Author: jvande

What Caused Brazil’s Great Recession?

The debate continues on what caused Brazil’s most recent economic crisis, the deepest and longest the country has experienced since the Great Depression.

Nobel Laureate, Paul Krugman, gave his view in his New York Times column a few weeks ago (“What the Hell Happened to Brazil?”,  Link). Krugman points to “bad luck” in the form of a severe terms- of- trade shock caused by falling commodity prices, which in turn led to an unwinding of excessive household debt and a severe drop in domestic consumer spending. Brazil, according to Krugman, underwent a debt deflation process, not the typical “sudden stop” emerging market crisis where a build-up in foreign debt reverses when foreign capital abandons a country. The duration and depth of the recession, Krugman believes, were caused by bad policy mistakes: a combination of fiscal austerity and monetary tightening, at a time when Keynesian stimulus could have been effective.

Barron’s Magazine has also chimed into the debate with two articles by Mathew Klein (“Understanding Brazil’s Latest Depression” and “What Triggered Brazil’s Crisis,” Link).  Klein points to a massive increase in private debt between 2005-2015 which was accompanied by a large increase in foreign capital inflows, mainly into stocks and bonds. When the capital flows reversed in 2012-14 and the downturn began, the Brazilian authorities tightened both fiscal and monetary policies and deepened the fall, Klein writes echoing Krugman. Klein notes a fiscal adjustment of 5% between 2013 and 2016 (from a surplus of 2% to a deficit of 3%) but still agrees with Krugman that the authorities were too conservative on the fiscal front and focused largely on the tightening of monetary policy to stabilize financial markets.

Both the Krugman and Klein articles are insightful, but I take issue on several points. First, both Klein and Krugman make a glaring omission by not considering political factors. The reelection of President Dilma Rousseff  (October 2014) was a great disappointment for the business community and financial markets and probably triggered the start of the recession. At the same time, Brazil entered an enormous political crisis, with the explosion of the “Car Wash” graft probe (initiated in 2014, and still going on)) which implicated hundreds of businessmen and their political cronies.  This was soon followed by the impeachment of President Dilma (2015). These unsettling political events certainly played a big role in deepening and extending the downturn.

Second, both Klein and Krugman somewhat mischaracterize the crisis: Krugman, by arguing that Brazil’s woes were more akin to a developed market crisis and could have been alleviated through  stepped-up fiscal spending; and Klein, by stating that the commodity cycle (2003-2012) should be considered  largely irrelevant to the discussion.

I think the evidence does no support Krugman’s idea. In fact, the crisis should be seen as a garden-variety boom-to-bust emerging market crisis. This is clear if we put the event  in the context of the many EM crises of the past decades.  Ray Dalio’s book Principles for Navigating Big Debt Crises (Link) provides a good account of the record. Dalio’s “Economic Machine” concept is that financial crises are linked to debt cycles which evolve in predictable patterns and all go through three phases:  the bubble build-up, the depression  adjustment and the reflationary recovery.  Dalio looks at the specifics of 48 crises, 23 of which occured in major emerging markets and are summarized in the chart below. Brazil’s latest crisis is not included in Dalio’s book but I have added it for comparative purposes. The chart shows each country’s characteristics at the peak of the boom cycle in terms of the following criteria:

  • Expansion of the Debt to GDP Ratio of at least 5%
  • Foreign Debt to GDP of at Least 30%
  • Fiscal Deficit at least 2% of GDP
  • GDP Output Gap of at least 5% (GDP 5% over trend growth)
  • Currency at least 10% overvalued
  • Current Account Deficit over 3% of GDP

When a country meets most of these criteria its economy is considered very overheated and vulnerable to a serious downturn.

Not every crisis is the same. Every crisis has its own particularities, but by-and-large they follow the same pattern, meeting the criteria over 80% of the time. Russia, with its structural current account surplus, is the only anomaly, with both booms and busts dictated by oil-driven terms-of-trade shocks.

Brazil’s crisis fits like a glove, amply meeting all the criteria with the exception of “foreign debt to GDP.” But, even this exception is due only to nomenclature, because foreign capital inflows this time took the form of  direct investment in Brazil’s liquid bond markets instead of foreign debt. Brazil does in fact experience a pretty standard “sudden stop” when the end of the commodity boom leads to a reversal in capital flows.

In regard to Klein’s discounting of the relevance of commodities as a major factor, I think this is very unlikely. Brazil, with its historical dearth of domestic savings, has always been very sensitive to terms-of-trade shocks. This latest boom-to-bust cycle for Brazil starts with the China-driven boost in commodity prices in 2003 and comes to an end with the collapse in prices that begins in 2012. A glance at any commodity chart confirms this.

Though Brazil is not nearly as sensitive to commodity prices as Russia, they still do matter a lot in that they drive the current account; and when they rise  a solvency effect occurs which lowers country-risk perceptions and attracts foreign capital flows.

I think we can safely say that Brazil experienced an entirely traditional boom-to-bust cycle triggered by an increase in commodity prices.

However, the duration and depth of the crisis are more difficult to explain. In the past, Brazil’s economy always proved to be resilient and bounced back quickly from downturns, but this decline  has lasted longer and caused more pain.   So, what happened?

Why Did Brazil’s Recession Dragged on for so Long?

Both Krugman and Klein blame Brazilian policy-makers for the economy’s extraordinary downturn. But, in arguing that traditional Keynesian fiscal stimulus would have worked, Krugman shows a lack of sensitivity for the “curse” of emerging markets, which is precisely the difficulty of implementing counter-cyclical policies. This “curse,”  which is arguably the defining characteristic of EM, exists mainly because of “hot” and fickle  foreign capital flows, and this is especially true for a savings-defficient  economy like Brazil’s facing a term-of-trade shock.

Klein is closer to the mark by stating that policy makers obsessed over meeting inflation targets because of Brazil’s recent experience with hyper-inflation.

Dalio’s data-base is useful to determine how the recent Brazilian crisis may be unique in terms of how policy makers responded. In Dalio’s framework, the bubble is followed by a “depression,” typically resulting in a deleveraging which sets the base for an eventual reflation period and the start of a new cycle. The chart below looks how during past EM crises emerging market policy makers have typically “engineered,” willfully or not, this depression phase. We focus on the three main levers of adjustment: currency devaluation, current account adjustment and inflation.

What we see clearly is that adjustment periods are all essentially the same, and Brazil in 2012-2017 is no exception. Countries devalue to smoothen the adjustment in the current account and they allow inflation to ramp up. Both devaluations and inflation are taxes on consumption, which drive the adjustment.

But, policy makers in Brazil opted to “cushion” the adjustment. We can see this in the following three charts.

Devaluation – The Brazilian real was allowed to fall, but slowly and not nearly as much as in previous downturns, and not enough to adjust the current account. Brazil’s authorities probably felt that the huge foreign currency reserves accumulated during the commodity boom gave them the luxury to soften the BRL’s decline, and this was orchestrated in the name of financial stability.

Current Account –  The current account adjusted, but only after commodity prices staged a rally in 2016-2017.  The lack of a strong current account adjustment in the face of a terms-of-trade shock is very unusual.

 

Inflation –  Inflation rose briefly, but was then squashed by extremely tight monetary policy. Brazilian real rates (after inflation) rose to as high as 7% at a time when U.S. and European real rates were negative.

Why did policy makers choose this path? First, politics interfered, as Rousseff primed the economy to ensure her reelection in 2013-14. This served to  worsen conditions and delay the adjustment. Also, I agree with Klein that the the Central Bank’s obsession with inflation-targeting was  rooted in historical experience. Policy makers understood that inflation is a direct and exclusive tax on the poor because the owners of capital in Brazil have safeguards. But, at the same time, the Central Bank in Brazil, like elsewhere, being a  captive of financial markets may have seen its mandate to be to preserve financial stability at any cost. By allowing greater changes  in both the value of the BRL and the level of inflation, authorities could have imposed a greater cost on foreign holders of domestic debt and domestic dollar-indebted corporates but they were very reluctant to do this.

Ironically, though financial stability was well maintained in Brazil and inflation was contained, it was still the poor that bore the burden of the crisis. This time it was not through the inflation tax but rather through a long and brutal decline in employment and wages.

Also, the policies had two highly perverse effects (shown in the charts below).

  • Very high interest rates dramatically increased public debt levels, causing a new source of potential stress. Brazil failed to take advantage of the crisis to engineer a deleveraging of the economy and set a new base for a new reflationary debt cycle.  The debt-to-GDP ratio actually increased by nearly 30 points since 2012, and now public debt sits at precariously high levels.  We can contrast this with the significant deleveraging that occured in the 2002 recession, setting a base for the economic boom starting in 2004.
  • The relatively strong and stable BRL encouraged Brazilian corporates to borrow in international markets, also creating a new source of stress. External debt to GDP has risen from 18% of GDP in 2012 to 27% in 2017 (World Bank data), now approaching dangerous levels.

If every crisis creates opportunities, in this case Brazil failed. On the other hand, the crisis led to the rise of Bolsonaro and the prospect of liberal reforms, so maybe it was not a total loss.

External Debt Metrics

 

Macro Watch:

  • A users guide to future QE (PIIE)
  • Economic brake-lights (Mauldin)

Trade Wars

  • The road to confrontation (NYT)
  • The real China challenge (NYT)
  • China and the uS are on a collission course (brookings)
  • How Trump and Xi got into a trade war (WSJ)

India Watch

  • Election uncertainty clouds Indian stock market (FT)
  • India electrification to impact copper demand (Gorozen
  • Can the rupee become a hard currency? (Livemint)

China Watch:

  • China picks tobacco taxes above public health (WIC)
  • How free is China’s internet? (MERICS)
  • China extends its global influence (NYT)
  • How cheap labor drives China AI (NYT)
  • China’s property barons (SCMP)

China Technology Watch

  • A profile of Bytedance, Chna’s short-video ap (The Info)
  • Sense-time’s smart cameras (Bloomberg)
  • China’s Electric Vehicle push (Bloomberg)

Brazil Watch

  • John Bolton’s Troika of Tyranny (The Hill)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

  • What drives the Russian state? (Carnegie)
  • Russia’s big infrastructure bet (WSJ)
  • Russia’s new pipeline (Business Week)
  • Indonesia’s elections (Lowy)
  • Chile’s renewable energy boom (Wiley

Tech Watch

  • Why have solar energy costs fallen so quickly (VOX
  • Asia leads in robot adoption (QZ)
  • The new industrial revolution (WSJ)

Investing

  • The top 100 asset managers in the world (Thinking Ahead)
  • An evolve or die momeent for the world’s great investors (Fortune)
  • Interview with William Eckhardt (Turtle Trader)
  • Why momentum inveting works (Anderson)

 

Billionaires in Emerging Markets

In April 2010 Brazil’s Eike Batista told the U.S. talk-show host Charlie Rose he would soon be the richest man in the world. As his vast oil discoveries came on stream, Batista said, his fortune would reach $100 billion, nearly double the $50 billion held by Bill Gates and Warren Buffet at the time. Three years later, after mostly dry wells, Batista’s oil company, OGX, filed for bankruptcy. Batista’s rise and fall is a good reminder of the ephemeral nature of great fortunes, particularly in the boom-to-bust conditions that characterize emerging markets. Huge wealth accumulation, particularly when it comes out of nowhere, is often a manifestation of extraordinary and temporary circumstances that have boosted asset prices to elevated levels. By looking at great wealth we can often identify where the greatest excesses are occurring in the markets. The chart below shows the ten-year evolution of the top ten richest individuals in the world, as compiled by Forbes magazine. Highlighted in red are the individuals who are based in emerging markets.

The first thing to note is the mercurial nature of the list. Only three names from 2008 remain on the list in 2018.

The changes in the list reflect economic and stock market cycles. Six out of the ten names in 2008 are from emerging markets, a consequence of the commodity-fueled liquidity boom that  greatly boosted asset prices in EM between 2002-2008.  India had an incredible four names on the list in 2008, the best possible indication of what has come to be known as the “billionaire Raj,” a process of enormous wealth accumulation and concentration based on “cozy” relations between business moguls and politicians.  Since 2012, India has disappeared from the top ten, as some of the excesses of the system have been curtailed.

Supported by the elevated commodity prices and global liquidity caused by China’s unprecedented credit-fueled construction boom, emerging markets remained active on the list until 2013. Eike Batista appears as the 8th name on the list in 2010, the year of the Charlie Rose interview, and peaks at seventh place in 2012.

After 2013, Carlos Slim has been the only representative of EM on the list, and his standing has been steadily declining because of the weakness of the Mexican peso and the very poor performance of his publicly-traded companies (since year-end 2012, Slim’s main asset, AMX, has lost 35% of its value while the S&P 500 has risen 110%.

Since 2012, the strength of the U.S. dollar, the remarkable outperformance of U.S. assets relative to the rest of the world and the surge of valuations for the FANG (Facebook, Amazon, Netflix and Alphabet-Google) and other tech stocks has led to the near-total domination of the top 10 ranking by Americans.  Bezos and Zuckerberg both appear on the list in 2016, and Bezos was crowned richest man in the world in 2018.

The most fascinating change of the past decade, the rise of China, is not done justice by the chart above. For this, we have to look at the top 100 names, as shown in the charts below.

 

There are many striking changes shown by these two charts, mainly driven by the end of the commodity/EM boom, the continued rise of China and the great rise of the QE-fueled U.S. bull market.

In 2018, China becomes the second largest contingent on the list with 19 names, compared to zero in 2008.

In 2018, 18 out of the top 30 are Americans and five are Chinese, compared to eight and zero, respectively, in 2008. Russia had seven names in the top 30  in 2008 but zero in 2018, and India goes from four to one.

The full list is shown below.

Macro Watch:

  • A users guide to future QE (PIIE)
  • Economic brake-lights (Mauldin)

Trade Wars

  • Henry Paulsen gets negative on China (WSJ)
  • U.S. accuses Cina firm of stealing Micron secrets (Wired)
  • Asia’s next trade agreement (Brookings

India Watch

  • India electrification to impact copper demand (Gorozen
  • Can the rupee become a hard currency? (Livemint)
  • Can India become the next $10 trillion economy ?(Wharton)
  • Apple is losing share in India to Chinese (Reuters)

China Watch:

  • China’s infrastructure investments in Latin America (The Dialogue)
  • China’s art-factory  town is evolving (Artsy)
  • China’s global infrastructure push (NYT)
  • Kevin Rudd on China reforms (Caixing)
  • 50 million empty homes in China (SCMP)
  • China and Myanmar approve port project (Caixing)
  • Four reasons to manage China’s rise  (Lowy)

China Technology Watch

  • China’s Electric Vehicle push (Bloomberg)
  • The rise of Asia’s research universities (The Economist)
  • China’s tech slowdown (Reuters)
  • China fights back on IP theft accusations (scmp
  • A graphic view on China’s tech progress (NYT)

Brazil Watch

  • The rise of evangelicals in Latin America (AQ)
  • Brazil’s new foreign minister says climate change is a marxist plot (The Guardian)
  • Brazil’s new finance tsar (Bloomberg)

EM Investor Watch

  • Russia’s new pipeline (Business Week)
  • Indonesia’s elections (Lowy)
  • Chile’s renewable energy boom (Wiley

Tech Watch

  • The new industrial revolution (WSJ)
  • Pathways for inclusive growth (BSG)
  • Paraguay is a bitcoin powerhouse (The Guardian)

Investing

  • The top 100 asset managers in the world (Thinking Ahead)
  • Interview with William Eckhardt (Turtle Trader)
  • Why momentum inveting works (Anderson)
  • Learning from investment history (Forbes)
  • The rise of “quantamentals” (FT
  • Monish Pabrai’s ten commandments (Youtube)
  • A profile of Paul Singer (New Yorker)

 

 

 

 

 

 

Brazil’s Low-hanging Fruit

 

Brazil’s newly elected president, Jair Bolsonaro, campaigned on a platform of liberal economics and deregulation to unleash the repressed spirit of the Brazilian entrepreneur. As I discussed last week(Link ), it is well documented that Brazil is an exceptionally difficult place to do business   compared to  other countries. The very high cost of regulation and bureaucracy forces small firms into the underground economy and gives a formidable advantage to larger firms with the scale and resources to deal with the regulatory burden. The good news for the incoming administration is that Brazil is  currently at such a low level of governance that any serious and concerted effort to deregulate should produce very high benefits over the short term.

In the World Bank’s ease of Doing Business Index, Brazil is by far the worst ranked of the major economies in emerging markets. The chart below shows how Brazil ranks compared to several emerging market peers and also compared to New Zealand, the country with the highest ranking in the World Bank’s Index. The data is collected from each country’s most important business center. In the case of large countries ,such as Brazil, the World Bank looks at two cities; Sao Paulo and Rio de Janeiro are used as the reference cities for Brazil with a weighting of 61% and 39%, respectively. What this means is that conditions for doing business are certainly significantly worse in other regions of the country.

The World Bank ranks 190 countries on ten different measures; starting a business, dealing with construction permits, getting electricity, registering property, protecting minority investors, paying taxes, trading across border, enforcing contracts and insolvency resolution. Brazil has the lowest ranking in this group in six of the ten categories. For paying taxes, a firm in Brazil needs 1,958 man-hours for the task, which is 6.6 times the second-worse, Chile, and 14 times more than New Zealand (57 times the 34 man-hours required in Hong Kong).

Low-Hanging Fruit

The good news is that things are so bad in Brazil that a concerted effort could bring rapid improvements. Brazil has a great amount of low-hanging fruit to harvest. Three years ago India’s incoming Prime Minister Narendra Modi specifically committed himself to a deregulation agenda to improve India’s ranking in the ”Doing Business” Index. In this short period of time India was able to bring its ranking from 130th to 77th, a remarkable achievement. Modi has set a target of reaching a top 50 ranking over the short term, which would place India in the global elite in terms of this measure. Modi correctly understands that the main beneficiaries of deregulation are small businesses. He said last week:

“The biggest benefit of Ease of Doing Business goes to the MSME (Micro, Small and Medium Enterprises) sector. Whether it is permissions for constructions, availability of electricity or other clearances, these have always been major challenges for our small industries.”

The chart below shows the evolution of both Brazil and India in the “Doing Business” rankings for the past three years. India has improved a remarkable 53 spots, improving its ranking in nine of ten categories. The most remarkable improvements have been with construction permits and access to credit, two areas of fundamental concern for small businesses. Brazil has improved 14 spots over the period, but remains at an extremely poor level. Brazil improved its ranking in five categories, but also worsened in five.  In the cases of securing construction permits and paying taxes Brazil’s ranking is among the worst in the world and got worse over the period. One area of some progress is for starting a business where the ranking has improved from 175 to 140 (from extremely poor to only very poor) because of improvements brought about by the launching of online systems for company registrations, licensing and employment notifications.

 

Macro Watch:

  • A users guide to future QE (PIIE)
  • Economic brake-lights (Mauldin)

Trade Wars

  • Henry Paulsen gets negative on China (WSJ)
  • U.S. accuses Cina firm of stealing Micron secrets (Wired)
  • Asia’s next trade agreement (Brookings

India Watch

  • Can the rupee become a hard currency? (Livemint)
  • Can India become the next $10 trillion economy ?(Wharton)
  • Apple is losing share in India to Chinese (Reuters)

China Watch:

  • Kevin Rudd on China reforms (Caixing)
  • 50 million empty homes in China (SCMP)
  • China and Myanmar approve port project (Caixing)
  • Four reasons to manage China’s rise  (Lowy)
  • The reforms China needs (Project Syndicate)
  • China’s Eastern Europe push (WSJ)

China Technology Watch

  • Tencent’s social responsibility drive (WSJ) (SCMP)
  • China’s giant transmission grid (Tech Review)
  • AI will develop under two separate spheres of influence (SCMP

Brazil Watch

  • The rise of evangelicals in Latin America (AQ)
  • Brazil’s new foreign minister says climate chnage is a marxist plot (The Guardian)
  • Brazil’s new finance tsar (Bloomberg)
  • President Cardoso’s speech at the Wilson Institute (Wilson Center)
  • Brazil may move embassy to Jerusalem (WSJ

EM Investor Watch

  • Mexico’s challenge with investors (FT)
  • Russia’s de-dollarization strategy (WSJ)
  • Africa’s overlooked business revolution (McKinsey)
  • Timing the EM cycle (Seeking Alpha)
  • The age of disruption, Latin America;s challenges (Wilson Center)
  • Rwanda, poster child for development (WSJ)

Tech Watch

  • Pathways for inclusive growth (BSG)
  • Paraguay is a bitcoin powerhouse (The Guardian)

Investing

 

 

 

Promoting Business Initiative in Emerging Markets

 

The World Bank has conducted its “Doing Business” survey since 2006, ranking countries according to the ease of conducting business. The rankings provide a useful comparison between countries, and the survey has enough history to show which countries are implementing the reforms needed to allow entrepreneurs of all sizes to thrive.

The chart below looks at the evolution of the rankings for those countries  that are important for emerging market investors. This data covers 10 years, which is, more or less, two full business or electoral cycles and enough time for government policy reforms to have an impact. What we see are dramatic changes, both on the positive and negative sides. On the positive side, Russia, India, Indonesia, China, Poland, Taiwan and Turkey have achieved transformational results. On the negative side, we see a very concerning collapse occurring in South Africa, and significant declines in Colombia, Nigeria, Thailand and Peru.

Change in Ease of Doing Business Rankings.  Best to worst over 10 years
Russia 89
India 56
Indonesia 49
China 43
Poland 38
Taiwan 33
Turkey 30
Vietnam 24
Brazil 20
Philippines 20
S Korea 14
Malaysia 8
Argentina -1
Mexico -3
Chile -7
Peru -12
Thailand -15
Nigeria -21
Colombia -28
South Africa -48

 

The criteria that the World Bank uses in its Doing Business methodology are shown in the chart below.

The full rankings for the 18 countries that make up the core of our EM universe for investors are shown below. The chart shows the rankings from 2006-2019. The World Bank currently ranks 190 countries, and the full ranking can be found on the World Bank website (Link). 

We can consider the top 25 to be the global elite, the absolute easiest places to start and run a business. The top 50 can be considered good; 50-100, mediocre;  and 100-130, bad.  Any ranking above 130 indicates a very hostile environment for entrepreneurs.  Countries above 100 are highly dominated by inefficient bureaucracies and by extractive entrenched interests such as oligarchies and politically connected rent-seeking agents.  Typically, in these countries you have to be big and politically connected to be successful, and most entrepreneurs are  forced into the underground economy. Four important markets – Brazil, Philippines, Nigeria and Argentina –  persistently rank very poorly and show little sign of progress. India, Indonesia and Vietnam in recent years have moved out of this group of “dysfunctionals,” showing clear signs of improvement.

 

We can dig deeper into the survey by looking at the rankings on a regional basis.

Asia

The evolution of the rankings for Asian countries is shown below.  This is the world’s most dynamic economic region and also where we see both the best and the most improving business conditions. We can separate this group into two cohorts: the “Asian Tigers” and the Asian laggards. Of the Asian Tigers, South Korea, Malaysia, Thailand are in the elite and have been so throughout the period. Korea, Malaysia and Taiwan have continued to improve over the period, while Thailand has shown some moderate slippage. China is between the Asian Tigers and the laggards, but appears to be moving rapidly towards the former. We also see in recent years that the laggards are making significant progress. India, Indonesia and Vietnam all have made large leaps forward. The case of India is noteworthy; Prime Minister Modi publicly committed to improving India’s ranking when he took office, and he is delivering through a major deregulation push.  (The tweet below from Modi shows the focus that he has on this measure.) The main exception in Asia is the Philippines where we see very little progress. It appears that the all-powerful oligarchs in the Philippines are not being challenged.

Latin America

The evolution of the rankings for Latin America are shown in the chart below. This region is characterized by the “middle-income-trap” malady: after reaching middle-income status, these countries fail to both invest in public goods (human capital and infrastructure) and to implement pro-business reforms. Like Asia, the region is divided into the good (Chile, Mexico, Colombia and Peru) and the laggards (Argentina and Brazil).  Of the better-ranked countries, none has made progress over the period. Worse, Chile has seen a worrisome decline from its former elite status, and Peru, after showing signs of improvement, has regressed. On the side of the laggards, Argentina has deteriorated significantly while Brazil is stable.

Europe, Middle East and Africa

This region is diverse and shows great divergence in results. Both Nigeria and South Africa are cause for concern. Nigeria has joined the camp of highly dysfunctional economies, and South Africa has gone from elite status to mediocrity and it shows no signs of halting this trend downward. Fortunately, all the other countries in this group show positive trends. Turkey and Russia, both run by nationalistic, pro-business “law-and-order” autocrats, have made remarkable progress. Poland, in line with most countries in Eastern Europe, has also risen sharply in the rankings and now borders “elite” status.

Macro Watch:

Trade Wars

  • Henry Paulsen gets negative on China (WSJ)
  • U.S. accuses Cina firm of stealing Micron secrets (Wired)
  • Asia’s next trade agreement (Brookings
  • Wisconsin has econd thoughts about Foxconn deal (New Yorker)
  • Australia blocks China pipeline takeover (SCMP
  • Firms shifting plants to ASEAN (SCMP)

India Watch

  • Can the rupee become a hard currency? (Livemint)
  • Can India become the next $10 trillion economy ?(Wharton)
  • Apple is losing share in India to Chinese (Reuters)
  • India’s central bank under pressure (NIKKEI)
  • India-sponsored Iranian port is a problem for th U.S. (WSJ)

China Watch:

  • China and Myanmar approve port project (Caixing)
  • Four reasons to manage China’s rise  (Lowy)
  • The reforms China needs (Project Syndicate)
  • China’s Eastern Europe push (WSJ)
  • Self-reliance is the new mantra in Beijing (Washington Post)
  • China’s southern Europe strategy (Carnegie)
  • The big story in China; no talk of autumn policy meet (SCMP)
  • The world is awash in waste after China ban (FT)
  • Trump’s decoupling with China will hurt Asian allies (Lowy)
  • Cruise companies rethink China bet (WIC)

China Technology Watch

  • Tencent’s social responsibility drive (WSJ) (SCMP)
  • China’s giant transmission grid (Tech Review)
  • AI will develop under two separate spheres of influence (SCMP
  • BAIDU and Volvo team up 0n self-driving cars (SCMP)
  • An AI war would be a huge mistake (Wired)
  • China robotic firm seeks to buy German competitor (Caixing)

Brazil Watch

  • President Cardoso’s speech at the Wilson Institute (Wilson Center)
  • Brazil may move embassy to Jerusalem (WSJ
  • Brazil’s new president (Wharton)
  • Brazil’s economy boss looks to Chile (FT)
  • A european view on Brazil’s new foreign policy (GGPI)
  • Trumpism comes to Brazil (Foreign affairs)
  • How will Bolsonaro deal with China (Caixing)
  • Brazil’s new foreign policy (Brookings)

EM Investor Watch

  • The age of disruption, Latin America;s challenges (Wilson Center)
  • Rwanda, poster child for development (WSJ)
  • The passing of the conscience of Venezuela’s left (NYT)
  • Poland moving back to the center (NYT)
  • Why Mexico and the U.S are getting closer (Wharton)
  • The short term case for EM (Disciplined investing)
  • China’s inroads in the Andean amazonian basin (Asia Dialogue)
  • Are developing countries converging (PIIE)

Tech Watch

  • Pathways for inclusive growth (BSG)
  • Paraguay is a bitcoin powerhouse (The Guardian)

Investing

  • Learning from investment history (Forbes)
  • Interview with Doug Kaas (RIA)
  • Investment value in an age of booms and busts:
    A reassessment (Edelweiss)
  • Monish Pabrai’s ten commandments (Youtube)
  • A profile of Paul Singer (New Yorker)

 

 

 

 

 

AMLO Shoots Himself in the Foot

 

The ability to invest in fundamental public goods – human and physical capital — is a primary characteristic that differentiates one emerging market country from another. The process of building-out infrastructure is particularly fraught with risks because of the complexity and flexibility of contracts, so countries also differentiate themselves in their ability to conduct business ethically and complete projects at reasonable costs.

Over the past weeks, we have seen this process at work, with very different outcomes. On the one hand, in China two enormous infrastructure projects were inaugurated – 1. The Hong-Kong Macau Seabridge;2. The Hong-Kong to the Mainland Bullet-Train link. On the other hand, in Mexico the incoming president canceled the new Mexico City Airport, the country’s largest and most needed project.

The decision this week by Mexico’s President-Elect, Andres Manuel Lopez Obrador (AMLO), to scuttle the new $13.3 billion airport being built on the outskirts of Mexico City is emblematic of the political obstacles face by many developing countries to provide basic public goods.

No one disagrees that Mexico City needs a new airport. The city’s main  airport has been saturated since the 1990s, which is very problematic for a country with a growing tourisn industry. Nevertheless,  over the past two decades multiple proposals for a new airport have been abandoned after fierce opposition from indigenous communities and environmentalists.

AMLO’s opposition to the current project, which is about one third completed, has been known for over two years, and he expressed it many times during the presidential campaign. He decried the complexity and cost of the project, as well as environmental considerations. But his main objection has been a belief that the contracts were awarded without transparency to political cronies of the outgoing party.  During the campaign AMLO had said: “It has been proven that this airport is going to be very costly for the country… It’s a bottomless pit… This isn’t a good deal for the country, for Mexicans. It is for a small group of contractors, they are going to make a lot.”

In an essentially symbolic process aimed at justifying his decision, AMLO hastily organized a “popular referendum,”  to “let the people decide.” This occured this past Sunday and resulted in 70% of the one million votes counted agreeing with the candidate to cancel the project.

The following day, a visibly delighted AMLO held a press conference praising the exercise in direct democracy: “The citizens took a rational, democratic and efficient decision. The people decided. And we have to keep on creating the democratic habit. Where there is democracy, corruption does not exist.”

AMLO’s decision to cancel the project, the biggest infrastructure project of the administration of President Enrique Peña Nieto, will result in very large losses (estimated by the WSJ at $5 billion) for bondholders, suppliers and contractors, including Mexican magnate Carlos Slim, one the biggest supporters of the project.

What has just happened in Mexico is not unusual at all in emerging markets. Ironically, as many countries have become more democratic, they have also lost the capacity to invest in public goods. This is particularly true in Latin America where democratization since the 1980s has implied a more free and inquisitive press, a more activist judiciary and independent regulatory agencies captured by special interests. In a country like Brazil where this has been accompanied by a dramatic expansion of the welfare state aimed at providing “social justice,” the state has found itself handcuffed, without funds and facing an incredibly laborious process to get anything done.

Ironically, in many emerging markets when the “grease” of corruption is not allowed to work things come to a complete stop. One of the companies involved in the Mexico City airport project, Grupo Hermes, is related to Carlos Hank Gonzalez, a well known Mexican politician linked Pena Nieto’s party, who famously quipped “a poor politician is a poor politician.” In a similar vein, it used to be said about a former governor of Sao Paulo, “he may steal, but he gets things done.”

The case of China is interesting. China’s unprecedented build-out of public infrastructure since the 1980s is a truly remarkable achievement which has brought the quality of infrastructure from one of the worst in the world to a very high level. However, it is no secret that the construction sector is ridden with corruption and that many of the great fortunes of China have been created by the unethical ties between contractors and municipalities. Not surprisingly, when President Xi Xinping came to power several years ago promising a total crackdown on corruption, for a while, activity came to a stop.

The same goes for India, where kickbacks in construction contracts essentially finance all political campaigns. Politicians and construction contractors in India have long worked under the assumption that the relationship is mutually beneficial and sustainable as long as contractors deliver the promised service. This has resulted in a certain risk aversion, where politicians will only work with the most efficient and technically competent contractors.

A similar approach goes in Turkey, where construction firms have worked closely with the Erdogan regime. As in India, Erdogan has been a tough task-master, demanding competency from contractors.

It is interesting to look at the connection between infrastructure and corruption. We can do this by looking at both the World Economic Forum’s 2019 infrastructure ranking (WEF) and Transparency International’s Corruption Index (Link).The first chart below shows the top 100 of WEF’s infrastructure ranking of 142 countries. The next chart shows the top 90 of the 154 countries covered by the corruption index. A final chart looks at where the primary EM countries fall in this infrastructure-corruption matrix.

Transparency International, Corruption Ranking

 

We can draw some interesting insights from these charts. Basically, there are three distinct groups of countries:

Group 1 – Good Infrastructure with low cost of corruption.

  • This includes all developed countries. We can venture to say that the ability to provide public goods at a low corruption cost is an intrinsic characteristic of development.
  • In EM, only Chile, Taiwan and Poland make the cut, and, in this sense, these countries can really be considered developed. Korea is borderline. Corruption has become a major political and social-media issue in recent years, and it may well fall rapidly from the current high levels.

Group 2 – Relatively Good Infrastructure with High Corruption.

  • These are the “He may steal, but he gets things done” countries. Corruption is high and costly, but politician and contractors have worked it out so that both sides benefit and infrastructure gets built.
  • In EM, China is the master of this group; Mexico, Malaysia, Turkey, Thailand, India and South Africa also qualify.
  • The direction that Mexico will take under AMLO will be interesting to see.

Group 3 – Bad Infrastructure with High Corruption.

  • In these countries, politics have become so dysfunctional that the “return” on corruption is near zero. Included in this list are: Brazil, Argentina, Indonesia, Vietnam, Columbia, Peru and the Philippines. At the extreme of this category and in a class of their own are semi-failed states: for example, Venezuela and Nigeria.
  • Most emblematic of this condition has been Venezuela under its Bolivarian regime. Thirty years ago, Venezuela had one of the best infrastructures of any developing country; today it ranks 118th in the WEF report. Venezuela now has zero capacity to invest in public goods, all of its fiscal resources either dedicated to welfare programs or syphoned-off to the offshore accounts of regime cronies.
  • Brazil faces an interesting situation today. It currently has the worst-of-all worlds, with very high corruption and close to zero capacity to carry out infrastructure public works. The election of Jair Bolsonaro was a repudiation of the kickback-driven political system, so going back to that model is impossible. To a considerable degree, the success of the new government will depend on quickly finding a new way to do business.

Macro Watch:

  • Gary Shilling interview on the global economy (Shilling)
  • Martin Wolf comments on Paul Volcker’s book (FT)
  • Is the Business cycle dead? (Robert Gordon)
  • Trump pushes Japan and China closer (Brookings)
  • Trump’s misguided trade war (SCMP)
  • Trade conflict and systemic competition (PIIE)

India Watch

  • India’s central bank under pressure (NIKKEI)
  • India-sponosred Iranian port is a problem for th U.S. (WSJ)
  • India partners with Russia in energy deals (Lowy)

China Watch:

  • The big story in China; no talk of autumn policy meet (SCMP)
  • The world is awash in waste after China ban (FT)
  • Trump’s decoupling with China will hurt Asian allies (Lowy)
  • Cruise companies rethink China bet (WIC)
  • Xi’s sothern China trip (WIC)
  • Chinese buy homes in Greece (reuters)
  • Chinese farmr live-streams her way to fame and fortune (New Yorker
  • The world’s longest sea-bridge opens (CNN) (QZ)
  • China provinces compete for talent (EIU)
  • China’s influence on global tourism is growing (SCMP)

China Technology Watch

  • BAIDU and Volvo team up 0n self-driving cars (SCMP)
  • An AI war would be a huge mistake (Wired)
  • China robotic firm seeks to buy German competitor (Caixing)
  • China aviation industry’s steep climb (SCMP ) (SCMP)
  • China’s AI ambitions (SCMP)
  • U.S. attacks China chip industry (FT)
  • China’s smart-phone offerings (The Verge)

Brazil Watch

EM Investor Watch

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

Investing

  • Learning from investment history (Forbes)
  • Interview with Doug Kaas (RIA)
  • Investment value in an age of booms and busts:
    A reassessment (Edelweiss)
  • Is your alpha big enough to cover taxes (Alpha Architect)
  • Systematic vs. discretionary investing (Integrating Investor)
  • KKR white paper on asset allocation (KKR)
  • Hedge funds fleecing investors (SL advisors)
  • Monish Pabrai’s ten commandments (Youtube)

 

 

 

 

 

 

Interview with Doug Kaas (RIA)

What is it that the foreign press doesn’t get about Brazil’s Bolsonaro?

If Jair Bolsonaro wins the election in Brazil this coming Sunday (October 28) one of the obstacles he will face is the severe skepticism of the international press. Important publications around the world have been nearly unanimous in their repudiation of the candidate, branding him as an uncouth, right-wing radical with authoritarian tendencies.

Typical of the onslaught against Bolsonaro was the article published by the Editorial Board of the New York Times this week. According to the NYT, Bolsonaro is an “offensive, crude and thuggish populist” who holds “gross and repulsive views” and ”is nostalgic for the generals and torturers” of the past…His election is a “frightening prospect.” The NYT also published an article by the well-known Brazilian musician, Caetano Veloso, warning that “dark times” are coming to Brazil. In a similar vein, The Economist Magazine recently wrote that Bolsonaro is a “dangerous politician… with an admiration for dictatorships,” and a “menace to Brazil and Latin America.”

There is a large disconnect between this furious criticism expressed by the foreign press (generally echoed by the progressive Brazilian media) and the reaction of the Brazilian stock market, which has rallied strongly in recent weeks as the polls have shown Bolsonaro surging ahead, and the large crowds expressing their enthusiastic support for him this past weekend in rallies held in major cities around Brazil. Part of this chasm can be explained by the high esteem which the international press still holds for former President Lula, despite his incarceration. For example, The Economist describes Lula “as a president who brought “prosperity to many poor Brazilians.” Lula’s hand-picked heir-apparent, Fernando Haddad, is said to be a “temperate moderate.”

So, what is going on with the Brazilian electorate?

The basic divergence can be explained by the almost exclusive focus of the foreign press on public persona. Lula is remembered as an endearing and charismatic crusader for the poor, and Haddad is seen as a boring moderate with good intentions. On the other hand, Bolsonaro is taken to task for a history or rude and politically incorrect statements on socially sensitive issues. Bolsonaro’s loose lip has resulted in comparisons with President Trump. However, the stock market and Bolsonaro’s supporters in Brazil, have been willing to overlook the candidate’s faux pas. They have preferred to focus on the almost diametrically opposed views that the two candidates have on society and the economy.

Brazil is a country that for the past four decades has favored a large and very interventionist government, with a dominant role for the state in economic planning and investment. After a brief period of economic liberalism in the late 1960s and early 1970s, which led to Brazil’s so-called “economic miracle,” the country changed direction. First under the military regime (until 1985) and then under a succession of elected presidents, entrepreneurial activity was squashed by a very interventionist and bureaucratic state. This reached its apogee during the Lula years, and was made even worse by a rapacious takeover of the state bureaucracy and state-run companies by corrupt politicians.  The result of this is that for the past four decades Brazil has become a major economic laggard, growing its per capita GDP at nearly half the OECD average. With its extremely protectionist policies, Brazil entirely missed out on the globalization boom of the past three decades. The country also provides a particularly hostile environment for business. For example, it ranks 125th in the World Bank’s 2018 “Ease of Doing Business” rankings, the worst of any significant emerging market.

The economic policies presented by the two candidates could not be more different. Simply put, Haddad offers a continuation of the failed policies of the past without any explanation for why they would now work, while Bolsonaro hopes to bring about a complete break. The differences in the economic agendas proposed by the two campaigns are at opposite sides of the ideological spectrum. A  cursory glance at the two candidates’ official websites makes this abundantly clear.

Haddad’s Plan (Link )

Haddad proposes a carbon copy of the policies followed during the Lula/Rousseff years. He offers:

  • A “developmentalist” agenda grounded in the state as the motor of the economy, through the actions of state companies and state banks. Privatizations are unacceptable. Foreign investments in the “pre-salt’ off-shore oil fields are to be unwound.
  • A trade and foreign policy focused on south-to-south initiatives, with a focus on regional integration and Africa.
  • Centralized power in the federal government, with a strongly activist role in social policy.
  • Repeal of the recently approved labor flexibilization law and a change in the mandate of the Central Bank to include employment targets.
  • The government will promote plebiscites and referendums to engage citizens in democracy.

Bolsonaro’s Plan (Link)

Bolsonaro offers a plan to unleash private entrepreneurial activity.

  • Private initiative is the principal motor to overcome poverty and develop the country. “We need free citizens, an efficient government with limited responsibilities, decentralized power, greater autonomy for municipalities and the engagement of civil society.” It is expected that Bolsonaro will announce a massive privatization effort.
  • Free Markets: Limited government and deregulation so that individuals and firms can act freely.
  • Decentralization: Private initiative come first. Activities best conducted by the public sector should be the responsibility of the municipality, the states and the federal government, in that order.
  • Social services provided by the state for the most needy, and reliance on private initiative to complement the role of the state.
  • A trade and foreign policy based on interaction with the most successful economies in the world, which can invest and provide technology for Brazilian development.
  • Representative democracy with the separation of powers is the best option for Brazil.

Anyone can agree or disagree with each one of the principles forwarded either by Haddad or Bolsonaro, but it is impossible to argue that the policy differences between the candidates are not profound. Haddad believes in state-driven development while Bolsonaro wants to unleash the “animal spirits” of Brazil’s entrepreneurs. For the first time in its democratic history, Brazilians are being offered the choice of taking the path of economic liberalism. In Brazil, as elsewhere, there is huge rejection of the political class and appetite for change, and this is driving the electorate to Bolsonaro.

Brazil’s task is not easy. The country has dug a deep fiscal hole for itself through bad policies, reckless spending and the world’s highest interest rates. But, we should all root for Bolsonaro to get this great nation back on the right track.

Macro Watch:

India Watch

  • India partners with Russia in energy deals (Lowy)
  • Golden opportunities in Indian agriculture (Mckinsey)
  • India’s auto sector (Mckinsey)
  • India PM performance (SPIVA)
  • India’s Russia arm deal (WSJ)
  • India’s game-changing healthcare plan (Lowy)

China Watch:

  • The world’s longest sea-bridge opens (CNN) (QZ)
  • China provinces compete for talent (EIU)
  • China’s influence on global tourism is growing (SCMP)
  • China,US, miscalculation, war (Axios)
  • Apple denies China hacking story (Buzzfeed)
  • US pork hit hard by China tariffs (WSJ)
  • China faces a debt iceberg (FT)
  • Hainan free trade zone to boost international tourism (Caixing )
  • Is there a new “cold war” (WIC)
  • China middle-class desperate to get money overseas (SCMP)
  • Yan Lianke’s forbidden satire of China (New Yorker)
  • Chinese actress to pay $129 million tax-evasion fine (WIC)

China Technology Watch

  • China’s smart-phone offerings (The Verge)
  • The battle for 5G (SCMP)
  • Dutch battery firm to build plant in China (FT)
  • Hacking accusations against China seek to undermine China tech (Lowy)
  • Big tech in China moving closer to Party (Lowy)

Brazil Watch

  • Dark times coming to Brazil (NYT)
  • Brazil’s Bolsonaro (New Yorker)
  • In Brazil, campaign promises but no money (WSJ)
  • Emerging markets’ lost decade (Blackrock)
  • Brazil’s gene-edited angus cow (WSJ)

EM Investor Watch

  • Are developing countries converging (PIIE)
  • Turkey, the 1994 crisis (Seeking Alpha)
  • What next for Turkish-American relations (GMFUS)
  • The Global Competitiveness Report  2018 (WEFORUM)
  • The World Bank’s Human Capital Report (World Bank)
  • Indonesia’s bullet-train is stalled (Caixing)
  • Russia’s missed tech opportunity (Hoover)

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

Investing

  • KKR white paper on asset allocation (KKR)
  • Hedge funds fleecing investors (SL advisors)
  • Monish Pabrai’s ten commandments (Youtube)
  • SPIVA’s mid-year assessment of mutual fund performance (SPIVA)
  • Update on the Buffett indicator (Advisor Perspectives)
  • Factor investing in emerging markets (http://ETF.com)
  • Challenging the conventional wisdom on asset managers (SSRN)
  • What does an EV/EBITDA multiple mean? (Blue Mountain)
  • Joel Greenblatt’s talk at Google (Youtube)
  • Consequences of current account imbalances (Private Debt Project)

 

 

 

 

 

Xi Returns to Shenzhen

Shenzhen is where China’s “economic miracle” started four decades ago. In 1980, Deng Xiaoping gave the sleepy fishing village which lies north of Hong Kong the status of “Special Economic Zone,” embracing market mechanisms and the process of integrating China into the world economy.  After the political turmoil and the events of Tiananmen Square in 1992, Deng returned to Shenzhen where he reaffirmed China’s commitment to “modernization… through reform and opening.”

In China, symbolism and slogans carry great weight, so the visit of President Xi Xinping to Shenzhen this week should be seen as highly significant. Xi has been repeatedly accused by critics both inside and outside of China of returning China increasingly towards the state-controlled dirigisme of the past, and his visit to Shenzhen aimed to reaffirm support for the private sector entrepreneurialism which has made Shenzhen into the world’s only rival to Silicon Valley.

In Shenzhen, Xi made comments aimed at bolstering confidence in China’s economic prospects. He paid tribute to Deng and vowed to continue China’s reform and opening up.

The road of “reform and opening up” was the “correct path” and China could create “bigger miracles” by sticking to it, Xi was quoted as saying by the official Xinhua news agency.

Xi added:

“I come to Shenzhen again … so that we can declare to the world: China’s reform and opening up will never stop.”

“We will continue down this path, unswervingly continue down the path of enriching the country and the people, and will break new ground.”

“This year marked the 40th anniversary of China’s reform and opening up. In the last 40 years, China’s development achievements have impressed the world…“So, since we are getting better and better, then why don’t we continue along the chosen path? Although we have some difficulties and problems, we have to solve and overcome them by going along the chosen road. We must firmly walk down the road of reform and opening up.”

 

Macro Watch:

India Watch

  • Golden opportunities in Indian agriculture (Mckinsey)
  • India’s auto sector (Mckinsey)
  • India PM performance (SPIVA)
  • India’s Russia arm deal (WSJ)
  • India’s game-changing healthcare plan (Lowy)

China Watch:

  • The world’s longest sea-bridge opens (CNN) (QZ)
  • China’s influence on global tourism is growing (SCMP)
  • China,US, miscalculation, war (Axios)
  • Apple denies China hacking story (Buzzfeed)
  • US pork hit hard by China tariffs (WSJ)
  • China faces a debt iceberg (FT)
  • Hainan free trade zone to boost international tourism (Caixing )
  • Is there a new “cold war” (WIC)
  • China middle-class desperate to get money overseas (SCMP)
  • Yan Lianke’s forbidden satire of China (New Yorker)
  • Chinese actress to pay $129 million tax-evasion fine (WIC)

China Technology Watch

  • China’s smart-phone offerings (The Verge)
  • The battle for 5G (SCMP)
  • Dutch battery firm to build plant in China (FT)
  • Hacking accusations against China seek to undermine China tech (Lowy)
  • Big tech in China moving closer to Party (Lowy)

Brazil Watch

  • Dark times coming to Brazil (NYT)
  • Brazil’s Bolsonaro (New Yorker)
  • In Brazil, campaign promises but no money (WSJ)
  • Emerging markets’ lost decade (Blackrock)
  • Brazil’s gene-edited angus cow (WSJ)

EM Investor Watch

  • Are developing countries converging (PIIE)
  • Turkey, the 1994 crisis (Seeking Alpha)
  • What next for Turkish-American relations (GMFUS)
  • The Global Competitiveness Report  2018 (WEFORUM)
  • The World Bank’s Human Capital Report (World Bank)
  • Indonesia’s bullet-train is stalled (Caixing)
  • Russia’s missed tech opportunity (Hoover)

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

Investing

  • KKR white paper on asset allocation (KKR)
  • Monish Pabrai’s ten commandments (Youtube)
  • SPIVA’s mid-year assessment of mutual fund performance (SPIVA)
  • Update on the Buffett indicator (Advisor Perspectives)
  • Factor investing in emerging markets (http://ETF.com)
  • Challenging the conventional wisdom on asset managers (SSRN)
  • What does an EV/EBITDA multiple mean? (Blue Mountain)
  • Joel Greenblatt’s talk at Google (Youtube)
  • Consequences of current account imbalances (Private Debt Project)

 

 

 

 

 

 

 

Emerging Markets Have a Human Capital Problem

Countries develop economically and allow their citizens to prosper when they provide basic public goods and services with reasonably low taxes.  The responsibility of government is to promote a healthy environment  for the development of human capital, which entails the provision of  an efficient legal system, public security and basic social and physical infrastructure. Once these are present, the conditions may be propitious to unleash entrepreneurial activity and innovation.

Most governments in developing countries do not achieve the good standards of governance that deliver sustained improvements in prosperity. After an initial wave of productivity growth driven by urbanization and technology transfer, growth stalls for most countries. Latin America, with its low productivity and GDP growth over the past three decades, typifies this process, while the Asian tigers (Hong Kong, Korea, Singapore, Taiwan) provide rare exceptions. The reasons for growth stagnation are many but one stands out:  rent-seeking, extractive agents are allowed to flourish at the expense of society as a whole, until eventually the capacity of the state to provide basic public goods is exhausted.

Two separate annual surveys – one by the World Bank (Doing Business)  and the other by the World Economic Forum (WEF 2018)  – describe in detail the burdens on growth imposed by extractive forces on countries, making difficult the activities of citizens and enterprises.  These surveys rank countries in terms of “the ease of doing business.”  Because they have been conducted for many years, they allow us to evaluate how countries evolve over time.  A new survey launched this week by the World Bank, which focuses exclusively on the quality of human capital, is an important addition to the understanding of the growth challenges faced by developing countries.

The measure of a country’s human capital is probably the most important indicator of whether a government is providing basic education and health services to its people.  A citizenry that is unhealthy and uneducated will not be productive in its own country and will not compete successfully in the world. The importance of human capital has never been greater than today as technology (robotics, 3D printing, etc…) increasingly poses a threat to menial labor around the world.

The World Bank Human Capital Index (HCI)  tabulates health and education indicators to measure the relative development of human capital in 157 countries. In this report, Singapore is ranked the country with the highest level of human capital while Chad has the lowest rank. The chart below shows a sample of the ranking, focusing on important countries for emerging markets investors.

 

The high rankings of the Asian tigers go a long way towards explaining their remarkable economic success (Taiwan is not included in the HCI, but it would also rank near the top). These countries have a high capacity for investing in public goods and do an exceptional job at providing the basic public services that their citizens need to prosper. China ranks relatively well in the context of emerging economies and appears to be moving in the direction of the Asian tigers, with already high levels of HCI in major cities like Shanghai and Beijing. Vietnam also shows positive signs that it may follow in the path of the Asian tigers.

The remainder of Asia is a mixed bag. Thailand and Malaysia are much less effective in providing public goods and services to their citizens. This likely will stifle their growth, and they may increasingly be squeezed between new low-labor-cost competitors and highly productive developed economies. Indonesia, Philippines and especially India all do a very poor job for their citizens. However, unlike Thailand and Malaysia, they have large markets and still have high, early-stage development growth potential.

Eastern European countries formerly of the Soviet bloc score well in the World Bank HIC rankings. With high-quality human capital and accelerated integration into the very large western European market, these countries are well positioned to prosper.  Russia less so; though HCI is good, the country has not chosen integration with Europe, preferring instead to pursue costly geopolitical ambitions.

Latin America, by-and-large, has low rankings which will compromise its future performance in the global economy.  Only Chile appears on the right track towards improving human capital. Most of Latin America consist of  middle-income countries with poor human capital and seems badly equipped to face the future. For small economies the best path must be to seek full integration with the global economy but distance is a problem. Brazil, with its large market and huge potential to improve the business environment, and Mexico with its proximity to the U.S. and trade integration,  have the best prospects.

The major African economies are very poorly positioned, with very poor HCI rankings. This bad situation is worsened by extensive “brain drain,” as educated people leave these countries for better opportunities elsewhere.

 

Macro Watch:

India Watch

  • India’s Russia arm deal (WSJ)
  • India’s game-changing healthcare plan (Lowy)

China Watch:

  • US pork hit hard by China tariffs (WSJ)
  • China faces a debt iceberg (FT)
  • Hainan free trade zone to boost international tourism (Caixing )
  • Is there a new “cold war” (WIC)
  • China middle-class desperate to get money overseas (SCMP)
  • Yan Lianke’s forbidden satire of China (New Yorker)
  • Chinese actress to pay $129 million tax-evasion fine (WIC)
  • A strategy for dealing with China (PIIE)
  • China and Islam ( Hoover)
  • Gloves off in China-US conflict (Axios)
  • The garlic war (AXIOS)

China Technology Watch

  • China’s smart-phone offerings (The Verge)
  • The battle for 5G (SCMP)
  • Dutch battery firm to build plant in China (FT)
  • Hacking accusations against China seek to undermine China tech (Lowy)
  • Big tech in China moving closer to Party (Lowy)
  • BMW takes control of China venture (WSJ
  • China aircraft sector slow take-off (SCMP)

Brazil Watch

  • Brazil’s Bolsonaro (New Yorker)
  • In Brazil, campaign promises but no money (WSJ)
  • Emerging markets’ lost decade (Blackrock)
  • Brazil’s gene-edited angus cow (WSJ)
  • Brazil’s social media election (FT)
  • How to fix Brazil’s economy (Project Syndicate)

EM Investor Watch

  • Turkey, the 1994 crisis (Seeking Alpha)
  • What next for Turkish-American relations (GMFUS)
  • The Global Competitiveness Report  2018 (WEFORUM)
  • The World Bank’s Human Capital Report (World Bank)
  • Indonesia’s bullet-train is stalled (Caixing)
  • Russia’s missed tech opportunity (Hoover)

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

Investing

 

 

 

 

 

 

The U.S.-China “Cold War”

 

Until recently, China and the United States had a convenient symbiotic relationship whereby China supplied cheap consumer goods to the U.S. consumer in exchange for dollars which it then invested in U.S. treasury bills. The relationship was perceived to be largely benign and mutually beneficial. For China, access to the U.S. market allowed it to follow the path followed in the past by its Northeast Asia neighbors (Japan, Korea and Taiwan), gradually moving up the value chain from toys, to textiles to electronics…etc. For the U.S., cheap Chinese goods increased consumer purchasing power at a time of stagnant wages. Geo-political strategists in Washington imagined that as China prospered it would start to act more like a Western liberal democracy.

However, since the arrival of Trump the relationship has frayed, and the two countries are now on the verge of a full-fledged “cold war.” Though Trump’s  anti-globalization and protectionist rhetoric may have galvanized opposition to China, the change in Washington is deep-rooted and largely consensual. Today, China-bashing is one of the few things that unite republicans and democrats, and the Washington establishment has made a remarkable about-face and now actively demonizes China. What was once seen as a “win-win” relationship is now perceived to be heavily skewed in favor of Beijing.

The current line of thinking in Washington is that China has abused American goodwill. While the U.S. opened its markets for Chinese exports and investments, China gamed WTO rules, restricted access to its market for trade and investments and sponsored the theft of intellectual property. Moreover, it has suddenly dawned on the Washington intelligentsia that China does not intend to become a liberal democracy. This makes China very different from previous beneficiaries of the “Pax Americana,” such as Germany, Japan and the Asian tigers. China is also different because of its huge scale and a growing economy that may, if it follows its current growth path, surpass the U.S. economy over the next decade. For the first time ever, China is now seen as a potential hegemonic rival that must be thwarted.

Washington’s new-found condemnation of China grew in tandem with the ascendency of Xi Xinping, his consolidation of power and his “coronation” in October, 2017 as “leader for life.”  Prior to Xi, Chinese leaders had projected  diffidence and humility. This was best expressed by Deng Xiaoping who advised: “Observe calmly; secure our position; cope with affairs calmly; hide our capacities and bide our time; be good at maintaining a low profile; and never claim leadership.”  However, Xi has come to symbolize a new more militant, arrogant and ambitious China, with pretentions of global leadership. Most emblematic of this are Xi’s two core policy initiatives: One-Belt-One-Road, which seeks to project Chinese influence and investments outside of China, particularly along the old “Silk Road” and international shipping routes; and the “Made in China 2025” industrial planning policy which aims to move Chinese manufacturing up the value chain into frontier technologies.

The U.S. is critical of both of these initiatives because they are seen as anti-market products of a command economy, made possible by state subsidies and state companies. These policies and Xi’s stated objective of strengthening state capitalism and the role of the Communist Party are seen by Washington as indicative that China is a non-market economy that operates by different rules than Western economies. Topping off Washington’s grievances is the perception that Xi is taking China down a new path of military expansionism which threatens Asian stability.

With Trump at the helm, there is a very high probability of further deterioration in the relationship with China. As JPMorgan strategists wrote last week  “a full-blown trade war becomes our new base case scenario for 2019.” It is increasingly likely that a 25% tariff will be imposed on all Chinese goods early next year.

Currently, the two countries are at an impasse. Trump believes that the Chinese will surrender on his terms as the Chinese economy deteriorates. Xi believes the state-run Chinese economy is resilient, and China can wait patiently for changes in the U.S. political and economic cycles. China is convinced that the U.S. is now undermining the post-war economic order because it is determined to thwart China’s economic rise. Its response has been to act as a responsible member of the rules-based international community, gradually adapting to the legitimate demands of its commercial partners. An example of this is China’s recent elimination of joint-venture requirements in the auto sector (this week BMW announced it is taking full control of its JV with Brilliance China).

The two countries are probably underestimating each other’s resolve, which means that the quarrel with have long-term consequences. What may be these be?

  • Tariffs and disruption of supply chains will boost inflation in the U.S. and bring the late-cycle U.S. economy closer to recession. Over the short term, little can be done to substitute Chinese imports, and tariffs will act as a large tax on consumers. Over the medium term, countries like Vietnam, Bangladesh, and Mexico can replace China as manufacturing bases for the U.S. consumer. Over the long-term robotics may change everything and allow a contraction of manufacturing supply chains.
  • European and Asian firms will take advantage of the trade war to take market share from U.S. firms in the Chinese market.
  • As indicated by the poor performance of the stock market, the Chinese economy may become less stable. China already faces big challenges dealing with high debt levels and malinvestment, while it moves from an investment and export driven economy to one based on consumption. A trade war with the U.S. can only make this transition more difficult, and this may have significant negative consequences for the global economy. Given that EM stocks are mainly driven by events in China and the U.S., the disruption of the China-U.S. relationship will surely have very serious consequences.
  • Over the medium term, there may be a retrenchment in globalization and an acceleration of regional blocs and multipolarity. Firms will have to think about operating in increasingly separate ecosystems, each with its own supply chains and technological platforms: one supply chain will serve the U.S. market; another will be structured for the Chinese market. This process is in full acceleration: Huawei and ZTE have been banned from the U.S.; the U.S. is accusing China of hacking supply-chain components sourced in China; China is determined to become self-reliant in key components for the high-tech sector.
  • Initially, one of the few clear winners of this “Cold War” may be Mexico. The Mexican government smartly outmaneuvered Trump and secured the basics of NAFTA in exchange for a new name (USMCA). The deal allowed Trump to say that “the worst trade deal ever” has now become “a great deal, the most important trade deal we have ever made.” The new deal may make Mexico the manufacturing base of choice for firms seeking the combination of easy access to the U.S. market and cheap labor.

Macro Watch:

  • The weak fundamentals of the global economy (Project Syndicate)
  • Trump’s poison pill for China (Yardeni)
  • U.S. tariffs on China are not short term strategy (WSJ)
  • The decline of the dollar standard (Project Syndicate)
  • The U.S. will win this trade war (Gary Shilling)
  • New NAFTA is a relief (The Economist)
  • Brazilian democracy on the brink (Project)
  • The Tyranny of the US dollar (Bloomberg)
  • Trump’s rebranded NAFTA (Bloomberg
  • New NAFTA shows limits of “America First” (WSJ)
  • NAFTA to USMCA – What in a name? (Lowy)

India Watch

  • India’s Russia arm deal (WSJ)
  • India’s game-changing healthcare plan (Lowy)
  • Measuring Indian equities (S&P)
  • Modi is no populist (Foreign Policy)

 

China Watch:

  • Chinese actress to pay $129 million tax-evasion fine (WIC)
  • A strategy for dealing with China (PIIE)
  • China and Islam ( Hoover)
  • Gloves off in China-US conflict (Axios)
  • The garlic war (AXIOS)
  • Chinese U.S. investments plummet (SCMP)
  • China-U.S. ties now driven by conflict and containment (CSIS)
  • VP Pence’s cold war China speech (NYtimes)
  • U.S.-China trade relations forever broken (SCMP)
  • The U.S. will lose its trade war with China   (Project Syndicate)
  • Hong Kong mainland bullet-train link opens (WIC)
  • China’s embracement of Russia (SCMP)

China Technology Watch

  • BMW takes control of China venture (WSJ
  • China aircraft sector slow take-off (SCMP)
  • How the US halted China cyber-attacks (Wired)
  • Huawei’s new chips (WSJ) and (Tech Review)
  • Most Chinese patents are worthless (Bloomberg)
  • Chinese provinces keen to attract EV investments (Caixing)
  • How China sustematically steals technology (WSJ)

Brazil Watch

  • Brazil’s Bolsonaro (New Yorker)
  • In Brazil, campaign promises but no money (WSJ)
  • Emerging markets’ lost decade (Blackrock)
  • Brazil’s gene-edited angus cow (WSJ)
  • Brazil’s social media election (FT)
  • How to fix Brazil’s economy (Project Syndicate)

EM Investor Watch

  • Indonesia’s bullet-train is stalled (Caixing)
  • Russia’s missed tech opportunity (Hoover)
  • Emerging markets’ lost decade (Blackrock)
  • SPIVA Latin American Scorecard (S&P)

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

Investing

 

 

 

 

The Outlook for Emerging Markets Stocks

 

As discussed in prior posts (stormy-waters-in-emerging-markets ), the environment for emerging markets investing has deteriorated since January of this year. We are in the midst of a typical “risk off” phase for global liquidity, which causes investors to seek the safety of dollar assets. This is happening after a period of historically low interest rates which lured many EM countries into borrowing in dollars. Turkey is the poster child for this moment, having as it has for several years funded a construction and consumption boom and large current accounts deficits with dollar-funding provided by yield-hungry foreign investors.

Poor Global Liquidity is Bad for EM Equities

The current rise in risk aversion has several explanations, all of which have led to a strengthening dollar, poor global liquidity  and pain for EM.

  • A huge, late cycle fiscal expansion has boosted U.S. GDP growth at a time when both China and Europe have experienced unexpected economic slowdowns.
  • Rising inflation expectations are leading the U.S. Fed to move forward to “normalize” monetary policy, resulting in significantly higher long-term interest rates and growing spreads between U.S. yields and those of Europe and Japan. Inflation expectations are rising because of economic overheating, rising tariffs and supply chain disruptions, and high oil prices.
  • President Trump’s anti-globalization policies and the unilateral “take it or leave it” approach to diplomacy is increasing tensions and forcing companies to reconsider investments.

Global dollar liquidity is now declining. In essence, dollar supply is tightening, which makes it difficult for dollar borrowers to repay loans and for global trade to grow. Chart 1  below shows the year-on-year change in dollar liquidity, measured by combining the U.S. monetary base with Foreign Central Bank Reserves. While global GDP is growing at above 3% per year, the data shows that dollar liquidity has been growing by less than 1% this year, a steady decline from the 8% growth achieved in 2012.  Chart 2  below shows that reserves held by foreign central banks also peaked in 2012. It is not a coincidence that the dollar has persistently strengthened  against EM currencies since 2012. This rise of the dollar against EM currencies is shown in Chart 3.

Chart 1. Year-on-year increase in global liquidity (IMF,FED)

Chart2. Dollar Reserves held by Central Banks (FED)

Chart 3. EM currencies against the U.S. dollar (MSCI, Yardeni Research)

Valuations are Compelling

Though current conditions of tight global liquidity and a rising dollar are detrimental for EM equities, valuations are compelling.  When global liquidity conditions improve, EM equities can provide high returns from current levels. Valuations are now at very attractive levels,  both in absolute terms and relative to history and alternative asset classes. As shown in the table below, expected dollar real returns for the next 7 years are in the order of  9.5% annually, which compares to 6% real returns (before dividends) experienced over the past three decades. These expected returns are estimated by assuming mean reversion for both valuations and earnings to historical trend lines and assuming earnings growth to be in line with GDP growth.

Similar exercises by GMO (Link) and Research Affiliates (Link) reach slightly different conclusions but all point to significantly superior returns in EM relative to other asset classes.

 

 

Conducting a similar exercise within the EM universe, we can rank from a quantitative viewpoint the expected returns of individual markets. The first chart below shows valuation parameters for major EM markets. The final column shows the gap between the current cyclically adjusted price earnings ratios and the historical “normalized” level for each market.

Finally, the table below ranks EM countries in terms of expected future returns from current levels. Not surprisingly, recent problematic markets such as Turkey, Colombia, Indonesia and Russia appear to be priced very low compared to their histories. As always, investors tend to extrapolate the recent past and find it very difficult to imagine a return to historical trends.

India, which until very recently was the market darling, also looks very attractive again., assuming it can deliver on very high expected GDP growth (IMF estimates) and return to higher earnings multiples.

Expensive markets, such as Taiwan, Thailand, Peru and the Philippines, all trade at multiples that are above historical norms and have enjoyed powerful earnings cycles that are also well above trend.

 

Macro Watch:

  • New NAFTA shows limits of “America First” (WSJ)
  • NAFTA to USMCA – What in a name? (Lowy)
  • Market Insights for a tripolar world  (TPWIM)
  • Robert Zoellick on China (Caixing)

India Watch

  • India’s Russia arm deal (WSJ)
  • India’s game-changing healthcare plan (Lowy)
  • Measuring Indian equities (S&P)
  • Modi is no populist (Foreign Policy)

 

China Watch:

  • Chinese U.S. investments plummet (SCMP)
  • China-U.S. ties now driven by conflict and containment (CSIS)
  • VP Pence’s cold war China speech (NYtimes)
  • U.S.-China trade relations forever broken (SCMP)
  • The U.S. will lose its trade war with China   (Project Syndicate)
  • Hong Kong mainland bullet-train link opens (WIC)
  • China’s embracement of Russia (SCMP)
  • MSCI to step-up A-share inclusion (SCMP)
  • Trump prepares new China attack (Axios)

China Technology Watch

  • Most Chinese patents are worthless (Bloomberg)
  • Chinese provinces keen to attract EV investments (Caixing)
  • How China sustematically steals technology (WSJ)
  • China and India lead the surge to renewables (FT)

EM Investor Watch

  • In Brazil, campaign promises but no money (WSJ)
  • Emerging markets’ lost decade (Blackrock)
  • Brazil’s gene-edited angus cow (WSJ)
  • Brazil’s social media election (FT)
  • SPIVA Latin American Scorecard (S&P)
  • What the crisis in Venezuela reveals (Project Syndicate)
  • Brazil’s polarized election  (Lombard Odier)

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

Investing

 

 

 

Weekend Reading

Macro Watch:

India Watch

China Watch:

  • The U.S. will lose its trade war with China   (Project Syndicate)
  • Hong Kong mainland bullet-train link opens (WIC)
  • China’s embracement of Russia (SCMP)
  • MSCI to step-up A-share inclusion (SCMP)
  • Trump prepares new China attack (Axios)
  • China’s steady deleveraging (Marcopolo)
  • China International Travel Monitor (Hotels.com)
  • China’s Tourism Boom (WIC)
  • Sany, inside the factory of China’s future (WSJ)
  • Trump is misreading China (Bloomberg)

China Technology Watch

  • How China sustematically steals technology (WSJ)
  • China and India lead the surge to renewables (FT)
  • The man behind Meituan (SCMP)
  • China’s authoritarian data strategy (MIT Tech Review)

EM Investor Watch

Tech Watch

  • The plan to end malaria with CRSPR (Wired)
  • Tesla; software and disruption (Ben Evans)
  • EV sales are ramping up (Bloomberg)

Investing

 

 

 

 

Gloom and Populism in Emerging Markets

A recent report by the Pew Research Center ( Link), a Washington think-tank that looks at U.S. and global trends, sheds some light on political trends and growth prospects in emerging markets.

Here are some highlights from the report:

The Present is Gloomy   

In the developed world people consider present economic conditions to be very good, at the highest level of approval since 2002. However, the situation in emerging markets is much less positive. The only countries where over half of respondents feel good about the present are Poland, India, Indonesia and the Philippines. In India, 56% see economic conditions as good but this has fallen from 83% in 2017. Only 9% of Brazilians, 17% of Argentines and 27% of Mexicans feel good about present conditions.

The Past Was Better

In most emerging markets there is nostalgia for supposed past “golden ages.” A general belief exists that financial conditions were the same or better twenty years ago. India, Indonesia and Poland are the only countries were a majority believes conditions are better today. In Mexico only 16% believe conditions have improved.

The Future is Bleak

There is a strong consensus in both developed and emerging markets that future generations will be worse off. This is true across-the-board in developed markets. In EM, only Poland, Russia, Indonesia, Nigeria, India and the Philippines are the exceptions. Only 42% of Brazilians, 36% of Mexicans and 37% of Argentines believe that their children will be better off (from currently dire conditions), and the median for EM as a group is 42%. The deterioration in Brazil has been dramatic. In 2013, 77% of Brazilians were confident that their children would have a better future.

Some Thoughts on the Data

  • Given nostalgia for the past and the belief that the future is bleak, it is not surprising that voters are turning away from political incumbents. Trump in the U.S. (nostalgia for 1950-60 manufacturing might); Bolsonaro in Brazil (a return to the stronghanded “law and order” regime of 1960-80); Lopez Obrador in Mexico (rejection of free-market technocrats). With only 16% of Mexicans believing that their situation has improved over the past 20 years, it is not surprising that they look for alternatives. The same goes for Brazilians, of which only 9% feel good about the present.
  • The recent deterioration in present conditions in India should be a worry for investors as we enter an election year. It would not be surprising for the government to pursue more populist policies ahead of the lection.
  • The Pew Research universe is limited and does not consider China. Adding China would probably skew the data more positively.

Here are a few charts from the report:

 

Macro Watch:

India Watch

China Watch:

China Technology Watch

EM Investor Watch

Tech Watch

Investing

 

 

Are Brazilian Stocks Cheap?

Brazilian stock prices have fallen by 35% in U.S. dollar terms since February, extending a decade long bear market. As shown in the chart below, Brazilian stocks (MSCI Brazil) have provided total investor returns of negative 40% over the past ten years. This compares to positive 27% for the broad MSCI Emerging Markets Index and 181% of the S&P 500 Index.

Much of this abysmal performance can be attributed to mean reversion, in the sense that Brazil has simply given back the high relative returns it enjoyed during the 2001-2011 period. In fact, over the past 18 years total stock market returns in Brazil  (including dividends) have surpassed those of the U.S. market and are only slightly inferior to those of MSCI EM. This is shown in the next chart.

Brazil’s boom-to-bust tale is easily explained. Ample global liquidity and cheap capital, high commodity prices and a weak dollar fueled a credit and consumption boom until 2012. Since then a strengthening dollar, tighter liquidity and falling commodity prices have taken the air out of Brazilian asset prices and weakened the Brazilian real (BRL).  The deteriorating global backdrop has been made much worse by Brazil’s own problems: debilitating corruption scandals, out-of-control government spending and a draconian monetary policy. Today, on the eve of a critical presidential election, the country faces the prospects of a severe deterioration in its solvency and an extended period of low GDP growth unless profound reforms can be implemented. The solvency problem is very real and the result of enormous fiscal deficits and growing entitlement spending. The chart below shows the growth of public debt and its expected further deterioration, according to IMF estimates.

Brazil is at a crossroads, facing a binary event with the upcoming election. If either one of the two reformist candidates (Jair Bolsonaro and Geraldo Alckmin) win the upcoming election the market is likely to applaud their ambitious free-market agendas. Successful reforms (privatization, deregulation, social security reform) could unleash “animal spirits” and propel the economy to a higher growth rate. However, the result of the election is unpredictable, and even if a reformist candidate wins it will be a battle to push legislation through a Congress captured by special interests.

Given the political uncertainty, how should the investor evaluate the potential upside from investing in Brazil?  We should start with a view on the economy and where we are in the business cycle. We also need to have an opinion on the Brazilian currency’s valuation relative to the dollar. This will provide us an idea of how much earnings can increase over the next 3-4 years. Finally, we should understand where valuations are today and a view on how they might evolve in the future.

What is Brazil’s long term potential GDP growth and where are we in the business cycle?

The base case for the conservative investors should be for Brazil to maintain its long-standing GDP growth path of 2-2.5% per year over a full business cycle. This low growth path has existed for three decades now, the result of a very bloated and ineffective government. Governance in Brazil is very poor, marred by extreme corruption and very powerful interest groups that oppose reforms.

However, Brazil is early in its business cycle, a period characterized by a large output gap and ample idle capacity. This provides the opportunity for the economy to grow above potential for several years as the output gap is closed, perhaps at a rate of 3-4% per year. The following chart shows the long-term trajectory of Brazilian GDP and where we stand today relative to trend (dotted line). In the wake of the 2014-2017 recession, we are clearly below trend, but not nearly as much as in 2002 when the previous bull market for stocks started.

The main reason that the output gap is much smaller than 2002 is because the BRL has been relatively stable. This is because of the war-chest in foreign reserves built up over the past decade and the Central Bank’s willingness to use them to stabilize the currency. The following chart, from the IMF,  shows Brazil’s real effective exchange rate for the past 30 years. Even after the recent weakness, the BRL is less than 10% undervalued, much less than it was in 1988, 2002 or 2016.

Earnings

If we assume that the economy continues on the path of recovery, the prospects for earnings and the stock market are relatively healthy. As shown below, earnings for the stock market (MSCI Brazil) –though they have rebounded from the trough of the recession — remain very depressed, at about the level of ten years ago. This is hown in the chart below.

As the economy recovers, firms will boost margins and return on capital will rise, so that we could see earnings grow significantly. At the same time the BRL could at least return to its REER trend, about 10% above today’s level. The result could easily be a 50-60% increase in dollar earnings from today’s depressed level over the next 2-3 years.

Historically, corporate earnings growth is very closely tied to GDP growth. Looking at the data in the chart above, between 1986 and 2018 USD nominal earnings grew by 5.8% , which can be decomposed into 2.5% real GDP growth, 2.5% inflation and 0.8% currency appreciation. This is a logical relationship premised on the corporate sector retaining  a relatively constant share of GDP. This link between earnings and GDP leads to the “Buffett Indicator,” a concept which famed investor Warren Buffett has cited as the best measure for valuing the stock market. The Buffett Indicator looks at the value of the stock market relative to GDP over time. Since earnings and GDP maintain a relatively constant relationship, any difference in the value of the stock market relative to GDP can be attributed to valuation (the multiple of earnings implied by the value of the stock market). The Buffett Indicator for Brazil is shown below. The graph shows the relationship between the stock market (Bovespa) and GDP for the past 50 years. Periods where the stock market has been well below GDP are those where valuation multiples have been very low, creating opportunities for investors. We can see that that was the case in 2016 but not so much today. What we do have today is a GDP line which lies well below the trend line (red dotted line). This brings us back to the output gap, and the potential market appreciation based on economic recovery.

Multiples

The price that the market is willing to pay for earnings can vary enormously over time. We look at both the price-to-earnings (PE) multiple on the earnings of the past 12 months and the Cyclically Adjusted Price Earnings multiple (CAPE), which is a ratio made popular by value investor Ben Graham in the 1950s and most recently by Yale professor Robert Schiller. The CAPE smooths out earnings by taking an average of the past ten years of earnings adjusted for inflation. The chart below looks at both PE and CAPE in Brazil for the past 30 years. The CAPE ratio is clearly the better indicator in Brazil, having nicely  pointed out the high valuation of the market in 1996 and 2008 and the low valuation in 2002 and 2014-16.

As the table below shows, the CAPE ratio of 9.6 is low compared to the historical average (1987-2018) and also the average of the past 15 years. However, it has been much lower in the past, ranging from 5.1 to 32.1. Assuming a positive business cycle in Brazil for the next five years, one might expect the CAPE ratio to eventually rise above historical averages.

We can also compare multiples to those of other markets, such as the United States. The table below looks at the sectorial composition of both the MSCI Brazil and the S&P 500, and the multiples by sector for the U.S. market. The U.S. market currently trades at a forward PE multiple of 17.2 times expected earnings for the next 12 months, compared to 10.2 times for Brazil. If we adjust the sector composition of the S&P 500 to make it the same as Brazil’s then the U.S. multiple falls to 15.1. In the case of the CAPE ratio, the S&P 500 currently stands at 33.3 (29.2 adjusted for Brazil’s sector composition) compared to 9.6 in Brazil.

Market Upside

The potential upside for the Brazilian market is good, though not as high as at the bottom of previous corrections in 1982, 1987, 1990 and 2002. The combination of multiple expansion (from a CAPE of 9.6 to 15) and earnings growth (+60% over the next 3 years) could easily result in a doubling or tripling of the stock market.

However, this doesn’t mean that investing in Brazil today is a simple proposition. The market has been much cheaper in the past because of a combination of lower multiples and a very depreciated BRL. The global environment is deteriorating right now for countries like Brazil with fragile economies. At the same time, if the election results in more “social populism” and Brazil’s finance deteriorate further, the BRL and the stock market may still need more time to find a bottom.

 

Macro Watch:

India Watch

China Watch:

China Technology Watch

  • China’s authoritarian data strategy (MIT Tech Review)
  • China’s Tianqi secures stake in Chilean lithium (Caixing)
  • China leads in CRISPR embryo editing (Wired)

EM Investor Watch

  • OUTPERFORMERS: HIGH-GROWTH EMERGING ECONOMIES AND THE COMPANIES THAT PROPEL THEM (Mckinsey Global Institute)
  • A symbol of Brazil’s indifference to history (WSJ)
  • Vietnam’s Economic Miracle (WEFORUM)
  • Moscow flexes its muscle in the East (Atlantic Council)
  • Russia and the U.S. are opposite personalities (Hoover)
  • Emerging markets are no bargains ( WSJ )
  • Par for the course in EM (Bloomberg)

Tech Watch

Investing

 

Global Growth Trends and Emerging Markets

The OECD’s recent report on the long-term growth potential of the global economy  (Link) provides valuable insights on prospects for investing in emerging markets.  Any such exercise on long-term forecasting is fraught with difficulties, as it combines relatively certain variables (population growth and ageing, fiscal sustainability, the catch-up of emerging economies) with complicated assumptions (eg. globalization, technological development) and relies heavily on the extrapolation of the status quo. Nevertheless, the report provides a practical view on medium to long-term prospects for emerging market countries that can be useful in evaluating investment opportunities.

The first chart below shows the expected growth rate of the global economy.  OECD’s economists  expect a significant slowdown in global growth, from 3.7% to 2.7% over the next decade. This assumes steady 2% growth in the OECD, but a sharp slowdown in BRIICS (Brazil, Russia, India, Indonesia, China and South Africa), from 5.5% in 2017 to 3.6% in 2030. The slowdown in BRIICS comes  mainly from much  lower growth in China.

The following chart shows the impact of the expected slowdown in China on the dynamics of global output. China has been the main driver of global growth since 2006, and its contribution to global growth peaked at nearly 50% in 2010 during its massive debt-fueled fiscal expansion which it conducted in response to the global financial crisis. By 2030 China is expected to contribute only 30% of global GDP growth, no more than the  OECD’s share, and it is expected to fall further after that. However, the rapid rise of India will partially compensate for China’s decline, so that if we look at China and India together – a hypothetical “Chindia” – we see that over 60% of global growth will continue to come from these two economies through the middle of the next decade. Over half of global growth will continue to come from “Chindia” for the next 25 years.

 

In fact, as shown in the next two charts, China’s share of global output, will peak over the next ten years. While the OECD’s share of global output will decline from 55% to 47%, China’s share of global output will rise from the current 23% to around 27% by 2030 and then stabilize around that level. This is because China is moving up the technology frontier at a time when the ageing of the population will impact the size of the workforce.   India will take the helm from China to become the main driver of global growth. It faces an entirely different situation than China because it lies very low on the technology frontier and has enormous room to grow its workforce through urbanization and the incorporation of women in the workforce.   “Chindia’s” share of global output will rise from 31% to 40% by 2030 and equal the OECD by 2040.

 

The rise of China and India, and also Indonesia to a lesser degree, are shifting the center of gravity of the world’s economic activity towards Asia. This cause a “remoteness” effect detrimental to countries that are far from Asia. Countries that for past decades have benefited from being near the all-important U.S. consumer market will now bear a remoteness cost with regards to their role in Asia. The chart below shows the winners and losers from this effect.

 

Finally, the OECD decomposes the structure of GDP per capita growth for the past two decades, the proximate future (2018-30) and the long term (2030-60), showing the contributions from labor, capital, working age population and active workforce. The data shows that China’s past growth has come mainly from labor efficiency (migrants moving from farm to factory) and to a lesser degree from more active workers. All of these growth factors for China are declining decade by decade, with a growing negative effect from labor supply. It is interesting to note that by 2030, China’s GDP per capita growth will be only slightly higher that that of the United States while total GDP growth may actually be lower in China because of worse demographics.

The OECD data also illustrates that relatively few emerging markets will maintain a significant growth premium for the next decade (China, India, Indonesia, Turkey); most will have  GDP per capita growth not to different than the U.S. with similar demographic trends (Latin America and South Africa); and Russia has a significantly worse growth profile. These growth profiles need to be incorporated into valuations.

Conclusions

  • For the next ten years and well beyond global growth will be driven by “Chindia.” Given that well over half of global growth will come from these two countries and this may be sustained for an extended period of time creating very large compounding effects, it would seem foolhardy for emerging market investors to not focus most of their attention on these two markets.
  • Over the next decade and beyond,  the world’s center of economic activity will continue to move to Asia. This creates important proximity benefits for countries within the region or with close ties (eg., southeast asia, northeast Asia, Australia, Iran) and remoteness costs to distant nations (eg., Latin America)
  • India will increasingly drive growth. As China increasingly competes with developed economies its growth will slow.
  • Concerns that China will dominate the world economy are probably misplaced. It is likely to become the largest economy in the world over the next 10-15 years but this will be at at time when growth has slowed substantially due to demographic pressures. Also, China’s authoritarian model is likely to create impediments to growth as it becomes more prosperous.
  • Many emerging market countries need to implement reforms to boost their growth profiles. Brazil is a good example of a country that can significantly improve its growth profile through market-friendly reforms.

Macro Watch:

  • Long View scenario for global growth (OECD)
  • Brazil: The first global domino tips (Alhambra Partners)
  • Europe is working on alternative to SWIFT (Zero Hedge)
  • BOE’s Haldane take on Institutions and Development (BOE)
  • Emerging vulnerabilities in emerging economies  (Project Syndicate)

India Watch

  • 70% of rail tickets booked on smartphones (Mumbai Mirror)
  • Buffett invests in India payments platform (WSJ)
  • India’s growing clean air lobby (BNEF)

China Watch:

  • China is bracing for a new cold war (AXIOS)
  • China’s long term growth will slip below the U.S. (Bloomberg)
  • China’s greater bay area (FT)
  • What does a Chinese suerpower look like? ( Bloomberg)
  • The rise of China’s super-cities (HSBC)
  • China’s urban clusters fuel growth (Project Syndicate)

China Technology Watch

  • China’s authoritarian data strategy (MIT Tech Review)
  • China leads in CRISPR embryo editing (Wired)
  • China’s EV start-ups forced to seek state partners (QZ)

EM Investor Watch

  • Emerging markets are no bargains ( WSJ )
  • Par for the course in EM (Bloomberg)
  • Brazil’s health catastrophe in the making (The Lancet)
  • The burden of disease in Russia (The Lancet)
  • Brazil’s nostalgia for dictatorship (NYT)
  • Turkey’s problem is not going away (Bloomberg)

Tech Watch

  • Tesla; software and disruption (Ben Evans)
  • EV sales are ramping up (Bloomberg
  • China and Japan agree to EV charging standard (Nikkei)

Investing

 

 

 

 

 

 

The Global Liquidity Cycle and Emerging Market Stocks

Investing in emerging market equities often requires an understanding of global liquidity cycles. There are two main drivers of global liquidity. First, in a world financial order that is largely U.S. dollar-based, the fiscal and monetary policies of the United States have great influence on global capital flows. Second, in times of heightened financial and political risks, the United States, with its highly liquid markets and rule of law, is seen as a “safe haven.”  When conditions draw international flows into the U.S. financial system, the dollar appreciates. These periods are known as “risk-off” periods, which means that  investors prefer the security and safe-haven nature of the U.S. markets over more volatile international markets. On the other hand, there are times when conditions in the United States become relatively unattractive to investors. During these “risk-on” episodes international investors seek the higher returns available in riskier financial markets like those of the emerging markets. During these periods, the dollar tends to depreciate, while the asset prices of emerging markets rise in value.

USD “risk-off” periods occur when return expectations are higher in the U.S. This is generally because of a combination of higher risk-adjusted returns on financial assets and higher GDP growth. We are currently in such a period. Until January of this year, it appeared that growth outside the U.S. was accelerating, and this was reflected in a weakening dollar. But the market narrative changed swiftly when signs appeared of slowing growth in Europe and China. Soon after, several emerging markets (Brazil, Argentina, Turkey) suffered significant economic setbacks. Global financial risks also rose because of political tension in Italy and concerns with the consequences of a “hard Brexit.” Moreover, an assertive U.S. foreign policy relying heavily on trade war threats and sanctions increased uncertainty.  As world growth sputtered, the late-cycle U.S. economy accelerated, fueled by tax cuts. Concurrently, the U.S. Fed sustained its commitment to raise rates. A   relatively strong U.S. economy with rising rates is very much a “risk off” mode and not surprisingly the dollar has appreciated since January. The rising dollar because of its dampening effect on inflation has also raised the prospect of a further extension of the U.S. business cycle.

During “risk off” periods global liquidity is drawn to the U.S. market, as capital seeks a safe haven.  As the tide of global liquidity ebbs, the most vulnerable merging markets are caught naked. The typical victims are those countries that have a high level of dependence on short-term cross-border financing, usually because they have indulged in a combination of elevated current account and fiscal deficits financed by short-term dollar debt. The current roster includes Turkey, Argentina, South Africa, Indonesia and Brazil. As is often the case, political uncertainties make a bad situation worse, as we see today in Turkey and Brazil.

Emerging markets experience shorter and sharper cycles than the United States. This is intrinsically linked to the nature of the global liquidity cycle. During emerging market downcycles, dollar appreciation accentuates corrections.  At the same time, policy makers are forced to implement pro-cyclical policies that further deepen the downside. A rising dollar acts like a combination of a tax increase and tighter credit, while also driving inflation higher. This is the situation today in Argentina and Turkey where markets (with or without the support of the IMF) are demanding large pro-cyclical adjustments at a time of extreme currency weakness. During upcycles, the opposite happens: currency appreciation and pro-cyclical policies turbo-charge the economy. A weak dollar usually signals world economic expansion and acceleration, and expanding credit.

The U.S. economy exists in a very different environment. The U.S. has  much greater control over its destiny and much longer business cycles, with the overwhelming fundamental advantage that policy makers have both fiscal and monetary tools available for counter-cyclical measures. The current U.S. business cycle, which is now the longest in history, has been made possible by a persistently strong dollar and unprecedented counter-cyclical policies, reaching a climax with President Trump’s massive tax cut. This extended cycle has been made possible by the strong dollar’s repression of inflation.

The end of the current liquidity cycle should bring about the next bull market for emerging market economies and asset markets. This will likely occur in the next 12-18 months as the U.S. business cycle finally exhausts itself. The short-term beneficial effects of Trump’s fiscal expansion and trade policy will wear off, leaving behind more debt and higher inflation. At the same time, U.S. monetary policy will gradually “normalize.” Dollar cycles tend to last 5-8 years. When the cycle eventually turns, a weaker dollar will drive inflation higher in the United States.

The charts below show how tied the investment and dollar cycles are in emerging markets. The first chart, from Yardeni Research, shows the MSCI Emerging Markets Currency Ratio (US$/local currency). This reveals the evolution of the implied exchange rate of a basket of currencies representing the country weights in the MSCI EM index. The index shows three clear periods: 1995-2002 (seven years of dollar strength; 2003-2011 (eight years of dollar weakness; 2012-2018 (six years of dollar strength).

The second chart shows the performance of a global index of emerging market stocks. EM stocks are shown to be a turbo-charged version of the dollar-index, doing well in times of dollar weakness and poorly when the dollar strengthens. Note that the EM equities rally of 2016-17, came to a brutal stop when the dollar resumed its rise. The third chart (capital spectator) illustrates more clearly the negative correlation between EM equities and a rising dollar.

The following three charts show the best two measures we have of how global liquidity is impacting emerging markets. The first chart shows the accumulation of US dollar assets by foreign institutions (ie. Central banks, sovereign funds). These funds come mainly from emerging market central banks that accumulate dollar reserves to stabilize their currencies during periods of sustained dollar weakness. These reserve accumulations are closely linked to episodes of elevated credit expansion because authorities are not willing or able to neutralize the impact on money supply. The second chart, from Gavekal Research, adds the U.S. monetary base to foreign central bank reserves to come up with an estimate of total global US dollar liquidity, which Gavekal calls the world monetary base (WMB).

We can see in these charts a repetition of the pattern we saw above with regards to the dollar and emerging market equities. During period of dollar strength (1995-2002 and 2012-2018) foreign reserves fall in real terms (leading to credit contraction) and poor performance for emerging market assets. Global liquidity contracts during periods of dollar strength, dampening growth prospects in emerging markets. My own data shown in the last chart  (M2 plus foreign assets held at the FED), updated through July 2018, shows a sharp fall in global liquidity since January of this year, signaling further pressure on emerging market assets prices.

Macro Watch:

India Watch:

  • Buffett invests in India payments platform (WSJ)
  • India’s growing clean air lobby (BNEF)

China Watch:

  • The rise of China’s super-cities (HSBC)
  • China’s urban clusters fuel growth (Project Syndicate)
  • Japan auto makers look to China (WSJ)
  • Is China really slowing? (PIIE)
  • The great Chinese art heist (GQ)
  • Thoughts from my Beijing trip (Sinocism)

China Technology Watch

  • China’s authoritarian data strategy (MIT Tech Review)
  • China leads in CRISPR embryo editing (Wired)
  • China’s EV start-ups forced to seek state partners (QZ)
  • How WeChat conquered China (SCMP)
  • Why do Western digital tech firms fail in China (AOM)

EM Investor Watch

  • Brazil’s nostalgia for dictatorship (NYT)
  • Turkey’s problem is not going away (Bloomberg)
  • Erdogan’s power grab (FT)
  • Malaysia rejects China “colonialism” (SCMP)
  • The new arab world order(Carnegie)
  • A history of EM bear markets (Wealthofcommonsense)
  • Turkey’s secular young are losing the country (Ft)

Tech Watch

  • China and Japan agree to EV charging standard (Nikkei)
  • Drones in mining (Youtube)
  • The future of batteries (Wired)

Investing

  • Li Lu’s lecture at Beijing University (Himalaya Capital)
  • Charlie Munger and Li Lu Interview (Guru Focus)
  • Interview with Bill Nygren (Youtube)
  • The 8 best predictors of market returns (WSJ)

 

A Reading List for Emerging Markets

Here is a list of books that I think are useful and interesting for any investor seeking to understand investing in emerging markets. The list reflects my bias for long-term investing rooted in knowledge of history and business cycles. I have included only books published in English, which is a big restriction. Also, I have not included basic investing books, which is an entirely sparate list.

The list is divided into three sections.

  • Macro Economics and Business Cycles
  • Development and Economic Convergence
  • Regions and Countries

The books in each section are listed in no particular order.

1 Macro-economics, business-cycles and financial bubbles

 The Volatility Machine by Michael Pettis

This Time is Different by Reinhart and Rogoff

The Bubble Economy by Chris Wood

Inflation and Monetary Regimes by Peter Bernholz

Money and Capital in Economic Development by Ronald McKinnon

How to Make Money with Global Macro by Javier Gonzalez

Business cycles: history, theory and investment reality by Lars Tvede

Emerging market portfolio strategies, investment performance, transaction cost and liquidity risk by Roberto Violi and  Enrico Camerini II (Link)

Against the Gods by Peter Bernstein

 Alchemy of Finance by George Soros

The Fourth Turning: What the Cycles of History Tell Us About America’s Next Rendezvous with Destiny by William Strauss, Neil Howe

Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages by Carlota Perez

Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay

Manias, Panics, and Crashes: A History of Financial Crises, by  Charles P. Kindleberger and Robert Z. Aliber

Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor

 

2 Development and Economic Convergence

 

 

Civilization and Capitalism, 15th-18th Century, Vol. I: The Structure of Everyday Life by Fernand Braudel

The  Pursuit of Power: Technology, Armed Force, and Society since A.D. 1000  by William H. McNeill

The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor by David S. Landes

Energy and Civilization: A History  by Vaclav Smil

Barriers to Riches (Walras-Pareto Lectures) by Stephen L. Parente, Edward C. Prescott

The Great Convergence: Information Technology and the New Globalization

by Richard Baldwin

A Discussion of Modernization Li Lu (Link)

Slouching Towards Utopia?: AnEconomic History of the Long 20th Century, Brad Delong

Breakout Nations. In Pursuit of the Next Economic Miracles by Rushir Sharma

Why Nations Fail: The Origins of Power, Prosperity, and Poverty  by Daron Acemoglu and James A. Robinson

The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor by David S. Landes

The Birth of Plenty : How the Prosperity of the Modern World was Created by William J. Bernstein

Why Did Europe Conquer the World?    by Philip T. Hoffman

Empire of Cotton: A Global History  by Sven Beckert

The Pursuit of Power: Technology, Armed Force, and Society since A.D. 1000 by William H. McNeil

The White Tiger by Aravind Adiga

How to get Filthy Rich in a Rising Asia by Mohsin Hamid

AI Superpowers: China, Silicon Valley, and the New World Order by Kai-Fu Lee

Growth and Interaction in the World Economy by Angus Maddison

 

 

3 Regions and Countries

 

Latin America

 

Guide to the Perfect Latin American Idiot by Plinio Apuleyo Mendoza, Carlos Alberto Montaner, Alvaro Vargas Llosa

Left Behind: Latin America and the False Promise of Populism by Sebastian Edwards

 

 

Brazil

 

Brazil: A Biography by Lilia M. Schwarcz and Heloisa M. Starling

The Military in Politics: Changing Patterns in Brazil by Alfred C. Stepan

Brazillionaires: Wealth, Power, Decadence, and Hope in an American Country 

by Alex Cuadros

Brazil: The Troubled Rise of a Global Power by Michael Reid

Lanterna na Popa by Roberto Campos

A Concise History of Brazil by  Boris Fausto

A History of Brazil by E. Bradford Burns

 

Mexico

 

The Course of Mexican History by Michael C. Meyer and William L. Sherman

Mexico: Biography of Power. A History of Modern Mexico, 1810-1996 by Enrique  Krauze

 

Turkey and the Middle East

 The Political Economy of Turkey by Zulkuf Aydin

Midnight at the Pera Palace. The Birth of Modern Instanbul, by Charles King

The Prize: The Epic Quest for Oil, Money & Power by Daniel Yergin

The Yacoubian Building by  Alaa Al Aswany

 

Russia

 

Wheel of Fortune. The Battle for Oil and Power in Russia by Thane Gustafson 2012

Red Notice: A True Story of High Finance, Murder, and One Man’s Fight for Justice by Bill Browder

The Future Is History: How Totalitarianism Reclaimed Russia  by Masha Gessen

 

 

 

Asia

 

Asian Godfathers: Money and Power in Hong Kong and Southeast Asia by Joe Studwell

How Asia Works: Success and Failure in the World’s Most Dynamic Region

by Joe Studwell

Lords of the Rim by Sterling Seagrave

 

 

China

 

Factions and Finance in China by Victor C. Shih

Capitalism with Chinese Characteristics. Entrepreneurship and the State by Yasheng Huang

China’s Crony Capitalism: The Dynamics of Regime Decay  by Minxin Pei

CEO, China: The Rise of Xi Jinping by Kerry Brown

Factory Girls: From Village to City in a Changing China by Leslie T. Chang

Avoiding the Fall. China’s Economic Restructuring by  Michael Pettis

The River at the Center of the World by Simon Winchester

Mr. China by Tim Clissold

The China Strategy by Edward Tse

River Town  by Peter Hessler

The Economic History of China: From Antiquity to the Nineteenth Century

by Richard von Glahn

Understanding China: A Guide to China’s Economy, History, and Political Culture 

by John Bryan Starr

China’s Economy: What Everyone Needs to Know  by  Arthur R. Kroeber

Modern China by Jonathan Fenby

The Chinese Economy: Transitions and Growth by Barry Naughton

Wealth and Power. China’s Long March to the 20th Century by David Schell and John Delury

China’s New Confucianism by Daniel Bell

China Fireworks: How to Make Dramatic Wealth from the Fastest-Growing Economy in the World by Robert Hsu

Cracking the China Conundrum: Why Conventional Economic Wisdom Is Wrong

by Yukon Huang

Little Rice: Smartphones, Xiaomi, and the Chinese Dream  by Clay Shirky

Alibaba: The House That Jack Ma Built  by Duncan Clark

 

India

 

India – A Wounded Civilization by by V. S. Naipaul

Behind the Beautiful Forevers by Katherine Boo

 India’s Long Road: The Search for Prosperity by Vijay Joshi

The Billionaire Raj: A Journey Through India’s New Gilded Age by James Crabtree 

Capital: The Eruption of Delhi by Rana Dasgupta

Investing in India: A Value Investor’s Guide to the Biggest Untapped Opportunity in the World by Rahul Saraogi

 

Macro Watch:

India Watch:

  • India’s strong economy leads global growth (IMF)
  • (King coal rules India (Economist)

China Watch:

  • China vs. the U.S.: the other deficits (Caixing)
  • Media warns to avoid Japan’s mistakes (SCMP)
  • China needs to get its house in order (SCMP)
  • China resumes urban rail incestments (Caixing)
  • Chinese firm will take over Iran gas project (Bloomberg)

China Technology Watch

  • How WeChat conquered China (SCMP)
  • Why do Western digital tech firms fail in China (AOM)
  • Hayden Capital on China tech investments (HaydenCapital)
  • A deep look into Alibaba’s 20F (Deep Throat)
  • China’s rise in bio-tech (WSJ)

EM Investor Watch

  • Turkey could be worse than Greece (dlacalle)
  • The West’s broken relationsip with Turkey (Project Syndicate)
  • Africa cannot count on growth dividend (FT)

Tech Watch

  • Drones in mining (Youtube)
  • The future of batteries (Wired)

Investing

  • Li Lu’s lecture at Beijing University (Himalaya Capital)
  • Charlie Munger and Li Lu Interview (Guru Focus)
  • Interview with Bill Nygren (Youtube)
  • The 8 best predictors of market returns (WSJ)

The “Buffett Indicator” and Emerging Markets

Market seers look at various indicators to predict future returns for stocks. By looking at the historical relationship between the indicator and the value of the stock market analysts seek to establish a statistical pattern that if repeated in the future can provide an indication of probable prospective returns for stocks from current levels. Several popular indicators used by forecasters include the following: market value to sales; market value to inflation-adjusted average ten-year earnings (CAPE); and market value to Gross National Product (GNP). This last one is known as the “Buffett Indicator” because Warren Buffett noted in 2001 that it is “probably the best single measure of where valuations stand at any given moment.” The underlying premise of the “Buffett Indicator” is that over the long-term corporate earnings remain constant in proportion to GDP. Though this is not true over the short term (e.g. corporate earnings have risen much more than GNP over the past decade), the assumption is that eventually they revert.

Let us look at the Buffett Indicator; first for the U.S. market, and then for several emerging markets. The chart below graphs both U.S. GDP and the U.S. stock market for the past sixty years. It is interesting to look at the graph in the context of Buffett’s investment career, which coincidentally extends for the sixty years of data. First, the period from 1960 to 1970 was one of consternation for value investors like Buffett who felt that valuations were extremely high. Buffett closed his initial partnership in 1969, partially because he felt valuations were too high to remain invested. Second, the period 1974 to 1997 which were Buffett’s most successful years. He thrived in the 1970s, an environment of very low valuations caused by high inflation. Third, 1998 to 2001 was a period of serious underperformance for Buffett, as he was out of the high-flying technology stocks. Fourth, from 2001 until today, Buffett has not performed as well as in the past, only outperforming the market during the large drawdowns of 2002 and 2008. The “Buffett Indicator” today points to very high valuations, and probably to a big opportunity for Buffett to capture alpha (relative market performance) in the next downturn.

It is easy to see why Buffett would like this indicator. When the market line is below the GNP line the investment environment is favorable to value investors like Buffett. When the market line is above the GNP line, the environment is favorable to “growth” investors who prefer leading-edge companies with rosy prospects.

In the case of emerging markets, we look at three countries: Brazil, Turkey and India (charts below). These three markets all have enough historical data to identify patterns, which is less true for markets with short histories like China and Russia. Brazil and Turkey are very volatile “trading” markets. India is a less volatile market with more extended trends. Our data is all dollarized because we are dollar-centric investors, but consequently both GNP data and market data are greatly accentuated by currency effects. The GNP data is from The World Bank.

Brazil

Following the “economic miracle” (1968-71), Brazil entered an extended period of rising inflation and malinvestment (1972-1980). During this period of high economic growth, the stock market greatly underperformed GNP, leading to exceptionally low valuations. During the period of “re-democratization”  (1982-1990), the market initially rallied strongly but then entered  into a long period of extreme volatility driven by various failed plans to bring economic stability. Since the economic stabilization brought by the Plano Real (1994) the stock market has followed GNP more closely, falling in periods of recession and rising during periods of economic growth and optimism. After the liquidity and credit driven boom of 2002-2010 economic recession and currency weakness has brought the market down. Since 2016 the market has rallied on the hope of new reforms and economic recovery. If this hope fades, the market is likely to resume its decline.

Turkey

Like Brazil, Turkey is a market of great stock market volatility cause by repeated economic instability and long periods of economic stagnation. Also, like Brazil, this volatility makes Turkey a great “trading” market. Though the market over time follows the course of GNP, over the shorter-term it constantly veers above and below the GNP trend line creating trading opportunities. Since the market collapse in 2008, the market has significantly disconnected from GNP. Unlike Brazil, where the market is pricing in economic recovery, the Turkish market is in deep value territory. Based on its history of sharp stock market recoveries, the current position well below the GNP trend line positions it for a sharp rally.

India

The Indian market has closely followed the GNP trend line. The chart below covers essentially the period since the economic “opening” launched by Finance Minister Manmohan Singh in 1991. This period, from 1991 to today, has been one of relative stability and rising economic growth, conditions which are highly favorable for stock market appreciation. Different to China or Brazil in the 1970s, the Indian market is dominated by profit-oriented private companies. The contrast with Turkey and Brazil is also obvious: the Indian market is much less volatile and has followed the course of a rising GNP more closely. Periods of relative pessimism, when the market has traded below the GNP trend line, have been valuable buying opportunities for the long-term investor, while the dramatic overshooting in 2008, in retrospect, was an obvious time to reduce positions. The market offered its last good buying opportunity in 2017 and today looks only slightly undervalued relative to the GNP trendline.

Problems with the Buffett Indicator

There are potential issues with the Buffett Indicator.

First, the underlying assumption of stable corporate earnings relative to economic activity may be wrong. Or it may be correct for the United States but not for other markets.

Second, there are many measurement issues. These relate to the accuracy of GNP measurements and accounting issues. Both GNP calculation methodology and accounting standards evolve over time, and this may undermine historical comparisons.

Macro Watch:

India Watch:

  • India’s strong economy leads global growth (IMF)
  • (King coal rules India (Economist)
  • Apple is struggling in India (Bloomberg)

China Watch:

China Technology Watch

  • China’s rise in bio-tech (WSJ)
  • Berlin blocks Chinese acquisition (Caixing)
  • The man behind Pinduoduo (WIC)
  • Wake up call for China’s chip industry (Caixing)

EM Investor Watch

  • Brazil’s populist temptation (Project Syndicate)
  • Turkey’s rejection of the West (FT)
  • Thailand’s economic challenge (Cogitasia)
  • GMO makes the case for EM

Tech Watch

  • The future of batteries (Wired)
  • The world’s largest solar farm in Egypt (LA Times)

Investing

  • Li Lu’s lecture at Beijing University (Himalaya Capital)
  • Charlie Munger and Li Lu Interview (Guru Focus)
  • Interview with Bill Nygren (Youtube)
  • The 8 best predictors of market returns (WSJ)

Mean Reversion in Emerging Markets

Over the short-term stock prices are mainly driven by liquidity and human emotions, but over the long-term fundamental valuation is the key variable.  This leads to mean reversion being one of the few constant rules of investing, as both liquidity and human behavioral cycles normalize over time. Over a ten-year period (approximately two investment cycles), one should expect mean reversion to run its course, and the evidence is strong that it does in emerging markets.

The past ten years in emerging markets have been dismal for investors, largely because the previous had been very good. As the chart below shows, emerging markets outperformed dramatically for the ten years leading to July-end 2008 and now have underperformed for the past ten years. By year -end 2017 the two indices were even, though during the first half of this year the S&P500 has once gain taken a small lead.

Over the long term there are only two drivers of stock performance: (1) Earnings growth, which is closely linked to GDP growth; and (2) the price-to earnings multiple, which is tied to liquidity and human emotions as well as interest rates and inflation. Current projections by the IMF and others anticipate that GDP growth for emerging markets as a whole will average about 5% for the next 5-10 years, compared to around 2% for the United States and other developed markets. This means that earnings growth in emerging markets should be significantly higher than in the United States. At the same time, P/E multiples in emerging markets are nearly half those in the United States (13.0 vs. 24.1). The combination of higher earnings growth and much lower starting multiples, all else being equal, points to relatively good prospects for emerging market equities over the next 5-10 years.

Another manifestation of mean reversion can be seen in stock leadership Every decade seems to have a few defining themes.  In emerging markets the decade ending in July 2008 was very driven by high prices for commodities. For the past ten years, the main themes have been the rise of both China as an economic power and technology as ia disruptive force. The charts below show the top ten stocks over the past three decades for both emerging markets and the U.S., with those stocks remaining on the list from one period to another highlighted in red. What we see in both cases is that market leadership constantly changes as investors shift their attention to the countries, companies and sectors experiencing the most positive narratives and best profit cycles. We can see how difficult it is for stocks to remain on the list. In both emerging markets and the United States between 80-90% of the ten most highly valued companies underperform the index for the next ten-year period as investors move on to new darlings. For the past ten-year period, of the leaders in 2008 only Microsoft outperformed the index in the United States and only TSMC and Samsung outperformed in emerging markets.

The current ten most valuable stocks in emerging markets reflect both the rise of China and the technology sector. Remarkably, seven out of ten stocks are Chinese  compared to only one ten years ago  (though Naspers is based in South Africa all of its value can be attributed to its Tencent stake) . This Chinese domination of the index occurs at a time when China faces a slowing economy, a credit bubble and unprecedented animosity from its main trading and investment partners. Last month Reliance Industries of India entered the list, replacing Ping Ang Insurance of China. Perhaps this is a harbinger of the next wave in emerging markets.

Macro Watch:

India Watch:

  • India’s internet shut-down problem (QZ))
  • India pushes coal (SCMP)
  • Samsung opens world’s largest smartphone factory in India (Bloomberg)

China Watch:

  • Protecting American tech from China (Foreign affairs)
  • Regrets on giving China entry to WTO (WSJ)
  • Foreign CEO’s on a tight leash in China (Foreign Policy)
  • The door is closing on Chinese investments abroad (FT)
  • China’s matchmakers (Spiegel)
  • China is losing the trade war (WSJ)
  • China’s New Silk Road (The Economist)
  • Why was the 20th Century not Chinese (Brad Delong)
  • The Chinese view Trump as cunning strategist (FT)

China Technology Watch

  • Berlin blocks Chinese acquisition (Caixing)
  • The man behind Pinduoduo (WIC)
  • Wake up call for China’s chip industry (Caixing)
  • China leads the way with electric vehicles  (McKinsey)
  • A global look on Chinese robotics (ZDNET)
  • Germany impedes China tech m&a (WSJ)
  • China is leading in the robot wars (QZ)
  • China’s BOE targets Apple screens (WSJ)
  • Tsinghua Unigroup bids for French tech firm Linxens (SCMP)

EM Investor Watch

  • Sec. Pompeo’s remarks on the Indo-Pacific (State)
  • Can Iran by-pass sanctions (Oil Price.com)
  • Can Brazil fix its democracy ? (FT)
  • Brazil’s military strides into politics (NYtimes)
  • Interview with Kissinger (FT)
  • Erdogan’s “New Turkey” (CSIS)

Tech Watch

  • The world’s largest solar farm in Egypt (LA Times)
  • Seven reasons why the internal combustion engine is dead (Tomraftery)

Investing

 

 

 

 

Emerging Markets’ Innovation Problem

The Global Innovation Index ( GII)  measures how countries compare in their ability to innovate. Presumably, innovation drives productivity and development, and, therefore, the most innovative economies are also those enjoying the best growth in living standards. Today we face revolutionary breakthroughs in artificial intelligence and automation technologies which promise to radically change  for the better the way we work and live. However, these changes present a heavy challenge for many emerging markets as new technologies eliminate the rote manufacturing jobs traditionally off-shored to labor-abundant developing countries.

Sponsored by Cornell University, INSEAD and WIPO (World Intellectual Property Organization),  since 2007 GII ranks countries in terms of their innovation potential. This gives us a decade of observation to gauge how different countries are progressing. Unfortunately for emerging markets, the evidence is disappointing, with a few important exceptions. By and large, emerging markets appear to be falling behind in their innovation capacity.

The chart below shows the rankings of the top 25 most innovative countries in both 2007 and 2017, with arrows pointing to the change in position.

 

The rise of small European countries is highly significant. Switzerland, the Netherlands, Ireland and the Nordic countries have all progressed very positively. This contrasts to the relative decline of France, Germany and Italy. In any case, eight  of the top 10 innovators in the ranking are European countries, which belies the prevalent market pessimism on the prospects for Europe. Italy, India, UAE and Belgium fell out of the “elite “top 25, replaced by China, Czech, Estonia and New Zealand.

In relation to emerging markets, the chart highlights the radical divergence of India and China. China has had a steady rise up the rankings from 29th in 2007 to 25th in 2016 and 22nd  in 2017. South Korea has also had an impressive escalation, from 19th to 11th; and, remarkably, it has surpassed Japan which has fallen from 4th to 14th. However, the most concerning performance has come from India which has seen its ranking fall from 23rd to 59th.  This result raises serious questions about the quality of Indian growth.

India’s decline is emblematic of a wider problem in emerging markets, as the below chart highlights

 

The chart highlights how the GII rankings have changed for the 18 most important countries for investors in emerging markets.  Of these 18, two-thirds have had significant declines in their rankings and only one-third has experienced improvement. Of these EM countries, only eight rank in the top 50 for innovation, compared to eleven in 2007. Aside from China and Korea mentioned above, Vietnam, Poland and Russia have risen in the rankings. The rise of Vietnam is impressive and gives credence to its claim as the rising star of “frontier markets.”

On the negative side,  India, Brazil, Mexico, South Africa, Thailand, Colombia and Indonesia are evolving very poorly, raising questions about how they can compete effectively in an increasingly competitive, technology-driven global economy. Also in this camp, the Philippines and Argentina are in dire situations. These countries do not seem able to nurture the institutions and make the public investments required for investment and productive innovation to take place. Consequently, their best minds are deserting, immigrating to more hospitable places.

Macro Watch:

India Watch:

  • India pushes coal (SCMP)
  • Samsung opens world’s largest smartphone factory in India (Bloomberg)
  • Scarsity of visas is shaking up Silicon Valley (SF Chronicle)

China Watch:

  • Why was the 20th Century not Chinese (Brad Delong)
  • The Chinese view Trump as cunning strategist (FT)
  • US-China Trade War – How we got here (CFR)
  • China will not reflate this time (Marcopolo)
  • Xi’s vision for China global leadership (Project Syndicate) (Kevin Rudd)

China Technology Watch

 

  • China’s BOE targets Apple screens (WSJ)
  • Tsinghua Unigroup bids for French tech firm Linxens (SCMP)
  • Interview with AI expert Kai-Fu Lee (McKinsey)
  • JD.com is driving commerce in rural china (Newyorker)

EM Investor Watch

  • Can Iran by-pass sanctions (Oil Price.com)
  • Brazil’s military strides into politics (NYtimes)
  • An update to the big mac index (Economist)
  • Interview with Kissinger (FT)
  • Erdogan’s “New Turkey” (CSIS)

Tech Watch

  • Seven reasons why the internal combustion engine is dead (Tomraftery)

Investing

 

 

 

 

The Impact of Trade Wars on Emerging Markets

The main goal of American diplomacy now appears to be to disrupt the post-war rules-based global economic order. President Trump viscerally believes that the status quo is rigged against the United States and in favor of America’s most important trading partners. In this scheme of things, traditional allies like Canada, Mexico and Germany are “ foes” and a rising economic power like China becomes an existential threat to American hegemony. On the other hand, countries do not export large amounts to the U.S are irrelevant (e.g. South America) or potential friends (e.g. North Korea, Russia)

According to the Trump Doctrine, global trade and investment are zero-sum games which should naturally be dominated by the U.S. because of its heft and competitive advantages. Trump believes that the U.S. is entitled to dictate terms to those countries that seek access to its markets, capital and technology. Central to this view, the U.S. has only two real rivals that challenge its hegemony: Germany and China.

Germany is seen as having taken control of Europe through the European Union, exploiting divisions to its own benefit, in order to further its global mercantilistic ambitions. Trump fervently supports Brexit because a divided Europe weakens Germany. Brexit would allow the U.S. to impose its own terms on a bilateral U.S.-U.K. trade deal.

China is seen by Trump to be a highly disloyal competitor which exploits the current global order to its own advantage. Allowing China into the WTO was “the worst deal ever,” and caused enormous damage to the U.S. economy. According to Trump, China’s business practices are utterly unfair for the following reasons:

  • Currency manipulation.
  • High tariff and non-tariff trade barriers.
  • Violation of intellectual property rights.
  • Highly restricted access for foreign investment, and imposition of JV requirements and technology transfer agreements.
  • State control of the economy, with huge subsidies provided to both state-controlled and private Chinese firms.

Moreover, as China steadily moves up manufacturing value chains, the U.S. has become obsessed with potential  future competition in high-technology goods. The focus of Washington’s anger is President Xi’s “Made in China 2025” plan to promote Chinese competency in key industrial technologies. Trump’s recent tariffs imposed on China are heavily targeted on the sectors that Xi has determined to be strategic, as shown in the chart below.

Consequences of the Trump Doctrine

As the U.S. questions the transatlantic alliance and the post W.W. II global institutional framework it will abdicate its role as the leader of the project. Without U.S. leadership new alliances will form in unpredictable ways. Though the current situation is highly dynamic and the future is unpredictable, some thoughts are in order:

  • The Trump Doctrine is isolationist for America. As Henry Kissinger has pointed out, the U.S. stands to become a “geopolitical island… without a rules-based order to uphold.” Nevertheless, as the largest and most diverse economy, the U.S. may have the least to lose.
  • America’s neighbors Mexico, and Canada will have no choice but to begrudgingly cave-in to U.S. bullying and accept Trump’s terms. Any deal will be better than no deal.
  • As it undermines the Western Alliance, The Trump Doctrine furthers the interests of both Russia and China. Ironically, both these dictatorships are more comfortable  dealing on a bi-lateral transactional basis than the U.S. with its checks and balances and elections. China is in a good position to trade access to its growing consumer economy on a transactional basis.
  • American isolationism and unilateralism also strengthens China’s hand in its One Belt one Road (OBOR) initiative which has as its primary objective the control of the Eurasian steppes (the old Silk Road, linking China with Europe and the Middle East.) Russia and China are enjoying the warmest diplomatic ties since the 1950s as they see eye-to-eye on this Eurasian strategy; for the Chinese it secures its borders and opens up commerce; for Russia it extends its geo-political reach. As Kissinger has noted,  Europe may become “an appendage of Eurasia.” Key targets here are Iran and Turkey, both of whom are currently at odds with American policy.  China has become Iran’s main trading partner and investor and is committed to buying its oil.
  • Both China and Russia see American “sanctions diplomacy” as a fundamental violation of the global rules-based economic order. U.S. imposed restrictions on Russia, Iran and other countries on the use of the SWIFT global financial transfer system and recent sanctions on Chinese telecom firm ZTE on the import of U.S. components have highlighted the urgency for reducing dependence on the U.S.  This will strengthen China’s resolve to achieve competence in key technologies and further efforts to develop alternatives to the U.S. dollar.  India is also dismayed by American strong-arm tactics, as sanctions are interfering with its commercial ties to Iran and the Middle East and its strong ties with Russia.
  • American antagonism towards the E.U. may also push Germany towards China. Germany may increasingly play its cards in Asia, which is increasingly the center of gravity of the global economy. It is probably not a coincidence that as Trump has launched his trade war against Beijing there has been a sudden rapprochement between Germany and China, and the announcement of a slew of important business transactions. First, BASF was given the go-ahead on a $10 billion fully-owned petrochemical plant, an unprecedented concession by the Chinese in a sector where Germany and the U.S are chief rivals. Second, German companies are securing preferential treatment in the auto sector, now by far the largest in the world and the focus of activity for electric vehicles and, increasingly, autonomous vehicles. In recent weeks, Daimler was awarded a permit to test driver-less cars In Beijing, a first for a foreign firm. Daimler is partnering with Baidu Apollo, a leader in mapping and artificial intelligence applications in China. Also last week Chinese Premier Li Keqiang said BMW may get control of its JV with Brilliance by 2022. BMW, which already has China as its largest market producing about 25% of global profits, has committed to a large increase in capacity and a partnership with Baidu. BMW also secured the right to take an equity stake in CATL, the world’s largest electric vehicle battery producer by sales, after the carmaker agreed to purchase $4.7bn worth of battery cells from the Chinese company. Finally, Volkswagen announced a partnership with FAW for electric vehicles and autonomous cars.
  • The announcement by Tesla last week that it would build its cars in a fully-owned plant in Shanghai is another sign of how companies are adapting to the Trump Doctrine. Chinese tariffs on American cars have increased the price of Teslas in China at a time when dozens of very well-financed local start-ups are coming on stream. Though the move is a significant market opening benefit for an American firm, it can also be seen for Tesla as a desperate attempt to remain relevant in China’s EV market at a time when sales are expected to ramp up dramatically. Still, it may be too late for Tesla, as its plant will not come on stream until 2020.
  • Access to the Chinese market is of great importance to multinationals. In a transactional world, the Chinese can provide access judiciously to secure powerful allies in developed countries. In the case of the U.S., China continues to offer incremental access to financial services, a long-standing demand of American firms.
  • “Winners” in the age of the “Trump Doctrine” are large countries with strategic importance. China is likely to come ahead, as it has strategic importance, a huge market and leadership with long-term objectives. India is not considered a rival by the U.S. and has high strategic value, so it also is in a good position to secure favorable terms. Brazil, though of no strategic value for the U.S., is not considered a rival by Trump and is also in a good position to negotiate.
  • “Losers” are small countries with no strategic value for the U.S.. As global value chains are disrupted by American unilateralism, those countries most dependent on exports to the U.S. are the most vulnerable. The chart below from Pictet Bank gives a good idea of which countries face the most downside: Mexico, Korea, Vietnam, Thailand, Taiwan, Indonesia and Malaysia. They will face unclear rules which will hurt investment. At the same time, the two largest economies in the world,  the U.S. and China will become more insular and self-sufficient.

Fed Watch:

India Watch:

  • Samsung opens world’s largest smartphone factory in India (Bloomberg)
  • Scarsity of visas is shaking up Silicon Valley (SF Chronicle)

China Watch:

China Technology Watch

  • Interview with AI expert Kai-Fu Lee (McKinsey)
  • JD.com is driving commerce in rural china (Newyorker)
  • Tesla-foe Xpeng’s $4 billion valuation (SCMP)
  • China’s tech lag highlighted (SCMP)
  • Tesla’s move to Shanghai (FT)
  • Tesla’s China plan (NYtimes)
  • BMW enters China’s fast lane (WSJ)
  • Daimler and Baidu get ahead on driverless cars in China (Reuters)
  • China wants high-tech cars with German help  (NYT)

EM Investor Watch

  • An update to the big mac index (Economist)
  • Interview with Kissinger (FT)
  • Erdogan’s “New Turkey” (CSIS)
  • Why Bolsonaro is leading Brazil’s polls (Foreign affairs)
  • Pundits are down on EM (Research Affiliates)
  • Indonesia takes control of mega copper mine (WSJ)

Tech Watch

  • Seven reasons why the internal combustion engine is dead (Tomraftery)