Jim McDonald is chief investment strategist for Northern Trust. In addition, he chairs the Tactical Asset Allocation Committee and is a member of the Investment Policy and Private Equity Investment Committees. He is a member of the CFA Society of Chicago and a registered CPA in the State of Michigan.
Q. For the past several months, you’ve been saying that you think the emerging market economies will lead the global economy out of recession. Why is that?
The emerging economies, broadly speaking, are in better financial shape than the developed economies because their financial systems weren’t as leveraged, and therefore they haven’t had the same level of losses in the wake of the credit crisis. Also, in many cases, emerging markets had the most severe downturns from the global inventory cycle downturn, and they are seeing the most robust recoveries because of that. For example, Singapore’s trade slowed dramatically at the end of last year, but it now is reporting growth in the second quarter of this year at an annualized rate of 21%. And that’s in a quarter during which Europe is estimated to contract by 4%, and the United States by 2%.
Q. In addition to not being as involved in the credit crisis, why are emerging market countries better positioned for strong recovery?
Emerging market countries had significantly higher savings rates, so they have greater foreign currency reserves and, in many instances, are running trade and budget surpluses. So they’ve been able to come out of the global recession with a stronger balance sheet than the developed countries.
Also, some of the emerging economies have significantly better demographic positions, whether it’s population growth in aggregate or a dynamic like China is experiencing where they’re modernizing the economy and taking workers who had been in rural functions and putting them in jobs that serve the global economy. Also, these markets have seen their standards of living rise, which leads to continued economic growth.
Q. Which emerging economies are showing the most robust growth? And why?
The Asian emerging economies are showing significant growth. Singapore at 21% and China at 16% are two of the most notable examples. They’re benefiting not only from some rebound in production, but also — especially in China’s case — because they have been able to inject significant government stimulus into their economies since they’re in better fiscal shape than most developed nations. And, secondly, as opposed to the U.S. and European growth slowdowns, which were not intentional, the Chinese government engineered a significant slowdown in 2008 to reign in growth.
Q. How, and why, did the Chinese government intentionally engineer that reduction in growth?
The Chinese government is able to pull numerous levers to govern the economic growth rate. In this case, they were able to slow down the economy by tightening financial conditions, including restricting the ability of banks to extend loans and changing tariffs to moderate exports. They were primarily concerned about the domestic economy becoming overheated. And that was the catalyst for their efforts to moderate growth in 2008.
Q. How does growth in emerging markets help the United States?
A significant portion of the growth the United States experienced during the last couple years came through exports to emerging economies. And that’s what’s going to help us rebalance our overall growth in the long term, because we’re not going to have the same level of domestic consumption spending driving growth going forward. So for the economy overall to grow at an acceptable pace to generate the kind of employment gains we need, the growth has to come from export-centric business. And the biggest incremental consumer in many of those instances will be emerging economies.
Q. How did U.S. consumers contribute to growth in these emerging markets?
The emerging markets are transitioning from being very export-dependent, in which they were more significantly tied to the behavior of U.S. consumers, to being more domestically focused. So building infrastructure and a focus on an increased standard of living are leading to increased domestic consumption in many emerging markets. For example, China today has approximately the same number of workers involved in construction as in export-related industries.
Q. What challenges do these emerging markets face when it comes to their continued growth?
It won’t be a smooth, uneventful transition for these countries from export-led growth to a more balanced domestic consumption orientation. And there will be periods of overshooting where the economies become too robust and the governments need to tighten financial conditions to slow the growth to make sure inflation doesn’t get too entrenched.
The governments in these emerging markets, especially in China, also need to make sure they’re able to keep growth strong enough to employ the significant number of workers moving from rural to urban areas. And doing that in a manner that keeps the domestic peace is central to their objective.
Q. How would you advise investors looking to capitalize on growth from these emerging markets to go about it?
The way you approach emerging markets is very important. While the long-term demographic outlook is compelling, this is not like investing in developed markets such as the United States, Europe or Japan. These are much riskier markets, and the individual companies are significantly riskier.
So we think you have to invest in emerging markets with a much more diversified approach. Although diversification alone doesn’t guarantee against a loss, it does minimize the risk of problems from any individual security you hold.
We approach the emerging markets through broad index funds that invest in all of the markets. So not only are you getting diversification through a broad number of companies, but you’re also getting it across a broad number of economies.
Q. When will developed economies start to benefit from emerging markets’ growth?
The United States and Europe are only showing the very earliest signs of benefiting from the rebound in these emerging economies. A very export-dependent economy like Germany is showing early signs, as is Japan. But the process of rebalancing global growth from being led by the U.S. consumer to more balanced growth and eventually to being led by the emerging economies is a relatively long process. So this is not something people should expect to change the landscape in the next three to six months. It’s a multi-year, multi-decade process.
