Category: Investing

Economic Convergence and the “Middle-Income Trap.”

Over the long term, the economic performance of countries around the world tends to converge as less developed countries “catch up” to richer ones by adopting existing  technologies and attracting capital which is eager to exploit relatively cheap labor. This convergence has been consistent over time, since the industrial revolution in the 19th century, and has flourished in recent decades, led by the extraordinary progress of China. Nevertheless, a significant number of countries have not participated at all in this process. Also, for many countries, convergence has been moderate and for others  it has plateaued or even regressed.   In particular, a cohort of middle-income countries have stalled in the process of convergence, a phenomenon which as been labelled as the “Middle Income Trap.” It seems that after reaching a certain level of convergence further “catch up” requires new skills, linked to institutions and human capital, which some  countries struggle to develop. This means that for many middle-income countries convergence becomes more arduous, and the result is that, over the past 50 years, only a handful of countries – Taiwan, Korea, Singapore, Hong Kong and Israel – have successfully graduated to high- income status.

Below, we look  at convergence for the past 50, 30 and 20 years, and follow with a focus on the evidence for the “Middle-Income Trap.”

The Past 50 Years

The table below shows 50-years of convergence based on World Bank data for 92 countries. Convergence is measured by a country’s change in GDP per Capita relative to that of the United States. For example, China’s score of 12.98 indicates that its GDP/Capita relative to the U.S. has gone from 1.1% to 14.2% over the 50-year period. Countries that are significant for emerging markets investors are highlighted in bold.

  • The top performers are very diverse, covering every region and population size, though Asian convergence is very strong.
  • Only half the countries enjoyed any convergence at all. Significant underperformers generally fall under two categories: 1. Countries which are categorized by the WB as pre-demographic dividend, meaning that they experienced high population growth and increasing dependency ratios; 2. Countries suffering political turmoil (civil strife, wars,etc…) or extreme political dysfunction (Argentina, Venezuela).
  • Focusing on those countries that matter for EM investors, eight important EM countries experienced significant convergence (China, Korea, Thailand, Malaysia, India, Indonesia, Turkey and Chile). Taiwan would also qualify but is not included in WB data. Three countries (Colombia, Brazil, Philippines) experienced either slight convergence or slight regression. Six countries experienced significant regression (Mexico, Peru, Argentina, Nigeria, South Africa, Venezuela). About half of the countries that investors follow closely in emerging markets over this long period have not enjoyed significant convergence.

The Past 30 Years

The World Bank data for the past 30 years (1988-2018) covers 150 countries. These years cover the modern period of institutional investment in emerging market stocks, as the widely-used EM indices (MSCI, IFC/S&P, FTSE) were launched in the second half of the 1980s, and many institutional investors began allocating to emerging markets in the early 1990s.

  • Once again, the best performers – those countries converging the most with the GDP/Capita of the U.S. – come from a broad variety of geographies and income groups. Asian convergence is exceptional.
  • Well over half the countries experienced positive convergence with the U.S.
  • Several new impressive convergers appear from emerging Asia (Myanmar, Vietnam, Bhutan Laos) and Africa (Equatorial Guinea,Cabo Verde, Mozambique).
  • The performance of significant countries for EM investors diverges greatly over this period. Asian markets all experience rapid convergence (China, India, Korea, Vietnam, Thailand, Indonesia, Malaysia, Hong Kong, Philippines), with the exception of Pakistan, which makes only slight progress. In Latin America, Chile enjoys strong gains and Peru and Colombia achieve significant positive convergence, but Argentina, Mexico and Brazil all lose ground and Venezuela experiences a collapse, moving from middle-income to low-income status. In Africa, Nigeria achieves moderate convergence, while South Africa suffers a severe deterioration.

The Past 20 Years

The past two decades saw a commodity boom and peak globalization characterized by the extensive development of global supply chains by multinational corporations. Most importantly, the incorporation of the formerly “Soviet Bloc” countries  had a big impact on the World Bank data for convergence, as these economies have enjoyed rapid progress by attracting capital and integrating into the global economy.

  • Nearly 70% of economies experience convergence over this period.
  • Once again, the best performers came from a wide variety of geographies and income groups. Formerly Soviet bloc countries dominate the list (Azerbaijan, Turkmenistan, Armenia, Georgia, etc…). In Africa, Ethiopia appears as a top performer, and, in Asia, Cambodia now arrives.
  • Looking a the countries of significance to EM investors, Asia performs well across-the-board; In Eastern Europe, the Middle-East and Africa (EMEA), Poland, Russia, Turkey and Nigeria experience strong convergence, while South Africa languishes; in Latin America, Peru and Colombia perform reasonably well, while Brazil and Mexico slip, Argentina slides and Venezuela crashes.

Evidence for the Middle Income Trap

In the table below, we look at the performance of middle-income countries over the past 30 years (1988-2018). We use a broad definition of middle-income, including countries having incomes which vary from 10% to 50% of the per capital income of the United States at the beginning of the period. 40 countries are included, which represents 27% of the WB database.

  • Half of the middle-income countries experience at least some convergence. The number of strong convergers is roughly the same as the number of underperformers. On average, convergence is low for this group. There are also about an equal number of big winners and big losers, with Hong Kong, Malta and Korea graduating to upper- income status, and Venezuela, Ukraine and Georgia falling out of middle-income status.
  • Neither geography nor relative income seems to determine either winners or losers. Nevertheless, there is a strong contrast between the high conversions of Asian middle-income countries (Korea, Malaysia) and weak performance of Latin American countries. To some extent, we can conclude that the “Middle-Income Trap” is largely a Latin American phenomenon.

Conclusion

The world has experienced significant economic convergence in recent decades, as expected by economic theory.

However, middle-income countries as a whole have had mediocre performance which is not explained by geography or relative income.

What is it that explains the great divergence within middle-income countries? Why have Korea and Chile prospered while Venezuela has collapsed and Brazil has languished? This is a key debate which we will explore in a future post.

The XP IPO and Market Efficiency in Brazil

The Brazilian capital markets are among the most sophisticated in the world. During periods of hyperinflation in the 1980s and 1990s, market participants adopted highly complex financial instruments for hedging and protecting returns. Over the past 25 years, as the country went through several boom-to-bust cycles and suffered a profound deindustrialization, Brazil has increasingly become a FIRE economy, driven by Finance, Insurance and Real Estate. During this period, Brazil’s best and brightest have flocked to financial jobs where salaries are multiples of those available in more productive sectors. At the same time, a steady rate of consolidation in most financial activities has led to a few preeminent dominant firms with strong pricing power and high profitability.

The incumbents – mainly, large dominant banks — over time may have become vulnerable to new entrants that introduce disruptive models and more efficient cost structures. A wave of new fintech firms have taken advantage of abundant global venture capital funding to take on the incumbents with new business models. At the forefront of these there is XP, a Brazilian brokerage firm/financial advisor, which is currently in the process of launching an IPO on Nasdaq. Founded in 2001 by Guilherme Benchimol, XP is probably the best Brazilian entrepreneurial success story of this generation. Influenced by the philosophy of Brazil’s Jorge Paulo Lehman (3G/Inbev) and by American discount brokers such as Charles Schwab, Benchimol  created a financial service platform which aims to democratize finance in Brazil and disrupt the entrenched incumbents (e.g., Banco Itau and Banco Bradesco).  Benchimol has largely achieved his goal and XP is now a major force in Brazil’s financial sector, with 1.4 million clients. The IPO’s bank underwriters are looking for a valuation of BRL 60 billion (USD 15 billion), about half that of banking behemoth Bradesco.

Ironically,  XP’s huge success may have now turned it into somewhat of an incumbent. Though much of the IPO prospectus extols how well positioned XP is to exploit the inefficiencies of the investment industry, a look at the details paints a different picture.

XP’s most profound innovation has been its open platform, which allows it to provide a financial supermarket of products, in contrast to the “walled-gardens” historically preferred by the big banks.  It has exploited this advantage with technological and marketing savvy. But, the one thing it hasn’t really done is attack the very high fee structures that characterize the Brazilian asset-management industry. In fact, XP has become the biggest distributor of the independent asset management industry and benefits from the juicy distribution fees that fund managers pay to raise assets.

The problem is that the Brazilian asset management industry today is an aberration in terms of the fees that investors pay for investment products, with 1% management fees common for bond funds and 3% (including prevalent performance fees) common for equity funds. These kind of fee structures exist in Brazil only because of the powerful pricing power enjoyed by the large banks.

The persistence of high fund management fees in Brazil is justified by the claim that the domestic markets are highly inefficient and present abundant market “alpha” (returns above those available from the market) to be harvested by active managers.

However, evidence of this market inefficiency is scarce. One might expect “alpha” to be available for professional investors in markets that are dominated by retail investors (e.g. China, India, Turkey), but Brazil is a market trafficked predominantly by sophisticated and highly-paid professional investors.  Also, most funds in Brazil invest in a very narrow cohort of some 100 stocks which are very closely followed by competent analysts; most funds are also short-term oriented trend followers, with low appetites for small and less liquid stocks.

The best analysis of the Brazilian domestic funds market is done by S&P Dow Jones Indices (Latin America Scorecard, SPIVA). A summary of the latest review (through 2018)  below shows how difficult it is for funds in Brazil to generate alpha, particularly in bonds, where 100% of funds underperform the benchmark. In equities, about 85% of Brazilian funds underperform the index for 3,5,and 10 year periods. Most likely, this is a consequence of the combination of market efficiency and very high fee structures.

Ironically, XP, to a degree, may be more vulnerable than the incumbents it purports to undermine. XP’s earnings stream relies heavily on brokerage revenues and fund distribution fees, which represent only a small part of the highly diversified revenues stream enjoyed by its competitors. These fees are high today, supported by the  large inefficiencies of the Brazilian financial sector but these are now ripe to be disrupted by innovation.   Of late, we have seen some of the incumbents slashing commissions, following in the foot-steps of the U.S. industry.

Also, Bradesco and Itau have taken the plunge and launched U.S.-style low cost ETFs.

If the name of the game is raising assets, the future in Brazil looks like the U.S, with a heavy presence of systematically managed passive products, both in the form of ETFs and mutual funds. This is not a space  where XP, in its current form, will prosper. So, it’s not surprising to see the budding ETF space in Brazil dominated by Itau, Bradesco and Blackrock’s Ishares.

In fact, a U.S. style transition to passive products is in full swing in the Brazil domestic market. Blackrock’s Ishares Bovespa ETF (BOVA11) has raised USD2.3 billion in Brazil. As the chart below shows, volumes are exploding. Interestingly, BOVA11 is priced at 30 basis points (.30%) annually, which is about half of the fee charged on its NYSE Brazil Ishares (EWZ). Itau has also launched a Bovespa ETF (BOVV11) for which it also charges 30 bp, and Bradesco has its own Bovespa ETF (BOVB11), with a 20 basis points management fee (currently, the cheapest Brazilian stock market ETF in the U.S. is Franklin’s, with a fee of 19 basis points.)  Itau’s ETF undercuts its own Bovespa Index mutual fund, for which it charges an astonishing 2% fee, a reminder of legacy practices.

As we have seen in the U.S., the growth of passive investing is very likely to force a consolidation of the Brazilian asset management industry and a dramatic reduction in the fee structure. Firms like Schwab are now staking their future on asset management and have become leaders in ETF issuance. The same will have important consequence for the fund distribution industry in Brazil, and this may resent a short-term challenge to XP’s talented management.

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

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

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

* Start slow and build local expertise.

* Focus on secular opportunities with very long runways.

* Focus on cash-generating businesses

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

Brookfield Asset Management Quarterly Conference Call (Link)

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

Anuj Ranjan

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A Primer on Emerging Market ETFs

 

In many ways investors have never had it so good. Since last week practically the entire U.S. brokerage industry has gone to zero commissions for stock trades. At the same time, the most prominent ETFs (exchange traded funds), which are ideal building blocks for any allocation strategy, are charging minuscule management fees. This means that a millennial investor today can build his wealth without incurring any transaction costs. Compare this baby-boomers  who accumulated savings while paying fees to financial service firms of 1-2% per year on assets.

This gradual disruption of the revenue base of the investment industry has occurred over the past 30 years, through the concurrent rise of discount brokers (e.g. Charles Shwabb) and low cost indexing strategies (initially driven by Vanguard mutual funds and later by ETFs). All of these changes are driven by computer automation and scale. In recent years, the trend has accelerated.  JPMorgan estimates that today 90% of U.S. equity trading volume comes from computer-driven systematic trading accounts, leaving 10% in the hands of discretionary traders.

This disruption in some ways is even more profound in emerging markets where transaction fees have historically been much higher than in developed markets.  ETFs are allowing investors  to largely bypass the high costs of investing in local markets because the great majority of trades can be settled internally within the funds, and only marginal increases/decreases in assets have to be funded externally. (e.g. EWZ, the Ishares Brazil ETF now settles daily within its own structure about the same volume as Brazil’s Bovespa index.) Moreover, emerging market asset managers in the past had been able to charge high management fees, typically in the 1.5-3.0% range, and even today very high fees remain the norm in most domestic markets. However, today any investor can get  broad global emerging market exposure through ETFs for an annual fee of 11 basis point (0.11%) and Franklin Templeton is offering a suite of country funds with annual expenses of 19 basis points (0.19%). When the first country funds where launched in the 1990s they had expense ratios of 2.5-3%.

The result is that emerging markets, like other asset classes, have come to be  dominated by low cost indexed products sold in the form of ETFs  and mutual funds. These funds which are computer driven and rules-based are said to be “passively” managed in contrast to “actively” managed funds where discretionary decisions are taken by managers on the basis of fundamental analysis. Passively managed products can charge very low fees because they are run systematically by computers, and as scale rises and computer costs decline they can continuously cut expenses further.

In the U.S. market alone, there are currently over 250 ETFs investing in emerging markets, with total assets of $250 billion. Including mutual funds, there are approximately $500 billion invested in EM assets in the U.S. market, of which about 60% of the total is invested passively. This compares to a 60/40 mix in favor of actively managed funds just five years ago, which shows how rapidly the industry is changing.

To get an idea of the characteristics of the passively-managed universe in emerging markets, we can look at the data provided by the website ETF.com.

The chart below shows the 20 largest EM ETFs as of September 30 of this year. There are several points that we can highlight:

  • The EM ETF world is already highly concentrated. The battle for this space was won in the early stages by Blackrock and Vanguard. 87% of all EM ETF assets are held by the twenty largest ETFs, of which 60% and 30% are in the hands of Blackrock and Vanguard, respectively. Charles Schwab, though a late comer, has successfully used its distribution power to become a significant third force.. All the remaining players have niche strategies, but most lack differentiation and scale. Not surprisingly, rumors abound of M&A activity to promote further consolidation.
  • The space is very dominated by basic global emerging markets (GEM) index products: Blackrock’s IEMG (MSCI EM) and Vanguard’s VWO (FTSE EM). The fees for these products have plummeted; in fact Blackrock’s initial GEM product, EEM, now slowly dissipates because of its “exorbitant” 0.67% expense ratio, compared to IEMG’s 0.14%. The cheapest GEM fund is now State Street’s SPEM (S&P EM), with a fee of 0.11%.
  • To lower expenses and remain competitive there is a broad trend for smaller firms to develop their own indexes.
  • With relentless pressure on fees,  industry asset-gatherers need to be creative to differentiate products from the basic GEM funds. Based on the complexity and marketing attractiveness of these differentiated strategies, fund companies aspire to secure higher fees.

GEM Plus Funds

The most basic differentiation strategies are “GEM Plus” funds where the manager has introduced a tweak to the basic GEM product which is deemed to be of interest to investors. These include the following:

    • RAFI Products – These funds, based on the Research Affiliates Fundamental Index, weigh stocks on the basis of fundamental characteristics (sales, cash flow, dividends and book value) in contrast to the market capitalization weights that are the rule for the big GEM funds. This provides investors with a “value” tilt, and periodic rebalancing to harvest mean reversion. The funds using the RAFI index are currently charging between 39-60 basis points, a large premium over the standard GEM funds.
    • GEM with Exclusions – These funds charge a moderate fee premium of 5-20 basis points and many keep their costs down by creating their own indexes:
        • GEM minus China.
        • GEM minus state-owned companies
        • GEM minus stocks which violate ESG (environmental, social and governance) standards.

 “Smart-Beta” Funds

The next area of differentiation is with the so-called “smart-beta” products. These funds seek to exploit academically recognized investment factors (value, growth, small cap, quality, income, momentum) which historically have provided higher returns.  These funds can be divided into those that focus on only one factor and those that combine multiple factors into their algorithm. In recent years, a wave of multifactor products have hit the market, most of which use a combination of factors deemed to provide benefits of diversification and non-correlation. Single-factor funds currently tend to charge fees between 30-50 basis points, while  multi-factor funds tend to gravitate towards the high end of that range with some closer to 60 basis points.

Country and Regional Funds

Another area of great importance for ETFs are country and regional funds. Single-country products have always found traction with investors, and some country funds have been around for decades, first in the form of mutual funds and now largely as ETFs. Many of these products enjoy legacy fees which range between 50-70 basis points which they can sustain because of their strong market presence. This segment is firmly dominated by Blackrock’s Ishares funds. Both Van Eck and WisdomTree have had some success by entering niche products and developing their own indexes. Franklin Templeton is the latest entrant in this space with its suite of low cost country funds (19 basis points) indexed to FTSE, but so far it has had limited success.

Sector Funds

Finally, sector funds are a poorly developed segment of the market. On a global basis, only a few funds have been launched, with the Ishares EM technology ETF (EMQQ) having had the most success. Several GEM consumer funds have also been launched by Columbia, WisdomTree and Kraneshares. These funds have high expenses (50-90 basis points). EMQQ currently charges 86 basis points.

An entire suite of China sector funds has recently been launched by Mirae, so far with limited success. These funds have 65 basis points of expenses.

The following chart summarizes the data for the EM ETF Universe. The first column shows the percentage total assets in each major segment and the second column shows the fee expense ratios for each segment.

% of Total Assets in Each Segment Average Annual Fee
Gem 65.43% 0.23%
Fixed Income 11.09% 0.38%
Country/Regional 16.82% 0.64%
One Factor 4.07% 0.38%
Multi-Factor 2.59% 0.56%

 

 

Trade Wars

  • The great decoupling (Oxford Energy)
  • KKR sees opportunity in China decoupling (KKR)
  • Banning technology will backfire on the U.S. (FT)

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

  • Expected returns in China (UBS)
  • China-Russia: cooperation in Central Asia  (AsanForum)

China Technology

 

Brazil Watch

EM Investor Watch

  • Naspers strategy to create value (FT)

Tech Watch

  • Risks and opportunities in the battery supply chain (squarespace)
  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)

Investing

  • Ten years of performance is still just noise (Swedroe)
  • Joe Greenblatt on value investing (wsj)
  • The correlation between stocks and bonds (Axioma)
  • A taxonomy of moats (reaction wheel)
  • An investment thesis for the next decade (Gavekal)

 

Argentina’s Debacle

The most remarkable aspect of Argentina’s latest financial meltdown is the feigned surprise expressed by economists and investors. The truth is that Argentina’s crisis largely repeats the steps of previous ones, including economic mismanagement, dysfunctional politics, too much debt, and a terms-of-trade shock caused by a plunge in grain prices.

As happens after every crash in asset prices, scalded investors claim the outcome was unforeseeable. In the days following the collapse of Argentina’s financial markets financial newspapers quoted investors referring to “black swans” and  “6+ sigma” events, implying the improbability of the event was so great that no investor could possibly have foretold it. Given that Argentina undergoes financial crises on a routine basis — every decade or so — this claim seems ingenuous.

Famed economist Paul Krugman, seeking an explanation for this crisis, generated an  interesting exchange on his Twitter feed (@paulkrugman).

Krugman noted that President Macri was vulnerable from the start, as he was dealt a hand of elevated fiscal and current account deficits, the infamous “twin deficits,” which always should raise concerns for emerging market investors. According to Krugman, the recommended course of action for Macri at the launch  of his administration in 2016 was to cut the deficit and devalue the currency. However abetted by yield-hungry foreign investors enthused by his pro-market reform agenda, Macri opted for foreign borrowing.

As economist Brad Setser noted in a response to Krugman, Macri’s policy option resulted in a sharp rise in foreign debt, which, given Argentina’s precarious export base, dramatically increased its vulnerability.

For the first two years of Macri’s term (2016-2017) the strategy seemed to be working, and Argentine asset prices boomed. In July 2017 Argentina successfully issued a $2.75 billion 100-year bond which was highly oversubscribed and appreciated sharply during the rest of the year. But, as Krugman notes, the fundamental issues were not addressed and Argentina succeeded only in digging itself into a bigger hole.

Unfortunately for Macri, the global economy turned down in early 2018, resulting in a strengthening dollar and falling commodity prices.  As they are wont to do, fickle foreign investors suddenly cooled on Argentina, and by the summer Macri had agreed to an $56 billion bailout from the IMF aimed at supporting “expansionary austerity.”  According to Krugman, time ran out on Macri and his final desperate measure to bring the situation under control by drastic interest rate hikes and last-minute austerity created a nasty slump and a loss of popular support.

Krugman blames the crisis on “neoliberalish reformers” and a naïve IMF. Krugman’s followers on Twitter responded in different ways. Some took offense to Macri being labeled a “neoliberal,” arguing that, if anything, he was a shy on reforms. Most commentators expressed a fatalistic anguish, stating that because of political polarization and a high dependence on fickle foreign savings these crises will routinely recur no matter who the leaders are. Most everyone seemed to agree that the IMF blundered, though perhaps only because it was pressured by a pro-Macri Trump Administration.

So, what really happened in Argentina?

A good place to start is to review the history of emerging market blow-ups and recognize the patterns. Ray Dalio’s Principles for Navigating Big Debt Crises (Link) provides a good template to do this, as it analyses 23 emerging market crises since the 1980s and identifies commonalities.

The chart below shows the macro characteristics of each country-specific crisis at the time of maximum vulnerability.

Dalio identifies six primary indicators that appear repeatedly.

  • Expansion of the Debt to GDP Ratio of at least 5%
  • Foreign Debt to GDP of at Least 30%
  • Fiscal Deficit at least 2% of GDP
  • GDP Output Gap of at least 5% (GDP 5% over trend growth)
  • Currency at least 10% overvalued
  • Current Account Deficit over 3% of GDP

Not every crisis is identical,  but by-and-large they follow the same pattern, meeting the criteria over 80% of the time. Russia, with its structural current account surplus, is the only anomaly, with both booms and busts dictated by oil-driven terms-of-trade shocks.

When a country meets most of these criteria its economy is considered very overheated and vulnerable to a serious downturn. A crisis is usually triggered when a slow-down in GDP growth unnerves investors.

How does Argentina’s present collapse fit into this framework? To begin, we note that Argentina has had three crises since 1980, all of them fitting nicely into the template. As discussed by Krugman and his Twitter-followers, Argentina’s twin deficits, debt accumulation and reliance on foreign debt put it at high risk.  A near-doubling of the country’s debt/GDP ratio from 2015-2018 and a heavy reliance on foreign debt were reckless. The following charts illustrate the deficits and debt profiles.

Twin Deficits

Total Debt and Foreign Debt

 

Moreover, as shown below, when Macri assumed office the Argentine economy  was overheated. After years of irresponsible populist policies, Argentina’s GDP was well above trend and the current account deficit  was elevated, meaning that cautious austerity measures were in order.

Where Argentina breaks the template is with regards to the valuation of the currency. As shown in the chart below, both in terms of its REER (Real Effective Exchange Rate) and the Big Mac Index, the peso was cheap relative to its history and in comparison to EM currencies.

Macri may have seen the cheap peso as his trump card, and it may well have been if the global economy had not weakened and if grain prices had risen. Unfortunately, the global economy did turn down and grain prices went into free-fall. Moreover, Brazil’s endless recession also weighed on Argentina’s manufacturing sector which depends heavily on this border trade

As the chart below makes clear, investors should have heeded the warning from falling commodity prices. By the time Macri took office, grain prices had already plummeted and they continued to fall, so that today they lie 60-70% below the 2012-2015 period.

What lessons can be drawn from the latest Argentine fiasco? First, in retrospect Macri’s task was probably thankless. With the mess left by the previous administration and collapsing farm prices his best strategy would have been to follow Krugman’s advice and bite the austerity bullet early. But in Argentina’s fractious political climate that may well have been a suicidal option. Instead he took the risky bet that favorable markets would sustain a gradual economic transition. Unfortunately, Macri’s luck ran out.

 

Trade Wars

  • The great decoupling (Oxford Energy)
  • KKR sees opportunity in China decoupling (KKR)
  • Banning technology will backfire on the U.S. (FT)

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

  • Expected returns in China (UBS)
  • China-Russia: cooperation in Central Asia  (AsanForum)

China Technology

Brazil Watch

EM Investor Watch

  • Naspers strategy to create value (FT)

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)

Investing

  • The age of wealth accumulation is over (FT)
  • An investment thesis for the next decade (Gavekal)

 

Active Management in Emerging Markets Equities

The long-term performance of U.S. actively managed mutual funds investing in emerging market equities has been problematic. This goes against the argument that emerging markets should provide more opportunities for skilled active investors because of greater market inefficiency. In fact, the ability of EM investors to provide results above their benchmarks has been in line with the experience of portfolio managers investing in the supposedly highly efficient U.S. markets for large capitalization stocks.

This disappointing reality is highlighted by a recent academic paper, “The performance of US-based emerging market mutual funds,” (Halil Kiymaz and Koray D. Simsek Rollins College – Crummer Graduate School of Business) (Link).

Kiymaz and Simsek looked at actively managed U.S. mutual funds classified as “Diversified Emerging Markets” during the January 2000 to May 2017 period, admittedly a relatively short period. They identified 222 specific mutual funds active over this period. The researchers did not adjust the results for style mandates. In other words, “growth” managers were not judged relative to the “growth” benchmark, and “value” investors were not compared to the “value” index.

A summary of their findings follows:

  • Median and mean annualized returns were 4.17 and 4.87%, respectively. This indicates better performance for the larger asset managers, presumably because of larger research budgets. These returns compare to 6.65% and 7.89% for the two major benchmarks, the MSCI Emerging Markets and the S&P/IFC Emerging markets, respectively.
  • Fee expenses, though declining during the period, reduced returns by 1.22%, with no difference between the smaller and larger managers.
  • Cash was a significant drag on performance, with larger managers holding more cash than smaller ones. The mean cash holding over the period was a very high 9%.
  • The mean turnover (a measure of the amount of change in a portfolio in a given year) of the fund universe was a high 65%, and very likely another drag on performance. Surprisingly, larger managers had considerably higher turnover than smaller ones, which may imply significant market impact on stock transactions.
  • The average fund was heavily over-weighted in larger capitalization, “blue chip” stocks. Moreover, a “quality” bias can be seen in the relatively low volatility of returns: standard deviation of returns were 17.43% compared to 22.2% for the benchmarks.
  • The average tenure of the portfolio managers responsible for the funds was only 4.5 years; once again, the larger funds having more experienced hands on the tiller.

Conclusions

The Kiymaz-Simsek paper point to various short-comings of active managers. First, of course, management fees and transactions costs reduce significantly the potential returns of the investor in the funds; second, managers do not seek to exploit well-documented small-cap and liquidity premiums, preferring the comfort of investing in the best “quality,” largest and most liquid companies; third, managers hold excess amounts of cash in what is most-likely a futile attempt to time the market.

With the abundance of very low-cost ETFs replicating most strategies now available to investors, fund managers need to provide a genuine alternative. In all likelihood, successful strategies will have to embrace some of the following characteristics:

  • High portfolio “active risk,” an industry metric which measures how different a portfolio is from its benchmark.
  • Greater focus on under-followed segments of the markets, which implies a disciplined contrarian mentality and focus on less liquid and unpopular stocks, and lower turnover and longer holding periods.
  • Boutique structures with experienced managers.

 

Trade Wars

 

  • The great decoupling (Oxford Energy)
  • KKR sees opportunity in China decoupling (KKR)
  • Banning technology will backfire on the U.S. (FT)
  • A G-2 world (project syndicate)
  • Ian Bremmer (Aviva)
  • Post-dollar networks (project syndicate)
  • Investing in the age of deglobalization  (FT)
  • Is American diplomacy with China dead? (AFSA)

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

 

China Technology

Brazil Watch

 

EM Investor Watch

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Mary Meeker’s Internet Trends report (techcrunch)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

  • The age of wealth accumulation is over (FT)
  • An investment thesis for the next decade (Gavekal)
  • Dalio on Diversification (Dalio)
  • AI Creates Strategic Dilemmas (FT)
  • Fooled by randomness (macro-ops)
  • The imperative for international diversification (Swedroe)
  • The end of sell-side research (Epsilon)
  • Understanding why currencies move (macro-ops)
  • EM value as an anti-bubble (research affiliates)

 

 

 

 

 

 

Update on the Expected Returns for Emerging Markets Stocks

Emerging markets have returned a decent 10.6% in dollar terms through June. However, over the past year EM has returned only 1.6% and over the past five and ten years EM annual returns have been a meager 2.9% and 6.2%, respectively. These returns have strongly disappointed investors, particularly in contrast to the stellar returns of U.S. stocks. As can be expected, the poor results have spawned dozens of articles on the futility of investing in emerging market equities, the latest this week from the Financial times (Does Investing in Emerging Markets Still Make Sense?).

Notwithstanding the poor recent results, if we look at the past twenty years the picture is very different, with EM significantly besting the S&P 500. In fact, the past two decades have been pretty much opposites. The previous decade (1999-2009) for emerging markets had started with low valuations and was characterized by favorable macro-conditions: rising commodity prices and a weak dollar. On the other hand, this past decade for EM started with very high valuations and was marked by falling commodity prices and a strong dollar. The chart below shows the relative performance of EM stocks relative to the U.S. market for the past two decades (SPY for the S&P500 and the Vanguard EM Fund-VEIEX)

So, where do we stand today as we approach 2020?. Investors, as usual, suffer from recency bias and now cannot fathom that current conditions may change and that the U.S. market could falter.  This, despite very high valuations in the U.S. on earnings which are inflated by low interest rates, loose fiscal policy, elevated margins and record levels of stock buybacks. In his latest article, Ray Dalio predicts that these conditions are unlikely to persist in the next decade, as authorities turn to debt monetization to address the rising tide of government debt and other liabilities (Link). If this were to happen, conditions much more favorable for EM stocks — a weak dollar and rising commodity prices — would follow. Given the low valuations and depressed earnings in EM, we could see much better returns ahead.

Based on current valuations and assuming a process of mean reversion supported by improved market conditions, we can try to estimate expected returns. The chart below does this be assuming that over the next seven years current valuations (based on CAPE-Cyclically Adjusted Price Earnings) will revert to the historical median, while the business cycle in each country will return to a neutral point at which earnings grow in tandem with nominal GDP growth. These highly simplistic assumptions is the best we can do to estimate future returns. Given that in EM we are now below normal in both multiples and earnings and observing that markets invariably overshoot on both the downside and  upside, these estimate may prove pessimistic if market conditions actually improve. An investor should optimize returns by tilting a portfolio to the countries that are currently valued well below historical norms and are also in depressed economic conditions; Turkey, Chile, Malaysia, Korea and Colombia currently promise the higher returns. Finally, it must be noted that these estimates assume no changes in current views on potential GDP growth. Therefore, for example, if a country like Brazil were to successfully implement deep structural reforms which boost potential GDP the estimates for that country would be too conservative.

CAPE Ratios Relative to History, June 30 2019
Current Cape Historical AVG CAPE Difference Earnings Cycle 7-Year Index Annual Return 7-Year Total Annual Return
Turkey 4.8 9.45 -49.21% Early 13.8% 16.7%
Chile 14 20.875 -32.93% Early 9.9% 12.9%
Malaysia 12.1 18 -32.78% Early 8.4% 11.7%
Korea 10 14.05 -28.83% Early 8.5% 10.2%
Colombia 11.2 15.55 -27.97% Early 8.8% 11.7%
Mexico 14.6 19.075 -23.46% Early 9.0% 11.0%
S. Africa 12.9 16.025 -19.50% Early 5.7% 8.8%
China 12.2 14.825 -17.71% Mid 8.5% 11.3%
Philippines 19.7 23.5 -16.17% Mid 9.0% 11.7%
Indonesia 15 17.725 -15.37% Mid 6.7% 9.5%
GEM 12 13.975 -14.13% Early 6.3% 9.2%
Russia 5.99 6.875 -12.87% Early-mid 4.9% 9.5%
Taiwan 16.3 17.85 -8.68% Late 5.0% 8.0%
China A-shares 16.3 17.025 -4.26% Mid 6.5% 9.1%
Brazil 12.3 12.225 0.61% Early-Mid 2.8% 6.4%
Peru 17.9 17.3 3.47% Mid 6.0% 8.6%
Argentina 10 9.525 4.99% Early 4.0% 6.6%
India 20.5 19.4 5.67% Mid 8.5% 10.0%
USA 30.2 26.3 14.83% Late 1.0% 3.3%
Thailand 17.8 13.25 34.34% Late 0.0% 3.5%

These estimates are broadly in line with those currently posted by GMO ( Link) and Research ( Link), two firms with  their own methodologies for predicting expected market returns.  The GMO numbers are for seven years in real terms, while the RA numbers are for 10 years in nominal terms.

Even with the good prospects for better relative performance over the next decade, current macro conditions still justify cautious positioning in EM stocks. The global economic slowdown, the U.S.-China trade and technology conflicts and a turbulent presidential election in the U.S. does not provide a backdrop propitious to increase “risky” investments in EM.  In any case, the macro indicators we look at remain neutral to unconstructive. Our macro drivers of EM stocks are 1.global liquidity, 2.risk aversion, 3. The dollar/EM currency trend and 4. Commodity prices.

Global Liquidity– Neutral.

The world economy runs on dollars and stalls when dollar liquidity tightens. Since the Fed pivot in January, year-on-year increase in dollar liquidity (U.S. money supply plus Central Bank reserves at the U.S. Fed) has recovered somewhat from very low levels. However, dollar reserves are contracting, a sign of declining global trade. Yardeni’s Global Capital Flows indicator also points ti tight dollar liquidity.

 

Risk Aversion – Neutral, with slight deterioration trend.

The best indicator for risk appetite is the spread between U.S. 10-year bonds and High-yield bonds. This indicator is highly correlated to EM sovereign spreads and appetite for EM risk in general. The spread appears to have started a rising trend, but remains very low. These low spreads indicate strong demand for yield in a world dominated by low and negative interest rates, and this is currently the major source of support for EM assets.

The Dollar Trend – Neutral to negative

The dollar is in a consolidation zone relative to emerging markets, but still appears in a long-term strengthening trend.

.

 

Commodities-Negative

The CRB Raw Materials index measures prices for a broad variety of industrial inputs. Historically, this index has the highest correlation with EM equities. Following a strong rebound in 2016-2018, the index has resumed the downtrend started in 2012. The metals component of the CRB is also in a sharp decline.

In conclusion, after the recent rally in EM assets, some caution is warranted. For investor optimism to be rewarded, it is important that the four pillars of EM asset prices (global liquidity, risk appetite, the dollar and commodities) turn favorably.

Trade Wars

 

  • Balkanizing technology will backfire on the U.S. (FT)
  • Is American diplomacy with China dead? (AFSA)
  • The Russia-China close partnership (Carnegie)
  • Gavekal on the U.S. China new cold war (gavekal)
  • China, the art of wait and see (project syndicate)
  • The imperative of a Euro-pacific partnership (Project Syndicate)
  • Investing  for a new cold war (Gavekal)
  • The trade war needs a global solution (Carnegie)

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

 

  • China and the World (Mckinsey)
  • Chinese internet weekly (seeking alpha)
  • China internet report (SCMP)
  • China’s elite obsession with Harvard (The Economist)
  • China’s Silicon valley (The Economist)
  • China’s sport-shoe capital  (SCMP)
  • Carrefour leaves China (WSJ)
  • The rise of factors in the China A share market (MSCI)
  • How does factor investing work in China (Indexology)
  • How smart-beta strategies work in China (Savvy Investor)
  • China’s healthcare sector (globalx)
  • China’s Communication Services Sector (globalx)
  • China’s rare earths strategy (China File)
  • China-India relations are stressed (Carnegie)
  • China opens yuan commodity futures (SCMP)

China Technology

  • Inside China’s biopharma market (McKinsey)
  • China’s food delivery war (Bloomberg)
  • How China took the lead in 5G technology (WP)
  • China’s MIC 2025 plans are roaring ahead (SCMP)
  • China’s EV future (The Econoist)
  • China’s EV bubble (Bloomberg)

Brazil Watch

 

EM Investor Watch

 

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Mary Meeker’s Internet Trends report (techcrunch)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

 

 

Why Own Emerging Market Stocks?

 

After a decade of poor performance, it is understandable that emerging market stocks are not popular. Yet, if we look at the long-run, EM stocks have performed relatively well and provided useful diversification for investors.

The following chart shows the total return for both EM stocks and the U.S. market’s S&P500 for the 1988-2018 period, a period of 31 years that encompasses the modern history of emerging markets as an institutional asset class. The chart also shows the returns of a 50/50 portfolio re-balanced at the start of every year.

Even in the wake a a period of huge outperformance for the S&P500, EM stocks are still outperforming U.S. stocks by a slight margin over the period. However, they achieve this with deeper draw-downs (maximum loss during a year) and with greater volatility, two attributes that unsettle investors. The Sharpe Ratio (annualized return/standard deviation of annual returns) is much worse for emerging markets. Moreover, this is before considering the higher risk and cost of capital for investing in EM. When investing in EM, investors expect to be paid a premium to compensate for the higher risk, but this has not been the case over the period.

Nevertheless, EM does provide valuable diversification benefits. A simple annual re-balancing strategy (50% EM and 50% S&P500) enhances returns significantly, while providing a much more stable path of capital appreciation. This is because the two asset classes show highly uncorrelated returns over multi-year periods. During the period under consideration both asset classes individually go through extended periods of stagnation which are largely avoided through a re-balancing strategy.  For example, U.S. stocks provided zero returns between 1999 and 2009, a period which saw EM nearly triple in value. The following decade(2009-2018)  saw the reverse happen, with stagnation for EM stocks and high returns for U.S. stocks. The chart below illustrates the returns of EM, the S&P500 and an annual re-balancing strategy.

 

Trade Wars

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

  • China deepens financial links as it joins benchmarks (IMF)
  • The rise of factors in the China A share market (MSCI)
  • How does factor investing work in China (Indexology)
  • How smart-beta strategies work in China (Savvy Investor)
  • China’s healthcare sector (globalx)
  • China’s Communication Services Sector (globalx)
  • China’s rare earths strategy (China File)
  • China-India relations are stressed (Carnegie)
  • China opens yuan commodity futures (SCMP)

China Technology

  • Inside China’s biopharma market (McKinsey)
  • China’s food delivery war (Bloomberg)
  • How China took the lead in 5G technology (WP)
  • China’s MIC 2025 plans are roaring ahead (SCMP)
  • China’s EV future (The Econoist)
  • China’s EV bubble (Bloomberg)

Brazil Watch

 

EM Investor Watch

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Mary Meeker’s Internet Trends report (techcrunch)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

 

 

 

 

 

 

 

The “Value” Opportunity in Emerging Markets

Investors categorize themselves as either in the “value” or “growth” camps. The “value” followers focus on stocks that are overlooked by investors and judged to be temporarily mispriced: this is akin to finding $100 bills on the sidewalk or, as value guru Ben Graham described it, picking up  “cigar butts” with one puff left in them. The “growth” proponents, on the other hand, look for companies with bright long-term prospects and the potential for compounding cash flow streams.  While value investors find the future to be opaque, growth investors visualize huge bonanzas on the horizon. Because growth investors see the future as much better than the present, they are happy to pay higher multiples on current earnings and owner’s equity (book value). Because of this, the investment industry has generally categorized “growth” stocks as those with high valuation multiples (price-to-earnings and price-to-book) relative to the market.

Looking at the historical record, “value” stocks have provided better returns than “growth” stocks. This is known in academia as the “value premium” and is attributed to value stocks being underpriced because they are riskier and unpopular while “growth” stocks are overpriced because of their notoriety and bright prospects. Glamorous growth stocks are sometimes compared to “lottery tickets” as they can generate the excitement of a potential huge pay-off in the future. One of the main features of “growth” stocks is that they benefit from low interest rate environments, such as the one we are currently experiencing; this is because the huge future pay-offs investors are counting on can be discounted at lower rates and are therefore worth much more.

Though the value premium is well-documented by academics and is persistent over time and geographies, it will not prevail at all times.  In fact, any “factor premium,” or for that matter any investment strategy,  will go through valuation cycles, from cheap to expensive and back again. Over the past decade, value has been in a severe declining cycle, becoming gradually cheaper relative to the market, setting itself up for another opportunity for investors to harvest premia.  The cyclical evolution of value over the past forty years is well depicted in the chart below from the asset-manager GMO, which shows that currently in both developed and emerging markets “value” is priced at a deep discounts to the market.

Value stocks in the U.S. have underperformed 9 of the past twelve years for an average of 2% annually, one of the longest losing streaks ever recorded. Over the past ten years, in non-U.S. developed markets and in emerging markets annualized value returns have lagged the market by 1.6% and 1.1%, respectively.

Predictably,  as “value”  has become cheaper it has also become less popular with investors. Over this period, assets in value funds have declined sharply relative to the market. In emerging markets, the decline of value has been particularly severe.

Historically, value investors have had a big role in emerging markets. Particularly in the 1990s, stocks in emerging markets were very inexpensive and in a process of re-rating in response to market reforms, privatizations and capital inflows. However, since the 2008 financial crisis, low GDP growth, reform-fatigue and the rise of the tech sector in Asia has changed the dynamics in favor of growth, both in developed and emerging markets. This has resulted in a sharp decline in “value” funds, with many losing assets and shutting down. Interestingly, in the ETF space, which is where almost all marginal flows have gone to over this period, there is not one traditional value fund offered.  Instead, the vast majority of assets are flowing into capitalization-weighted indices (MSCI EM, FTSE). Taking the place of “value,” the industry has promoted RAFI and multi-factor “smart-beta” ETFs.  RAFI, which stands for Research Affiliates Fundamental Index, is a partial “value” substitute to the extent that position sizes are determined by fundamental factors (sales, cash flow, book value and dividends) in contrast to the capitalization-weighted method most commonly used.  Multi-factor “smart-beta” funds, on the other hand, use a mix of “factors” such as price-momentum, sales growth, “quality” and low-volatility in addition to traditional value measures.

Assuming that markets and valuations will continue their historical patterns of mean-reversion, the current opportunity for outsized returns in emerging markets “value” stocks is substantial. Emerging Markets by themselves are already very cheap relative to developed markets, so the deep discount of the value segment provides a significant opportunity for extraordinary returns. Those few remaining funds that still specialize in buying discounted “value” stocks are likely to enjoy a very good run as other investors and ETFs start chasing the return of the “value” premium.

However, a word of caution is warranted. Value stocks are usually cheap for a reason and this is tied to the more problematic and stressed nature of the companies (e.g., more debt, cyclical margins, vulnerability to economic downturns). Given the current global slow-down and the rising risk of U.S. recession, “value” may still have another leg of underperformance. The currently undergoing and expressive decline of global interest rates also continues to favor long-duration “growth” stocks. In short, value may have to wait a while longer, but this will only make the upcoming opportunity even greater.

Trade Wars

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

 

  • The rise of factors in the China A share market (MSCI)
  • How does factor investing work in China (Indexology)
  • How smart-beta strategies work in China (Savvy Investor)
  • China’s healthcare sector (globalx)
  • China’s Communication Services Sector (globalx)
  • China’s rare earths strategy (China File)
  • China-India relations are stressed (Carnegie)
  • China opens yuan commodity futures (SCMP)
  • China’s private firms struggle under Xi regime (PIIE)
  • Chinese quants (Bloomberg)
  • Oddities of the Chinese stock market (Bloomberg)
  • China’s quant Goddess (Bloomberg)
  • Guide to Quant Investing (Bloomberg)
  • China is a stock picker’s paradise (WSJ)
  • China’s middle-income consumer (WIC)

China Technology

  • Inside China’s biopharma market (McKinsey)
  • China’s food delivery war (Bloomberg)
  • How China took the lead in 5G technology (WP)
  • China’s MIC 2025 plans are roaring ahead (SCMP)
  • China’s EV future (The Econoist)
  • China’s EV bubble (Bloomberg)

Brazil Watch

 

EM Investor Watch

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Mary Meeker’s Internet Trends report (techcrunch)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

 

 

 

 

Are Emerging Markets Stocks a Viable Asset Class?

It is a basic fact of investing that stock market returns are determined by earnings growth and the multiple that investors will pay for them. Over time corporate earnings generally grow in line with GDP growth, while the multiple put on earnings varies depending on how fearful or optimistic investors may be. Stock valuations may also be impacted by the cost of capital, so that investors will pay higher multiples on earnings when interest rates are low and vice versa. These relationships apply across all geographies, including emerging markets.

Valuations in emerging markets have persistently been lower than in the U.S. and other developed markets even though emerging market economies grow at nearly three times the rate. Relatively low valuations and high GDP growth are the perennial selling points for investing in EM stocks. However, at least for the past decade, returns in EM have lagged well behind those for U.S. stocks, and, understandably, this has raised concerns about the viability of the EM asset class.

However, there are good reasons to believe that the poor performance of EM stocks is temporary. Explanations for weak EM returns point to cyclical and circumstantial causes that should eventually revert.

First, the valuation gap between emerging markets and the U.S, market has widened considerably over the past ten years because of structural issues which are probably temporary. While EM stock markets continue to be dominated by low-growth capital intensive sectors (e.g. banking, manufacturing and natural resources), the U.S. stock market has been driven by “growthy” capital-light companies (e.g. Facebook, Apple, Netflix, Google). “Growth” stocks are long-duration assets (i.e., The concentration of cash flow and dividend payments are in the distant future) and therefore they benefit from the low discount rates implied by the current low inflation and  low interest rate environment. Concurrently, the combination of low-growth/low investment with historically low interest rates in the U.S. has resulted in unprecedented stock buy-back activity by U.S. corporations over the past seven years. This structural cause of EM underperformance is largely the same that has led to the poor relative returns of “value” vs. “growth” investing in the U.S. and global markets, since value stocks are also “short-duration” investments.

This importance of buy-backs is highlighted in a recent paper from analysts at ADIA, the Abu Dhabi Investment Authority (“Net Buy-Backs and the Seven Dwarfs”, Link). The ADIA researchers looked at the MSCI All Country World Index (ACWI) for the 1997-2017 period and determined that the primary determinant of country-specific returns was net buy-back activity (NBB), a measure of the net increase in issued stock in a market (e.g., IPOs, delistings, corporate buy-backs, mergers and acquisitions). Depending on the nature of the NBB, it may enhance or take away from shareholder returns. Markets where companies constantly issue stock –  either because they are in low-return capital-intensive businesses or because they lack capital discipline and shareholder alignment – do poorly. In this regard, the data shows evidence that poor corporate governance manifested by undisciplined capital management has suppressed returns in EM, with the result that earnings have grown at a rate well below GDP growth.

Over the period covered by the study this has especially been the case in China where huge and overpriced initial public offerings (IPOs) of state-owned companies (SOEs) have severely  hurt shareholder returns. The Philippines, Indonesia, Chile, Russia and Thailand have also suffered from negative effects of NBB. The data on NBBs for emerging markets from the ADIA study is shown in the chart below. NBBs had a an average negative 3.4% impact on annualized returns, with less than a third of EM countries showing positive NBBs. Given that stock buy-backs are rare in EM, those countries showing positive NBBs had this as a result of M&A activity and delistings (e.g., ABInbev’s takeover of Modelo in Mexico). The study’s total sample of 41 countries had a negative 2.2% impact on annual returns, slightly above the U.S. market’s negative 1.8%. Interestingly, NBBs for the U.S. market become hugely positive over the 2009-2019 decade and are a major reason for U.S. stocks outperformance over this period.

The second reason for the underperformance of EM stocks over the past decade is the mean-reversion of both valuations and the U.S. dollar.  The charts below show (left) the relative performance of the FTSE EM Index (VEIEX) and the S&P 500 (SPY) over the past twenty years and (right) the EM MSCI Currency Ratio which is the performance of the currencies in the EM stock index relative to the USD. The twenty-year period is neatly divided into the first 10 years of EM stock outperfomance and dollar weakness and the following ten years of EM stock weakness and USD strength.

The strength of the dollar has been a major headwind for EM stocks over the past ten years, reducing returns by 3% annually, as shown below.

Over this period, valuations in EM and the U.S. market follow highly divergent paths. The chart below shows the evolution of valuations for both markets using cyclically inflation-adjusted price-earnings ratios (CAPE), a measure that smoothes out earnings and provides a better basis for comparison. EM started with a very low CAPE ratio of 9.2x in 1999, which rose sharply to 19.6x in 2009 (after reaching a peak of 30x in 1997) and then falls back to 11.5x in 2019. S&P500 valuations start at a bubble -level ratio of 42x  in 1999, fall by half to 20.5x in 2009 and are currently at 29x today.

Conclusion

The outperformance of the U.S. market over the past ten years can be attributed to circumstances that are probably temporary. U.S. returns were boosted by the relatively low level of initial valuations 10 years ago, historically low interest rates over the period, buy-backs and a strong dollar. On the other hand, EM returns have been hurt by relatively high initial valuations, a strong dollar and negative net buy-backs. Predicting the next ten years is a fool’s errand, but low valuations, a weakening dollar and relatively high GDP growth may put the odds in favor of EM stock outperformance.

Trade Wars

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

  • China’s rare earths strategy (China File)
  • China opens yuan commodity futures (SCMP)
  • China’s voracious appetite for Russia’stimber (NYT)
  • China’s  control of the lithium battery chain (FT)
  • Australia turns to China (NYT)
  • China’s private firms struggle under Xi regime (PIIE)
  • Chinese quants (Bloomberg)
  • Oddities of the Chinese stock market (Bloomberg)
  • China’s quant Goddess (Bloomberg)
  • Guide to Quant Investing (Bloomberg)
  • China is a stock picker’s paradise (WSJ)
  • China’s middle-income consumer (WIC)

China Technology

Brazil Watch

EM Investor Watch

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

 

 

 

 

Asset Management Fees are Moving Towards Zero

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

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

 

The Shift from Active to Passive

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

Persistent Reduction in Fees

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

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

 

Chinese quants (Bloomberg)

Oddities of the Chinese stock market (Bloomberg)

China’s quant Goddess (Bloomberg)

Guide to Quant Investing (Bloomberg)

Trends Everywhere (AQR)

Ten bits of advice from Buffett (Seeking Alpha)

Value + Catalyst: the Gazprom case (Demonitized)

Latin America’s missing middle (McKinsey)

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

 

Expected Returns in Emerging Markets

Emerging market equities continue to perform poorly relative to U.S. stocks, a trend that now has persisted for nearly 8 years, since 2011. This poor relative performance is largely explained by the very high starting level of EM valuations, which may be considered to have reached “bubble” levels during the 2008-2012 period.  However, valuations are now back to attractive levels both in historical and relative terms, particularly compared to the richly valued U.S. market, so investors can expect returns in emerging markets to do considerably better over the next 5-10 years. Nevertheless, EM stocks continue to fare poorly, and they have underperformed the S&P 500 by a large margin over both the past quarter and the past year. Furthermore, short-term prospects appear muted, as macro factors provide significant challenges. IMF Manager Director Christine Lagarde reminded us of this this week in pointing out the “precarious” state of the global economy.

Experience tells us that EM assets perform well when there is strong global growth accompanied by a weakening U.S. dollar, the opposite of current conditions. What we have seen since 2012, pretty much on a persistent basis, is relatively weak global growth and a strengthening dollar. This has led to a condition of tight global dollar liquidity, marked by consistent flows into dollar assets. Ironically, this condition of the markets has allowed for massive amounts of issuance of dollar-denominated debts by EM corporates, which now may face severe difficulties in refinancing these loans if the trends of global weakness and dollar strength persist.

Nevertheless, the scenario is not all bad for EM assets. Several developments point to improving conditions going forward:  looser U.S. monetary policy; and a recovering Chinese economy which in turn is driving an increase in commodity prices.

The charts below illustrate current market conditions. The first chart shows global liquidity as measured by the U.S. monetary base (M2) and international dollar reserves. The recent surge can be attributed to the “Fed pivot,” and, if sustained, would be supportive of better global dollar liquidity. The second chart, from Yardeni.com, shows a different measure based on international trade surpluses and reserves, less supportive of an improvement in liquidity conditions. The third chart, also from Yardeni.com, shows the MSCI EM currency index, which represents the performance of the currencies in the benchmark relative to the USD. The recent uptick in the data is caused by the strengthening of the yuan and Indian rupee in recent weeks. On an equal weighted basis, the persistent strengthening of the dollar is still very obvious, and, overall, we can state that the dollar strengthening trend looks to be intact.  

Finally, the third macro factor which is highly correlated to positive EM performance – the price trend of commodities – is shown below. The chart shows the recent surge in the CRB Raw Industrials index, and especially the metals component. This is a clear sign that China’s stimulus is having an impact, and certainly a bullish sign for emerging market assets.

In conclusion, macro factors are a mixed-bag. Global growth is weak and the dollar is strong; on the other hand, there are some signs of improved dollar liquidity and commodity prices are acting well. The balance will tilt depending on China, with a recovery in the Chinese economy during the second half of this year supporting an improved environment for EM investors.

        Valuations are Compelling

The main reason to own emerging market equities is that after a long period of underperformance they are now inexpensive relative to their own history and compared to the U.S. market. For the investor with a long-term  view, current valuation strongly argue for increasing allocations to the asset class. The following table ranks the expected returns for the major EM countries as well as for the global emerging market benchmark and for the S&P 500. The dollarized nominal expected returns are derived by assuming that market Cyclically Adjusted Price Earnings(CAPE) ratios return to historical averages. Then this multiple is applied to “normalized earnings” which take into account where a country is in terms of its business-earnings cycle. Finally, normalized earnings are grown for the seven-year period by nominal USD-denominated GDP.

The table points to attractive returns for EM equities over the period, compared to very low returns in U.S. equities. An investor should seek to enhance EM returns by overweighting the highly discounted “riskier” markets such as Turkey, Colombia, Malaysia and Russia.

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

  • Trade Wars

  • After the deal “Cold War II” will continue (SCMP Stephen Roach)
  • The reemergence of a two-bloc world (FT)
  • The deepening U.S. China crisis (Carnegie)

 

India Watch

  • India’s internet users are addicted to these apps from China (WSJ)
  • India’s digital transformation (McKinsey)
  • The chinese are taking over smartphone apps in India (factordaily)
  • India ex-SOE Fund launched by Wisdom Tree (Wisdom Tree)
  •   A bullish view on India (Wisdom Tree)
  • How Youtube conquered India (FT)

China Watch:

  • China and its Western critics (Project Syndicate)
  • The chinese economy is stabilizing (FT)
  • China’s SOE reform (WIC)
  • Europe’s different take on China (SCMP)
  • A view on the Chinese economy (McKinsey)
  • Can outside pressure shift Beijing (Lowy)

China Technology

Brazil Watch

EM Investor Watch

  • AMLO’s first 100 days (Wilson Center)
  • The strongmen strike back (Washington Post)
  • Argentina’s downwards slide (FT)
  • What’s driving Turkey’s market wild (WSJ)
  • Turkey needs a better powerpoint (FT)
  • South Korea launches 5G network (Bloomberg)
  •  Malaysia’s four key challenges  (Lowy)
  • Turkey’s momentous election (Carnegie)

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

An Update on Active vs. Passive Investing in Emerging Markets

The  most under-rated aspect of investing is simplicity. Investors feel obliged to pursue complex methods to predict the future of the economy, the markets and corporate earnings and they then develop elaborate trading systems to leverage “superior” insights. This is often driven by clients who demand large teams of highly paid experts involved in complex strategies in order to justify paying management fees. If a process is too simple and transparent, the client may conclude that the manager is dispensable .

This dilemma is heightened  by the growing preponderance of passive indexing and “smart-beta” strategies, which offer market performance (“beta”) or the promise of factor-driven market outperformance (“alpha”) at ever-declining prices. These computer-driven quantitative strategies are the image of simplicity and transparency and can be manufactured cheaply.

These “passive “products increase the pressure on actively managed funds in two ways; first, they compress fees; second, they push managers to add skill and complexity which increases costs. This bad combination of lower fees and higher costs can only lead to a concentration of assets in those few active managers who can offer highly differentiated products.

These trends can be seen in the Year-end 2018 SPIVA Scorecard (Link, Link), which compares returns for U.S. mutual funds with their respective benchmarks. Here are some highlights from the report which concern emerging markets funds:

  • The number of available funds is declining, from 233 in 2015 to 210 a year-end 2018.
  • Larger funds perform better than smaller ones. This is seen in the higher returns on an asset-weighted basis than on an equal-weighted-by-fund basis. This advantage of larger funds over smaller funds is persistent over all time-periods and can be attributed to lower fees and higher skill.
  • 2018 was a difficult year for active managers, with 78% of managers underperforming their indices. The data for the past 15 years is shown below. Beyond, a one year time-frame, around 90% of managers underperform their indices.

Rolling three-year returns have also deteriorated, as shown in the following graph. This deterioration is also seen for global and  international funds.

     

  • Finally, SPIVA identifies low persistency in results for EM managers. While 41% of EM funds outperformed their indices for the 2012-2015 3-year period, only 7.5% of these funds continued to outperform the next year  (2016), 4.5% outperformed over the next two years (2016-2017) and zero outperformed for the next three years (2016-2018).

  Conclusion

The sobering data from the SPIVA scorecard highlights the challenges of active managers. To be successful, increasingly, active managers will need to focus on market niches where they can deploy unique skills and expertise, and/or pursue strategies that provide returns that are uncorrelated  to mainstream emerging market products. Some areas where active management may continue to be highly successful in “harvesting alpha” are the following:

  • Deep value contrarian investing. This strategy is highly out-of-favor because of a long period of underperformance of the value factor. Consequently, though it requires skillful fundamental research, it is under-researched because most managers have abandoned this discipline. This is the case at a time when opportunities are plentiful in the Indian and Brazilian markets, and particularly in the China A-share market.
  • Hedge Fund structures: Pure Alpha, shorting and trend following (CTA) strategies can provide returns uncorrelated to EM equities and valuable diversification.
  • Long-only, mainstream EM investors with low cost structures, long-term horizons and the ability to pursue strategies with high “tracking error” (the degree of  portfolio return uncorrelation with the benchmark). The problem is finding clients with long-term horizons and tolerance for “tracking error”.  The vast majority of both investors and clients prefer strategies that “hug” the benchmark, which makes alpha creation a remote possibility.

Trade Wars

  • Xi needs a trade deal (FT)
  • The reemergence of a two-bloc world (FT)
  • The deepening U.S. China crisis (Carnegie)
  • European Commission report on China relations (EC)
  • Should the U.S. run a trade surplus (Carnegie, Michael Pettis)
  • Why the U.S. debt must continue to rise (Carnegie, Pettis)
  • Turkey and India denied preferential U.S. trading status (FT)

India Watch  

  • India’s internet users are addicted to these apps from China (WSJ)
  • How India conquered youtube (FT)
  • Modi’s track record on the economy (The economist)
  • Increasing Indian demand for copper (Gorozen)
  • India’s growing share of oil imports (blog)
  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)

China Watch:

  • Quality will drive China A- share returns (FT)
  • Lessons from Li Keqiang’s report to Congress (SCMP)
  • China breaks world box office record (SCMP)
  • Why China supports North Korea (Lowy)
  • China’s PM frets about the economy (The Economist)
  • China has no choice (Alhambra)
  • China’s economy is bottoming (SCMP)

China Technology  

Brazil Watch

EM Investor Watch

  • AMLO’s first 100 days (Wilson Center)
  • South Africa’s electricity sector woes (FT)
  • OECD Report on Global Corporate Debt (OECD)
  • Russia’s global ambitions in perspective (Carnegie)
  • South Africa stagnates as confidence wanes  (Bloomberg)
  • Postcard from Malaysia (Foreign Policy Journal)

Tech Watch

Investing

 

Bond market risk and emerging markets

 One of the most salient concerns with the current state of the the global economy  is the very high level of corporate debt. This past week the OECD, the Dallas Federal Reserve and the Bank for International Settlements all warned that in an eventual economic downturn the solvency of corporate debt issuers  is likely to deteriorate quickly and deepen the contraction. 

The warning is highly relevant for emerging markets investors for two reasons; first, EM corporates have been active particants in the ramp up of debt, eagerly satisfying the chase for yield that lenders have pursued in response to quantitative easing policies; second, EM borrowers can be expected to suffer disproportionately if the lending cycle were to turn sour.

Rob Kaplan of the Dallas Federal Resrve did not mince his words this week (Link) in issuing a stark warning of the risk to the economy caused by the buildup of U.S. Corporate debt. Kaplan is concerned that the current high level of corporate debt will sharply deepen an eventual economic downturn. He points out that a preponderance of recent debt issuance has been used for non-productive and non-self-liquidating activities, mainly dividends, debt buy-backs and M&A activity. In addition, to an unprecedented degree, the debt has been rated BBB (barely one notch above high-yield, “junk”), and has come with more relaxed covenants. This is shown in the following chart two charts. The first shows the cyclical behavior of the corporate debt market and the current very high level relative to GDP, and the second shows the growing preponderance of lower quality issuers.

  Kaplan notes that “in the event of an economic downturn and some credit-quality deterioration, the reduction in bank broker-dealer inventories and market-making capability could mean that credit spreads might widen more significantly, and potentially in a more volatile manner, than they have historically.” As in past recessions, downgrades of BBB-rated debt may flood the relatively illiquid market for high-yield bonds and cause severe dislocations.

Unfortunately for investors in EM debt, the U.S. high-yield bond market and the market for EM debt are extremely correlated. Therefore, any disruption in the U.S. high-yield market will be felt immediately in an accentuated fashion in the EM debt market.

This is the view expressed in the recently published OECD study, “Corporate Bond Markets in a Time of Unconventional Monetary Policy.” The report  describes in ample detail a “prolonged decline in overall  bond quality…and  decrease in covenant  protection” and  predicts that many corporates issuers will suffer a downgrade to “junk” in an eventual economic downturn  and face amplified borrowing costs. The report repeats the concerns expressed by Kaplan with regards to the size and low quality of global corporate debt. In addition, it focuses on the specifics of the EM debt market.

The OECD points to an “extraordinary acceleration of corporate bond issuance in emerging markets,”  from$70 billion/year in 2007 to $711 billion in 2016. This is shown in the chart below.

  The rise in borrowing has been particularly acute in China, but also highly significant across the rest of the emerging markets. Total EM corporate debt reached $2.78 trillion in 2018, up 395% in ten years. 

 The OECD identifies an alarming decline of the overall quality of the global corporate bond market. According to OECD analysis, by historical standards the quality of bonds is exceptionally low for where we are in the economic cycle. This is shown in the chart below.

 The decline in quality is particularly severe for the overall quality of EM bonds, which just barely qualify as investment grade in 2018 after falling into junk status in 2017. The chart  below compares the quality of EM bonds to developed market bonds, according to the rating methodology ued by the OECD.

To make matters worse, the repayment profile for emrging markets is considerably worse than for DM, with 80% of loans due over the next five years.

 Interestingly, even though concerns of a global slowdown are growing, high yield bonds in general are  performing well, displaying very low premiums by historical standards to risk-free bonds. This is partially because of QE (especially in Europe) but also because of desperate efforts to secure yield in a low-return environment. Look, for example, at the chart below of the HYEM, the emerging markets high yield bond ETF, which has rallied strongly since last September.

Conclusion

 Investors in emerging markets should be aware of the considerable risks presented by the bond market. Any significant downturn in the global economy would likely lead to significant downgrades to high yield bonds and a strengthening of the U.S. dollar, and this may cause severe disruption of the high-yield market. The performance of emerging market equity markets, which are highly correlated to the EM high yield market, would suffer accordingly.

Trade Wars  

  • Xi needs a trade deal (FT)
  • Should the U.S. run a trade surplus (Carnegie, Michael Pettis)
  • Why the U.S. debt must continue to rise (Carnegie, Pettis)
  • Turkey and India denied preferential U.S. trading status (FT)
  • China, India and the rise of the civilisation state (FT)
  • When democracy is no longer the only path (WSJ)
  • The tremendous impact of the China-U.S. tech war (Lowy)
  • Huawei hits back at the U.S. (FT)

India Watch

  • Modi’s track record on the economy (The economist)
  • Increasing Indian demand for copper (Gorozen)
  • India’s growing share of oil imports (blog)
  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)

China Watch:

  • Quality will drive China A- share returns (FT)
  • China breaks world box office record (SCMP)
  • Why China supports North Korea (Lowy)
  • China’s PM frets about the economy (The Economist)
  • China has no choice (Alhambra)
  • China’s economy is bottoming (SCMP)
  • MBS in Beijing (WIC)
  • The story of the world’s biggest building (The Economist)
  • U.S. cars are strugling in China (NYT)
  • China’s tourist have political clout (The Economist)

China Technology

  • Huawei’s big AI ambitions (MIT Tech)
  • China’s EV startup Xpeng (WIC)
  • An interview with fintech Creditease CEO (Mcinsey)

Brazil Watch

EM Investor Watch

  • OECD Report on Global Corporate Debt (OECD)
  • Russia’s global ambitions in perspective (Carnegie)
  • South Africa stagnates as confidence wanes  (Bloomberg)
  • Postcard from Malaysia (Foreign Policy Journal)
  • South Africa slumps (Barrons) South Africa Innovation (FT)
  • Make hay while the sun shines in emerging markets (FT)
  • Globalization in Transition (mckinsey)

Tech Watch

Investing

 

 

 

 

 

Caution Remains in Order For Emerging Markets

 

Financial markets have rallied strongly since the “Christmas Eve massacre.”  Since the December bottom, the S&P 500 has rallied 17% and emerging markets are 10% higher. Wall Street has put a positive spin on Fed Chairman Jay Powell’s sudden pivot to the dovish camp, and the bet is that a soft landing for the U.S. economy will be achieved. President Trump’s eagerness to sign a trade deal with China  also has lifted spirits.

For emerging markets, however, we have mixed signals and caution is still advised.

First, it may be that Wall Street,  for the time being, has interpreted the Fed in too optimistic a manner. The Fed’s pivot may be an indication that the interest rate cycle has peaked and that the next move in interest rates is down. This would not be bullish for EM equities, which tend to do well when the economy is over-heating and the Fed is raising rates (2016-2018) but then do poorly when the cycle turns. The Fed’s own recession probability indicator has shot upwards recently, even before the very poor December retail sales numbers released this week. This rising fear of a slowdown is seen also in Duke University’s CFO survey, which has 75% of CFO’s expecting a recession by 2020. This becomes a self-fulfilling prophesy, as CFO pessimism drives down investment and hiring plans.

Second, EM assets appear to be  in overbought territory. There has been a strong inflow of funds over the past two months into the three main EM asset classes: equities, local currency bonds and dollar-denominated bonds. Bonds started to rally before equities, an indication of increasing appetite for EM yield, as expectations for U.S. rate increases collapsed. Interestingly, according to Merrill Lynch’s survey of fund managers, EM equities have gone from the most shorted to the “most crowded trade” over a three-year period. The table below shows that today is the only time over the past five years that portfolio managers have been so keen on EM equities. Portfolio manager positioning tends to be a strong contra-indicator. In March 2016, at the lowest level since the great financial crisis and right at the beginning of a powerful rally for EM equities, Merrill’s survey identified being short EM equities as their highest conviction trade for portfolio managers.

Another indication that the markets may be overbought can be see in the following chart from Goldman Sachs. The chart shows a very unusual situation where EM assets have appreciated sharply in the face of deteriorating economic conditions.

In addition to the current overbought condition of EM, there are several additional indicators that merit investor attention. These are: dollar strength, commodity weakness and global liquidity.

Historically, EM assets sustain rallies when (1) the global supply of dollars is high, (2) the dollar is trending down (weakening relative to EM currencies) and commodities are appreciating.

Not one of these indicators is currently positive.

Global Liquidity

We can look at several indicators of the supply of dollar liquidity in international markets. These are shown below.

First, global dollar liquidity as measured by U.S. M2 plus international dollar reserves. This indicator moves up in December, but remain in depressed territory.

Second, International dollar reserves, which are still trending down.

Third, Ed Yardeni’s “Implied International Capital Flows,” which is in a sharp downtrend.

Fourth CrossBorder Capital’s “Emerging Markets Liquidity Cycle” which also is in a sharp downtrend.

The Dollar Trend

The dollar continues to strengthen relative to EM currencies.

First, the EM MSCI Currency Ratio, which continues in a major downtrend. The index has ticked up recently, only because it is heavily weighted in China, where the yuan has stabilized on trade-talks optimism.

Second, both the DXY dollar index (heavily weighted to developed currencies) and the equally weighted EM index show the dollar strengthening trend to be persistent.

 

Commodities

The CRB Raw Materials index measures prices for a broad variety of industrial inputs. Historically, this index has the highest correlation with EM equities. Following a strong rebound in 2016-2018, the index has resumed the downtrend started in 2012.

In conclusion, after the recent rally in EM assets, some caution is warranted. For investor optimism to be rewarded, it is important that the three pillars of EM asset prices (global liquidity, the dollar and commodities) turn favorably. Perhaps the greatest cause for bullishness would be a conviction that China’s efforts to stimulate its economy through fiscal and monetary measures will bare fruit during the course of the year. So, investors should focus keenly on the data coming out of China.

Trade Wars

  • A look at the future of Sino-U.S. relations (Li Lu Himalaya Capital)
  • The internet has become a battleground between the U.S. and China (WSJ)
  • Senator Rubio’s report on the China threat (U.S. Senate)
  • Is China or Russia are new rival (The Atlantic)
  • China, an existential threat for the 21st century (NYT)
  • New Zealand feels China’s anger (NYT)
  • The trade war is only about theft of technology (Project Syndicate)

India Watch

  • India curbs create chaos for Amazon and Walmart (Bloomberg)
  • India’s big upcoming election (Lowy)
  • India’s vote-buying budget (Project Syndicate)
  • India looks to China to shape mobile internet (WSJ)
  • Amazon adapts to India (WSJ)
  • India’s love of mobile video (WSJ)
  • India’s potential in passive investing (S&P)
  • India’s food-delivery startup, Swiggy, backed by Tencent (SCMP)
  • Modi’s election troubles (WSJ)

China Watch:

  • Haier’s turnaround of GE Appliances (Bloomberg)
  • China’s consumer is losing confidence (WSJ)
  • China real estate bubble (Nikkei)
  • Will China fail without political reform? (Project Syndicate)
  • S&P gets go-ahead to issue China debt ratings (WIC)
  • Stable growth expected for China’s Economy (AMP Capital)
  • China’s infrastructure spending to boost economy (SCMP)
  • The new Beijing-Moscow axis (WSJ)

China Technology

  • CTrip’s strategy (Mckinsey)
  • DJI’s rise (SCMP)
  • China’s decade-long Bullet-train revolution (WIC)
  • China’s lead in EVs and EV infrastructure (Columbia)
  • China’s high-flying car market (McKinsey )
  • China’s place in the autonomous vehicle revolution (McKinsey)
  • Can China become a scientific superpower? (The Economist)

Brazil Watch

  • Brazil’s finance guru (FT)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

  • Globalization in Transition (mckinsey)
  • World Bank Report, Global Economic Prospects (World Bank)
  • Indonesia’s economic populism (The Economist)
  • EM’s Corporate debt bomb (FT)

Tech Watch

Investing

 

 

 

 

 

Shedding Some Light on China’s GDP Data

China watchers have long debated the reliability of the country’s GDP numbers, and for many years the pessimists have argued that official figures are overstated. This is not a trivial debate anymore because China has become a major driver of global growth over the past decade, on par with the United States. Recent signs of slowing growth in China, blamed on trade wars and declining consumer confidence, have only heightened the debate.

The first thing to understand  about China’s GDP is that the concept of GDP targeting in China is very different from what investors are familiar with,  and this leads to confusion. One insightful  China watcher, Michael Pettis, who is  professor at Peking University’s Guanhua School of management, makes this argument in a recent article (What is GDP in China?). Pettis reminds us that the Chinese, with their deep tradition of economic planning, think of GDP as a pre-determined input figure not as a variable output. It is not a coincidence, therefore, that magically year after year the Chinese meet their GDP growth goal. Part of the reason for this may be some window-dressing for political reasons but much of it comes from active intervention. For instance, if the economy appears to be running below expectation, the authorities will respond quickly with increased spending and lending to set it back on target.

Unlike the U.S. Fed, which has only the blunt tool of monetary policy to achieve its pretentions of smoothing out the economic cycle (eg. Ben Bernanke’s “Great Moderation”), the Chinese authorities have an expanded toolkit of monetary policy, bank lending and fiscal spending which they have immediate access to.

Of course, achieving such fine tuning is easier said than done. The pessimists on China will argue that the Chinese authorities have exhausted the utility of these tools.  This may be because of a combination of excess debt and declining returns on fixed capital investments in real estate and infrastructure, and also because saturated foreign markets have become a much more volatile driver of growth. This state of affairs increasingly has raised the issue of the “quality” of China’s GDP growth. If the GDP numbers are being achieved by increasing debt that won’t be repaid – either for domestic investments or for ports in Pakistan – and the end-result is more empty real estate and under-used bullet trains, than the effort is counterproductive. The Chinese have long been aware of the unbalanced nature and the limits of their debt-driven fixed-asset investment model, but it is not easy to change behavior. China’s vice president, Wang Qishan, reiterated the government commitment to its GDP growth target this week in Davos. Wang pledged,   “There will be a lot of uncertainties in 2019, but something that is certain is that China’s economy, China’s growth, will continue and will be sustainable.” In other words, the authorities commit a-la-Draghi to do “whatever it takes” to meet the 6.5% annual growth target.

Nevertheless, foreign observers are always skeptical of China’s growth figures and seek alternative yardsticks to corroborate the official data. For example, electricity consumption is looked at in comparison to GDP growth. The recent numbers forelectricity consumption, shown below, at least have the merit of displaying year-to-year variability.

Along this line,  Barclay’s bank looks at a series of alternative indicators to provide a comparison to official figures. Based on this exercise, Barclay estimates that China’s economy has been performing well below targets for the past five years.

 A new paper by Yingya Hu and Jiaxiong Yao  of John Hopkins University  (“Illuminating China’s GDP Growth) uses a very innovative methodology and arrives at the same conclusion. Hu and Yao analyse  satellite-reported nighttime light over time to measure changes in economic activity. As shown below, they estimate that China’s GDP may be some 20% overstated. The authors have done this for a wide variety of markets and find the data in China to be one of the most overstated. As shown below, India is also slightly overstated while both Brazil and South Africa are actually understated. 

It is not clear what is causing this discrepancy in China. One theory is that a significant part of the real-estate stock remains dark, as properties are being bought for investment purposes and not occupied.

In any case, these theories of overstated GDP growth raise several worrisome questions. First, this may be evidence that the authorities may be pursuing unproductive policies as marginal returns from debt accumulation and fixed asset investments have declined.  Second, the country’s very high credit/GDP ratio of 300% may be significantly understated, and could be closer to 360%.

Trade Wars

India Watch

  • Amazon adapts to India (WSJ)
  • India’s love of mobile video (WSJ)
  • India’s potential in passive investing (S&P)
  • India’s food-delivery startup, Swiggy, backed by Tencent (SCMP)
  • Modi’s election troubles (WSJ)

China Watch:

  • What next for China’s development model (Project Syndicate)
  • An entrepreneur’s tale of adaptation (NYT)
  • China boosts new airport spending (Caixing)
  • An analysis of nightlight points to overstated Chinese GDP (JHU)
  • China’s slowdown (CFE)
  • China’s GDP (Carnegie Pettis)
  • Zero growth in car sales expected for 2019 (Caixing)
  • Looking back on 40 years (Ray Dalio)
  • China steps up bullet train spending (scmp
  • On sector investing in China (Globalx)
  • The Future Might Not Belong to China (FT)
  • Will China reject capitalism (SCMP
  • The rise of China’s steel industry (WSJ)

China Technology Watch

Brazil Watch

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

EM Investor Watch

  • Indonesia’s economic populism (The Economist)
  • EM’s Corporate debt bomb (FT)
  • Holding’s digital transformation (Mckinsey)
  • Lowy Institute Asia Power Index (Lowy
  • In pursuit of prosperity (Mckinsey)
  • What drives the Russian state? (Carnegie)
  • Russia’s big infrastructure bet (WSJ)

Tech Watch

Investing

 

 

 

 

 

 

 

The Last Ten Years in Emerging Markets

 

 

Around the world asset prices performed poorly in 2018, and  U.S. dollar cash had the best returns of any major asset class. Emerging markets, as all international assets, suffered from the combination of a slowing global economy, falling commodity prices and a rising dollar. Global Emerging Markets (GEM), according to the MSCI EM index, fell by 16.6% in 2018, of which 4.4% can be attributed to the USD’s rise against EM currencies.

The Table below shows returns for the primary EM countries and U.S. stocks for the past ten years. 2018 was the second time over the last ten years when every country provided negative returns, though 2011 was also painful because only Indonesia gave positive returns that year.

Brazil and Peru were the best performing EM markets in 2018. These two countries are also the best EM performers over the past three years. Brazil has now appreciated 120% since it bottomed in January 2016. This compares to a 30% return for the S&P 500. This is a good reminder that markets should be bought at the point of maximum pessimism, particularly if, like Brazil, they are large and diversified and the country has stable institutions. Of course, this is difficult to do, especially for large institutional investors.

Returns across the asset class are volatile and unpredictable. For example, over the period, Brazil has been a top-2 performer three times and also in the bottom-2 three times. Russia also has careened from top to bottom regularly.

The table also shows returns for the past decade, a period marked by unorthodox monetary policies and Quantitative Easing.  It has been a tough slog for EM, as investors have achieved only 5.5% annual returns compared to the 10.8% annual returns in the U.S. stock market. Nevertheless, three EM markets – Thailand, Philippines and Indonesia – did better than the U.S. The USD has been strengthening relative to EM currencies since 2012. This has reduced returns in EM by 1.5% annually over the decade, from 7% to 5.5%.

.

Looking Back: what explains performance?

Currency

Currencies had major impacts on performance for Global Emerging Markets and individual countries. Currencies tend to trend over multi-year periods and the past seven years have seen a persistent strengthening dollar. Many EM commodity producers saw currency appreciation until 2012, but when commodity prices reverted the currencies also turned down. The chart below shows annual returns for EM countries in both USD and local currency. Of the eight EM markets with the highest annual returns, six – Thailand, Philippines, Peru, Korea, Taiwan and China – has stable currencies relative to the USD.  The bottom eight, with the exception of Chile all had very weak currencies.

EM Countries Annualized Returns

  
 

USD

Local Currency

Difference

Thailand

12.6%

11.9%

0.7%

Philippines

11.5%

12.6%

-1.1%

Indonesia

10.9%

14.1%

-3.2%

USA

10.8%

    

India

9.1%

13.1%

-4.0%

Peru

8.7%

8.5%

0.2%

Korea

8.3%

7.0%

1.3%

Taiwan

8.2%

7.5%

0.7%

China

5.6%

5.7%

-0.1%

GEM

5.5%

7.0%

-1.5%

Malaysia

4.2%

6.1%

-1.9%

S. Africa

3.8%

8.5%

-4.7%

Russia

3.7%

9.9%

-6.2%

Chile

3.5%

4.4%

-0.9%

Mexico

2.7%

6.4%

-3.7%

Colombia

2.0%

5.9%

-3.9%

Brazil

1.7%

7.0%

-5.3%

Turkey

-1.4%

11.6%

-13.0%

Earnings and Multiple Expansion

The chart below looks at the evolution of Cyclically Adjusted Price Earnings Ratios (CAPE)  and earnings over the last ten years. The seven best performers all saw expansion in the CAPE multiple, which means investors are now paying more for stocks relative to their earnings power than they did ten years ago. The top nine performers also experienced healthy annualized earnings growth, so that by the end of the period investors were paying higher multiples on a significantly higher earnings base.

The opposite is true for the bottom eight, the laggards. These all saw multiple contraction (except Mexico) and flat to negative earnings growth.

 

CAPE as a Predictor of Future Returns

Though over the short-term valuation is a poor timing instrument, over ten-year periods it should have some forecasting value and/or at least serve as an allocation tool. Unlike in 2007, when valuations in many EM countries had reached extremely high levels both in absolute terms and relative to history, at year-end 2008 valuations in EM were closer to the historical norm (based on a 15-year trailing average of CAPE ratios).The following two tables below show the situation at the end of 2017 and then a year-end 2018. Note the remarkable contraction in CAPE multiples that occured between 2007 and 2017 and led to very poor returns over that ten-year period.

Nevertheless, five of the countries with better returns over the 2008-2018 period, started with CAPE ratios below average and saw multiple expansion (Thailand, Indonesia Korea, Taiwan). Two of the worst performers started with CAPE ratios above average and saw multiple contraction (Brazil, Colombia).

Using CAPE as an allocation tool is probably most effective at the extremes. At the end of 2008 this was clearest with the S&P 500 with a CAPE of 15.2 compared to a 15-year average of 27.8, which pointed to a significant opportunity to buy.  Also, Colombia, with a CAPE of 23.6 compared to an average of 16.8 was notably out of line, and this was a strong argument to sell.

Trade Wars

  • Seven issues will drive the trade talks (Caixing)
  • King dollar? (Kupy)
  • Europe is wary of Chinese M&A (SCMP)
  • Obama administration view on China issues (Caixing)
  • China’s tantrum diplomacy   (Lowy)
  • Making sense of the war on Huawei  (Wharton)
  • The war on Huawei (Project Syndicate)

India Watch

  • India’s potential in passive investing (S&P)
  • India’s food-delivery startup, Swiggy, backed by Tencent (SCMP)
  • Modi’s election troubles (WSJ)

China Watch:

  •  
  • Looking back on 40 years (Ray Dalio)
  • China steps up bullet train spending (scmp
  • On sector investing in China (Globalx)
  • The Future Might Not Belong to China (FT)
  • Will China reject capitalism (SCMP
  • The rise of China’s steel industry (WSJ)
  • Nobel economists comment on Chinese model (ECNS
  • Learning from China’s development model (scmp)
  • China debates economic policy (FT)
  • China is stepping-up infrastructure investments again (Caixing)
  • China’s radical experiment (Project Syndicate)

China Technology Watch

Brazil Watch

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

EM Investor Watch

  • Koc Holding’s digital transformation (Mckinsey)
  • Lowy Institute Asia Power Index (Lowy
  • In pursuit of prosperity (Mckinsey)
  • What drives the Russian state? (Carnegie)
  • Russia’s big infrastructure bet (WSJ)

Tech Watch

Investing

What Caused Brazil’s Great Recession?

The debate continues on what caused Brazil’s most recent economic crisis, the deepest and longest the country has experienced since the Great Depression.

Nobel Laureate, Paul Krugman, gave his view in his New York Times column a few weeks ago (“What the Hell Happened to Brazil?”,  Link). Krugman points to “bad luck” in the form of a severe terms- of- trade shock caused by falling commodity prices, which in turn led to an unwinding of excessive household debt and a severe drop in domestic consumer spending. Brazil, according to Krugman, underwent a debt deflation process, not the typical “sudden stop” emerging market crisis where a build-up in foreign debt reverses when foreign capital abandons a country. The duration and depth of the recession, Krugman believes, were caused by bad policy mistakes: a combination of fiscal austerity and monetary tightening, at a time when Keynesian stimulus could have been effective.

Barron’s Magazine has also chimed into the debate with two articles by Mathew Klein (“Understanding Brazil’s Latest Depression” and “What Triggered Brazil’s Crisis,” Link).  Klein points to a massive increase in private debt between 2005-2015 which was accompanied by a large increase in foreign capital inflows, mainly into stocks and bonds. When the capital flows reversed in 2012-14 and the downturn began, the Brazilian authorities tightened both fiscal and monetary policies and deepened the fall, Klein writes echoing Krugman. Klein notes a fiscal adjustment of 5% between 2013 and 2016 (from a surplus of 2% to a deficit of 3%) but still agrees with Krugman that the authorities were too conservative on the fiscal front and focused largely on the tightening of monetary policy to stabilize financial markets.

Both the Krugman and Klein articles are insightful, but I take issue on several points. First, both Klein and Krugman make a glaring omission by not considering political factors. The reelection of President Dilma Rousseff  (October 2014) was a great disappointment for the business community and financial markets and probably triggered the start of the recession. At the same time, Brazil entered an enormous political crisis, with the explosion of the “Car Wash” graft probe (initiated in 2014, and still going on)) which implicated hundreds of businessmen and their political cronies.  This was soon followed by the impeachment of President Dilma (2015). These unsettling political events certainly played a big role in deepening and extending the downturn.

Second, both Klein and Krugman somewhat mischaracterize the crisis: Krugman, by arguing that Brazil’s woes were more akin to a developed market crisis and could have been alleviated through  stepped-up fiscal spending; and Klein, by stating that the commodity cycle (2003-2012) should be considered  largely irrelevant to the discussion.

I think the evidence does no support Krugman’s idea. In fact, the crisis should be seen as a garden-variety boom-to-bust emerging market crisis. This is clear if we put the event  in the context of the many EM crises of the past decades.  Ray Dalio’s book Principles for Navigating Big Debt Crises (Link) provides a good account of the record. Dalio’s “Economic Machine” concept is that financial crises are linked to debt cycles which evolve in predictable patterns and all go through three phases:  the bubble build-up, the depression  adjustment and the reflationary recovery.  Dalio looks at the specifics of 48 crises, 23 of which occured in major emerging markets and are summarized in the chart below. Brazil’s latest crisis is not included in Dalio’s book but I have added it for comparative purposes. The chart shows each country’s characteristics at the peak of the boom cycle in terms of the following criteria:

  • Expansion of the Debt to GDP Ratio of at least 5%
  • Foreign Debt to GDP of at Least 30%
  • Fiscal Deficit at least 2% of GDP
  • GDP Output Gap of at least 5% (GDP 5% over trend growth)
  • Currency at least 10% overvalued
  • Current Account Deficit over 3% of GDP

When a country meets most of these criteria its economy is considered very overheated and vulnerable to a serious downturn.

Not every crisis is the same. Every crisis has its own particularities, but by-and-large they follow the same pattern, meeting the criteria over 80% of the time. Russia, with its structural current account surplus, is the only anomaly, with both booms and busts dictated by oil-driven terms-of-trade shocks.

Brazil’s crisis fits like a glove, amply meeting all the criteria with the exception of “foreign debt to GDP.” But, even this exception is due only to nomenclature, because foreign capital inflows this time took the form of  direct investment in Brazil’s liquid bond markets instead of foreign debt. Brazil does in fact experience a pretty standard “sudden stop” when the end of the commodity boom leads to a reversal in capital flows.

In regard to Klein’s discounting of the relevance of commodities as a major factor, I think this is very unlikely. Brazil, with its historical dearth of domestic savings, has always been very sensitive to terms-of-trade shocks. This latest boom-to-bust cycle for Brazil starts with the China-driven boost in commodity prices in 2003 and comes to an end with the collapse in prices that begins in 2012. A glance at any commodity chart confirms this.

Though Brazil is not nearly as sensitive to commodity prices as Russia, they still do matter a lot in that they drive the current account; and when they rise  a solvency effect occurs which lowers country-risk perceptions and attracts foreign capital flows.

I think we can safely say that Brazil experienced an entirely traditional boom-to-bust cycle triggered by an increase in commodity prices.

However, the duration and depth of the crisis are more difficult to explain. In the past, Brazil’s economy always proved to be resilient and bounced back quickly from downturns, but this decline  has lasted longer and caused more pain.   So, what happened?

Why Did Brazil’s Recession Dragged on for so Long?

Both Krugman and Klein blame Brazilian policy-makers for the economy’s extraordinary downturn. But, in arguing that traditional Keynesian fiscal stimulus would have worked, Krugman shows a lack of sensitivity for the “curse” of emerging markets, which is precisely the difficulty of implementing counter-cyclical policies. This “curse,”  which is arguably the defining characteristic of EM, exists mainly because of “hot” and fickle  foreign capital flows, and this is especially true for a savings-defficient  economy like Brazil’s facing a term-of-trade shock.

Klein is closer to the mark by stating that policy makers obsessed over meeting inflation targets because of Brazil’s recent experience with hyper-inflation.

Dalio’s data-base is useful to determine how the recent Brazilian crisis may be unique in terms of how policy makers responded. In Dalio’s framework, the bubble is followed by a “depression,” typically resulting in a deleveraging which sets the base for an eventual reflation period and the start of a new cycle. The chart below looks how during past EM crises emerging market policy makers have typically “engineered,” willfully or not, this depression phase. We focus on the three main levers of adjustment: currency devaluation, current account adjustment and inflation.

What we see clearly is that adjustment periods are all essentially the same, and Brazil in 2012-2017 is no exception. Countries devalue to smoothen the adjustment in the current account and they allow inflation to ramp up. Both devaluations and inflation are taxes on consumption, which drive the adjustment.

But, policy makers in Brazil opted to “cushion” the adjustment. We can see this in the following three charts.

Devaluation – The Brazilian real was allowed to fall, but slowly and not nearly as much as in previous downturns, and not enough to adjust the current account. Brazil’s authorities probably felt that the huge foreign currency reserves accumulated during the commodity boom gave them the luxury to soften the BRL’s decline, and this was orchestrated in the name of financial stability.

Current Account –  The current account adjusted, but only after commodity prices staged a rally in 2016-2017.  The lack of a strong current account adjustment in the face of a terms-of-trade shock is very unusual.

 

Inflation –  Inflation rose briefly, but was then squashed by extremely tight monetary policy. Brazilian real rates (after inflation) rose to as high as 7% at a time when U.S. and European real rates were negative.

Why did policy makers choose this path? First, politics interfered, as Rousseff primed the economy to ensure her reelection in 2013-14. This served to  worsen conditions and delay the adjustment. Also, I agree with Klein that the the Central Bank’s obsession with inflation-targeting was  rooted in historical experience. Policy makers understood that inflation is a direct and exclusive tax on the poor because the owners of capital in Brazil have safeguards. But, at the same time, the Central Bank in Brazil, like elsewhere, being a  captive of financial markets may have seen its mandate to be to preserve financial stability at any cost. By allowing greater changes  in both the value of the BRL and the level of inflation, authorities could have imposed a greater cost on foreign holders of domestic debt and domestic dollar-indebted corporates but they were very reluctant to do this.

Ironically, though financial stability was well maintained in Brazil and inflation was contained, it was still the poor that bore the burden of the crisis. This time it was not through the inflation tax but rather through a long and brutal decline in employment and wages.

Also, the policies had two highly perverse effects (shown in the charts below).

  • Very high interest rates dramatically increased public debt levels, causing a new source of potential stress. Brazil failed to take advantage of the crisis to engineer a deleveraging of the economy and set a new base for a new reflationary debt cycle.  The debt-to-GDP ratio actually increased by nearly 30 points since 2012, and now public debt sits at precariously high levels.  We can contrast this with the significant deleveraging that occured in the 2002 recession, setting a base for the economic boom starting in 2004.
  • The relatively strong and stable BRL encouraged Brazilian corporates to borrow in international markets, also creating a new source of stress. External debt to GDP has risen from 18% of GDP in 2012 to 27% in 2017 (World Bank data), now approaching dangerous levels.

If every crisis creates opportunities, in this case Brazil failed. On the other hand, the crisis led to the rise of Bolsonaro and the prospect of liberal reforms, so maybe it was not a total loss.

External Debt Metrics

 

Macro Watch:

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

Trade Wars

  • The road to confrontation (NYT)
  • The real China challenge (NYT)
  • China and the uS are on a collission course (brookings)
  • How Trump and Xi got into a trade war (WSJ)

India Watch

  • Election uncertainty clouds Indian stock market (FT)
  • India electrification to impact copper demand (Gorozen
  • Can the rupee become a hard currency? (Livemint)

China Watch:

  • China picks tobacco taxes above public health (WIC)
  • How free is China’s internet? (MERICS)
  • China extends its global influence (NYT)
  • How cheap labor drives China AI (NYT)
  • China’s property barons (SCMP)

China Technology Watch

  • A profile of Bytedance, Chna’s short-video ap (The Info)
  • Sense-time’s smart cameras (Bloomberg)
  • China’s Electric Vehicle push (Bloomberg)

Brazil Watch

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

EM Investor Watch

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

Tech Watch

  • Why have solar energy costs fallen so quickly (VOX
  • Asia leads in robot adoption (QZ)
  • The new industrial revolution (WSJ)

Investing

  • The top 100 asset managers in the world (Thinking Ahead)
  • An evolve or die momeent for the world’s great investors (Fortune)
  • Interview with William Eckhardt (Turtle Trader)
  • Why momentum inveting works (Anderson)

 

The Outlook for Emerging Markets Stocks

 

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

Poor Global Liquidity is Bad for EM Equities

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

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

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

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

Chart2. Dollar Reserves held by Central Banks (FED)

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

Valuations are Compelling

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

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

 

 

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

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

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

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

 

Macro Watch:

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

India Watch

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

 

China Watch:

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

China Technology Watch

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

EM Investor Watch

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

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

Investing

 

 

 

Global Growth Trends and Emerging Markets

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

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

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

 

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

 

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

 

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

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

Conclusions

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

Macro Watch:

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

India Watch

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

China Watch:

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

China Technology Watch

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

EM Investor Watch

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

Tech Watch

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

Investing