The Great Convergence And What It Means To Investors

Includes: SPY, VWO
by: Nicholas Pardini

Emerging market investing (NYSEARCA:VWO) has always been an important part of an investor's portfolio. However, the changing winds in the global economy make it even more important for investors to invest in assets outside of the United States and Europe. With Central Banks easing and the current slowdowns in China and Brazil, are US and European stocks still the safest bets? The answer is no. Investors need to look beyond Pavlovian policy responses and focus on the bigger picture.

The biggest economic trend of the 21st century is the global convergence of living standards. With more competitive economies, more stable debt levels, and the drive to climb out of poverty, a global emerging market middle class is on the rise. On the other hand, currency debasement, mismanaged government fiscal issues, increased corruption, high levels of consumer debt, along with cultural issues related to mass cynicism and entitlement have caused a decline in wealth in Western nations.

The growth of economic power and the rise of the middle class in East Asia and Latin America causes half of the global convergence. Ever since trans-Pacific trade surpassed Trans-Atlantic trade in 1980, developing nations in East Asia and South America have been the fastest growing economies. With large populations of new middle class citizens and savings rates that average over 40%, emerging market consumers have more money to buy basic luxuries such as cars, washing machines, and televisions for the first time. This has and will continue to create a sustained period of high growth for decades to come. Liberalization of these countries' markets, a lack of entitlement spending, low sovereign debt levels, and changing values towards discretionary spending of younger generations will boost this trend. A similar historical example of what is going on in emerging markets today is the boom that happened in the United States between 1865-1929. Like the post-Civil War United States, growth will be cyclical, but the macro trend in East Asia will continue to boost the financial markets in these regions towards a steady upward trend.

Outside of East Asia, other countries seek to benefit from this trend as well. Commodity exporting countries such as Canada, Australia, New Zealand and Chile will benefit from the demand on raw materials coming from resource poor countries such as China and India. Many South American countries, such as Brazil and Chile are experiencing freer economic markets and growing middle classes like China and India, but without the ethnic violence or political instability plaguing the latter two countries. With large reserves of natural resources such as copper and oil, emerging Latin American nations have a strong possibility of performing on par with their Asian competitors.

The other unfortunate component of global convergence is the decline of Western living standards and geopolitical influence. Choked by high levels of both private and sovereign debt, Western consumers simply have lost their discretionary incomes. The Federal Reserve is not helping things with its continuous debasement of the US dollar. In real terms, wages have fallen over 10% in the US since 2000, and this trend will continue. A globalized labor market and automation will keep wages up, but bad monetary policy will continue to drive up prices through inflation (whether the CPI is accurate or not). The global convergence started with the tech bubble crash, but easy lending delayed the declining purchasing power of the American consumer.

A comparative example is the outcome of a college graduate in the US versus and emerging country such as Indonesia. An Indonesian college grad may only make $20,000 per year, but he or she has no debt and living expenses/taxes of $15,000. Due to the fortunes of an emerging economy, he can expect to get a raise of 5-10% the next year. On the other hand, the American college grad struggles to find a job that can pay $35,000. His or her living expenses and taxes add up to be $30,000 per year. In addition the grad has $30,000 of student loan debt that needs to be paid off each month. Due to the structural problems with the American job market, this grad will not get a raise, but will likely get a pay cut to $32,000 if the grad even keeps the job. The Indonesian may be nominally poorer, but is able to save money and have disposable spending income which both drive economic growth. The American, on the other hand, is living paycheck to paycheck and struggling to stay out of further debt and thus not contributing towards any real GDP growth.

Overall, the great convergence explains why investors should expect subpar net of inflation returns from the US economy (NYSEARCA:SPY) and positive long run returns from emerging markets. For longer term index investors the Vanguard FTSE Emerging Markets ETF (VWO) is the best way to buy into emerging markets due to its comprehensive holdings (over 900 stocks) along with having the lowest fees among emerging market ETFs. Growth in emerging markets is sustainable because it is based on savings and capital investment whereas growth in the West is untenable due to its basis on debt and government spending.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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