The inexorable rise of emerging markets -- especially those with large populations as China, India, Indonesia, Brazil, Russia, Mexico, and Turkey (to name a few) -- has some wondering whether investors should turn their back on problem-ridden Western economies and look for better growth opportunities in these emerging markets. We don't really agree.
There exists a fair amount of doom about the economic future of the developed economies (North America, Europe, and Japan) and, indeed, after the financial crisis, growth has been tepid (the U.S. and Japan) or downright horrible (much of Europe). And low growth is compounding all sorts of other problems, like public (and private) debt burdens and the demographic shift going on in which a shrinking workforce has to care for a growing older population.
Stephen King, the HSBC chief global economist, has written a book with the ominous title, When The Money Runs Out, The End Of Western Affluence. The title speaks for itself. Even former U.K. central banker Mervyn King has joined the pessimists:
The country has just completed one 'lost decade,' measured on growth per person, he says, and is about to enter a second.
King's deputy at the Bank of England, John Gieve, suggested that the sustainable rate of growth in the U.K. "may now be 1.25% -- half the pre-crisis level." In much of Europe, the situation is even worse as parts of it (most notably the eurozone periphery) are experiencing a longer recession than even the one in the 1930s.
But is all this doom and gloom justified? Should we rush to take profits in developed markets and invest all in the rising Asian powerhouses that will outgrow and out-compete us? We're not so pessimistic.
There is little to suggest that innovation and technological progress are running out of steam, let alone slowing down. These are the most important determinants of that all-important metric: productivity. If the productivity of input factor keeps increasing as it has done over the last decades, there is simply no reason for doom and gloom. That's because the economy can grow at the same pace as it did, at least potentially.
It is entirely possible that we're seeing the same lagged response to the advancements in extensive connectivity, handheld devices, and ever greater and cheaper computing power as we did in seeing a lagged response from the beginnings of the IT revolution. There are revolutions in energy materials, biotechnology, and a host of other fields that are only beginning. See, for instance, the report by McKinsey on disruptive technologies:
...together, applications of the 12 technologies discussed in the report could have a potential economic impact between $14 trillion and $33 trillion a year in 2025.
In short, we side with Ben Bernanke in seeing near-infinite potential for innovation to boost the economy and improve life. We have done so for many decades and there is no reason to think this will all suddenly decline, even if there are some worries about the net employment effect.
That doesn't mean that the West doesn't face serious economic problems. Implementation of technological progress is being hurt in many Western countries by insufficient demand, a result of the deleveraging in the private sector and austerity in the public sector. If companies cannot sell all they produce, there is little incentive for them to increase capacity embodying newer technology.
The longer this process of insufficient demand lasts, the more serious this so-called "hysteresis problem" becomes. It's not only the capital stock that is slowly decaying and not expanding at the pace it could, it's also labor. The more unemployed and the longer the duration of unemployment, the more these unemployed workers will lose skills, motivation, and will be discriminated against when the economy improves, leading to a decay in labor capacity.
So while there is no supply problem as such (innovation and technological progress are running full-steam ahead), there is something of a demand problem that slowly eats away at the productive capacity of the economy. These effects aren't very large in the short term, but compounded they do have a serious enough effect to worry about it. Therefore, we find it difficult to imagine why King calls the austerity vs. stimulus debate spurious. A lack of demand is responsible for the economy to grow slower and leave capacity unused, and doing that for a long time will affect the quality and quantity of the productive capacity itself.
We could simply grow faster if demand was stimulated more, so the low growth problem isn't something we're doomed to accept, it's a problem created by ourselves. If you don't believe us, believe the IMF:
The International Monetary Fund has called on the U.K. government to take more action to boost the economy, which it warns is 'still a long way from a strong and sustainable recovery.' It said the £10bn-worth of spending cuts and taxes planned for the coming year would be a 'drag on growth' and urged the government to do more to stimulate the economy.
Higher growth will also cure the deficit and debt burdens. In the U.S., even with moderate growth, this is already happening at a surprisingly quick rate. Compare that to the austerity induced recessions in much of the eurozone, and look what is happening to public deficits and debt burdens there.
Western economies, especially Japan and much of the eurozone, could do much more to revive their economic fortunes. Embarking on market-friendly structural reforms can yield big dividends, as the case of Germany has shown. As The Economist wrote, a decade ago Germany had one of the worst jobless rates in the rich world, but today (at 5.4%) it's one of the lowest. Youth employment (below 8%) especially is low in Germany; compare that with the generational disasters in Italy, Portugal (30%+), and even more so in Spain and Greece (50%+) and it's a world of difference. These countries don't only suffer from a lack of demand, but they tend to protect the insiders in the labor market -- those with jobs -- at the cost of outsiders. Germany has, with the sweeping tax, regulatory, and labor market reforms implemented in 2003, shown that reforms can make a considerable difference in this respect, although these are no quick fixes.
While some progress is being made in the eurozone periphery, much political capital has been spent on counterproductive austerity, which is now greatly complicating implementing necessary structural reforms. The same holds, grosso modo, for Japan, although we shouldn't lose sight of the fact that the Japanese labor market is institutionally very different from the West and hasn't performed that badly -- even if it protects insiders (even more so than in most countries).
Another necessary reform that hasn't gone far enough is that of the financial sector. The main task of the financial sector should be to provide capital for value adding economic activities and assessing the accompanying credit risks, but much of the new activities are of a zero-sum (my gain is your loss), or even negative sum nature (we explained this at length here). Working financial regulation isn't rocket science, we know roughly what to do, but there are too many entrenched interests in working against that. This is actually a wider theme, first taken up by economist Mancur Olson, who argued that long periods of stability made it easier for interest groups to become entrenched.
Structural reform almost invariably takes these entrenched interests on, but often this can only be done when there is a crisis of sufficient magnitude. Gerhard Schröder, the German Chancellor behind the reforms in 2003, lost the elections because of these -- let's not forget that. So while the decline of the West looks mostly like a self-inflicted wound, one can still argue the West is declining in relative terms. Should you rush to buy emerging markets instead? Consider this:
The stock of capital flowing into emerging markets has doubled from $4 trillion to $8 trillion since the Lehman Crisis, chasing a catch-up growth story that looks tired and has largely sputtered out in Brazil, Russia and South Africa. (Evans-Pritchard)
Perhaps not. Indeed, emerging market stock markets are in somewhat of a free fall, although this seems the combination of the fear of the end of Western monetary stimulus and a measure of slowdown in economic growth, rather than the forebode of some structural shift in economic fortunes. While the West might be in (relative) decline, equity investors are profiting from a substantial income shift from labor to capital in many countries, especially the U.S. As long as companies can sell to a rising middle class in emerging markets, this might not generate too many problems -- at least not for equities.
So we can see how monetary tightening could reverberate around the increasingly interdependent world. Most of the growth and the numbers are in emerging markets, and many Western companies are increasingly dependent on these for top-line growth. However, the emerging markets are still very much tied to the Fed monetary cycle and the technology frontier.
And lest we forget, it's companies that compete with one another, not countries. The growth of emerging economies does not have to come at the cost of living standards in the West -- quite the contrary. So we wouldn't flee Western stock markets anytime soon, at least not out of fear of some Western decline. If we look at how stock markets performed year to date (as of June 8), you'll see that the G7 countries are doing a lot better than the BRICs (Brazil, Russia, India, and China).
Zacks noted the following already back at the beginning of April:
Emerging market ETFs have been lagging their developed counterparts this year and have been among the worst performing products in the first quarter. This is largely due to a slowdown in domestic demand in the key emerging markets, a lingering eurozone crisis (which can impact exports), and appreciation in the U.S. dollar. In fact, these ETFs clearly underperformed the broader U.S. market funds like SPDR S&P 500 ETF (NYSEARCA:SPY) and Dow Jones Industrial Average ETF (NYSEARCA:DIA), and the world market funds like iShares MSCI World Index Fund (NYSEARCA:URTH) by a wide margin in the quarter.
Of course, this is just recent performance while we're talking longer-term trends, but when growth in the U.S. is tepid and really bad in Europe, it's still quite remarkable. If we look at a five-year period (reading from Yahoo's charts) we can see that:
Russia's RTSI index declined from above 2,000 to under 1,300
- The U.S.'s S&P 500 is up from just above 1,300 to above 1,600
Only India is up in a similar fashion as the S&P 500; the other three markets are down considerably. This is a five-year period. Now, this could be a bit of a freak, and there is little doubt that economic growth has been considerably faster in emerging markets compared to the West. However, many western companies benefit considerably from that emerging market growth, and as stock market returns indicate, fast economic growth is not a guarantee for stellar returns.
While emerging markets, just like their currencies and bonds (or commodities), are likely to turn, we think it will be awhile yet. While Zacks argued in that April article that the time was ripe to take positions, most notably in the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM), that turned out to be a little premature:
We would prefer to wait until the dust settles.