OP-ED CONTRIBUTOR
By Stephen King

We have reached a tipping point in global economic affairs. While there are some encouraging signs of recovery in the developed world, the real economic action is taking place elsewhere. For both cyclical and structural reasons, the emerging nations are set to dominate world economic activity in the years ahead. Although we have revised up our 2010 projections for most countries in the world, the revisions leave the emerging world looking particularly healthy: we now expect emerging nations to see economic growth of 6.0% next year (up from 5.3% last quarter) while the developed world will expand by only 1.8% (from 1.2% previously).

Part of the emerging nations’ dominance reflects ongoing struggles in the developed world. A combination of low interest rates, quantitative easing and loose fiscal policy has returned stability to financial markets and raised hopes that the worst of the crisis is now safely behind us. Nevertheless, some of the central problems of recent years have yet to go away. Banks no longer enjoy the funding of old. Households and governments are awash with debt. Developed economies remain on life-support systems imposed by policymakers.

While, then, there has been a welcome turnaround in the inventory cycle and we have been in the process of revising up many of our forecasts, we expect policymakers to maintain stimulus packages for a long time. In the US, for example, even though growth prospects have improved, the level of activity is set to remain very low, suppressing core inflation and keeping unemployment unacceptably high.

Over coming months, investors will doubtless focus on so-called ‘exit strategies’, assuming that the financial system is not about to suffer any more nasty financial shocks. We think the exit ‘sequence’ is of considerable importance. Tighter fiscal policy should ideally come before tighter monetary policy in a bid to ensure no sudden, and unwelcome, rise in bond yields. Co-ordination between fiscal and monetary authorities is, therefore, vital even at the cost, however temporary, of central bank independence.

The merry-go-round

The structural arguments in favour of outperformance by emerging economies are compelling. Low per capita incomes offer plenty of room for catch-up. Thawing political relations have allowed companies from all over the world to invest in emerging nations. Information travels around the world much more quickly and much more cheaply thanks to new telecommunications technologies, making the management of assets within the emerging world much easier than before. Trade linkages between emerging nations have increased rapidly in recent years. And banking systems in the emerging world have come out of the crisis relatively unscathed.

In the short term, however, emerging nations will also benefit from what we call the monetary merry-go-round. Low US interest rates typically encourage capital to flow into the emerging world. Attempts by emerging nations to limit the resulting exchange rate appreciation lead to offsetting capital outflows in the form of rising foreign exchange reserves which are often invested in Treasuries. Higher demand for Treasuries keeps yields low and, hence, leaves US interest rates low, thereby allowing the merry-go-round to repeat, seemingly ad infinitum.

The global cost of capital ends up being too low as a result. A hunt for yield develops. Before the credit crunch, this led to huge investments in mortgage-backed securities which, in turn, fuelled the US housing boom. Post-credit crunch, however, the hunt for yield has gone elsewhere. Investors are now keen on the emerging nations with their strong secular economic prospects.

The implications are simple. Emerging currencies will be under upward pressure, their asset markets should appreciate and their sources of growth should switch from exports towards domestic demand, thereby narrowing their currently high current account surpluses. In time, problems will arise, either in the form of higher inflation or the re-emergence of rapidly widening current account deficits but, at this moment, we are only in the foothills of the process. With no imminent upward move in US interest rates likely, the merry-go-round should be able to spin a few times more. China and India will continue to expand at a rapid rate: we project economic growth for these two giants in 2010 of 9.5% and 7.2%, respectively.

A raw deal

A switch from developed to emerging-led economic growth, combined with loose US monetary conditions, should pave the way towards higher commodity prices. Demand for commodities is now disproportionately focused on the emerging world: lower incomes per capita tend to be associated with much more incremental spending on infrastructure and the basics of human life, all of which are highly commodity-intensive.

Apart from benefiting some of the commodity producers in the emerging world (among them, Brazil, Russia and Saudi Arabia), higher commodity prices will also offer currency support to the likes of Canada, Australia, New Zealand and Norway. Meanwhile, for those countries still pondering exit strategies and faced with multiple years of debt repayment, we suspect currencies will be weak: the most obvious candidates are the US dollar and sterling.

Our asset allocation recommendations continue to thrive on the mountains of liquidity created by central banks and fiscal authorities around the world. Within our preference for risky assets, we favour corporate bonds over equities: low levels of activity will, in our view, lead to anxiety over long-run sources of corporate profits. Meanwhile, with liquidity flowing from the developed to the emerging world, we favour emerging market assets in general over their equivalents in the developed world.

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Stephen King is the Group Chief Economist and Global Head of Economics and Asset Allocation Research at HSBC.