Episode #387: Whitney Baker, Totem Macro – How To Play A Once-In-A-Generation Opportunity in Emerging Markets
Guest: Whitney Baker is the founder of Totem Macro, which leverages extensive prior buyside experience to create unique research insights for an exclusive client-base of some of the world’s preeminent investors. Previously, Whitney worked for Bridgewater Associates as Head of Emerging Markets and for Soros Fund Management, co-managing an internal allocation with a dual Global Macro (cross-asset) and Global Long/Short Financial Equity mandate.
Date Recorded: 1/19/2022 | Run-Time: 1:24:21
Summary: In today’s episode, Whitney shares her flows based macro lens for looking at the markets, one she honed at famed shops like Bridgewater and Soros Fund. She says we’re experiencing a cyclical and secular regime change that the market has yet to adjust to.
Then Whitney shares why she believes the US is in an once-in-a-lifetime bubble…and at the same time have a once-in-a-generation value opportunity in broad sections of EM. We touch on the implications of this for both foreign and domestic markets and hear where she sees opportunity.
Whitney shared one of her recent research pieces which are normally only for a select number of the world’s most sophisticated investors, so be sure to check it out here. It – is – fire.
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Links from the Episode:
- 0:40 – Sponsor: The Idea Farm
- 1:10 – Intro
- 2:09 – Welcome to our guest, Whitney Baker
- 2:41 – Whitney’s investing framework
- 9:28 – Where flows have gone and are going
- 14:37 – Inflation and the impact of supply constraints
- 24:01 – The case for today’s emerging markets
- 37:52 – Cycles in emerging markets compared to the US
- 43:21 – Can emerging markets thrive without a weak US dollar?
- 49:54 – Distinguishing between different emerging markets
- 56:09 – How equities rank across emerging markets
- 1:05:07 – What’s the bear case for Whitney’s thesis?
- 1:08:36 – Does investing in the S&P give you global diversification?
- 1:10:55 – What role should emerging markets play in someone’s portfolio?
- 1:15:19 – Major lessons from Whitney’s early roles at Bridgewater & Soros
- 1:18:50 – Whitney’s most memorable investment
- 1:21:05 – Ways to connect with Whitney: http://totemmacro.com/
Transcript of Episode 387:
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Meb: What’s up, friends? We have an amazing show for you today. Our guest is the founder of Totem Macro, an emerging markets macro consultancy in hedge fund advisory boutique. In today’s show, our guest shares her flow-based macro lens for looking at the markets, one she honed at famed shops like Bridgewater and Soros. She says we’re experiencing a secular encyclical regime change that the market is yet to adjust to. She shares why she believes the U.S. is in a once-in-a-lifetime bubble, at the same time, we have a once-in-a-generation value opportunity in broad sections of emerging markets. We touched on the implications for both foreign and domestic markets and hear where she sees trading opportunities today. Now we talked Whitney into sharing one of her recent private research pieces, which, by the way, are normally only for a select number of the world’s most sophisticated investors. So, be sure to check it out in the show notes at mebfaber.com/podcast. I promise you, it is fire. Please enjoy this episode with Totem Macro’s Whitney Baker. Whitney, welcome the show.
Whitney: Thanks for having me.
Meb: I am so excited to have you today. I’ve read and re-read a couple of your last letters, which have been fire. And this is going to be a hard podcast for me because I agree with a lot of what you’ve said these letters, but I’m going to warn you, I’m going to play devil’s advocate for part of this. Okay? So…
Whitney: Great.
Meb: This is my job, I suppose. But we’re going to talk about macro, emerging markets, all sorts of fun stuff. But before we get started, let’s hear about your framework. How do you think about investing in general? How do you guys apply this lens at Totem? And then we’ll dig in deep.
Whitney: Yeah, great place to start. I think probably the way that we would describe our investment process is to think about macro as a flows-based asset class, cross asset, and so forth. And what I mean by that is we basically think that money and credit flows drive economic conditions and form asset prices with where they go and don’t go, and so forth. And so, our core process is basically trying to understand and anticipate shifts in those flows so that we can anticipate, as an example, which asset prices are based on unsustainable flows coming in or an unsustainable set of economic conditions that those flows and that kind of sort of domestic environment has created. We do that in a way that, I think about money and credit, it’s something that occurs and finances every transaction that you have. Whether you’re buying a car, you either buy it with cash or with a loan or with your credit card or whatever. So, it’s money or credit there and it’s money or credit in the financial space as well. If you think about, money flows into different assets and cross-border flows and so on.
And all of that’s super important for EM. So, what we try to do is understand the frameworks which are based on cause-effect linkages that are predictable and repeating through time, in terms of how those money and credit flows go, what drives them, where are you in the cycle, what is the nature of the cycle, how are asset prices responding to that and, so, therefore, what’s going to change as we move forward.
I think what’s really, really interesting right now…I think, in my career, this is probably the most excited about the asset market opportunity, the landscape that we’re in, and various macro inflections that are going on, and I think the opportunity that creates for a broad part of EM. I’ve been excited to see this inflection coming, more so than I think at any point trading at EM just because there are so many interesting things. I think we’re actually on the verge of return to sort of more productive macro investing environment rather than sort of ducking and weaving through alpha calls and diffs and stuff like that in EM. And so, a lot of what’s going on in terms of the money and credit flows and how those are changing is massive.
Secularly, we haven’t seen things like this in 40-50 years, so, there’s a lot going on in that dimension. And then, obviously, just to tie it back to today and the situation we see, we basically feel like there’s a dollar asset bubble in the U.S. and U.S. assets, whether you think about all of the sort of new growth areas, techy stuff that’s been doing well in the last cycle. There’s that extreme bubble, the extremity of which I’m doubtful I will see again.
And on the other side of that, there’s like a once-in-a-generation value opportunity across broad sways of EM. Obviously, within EM, there are a lot of divergences as well. But that kind of dichotomy and U.S. assets having received all the flows in the last 10 years and priced themselves to kind of crazy valuations and predicated on peak multiples, peak earnings into forever, that’s unwinding now. I think this year is a good example of that. So, that’s one of those dynamics of inflection that we’re getting kind of psyched about.
Meb: Well, wow. Okay, you’ve dropped a few bombs already. So, everyone who listen to this, probably grab another cup of coffee because we’re going to settle in. It’s funny, I mean I was talking about flows, about a week ago on Twitter, and how they kind of affect assets and change the composition. I think an easy way for people to really visualize this is certainly with like very specific niche asset classes. I think some of the high growth ETFs and mutual funds of the past couple years, a lot of the research that Morningstar puts out, you see the money wash in as the performance is great. And then it has the same sort of reflexive process on the other side. As money is coming out currently, you’re seeing almost every day some of these funds down. Talk to me a little bit about what you mean when you say “flows” because…so, I’m speaking specifically to like flows into funds here, domestically. You’re probably talking about these giant flows in between economies…or maybe just kind of elaborate what you mean when you say, “Tracking these flows.” Are these currency flows? Are they flows across regions?
Whitney: I don’t mean to give the impression that anything we do is very tactical or arby or you can think about sort of quant strategies and that kind of thing as being flows-based in some respects. And that’s not really what I’m talking about. What I’m talking about is saying, “Look, if I could add up every piece of every debit-card transaction, every piece of borrowing,” this is from the sort of like spender side of things, people who are engaging in economic transactions, “if I could add up all of that financing, I could understand every single thing that is happening in an economy cross borders by different players in different sectors, and so on.”
And really then, when you come to the supply side of money and credit, if you want to think about it that way, all the aggregate financing that’s available in any given economy or even just at the global level, obviously, it can move around within that, is driven by, what I would call, base money creation. Which is when the central bank creates money. And we, obviously, have seen a ton of that. And then on the other hand, you’ve got, what I would call, “commercial bank money creation.” And that’s basically any lending that is done by any banking system that, effectively, can create broad money itself through issuing loans and acquiring credit.
And so, the point is, if you look at something like the broadest reads of money you can get, they will encapsulate what the central bank is doing and what borrowing and lending activity is going on in that economy. So, what we want to try to understand is all of those pieces. Where’s the central bank money going? How sustainable is that? Why are they doing this printing at such a high degree? Yada, yada, yada. And on the private side it’s, “Okay, well, what flows of capital is this asset or economy, or even Chinese property would be a player or sector, where is the money going? Who’s dependent on what?”
And so, as an example, if we’ve got a global macro review that basically says, “Look, there are a huge set of divergences in the world that exist today between macro conditions and market pricing in terms of the assets that are usually very directly tied to those macro conditions.” Last year, we had macro conditions effectively evolving exactly as we expected, which was your sort of commodity bull run, your growth uptake, your probationary momentum in the beginning of the year, the cyclical preference. All of that. The big inflation problems, the faster pull forward of tightening. All of that stuff happened but the assets most geared to it didn’t really do much. Like yields didn’t move, and so on and so forth, even though there’s a huge commodity boom. And whether you’re a goods exporter or commodity exporter, in EM, you had this huge external windfall, EMFX was flat. I can give you a million examples of those sorts of divergences that formed last year. And now, this year, I think we’re, essentially, moving into a reconnection of, if you think about where those flows have gone, the macro conditions that they’ve created…so, while we had a lot of central bank printing, unlike 2008-9, the private credit side of the pie never went negative. So, the foundational reason for this big disconnect and the big opportunities that we see is, if you come back to COVID and the response, the sheer size of the QE relative to the shock was massive. And even today we’re still printing money at 5% of GDP flow in the U.S., which compares to a peak flow post GFC of like 7%. So, even today, like years into this thing, with an economy running extremely hot, all of the issues we can talk about on, excess demand and how that’s created the supply chain ripples that it has, with all of those things having happened last year, you’ve got this big QE, you’ve got no credit contraction, you now have a credit acceleration…so, again, broad financing is expanding at this sort of unprecedented pace that people have pointed to and talked about.
And I think probably one of the biggest foundational differences that’s important to get is that, when the Fed is just doing QE, as an example, tracking those money flows, where are they going? They’re generally buying bonds from either banks or private-sector players who are financial investors of some kind. Those guys take the bonds, put them into some other financial investment. It can create this sort of disconnect between asset pricing and the economy but not really much by way of broad inflation. Particularly like back in 2009 because it was just offsetting a huge deleveraging pressure.
So, this time, that’s different. Now you’ve got the coordination, sheer size of the QE, the coordination between that and the fiscal transfers I think is a very important thing. So, fiscal stimulus has been just like appallingly large. Like they’ve massively, massively overreacted. We can get into the numbers on that. But the point is, when you mail the entire population 15% of GDP’s worth of stimulus, there’s no economy or supply chain in the world that is queued to expand that quickly. And so what that means is you’re giving a lot of people a little bit of money and they’re going on spending it on things in the CPI basket. So, you need a lot of people to do things to create broad CPI.
And that’s why we’ve, effectively, had this issue where it’s too much financing, it’s going to a different set of actors, those actors are spending it on goods and other consumer products, and now we’ve got this investment boom follow on which is only increasing the demand for goods further and borrowing further and so on. And so we’ve really like set in motion this kind of event. So, I’ve kind of gone on a tangent here but that’s what I mean when I say, “We think about those flows.”
Now, in different cycles, those flows go to different geographies, different sectors, different players. There’s a different nature of each cycle that happens. And if you think about when these cycles get to their logical extreme…so, coming back to what you’re saying on the retail side of things, at the tail end of these big long booms and cyclical expansions…where like, if you look at the U.S. it’s been one of the only two markets, U.S. and China, post GFC, that was really able to re-leverage, get its house in order, clean up the banks sufficiently, and get out of it. And the rest of the world has been deleveraging, more or less, for the last decade.
And so, you had this U.S. exceptionalism dynamic. It pulled all the capital out of the rest of the world into U.S. assets. It made U.S. assets extremely overvalued. When COVID happened, the money printing that the U.S. responded with then pushed, particularly U.S. retail investors, into that market. And that’s why you got some of that really frothy like blow off tops type stuff, like you’re talking about in the really sort of loss-making tech and the frothier stuff. Which really just cannot bounce here at all.
And so, it set up this extremity of asset valuations positioning being already pretty much as high as it can be in U.S. assets, both from a global standpoint and in terms of local risk positioning. At the same time, the conditions that would enable like a disinflationary tech secular type of boom like we’ve had, macro conditions that favor that are long since dead. And so, we’re kind of in this weird mid-cycle transition now where we think the next global upswing is basically going to be much more driven by classic sort of cyclical growth, old economy, parts of the EM value sphere, all of that kind of stuff, inflation hedge protection, all of these dynamics.
And yet, the markets still today, if you look at the breakeven curve, if you look at where the dollar is trading, if you look at even economist expectations of where growth is going to be and where fiscal’s going to be and so forth, it all looks exactly like what happened from 2009 to 2012.
Essentially, the market is queued to the last cycle. And this is a normal dynamic. And it takes a while to get the losses that we’re seeing I think now, we’re starting to see now in these assets, the flows will then leave those assets.
One important dynamic about retail players is they’re incredibly responsive to momentum. And so, retail flows then leave and that creates this self-reinforcing downswing. And as soon as U.S. assets aren’t the only game in town, it frees up flows to go to these other economies that have been starved for a decade or more of pretty much all-foreign involvement.
Meb: All right. So, you have, what I like to call, sophisticated technical term of, “Feels like there’s been a disturbance in the force,” for the “Star Wars” fans. So, the regime change feels like is here, secular, cyclical, but you still have this world where it’s pricing in the pass. And I was reading one of your notes, you were talking about this back in 2020, you were like, “Here’s some things. If they come to pass, this is where we see the world going,” and then they’ve now transpired.
And you started talking about the big topic, last fall, and then it even seems to be accelerating and everyone’s topic, which is inflation. But you start talking about things being a double-edged sword for emerging markets. So, I’m going to let you choose where you want to go with this. If you want to start with inflation, if you want to start with U.S., or you want to hop on to emerging markets, I’ll let you pick the path. But there seems to be this market we had for almost a decade, seems to be already a big shift. So, take this one wherever you want with.
Whitney: Let me just say a few things on inflation I think because, honestly, I’m quite honestly annoyed by the nature of the discussion that’s happened over the last 6 months. And we’re getting to the point now that I think it’s like, “Yes, this makes sense that the market is finally coming around to this realization,” but the narrative that this is a supply shock of some kind or like a bottleneck issue is just complete garbage, just to be frank about it. I mean supply of literally every item has expanded by 10% to 15% in real terms, obviously, you’re getting the price increases on that, versus pre-COVID levels.
There’s the record supply of semiconductor shifts, even the things that you think of as being supply-constrained, there’s a record supply of container throughput of freight. All of these things that are actually the bottlenecks, the reason they’re bottlenecks is because we’ve tried to shove all of this demand through those channels that just, like I’m saying, aren’t wired for that extremity of a demand shock.
So, I think that the first thing I want to say on inflation, and coming back to like the report you mentioned, I think it was May, 2020, I want to say, where we said, “Look…” it was like May or June, 2020, we said, “Okay, we’ve had this massive economic shock. This is an EM-style shock on DM-style balance sheets is what we said. This is 8% of GDP income contraction. Emerging markets are used to that kind of thing, big balance of payments crisis or so every 15-20 years type of thing. They don’t run with high debt levels, they’re kind of queued to having volatility in their interest rates and FX and so forth. Whereas the developed world doesn’t.
So, we said, “Look, there’s a big shock. They got a lot of balance sheet exposures. If incomes contract this much, you need to have offsetting income relief to basically allow people in the developed world to service the debt.” So, what we would’ve liked to see is a fiscal stimulus of roughly 8% of GDP geared to replacing each dollar of lost income, effectively. What we got was 15 points and a huge amount of Fed expansion and a private-sector borrowing expansion at the same time. May-June, 2020, we said, “If these things happen, if we start to see that, effectively, the stimulus is greater than the income shock, if we start to see that the Fed is basically looking like they’re hunkering down to keep printing for a long time, if it starts to look like private credit is staying positive and there aren’t really any signs of a balance-sheet stress event here, if all those three things come to pass, we are going to have a really big inflation problem.”
And within like 2 months those things had come to pass. It was pretty clear that the balance sheet issues had been dealt with through the Fed intervention and through the huge transfer amounts. It was pretty clear that there was a massive V-shape recovery in consumer spending, obviously, the consumer incomes never even went down in this recession. And so, that’s, ultimately, the nature of both the inflation and the double-edged sword issue that you mentioned.
On the inflation, the point here is just simply, “Look, we are way behind the curve.” There’s not a lot of evidence that it’s going to accelerate a lot from here, our indicators point to something like a peak inflation rate, and we look at things tend to be in shorter terms, so 3 or 6 months or whatever, but peak inflation rate at about 8%. We’ve got another 1.7 percentage points or so on the headline of housing inflation to pass through. But everything else, all our other indicators are basically consistent with inflation staying around where it is, which is very high.
So, you don’t actually need a continued acceleration from here, even though I think you’re in for this period of, effectively, a paradigm shift from 40-50 years of falling rates, falling inflation to now the policy reaction. Throughout that time, honestly, it goes back to the GFC but even more so, obviously, more extremely during COVID, has completely upset that secular trend. So, there’s those two points. So, how do you think about DM and EM and very geared-up balance sheets, particularly in the developed world, in that kind of a secular environment. That’s point one.
EM doesn’t really have to deal with that. As I say, balance sheet debt levels are typically low outside of Asia, across all of EM, and they’re used to this volatility and that’s why they run that way. They also didn’t have the same degree of sort of propping up or stimulus that the U.S. and the other developed markets did in COVID. And so, the double-edged sword for them has been, on the one hand, particularly the U.S. but it’s a developed-market phenomenon in general, but the U.S. has over stimulated to such a degree the EM is the makers of things, they make our commodities, they make our consumer goods and capital goods and so on, they’re the makers, there’s this huge demand shock in the U.S., there’s no ability to cater to that demand shock so you get this external windfall. And like, if you’re in EM, you’ve already spent 10 years, I mean like outside of Asia, one of the sort of more volatile boom-bust EMs, you spent 10 years dealing with your own deflating boom that you had. So, EMs were where the U.S. is today in 2013. Hugely relying on foreign capital flows into domestic risky bubbly assets, twin deficits, inflation shooting up, central bank way behind the curve, and so on. That’s where they were then. And they’ve spent 10 years basically de-gearing and adjusting, and so they’re in current account surplus, they’ve got very low debt levels, and so on. That’s even before COVID. You then get this external windfall. And whether you’re producing goods or commodities of any kind, you’re getting this huge external stimulus boost that’s flowing through. So, that’s the good side of the sword.
The bad side is that, because the U.S. has, effectively, inflated global commodity prices and goods demand to such degree, they’re also importing inflation back from the developed world or I guess like the global market, if you want to think about it that way. Now, like EMs are used to import inflation and balance of payments crises when their currencies are going down. And then they would hike and there would be a recessionary import contraction, and that’s how they would deal with that. This is actually…their currencies are flat, all the prices of everything globally are going up, even in dollar terms, and that’s translating to inflationary pressure in EM.
Interesting thing though, and I should maybe add that, as the growth-inflation mix gets worse, and it did get worse last year in the developed world in particular, the bad part of the double-edged sword starts to get a little bit more important. Because you’re already reaching capacity, you can’t really sell people that many more goods, if you know what I mean. And so, if U.S. consumers are now just spending their dollars to afford the same stuff they were already buying, which is now more expensive, you still get the inflation problem in EM but you get less of a sort of external support from that export windfall. But the interesting thing here is, for me, what we tend to call “reform debtor EM,” so these classically volatile twin-deficit countries that are now in surplus, now very cheap and so on, those guys, essentially, those guys were already in a position of external and domestic strength and balance sheet adjustment coming into this. But they took a very different approach, I think it’s fair to say, to the developed world, which is they fiscally tightened, they monetarily tightened. And I think what’s very interesting is, even though they’re importing those inflation pressures, inflation differentials between the developed world and the EM, even the riskiest EMs, as an example, are at all time lows, effectively, now. And so, the delta in core inflation and headline inflation, even in the EMs that are hiking the most aggressively right now, has been less than the delta in developed-world inflation, in particular the U.S., which has, obviously, been the most extreme.
So, what I think that kind of opens the door to here is, coming back to one of those divergence points from before, which is like think about last year, EM growth, in real terms, is pretty dramatically outperforming DM growth. Because DM propped up consumption in 2020-2021, they’re getting that rolling off now. Whereas EMs never really propped up the economy after COVID, so, they’ve still got this kind of V-shaped activity recovery going on. So, positive growth differentials, inflation differentials at basically all-time lows, huge rate premium, hugely positive real rates, foreigners have no positions and so on. Through time, the biggest drivers of capital flows into EM economies are growth differentials, valuations, inflation differentials, and rate differentials. And all of those things went just dramatically in EM’s favor. And yet EM flows have been flat, and again, that comes back to the point about people kind of playing the U.S. bubble to its logical death, which we’re I think starting to see here.
Meb: When people think of emerging markets, I think they think of emerging markets from like 30 years ago where they had a very different composition, whether it was debt or growth or on and on and on. Talk to us about kind of this case for emerging markets now, what that means, and why they look attractive and why these aren’t our parents’ emerging markets.
Whitney: I could tackle that from either. And both I think are important from cyclical and secular standpoint. Let me just get the secular stuff out of the way. EM, to me, it may sound weird, but conceptually, it’s not an asset class, it’s just a whole bunch of different wildly divergent countries with all sorts of different economic sensitivities and drivers merged into one thing. To your point, EM is heavily dominated by China and North Asia but there’s like this long tail of 20 other countries that are in there with their own different dynamics. The thing that I would say has been broadly true through time is that, to different degrees, and let’s hold Asia out of this conversation for a second, to different degrees, EMs have been traumatized by whatever happened to them in the 80s and 90s. Really, at the tail end of it, the 2001-2002 period, was the last real big balance sheet crises for EM. And I’ll come back to that in a second. But there’s been this cultural trauma related to the inflations of the 80s and 90s and the cause of that, which if you think about what their main problems were, it’s not that sometimes you have to do a balance of payments adjustment and you have these cycles and your current account gets really in a large deficit, like we had, your currency’s overvalued, you rely on foreign capital you have to deal with that, we’ve had 10 years of dealing with that issue. But the thing to point out is, aside from a few bad eggs, we haven’t had any massive or broad-based IMF bailouts or defaults or talk of Paris Club things, the basic point is there’s just a cyclical adjustment that’s happened for 10 years for these countries as each one of them dealt with these imbalances. But from a balance sheet perspective, they no longer borrow in FX, that’s the most important thing.
So, if you think about, back in the early 2000s, late 90s, what was going on in the Asian crisis was a cyclical boom that had, throughout the 90s, money flowing massively into Asia, into EM, from both Japan and the U.S., manufacturing, globalization boom, all of that kind of stuff is going on and it drives huge deficits in Asian countries. Foreign capital in dollars is coming in. Typically, it’s short-term capital to the sovereign from like leveraged lenders, like banks, Western banks, U.S. banks, and so on. And the sovereign debt rolls, on average, back at that time, were something like 45% of GDP annually.
So, let’s say, you’re running a 6% current account deficit, you need to have your currencies under pressure, no one wants to give you those flows to keep running that. You have to tighten your policy, have a recession, your current account goes back in a surplus. That’s a recession in EM, like that’s what that looks like. Let’s say you have to also try to find a way to roll your 40% of government FX debt. That’s very hard when you’re cut off from foreign capital and your imports are just not large enough to ever be able to deal with that size of adjustment on their own. Which is why you saw all of the defaults and lending support programs back then.
So, basically, point is EMs writ large run with pretty tight fiscal because of that. What borrowing they do do, and there’s some exceptions like Brazil and things we can talk about, what borrowing they do is in local currency at term, for the most part. And because we had that whole decade, from 2000 to 2013, where EMs were the players that were driving that cycle, as well as obviously the U.S. and global housing boom, during that whole upswing, EMs accumulated a huge amount of FX reserves.
And so, if you look at these countries, not just at the sovereign level but pretty much throughout every sector, they now have more FX assets than any FX liabilities coming due, by a huge margin. Any idea, and there was a lot of calls earlier on in COVID for there to be a spate of EM defaults and so on, that’s just, to me, like very misguided. Because the only thing that, ultimately, creates defaults is when you run out of the liquidity to service your debts, you only run out of liquidity, if you can’t access foreign capital, if it’s a foreign-currency debt, or domestically, essentially, if you had an inflationary problem and you had to tighten what would happen as a recession but you would still be able to service your debts. And so, there’s just been a huge balance sheet change, that’s the first thing I want to say.
Second thing I want to say on the secular point is, at times like these, after a 10-year downswing in EM, you’ve had like a pretty vicious set of adjustments across a variety of countries. You’ve now got this inflation. And so, this is classically true that, at the bottom of these cycles, there are always political upheavals and civil unrest and protests. And usually a lot of our work on how political regimes shift in EM looks at what happens when there’s an election during a balance of payments crisis/recession or in the subsequent 2 years? And the basic point with that is like 70% of the time it just goes to the anti-incumbent candidate. So, there’s this tendency for political volatility, not necessarily populism of the left or right, but some move away from the status quo. And so, we’re seeing a lot of those political type dynamics crop up in EMs today as well, which are sort of giving people another reason to write it off. When really actually the only reason I think that people have written it off and their selling has actually created the downturn it’s just because EM had to do a set of adjustments after the boom that ended in, let’s call it, 2013.
So, for me, this is very much an EM cyclical downturn that is now over and inflecting in a very positive way, that is reinforced by an alignment of trough positioning to all of your points before. Trough positioning, trough valuations, trough macro conditions, and trough corporate conditions. It’s all happening at the same time, it’s all inflecting in a hugely powerful way.
But coming back to this political argument that people use to, basically, kind of reinforce their current negative positioning/stance on it, it’s all like, “How can you trade? There’s populists showing up? How can you trade EM, Latam, blah, blah, blah. Point is go back to the 80s or 90s, these were military dictatorships, by and large. They didn’t even understand the concepts of economic orthodoxy as relates to how you run a central bank, which currencies you should be borrowing in, and so on and so forth. And so, even the populists that are getting in an EM today, like I’m thinking about Castillo and … these guys in Latam, they’re like, “Listen, first things first here. We are not changing the inflation regime, we’re not compromising central bank independence, we’re not fiscally expanding.” I mean look at AMLO, right, key example. Populist, Mexican market, hugely de-rated after his win. And actually he did the least fiscal expansion of anywhere globally during COVID, in response to COVID.
So, anyway, basic point is you can always point to volatility in EM and politics and whatever else you want to point to as a reason to not get involved. But secularly, politics and economic management, governance in these countries, and their balance sheet quality and strength has never been better. So, that’s the secular point, I think.
On the cyclical point, I think really this comes back to the previous discussion, which is like buying the dip in a boom, an arguably a bubble in U.S. tech and other frothy assets in the U.S., you’ve had this very long upswing and very long gradual cyclical expansion in the U.S., culminating in this bubble. People are used to buying it, it’s worked for 10 years. For a lot of people in the markets, the new entrants in the markets today, so, like the millennials, the retail story, and all that, there’s not really been a lot of trading through downside and understanding the dynamic of how cycles work.
And because that cycle was so drawn out in so long, it also meant that the EM adjustments that the Fed tightening cycle in 2013 ushered in took a long time to kind of play themselves out. Let’s call it 2011-13, you started to get the peak. And people who were particularly reliant on high commodity prices, they started to fall. Bond inflows from QE started to slow. And so, you’re starting to get EM adjustments in those players who are reliant on those things, Indo, South Africa, etc., from 2011 to 13. The oil guys went in 2014-15 when the fed actually tapered and started to hike, the dollar surged, oil collapsed, and Russia Brazil had massive adjustments and so on. And then it kind of just progressed through Mexico was 2016-17, Turkey 2018 through now, RG, obviously, 2018. Anyway, point being that there’s been this long drawn out state of external withdrawal that has forced these countries to cut their spending so that they can basically deal with that imbalance.
Meanwhile, all of that global withdrawal that was driven by the combo of Fed tightening and, so, the U.S. having, for the first time, really the world’s reserve currency having premium interest rates versus everywhere else, that’s unusual, so that combo and, even though it was weak growth, U.S. did better at secular growth, like the tech dynamics and so on, all of that pulled capital into the U.S. And when the Fed started to hike and deal with that, when they got liftoff coming out of GFC…what was the bubble then? It was effectively EM. So, what got disrupted? The flows into EM.
So, EM assets were the ones, at that time, that were pricing these unsustainable cyclical conditions, becoming hugely dependent on foreign capital, record high commodity prices, all that kind of stuff at a time when they were the least attractive destinations for that capital and their currencies were overvalued, their rates were low and very negative in real terms, and so on and so forth.
My point is, cyclically, that whole adjustment process outside of Asia has happened. And on top of that, you’re getting this huge extra export uplift that has pushed a lot of these countries into extremely high trade surpluses. And so, you got a lot of innate currency support from that. And so, I think, basically, the point is, when the U.S. sort of everything bubble dies, so does the dollar because the flows actually that went into the U.S. equity bubble and U.S. risk assets in general, in this cycle…and again, because of that positive rate gap, there were some fixed income flows into the U.S. as well, those flows, ultimately, created the overvaluation of the dollar. And so, now you’re at a situation…like you were, by the way, we’ve had these weak global U.S. exceptional type cycles in the 1920s, in the 1990s, in this decade. And so, it’s a similar dynamic every time where foreign capital into…like the only assets that are doing anything pushes up those assets, pushes up the dollar, if gets overvalued, and then, ultimately, it sets the stage for unwind and reversal. Just like the unwind and reversal we had in 2013 for EM. So, I guess the final point there is we’re really excited about this year’s market action in this particular respect.
One of the other narratives on EM is like, “Oh man, we’re going into a Fed hiking cycle. And how can you possibly have any exposure to EM in that kind of an environment?” So, first point is, as soon as the U.S. outperformance tech bubble disinflationary secular growth type assets unwind, so does the dollar. So, A, that’s a hugely supportive tailwind for flows coming out of this stuff and going back into assets in the rest of the world. And so, we’ve expected that. And then, I think the thing about the action so far this year is, basically, we have…like, if I’m synthesizing what we’re playing for here, it’s three things, it’s that, like I said, everything U.S. bubble ending and with it the support for the dollar. So, you get dollar cheapening, flows coming out, etc., and that helping EM on the flow side of things. We’re playing for inflation hedge protection because of all the things we’ve talked about. And by the way, EM assets and all our work in cases of high U.S. inflation are the ones that do best because of their commodity gearing innate sort of inflation protection. And because, to be fair, every one of those inflation cases is a very dollar-bearish outcome. The dollar is not a good asset in an inflationary situation. So, we’re playing for the inflation hedge assets and the rotation that comes with that and, like I say, the return of flows into EM.
So far this year, what’s been very interesting is, effectively, it’s played out along those three dimensions. So, asset perf so far, in January, is basically lining up exactly with the ranking of how different assets globally perform in inflationary environments, since our data shows since 1960 or something, all the different cases.
And so, that rank ordering, this year, is one for one in line with how things look when inflation becomes a problem. Secondly, it’s shown that the dollar unwind has gone hand in hand with the fates of the U.S. equity market and particular equity underperformance and that bubble unwinding. And thirdly, coming back to the key point, I think, on the cyclical is it’s shown that that’s been driven by this yield move in the U.S. and rate expectations catching up with finally people being concerned about inflation. So, a big pull forward of U.S. Fed hiking expectations, a big move in U.S. yields, and yet EM commodity producers are the best performing currencies, bonds, and stocks this year, that narrative about, “In a hiking cycle, you can’t do X,” whenever there’s a narrative like that, it usually lacks historical perspective. It’s usually geared to the cycle that just happened. So, people are saying, “You can’t invest in EM because, in 2013, there was a hiking cycle and EM did badly,” my point is
every hiking cycle the Fed does pops a different bubble that it has created in the easing cycle that came before.
And so, what you need to think about is like which bubble is going to pop here, where are the flows currently going that will get disrupted by this tightening? And I’m telling you, it’s not EM. And that’s why, this year in risk-off, we’ve had 8% or 10% dollar returns in EM commodity producer stocks and so forth.
Meb: That was an awesome comment you just made. I love it. Everyone’s always fighting the last battle. And so, you mentioned late 90s, you had a lot of the dot coms, obviously, 2007 into the financial crisis, ended up being housing, etc. One of the common criticisms…and by the way, your former employer put out an amazing report that touches on what you talked about. I post about emerging markets on Twitter and, invariably, I’ll get 50 responses that just show U.S. versus emerging market performance since 2009. And I said, “You’re literally making my point.” That’s what I’m talking about is, yes, the U.S. has creamed everything this past decade. It happened in the 90s. And I think you said, before that, it was like what…the 1910 or…
Whitney: The 20s. That whole roaring 20s dynamic was like the rest of the world’s falling apart. Obviously, Europe is dealing with post-war inflationary chaos, all of the flows are coming into the U.S. because it’s the only thing that’s doing anything. And again, you had a long upswing, which then culminated in a retail frenzy. And what was actually really interesting about that is not every cycle is a bubble, obviously, sometimes you just end up with a credit cycle that then inflects when they tighten and you get a normal sort of garden variety recession, the U.S. ones have been bubbles. U.S. exceptionalism was a bubble in the 20s, a bubble in the 90s, and a bubble today.
And what’s interesting is they always follow the same kind of even like internal breadth indicators and things like that. Like what happened in 1928 was the Fed was hiking aggressively, commodities collapsed because they sort of sniffed out that global growth and inflation would be impacted by this. And then it was, basically, second half of 28 through beginning of 29, it was only the fang of the day, effectively, radio and stuff like that that was getting any flows and doing anything. They were the only…it was like, again, five stocks doing everything. It’s almost like the last vestige of the bubble mentality because you’re like, “Oh man, I really feel like I should buy the dip but I’m not sure I want to have something that’s going to be negative free cash flow till 2048. So, maybe I’ll just buy Amazon or whatever.” Same kind of thing goes on and then, ultimately, it’s the whole sort of range of those bubble assets and those flows that unwind.
My big concern here, when I think about secularly outlook, I’m not necessarily talking about EM here, but we have had an insane increase in metrics of U.S. wealth as a ratio of GDP, as a ratio of disposable household income, anything like that. It’s like six to seven times, it’s never been anywhere remotely close to this. And it’s gone up by about one and a half terms of GDP in the last couple years. Now, assets are just things that are tied to future cash flows. Cash flows are tied to the economy and earnings or spending of some kind. And so, what you have here is this huge disconnect between asset valuations and the cash flows that can support them.
And when you think about a stock, let’s say, it’s trading on 30 times earnings, whether earnings grow 10% next year like they grew 10% last year or whatever, when you’re just trading at such an expensive multiple, the earnings themselves are not really the thing that becomes attributionally what drives the stock volatility. It’s changes in that multiple that drive much more of what’s going on.
So, anyway, ultimately, you get this unwind. And when the bubbles pop, I think, this time around, my main concern here is there’s going to be a lot of wealth destruction. When I think about how they’re going to slow this inflation problem down, normally…like let’s go back 2006-7, what they did was raised rates, there’s a big credit boom ongoing globally, but especially in the developed world, and they raised rates and then values start to fall, so house prices start to fall, credit rolls over, and this whole borrowing cycle ends. And that’s how, normally, hiking brings about the end of cycle and disinflation. This time around this isn’t a credit-driven thing, this is like lots of money being printed, lots of checks being mailed to people, 2.7 trillion dollars of which are sitting there unspent in the excess savings that everybody talks about in the U.S. And so, there’s a lot of dry powder to go, this hasn’t been driven by credit, it’s been driven by money and fiscal. Fiscal’s going to be higher through the cycle than we’ve been used to. And it’s very difficult, given the polarization, for any kind of fiscal retrenchment.
And so, it’s hard for me to see how through the normal channels of like moderate rate hikes we actually get a meaningful slowdown here other than through wealth destruction and that recoupling of huge asset values with the economy and, therefore, things like the market cap to GDP or household wealth to GDP, these sorts of crude reads sort of go back to something more normal. And it’s through that channel that you actually get a reduction in spending and so on and so forth. Because, if anything, credit is accelerating. And I think that’s natural because you’re getting such a massive investment boom. So, there’s a response that’s going on now to the first round of inflationary problems which is perpetuating the inflation, which is, obviously, the labor market and wage gains and the capex boom that’s going on. All of that, just more demand for goods and labor right now, more spending power for labor, and it only actually gets disinflationary later on. So, that’s really starting to come in now and it’s offsetting any fiscal drag people are talking about. Plus, you’ve got this dry powder issue.
So, anyway, for me, globally, as investors and also just as a society, how we navigate the challenges of dealing with the shifting inflation and interest rate paradigm, secular change there, huge debt levels, assets that are extremely expensive and probably not offering you decent forward returns in the U.S. in particular, how does that whole thing play out in a benign way it’s very hard to see.
Meb: One of the comments that the EM critics often come at me with is they say, “This is just a dollar play. You have to have a dollar bear market for EM to do well.” Is that a requirement or is it more of a tailwind? Because one of the cool parts about your report you drop such incendiary terms like, “U.S. is the new Brazil,” and I don’t think you’re talking about soccer, to be clear, that our soccer team is on the up and up because we still…
Whitney: I wouldn’t know.
Meb: Yeah, we still kind of stay. But currencies really confuse people all the time. And is this something that like we have to have, U.S. dollar bear, or is it just actually like something that would be a tailwind to EM, how do you think about that? And let’s hear about the Brazil comment too.
Whitney: On the currency dynamic. Firstly, it depends, I would say, what asset you’re talking about trading in EM. But then, secondly, I think there’s a number of ways to kind of think about where we are cyclically but how a weak dollar even benefits EM. So, I think a lot of this idea or this narrative, in a generous interpretation, you can say, “Look, obviously, if you’re trading EMFX, it’s helpful if the dollar is going down,” that’s just like an obvious point. It just helps returns mechanically because it’s a zero-sum asset class, probably a more informational level.
I think this also anchors back to people’s concerns about EM balance sheets, the thing we talked about before, which is like people have this view of EM as always the ones that are out borrowing dollars and they’re borrowing it short and they don’t have enough assets and they can’t cover, they’ve got all these solvency risks and yada, yada. That’s the narrative I think that people haven’t quite internalized the shift there. And so, when I hear people talk about, “You need dollar weakness,” and so on, a lot of it relates to the balance sheet, what they think EMs need to do to be able to service their balance sheet.
Now, on that dimension, I would say, the value of the dollar has absolutely no bearing at this point. Because, as I say, they’re actually net-long dollars, they have more assets to use to service their dollar liabilities than liabilities coming due. And so, it doesn’t matter what the value of the dollar is or what the availability of dollar capital is for that specific purpose. For the purpose of understanding EM asset returns…so, again, on the currency side, I like your point that people just kind of think about currencies as an afterthought. And I think that’s going to become a really big issue because for, like I say, 40-50 years, we haven’t had to worry about inflation, inflation and rate volatility goes hand in hand with FX volatility, EMs are very cute, FX volatility, DMs, and global investors haven’t so much been treating that as a factor for quite a while. And so, the inflation-volatility piece of the pie I think is going to make currencies a more important component of total returns, let’s say, for global investors going forward.
What I would say in terms of how we think about currencies is, again, from a flow’s perspective. So, we’re looking at…let’s say, you’ve got a country that’s producing more…it’s exporting more than it’s importing. So, it’s running a big surplus externally. Any balance of payments, conceptually, you can think about it as whatever’s going on on the trade side of things or the current account side of things, whatever the domestic population is doing with their capital, that relates to outflows, and whatever foreigners are doing related to their capital. So, you got, basically, three contingents you can think about. You do not need a falling dollar to create flows in any of those areas. Let’s say you’re running a surplus, a huge surplus. A lot of the Asian countries in the early 2000s, like after their big adjustments, they’re running 18-20% surpluses. South Africa is another good example back then. You get massive rebounds in those assets, well before…the dollar didn’t start going down until 2001, foreign capital didn’t really start coming back into EM with a lot of speed until 2003, commodities kicked off really from 2003-4 onwards.
So, my point is you were getting huge returns in EM assets just trading the bottom of those adjustment processes. And that’s because the assets are trading at such distressed valuations that all you need is an absence of like a financial crisis and then you’re in the money. It’s almost like think about it like, if a bond is priced at 60 cents but then doesn’t default, you’re going to price and pull back to par, it doesn’t really matter what capital is going to come in or out of that asset. Ultimately, you’ll get paid back the 100, if you see what I mean.
And so, I think that, of course, a weak-dollar environment is a tailwind. It is that way, mechanically, on FX. It is that way because it tends to mean that people are getting out of U.S. assets, so, flows are looking for a home elsewhere. And obviously, the U.S. has been the biggest exporter of global capital flows. And so, the dollar’s been important just as a gauge of whether, effectively, global capital is on or off.
And so, you could imagine we’ve got EMs right now with a bunch of surpluses because the commodity boom, the export windfall, the previous adjustments they’ve done, if you then start to get flows coming out of…and to the Brazil comment, foreigners have more exposure to U.S. assets and the U.S. dollar by a factor of like 20 points of GDP than ever before. So, let’s say foreigners think, “Oh man, I don’t want any more of these treasuries,” or, “I don’t want to have this arc stuff or whatever,” they all get out…or even just fang, they all get out of that stuff going back to their sort of risk neutral positions or home currencies or whatever. Ultimately, that frees a lot of the dollars going down it, it creates a reinforcing cycle of losses that push these flows out, and then those flows go looking for healthier fundamentals and cheaper valuations elsewhere.
And my point is, pretty much across the piece in all of these, what we would call, reform debtors, there’s exceptions that, of course, we’re bearish on, there’s stuff in Asia we’re bearish on for sure, divergences intra-EM are extremely large right now as well. That’s the kind of powerful dynamic where you get, “Okay, one, you’ve done your adjustment, you have no deficit. Two, you get an external income sort of windfall gain from the global environment. And three, ultimately, capital starts coming back in.” And that, in this cycle, will align with the falling dollar because the dollar is so expensive and so propped up by these foreign asset exposures that, ultimately, I do believe this will be pretty dollar bearish rotation. And that will be translationally beneficial for EM assets, of course, and it will also probably, just as an indicator, indicate that flows are leaving U.S. assets and going into EM. It’s more that flow piece that could turbo charge EM returns. Which, as I say, are already basically in surplus and at or near trough valuations.
Meb: Go with the flow, it sounds like good advice for anything. As we talk about EM, there’s a giant elephant in the room, maybe a giant panda would be the better way to describe it, which is EM’s just not one thing, you mentioned earlier it’s kind of this amalgamation of countries that look very different. China, obviously, has a big footprint being one of the biggest parts of it but, at the same time, India is not China, which is not Russia, which is not Colombia, which…on and on. How do you kind of distinguish between whether it’s regions or countries? And are there any particular areas within EM that you think are particularly attractive or that maybe you would tilt away from?
Whitney: Let me deal with the China issue. So, I think you’re right. And this is why EM actually is a pretty difficult asset class, at this point, having not had a lot of attention for 10 years, for people to allocate passively to because so much of it is dominated by North Asia. In particular, China’s a third of it and then you’ve got Korea and Taiwan and so forth. And then only really about, let’s say, 30% or 40% of it is this broad tale of countries that would fit the sort of archetype that I’ve been talking through, the like reformed debtors, boom-bust guys who are now in surplus, who’ve been dealing with these adjustments, and so on. They’re in SEMA and Latam and so forth, we can come back to that.
But in terms of the process, I completely agree with you, there’s nothing that makes an EM an EM. Every economy in the world is just plumbed, effectively, the same way. They have different reliances on different sectors and different types of borrowing that get done and different types of spending that get done. But at the end of the day, when rates go up, borrowing’s going down. That’s a linkage that you can apply in any country through time and it works the same way. There are different linkages that matter more in richer economies and there’s different linkages that matter more in developed economies but, fundamentally, the machines behind how these economies work are similar.
So, for us, it’s just a process of analyzing the global dynamics and what we expect to dominate there and then rippling that down vertically through the particular country’s own domestic conditions, policy parameters and flexibility, valuations, the foreign flows there, and stocks of exposures foreigners have they’re reliant on, domestic credit cycles…all of the different bits and pieces, applying and plugging them into this sort of flows-based framework that we have. I’m kind of explaining it in a conceptual way but we systemize and look at all of these linkages and maintain all of these sorts of indicators and artifacts across all of the countries and assets that we cover. Which, of course, is like all macro assets across these 20 liquid markets. And so, that’s how we keep track of all of those dynamics going on.
And so, maybe to tie it back to like a specific example we were talking about before, when the Fed taper happened in 2013 and that kicked it all off, you had different countries that, fundamentally, had some similar characteristics. They were commodity producers, they were running deficits, and they were receiving foreign capital into their bond markets, they were overvalued. And so, you can look at countries that are different and say, “Oh, but they have these similar sensitivities.” Okay, so, if I think that…let’s say it’s a question of, “Do I short Brazil or do I short South Africa here?” Similar countries, similar dynamics at that time. We can then say, “All right, well, what is it that’s going to make Brazil hit the wall versus South Africa hit the wall?” And you can see, at the country level, “Okay, well, what’s actually going on here?” Back then, it was foreign flows into the South African bond market in local currency, that’s going to be very sensitive to taper and a movement in quantitative easing. On the other hand, you had Brazil, which was basically issuing dollar credit and had an oil production tailwind going on. And so, Brazil didn’t hit a wall until dollar credit related to oil ended, which was like 2014. So, it’s trying to tie the overall global picture with how we think about money and credit frameworks and the particular reliances and sensitivities that individual markets and the assets within them all have.
We integrate all that, come up with the most compelling trade views that we can, so, the highest risk reward, concentrated punchy positions where we think we can make a ton of upside. And even if we’re wrong for a little bit, let’s say, at a cyclical peak or a cyclical trough, because so much adjustment has been done and foreigners have reversed their previous, whether it was buying or selling to such a degree, or even now in tech, it’s like maybe it goes on a little bit longer at these extremes but, fundamentally, the asymmetry on the risk reward side is pretty acute. And that derives from valuations. It also derives from how many things are going right or wrong at the same time.
Let me give you an example in Russia, let’s say, where…let’s put aside the geopolitics, we don’t really need to get into that whole discussion…but just in terms of how to think about the Russian economy.
So, we’ve said, “Look, what we like globally is value rotation, commodities, oil catch up, inflation protection, weak dollar, return of flows into yielders, assets that already price in a very high real interest rate,” there’s a bunch of things there that we like. Russia’s got all of them, effectively.
I guess my point is our confidence in having views in markets where there are so many dynamics at the macro level that are going right and then, when you feed it down to the country level, you see, “Oh man, okay.” Well, they actually also have an incredibly high surplus already, so, now it’s going from 10 to 15, the fiscal is in balance, the rates are high…you look at the domestic conditions and say, “Okay, there’s another set of things here that are already at a sort of cyclical trough, fiscal’s tight, rates have tightened. So, levels of economic activity are reasonably low or early cycle or whatever, positioning is low, and so on.” And then you can tie that, at the final level, to asset valuations and, “Okay, well, what is this asset market pricing?” And what I can tell you is most asset markets in EM right now are pricing that EM is just a dead asset class.
I think there are similarities, particularly in those groups where you can identify particular flows or factors, so, commodity income or local bond borrowing or dollar credit borrowing or whatever, there’s certain commonalities that countries can have over time and be sensitive to but I think the key discipline is integrating your synthesis and trying to deal with, “How is this particular country going to respond to the evolution of macro drivers?” I expect.
Meb: Russia’s interesting because we tweeted about it, I said, “Despite being a single-digit P/E,” well, at least until about a week ago, we’ll see what happens, but they’ve been similar or outperforming the U.S. market for the last 3-5 years. And that’s with no multiple expansion but the U.S having massive multiple expansion.
And EM is interesting because you do these wonderful beautiful rankings where you’ll talk about like all the countries in the world exposed to interest rates rising risk or all the countries…I actually love this framing, by the way, you were talking about value versus growth composition within countries and you actually said, “It’s really cyclical growth versus secular growth,” which I thought was such a beautiful way of putting that. A lot of the EM ends up on the kind of places that I think you would want to be if these sort of things transpire.
Whitney: Totally. I think particularly with respect to equities and how we want to be positioned and think about that, it comes back to the point you made before, which is there’s Asia and then there’s all these other markets and EM is not just one blob of things. And actually right now…so, like if you look at a chart of the S&P versus EM assets or whatever, there’s a huge premium, obviously, that divergence looks like the widest it’s been since the dot com, the same thing actually is true if you look at the difference between North Asia in terms of asset valuations and these reform debtors, which are a lot of the Andean countries, Mexico, Brazil, South Africa, Central and Eastern Europe, etc. There’s a huge degree of divergence within EM.
What I think is about to happen is we’re setting up for a pretty good beta/rotation opportunity but in the equity space, because I think there’s going to be this unwind in the U.S. and equity markets, at the end of the day, remain, to some degree, geared I mean to each other…so, like let’s go back to dot-com unwind. U.S. stocks are down a huge amount, EM stocks are down sub 10%. So, it’s that kind of potential landscape we could be in for. In that world, I want to be maximum probationary. I’m playing for alpha diffs, so, I’m like, basically, a lot of the stuff we’ve talked about, the Andeans, particular markets in Central and Eastern Europe, versus being short the growthy stuff in North Asia.
And so, I think that divergence, that’s the first point. We’d rather play for that than beta risk in equities right now because of how perilous this dynamic of wealth destruction in the U.S., rates rising, the shift in the inflation paradigm in the developed world, populism and how all that plays out. Like during this beginning part of this hiking cycle and market risk off I think, in the U.S., we pretty much want to steer clear of directional beta. So, we would just lean into grossing up your diffs and playing for alpha within EM because, like I say, divergences are very wide. And actually, the intra-EM correlations now of stock markets and local currency terms are the lowest levels they’ve been since 2002. So, actually, the alpha landscape is good. And then, within that, we, to your point, would have a preference for, what we would call, value sectors in value countries that have trough or near trough currencies and foreign positioning. So, we get the upswing of the rotation, the earnings benefit that banks and cyclical plays will get. The benefit of being able to capture, effectively, high nominal GDP growth as profit rather than just revenue or whatever, monetizing the high nominal growth environment, they’ll be able to do that. They’ll have the inflection from currency gains, as flows come back into these markets.
And I love your point on Russia because I think it just connects nicely to the prior convo, which is like Russia had a balance of payments crisis in 2014-15 the size of which is comparable to what they dealt with in the 90s. So, they had 8% of GDP loss in oil income because of the oil price collapse. And so, that would’ve pushed them into deficit but, of course, they were sanctioned at the same time so they couldn’t borrow externally so they did a huge adjustment. Rates went to 14, interbank rates went to 31, stocks went to 4 times earnings, to your point. Earnings as a share of GDP, never lower. Like everything is just as terrible as it can be, we didn’t get an oil rebound after that, you don’t need a huge oil rebound, you don’t need a huge rebound in foreign capital. All you need is for the adjustment process to be over so that, once that need for foreign capital is no longer a problem and impacting your currency, you can ease rates, ease up on the fiscal tightening, growth can come off the floor a little bit, and you get the asset re-rating that just comes with like relief. “Oh, okay, relief. We’re not in a crisis anymore.”
And, as I say, it’s very typical to have political disruptions at those points, and people point to them today all the time, and geopolitics in Russia is just another one of those things, but, at the end of the day, you had geopolitics in Russia, that entire time you’re talking about and, despite sanctions on foreign capital, despite all of the geopolitics, you had huge rationale performance from the 2015 BOP trough straight through to, basically, September. Even through COVID you’ve had it. I think that’s a nice thread because it pulls together what you were saying before.
Meb: I like to needle my followers and frame things in a certain way that gets them to think…an advisor had emailed in and said, “Meb, I like your thesis on valuations and emerging markets but…”and he’s using an example of Russia, he goes, “look, Russia outperforms sometimes not because of valuation but because people die and disappear, accounting is suspect, property can be seized by Putin, liquidity, etc., etc.” I took his email and I responded and I just edited it and I said, “Maybe my devil-advocate response may make you think a little bit,” I said, “perhaps the U.S. outperforms sometimes not because of its valuation, because people die and disappear,” and I said, “Epstein and Princess,” “accounting is suspect, Enron, property can be seized by the government,” and I said this has literally happened across the street from my house, if you google “Bruce’s beach,” liquidity flash crash, etc., etc.
Whitney: Even the arbitrary treatment of capital during crises, like Washington Mutual, why were the bondholders let go, whenever something happens in EM at one of these troughs, that seems to cut across the grain of what people want to see who are already bearishly inclined and so forth. There’s this, “EM, oh, it’s dead, it’s never coming back, it’s all over from here.” The reality is like Russian assets, Russian stocks trade in a multiple range of four times to eight times. Okay? So, the point is there’s a few reasons behind that, one, is yeah, sure, China Russia, terrible rule of law compared to pretty much any other market in EM. Systematically, if you look at this through time, the bigger driver of the Russian P/E discount is that it has the highest economic growth and inflation volatility of any market in the world. So, if you think about investing in stocks, you would pay a higher multiple for steadier earnings streams. You can take that logic and apply it to Russia. But the reality is going from four times earnings to eight times earnings, you can still double. And the thing about Russia and EM in general is you’ve got these structurally high returns in terms of profitability, you’ve got extremely high capitalization levels, valuations of like, as I say, three to four times today across many of these markets, and yet no external or balance-sheet fragility, surpluses. No inflation issue, which is much less bad than the U.S. and the developed world in general, tightening that’s already been done to deal with that inflation proactively. So, like my issue with the U.S. and what’s going to happen here, what has been happening is you point to problem-children EM but it’s the developed world that has turned out to have peroneus monetary and fiscal policy. They’re the ones with these deeply negative real rates, twin deficits, printing, and spending, and so forth. So, it’s the EMs who have been…even if you don’t like their leaders or they don’t say nice things or there’s geopolitical tensions or, in a level sense, there’s always going to be a discount on Russian equities, which is probably true, that the cyclical dynamics don’t mean that you can’t generate huge amounts of return, just like you did in the 2000s upswing. All these things were true, have been true in EM for a long time in a level sense. So, why point to like a secular thing that’s existed and, if anything, gotten better, which is economic and administrative governance, take that thing and then point to it cyclically and say, “Okay, I’m not going to buy the cyclical trough.” Like that doesn’t make any sense to me. You make the most money at either end of those cyclical inflections, whether you’re shorting on sustainable booms or you’re buying unsustainably-distressed assets after one of these adjustments.
Meb: I think it’s a great point when you talk about a lot of these markets where there’s, quote, blood on the streets but they get to be so cheap. It’s not that you need things to go magically so right, you just need them to not go terrible. And so many conversations I have with advisors and investors and they say, “Meb, I don’t know what to do. The U.S. market, I hear AQR, Research Affiliates, or GMO, all these huge investors say that…” even Vanguard before BOGOF passed, he’s like, “I expect U.S. stocks to do 4% nominal.” This is, I don’t even know, 50% ago or whatever it may be but it’s low expectations. They say, “Bonds yield nothing, there’s nothing to do.” And I’m like, “What are you talking about? You look at emerging markets, some of these funds, the value funds, yield 5-6%.” Like what you’re talking about, some of these Russian stocks are so stupid cheap.
Whitney: Twenty percent yields plus.
Meb: Twenty percent yields.
Whitney: And secure cash flows.
Meb: All right, a couple more questions. I’d love to keep you all day. What could go wrong? So, as a good analyst, you’ve been through the cycles, you know that every portfolio manager, investor in the world has to think about the opposite case. And despite this being a pretty hard obvious bull case, this is like a high school level debate class, I’m like, “All right, Whitney, sorry, I got to be on the emerging-market bear side.” What could theoretically go wrong to, potentially, derail or delay this thesis?
Whitney: The first thing I think I would say is, to your previous point, the starting point gives us a lot of buffer. And coming back to the asymmetry issue, like there’s distress priced in. So, something worse than distress has to happen if you think about how to generate really bad outcomes. I think the most bearish scenario, which I think is…I mean we talked about this in a report a couple months ago, I put a probability of like 5% on it, is a global deflationary scare of some kind which brings down everything that’s gone up. It brings down commodities, it brings down consumer demand. So, you get a big real growth and nominal contraction or even just a big slowdown. It’s really the inflation part of the story would need to falter, I think.
And so, otherwise, I think we’re pretty much on a course here for a Fed tightening, very strong real global growth. So, there’s a global growth boom going on, it’s essentially accelerating in EM. It will accelerate again in DM, as we get into this year. And so, we’re in a pretty good environment from a growth standpoint. Yeah, sure, the mix has gone to more like every dollar spent 75 cents is on inflation or affording the same thing you were buying before, 25% is on buying more stuff. So, you got a bit of a deteriorating mix. But I think the unwind of all of that it’s hard to understand how it would play out because you’d have to then kind of piece it together with what the policy response would look like. Because it seems to me we’re going to get a hiking cycle. I think the biggest questions are, “Is there just enough rapid supply that can come on stream somehow or something that unlocks bigger supply expansion than we’ve already had to bring that down?” Or is it going to prove to be the case that the rate hiking cycle, the economy is very sensitive to that and we end up overdoing it? Or whatever. Something like that I think. But even in that scenario that would be like a global risk-off event. Foreign capital would not go back to EM, commodity incomes would fall, EM earnings would fall, but so would earnings, obviously, everywhere else. Probably more so. DM economy should be much more geared to that kind of environment, I think. Potentially a weak growth problem, some destruction of wealth having created a growth slowdown, that type of idea.
In that eventuality, it’s like people sell the assets that they own. If there’s a de-risking, you have to have the risk to sell. And no one owns anything in EM. Almost to your point, they’ve withered to markets that are incredibly small. In a lot of the markets we like, foreign involvement in their entire stock and bond market in local currency is 5% to 10% of GDP, it’s just nothing. So, it’s actually I think very difficult. You can get acute periods of weakness because foreigners can sell very fast but they just don’t have very much left to sell, so, you can’t really get a prolonged…like we’re not going to see another 10 years, like we’ve had an EM, where you go from record foreign dependency and record overevaluation and positioning, you do the 10-year adjustment, now you’re at the trough on all of those things. Even if there is like a risk off event or something like that, globally, it’s hard for me to imagine a lot of EM underperformance, if you see what I’m saying.
Meb: All right. We got maybe three questions left. We’ll tie on to that one. And here’s another one I get almost every day, they say, “Meb, I hear what you’re saying but I invest in the S&P. Forty percent of the S&P’s revenues come from abroad, therefore, I’m diversified, I’m good, I have all my money in S&P.” How would you respond to that? They think the revenue diversification gives them the portfolio diversification of foreign and emerging.
Whitney: So, I think that’s probably not going to work because, at this point, it’s not the earnings that matter. It’s not like who’s earning streams you’re exposed to, like I sell some cars in China, it’s what multiple is my stock trading at because everybody in the world has bought S&P index futures or whatever. People talk about this all the time with respect to tech, “Oh yeah, but Amazon’s still going to exist in 10 years, they’re still going to grow earnings X percent.” It’s like, yeah, of course they are. Like Amazon existed at the peak of the dot-com bubble too, they just went down a lot after. So, it’s more of that the valuation correction that needs to happen here has been propped up by both that insane amount of domestic flows that have been created but also foreigners seeing, for 10 years now, that the U.S., and earlier on China, were the only games in town, putting all their money into it.
So, I think, when you think about diversification, there’s a lot of different ways to think about that, you should have as much of it as you can I think while concentrating some of your higher conviction alphabets. But when I think about it, it’s like, “Okay, I want to have exposure to particular markets that benefit from commodities and inflation hedge assets and will be the recipient of these equity flows when they leave U.S. assets and they go into other markets, chasing banks because rates are going up or materials or energy,” or whatever it might be. It’s the valuation that the flows create that you’re pretty much needing to diversify yourself.
Meb: I always tell people, I say…actually, your comment is arguing for the opposite. I say, “In a world of globalization, where most of these countries, by the way, have a higher percentage of revenues from abroad, you should be border agnostic and want the companies that are much cheaper or the ones that you could buy for a lot less.”
Whitney: Yeah, it’s not that you’re playing the earnings stream abroad, you’re playing the, “Oh man, U.S. equities are more expensive versus literally everything else in the world than they’ve ever been.” So, you want to play the actual P/E multiple abroad effectively.
Meb: All right. So, let’s say, a giant institution…maybe not giant, let’s say, a 500-million-dollar institution listens to “The Meb Faber Show.” They say, “I love…Whitney,” ring you up and say, “we’re going to subscribe to your research offering. Make some room for us, I know you’re full up, but we’ll squeeze in.” Maybe this isn’t specific to this one, maybe this is just broad generalization advice. Someone comes to you and they say, “All right, how much EM should I include in my strategic allocation for the next decade? I’m a traditional 60/40, U.S.-only, plain vanilla shop. We’re thinking about our endowment, we got a long-term time horizon. How much is a reasonable amount?”
Whitney: The first thing to say is, by and large…I mean we got a tail of institutional types, by and large, we deal with a lot of macro CIOs and their teams. And they’re doing more of the trading in and out of particular assets within EM. We do have some endowments and institutions as well. And so, what I would say there is there’s not an easy solution.
Meb: You can say all of it. You can say just, “Sell it all and put it all…”
Whitney: No, it’s not possible. The thing is it’s not even possible. Like, to your point before, EM market caps have shrunk to such a degree that it’s a really narrow door now on the way in. And that’s also part of the argument and part of the coiled spring dynamic when foreigners start to come in and the market is so small. They tend to come in through mutual funds or vehicles, you get this allocation on mass, and that’s why you get these really jumpy price moves on the upside when that whole cycle kicks off.
But it’s not a big enough asset class for your endowments and your pensions and your insurers and so forth in, let’s say, North America to really consider putting a huge amount of their book in it. And the problem is…I mean they should definitely have, I think, more than they do now and, to the extent they have ability, to look for alpha in EM as well, I think there’s that whole plethora of opportunities is better than, almost to your point before, like Latam, the hardest hit of the hardest hit there where you actually see some prospect of forward returns and you’ve got the inflation protection or the sort of secular angle here, which is protecting yourself from the issue with rising nominal rates and rising inflation.
Because the problem is, for 40-50 years, these guys have been riding this move down in yields and that’s underwritten all balanced portfolios. So, you have, you know, when it’s risk-off, my stocks go down but my bonds go up and so on. What happens if the risk off is happening like the 70s or something like that where it’s more inflation-driven and so your bonds don’t offer you protection? You have a huge home bias to dollar, which is, obviously, hugely overvalued in real terms and, as we’ve talked about, propped up by these flows.
Mainly, I think, my advice would be to get out of as much dollar stuff as you can and to try to find a broad…even to be diversified within your inflation hedges.
So, like a funny thing last year was that inflation, obviously, shot up and the whole thing went according to script, inflation hedge assets didn’t do well, except for commodities, and yields didn’t move. So, that’s just another one of those disconnects that exists. This year, they’re all lining up and going sort of properly but you’d want to have some other developed-world effects. You would want to have some tips and some precious metals and some broad commodities and other elements. EM currencies and, I said before, EM high-yield commodity plays tend to be the ones that just are standout outperformers, even absolute performers, in those environments. So, those are parts of the kind of inflation protection mix you should have, as well as having this other huge cyclical opportunity in those markets. It’s just going to be hard to get out when U.S. assets, at this point, dominate so much of global market cap. There are going to be wealth losses created by the reallocation. It can’t possibly happen fast enough, I think, given what’s going on with inflation, to actually protect.
Meb: I tweeted out something where I was talking about a lot of these really expensive stocks in the U.S. and I said, “It feels like one of these moments where you blink and many of these companies are down 40-60-80 very quickly.” And a lot of them are now. But on the flip side, it’s you blink and, all of a sudden, some of these totally huge drawdown low valuation you started to see in the U.S. with some of the companies last year where the shorts just got incinerated. And people I think framed it as a meme world, but a lot of it is just like they’re so cheap that it’s like kindling where it just totally combusts.
All right, two more questions real quick. You worked for two of the macro sort of like Mount Rushmore shops in your career, which is incredible. Any major lessons learned you picked up from those shops that have really stuck with you and you keep in your tool kit today, whether it’s framework, whether it’s just ways to think about markets, etc.?
Whitney: In terms of refining our investment process and how I think about macro investing and running our portfolios, I take a lot away from all of those roles. At Soros, I would say, my strategy was, effectively, running a macro book and a financials long-short book. So, I started as a financials equity person in EM. And so, that sort of naturally brought the money and credit angle to the macros, I always treated them as macro instruments anyway.
And so, in that role…I’ll give you two things, one’s very tactical and one’s related to process. The tactical thing I learned through that period was, if you have a view on something, let’s say, you have a macro view, try to be exposed to the thing that’s the closest to that view. Like, if you like gold, buy gold, don’t buy gold miners. Or something like. That basically concentrating your conviction views in things that are very geared to those and then hedging out the stuff that are the risks that you don’t have a view on or you don’t want to take or whatever and getting concentration that way. So, that I think was important.
The second thing I think is just really I think from Soros that it’s a bit of a more concentrated style, when I was working there. And I think the idea of just kick the tires until there’s no tires left to kick, basically. Like have the most rigorous process for increasing your own conviction. Because, if you can demonstrate a high win rate through time, I mean, obviously, it brings down the diversification of your portfolio but, if you can kick the tires really hard and make sure that you are concentrated in stuff you have the most conviction in, for me, I found that to be additive.
At Bridgewater, I was the head of emerging markets for them for 5 years. That was a very different role, much bigger, more focused on big liquid assets, big macro trades, no more dealing in single equities and so forth. And I think the biggest thing that I learned from Bridgewater…so, I mean I had a, I would say, quasi-systematic process before I came to Bridgewater, in the sense that I had created all of these signals and artifacts and me and my team had this, sort of, IP built up. But not to the degree that I do now with my investment process that we do now.
What I think is so great about it, like, let’s say, you’re a discretionary stock investor and you’ve got a portfolio of 30 stocks and you’ve got like a whole story to remember on all of those stocks, or whatever, it’s, obviously, not what we do but just as a good example. A lot of your mindshare is taken up by all the 80 things going on across the micro of your book. Having the ability to basically free your mind share by saying systematically, “Oh, here’s a risk. Plug it into my framework. Does it matter or does it not matter? Oh, no, it’s too small a flow, doesn’t matter. Okay. Well, get out of my face, I don’t care. Next thing.”
It’s like the systemization of having frameworks that are tightly substantiated with systemizing these linkages and how they work really allows, me anyway, to cut through a lot of the noise. And trading across 20 countries and 5 asset classes, there’s a lot of noise. Most of it doesn’t matter at all. And so, the more I can free up my mindshare by having a process and an architecture that allows me to discount things and get them out of my head when I don’t need to worry about them, the better I am. So, I think that was the main thing about systemization.
Meb: What’s been your most memorable investment over your career? Good, bad, in between, but one that’s just burned into the brain.
Whitney: Oh man, there’s so many.
Meb: Well, you can tell a couple, if you want, but usually, we’ll start with one.
Whitney: No, I’m going to tell you one that’s kind of cute. And this is going way, way back. This is back when I was investing in financials. And there’s something very great to me about…because our process tends to be a little bit counter consensual, we’re shorting stuff, we’re at the end of the cycle. When everyone’s all in, we’re longing stuff everyone hates, and so forth. It’s always very satisfying to me when there’s a consensus view that turns out to be wrong. As a sort of description of the trades that make me the happiest, I like those ones. But as a fun thing, you always like those trades that are huge moves in one day. I’m not giving you any sort of like useful input here but they’re always the most fun.
So, I remember way back, when I was in Scotland at a place called “Resolution,’ at the time, this was 2009, I was working as a financials PM on the North American desk, actually, at the time, and I was involved in one of these FDIC deal banks. And I was just waiting, I just got so much conviction that this deal was going to happen, the bank was super cheap, super rate-sensitive anyway, and there was all sorts of reasons, I liked it from a macro perspective. And then like one day you come in and the deals happened and the thing’s up 60%.
Or like, more recently, we did a trade which actually made me feel slimy on the inside, and still does, which, obviously, I’m happy we made because it was profitable. But it was China Huarong Asset Management, which is one of the big resolution trust corp equivalents in China. So, one of the four big asset managers that helped take over all the bad assets off the banks. These things have been around for ages and they’re systemically…I called it “China’s vampire squid” because it’s like that kind of thing where they’re in every systemically important part of the economy. And that thing got down to like 57 cents. I know the internals of that whole part of China so well, the Chinese financial system and balance sheet, that there’s no way they could’ve let that thing go. I mean it just would’ve been like Lehman times five, for China at least. And so, that was a trade that made me feel really creepy but that, ultimately, pulled back to par and was satisfying.
Meb: Whitney, I love it. This has been such a fun chat. We’re going to do this again in the future, I hope, and get into all sorts of my other notes. Where do people find you? They’re not going to find you on Twitter, what’s the best place to go and try to ‘pretty please’ talk their way into, getting a hold of some of your research, what’s the best home base for you?
Whitney: I’m super analog. We just have a website, I don’t do any of the Twitter stuff or any of that. So, I think, if you’re interested, just go to totemmacro.com and just shoot us an email through there and we can get in touch.
Meb: Awesome. Whitney, thanks so much for joining us today.
Whitney: Great. Thanks so much for having me, this was fun.
Meb: Podcast listeners, well post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at feedback@themebfabershow.com. We love to read the reviews. Please review us on iTunes and subscribe the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.
