The yuan’s Long Road To Hegemony

Talk of the yuan replacing the U.S. dollar as the global reserve currency is mostly idle because China neither provides the conditions for this to occur nor appears to desire this outcome over the short term. Nevertheless, over time, the U.S. dollar’s hegemony is fraying, leaving a vacuum which will be filled by alternative currencies.

The conditions for a currency to establish itself as the dominant global instrument for trade transactions and storing wealth are shown by history. First, reserve currency status is a function of a country’s dominance of economic output (GDP), trade and net creditor status. Second, certain arduous requirements need to be met:

  • Trustworthiness
  • Institutional strength (rule of law, property rights)
  • Large economy and reliable trading partner
  • Free movement of capital and strong banking system
  • Large and liquid sovereign bond issuance providing safe assets
  • Willingness to provide global currency liquidity

 

No previous reserve currency has had the scale or scope that the U.S. dollar has had over the past seventy years, being generally limited by the country’s geographic hegemony. For example, the British pound was the leading reserve currency for a century (aprox. 1814-1914) because of its global empire and naval domination but it still left much of the world uncovered and faced competition from European rivals (France, Germany).

Post W.W. II U.S. dollar hegemony was secured because of America’s near total economic dominance. However, over time this has changed dramatically. The following chart from the IMF, which measures GDP, trade and net creditor status, shows the evolution over time: the U.S. goes from absolute dominance in the 1950s to a much weaker position today. By this measure, China has already surged and is poised to assume more influence.

 

 

The following three charts show this in detail: 1. Share of global GDP; 2. Share of global trade; 3. Net creditor status. The first two are shown for both the U.S. and China; the third shows the evolution of the U.S. net creditor position, from 20% positive in 1950 to over 80% negative in 2022 (China’s positive net creditor position is estimated to be about 15% of GDP, similar to the U.S. position in the 1950s).

 

On the other hand, with regards to the “institutional” and policy characteristics required to establish reserve status China lags far behind.

  • Trustworthiness – Though trust in the U.S. has declined in recent years because of the heavy-handed use of “sanctions diplomacy” it retains considerable advantages over China. China has antagonized a great many potential partners by engaging in provocative “wolf warrior” diplomacy. Moreover, China is even more prone to sanctions diplomacy than the U.S., as shown recently by retaliations against Korea, Australia and Lithuania for criticizing China’s policies.
  • Rule of Law – China’s lack of due process and judicial independence makes it a poor safe haven. Though the recent freeze on Russian assets held abroad by the U.S. and other western countries have created a terrible precedent, by and large investors still expect to be treated fairly by U.S. courts.
  • Large economy and reliable trading partner – This is China’s strong point and where it can increasingly contend with the U.S..
  • Free movement of capital and strong banking system – China fails on both counts. It has strict capital controls, mainly to keep domestic capital from fleeing. Also, it remains fully committed to managing its currency to preserve export competitiveness. Its banks are agents of the state and can be considered “highly liquid but insolvent.”
  • Large and liquid sovereign bond issuance providing safe assets – China is improving quickly on this count, but is still way behind the U.S., and the lack of rule of law and the presence of strict capital controls will impede progress.
  • Willingness to provide global currency liquidity – This is the biggest impediment for China to move forward on reserve currency status. The global economy needs a constant and predictable increase in the volume of the reserve currency. Under the British Gold Standard gold output increased by over 2% a year to keep the system liquid. Under the U.S. fiat currency system, the U.S. has run persistent current account deficits to feed dollars into the global economy. Since 1980, the U.S. has run annual current account deficits of on average -2.7%. This global liquidity is the counterpart to the growth in the U.S.’s negative net creditor position. Meanwhile, since 1980 China has run current account surpluses of 2% of GDP, allowing it to build its net creditor position. There is no evidence at this time that China would  change the mercantilist policies that support its export competitiveness and sustain current account surpluses, and until it does the yuan cannot increase its global hegemony.

Conclusion

Over the past twenty years China has become the primary buyer of global commodities. For example, China has replaced the U.S. as the biggest importer of oil. This raises the possibility that the dollar’s stranglehold on the pricing of most commodities may not persist. U.S. sanctions diplomacy against major oil producers such as Iran and Russia have already thrown these countries into the arms of China and reportedly have resulted in a significant amount of Chinese imports being invoiced in yuan. At the same time, China has established close diplomatic ties with Saudi Arabia which may be considering similar arrangements. A deal with the Saudis would be a watershed event, given how important the U.S.’s deal with the Saudis in 1974 was in securing the dollar’s hegemony  in the 1970s. However, unlike the Iranians and the Russians, the Saudis have options. In the end, the Chinese will need to convince the Saudis to invest in the Chinese capital markets which brings us back to the inadequacy of the yuan as a reserve currency for the reasons listed previously.

King dollar Will Rise Before it Falls

The U.S. dollar’s role as the global reserve currency has been questioned repeatedly during the 7o years since it was established at the Bretton Woods conference in  1944. Current opposition to the U.S. monetary order and calls for its replacement are nothing new and echo past critics who have complained that the U.S. abuses the system to favor its own interests.  Yet, the dollar system today in many ways is stronger than ever, and  there are currently no viable alternatives.

At the Bretton Woods conference strong opposition to a U.S. centric monetary order  was voiced by Maynard Keynes who argued instead for a decentralized system which would prevent countries from running persistent current account imbalances.  Keynes’s fears proved well-founded,  and by the late 1960’s persistent U.S. current account deficits led France to denounce what it called America’s “exorbitant privilege” (i.e., the ability to pay for imports with printed fiat money).  First France and then several more countries demanded to move their gold reserves back home, which left U.S. dollar reserves depleted and undermined the implicit U.S. dollar-gold connection that had been a key feature of the Bretton Woods agreement. In August 1971, Richard Nixon announced the end to the convertibility of dollars into gold, which gave birth to the current U.S. fiat currency monetary system.

The current dollar reserve system has been unique in both its nature and scope. It is the first major currency  reserve system in 700 years of Western financial  history which is not linked to a metal and relies exclusively on the creditworthiness of the issuer. Second, the U.S. dollar can be considered the first truly global currency, as no previous reserve currency has had its geographical reach.

Nixon’s decision was momentous. It had been assumed that a stable monetary order would require a link to gold. England had been able to maintain a stable gold price for nearly 200 years. The U.S. has secured a stable gold price around $20/ounce since 1792, with the only exception being FDR’s devaluation in 1934, to $35/ounce.  FDR’s decision had been seen to be an adjustment within the system, while Nixon’s was perceived as its full repudiation. The chart below shows the evolution of the USD/gold price from 1931 (before FDR’s decision) until 1980.

Not surprisingly, Nixon’s decision was not well received by global capital.  It led to the first genuine dollar crisis  (chart below) and to a long period of dollar weakness,  high inflation and economic “malaise,” as described by Jimmy Carter. During the 1970s talk of the rise of the Deutsche mark and the Japanese yen as viable reserve currencies was prevalent and both currencies appreciated by more than 40% against the USD.

Two separate events were instrumental in recovering the dollar’s credibility. First, behind the scenes, in 1974 a secret deal was reached between Treasury Secretary William Simon and Saudi Arabia’s King Faisal for the Saudis to agree to invoice all oil exports in USD in exchange for U.S. weaponry and protection. This deal, in essence, defined the terms of the new fiat monetary system, providing a mechanism for recycling persistent U.S. current account deficits back into U.S. financial assets. The new “petrodollar system” allowed for the “neutralization” of the high commodity prices of the 1970s by channeling windfall OPEC oil profits into Wall Street banks, which, in turn, flooded the world with dollar loans.

The second event that established the dollar’s supremacy was the appointment of  Paul Volcker to head the U.S. Treasury in 1979 . He  proceeded to raise  the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981.  Volcker’s super-hawkish policy coincided with the election of Ronal Reagan in November 1980,  and the combination of tight monetary policy with the promise of economic rejuvenation through “supply-side” economics led to a massive dollar rally, lasting t0 1985.

The twenty years between 1980 and 2000 can be considered the golden age of the dollar.  The “Petrodollar System” for recycling U.S. current account deficits back into the U.S. financial system worked smoothly over this period of relative economic and price stability. One of the assumptions of the system was that the U.S. would manage its economy to maintain general price stability and the purchasing power of commodities. We can see in the following chart that this was largely achieved  during this time, as oil prices were kept stable in both nominal and real terms (and at acceptably high prices for OPEC).

This period of faith in dollar supremacy led global central banks to sell  long-held gold reserves in exchange for treasury notes and other U.S. assets. The following chart from Ray Dalio shows clearly why the 1980-2000 can be considered the dollar’s heyday.  We can see that Central Banks aggressively  sold dollars for gold and Deutsche marks during the 1970s, only to about-face when Volcker hiked rates. Central Banks then proceeded to dump gold reserves  for the next twenty years. By 2000, the dollar’s share of central bank reserves was at its all-time high while gold reserves were at all-time lows.

This golden period for the USD unleashed two powerful trends: first, deflation (closely linked to hyper-globalization and the rise of China); second, hyper-financialization and chronic financial bubbles (directly linked to asymmetric policies pursued by an emboldened Fed convinced that modern macro economists had discovered the key to the “Great Moderation.” Naturally, these two trends are interdependent. Hyper-globalization could never have occurred without  a financial system able to absorb enormous inflows of foreign dollar reserves and also systematically increase credit to the U.S. consumer. At the same time, hyper-financialization relied on deflation  persistently repressing interest rates which enabled the Fed “put” to be activated anytime the system was perturbed.

Since its peak around 2000, the dollar fiat system has been under stress. The unwinding of the great TMT bubble in 2000 , the Great Financial crisis in 2008 and then a long period of extraordinary “experimental” Fed policy from 2008 until today are manifestations of an unanchored monetary policy. Going back to the previous chart showing historical WTI prices, we can see that the the assumption of price stability which was part of the “Petrodollar anchor” has come completely unglued since 2000, with enormous volatility on both the up and downside.

The only thing left from the Petrodollar regime are enormous current account deficits , now no longer driven by energy imports but rather by Asian consumer manufactured goods (the U.S. is now a net exporter of energy and commodities).  Keynes’s imbalances and France’s “exorbitant privilege” are greater than ever, remaining the essence of the U.S. centric monetary system.

But, as the eminent economist Joseph Stiglitz has noted ,”The system in which the dollar is the reserve currency is a system that has long recognized to be unsustainable in the long run.”  This is because, over time, structural current account deficits erode a country’s manufacturing base and competitiveness. This is even more true when, as has been the case for decades, prominent competitors pursue mercantilistic policies to promote their industrial exports (e.g., China, East Asia, Germany). The two charts below illustrate the essence of these circumstances: first, the persistent U.S.  current account deficits over the past 40 years; second, the U.S. role in absorbing the impact of trade surpluses generated by mercantilist competitors).

As shown below, not only has the U.S. lost competitiveness, it has also sold off  a significant part of its industrial base and corporations to foreign creditors, moving from a positive  international investment position to a highly negative one since 1980. This deterioration in net creditor status has accelerated in the past decade, and foreign creditors have increasingly shunned treasury bills in favor of direct investments, stocks and real estate.

If the current system is untenable, what can replace it?   Talk of a new monetary order built around China is idle,  as the RMB does not meet the basic requirements of a  reserve currency (rule of law, property rights, deep and liquid capital markets, free movement of capital).  Moreover,  a formidable mercantilist  China could never assume the responsibility of providing liquidity to the global market. Most likely, eventually Keynes’s old proposal from Bretton Woods will be resurrected.

Meanwhile, the USD remains king. Ironically,  the system’s  probable slow death will create intense havoc and uncertainty, conditions that favor USD strength not weakness. We have seen this clearly in recent years as the dollar has been strengthening, driven by massive capital flows out of international and emerging markets.

 

 

 

 

 

 

 

 

 

 

Don’t Fight the Rising Dollar!

Periods of dollar strength are deflationary in the context of the current dollar-centric global monetary system. A strong dollar is generally associated with global inflows into the U.S. either because the U.S. provides superior returns on capital relative to international markets or because high levels of risk aversion drive global capital into the “safe-haven” U.S. capital markets (liquidity, transparency and rule of law).

Periods of dollar strength are the two corners of the “dollar smile” as previously discussed  (Link ) and as shown below.

 

Dollar strength saps liquidity out of international markets, especially in emerging markets where governments and companies  are overly reliant on dollar funding because of shallow domestic capital markets. The combination of higher funding costs for these borrowers and flight capital often results in emerging market financial crisis, 1980, 1997  and 2008 being some of the most painful episodes.  Because of the ongoing surge in the dollar in 2022, we should expect that emerging market economies and asset prices will be under significant stress for the time being.

Because most commodities and a significant amount of global debt are  priced in dollars, a rising dollar depresses global demand and economic growth. This impacts global corporate margins and profitability , including American exporters and domestic industries that compete against foreign imports.

The deflationary nature of dollar strength has a strong impact on global stock market returns because it depresses the earnings of cyclical companies, particularly commodity and industrial companies and banks. Global stock markets in general and emerging markets in particular have much greater exposure to cyclical industries and therefore suffer more during these periods. In the U.S. market, industrials and multinationals with heavy foreign exposure also suffer from a strong dollar. The chart below shows how this phenomenon plays out in the U.S. stock market. During periods of dollar strength (1997-2000) and 2012-2021), the Nasdaq index dramatically outperformed the Dow Industrials Index because the Nasdaq is composed mainly of growthy, long-duration stocks while the Dow includes mainly cyclical businesses such as industrial and banks.

The chart below shows the impact on Dow Index earnings  caused by strong dollar deflationary periods. The three periods of dollar strength since the inception of the fiat dollar regime in 1971 are highlighted by the dark bars.  We can see flat to negative earnings in the first two periods and very choppy earnings in the current third period despite the Trump corporate tax cuts and huge stock buy-backs (the final leg up in earning was driven by the recovery in commodity prices in 2021.)

The charts below show the strongly negative effect that a strong dollar has on corporate earnings in emerging markets. The first chart shows that earnings  (in nominal dollar terms) for Global Emerging Markets (MSCI EM Index) were highly depressed during the last two phases of dollar strength (1997-2002) and 2012-2021.  The following chart shows the poor earnings performance of Chinese stocks, over the past decade despite  the RMB’s appreciation over the period, which is a testament to the poor governance and the deflationary effects of overinvestment in industrial capacity and debt expansion. Next, we see the same for Brazilian corporate earnings which by the end of 2021 have still not returned to 2012 levels in nominal dollar terms, despite very strong earnings growth for commodity producers in 2021. Same for India, which barely returned to 2012 earnings level in nominal terms in 2021 even though the Indian economy has enjoyed high rates of GDP growth. Mexico and Korea show a similar story. The one outstanding exception is Taiwan, which has seen good earnings growth because of strong links to the  global technology sector.

The history of emerging markets shows that practically all earnings growth comes in periods when the dollar is depreciating. The current dollar upcycle will eventually turn, bringing better prospects for investing in EM assets. Rising inflationary pressures and buoyant commodity prices may portend that a change is coming.

 

 

The “dollar Smile” does not favor Emerging Markets

The U.S. dollar’s recent surge against both developed and emerging market currencies has extended the current dollar upcycle into its tenth year. Since the end of the Bretton Woods gold-anchored monetary system in 1971, the dollar’s viability as a fiat reserve currency  has relied on the credibility of the Federal Reserve and the willingness of foreigners to own U.S. assets. Since 1971, a relatively predictable 16-18 year cycle has occurred, with 8-9 years of dollar strength followed by 8-9 years of dollar weakness.

Given the short life of the current dollar fiat-global reserve currency system and its absolute uniqueness in historical terms,   it is difficult to generalize and define trends. However, we can say that we are currently in a third upcycle for the USD in what appears to be a declining trend. This is highlighted in the charts below. The second chart details the current dollar upcycle, which started in early 2011. The current upcycle is now in its eleventh year, and, with the recent surge of the DXY to the 103 level, we are now at the long-term downward sloping trendline. We are currently seeing a triple top for the DXY as it has returned to peaks previously reached in 2017 and 2020.

The prolongation of the current dollar upcycle  may have several explanations. Both in 2017 and in 2020 the dollar experienced significant weakness which seemed to indicate the beginning of a downtrend. However, both these downtrends were aborted by market -shaking events that drove investors into U.S. assets: In 2017-2018, Brexit, the Trump tax cut and the  Powell pivot from hawk to dove; in 2021, the extraordinary combination of U.S. fiscal and monetary stimulus and surprisingly strong U.S. economy. Furthermore, the 2017-2022 period has been marked by the strong returns of U.S. equity markets driven by the phenomenal operational performance during the pandemic of America’s “winner-take-all” tech hegemons. Finally, the Russian invasion of Ukraine and China’s economic problems (bursting of the real estate bubble and mismanagement of COVID) have accentuated flows into  U.S. safe haven assets, mainly stocks and real estate.

The current strength of the dollar relies on the notion of American exceptionalism. The U.S. goes through periods of “exceptionalism” and “malaise” which have influence on investor appetite for U.S. dollar assets and set the course for the dollar. Despite all of its stark deficiencies, relative to the rest of the world today the U.S. looks very stable and attractive for investors and it is sucking up excess capital which drives dollar strength.

The chart below schematically describes a framework for understanding the drivers of the U.S. dollar. This so-called “Dollar Smile” framework , which is built on the insights of macro traders like George Soros and others, pinpoints how the dollar behaves in diverse economic environments.

‘

At the two corners of the mouth, conditions exist for a strong dollar. The right corner represents periods of U.S. exceptionalism when the U.S. leads the world in economic growth and attracts global savings. The left corner represents periods of global crisis when capital flows to the safety of financial havens, especially the U.S. with its large and liquid capital market. The current dollar upcycle over the past eleven years has been supported by one or both  corners of the smile at different times.

At the bottom of the smile, conditions exist for a weak dollar. These are periods of synchronized global growth when the rest of the world is relatively stronger than the U.S. and is attracting capital (e.g. the 1970s in Europe and developed Asia; emerging markets, 2000-2012).

At the present time, the dollar is supported by high levels of economic uncertainty arising from geostrategic conflict and the consequences of an extended period of global fiscal and monetary adventurism. The left corner of the smile is likely to dominate currency movements for the foreseeable future, which portends a strong dollar. Under these conditions, emerging market countries will continue to see persistent capital flight and their assets are not likely to offer attractive returns.

Expected Returns for Emerging Markets, 1Q 2022

After a dismal decade of slowing GDP growth and stagnant earnings, emerging stock markets are showing signs of life. Overall returns are dampened by the value destruction of private company stocks which has been engineered by China’s government over the past year, but returns for EM ex-China have been much better. Most importantly, some of the cheaper markets in EM have started to take off, which is catching the attention of trend followers and bringing new capital into play. This is happening partially because of a more favorable environment for value stocks, cyclicals and commodities, but also because a rotation out of  long-duration tech “dreamer” stocks has been triggered by rising interest rates. All of this is good, but, unfortunately, EM is not yet out of the woods because storm clouds are staying put; these are, specifically ,the rising USD,  the tightening of U.S. monetary policy and the explosion of food and energy prices. This is a lethal combination for emerging markets.

Looking beyond the turbulence of the short term, the market action should be a major comfort to long run investors. For the first time in a while, the cheap markets are performing much better than the expensive markets, and investors are taking notice.

We turn to our CAPE methodology as a contribution to taking long term allocation decisions in emerging markets. CAPE provides insight on where valuations stand relative to historical trends and can help to structure mean reversion trades which have a good chance of working over  a 3-5 year time horizon. We combine CAPE with macro-economic conditions and market technicals  to determine entry and exit points in the context of a long term allocation strategy. The CAPE (cyclically adjusted price earnings) takes 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. At extreme valuations, the tool has had very good predictive capacity in the past.  We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized more recently by professor Robert Shiller of Yale University.

The methodology sets a long-term price objective based on the expected CAPE earnings of the target year, which in this case is seven years (2028). The CAPE earnings of the target year are multiplied by the historical median CAPE for each market. The underlying assumption of the model is that over time markets tend to revert back to their historical median valuations.

The table below summarizes the results of our calculations for 17 EM countries, global emerging markets (GEM, MSCI) and the S&P500. The expected returns of markets depend on valuation (CAPE ratio) and earnings growth (largely a function of GDP growth). No consideration is given here to possible multiple expansion or the liquidity factors that may have a major influence on market returns.

Not surprisingly, all the  markets with the lowest valuations and highest expected returns are currently facing difficult economic and/or political prospects  Investing in these countries requires a leap of faith that “normalization” is possible. For example, it assumes that the current crisis in Turkey will be resolved adequately, that Chile’s constitutional reform will not structurally impair growth prospects and that China’s absurd vendetta against its most innovative and dynamic private firms will come to an end.  Until recently, none of these trades has worked. Still today, Chinese stocks are sliding, but the other cheap markets — Turkey, Brazil, Chile  and South Africa — are all doing much better, which is heartening.

 

High Commodity Prices for Brazil Probably Mean Another Wave of Dutch Disease

It is an unfortunate reality that for most countries natural resource wealth is counterproductive. This phenomenon is known in economics as “Dutch Disease,” in reference to the Dutch natural gas boom in the 1960s which resulted in currency overvaluation, declining manufacturing exports ,  higher unemployment and lower GDP growth.

In the Post W.W. II period, which has been marked by declining trade transaction costs and more open borders, few countries have avoided the resource curse. Norway, having learned from the Dutch experience, carefully managed the windfall from its oil boom in the 1970s by creating a Sovereign Wealth Fund to distribute benefits over generations. The United Arab Emirates has also squirreled away oil income into Sovereign Funds which make long-term investments to reduce dependence on finite oil resources.

In emerging markets it is difficult to exercise this discipline because of weak institutions and the pressing needs of the poor. Rent-seeking elites, crony capitalists and corrupt politicians inevitably take advantage of this institutional fragility to appropriate a disproportionate share of the resource windfall.

Brazil is perhaps the best recent example of the curse at work. A discovery of very large offshore oil reserves in 2006 was expected to be transformational for a country with a history oil deficiency. Predictions were made for an expansion of oil production from 2 million b/d to over 7 million over the next decade. The discovery sparked a euphoric mood, and  investors and policy makers projected positive effects on GDP growth, fiscal accounts and the balance of payments.

Brazil’s oil discovery  turbo-charged the commodity super-cycle (2002-2010),  which was already underway,  causing  a positive terms of trade shock, currency appreciation, and a massive credit boom. Instead of saving for the future, the government dramatically increased spending on social welfare programs and public sector benefits.

Unfortunately, the commodity boom brought all the negative consequences which are associated with “Dutch disease.”

  1. Worsening governance and corruption

The commodity boom brought forth the worse tendencies of  Brazilian governance,  well described by former Central Bank president Gustavo Franco as “An obese state  fully captured  by parasites and opportunists always  fixated on protecting their turf.”  We can see how governance (government effectiveness), as measured by the World Bank, deteriorated in the following chart.

Corruption also reached unprecedented levels over this period, as measured by the World Bank.

  1.  Currency appreciation followed by eventual depreciation.  Instead of squirrelling away the commodity windfall, Brazil allowed the currency to sharply appreciate. International reserves were also increased significantly, but without sterilizing the impact on domestic supply, which fueled credit growth.

 

  1. Deindustrialization

The huge appreciation of the BRL caused an accelerated loss of competitiveness of the manufacturing sector, which we can see in the fall of manufacturing share of GDP and an accelerated decline in manufacturing complexity. The first chart below shows the evolution of manufacturing value-added  as a share of GDP for resource-rich economies  compared with resource-poor economies, highlighting that Dutch Disease impacted all commodity exporters. The next two charts also show the evolution of manufacturing by comparing economic complexity in Latin America and  Asia.

  1. Lower Potential Growth. The erosion of manufacturing capacity led to massive replacement of “quality” industry jobs with low valued-added service jobs, and, consequently, a collapse in productivity. Potential GDP growth was about 2.5% annually before the commodity boom and has now fallen to less than 1.5%. As shown below, over the past decade total factor productivity has collapsed in Brazil.

 

 

As a result of this aggravated case of Dutch Disease, Brazil is more than ever dependent on its world class natural resource sectors: export-oriented farming, and export-oriented mining. Both of these sectors are highly competitive globally but very technology and capital intensive , providing  few jobs (Vale’s enormous iron ore operations generate only 40,000 jobs in Brazil.) Paradoxically, Brazil’s  farm sector has similarities with South-East Asia’s “Tiger” economies. Like in Taiwan, Korea and China, Brazilian farmers have benefited from ample credit,  state R&D support and export subsidies.

Ironically, current prospects for rising commodity prices are not necessarily  good news for Brazil as there  is no evidence that lessons have been learned from the past.

Value is Dead; Long Live Value!

Growth stocks, defined as those with underlying businesses growing much faster than GDP, flourished over the past decade. Tepid global growth, marked by aging work forces and declining productivity growth, put a high premium on those few sectors and companies with high secular growth, mostly in the tech driven digital economy. At the same time, extraordinarily loose monetary policies which drove real interest rates to negative levels around the world , sparked a speculative stock market frenzy, directed mainly to the most speculative “pie-in-the-sky” stories of  technological disruption.

For value investors the environment of the past decade was devasting, and believers in the old “Graham and Dodd” mindset of fundamental investing became an endangered species. In recent years, business publications and academic journals were full of declarations on “The Death of Value.”

Metrics from Google’s search engine give an idea of the narrative that dominated the scene, as shown below.

Of course, we know that this kind of media attention is a contrary indicator. For example, we can be confident that any business publication cover declaring the certainty of any investment trend is good evidence for the end of that trend (e.g. The Economist has marked multiple peaks and troughs in the Brazilian stock market with its covers.)

So, it really should not be a surprise with regards to value investing that, as Mark Twain once quipped: “The reports of my death are greatly exaggerated.”

Lo and behold, over the past year value has made an impressive comeback.

Warren Buffett, the doyen of “Graham-and-Dodd’s-Ville, who had underperformed the S&P500 for over ten years, made a big comeback over the past year, outperforming the index by 16%, as we can see below. A simple value strategy of weighing the index by fundamentals (sales and profits)  instead of market capitalizations also outperformed neatly.

The same has happened in emerging markets where, over the past year, EM value has had one of its best years ever relative to EM growth, leaving the vast majority of portfolio managers (today, almost all fully-declared growth investors or really “closet” growth investors) licking their wounds. We can see below that in every region  of EM (except for the GCC, for classification reasons) value has beaten growth by a huge margin.

As in the case of the U.S., a simple strategy based on fundamentals instead of market capitalization also beat the index by a huge margin and outperformed 90% of active managers in emerging markets.

What the future brings, we don’t know. But, historically, regime changes in favor of value can last for many years. If we have really moved into a more inflationary environment, which is typically good for value, then perhaps value has a ways to go.

 

The Cycle is Turning; Winter is Coming

Since the outset of the pandemic the global economic cycle has been in accelerated mode. We witnessed one of the shortest downcycles ever and the quickest recovery of employment for any recession in decades. By the middle of last year, the U.S. economy showed clear signs of mid-to-late  cycle behavior, with low employment and rising prices. Now, we are clearly late cycle, with Central Banks having to tighten monetary policy and yield curves flattening underway.

Asset prices have behaved as expected both on the way down and the way up: risk assets (value, small caps, cyclicals) did very poorly on the way down and then very well on the way up. Defensive assets such as quality growth held up on the way down, underperformed on the way up and have proved resilient in the current late phase. Increasing volatility in asset prices and the collapse of speculative bubbles are also signs of a cycle end.

We are now seeing the cycle go full circle, with the typical signs of contraction appearing.

Leading Economic Indicators are pointing down, as shown in the charts below. The first chart is the OECD’s global LEI; the second chart shows LEIs for the U.S. and Korea, the two most important bellwethers of the global growth cycle.

Dr. Copper, also famous for his ability to predict global cycles, also is signaling problems ahead.

The implication is that we are entering a risk-off phase when investors will shun value, small caps and cyclicals. Of course, this includes emerging markets, particularly non-China assets. This will create the next good buying opportunity.

Does CAPE Work For 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 usually 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 and the CAPE has proven effective in highlighting them.

The CAPE (Cyclically adjusted price earnings) 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.

The charts below illustrate the relationship between stock market total nominal returns and the level of the CAPE ratio for Global Emerging Markets, the S&P500 and 18 emerging markets. 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 data is more significant because the CAPE ratios capture better the evolution of the single asset.

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

  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 2021 was 39.3, the second highest in history.

2. All date points, including GEM and 18 countries: This is a very noisy graph  but the trend is clear. All 10 year periods with returns at least 15% annually started with CAPE below 25.

3. Global Emerging Markets: Clear trend.  GEM has never returned less than 10% annually with cape below 10; returns have never been above 5% with CAPE above 20. GEM CAPE ended 2021 at 14.4.

 

4. China: All high return years started at CAPE below 10; all low returns started at CAPE above 20. China end 2021 at 13.3.

 

5. India: India performs best with CAPE below 20 and really struggles above 25. 2021 ended at 31.1 which should weigh heavily on future returns.

6. Korea: Clear trendline but slightly more dispersion than in most other markets. Current CAPE is 9.6.

7. Taiwan; All high return decades have started with CAPE  below 15; low returns have started above 20. The current level is 27.1, the highest since the Taiwan bubbles of the 1990s.

8. Brazil: Brazil is a good example of a highly cyclical economy prone to boom-bust cycles and unstable liquidity flows. A CAPE of 15 seems to be the dividing line for returns, with equity booms starting with CAPES in the low teens and the market struggling with CAPES in the high teens.  At the current CAPE of 10.9, the market is priced to provide high returns.

9. Turkey: Annual returns have been very high when CAPE has approached the five level, and very poor when CAPE reaches the high teens. The current CAPE of 4.1 is the lowest since the early 1990s. This is the fourth time that CAPEs have been below five and on every occasion very high returns have followed.

10. Mexico. Current CAPE is 18.2

 

11. Philippines

12. Thailand

13. Russia

14. Malaysia

15. South Africa

16. Indonesia

17. Peru

18. Chile

19. Colombia

20. Argentina

CAPE and Expected Returns in Emerging Markets, 2022-2028

The past decade in emerging markets has been one of slowing GDP growth, low earnings and poor returns. By and large, today valuations have come down enough from the lofty levels of 10 years ago to make the markets attractive, particularly compared to the high valuations of the U.S. market. Emerging markets are under-owned and certain segments of the market are extraordinarily cheap. If “value” segments of the market (industrial cyclicals, banks, commodities) continue to rally like they did in 2021, then prospects may be quite good. However, at the same time, the markets face a Fed monetary tightening process that may broadly challenge asset prices and, if history repeats itself, be particularly troublesome for emerging markets.

We turn to our CAPE methodology periodically to shed some light on relative valuations and derive estimates of “probable” future returns. The CAPE (Cyclically adjusted price earnings) takes 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 too lfor highly cyclical assets like EM  stocks. At extreme valuations, the tool has had very good predictive capacity in the past.  We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized more recently by professor Robert Shiller of Yale University.

The methodology sets a long-term price objective based on the expected CAPE earnings of the target year, which in this case is seven years (2028). The CAPE earnings of the target year are multiplied by the historical median CAPE for each market. The underlying assumption of the model is that over time markets tend to revert back to their historical median valuations.

The table below summarizes the results of our calculations for 17 EM countries, global emerging markets (GEM, MSCI) and the S&P500. The expected returns of markets depend on valuation (CAPE ratio) and earnings growth (largely a function of GDP growth). No consideration is given here to possible multiple expansion or the liquidity factors that may have a major influence on market returns.

Not surprisingly, the markets with the lowest valuations and highest expected returns are currently facing difficult economic and/or political prospects and, consequently, have been abandoned by investors. Investing in these countries requires a leap of faith that “normalization” is possible. For example, it assumes that the current crisis in Turkey will be resolved adequately and that Chile’s constitutional reform will not structurally impair growth prospects.

The CAPE methodology is a poor predictor of short-term results. For example, the cheap markets at year-end 2021 all did poorly over the past year while the expensive markets (USA, India) just got more expensive.

Emerging Markets: 2021 in a few charts

1.

2021 saw more underperformance for international stocks (MSWORLD) and emerging markets stocks (EEM)s relative to the S&P500. The U.S. tech titans have become the darling of global investors, considered as the last remaining “safe haven”  asset in a low growth and risky world.

2.

EM ex China (EMXC) didn’t perform too badly in absolute terms, in line with MSCI World ex U.S. EM as a whole was weighed down by the collapse of China’s internet stocks (KWEB), the favorites of international funds.

3.

In 2021 investors learned that China cares about its currency and its bond market but not much about stocks , particularly those of “frivolous” companies engaging in anti-social activities (internet). While EM bonds (EMCB,EMHY) lost value relative to U.S. High Yield, China’s bonds (CBON) rose steadily.

4.

In the Chinese market (MCHI), stocks held mainly by foreigners (KWEB, CQQQ) did poorly but local stocks (CNYA) and, even more so, local tech stocks (CNXT) picked up the slack.

5.

Global EM stocks, despite the rally in commodity prices (GYX, industrial) commodities index), did poorly, which is unusual. Commodity-rich markets like Chile (ECH) and Brazil (EWZ) lagged badly. Commodity prices were driven by climate politics and inflation, no longer by China which is not the driver of global growth it once was.

6.

The collapse in the correlation between commodity prices and EM is seen in the extraordinary divergence between Chilean stocks and copper. Chile is overwhelmed by politics, and copper inflows are serving only to facilitate capital flight. Investors in Chile and elsewhere may be  anticipating the likely return of strict capital controls.

7.

EMEA ( Europe, Middle East, Africa) led EM equity returns in 2021, boosted by the oil-sensitive markets of the Persian Gulf.

8.

There’s always a bull market somewhere. In 2021 it was U.S. tech titans  and the Middle East. Taiwan, India and Vietnam were also winners.

 

9.

Latin America stocks (ILF) underperformed Asia EM (EMEA), as they have persistently for the past decade.

 

 

10.

Technology stocks outside of China fell back to earth in 2021. Latin American tech stocks, fueled by the happy dreams of global venture capitalists led by Softbank, experienced a general collapse.

11.

China’s share of the MSCI EM index fell sharply, replaced mainly by Taiwan and India.

12.

The fall of China’s internet titans caused significant changes to the MSCI EM’s top holdings. Indian stocks are becoming more prominent, a story likely to extend for the coming decade. Commodity related stocks (Gazprom, Vale, Al Rajhi Bank) are back, also a harbinger of things to come

 

13.

After a decade dominated by growth and momentum, other factors started to work in  2021. Value and small caps outperformed in global EM and every region. The very few still active value investors in EM finally had a good year while most EM active managers (by now almost all closet growth investors) suffered.

14.

All the traditional academic factors did well in 2021, led by small caps (EEMS) and momentum (PIE).

15.

The Covid-19 pandemic has been disastrous for much of emerging markets, the worse hit being Eastern Europe and Latin America. The fiscal impact (higher debt levels) and social consequences (impaired education for the poor) have severely undermined the growth prospects for Latin America.

Protest Songs that Rocked Latin America in 2021

 

In 2021, two powerful protest songs expressed the state of mind of Latin American youth with regards to democracy: one condemning its shortcomings; the other longing for its blessings and the freedom it brings.

I.La Democracia

Chile’s Mon Laferte expresses the frustration and disappointment and the feeling that democracy is really just another scam run by elites to benefit themselves. This is the spirit of the youth and probably the driving force behind Chile’s Constitutional Reform

 

Mon Laferte – La Democracia (Lyric Video) – YouTube

 

Tú no tienes la culpa de que la plata a nadie le alcanza ( It is not your fault that no one has enough money)

Tú no tienes la culpa de la violencia y de la matanza (You are not to blame for the violence and the killing)

Así el mundo nos recibió (So the world received us)

Con muchas balas, poca esperanza (With many bullets, little hope)

Quiero que todo sea major ( I want everything to be better)

Que se equilibre esa balanza (That things settle down)

Tú no tienes la culpa de que a los pobres los lleven presos (It is not your fault that the poor are taken prisoner

Tú no tienes la culpa que quemen bosques por el progreso (It’s not your fault that they burn forests for progress)

 

Y los de arriba sacan ventaja (And those from above take advantage
Y la justicia que sube y baja (And the justice that rises and falls)
Nos tienen siempre la soga al cuello (They always have a rope around our necks)

La vida al filo de una navaja ( Life on a razor’s edge)

Que alguien me explique lo que pasó (Someone explain to me what happened)

(Por la democracia, la democracia) (For democracy, democracy)
Me confundí o alguien me mintió (I got confused or someone lied to me)

(La democracia, la democracia)
¿Pa dónde fue? ¿Quién se la robó? (Where did it go? Who stole it?)

(La democracia, la democracia)
Vamos a tomarnos unos vinitos( Let’s have some wine)

(La democracia, la democracia)

Ahí tení. Para que te engañen (There you have it. So they fool you

 

Tú no tienes la culpa de que persigan a los migrantes I(t is not your fault that they persecute migrants)
Tú no tienes la culpa de la masacre a los estudiantes (You are not to blame for the massacre of the students)

De las promesas y las banderas (Of promises and flags)

Los caballeros se llenan la panza (Gentlemen fill their bellies)

Aquí te van unas melodías (Here are some melodies)

Y algunas rimas pa la venganza (And some rhymes for revenge)

Que alguien me explique lo que pasó (Someone explain to me what happened)

(Por la democracia, la democracia)

Me confundí o alguien me mintió( I got confused or someone lied to me)
(La democracia, la democracia)
¿Pa dónde fue? ¿Quién se la robó? (Where did it go? Who stole it?)
(La democracia, la democracia)
Vamos a tomarnos unos vinitos (Let’s have some wine)

(La democracia, la democracia)

Hagan un trencito  (Make a train)

 

Make a train

Make a train

On this side and on the other

Dancing the cumbia they look prettier

Hagan un trencito
De este lado y del otro (On this side and on the other)
Bailando la cumbia se ven más bonitos (Dancing the cumbia they look prettier)

Hagan un trencito
Hagan un trencito
De este lado y del otro
Bailando la cumbia se ven más bonitos

Que alguien me explique lo que pasó
(Por la democracia, la democracia)
Me confundí o alguien me mintió
(La democracia, la democracia)
¿Pa dónde fue? ¿Quién se la robó?
(La democracia, la democracia)
Vamos a tomarnos unos vinitos
(La democracia, la democracia)
(La democracia, la democracia)
(La democracia, la democracia)

 

 

II.Patria y Vida

 

A collaboration 0f Cuban musicians, both in exile and on the island, in exile this powerful protest song swept the island (until it was banned) and the international latino community. It is a cry of despair for freedom and a denunciation of the scenescence and hypocricy of the regime.

 

.Patria y Vida      (Homeland and Life)

 

And you are my siren song
Y eres tú mi canto de sirena

Because with your voice my sorrows go away
Porque con tu voz se van mis penas

And this feeling is already stale
Y este sentimiento ya está añejo

You hurt me so much even though you are far away
Tú me dueles tanto aunque estés lejos

Today I invite you to walk through my lots
Hoy yo te invito a caminar por mis solares

To show you that your ideals serve
Pa’ demostrarte de que sirven tus ideales

We are human although we do not think alike
Somos humanos aunque no pensemos iguales

Let’s not treat or harm ourselves like animals
No nos tratemos ni dañemos como animales

This is my way of telling you
Esta es mi forma de decírtelo

My people cry and I feel their voice
Llora mi pueblo y siento yo su voz

You five nine me, double two
Tu cinco nueve yo, doble dos

Sixty years locked the domino
Sesenta años trancado el dominó

Bass drum and saucer to the five hundred of Havana
Bombo y platillo a los quinientos de la Habana

While at home in the pots they no longer have jama
Mientras en casa en las cazuelas ya no tienen jama

What do we celebrate if people walk fast?
¿Qué celebramos si la gente anda deprisa?

Trading Che Guevara and Martí for the currency
Cambiando al Che Guevara y a Martí por la divisa

Everything has changed, it is no longer the same
Todo ha cambiado ya no es lo mismo

Between you and me there is an abyss
Entre tú y yo hay un abismo

Advertising a paradise in Varadero
Publicidad de un paraíso en Varadero

While mothers cry for their children who left
Mientras las madres lloran por sus hijos que se fueron

you five nine, me, double two
tu cinco nueve, yo, doble dos

(It’s over) sixty years locked dominoes, look
(Ya se acabó) sesenta años trancado el dominó, mira

(It’s over) your five nine, me, double two
(Se acabó) tu cinco nueve, yo, doble dos

(It’s over) sixty years locking the domino
(Ya se acabó) sesenta años trancando el dominó

We are artists, we are sensitivity
Somos artistas, somos sensibilidad

The true story, not the wrong one
La historia verdadera, no la mal contada

We are the dignity of a whole town trampled on
Somos la dignidad de un pueblo entero pisoteada

At gunpoint and with words that are still nothing
A punta de pistola y de palabras que aún son nada

No more lies
No más mentiras

My people ask for freedom, no more doctrines
Mi pueblo pide libertad, no más doctrinas

Let’s no longer shout homeland or death but homeland and life
Ya no gritemos patria o muerte sino patria y vida

And start building what we dream of
Y empezar a construir lo que soñamos

What they destroyed with their hands
Lo que destruyeron con sus manos

That the blood does not continue to flow
Que no siga corriendo la sangre

For wanting to think differently
Por querer pensar diferente

Who told you that Cuba is yours?
¿Quién le dijo que Cuba es de ustedes?

If my Cuba belongs to all my people
Si mi Cuba es de toda mi gente

your time is up, the silence is broken
ya se venció tu tiempo, se rompió el silencio

(It’s over) the laughter is over and the crying is already running
(Ya se acabó) ya se acabó la risa y el llanto ya está corriendo

(It’s over) and we’re not afraid, the deception is over
(Se acabó) y no tenemos miedo, se acabó el engaño

(It’s over) it’s sixty-two hurting
(Ya se acabó) son sesenta y dos haciendo daño

There we live with the uncertainty of the past, planted
Allí vivimos con la incertidumbre del pasado, plantado

Fifteen friends on, ready to die
Quince amigos puestos, listos pa’ morirnos

We raise the flag still the repression of the regime to the day
Izamos la bandera todavía la represión del régimen al día

Anamel and Ramón firm with their poetry
Anamel y Ramón firme con su poesía

Omara Ruiz Urquiola giving us encouragement, of life
Omara Ruiz Urquiola dándonos aliento, de vida

They broke down our door, they raped our temple
Rompieron nuestra puerta, violaron nuestro templo

And the world is conscious
Y el mundo ‘tá consciente

That the San Isidro movement continues, since
De que el movimiento San Isidro continua, puesto

We continue in the same, security putting prism
Seguimos en las mismas, la seguridad metiendo prisma

These things make me indignant, the enigma is over
Esas cosas a mí como me indignan, se acabó el enigma

Ya sa ‘your evil revolution, I am Funky style, here is my signature
Ya sa’ tu revolución maligna, soy Funky style, aquí tienes mi firma

You are already left over, you have nothing left, you are already going down
Ya ustedes están sobrando, ya no le queda nada, ya se van bajando

The town got tired of holding on
El pueblo se cansó de estar aguantando

A new dawn we are waiting for
Un nuevo amanecer estamos esperando

It’s over, you five nine, me, double two
Se acabó, tu cinco nueve, yo, doble dos

It’s over, sixty years locked dominoes, look
Ya se acabó, sesenta años trancado el dominó, mira

It’s over, you five nine, me, double two
Se acabó, tu cinco nueve, yo, doble dos

It’s over, sixty years locking the dominoes
Ya se acabó, sesenta año trancando el dominó

Homeland and life
Patria y vida

Homeland and life
Patria y vida

Homeland and life
Patria y vida

Sixty years locked the domino
Sesenta años trancado el dominó

 

 

Can China Avoid the Middle-Income Trap?

Over the past 60 years few countries have grown their economies at a faster rate than the United States and improved their citizens’ incomes relative to those of Americans. This process of convergence has happened almost exclusively in the poorer countries of Europe. In developing economies, we can count the success stories on one hand (Singapore, Hong Kong, Taiwan and Korea). In recent decades China has experienced extraordinary growth, which raises the question of whether it can join the club of rich countries.

Undoubtedly, the rise of China’s economy over the past 40 years has been miraculous.  China’s GDP per capita increased from $200 in 1980 to $10,500 in 2020, taking it from 10% to 160% of Brazil’s level or from 1.5% to 16% of the U.S. level.

However, China’s ability to sustain high levels of growth in the future is far from certain. The history of the global economy in the post W.W. II period shows that growth for the majority of developing countries falters after reaching middle income status ($10,000-$12,000 PC income). Once countries  reach this level they tend to have exhausted the easy gains from rural migration, basic industrialization and urbanization. Sustaining growth then requires an institutional framework that promotes social inclusion, efficient markets and innovation. Countries like Brazil and Mexico utterly failed in developing these institutions and they have become emblematic of  the “middle-income trap.”

The chart below shows the elite group of “convergers” over this long period. The list can be separated into three distinct groups: 1. Beneficiaries of European economic integration (which, starting in the 1980s, will also include Eastern European former Soviet Block economies); 2. Beneficiaries of special economic ties with rich countries (Hong Kong, Bermuda, Puerto Rico, St. Kitts); 3. Countries of special geo-political importance to the United States (Taiwan, Korea, Israel). If we take out European countries and territories closely dependent on rich countries, we can further focus on the exceptionality of the few countries that have succeeded: Hong Kong, Singapore, Korea, Taiwan and Oman.

  • Hong Kong and Singapore are small islands that prospered as reliable trading and service hubs for the expansion of global commerce.
  • Korea and Taiwan were of major geopolitical importance to the United States, received considerable financial support and were allowed to engage in mercantilist policies that may not be available for other developing countries.
  • Israel benefited from waves of highly educated immigrants, abundant foreign investment and generous U.S. geopolitical and financial support.
  • Oman started from a very low level and made important oil discoveries in the 1960s. It has been a important strategic ally of the United States in the Middle-East.

 

 

None of these special conditions apply to China. Though the U.S. was initially supportive of China’s growth (1970-2016), it now considers China to be a key economic competitor and a major geopolitical rival. Therefore, the U.S. cannot be expected to give China the slack that was awarded to Taiwan and Korea in the past (as well as to Japan and probably to India in the future).

China’s leaders are fully aware of the challenges ahead and the importance of reforms. They have consistently expressed concerns about the imbalances of the economic model and the sustainability of growth.  As early as 2007,  premier Wen Jiabao argued  that “the biggest problem with China’s economy is that the growth is unstable, unbalanced, uncoordinated and unsustainable.”  Shortly after taking the helm in 2013,  President Xi Jinping warned that China faced a “blind alley without deepening reform and opening to the world.”

In the early days of the Xi Administration in 2013 two important government policy statements outlined the strategic path required for China to avoid the “blind alley.” In his comments at the Third Plenum of the Party Central Committee in November 2013, President Xi proposed reforms to increase the role of markets and the capacity for state regulatory oversight. Xi’s comments were in line with the report issued earlier by the World Bank and the Development Research Centre of China’s State Council titled China 2030: Building a Modern Harmonious and Creative Society which highlighted the need for more reliance on markets and free enterprise and openness to world markets and scientific research.

However, since 2013 the Xi Administration has veered off the planned reform path. Perhaps, powerful political and economic groups with vested interests have resisted the changes; or it may be that the reforms were not considered timely or politically expedient.  At the same time, an increasingly acrimonious relationship with the United States marked by tariffs and severe sanctions on technology transfers altered the Xi Administration’s view on “opening to the world.”

The recent messaging from the Xi Administration is autarkic. China is said to face a “protracted struggle” with America and cadres are encouraged to “discard wishful thinking, be willing to fight, and refuse to give way.” President Xi now touts a “new development concept” based on self-reliance aimed at securing domestic control over the key technologies of the future and their supply chains.

The hope is that China can avoid the pitfalls faced by almost all developing countries that have pursued “import substitution” strategies.  This may be the case because of China’s particular characteristics: A high degree of internal competition; enormous  economies of scale provided by 1.4 billion consumers; world-class manufacturing capacity achieved as the “factory of the world” ; and a heavy tradition of investment in research and development. Moreover, China has considerable experience with the East-Asia “Tiger” model in corralling investments into priority areas through credit and fiscal subsidies and control over banks and resourceful state firms.

In any case, the “new development concept” implies expanded state control over investments and markets. The Xi Administration’s policy about-face was recently acknowledged by Katherine Tai, the Biden Administration’s top trade official: “China has doubled down on its state-centric model…It is increasingly clear that China’s plans do not include meaningful reforms.”

The main risk for China is that autarkic ambitions, particularly those relating to complex efforts to replicate frontier technologies, will prove prohibitively costly and divert resources away from more basic priorities such as bridging the enormous wealth gap between rich coastal provinces and the rural interior provinces.

The Wikipedia chart below shows the discrepancy in wealth between China’s prosperous coastal provinces and Beijing and the rest of the country. Stripping out the rich provinces,  GDP per capital falls to around $8,400, a level similar to Mexico.

 

This divide is illustrated by the contrast between the high educational standards in provinces like Shanghai, which ranks at the top of the OECD’s PISA (Program for International Student Assessment),  and the generally low schooling of most of the population. For example, as shown in the OECD data below, China’s overall educational achievement, as measured by the percentage of the population which does not complete High School, is very low, near Indian levels and worse than Mexico. The difference between China and recent convergers like Poland and Korea (at the far right of the table below) is telling.

The extreme divide between the rich and educated and the masses of uneducated poor has proven to be a critical growth barrier for developing countries and a root of the middle-income trap in Latin America. In the mid-1970s both Brazil and Mexico (the “next Taiwan”) were considered “miracle” economies on the verge of high-income status. Both countries had enjoyed high growth since the early 1960s, relying heavily on import-substitution strategies, and reached per capita incomes near 20% of the U.S. level (China’s PC GDP has gone from 1.6% of the U.S. level in 1980 to 16% today). Unfortunately, since then both Brazil and Mexico have lost ground, now standing at 11% and 13% of U.S. GDP per capita.

One of the fundamental reasons for the failures of Brazil and Mexico (Turkey, South Africa and others as well) is the inability to incorporate the bulk of the population into the formal economy, either as productive labor or as sources of demand. This situation is encapsulated in the description of Brazil as a “Belindia”:  a combination of Belgium (some 10-20% of the population working and living the lifestyle of rich Europeans), and India (the remainder having more in common with poor Indians.) Of course, this situation leads to low productivity, social and political tension and a large underground economy where crime prevails. None of this was intentional, but it happened because of political choices dictated by powerful vested interest groups seeking to protect their benefits and economic rents.

To avoid this path China should do all it takes to incorporate its 950 million low-income citizens into the economy as productive workers and new consumers. Though these policies may not be popular with elites, they are  the key for assuring sustained growth in the future.

A Tale of Two Decades For Emerging Markets

For investors in emerging markets, the past decade has been a mirror image of the previous one. The S&P500 treaded water between 2001-2010, at first held back by the hangover of the technology-media-telecom bubble and then crashing with the Great Financial Crisis. Emerging markets, on the other hand, benefited from the peak growth years of the Chinese economic miracle and the commodity super-cycle that it engendered, and sailed through the GFC thanks to the extraordinary stimulus measures adopted by China. Over the past ten years, the opposite has happened. Emerging markets have languished as the U.S. dollar went from weak to strong, commodity prices collapsed and the pace and quality of China’s growth worsened. U.S. stocks, on the other hand, were turbocharged by waves of Quantitative Easing, which channeled liquidity into financial assets,  deflationary forces and the remarkable maturation of America’s tech monoliths into cash-generating machines.

We can see this evolution clearly in the following chart, which includes the EAFE index (Europe, Asia, Far East developed markets) and the Dow Index, in addition to the FTSE EM Index and the S&P500. The EAFE index is the biggest loser over the combined period, as it was hit hard by the GFC and lagged in the recovery. These two periods can also be explained in terms of the performance of the dollar and the nature of the components of the different indices. Non-U.S. developed market currencies appreciated nearly 40% over the first period and lost 20% over the second period, while EM currencies appreciated by 33% and then fell by 30%.

In terms of index components, EM and EAFE (and the Dow) are weighted towards cyclical stocks (industry, commodities and banks) much more than the tech heavy S&P500. This means that, to a significant degree, the relative performance of these indices can be considered in terms of the  value-growth style factors. Traditional value stocks performed well in the first period and miserably in the second.

 

How can we explain the poor performance of cyclical stocks over the past decade?  Probably the answer lies in several coincident developments in the world economy that have resulted in excess capacity and low demand for commodities and industrial goods:

  • The great financialization of the global economy, which peaked with the Great Financial Crisis, has sapped investment and growth at a time when rich countries are ageing and losing dynamism. Debt-to-GDP ratios are at peak historical levels in most developed and EM countries with not much to show in terms of productive investments.
  • The end of China’s economic miracle. Since the GFC, China’s authorities have mainly concerned themselves, with little success, with correcting growing economic imbalances. Efforts to boost consumption and reduce dependence on non-productive investments have not been successful.
  • The 2001-2011 decade left many industries and commodity producers with excess capacity. The commodity super-cycle turned out to be much more of a bane then a boom for commodity dependent economies which subsequently have suffered from a heavy dose of “Dutch Disease.” (Brazil, South Africa, Chile, Indonesia)
  • Technological disruption is hitting many of the traditional cyclical industries (banking, autos).

The combination of these factors have led to a state of quasi-depression for most emerging markets over the past decade. We can see this in earnings growth over the two decades, as shown in the following charts.

The 2001-2011 decade was outstanding for corporate earnings, particularly for countries highly engaged in the China trade (Chile, South Africa, Indonesia, Korea). The U.S. lagged considerably, worse than appears on the chart because the base for the U.S. is the trough of the 2001 U.S. recession.

The chart for the 2011-2021 period paints a very different picture. The beneficiaries of the China trade of the previous decade all suffer deeply from a combination of “Dutch Disease,” terms-of-trade shocks and global excess capacity. Almost all the countries show low to negative earnings growth over the decade, the exceptions being the U.S. (strong dollar and tech stocks) and Taiwan (TSMC).

The past decade has seen a revival of “American exceptionalism,” premised on the relative strength of U.S. capitalism and economic dynamism compared to the rest of the world. The unique capacity of American venture capitalism, Washington’s pro-business and pro-Wall Street stance, the ocean of liquidity provided by the Federal Reserve and its perceived commitment to backstop equity markets, and corporate America’s keen focus on shareholder value have made America’s stock market the magnet for international capital looking for safety in a turbulent world.

Chile’s Constitutional Trap

Latin America’s persistent economic decline relative to other emerging markets over the past 40 years can largely be attributed to poor governance. The region has become the main example for the “Middle-Income Trap” which results when rent-seeking interest groups institutionalize policies that make reforms nearly impossible in the future. Typically, these policies are introduced at times when social turmoil leads to “regime changes,” often through constitutional reforms. Brazil went through this process in the 1980s. Chile is going through a similar experience today.

Over the past thirty years, Chile has been the only successful major economy in Latin America. Until recently,  it was considered a serious candidate to join the club of high income and developed economies. However, inconsistent economic policies over the past decade and an explosion of social turmoil in 2019 appear to have brought about a regime change, which would reverse most of the pro-investment policies introduced during the military regime by its free-market “Chicago Boys.” A Constitutional Convention, firmly dominated by progressive and parochial interests, is now in session to define the rules of this new regime.

The example of Brazil should make Chileans very nervous. Brazil’s military regime (1965-1985) collapsed during the Latin American debt crisis of the early 1980s, a period  of increased political and social protest. Amidst this popular demand for change, progressive politicians filled the political vacuum left by the military. A Constitutional Assembly dominated by progressives came up with the “People’s Constitution,” which, according to its President, Ulysses de Guimaraes, would protect Brazil’s “suffering poor, massacred, humiliated and abused throughout history.” The new Constitution was a full rejection of the Military Regime’s trickle-down, investment-led approach in favor of one focused on securing social rights and economic safety nets.  Important interest groups with political influence, particularly civil servants, captured for themselves juicy windfalls. (One lone dissident voice at the convention, Senator Roberto Campos, a leading figure in economic policy during the military regime, decried the new constitution as “a mix of panaceas and passions…a catalogue of utopias… a civic Carnival… a hodgepodge of pettiness, xenophobia, irrational economics, corporativism, pseudo-nationalism and other foul “isms.”)

Very soon following its approval in 1988, more sober economists and policy makers began arguing that the Constitution – particularly its extremely generous provisions for civil servants–would prove a fiscal straitjacket and a severe burden on public policy.  For the past thirty years, successive governments have sought, with little success, to reform the Constitution to allow more flexibility in fiscal spending

One of the first critics was Raul Velloso, an expert on public finances with a PhD from Yale University. From day one, Velloso warned that the fixed expenditures mandated by the  Constitution  would prove catastrophic for economic growth. This week Velloso published an article in the Estado de Sao Paulo newspaper (Link) summarizing the consequences  of Brazil’s “Citizens Constitution.”

Since 1988 fiscal expenditures in Brazil have become dominated by mandated disbursements for social welfare benefits and civil servant salaries and pensions. We can see this in the chart below, based on Velloso’s data. Government expenditures have become increasingly channeled into constitutionally mandated social spending and civil servant benefits, leaving  scarce resources for anything else. The biggest victim has been investments, which according to Velloso, fell from 16% of the budget to 3%. Public sector investments in infrastructure have fallen from 5.1% of GDP to 0.7% over this period.

The lessons of Brazil are clear. Idealistic social mandates written into Constitutions during times of social upheaval have predictably nefarious long-term consequences. Once granted, benefits are extremely difficult to withdraw. Economic growth and prosperity lose. For Chile, Brazil provides a roadmap for what to avoid.

Emerging Markets Should not be Complacent About Debt

The  monetary and fiscal policies pursued since the Great Financial Crisis and greatly expanded during the COVID pandemic have repressed interest rates and flooded the global economy with liquidity. Low interest rates have promoted debt accumulation and stimulated a global yield chase. This environment has supported the widespread complacency of policy makers and investors who assume that these conditions are here to stay.

The fundamental argument of those who argue that the current mix of policies is sustainable is that low nominal interest rates and negative real rates make the burden of debt low by historical standards. The data series published quarterly by the Bank for International Settlements (BIS) allow us to evaluate this claim. What the BIS data shows is that some important qualifications are in order. Though low debt servicing costs may persist in  the U.S., it seems stretched for many other countries to believe they will be so fortunate.

The chart below shows the latest  non-financial private sector debt service ratios for emerging markets as well as for several key developed markets. Private sector ratios are important as they are very sensitive to credit cycles and the private sector in all these countries is the driver of productivity and growth. The data for China may be less meaningful because of the dominant role of the state in the economy and the difficulty in distinguishing between public and private companies.

What we see is that these ratios vary tremendously across the world and within regions. The United States is in the middle of the pack, a comfortable position for the issuer of the global reserve currency and also the deepest market for “safe” assets. The countries on the left of the chart appear in good shape. On the other hand, on the right side of the chart there are obvious vulnerabilities. France is probably the weakest link among developed countries (twice the level of Germany though below Canada). In emerging markets, Brazil, Turkey and Korea are around the critical 20% level.

These debt service coverage ratios must be seen in the context of the recent wave of Central Bank tightening cycles that have been initiated  to confront rising inflation and capital flight. The chart below from Charlie Billelo details the recent wave of tightening measures. Both Brazil and South Korea are now in tightening mode but still have negative real central bank rates.

We should also be aware of the historical context. We can see the historical trends for each individual country in the three regional charts below. First, in Asia it is noteworthy that Korea may soon be back to the record-high debt service ratios experienced after the Asian financial crisis.

In EMEA (Europe, Middle East and Africa), the very high and persistently rising ratios of France and Turkey are noteworthy.

Finally, in the Americas the contrast is striking. Both the United States and Mexico have relatively low ratios which are very consistent over time. The U.S. is in a privileged situation as the recipient of global capital flight, and the Federal Reserve may be in a position to maintain negative real interest rates for the foreseeable future. Mexico’s private sector is underleveraged and poised to take advantage of growth opportunities. The situation is very different in Brazil.  Brazil has a history of high and volatile debt ratios. Corporate debt is at record-high levels at a time when the Central Bank may have to tighten sharply,  the economy is slowing to a crawl and capital flight is high.

The BIS data is a warning to not make global generalizations about debt sustainability. Arguments for Modern Monetary Theory, unrestrained fiscal expansion and financial repression may be justified for the U.S., but inapplicable for most countries.

Economic Freedom in Emerging Markets

It is widely acknowledged by development economists that a country’s wealth is correlated to the economic freedom enjoyed by its citizens. The history of Europe supports this idea. From the Italian and Flemish city-states of the 15th century to the United Provinces of the Netherlands in the 17th century and finally England’s Glorious Revolution and the take-off of the industrial revolution in the 18th century, every great surge of prosperity in Europe occurred when republican ideals, open markets and tolerance for new ideas were allowed to flourish and overcome centralized, absolute rule. Moreover, these Anglo-Dutch ideals were the philosophical foundation of the American Revolution and instrumental to the United States’ rise as the world’s most dynamic economy in the 19th century.

The rise of the Soviet Union as an economic power in the 1960s raised doubts about “economic freedom”  being the only path to prosperity. Famously, the economist Paul Samuelson included the chart below in his widely read college textbook between 1961 and 1980, showing the Soviet economy on the path to overtake the United States. Samuelson’s basic argument was that the Soviets would grow faster because investment rates were higher and potential for efficiency gains were greater. Similar arguments were made in favor of the Japanese economy in the 1980s and have returned with even more vigor in relation to China in recent years.

The confidence in China’s ability to sustain high rates of GDP growth in the future is grounded in a belief that  the government is able to successfully steer investments into sectors of the economy with high growth potential. This thinking is rooted in the extraordinary success of the “East Asia Development Model” pursued by Japan, Taiwan, Korea and China which relies on  state support (tariffs, fiscal subsidies, credit subsidies) to corral investments into “frontier” industries with high export potential. It is also supported by arguments, back in favor in Western economic academia (e.g. Mariana Mazzucato, Carlota Perez), which proffer a key role for the state as an inducer of investment in vital industries.

Though it can be debated what the exact role of the state should be as an inducer of economic activity there are a series of objective criteria that can be identified as necessary to provide the appropriate institutional conditions for human and financial capital to be deployed in entrepreneurial activities. These basic conditions can be said then to provide the institutional framework for “economic freedom.”

Several institutions (e.g., The World Bank, The Fraser Institute, The Heritage Institute) have developed methodologies to rank countries in terms of economic freedom over time.

All of these look at a combination of the following factors:

  1. Rule of Law (property rights, government integrity, judicial effectiveness)
  2. Government Size (government spending, tax burden, fiscal health)
  3. Regulatory Efficiency (business freedom, labor freedom, monetary freedom)
  4. Open Markets (trade freedom, investment freedom, financial freedom)

 

The table below is from The Fraser Institute’s 2021 report which is based on 2019 data. The countries are ranked and separated into four quartiles, the top quartile being the countries with the highest level of economic freedom. These rankings are available for the past 40 years to provide a history for evaluating progress or regression over time.

 

The following maps show the Fraser Ranking in both 1980 and 2019. Note the tragic fall of Venezuela from one of the most economically free countries in the world to the bottom.

The following graph looks at the relationship between economic freedom and wealth, using Fraser’s country data and the World Bank’s  2019 GDP per capita as a proxy for wealth. We can see a strong correlation between economic freedom and wealth. Two noteworthy outliers are petro-states (UAE, Quatar, Brunei) and tax havens (Luxembourg) which are considerably above the trend line and Eastern European “reformers” (Lithuania, Lativia, Estonia, Georgia, Poland) which are well below the trendline. Presumably, the Eastern Europeans will experience a period of catching up as they enjoy the benefits of the reforms that have been implemented since the 1990s.

The table below narrows the Fraser Institute’s data for the primary emerging markets of interest to investors. The table shows the four quartiles, the country’s overall rank and the change in the quartile since 1980.

In conclusion, there are several interesting facts to note about the table.

  • Overall, EM has had a small improvement over the past 40 years.
  • In terms of the importance of countries relative to their weight in benchmarks, the rankings are not auspicious. India, Brazil and China, which are really the core of emerging markets as an asset class, are all in the bottom of the Third Quartile. Vietnam, considered by many the most promising frontier market, is in the Fourth Quartile.
  • Those countries in the Second Quartile may offer the best opportunities. I would highlight the Philippines and Indonesia which are on the right path and continue to enjoy high potential growth.
  • The three countries in the top quartile – Taiwan, Chile and Peru — are new entrants to this elite, with Peru coming all the way from the Fourth Quartile. In 1980 EM  had these three countries in the First Quartile, Venezuela, Malaysia and the UAE. Venezuela went from the First Quartile with a highly ranked 16th overall in 1980 to absolute bottom ranking in 2019. Peru’s rise and Venezuela’s collapse are a testament to the institutional precariousness of Latin American institutions.

 

Emerging Markets Stocks Expected Returns, 3Q2021

If forecasting is foolhardy in the most stable of times, trying to make predictions under current circumstances is risible. For the time being, financial markets are driven by the extraordinary policies of U.S. monetary and fiscal authorities which support consumption and provide liquidity to backstop asset prices. The limits of these policies are unknown, but, for now, investors from around the world are willing to engage in this lucrative scheme.

Predictions for the short term are always haphazard. Most market participants simply assume that current trends will continue. They are usually right because trends are persistent while mean reversion occurs over the long-term horizon. The current trends favor investing in U.S. stocks. These have outperformed for over a decade and the biggest and most dominant tech stocks have metamorphized into the new global “safe” asset of choice, replacing return-less U.S. Treasury bonds. Investors have concluded that these quasi-monopolies in winner-take-all growing sectors of the economy are pillars of stability in a turbulent world. The assumptions that underlie this investment thesis are that: 1.  the Federal Reserve is fully committed to sustaining the stock market because it believes that a market correction from the current high levels would cause  a negative “wealth effect” that would precipitate an economic depression; and 2. The Fed desires sustained higher inflation to erode the value of the Federal debt.

The COVID pandemic in a perverse way facilitated the work of the Fed and consolidated what could be called the “FAANG Monetary Standard.”  COVID justified unprecedented levels of monetary intervention and fiscal expansion and drove the stock market to record prices. The exceptional efforts of U.S. authorities made the 2021 recession one of the shortest ever and allowed the U.S. economy to outperform the global economy by a wide margin. Rising asset prices in the U.S. sucked in global capital and pushed up the value of the USD.

Unfortunately, none of this was beneficial for emerging markets. With the exception of China which managed the pandemic well and benefited from the surge of U.S. imports of consumer goods, emerging markets suffered profoundly from COVID, both in terms of short-term growth and long-term growth potential. COVID only accentuated what has been a state of semi-depression in emerging markets for the past decade, as a strong USD and U.S. financial markets have drained them of capital resources.

Ironically, the accelerated nature of the COVID recession in the U.S. will now play against emerging markets as we enter 2022. The United States and China, the two main drivers of the global economy, are now in the process of slowing dramatically as the effects of the COVID stimulus wear off. This means that the expected late recovery of most EM countries will be muted.

In fact, 2022 is likely going to be the year when the markets fully appreciate the devastating long-term consequences of COVID. The enormous increases in government debt incurred by the United States, China and most EM countries in 2021 will weigh on growth for years to come. U.S potential real GDP growth, which was considered to be around 2% before the pandemic, can now be assumed to be considerably lower. Many emerging market countries, including China and Brazil, are facing poor growth prospects as they deal with high levels of unproductive debt.

Ironically, the coming slowdown in the U.S. may continue to favor U.S. stocks and the USD. As the economy slows in coming months, the Fed will have to provide more liquidity to the markets to avoid a correction in asset prices. This may well lead to a further expansion in valuation levels for the tech stocks and final blow off for the S&P500.

The two charts below show the current debt levels in emerging markets and the five-year increase in the level of the debt to GDP ratio for these countries and the United States. The countries with high debt levels and very high recent accumulation of debt generally face difficult challenges ahead. These include, China, Brazil, Chile and Korea.

The next chart shows expected long term stock market returns for EM countries and the United States. The annual returns are for the next seven years but would be similar for 10 years. These returns are in USD terms and assume that EM currencies maintain current valuations relative to the USD over the period. If EM currencies were to appreciate over the period (likely in my view) then returns would be higher.

The details are shown in the next table. Turkey tops the chart and probably provides the best bet for high returns. CAPE ratios below 5 have been in the past fail-safe as an indicator of high future returns. Turkey is well underway in its economic adjustment, with a very competitive currency and export sector and rising business confidence. The Philippines are also well positioned, but do have a challenge to return to the very high historical CAPE, particularly given the lofty weight of financials and real estate in the index. Brazil is cheap but faces high debt and a weak economy as it enters a complicated election year. This is a reminder that CAPE ratios are not helpful for short- term predictions. Moreover, valuation is never enough. Markets always need a trigger.

On the negative side, Taiwan and India both stand out for their very high CAPE ratios. For these valuations to be justified, earnings will have to be much higher than currently anticipated. This means a major ramping up of margins and corporate profitability in India and an extension of the semi-conductor super-cycle in Taiwan.

CAPE Ratios Relative to History and Real Expected Returns, September 2021
Current Cape Historical AVG CAPE Difference Earnings Cycle Expected 7-Year Total Real Annual Return
Turkey 4.4 8.6 -48.84% Early 12.0%
Philippines 15.8 22.8 -30.70% Early 10.3%
Brazil 11.5 12.3 -6.50% Late 9.2%
Malaysia 11.9 15.6 -23.72% Early 7.7%
S. Africa 13 14.5 -10.34% Early 7.6%
Colombia 9.2 14.2 -35.21% Early 7.0%
Peru 16.5 16.9 -2.37% Early 6.4%
China 13.5 15 -10.00% Late 6.3%
Indonesia 13.5 16.1 -16.15% Early 5.4%
Thailand 13.7 14.7 -6.80% Early 4.9%
Mexico 17 17.4 -2.30% Early 4.7%
GEM 14.6 14.3 2.10% Early 4.4%
Chile 14.6 17.9 -18.44% Early 4.3%
Korea 11.6 13.2 -12.12% Early 4.2%
Taiwan 24.9 18.5 34.59% Mid 4.0%
USA 37.9 24.8 52.82% Late 3.3%
Russia 7.9 6.8 16.18% Early 0.8%
India 30.4 20.8 46.15% Early 0.6%
Argentina 9.5 8.5 11.76% Early -7.9%

The methodology used to determine expected returns is the following:

  1. Forecasted earnings for 2022-2028 assume earnings growth of nominal GDP, making adjustments for each country’s place in the business cycle.
  2. A cyclically-adjusted earnings value for 2028 is calculated as an average of inflation-adjusted earnings for the 10-year period ending in 2028.
  3. Each country’s historical cyclically adjusted price earnings ratio (CAPE) is calculated as an average of CAPE ratios for the country since its inclusion in the MSCI index, with an increased weight given to the past 15 years.
  4. The historical CAPE ratio is applied to 2028 earnings to determine the expected level of the country index in 2028.

 

Emerging Markets are Loaded with Debt So Pick Your Countries Carefully

The world is awash in debt. Much of this debt has been accumulated over the past 20 years, and has served to support consumption, government spending and financial markets during a period of declining productivity and slowing economic growth.  Unfortunately,  because this debt was not acquired to increase productive activities, it is not self-sustaining and has become a drag on economic activity.

The chart below shows the steady accumulation of debt in both advanced and emerging market economies. Advanced economies had steady debt accumulation over the past twenty years with peaks around the Great Financial Crisis and the Covid pandemic. Emerging markets saw most of the debt accumulated over the past decade, a period that has had depression like characteristics for most countries and has seen a dramatic decline in the level and quality of China’s economic growth. (All data is from the Bank for International Settlements, BIS Link)

 

The growth in debt in emerging markets has been general. We can see in the following chart that practically all emerging market countries have ramped up debt over the past decade and now find themselves at record levels.

However, not all emerging economies are in the same condition. We can differentiate by both debt levels and rate of accumulation, which is shown in the next two charts.

 

Several countries stand out in having very high debt levels and accelerated accumulation: China, Korea, Chile and Brazil. In none of these countries has the debt been used to increase productive activities. In China, debt mainly supports the real estate bubble and infrastructure investments of marginal utility; in Korea, debt increases have flowed mainly to support consumption. In Chile and Brazil, debt has served to support government current spending and capital flight. Moreover, China, Brazil and Chile face serious economic challenges. Both Brazil and Chile will likely be in recession in 2022, and China’s sustainable growth level is in steep decline.

On the other hand, Indonesia, Mexico, Turkey, Poland Russia and Colombia all have lower debt levels and slower debt accumulation. These economies are coming out of the pandemic in relatively good shape and with the prospect of healthy economic rebounds in 2022-23.

Given a world awash in debt and suffering from low GDP growth, investors should focus on the few countries with good debt profiles and positioned for a rebound.

Is India Assuming Leadership in Emerging Markets?

For those investors who believe in mean reversion and the cyclical nature of capitalism, it is reassuring that sectors and companies do not to retain market leadership for long. However, because of momentum and recency bias, investors always extrapolate the present into the future. So, we see today’s near unanimous agreement that the current crop of great U.S. companies – the tech behemoths – will rule forever, expanding their reach into every nook and cranny of the economy. Until recently, this also seemed obvious in emerging Markets

Just to be contrarian, I’ve argued that, given how utterly unpredictable the future is, new leadership would somehow take over in emerging markets during the 2020s. Given that the past decade belonged to China, and the one before that was all about commodity producers, perhaps India could now have its “roaring” 20s.

The table below shows the ten largest stocks in the MCI Emerging Markets index since its early days, 30 years ago. We can see that every decade was marked by an exceptional trend: 1990, the great Taiwan stock bubble; 2000, the technology-media-telecom frenzy; 2010, the commodity super-cycle; and 2020, the rise of China and its “invincible” tech giants. Well, now it seems China’s tech leaders may have been more Goliaths than behemoths, as they  are being taken down by government regulators who, unlike their U.S. counterparts, have the power to dictate rules to these firms in accordance with their notion of what serves “common prosperity.” China, which had 7 stocks in the top ten at year-end 2020 (including Naspers), now has five; and India has increased its count to two. If we look at the next ten stocks in the following table, we get an even better idea of the change in the investment environment: China had half of these stocks at year-end 2020 and now only two; India had two and now has three. Also joining the list are two more commodity/reflation stocks, Gazprom and Sberbank, both from Russia.

The changes this year in the rankings of the most prominent stocks in EM has resulted from the outperformance of Indian stocks relative to Chinese stocks, as shown in the table below. Year-to-date, Chinese stocks have lost 16% of their value while Indian stocks have appreciated by 27%. Consequently, the weight of China in MSCI EM has fallen from 40% to 35%, while India has risen from 9% to 12%.

So, what is causing the rise of Indian stocks and can this be sustained?

India’s current advantages over China can be resumed as follows: much better demographics, much less debt and relatively greater support for private enterprise over the state sector. Also, India’s GDP is expected to grow much faster than China’s. Moreover, while exports and urbanization (infrastructure/real estate) are mostly tapped out as sources of growth for China, India has long runways in both these areas. Finally, India’s blue chip corporations generally wield significant political power and are unlikely to face the regulatory risks faced by Chinese companies.  To the contrary, India is likely to promote national champions in frontier tech industries, limiting the reach of the American tech giants.

Unfortunately, investors may have already priced in India’s growth opportunity to a considerable extent. Though, in a world of scarce growth and record-low interest rates, Indian blue chips with good growth profiles should be expected to trade at high valuations, Indian stocks now trade at record levels and sky-high valuations. The chart below shows PE and CAPE ratios for MSCI India, with consensus earnings for 2021. CAPE ratios are nearing the “bubble” levels of 2010.

 

The following chart shows historical earnings. It includes the 2021 consensus which appears very optimistic relative to the current condition of the economy and business confidence. We can see in the next chart from Variant Perception that there is currently a severe and unusual disconnect between the level of stock prices and business confidence.

 

The future path of the market will be determined by how this divergence between stock prices and business confidence is decided.

For the market to make further progress from here, India, like almost all non-U.S. stock markets, needs to break out from a long period of earnings stagnation. We can see in the following chart that India over the past four decades has undergone several long periods of earnings stagnation which were followed by sudden bursts of profitability.

 

 

We can see in the final chart that the market is now anticipating another earning surge. The market has  risen well ahead of GDP and earnings (consensus 2021). Of course, this optimism needs to be confirmed. To a considerable degree, this will depend on global developments: basically, a weakening of the USD and a shift away from risk aversion and liquidity preference to higher risk opportunities outside the United States. If earnings can really break out in India, then, it’s off to the races.