- The global economy is well into its third emerging markets crisis since the end of Bretton Woods, but there has been no panic yet.
- Historically, investing in the global growth story has been very risky over both the short and long term.
- The best time to risk exposure to emerging markets may be after significant appreciation in the dollar against rich-world currencies.
- Previous emerging market panics seem to have been triggered by Fed tightening.
- In light of weak global growth and commodity prices in this cycle, tightening by the Fed in the coming months may trigger the panic that has been missing so far.
The distribution of global growth is highly correlated with dollar weakness. The curious thing about this, however, is that it is not the weakness of the dollar relative to the ruble, the rupee, or the renminbi that matters but rather its weakness relative to the euro, the yen, and the pound.
In the first chart, I plot the degree to which the distribution of seven-year growth rates among the OECD, the BRICS, Indonesia, and Thailand has been predicted by relative wealth levels (per capita GDP calculated according to purchasing power parity (PPP)) alongside the dollar index for "major currencies" (roughly the G7 and a few others). The second chart shows that it is the narrower index that is key; in Part II, I will show why I think that is.
The negative correlation between relative wealth and relative growth rates is called the "catch up effect" or "convergence:" poor countries are supposed to grow faster than rich ones, presumably because they can acquire rich-world innovations at a lower cost than they were obtained by the pioneering economies. The correlation has been consistently negative for the better part of the post-World War II era, but it is obviously highly cyclical, too. The first decade of the 2000s experienced catch up in a highly concentrated form, for example, but during the early 1980s and the late 1990s, the correlation was much more subdued.
The respective nadirs for those two episodes were in 1985 and 2000, in both cases roughly three years after major emerging market crises that seem to have been kicked off by the Federal Reserve's attempts to squeeze bubbles (almost always to the benefit of American equities, as it turned out). I suspect 2011 was a similar such episode. The Fed raised rates as inflation picked up, a severe recession hit, and then the onset of the Mediterranean and Black Sea crises (economic crises on the northern shores, political crises on the southern and eastern).
What we are missing this time around, however, is the sharp appreciation of the dollar against the other G7 currencies, and in many ways, we seem to be lacking the panic of a 1997/1998-style emerging markets crisis. At the same time, we do not seem to have the rebound in middle- and upper-income economies that typically leads the revival in EM growth.
In short, the global economy remains moribund. It has never properly purged itself of its excesses and imbalances, and therefore, it continues to grind through the last crisis, while the Fed is preparing to induce yet another one in an attempt to return to some semblance of "normality."
In other words, the Fed may be, if however unwittingly, preparing to supply the two missing elements of the current slow-motion collapse in global growth (in terms both of aggregate growth and the structure of that growth): a bona fide EM crisis and a sharp appreciation of the dollar.
Supposing that the scenario I am sketching is some reasonable approximation of the truth, what should we do?
I have made my case for American equities over the short-term (two to three years) in previous articles, as well as for Treasuries over a similarly short timeframe. And, I have also argued against any meaningful resuscitation of the commodity bull for the next two years and possibly until the end of the decade.
But, setting those arguments aside, the implication of the present contention so far is that we should be going long the dollar and shorting paper with queens on it or funny-looking scripts. Once the crisis kicks into a higher gear, historical precedent suggests that there will be a worldwide mad dash for the dollar. We have seen flashes of dollar strength since the onset of the crisis six years ago, but not a convincing run so far.
Even if my fears about the immediate outlook for global growth play out, however, does it matter? More specifically, what does this sort of analysis say about global equities? And second and more importantly perhaps, what about the long run? Why abandon the long-term global growth narrative in an attempt to time the market?
My answer is twofold. The first part is rather straightforward: the only way to win in global equity markets is to be skillful at timing them. The second is somewhat more difficult and complicated, because it contravenes some of our basic assumptions about the nature of growth. I intend to argue in Part II that the catch-up phenomenon is artificial: the tendency for growth rates to be determined by the initial level of productivity is unsustainable. It is the eponymous "Big Macs" that point to the problem of long-term global growth as well as the curious relationship between rich-country currencies and emerging market growth rates that I described in the first paragraph of this article.
In Part I, however, let's address the necessity of being timely in global markets first:
Equities & Growth
Over the very long term, as pointed out by Jay Ritter, a professor at the University of Florida, stock market returns and real economic growth are inversely correlated across countries. (The Economist and The Financial Times pondered his findings earlier in the year). Over the last century, one would have done better to invest in slow-growth (typically, rich) countries rather than betting on the catch-up dynamic.
Using stock market data provided by the OECD (unfortunately, the organization does not provide data on dividends) on its members, as well as for the BRICS and Indonesia, and looking at the performance of 17 countries from 1971-2010, the correlation between GDP growth and stock market performance was positive but very weak (0.19).
In the first chart in this article, I looked at the annual rolling correlation between seven-year growth rates and wealth levels. That rolling correlation is reproduced in the following chart and set alongside the rolling correlation between seven-year stock market performance and wealth levels. There is a similar pattern, but the correlation between stock market performance and initial wealth levels is much lower. In other words, in order to capture the benefits of global growth, you must be able to time the markets with some precision. Otherwise, by blindly playing the global growth game, you are importing both lower returns and higher volatility into your portfolio.
(click to enlarge)(Sources: St Louis Fed, and my calculations from OECD and Maddison data)
If we look at the degree to which seven-year growth rates themselves correlate with seven-year stock market performance, we get a similar sort of cycle but one that seems to lead the overall global growth cycle. The periods in which relative stock market performance is highly correlated with relative GDP growth are brief. Needless to say, predicting GDP growth is difficult enough without having to consistently and accurately predict relative GDP growth levels. Except for select episodes, it seems you would do better to be wrong about growth prospects or, better still, to be blissfully unaware that other countries even have stock markets.
(Sources: St Louis Fed, OECD, and Maddison Project)
Betting on currency strength in the equity markets would hardly be any better. Earlier in the year, using the OECD data for the 17 countries referred to above from 1971-2010, I found that, although the average stock market boom coincided with an appreciation of the domestic currency, countries with weakening currencies had a tendency to outperform countries with strengthening ones over that 40-year period.
In short, when investing in global equity markets, if you are unable to time global cycles, it might be best to invest in slow-growth countries with depreciating currencies. If you are able to time the markets, however, you should invest in fast-growing economies with appreciating currencies (except when you shouldn't, of course). Either way, typically, it would be best to buy emerging market equities only after a global crisis and after the dollar index has appreciated substantially.
The more things change…?
The historical data seem to be fairly clear on the difficulties of cashing in on global growth, but will the future really look like the past? If Indonesia's per capita GDP is 15% of the average American's income (as of 2010), China's 26%, Brazil's 23%, South Africa's 17%, and India's 11% and those percentages are en route to even just 75% (and why only there?), is it really conceivable that their equity markets would lag?
Obviously, when we get to certain extremes, this historical pattern could not hold true. If America were to enter into a long-term decline to the point that the ratios were reversed (so that American per capita GDP were only 10% of Indonesian GDP, for example), it would be preposterous to expect Indonesian equities to underperform. There must be, in other words, some logical limit to Ritter's inverse relationship between growth and stock market returns, and the question is where that limit lies. And, I don't know.
I have to confess, therefore, that my argument against investing in emerging markets is not as open-and-shut as I would like. If I were convinced that the gravitational pull of globalization will inexorably pull the rest of the world towards parity over the next sixty years, it would be hard to take a dogmatic stance against investing in developing economies over the long term, despite what history has to say about these things.
And, I do not intend to take a dogmatic stance against investing in global growth. Rather, what I wish to argue is that we should be very selective about how we apply the lessons of the last sixty years to the next sixty years and beyond. The arguments made in this article are contingent upon a particularly Americanized form of globalization since World War II (and perhaps as far back as World War I).
In Part II, I will try to illustrate the nature of the connection between rich-world currencies and poor-world growth rates and why I think that this dynamic is unsustainable in the long run.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.