Our Two Investment Implications
1. Emerging markets will go mainstream
Investors remain underinvested in emerging markets, if we consider portfolios on a GDP-weighted basis: the MSCI All Country World Index allocates around 13% to emerging markets, and the emerging world accounts for about one quarter of the world’s total public and private debt, but its share of global GDP is close to 40% and rising. That underinvestment is likely to continue to correct, especially as the emerging world becomes the main source of global economic activity in addition to just being the marginal driver of global growth.
Recent developments, from China‘s “Belt and Road“ initiative to the expansion of local-currency debt markets since the financial crisis and the inclusion of China’s huge onshore equity and bond markets in global benchmark indexes, already point to this transition.
It is worth remembering the sheer scale of what is implied by the liberalization of China’s onshore securities markets for international investors. In accordance with its sizable economy China has the world’s second largest equity market by value. More than 4,000 publicly traded “A shares” are listed across various markets, with a total market capitalization of $12 trillion. The market in renminbi-denominated bonds that are traded and cleared onshore (the “CNY” market) is also worth almost $12 trillion, compared with just $82 billion worth of bonds in the U.S. dollar and offshore “dim sum” CNH markets combined. The renminbi is now the sixth most traded currency in the world, its share of global FX turnover having doubled since 2013.
Chinese A shares were included in the MSCI Emerging Market Index for the first time in June 2018, and following the launch of the “Bond Connect” trading channel in 2017, government bonds and policy-bank notes are set to be included in the Bloomberg Barclays Global Aggregate Index from April 2019. This will make it much easier for international investors to take exposure—indeed, it will mean additional benchmark tracking risk if they do not take exposure—and as such these moves are expected to attract billions of dollars of inflows.
We expect international investors’ engagement with emerging markets to become deeper as well as broader. As private markets begin to represent a greater proportion of economic activity in general, we also expect investment in public emerging markets to be complemented by bigger allocations to private assets. In fact, investors may perceive that genuine economic exposure to some emerging and frontier countries can be gained more easily through more domestically focused private companies than through public markets that can be extremely small and sometimes dominated by local champions that trade globally. Similarly, active managers’ environmental, social and governance (ESG) analysis is likely to penetrate deeper into securities research in emerging markets, not least because the major emerging countries’ stock exchanges often have stricter reporting requirements than those in the U.S.
Over the coming decade, as lower return outlooks incentivize allocations to high-growth, high-return markets, we fully expect the current distinctions between the developed and emerging worlds to dissolve; investors are increasingly likely to reject this somewhat arbitrary division in favor of pursuing the best investment opportunities across the multipolar world.
2. The Great Disinflation is likely over
The financial crisis exacerbated existing disinflationary trends of globalization, technological change and aging demographics—but now we anticipate something more balanced.
The Digital Price Index of online inflation maintained by customer-trends specialist Adobe Analytics shows that online deflation is significantly outpacing deflation at large, with clear implications as e-commerce gains a greater share of the retail market. The related phenomenon of the so-called sharing economy has employed underutilized assets such as spare rooms (Airbnb) and cars (Uber, Lyft), thereby driving down prices. Knock-on effects—such as the tendency for millennials to buy fewer used cars—spread that disinflation into other parts of the economy.
At the same time, wages and productivity appear to be rising more slowly than historically due to a rapidly aging and retiring workforce; automation of manufacturing and even some lower-level service jobs; the disempowerment of labor unions; a lack of corporate and government investment in capital assets due to economic uncertainty in the private sector and burdensome indebtedness in the public sector; and an increasing burden of economically significant regulation.
Nonetheless, while the disinflationary effects of technology are real, they remain limited in scope and potentially hemmed in by social constraints. Demographic aging and the fact that the average lifelong salary tends to be lower for those who graduate during a recession will likely be partly balanced out as millennials in both the developed and developing economies enter their most productive years and potentially generate upward pressure on wages.
China, which for decades has exported disinflation as the low-cost factory for the globe, is now experiencing a rapid transition toward being a more self-sufficient, consumption-led economy, while the rate of urbanization is likely to slow—making its inflationary influence on the rest of the world more balanced. The increasing self-sufficiency of China is part of the broader trend toward a slower pace of globalization, which may be exacerbated by populist and nationalist political pressure in the developed world. Should that translate into more protectionism, consumer prices are likely to rise.
The past 10 years may have created a psychological bias toward expecting low inflation to persist forever. While we might not see a definite trend for higher inflation, we do expect more of a “two-way” dynamic—and volatility and higher correlations may result as investors slowly adapt to this new reality. Alongside the heavy global debt burden, the end of the Great Disinflation and bond bull market of the past 30 years raises profound questions about what constitutes a “low-risk” asset, how to balance risk in a long-term investment portfolio, and the relative attractiveness of inflation-sensitive assets.