A booming population and widespread immigration is fuelling worldwide growth. CSFB head of research Giles Keating looks at the likely impact on the global economy.
The number of people in the world has almost doubled over the past three decades to reach 6.5 billion, yet some three-quarters of them remain outside the economic mainstream, in rural China and India, in much of Africa, and elsewhere.
Many aspire to join that mainstream, and the result is migration on a scale unprecedented in human history. Each year, an estimated 15-20 million people move from the countryside into China’s cities, some three million become immigrants into the US, Europe and other developed nations, and unrecorded numbers make the transition to or from Brazil’s favelas or South Africa’s townships. In total, there is a net addition of perhaps 1.5%-2% a year to the world’s effective labour force, an enormous impetus for high and sustained global growth.
Dual development
For more than 200 years, expanding the economy to absorb new people has always involved a combination of physical construction of buildings and objects on the one hand, and the application of new and existing technologies and other intellectual property on the other. This time around is no exception, with the need to feed, house, clothe and transport all these new urban dwellers offering enormous investment opportunities.
But compared with previous phases of development, proportionately larger opportunities are likely to come from the application of intellectual property. One reason is that there is far more of it around than in the past – not just technologies, but also brands, music and movies. In addition, the size of the current demographic expansion is far larger than any that went before, meaning bigger economies of scale when exploiting intellectual property.
From a macro-economic perspective, the effect is to create remarkable leverage. Imagine a pair of designer jeans sold for $100 on Madison Avenue, New York, in London’s Bond Street and in the ubiquitous air-conditioned shopping malls now spread across Asia and the Middle East. This might incorporate labour, materials, transport and distribution costs of $35, with the remainder being a charge for the intellectual property inherent in the brand and the design.
So every time an extra pair of these jeans is sold, only $35 of costs are incurred, with the remaining $65 being profit that adds to the bottom line of the company and to gross domestic product (GDP). It is a pure productivity gain, a kind of free lunch. For some other consumer products, such as electronics or automobiles, the intellectual property component may not be as large as for designer jeans but is still substantial, while in some cases, it is even larger – downloaded music tracks being an obvious example.
Through this mechanism, every time an extra person migrates from the Chinese countryside to Shanghai or Guangzhou and starts working in a factory there, global GDP is boosted not only by their wage, but also by the mark-up on the goods they produce, representing intellectual property.
At the moment, the people who benefit most from this mark-up are the shareholders and the higher-paid employees of companies in America, Europe or Japan. Thus there is a kind of supply-side multiplier effect: a relatively modest amount of low-cost labour input generates a rather larger amount of GDP.
This supply-side process has to be balanced by sufficient demand – consumers must be persuaded to pay for the technology, the fashion or the artistry embedded in these products. Here, there is likely to be a problem, since a lot of the benefit from the intellectual property accrues to higher-income people, who often don’t spend all of their extra income, especially if they are saving for retirement. The result is a chronic tendency for demand to fall short of supply, producing a bias towards goods price deflation – a savings glut.
To tackle this, demand needs to be stimulated through low short-term and long-term interest rates – and since the demand shortfall is not just temporary, this implies interest rates need to be low on a structural basis.
Reflecting this, in the current cycle the world’s central banks seem set to raise short rates only modestly – to between 4.5% and 5% in the US, to 3% or perhaps less in the euro-zone, in our view. And for similar reasons, 10-bond yields are also likely to follow a very damped cycle, with the peak being maybe no more than about 5% in the US, no more than 4% in the euro-zone, around 4.5% in the UK. There is much focus on the downward pressure on bond yields caused by pension fund demand, and this can be regarded as part of this overall savings glut, exacerbated by increasingly over-rigorous application of asset-liability matching requirements.
These low levels of bond yields are below-trend nominal GDP growth, so they would give investors a powerful signal to avoid debt and instead invest in equities and real estate, which tend to grow in line with, or above, GDP. And in particular, to buy into the new technologies able to benefit from the economies of scale described above.
One example is the cluster of products and services associated with personal, on-demand media. As people start to pay to download videos as well as music, or access personally chosen programmes via cable, many new investment opportunities are appearing. Equally, old mass-media models of advertising are under pressure.
Harder fight
In recent years, another approach for exploiting worldwide economies of scale has been to invest in firms owning global brands. But this strategy needs to be handled with care going forward, because incumbent brands will increasingly have to fight extra hard for market share with upstart newcomers from China and elsewhere.
Those likely to do best are companies that are best at ploughing profits back into new technologies, rather than those that have spent heavily on marketing existing products, or on making merely incremental improvements to old lines. Such approaches can give a bigger bottom line in the short run but leave the company vulnerable longer-term.
This is well illustrated by comparing (most of) the big US pharma companies, which have emphasised the marketing-led approach, with their European counterparts, which have put greater stress on genuine innovation and now tend to have stronger product lists. Or analogously, comparing the large US auto makers with the largest, more technologically innovative Japanese car manufacturers. But this is not a one-way criticism of the US, which on this kind of analysis has a clear edge in some areas including software.
Overall for equities, this is a reasonably favourable environment, given the powerful medium-term drivers of growth described here and with valuations close to fair value for developed markets at the time of writing, and emerging markets in aggregate somewhat cheap. But it is a different story for investors in corporate debt.
In some overall sense, current tight spreads reflect the strong state of corporate finances. But a structural environment of this type, with its process of creative destruction generating a sharp division between winners and losers in many sectors, is bound to generate dispersion, with some credits performing very poorly.
Giles Keating is head of global research at Credit Suisse.
