Commentary on Political Economy

Thursday 18 November 2021



A Deeper Submergence?

Emerging markets are back in the morass. They were supposed to be prime beneficiaries of a broad global reflation this year, and it hasn’t happened. The challenge is to work out why.

The basic facts are clear enough. The currencies of these countries, as measured by the JPMorgan EM FX index, have dipped to an 18-month low, approaching the all-time trough during last year’s Covid-19 shutdown. And earlier this week, their stocks, as measured by the MSCI emerging markets index, dropped to a new low compared to the developed world (represented by the MSCI World index):  

Looking further, we can see that the way emerging markets behave as an asset class has changed. Their drivers in the last decade have been utterly unlike those of the prior 10 years, when they led the world. 

The most poignant illustration comes from Brazil, Russia, India and China, or the BRICs. After the 9/11 terrorist attacks in 2001, Goldman Sachs Group Inc. published a report suggesting the world “needed better BRICs.” The idea was that in these new and frightening circumstances, the addition of four big emerging economies to the G-7 and other international groupings would help the world cohere. Somehow, in the months that followed, this turned into a popular investment strategy. China and India, it was argued, would buy natural resources from Brazil and Russia. The big economies would support each other.

It worked spectacularly for a while, and then it didn’t. This shows how MSCI’s BRIC index has performed since 9/11, compared to the World index:

The big four emerging markets are still below the peak set on Halloween 2007. Even though China was critical in helping the world through the Great Recession, they have consistently lagged behind the developed world since then.

This was ironic because one of the key arguments made for the BRICs 20 years ago was “decoupling.” As these huge economies reached maturity and built thriving consumer markets, the theory was that they would move independently. Even if the U.S. and western Europe went into recession, the argument went, the emerging markets would be fine.

In fact, experience was the opposite. As seen in the charts, from 2001 to 2011, emerging markets were a leveraged play on the developed world. The better developed markets did, the more EM outperformed them, and vice versa. This is the polar opposite of decoupling. 

In the decade since 2011, however, the pattern is different and emerging markets have indeed decoupled. Sadly, this hasn’t been in a good way. They have continued to decline in relative terms as the developed world has prospered:

For a decade, when asset allocators felt “risk-on” they would put even more into emerging markets. These days, they prefer developed markets, however good their risk appetite is.

The perceived macro underpinnings of the emerging world have also ceased to help. Previously, the boom in commodities — especially industrial metals — boosted EM. High demand for metals showed China was in good shape, the argument went, and meant money for Brazil. The entire emerging market complex tended to move in line with bull and bear markets in industrial commodities. No longer. Metals staged a massive rally after the Covid shutdown, and it hasn’t helped emerging stocks a bit:

This brings another issue. For years, the whole emerging world behaved as though it was a direct extension of China. The MSCI index looked pretty similar whether or not it included the country. But this year, China has been a lead weight. The full EM gauge has fallen this year, while the index excluding China is faring well:

One important point: Correlated markets in the years before the credit crisis were a symptom of poor allocation and faulty risk management. Investors thought they had diversified by moving into different asset classes. In fact, they had made the same bet several times. As we know, they all fell together in 2008.

Something much more discriminating is afoot now. This isn’t a repeat of naive investment using indexed commodities and passive equity funds, and for this we can be grateful. But if investors are more discerning, it’s disquieting that they no longer perceive great value in countries that support the majority of the world’s population, and are still trying to grow from a lower base. 

Why is this happening? And are investors right?

China, Xi and the Private Sector

One profound issue is China’s clampdown on the private sector. Whether this is the Communist Party rediscovering its true colors, or (more likely) a pragmatic attempt to limit possible centers of opposition, it’s bad news for investors in private Chinese companies. 

It’s always possible that investors have overreacted, and there’s a decent chance that valuations already reflect the new dirigiste reality. But for now, it’s hard to invest in Chinese stocks. This isn’t just about perceptions. The clampdown, in which authorities stopped Alibaba Group Holding Ltd. and others from continuing exclusivity arrangements with retailers, has had a real effect on profits as other companies made inroads. A downbeat forecast for sales next year led to a savage reaction in Alibaba’s ADRs, which have now underperformed the S&P 500 since their 2014 listing:

It’s just possible that some of Beijing’s interventions are for the long-run good of consumers and the economy. They’ve unquestionably been awful for shareholders of leading companies like Alibaba.

China’s Property Market

The single biggest reason for emerging market underperformance this year is the Chinese property market. The problems of China Evergrande Group sparked fears of a Lehman-style crisis, or “Minsky Moment.” And the elements seemed to be in place. Lots of developers have sunk money into a wildly over-extended housing industry. The following chart, from Barclays Plc, shows that China’s real estate market is far more overblown than Japan in 1989 or the U.S. in 2006, which is terrifying:

So why should we be calm? Firstly, a critical element in the Lehman crisis is missing: leverage. Adam Wolfe, emerging markets economist for Absolute Strategy Research Ltd., shows that property developers’ funding has come primarily from pre-selling houses yet to be built. Reliance on loans is far less than it was during China’s near-crisis of 2015, and inordinately less than in the U.S. housing bubble:

Further, contrary to appearances, the primary problem isn’t wildly overblown valuations. As a share of disposable incomes, house prices have fallen considerably over the last quarter century, as Wolfe shows in this chart. Homebuyers may be getting a bad deal, but they aren’t overstretching themselves:

Rather, the dilemma is that China has built far more houses than it needs. Such excessive supply will mean losses for developers, and declines in house prices. This isn’t good for the economy, and is reason to expect that growth can no longer continue rocket-like at 6% or more per year. This justifies the downgrading of emerging markets. But the problem seems bad, not cataclysmic:

The wider issue is asset allocation. As Wolfe puts it, China’s leaders know that the economy is too reliant on housing. Engineering a deflationary move away from property is much easier now, amid signs of accelerating inflation, than it was when China first attempted it in 2014 and 2015. Then, prices were stagnant, and housing deflation was dangerous.

Meanwhile, Chinese people continue to save at a prodigious rate, but as most financial investments have been disappointing in recent years, they still favor property. The challenge is to get them to switch to the kind of tech investments that can reinforce China’s competitive position, and help the economy grow. Jian Chang of Barclays summarizes China’s policy as follows:

  • “Three stability”: To stabilize land prices, home prices and market expectations. This was first mentioned by the Ministry of Housing in late December 2018 as the “predominant objective” for its 2019 work agenda. 
  •  “Housing is for living in, not for speculation.” This was said for the first time at the 2016 Central Economic Work Conference and reiterated at high-level meetings including by President Xi. 
  • The property sector won’t be used as a short-term tool to stimulate growth. This was said for the first time at the Politburo meeting in July 2019 and reiterated in September this year.

As this chart from Barclays shows, this is a big job, but nudging Chinese savers only a little out of property into something riskier could make the economy far more productive:

Where does this leave us? China is trying to turn the housing market around in a way that will help in the long term and probably hurt a lot in the short run. It therefore makes sense for investors to exit while they wait to see whether the government can pull off the trick. Authorities have made clear for years that they wish to avoid a “Minsky moment” and it looks as though they should succeed. 

But China is a special case. Other emerging markets face more of a problem fighting inflation without provoking a recession. On which note:

Thanksgiving Thought: Be Thankful You’re Not Turkey

Many of us are being driven to distraction by the wait to discover who President Biden will nominate to head the Fed for the next four years. It is the one moment that the democratic process gets to exert any control over an independent central bank, and the two candidates have both already spent years as governors.

Perhaps we should look at Turkey. Thursday saw the country’s central bank cut its benchmark lending rate for the third month in succession, by a full percentage point. The bank has already been through enough personnel shifts over the last few years to sustain a Mexican soap opera, as Turkey’s increasingly autocratic President Recep Tayyip Erdogan has sought an appointee to do what he wants. These cuts have been made at Erdogan’s insistence, despite serious and rising inflation. The country is bucking the global trend, and the impact on the Turkish lira has been predictable:

This looks like flagrant irresponsibility, and threatens to bring Turkey into a full-blown financial crisis. It is as prone to inflationary pressure as anyone, and this more or less guarantees that prices will now run unchecked. As markets expect rates to rise in the U..S. and Europe, cutting them is bound to damage the currency. Perhaps we should be thankful to have an independent central bank that won’t follow the whims of politicians, even if they are democratically elected. Turkey’s series of changes and reverses to monetary policy is indefensible.

And yet. Turkey has been inconsistent, but it might have been able to get away with such inconsistency had it been the Fed. Amazingly, real rates, with inflation subtracted from the current target rate, are lower in the U.S. than in Turkey. This is true whether using headline levels or, as in the chart below, core rates that exclude food and fuel:

This is another fact of post-crisis life for emerging markets. With economies dependent on bond purchases from the developed world, their wiggle room is much more limited. And the U.S. advantage from its Treasury market and global reserve currency, described 50 years ago by French president Valery Giscard D’Estaing as “exorbitant privilege,” is now even more exorbitant. The U.S. can set rates four whole percentage points below the core inflation rate and get away with it. Turkey can’t. And neither can anyone else in the emerging world. 

It helps explain why emerging markets are in trouble. And it shines a light on just how privileged the U.S. has become,

Survival Tips

People say the internet is no longer fun, and largely they’re right. But the growth of livestreaming is bringing back a sense of community with people far away, much as we had in the early days 20 years ago. 

When I was at high school, I used to pass the stadium (if you can call it that) of Lewes Football Club every day. A few hundred people at most show up for games (I was almost never one of them). But these days the club is a community-owned organization (full disclosure: I’m a shareholder, but I don’t expect to make any money out of this). It pays equal wages for its men’s and women’s teams. That buys us a men’s team that plays clubs from other Sussex towns, and a women’s team that plays the likes of Manchester United.

Livestreams of the women’s games now get a few hundred viewers, from as far afield as Vancouver, Dubai and Perth. Nobody takes it too seriously, but it’s fun — far more about small-town togetherness than antagonism toward opponents. The latest livestream, featuring the most partisan “color” commentator I’ve ever heard, made me (and the rest of my family) laugh like a drain. It’s nice that Lewes won 4-1, with a second goal that Ronaldo might have been proud of; the commentator made it perfection. 

You might enjoy it. Have a good weekend, everyone.

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