Author: jvande

AMLO’s Embrace of the United States

Mexico’s president Andres Manuel Lopez Obrador, popularly referred to as AMLO, is a quixotic figure, enthralled with the leftist ideals of the past and nostalgic for state-led economic growth.  But, at the same time, unlike most of the traditional left, he is both socially and fiscally conservative. This leads him to assume seemingly contradictory positions.  At heart a populist with a genuine preoccupation with the concerns of the poor, he dislikes debt and is a fiscal hawk ; and though he relishes fiery anti-American rhetoric, as president he has pursued pragmatic and cordial relations with the U.S. and even embraced the shameless Mexico basher Donald Trump “as a friend of Mexico who respects our sovereignty.”

AMLO’s contradictions were in full view in an important speech he delivered July 24 at the Castillo Chapultepec to commemorate the birthday of Simon Bolivar, the “libertador” of South America. Surrounded by diplomats and intellectuals from across Latin America, AMLO provided a whirlwind overview of Latin American history and centuries of oppression at the hands of Spain and the United States.  The nefarious rule of the hegemon continues to this day and only glorious Cuba has successfully defied it, AMLO declared.

AMLO repeated the standard claim of the Latin American political left that all of the region’s problems have been caused by the United States. According to AMLO, it all started when Thomas Jefferson convinced President James Monroe that “the Americas are for the Americans”  which led to the “disintegration of the peoples of our continent and destroying what was built by Bolivar.” Using military force and conducting overt and covert operations against independent countries, the U.S. has imposed its will in the region. Only the people of Cuba have resisted and they “deserve the prize of dignity, and that island should be considered as the new Numantia for its example of resistance, and I think that for the same reason should be declared a world heritage site.”

So far, so good; all this was standard leftist rhetoric pleasing to the ears of most Latin American politicians and intellectuals. This would have been a good time to finish the speech with warm applauses from the audience. But AMLO can be full of surprises. After the traditional bashing of the U.S. and the adulation for Cuba, AMLO suddenly pivoted from  confrontation to conciliation.

Actually, AMLO claimed, we now live in a new world where the past is not relevant.

Times have changed, AMLO said. The policies of the past benefit no one. “Unbeatable conditions” currently exist for a new relationship based on respect and common purpose. According to AMLO, the “rise of China has strengthened the opinion in the United States that we should be seen as allies and not as distant neighbors.”  Nearly 30 years of integration with the United States through NAFTA make the countries “mutually indispensable and well positioned to recover what was lost with respect to production and trade with China, than to continue weakening as a region and to have in the Pacific a scene plagued with warlike tensions; To put it in other words, we want the United States to be strong economically and not just militarily. Achieving this balance and not the hegemony of any country, is the most responsible and most convenient way to maintain peace for the good of future generations and humanity.”

According to AMLO, Mexico’s best way forward is to participate in a vibrant and successful North American economy. “Besides, I don’t see any other way out; We cannot close our economies or bet on the application of tariffs to exporting countries of the world, much less should we declare a trade war on anyone. I think the best thing is to be efficient, creative, strengthen our regional market and compete with any country or region in the world.”

Conclusion

What should we make of AMLO’s remarkable speech?  

First, It is obviously a sign that the initial contacts with the Biden Administration have been constructive. Given AMLO’s strange “love affair” with Trump and initial coolness towards Biden,  concerns of a falling out were real but it now appears that they were unfounded. AMLO’s positioning towards the United States  is grounded in a pragmatic understanding of interdependence.

Second,  in this speech AMLO expresses a sound understanding of Mexico’s strategic opportunities  in the context of the decoupling of the Chinese and American economies. This should  provide some comfort to investors on both sides of the border.

Constructive relations between the U.S. and Mexico and a understanding that the two countries  have a common purpose is certainly good news. Nevertheless, there remain many contentious issues to resolve.

From the American point of view, AMLO’s view on state domination of key sectors is not compatible with the updated USCMA trade agreement. Recent violation of contracts with American companies in the energy sector are not acceptable to the U.S.

Nevertheless, the conciliatory and optimistic tone of the speech is important. There are few countries in emerging markets today that have brighter prospects for their stock market than Mexico  which has low valuations, an undervalued currency and strong fiscal position. Mexico could  potentially attract huge investments for the reshoring of U.S. manufacturing supply chains which could boost GDP growth from the current low levels. Until today,  AMLO’s hardline anti-business stance has been the major impediment to investing in Mexico. A more pragmatic , conciliatory and forward thinking AMLO could possibly be a catalyst for better days ahead.

Update on Emerging Market Valuations and Expected Market Returns

 

Emerging market stocks ended the second quarter badly underperforming the S&P500 and the MSCI All Country World Index (ACWI) year-to-date, as well as for the past one, three, five and ten years.  There had been some hope during the first quarter that rising inflation and interest rates would squash long duration assets like U.S. tech and give a chance for value stocks and emerging markets to outperform. However, this was short-lived. By the end of the second quarter, interest rates were collapsing, U.S. tech stocks were leading the way again and American exceptionalism was reaffirmed by the U.S. indexes hitting record levels at near-record valuations.

The second quarter and the year so far, therefore, brought more woes for emerging markets. Momentum has been the primary force for markets, driving the expensive stocks higher and the cheap stocks lower.  We can see this clearly in the charts below which show (1) country returns YTD for EM and (2) expected returns based on relative cyclically adjusted price earnings (CAPE) ratios.

With the exception of Brazil and South Africa, two countries benefitting from positive terms of trade shocks from rising commodity prices, the countries with the highest expected future returns (Turkey, Philippines, Peru, Colombia. Indonesia, Chile and Malaysia) are also the ones with the lowest returns for the period. On the other hand, the expensive countries with low expected future returns (India, Korea, Russia, Mexico, Taiwan) continue to outperform. Of course, the United States, the most expensive of any market around the world, provided stellar returns of 14.9% during the first half of the year.

Unfortunately, the countries with very inexpensive markets relative to their history are not helping themselves. Sadly, none of the “cheap” markets currently provide a positive narrative for investors. In addition to the pandemic which continues to wreak havoc across EM, many countries also face deteriorating political and economic fundamentals which would justify lower earnings multiples than a relative cape ratio methodology implies. We could argue that the growth prospects for Brazil, Chile, Colombia, Peru and South Africa have deteriorated enough over the past decade to justify lower CAPE multiples.  In many cases, historical CAPE multiples may have been distorted by the stratospheric-level valuations reached during the 2007-2012 EM bubble. It may be that some of these markets need to trade at much lower multiples to become attractive investments, say more in line with Turkey today (4.4 CAPE). Arguably, investors should be very cautious at deploying capital until a positive narrative can be developed in these countries.

This leaves us with very few markets to focus on. In Asia, which is where almost all the growth in GDP and consumption will occur over the next decade, Indonesia and Malaysia have good growth prospects and political stability.  Their CAPE ratios are cheap in both relative and absolute terms and promise good future returns. Moreover, we can see in the following chart that they both have competitive currencies and good economic fundamentals. The Philippines also appear attractive, given low valuations and a good growth profile, but have an overvalued currency and weaker fundamentals. In Latin America, Mexico also has a nice combination of an attractive CAPE valuation, competitive currency and good economic fundamentals.

The best opportunity in EM stocks today is in Turkey which has the compelling combination of very low CAPE valuation and undervalued currency. The patient investor would be well advised to build positions ahead of an eventual change in government or economic policy.

The Lure of Complexity Drains Pension Schemes Around the World

The debate over whether to invest “passively” through index funds or “actively” through professionally managed funds has largely been resolved in favor of the passive camp. Decades of empirical data have made the case for passive and the result has been the persistent growth of index investing for both individual and institutional investors. Yet, in defiance of this trend, the financial industry continues to create and sell trillions of dollars in increasingly complex products with much higher fees. These so-called “alternative” financial products have made huge fortunes for managers of hedge funds, private equity funds, and other exotic products. Unfortunately, by and large, they fail to provide value for the investors that have been lured into believing that complexity brings higher returns.

David Swensen of the Yale Endowment was a pioneer in the use of alternative assets. The good performance of this strategy in the 1990s and several books by Swensen lauding its merits attracted many imitators to the “Yale Model.” At the same time, the rise of low-cost index funds on traditional equity products drove the wily Wall Street marketing machine to promote new products with high fees. As a result, from 1997 to 2018 hedge fund assets under management grew from $118 billion to $3.5 trillion. Over the same period, the number of active private equity firms grew more than tenfold, from fewer than 1,000 to roughly 10,000. In the case of educational endowments like Swensen’s Yale, the average exposure to alternatives has risen from 12% in 1990 to 34% in 2002 and to around 60% of total assets today.

Unfortunately, Swensen was not able to sustain the high returns achieved in the 1990s, the “Golden Age of alternative investing.”  Ironically, the popularity of the Yale model may have been its undoing. Over the 2010-2019 period Yale returned 11.1% annually compared to S&P 500 returns of 14.7% and returns of 11.4% for a traditional 70/30 stock/bond mix. This is before the operating expenses of the Yale endowment which total 0.38% annually. Nevertheless, Yale continued to be one of the best performing university endowments over this period.

The most recent study of the performance of public pension funds and university endowments, “HOW TO IMPROVE INSTITUTIONAL FUND PERFORMANCE,” by Richard M. Ennis (link) describes how the Yale model has destroyed value for institutional investors. Desperate for higher returns in a world of overvalued assets and low prospective returns, these funds have allocated over a trillion dollar s to alternatives and have nothing to show for it. As a group, they would have been much better off buying a few Vanguard index funds.

Ennis’s  study of  46 public pension funds highlights the following:

  • Only two of the 46 endowments outperformed with statistical significance.
  • A composite of the funds surveyed underperformed by 155 bps per year for the 12 years ending June 30,2020, and the composite underperformed in 11 of the twelve years.
  • Alternatives, which represented 30% of assets, provided no diversification benefits, acting equity-like in their risk profile, with added leverage.
  • Poor performance is not tied to size of the fund. In fact, most underperformance was attributed to exposure to alternatives.

Ennis’s survey of university endowments identified even poorer performance than for public pension funds. This is remarkable given that the staffs of endowments are considered to be more skilled and are paid multiples more than the public servants that typically staff pension funds.

Here are the key findings from Ennis’s research:

  • Endowments with assets greater than $1 billion underperformed by 1.87% per year over the period and trailed the benchmark in 12 out of 12 years.
  • Alternatives represented 60% of the asset allocation of endowments, providing no diversification benefit but dramatically increasing costs. Ellis estimates that the fees paid to managers by these endowments run at about 1.8% of assets per year and explain almost all the underperformance.
  • The performance of endowments actually is overstated, since they do not include their own operational expenses in their performance numbers. In the case of Yale these expenses were 0.38% of assets under management.

Ellis estimates that pension funds paid around $70 billion in fees to Wall Street in 2020 all of which they could have saved by investing in low-cost index products. Endowment funds paid $11.5 billion in fees plus about $2.5 billion in expenses (salaries, rents), all of which they could have avoided by investing in index funds.

Ellis’s data on endowments comes primarily from the annual NACUBO-TIAA (link) study of endowments which reports on the sector’s overall results. Using this same source Fiduciary Wealth Partners, a firm that provides investment advice to high net-worth clients, has tracked the returns provided by the top quartile performing endowment funds for the past twenty years and compared these to returns achievable through low-cost index funds. FWP confirms Ellis’s finding that even the elite of the endowments have destroyed value. The two charts below show (1) the portfolio allocation of low cost index funds used by FWP and (2) the 10-year rolling returns of this model portfolio including all fees compared to the composite returns of the top quartile endowments. The 70/30 index portfolio has outperformed in every 10-year rolling period and by a considerable margin over the time frame considered. This is before considering the internal operating expenses of the endowments.

Implications for public pension funds around the world

The case of U.S. pensions and endowments should provide a good example for the world. The lure of complexity and the belief that sophisticated high-fee managers can add value after fees is as prevalent in public pension schemes in Latin America and sovereign funds around the world as it is in the U.S.

Ellis describes the situation of the public pension funds of the City of Los Angeles as a microcosm of what ails public pension systems around the world. Taxpayers of the city back six different public pension funds representing different groups (teachers, fire-police, city employees, water-power, county employees and state employees.) All these funds replicate a similar investment cost-base and follow similar “diversified” investment processes. The final result is an immense index-like fund with an expense of 1.1% per year. This cost, in the end is born by the taxpayer.

The obvious path for these public pension funds would be to merge and simplify their investment processes through low-cost indexing approaches.  However, this is difficult to do because of the resistance from the agents currently involved in the process: the managers, investment professionals, trustees and outside advisors that have a stake in the current system.

This situation of Los Angeles is repeated across the world.

An extreme example this is the Chilean AFP system of privately managed pensions. Designed by Chile’s “Chicago Boys” free market ideologues in the 1980s, the AFP model was based on the conviction that private competition would bring about a fruitful combination of minimal costs and maximum returns, to the benefit of Chilean pensioners. However, after 35 years of the AFP model we can see a situation similar to the one of the the City of Los Angeles. The system has high costs which hurt returns for pensioners; seven AFP firms compete for customers, replicating high administrative and marketing costs, for a relatively small pool of assets of $200 billion. The primary beneficiaries of the AFP system, as in Los Angeles, are the agents (owners of the AFPs, managers, administrators, regulators). Much better results could be achieved by a small committee deciding on a long term allocation strategy and allocating the system’s funds to index products.

In fact, there are a few examples of funds that have  followed the path recommended by Ellis.

One example is Nevada’s $35 billion Public Employees Retirement System (link). Unlike Los Angeles and Chile with their teams of managers, administrators, marketers and advisers, the CIO, Steve Edmunson,   manages the fund by himself. Following Warren Buffet’s advice, Edmunson shuns fees and practices inactivity. Nevada’s funds are allocated to ETFs and a few trades a year suffice to keep them aligned with the long-term strategy. With an investment staff of one person, Nevada’s costs are 5 basis points (0.05%) compared to the 1.5% average estimated by Ennis for U.S. public pension funds.

Currency Wars, the Dollar and Emerging Markets

Worsening economic conditions in the United States point to a weaker dollar in the future. The combination of low GDP growth, high debt levels, unsustainable fiscal and current account deficits and an overvalued USD makes devaluation the path of least resistance. However, most of America’s trading partners either face equally poor monetary and fiscal challenges or are determined to avoid allowing their currencies to appreciate. This creates a stalemate in the currency wars which facilitates more money printing and debt accumulation, with the consequence that asset prices rise to compensate for currency debasement. Until this predicament changes, the currency adjustments that a healthy and balanced global financial system would produce are not likely to occur.

At the heart of this dilemma lie on one side the mercantilist economies that repress consumption to promote exports (China, Japan, Korea, Taiwan, Germany) and on the other the Anglo-Saxon economies that promote consumption and accept persistent current account deficits (United States, United Kingdom, Canada, Australia). These conditions have persisted for decades because on each side powerful interests assert their influence to preserve them: in the case of the mercantilist, the manufacturing lobby; in the Anglo-Saxon economies, the banks which benefit from the financialization of the economy.  Germany conveniently benefits from the euro which is structurally undervalued to support the weaker economies of the region.

The following table illustrates the current currency panorama and gives some insights on a few potential trading opportunities at the present time. The first column shows the deviation of the Real Effective Exchange Rate (REER) from the 30-year median level for the major EM countries and also the primary trading partners of the United States. The currencies above 100% are expensive relative to the median level of the past 30 years. This group is extremely heterogeneous. We would expect high-growth and productive exporters (China, Vietnam, Thailand, Korea, Taiwan and Poland) to have appreciating currencies over time, and that is what we see here. However, all these countries are bent on maintaining competitive currencies and current account surpluses. These economies all have strong fundamentals and moderate twin deficits (current account plus fiscal account). The remaining countries with currencies above the 30-year median face more problematic circumstances. India, the Philippines, Nigeria, and the United States all have low productivity growth, chronic current account deficits and high twin deficits. These countries have all allowed their currencies to appreciate to the detriment of their export competitiveness, and all of them tend to favor finance over the manufacturing sector. In this second group, the currencies of the United States and India are propped up by financial capital flows.

At the other end of the table, we have the countries which have currencies at weak levels relative to the 30-year median REER. Most of the cheap currency countries have a history of high currency volatility, driven by commodity cycles and flows of speculative capital (“hot money”).  Argentina, Brazil, Russia, Colombia, Peru, Chile and South Africa are prematurely deindustrialized and dependent on exports of basic commodities that are increasingly capital intensive. The high levels of currency volatility are linked to boom-to-bust cycles, which disincentivize exports of manufacturing goods and increase dependence on commodities and debt accumulation. Typically, these countries will see significant currency appreciation during commodity upcycles, and, given how cheap the currencies are today, it is plausible this will happen again. The problem for these countries is that economic mismanagement and unproductive debt accumulation have left them with very high twin deficits and, consequently, very vulnerable to global financial volatility.

This leaves us with Malaysia, Mexico, Japan and Turkey. These four countries all have competitive currencies and are important participants in global manufacturing supply chains and stand to benefit from the current trend towards reshoring and restructuring of supply chains. Moreover, all of them except for Turkey, have sound economic fundamentals. These are probably the currencies with the most upside in a global synchronized economic recovery in 2022.  In the case of Turkey any progress towards stabilizing the economy could lead to significant currency appreciation.

Whither the U.S. Dollar?

Investing in emerging market stocks and bonds is primarily driven by macro factors, such as liquidity, relative growth, politics and, most importantly, the mighty U.S. dollar. The importance of macro trends  is the reason that emerging market investing has traditionally been dominated by short-term oriented hedge funds and Wall Street trading desks. This has been true since the early 1980s when the liberalization of global financial capital flows allowed traders like George Soros to actively engage in EM equity and debt markets. More recently, firms like Ray Dalio’s Bridgewater have made EM a key part of their global diversification strategies.

In global macro, everything is in some sense a dollar trade, so it is imperative that investors have a view on the direction of the dollar.  In fact, the dollar’s trend clearly separates the world of financial assets into two camps: Long USD trades — risk tolerant and rate sensitive – which include bonds, growth stocks and other long-duration assets; Short USD trades – risk intolerant – which include value and small cap stocks, EM stocks and bonds and commodities.

Based on recent empirical evidence, investors have developed models to predict the future course of the dollar. Unfortunately, there is not a lot of historical data since the current USD regime is based on a fiat monetary system which has existed only since 1971.

George Soros is said to have come up with a visionary and innovative approach to currency trading in the early 1980s when he proposed that the dollar trend could be determined by the strength of the U.S. economy relative to the global economy. In periods of relative U.S. economic vigor, sometimes referred to as phases of “American Exceptionalism,” the U.S. attracts foreign flows into its capital markets and the dollar appreciates. Under these circumstances, the dollar can remain strong until the cycle exhausts itself because of rising macroeconomic imbalances. In periods of relative global economic vigor, capital flows out of the U.S. into more attractive international assets.

This dollar cycle as suggested by Soros is underpinned by reflexive investor behavior. As the USD appreciates the returns on U.S. assets increase for foreign investors which attracts more investment. When the USD begins a downward trend, then the opposite happens.

The empirical evidence for the Soros model is shown in the graph below. The top segment of the chart shows the evolution of the USD index (DXY) since the 1970s. We can see that there have been three major upswings of the USD over this period, in what appears to be a long-term downtrend. The cycles have lasted about 8-9 years on the uptrend and 8-9 years on the downtrend, for a total of 16-18 years. Given that the current dollar uptrend started in 2011, we would now expect a dollar downtrend to be under way. However, this remains to be confirmed, as currently the effects from the pandemic and extraordinary fiscal and monetary policies adopted around the world may be overwhelming long-term fundamentals.

The bottom segment of the chart shows the performance of the global economy relative to the U.S., with outperformance shown when the blue line is above the bar. One can see that Soros’s  insight is largely confirmed by the data: when U.S. growth is relatively strong, the USD tends to appreciate considerably.

The past several years have been extraordinary in the sense that official interventionism in financial markets has reached unprecedented levels.  First, we saw exceptional monetary policy adventurism with a novel focus on propping up asset prices in the name of “financial stability.” Second, we saw equally unheard of fiscal adventurism when Donald Trump slashed taxes at the tail end of a business cycle expansion with unemployment at record low levels. Third, the pandemic was met by enormous monetary and fiscal support which boosted the operations and valuations of America’s leading corporations in the tech sector. Fourth, we are now seeing new radical policies from the Fed (average inflation targeting) and the Biden Administration (fiscal expansionism to “Build America Back Better”). Finally, this year we saw the U.S. take the lead  in Covid-19 vaccinations which makes it likely that U.S GDP growth will outperform the global economy in 2021. All these factors have contributed to higher U.S. stock prices and a narrative of U.S. exceptionalism, and may have postponed the normal cyclical downtrend of the dollar.

In a recent interview, the investor Stan Druckenmiller made this point when he attributed the recent strength in the USD to foreign inflows into the U.S. tech stocks during the pandemic:

“It just so happened that the FAANG stocks, and many US companies like Zoom were better positioned to deal with COVID than any of our foreign counterparts, so we had a huge inflow into the equity market here. It made up for the change in the bond flow, but once valuations got high, that dissipated, and the dollar peaked out in July.”

Druckenmiller believes that the factors supportive of the dollar have run their course. The rest of the world will soon catch up in vaccinations and by 2022 the global economy will be in full recovery and outpacing the U.S. economy. Moreover, by next year, capital allocators are likely to begin to refocus  on the serious structural deficiencies of the U.S. economy: namely, the high and rising debt levels and the gigantic twin deficit (current account plus fiscal deficit.)

The U.S. will come out of the pandemic with historically high debt levels and deficits which are projected to remain at high levels for the foreseeable future. The first chart below shows the progression in U.S. debt levels as reported by the Bank for International Settlements (BIS). The next two charts show the U.S. fiscal and current account deficits and the twin deficit’s relationship with the USD. The twin deficit is projected to widen considerably during the decade as Social Security and Medicare outlays ramp up when the majority of baby-boomers retire. Also, any increase in interest rates from the current levels would worsen the fiscal accounts further.

We can see that the USD did not follow its normal reaction to gapping twin deficits during the pandemic. However, as these deficits persist in the future and the global economy recovers the USD this should change. The expectation that unsustainable  twin deficits will persist for the foreseeable future  is the primary argument for a weaker USD in coming years.

However, nothing may be so simple in our current macro world of extreme state interventionism and dysfunctional politics driven by populism.

First, for the dollar to fall other currencies must rise, but all the major trading partners of the U.S. appear determined to avoid this from happening  Most, like China, have adopted some sort of peg to a basket of currencies to protect their exporters. This means that it would require significant strong-arming from the U.S. to engineer an appreciation of foreign currencies, something that Washington has been reluctant to do.

This raises the scenario predicted by Raoul Pal (Real Vision ) of an orchestrated debasement of global currencies as all major economies seek to print themselves out of their fiscal and competitive dilemmas. The consequences of this would be a massive flight into any scarce real assets (gold, bitcoin, real estate, etc…). Pal argues we are already seeing this play out as most asset classes are trading at record highs.

The Raoul Pal scenario has interesting implications for emerging markets. The EM asset class is almost equally divided into commodity importers and exporters. Most importers of commodities (China, Korea, Taiwan, India) are not likely to tolerate currency appreciation, as long as Washington does not wage war against mercantilist policies. This leaves the commodity exporters to possibly allow their currencies to appreciate. We have seen this happen this year as the South African rand, the Russian rubble and the Brazilian real have appreciated. This process has been abetted by foreign hot money and welcomed by central banks for its deflationary effects.  Some other EM countries which have depressed currencies, (Mexico, Turkey) also have much room to allow appreciation and may be the best options for  investors to benefit in the coming currency wars.

Emerging Markets Debt Pile Impedes Growth

In a normally functioning economy debt has an important and beneficial role. It shifts purchasing power from savers to consumers of capital, allowing young people to anticipate consumption and governments and entrepreneurs to invest. This process is healthy and promotes growth.

However,  debt accumulation loses its utility under several circumstances. First, it tends to be highly cyclical and prone to accentuate the volatility and swings of both the economic cycle and asset prices.  Second, it exhausts itself when debt is directed to unproductive ends which do not generate the cash flows to service interest.

The debt cycle that the world has experienced over the past decades is characterized by these two circumstances. As debt levels have skyrocketed in both China and the United States, the marginal utility of the debt has diminished. Both countries face a reckoning of massive debt overhangs, which will impede future growth, made even worse by the worst demographics in a century. Moreover, as the credit data from the Bank for International Settlements (BIS) shows below, the debt problem is global in nature. Emerging Markets as a whole face the same quandary, facing a large overhang of debt, often with currency mismatched, much of which was used to finance non-productive activities.

However, the emerging market debt figures are highly influenced by the weight of China. A more granular view of emerging markets shows considerable differences within the asset class. We can see this in the table below. Several countries stand out for their relatively low  total debt-to-GDP ratios, particularly Mexico and Indonesia which are both below 100% of GDP, while others are noteworthy for the very high levels of debt assumed in absolute terms and relative to their financial histories (China, Korea, Malaysia, Chile, Brazil).

 

It is also important to look at the composition of this debt for each country, between public and private debt, and the growth rate of the debt. Relative low public debt indicates the capacity to invest in the public goods (social and physical infrastructure) which are needed for countries to grow. High levels of public debt also cause a crowding out of the private sector and more productive investments. We can see that in this regard South Africa, Brazil, China and Argentina are in bad shape as they have very high and increasing debt levels, and these are countries that face enormous demands from their citizens for public goods (infrastructure, education, social safety nets, etc…) With the exception of China, these countries have managed to accumulate this debt without investing in public goods and continue to borrow to cover current spending. Not by coincidence, the countries that have the lowest levels of public debt are also those that have seen the slowest pace of debt accumulation: Russia, Chile, Thailand, Turkey, Indonesia, Mexico and Korea. These countries have maintained the capacity to invest in public goods.

With regards to private debt, several countries also stand out. China, Korea and Chile have high levels of private debt which has grown at a rapid pace. In the case of China and Korea, this points to vulnerability for sustained consumption and potential deflationary pressures. For Chile, much of the private debt has been assumed for foreign ventures, with dubious benefits for the domestic economy and uncertain returns. Colombia, Mexico and Indonesia have low levels of private debt and low growth of debt, and therefore have capacity for reflationary credit expansion.

Finally, we should look at these relatively unleveraged countries in the context of potential GDP growth. Countries with debt accumulation potential, growth in the working age population and GDP growth above 3% should offer relatively better opportunities for investors. I would put the Philippines, India, Mexico, Indonesia and Turkey at the top of my list of countries that retain healthy growth profiles. Unfortunately, both Turkey and Mexico currently face problematic political leadership which makes it difficult to attract investment capital.

The Count of Ipanema’s Real Estate Fiasco

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

The trail of the Ipanema de Moreira family starts in the city of Sao Paulo, Brazil in the late 18th century.  Jose Antonio Moreira, the future Count of Ipanema, was born in Sao Paulo, October 23, 1797, the son of Jose Antonio Moreira (Father) and Ana Joaquina de Jesus. The family was of noble origin, from the Braga District of northern Portugal. Moreira is a common name in Portugal, meaning mulberry tree.

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

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

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

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

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

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

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

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

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

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

 

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

 

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

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

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

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

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

 

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

There are thousands of covers of Girl From Ipanema; the most recent from Anitta.

Astrud Gilberto Version

Getz Gilberto

Anitta

 

 

 

The Girl From Ipanema

https://apnews.com/article/anitta-girl-from-ipanema-rio-brazil-bb45163a74e7d47c23a38f09a4cbe1e3

 

 

Emerging Market Small Caps Are on Fire

Different kinds of stocks perform differently during the business cycle. This is because markets tend to “fear the worst”  when recessions occur and “hope for the best” when economic expansions are going on. This means that economically sensitive segments of the market typically get crushed during contractions and then bounce back strongly when a recovery is anticipated.

The mega funds that dominate long only fundamental equity investing don’t care a lot about these business cycles.  Their “holy grail” is high “quality” which is defined by sustainably high returns that can be compounded over many years. These quality companies typically are not stressed by economic downturns so investors are happy to stay pat.

However, for traders and other investors that are more nimble the business cycle provides repeatable opportunities.

Economically sensitive stocks include value (low growth), small capitalization and cyclical stocks. These stocks are characterized by weaker balance sheets, high operational leverage and low market liquidity; they are also poorly covered by Wall Street and have less-acclaimed management.

In emerging markets, investors have plenty of opportunities to harvest returns from the business cycle. These markets have more and deeper economic downturns, and, also, greater variability in liquidity flows. Liquidity will dry up entirely during downturns and then ramp up giddily during the good times.

The past year gives a typical example of this investment cycle playing out in real time, just as expected. The chart below shows the performance of the Ishares EM small caps  ETF relative to the EM Index. Small caps underperformed sharply when the recession began in February of last year, and then bounced back strongly as recovery was anticipated. Normally, this outperformanse persists into the expansionary phase of the business cycle which for EM should persist well into 2022. Out-performance for the past twelve months is now 25%.

We see the same thing on a country-by-country basis. The charts below show performance of small caps relative to their country index for China, India and Brazil. The Chinese recovery is by far the most advanced of the three. In fact, Chinese authorities already are in a tightening mode, so we can say that this business cycle is well into the expansionary phase. Therefore, time may be running out on this trade. Chinese small caps outperformed the China index by 29% over the past year, so this trade has already been fruitful.

 

The India chart looks the same: a deep drawdown followed by steady performance. The Indian economy is still far from entering the expansionary phase so this trade may have a long way to go. Indian small caps have out-performed the India MSCI index by 36% over the past year.

 

 

Finally, the Brazilian chart also looks the same. Like India, Brazil has not yet entered the expansionary phase so this trade may have legs. Brazilian small cap stocks have now outperformed the MSCI Brazil index by 25% over the past twelve months.

Pinera’s Gambit has Caused an Earthquake in Chile

Politics are mainly about how to distribute wealth. In democracies, despite the lobbying influence of plutocrats, occasionally the people will vote for radical changes to laws and institutions to tear down existing structures and accelerate progress towards more egalitarian and socially progressive outcomes. This has now happened in Chile where the recent constitutional referendum and local elections have resulted in a cataclysmic earthquake for the conservative establishment.

In agreeing to a constitutional referendum, Chile’s President Sebastian had hoped to calm social unrest, under the assumption that traditional conservative forces would retain enough power in a constitutional assembly to moderate the result. The results of the May referendum have shown this to be a huge and costly miscalculation.

Pinera’s conservatives were obliterated in the election by an alliance of highly progressive candidates from the left, including traditional leftist (socialists, communists, etc…) and independents (greens, feminists, native Indian, LGBT).

This progressive coalition has a solid mandate to put a close to an era defined by the military regime of Augusto Pinochet, the “Chicago Boys” neo-liberal economic reforms of the 1970s and the conservative constitution of 1980.

The circumstances in Chile are reminiscent of the process that resulted in Brazil’s “peoples” constitution of 1988, with its 70,000 pages defining “citizens rights.”  The fiscal commitments enshrined in the new constitution have burdened the economy since then and are a major reason for decades of low GDP growth.

The Brazilian constitutional reform was led by leftist politicians who felt aggrieved by the policies of the military regime. Now, in Chile, the new wave of progressives are determined to do away with the legacy of Pinochet.

The primary grievance of Chile’s progressive is that the previous model was structured to benefit the conservative elite and its economic interests. Chile’s pro-business neoliberal model, which promoted open markets and low corporate taxes, will almost certainly be revised with a focus on social distribution. Also, Chile’s innovative privately-managed pension fund system is likely to be unwound and replaced by an expanded social security benefits.

The evolution of the private pension system over four decades of existence is emblematic of the sclerosis that came to characterize the Chilean conservative movement as policy makers came to be captured by the business elite. Initially considered a thoughtful innovation, the system over time has been ineffective because of high costs and low returns. The system should have been reformed years ago but was not. The final nail for the AFPs was the dismal returns over the past decade, as shown below.

In fact, much of what has happened with the AFPs and with Chile in general should be seen in the context of the aftermath of the commodity super-cycle which ended in 2012. Chile, like most commodity producers, underwent a typical boom-t0-bust economic cycle and the consequent “Dutch Disease”: first, financial speculation (e.g. real estate), debt accumulation, overvalued currency, complacency of policy makers; followed by over-indebtedness, currency weakness and capital flight. The bust-phase of the past ten years has caused a deep social malaise for a young and educated population with high expectations, leading to a feeling of disenfranchisement and the recent street protests.

The irony is that a new commodity upcycle may now have started. Pinera’s gambit will have been tragically mistimed.

The Falling Dollar; Cyclical or Secular?

The U.S. dollar has been trending down for the past year relative to the currencies of the major trading partners of the United States. This raises the possibility that the cycle of dollar strength which started in 2012 may have ended. Moreover, the remarkable fiscal extravagance of the American government and gaping current account deficits have led some to predict a more severe permanent deterioration in the status of the USD.

Renowned macro-trader Stanley Druckenmiller said last week that persistent U.S. fiscal and monetary profligacy and rising debt level will have serious consequences: “The Fed will have to monetize it. I believe it will have horrible implications for the dollar…. it’s more likely than not within 15 years that we lose reserve currency status.”

These concerns with the fate of the dollar come at a time when a possible alternative reserve currency is  becoming realistic for the first time since the 1970s when the Deutsche mark briefly rose in prominence until Fed Chairman Paul Volcker’s monetary rectitude restored the USD’s credibility.

Taking a long term view, Ray Dalio of the Bridgewater hedge fund argues that it is only a question of time before China  assumes that mantle: “China already has the world’s second largest capital markets, and I think they will eventually vie for having the world’s financial center. Throughout history, the largest trading countries evolved into having the global financial center and the global reserve currency. When you see the transition from one empire to another, from the Dutch to the British to the American, to me it just looks like that all over again.”

Dalio’s view of financial history is that it consists of various cycles that repeat themselves over and over again on relatively predictable timeframes. Countries achieve great power status by attaining  measurable metrics and this hegemonic influence manifests itself through control over trade and finance, including reserve currency status. Eventually, great powers overextend themselves militarily, slide into financial, political and social decadence and enter into decline.

Dalio’s two charts below show this process at work. The first chart shows 500 years of the ebb and flow of global hegemonic power. The periods of dominance seem to last in the order of 150 years, which would imply that the United States is in the late stages. The second chart shows the evolution of the  different attributes required to achieve hegemonic influence, including reserve currency status which is seen as a lagging indicator.

Academic specialists such as Berkeley’s Barry Eichengreen provide a similar framework for understanding the process of achieving reserve currency status. The conclusion is that reserve currency status is a consequence of economic dominance which  can be measured by three statistics: economic output; share of trade; and net creditor standing.

Since Roman times, every dominant economic power has had these characteristics and seen its money prevail. We can separate the reserve currencies in the chart below in terms of the central axis of the international trade flows they facilitated: Mediterranean (denari, solidus, dinar, ducato and florin); Spain/Mexico (Spanish dollar based on Mexican and Peruvian silver); Northern Europe (guilder, franc, pound); and United States (dollar). The Spanish dollar can be considered the first truly global currency, as it was  widely used in China and the British colonies from the 16th to the 19th century.

 

The chart below shows the evolution of economic dominance over the past 150 years based on economic output, share of global trade and creditor status.  Around 1870 can be considered the peak of Britain’s economic dominance. By the eve of W.W. I, the UK’s edge had been greatly narrowed by both Germany and the U.S.. Coming out of the war, the U.S. was the clear dominant economy and it reached its peak soon after W.W. II. The post-war recovery of Europe and Asia has slowly undermined American dominance, and the recent rise of China has made it questionable.

The brief 70-year history of USD dominance can be separated into four periods, as  illustrated in the following chart. The U.S. came out of WW II as the undisputed global hegemon and the USD consistently replaced gold and pound sterling as the reserve currency of choice (period 1). After President Nixon broke the USD link with gold in 1971, gold and the deutsche mark  partially  replaced the USD (period 2).  A hawkish Fed under Paul Volcker and the deflationary forces unleashed by neoliberal economic policies and accelerated trade globalization resulted in the heyday of the USD (period 3). Finally, increasing financial instability caused by high debt and chronic fiscal and current account deficits have gradually undermined U.S. monetary policy effectiveness and increased demand for alternative currencies and gold. (period 4)

The next three charts show graphically the decline in the dominance of the U.S. economy. The first chart shows that share of global GDP peaked soon after W.W. II and has been on a rapid pace of decline since the USD was unfettered from gold in 1971. The second chart shows that American participation  in global trade peaked in 2000 and has fallen sharply since then because of the rise of China. The third chart shows the evolution of the U.S. from the primary creditor nation to the world’s largest debtor, a result of chronic current account deficits.

Clearly the evidence shows a steady fall in the justification for U.S. reserve currency status. However, there are two reasons to believe that the USD is not under imminent threat of losing its dominance. First, historical evidence tells us that reserve currencies lose their relevance slowly.  The Spanish dollar remained widely used long after Spain entered economic irrelevance. As the next chart shows, the same can be said about the British pound which remained an important reserve currency in the 1950s and beyond. This points to a slow decline of the USD, unless the U.S. accelerates its fiscal and monetary profligacy. Of course, the USD is a fiat currency not backed by anything more than the credibility of the government, so the risk of a steeper decline than with previous reserve currencies is not negligible.

The second reason that the USD reserve status is safe for now is that modern fiat currency reserve systems are much more a “debilitating burden” then the “extravagant privilege” once denounced by French  finance minister Valery Giscard D’Estaing. The American experience has shown how under a fiat currency regime  the U.S. has had to assume the responsibility for absorbing global trade imbalances through persistent current account deficits which can be financed indefinitely as along as foreigners are willing to accumulate American assets, both physical and financial. The consequence for the U.S. has been hyper-financialization,  deindustrialization  and an increasingly vulnerable American economy, kept afloat only by monetary bailouts and rising stock prices.

It is a safe bet that, at least for now, the Chinese are not interested in shouldering this debilitating burden of having to absorb global imbalances.  Quite the opposite, more than ever China is committed to its mercantilist “China 2025”  industrial planning model, as it is determined to wean itself from  dependency on the West for key technologies. This model is built on financial repression and is incompatible with currency reserve status which would require current account deficits to provide renminbi liquidity to the global economy.

Internationalization and Economic Convergence

Very few countries in emerging markets have sustained high GDP growth levels long enough to  aspire to convergence with  the developed world. These include the members of the club of Asian “tigers ,” originally formed by Taiwan, Korea and Singapore,  and now being joined by China, Vietnam, Thailand and Malaysia. Outside of Asia, Poland, Hungary and other formerly Comecon states have made huge strides towards catching up.  One thing all of these success stories have in common is openness to trade and integration into international supply chains.

The chart below shows the internationalization rate for the primary emerging markets.

The successful convergers have a high level of internationalization of their economies, as measured by total trade (imports plus exports) divided by GDP  minus net trade.  Asian countries have followed  a mercantilistic framework of  industrial planning and subsidies supported by  currency manipulation to maintain export competitiveness. Eastern Europe and Mexico have relied more on integration into regional trade networks. The focus on international trade has required that these countries focus on comparative advantages and market-based decisions, and this process has facilitated an accumulation of knowledge and skills which can lead to gradual moves up the industrial value chain.

This path of convergence is obviously not easy to follow or else more countries would do it. It requires long-term planning and economic stability, including a stable and competitive currency. Countries that experience frequent boom-to-bust cycles because of economic instability or commodity cycles will not succeed in this path. Moreover, many countries fall into the “middle-income trap”  which is caused by  dominant interest groups lobbying against open-market policies and other reforms.

Latin America is where the middle-income trap has become most prevalent.  The region suffers from a high dependence on commodities and repeated  phases of “Dutch Disease,”  the destructive aftermath of commodity busts, such as the one the region has experienced since the end of the 2002-2012 commodity super-cycle. The region also bought into the wrong elements of the neo-liberal “Washington Consensus.”  It adopted financial liberalization while failing  on fiscal reforms.

Brazil has become the poster child of the middle-income trap. Its gross mismanagement of the commodity boom (overvalued currency, corruption) left behind increased de-industrialization, debt and financialization of the economy. Ironically, while developmentalist policies are back in favor in Biden’s Washington, they are totally out of favor in Brazil where the finance minister espouses 1970s style Chicago School economics.

 

Update on Expected Returns For Emerging Market Stocks

The first quarter for emerging market stocks can be characterized as more of the same. EM equities once again underperformed U.S. stocks, as they have consistently for the past decade. The year started with a spurt of optimism, but then the cold reality of the pandemic sobered investor spirits. Meanwhile, the U.S. surprised with competent delivery of vaccines and an  extraordinary blend of fiscal largesse and monetary expansion.  The combination of vaccines and stimulus convinced markets that the U.S. might achieve a rapid return to trend growth, and this triggered a strengthening of the dollar. By quarter-end it looked like the long-awaited EM recovery was on hold again, until markets  begin to consider the aftermath of the the U.S. extravaganza.

For the long-term investor hoping for mean-reversion to cause cheap markets to outperform pricy ones, the first quarter was another disappointment.  As the chart below shows, by and large, the least expensive markets were the worst performers for the quarter, as investors  continued to focus on the reasons that made these markets cheap to begin with. Leading the way was Turkey, where Erdogan doubled up on his quarrel with economic sanity. Brazil was close behind, as Bolsonaro continued to demonstrate remarkable incompetence at managing public policy.   South Africa and Chile were exceptions, both benefitting from rising prices for industrial minerals, and, at least in the case of Chile, a proficient job with delivering vaccines.  On the other hand, the expensive markets all outperformed. Ironically, the two most expensive markets in the table were also the best outperformers, which is a good reminder that , over the short-to-medium term , momentum is a more powerful force than mean reversion.

Unfortunately,  some of the worst performing markets may have fallen for good reasons. The pandemic  and general government incompetence will have left a devastating impact on countries like Brazil, resulting in diminished growth prospects.  We can see this in the chart below which shows the IMF’s latest World Economic Outlook forecasts. Few emerging market countries  are expected to experience high growth, and they are all in Asia. Some of these like Indonesia, the Philippines and Malaysia also appear inexpensive in the previous chart, and therefore should be the best ponds to fish in. In Latin America, Colombia looks attractive.

Investors should focus on the inexpensive markets with good growth prospects. In addition, assuming that recent commodity price increases can be sustained, markets like Chile and South Africa may surprise to the upside. The remaining inexpensive markets — Brazil and Turkey — need some sort of a trigger (e.g. economic reform, political transition) to bring them back to life. Mexico is an interesting outlier. It is so extraordinarily  well positioned in terms of the current incentives for multinational firms to near-shore production and  reorganize supply chains, that even the best efforts of AMLO may not get in the way of success.

Should you Buy and Hold in Emerging Markets?

 

When I first started investing in emerging market equities in the 1980s, I brought the traditional tool kit of an institutional investor. This was a  “Graham-and-Doddsville” view of the world, the same mindset applied by Warren Buffett: find “quality” companies – defined as ones with trustworthy management/controlling shareholders and profitable businesses in sectors with good growth characteristics – and ride them to compounding heaven.

At that time, I invested in Latin America, and, fortunately, good companies at low valuations were abundant. Latin America was coming out of the 1981-83 debt crisis and experiencing high levels of economic and policy volatility. The Brazilian market was dominated by individual investors who looked for yield and by traders who played short-term trends. “Quality” growth companies with good prospects were not really on the radar of these investors.

In the mid-1980s, both the World Bank’s IFC and MSCI introduced emerging markets stock indices for institutional investors, and, as a positive narrative grew on investing in developing countries (higher GDP growth leads to higher returns), portfolio capital started to flow into Latin America and other emerging markets. This was a time when macro hedge fund managers, such as George Soros, also started to deploy significant capital in these markets.

Lo and behold, emerging market stock prices surged. Five years after the launch of the MSCI Index in 1987, it had appreciated by over 6 times, as shown in the chart below of the Global Financial Data’s Composite EM Index.

As usually happens when new assets classes are created (e.g. Bitcoin), investors struggled to anchor valuations and they put long-horizon hopes well ahead of cool-headed skepticism. During the  1990-95 period  large U.S. and European pension and endowment funds began allocating to emerging markets stocks, and flows rushed into markets like Brazil.  Fundamental investment strategies worked very well, and the valuation parameters  for the “quality” gems which institutional investors looked for expanded  by 3 to 4 times. Investors like myself felt smart  and perfectly justified in charging 2-3% management fees for our services (today EM ETFs can be bought free of commission with management fees as low a 7 basis points, or 0.07%). I was convinced that my quality stocks would compound for ever in a “buy-and-hold” strategy, and this made me quite reluctant to take profits despite high valuations.

To make a long story short, the 1993 highs were not breached until 2004, eleven years later. It turned out that all was not a bed of roses in EM investing. The “Tequila” crisis in Mexico in 1994 was followed by the Asian crisis in 1997-1998 and the Russian crisis in 1999. The capital that poured into EM stocks during 1992-95 had terrible returns and what was left of it was largely sent back to safer shores.

Emerging market stocks bottomed in 2001. With the rise of China and the initiation of a commodity super-cycle,  a new EM bull market got under way, not unlike the previous one. During 2004-2007,   institutional investors came roaring back into emerging markets, making stocks like Mexico’s America Movil key holdings in global and even U.S. domestic portfolios (by the way, America Movil today trades at less than half the price of it 2007 high). The MSCI EM index peaked in 2012 and then did not breach that level until 2019, and this only because of the boom in Chinese tech stocks. Leaving out the Asian tech sector, most emerging markets indices are still well below the levels of ten years ago.

The boom-to-bust nature of emerging markets investing is a quandary for investors. Institutional  investors typically  are not well positioned to deal with this dynamic because the business dictates that inflows are concentrated at cycle tops and outflows peak when prices are collapsing. Also, many institutional investors endeavor to add value through fundamental research with a long-term focus, which makes analysts and managers oblivious to cyclical reversions (The latest fad in EM investing has been Chinese tech stocks).

So, what should an investor do to avoid the drawdowns in emerging market stocks?  Several investors have proposed rational approaches that are likely to succeed. GMO, a Boston-based value investor, recommends a two-pillared quantitative model that (1) pinpoints macro-economic risks and (2) monitors country-sector valuations, the premise being that success lies in owning cheap stocks in countries with low macro risk (GMO).  Verdad Capital’s Dan Rasmussen recently has offered an elegant systematic framework to harvest EM equity alpha by limiting market exposure only to high-return post crisis environments (Verdad Capital). My own approach is similar. I focus on (1) Global macro (USD flows); (2) Country macro (growth trends, current and fiscal accounts, debt dynamics);  and (3) Valuation (CAPE relative to country history.)  This model can be run effectively in a systematic manner.  Stock picking can be added as a fourth stage of the model, and my experience is that a combination of systematic algorithmic tools and discretionary research (focusing on management quality and growth prospects)  is most effective.

This approach requires a change in the buy-and-hold mindset to a disciplined focus on valuation parameters. It entails more turnover than a buy-and-hold approach, and therefore may be best suited for small-to- medium-sized funds (e.g. family offices).

Let’s look at Brazil to see how simple valuation tools can be used to exploit cycles.

The chart below shows the dollarized performance of the Bovespa index since 1967. That year is significant as it corresponds with the beginning of the “Brazilian Economic Miracle,” a period of nearly a decade of very high GDP growth. It was also a market bottom for the Bovespa, which had treaded water for the previous ten years. Not surprisingly, the stock market did very well from that point, appreciating by nearly twenty-fold over the next 4.5 years. Though Brazil would never again see this kind of “Asian- Tiger” GDP growth levels, the Bovespa has repeated these boom-to-bust cycles another five times, if we assume that another cycle began in 2016. Each one of these cycles has produced enormous returns over brief, but investable periods.

The Bovespa compounded at 11.3% annually over this period, which compares to 7.3% for the S&P500 (before dividends, which have been 85  basis points higher in Brazil.) However, the investor in Brazil experienced much greater volatility. Moreover, the Bovespa had negative performance in 24 years (compared to twelve for the S&P500) and suffered much greater drawdowns. Also, if we change the beginning of the calculation from the bottom of the 1967-1972 cycle to the top, then returns for the 1971-2020 period are only 5% a year. This highlights perfectly the importance of getting the cycles right.

Traditional buy-and-hold institutional investors are highly disadvantaged  at playing the cycle game, as it is usually at the peak of the cycles that they are able to raise more funds and they are obliged to deploy them. On the other hand, in Brazil a generation of macro hedge fund traders hit pay dirt in the 1983-1997 decade, systematically playing the cycles in an anti-buy-and-hold framework. In fact, these investors exploited the gullible foreign institutional investors, feeding them stories and front-running their flows. Knowing when to cash out of the market has been the key to success for Brazilian traders.

Fortunately, market cycles are often clearly marked by valuation signals. Invariably, the great cycles of the Bovespa have started when valuations were very low and the currency highly  depreciated. The dollarized cyclically adjusted price earnings ratio (CAPE) is a simple methodology that has clearly identified the key trading points, as it smoothens out the highly cyclical path of earnings in Brazil as well as the persistent multi-year trends of BRL relative to the dollar.

The chart below shows both PE and CAPE multiples for Brazil over the 1986-2020 period. Referring back to the previous chart, it is clear that the CAPE has proven to be well suited for identifying market extremes in 1990 (buy), 1997 (sell), 2002 (buy), 2008 (sell), 2010 (sell) and 2016 (buy). The CAPE therefore can be useful to evaluate valuation risk in specific countries (measuring levels relative to history).

Combining a macro framework with a CAPE valuation methodology works well to capture market surges  and avoid steep drawdowns in Brazil and across emerging markets. This approach is systematic and easy to implement and can be effectively incorporated into a global allocation  strategy .  

 

 

 

 

 

 

 

Expected Return for Emerging Markets, 2020-2027

The global Covid-19 pandemic has inflicted severe damage on emerging markets. Asia has fared relatively well and will bounce back quickly. However, Latin America and some EMEA countries (Turkey, South Africa) will take years to return to trend growth and are coming out structurally weaker in terms of debt, education and economic prospects.

Taking into account the highly uncertain evolution of the pandemic and its economic and corporate consequences,  making a forecast is more difficult than ever.  Nevertheless, we stick to our process and hope that it can provide some guidance for investment decisions.

Our main objective is to identify  extreme  valuation discrepancies. As in past efforts (Link ), we assume that valuations will mean-revert to historical levels over a 7-10 year time frame;  also, we expect that GDP growth and corporate earnings will return to trend over the forecast period; finally, after deriving a long term earnings forecast, we apply a “normalized Cyclically-Adjusted Price Earnings (CAPE) ratio to determine a price target and expected return. We assume that historical valuation parameters still have some validity in a world characterized by Central Bank hyper-activism and financial repression. The methodology has negligible forecasting accuracy over the short-term (1-3 years) but, at least in the past, has had significant success over the long term (7-10 years), particularly at market extremes.

The chart below shows the result of this exercise. The first thing to note is that, by-and-large,  current expected returns are muted. This is not  surprising in a world of declining growth and negative real interest rates.  Global emerging markets (GEM) are expected to provide total returns (including dividends) of  7.5% annually in nominal terms (including inflation) over the next seven years. This is below historical returns and disappointing in light of the poor results of the past decade. Nevertheless, these expected returns are attractive compared to the low prospects for U.S. stocks. The U.S. is trading in CAPE terms at the second highest levels ever  while emerging markets are priced slightly above historical averages.

To secure more attractive expected returns the investor needs to venture into cheaper markets. Brazil, South Africa, Colombia, Turkey, Chile, Philippines and Malaysia promise higher returns if mean-reversion occurs.

These expected returns do not assume a major recovery in cyclical and commodity stocks or other aspects of a reflation trade. Early signs of a weak dollar and rising commodity prices since March 2020 have pointed to the beginning of a reflation trade that could be beneficial to EM, particularly commodity producers. In these cycles, EM currencies appreciate and domestic economies benefit from expansion in liquidity and credit, and stock returns could be significantly higher in USD terms.

However, returns may be held back by the high debt levels in many countries and the reality that we are not at low valuations, compared to previous bottoms. The two following charts show the evolution of earnings multiples in EM and earnings, both on the basis of regular annual earnings and in terms of CAPE. CAPE ratios are not nearly as low as during the two previous good buying opportunities in 199-2001 and 2016. Moreover, in terms of CAPE earnings,  we are not as depressed relative to trend as during the 2000-2001 recession.

 

Big Mac Index Update

The Economist’s Big Mac Index ( Link  ) looks at the dollar cost of a hamburger sold by McDonald’s restaurants in some 60 countries. The index shows a remarkable range of prices around the world. In the latest survey, the most expensive burger was found in Switzerland ($7.29) and the cheapest in Russia ($1.81).  Presumably, these hamburgers are identical, with the same combination of bread, beef patty, lettuce and sauce. The price in each country should reflect the cost of the materials, labor and rent, profit margins and taxes. The index aims to shed some light on the relative costs of doing business in different countries, and, given that it has been measured for some 30 years, it can also provide an indication of the evolution of business costs. Moreover, it can be used as a proxy to measure the relative competitiveness of currencies around the world.

The Big Mac data confirms the strength of the USD following a 9-year period of USD appreciation against both developed and emerging market currencies. EM currencies are inexpensive compared to the high levels of 2007-2011 and generally in line with long-term historical levels. Competitive currencies, low earnings multiples and higher GDP growth compared to the United States are the foundation for a positive outlook for EM stocks. Some noteworthy developments are as follows:

Brazil at last has finally fallen from the high relative price levels it has experienced since the early 2000s, and is now placed towards the middle of the pack. Given the bad state of the economy and the significant depreciation of the BRL that it is not even lower is indicative of the high structural costs of doing business (taxes, regulations).

Most Asian currencies are perennially cheap, as governments intervene to  support export competitiveness.  South Korea and Thailand are straying from this a bit. This may be a natural evolution for Korea but a potential problem for the much less productive Thai industry.

Turkey, Russia and South Africa are dirt cheap and can be expected to bounce back when their economies move up the business cycle.

Mexico is well positioned to benefit from reshoring of manufacturing to North America.

 

Ten Years of Woe in Emerging Market Stocks

During the past ten years global stock markets experienced depression-like performance. The aftermath of the Global Financial Crisis was high debt and low growth and ineffective  monetary policy despite huge  money printing and zero interest rates.

The policies of Central Banks only benefited stocks in the  United States where technology and innovation sectors benefitted from low discount rates and earnings were pumped up by tax cuts and stock buybacks. The rest of the world by-and-large saw low earnings growth, declining multiples and weak currencies. Global stocks also started from relatively high valuations and margins, as ten years ago global growth had been highly stimulated by China’s investment boom.

We can see how this developed in the charts below. The first chart shows the performance of the S&P 500 vs the MSCI Emerging Markets stock index. The left side shows the evolution of earnings multiples, the price earnings ratio and the cyclically adjusted price earnings ratio (CAPE, average of 10-year inflation adjusted earnings).  Note the remarkable expansion of the U.S. CAPE from 25 to 34, which is the second highest level in history. At the same time the EM CAPE ratio fell from 20 to 15. The right side of the chart shows the evolution of the indexes and earnings. U.S. earnings were basically flat through 2015 and then took off, and, based on forward PE estimates for 2021, will end about double 2010 levels. EM earnings, based on forward PE estimates for 2021, will be at exactly the same level as 2010. Of course, the combination of the evolution of earnings and multiples explains the dramatic outperformance of U.S. stocks.

The following chart provides some granularity within emerging markets. The same charts as above are shown for three primary emerging markets, China, Brazil and Taiwan. Brazil in 2010 was a major beneficiary of the commodity bubble but since  then has suffered a vicious case of “Dutch Disease,” the natural resource curse. All other commodity producers (Chile, Peru, Indonesia, S. Africa, Indonesia) went through a similar process, though none as painfully as Brazil. Brazil’s CAPE ratio has fallen from 22 to 12 over the period and earnings in 2021 earnings are expected to still be 60% lower than in 2010.

China has seen a significant reduction in its CAPE ratio which went from 22 in 2010 to 11 in 2016 and 16.8 at year-end 2020. Over this period, the Chinese stock market has transformed itself from heavy with banks and industrials to one dominated by tech. These old economy sectors explain the flat evolution in earnings over the period, but in the future technology and innovation stocks will drive results.

Finally, Taiwan is shown as an example of an outlier. Taiwan, like Korea, is a stock market that is dominated by world-class technology companies. Not surprisingly, its CAPE multiple at year-end 2020 was higher that in 2010 and earnings are up over 50% during the period.

2020 was a Pivotal Year for Emerging Markets

2020 may have been a turning point for emerging market assets. At least, all the traditional indicators supporting emerging markets have turned positive: the USD is trending down; commodities are trending up; USD liquidity is abundant; and tolerance for risk is high. Also, emerging markets stocks have started to outperform and ended the year almost even with the S&P 500. Though these trends tend to last, we will need confirmation over the next six months. Still, these conditions are enough to be bullish emerging markets and be fully loaded in terms of portfolio allocation.

The year of the great pandemic will probably be seen as pivotal in that it accelerated existing trends  and starkly highlighted strengths and weaknesses. Good governance was demonstrated by how countries dealt with Covid both in terms of public health policy and fiscal response. It turned out that those countries least able to control Covid were also those most inclined to monetize initiatives to support consumption through fiscal handouts. In many cases (e.g. the U.S., Brazil) these were also countries with weak fiscal positions before the pandemic, and therefore much worse positions by the end of the year. Moreover, those countries that dealt correctly with Covid (almost all in Asia) also represent the manufacturing base of the world, so that money printing to support consumption in developed countries went to Asian exporters. The charts below show total annual returns for the past year and past ten years (MSCI). What we see is that 2020 simply accentuated the trends of the past decade. It was a year when Asia showed all of its strengths (good governance, fiscal probity, commitment to value-added manufacturing, managed currencies) and most of the rest of emerging markets were characterized by dysfunctional politics, incoherent and inconsistent economic policies, and fiscal profligacy.

We show below the returns for the major MSCI EM regions for 1yr,3yr,5yr and 10yr to point out the consistency over time.

We see a similar pattern in terms of currencies in the following charts. Asian economies have been able to maintain their currencies stable and at competitive levels, while most other EM currencies lose value over time and are extremely volatile. Of course, Asian manufacturing benefits greatly from this while manufacturers in countries like Brazil are at a huge disadvantage.

Undoubtedly, Asian stock prices have benefited from exposure to growth sectors, especially technology. Almost 90% of the EM tech sector is based in Asia, with 70% in China alone. As shown below, growth has underperformed in emerging markets, as it has in other regions, because of the scarcity of growth companies in a stagnant global economy and low interest rates. On the other hand, value has performed poorly (Total returns, annualized).

Of course, past performance is not necessarily indicative of the future. Value is now relatively cheap and, due to its cyclical nature, tends to do well when EM does well.  This means that, in spite of secular trends that favor Asia, the rest of EM may actually perform well in a reflationary cyclical emerging market rally. By the way, this would catch by surprise almost all EM actively managed funds that are now largely proxies for Asian tech.

Global Liquidity, For Now, is Flooding Emerging Markets

The extraordinary policies implemented this year by the the U.S. Fed and fellow central bankers around the world have flooded the global economy with liquidity. In addition to jacking up asset prices and enriching the holders of financial assets around the world, extremely loose financial conditions may have triggered a change in global economic conditions towards a weaker U.S. dollar and, consequently, higher commodity prices and better prospects for emerging markets asset prices.

Global U.S. dollar liquidity, as measured by U.S. money supply (M2) added to  foreign reserves held in custody at the Federal Reserve, has risen at the fastest pace ever recorded over the past year.  This indicator in the past has been a very good measure of global financial conditions and is strongly correlated to economic and financial conditions in the typically “dollar short” emerging markets. The chart below shows the evolution of this indicator over time, measured in terms of year-on-year real growth. The indicator  shows clearly the loose conditions during the 2002-2012 commodity supercycle which was a period of very robust performance for EM assets. On the other hand,  liquidity has been tight since 2012 (when the commodity-supercycle ended), only interrupted by brief expansions in 2014 and 2016. This period of tight global dollar liquidity resulted in very poor conditions for emerging markets, particularly for those cyclical economies outside of NE Asia .  Interestingly,  during this long downtrend emerging market stocks had two brief periods of strength, in 2014 and 2016. Not surprisingly, the outperformance of EM stocks since April of this year has happened concurrently with a massive expansion of global liquidity.

Increased U.S. money supply, particularly at times of low growth and gaping fiscal and current account deficits, tends to be associated with a weak USD. In the past we have seen that during these periods major emerging markets, either because they practice persistent mercantilistic policies (Korea, Taiwan, China) or because they introduce “defensive” anti-cyclical measures aimed at avoiding the negative effects of “hot money”  (Brazil), have accumulated foreign reserves which they hold in Treasuries at the U.S. Fed. The effects on domestic monetary policies that these efforts to manipulate currencies bring about are very difficult to neutralize and have invariably led to strong expansions in money and credit in domestic economies. This occurred  intensively in the 2005-2012  period and was the primary cause of the great EM stock bubble. The opposite has taken place since 2012, with foreign reserves declining and tight credit conditions existing  in most EM countries. The charts below show : 1, the progression in foreign reserves held in custody at the U.S. Fed; and 2, the year-on-year growth in these reserves.

Note the recent uptick in the second chart which indicates a recent turn in the trend of foreign reserve accumulation. This upturn has been caused by the large current account deficits that the U.S. has had with Asia this year while it has sustained consumption of imported goods through fiscal and monetary policies while both the consumption of domestic goods (services) and manufacturing were stifled by Covid.

Is a Repeat of the 2000s in the Cards for Emerging Markets?

The current expansion of global liquidity and the weakening USD are unquestionably bullish for emerging markets. However, there are several  reasons to believe that the conditions do not exist for an emerging market super-boom like we saw in the 2000s.

First, the U.S. has clearly evolved in its awareness of the negative effects that unfettered globalization has had on its working class. This means it now has much less tolerance for the mercantilistic currency manipulation practiced by allies (e.g., Korea, Taiwan) and zero tolerance for those practiced by strategic rivals (China).  This reality is shown by the increasing attention given to the U.S. Treasury’s bi-annual Currency Manipulator Watchlist Report which this week added India and Vietnam, in addition to China, Japan, Korea, Germany, Italy, Singapore, Malaysia, Taiwan, Thailand, and India. Most of these countries are close strategic allies of the U.S. that in the past had been given a free-pass, but that is not likely to be the case in the future. Until now, the U.S. has not used the Watchlist to impose sanctions on trading partners,  but the mood in Washington has changed and we will see what attitude the Biden Administration assumes.

This means that countries may no longer be allowed to run large current account surpluses and accumulate foreign reserves. It may also mean that countries that are subject to highly cyclical inflow of hot money will  be restricted in accumulating reserves, like Brazil did in the 2000s.  In that case, they will have to turn to some sort of capital controls to regulate flows.

Second, emerging markets are much more indebted than they were 15-20 years ago when the previous cycle started. This means that even if countries were allowed to manipulate their currencies, the domestic economies have much less room to absorb credit expansion without creating instability.

Finally, though valuations in EM are lower than for the bubbly U.S. market, they are much higher than they were in the early 2000s.

In conclusion, the 2020s will probably not look much like the 2000s. The U.S. is likely to be a much more cantankerous partner, and one much less willing to assume the costs of globalization.

 

 

 

The Next Commodity Cycle and Emerging Markets

 

The stars may be aligned for a new cycle of rising prices for industrial and agricultural commodities. It has been nine years since the 2002-2011 “supercycle” peaked, and the malinvestment and overcapacity from that period has been largely washed out. Over the past several months, despite economic recession around the world, commodity prices have started to rise in response to supply disruptions and the anticipation of a strong global synchronized recovery in 2021. Moreover, in recent weeks the victory of Joe Biden in the U.S. elections has raised the prospect of a combination of loose monetary policy and robust fiscal policy, with the added benefit that a good part of the fiscal largess will be directed to infrastructure and “green” targets which will increase demand for key commodities. Finally, global demographics are once again becoming supportive of demand.

The chart below shows 25 years of price history for the CRB Raw Industrials Spot Index and the Copper Spot Index. Not surprisingly, these indices follow the same path. Interestingly, they are also closely linked with emerging markets stocks. This is is shown in the second chart. (VEIEX, FTSE EM Index). This is clear evidence of the highly cyclical nature of EM investing, and it is the explanation for why EM stocks outperform mainly when global growth is strong,  commodity prices are rising and the USD is declining.

Since the early 2000s, China has been the force driving global growth and the cyclical dynamic. Since that time China has been responsible for generating most of the incremental demand for commodities. Starting in 1994, China embarked on a twenty-year stretch of very high and stable GDP growth which took its GDP per capita from $746 to $7,784. In 1994, China’s GDP/capita was in line with Sudan and only 15% of Brazil’s. By 1994, China’s GDP/capita reached 65% of Brazil’s. By 2018, China had surpassed Brazil.

By the turn of the century, China’s coastal regions which dominate economic activity had already reached the transformation point when consumption and demand for infrastructure and housing result in a surge of demand for commodities. This transformation point typically occurs  around when GDP/capita surpasses $2,000, which happened for Brazil in 1968 and in Korea in 1973. In 2005 China’s overall GDP/capita reached $2,000 and the commodity super-cycle was well under way. (All GDP/capita figures cited are from the World Bank database and based on 2015 constant dollars.)

Moreover, China was not the only significant country to enter this commodity-intensive phase of growth during the 2000s. The chart below shows the list of new entrants to the $2,000/capita club since the late 1960s. During the 2000s, three large EM countries, Indonesia, the Philippines and Egypt,  also broke the barrier. These three countries added fuel to the commodity boom created by China’s hyper-growth and infrastructure buildout, generating the commodity “supercycle.”

The historical link between rising commodity prices, a falling dollar and the incorporation of large amounts of new consumers into the world economy can be seen in the following three charts which cover the 1970-2020 period.. The first chart shows the rolling three-year average of the total annual increase in the population of global citizens with an annual income above $2,000. The second chart shows the  increase in commodity prices relative to the S&P 500; and the third chart shows the evolution of the nominal effective U.S. dollar. The connection between the three charts is clear: every period of rapid growth in new developing world consumers coincides with both rising commodity prices and a weaker USD. Not surprisingly, every bull market in EM stocks (1969-1975, 1987-92, 2002-2010) also follows this pattern.

 

The bull case for emerging markets investors today is that we are on the verge of entering a new cycle as five more countries pass the $2,000/capita barrier.  Already this year, Kenya and Ghana will reach this level. These two countries in themselves are not that significant but they point to the importance of Africa for the future. Then in 2021 India (pop. 1.4 billion) reaches the benchmark, followed by Bangladesh (pop. 170 million) in 2022. The following chart shows the evolution of the total global population with per capita GDP above $2,000 and the annual increases for the past 50 years and the next five years. The potential significance of India and Bangladesh are clear.

India will likely have an  impact on a different set of commodities  than China had. India is unlikely to achieve the pace of infrastructure growth that China had, and has significant iron ore resources. This means the impact on iron ore and other building materials will not be as great. On the other hand, India imports most of its oil and will have an increasing impact on the oil markets. India also faces great urgency to electrify the country and to do this with clean energy. This points to growing demand for copper , cobalt and silver, three markets that already appear to be undersupplied in coming years.