Emerging Markets... Emerging.
- The developing world has driven global economic growth over the last decade, and we expect that this shift in economic leadership will continue.
- Emerging economies' growth is refocusing on other emerging markets and their own growing consumer basees, which will help sustain rapid growth rates even as developed countries experience weak growth.
- If we are wrong about the strong economic growth and capital market returns we predict over the next 20 years, we believe the most likely causes will be resource constraints or geopolitical conflict.
- We can (and should) use the same methods of analysis on emerging markets investments as we do in the rest of the portfolio.
Over the past decade, a group of emerging and developing economies have shifted the world's economic center of gravity — global growth in gross domestic product (GDP) in the last ten years owes more to the developing world than to the advanced economies. The implications of shifting wealth for the global economic and social landscape are only starting to be understood, but it is clear that issues which primarily affect developed markets (for example, the indebted US consumer) are not the entire (or even the primary) story.
Emerging markets and the global economy
An additional 1.5 billion workers joined the global economy in the 1990s1. These workers became productive very quickly — in China, the percentage of the population living in poverty fell from 60% in 1990 to 16% in 2005. The number of poor people worldwide declined by 120 million in the 1990s and by nearly 300 million in the first half of the 2000s. The magnitude of these changes dwarfed the marginal changes in the developed economies.
It is widely known (and decried in the US) that there has been a massive shift in manufacturing capacity from Organization for Economic Cooperation and Development (OECD) members to the developing world, particularly to East Asia. But shifts are also evident in the distribution of technological capacity, reflected in the rising amount of R&D being carried out in the developing world both by developed market multinationals and by local companies. Many of these local R&D teams are focused on a new business model involving "frugal innovation" — designing products and production processes to meet the needs of the poorest consumers. These innovations are increasing the effective market size by an order of magnitude relative to the typical developed market innovations, which is reflected in the trade between these developing countries.
After World War II, international trade was predominantly among high-income countries, particularly Europe, the United States and Japan2. But over the last two decades that picture has changed significantly. In 2008, trade between developed market economies accounted for 41% ($6.5 trillion) of the world total, down from 58% in 1990. Developing countries were responsible for 23% of global exports in 1990 ($0.82 trillion) and 37% ($6.2 trillion) in 2008. Within this total, exports from developing countries to other developing countries increased from 7.8% to 19% of global trade.
The above suggests that the continued growth of consumption in developed markets may not be a limiting factor to growth of emerging economies. Despite expectations for weak growth in developed markets, the World Bank expects good growth in emerging markets as these countries shift from being dependent on exports to developed nations to refocusing on other emerging markets and their own growing consumer base.
World Economies at a Glance
Share of GDP (in USD)
Data: Year-end GDP in USD; 2015 is an estimate. Due to rounding, share numbers may not equal 100%. Source: International Monetary Fund; Crandall, Pierce.
Impact on the global capital markets
It is beyond the scope of this article to discuss the many implications of the rise of emerging markets for the global capital markets. But one has direct consequences for Aspiriant's long-range capital market expectations that drive clients' investment portfolios — the rise of foreign reserves in large developing economies, particularly China. China has seen a strong rise in retained corporate earnings, surpluses of government-owned enterprises, and personal savings in recent years3. By earning and saving wealth from the global economy, the Chinese are running a significant current account surplus with other countries like the US. Much of these savings are invested in global bond markets, driving down interest rates. This "savings glut" produced very unusual US yield curve behavior in 2005-2006, with intermediate-term rates remaining stubbornly low despite increasing short-term rates driven by the Federal Reserve.
Savings Balances in China and OECD Countries
The array of socio-structural explanations for China's saving surplus suggests that monetary tools and exchange rate management alone will be insufficient to restore balance to the global capital markets — we believe the savings glut is here to stay. This is incorporated into our capital market expectations, which reflects a long period of below average bond returns.
Elsewhere in this Insight, we present an overview of the other impacts we expect to arise from the rapid development of emerging markets, including returns for public equity, real estate and private equity/opportunistic strategies which are much higher than we've experienced over the last 10 years, though in some cases lower than the long-term averages.
What if we're wrong?
The improved economic performance of emerging countries raises the question of whether we are truly in the early stages of an extended period of growth across the developing world or, instead, if we are merely in the kind of cyclical upturn that we have seen in the past.
There is a long tradition of economists and economic historians trying to identify the point of "take off" into sustainable growth.4 We believe that it is different this time because of a number of factors at play in the large emerging markets:
- Sound macroeconomic policies;
- Pro-business orientation;
- Build up of significant foreign exchange reserves;
- Movement up the value chain and diversification away from natural resources and labor-intensive industries; and
- A viable domestic consumer market, in part due to urbanization.
If we are wrong about the strong economic growth and capital market returns we predict in emerging markets over the next 20 years, we believe the most likely causes will be resource constraints (including pollution and the disposal of waste) or geopolitical conflict.
Investors tend to be in two camps with respect to evaluating investments in emerging markets:
- Emerging markets groupies who believe the growth story of emerging markets, particularly relative to developed markets, makes emerging markets a can't lose opportunity; or
- Emerging markets xenophobes who believe emerging markets are foreign, lawless places offering volatile investments which are best avoided or minimized.
Of course, neither of these represents the appropriate perspective. Though they may have different opportunities and challenges, emerging markets must play by the same rules of economic gravity as all countries. Therefore, we can (and should) use the same methods of analysis on emerging markets investments as we do in the rest of the portfolio.
We look forward to sharing our analysis and perspective with you over the coming months.
Jason Thomas, Ph.D., CFA
Chief Investment Officer, Principal
Grimwade, N. (2000), International trade: new patterns of trade, production and investment. Routledge, London. Maddison, A. (1970), Economic Progress and Policy in Developing Countries. Allen and Unwin, London. OECD (2010), Perspectives on Global Development 2010. OECD, Paris. Reynolds, L.G. (1983), "The Spread of Economic Growth to the Third World: 1850-1980", Journal of Economic Literature, Vol. 21, No. 3, pp. 941-80. Rostow, W.W. (1960), The Stages of Economic Growth: A Non-Communist Manifesto. Cambridge University Press, Cambridge.
1 OECD (2010).
2 Grimwade (2000).
3 OECD (2010).
4 Rostow (1960), Maddison (1970), Reynolds (1983).