Sub-par growth and low inflation mean that monetary policy in developed countries is likely to remain pretty easy. We don’t expect the US and European central banks to start raising interest rates until the second half of next year and tightening in Japan may be two years or more away.
The outlook for the emerging world is much brighter.
They are not lumbered with the same debt problems as many advanced countries (see the chart above on showing public debt), tend to have far more favourable demographics and have plenty of scope to boost their own consumption to make up for weaker growth in developed countries and are moving to do just that.
Reflecting this, the emerging world is leading the way out of the global recession with growth in many Asian countries rebounding earlier and much faster than has been the case in the developed world. But not only is the emerging world leading the recovery, this is the first global economic recovery to occur with the emerging world actually being a bigger proportion of the global economy than the developed world (on a purchasing power parity basis).
While consumer spending is a smaller proportion of GDP in emerging countries, emerging world consumer spending is now equal to that in the US. This all holds out the hope that the global economy can be less reliant on US consumers.
So while there is nothing new in a cyclical economic upswing, the big difference this time around will be the much greater role played by emerging countries.
The greater importance of the emerging world and the constrained, more fragile, outlook in the US and other developed countries has a number of implications for investors.
First, investors need to move away from the concept of traditional international equity funds and rather allocate more to stronger growth Asian and other emerging countries. Traditional international equity funds are benchmarked against indices that have an 80 or 90% exposure to slow growth advanced countries. They are lagging way behind the reality that the emerging world is now playing a much bigger role in the global economy which is set to get even bigger.
Second, growth in the emerging world is commodity intensive as most emerging countries are still rapidly industrialising. For example, they now consume more oil than developed countries – see the next chart. This suggests an allocation to commodities should also be considered.
Third, strong commodity prices are likely to be favourable for commodity currencies such as the Australian dollar which suggests a need to be aware of unhedged exposures to traditional offshore investment markets.
Fourth, Australia’s strong exposure to high growth Asia and commodities and its rapid population growth provides a positive backdrop for Australian shares and suggests investors should have a bias towards Australian shares.
Fifth, the greater fragility of US consumers, the risks associated with rising public debt levels (and measures to deal with it) in major advanced countries and the inherent volatility of emerging markets means that the economic and investment cycle could be more volatile going forward.
Finally, it’s worth observing that bubbles are part and parcel of investment markets and they usually form from the ashes of the previous bust. It’s hard to see another bubble forming any time soon in the US – after all the US has had a monopoly on major bubbles and busts over the last decade having had both the tech boom and bust and the housing boom and bust.
However, the combination of easy money conditions in the US and other advanced countries, the positive fundamentals in the emerging world and as the transition to a more China centric world inspires the imagination of investors, there is a good chance that the next bubble will be in or around the emerging markets and related trades such as commodities. Officials in several Asian countries seem to recognise this and are making noises about the dangers of low US interest rates fuelling a bubble in their own countries.
Of course the best way to minimise this is for emerging countries to let capital inflows simply drive up their currencies so that they are then free to tighten their monetary policies to deal with any asset bubbles. But since the US is unlikely to set its monetary policy on the basis that it may contribute to bubbles in other countries (and why should it) and key emerging countries are unlikely to simply let their exchange rates float higher, the risk of bubbles forming in the emerging world is high. That said asset bubbles take 4 or 5 years to form and it is still very early days yet.
So while there is always a cycle and there will always be bubbles, they are always at least a bit different and this time around the rise in the relative fortune of emerging countries versus developed countries is different enough to have significant implications for investors.
Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.
James was the editor and publisher of SmartCompany and LeadingCompany for five years. He is now the Australian Financial Review‘s companies & markets editor, and a former BRW editor.
