Category: Investing

Emerging market stocks are once again proving to be disappointing in 2023 due to increasing risk aversion. Geopolitical and domestic political factors, along with a strengthening dollar, are causing investors to seek the safety of U.S. blue-chip stocks and cash. Rising interest rates, concerns about a global recession, and weak earnings in many countries are all contributing to bleak short-term prospects. Investors can only find comfort in the expectation of longer-term returns.

The chart below illustrates the current expected returns for EM markets and the S&P500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings Ratio (CAPE) is calculated using the average of inflation-adjusted earnings for the past ten years, which helps to smooth out earnings’ cyclicality. This tool is particularly useful for highly cyclical assets like EM stocks and has a long history of use among investors, gaining popularity through Professor Robert Shiller at Yale University. We employ dollarized data to capture currency trends. The seven-year expected returns are calculated assuming that each country’s CAPE ratio will revert to its historical average over the period. Earnings are adjusted according to each country’s current position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (IMF WEO, October 2023).

As expected, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those considered “expensive” with CAPE ratios above their historical average. These expected returns are based on two significant assumptions: first, that the current level of CAPE relative to the historical level is not justified; second, that market forces will correct the current discrepancy.

Historical data strongly supports the second assumption when considering seven-to-ten-year periods but not in the short term (one to three years).

Nevertheless, during certain periods when “cheap” markets on a CAPE basis exhibit short-term outperformance, investors should take note, as the combination of value and momentum can be compelling. As shown in the chart below, we are currently in such a period. Over the past twelve months, holding the “cheapest markets” has generated alpha in an EM portfolio. Although Turkey is no longer “cheap,” it was clearly so a year ago and continues to enjoy that momentum. Nearly all the better performers are inexpensive markets. The one exception is India, which, despite very high valuations, continues to attract flows from investors enamored with EM’s “last growth story.” Chile is also an obvious anomaly, as it should be delivering better returns. It is very cheap relative to its history and, being the world’s leading copper producer, offers an excellent hedge against inflation.

The fact that cheap markets are now performing well is encouraging for EM investors. However, rising geopolitical tension and slow growth do not create a conducive investment environment. As always, a strengthening dollar signals the need to stay invested in dollar-denominated quality assets.

The past decade has been a disaster for investors in emerging markets because nominal earnings measured in dollars have not grown.

There are several reasons for this earnings stall:

First, the past 11 years have been a period of dollar appreciation. Due to its broad global use in invoicing and financing commercial flows, a strengthening dollar has had a depressing impact on most developing countries. Moreover, as typically occurs, a strong dollar has meant weak commodity prices and poor results for commodity producers (Latin America, Russia, South Africa, etc.).

Second, the fall in earnings and investor returns can be seen as a bearish cyclical adjustment after the prior decade of plenty. The weak dollar and commodity boom of the 2002-2012 decade provided outsized results for emerging markets, which were given back over the next ten years.

Third, profitless China has weighed down the asset class. China’s capital-intensive state-run economy has resulted in very low returns on capital and persistent dilution of investors in the stock market. This was a minor issue in 2000 when China was only a small part of the EM stock indices but became a huge burden over the past decade when Chinese stocks came to dominate the indices. The brief tech boom in China (e.g., Alibaba, Tencent, massive foreign private equity inflows) changed the perceptions of investors until it was crashed by Xi’s crackdown on the companies for their “socially destructive” behavior.

The following charts illustrate the evolution of nominal dollarized earnings over time for emerging market stocks. The first chart shows earnings data for the primary EM countries and the S&P 500 during the modern era heralded by the introduction of the MSCI EM index in 1986, including estimates for 2024. Over this long period, Mexico leads by a considerable margin, while India and Taiwan are neck-and-neck with the S&P 500. Before the S&P 500’s recent spurt (2020-2023), earnings growth in EM was broadly in line with the S&P 500.

The next chart shows earnings data starting in 1992 when China was included in the MSCI EM Index. Remarkably, China’s earnings in 2023 are below the level of 1992. Brazil leads the pack over this period, with the characteristic extreme cyclicality of commodity dependence, surging during the commodity supercycle (2002-2012), tanking during the commodity collapse (2012-2016), and recovering with the bounce in commodity prices starting in 2016. India stands out as the star performer over this period, as it has provided high earnings growth without the volatility of commodity producers. Also, unlike the capital-intensive, export-oriented businesses of China, Korea, and Taiwan, India’s mogul-controlled corporates enjoy strong market power, allowing for high and consistent returns. The S&P 500 experienced enormous volatility over this period marked by the combination of financialization of the Information and Communications Technology (ICT) cycle and monetary adventurism: two bubbles (tech, 1999-2001; real estate, 2003-2007), followed by crashes; an increasingly activist Federal Reserve, resulting in 15 years of negative real interest rates. Nevertheless, the enormously profitable tech giants supported the S&P 500.

The last chart shows the period after the Great Financial Crisis (GFC), 2010-2024. The post-GFC is characterized by “secular stagnation,” a period of low growth and low inflation which was met by the Federal Reserve with policies last seen in the Great Depression of the 1930s: massive money printing, negative interest rates (financial repression), and increasingly large interventions to support asset prices. This period also saw a persistent appreciation of the USD. The clear leader over this period has been the S&P 500, propelled not only by the rising USD but also by the remarkable expansion of profit margins for the monopolistic tech giants (FAANG) which saw profit margins rise from around 10% to the current 25%. Since 2019, earnings in both Taiwan and Mexico have recovered because of stellar results from TSMC in the former and a strengthening of the peso in the latter. Weighed down by China, EM nominal earnings have fallen over this long period. These years have been equally bad for commodity producers (low prices) and East Asian exporters (rising operating and financing costs and brutal competition from China). Even India, with its high GDP growth and booming asset prices, has seen no earnings growth over this period.

Emerging market stocks once again lagged U.S. stocks in 2022, as they have consistently over the past decade.  A rising dollar and persistent economic instability and risk aversion all have contributed to making emerging market stocks a poor asset class over the past year and the last decade. However, there are signs that the environment may be changing. EM stocks are now very cheap relative to the S&P 500, the dollar shows signs of having peaked and, most importantly, investors are looking for real assets that may perform better in a more inflationary environment. EM stocks, which have a high concentration of commodities and cyclical businesses , may be better positioned in the future than they have been in the “growth”-dominant investment world of the past decade.  Moreover, after a decade of poor returns, value investing (contrarian investing in cheap stocks in cyclical industries with little growth) is working again in emerging markets.

The MSCI EM value index outperformed the MSCI EM core index by 5% over the year, and, more importantly, the cheapest countries in the EM index were the best performers. This is in stark contrast to the past five years when cheap only became cheaper and rich only became richer.

The chart below shows the 2022 returns for all the countries in the MSCI EM index. On the right margin countries in the index are shown ranked in terms of a CAPE valuation based expected returns analysis at year-end 2021, with the cheapest on the top and the most expensive on the bottom. We can see that the cheapest countries (Chile, Turkey and Brazil) were the best performers in 2022 while expensive countries (India, Russia, USA, Taiwan) generally did poorly. The Philippines are one important exception to this trend, having started the year as “cheap” and ended even “cheaper.”

This trend should boost the confidence of EM investors. Emerging markets are by nature a value asset (highly weighted to cyclical businesses) and should not be performing well in an environment of rising risk aversion.  But investors are now betting that these markets are too cheap to avoid because low valuations promise high expected returns that more than compensate for short-term risks.

The chart below shows the current expected returns for EM markets and for the S&P500 based on a CAPE ratio analysis. The Cyclically Adjusted Price Earnings Ratio (CAPE)  is based on the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful tool for highly cyclical assets like EM stocks.  We use dollarized data to capture currency trends. This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University.

As we have seen in recent years, CAPE is not a good timing tool, but it does tend to work well over time, particularly at extreme valuations.  CAPEs below five, such as Turkey ‘s at the end of 2021, historically have been a failsafe indicator of high future returns. CAPE ratios that are completely out of sync with historical averages for the country are also powerful predictors of future returns.

The table above points to significant opportunities in EM. Global EM (GEM) on its own is cheap relative to the U.S., but more attractive opportunities exist at the top of the chart, particularly in Colombia, Brazil Chile, Taiwan, Peru, South Africa, the Philippines, Mexico, Turkey and Korea, which all promise high returns. Moreover, these countries offer significant, geographical, geopolitical and business cycle diversification opportunities. Colombia, Chile, Philippines and Korea are all extremely cheap relative to their valuation history and are well positioned for business cycle recovery in 2023. On the other hand, India , the most popular market with investors today, is an absolute outlier on the expensive side.

That cheap markets are now performing well in a risky environment is very encouraging for EM investors. If value continues to do well, EM stocks will likely do very well when the coming synchronized global and U.S. recessions hit bottom.

For over a decade earnings and earnings multiples have declined for emerging market stocks, leading to very poor returns both in absolute terms and relative to the S&P 500. Over this period, these markets went from “bubble” conditions in 2010-2013, fueled by the commodity super-cycle and the rise of China, to the current depressed state which reflects slowing growth, Covid, geopolitical risk and  global financial instability caused by high debt levels and a rising USD.

We can see this evolution in the following tables. On the left, Cyclically Adjusted Price Earnings (CAPE) multiples are shown for the S&P500, EM stocks (MSCI) and a sample of emerging market countries. Note the contrast between the sharp rise in the U.S. and the decline in most emerging markets, with the exception of the tech-centric Taiwan. On the right, dollarized MSCI EM earnings are rebased to 100 in 2010. Here we see the striking contrast between surging earnings in the U.S. market and the flat to negative earnings in EM, once again except for Taiwan (TSMC). Even China, with its supposedly high GDP growth, strong RMB and enormously successful tech stocks, has seen no earnings growth over this period.

Predicting the future evolution of geopolitics, Fed policies and the other myriad factors that impact economies, capital flows and stock markets is always a daunting challenge for investors. For this reason, it is often best and easiest to assume that historical patterns of valuation and mean reversion will persist. In this regard, we can use CAPE analysis to provide a basis for valuation parameters. Though CAPE is not a short-term timing tool, it has proven effective in predicting long term returns. This is particularly true at market extremes, like 2010-2012 when CAPE was screaming “bubble” across EM.

The CAPE  takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful tool for highly cyclical assets like EM stocks.  We use dollarized data to capture currency trends. This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University.

The chart below shows CAPE ratios for 16 EM countries, global emerging markets (GEM, MSCI) and the S&P500 relative to each country’s history. This gives a general idea of where valuations are on a historical basis for each country. Extreme discrepancies from historical patterns are currently evident in the U.S. and India on the overvalued side. Most emerging markets appear to be very undervalued; Turkey, Korea, Colombia, Philippines and Chile are at extremes.

In the table below we show the results of our adjusted CAPE methodology for estimating future expected returns. The expected returns of markets depend on valuation (CAPE ratio) and earnings growth (largely a function of GDP growth). No consideration is given here to possible multiple expansion or the liquidity factors that may have a major influence on market returns. The two columns on the far right show (1) the expected nominal return for  each index and (2) the real (inflation adjusted) expected return for each index with the addition of expected dividends.

The methodology derives expected returns by setting a long-term price objective based on the expected CAPE earnings of the target year, which in this case is 2028. The CAPE earnings of the target year are multiplied by the historical median CAPE for each country. The underlying assumption of the model is that over time markets tend to revert to their historical median valuations.

The countries with very low expected returns (Indonesia, U.S., Thailand and India)  each have their specific issues. Given the stretched valuation, Indian firms will have to surprise the markets with better than expected earnings growth.  The U.S. faces the challenge of high CAPE multiples, record corporate operating margins and declining  potential GDP growth.  Thailand and Indonesia are reasonably priced  and could enjoy higher returns if GDP growth surprises on the upside. This would require a boost in productivity to break out of the current trap these countries face, stuck between new low-cost competitors (e.g. Vietnam) and China’s industrial might.

The five markets with the highest expected returns (Turkey, Brazil Colombia, Chile and Peru) are all in countries with significant economic and political concerns. In the case of Turkey, the destitution  of President Erdogan is probably necessary for these returns to materialize. As for the Latin American countries, political stability and high commodity prices would make these returns likely.

Taiwan’s high expected returns require a recovery of the semiconductor cycle, which is likely. Also, investors have to be comfortable with rising geopolitical risk in the Taiwan Strait.

After a dismal decade of slowing GDP growth and stagnant earnings, emerging stock markets are showing signs of life. Overall returns are dampened by the value destruction of private company stocks which has been engineered by China’s government over the past year, but returns for EM ex-China have been much better. Most importantly, some of the cheaper markets in EM have started to take off, which is catching the attention of trend followers and bringing new capital into play. This is happening partially because of a more favorable environment for value stocks, cyclicals and commodities, but also because a rotation out of  long-duration tech “dreamer” stocks has been triggered by rising interest rates. All of this is good, but, unfortunately, EM is not yet out of the woods because storm clouds are staying put; these are, specifically ,the rising USD,  the tightening of U.S. monetary policy and the explosion of food and energy prices. This is a lethal combination for emerging markets.

Looking beyond the turbulence of the short term, the market action should be a major comfort to long run investors. For the first time in a while, the cheap markets are performing much better than the expensive markets, and investors are taking notice.

We turn to our CAPE methodology as a contribution to taking long term allocation decisions in emerging markets. CAPE provides insight on where valuations stand relative to historical trends and can help to structure mean reversion trades which have a good chance of working over  a 3-5 year time horizon. We combine CAPE with macro-economic conditions and market technicals  to determine entry and exit points in the context of a long term allocation strategy. The CAPE (cyclically adjusted price earnings) takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful tool for highly cyclical assets like EM  stocks. At extreme valuations, the tool has had very good predictive capacity in the past.  We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized more recently by professor Robert Shiller of Yale University.

The methodology sets a long-term price objective based on the expected CAPE earnings of the target year, which in this case is seven years (2028). The CAPE earnings of the target year are multiplied by the historical median CAPE for each market. The underlying assumption of the model is that over time markets tend to revert back to their historical median valuations.

The table below summarizes the results of our calculations for 17 EM countries, global emerging markets (GEM, MSCI) and the S&P500. The expected returns of markets depend on valuation (CAPE ratio) and earnings growth (largely a function of GDP growth). No consideration is given here to possible multiple expansion or the liquidity factors that may have a major influence on market returns.

Not surprisingly, all the  markets with the lowest valuations and highest expected returns are currently facing difficult economic and/or political prospects  Investing in these countries requires a leap of faith that “normalization” is possible. For example, it assumes that the current crisis in Turkey will be resolved adequately, that Chile’s constitutional reform will not structurally impair growth prospects and that China’s absurd vendetta against its most innovative and dynamic private firms will come to an end.  Until recently, none of these trades has worked. Still today, Chinese stocks are sliding, but the other cheap markets — Turkey, Brazil, Chile  and South Africa — are all doing much better, which is heartening.

The past decade in emerging markets has been one of slowing GDP growth, low earnings and poor returns. By and large, today valuations have come down enough from the lofty levels of 10 years ago to make the markets attractive, particularly compared to the high valuations of the U.S. market. Emerging markets are under-owned and certain segments of the market are extraordinarily cheap. If “value” segments of the market (industrial cyclicals, banks, commodities) continue to rally like they did in 2021, then prospects may be quite good. However, at the same time, the markets face a Fed monetary tightening process that may broadly challenge asset prices and, if history repeats itself, be particularly troublesome for emerging markets.

We turn to our CAPE methodology periodically to shed some light on relative valuations and derive estimates of “probable” future returns. The CAPE (Cyclically adjusted price earnings) takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful too lfor highly cyclical assets like EM  stocks. At extreme valuations, the tool has had very good predictive capacity in the past.  We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized more recently by professor Robert Shiller of Yale University.

The methodology sets a long-term price objective based on the expected CAPE earnings of the target year, which in this case is seven years (2028). The CAPE earnings of the target year are multiplied by the historical median CAPE for each market. The underlying assumption of the model is that over time markets tend to revert back to their historical median valuations.

The table below summarizes the results of our calculations for 17 EM countries, global emerging markets (GEM, MSCI) and the S&P500. The expected returns of markets depend on valuation (CAPE ratio) and earnings growth (largely a function of GDP growth). No consideration is given here to possible multiple expansion or the liquidity factors that may have a major influence on market returns.

Not surprisingly, the markets with the lowest valuations and highest expected returns are currently facing difficult economic and/or political prospects and, consequently, have been abandoned by investors. Investing in these countries requires a leap of faith that “normalization” is possible. For example, it assumes that the current crisis in Turkey will be resolved adequately and that Chile’s constitutional reform will not structurally impair growth prospects.

The CAPE methodology is a poor predictor of short-term results. For example, the cheap markets at year-end 2021 all did poorly over the past year while the expensive markets (USA, India) just got more expensive.

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

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

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

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

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

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

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

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

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

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

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

The methodology used to determine expected returns is the following:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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