From the book “The Gathering Storm”
http://www.amazon.co.uk/Gathering-Storm-Lee-Robinson/dp/836262700X
Imagine you are starring in the financial equivalent of the “Life On Mars” TV show. You wake up one morning to find you have time-travelled back to the early nineteen nineties. The Berlin Wall has just fallen. The triumph of capitalism is unleashing a tsunami of globalization as billions of people join the market economy as workers and consumers.
Exciting times. Having just arrived from the year 2010, you know this has profound implications for the world of investment. Granted, you didn’t pay much attention to how markets actually performed in the decades to come, but you sense an opportunity to become very rich. After all you have the ultimate form of insider information; a sure knowledge of the economic future.
So you do the obvious thing – you set up a hedge fund. You rack your brains for the best trades to put on. Keep it simple, you tell yourself. Which economy will make the transformation from emerging to developed in the years ahead? South Korea is the obvious choice. You remember that it becomes a member of the OECD, that its GDP per head soars from $6,100 in 1990 to $28,000 in 2010. Most of all, you remember the astonishing success of Korean brands, which screamed from billboards all over the world in 2010, but are largely unknown in 1990. Why, you even used to own a Samsung mobile phone, a flat-screen TV made by LG, and a Hyundai people carrier!
You decide to leverage up and take a large long position in the South Korean stock market. What short position should you set against it? You know that globalization creates losers as well as winners. You need to find a clear loser. A good candidate, you decide, is Pakistan. All you remember about the country is bad news; the poverty, the social fracture, the rise of Islamic fundamentalism, the political assassinations, the failure to modernize. So you do the logical thing. You balance your Korean long with a short on Pakistan and sit back and watch the profits roll in.
Except, of course, they don’t. What happens over the next twenty years is that the Korean Kospi index rises a somewhat underwhelming 40% in US dollar terms. Meanwhile Pakistan’s Karachi 50 Index rises 350% in US dollars. Unfortunately the final tally is irrelevant to you since your fund blew up long before.
After a few years of hard scrabble, you decide to have another try in 1995. This time you’ll stake everything on the most obvious trade of all – China. You remember year after year of double digit GDP growth; the Beijing Olympics; the transformation of Shanghai from dowdy backwater to hyper-modern global megalopolis. More to the point, you remember how China emerged apparently unscathed from the global credit crisis of 2008; how its insatiable thirst for raw materials buoyed up the commodities markets; how the shift of economic power from west to east was in the minds of thinking people the world over.
So you go long China – that’s a no-brainer. But what to set against it? This time you decide not to short any Asian markets – they are just too dangerous. But there is one continent that was definitely left behind by globalization, to the extent that Western charities flocked there and rock stars mounted campaigns for debt forgiveness. You remember reading an article in The Economist which discussed the problems of sub-Saharan Africa in detail. Living standards, it said, had actually gone down over the past forty years. A tragic story, but the investment implications are clear. You take out a large short position on the most liquid market, Nigeria.
This time you know you cannot fail. But somehow you do. Incredibly, this trade turns out to be a bigger disaster than the first one. Between 1995 and 2010, the Chinese market rises 450% in US dollar terms. An annualized gain of 12% – not bad at all. The real damage, however, comes from the performance of the Nigerian market, which rises an astonishing 1200% in US dollars over the same period.
Having blown up the fund again, you decide to quit investment and set up a software consultancy to profit from the Y2K bug. But why did your trades go so wrong? What did you miss? You missed the most fundamental point of all. You were not investing in the statistical construction known as GDP. You were investing in real world companies with employees and customers and suppliers. The key determinant of investment returns is the price paid for the asset – its degree of expensiveness or cheapness in relation to prospective cashflows. Compared to that, whether GDP growth is 3% or 8% is a trivial issue.
Trivial? Surely not. Surely it is better to invest in countries with high growth and rising living standards than those that are going nowhere. You might think so, but there is no historical support for that view. Academic studies show little relationship between economic growth and investment returns. If anything the correlation is slightly negative. Professor Jay Ritter of the University of Florida is the author of one such study* ranging over a hundred years of data from sixteen different countries. His conclusion is clear: “Countries with high growth potential do not offer good investment opportunities unless valuations are low.”
What lies behind this counter-intuitive finding? One plausible reason is that shares in fast-growing economies are rarely cheap – in other words, sentiment is too bullish and growth prospects get priced in at an early stage. This is a version of the growth paradox in individual shares. Ebay, for example, has been an extraordinary success as a company. As an investment, though, it has been an unspectacular performer. As of May 2010, the stock price was no higher than in May 1999. It was a case of too much too young; the company’s explosive growth was fully discounted in the first year after the IPO.
There is another lesson from the dotcom frenzy that casts light on the relationship between GDP growth and investment returns. The wild-eyed dotcom gurus of the late nineteen nineties turned out to be right about many things. The internet has indeed spread through the world at warp speed, becoming indispensable to the lives of billions. It has set off a chain reaction of creative destruction that has devastated “bricks and mortar” companies and made all kinds of goods and services available at the click of a mouse.
What the dotcommers failed to predict, however, was the difficulty that even the winners would have in monetizing their success. The losers, of which there were many, simply fell by the wayside. While the power of the internet was if anything underestimated, the quality of the cashflows it would generate was massively overestimated.
Something similar could be said about emerging economies. By definition, they are in a state of flux. The companies that end up winning the struggle for survival may not even exist yet. That was certainly so in the case of Japan’s economic miracle. In the 1950s there were more than one hundred motorbike manufacturerers. The market leader, Tohatsu, was driven out of business by the cut-throat pricing of a flaky upstart called Honda.
Even the companies that do survive and prosper – the emerging world’s emerging champions – will likely finance their growth by repeatedly raising large amounts of new capital. This is of no benefit to shareholders without an overall improvement in return on capital; repeated dilution means that while the company itself may experience strong growth, on a per share basis earnings and dividends will follow a much less impressive trajectory. Emerging economies often have large reserves of under-utilised savings and human resources. Mobilising them is both the key to development and the guarantor of mediocre investment returns. Why waste time attempting to raise returns on your existing capital when you can easily access more?
There’s nothing new about emerging market bubbles and investment disasters. In fact the arrival of a new economic power, like the spread of a transformative new technology, seems almost destined to generate bubbles. The American railway boom of the 1870s, Argentina in the 1880s and 1890s, the US again in the 1920s, Japan in the 1980s, south east Asia in the early 1990s, the BRICs, in the 2000s – the bubble-bust cycle seems to repeat endlessly.
Why should this be so? Most investors are mostly rational most of the time. To turn them into bubble jockeys you need what the great American economist Hyman Minsky called a “displacement,” meaning a shock to prevailing assumptions. A tectonic shift in the global economy occasioned by the rise of a new power is one such displacement. The Internet was a technological example of the same phenomenon. Both convince investors that history has changed course and you need to be on the right side of it. This time, you think, it really does feel different. And yet the iron law of investment never changes. If you pay a lousy price, you get a lousy return.
The other indispensable condition is liquidity, lots of it. For small economies, hot money inflows from hyped-up global investors can be enough to do the trick – as was the case with Thailand, Malaysia and other Asian countries in the period leading up to the mid-nineties Asian crisis. For large countries, you need something more powerful – massive amounts of domestic liquidity sloshing around the financial system. This can only occur if monetary policy is too loose for too long, leading to credit creation well beyond the needs of the real economy.
There are various political and social factors that may encourage the preference for super-easy money. One such is the imperative, especially strong in politically fragile countries, to force rapid industrialization by capture of export markets. The most powerful weapon in the mercantilist armoury is a cheap currency – maintained by pegs or direct intervention in the forex market – which generates an invisible subsidy to exporters at the expense of everyone else.
Policy makers cannot control the external value of the currency and domestic interest rates at the same time. By choosing to target a particular exchange rate, they are giving up on matching interest rates to domestic economic conditions. Instead they are effectively “importing” the monetary policy of the country whose currency they are targetting. If there is not much difference in the economic fundamentals of the two countries, that will not matter much. The bigger the difference, though, the bigger the consequences
The Swedish economist Knut Wicksell defined an economy’s natural interest rate as equivalent to the rate of nominal economic growth. Two countries with wildly divergent rates of economic growth will have wildly different natural interest rates too. For a high growth country to import monetary policy from a low growth country means importing a much lower than natural interest rate.
What happens if interest rates are much lower than natural for an extended period? You get bubble trouble. In fact it was the eurozone’s “one-size -fits-all” monetary policy that set off the vicious boom-bust cycle in Greece, Portugal and Spain. For rapidly growing emerging economies the pathology is slightly different. Rather than consumption binges and trade deficits, you are more likely to see capital investment binges and trade surpluses. That means a classier kind of bubble, but a bubble all the same. And when it bursts the consequences are equally, if not more devastating. Over-capacity, low returns on investment, excessive reliance on external demand – these are problems that cannot be solved by cost-cutting and belt-tightening.
When the bubble is up and running, all seems perfectly fine and normal/. The stock market may be frothing over like a malfunctioning cappuccino machine, but the excesses are matched and appear justified by excesses in the real economy. The true extent of the economic distortion – the mal-investment and hidden leverage- only becomes obvious after the bubble has burst. As Chinese premier Jiang Zemin said during the Asian crisis of 1997/8, “wait for the tide to go down to see who’s not wearing any swimming trunks.”
Behind financial bubbles and real economy bubbles there is always a third invisible bubble which spawns the other two. That is the intellectual bubble, the “this time it’s different” psychology occasioned by Minsky’s “displacement.” The concept has to be credible – if not, large numbers of experienced investors would not be persuaded. In the case of a world-class bubble, it has to be a key narrative of the era – the subject of best-selling books, opinion columns, political speeches, dinner party conversations and so on. The rise of China, for example, has such power as a narrative because we can see the evidence before us in our daily lives. As an investor, how can you not want to be part of such an epochal event? Isn’t it more risky, not to be involved? After all, a lot of highly knowledgeable and eloquent people are very bullish on prospects. Needless to say, the investment opportunities in Pakistan and Nigeria could never be packaged in such compelling terms.
What does this tell us about investing in emerging economies? Put simply, that the same rules apply as to investing in anything else.
Firstly, emerging markets, especially those with dollar-linked currencies are prone to vicious boom-bust cycles.
Secondly, as Warren Buffett has said “you pay a high price for a bullish consensus.” Conversely a bearish consensus may obscure attractive valuations. When there’s “blood on the streets,” you can still lose 100% of your capital, but you may stand to make considerably more.
Thirdly, GDP growth has little, if anything to do with investment returns. Shoot your inner economist and concentrate on the fundamentals of the companies.
Fourthly, beware of narratives. The more eloquent the narrators, the more cautious you should be. If it looks like a bubble and floats like a bubble, then it probably is a bubble.
Emerging markets have gone mainstream as the principles and infrastructure of financial capitalism have spread across the world. Bold investors have been rewarded with extraordinary profits, and there are still many exciting investment opportunities to be found. They just may not be where you think they are.
Peter Tasker
* “Economic Growth And Equity Returns” Jay R. Ritter, November 2004.