Emerging Markets Valuations in a Global Context

 

Successful investors are never shy to avoid expensive markets, preferring to build cash reserves to deploy when other investors are less greedy and more fearful. Much of the success of investors like Warren Buffett or Seth Klarman (Baupost) has come from having plenty of cash on hand when markets suffer cyclical downturns, like in 2000 and 2008. Klarman was once asked by a client why he should be paid his high fees for holding very large amounts of cash (sometimes well above 50%). His answer: “You are paying us to decide when to hold onto cash and when to invest.”

Well, it appears it may be happening again. It was revealed this week that Buffett’s Berkshire Hathaway holds over $100 billion in cash, and Klarman also has well over a quarter of his fund in cash.  Meanwhile individual investors have reduced cash to the lowest levels since the peak of the 2000 bubble.

Buffett and Klarman are not alone. It is commonly accepted by market historians, though certainly not by technicians and momentum traders, that the U.S. market is at very high levels. This view is based on the premise that market valuations mean-revert over time in a somewhat predictable fashion. Though valuations are by no means a timing instrument, they do have a good track record of predicting long-term (5-10 years) future returns. For example, Robert Schiller’s CAPE ratio (Shiller), which measures valuations based on 10-years of inflation-adjusted earnings, currently shows extraordinarily high levels, which at least in the past have been highly predictive of  low prospective returns.

Shiller CAPE Ratio

Crestmont Capital’s extremely thorough analysis of U.S. valuation (1926-2017) history points to a near certainty of lower than normal returns from current levels. Historical U.S stock market returns of 10.0%, came from nominal earnings growth (5.1%), price-earnings multiple expansion (0.6% annually, starting from a low level of 10.2 in 1926) and dividend yield (4.3%).  Annual Real GDP growth and inflation over the period averaged 3.3% and 2.9%, respectively, both of which are currently expected to be lower over the next ten years. The table below shows Crestmont’s absolute best case forecast for market returns for the next ten years to be in the order of 7.1%, well below historical levels. Earnings growth is optimistically assumed to grow 5.1%, in line with history, even though GDP growth and inflation are both likely to be lower. Price-earnings ratios are assumed to remain at the current very high levels. Dividend yield is determined by current valuations. Any contraction of PE levels or lower than historical earnings growth would result in lower returns.

The logic of Shiller’s CAPE and Crestmont’s analysis leads to forecasts of low expected returns for U.S. equities, and all other asset classes impacted by similar factors. For example, relying on historical analysis and reversion-to-the-mean assumptions, Jeremy Grantham’s GMO  (GMO) predicts abysmally low returns for almost all of the asset classes it follows.

Similar analysis produced by Research Affiliates points to equally poor results for the next decade: near zero real returns for U.S. stocks, 2%+ returns for international stocks and 6%+ stocks for emerging markets:

Both GMO and Research Affiliates highlight the relative attractiveness of emerging markets equities in a very low return world. An extended period of under-performance of emerging markets relative to the U.S. market in particular has created a significant gap for investors to exploit. Not only are emerging markets cheap relative to the U.S. and other developed markets, they also are inexpensive relative to their own history. On a cyclically adjusted basis (CAPE EM), valuations in EM are still below average and very far from historical peaks, in contrast to the U.S. which is well above average and near historical peaks. Price earnings ratios  for EM, are near historical averages, in a world where most asset prices are well above historical levels.

To conclude, a further comment on U.S. valuations is in order. It can be argued that current U.S. valuations reflect the reality of extraordinarily low interest rates. The puzzle lies in determining the cause of these low rates; is it Federal Reserve manipulation?; is it deflation caused by globalization and technology?; or does it point to low real growth in real GDP and earnings  in the future caused by demographics and low productivity? The answer to this puzzle will likely explain the short term course of the U.S. market.

Us Fed watch:

India Watch:

  • India’s stock market is set for a huge bull run (Wisdom Tree)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

  • The geopolitical landscape of Asia Pacific is changing (WEF)
  • China’s ascent is slowing (Bloomberg)
  • China needs more reform to progress (Caixing)
  • Trump on the verge of trade war with China (Brookings)
  • Foreign tourists are shunning China (SCMP)

China Technology Watch:

  • China now has 751 million internet users (Caixing)
  • China is the next tech superpower (Diamandis)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch

  • Bangladesh’s rise to manufacturing powerhouse (FT)
  • Venezuela’s total collapse (Project Syndicate)
  • Venezuela was once Latin America’s richest country (WEFORUM)
  • Military unrest on the rise in Venezuela (Geopolitical Futures)
  • In Brazil highway robbery is a growth industry (Bloomberg)

Investor Watch:

Notable Quotes: (Avondale)

It’s a low return high risk world

  • “Markets normally respond to elevated uncertainty with lower asset prices and compensatorily higher returns. But that’s not what we are encountering today. We are living in a low-return, high risk world and an environment where most investors are happy to bear risk.” —Oaktree CEO Jay Steven Wintrob (Investment Management)

China is likely to lead the world in electrification

  • “China’s forecasted to lead the global trend in Powertrain electrification, representing over 50% of unit production in 2025, reflecting a 40 fold increase over today’s levels. We remain optimistic about the China market as a result of the underlying macro trends which include increased government focus on emissions regulations, which are increasing demand for China’s new energy vehicles” —Delphi CEO Kevin Clark (Auto Parts)

Australian Iron Ore is being sold to traders, not users

  • “what these guys are doing, these guys mean, for abundance of clarity, Fortescue, BHP and Rio Tinto, Vale and even the midget, Roy Hill, they sell to traders. And these traders do not have blast furnaces. They buy because it’s cheap to borrow money in Chinese banks. Then they put that iron ore in the ground, not in a blast furnace, at the port. And then they go back to the banks, and say, hey, I have collateral, can I borrow more? And the banker say, yes, and they borrow more, and they buy more for the same idiots…That’s my problem with the business in Australia. Then comes the question, will this be happening forever? Yes or no? Of course, the answer is no. One day, this bubble will burst. And on that day, people will say, oh, we are surprised that we are not seeing iron ore inventories going up.” —Cliffs Natural Resources CEO Lourenco Goncalves (Iron Ore)

Notable Charts:

The Lottery of Stock Picking

Academic research has highlighted the high risk of investing in individual stocks. Stock-specific risk, in contrast to market risk, can be diversified away, so investors are not compensated for taking it. One study by Blackstar Funds  (The Capitalism Distribution), for example, showed that for the period 1983-2006 the 3,000 largest U.S. stocks had an average return of -1.1% compared to a 12.8% return for the Russell 3000 Index. 39% of stocks lost money during this 25-year period and all of the market return could be attributed to 25% of the stocks. Like most indices used by investors the Russell 3000 is market-capitalization-weighted, which means that the losers have increasingly smaller weights in the index while the winners constantly increase their weight. The indices follow mechanically the trend-following rule of cutting losses and sticking with rising stocks.

Another study by Hendrik Bessembinder (Do Stocks Outperform Treasury Bills) provides more recent data. Bessembinder covered all U.S stocks for the 1926-2015 period. According to the study, only 42% of stocks beat the returns of 1-month Treasury bills and less than half of stocks achieve positive nominal returns over their lifetimes. Over this 90-year period, only 86 stocks accounted for 50% of returns and an incredible 96% of stocks did not surpass the returns of 1-month treasury bills. Bessembinder compares stock-picking by individuals as “lotterylike” behavior; the hope of picking an Amazon and seeing it appreciate by thousands of percent.

What can be said  about the experience of emerging markets? Our data history is short and complicated by frequent changes in the indices, including the addition and exclusion of entire countries. Nevertheless, looking at Ishares Emerging Markets (EEM), which is based on the MSCI EM Index, for the period starting at year-end 2016 until mid-year 2017, we can draw some interesting parallels.

  • Of the 274 stocks in the index in 2006 only 148 (54%) remained in July 2017. These 148 remaining stocks provided a nominal return of -46.1% over the period, compared to a 7.5% return (before dividends) of EEM.
  • Of the top 10 stocks in 2006 (Gazprom, Samsung, TSMC, Posco, Kookmin Bank, Lukoil, UMC. KEPCO, Chunghwa and Silicon Precision) all except for Samsung, TSMC and Chunghwa have underperformed, dramatically in the case of the commodity stocks, Kookmin and UMC.
  • Of the original stocks only a handful have had good performance: Naspers, TSMC, Samsung Electronics, Ambev and Steinhoff.
  • Positive returns can be attributed to a few stocks, mainly East Asian tech stocks: Tencent-Naspers, Alibaba, TSMC, Samsung Electronics, Hynix, Netease, JD.Com, Naver, CTRIP and Largan.

The case of South Africa’s NASPERS is an interesting illustration of the “lotterylike” nature of investing. NASPERS has long been Africa’s most important and valuable media company. Like almost all South African corporates it began reducing its domestic exposure some twenty years ago. Adopting a incubator-venture capital model, it adopted a shotgun strategy, investing in a multitude of media and e.commerce ventures around the world,  including a stake in China’s Tencent in 2001. NASPERS’s business in Africa has stagnated and most of its foreign investments have floundered, except for Tencent where it hit the jackpot. Naspers’s original $34 million investment in Tencent in now worth $120 billion. Interestingly, the entire market value of Naspers is only $88 billion, so the market gives little real or optional value for the remaining assets.

Most individuals and professionals alike don’t have an identifiable edge in picking stocks and are compelled to the exercise for the lottery-like thrill of hoping to pick a winner. Picking a winner and holding on to it can be hugely profitable and make a career.

Us Fed watch:

India Watch:

  • Outsourcers are returning to the U.S. (NYT)
  • Is India like East Asia or Latin America? (Livemint)

China Watch:

China Consumer Watch:

  • Starbucks bullish on China growth Caixing
  • China’s Wanda slims down (NY Times)

China Technology Watch:

  • China’s surveillance giant, Hikvision, is worth $55 billion (WIC)
  • China’s phones growing share in EM (SCMP)
  • Chinese cellphone brands account for half of global sales (SCMP)
  • China targets U.S. microchip hegemony (WSJ)

EM Investor Watch:

  • South Africa’s great reconciliation is coming apart (WSJ)
  • Brazilian billionaires swap assets (bloomberg)
  • EM Valuations strong buy signal (Wisdom Tree)
  • Revisiting Allocation decisions in EM (GMO)
  • EM ETFs don’t all track the same index (ETF.com)

Technology Watch:

  • Summer of Samsung (Bloomberg)
  • TVs are disappearing from American homes (Recode)

Investor Watch:

Notable Quotes: (Avondale)

This quarter may have been more challenging than advertised

“this indeed was another challenging quarter and as I think we all know, the industry continues to face global market volatility and we have seen a further slowdown in consumer demand in several key markets, most especially the U.S. Southeast Asia and South Pacific.” —Colgate CEO Ian Cook (Packaged Goods)

Healthcare: Birthrates around the world have been disappointing

“So we had kind of projected 2016 was going to be a flat birthrate year. In the second quarter, we got the final fourth quarter numbers that showed it down 2% for the fourth quarter, which brought the full year down 1%…Korea’s birthrate…was down 7%, which is a pretty big, big drop…we don’t really understand it at a deep enough consumer insight level…But a broad trend is that Millennials are having their children a little later.” —Kimberly Clark CEO Thomas Falk (Packaged Goods)

There’s a lot of capital sloshing around the world

“there is a lot of capital that’s being raised and has been raised. And in general, there is just a whole lot capital sloshing around the world, looking for returns. ” —Blackstone COO Tony James (Private Equity)

“In the vast majority of asset classes, prospective returns are just about the lowest they have ever been,” Howard Marks (Oaktree Capital).

Notable Charts:

 

 

 

 

 

 

 

 

 

 

 

Emerging Market Portfolio Managers Against the ETFs

In the world of emerging markets it has generally been presumed that managers can justify higher fees for this asset class because they add more value. It is argued that emerging markets are less efficient because they are complex and under-followed by professional investors.  The relatively scarce qualified portfolio managers and analysts with the skills and experience to navigate the territory should command higher compensation.

While low-cost indexed products have increasingly disrupted the asset management industry, the arguments in favor of active management for the emerging markets asset class have persisted: (Bloomberg)

  • Market inefficiency – More complexity and less professional analysis gives a tangible advantage to managers capable of conducting in-depth research.
  • Benchmark composition – The index benchmark is full of unattractive countries, sectors and companies, that can be avoided by skilled managers. For example, heavy index weightings in poorly managed state enterprises and commodity producers can be avoided to outperform.

Moreover, EM managers may have the advantage that because of its relatively short history as an asset class less academic research has been conducted on performance factors. While in the U.S. academic research has identified the performance “anomalies” caused by tilting portfolios for value, size, quality and momentum, these factors are less well understood in EM and may be easier to exploit by managers.

The evidence partially supports the argument that professional managers of emerging markets funds add value, at least in comparison to managers of U.S. domestic and international funds.

For example, the table below shows the latest results of Morningstar’s Active/Passive Barometer (Morningstar ). Active EM managers, despite higher fees, are seen to perform better than their peers in U.S. and International asset classes, with particularly impressive results over the three and five year periods. On an asset weighted basis, which gives greater consideration to the larger funds, performance is even better. (Note, the data does not consider the greater tax efficiency and lower acquisition costs for ETFs).

The SPIVA Scorecard published annually by S&P Dow Jones Indices (S&P Indices)  shows much less impressive results for EM active managers. SPIVA claims to have a more rigorous approach, adjusting results for survivor bias and for style (e.g., growth vs. value). The SPIVA scorecard shows EM active funds under-performing indices over all periods, largely in a fashion similar to U.S. and International funds. As with Morningstar, SPIVA shows larger managers with better results.

Part of the discrepancy between SPIVA and Morningstar can be explained by the significantly stronger performance of the S&P/IFCI EM Index used by SPIVA compared to the ETF composite used by Morningstar. This causes confusion as both ETFs and active funds use various indices, and neither study adjusts for this. In any case, both reports agree on several points. First, active managers have not created value over the long term; second, larger asset managers create more value. The better performance of the larger funds may show that larger managers with greater analytical resources can add more value.

The Morningstar report also points out that the primary source of outperformance relative to peers for active managers is lower fees. This may also explain the better performance of the larger managers, assuming that they are passing on the benefits of scale economies to clients.

Certainly, the disruptive influence of EM indexed products will not go away and may worsen. It may be that EM active managers have benefited of late from the bear market of the past five years for several reasons. First, during down markets active managers benefit from holding cash. This becomes a source of performance drag during bull markets, and we may have already seen this effect during 2016. Furthermore, assuming positive performance for EM equities, indexed products are likely to be more formidable competitors in coming years, as they tend to outperform in bull markets.

Index products should be easier to beat in a five-year bear market for EM like the one we saw between 2011-2016. The benchmarks which most active managers as well as ETFs observe are market cap-weighted indices, which makes them classic trend-following instruments. When markets are rising and flows are abundant, the index keeps on increasing position sizes in winners and reducing positions in laggards. This led to huge positions in commodity stocks in 2006-2007 and to very high weightings in tech companies today. During bull markets, most active investors become nervous about valuations and the size of positions and retreat ahead of the indices. In a bear market the process reverses. The index pressures prices by selling its largest most overvalued positions. The collapse of commodity stocks during 2012-2014 created “easy alpha” for managers who were comfortable in stepping aside and waiting for valuations to return to normal levels.

The dilemma for EM managers is the same faced by managers in all asset classes disrupted by low-cost index funds. To justify their existence managers have to take much more risk than they are comfortable with. The vast majority of professionally managed funds can be considered “closet index funds” in the sense that they manage around the index. The difference between the portfolio and the index is known as the “active risk.”  Many actively managed funds will have around 15% of active risk, the remainder of the portfolio mimicking the benchmark. The problem is that an ETF like Vanguard’s VWO, charges a management fee of only 14 basis points (0.14%), while the active manager charges, on average, 1.5%  even though  85% of his assets only mimic the benchmark. Clearly identifying this issue, a firm like Blackrock, which manages both ETFs and active funds, is moving aggressively into highly concentrated actively managed portfolios with very high levels of active risk.

However, moving to highly concentrated portfolios with high active risk is something that very few managers can countenance. AS GMO’s Jeremy Grantham  never tires of saying, the primary behavior driver of asset managers is career risk ( GMO ). Unfortunately, the proliferation of low-cost alternatives is undermining the economics of the asset management industry and decreasing job security just at the time that managers need to embrace risk.

Us Fed watch:

India Watch:

  •  Indian market can triple over the next five years (Wisdom Tree)

China Watch:

China Technology Watch:

  • China outlines plans to be world leader in AI (Caixing Global)
  • Lenovo announces big push into AI (SCMP)

Technology Watch:

  • The return of basic sewing manufacuring to the U.S. ((FT)
  • Are robots the future of global finance (UBS)

EM Investor Watch:

  • Emerging Markets rally has “legs” (Van Eck)
  • Revisiting Allocation decisions in EM (GMO)
  • EM  breaks 10-year downtrend (The Reformed Broker)
  • The bullish case for EM (Mark Dow)
  • EM ETFs don’t all track the same index (ETF.com)

Investor Watch:

Notable Quotes: (Avondale)

 

Emerging markets have been weak for a long time: “since the financial crises, interest rates, currencies etcetera, we’ve had a prolonged period of about eight, nine years now where we have seen significant weakening of emerging market currencies…you actually see the volume component of these emerging markets continuing to be very, very low, while historically it was all volume-driven growth. I am convinced that that is coming back now.” —Unilever CEO Paul Polman (Packaged Goods)

China may be stabilizing: “China for example is actually much more stable than the last 12 to 18 months. I like what I’m seeing in China right now.” —Abbott CEO Miles White (Medical Device)

Chinese are still buying international assets: “we’re still seeing the trend of Chinese buying and international assets. ” —Goldman Sachs CFO Martin Chavez (Investment Bank)

“In the vast majority of asset classes, prospective returns are just about the lowest they have ever been,” Howard Marks (Oaktree Capital).

Notable Chart:

In Emerging Markets The Only Constant is Change

Antoine van Agtmael, the man who coined the term “emerging markets,” was a pioneer. His firm Emerging Markets Management was founded in 1988 to provide institutions access to what was at that time a very small emerging markets asset class, with fewer than 20 companies with revenues over $1 billion, almost all of them either banks or commodity producers. In his book, The Emerging Markets Century (2007), van Agtmael stressed the violent pace of change for the asset class. Fifteen years after launching the fund, 80% of the largest 100 companies had disappeared from the list. Not one of the top ten most valuable stocks remained 15 years later. Several factors drove this revolution, according to van Agtmael.

  • The move of China, Russia and Eastern Europe from centrally-planned to market-oriented economies and their integration into the global economy through trade and investments.
  • A neo-liberal wave of privatizations across emerging markets, leading to private investment in energy, telephone and power companies and a wave of public listings.
  • Improved economic policies and lower tariffs (The Washington Consensus), resulting in the control of hyperinflation in Argentina and Brazil, fiscal discipline and deleveraging in Asia and trade expansion.

The chart below  lists the top ten most valuable emerging market stocks in 1990 and 2005, taken from van Agtmael’s book. I have added the current standings, as of July 2017.

 

These lists give us several valuable insights on emerging markets investing.

  • Change is constant. The “revolution” continues. The 1990 list was dominated by Taiwan which was at the top of an epic stock market bubble. The 2005 list is dominated by commodity stocks, propped up by the China-induced commodity bubble. The current list is all China and tech. Emerging markets have their own version of FANG (Facebook, Apple, Netflix, Google), which is BATS (Baidu, Alibaba, Tencent, Samsung).
  • The drivers cited by van Agtmael have lost traction. We are seeing a backlash against neo-liberal reforms and globalization, and few privatizations. Countries with large domestic markets to protect and exploit are now seen to have the advantage.
  • Bubbles in specific geographies or segments can have a huge impact on performance. The 1990 list coincides with the peak of the great Taiwan bubble. Bubbles in Mexico (1992), Malaysia (1996), Brazil (1997), Korea (2005) had similar distortionary effects on the rankings. Same for the  commodity bubble (2005-2010), which rules the 2005 list. The 2017 list is greatly impacted by the current boom in tech stocks. There seems to always be a major bubble brewing somewhere in emerging markets.
  • There are fewer changes between the 2017 list and the 2005 list than there were between 2005 and 1990, with four stocks remaining on the list. All of the surviving stocks are either China or tech related, which may indicate we are seeing long-term secular shifts happening.
  • The expansion of China in general and China and tech in particular seem inexorable. Or are they? Only time will tell. Of the 2017 top ten, eight are essentially Chinese stocks, as Naspers’s value is mainly in its holdings in Tencent and Hon Hai’s operations are mainly based in China. Only Samsung and TSMC are independent of China. China’s market weight is likely to grow further, as its economy grows above the global average and benchmark indices include more Chinese stocks.
  • India’s absence is noteworthy. If the current hype on India is justified, ten years from now we will likely see a few Indian names on the list.

 

Us Fed watch:

Brazil Watch :

India Watch:

  • The Indian economy; a tale of two narratives (Livemint)
  •  Indian market can triple over the next five years (Wisdom Tree)

China Watch:

  • China broad credit growth slows to zero (Variant Perception)
  • Making sense of China’s foreign M&A (McKinsey)
  • Zombies are dragging down China’s productivity (Bloomberg)
  • The CEO guide to China (McKinsey)
  • The Chinese bought $32 billion in U.S. residential real estate in 2016 (WSJ)
  • Xi’s Tiger Hunt (Sinocism)

China Technology Watch:

  • Chinese military drones gaining foreign markets at U.S. expense (WSJ)
  • JD.COM invests in drone delivery (China Daily)

China Consumer Watch:

  • Chinese have all the appliances they need (SCMP)
  • China’s Hisense wins sponsorship for FIFA 2018 (China Daily)

Eastern Europe Watch:

  • Poland is breaking out of the Middle-Income Trap (NY Times)

Technology Watch:

  • The return of basic sewing manufacuring to the U.S. ((FT)
  • Are robots the future of global finance (UBS)

EM Investor Watch:

Investor Watch:

Notable Charts:

 

Learning to Love Volatility in Emerging Markets

Though economic and currency volatility may reduce the long-term sustainable GDP growth of countries like Brazil ( Brazil’s Economic Stagnation), paradoxically,  volatility is also the primary source of returns for the emerging markets investor. Economic booms, with rising stock markets and strengthening currencies, are invariably followed by busts, with collapsing markets and weaker currencies. For the investor who measures returns in dollar terms, the more volatile emerging markets provide turbo-charged results both on the way up and the way down. Learning to love that volatility is often the key to success.

Brazil is one stock market that is marked by enormous swings. Since 1990 Brazil has seen three market collapses; -88% in 1997, -76% in 2008, and -88% in 2011 (all measured in USD terms). Brazil also had a 80% collapse in the seventies and an 88% drawdown concluding in 1990. It seems that about once a decade, a period that should be well within a reasonable time horizon for most investors,  an investor in Brazil suffers  losses of between 80-90% in terms of U.S. dollars.. But Brazil is far from being unique in emerging markets in this regard. Since 1990, there have been 41 cases of a stock markets losing more than 50% of their value, with an average drawdown of 72%. Over this period, Turkey and Argentina are the champs, each experiencing six drawdowns of over 50%.

On the positive side, drawdowns are followed by bull markets, like day follows night. Over the next two and half years following the 41 market bottoms, investor see average returns of over 500%. Every Brazilian collapse has been followed by a extraordinary bull market:

  • 1983 bottom (-80%), followed by 14x return of capital
  • 1991 bottom (-87%), followed by 24x return of capital
  • 2002 bottom (-83%), followed by 17x return of capital

For the value investor, the brutality and frequency of emerging market drawdowns creates a dilemma. Value investors, indoctrinated by Warren Buffett’s consistent wisdom, believe in investing for the long-term. For example, two commonly cited quotes from Buffett are:

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 year;”

And “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”

An emerging markets investor could follow Buffet’s advice, patiently sitting through the drawdowns. By sticking with only the highest quality companies, the drawdowns can be minimized. The astute investor can also improve returns by trimming positions when valuations are high and taking advantage of market meltdowns to add to positions.

However, an alternative and often more productive better way to invest in emerging markets is to learn to love the volatility and skillfully harness it as the major source of returns.  Emerging markets, like commodities, often experience extreme cyclicality with predictable patterns. Investors that are aware of the patterns, can exploit them repeatedly. As commodity markets investor Martin Katusa says, investors in markets characterized by extreme cyclicality can best be “be approached with a ‘rent, don’t own” mentality.”

A strategy which may be anathema to value investors but is very effective in emerging markets and commodity investing is to marry a valuation process with basic trend-following techniques. An investor can patiently wait for a market to meltdown and then watch like a hawk for an entry point to ride the inevitable bounce-back. Typically, good entry points are created when a market has reached extraordinarily low valuations and is showing signs of trending up. Market bottom valuations, in my view, are often signaled by cyclically adjusted price/earnings ratios (like the CAPE Schiller ratio), which should be dollarized to fully measure the volatility of the markets. Timing decisions can be influenced by simple trend-following indicators, like the 50-day or 200-day moving average.

The advantage of patiently waiting for markets to bounce back before deploying capital is that the investor does not experience massive losses of capital on the downside. The absolute investor without concern for benchmarks is in a better position to do this than most institutional investors who are not willing or permitted to stray from their benchmarks for long periods of time.

Us Fed watch:

Brazil Watch :

  • China’s Fosun looking at Brazil Healthcare (SCMP)
  • IMF On Latin America Currency Flexibility ( IMF)

Mexico Watch:

  • WEF Tourism Competitiveness Report shows Mexico’s Rise (WEFORUM)
  • Mexico’s surprising oil finds (NY Times)

India Watch:

China Watch:

  • Mark Mobius on China  (Templeton)
  • Beijing’s New Airport (Caixing)
  • Xi Jinping’s War on Financial Crocodiles (FT)

China Technology Watch:

  • Chinese train maker expands U.S. market  (China Daily) 
  • China Launches new generation bullet train (WIC)
  • Beijing Subway Blocks ApplePay WIC
  • JD.COM invests in drone delivery (China Daily)
  • China plans $108 BB investments in chips (WSJ)

China Consumer Watch:

  • China’s Hisense wins sponsorship for FIFA 2018 (China Daily)
  • China rises in global tourism competitiveness (China Daily)

Korea Watch:

Eastern Europe Watch:

  • Poland is breaking out of the Middle-Income Trap (NY Times)

Commodity Watch:

  • Oil’s Game of Chicken; Can OPEC Finally Bankrupt U.S. Production (Seeking Alpha)

Anti-Globalization Watch:

Emerging Markets Investor Watch:

Guru Watch:

  • An Interview with Peter Bernstein (Jason Zweig)
  • Chano’s sees weak U.S. economy (Inetenomics)Notable Charts:
  • China Inverted yield Curve signals slowdown
  • Commodities at record low valuations relative to the S&P 500

Notable Quotes:

  • When markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.” (Bob Rodriguez – We are witnessing the development of a “perfect storm”(seeking alpha)

“Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepted theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.” (Robert Schiller)

 

 

 

 

 

 

 

 

 

 

 

 

Brazil’s Economic Stagnation

Brazil is a poster child for the “middle-income trap,” the phenomenon that keeps developing economies from narrowing the wealth gap with wealthy countries once they have reached a moderate level of prosperity. As is typical for many emerging market countries which are over-dependent on commodity exports and foreign capital inflows, the Brazilian economy experiences frequent boom-to-bust cycles, the latest being the commodity/liquidity/credit-fueled consumption boom of 2003- 2013 which was followed by a deep recession in 2014-2017. The overall result is mediocre growth. Brazil’s GPD per capita relative to the high-income economies is at the same level as in 1960, and actually has deteriorated significantly since the late 1970s.

A recent paper by Jorge Arbache and Sarquis J. B. Sarquis, Growth Volatility and Economic Growth in Brazil (Arbache-Sarquis) argues that Brazil’s poor performance is tied to the high volatility of the economy which in turn is caused by uncertain commodity prices and capital flows and their effects on currency valuation. It makes intuitive sense that volatility would hurt growth; boom-to-bust cycles are inefficient, as economic agents over-indulge in good times and retreat in bad times. Volatility also makes it difficult for both the public and private sector to plan and budget long term investments.

Brazil’s economic volatility is caused by well-known factors:

  • Chronic low savings and high current account deficits financed by fickle foreign capital flows.
  • Exports dominated by commodities, and the current account highly impacted by commodity prices. High commodity prices improve the current account which lowers country risk premia and leads to higher foreign financial and investment When commodity prices fall, the process unwinds.
  • Pro-cyclical currency valuation. The currency appreciates during good times and weakens during busts. During currency appreciations manufacturers lose export competitiveness and focus on growing domestic consumption.
  • Monetary policies dictated by the U.S. Fed. The deep recession of 1981-83 was triggered by U.S. Fed Volcker’s high interest rates imposed to wage his war on inflation. The boom of the last decade was fueled by Fed-fueled global liquidity.
  • Pro-cyclical fiscal and monetary policies; fiscal expansion during booms and retraction during busts. During the current deep recession in Brazil, the authorities have both increased real interest rates and tightened fiscal spending.
  • Chronic fiscal imbalances cause uncertainty and high country risk premia.

The current boom-bust cycle has been particularly destructive for Brazil. The china-induced commodity boom caused excessive currency appreciation, a credit-fueled consumption surge and severe deindustrialization.  In sharp contrast to successful Asian economies that have promoted the exports of manufactured goods, Brazil has evolved prematurely into a service economy. 76% of jobs in the Brazilian economy are now generated by the service sector, and the great majority of these jobs are low-skill, low wage jobs. Manufacturing’s share of GDP has fallen from 34% in 1980 to 10% in 2015, and Brazil has become increasingly dependent on commodity exports.

Brazil’s Central Bank has pursued inflation-targeting, the latest fashion for global monetary authorities, with abandon. During the past decade and especially the past three years of deep recession, Brazil has consistently had the highest real interest rates in the world. The famous dictum voiced by former Finance Minister Mario Henrique Simonsen  — “A inflação incomoda, mas o câmbio mata (Inflation bothers but the foreign exchange rate kills.“ ) has been entirely forgotten.

How can Brazil avoid boom-bust cycles in the future? As Arbache and Sarquis state in their paper, given Brazil’s history it is better to aim to grow in a stable and sustained manner than to seek high rates of growth. Solving chronic fiscal and foreign account imbalances are at the center of any reduction in volatility. On the foreign account side, it would be imperative for Brazil to maintain a competitive currency to promote domestic manufacturing and gradually diversify from commodities.

However, Brazil’s poor economic performance is only partially explained by volatility. More importantly, Brazil does poorly in human capital development and in providing a good environment for business. Steady improvement in both these areas would boost sustainable growth. Unfortunately, Brazil has shown no progress in these areas. Its ranking in the United Nations Human Development Index has fallen from 69 to 79 over the past 15 years. Ditto for the World Bank’s Doing Business survey which ranks countries in terms of the quality of the regulatory and institutional framework for business and where Brazil has shown no progress whatsoever.  Brazil ranks a miserable 123rd on the list, lower than 119 in 2006, and the worst performing of the major emerging markets except for India.

 

Us Fed watch:

Brazil Watch :

India Watch :

China Watch:

  • Beijing’s New Airport (Caixing)
  • Xi Jinping’s War on Financial Crocodiles (FT)

China Technology Watch:

  • China aims to be a leader in 5G  technology (WIC)
  • China Shows off New Generation of High-Speed Trains (Caixin)
  • CRRC Wins Train Supply Deal in Montreal (Caixin)
  • Chinese Phones Take over Indian Market (SCMP)

China Consumer Watch:

  • China’s aging (Bloomberg)
  • P&G Refocuses Strategy on Premiumisation ( SCMP)

Eastern Europe Watch:

Poland is breaking out of the Middle-Income Trap (NY Times)

Commodity Watch:

  • Oil’s Game of Chicken; Can OPEC Finally Bankrupt U.S. Production (Seeking Alpha)
  • Will U.S. Drillers Drive Oil Prices Into the Ground (Fed Up)
  • Temasek on Chinese Overinvestment (CNBC.com)
  •  China’s Steel Overcapacity (Peterson Institute)

Technology Disruption Watch:

Anti-Globalization Watch:

Emerging Markets Investor Watch:

Notable Blogs:

Notable Quotes:

“The biggest unknowable is that you have the illusion of liquidity. You have people who promise overnight liquidity that have taken quite illiquid positions, particularly lending to various entities. As long as the party continues that’s fine, but should this liquidity be tested it’s not going to be as deep as people think.” – Mohamed El-Erian

“When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.” (Bob Rodriguez – We are witnessing the development of a “perfect storm”(seeking alpha)

“Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepte theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.” (Robert Schiller)

China, the Middle Income Trap and Beyond

Emerging market countries can be categorized according to the level of prosperity achieved by their populations.  Generally, poor countries, with lower GDP per capita, should grow faster than richer countries, as they adopt well-known technologies to boost productivity. Assuming a stable social and political environment and basic legal and economic conditions, high growth, driven by urbanization and basic manufacturing, can be achieved for long periods. India and Indonesia, for example, today are in this “catch-up” phase, growing their GDP at well above average global rates. China has achieved phenomenal growth since it launched economic reforms in the late 1970s, following the path previously taken by its neighbors South Korea, Taiwan and Japan.

However, once middle-income status has been achieved most countries are unable to further reduce the gap with the United States and the other highly developed countries. This is called the “middle-income trap.” Aside for a few city-states (Singapore and Hong Kong) and oil-rich sheikdoms,  few  have broken the trap.  The exceptions may be Taiwan, South Korea and Israel. These three have benefited from a special relationship with the U.S. hegemon and successfully pursued education-intensive, high-tech strategies. On the other hand, some countries regress after reaching middle-income level; Argentina, Venezuela and South Africa are examples of this. Brazil is another worry; it has grown GDP/capita at less than 0.9% per year since its “miracle” came to an end in the late 1970s.

China clearly sees itself following the path of Taiwan and South Korea. Though it will not enjoy U.S. support, some indicators point to good prospects.

For  a middle-income country to sustain high growth it needs to move up the value chain which means higher innovation and productivity, which requires a highly educated workforce. The Global Innovation Index ranks countries in terms of their innovative capacity and has been doing this for 10 years using the same methodology. In its 2017 report, GII highlights the stagnation of middle-income countries in bridging the gap with rich countries, but singles out China as the exception. GII ranks China as the 22nd most innovative economy, closing in on the elite. This compares to its 37th ranking in the 2008 GII report

China’s growing capacity to innovate is confirmed by its increase in patent filings. In fact, according to the World Intellectual Property Organization (WIPO),  in 2016 China filed for over 38% of international patents, surpassing the  United States with 20.4%.

The OECD Program for International Student Assessment (PISA)  evaluations point to China’s spectacular rise in science and technology and give credence to its ambitions. According to the 2015 PISA report, the most developed parts of China, as represented by Beijing-Shanghai-Jiangsu-Guangdong, already score in line with the best Asian performers and well above the United States and European levels, particularly in mathematics.

Chinese policy makers are well aware of the “middle-income trap,” and are determined to avoid it. The legitimacy of the authoritarian political regime to a degree rests on its ability to sustain growth and rising living standards. That is why promoting innovation was given the highest priority in the governments 13th Five-Year Plan for Economic and Social Development, 2016-2020, and a commitment was made to harness resources to achieve breakthroughs in key technologies. The 13th plan goes so far as to specify the technologies that China must dominate and makes an explicit commitment to provide the financial and institutional support to promote success.

 

Us Fed watch:

 

Brazil Watch :

India Watch :

China Watch:

Xi Jinping’s War on Financial Crocodiles (FT)

China and Africa (Mckinsey)

China Technology Watch:

China Shows off New Generation of High-Speed Trains (Caixin)

CRRC Wins Train Supply Deal in Montreal (Caixin)

Chinese Phones Take over Indian Market (SCMP)

Tech Titans in China Take Battle to a New Frontier (Bloomberg)

 

China Consumer Watch:

  • P&G Refocuses Strategy on Premiumisation ( SCMP)

 

Commodity Watch:

  • China Scap Metal Exports Balloon (Caixin)
  • “The mining methods of the past have changed. And where we’re controlling mines from for the future from pit support is located in office buildings instead of the mine sites…I was talking to a customer last week about autonomy and they have a goal to be fully autonomous on every mine site by 2025. And they have thousands of pieces of equipment. So, you’ve got these bold goals being placed out there. So, clearly, the momentum is moving.” —Caterpillar Resource Industries President Denise Johnson (Mining)
  • And this chart from Martin Katusa shows how weak demand and declining production costs lead to low prices, and commodity prices at all-time lows relative to the S&P 500.

  • The Collapse of South Africa’s Mining Sector Valuewalk

Technology Disruption Watch:

Anti-Globalization Watch:

 

Notable Blogs:

 

Notable Quotes:
• “Xi’an only has a little over 40 Starbucks at the moment. This is definitely not enough. I think 400 would be more appropriate.” Wang Yongkank, Party Secretary of Xi’an, as reported by Week in China.
• “The reality is that as a planned economy and with the government having control of the major banks and large companies, a financial crisis is simply not in the cards.” Mark Mobius, Templeton Investments on China.

The Case for Emerging Markets

Warren Buffett and Jorge Paulo Lehman, two of the best investors of the past decades, recently met with students at a conference at the Harvard Business School organized by Brazilian business students. Asked for their opinion on opportunities for investing in emerging markets, both Buffett and Lehman deflected the question, preferring to highlight a preference for the depth and wealth of opportunities available in the United States. “If we’re going to prospect,” Buffett said, “this is a huge, huge market, and if there is something modestly better where I don’t understand the culture that well or the laws of have an acquaintance with the business people and were missing that that doesn’t bother me at all.” “America”, he added, “is a pretty darn good place to invest.”
Should the individual investor follow the advice of the Sage of Omaha? Surely there is wisdom in investing in things that one understands, and the dynamism and diversity of the American capital markets are unsurpassed. Yet, there is a good case for allocating some capital outside the United States.
When Buffett started investing in the 1950s and 1960s the U.S. was a global hegemon with a preponderant economy and matchless capital markets, but today the global economy is increasingly driven by Asia. Aging populations, low productivity growth and high levels of debt in the U.S. and other developed countries point to slower growth than in the past. Younger populations and more opportunities for increasing productivity mean that emerging markets can count on relatively higher economic growth and expanding capital markets. Most of the wealth creation in the world today is being generated in Asia. Many traditional industries, such as oil and electricity, face declining volumes in developed markets, and will rely entirely on emerging markets to sustain any growth.
In addition to providing investors the opportunity to tap into the faster growing economies of the world, Emerging markets provides the investor with some diversification, the only “free lunch” in the investing world.
Notwithstanding Jorge Paulo Lehman’s appreciation for the depth and scale of the U.S. capital markets which he now finds indispensable to deploy the fire-power of 3G Capital, his partnership continues to treasure its Brazilian roots. The beer and food empire which now includes Budweiser and Kraft all started from nothing some 30 years ago in Brazil, and even today the group harnesses the best of Brazilian entrepreneurial creativity and dynamism. After the recent merger of ABInBev and SABMiller, Lehman’s beer juggernaut will have more than half of sales and practically all of its growth generated by its breweries in emerging markets. As Lehman told the Harvard students, though “America is wonderful compared to the rest of the world,” beer is not growing in developed markets, so ABInbev has gone to Africa in “a big way” where “there is a hot climate, young population” that will double from 1 billion to 2 billion in the next thirty years. AbInBev now has six of the top ten best-selling beer brands in China, the largest potential source of earnings growth for the global beer industry in the coming decade, and near-monopolistic positions in the African and Latin American continents.
This blog will explore the opportunities for investing in emerging markets created by entrepreneurs like Jorge Paulo Lehman. It will seek to educate the common investor about the main trends in these markets and explore the controversial issues that affect the investor in emerging markets.

Us Fed watch:
• Ady Barkan sees changes coming at the Fed (Fed Rethink Coming ).
• Ben Hunt on who is master of the FED( Tell My Horse).
• Larry Summers on Why the Fed is making a mistake(Larry Summers)
• Unprecedented valuations of financial assets (The Felder Report).

Emerging Markets Watch :
Bloomberg says BRICS are back in favor. (Bloomberg)

Brazil Watch :
• Brazil’s Argentina Moment Project Syndicate

India Watch :
• A New Emphasis on Gainful Employment In India McKinsey

• India’s PayTM said to seek license to offer money market fund. Bloomberg

China Technology Watch:

• China Shatters “Spooky Action at a Distance” Record, Preps for Quantum Internet  Scientific American

Commodity Watch:
• “The mining methods of the past have changed. And where we’re controlling mines from for the future from pit support is located in office buildings instead of the mine sites…I was talking to a customer last week about autonomy and they have a goal to be fully autonomous on every mine site by 2025. And they have thousands of pieces of equipment. So, you’ve got these bold goals being placed out there. So, clearly, the momentum is moving.” —Caterpillar Resource Industries President Denise Johnson (Mining)
• And this chart from Martin Katusa shows how weak demand and declining production costs lead to low prices, and commodity prices at all-time lows relative to the S&P 500.

• Fear is What Changed Saudi Arabia (WSJ)
• “You go to Asia. You go to Europe. You go to the Middle East. They realize the position of the U.S. in the world is different today because of this change in our energy position. Among other things, the sanctions on Iran would not have worked had it not been for shale, because you could not have replaced the Iranian oil that was taken off the market. And so now instead of just OPEC and non-OPEC, you have the big three. You have Saudi Arabia, you have Russia, and you have a country called the United States.”— Daniel Yergin, vice chairman, IHS Markit (WSJ)
• Measuring Labor Productivity in the Gold Mining Industry S&P Global Market Intelligence
• The Collapse of South Africa’s Mining Sector Valuewalk

Technology Disruption Watch:
• Amazon’s New Customer  Stratechery
• Why Amazon Bought WholeFoods L2

Anti-Globalization Watch:
• Commerce Secretary Wilbur Ross Talks Trade  WSJ

Notable Blogs:
• On My Radar: Investment Ideas — Notes from the 2017 Strategic Investment Conference   CMGwealth
• Peak Stimulus has Passed  CreditBubbleBulletin
• Yardeni on tech valuations Yardeni
• On momentum investing and buying all-time highs. Of dollars and data

Notable Quotes:
• “Xi’an only has a little over 40 Starbucks at the moment. This is definitely not enough. I think 400 would be more appropriate.” Wang Yongkank, Party Secretary of Xi’an, as reported by Week in China.
• “The reality is that as a planned economy and with the government having control of the major banks and large companies, a financial crisis is simply not in the cards.” Mark Mobius, Templeton Investments on China.

Notable Chart from Gavekal Research