Category: Global Emerging Markets

Chile’s Constitutional Trap

Latin America’s persistent economic decline relative to other emerging markets over the past 40 years can largely be attributed to poor governance. The region has become the main example for the “Middle-Income Trap” which results when rent-seeking interest groups institutionalize policies that make reforms nearly impossible in the future. Typically, these policies are introduced at times when social turmoil leads to “regime changes,” often through constitutional reforms. Brazil went through this process in the 1980s. Chile is going through a similar experience today.

Over the past thirty years, Chile has been the only successful major economy in Latin America. Until recently,  it was considered a serious candidate to join the club of high income and developed economies. However, inconsistent economic policies over the past decade and an explosion of social turmoil in 2019 appear to have brought about a regime change, which would reverse most of the pro-investment policies introduced during the military regime by its free-market “Chicago Boys.” A Constitutional Convention, firmly dominated by progressive and parochial interests, is now in session to define the rules of this new regime.

The example of Brazil should make Chileans very nervous. Brazil’s military regime (1965-1985) collapsed during the Latin American debt crisis of the early 1980s, a period  of increased political and social protest. Amidst this popular demand for change, progressive politicians filled the political vacuum left by the military. A Constitutional Assembly dominated by progressives came up with the “People’s Constitution,” which, according to its President, Ulysses de Guimaraes, would protect Brazil’s “suffering poor, massacred, humiliated and abused throughout history.” The new Constitution was a full rejection of the Military Regime’s trickle-down, investment-led approach in favor of one focused on securing social rights and economic safety nets.  Important interest groups with political influence, particularly civil servants, captured for themselves juicy windfalls. (One lone dissident voice at the convention, Senator Roberto Campos, a leading figure in economic policy during the military regime, decried the new constitution as “a mix of panaceas and passions…a catalogue of utopias… a civic Carnival… a hodgepodge of pettiness, xenophobia, irrational economics, corporativism, pseudo-nationalism and other foul “isms.”)

Very soon following its approval in 1988, more sober economists and policy makers began arguing that the Constitution – particularly its extremely generous provisions for civil servants–would prove a fiscal straitjacket and a severe burden on public policy.  For the past thirty years, successive governments have sought, with little success, to reform the Constitution to allow more flexibility in fiscal spending

One of the first critics was Raul Velloso, an expert on public finances with a PhD from Yale University. From day one, Velloso warned that the fixed expenditures mandated by the  Constitution  would prove catastrophic for economic growth. This week Velloso published an article in the Estado de Sao Paulo newspaper (Link) summarizing the consequences  of Brazil’s “Citizens Constitution.”

Since 1988 fiscal expenditures in Brazil have become dominated by mandated disbursements for social welfare benefits and civil servant salaries and pensions. We can see this in the chart below, based on Velloso’s data. Government expenditures have become increasingly channeled into constitutionally mandated social spending and civil servant benefits, leaving  scarce resources for anything else. The biggest victim has been investments, which according to Velloso, fell from 16% of the budget to 3%. Public sector investments in infrastructure have fallen from 5.1% of GDP to 0.7% over this period.

The lessons of Brazil are clear. Idealistic social mandates written into Constitutions during times of social upheaval have predictably nefarious long-term consequences. Once granted, benefits are extremely difficult to withdraw. Economic growth and prosperity lose. For Chile, Brazil provides a roadmap for what to avoid.

Emerging Markets Should not be Complacent About Debt

The  monetary and fiscal policies pursued since the Great Financial Crisis and greatly expanded during the COVID pandemic have repressed interest rates and flooded the global economy with liquidity. Low interest rates have promoted debt accumulation and stimulated a global yield chase. This environment has supported the widespread complacency of policy makers and investors who assume that these conditions are here to stay.

The fundamental argument of those who argue that the current mix of policies is sustainable is that low nominal interest rates and negative real rates make the burden of debt low by historical standards. The data series published quarterly by the Bank for International Settlements (BIS) allow us to evaluate this claim. What the BIS data shows is that some important qualifications are in order. Though low debt servicing costs may persist in  the U.S., it seems stretched for many other countries to believe they will be so fortunate.

The chart below shows the latest  non-financial private sector debt service ratios for emerging markets as well as for several key developed markets. Private sector ratios are important as they are very sensitive to credit cycles and the private sector in all these countries is the driver of productivity and growth. The data for China may be less meaningful because of the dominant role of the state in the economy and the difficulty in distinguishing between public and private companies.

What we see is that these ratios vary tremendously across the world and within regions. The United States is in the middle of the pack, a comfortable position for the issuer of the global reserve currency and also the deepest market for “safe” assets. The countries on the left of the chart appear in good shape. On the other hand, on the right side of the chart there are obvious vulnerabilities. France is probably the weakest link among developed countries (twice the level of Germany though below Canada). In emerging markets, Brazil, Turkey and Korea are around the critical 20% level.

These debt service coverage ratios must be seen in the context of the recent wave of Central Bank tightening cycles that have been initiated  to confront rising inflation and capital flight. The chart below from Charlie Billelo details the recent wave of tightening measures. Both Brazil and South Korea are now in tightening mode but still have negative real central bank rates.

We should also be aware of the historical context. We can see the historical trends for each individual country in the three regional charts below. First, in Asia it is noteworthy that Korea may soon be back to the record-high debt service ratios experienced after the Asian financial crisis.

In EMEA (Europe, Middle East and Africa), the very high and persistently rising ratios of France and Turkey are noteworthy.

Finally, in the Americas the contrast is striking. Both the United States and Mexico have relatively low ratios which are very consistent over time. The U.S. is in a privileged situation as the recipient of global capital flight, and the Federal Reserve may be in a position to maintain negative real interest rates for the foreseeable future. Mexico’s private sector is underleveraged and poised to take advantage of growth opportunities. The situation is very different in Brazil.  Brazil has a history of high and volatile debt ratios. Corporate debt is at record-high levels at a time when the Central Bank may have to tighten sharply,  the economy is slowing to a crawl and capital flight is high.

The BIS data is a warning to not make global generalizations about debt sustainability. Arguments for Modern Monetary Theory, unrestrained fiscal expansion and financial repression may be justified for the U.S., but inapplicable for most countries.

Economic Freedom in Emerging Markets

It is widely acknowledged by development economists that a country’s wealth is correlated to the economic freedom enjoyed by its citizens. The history of Europe supports this idea. From the Italian and Flemish city-states of the 15th century to the United Provinces of the Netherlands in the 17th century and finally England’s Glorious Revolution and the take-off of the industrial revolution in the 18th century, every great surge of prosperity in Europe occurred when republican ideals, open markets and tolerance for new ideas were allowed to flourish and overcome centralized, absolute rule. Moreover, these Anglo-Dutch ideals were the philosophical foundation of the American Revolution and instrumental to the United States’ rise as the world’s most dynamic economy in the 19th century.

The rise of the Soviet Union as an economic power in the 1960s raised doubts about “economic freedom”  being the only path to prosperity. Famously, the economist Paul Samuelson included the chart below in his widely read college textbook between 1961 and 1980, showing the Soviet economy on the path to overtake the United States. Samuelson’s basic argument was that the Soviets would grow faster because investment rates were higher and potential for efficiency gains were greater. Similar arguments were made in favor of the Japanese economy in the 1980s and have returned with even more vigor in relation to China in recent years.

The confidence in China’s ability to sustain high rates of GDP growth in the future is grounded in a belief that  the government is able to successfully steer investments into sectors of the economy with high growth potential. This thinking is rooted in the extraordinary success of the “East Asia Development Model” pursued by Japan, Taiwan, Korea and China which relies on  state support (tariffs, fiscal subsidies, credit subsidies) to corral investments into “frontier” industries with high export potential. It is also supported by arguments, back in favor in Western economic academia (e.g. Mariana Mazzucato, Carlota Perez), which proffer a key role for the state as an inducer of investment in vital industries.

Though it can be debated what the exact role of the state should be as an inducer of economic activity there are a series of objective criteria that can be identified as necessary to provide the appropriate institutional conditions for human and financial capital to be deployed in entrepreneurial activities. These basic conditions can be said then to provide the institutional framework for “economic freedom.”

Several institutions (e.g., The World Bank, The Fraser Institute, The Heritage Institute) have developed methodologies to rank countries in terms of economic freedom over time.

All of these look at a combination of the following factors:

  1. Rule of Law (property rights, government integrity, judicial effectiveness)
  2. Government Size (government spending, tax burden, fiscal health)
  3. Regulatory Efficiency (business freedom, labor freedom, monetary freedom)
  4. Open Markets (trade freedom, investment freedom, financial freedom)

 

The table below is from The Fraser Institute’s 2021 report which is based on 2019 data. The countries are ranked and separated into four quartiles, the top quartile being the countries with the highest level of economic freedom. These rankings are available for the past 40 years to provide a history for evaluating progress or regression over time.

 

The following maps show the Fraser Ranking in both 1980 and 2019. Note the tragic fall of Venezuela from one of the most economically free countries in the world to the bottom.

The following graph looks at the relationship between economic freedom and wealth, using Fraser’s country data and the World Bank’s  2019 GDP per capita as a proxy for wealth. We can see a strong correlation between economic freedom and wealth. Two noteworthy outliers are petro-states (UAE, Quatar, Brunei) and tax havens (Luxembourg) which are considerably above the trend line and Eastern European “reformers” (Lithuania, Lativia, Estonia, Georgia, Poland) which are well below the trendline. Presumably, the Eastern Europeans will experience a period of catching up as they enjoy the benefits of the reforms that have been implemented since the 1990s.

The table below narrows the Fraser Institute’s data for the primary emerging markets of interest to investors. The table shows the four quartiles, the country’s overall rank and the change in the quartile since 1980.

In conclusion, there are several interesting facts to note about the table.

  • Overall, EM has had a small improvement over the past 40 years.
  • In terms of the importance of countries relative to their weight in benchmarks, the rankings are not auspicious. India, Brazil and China, which are really the core of emerging markets as an asset class, are all in the bottom of the Third Quartile. Vietnam, considered by many the most promising frontier market, is in the Fourth Quartile.
  • Those countries in the Second Quartile may offer the best opportunities. I would highlight the Philippines and Indonesia which are on the right path and continue to enjoy high potential growth.
  • The three countries in the top quartile – Taiwan, Chile and Peru — are new entrants to this elite, with Peru coming all the way from the Fourth Quartile. In 1980 EM  had these three countries in the First Quartile, Venezuela, Malaysia and the UAE. Venezuela went from the First Quartile with a highly ranked 16th overall in 1980 to absolute bottom ranking in 2019. Peru’s rise and Venezuela’s collapse are a testament to the institutional precariousness of Latin American institutions.

 

Emerging Markets Stocks Expected Returns, 3Q2021

If forecasting is foolhardy in the most stable of times, trying to make predictions under current circumstances is risible. For the time being, financial markets are driven by the extraordinary policies of U.S. monetary and fiscal authorities which support consumption and provide liquidity to backstop asset prices. The limits of these policies are unknown, but, for now, investors from around the world are willing to engage in this lucrative scheme.

Predictions for the short term are always haphazard. Most market participants simply assume that current trends will continue. They are usually right because trends are persistent while mean reversion occurs over the long-term horizon. The current trends favor investing in U.S. stocks. These have outperformed for over a decade and the biggest and most dominant tech stocks have metamorphized into the new global “safe” asset of choice, replacing return-less U.S. Treasury bonds. Investors have concluded that these quasi-monopolies in winner-take-all growing sectors of the economy are pillars of stability in a turbulent world. The assumptions that underlie this investment thesis are that: 1.  the Federal Reserve is fully committed to sustaining the stock market because it believes that a market correction from the current high levels would cause  a negative “wealth effect” that would precipitate an economic depression; and 2. The Fed desires sustained higher inflation to erode the value of the Federal debt.

The COVID pandemic in a perverse way facilitated the work of the Fed and consolidated what could be called the “FAANG Monetary Standard.”  COVID justified unprecedented levels of monetary intervention and fiscal expansion and drove the stock market to record prices. The exceptional efforts of U.S. authorities made the 2021 recession one of the shortest ever and allowed the U.S. economy to outperform the global economy by a wide margin. Rising asset prices in the U.S. sucked in global capital and pushed up the value of the USD.

Unfortunately, none of this was beneficial for emerging markets. With the exception of China which managed the pandemic well and benefited from the surge of U.S. imports of consumer goods, emerging markets suffered profoundly from COVID, both in terms of short-term growth and long-term growth potential. COVID only accentuated what has been a state of semi-depression in emerging markets for the past decade, as a strong USD and U.S. financial markets have drained them of capital resources.

Ironically, the accelerated nature of the COVID recession in the U.S. will now play against emerging markets as we enter 2022. The United States and China, the two main drivers of the global economy, are now in the process of slowing dramatically as the effects of the COVID stimulus wear off. This means that the expected late recovery of most EM countries will be muted.

In fact, 2022 is likely going to be the year when the markets fully appreciate the devastating long-term consequences of COVID. The enormous increases in government debt incurred by the United States, China and most EM countries in 2021 will weigh on growth for years to come. U.S potential real GDP growth, which was considered to be around 2% before the pandemic, can now be assumed to be considerably lower. Many emerging market countries, including China and Brazil, are facing poor growth prospects as they deal with high levels of unproductive debt.

Ironically, the coming slowdown in the U.S. may continue to favor U.S. stocks and the USD. As the economy slows in coming months, the Fed will have to provide more liquidity to the markets to avoid a correction in asset prices. This may well lead to a further expansion in valuation levels for the tech stocks and final blow off for the S&P500.

The two charts below show the current debt levels in emerging markets and the five-year increase in the level of the debt to GDP ratio for these countries and the United States. The countries with high debt levels and very high recent accumulation of debt generally face difficult challenges ahead. These include, China, Brazil, Chile and Korea.

The next chart shows expected long term stock market returns for EM countries and the United States. The annual returns are for the next seven years but would be similar for 10 years. These returns are in USD terms and assume that EM currencies maintain current valuations relative to the USD over the period. If EM currencies were to appreciate over the period (likely in my view) then returns would be higher.

The details are shown in the next table. Turkey tops the chart and probably provides the best bet for high returns. CAPE ratios below 5 have been in the past fail-safe as an indicator of high future returns. Turkey is well underway in its economic adjustment, with a very competitive currency and export sector and rising business confidence. The Philippines are also well positioned, but do have a challenge to return to the very high historical CAPE, particularly given the lofty weight of financials and real estate in the index. Brazil is cheap but faces high debt and a weak economy as it enters a complicated election year. This is a reminder that CAPE ratios are not helpful for short- term predictions. Moreover, valuation is never enough. Markets always need a trigger.

On the negative side, Taiwan and India both stand out for their very high CAPE ratios. For these valuations to be justified, earnings will have to be much higher than currently anticipated. This means a major ramping up of margins and corporate profitability in India and an extension of the semi-conductor super-cycle in Taiwan.

CAPE Ratios Relative to History and Real Expected Returns, September 2021
Current Cape Historical AVG CAPE Difference Earnings Cycle Expected 7-Year Total Real Annual Return
Turkey 4.4 8.6 -48.84% Early 12.0%
Philippines 15.8 22.8 -30.70% Early 10.3%
Brazil 11.5 12.3 -6.50% Late 9.2%
Malaysia 11.9 15.6 -23.72% Early 7.7%
S. Africa 13 14.5 -10.34% Early 7.6%
Colombia 9.2 14.2 -35.21% Early 7.0%
Peru 16.5 16.9 -2.37% Early 6.4%
China 13.5 15 -10.00% Late 6.3%
Indonesia 13.5 16.1 -16.15% Early 5.4%
Thailand 13.7 14.7 -6.80% Early 4.9%
Mexico 17 17.4 -2.30% Early 4.7%
GEM 14.6 14.3 2.10% Early 4.4%
Chile 14.6 17.9 -18.44% Early 4.3%
Korea 11.6 13.2 -12.12% Early 4.2%
Taiwan 24.9 18.5 34.59% Mid 4.0%
USA 37.9 24.8 52.82% Late 3.3%
Russia 7.9 6.8 16.18% Early 0.8%
India 30.4 20.8 46.15% Early 0.6%
Argentina 9.5 8.5 11.76% Early -7.9%

The methodology used to determine expected returns is the following:

  1. Forecasted earnings for 2022-2028 assume earnings growth of nominal GDP, making adjustments for each country’s place in the business cycle.
  2. A cyclically-adjusted earnings value for 2028 is calculated as an average of inflation-adjusted earnings for the 10-year period ending in 2028.
  3. Each country’s historical cyclically adjusted price earnings ratio (CAPE) is calculated as an average of CAPE ratios for the country since its inclusion in the MSCI index, with an increased weight given to the past 15 years.
  4. The historical CAPE ratio is applied to 2028 earnings to determine the expected level of the country index in 2028.

 

Emerging Markets are Loaded with Debt So Pick Your Countries Carefully

The world is awash in debt. Much of this debt has been accumulated over the past 20 years, and has served to support consumption, government spending and financial markets during a period of declining productivity and slowing economic growth.  Unfortunately,  because this debt was not acquired to increase productive activities, it is not self-sustaining and has become a drag on economic activity.

The chart below shows the steady accumulation of debt in both advanced and emerging market economies. Advanced economies had steady debt accumulation over the past twenty years with peaks around the Great Financial Crisis and the Covid pandemic. Emerging markets saw most of the debt accumulated over the past decade, a period that has had depression like characteristics for most countries and has seen a dramatic decline in the level and quality of China’s economic growth. (All data is from the Bank for International Settlements, BIS Link)

 

The growth in debt in emerging markets has been general. We can see in the following chart that practically all emerging market countries have ramped up debt over the past decade and now find themselves at record levels.

However, not all emerging economies are in the same condition. We can differentiate by both debt levels and rate of accumulation, which is shown in the next two charts.

 

Several countries stand out in having very high debt levels and accelerated accumulation: China, Korea, Chile and Brazil. In none of these countries has the debt been used to increase productive activities. In China, debt mainly supports the real estate bubble and infrastructure investments of marginal utility; in Korea, debt increases have flowed mainly to support consumption. In Chile and Brazil, debt has served to support government current spending and capital flight. Moreover, China, Brazil and Chile face serious economic challenges. Both Brazil and Chile will likely be in recession in 2022, and China’s sustainable growth level is in steep decline.

On the other hand, Indonesia, Mexico, Turkey, Poland Russia and Colombia all have lower debt levels and slower debt accumulation. These economies are coming out of the pandemic in relatively good shape and with the prospect of healthy economic rebounds in 2022-23.

Given a world awash in debt and suffering from low GDP growth, investors should focus on the few countries with good debt profiles and positioned for a rebound.

Is India Assuming Leadership in Emerging Markets?

For those investors who believe in mean reversion and the cyclical nature of capitalism, it is reassuring that sectors and companies do not to retain market leadership for long. However, because of momentum and recency bias, investors always extrapolate the present into the future. So, we see today’s near unanimous agreement that the current crop of great U.S. companies – the tech behemoths – will rule forever, expanding their reach into every nook and cranny of the economy. Until recently, this also seemed obvious in emerging Markets

Just to be contrarian, I’ve argued that, given how utterly unpredictable the future is, new leadership would somehow take over in emerging markets during the 2020s. Given that the past decade belonged to China, and the one before that was all about commodity producers, perhaps India could now have its “roaring” 20s.

The table below shows the ten largest stocks in the MCI Emerging Markets index since its early days, 30 years ago. We can see that every decade was marked by an exceptional trend: 1990, the great Taiwan stock bubble; 2000, the technology-media-telecom frenzy; 2010, the commodity super-cycle; and 2020, the rise of China and its “invincible” tech giants. Well, now it seems China’s tech leaders may have been more Goliaths than behemoths, as they  are being taken down by government regulators who, unlike their U.S. counterparts, have the power to dictate rules to these firms in accordance with their notion of what serves “common prosperity.” China, which had 7 stocks in the top ten at year-end 2020 (including Naspers), now has five; and India has increased its count to two. If we look at the next ten stocks in the following table, we get an even better idea of the change in the investment environment: China had half of these stocks at year-end 2020 and now only two; India had two and now has three. Also joining the list are two more commodity/reflation stocks, Gazprom and Sberbank, both from Russia.

The changes this year in the rankings of the most prominent stocks in EM has resulted from the outperformance of Indian stocks relative to Chinese stocks, as shown in the table below. Year-to-date, Chinese stocks have lost 16% of their value while Indian stocks have appreciated by 27%. Consequently, the weight of China in MSCI EM has fallen from 40% to 35%, while India has risen from 9% to 12%.

So, what is causing the rise of Indian stocks and can this be sustained?

India’s current advantages over China can be resumed as follows: much better demographics, much less debt and relatively greater support for private enterprise over the state sector. Also, India’s GDP is expected to grow much faster than China’s. Moreover, while exports and urbanization (infrastructure/real estate) are mostly tapped out as sources of growth for China, India has long runways in both these areas. Finally, India’s blue chip corporations generally wield significant political power and are unlikely to face the regulatory risks faced by Chinese companies.  To the contrary, India is likely to promote national champions in frontier tech industries, limiting the reach of the American tech giants.

Unfortunately, investors may have already priced in India’s growth opportunity to a considerable extent. Though, in a world of scarce growth and record-low interest rates, Indian blue chips with good growth profiles should be expected to trade at high valuations, Indian stocks now trade at record levels and sky-high valuations. The chart below shows PE and CAPE ratios for MSCI India, with consensus earnings for 2021. CAPE ratios are nearing the “bubble” levels of 2010.

 

The following chart shows historical earnings. It includes the 2021 consensus which appears very optimistic relative to the current condition of the economy and business confidence. We can see in the next chart from Variant Perception that there is currently a severe and unusual disconnect between the level of stock prices and business confidence.

 

The future path of the market will be determined by how this divergence between stock prices and business confidence is decided.

For the market to make further progress from here, India, like almost all non-U.S. stock markets, needs to break out from a long period of earnings stagnation. We can see in the following chart that India over the past four decades has undergone several long periods of earnings stagnation which were followed by sudden bursts of profitability.

 

 

We can see in the final chart that the market is now anticipating another earning surge. The market has  risen well ahead of GDP and earnings (consensus 2021). Of course, this optimism needs to be confirmed. To a considerable degree, this will depend on global developments: basically, a weakening of the USD and a shift away from risk aversion and liquidity preference to higher risk opportunities outside the United States. If earnings can really break out in India, then, it’s off to the races.

America Sucks Up Global Capital and Emerging Markets Languish

 

The collapse of the United States-centered global financial system in 2008 made clear the fragility of the post-industrial model of capitalism built on increasing debt and financial complexity. Since the Great Financial Crisis awareness of the system’s fragility has dominated global investor behavior, causing a long period of global semi-depression, U.S. dollar appreciation and investor preference for the liquid and safe assets available in the U.S. capital markets. Periodic Fed interventions through QE aimed at sustaining asset prices have eliminated downside risk and encouraged this hoard of capital to find its way to Wall Street, causing interest rates on U.S. treasuries to fall to record low levels and the appreciation of all financial assets. Furthermore, it has brought about the extraordinary conversion of the leading technology growth stocks, with their supposed fail-safe winner-take-all business models, into the new global safe-haven liquid asset of choice.

This series of events has brought on a new period of American “exceptionalism.” As shown in the chart below, these are phases in the global economy when through a combination of superior growth, dollar appreciation and risk aversion global capital flows into the United States and U.S. asset prices enjoy an extended period of outperformance. We can see that since President Nixon abandoned the gold standard 50 years ago, the U.S. has had three periods when it has grown more than the global economy: 1980-86 when the combination of Volcker and Reagan boosted confidence in the USD and in the U.S. economy; 1994-2001, the Asian financial crisis and the Telecom-Tech-Media boom; and 2011-2021, QE, fiscal expansion and the new tech boom. Though the long-term trend is clearly for a sharp decline in the U.S. share of global GDP, each one of these upcycles in U.S. relative growth is accompanied by a strong dollar, large capital inflows and a booming stock market. The flip side of these periods of perceived American exceptionalism when the U.S. sucks up much of global capital is weak commodity prices, depressed growth and poorly performing stock prices in Emerging Markets. On the other hand, every downward swing in the chart (1971-1979, 1986-1994, 2001-2011) has seen strong growth and booming asset prices in EM.

 

The current period of  American “exceptionalism” has been particularly painful for most emerging markets.  Even before Covid, emerging markets had suffered a decade of low growth and low investment abetted by weakening currencies and persistent capital flight. Covid seriously worsened this trend, leaving most countries with more debt and worse growth prospects. Capital flight has only increased, much of it headed for “safe-haven” U.S. tech stocks.

The events of the past decade have led to extraordinary divergence between emerging markets and the United States in terms of corporate earnings and stock market performance. The charts below for the United States and major emerging markets seek to contrast the performance of the different markets in what has been an extraordinary era of superior returns for U.S. assets.

The first chart below seeks to provide the context of the long-term  experience of the U.S. stock market since W.W. II , showing the annualized growth in stock prices, earnings and GDP.

We can see that stock prices, earnings and GDP tend to be tied together. This is because over time profit margins tend to revert to the mean and nominal earnings generally follow the path of nominal GDP. Stock prices should marginally rise more than both earnings and GDP over time because price-earnings multiples slowly move higher because of declining transaction costs. Therefore, though earnings rise by 5.8% over this period, compared to 6.0% for nominal GDP, the S&P500 index rises by 7.7% annually.

The second chart focuses on 1986-2021, the post-industrial era. when the pillar of the American economy became services – especially financial services. This has been a very good period for American corporations. This period, marked by hyper-globalization/offshoring, deregulation, lax anti-trust enforcement, declining taxes and interest rates, and ever-increasing financial engineering (leverage, buybacks) – all factors that boosted corporate profitability – has been very favorable for the profitability of U.S. corporations relative to non-U.S. ones.  This period coincides with the modern era of emerging markets investing when institutional benchmarks (e.g., MSCI, IFC) became available. Over this period, we see an extraordinary disconnect between stock prices and earnings and GDP. The table below details the relative growth of the index, earnings and nominal GDP over distinct period. We can see that during periods of American exceptionalism, the U.S. stock market moves well above the long term trends for the market and GDP, with the current level at an extraordinary level of divergence.

The disconnect between index returns, earnings and GDP has been extraordinary. During 1986-2021, the S&P500 index has appreciated at nearly twice the rate of GDP growth while earnings have beaten GDP by about 35%. We can see this gap widening over the past 20 years as earnings grew at nearly twice the clip of GDP. Over the past ten years, the index’s gap over GDP has widened immensely, almost all due to multiple expansion. This multiple expansion can be explained by the “wealth effect” of the Fed’s QE policy, which has pushed up asset prices by eliminating downside risk and lowering discount rates.

A comparison of the U.S and Chinese stock markets reveals stark differences. First, China’s monetary policy has been much tighter and monetary interventions have been aimed exclusively at maintaining the stability of the real estate and banking sectors. While the U.S. Fed can be said to be fixated on stock prices, China’s central bank cares primarily  about real estate prices. This makes sense because the Chinese have most of their wealth in residential properties. Second, while the focus of U.S corporate executives is shareholder returns, China’s companies are mostly controlled by the public sector and their executives are agents of the government. The exception has been venture-capital financed technology companies seeking to emulate the business models and corporate cultures of Silicon Valley, but, as recent events have shown, even these companies are on a tight leash with Beijing.

The nature of China’s listed companies is reflected in their historical performance which we can see in the charts below. The first thing to note is the relationship between the stock market and earnings and GDP. While this relationship in the U.S. has been constant over time (corporate margins and stock multiples revert to the mean and expand in line with GDP), in China they are unrelated. While China’s GDP has been on an unprecedented 30-year expansion, this is not reflected in stock prices or earnings. (However, over this period there has been an extraordinary appreciation in real estate prices). Remarkably, since 1992, China’s GDP has expanded at a rate of nearly 13% annually, while stock prices and earnings have declined. Even over the last decade which has been marked by the rise of China’s privately owned tech giants and yuan appreciation relative to the USD, earnings have been negative. This is a testament to global depression-like conditions, manufacturing oversupply, and misallocation of capital by state firms in China’s debt-driven economy. These conditions are likely to persist into the future as China’s government forces both public and private firms to invest in “strategic” frontier industries to secure independence from western suppliers.

Finally, we look below at three other EM countries: India, Brazil, and Taiwan.

India: The charts show that the long-term relationship between stock index appreciation, earnings and GDP has occurred in India as should be expected. Over the 1990-2021 period, Indian earnings and GDP growth are very similar. Stock prices have grown at a slightly higher rate which can be explained by multiple expansion and the current high level of the market. Over the 2001-2021 period the relationship between earnings and GDP holds tightly, while stock prices race ahead and experience two “bubbles,” in 2008 and at the present time. Over the past ten years, the global depression/strong dollar environment impacted GDP and especially earnings while the stock market disconnected as valuations returned to “bubble” levels (CAPE ratio at 28.1 which is the second highest ever, only below 30.6 in 2010).

In Brazil the relationship between GDP growth and stock price appreciation holds up as expected. However, earnings do not keep up. The 1986-2021 period in Brazil is marked by high economic volatility, boom-to-bust cycles and mismanagement of state companies, conditions which are detrimental to corporate investment and profits. Brazil missed out on the trade benefits of hyper-globalization and underwent a process of accelerated premature deindustrialization, leaving the economy and stock market highly vulnerable to commodity boom-to-bust cycles. Over the past decade, Brazil has been hit twofold by the collapse of the commodity supercycle and the global depression/strong dollar environment. Unlike EM countries in East Asia and India which have produced tech champions , Brazil has been largely “colonized” by Silicon Valley.

Taiwan provides an interesting contrast to Brazil, India and China. Over the 1986-2021 period stock price and earnings are closely tied but GDP lags behind. This is because Taiwan’s highly dynamic and increasingly profitable tech companies have a greater weight in the stock index than their share of GDP. Also, these numbers reflect the current “bubble” valuations and unusually high margins of tech companies, both of which should revert over the medium term. This effect has been particularly important over the past ten and twenty years, as TMSC has become one of the largest and most profitable global technology firms.  In contrast to Brazil which exports commodities and China where exporters have a small weight in the stock index, Taiwan’s market-driven technology companies dominate the index. This has enabled Taiwan to sail through the global depression/strong dollar environment of the past decade.

What these charts show is how difficult it is for emerging markets to do well in periods of perceived American exceptionalism. Though Taiwan appears to be an exception, its performance is driven mainly by the enormous success of TSMC. In China, India and Brazil it has been a very poor past decade for corporate earnings. This is not likely to change until the current cycle of American exceptionalism ends. This is long overdue and will happen eventually,  triggered by a new wave of optimism on global growth. However, for the time being, fear still dominates and the capital hoards will go to the “safety” of U.S. tech stocks.

Chile’s New Reality; from Tiger to Sloth

In the past, Chile was considered a rare economic success story in emerging markets,  in the same vein as the high-growth “Tigers”  of East Asia. After the neo-liberal reforms introduced by the “Chicago Boys” of the military dictatorship (1973-1990), Chile enjoyed high GDP growth and significant improvements in social indicators. However, in recent years progress has stalled and Chile has started to look a lot more like its regional neighbors than like an East Asia tiger. Moreover, this process of convergence with the region is expected to accelerate in the near term as a constitutional assembly approves a new progressive constitution that is expected to greatly increase social rights and benefits and undo much of the  neoliberal economic framework imposed during  the military regime. Undoubtedly, these important changes will impact growth and the investment environment. Investors would be negligent to not incorporate this new reality into their analysis of business opportunities.

Chile’s growth path has been on a steady decline. Following about a decade of spectacular growth (1986-1997) the economy has gradually lost its dynamism.  Even during the commodity super-cycle of (2003-2012), growth levels were a step below the previous trend. Like in the rest of commodity-producing Latin America, the commodity boom was more a curse than a blessing, leaving behind high debt levels, an overvalued currency and deteriorated governance.  Since the commodity bust in 2012, the country has entered a low growth path and faces increasing social instability resulting from the unmet high expectations generated during the boom years. The chart below shows Chile’s GDP growth path since 1980 and the IMF World Economic Outlook projections through 2026. The IMF now sees Chile’s sustainable GDP growth path to be around 2.5%, which is only slightly above the regional average and a fraction of previous growth. Moreover, the IMF’s numbers do not yet take into account the considerable economic disruption that will probably result from the upcoming constitutional reform.

The marked reduction in growth prospects for Chile will mean lower corporate profit growth and impact  stock market valuations.  We can look at history to put this in context.

The first chart below shows the performance of stocks on the Santiago exchange for the very long term (1894-2021). We can see a long decline from the 1890s through 1960, and then a more precipitous decline caused by the political agitation of the 1960s and the rise to power in 1970 of the socialist,  Salvador Allende. The concurrence of the military coup in 1973 and a boom in commodity prices led to a huge stock market rally in the 1970s, with the index rising by 125 times (a dollar invested in 1970 would have appreciated to 125 dollars in 1980). Then came the collapse in  commodity prices and the Latin American debt crisis, and the market lost 86% of its value before stabilizing in December 1984. From that low point the market would rally 33.5x before topping in July 1995. In retrospect, we can say that 1995 was the glorious peak for Chilean stocks. The stock market provided dollarized annualized returns of 39.6% between 1973 and 1994. Between 1994 and today annualized returns have been a measly 1.9% (These numbers are before dividends which increase returns by about 2% per year). About 70% of contributors to the Chilean Pension fund system joined after 1994 and therefore have experienced low returns on their investments in Chilean stocks.

The following chart shows the more recent performance in greater detail. We can see that the 1994 peak was built on a period of rising earnings and rising PE multiples, with the PE reaching 26.4, the highest ever for Santiago. The commodity boom  bull market (2002-2012) was built essentially on USD earnings growth, a combination of corporate earnings and a strengthening peso. Since the commodity bust in 2012,  USD earnings have fallen by half because of a combination of lower corporate earnings and a weakening peso. Nominal USD earnings today are at the same level as 14 years ago.

We can shed more light on valuations by considering cyclically-adjusted Price-Earnings ratios (CAPE)  for the Chilean market.  What we see here is that Chilean stocks have had two “bubbles” over the past 30 years: first in 1994, based on the extrapolation of the “miracle” economy and optimism on the transition to democracy; second in 2007-2010, when the commodity super-cycle drove up both USD earnings and multiples.

 

What do these numbers tell us about future returns? First, we can see that current CAPE  earnings are about 20%  below trend. Second, we see that the cape ratio is well below the trend-line which is also in sync with the historical median CAPE for Chile of 17.9. Assuming a return to earnings trend in several years and the historical median CAPE ratio, Chilean stocks would have nearly 80% upside from current levels.

This is the normal analysis done with CAPE. Fraught as it is with problems, it does generally provide a reasonable indicator of return potential. But perhaps the case of Chile does not fit into this easy analysis.

First, the historical median cape may be distorted by two periods of extraordinarily high CAPEs over the 30-year period, during the 1994 and the 2007-2012 bubbles. What if current CAPE ratios reflect more realistically Chile’s current prospects of low growth? Second, perhaps the earnings trendline should be sloping downwards to take into consideration these diminishing growth expectations. No one believes that Chile can return to the kind of growth it saw in the 1990s. On the contrary, the low GDP growth expected by the IMF is in line with consensus and may even be optimistic if the constitutional reform is as anti-business as many observers now fear.

The fact is that a return to normalcy is a low probability scenario. Investors have the difficult task of evaluating what the new Chilean growth model will look like and project expected returns on that basis.

The case of Chile illustrates one of the characteristic traps of emerging market investing. Sudden and radical changes in political and regulatory environments can completely undermine an investor’s valuation framework. We are currently seeing this in China where regulators have suddenly put in question the financial models of most of the prominent tech firms. In Chile, the protests of recent years and the prospects of constitutional reform have signaled the end of the pro-business neo-liberal regime, meaning that the high valuation multiples of the past are probably irrelevant.

Update on Emerging Market Valuations and Expected Market Returns

 

Emerging market stocks ended the second quarter badly underperforming the S&P500 and the MSCI All Country World Index (ACWI) year-to-date, as well as for the past one, three, five and ten years.  There had been some hope during the first quarter that rising inflation and interest rates would squash long duration assets like U.S. tech and give a chance for value stocks and emerging markets to outperform. However, this was short-lived. By the end of the second quarter, interest rates were collapsing, U.S. tech stocks were leading the way again and American exceptionalism was reaffirmed by the U.S. indexes hitting record levels at near-record valuations.

The second quarter and the year so far, therefore, brought more woes for emerging markets. Momentum has been the primary force for markets, driving the expensive stocks higher and the cheap stocks lower.  We can see this clearly in the charts below which show (1) country returns YTD for EM and (2) expected returns based on relative cyclically adjusted price earnings (CAPE) ratios.

With the exception of Brazil and South Africa, two countries benefitting from positive terms of trade shocks from rising commodity prices, the countries with the highest expected future returns (Turkey, Philippines, Peru, Colombia. Indonesia, Chile and Malaysia) are also the ones with the lowest returns for the period. On the other hand, the expensive countries with low expected future returns (India, Korea, Russia, Mexico, Taiwan) continue to outperform. Of course, the United States, the most expensive of any market around the world, provided stellar returns of 14.9% during the first half of the year.

Unfortunately, the countries with very inexpensive markets relative to their history are not helping themselves. Sadly, none of the “cheap” markets currently provide a positive narrative for investors. In addition to the pandemic which continues to wreak havoc across EM, many countries also face deteriorating political and economic fundamentals which would justify lower earnings multiples than a relative cape ratio methodology implies. We could argue that the growth prospects for Brazil, Chile, Colombia, Peru and South Africa have deteriorated enough over the past decade to justify lower CAPE multiples.  In many cases, historical CAPE multiples may have been distorted by the stratospheric-level valuations reached during the 2007-2012 EM bubble. It may be that some of these markets need to trade at much lower multiples to become attractive investments, say more in line with Turkey today (4.4 CAPE). Arguably, investors should be very cautious at deploying capital until a positive narrative can be developed in these countries.

This leaves us with very few markets to focus on. In Asia, which is where almost all the growth in GDP and consumption will occur over the next decade, Indonesia and Malaysia have good growth prospects and political stability.  Their CAPE ratios are cheap in both relative and absolute terms and promise good future returns. Moreover, we can see in the following chart that they both have competitive currencies and good economic fundamentals. The Philippines also appear attractive, given low valuations and a good growth profile, but have an overvalued currency and weaker fundamentals. In Latin America, Mexico also has a nice combination of an attractive CAPE valuation, competitive currency and good economic fundamentals.

The best opportunity in EM stocks today is in Turkey which has the compelling combination of very low CAPE valuation and undervalued currency. The patient investor would be well advised to build positions ahead of an eventual change in government or economic policy.

The Lure of Complexity Drains Pension Schemes Around the World

The debate over whether to invest “passively” through index funds or “actively” through professionally managed funds has largely been resolved in favor of the passive camp. Decades of empirical data have made the case for passive and the result has been the persistent growth of index investing for both individual and institutional investors. Yet, in defiance of this trend, the financial industry continues to create and sell trillions of dollars in increasingly complex products with much higher fees. These so-called “alternative” financial products have made huge fortunes for managers of hedge funds, private equity funds, and other exotic products. Unfortunately, by and large, they fail to provide value for the investors that have been lured into believing that complexity brings higher returns.

David Swensen of the Yale Endowment was a pioneer in the use of alternative assets. The good performance of this strategy in the 1990s and several books by Swensen lauding its merits attracted many imitators to the “Yale Model.” At the same time, the rise of low-cost index funds on traditional equity products drove the wily Wall Street marketing machine to promote new products with high fees. As a result, from 1997 to 2018 hedge fund assets under management grew from $118 billion to $3.5 trillion. Over the same period, the number of active private equity firms grew more than tenfold, from fewer than 1,000 to roughly 10,000. In the case of educational endowments like Swensen’s Yale, the average exposure to alternatives has risen from 12% in 1990 to 34% in 2002 and to around 60% of total assets today.

Unfortunately, Swensen was not able to sustain the high returns achieved in the 1990s, the “Golden Age of alternative investing.”  Ironically, the popularity of the Yale model may have been its undoing. Over the 2010-2019 period Yale returned 11.1% annually compared to S&P 500 returns of 14.7% and returns of 11.4% for a traditional 70/30 stock/bond mix. This is before the operating expenses of the Yale endowment which total 0.38% annually. Nevertheless, Yale continued to be one of the best performing university endowments over this period.

The most recent study of the performance of public pension funds and university endowments, “HOW TO IMPROVE INSTITUTIONAL FUND PERFORMANCE,” by Richard M. Ennis (link) describes how the Yale model has destroyed value for institutional investors. Desperate for higher returns in a world of overvalued assets and low prospective returns, these funds have allocated over a trillion dollar s to alternatives and have nothing to show for it. As a group, they would have been much better off buying a few Vanguard index funds.

Ennis’s  study of  46 public pension funds highlights the following:

  • Only two of the 46 endowments outperformed with statistical significance.
  • A composite of the funds surveyed underperformed by 155 bps per year for the 12 years ending June 30,2020, and the composite underperformed in 11 of the twelve years.
  • Alternatives, which represented 30% of assets, provided no diversification benefits, acting equity-like in their risk profile, with added leverage.
  • Poor performance is not tied to size of the fund. In fact, most underperformance was attributed to exposure to alternatives.

Ennis’s survey of university endowments identified even poorer performance than for public pension funds. This is remarkable given that the staffs of endowments are considered to be more skilled and are paid multiples more than the public servants that typically staff pension funds.

Here are the key findings from Ennis’s research:

  • Endowments with assets greater than $1 billion underperformed by 1.87% per year over the period and trailed the benchmark in 12 out of 12 years.
  • Alternatives represented 60% of the asset allocation of endowments, providing no diversification benefit but dramatically increasing costs. Ellis estimates that the fees paid to managers by these endowments run at about 1.8% of assets per year and explain almost all the underperformance.
  • The performance of endowments actually is overstated, since they do not include their own operational expenses in their performance numbers. In the case of Yale these expenses were 0.38% of assets under management.

Ellis estimates that pension funds paid around $70 billion in fees to Wall Street in 2020 all of which they could have saved by investing in low-cost index products. Endowment funds paid $11.5 billion in fees plus about $2.5 billion in expenses (salaries, rents), all of which they could have avoided by investing in index funds.

Ellis’s data on endowments comes primarily from the annual NACUBO-TIAA (link) study of endowments which reports on the sector’s overall results. Using this same source Fiduciary Wealth Partners, a firm that provides investment advice to high net-worth clients, has tracked the returns provided by the top quartile performing endowment funds for the past twenty years and compared these to returns achievable through low-cost index funds. FWP confirms Ellis’s finding that even the elite of the endowments have destroyed value. The two charts below show (1) the portfolio allocation of low cost index funds used by FWP and (2) the 10-year rolling returns of this model portfolio including all fees compared to the composite returns of the top quartile endowments. The 70/30 index portfolio has outperformed in every 10-year rolling period and by a considerable margin over the time frame considered. This is before considering the internal operating expenses of the endowments.

Implications for public pension funds around the world

The case of U.S. pensions and endowments should provide a good example for the world. The lure of complexity and the belief that sophisticated high-fee managers can add value after fees is as prevalent in public pension schemes in Latin America and sovereign funds around the world as it is in the U.S.

Ellis describes the situation of the public pension funds of the City of Los Angeles as a microcosm of what ails public pension systems around the world. Taxpayers of the city back six different public pension funds representing different groups (teachers, fire-police, city employees, water-power, county employees and state employees.) All these funds replicate a similar investment cost-base and follow similar “diversified” investment processes. The final result is an immense index-like fund with an expense of 1.1% per year. This cost, in the end is born by the taxpayer.

The obvious path for these public pension funds would be to merge and simplify their investment processes through low-cost indexing approaches.  However, this is difficult to do because of the resistance from the agents currently involved in the process: the managers, investment professionals, trustees and outside advisors that have a stake in the current system.

This situation of Los Angeles is repeated across the world.

An extreme example this is the Chilean AFP system of privately managed pensions. Designed by Chile’s “Chicago Boys” free market ideologues in the 1980s, the AFP model was based on the conviction that private competition would bring about a fruitful combination of minimal costs and maximum returns, to the benefit of Chilean pensioners. However, after 35 years of the AFP model we can see a situation similar to the one of the the City of Los Angeles. The system has high costs which hurt returns for pensioners; seven AFP firms compete for customers, replicating high administrative and marketing costs, for a relatively small pool of assets of $200 billion. The primary beneficiaries of the AFP system, as in Los Angeles, are the agents (owners of the AFPs, managers, administrators, regulators). Much better results could be achieved by a small committee deciding on a long term allocation strategy and allocating the system’s funds to index products.

In fact, there are a few examples of funds that have  followed the path recommended by Ellis.

One example is Nevada’s $35 billion Public Employees Retirement System (link). Unlike Los Angeles and Chile with their teams of managers, administrators, marketers and advisers, the CIO, Steve Edmunson,   manages the fund by himself. Following Warren Buffet’s advice, Edmunson shuns fees and practices inactivity. Nevada’s funds are allocated to ETFs and a few trades a year suffice to keep them aligned with the long-term strategy. With an investment staff of one person, Nevada’s costs are 5 basis points (0.05%) compared to the 1.5% average estimated by Ennis for U.S. public pension funds.

Currency Wars, the Dollar and Emerging Markets

Worsening economic conditions in the United States point to a weaker dollar in the future. The combination of low GDP growth, high debt levels, unsustainable fiscal and current account deficits and an overvalued USD makes devaluation the path of least resistance. However, most of America’s trading partners either face equally poor monetary and fiscal challenges or are determined to avoid allowing their currencies to appreciate. This creates a stalemate in the currency wars which facilitates more money printing and debt accumulation, with the consequence that asset prices rise to compensate for currency debasement. Until this predicament changes, the currency adjustments that a healthy and balanced global financial system would produce are not likely to occur.

At the heart of this dilemma lie on one side the mercantilist economies that repress consumption to promote exports (China, Japan, Korea, Taiwan, Germany) and on the other the Anglo-Saxon economies that promote consumption and accept persistent current account deficits (United States, United Kingdom, Canada, Australia). These conditions have persisted for decades because on each side powerful interests assert their influence to preserve them: in the case of the mercantilist, the manufacturing lobby; in the Anglo-Saxon economies, the banks which benefit from the financialization of the economy.  Germany conveniently benefits from the euro which is structurally undervalued to support the weaker economies of the region.

The following table illustrates the current currency panorama and gives some insights on a few potential trading opportunities at the present time. The first column shows the deviation of the Real Effective Exchange Rate (REER) from the 30-year median level for the major EM countries and also the primary trading partners of the United States. The currencies above 100% are expensive relative to the median level of the past 30 years. This group is extremely heterogeneous. We would expect high-growth and productive exporters (China, Vietnam, Thailand, Korea, Taiwan and Poland) to have appreciating currencies over time, and that is what we see here. However, all these countries are bent on maintaining competitive currencies and current account surpluses. These economies all have strong fundamentals and moderate twin deficits (current account plus fiscal account). The remaining countries with currencies above the 30-year median face more problematic circumstances. India, the Philippines, Nigeria, and the United States all have low productivity growth, chronic current account deficits and high twin deficits. These countries have all allowed their currencies to appreciate to the detriment of their export competitiveness, and all of them tend to favor finance over the manufacturing sector. In this second group, the currencies of the United States and India are propped up by financial capital flows.

At the other end of the table, we have the countries which have currencies at weak levels relative to the 30-year median REER. Most of the cheap currency countries have a history of high currency volatility, driven by commodity cycles and flows of speculative capital (“hot money”).  Argentina, Brazil, Russia, Colombia, Peru, Chile and South Africa are prematurely deindustrialized and dependent on exports of basic commodities that are increasingly capital intensive. The high levels of currency volatility are linked to boom-to-bust cycles, which disincentivize exports of manufacturing goods and increase dependence on commodities and debt accumulation. Typically, these countries will see significant currency appreciation during commodity upcycles, and, given how cheap the currencies are today, it is plausible this will happen again. The problem for these countries is that economic mismanagement and unproductive debt accumulation have left them with very high twin deficits and, consequently, very vulnerable to global financial volatility.

This leaves us with Malaysia, Mexico, Japan and Turkey. These four countries all have competitive currencies and are important participants in global manufacturing supply chains and stand to benefit from the current trend towards reshoring and restructuring of supply chains. Moreover, all of them except for Turkey, have sound economic fundamentals. These are probably the currencies with the most upside in a global synchronized economic recovery in 2022.  In the case of Turkey any progress towards stabilizing the economy could lead to significant currency appreciation.

Whither the U.S. Dollar?

Investing in emerging market stocks and bonds is primarily driven by macro factors, such as liquidity, relative growth, politics and, most importantly, the mighty U.S. dollar. The importance of macro trends  is the reason that emerging market investing has traditionally been dominated by short-term oriented hedge funds and Wall Street trading desks. This has been true since the early 1980s when the liberalization of global financial capital flows allowed traders like George Soros to actively engage in EM equity and debt markets. More recently, firms like Ray Dalio’s Bridgewater have made EM a key part of their global diversification strategies.

In global macro, everything is in some sense a dollar trade, so it is imperative that investors have a view on the direction of the dollar.  In fact, the dollar’s trend clearly separates the world of financial assets into two camps: Long USD trades — risk tolerant and rate sensitive – which include bonds, growth stocks and other long-duration assets; Short USD trades – risk intolerant – which include value and small cap stocks, EM stocks and bonds and commodities.

Based on recent empirical evidence, investors have developed models to predict the future course of the dollar. Unfortunately, there is not a lot of historical data since the current USD regime is based on a fiat monetary system which has existed only since 1971.

George Soros is said to have come up with a visionary and innovative approach to currency trading in the early 1980s when he proposed that the dollar trend could be determined by the strength of the U.S. economy relative to the global economy. In periods of relative U.S. economic vigor, sometimes referred to as phases of “American Exceptionalism,” the U.S. attracts foreign flows into its capital markets and the dollar appreciates. Under these circumstances, the dollar can remain strong until the cycle exhausts itself because of rising macroeconomic imbalances. In periods of relative global economic vigor, capital flows out of the U.S. into more attractive international assets.

This dollar cycle as suggested by Soros is underpinned by reflexive investor behavior. As the USD appreciates the returns on U.S. assets increase for foreign investors which attracts more investment. When the USD begins a downward trend, then the opposite happens.

The empirical evidence for the Soros model is shown in the graph below. The top segment of the chart shows the evolution of the USD index (DXY) since the 1970s. We can see that there have been three major upswings of the USD over this period, in what appears to be a long-term downtrend. The cycles have lasted about 8-9 years on the uptrend and 8-9 years on the downtrend, for a total of 16-18 years. Given that the current dollar uptrend started in 2011, we would now expect a dollar downtrend to be under way. However, this remains to be confirmed, as currently the effects from the pandemic and extraordinary fiscal and monetary policies adopted around the world may be overwhelming long-term fundamentals.

The bottom segment of the chart shows the performance of the global economy relative to the U.S., with outperformance shown when the blue line is above the bar. One can see that Soros’s  insight is largely confirmed by the data: when U.S. growth is relatively strong, the USD tends to appreciate considerably.

The past several years have been extraordinary in the sense that official interventionism in financial markets has reached unprecedented levels.  First, we saw exceptional monetary policy adventurism with a novel focus on propping up asset prices in the name of “financial stability.” Second, we saw equally unheard of fiscal adventurism when Donald Trump slashed taxes at the tail end of a business cycle expansion with unemployment at record low levels. Third, the pandemic was met by enormous monetary and fiscal support which boosted the operations and valuations of America’s leading corporations in the tech sector. Fourth, we are now seeing new radical policies from the Fed (average inflation targeting) and the Biden Administration (fiscal expansionism to “Build America Back Better”). Finally, this year we saw the U.S. take the lead  in Covid-19 vaccinations which makes it likely that U.S GDP growth will outperform the global economy in 2021. All these factors have contributed to higher U.S. stock prices and a narrative of U.S. exceptionalism, and may have postponed the normal cyclical downtrend of the dollar.

In a recent interview, the investor Stan Druckenmiller made this point when he attributed the recent strength in the USD to foreign inflows into the U.S. tech stocks during the pandemic:

“It just so happened that the FAANG stocks, and many US companies like Zoom were better positioned to deal with COVID than any of our foreign counterparts, so we had a huge inflow into the equity market here. It made up for the change in the bond flow, but once valuations got high, that dissipated, and the dollar peaked out in July.”

Druckenmiller believes that the factors supportive of the dollar have run their course. The rest of the world will soon catch up in vaccinations and by 2022 the global economy will be in full recovery and outpacing the U.S. economy. Moreover, by next year, capital allocators are likely to begin to refocus  on the serious structural deficiencies of the U.S. economy: namely, the high and rising debt levels and the gigantic twin deficit (current account plus fiscal deficit.)

The U.S. will come out of the pandemic with historically high debt levels and deficits which are projected to remain at high levels for the foreseeable future. The first chart below shows the progression in U.S. debt levels as reported by the Bank for International Settlements (BIS). The next two charts show the U.S. fiscal and current account deficits and the twin deficit’s relationship with the USD. The twin deficit is projected to widen considerably during the decade as Social Security and Medicare outlays ramp up when the majority of baby-boomers retire. Also, any increase in interest rates from the current levels would worsen the fiscal accounts further.

We can see that the USD did not follow its normal reaction to gapping twin deficits during the pandemic. However, as these deficits persist in the future and the global economy recovers the USD this should change. The expectation that unsustainable  twin deficits will persist for the foreseeable future  is the primary argument for a weaker USD in coming years.

However, nothing may be so simple in our current macro world of extreme state interventionism and dysfunctional politics driven by populism.

First, for the dollar to fall other currencies must rise, but all the major trading partners of the U.S. appear determined to avoid this from happening  Most, like China, have adopted some sort of peg to a basket of currencies to protect their exporters. This means that it would require significant strong-arming from the U.S. to engineer an appreciation of foreign currencies, something that Washington has been reluctant to do.

This raises the scenario predicted by Raoul Pal (Real Vision ) of an orchestrated debasement of global currencies as all major economies seek to print themselves out of their fiscal and competitive dilemmas. The consequences of this would be a massive flight into any scarce real assets (gold, bitcoin, real estate, etc…). Pal argues we are already seeing this play out as most asset classes are trading at record highs.

The Raoul Pal scenario has interesting implications for emerging markets. The EM asset class is almost equally divided into commodity importers and exporters. Most importers of commodities (China, Korea, Taiwan, India) are not likely to tolerate currency appreciation, as long as Washington does not wage war against mercantilist policies. This leaves the commodity exporters to possibly allow their currencies to appreciate. We have seen this happen this year as the South African rand, the Russian rubble and the Brazilian real have appreciated. This process has been abetted by foreign hot money and welcomed by central banks for its deflationary effects.  Some other EM countries which have depressed currencies, (Mexico, Turkey) also have much room to allow appreciation and may be the best options for  investors to benefit in the coming currency wars.

Emerging Markets Debt Pile Impedes Growth

In a normally functioning economy debt has an important and beneficial role. It shifts purchasing power from savers to consumers of capital, allowing young people to anticipate consumption and governments and entrepreneurs to invest. This process is healthy and promotes growth.

However,  debt accumulation loses its utility under several circumstances. First, it tends to be highly cyclical and prone to accentuate the volatility and swings of both the economic cycle and asset prices.  Second, it exhausts itself when debt is directed to unproductive ends which do not generate the cash flows to service interest.

The debt cycle that the world has experienced over the past decades is characterized by these two circumstances. As debt levels have skyrocketed in both China and the United States, the marginal utility of the debt has diminished. Both countries face a reckoning of massive debt overhangs, which will impede future growth, made even worse by the worst demographics in a century. Moreover, as the credit data from the Bank for International Settlements (BIS) shows below, the debt problem is global in nature. Emerging Markets as a whole face the same quandary, facing a large overhang of debt, often with currency mismatched, much of which was used to finance non-productive activities.

However, the emerging market debt figures are highly influenced by the weight of China. A more granular view of emerging markets shows considerable differences within the asset class. We can see this in the table below. Several countries stand out for their relatively low  total debt-to-GDP ratios, particularly Mexico and Indonesia which are both below 100% of GDP, while others are noteworthy for the very high levels of debt assumed in absolute terms and relative to their financial histories (China, Korea, Malaysia, Chile, Brazil).

 

It is also important to look at the composition of this debt for each country, between public and private debt, and the growth rate of the debt. Relative low public debt indicates the capacity to invest in the public goods (social and physical infrastructure) which are needed for countries to grow. High levels of public debt also cause a crowding out of the private sector and more productive investments. We can see that in this regard South Africa, Brazil, China and Argentina are in bad shape as they have very high and increasing debt levels, and these are countries that face enormous demands from their citizens for public goods (infrastructure, education, social safety nets, etc…) With the exception of China, these countries have managed to accumulate this debt without investing in public goods and continue to borrow to cover current spending. Not by coincidence, the countries that have the lowest levels of public debt are also those that have seen the slowest pace of debt accumulation: Russia, Chile, Thailand, Turkey, Indonesia, Mexico and Korea. These countries have maintained the capacity to invest in public goods.

With regards to private debt, several countries also stand out. China, Korea and Chile have high levels of private debt which has grown at a rapid pace. In the case of China and Korea, this points to vulnerability for sustained consumption and potential deflationary pressures. For Chile, much of the private debt has been assumed for foreign ventures, with dubious benefits for the domestic economy and uncertain returns. Colombia, Mexico and Indonesia have low levels of private debt and low growth of debt, and therefore have capacity for reflationary credit expansion.

Finally, we should look at these relatively unleveraged countries in the context of potential GDP growth. Countries with debt accumulation potential, growth in the working age population and GDP growth above 3% should offer relatively better opportunities for investors. I would put the Philippines, India, Mexico, Indonesia and Turkey at the top of my list of countries that retain healthy growth profiles. Unfortunately, both Turkey and Mexico currently face problematic political leadership which makes it difficult to attract investment capital.

The Count of Ipanema’s Real Estate Fiasco

There are two streets in Rio de Janeiro that commemorate the passage of Jose Antonio Moreira. One is the Rua Barao de Ipanema in the neighborhood of Copacabana Beach and the other the Rua Conde de Ipanema in the adjacent barrio of Ipanema Beach. Not much has been written about this influential Brazilian businessman of the Portuguese colony who was active during the reigns of  Dom Joao VI , Pedro I and Pedro II. He happens to be my ancestor, and so I have  put together a short and sketchy biography which relies on public documents and family archives. His story reflects the modernization of Brazil in the 19th century – from a slavery-manned plantation economy to a modern industrializing nation. It is also a tale of poor timing in real estate speculation and the dissipation of wealth by idle descendants.

The trail of the Ipanema de Moreira family starts in the city of Sao Paulo, Brazil in the late 18th century.  Jose Antonio Moreira, the future Count of Ipanema, was born in Sao Paulo, October 23, 1797, the son of Jose Antonio Moreira (Father) and Ana Joaquina de Jesus. The family was of noble origin, from the Braga District of northern Portugal. Moreira is a common name in Portugal, meaning mulberry tree.

Jose Antonio Moreira (father) was a prosperous merchant in Sao Paulo with close links to the colonial administration.  He had a key role in developing Brazil’s first modern industrial enterprise, the Ipanema iron works (Fundicao Ipanema).

Napoleon’s invasion of Portugal caused the Portuguese court of Dom Joao VI to flee to Rio de Janeiro in 1808. Dom Joao VI immediately eliminated all existing mercantilist restrictions on domestic manufacturing and actively supported industrial self-sufficiency. Iron smelting was considered a high priority and an area of with iron deposits in the vicinity of the city of Sao Paulo was chosen as a site for development.

The existence of iron ore deposits on the Ipanema Hills in an area known as the Fazenda Ipanema, nearby the village of Iperó, 125 km northwest of the city of Sao Paulo, had been known since the early days of the Portuguese colony. The site chosen for the iron smelter was located on the Ipanema River, a tributary of the Sorocaba River, and was surrounded by forests which could be used as fuel for smelting. The area had previously been inhabited by Tupi Indians, who had named it “Ipanema,” a reference to a river that has its source there. Ipanema means “stagnant or barren water” in Tupi-Guarani.

The company was established by Royal Charter in December 4, 1810 as a mixed capital shareholder company, with 13 shares belonging to the Portuguese Crown and 47 to private shareholders, businessmen with connections to the court. Jose Antonio probably represented the crown’s interests and was a founding investor. The project was of keen interest to Dom Joao IV who enlisted technical support from Swedish and German specialists, and he is s known to have visited the mill on multiple occasions.

The Fazenda Ipanema Ironworks, known as the Real Fábrica de Ferro de São João de Ipanema, smelted its first iron in 1816 and operated until 1895.  A picture from 1890 is shown below.

The enterprise, which can be considered Brazil’s first modern industrial undertaking, included a dam and a 4-km railroad connecting the iron ore deposits with the plant. The area is now a national park and a popular tourist attraction. The structures of the mill are intact, as shown in the pictures below, and can be visited by the public.

The geographical location of the site is shown in the maps below.

Jose Antonio Moreira , both father and son, were actively involved with the Fundicao Ipanema.  The future Count of Ipanema, who will be referred to as Jose Antonio Moreira from now on, was involved with the Ipanema Fundicao from an early age, and he would remain connected to industrial ventures in metallurgy and metal-working in Brazil’s first wave of industrialization during the imperial regime.

From the time of the Fundicao Ipanema, the Moreira family remained closely tied to the imperial court in Rio de Janeiro. By the early 1820s, Jose Antonio Moreira had settled in Rio De Janeiro where in 1823 he married Laurinda Rosa Ferreira dos Santos, the daughter of a Portuguese aristocrat from Porto.   She was born in Rio de Janeiro in 1808 and died in Brussels in 1881. They has six children: José Antonio Moreira Filho, future 2 º Barão de Ipanema (1830-1899); João Antonio Moreira (1831-1900); Joaquim José Moreira (1832-?); Manoel Antônio Moreira (1833-?); Laurinda Rosa Moreira (1837-1920); Mariana Rosa Moreira (1842-?) and Francisco Antônio Moreira (1845-1930). (Francisco Antonio Moreira is my great-great-grandfather.)

Jose Antonio’s success as an entrepreneur and his service to the Imperial Court was recognized on numerous occasions with the highest honors:  Comendador da Imperial Ordem de Cristo and Dignitário da Imperial Ordem da Rosa (Commander of the Order of Christ and Officer of the Imperial Order of the Rose), 1845; Baronato  de Ipanema (Barony), 1847;  Grandezas de Barão de Ipanema (Barony Grandee), 1849; Viscondado com Grandeza  de Ipanema (Viscount Grandee), 1854; and Conde de Ipanema, 1868 (Count).  Jose Antonio’s association with the Ipanema Iron Works and metallurgy are made clear by the choice of the Ipanema name.  (Imperial titles of nobility were awarded on the basis of merit and service to the crown and. Generally, were not hereditary.)

 

The heraldic shields of both the Portuguese Moreiras and the Brazilian Ipanemas are shown below. Notice that both shields have the flourished cross, which in Portugal was the symbol of the Knights of  Saint Benedict of Aviz, an order of chivalry founded in 1146. The Ipanema shield also has a blue line with five stars (representing the Ipanema River) and a Caduceu of Hermes (wisdom).

 

In 1844, during the reign of Pedro II (1831-89), Brazil adopted policies to promote industrialization and the import-substitution of manufactured goods which included stiff tariffs of up to 60% on imports.  Prior to this reform, the country had relied extensively on British imports. The policy shift resulted in Brazil’s first wave of industrialization, which had as its leading entrepreneur Irineu Evangelista de Sousa (Visconde de Maua). Jose Antonio Moreira was an early investment partner and investment adviser to the Visconde de Maua.  It is clear that Jose Antonio put his court connections and expertise in metallurgy to good use over this period, and he coinvested with the Visconde de Maua  in steel, shipyard, banking, steamboat and railroad ventures.

Jose Antonio Moreira was the first president of the Banco do Brasil, a Visconde Maua venture that was crucially important in financing Brazil’s early industrialization and still plays a vital role in Brazil’s economy today.

Interestingly, in the Banco do Brasil’s founding charter documents Jose Antonio is described as a “national businessman involved in the business of ships and national goods” (comercio de navios e generos nacionais).

Jose Antonio also had business partnerships with foreign investors, including steel concerns in Belgium. From the mid-1850s Jose Antonio is connected to Brussels, and in 1860 his wife, Laurinda Rosa Ferreira dos Santos, takes up residence there. From this time, four of their six children are established in Brussels: Manoel Antonio, Marriana-Rosa, Laurinda Rosa and Francisco Antonio Moreira. Manoel remained in Brussels where he served a Brazil’s general consul, and his son, Alfredo de Barros Moreira, would serve as Brazil’s first ambassador to Belgium.

We have two portraits of Jose Antonio. The first is a sketch of him as a young man; the second, dating from the 1860s, shows him in his prime.

 

It is during the final phase of his life in the 1870s that Jose Antonio Moreira purchased an estate located some 12 km south of the center of the city of Rio de Janeiro. This area with more than 3 km of beaches facing the Atlantic is now known as the Ipanema Beach neighborhood.

The estate was purchased in 1878 and initially it was used as a country house (chacara). An artistic rendition of what the area may have looked like in the 1870s by the painter Eduardo Camoes  (b. 1955- ) is shown below.

The map below shows the estate in the context of today’s Rio de Janeiro. The chacara extended from  the southern tip of Copacabana Beach (delineated by the current Rua Barao de Ipanema) to the canal that connects the ocean with the Rodrigo das Freitas Lagoon and creates the division between the neighborhoods of Ipanema and Leblon. The property stretched into parts of modern-day Leblon, including the current site of the Monte-Libano sports club.

 

The land purchased by Jose Antonio Moreira was known at the time as “Praia de Fora de Copacabana,” which was part of a larger area called the “Fazenda Copacabana.” Most of the property was purchased from Charles Le Blond, a French entrepreneur who ran a whaling operation called “Alianca,´ and had secured a monopoly on supplying Rio de Janeiro with whale oil. Le Blond went out of business in the 1860s when the Visconde de Maua introduced gas lighting to the city of Rio de Janeiro, and this may have provoked the sale of the property.  Vestiges of Le Blond’s whaling operation include the names of the Leblon Beach neighborhood as well as Arpoador  (Harpooner) Beach at the easternmost point of  Praia de Fora. The rocky promontory which separates Arpoador Beach from Copacabana  played an important part in the whaling operation as an ideal lookout to detect migrating pods of whales.

The area was originally occupied by Tamoia Indians, and, briefly, in the 1550s it was the site of a French military outpost. Reportedly, an early Portuguese governor eradicated the Indian population by furnishing them with blankets infected with smallpox (apparently a common practice in the 16th century).

The southern and western parts of the “Fazenda Copacabana” also were widely used for large sugar cane milling operations and cattle grazing from the 16th to the 19th centuries in the area which stretches from Leblon to the Jardim Botanico. The eastern part of the Fazenda Copacabana (modern day Copacabana and Ipanema) were inappropriate for farming because of sandy, acidic soil (restinga) and, in the case of Ipanema, frequent flooding from the lagoon.  One of the few structures in the area was the Igreja of Nossa Senhora de Copacabana, a Carmelite hermitage founded in the early 16th century. The hermitage had a copy of a statue of the Virgin Mary from the Church of Nossa Senora de Copacabana on the shores of Lake Titicaca in Peru which was said to have miraculous qualities, and that is the source of the name of the beach.

In all likelihood, the purchase of the Praia de Fora was made as a farsighted speculative real estate bet. As a prominent businessman with close ties to the Viscount of Maua and the imperial administration, the Count of Ipanema knew the city’s plans for urban development. Central to this vision was the Companhia Ferro-Carril Jardim Botanico, a Viscount of Maua venture, that was planning to expand its tramway coverage to the southern beaches of Rio de Janeiro. Moreover, he was certainly aware of the mid-19th century European boom in beach resorts made possible by railroads and by a newfound appreciation for the health benefits of the sea. Unfortunately, the Count passed away in 1879, leaving the future development of the area in the hands of his eldest son.

Jose Antonio Moreira Filho was 49 years old when his father passed away.  He appears to have been a successful businessman in his own right and highly regarded by the Imperial Court, and he was decorated on several occasions:  Commander of the Military Order of Christ and  the  Order of Our Lady of the Conception of Vila Vicosa (the paramount award given by the sovereign for services rendered to the Royal House). He received his baronage by decree in 1885, and the grandeeship by decree in 1888. He married Luisa Rudge, daughter of George Rudge and Sofia Maxwell.  His father-in-law was Joseph Maxwell (1772-1854), one of Brazil’s richest men, founder of the Maxwell Wright commission house. This was a trading house with strong links to the American and British markets which was a leading participant in the coffee export boom and a facilitator of the Atlantic triangle trade (imports of grains and manufactured goods from America, exports of coffee and slave trading with Africa). The Rudges were business partners with Joseph Maxwell. Both the  Rudge and Maxwell families were originally merchants from Gloucester, England.

The only portrait we have of Jose Antonio Filho is the one shown below, made in the 1870s before he had become the Baron of Ipanema.

Jose Antonio Moreira Filho’s plans for “Praia de Fora” depended on improved access to the southern beaches. The estate had been accessed primarily from the sea by occasional tourists. This changed when in 1892 the Companhia Ferro-Carril Jardim Botanico inaugurated the Copacabana Tunnel (today known as Alaor Prata), linking Botafogo Beach with Copacabana Beach, and providing tram service between the center of Rio and the southern beaches. A tram line covering the entire extension of Copacabana beach was completed by early 1894.

In anticipation of the further extension of the tram service, in April 1894 the Vila Ipanema real estate development project was officially launched. The land holdings owned in Copacabana and Leblon were not included in Vila Ipanema, and may have been donated to the city or incorporated into other developments being actively promoted at the time.

The layout of the Vila Ipanema can be seen in the two documents below. The first, dating from 1894, is the original urban design commissioned to Luiz Rafael Vieira Souto who was the Chief Engineer of the Municipality of Rio de Janeiro.  The second, dating from 1919, is from a marketing brochure.

Vila Ipanema divided the area into 45 blocks.  The standard block was broken into 40 lots, each measuring 10 meters by 50 meters. More than a million m2 of real estate were put on the market.

 The initial launch included 19 streets and two public squares (General Osorio and Nossa Senhora da Paz). Most of the street names honored family members, associates and political allies of the Baron and his partners. For example, the main road at the time of launch was the Rua 20 de Novembro (Visconde de Piraja), which commemorated the date of birth of Luisa Rudge. Of the original names few remain: Alberto Campos (brother in law) remains; Avenida Vieira Souto, in honor of the urban planner, still graces the waterfront.

Jose Antonio Moreira Filho had several partners in Vila Ipanema: Coronel Antonio Jose Silva, Jose Luis Guimaraes Caipora and Constante Ramos.  The Coronel incorporated land he owned in Praia de Fora into the Vila Ipanema project. In 1901 the shareholders of Vila Ipanema were:  Ipanema de Moreira family, 90%; E. de Barros, 6.5%; Coronel Silva, 3.5%; Ulysses Vianna, 1.0%.

Jose Antonio Moreira Filho’s luck seems to have run out in his final years. He was 64 years old when Vila Ipanema was launched and in bad health. Given his intimacy with the imperial court, the deposition of Pedro II in 1889 and his exile to Paris may have seriously undermined his business affairs. Surely, when the Count acquired the estate he had not countenanced an end to the imperial regime. The proclamation of the First Republic in 1889 was followed by political instability and economic crisis, and the flight of both human and financial capital. In the five years from the time of the coup-d’etat which ousted Pedro II to the launch of Vila Ipanema in 1894, the real, the Brazilian currency, lost 60% of its value relative to the U.S, dollar, and it would lose another 40% before stabilizing in 1899. The 1890s would also see the rise of Sao Paulo as Brazil’s dynamic economic center and the magnet for waves of Italian and Japanese immigrants.

By the mid-1890s almost all of the Ipanema de Moreira family was settled in Europe, either in Paris or Brussels. Brazil was far away and becoming a distant memory. When the Baron passed away in 1899, the majority control of Villa Ipanema went to Francisco Antonio Morreira who resided in Paris and had not lived in Brazil in 40 years.

 

The following account from Francisco Antonio’s son (nephew of the baron), Alberto Jorge de Ipanema Moreira, gives some color:

“In the spring of 1898 we travelled to Rio, my father, my aunt and I. My father and my aunt went to try to salvage what was left of a brilliant fortune. Their brother, the Baron of Ipanema, who was their proxy, was old and sick and his business affairs had collapsed. The only thing left were the immense land holdings in Copacabana and the “Praia do Arpoador’” now renamed “Villa Ipanema.” Following the death of the Baron of Ipanema, an agreement was reached with his heirs on one side and my father and my aunt on the other, that the remaining land for sale would be divided  so that the heirs would keep 35% and my father and my aunt would receive 65%. Though born in Rio, my father,  my aunt and my mother – she of English descent, Rudge by her father and Maxwell by her mother – had spent little time in Rio, having been sent at a young age to study in England. They had little notion of the assets they had in Brazil.”

Franciso Antonio Moreira, my great-great grandfather, was a bon vivant living the high life between Paris and Nice. He was married to Maria Tereza Rudge, the second daughter of Joseph Maxwell, and, presumably they both had inherited large fortunes from their parents. However, it seems that they lived well beyond their considerable means. More on this from his son Alberto Jorge:

“It would seem that this family settlement had been very favorable for my parents. It didn’t turn out that way; quite the contrary, they lived for the next thirty years receiving only crumbs. This great capital withered away, used only to cover the most basic and indispensable expenses. The lots in Ipanema sold poorly, and my father wanted to sell at any price. He was born a great lord, and had no notion of thrift. Very elegant and handsome, he loved sport, especially horses; generous and extremely charitable, of an uncommon righteousness, he saw no evil and was not made to manage a fortune.”

Francisco Antonio had six children: Alberto Jorge (Brazilian diplomat), Maria Luiza (my great grandmother who married Eugene Robyns de Schneidauer who was a Belgian diplomat), Leonora, Maria Thereza and Jose. All of them resided and passed away in Europe. The first photo shows him around 1900 in ceremonial Court regalia. The second photo is a family portrait taken in 1929, near the end of his life, where he is seated next to his wife in the middle, up front.

The following pictures shows Ipanema Beach at the turn of the 19th century and in 1930. Notice how poorly developed it remained in 1930, still marked by the characteristics of the “restinga.”

The sales of the Vila Ipanema lots were painfully slow, as no one wanted to invest in that “fim do mundo.” This was in part because of competition from developers in Copacanana Beach who offered plenty of supply with closer proximity to the city and public transport. Moreover, though both Ipanema and Copacabana were marketed as “healthy and hygienic,” Ipanema was plagued by mosquito swarms when the lagoon periodically overflooded.

Poor sales also were caused by the delayed expansion of the tram service, which reached the General Osorio Square only in 1902. By the end of that year only 112 lots had been sold, which represented about 6% of the available inventory.

Development expenses also ran out of control. Capital, administrative and selling expenses were still taking up over 60% of revenues in the early 1900s.  High construction costs led to the farming out of development work to a contractor in 1905, the Companhia Constructora de Ipanema, which did similar work in Copacabana and Leblon. In 1906, this company completed the embankments of the lagoon, providing a permanent solution to the flooding.

The table below shows the Vila Ipanema sales revenue stream from 1900 to 1930, by which time very few lots remained. These numbers are presented in 2020 U.S. dollars, adjusting for inflation and currency depreciation. The real lost half of its value over this period. The peak of sales occurred between 1911-1915, a period of economic strength and real appreciation. The evolution of the real from 1984 to 1930 is shown in the following chart.

 

Over this 30-year period, total Vila Ipanema gross revenues were $15.1 million (constant 2020 USD). Net revenues after all expenses amounted to $12 million, of which $6.5 million went to my great-great grandfather, Antonio Francisco Moreira. By the time of his death in November 1930, a small fraction of that capital remained.

Of course, in retrospect it I easy to say that this capital was grossly and irresponsibly dilapidated. Ipanema today is prime luxury real estate and a beachfront apartment on Ipanema Beach may cost 3 to 4 million dollars. Unquestionably, the best strategy for a long-term investor would have been to build a big wall around the property and wait.

However, the reality is that Ipanema remained a sleepy and distant neighborhood, particularly compared to Copacabana, until recent decades.  It was not until the 1960s that it received some notoriety as a fashionable destination. Since the 1960s, the social and cultural center of Rio de Janeiro has moved rapidly to the southern beaches, leading to huge appreciation in real estate.

When Antônio Carlos Jobim’s family moved to Ipanema in 1933 it was because his mother was recently divorced and could not afford to live in a nice neighborhood. For the same reason, a wave of immigrants settled there after W.W. II.  In the 1960s, Antonio Carlos (Tom) Jobim’s generation made Ipanema famous with the Bossa Nova.  It was from the terrace of the Bar Veloso on the Avenida Prudente de Moraes that Tom spied the “girl from Ipanema”, Helo Pinheiro, walking home bikini-clad from the beach, and the rest is history.

There are thousands of covers of Girl From Ipanema; the most recent from Anitta.

Astrud Gilberto Version

Getz Gilberto

Anitta

 

 

 

The Girl From Ipanema

https://apnews.com/article/anitta-girl-from-ipanema-rio-brazil-bb45163a74e7d47c23a38f09a4cbe1e3

 

 

Pinera’s Gambit has Caused an Earthquake in Chile

Politics are mainly about how to distribute wealth. In democracies, despite the lobbying influence of plutocrats, occasionally the people will vote for radical changes to laws and institutions to tear down existing structures and accelerate progress towards more egalitarian and socially progressive outcomes. This has now happened in Chile where the recent constitutional referendum and local elections have resulted in a cataclysmic earthquake for the conservative establishment.

In agreeing to a constitutional referendum, Chile’s President Sebastian had hoped to calm social unrest, under the assumption that traditional conservative forces would retain enough power in a constitutional assembly to moderate the result. The results of the May referendum have shown this to be a huge and costly miscalculation.

Pinera’s conservatives were obliterated in the election by an alliance of highly progressive candidates from the left, including traditional leftist (socialists, communists, etc…) and independents (greens, feminists, native Indian, LGBT).

This progressive coalition has a solid mandate to put a close to an era defined by the military regime of Augusto Pinochet, the “Chicago Boys” neo-liberal economic reforms of the 1970s and the conservative constitution of 1980.

The circumstances in Chile are reminiscent of the process that resulted in Brazil’s “peoples” constitution of 1988, with its 70,000 pages defining “citizens rights.”  The fiscal commitments enshrined in the new constitution have burdened the economy since then and are a major reason for decades of low GDP growth.

The Brazilian constitutional reform was led by leftist politicians who felt aggrieved by the policies of the military regime. Now, in Chile, the new wave of progressives are determined to do away with the legacy of Pinochet.

The primary grievance of Chile’s progressive is that the previous model was structured to benefit the conservative elite and its economic interests. Chile’s pro-business neoliberal model, which promoted open markets and low corporate taxes, will almost certainly be revised with a focus on social distribution. Also, Chile’s innovative privately-managed pension fund system is likely to be unwound and replaced by an expanded social security benefits.

The evolution of the private pension system over four decades of existence is emblematic of the sclerosis that came to characterize the Chilean conservative movement as policy makers came to be captured by the business elite. Initially considered a thoughtful innovation, the system over time has been ineffective because of high costs and low returns. The system should have been reformed years ago but was not. The final nail for the AFPs was the dismal returns over the past decade, as shown below.

In fact, much of what has happened with the AFPs and with Chile in general should be seen in the context of the aftermath of the commodity super-cycle which ended in 2012. Chile, like most commodity producers, underwent a typical boom-t0-bust economic cycle and the consequent “Dutch Disease”: first, financial speculation (e.g. real estate), debt accumulation, overvalued currency, complacency of policy makers; followed by over-indebtedness, currency weakness and capital flight. The bust-phase of the past ten years has caused a deep social malaise for a young and educated population with high expectations, leading to a feeling of disenfranchisement and the recent street protests.

The irony is that a new commodity upcycle may now have started. Pinera’s gambit will have been tragically mistimed.

The Falling Dollar; Cyclical or Secular?

The U.S. dollar has been trending down for the past year relative to the currencies of the major trading partners of the United States. This raises the possibility that the cycle of dollar strength which started in 2012 may have ended. Moreover, the remarkable fiscal extravagance of the American government and gaping current account deficits have led some to predict a more severe permanent deterioration in the status of the USD.

Renowned macro-trader Stanley Druckenmiller said last week that persistent U.S. fiscal and monetary profligacy and rising debt level will have serious consequences: “The Fed will have to monetize it. I believe it will have horrible implications for the dollar…. it’s more likely than not within 15 years that we lose reserve currency status.”

These concerns with the fate of the dollar come at a time when a possible alternative reserve currency is  becoming realistic for the first time since the 1970s when the Deutsche mark briefly rose in prominence until Fed Chairman Paul Volcker’s monetary rectitude restored the USD’s credibility.

Taking a long term view, Ray Dalio of the Bridgewater hedge fund argues that it is only a question of time before China  assumes that mantle: “China already has the world’s second largest capital markets, and I think they will eventually vie for having the world’s financial center. Throughout history, the largest trading countries evolved into having the global financial center and the global reserve currency. When you see the transition from one empire to another, from the Dutch to the British to the American, to me it just looks like that all over again.”

Dalio’s view of financial history is that it consists of various cycles that repeat themselves over and over again on relatively predictable timeframes. Countries achieve great power status by attaining  measurable metrics and this hegemonic influence manifests itself through control over trade and finance, including reserve currency status. Eventually, great powers overextend themselves militarily, slide into financial, political and social decadence and enter into decline.

Dalio’s two charts below show this process at work. The first chart shows 500 years of the ebb and flow of global hegemonic power. The periods of dominance seem to last in the order of 150 years, which would imply that the United States is in the late stages. The second chart shows the evolution of the  different attributes required to achieve hegemonic influence, including reserve currency status which is seen as a lagging indicator.

Academic specialists such as Berkeley’s Barry Eichengreen provide a similar framework for understanding the process of achieving reserve currency status. The conclusion is that reserve currency status is a consequence of economic dominance which  can be measured by three statistics: economic output; share of trade; and net creditor standing.

Since Roman times, every dominant economic power has had these characteristics and seen its money prevail. We can separate the reserve currencies in the chart below in terms of the central axis of the international trade flows they facilitated: Mediterranean (denari, solidus, dinar, ducato and florin); Spain/Mexico (Spanish dollar based on Mexican and Peruvian silver); Northern Europe (guilder, franc, pound); and United States (dollar). The Spanish dollar can be considered the first truly global currency, as it was  widely used in China and the British colonies from the 16th to the 19th century.

 

The chart below shows the evolution of economic dominance over the past 150 years based on economic output, share of global trade and creditor status.  Around 1870 can be considered the peak of Britain’s economic dominance. By the eve of W.W. I, the UK’s edge had been greatly narrowed by both Germany and the U.S.. Coming out of the war, the U.S. was the clear dominant economy and it reached its peak soon after W.W. II. The post-war recovery of Europe and Asia has slowly undermined American dominance, and the recent rise of China has made it questionable.

The brief 70-year history of USD dominance can be separated into four periods, as  illustrated in the following chart. The U.S. came out of WW II as the undisputed global hegemon and the USD consistently replaced gold and pound sterling as the reserve currency of choice (period 1). After President Nixon broke the USD link with gold in 1971, gold and the deutsche mark  partially  replaced the USD (period 2).  A hawkish Fed under Paul Volcker and the deflationary forces unleashed by neoliberal economic policies and accelerated trade globalization resulted in the heyday of the USD (period 3). Finally, increasing financial instability caused by high debt and chronic fiscal and current account deficits have gradually undermined U.S. monetary policy effectiveness and increased demand for alternative currencies and gold. (period 4)

The next three charts show graphically the decline in the dominance of the U.S. economy. The first chart shows that share of global GDP peaked soon after W.W. II and has been on a rapid pace of decline since the USD was unfettered from gold in 1971. The second chart shows that American participation  in global trade peaked in 2000 and has fallen sharply since then because of the rise of China. The third chart shows the evolution of the U.S. from the primary creditor nation to the world’s largest debtor, a result of chronic current account deficits.

Clearly the evidence shows a steady fall in the justification for U.S. reserve currency status. However, there are two reasons to believe that the USD is not under imminent threat of losing its dominance. First, historical evidence tells us that reserve currencies lose their relevance slowly.  The Spanish dollar remained widely used long after Spain entered economic irrelevance. As the next chart shows, the same can be said about the British pound which remained an important reserve currency in the 1950s and beyond. This points to a slow decline of the USD, unless the U.S. accelerates its fiscal and monetary profligacy. Of course, the USD is a fiat currency not backed by anything more than the credibility of the government, so the risk of a steeper decline than with previous reserve currencies is not negligible.

The second reason that the USD reserve status is safe for now is that modern fiat currency reserve systems are much more a “debilitating burden” then the “extravagant privilege” once denounced by French  finance minister Valery Giscard D’Estaing. The American experience has shown how under a fiat currency regime  the U.S. has had to assume the responsibility for absorbing global trade imbalances through persistent current account deficits which can be financed indefinitely as along as foreigners are willing to accumulate American assets, both physical and financial. The consequence for the U.S. has been hyper-financialization,  deindustrialization  and an increasingly vulnerable American economy, kept afloat only by monetary bailouts and rising stock prices.

It is a safe bet that, at least for now, the Chinese are not interested in shouldering this debilitating burden of having to absorb global imbalances.  Quite the opposite, more than ever China is committed to its mercantilist “China 2025”  industrial planning model, as it is determined to wean itself from  dependency on the West for key technologies. This model is built on financial repression and is incompatible with currency reserve status which would require current account deficits to provide renminbi liquidity to the global economy.

Internationalization and Economic Convergence

Very few countries in emerging markets have sustained high GDP growth levels long enough to  aspire to convergence with  the developed world. These include the members of the club of Asian “tigers ,” originally formed by Taiwan, Korea and Singapore,  and now being joined by China, Vietnam, Thailand and Malaysia. Outside of Asia, Poland, Hungary and other formerly Comecon states have made huge strides towards catching up.  One thing all of these success stories have in common is openness to trade and integration into international supply chains.

The chart below shows the internationalization rate for the primary emerging markets.

The successful convergers have a high level of internationalization of their economies, as measured by total trade (imports plus exports) divided by GDP  minus net trade.  Asian countries have followed  a mercantilistic framework of  industrial planning and subsidies supported by  currency manipulation to maintain export competitiveness. Eastern Europe and Mexico have relied more on integration into regional trade networks. The focus on international trade has required that these countries focus on comparative advantages and market-based decisions, and this process has facilitated an accumulation of knowledge and skills which can lead to gradual moves up the industrial value chain.

This path of convergence is obviously not easy to follow or else more countries would do it. It requires long-term planning and economic stability, including a stable and competitive currency. Countries that experience frequent boom-to-bust cycles because of economic instability or commodity cycles will not succeed in this path. Moreover, many countries fall into the “middle-income trap”  which is caused by  dominant interest groups lobbying against open-market policies and other reforms.

Latin America is where the middle-income trap has become most prevalent.  The region suffers from a high dependence on commodities and repeated  phases of “Dutch Disease,”  the destructive aftermath of commodity busts, such as the one the region has experienced since the end of the 2002-2012 commodity super-cycle. The region also bought into the wrong elements of the neo-liberal “Washington Consensus.”  It adopted financial liberalization while failing  on fiscal reforms.

Brazil has become the poster child of the middle-income trap. Its gross mismanagement of the commodity boom (overvalued currency, corruption) left behind increased de-industrialization, debt and financialization of the economy. Ironically, while developmentalist policies are back in favor in Biden’s Washington, they are totally out of favor in Brazil where the finance minister espouses 1970s style Chicago School economics.

 

Update on Expected Returns For Emerging Market Stocks

The first quarter for emerging market stocks can be characterized as more of the same. EM equities once again underperformed U.S. stocks, as they have consistently for the past decade. The year started with a spurt of optimism, but then the cold reality of the pandemic sobered investor spirits. Meanwhile, the U.S. surprised with competent delivery of vaccines and an  extraordinary blend of fiscal largesse and monetary expansion.  The combination of vaccines and stimulus convinced markets that the U.S. might achieve a rapid return to trend growth, and this triggered a strengthening of the dollar. By quarter-end it looked like the long-awaited EM recovery was on hold again, until markets  begin to consider the aftermath of the the U.S. extravaganza.

For the long-term investor hoping for mean-reversion to cause cheap markets to outperform pricy ones, the first quarter was another disappointment.  As the chart below shows, by and large, the least expensive markets were the worst performers for the quarter, as investors  continued to focus on the reasons that made these markets cheap to begin with. Leading the way was Turkey, where Erdogan doubled up on his quarrel with economic sanity. Brazil was close behind, as Bolsonaro continued to demonstrate remarkable incompetence at managing public policy.   South Africa and Chile were exceptions, both benefitting from rising prices for industrial minerals, and, at least in the case of Chile, a proficient job with delivering vaccines.  On the other hand, the expensive markets all outperformed. Ironically, the two most expensive markets in the table were also the best outperformers, which is a good reminder that , over the short-to-medium term , momentum is a more powerful force than mean reversion.

Unfortunately,  some of the worst performing markets may have fallen for good reasons. The pandemic  and general government incompetence will have left a devastating impact on countries like Brazil, resulting in diminished growth prospects.  We can see this in the chart below which shows the IMF’s latest World Economic Outlook forecasts. Few emerging market countries  are expected to experience high growth, and they are all in Asia. Some of these like Indonesia, the Philippines and Malaysia also appear inexpensive in the previous chart, and therefore should be the best ponds to fish in. In Latin America, Colombia looks attractive.

Investors should focus on the inexpensive markets with good growth prospects. In addition, assuming that recent commodity price increases can be sustained, markets like Chile and South Africa may surprise to the upside. The remaining inexpensive markets — Brazil and Turkey — need some sort of a trigger (e.g. economic reform, political transition) to bring them back to life. Mexico is an interesting outlier. It is so extraordinarily  well positioned in terms of the current incentives for multinational firms to near-shore production and  reorganize supply chains, that even the best efforts of AMLO may not get in the way of success.

Expected Return for Emerging Markets, 2020-2027

The global Covid-19 pandemic has inflicted severe damage on emerging markets. Asia has fared relatively well and will bounce back quickly. However, Latin America and some EMEA countries (Turkey, South Africa) will take years to return to trend growth and are coming out structurally weaker in terms of debt, education and economic prospects.

Taking into account the highly uncertain evolution of the pandemic and its economic and corporate consequences,  making a forecast is more difficult than ever.  Nevertheless, we stick to our process and hope that it can provide some guidance for investment decisions.

Our main objective is to identify  extreme  valuation discrepancies. As in past efforts (Link ), we assume that valuations will mean-revert to historical levels over a 7-10 year time frame;  also, we expect that GDP growth and corporate earnings will return to trend over the forecast period; finally, after deriving a long term earnings forecast, we apply a “normalized Cyclically-Adjusted Price Earnings (CAPE) ratio to determine a price target and expected return. We assume that historical valuation parameters still have some validity in a world characterized by Central Bank hyper-activism and financial repression. The methodology has negligible forecasting accuracy over the short-term (1-3 years) but, at least in the past, has had significant success over the long term (7-10 years), particularly at market extremes.

The chart below shows the result of this exercise. The first thing to note is that, by-and-large,  current expected returns are muted. This is not  surprising in a world of declining growth and negative real interest rates.  Global emerging markets (GEM) are expected to provide total returns (including dividends) of  7.5% annually in nominal terms (including inflation) over the next seven years. This is below historical returns and disappointing in light of the poor results of the past decade. Nevertheless, these expected returns are attractive compared to the low prospects for U.S. stocks. The U.S. is trading in CAPE terms at the second highest levels ever  while emerging markets are priced slightly above historical averages.

To secure more attractive expected returns the investor needs to venture into cheaper markets. Brazil, South Africa, Colombia, Turkey, Chile, Philippines and Malaysia promise higher returns if mean-reversion occurs.

These expected returns do not assume a major recovery in cyclical and commodity stocks or other aspects of a reflation trade. Early signs of a weak dollar and rising commodity prices since March 2020 have pointed to the beginning of a reflation trade that could be beneficial to EM, particularly commodity producers. In these cycles, EM currencies appreciate and domestic economies benefit from expansion in liquidity and credit, and stock returns could be significantly higher in USD terms.

However, returns may be held back by the high debt levels in many countries and the reality that we are not at low valuations, compared to previous bottoms. The two following charts show the evolution of earnings multiples in EM and earnings, both on the basis of regular annual earnings and in terms of CAPE. CAPE ratios are not nearly as low as during the two previous good buying opportunities in 199-2001 and 2016. Moreover, in terms of CAPE earnings,  we are not as depressed relative to trend as during the 2000-2001 recession.

 

Big Mac Index Update

The Economist’s Big Mac Index ( Link  ) 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 ($7.29) and the cheapest in Russia ($1.81).  Presumably, these hamburgers are identical, with the same combination of bread, beef patty, lettuce and sauce. The price in each country should reflect the cost of the materials, labor and rent, profit margins and taxes. The index aims 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 Big Mac data confirms the strength of the USD following a 9-year period of USD appreciation against both developed and emerging market currencies. EM currencies are inexpensive compared to the high levels of 2007-2011 and generally in line with long-term historical levels. Competitive currencies, low earnings multiples and higher GDP growth compared to the United States are the foundation for a positive outlook for EM stocks. Some noteworthy developments are as follows:

Brazil at last has finally fallen from the high relative price levels it has experienced since the early 2000s, and is now placed towards the middle of the pack. Given the bad state of the economy and the significant depreciation of the BRL that it is not even lower is indicative of the high structural costs of doing business (taxes, regulations).

Most Asian currencies are perennially cheap, as governments intervene to  support export competitiveness.  South Korea and Thailand are straying from this a bit. This may be a natural evolution for Korea but a potential problem for the much less productive Thai industry.

Turkey, Russia and South Africa are dirt cheap and can be expected to bounce back when their economies move up the business cycle.

Mexico is well positioned to benefit from reshoring of manufacturing to North America.