Author: jvande

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.

 

 

 

 

 

 

 

Jorge Paulo Lemann’s Mea Culpa

The past week has seen wrenching performances by two of the investment world’s greatest icons, Warren Buffett of Berkshire Hathaway and Jorge Paulo Lemann of 3G capital. First, during the traditionally upbeat BH annual meeting, investors were shaken by Buffett’s cheerless discussion of financial history and his gloomy assessment of current investment opportunities. Buffett’s pessimism, a reflection of his huge exposure to “Old Economy,” mature and highly cyclical industries, highlighted his neglect of the market’s tech darlings, which has caused his underperformed relative to the S&P 500 for well over a decade. A few days later, speaking at the annual Brazil Conference at Harvard-MIT, Lemann also appeared beaten and forlorn. Lemann, who has recently characterized himself as a “terrified dinosaur” in the face of accelerated innovation and disruption, provided a brutally honest account of past mistakes and the difficult road ahead.

Until a few years ago, Lemann’s 3G Capital was at the top of the financial world. Masters of financial engineering, operations and cost control, 3G built an empire by acquiring  beer companies with bloated cost structures which were then aggressively benchmarked to industry-best standards. Unfortunately, at one point hubris led to expansion into new segments (fast food, Kraft-Heinz) and overpayment for beer assets (SAB Miller).  The company relied extensively on a brotherhood of Brazilian managers that embraced an aggressive macho culture of results. As the company grew these Brazilian managers were dispatched around the world, finding themselves running businesses that they didn’t understand in countries they had no familiarity with. (e.g. A Brazilian executive was relocated from running a faltering railroad chain in southern Brazil to become CEO of Burger King).

For years, 3G’s Brazil operation was considered the best place to work for ambitious graduates from Brazil’s best universities. However, in recent year’s  Brazil’s best and brightest have turned their backs on the company, preferring instead  more entrepreneurial and tech-driven start-ups. The same has happened with millennial MBAs in the U.S. who reject the company’s in-your-face, “macho” culture.

Lemann points to three had lessons the company has learned.

  1. The company has to transform itself from a production-driven operation to one that is consumer-centric.
  2. The company needs to bring in new talent. This means building a team of managers who understand new distribution and information channels and modern data-gathering/artificial intelligence tools. These are different people than the ambitious hustlers that came up the ranks in the past.
  3. ABInbev overpaid for SAB Miller and the acquisition was so large that it taxed the management capacity of the company.

The two charts below show the poor performance of 3G’s beer publicly traded beer assets (Ambev and ABInbev) on an absolute basis and also relative to their primary competitor Heineken.

Here follows Lemann’s apology:

Jorge Paulo Lemann at the annual “ Brazil Conference Harvard-MIT”, May 8, 2020.

“I think about 30 years ago, more or less, we bought Brahma, and the first 25 years were very, very successful; return on equity and everything was exceptional. Then, these last five or six years, we haven’t done as well; and I think a lot about why we haven’t done as well.  And, so we had a formula which was to attract very good people, pay them very well, manage things very efficiently, keep expenses down, have a big dream and everybody driven in that direction.

And, we sort of missed out a little bit on two things. We missed out on being more consumer centric. You know, the whole world has become consumer centric; the consumer has many more options than he had before. He can access things over the internet and so on. An, we remained with our focus on producing things well, good quality, cheaply, etcetera… and assuming they will be bought. We never really paid attention, as we should have, to what the consumer really wanted… So that was the first thing. The culture we built our companies on was very production, bottom-line oriented and did not take into consideration as much as we should have what the consumer wants.

The second thing is that the world has changed a lot; there’s artificial intelligence; there’s a lot more digital information and you have to have different people running your businesses and people who are much more familiar with getting information from your clients as they are today – knowing how to deal with that – and, so, we have been a little bit late on that also. The businesses we had all had big market shares. We were comfortable with that market share we had, and, so, basically we didn’t give tge consumer enough attention. And, we didn’t attract the people to our culture that know how to deal with the information that you need nowadays to deal with becoming a consumer-centric company. So, we were late in that. We’ve been punished in terms of our market value in recent years and we’re having to adjust. We have now new people, different people, who are much more focused on the kind of things that I have been talking about and that’s going on in all our organization, at the beer company, at Kraft/Heinz, at RBI., etcetera… So, we’re doing it. It’s an ongoing process. It will take some time, I think we realize.

An then, we were a little bit over-ambitious four to five years ago. We made a very big purchase of SAB-Miller, this company that has a big presence in Africa, and Africa is where all the growth in consumption of beer will probably come from in the next 20 years… So, we overpaid for that and it also took our focus off what was a very well-run business. We had to deal with new things, a bigger company. So, that has hampered us a bit. So, we’re fixing that.

We are still very optimistic for the next 10-20 years, but we are having to deal with these problems at the moment, and, obviously, having to deal with these problems in the current circumstances of the virus, and that makes it a little bit more difficult. But, you know, we are confident that we will make it and that twenty years from now we will look back and say we did it again…”

Batten Down the Hatches in Emerging Markets

The environment for emerging market stocks is poor and likely to get worst. Investors should recognize that the current storm may last a considerable amount of time and that it  inflict severe damage.

At the start of this year, there was, briefly, an illusion of blue skies ahead for investing in emerging markets. Global growth was expected to improve and surpass the United States. In emerging markets, growth prospects looked good in China, and recoveries in Brazil and Turkey, the two serious laggards of recent years, appeared to be firm. Commodity prices also were rising and the USD was slipping. All of this was setting the stage for capital inflows into emerging market stocks and a period of outperformance.

Unfortunately, the positive scenario suddenly unraveled when the coronavirus hit China and put a sudden stop to Chinese growth.

Today, the relevant indicators all point to sustained difficult conditions for emerging markets.

The US dollar is once again appreciating, as risk aversion around the world has caused capital to flee to safe assets like the dollar, the yen, the Swiss franc and gold. This has been particularly acute in emerging markets, with many countries seeing their currencies plummet. The MSCI Emerging Market Currency Index, which shows the value of all the currencies in this stock index relative to the dollar, has traded down to record lows, as shown in the chart below. Latin American currencies are in free-fall. This extends a trend started in 2012 and has happened in spite of massive intervention by central banks and large swap lines provided by the US Fed. Many emerging markets have participated in a massive yield-chasing “carry trade” over the past five years. We are now seeing this trade being unwound. At the same time, recent years have seen a marked increase in capital flight from domestic investors.

Risk aversion is on the rise. Emerging market stocks and bonds are “risk-on” assets that perform well when investors have increasing tolerance for risk and/or are induced by low expected returns in their domestic markets to seek higher returns abroad. This appetite for risk only persists if volatility is predictable, which had been the case until recent weeks.. We can measure risk appetite by the spreads that investors demand to invest in riskier assets. The spread between high-yield bonds  and US Treasuries, shown below in a chart rom Yardeni.com, is an accurate measure of this. We see that spreads have rocketed in recent weeks, despite the enormous liquidity being provided by the US Fed.

It is very difficult for emerging markets to perform well when commodity prices are weak. Falling commodity prices indicate both a  weak Chinese economy and deteriorating conditions for many of the emerging economies that rely on commodity exports. It also normally means declining US current account deficits and tight global liquidity. As the chart below shows, commodity prices have been taken a further notch down in a long-term declining trend started  in 2012. This week the CRB spot commodity index broke below the previous cycle low from 2016.

Low commodity prices and rising risk aversion are both contributing to very tight dollar liquidity and the persistent rise of the dollar. The chart below shows global liquidity as measured by central bank reserves held at the Fed plus US M2, and illustrates how tight these conditions have been in recent years. In recent months, the US Fed has recognized this, resuming quantitative easing and providing swap lines to foreign central banks.

Tight global liquidity, a rising dollar, falling commodity prices and heightened risk aversion translate into a very difficult environment for emerging economies. Just dealing with the coronavirus alone would already be an enormous challenge for the majority of emerging economies that don’t have the public health systems for preventive and active care and also don’t have the fiscal resources for alleviating economic losses. Unfortunately, many emerging economies will suffer additional challenges because the find themselves at record levels of indebtedness.

EM countries, as a whole, have increased debt levels dramatically in recent years. The chart below shows the increase in debt-to-GDP ratios for EM countries over the past five years.  This remarkable increase in debt levels across EM has occurred at a time of low growth and low investment. In the case of Latin America, debt increases have served only to finance interest and current payments and capital flight. Any increase in the ratio above 5% would be noteworthy. Only India, Russia and Thailand are below those levels. It may turn out that for Russia sanctions were a blessing in disguise.

External debt levels for many countries also are  at dangerous levels, as shown in the table below. Countries are considered to be overexposed to foreign credit when this ratio passes 30%. It should be noted that some of these ratios are understated, as debt issued offshore through subsidiairies is not included (eg., Petrobras issuing bonds in the Cayman Islands).

On the positive side, and looking forward to the reflation trade.

Not all is gloomy. Resilient EM countries will bounce back, particularly those that can implement financial repression to reduce debt levels. Asset prices in emerging markets are at very low levels. This is reflected in the value of most currencies, now well below fair value. We can see this in the chart below from Alpine Macro.

 

More importantly, the shift in the U.S. and Europe to “QE Infinity,” modern monetary theory and fiscal exuberance is likely to mark the beginning of a new inflationary cycle which will bring the dollar down and commodities up and trigger a new liquidity cycle supportive of EM assets.

Emerging Markets: A Roadmap for the Post-Crisis World

Markets are in free-fall for the third time in twenty years. Unlike the aftermath of the 2008-2009 Great Financial Crisis when the combination of Chinese stimulus and Western Central Bank Quantitative Easing produced a quick recovery for emerging markets, today a long slog appears more likely.

The hyper-globalization of the past three decades suppressed inflation and encouraged borrowing. As leverage increased through financial engineering, shadow-banking and creative derivatives, politicians, the U.S. Fed and Wall Street eagerly embraced mechanisms to backstop markets and preserve “financial stability – the Central Bank “whatever-it-takes”  “put” – which repressed volatility and promoted more leverage. Asymmetric policies, capping the downside while cheer-leading the upside, tied the economy’s performance to the “wealth effect” experienced by the owners of financial assets.

The cycle of global debt accumulation in a deflationary environment may be on its last leg. Every new crisis requires an exponential increase in fiscal and monetary intervention to ease “investors” out of  leveraged positions which have suddenly become illiquid. Investors have been trained to expect the “Fed put” and “buy the dips.” The size of the current intervention – expected to be in the order of 50% of GDP — more than ever undermines the essence of price discovery in a capitalistic system and is likely to provoke unprecedented “populist” opposition. This sets the scene for a new paradigm for the markets as we look forward beyond the tempest.

The new paradigm for financial markets, in many ways, may be diametrically opposed to that of the previous decades.

  • The Rise of Populism. The protest votes that brought forth Trump, Brexit and Bolsonaro were symptomatic of the need for politicians to focus on the narrow sentiments of ordinary people.
  • Anti-globalization. Shorter supply chains and more control of the domestic production of “strategic”  industries. Having most of your medical equipment and 75% of your pharmaceuticals produced in China will be a thing of the past.
  • Modern Monetary Theory. The current recession in the U.S. is likely to result in a fiscal deficit of $4 trillion, boosting the public debt to 125% of GDP. This comes at a time when  Medicare and Social Security payments are ramping up. This debt will be monetized; initially under the pretense that deficits don’t matter, and then through interest rate suppression, which will start a process of deleveraging similar to the one the US went through following W.W II.
  • Current Account Deficits and the U.S. Dollar. MMT will produce inflation and negative real interest rates in the U.S. The Fed will become increasingly tolerant of inflation to promote deleveraging and GDP growth. Foreigners that have been funding U.S. current account and fiscal deficits will sell U.S. assets. This will play out over time, but the end-result will be a weaker dollar and smaller current account deficits. This transition will take place around the world. It is unclear how this can happen without sovereigns imposing repressive controls on capital. A return to the capital controls which were normal before the current cycle (1960s-1970s) are likely.
  • The end of U.S. Fed-Imposed Central Bank Orthodoxy. As the U.S. Fed became the back-stop for the financial market it has increasingly pursued policies which are at odds with the interests of other countries. As capital controls and other forms of financial repression are re-introduced, countries will be able to pursue policies which make sense for their own circumstances. The S.East Asia-Chinese model of capital controls and managed currencies will become more common. Strict controls on “hot money” – a policy already supported by the IMF – will rule.
  • Multi-reserve-currency World. An increasingly insular U.S. pursuing financial repression will promote the rise of alternative reserve currencies. Gold is an obvious beneficiary, but the Chinese Yuan and the Euro will also gradually gain traction with trading partners.
  • Multi-polar World. The rise of alternative reserve currencies is one example of the end of the U.S.-centric global economy of the 1950-2020 period. Supply chains also may increasingly regionalize and countries will insist on self-sufficiency for key industries, which will increase production costs and raise inflation. China has already created its own internet eco-system and is moving aggressively to develop key frontier industries. We can expect India and other large and growing economies to follow that path. Large emerging market economies which provide most of the growth in global demand will seek to keep that demand on-shore, and will make concessions only to strategic partners which are  under their sphere of influence (e.g. Mexico and Canada for the United States; certain Asian countries for China). In this multi-polar world, China and the U.S. should fare relatively well; China because it sits at the center of Asia, the most dynamic region in the world; the U.S., because of its resources and an entrepreneurial class that can lead a renaissance of manufacturing. Smaller, export-oriented countries will have to carefully negotiate their way into the commercial networks of the two hegemons.

Most emerging markets are unprepared for the new financial paradigm. The successful ones will be those that have the social cohesion and political frameworks necessary to adapt.  A few thoughts on specific countries follow.

Large countries with scale and demand growth (China, India and Indonesia)

These countries are well-positioned to pursue autonomous policies to promote domestic investment and partner in foreign trade. As of today, China is the only one that appears to have the planning and execution  capacity to be successful.

Large countries with moderate scale and moderate demand growth (Brazil, Mexico, Turkey)

These countries are similar in some ways but also have major differences. Turkey and Mexico have benefited from the past forty years of globalization and are well positioned to continue on that path, if they can overcome current incongruent policy frameworks and political instability. Brazil missed out on globalization and suffers deeply from a lack of the confidence  necessary to pursue independent financial and trade policies. Brazil is currently espousing archaic market liberalism, at a time when strong government dirigisme will be vital. Brazil also contends with a dysfunctional political system and a lack of social cohesion.  It will also have to pursue financial repression to reduce the government debt burden which has resulted from ultra-orthodox monetary policy.

 

Small countries with small  scale and moderate demand growth (Korea, Taiwan, Thailand, Chile…etc.)

These countries represent the bulk of emerging markets. Those that have thrived in the past did so because they took advantage of globalization and participated in the growth of global supply chains. Many did not do this, and they have been at the mercy of commodity and financial cycles. These countries face challenging times ahead. Through intelligent diplomacy, they will have to negotiate partnerships with the major trading blocks led by the U.S., China and Europe, without anything to offer. On-shoring through robotics will make it difficult for the traditional model of low-cost manufactuting of basic goods to work, cutting off a path of growth for the poorest countries.

Emerging Markets After the Crash

Emerging Market Valuations After the Crash

 

The ongoing correction in asset prices worldwide may be a boon to opportunistic investors with cash and a long-term view. Emerging market stocks which started the year at low valuations relative to history are now even more attractive, and in some countries at fire sale prices.

We look at expected returns below. We assume that 2020 is a lost year, with scarce growth anywhere in the global economy.  Also, we consider that most countries will see economic recovery in 2021 and 2022 and that earnings will recover to trend. The first chart  shows the current projections based on the close of March 16.  The second chart shows the projections made at year-end 2019.

This exercise has proven useful in the past, particularly at times of extreme valuations such as we see today. However, the projections are based on a simplistic model with the following premises:

  • We look at where each individual country is in its earnings cycle and we assume a normalization of earnings over a two-year period. We then project that normalized earnings will grow at the rate of nominal GDP through the target-period, which in this case is seven-years. Given the nature of the model, expected returns don’t vary greatly if the target period is extended to 10 years.
  • We use cyclically adjusted price earnings ratios (CAPE) to determine the target value of the market. The historical average CAPE ratio for the market is used as the multiplier for the CAPE Earnings of the target year, which gives us the target market price for the target year.
  • The model will fail when the historical CAPE ratios prove to be irrelevant and/or if the simplistic earning projections are far off the mark.

 

A few comments are in order:

  • Valuations have improved dramatically almost everywhere. The US is now valued almost in line with its history and can be expected to provide return only moderately below historical levels.
  • In EM only Thailand is on the expensive side.
  • More than half of the EM markets are heavily discounted and now offer the prospect of very high returns. Colombia, Chile, Turkey, Philippines, Korea and Malaysia offer the prospect of extraordinary returns.
  • Global emerging markets now offer nominal returns of 12.5% annually, still about two times the expected returns for the US market.
  • Returns for emerging markets could be significantly higher if the USD enters into a weakening cycle and/or commodities recover from the current decade-low prices.

Increasing Debt Levels Raise Risks for Emerging Markets

Increasing debt levels are a major source of vulnerability  for  boom-to-bust prone emerging markets. In its latest Global Financial Stability, the IMF highlighted its concerns for rising debt levels in emerging markets, particularly for corporations seeking cheap dollar financing. (Link)

The IMF report points out that external debt ratios have deteriorated to levels that in the past have signaled high risk, as shown in the two charts below. The IMF’s concern is that this funding will dry up when there occurs a shift in global liquidity conditions.

An important measure of vulnerability for emerging market debtors is the recent rate of  debt accumulation. The charts below show  the five and ten-year increase in debt-to-GDP ratios for the primary emerging markets. The first chart shows total debt (public and private), while the second chart shows only private debt. Any increase in total debt/GDP ratios of 5-10% during a mere five years  can be considered to be excessive and a considerable source of risk.  As we can see in the first chart below, China and most of Latin America  have been the worst abusers in the past five years.  This accumulation of debt is bad in itself but made even worse by the use of the debt: in China, mainly for sustaining low-return investments by state firms; in Latin America, to sustain public sector current expenditures and capital flight.

The accumulation of private debt, shown in the second chart, points to several critical stress points: China, Turkey, Korea and Chile.  Chile, which is currently undergoing a severe political crisis that will have an impact on confidence and growth, should be an area of particular concern.

 

30 Years after the Caracazo

Last year millions of ordinary citizens took to the streets in Chile in what was the most disruptive and violent popular protest in Latin America since the “Caracazo” in Venezuela thirty years earlier. As we reflect on these unsettling events, we should not forget that the “big thing in Caracas” led to Hugo Chavez and his catastrophic Bolivarian Revolution.

There are some similarities between the Chile of 2019 and the Caracas of 1989.  Both were seemingly “successful” economies with “stable” democracies, and both had recently benefited from a cycle of high commodity prices that had raised the economic expectations of their citizens. When the inevitable bust occurred and the belt tightening followed, expectations were crushed.  The popular narrative suddenly shifted to a viral rejection of what was now seen as a “rigged” system promoted by corrupt politicians and their crony business elites.

In the Spring of 1989, the “Caracazo” street riots erupted in response to prices increases for gasoline and public transport, a situation similar to the 2019 chaos in Santiago.  After oil prices collapsed in 1986, Venezuela’s economy  tumbled and investors deserted.  In February 1989, a newly-elected president, Carlos Andres Perez (CAP), took office. Though during the campaign CAP had denounced the IMF as “a neutron bomb that kills people, but leaves buildings standing,” he now requested the organization’s support, agreeing to a traditional belt-tightening program. The  Caracazo upheaval paralyzed the country and resulted in hundreds of deaths. More protests persisted into 1990. They were followed by  two coup attempts in 1992 and, shortly after,  the rise of Colonel Hugo Chavez and his “Bolivarian Revolution.”

I lived in Caracas from 1980-1984, working as a journalist and business consultant. This was the tail end of the “OPEC oil boom” and the beginning of the debt crisis that was to result in a “lost decade” for all Latin America. When I lived in Venezuela it appeared to be a stable and functional democracy, with regular alternation of power between the left and the right.  Despite its problems (traffic, corruption of all sorts, and poor public services), Caracas was a delightful place to live and work. Venezuela was a prosperous country with a large and thriving middle class, and it attracted legions of immigrants from Latin America and the rest of the world.  It had a world class oil industry and was a magnet for multinational investments. In the early 1980s, Caracas was the most cosmopolitan city in Latin America, with the best restaurants and lifestyle. Its airport hosted a daily Concord flight to Paris and six daily flights to Miami.

After 25 years of misrule by Chavez and his lieutenant Nicolas Maduro, Venezuela today can only be characterized as a failed state. Its collapsed economy serves only the interests of a small group of kleptocrats.

Venezuela is now ranked 188th in the World Bank’s “Ease of Doing Business” survey, with only Eritrea and Somalia considered to be worse.

GDP per Capita has fallen by half since Chavez took power, as the World Bank’s data shows below.

I left Venezuela in 1984 to pursue an MBA. I returned periodically, including in 1996 when Chavez was the leader of the opposition and in 1999 and 2002 when he had already been elected president. On each visit, I made the rounds of business leaders and friends. The message was one of complacent resignation. Most Venezuelans saw Chavez as a temporary problem. This complacency was all that Chavez, with the assistance of his Cuban mentors, needed to entrench himself by gradually undermining democratic institutions and the rule of law.  Chavez was very fortunate that oil prices rose sharply between 2002-2007 which allowed him to fund his nationalizations and social programs and cement his control of the military, the courts and the legislature. By the time Venezuelans realized that Chavez had secured power, it was too late to do anything about it. Millions of Venezuelans, including the most educated and productive, since then have left the country, resettling in Colombia, Chile, Brazil, Miami and Madrid. It is ironic that in the 1970s and early 1980s, Colombians, Chileans and Spaniards had all flocked to Venezuela. Isabel Allende spent her formative years in Caracas, an exile from Chile.

Chavez was clever in securing international support for his experiment, including from prominent foreign leaders and intellectuals. To deceive and disarm his opponents, he tightened the screw in steps, gradually eroding property and democratic rights. The charts below, which come from the World Bank’s Government Indicators, show how freedoms were taken away step-by-step during the course of the Bolivarian Revolution. Today, Rule of Law is near zero on the World Bank’s scale.

Lessons for Chile and Others

What are the lessons to be learned from the Venezuelan catastrophe? Perhaps the only obvious one is that success and stability are precarious. This means that no effort should be spared to strengthen institutions and governance. Also, it should be recognized that in the present environment of slow growth stability will be difficult to maintain unless societies are able to generate more equitable distributions of incomes. Latin America currently fails miserably in providing equal opportunities to all. Entrenched interest groups fight tooth and nail to preserve their privileges.  Matters are complicated by the fact that capital is mostly in the hands of a highly globalized elite which is risk-averse and prefers “safe” assets in the U.S. or Europe. During the slow burn of the Chavez regime, domestic capital deserted, to never return.

 

Expected Returns in Emerging Markets

After a decade of poor returns in emerging market stocks, the asset class suffers a crisis of credibility. But, cheer up;  prospects for future returns have improved.  As we enter the new decade, we may be diametrically opposed to where we stood a decade ago when  EM stocks were expensive and U.S. stocks were cheap.

Investors in emerging market stocks had total returns of 18.5% in 2019, ending a dismal decade on a positive note. Total returns (including dividends) over the past ten years have been just 4% per year, which is well below the historical average of 10.3%. EM net returns also have paled in comparison to those of the mighty S&P 500.  As the chart below shows, over the decade the S&P 500 provided total returns of 253% compared to 33% for the MSCI EM.

The chart below provides some perspective by showing performance for the S&P500 and the MSCI EM Index by decade.

Investors suffer deeply from “recency bias,” the tendency to believe that market trends will continue. This means that today there is a strong bullish consensus on the rising U.S. market and pessimism on the relatively weak emerging markets. However, if we are patient and can take a longer term view, we can expect that valuation fundamentals will weigh heavily on stock prices, triggering a process of mean reversion. Because of this, rational investors take a long-term probabilistic view of capital allocation, assuming that over an extended time-frame (e.g., 7-15 years) mean reversion is likely to play out. While Wall Street enthralls the public with bold annual forecasts, long term investors should develop a humble and long-term view on the probability of future outcomes.

Any analysis of historical returns shows that, over the long-term, stock prices have two drivers:  earnings and the multiple on earnings that investors will pay. Earnings are generally driven by GDP growth, though over the short to mid-term they are affected by business cycles and corporate margins. The relationship between earnings and GDP is the basis for Warren Buffet’s favorite stock market valuation indicator (S&P500/GDP).  Multiples vary depending on the mood and risk-taking appetite of the investment public and also on the level of interest rates (lower interest rates lead to higher multiples). Multiples also are sensitive to inflation. The low inflation and negative real interest rates of recent years are the main reason for the high multiples that we see for U.S. growth stocks.

Capital allocators estimating long-term probable returns generally  must take a simplistic view. In terms of earnings they will try to establish a normalized level which adjusts for business cycle effects. Future multiples are assumed to revert  to historical levels, or at least move in that direction. There is no standard way of doing this, and each practitioner may do it slightly differently, but in general results tend to be similar. In the charts below we look at the current expected return forecasts made by two prominent asset managers/allocators: GMO (Link)  and Research Affiliates (Link).

Both GMO and Research Affiliates expect emerging markets stocks to be the star performers over the forecast. GMO expects 4.5% real annual returns for EM and 9.3% for EM value and negative 4.4% for U.S. large cap stocks. Research affiliates sees 6.8% real annual returns for EM and o.3% real annual returns for U.S. large caps over the next ten years.  Star Capital, a European asset manager, reaches similar conclusions, estimating expected real returns for the next 10-15 years to be 7.6% for EM and 2.8% for the U.S (Link).

We conduct a similar exercise with a focus on emerging markets. Our forecast is for 6.2% real annual returns over the next seven-year period and 0.8% real annual returns for the S&P 500.

We make three assumptions: 1. Valuations will move back to the historical CAPE average over the next seven years; 2. Earnings return to the historical cycle-adjusted trend; and 3. Normalized earnings grow by nominal GDP. To determine the historical earning trend we take a view of where we are in the business-earnings cycle. We calculate the historical average CAPE by taking a weighted-average of the CAPE-ratio for the past 15 years (75%) and the CAPE-ratio over the entire period that data is available (25%)

On  a country-by-country basis, as one would expect, great differences appear. Countries find themselves at different points in the business-earnings cycle and their valuations may vary greatly depending on the mood and perceptions of investors. The chart below shows where country-specific valuations stand relative to the  CAPE average for the primary EM markets. The third column shows the difference between the current CAPE and the historical average CAPE. For example, Turkey’s valuation, in accordance with CAPE, is 40.5% below normal. The markets in the chart are ranked in terms of probable long-term returns (7 years). The table also shows where markets are currently in their business/earnings cycle.

We can see that valuations are generally low in emerging markets.  The majority of markets in EM trade at CAPE ratios which are below average, and Turkey, Malaysia, Chile and Argentina are heavily discounted. On the expensive side, only Thailand stands out. The contrast with the U.S, is striking. While 10 years ago the CAPE ratio in the U.S. was well below normal, today it is more than one standard deviation above normal.

The methodology assumes a stable dollar, meaning the dollar will neither appreciate nor lose value relative to the basket of currencies represented in the MSCI EM Index. The actual trajectory of the dollar will have a big impact. The experience in emerging markets is that a weak dollar generates liquidity and higher earnings growth, as well as higher multiples. If the dollar were to lose relative value over the forecast period it is probable that returns in EM would be significantly higher. This is particularly true for commodity-exporting countries like Brazil which would experience liquidity windfalls.

Furthermore, we can expect markets to overshoot both on the up and downside. Forecasts assume a return to normalized historical statistical trends, but markets can be expected to surpass those levels as enthusiasm builds momentum.

In conclusion, allocators should consider increasing positions in emerging markets where returns will probably be relatively strong in coming years.

 

 

What to Expect for the 2020s in Emerging Markets

A decade seems like a long time but in investing it should be considered a reasonable period for evaluating results. Ten years covers several economic/business cycles and allows both valuation anomalies and secular trends to play out. Moreover, it gives time for the fundamental investor to show skill. Though over the short-term – the months and quarters that the great majority of investors concern themselves with – the stock market is a “voting machine,” over the long-term the market becomes a “weighing machine” which rewards the patience and foresight of the astute investor.

When we look at the evolution of markets over a decade we can clearly see how these big long-term trends play out. The chart below shows the evolution of the top holdings in the MSCI Emerging Markets Index over the past three decades. We can appreciate how constant and dramatic change has been in the twenty years since 1999, and we should recognize that the next decade will be no different.

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The top holdings at the end of each decade reflect the stocks and countries that have been favored by investors and, presumably, bid up to high valuations.

At the end of 1999, countries in favor were Taiwan, Korea, Mexico and Greece, and the hot sectors were telecommunications and utilities.

By year-end 2009, the new craze was for anything commodity related, and Brazil was the new craze. Banks, which benefited from a global liquidity boom also came into favor.

By year-end 2019, telecom/utility stocks and commodities were all deeply out of favor.  The high-flying markets of the previous decade (eg. Brazil) suffered negative total stock market returns for the whole period. The past decade has been all about the rise of China and the internet-e.commerce platforms and the chips and storage (the cloud) required to make it all work.

What will the next ten years bring.  Only one thing is certain: the pace of change and disruption will accelerate. Whether this will benefit the current champions or create new ones is anyone’s guess.

One difference from ten years ago is that emerging markets are not expensive. Unlike in 1999, the market leaders don’t seem to be at unsustainable valuations. On the other hand, there a few markets that sport very low valuations. These are mainly either commodity producers (Colombia, Chile, Brazil, Russia) or markets that have been through tough economic/political cycles (Argentina, Turkey, India).

Good luck to all!

Explanations for the Middle-Income Trap in Emerging Markets

Only a few middle-income countries have been able to graduate to high-income status, a phenomenon which has been labeled the “middle-income trap.”  We discussed the data on economic convergence in a previous post (link) and now look at the possible explanations for the “middle-income trap.”

The literature on economic convergence and the “middle-income trap” is extensive, as this is a contentious debate in developmental economics. Most economists agree that many middle-income countries find themselves caught between low-wage poor countries that are competitive in mature industries and high-income rich countries that dominate the technologies that drive frontier industries. There is also agreement that for middle-income countries to continue to converge they need to improve institutions, governance and human capital. Moreover, it is widely accepted  that savings-poor middle- income countries suffer from frequent economic slowdowns caused by  unstable cross-border financial flows.  Beyond this consensus, the debate broadly separates commentators into two camps with different policy recommendations:

  • The institutionalists argue that countries are held back by weak institutions, which include rule of law, governance, public sector focus and efficiency, and transparency (democracy and press freedom). The problem for middle-income countries is that the reforms that are necessary to improve the institutional framework may be strongly opposed by entrenched interest groups. The quality of the institutional framework can be described in terms of whether institutions are “extractive” of “inclusive.” (Acemoglu and Robinson, Why Nations Fail). “Extractive” institutions empower the few at the expense of the public good, and the favored elites resist reforms with tooth and nail. Brazil and Argentina are countries which have stalled because of poor institutions that are structured to benefit narrow interest groups.
  • The Structuralists argue that the key issue that middle-income countries face is the development of innovation capacity. Those middle-income countries that import all their technology or rely on multinational corporations eventually hit a wall (e.g.  Malaysia and Mexico). The question is how does a country promote innovation?  The institutionalists focus on guaranteeing strong intellectual property protection. The structuralist’s  disagree and argue that strong and dirigiste governments are necessary to implement  an industrial policy with incentives/subsidies to attract domestic capital and training programs to upgrade the skills of workers. In order for these interventionist policy initiatives to not turn into boondoggles for crony capitalists, companies must face the discipline of both domestic and international competition.  Therefore, the structuralists argue for trade openness and export-driven growth.

On the surface, the arguments of the institutionalist seem more straight-forward and implementable. For this reason, the standard advice of the IMF and World Bank has relied heavily on promoting institutional reforms that improve governance and the delivery of quality public goods (justice, property rights, healthcare, education, infrastructure). Though these reforms are often blocked by entrenched interests, most newly-elected governments spout a ready-made agenda of improving justice, reducing regulation, cutting bureaucratic waste and improving public services. India’s president Modi famously promised at the beginning of his first administration that he would improve the country’s ranking in the World Bank’s “Ease of Doing Business” Index from the high 120s to the 50s, and it appears that he will achieve it.  Brazil, which has made no progress on its “Ease of Doing Business” in 15 years and holds a miserable 124th position, now has a finance minister determined to address this.  However, for those countries with more reasonable rankings (Malaysia,12; Thailand,21; Turkey,33; China, 31) those opportunities are  more limited.

The structuralists argue that improving institutions is necessary but not sufficient, and  only a stop-gap measure for middle-income countries with very poor governance, such as most Latin American countries. Chile is a warning for countries following this simple path: though at one point reaching the 25th position in the “Ease of Doing Business” rankings, it has fallen to 54th  as the domestic consensus for reforms has softened in line with slowing GDP growth and growing social demands.

The nice thing about the arguments made by the structuralists is that they are solidly backed by empirical evidence. In effect, the structuralists look to the “Asian Tiger” model that has worked historically for Japan, Hong Kong, Singapore, Taiwan and Korea, and is now espoused by China and Vietnam.

The Asian Tiger model follows a few simple steps:

  • Harness agricultural surplus and forced savings through financial institutions closely controlled by the government and seen to be at the service of nation-building.
  • Manufacturing supported by state-driven industrial policy and credit.
  • Exports supported by competitive currencies
  • Capital controls to Foreign capital “hot money” flows seen as leading to financial instability

China’s “Made in China 2025” industrial plan to achieve competence in ten key high-tech frontier sectors is straight out of the structuralists game-plan. In fact, China has largely followed the “Asian Tiger” model for the past three decades of its accelerated development.

Unfortunately, the future of the Asian Tiger model is unclear. The worse-kept secret about the success of the Asian Tigers is that, either because they were small (Hong Kong, Singapore) or key American strategic geopolitical allies (Japan, Taiwan, Korea) they were allowed to flout the rules, as Washington looked the other way on intellectual property theft and industrial subsidies. Until recently China was also given some leeway, but those days are gone because Washington now sees China as a key strategic rival. The “Trump Doctrine,” which is likely to remain after he leaves office, is that the U.S. will no longer tolerate interventionist policies, particularly if they affect American companies.

Moreover, structuralist policies have a bad name in many countries where attempts to implement them in the past were undermined by incompetence and corruption. For example, Brazil has a tradition of subsidizing and protecting sectors but it has done this without weeding out the underperformers or demanding export competitiveness. The consequence is that in Brazil and many other countries these policies are deeply associated with crony capitalism. Ibid for “financial institutions at the service of nation building,” In most countries these policies are seen as mainly benefiting politicians and their cronies.

Also, for structuralist policies to function countries need strong governments that can pursue initiatives over the long term and stable economies which facilitate long-term planning by public officials and firms. Unfortunately, these are rare attributes. In Latin America we see the opposite of this, with brusque changes of policies with every incoming government and economies prone to repetitive boom-to-bust cycles.

The Case of Emerging Markets

The table below shows the countries that are considered middle-income on the basis of having per capita incomes between 10% and 50% of the per capita income of the United States. EM countries of significance to investors are highlighted in bold and make up the majority of EM countries of importance to investors.


The low-income EM countries (India, Indonesia, Vietnam, Nigeria) should face fewer challenges to  high relative growth and convergence simply because of demographic dividends and technology leapfrogging.

In terms of EM countries, which ones are likely to be middle-income trapped? A few comments on the main countries in EM.

China

China’s future growth path is debatable, with strong views on both sides. On the one hand, the country is assiduously following the path of the Asian Tigers with a keen focus on innovation and human capital. Also, it still benefits from urbanization and the development of backward geographies. On the other hand, rising tensions with the U.S. are leading to trade and technological decoupling which will be a burden. Moreover, a massive debt build-up to finance increasingly unproductive investments is unsustainable. My guess is that, if a financial crisis can be avoided, China’s growth will stabilize around the 3-4% level, still well above expected U.S. growth of 2%

South-East Asian

Thailand and Malaysia are dependent on export, which is a negative in a de-globalizing world. Moreover, they suffer increased competition from new low-cost producers but have very limited innovation capacity of their own.

Europe, Middle-East and Africa

The Eastern European countries have mostly been strong convergers, and Poland is no exception. They still benefit from relatively low costs and opportunities to integrate with Western Europe and have the human capital to participate in high-tech innovation.

Russia’s situation is different, as is it increasingly isolationist. Bad demographics, weak institutions and an overbearing state sector are additional challenges.

Turkey suffers from political and financial instability, a significant brain drain and weakening transparency (democratic and press freedoms).

South Africa appears to be in prolonged decline, with weakening institutions.

Latin America

The region has poor institutions, and political and economic instability, characterized by frequent policy changes and boom-to-bust economies. Innovation capacity is lacking, with the exception of some tech savvy which should be strongly supported by governments. For Latin America, those countries able to improve institutions and business conditions have some upside. Today, it seems Brazil and Colombia are best positioned for this. Mexico is exceptionally placed to take advantage of the current global trade environment but faces declining governance and institutions.

 

For further reading on convergence and the middle-income trap:

“Convergence Success and the Middle-Income Yrap,”  byJong-Wha Lee, ERBD, April 2018 (ERBD)

“Growth Slowdowns and the Middle-Income Trap,” by Shekk Aariyar ; Romain A Duval ; Damien Puy ; Yiqun Wu ; Longmei Zhang, IMF, March 2013 (Link)

“Middle-Income Traps A Conceptual and Empirical Survey,” by Fernando Gabriel Im and David Rosenblatt, The World Bank, September 2013 (Link)

“Avoiding Middle-Income Growth Traps,” by Pierre-Richard Agénor, Otaviano Canuto, and Michael Jelenic, World Bank, November 2012. (Link)

Economic Convergence and the “Middle-Income Trap.”

Over the long term, the economic performance of countries around the world tends to converge as less developed countries “catch up” to richer ones by adopting existing  technologies and attracting capital which is eager to exploit relatively cheap labor. This convergence has been consistent over time, since the industrial revolution in the 19th century, and has flourished in recent decades, led by the extraordinary progress of China. Nevertheless, a significant number of countries have not participated at all in this process. Also, for many countries, convergence has been moderate and for others  it has plateaued or even regressed.   In particular, a cohort of middle-income countries have stalled in the process of convergence, a phenomenon which as been labelled as the “Middle Income Trap.” It seems that after reaching a certain level of convergence further “catch up” requires new skills, linked to institutions and human capital, which some  countries struggle to develop. This means that for many middle-income countries convergence becomes more arduous, and the result is that, over the past 50 years, only a handful of countries – Taiwan, Korea, Singapore, Hong Kong and Israel – have successfully graduated to high- income status.

Below, we look  at convergence for the past 50, 30 and 20 years, and follow with a focus on the evidence for the “Middle-Income Trap.”

The Past 50 Years

The table below shows 50-years of convergence based on World Bank data for 92 countries. Convergence is measured by a country’s change in GDP per Capita relative to that of the United States. For example, China’s score of 12.98 indicates that its GDP/Capita relative to the U.S. has gone from 1.1% to 14.2% over the 50-year period. Countries that are significant for emerging markets investors are highlighted in bold.

  • The top performers are very diverse, covering every region and population size, though Asian convergence is very strong.
  • Only half the countries enjoyed any convergence at all. Significant underperformers generally fall under two categories: 1. Countries which are categorized by the WB as pre-demographic dividend, meaning that they experienced high population growth and increasing dependency ratios; 2. Countries suffering political turmoil (civil strife, wars,etc…) or extreme political dysfunction (Argentina, Venezuela).
  • Focusing on those countries that matter for EM investors, eight important EM countries experienced significant convergence (China, Korea, Thailand, Malaysia, India, Indonesia, Turkey and Chile). Taiwan would also qualify but is not included in WB data. Three countries (Colombia, Brazil, Philippines) experienced either slight convergence or slight regression. Six countries experienced significant regression (Mexico, Peru, Argentina, Nigeria, South Africa, Venezuela). About half of the countries that investors follow closely in emerging markets over this long period have not enjoyed significant convergence.

The Past 30 Years

The World Bank data for the past 30 years (1988-2018) covers 150 countries. These years cover the modern period of institutional investment in emerging market stocks, as the widely-used EM indices (MSCI, IFC/S&P, FTSE) were launched in the second half of the 1980s, and many institutional investors began allocating to emerging markets in the early 1990s.

  • Once again, the best performers – those countries converging the most with the GDP/Capita of the U.S. – come from a broad variety of geographies and income groups. Asian convergence is exceptional.
  • Well over half the countries experienced positive convergence with the U.S.
  • Several new impressive convergers appear from emerging Asia (Myanmar, Vietnam, Bhutan Laos) and Africa (Equatorial Guinea,Cabo Verde, Mozambique).
  • The performance of significant countries for EM investors diverges greatly over this period. Asian markets all experience rapid convergence (China, India, Korea, Vietnam, Thailand, Indonesia, Malaysia, Hong Kong, Philippines), with the exception of Pakistan, which makes only slight progress. In Latin America, Chile enjoys strong gains and Peru and Colombia achieve significant positive convergence, but Argentina, Mexico and Brazil all lose ground and Venezuela experiences a collapse, moving from middle-income to low-income status. In Africa, Nigeria achieves moderate convergence, while South Africa suffers a severe deterioration.

The Past 20 Years

The past two decades saw a commodity boom and peak globalization characterized by the extensive development of global supply chains by multinational corporations. Most importantly, the incorporation of the formerly “Soviet Bloc” countries  had a big impact on the World Bank data for convergence, as these economies have enjoyed rapid progress by attracting capital and integrating into the global economy.

  • Nearly 70% of economies experience convergence over this period.
  • Once again, the best performers came from a wide variety of geographies and income groups. Formerly Soviet bloc countries dominate the list (Azerbaijan, Turkmenistan, Armenia, Georgia, etc…). In Africa, Ethiopia appears as a top performer, and, in Asia, Cambodia now arrives.
  • Looking a the countries of significance to EM investors, Asia performs well across-the-board; In Eastern Europe, the Middle-East and Africa (EMEA), Poland, Russia, Turkey and Nigeria experience strong convergence, while South Africa languishes; in Latin America, Peru and Colombia perform reasonably well, while Brazil and Mexico slip, Argentina slides and Venezuela crashes.

Evidence for the Middle Income Trap

In the table below, we look at the performance of middle-income countries over the past 30 years (1988-2018). We use a broad definition of middle-income, including countries having incomes which vary from 10% to 50% of the per capital income of the United States at the beginning of the period. 40 countries are included, which represents 27% of the WB database.

  • Half of the middle-income countries experience at least some convergence. The number of strong convergers is roughly the same as the number of underperformers. On average, convergence is low for this group. There are also about an equal number of big winners and big losers, with Hong Kong, Malta and Korea graduating to upper- income status, and Venezuela, Ukraine and Georgia falling out of middle-income status.
  • Neither geography nor relative income seems to determine either winners or losers. Nevertheless, there is a strong contrast between the high conversions of Asian middle-income countries (Korea, Malaysia) and weak performance of Latin American countries. To some extent, we can conclude that the “Middle-Income Trap” is largely a Latin American phenomenon.

Conclusion

The world has experienced significant economic convergence in recent decades, as expected by economic theory.

However, middle-income countries as a whole have had mediocre performance which is not explained by geography or relative income.

What is it that explains the great divergence within middle-income countries? Why have Korea and Chile prospered while Venezuela has collapsed and Brazil has languished? This is a key debate which we will explore in a future post.

The XP IPO and Market Efficiency in Brazil

The Brazilian capital markets are among the most sophisticated in the world. During periods of hyperinflation in the 1980s and 1990s, market participants adopted highly complex financial instruments for hedging and protecting returns. Over the past 25 years, as the country went through several boom-to-bust cycles and suffered a profound deindustrialization, Brazil has increasingly become a FIRE economy, driven by Finance, Insurance and Real Estate. During this period, Brazil’s best and brightest have flocked to financial jobs where salaries are multiples of those available in more productive sectors. At the same time, a steady rate of consolidation in most financial activities has led to a few preeminent dominant firms with strong pricing power and high profitability.

The incumbents – mainly, large dominant banks — over time may have become vulnerable to new entrants that introduce disruptive models and more efficient cost structures. A wave of new fintech firms have taken advantage of abundant global venture capital funding to take on the incumbents with new business models. At the forefront of these there is XP, a Brazilian brokerage firm/financial advisor, which is currently in the process of launching an IPO on Nasdaq. Founded in 2001 by Guilherme Benchimol, XP is probably the best Brazilian entrepreneurial success story of this generation. Influenced by the philosophy of Brazil’s Jorge Paulo Lehman (3G/Inbev) and by American discount brokers such as Charles Schwab, Benchimol  created a financial service platform which aims to democratize finance in Brazil and disrupt the entrenched incumbents (e.g., Banco Itau and Banco Bradesco).  Benchimol has largely achieved his goal and XP is now a major force in Brazil’s financial sector, with 1.4 million clients. The IPO’s bank underwriters are looking for a valuation of BRL 60 billion (USD 15 billion), about half that of banking behemoth Bradesco.

Ironically,  XP’s huge success may have now turned it into somewhat of an incumbent. Though much of the IPO prospectus extols how well positioned XP is to exploit the inefficiencies of the investment industry, a look at the details paints a different picture.

XP’s most profound innovation has been its open platform, which allows it to provide a financial supermarket of products, in contrast to the “walled-gardens” historically preferred by the big banks.  It has exploited this advantage with technological and marketing savvy. But, the one thing it hasn’t really done is attack the very high fee structures that characterize the Brazilian asset-management industry. In fact, XP has become the biggest distributor of the independent asset management industry and benefits from the juicy distribution fees that fund managers pay to raise assets.

The problem is that the Brazilian asset management industry today is an aberration in terms of the fees that investors pay for investment products, with 1% management fees common for bond funds and 3% (including prevalent performance fees) common for equity funds. These kind of fee structures exist in Brazil only because of the powerful pricing power enjoyed by the large banks.

The persistence of high fund management fees in Brazil is justified by the claim that the domestic markets are highly inefficient and present abundant market “alpha” (returns above those available from the market) to be harvested by active managers.

However, evidence of this market inefficiency is scarce. One might expect “alpha” to be available for professional investors in markets that are dominated by retail investors (e.g. China, India, Turkey), but Brazil is a market trafficked predominantly by sophisticated and highly-paid professional investors.  Also, most funds in Brazil invest in a very narrow cohort of some 100 stocks which are very closely followed by competent analysts; most funds are also short-term oriented trend followers, with low appetites for small and less liquid stocks.

The best analysis of the Brazilian domestic funds market is done by S&P Dow Jones Indices (Latin America Scorecard, SPIVA). A summary of the latest review (through 2018)  below shows how difficult it is for funds in Brazil to generate alpha, particularly in bonds, where 100% of funds underperform the benchmark. In equities, about 85% of Brazilian funds underperform the index for 3,5,and 10 year periods. Most likely, this is a consequence of the combination of market efficiency and very high fee structures.

Ironically, XP, to a degree, may be more vulnerable than the incumbents it purports to undermine. XP’s earnings stream relies heavily on brokerage revenues and fund distribution fees, which represent only a small part of the highly diversified revenues stream enjoyed by its competitors. These fees are high today, supported by the  large inefficiencies of the Brazilian financial sector but these are now ripe to be disrupted by innovation.   Of late, we have seen some of the incumbents slashing commissions, following in the foot-steps of the U.S. industry.

Also, Bradesco and Itau have taken the plunge and launched U.S.-style low cost ETFs.

If the name of the game is raising assets, the future in Brazil looks like the U.S, with a heavy presence of systematically managed passive products, both in the form of ETFs and mutual funds. This is not a space  where XP, in its current form, will prosper. So, it’s not surprising to see the budding ETF space in Brazil dominated by Itau, Bradesco and Blackrock’s Ishares.

In fact, a U.S. style transition to passive products is in full swing in the Brazil domestic market. Blackrock’s Ishares Bovespa ETF (BOVA11) has raised USD2.3 billion in Brazil. As the chart below shows, volumes are exploding. Interestingly, BOVA11 is priced at 30 basis points (.30%) annually, which is about half of the fee charged on its NYSE Brazil Ishares (EWZ). Itau has also launched a Bovespa ETF (BOVV11) for which it also charges 30 bp, and Bradesco has its own Bovespa ETF (BOVB11), with a 20 basis points management fee (currently, the cheapest Brazilian stock market ETF in the U.S. is Franklin’s, with a fee of 19 basis points.)  Itau’s ETF undercuts its own Bovespa Index mutual fund, for which it charges an astonishing 2% fee, a reminder of legacy practices.

As we have seen in the U.S., the growth of passive investing is very likely to force a consolidation of the Brazilian asset management industry and a dramatic reduction in the fee structure. Firms like Schwab are now staking their future on asset management and have become leaders in ETF issuance. The same will have important consequence for the fund distribution industry in Brazil, and this may resent a short-term challenge to XP’s talented management.

A Guide to Investing in Emerging Markets: BAM on the India Opportunity

For anyone interested in investing in emerging markets, these comments from Brookfield Asset Management’s India Managing Partner made during the company’s 3Q conference call are elucidating.

BAM is a major investor in emerging markets, and has been in Brazil for decades (originally Brascan). Ranjan explains the time-proven process:

* Start slow and build local expertise.

* Focus on secular opportunities with very long runways.

* Focus on cash-generating businesses

* Most importantly, be aggressive during economic downturns when there are many distressed assets and capital is scarce.

Brookfield Asset Management Quarterly Conference Call (Link)

Anuj Ranjan – Managing Partner and CEO, India and Middle East

Anuj Ranjan

Thank you, Brian, and good morning, everybody. Today, I want to talk about our journey in India, our outlook on the Indian economy and where we see investment opportunities emerging. We’ve now been in India for more than a decade and have over $16 billion of assets under management with investments across all of our businesses, real estate, infrastructure, power and private equity. Now while we entered India in 2008, we did not close our first major transaction until 2014. Since India was a new market for us then, we were guided by our philosophy of being patient and invested capital only where we saw value opportunities. Initially, when we arrived in India, the country was going through an economic boom that was reflected in valuations that we thought were too high. So we decided to spend the first 5 years really understanding the market and building out our operating capabilities on the ground. We did this by creating operating platforms that would provide services to domestic real estate and infrastructure companies. By 2012, we saw signs of distress and a dislocation of capital emerging, and we spent 2 years putting together what became our first significant transaction in the market, which was a commercial office property owner.

This was a large and complex situation that involved privatizing an offshore public company, backing the local banks and the foreclosure of debt and ultimately, taking over all operations of the business. We learned a lot in the process, and this was truly the start of our journey in India. Maintaining this investment and operating discipline, we’ve incrementally built what is now one of the largest foreign investment platforms in the country. In our real estate business, we own more than 30 million square feet of high-quality office space across several key markets. And more recently, we acquired a vertically integrated luxury hospitality group, which has 3,000 owned and managed keys. Our infrastructure business consists of a roads platform with 5 national highways, the only cross-country gas pipeline and more recently, we signed agreements to acquire the second-largest telecom tower portfolio in the world through a large corporate carve-out. Our renewable power business owns and operates over 500 megawatts of capacity across solar and wind assets. And our private equity group has created a financial services business, which provides credit to residential developers who aren’t able to access traditional bank financing.

Through this growth, we have built a strong investment and operating team. Our team is over 40 investment professionals and support staff across our operating businesses, though we also employ well over 6,000 people. This gives us a unique competitive advantage when evaluating opportunities. Not only can we provide large amounts of capital where it’s needed, but we can more easily assess the risks, challenges and operating requirements of the asset or business. We’re also able to implement and execute our business plans, not necessarily requiring a local partner. This is very useful, especially when you’re using the opportunity to acquire businesses from banks where the prior owner is in some distress.

Moving on to the economy. There are certainly some near-term challenges in terms of a slowdown being driven by a tightening of credit availability that has led to multiple defaults. However, we believe the long-term fundamentals of the country continue to be quite strong, and India remains one of the most attractive markets in the world. More specifically, over the last few years, there have been some significant developments that are very encouraging for the country’s long-term growth. First, to set the context on the economy, it’s hard to generalize a country as big as India. We like to think of it as three economies, which we will refer to as India 1, 2 and 3.

India 1 includes the wealthiest 100 million people, which make up only 8% of the population and have very similar metrics to Mexico. GDP per capita, spending habits and consumer behavior, almost exactly the same as Mexico. They contribute 40% of India’s economy today and have largely historically driven consumption.

Next you have India 2, which is another 100 million people and could be described as the middle-class. It’s similar in economic makeup to the Philippines in terms of GDP per capita and spending. And finally, we have India 3 with a population in excess of 1 billion people who have a GDP per capita of Sub-Saharan Africa. These are the poorest people, largely in rural areas who have not historically been a part of the formal economy.

For the first time ever, we’re seeing a transformation in which India 2 and India 3 are becoming included in the formal economy, and this is happening for 3 reasons: data penetration, reforms targeting inclusion and a strong government that’s driving change. Let’s start with data. India has risen from being 150th to the first ranked country in the world in mobile data consumption in only the last 3 years. This explosive growth has been brought about by affordable data plans and falling smartphone prices. India now has 600 million Internet users, but what is shocking is this is only 40% of the population, implying a sustained and continued growth in the future. This digitization has contributed substantially to the inclusion of India’s large population, and it is translating to high growth across most businesses. We’re excited about this trend and actively evaluating opportunity in data infrastructure, including the acquisition, I earlier mentioned, of the country’s largest telecom portfolio.

Secondly, we witnessed landmark steps being taken to create an inclusive, transparent and formal economy. Policies such as the creation of the Aadhaar card, which is a unique biometric identifier for every Indian citizen and banking for all in which over 300 million bank accounts were rolled out for the rural population have created an integrated ecosystem that can form the backbone for delivering grassroot reforms and growth. As one small example, in a very short time, this has already led to an increase in bank deposits of $15 billion. Thirdly, we’re in a period of sustained political stability with a strong government at the helm. The government has launched some breakthrough reforms, including the Insolvency and Bankruptcy Code, goods and services tax and a 10% reduction in corporate rates. While the processes are being streamlined and there’s some teething issues which remain, as a result of these initiatives, India has moved up 67 places in the global ease of doing business rankings in the past three years. This has, in turn, led to record foreign investment inflows.

This is all supported by the fact that the Central Bank has done an incredible job targeting inflation and getting it under control. Consumer price inflation, which used to be as high as 10%, is now under 4% and has been in the target range for over 5 years. This gives India one of the highest spreads in the world between the current bank rate and inflation, leaving ample room to cut rates further.

Now while data inclusion and good government are creating a platform for India to, one day, become a $5 trillion economy, there exist some immediate challenges that the country is grappling with. India’s banking system has saddled with close to $130 billion of nonperforming loans, which at roughly 10% is the highest ratio among the top 10 economies in the world. This is compounded further by the crisis in the shadow banking sector, which makes up over 20% of India’s overall credit.

Unlike developed markets where shadow banks do only specialty or high-risk lending, in India, due to regulatory restrictions, the nonbanking financial companies are also providing credit where banks can’t lend, for example, loans against property, margin loans against shareholder equity. Most of the distressed debt is in wholesale or corporate credit, which presents a sizable opportunity for us to acquire high-quality businesses at a time when capital is needed.

To conclude, we’re excited about the opportunity India provides. On the one hand, we have the fastest-growing major economy in the world, taking steps to access their enormous population by including them in the formal economy. On the other hand, in the short term, liquidity is scarce and the credit markets are in distress, creating a tremendous opportunity for private capital providers like us.

The challenge is that while businesses or assets can come at attractive valuations, operating them under Indian conditions can be a challenge, which is where our 6,000-person strong operating platforms give us a unique advantage. To navigate India in this period, our key investment themes are to focus on businesses that benefit from inclusion of that final 1 billion people, acquiring assets or businesses from over-labeled corporates, making stable bond-like investments that generate a high cash yield, and lastly, looking at private credit opportunities where banks cannot lend.

Thank you. That concludes my remarks. I will now turn the call back to the operator for questions.

The Chilean Riots and the Privatization of Public Goods

The recent riots in Chile, triggered by a small increase in the subway fare, have highlighted the politically explosiveness of the pricing of “public goods,” particularly in societies with high wealth concentration.

The root cause of the Chilean riots appears to be a strong  conviction held by the main population that the  “system”  is rigged in favor of the elites and  will not provide the most basic public goods necessary for anyone to have a fair shake at improving one’s lot.

For a major metropolitan area like Santiago this means an efficient subway system to transport the less-well-off from the distant suburbs to the jobs in the prosperous city center.  The Santiago Metro does this pretty well.  But, ironically, having a good subway system causes new issues, such as making the poor much more aware of wealth disparities, and making them highly dependent on continued access to maintain their jobs. Apparently, even small increases in fares can be very unsettling for workers and students living in precarious situations.

This raises the question of what role the government should play in providing public goods and how to pay for them.  This is a huge dilemma everywhere but especially in Latin America where government finances have historically been poorly managed and debt levels are high. Over the past decades, governments have pretended they could dismiss the problem by turning to privatization and “high finance”: public companies financed in the bond market and concessions. This is the case, for example of the Santiago Metro, which is a corporation with close ties to the Chilean capital markets.

This abdication of the responsibility for investment in public goods has increasingly become the norm in many Latin American countries where most infrastructure (airports, highways,etc…) has been turned over to the private sector. Increasingly, this also applies to healthcare and higher education, where dysfunctional public institutions are hopeless.

The current government in Brazil is pursuing the most pro-markets policies that the country has seen since the 1960s. The finance minister, Paulo Guedes, would like to privatize and deregulate everything as fast as possible, hoping to spark an entrepreneurial revolution in the country.

But, this is the same country which was paralyzed by a truckers’s strike in 2018, in response to diesel and toll prices. President Bolsonaro’s honeymoon is over now, and as we have seen in Argentina, Chile, Hong Kong and elsewhere, patience is running thin.

 

Competitiveness in a Global Economy

Since 2004, The World Economic Forum (WEF), a Switzerland-based NGO with strong ties to the business community, has published the Global Competitiveness Report  (GCR) which ranks countries on the basis of their ability to compete in the world economy.  The report (Link) gives us a snapshot of where countries stand relative to their peers on a wide variety of measures, and long-term comparisons provide a good indication of which countries are taking the steps to improve their ability to compete and prosper.

The methodology of the GCR incorporates a wide variety of factors, but the focus is squarely on the quality of institutions and other “soft” elements, rather than on the quantity of capital and labor. The rankings purport to show which countries provide the best business environment to unleash the animal spirits of  entrepreneurship and innovation.This may be a particularly useful approach in this day and age when increasingly growth seems to be driven by innovation and the other intangible forces that impact “total factor productivity.”  Importantly, the report shies away from passing judgement on the pros-and-cons of  democratic versus more authoritarian regimes, beyond what the immediate implications might be for business and development.

The CGR ranks each one of 144 countries according to 12 “pillars” of competitiveness:

  1. Institutions
  2. Appropriate infrastructure
  3. Information and communication technology adoption
  4. Macroeconomic stability
  5. Health
  6. Education and skills
  7. Efficient goods markets
  8. Efficient labor markets
  9. Efficient financial markets
  10. Market size
  11. Business dynamism
  12. Innovation capability

 

Each one of these pillars is explored in detail.  The following chart shows the latest WEF, Global Competitiveness Rankings, with emerging markets highlighted in bold black and frontier markets in red.

The first quartile are mainly “Western” democracies, with Japan, Taiwan and Korea representing Asia. Two, non-democratic, authoritarian and dirigiste regimes –Singapore and UAE –also make this list.

The second quartile includes the remainder of the Western democracies (except for Greece), most of eastern Europe and the remaining Middle-East authoritarian states. This quartile of semi-competitive countries also includes China, Indonesia, Malaysia and Thailand in Asia and Chile and Mexico in Latin America. These countries range across the political spectrum, from highly authoritarian to fully democratic. China is very close to reaching elite status, and sees itself on the same path as Singapore.

The third quartile are countries with serious competitive issues this includes many core emerging markets such as Colombia, South Africa, Turkey, India and Brazil. This group’s political inclinations also range from dictatorships (Vietnam) to full democracies (Brazil).

The last quartile shown here (not including another 44 countries at the bottom of the rankings) are all severely impaired from a competitive aspect. This includes Argentina, Egypt and Pakistan in emerging markets and Bangladesh and Nigeria in frontier markets.

The next chart below shows the evolution of rankings over the past 10 years.  The left side of the chart shows countries with improved or no change in ranking, while the right side shows countries with declining rankings. EM economies with either significant improvements or declines are highlighted in bold.

 

Non-competitive countries with declining rankings are those highlighted in the bottom of the right-hand side of the chart. These countries should be considered problematic for investors, and it is therefore no coincidence that these countries suffer from low investment and capital flight. This includes major economies and population centers that are of major concern to emerging markets investors – Brazil, India, South Africa, Nigeria, Egypt and Pakistan.

Trade Wars

  • The great decoupling (Oxford Energy)
  • KKR sees opportunity in China decoupling (KKR)
  • Banning technology will backfire on the U.S. (FT)

India Watch

China Watch:

  • Expected returns in China (UBS)
  • China-Russia: cooperation in Central Asia  (AsanForum)

China Technology

Brazil Watch

EM Investor Watch

  • The open secret of development (project syndicate)
  • IMF, Global Financial Stability Report (IMF)
  • Russia, the cheapest market in the world (seeking alpha)
  • Global Competitiveness report 2019 (WEF)
  • Naspers strategy to create value (FT)

Tech Watch

  • Risks and opportunities in the battery supply chain (squarespace)
  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)

Investing

  • Larry Hite on trend following (marketwatch)
  • Ten years of performance is still just noise (Swedroe)
  • Joe Greenblatt on value investing (wsj)
  • The correlation between stocks and bonds (Axioma)
  • A taxonomy of moats (reaction wheel)
  • An investment thesis for the next decade (Gavekal)

 

 

 

 

 

 

 

 

A Primer on Emerging Market ETFs

 

In many ways investors have never had it so good. Since last week practically the entire U.S. brokerage industry has gone to zero commissions for stock trades. At the same time, the most prominent ETFs (exchange traded funds), which are ideal building blocks for any allocation strategy, are charging minuscule management fees. This means that a millennial investor today can build his wealth without incurring any transaction costs. Compare this baby-boomers  who accumulated savings while paying fees to financial service firms of 1-2% per year on assets.

This gradual disruption of the revenue base of the investment industry has occurred over the past 30 years, through the concurrent rise of discount brokers (e.g. Charles Shwabb) and low cost indexing strategies (initially driven by Vanguard mutual funds and later by ETFs). All of these changes are driven by computer automation and scale. In recent years, the trend has accelerated.  JPMorgan estimates that today 90% of U.S. equity trading volume comes from computer-driven systematic trading accounts, leaving 10% in the hands of discretionary traders.

This disruption in some ways is even more profound in emerging markets where transaction fees have historically been much higher than in developed markets.  ETFs are allowing investors  to largely bypass the high costs of investing in local markets because the great majority of trades can be settled internally within the funds, and only marginal increases/decreases in assets have to be funded externally. (e.g. EWZ, the Ishares Brazil ETF now settles daily within its own structure about the same volume as Brazil’s Bovespa index.) Moreover, emerging market asset managers in the past had been able to charge high management fees, typically in the 1.5-3.0% range, and even today very high fees remain the norm in most domestic markets. However, today any investor can get  broad global emerging market exposure through ETFs for an annual fee of 11 basis point (0.11%) and Franklin Templeton is offering a suite of country funds with annual expenses of 19 basis points (0.19%). When the first country funds where launched in the 1990s they had expense ratios of 2.5-3%.

The result is that emerging markets, like other asset classes, have come to be  dominated by low cost indexed products sold in the form of ETFs  and mutual funds. These funds which are computer driven and rules-based are said to be “passively” managed in contrast to “actively” managed funds where discretionary decisions are taken by managers on the basis of fundamental analysis. Passively managed products can charge very low fees because they are run systematically by computers, and as scale rises and computer costs decline they can continuously cut expenses further.

In the U.S. market alone, there are currently over 250 ETFs investing in emerging markets, with total assets of $250 billion. Including mutual funds, there are approximately $500 billion invested in EM assets in the U.S. market, of which about 60% of the total is invested passively. This compares to a 60/40 mix in favor of actively managed funds just five years ago, which shows how rapidly the industry is changing.

To get an idea of the characteristics of the passively-managed universe in emerging markets, we can look at the data provided by the website ETF.com.

The chart below shows the 20 largest EM ETFs as of September 30 of this year. There are several points that we can highlight:

  • The EM ETF world is already highly concentrated. The battle for this space was won in the early stages by Blackrock and Vanguard. 87% of all EM ETF assets are held by the twenty largest ETFs, of which 60% and 30% are in the hands of Blackrock and Vanguard, respectively. Charles Schwab, though a late comer, has successfully used its distribution power to become a significant third force.. All the remaining players have niche strategies, but most lack differentiation and scale. Not surprisingly, rumors abound of M&A activity to promote further consolidation.
  • The space is very dominated by basic global emerging markets (GEM) index products: Blackrock’s IEMG (MSCI EM) and Vanguard’s VWO (FTSE EM). The fees for these products have plummeted; in fact Blackrock’s initial GEM product, EEM, now slowly dissipates because of its “exorbitant” 0.67% expense ratio, compared to IEMG’s 0.14%. The cheapest GEM fund is now State Street’s SPEM (S&P EM), with a fee of 0.11%.
  • To lower expenses and remain competitive there is a broad trend for smaller firms to develop their own indexes.
  • With relentless pressure on fees,  industry asset-gatherers need to be creative to differentiate products from the basic GEM funds. Based on the complexity and marketing attractiveness of these differentiated strategies, fund companies aspire to secure higher fees.

GEM Plus Funds

The most basic differentiation strategies are “GEM Plus” funds where the manager has introduced a tweak to the basic GEM product which is deemed to be of interest to investors. These include the following:

    • RAFI Products – These funds, based on the Research Affiliates Fundamental Index, weigh stocks on the basis of fundamental characteristics (sales, cash flow, dividends and book value) in contrast to the market capitalization weights that are the rule for the big GEM funds. This provides investors with a “value” tilt, and periodic rebalancing to harvest mean reversion. The funds using the RAFI index are currently charging between 39-60 basis points, a large premium over the standard GEM funds.
    • GEM with Exclusions – These funds charge a moderate fee premium of 5-20 basis points and many keep their costs down by creating their own indexes:
        • GEM minus China.
        • GEM minus state-owned companies
        • GEM minus stocks which violate ESG (environmental, social and governance) standards.

 “Smart-Beta” Funds

The next area of differentiation is with the so-called “smart-beta” products. These funds seek to exploit academically recognized investment factors (value, growth, small cap, quality, income, momentum) which historically have provided higher returns.  These funds can be divided into those that focus on only one factor and those that combine multiple factors into their algorithm. In recent years, a wave of multifactor products have hit the market, most of which use a combination of factors deemed to provide benefits of diversification and non-correlation. Single-factor funds currently tend to charge fees between 30-50 basis points, while  multi-factor funds tend to gravitate towards the high end of that range with some closer to 60 basis points.

Country and Regional Funds

Another area of great importance for ETFs are country and regional funds. Single-country products have always found traction with investors, and some country funds have been around for decades, first in the form of mutual funds and now largely as ETFs. Many of these products enjoy legacy fees which range between 50-70 basis points which they can sustain because of their strong market presence. This segment is firmly dominated by Blackrock’s Ishares funds. Both Van Eck and WisdomTree have had some success by entering niche products and developing their own indexes. Franklin Templeton is the latest entrant in this space with its suite of low cost country funds (19 basis points) indexed to FTSE, but so far it has had limited success.

Sector Funds

Finally, sector funds are a poorly developed segment of the market. On a global basis, only a few funds have been launched, with the Ishares EM technology ETF (EMQQ) having had the most success. Several GEM consumer funds have also been launched by Columbia, WisdomTree and Kraneshares. These funds have high expenses (50-90 basis points). EMQQ currently charges 86 basis points.

An entire suite of China sector funds has recently been launched by Mirae, so far with limited success. These funds have 65 basis points of expenses.

The following chart summarizes the data for the EM ETF Universe. The first column shows the percentage total assets in each major segment and the second column shows the fee expense ratios for each segment.

% of Total Assets in Each Segment Average Annual Fee
Gem 65.43% 0.23%
Fixed Income 11.09% 0.38%
Country/Regional 16.82% 0.64%
One Factor 4.07% 0.38%
Multi-Factor 2.59% 0.56%

 

 

Trade Wars

  • The great decoupling (Oxford Energy)
  • KKR sees opportunity in China decoupling (KKR)
  • Banning technology will backfire on the U.S. (FT)

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

  • Expected returns in China (UBS)
  • China-Russia: cooperation in Central Asia  (AsanForum)

China Technology

 

Brazil Watch

EM Investor Watch

  • Naspers strategy to create value (FT)

Tech Watch

  • Risks and opportunities in the battery supply chain (squarespace)
  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)

Investing

  • Ten years of performance is still just noise (Swedroe)
  • Joe Greenblatt on value investing (wsj)
  • The correlation between stocks and bonds (Axioma)
  • A taxonomy of moats (reaction wheel)
  • An investment thesis for the next decade (Gavekal)

 

A Blueprint for a China-U.S. Detente

As China has reached middle-income status its rate of economic growth has slowed down sharply. For the past four decades China adroitly took advantage of powerful drivers of growth, but several of these have exhausted themselves or turned into headwinds. For example, a huge demographic bonanza has morphed into a drag on growth, as the working-age population has started to decline, and China now faces the prospect of becoming the first major economy to grow old before it gets rich. Also, global trade, for long a boon to China’s wealthy coastal economy, is now dwindling, and rising trade tensions and protectionism make further gains implausible. Moreover, previously fruitful growth strategies based on fixed capital formation, debt-accumulation and environmental degradation have lost traction as volumes have reached levels where marginal returns are unattractive.  Policy makers in China are well aware of the predicament they face. One of their most publicized responses to the growth slowdown has been President Xi Jinping’s “China 2025” strategy, which is a firm commitment to use concerted state-led promotion and support with the objective of moving up industrial value chains and making China dominant in high tech frontier industries. However, “China 2025” has contributed to the growing acrimony between China and the United States, as Washington has assailed the initiative as a violation of the norms of global capitalism and sees it as designed to undermine strategic business sectors in America.  U.S. sanctions on Chinese tech companies and restrictions on access to technologies implemented by the Trump Administration  have only increased the conviction of Chinese leaders that technological autarky is now a question of national security, and has further deepened the sentiment that the two countries are engaged in a new  “cold War .”

It is in this context of slowing growth, trade tensions and tech sanctions that the World Bank has issued a report, “Innovation in China,” (Link) which provides a blueprint for sustaining Chinese growth in a non-confrontational manner. The World Bank, which has been very active in China since the 1980s and sees itself as a trusted and impartial advisor and is now run by  the Trump-appointed David Malpass, co-authored the report with the Development Research Center of the State Council of the People’s Republic of China, (DRC),  a think tank which  advises China’s senior leadership. The combined effort, therefore, is meant to provide a technically-based proposal which reflects the sensibilities of both Chinese and U.S. policy makers.

The conclusions reached by the report are highly significant because they show a path forward which is very different from the “Cold War” clash now assumed to be inevitable in Washington. Whether this faithfully expresses the conviction of either President Xi Jinping or Damald Trump  is unknown but the report does show that there is considerable support within China’s top leadership for avoiding a confrontation with the U.S. by pursuing a technical approach that diminishes the current areas of tension.

The World Bank/DRC report’s primary message is that China can best achieve its objectives by focusing on traditional developmental strategies that have not been fully exploited. The report advocates for deepening governance and institutional reforms in order to facilitate a three-pronged strategy of: 1. Accelerating the diffusion of currently available technologies (the traditional “catching-up” process available to developing countries which operate well below the “technology frontier”);  2. Reducing distortions which currently affect market prices and result in poor resource allocation and 3. Promoting  technological innovation (discovery) on the global technological frontier.

The report espouses a market friendly agenda to promote an innovation economy: the removing of Distortions in the allocation of resources; the acceleration of Diffusion of existing technologies; and fostering the Discovery of new technologies. This “3D” strategy, as it called in the report, defines the government’s primary role as the supporter of markets.

The report emphasizes that the potential benefits from the first two Ds are ample and relatively easy to achieve and should be the main drivers of growth over the midterm, while discovery on the global technological frontier will gain importance over the long term as China becomes richer.  It argues that China could more than double its GDP simply by catching up to the OECD average in Total Factor Productivity, by propagating existing technologies and eliminating the distortions in resource allocation which are endemic to an economy dominated by central planners, state-owned firms (SOEs) and state banks. Moreover, the report supports changing the focus of industrial policy away from targeted support for preferred firms and towards industrial policies that promote level competition. Though SOEs are seen as an integral part of the economy, the report advocates that they be fully exposed to competitive pressure.

This clear statement of priorities expressed by the World Bank/DRC report is highly significant in the context of Washington’s condemnation of current “discriminatory’ policies regarding foreign investments, technology transfer and the protection of intellectual rights in China. In essence, the report insinuates that it is today in the best interest of China to address these concerns in order to accelerate the adoption of foreign technology and best practices and keep China on a path of high GDP growth.

Of course, China has frequently expressed these views in the past: pro-market reforms have been formally espoused in all the government’s policy statements.  However, progress has been slow, and there is now a widely-held outside of China that there has been backtracking during the Xi Administration. For whatever reason, China continues to “talk the talk but does not walk the walk.”  However, the World Bank/DRC report shows that a significant portion of the Chinese political establishment still sees a “win-win” outcome based on self-interested accommodation. Let us hope that politics and personalities will facilitate this outcome.

Trade Wars

  • The great decoupling (Oxford Energy)
  • KKR sees opportunity in China decoupling (KKR)
  • Banning technology will backfire on the U.S. (FT)

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

  • Expected returns in China (UBS)
  • China-Russia: cooperation in Central Asia  (AsanForum)

China Technology

 

Brazil Watch

EM Investor Watch

  • Naspers strategy to create value (FT)

Tech Watch

  • Risks and opportunities in the battery supply chain (squarespace)
  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)

Investing

  • The age of wealth accumulation is over (FT)
  • A taxonomy of moats (reaction wheel)
  • An investment thesis for the next decade (Gavekal)