Climate change

The truly extraordinary events that have unfolded since the collapse of Lehman Brothers have accelerated a process which has been underway for some time. Developed western economies have been burdened by, among other things, excessive debt (both sovereign and in many cases personal), low savings ratios, uncompetitive workforces, excessive red tape and expensive welfare systems all contributing to sluggish, or even declining, economic growth. In stark contrast the likes of China and much of the somewhat ironically termed ‘developing’ economies have envious fiscal positions, trade surpluses and a competitive labour market.

History books

These countries, and China in particular, are creditors to the west and history will tell us that economic and geopolitical power has tended to rest with the largest creditor nations. Spain was dominant during much of the 16th century, largely thanks to south American gold, Holland during the 17th century on the back of seafaring trade, Great Britain during the 18th and 19th century thanks to industrialisation and imperial advantages.
The US took on the mantel more recently, but now that China holds roughly US$740bn in US treasuries (equal to 60 per cent of the US national debt) it would seem that China has stepped into the driving seat. Just as there are well known and well documented economic cycles, the evidence would also suggest that superpowers are subjected to their own cycle (although rather than measured in years they tend to occur over many decades). As such, the shift of economic power from west to east and the emergence of a new superpower would be supported by historical precedent.

The statistics highlighting the growth of the E7 (a term coined by Goldman Sachs which stands for the ‘Emerging Seven - China, India, Brazil, Russia, Mexico, Indonesia and Turkey) make for compelling reading and would imply incontrovertible proof that the economic dominance of the west, and in particular the US and western Europe, is being eroded relative to China and India. Goldman Sachs wrote in March 2010 that: “It is now possible that China will become as big as the US by 2027 and the BRICs as big as the G7 by 2032.” Since 1995 Asia’s real GDP (even including Japan) has grown more than twice as fast as that of America or western Europe. The statistics are all the more compelling when you consider that it was only in the late 1990s that Russia suffered a debt default and Brazil a major currency crisis.

Power house

However, it would be an error to either underestimate the resilience of the US and the G7 in general or to ignore the social, demographic, political and economic shortcomings of some of these emerging power-houses. Such preconceptions may obscure the fact that while a shift of economic power is undoubtedly underway (and has indeed accelerated due to the current crises besetting Europe) it may still be working to a timeline that investors will fail to appreciate.

You only need to witness the many years it took for sterling to lose its status as the world’s reserve currency to appreciate the slow pace at which such changes unfold. Post World War One the writing was already on the wall that sterling was losing its dominance. However, at the time of sterling decimalisation in 1971, sterling still accounted for around 35 per cent of world trade. The unwinding of the status quo occurs at a glacial pace.

As Warren Buffet said: “In the 20th century the United States endured two world wars and other traumatic and expensive military conflicts; the Depression, a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”
You could further argue that the US still remained, and remains, the undisputed global superpower. America is an exceptionally dynamic market place, as evidenced by its leadership in the most recent global industry to emerge, the internet. Companies like Amazon, Apple, Ebay and Facebook all bear testimony to the ability of the US to redefine itself and such entrepreneurial zeal will enable the US to maintain sustainable long-term economic growth.

The E7, and China in particular, also have some of their own structural shortcomings that will ensure any shift of economic power is slow and that America’s position as the world’s economic superpower will likely outlive us. The US has supportive demographics whereas China will soon be contending with the impacts of its one-child policy. Furthermore, underlying social issues (and occasional unrest) immature markets, corruption and political instability will all combine to slow the emergence of some of the E7 countries.

Slow progress

In summary, we would be foolish to deny that the relative shift of economic power from west to east is underway but, like the turning of a supertanker, these trends will take some time to complete.
Where does this leave equity investors? The relentless rise in computer inter-connectivity has taken the concept of globalisation to a new level and resulted in inter-asset class correlation irrespective of differing economic outlooks. During the course of the most recent market rout, of which the peak to trough occurred between 7 July and 22 September 2011, European markets, which were at the very heart of the problems, fell by 22 per cent (as measured by the FTSE Europe Index in sterling terms).
Over the same period the Emerging Markets, supposedly untainted by western excesses, fell by an equally painful 20 per cent (as measured by the FTSE Emerging Markets Index in sterling terms). Such correlation has meant that much of our exposure to the growth of the E7 remains through western blue chip companies with E7 exposure such as Colgate-Palmolive. This company has the twin benefits of exposure to growth markets while having the strong corporate governance associated with a multi-national US-based business.

Markets will move on and the current obsession with the decline in the relative standings of the US versus China (a proxy for the G7 versus E7) will become sidelined by some other story ‘du jour’. The human mind is notoriously poor at grasping the significance of events that unfold over decades rather than days. Such shortcomings will lead to opportunities for investors who are prepared (and allowed) to take longer-term investment decisions. Investors should therefore position their portfolios to benefit from the growth of the E7 but should be patient and be prepared for the hiccups that will inevitably occur along the way.

Rupert Elwes is a director and portfolio manager at J O Hambro Investment Management Ltd