Investing in the third super-cycle

By Michael Preiss

Singapore Business Times: As we approach 2011, the global macroeconomic environment has stabilised. While the biggest immediate worry in the West is a double-dip, we do not think it will happen. Meanwhile, the balance of economic and financial power continues to shift towards the East.

But risks abound, including geopolitical tensions on the Korean peninsula and in the South China Sea, over-regulation, another bank and government debt crisis in the West, inflation bubbles across Asia, and trade protectionism.

Although it is vital not to underestimate the risks, it is equally important to recognise the upside potential. That means it is paramount for investors to combine local knowledge with global perspective.

The year 2011 will be characterised by an uneven recovery in the world economy, leading different authorities to adopt diverging policies. This may raise conflicts and uncertainties, but also bring opportunities.

Financial markets are increasingly focusing on the story of a rich world struggling with a weak and jobless recovery and an emerging world, including the rising economic giant China and India, challenged by inflationary pressures and negative real interest rates. We expect interest rates in the West to stay close to record lows in 2011, but in the East there is pressure on interest rates to rise.

In 2011, the West will struggle with debt, deflation and deleveraging. The US is past the worst, but it faces a below-trend recovery bordering on stagnation. Europe, especially the periphery, is the big problem area.

Europe divided between the solid centre of its euro zone and a weak PIIGS (Portugal, Ireland, Italy, Greece and Spain) periphery. The euro is likely to collapse at some stage if the euro area fails to become a political union.

This year has been a challenging one for global financial markets with post sub-prime challenges, a European sovereign debt crisis and recently renewed tensions on the Korean peninsula.

It was a year when many economists and market commentators spoke about the possibility of a “double-dip,” the fear that the global economy could fall back into recession and deflationary pressures.

The world economy has moved into a recovery phase, albeit that the growth momentum is weaker than in past recoveries, especially in the advanced economies. By contrast, growth momentum is strong in the emerging markets.

Before the financial crisis, many economies around the world were booming in unison. After the sub-prime collapse and credit crunch, the differences between developed markets and the emerging countries look stark, and in 2011 they will increasingly become more obvious.

While the situation in the US is expected to improve, the uncertainty in the peripheral euro-area economies is again heightened, arid is reflected in Standard Chartered Global Research’s revised forecast for the euro at 1 .20. Euro area negatives most probably will be a major focus for FX markets in 2011.

Despite the current economic challenges, it important to recognise that the world is in the middle of a super-cycle.

This is a period of historically high global growth, lasting a generation or more. There are several fundamental factors driving this, including rising trade, high rates of investment, rapid urbanisation and technological innovation. Super-cycles are also characterised by the emergence of economies enjoying rapid growth, such as china, India, Indonesia, the Middle East and several African economies now.

The world economy has twice enjoyed super-cycles before. The first, from 1870 to 1913, saw a significant pick-up in global growth, with the world growing on average each year by 2.7 per cent, a full one per cent higher than previously seen.

That cycle was led by the emergence of the US and saw increased trade and greater use of technologies from the Industrial Revolution. The second super cycle from 1945 to the early 1970s saw growth averaging five per cent, characterised by the post-War reconstruction and catch up across large parts of the globe. It saw the emergence both of a large middle class in the West and of exporting nations across Asia, led by Japan.

For many investors, the thought of a super-cycle may sound strange, given the present problems confronting the world economy.

Yet, the reality is the world economy is now over US$ 62 trillion, about twice the size it was a decade ago, and it has already exceeded its pre-recession peak. Over the last two years, the economic rebound has been driven by quantitative easing in the West and by stronger growth in the emerging markets. Indeed emerging economies, which are one-third of the world economy, currently account for two-thirds of its growth. This trend looks set to continue.

China and India

By 2030, the world economy could grow to US$ 308 trillion. Excluding inflation, that would equate to US$ 129 trillion in real terms, or in today’s prices, and to US$ 143 trillion, keeping prices constant, but allowing for some emerging market currency appreciation.

The balance of the world economy will reverse, with the combined share of the US, the EU and Japan shrinking from 72 per cent in 2001) to 29 per cent in 2030.

China will provide 20 per cent of global growth in the next 20 years, the largest chunk, arid it will be the world’s largest economy by 2020. By 2030, China will be nearly twice the size of the US, but its income per head will still only be half of the US, leaving room for further catch-up. China will also drive growth in Africa and Latin America as it seeks commodities.

India will become the fastest growing major economy in the next 20 years, with growth rates overtaking China by 2012. Not even in the top 10 in 2000, India will overtake Japan as the world’s third-largest economy by 2030. India will have the single largest tertiary-educated population by 2030. These factors underpin our structural bullish view on the Indian rupee and Indian assets.

The growing emerging markets middle class will help fuel commodity prices, with energy and food continuing to become more expensive. As purchasing power increases across the emerging world, trade among Asian economies and Asia’s trade with the Middle East, Africa and Latin America will increasingly dominate world trade, overtaking trade with the developed world.

These ‘South-South’ trade corridors will account for over a third of global trade within the next 20 years. The Middle East will outstrip the US as Asia’s leading trading partner, while China will see Africa as a more important trading partner than Europe within the next two decades.

Indonesia is an economy that has surprised many investors. The JCI (Jakarta Composite Index) rose 51 per cent in 2010, making it the world’s fourth best performing equity market. In the super-cycle, we expect that Indonesia will continue to be a star performer. The 28th largest economy in 2000, Indonesia may be the world’s 10th largest in 2020 and fifth-largest in 2030.

The ‘7 per cent Club’

For 2011, we expect positive surprises to emerge from Africa. Many of the promising countries that we refer to as the ‘7 per cent Club’ are in Africa. The ‘7 per cent club’ are countries that are expected to achieve +7 per cent growth on average for several years. The reason why this matters is that growth doubles in a decade.

The biggest concentration of overlooked markets that could grow over seven per cent is in Africa.

There are, of course, risks to this outlook. Avoiding a hard landing in China is crucial. Avoiding deflation in the US is another necessity. The greatest risk is protectionism. Protectionism and different combinations of fiscal austerity and monetary police could bring turbulence to currency markets Escalation of currency intervention in the developed markets as well as the emerging world could be a potential policy mistake.

How long the current deflationary environment persists, and how well the exit from quantitative easing is implemented will determine the relative performance of the three principal asset classes, fixed income, precious metals and equities Longer-term, we expect that large-cap equities with significant sales to emerging markets will be the preferred asset class.

Which are the markets and countries that are likely to benefit the most? The countries that will succeed are those with the cash, the commodities and the creativity. It is still possible for the West, including the American and European companies, to do well in this environment, particularly if they are creative. Yet, it is the emerging and frontier markets that appear to be the clear winners.

We believe that the world economy is on an upward path, which is albeit not always a straight line. In the final analysis and in the words of a Chinese proverb: “Fortune favours the brave and the prepared mind.”

Welcome to the third super-cycle.

The writer is Chief Equity

Strategist at Standard Chartered Bank and Director/Economic Advisor of Ceylon Asset Management Sri Lanka.)