If forecasting is foolhardy in the most stable of times, trying to make predictions under current circumstances is risible. For the time being, financial markets are driven by the extraordinary policies of U.S. monetary and fiscal authorities which support consumption and provide liquidity to backstop asset prices. The limits of these policies are unknown, but, for now, investors from around the world are willing to engage in this lucrative scheme.
Predictions for the short term are always haphazard. Most market participants simply assume that current trends will continue. They are usually right because trends are persistent while mean reversion occurs over the long-term horizon. The current trends favor investing in U.S. stocks. These have outperformed for over a decade and the biggest and most dominant tech stocks have metamorphized into the new global “safe” asset of choice, replacing return-less U.S. Treasury bonds. Investors have concluded that these quasi-monopolies in winner-take-all growing sectors of the economy are pillars of stability in a turbulent world. The assumptions that underlie this investment thesis are that: 1. the Federal Reserve is fully committed to sustaining the stock market because it believes that a market correction from the current high levels would cause a negative “wealth effect” that would precipitate an economic depression; and 2. The Fed desires sustained higher inflation to erode the value of the Federal debt.
The COVID pandemic in a perverse way facilitated the work of the Fed and consolidated what could be called the “FAANG Monetary Standard.” COVID justified unprecedented levels of monetary intervention and fiscal expansion and drove the stock market to record prices. The exceptional efforts of U.S. authorities made the 2021 recession one of the shortest ever and allowed the U.S. economy to outperform the global economy by a wide margin. Rising asset prices in the U.S. sucked in global capital and pushed up the value of the USD.
Unfortunately, none of this was beneficial for emerging markets. With the exception of China which managed the pandemic well and benefited from the surge of U.S. imports of consumer goods, emerging markets suffered profoundly from COVID, both in terms of short-term growth and long-term growth potential. COVID only accentuated what has been a state of semi-depression in emerging markets for the past decade, as a strong USD and U.S. financial markets have drained them of capital resources.
Ironically, the accelerated nature of the COVID recession in the U.S. will now play against emerging markets as we enter 2022. The United States and China, the two main drivers of the global economy, are now in the process of slowing dramatically as the effects of the COVID stimulus wear off. This means that the expected late recovery of most EM countries will be muted.
In fact, 2022 is likely going to be the year when the markets fully appreciate the devastating long-term consequences of COVID. The enormous increases in government debt incurred by the United States, China and most EM countries in 2021 will weigh on growth for years to come. U.S potential real GDP growth, which was considered to be around 2% before the pandemic, can now be assumed to be considerably lower. Many emerging market countries, including China and Brazil, are facing poor growth prospects as they deal with high levels of unproductive debt.
Ironically, the coming slowdown in the U.S. may continue to favor U.S. stocks and the USD. As the economy slows in coming months, the Fed will have to provide more liquidity to the markets to avoid a correction in asset prices. This may well lead to a further expansion in valuation levels for the tech stocks and final blow off for the S&P500.
The two charts below show the current debt levels in emerging markets and the five-year increase in the level of the debt to GDP ratio for these countries and the United States. The countries with high debt levels and very high recent accumulation of debt generally face difficult challenges ahead. These include, China, Brazil, Chile and Korea.
The next chart shows expected long term stock market returns for EM countries and the United States. The annual returns are for the next seven years but would be similar for 10 years. These returns are in USD terms and assume that EM currencies maintain current valuations relative to the USD over the period. If EM currencies were to appreciate over the period (likely in my view) then returns would be higher.
The details are shown in the next table. Turkey tops the chart and probably provides the best bet for high returns. CAPE ratios below 5 have been in the past fail-safe as an indicator of high future returns. Turkey is well underway in its economic adjustment, with a very competitive currency and export sector and rising business confidence. The Philippines are also well positioned, but do have a challenge to return to the very high historical CAPE, particularly given the lofty weight of financials and real estate in the index. Brazil is cheap but faces high debt and a weak economy as it enters a complicated election year. This is a reminder that CAPE ratios are not helpful for short- term predictions. Moreover, valuation is never enough. Markets always need a trigger.
On the negative side, Taiwan and India both stand out for their very high CAPE ratios. For these valuations to be justified, earnings will have to be much higher than currently anticipated. This means a major ramping up of margins and corporate profitability in India and an extension of the semi-conductor super-cycle in Taiwan.
| CAPE Ratios Relative to History and Real Expected Returns, September 2021 | |||||
| Current Cape | Historical AVG CAPE | Difference | Earnings Cycle | Expected 7-Year Total Real Annual Return | |
| Turkey | 4.4 | 8.6 | -48.84% | Early | 12.0% |
| Philippines | 15.8 | 22.8 | -30.70% | Early | 10.3% |
| Brazil | 11.5 | 12.3 | -6.50% | Late | 9.2% |
| Malaysia | 11.9 | 15.6 | -23.72% | Early | 7.7% |
| S. Africa | 13 | 14.5 | -10.34% | Early | 7.6% |
| Colombia | 9.2 | 14.2 | -35.21% | Early | 7.0% |
| Peru | 16.5 | 16.9 | -2.37% | Early | 6.4% |
| China | 13.5 | 15 | -10.00% | Late | 6.3% |
| Indonesia | 13.5 | 16.1 | -16.15% | Early | 5.4% |
| Thailand | 13.7 | 14.7 | -6.80% | Early | 4.9% |
| Mexico | 17 | 17.4 | -2.30% | Early | 4.7% |
| GEM | 14.6 | 14.3 | 2.10% | Early | 4.4% |
| Chile | 14.6 | 17.9 | -18.44% | Early | 4.3% |
| Korea | 11.6 | 13.2 | -12.12% | Early | 4.2% |
| Taiwan | 24.9 | 18.5 | 34.59% | Mid | 4.0% |
| USA | 37.9 | 24.8 | 52.82% | Late | 3.3% |
| Russia | 7.9 | 6.8 | 16.18% | Early | 0.8% |
| India | 30.4 | 20.8 | 46.15% | Early | 0.6% |
| Argentina | 9.5 | 8.5 | 11.76% | Early | -7.9% |
The methodology used to determine expected returns is the following:
- Forecasted earnings for 2022-2028 assume earnings growth of nominal GDP, making adjustments for each country’s place in the business cycle.
- A cyclically-adjusted earnings value for 2028 is calculated as an average of inflation-adjusted earnings for the 10-year period ending in 2028.
- Each country’s historical cyclically adjusted price earnings ratio (CAPE) is calculated as an average of CAPE ratios for the country since its inclusion in the MSCI index, with an increased weight given to the past 15 years.
- The historical CAPE ratio is applied to 2028 earnings to determine the expected level of the country index in 2028.