While the last decade belonged to emerging markets, the next ten years will see the developed world take back the crown, writes Rathbone's James Thomson.
The last decade belonged to emerging markets; this decade is ours. Welcome to a new super-cycle of decoupling and recoupling, and perhaps the impossibility of the US and emerging markets outperforming at the same time.
Since the start of 2013, there has been a painful realisation for investors in emerging markets. The ‘infallibility’ of the emerging story, which was founded on an exponential growth in exports, domestic credit expansion and huge current account surpluses, is no more.
There is no denying that, over the last decade, emerging markets have experienced an impressive run. Ten years to date, the MSCI Emerging Markets index (TR sterling) has returned about 241%. The MSCI World (ex-emerging), on the other hand, has returned 117% over the same period and on the same terms.
Mega trends: How the West will win
However, since the start of this year, the emerging world has gone from a big bang to whimper: year-to-date, emerging markets have gained just 2.1%, versus 24% from their developed counterparts. Over the next ten years, investors should expect more of the same.
The structural cracks are now apparent. My view is that the emerging markets have had their decade-long run but, in the next decade, the headlines will be about developed markets, meaning the US, the UK and perhaps even Europe might do well.
I have never invested directly in emerging markets, largely owing to a lack of experience in negotiating their perilous imbalances. Quite frankly, I have never considered myself the man for that job. Investing in heavily nuanced markets such as the emerging world requires a certain expertise, with fund managers and analysts stationed in that market to obtain the best quality information – something I cannot hope to recreate while sat in London. I prefer to stick with what I know – that is what keeps me in developed markets.
During the next decade, I believe we will enter a world of slower economic growth and a much choppier environment. Within this, many emerging markets will continue to battle inflation, overcapacity and wasteful investment. Furthermore, we have just hit a three-year low for commodity prices: a lingering omen for the emerging markets but a boon for developed ones.
The slowdown in China continues to be a gift for developed markets. I hold only indirect exposure to China but I am acutely aware of the dangerous imbalances that any exposure to China can embody.
Investment, as a percentage of GDP, is 48% in China. This compares unfavourably to developed markets, such as the US and the UK, at 15%, and India (although still high) at 35%.
There is a dire need to rebalance. The problem is that China is experiencing an awkward transition and a period of much slower growth in order to get there. But this slower growth implies less demand for commodities and lower commodity prices lead to lower inflation for the developed world (because it behaves like a tax cut).
The plus-point for the investor is that there is a strong link between low inflation and rising valuations. Not a bad backdrop for market performance.
All about the US
The next decade will be driven by growth in the US. I am putting my money where my mouth is: I now hold nearly 60% of my portfolio in US equities, the highest allocation in the fund’s history, and a position that has increased over the last year.
This includes mainly mid- and large-cap cyclical areas. Why? Because the US is undergoing a renaissance period, where sectors such as the consumer, online retail businesses and shale oil and gas should provide interesting areas for outperformance.
But that is not to say the US is not without issues. Some market commentators have been highlighting the risk of a major market correction due to higher valuations. It is true that valuations have risen but I do not believe there is a major correction on the cards.
Indeed, it is arguable that, having looked at previous corrections, toppy valuations have never provided a meaningful catalyst. The catalyst has always been Fed tightening, higher inflation or some kind of energy crisis. As long as growth continues to outpace inflation, valuations can still, quite feasibly, creep higher.
Of course, many investors remain quizzical, wondering how stocks can keep powering ahead when faced with such all-round pallid economic growth. Well, part of that weakness is transient – growth has been restrained by fiscal tightening that took effect earlier this year and it will not be repeated in 2014.
GDP growth in the US is about 1.8% this year; without fiscal tightening, it is closer to 3%. That is where I think it will be next year and with it comes that elusive earnings growth.
With the Fed contemplating tapering, emerging markets should continue to underperform developed markets; certainly, until the growth and trade cycles inflect. The biggest risk to the emerging world, however, is the potential for policy error by the regional central banks, especially as current accounts continue to contract. All things considered, I am happy to remain sceptical about emerging markets for a few more years.
An ambitious objective
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