The Persistent Decline of Latin American Competitiveness

In a globalized world, capital will flow to the countries that provide the best conditions for businesses to operate. The IMD business school in Lausanne, Switzerland conducts a survey annually to measure how well governments  “provide an environment characterized by efficient infrastructures, institutions, and policies that encourage sustainable value creation by enterprises.” This survey is particularly significant because previous efforts by the World Bank (Doing Business) and the World Economic Forum (World Competitiveness Report) have been abandoned. The latest editition of the IMD World Competitiveness Report provides more damning evidence of the poor performance of many emerging markets, particulalry those in Latin America.

The IMD survey focuses on the 64 countries considered most relevant for multinational businesses. The latest rankings are shown in the chart below. Of the 15 largest countries in the MSCI Emerging Markets Index, only seven make it in the top half of the rankings (Taiwan, Saudi Arabia, UAE, China, Malaysia, Korea and Thailand). The two  in the top quintile (Taiwan and UAE) are rich countries, only included in the EM Index because of market access issues. On the other hand, in the bottom quintile, there are eight EM countries (Philippines, Peru, Mexico, Colombia, Brazil, South Africa, Argentina and Venezuela). Every Latin American country, except for Chile,  is in the bottom quintile, and four are in the bottom decile (Colombia, Brazil, Argentina and Venezuela. (Latin American countries are in bold and remaining EM countries in red)

The poor performance of Latin America has worsened over time. This can be seen in the following chart that shows IMD rankings since 1997 in decile form. There is a pronounced deterioration in the region’s rankings over this period, particularly after the commodity boom of the mid-2000s and the Great Financial Crisis. The decline of Argentina, Brazil and Chile, all commodity producers suffering from acute “Dutch Disease” (the commodity curse), is most pronounced, but even Mexico with the great advantage of NAFTA, has done poorly over the past ten years.

In addition to the devastating effects of the boom-to-bust commodity boom (2002-2012), the region suffers from multiple ills.

  • Political turbulence throughout the region, with the important exception of Mexico.
  • Poorly designed economic policies, often anti-business and generally poorly executed and unsustained.
  • Rampant capital flight, as elites and middle classes seek the security of Miami, Lisbon, Dallas, Punta del Este, etc…
  • The onslaught of Asian mercantilists, dumping manufactured goods in Latin American domestic markets.
  • Rising wealth inequality, as governments are unable to formulate and/or execute policies to provide employment or income to large segments of the population.

 

Stages of Development; Current Implications for Emerging Markets Part2

In a previous post (link) the stages of development were discussed in the context of the transition from a traditional rural society to a modern capitalistic consumer-driven economy.  Initially, abundant labor and high returns on capital  spark lengthy periods of “miraculous” growth. Later, as labor becomes scarce and the technology frontier is approached, returns on capital decline and GDP growth has to be driven by household consumption.  In this post, the factors of production (labor and capital) are looked at in detail.

The expenditure approach is commonly used in macroeconomics to describe economic output in terms of the money spent by consumers (households and government) and investors (private business and government). Net exports are added to measure whether an economy captures foreign consumer demand through exports  or relinquishes foreign demand through imports. For example, as a net exporter China is repressing domestic consumption to capture foreign consumer demand, while as a net importer, the United States is  stimulating domestic consumption and relying on foreign producers. Another approach to understand economic output is to measure the contribution to GDP growth coming from the  factors of production: labor and capital.

The Conference Board database on national accounts (link) provides a long-term view on productivity. The data illustrates what factors of production are driving the economy, and it is useful to measure the evolution of productivity over time.

As an economy begins to  modernize, labor productivity growth will be high and investors can deploy capital with high returns. As rural migration accelerates and more capital is deployed, countries experience stages of “miracle” growth when both labor and capital productivity are high. Eventually, a country achieves a significant degree of integration into the modern global capitalistic economy. At this time, labor becomes scarce and capital returns muted. Mature economies come to rely for growth mainly on the expansion of consumer services and hard-to-achieve technological innovation.

The charts below, based on the Conference Board data, aim to illustrate how the process plays out over time for countries at different stages of the development process. The first section looks at the United States and several mature emerging markets that have already experienced a one-time phase of “miracle” growth. The second section looks at India and Vietnam, two economies currently experiencing high growth

I. Mature Economies

The United States 

The United States has been a mature economy at the technology frontier since the early 2oth century. A broad expansion of consumption in the 1950s and 1960s drove high GDP growth. GDP Growth trended down from over 4% in the 1950s to below 2% in the 2020s, and has become  dependent on debt accumulation and Fed-driven asset appreciation. Contribution to GDP growth from labor has gradually declined over the period, despite high immigration, a huge one-time increase in female participation in the workforce, and steady improvements in the quality of labor. Growth in the working age population is projected to be near zero in the 2020s. Despite the United States’s dominant position in technological innovation, total factor productivity (the residual increase in growth that is not driven by capital and labor) has fallen from 1.5% in the 1950s to zero over the past decade.

 

Brazil

Brazil’s economy took off in the 1950s and experienced “miraculous”growth in the 1960s and 1970s, driven by high levels of investment and labor growth. Since the 1980s, Brazil has been mired in a “middle-income trap” caused by  a massive expansion of unproductive government spending, a stagnant consumer, a failure to promote innovation, and institutional breakdowns (i.e. corruption). Since 1980, GDP growth has averaged about 2%, falling to near zero over the past 12 years.

Labor quantity growth in Brazil is now near zero, though labor quality continues to improve.  Capital investment has not been driving growth, due to low returns on investment. Remarkably, total factor productivity, which was high in the 1950-1980 period, has now been negative over the past 40 years, and fell by 1.4% annually during the 2010s.

Korea

Korea’s economy took off in the 1970s and experienced its economic miracle between 1983 and 1997. Real GDP growth was very high for nearly three decades (1969-1997). As the economy  achieved advanced economy status, growth has slowed down over the past 20 years. GDP growth has fallen from 7% annually in the 1990s, to 4.5% in the 2000s and 2.5% over the pat 12 years. Over the past decade, labor quantity growth has been near zero, and though still positive, labor quality improvements are well below those of the miracle years. Total factor productivity has fallen from the 2.5% annually of the miracle years to 0.5% over the past decade. Korea is now a mature economy operating at the technology frontier. This means it competes directly in innovative products with developed nations, while facing strong competition from China on traditional products.

China

China’s economy took off in the 1970s, and then entered a 30-year period of “miraculous” growth with Deng Xiaoping’s reform in the 1980s. This extended period of growth allowed China’s coastal areas to reach a significant level of economic maturity, though much of the hinterlands remained isolated from the modern economy. China’s growth was driven by massive rural immigration and  high levels of investment by both the government and foreign enterprises, which converted China into the “workshop of the world.” The growth model followed closely what Paul Krugman described in his 1994 paper “The Myth of Asia’s Miracle,” which pointed out that growth in Korea, Thailand and Malaysia was driven by extraordinary growth in inputs like labor and capital rather than productivity.

China (Alternative)

China’s economic growth is considered by many economists to be overstated by the Chinese government. This is particularly valid over the past decade as the quality of growth has declined because of unproductive investments. The Conference Board provides an alternative measure of GDP which may be more realistic. According to the Conference Board’s alternative estimates, China’s GDP growth for the past twenty years was 7.1% compared to the 8.6% recognized by the government (and reported by institutions like the IMF and World Bank). If the alternative numbers are accepted, then China’s GDP output can be considered to be 30-40%  less than reported. Alarmingly, under the alternative analyst, investment drove almost all growth over the past twenty years, and the contribution to growth from total factor productivity has been negative over the period (-0.1 annually compared to 1.3% annually reported officially.)

Thailand

Thailand took off in the 1950-1970 period, with high GDP growth fueled by a healthy combination of labor, capital and total factor productivity. It enjoyed its “miracle” growth phase between 1980-1997, marked by slower labor growth, more moderate TFP growth, and, as Krugman pointed out, increasing reliance on the capital input. The “miracle” came to an end with the “Asian Financial Crisis” (1997-1990), and since then growth has moderated, with a decline in both labor and TFP growth. Since the financial crisis, TFP growth has averaged 0.6% annually and labor quantity growth has been a meager 0.1% annually, turning negative over the past decade. Apart from the high growth take-off period of 1950-1970, Thailand’s growth has relied heavily on capital inputs.

 

Malaysia

Malaysia, more than Thailand, fits Krugman’s observation that Asian growth is overly driven by capital.  Malaysia took off in the 1960s, and like Thailand, had a period of “miracle” growth in the 1980s and 1990s, ending with the 1997 Asian financial crisis. Growth recovered in the early 2000s, but since then has drifted down to moderate levels. Malaysia’s growth throughout this entire period has been driven by capital expansion, with only moderate contribution from labor and, remarkably, none from total factor productivity. Malaysia had some moderate growth in TFP during the 1960s take-off period, but since then TFP’s annual contribution to GDP growth has been negative every decade. Labor’s contribution has been healthier, providing a constant contribution of around 1% annually over the past five decades.

 

New “Miracle Economies”

India

India’s economy initiated a moderate take-off in the mid-1980s, with the launching of structural reforms. Growth accelerated in the 1990s, reaching high miracle-like levels in the 200os. Growth slowed to mid-single digit levels in the 2010s and is expected to remain at this level, which is high for current international parameters, but low in comparison to previous “miracle” economies. India has displayed Asian-style reliance on the capital input, with unusually low contribution to GDP from growth in labor inputs. India had a brief surge in labor in the 1970s, but this had fallen to 0.5% annually in the 200os and zero annually during the 2010s. This is an anomaly compared to other developing countries at this stage of growth when rural labor is very abundant. It can perhaps be explained by( 1)  scarce growth in mass production, labor-intensive manufacturing, (2) very low levels of female incorporation into the workforce, and (3) government initiatives to improve living conditions in rural villages. TFP was low to negative in the decades before structural reforms were implemented.  TFP’s contribution to annual GDP growth rose to 1.1% in the 1980s and 0.9% in the 1990s, 1.1% in the 2000s and 2.2% in the 2010s. For the miracle-like growth enjoyed by India in the decade prior to the pandemic to persist, it will be necessary for TFP contribution to remain high and for labor quantity growth to improve considerably.

Vietnam

Vietnam’s economy took off in the 1980s, supported by massive migration and capital deployment. Investment surged in the 1990s and has remained high since then, converting Vietnam into an alternative manufacturing  center for many multinationals. Labor growth remained high through the 2000s, but fell sharply in the 2010s. Vietnam fits squarely in Krugman’s description of a capital intensive Asian “tiger.” Total factor productivity has had negative contribution to GDP growth for most of postwar Vietnam’s economic history, turning positive only during the 2010s. A combination of high TFP growth, a resumption of labor growth and continued foreign direct investment will be needed for Vietnam to sustain high GDP growth levels. So far, Vietnam has closely followed the growth path of China. However, if its Communist Party  follows the ideological course taken by Xi’s China, foreign investors are likely to quickly move on.

 

 

 

Current Implications of the Development Process For Emerging Markets Part I

 

As countries develop, they follow a process of gradual absorption of both labor and capital into the “modern” economy. This model of development was described in Walter Rostow’s book The Stages of Development (1960), and the concept has influenced policy decisions since that time. Rostow’s five stages are outlined in the chart below.

The process is driven by the migration of labor from rural to urban locations, followed by the decline in fertility and family size. In Europe, it started in the late Medieval period (13th century) with the rise of city-states in Italy and the Netherlands, though serfdom persisted in Eastern Europe into the 19th century. The rise in urbanization allows for increased labor specialization and industrialization. Migration provides abundant labor which promotes investment and capital accumulation, until, eventually, as fertility declines wages rise, and consumption expands. The five stages are detailed below. It is important to stress that the stages are not clear cut either chronologically or geographically. For example, India’s current standing covers the first three stages; though the country is arguably on the verge of take-off, it has a large traditional rural population. Though China can be categorized as mature, one third of its population remains in a traditional rural condition. Brazil is also is a mature economy with a significant population of subsistence farmers.

Stage 1- Traditional Rural – Populations are rural and consist of subsistence farmers with minimal engagement in commerce. Much of sub-Saharan Africa, rural India and rural Indonesia are still at this stage today. At this stage, capital deployment and economic output are minimal.

Stage 2- Pre-take Off – Migration from farm to city provides cheap labor and initiates specialization and capital accumulation. The poor consume little, the rich consume luxury goods.

Stage 3- Take Off – The culmination of stage 2: super-abundant labor and rapid industrialization lead to high growth and capital accumulation and great fortunes (“robber barons”). This is the period of “economic miracles,” also called Golden Ages: England (1850-1870); United States (1870-1910); Argentina (1880-1900); Brazil (1950-1970); China (1980-2008), etc… Arguably, India is in this stage today, ruled by an alliance of robber barons and politicians.

Stage 4 – Maturity – Labor becomes scarcer, leading to pressure for higher wages and political conflict. Organized labor gains bargaining power, with the support of politicians. Wages rise, boosting consumption, but returns on capital decline:  Western Europe (starting in the 1870s), the United States starting in 1900, Brazil in the 1970s, China starting in 2015 (despite Xi’s efforts to stifle dissent). Mercantilist countries (Germany, the Asian Tigers, including China) seek to repress labor by capturing foreign demand.

Sometime between Stage 4 and Stage 5, the Lewis Turning Point occurs. This concept describes the moment when excess rural labor is fully absorbed into the manufacturing sector, causing unskilled industrial  wages to rise. Economists guesstimates for the turning point are:  England (1890), France (1900), the U.S. (1910), Japan (1965), Brazil (1975), Korea (1975), Mexico (2000) and China (2015). India, Indonesia and Vietnam are expected to reach the Lewis turning point in the next 15 to 20 years.

Stage 5  – Mass Consumption – Most developed countries now have economies dominated by the consumer. These countries are at or near the technological frontier and have highly developed physical infrastructure and costly labor, conditions that result in the share of GDP coming from consumption dominating that revived from investment. Mercantilist countries like Germany and Japan reduce consumption to some degree by repressing wages, allowing them to capture through exports some of the consumption demand from countries like the U.S., France and Spain. East Asian “Tigers” have delayed the mass consumption stage by implementing mercantilist policies which enable them to capture foreign demand through exports. Latin American countries have badly managed the transition from maturity to mass consumption, and they find themselves in the “Middle-income Trap,” with low returns on investment and insufficient consumer demand from most of their citizens.

Below, a few graphic examples of the different stages are shown. The data measures the components of GDP (World Development Indicators, World Bank)

Senegal (Traditional Rural, entering Pre-Take Off): Senegal is a low-income country with a large part of the population engaged in low-tech farming. Household consumption has dominated the economy but is now declining quickly as investment is ramping up. The current account is negative, as the country imports capital to finance investment.

 

 

Indonesia (Take-off): Indonesia entered the Pre-Take Off stage in the late 1960s, as migrants left subsistence farming to settle in urban areas. Take-off occurred in the 1980s (briefly interrupted by the Asian financial crisis). Rising capital accumulation and investment have brought high GDP growth and caused a reduction in the consumption share of GDP.  As Indonesia approaches the Lewis Turning Point in the 2030s, investment can be expected to start declining and consumption should rise.

India (Take-off): India entered the Pre-Take Off stage with economic reforms in the 1980s, leading to a long period of high GDP growth, rising investment contribution to GDP and declining consumption share of GDP. India is now in a typical Take-Off, with high capital accumulation and obscenely rich “robber barons” dominating the economy (like China in 2000).  India should reach the Lewis Turning Point over the next 20 years, at which time returns on investment will decline and the economy will become driven more by consumption.

China (Maturity):  China had its Pre-Take Off (with plenty of ups and downs) in the 1950s and 1960s. Take Off came with the economic reforms in 1980, resulting in very high GDP growth driven by investments and marked by enormous capital accumulation concentrated in few hands. The 1980-2005 “economic miracle” saw investments reach extremely high levels and plummeting of consumption’s share of GDP. The economy started losing steam in the 2000s because of high debt and declining returns on investments.  China reached the Lewis Turning Point around 2015. It now has approached the technology frontier and faces rising labor costs and low returns on investment. In this Maturity stage, investment share of GDP should decline, and consumption contribution should rise, but China is finding it difficult to abandon its debt-fueled investment model because of entrenched political interests. This raises the possibility of a long period of low growth and a “Middle-Income Trap.”

 

Korea (Maturity): Korea had its Pre- Take Off and Take Off stages in rapid succession in the 1960s. A twenty-year “Economic Miracle” was marked by high levels of investment and capital accumulation and a plummeting of the consumption share of GDP. The country reached the Maturity Stage in the 2000s, and now operates largely at the technology frontier. Korea, like China, is finding it difficult to move to a more consumer-driven economy. The country has been able to pursue mercantilist policies to secure demand from abroad for its exporters, so that it can delay increasing domestic consumption.

A Tales of Two Decades for Emerging Markets and the S&P 500 (Part 2)

Emerging market stocks have suffered a decade of dismal returns while American stocks have soared. In a previous post (link),  this divergence was  explained by valuations (high in EM and low in the U.S. in 2012) and the appreciation of the U.S. dollar over the past ten years. In addition, U.S. corporations have  benefited from historically low interest rates and tax cuts. All of the factors that benefitted U.S. stocks are likely to eventually revert, which  would lead to a new period of outperformance for international assets. In this post, we look  at this matter in further detail.

The chart below shows the twenty-year performance of the primary emerging market country MSCI indices, as well as the MSCI EM index and the S&P 500. During the 2002-2012 decade, the S&P500 underperformed the MSCI EM Index as well as every major country in the index. The opposite occurred from 2012-June 2023, as the S&P500 soarer while EM languished. Only tech-heavy Taiwan and India managed positive returns over this period.

Two Decades of Index Returns for Emerging Markets and the S&P500

In the chart below,  this divergence of returns is explained in detail by changes in valuation parameters (CAPE ratios, cyclically adjusted price earnings) and dollar-denominated earnings growth. There are two primary conclusion from this analysis. First, CAPE ratios have gone full circle.  S&P500 CAPE ratios started high in 2002, edged down through 2012 and then soared back to very high levels over the past decade. Global EM CAPE ratios started low, went up to high levels in 2012 and then went right back to where they started. As for earnings, for the S&P500, coming out of recession in 2002, earnings growth for the first decade was high and then moderate for the second decade (propped up by low interest rates and tax cuts). EM earnings were very high for the first decade and flat to negative for the second decade, with the exception of tech-heavy Taiwan. (Argentina should be taken with a grain of salt, as numbers are distorted by exchange controls)

The last column to the right in the chart above shows expected returns for the next seven years. The three countries with the highest expected return -Colombia, Chile and Turkey – have returned to the valuation levels they had in 2002 after reaching very high levels in both 2007 and 2012. Brazil’s CAPE ration went from 5.1 in 2002 to 12.9 in 2012 (after peaking at 32.1 in 2007!) and is now at 9.7. Similar to Brazil, the Philippines and Peru now have CAPE ratios well below 2012 but not nearly as low as in 2002. The two most expensive markets – the S&P500 and India – have CAPE ratios well above 2005 and 2012, both at near record levels.

Earnings growth in dollars for most EM countries was extraordinarily good between 2002 and 2012 and dismal in the 2012-June 2023 period, even considering the big surge in earnings in 2022 experienced by commodity producers (Chile and Brazil.)  Poor earnings growth is explained by a strong dollar, low commodity prices and intense competition for manufacturing nations  in a depressionary global environment. Surprisingly, despite an appreciating currency and a significant tech sector, China had negative 0.7%  annualized earnings growth during this period.

The expected returns displayed in the chart above assume that earnings will grow in line with nominal GDP growth for all countries. This also assumes that the currencies will be stable relative to the dollar. Given the current direction of China and its large weight in the MSCI Index, this may be an overly optimistic assumption which exaggerates potential returns for global emerging markets.

A Tale of Two Decades for Emerging Markets and the S&P 500 (Part 1)

 

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.

2Q 2023 Expected Returns for Emerging Markets

Emerging market stocks once again are lagging U.S. stocks in 2023, as they have consistently over the past decade, rising by 3.5% during the first semester compared to 16.8% for the U.S. market. The strength of U.S. stocks can be attributed to the resilient American economy and a return of speculative fervor for tech stocks, this time driven by the sudden discovery of the transformative power of “Artificial Intelligence.” Nevertheless, below the surface conditions are also positive for emerging market stocks. Almost all the underperformance of EM stocks can be attributed to China, while most other markets are not doing badly at all. Moreover, EM stocks are now very cheap compared to the U.S. market and value is being rewarded. Also, the U.S. dollar has been on a significant downtrend which, if sustained, will provide a significant tailwind for international assets, including emerging market stocks.

The chart below shows the current expected returns for EM markets and for the S&P500 based on a CAPE ratio analysis. The Cyclically Adjusted Price Earnings Ratio (CAPE) is based on the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful tool for highly cyclical assets like EM stocks.   This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University. We use dollarized data to capture currency trends. 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 place in the business cycle and then assumed to grow in line with nominal GDP projections taken from the IMF’s World Economic Outlook.

As expected, “cheap” countries (CAPE ratios below their historical average) tend to have higher expected returns than “expensive” ones (CAPE ratios above the historical average). These expected returns make two huge 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.

The second assumption is well supported by historical data if seven-to-ten-year periods are considered, but not over the short term (one to three years).

However, when during certain periods “cheap” markets on a CAPE basis are enjoying short-term outperformance investors should take note, as the combination of value and momentum can be compelling. As the chart below shows, we are currently in such a period. Over the past twelve months, holding the “cheapest markets” would have provided very high returns, even considering negative returns from Colombia. The chart shows Expected Return rankings from one year ago and, in the last column to the right, the total returns over the past year.

That cheap markets are now performing well is very encouraging for EM investors.  To cheap valuations, momentum, and a weakening U.S. dollar we can add the improvement in global business conditions. Almost all EM countries are now in the upswing of the business cycle, a time when they tend to outperform significantly. Moreover, the global economy is also recovering, and the U.S. is expected to achieve a soft landing later this year. This synchronized global recovery should be supportive of cyclical assets like commodities, value stocks and emerging markets.

The Beautiful Deleveraging From Financial Repression

Historically, the most effective manner to reduce excess debts held by the government and the public at large has been to inflate it away. This tool has been successfully implemented both by emerging markets and developing countries, most significantly by the U.S. during the 1950s. We see it at work once again today in a big way, with some countries making remarkable progress at reducing debt levels.

Financial repression consists of imposing negative real returns on the holders of fixed income securities by allowing inflation to be higher than interest rates. This can be done either through Central Bank monetary policy or by regulators forcing financial agents to hold unattractive securities. The winners in this game are the debtors at the expense of the creditors, which can lead to a significant redistribution of wealth.  For example, the archetypical old lady living off interest payments suffers badly, while the millennial with a fixed mortgage gains handsomely. Governments with high debt levels are big winners.

The chart below shows the one-year evolution of total debt to GDP (left side) and government debt to GDP (right side) for a broad group of emerging market and developed economies, based on Bank For International Settlements (BIS) data through December 2022. These numbers show the remarkable different paths countries have taken over this period. Most remarkably, highly indebted countries in Europe (UK, Spain, Italy) have achieved large reductions in total debt to GDP ratios through financial repression. For example, negative interest rates in the UK have brought the total debt to GDP ratio down by 52.4 percentage points, from 297.5% to 245.1%, and government debt to GDP, from 134.2% to 93.7%.  British monetary authorities must be delighted at the result of their policies, which they have continued to pursue through the first semester of 2023. China, on the other hand, with massive debt accumulating at a  furious pace, saw its total debt to GDP ratio rise from 285.1% to 297.2% and government debt to GDP rise from 71.7% to 77.7%, mainly because overcapacity and malinvestment have persistent deflationary effects.

In emerging markets, most countries have benefited from financial repression. In addition to China, Korea, South Africa and Argentina can be singled out as countries with rising debt ratios over the past year.

Unfortunately, this positive effect from financial repression may not persist for all. Continued winners in 2023 include the UK, the U.S. and the Euro area, all of which continue with negative interest rates while pretending to execute tight monetary policies. However, countries like Brazil now have very high real interest rates and are seeing renewed increases in debt ratios.

Brazil’s debt ratios increased in the 4th quarter of 2022 and will surge through 2023 unless the Central Bank  changes its current ultra-orthodox posture, repeating the policy mistake of the 2015-2019 period when high real rates led to a ramp up of debt levels, as shown below.

A New Path for Industrial Policy in Brazil

In recent decades, very few developing countries have reduced the income gap with rich nations, and those that have are either in East Asia or Eastern Europe. The successful “climbers” have prospered by integrating themselves into an increasingly globalized economy, gradually increasing the volumes and complexity of their exports. The “laggards” across the developing world have typically suffered from economic and political instability and shunned the competition of global markets. Brazil, the “poster child” for the laggards, has been stuck in a “middle-income trap” for over thirty years, caused by public policy errors resulting from political dynamics.

Since the 1980s “lost decade” Brazil’s politicians have pursued “distributional politics” aimed at correcting wealth disparities between regions and social classes. The previous model (like China’s current model), which for three decades (1950-1980) had been aimed at building mass production manufacturing and infrastructure, was largely discarded as inefficient and costly.

The new development model for Brazil, still very much extant today, has been driven by the “Welfare” Constitution of 1988 that imposed an extreme form of federalism which gives scarcely populated states enormously disproportionate representation in both chambers of Congress.

Unlike the successful economies of Asia and Easter Europe, since the 1980s Brazil’s industrial policy has been inward looking and aimed directly at achieving social objectives instead of economic results. The main goal of industrial policy has been to relocate industrial activity from rich states to poor states by providing abundant tax incentives to investors. The result has been the hugely wasteful Manaus Economic Free Zone and some uneconomic and nonproductive relocation of manufacturing facilities from the south to the north. Consequently, since 1980, Brazil has gone from being the prominent industrial nation in the developing world to a minor player undergoing large-scale deindustrialization.

The major winner from federal political dynamics has been the farm sector which is broadly diffused geographically in states with low population density. In this case the policies have led to massive increases in output and productivity.

In essence, Brazil’s farm sector is a disguised “Asian Tiger.”  Like in Asia, government support for Brazil’s farmers has been broad and extensive and consistent for decades. In addition to substantial fiscal, credit and export subsidies, the sector has benefitted greatly from the work of the national Brazilian Agricultural Research Corporation (Embrapa), which is widely recognized as a global leader in tropical agriculture research and has been instrumental in boosting crop productivity. Furthermore, the farm sector benefits from two more characteristics integral to the “East-Asian” development model. First, domestic competition is acute, therefore, even though state support is available to all, only the most productive farmers can thrive.  Second, because agricultural commodity markets are global in nature, the sector is export driven. This means that Brazilian farmers compete with American farmers and must remain at the forefront of technological innovation.

Unfortunately, the farm sector is not a good substitute for industry. In contrast to the job creation, work training and other multiplier effects that are integral to Asian industrial policy, the farm sector in Brazil is highly capital and technology intensive and does not generate many jobs or ancillary economic activity. Also, its success has significantly increased the commodity dependence of the Brazilian economy and led to a structural appreciation of the Brazilian real. Finally, this commodity dependence generates economic and currency instability which further undermines the competitiveness of the manufacturing sector.

The challenge for Brazil is to find new growth sectors which can secure sustainable political support and lead to productive investments that generate quality jobs. The markets are very skeptical that this can be done.

A brief effort at industrial policy during the first Lula Administration collapsed under mismanagement and corruption and was followed by an equally brief romance with neoliberal policies under Bolsonaro.

Lula’s return to power this year has revived talk of industrial policy in Brazil, abetted by a shift away from neoliberalism in the United States and China’s aggressive state-led push to achieve industrial self-sufficiency in all “strategic” industries. Unsurprisingly, given Lula’s track record, market skepticism is high. Initial signs from the new government do not give much hope. The best that the new administration has come up with so far is a hare-brained scheme to provide temporary subsidies for purchases of automobiles.

Any viable industrial policy will need broad and sustainable political support in Congress. This means that the benefits must be broadly distributed geographically. Unfortunately, Lula’s atavistic vision of development is rooted in the state-led, capital-intensive model of the 1970s (e.g. Petrobras leading investments in refining and infrastructure).

A better approach would be to focus on strategies that have been successful in other countries: tourism and “green” energy, for example. Building a national consensus with political support to provide long-term  incentives for private businesses to invest in tourism and alternative energy could set Brazil on a new growth path. Policies should be structured so that  investors face both domestic and foreign competition to weed out the weaker players.

These are two sectors that are labor intensive and with potential for broad geographical dispersion of benefits. Brazil’s woefully underdeveloped tourism industry can learn from countries like Mexico and the Dominican Republic. In the case of alternative energy, the policies pursued by the Biden Administration in the U.S., the roll out of wind and solar capacity in Texas and initiatives pursued in many other countries can be copied. The roll out of wind and solar energy in Texas is highly relevant, as Brazil has outstanding conditions  to do this, with many locations in poor states. 150,000 well-paid clean energy jobs have been created in Texas over the past eight years and the sector is growing fast.

Mexico’s Bull Run

Despite the antics, the atavistic fondness for state intervention and control, and the frequent attacks on both local and foreign business interests, Mexico’s populist leader Andres Manuel Lopes Obrador (AMLO) is presiding over the country’s best financial markets  in years.

AMLO can be credited for a sound fiscal policy and for letting the orthodox  Central Bank  do its job. This hasn’t resulted in better economic growth but it has allowed for a more stable economy than most of Mexico’s peers around emerging markets. However, the main cause for market enthusiasm seems to be the hope that Mexico will be a major beneficiary of  “friend-shoring” investments, as global manufacturers look for ways to diversify away from China.

The performance of Mexican assets has been remarkable. As shown below, the Mexican peso is the strongest currency in the world for the past one and three years,  periods marked by considerable chaos in currency markets in many other emerging markets

The Mexican stock market also has done exceptionally well, as shown in the chart below. The Bolsa is a top performer for both the past one and three years. For the past five years it is near the top, surpassed mainly by tech-heavy markets (U.S., Taiwan,  Netherlands, Denmark). This is impressive given that Mexico does not have a tech sector.

The current sectorial composition of the Mexican market relative to other markets is shown below.  A characteristic of the Mexican market is the high weight of defensive stocks, mainly consumer oriented telecom, food and retailing businesses. Unlike in most other emerging markets, the Bolsa is not dominated by state companies or mature cyclicals, but rather by well managed private concerns. The combination of a stable economy and well-managed private companies is a rarity in emerging markets.

The ten largest stocks in the MSCI Mexico index are listed below. With the possible exceptions of Banorte and Cemex, these are profitable world class companies with dominant market positions, all trading at near all-time high stock prices.

After this impressive bull run, what are the prospects for the Mexican market?

It should be noted that both the currency and stock prices started this run at low levels in both relative and absolute terms. As the chart below shows, Mexico’s Real Effective Exchange Rate was at historically low levels in 2019, and it remains competitive today. Over the past 20 years the peso has been managed like an Asian currency, for stability and export competitiveness. The Brazilian REER,  shown for contrast, is much more volatile, which causes havoc for managing the current account and promoting manufacturing exports.

 

The next chart shows that the cyclically-adjusted price earnings ratio (CAPE)  for Mexico was at historically low levels in 2019, and the PE ratio was well below trend. The CAPE ratio has now normalized but is still far from stretched.

Mexico’s CAPE ratio based on expected earnings for 2023 is currently at 17.2 which is in line with the country’s average for the past three decades. As shown below, based on historical returns, prospects for future seven- and ten-year returns are moderately positive.

 

Bull runs are not usually stopped by valuation concerns. Along with India, Mexico may continue to be one of the few large emerging market with a credible narrative and the capacity to absorb foreign capital. Nevertheless, in coming years, investors will need to see “Friend-shoring” capital flows go from hope to reality to sustain the Mexico story.

 

 

 

 

 

 

Will China’s Economic “Miracle” End in Tears?

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.

Growth and Economic Complexity

Rich countries have complex economies, and poor countries get richer by increasing the technological content of what they produce. This requires many things, such as good institutions (e.g., law and order, property rights) as well as an educated population and research institutions that drive innovation. The Atlas of Economic Complexity (AEC) , a joint project of the Massachusetts Institute of Technology and Harvard University, provides  insight into the progress countries around the world are making towards increasing their innovative capacity by measuring the degree of complexity and diversity of what they produce for global markets.

The work of the AEC was summarized in the 2011 book The Atlas Of Economic Complexity: Mapping Paths To Prosperity,  by Ricardo Haussman and Cesar Hidalgo, and it is  periodically updated by the Harvard Growth Lab (link) and the Observatory of Economic Complexity (link). The AEC solves the complex problem of measuring technological advancement by focusing on the degree of complexity and the diversity of a country’s exports and comparing this over time and with trading partners.

The chart below uses the AEI data to compare the top 25 most “complex” economies of 1995 to those of 2021. Not surprisingly, the leaders  of the Economic Complexity Index (ECI) are mainly the highest income countries. But this is less true in 2020 when compared to 1998, as Asian and Eastern European middle-income countries are moving up the ranking.

 

Although the list is relatively stable, there are five changes: five entrants, China, Malaysia, Mexico,  Taiwan and Romania,  replacing  Canada, Norway, Spain, Netherlands and Brazil.

All of the new entrants are countries well integrated into regional or global trade value chains that import almost all their commodity needs, while three of the departees (Canada, Brazil, Norway) are commodity producers.  This is interesting because the period saw the commodity super-cycle (2002-2012),  which greatly boosted the incomes and exports of commodity producers. The drop in the rankings of these countries is evidence of the “commodity curse” at work, whereby commodity boom-to-bust cycles create economic turbulence with long-term debilitating effects. In 2020 there are no commodity producers in this top 25 group, unless one counts the United States, which, in any case, saw its ranking fall from 9th to 13th.

The significant deterioration suffered by commodity producing countries is shown in detail below. These include the highly financialized Anglo-Saxon economies (Canada, Australia, New Zealand and the United States); and the traditional emerging market commodity exporters (Brazil, Chile, Argentina, Peru, Indonesia and South Africa). Brazil shares some of the characteristics of the Anglo Saxons, as it is also a highly financialized economy suffering rapid deindustrialization.

The change in the rankings from 1995 to 2020 for commodity producers is shown below. Indonesia is the only commodity exporter with an improved ranking, no doubt because it has been influenced by the mercantilist policies followed by its neighbors in South East Asia.

The contrast with the manufacturing-export-focused economies of Asia and Eastern Europe is shown below. These are all countries that have benefited from free trade and regional integration policies.

 

Finally, the following chart highlights the different paths taken by Brazil, Mexico and Turkey. Brazil has deindustrialized dramatically since 1995 and further  increased its dependence on commodities. Moreover, it has rejected globalization and regional integration.  On the other hand, Mexico and Turkey have embraced regional integration and successfully found their place in global value chains.

 

 

The Return of Deflation Raises Caution in Emerging Markets

All signs point to an imminent recession in the U.S. and the return of deflationary forces. The markets are pricing this in, forecasting that the Fed will begin to cut interest rates this summer. The debate is now between the soft-landing and hard-landing camps and on the length of the coming downturn, and on whether Jeremy Powel has the stomach for austerity or whether he will happily return to ZIRP and money printing.

In this environment, safety will trump risk. The recent surge in the infallible FAANG stocks — the current preferred safe haven for global investors — and the poor returns for value, small cap and cyclical stocks shows that we are in the very late stage of the business cycle or already in recession. Emerging market assets are not likely to do well at this time.

Commodity prices are leading the way in this deflationary push. As the chart below shows, oil and lumber, which are the two most significant economic indicators in the U.S. are down sharply relative to inflation (CPI). Oil is down 37% over the past year and natural gas is down 74%.  Lumber prices have fallen 50% more than the CPI. Even copper, which is supported by tight supplies and rising demand from “climate change” policies, is  still down 13% and supporting the deflationary push.

 

We also see broad deflationary forces in the broad commodity indices. forces. The S&P GSCI Commodity Index (GTX) and the S&P GSCI Industrial Metals Index are down 18% and 15%, respectively, over the past year, while the CPI has risen 6%.

The Industrial metals index is most significant for emerging markets because historically it has led the way for EM stocks. We can see this below.

Investors should keep their powder dry for the beginning of a new cycle in 2024.

Brazil’s Grievous Manufacturing Collapse

Brazil has become a posterchild for the Middle-Income Trap which hinders countries  no longer able to compete against low-wage countries but without the productivity growth to compete in the higher value added industries dominated by advanced economies. But little attention has been given to the related  economic phenomenon which strikes commodity producers – “Dutch Disease,” also known as the Natural Resource Curse. The combination of the two for Brazil  has caused crippling premature deindustrialization.

Brazil has suffered two severe bouts of “Dutch Disease.” The first during the commodity boom of the 1970s which was followed by the bust of the 1980s and a “lost decade” of economic stagnation. The second, during the 2001-2012 commodity super-cycle  driven by China’s “economic miracle, which was also followed by a long economic depression. These two commodity booms were marked by similar excesses — overvalued currencies, unsustainable consumer booms, excess fiscal spending and high levels of debt accumulation, a deterioration of governance and a rise in corruption. In their wakes, the booms left behind a debilitated manufacturing sector, high debt levels and lower growth prospects.

 

 

Brazil’s “Dutch Disease” has been worsened by the concurrent strong growth of the farming, mining and oil sectors — all productive and  capital intensive activities with a high degree of export competitiveness. The rapid growth of these sectors, and the discovery of the giant offshore pre-salt oil fields,  has strengthened the current account and caused a structural appreciation of the Brazilian real. The loss of competitiveness of Brazil’s manufacturing sector has been more than compensated by the increased production and dollar revenues of the growth sectors. Unfortunately, these successful sectors generate scarce jobs and lack the significant multiplier effects of the manufacturing sector.

The chart below shows manufacturing GDP as a percentage of GDP for both resource rich and resource poor countries in emerging markets. The declining trend for commodity exporters relative to commodity importers is notable, and Brazil stands out in particular.

 

In 1980, at the end of the 1970s commodity boom, Brazil was the dominant manufacturing power in emerging markets  (China surpassed Brazil’s production levels but was behind in terms of complexity and quality of manufacturing). The following chart from the World Bank shows manufacturing value added for the primary emerging markets (and France for comparative purposes) both for 1980 and 2021. The rise of China and the relative decline of Brazil are striking.

The same data is shown below with Brazil as the benchmark, to measure relative performance.  Over this period, China’s manufacturing value added went from two times Brazil’s to 31.3x, a relative increase of  15.7x. India went from 44% of Brazil’s level to 2.9x. Every single country in the chart has gained relative to Brazil. This includes commodity producers (highlighted in red) which also may have suffered Dutch Disease. Most striking are Indonesia and Malaysia which went from 15% of Brazil to 150%, and 8% to 56%, respectively, a testament to the Asian commitment to currency stability and manufacturing exports.

 

 

Finally, the following chart shows the decline in industrial employment in Brazil over the past decade. In 2019, according to World Bank data, only 20% of employment in Brazil was in industry, a decline from 23.4% in  1991. This places Brazil at a level similar to advanced rich countries with service-intensive economies. In Brazil these service jobs tend to be poorly paid and unproductive with very few opportunities for training and advancement.

Brazil’s manufacturing collapse has no easy solution. Brazil’s successful commodity exporters yield extensive political power, not the least with the oversized financial sector. Schemes like those adopted by Argentina, featuring  multi-tiered currencies and taxes on exporters are difficult to implement and have high costs. A return to high tariffs on imports would be highly unpopular. A mix of these policies is likely to be introduced by the new administration with elevated short-term costs and unclear long=term benefits.

The Big Mac, Neo-mercantilists and the Commodity Curse

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.

Brazil and the Return of Neomercantilism

The principal challenge of emerging markets policy makers is to provide the business environment for private enterprise to invest in activities that generate sustainable and equitable growth.

When they fail to do this they face the crippling flight of both financial and human capital. The ease  of communications, travel and capital movements make it easier than ever for wealthy and cosmopolitan elites to move their families and capital abroad.

Human and financial  capital drain can be devastating for emerging markets. Some 4.5 million Indians,  generally well-educated, have immigrated to the U.S. and the U.K. since 1980, contributing greatly to these developed economies. Venezuela has lost most of its educated elite and middle class over the past 15 years, leaving the country with dire prospects of ever recovering the middle-income status it once enjoyed. The past decade of slow growth and political unrest in Latin America has caused massive  capital flight from historically more stable countries like Brazil and Chile.

Brazil, which in the past largely avoided the drain of human and financial capital, now faces an exodus, with Portugal and the U.S. as the favorite destinations. With the return to power of the leftist Lula — reenergized, more bitter and radical after his two-year prison confinement — this flight from Brazil is sure to accelerate.

Ironically, the policies proposed by Lula are no longer on the ideological extreme. On the contrary, the new government’s policy proposals – government support through subsidies and credit for industrial onshoring and green technologies, all justified under the banner of national security and sovereignty – are a carbon copy of those promoted by the Biden Administration in the U.S. Moreover, the quote below, which was made this week by President Biden, could have come out of Lula’s mouth

“What it’s about is giving working folks a chance. I’ve never been a big fan of trickledown economics. In the family I was raised in not a lot trickled down to our table. When the middle-class does well, everybody does well. I campaigned on build from the bottom and middle out and when that happens the poor have a chance up, the middle class does well, and the wealthy always do well.”

In many ways, Biden’s quote applies even more to Brazil than it does to the U.S., as Brazil’s has suffered more deindustrialization than the U.S., and its inequality is one of the worst in the world and worsening.

Brazil desperately needs a new policy framework which promotes investment in productive activities with jobs that provide a middle-class lifestyle, not the service jobs (e.g. food delivery) that have been the only source of jobs in recent years. Or else, it will continue deeper into a peripheral role as a  supplier of commodities, mainly to China. The core of any economic strategy has to be to improve the income of the mass of Brazilians that currently barely participate in the productive economy.

According to the World Inequality Database, the poorest 50% of Brazil’s populations have about 8% of the country’s income and none of its wealth.  The consequence of this is that Brazil is really two countries: one country of some 20 million people  who have the income level of southern Europeans and are genuine consumers; and another country of 200 million people – including  a large poor segment relying extensively on government handouts – that has little purchasing power. The charts below compares Brazil to other countries in this regard. With a little over 20% of its population able to consume, Brazil’s consumer market is small. Worse, it hasn’t grown much over the past twenty years, increasing only during commodity booms.

Given the size of its available market, Brazil does not underproduce. For example, production of motor vehicles per potential consumer is comparable to other countries. Given current circumstances opportunities for capturing foreign demand are scarce, so the only opportunity for growth would come from an increase in the population of consumers.

Brazil’s new government understands Brazil’s challenges and has ambitious plans to relaunch the economy through an active promoter-state. Unfortunately, it maintains its traditional penchant for doing this through state companies and a big-state mentality.

However, Lula’s main problem is that his Labor Party lacks credibility. Lula pretends that the rampant corruption and incompetent management of the last PT government (2002-2016) never happened, but for most Brazilians the memory of that period is still vivid. No one has forgotten that the previous PT government’s (2002-2016) efforts to implement similar policies were crippled by graft and poor execution, and expectations are high that the same will occur again.

The tragedy of Brazil is that it is likely to miss the boat again. It was a major loser of the past 40 years of neoliberalism and globalization (starting the process at its end with Finance Minister Paulo Guedes) and now, as the world turns to neomercantilism, it is unprepared to respond adequately.

 

 

 

 

 

China’s Existential Threat to Emerging Market Economies

The model of development followed by most developing countries has been to gradually move up the value chain of manufactured goods while at the same time establishing control of the production of the basic inputs of industrialization which are steel, cement, ammonia, and plastics.

This model of development worked well for many of the current middle income emerging market countries. Brazil and Mexico, for example, developed its steel, cement, ammonia and petrochemical industries in the 1950s and 1960s while it concurrently dominated the process of mass production of motor vehicles, capital goods and many other basic consumer goods. Those years were the golden years for these countries and were broadly perceived as economic “miracles.” Most middle-income Asian countries (Thailand, Malaysia, Indonesia) repeated this process in the 1960s, 1970s and 1980s with similar success, now followed by Vietnam.

This process of basic industrialization was achieved with foreign investment and the transfer of mature technologies from the U.S. and other developed countries. The technologies were easy to transplant to developing countries and had the advantage of being scalable to different markets and often  large generators of low-skill “quality” jobs. Generations of Brazilians were integrated into the modern economy and learned the skills of industrialization and the routines of modern enterprises by working in manufacturing, and they entered into the middle class and became consumers (e.g., Brazil’s current president, Lula, worked in an auto plant in Sao Paulo in the 1960s as a metalworker before becoming a union leader).

Two things happened to dramatically undermine this trend. First, the neoliberal revolution of the 1980s spawned the “Washington Consensus” for free trade and capital movements and the great wave of hyper-globalization of the past decades. Second, in the 1980s,  China entered the phase of rapid development, following the path set by Brazil and others: exploiting foreign investment and technology transfer to dominate the production of the basic inputs of industry (steel, cement, ammonia and plastics) and the mass production of consumer and capital goods.

While the mass production technological cycle (“Fordism”) was exhausting itself in both the industrialized world and middle-income emerging markets, giving way to the Information and Communication Technology revolution (ICT), China gave it new life. With abundant cheap labor and clever incentives, China became the dominant global producer of most basic industrial goods,  replacing production capacity in both developed and developing markets. In a neoliberal era of free markets, multinationals gladly offshored the mature mass production function to China, to gain access to cheap labor, subsidies and lax environmental rules. The combination of a large and growing domestic market and access to international markets gave China a scale advantage which previous fast-growing developing countries had never enjoyed during this period of learning to dominate the mass production process.

The degree to which China has taken over the mass production paradigm is shown in the following charts: 1. Global Primary Energy Consumption; 2. Global steel production; 3. Global cement production; 4. Global ammonia production; 5. Global plastics production. The growth of output that China has experienced in all of these areas is astonishing in a historical context. China consumed one third the primary energy consumed by the U.S. in 1980 and 1.7 times as much in 2021; it produced about the same amount of steel as the U.S. in 2000 and now produces 10 times more; China’s cement output in 2020 was 27 times the U.S.’s peak production year; China produced 2.5 times more ammonia than the U.S. did in 2021; and China now produces 1.5 times the plastics made by the U.S.

 

As China moves up the manufacturing value chains, it now seeks to dominate global markets for consumer durables, such as computers, televisions and cars. The charts below show the astronomical growth of China’s car production and its recent progress in tapping export markets. China’s growth in auto production over the past decade is greater than the entire growth of the industry on a global basis. And now, China’s auto firms, as the economist Brad Setser recently noted, are ramping up exports. In a few years’ time, Chinese passenger car exports have grown to surpass those of the U.S. and Korea and match those of Germany. Most of these highly subsidized exports are finding their way to developing countries.

The extension of the mass production technology cycle was an unequivocal boon for China but a mixed blessing for developed countries and the middle-income emerging markets. In exchange for cheap consumer goods and high corporate profits, manufacturing sectors were decimated, jobs were lost and income inequality and political rage increased. Moreover, while the mass production cycle was extended, with dire consequences for CO2 emissions, the potential benefits of the ICT revolution were delayed. Instead of focusing on making industry more productive and greener, Silicon Valley has channeled most of ICT investments into social networking, search, delivery and gaming applications.

For developing markets, China’s rise is an existential threat. Unless they can defend themselves with tariffs, they are condemned to handing over their consumer demand for manufactured goods to China in exchange for commodities.

Emerging Markets’ no Growth Decade

Emerging market stocks have performed poorly for more than a decade both in relative and absolute terms. This can be explained by a marked decline in price to earnings multiples since the very high levels achieved in 2008 and 2012 combined with poor growth in these earnings. In turn, low growth in earnings were caused by a significant deterioration in the GDP growth of most emerging markets.

We show the evolution of multiples and earnings in the following charts.  CAPE multiples are at a third of the level reached in 2008 while earnings have been flat in nominal USD terms.

 

This remarkable result can be explained by the unbalanced growth of the global economy. While emerging markets are said to be growing GDP at a higher rate than developed markets, the growth is highly concentrated in China (and to a degree India). Emerging markets ex China and India have languished over this period. We show this in the chart below.

 

Given the disappointing growth of emerging markets ex China since the GFC,  it is not surprising that earnings growth has been poor. What is stunning is the lack of earnings growth in both China and India, despite their high GDP growth, as shown below.

The explanation lies in the unbalanced nature of Chinese growth, which relies on the repression of the consumer to subsidize the export sector and unproductive state investments in infrastructure and industry. China’s excess capacity is increasingly dumped on emerging markets, leading to deindustrialization, low productivity and low growth.

Using CAPE Ratios in Emerging Markets

 

The CAPE methodology is well suited for volatile and cyclical markets such as those we find in Emerging Markets. Countries in the EM asset class are prone to boom-to-bust economic cycles which are accompanied by large liquidity inflows and outflows that have significant impact on asset prices. These cycles often lead to periods of extreme valuations both on the expensive and cheap side. The Cyclically Adjusted Price Earnings multiple (CAPE) has proven effective in highlighting them.

The CAPE takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings.  We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized recently by professor Robert Shiller of Yale University.

CAPE is best used as a long-term allocation tool. However, it is not effective  as  a timing tool. Market timers seeking short-term returns will be more successful using traditional technical analysis to identify trends and paying close attention to investor sentiment and liquidity flows.

CAPE works particularly well in markets with highly cyclical economies subject to volatile trade and currency flows (Latin America, Turkey, Indonesia);  it works less well for more stable economies (e.g., East Asia).

In recent years CAPE has  has been ineffective in predicting forward annual returns. This has occurred because momentum has been more important in determining stock performance than valuation indicators. Moreover, emerging markets started the past decade at very high valuations, and only recently have come to trade at cheap levels and, in some cases, extremely low valuations.

Since  October 2020, we have seen a marked change in the investment environment, with the value factor in both U.S. and international stocks starting to outperform “growth” stocks. Emerging market value stocks have outperformed the EM index by over 20% during 2021-2022. Also, by and large, “cheap” CAPE stocks have started to reward investors. The cheapest stocks on a CAPE basis at the end of 2021 (Turkey, Chile and Brazil) all performed exceptionally well in 2022.

In the charts below we see  what CAPE ratios are currently telling us about future returns based on historical precedents. We map index returns and CAPE ratios for the U.S., GEM (Global Emerging Markets) and the most important emerging market countries (China, India, Taiwan, Korea and Brazil) and also for several countries of interest (Turkey, Philippines and Mexico). The data covers the period since 1987 when the MSCI EM index was launched. The charts show a clear linear relationship between CAPE and returns with particular significance at extreme valuations. Country specific data is more significant because the CAPE ratios capture better the evolution of the single asset.

  1. S&P 500 :  The market has not provided 10-year annualized returns above ten percent when CAPE is above 25. Every time that the market has provided lower than 5% annualized return the CAPE has been above 30. The CAPE at year-end 2022 was at 27.3, a level which suggests moderate nominal returns in the low single digits for the next 7-10 years.

  1. Global Emerging Markets. At the current level (15.4) the GEM CAPE provides little insight. The probability of negative or high returns both appear to be low. GEM should be bought below 15 and sold above 20.

3. China’s short and turbulent stock market history provides few data points for CAPE analysis. Nevertheless, the current CAPE (9.5) has provided high returns in the past and points to low risk of negative returns. Chinese stocks should be bought below 12 and sold above 20.

 

4.India: The CAPE for India (25.6) is high both in absolute terms and relative to the country’s history, reflecting a good GDP growth profile in a world with scarce growth and investor enthusiasm. At this high level  return prospects are poor and negative returns are a distinct possibility. Indian stocks should be bought in the high teens and sold in the high twenties.

5. Brazil: At the current CAPE (9.4) history points to potentially high returns, but not without risk of disappointment. The ideal entry point for Brazil is below 8 and the market should be sold around 18.

  1. Korea: The CAPE for Korea (6.4) is low both in absolute terms and relative to the country’s history. At this CAPE level high returns are likely and negative returns are a low risk. Korean stocks should be bought below 10 and sold in the high teens.

5.Taiwan: The current CAPE for Taiwan (14.9) is cheap. Future returns appear attractive but Taiwan has a turbulent stock market history, a highly cyclical market and geopolitical risk, so caution is advised. Taiwan should be bought below 15 and sold above 20.

6.Mexico:The CAPE for Mexico (15.3) is in neutral territory, implying fair valuation. The market should be bought in the low teens and sold in the mid twenties.

7. Philippines: The current CAPE (13.1) is on the low side and offers the prospect of high returns with some risk. The market should be bought below 15 and sold above 25.

8.Turkey: The current CAPE (6.9) is low in absolute terms and relative to the country’s history and offers the prospect of high returns, made more likely by the recent momentum. Nevertheless, this is  always a very risky market with turbulent macroeconomics and politics and short cycles. This market should be bought below 10 and sold above 15.

4Q 2022 Expected Returns for Emerging Market Stocks

Emerging market stocks once again lagged U.S. stocks in 2022, as they have consistently over the past decade.  A rising dollar and persistent economic instability and risk aversion all have contributed to making emerging market stocks a poor asset class over the past year and the last decade. However, there are signs that the environment may be changing. EM stocks are now very cheap relative to the S&P 500, the dollar shows signs of having peaked and, most importantly, investors are looking for real assets that may perform better in a more inflationary environment. EM stocks, which have a high concentration of commodities and cyclical businesses , may be better positioned in the future than they have been in the “growth”-dominant investment world of the past decade.  Moreover, after a decade of poor returns, value investing (contrarian investing in cheap stocks in cyclical industries with little growth) is working again in emerging markets.

The MSCI EM value index outperformed the MSCI EM core index by 5% over the year, and, more importantly, the cheapest countries in the EM index were the best performers. This is in stark contrast to the past five years when cheap only became cheaper and rich only became richer.

The chart below shows the 2022 returns for all the countries in the MSCI EM index. On the right margin countries in the index are shown ranked in terms of a CAPE valuation based expected returns analysis at year-end 2021, with the cheapest on the top and the most expensive on the bottom. We can see that the cheapest countries (Chile, Turkey and Brazil) were the best performers in 2022 while expensive countries (India, Russia, USA, Taiwan) generally did poorly. The Philippines are one important exception to this trend, having started the year as “cheap” and ended even “cheaper.”

This trend should boost the confidence of EM investors. Emerging markets are by nature a value asset (highly weighted to cyclical businesses) and should not be performing well in an environment of rising risk aversion.  But investors are now betting that these markets are too cheap to avoid because low valuations promise high expected returns that more than compensate for short-term risks.

The chart below shows the current expected returns for EM markets and for the S&P500 based on a CAPE ratio analysis. The Cyclically Adjusted Price Earnings Ratio (CAPE)  is based on the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful tool for highly cyclical assets like EM stocks.  We use dollarized data to capture currency trends. This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University.

As we have seen in recent years, CAPE is not a good timing tool, but it does tend to work well over time, particularly at extreme valuations.  CAPEs below five, such as Turkey ‘s at the end of 2021, historically have been a failsafe indicator of high future returns. CAPE ratios that are completely out of sync with historical averages for the country are also powerful predictors of future returns.

The table above points to significant opportunities in EM. Global EM (GEM) on its own is cheap relative to the U.S., but more attractive opportunities exist at the top of the chart, particularly in Colombia, Brazil Chile, Taiwan, Peru, South Africa, the Philippines, Mexico, Turkey and Korea, which all promise high returns. Moreover, these countries offer significant, geographical, geopolitical and business cycle diversification opportunities. Colombia, Chile, Philippines and Korea are all extremely cheap relative to their valuation history and are well positioned for business cycle recovery in 2023. On the other hand, India , the most popular market with investors today, is an absolute outlier on the expensive side.

That cheap markets are now performing well in a risky environment is very encouraging for EM investors. If value continues to do well, EM stocks will likely do very well when the coming synchronized global and U.S. recessions hit bottom.

A Simple Allocation Strategy for Including EM Stocks in Global Portfolios

After a brutal decade for emerging markets stocks marked by poor absolute returns and dismal performance relative to the S&P 500, it is timely to review how the asset class fits into a global allocation process.

Any investor in emerging market bonds or stocks, unless he or she is a dedicated portfolio manager with a mandate to outperform an EM index on a short term basis (1-3years), should operate under the following assumptions.

1.“Buy-and-hold” does not work in EM.

2. Risk always trumps valuation in EM stocks and bonds.

3. EM stocks are liquidity-driven trending assets.

4. The U.S. dollar drives returns and is negatively correlated to EM stocks and bonds.

The first premise – “Buy-and-hold” does not work in EM – is derived from the other premises. Emerging markets are too subject to “sudden stops” of liquidity to provide reliable returns for investors over meaningful periods, say over a decade. Empirical evidence clearly guides investors to avoid “sudden stops” by focusing more on risk than on valuation. Risky market conditions, measured by macro vulnerability (debt, deficits, overvalued currencies), domestic politics and geopolitics (e.g., Russia), will almost always trump low valuations. Low valuations and low risk provide the best conditions, but you are better off owning expensive stocks in a low-risk country than cheap stocks in a risky country. Of course investors tend to do the opposite,  as we last saw in 2008-2012 when EM bulls courted disaster by buying extreme valuations at a time of extreme risk.

If buy-and-hold is a losing strategy, the question is how to time allocation exposure to EM markets. The answer lies in premise three and four. History shows us that EM assets are trending assets, and this is for good reasons. Therefore the job of the allocator is to identify the trends and ride them  until they exhaust themselves. The first chart below shows the performance of the MSCI EM stock index relative to the S&P 500  over its 35-year history. We can clearly see two periods when allocations to EM stocks paid off handsomely for investors: 1987-1994 and 2001-2012. Unfortunately, all this relative outperformance was wiped out in the past ten years. The second chart, from BOFA’s recent 2023 Market Outlook, shows the relative performance over a much longer 72-year period. Though it is problematic to come up with a realistic EM index over this period, BOFA’s data shows a third massive cycle of outperformance for EM stocks lasting from 1970-1980.

There are two fundamental causes behind these long trends: valuations and the U.S. dollar. Three of the peaks in U.S. performance (1970, 2000, 2022) are characterized by very high valuations in the U.S. (the Nifty Fifty bubble in 1970, the TMT bubble in 2000 and the Everything Bubble of 2022) and an overvalued dollar. All the periods of EM outperformance start with low relative valuations and an expensive dollar. This insight is confirmed by the DXY dollar index, shown in the next chart. Every spike in the DXY (dollar strength) is accompanied by strong relative performance of U.S. assets.

This relationship between the USD and EM stocks is further illustrated in the chart below. We can see the obvious negative correlation between EM stock prices and the DXY.

 

Another chart from the BOFA 2023 Outlook points to another fundamental correlation with important consequences for EM investing. This chart shows how growth stocks (tech and healthcare ) are negatively correlated to value/cyclical stocks (energy and financials).

This is a critical insight with important implication for EM allocation. EM stocks can be considered value stocks with a dominance of cyclical exposure in commodities and industrials.

We can see this insight confirmed by the chart below which shows the correlation between the S&P Industrial Metals Index (GSCI) and the DXY. The chart looks almost the same as the chart above that showed the relationship between EM stocks and the DXY.

 

 

As we can deduce from the following chart, EM stocks are a leveraged play on the prices of industrial metals.

This relationship leads to a further important insight for EM allocation. On both a global or a country basis, the simplest and most cost-effective manner to gain exposure to EM stocks is through commodity stocks. This is shown in the next two charts, which show first the performance of mining companies relative to the EM index and the performance of Vale relative to the Brazilian index. These stocks outperform massively on the uptrend and underperform on the downtrend.

Therefore, for a global allocator investing in emerging markets can be simplified to owning blue-chip mining firms during upcycles and unloading them when the cycle turns. However, we still have to identify the cycles. To do this the allocator must follow the trends and valuations.

A simple method to gauge the condition of the long-term trend is to look at the one-year relative performance of the S&P 500 relative to EM stocks and the U.S. dollar relative to other currencies.

The chart below shows that the S&P 500 continued to outperform EM stocks (with and without China) over the past year.

The DXY also is still in an upward trend on a 1-year, 3-year and 5-year basis, as shown below.

Valuation is also an important element in determining turning points. We know that U.S. stocks and the U.S. dollar both are very expensive relative to history. As shown below, we also can be confident that EM stocks are cheap relative to their own histories and compared to U.S. stocks.

A sign that a new trend may be forming is that value, cyclicals and the cheapest EM stocks (e.g., Turkey) all have been outperforming this year, while U.S. tech is faltering.