Too early to tell
It’s clear to everyone that globalisation is re-shaping the world economy. But Maha Khan Phillips asks questions of the consensus around which sectors will benefit
In September, Robert Zoellick, the World Bank president, gave a speech at George Washington University in which he told his audience that the world was at a critical ‘inflection point’ in its history.
There is a new order.
According to Zoellick, while it may be tempting for policymakers, and others, to compare current economic and political upheaval to previous periods in history, the world is actually facing something new. “Today, history’s warning lights are flashing again. Will we face the challenges of 2011 in denial with our head stuck in the sand?” he asked.
His point was that developing countries are gaining economic and political power. In the 1990s, they accounted for a fifth of global growth but by 2025, six of the biggest emerging economies, India, China, Brazil, South Korea, Russia and Indonesia, will account for half. “As with every great historical shift, we need to ask what’s going on,” he stated.
Zoellick’s comments are mirrored by economists and fund managers who talk about paradigm shifts in the global economic order. Some say they are changing their investment approach to take advantage of new trends.
“We are moving to a two-engine world, where there has been a permanent change which has taken place since the start of this century. There is the increasing economic importance of emerging countries, while developed markets are characterised by an ongoing deleveraging process which takes a lot of time,” says William De Vijlder, chief investment officer for strategy at BNP Paribas Investment Partners.
Of course that is the simple answer, but it still has a host of implications. As economic research house GaveKal points out, the story of the past decade has been that of an overly dovish Fed and a ‘guns and butter’ US government (which has decided not to choose between funding two wars and public spending to deal with domestic concerns), a Germany “happy to provide cheap vendor financing to Club Med nations enjoying a consumption boom”, and a free-spending China that, according to some economists, may be in for a hard landing. All of this is now coming to an end, suggests GaveKal.
It is clear that US policy certainly has changed and will continue to evolve. In a paper titled ‘Where to From Here?’ Towers Watson argues that the current and projected size of fiscal deficits is unsustainable, as is the likely trajectory of public debt-to-GDP ratios. Assuming no adjustments are made to promised benefits, the public debt-to-GDP ratio for the UK would exceed 500% by 2040, and be around 450% for the US, the paper observes. “The interest burden of this debt would exceed 25% and 20% of GDP for the two countries respectively, or about 100% of the revenue you would expect to raise through taxation.” Clearly, the US can afford neither ‘guns’ nor ‘butter’.
It means investors are hard hit. “How do you position yourself to deal with a painful de-leveraging process that not only slows things down but has different effects with different asset categories?” muses James Shinn, a lecturer at Princeton University’s School of Engineering and Applied Sciences, and a member of the Global Advisory Forum convened by London-based hedge fund CQS. “Governments in both the US and Europe are trying to oppose the deleveraging process by driving the risk-free rate down to virtually zero, but you put investors searching for absolute returns in a terrible spot here. Deleveraging means assets have to be priced down, so you’re taking real capital losses as growth slows.”
Germans are tired of what they perceive to be handouts to nations like Greece. And China, currently being pushed by the euro-zone to contribute to its bailout fund, may not have the hard landing that some economists are concerned about but certainly has to deal with issues of systemic risk and overspending (50% of its GDP is allocated to capital expenditure).
So what does this mean for the global economy? For GaveKal, it means a change in market leadership. As Charles Gave, Louis Gave, and Anatole Kaletsky argued in their book, Brave New World, successful companies of the past designed a product, manufactured it, and then sold it. Really successful companies then followed success at home by selling abroad, becoming multi-nationals. All this will change.
“The new business model is to produce nowhere, but sell everywhere,” they argue. So-called ‘platform companies’ will keep the high added-value parts of research, development, treasury, and marketing in-house, and farm out all the rest to producers. The economy will be divided into manufacturers, mostly in developing countries, and platform company economies, which will exist in the developed world. If this is true, then intellectual property will move centre stage.
“Intellectual property will continue to be important, and that is one competitive advantage in developed markets,” agrees Ted Chu, chief economist at the Abu Dhabi Investment Authority (ADIA), the soveriegn wealth fund. “Companies with strong intellectual properties or proprietary secret formulas, something difficult to replicate, should do well.”
Anthony Cross, co-manager of the UK Growth, Special Situations, and Smaller Companies funds at Liontrust Asset Management, goes so far as to describe this as an “arms race”: “We’ve got to keep ahead all the time in terms of intellectual property and brands. Western economies will have to focus on their intellectual capital to maintain living standards, while you’ll continue to see a shift around the world in terms of who is offering the lowest cost of production.”
Investors also have to realise that the structure of global corporate profits will change. For one thing, emerging markets exporters are competing head to head with multi-nationals. “Emerging markets have changed,” explains Wahid Chammas, co-portfolio manager of the Janus Emerging Markets Equity and Janus European Equity strategies. “Their companies are not the immature companies of yesterday. The largest beer company in the world is Brazilian-led, and the second is South African, for example. The paradigm shift is that you aren’t investing in emerging markets for high risk and high reward, you’re actually going to pick emerging market companies that compete with other international companies.”
The deleveraging process in developed markets will put pressure on demand, which will in turn accelerate the need for emerging markets exporters to transform themselves back into domestic players, says Didier St Georges, member of the Investment Committee at Carmignac Gestion. “It is a natural evolution to increase the purchasing power of your population as you get richer. These countries have accumulated so much surplus in the previous paradigm that there is a lot of room to manoeuvre,” he argues.
John Greenwood, chief economist at Invesco, also believes that emerging markets exporters will grow less rapidly than they have previously done. “Conversely, you’ll want to hold domestic demand-driven stocks in China, India, and Latin America, and you’ll want to hold companies in the developed world that are linked to emerging markets,” he says.
Emerging markets consumption will also have an impact on commodity prices, and on currencies. In his quarterly newsletter, industry veteran Jeremy Grantham, urges investors to recognise that we now live in a different, more constrained world in which prices for raw materials will rise and shortages will be common. After a century of price declines, the price of resources are now rising, and the last eight years have undone, remarkably, the effects of the last 100-year decline, he states. “Rapid growth is not ours by divine right; it is not even mathematically possible over a sustained period,” said Grantham. He points out that China makes up 50% of the world’s consumption in some commodities.
It is difficult to imagine then, that constraints on resources, now that the world population has officially reached seven billion, will not continue. “Growth in emerging markets requires that you need far more energy, commodities, food, metals, and raw materials, than growth in developed markets which are service intensive,” explains ADIA’s Chu. He also believes tension in the global economy can be traced back to a bottleneck in material supplies to the global economy, particularly on the commodities side. “We are bullish over the long term in emerging markets growth. The key issue is how you resolve the resource bottle neck issue.”
Currencies will also be impacted. St Georges believes that emerging market currencies will appreciate as countries reduce their commercial surplus and look to increase their purchasing power against the dollar.
Chu says tracking the dollar is not that easy. “The US dollar is very hard to predict because the drivers of currencies change rapidly over the historical period. Currencies are driven by safe haven effects and interest rate fundamentals and are difficult to predict overall. But over the long term, the currency will be driven by productivity differentials between the US and its trading partners. US productivity is likely to grow at or above OECD countries but slower than emerging markets.”
It’s the consensus view - but one that GaveKal, from its vantage point in the heart of emerging Asia, has been arguing against. Austerity-hungry Germans, slowing China and a political backlash against the ever-loosening Fed (Gavekal points out that, since John Boehner sent his 20 September letter to chairman Bernanke warning against further intervention, the US dollar has not stopped rallying): all add to the potential for “a prolonged strengthening of the US dollar and fall of commodity prices” which “seems a very different macro environment than the one that profiled the 2000s”, as a recent note from the firm put it. US multinationals will suffer but European and Asian exporters will be in clover; drillers and miners will be out of favour, and those ‘platform companies’ very much back in. In the words of one of Gavekal’s clients: “The structure and composition of the world economy and corporate profits are changing, perhaps quite radically. Everything the casual observer thinks they know about the world economy and how the world works-based on ten years of reinforcement-is changing.”
Who is right? In the famous words of one Chinese premier, ‘It’s too early to tell.’ Understanding the implications of the ‘new world order’ will take some time, as will understanding whether structural changes will last a generation, or more. The major force of globalisation can re-shape the landscape in unpredictable ways. In 1989 for example, when Mitsubishi, the Japanese manufacturer, bought a majority stake in New York City’s Rockefeller Center, the acquisition sent shock waves through the US, with newspaper headlines screaming that the Japanese were ‘buying up America’. Liontrust’s Cross points out that in 1988, the two largest emerging market countries in the world were Malaysia and Mexico, and now both are relatively small. In 1990, Hong Kong was the biggest port in the world, now it is surpassed by both Singapore and Shanghai. Eight per cent of the world’s countries had liberal free market regimes in 1975. Now that figure is one-third and growing.
Will commodities and natural resources become even more precious in 25 years time? Most likely. Will platform companies in developed markets (which will include today’s BRICs) be outsourcing manufacturing to today’s frontier economies? Also likely. But whether the US will remain the world’s reserve currency, or how the changes to the world economy will affect investments in the long term, is harder to predict.