Macro events have been at the centre of investors’ attention over the past eight months.
In 2011, the world experienced new fragmentations, breaking from some of the key trends seen since the Second World War. Some of those fragmentations – economic, social or political – might be with us for a while; they are not only emanating in part from the impact of the financial crisis, but are also linked to long term developments and trends in technology as well as information and cultural globalisation.
2012 will still see volatility as European challenges, electoral cycles in various parts of the world and geopolitical adjustments in the Middle East unfold. However, the key to performance is the assessment of sustainable growth beyond the financial crisis and a reconnection with long term fundamentals.
In a developed world, juggling the constraints of deleveraging and, in some cases newly found fiscal discipline, companies will need to continuously assess the opportunities for sustainable end demand while also exploring the power of emerging market demand.
Leaving aside the quality of management that companies must demonstrate to be successful, the debate around corporate growth sustainability can be articulated around the elements of demand, resources and debt. With this in mind, key themes need to be considered very carefully. These include demographics, climate change related issues (energy) and the ‘Supercycle’ – the evolving role of the large emerging market economies in the global economy with regard to resources and geopolitics.
Demographics
Demographic factors have a strong role in evaluating demand sustainability. Powerful shifts in population growth, ageing and urbanisation provide compelling long term opportunities for companies.
The world’s population is set to explode to 9bn by 2050 from 7bn today – driven by emerging markets. As the emerging market middle classes grow in number and wealth, consumer patterns will shift dramatically as purchasing power increases.
Trends emerging from this include increased demand for luxury goods, growing spending on health care and education, and dietary changes.
As well as increasing in number, the world’s population is getting older at an unprecedented rate. The majority of population growth is actually occurring at the upper end of the age distribution due to gains in life expectancy. Fertility is falling rapidly and is well below the replacement rate in much of Europe and Asia, including China.
Europe, for example, has a median age of almost 40, making its population one of world’s oldest. Overall population decline in Europe will begin in the next 10-15 years. Currently, dependency ratios are relatively similar across the region, but will diverge over the next 40 years, ranging from under 38% in the UK to over 62% in Italy.
With growth in working age population a key driver of economic growth, companies have to be extremely tactful and position themselves strategically to tap growing niche demand.
With ageing populations for example, the types of goods and services in demand will change: older people will spend more of their income on food and, as they become more health conscious, nutritious and local produce should win out over fast food or eating out.
Evidence suggests that older people also tend to spend less on clothing, furniture and entertainment, but more on home help, books and utilities. While this section of the population spends less on public transport and buys fewer cars, it is the main consumer of package holidays and cruises.
In the absence of major fiscal reform, the impact of ageing on government budgets will be substantial, especially in terms of the cost of public pensions, health and long term care. The IMF finds that, in NPV terms, age related spending would cost nine times as much as the 2008/9 financial crisis, including fiscal stimulus packages, financial sector support and automatic stabilisers.
In the absence of major reform of public health and pension systems, this could drive debt/GDP ratios in excess of 300% in 2050 – an unsustainable level.
Emerging markets: ‘supercycle’
With a large part of the developed world coping with the dual challenges of rapid ageing and the long term impacts of the excesses that led to the crisis, the importance for companies to successfully tap into a newer and growing pool of meaningful demand has accelerated even further.
Emerging markets have provided that pool for the past 20 years but are now getting to a size where they are more significant than the developed world in some cases. Just as a reminder, on a PPP basis, emerging markets’ nominal GDP is set to surpass that of developed markets by 2015.
China is now the second largest economy at about US$6trn in nominal GDP and is now approximately the same size as India, Russia and Brazil together. Some foresee China surpassing the US on a nominal basis in 2027. Furthermore, if the expected growth contribution to the global economy for the 2010-2019 period is focused upon, China represents the largest contributor at over 30%.
While many did not believe in the Chinese ‘economic miracle’ 25 years ago, consensus now has shifted. However, we remain convinced that China’s impact on the world over the next 20 years is not fully discounted. Other large countries or continents such as India, Brazil and Africa will also be significant sources of demand that companies should not ignore.
The impact of emerging market demand and development will also clearly continue to have an impact on resources. Looking at iron ore, oil and many other commodities where China or other emerging markets such as Brazil have a large impact both from a demand or a supply perspective, the topic of growth sustainability cannot be considered without taking into account resources at a global level.
One reason to believe that commodity prices will continue to trend upward is the difference in population dynamics between the developed world and the emerging markets. While the US, Europe and Japan were relatively small in terms of population, the new big growers are large.
In 1900, the US, Japan and Europe accounted for about 350m people. By 2000 this pool of demand had approximately tripled but was still less than a sixth of the global population.
This is very different from the current situation, where China and India alone represent over a third of the world’s population. Apart from the impact on commodity prices, another key factor to consider is the sustainability of production of those resources given current ecological stress and resource scarcity.
Given the finite nature of those factors, investors will find opportunities in companies offering innovation and efficiency in resources exploration and usage. Companies using commodities must also be carefully selected in high added value areas, given the ongoing cost pressures.
Climate change: the next industrial revolution
The combination of demographic shifts and ‘supercycle’ mentioned above is inevitably leading to an assessment of the impact on climate change and the debate around energy security.
With energy prices increasingly driven by emerging market demand, and a finite and declining fossil fuel supply, the impact of high energy prices on a developed world experiencing declining trend growth is a substantial geopolitical issue. Energy efficiency and innovation, including shale gas, wind, solar etc, are key in our view to the climate change debate or what we call the new industrial revolution.
Growing pressure on government finances means that climate solutions that have a clear positive return on investment – and thus do not require subsidies – will see increasing demand. Energy efficient technologies are therefore one of the most exciting growth areas related to climate change prevention.
To meet energy efficiency targets, new technologies will have to be deployed across all energy consuming products. For example, new lighting technologies such as compact fluorescent (CFL) and light emitting diode (LED) light sources are far more efficient in their use of energy than traditional sources and are fast becoming commercially viable.
These are just examples, but we expect these technologies to take share from older technologies at a rapid rate.
Dealing with debt
Another key element of growth sustainability over the next five years is the ability that governments exhibit in dealing with the debt burden linked to the excesses of the past and worsening demographics.
While it seems difficult to see countries with high debt-to-GDP ratios adjusting down to the reasonable theoretical level of 80-90%, given the economic impact of such tightening, growth will be seriously challenged.
Trend growth will therefore settle at a lower level and investors will have to make judgements regarding the sustainability of that growth, taking into account the ability of governments to find the right mix of fiscal adjustments, growth, innovation and funding from the markets or from their domestic institutions – ‘financial repression’.
This will be difficult for companies as political and social instabilities may continue to have a serious impact on the demand framework. In this environment, investing on a global basis to provide sufficient scope to find sustainable growth at a reasonable price is key to identifying appealing earnings streams in developed or emerging markets and building outperforming portfolios with best ideas for the long run.
The debate around sustainability will undoubtedly continue to evolve and investors must be vigilant to assess it in any form on a continuous basis.
Virginie Maisonneuve is head of global and international equities at Schroders
