Category: Brazil

Brazil’s Stock Market and the Rise of Jair Bolsonaro

 

 

The Brazilian stock market has fallen by nearly 30% since the end of January, leading a correction in emerging market equities.  In part, this has been caused by a rising dollar, a manifestation of a vibrant U.S. economy and Federal Reserve rate hikes. The strong dollar has the collateral effect of reducing investor appetite for the more vulnerable emerging markets, such as Brazil, Argentina, and Turkey, which depend on foreign inflows to finance large current account and fiscal deficits. In addition, investors are being spooked by political uncertainty. In Mexico, Andres Manuel Lopes Obrador, a radical populist with authoritarian tendencies is likely to win the upcoming presidential election, promising “regime change,” and in Brazil, a somewhat similar character, Jair Bolsonaro, is leading the polls and promising the same.

Though it is way to early  to predict the results of Brazil’s October presidential election, there is no question that the electorate’s very sour mood is increasing receptiveness for Bolsonaro’s populist, strong-man, “law-and-order” message. After four years of recession, made much worse by a draconian monetary policy, a corruption scandal which has permeated the entire political establishment and a dramatic decline in public order, voters are eager for radical change and warming to Bolsonaro. A retired army officer who has been in the Chamber of Deputies since 1991, Bolsonaro expresses nostalgia for the military regime and his conservative Christian views have resonated with the increasingly influential evangelical community. He has the distinction of being one of the few politicians in Brasilia not tainted by the “Car Wash” corruption investigations being carried out by the judiciary.

Bolsonaro’s views on economic issues are unclear. His voting record as a deputy in Congress has been supportive of policies pursued by the leftist Workers Party, and throughout his legislative career he has tended to side with Brazil’s mainstream in support of state capitalism and trade protectionism. However, at the same time, Paulo Guedes, his chief financial advisor and probable Minister of finance, is a dyed-in-the-wool supporter of free markets, privatization, deregulation and the shrinking and decentralization of the state. With a PHD in economics from the University of Chicago, Guedes has been for decades a proponent for radical free-market reforms in Brazil to unleash the country’s productive potential.

Guedes views have been shared by very few politicians in Brazil, a country that for decades has had a strong consensus in favor of a dominant role for the central government in Brazil’s economy. However, the tide may be changing in Brazil because the recent corruption scandals have made clear the degree to which the state apparatus has been taken over by rent-seeking politicians and their business cronies. That may explain why Bolsonaro has latched on to Guedes. A politician wanting real change in Brazil today may have as the best option a promise to unleash Brazil’s repressed entrepreneurial spirit by state reform. In a recent interview, Guedes commented: “Jair has evolved much more quickly than Brazil’s economists or past presidents have evolved.”

Free-market reforms, deregulation and privatizations could provide an enormous boost to Brazil’s stagnant economy. As Guedes says “Brazil is paradise for the rentier class and hell for the entrepreneur.”

Brazil’s ranking in the World Bank’s Annual Ease of Doing Business Survey  is emblematic of the regulatory burdens imposed by the state. Brazil’s ranks 125th in the latest survey, the worst ranking of a major emerging market and even terrible by the poor standards of Latin America (Argentina 117, Colombia 59, Peru 58, Chile 55, Mexico 49). A few examples from the World Bank survey will suffice to show the regulatory oppression faced by Brazilian businesses.

 

China’s tech boom (The Atlantic)

China stock market valuations (Wisdom Tree)

China’s Tianqui buys stake in Chile’s SQM lithium giant (FT)Brookings

Russia gets closer with Europe (NYtimes)

Energy and politics in Mexico (Brookings)

Our two cents on the dollar (Real Investment Advice)

Financial Bubbles in Emerging Markets – The Case of Brazil

The modern era of the emerging markets asset class began with the creation of benchmarks by the World Bank-IFC and Morgan Stanley Capital International (MSCI) in the late 1980s, which in turn led to gradual  participation first by institutional investors and later by retail investors. This brief period of 30 years for the asset class coincided with a period during which developed markets have experienced serial financial market bubbles,  including  the Japanese stock  and real estate markets (1990), the dot-com bubble (2000), the U.S. stock and real estate bubbles in 2007, and currently the Canadian and Australian real estate markets. Consequently, emerging market assets, which already have to contend with more volatile economies and fickle foreign capital flows, have also had to deal with the winding and unwinding of bubbles happening far from their own shores.

Bubbles are not always easy to identify and are only confirmed post-facto by a crash. So, for example, though Bitcoin may be a “crazy bubble,” we will know that for sure only if it eventually collapses.

Nevertheless, financial bubbles tend to have some common sources. They seem to originate in circumstances of technological breakthroughs (e.g.,19th century British railroads, the internet, bitcoin)  which engender great expectations of future profits. Also, they are often linked to periods of financial innovation/deregulation which lead to credit expansions and a sustained rise in asset prices (e.g. real estate, art, stocks).

Additionally, many bubbles are marked by opaque fundamentals. The more difficult it is to value an asset, the higher the propensity for prices to be determines by unfettered human imagination.

Emerging markets are subject to bubbles for all of these reasons. However,  several additional factors further increase the propensity for bubbles to develop  These include:

  • As many markets have short histories (eg., China, Vietnam) historical empirical data is lacking. Combining this with a high participation rate of new investors, the foundations for price discovery are poor.
  • Given the higher economic and currency volatility of many emerging markets and frequent boom-to-bust cycles, it is difficult for investors to maintain a firm grasp of “normal” valuations. This is further complicated by elevated currency volatility.
  • In many markets the marginal investor is often an opportunistic foreigner with low tolerance for losses; this results in few “firm hands,” and greatly enhanced volatility both on the up and downside caused by changes in the direction of liquidity flows. This is especially true in frontier markets (the second-tier of emerging markets), an asset class with a shorter existence and poorly-followed securities.

In a recent research paper from the Swiss Finance Institute, (Link) the authors studied 40 bubbles of the past 30 years, of which 19 occurred in emerging markets. The paper sought to establish increasing volatility as a predictor for the imminent collapse of a bubble but found no significant correlation. Also, the authors found that credit conditions varied considerably and that credit growth was not a necessary pre-condition for a bubble to develop.

Even if every bubble has its own particular characteristics, there do seem to be a few things necessary for a bubble to develop. Almost all bubbles in emerging markets seem to have been associated with a strong rise in expectations of future profits caused by either: 1. Political or Economic Reforms; or 2. financial deregulation (privatizations, bank reform, elimination of exchange controls). In turn, these changes in the domestic environment have usually caused large inflows of foreign capital and currency appreciation., both of which add fuel to the trend of rising asset prices.

The paper unfortunately covers only a minority of the stock market bubbles that have occurred in emerging market in recent decades. By my count, over the past 30 years there have been in the order of 45 single-country stock market bubble experiences, ending, on average, with a peak-to-bottom drawdown of -71.5% (in US$ terms). Three countries  – Brazil, Argentina and Turkey – have been the most prone to powerful boom-to-bust equity cycles. Over this period, Argentina and Turkey have each had six drawdowns of over 50%, the worst being 94% for Turkey in 2000.

These emerging market stock market cycles  can be characterized as bubbles because they are of enormous scale in terms of stock price movements and are generally triggered by a large, though ephemeral, increase in investor expectations. However, to a degree they are also simply the manifestation of the response of investors to boom-to-bust economic cycles in environments of fickle capital flows and high interest rates.

We now look in detail at the Brazilian experience.

The Case of Brazil

Brazil has experienced five enormous stock market “bubbles” since the 1970s, which amounts to one per decade.

  1. December 1967 – May, 1971.
    • Cause: enthusiasm for economic reforms leading to the “Brazilian Economic Miracle.”
    • 1,120.3% appreciation.
    • Subsequent correction of -77.61%
    • 4 years required to reach new highs.
  2. August 1983 – May 1986
    • Enthusiasm for political and economic reform.
    • 1,141.23% appreciation.
    • Subsequent correction of -88.1%
    • 6 years required to reach new highs.
  3. December 1987- October 1989
    • Temporary recovery, mini-bubble
    • 550% appreciation.
    • Subsequent correction of -87%
    • 2 years required to reach new highs.
  4. December 1990 – July 1997
    • Enthusiasm for economic reform.
    • 2,812.8% appreciation.
    • Subsequent correction of -88.1%
    • 1 years required to reach new highs.
  5. September 2002 – May 2008
    • Commodity boom and credit expansion
    • 1,912.6% appreciation.
    • Subsequent correction of -77.6%
    • Years required to reach new highs: unknown
  6. January 2016 – ?

What can we say about this recurrent pattern of “bubbles” in Brazil.

  • These great stock market surges are founded in Brazil’s volatile, boom-to-bust economic business cycle.
  • Brazil’s stock market has provided good returns over the past 50 years (compound annualized returns of 11.6% in US$), but with very high volatility. The market rarely trades on its trend line, but rather lurches from one side to the other. (See chart below).
  • Stock market cycles have been mainly caused by changes in economic policies, often triggered by political shifts.
  • Foreign capital inflows have certainly abetted stock prices moves both to the upside and downside, to one degree or another. Surges in stock prices are typically concurrent with large foreign capital inflows, which lead to currency appreciation and reinforcing positive feedback loops on the upside. The opposite occurs on the downside.
  • The last bubble cycle (2002-2008) was highly unusual, as it was not associated with political or economic reform. Quite the opposite, the boom defied a serious deterioration in both economic policy and political governance. This bubble seems to have been caused mainly by an expansion of credit and an appreciation of the currency brought about by the China-induced commodity boom and massive foreign capital inflows into Brazilian financial securities,
  • For the current surge in the stock market initiated in January 2016 to continue a new wave of political and economic reform will be necessary, since credit expansion and currency appreciation are already near their limits.

Fed Watch:

  • Gavekal view on the cycle, China, commodities and EM (CMG Wealth)
  • The Fed’s ammunition ran out (Zerohedge)
  • High Wages and high savings in a globalized world (Carnegie)

India Watch:

  • India’s demographic dividend (Livemint)
  • Modi’s make-in-India strategy (NYT)
  • Infosys to sacrifice margins for growth (Bloomberg)
  • Reset with China is a grand illusion (Livemint)
  • Gujarat plans world’s largest 5GW solar park (India Express)
  • Alstom and GE’s made-in-India locomotives (Swarajya)
  • Xiaomi’s made-in-India phones (Caixing)
  • India’s biometric data program growing pain (NYT)
  • Mohnish Pabrai on the Indian market (Youtube)
  • Half a billion mobile internet users in India (Quint)
  • Digital streaming is taking over cinema (Quint)

China Watch:

  • China’s big plans for Hainan include gambling (WIC)
  • China grants visa-free travel to Hainan (SCMP)
  • China’s economy is closing not opening (SCMP)
  • Qingdao Haier to list in Germany (Caixing)
  • JPM China stock investment strategy (SCMP)
  • Trade war ominous implications (George Magnus)
  • China airline threatens move to Airbus (SCMP)

China Technology Watch:

  • The O2O wars intensify (WIC)
  • US likely to block China tech M&A (Bloomberg)
  • The next Alibaba?(WIC)
  • Alibaba’s new Tencent-backed challenger (Seeking Alpha)
  • US moves to block China’s telecom hardware firms (NYtimes)
  • China is increasing state-oversight of tech firms (bloomberg)
  • Xiaomi’s internet strategy (SCMP)
  • What China wants to win is the computing war (SCMP)

Technolgy Watch

EM Investor Watch

  • Vietnam’s booming stock market (FT)
  • Vietnam’s socialist dream hits hard times (Asian Times)
  • Swedroe, don’t exclude EM (ETF.com)
  • EM markets are getting bumpier (bloomberg)
  • Van Eck’s EM strategy (Van Eck)
  • Saudi’s inclusion in EM funds (FT)
  • The case for Russian stocks (GMO)
  • Jeremy Grantham is still bullish on EM (Economist)

Investor Watch:

 

 

Big Macs and Emerging Markets

The Economist’s Big Mac Index looks at the dollar cost of a hamburger sold by McDonald’s restaurants in some 60 countries. The index shows a remarkable range of prices around the world. In the latest survey, the most expensive burger was found in Switzerland ($6.80) and the cheapest could be bought in Ukraine ($1.60). Presumably, these hamburgers are identical, with the same combination of bread, beef patty, lettuce and sauce in every unit. The price in each country should reflect the cost of the materials, labor and rent, as well as profit margins and taxes. The index pretends to shed some light on the relative costs of doing business in different countries, and, given that it has been measured for some 30 years, it can also provide an indication of the evolution of business costs. Moreover, it can be used as a proxy to  measure the relative competitiveness of currencies around the world.

The results of the January 2018 survey are shown below.

A Few observations:

  • No surprise to see Switzerland and Scandinavian countries at the top, where they have been for a long time. This makes sense, given high labor costs and value added taxes in these highly productive economies.
  • The high ranking of the United States is relatively new. The U.S. had ranked in the third and fourth decile, until 2016. This is the consequence of U.S. dollar strength, and a very surprising 4.1% annual increase in prices, more than twice U.S. inflation.
  • Brazil is back in the top decile, and it secures its place as the most expensive burger in emerging markets. Brazil is a complete anomaly, the only EM country in the top 20, and this in spite of being an extremely competitive producer of beef and other agricultural product. The high ranking is caused by the chronic overvaluation of the real, excessive business regulations and very high taxes. It will be interesting to see whether the recent labor reform can result in lower costs and if a significant fall in interest rates over the past year will lead to a weaker currency.
  • Turkey has fallen to the bottom decile for the first time in over a decade, the result of a weak economy and currency devaluation.
  • The traditional export-focused countries all maintain competitive currencies and cheap burgers. Of the Asian countries, only South Korea appears in the top half. In Latin America, Mexico remains very competitive.

The charts below show Big Mac prices relative to the U.S. price over the past twenty years, by region.

Asia is characterized by consistently stable and low prices. Chin has seen the most appreciation, caused by the appreciation of the yuan.

Latin America is characterized by unstable prices, with episodes of high overvaluation. Mexico is the exception, maintaining a more stable and competitive peso which is essential for its export-driven economy.

In Europe and Africa, Turkey behaves more like a Latin American market. After several decades of abusing with current account deficits, Turkey has had to devalue the lira to regain competitiveness. Russia, on the other hand, has managed its currency relatively well in spite of the volatility of oil prices.

For comparative purposes, the table below shows the REER (Real effective exchange rate), since 1995.

  • High volatility in Brazil and Turkey.
  • Gradually appreciating currencies China and Indonesia.

Fed Watch:

  • Gray Shilling on the Fed (Shilling)
  • World Finance in peril (Telegraph)
  • China is the leading candidate for the next financial crisis (FUW)
  • The coming melt-up in stocks (GMO)

India Watch:

  • RBI warns on Modi’s budget (QZ)
  • India’s protectionist budget (Swarajyamag)
  • India launches Modicare (Swarajyama)

China Watch:

  • China and free trade (NYtimes)
  • China mulls gambling on Hainan (SMH)
  • When will China become the biggest consumer economy (WIC)
  • Xi ally highlights financial risks (SCMP)

China Technology Watch:

  • China and the AI war (Science Mag)
  • Interview with JD.com’s Richard Liu (Youtube)
  • China and the U.S. wage the battle for AI on the cloud (Technology Review)
  • Hong Kong-mainland bullet-train links ready (Caixing)

EM Investor Watch:

Technology Watch:

  • Renewable power costs in 2017 (Irena)
  • Apple’s share of smartphone profits is falling (SCMP)

Investor Watch:

India, Urbanization and a New Commodity Bull Market

Around the turn of the century, China’s economy entered in a phase of very high growth which was fueled by investments in infrastructure and heavy industry and was extremely intensive in the use of hard commodities. A surge of demand from China caught producers by surprise and drove prices  for commodities, such as iron ore and copper, to very high levels for an extended period of time (2003-2011).  A typical boom-to-bust cycle ensued, with overinvestment by producers eventually resulting in over-capacity and a return to low prices.

Commodity markets have been depressed for the past five years and valuations for the stocks of the producer firms have reached record lows relative to stocks in other sectors.

China’s impact on commodity prices, though extraordinary, was not atypical. Historically, countries have entered periods of commodity-intensive growth when they reach a certain level of wealth and experience high urbanization rates: for example, the U.S. in the 1920s, Japan in the 1950s, Brazil in the 1960s and Korea in the 1970s. All these countries saw a period of massive growth in commodity consumption, which eventually leveled off. U.S steel consumption today is at the same level as in 1950, while the Japanese consume steel at 1975 levels.

We can see in the following chart the recurring pattern, when countries suddenly ramp up urbanization rates. High income nations have largely stabilized urbanization levels, while China, India and  all lower-income developing countries still have several decades ahead.

 

If we can identify the next countries experiencing high growth and urbanization, we can go a long way towards understanding the next upcycle in commodities. From looking at historical data, it is the case that urbanization rates ramp up when countries reach a level of wealth around $2,000 per capita (2016, constant USD). The table below shows the progression by decade of new countries entering this wealth level, according to IMF and World Bank data. During the decade ending in 1980, Korea, Poland and Thailand entered into this group; none entered in the 1980s; Russia (and other Eastern European state) appear in the 1990s; and China, Nigeria, Ukraine and Indonesia enter in the 2000s. In this current decade only Vietnam has appeared, so far; but if we look through 2022, we see a massive swell led by India but also including Uzbekistan, Myanmar and Kenya.

It is not the number of countries that matter, of course, but rather the population impact that they represent. The chart below shows the population impact by period, in terms of new entrants as a percentage of global population. We can see a huge surge representing 21.8% of the global population (23%, including Vietnam), surpassed only by the China-led surge of the 2000s.

Equally important, the upcoming surge will happen at a time when China sustains relatively high growth and increasing urbanization, so that we will have both China and India sustaining demand at the same time.

A new upcycle in commodity prices is obviously bullish for emerging market producers, such as Chile, Brazil, Indonesia, Russia and South Africa. It also likely points to a weak dollar and good performance for emerging market stocks in general.

Fed Watch:

India Watch:

China Watch:

 

  • US politics gets in the way of Ant Financial’s US plans (SCMP)
  • Making China Great Again (The New Yorker)
  • Geely invests in AB Volvo trucks (SCMP)
  • China’s commodity demand (Treasury)
  • Ground broken on China-Thai railroad (Caixing)

China Technology Watch:

EM Investor Watch:

 

  • France seeks closer ties with Russia and China (WSJ)
  • Latin America’s rejection of the left (Project Syndicate)
  • Indonesia’s bullet-train project stalls (Asia Times)
  • Boeing’s bid for Embraer (Bloomberg)

Technology Watch:

  • Apple’s share of smartphone profits is falling (SCMP)
  • Fanuc’s robots are changing the world (Bloomberg)
  • Battery costs coming down (Bloomberg)

Investor Watch:

 

 

 

 

Business Corruption in Emerging Markets

It is obvious to the casual observer that many successful entrepreneurs in the United States and Europe are immigrants from countries known for their corrupt business practices. Turks in Germany, Indians and Nigerians in England and Mexicans and Brazilians in the U.S., to name a few examples, make enormous contributions to the entrepreneurial dynamism of their adopted countries while upholding the highest business ethics.

Why do immigrants change their behavior when they leave their home country? A Nigerian or Indian businessman in his home country might dedicate a significant part of his time and resources to corrupt practices but when in England apply all his efforts to making his business more innovative and efficient. The very recent case of the Batista brothers in Brazil highlights this phenomenon. Joesley and Wesley Batista, over a period of 15 years, grew their company, JBS, from a small regional meat-packing business in Brazil into the largest meat-processing firm in the world, with dominant operations in Brazil, the U.S., Europe and Australia. There is no doubt that the Batista brothers were very astute and visionary businessman, and they ran their operations very efficiently and professionally. However, it has been revealed in recent months that one of the brothers, Joesley, dedicated essentially all of his time to greasing the hands of politicians in Brazil to secure cheap financing from public banks and other favors.  While Joesley acted with total impunity in Brazil and is reported to have paid more than $150 million in bribes to over 1,800 politicians, there is no evidence of any illegal acts by the Batista’s or their employees outside of Brazil where by all accounts they acted as upright corporate citizens.

The case of the Batista brothers illustrates perfectly a theory proposed by the American economist William Baumol. In a seminal 1990 paper, “Entrepreneurship; Productive, Unproductive and Destructive behavior,” Baumol argued that though some societies or cultures may have more entrepreneurial dynamism than others what matters more is how that entrepreneurial spirit is allocated. Business people can apply their entrepreneurial spirit towards productive activities such as innovation or to non-productive activities such as rent-seeking, or, in a worse-case scenario, to destructive activities such as organized crime.  According to Baumol, the actual supply of entrepreneurship does not vary as much as its allocation to productive or non-productive activities. Entrepreneurs react rationally to the different payoffs society offers and will dedicate themselves to non-productive activities if that is where they find the highest returns. As the theory predicts, when in Brazil the Batista’s applied themselves assiduously to rent-seeking behavior because payoffs were high, but outside of Brazil they stuck to a strict legal path and focused on management and innovation.

The case of the Batista’s is not at all unique. Brazilian’s have long quipped that “businessmen work when the government goes to sleep at night.” The CEOs and CFOs of Brazil’s leading companies, even when they espouse the highest ethical standards, are required to spend an inordinate amount of time courting politicians and are expected to travel frequently to Brasilia at a moment’s notice.

Baumal’s theory links well with the argument of the “institutionalists” like Daron Acemoglu (Why Nations Fail) who argue that strong institutions (e.g., the judiciary) underpin development.  Clearly, an efficient bureaucracy and effective judiciary would reduce the opportunities and greatly increase the cost of corruption in Brazil and motivate entrepreneurs to direct their energies to legal activities.

In any case, the implications for policy makers are clear. Countries like Brazil, Argentina, India and Nigeria have huge repressed entrepreneurial spirit that could be unleashed if the business environment was less conducive to corruption.  Reducing bureaucracy, regulations and taxes should be at the top of the list. It is not a coincidence that the countries that rank poorly in the World Bank’s Ease of Doing Business survey tend to be the same where corruption is most prevalent. Straight-forward bureaucratic reforms can make a large difference. For example, in many countries, something very basic like opening or closing a business can require large expenses and months of time, pushing small businesses to take the path of informality. Privatizing state-owned firms also must be pursued, as time and time again we see these entities at the center of political influence-peddling and rent-seeking behavior.

As Baumal concludes, “the overall moral, then, is that we do not have to wait patiently for slow cultural change in order to find measures to redirect the flow of entrepreneurial activity toward more productive goals… It may be possible to change the rules in ways that help to offset undesired institutional influences or that supplement other influences that are taken to work in beneficial directions.”

 

India Watch:

China Watch:

  • Meet China’s evolving car buyer (McKinsey)
  • Beijing praises patriotic entrepreneurs (SCMP)
  • Reconnecting Asia (CSIS)

China Technology Watch:

  • FT has lunch with JD.com’s Liu Qiangdong (FT)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

  • The collapse of Venezuela (Vox)
  • Chile’s energy transformation (NYT)
  • Reconnecting Asia (CSIS)
  • Sam Zell is back in Brazil (CFA Institute)
  • Corruption in Latin America (IMF)

Technology Watch:

Investor Watch:

Notable Quotes:

Opportunity for Growth and Scale in Emerging Markets: In the 1990s, Zell and his team were intrigued by the opportunities in emerging market real estate platforms and other types of emerging market companies and started investing. Even though the potential for strong returns was much higher, Zell’s team wasn’t deluded about the trade-offs. “Investing in emerging markets is a bet on growth,” he said. “But what’s being given up is the rule of law.” That compromise is one he never takes lightly.  Sam Zell (CFA Institute)

Before I begin telling you what I think, I want to establish that I’m a “dumb shit” who doesn’t know much relative to what I need to know. Whatever success I’ve had in life has had more to do with my knowing how to deal with my not knowing than anything I know. The most important thing I learned is an approach to life based on principles that helps me find out what’s true and what to do about it.  Ray Dalio, Bridgewater

 

 

Venezuela’s Tragic Collapse

 

Venezuela’s catastrophic social and economic collapse, the result of two decades of authoritarian populism, shows the precariousness of development for countries with weak institutions. Similar forces in recent times have brought misery to Zimbabwe and threaten both South Africa and Brazil.

Once Latin America’s richest nation, a thriving middle-income democracy which attracted immigrants and capital investments from around the world, Venezuela fell prey to Hugo Chavez, a charismatic “caudillo,” who promised a “Bolivarian Revolution” to bring social justice and prosperity for all.

Chavez cleverly exploited a serious economic downturn in 1998 in Venezuela caused by a collapse in oil prices, and he also tapped into popular disenchantment with a democratic regime marred by corruption, mismanagement and by a failure to renew its leadership. At year-end 1998, Chavez was elected president on a populist, anti-establishment, “drain-the-swamp” platform.

Chavez faced severe opposition in his early years. His efforts to concentrate power in the presidency and weaken the judiciary were rebuked by an anxious middle class, the media and the business community, and he was almost ousted by a military revolt in 2002.

But then, the winds of fortune changed for Chavez. Just as he was doubling down on his Bolivarian Revolution by purging the military and the national oil company PDVSA of “anti-revolutionaries” and accelerating the nationalization of industry and the socialization of farming, oil prices began to rise because of the China-fueled global commodity boom (2003-2012). At the same time, the global capital markets opened for Venezuela, and the country began a massive credit-binge. Accompanied by price controls, all of this created an enormous temporary illusion of prosperity.

Though the George W. Bush Administration initially took a strong stand against Chavez, once Chavez was able to use the oil bonanza and foreign credit to fund social programs the apologists for the regime started to dominate the discourse. Perhaps swayed by a parade of intellectuals and Hollywood figures who fell for the Chavez charisma and sang the praises of his Cuban-designed social programs, the Obama Administration sought to normalize relations with Venezuela. President Obama also heaped praise on Brazil’s President Lula (“That’s my man right here… Love this guy. He’s the most popular politician on earth.”) whose popularity also increased in line with commodity-boom-fueled economic growth and ample global liquidity. Eminent economists like Joseph Stiglitz, Noam Chomsky and Paul Krugman and institutions like the World Bank also fell in line and lauded Lula and Chavez for improving wealth distribution and giving the poor access to public services. Hollywood director Oliver Stone released a fawning documentary on Chavez in 2009 (South of the Border) acclaiming “a triumph for Venezuelan democracy” and an “alternative to capitalism.”

Washington abdicated its traditional strong influence on Venezuelan affairs in deference to South American sensibilities on non-intervention and in response to a vigorous defense of the Chavez regime led by the leftist governments of Brazil and Argentina. A policy of appeasement was taken as Venezuela pursued its course towards dictatorship and economic collapse.

The plummeting of oil prices in 2014 brought Venezuela’s dream of an alternative capitalism to a brutal end. Chavez had the good luck of dying just before the global capital markets shut down for Venezuela (2013) and oil prices collapsed (2014). He left the country and his successor, Nicolas Maduro, with gargantuan deficits and rampant inflation. Over the past three years, Venezuela has suffered what is perhaps the worst economic collapse of any country in modern history. Harvard Professor Ricardo Haussmann, a Venezuelan who served as planning minister in 1992-93, has documented the extent of the collapse (Venezuelan Tragedy, FT AlphaChat):

  • Output from the productive sector of the economy has fallen by 55% since 2013.
  • The median household wage at the black-market rate is $20/month, and buys 7,000 calories/day compared to 55,000 in 2012.
  • Collapse in public services and health standards are “beyond belief,” and Caracas is the murder capital of the world.
  • Assets of the financial system have fallen by over 90% since 2012 and the banking system has essentially ceased to exist.
  • Public external debt rose from $24 billion in 2004 to $178 billion today, of which $56 billion is owed to China. Haussmann questions the ethics of this lending which served only to prop-up the regime, and he is particularly critical of a recent $850 million “odious” transaction with Goldman Sachs carried out with an expected yield of over 50% annually.
  • To remain current on the servicing of the foreign debt the government has cut imports by over 80%.
  • The productive capacity of PDVSA has been compromised, with oil output falling from 3.7 million barrels/day in 1998 to 2 million today. PDVSA has become the funder and administrator of social programs and the primary locus of corruption.
  • Nationalized firms have been decimated. For example, the steel company, SIDOR, now produces 200,000 tons/year with 22,000 workers, compared to 4.5 million tons with 5,000 employees before.
  • The private sector has been destroyed by expropriations and price and currency controls.

The damage done is irreparable and Venezuela will take decades to recover. The country has become one of the most hostile places to run a business in the world, ranked 187th out of 190 countries in the World Bank’s Ease of Doing Business 2017 survey, surpassed only by Libya, Eritrea and Somalia. An enormous brain-drain of educated Venezuelans working in the oil sector and the private economy and the closure of thousands of businesses can only be reverted over time. Haussmann points to Albania, the former basket case of Eastern Europe that has started a recovery process over the past twenty years, as a source of hope.

Hopefully, the United States and the global community will orchestrate a massive humanitarian and financial effort to help Venezuela recover once the Bolivarian Revolution dies.

Why has Venezuela’s tragic collapse happened?  It took a coincidental combination of a charismatic demagogue and discredited institutions for the process to be triggered and a pliable and easily hijackable political system for it to flourish. Fortunately, in Brazil, at least for the time being, the judiciary, the press and the political establishment have been able to thwart Lula’s project.

Us Fed watch:

China Watch:

China Technology Watch:

  • How Baidu will win the global AI race (Wired)
  • China leads the world in digital economy (McKinsey)

EM Investor Watch:

  • Russia is becoming a food superpower (Bloomberg)
  • Norway’s sovereign fund drops EM bonds (Bloomberg)
  • Emerging Markets look undervalued (Seeking Alpha)
  • No crisis in Venezuela (Al Jazeera)
  • How Western capital colonized Eastern Europe (Bloomberg)
  • From Soviets to oligarchs (NBR Working Papers)
  • Emerging Markets are turning the corner (Seeking Alpha)
  • Understanding the Russian mind-set (Spiegel)

Technology Watch:

  • Pandit says 30% of bank jobs will disappear in next 5 years (Bloomberg)
  • Nike’s Static-Electricity robots (Bloomberg)
  • Government Investment was key to US success (Teasri)

Investor Watch:

The EVP of Johnson and Johnson’s consumer products  did a great job of summarizing the immense challenges facing the industry and features heavily in this week’s post. He argues that historical barriers to entry are crumbling and that data is the new barrier to entry. It’s an interesting thesis, and only time will tell if it’s the right one, but it explains why companies are scrambling to use machine learning to make sense of the data that they have access to. One might wonder though, if old-line companies are leveraging tech companies’ cloud and engineers to unlock insights into their data, who’s data is it anyways? (Avondale)

Consumer:

The head of J&J’s consumer division laid out the problems facing consumer products companies:

Competitive advantages are being dismantled

“the reality is that the pace of change in our industry is truly accelerating…If you look at our last few decades in this industry, there were a series of barriers for entry or sources of competitive advantage that were well established but those are becoming less and less unique.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

It’s hard to have a monopoly on talent

“It used to be that companies like ours would acquire the best talent through our recruiting human resources mechanism, but it’s never been easier for you to source great talent across the world on demand.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

It’s never been easier to build a brand

“Our ability to build and nurture brands, brand building competencies used to be again a source of competitive advantage but the reality is it’s very easy for you to start building a business, building a brand from scratch and you really don’t need a ton of money to get a community of active users that support you.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

It’s not hard to access global manufacturing expertise

“Large scale manufacturing assets used also to be a source of competitive advantage. But the reality is if you want to compete in this industry, you can access high quality contract manufacturing work any place in the world.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

Retailer relationships are no longer a moat

“Retailer relationships used to be also a source of advantage and a barrier for entry, but as you all know, new companies can now sell directly to consumers profitably in most markets. And then financial firepower for companies like J&J is not as critical as it used to be because new startup entrants can access capital relatively easy through VCs.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

The disruption is digitally enabled

“So this disruption that is happening is digitally enabled and is changing the face of our industry. You see these new players coming into our category and at the heart of this disruption, there is a new consumer centric paradigm and that’s challenging completely the cost of goods scale and the value scale as we know it and its forcing a change in both the retail and the media landscape.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

Small companies are succeeding because they stay close to the consumer and have digital DNA

“small players are the ones that are gaining share and majority of large companies are losing market share…they are really committed to breakthrough innovation by staying really close to consumers and customers and staying on top of consumer trend. They see where the product is going and they are designing to what that emerging consumer need is. They are focused on building digital first brands that have a clear purpose and a reason for being that resonates with millennial consumers. They capitalize on the rise of emerging channels. They don’t just play in the legacy channels but they figure out what are the new shopping behaviors, new emerging channel trends and they disproportionately drive growth in those channels. They are hyper efficient. Normally have very lean cost structures, flat organizations, no bureaucracy and as a result they move very fast. Speed is a great currency for them.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

Big companies are becoming value added VCs

“the innovators are launching hundreds of new products every year. But once they’re successful, they all have the same kind of issues, issues like buying, procurement, like selling, distributing, manufacturing and capital. And so, we have a venture group that we started about ten years ago and, basically, it goes out to all the entrepreneurs and says, instead of going to private equity to get money, why don’t we work with you, we’ll invest in you and we’ll help you. And we’ll help you take your idea, solve some of the issues you might have, and we can see how you can be a part of what we’re doing and we can help you achieve your dreams as an entrepreneur…All of that allowing us to kind of source external innovation, so that when you take a healthy core, build strong, new businesses, and then bring all the next businesses in, it gives you a sustainable top line.” —Coca Cola EVP Sandy Douglas (Beverage)

Data is the new barrier to entry

“And what we’re seeing now is there is a new playbook emerging, a new how-to-win playbook that is really characterized by an asset light infrastructure. And the control of the consumer relationship, via the acquisition of the…data that allows for you to have a highly personalized iterative on demand consumer experience. And the ownership of this relationship with consumers and associated ecosystem that comes with it is now the new playbook. It is now the greatest new source of competitive advantage.” —Johnson and Johnson EVP Jorge Mesquita (Healthcare)

The Bullish Case for Brazilian Stocks

Brazil is coming out of one of the worst economic slumps in its history, after having lost more than 7% of its GDP over the past three years. A huge binge caused by a boom in commodity prices (2004-2011) which led to hot-money capital inflows and excessive credit and consumption was followed by a large hangover, made much worse by a political crisis and a draconian monetary policy of extremely high real interest rates. But all downturns come to an end, and Brazil is now poised to start a new growth cycle on solid ground. Corporates now have very lean cost structures, and they will see significant margin leverage as sales recover. Profits are very depressed; in 2016 they were at 2005 levels. At the same time, the market is inexpensive relative to its history and one of the cheapest in the world, so there are good prospects for both vigorous profits growth and multiple expansion over the coming years.

It can be argued that the past 10-15 years were wasted by Brazil. The Workers Party (PT) governments of Presidents Lula and Rousseff coasted on the reforms passed by the previous administration and sat back to enjoy high commodity prices and ample foreign capital inflows.  Several important achievements of the previous government, such as depoliticized regulatory agencies and the professionalization of public companies, were discarded, and new reforms were taken off the agenda. The PT focused mainly on a multitude of poorly-designed social welfare programs and corporate subsidies, without consideration for the fiscal consequences. When commodity prices retreated and the mismanagement and corruption of the public sector was revealed, the party came to an end.

The interim president Michel Temer, who replaced Rousseff after her impeachment, has made good progress towards putting Brazil’s economy back on the right track. For the first time in nearly twenty years, Brazil now has a reform agenda and a real opportunity to break out of economic stagnation (Brazil’s Economic Stagnation). An inbred love for experimental developmental economics and a complacency facilitated by the commodity boom and Petrobras’s oil finds, seem to finally have been replaced by a new realism and a desire to follow market economics. The country has woken up to the evidence that Argentina and Venezuela are not better models to follow than Chile and Mexico, and that wholesale antagonization of the U.S. leads nowhere.

Temer has already secured passage of a “fiscal responsibility law” which limits public spending increases to inflation and provides a possible anchor to a future of fiscal rectitude.

Temer has also brought competent management back to the state-owned national oil company  Petrobras, the electricity-holding Eletrobras and other public entities. Petrobras has started a process of selling non-core distribution and refinery assets, to focus on managing the development of its prodigious deep-water oil reserves. Temer has also proposed privatizing Eletrobras, a state electricity conglomerate that has long been a hotbed of patronage for politicians. Moreover, additional privatizations and infrastructure concessions once again are being advanced. It appears that these will be done in a manner to promote investment and efficiency, not for the convenience of corrupt construction companies and their political friends, as was the case during the Lula and Rousseff governments.

The good news for the stock market is that there are plenty of low-hanging fruits for Brazil to collect.

First, after this dire 3-year economic recession Brazil will enjoy a natural rebound. That alone should guarantee moderate growth in coming years. The negative effects of low commodity prices have already been felt and these are likely to stabilize from now on.

Second, important reforms of social security and labor are likely to pass. Consensus appears to have evolved in favor of these fundamental reforms. Social security reform is vital to stabilize fiscal spending. A labor reform could create enormous opportunities to create jobs in the formal economy.

Third, productivity is very low (at about a quarter of US levels) and productivity growth has been abysmal. Brazil has huge potential to increase productivity by pursuing two tracks:

  • Lower tariff and non-tariff barriers to open the economy. Brazil can take advantage of the enormous presence of mutinationals and the scale of their Brazilian businesses to promote integration into global supply chains and increase exports. For example, the auto industry currently has very low productivity and is mainly domestic focused.
  • Brazil has a pathetically low rank in the World Banks’s “ease of doing business survey”, and has seen no progress over the past decade. It has the worse ranking in Latin America and one of the worse for the main emerging markets. A methodical approach towards deregulation and tax-simplification would quickly yield high dividends.

World Bank’s Cost of Doing Business Country Rankings

Fourth the stocks market is inexpensive relative to both its history and other stock markets.

  • Dollarized earnings rebounded strongly in 2016 and will rise another 20% this year, but they remain below the level of 2005 and at about half the level of 2010-11. With very lean cost structures, companies will see better margins and earnings as the recovery progresses.
  • Cyclically adjusted price earnings (CAPE) ratios on a dollarized basis are cheap relative to Brazil’s stock market history as well as compared to other markets. In a world of very high assets prices caused by the impact of monetary policies on the pricing curve for capital duration and risk, emerging markets equities in general and Brazilian equities  in particular still trade below long term averages. Though CAPE ratios in general are not a good timing tool, they are very predictive of market performance on a 7-10 year basis in developed markets and a 3-5 year basis in emerging markets where cycles tend to be shorter and more abrupt.

There are sufficient risks in Brazil so that the market will face a wall of worry. At the top of the list is the outcome of next year’s presidential election. A successful run by Lula, a low probability at this time because of his legal problems, would certainly unsettle the markets.

Longer term, Brazil faces two fundamental issues.

  • A chronically overvalued currency. It is an absurdity that Brazil has the sixth  most expensive BigMac in the world, a reflection of the very high costs of doing business and an over-valued currency. Policymakers need to constantly remind themselves of former Finance Minister Mario Simonsen’s dictum, “A inflação incomoda, mas o câmbio mata. (Inflation is a nuisance but the foreign exchange rate kills.“ )

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  • Pro-cyclical policies. Every cycle, Brazil ‘s politicians increase spending during the boom times and then are forced to retrench during the busts. As John Maynard Keynes wisely noted, “The boom, not the slump, is the right time for austerity at the Treasury.”

 

Us Fed watch:

India Watch:

  • India’s rural distress puzzle (livemint)
  • The battle for India’s gold market (Bloomberg)
  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The coming clash of empires, Gavekal  (Zero Hedge)
  • The global economy’s new rule maker (Project Syndicate)
  • Chinese millenials will drive global growth (SCMP)
  • China’s booming pet-care industry (WIC)
  • Hyundai feels the wrath of China (Caixing)

China Technology Watch:

  • Chinese firms eyeing passinger drones (WIC)
  • China military focuses on drone swarms (FT)
  • Big data war in China (WIC)
  • Qualcomm plays the China tech game (WIC)
  • Alibaba wants to bring big data to 1 million small shops (Caixing)

EM Investor Watch:

Technology Watch:

  • Nike’s Static-Electricity robots (Bloomberg)
  • Government Investment was key to US success (Teasri)

Investor Watch:

Brazil’s Economic Stagnation

Brazil is a poster child for the “middle-income trap,” the phenomenon that keeps developing economies from narrowing the wealth gap with wealthy countries once they have reached a moderate level of prosperity. As is typical for many emerging market countries which are over-dependent on commodity exports and foreign capital inflows, the Brazilian economy experiences frequent boom-to-bust cycles, the latest being the commodity/liquidity/credit-fueled consumption boom of 2003- 2013 which was followed by a deep recession in 2014-2017. The overall result is mediocre growth. Brazil’s GPD per capita relative to the high-income economies is at the same level as in 1960, and actually has deteriorated significantly since the late 1970s.

A recent paper by Jorge Arbache and Sarquis J. B. Sarquis, Growth Volatility and Economic Growth in Brazil (Arbache-Sarquis) argues that Brazil’s poor performance is tied to the high volatility of the economy which in turn is caused by uncertain commodity prices and capital flows and their effects on currency valuation. It makes intuitive sense that volatility would hurt growth; boom-to-bust cycles are inefficient, as economic agents over-indulge in good times and retreat in bad times. Volatility also makes it difficult for both the public and private sector to plan and budget long term investments.

Brazil’s economic volatility is caused by well-known factors:

  • Chronic low savings and high current account deficits financed by fickle foreign capital flows.
  • Exports dominated by commodities, and the current account highly impacted by commodity prices. High commodity prices improve the current account which lowers country risk premia and leads to higher foreign financial and investment When commodity prices fall, the process unwinds.
  • Pro-cyclical currency valuation. The currency appreciates during good times and weakens during busts. During currency appreciations manufacturers lose export competitiveness and focus on growing domestic consumption.
  • Monetary policies dictated by the U.S. Fed. The deep recession of 1981-83 was triggered by U.S. Fed Volcker’s high interest rates imposed to wage his war on inflation. The boom of the last decade was fueled by Fed-fueled global liquidity.
  • Pro-cyclical fiscal and monetary policies; fiscal expansion during booms and retraction during busts. During the current deep recession in Brazil, the authorities have both increased real interest rates and tightened fiscal spending.
  • Chronic fiscal imbalances cause uncertainty and high country risk premia.

The current boom-bust cycle has been particularly destructive for Brazil. The china-induced commodity boom caused excessive currency appreciation, a credit-fueled consumption surge and severe deindustrialization.  In sharp contrast to successful Asian economies that have promoted the exports of manufactured goods, Brazil has evolved prematurely into a service economy. 76% of jobs in the Brazilian economy are now generated by the service sector, and the great majority of these jobs are low-skill, low wage jobs. Manufacturing’s share of GDP has fallen from 34% in 1980 to 10% in 2015, and Brazil has become increasingly dependent on commodity exports.

Brazil’s Central Bank has pursued inflation-targeting, the latest fashion for global monetary authorities, with abandon. During the past decade and especially the past three years of deep recession, Brazil has consistently had the highest real interest rates in the world. The famous dictum voiced by former Finance Minister Mario Henrique Simonsen  — “A inflação incomoda, mas o câmbio mata (Inflation bothers but the foreign exchange rate kills.“ ) has been entirely forgotten.

How can Brazil avoid boom-bust cycles in the future? As Arbache and Sarquis state in their paper, given Brazil’s history it is better to aim to grow in a stable and sustained manner than to seek high rates of growth. Solving chronic fiscal and foreign account imbalances are at the center of any reduction in volatility. On the foreign account side, it would be imperative for Brazil to maintain a competitive currency to promote domestic manufacturing and gradually diversify from commodities.

However, Brazil’s poor economic performance is only partially explained by volatility. More importantly, Brazil does poorly in human capital development and in providing a good environment for business. Steady improvement in both these areas would boost sustainable growth. Unfortunately, Brazil has shown no progress in these areas. Its ranking in the United Nations Human Development Index has fallen from 69 to 79 over the past 15 years. Ditto for the World Bank’s Doing Business survey which ranks countries in terms of the quality of the regulatory and institutional framework for business and where Brazil has shown no progress whatsoever.  Brazil ranks a miserable 123rd on the list, lower than 119 in 2006, and the worst performing of the major emerging markets except for India.

 

Us Fed watch:

Brazil Watch :

India Watch :

China Watch:

  • Beijing’s New Airport (Caixing)
  • Xi Jinping’s War on Financial Crocodiles (FT)

China Technology Watch:

  • China aims to be a leader in 5G  technology (WIC)
  • China Shows off New Generation of High-Speed Trains (Caixin)
  • CRRC Wins Train Supply Deal in Montreal (Caixin)
  • Chinese Phones Take over Indian Market (SCMP)

China Consumer Watch:

  • China’s aging (Bloomberg)
  • P&G Refocuses Strategy on Premiumisation ( SCMP)

Eastern Europe Watch:

Poland is breaking out of the Middle-Income Trap (NY Times)

Commodity Watch:

  • Oil’s Game of Chicken; Can OPEC Finally Bankrupt U.S. Production (Seeking Alpha)
  • Will U.S. Drillers Drive Oil Prices Into the Ground (Fed Up)
  • Temasek on Chinese Overinvestment (CNBC.com)
  •  China’s Steel Overcapacity (Peterson Institute)

Technology Disruption Watch:

Anti-Globalization Watch:

Emerging Markets Investor Watch:

Notable Blogs:

Notable Quotes:

“The biggest unknowable is that you have the illusion of liquidity. You have people who promise overnight liquidity that have taken quite illiquid positions, particularly lending to various entities. As long as the party continues that’s fine, but should this liquidity be tested it’s not going to be as deep as people think.” – Mohamed El-Erian

“When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.” (Bob Rodriguez – We are witnessing the development of a “perfect storm”(seeking alpha)

“Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepte theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.” (Robert Schiller)