History Did Not End. The Emerging Markets Story Did.


Warsaw, Poland

In a famous book * published in 1992, Fukuyama boldly proclaimed the end of history. By this he meant that the world had finally reached a consensus on the best form of government. History, he opined, was on an irreversible journey toward liberal (i.e. free market) democracy. There would be setbacks, but the end point, according to him, was a world in which all countries would eventually adopt Western style free markets and democracy.

Fukuyama went even further. He suggested that a “post-historical world” would be established on a transnational rule of law, something like the European Union. “God, national sovereignty and their military” would be things of the past.

Tell that to Vladimir Putin, Shinzo Abe and Xi Jiping!

Without getting into an academic debate that I am sure to lose (Mr. Fukuyama’s credentials are much higher than mine and he has since nuanced his views) let’s agree that with hindsight all this seems a bit optimistic.

Nonetheless, the brief burst of capitalism around the world at the end of the last century has substantially influenced investors’ behavior. After having shied away from international funds, American investors suddenly became enamored with frontier investing. They flooded ever more risky emerging markets with ever more money. The less developed a country was, the better the opportunity it appeared to be. This was because of the greater distance it had to travel on the supposedly clear path to prosperity.

For two decades, massive liquidity flows turned the emerging market story into a self-fulfilling prophecy. They have slowed down recently.Today, the Morgan Stanley Emerging Markets Fund Inc. (EMF) trades at the $15 level it traded four years ago. Even worse, the flow of money into emerging market funds has reversed.

Investors are taking their cue from local capital which usually knows best. Already in 2011, $946.7 billion of illicit capital fled from developing countries according to he non-profit organization Global Financial Integrity . This trend has likely continued.

While this reduction in flows may not prove permanent, for the time being at least, it is clear that appetites for risky country investments have diminished. Emerging market growth has disappointed and many regimes have shown their true colors. It appears simplistic now to paint emerging markets with broad brush strokes. The BRIC countries, for example,no longer appear to have much in common. India is mired in corruption. Russia is a kleptocracy wholly dependent on commodity cycles. Brazil is again “the country of the future”; it always is. Only China is still enjoying rapid growth, although this miracle economy is also beginning to experience growing pains.

If humanity is on a long march to political and economic freedom, countries are taking very different paths. Declaring the End of History was premature.

I trust our children are happy to know they are not irrelevant, after all.

The World After it Ended.

The global flirtation with free markets and democracy has been short lived. Francis Fukuyama – and so many other pundits – mistook the global wave of freedom set in motion by the Thatcher/Reagan revolution for the inevitable march of history. One problem here: history is written by men and women. Different generations have different views and priorities. So do different leaders.

Countries around the world are returning to more comfortable ideologies. Tony Blair and Bill Clinton may have kept the flame of economic freedom burning for awhile, but they are similarly fading in people’s memories.

Well into the new century, there is no denying that the pendulum of history is swinging back. In the developing countries, interventionism, stronger regulations and money printing have replaced supply side economics, deregulation and monetary orthodoxy of yesteryear. Add to the mix a strong dose of isolationism in the US, currency manipulation and militarism in Japan, bland social-democracy in Europe, fascism in China and the glorious uniform world imagined by Fukuyama starts to look more like a messy patchwork. Not to speak of Russia’s ambition to recreate a Soviet-Lite empire.

Implications for Investors.

International investors should pay attention. Political risk has been absent from our lexicon for too long. Flows of funds and commodity cycles should not be confused with structural changes. In other words, Brazil is not Mexico. Asset inflation is not wealth creation, no matter what the Federal reserve Bank wants us to believe. Mexico’s difficult road to competitive capitalism is much more promising than Brazil’s commodity induced boom.

Similarly, earnings in Egypt are obviously not the same as earnings in Germany. PE ratios should reflect that. Too often in the past two decades earnings multiples have been determined by growth projections with no regard for risk. It was thus not uncommon to see emerging markets trade at a premium to mature ones. Today, some sectors in China or India are still trading at multiples that do not take political risks into account.

Political and economic systems do matter when making asset allocation. Once the effects of massive liquidity fluxes evaporate, fundamentals will reassert themselves. When that finally happens, would you rather overweight Greece or the Netherlands?

Asset Bubbles

The Japanese know a few things about excessive liquidity. The Tokyo stock market is actually the poster boy of bubble-burst cycles. Japan’s experience has therefore been studied at length by economists around the world. Ben Bernanke, for one, has paid close attention.

So, how did Japan react to the stock market crash of 1989? It spent money, lots of it. The country has since been a revolving door of Prime Ministers, each trying to outdo his predecessor with a better Keynesian stimulus program. And what does Japan have to show for it? Growth remains elusive and the country’s public debt load is now crippling.

Something is changing now, but for reasons people do not talk about much. Japan has enjoyed a new dawn with Shinzo Abe’s well publicized “Three Arrows” policy: deficit spending, money printing and vague structural reforms. It all sounds refreshing, but these arrows have been shot before. What makes Prime Minister Abe’s plan substantially different from his predecessors’ lies elsewhere: two more stealth arrows consisting of a currency war and remilitarization.

The effects of the former are clear to see. The yen has lost 25% against most currencies over the past year. The orchestrated devaluation has resulted in an explosion of earnings at most export-oriented blue chip companies, further instilling a new sense of optimism that greatly benefits the domestic economy as well.

Japan is back. The stock market is rebounding and GDP is growing again. The temporary wealth effect is fueling consumption and it is not unreasonable to expect it to go on for a while. In spite of the coming sales tax increase, redistribution of wealth Japanese style should keep the economy going.

Prime Minister Abe wants the private sector to help him increase people’s buying power. Keidanren, the influential employers’ organization, got the message. It is thus officially encouraging its members to help create a virtuous circle by raising wages. This being a disciplined and egalitarian society, companies are likely to comply.

In light of these developments, how can one not be bullish on the country’s stock market prospects? Next year Japan is going to experience the continuation of its current very loose monetary policy combined with wage inflation and more debt financed public stimulus, focused on the defense industry this time. Being long Japanese stocks while hedging the currency should pay handsomely for a little while longer.

However, history buffs will notice some worrying parallels with the 1930’s here. In a depressed world economy, seeking advantage through a weak currency has been tried before. Even more worrisome is the possible repeat of 1930’s military adventurism. Abe is rearming Japan. He is changing Japan’s pacifist laws. The escalation of tension with China is even bringing Japan to conduct military exercises with unlikely allies like India.

So, while watching with great apprehension the military build up in the region, I am still overweighting Japanese stocks. The portfolio includes export champions like Komatsu (KMTUF) and Toyota (TM) as well as leading internet consumer stocks, including Rakuten (RKUNF) and Yahoo Japan (YAHOY). The best way to play Japan’s defense sector is Mitsubishi Heavy Industries (MHVYF).


It is difficult to know what is really happening in China. Rumors abound of pending destabilizing bankruptcies. Many large state owned enterprises (SOEs) and their bankers are most certainly insolvent. So are many local governments that have been unwisely encouraged to spend recklessly in the aftermath of the global financial crisis. Furthermore, the volume of non-banking loans has exploded. According to an article in MarketWatch*, nearly half of the $2.3 trillion credit growth in the first 10 months of 2013 in China came from non-bank institutions.

Does this mean that China is about to experience a financial meltdown similar to the US five years ago? Some believe so. But, even though it is possible the incoming administration will be able to clean up the mess without creating a liquidity crisis, one thing is clear: China, like all command economies, is suffering from gross misallocation of resources. What happens after such misallocation is a game of whack-a-mole where the central planners attempt to solve one problem only to see another popping up elsewhere, always in an unforeseen place.

Many have touted China’s efficiency. But China is efficient the way Mussolini’s fascism was. Isn’t fascism famous for making trains run on time?

Twenty-first century China has an authoritarian form of government that is closely linked to corporatism and is strongly nationalistic and militaristic. China advocates a mixed economy with the goal of achieving autarky. It is hostile to liberal democracy and it believes in dirigisme or industrial policy. All this defines fascism. Unlike European-style fascism, however, the Chinese version does not bother to add a social element to it.

Again, this matters to investors. History teaches us that fascism is dangerous for neighboring countries. Even if an economic policy directed from above often appeals to the rational mind, the eventual negative effects are far larger than the early positive ones. This is becoming more obvious today in China with all the money wasted in solar energy, for example. Furthermore let us not forget that fascism and the rule of law, notably property law, never go well together.

Ultimately, in spite of the spectacular growth in dirigist China, brownian capitalism is much better at allocating capital and resources in the long run. A system where economic power is highly concentrated also breeds corruption. Finally, China may be good at producing copy cats, but creativity cannot flourish in an authoritarian regime. A Chinese Silicon Valley is unthinkable as long as free thinking is not allowed.

To top it all, China’s major competitive advantage is fading. Wage inflation greatly diminished China’s appeal as a production hub. It now costs less to produce spun yarn in the US than in China! According to the Wall Street Journal, Brian Hamilton’s Ph.D dissertation puts these costs at $3.45 per kilogram in the US vs $4.13 in China**.

For all these reasons, at this point, I am willing to sit on the sideline. I have no investments in China. A safer way for the audacious investor to participate in that area’s still superior growth is thru US or European companies. Yum Brands (YUM) or Danone ( DANOY) come to mind. Even Apple (AAPL) is a good bet now that they have secured a deal with China Mobile (CHL).


For many, the biggest surprise of last year has been the strength of the euro. Every Anglo-Saxon investor and his brother has now predicted the end of the euro at one stage or another. It did not happen. Neither will it happen in the foreseeable future. On the contrary, the euro club keeps growing as new candidates beg to join, Latvia being the last example. American investors need to face it. The euro exists because of an overwhelming political consensus. Europeans want it. Even in the south of Europe, they realize that adopting the common currency is a way to import German-style social democracy.

What does that mean? Simply put, social democracy is socialism with your eyes wide open. French socialism always runs into a wall because of unrealistic social programs, choking regulations and prohibitive taxes. Social democrats, on the other hand, are realists. Germans like socialism as much as the French, but Germans know how to keep the economic engine going. When it sputters, Germans are wise enough to introduce a little less regulation, fewer benefits and even lower taxes in order to get it going again.

The euro, a mechanism to export Teutonic pragmatism to the more emotional or less disciplined members of Euroland, has worked marvels. Because Spain, to pick one, wants to stay in the euro zone, it has to make structural adjustments. A little less regulation, fewer benefits, etc.. The result is a more business-friendly Europe. How can one argue with that?

Now, with the euro crisis firmly behind us, Europe is calmly reverting back to its long term objectives: sharing the relative wealth and the benefits of modest growth. Europe has fully embraced its place in the world as a demilitarized zone with a me-too economy and pedestrian growth. It is not exciting, but the Continent and the British isles offer some decent companies to invest in.

Among the European world class companies, internet leaders like Sports Direct (SDISY) or Schibsted (SBSNY) stand out. Volkswagen (VLKPY) is likely to overtake Toyota (TM) as the world’s biggest car manufacturer and some technology companies like Gemalto (GTOMY) or Carmat (FR:ALCAR), the artificial heart maker, look attractive. Finally Nokia (NOK) still offers good value at $8.

The End of History and the Last Man ( by Francis Fukuyama, 1992) 
* Illicit Financial Flows from Developing Countries 2002-2011, published by Blobal Financial Integrity 
China Hard Landing is Likely by Andy Xi, MarketWatch of November 20, 2013 
“The Latest Chinese Export to America: Textile Jobs”, The Wall Street Journal of December 20, 2013

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