BREWIN DOLPHIN HOLDINGS PLC : Market Perspective: Industrial renaissance – 4-traders (press release)

Emerging markets have a natural allure for investors. This stems from the perceived wealth of riches that they hold compared to the staid and stolid developed world. Some have gone as far as to suggest that former members of the rich nations club – particularly Greece but arguably one day Spain and Italy – could be considered to be emerging markets. On the basis of their weak credit ratings, some peripheral European states have seen their debt fall into emerging market bond indices.

The idea that a state can recede into emerging status must be one of the investment world’s more farcical misnomers, but it is not as bizarre as it may sound. Argentina, which arguably has been emerging for around a century, has recently been dropped from emerging market indices having taken significant backward steps in its global integration. These have included refusing to honour international court decisions, providing false inflation data and nationalising, or confiscating, a 51% stake in Argentinean energy producer YPF from its Spanish parent Repsol.

Chart 1: The growing influence of the developing world on global GDP

Emerging or receding?

The risks of such errant states may one day dissipate, but those declaring that the emerging markets have entered a new paradigm of safety are being careless, or indiscriminate, or possibly both.

Emerging markets have been one of the key drivers of economic returns over recent years. Much of the resource demand and commodity growth of energy or mining-focussed companies on western equity markets originates from the emerging world. Most western companies have benefited to some extent from offshoring their manufacturing, or some other aspects of their supply chains, to less developed states.

But the really attractive emerging market theme is that of selling western brands and services into the expanding emerging population. Brands and intellectual property are the most valuable assets of companies precisely because they can be levered aggressively. The aspirations of the emerging middle classes in developing market allows western companies to distribute established brands such as Hennessey cognac and Lipton’s tea to ever growing markets.

Chart 2: Consumer price inflation in China and the US

Beyond companies, the emergence of these new markets, particularly China, has driven down the cost of manufactured goods in the western world, contributing to the great moderation of inflation in the 1990s. The benefit of the great moderation was, however, somewhat mixed in the sense that many manufacturing and blue collar roles were rendered structurally uncompetitive by cheaper labour overseas. The off-shoring drive gradually built a structural surplus of low-skilled labour in so-called rich countries as the manufacturing base was hollowed out. This added to the continuing bifurcation of wealth in many markets (particularly the US).

Much changed in the 2000s. Initially this was because emerging market growth placed upward pressure on food and (particularly) energy prices, but tightening labour markets in many of the first tier of emerging markets also led to rising wages and higher export costs.

The imported deflation of the great moderation has therefore switched to become an inflationary influence a decade or so later.

Before bemoaning the apparent secular shift to an environment of weaker growth and higher prices, it is important to consider all the ramifications of the decline of the emerging markets. In some cases, for example, the rise in Chinese wages has led to further “re-off-shoring” from China to less mature markets such Vietnam and Indonesia, so deflationary pressures still exist.

Chart 3: Relative unit labour costs for China and various developed economies (1995=100)

Furthermore, however, we have written many times about the recovery in western (and particularly US) competitiveness. This stems from the medium term decline in the relative value of the dollar, but also the slow growth of US wages compared to those in markets such as China.

The rise in energy prices, meanwhile, has rather hindered the centralised manufacture-and-distribute business model of the emerging markets by increasing the distribution costs.

Chart 4: The trade weighted dollar has been in long term decline

Together, these factors have enhanced the case for manufacturing close to the end market – amongst emerging market investors this has created a meaningful buzz about opportunities in Mexico. But less intuitively, the manufacturing industry is moving back to the US in what is termed on-shoring or more poetically: the American industrial renaissance.

In addition to eliminating or reducing transportation costs, the US also offers manufacturers cheaper power for manufacturing. America is one of the cheapest producers of electricity in the world by virtue of having both developed market infrastructure and, one might almost say, developing market natural resources.

The shale gas revolution which the US has enjoyed means that natural gas in the US is less than one third of the cost in rival European or Asian economies. US gas costs just $3MBTU compared to $15MBTU in Japan.

Chart 5: Natural gas proxies in Japan and the US

Recent weakness of the dollar versus the yen of course amplifies this energy non-competitiveness. Even closer to home, Mexico’s electricity prices are thirty percent above those in the US because of the efficiency of the US energy infrastructure.

The combination of plentiful un-unionised labour and low gas prices make the US the new favourable location for the manufacture of technology and energy intensive goods – a point exemplified by the location of new plants by a wide range of different manufacturers. Airbus is building a plant in Alabama, Samsung are manufacturing in Texas and Apple has announced they will shift some manufacturing of Macs to the US.

If we were to categorise emerging markets based strictly on whether they were on the up, or on the wane, then the southern states of America might demand a place in several indices. The advantages they offer in terms of plentiful natural resources and non-unionised, competitively priced labour, are reminiscent of the emerging market presentations of old – with the added advantage of being located within the largest internal market in the world.

Whilst there are clearly some meaningful fiscal hurdles for the US to clear, the economy and the market should have the resilience to absorb these, given the stronger state of growth and reduction in tail risks. The disappointing fourth quarter GDP figures contained gems such as improved trade data. Furthermore,the drag of inventory depletion on last year’s GDP numbers bodes well for the start of 2013.

The wind is now behind the US economy…

Rebuilding inventories during the current quarter, sharply higher payroll growth and the wealth effect of the rising US housing market are starting to make the sequester cuts appear digestible. Once the political impact of the sequester headline has registered, its provisions may, of course, be supplanted by a more measured cost reduction plan.

Recognising the challenges faced by Asia in adapting to an inflationary world does not dissuade us from investing in the region. Many Asian exporters are among those benefiting from the changing competitive landscape by relocating facilities to the southern states of the US and will see their bottom lines benefiting from the move. That includes Toyota who, after a history of steadfastly building their cars on the structurally uncompetitive Japanese mainland, are now locating a facility in Kentucky, for export to Asia!

…but challenges endure for Europe

The conclusion of this discussion, which has largely focussed on the diverging competitive landscapes of Asia and the US, is nuanced. Perhaps most strikingly it demonstrates the challenges faced by European economies in their own quest for competitiveness. The Eurozone will have to overcome a historic reliance on unionised labour; under-funded defined benefit pension schemes will need to be funded through lower wages or higher prices; state pensions will need to be funded through higher taxes or lower state spending; energy prices will remain high, and to cap it all, demographics are poor. The Bundesbank’s insistence on avoiding competitive or any other kind of devaluation provides a further challenge.

All in all, the route to growth for Europe remains extremely challenging, specifically compared to the US. So much so that Europeans might be justified in wondering whether they will ever experience a renaissance of their own.

Appendix

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