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Emerging market stocks outperformed the S&P 500 during the third quarter, primarily due to new promises of economic stimulus from China’s government. However, emerging markets underperformed the S&P 500 during the first nine months of 2024, extending a long losing streak. This marks the seventh consecutive year of underperformance by emerging markets and the tenth in the last eleven years. The recent outperformance of emerging markets, driven by a surge in Chinese stocks, has brought the S&P 500’s valuation premium down to more reasonable levels.

The U.S. market appears to be experiencing a blow-off rally, fueled by a broad consensus on an immaculate soft landing for the U.S. economy and optimism about AI-driven productivity growth. The U.S. market is also benefiting from a remarkable resurgence in profit margins, driven almost exclusively by the “Magnificent Seven” technology giants.

The strength of the S&P 500 can be attributed to both multiple expansion and earnings growth. The recent outperformance of emerging markets, driven by a surge in Chinese stocks, has brought the S&P 500’s valuation premium down to more reasonable levels, but it remains elevated though well below in 2000 or 2015—the last two opportunities to generate extraordinary relative returns in emerging markets. The rising valuation premium over the past three decades reflects the U.S. market’s transition from one dominated by capital-intensive cyclical businesses to one dominated by capital-light companies with persistent and rising monopolistic profits.

Earnings growth has been the main driver of the S&P 500’s outperformance relative to emerging markets over the past ten years, as shown below. While emerging markets have been in a prolonged earnings slump, S&P 500 earnings have surged since 2014, largely due to the spectacular margin expansion of the tech giants. Although the strong dollar has contributed, it accounts for only about 20% of the relative outperformance. Thus, the key question for investors is: How much longer can the “Mag 7” phenomenon continue?

The chart below estimates the current expected returns for emerging markets and the S&P 500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings (CAPE) ratio, which calculates the average of inflation-adjusted earnings over the past ten years, helps to smooth out earnings cyclicality. This tool is especially useful for highly cyclical assets like emerging market stocks and has a long history of use among investors, gaining popularity through the work of Professor Robert Shiller at Yale University. We use dollarized data to account for currency trends, and the seven-year expected returns are calculated assuming each country’s CAPE ratio will revert to its historical average over time. Earnings are adjusted according to each country’s position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (April 2024).

As expected, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those with CAPE ratios above their historical average. These expected returns are based on two key assumptions: first, that the current CAPE levels relative to historical averages are unjustified; and second, that market forces will correct the discrepancy. Historical data strongly supports the second assumption over seven- to ten-year periods, though not in the short term (one to three years). The model may give a false signal if a country’s historical CAPE average is out of sync with its growth prospects. For example, one could argue that Chile’s current growth prospects do not justify its historically high CAPE ratios.

Nonetheless, when “cheap” markets on a CAPE basis exhibit short-term outperformance (one year or less), investors should take note, as the combination of value and momentum is compelling. As shown in the chart below, the current environment does not support using CAPE as a timing tool for investment. Over the past twelve months, investing in the “cheapest markets” (on the left side of the chart) has yielded mixed results, working well for Colombia and Turkey but not for Brazil or Chile. Meanwhile, expensive markets (on the right side of the chart), such as the U.S., India, Thailand, and Malaysia, have delivered stellar results. This suggests that, for now, liquidity—not value—is driving performance.

Looking ahead, Colombia, Peru, and the Philippines appear well-positioned to perform, as they offer both cheap valuations and momentum and are in the early to middle phases of their business cycles. However, rising geopolitical tensions and sluggish global growth create a less favorable investment environment. As always, a strengthening dollar indicates the need to remain invested in dollar-denominated quality assets.

Much of the excitement that investors have for emerging markets is anchored in the idea that developing countries grow faster than the sclerotic rich countries of the West and that this growth brings opportunities for extraordinary portfolio returns. Unfortunately, this is largely wishful thinking, as the evidence shows that countries in the developing world have experienced mediocre growth. Nevertheless, there have been important exceptions. A select group of countries have achieved periods of “miracle growth,” allowing them to significantly reduce the income gap with rich countries.

Developing countries, including many key emerging markets, have grown at a slower rate than the bellwether economy of the United States since 1980. This period includes the entire modern era of emerging market institutional investing, which can be considered to have started in the mid-1980s with the launch of the IFC and MSCI indices. It covers the entire era of the “Washington Consensus” for free trade and capital movements, which theoretically should have favored developing countries, and also coincides with a significant decline in the rate of growth of the American economy. The data from the World Bank on GDP per capita growth in dollar terms from 1980-2023 is shown below. About two-thirds of countries have grown at a slower rate than the United States. In emerging markets, these laggards include most of Latin America and Africa—countries which, with the exception of Mexico, failed to participate in the globalization trend. On the other hand, the “convergers,” with the exception of India and Egypt, are all countries that deeply benefited from expanding global trade.

Of the convergers listed above, few achieved impressive growth levels; Turkey, Bangladesh, Egypt, Chile, Indonesia, Malaysia, and India all grew GDP per capita by less than 3% per year. Very few countries are achieving the kind of “miraculous” growth that can be transformational over a generation.

The chart below highlights the few countries that have aspired to “miracle” growth status. True economic “miracle” growth stories have been exceptionally rare in the past 60 years. Only five countries—Singapore, Taiwan, South Korea, and China—have achieved the high GDP growth over extended periods necessary to make giant leaps in the rankings of the wealth of nations. This group of countries, the so-called Asian Tigers, all pursued similar export-oriented mercantilist policies based on the repression of domestic wages and benefited greatly from U.S.-sponsored trade liberalism.

Several countries once labeled “miracles” have been unable to sustain growth. These countries have seen their miracle growth aborted for a variety of reasons related to poor governance and weak institutions. Latin American economies once considered to be on the “miracle” path, such as Brazil and Chile, have fallen into “middle-income traps” characterized by low growth and political and social instability. Brazil, in particular, rejected the globalization trend, doubling down on its reliance on commodity exports. Botswana, once considered the stellar success of Africa, has also slowed.

The integration of Eastern Europe into the rich economies of Western Europe has been an outstanding success, allowing countries like Poland to make significant strides toward convergence, which appears to be sustainable. Poland and other countries of Eastern Europe have benefited from exceptional financial assistance from Western governments and abundant access to private capital made possible by geopolitical and historical considerations.

Most of the miracle economies of the past decades have exhausted the high-growth phase and are now expected to experience mundane to low growth. The chart below shows the IMF’s GDP growth expectations for the remainder of the decade. The new growth hopefuls—Bangladesh, India, Vietnam, and the Philippines—will face more difficult conditions than in the past, as the U.S.-imposed “Washington Consensus” has been replaced by deglobalization and geopolitical conflict.

 

A basic characteristic of emerging markets is a high level of income inequality. Most countries have small elites that dominate politics and business and control a large share of financial income and assets. Income concentration creates a chasm between the elites and the general population, significantly reducing the market potential for business, and thereby reducing investment, employment, and consumption.

 

 

 

Emerging market stocks underperformed the S&P 500 during the first half of 2024, extending a long losing streak. This is the seventh year in a row of EM underperformance, and the tenth out of the last eleven years. This leaves the valuation premium of the S&P 500 at its highest level since the peak of the tech bubble in 2000. The U.S. market appears to be enjoying a blow-off, driven by a consensual view on an immaculate soft landing for the U.S. economy and optimism about future AI-fueled productivity growth. The U.S. market is also enjoying a remarkable resurgence in profit margins driven almost exclusively by the Magnificent Seven technology titans.

The strength of the S&P 500 can be attributed to both multiple expansion and earnings growth. The valuation premium of the S&P 500, as shown below, is at very high levels, but still lower than in 2000 or 2015, which were the last two opportunities to make extraordinary relative returns in EM.

However, earnings growth has been by far the main contributor to S&P 500 outperformance over the past ten years, as shown below. While EM has been in a prolonged earnings funk, S&P 500 earnings have surged since 2014, mainly because of the spectacular margin expansion of the tech titans. Though the strong dollar has helped, it accounts for only some 20% of the relative outperformance. Therefore, the question all investors should ask themselves is how much longer the “Mag 7” phenomenon can continue?

The chart below estimates the current expected returns for EM markets and the S&P 500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings Ratio (CAPE) is calculated using the average of inflation-adjusted earnings for the past ten years, which helps to smooth out earnings’ cyclicality. This tool is particularly useful for highly cyclical assets like EM stocks and has a long history of use among investors, gaining popularity through Professor Robert Shiller at Yale University. We employ dollarized data to capture currency trends. The seven-year expected returns are calculated assuming that each country’s CAPE ratio will revert to its historical average over the period. Earnings are adjusted according to each country’s current position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (IMF WEO, April 2024).

As expected, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those considered “expensive” with CAPE ratios above their historical average. These expected returns are based on two significant assumptions: first, that the current level of CAPE relative to the historical level is not justified; second, that market forces will correct the current discrepancy. Historical data strongly supports the second assumption when considering seven-to-ten-year periods but not in the short term (one to three years).

Nevertheless, during certain periods when “cheap” markets on a CAPE basis exhibit short-term outperformance (one year or less), investors should take note, as the combination of value and momentum is compelling. As depicted in the chart below, the current environment is not particularly supportive of using CAPE as an investment timing tool. Over the past twelve months, holding the “cheapest markets” (on the left side of the chart) has had mixed results, working for Colombia and Turkey but not for Brazil, Chile, or the Philippines. On the other hand, expensive markets (right side of the chart) like the U.S., India, and Argentina have produced stellar results. It can be concluded that for the time being, liquidity and not value is driving performance.

Looking forward, Turkey, Colombia, and Peru look well-positioned to perform, having both cheapness and momentum and being in the early to middle phase of their business cycles. The Philippines looks compelling from a valuation and business cycle aspect but lacks price momentum.

Rising geopolitical tension and slow growth do not create a conducive investment environment. As always, a strengthening dollar signals the need to stay invested in dollar-denominated quality assets.

 

The U.S. dollar reserve currency regime in place since President Richard Nixon broke the dollar’s link with gold in 1971 is unique in nature and scope. It is the first fiat currency entirely reliant on the market’s trust in the issuer, which is the U.S. government, and it is the first truly global currency. Because of the lack of support from a traditional metallic anchor such as gold, U.S. monetary authorities have had to work hard to provide incentives for financial agents around the world to hold dollar assets. The policies required to preserve dollar hegemony have evolved over time as global conditions have changed. Today, the dollar system is once again experiencing significant pressures from multiple sources, including from the U.S. itself, which is questioning its usefulness.

To understand the current state of the dollar system, it is important to understand its history. The post-WWII dominance of the U.S. dollar can be broken up into six distinct phases.

Phase 1 – Bretton Woods Harmony, 1945-1964 – This period, following the Bretton Woods agreement (1947) which created a gold-anchored system centered around the U.S. dollar, was characterized by U.S. capital exports to rebuild war-torn Europe and Asia, and large U.S. current account surpluses.

Phase 2 – Bretton Woods Disharmony, 1964-1971 – The rapid recovery of European and Japanese industrial output during the 1950s resulted in manufacturing surpluses being exported to the U.S. and the beginning of U.S. trade deficits. Led by the French, who denounced America’s “exorbitant privilege” of seigniorage and trade deficits (1965), America’s main trading partners increasingly questioned the integrity of the Bretton Woods system and began to repatriate gold reserves held at the New York Fed. Rising inflation in the U.S. due to the Vietnam War and the “war on poverty” further increased concerns that the dollar was overvalued.

Phase 3 – Chaos and Inflation with the Launch of  the Fiat dollar system, 1971-1981 – The cutting of the gold anchor severely undermined the credibility of the dollar as a reserve currency. The 1970s saw a surge in demand for alternatives, including gold, the Deutsche mark, the Swiss franc, and the Japanese yen. Two key policy initiatives successfully checked the dollar’s decline. First, in 1974 the U.S. convinced Saudi Arabia to invoice oil exports in dollars and channel its central bank reserves into U.S. T-bills. In exchange, the U.S. agreed to provide defense guarantees and military hardware. This recycling of oil revenues into U.S. financial assets created a new anchor for the dollar sometimes called the Petrodollar system. Second, in 1981 U.S. Federal Reserve Chairman Paul Volcker jacked up interest rates to nearly 20% to shock inflation into decline. Concurrently, the elections of Ronald Reagan in the U.S. and Margaret Thatcher in the U.K. launched the Washington Consensus for free markets and free capital flows in global markets. These deflationary policies started a 40-year trend of falling prices and interest rates.

Phase 4 – The Heyday of the Dollar, 1981-2001 – This period can be considered the zenith of the dollar system. It starts with Reagan and Volcker and is marked by disinflation, the globalization of trade and capital flows, and the great financialization of the American economy. The pillars of this phase of peak dollar hegemony were (1) persistently high U.S. current account deficits that were recycled into U.S. financial assetss by America’s mercantilist trade partners (Japan, Germany, Korea, Taiwan) and commodity producers; (2) an increasingly activist and interventionist U.S. Fed that aimed to backstop Wall Street; and (3) a relatively stable oil price which buttressed the Petrodollar system. During this period the dollar’s share of total central bank international reserves went from 22% to 64% while gold’s share fell from 65% to 15%.

Phase 5 – Chimerica and Fed Adventurism, 2001-2012 – The entry of China into the WTO in 2001 heralded “hyper-globalization” and China’s economic miracle and infrastructure boom, resulting in a commodity super-cycle. The deflationary impact of China trade offset the inflation caused by the surge in the price of oil and other commodities, allowing the U.S. to pursue expansionary monetary policies. The extraordinary surge in China’s exports to the U.S. gave rise to the “Chimerica” concept, by which China’s enormous trade surpluses were recycled by China into U.S. treasury securities. The Great Financial Crisis saw the U.S. Fed doubling down on its commitment to buttress Wall Street and the Great Financialization, allowing Fed Chairman Bernanke to aggressively pursue expansionary monetary policies aimed at boosting asset prices to create a “wealth effect.”

Phase 6 – A New Cold War, Sanctions Diplomacy, The Anchorless Dollar, 2012-2023 – Xi’s rise to power in China in 2012 marked the end of the China “economic miracle” and resuscitated the traditional Leninist ideology abandoned in the 1980s, with a focus on reestablishing Party control over all aspects of Chinese politics and society. The shift in China completely undermined the premise of “Chimerica” and transformed what has been seen as a beneficial partnership into a bitter rivalry. Over the past decade, a new Cold War has spawned an alliance of anti-American countries (China, Russia, Iran, North Korea) all of them facing U.S. financial sanctions. Since 2012, the U.S. dollar has been essentially anchorless for the first time since the early 1970s, without a clear mechanism for recycling U.S. trade deficits into U.S. assets. Dollar hegemony has been threatened by a broad initiative by China and others to diversify reserves into alternatives. This has meant mainly a revival in interest in gold but also China’s efforts to create a “sinodollar” by recycling dollar reserves into loans as part of Xi’s Belt and Road Initiative. China has also structured several bartering agreements with Russia, Iran, Saudi Arabia, and others which aim to bypass the dollar system.

The dollar’s strength since 2015 has relied on a fortuitous combination of the two factors that historically have boosted the value of the greenback. First, growing geopolitical tensions have raised the dollar’s safe-haven status, leading to massive amounts of capital flight into U.S. assets. By some estimates, capital flight from developing countries into the U.S. has been in the order of $1 trillion annually, over half of that coming from China’s private sector (Brad Setser, CFR). Second, America has experienced a remarkable phase of economic “exceptionalism” underpinned by the shale oil boom and by the extraordinary global domination and financial success of its Silicon Valley tech titans. This powerful phase of American Exceptionalism has boosted growth and wealth creation in the U.S. and sucked in savings capital from around the world.

The chart below illustrates how the dollar has trended according to economic, political, and social factors related to growth, inflation, and cycles of American malaise and exceptionalism.

The next chart looks at the M2 measure of money supply in real terms in the U.S., highlighting how Fed policy became more and more activist and interventionist over time. From the end of Bretton Woods in August 1971 until mid-1997, the Fed pursued a tight monetary policy, with annual increases of M2 at 1.45%. In the mid-1990s Fed Chairman Alan Greenspan, facing “exuberant” markets and increasing leverage in the financial system, moved the Fed’s focus to monitoring systemic risk. In reaction to repeated “shocks” (e.g., the Asian and Russian financial crises, the collapse of the LTCM hedge fund, the bursting of the tech bubble, and the Great Financial Crisis), the Fed injected liquidity into the financial system. Under Greenspan, Bernanke, and Powell, the Fed has injected increasingly large amounts of liquidity to preserve financial stability. Starting in 1997, in sharp contrast to its previous behavior, the Fed has always increased the money supply during downturns. The annual real increase in M2 over the 1997-2024 period has been 3.82%, nearly three times the rate of growth of the 1971-1997 period of Fed monetary discipline.

The following chart shows the long-term evolution of the composition of reserves held by central banks around the world. Under the Bretton Woods system, central banks held mainly gold reserves while gradually increasing dollars and reducing sterling. After the collapse of Bretton Woods, central banks shifted reserves back into gold and into alternative currencies (mark, yen, franc), so that by 1980 the share of dollar reserves had fallen back to the 1962 level. During the dollar’s heyday, from 1981 to 2001, dollar reserves rose from 22% to 65%, mainly at the expense of gold. Since 2001, the dollar’s share of reserves has been gradually eroded by the euro and alternative currencies. Over the past ten years, central banks, led by China, have started to accumulate gold reserves, ending a 30-year period of neglect for the “barbarous relic.”

The defining characteristic of dollar hegemony has been large and chronic U.S. current account deficits, which are recycled by trading partners into U.S. financial assets, mainly T-bills. These deficits were initially denounced by the French and others as an “exorbitant privilege,” meaning that they gave America the ability to pursue growth and consumption without the discipline imposed by the classical British-run gold standard (1816-1914). As shown in the chart below, under the fiat dollar system these deficits have been persistent. During global downturns they have regularly been excessive, allowing the U.S. to serve as the consumer of last resort for the world and to promote the supply of cheap foreign goods for American consumers.

In recent years, however, under both presidents Trump and Biden, these chronic current account deficits have been blamed for the deindustrialization of America and the loss of millions of well-paid manufacturing jobs. Moreover, it is now argued that America’s loss of industrial capacity has made it very vulnerable to unreliable global supply chains and untrustworthy trading partners, leaving it weakened to address economic and security objectives. What was previously seen as an “exuberant privilege” is now widely considered an “exuberant burden,” and anti-trade policies such as tariffs and subsidies are easily justified by politicians. In the current presidential campaign, both parties have argued for “balanced trade” and justified tariffs to boost American manufacturing. Given that chronic and persistent deficits have been at the core of the dollar system, it is logical to believe that the world monetary system is in a phase of transition to something different.

The Future of the Fiat Dollar Reserve System

If the fiat dollar currency reserve model is no longer attractive for the U.S. and foreign central banks are diversifying into alternatives to the dollar, what will replace the current model? Some ideas being discussed by Washington insiders and policy think tanks are as fiollows:

1. A return to a commodity-centric model.
   • Zoltan Pozsar, a prominent financial strategist, has argued that geopolitical conflict is driving the world to a multipolar monetary system where the dollar, alternative fiat currencies, and commodities will all be important. Pozsar sees gold and a variety of other commodities anchoring the yuan and other non-dollar currencies. He points to the accumulation of gold by Russia and China and China’s initiatives to build financial ties with commodity heavyweights Iran and Saudi Arabia. According to Pozsar, a new multi-polar order will take shape where regional financial systems will dominate, at the expense of the U.S. dollar.
   • Jeff Currie, a highly regarded Wall Street commodity analyst who is currently the Chief Strategy Officer of Energy Pathways at The Carlyle Group, also sees a prominent role for commodities in a new evolving global monetary system. According to Currie, the Petrodollar system which somewhat anchored the dollar from 1974 to 2001, is being replaced by  “superconductor” commodities which are replacing oil at the center of economic activity. The countries that control the supply and stock of the metals that are cost-effective to conduct electricity (copper, silver, gold, aluminum, and nickel) will play a key role in the new system. Unsurprisingly, given its significant lead in the electrification of its economy, China has been very active in building stocks of these metals and securing global supplies in Africa, Latin America, and wherever it can deploy capital and influence.
2. A return to restricted international capital flows.
   • Prior to the 1980s and the rise of the Washington Consensus, almost all countries had controls on international capital flows. In many emerging markets, these controls were lifted only in the 1990s. In countries like Brazil, this has complicated monetary policy as “hot money” flows in during good times and leaves in bad times, and, in recent years, the deregulation of capital flows has greatly facilitated high levels of capital flight. Ironically, the U.S. has the opposite problem. With the largest and most liquid capital markets in the world and  attractive market returns available relative to the rest of the world, the U.S. is a magnet for global capital. Some analysts (e.g. Michael Pettis) have argued that the U.S. cannot address its current account deficit without taxing foreign inflows. This raises the possibility that in coming years the U.S. will be imposing regulatory restrictions on foreign inflows while countries like Brazil will be obstructing outflows.

The global monetary system may be in a phase of transition to a system that assures more balanced trade. This will produce a series of losers and winners, very different from those of the past 40 years. Mercantilist countries that repress their domestic consumption and capture foreign demand (e.g., the East Asia tigers, Germany) may have a difficult road ahead. Countries with large domestic markets and that can reindustrialize (e.g., the U.S., Brazil) may be better positioned. Regional groups with well-defined trade rules that assure balanced trade (NAFTA) may also prosper. None of this is certain, but countries should be planning for a new world monetary order.

 

As the world economy moves away from the globalization of manufacturing value chains and finance, the protection of domestic markets is back in favor with policymakers. However, the neo-mercantilists will have to overcome high costs, including overvalued currencies.

The case of TSMC’s investment in a new $40 billion semiconductor plant in Arizona is illustrative. The Taiwanese chipmaker gave in to pressure from the Biden Administration and agreed to build a “fab” in Arizona, but it does not seem to be happy about it. The company has complained about “exorbitant costs, unmanageable workers… and a lack of local expertise,” and it has repeatedly delayed the project and asked for more subsidies from Washington.

TSMC’s preference for manufacturing at home is not surprising. Taiwan is a model of successful mercantilist policies (repression of wages, directed credit, and a stable and highly competitive currency) that create fruitful conditions for manufacturing exports. Taiwan, and other Asian “tigers,” including China, carefully manage their currencies to assure export competitiveness. The U.S., on the other hand, has long favored consumers over manufacturers and has an overvalued currency, which serves as the safe haven asset for the rest of the world. Manufacturing powerhouses are all commodity poor, which facilitates currency management, while the U.S. is commodity-rich, which subjects it to repeated commodity boom-to-bust cycles. The latest of these often violent commodity cycles in the U.S. – the massive boost in shale oil and gas output from Texas’s Permian Basin – has been an important source of strength for the U.S. dollar over the past decade.

We can see the challenges faced by the U.S. and other aspiring mercantilists by looking at current and historical relative exchange rates. Below, we show the Real Effective Exchange Rate (REER) for the U.S., which measures the value of the dollar relative to the currencies of trading partners. The REER is at near-record levels for the U.S., the result of the shale oil boom, rising geopolitical risk, and a long period of economic “American Exceptionalism” marked by relatively higher GDP growth and the stock market success of America’s magnificent technology titans.

The chart below shows REERs for a sample of developed and emerging countries relative to their long-term histories (1987-2024), telling the same story. We can highlight the competitiveness of “producer” countries (Germany, Japan, Thailand, Malaysia, and Turkey) compared to “consumer” countries (e.g., the U.S., Australia, New Zealand). China and Vietnam have appreciated from very low levels but are not likely to let their currencies appreciate more in the future. Eastern European countries have lost competitiveness over this period but are unlikely to be allowed to manage their currencies downwards. The recent appreciation of the Mexican peso is probably explained by hot money flows exploiting currently high interest rates.

We look below at the annual volatility of currencies over this period. We highlight the stability of champion exporters of manufactured goods like Germany, Korea, Taiwan, Singapore, Mexico, and Malaysia.

The Big Mac Index ranking from The Economist Magazine is another good measure of the overall cost for businesses to operate in an economy, as it reflects costs from the farm, manufacturing and service sectors, including taxes and regulations. In the chart below, “producers” — countries with an established vocation for manufacturing exports — are labeled in green, while commodity producers that rely more on manufactured imports are labeled in bold black. The chart compares three data points — January 2024, 2020 pre-COVID, 2010, and 2000. We can see that across these periods exporters of manufactured goods generally have cheap Big Macs and importers have expensive Big Macs. The exemptions can be explained by either periods of excessive political turmoil and capital flight (South Africa, Argentina) or cycle-low commodity prices (2000). Mexico and Turkey, two countries that play a fundamental role in the manufacturing value chain for their respective regions, do not manage their currencies as well as the Asian “tigers.” Both suffer from more macro-economic instability than their Asian counterparts. The near-doubling of the price of the Big Mac in Mexico since 2020 is a cause for concern. In this regard, Poland is also apparently losing competitiveness in the European market. Contrast this with Taiwan’s remarkable ability to keep prices near the bottom of the table.

Brazil and the United States, two countries now enthusiastically pursuing neo-mercantilist agendas, are interesting cases with similarities. Both have severely deindustrialized while at the same time expanding energy production aggressively. Both went from being large importers of oil to self-sufficiency since 2010, which, all else being equal, should translate into stronger currencies. The implication is that neo-mercantilist policies may be pursued at a high cost, without the luxury of a weak currency.

The irony is that commodity prices are likely to remain high in the 2020s because of a more inflationary environment and production bottlenecks. This would mean stronger currencies for commodity producers and even higher costs to implement reindustrialization policies. The “commodity curse” is difficult to shed.

 

 

 

 

 

 

 

 

Emerging market stocks underperformed the S&P500 in 2023, for the sixth year in a row and the ninth  out of the last ten years. This leaves the valuation premium of the S&P500 at its highest level since the peak of the previous tech bubble in 2000. The U.S. market appears to be enjoying a blow-off, driven by a consensual view on an immaculate soft-landing for the U.S. economy and optimism on future AI-fueled productivity growth.

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

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

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

Nevertheless, during certain periods when “cheap” markets on a CAPE basis exhibit short-term outperformance, investors should take note, as the combination of value and momentum can be compelling. As depicted in the chart below, we are currently in such a period. Over the past twelve months, holding the “cheapest markets” has generated alpha in an EM portfolio. The chart shows markets from left to right based on how cheap they appeared a year-end 2022. By and large, cheap paid and expensive did not, with the U.S. and India being the two outliers, both going from very expensive to even more expensive.

For 2024, Turkey, Taiwan and the Philippines look compelling. In addition to being “cheap,” their economies are in the early phase of the business cycle and earnings are expected to be strong.

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

Lula’s speech in Salvador inauguration of Aeronautic Institute, in defense of a big activist welfare state working in benefit of the people and against the reactionary elites.

“I don’t know if you noticed that, after listening to everyone speak, it would be unnecessary to make speeches here about the Aerospace Technological Park of Bahia. But I think this is the first time I visit Bahia in 2024. And I wanted to tell you that visiting the states of the Federation will be a routine for me from now on. Unlike Jerônimo, who inherited a well-planted farm, with prepared seeds, meaning fertilizer already placed in the soil, and he is in the first year only harvesting what has been planted over the years.

I inherited a country devastated by a locust plague that destroyed almost everything we had done in thirteen years of government. I don’t know if you noticed that we no longer had the Ministry of Culture, we no longer had the Ministry of Fisheries. We never had a Ministry for Indigenous Peoples.

We not only eliminated Ministries, but we also ended public policies. Just so you have an idea, Jerônimo, it had been almost 7 years since there was a raise in the school lunch for 47 million children in this country.

Luciana knows, Luciana knows that in just one year, she had to invest much more in Science and Technology, in scholarship payments, than had been done in the previous 4 years because practically any possibility of investment in this country had been destroyed.

And what worries me is that a country the size of Brazil, with the quality of the Brazilian people and the size of the Brazilian people’s dream, cannot live on lies. We cannot live on recklessness, we cannot live on provocations, we cannot live on fake news, as if it were a 24-hour lie industry in this country.

This country needs to give itself a chance. This country is too big to be treated as if it were a small country. This country has extraordinary potential, and we have proven that twice. This country could have been recognized as the fifth-largest economy in the world long ago. But there are many people in this country who insist on regressing.

What have they done to our Petrobras? The privatization of Eletrobras. The privatization of Eletrobras, people don’t like it to be mentioned, but it was a mockery in this country in a strategic sector like the energy sector.

I am indignant because just last night I had a meeting of almost two hours with comrade Haddad discussing the economic future of this country, the perspective of what is happening in the world. And I want to tell you that I am more optimistic today than I was during the campaign, Wagner. I am much more optimistic. Because I think that we, who have taken on the role of governing an important state like Bahia, an important municipality, or an important country, cannot say that things cannot be done; we cannot say that we cannot do things.

What we need is the courage to assume our role. This country will never be the country we want if we do not consider that we need to improve the quality of life of 80% of the Brazilian population, that we need to improve the minimum wage, that the poorest people need the right and opportunity to study and work. We want to create a society of middle-class standards.

I don’t want a society with someone sleeping on the street, in the gutter, with people begging for soup at the end of the week at the city hall door. This is not the country we want. The country we want is one where everyone has equal opportunities, a chance to study, a chance to work, and take care of their lives. And we will not build this country if we are not stubborn. If we kept discussing whether we could do things, we wouldn’t do them.

So I wanted to tell you that I came here to announce the launch of an Aerospace Technological Park, and it’s not just anything. It’s important to understand, my dear Deputy Pastor Isidório, with your famous bible in hand. It is necessary to understand that we were placed in the world to persist, not to accept anything as impossible. The only thing impossible in the world is God sinning; everything else we can do, and we can do a lot. And this PAC, Jerônimo, this PAC has to be executed.

You saw what happened in Rio de Janeiro with the flood. And when any flood happens, the first response is always from the Federal Government. And people always need the Federal Government, and the Federal Government has to help.

But analyzing what happened in Rio de Janeiro, we realized that since 2013, there are several contracted works to take care of hills and streams that were not used. Most of the works were not done. Many works are only 15%, 20% complete. Only R$ 1 billion out of R$ 1.6 billion was used, and of that one billion, no work was finished, none.

So it is important, Jerônimo, that you inherited this state. You inherited a state administered for 16 years by PT people, by a person of the quality of Wagner and Rui. And you are very clever because what I saw, you have already improved a lot there. From the first speech I saw you make to today, you have already advanced a lot. You have to do more than both of them. What they did is already in the past. You know, Bahia has already used it, Bahia has already enjoyed it, and now you have to have something new.

And that’s why this year is the year of harvest. Last year we dealt with, we took over a country almost destroyed, with thousands of paralyzed projects, from daycare to university. From daycare to school, from UBS to hospitals, all paralyzed. Stubbornly paralyzed because it was not part of the logic of the past government to make this country grow. We decided to make this country grow.

So last year, we planted. We took care of plowing the land, fertilized it, planted the seeds, covered the seeds, and now the weather is good. I know that in the Northeastern sowed land, the weather is not good. The drought is affecting our small and medium producers. I want to say right now not to worry because the Federal Government will help you get out of this predicament. You can bring a piece of the bill to us; we will be partners in the reconstruction of production capacity.

So, this year is a year when I will travel a lot around Brazil. I am leaving here, going to Recife, visiting the refinery that was paralyzed for 14 years. It could already be refining 260 thousand barrels of oil per day, but it isn’t. I am going there to finish that refinery.

After that, I will launch the ITA (Aeronautics Institute) in Ceará. And why ITA in Ceará? For those who don’t know, ITA is located in the city of São José dos Campos, in São Paulo. It is perhaps one of the most important technological institutes we have in Brazil. People educated at ITA, people who graduate from ITA, know. Everyone says, “I’m a graduate engineer from somewhere.” But the ITA guy says, “I’m an engineer graduated from ITA.” Because it is a center of excellence.

And why are we going to do it in Ceará, Jerônimo? Because in Ceará, 40% of the young people who take the entrance exam to go to ITA are from Ceará. So I think we need to pay tribute to the state of Ceará by taking a branch of ITA so that it becomes as great as São Paulo.

And we will travel a lot; we will travel this country. Rest assured, Jerônimo, that if there is the inauguration of a toothpick factory, invite me, because it is necessary to show that good things happen in this country.

Sometimes you sit in front of a television, you almost fall into depression because it seems that nothing good is happening in the country, nothing good is happening in Bahia, nothing good is happening anywhere, despite the work. I want to tell you that I have never worked so much in eight years of presidency as I have this year. Because rebuilding is more difficult than doing something new. And we will rebuild this country.

Dear Alice Portugal, rest assured that you will be proud to have been a deputy again in my term as President of the Republic. And we will make this country grow again. We will make this country generate employment. We will increase the minimum wage. We will improve basic education. We will improve high school education. We will create more universities. And we will create a hundred more federal institutes in this country.

Because I want to prove once again, I apologize to the Brazilian elite, forgive me if this hits close to home, but the Brazilian elite never intended to educate our people. I say this repeatedly. And I will tell you why. This country was discovered in 1500. Spanish America was discovered in 1498, eight years earlier. By 1554, Peru already had its first university. And our first university came in 1920, 420 years after the discovery.

And why did we have the first university called “Universidade Brasil”? It wasn’t because they were worried that Wagner would take an engineering course there. It was because the King of Belgium was coming here. And at that time, the king, to travel, had to receive an honorary doctorate. So they gathered various faculties that Brazil had and created a university.

And I want to know if you know of any country in the world that developed without first investing in education? When will we have a Silicon Valley here in Brazil? How is it possible that China, until recently, had a GDP smaller than Brazil’s? China was a very poor country. What was the revolution that happened in China? First, investment in education. The number of Chinese and engineering students worldwide is much higher than what we have studying here in Brazil.

Because education was never considered essential. I never forget that in the first ministerial meeting of 2003, a minister said there was no money to spend on education. I said, “Look, let’s prohibit the use of the word ‘expense’ in education.” Every time we talk about education, it’s an investment, and investment has an extraordinary return.

So, comrades, I want you to know that this year is the year of harvest. We will harvest many things that we planted. I will travel many times. I will come to Bahia many times. I can’t come during Carnival because during Carnival, I will work. Someone needs to work in Brazil, so I will work. I will work and cannot participate in Carnival.

But the concrete fact is this: I will have to take a trip on the night of the 13th. I am going to Egypt. And from Egypt, I will go to Ethiopia to participate in the African Union Congress because Brazil needs, once and for all, to start repaying the historical debt we have with the African people. Since Brazil is a poor country that cannot pay its debt in money, we pay in the transfer of knowledge, in the transfer of successful public policies, in the transfer of technology. That’s what I want to do because now we are in an exceptional moment.

I want you to pay attention to something that you can hold me accountable for from now on. This country has never had the opportunity to become a great nation as we have now. I will repeat: in 500 years, this country has never had the opportunity to become a great nation as it has now.

Brazil has done an extraordinary thing by recovering its international relations. Today I can tell you that Brazil is again an international protagonist. I can tell you that Brazil is respected in the world again. It’s important to remember that this year we will host the G20 in Brazil. Next year, we will hold it in the state of Pará. And then, next year, I will hold a BRICS meeting here in Brazil.

“And why does Brazil have a chance to grow? Because there’s this thing called, you know, Planet Earth being destroyed by human irresponsibility. In fact, humans are fantastic because they are so creative that they can self-destruct. So what’s the problem? The world needs to make a gigantic effort so that we reduce the possibility of global warming. Those who don’t believe in global warming need to notice the changes in weather conditions in various parts of the world. It’s raining a lot where it didn’t rain. It’s raining little where it always rained a lot. It’s flooding where it never flooded. It’s drying up where it never dried up. Even worldwide, fires in places that were not prone to fires. And all of this is due to global warming. Have you noticed the heat we are experiencing? We have experienced periods where this heat in Brazil was the strongest in the last 100 years. In Europe, the heat reached 40 degrees.

And Brazil has the greatest potential in the world to help solve this problem with so-called renewable energy. This country already has 87% of its electrical energy renewable. No other country in the world has this; we do. But this country has ethanol; this country can have biodiesel; this country can have biomass. This country can produce a thousand types of fuels that other countries cannot.

Furthermore, this country is going to be the largest producer of green hydrogen in the world. And we don’t want to produce hydrogen just to sell. We want to be the major hydrogen producer so that industries come to produce their green products here in Brazil. If we want to reduce emissions and the aggravation of the greenhouse effect, Brazil is a chance. And then there’s the issue of the African continent, which is also an extraordinary opportunity.

That’s why we are very, very interested in discussing this issue of the ecological transition of this country, the climate transition of this country, the energy transition. It’s an opportunity, it’s an opportunity that God is giving us. So, friends, it’s an extraordinary chance.

I know that you are investing a lot in the potential of green hydrogen. I know that other states are investing. Piauí is investing, Ceará is investing, Rio Grande do Norte is investing. And when I talk about Brazil, I’m talking about the Brazilian Northeast as well. It’s a great opportunity in the Northeast. I think that since the Portuguese crown arrived here in Brazil, or since Brazil was discovered, possibly the Northeast has in this half of the 21st century, listen, governor, the chance to have the development potential equal to any state in the country.

The Northeast cannot accept that it was born to be seen by the world as the place with the highest infant mortality, the highest illiteracy, the highest school dropout, the most people receiving Bolsa Família, the most people dying of malnutrition. It’s not the Northeast we want to create, people. It’s not that Northeast. I can tell you from life experience that it costs very little, very little, to invest in the poor of this country and invest in improving their lives.

When we improve people’s lives, you know what will happen? There will be less robbery, less violence. Did you see, Rui, yesterday there was a crime spree in Rio de Janeiro at 3 o’clock in the afternoon? These phenomena that are happening, this abuse of organized crime, this growth of all this, I can say that there are a thousand cases, but the main one is the absence of the Brazilian state in not taking care of people at the right time.

And the right time starts with elementary education. Elementary education has to be a priority. If the child is well educated in the early years, that child will thrive and grow. If they are not well educated, they will have a genetic defect, they will have a defect of origin, and they will not be able to progress.

And you can help build this country. Rui believes a lot in this PPP thing. Let’s see if we can do it in Brazil. Let’s see if we can do it in Brazil, make this country take a leap in quality. Who takes pleasure in seeing people starving on the street? Who takes pleasure in seeing children begging on the street? Who takes pleasure in seeing women with children lying on a sidewalk? And often we pass by and even turn away because it’s ugly? Who is to blame for this? Is it the president? Is it the governor? Is it the mayor? No. It’s us. It’s us, the Brazilian society, who need to raise our heads and take care of this country because it is our responsibility. And may Bahia serve as an example for many things that I will do from now on in this country.

Congratulations to the Aeronautics, congratulations to the Governor, because now you will have an Aerospace Technological Park in Bahia. The name is so beautiful that Jerônimo couldn’t even say it right, “Technological Park.”

And this is what will happen all over Brazil. Get ready, folks, get ready, because I want to have. I have three years in office, and in these three years, I want to dedicate so that you still live in a country where people smile again. Don’t be afraid of violence, don’t sleep on the street, don’t beg for alms.

And then, Wagner, I see you there, we are going to create a special policy for the elderly. This is something that we are going to create. This is something that we are going to create a working group to think carefully because Brazil is becoming an old country. Brazil is having an old population. And not everyone is fortunate enough to be a strong old person like me, like Otto, like Wagner, like José Mucio. Not everyone has a young person at 78 looking like they’re 30.

But I am concerned about creating a working group to present to Brazil a proposal for special attention to people who are getting old and who have no one to take care of them. This is a problem that will arise. So, we have to take care of the child, the teenager. I don’t know if you saw this week, we approved the law, the law was sanctioned that every young person going to high school has a savings account. He will receive, you know, R$ 200 reais per month deposited in a savings account for him. And if he manages to graduate, he can only withdraw the total when he graduates; he can take a little bit during the study. Because the highest school dropout is in high school.

The boys can’t complete the entire course, or they don’t like to do it, or we can’t motivate them. So, we are trying to see if with the scholarship, we can motivate these boys to finish their technical courses, learning a profession. If not, we won’t take a leap in quality.

That’s why, Jerônimo, I’m here happy. I didn’t know it was Rui Costa’s birthday party because if I had known, I would have done it in Brasília last night, but I didn’t know. I want to tell you that I will come here to Bahia other times. This is a state that I have a relationship of love, a very affectionate relationship, not only for the people in this fight but because Bahia represents a lot for this country.

So, comrades from Bahia, I won’t say ‘long live Bahia’ because here I know that the governor cheers for Vitória. I also want to say that I didn’t know about the attachment of the people to Bahia. I also cheer for Vitória. Solidarity. We’re back to Serie A with the goal of being champions this year.

A kiss in the heart, a kiss to all of you, and until our next visit to Bahia. Have a good carnival!”

 

Nice speech by Argentina’s Milei at Davos. Not sure how any of this works in practice, but surely refreshing after 40 years of socialism in Latin America.

Good afternoon, thank you very much. Today I am here to tell you that the West is in danger. It is in danger because those who are supposed to defend Western values are co-opted by a worldview that inexorably leads to socialism and, consequently, to poverty.

Unfortunately, in recent decades, motivated by well-intentioned desires to help others and by the ambition to belong to a privileged caste, the main leaders of the Western world have abandoned the model of freedom for various versions of what we call collectivism.

We are here to tell you that collectivist experiments are never the solution to the problems affecting the citizens of the world; on the contrary, they are the cause. Believe me, no one better than us Argentinians can testify to these two issues.

When we adopted the freedom model around 1860, in 35 years, we became the world’s leading power. However, when we embraced collectivism over the last 100 years, we saw our citizens systematically becoming impoverished, falling to the 140th position globally. But before we can have this discussion, it’s important to look at the data that supports why not only is free-market capitalism a possible system to end world poverty, but it is the only morally desirable system to achieve it.

If we consider the history of economic progress, we can see that from year zero until around 1800, the world’s per capita GDP remained virtually constant throughout the reference period.

If one looks at a graph of economic growth throughout human history, it would resemble an exponential curve, remaining constant for 90% of the time and sharply rising from the 19th century onwards. The only exception to this stagnation occurred in the late 15th century with the discovery of America.

But aside from this exception, between the year zero and 1800, global per capita GDP remained stagnant.

Now, not only did capitalism generate an explosion of wealth since it was adopted as an economic system, but if you analyze the data, you’ll see that growth has been accelerating throughout the entire period.

During the period from 1800 to 1900, the per capita GDP growth rate remained stable at around 0.02 percent annually, almost no growth. From the 19th century with the industrial revolution, the growth rate increased to 0.66 percent. At that rate, it would take 107 years to double per capita GDP.

Now, if we look at the period between 1900 and 1950, the growth rate accelerates to 1.66 percent annually. We no longer need 107 years to double per capita GDP, but 66. And if we take the period from 1950 to the year 2000, we see that the growth rate was 2.1 percent annually, meaning we could double our per capita GDP in just 33 years. This trend, far from stopping, remains alive even today. If we take the period from 2000 to 2023, the growth rate accelerated to 3 percent annually, implying that we could double our per capita GDP in the world in just 23 years.

Now, when studying per capita GDP from 1800 to today, it is observed that, after the industrial revolution, the world’s per capita GDP multiplied by more than 15 times, generating an explosion of wealth that lifted 90 percent of the world’s population out of extreme poverty.

We must never forget that, by the year 1800, about 95 percent of the world’s population lived in extreme poverty; while that number dropped to 5 percent by the year 2020, before the pandemic.

The obvious conclusion is that, far from being the cause of our problems, free-market capitalism, as an economic system, is the only tool we have to end hunger, poverty, and destitution worldwide. The empirical evidence is unquestionable. Therefore, as there is no doubt that free-market capitalism is superior in productive terms, the left-wing doxa has attacked capitalism for its alleged moral shortcomings, claiming it is unjust.

They say that capitalism is bad because it is individualistic, and that collectivism is good because it is altruistic, advocating for “social justice.” But this concept, which has become fashionable in the first world in the last decade, has been a constant in the political discourse in my country for more than 80 years.

The problem is that social justice is not only unjust but also does not contribute to the general well-being. Quite the opposite, it is inherently unjust because it is violent. It is unjust because the state is funded through taxes, and taxes are collected coercively. Can any of us choose not to pay taxes? This means that the state is funded through coercion, and with a higher tax burden, there is more coercion and less freedom.

Those who promote social justice start from the idea that the economy is a pie that can be distributed differently. However, that pie is not given; it is wealth generated in what Kirzner calls a discovery process. If a product is of good quality at an attractive price, it will do well and produce more. Thus, the market is a discovery process in which the capitalist finds the right path on the go.

But if the state punishes the capitalist for being successful and hinders this discovery process, destroys incentives, the consequence is that less will be produced, and the “pie” will be smaller, causing harm to society as a whole.

Collectivism, by inhibiting these discovery processes and hindering the appropriation of what is discovered, ties the hands of the entrepreneur and makes it impossible to produce better goods and offer better services at a better price.

So how is it possible that from academia, international organizations, politics, and economic theory, an economic system that not only lifted 90% of the world’s population out of extreme poverty but does so increasingly faster is demonized, claiming it to be unjust?

Thanks to free-market capitalism, the world is currently in its best moment. There has never been, in the entire history of humanity, a time of greater prosperity than what we live in today.

Today’s world is freer, richer, more peaceful, and more prosperous than at any other time in our history. This is true for everyone but particularly true for those countries that are more free, respect economic freedom, and the property rights of individuals. Because those countries that are more free are eight times richer than the repressed ones; the lowest decile of the distribution of free countries lives better than 90% of the population of repressed countries, has 25 times fewer poor people in the standard format, and 50 times fewer in the extreme format. And as if that were not enough, citizens of free countries live 25% longer than citizens of repressed countries.

Now, to understand what we come to defend, it is important to define what we mean when we talk about libertarianism.

To define it, I take the words of the greatest proponent of freedom in our country, Alberto Benegas Lynch (h), who says: “Libertarianism is the unrestricted respect for the life project of others, based on the principle of non-aggression, in defense of life, liberty, and property of individuals. Its fundamental institutions are private property, free markets free from state intervention, free competition, the division of labor, and social cooperation. Where one can only be successful by serving others with better quality or better-priced goods.”

In other words, the capitalist is a social benefactor who, far from appropriating others’ wealth, contributes to the general well-being. Ultimately, a successful entrepreneur is a hero.

This is the model that we are proposing for the future of Argentina. A model based on the fundamental principles of libertarianism: the defense of life, liberty, and property.

Now, if free-market capitalism and economic freedom have been extraordinary tools to end poverty in the world, and we are currently in the best moment in human history, why do I say that the West is in danger?

I say that the West is in danger precisely because in those countries that should defend the values of the free market, private property, and other libertarian institutions, sectors of the political and economic establishment, some due to errors in their theoretical framework and others due to the ambition for power, are undermining the foundations of libertarianism, opening the doors to socialism, and potentially condemning us to poverty, misery, and stagnation.

Because it must never be forgotten that socialism is always and everywhere an impoverishing phenomenon that failed in all countries where it was attempted. It was a failure economically. It was a failure socially. It was a failure culturally. And it also killed more than 100 million human beings.

The essential problem of the West today is that we must not only confront those who, even after the fall of the wall and overwhelming empirical evidence, continue to advocate for impoverishing socialism, but also our own leaders, thinkers, and academics who, sheltered in a mistaken theoretical framework, undermine the foundations of the system that has given us the most spectacular expansion of wealth and prosperity in our history.

The theoretical framework I refer to is that of neoclassical economic theory, which designs an instrumental that, unintentionally, ends up being functional to state intervention, socialism, and the degradation of society. The problem with neoclassicals is that, as the model they fell in love with does not map to reality, they attribute the error to supposed market failures instead of reviewing the premises of their model.

Under the pretext of a supposed market failure, regulations are introduced that only generate distortions in the price system, hinder economic calculation, and consequently, savings, investment, and growth.

This problem essentially lies in the fact that not even supposedly libertarian economists understand what the market is, because if it were understood, it would quickly be seen that there is no such thing as market failures. The market is not a supply and demand curve on a graph. The market is a mechanism of social cooperation where exchanges occur voluntarily. Therefore, given that definition, market failure is an oxymoron. There is no market failure. If transactions are voluntary, the only context in which there can be market failure is if there is coercion. And the only one with the ability to coerce on a large scale is the state that has a monopoly on violence. Consequently, if someone believes that there is a market failure, I would recommend that they check if there is state intervention in the middle. And if they find that there is no state intervention in the middle, I suggest they analyze it again because it is definitely wrong. Market failures do not exist.

An example of the supposed market failures described by neoclassicals is concentrated structures in the economy. However, without functions that exhibit increasing returns to scale, whose counterpart is the concentrated structures of the economy, we could not explain economic growth from 1800 to today.

Notice how interesting. From 1800 onwards, with the population multiplying more than 8 or 9 times, per capita product grew more than 15 times. There are increasing returns, which led extreme poverty from 95% to 5%. However, the presence of increasing returns implies concentrated structures, what would be called a monopoly. How can something that has generated so much well-being for neoclassical theory be a market failure? Neoclassical economists, think outside the box. When the model fails, don’t get angry with reality, get angry with the model and change it.

The dilemma facing the neoclassical model is that they claim to want to improve the functioning of the market by attacking what they consider failures, but by doing so, they not only open the doors to socialism but also undermine economic growth. For example, regulating monopolies, destroying their profits, and smashing increasing returns would automatically destroy economic growth.

In other words, every time you want to correct a supposed market failure, inevitably, due to not understanding what the market is or falling in love with a failed model, you are opening the doors to socialism and condemning people to poverty.

However, in the face of the theoretical demonstration that state intervention is harmful and the empirical evidence that it failed – because it could not be otherwise – the solution that collectivists will propose is not more freedom but more regulation, generating a downward spiral of regulations until we are all poorer, and everyone’s life depends on a bureaucrat sitting in a luxury office.

Given the resounding failure of collectivist models and the undeniable advances of the free world, socialists were forced to change their agenda. They abandoned the class struggle based on the economic system to replace it with other supposed social conflicts equally harmful to community life and economic growth. The first of these new battles was the ridiculous and unnatural fight between man and woman.

Libertarianism already establishes equality between the sexes. The foundational stone of our creed says that all are created equal, that we all have the same unalienable rights granted by the creator, among which are life, liberty, and property.

The only result of this radical feminist agenda is increased state intervention to hinder the economic process, providing jobs for bureaucrats who contribute nothing to society, whether in the form of women’s ministries or international organizations dedicated to promoting this agenda.

Another conflict that socialists pose is that of man against nature. They argue that humans harm the planet and that it must be protected at all costs, even advocating for population control mechanisms or the bloody agenda of abortion.

Unfortunately, these harmful ideas have strongly permeated our society. Neo-Marxists have managed to co-opt the common sense of the West. They achieved this thanks to the appropriation of the media, culture, universities, and yes, also international organizations.

Fortunately, more and more of us dare to speak out. Because we see that if we do not confront these ideas head-on, the only possible destiny is more state, more regulation, more socialism, more poverty, less freedom, and consequently, a worse quality of life.

The West, unfortunately, has already begun to travel this path. I know it may sound ridiculous to suggest that the West has turned to socialism. But it is only ridiculous to the extent that one restricts oneself to the traditional economic definition of socialism, which establishes that it is an economic system where the state owns the means of production.

This definition should be updated to present circumstances. Today, states do not need to directly control the means of production to control every aspect of individuals’ lives. With tools like monetary issuance, debt, subsidies, interest rate control, price controls, and regulations to correct supposed “market failures,” they can control the destinies of millions of human beings.

This is how we reach the point where, under different names or forms, a good part of the generally accepted political offers in most Western countries are collectivist variants. Whether openly declaring themselves communist, socialist, social-democrats, Christian democrats, neo-Keynesians, progressives, populists, nationalists, or globalists. In essence, there are no substantive differences: all argue that the state must direct all aspects of individuals’ lives. All defend a model contrary to what led humanity to the most spectacular progress in its history.

We come here today to invite other Western countries to return to the path of prosperity. Economic freedom, limited government, and unrestricted respect for private property are essential elements for economic growth.

This phenomenon of impoverishment produced by collectivism is not a fantasy. Nor is it fatalism. It is a reality that Argentinians know very well. Because we have already lived through it. Because, as I said before, since we decided to abandon the model of freedom that had made us rich, we have been trapped in a downward spiral where every day we become poorer.

We have already experienced it. And we are here to warn you about what can happen if Western countries that became rich with the model of freedom continue on this path of servitude.

The Argentine case is the empirical demonstration that no matter how rich you are, how many natural resources you have, no matter how capable the population is, how educated it is, or how many gold bars are in the central bank’s vaults. If measures are adopted that hinder the free functioning of markets, free competition, free price systems, if trade is hindered, if private property is attacked, the only possible destiny is poverty.

In conclusion, I want to leave a message to all the entrepreneurs present here and those watching from every corner of the planet. Do not be intimidated by the political caste or the parasites living off the state. Do not surrender to a political class that only wants to perpetuate itself in power and maintain its privileges.

You are social benefactors. You are heroes. You are the creators of the most extraordinary period of prosperity we have ever experienced. Let no one tell you that your ambition is immoral. If you make money, it is because you offer a better product at a better price, contributing to the general well-being.

Do not yield to the advance of the state. The state is not the solution. The state is the problem itself. You are the true protagonists of this story, and know that from today, you have an unwavering ally in the Argentine Republic.

Thank you very much, and Long live freedom!

South Korea and Brazil followed similar development paths until the mid-1980s. Then, they separated, with South Korea progressing into the club of rich nations while Brazil languished in the “Middle-Income Trap.” South Korea took the arduous path of moving up value chains and conquering global markets for manufacturing exports; Brazil deindustrialized and reverted to its historic dependence on commodities.

Looking back to distant history, both South Korea and Brazil were regional laggards. Korea trailed Japan and Taiwan on the path to industrialization; Brazil fell behind its Southern Cone neighbors, Argentina, Chile, and Uruguay. Korea suffered the collapse of the Joseon Dynasty (1897), Japanese colonization (1910-1945), and a catastrophic civil war (1950-1953), entering the 1960s as one of the poorest nations in the world. Brazil meandered until the 1920s, destabilized by the abolition of slavery (1888) and the collapse of the Empire (1889).

The two charts below show the evolution of GDP per capita for Korea and Brazil relative to that of the United Kingdom, which was the first country to industrialize in the 19th century. Korea is compared to its regional peers—Japan, Taiwan, and Singapore; and Brazil is compared to other “Western Offshoots,” countries closely integrated financially and commercially with the North Atlantic countries leading the process of industrialization (Argentina, New Zealand, Australia, and Chile). In the East, Japan led the way, followed by Singapore and Taiwan. Korea only took off in the 1960s, some 80 years after Japan. For the Western Offshoots, Australia and New Zealand had fully converged with the UK by 1900, and, until the 1920s, Argentina and Chile were close behind. Brazil, set back by political instability and the legacy of slavery, lagged far behind until its take-off in the 1950s, and then caught up with its floundering Latin American neighbors.

The following chart shows GDP per capita (in 2011 USD) for Brazil and Korea over the past century. The two countries followed similar paths until Brazil distanced itself during its “economic miracle” (1950-1979). Korea took off in the 1960s, passed ahead of Brazil in 1982, and then left Brazil far behind during the culmination of the “Miracle on the Han River.”

The following chart shows more recent GDP per capita data, including IMF forecasts through 2028, at which time Korea’s GDP per capita is expected to be 3.1 times Brazil’s. This period for Brazil includes two lost decades (the 1980s and 2010s). Korea recovered quickly from two stumbles—the Asian Financial Crisis (1997) and the Great Financial Crisis (2008).

Over this period (1980-2023), Brazil became the “poster child” for the “Middle-Income Trap.” The Latin American Debt Crisis (1982) and the fall of the military dictatorship (1964-1985) enabled the rise of the socialist left and resulted in the passage of an illiberal and statist “welfare” constitution (1988) that severely debilitated public finances and dramatically increased the political and financial power of rural states at the expense of urbanized industrial states. The new constitution led to rising public sector spending, fiscal incontinence, and a sharp reduction of the capacity of the state to invest in public goods. While government revenues as a percentage of GDP rose from the mid-20s in the 1980s to the low 40s over the past decade, deficits have been chronic, and the capacity of the public sector to invest has fallen to near zero. As shown in the charts below, the contrast with Korea is shocking. The Korean public sector operates with half the revenue of Brazil yet achieves consistent fiscal surpluses and is able to deliver world-class public goods (infrastructure, education, healthcare, and support for cultural institutions).

The collapse in the state’s ability to invest in public goods can be seen in the deterioration of infrastructure and education and human capital. The next charts show the World Bank’s rankings for infrastructure and logistics, the OECD’s rankings for education assessment, and the World Bank’s Human Capital Index. In all these measures, Korea ranks near the top while Brazil does poorly even compared to emerging market peers.

In 1982, the year that Korea passed Brazil in terms of GDP per capita, the two countries were at similar levels of industrialization, with Brazil having a small edge. Both countries, relying on similar models of industrial policy, forced savings, and directed lending, had dominated basic industries (steel, petrochemicals, cement, etc…) and mass manufacturing (autos, appliances, etc…) and had made important strides in the production of capital goods. As the following table shows, a decade later, the situation had changed dramatically. Brazil experienced a significant reduction in its manufacturing value-added to GDP ratio between 1984 and 1994. This period coincides with the passage of the new illiberal constitution in Brazil, economic volatility and hyperinflation, and a widespread belief that the industrial policies and protectionism supported by the military regime had engendered inefficient and coddled oligopolies.

Starting in the early 1980s, the world entered a period of trade hyper-globalization underpinned by the Reagan-Thatcher Neoliberal “Revolution and the “Washington Consensus” for the liberalization of trade and financial flows. Unfortunately, Brazil, unlike Korea, was poorly positioned to benefit from the trend towards open markets. Brazil, in fact, was a primary loser of globalization. If one agrees that a key measure of economic development is the complexity of a country’s exports—the premise of the Economic Complexity Index (ECI) compiled by Harvard’s Growth Lab—then globalization has been a catastrophe for Brazil and a huge boon for Korea. The chart below shows the evolution of the ECI since 1995. While Korea and Brazil were at similar levels of ECI in 1995, by 2020 Korea has moved to the top 5 while Brazil had plummeted. Over this period, Korea became a leading exporter of advanced technologies (semiconductors, digital displays, electric batteries, etc…) while Brazil returned to being almost exclusively an exporter of commodities (Embraer’s regional jets being an exception).

The success of Korea, as well as all the Asian Tiger economies, has been based on capturing export markets for manufacturing goods. Foreign markets have been instrumental in providing both scale and discipline to domestic firms. As shown in the chart below, by 1985 Korea, with an economy less than half the size, already exported more than Brazil.

The accelerated rise of China in the 1990s presented a momentous threat to Korea, which found itself caught in a “sandwich” between advanced economies that dominate the high-end market and Chinese manufacturers that were quickly catching up.

Over the next crucial decade, Korean firms successfully moved up into frontier technologies while Brazil turned away from manufacturing, as shown in the next chart. While both Brazil and Korea have increased their exports to GDP ratio since the 1980s, for Brazil, all the increase has come from commodities, while for Korea, most of the increase has come from manufactured goods.

The deindustrialization of Brazil has had enormous and probably irreversible consequences for labor productivity and consumption. Highly productive and well-remunerated jobs in manufacturing and industry have been replaced by service jobs with low productivity, providing little training. As shown below, though productivity growth in Brazil had been in line with Korea’s, it collapsed in the 1980s and has been near zero over the past decade.

Manufacturing jobs and the training they provide created the middle-class consumer in Brazil. Without the expansion of the middle class, Brazil is now unable to grow as a consumer market unless state welfare handouts increase. We can see this in the inequality data collected by the World Bank and The World Inequality database shown below. Over the past 40 years, Korea has incorporated nearly the entirety of its population into the middle class (measured at annual GDP per capita of over $10,000 in 2015 USD) while Brazil’s middle class still is almost wholly concentrated in the top income decile of the population. This means Korea, with a quarter of Brazil’s population, has more “consumers” than Brazil and grows consumption at a faster pace.

While Brazil missed the boat on trade globalization, it did embrace the opening of financial flows. Unlike Korea, which has maintained capital controls, Brazil abandoned them in 1990, subjecting itself fully to the vicissitudes of “hot money” flows. The concurrent deindustrialization and financialization of the Brazilian economy led to generations of engineering graduates migrating from industry to financial engineering, while in Korea, they continue to build things. In a generation, Sao Paulo has repositioned itself from an industrial powerhouse to a city centered around the “Faria-Lima” financial casino.

Brazil’s economy has returned to a level of dependence on commodities last experienced in the early 1950s. There have been two major drivers of this process. First, while since the 1980s state support for industry has disappeared, support for agriculture has been consistently abundant. Ironically, while Brazil abandoned the East Asia-like state incentives for industry it had under the military regime (subsidies, directed credit, and market protection) for farm commodities, these kinds of policies continue to be embraced by Brasilia, in part because of the increased political clout given to farm states by the 1988 Constitution. Moreover, like in the case of Asian Tigers, state support is now being directed to a sector that is extremely competitive and export oriented. However, unlike Asian manufacturing exports, the commodity sector has low economic complexity and value added and provides few jobs.

The second driver was the discovery of enormous pre-salt offshore oil fields (2005) which have eliminated Brazil’s historical dependency on oil imports. Oil production and exports are expected to ramp up over the next decade providing structural support for the current account and the currency. As in the case of farm commodities, the oil sector is capital intensive and generates few jobs.

Both these commodities have volatile prices that cause economic and currency instability and other ills. The “Commodity Curse” and “Dutch Disease” are terms coined by economists to describe the malign influence commodity dependence has on institutions (law and order, corruption, etc…) and other drivers of growth.

Dependence on commodities creates a vicious cycle of deindustrialization through currency volatility. Manufacturing exporters like Korea manage their currencies to preserve competitiveness. Brazil with its exposure to hot money flows and commodity prices is a volatility machine which makes life impossible for exporters of manufacturing goods. We see this in the chart below. While Brazil’s currency is a roller coaster, soaring and diving in function of commodity prices and hot money flows, the Korean won is managed for stability and competitiveness.

Conclusion – What will the future bring?

Brazil missed the boat on the trade globalization of the past 40 years while Korea was a primary beneficiary. However, the world is now changing, as protectionism and industrial policy cycle back into favor.

Korea’s “sandwich” problem has not gone away, and its reliance on foreign markets may now be a liability. Moreover, Korea faces a severe demographic problem with the prospect of a declining population and workforce for decades to come. Regional geopolitical tensions may also be highly destabilizing. On the positive side, Korean society is highly homogeneous, collective, and collaborative and has proven highly adaptive to change.

Demography is a lesser issue for Brazil, though its “demographic dividend” of the past decades will become a drag in the coming years. Deglobalization and the newfound popularity of industrial policy may provide an opportunity for productive investment. On the negative side, Brazil’s highly heterogeneous population, a total lack of collective and collaborative spirit, and fractured politics do not promise an easy turnaround.

 

That economic activity is transformed energy is a truism. Technological innovations, allowing the harnessing of wind, water, coal, oil, nuclear, and solar power, were the driving force behind the Industrial Revolution since the 18th century. Yet, because of environmental concerns, energy consumption growth has slowed, and political pressures are increasing to radically reduce the consumption of hydrocarbons, which are still by far the primary source of fuel.

The two charts below show the dramatic slowdown in global energy consumption growth, based on data from the Energy Institute Statistical Review of World Energy  (link). This decline has been partially voluntary to the extent that conservation policies and higher energy taxes since the 1970s have incentivized lower consumption. In effect, many “rich” countries have chosen to explicitly recognize the economic externalities related to hydrocarbon consumption (pollution, climate change), even if with some hypocrisy to the extent that polluting industries have simply moved offshore (e.g., petrochemicals to China and the Middle-East). Also, lower consumption growth resulted from the Great Financial Crisis (2007-08) and the decade-long period of sub-par growth that it engendered. Consumption growth in the OECD has been negative since the 2000 recession. This is the first time in 200 years that this has happened for such a long period of time and certainly has contributed to declines in productivity and GDP growth.

As primary energy consumption growth has stalled in rich countries, developing countries have taken up some of the slack, as shown in the following chart from the FT.

In addition to China and India, rapidly growing developing countries in South Asia and Africa representing about 30% of the world population also continue to grow energy consumption quickly. These countries all have per capita consumption levels well below the level of the OECD countries and the US, and their future growth and welfare are tied to increased energy consumption to raise living standards and acquire the basic comforts of modern life.

The Non-OECD countries consume about a third as much energy per capita as the OECD countries and 17% of the energy consumed by Americans, as shown in the following chart. Indians consume 15% and 9% of the per capita energy consumed in the OECD and the US, respectively. Africans consume less than 3% and 2% of the per capita consumption in the OECD and the US.

The negative impact on the growth of world energy consumption caused by stagnation in the OECD is losing strength for the simple reason that the OECD’s share of total consumption is rapidly declining, as we can see in the next chart. When consumption growth stalled in OECD countries some twenty years ago, the OECD had 60% of world consumption, but that has now fallen to 39%.

If we assume that the growth trends of the past decade persist for the next ten years, then world primary energy consumption annual growth would increase from 1.1% to 1.9%, and the Non-OECD share of total consumption will rise from 61% to 65%. As shown in the chart below, under this scenario, total primary energy consumption would rise a further 20% over the next ten years.

In a world facing increasing risks from global warming, ideally, this increased consumption will be met by “clean” energies, but so far only Europe seems committed to this goal. Both China and India remain wedded to coal, nuclear remains generally taboo, and most countries face political opposition to the high cost of transitioning to solar and wind.”

In the following blog, we will explore the role of hydrocarbons in the ongoing transition to clean energy.

 

 

 

Recent decades have brought impressive gains in prosperity for many developing countries. By attracting investment and opening up to the world, many countries have been able to grow more quickly than rich countries that operate at the technological frontier. However, this process of growth has not benefited all countries. Worse, many poor countries have fallen behind, becoming relatively poorer.

Convergers in emerging markets can broadly be separated into two categories: first, countries attracting foreign direct investment and participating in the globalization of trade; second, countries starting from a very low base and achieving high growth because of successful economic reforms leading to increases in productivity. Highly successful convergers (e.g., China, Vietnam) have benefited both by launching economic reforms and by integrating into the global economy.

The chart below shows increases in GDP per capita, measured in 2015 constant USD, for the 1995-2022 period, as calculated by the World Bank. 1995 is used as a starting point because this is when the World Bank starts showing data for “Eastern Bloc” countries. We can see in the chart that the U.S., with GDP per capita growth of 50% over this period, is near the middle, so about half the countries in the sample “converged” by growing more than the U.S. benchmark, and about half fell behind. About 20% of the sample, typically countries undergoing revolutions, wars, or environmental disasters, had zero to negative growth. The chart highlights China and Vietnam as star convergers, Brazil as a laggard, and Zimbabwe as a country suffering a severe institutional breakdown.

Convergers

Northeast Asia, Southeast Asia and Eastern Europe have been the major beneficiaries of capital flows and trade liberalization and have all experienced GDP per capita growth well in excess of the United States. We show this in the charts below for the 1986-2022 period using data from the World Bank. 1986 is a convenient starting point as it marks the initiation of MSCI’s Emerging Markets Index and, approximately, the beginning of globalization and financialization of the world under the “Washington Consensus.” For Eastern Europe, the World Bank data is available only starting in 1995.

The Asian “Tigers” have all followed similar mercantilistic policies, subsidizing exports through subsidies and repressing domestic demand and wages to support competitiveness. All of them have benefited greatly from U.S. policy support and easy access to the U.S. consumer market. This U.S. support of China has been significantly reduced since 2019 when China was determined to be a strategic adversary, which raises serious doubts about future convergence. (Data for Taiwan is not included because the World Bank neglects to include the country in its database)

 

The chart below shows the growth of GDP per capita for the major economies in South-East Asia plus India. The countries in this region, with the exception of India and the Philippines, have largely followed the same policies as the East-Asia “Tigers,” including direct and indirect subsidies for exports and foreign direct investment (FDI), especially after the hard-earned lessons of the 1997 Asian Financial Crisis. These countries have all achieved significant convergence. The Philippines has traditionally been a more concentrated, financialized, and volatile economy with less attractiveness for FDI and less support for exports, but in recent years, it has improved its performance and also achieved some convergence. India has experienced strong growth since economic reforms in the 1980s and is starting to attract more FDI, even though its growth is driven more by infrastructure spending and rural support than by manufacturing. India, benefiting from a starting point of exceptionally low GDP per capita, has rapidly converged over this period. Pakistan’s efforts to grow by attracting FDI into manufacturing export industries have been undermined by political instability, but still, it has achieved some convergence.

The following chart shows the countries of Eastern Europe. These countries have all benefited from the collapse of the Eastern Bloc, which freed them to promote private investment and integration into western Europe. Greatly helped by support from the European Union, they have become manufacturing centers for global corporations, taking advantage of low wages to access the European market. All of these countries have experienced significant convergence relative to both the U.S. and the Euro Area since 1995.

Middle-East and Africa (EMEA)

The EMEA region is a motley group, including both rapid convergers and laggards. Turkey, which is more like an Eastern European country in its success in attracting FDI and exporting to the European market, leads thisregion in convergence. In the Middle East, Egypt has converged, starting from a very low level of GDP per capita and benefiting from ample U.S. support. On the other hand, the UAE and Saudi Arabia have significantly lost pace due to rapid population growth, volatile and declining oil prices, and costly initiatives to reduce dependence on the oil sector. In Sub-Saharan Africa, Botswana has achieved convergence through sound and consistent macroeconomic policies and successful diversification away from diamond exports. On the other hand, both South Africa and Nigeria have lost ground because of corruption, political instability, and sustained flight of human and financial capital.

Laggards – Latin America

Finally, Latin America is the major outlier in emerging markets in its sustained poor economic performance and lagging GDP per capita growth. This conundrum has been called by economists the “Middle-Income Trap” and is loosely attributed to inconsistent and poorly designed policies and deteriorating “institutions.” Other possible contributors to Latin America’s decline have been extreme wealth concentration and sustained human and capital flight. Also, the region’s excessive and increasing dependence on commodity exports have subjected countries to highly destabilizing boom-to-bust cycles (referred to in economics as the “Natural Resource Curse).

The three largest economies in Latin America—Brazil, Mexico, and Argentina—have all grown GDP per capita at a rate well below the U.S. and can be considered poster children for the “Middle-Income Trap.” Chile, the strongest economy in the region, has stagnated over the past decade and faces increased political discord and policy confusion. Colombia and Peru have also stagnated and face similar uncertain policy environments. The highlight of the region is Uruguay, a small economy that has avoided the pitfalls of its neighbors and quietly pursued prudent policies.

 

 

 

 

The world’s most prominent central banks operating in the largest and most liquid financial markets have successfully implemented financial repression policies over the past three years which have significantly reduced debt burdens.

The prize for the most agressive financial repression goes to the Bank of England. Negative interest rates over the past three years averaging -3% have reduced the U.K.’s total debt to GDP ratio by a whopping 71%, from 315% to 243%; and government debt to GDP was reduced by 47% , from 141% to 94%. As the chart below shows (data from the Bank for International Settlements, BIS) this pattern of financial repression has been the norm, and led by the world’s leading financial powers, the Euro Group and the United States in particular. The United States has has negative interest rates in 14 of the past twenty years, and since 2020, these policies teamed with “fiscal dominance” have caused a sharp fall in debt ratios.

In the case of emerging markets, Turkey, Poland, Malaysia, Argentina, Chile and Saudi Arabia stand out for their reductions in debt loads. Korea, China and Thailand are among the few countries that saw their debt burdens increase over this period. China, which faces strong deflationary forces caused by excess capacity, malinvestment, a real estate bust and a sharp decline in consumer confidence, has seen its debt ratios continue to rise from already extremely high levels. China’s total debt to GDP ratio rose over the past three years from 294% to 306%. Moreover, if China’s GDP is overstated by as much as 25% as many economists argue, China’s ratio may be approaching Japan’s stratospheric 407% ratio.

The case of Brazil is somewhat unique and points to the future for other countries. Brazil’s central bank has pursued ultra-orthodox policies, meaning that it has managed only a brief honeymoon with negative interest rates and now faces a long period with high real rates. Central bankers in Brazil don’t have room for financial repression, being as they are reined in by unstable “hot money” capital flows from both domestic and foreign investors.

The U.S. Fed, though in a much better shape than Brazil’s central bankers, is also facing challenges from new inflationary forces and fiscal deficits that are expected to rise consistently to fund the retirement of Baby Boomers.

The losers of financial repression (e.g., holders of government bonds and mortgage securitizations) have surely learned their lessons and, at any sign of a new crisis addressed with more quantitative easing, will flee to real assets that have a better chance of preserving value.

 

 

 

Emerging market stocks have persistently underperformed the S&P 500 for the past decade, leading to renewed faith in American exceptionalism and consistent international flows into the perceived soundness and reliability of U.S. assets. Nevertheless, if we look at the data, we can conclude that there are good reasons for the run in U.S. stocks but also evidence to believe it will not last for ever.

The performance of EM stocks relative to the S&P 500 can be seen as a tale of two decades. As the chart below shows, EM stocks dominated for the first ten years while the S&P 500 won handily in the second decade, through June 2023.

Most of this performance can be explained by  changes in valuation as measured by price-earnings and CAPE ratios (CAPE, cyclically adjusted PE), as shown below.  U.S. ratios started high in 2002 and fell during the next decade and then rebounded in the 2012-2023 period. The exact opposite occurred for EM:  ratios were at very low levels in 2012, rose during the decade and now have fallen back to low levels.

The chart below digs deeper to further explain the disparate performances of EM and S&P 500 stocks over the past two decades, by showing annualized earnings growth and currency effects for both assets. The chart breaks down annualized index performance for both decades in terms of earnings and PE multiple expansion, and also provides the contribution from currency exchange  rate movements for emerging markets. The S&P suffered from significant multiple contraction in the first decade and benefited from a large multiple expansion in the second decade. EM benefitted from strong earnings growth boosted by currency appreciation in the first decade and suffered from negative earnings growth pushed down by  currency depreciation in the second decade. CAPE ratio for the S&P 500 fell slightly between 2002 and  2012 and then expanded massively in the second decade, while CAPE ratios for EM rose sharply between 2002 and 2012 and then collapsed from 2012 to 2023.

The drivers of S&P relative performance over the past decade have been primarily multiple expansion and dollar appreciations, two factors that have proven to be cyclical in the past and highly prone to reversion.

We can also point to other extraordinary events that have provided a one- time boost to the S&P 500 index.   Recent work from Michael Smolyansky at the Federal Reserve ((link) and Minje Kwun at Verdad Capital (link)  highlight the importance that reductions in corporate taxes and low interest rates have had in driving earnings growth over the past decade. The chart below shows the remarkably favorable circumstances that American corporations have had since the late 1980s, and the sharp fall in interest rates and taxes over the 2012-2022 period. The recent rise in interest rates and the prospect of rising U.S. debt and fiscal deficits point to a cyclical reversion of these trends in the coming decade.

None of the factors boosting U.S. stocks have benefitted emerging market stocks over the past ten years, which may leave EM stocks better positioned to outperform.

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During my freshman year in college in 1976, I took a class on development of the “Third World” which highlighted Brazil’s “economic miracle” and its rise as a leading economic power. That same year, the renowned MIT economic historian Charles Kindleberger, mulling over what country might assume global leadership from a waning United States, suggested Germany, Japan “or some country of energy and wealth, like Brazil, which has yet to make its presence felt on the world scene.”

By the early 1980s, Japan was considered by many to be the most dynamic economy in the world and on the way to surpassing the U.S.  This “miracle” economy was accompanied by a huge asset bubble, with real estate prices in Tokyo peaking in 1989 at 300 times the level of equivalent space in Manhattan.

China, the latest “economic miracle,” is now expected to become the largest economy in the world by the middle of this decade. The debates of the 1970s on global leadership have resurfaced, as the U.S.  shows signs of fatigue from shouldering the burdens of a benevolent hegemon, and China aims to reshape the world economic order into something new.

However, history shows us that economic “miracles” end in excesses of debt and speculation, and are followed by long periods of stagnation.  The Brazilian and Japanese booms are distant memories, and these economies have struggled to work out the large imbalances built up during the good years.  China’s rise also came with massive debt accumulation and an enormous real estate bubble, and it too faces a difficult transition.

At least, this is the view of the Beijing-based economist Michael Pettis, a Professor at Peking University’s Guanghua School of Management, and a keen observer of China’s developmental challenges. Pettis argues that China’s economic miracle peaked many years ago, and the drivers of growth – labor growth, investment, and exports – are now all severely constrained. Given its level of development and these constraints, Pettis argues, China now should promote consumption to sustain growth, but this path is blocked by vested interests (the beneficiaries of the previous model: provincial governments, exporters, business elites). Pettis sees a clear parallel with what has happened in Brazil and Japan, where reactionary political, business, and financial elites blocked the reforms necessary to secure sustained economic expansion.

The imbalances of China are well known and long dated. Early in 2007, Wen Jiabao (溫家寶), premier of China at the time, declared that the country’s economic growth trajectory was “unstable, unbalanced, uncoordinated and unsustainable.” Since Wen Jiabao expressed his concern, China’s debt to GDP ratio has doubled, and the real estate sector’s share of GDP grew by 50% to unprecedented heights. We can see the rise in debt levels in the chart below from the Bank for International Settlements. Given that most economist believe that China’s GDP is overstated by at least 20%, actual debt ratios may be considerably higher.

The following chart from  Rogoff and Yang (2020) shows the disproportionate share of China’s GDP related to real estate, surpassing greatly the levels reached in other countries affected by real estate bubbles.

The Chinese “economic miracle,” Pettis argues, petered out over a decade ago as productivity growth and returns on investment collapsed. GDP growth has slowed sharply, and the quality of that growth is dubious, as it comes increasingly from unproductive investments related to infrastructure and real estate. We can see this in the three charts below. The first shows the path of GDP growth, both based on official data and on the basis of an alternative methodology which aims to align China’s numbers with those of other countries. The second and third chart  show the composition of that growth for both GDP data sets. Over the past ten years, GDP growth has been cut by more than half, from the low teens to below 5%.  Meanwhile, the quality of the growth has deteriorated dramatically, coming now primarily from investment capital instead of labor growth and productivity. We can see this deterioration more starkly in the alternative data. This data comes from The Conference Board and has been developed in a partnership with the Groningen Growth and Development Centre (University of Groningen, The Netherlands) (Link).

China’s over-dependence on capital investment is in line with the experience of other Asian “tiger” economies, as described by Paul Krugman in his 1994 article “The Myth of Asia’s Miracle.” Both the Brazilian “miracle” of the 1960s and 1970s and the Japanese “miracle” of the 1980s followed a similar pattern of investment-led growth hitting a wall when returns on capital declined and debt levels reached high levels.

The Brazilian Miracle

 Brazil experienced very high growth from the 1950s to the end of the 1970s. Much of the growth in the 1950s was driven by multinational firms bringing mass production manufacturing to the country, in a process very similar to what China went through in the 1990s and 2000s. Mature technologies and business models were easily assimilated and had the advantage of being highly labor intensive. In the 1960s, more FDI came to meet Brazil’s growing consumer market, and “Asian-like” public policies were introduced to promote domestic savings and investment. During the 1970s, Brazil, benefited from a commodity boom but debt levels rose sharply (especially external debt), and investment quality and returns plummeted (increasingly pharaonic projects, roads to nowhere, as in China). The boom came to an end in 1980, and since then Brazil has stagnated, achieving growth of GDP 2.1% per year and GDP per capita growth of 0.8% annually. The mass production paradigm that benefitted Brazil so much in the 1960s and 1970s was exhausted by 1980. Since then, Brazil has been unable to grow its consumer market, leading MNCs to focus on better opportunities elsewhere (Asia, Mexico). Brazil became the poster-child for the “middle-income trap” – a middle-income economy unable to build the institutions required to sustain growth.

The first chart shows the path of GDP growth, and the second shows the enormous debt accumulation and fiscal deficits towards the end of the “miracle” in the 1970s. The third chart shows the composition of growth from 1952-2023. Remarkably, total factor productivity declined from 1.6% annually between 1952 and 1979) to negative 0.9% annually from 1980 to 2023. TFP declined sharply in the second half of the 1970s as investment-led growth lost traction.  Since 1980, Brazil has deindustrialized dramatically, and today the economy has returned to the commodity-dependence levels experienced before the industrialization process took off in the early 1950s.

Japan’s “Economic Miracle”

Japan enjoyed very high GDP growth during the 1950s and 1960s. This growth was briefly interrupted by the 1973 oil crisis, but then resumed in the second half of the 1970s and into the 1980s. This later phase of growth was characterized by real estate and stock market speculative bubbles. The asset bubble popped in 1989, and since then annual GDP growth has averaged 0.9%.

The chart below shows the contribution of labor, capital, and total factor productivity to Japan’s GDP growth. We can see broad contributions from all these factors from the 1950s until 1989, with a sharp increase of reliance on capital in the 1980s. As in Brazil in the 1970s and China over the past decade, declining returns on capital during the 1980s asset speculative boom marked the end of the Japanese miracle. From 1951 to 1989 TFP contributed 2.4% to annual GDP growth, but from 1990 until 2023, this contribution has been -0.9% annually.

 

Conclusion

Unfortunately, “economic miracles” are more chimerical than miraculous. This is most true in the last phase of the boom when excesses and speculation generate mainly malinvestment.

The post-boom periods tend to be painful and drawn-out because the beneficiaries of the past resist the reforms necessary to achieve a rapid transition to a more sustainable growth model. The U.S came out of the Great Recession of the 1930s because radical “anti-elite” measures implemented by President Roosevelt became consensual in the post-war boom. Brazil’s political and financial elites have resisted the reforms needed to improve income distribution and create a broader consumer market. The political process in Japan also has failed to change the investment and export-focused economic model. China appears to be following Japan’s example, as it continues to focus on the exhausted drivers of past growth instead of actively pushing for policies that would build the purchasing power of households in a consumption-driven economy.

As the world moves away from the globalization of manufacturing value chains and finance, the protection of domestic markets is back in favor with policy makers. However, the new mercantilists will have to overcome high costs, including overvalued currencies.

The case of TSMC’s investment in a new $40 BB semiconductor  plant is illustrative. The Taiwanese chipmaker gave in to pressure from the Biden Administration  and agreed to build a “fab’ in Arizona, but it does not seem to be happy about it. Recent press reports say the Taiwanese chipmaker’s management is dismayed by “exorbitant costs and unmanageable workers.”

TSMC’s preference for manufacturing at home is not surprising. Taiwan is a model of successful mercantilist policies (repression of wages, directed credit and competitive currency) that create a haven for manufacturing exports. Taiwan, and other Asian “tigers”, have carefully managed their currencies to assure export competitiveness. The U.S., on the other hand, has long favored consumers over manufacturers, and has an overvalued currency, which serves as the safe haven asset for the rest of the world.

We can see the challenges faced by the new mercantilists by looking at relative exchange rates. Below, we shows the Big Mac Index rankings and Real Effective Exchange rates. The Economist’s Big Mac index is a good measure of the overall cost for  businesses to operate in an economy, as the product being compared incorporates farm, manufacturing, and services, including taxes and regulations. Countries with an established vocation for manufacturing exports are labeled in green, while commodity producers that rely more on imports are labeled in bold black. The chart compares three data points — today, 2020 pre-covid and 2010. We can see that across these periods exporters have cheap Big Macs and importers have expensive Big Macs. There are some exceptions for importers, explained by excessive political instability and capital flight (South Africa, Argentina in 2010, Peru and Brazil in 2023).

Brazil and the United States, two countries now enthusiastically pursuing neo-mercantilist agendas, are interesting and similar cases. They both are  countries that have severely deindustrialized, while at the same time expanding energy production aggressively. Both went from large importers of oil to self-sufficient since 2010, which, all else being equal, means  stronger currencies. The implication is that neo-mercantilist policies will be pursued at a high cost, without the luxury of a weak currency.

Real Effective Exchange Rates (REER) tell the same story. The exporters are all close or below long-term averages, with Thailand the possible exception. Vietnam is an interesting case of an aspiring Asian “Tiger” that may be undermined by an appreciating currency, the result of diplomatic pressure from the U.S.

The irony is that commodity prices are likely to remain high in the 2020s because of a more inflationary environment and production bottlenecks. This would mean stronger currencies for commodity producers and even higher costs to implement reindustrialization policies. The “commodity curse” is difficult to shed.