This Number Points The Way To Outsized Emerging-Market Gains
Growing up in the 1970’s, I thought America was doomed. Inflation was on a path into double-digit territory, and unemployment rates remained stubbornly high. Economists even coined a term for our malaise, adding the unemployment and inflation rates together in a combined “misery index.” By 1980, this figure briefly exceeded 20%.
|Unemployment Rate||+ Inflation Rate||= Misery Index|
Although it may seem counter-intuitive, 1980 would have been a brilliant time to become bullish. Indeed the major stock market indices have risen so much in the past 35 years precisely because the misery index has fallen from its lofty heights.
The reasoning is quite simple. Falling inflation helps boost the earnings multiple applied to stocks, because corporations generate higher profits when they operate in an environment of fuller employment. And higher multiples on higher profits always translates into market gains.
Misery Can Help Change The Status Quo
This might seem like an isolated example, except that this trend plays out repeatedly in stock markets across the globe. Indeed history is repeating itself as we speak. At the start of 2015, Argentina had the second highest Misery Index of any nation, according to the Cato Institute (behind Venezuela). Yet Argentina’s stock market has posted the third-best gains in the world this year, rising 30% (behind Hungary and Denmark, which are each up around 35%). The simple explanation: Argentina’s annualized inflation rate has fallen for seven straight months, to a recent 15%. (Well, that’s the “official rate,” anyway).
It also helps that Argentina appears to be waking up to the ramifications of a disastrous economic policy, as recent polls suggest major political changes are coming. The point is that Argentina’s economic situation remains bad, but is growing less dire.
That was precisely the political backdrop in place in the United States in the late 1970’s, when the Fed was forced to push interest rates to punitive levels to break the back of inflation. That tough medicine set the stage for an eventual economic boom.
Who’s Going To Benefit Next?
This backdrop shouldn’t serve as an endorsement for Argentina. That country will undoubtedly snatch defeat from the jaws of victory, as it has repeatedly in the past.
But there are a host of other countries that are grappling with a high Misery Index. And once they make progress on the twin pillars of unemployment and inflation, their stock markets could boom.
Let’s start with Brazil.
At the start of 2015, the company had a Misery Index of 43%, the sixth-highest figure in the world, according to the Cato Institute. The Brazilian economy, which had grown an impressive 7.6% in 2010, has been slowing ever since. It grew just 0.1% in 2014, according to the World Bank.
Now, let me reel off a series of recent headlines in the financial press last week:
• “The World’s Seventh-Largest Economy is in a Downward Spiral” — Business Insider
• “Brazil Faces Political and Economic Chaos With an Uncertain Future” — Canada’s The Globe and Mail
• “Brazil Inflation Hits 12-Year High” — BBC
• “Analysts Expect Brazil’s Economy to Contract 1.8% This Year” — Fox News Latino
That’s a scary enough backdrop to make you run for the hills. But investors already have. Brazilian stocks, as measured by the BOVESPA index, have lagged the S&P 500 by more than 100 percentage points over the past five years. Thanks to a sharp drop in the Brazilian real, the return for U.S. investors has been even worse.
Yet here is what the financial press always misses. When a country is suffering from bad economic policies, the pressure builds for a wholesale replacement of the political class. And that is precisely what is happening in Brazil right now. Rumors abound that the country’s vice-president, Michel Temer, may be angling to take the reins from president Dilma Rousseff, who has an approval rating of just 8%, according to the New York Times.
This is an instance where the economic environment in Brazil may continue to languish but shares may stage a robust relief on hopes for governmental change. If you wait for the Misery Index to fall, you will already have missed out on this market’s eventual rebound.
Infrastructure Spending Could Jumpstart India’s Economy
A similar scenario is underway in India. That country’s central bank is holding the bank repurchase interest rate at 7.25%, which is among the highest rates in Asia. Yet wholesale prices in India have been steadily dropping this year, which could lead to an eventual cut in interest rates. Recall that it was the beginning of a rate cutting cycle here in the United States in the 1980’s that launched our bull market.
I’m equally intrigued about India’s plans for major infrastructure investments, which I spelled out last month. My colleague Amy Calistri, who pens our Stock of the Month newsletter, is a big fan of a key ETF targeting this niche. Investments in infrastructure help to reduce inflationary bottlenecks while enhancing an economy’s productive capacity.
Risks To Consider: Can things get worse in emerging market economies such as these? Surely. Ongoing economic weakness can lead to civil unrest, which can spook global investors. These are not investments for the faint of heart.
Action To Take –> If you want to score the most robust returns in emerging markets, you have to focus on countries with deeply-rooted problems. It can be challenging to stand your ground when the monthly economic reports roll in, but efforts to tackle a high Misery Index almost always pay off for investors over the long haul. Other countries with currently high misery indexes include South Africa, Spain, and Turkey.
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