Author: jvande

If you Like Emerging Markets, Buy Mining Stocks

Emerging market assets have always experienced good performance during times when commodity prices are rising. These periods are characterized by strong economic performance of the  global economy relative to the that of the United states and they are normally accompanied by a weak U.S. dollar. This combination of relatively strong growth and a weak dollar and the stimulative effect of higher commodity prices on commodity-dependent economies typically underpins bullish stock markets in EM.

The persistent relationship between commodities and emerging market stocks is illustrated in the chart below which tracks the prices of copper (black), EM (red) and the copper mining giant Freeport-McMoRan (blue).  (Copper is used as a surrogate for economically sensitive commodities). The chart shows that the prices of these three assets are directionally linked. Arguably, copper is a leveraged play on emerging markets and copper mining stocks provide further leverage on copper itself. This illustrates clearly the cyclical nature and economic sensitivity of emerging markets. It also raises an interesting and perhaps disturbing question for emerging market portfolio managers: why not obtain your general exposure to EM by simply timing the cycle and piling into a few mining stocks?

The viability of this strategy is shown in the next two charts. The first chart shows the performance of emerging market stocks (VEIEX) and of several of the most prominent mining stocks (Vale, Freeport-McMoRan, Vale, SQM and Southern Copper). These mining stocks all dramatically outperformed during the four cycles under consideration (2000-2008, 2009-2012, 2016-2018, and 2020-). Using a very simple 200 day moving average to trigger buys and sells, an investor could have enjoyed most of the upside and very little downside. The investor could have either shifted into cash or stayed invested by owning the EM index  whenever the copper price moved below the 200-day moving average.  The entry point this year would have been the first week of June. As the second chart shows, since that time the mining stocks have ramped up and left the EM index behind. This outperformance has occurred even though tech stocks in Asia have become much more important in recent years. Moreover, the performance is even much better compared to the EM ex-China index or a commodity-heavy index like Latin America.

 

Historically, reflation trades trend for long periods. If this one gets traction during the next six months, this trade may be only beginning.

The CAPE Ratio and Emerging Market Stock Returns

The cyclically adjusted price earnings (CAPE) ratio augurs low perspective returns for U.S. stocks  and improved performance for the battered and unpopular emerging markets equities. After a decade of very poor returns in emerging markets  compared to the  S&P500, relative valuations now favor emerging stocks to the same degree as in 2000. The following decade (2000-2010) saw strong emerging market  outperformance.

The CAPE smooths out earnings by  taking an inflation-adjusted average of the past ten years.  It has been a popular measure with fundamental investors since the 1950s, and  has been a reliable tool for forecasting  long-term stock market returns.  High valuations both in absolute terms and relative to a market’s history normally point to low returns in the future.

The S&P500 CAPE ratio is now the second most expensive it has ever been, only surpassed at the peak of the telecom, media and tech bubble in 2000.  In line with the logic behind CAPE,  in the decade after the TMT bubble the S&P500 produced negative returns for investors.  During the 2000-2010 period, the CAPE ratio for the S&P 500 plummeted from 37 to 23, bringing it back to slightly below the historical average.

On the other hand, at the end of 2000 the MSCI Emerging Markets index was valued at a CAPE of 10, which was slightly below its historical mean. Over the net decade, the EM CAPE more than doubled to 20.4 and the MSCI EM index more than tripled in value.

Today, we appear to have gone full circle back to where we were in 2000. The S&P500 CAPE is once again at very high levels and the EM CAPE has returned to depressed levels. Both are near where they were in 2000.

The current condition of CAPE ratios is shown in the two charts below. The first chart shows  both the present and the historical average levels of the CAPE for the EM index and most individual emerging  markets and also for the S&P 500.  The second chart illustrates the difference between the current levels and historical norms. Positive numbers indicate high valuations relative to history and probable low future returns.

The S&P500  is expensive in both absolute and relative terms.  The S&P500 CAPE is 33% above its historical mean, which is similar to  where it was  at the end of 2000.

The CAPE for Emerging markets is slightly below the historical average.

In EM only Taiwan and India look expensive relative to historical CAPE norms. Of the 19 EM markets in the charts, nine are valued at 30% or more below normal.

The predictive power of CAPE ratios relies entirely on markets remaining structurally similar over time and on valuations regressing to the mean.  Neither of these requirements will necessarily prevail. Market structures may change abruptly, as we have seen over the past decade in China where the index has gone from heavy in state-owned industrials to dominated by private technology companies. Also, mean regression may not occur because fundamentals (economics, politics, etc…) have changed either for the better or for the worse. Furthermore, we should expect CAPE ratios to gradually move higher because of declining transaction costs and rising liquidity.

Determining  which countries deserve to be upgraded or downgraded  is complicated and subjective because there are many moving parts. For example, in the case of China we can argue that slowing growth and high debt warrant lower valuations but also that the structural change of the market in favor of “growthier” private companies argues for higher valuations.

Relatively few countries have had a clearly delineated change in their fundamentals in recent years. I think a good case can be made for declining  fundamentals in the following countries: South Africa, Thailand, Chile, Brazil and Turkey. These countries have had fundamental deterioration in growth prospects because of the evolution of political and economic trends, and, therefore, may not offer the upside that the  CAPE framework assumes.

 

 

Bitcoin is Digital Gold for Emerging Markets

The price of the bitcoin blockchain currency has more than doubled since the beginning of the year and has appreciated by 450% since the bottom of the most recent financial meltdown in March. The financial crisis and Covid epidemic have been brutal for many emerging market currencies and financial assets and, not surprisingly have provoked a wave of capital flight from EM.  For the first time, bitcoin appears to have had a significant role in this movement of capital, a testament to growing trust in its value for both cross-border transactions and the preservation of wealth.  What initially had been mainly of interest to financial and tech geeks and criminals seeking anonymity, now appears to have gained mainstream status with EM elites seeking paths to preserve wealth in a world of growing financial instability and currency debasement.

Not surprisingly, Bitcoin is finding more early adopters in countries which have a combination of financial instability and governments with weak deterrence ability. Therefore,  as expected,  Bitcoin adoption is more prevalent  in a country like Nigeria  than it is in China. The following chart from CoinDesk Research, a media outlet that focuses on blockchain and bitcoin news, confirms this. In the case of Nigeria, bitcoin “cryptowallet” payment systems, which bypass banks and regulators, have become prevalent for conducting all sorts of international transactions, ranging from receiving  remittances to paying for imports to facilitating capital flight. Though not appearing in CoinDesk’s survey, Russia, Argentina and Brazil have also become big bitcoin adopters. These three countries all have precarious financial systems and poor prospects of economic growth and highly sophisticated elites with a penchant for seeking offshore havens to preserve financial wealth. A network of specialized broker dealers/asset managers/fintech platforms has been set up mainly in London and Zurich to service the needs of this clientele.

The rising prominence of bitcoin is a response to the high costs and increased monitoring of more traditional channels, especially private banks. Governments have become more effective at monitoring  cross-border financial flows through regulated financial institutions.

With currency debasement and unorthodox monetary policies reaching ever higher levels, EM investors are being proactive in anticipating the probable consequence of these policies (capital controls and confiscatory tax policies) sometime  in the near future. In this context, bitcoin’s attractiveness is enhanced by its “digital-gold” status in a world of inflated fiat currencies.

At the same time, bitcoin is slowly but surely gaining status with institutional investors in developed markets as a legitimate asset with valuable diversification benefits.  This year, for the first time, prominent investors in the investment world have touted bitcoin, and some large conservative institutional funds have started to  nibble. So what started as a currency for geeks and criminals is now moving into the mainstream led by emerging market flight capital.

Latin America: Before and After the Pandemic

Latin America has been hit  hard by the pandemic.  The region’s economic and social concerns have worsened.

Both cases and mortality rates are some of the highest in the world, and probably under-reported relative to many countries (eg Mexico).

The region was the epicenter of the pandemic from late spring through the summer (the winter region in the southern cone).

The IMF forecasts that the region will be hit harder and recover more slowly than other regions, especially Asia. This comes in the wake of a decade of economic underperformance.

The fiscal response has varied tremendously, as elsewhere in the world, depending on ideology and politics, not so much fiscal space. Brazil and Argentina, the two most fiscally constrained countries, have spent the most. Mexico, which has most fiscal space, has spent the least.

Fiscal generosity in Brazil created a financial windfall for low-income families which resulted in a financial and consumption boomlet.

In Brazil the fiscal response has caused a deterioration of public finances which is likely to have  negative consequences for growth prospects.

Brazil’s debt levels are very high given its history and volatile economy.

The pandemic is increasing inequality and social division. ECLAC estimates a 45 million increase in poverty (30% to 37.5%) and 30 mm increase in extreme poverty (11% to 15.5%).

Poor, women and children most impacted.  The poor cannot social distance or work at home . Poor children do not have access to online schooling.

All is well in the “elite bubble,” and the “Gig Economy” is booming.

The poor and the rich used to watch the telenovelas together. Now the rich are on Netflix, HBO and Youtube.

The region’s problems predate the pandemic. The region has been characterized by low and volatile growth, deteriorating fundamentals, and premature deindustrialization.

Latin America is the poster child of the “Middle-Income Trap”

Investment is too low to promote growth.

The region suffers from acute premature deindustrialization.

Well-paid unionized manufacturing jobs are disappearing, replaced by the “gig economy.”  Brazil is Uber’s largest market measured by rides. There are  3.8 million delivery workers.

Latin America has had a lost decade. Before the pandemic it was crippled by Dutch Disease (The Natural Resource Curse), which is caused by boom-to-bust commodity cycles and entails vicious asset, debt and currency cycles and tends to result in the weakening of institutions and the worsening of long-term growth. This was the situation before the pandemic.

Asset Bubbles

Increased Corruption and Crime

Deterioration of Business Environment (regulation, laws, etc…)

Not one Latin American country ranks well. Chile has fallen from the elite to second class.

EM Asian countries are all improving, including India. Vietnam is the new Asian Tiger.

A terrible decade for the stock market.

The region suffered a huge hangover from the commodity boom bubble combined with the onslaught of slowing global growth and technological disruption. Emerging markets are a value trade and value has been out of favor because of low growth and worsening fundamentals.

Earnings and valuation started high and have drifted down.

The region has severely underperformed both EM and Asia.

Latin America has become irrelevant as an asset class. It peaked at nearly half the index during the 1990s. It is now 7% and declining.

The region’s sectorial composition looks like a flashback to the 1990s.

 

Tech disruption is the main driver of market performance.

But Latin America trades like a copper stock.

Tech is small but it outperforming.

 

 

Latin American Stocks Are Getting Some Help From Tech

Latin American stocks have performed poorly for the past decade, relative to Global Emerging Markets and even more so compared to the S&P500. The explanation for this sustained period of poor results is threefold:

  1. The global economy has been characterized by enormous technological disruption which is undermining the value of many of the industrial and commercial models of the post W.W. II period. At the same time, demographics and rising debt levels have reduced growth and driven interest rates to historically low levels. These low rates have dramatically favored the valuations of the disruptive tech companies with long-term growth profiles. Unfortunately, the Latin American stock indexes have very few tech companies but rather are very heavily weighted towards the  industries which are being disrupted by newcomers. In this regard, Latin American stocks are similar to the “value” segment of the U.S. market which has also had a decade of weak relative performance.
  2. Measured in U.S. dollars, earnings growth for Latin American publicly trade companies has been negative for the past decade (chart 1). This is because of low GDP growth and technological disruption and also the result of an extensive period of currency weakness (chart 2).
  3. Valuations for Latin American stocks have plummeted (chart 3). As in the case of currencies, public companies were very highly priced 10 years ago. The region was enjoying ample liquidity induced by the commodity super cycle and investors priced in a bountiful future.

Chart 1

Chart 2

The Latin American stock indexes are dominated by financials (32%), materials (21%), consumer staples (14%), energy (13%), communication (6%) and industrials (4%).  All of these sectors are full of legacy business models and traditional companies. Moreover, all of them, except for materials and consumer staples, are under pressure from new entrants empowered by digitalization and artificial intelligence.  The technology-driven sectors (Information technology, internet, eCommerce and healthcare) which drive the S&P500 and the China’s stock market, are very poorly represented in Latin American stock indices.

Nevertheless, this may be changing. Venture capital is flowing into tech startups in Latin America and several of these companies have established success as public companies. Also, some legacy companies are successfully transforming themselves by adopting digital models and have seen their valuations enhanced. If we create an equally-weighted ad hoc index of Latin American tech stocks by adding up the stock market performance of all these companies we can see a strong trend developing (chart 4). Over the past three years, the MSCI Latin American stock index has lost 40% of its value while out Latin American tech index has appreciated by 232%.

The ad-hoc index is made up of eight companies; two from Argentina (Mercado Libre and Globant) and six from Brazil (Via Varejo, Locaweb, B2W, Magazine Luiza, Pagseguro and Stone.) The group is dominated by four eCommerce players (Mercado Libre, B2W, Via Varejo, and Magazine Luiza) who are all active in the highly competitive Brazilian online marketplace space. A second group is active in the fintech payments space (Pagseguro and Stone.) Finally, two companies provide software services : Locaweb is involved in web-hosting and cloud services.; Globant develops software solutions.

 

Brazil’s “Dutch Disease” is Morphing into “Japanification”

 

A defining characteristic of emerging markets is the high economic dependence that many countries have on commodity exports. Unfortunately, this dependence is  a weakness and a major reason for poor economic performance. Financial windfalls and wealth effects triggered by sudden changes in commodity prices or resource discoveries usually lead to boom and bust cycles which bring about negative effects on long-term growth. This has played out repeatedly in emerging markets, most recently with the 2002-2011 commodity “supercycle” and its aftermath.

Venezuela and Nigeria are the most extreme cases of mismanagement of natural resource windfalls,  both having squandered their oil wealth and left behind only misery.  However, almost all developing countries mismanaged the abundant windfalls experienced during the 2002-2011 commodity “supercycle,” leaving their economies in worse shape than before. This recurring phenomenon of mismanagement  of commodity windfalls which undermine long-term growth prospects is known in economics as the “natural resource curse.”

The “natural resource curse” is also known as “Dutch Disease” because the Netherlands suffered a severe drop in competitiveness after discovering vast natural gas reserves in the North Sea. The causes of the “curse” have been extensively covered in the economics literature in recent years.

Frederick van der Ploeg in his 2011 paper “Natural Resources: Curse or Blessing?” (Link) discusses the literature and provides a framework of analysis which we summarize below. Following this, we look at the specific case of the 2002-2011 commodity boom on Brazil’s development prospects.

The historical evidence points to “Dutch Disease” being a phenomenon of the post-World War  II  period.  Looking further back to the first century of the Industrial Revolution, resource wealth appears to be a main contributor to economic growth and development.  Abundant, cheap and easily accessible coal and iron ore deposits were a key factor for Great Britain’s  early industrial takeoff, as they were for Belgium’s (1830s) and Germany’s (1850s).  The United States’s industrial takeoff after the Civil War also was supported by ample resources of coal and iron ore and later petroleum. Van der Ploeg attributes these early successes of the industrial revolution to a combination of propitious conditions for private initiative and supportive public policies:

  1. Privately-owned mineral rights and attractive conditions for capital.
  2. Strong commitments to education and research and development of leadership in mining and agricultural engineering
  3. Rapid process of linkages with the manufacturing sector.
  4. Particularly in the case of the U.S., persistently high levels of tariff protection.
  5. Highly diversified economies which could absorb shocks to one sector.

In the post-W.W. II period successful development is no longer correlated to resource wealth. The economic miracles of this period occur mostly in resource poor countries, like Japan, Taiwan, Korea, Singapore and, most recently, China.  Though  “Dutch Disease” marks the economic development of most commodity producers., there are significant exceptions. Norway, Australia, UAE, Botswana,  Malaysia and Thailand are  examples of commodity-rich countries that found a way to avoid the pitfalls caused by price volatility and boom-to-bust cycles. Van der Ploeg attributes the success of these countries to two primary factors: ( 1) strong institutions; and (2) savings mechanisms to smooth out the financial effects of commodity price changes, such as sovereign funds.

Unfortunately, in emerging markets the successful cases are few. None of the conditions listed above which existed in Europe and the United States in the past are today present in most developing countries. The opposite is true. Most commodity sectors in developing countries are dominated by the state, linkages with manufacturing are difficult to achieve and economies tend to be poorly diversified and rely heavily on  a few commodity exports for their foreign exchange inflows. Moreover, countries have less flexibility to impose high tariff protection as the U.S. did in the past, which inhibits the creation of linkages with mufacturing. Furthermore,  the  past four decades of hyper-financialization of markets and open global capital flows have greatly increased the challenges for policy makers. Finally, Van der Ploeg suggests that fledgling democracies, like those of Latin America, are particularly vulnerable to “Dutch Disease” because institutional development has not kept up with political liberties.

The Causes of “Dutch Disease”

The simple explanation for “Dutch Disease” is that financial windfalls from commodity booms promote rent-seeking behavior which concentrates wealth and political power and buttresses the forces opposed to modernization. According to van der Ploeg, commodity windfalls have the following effects:

  1. They raise the value for politicians to remain in power and increase their resources to “buy off” constituencies. Patronage is increased at the expense of productive activities.
  2. They undermine institutions (justice, press freedom) that oppose corruption and rent-seeking behavior.
  3. They undermine entrepreneurship and productive behavior, as the attractiveness of rent-seeking behavior relative to profit-seeking entrepreneurial activity is increased. Businesses find it more profitable to lobby politicians for protection and exclusive licenses  than to invest in productivity.

These consequences of commodity windfalls appear to be more pervasive for “point-source” resources with concentrated production, such as oil and mining (and much less so for highly diluted activities like farming). Oil and mining in emerging markets tend to be either controlled by the public sector or subjected to heavy licensing and regulatory requirements that increase the influence of politicians.

The Symptoms of “Dutch Disease”

In addition to promoting  corruption and rent-seeking behavior, poorly managed commodity  windfalls beget economic instability. A surge in commodity prices for a country with a high dependence on commodity exports results in a liquidity shock and a sudden improvement in solvency. Currency appreciation accompanied by booms in credit and asset prices follow quickly. The typical economic symptoms of a commodity boom are the following.

  1. Currency appreciation
  2. Deindustrialization; contraction of the traded sector (increased manufacturing trade deficits)
  3. Expansion of non-traded sectors
  4. Increased monetary liquidity and credit expansion
  5. Negative savings
  6. Increased vulnerability to economic instability (debt levels, current account deficits)

Typically, when the commodity boom turns to bust, the country finds itself in a very vulnerable situation. A period of austerity follows, currencies depreciate, credit contracts, and asset prices collapse.

Unfortunately, the boom-to-bust cycle has important negative consequences that may persist for extended periods. The aftermath of the cycle entails:

  1. Weaker long-term growth prospects
  2. Trade sector and its positive externalities (human capital spilllover effects) do not recover fully when the bonanza is over.
  3. Weakened institutions

The Case of Brazil

In 2002 a huge surge in Chinese orders for Brazil’s iron ore giant Vale signaled the beginning of a commodity super-cycle. High prices for iron ore and Brazil’s other commodity exports – coffee, soybeans, sugar, and cocoa – persisted until 2011, with a brief interlude during the great financial crisis. Coincidentally, in 2006 Brazil’s national oil company Petrobras announced the discovery of enormous oil reserves in  pre-salt deep-water oil fields.  This led Petrobras to announce plans to spend $400 billion to raise production from 1.8 million b/d in 2008 to 5.1 million b/d by 2020. Additional plans by Petrobras’s pre-salt partners and independent producers promised to raise output by another 2 million b/d by 2020, so that by that year Brazil, with a production of 7.1 million b/d,  would become the fifth largest producer and exporter in the world. (Oil and gas output for 2020 is now expected to be 3 million b/d)

The combination of a dramatic improvement in Brazil’s terms of trade and the anticipation of a more than tripling of oil output led to a sudden and massive solvency-wealth effect and a financial boom. Unfortunately, the boom did not last, the bust has been dreadful and the long-term consequences for growth appear to have been very negative. Is Brazil suffering a bad case of “Dutch Disease”?  To answer this question, we can study how its experience fits into van de Ploeg’s framework.

Increased Patronage, Corruption and Rent-seeking

The commodity boom unleashed in Brazil a binge of patronage aimed at securing political power.  The ruling  Workers Party  (PT) government beefed up the privileges of the state bureaucracy and introduced myriad welfare programs to cement important electoral constituencies. At the same time, schemes were organized to syphon off funds from state companies and public auctions. Petrobras, the national oil company, became the epicenter of a frenzy of  kickbacks on licenses, procurement contracts and international transactions involving hundreds of politicians and businessmen. Brazil’s largest private contractor, Odebrecht, led a ravenous and pervasive scheme to rig public auctions. Transparency International’s “Corruption Perceptions Index” (chart 1) captures well the dramatic expansion in corruption engendered by the commodity boom. The World Bank’s Worldwide Governance Indicators for Brazil, a good measure of the strength of institutions,  show significant declines for all categories. (chart 2)

Chart 1

Chart2 

 

Currency appreciation and deindustrialization.

The Brazilian real (BRL) appreciated sharply over the  2002-2011 period (Chart 3). The BRL bottomed in July 2002 and peaked in September 2011, moving two standard deviations, from very undervalued to very overvalued. This degree of currency volatility would make it difficult for any manufacturer of traded goods to remain competitive and committed to export markets. Consequently, it is not surprising that Brazil has undergone a severe process of premature deindustrialization (chart 4). This process had started during a previous period of currency overvaluation in 1994-1999 and has intensified since 2004 until now. This extreme level of currency volatility is primary evidence of the mismanagement of natural resource windfalls, and it is in stark contrast to the healthy economies of Asia that are committed to maintaining stable and competitive currencies.

Chart 3

Chart 4

Credit Expansion and Asset Appreciation

The commodity boom brought with it a surge of domestic liquidity. Bank lending  to households rose from 7.3% of GDP in 2003 to 18.6% of GDP in 2010 (chart 5). Since the end of the commodity boom in 2011, Brazil’s total debt to GDP has ballooned from 120% GDP to 160% of GDP (chart 6). Public debt to GDP will handily surpass 100% of GDP this year.

Chart 5

Chart 6

The surge in domestic liquidity during the boom years created a huge asset bubble, driving financial assets and real estate prices to record levels. Brazil’s Bovespa stock market index level rose by more than 20 times in U.S dollar terms between September 2002 and August 2008. (Chart 7). The cyclically adjusted price earnings ratio (CAPE) valuation of the stock market reached 34 times, more than triple its historical average. The stock market today is worth less than a third of its value in August 2008 and valuation multiples have returned to historical norms.

Chart 7

 

From Dutch Disease to Japanification

The evidence shows that Brazil clearly has had a bad case of “Dutch Disease.” Sadly, one could argue that the country would be much better off today if the giant pre-salt oil discoveries had never been made. The corruption scandals of the boom led to the fall of a president and the rise of populism, and the weakening of core institutions. A trend of  premature deindustrialization has been accelerated, and the economy is mired in low productivity and low growth. Fixed capital formation is weak and debt has  risen to dangerous levels.

Brazil has entered into a process of Japanification where high debt levels and anaemic growth dynamics make monetary policy ineffective. Brazil is the first major emerging market to join the camp of countries with negative real interest rates, which will have unpredictable consequences.

Even with a much weakened currency, the manufacturing sector is not competitive and continues to decline. Ironically, with low growth and low demand for imports, the Brazilian real is very likely to appreciate in the future. This is because the increase in oil production has dramatically improved Brazil’s structural current account, while the agro-export complex and iron ore exports are more competitive than ever. If the current surge in commodity prices, triggered by Chinese stimulus, persists and a new positive commodity cycle gets underway, the BRL will appreciate and new wave of liquidity will drive the financial economy. This could result in a spurt of artificial growth and asset appreciation and a new dose of Dutch Disease.

 

The Yuan’s Run has Legs

It has been an interesting year in global currency markets. Early in the year, the U.S. dollars spiked, as the combination of the pandemic and fears of discord within the European Union triggered a trade to “safe haven” assets. However, since May, following a friendly resolution of tensions in the EU, the euro rallied strongly, taking with it the DXY index, which is the market bell-whether for the relative value of the USD. The significant weakening of the dollar against the euro, and to a lesser degree against the Japanese yen, has raised hopes for international investors that the strong-dollar cycle started in 2011 may have ended, which would be supportive of better performance for non-U.S. assets. The chart below shows the DXY’s evolution for the past twenty years: a sharp downcycle for the dollar from 2001 to 2011, followed by a persistent dollar upcycle from 2011 to this year until the recent sharp correction.

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Unfortunately for EM investors, when looked at on a broader basis the USD is not as weak as it is against the euro-heavy DXY index. For example, on a trade-weighted basis, as shown below, the dollar has strengthened by 2.1% since the beginning of the year.

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In the case of a currency index based on the country component weights in the MSCI EM equity index, the USD has appreciated by 4.2% this year. The yuan has appreciated by about 1% against the USD over this period, while the rest of EM has experienced currency losses of 6.2%.The evolution of the MSCI EM currency index is shown in the chart below from Yardeni.com. We can see that EM as a whole still appears to be in a downtrend relative to the dollar, and both the EMEA and Latin American regions have currencies which are persistently weak relative to the USD.

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So, the important question is why is the yuan strengthening at this time and is its rise sustainable? This is what matters to EM investors as China is now 42% of the MSCI index. The answer is in the two charts below. The first chart shows the yuan on the left side and the interest rate differential between China and the U.S. for 2-year government notes on the right side. In a world of negative real rates in both developed and emerging markets, China now has real rates and a growing differential in its favor. The second chart shows China’s trade surplus back at record levels (at a time when both tourism and capital outflows have come down sharply).

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It is logical that a combination of high rates and strengthening trade and current accounts would lead to currency yuan strengthening. Given trade tensions with the U.S. (and the rest of the world) and a clear commitment to boosting consumption and moving up the manufacturing value-added chain, it is likely in Beijing’s interest to let the yuan move higher.

A New Development Model for Brazil

Over the past fifty years, very few countries have successfully progressed from lower-income status to developed status. This very short list includes Korea, Taiwan, and the island city-states of Hong Kong and Singapore. We can also add coastal China, the extraordinary case of the past decades. These countries all have followed the model pursued by the United States, Germany and northern Europe, which was prescribed by the first Treasury Secretary of the United States in his seminal “Report on Manufacturers.”

Hamilton asserted that no country would prosper without a strong manufacturing sector, and noted that case for free-markets made by Great Britain was self-serving, to preserve its hegemony.”

In defense of trade tariffs, Hamilton argued that:

“There is no purpose to which public money can be more beneficially applied, than to the acquisition of a new and useful branch of industry; no consideration more valuable, than a permanent addition to the general stock of productive labor.”

Every successful country has followed this mantra. The “Asian Model” espoused by Japan, Korea, Taiwan and China, has relied intensively on manufacturing. The “ China 2025” industrial policy, which has annoyed the current hegemon, the United States, takes to heart Hamilton’s focus on “new and useful branch of industry” by focusing government support on frontier industries. In addition to targeting subsidies for industry the “Asian Model” prescribes the following:

·      The promotion of competition in manufacturing, with prioritization of exports.

·      Competitive currencies. (This has always been important but now more than ever in a world of low-cost container shipping and erratic capital flows.)

·      Create conditions for small farmers to thrive.

·      Channel agricultural surpluses and savings into productive investments by regulating lending by financial institutions.

The resilience of manufacturing promoted by the Asian Model is in sharp contrast to the “Latin American Model.” The result can be seen in the following chart. Brazil has essentially abandoned its manufacturing sector and faces a crippling state of premature deindustrialization. Mexico has done much better than Brazil, but has focused, almost exclusively, on serving as a “workshop assembly line” for the U.S. market, with little value added.

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Brazil gave up on its industrial model in the 1980s. Since then, it has essentially followed policies that are the antithesis to the “Asian Model.” Unlike in Asia, where export-competitiveness was stipulated, Brazilian industry lost support because of a reputation for high costs and poor quality. Brazil’s foreign currency management has also been incongruous, leading to extreme volatility in the exchange rate and a persistent tendency for overvaluation, conditions that are unbearable for the manufacturing sector.

Furthermore, the Brazilian policy framework has promoted an oversized financial system which thrives on speculation, and serves almost no purpose in funneling savings into productive activities. The past ten years have seen the logical culmination of this process, as debt levels have exploded at a time of extremely low investments in productive activities.

The current conditions in Brazil don’t look propitious for a major change of course. For the short term investors can hope only for some progress in terms of current government initiatives to reduce the excessive cost of government bureaucracy, simplify the tax system and deregulate several industries to encourage more investment. None of this can solve the structural issues that the country faces, particularly the excessive debt levels

If the current Brazilian model has run its course, what lies in the future? What could a new Brazilian development model look like?

1.     First, the country will have to address excessive debt levels. Current debt levels asphyxiate growth, so some form of financial repression is inevitable to brings levels back to sustainable levels.

2.     Second, Brazil will have to stabilize its currency at a competitive level and convince markets of a long-term commitment to currency competitiveness.

3.     Third, Brazil needs to credibly commit itself to a new industrial policy. This is a huge challenge because of a lack of confidence in policy makers, but it is imperative. Legislation should be passed to provide long-term support or several “frontier industries,” while encouraging a competitive environment and a priority for exports. I suggest three candidates:

  1. Renewable energy – Brazil is well-positioned to be a global leader in solar, wind, and bio energy. It has ample resources, a large market and already a solid industrial base.
  2. “Green” farming – Agriculture is the one sector where Brazil has maintained global competitiveness, and it is well positioned to meet global demand for ecologically-sound farmed products.
  3. Deep-water oil production – Brazil has huge deep-water oil fields that will provide demand for capital goods for decades to come. However, the poorly structured policies and inconsistency of previous efforts have undoubtedly left a bitter taste.

Expected Returns in Emerging Markets

The global Covid-19 pandemic has had a grave impact on emerging markets. As has happened broadly across the world,  the pandemic has accelerated existing trends and highlighted the strengths and weaknesses of countries and companies. It has also grievously exacerbated income  and wealth inequality in most countries, increasing the divide between the tech-connected “haves” and the disconnected “have-nots.” We can group emerging market countries in terms of how well they have dealt with the virus and the impact that the pandemic will have on GDP growth and public finances. Also, we should differentiate those markets with ebullient tech sectors from those with little presence of tech companies. All these factors have had important ramifications for market performance so far this year and are likely to continue to do so for the foreseeable future.

Taking into account the highly uncertain evolution of the pandemic and its economic and corporate consequences, we live in times when making forecasts is a thankless task.

It may also be senseless when the objective is to identify probable long-term returns in the context of extraordinary monetary and fiscal policies and major shifts in the global trading system.

Nevertheless, we plod on with this exercise in the hope of identifying 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, perhaps naively, 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,  returns are muted, which 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  6.7% annually in real terms (net of inflation) over the next seven years. This is below historical returns and disappointing in light of the poor results of the past decade. These returns, however, are attractive compared to the dismal prospects for U.S. stocks. The U.S. is trading a near record-high valuations while emerging markets are priced at large discounts to historical valuations.

To secure more attractive expected returns the investor needs to venture into the riskier and cheaper markets. Colombia, Turkey, Chile, Philippines, Mexico and South Africa all trade at very sharp discounts to historical valuations and will provide high returns if mean-reversion occurs. The markets currently are pricing in difficult economic prospects for these markets. However, narratives change quickly. For example, South Africa, Chile, Mexico and Colombia would all benefit from rising commodity prices., and the recent decline of the U.S. dollar and the sharp rise in gold may portend a reflationary trend for the global economy.

There is no hiding from the reality that most assets are priced richly, and investors should not be counting on high returns.

GMO, an asset manager based in Boston, (Link) expresses this clearly in their most recent 7-year forecast for the expected real returns of different asset classes. As shown below, GMO expects negative real returns for most asset classes and a meager 1.6% annually for emerging markets. To garner high returns, GMO recommends investors venture into “value” stocks in emerging markets. This “active” position may be promising because it is diametrically opposed to the positioning of the great majority of “active” investors who are extremely concentrated in “growth” stocks, especially the e.commerce and internet platforms around the world.

This view is also echoed by Research Affiliates (Link), as shown below.  RA’s methodology is similar to the one highlighted above, relying on mean-reversion to historical valuation parameters to forecast expected returns. However, RA is more optimistic on EM stocks, where it expects real annual returns of 7.7%

Our forecasts reflect both the views of GMO and RA. We expect decent, if not stellar, returns for EM stocks, with the possibility of much higher returns if a global reflation trade allows deeply discounted stocks to outperform.

The U.S. Dollar and Emerging Markets

The recent weakening of the U.S. dollar has raised hopes that international stocks, including those of emerging markets, may be ready for a period of superior performance compared to those of the United States. This is because, in the past, foreign stocks have enjoyed strong results during periods of dollar weakness. The dollar cycle has tended to last about a decade and a half, with some eight years of dollar strength followed by some eight years of dollar weakness. The dollar has been strong relative to foreign currencies since 2012, so perhaps the recent weakness of the greenback may indicate the cycle is now turning.

The strength of the dollar tends to be associated with periods of U.S. “exceptionalism:” times when the U.S. is growing more and creating more wealth than the rest of the world and, consequently, attracting more capital to its shores. The U.S. is also often seen as the primary safe haven for capital, given its deep capital markets, rule of law and friendly attitude to foreign capital inflows. During times of global political or financial stress this “safe-haven” status of the U.S. is especially important. This has certainly been the case for the past eight years which have seen negative interest rates in Europe and Japan and massive capital flight from many emerging markets, including China and Latin America.

The U.S. safe haven status diminishes in importance when the prospects for economic growth and returns on capital appear to be relatively better in foreign markets. This may be the case today given the complicated circumstances of U.S. in terms of politics and the economy in the wake of the disastrous management of the Covid-19 pandemic. The U.S. is now committed to negative real interest rates for the foreseeable future and is likely to turn to financial repression to face growing debt and social liabilities. Ten-year Treasury bills now yield 0.5%, which points to a combination of low growth and deflation for the foreseeable future. Moreover, high U.S stock prices also point to very low forward returns.

On the other hand, growth prospects now look relatively more attractive in Europe, Asia and emerging markets, and the valuation differential between U.S. and foreign stocks are near record highs. This has set the stage for the current weak performance of the U.S. dollar. As shown in the chart below, The U.S Dollar Index (DXY) has fallen sharply, by about 10% since its March high and is now trading well below its 200-day moving average.

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However, it is important to note that the DXY, though the most watched indicator of the USD, is weighed heavily to the Euro and the Japanese Yen. To get an idea of the trends for emerging markets we have to look at the MSCI emerging markets currency ratio which shows the weighed relative performance for all of the countries included in the MSCI EM index. The following chart, from Yardeni Research shows this ratio. We can see here that there has been so far only a slight uptick in this ratio, not enough to indicate a trend.

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Furthermore, the previous chart obfuscates the continued poor performance of the majority of EM currencies. Aside from China and a few other Asian currencies, all the major EM currencies continue to lose value. We can see this in the chart below. Not surprisingly, the worse performing currencies belong to those countries that have poorly controlled the pandemic and suffer from financial and political instability.

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In conclusion, it is still early to bring out the champagne. Though the USD is weakening relative to the Euro and the Yen, and especially gold, emerging markets are not yet participating because fundamentals are in many cases still deteriorating.

Global Macro Outlook for Emerging Markets

Emerging market economies and assets are sensitive to global U.S. dollar liquidity, the global economic cycle and the fluctuations of investor appetite for risk. The past decade has been one of relative strength for the U.S. economy in an environment of declining global growth. Relatively high returns on capital in the U.S. on both risk-free assets and stocks have sucked in capital from around the world and caused a prolonged cycle of appreciation of the U.S. dollar. These circumstances have been negative for emerging market asset prices and caused a decade of poor performance for stocks. Periodically, it behooves us to evaluate market conditions to ascertain whether circumstances are changing, and we do this by following a simple framework which considers:  Global U.S. dollar liquidity; currency trends; commodity prices; and risk aversion.

Global U.S. Dollar Liquidity

The chart below shows a measure of global U.S. dollar liquidity based on the evolution of  the combined values of (1) global central bank dollar reserves and (2) the U.S. M2 monetary base, data provided weekly by the U.S. Fed. The second chart shows separately global central bank reserves.  We can see from these charts the extraordinary nature of the times we are in.  The unprecedented increase in USD liquidity has been driven exclusively by massive money printing by the Federal Reserve, and this liquidity is finding its way into markets through fiscal spending and mandatory lending programs. This is in sharp contrast to the 2008-2009 (GFC) crisis when most of the increase in global dollar liquidity was caused by China’s infrastructure stimulus, which boosted commodity prices and underpinned international trade. In the current situation, international reserves have seen only a slight increase, but only because of some $700 billion in emergency swap lines provided to U.S. allies by the U.S. Fed.

 The U.S Dollar Cycle

The Fed’s unprecedented interventions made in concert with Treasury,  as well as gargantuan fiscal deficits, steep increases in U.S. government debt and the prospects of a sustained period of high fiscal deficits underpinned by financial repression (forced lending and negative real interest rates) may be unsettling the U.S. dollar. Debt levels in the U.S. are rising precipitously at a time when, for the first time in a decade, interest rates in the U.S. are no longer higher than in Japan or Europe and may no longer attract foreign capital.  Interestingly, the spread in favor of Chinese government bonds vs. U.S treasuries has been rising and is now at near record levels. The charts below show the DXY index, which measures the evolution of the U.S dollar primarily vs. the euro and the yen, and also the MSCI Emerging Markets Currency Index, which measures the value of EM currencies relative to the USD. The DXY has fallen from its March high of 103.5 to 95, breaking through the 50-day, 200-day and 18 month moving averages. This has happened concurrently with a sharp rise in the price of gold, which is further evidence that the confidence in the USD may be breaking. Nevertheless, for emerging market currencies, the breakdown of the USD is much less pronounced. Still, the recent weakness of the USD is certainly heartening for EM investors.

Commodity Prices

Commodity prices reflect both the value of the USD and global economic activity. At the same time, in recent decades they have been a key factor in determining global liquidity because major commodity producers typically sharply increase dollar reserves when prices rise. Rising commodity prices lead to significant increases in both global liquidity and domestic liquidity for many emerging markets, and they are generally necessary for asset appreciation throughout EM. The chart below, from Yardeni.com, shows the Commodity Research Bureau (CRB) Industrials Index, which historically has been highly correlated to emerging market asset prices.  We also show the chart for the spot price of copper, which has rallied strongly over the past two months. We can see from these charts – particularly the CRB Metals and copper – that industrial metals are on the rise. The likely explanation is the current surge in infrastructure spending by the Chinese government in a mini-version of the great 2008-2009 stimulus. These are bullish trends which further should improve investor appetite for EM assets.

 

Risk Aversion

Emerging market assets are considered high-risk investments that require a large risk premium.  In times of market turbulence, these premiums tend to expand dramatically. Emerging market premiums for both stocks and bonds are closely linked in their trading patterns to U.S. high yield bonds. The chart below, from Yardeni.com, shows the spread between U.S. Treasuries and U.S. high yield bonds. This is a very good measure of risk aversion, which serves for EM. We can see that these spreads have come down steadily since March. They remain at relatively high levels, but mainly because Treasury yields have collapsed. The question that investors have to ask themselves is whether market prices reflect reality at a time of unprecedented intervention by monetary authorities.

Conclusion

Though it may be early to call for the beginning of a new cycle of strong performance for emerging market stocks,  several signs are supportive of this thesis.  The recent weakness of the USD and the growing challenges for the U.S. economy may point to an extended period of  relative strength for emerging markets. Further USD weakness and commodity strength would support increasing exposure to EM assets.

Ten-Year U.S. Treasury Rates and the Reflation Trade

The ten-year U.S. Treasury bond rate is the most important parameter in investing, used by investors of all types to establish relative return metrics. Ten years encompasses about two regular business cycles and is a practical time-frame for investors to work with: it avoids both counterproductive “shortermism” as well as the unfathomable long term. Therefore, investors estimate cash flows ten years in advance and discount these by the risk-free treasury rate added to a premium which measures the specific risk of the investment.

So, what happens when 10-year rates approach zero or even negative rates, as they now have across Europe and Japan? U.S. rates, currently around 0.60%, are at historical lows in nominal terms and well into negative territory in real (inflation adjusted) terms, as shown in the graph below.

 

What do these historically low interest rates tell us?  In the past, the nominal ten-year rate has been a relatively good predictor of nominal GDP growth. This relationship has been reliable over the 1970-2020 period when both nominal GDP and the 10-year Treasury rate have averaged a little over 6% per year. The current low rates, then, may point to a combination of deflation and low GDP growth in coming years, unless an argument can be made that rates are being artificially repressed by the Fed (and elsewhere).

If valuations for stocks are determined by discount rates linked to the 10-year rate, what are the investment implications of the current circumstances? On the one hand, very low rates imply high valuations, as long-term cash flows increase in value as discount rates decline; on the other hand, tepid economic growth pushes down valuations, as cash flows for most company are closely linked to economic output. In summary, what the investor gains from low valuations he losses from low cash flow growth.

The current state of the global economy is depressive with low growth prospects. Most countries face poor demographics and excess debt. Concurrently, most industries are being brutally disrupted by an eruption of practical innovations spawned by the “information and communications” revolution. In this environment of low growth and disruption, one would expect that, in general, corporate profit growth would be weak, but that those few companies enjoying growth and benefiting from disruption would be rewarded with high valuations. The current Covid-19 environment has starkly heightened these trends, as most companies  have been devastated by the crisis while for a few disruptors it has been a boon.

Of course, most of these winning companies are U.S. based, and that explains the high valuations for tech companies in Silicon Valley and other frontier industries. These companies either have predictable long-term growth (eg. Amazon, Microsoft) or exceptional market opportunities (eg., biotech). These sectors benefit from long-duration cash flows which discounted at today’s low rates result in very high values. When found outside the U.S. — tech in China, Korea and Taiwan, e.commerce in Latin America (Mercado Libre) or South-East (SEA) — these firms are also highly valued.

In both the U.S. and international markets, “growth” stocks have performed much better than “value” stocks over the past decade. This is because growth has been scarce and low discount rates have boosted the value of long-duration cash flows. The problem for international and emerging markets is that “growthier” sectors (information technology, fintech, e.commerce and bio-pharma) have much less weight than they do in the tech-heavy U.S. stock indexes. This is particularly true in emerging markets where financials, industrials and commodities dominate the indexes. To make matters worse for emerging markets, at the beginning of this period of low growth and great disruption, around 2010-2012, these sectors had extremely high valuations.

Take the case of financials. In the past in emerging markets highly profitable banks with dominant market positions were favorites of investors. 10 years ago, financials in EM represented 24% of the index, led by the Chinese and Brazilian banks. Today, financials in EM represent only 18.5 of the MSCI index and they are suffering from a combination of low growth, historically low interest rates and attacks from tech-enabled disruptors which are often abetted by regulators. Technology only represents 16.5% of the EM index (most of which is in China) compared to about 45% of the S&P 500, while financials have fallen to only 10% of the U.S. index.

So, what could change the current paradigm of the market and make emerging markets attractive again?

Well, obviously a rise in inflation and interest rates would be beneficial, since this would reverse the cause of high valuations for growth stocks. A spike in the ten-year treasury rate would have a large impact on the valuation of companies with long-duration cash flows and cause a major shift in valuations, allowing “value” stocks to outperform in relative terms. However, this does not appear to be imminent. On the contrary, rates continue to be on a strong downtrend.

Nevertheless, we may be seeing some  “green shoots” of a reflation trade. These can be listed as follows:

  • High valuations for growth stocks are causing a rotation into underperforming segments of the market, including emerging markets.
  • China stimulus is pushing up commodity prices. Industrial commodities, led by copper and iron ore, have rebounded strongly.
  • Potential inflationary shifts in U.S. public policy: forced reshoring of manufacturing, boosts in minimum wages and union influence, universal income and expansive monetary and fiscal policy.
  • A weakening dollar and concurrent rise in alternative currencies (gold, bitcoin).

The USD has weakened significantly from the March high, and an extension of this trend would be important evidence supporting a regime change towards higher inflation

Capital Flight Into U.S. Residential Real Estate

Over the past decade (2010-2019) foreigners have invested more than a trillion dollars  in American residential real estate. This inflow of “flight capital” into U.S. homes reflects financial and political unease around the world and is a testament to the continued safe-haven status enjoyed by the U.S. These inflows have contributed to the persistent strength in the U.S. dollar over this period.

The National Association of Realtors (NAR)  in the U.S. publishes an annual report on foreign participation in the U.S. residential real estate (Profile of international activity in U.S. Residential Real Estate  Link.)  The chart below details the data for the past decade. According to the NAR, foreigners bought $934 billion in residential properties over the period. Because buyers may frequently not reveal their nationality or/and carry out purchases through legal entities, the NAR figures significantly understate reality. Also, these figures do not include commercial real estate transactions which also were pronounced over the period. Nevertheless, the data can provide some color on the scale and trends of the activity and who the buyers are .

Canada and the UK represent mainly buyers of vacation and retirement homes. The remainder of the primary buyers and the majority of the “others” category represent “flight capital” from a wide variety of emerging markets. These buyers have as their primary objective s to diversify their financial holdings away from their home country and to secure a “safe haven” residence for their families. Chinese buyers have been prominent over the period, particularly between 2014-2018, when capital flight from China was elevated. 2019 saw a large decline in purchases in general and from Chinese buyers in particular. This may be explained by the sharp appreciation of the dollar, the U.S.-China trade tensions and tighter capital controls in China.  The election of the anti-business populist AMLO in Mexico, has triggered a sharp increase in Mexican capital flight into residential properties across the northern border.

The top four destinations for foreign buyers are Florida, California, Texas and Arizona. Canadian “snowbirds”  flock mainly to Florida and Arizona, while the Chinese prefer California, and Mexicans go to Texas and California. Aside from the Mexicans, Latin Americans largely prefer Florida, where they are the dominant buyers in the Miami and Orlando areas and up the eastern coast.

The NRA’s Profile of International Real Estate Investing in Florida 2019 (Link) details Latin American flight capital into Florida. The chart below shows the total purchases by foreigners in the Florida market over the past 10 years in both units and values. Latin Americans represent about 45% of the foreign buyers in Florida, led by Brazil, Venezuela, Argentina and Colombia. Mexico and smaller Latin American countries represent about 40% of the “others” line. Mexicans  represent only about 2% of foreign buyers in Florida.

Foreign Buyers of Florida Homes, 2010-2019

The table below details the value of purchases by year. The past decade was turbulent in Latin America with political chaos and economic collapse in Venezuela and stagnation or deep recessions in most countries. The decade also started out with overvalued currencies in most Latin American countries and a depressed real estate market in Florida, which was a combination that favored inflows into Florida’s market. The scale of the flight capital from these savings-poor countries is very concerning, and a clear indication that elites are increasingly estranged and disassociated from the fortunes of their home countries.

Tech Drives EM stocks, Leaving Value Behind

Emerging Markets stocks have traditionally been an asset class closely tied to the global economic cycle. When the global economy was strong relative to the U.S. economy, the dollar would depreciate, commodity prices would rise and emerging markets would enjoy a period of ample liquidity and rising asset prices.

We can see this clearly in the chart below: since the 1980s, there have been two downcycles for the USD (1985-1997 and 2002-2012) which have coincided with bull markets in EM equities. We are now in the ninth year of a dollar upcycle, which has resulted in very poor returns for emerging markets investors.

It is not happenstance that emerging market stocks and “value” stocks are strongly correlated. The periods of strong performance for “value” (stocks with low prices relative to book value, earnings or sales compared to the overall market) have been largely concurrent with those for EM stocks, and the past ten years have been terrible for both. This is because both the value and EM universes are heavily weighted to cyclical and mature industries and sectors that are vulnerable to technological disruption. The chart below shows the performance of both the value and core indexes for U.S. and EM stocks for the past 10 years.

If we look at the performance data for EM in more detail we can see that regional disparaties are pronounced. The chart below highlight the enormous transformation that the asset class is undergoing, both in terms of the growing weight of China and Asia but also in terms of the surge of the technology sector. While 10-years ago the index was dominated by commodity producers, today almost every stock in the list is driven by the smart-phone/e.commerce revolution. Every single stock, except for Reliance of India operates in North Eastern Asia.

 

The charts below detail total annual returns by region and by style (value) year-to-date, 1-year, 5-years, and 10-years. A cursory glance at these numbers makes one thing clear: over the past ten years, in emerging markets it has always paid to be in Asia and out of value stocks.

The outperformance of Asia is explained by growing importance of the tech sector, both traditional players (TSMC, Samsung) and a plethora of newcomers in e.commerce.  The lack of tech in Latin America can be seen in the poor performance relative to Asia and in the similar returns between the Latin America core index and its value index. Just like in the U.S., emerging markets are now driven by tech, as shown in the chart below.

Even within regions or countries, owning tech has been the correct  strategy. Value has underperformed in every region. Within China, owning tech and avoiding value (state companies, banks) has been the trade.

In Indonesia, buying SEA Ltd, the country’s largest e.commerce company, has been the trade.

 

In Latin America, the one thing to do has been to buy Mercado Libre, the leading e.commerce site in Brazil and Argentina.

What the future will bring is anyone’s guess. Another downcycle  for the USD is likely to start over the next several years, providing support for EM value stocks. On the other hand, low global growth and intensive technology disruption should continue to boost the valuations of scarce growth opportunities.

 

 

The Death of Value Investing (and Emerging Markets)?

 

The current investment environment, with its apparent disconnect between economic and financial conditions, has been discomfiting for some of the world’s most famous investors. “Has Warren Buffett Lost His Mojo?” the Financial Times asked this week, accusing the Sage of Omaha of poor timing and awful stock picking. Two hedge fund titans, Paul Tudor Jones and Stan Druckerman, recently both owned up to be out of sync with the markets. Druckenmiller apologized for being “far too cautious” and having “missed a great opportunity.”  Jones, speaking to The Economic Club of New York, said: “If there was a franchise for humble pie, oh my lord they’d be a mile long to own that, because we all had huge gulps of it — me included.”  And, now, Jeremy Grantham, the modern doyen of value investors, has said  that, even though “value” stocks have had a epic run of poor performance, “this time may be different” and he is not confident that they will bounce back. Grantham warns that cheap stocks are cheap for good reasons and investors should be careful before selling the high-flying FAANG stocks which are driving the markets upwards.

Grantham is a founder of GMO, a Boston-based asset management firm which has made its reputation over many decades by sticking to its value methodology through cycles. Grantham’s brilliant essays on investing have been required reading for a generation of “value” investors.

Value investing – defined as stock-picking based on quantitative metrics of cheapness (price-to-book, price-to-earnings, price-to-sales, etc…)  — has been a very successful strategy over the years. The superior performance of value stocks over time  — the value premium – is well  documented in academic research.  However, over the past ten years, the strategy has lagged badly, raising claims of “the death of value.”

Grantham’s Case for “This Time is Different.”

In the past, value investors would relish a period of underperformance, believing that mean reversion would work its magic. However, this time Grantham is not convinced. Even though this crisis is the “fourth major event” of his career and the previous three created enormous opportunities for value investors, Grantham thinks this one is the most “uncertain” because the world may have fundamentally changed.

In a very thoughtful interview on the “Invest Like the Best Podcast” (Link) Grantham says that the value premium of the past may have been a temporary aberration. Value stocks are cheap as a reflection of the market’s disgust and there is no intrinsic reason that they should provide higher returns, Grantham says. The strategy worked in the past because:

“The general caliber of competition back in those days was very weak and therefore if you did decent analysis, looked for value you could find it. So we were able to build simple mechanistic models by giving points for cheap book and so on and have a win on a very broad basis, so we could manage a lot of money. And we were winning 2 out of 3 years and adding a few points on average per year.”

However, that era came to an end about 20 years ago, according to Grantham. The “simpleminded”  nature of the strategy was made evident by academic research and arbitraged away by quantitative investors:

“Too many machines were picking it up, too many quants, too much money, and pretty soon the historical aversion to cheap stocks had disappeared because they acquired the reputation for having won. The quants made it clear they understood that for 1800 years into the mist of time these were factors that worked, and indeed academics wrote it up and got a lot of credit for such a simpleminded idea.”

Moreover, several other factors have contributed to making the investment environment less friendly for value investors, Grantham says:

  • The U.S. has drifted away from a healthy capitalistic system, experiencing a gradual increase in the power of big corporations: “the degree of corporate influence over government and regulation has climbed which facilitates monopoly. The willingness of the justice department to break companies up has declined, not surpringly, under those conditions.” This has resulted in a a “weakening in competitive spirit and speed. Conservatism and high return is put ahead now of growth and being the first and the biggest at something new.”
  • The Federal Reserve has become a dominant presence in the markets. In the past, value investors could ignore the Fed in expectation that the market would self-correct, but now the Fed rules the market.
  • The market leaders today – the FAANGs (Facebook, Amazon, Apple, Neflix and Google) – “ are unlike anything that ever walked the face of the earth. They generate market cap out of thin air, their use of assets is unlike anything it used to be; it’s not about traditional capital being depreciated and replaced and cranking out widgets, it’s all about intangible capital and brand and speed and using your brains to innovate.”

How much of an aberration is value’s recent underperformance?

In a recent paper, “Factor Performance 2010-2019: A Lost Decade? “ David Blitz, Head of Quantitative Research at Robeco in the Netherlands,  argues that the recent troubles of value are not unusual. Value’s poor results over the past decade  are typical when the market is very strong and dominated by other factors such as momentum and profitability. As the table below shows, value also performed poorly in 1990-1999, a similar period when the stock market was driven higher by high-growth technology stocks. The data is from the Kenneth French Data Library.

The chart below is from Your Complete Guide to Factor Investing by Andrew Berkin and Larry Swedroe, which looked at the data for a 90-year period, through 2017. On the right side, we can see the value premium harvested over this period. It is important to see the premiums in the context of the data on the right side of the chart which shows the probability of negative premiums over different periods. We can see that value has had a 14% chance of providing negative premiums over any 10-year period, and a six percent chance over any twenty-year period.

Therefore, long periods of negative premiums are not extraordinary. Moreover, we can probably say that these periods of underperformance are a necessary condition for the factor to work over time, because we should not expect anything easy to work in investing. Therefore, “no pain, no gain,”  and one should not expect to harvest the value premium without facing the risk of long periods of failure.

The “Death of Value” and Emerging Markets

It is no coincidence that emerging market stocks and value have both performed very poorly over the past decade. To a considerable degree, they are tied at the hip, both representing exposure to more risky and more cyclical segments of the market (though this has been somewhat mitigated in recent years with the rise of Chinese tech stocks).  The chart below shows the annual returns by decade for emerging market stocks and the S&P 500, since the launch of the MSCI EM Index at the start of 1987. If we compare these returns with those from the first chart from the Robeco paper, we can see that EM stocks and value both perform relatively well in decades when the S&P 500 does poorly. Both value and EM are “risk-on” trades, that do poorly in those decades of “American Exceptionalism” when investors are enamored with American growth stocks. We are coming out of such a decade, when the FAANGs, turboed by record-low interest rates, have dominated the markets.

No surprisingly, EM value stocks have done even worse over this past decade, as can be seen in the following chart, which compares the returns of the FTSE-Russel EM Index with that of the Dimensional EM Value Fund.

In conclusion, investors in emerging market stocks must hope that Grantham is wrong and that “This time is different” continues to be the four most dangerous words in the English language, as Sir John Templeton once said.

This hope is founded on the expectation that a combination of the following events will materialize:

  1. The FAANGS will peter out, weighed down by valuation, size and regulatory pressure.
  2. American Exceptionalism will take a rest.
  3. The U.S. economy will slow, the dollar will weaken and commodity prices will rise.
  4. Global growth will accelerate relative to the U.S. economy.

Are Brazilian Stocks Cheap?

Brazilian stocks have rallied by over 50% since March 24, driven by bottom-fishers and a new generation of avid speculators trading through online brokers. The Brazilian trade has similarities with the “dash-to-trash” trade that has pushed up the worst performers and “zombie” stocks of the U.S. market (cruise-lines, airlines, malls, etc…). Brazilian stocks have also benefited from a weakening dollar, which, in itself, is a reflection of increasing investor appetite for risk.

The “risk-on” trade is underpinned by the following narrative:

  • The Covid-19 pandemic is in retreat, and vaccines and therapeutics are forthcoming. This implies a “V-shaped” recovery of the economy.
  • The U.S. Fed is fully committed to propping-up financial markets and provides a “put” which provides downside protection.

Moreover, according to the bullish-case, emerging markets such as Brazil from now on will benefit from a strong tail-wind from the following forces:

  • Strong stimulus in China, which is evident from rapid credit growth (27% y/y) and surging cement and steel sales. China appears to be implementing a mini-version of its gargantuan 2009 stimulus.
  • Commodity prices, which are at decade lows, will be pushed up by Chinese stimulus. We can see this already in iron ore and copper prices, which are both well off the bottom and trending higher.
  • After a decade-long strengthening, the dollar may have started a down cycle. This would be caused by a combination of (1) the reckless implementation of Modern Monetary Theory in the U.S. (eg. fiscal deficits financed by money printing) and (2) improving growth prospects outside the U.S.
  • Record-low interest rates around the world and persistent deflationary trends are allowing EM central banks to reduce benchmark interest rates. This is particularly true in Brazil where interest rates at historical lows are pushing the rentier class into stocks.

Finally, the bulls believe that a great rotation has started, from expensive “growth” stocks (eg, FAANGS) into dirt-cheap “value” stocks. This rotation has been happening in recent weeks and partially explains the rise in Brazilian stocks. Emerging markets in general and Brazil in particular would greatly benefit from such a rotation. This is because, aside from China, Korea, and Taiwan, which have buoyant tech sectors, growth stocks are exceedingly uncommon in emerging markets.

For the current rally in Brazilian stocks to continue this narrative will have to be confirmed. Given the enormous lack of visibility on several issues, however, a cautious positioning is warranted. In particular, the continued virulence of COVID-19 across many emerging markets, and especially Brazil, is of great concern, and the risk of a second-wave later this year is real.

Moreover, the bulls may not be giving proper consideration to the disastrous impact that the pandemic has wrought on present economic output and future growth prospects. Both the OECD and the World Bank this week released growth forecasts for Brazil pointing to the devastating effect of the pandemic this year and slow recovery next year. These forecasts are shown below.

Furthermore, the crisis will have a very debilitating effect on Brazil’s fiscal accounts and result in a massive increase in the debt-to-GDP ratio. This ratio has been ramping-up dangerously for the past five years and will surpass 100% of GDP over the short-term. The very high levels of debt in Brazil can be expected to significantly reduce the potential for GDP growth in the years to come. This is shown in the chart below.

Furthermore, the claim that Brazilian assets are cheap should be qualified.

First, let’s look at Brazilian stocks on a historical basis. The chart below shows price-earnings ratio (PE) and cyclically-adjusted price-earnings ratios (CAPE) for Brazil, with 2020 numbers from sell-side estimates. Based on history, Brazilian stocks appear relatively close to historical averages.

The following chart, based on MSCI data and sell-side estimates, shows the MSCI Brazil index and Brazilian GDP (LHS) and earnings (RHS), all in USD terms. What the chart shows is that the perceived cheapness of Brazilian stocks is the result of a decade of currency weakness and GDP stagnation, which have led to no earnings growth.

The unfortunate reality is that Brazil has undergone a disastrous lost decade, as far as corporate profits are concerned. Given the Coronavirus, the expected slow recovery and the poor prospects for GDP because of excessive debt, there is no clear end in sight for these woes. Remember that Brazil’s stock market is largely composed of banks, commodity producers and mature consumer businesses, none of which are benefited by the global environment of low growth and disruption. The chart below shows historical and expected MSCI Brazil dollar earnings. These assume a gradual appreciation of the BRL over the 2020-2029 period.

Applying a CAPE methodology to this earnings forecast, we put a  Brazilian normalized CAPE ratio of 13.6x on 2027 CAPE earnings (10-year average inflation adjusted earnings), which gives us a target MSCI Brazil index value of  2383 in 2027, vs. today’s 1633. This translates into an expected annual total real return of 5.7% (including dividends). Needless to say, these expected returns are not enticing.

Of course, these kind of forecasts are full of pitfalls. Many things could happen to improve the prospects for Brazil. These are the primary ones:

  • A strong weakening of the USD and sharp rise in commodity prices could dramatically improve economic growth, liquidity, the debt profile and earnings. This is not currently in analysts earnings forecasts, but the chances of this happening in coming years are relatively good.
  • Successful economic reforms implemented in Brazil. Low-hanging fruit to increase productivity and growth potential are enormous. For example, Brazil has an abysmal ranking of 124th in the World Bank’s Doing Business ranking and has made no progress over the past 15 years.
  • Successful financial repression, to allow a managed reduction in government debt.
  • An innovation renaissance in Brazil, resulting in “new economy” companies. If Argentina could spawn a Mercado Libre, perhaps Brazil will do the same.

Hamilton, Xi Jinping and Microchips

Alexander Hamilton, the first Secretary of the Treasury of the United States (1789), argued for tariffs and subsidies to promote domestic industry. In a society dominated by farmers and powerful commodity exporters (cotton and tobacco), this was not an easy argument to make. Nevertheless, the case made by Hamilton in his seminal “Report on Manufacturers” had a profound influence on  policy makers for the next century.  Hamilton argued that the case for free trade made by Adam Smith relied on ideal conditions that did not exist in the real world of commerce. He asserted that Britain, which was the main trading partner of the United States, imposed “injurious impediments” on commodity exports from the United States and “bestowed gratuities and remunerations” in support of its own manufacturers. Hamilton argued subsidies were fundamental for “military and essential supplies” of importance to national security. His report to Congress singled out coal, raw wool, sail cloth, cotton manufacturers and glass (windows and bottles) as industries meriting subsidies. He also encouraged support for “infant manufacturers”:  “new inventions…particularly those which relate to machinery.”  In response to criticism of the fiscal burden of these subsidies, Hamilton responded:  “There is no purpose to which public money can be more beneficially applied, than to the acquisition of a new and useful branch of industry; no consideration more valuable, than a permanent addition to the general stock of productive labor.”

The U.S. heeded Hamilton’s recommendations throughout during the 19th century and until W.W. II, sheltering its industry behind a wall of tariffs. The German economist Friedrich List applied Hamilton’s framework to the case of Germany in the 1840s in his book The National System of Political Economy  (1841).  List echoed Hamilton in arguing that Britain’s defense of “laissez faire” economics was a disingenuous stratagem to contain the development of rivals. He promoted the idea of state-fostered industrial planning as necessary for a country to achieve the capability to compete on equal terms with foreign industries. To transition an economy to the more developed stage, List argued, it is imperative that governments (1) develop public infrastructure, (2) provide incentives for savings and for the accumulation of capital and the channeling of capital into productive industries and (3) promote “mental capital” (education and research). List’s ideas, which came to be known as the German Model, were very influential during Bismark’s Germany (1870s) and Japan’s industrialization (1860s) and later for the development models espoused by Taiwan, Korea, and Singapore. In developmental economics, this model is known as the East Asian Model of Capitalism. Since its opening under Deng Xiaoping in the 1980s, China has, by-and-large, followed the course of its East Asian neighbors, with astonishing results.

The success of the East Asian Model of Capitalism  is an anomaly in developmental economics which is not easy to explain. Korea, Taiwan and Singapore are the only countries in the 20th Century that have joined the club of developed industrialized nations, leaving behind other emerging markets which cannot overcome the “Middle-Income Trap” and the  myriad other forces which impede economic convergence (Eastern Europe, with its rapid integration with Western Europe is a different case). Many of the policies pursued by the East Asians have been tried, to one degree or another,  in most developing countries, but have tended to mainly benefit entrenched elites at the expense of the public. For example, Brazil adopted something quite similar to the East Asian Model framework in the late sixties and enjoyed a decade of high growth labeled the Brazilian “Economic Miracle.” However, political and economic instability, malinvestment and corruption have discredited the model in Brazil. In a bizarre evolution, Brazil has now gone to the opposite extreme and is flirting with Chicago School free-marketism. The one fundamental success which Brazil had in terms of promoting a world class company in a frontier industry, the aeronautics concern, Embraer, has lost government support.

One of the main challenges of development that the East Asian model seeks to address is the creation of world class companies in “infant industries.”  Naturally, the targeted sectors change constantly. What Treasury Secretary Hamilton considered to be critical for national security and to ensure industrial development (coal, sail cloth, glass) is now considered mundane. Fifty years ago, every country wanted to dominate the steel and automobiles industries; these are now considered mature and of lesser importance.

In harmony with Hamilton, China has boldly outlined its own list of essential “infant industries” in its “Made in China 2025” initiative. China today finds itself in a position similar to that  the  U.S. faced  relative to Britain in the 19th Century, and  which Germany and Japan faced relative to Britain and the U.S. in the late 19th Century and the first half of the 20th Century. As is to be expected, the dominant commercial power of today (United States) preaches free trade and reacts with outrage to the newcomers use of tariff and subsidies to support “infant manufacturers.”  China, like the U.S., Japan and Germany did before, objects that the U.S.  is  determined to unfairly contain its development. This dynamic between rising states and hegemons is a recurring pattern described as “the Thucydides Trap”  by Harvard’s Graham Allison in his book Destined for War.  Thucydides, an historian of ancient Greece, attributed the cause of the Peloponnesian Wars to Sparta’s inability to accept the rise of Athens as an equal. In his book, Allisson reviews 16 cases of rivalries between rising and established powers over the past 500 years, and he notes that 12 of the cases ended in wars.

Semiconductors are a pillar of “Made in China 2025.” If sail-cloth and coal were considered vital in Hamilton’s time, it is no wonder that semiconductors are the same for China today. Semiconductors are the “new oil” because they are at the core of the modern economy and drive all critical frontier technologies (communications, 5G, quantum computing, artificial intelligence, autonomous vehicles, drones, etc…), many of which have obvious military uses.  No country can aspire to play a leading role in any of these industries without having secure access to state-of-the-art microchips. China imported $350 billion in semiconductors in 2019, almost entirely from the United States, Taiwan and Korea. Furthermore, it relies on U.S. technology for the vast majority of its own semiconductor industry, which is two to three generations behind market leaders.

One of the main fronts of the semiconductor industry wars is currently being  fought in East Asia, so it is interesting to understand the history.

Korea and Taiwan are key global players in semiconductors. Both countries singled out semiconductors in their industrial planning and provided vital government support (logistics, financial, fiscal, R&D). In 1974, following the government designation of electronics as one of six strategic industries,  Korea’s Samsung entered the memory chip industry (integrated circuits) by partnering with Kang Ki-Dong, an electronic engineer with a PHD from Ohio State University, who had worked at Motorola before starting a chip fabrication line in Korea. Samsung faced huge challenges in securing technology and invested heavily to reverse engineer advanced technologies. Defying the odds, by 1993, Samsung Electronics became the largest manufacturer of memory chips in the world. Samsung today is one of the very few fully integrated semiconductor firms, from foundry to design.

Taiwan Semiconductor Manufacturing Company (TSMC) is another outstanding outcome  of the East Asian Model. TSMC is now the world’s most valuable semiconductor firm, with a market value of $240 billion. It was founded by Morris Chang, a native of China who studied electrical engineering as an undergraduate at MIT and as a doctoral students at Stanford University. Chang worked for decades for Texas Instruments, an American company at the forefront of semiconductor technology, and he rose to the ranks of senior management after making important contributions to the company’s success. Chang was eventually lured to Taiwan to head the country’s technology research institute (ITRI). With extensive logistical and financial support and subsidies from the government, Chang started TSMC in 1987.  TSMC has been hugely successful, carving for itself a niche as the dominant independent semiconductor foundry (both Intel and Samsung are fully integrated) and as the primary supplier to independent chip designers. In fact, because of the importance it has for “fab-less” U.S. chip designers, TSMC is a significant geopolitical concern for the United States, given Taiwan’s unique relationship with the mainland.

Neither Samsung Electronics nor TSMC were sure bets. In addition to requiring massive and long-term government support, they faced stiff competition from established players and frequent litigation for patent infringement. They would never have been successful without extensive  access to American  technology and American markets

China’s leading semiconductor firm, SMIC (Semiconductor Manufacturing International Corporation), has an origin story similar to TSMC’s. The company was founded by Richard Chang (no relation to Morris Chang), a native of Taiwan, who also studied electrical engineering in the U.S.  and worked at Texas instruments for over 20 years. Like Morris Chang, he was lured  back to Taiwan by ITRI where he ran a rival to TSMC until the two government-supported firms were merged. Finally, with the support of the Shanghai government and financial investors from the U.S., Taiwan and Singapore, he took on the mission to create a Chinese version of TSMC. SMIC has basically followed TSMC’s non-integrated foundry model, with the objective of providing a domestic alternative for Chinese chip designers.

However, in spite of abundant capital and government support, SMIC has not found it easy to follow in TSMC’s path.  From its start in 2001, SMIC encountered obstacles rooted in the different objectives of its shareholders: financial backers saw a road to quick profits for SMIC in using older generation technology that could easily be secured from the U.S.; government backers wanted the company to invest heavily to climb the technology ladder and promote regional dispersion in collaboration with municipalities. Richard Chang left SMIC in 2009 having failed in reconciling the interests of the different shareholders.

Moreover, from the beginning SMIC has been stalled by restricted access to advanced technologies, always remaining two generations behind the industry leaders. Unlike TSMC, the company was severely handicapped by export restrictions tied to the Wassenaar Arrangement (WA), a multinational pact set up in 1996 to limit dissemination of technology that could have military use.  SMIC also was embroiled in litigation with TSMC and other technology suppliers who were determined to slow its progress.

SMIC’s difficulties highlight some of the particular  barriers that China faces in climbing the technology ladder to compete in strategic industries. Most importantly, unlike Korea and Taiwan, which are important strategic geopolitical allies of the United States, China has been considered to be a rival and a potential threat to Pacific Basin stability. The United States is disposed to promoting the development and prosperity of South Korea and Taiwan to an extent that it will never be for China which is much bigger and a much greater ideological and commercial adversary. Inevitably, as China’s economic clout grows and its diplomacy becomes more assertive, the probability of confrontation with the U.S. becomes more likely.

The arrival on the scene of Xi Jinping as paramount leader in 2012  brought a new sense of nationalism, bravado and urgency to China’s government and contributed to triggering a more confrontational relationship with the U.S.  This became immediately apparent in semiconductor policy with the announcement in 2013 of the  new Guidelines to Promote National Integrated Circuit Industry (National IC Plan) and the establishment of the National Integrated Circuit Investment Fund (National IC Fund). China’s growing dependence on semiconductor imports ($311 billion in 2018) was identified as a serious vulnerability to be addressed through the identification of “national champions,” increased investment in research and the promotion of both inbound and outbound FDI. This was followed in 2015 by the “Made in China 2025” initiative, setting a roadmap for “the main segments of the IC industry . . . to reach advanced international levels” by 2030.

Xi’s ambitions have ruffled feathers in Washington. The Office of the United States Trade Representative (USTR) recently commented: “China’s strategy calls for creating a closed-loop semiconductor manufacturing ecosystem with self-sufficiency at every stage of the manufacturing process—from IC design and manufacturing to packaging and testing, and the production of related materials and equipment.”  According to the U.S. based Semiconductor Industry Association, China threatens to :

“ (1) force the creation of market demand for China’s indigenous semiconductor products; (2) gradually restrict or block market access for foreign semiconductor products as competing domestic products emerge; (3) force the transfer of technology; and (4) grow non-market based domestic capacity, thereby disrupting the fabric of the global semiconductor value chain.”

As the China-U.S. relationship has spiraled downwards during the Trump Administration, the U.S. has become  increasingly determined to thwart China’s  “Made in China” initiative.  The U.S has campaigned aggressively against Huawei, China’s leader in both 5G technology and  smartphones, blocking its sales in the U.S. and lobbying for other countries to do the same, and cutting off its access to Google’s software for its smartphones.

The Bureau of Industry and Security (BIS), an agency under the US Department of Commerce, has put Huawei on an Entity List, requiring that any US firm wanting to sell American tech components or software to Huawei obtain a license from the U.S. government. Moreover, the BIS announced that all foreign firms that supply semiconductors to Huawey will also need a license if they in any way rely on U.S technology, which they all do.

The BIS licensing requirement puts China’s technology development at the mercy of America’s increasingly jingoistic politicians. For China’s leaders it confirms their worst fears that the U.S. will stop at nothing to contain Chinese development.

Ironically, the only certain consequence of the U.S.’s war against Chinese technology companies is that it will motivate China to double down on its efforts to reach the technological frontier in the key industries of the future.

Two weeks ago, SMIC announced that it has secured an additional $2.2 from government funds to accelerate investment. SMIC now appears to be the domestic champion in the sector.

The U.S. and China appear to be entering into a “great decoupling” with profound consequences for global trade and the tech sector.

Brazil: Deindustrialization, Japanification and Beyond

Brazil’s peripatetic, globetrotting elite brought home the COVID-19 virus.  In late January, a tourist returning from vacation in Lombardy was found to have contracted the virus . Yet, Latam Airlines did not cancel its daily flight from Sao Paolo to Milan until March 2, and thousands more passengers flew  from Milan to Sao Paolo through connecting flights. The viruses first Brazilian victims were treated in Sao Paolo’s world-class private hospitals, and social distancing and sheltering-in-place polices imposed by city governments were readily adhered to in the posh neighborhoods of Sao Paulo and Rio de Janeiro. Many of these people easily adapted to working online, enjoying relief from the usual traffic jams. Then, the pandemic ran into the reality of Brazil: a vast majority of the population lives day-to-day with no savings, no safety net and in precarious living conditions which are not suited to social distancing.

As elsewhere, in Brazil the pandemic has  worsened what were already fragile conditions.

In Brazil, like in the U.S. where educated coastal elites are more supportive of behavioral restrictions than the less educated and poorer small town and rural inhabitants of the “fly-over” states,  the gap between the “enlightened” elite and the “ignorant” masses has been accentuated. The pandemic has become intertwined with the “class warfare” of contemporary politics. President Jair Bolsonaro has infuriated the elites and the media by taking the side of the masses, a stance that is influenced by an evangelical “come-what-may, God-willing” view of the world.

More importantly, Bolsonaro is deeply worried about his political survival. Abhorred by Brazil’s media and intellectual establishment for his reactionary views on social issues and without broad support in Congress, Bolsonaro had been banking on a vigorous economic recovery this year after five years of recession. Instead, the pandemic is expected to cause Brazil’s worst downturn in a century. Moreover, this latest crisis will leave Brazil’s finances in tatters, seriously undermining its growth path in the future.

Over the past three decades Brazil has already undergone a process of severe, premature de-industrialization. Aside from a buoyant agro-industry, the economy has come to depend heavily on basic services and an increasingly bloated financial sector. Now, the expected increase in government debt may condemn Brazil to a state of “Japanification,” where the economy’s potential growth rate falls well below the level necessary to promote social well-being and political stability.

As the chart below based on BIS data shows, Brazil has increased its debt-to-GDP ratio at a reckless pace in recent years. A combination of recession, fiscal incontinence and extremely high interest rates pursued by the  Central Bank in a bout of radical orthodoxy pushed the ratio from  130% to 163% from 2014 to the end of 2019. This is an already enormous increase, but based on current projections, the ratio may reach 176% by year-end 2020.  All of these increases have come from the expansion of government debt, which by itself  will reach the critically important level of 100% this year.

These are very high levels of debt by any standards, and unsustainable levels for a country with a chronic lack of savings like Brazil. The experience of savings-poor emerging market countries is shown in the chart below. There is no case of a country reaching these levels of debt without having to go through an extended period of deleveraging, either through default, austerity or financial repression.

Unfortunately, almost none of this debt accumulation in Brazil has been or will be directed to investment. Instead, it has served to pay current expenses, pensions and interest payments. The following chart, based on IMF data, shows the extremely low and declining levels of fixed asset investments in Brazil as compared to other “savings-poor” countries.

Fortunately, unlike Argentina or Turkey, most of Brazil’s debt is denominated in local currency, reais (BRL). This means that the default route is unnecessary. In addition, after another lost decade of growth, austerity is not politically viable. Therefore, the only remaining path towards regaining public investment capacity and  to “crowd-in” private investments,  will be some form of financial repression. This will require an extended period of interest rates well below the growth in nominal GDP, which in turn can only be achieved by mandatory credit allocation schemes and some-form of capital controls. The irony is that these policies are anathema to the current finance minister who advocates for the Chicago School free-market policies which were popular in the 1980s and followed with some early success by Chile. Nevertheless, the markets are probably sniffing out that financial repression is unavoidable, as can be seen by the persistent capital flight, shown in the chart below.

Given the chaos of the current triple crisis (health, economic and political), no coherent policy framework can be expected out of Brasilia anytime soon. However, sooner or later a new economic regime will emerge.