8/12/13 – Sources of Growth and Emerging Markets

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Aug 12, 2013 9:56:13 AM

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One interesting trend recently has been the outperformance of the U.S. and other developed markets over emerging markets. A number of factors are behind this, notably capital flows, but shifting relative growth rates have been a primary driver. In this post, I want to take a look at the basic sources of growth to see how this trend might evolve over the next couple of years.

As I’ve written before, growth comes from three main areas: (1) demographics, since more workers means more growth; (2) capital investment; and (3) total factor productivity, a catchall category that essentially means learning to do things better, often through technology. Each of these components has a different value at different stages of the economic cycle, and this is where the emerging markets are starting to face challenges.

We’ll use China as an exemplar of the emerging markets, as its experience captures most of what I want to say. With demographics, for example, China has benefited from a large supply of cheap labor for the past 30 years. That wave has now crested, with the country’s working population expected to decrease in the next couple of years. Even as China’s demographic advantage begins to fade, other countries, such as Vietnam and India, are poised to pick up the baton. The absolute advantage, in worldwide context, is shrinking. And, as the world has become used to cheap labor, the relative advantage has diminished as well. China is seeing this now, and I suspect the other countries will encounter it sooner than they expect.

Capital investment typically serves as the next phase of the cycle. As labor gets more expensive, capital is substituted, and capital investment drives higher productivity and higher GDP growth. Again, China is the poster child here, with very high levels of fixed investment supporting and enhancing GDP growth. Again, though, China is approaching the point of diminishing returns, if it hasn’t passed it already. Other emerging markets aren’t as far along, but they’re getting there.

In short, emerging markets, led by China, are reaching a point where many of the easy gains have been made. Demographics and capital investment are getting played out, and future gains will depend on increased productivity, which is much harder to achieve.

Another way to look at this is through the technology lens. Toy manufacturing, for instance, uses simple and well-established technology, easily imported and learned. As countries move up the value curve, they can simply import technology and business methods and implement them more cheaply. For example, building PCs with standard chipsets is pretty easy; developing the next generation of microprocessor is much more difficult. Having fully exploited most existing technology, China is increasingly being forced to develop its own. Although it’s doing so successfully, there is no doubt this has slowed growth.

As you get closer to the bleeding edge, progress has to be invented, not imported. As the U.S. has found, intellectual property becomes more important as basic manufacturing becomes more commoditized. For countries looking to grow beyond basic manufacturing, the competition moves beyond cost, which has been China’s primary advantage historically. This shift will further slow growth.

The key takeaway here is that the emerging markets are being forced to move away from an area of competition where they’ve had a significant advantage—cost of labor—and into an area where they haven’t developed a similar level of dominance. At the same time, many are also attempting to make the shift from an export economy to an internal consumption economy—another difficult transition.

The U.S. and other developed markets, by contrast, were forced to make the transition to productivity-led growth some time ago. While demographics and capital investment continue to be important contributors, economic growth has largely been driven by productivity growth. We are used to being at the bleeding edge, rather than trying to shift both our economic structure and our growth models at the same time. Absent the need to move away from export-led growth to the same degree, the developed markets are better positioned to compete against the emerging markets in the future.

None of this is to diminish the very real future economic prospects of the emerging markets, just to point out that their past sources of growth will have to change in the future. With that, the developed economies will be much better positioned to compete, as the new sources of growth will play against their established areas of strength. The recent outperformance of the developed markets may just be getting under way.

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