In my last three posts I took issue with the idea that faster growth in the emerging economies would necessarily lead to better investment returns; I took issue with the EM growth story itself, suggesting that the developmental model for emerging societies may be irretrievably broken; and I pointed out that for emerging societies to truly emerge and stay emerged, they had to develop inclusive civil societies, which few seem likely to do.
For me, the final nail in the let’s-all-overweight-EM coffin doesn’t have anything directly to do with the EM countries themselves, but rather with the relative attractiveness of EM versus other regions of the world looking forward.
For example, many of the developed countries of the world aren’t just going to roll over and let the emerging markets eat their lunch. While some developed economies do seem to be well into their dotage (Southern Europe, for example(1)), Northern Europe and North America – including Mexico – are enjoying an unexpected renaissance.
In the US, cheap energy from shale and smart manufacturing have turned the competitive world on its head. Companies in India and Germany are building new factories in the US, and many US companies have decided not to build again in China, but to build instead in the US or Mexico. Here is what Antoine van Agtmael and Fred Bakker have to say about this:
“It is not surprising, then, that an April 2012 survey by the Boston Consulting Group found that half of all companies with sales over $10 billion are actively considering reshoring production back to the United States and more than one-third of companies with sales over $1 billion. Of those surveyed, 70% found sourcing from China more expensive than they had believed and 90% worried about further raises in wages in China. Needless to say, this is a huge reversal.”(2)
I’ve written about this phenomenon before:
“[I]t’s one thing to convert an agrarian society into an industrial society. A strong and determined (Communist) central government can basically decree that it will happen and it will. (Note, on the other hand, that a determined but weak—democratic—central government, as in India, will have a much tougher road.) But for the Chinese economy to continue to grow at anything like its former glory, that economy can’t remain a simple industrial society in which capital is allocated mainly to create jobs and keep the populace docile. China has to transform itself into a vastly more complex postindustrial economy, where capital is allocated moment by moment to where it is needed most. And that is something that no society has ever achieved using a top-down, command economy approach. The Soviet Union collapsed when it tried to compete with the complex U.S. economy, and there is little reason to suppose that the Chinese will fare any better.”(3)
Knowledge economies don’t work by disseminating knowledge among a small elite at the top of the society and then ordering the rest of the population to do the right thing. Knowledge economies operate exactly in the opposite manner: millions of small, innovative decisions are made every day by people who have both the ability and the freedom to make those decisions.
The American manufacturing renaissance is a spectacular example of how this works in an open society, but doesn’t in a closed society. Men and women on the assembly line – working with increasingly high-tech equipment, including robots – constantly suggest improvements. Engineers, many of whom now work side-by-side with the line workers, design solutions. Foremen and other supervisors encourage collaboration and idea-sharing and reward innovation. The result is an incredibly efficient, customized manufacturing plant in which innovation is embedded almost invisibly throughout the process.(4) Nothing like this happens in command economies, where thinking people are dangerous. As someone recently put it, apropos of China, “[Y]ou can move someone to a factory [but] you cannot make them think.”(5)
It’s certainly true that a good part of the American manufacturing renaissance has been fueled by cheap energy via shale, but that simply proves my point. The shale revolution didn’t happen because somebody stumbled on a big, easily accessible shale deposit. We’ve known about shale for decades. Shale happened because of crucial innovations in the drilling and extraction process, innovations that happened in the US.(6)
The results of the manufacturing renaissance are often startling: GE bringing the manufacture of household appliances back from China to Kentucky; Ford building truck plants in Ohio; Otis building elevators in South Carolina. Most remarkable of all, although Steve Jobs confidently predicted that Mac computers could never be made in the US, he was barely cold in his grave before Apple announced that it would build Macs in America.(7)
To make matters worse for the emerging markets countries, while North America and Northern Europe are eating the EM’s lunch, the frontier markets and the more Western-oriented emerging societies are after their dinner. China has already lost its manufacturing cost advantage to places like Vietnam and Thailand, for example, and the so-called MIST countries – Mexico, Indonesia, South Korea and Turkey – seem to be prospering while the air goes out of the BRICs. (The MISTs have one overwhelming advantage over most of the BRICs – true multi-party electoral systems, as do Taiwan, Singapore, etc.) If the Islamic societies can gain control of their radical fringes (and, eventually, heal the schism between Shia and Sunni(8)), large countries like Iran (pop. 75 million) and Egypt (pop. 83 million) could become serious competitors.
So what’s a poor investor to do with an EM allocation? In the short term, none of what I’ve written about in my four recent posts really matters, as they are longer term concerns. What matters in the short-term is valuation and interest rate policy. Valuation issues currently favor EM, and if Western central bankers keep rates low for several more years, that will be a big help to EM equities. On the other hand, if rates in the West rise, EM will get hurt, possibly badly. Just thinking out loud, I’d tend to overweight the US and Northern Europe, underweight Southern Europe (including most of France until we see how things go over there),(9) hold a market weight in EM broadly, but with an underweight to the BRICs, and start looking hard at frontier markets. That’s for the short-term. Longer term, I’d maintain a market weighting in EM but focus on the non-BRICs.
(1) Many of the countries of the European periphery seem to have settled into a kind of sovereign senility, content to exist as permanent wards of Germany.
(2) Unpublished article, draft dated 5.4.2013. In the 1980s Antoine van Agtmael was an economist with the World Bank, where he began to speak of the “emerging markets,” meaning societies that are somewhere between developed and undeveloped. Recognizing that there was a (whole) lot more money to be made managing assets than being an economist, van Agtmael launched Emerging Markets Management in 1987, becoming one of the first to focus on investing in EM. For nearly 25 years, van Agtmael was a tireless promoter of the wisdom of adding EM to portfolios, and for most of those 25 years he was right. Recently, though – just within the past year – van Agtmael has begun to rethink the conventional wisdom that the emerging markets represent the future and US and Europe represent the past. His various writings on the subject are insightful and challenging: his book (now slightly dated in terms of his own thinking), The Emerging Markets Century (2007); his article in Foreign Policy (“Think Again: The BRICs,” November 2012); the unpublished article referenced above; his various speeches.
(3) The Stewardship of Wealth, pp. 15-16.
(4) This is one big reason why Americans and Northern Europeans are moving quickly away from building plants in places like China: merely by building and operating the plants, they are giving away intellectual property to the Chinese.
(5) Daron Acemoglu and James Robinson, Why Nations Fail.
(6) Other countries have large shale deposits, including China, but few of them have the water resources required to make shale extraction work – shale drilling is extremely water-intensive.
(7) Apple announced in December of 2012 that a new line of Macs would be produced in the US. In May, CEO Tim Cook announced that the Macs would be built in Texas, using components made in Illinois, Florida, Kentucky and Michigan.
(8) I hope we haven’t forgotten that our own schism in the West, between Catholics and Protestants, persists into this century in Northern Ireland. (The so-called “Good Friday” Agreement, signed in Belfast in 1998, formally ended The Troubles, but the dying has continued.)
(9) If you’re good at evaluating individual securities, there are loads of top-flight businesses in Europe and the EM selling at significant discounts to their US counterparts, simply because of where they’re domesticated.
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