The trade after the trade – The markets formerly known as “emerging”

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Before we evolved our process into the format which many of our readers are by now familiar with, we were fundamental Emerging Markets specialists – back at a time when Emerging Markets were truly emerging.

And we’d be the first to call BS on that term as it is commonly used now: as we’ve written before, “Emerging Markets” eventually became little more than another label for top-down allocation, or even worse a meme of “Emerging Markets™” amenable to marketing teams.

We won’t rehash the entire rationale here, but it would suffice to say that if we were to go back to the original definition of “emerging markets” (no capitals), we would promptly exclude China (superpower), Korea and Taiwan (long done with “emerging”) from the list. On the other end of the spectrum, the likes of Turkey is a shadow of its former “emerging” self, and Argentina has been duly re-downgraded into the “frontier” basket. What’s the most exciting thing in “Emerging Markets” these days?

For most people, it’s Saudi Arabia. For us, it reminds us of when Russia was the most exciting thing for most people.

The reality is that the universe of markets that fit that original definition has dwindled significantly, squeezed from the bottom as well as from the top, at the same time as the structure and dynamics of these markets (and that of the global macroeconomy) have been drastically transformed. Putting our former EM hats on, realistically the only markets we’d recognise as having traditional “EM” characteristics would be Brazil, Mexico, Indonesia, India and perhaps South Africa.

We also benefit from hindsight here: looking back, it was clear that the EM bull market that we enjoyed in the firsr decade of the 2000’s was largely a function of China’s hyperspeed industrialisation driving commodity demand from the likes of Brazil, South Africa and Russia. Can we get a repeat of that China-driven bull run? Maybe, but it won’t be driven by China.

In the old EM space, as is happening in the rest of the market, we expect to see the return of dispersion. Working dispersion out requires digging into the peculiarities of each of these markets.

Not same-same, in fact very different

If we had to pick our top candidates for an EM renaissance, we’d have our eye on Brazil and Indonesia, with the driver being commodities.

India would be the idiosyncratic one of the lot: powered by a massive domestic institutional investor base of mutual funds, it is a market that is dominated by domestic flows in all its peculiarity and glory. Foreign investors are welcome, not without their fair share of paperwork, but make no mistake, India is a market for Indian investors to profit from – everyone else is just coming along for the ride.

Brazil likewise has a huge domestic investor base, but Brazil has been a long-time favourite of foreign institutional investors. Unlike India, the investor mix is much more balanced, and foreign participation has a much greater impact on sentiment and price action. ADRs of the likes of Itau and Vale trade in huge liquidity in the US, making Brazil a market that foreigners are comfortable with. A key caveat: the political situation needs to remain stable. It doesn’t need to be perfect, but if we don’t get a Lula government that’s full-on socialist, nor a disorderly contest of election outcomes from Bolsonaro in the event he doesn’t win, things will probably be good enough.

Then, there’s one of our favourite places in the world, Indonesia. As we’ve written before, Indonesia has over the past decade been completely revolutionised, thanks to a decade of what is clearly the best governance in the emerging world, or even THE world. Under President Jokowi’s 2 terms, Indonesia has taken the tough decisions needed to build value add and most importantly value accrual in their commodities space. No longer the target of plunder by foreign companies exploiting the country’s rich natural resources and low-cost labour, Indonesia’s policies were put in place to ensure that value-add derived from natural resource extraction stayed in Indonesia and benefited their people.

From banning raw metal ore exports to requiring majority state ownership of key commodity production infrastructure (e.g. Freeport’s copper mines in Grasberg, or the Nickel mines of Sulawesi), Indonesia has executed with finesse the balance of encouraging foreign direct investment into the country, bringing much needed expertise, technology and capital, and protecting the interests of the country. The result: steady and stable economic growth that is not only sustainable in the near term, but also sets the country up for prosperity in the future, all the result of well-considered long-term thinking rather than simplistic populism and easy fixes.

The people of Indonesia have only themselves to thank: for voting in the right government and supporting the right policies that would bring them long-term prosperity over some short-term compromises. As always, with a two-term limit in place, the question of whether this streak of excellent governance continues come the next elections in 2024 is paramount. We’ll cross that bridge when we get there.

Finally, it’s worth mentioning South Africa as one candidate to keep on the radar. At the margin, South Africa could benefit broadly from new inflows into “emerging markets” as a whole, although it is unfortunately plagued with its own problems: energy infrastructure in disrepair, labour disputes leading to closures at ports and train lines that can’t bring minerals from the mines to where they need to go, to say the least.

Supercycle?

It’s all about the specifics this time: the years of “buy an ETF” are over, even more so “buy the EM ETF”. It isn’t even about “just buy commodities”.

We need to get into the details here, and things need to get quite specific.

When we say we’re on the lookout for a significant bid in EM, there are a couple of triggers that we need to watch for.

Firstly, in commodities. We’ve already seen the seeds of this: a decade of disinvestment in commodity production capacity is the reason behind much of the difficulty in sourcing everything from oil to copper to wheat. We wrote about this here, and notwithstanding ongoing fears of an impending global recession taking the wind out of the sails of commodity demand, our longer-term views remain unchanged. Commodities are in short supply, and countries that control that supply are in a strong bargaining position (as OPEC+ most recently demonstrated with oil).

If we are to subscribe to the view that EVs and renewables are the future, notwithstanding the ebb and flow of sentiment around ESG, then demand for the likes of Copper, Nickel, Cobalt, Lithium and Aluminium, to name a few of these key commodities, becomes structural in nature. One could almost call it a new supercycle.

To that end, simply buying everything across a broad basket of EM names isn’t going to work. Many of the structural trends that are weighing on businesses all around the world also impact many traditional businesses in the emerging world – this is not a return to the “good ol’ days”. Rather, a new breed of companies is likely to draw new flows: businesses that are innovative, deploying technology into industrial applications relating to these commodities and adding value on top of them.

We’re talking hard technology, rather than the fuzzy-wuzzy stuff that characterised the last bull market.

Secondly, there’s the matter of the US Dollar. As it stands, we are seeing a liquidity squeeze happening all around the world, at the end of a 13-year bull market in US assets. In a way, this is the end of the US bubble that started post GFC. The Fed is now relentlessly pulling out liquidity from markets, and faced with a shortage of US Dollars, it is not surprise that the remaining USD in the system is being bid up – hence a strong dollar.

Indeed, USD strength has very little to do with the prospects of the US economy or its expected future standing on the global stage. But one need only look at relative exchange rates to see the picture that is less talked about: the USD index DXY has put on just under 20% this year, with the USD strengthening significantly against most of its developed market peers. In contrast, against the Indonesian Rupiah, it has only strengthened around 9%; against the Brazilian Real, it has actually weakened by about 5%.

Not all currencies are made equal, and certainly not all EM currencies are made equal either. There is dispersion even in the FX markets – the markets know that there’s a difference, and they are expressing that view, whether we notice it or not.

The trade after the trade

To be sure, markets are in a rather precarious position right now. The occurrence of violent intraday moves is ever more frequent, which is never a good sign. We’re not here to call the end of the USD or the end of the American hegemony – we’re not experts in that field. What we do know is that the USD currently remains the currency of choice for trade, especially in energy markets, and that in itself is key.

Does that eventually change? Sure, there are those that point to US action in confiscating US Treasuries and the shattering of trust in the USD as a reserve system as the starting point of the USD’s decline. And with the likes of China, Russia, Saudi Arabia and India all actively and publicly considering settling energy purchases in different currencies, there is a case to say that the wheels have been set in motion.

But for how long they have to turn before we see any significant change – who knows. One does not simply overhaul the global monetary system overnight. Additionally, we’ve now had a bull market in USD that has been nothing short of exponential. After strength, there is always a pullback, and one should not be hasty in interpreting technical pullbacks as structural evolution.

Either way, a slowdown in the USD’s meteoric surge – or even a weakening of the USD – with a backdrop of potentially persistent inflation is a prime concoction for a commodity-driven EM bid to take place, a rhyme (though not a repetition) of the previous EM bull run.

The combination of these ingredients just needs a spark to set it off, and the tinder for that spark to trigger a conflagration is positioning, or rather, the lack of it.

After more than a decade of outflows of foreign capital from EM markets, leaving in search of greener pastures in US listed stocks, the foreigners are almost gone from many of these markets. Ask any local broker in Brazil, Indonesia, India or South Africa about the presence of foreign flows on their books and you’d very likely be met with a shrug – we know, we’ve heard these stories straight from the very people on the ground.

Even if there were foreign flows, they’d be program flows: ETF programs that buy/sell baskets electronically without particular discretion. For many local brokers, their businesses have become almost fully domestic. No one owns EM exposure in any significant size – at least, not the version of emerging markets that we’re talking about.

Yes, at risk of too much repetition, Chinese internet/banks, Samsung Electronics and TSMC aren’t “emerging markets”.

Our base case for the trade after the trade is a commodity driven bull market in emerging markets and the only question we have to ask ourselves is what exactly does emerging even mean anymore. Isolate those like we think we have, and we have a trade that can unfold over a long period of time.