By Economic Strategist, Hottinger Investment Management
A few years ago, the management consulting firm McKinsey produced a striking graphic. It showed how the economic centre of gravity has shifted over the millennia. In AD 1, the place to be was Asia. China and India produced about 70% of world GDP, with the rest shared by the Ancient world (Greece, Egypt, Turkey and Iran), Europe and Africa. That centre of gravity only really started to move in the 1500s, after the Black Death had transformed Europe’s social and economic institutions. By WW2 it was at its most westerly point, between Western Europe and the United States, as those two places accounted for 70% of world GDP. By 2025, McKinsey expects the world to be back to where it was in AD 1.
China and India will soon again account for the lion’s share of the world economy as the trend for countries with large, well-educated populations with strong governance systems to dominate takes hold. The French essayist Paul Valery was probably the first to notice this trend, writing in the aftermath of the first world war:
“So, the classification of the habitable regions of the world is becoming one in which gross material size, mere statistics and figures (e.g., population, area, raw materials) finally and alone determine the rating of the various sections of the globe.”
In the coming decades, it will make sense from an investment point of view to have an Asia-first focus, with the deliberations of the Central Bank of India and the People’s Bank of China carrying the weight that the decisions of the Federal Reserve and the European Central Bank have today. The International Monetary Fund predicts that in the next few years at least the continent of Asia will grow at 5.5% per year and account for two-thirds of all the world’s growth. By contrast, the U.S and Europe will struggle to grow faster than 2.5% per year.
It is in this context that we should see the rise in volatility in emerging markets in the last few months (see chart below). Over the last five years, there has been remarkable convergence between market volatility in the G7 and that in the emerging markets. Usually, emerging markets are attractive for investors who have long time horizons and a preference for growth over income in their portfolios, but in 2016 and 2017, according to the JP Morgan indices for volatility, emerging markets had as much average risk as that in G7 countries.
This year, emerging market volatility has risen sharply. Some of it is on the back of concerns over the fiscal sustainability of particular countries such as Turkey and Argentina; both of these countries have low levels of foreign reserves to support public debt in the event that tax revenues come up short. Similar to the situation in the United States, there is concern about over-leverage in corporate debt in some developing countries.
But much of the explanation lies with what developed-market central banks are doing with their monetary policies. The Federal Reserve has raised rates significantly in the last year, and have the intention to continue increasing rates until 2020. It is also selling Treasury bonds that it holds on its balance sheet at the time when the Trump Administration is planning to run $1trn annual budget deficits, funded by sales of new bonds to the public. With US interest rates still seen as a benchmark for the global economy, all these developments mean that global yields are rising on government and corporate bonds; additionally, the supply of dollars is more limited, strengthening the dollar exchange rate and making it harder for emerging markets to service their dollar debts.
This latter explanation reflects emerging markets’ vulnerability to external factors more than fundamental unsoundness with the direction of economic policy and development. It is why in the medium-run we should still expect relatively higher volatility to be the price to pay for exposure to developing countries, and why–although we should be concerned with the big uptick in EM volatility–we should place it in its proper perspective. As emerging economies grow, they will develop policy independence and less sensitivity to global events.
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