Author: jvande

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

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

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

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

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

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

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

  1. Worsening governance and corruption

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

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

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

 

  1. Deindustrialization

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

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

 

 

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

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

Value is Dead; Long Live Value!

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

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

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

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

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

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

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

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

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

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

 

The Cycle is Turning; Winter is Coming

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

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

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

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

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

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

Does CAPE Work For Emerging Markets?

The CAPE methodology is well suited for volatile and cyclical markets such as those we find in Emerging Markets. Countries in the EM asset class are prone to boom-to-bust economic cycles which are usually accompanied by large liquidity inflows and outflows that have significant impact on asset prices. These cycles often lead to periods of extreme valuations both on the expensive and cheap side and the CAPE has proven effective in highlighting them.

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.  We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized recently by professor Robert Shiller of Yale University.

The charts below illustrate the relationship between stock market total nominal returns and the level of the CAPE ratio for Global Emerging Markets, the S&P500 and 18 emerging markets. The data covers the period since 1987 when the MSCI EM index was launched. The charts show a clear linear relationship between CAPE and returns with particular significance at extreme valuations. Country data is more significant because the CAPE ratios capture better the evolution of the single asset.

CAPE works particularly  well in markets with highly cyclical economies subject to volatile trade and currency flows (Latin America, Turkey, Indonesia); less well for more stable economies (eg, East Asia).

  1. S&P 500 :  The market has not provided 10 year annualized returns above ten percent when CAPE is above 25. Every time that the market has provided lower than 5% annualized return the CAPE has been above 30. The CAPE at year-end 2021 was 39.3, the second highest in history.

2. All date points, including GEM and 18 countries: This is a very noisy graph  but the trend is clear. All 10 year periods with returns at least 15% annually started with CAPE below 25.

3. Global Emerging Markets: Clear trend.  GEM has never returned less than 10% annually with cape below 10; returns have never been above 5% with CAPE above 20. GEM CAPE ended 2021 at 14.4.

 

4. China: All high return years started at CAPE below 10; all low returns started at CAPE above 20. China end 2021 at 13.3.

 

5. India: India performs best with CAPE below 20 and really struggles above 25. 2021 ended at 31.1 which should weigh heavily on future returns.

6. Korea: Clear trendline but slightly more dispersion than in most other markets. Current CAPE is 9.6.

7. Taiwan; All high return decades have started with CAPE  below 15; low returns have started above 20. The current level is 27.1, the highest since the Taiwan bubbles of the 1990s.

8. Brazil: Brazil is a good example of a highly cyclical economy prone to boom-bust cycles and unstable liquidity flows. A CAPE of 15 seems to be the dividing line for returns, with equity booms starting with CAPES in the low teens and the market struggling with CAPES in the high teens.  At the current CAPE of 10.9, the market is priced to provide high returns.

9. Turkey: Annual returns have been very high when CAPE has approached the five level, and very poor when CAPE reaches the high teens. The current CAPE of 4.1 is the lowest since the early 1990s. This is the fourth time that CAPEs have been below five and on every occasion very high returns have followed.

10. Mexico. Current CAPE is 18.2

 

11. Philippines

12. Thailand

13. Russia

14. Malaysia

15. South Africa

16. Indonesia

17. Peru

18. Chile

19. Colombia

20. Argentina

CAPE and Expected Returns in Emerging Markets, 2022-2028

The past decade in emerging markets has been one of slowing GDP growth, low earnings and poor returns. By and large, today valuations have come down enough from the lofty levels of 10 years ago to make the markets attractive, particularly compared to the high valuations of the U.S. market. Emerging markets are under-owned and certain segments of the market are extraordinarily cheap. If “value” segments of the market (industrial cyclicals, banks, commodities) continue to rally like they did in 2021, then prospects may be quite good. However, at the same time, the markets face a Fed monetary tightening process that may broadly challenge asset prices and, if history repeats itself, be particularly troublesome for emerging markets.

We turn to our CAPE methodology periodically to shed some light on relative valuations and derive estimates of “probable” future returns. 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 too lfor 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, the markets with the lowest valuations and highest expected returns are currently facing difficult economic and/or political prospects and, consequently, have been abandoned by investors. 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 and that Chile’s constitutional reform will not structurally impair growth prospects.

The CAPE methodology is a poor predictor of short-term results. For example, the cheap markets at year-end 2021 all did poorly over the past year while the expensive markets (USA, India) just got more expensive.

Emerging Markets: 2021 in a few charts

1.

2021 saw more underperformance for international stocks (MSWORLD) and emerging markets stocks (EEM)s relative to the S&P500. The U.S. tech titans have become the darling of global investors, considered as the last remaining “safe haven”  asset in a low growth and risky world.

2.

EM ex China (EMXC) didn’t perform too badly in absolute terms, in line with MSCI World ex U.S. EM as a whole was weighed down by the collapse of China’s internet stocks (KWEB), the favorites of international funds.

3.

In 2021 investors learned that China cares about its currency and its bond market but not much about stocks , particularly those of “frivolous” companies engaging in anti-social activities (internet). While EM bonds (EMCB,EMHY) lost value relative to U.S. High Yield, China’s bonds (CBON) rose steadily.

4.

In the Chinese market (MCHI), stocks held mainly by foreigners (KWEB, CQQQ) did poorly but local stocks (CNYA) and, even more so, local tech stocks (CNXT) picked up the slack.

5.

Global EM stocks, despite the rally in commodity prices (GYX, industrial) commodities index), did poorly, which is unusual. Commodity-rich markets like Chile (ECH) and Brazil (EWZ) lagged badly. Commodity prices were driven by climate politics and inflation, no longer by China which is not the driver of global growth it once was.

6.

The collapse in the correlation between commodity prices and EM is seen in the extraordinary divergence between Chilean stocks and copper. Chile is overwhelmed by politics, and copper inflows are serving only to facilitate capital flight. Investors in Chile and elsewhere may be  anticipating the likely return of strict capital controls.

7.

EMEA ( Europe, Middle East, Africa) led EM equity returns in 2021, boosted by the oil-sensitive markets of the Persian Gulf.

8.

There’s always a bull market somewhere. In 2021 it was U.S. tech titans  and the Middle East. Taiwan, India and Vietnam were also winners.

 

9.

Latin America stocks (ILF) underperformed Asia EM (EMEA), as they have persistently for the past decade.

 

 

10.

Technology stocks outside of China fell back to earth in 2021. Latin American tech stocks, fueled by the happy dreams of global venture capitalists led by Softbank, experienced a general collapse.

11.

China’s share of the MSCI EM index fell sharply, replaced mainly by Taiwan and India.

12.

The fall of China’s internet titans caused significant changes to the MSCI EM’s top holdings. Indian stocks are becoming more prominent, a story likely to extend for the coming decade. Commodity related stocks (Gazprom, Vale, Al Rajhi Bank) are back, also a harbinger of things to come

 

13.

After a decade dominated by growth and momentum, other factors started to work in  2021. Value and small caps outperformed in global EM and every region. The very few still active value investors in EM finally had a good year while most EM active managers (by now almost all closet growth investors) suffered.

14.

All the traditional academic factors did well in 2021, led by small caps (EEMS) and momentum (PIE).

15.

The Covid-19 pandemic has been disastrous for much of emerging markets, the worse hit being Eastern Europe and Latin America. The fiscal impact (higher debt levels) and social consequences (impaired education for the poor) have severely undermined the growth prospects for Latin America.

Protest Songs that Rocked Latin America in 2021

 

In 2021, two powerful protest songs expressed the state of mind of Latin American youth with regards to democracy: one condemning its shortcomings; the other longing for its blessings and the freedom it brings.

I.La Democracia

Chile’s Mon Laferte expresses the frustration and disappointment and the feeling that democracy is really just another scam run by elites to benefit themselves. This is the spirit of the youth and probably the driving force behind Chile’s Constitutional Reform

 

Mon Laferte – La Democracia (Lyric Video) – YouTube

 

Tú no tienes la culpa de que la plata a nadie le alcanza ( It is not your fault that no one has enough money)

Tú no tienes la culpa de la violencia y de la matanza (You are not to blame for the violence and the killing)

Así el mundo nos recibió (So the world received us)

Con muchas balas, poca esperanza (With many bullets, little hope)

Quiero que todo sea major ( I want everything to be better)

Que se equilibre esa balanza (That things settle down)

Tú no tienes la culpa de que a los pobres los lleven presos (It is not your fault that the poor are taken prisoner

Tú no tienes la culpa que quemen bosques por el progreso (It’s not your fault that they burn forests for progress)

 

Y los de arriba sacan ventaja (And those from above take advantage
Y la justicia que sube y baja (And the justice that rises and falls)
Nos tienen siempre la soga al cuello (They always have a rope around our necks)

La vida al filo de una navaja ( Life on a razor’s edge)

Que alguien me explique lo que pasó (Someone explain to me what happened)

(Por la democracia, la democracia) (For democracy, democracy)
Me confundí o alguien me mintió (I got confused or someone lied to me)

(La democracia, la democracia)
¿Pa dónde fue? ¿Quién se la robó? (Where did it go? Who stole it?)

(La democracia, la democracia)
Vamos a tomarnos unos vinitos( Let’s have some wine)

(La democracia, la democracia)

Ahí tení. Para que te engañen (There you have it. So they fool you

 

Tú no tienes la culpa de que persigan a los migrantes I(t is not your fault that they persecute migrants)
Tú no tienes la culpa de la masacre a los estudiantes (You are not to blame for the massacre of the students)

De las promesas y las banderas (Of promises and flags)

Los caballeros se llenan la panza (Gentlemen fill their bellies)

Aquí te van unas melodías (Here are some melodies)

Y algunas rimas pa la venganza (And some rhymes for revenge)

Que alguien me explique lo que pasó (Someone explain to me what happened)

(Por la democracia, la democracia)

Me confundí o alguien me mintió( I got confused or someone lied to me)
(La democracia, la democracia)
¿Pa dónde fue? ¿Quién se la robó? (Where did it go? Who stole it?)
(La democracia, la democracia)
Vamos a tomarnos unos vinitos (Let’s have some wine)

(La democracia, la democracia)

Hagan un trencito  (Make a train)

 

Make a train

Make a train

On this side and on the other

Dancing the cumbia they look prettier

Hagan un trencito
De este lado y del otro (On this side and on the other)
Bailando la cumbia se ven más bonitos (Dancing the cumbia they look prettier)

Hagan un trencito
Hagan un trencito
De este lado y del otro
Bailando la cumbia se ven más bonitos

Que alguien me explique lo que pasó
(Por la democracia, la democracia)
Me confundí o alguien me mintió
(La democracia, la democracia)
¿Pa dónde fue? ¿Quién se la robó?
(La democracia, la democracia)
Vamos a tomarnos unos vinitos
(La democracia, la democracia)
(La democracia, la democracia)
(La democracia, la democracia)

 

 

II.Patria y Vida

 

A collaboration 0f Cuban musicians, both in exile and on the island, in exile this powerful protest song swept the island (until it was banned) and the international latino community. It is a cry of despair for freedom and a denunciation of the scenescence and hypocricy of the regime.

 

.Patria y Vida      (Homeland and Life)

 

And you are my siren song
Y eres tú mi canto de sirena

Because with your voice my sorrows go away
Porque con tu voz se van mis penas

And this feeling is already stale
Y este sentimiento ya está añejo

You hurt me so much even though you are far away
Tú me dueles tanto aunque estés lejos

Today I invite you to walk through my lots
Hoy yo te invito a caminar por mis solares

To show you that your ideals serve
Pa’ demostrarte de que sirven tus ideales

We are human although we do not think alike
Somos humanos aunque no pensemos iguales

Let’s not treat or harm ourselves like animals
No nos tratemos ni dañemos como animales

This is my way of telling you
Esta es mi forma de decírtelo

My people cry and I feel their voice
Llora mi pueblo y siento yo su voz

You five nine me, double two
Tu cinco nueve yo, doble dos

Sixty years locked the domino
Sesenta años trancado el dominó

Bass drum and saucer to the five hundred of Havana
Bombo y platillo a los quinientos de la Habana

While at home in the pots they no longer have jama
Mientras en casa en las cazuelas ya no tienen jama

What do we celebrate if people walk fast?
¿Qué celebramos si la gente anda deprisa?

Trading Che Guevara and Martí for the currency
Cambiando al Che Guevara y a Martí por la divisa

Everything has changed, it is no longer the same
Todo ha cambiado ya no es lo mismo

Between you and me there is an abyss
Entre tú y yo hay un abismo

Advertising a paradise in Varadero
Publicidad de un paraíso en Varadero

While mothers cry for their children who left
Mientras las madres lloran por sus hijos que se fueron

you five nine, me, double two
tu cinco nueve, yo, doble dos

(It’s over) sixty years locked dominoes, look
(Ya se acabó) sesenta años trancado el dominó, mira

(It’s over) your five nine, me, double two
(Se acabó) tu cinco nueve, yo, doble dos

(It’s over) sixty years locking the domino
(Ya se acabó) sesenta años trancando el dominó

We are artists, we are sensitivity
Somos artistas, somos sensibilidad

The true story, not the wrong one
La historia verdadera, no la mal contada

We are the dignity of a whole town trampled on
Somos la dignidad de un pueblo entero pisoteada

At gunpoint and with words that are still nothing
A punta de pistola y de palabras que aún son nada

No more lies
No más mentiras

My people ask for freedom, no more doctrines
Mi pueblo pide libertad, no más doctrinas

Let’s no longer shout homeland or death but homeland and life
Ya no gritemos patria o muerte sino patria y vida

And start building what we dream of
Y empezar a construir lo que soñamos

What they destroyed with their hands
Lo que destruyeron con sus manos

That the blood does not continue to flow
Que no siga corriendo la sangre

For wanting to think differently
Por querer pensar diferente

Who told you that Cuba is yours?
¿Quién le dijo que Cuba es de ustedes?

If my Cuba belongs to all my people
Si mi Cuba es de toda mi gente

your time is up, the silence is broken
ya se venció tu tiempo, se rompió el silencio

(It’s over) the laughter is over and the crying is already running
(Ya se acabó) ya se acabó la risa y el llanto ya está corriendo

(It’s over) and we’re not afraid, the deception is over
(Se acabó) y no tenemos miedo, se acabó el engaño

(It’s over) it’s sixty-two hurting
(Ya se acabó) son sesenta y dos haciendo daño

There we live with the uncertainty of the past, planted
Allí vivimos con la incertidumbre del pasado, plantado

Fifteen friends on, ready to die
Quince amigos puestos, listos pa’ morirnos

We raise the flag still the repression of the regime to the day
Izamos la bandera todavía la represión del régimen al día

Anamel and Ramón firm with their poetry
Anamel y Ramón firme con su poesía

Omara Ruiz Urquiola giving us encouragement, of life
Omara Ruiz Urquiola dándonos aliento, de vida

They broke down our door, they raped our temple
Rompieron nuestra puerta, violaron nuestro templo

And the world is conscious
Y el mundo ‘tá consciente

That the San Isidro movement continues, since
De que el movimiento San Isidro continua, puesto

We continue in the same, security putting prism
Seguimos en las mismas, la seguridad metiendo prisma

These things make me indignant, the enigma is over
Esas cosas a mí como me indignan, se acabó el enigma

Ya sa ‘your evil revolution, I am Funky style, here is my signature
Ya sa’ tu revolución maligna, soy Funky style, aquí tienes mi firma

You are already left over, you have nothing left, you are already going down
Ya ustedes están sobrando, ya no le queda nada, ya se van bajando

The town got tired of holding on
El pueblo se cansó de estar aguantando

A new dawn we are waiting for
Un nuevo amanecer estamos esperando

It’s over, you five nine, me, double two
Se acabó, tu cinco nueve, yo, doble dos

It’s over, sixty years locked dominoes, look
Ya se acabó, sesenta años trancado el dominó, mira

It’s over, you five nine, me, double two
Se acabó, tu cinco nueve, yo, doble dos

It’s over, sixty years locking the dominoes
Ya se acabó, sesenta año trancando el dominó

Homeland and life
Patria y vida

Homeland and life
Patria y vida

Homeland and life
Patria y vida

Sixty years locked the domino
Sesenta años trancado el dominó

 

 

Can China Avoid the Middle-Income Trap?

Over the past 60 years few countries have grown their economies at a faster rate than the United States and improved their citizens’ incomes relative to those of Americans. This process of convergence has happened almost exclusively in the poorer countries of Europe. In developing economies, we can count the success stories on one hand (Singapore, Hong Kong, Taiwan and Korea). In recent decades China has experienced extraordinary growth, which raises the question of whether it can join the club of rich countries.

Undoubtedly, the rise of China’s economy over the past 40 years has been miraculous.  China’s GDP per capita increased from $200 in 1980 to $10,500 in 2020, taking it from 10% to 160% of Brazil’s level or from 1.5% to 16% of the U.S. level.

However, China’s ability to sustain high levels of growth in the future is far from certain. The history of the global economy in the post W.W. II period shows that growth for the majority of developing countries falters after reaching middle income status ($10,000-$12,000 PC income). Once countries  reach this level they tend to have exhausted the easy gains from rural migration, basic industrialization and urbanization. Sustaining growth then requires an institutional framework that promotes social inclusion, efficient markets and innovation. Countries like Brazil and Mexico utterly failed in developing these institutions and they have become emblematic of  the “middle-income trap.”

The chart below shows the elite group of “convergers” over this long period. The list can be separated into three distinct groups: 1. Beneficiaries of European economic integration (which, starting in the 1980s, will also include Eastern European former Soviet Block economies); 2. Beneficiaries of special economic ties with rich countries (Hong Kong, Bermuda, Puerto Rico, St. Kitts); 3. Countries of special geo-political importance to the United States (Taiwan, Korea, Israel). If we take out European countries and territories closely dependent on rich countries, we can further focus on the exceptionality of the few countries that have succeeded: Hong Kong, Singapore, Korea, Taiwan and Oman.

  • Hong Kong and Singapore are small islands that prospered as reliable trading and service hubs for the expansion of global commerce.
  • Korea and Taiwan were of major geopolitical importance to the United States, received considerable financial support and were allowed to engage in mercantilist policies that may not be available for other developing countries.
  • Israel benefited from waves of highly educated immigrants, abundant foreign investment and generous U.S. geopolitical and financial support.
  • Oman started from a very low level and made important oil discoveries in the 1960s. It has been a important strategic ally of the United States in the Middle-East.

 

 

None of these special conditions apply to China. Though the U.S. was initially supportive of China’s growth (1970-2016), it now considers China to be a key economic competitor and a major geopolitical rival. Therefore, the U.S. cannot be expected to give China the slack that was awarded to Taiwan and Korea in the past (as well as to Japan and probably to India in the future).

China’s leaders are fully aware of the challenges ahead and the importance of reforms. They have consistently expressed concerns about the imbalances of the economic model and the sustainability of growth.  As early as 2007,  premier Wen Jiabao argued  that “the biggest problem with China’s economy is that the growth is unstable, unbalanced, uncoordinated and unsustainable.”  Shortly after taking the helm in 2013,  President Xi Jinping warned that China faced a “blind alley without deepening reform and opening to the world.”

In the early days of the Xi Administration in 2013 two important government policy statements outlined the strategic path required for China to avoid the “blind alley.” In his comments at the Third Plenum of the Party Central Committee in November 2013, President Xi proposed reforms to increase the role of markets and the capacity for state regulatory oversight. Xi’s comments were in line with the report issued earlier by the World Bank and the Development Research Centre of China’s State Council titled China 2030: Building a Modern Harmonious and Creative Society which highlighted the need for more reliance on markets and free enterprise and openness to world markets and scientific research.

However, since 2013 the Xi Administration has veered off the planned reform path. Perhaps, powerful political and economic groups with vested interests have resisted the changes; or it may be that the reforms were not considered timely or politically expedient.  At the same time, an increasingly acrimonious relationship with the United States marked by tariffs and severe sanctions on technology transfers altered the Xi Administration’s view on “opening to the world.”

The recent messaging from the Xi Administration is autarkic. China is said to face a “protracted struggle” with America and cadres are encouraged to “discard wishful thinking, be willing to fight, and refuse to give way.” President Xi now touts a “new development concept” based on self-reliance aimed at securing domestic control over the key technologies of the future and their supply chains.

The hope is that China can avoid the pitfalls faced by almost all developing countries that have pursued “import substitution” strategies.  This may be the case because of China’s particular characteristics: A high degree of internal competition; enormous  economies of scale provided by 1.4 billion consumers; world-class manufacturing capacity achieved as the “factory of the world” ; and a heavy tradition of investment in research and development. Moreover, China has considerable experience with the East-Asia “Tiger” model in corralling investments into priority areas through credit and fiscal subsidies and control over banks and resourceful state firms.

In any case, the “new development concept” implies expanded state control over investments and markets. The Xi Administration’s policy about-face was recently acknowledged by Katherine Tai, the Biden Administration’s top trade official: “China has doubled down on its state-centric model…It is increasingly clear that China’s plans do not include meaningful reforms.”

The main risk for China is that autarkic ambitions, particularly those relating to complex efforts to replicate frontier technologies, will prove prohibitively costly and divert resources away from more basic priorities such as bridging the enormous wealth gap between rich coastal provinces and the rural interior provinces.

The Wikipedia chart below shows the discrepancy in wealth between China’s prosperous coastal provinces and Beijing and the rest of the country. Stripping out the rich provinces,  GDP per capital falls to around $8,400, a level similar to Mexico.

 

This divide is illustrated by the contrast between the high educational standards in provinces like Shanghai, which ranks at the top of the OECD’s PISA (Program for International Student Assessment),  and the generally low schooling of most of the population. For example, as shown in the OECD data below, China’s overall educational achievement, as measured by the percentage of the population which does not complete High School, is very low, near Indian levels and worse than Mexico. The difference between China and recent convergers like Poland and Korea (at the far right of the table below) is telling.

The extreme divide between the rich and educated and the masses of uneducated poor has proven to be a critical growth barrier for developing countries and a root of the middle-income trap in Latin America. In the mid-1970s both Brazil and Mexico (the “next Taiwan”) were considered “miracle” economies on the verge of high-income status. Both countries had enjoyed high growth since the early 1960s, relying heavily on import-substitution strategies, and reached per capita incomes near 20% of the U.S. level (China’s PC GDP has gone from 1.6% of the U.S. level in 1980 to 16% today). Unfortunately, since then both Brazil and Mexico have lost ground, now standing at 11% and 13% of U.S. GDP per capita.

One of the fundamental reasons for the failures of Brazil and Mexico (Turkey, South Africa and others as well) is the inability to incorporate the bulk of the population into the formal economy, either as productive labor or as sources of demand. This situation is encapsulated in the description of Brazil as a “Belindia”:  a combination of Belgium (some 10-20% of the population working and living the lifestyle of rich Europeans), and India (the remainder having more in common with poor Indians.) Of course, this situation leads to low productivity, social and political tension and a large underground economy where crime prevails. None of this was intentional, but it happened because of political choices dictated by powerful vested interest groups seeking to protect their benefits and economic rents.

To avoid this path China should do all it takes to incorporate its 950 million low-income citizens into the economy as productive workers and new consumers. Though these policies may not be popular with elites, they are  the key for assuring sustained growth in the future.

A Tale of Two Decades For Emerging Markets

For investors in emerging markets, the past decade has been a mirror image of the previous one. The S&P500 treaded water between 2001-2010, at first held back by the hangover of the technology-media-telecom bubble and then crashing with the Great Financial Crisis. Emerging markets, on the other hand, benefited from the peak growth years of the Chinese economic miracle and the commodity super-cycle that it engendered, and sailed through the GFC thanks to the extraordinary stimulus measures adopted by China. Over the past ten years, the opposite has happened. Emerging markets have languished as the U.S. dollar went from weak to strong, commodity prices collapsed and the pace and quality of China’s growth worsened. U.S. stocks, on the other hand, were turbocharged by waves of Quantitative Easing, which channeled liquidity into financial assets,  deflationary forces and the remarkable maturation of America’s tech monoliths into cash-generating machines.

We can see this evolution clearly in the following chart, which includes the EAFE index (Europe, Asia, Far East developed markets) and the Dow Index, in addition to the FTSE EM Index and the S&P500. The EAFE index is the biggest loser over the combined period, as it was hit hard by the GFC and lagged in the recovery. These two periods can also be explained in terms of the performance of the dollar and the nature of the components of the different indices. Non-U.S. developed market currencies appreciated nearly 40% over the first period and lost 20% over the second period, while EM currencies appreciated by 33% and then fell by 30%.

In terms of index components, EM and EAFE (and the Dow) are weighted towards cyclical stocks (industry, commodities and banks) much more than the tech heavy S&P500. This means that, to a significant degree, the relative performance of these indices can be considered in terms of the  value-growth style factors. Traditional value stocks performed well in the first period and miserably in the second.

 

How can we explain the poor performance of cyclical stocks over the past decade?  Probably the answer lies in several coincident developments in the world economy that have resulted in excess capacity and low demand for commodities and industrial goods:

  • The great financialization of the global economy, which peaked with the Great Financial Crisis, has sapped investment and growth at a time when rich countries are ageing and losing dynamism. Debt-to-GDP ratios are at peak historical levels in most developed and EM countries with not much to show in terms of productive investments.
  • The end of China’s economic miracle. Since the GFC, China’s authorities have mainly concerned themselves, with little success, with correcting growing economic imbalances. Efforts to boost consumption and reduce dependence on non-productive investments have not been successful.
  • The 2001-2011 decade left many industries and commodity producers with excess capacity. The commodity super-cycle turned out to be much more of a bane then a boom for commodity dependent economies which subsequently have suffered from a heavy dose of “Dutch Disease.” (Brazil, South Africa, Chile, Indonesia)
  • Technological disruption is hitting many of the traditional cyclical industries (banking, autos).

The combination of these factors have led to a state of quasi-depression for most emerging markets over the past decade. We can see this in earnings growth over the two decades, as shown in the following charts.

The 2001-2011 decade was outstanding for corporate earnings, particularly for countries highly engaged in the China trade (Chile, South Africa, Indonesia, Korea). The U.S. lagged considerably, worse than appears on the chart because the base for the U.S. is the trough of the 2001 U.S. recession.

The chart for the 2011-2021 period paints a very different picture. The beneficiaries of the China trade of the previous decade all suffer deeply from a combination of “Dutch Disease,” terms-of-trade shocks and global excess capacity. Almost all the countries show low to negative earnings growth over the decade, the exceptions being the U.S. (strong dollar and tech stocks) and Taiwan (TSMC).

The past decade has seen a revival of “American exceptionalism,” premised on the relative strength of U.S. capitalism and economic dynamism compared to the rest of the world. The unique capacity of American venture capitalism, Washington’s pro-business and pro-Wall Street stance, the ocean of liquidity provided by the Federal Reserve and its perceived commitment to backstop equity markets, and corporate America’s keen focus on shareholder value have made America’s stock market the magnet for international capital looking for safety in a turbulent world.

Chile’s Constitutional Trap

Latin America’s persistent economic decline relative to other emerging markets over the past 40 years can largely be attributed to poor governance. The region has become the main example for the “Middle-Income Trap” which results when rent-seeking interest groups institutionalize policies that make reforms nearly impossible in the future. Typically, these policies are introduced at times when social turmoil leads to “regime changes,” often through constitutional reforms. Brazil went through this process in the 1980s. Chile is going through a similar experience today.

Over the past thirty years, Chile has been the only successful major economy in Latin America. Until recently,  it was considered a serious candidate to join the club of high income and developed economies. However, inconsistent economic policies over the past decade and an explosion of social turmoil in 2019 appear to have brought about a regime change, which would reverse most of the pro-investment policies introduced during the military regime by its free-market “Chicago Boys.” A Constitutional Convention, firmly dominated by progressive and parochial interests, is now in session to define the rules of this new regime.

The example of Brazil should make Chileans very nervous. Brazil’s military regime (1965-1985) collapsed during the Latin American debt crisis of the early 1980s, a period  of increased political and social protest. Amidst this popular demand for change, progressive politicians filled the political vacuum left by the military. A Constitutional Assembly dominated by progressives came up with the “People’s Constitution,” which, according to its President, Ulysses de Guimaraes, would protect Brazil’s “suffering poor, massacred, humiliated and abused throughout history.” The new Constitution was a full rejection of the Military Regime’s trickle-down, investment-led approach in favor of one focused on securing social rights and economic safety nets.  Important interest groups with political influence, particularly civil servants, captured for themselves juicy windfalls. (One lone dissident voice at the convention, Senator Roberto Campos, a leading figure in economic policy during the military regime, decried the new constitution as “a mix of panaceas and passions…a catalogue of utopias… a civic Carnival… a hodgepodge of pettiness, xenophobia, irrational economics, corporativism, pseudo-nationalism and other foul “isms.”)

Very soon following its approval in 1988, more sober economists and policy makers began arguing that the Constitution – particularly its extremely generous provisions for civil servants–would prove a fiscal straitjacket and a severe burden on public policy.  For the past thirty years, successive governments have sought, with little success, to reform the Constitution to allow more flexibility in fiscal spending

One of the first critics was Raul Velloso, an expert on public finances with a PhD from Yale University. From day one, Velloso warned that the fixed expenditures mandated by the  Constitution  would prove catastrophic for economic growth. This week Velloso published an article in the Estado de Sao Paulo newspaper (Link) summarizing the consequences  of Brazil’s “Citizens Constitution.”

Since 1988 fiscal expenditures in Brazil have become dominated by mandated disbursements for social welfare benefits and civil servant salaries and pensions. We can see this in the chart below, based on Velloso’s data. Government expenditures have become increasingly channeled into constitutionally mandated social spending and civil servant benefits, leaving  scarce resources for anything else. The biggest victim has been investments, which according to Velloso, fell from 16% of the budget to 3%. Public sector investments in infrastructure have fallen from 5.1% of GDP to 0.7% over this period.

The lessons of Brazil are clear. Idealistic social mandates written into Constitutions during times of social upheaval have predictably nefarious long-term consequences. Once granted, benefits are extremely difficult to withdraw. Economic growth and prosperity lose. For Chile, Brazil provides a roadmap for what to avoid.

Emerging Markets Should not be Complacent About Debt

The  monetary and fiscal policies pursued since the Great Financial Crisis and greatly expanded during the COVID pandemic have repressed interest rates and flooded the global economy with liquidity. Low interest rates have promoted debt accumulation and stimulated a global yield chase. This environment has supported the widespread complacency of policy makers and investors who assume that these conditions are here to stay.

The fundamental argument of those who argue that the current mix of policies is sustainable is that low nominal interest rates and negative real rates make the burden of debt low by historical standards. The data series published quarterly by the Bank for International Settlements (BIS) allow us to evaluate this claim. What the BIS data shows is that some important qualifications are in order. Though low debt servicing costs may persist in  the U.S., it seems stretched for many other countries to believe they will be so fortunate.

The chart below shows the latest  non-financial private sector debt service ratios for emerging markets as well as for several key developed markets. Private sector ratios are important as they are very sensitive to credit cycles and the private sector in all these countries is the driver of productivity and growth. The data for China may be less meaningful because of the dominant role of the state in the economy and the difficulty in distinguishing between public and private companies.

What we see is that these ratios vary tremendously across the world and within regions. The United States is in the middle of the pack, a comfortable position for the issuer of the global reserve currency and also the deepest market for “safe” assets. The countries on the left of the chart appear in good shape. On the other hand, on the right side of the chart there are obvious vulnerabilities. France is probably the weakest link among developed countries (twice the level of Germany though below Canada). In emerging markets, Brazil, Turkey and Korea are around the critical 20% level.

These debt service coverage ratios must be seen in the context of the recent wave of Central Bank tightening cycles that have been initiated  to confront rising inflation and capital flight. The chart below from Charlie Billelo details the recent wave of tightening measures. Both Brazil and South Korea are now in tightening mode but still have negative real central bank rates.

We should also be aware of the historical context. We can see the historical trends for each individual country in the three regional charts below. First, in Asia it is noteworthy that Korea may soon be back to the record-high debt service ratios experienced after the Asian financial crisis.

In EMEA (Europe, Middle East and Africa), the very high and persistently rising ratios of France and Turkey are noteworthy.

Finally, in the Americas the contrast is striking. Both the United States and Mexico have relatively low ratios which are very consistent over time. The U.S. is in a privileged situation as the recipient of global capital flight, and the Federal Reserve may be in a position to maintain negative real interest rates for the foreseeable future. Mexico’s private sector is underleveraged and poised to take advantage of growth opportunities. The situation is very different in Brazil.  Brazil has a history of high and volatile debt ratios. Corporate debt is at record-high levels at a time when the Central Bank may have to tighten sharply,  the economy is slowing to a crawl and capital flight is high.

The BIS data is a warning to not make global generalizations about debt sustainability. Arguments for Modern Monetary Theory, unrestrained fiscal expansion and financial repression may be justified for the U.S., but inapplicable for most countries.

Economic Freedom in Emerging Markets

It is widely acknowledged by development economists that a country’s wealth is correlated to the economic freedom enjoyed by its citizens. The history of Europe supports this idea. From the Italian and Flemish city-states of the 15th century to the United Provinces of the Netherlands in the 17th century and finally England’s Glorious Revolution and the take-off of the industrial revolution in the 18th century, every great surge of prosperity in Europe occurred when republican ideals, open markets and tolerance for new ideas were allowed to flourish and overcome centralized, absolute rule. Moreover, these Anglo-Dutch ideals were the philosophical foundation of the American Revolution and instrumental to the United States’ rise as the world’s most dynamic economy in the 19th century.

The rise of the Soviet Union as an economic power in the 1960s raised doubts about “economic freedom”  being the only path to prosperity. Famously, the economist Paul Samuelson included the chart below in his widely read college textbook between 1961 and 1980, showing the Soviet economy on the path to overtake the United States. Samuelson’s basic argument was that the Soviets would grow faster because investment rates were higher and potential for efficiency gains were greater. Similar arguments were made in favor of the Japanese economy in the 1980s and have returned with even more vigor in relation to China in recent years.

The confidence in China’s ability to sustain high rates of GDP growth in the future is grounded in a belief that  the government is able to successfully steer investments into sectors of the economy with high growth potential. This thinking is rooted in the extraordinary success of the “East Asia Development Model” pursued by Japan, Taiwan, Korea and China which relies on  state support (tariffs, fiscal subsidies, credit subsidies) to corral investments into “frontier” industries with high export potential. It is also supported by arguments, back in favor in Western economic academia (e.g. Mariana Mazzucato, Carlota Perez), which proffer a key role for the state as an inducer of investment in vital industries.

Though it can be debated what the exact role of the state should be as an inducer of economic activity there are a series of objective criteria that can be identified as necessary to provide the appropriate institutional conditions for human and financial capital to be deployed in entrepreneurial activities. These basic conditions can be said then to provide the institutional framework for “economic freedom.”

Several institutions (e.g., The World Bank, The Fraser Institute, The Heritage Institute) have developed methodologies to rank countries in terms of economic freedom over time.

All of these look at a combination of the following factors:

  1. Rule of Law (property rights, government integrity, judicial effectiveness)
  2. Government Size (government spending, tax burden, fiscal health)
  3. Regulatory Efficiency (business freedom, labor freedom, monetary freedom)
  4. Open Markets (trade freedom, investment freedom, financial freedom)

 

The table below is from The Fraser Institute’s 2021 report which is based on 2019 data. The countries are ranked and separated into four quartiles, the top quartile being the countries with the highest level of economic freedom. These rankings are available for the past 40 years to provide a history for evaluating progress or regression over time.

 

The following maps show the Fraser Ranking in both 1980 and 2019. Note the tragic fall of Venezuela from one of the most economically free countries in the world to the bottom.

The following graph looks at the relationship between economic freedom and wealth, using Fraser’s country data and the World Bank’s  2019 GDP per capita as a proxy for wealth. We can see a strong correlation between economic freedom and wealth. Two noteworthy outliers are petro-states (UAE, Quatar, Brunei) and tax havens (Luxembourg) which are considerably above the trend line and Eastern European “reformers” (Lithuania, Lativia, Estonia, Georgia, Poland) which are well below the trendline. Presumably, the Eastern Europeans will experience a period of catching up as they enjoy the benefits of the reforms that have been implemented since the 1990s.

The table below narrows the Fraser Institute’s data for the primary emerging markets of interest to investors. The table shows the four quartiles, the country’s overall rank and the change in the quartile since 1980.

In conclusion, there are several interesting facts to note about the table.

  • Overall, EM has had a small improvement over the past 40 years.
  • In terms of the importance of countries relative to their weight in benchmarks, the rankings are not auspicious. India, Brazil and China, which are really the core of emerging markets as an asset class, are all in the bottom of the Third Quartile. Vietnam, considered by many the most promising frontier market, is in the Fourth Quartile.
  • Those countries in the Second Quartile may offer the best opportunities. I would highlight the Philippines and Indonesia which are on the right path and continue to enjoy high potential growth.
  • The three countries in the top quartile – Taiwan, Chile and Peru — are new entrants to this elite, with Peru coming all the way from the Fourth Quartile. In 1980 EM  had these three countries in the First Quartile, Venezuela, Malaysia and the UAE. Venezuela went from the First Quartile with a highly ranked 16th overall in 1980 to absolute bottom ranking in 2019. Peru’s rise and Venezuela’s collapse are a testament to the institutional precariousness of Latin American institutions.

 

Emerging Markets Stocks Expected Returns, 3Q2021

If forecasting is foolhardy in the most stable of times, trying to make predictions under current circumstances is risible. For the time being, financial markets are driven by the extraordinary policies of U.S. monetary and fiscal authorities which support consumption and provide liquidity to backstop asset prices. The limits of these policies are unknown, but, for now, investors from around the world are willing to engage in this lucrative scheme.

Predictions for the short term are always haphazard. Most market participants simply assume that current trends will continue. They are usually right because trends are persistent while mean reversion occurs over the long-term horizon. The current trends favor investing in U.S. stocks. These have outperformed for over a decade and the biggest and most dominant tech stocks have metamorphized into the new global “safe” asset of choice, replacing return-less U.S. Treasury bonds. Investors have concluded that these quasi-monopolies in winner-take-all growing sectors of the economy are pillars of stability in a turbulent world. The assumptions that underlie this investment thesis are that: 1.  the Federal Reserve is fully committed to sustaining the stock market because it believes that a market correction from the current high levels would cause  a negative “wealth effect” that would precipitate an economic depression; and 2. The Fed desires sustained higher inflation to erode the value of the Federal debt.

The COVID pandemic in a perverse way facilitated the work of the Fed and consolidated what could be called the “FAANG Monetary Standard.”  COVID justified unprecedented levels of monetary intervention and fiscal expansion and drove the stock market to record prices. The exceptional efforts of U.S. authorities made the 2021 recession one of the shortest ever and allowed the U.S. economy to outperform the global economy by a wide margin. Rising asset prices in the U.S. sucked in global capital and pushed up the value of the USD.

Unfortunately, none of this was beneficial for emerging markets. With the exception of China which managed the pandemic well and benefited from the surge of U.S. imports of consumer goods, emerging markets suffered profoundly from COVID, both in terms of short-term growth and long-term growth potential. COVID only accentuated what has been a state of semi-depression in emerging markets for the past decade, as a strong USD and U.S. financial markets have drained them of capital resources.

Ironically, the accelerated nature of the COVID recession in the U.S. will now play against emerging markets as we enter 2022. The United States and China, the two main drivers of the global economy, are now in the process of slowing dramatically as the effects of the COVID stimulus wear off. This means that the expected late recovery of most EM countries will be muted.

In fact, 2022 is likely going to be the year when the markets fully appreciate the devastating long-term consequences of COVID. The enormous increases in government debt incurred by the United States, China and most EM countries in 2021 will weigh on growth for years to come. U.S potential real GDP growth, which was considered to be around 2% before the pandemic, can now be assumed to be considerably lower. Many emerging market countries, including China and Brazil, are facing poor growth prospects as they deal with high levels of unproductive debt.

Ironically, the coming slowdown in the U.S. may continue to favor U.S. stocks and the USD. As the economy slows in coming months, the Fed will have to provide more liquidity to the markets to avoid a correction in asset prices. This may well lead to a further expansion in valuation levels for the tech stocks and final blow off for the S&P500.

The two charts below show the current debt levels in emerging markets and the five-year increase in the level of the debt to GDP ratio for these countries and the United States. The countries with high debt levels and very high recent accumulation of debt generally face difficult challenges ahead. These include, China, Brazil, Chile and Korea.

The next chart shows expected long term stock market returns for EM countries and the United States. The annual returns are for the next seven years but would be similar for 10 years. These returns are in USD terms and assume that EM currencies maintain current valuations relative to the USD over the period. If EM currencies were to appreciate over the period (likely in my view) then returns would be higher.

The details are shown in the next table. Turkey tops the chart and probably provides the best bet for high returns. CAPE ratios below 5 have been in the past fail-safe as an indicator of high future returns. Turkey is well underway in its economic adjustment, with a very competitive currency and export sector and rising business confidence. The Philippines are also well positioned, but do have a challenge to return to the very high historical CAPE, particularly given the lofty weight of financials and real estate in the index. Brazil is cheap but faces high debt and a weak economy as it enters a complicated election year. This is a reminder that CAPE ratios are not helpful for short- term predictions. Moreover, valuation is never enough. Markets always need a trigger.

On the negative side, Taiwan and India both stand out for their very high CAPE ratios. For these valuations to be justified, earnings will have to be much higher than currently anticipated. This means a major ramping up of margins and corporate profitability in India and an extension of the semi-conductor super-cycle in Taiwan.

CAPE Ratios Relative to History and Real Expected Returns, September 2021
Current Cape Historical AVG CAPE Difference Earnings Cycle Expected 7-Year Total Real Annual Return
Turkey 4.4 8.6 -48.84% Early 12.0%
Philippines 15.8 22.8 -30.70% Early 10.3%
Brazil 11.5 12.3 -6.50% Late 9.2%
Malaysia 11.9 15.6 -23.72% Early 7.7%
S. Africa 13 14.5 -10.34% Early 7.6%
Colombia 9.2 14.2 -35.21% Early 7.0%
Peru 16.5 16.9 -2.37% Early 6.4%
China 13.5 15 -10.00% Late 6.3%
Indonesia 13.5 16.1 -16.15% Early 5.4%
Thailand 13.7 14.7 -6.80% Early 4.9%
Mexico 17 17.4 -2.30% Early 4.7%
GEM 14.6 14.3 2.10% Early 4.4%
Chile 14.6 17.9 -18.44% Early 4.3%
Korea 11.6 13.2 -12.12% Early 4.2%
Taiwan 24.9 18.5 34.59% Mid 4.0%
USA 37.9 24.8 52.82% Late 3.3%
Russia 7.9 6.8 16.18% Early 0.8%
India 30.4 20.8 46.15% Early 0.6%
Argentina 9.5 8.5 11.76% Early -7.9%

The methodology used to determine expected returns is the following:

  1. Forecasted earnings for 2022-2028 assume earnings growth of nominal GDP, making adjustments for each country’s place in the business cycle.
  2. A cyclically-adjusted earnings value for 2028 is calculated as an average of inflation-adjusted earnings for the 10-year period ending in 2028.
  3. Each country’s historical cyclically adjusted price earnings ratio (CAPE) is calculated as an average of CAPE ratios for the country since its inclusion in the MSCI index, with an increased weight given to the past 15 years.
  4. The historical CAPE ratio is applied to 2028 earnings to determine the expected level of the country index in 2028.

 

Emerging Markets are Loaded with Debt So Pick Your Countries Carefully

The world is awash in debt. Much of this debt has been accumulated over the past 20 years, and has served to support consumption, government spending and financial markets during a period of declining productivity and slowing economic growth.  Unfortunately,  because this debt was not acquired to increase productive activities, it is not self-sustaining and has become a drag on economic activity.

The chart below shows the steady accumulation of debt in both advanced and emerging market economies. Advanced economies had steady debt accumulation over the past twenty years with peaks around the Great Financial Crisis and the Covid pandemic. Emerging markets saw most of the debt accumulated over the past decade, a period that has had depression like characteristics for most countries and has seen a dramatic decline in the level and quality of China’s economic growth. (All data is from the Bank for International Settlements, BIS Link)

 

The growth in debt in emerging markets has been general. We can see in the following chart that practically all emerging market countries have ramped up debt over the past decade and now find themselves at record levels.

However, not all emerging economies are in the same condition. We can differentiate by both debt levels and rate of accumulation, which is shown in the next two charts.

 

Several countries stand out in having very high debt levels and accelerated accumulation: China, Korea, Chile and Brazil. In none of these countries has the debt been used to increase productive activities. In China, debt mainly supports the real estate bubble and infrastructure investments of marginal utility; in Korea, debt increases have flowed mainly to support consumption. In Chile and Brazil, debt has served to support government current spending and capital flight. Moreover, China, Brazil and Chile face serious economic challenges. Both Brazil and Chile will likely be in recession in 2022, and China’s sustainable growth level is in steep decline.

On the other hand, Indonesia, Mexico, Turkey, Poland Russia and Colombia all have lower debt levels and slower debt accumulation. These economies are coming out of the pandemic in relatively good shape and with the prospect of healthy economic rebounds in 2022-23.

Given a world awash in debt and suffering from low GDP growth, investors should focus on the few countries with good debt profiles and positioned for a rebound.

Is India Assuming Leadership in Emerging Markets?

For those investors who believe in mean reversion and the cyclical nature of capitalism, it is reassuring that sectors and companies do not to retain market leadership for long. However, because of momentum and recency bias, investors always extrapolate the present into the future. So, we see today’s near unanimous agreement that the current crop of great U.S. companies – the tech behemoths – will rule forever, expanding their reach into every nook and cranny of the economy. Until recently, this also seemed obvious in emerging Markets

Just to be contrarian, I’ve argued that, given how utterly unpredictable the future is, new leadership would somehow take over in emerging markets during the 2020s. Given that the past decade belonged to China, and the one before that was all about commodity producers, perhaps India could now have its “roaring” 20s.

The table below shows the ten largest stocks in the MCI Emerging Markets index since its early days, 30 years ago. We can see that every decade was marked by an exceptional trend: 1990, the great Taiwan stock bubble; 2000, the technology-media-telecom frenzy; 2010, the commodity super-cycle; and 2020, the rise of China and its “invincible” tech giants. Well, now it seems China’s tech leaders may have been more Goliaths than behemoths, as they  are being taken down by government regulators who, unlike their U.S. counterparts, have the power to dictate rules to these firms in accordance with their notion of what serves “common prosperity.” China, which had 7 stocks in the top ten at year-end 2020 (including Naspers), now has five; and India has increased its count to two. If we look at the next ten stocks in the following table, we get an even better idea of the change in the investment environment: China had half of these stocks at year-end 2020 and now only two; India had two and now has three. Also joining the list are two more commodity/reflation stocks, Gazprom and Sberbank, both from Russia.

The changes this year in the rankings of the most prominent stocks in EM has resulted from the outperformance of Indian stocks relative to Chinese stocks, as shown in the table below. Year-to-date, Chinese stocks have lost 16% of their value while Indian stocks have appreciated by 27%. Consequently, the weight of China in MSCI EM has fallen from 40% to 35%, while India has risen from 9% to 12%.

So, what is causing the rise of Indian stocks and can this be sustained?

India’s current advantages over China can be resumed as follows: much better demographics, much less debt and relatively greater support for private enterprise over the state sector. Also, India’s GDP is expected to grow much faster than China’s. Moreover, while exports and urbanization (infrastructure/real estate) are mostly tapped out as sources of growth for China, India has long runways in both these areas. Finally, India’s blue chip corporations generally wield significant political power and are unlikely to face the regulatory risks faced by Chinese companies.  To the contrary, India is likely to promote national champions in frontier tech industries, limiting the reach of the American tech giants.

Unfortunately, investors may have already priced in India’s growth opportunity to a considerable extent. Though, in a world of scarce growth and record-low interest rates, Indian blue chips with good growth profiles should be expected to trade at high valuations, Indian stocks now trade at record levels and sky-high valuations. The chart below shows PE and CAPE ratios for MSCI India, with consensus earnings for 2021. CAPE ratios are nearing the “bubble” levels of 2010.

 

The following chart shows historical earnings. It includes the 2021 consensus which appears very optimistic relative to the current condition of the economy and business confidence. We can see in the next chart from Variant Perception that there is currently a severe and unusual disconnect between the level of stock prices and business confidence.

 

The future path of the market will be determined by how this divergence between stock prices and business confidence is decided.

For the market to make further progress from here, India, like almost all non-U.S. stock markets, needs to break out from a long period of earnings stagnation. We can see in the following chart that India over the past four decades has undergone several long periods of earnings stagnation which were followed by sudden bursts of profitability.

 

 

We can see in the final chart that the market is now anticipating another earning surge. The market has  risen well ahead of GDP and earnings (consensus 2021). Of course, this optimism needs to be confirmed. To a considerable degree, this will depend on global developments: basically, a weakening of the USD and a shift away from risk aversion and liquidity preference to higher risk opportunities outside the United States. If earnings can really break out in India, then, it’s off to the races.

America Sucks Up Global Capital and Emerging Markets Languish

 

The collapse of the United States-centered global financial system in 2008 made clear the fragility of the post-industrial model of capitalism built on increasing debt and financial complexity. Since the Great Financial Crisis awareness of the system’s fragility has dominated global investor behavior, causing a long period of global semi-depression, U.S. dollar appreciation and investor preference for the liquid and safe assets available in the U.S. capital markets. Periodic Fed interventions through QE aimed at sustaining asset prices have eliminated downside risk and encouraged this hoard of capital to find its way to Wall Street, causing interest rates on U.S. treasuries to fall to record low levels and the appreciation of all financial assets. Furthermore, it has brought about the extraordinary conversion of the leading technology growth stocks, with their supposed fail-safe winner-take-all business models, into the new global safe-haven liquid asset of choice.

This series of events has brought on a new period of American “exceptionalism.” As shown in the chart below, these are phases in the global economy when through a combination of superior growth, dollar appreciation and risk aversion global capital flows into the United States and U.S. asset prices enjoy an extended period of outperformance. We can see that since President Nixon abandoned the gold standard 50 years ago, the U.S. has had three periods when it has grown more than the global economy: 1980-86 when the combination of Volcker and Reagan boosted confidence in the USD and in the U.S. economy; 1994-2001, the Asian financial crisis and the Telecom-Tech-Media boom; and 2011-2021, QE, fiscal expansion and the new tech boom. Though the long-term trend is clearly for a sharp decline in the U.S. share of global GDP, each one of these upcycles in U.S. relative growth is accompanied by a strong dollar, large capital inflows and a booming stock market. The flip side of these periods of perceived American exceptionalism when the U.S. sucks up much of global capital is weak commodity prices, depressed growth and poorly performing stock prices in Emerging Markets. On the other hand, every downward swing in the chart (1971-1979, 1986-1994, 2001-2011) has seen strong growth and booming asset prices in EM.

 

The current period of  American “exceptionalism” has been particularly painful for most emerging markets.  Even before Covid, emerging markets had suffered a decade of low growth and low investment abetted by weakening currencies and persistent capital flight. Covid seriously worsened this trend, leaving most countries with more debt and worse growth prospects. Capital flight has only increased, much of it headed for “safe-haven” U.S. tech stocks.

The events of the past decade have led to extraordinary divergence between emerging markets and the United States in terms of corporate earnings and stock market performance. The charts below for the United States and major emerging markets seek to contrast the performance of the different markets in what has been an extraordinary era of superior returns for U.S. assets.

The first chart below seeks to provide the context of the long-term  experience of the U.S. stock market since W.W. II , showing the annualized growth in stock prices, earnings and GDP.

We can see that stock prices, earnings and GDP tend to be tied together. This is because over time profit margins tend to revert to the mean and nominal earnings generally follow the path of nominal GDP. Stock prices should marginally rise more than both earnings and GDP over time because price-earnings multiples slowly move higher because of declining transaction costs. Therefore, though earnings rise by 5.8% over this period, compared to 6.0% for nominal GDP, the S&P500 index rises by 7.7% annually.

The second chart focuses on 1986-2021, the post-industrial era. when the pillar of the American economy became services – especially financial services. This has been a very good period for American corporations. This period, marked by hyper-globalization/offshoring, deregulation, lax anti-trust enforcement, declining taxes and interest rates, and ever-increasing financial engineering (leverage, buybacks) – all factors that boosted corporate profitability – has been very favorable for the profitability of U.S. corporations relative to non-U.S. ones.  This period coincides with the modern era of emerging markets investing when institutional benchmarks (e.g., MSCI, IFC) became available. Over this period, we see an extraordinary disconnect between stock prices and earnings and GDP. The table below details the relative growth of the index, earnings and nominal GDP over distinct period. We can see that during periods of American exceptionalism, the U.S. stock market moves well above the long term trends for the market and GDP, with the current level at an extraordinary level of divergence.

The disconnect between index returns, earnings and GDP has been extraordinary. During 1986-2021, the S&P500 index has appreciated at nearly twice the rate of GDP growth while earnings have beaten GDP by about 35%. We can see this gap widening over the past 20 years as earnings grew at nearly twice the clip of GDP. Over the past ten years, the index’s gap over GDP has widened immensely, almost all due to multiple expansion. This multiple expansion can be explained by the “wealth effect” of the Fed’s QE policy, which has pushed up asset prices by eliminating downside risk and lowering discount rates.

A comparison of the U.S and Chinese stock markets reveals stark differences. First, China’s monetary policy has been much tighter and monetary interventions have been aimed exclusively at maintaining the stability of the real estate and banking sectors. While the U.S. Fed can be said to be fixated on stock prices, China’s central bank cares primarily  about real estate prices. This makes sense because the Chinese have most of their wealth in residential properties. Second, while the focus of U.S corporate executives is shareholder returns, China’s companies are mostly controlled by the public sector and their executives are agents of the government. The exception has been venture-capital financed technology companies seeking to emulate the business models and corporate cultures of Silicon Valley, but, as recent events have shown, even these companies are on a tight leash with Beijing.

The nature of China’s listed companies is reflected in their historical performance which we can see in the charts below. The first thing to note is the relationship between the stock market and earnings and GDP. While this relationship in the U.S. has been constant over time (corporate margins and stock multiples revert to the mean and expand in line with GDP), in China they are unrelated. While China’s GDP has been on an unprecedented 30-year expansion, this is not reflected in stock prices or earnings. (However, over this period there has been an extraordinary appreciation in real estate prices). Remarkably, since 1992, China’s GDP has expanded at a rate of nearly 13% annually, while stock prices and earnings have declined. Even over the last decade which has been marked by the rise of China’s privately owned tech giants and yuan appreciation relative to the USD, earnings have been negative. This is a testament to global depression-like conditions, manufacturing oversupply, and misallocation of capital by state firms in China’s debt-driven economy. These conditions are likely to persist into the future as China’s government forces both public and private firms to invest in “strategic” frontier industries to secure independence from western suppliers.

Finally, we look below at three other EM countries: India, Brazil, and Taiwan.

India: The charts show that the long-term relationship between stock index appreciation, earnings and GDP has occurred in India as should be expected. Over the 1990-2021 period, Indian earnings and GDP growth are very similar. Stock prices have grown at a slightly higher rate which can be explained by multiple expansion and the current high level of the market. Over the 2001-2021 period the relationship between earnings and GDP holds tightly, while stock prices race ahead and experience two “bubbles,” in 2008 and at the present time. Over the past ten years, the global depression/strong dollar environment impacted GDP and especially earnings while the stock market disconnected as valuations returned to “bubble” levels (CAPE ratio at 28.1 which is the second highest ever, only below 30.6 in 2010).

In Brazil the relationship between GDP growth and stock price appreciation holds up as expected. However, earnings do not keep up. The 1986-2021 period in Brazil is marked by high economic volatility, boom-to-bust cycles and mismanagement of state companies, conditions which are detrimental to corporate investment and profits. Brazil missed out on the trade benefits of hyper-globalization and underwent a process of accelerated premature deindustrialization, leaving the economy and stock market highly vulnerable to commodity boom-to-bust cycles. Over the past decade, Brazil has been hit twofold by the collapse of the commodity supercycle and the global depression/strong dollar environment. Unlike EM countries in East Asia and India which have produced tech champions , Brazil has been largely “colonized” by Silicon Valley.

Taiwan provides an interesting contrast to Brazil, India and China. Over the 1986-2021 period stock price and earnings are closely tied but GDP lags behind. This is because Taiwan’s highly dynamic and increasingly profitable tech companies have a greater weight in the stock index than their share of GDP. Also, these numbers reflect the current “bubble” valuations and unusually high margins of tech companies, both of which should revert over the medium term. This effect has been particularly important over the past ten and twenty years, as TMSC has become one of the largest and most profitable global technology firms.  In contrast to Brazil which exports commodities and China where exporters have a small weight in the stock index, Taiwan’s market-driven technology companies dominate the index. This has enabled Taiwan to sail through the global depression/strong dollar environment of the past decade.

What these charts show is how difficult it is for emerging markets to do well in periods of perceived American exceptionalism. Though Taiwan appears to be an exception, its performance is driven mainly by the enormous success of TSMC. In China, India and Brazil it has been a very poor past decade for corporate earnings. This is not likely to change until the current cycle of American exceptionalism ends. This is long overdue and will happen eventually,  triggered by a new wave of optimism on global growth. However, for the time being, fear still dominates and the capital hoards will go to the “safety” of U.S. tech stocks.

China’s Growth Stocks Run Into the Ire of the Government

China’s ongoing regulatory/political onslaught against popular growth stocks has left investors rattled and confused. Given the tense relations between China and the United States and determined efforts on both sides to reduce interdependence, questions are being raised on the basic viability of investing in Chinese assets.

In one camp, the stalwart aficionados for investing in China are keeping the faith. These include two groups with fundamentally different motivations: 1. Long-term investors like Bridgewater’s Ray Dalio and global asset allocators who believe that the continued rise of China’s economy and its capital markets are inevitable and that Chinese markets provide a invaluable source of portfolio diversification. For these investors, periods of turmoil are temporary and provide buying opportunities; 2. Major Wall Street firms, such as Blackrock and JPMorgan, which for years have lobbied both Beijing and Washington to get access to the Chinese capital markets. Not surprisingly, in recent days both Blackrock and JPMorgan have encouraged their clients to increase investments in China.

The idea of investing in Chinese assets for diversification is certainly compelling. The current process of decoupling  of the world’s two largest economies may also reduce the correlation of asset prices and improve diversification opportunities. Given high valuations and low forecasted returns in U.S. assets, diversification may be of particular benefit at this time.

The argument for diversification is most compelling for fixed income. China has a strong currency relative to the USD and its fixed income markets currently provide a large positive yield spread to U.S. instruments. The Chinese government cares about maintaining a stable currency and a solid  and growing fixed income market as this is seen as a pillar of the long term objective of raising the profile of China’s capital markets and reducing dependence on the USD. Significant amounts of foreign capital have flowed into Chinese fixed income over the past year. This should continue.

For other assets, the case is less clear. Real estate in China is as overbuilt as in the U.S. and generally has lower rental yields than in western countries. Stocks are a complicated story with a checkered past and unclear prospects.

Strangely, to a significant degree what most investors outside of China think of as Chinese stocks are an ingenious creation of Wall Street and Silicon Valley. U.S. venture capital firms who backed almost all the major China tech firms (Tencent, Alibaba, etc…) allied with Wall Street and a compliant Securities and Exchange Commission to bring these companies to  U.S. stock exchanges in the form of Cayman Island registered shell companies. Concurrently, the SEC agreed to significantly lower reporting standards for foreign issuers, supposedly to promote the development of U.S. capital markets. Ironically, none of these firms could have listed in China where listing and reporting standards have been and continue to be much more rigorous.

Unfortunately, the chickens have come home to roost. Weirdly, both Chinese and U.S. regulators now concur that the U.S. listings were a mistake. The disastrous recent listing in New York of Didi Chuxing, which was done hastily to ease the exit of VC firms, may have been the death knell for this model. This poses a serious problem for current VC investors in China’s tech “unicorns” who will probably have to list in China’s domestic markets from now on.

Moreover, the problems for the “unicorns” do not stop there. Recent political developments in Beijing indicate a strong negative bias against a large segment of the tech sector. One of the key attractions for the VC model of investing is the “winner-take-all” nature of many tech sectors built on scale and network effects. This dynamic, which leads to huge growth and value creation for investors, is anathema to Beijing. The emasculation of Alibaba’s Jack Ma was a warning that Beijing will not brook dissent from tech billionaires. The wealth concentration and political power that “winner-take-all” tech has given to U.S. moguls like Bezos and Zuckerberg is seen by Beijing as incompatible with its vision of a “harmonious” society led by the Communist Party.

It is also evident that Beijing sees the current U.S. driven tech model as an impediment to China’s economic development objectives as dictated by the China 2025 industrial planning goals. The primary focus of listed tech firms and unicorns has been directed at what authorities now see as either frivolous consumer distractions (e.g., e-commerce, gaming, social chat and video) or else fintech applications that disintermediate and destabilize the state-controlled  financial system.  Beijing believes that these firms are mobilizing scarce financial and human resources that would best be allocated to key strategic industries (semiconductors, electric vehicles, quantum computing, etc…). The following chart shows just how misaligned venture capital is with the government’s objectives. Interestingly half of the recent valuation of China’s unicorns was in fintech, presumably in companies that aim to disintermediate China’s state banks. However, as we saw in the case of Ant Financial, the authorities have no tolerance for anything that weakens state banks ability to serve as a pillar of China’s state capitalism and direct capital to preferred sectors.

China’s political agenda regarding corporations goes beyond tech. Beijing’s latest slogan – “common prosperity” – guides corporations to ‘continuously improve themselves in patriotism, innovation, integrity and social responsibility” ; in other words, to follow the dictates of the communist party.  The after-school education sector has already been crippled by regulators under the pretense that it accentuates inequality and unsocial behavior. This means tech companies will be expected to invest in areas of interest to Beijing, in a form of social service.

Looking forward, the problem for China’s stock market may be that heavy-handed government intervention in corporations to meet social and economic mandates will likely hamper profitability and investor support, resulting in lower valuations. As in the rest of the world, over the past decade in China the tech sector has been the driver of earnings growth and stock market appreciation. Without the dynamism of stocks like Tencent and Alibaba, which gave the Chinese market a high growth profile (exactly like the FAANG stocks in the U.S), the opportunity set in China will look more like those in other emerging markets; that is to say, dominated by cyclical, low growth value stocks.

 

The fact is that, despite the huge success of the tech sector, China’s stock market already has had underlying weaknesses. China’s corporate world is heavily dominated by a combination of very large state companies, which have the low-return profile of publicly managed firms around the world, and provincial government-sponsored firms that participate in “strategic” sectors, following the guidance of Beijing. The herd-like behavior of these local government firms leads to overinvestment and low returns. This occurs repeatedly, as we are seeing today with massive investments in electric vehicles and semi-conductors by local government firms. Finally, we have non-strategic sectors, such as consumer goods and services, where private entrepreneurs dominate and compete ferociously for market share.

This combination of a prevalence of state and local government firms and ferocious competition for private markets results in low returns and mediocre growth in earnings. We can see this in the following chart which shows the historical growth in earnings denominated in U.S. dollars for the Shanghai Exchange, the MSCI China Index (MCHI) and, for comparison purposes, the S&P500. When seen in relation to GDP growth, the contrast between China and the U.S. is shocking. The past three decades in the U.S. have been the heyday of financial engineering (leverage and buybacks) and globalization /offshoring and tax cuts have resulted in a major expansion of profit margins for U.S. firms. This has caused an extended period of earnings growth well above GDP growth, which is unprecedented. Meanwhile, in China corporations have sacrificed earnings to meet government objectives which has resulted in an equally extraordinary (by global standards) and extended period of earnings growth well below GDP growth.

 

Without the sizzle of tech stocks, Chinese equities may become a much more mundane affair, more in line with other emerging markets. This raises the question of whether the market should trade at lower multiples. We can see in the chart below that price earnings (PE) and cyclically adjusted price earnings (CAPE) ratios have been trending higher. If the government persists in suppressing dynamic private firms, we should expect multiples to move lower.

In conclusion, the prospects for Chinese stocks look poor, as it is probable that the market is experiencing a de-rating. Investors should focus their attention on the fixed income markets where they will be aligned with the policy objectives of the government.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Chile’s New Reality; from Tiger to Sloth

In the past, Chile was considered a rare economic success story in emerging markets,  in the same vein as the high-growth “Tigers”  of East Asia. After the neo-liberal reforms introduced by the “Chicago Boys” of the military dictatorship (1973-1990), Chile enjoyed high GDP growth and significant improvements in social indicators. However, in recent years progress has stalled and Chile has started to look a lot more like its regional neighbors than like an East Asia tiger. Moreover, this process of convergence with the region is expected to accelerate in the near term as a constitutional assembly approves a new progressive constitution that is expected to greatly increase social rights and benefits and undo much of the  neoliberal economic framework imposed during  the military regime. Undoubtedly, these important changes will impact growth and the investment environment. Investors would be negligent to not incorporate this new reality into their analysis of business opportunities.

Chile’s growth path has been on a steady decline. Following about a decade of spectacular growth (1986-1997) the economy has gradually lost its dynamism.  Even during the commodity super-cycle of (2003-2012), growth levels were a step below the previous trend. Like in the rest of commodity-producing Latin America, the commodity boom was more a curse than a blessing, leaving behind high debt levels, an overvalued currency and deteriorated governance.  Since the commodity bust in 2012, the country has entered a low growth path and faces increasing social instability resulting from the unmet high expectations generated during the boom years. The chart below shows Chile’s GDP growth path since 1980 and the IMF World Economic Outlook projections through 2026. The IMF now sees Chile’s sustainable GDP growth path to be around 2.5%, which is only slightly above the regional average and a fraction of previous growth. Moreover, the IMF’s numbers do not yet take into account the considerable economic disruption that will probably result from the upcoming constitutional reform.

The marked reduction in growth prospects for Chile will mean lower corporate profit growth and impact  stock market valuations.  We can look at history to put this in context.

The first chart below shows the performance of stocks on the Santiago exchange for the very long term (1894-2021). We can see a long decline from the 1890s through 1960, and then a more precipitous decline caused by the political agitation of the 1960s and the rise to power in 1970 of the socialist,  Salvador Allende. The concurrence of the military coup in 1973 and a boom in commodity prices led to a huge stock market rally in the 1970s, with the index rising by 125 times (a dollar invested in 1970 would have appreciated to 125 dollars in 1980). Then came the collapse in  commodity prices and the Latin American debt crisis, and the market lost 86% of its value before stabilizing in December 1984. From that low point the market would rally 33.5x before topping in July 1995. In retrospect, we can say that 1995 was the glorious peak for Chilean stocks. The stock market provided dollarized annualized returns of 39.6% between 1973 and 1994. Between 1994 and today annualized returns have been a measly 1.9% (These numbers are before dividends which increase returns by about 2% per year). About 70% of contributors to the Chilean Pension fund system joined after 1994 and therefore have experienced low returns on their investments in Chilean stocks.

The following chart shows the more recent performance in greater detail. We can see that the 1994 peak was built on a period of rising earnings and rising PE multiples, with the PE reaching 26.4, the highest ever for Santiago. The commodity boom  bull market (2002-2012) was built essentially on USD earnings growth, a combination of corporate earnings and a strengthening peso. Since the commodity bust in 2012,  USD earnings have fallen by half because of a combination of lower corporate earnings and a weakening peso. Nominal USD earnings today are at the same level as 14 years ago.

We can shed more light on valuations by considering cyclically-adjusted Price-Earnings ratios (CAPE)  for the Chilean market.  What we see here is that Chilean stocks have had two “bubbles” over the past 30 years: first in 1994, based on the extrapolation of the “miracle” economy and optimism on the transition to democracy; second in 2007-2010, when the commodity super-cycle drove up both USD earnings and multiples.

 

What do these numbers tell us about future returns? First, we can see that current CAPE  earnings are about 20%  below trend. Second, we see that the cape ratio is well below the trend-line which is also in sync with the historical median CAPE for Chile of 17.9. Assuming a return to earnings trend in several years and the historical median CAPE ratio, Chilean stocks would have nearly 80% upside from current levels.

This is the normal analysis done with CAPE. Fraught as it is with problems, it does generally provide a reasonable indicator of return potential. But perhaps the case of Chile does not fit into this easy analysis.

First, the historical median cape may be distorted by two periods of extraordinarily high CAPEs over the 30-year period, during the 1994 and the 2007-2012 bubbles. What if current CAPE ratios reflect more realistically Chile’s current prospects of low growth? Second, perhaps the earnings trendline should be sloping downwards to take into consideration these diminishing growth expectations. No one believes that Chile can return to the kind of growth it saw in the 1990s. On the contrary, the low GDP growth expected by the IMF is in line with consensus and may even be optimistic if the constitutional reform is as anti-business as many observers now fear.

The fact is that a return to normalcy is a low probability scenario. Investors have the difficult task of evaluating what the new Chilean growth model will look like and project expected returns on that basis.

The case of Chile illustrates one of the characteristic traps of emerging market investing. Sudden and radical changes in political and regulatory environments can completely undermine an investor’s valuation framework. We are currently seeing this in China where regulators have suddenly put in question the financial models of most of the prominent tech firms. In Chile, the protests of recent years and the prospects of constitutional reform have signaled the end of the pro-business neo-liberal regime, meaning that the high valuation multiples of the past are probably irrelevant.

The S&P 500 Foundation of Optimism

The S&P500, the most followed index of U.S. stock indexes, is now valued at its second highest level in history. In terms of the widely followed Shiller CAPE  index, valuations have only been higher at the peak of the 2000 bubble. Yet, complacency reigns on the conviction that U.S. Fed monetization will fuel further rises. Moreover, investors have a remarkably ebullient view of the prospects of corporate America.

The Shiller CAPE ratio is shown in the chart below. At the current level, the market is valued at nearly 39 times inflation adjusted earnings of the past ten years.  At this level of valuation, investors should expect low to negative future returns.

 

All the traditional valuation  measures , except for one, point to an extraordinarily expensive stock market. The one exception — the multiple of 12 month forward earnings  — is the pillar of optimism that supports the market.

The financial press has been full of headlines of late pointing to declining forward PE ratios as bullish for stocks. The chart below shows clearly this compelling argument. According to the reasoning, even though the S&P500 has risen sharply, it is actually the cheapest it has been in two years because earnings are rising dramatically.

The expected surge in U.S. corporate earnings assumes a sustained U.S. economic recovery from the Covid recession and, most importantly, a remarkable increase in profit margins. These have ramped up over the past two decades and are now expected to jump further, to record levels. We can see this in the chart below, courtesy of Ed Yardeni.

The expected expansion of earnings reflected in the forward PE is shown in  a historical context below. This chart shows the post-war history of S&P earnings (1950-2021) in real (inflation adjusted) terms in logarithmic scale.  We have added the consensus FPE to the series.  What we can easily see is an unprecedented divergence from the trend.

 

Therefore, we have a bubble built on popular delusions. First, investors believe that the Fed will never let the market down; second, corporate profit margins which are already at record levels are going to increase much more; third, earnings will disconnect entirely from historical  trends and from GDP output.

Good luck  with that.

 

 

 

 

Can MMT Get Brazil Out Of Its Deep Slump?

Brazil’s dismal economic performance since the debt crisis of the 1980s has made it the poster child of the “middle-income trap.”  Over this period, Brazil’s economy, like those of most Latin American countries, stopped converging with developed economies, in sharp contrast to the high-growth emerging markets in East Asia and Eastern Europe. This extended period of economic failure has led to rising anxiety and calls for new approaches from policy makers and intellectuals  of both the left and the right.

Brazil’s Finance Minister Paulo Guedes has argued for a liberal agenda of privatizations, trade liberalization and smaller more efficient government, but he has run into the rock-hard resistance of powerful interest groups which extract benefits from the status quo and he has had only tepid support from his boss, President Bolsonaro. Unfortunately, though Guedes’s “Chicago School” framework would have produced high returns if introduced decades ago  today  it  seems woefully anachronistic in the context of a global reaction against neo-liberalism and the renewed popularity of industrial policy in the U.S. and its allies (WSJ). More in tune with the times, Brazilian financier Andre Lara Resende has caused an intellectual ruckus by advocating that Brazil break out of its torpor by adopting Modern Monetary Theory, the combined expansion of money printing and fiscal expansion that President Biden is pursuing in the U.S.  The underlying premise for both Lara Resende and U.S policy makers is that their respective economies have an abundance of high return public sector investment opportunities (infrastructure, basic research, broadband access, education, etc…) that pay for themselves through higher productivity and GDP growth and are easily financed today given the current extraordinary financial conditions of excess savings and historically low interest rates.

Lara Resende’s thinking reflects a profound change in the popularity of developmentalist economic theories in favor of a more activist state. The phenomenal rise of China with its super interventionist public sector and its sector-targeted industrial policies occurred during a 40-year period of neo-liberal tendencies and public sector retrenchment in the West. But now the pendulum has turned and a new generation of influential economists, such as Carlota Perez and Mariana Mazzucato, are convincing policy makers in the West that the public sector has a critical role to play in inducing innovation and growth. The Biden Administration is particularly smitten with these ideas, believing that these policies will put the U.S. on a higher, socially equitable and greener growth path.

In Brazil, these state-supported developmentalist policies have been deeply out of favor since the 1980s. Even the leftist ideologues of the PT administrations of Lula and Dilma rejected industrial policy in favor of social welfare initiatives. Since the 1980s, the Brazilian state’s capacity for investing in public goods has been severely eroded. Despite chronic fiscal deficits and a near-doubling of the ratio of public debt to GDP over the past decade, almost nothing has been spent on infrastructure. Also, government support for critical sectors through financial subsidies and research and development has dwindled. Over the past decades as government capacity for investing in public goods has fallen Brazil has become increasingly reliant on private capital for the scarce investments made in physical infrastructure, education and healthcare.

But this was not always the case. In fact, the kind of strategies advocated by Lara, Resende, Perez and Mazzucato have a better track in Brazil than neo-liberal ideologues like Guedes would admit. We can point to two of Brazil’s great success stories of the past decades as evidence of this: agroindustry and Embraer.

 

  • Brazil’s world class agro-industrial sector was heavily supported by the public sector which sponsored through the agriculture research institute, Embrapa, innovation breakthroughs in tropical agriculture. Also, a wave of investments in roads and highways and port infrastructure during the 1970s provided the physical backbone for grain exports. Finally, for decades through Banco do Brasil, the government has provided cheap investment and working capital to the farm sector. All of this public sector support has induced the enormous success of thousands of entrepreneurs in the farm sector and related activities (services, meatpacking, etc…).
  • Brazil’s aircraft manufacturer Embraer was heavily promoted and subsidized by the military regime (1964-1980) and provided with a captive market for military and civilian planes. The company’s success was always tied to the state-run Aeronautics Institute of Technology (ITA) which partnered with leading global research institutions such as MIT to achieve a high level of academic excellence. ITA has educated the vast majority of the engineers employed by Embraer, and one of its graduates, Ozires Silva, was the driving managerial force behind its success. Embraer and ITA are both based in Sao Jose dos Campos and support a cluster of world-class aeronautics expertise.

In today’s Brazil there are many opportunities to use the public sector to promote strategic industries that generate growth and employment. For example, tourism could benefit from long-term planning, infrastructure investments, vocational training and preferential tax and financial regimes. Green technologies, from ethanol to solar and wind, also would benefit from public support. The automotive industry stands to be thoroughly disrupted by electrification over the coming decade unless the public sector has a plan to maintain the country’s relevance in this industry. Unfortunately , under current circumstances there are serious impediments to pursuing these efforts; namely, the insolvency of the state and chronic fiscal incontinence.

The Impossible Trinity

Lara Resende assures that there is a long list of badly needed investments that would increase growth and productivity and therefore pay for themselves. However, given Brazil’s current high debt levels and chronic fiscal deficits, how do you convince financial markets to accept higher public debt levels? Any indication of increased public spending today, no matter how well intentioned,  would trigger capital flight, a weaker BRL and higher nominal interest rates. Under current circumstances, Brazil is severely constrained by The Impossible Trinity, the concept in economics which states that it is impossible to control the exchange rate, capital movements and monetary policy at the same time. In Brazil, any version of Modern Monetary Theory that pretends to finance stepped-up fiscal spending and debt accumulation  would almost certainly result in a combination of higher inflation and currency devaluation unless capital controls were imposed. Of course, any hint from policy makers that they are thinking of stricter controls on capital flows would accelerate outflows.

Whatever the MMT proponents say, in Brazil, and in many other countries around the world, there is no way to get around the fact that the current very high debt levels are an impediment to growth and tie the hands of policy makers. After a decade of quasi-recession conditions, Brazil will not follow a path of austerity to reduce these debt levels. So, in the end, it will have to follow the path of financial repression like developed countries were able to do in the 1950s and hope to do again this decade. Hopefully, Brazil will not try to inflate the debt away (which would place the adjustment burden on the poor) but rather will find a way to pass the cost to Brazil’s rentier class.