Category: Global Emerging Markets

The U.S.-China “Cold War”

 

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

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

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

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

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

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

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

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

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

Macro Watch:

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

India Watch

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

 

China Watch:

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

China Technology Watch

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

Brazil Watch

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

EM Investor Watch

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

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

Investing

 

 

 

 

The Outlook for Emerging Markets Stocks

 

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

Poor Global Liquidity is Bad for EM Equities

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

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

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

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

Chart2. Dollar Reserves held by Central Banks (FED)

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

Valuations are Compelling

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

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

 

 

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

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

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

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

 

Macro Watch:

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

India Watch

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

 

China Watch:

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

China Technology Watch

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

EM Investor Watch

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

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

Investing

 

 

 

Weekend Reading

Macro Watch:

India Watch

China Watch:

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

China Technology Watch

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

EM Investor Watch

Tech Watch

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

Investing

 

 

 

 

Gloom and Populism in Emerging Markets

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

Here are some highlights from the report:

The Present is Gloomy   

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

The Past Was Better

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

The Future is Bleak

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

Some Thoughts on the Data

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

Here are a few charts from the report:

 

Macro Watch:

India Watch

China Watch:

China Technology Watch

EM Investor Watch

Tech Watch

Investing

 

 

Global Growth Trends and Emerging Markets

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

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

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

 

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

 

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

 

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

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

Conclusions

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

Macro Watch:

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

India Watch

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

China Watch:

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

China Technology Watch

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

EM Investor Watch

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

Tech Watch

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

Investing

 

 

 

 

 

 

The Global Liquidity Cycle and Emerging Market Stocks

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

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

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

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

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

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

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

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

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

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

Macro Watch:

India Watch:

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

China Watch:

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

China Technology Watch

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

EM Investor Watch

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

Tech Watch

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

Investing

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

 

A Reading List for Emerging Markets

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

The list is divided into three sections.

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

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

1 Macro-economics, business-cycles and financial bubbles

 The Volatility Machine by Michael Pettis

This Time is Different by Reinhart and Rogoff

The Bubble Economy by Chris Wood

Inflation and Monetary Regimes by Peter Bernholz

Money and Capital in Economic Development by Ronald McKinnon

How to Make Money with Global Macro by Javier Gonzalez

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

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

Against the Gods by Peter Bernstein

 Alchemy of Finance by George Soros

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

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

Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay

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

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

 

2 Development and Economic Convergence

 

 

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

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

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

Energy and Civilization: A History  by Vaclav Smil

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

The Great Convergence: Information Technology and the New Globalization

by Richard Baldwin

A Discussion of Modernization Li Lu (Link)

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

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

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

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

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

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

Empire of Cotton: A Global History  by Sven Beckert

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

The White Tiger by Aravind Adiga

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

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

Growth and Interaction in the World Economy by Angus Maddison

 

 

3 Regions and Countries

 

Latin America

 

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

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

 

 

Brazil

 

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

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

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

by Alex Cuadros

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

Lanterna na Popa by Roberto Campos

A Concise History of Brazil by  Boris Fausto

A History of Brazil by E. Bradford Burns

 

Mexico

 

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

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

 

Turkey and the Middle East

 The Political Economy of Turkey by Zulkuf Aydin

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

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

The Yacoubian Building by  Alaa Al Aswany

 

Russia

 

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

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

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

 

 

 

Asia

 

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

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

by Joe Studwell

Lords of the Rim by Sterling Seagrave

 

 

China

 

Factions and Finance in China by Victor C. Shih

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

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

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

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

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

The River at the Center of the World by Simon Winchester

Mr. China by Tim Clissold

The China Strategy by Edward Tse

River Town  by Peter Hessler

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

by Richard von Glahn

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

by John Bryan Starr

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

Modern China by Jonathan Fenby

The Chinese Economy: Transitions and Growth by Barry Naughton

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

China’s New Confucianism by Daniel Bell

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

Cracking the China Conundrum: Why Conventional Economic Wisdom Is Wrong

by Yukon Huang

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

Alibaba: The House That Jack Ma Built  by Duncan Clark

 

India

 

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

Behind the Beautiful Forevers by Katherine Boo

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

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

Capital: The Eruption of Delhi by Rana Dasgupta

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

 

Macro Watch:

India Watch:

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

China Watch:

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

China Technology Watch

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

EM Investor Watch

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

Tech Watch

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

Investing

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

The “Buffett Indicator” and Emerging Markets

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

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

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

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

Brazil

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

Turkey

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

India

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

Problems with the Buffett Indicator

There are potential issues with the Buffett Indicator.

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

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

Macro Watch:

India Watch:

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

China Watch:

China Technology Watch

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

EM Investor Watch

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

Tech Watch

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

Investing

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

Mean Reversion in Emerging Markets

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

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

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

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

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

Macro Watch:

India Watch:

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

China Watch:

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

China Technology Watch

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

EM Investor Watch

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

Tech Watch

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

Investing

 

 

 

 

Emerging Markets’ Innovation Problem

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

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

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

 

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

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

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

 

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

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

Macro Watch:

India Watch:

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

China Watch:

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

China Technology Watch

 

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

EM Investor Watch

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

Tech Watch

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

Investing

 

 

 

 

The Impact of Trade Wars on Emerging Markets

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

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

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

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

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

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

Consequences of the Trump Doctrine

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

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

Fed Watch:

India Watch:

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

China Watch:

China Technology Watch

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

EM Investor Watch

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

Tech Watch

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

 

 

 

 

 

 

 

 

Valuations in Emerging Markets

The current environment appears unattractive for emerging market equities (The Outlook for 2018). Nevertheless, for those disposed to stand pat and allow time to deliver the long-term returns and diversification benefits of investing in emerging markets current valuations are compelling enough to remain invested.

Over the short-term (1-2 years) valuations are not he main driver of stock performance. Liquidity, driven by monetary policy and human psychology are much more important over the short term. This is well expressed in this  quote from the legendary investor Stan Druckemiller:

“Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”

However, over the long term valuations do matter. As Ben Graham once said: ““In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Valuations do matter and they are the key driver of long-term performance. So, where are we now with vauations in emerging markets?

At the end of June, emerging market equities remained inexpensive relative to their own history and very cheap compared to the S&P 500. As the table below details, EM equities trade at about half the level of the U.S. market on a price-to-earnings basis and are even much cheaper on the basis of a cyclically adjusted price-to-earnings ratio (CAPE; price divided by 10-year average inflation-adjusted earnings).  While the S&P500 CAPE is priced at one standard deviation above its recent 15-year average, the EM CAPE is well below its 15-year average. Compared to their own history, EM equities are relatively cheap while the U.S. stock market is very elevated.

 

 

The work of two prominent firms that recommend allocation strategies — GMO and Research Associates – points to the same conclusion.  GMO, in its most recent 7-year forecast recommends EM for its relative attractiveness. As shown in the chart below, GMO sees real (after inflation) annual returns of 2.4% for the next seven years for EM and -4.4% for the S&P500.

Research Affiliates projects similar outperformance for EM, with 6.7% real annual returns for the next ten years from EM, compared to 0.3% for the S&P500.

These attempts at projecting future returns are, to a large degree, based on the assumption  that valuations revert to historical means over the long term (7-12 years).

Country-specific Valuations

Emerging markets are a very broad asset class, so it is not surprising that valuations vary greatly  across the markets. One of the main reasons for differences in valuations is that sectorial composition  is not consistent across markets. Because of this, it is generally more useful to compare valuations to a country’s own history rather than to other countries or EM as a whole. This works for most markets but not all. For example, historical comparisons are largely irrelevant in China which has a short trading history and a rapidly changing market structure (10 years ago industrial state companies dominated the market; today private tech firms stand out).

In any case, the charts below rank key emerging market countries in terms of valuation. The first group consists of markets that are valued well below their own history and therefore stand to offer high upside for the future. The second group have low valuations and can be expected to provide above average long-term returns. The third group of countries have relatively high valuation and should provide more modest returns in the next 7-10 years.

The markets with low valuations include several countries – Turkey, Russia and Brazil – that have recently experienced turbulent political disruptions which have caused economic distress and a loss of investor confidence. Argentina is in a similar situation. These markets may require a break with the past through elections or transformational reforms for market recovery to occur. For example, if a reformist leader is elected in Brazil this year, this could provide a trigger for the market to recover strongly.  On the other hand, Colombia, Chile, Malaysia and Indonesia already appear poised for stock market appreciation.

 

 

One-Year Positioning    

 To rank markets in terms of attractiveness for the next twelve months we look at valuations,  and macro and liquidity factors.  Each factor is scored from 2 to -2 for each country. The macro factor measures where a country is in its business cycle; and the liquidity factor looks at credit and flows. Results are shown below. Scores of three and above indicate relatively positive prospects.

 

 

Fed Watch:

India Watch:

  • Samsung opens world’s largest smartphone factory in India (Bloomberg)
  • Scarsity of visas is shaking up Silicon Valley (SF Chronicle)
  • India’s national strategy for artificial intelligence (NITI.Gov)
  • A look at the value factor in the Indian stock market (Indexology)

China Watch:

China Technology Watch

  • Tesla’s move to Shanghai (FT)
  • Tesla’s China plan (NYtimes)
  • Daimler and Baidu get ahead on driverless cars in China (Reuters)
  • China wants high-tech cars with German help  (NYT)
  • The battle to build the next super-computer (Tech Review)
  • America’s war on China tech (FT)
  • China tech start-ups lead VC funding (SCMP)
  • Shanghai aims to raise $15 billion for AI investments (SCMP)

EM Investor Watch

Tech Watch

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

 

 

 

 

The Outlook for Emerging Markets in 2018

Investors in emerging markets stocks started the year upbeat, expecting a two-year rally to continue. Market conditions appeared favorable. Valuations were low relative to the U.S. and other developed markets; and the global economy appeared strong, marked by “synchronized” growth across the developed world, China and emerging markets. Emerging markets also were expected to continue to benefit from rising commodity prices and a weakening dollar, both of which tend to occur during the later stages of the U.S. business cycle.

Unfortunately, by late-January the bullish thesis began to unravel.. The first sign of changes in the market environment was the sudden increase in volatility in the U.S. stock market. After the exceptionally low stock market volatility of 2017, the surge in volatility signaled a new regime of higher market risk. This was confirmed by a sudden appreciation of the U.S. dollar, a tell-tale sign of rising investor risk aversion.  The first chart below from Credit Suisse show the remarkable increase in risk aversion that has occurred since late January. In the second chart , the JP Morgan EM Currency Index highlights the concurrent break in the two-year trend of dollar appreciation.

 

 

 

Concurrently with the return of volatility, during February economic indicators began pointing to unexpected slowdowns in economic activity in both Europe and China. This undermined the thesis of global synchronized growth. Worse, U.S. growth, fueled by enormous fiscal deficits in a late cycle economy operating at full employment, now appeared to be growing at a higher rate than the global economy. The chart below shows the worrisome slowdown experienced by China.

 

Also, early this year we saw an important radicalization of Trump’s “America First” agenda., with a strong rejection of traditional American diplomacy. In particular, his threats of engaging in trade wars with foes and allies alike has significantly increased risks to the global economy.

Finally, early this year markets have started to accept that the U.S. Fed is serious about the normalization of monetary policy. A new, less-dovish Fed governor and the inflationary impact of fiscal expansion and trade wars has convinced investors that monetary tightening is for real.

The new environment that has existed since February – relatively strong U.S. growth, Fed tightening and rising risk aversion – has triggered a strengthening of the U.S. dollar and a downtrend for EM equities. As the following chart from Ed Yardeni Research shows, as usually happens, emerging market stocks started to trend down at the same time that the dollar began to appreciate. The negative correlation of EM stocks with the US dollar (ie. EM stocks fall in local currency terms as the USD appreciates) significantly increases the volatility of the asset class.

 

 

The value of the dollar relative to EM currencies is a key indicator for EM equities, a rising dollar pointing to a move from investors way from high- risk EM securities to the safe haven of U.S. treasury bills. On the other hand,  the two other key indicators to watch for emerging market equities – commodity prices and the spreads on high-yield bonds (U.S. and emerging markets) did not show initial signs of deterioration. In fact, as the charts below show both commodity prices and bond spreads have been stable since late January. It is only in recent weeks that both commodity prices and high-yield spreads appear to have started negative trends. The first chart, the Bloomberg Commodity Index, shows that commodity prices remained resilient through May, but have drifted down slowly since then. The second chart, from the Federal Reserve Bank of St.Louis, shows the difference in yield between high yield bonds and treasure bonds. This spread is a reliable indicator of aversion for risky assets and very negatively correlated to EM equities (as the spread goes up, EM equities fall).

 

 

Conclusion

For the time being, the trend does not favor EM equities, and a cautious stance is in order. If anything, the recent weakness in commodity prices and the rise in high yield spreads points to further troubles for EM equities. Nevertheless, for the medium term a more bullish stance is justified.

First, after the recent correction valuations are once again very compelling.

Second, by the end of this year a series of events weighing on the markets will have passed. The Chinese economy, which has been weighed down by official measures to deleverage corporations , is likely to see a rebound before the end of the year. In addition, the completion of a wave of elections in Turkey, Colombia, Mexico and Brazil will soon bring more clarity to policies for important EM markets.

Third, and perhaps most importantly, next year the U.S. economy is likely to slow down considerably, so that U.S. growth will no longer be higher than that of the global economy. As concerns rise with U.S deficits and the ageing business cycle, dollar weakness may resume.

In conclusion, keep your powder dry as 2019 may be a much better year for EM equities.

Fed Watch:

  • Don’t blame Trump for the decline of globalization (SCMP)
  • The rising USD and EM (WSJ)

India Watch:

  • Scarsity of visas is shaking up Silicon Valley (SF Chronicle)
  • India’s national strategy for artificial intelligence (NITI.Gov)
  • A look at the value factor in the Indian stock market (Indexology)

China Watch:

  • Beijing completes its seventh ring road (WIC)
  • The demonization of China (Foreign Policy)
  • A look at Chinese ETFs (ETF.com)
  • Xi tells CEOs he will strike back at the U.S. (WSJ)

China Technology Watch

  • America’s war on China tech (FT)
  • China tech start-ups lead VC funding (SCMP)
  • Shanghai aims to raise $15 billion for AI investments (SCMP)
  • China plans to leapfrog ahead in key technologies (SCMP)
  • China extends lead in most powerful computers (NYtimes)
  • Google invests in JD.com (CNBC)

EM Investor Watch

Tech Watch

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

 

 

 

 

 

 

Emerging Markets and “America First”

Donald Trump’s “America First” ideology is one of many manifestations of a break in the process of globalization. The incremental increase in open markets for trade, capital and labor which for decades was promoted by the U.S. now faces opposition from domestic interest groups that have been left behind. Politicians are exploiting the built-up resentment of “silent majorities” which feel that they have been exploited by a darwinian system that combines market fundamentalism with meritocracy to promote the interests of a self-serving elite. At the same time, this new global elite, a “noisy minority”  with highly progressive views on social issues, has clashed with a “silent majority” which identifies with traditional conservative social values. Trump has masterfully played upon this resentment, by espousing anti-globalization positions on trade, immigration and climate change, and by touting “politically incorrect” views on foreigners, immigrants and minority groups.

The resentment is not only a U.S. phenomenon, but also obvious in Brexit, Italian and German political instability, the rise of strongmen in Turkey, Poland and the Philippines, etc… The consolidation of Xi’s power in China also is rooted in the same soil, as the Communist Party recognized that the enormous rise in wealth concentration in China would inevitably cause political chaos without the re-imposition of order by strong reins. The process continues around the world with or without the democratic process; Erdogan’s supremacy was confirmed in Turkey last Sunday, and both Mexico and Brazil are headed for controversial elections which are likely to mean decisive breaks with the past.

These powerful domestic political forces can play out in unexpected ways. In France, disruption has produced Macron and a shift to the right. Something similar may happen in Brazil, where the current leader in the polls, Jair Bolsonaro, promises a sharp turn to the right.  Brazil has been a reluctant participant in trade liberalization, choosing to pursue long-standing protectionist policies. On the other hand, for decades it has fully embraced financial liberalization and a highly orthodox (i.e. U.S. determined) monetary framework. The result has been an over-sized financial sector, a rapid process of premature de-industrialization, wealth concentration and economic stagnation. Several generations of the best students from Brazilian universities have flocked to banks (Brazil’s leading bank, Itau, prides itself on its engineering culture.) Into this mess has stepped Bolsonaro, with a message of “Law and Order” and support for traditional “family values” which appeals to a “silent majority” heavily influenced by evangelical churches. Ironically, in highly bureaucratized, statist, leftist Brazil, change means a move to entrepreneurial freedom, and Bolsonaro, so far, has espoused a very pro-business, economic-freedom agenda.

The new resistance to globalization has several important consequences.

First, over the short-term it may favor the U.S.. This is certainly Trump’s political calculus. As the largest economy in the world, the U.S. relies less on trade than almost any other country, and it can move to self-sufficiency more quickly than others can. As the largest consumer market in the world and the prominent importer, it can largely impose its own terms on those seeking access  to its market.

The opposite goes for small countries with export-oriented economies. The big losers are countries like Taiwan, Korea, Thailand and Mexico, all of which are key players in global value chains. For example, those most hurt by Trump’s proposed tariffs against Chinese imports, aside from the American consumer, will be the Taiwanese and Korean producers of electronic parts. Ironically, as more countries favor nationalistic approaches over global connectivity, large protectionist economies such as Brazil and India may now gain a significant edge in attracting investment.

Second, Trump’s policies are inflationary. They will push wages up, which will benefit Trump politically. The Federal Reserve is likely to be compliant and allow inflation to rise, as it is in the interest of the U.S. to see nominal GDP higher than nominal interest rates.  However, higher nominal rates and a rising dollar will be a heavy burden on EM countries that have borrowed heavily in U.S. dollars and on those that need foreign funds to finance current account and fiscal deficits.

Third, higher wages will accelerate the trend towards robotization in developed countries. This is already happening in an accelerated fashion in Japan with its declining work-force, and it will spread quickly to the U.S. Trump’s “America First” protectionism is happening exactly at a time when automation technology is making it increasingly practical to “reshore” supply chains and final-stage manufacturing back to the U.S. Interestingly, this week Foxconn, the world’s largest electronics contract manufacturer, broke ground on a $10 billion investment to manufacture flat-screen liquid crystal display panels in Wisconsin, its first investment outside of Asia.

The disruption in supply chains  will be extremely disruptive to those EM countries that actively participated in them. Once again, the small export-led economies will suffer the most. However, large EM economies with big domestic markets like Brazil and India have the least to lose. China will combine automation with a rapid move up manufacturing value chains in order to increase the in-sourcing of intermediate goods, creating more pressure on small export-led economies.

Fourth, as the U.S. increasingly flaunts the rules of global trade to promote ”America First,” it will seek to impose bilateral deals on exporters wanting to access the its market. Other large economies will do the same, reluctant to export consumer demand. Regional blocks will increase in importance, with China determined to dominate an Asian trading block. If the U.S. pursues its popular “cold war” against Chinese technology companies it will force Beijing to double-down on its efforts to dominate frontier technologies. The result may be a strange new tech world which revolves around two separate ecosystems, one dominated by Silicon Valley, the other by Beijing. The current structure of the technology venture capital system which now invests with equal eagerness in both countries may be completely disrupted. We may see the same happening in the auto sector, with the industry revolving around the two largest markets China and the U.S., with separate supply chains.

Fifth, as regional trading blocks gain traction, U.S. dollar supremacy is likely to decline. In particular, the Chinese yuan will gradually gain space as China becomes the key player in Asian trade. China has already replaced the U.S. has the largest importer of hydrocarbons and will increasingly insist on having contracts priced in yuan. The U.S.’s heavy handed implementation of trade and financial sanctions, such as those on Iran, Russia and North Korea, also will accelerate the acceptance of yuan-based contracts.

Fed Watch:

  • Don’t blame Trump for the decline of globalization (SCMP)
  • The rising USD and EM (WSJ)

India Watch:

  • India’s national strategy for artificial intelligence (NITI.Gov)
  • A look at the value factor in the Indian stock market (Indexology)

China Watch:

  • A look at Chinese ETFs (ETF.com)
  • Xi tells CEOs he will strike back at the U.S. (WSJ)
  • Beijing’s big idea for southern China (SCMP)
  • How China secured a port in Sri Lanka (NYtimes)
  • JPMorgan on MSCI A share inclusion (SCMP)

China Technology Watch

  • China extends lead in most powerful computers (NYtimes)
  • Google invests in JD.com (CNBC)
  • U.S. faces unprecedented threat from China tech (bloomberg)
  • CATL, the rise of China’s new EV battery champion (Technology Review)
  • Competition in energy storage markets (McKinsey)
  • The disruption of battery storage technology (McKinsey)

EM Investor Watch

  • The Erdogan Supremacy (NYtimes)
  • Erdogan’s   bet pays off  (Brookings)
  • India’s shaky reforms (FT)
  • Now Erdogan faces his economic mess (NYtimes)
  • The roots of Argentina’s surprise crisis (Project Syndicate)
  • The rise of strongmen in global politics (Time)

Tech Watch

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

 

 

 

 

 

Market Efficiency in Emerging Markets

The emerging markets asset class is said to provide better opportunities for skilled investors because stocks are supposed to be priced more inefficiently than those in developed markets like the United States. However, important markets such as Brazil and Mexico have come to be dominated by highly sophisticated local and foreign institutional investors and are now probably nearly as efficiently priced as developed markets. Nevertheless, there are still significant pockets of inefficiency in markets where short-term traders and retail investors have a dominant presence and in large markets with many smaller stocks which are not on the radars of institutional investors. The Chinese A-share market and India are arguably the two markets which perhaps best display these characteristics and therefore offer the best opportunities for skilled investors to profit.

The SPIVA Scorecard, which is compiled bi-annually by S&P Dow Jones Indices, provides regular comparative data on the relative performance of actively and passively managed portfolios in different markets around the world. As previously discussed (active-vs-passive-in-emerging-markets), the data shows that emerging markets in general are somewhat less efficient than developed markets and provide some opportunities for skilled asset managers to outperform indices. This is particularly true for the larger asset managers, presumably because they have more and better resources to conduct fundamental research. SPIVA also provides detailed analysis on specific countries which provides an interesting view on which markets may provide the best opportunities for skilled managers to harvest alpha (i.e. outperformance relative to the market).

The table below shows the percentage of managers able to outperform indices over five and ten year periods in representative U.S. and emerging markets for the period ending at year-end 2017. The figures refer to managers in each country investing in their own domestic markets (i.e. Brazilian managers investing in Brazilian equities.) SPIVA uses its own indices for each market, and these are constructed to represent a market universe of easy accessible to the standard international investor. Domestic managers in each country may be measuring their performance in comparison to other benchmarks, which may be significantly different than the index used by SPIVA.

The first thing to note is that, by and large, markets are efficient.  U.S. large caps are exceptionally efficient, with only 10% of funds able to outperform over the long-term (10 years). Though smaller companies with less market capitalization are much less followed by Wall Street research firms and are deemed to be less efficiently priced, the evidence from SPIVA shows that only 4% of managers can beat the small-cap index over the long-term. The same is true in Europe where less than 15% of managers beat the index over the long-term.

Outside of the U.S., however, there appears to be large differences in the degree of market efficiency. Latin American markets, which are increasingly institutionalized and have a large participation of foreign institutional investors, appear highly efficient. SPIVA provides results net of fees, so in Latin America where fees can be exceptionally onerous, the numbers may be partially explained by high expenses. South Africa is another market highly dominated by institutional investors, which helps to explain why the market appears very efficient.

In addition to the high participation of institutional investors, the opportunity-set of investable stocks is another factor that determines market efficiency. Mexico, Chile and South Africa are very shallow markets dominated by very few stocks, so these are very well followed by investors. Brazil’s equity market has more depth, but still the very large and competent institutional investor base focuses mainly on a few dozen securities.

In the SPIVA data-base, India stands out as a particularly good environment for active investors. Well over half of managers outperform the index over five year periods, and almost half over ten years, despite relatively high fee structures. This high level of inefficiency points to a market where institutions still have a weak presence. This is particularly true in small and mid-caps, where foreigners are largely absent.

Though not yet covered by SPIVA, the other large and inefficient market is China. The China  A-share market (stocks listed in Shenzhen and Shanghai) is a very deep and growing market dominated by local traders and retail investors and with very little participation from institutional investors. Chinese A-shares were recently included for the first time  in both the FTSE and MSCI emerging markets indices followed by foreign investors and will become increasingly important in coming years.

In addition to having the highest -growth economies and the largest and most dynamic stock markets, China and India also provide the best opportunities for investors to outperform their competitors by engaging in thorough fundamental research.

Fed Watch:

  • Don’t blame Trump for the decline of globalization (SCMP)
  • The rising USD and EM (WSJ)

India Watch:

  • India’s national strategy for artificial intelligence (NITI.Gov)
  • A look at the value factor in the Indian stock market (Indexology)

China Watch:

  • JPMorgan on MSCI A share inclusion (SCMP)

China Technology Watch

  • CATL, the rise of China’s new EV battery champion (Technology Review)
  • Competition in energy storage markets (McKinsey)
  • The disruption of battery storage technology (McKinsey)

EM Investor Watch

  • The roots of Argentina’s surprise crisis (Project Syndicate)
  • The rise of strongmen in global politics (Time)

 

 

 

 

Winds of Change in Emerging Markets

The pace of change in emerging markets is accelerating. Unfortunately, in most countries the political class and policy makers are entirely oblivious of the future trends.

The enormous changes come on three fronts.

  1. The End of Bretton Woods

President Trump’s “America First” dogma is emblematic of a change in mood both in America’s heartland and Washington thinktanks. Americans increasingly don’t see the value in paying for the “Pax Americana” announced at the Bretton Woods Conference in 1949; an American promise to pay for the security of its allies and provide open, rules-based markets. The model worked incredibly well for over six decades bringing peace and growing prosperity for most of the world and exceptional success to those countries, not only in Europe, but also in Japan, Singapore, Taiwan, and Korea, which exploited its full potential. With the entry of China into the picture, America is reconsidering Bretton Woods. China rocked the boat in two ways: first it is too big and has become too powerful economically to be allowed to play the same game; second, it is considered not an ally but an adversary. For Donald Trump it does not make sense to pay for a system that promotes the rise of a potential rival.

  1. “Re-shoring

The end of the Bretton Woods model likely means a much less secure world with less trade. Trump’s comment this week about reducing the U.S. troop count in Korea is a sign of things to come, which will result in Japan, Korea and Europe having to foot more of the bill for their security. It also means companies will be much more reluctant to rely on value chains stretching around the globe. This will accelerate the existing trend towards so-called “re-shoring,” where companies bring production back closer to the final consumer. We see this already in “fast-retail” where Zara is the new model of success, with almost all its production in northern Iberia. Also, as Adidas is showing, robotic automation and 3D printing is bringing the manufacturing of sneakers and basic clothing back to Germany and the United States.

For small countries running apparel sweatshops for export (e.g., Mauritius or even Bangladesh), the future looks bleak. For large economies, like Brazil, India or China there is an opportunity to keep production at home instead of exporting demand. The Chinese have clearly understood this, and they are leading the way to automating basic industries. For Brazil, a country undergoing a dramatic case of what Harvard professor Dani Rodrick has dubbed “premature de-industrialization”, there may be a golden opportunity to revive once vibrant shoe and apparel industries.

Energy is another area where “reshoring” and its effect on global trade is occurring before our eyes. Breakthroughs in technology for the production of shale oil and gas and the declining cost of wind and solar energy have made North America fully self-sufficient in energy, undermining the U.S. commitment to the security of Middle-Eastern oil producers. This is another area where policy makers in emerging market countries need to act to secure cheap and decentralized energy for the future. Chile is the example to follow, with its ambitious plans to dramatically reduce its dependence on imported fossil fuels by developing its world class potential in solar, wind and geo-thermal resources.

  1. A World of Scarce Capital

Finally, unavoidable demographic trends will increase the cost of capital. Capital has been super-abundant for the past two decades because of the peak saving years of the baby-boom generation, but boomers are now retiring and moving from savers to pensioners.  The increasing scarcity of capital and rising interest rates will be a huge challenge to most emerging market economies, as markets will become much less forgiving of highly indebted countries and those that provide hostile conditions for business.

 

 

 

Fed Watch:

  • The rising USD and EM (WSJ)

India Watch:

  • Stock fever grips India retail  (WSJ)
  • Ray Dalio is bullish on India (IB Times)
  • The strategic importance of India’s rise (CSIS)

China Watch:

  • JPMorgan on MSCI A share inclusion (SCMP)
  • Korean cosmetics lose their edge in China (WIC)
  • Samsung’s sales collapse in China (WIC)
  • Thoughts from China’s elites (FT)

China Technology Watch:

  • China’s response to US on tech (Axios)
  • DJI is shaking up China private equity (WIC)
  • China installed 10 GW of solar in Q1 (Tech Review)

Technolgy Watch

  • Taiwan is falling behind Korea (SCMP)

EM Investor Watch

Investor Watch:

Stormy Waters in Emerging Markets

 

Stormy waters are putting on hold the two-year bull market in emerging market equities, leading cautious investors back to port.

Emerging market securities – both stocks and bonds – are relatively risky assets that attract investors when the global economic scene is benign and potential returns for investments are better in international markets than in the United States. This has been the case for the past two years, and, as usually happens during these periods, the U.S. dollar has weakened, serving to further enhance returns outside the U.S.

The recent break-out of the dollar after a 3-month consolidation, points to an important change in the trend.  Yield-chasing investors have started moving back to safety, abandoning “carry trade” currencies that were attractive for the past several years because high interest rates were enhanced by appreciating currencies. The major “carry trade” currencies – Indonesia, Turkey, Brazil, Argentina – have all seen their stocks, bonds and currencies trashed in recent weeks.

The move in the dollar is probably related to an incipient deterioration in the global economic environment. The market narrative since late last year was of a strong “global synchronous recovery,” but signs of slowdowns in Europe, China, Japan and Brazil have thrown some cold water on this.    Very contentious and possibly calamitous upcoming elections in Brazil and Mexico are also cause for concern.

However, the most important development is the dramatic attack on global trade being carried out by President Trump. The anti-trade zealots in the U.S. Administration, who now have the upper hand in the White House, stepped-up their hostile stance towards China in this week’s meetings in Beijing. At the same time, Washington has started a full-scale war against Chinese tech companies, Huawei and ZTE. Also, hopes of reaching a NAFTA settlement before the Mexican elections are fading, as the U.S. insists on industry-by-industry micro-management.

The intransigent, “take it or leave it attitude” of U.S. negotiators is causing enormous ill-will with America’s allies and major trading partners. The imposition of steel and aluminum quotas on Brazil last week stunned Brazilian negotiators. The spokesman for Brazil’s aluminum firms, Milton Rego, described U.S. tactics as “Al Capone-like,” and added: “You get better results by pointing a gun to the head.”

On the positive side, emerging markets are still well positioned in terms of very low valuations relative to the U.S. and the recovery in commodity prices. Oil prices, in particular, continue their rising trend. Increasing investments in oil producing countries and reducing positions in oil importers may be one of the few attractive trades in these turbulent waters, but in general it is probably best to stay closer to shore.

Fed Watch:

  • The rising USD and EM (WSJ)

India Watch:

  • Stock fever grips India retail  (WSJ)
  • Ray Dalio is bullish on India (IB Times)
  • The strategic importance of India’s rise (CSIS)

China Watch:

  • JPMorgan on MSCI A share inclusion (SCMP)
  • Korean cosmetics lose their edge in China (WIC)
  • Samsung’s sales collapse in China (WIC)
  • Thoughts from China’s elites (FT)

China Technology Watch:

  • China’s response to US on tech (Axios)
  • DJI is shaking up China private equity (WIC)
  • China installed 10 GW of solar in Q1 (Tech Review)

Technolgy Watch

  • Taiwan is falling behind Korea (SCMP)

EM Investor Watch

Investor Watch:

 

 

 

 

 

 

 

Exploiting Boom-to-Bust Cycles in Emerging Markets

Emerging market stocks are highly prone to recurring bubble-like cycles caused by economic and currency volatility and erratic “hot money” flows. As I discussed last week (link), recent experience over the past five years indicates that this high degree of volatility very much continues to be a defining characteristic of emerging market equities. If anything, with rising debt levels and newly forming markets in the frontier world such as Vietnam, everything points to more volatility in the future.

The chart below from a recent article from value investors GMO Asset Management (Link) shows the incredible economic volatility suffered by emerging markets compared to the S&P 500. Focusing on the grey bar of the chart, which represents the three worst performing EM markets, the chart shows the probability of declining earnings per share for any given year.  For the 1995-2017 period,  there was a 30% probability for the bottom three EM countries to have EPS growth of -50%. Given the very high correlation between EPS growth and market returns, this, in essence, means that an investor can expect about one 50% plus drawdown (market correction) for at least one country in the emerging markets universe in any given year.

 

 

The chart below confirms this with data on 46 market drawdowns of over 50% since 1990. This period of 28 years covers pretty much the entire period of institutional investor participation in emerging markets. Therefore, on average  1.7 specific country drawdowns of over 50%  occur every year. Since 2015, seven such drawdowns have occurred, right in sync with the trend of the past 28 years.

The huge price corrections that emerging markets consistently experience raises the question of whether these markets are suited for the buy-and-hold passive investor. Nevertheless, almost all of the flows invested in EM today are participating through passive indexed instruments like ETFs, and the majority of active investors also tend to track the indices closely, so that most investors are subjected to these violent drawdowns.

On the other hand, the active investor with a systematic methodology for avoiding drawdowns stands to have a very significant advantage in these markets, following a few basic rules:

  1. Focus on countries having recently experienced severe drawdowns, and which are valued significantly below long-term average multiples of cyclically-adjusted earnings.
  2. Identify a turning point; usually a political change or economic reforms which trigger recovery.
  3. Increase positions as a positive trend develops.
  4. Increase caution as markets gain momentum and valuations reach levels well above long-term averages.

Fed Watch:

  • Trade and Globalization in EM (Voxdev)
  • Gavekal view on the cycle, China, commodities and EM (CMG Wealth)

India Watch:

  • Ray Dalio is bullish on India (IB Times)
  • The strategic importance of India’s rise (CSIS)
  • Walmart prepares bid for Flipkart (Bloomberg)
  • India’s demographic dividend (Livemint)
  • Modi’s make-in-India strategy (NYT)
  • Infosys to sacrifice margins for growth (Bloomberg)

China Watch:

  • Starbuck’s has a new competitor in China (WIC)
  • The craft beer war in China (supchina)
  • Police nab bandit at concert using facial recognition tech (WIC)
  • China plays it cool (Mauldin)
  • Brookfield is bullish on China real estate (Forbes)
  • Trump’s weak case against China (Project Syndicate)
  • Anbang’s political connections worked until they didn’t (Caixing)

China Technology Watch:

  • DJI is shaking up China private equity (WIC)
  • China installed 10 GW of solar in Q1 (Tech Review)
  • China to double-down on chip development (Reuters)
  • Didi launches in Mexico (Recode)

Technolgy Watch

  • Taiwan is falling behind Korea (SCMP)

EM Investor Watch

Investor Watch:

 

 

 

 

Financial Bubbles in Emerging Markets – The Case of Brazil

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

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

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

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

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

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

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

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

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

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

We now look in detail at the Brazilian experience.

The Case of Brazil

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

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

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

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

Fed Watch:

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

India Watch:

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

China Watch:

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

China Technology Watch:

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

Technolgy Watch

EM Investor Watch

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

Investor Watch:

 

 

Trends in Emerging Markets ETFs

 

The rise of the Exchange Traded Fund (ETF) over the past decade has been a huge benefit for the investor in emerging market. ETFs give investors access to the broad asset class with low fees and significant tax advantages. Increasingly, these same benefits are provided to investors looking for exposure to specific countries and various investment factors. All of these products together provide the tools for the both the passive and active investor to develop intelligent and cost-efficient strategies for investing in emerging markets.

ETF emerging market assets are highly concentrated, with the ten largest funds gathering 81% of the $240 billion invested in U.S. listed ETFs.  These include the mammoth core emerging markets ETFs that follow the primary EM benchmarks provided by FTSE-Russell  (Vanguard) and MSCI (Blackrock-iShares). Fees for these funds have been consistently reduced and are now about 0.14% of assets. A clear indication of the relentless downside pressure on fees is that in 2012 Blackrock had to launch a new lower-fee core emerging markets fund, IEMG, to compete with its own original EEM fund. EEM continues to charge its legacy fees of 0.69%, but gradually is losing ground. Newcomers, Charles Schwab, and State Street, have secured market share by taking fees even lower.  Schwab’s FTSE-based core EM ETF, SCHE, currently has a 0.13% fee, and State Street’s SPEM ETF, benchmarked to the S&P BMI Emerging Markets Index has lowered its fee to 0.11%.

A similar story is unfolding with country-specific ETFs, a category until today largely dominated by Blackrocks’s MSCI-based iShares. The big funds in this space are iShares Brazil (EWZ), iShares India (INDA), iShares Taiwan (EWT), iShares China Large Cap (FXI, iShares China MSCI (MCHI) and iShares Latin America (ILF). All of the iShares country-specific products have maintained fees above 0.60%. So far, Ishares, with its first-mover advantage and the superior liquidity of its shares, has felt limited competition in this space, but that may be changing. This year Franklin Templeton launched a family of FTSE-based country funds under the Franklin LibertyShares label with 0.09% a fee for developed markets and a 0.19% fee for emerging markets. Brazil, China, Taiwan, Russia and Mexico have already been launched with good traction.

Another interesting trend in emerging markets ETFs are “Smart Beta” funds. This is a vague term that has come to include a category of products that feature a quantitative tilt towards specific valuation attributes (factors) or portfolio structures that aim to enhance returns. Most of these funds seek to exploit the “investment factors” —  value, size, momentum, and quality – that have been shown by long-standing academic research to improve portfolio returns over the long term. These techniques, commonly espoused by active managers, tilt portfolios towards stocks with low price-to-book ratios (value), smaller stocks (size), rising stocks (momentum) and stocks with strong balance sheets and steady returns (quality). Moreover, academic research supports the idea that portfolio returns can also be enhanced by changing the weights of stocks in a portfolio from one based on market capitalization to one based on equal weights or one based on fundamental factors, like sales, cash flows or book values.

Smart Beta funds were initially launched with higher fees, in the 0.7% range. However, fee compression is affecting these products as well, and recent launches are charging fees closer to 0.3%.

Some ETFs following the Smart Beta  track include Goldman Sachs Active Beta Emerging Markets (GEM) (value, momentum, quality, low volatility); Invesco, whose Powershares FTSE RAFI EM (PXH) weighs its portfolio positions based on book value, cash flow, sales and dividends,  a fundamental value strategy; Northern Trust EM Factor Tilt (TLTE) (small caps and value); FirstTrust EM AlphaDEX (FEM) (value and quality); SPDR EM Small Caps (EWX); and JPMorgan’s Diversified Return EM Equity (JPEM) (value, quality, momentum).

The chart below shows the twenty largest EM ETFs, with factor tilts listed on the far right. The top twenty ETFs represent nearly 90% of the EM ETF assets in the U.S. market.

Source: ETF.Com

A very successful player in the “factor” space is Wisdom Tree (WT), which has its academic credibility supported by having Wharton’s Jeremy Siegel as its senior investment strategy advisor.  WT has funds tilted towards high dividend stocks; high dividends serving as a proxy for value, quality and corporate governance. These include a core EM ETF (DEM)  and a small cap EM ETF (DGS). WT also has an India ETF (EPI), with factor-tilts towards small caps, value and quality. Moreover, WT has launched both an EM ETF and a China ETF which avoid state-run companies. This seeks to tilt the portfolio towards higher quality companies with better corporate governance, under the assumption that very few state-run companies care about creating value for minority shareholders.

WT  has the advantage that it cuts expenses by creating its own indices. This strategy has also been followed by Van Eck Funds and Cambria, among others, and this is adding pressure on the leading index providers  (FTSE and MSCI) to further reduce fees.

In conclusion, this plethora of core EM funds, country and regional funds and factor-tilted smart beta ETFs means it has never been easier and cheaper to build intelligent EM strategies. The investor has the opportunity to generate significant alpha in emerging markets by strategically tilting portfolios towards countries and factors. Once this has been accomplished, 80-90% of the task is done. The remaining 10-20% —  capturing stock-specific alpha – is both the most difficult and the least important. For those investors with the skill, free-time and patience to do this, I recommend a portfolio overlay of one or a combination of the two following strategies:

  • Invest with an active manager with a highly concentrated, long-term oriented portfolio.
  • Invest in a 15-30 high quality EM blue chips which have very long investment runways, and hold for the very long-term.

Fed Watch:

  • The Fed’s ammunition ran out (Zerohedge)
  • High Wages and high savings in a globalized world (Carnegie)

India Watch:

  • Mohnish Pabrai on the Indian market (Youtube)
  • Half a billion mobile internet users in India (Quint)
  • Digital streaming is taking over cinema (Quint)

China Watch:

  • China airline threatens move to Airbus (SCMP)

China Technology Watch:

  • China 2017 tech strides (Youtube)
  • Transsion is the leading cel-phone in Africa (bloomberg)
  • China moves up the value chain (bloomberg)

Technology Watch

EM Investor Watch

  • Russia and China’s uneasy Far-East partnership (Carnegie)
  • Thailand is he next Japan (The Economist)
  • Korean millenials  feeling the Bitcoin pain (The Verge)
  • Sam Zell is back in Buenos Aires (WSJ)
  • EM countries getting old; the case of Brazil (WSJ)

Investor Watch: