Category: Investing

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

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

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

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

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

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

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

 

During the past ten years global stock markets experienced depression-like performance. The aftermath of the Global Financial Crisis was high debt and low growth and ineffective  monetary policy despite huge  money printing and zero interest rates.

The policies of Central Banks only benefited stocks in the  United States where technology and innovation sectors benefitted from low discount rates and earnings were pumped up by tax cuts and stock buybacks. The rest of the world by-and-large saw low earnings growth, declining multiples and weak currencies. Global stocks also started from relatively high valuations and margins, as ten years ago global growth had been highly stimulated by China’s investment boom.

We can see how this developed in the charts below. The first chart shows the performance of the S&P 500 vs the MSCI Emerging Markets stock index. The left side shows the evolution of earnings multiples, the price earnings ratio and the cyclically adjusted price earnings ratio (CAPE, average of 10-year inflation adjusted earnings).  Note the remarkable expansion of the U.S. CAPE from 25 to 34, which is the second highest level in history. At the same time the EM CAPE ratio fell from 20 to 15. The right side of the chart shows the evolution of the indexes and earnings. U.S. earnings were basically flat through 2015 and then took off, and, based on forward PE estimates for 2021, will end about double 2010 levels. EM earnings, based on forward PE estimates for 2021, will be at exactly the same level as 2010. Of course, the combination of the evolution of earnings and multiples explains the dramatic outperformance of U.S. stocks.

The following chart provides some granularity within emerging markets. The same charts as above are shown for three primary emerging markets, China, Brazil and Taiwan. Brazil in 2010 was a major beneficiary of the commodity bubble but since  then has suffered a vicious case of “Dutch Disease,” the natural resource curse. All other commodity producers (Chile, Peru, Indonesia, S. Africa, Indonesia) went through a similar process, though none as painfully as Brazil. Brazil’s CAPE ratio has fallen from 22 to 12 over the period and earnings in 2021 earnings are expected to still be 60% lower than in 2010.

China has seen a significant reduction in its CAPE ratio which went from 22 in 2010 to 11 in 2016 and 16.8 at year-end 2020. Over this period, the Chinese stock market has transformed itself from heavy with banks and industrials to one dominated by tech. These old economy sectors explain the flat evolution in earnings over the period, but in the future technology and innovation stocks will drive results.

Finally, Taiwan is shown as an example of an outlier. Taiwan, like Korea, is a stock market that is dominated by world-class technology companies. Not surprisingly, its CAPE multiple at year-end 2020 was higher that in 2010 and earnings are up over 50% during the period.

2020 may have been a turning point for emerging market assets. At least, all the traditional indicators supporting emerging markets have turned positive: the USD is trending down; commodities are trending up; USD liquidity is abundant; and tolerance for risk is high. Also, emerging markets stocks have started to outperform and ended the year almost even with the S&P 500. Though these trends tend to last, we will need confirmation over the next six months. Still, these conditions are enough to be bullish emerging markets and be fully loaded in terms of portfolio allocation.

The year of the great pandemic will probably be seen as pivotal in that it accelerated existing trends  and starkly highlighted strengths and weaknesses. Good governance was demonstrated by how countries dealt with Covid both in terms of public health policy and fiscal response. It turned out that those countries least able to control Covid were also those most inclined to monetize initiatives to support consumption through fiscal handouts. In many cases (e.g. the U.S., Brazil) these were also countries with weak fiscal positions before the pandemic, and therefore much worse positions by the end of the year. Moreover, those countries that dealt correctly with Covid (almost all in Asia) also represent the manufacturing base of the world, so that money printing to support consumption in developed countries went to Asian exporters. The charts below show total annual returns for the past year and past ten years (MSCI). What we see is that 2020 simply accentuated the trends of the past decade. It was a year when Asia showed all of its strengths (good governance, fiscal probity, commitment to value-added manufacturing, managed currencies) and most of the rest of emerging markets were characterized by dysfunctional politics, incoherent and inconsistent economic policies, and fiscal profligacy.

We show below the returns for the major MSCI EM regions for 1yr,3yr,5yr and 10yr to point out the consistency over time.

We see a similar pattern in terms of currencies in the following charts. Asian economies have been able to maintain their currencies stable and at competitive levels, while most other EM currencies lose value over time and are extremely volatile. Of course, Asian manufacturing benefits greatly from this while manufacturers in countries like Brazil are at a huge disadvantage.

Undoubtedly, Asian stock prices have benefited from exposure to growth sectors, especially technology. Almost 90% of the EM tech sector is based in Asia, with 70% in China alone. As shown below, growth has underperformed in emerging markets, as it has in other regions, because of the scarcity of growth companies in a stagnant global economy and low interest rates. On the other hand, value has performed poorly (Total returns, annualized).

Of course, past performance is not necessarily indicative of the future. Value is now relatively cheap and, due to its cyclical nature, tends to do well when EM does well.  This means that, in spite of secular trends that favor Asia, the rest of EM may actually perform well in a reflationary cyclical emerging market rally. By the way, this would catch by surprise almost all EM actively managed funds that are now largely proxies for Asian tech.

The cyclically adjusted price earnings (CAPE) ratio augurs low perspective returns for U.S. stocks  and improved performance for the battered and unpopular emerging markets equities. After a decade of very poor returns in emerging markets  compared to the  S&P500, relative valuations now favor emerging stocks to the same degree as in 2000. The following decade (2000-2010) saw strong emerging market  outperformance.

The CAPE smooths out earnings by  taking an inflation-adjusted average of the past ten years.  It has been a popular measure with fundamental investors since the 1950s, and  has been a reliable tool for forecasting  long-term stock market returns.  High valuations both in absolute terms and relative to a market’s history normally point to low returns in the future.

The S&P500 CAPE ratio is now the second most expensive it has ever been, only surpassed at the peak of the telecom, media and tech bubble in 2000.  In line with the logic behind CAPE,  in the decade after the TMT bubble the S&P500 produced negative returns for investors.  During the 2000-2010 period, the CAPE ratio for the S&P 500 plummeted from 37 to 23, bringing it back to slightly below the historical average.

On the other hand, at the end of 2000 the MSCI Emerging Markets index was valued at a CAPE of 10, which was slightly below its historical mean. Over the net decade, the EM CAPE more than doubled to 20.4 and the MSCI EM index more than tripled in value.

Today, we appear to have gone full circle back to where we were in 2000. The S&P500 CAPE is once again at very high levels and the EM CAPE has returned to depressed levels. Both are near where they were in 2000.

The current condition of CAPE ratios is shown in the two charts below. The first chart shows  both the present and the historical average levels of the CAPE for the EM index and most individual emerging  markets and also for the S&P 500.  The second chart illustrates the difference between the current levels and historical norms. Positive numbers indicate high valuations relative to history and probable low future returns.

The S&P500  is expensive in both absolute and relative terms.  The S&P500 CAPE is 33% above its historical mean, which is similar to  where it was  at the end of 2000.

The CAPE for Emerging markets is slightly below the historical average.

In EM only Taiwan and India look expensive relative to historical CAPE norms. Of the 19 EM markets in the charts, nine are valued at 30% or more below normal.

The predictive power of CAPE ratios relies entirely on markets remaining structurally similar over time and on valuations regressing to the mean.  Neither of these requirements will necessarily prevail. Market structures may change abruptly, as we have seen over the past decade in China where the index has gone from heavy in state-owned industrials to dominated by private technology companies. Also, mean regression may not occur because fundamentals (economics, politics, etc…) have changed either for the better or for the worse. Furthermore, we should expect CAPE ratios to gradually move higher because of declining transaction costs and rising liquidity.

Determining  which countries deserve to be upgraded or downgraded  is complicated and subjective because there are many moving parts. For example, in the case of China we can argue that slowing growth and high debt warrant lower valuations but also that the structural change of the market in favor of “growthier” private companies argues for higher valuations.

Relatively few countries have had a clearly delineated change in their fundamentals in recent years. I think a good case can be made for declining  fundamentals in the following countries: South Africa, Thailand, Chile, Brazil and Turkey. These countries have had fundamental deterioration in growth prospects because of the evolution of political and economic trends, and, therefore, may not offer the upside that the  CAPE framework assumes.

 

 

The global Covid-19 pandemic has had a grave impact on emerging markets. As has happened broadly across the world,  the pandemic has accelerated existing trends and highlighted the strengths and weaknesses of countries and companies. It has also grievously exacerbated income  and wealth inequality in most countries, increasing the divide between the tech-connected “haves” and the disconnected “have-nots.” We can group emerging market countries in terms of how well they have dealt with the virus and the impact that the pandemic will have on GDP growth and public finances. Also, we should differentiate those markets with ebullient tech sectors from those with little presence of tech companies. All these factors have had important ramifications for market performance so far this year and are likely to continue to do so for the foreseeable future.

Taking into account the highly uncertain evolution of the pandemic and its economic and corporate consequences, we live in times when making forecasts is a thankless task.

It may also be senseless when the objective is to identify probable long-term returns in the context of extraordinary monetary and fiscal policies and major shifts in the global trading system.

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

The chart below shows the result of this exercise. The first thing to note is that, by-and-large,  returns are muted, which is not surprising in a world of declining growth and negative real interest rates. Global emerging markets (GEM) are expected to provide total returns (including dividends) of  6.7% annually in real terms (net of inflation) over the next seven years. This is below historical returns and disappointing in light of the poor results of the past decade. These returns, however, are attractive compared to the dismal prospects for U.S. stocks. The U.S. is trading a near record-high valuations while emerging markets are priced at large discounts to historical valuations.

To secure more attractive expected returns the investor needs to venture into the riskier and cheaper markets. Colombia, Turkey, Chile, Philippines, Mexico and South Africa all trade at very sharp discounts to historical valuations and will provide high returns if mean-reversion occurs. The markets currently are pricing in difficult economic prospects for these markets. However, narratives change quickly. For example, South Africa, Chile, Mexico and Colombia would all benefit from rising commodity prices., and the recent decline of the U.S. dollar and the sharp rise in gold may portend a reflationary trend for the global economy.

There is no hiding from the reality that most assets are priced richly, and investors should not be counting on high returns.

GMO, an asset manager based in Boston, (Link) expresses this clearly in their most recent 7-year forecast for the expected real returns of different asset classes. As shown below, GMO expects negative real returns for most asset classes and a meager 1.6% annually for emerging markets. To garner high returns, GMO recommends investors venture into “value” stocks in emerging markets. This “active” position may be promising because it is diametrically opposed to the positioning of the great majority of “active” investors who are extremely concentrated in “growth” stocks, especially the e.commerce and internet platforms around the world.

This view is also echoed by Research Affiliates (Link), as shown below.  RA’s methodology is similar to the one highlighted above, relying on mean-reversion to historical valuation parameters to forecast expected returns. However, RA is more optimistic on EM stocks, where it expects real annual returns of 7.7%

Our forecasts reflect both the views of GMO and RA. We expect decent, if not stellar, returns for EM stocks, with the possibility of much higher returns if a global reflation trade allows deeply discounted stocks to outperform.

Emerging Markets stocks have traditionally been an asset class closely tied to the global economic cycle. When the global economy was strong relative to the U.S. economy, the dollar would depreciate, commodity prices would rise and emerging markets would enjoy a period of ample liquidity and rising asset prices.

We can see this clearly in the chart below: since the 1980s, there have been two downcycles for the USD (1985-1997 and 2002-2012) which have coincided with bull markets in EM equities. We are now in the ninth year of a dollar upcycle, which has resulted in very poor returns for emerging markets investors.

It is not happenstance that emerging market stocks and “value” stocks are strongly correlated. The periods of strong performance for “value” (stocks with low prices relative to book value, earnings or sales compared to the overall market) have been largely concurrent with those for EM stocks, and the past ten years have been terrible for both. This is because both the value and EM universes are heavily weighted to cyclical and mature industries and sectors that are vulnerable to technological disruption. The chart below shows the performance of both the value and core indexes for U.S. and EM stocks for the past 10 years.

If we look at the performance data for EM in more detail we can see that regional disparaties are pronounced. The chart below highlight the enormous transformation that the asset class is undergoing, both in terms of the growing weight of China and Asia but also in terms of the surge of the technology sector. While 10-years ago the index was dominated by commodity producers, today almost every stock in the list is driven by the smart-phone/e.commerce revolution. Every single stock, except for Reliance of India operates in North Eastern Asia.

 

The charts below detail total annual returns by region and by style (value) year-to-date, 1-year, 5-years, and 10-years. A cursory glance at these numbers makes one thing clear: over the past ten years, in emerging markets it has always paid to be in Asia and out of value stocks.

The outperformance of Asia is explained by growing importance of the tech sector, both traditional players (TSMC, Samsung) and a plethora of newcomers in e.commerce.  The lack of tech in Latin America can be seen in the poor performance relative to Asia and in the similar returns between the Latin America core index and its value index. Just like in the U.S., emerging markets are now driven by tech, as shown in the chart below.

Even within regions or countries, owning tech has been the correct  strategy. Value has underperformed in every region. Within China, owning tech and avoiding value (state companies, banks) has been the trade.

In Indonesia, buying SEA Ltd, the country’s largest e.commerce company, has been the trade.

 

In Latin America, the one thing to do has been to buy Mercado Libre, the leading e.commerce site in Brazil and Argentina.

What the future will bring is anyone’s guess. Another downcycle  for the USD is likely to start over the next several years, providing support for EM value stocks. On the other hand, low global growth and intensive technology disruption should continue to boost the valuations of scarce growth opportunities.

 

 

 

The current investment environment, with its apparent disconnect between economic and financial conditions, has been discomfiting for some of the world’s most famous investors. “Has Warren Buffett Lost His Mojo?” the Financial Times asked this week, accusing the Sage of Omaha of poor timing and awful stock picking. Two hedge fund titans, Paul Tudor Jones and Stan Druckerman, recently both owned up to be out of sync with the markets. Druckenmiller apologized for being “far too cautious” and having “missed a great opportunity.”  Jones, speaking to The Economic Club of New York, said: “If there was a franchise for humble pie, oh my lord they’d be a mile long to own that, because we all had huge gulps of it — me included.”  And, now, Jeremy Grantham, the modern doyen of value investors, has said  that, even though “value” stocks have had a epic run of poor performance, “this time may be different” and he is not confident that they will bounce back. Grantham warns that cheap stocks are cheap for good reasons and investors should be careful before selling the high-flying FAANG stocks which are driving the markets upwards.

Grantham is a founder of GMO, a Boston-based asset management firm which has made its reputation over many decades by sticking to its value methodology through cycles. Grantham’s brilliant essays on investing have been required reading for a generation of “value” investors.

Value investing – defined as stock-picking based on quantitative metrics of cheapness (price-to-book, price-to-earnings, price-to-sales, etc…)  — has been a very successful strategy over the years. The superior performance of value stocks over time  — the value premium – is well  documented in academic research.  However, over the past ten years, the strategy has lagged badly, raising claims of “the death of value.”

Grantham’s Case for “This Time is Different.”

In the past, value investors would relish a period of underperformance, believing that mean reversion would work its magic. However, this time Grantham is not convinced. Even though this crisis is the “fourth major event” of his career and the previous three created enormous opportunities for value investors, Grantham thinks this one is the most “uncertain” because the world may have fundamentally changed.

In a very thoughtful interview on the “Invest Like the Best Podcast” (Link) Grantham says that the value premium of the past may have been a temporary aberration. Value stocks are cheap as a reflection of the market’s disgust and there is no intrinsic reason that they should provide higher returns, Grantham says. The strategy worked in the past because:

“The general caliber of competition back in those days was very weak and therefore if you did decent analysis, looked for value you could find it. So we were able to build simple mechanistic models by giving points for cheap book and so on and have a win on a very broad basis, so we could manage a lot of money. And we were winning 2 out of 3 years and adding a few points on average per year.”

However, that era came to an end about 20 years ago, according to Grantham. The “simpleminded”  nature of the strategy was made evident by academic research and arbitraged away by quantitative investors:

“Too many machines were picking it up, too many quants, too much money, and pretty soon the historical aversion to cheap stocks had disappeared because they acquired the reputation for having won. The quants made it clear they understood that for 1800 years into the mist of time these were factors that worked, and indeed academics wrote it up and got a lot of credit for such a simpleminded idea.”

Moreover, several other factors have contributed to making the investment environment less friendly for value investors, Grantham says:

• The U.S. has drifted away from a healthy capitalistic system, experiencing a gradual increase in the power of big corporations: “the degree of corporate influence over government and regulation has climbed which facilitates monopoly. The willingness of the justice department to break companies up has declined, not surpringly, under those conditions.” This has resulted in a a “weakening in competitive spirit and speed. Conservatism and high return is put ahead now of growth and being the first and the biggest at something new.”
• The Federal Reserve has become a dominant presence in the markets. In the past, value investors could ignore the Fed in expectation that the market would self-correct, but now the Fed rules the market.
• The market leaders today – the FAANGs (Facebook, Amazon, Apple, Neflix and Google) – “ are unlike anything that ever walked the face of the earth. They generate market cap out of thin air, their use of assets is unlike anything it used to be; it’s not about traditional capital being depreciated and replaced and cranking out widgets, it’s all about intangible capital and brand and speed and using your brains to innovate.”

How much of an aberration is value’s recent underperformance?

In a recent paper, “Factor Performance 2010-2019: A Lost Decade? “ David Blitz, Head of Quantitative Research at Robeco in the Netherlands,  argues that the recent troubles of value are not unusual. Value’s poor results over the past decade  are typical when the market is very strong and dominated by other factors such as momentum and profitability. As the table below shows, value also performed poorly in 1990-1999, a similar period when the stock market was driven higher by high-growth technology stocks. The data is from the Kenneth French Data Library.

The chart below is from Your Complete Guide to Factor Investing by Andrew Berkin and Larry Swedroe, which looked at the data for a 90-year period, through 2017. On the right side, we can see the value premium harvested over this period. It is important to see the premiums in the context of the data on the right side of the chart which shows the probability of negative premiums over different periods. We can see that value has had a 14% chance of providing negative premiums over any 10-year period, and a six percent chance over any twenty-year period.

Therefore, long periods of negative premiums are not extraordinary. Moreover, we can probably say that these periods of underperformance are a necessary condition for the factor to work over time, because we should not expect anything easy to work in investing. Therefore, “no pain, no gain,”  and one should not expect to harvest the value premium without facing the risk of long periods of failure.

The “Death of Value” and Emerging Markets

It is no coincidence that emerging market stocks and value have both performed very poorly over the past decade. To a considerable degree, they are tied at the hip, both representing exposure to more risky and more cyclical segments of the market (though this has been somewhat mitigated in recent years with the rise of Chinese tech stocks).  The chart below shows the annual returns by decade for emerging market stocks and the S&P 500, since the launch of the MSCI EM Index at the start of 1987. If we compare these returns with those from the first chart from the Robeco paper, we can see that EM stocks and value both perform relatively well in decades when the S&P 500 does poorly. Both value and EM are “risk-on” trades, that do poorly in those decades of “American Exceptionalism” when investors are enamored with American growth stocks. We are coming out of such a decade, when the FAANGs, turboed by record-low interest rates, have dominated the markets.

No surprisingly, EM value stocks have done even worse over this past decade, as can be seen in the following chart, which compares the returns of the FTSE-Russel EM Index with that of the Dimensional EM Value Fund.

In conclusion, investors in emerging market stocks must hope that Grantham is wrong and that “This time is different” continues to be the four most dangerous words in the English language, as Sir John Templeton once said.

This hope is founded on the expectation that a combination of the following events will materialize:

1. The FAANGS will peter out, weighed down by valuation, size and regulatory pressure.
2. American Exceptionalism will take a rest.
3. The U.S. economy will slow, the dollar will weaken and commodity prices will rise.
4. Global growth will accelerate relative to the U.S. economy.

Markets are in free-fall for the third time in twenty years. Unlike the aftermath of the 2008-2009 Great Financial Crisis when the combination of Chinese stimulus and Western Central Bank Quantitative Easing produced a quick recovery for emerging markets, today a long slog appears more likely.

The hyper-globalization of the past three decades suppressed inflation and encouraged borrowing. As leverage increased through financial engineering, shadow-banking and creative derivatives, politicians, the U.S. Fed and Wall Street eagerly embraced mechanisms to backstop markets and preserve “financial stability – the Central Bank “whatever-it-takes”  “put” – which repressed volatility and promoted more leverage. Asymmetric policies, capping the downside while cheer-leading the upside, tied the economy’s performance to the “wealth effect” experienced by the owners of financial assets.

The cycle of global debt accumulation in a deflationary environment may be on its last leg. Every new crisis requires an exponential increase in fiscal and monetary intervention to ease “investors” out of  leveraged positions which have suddenly become illiquid. Investors have been trained to expect the “Fed put” and “buy the dips.” The size of the current intervention – expected to be in the order of 50% of GDP — more than ever undermines the essence of price discovery in a capitalistic system and is likely to provoke unprecedented “populist” opposition. This sets the scene for a new paradigm for the markets as we look forward beyond the tempest.

The new paradigm for financial markets, in many ways, may be diametrically opposed to that of the previous decades.

• The Rise of Populism. The protest votes that brought forth Trump, Brexit and Bolsonaro were symptomatic of the need for politicians to focus on the narrow sentiments of ordinary people.
• Anti-globalization. Shorter supply chains and more control of the domestic production of “strategic”  industries. Having most of your medical equipment and 75% of your pharmaceuticals produced in China will be a thing of the past.
• Modern Monetary Theory. The current recession in the U.S. is likely to result in a fiscal deficit of $4 trillion, boosting the public debt to 125% of GDP. This comes at a time when  Medicare and Social Security payments are ramping up. This debt will be monetized; initially under the pretense that deficits don’t matter, and then through interest rate suppression, which will start a process of deleveraging similar to the one the US went through following W.W II.
• Current Account Deficits and the U.S. Dollar. MMT will produce inflation and negative real interest rates in the U.S. The Fed will become increasingly tolerant of inflation to promote deleveraging and GDP growth. Foreigners that have been funding U.S. current account and fiscal deficits will sell U.S. assets. This will play out over time, but the end-result will be a weaker dollar and smaller current account deficits. This transition will take place around the world. It is unclear how this can happen without sovereigns imposing repressive controls on capital. A return to the capital controls which were normal before the current cycle (1960s-1970s) are likely.
• The end of U.S. Fed-Imposed Central Bank Orthodoxy. As the U.S. Fed became the back-stop for the financial market it has increasingly pursued policies which are at odds with the interests of other countries. As capital controls and other forms of financial repression are re-introduced, countries will be able to pursue policies which make sense for their own circumstances. The S.East Asia-Chinese model of capital controls and managed currencies will become more common. Strict controls on “hot money” – a policy already supported by the IMF – will rule.
• Multi-reserve-currency World. An increasingly insular U.S. pursuing financial repression will promote the rise of alternative reserve currencies. Gold is an obvious beneficiary, but the Chinese Yuan and the Euro will also gradually gain traction with trading partners.
• Multi-polar World. The rise of alternative reserve currencies is one example of the end of the U.S.-centric global economy of the 1950-2020 period. Supply chains also may increasingly regionalize and countries will insist on self-sufficiency for key industries, which will increase production costs and raise inflation. China has already created its own internet eco-system and is moving aggressively to develop key frontier industries. We can expect India and other large and growing economies to follow that path. Large emerging market economies which provide most of the growth in global demand will seek to keep that demand on-shore, and will make concessions only to strategic partners which are  under their sphere of influence (e.g. Mexico and Canada for the United States; certain Asian countries for China). In this multi-polar world, China and the U.S. should fare relatively well; China because it sits at the center of Asia, the most dynamic region in the world; the U.S., because of its resources and an entrepreneurial class that can lead a renaissance of manufacturing. Smaller, export-oriented countries will have to carefully negotiate their way into the commercial networks of the two hegemons.

Most emerging markets are unprepared for the new financial paradigm. The successful ones will be those that have the social cohesion and political frameworks necessary to adapt.  A few thoughts on specific countries follow.

Large countries with scale and demand growth (China, India and Indonesia)

These countries are well-positioned to pursue autonomous policies to promote domestic investment and partner in foreign trade. As of today, China is the only one that appears to have the planning and execution  capacity to be successful.

Large countries with moderate scale and moderate demand growth (Brazil, Mexico, Turkey)

These countries are similar in some ways but also have major differences. Turkey and Mexico have benefited from the past forty years of globalization and are well positioned to continue on that path, if they can overcome current incongruent policy frameworks and political instability. Brazil missed out on globalization and suffers deeply from a lack of the confidence  necessary to pursue independent financial and trade policies. Brazil is currently espousing archaic market liberalism, at a time when strong government dirigisme will be vital. Brazil also contends with a dysfunctional political system and a lack of social cohesion.  It will also have to pursue financial repression to reduce the government debt burden which has resulted from ultra-orthodox monetary policy.

 

Small countries with small  scale and moderate demand growth (Korea, Taiwan, Thailand, Chile…etc.)

These countries represent the bulk of emerging markets. Those that have thrived in the past did so because they took advantage of globalization and participated in the growth of global supply chains. Many did not do this, and they have been at the mercy of commodity and financial cycles. These countries face challenging times ahead. Through intelligent diplomacy, they will have to negotiate partnerships with the major trading blocks led by the U.S., China and Europe, without anything to offer. On-shoring through robotics will make it difficult for the traditional model of low-cost manufactuting of basic goods to work, cutting off a path of growth for the poorest countries.

Emerging Market Valuations After the Crash

 

The ongoing correction in asset prices worldwide may be a boon to opportunistic investors with cash and a long-term view. Emerging market stocks which started the year at low valuations relative to history are now even more attractive, and in some countries at fire sale prices.

We look at expected returns below. We assume that 2020 is a lost year, with scarce growth anywhere in the global economy.  Also, we consider that most countries will see economic recovery in 2021 and 2022 and that earnings will recover to trend. The first chart  shows the current projections based on the close of March 16.  The second chart shows the projections made at year-end 2019.

This exercise has proven useful in the past, particularly at times of extreme valuations such as we see today. However, the projections are based on a simplistic model with the following premises:

• We look at where each individual country is in its earnings cycle and we assume a normalization of earnings over a two-year period. We then project that normalized earnings will grow at the rate of nominal GDP through the target-period, which in this case is seven-years. Given the nature of the model, expected returns don’t vary greatly if the target period is extended to 10 years.
• We use cyclically adjusted price earnings ratios (CAPE) to determine the target value of the market. The historical average CAPE ratio for the market is used as the multiplier for the CAPE Earnings of the target year, which gives us the target market price for the target year.
• The model will fail when the historical CAPE ratios prove to be irrelevant and/or if the simplistic earning projections are far off the mark.

 

A few comments are in order:

• Valuations have improved dramatically almost everywhere. The US is now valued almost in line with its history and can be expected to provide return only moderately below historical levels.
• In EM only Thailand is on the expensive side.
• More than half of the EM markets are heavily discounted and now offer the prospect of very high returns. Colombia, Chile, Turkey, Philippines, Korea and Malaysia offer the prospect of extraordinary returns.
• Global emerging markets now offer nominal returns of 12.5% annually, still about two times the expected returns for the US market.
• Returns for emerging markets could be significantly higher if the USD enters into a weakening cycle and/or commodities recover from the current decade-low prices.

After a decade of poor returns in emerging market stocks, the asset class suffers a crisis of credibility. But, cheer up;  prospects for future returns have improved.  As we enter the new decade, we may be diametrically opposed to where we stood a decade ago when  EM stocks were expensive and U.S. stocks were cheap.

Investors in emerging market stocks had total returns of 18.5% in 2019, ending a dismal decade on a positive note. Total returns (including dividends) over the past ten years have been just 4% per year, which is well below the historical average of 10.3%. EM net returns also have paled in comparison to those of the mighty S&P 500.  As the chart below shows, over the decade the S&P 500 provided total returns of 253% compared to 33% for the MSCI EM.

The chart below provides some perspective by showing performance for the S&P500 and the MSCI EM Index by decade.

Investors suffer deeply from “recency bias,” the tendency to believe that market trends will continue. This means that today there is a strong bullish consensus on the rising U.S. market and pessimism on the relatively weak emerging markets. However, if we are patient and can take a longer term view, we can expect that valuation fundamentals will weigh heavily on stock prices, triggering a process of mean reversion. Because of this, rational investors take a long-term probabilistic view of capital allocation, assuming that over an extended time-frame (e.g., 7-15 years) mean reversion is likely to play out. While Wall Street enthralls the public with bold annual forecasts, long term investors should develop a humble and long-term view on the probability of future outcomes.

Any analysis of historical returns shows that, over the long-term, stock prices have two drivers:  earnings and the multiple on earnings that investors will pay. Earnings are generally driven by GDP growth, though over the short to mid-term they are affected by business cycles and corporate margins. The relationship between earnings and GDP is the basis for Warren Buffet’s favorite stock market valuation indicator (S&P500/GDP).  Multiples vary depending on the mood and risk-taking appetite of the investment public and also on the level of interest rates (lower interest rates lead to higher multiples). Multiples also are sensitive to inflation. The low inflation and negative real interest rates of recent years are the main reason for the high multiples that we see for U.S. growth stocks.

Capital allocators estimating long-term probable returns generally  must take a simplistic view. In terms of earnings they will try to establish a normalized level which adjusts for business cycle effects. Future multiples are assumed to revert  to historical levels, or at least move in that direction. There is no standard way of doing this, and each practitioner may do it slightly differently, but in general results tend to be similar. In the charts below we look at the current expected return forecasts made by two prominent asset managers/allocators: GMO (Link)  and Research Affiliates (Link).

Both GMO and Research Affiliates expect emerging markets stocks to be the star performers over the forecast. GMO expects 4.5% real annual returns for EM and 9.3% for EM value and negative 4.4% for U.S. large cap stocks. Research affiliates sees 6.8% real annual returns for EM and o.3% real annual returns for U.S. large caps over the next ten years.  Star Capital, a European asset manager, reaches similar conclusions, estimating expected real returns for the next 10-15 years to be 7.6% for EM and 2.8% for the U.S (Link).

We conduct a similar exercise with a focus on emerging markets. Our forecast is for 6.2% real annual returns over the next seven-year period and 0.8% real annual returns for the S&P 500.

We make three assumptions: 1. Valuations will move back to the historical CAPE average over the next seven years; 2. Earnings return to the historical cycle-adjusted trend; and 3. Normalized earnings grow by nominal GDP. To determine the historical earning trend we take a view of where we are in the business-earnings cycle. We calculate the historical average CAPE by taking a weighted-average of the CAPE-ratio for the past 15 years (75%) and the CAPE-ratio over the entire period that data is available (25%)

On  a country-by-country basis, as one would expect, great differences appear. Countries find themselves at different points in the business-earnings cycle and their valuations may vary greatly depending on the mood and perceptions of investors. The chart below shows where country-specific valuations stand relative to the  CAPE average for the primary EM markets. The third column shows the difference between the current CAPE and the historical average CAPE. For example, Turkey’s valuation, in accordance with CAPE, is 40.5% below normal. The markets in the chart are ranked in terms of probable long-term returns (7 years). The table also shows where markets are currently in their business/earnings cycle.

We can see that valuations are generally low in emerging markets.  The majority of markets in EM trade at CAPE ratios which are below average, and Turkey, Malaysia, Chile and Argentina are heavily discounted. On the expensive side, only Thailand stands out. The contrast with the U.S, is striking. While 10 years ago the CAPE ratio in the U.S. was well below normal, today it is more than one standard deviation above normal.

The methodology assumes a stable dollar, meaning the dollar will neither appreciate nor lose value relative to the basket of currencies represented in the MSCI EM Index. The actual trajectory of the dollar will have a big impact. The experience in emerging markets is that a weak dollar generates liquidity and higher earnings growth, as well as higher multiples. If the dollar were to lose relative value over the forecast period it is probable that returns in EM would be significantly higher. This is particularly true for commodity-exporting countries like Brazil which would experience liquidity windfalls.

Furthermore, we can expect markets to overshoot both on the up and downside. Forecasts assume a return to normalized historical statistical trends, but markets can be expected to surpass those levels as enthusiasm builds momentum.

In conclusion, allocators should consider increasing positions in emerging markets where returns will probably be relatively strong in coming years.