A friend asks:
I’m interested in your thoughts on how you would look at [macroeconomic] fundamentals [for international investing]. Presumably that would involve (among other things) looking at the top industries that drive the national economies?
This question inspired me. Now, I am not a “macro guy” and I am definitely not an academic. I am mostly concerned with understanding the handful of key drivers that might impact a given investment. So if you are a pedant you can quit reading now. You’re not going to find anything to like about this.
Have all the pedants left now?
Great. Before we get in to economic fundamentals it’s worth specifying the high level variables that shape every investment environment:
- Economic growth prospects & fundamentals
- Rule of law / protection of property rights
- Asset valuations
The ideal investing environment is one with strong economic fundamentals; where the rule of law is upheld; and where cheap valuations are cheap. The stars will almost never align in this way, if for no other reason that if the first two variables are looking good, you are going to have to pay up for assets. But that’s the dream, anyway.
This post will focus on the first bullet: economic growth prospects and fundamentals.
The Most Important Things
Before we go any further, I need to emphasize that investing is not as simple as saying: “oh GDP growth looks good so it’s a good time to invest.” In fact, there is essentially zero correlation between GDP growth and stock market performance. What macro analysis helps you do is assess the drivers and risks associated with an economy. When you consider those drivers and risks in relation to valuations, you can use them to help formulate and/or evaluate various investment cases.
Seth Klarman said it best: every asset is a buy at one price, a hold at another price, and a sell at another.
Note that all of this is addressed toward folks who are thinking of investing with a fundamental view over a multi-year time horizon. If you are trying to swing trade currencies you will need to look at the world very differently. (And good luck with that, by the way)
Some of you might say, “well I will be a contrarian and just push money into bombed out economies where stocks trade on single-digit PEs and mean reversion will do the heavy lifting.” That’s all well and good. But if you really think this way I would expect to see a not-insignificant exposure to places like Russia, Brazil and Turkey in your portfolio today.
Otherwise quit kidding yourself. You are a phony.
Why Macro Matters
I talk to a lot of investors who say “we’re bottom-up stock pickers” as if the macroeconomic environment somehow has no impact on their portfolios. I am not sure if these people are genuinely delusional or if this is just something they are used to putting in their pitch decks and have come to recite by rote without thinking.
If you genuinely believe this I think you are reckless at best and a complete idiot at worst. Of course the macroeconomic environment matters. At the very least it shapes the opportunity set.
We also do people a huge disservice by teaching them economics as if it’s physics. Not only is it obnoxiously intimidating but it lends economics a false sense of precision. I believe we should really teach economics using an ecological framework. Macro fundamentals define our economic habitat. There is often a feedback loop between macro fundamentals and investor behavior. If you can develop actionable insights into that feedback loop, you can make a lot of money.
So what we’re really doing with macro analysis is trying to understand our habitat. Thinking about it this way de-emphasizes making point estimates of future economic growth, which are notoriously inaccurate.
What Does a Healthy Habitat Look Like?
In the natural world, we can evaluate the health of an ecosystem based on its values. Here are some ecosystem values courtesy of the EPA:
Economies can be evaluated along similar lines:
- “Biotic Resources” (Demographics)
- Is the labor force growing?
- Is the labor force becoming more or less productive?
- How educated and innovative is the labor force?
- “Biodiversity” (How Diversified Is The Economy?)
- Is economic activity highly concentrated in particular industries? If so, what are their characteristics?
- Is there a diverse array of financial market participants providing ample liquidity? Or are markets fragmented and illiquid?
- “Energy & Nutrients” (How Is The Economy Financed?)
- What does national income look like?
- Is there a current account deficit? If so, is the country heavily dependent on external debt?
- Where is the economy in the credit cycle?
More Energy & Nutrients
I want to spend a little more time on “Energy & Nutrients” as this is where many of the traditional textbook macro concepts come into play. More importantly, when this area of the ecosystem gets squirrelly, really nasty outcomes tend to result. Financial crises and deep depressions and hyperinflations and such.
Let’s start with the classic GDP identity:
GDP = Government Spending + Consumer Spending + Investments + (Exports – Imports)
More commonly written as:
GDP (or Y) = G + C + I + (X-M)
Most of this is pretty self-explanatory, but the X – M term bears further scrutiny. This term is also called the “current account.” If it is positive you are net exporter (trade surplus) and if it is negative you are a net importer (trade deficit). Negative current account balances must be financed somehow. Countries do this either by selling claims on their assets to foreigners or by drawing down foreign currency reserves.
You can decompose and rearrange this identity in various ways. I’m not going to spend a bunch of time doing that here. You can find plenty of resources online. For now just trust me when I say the current account is equal to the difference between investment and domestic savings.
This is a critical concept because there are three and exactly three ways to finance private investment (a.k.a economic growth): 1) out of consumer savings, 2) with a current account (trade) surplus, 3) debt and equity issuance.
There is a school of thought among certain individuals that trade deficits are always and everywhere evil. That issue lies well beyond the scope of this post. What’s more relevant is the potential for dangerous imbalances to build up inside economies dependent on external financing. Dangerous imbalances are the stuff of financial crises, political revolutions and sovereign defaults.
The Example of Egypt
The Egyptian economy is a disaster.
For much of the recent past Egypt was dependent on direct foreign investment and tourism for foreign currency to fund its current account deficit (Egypt imports significant quantities of food and fuel). These sources of financing dried up following the country’s 2010 revolution and ensuing political turmoil, draining foreign currency reserves, driving up government debt levels and ultimately forcing a devaluation of the Egyptian pound (which is pegged to the dollar in a futile valiant effort to maintain price stability).
Essentially, the Egyptian government printed money to finance economic activity. Naturally, this resulted in a dramatic spike in inflation.
Needless to say this is a fragile ecosystem (spoiler: most developing economies are). That doesn’t mean all Egyptian securities are automatically bad investments. However, it has direct implications for the kind of margin of safety you should demand when considering an investment.
You will notice I haven’t said anything about the domestic credit cycle. That’s because I’m not going to bang on about the credit cycle here when I can just have you watch Ray Dalio explain it in a slick YouTube video.
To Conclude: A Brief Note On Currencies
I picked the Egypt example above because of the currency component. Currency is an important wrinkle in international investing. There are lots of different approaches to currency valuation but longer term investors should mostly be focus on the idea of purchasing power parity. All else equal, a basket of goods in Country A should cost the same as an identical basket of goods in Country B.
In the real world all else is not equal. Namely: inflation. So if inflation is 2% in Country A and 10% in Country B, we would expect Country B’s currency to depreciate by 8% relative to Country A.
Purchasing power parity tends to hold up pretty well over long time horizons. In the short term, however, divergences can be significant. For our purposes the important thing to recognize is that a country’s national income and balance of payments have a direct impact on the inflation rate. Inflation differentials are important variables to consider when making international investments, because they influence the currency component of the investment return, which can be significant.