How do you give a country a cardio stress test?
This question drifted through my brain yesterday as I huffed uphill on a treadmill. I was hooked up to a bulky medical machine with a printer that spat out paper showing squiggly lines that reflected the flow of blood through my heart.
The curly lines show the chances that your heart will stop working properly… and lead to a heart attack.
So, how can you tell if an economy is about to have a heart attack?
An economic crisis – a “cardiac event” for a country – can be caused by debt, a fragile property sector or bad banks.
As an investor, you want to be comfortably distanced from these events, lest your wealth gets taken down during the crisis.
In a recent book, The Rise and Fall of Nations: Forces of Change in the Post-Crisis World, Ruchir Sharma – Head of Emerging Markets for Morgan Stanley’s asset management business – identifies 10 indicators to assess a country’s future “health” prospects.
These aren’t just to gauge asset market performance for a country. They’re more like a full-day physical exam, to warn of a full-blown economic crisis.
Sharma looks at these indicators…
Two things drive economic growth – population growth (whether it’s natural or through immigration), and higher productivity (that is, how much a person, business or country produces within a certain period).
If a country’s population isn’t growing, its economy will have difficulties growing. By this measure, Africa is in a great place, and parts of Asia are poised to benefit from growing populations. Japan, on the other hand, is the poster child of terrible demographics. And for much of the developed world – with the important exception (for now) of the U.S. – the demographic destiny isn’t a happy one.
- Billionaire lists.
Over the long term, Sharma says, socioeconomic inequality tends to result in political revolt. To gauge this, he looks at billionaire wealth (for example, from those lists in Forbes magazine) as a percentage of GDP; the share of billionaire wealth that’s inherited; and wealth that comes from corrupt industries.
A more common alternative way to look at this is using the Gini coefficient, which measures the level of income inequality within a country. By this measure, South Africa and Namibia are the most unequal economies in the world… and Finland and Romania are among the most equal.
- Cover story curse.
As soon as the hot stock, market or country hits the cover of Time magazine, it’s already crested – and is on its way down. (Or with the oil image below, it’s on its way back up.) As my colleague Peter Churchouse puts it, “if it’s in the press, it’s in the price”.
Sharma warns to watch out for the “hot” country on the cover.
- Asset price inflation.
In recent years, the fear of deflation – that is, prices going down – has haunted central bank policy makers around the world (Japan, again, is a trend leader). Sharma advises keeping a close watch on asset price inflation because of the tight link between asset bubbles and recession.
If asset prices – like stocks or real estate – move up too much too fast, a bust may be on its way.
You might think that the 2008-2009 global economic crisis delivered a crowbar-to-the-head message about debt: Too much debt is bad. But since then, overall levels of debt haven’t declined. Total lending has actually risen – by 40 percent.
As of late 2014, the world economy owed itself US$199 trillion, which was US$112 trillion more than it owed in 2007. Markets where private debt rises a lot faster than the economy as a whole are particularly worth keeping a close eye on.
- The “second city” rule.
If the population of the capital of a country is far bigger than the second-largest city (for example, more than three times bigger), Sharma looks for a high risk of rural rebellion.
For example: Bangkok, Thailand’s capital, has 8.3 million people. The country’s second-biggest city, Samut Prakan, has just under 400,000. And… Thailand has a long and rich history of city-vs-country divisions.
The implications for Thailand of the “second city” rule.
- Domestic capital flows.
If local capital leaves the country, it’s bad news. After all, who knows better than people at home whether their currency is in trouble, and whether they can earn a reasonable return that reflects the risk of holding the currency.
Foreign capital – “hot money” – is often pointed to as the cause of currency crises, but frequently it’s local money that is the first down the spillway.
I’ve seen this in a number of markets… most memorably in 1998, when Russian investors were selling everything that wasn’t nailed down to ditch the ruble. Meanwhile, foreigners were gleefully lining up to buy ruble-denominated sovereign bonds, drawn in by sky-high yields. Then the ruble collapsed and the Russian government defaulted on its debt. Local investors may have missed out on a bit of yield, but they had the right idea all along.
- Stale leaders.
Sharma shows that economic reform – for many emerging markets, a critical building block of growth – usually happens during a leader’s first term. After that, it probably won’t happen at all. Leaders lose the impetus to change, and grow content with the status quo. That’s especially true (in more corrupt countries in particular) if the status quo entails state-sponsored stealing by the head of government to enrich himself.
- Good spending vs bad spending.
An investment bubble that results in acres of empty office buildings – which don’t produce anything or help anyone – is an example of “bad” spending. But if investors, or the government, go overboard on spending on assets that will eventually boost productivity (like technology, research or manufacturing), it will be a lot better for the long-term health of the economy.
- How cheap is it really?
Central banks can do a lot of different things to manipulate the value of a country’s currency. Sharma says that there’s a lot of value in investors getting an on-the-ground sense of how cheap, or expensive, a currency is.
The cheapest place I’ve been to in a while? Cambodia. The most expensive? Singapore, by a long shot.
No country is going to fail on all these measures – just like no economy is going to sail through. But they are important to keep in mind as you look at market opportunities around the world. If a country fails more measures than it passes, you may want to avoid investing there.
And pay careful attention to these four: debt, asset price inflation, domestic capital flows and good spending vs bad spending.
They’ll help you avoid investing in a heart attack of a country.