Time of Transition

Time Of Transition: The Future of The Global Economy
by Michael Hughes

Recent events in financial markets suggest that this is a period of transition for the global economy. This transition represents a change from a high debt environment to a more sustainable set of financial conditions, and from a low growth and high inflation environment to a high growth and low inflation era. There is also a change in industrial structure from a period of product innovation to process innovation. Finally, we are changing from a government dominated to a consumer-oriented society.

By considering each of these changes, we can define a vision of the future which assists with the design of an investment strategy.

Debt Hangover
The levels of debt to GDP experienced by most G7 economies are unsustainably high. It is notable that for most of these economies the private debt ratios are more extreme than their public debt counterparts. Whereas the solution to a public debt problem in the past has been governments pursuing inflationary policies to debase the currency, this is not the solution for a private debt problem. For that, encouraging more economic growth to help repay debts is more appropriate, hence the shift in monetary policy to encourage people to take risk and encourage higher economic growth. In the last 18 months, we have seen the marginal cost of capital, represented by real bond yields, fall below the productive growth rates of most G7 economies. This is in contrast to the monetary conditions that prevailed from 1981 until recently, when policy was geared to fighting inflation and had the effect of discouraging risk taking. This shift in monetary conditions is one we see as being permanent over the next five years, in order to reduce debt ratios to more sustainable levels.

High Growth and Low Inflation
During the latest economic cycle we have experienced a different type of inflation. Not only has inflation been lower, but it has also behaved differently. The relationship between economic growth and inflation is noticeably different than in the last 20 years. We believe inflation in this environment is more supply than demand determined. There are a range of factors which have led to this change. The growth of technology and the transparency of pricing which it implies has been a big factor. But so too has been the demise of communism and the shifting of defence spending to more productive activities. In addition, the establishment of a single European market in Europe and the growth of additional capacity in Asia have all contributed to this change. If the relationship between economic growth and inflation is now different, it follows that the relationship between bonds and equities should also change. Indeed, it appears to be the case that equities and bonds now have a lower correlation than they had in the high inflation period of the last 20 years. This we regard as a permanent feature of markets, which implies that bonds offer diversification benefits in a low inflation world which they did not in a high inflation era.

Product to Process Innovations
Broadly speaking, there have been four innovation cycles this century: organic chemistry, followed by nuclear fission, then the transistor (and subsequently the integrated circuit), and bio-genetics.

Product innovation gives rise to emerging companies and industries. The investment lesson of the 1990s has been that investors should have paid more attention to emerging industries than emerging markets.

An examination of long-term economic cycles shows that in the recovery stage emerging industries dominate. They create new markets in which there are relatively few competitors. Economic growth rates begin to accelerate from the low rates recorded during the depression stage of this long-term cycle. Emerging industries play a central role in stimulating the revival from depressed economic conditions.

However, the products of emerging industries change the behaviour of other companies, allowing them to make the transition from old to new product life cycles. Hence, a period of economic prosperity can ensue with the breakthrough of new lines of activities and companies re-engineered to take account of new technologies. This is the phase we believe we are now moving into, and as such the impact of process innovation should be dominant. Some of the old economy sectors should now be viewed more positively in the expectation that individual companies should begin to transform themselves.

Consumer Empowerment
The next 10 to 20 years should be thought of as the era of the consumer. This follows on from the era of the mega corporation in the 1980s and 1990s and that of the government in the 1960s and 1970s. This shift in economic power from governments to consumers has important implications for profitability.

The empowerment of consumers has come from a variety of sources. The current generation of consumers is much more demanding than those of the past. It is also the generation that came to depend on government for health services, education and welfare support. The government is now backing away from these obligations. This encourages consumers to demand greater value for money, especially in areas such as health and education. The next generation is building on these values and demanding that goods meet environmental, ethical, and even religious standards.

On top of all this, technology is enabling consumers to have greater choice. Prices can be compared quickly and easily, companies can be communicated with directly rather than through an intermediary, and new products and services can be designed with individuals rather than markets in mind. The consumer is therefore taking control and exercising buying power as never before.

One of the consequences of this is that companies need to have relevant positioning and standards to receive the benefits of this consumer shift. Companies with strong brands and global presence clearly have advantages. Hence, the shift in the incidence of profitability to such companies suggests greater stock-specific risks to equity investors. Companies can only succeed at the expense of others failing, the implication of which is that for any equity portfolio the stock risks are higher.

In order to control the overall level of risk in a portfolio we recommend the use of bonds. Bonds offer diversification benefits in such an environment and help to reduce the overall level of portfolio risk.

We believe we are entering a new period of economic prosperity where economic growth rates will be high by past standards. However, within this scenario lie the seeds of the next bear market. Once economic growth gathers momentum, the competition for funds between markets and economies will intensify. Eventually, this will drive the cost of capital up, and a combination of this and the intensification of competition will drive profit margins down. It is too early to be planning a very defensive strategy, but it would be wise to bear in mind, after the extended bull run of the last 20 years, that a proper bear market is one where real capital values not only fall by at least 25%, but do not regain their previous peaks for five years or more. At some stage in the next decade, such a bear market may reappear.

Michael Hughes is the director of Baring Asset Management in London, England.

Transcontinental Media G.P.