Category Archives: Emerging Markets

India: The Standout Emerging Market (Part 1)

I am a long-term bull on India, However, I do have some concerns that make me cautious in the near to intermediate term. As a result, I currently only have a tiny position allocated to Indian stocks, but am ready to increase my position substantially upon a significant selloff or once my confidence increases that the Indian economy is about to accelerate.

History of Subpar Growth

Politics in the first half-century after Indian independence in 1947 was dominated by the Congress Party which had a socialist bent and looked towards the Soviet Union as an economic model to emulate. In the 1950s, steel, mining, water, telecommunications and electricity generation were effectively nationalized.

The Industries Act of 1951, which required all businesses to get licenses from the government before they could launch, expand or change their products, stifled innovation. The “licence raj” reigned. The government imposed import tariffs in the name of encouraging domestic production, and domestic firms were prohibited from opening foreign offices. Foreign investment dried up under stringent restrictions and lack of competition meant that Indian firms could survive with inefficient operations.

As a result, manufacturing was unable to be a driving force and the economy grew at a subpar rate of 3-4% while many other Asian economies boomed. Between 1950 and 1973, the Indian economy annually grew 3.7 percent, or 1.6 percent per capita. Japan’s economy grew 10 times faster and South Korea’s five times faster. China grew at a sustained 8 percent annual rate. All that began to change dramatically in 1991 with the dissolution of the Soviet Union and the realization that the capitalistic model was superior.

Economic Liberalization

In addition, India faced a severe balance of payments deficit in 1991, and could no longer rely on the Soviet Union for support. With no other option, the Congress-led government sought funds from the IMF in exchange for implementing policies that would open up the economy. Additional rounds of market-oriented reforms by later governments, helped to boost economic growth in the 1990s and 2000s. India’s massive low wage, English speaking, and technologically savvy labor force was well-suited to make India a global leader in the IT and BPO outsourcing industries and attracted much needed foreign direct investment.

Modi liberalization

Despite significant progress made by the different Congress governments over the years in freeing up the economy and boosting growth, there was a sense of disappointment with the pace of reforms, the many corruption scandals, and development which eluded the poor. For the 2014 general election, the National Democratic Alliance (NDA) named Narendra Modi who was chief minister of the Indian state of Gujarat, as its prime ministerial candidate against the Congress-led UPA government.

Narendra Modi stood for everything that the Congress Party and its four generations of leadership by the Gandhi family lacked: a track record of responsible development which saw Gujarat improve upon several human-development indicators; a history of strong leadership by running a small government and putting his foot down when officials were out of line; a squeaky clean image; and a rise from humble beginnings as a tea seller.

As a result, Narendra Modi delivered the most resounding electoral victory in 30 years. Indian stocks surges as excited investors were filled with the hope that Modi’s successful governance would be replicated at the national level.

However, two years into the Modi government, there is a feeling among some investors that Modi has underperformed by failing to pass key bills such as GST and land acquisition. However, I believe that there was excessive optimism about what Modi could immediately achieve given the political environment he was handed.

To become law, bills must pass both the lower house of Parliament, or the Lok Sabha, and the upper house, or Rajya Sabha. Members of the Lok Sabha are elected by adult citizens and they hold their seats for five years or until the body is dissolved by the President. Most of the members of the Rajya Sabha are indirectly elected by state and territorial legislatures. Members sit for staggered six-year terms, with one third of the members retiring every two years.

While the BJP does enjoy a majority in the lower house of Parliament due to its resounding 2014 election victory, it only has 55 seats out of 200 in the upper house, which means that the support of rival parties are necessary to pass bills. The BJP’s main rival, the Congress Party, is resisting many of the major proposed bills despite being in favour of them when it was in power. The Congress Party’s goal seems to be to prevent the BJP from achieving anything of substance while in power so that voters would view the Modi government as ineffective by the time of the 2019 elections.

However, the BJP’s seat share in the upper house is about to increase as a result of elections being held for a portion of its seats each year and due to the BJP’s electoral success at the state level in recent years. In fact, the BJP is due to overtake the Congress in seats later this year. Though still short of a majority, the BJP need only to garner support from a few small regional parties to pass bills currently being held up.

Once these major bills pass in the next year, the Indian economy’s potential growth level will rise, though the GST is expected to hinder growth in its initial two years. Moreover, Modi still remains popular, and according to a recent survey, is projected to win again in 2019. Several more years of a market friendly government will help to ensure that India achieves its potential of high single digit growth.

In my next post, I will examine the demographic dividend that India enjoys, changing leadership at the Reserve Bank of India, and Indian equity valuations.

I’m Not Betting on Emerging Markets… Yet!

After topping out between 2008 and 2010, emerging markets have woefully underperformed the US. I remember at the top the extreme amount of optimism that investors had towards China and other developing economies, while the US was shunned.

Emerging Markets vs. S&P 500 Performance

I first expressed my bearishness on emerging markets in a blog post in early 2007 titled “Beware of Emerging Markets”. It turned out to be a correct stance. The $EEM ETF got cut in half in the next year during the financial crisis, and, although it recovered all its losses, is still trading at the same levels from the time of my blog post nine years earlier.

Emerging Markets Equity Returns

My bearishness stemmed from the massive credit-fueled mal-investments that were made during the early part of the last decade in emerging economies. This was caused by a series of events: first, China entered the WTO in 2001 with a cheap currency and a large, low-wage workforce that it utilized to manufacture goods cheaply for the world; second, Greenspan kept interest rates artificially low to counteract  the fallout from the bursting of the technology investment bubble; third, borrowed money poured into China setting off a fixed asset investment boom there; fourth, the industrialization of China drove a huge demand for energy and metals, creating a commodity bubble; and finally, most emerging economies, which are commodity producers, also boomed due to an inflow of capital into mining and related industries.

Emerging markets are now dealing with a commodity downturn, large US dollar-denominated debts, and weak global growth. Complicating problems is that the US is experiencing solid growth and the Fed is embarking on a rate hiking cycle. Whenever, the US appears to be a more attractive investment destination than emerging economies, capital will gravitate towards the US and cause a loss of reserves for emerging economies, thereby tightening financial conditions.

I find it hard to pinpoint when this pressure will abate for emerging markets. In my view, the US economy will remain in decent shape and interest rates will go higher in the next couple of years – all of which suggest that the US is still the better place to invest. That said, I am compelled by emerging markets’ equity valuations which are at the low end of their historical range.

Emerging Stock Market Forward PE Ratio

The price to book ratio conveys a similar message.

Emerging Markets Price to Book Valuation
Source: J.P. Morgan Asset Management Guide to the Markets, March 31, 2016

Earnings expectations have experienced a substantial decline and are reflecting a further deterioration in economic conditions.

EM Earnings Expectations
Source: (Left) J.P. Morgan Economic Research, J.P. Morgan Asset Management. External debt includes public and private debt. (Top right) MSCI, US Federal Reserve, J.P. Morgan Asset Management. (Bottom right) FactSet, MSCI, J.P. Morgan Asset Management. REER is real effective exchange rate.
Guide to the Markets – Europe. Data as of 31 March 2016.

Unlike nine years ago, when I wrote my initial bearish post on emerging markets, sentiment has reversed and investors are favoring the US over emerging markets. Coupled with cheap valuations, emerging markets may be a great long term buying opportunity. In fact, I have bought a tiny position in Brazilian and Indian stocks to motivate me to keep a close eye on those markets.

However, I am hesitant to commit a bigger position to emerging markets. My experience has taught me that bearish sentiment and cheap valuations can remain for a very long time. Often the trigger for starting a new bull market is the assertion of favorable economic and business conditions. Unfortunately, I do not see any evidence of that just yet.

Closing Russia (NYSE:RSX)

Last Friday I closed my long position in the Russia ETF (RSX) at $24.80 which is equal to my initial buying price. As I mentioned in this post, if the RTS index were to have a weekly close below 1220 I would close the trade. As it turned out, the RTS finished the week on August 1st at 1212 for a second false breakdown this year making the triangle pattern unreliable.

Russian Trading Systems-2

I was hoping to wait and sell out at a better price, but the geopolitical situation in Russia seems to be deteriorating and beyond my area of competence so I decided to close the position before the weekend.

My rationale for the trade was based on the chart and valuation. While Russian equities remain extremely cheap relative to other markets and its own history, it can remain so for years. I was hoping the false breakdown would signal that Russian stocks were ready to close the valuation gap, but the unexpected shooting of flight MH-17 along with the increased sanctions between Russia and NATO countries has trumped the chart.



Buying Russia (NYSE:RSX)

I recently bought the Market Vectors Russia (NYSE:RSX) etf at $24.80. I am bullish on Russian equities based on its terrible past price performance, negative sentiment, dirt cheap valuation, and attractive chart pattern.

After Russia’s debt default in 1998, the Russian stock market went on an explosive run for 10 years appreciating by 50 times. Since the global financial crisis, however, it has been among the worst performers globally declining 50% during the past six years. This is because Russia’s economy has been grappling with slowing growth, high inflation, shrinking current account surpluses, and a weak ruble. The recent tensions with Ukraine have only exacerbated investor antipathy.

As Nathan Rothschild famously said, “the time to buy is when there’s blood in the streets.” It’s hard to find an investment today where that is more applicable than Russian equities. Russia’s incursion into eastern Ukraine and its annexation of Crimea has sparked worldwide concern of potential war. Hillary Clinton, John McCain, and German finance minister Wolfgang Schäuble have gone so far as to compare Vladimir Putin’s actions to Adolf Hitler’s aggressions in the 1930s.

I am no expert on Eastern European geopolitics, however former U.S. Secretary of State Henry Kissinger doesn’t believe the Putin-Hitler comparison is valid. Speaking to CNN earlier this month he says,

“One has to ask oneself this question: He spent $60 billion on the Olympics. They had opening and closing ceremonies, trying to show Russia as a normal progressive state. So it isn’t possible that he, three days later, would voluntarily start an assault on Ukraine.”

“I think at all times he wanted Ukraine in a subordinate position. And at all times, every senior Russian that I’ve ever met, including dissidents like Solzhenitsyn and Brodsky, looked at Ukraine as part of the Russian heritage. But I don’t think he had planned to bring it to a head now. I think he had planned a more gradual situation, and this is sort of a response to what he conceived to be an emergency situation.”

A full blown war could certainly breakout and cause Russian stocks (as well as stocks around the world) to drop further. But a lot of the fear is priced into Russian stocks since they trade at the cheapest valuation relative to the world and to its own history.

Russia Valuation

The chart of the US $ denominated RTS looks like a false breakdown recently took place. If so, it should signal an explosive move higher.

RTS Russian Stocks

What I like most about this trade is that there is a clear stop loss level at the bottom support line. I am willing to own RSX as long as the RTS does not post a weekly close below 1220. I will keep track of the performance of this trade here.

The World Should Fear a US Slowdown

I am in the camp that believes the US will soon enter a period of economic stagnation or recession, which will significantly cut growth in most parts of the world. To elaborate, I am posting the following excerpt from the recent Quarterly Review and Outlook, Second Quarter 2007 from Hoisington Investment Management:

It is incorrect to believe that the rest of the world is strong enough to boost our exports and keep our economic activity on an even keel in the face of a slowdown in U.S. consumer spending. Importantly, real exports constitute only about 11% of economic activity, versus 68% for real PCE. Thus, a massive lift in exports would be needed to keep the economy expanding in the face of consumer retrenchment. However, the statistics and economic history suggest that world growth causality runs from the U.S. to the world, not vice versa. The World Bank provides a breakdown of world GDP in real terms (Table 1).

HIM2007Q2NP.pdf (5 pages)

At present, the world is a mix of rapidly growing and significantly underperforming economies, with the BRIC (Brazil, Russia, India, China) countries on the high growth side and Japan, the United States, and those closely aligned with the U.S. on the slow side. The rest are largely somewhere in between these strong and weak groups. The United States accounts for 31% of world GDP with Japan next in line with 14.1%, meaning these two countries account for 45.2% of total world output. The BRIC countries, on the other hand, control 10% of global output. Although Mexico and Canada diverge from the United States over shorter intervals, over the long run they are tied to the fortunes of the United States. Adding those figures to the United States and Japan boosts the total to 49.3% of global GDP, a figure that easily rises to about 50% if one takes into account the Latin American countries influenced more by the United States than any other country.

But even this analysis is not a complete description of the impact of the United States on the global economy. A main source of Chinese growth is their burgeoning trade surplus, most of which is with the United States. According to official Chinese figures, the Chinese had a record trade surplus for the first half of this year of $112.5 billion, with $73.9 billion or 65% with the United States. U.S. records indicate that its deficit with China is bigger than the official Chinese figures show. The boost to Chinese GDP is even greater when one takes into account the foreign trade multiplier, or indirect economic effects. It then becomes clear that the Chinese trade surplus against the U.S. has been a powerful stimulant to their economy. They will indeed feel the slowdown in U.S. consumption. The U.S. trade deficit also plays a major role in domestic economic growth for India and Brazil, not to mention Europe.

Econometric studies provide important insight into the global impact of the U.S. economy. These studies have shown that U.S. imports increase $2 for each $1 rise in income, but that U.S. exports go up just $1 for each $1 gain in foreign income. Thus, when U.S. consumption is accelerating the world economy is a major beneficiary, but when it slows, as it is now doing, the rest of the world will lose forward momentum. This relationship explains why U.S. domestic demand leads the domestic demand in the large foreign economies by six to nine months (Chart 3).

HIM2007Q2NP.pdf (5 pages)-1

In the second quarter real domestic final sales slumped in the United States and U.S. imports fell, aligning with the econometric studies. Industrial production has contracted for three straight months in Japan, and Germany registered a net decline over the past two months. Thus, the process of transmitting U.S. weakness to the rest of the world has begun.

Investors holding foreign stocks hoping for protection from a US economic contraction might be disappointed.

Beware of Emerging Markets

Never before in history has the world experienced such synchronized growth. Improvements in communication and transportation, along with a reduction in duties and tariffs have made trade an important part of the global economy. When one country experiences rapid growth, its imports rise benefiting the economies of its trading partners.

Compounding this is that we are living in a fiat money world that is fueled by US debt growth. American consumers are buying goods on credit from around the world. Other nations are happy to sell their goods as long as they believe they will eventually be repaid. So both US consumption and foreign production are able to carry on at a brisk pace leading to a synchronized global expansion.

This interdependence can be seen in the similarity of the charts of stock markets around the world:


What is clear from these graphs is that although the timing of the price gyrations are identical, emerging markets seem to experience greater gyrations. This should not be surprising. Emerging markets are comprised of companies that generate less revenue and operate at thinner margins than those of developed countries.

In the past few years, rising liquidity has benefited companies across the world. But Brazilian, Chinese and Indian stocks have been able to outperform American, German and Japanese stocks.

The reverse can also occur. When money becomes tight — like I believe will soon happen due to further weakness in US housing and an unwinding of the yen carry trade — stocks around the world will fall with the greatest declines being experienced by emerging markets. The period from May to June of last year offered a taste of this.

It may be difficult to realize under present conditions, but volatility can cut both ways. Unfortunately, many emerging markets investors will soon learn this the hard way.