Ascent of the emerging world

- AMP Capital Investors


It usually gets wheeled out near the end of a bull market to explain why the bull market will continue forever. And, usually, when said en masse it marks the turn in the cycle and makes those who said it look foolish.
However, while the fundamental drivers of the investment cycle remain alive and well (human psychology means reversion and the countervailing force of fiscal and monetary policy), it does need to be recognised that there are subtle differences in each cycle that make them slightly different. And there are certainly differences in the current economic and investment cycle that investors need to be aware of.

Uninspiring conditions in developed countries ....

While the financial constraints in the US don’t seem to be stopping a recovery, they will probably constrain it.
Following the financial crisis, US credit creation is likely to be impaired for some time and US households are likely to be more focused than normal on reducing their debt levels. So, despite the potential for a solid initial bounce as pent up demand is unleashed, the result is likely to be relatively constrained economic growth in the US for the next few years. This is likely to be reinforced as the US moves towards a greater focus on regulation, which will boost the cost of doing business in the US.

At the same time, structural problems and poor demographics mean it is hard to see either Japan or Europe filling the void. And, of course, most advanced countries will need to deal with very high public debt to GDP ratios, which will provide another constraint to growth and a potential source of volatility.

So,  the overall picture for mainstream developed countries points to relatively unexciting growth over the next five or so years. And, given substantial amounts of excess capacity in the advanced world combined with subdued credit growth, it’s hard to see inflation being a problem any time soon.

... but emerging conditions in the emerging world

The outlook for the emerging world is much brighter.
They are not lumbered with the same debt problems as many advanced countries. The emerging world also tends to have far more favourable demographics and plenty of scope to boost their own consumption to make up for weker growth in developed countries (and are moving to do just that).

The emerging world is leading the way out of the global recession, with growth in many Asian countries rebounding earlier and much faster than has been the case in the developed world. But not only is the developed world leading the recovery to occur with the emerging world actually being a bigger proportion of the global economy than the developed world.

While consumer spending is a smaller proportion of GDP in emerging countries, emerging world consumer spending is now equal to that in the US. This holds out the hope that the global economy can be less reliant on US consumers.

So while there is nothing new in a cyclical economic upswing, the big difference this time around will be the much greater role played by emerging countries.

What does it all mean for investors?

The greater importance of the emerging world and the constrained, more fragile outlook in the US and other developed countries has a number of implications for investors.

1. Firstly investors should consider moving away from the concept of traditional international share funds and allocate more to stronger growth emerging countries. Traditional international share funds are benchmarked against indices that have an 80 or 90% exposure to slow growth advanced countries. The emerging world is now playing a much bigger role in the global economy and it is set to get even bigger.
2. Growth in the emerging world is commodity intensive, as most emerging countries are still rapidly industrialising. For example they now consume more oil than developed countries. This suggests an allocation to commodities should also be considered.
3. Strong commodity prices are likely to be favourable for commodity currencies, such as the Australian and New Zealand dollars. This suggests a need to be aware of unhedged exposures to traditional offshore investment markets.
4. Australia’s strong exposure to high growth Asia, commodities and its rapid population growth provides a positive backdrop for Australian shares and suggests investors should also have a bias towards them.
5. The greater fragility of US consumers, the risks associated with rising public debt levels (and measuresto deal with it) in major advanced countries and the inherent volatility of emerging markets means that the economic and investment cycle could be more volatile going forward.
6. Finally, it’s worth observing that bubbles are part and parcel of investment markets and they usually form from the ashes of the previous bust. It’s hard to see another bubble forming any time soon in the US. After all, the US has had a monopoly on major bubbles and busts over the last decade (including the tech boom and bust, and the housing boom and bust). So, there is a good chance that the next bubble will be in or around, the emerging markets and related trades such as commodities. This is likely because of the combination of easy money conditions in the US and advanced countries, the positive fundamentals in the emerging world and as the transition to a more China-centric world inspires the imagination of investors. Officials in several Asian countries seem to recognise this and are making noises about the dangers of low US interest rates fuelling a bubble in their own countries to let capital inflows simply drive up their currencies, so that they are then free to tighten their monetary policies to deal with any asset bubbles. But since the US is unlikely to set its monetary policy on the basis that it may contribute to bubbles in other countries and key emerging countries are unlikely to simply let their exchange rates, float higher, the risk of bubbles forming in the emerging world is high. That said, bubbles take four or five years to arise and it is still early days yet.

Different enough to matter

So, while there is always a cycle and there will always be bubbles, they are always at least a little bit different and this time around, the rise in the relative fortune of emerging countries is different enough to have significant implications of investors