Tuesday, July 25, 2023

Country Risk: A July 2023 Update!

I have looked at country risk, in all its dimensions, towards the middle of each year, for the last decade, for many reasons. One is curiosity, as political and economic crises roll through regions of the world, roiling long-held beliefs about safe and risky countries. The other is pragmatic, since it is almost impossible to value a company or business, without a clear sense of how risk exposure varies across the world, since for many companies, either the inputs to  or their production processes are in foreign markets or the output is outside domestic markets. Coca Cola is a US company, in terms of history and incorporation, but it generates a significant portion of its revenues from the rest of the world. Royal Dutch may be a UK (or Dutch) company, in terms of incorporation and trading location, but it extracts its oil and gas from some of the riskiest parts of the world. Since country risk is multidimensional and dynamic, my annual country risk update runs to more than a hundred (boring) pages, but I will try to summarize what the last year has brought in this post.

Drivers of Country Risk

    What makes some countries riskier than others to operate a business in? The answer is complicated, because everything has an effect on risk, starting with the political governance system (democracy, dictatorship or something in between), the extent of corruption in the system, the legal system (and its protection for property rights) and the presence or absence of violence in the country (from wars within or without). The table below, which I have used in prior updates, captures the mail drivers of country risk:

Things get even more complicated when you recognize that these drivers are often correlated with, and drive, each other. Thus, a country that is ravaged by war and violence is more likely to have a weak legal system and be corrupt.  Furthermore, all of these risk exposures are dynamic, and change over time, as governments change, violence from internal or external forces flares up. 
    As you assess these factors, you can see very quickly that country risk is a continuum, with some countries exposed less to it than others. It is for that reason that we should be cautious about discrete divides between countries, as is the case when we categorize countries into developed and emerging markets, with the implicit assumption that the former are safe and the latter are risky. To the extent that divide is not just descriptive, but also drives real world investment, both companies and investors may be misallocating their capital, and I will argue for finer delineations of risk.

1. Democracy across the Globe

    If your focus stays on economic risk, the question of whether democracies or authoritarian regimes are less risky for businesses to operate in depends in large part on whether these businesses are more unsettled by day-to-day continuous risk, which is often the case with democracies, where the rules can change when new governments gets elected, or by discontinuous risk, which can lie dormant for long periods, but when it does occur, it is larger and sometimes catastrophic, in an authoritarian government.  Assessing freedom and democracy in countries is a fraught exercise, with both political and regional biases playing out, and that should be kept in mind when you look at the heat map that shows the results of the Economist's  measures of democracy, by country and region, in 2022, as well as trend lines across time: 

Source: Economist Intelligence Unit (EIU)

While the global aggregate value for 2022 is very similar to the value in 2021, there has been a significant drop off since 2016, at least according to this measure.  In 2022, North America and Western Europe scored highest on the democracy index, and Middle East and Africa scored the lowest. 

    In my view, the question of whether businesses prefer the continuous change (or, in some cases, chaos) that characterizes democracies or the potential for discontinuous and sometimes jarring change in authoritarian regimes has driven the debate of whether a business should feel more comfortable investing in India, a sometimes chaotic democracy where the rules keep changing, or in China, where Beijing is better positioned to promise continuity. For three decades, China has won this battle, but in 2023, the battleground seems to be shifting in favor of India, but it is still too early to make a judgment on whether this is a long term change, or just a hiccup.

2. Violence across the Globe

    When a country is exposed to violence, either from the outside or from within, it not only exposes its citizens to physical risk (of assault or death), but also makes it more difficult to run businesses within its borders. That risk can show up as costs (of buying protection or insurance) or as uninsurable risks that drive up the rates of return investors and businesses need to make, in order to operate. Again, there are subjective judgments at play in these measures, but the map below gives you 2023 scores for peace scores, with lower (higher) scores indicating less (more) exposure to violence.

Source: Vision of Humanity

Iceland and Denmark top the list of most peaceful countries, but in a sign that geography is not destiny, Singapore makes an appearance on that list as well. On the lease peaceful list, it should come as no surprise that Russia and Ukraine are on the list, but Sub-Saharan Africa is disproportionately represented. 

3. Corruption across the Globe

   Corruption is a social ill that manifests itself as a cost to every business that is exposed to it. As anyone who has ever tried to get anything done in a corrupt setting will attest, corruption adds layers of costs to routine operations, thus become an implicit tax that companies pay, where the payment instead of going to the public exchequer, finds its way into the pockets of intermediaries. Transparency International measures corruption scores, by country, across the world and their 2022 measures are in the map below:

Transparency International

Much of Western Europe, Australia & New Zealand and Canada/United States fall into the least corrupt category, but corruption remains a significant concern in much of the rest of the world. While it easy to attribute the corruption problem to politicians and governments, it is worth noting that once corruption becomes embedded in a system, it is difficult to remove, since the structure evolves to accommodate it. Put simply, a system where the rule-makers, regulators and bureaucrats get paid a pittance (on the assumption that they will be supplement their pay with side payments) to sign off on contracts that are worth billions will inevitably create corruption as a side cost.

4. Legal Protection across the Globe

    To operate a business successfully, you need a legal system that enforces contractual obligations and protects property rights, and does so in a timely manner. When a legal system allows contracts and legal agreements to be breached, and property rights to be violated, with no or extremely delayed consequences, the only businesses that survive will be the ones run by lawbreakers, and not surprisingly, violence and corruption become part of the package. The Property Rights Alliance measures the protection offered for property rights (intellectual, physical), with higher (lower) scores going with better (worse) protection, and their most recent update (from 2022) is captured in the picture below:

Source: Property Rights Alliance

By now, you can see the point about the correlation across the various dimensions of country risk, with the parts of the world (North America, Europe, Australia and Japan) that have the most democratic systems and the least corruption scoring highest on the legal protection scores. Conversely, the regions (Africa, large portions of Asia and Latin America) that are least democratic, with the most violence and corruption, have the most porous legal systems. 

Measures of Country Risk

    With the long lead in on the dimensions of country risk, we can now turn to the more practical question of how to convert these different components of risk into country risk measures. We will start with a limited measure of the risk of default on the part of governments, i.e., sovereign default risk, before expanding that measure to consider other country risks, in political risk scores.

1. Default Risk

    Businesses and individuals that borrow money sometimes find themselves unable to meet their contractual obligations, and default, and so too can governments. The difference is that government or sovereign default has much greater spillover effects on all entities that operate within its borders, thus creating business risks. We start with an assessment of sovereign ratings, a widely accessible and hotly contested, of government default risk and then move on to market-based measures of this risk in the form of sovereign default spreads.

a. Sovereign Ratings

    The most widely used measures of sovereign default risk come from a familiar source for default risk measures, the ratings agencies. S&P, Moody's and Fitch, in addition to rating companies for default risk, also rate governments, and they rate them both on local currency debt, as well as foreign currency debt. The reason for the differentiation is simple, since countries should be less likely to default, when they borrow in their domestic currencies, than when they borrow in a foreign currency. The table below summaries the sovereign local currency ratings for countries in June 2023, from S&P and Moody's:

Local Currency Ratings for countries (Some UAE emirates have ratings that are independent of the ratings for the UAE, because they issue their own sovereign debt) 
The ratings scheme mirrors the one used to rate companies, with the key difference being at the Aaa (AAA) rating, with a sovereign getting that rating viewed as having no default risk, whereas a corporate with that rating still has some. If you are wondering why there should be any default risk when governments borrow in a domestic currency, since these governments should be able to print money to pay off debt, the answer is that money-printing debases a currency and given a choice between currency debasement and default, many countries choose to default. The figure backs up this proposition:

Note that while countries are less likely to default on local currency than foreign currency bonds, the default rates in the former remain substantial. In addition, the good news, if you are a user of sovereign ratings, is that they clearly are correlated strongly with ratings, with higher default rates for lower-rated sovereigns. 
    I know that there are many who have issues with the ratings agencies, but I do think that the conflict of interest story, where ratings agencies attach higher ratings to entities, because they get paid to rate them, is overdone, and especially so with sovereign ratings (where the revenue streams are paltry). In my view, the biggest problem with ratings agencies is not that they are biased, but that they take too long to adjust ratings to changes in a country and that they sometimes underrate or overrate regions of the world, because of their histories. Consequently, Latin American countries have to work harder to improve their ratings, or sustain current ratings, than the US or European countries, which get a bye, because they do not have a history of default.

b. Sovereign CDS Spreads

    One of the advantages of a market-based measure is that the market price reflects investor perceptions of risk at the moment. Sovereign Credit Default Swaps (CDS) offer a market-based measure of default risk, since investors buy these swaps as protection against default on government bonds. When the sovereign CDS market came into being a few decades ago, there were only a handful of countries that were traded, but the market has expanded, and there are traded credit default swaps on almost 80 countries in June 2023. The graph below shows the sovereign CDS levels, by country:

Source: Bloomberg (July 2023 data)

There are three things to note, as you browse these numbers. The first is that these are dollar spreads (though a Euro CDS market exists as well), and thus are most suited for use with dollar-denominated government bonds. The second is that what comprises default in the sovereign CDS market may not coincide with investor definitions of default , though there are approaches that can be used to back out the likelihood of default from a CDS value. The third is that there are no countries with traded CDS that have zero risk of default, at least according to the sovereign CDS market. Consequently, I have also computed a version of the sovereign CDS spread that is net of the US CDS (on the assumption that default risk is zero in the US, a debatable proposition after the recent debt ceiling debate).
    Is a sovereign CDS spread a better measure of default risk than a sovereign rating? The answer is mixed. It is true that a sovereign CDS spread gives you a more updated measure of default risk, since it is market-set, but as with all market-based measures, it comes with far more volatility and overshooting than a ratings-based spread, and it is available for only a subset of countries. My suggestion is that for countries where recent political or economic events would lead you to believe that sovereign rating is dated, you should switch to using sovereign CDS spreads.

2. Risk Scores

    The advantage of default spreads is that they provide an observable measure of risk that can be easily incorporated into discount rates or financial analysis. The disadvantage is that they are focused on just default risk, and do not explicitly factor in the other risks that we enumerated in the last section. Since these other risks are so highly correlated with each other, for most counties, it is true that default risk becomes an reasonable proxy for overall country risk, but there are some countries where this is not the case. Consider portions of the Middle East, and especially Saudi Arabia, where default risk is not significant, since the country borrows very little and has a huge cash cushion from its oil reserves. Investors in Saudi Arabia are still exposed to significant risks from political upheaval or unrest, and may prefer  a more comprehensive measure of country risk. 

    There are many services, including the World Bank and the Economist, who offer comprehensive country risk scores, and the map below includes composite country risk scores from Political Risk Services in June 2023:

The pluses and minuses of comprehensive risk scores are visible in this table. In addition to capturing risks that go beyond default, Political Risk Services also measures risk scores for frontier markets (like Syria, Sudan and North Korea), which have no sovereign ratings. The minuses are that the scores are not standardized; for instance, PRS gives its highest scores to the safest countries, whereas the Economist gives the lowest scores to the safest countries. In addition, the fact that the country risk is measured with  scores may lead some to believe that they are objective measures of country risk, when, in fact, they are subjective judgments reflecting what each service factors into the scores, and the weights on these factors. Just to illustrate the contradictions that can result, PRS gives Libya a country risk score that is higher (safer) than the scores it gives United States or France, putting them at odds with most other services that rank Libya among the riskiest countries in the world.

Equity Risk across Countries

    Default risk measures how much risk investors are exposed to, when investing in bonds issued by a government, but when you own a business, or the equity in that business, your risk exposure is not just magnified, but also broader.  For three decades, I have wrestled with measuring this additional risk exposure and converting that measurement into an equity risk premium, but it remains a work in progress. 

    To estimate the equity risk premium, for most countries I start with default spreads, either based on the sovereign ratings assigned by the ratings agencies, or from the market, in the form of sovereign CDS spreads. To account for the fact that equities are riskier than bonds, I scale the standard deviation of an emerging market equity index (S&P Emerging BMI) to an emerging market government bond ETF (iShares JPM USD Emerging Markets Bond ETF), and use this ratio (1.42 in my July 2023 update) and apply this scalar to the default spread, to arrive at a country risk premium. Adding that country risk premium on to the premium that I estimate for the S&P 500 (which was 5.00% at the start of July 2023, and is my measure of a mature market premium), yields the total equity risk premium for a country:

To provide an example, consider India, which with a sovereign rating of Baa3, has a default spread of 2.35% in July 2023. Multiplying this default spread by the scalar (1.42) and adding to the equity risk premium for the S&P 500 results in an equity risk premium of 8.33% for India. 
India ERP     = Implied ERP for S&P 500 + Default spread for India * Scalar for Equity Risk
                     = 5.00% + 2.35% (1.42) = 8.33%
It is worth noting that using the sovereign CDS spread for India of 1.42% would have resulted in a lower equity risk premium for India, at 7.02%.
    Using the ratings-based default spreads as starting points, I estimate the equity risk premiums for all countries rated by either S&P and Moody's in the picture below. (For the many people who will point to their country's geographical boundaries being misrepresented on this map, please cut me some slack. This map is purely a device to summarize equity risk premiums, by countries, not arbitrate on where borders should go. Suffice to say that if you are operating a business in a part of the world that is contested by two countries, your risk levels are in the danger zone, no matter where in the world you are.)

Download spreadsheet with data

You will notice that there are countries that are not rated (NR) that have equity risk premiums attached to them. For these frontier markets, I used the PRS score for the country as a starting point, found other (rated) countries with similar PRS scores, and extrapolated an equity risk premium. The caveat, though, is that these equity risk premiums are only as good as the PRS scores that goes into them, and you can see the effect in Libya, which if PRS is right, is a green (low risk) standout in a region (North Africa) of red.

Caveats and Questions

   I started publishing equity risk premiums about 30 years ago, and while data sources have become richer and more complete, the core approach that I use for the estimation has remaining stable. That said, there is no intellectual firepower or research behind these numbers, since I am letting the default ratings agencies and risk measurement services carry that weight. I am not a country risk researcher, and I try not to let my personal views alter the numbers that emerge from the analysis, since that would open the door to my biases. I will use three countries in the latest update to illustrate my point:

  1. Saudi Arabia: As I noted earlier, using default spreads as my starting point can result in understating the risk premium for countries like Saudi Arabia, which score low on default risk but high on other risks. 
  2. Libya: As indicated in the last section, the equity risk premium for Libya, an unrated country, is entirely based upon the country risk score from PRS. That country risk score is surprisingly high (indicating low risk) and it results in an equity risk premium that is low, relative to other countries in the region. 
  3. China: China has a high sovereign rating and a low sovereign CDS spread, indicating that investors in Chinese government bonds don't see much default risk in the country. In the aftermath of a Beijing crackdown on Chinese tech giants and talk of a trade war between China and the US, the perception seems to be that China has become a riskier place to invest. That may or may not be true, but looking at how Chinese equities are priced, trading still at some of the highest multiples of earnings in the world, investors in equity markets don't seem to share that view.
With all three of these countries, I chose not to change the numbers that emerged from the data, but if you have strong views on these countries or others, nothing is stopping you from replacing my numbers with yours. 

Company Hurdle Rates

    This post has already become much longer than I intended it to be, but I want to end by bringing these equity risk premiums down to the company level, and examining how they play out in hurdle rates, to be used in investment analysis by companies and valuation by investors.

The Currency Question

    In my discussion so far, you will notice that I have stayed away from talking about currency risk in my equity risk premium discussion and from currency choices in investment analysis. I have my reasons.

  • I know that the currency choice is the source of angst for many analysts, and I think unnecessarily so. Your choice of currency will affect your cash flows and your discount rates, but only because each currency brings it's own expectations of inflation, with higher inflation currencies leading to higher growth rates for cash flows and higher discount rates.

    The mechanism that allows for the discount rate adjustment to reflect currency is the risk free rate, with currencies with higher expected inflation carrying higher risk free rates. In a downloadable dataset linked at the end of this post, I estimate riskfree rates in global currencies, based upon the US T.Bond rate as the riskfree rate in US dollars) and differential inflation. To provide an example, using the IMF's estimate of expected inflation for 2023-28 of 3% for the US and 13.50% for Egypt, and building on the US treasury bond rate of 3.80%. the riskfree rate in Egyptian pounds is 14.38%. 
    Riskfree Rate in EGP     = (1+ US T.Bond Rate) (1 + Exp Infl in Egypt) (1+ Exp Infl in US) -1
    = (1.038)* (1.135/1.03) -1 = .1438 or 14.38%)
  • To the extent that currency risk adds to the operating risk of a company, it is, in my view,  already embedded in the equity risk premiums that I have computed in the last section. After all, countries with unstable governments, plagued by war and corruption, also have the most unstable currencies. The other reason to tread lightly with currency risk is that for investors with global portfolios, it becomes diversifiable risk, as some companies benefit as a currency strengthens or weakened more than expected and others lose for exactly the same reason.
My advice to you when you make a currency choice for your analysis is that you pick a currency that you are comfortable working with, but then make sure that you stay consistent with that currency in all of your estimates. Thus, if you choose to value a Russian company in Euros, rather than rubles, make sure that your growth rates reflect inflation in the Euro zone, but that you risk premiums and real growth reflect its Russian operations.

Exposure to Country Risk

    For much of my valuation journey, the status quo in valuation has been to look at where a company is incorporated to determine its risk exposure (and the equity risk premium to use in assessing a hurdle rate). While I understand that where you are incorporated and traded can have an effect on your risk exposure, I think it is dwarfed by the risk exposure from where you operate. A company that is incorporated in Germany that gets all of its revenues in Turkey, is far more exposed to the country risk of Turkey than that of Germany. In the picture below, I contrast the traditional country-of-incorporation based risk measure with my alternative, where equity risk premiums come from where you operate:

We can debate how best to measure operating risk exposure, since it can come from both where you sell your products and services (revenues) as well as where you produce those products and services. 

    There are implications not just for investors, but for companies. For investors, an operating-risk perspective will mean that there are some emerging market companies that others may perceive as risky, simply because of their country of incorporation, but are much safer, because they get their revenues from much safer parts of the world.   Embraer, the Brazilian aerospace company, and Tata Consulting Services, an Indian software company, would be good examples. Conversely, there are developed market companies that are significantly exposed to country risk, either because of where they produce (Royal Dutch) or where they sell their products and services (Coca Cola). For multinational companies, an operating risk perspective will imply that there can be no one hurdle rate across geographies, since a project in Turkey should require a higher equity risk premium (and hurdle rate) than an otherwise similar project in Germany.


    It is ironic that a post that was meant to shorten and summarize a long paper has itself stretched to become the equivalent of a long paper, and I apologize. I do hope that you get a chance to read the paper or at least review my country risk measures in this post, since there is significant room for improvement.  I don't have all the answers, and I probably never will, but progress is incremental, and each year, I hope that I can add a tweak or a component that will move me in the right direction. Also, please don’t take any of these numbers personally. In short, if you feel that I have overestimated the risk in your country and given it an equity risk premium that you believe is undeservedly high, it is not because I do not like you and your country. It is entirely Moody’s fault for giving your country too low a rating, and you should take it up with them!

YouTube Video

Country Risk Paper

  1. Country Risk: Determinants, Measures and Implications - The 2023 Edition

Country Risk Data

  1. Democracy, Violence, Corruption and Legal System Scores, by Country, in July 2023
  2. Sovereign Ratings and CDS Spreads for Countries in July 2023
  3. Equity Risk Premiums, by Country, in July 2023
Currency Data

Monday, July 17, 2023

Market Resilience or Investors In Denial? A Mid-year Assessment for 2023!

I am not a market prognosticator for a simple reason. I am just not good at it, and the first six months of 2023 illustrate why market timing is often the impossible dream, something that every investor aspires to be successful at, but very few succeed on a consistent basis. At the start of the year, the consensus of market experts was that this would be a difficult year for markets, given the macro worries about inflation and an impending recession, and adding in the fear of the Fed raising rates to this mix made bullishness a rare commodity on Wall Street. Markets, as is their wont, live to surprise, and the first six months of 2023 has wrong-footed the experts (again).

The Start of the Year Blues: Leading into 2023

   As we enjoy the moment, with markets buoyant and economists assuring us that the worst is behind us, both in terms of inflation and the economy, it is worth recalling what the conventional wisdom was, coming  into 2023. After a bruising year for every asset class, with the riskiest segments in each asset class being damaged the most, there were fears that inflation would not just stay high, but go higher, and that the economy would go into a tailspin.  While this may seem perverse, the first step in understanding and assessing where we are in markets now is to go back and examine where things stood then.
    In my second data update post from the start of this year, I looked at US equities in 2022, with the S&P 500 down almost 20% during the year and the NASDAQ, overweighted in technology, feeling even more pain, down about a third, during the year.


Looking across company groupings, returns on stocks in 2022 flipped the script on the market performance over much of the prior decade, with the winners from that decade (tech, young companies, growth companies) singled out for the worst punishment during the year.
    While stocks had a bad year (the eighth worst in the last century), the bond market had an even worse one. In my third post at the start of 2023, I looked at US treasuries, the long-touted haven of safety for investors. In 2022, they were in the eye on the storm, with the ten-year US treasury bond depreciating in price by more than 19% during the year, the worst year for US treasury returns in a century.

The decline in bond prices was driven by surging interest rates, with short term treasuries rising far more than longer term treasuries, and the yield curve inverted towards the end of the year.
    The rise in US treasury rates spilled over into the corporate bond market, causing corporate bond yields to rise. Exacerbating the pain, corporate default spreads rose during the course of 2022:

While default spreads rose across ratings classes, the rise was much more pronounced for the lowest ratings classes, part of a bigger story about risk capital that spilled across markets and asset classes. After a decade of easy access, translating into low risk premiums and default spreads, accompanied by a surge in IPOs and start-ups funded by venture capital, risk capital moved to the sidelines in 2022.

            In sum, investors were shell shocked at the start of 2023, and there seemed to be little reason to expect the coming year to be any different. That pessimism was not restricted to market outlooks. Inflation dominated the headlines and there was widespread consensus among economists that a recession was imminent, with the only questions being about how severe it would be and when it would start. 

The Market (and Economy) Surprises: The First Half of 2023

    Halfway through 2023, I think it is safe to say that markets have surprised investors and economists again, this year. The combination of high inflation and a recession that was on the bingo cards of some economists at the start of 2023 did not manifest, with inflation declining sooner than most expected during the year:

It is true that the drop in inflation was anticipated by some economists, but most of them also expected that decline to come from a rapidly slowing economy, i.e., a recession and to be Fed-driven. That has not happened either, as employment numbers have stayed strong, housing prices have (at least up till now) absorbed the blows from higher mortgage rates and the economy has continued to grow.

It is true that economic activity has leveled off and housing prices have declined a little, relative to a year ago, but given the rise in rates in 2022, those changes are mild. If anything, the economy seems to have settled into a stable pattern, albeit at the high levels that it reached in the second half of 2021. I know that the game is not done, and the long-promised pain may still arrive in the second half of the year, but for the moment, at least, markets have found some respite.

            During the course of 2023, the Fed was at the center of most economic storylines hero to some and villain to many others, with every utterance from Jerome Powell and other Fed officials parsed for signals about future actions. That said, it is worth noting that there is very little of consequence in the economy or the market, in 2023, that you can attribute to Fed activity. The Fed has raised the Fed Funds rate multiple times this year, but those rate increases have clearly done nothing to slow the economy down and inflation has stabilized, not because of the Fed but in spit of it. I know that there are many who still like to believe that the Fed sets interest rates, but here is what market interest rates (in the form of US treasury rates) have done during 2023: 

If there is a Fed effect on interest rates, it is almost entirely on the very short end of the spectrum, and not on longer term rates; the ten-year and thirty-year treasury bond rates have declined during the year. That does not surprise me, since I have never bought into the “Fed did it” theme, and have written multiple posts about why it is inflation and economic growth that drive interest rates, not central banks. As inflation has dropped and the economy has kept its footing, the corporate bond market has benefited from default spreads declining, as fears subside:

As in 2022, the change in default spreads is greatest at the lowest ratings, with the key difference being that spreads are declining in 2023, rather than increasing, though the spreads still remain significantly higher than they were at the start of 2022.

Stock Markets Perk Up: The First Half of 2023

     I noted that risk capital retreated from markets in 2022, with negative consequences for risky asset classes. To the extent that some of that risk capital is coming back into the markets, equity markets have benefited, with benefits skewing more towards the companies and markets that were punished the most in 2022.  To understand the equity comeback in 2023, I start by looking at the increase in market capitalizations, in US $ terms,  across the world in the first six months of the year, with the change in market capitalizations in 2022 to provide perspective:

In US dollar terms, global equities have reclaimed $8.6 trillion in market value in the first six months in the year, but the severity of last year's decline has still left them $14.4 trillion below their values from the start of 2022. Looking across regions, US equities have performed the best in the first six months of 2023, adding almost 14% ($5.6 trillion) to market capitalizations, regaining almost half of the value lost in last year's rout. In US dollar terms, China was the worst performing region of the world, with equity values down 1.01% in the first six months on 2023, adding to the 18.7% that was lost last year. The two best performing parts of the world in 2022, Africa and India, performed moderately well in the first half of 2023. In US dollar terms, Latin America was flat in the first half of 2023, though there were a couple of Latin American markets that delivered stellar returns in local currency terms, albeit with high inflation eating away at these returns. It is currency rate changes that explains that contrast between local currency and dollar returns, and in the graph below, I look at the US dollar's performance broadly (against other currencies) as well as against emerging market currencies , between 2020 and 2023;

After strengthening in 2022, the US dollar has weakened against most currencies in 2023, albeit only mildly.

US Equities in 2023: Into the Weeds!

    The bulk of the surge in global equities in 2023 has come from US stocks, but there are many investors in US stocks who are looking at their portfolio performance this year, and wondering why they don't seem to be sharing in the upside. In this section, I will start by looking with an overall assessment of US equities (levels and equity risk premiums) before delving into the details of the winners and losers this year.    

Stocks and the Equity Risk Premium 

    I start my assessment of US equities by looking at the performance of the S&P 500 and the NASDAQ during the first half of this year:

As you can see, why the S&P has had a strong first half of 2023, increasing 15.91%, the NASDAQ has delivered almost twice that return, with its tech focus. One reason for the rise in stock prices, at least in the aggregate, has been a dampening of worries of out-of-control inflation or a deep recession, and this drop in fear can be seen in the equity risk premium, the price of risk in the equity market. In the figure below, I have graphed my estimates of expected returns on stocks and implied equity risk premiums through 2022 and the first six months of 2023:

After a year for the record books, in 2022, when the expected return on stocks (the cost of equity) increased from 5.75% to 9.82%, the largest one-year increase in that number in history, we have had not just a more subdued year in 2023, but one where the expected return has come back down to 8.81%. In the process, the implied equity risk premium, which peaked at 5.94% on January 1, 2023, is back down to 5% at the start of July 2023. Even after that drop, equity risk premiums are still at roughly the average value since 2008, and significantly higher than the average since 1960. If the essence of a bubble is that equity risk premiums become "too low", the numbers, at least for the moment, don't seem to signaling a bubble (unlike years like 1999, when the equity risk premium dropped to 2%).

Sector and Industry

    The divergence between the S&P 500 and the NASDAQ's performance this year provides clues as to which sectors have benefited the most this year, as risk has receded. In the table below, I break all US equities into sectors and report on performance, in 2022 and in the first half of 2023:

As you can see, four of the twelve sectors have had negative returns in 2023, with energy stocks down more than 17% this year. The biggest winner, and this should come as no surprise, has been technology, with a return of 43% in 2023, and almost entirely recovering its losses in 2022. Financials, handicapped by the bank runs at SVB and First Republic, have been flat for the year, as has been real estate. Communication services and consumer discretionary have had a strong first half of 2023, but remain more than 20% below their levels at the star of 2022.
    Breaking sectors down into industry-level details, we can identify the biggest winners and losers, among industries. In the table below, I list the ten worst performing and best performing industry groups, based purely on market capitalization change in the first half of 2023:

The worst performing industry groups are in financial services and energy, with oilfield services companies being the worst impacted. The best performing industry group is auto & truck, but those results are skewed upwards, with one big winner (Tesla) accounting for a large portion of the increase in market capitalization in the sector. There are several technology groups that are on the winner list, not just in terms of percentage increases, but also in absolute value changes, with semiconductors, computers/peripherals and software all adding more than a trillion dollars in market capitalization apiece.

Market Capitalization and Profitability

    The first six months of the year have also seen concentrated gains in a larger companies and this can be seen in the table below, where I break companies down based upon their market capitalizations at the start of 2023 into deciles, and then break the stocks down in each decile into money-making and money-losing companies, based upon net income in 2022:

Again, the numbers tell a story, with the money-making companies in the largest market cap decile accounting for almost all of the gain in market cap for all US equities; the market capitalization of these large money-making companies increased by $5.3 trillion in the first six months of 2023, 97.2% of the $5.45 trillion increase in value for all US equities.

Value and Growth 
    Over the last decade, I have written many posts about how old-time value investing, with its focus low PE and low price to book stocks, has lagged growth investing, with high growth stocks that trade at higher multiples of earnings and book value delivering much higher returns than old-time value stocks (low PE ratios, high dividend yields etc.). In 2022, old-time value investors felt vindicated, as the damage that year was inflicted on the highest growth companies, especially in technology. That celebration has not lasted long, though, since in 2023, we saw a return to a familiar pattern from the last decade, with the highest price to book stocks earning significantly higher returns than the stocks with the lowest price to book ratios:

As you can see from the chart, almost all of the value increase in US equities has come from the top two deciles of stocks, in terms of price to book ratios. Looking at value and growth go back and forth between the winning and losing columns in 2023, I believe that this is a pattern that will continue to play out for the rest of the decade, with no decisive winner.

An Assessment

    I know that one of the critiques of this market rise is that it has been uneven, but almost all market recoveries are uneven, with some groupings of companies always doing better than others. That said, there are lessons to be learned from looking at the winners and the losers in the first half of 2023 market sweepstakes:

  • Big tech: There is no doubt that this market has been largely elevated not just by tech companies, but by a subset of large tech companies. Seven companies (Apple, Microsoft, NVIDIA, Amazon, Tesla, Meta and Alphabet) have seen their collective market capitalization increase by $4.14 trillion in the first half of 2023, accounting for almost 80% of the overall increase in equity values at all 6669 publicly traded US equities. If these stocks level off or drop, the market will have trouble finding substitutes to keep the market pushing higher, simply because of the size of the hole that will need to be filled. 
  • With a profitability skew: While this does seem like a reversion to the tech boom that drove markets prior to 2022, the market seems to be more inclined to rewarding money-making tech companies, at the expense of money-losers. If risk capital is coming back in 2023, it is being more selective about where it is directing its money, and it is therefore not surprising that IPOs, venture capital and high yield bond issuances have remained mired in 2022 (low) levels.
  • And an economic twist: One reason that these big and money-making tech companies may be seeing the return of investor money is that they have navigated the inflation storm relatively unscathed and some have emerged more disciplined, from the experience. The two best cases in point are Meta and Google, both of which have not only reduced payrolls but also seem to have shifted their narrative from a relentless pursuit of growth to one of profitability.

It is true that as market rallies lengthen, they draw in more stocks into their orbit, and it is possible that the market rally will broaden over the course of the year. That said, this has been a decade of unpredictability, starting with the first quarter of 2020, where COVID ravaged stocks, and I don't think it makes much sense to take charts from 2008 or 2001 or earlier and extrapolating from those.

The Rest of the Year: What's coming?

   The market mood is buoyant, as investors seem to be convinced that we have dodged the bullet, with inflation cooling and a soft landing for the economy.  The lesson that I have learned not just from the first six months of 2023, but from market performance over the last three years, has been that macro forecasting is pointless, and that trying to time markets is foolhardy. If I were to make guesses about what the rest of the year will bring, here are my thoughts:

  • On inflation, the good news on inflation in the first half of the year should not obscure the reality that the inflation rate, at 3% in June, still remains higher than the Fed-targeted value (of 2%). That last stretch getting inflation down from 3% to below 2% will be trench warfare, and we will be exposed to macro shocks (from energy prices or regional unrest) that can create inflationary shocks.
  • On the economy, notwithstanding good employment numbers, there are signs that the economy is cooling and it is again entirely possible that this turns into a slow-motion recession, as real estate (especially commercial) succumbs to higher interest rates and consumers start retrenching. 
  • On interest rates, I do think that hoping and praying that rates will go back to 2% or lower is a pipe dream, as long as inflation stays at 3% or higher. In short, with or without the Fed, long term treasury rates have found a steady state at 3.5% to 4%, and companies and investors will have to learn to live with those rates. I have never attached much significance to the yield curve inversion as a predictor of economic growth, but that inversion is unlikely to go away soon, as near term inflation remains higher than long term expectations.
  • On equities, the one certainty is that there will be uncertainties, and it is unlikely that the market will repeat its success in the second half of 2023. I did value the S&P 500 at the start of the year, and and argued that it was close to fairly valued then. Updating this valuation to reflect updated perspectives on both dimensions, as well as an index price that is about 16% higher,  here is what I see:
    Download spreadsheet with valuation

    Note that I have used the analyst projections of earnings for the index for 2023 to 2025, and adjusted the cash payout over time to reflect reinvestment needed to sustain growth in the long term (set to 3.88%, after 2027). After the run up in stock prices in the first six months, stocks look fairly valued, given estimated earnings and cash flows, and assuming that long term rates have found their steady state. (Unlike market strategies who provide target levels for the index, an intrinsic value delivers a value for the index today; to get an estimate of what translates into as a target level of the index, you can apply the cost of equity as the expected return factor to get index levels in future time periods.)
It goes without saying, but I will say it anyway, that the economy may still go into a recession, analysts may be over estimating earnings and inflation may make a come back (pushing up long term rates). If you have concerns on those fronts, your investing should reflect those worries, but your returns will be only as good as your macro forecasting abilities. Mine are not that good, and it is why I steer away from grandiose statements about equities being in a bubble or a bargain. While uncertainties abound, there is one thing I am certain about. I will be wrong on almost every single one of these forecasts, and there is little that I can or want to do about that. That is why I demand an equity risk premium in the first place, and all I can do is hope that it large enough to cover those uncertainties.

A Time for Humility
    If the greatest sin in investing is arrogance, markets exist to bring us back to earth and teach us humility. The first half of 2023 was a reminder that no matter who you are as an analyst, and how well thought through your investment thesis is, the market has other plans. As you listen to market gurus spin tales about markets, sometimes based upon historical data and compelling charts, it is worth remembering that forecasting where the entire market is going is, by itself, an act of hubris. In the spirit of humility, I would suggest that if you were a winner in the first half of this year, recognize that much of that can be attributed to luck, and what the market gives, it can take away. By the same token, if you were a loser over the course of the last six months, regret should not lead you to try to load up on the winners over that period. That ship has sailed, and who knows? Your loser portfolio may be well positioned to take advantage of whatever is coming in the next six months.    

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