Category: India

Winter is Here for Emerging Markets

The first half of 2022 has been another big disappointment for investors in emerging markets as EM stocks fell 17%. On the positive side, EM stocks did better than the S&P 500, which fell by 20% during this period. Unfortunately, the rest of the year does not look better. The environment is simply not positive for EM assets. I wrote in February that Winter was  coming  (link)   ; now we can say that we are in the thick of winter.

All the indicators that we look at to mark the investment climate point firmly to more trouble ahead. Let’s look at these one by one.

  1. King dollar – EM assets usually do poorly when the dollar strengthens, mainly because most EM countries are short dollars and because commodity prices tend to do poorly during these times. The dollar has been strong since 2012, and this has been an awful period for EM investors. The recent surge in the dollar caused by high global risk aversion and flight of capital into U.S. assets, is a huge headwind for EM. The charts below show  first the DXY (heavily weighed towards the euro and the yen) and second the MSCI EM currency index, both of which show the sustained run the dollar has had for 10 years.

2. Global dollar Liquidity – Risky assets like EM stocks and bonds do well when dollar liquidity is ample and poorly when it dries up. After the money printing orgy of 2021, the tide has ebbed. The charts below show: first, one measure of global liquidity (U.S. M2 plus central bank reserves held at the Fed);  and second, central bank reserves held a the Fed. Liquidity is now in free fall. Foreign reserves held at the Fed are also plummeting, as countries like China and Russia have dramatically reduced their positions for geopolitical reasons and other countries are fleeing the negative real yields of Treasury notes.

3. Yield spreads – The spread between the yield of U.S. high yield bonds and Treasury bonds is one of the best indicators of risk aversion and recession risk. Historically, rising spreads point to problems for EM. We can see in the next chart the recent rise in the spread. Moreover, the rise in the spread has been tempered by the benefit of high oil prices for oil companies. Stripping these out the spreads would be much higher.

 

4. The CRB Industrial Index – Commodity prices and in particular industrial commodity prices are a tried and true indicator ofmarket trends for EM assets. This has been even more so since the rise of China twenty years ago because China is the primary consumer of industrial commodities, and any slowdown in China now spreads rapidly to the rest of EM. The CRB index, shown in the chart below from Yardeni.com,  has turned down since February and now appears in free fall. The combination of high oil prices and low industrial metal prices is a very bad one for EM.

5. Copper price – Finally, the price of copper is a good indicator of global economic activity, as Dr. Copper is known to sniff out recessions earlier than most economists. Unfortunately, copper also appears in free fall now.

So, all the relevant indicators tells us we are in a winter storm. It is best to sit be the fire with cash in hand and wait for calmer times.

Is India Assuming Leadership in Emerging Markets?

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

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

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

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

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

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

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

 

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

 

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

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

 

 

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

The Next Commodity Cycle and Emerging Markets

 

The stars may be aligned for a new cycle of rising prices for industrial and agricultural commodities. It has been nine years since the 2002-2011 “supercycle” peaked, and the malinvestment and overcapacity from that period has been largely washed out. Over the past several months, despite economic recession around the world, commodity prices have started to rise in response to supply disruptions and the anticipation of a strong global synchronized recovery in 2021. Moreover, in recent weeks the victory of Joe Biden in the U.S. elections has raised the prospect of a combination of loose monetary policy and robust fiscal policy, with the added benefit that a good part of the fiscal largess will be directed to infrastructure and “green” targets which will increase demand for key commodities. Finally, global demographics are once again becoming supportive of demand.

The chart below shows 25 years of price history for the CRB Raw Industrials Spot Index and the Copper Spot Index. Not surprisingly, these indices follow the same path. Interestingly, they are also closely linked with emerging markets stocks. This is is shown in the second chart. (VEIEX, FTSE EM Index). This is clear evidence of the highly cyclical nature of EM investing, and it is the explanation for why EM stocks outperform mainly when global growth is strong,  commodity prices are rising and the USD is declining.

Since the early 2000s, China has been the force driving global growth and the cyclical dynamic. Since that time China has been responsible for generating most of the incremental demand for commodities. Starting in 1994, China embarked on a twenty-year stretch of very high and stable GDP growth which took its GDP per capita from $746 to $7,784. In 1994, China’s GDP/capita was in line with Sudan and only 15% of Brazil’s. By 1994, China’s GDP/capita reached 65% of Brazil’s. By 2018, China had surpassed Brazil.

By the turn of the century, China’s coastal regions which dominate economic activity had already reached the transformation point when consumption and demand for infrastructure and housing result in a surge of demand for commodities. This transformation point typically occurs  around when GDP/capita surpasses $2,000, which happened for Brazil in 1968 and in Korea in 1973. In 2005 China’s overall GDP/capita reached $2,000 and the commodity super-cycle was well under way. (All GDP/capita figures cited are from the World Bank database and based on 2015 constant dollars.)

Moreover, China was not the only significant country to enter this commodity-intensive phase of growth during the 2000s. The chart below shows the list of new entrants to the $2,000/capita club since the late 1960s. During the 2000s, three large EM countries, Indonesia, the Philippines and Egypt,  also broke the barrier. These three countries added fuel to the commodity boom created by China’s hyper-growth and infrastructure buildout, generating the commodity “supercycle.”

The historical link between rising commodity prices, a falling dollar and the incorporation of large amounts of new consumers into the world economy can be seen in the following three charts which cover the 1970-2020 period.. The first chart shows the rolling three-year average of the total annual increase in the population of global citizens with an annual income above $2,000. The second chart shows the  increase in commodity prices relative to the S&P 500; and the third chart shows the evolution of the nominal effective U.S. dollar. The connection between the three charts is clear: every period of rapid growth in new developing world consumers coincides with both rising commodity prices and a weaker USD. Not surprisingly, every bull market in EM stocks (1969-1975, 1987-92, 2002-2010) also follows this pattern.

 

The bull case for emerging markets investors today is that we are on the verge of entering a new cycle as five more countries pass the $2,000/capita barrier.  Already this year, Kenya and Ghana will reach this level. These two countries in themselves are not that significant but they point to the importance of Africa for the future. Then in 2021 India (pop. 1.4 billion) reaches the benchmark, followed by Bangladesh (pop. 170 million) in 2022. The following chart shows the evolution of the total global population with per capita GDP above $2,000 and the annual increases for the past 50 years and the next five years. The potential significance of India and Bangladesh are clear.

India will likely have an  impact on a different set of commodities  than China had. India is unlikely to achieve the pace of infrastructure growth that China had, and has significant iron ore resources. This means the impact on iron ore and other building materials will not be as great. On the other hand, India imports most of its oil and will have an increasing impact on the oil markets. India also faces great urgency to electrify the country and to do this with clean energy. This points to growing demand for copper , cobalt and silver, three markets that already appear to be undersupplied in coming years.

What to Expect for the 2020s in Emerging Markets

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

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

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

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

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

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

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

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

Good luck to all!

Explanations for the Middle-Income Trap in Emerging Markets

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

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

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

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

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

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

The Asian Tiger model follows a few simple steps:

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

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

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

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

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

The Case of Emerging Markets

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


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

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

China

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

South-East Asian

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

Europe, Middle-East and Africa

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

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

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

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

Latin America

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

 

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

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

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

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

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

A Guide to Investing in Emerging Markets: BAM on the India Opportunity

For anyone interested in investing in emerging markets, these comments from Brookfield Asset Management’s India Managing Partner made during the company’s 3Q conference call are elucidating.

BAM is a major investor in emerging markets, and has been in Brazil for decades (originally Brascan). Ranjan explains the time-proven process:

* Start slow and build local expertise.

* Focus on secular opportunities with very long runways.

* Focus on cash-generating businesses

* Most importantly, be aggressive during economic downturns when there are many distressed assets and capital is scarce.

Brookfield Asset Management Quarterly Conference Call (Link)

Anuj Ranjan – Managing Partner and CEO, India and Middle East

Anuj Ranjan

Thank you, Brian, and good morning, everybody. Today, I want to talk about our journey in India, our outlook on the Indian economy and where we see investment opportunities emerging. We’ve now been in India for more than a decade and have over $16 billion of assets under management with investments across all of our businesses, real estate, infrastructure, power and private equity. Now while we entered India in 2008, we did not close our first major transaction until 2014. Since India was a new market for us then, we were guided by our philosophy of being patient and invested capital only where we saw value opportunities. Initially, when we arrived in India, the country was going through an economic boom that was reflected in valuations that we thought were too high. So we decided to spend the first 5 years really understanding the market and building out our operating capabilities on the ground. We did this by creating operating platforms that would provide services to domestic real estate and infrastructure companies. By 2012, we saw signs of distress and a dislocation of capital emerging, and we spent 2 years putting together what became our first significant transaction in the market, which was a commercial office property owner.

This was a large and complex situation that involved privatizing an offshore public company, backing the local banks and the foreclosure of debt and ultimately, taking over all operations of the business. We learned a lot in the process, and this was truly the start of our journey in India. Maintaining this investment and operating discipline, we’ve incrementally built what is now one of the largest foreign investment platforms in the country. In our real estate business, we own more than 30 million square feet of high-quality office space across several key markets. And more recently, we acquired a vertically integrated luxury hospitality group, which has 3,000 owned and managed keys. Our infrastructure business consists of a roads platform with 5 national highways, the only cross-country gas pipeline and more recently, we signed agreements to acquire the second-largest telecom tower portfolio in the world through a large corporate carve-out. Our renewable power business owns and operates over 500 megawatts of capacity across solar and wind assets. And our private equity group has created a financial services business, which provides credit to residential developers who aren’t able to access traditional bank financing.

Through this growth, we have built a strong investment and operating team. Our team is over 40 investment professionals and support staff across our operating businesses, though we also employ well over 6,000 people. This gives us a unique competitive advantage when evaluating opportunities. Not only can we provide large amounts of capital where it’s needed, but we can more easily assess the risks, challenges and operating requirements of the asset or business. We’re also able to implement and execute our business plans, not necessarily requiring a local partner. This is very useful, especially when you’re using the opportunity to acquire businesses from banks where the prior owner is in some distress.

Moving on to the economy. There are certainly some near-term challenges in terms of a slowdown being driven by a tightening of credit availability that has led to multiple defaults. However, we believe the long-term fundamentals of the country continue to be quite strong, and India remains one of the most attractive markets in the world. More specifically, over the last few years, there have been some significant developments that are very encouraging for the country’s long-term growth. First, to set the context on the economy, it’s hard to generalize a country as big as India. We like to think of it as three economies, which we will refer to as India 1, 2 and 3.

India 1 includes the wealthiest 100 million people, which make up only 8% of the population and have very similar metrics to Mexico. GDP per capita, spending habits and consumer behavior, almost exactly the same as Mexico. They contribute 40% of India’s economy today and have largely historically driven consumption.

Next you have India 2, which is another 100 million people and could be described as the middle-class. It’s similar in economic makeup to the Philippines in terms of GDP per capita and spending. And finally, we have India 3 with a population in excess of 1 billion people who have a GDP per capita of Sub-Saharan Africa. These are the poorest people, largely in rural areas who have not historically been a part of the formal economy.

For the first time ever, we’re seeing a transformation in which India 2 and India 3 are becoming included in the formal economy, and this is happening for 3 reasons: data penetration, reforms targeting inclusion and a strong government that’s driving change. Let’s start with data. India has risen from being 150th to the first ranked country in the world in mobile data consumption in only the last 3 years. This explosive growth has been brought about by affordable data plans and falling smartphone prices. India now has 600 million Internet users, but what is shocking is this is only 40% of the population, implying a sustained and continued growth in the future. This digitization has contributed substantially to the inclusion of India’s large population, and it is translating to high growth across most businesses. We’re excited about this trend and actively evaluating opportunity in data infrastructure, including the acquisition, I earlier mentioned, of the country’s largest telecom portfolio.

Secondly, we witnessed landmark steps being taken to create an inclusive, transparent and formal economy. Policies such as the creation of the Aadhaar card, which is a unique biometric identifier for every Indian citizen and banking for all in which over 300 million bank accounts were rolled out for the rural population have created an integrated ecosystem that can form the backbone for delivering grassroot reforms and growth. As one small example, in a very short time, this has already led to an increase in bank deposits of $15 billion. Thirdly, we’re in a period of sustained political stability with a strong government at the helm. The government has launched some breakthrough reforms, including the Insolvency and Bankruptcy Code, goods and services tax and a 10% reduction in corporate rates. While the processes are being streamlined and there’s some teething issues which remain, as a result of these initiatives, India has moved up 67 places in the global ease of doing business rankings in the past three years. This has, in turn, led to record foreign investment inflows.

This is all supported by the fact that the Central Bank has done an incredible job targeting inflation and getting it under control. Consumer price inflation, which used to be as high as 10%, is now under 4% and has been in the target range for over 5 years. This gives India one of the highest spreads in the world between the current bank rate and inflation, leaving ample room to cut rates further.

Now while data inclusion and good government are creating a platform for India to, one day, become a $5 trillion economy, there exist some immediate challenges that the country is grappling with. India’s banking system has saddled with close to $130 billion of nonperforming loans, which at roughly 10% is the highest ratio among the top 10 economies in the world. This is compounded further by the crisis in the shadow banking sector, which makes up over 20% of India’s overall credit.

Unlike developed markets where shadow banks do only specialty or high-risk lending, in India, due to regulatory restrictions, the nonbanking financial companies are also providing credit where banks can’t lend, for example, loans against property, margin loans against shareholder equity. Most of the distressed debt is in wholesale or corporate credit, which presents a sizable opportunity for us to acquire high-quality businesses at a time when capital is needed.

To conclude, we’re excited about the opportunity India provides. On the one hand, we have the fastest-growing major economy in the world, taking steps to access their enormous population by including them in the formal economy. On the other hand, in the short term, liquidity is scarce and the credit markets are in distress, creating a tremendous opportunity for private capital providers like us.

The challenge is that while businesses or assets can come at attractive valuations, operating them under Indian conditions can be a challenge, which is where our 6,000-person strong operating platforms give us a unique advantage. To navigate India in this period, our key investment themes are to focus on businesses that benefit from inclusion of that final 1 billion people, acquiring assets or businesses from over-labeled corporates, making stable bond-like investments that generate a high cash yield, and lastly, looking at private credit opportunities where banks cannot lend.

Thank you. That concludes my remarks. I will now turn the call back to the operator for questions.

Asset Management Fees are Moving Towards Zero

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

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

 

The Shift from Active to Passive

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

Persistent Reduction in Fees

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

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

 

Chinese quants (Bloomberg)

Oddities of the Chinese stock market (Bloomberg)

China’s quant Goddess (Bloomberg)

Guide to Quant Investing (Bloomberg)

Trends Everywhere (AQR)

Ten bits of advice from Buffett (Seeking Alpha)

Value + Catalyst: the Gazprom case (Demonitized)

Latin America’s missing middle (McKinsey)

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

 

Emerging Markets Debt Bomb

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

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

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

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

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

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

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

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

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

Macro Watch:

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

Trade Wars

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

India Watch

  • Election uncertainty clouds Indian stock market (FT)

China Watch:

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

China Technology Watch

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

Brazil Watch

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

EM Investor Watch

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

Tech Watch

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

Investing

Billionaires in Emerging Markets

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

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

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

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

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

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

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

 

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

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

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

The full list is shown below.

Macro Watch:

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

Trade Wars

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

India Watch

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

China Watch:

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

China Technology Watch

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

Brazil Watch

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

EM Investor Watch

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

Tech Watch

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

Investing

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

 

 

 

 

 

 

Brazil’s Low-hanging Fruit

 

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

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

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

Low-Hanging Fruit

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

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

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

 

Macro Watch:

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

Trade Wars

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

India Watch

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

China Watch:

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

China Technology Watch

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

Brazil Watch

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

EM Investor Watch

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

Tech Watch

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

Investing

 

 

 

Promoting Business Initiative in Emerging Markets

 

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

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

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

 

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

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

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

 

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

Asia

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

Latin America

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

Europe, Middle East and Africa

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

Macro Watch:

Trade Wars

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

India Watch

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

China Watch:

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

China Technology Watch

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

Brazil Watch

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

EM Investor Watch

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

Tech Watch

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

Investing

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

 

 

 

 

 

AMLO Shoots Himself in the Foot

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Transparency International, Corruption Ranking

 

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

Group 1 – Good Infrastructure with low cost of corruption.

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

Group 2 – Relatively Good Infrastructure with High Corruption.

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

Group 3 – Bad Infrastructure with High Corruption.

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

Macro Watch:

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

India Watch

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

China Watch:

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

China Technology Watch

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

Brazil Watch

EM Investor Watch

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

Investing

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

 

 

 

 

 

 

Interview with Doug Kaas (RIA)

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

 

 

 

 

 

 

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)

Geopolitics and Asia’s growing role in the Oil Markets

British Petroleum’s annual energy outlook published this week (BP -energy-outlook-2018.pdf) highlights the enormous shifts taking place in the supply and demand for oil and other fuels. Energy consumption drives development and higher living standards, and, over the past 100 years, oil politics have heavily influenced international relations. Much of Post WW II geopolitics has been influenced by the growing dependence of the industrialized world on unstable sources of oil supplies from the Middle East. But the future is now starting to look very different, as dependence on the Persian Gulf oil  is moving from the U.S. and Europe to China and India.

Long the dominant oil importer, the U.S. will soon be self-sufficient, because of rising shale oil production. As shown in the charts below, U.S. oil output is returning to levels last seen in the early 1970s, and imports are approaching zero compared to a peak of 12.5 million barrels per day 15 years ago.

On the other hand, Asian demand, mainly from China and India, is ramping up.  China started to have a significant impact on oil markets in the early 2000s, and now  it is India’s turn. Asia’s growing share of global imports is shown below in a chart from the BP report.

I

As I discussed in a previous blog ( India-urbanization-and-a-new-commodity-bull-market), India is having  growing impact on commodity markets. Indian oil consumption has increased by nearly 5% a year since 1990, growing from 1.2 million barrels/day to 4.2 million b/d. In 2016, India surpassed China has the largest contributor to marginal global demand for oil. India’s production meanwhile it around 700,000 b/d, and not expected to grow much, so India’s impact on the oil market will only increase with time. China and India are expected to import 9.5 million  and 3.7 million b/d in 2018, respectively.

Over the next twenty years, according to BP, demand for oil will start to decline in the OECD countries. As shown in the chart below, almost all demand growth will come from Asia.

The global oil market over the next decade will become almost completely Asia-centric. With its geographical proximity to the Persian Gulf and its historical and cultural ties, it is highly likely that India will become increasingly influential in the region. Both India and China will step into the vacuum left by the U.S. as it loses interest in the region, and this may lead to fascinating developments in our increasingly multi-polar world.

Fed Watch:

India Watch:

China Watch:

China Technology Watch:

  • China on the leading edge of science (The Guardian)
  • China’s Uber killer ((Wired)
  • How China became a tech superpower (Wired)
  • China shows of tech in Spring Festival Gala (SCMP)

EM Investor Watch:

  • Unlocking Indonesia’s digital opportunity (McKinsey)
  • Transparency International 2017 Corruption Index (Transparency)
  • Turkey’s challenges in the Black Sea (CSIS)
  • The future of economic convergence (Project Syndicate)
  • The decline of governance in Turkey  (The Economist)

Investor Watch:

 

 

 

Emerging Markets and the Global Allocation Process.

Emerging market countries now represent over 40% of the global economy, and over 60% of its growth. This will only increase in the future. The IMF forecasts that emerging markets will grow a nearly three times the pace of developed markets over the 2017-2022 period, led by India and China. These two countries increasingly dominate EM investing. The two markets are relatively easy to invest in because of an abundance of large firms with liquid stocks, and they are becoming more and more attractive as companies tap into the world’s two fastest growing pools of middle class consumers.  Yet most investors in wealthy countries have very little invested in EM, and consider anything above a 10% allocation to be near-reckless. This is mainly because of “home-country bias” and investor preference for the familiar. However,  given the nose-bleed valuations in the U.S. and the relatively cheap stocks in EM, it is a risky allocation strategy to pursue. This was the point made recently by GMO strategist Jeremy Grantham when he encouraged his clients to put as much of their assets in EM as they can possibly stomach (GMO).

In addition to providing growth, emerging markets also provide significant diversification benefits. With only little over 40% correlation with the U.S., combining EM with an investment in the S&P500 reduces volatility by about 2.2%.

The diversification effect occurs because EM and the U.S. market tend to trend in opposite directions for extended periods of time. Because of links to the U.S. business cycle, Federal Reserve policy and the U.S. dollar, EM tends to perform well when the U.S. dollar weakens, providing a strong diversification benefit to dollar-based investors. The dollar typically weakens when global growth is strong and investors raise their appetite for “risky” EM assets. The weak dollar creates liquidity and credit in EM economies, resulting in strong upswings which are very rewarding for equity investors.

A simple strategy of rebalancing an EM index and the S&P500 provides surprisingly positive results. Rebalancing a 50/50 portfolio with the two assets increases returns while significantly reducing volatility over long holding periods. This is shown in the table below.

Moreover, significantly enhanced results can be achieved by adding some complexity to this strategy.

First, adding a timing tool, such as one-year relative momentum or a 200-day moving average, is effective. This allows the investor to stay fully invested during the long uptrends and avoid steep drawdowns. Such as strategy pursued over the past twenty years has produced annual returns of 13%, nearly double the returns provided by a 50/50 mix of and EM index and the S&P500 Index.

Second, the EM portfolio can be tilted towards the cheaper countries, also re-balanced on a periodic basis. Countries coming out of large down-cycles and trading with valuations well below their historic averages can be over-weighted as they initiate their recovery processes  (The Next ten years in EM ).   Boom-to-bust cycles are a feature of emerging markets, and the investor should have a well-defined methodology to exploit them for enhancing returns.

Lastly, an astute investor can create additional value (alpha) by  methodically tilting the portfolio to certain factors and picking superior stocks. My personal experience is that this can be achieved most effectively with a replicable,  formulaic approach. My preference is for a “Warren-Buffet-like” ranking of stocks in terms of both quality and profitability, building a screen which identifies stocks with the ability to compound high returns over time and that are valued at relatively low valuations.

 

Fed Watch:

  • China is the leading candidate for the next financial crisis (FUW)
  • The coming melt-up in stocks (GMO)

India Watch:

China Watch:

  • When will China become the biggest consumer economy (WIC)
  • Xi ally highlights financial risks (SCMP)
  • Davos; MNCs troubles in China (Holmes Report)
  • China’s rise is over (Stanford Press)
  • Dockless bike-sharing in China (Bikebiz)
  • Bridges to Nowhere, Michael Pettis (Carnegie)

China Technology Watch:

  • China and the U.S. wage the battle for AI on the cloud (Technology Review)
  • Hong Kong-mainland bullet-train links ready (Caixing)
  • China’s rental market takes off, led by techs (bloomberg)
  • The life of an express delivery man (FT)

EM Investor Watch:

 

Technology Watch:

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

Investor Watch:

India, Urbanization and a New Commodity Bull Market

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

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

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

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

 

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

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

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

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

Fed Watch:

India Watch:

China Watch:

 

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

China Technology Watch:

EM Investor Watch:

 

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

Technology Watch:

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

Investor Watch:

 

 

 

 

India’s Star Rises in the World Bank’s Doing Business 2018 Survey

The World Bank has conducted its “Ease of Doing Business” survey for fifteen years, providing a comparative view of business regulation around the world over an extended period of time. The survey is aimed at providing a comparative basis to help policy makers address issues that impact entrepreneurial activity. The rankings resulting from the survey are an important indication of how business-friendly countries are and how successful they can be in attracting the entrepreneurial capital to succeed in an increasingly competitive global environment. The survey ranks 190 countries. The top thirty can be considered an elite in terms of providing a regulatory environment amenable to business. A top 50 ranking is good. A ranking above 100 indicates that a country’s business community is crippled by bureaucracy and rent-seeking agents. A poor ranking is particularly debilitating for a small country that does not have the market scale and diversity to attract capital that large countries like Brazil, China and India have.

There were several important revelations from the 2018 survey published this week.

  • India improved its ranking from 130th to 100th, which is a significant improvement. This confirms a recent trend and lends credence to the government’s very ambitious objective of improving the country’s ranking to 50 during the current Modi Administration.
  • India’s improvement highlights Brazil’s sorry performance. Brazil and India have long been competing for the position of lowest ranked of the major emerging market economies. Brazil fell two points in the latest ranking, to 125th and now has a secure hold on the bottom rung.
  • Indonesia, the third of the large emerging markets economies with consistently poor scores over the history of the survey, has been steadily improving its performance for the past six years, and reached 72nd in 2018, which compares to 129th in 2012.
  • Asia, by and large, provides good business regulation and is improving. In addition to India and Indonesia, Vietnam is showing steady improvements and now has a ranking of 68, compared to 99 in 2014. China also is gradually improving. Taiwan, Malaysia, Thailand and South Korea are all elite in terms of business regulation.
  • The Philippines provide somewhat of a glaring exception in Asia. Though the country has improved significantly from the very low ranking of 2011, it has significantly deteriorated over the past four years, and it obtained a ranking of 113th in the 2018 survey. Given how competitive the Asian region is and the improving trends, the Philippines appear to be at a growing disadvantage.
  • In Europe, the remarkable trend is the surge of Russia and much of Eastern Europe. At a 2018 ranking of 35th, Russia is approaching the “elite” countries in terms of the quality of business regulation. Russia has improved every year since 2012, when it ranked at 123rd. Poland’s ranking at 27th secures an “elite” standing. Moreover, the improvements in Eastern Europe are much more profound. Georgia, Macedonia, Estonia, Lithuania and Latvia all rank in the top twenty, ahead of most Western European countries, including Germany, and are well ahead of the Mediterranean countries, France, Spain, Italy, Greece and Turkey.
  • South Africa appears to be on a ruinous path. Its ranking has fallen steadily for nine years, taking the country from elite status to 82nd.
  • Latin America is also on a steady decline, losing competitiveness to the other regions of the world. Mexico is the only bright spot, just because it has maintained its decent ranking around the 50th level. Chile, Peru and Colombia have all seen consistent and worrisome declines in recent years. Argentina and Brazil are secure in their abysmal rankings, near the bottom for economies of this relative importance. Not to mention, Venezuela which is essentially closed for business. With a wave of business-friendly governments now rising to power in Latin America, it will be interesting to see if these negative trends can be reverted in upcoming surveys.

Fed Watch:

India Watch:

China Watch:

China Technology Watch:

  • How China will rate its citizens with AI technology (Wired)
  • China’s focus on practical AI application (Arxiv.org)
  • China and Russia invest in face-recognition start-up (Bloomberg)
  • Automaker Changan to go 100% electric (Caixing)

EM Investor Watch:

Technology Watch:

Commodity Watch:

 

 

 

 

 

 

 

 

 

 

 

Business Corruption in Emerging Markets

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

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

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

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

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

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

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

 

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Notable Quotes:

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

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

 

 

Caution Is Merited For India’s Stock Market

The stock market of India today is probably the most hyped and loved by emerging markets investors. Investor enthusiasm is rooted in the assumption that the country’s high growth rate can be sustained by structural reforms aimed at boosting productivity and modernizing the economy.

As a low-income economy, India has considerable potential for boosting economic growth simply by narrowing the productivity gap that it has with more developed economies. Though India has many world class companies in sectors such as information technology, pharma, manufacturing and banking, much of the economy, particularly small-scale informal manufacturing and farming, suffers from abysmal levels of productivity. Stifling bureaucracy and corruption make operating a business very difficult in India and promote informality. India ranks 130th in The World Bank’s 2017 Ease of Doing Business survey, the worst of any large economy.

Since market-oriented reforms were first introduced in 1991, India has entered into an accelerated catch-up phase, enjoying GDP growth of 6-7%.  For the 2014-2018 period, GDP growth will average about 7% annually, making India the fastest growing large economy in the world. Moreover, in recent years India’s trade accounts and inflation have benefitted from low commodity prices.

In principle, higher GDP growth should justify higher stock market valuations. In many countries, there is a well-established and logical correlation between GDP growth and corporate earnings growth. A generally optimistic view of the potential for long-term growth in earnings has resulted in high multiples for Indian stocks. Moreover, the relatively high valuations in India may be validated by the corporate structure of the Indian market which is dominated by well-managed and profitable private companies operating in industries with stable growth characteristics, in contrast to the much higher concentration of cyclical businesses and mismanaged state-owned firms in the stock markets of Russia, China and Brazil.  We can see this in the chart below, which shows cyclically adjusted, 10-year average price earnings ratios (CAPE) for major emerging markets. India has traded at the highest PE multiples for this group of countries for the past 15 years, as the market has priced in high expected earnings growth and low expectations for future volatility. The market sees India as a “high quality” stock market, with high earnings and low volatility, in contrast to markets like Turkey, Brazil or Russia which are seen as low-growth and high volatility. The only other market currently held in such high esteem by investors is the Philippines.

However, investor enthusiasm for India’s stock market may be misplaced.

India, with its bouts of uncontrolled inflation, high fiscal deficits and elevated public debt levels, recurring balance of payments crises, currency volatility, extreme inequality,  complex democratic politics, and highly inefficient and corrupt bureaucracy, resembles Latin America more than it does East Asia. East Asia has benefited from strong commitments to competitive currencies, a financial system geared to support manufacturing, trade and small-scale farming, and widespread education, none of which are the reality in India or Latin America. Consequently, though India’s GDP growth may be relatively high, it is likely to be volatile, leading to choppy earnings growth for its listed companies.

Furthermore, high GDP growth may be more a curse than a blessing for many of India’s blue chips as it promotes more competition. In recent years, India is seeing many new entrants in sectors like consumer goods and banking. IT powerhouses like TCS and Infosys are threatened by disruption from cloud-based providers. India’s high growth and looser regulations are bringing more foreign competition in many industries (e.g., motor vehicles), potentially disrupting powerful incumbents over time.

In general, stock markets that are very popular with investors because of attractive growth prospects do not tend to perform well in the future. Nevertheless, though expensive relative to other emerging markets, the Indian stock market may continue to do well. It trades today at a CAPE valuation which is below its long-term average and about in the middle of its long-term range, which does not seem prohibitive at a time of very high asset prices around the world.

Still, from a relative performance point of view, there is a high probability that over the next 3-5 years, India will not perform as well as cyclically depressed markets such as Turkey, Russia and Brazil.

One of the ironies of investing in emerging markets is that high GDP growth most often results in excess investment and low future returns. The best stock market returns are often found in depressed cyclical markets which have seen a period of low investment and where companies stand to benefit from operating leverage during powerful cyclical rebounds.

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