Category: Brazil

Brazil: Deindustrialization, Japanification and Beyond

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

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

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

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

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

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

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

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

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

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

 

 

 

 

 

 

 

Jorge Paulo Lemann’s Mea Culpa

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

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

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

Lemann points to three had lessons the company has learned.

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

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

Here follows Lemann’s apology:

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

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

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

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

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

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

What to Expect for the 2020s in Emerging Markets

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

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

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

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

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

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

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

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

Good luck to all!

Explanations for the Middle-Income Trap in Emerging Markets

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

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

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

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

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

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

The Asian Tiger model follows a few simple steps:

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

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

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

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

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

The Case of Emerging Markets

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


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

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

China

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

South-East Asian

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

Europe, Middle-East and Africa

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

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

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

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

Latin America

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

 

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

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

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

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

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

Economic Convergence and the “Middle-Income Trap.”

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

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

The Past 50 Years

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

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

The Past 30 Years

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

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

The Past 20 Years

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

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

Evidence for the Middle Income Trap

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

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

Conclusion

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

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

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

The XP IPO and Market Efficiency in Brazil

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

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

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

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

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

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

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

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

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

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

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

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

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

The Chilean Riots and the Privatization of Public Goods

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

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

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

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

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

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

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

 

Asset Management Fees are Moving Towards Zero

The individual investor in the United States has never had it easier, at least when it comes to the expenses incurred to get broad exposure to the global stock and bond markets. The common investor now pays fees which are a fraction of the cost paid a few decades ago, and every year fees fall further.  The collapse in fees has transformed the business of asset management in the United States, leading to a decline in active management and persistent concentration of assets in fewer firms. These trends are fast spreading to Europe and developed Asia. Inevitably, they will soon reach markets like India and Brazil, where powerful incumbents are still able to charge their clients 2-4% of assets under management .

The evolution of the industry is well described in The Investment Company Institute’s Factbook (2019 ICI Factbook), a compendium of data on the investment industry in the United States.

 

The Shift from Active to Passive

The primary shift in the asset management industry has been from high-cost actively managed products to low-cost indexed products in the form of both mutual funds and ETFs (exchange traded funds). As shown in the chart below, about 1.5 trillion dollars in actively-managed funds have been replaced by indexed-products.

Persistent Reduction in Fees

The expense incurred by investors in funds have fallen every year, from nearly 1% of assets in 2000 to 0.55% in 2018. The average fee charged by funds has fallen from 1.60% to 1.26%, but assets are increasingly  migrating  to low-cost providers like Vanguard and Charles Schwab. The industry is rapidly consolidating in fewer players. Many active managers are closing funds after milking their client-base for as long as possible. The final destination of this process is likely to be a few very large low-cost providers and a limited amount of highly skilled active managers still able to charge fees above 1% of assets under management.

The data is further broken down in the chart below. The key data point to focus on is the asset-weighted cost of indexed mutual funds which was 0.08% in 2018. These funds are weighted heavily towards  U.S. large capitalization stocks, a category which is seeing fees move to zero (made possible by stock-lending revenues received by the fund manager).

 

Chinese quants (Bloomberg)

Oddities of the Chinese stock market (Bloomberg)

China’s quant Goddess (Bloomberg)

Guide to Quant Investing (Bloomberg)

Trends Everywhere (AQR)

Ten bits of advice from Buffett (Seeking Alpha)

Value + Catalyst: the Gazprom case (Demonitized)

Latin America’s missing middle (McKinsey)

China’s  control of the lithium battery chain (FT)

 

Domestic Capital is Fleeing Emerging Markets

Plutocratic elites in emerging markets often “hedge” their bets by funneling financial assets out of their home countries into “safe havens” such as Switzerland and the United States. Maintaining bank accounts and second homes offshore and educating their children in foreign schools provides an insurance policy to protect against eventual political and economic turmoil at home.

In recent years this “keeping-one-foot-out-the-door” mentality seems to have spread dramatically since the great financial crisis. Slowing global growth and high risk-aversion have contributed to the strengthening of the U.S. dollar and the rise of dollar-denominated assets. This period has seen the rise of several very large new contributors, namely China, Turkey and Brazil, to the migration of wealth to safe-havens..

Not one of these countries played a big role in flight capital in the past. Rich Brazilians, for example, historically have had a preference for high-yielding domestic bonds and local real estate, unlike their fleet-footed Argentine neighbors who for decades have taken their assets offshore. But today, these countries are the primary drivers of capital migration. If you add the South Africans, who have been systematically moving both their assets and brain-power out of the country for decades, all of the BRICS (Brazil, Russia, India, China and South Africa), the supposed engines of emerging markets, are seeing persistent capital flight. India is possibly an exception, only because wealth creation is still greater than the funds leaving the country.

The anecdotal evidence on this is overwhelming. Chinese buyers are reported to have spent around $200 billion on foreign real estate in 2018 ($32 billion in Australia alone) and are the major drivers of real estate markets in popular destinations such as Sydney and Vancouver. Russian are known to favor Dubai, Cypress and London; and Brazilians love South Florida, Lisbon and New York. Realtor transaction data point to one-third of total real estate transactions in Lisbon and Vancouver being transacted by Brazilians and Chinese buyers, respectively.

Afrasia Bank’s “Global Wealth Migration Review 2019”( Link ) a compilation of data on the transaction flow of wealthy individuals around the world, provides some color on recent trends in capital flight. The report estimates that in 2018 108,000 High Net Worth Individuals (HNWI) with net assets above $1 million emigrated from their home countries, mainly emerging markets.

The map below, prepared by VisualCapitalist.com, graphically shows the origin and destination of migrant flight capital using Afrasia’s data.

More detailed data on the origin and destination of flows is shown below. A few destinations are highly preferred as safe-havens, with Australia, the U.S., Canada, Switzerland and the U.A.E. receiving most migrant flows. In the case of Australia, the inflows are enough to have a material impact on the total stock of HNWI. Though China and India are seeing significant outflows they also continue to generate many new HNWI. That is not the case in Brazil, Russia and Turkey where the outflows are resulting in a net decrease in the HNWI population. The situation is particularly dire in Russia and Turkey where outflows represent a large part of the home HNWI population and have been persistent in recent years. Other countries cited by the report as important sources of HNWI migrants are Venezuela, Nigeria and Egypt. In the case of Venezuela, HNWI’s have practically abandoned the country, resettling mainly in Spain and South Florida.

Though Afrasia’s data may be a good indication of trends, it probably understates the volume of migrants. This can be seen by looking in more detail at one segment: Brazilians in Florida.

The Case of Brazilians in South Florida

Every country’s HNWI migrants have distinct geographical preferences. As mentioned above, Brazilians have a strong affinity for South Florida. Realtor data for the Florida market indicates that the Afrasia Bank report significantly understates flight capital from Brazil.

A report from the National Association of Realtors on international real estate activity in Florida in 2018  (Link)  cites Brazilians as the most active foreign buyers in Florida in 2018. According to the report, Brazilians accounted for 17% of all real estate transaction in Miami-Dade County, equivalent to 2,400 residences for a disbursement of $1.5 billion.

Moreover, Brazilians are active buyers in other Florida markets, specifically Fort Lauderdale, Palm Beach and Orlando. According to the NAR report, Brazilians bought 2,280 homes outside of Miami-Dade County in 2018. This brings the total of Florida homes purchases by Brazilians last year to 4,680. Total disbursements in the Florida market in 2018 are estimated at $2.87 billion.

The chart below shows the persistent rise of Brazilian buyers in Florida since the great financial crisis. Over this period, Brazilian are estimated to have spent between $18-20 billion in Florida for a total of some 38,000 homes.

The chart below shows the strong presence of Brazilians  buyers in Miami and Orlando.

Interestingly, as the chart below shows, Brazilians are paying significantly more for Florida residence than other foreigners. This is probably an indication that purchases are meant to be primary residences and not vacation homes.

Trade Wars

India Watch

China Watch:

  • Chinese investors are inflating foreign real estate (Business Insider)
  • China’s voracious appetite for Russia’stimber (NYT)
  • China is a stock picker’s paradise (WSJ)
  • China’s middle-income consumer (WIC)
  • China’s tourism boom (WIC)
  • China commits to Russian LNG (SCMP)
  • America’s false narrative on China (Project Syndicate)
  • FBI Director Wray on China threat (CFR)
  • For the US to dismiss BRI is a mistake (Politico)
  • Time for a new approach towards Beijing (Der Spiegel)
  • China internet weekly (Seeking alpha)

China Technology

  • China’s food delivery war (Bloomberg)
  • How China took the lead in 5G technology (WP)
  • China’s MIC 2025 plans are roaring ahead (SCMP)
  • China’s EV future (The Econoist)
  • China’s EV bubble (Bloomberg)

Brazil Watch

EM Investor Watch

  • Why do investors keep on coming back to Argentina (FT)
  • Malaysia cuddles up with China (SCMP)
  • Erdogan’s new Turkey (Bloomberg)
  • Turkey will recapitalize state banks (FT)
  • Turkey’s bubble has popped (Forbes)
  • Istanbul’s new airport (The Economist)
  • Turkey’s key role in the Mediteranean gas market (GMFUS)
  • Malaysia restarts China rail project (SCMP)

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

Bond market risk and emerging markets

 One of the most salient concerns with the current state of the the global economy  is the very high level of corporate debt. This past week the OECD, the Dallas Federal Reserve and the Bank for International Settlements all warned that in an eventual economic downturn the solvency of corporate debt issuers  is likely to deteriorate quickly and deepen the contraction. 

The warning is highly relevant for emerging markets investors for two reasons; first, EM corporates have been active particants in the ramp up of debt, eagerly satisfying the chase for yield that lenders have pursued in response to quantitative easing policies; second, EM borrowers can be expected to suffer disproportionately if the lending cycle were to turn sour.

Rob Kaplan of the Dallas Federal Resrve did not mince his words this week (Link) in issuing a stark warning of the risk to the economy caused by the buildup of U.S. Corporate debt. Kaplan is concerned that the current high level of corporate debt will sharply deepen an eventual economic downturn. He points out that a preponderance of recent debt issuance has been used for non-productive and non-self-liquidating activities, mainly dividends, debt buy-backs and M&A activity. In addition, to an unprecedented degree, the debt has been rated BBB (barely one notch above high-yield, “junk”), and has come with more relaxed covenants. This is shown in the following chart two charts. The first shows the cyclical behavior of the corporate debt market and the current very high level relative to GDP, and the second shows the growing preponderance of lower quality issuers.

  Kaplan notes that “in the event of an economic downturn and some credit-quality deterioration, the reduction in bank broker-dealer inventories and market-making capability could mean that credit spreads might widen more significantly, and potentially in a more volatile manner, than they have historically.” As in past recessions, downgrades of BBB-rated debt may flood the relatively illiquid market for high-yield bonds and cause severe dislocations.

Unfortunately for investors in EM debt, the U.S. high-yield bond market and the market for EM debt are extremely correlated. Therefore, any disruption in the U.S. high-yield market will be felt immediately in an accentuated fashion in the EM debt market.

This is the view expressed in the recently published OECD study, “Corporate Bond Markets in a Time of Unconventional Monetary Policy.” The report  describes in ample detail a “prolonged decline in overall  bond quality…and  decrease in covenant  protection” and  predicts that many corporates issuers will suffer a downgrade to “junk” in an eventual economic downturn  and face amplified borrowing costs. The report repeats the concerns expressed by Kaplan with regards to the size and low quality of global corporate debt. In addition, it focuses on the specifics of the EM debt market.

The OECD points to an “extraordinary acceleration of corporate bond issuance in emerging markets,”  from$70 billion/year in 2007 to $711 billion in 2016. This is shown in the chart below.

  The rise in borrowing has been particularly acute in China, but also highly significant across the rest of the emerging markets. Total EM corporate debt reached $2.78 trillion in 2018, up 395% in ten years. 

 The OECD identifies an alarming decline of the overall quality of the global corporate bond market. According to OECD analysis, by historical standards the quality of bonds is exceptionally low for where we are in the economic cycle. This is shown in the chart below.

 The decline in quality is particularly severe for the overall quality of EM bonds, which just barely qualify as investment grade in 2018 after falling into junk status in 2017. The chart  below compares the quality of EM bonds to developed market bonds, according to the rating methodology ued by the OECD.

To make matters worse, the repayment profile for emrging markets is considerably worse than for DM, with 80% of loans due over the next five years.

 Interestingly, even though concerns of a global slowdown are growing, high yield bonds in general are  performing well, displaying very low premiums by historical standards to risk-free bonds. This is partially because of QE (especially in Europe) but also because of desperate efforts to secure yield in a low-return environment. Look, for example, at the chart below of the HYEM, the emerging markets high yield bond ETF, which has rallied strongly since last September.

Conclusion

 Investors in emerging markets should be aware of the considerable risks presented by the bond market. Any significant downturn in the global economy would likely lead to significant downgrades to high yield bonds and a strengthening of the U.S. dollar, and this may cause severe disruption of the high-yield market. The performance of emerging market equity markets, which are highly correlated to the EM high yield market, would suffer accordingly.

Trade Wars  

  • Xi needs a trade deal (FT)
  • Should the U.S. run a trade surplus (Carnegie, Michael Pettis)
  • Why the U.S. debt must continue to rise (Carnegie, Pettis)
  • Turkey and India denied preferential U.S. trading status (FT)
  • China, India and the rise of the civilisation state (FT)
  • When democracy is no longer the only path (WSJ)
  • The tremendous impact of the China-U.S. tech war (Lowy)
  • Huawei hits back at the U.S. (FT)

India Watch

  • Modi’s track record on the economy (The economist)
  • Increasing Indian demand for copper (Gorozen)
  • India’s growing share of oil imports (blog)
  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)

China Watch:

  • Quality will drive China A- share returns (FT)
  • China breaks world box office record (SCMP)
  • Why China supports North Korea (Lowy)
  • China’s PM frets about the economy (The Economist)
  • China has no choice (Alhambra)
  • China’s economy is bottoming (SCMP)
  • MBS in Beijing (WIC)
  • The story of the world’s biggest building (The Economist)
  • U.S. cars are strugling in China (NYT)
  • China’s tourist have political clout (The Economist)

China Technology

  • Huawei’s big AI ambitions (MIT Tech)
  • China’s EV startup Xpeng (WIC)
  • An interview with fintech Creditease CEO (Mcinsey)

Brazil Watch

EM Investor Watch

  • OECD Report on Global Corporate Debt (OECD)
  • Russia’s global ambitions in perspective (Carnegie)
  • South Africa stagnates as confidence wanes  (Bloomberg)
  • Postcard from Malaysia (Foreign Policy Journal)
  • South Africa slumps (Barrons) South Africa Innovation (FT)
  • Make hay while the sun shines in emerging markets (FT)
  • Globalization in Transition (mckinsey)

Tech Watch

Investing

 

 

 

 

 

The Fed and EM Debt

 

Federal Reserve Chairman Jay Powell, unruffled by the bullying of President Trump and market commentators, raised interest rates this week and reaffirmed his commitment to unwind the extraordinarily loose monetary policies of the past decade. Suddenly, it is dawning on investors that the infamous Fed “put” – the firm commitment of the Federal Reserve to support the stock market in the name of financial stability and the “wealth effect” – can no longer be taken for granted. The Fed’s return to orthodoxy, if pursued, will not only unsettle the U.S stock market. It will have far-reaching consequences across financial markets, and certainly present a challenge for emerging markets.

The problem for emerging markets comes on two fronts. Tightened liquidity will lead to higher interest rates across global bond markets. As markets reprice the cost of credit, the “yield chase” which occurred in recent years will revert: investors will no longer have to pursue ever-more risky borrowers to achieve a modicum of returns. One of the best indicators of the changing market environment is the spread between the interest which high-yield lenders (“junk’) have to pay over the risk-free U.S. Treasury rate. As shown in the chart below, this spread has been surging. This is bad news for emerging markets because EM debt is a substitute for U.S. high yield debt.

Moreover, the higher cost of credit for emerging markets comes in the wake of a huge credit splurge. EM borrowers enthusiastically took advantage of the appetite of global yield-chasers over the past five years. As the tide now ebbs, borrowers will have to refinance at higher rates. Unfortunately, it appears that most of this lending did not go into productive investments and it did little to boost economic output. The chart below shows the increase in the total credit- to- GDP ratios for major EM countries, as reported in the data of the Bank for International Settlements (BIS).

The following chart shows the average GDP growth for the past five years compared to the past 20 years and also Fixed Capital Formation over the past five and 20 years.

 

These chart show that this debt accumulation has by-and-large not led to more investment or more growth. Quite the opposite, In many countries it appears that the marginal returns from debt are declining.

A few country-specific comments:

China’s debt load increase is unprecedented. Though it has financed increased capital formation it appears that a significant amount of investment has been in very low return infrastructure and real estate developments. Marginal returns from debt and investment are declining fast, and GDP growth is expected to fall below the current 6% annual rate.

Brazil’s debt load has increased at a very high rate and is now at very high levels for a country with high interest rates and prone to financial instability. The increase in debt of the past five years was used to finance current spending and interest expense.

Colombia’s debt increase is very large but absolute levels are moderately high and at least GDP growth has been sustained and capital formation has been boosted.

Chile’s debt ratio has increased sharply and debt levels are very high, but growth has sputtered. Though capital formation has increased, I suspect a significant amount of investment has been  in “glamour” real estate developments.

Turkey has seen a large increase in debt, much of it sourced in foreign currency. Debt levels are approaching high levels. The country has seen high growth in GDP and increasing capital formation, much of this in large infrastructure projects but also in glamour real estate. The crisis this year has thrown Turkey into what is likely to be a multi-year period of austerity and deleveraging.

Mexico’s debt has increased but remains at manageable levels. Growth and capital formation are steady at low levels.

India is the main outlier in EM. Debt is moderately high but it is has been declining. Both GDP growth and capital formation have increased. India appears well positioned for a new credit cycle.

 

Macro Watch:

  • The future of the dollar and U.S. diplomacy (Carnegie)
  • The emergence of the petro-yuan (APJIF)  
  • A users guide to future QE (PIIE)

Trade Wars

  • Europe is wary of Chinese M&A (SCMP)
  • Obama administration view on China issues (Caixing)
  • China’s tantrum diplomacy   (Lowy)
  • Making sense of the war on Huawei  (Wharton)
  • The war on Huawei (Project Syndicate)

India Watch

  • India’s potential in passive investing (S&P)
  • India’s food-delivery startup, Swiggy, backed by Tencent (SCMP)
  • Modi’s election troubles (WSJ)

China Watch:

  • China debates economic policy (FT)
  • China is stepping-up infrastructure investments again (Caixing)
  • China’s radical experiment (Project Syndicate)

China Technology Watch

Brazil Watch

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

EM Investor Watch

  • Koc Holding’s digital transformation (Mckinsey)
  • Lowy Institute Asia Power Index (Lowy
  • In pursuit of prosperity (Mckinsey)
  • What drives the Russian state? (Carnegie)
  • Russia’s big infrastructure bet (WSJ)

Tech Watch

Investing

 

 

Emerging Markets Debt Bomb

Business and investment cycles follow predictable patterns, starting out with pessimism and plenty of idle capacity and ending with optimism and the economy running above potential. But, every cycle also has its particularities. In the case of emerging markets, this current investment cycle is characterized by a very large accumulation of debt.

While emerging market stocks have performed very poorly compared to the U.S. market since 2012 and are now relatively undervalued, they are likely to be constrained by this debt accumulation. Typically, a new period of outperformance for emerging markets would be marked by new capital inflows and credit expansion, but given the rapid debt accumulation of recent years this may not happen this time. In fact, under current conditions of dollar strength, rising interest rates and weak commodity prices, this debt load is proving to be a heavy burden for many countries and causing stock markets to fall further.

Of course, the reason that this cycle is proving to be so different is the unprecedented and sustained Quantitative Easing (QE) programs pursued by the central banks of the world’s main financial centers since 2010. The long period of extraordinarily low interest rates motivated investors to “chase” for yield where ever they could find it and banks and corporations around the emerging market world were more than happy to oblige them. As QE is now being unwound and interest rates are rising, emerging market borrowers are having to refinance at much higher rates. This new trend of rising rates is being compounded by a rising dollar and the return of volatile financial markets.

The charts below, based on data from the Bank for International Settlements (BIS), shows the increase in total debt to GDP ratios for the primary emerging markets for the past 10 years, five years and three years. Note the extremely high increase in this ratio for many countries. These increases would be remarkable under any circumstances but are especially concerning in that this has been a period of relatively low growth. Look at the example of Brazil: the very large increase in the debt was not used at all for investment and therefore will in no way produce the cash flows to service interest.

What is remarkable is how generalized and sustained the trend has been over this entire period.

China’s course is unprecedented. Though marked by the dominant role of public sector corporates and therefore, arguably, quasi-fiscal in nature, the unsustainable increase and the high level of debt raises concerns about a Japan-like “zombification” of the economy. Chile’s path is also very concerning.

India is the outstanding exception. High GDP growth, tight control over state banks and a reluctance to tap cross-border flows are the explanation, and this positions India very well for the future.

Not only have debt ratios for EM countries increased at a very high pace they are also approaching high levels in absolute terms. The rise in EM debt levels has occurred while debt levels in developed economies have been somewhat stable, rising from 251% of GDP to 276% over the past ten years. As the table below shows, China and Korea are now at levels associated with developed economies and Malaysia is not far behind.

Finally, external debt levels have also risen consistently, as shown in the charts below. If we consider a level above 30% of external debt to GDP to mark vulnerability, most EM countries find themselves in this condition, at a time when the dollar is strengthening and U.S. interest rates are rising.

Macro Watch:

  • The emergence of the petro-yuan (APJIF)
  • A users guide to future QE (PIIE)
  • Economic brake-lights (Mauldin)

Trade Wars

  • Trump pushes China to self-sufficiency (SCMP)
  • The road to confrontation (NYT)
  • The real China challenge (NYT)

India Watch

  • Election uncertainty clouds Indian stock market (FT)

China Watch:

  • China picks tobacco taxes above public health (WIC)
  • How free is China’s internet? (MERICS)

China Technology Watch

  • The Huawei security threat (Tech Review)
  • China’s Big Tech Conglomerates (IIF)
  • How China raised the stakes for EV  (WEF)
  • A profile of Bytedance, China’s short-video app (The Info)

Brazil Watch

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

EM Investor Watch

  • In pursuit of prosperity (Mckinsey)
  • 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

  • Bloomberg energy finance, 2018 report (Climatescope)
  • Fast-tracking zero-carbon growth (Ambition loop)
  • Why have solar energy costs fallen so quickly (VOX)
  • Asia leads in robot adoption (QZ)
  • The new industrial revolution (WSJ)

Investing

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)

 

 

 

 

 

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

 

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)