In this article, I will be discussing the two key reasons for believing that the era of high growth for advanced economies is over and most advanced economies will witness sluggish economic growth over the next decade and further. Before I discuss the factors, it is important to emphasize that this article does not suggest that investors need to completely stay away from advanced economies. The conclusion focuses on relatively higher portfolio allocation to emerging markets.
Two most important reasons for believing that higher growth will not be experienced in the long-term for advanced economies are debt and demographics. Investors can revisit economic history to see that unfavourable demographics will invariably lead to weak economic growth as the dependent population increases. Also, higher debt results in a prolonged period of deleveraging, which is negative for economic growth.
The point I am trying to make on low growth is best represented by the chart below, which gives the 10-year average GDP growth rate for advanced economies from 1970's to 2010. Very clearly, the average GDP growth rate for all advanced economies has been trending down. Even beyond 2010, growth remains sluggish for advanced economies with some countries still experiencing recession.
I would first like to explain this muted economic growth from a demographic perspective. As mentioned earlier, a higher proportion of non-working population can lead to additional pressure on the working population and also impact GDP growth as spending on Medicare, Medicaid and other social security programs surges. The charts below for five advanced economies give a good indication of the impact of demographics on growth. For all the countries represented, the average per-capita growth rate has witnessed a decline with a decline in the inverse dependency ratio. Clearly, as the population of dependent increases, GDP growth is negatively impacted.
Coming to the aspect of debt and deleveraging, the government debt in advanced economies is at near record highs (on a historical basis) as shown in the chart below. In all previous instances, the current level of government debt has resulted in an era of financial repression, defaults, inflation and hyperinflation.
As the deleveraging process begins in the future, GDP growth will be impacted for long-term. The process of deleveraging in itself is painful and prolonged. Readers might argue that the process of deleveraging began after 2007 and we might be in the midst of the deleveraging cycle. That is only true with respect to private debt. If investors consider the total debt (private and public), the advanced economies are still in a process of leveraging than deleveraging. The two charts below underscore my point.
The impact of high government debt on GDP growth is also negative as concluded by Carmen M. Reinhart, Vincent R. Reinhart and Kenneth S. Rogoff in their paper Debt Overhangs: Past and Present. According to the summary of the paper -
We identify the major public debt overhang episodes in the advanced economies since the early 1800s, characterized by public debt to GDP levels exceeding 90% for at least five years. Consistent with Reinhart and Rogoff (2010) and other more recent research, we find that public debt overhang episodes are associated with growth over one percent lower than during other periods. Perhaps the most striking new finding here is the duration of the average debt overhang episode. Among the 26 episodes we identify, 20 lasted more than a decade. Five of the six shorter episodes were immediately after World Wars I and II. Across all 26 cases, the average duration in years is about 23 years. The long duration belies the view that the correlation is caused mainly by debt buildups during business cycle recessions. The long duration also implies that cumulative shortfall in output from debt overhang is potentially massive. We find that growth effects are significant even in the many episodes where debtor countries were able to secure continual access to capital markets at relatively low real interest rates. That is, growth-reducing effects of high public debt are apparently not transmitted exclusively through high real interest rates.
Therefore, with some major advanced economies having government debt well over 90% (as percent of GDP), growth is likely to be impacted meaningfully in the medium to long-term. Considering these two major factors, it would be a good idea to allocate a relatively high proportion of funds to emerging market equities. There will surely be phases where the advanced economy equities outperform. In general, emerging market equities will do relatively well in the long-term. As mentioned earlier, it certainly does not mean that investors immediately allocate their entire portfolio to emerging markets. In the current global scenario, diversification is of paramount importance. However, of the equity allocation, I would gradually look at having 30-50% of exposure to emerging markets.
The following ETF's can be considered for exposure to emerging market equities -
iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) - The iShares ETF corresponds generally to the price and yield performance, before fees and expenses, of publicly-traded securities in emerging markets, as represented by the MSCI Emerging Markets Index.
iShares FTSE/Xinhua China 25 Index (NYSEARCA:FXI) - for specific exposure to Chinese equities. China looks attractive at current levels and growth in China has bottomed out in all probability in 2012. I would still take a cautious stance and gradually invest in China.
iShares S&P India Nifty 50 Index Fund (NASDAQ:INDY) - for specific exposure to Indian equities. I would like to mention here that Indian markets have rallied significantly in the last few months. Therefore, investors can wait for some correction before considering exposure to Indian equities.
iShares MSCI Russia Capped ETF (NYSEARCA:ERUS) - The investment seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the MSCI Russia 25/50 Index. The fund has an expense ratio of 0.6% with the largest exposure to the energy sector followed by financial and materials.
iShares MSCI BRIC Index (NYSEARCA:BKF) - The investment seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the MSCI BRIC Index. The fund has an expense ratio of 0.66% with 40.7% exposure to China, 28.6% in Brazil, 15.4% in India and 14% in Russia. In terms of sectors, the highest exposure is towards the financial sector followed by energy and materials.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.