Across the world many countries are faced with rising food and fuel prices as result of the invasion of Ukraine. This is particularly worrisome for emerging market economies as the FED has started raising interest rates – usually a negative for these economies. The rise in interest rates in the US and a stronger dollar makes import dependent nations with low foreign exchange reserves vulnerable to defaulting on their debts. The strength of the dollar coupled with inflation makes imports that much more expensive relative to weakened currencies. Like the Asian Financial Crisis in 1997 once the global interest rate environment changes emerging market economies will end up hurt from capital outflows and asset busts within their respective countries. This cycle in the globalized financial system is often referred to as the global financial cycle.
The global financial cycle as thought by French economist, Hélène Rey, is the idea that asset boom and bust cycles tend to be more aligned with other economies around the globe due to the shared dollar system. These asset booms tend to be aligned with periods of low interest rates in the United States. Eventually when the FED opts to hike interest rates, dollar denominated private finance heads back to the US and out of the emerging markets resulting in a bust globally.
Photographs of: Hélène Ray and Jerome Powell
In the following blog post: Emerging Market Crisis (2). I will explore a few examples across the globe of the consequences of the global financial cycle. Some countries have already began searching for bailouts from international lending organizations and others have defaulted on their debts. The benefits of a globalized financial system are many in number, but this current period may end up being a warning of the negatives of a globalized system.
In the Berkshire Hathaway annual letter to shareholders for the year 2000, Warren Buffett credits Aesop (Greek fabulist) for laying out the formula in valuing assets in what would’ve been around 600 BC. The fable is as follows:
“A Nightingale, sitting aloft upon an oak, was seen by a Hawk, who made a swoop down, and seized him. The Nightingale earnestly besought the Hawk to let him go, saying that he was not big enough to satisfy the hunger of a Hawk, who ought to pursue the larger birds. The Hawk said: “I should indeed have lost my senses if I should let go food ready to my hand, for the sake of pursuing birds which are not yet even within sight.”
A bird in the hand is worth two in the bush.“
The formula when replacing birds with dollars has 3 essential questions an investor needs to answer. The 1st being how confident is the investor that the bush contains birds. The 2nd is a question of how many birds are there and whenthey will emerge. The 3rd and final question is to determine what the risk-free interest rate is. Essentially, investing is finding the present value of future cash flows and determining if it is sensible at present interest rates to outlay the cash now. This formula on determining the value of an asset is immutable. No new inventions now or far into the future will change the formula one bit. All that needs to be done is plugging in the correct numbers (far easier said than done) in the formula and one can begin rank the attractiveness of different assets.
Buffett also warns that common yardsticks like dividend yield, the ratio of price to earnings or book value, and growth rates don’t inform you on the valuation of a business but instead should be used as clues for the amount and timing of cash flows in and out of the business. For example, if someone pays an amount of cash on the promise of future growth that exceeds the discounted value of cash that assets will generate in later years this will lead to a poor return on investment. This shows that the price paid directly affects the return on investment. Growth is a component in the equation of finding value that is usually a positive but can be a minus. Growth & value should not be looked at as two competing investment styles as they are joined at the hip.
Another important element to the formula to consider is the difficulty of predicting when and how many dollars (or birds) will come out of the business (or bush). It is better for the investor to remember the words of Keynes in this regard: “Better roughly right than precisely wrong”. It is better to consider ranges than exact figures. On some occasions the very conservative estimate may see a price quotation very cheap in relation to its value. If this condition can be met the investor can then realize a margin of safety and make an investment decision. To reach such a conclusion an investor should understand the business economics of the companies in question.
Most of the time, it will be difficult for the investor to come up with a logical conclusion on the number of birds inside the bush even with broad estimates. This occurs when the looking at newer businesses and rapidly changing industries. An investor should try their best to remain in their circle of competence – even then there will be mistakes to come. It is best for the investor to stay away and avoid any speculative capital commitment.
Over the long term, many businesses will continue to uncover their birds in the bush and create immense value. But for the businesses that lose money over their lifetime, value can only be destroyed and not created regardless of how high their valuations may rise in the short term.
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