The emerging pendulum

A 2-decades long cycle is turning

(this is the second iteration in the new quick writeup series, with the concept of “one simple idea, one dataset, one investing theme”)

Emerging vs USA

Over the last 3 decades, the balance between markets in emerging markets and the US has relatively steadily swung like a pendulum. One slooow tick to the left, one slooow tick to the right.

See the graph below. Essentially, there is a roughly 20-24 years cycle when the balance swing in favor of the emerging market, before going back to the US and back again. Once in motion, these swings are like massive cargo ships, very slow to stir away.

Like for all very long cycles, it is hard to nail the top or the bottom. But even getting it somewhat right provides handsome rewards. Like investing in emerging equities in the 2000s, or US large-caps in 2010.

Remarkably, each time the emerging markets are on the top, some sort of moral panic about the imminent US decline hits. It was the impending domination of the Japanese economy and even culture until it blew up in the early 90s. And the soon-to-be top world power of China after the 2008 financial crisis.

Alternatively, the bottom of the chart marks the top optimism about the US technological prowesses. It notably marked the top of the dot-com bubble. It is also periods of clear US outperformance geopolitically. Post-cold war, pre-9/11 was the highs of the US unipolar moment. The current solidification of the NATO alliance and massive sanctions on Russia might mark such a moment again.

US Tech rules! Right?

Currently, we are to believe that the US advancement in ultra-advanced chips, AI, search engines, electric cars, self-driving software, cloud computing, electronic consumer products, biotech, blockbuster movies, etc… is a permanent situation.

The world will always socialize on Meta social network, find information through Google, host data on Amazon cloud, want to drive a Tesla and use an iPhone, watch Netflix and Marvel/Disney/Star Wars movies, etc…

Many people have compared our current period to a Tech bubble 2.0. I feel there is a lot of truth to it. But what really matters beyond valuation is the zeitgeist, the spirit of the moment. The US is the best/safest/most profitable market to invest in, and everybody agrees with it. Such confidence might be misguided.

Julian Brigden@JulianMI2

I understand that inertia is a powerful force. But I find it amazing that investors still think that US stocks are the place to be invested and will continue to outperform the rest of the world. I for one, don't take 5 standard deviations (1 in 1mio) bets.

12:58 AM · Feb 19, 2022

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403 Reposts · 2.11K Likes

Even when leading companies like Meta/Facebook (but also Shopify, Netflix, etc…) can collapse by 25% over a bad quarter, this is just a “temporary setback to grab quality assets on the cheap”.

A clear sign of capitulation to me is a lot of otherwise disciplined value investors buying the dip on FB, Netflix, etc…

10-14 Good years ahead

Considering how both returns on stocks and the ratio with emerging market looks, it is time to take most chips off the US table and look for greener pastures. Considering the emerging crisis in Europe from inflation/energy shortages/food prices/war in Ukraine, emerging markets seem to me to make an acceptable destination anyway.

Africa and the Middle East are going to be hit hard by the emerging food crisis. Asia is a good option, especially in mining and agricultural regions.

The easiest pick for me seems South America, especially Brazil. While the incoming election in autumn generates a lot of worries, I fail to see how it is worse than the European situation. In the middle of a commodity boom and rise in food prices, an entire continent mostly exporting those should do fine. The boom will also provide extra cash for social programs without having to resort to outright nationalization or a full socialist turn.

I am slightly concerned about political tides to the left in Peru and Chile, but it is possible that a simple extra tax on mining profit and food subsidies will limit damages.

The quick ideas combo

The previous quick write-up emphasized the undervaluation of commodities compared to financial assets. This is obviously correlated to the outperformance of Western markets, especially US markets, over emerging markets producing said commodities.

So I think the crossing of both ideas can be powerful for the years to come. Commodity-producing companies in commodity-rich emerging markets seem ideal.

I would look more precisely at Vietnam, Indonesia, the Philippines, Brazil, and Argentina. And oil/gas/coal + foodstuff over other commodities, except maybe for gold and copper.

If you are reluctant to look at emerging markets, Australia and Canada are commodity-rich and low population density. So they are likely to be a better proposition than the USA (overvalued) or Europe (in a everything-shortage inflationary crisis).

Unsurprisingly, my personal, very concentrated, high-volatility portfolio built over the last 2 years reflects these themes quite well:

• Brazilian hydropower and oil (Copel/ELP and Petrobras/PBR)

• Argentinian farms and real estate (Cresud/CRESY)

• China/Guyana oil (CNOOC/0883.HK)

• Philippines gold mine (Medusa mining/MML)

• Australian gold mine (Regis resources/RRL)

• Iron/copper/lithium miner in Australia/Mongolia/Argentina respectively (Rio Tinto/RIO)

• Oil & gas deepwater drilling (Transocean/RIG)

Looking at this risk, I guess I should add some more Asia to the list, especially still poor-but-commodity-rich countries like Vietnam and Indonesia.

Most have already moved significantly from their low point, many offering generous (and for Brazilians, outrageously high) dividends. With the cycles of “emerging vs USA” and “commodities vs stocks” both turning slowly in my direction, I feel able to stomach the brutal volatility of these investments.

Political risk is THE major concern, so spreading between 5-6 jurisdictions and 3 continents seems a minimum.

Risk mitigation

One risk that could make this strategy fail is a global tidal wave of populism and the nationalization of lands and mining assets. There is little to do about it, except hope that at least, the dominos will not all fall at once. And stay wary of it to move out the way quickly enough.

Re-investing the dividends in new sectors (China tech?) and quality undervalued compounders like Pepco or Rakuten might be an option as well. I fully expect Eastern Europe and Japan to turn into interesting investment destinations in a few years.

Another risk is a worldwide depression. This could kill the demand for commodities. But in that case, between overvalued financial and tech stock, and the very bottom of Maslow's pyramid, I know which I would pick. If such a scenario looked possible, much less energy and much more farmland would probably be the right rotation.

Disclaimer: I own multiple stocks mentioned in this article, and I am likely to increase this position in the future. This article is for educational purposes only, please do your own diligence, this does NOT constitute investment advice.