The world has changed for investors, more than most advisors might realize. Despite everything that has occurred to markets and the economy over the past 10 years, the world economy has gotten much, much bigger. The reasons for that are the “tectonic shifts,” as Doug Coté, chief market strategist at ING U.S. Investment Management, likes to call the forces that have been driving the global economy over the past few years. Those forces include the widespread penetration of technology; the rise in global manufacturing; the importance of the global consumer; and continued innovations in the energy industry.
Few observers, however, realize the extent to which these ongoing forces have impacted global economic expansion, Coté said. Nor do they realize how just a few years after the greatest economic recession in recent history, those forces have successfully pushed total global output from $37 trillion to $73 trillion.
“Everyone was focused on the depression we went through, but right underneath our noses, these changes have been going on, and the world economy is now twice the size it was a decade ago,” Coté said.
That positive momentum, Coté believes, is only going to gain steam going forward, with emerging and frontier markets benefiting the most from the inevitable and underlying global dynamics.
Last year, emerging markets debt and equity were among investors’ least favorite asset classes, but long term, investment opportunities in developing economies abound, Coté said. That’s because these countries more or less have it all: commodities and raw materials, a stronghold on manufacturing, young populations and a continued increase in consumer spending. That spending is growing to such an extent that Chinese consumers are forecasted to make up 5% of global consumption by 2020, and the African Development Bank projects consumer spending in sub-Saharan Africa will reach $2.2 trillion in 2030.
As that dynamic continues to play itself out, the increasing incomes and improved lifestyles in the emerging and frontier markets are also leading to other kinds of cultural shifts, which in turn are creating new kinds of investment opportunities.
The Good and Bad of Emerging Markets
As an example of the big cultural changes around the world, consider a recent report from U.K.-based research firm the Overseas Development Institute. It found that rising incomes in developing economies are leading to higher rates of obesity and diabetes among their populations as traditional diets are abandoned in favor of fast food and other more unhealthy options.
“This is a disturbing trend that we’re going to continue to see as first-world lifestyles catch on in these countries,” said Clem Miller, investment strategist at Wilmington Trust Investment Advisors. “Ironically, though, and sad as it may be, it makes for a great long-term investment opportunity in companies that make diabetes drugs, for example.”
On a fundamental economic basis, Miller is of the opinion that developed economies—European ones in particular—don’t stand a chance against developing economies.
The United States’ abundant supplies of affordable energy, especially natural gas, are a magnet for both foreign direct and portfolio investment, and the country is quickly moving from a net energy importer to a net exporter. Europe, however, is dogged by a host of challenges. Those include aging populations and high wages, Miller said, all of which have been compounded by the problems brought on by the sovereign debt crisis and the ensuing recession.
“I believe the only direction we’re moving in is toward an Asia-Pacific, Latin America and Africa-led world,” he said.
Nevertheless, most large companies are no longer truly European or American, even if they’re listed on a particular exchange.
“A large percentage of the U.K.’s stock market, for example, is made up of energy and raw material companies, so it’s clear that it is more correlated with raw material prices around the world than with the U.K. economy,” Miller said.
How Europe Is Changing
More importantly, though, the crisis has highlighted the need for fundamental changes in the existing European economic model. Already there has been a noticeable cultural shift in certain areas that may well inspire a more competitive model for business and create a better framework for corporate activity and investment.
According to Giorgio Caputo, portfolio manager and senior research analyst at First Eagle Investment Management, one of the more positive developments in the post-crisis period has been the gradual shift from bank-led debt markets to institutional debt markets.
Historically, banks and businesses in Europe enjoyed cozy relationships, but with problem loans still lurking on bank balance sheets and new capital requirements specified in Basel III, “we are starting to see the further development of an institutional lending market in Europe that I think is set to continue,” Caputo said.
High-yield bond issuance, for example, has roughly doubled in the last year in Europe, and this presents opportunities for global income funds like First Eagle’s. Caputo is also encouraged by the improvement in bankruptcy regulations in Europe that are helping creditors feel more comfortable in certain jurisdictions. Great progress has been made in several European countries in terms of creditors being able to enforce their rights, he said.
“In the past, regulation tended to extort value from senior secured lenders and this impacted the future of even viable businesses because the reorganization process could be so expensive and time consuming,” Caputo said. “So to have an improved, better controlled [bankruptcy] process that gives businesses a greater say, similar to the way Chapter 11 provides a means to rehabilitate business in the U.S., is a good step forward for Europe. Allowing businesses to declare bankruptcy and then restructure rather than limping along means that resources can be redirected to more productive uses.”
Innovation Among European Financials
Financial sector innovation is definitely one of the more positive consequences of Europe’s protracted crisis, agreed Bill McQuaker, deputy head of equities at Henderson Global Investors. That’s particularly seen in the extent to which the financial markets are evolving to replace bank lending as a source of capital, and the creative ways in which companies are seeking out that capital.
Over the past months, Henderson has been approached by a few companies that want to source fund capital as opposed to bank loans or high-yield bonds, and are doing so in partnership with their banks by using the banks’ credit network to source cash that would come from a third-party investment fund and not the bank’s balance sheet.
“This is one example of how the financial sector is evolving quite significantly and, given time, we should see companies being able to access other sources of financing above and beyond bond financing,” McQuaker said. “The notion of a fund manager teaming up with a credit officer at a bank and using the bank’s credit network to ensure asset quality has some appeal. And smaller companies often find it tough to access bond financing, so the idea of an emerging loan market that’s independent of the banks is good.”
Overall, the shift toward a more institutional capital market system in Europe is very promising for European economies, as it leads to more arms-length transactions rather than clubby relationships between companies and banks.
At the end of the day, cosmetic changes alone won’t help Europe. The cultural shifts needed to make the European corporate sector and Europe’s economies more robust and vibrant must be deeper, longer lasting and designed to improve competitiveness in the global marketplace. That can’t happen unless changes are made to the very core of the European system.
What Europe Still Needs
Labor market inflexibility has been and is still one of Europe’s greatest problems, Caputo said, and together with the continent’s robust social safety net and burdensome bureaucracy, several European nations continue to be at a disadvantage compared to the more flexible labor markets of Asia and the United States. Even Germany, which has remained the most resilient economy in Europe and a leader in the export sector (where countries like Spain are still sorely lagging), is in need of serious labor market reform.
Ultimately, the rigidity of Europe’s labor markets will come to bear even on those companies that are securing revenues from places in the world where growth is strong.
“Developed-market-based global champions such as Nestle often derive much of their growth from emerging markets, yet provide investors with a more stable jurisdiction within which to be minority investors,” Caputo said. But with youth unemployment now as high as 40% to 50% in some Western European countries, “the problem has to involve the labor market structure and the investment climate, and this is not just driven by the business cycle,” he said. “Significant, additional reform is needed to make these countries attractive areas for investment. Otherwise job creation will continue to go elsewhere, and large parts of Europe will have an ongoing youth employment crisis.”
While there is undeniably a cultural shift that’s occurring in Europe, and some of the developments have been quite positive, it is too early to speak about any real or meaningful change, McQuaker said, particularly since the changes that are required are tough to achieve.
“But on balance, we’re in a better place than we were two years ago. We shouldn’t forget that,” he said.
Challenges for Emerging Markets
Last year was a challenging year for emerging markets, and if there was one lesson to be learned, it was that despite favorable demographics and the direction of global economic trends, the market may not always be there for these countries.
In 2013, many emerging market nations lost out on the liquidity they had always banked upon. That money went elsewhere, although that doesn’t mean it won’t come back. The capital flight has revealed the need for many countries to fix some serious underlying issues and to find other ways to attract investment, McQuaker said, because “those economic policies that drove growth so well for more than a decade are reaching the end of their shelf life.”
The BRIC model, for example, was well-developed and successfully exploited, and gave those countries a good run. Brazil benefited immensely from Chinese demand for commodities, and India’s service economy rolled it forward. But now these models no longer have the validity they once did (Brazil’s growth rate is negligible), and they must be revised in order to move these nations to the next level of economic growth.
“The challenge for these countries is to be able to evolve their underlying economic models and effectuate the shifts needed to bring about growth in different areas without compromising it as a whole,” McQuaker said. “They must enact the necessary changes to allow the underlying dynamics—the emerging middle classes and the growing financial sector, for example—to deliver on the same scale.”
McQuaker believes that China faces the greatest challenge in transitioning its economy from a fixed-asset model to a more consumer-oriented model.
Other economies around the world, developed or developing, rely upon China as the world’s second largest economy and a key driver of global growth.
There has been a great deal of skepticism about China’s transition, or at any rate the pace of that transition, from a manufacturing economy to a consumption-based economy. But ING’s Coté is optimistic that the shift is happening and that the Chinese authorities are determined to see it through, having recently announced sweeping reforms aimed at economic growth and a concerted tilt toward greater market orientation.
In addition, China recently relaxed its one-child policy, recognizing that an aging population is an impediment to growth.
Coté believes that what’s needed now in China—and in many emerging markets, including India and Brazil—is an end to state-controlled capitalism and a move toward greater private capitalism.
This is a huge cultural shift but a necessary one because while “the state—not just in China, but in other countries like India as well—gave these economies a boost and got the systems going, we are now starting to see that the state is an impediment to the private economy, which is what these countries need to develop,” Coté said. “One of the most important shifts we would want to see happening is the shift toward greater private capitalism over state capitalism to create that next level of economic growth.”
A Need for Recovery, but Also Leadership
This shift is happening in some countries. Mexico, for instance, recently introduced legislation to open up its highly protected oil and gas sector to private investment. Last September, China launched the Shanghai Free Trade Zone, a special area demarcated to invite private investment in a range of different areas. The country is also taking steps toward financial sector reform, including internationalizing its currency. In 2013, the renminbi overtook both the euro and the yen as a currency of choice for trade finance, coming in second behind the U.S. dollar, according to currency tracking firm Swift.
But as much as the push and pull of underlying global economic dynamics may require different kinds of shifts in different parts of the world, they must also be made with care. Emerging market countries like India have been promising for some time now to deliver more inclusive economic growth. In Europe, the rise of both extreme right and left wing political parties has raised different issues that may affect the direction of recovery as well as its beneficiaries, McQuaker said.
“Right now, the benefits of recovery are quite widespread, but if they are felt in a broader way, the growing discontent will disappear like snow in spring,” he said. “If other developments come along, there are some meaningful risks for Europe that will require a political class capable of really leading.”