.

Expected Returns for Emerging Markets, 1Q 2022

After a dismal decade of slowing GDP growth and stagnant earnings, emerging stock markets are showing signs of life. Overall returns are dampened by the value destruction of private company stocks which has been engineered by China’s government over the past year, but returns for EM ex-China have been much better. Most importantly, some of the cheaper markets in EM have started to take off, which is catching the attention of trend followers and bringing new capital into play. This is happening partially because of a more favorable environment for value stocks, cyclicals and commodities, but also because a rotation out of  long-duration tech “dreamer” stocks has been triggered by rising interest rates. All of this is good, but, unfortunately, EM is not yet out of the woods because storm clouds are staying put; these are, specifically ,the rising USD,  the tightening of U.S. monetary policy and the explosion of food and energy prices. This is a lethal combination for emerging markets.

Looking beyond the turbulence of the short term, the market action should be a major comfort to long run investors. For the first time in a while, the cheap markets are performing much better than the expensive markets, and investors are taking notice.

We turn to our CAPE methodology as a contribution to taking long term allocation decisions in emerging markets. CAPE provides insight on where valuations stand relative to historical trends and can help to structure mean reversion trades which have a good chance of working over  a 3-5 year time horizon. We combine CAPE with macro-economic conditions and market technicals  to determine entry and exit points in the context of a long term allocation strategy. The CAPE (cyclically adjusted price earnings) takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful tool for highly cyclical assets like EM  stocks. At extreme valuations, the tool has had very good predictive capacity in the past.  We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized more recently by professor Robert Shiller of Yale University.

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

The table below summarizes the results of our calculations for 17 EM countries, global emerging markets (GEM, MSCI) and the S&P500. The expected returns of markets depend on valuation (CAPE ratio) and earnings growth (largely a function of GDP growth). No consideration is given here to possible multiple expansion or the liquidity factors that may have a major influence on market returns.

Not surprisingly, all the  markets with the lowest valuations and highest expected returns are currently facing difficult economic and/or political prospects  Investing in these countries requires a leap of faith that “normalization” is possible. For example, it assumes that the current crisis in Turkey will be resolved adequately, that Chile’s constitutional reform will not structurally impair growth prospects and that China’s absurd vendetta against its most innovative and dynamic private firms will come to an end.  Until recently, none of these trades has worked. Still today, Chinese stocks are sliding, but the other cheap markets — Turkey, Brazil, Chile  and South Africa — are all doing much better, which is heartening.