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A review of Megatrend
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# Rise of the East

## Issues to be addressed in this paper

The first time I turned my attention to this topic was when, years ago, I read in The Independent newspaper that Afghan poppy growers had begun to switch from opium to wheat. Although I am not sure that’s still the case, back then, I said to myself that something must have gone astray for that to happen. Consequently, I began to investigate, and an interesting story unfolded.

I quickly realised that food and water are increasingly becoming scarce resources, and that a true crisis could unfold in the years to come. Climate change is often considered the biggest challenge humanity is faced with today, but it would be a grave mistake to underestimate the pending food and water crisis which is linked to rapidly rising living standards in Asia (Exhibit 1).

When referring to the opportunity set in Asia, many focus almost exclusively on China and, yes, China is indeed very important to the Asian growth story. If it continues its meteoric rise, it is only a question of time before China overtakes the US and becomes the largest and most powerful economy in the world. That said, as China continues to grow, other Asian countries will be dramatically affected too.

In the following, I will look into when the Chinese economy is likely to outgrow the US economy and become the biggest economy in the world, and I will look at the implications of that.

Furthermore, I will look at the other sources of power, as overall power is not only about economic power. And, in the context of that, I will look at how the other Asian countries fit into the China story. Although those countries do not possess the sheer might of China, the impact on, and of, other Asian countries should not be underestimated.

For all those reasons, my definition of the East includes China as well as all those countries throughout Asia that stand to benefit from rapid Chinese growth. I would even include Australia, although I am very much aware that Australia is not an Asian country.

Finally, I should point out that there are also political implications associated with China outgrowing the US which will only be discussed peripherally in this paper. I will focus almost exclusively on the economic ramifications.

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## The human economic development ladder

A tsunami that could undermine political and economic stability in large parts of the world is slowly building – a global food and water crisis. According to FAO, in the years to come, mankind will be facing a formidable challenge. Between now and 2050, we will need to produce more food than we have done in the previous 10,000 years put together (see here), and that is very much associated with rising livings standards across emerging markets – particularly in Asia.

Linked to the pending food crisis is a rapidly growing water scarcity problem which could result in even bigger problems, but that will be covered in megatrend paper #6 – Running out of Freshwater. I only mention it in the context of this megatrend, as the agricultural industry will be busy satisfying the demands of the rising Asian middle classes, and the agricultural industry accounts for over 60% of all freshwater consumption worldwide. In other words, as Asian living standards surge, demand for water can only increase.

## Other sources of power

If the anticipated shift in economic power from West to East is only 11 years away, neither may we be far away from a shift in overall power. That view is further reinforced when looking at the other sources of power.

Since the Global Financial Crisis, risk tolerance in the West has been in decline. In the US, recent administrations have clearly been more risk-averse than what used to be the case, although President Trump seems to be keen to reverse that trend.

European governments, which have been more risk-averse than US administrations for many years, haven’t exactly picked up the baton. Take Africa; while both Europe and the US have struggled in the aftermath of the Global Financial Crisis, China has roamed freely in Africa, pretty much unchallenged (see for example this story). One Chinese tactic in Africa is to overload the countries they operate in with debt so that a debt crisis will eventually unfold, making it easier for the Chinese to set the agenda (Source: Financial Times).

Looking forward, as people age and demand for social welfare programmes rises further, I would fully expect risk tolerance in the West to continue to decline. Domestic challenges will simply reduce the West’s appetite for risk internationally.

As a natural consequence of falling risk tolerance, the West’s threat power is also in decline. Under President Obama, the US made an unusually low number of credible threats (ISIS kept the Americans busy). At first, President Trump continued that line by pulling out of Syria but, more recently, he has reversed that line by taking out General Qassem Soleimani on Iraqi soil. A very risk-averse Europe has made virtually no threats in recent years. Meanwhile, China has been busy making credible threats in Asia. In 2011, China collided with Japan in the South China Sea and, only a few years later, the Chinese threatened the Philippines.

Finally, as far as coalition power is concerned, there appears to be a growing perception in the West that perhaps we shouldn’t rely on our traditional coalition partners the way we have done for many years. Washington clearly doesn’t rate the relationship with Europe as highly as it used to and, in Europe, ever since the Eurozone crisis blew up in 2011, the focus has been on keeping the Eurozone together rather than nurturing the relationship with the US.

More recently, the UK’s decision to leave the EU hasn’t exactly strengthened coalition powers in the West. President Trump quite clearly sees Brexit as an opportunity, as the Americans stand to benefit from a divided Europe. Meanwhile, China has been very busy strengthening its own coalition powers – particularly in Africa, where it used to be non-existent. Consequently, it would only be fair to conclude that China’s overall power is unquestionably on the rise and that, by association if for no other reason, the overall power of the East is rising.

## The flipside of the China story

Before I relinquish all power to the Chinese, let me make a couple of points. There is no doubt that China’s economic power is growing; its risk tolerance is higher than it is in the West; its threat power, if not higher in absolute terms, is growing more rapidly, and its coalition power is also in ascendancy.

The China story is not quite that simple, though, as China’s growth engine is extraordinarily one-dimensional. As of the latest count, capital investments account for almost 45% of GDP in China (Exhibit 5), with the corresponding number in the EU and the US around 20%.

China’s investment programme is designed to ensure social stability, as millions of people continue to migrate from the rural parts of the country to urban areas in search of a better life. As urban populations have swelled, the government has responded by creating jobs, often in construction, and habitually by building bridges to nowhere. Meanwhile, Chinese consumers continue to hold back on spending as general distrust in the government’s welfare programme has driven savings rates to extreme levels.

Vast amounts of government spending have resulted in total financial leverage now being at par with the over-leveraged G7 countries (Exhibit 6) whereas, going into the Global Financial Crisis in 2007-08, total debt-to-GDP in China was only about 150%. China has now joined a small but growing number of countries which are extremely vulnerable to rising interest rates.

Chinese household debt-to-GDP, on the other hand, is a relatively low 50%. In addition to that, total household savings add up to about 80% of GDP. In other words, net household debt-to-GDP in China is actually negative which should make the debt problem much more manageable (see Investment Europe). For that reason, I think the debt problem is easier to manage in China than it is in the West.

On top of that, China has never opened its current account, as it promised it would do when entering the WTO in December 2001. This has had the effect of keeping the Chinese currency artificially low, providing an additional boost to Chinese GDP growth.

Had China opened its current account as it promised back in 2001, the renminbi would be dramatically higher than it is today, and annual GDP growth would be lower. Consequently, perception in the West is that the Chinese are simply cheating, and the rest of the world paying the price.

Adding to those credibility issues, as far as demographics are concerned, the Chinese outlook is far from rosy. Although the percentage share of 60+ year-olds is currently lower in China than it is in the US or Japan, it is growing faster (Exhibit 7). In the years to come, that will put tremendous pressure on the government in Beijing to handle ageing of the Chinese populace more eloquently than it does at the moment.

## Could the West suddenly demand that China play by the rules?

One of the problems is that the West is not unified in its criticism of China, weakening the coalition power. Being a major importer of Chinese goods, the US is in the hawks’ camp (but have been lousy at bargaining), whereas Germany, being a net exporter to China, has taken a very different approach. Having said that, my guess is that, one day, the West will say that enough is enough.

One further point on China – it is not only when reporting macroeconomic numbers or when dealing with the WTO that the Chinese cheat. Take the crisis in the South China Sea, where China first had a territorial dispute with Japan, and then one with the Philippines. Despite the international court in The Hague ruling against China, it chose to ignore the court’s rulings.

That sort of behaviour weakens its coalition powers and could turn the entire world against the Chinese. If they are not prepared to respect and adhere to international law, do you want to do business with them?

## China’s likely impact on the rest of Asia

I mentioned earlier that China is already the biggest economy in the world on a PPP-adjusted basis, but that is not the end of that story. Asia is about to outgrow the rest of the world – at least on a PPP-adjusted basis (Exhibit 8a).

India is already the third-largest economy when adjusting for purchasing power parities, and Indonesia will overtake Russia within a handful of years and become the sixth-largest economy on Earth (Exhibit 8b). The Asian century is about to begin!

This has significant implications – positive as well as negative. On the positive side, as living standards in Asia continue to rise, demand for many types of products will increase, and many US and European companies are in a good position to benefit from such demand.

On the negative side (from a European/US point-of-view), higher growth rates in Asia than in the West will probably drive a rising number of companies to invest less in the old world and more in the new. Adding to that, rising living standards throughout Asia will most likely add to the already growing list of environmental problems. Drinkable water will increasingly become a scarce resource, and food shortages could become a regular feature in large parts of the world.

Assuming China continues to grow rapidly, its dependency on imports from other parts of the world will most definitely rise, and the rest of the East is in a much stronger position to benefit from that than Europe and the US are.

One example:

As per capita income grows, so does the protein intake. That has always been, and always will be, the case. As far as Asian consumers are concerned, meat will increasingly become part of the daily diet. To supply more meat to billions of Asians, more beef, lamb and pork must be reared. Because of meat’s limited shelf life and modest food budgets amongst many Asian consumers, proximity and cost efficiency is important, and that is where Australia enters the frame. Australia can not only produce vast amounts of meat; they can also do it very cost effectively. Australia is therefore likely to be a major beneficiary of the overall Asian drive towards more protein-rich food.

## How to invest in Rise of the East

To gain exposure to this megatrend, investors should target investments which are linked, directly or indirectly, to Asia’s economic transformation. The bulk of the transformation is expected to take place in the fast-growing emerging markets throughout Asia – not in developed markets such as Japan and Australia. As such, your core exposure should be to opportunities in Asian emerging markets.

There are some issues to take into consideration, though. Firstly, these markets can experience significant volatility. MSCI Asia ex. Japan fell by over 65% during the Asian financial crisis in 1997 and fell by a similar amount in the Global Financial Crisis. Therefore, unless you are willing to take on those levels of risk, an allocation to Asia would ideally be risk-managed. This would imply an ability to go short which is currently not possible in all Asian markets. Hence, any exposure to the less sophisticated markets in Asia should be capped. Furthermore, if investing in an equity long/short manager, the risk management discipline needs to be robust and proven.

Geopolitical tensions, such as the ongoing trade war between the US and China, is another challenge investors face when investing in Asia. To avoid this problem, you should zoom in on companies that are exposed to the domestic market in China. Another way to sidestep this problem would be to allocate to Asian countries which actually benefit from a transition of manufacturing hubs away from China, e.g. Vietnam. Hence, we would opt for a diversified exposure to the region, as you can reduce your idiosyncratic exposure to any one country this way.

In order to fully grasp the idiosyncratic risks of each country, it is crucial that an exposure to Asia is gained via a manager that has many years of experience in each of the markets, is based locally, is fully immersed in the culture and speaks the languages of the markets where the allocations are made to. Being local also assists in avoiding fraudulent companies. A large number of Chinese companies have had serious issues with fraud in recent history. Hence a local presence with a focus on corporate governance should be an overriding factor in any allocation.

Finally, technological innovation is arguably the fuel driving the economic transformation in Asia. Hence a player in the market would ideally have a strong background in the technological sector. Today, much of the technological innovation takes place in the healthcare industry, which is poised to benefit from Asia’s large and ageing population. Healthcare expertise should therefore be another characteristic investors should target when investing in Asia.

Yet another opportunity, which Asia stands to benefit from, is the global drive towards Electrification of Everything (our megatrend #7). The Korean are amongst the largest and most sophisticated producers of solar panels and electric car batteries.

## Some further observations

One cannot deny that the Chinese have built a horrendous number of bridges to nowhere in recent years, and that could come back and bite them at some point. Should you worry about that, one option would be to play this megatrend away from China, i.e. to invest in countries and investment strategies that benefit from the rapidly growing Chinese economy without being directly exposed to the Chinese financial system.

That said, I don’t agree with all those who believe the financial system in China is about to collapse. Whereas the financial system in the West, although publicly regulated, is (largely) private in nature, the financial system in China is 100% government controlled; i.e. you cannot compare the two. The implications of 250% debt-to-GDP are quite simply not the same in China as they are in the West.

Should you still want to minimise your direct exposure to China, an obvious way to invest in the Rise of the East would be to invest in trade finance, which is an investment strategy that provides export/import finance, mostly to companies in emerging markets.

Asian banks have, not unlike banks in other parts of the world, pulled away from much of this business in recent years, as they continue to repair their balance sheets, following the Global Financial Crisis and the regulatory demands that followed. A trade finance fund simply steps in when a bank pulls out. We currently have one Asian trade finance fund on our recommended list.

Niels C. Jensen

13 January 2020

## Three fundamental rules as to how to invest in China

If you wish to invest directly in China, I would advise you to follow the following three rules:

1. Never invest passively. For a number of structural reasons, Chinese equity indices do comparatively poorly, and it is relatively easy for active managers to do better than that.
2. Invest only with investment managers located in China. It is a relatively immature market where having access to the local gossip is far more important than it is in the more efficient equity markets in the West.
3. If at all possible, go long/short rather than long only. Again, because of the comparatively immature nature of Chinese equity markets, the gap between winners and losers is massive when compared to the more mature markets in the West.

## Megatrend #4 and its associated sub-trends

As we always do, when we identify a megatrend, we zoom in on a number of so-called sub-trends which are a direct result of the megatrend in question. In the case of Rise of the East, we have (so far) identified a total of four such sub-trends (Exhibit A1).

Rise of the East will result in significant GDP growth throughout Asia for many years to come with all the implications that follow. Countries in the old world will come under rising pressure to remain competitive, which will most likely lead to more advanced robotics being introduced. Furthermore, old world governments will be tempted to manipulate exchange rates lower, so that local businesses can better compete against a rapidly advancing East.

Urbanisation will also be affected. The opportunity set on offer in the bigger cities in Asia will drive hundreds of millions of people into towns in search of a better life. Finally, globalisation will also, whether the populists amongst us like it or now, gain further momentum as a result of the Rise of the East.

## Currency Wars aka QE

The first country to experiment with QE (Quantitative Easing) was Japan in the early 2000s. In the West, QE was first applied in late 2008 by the US Federal Reserve Bank in response to the Global Financial Crisis.

These days, QE is an active part of monetary policy in both Japan, Europe and the US. More recently, governments around the world have been criticised for not bringing QE to an end, potentially even replacing it with QT (Quantitative Tightening) as the Americans have done more recently – although half-heartedly, I hasten to add.

Governments around the world have noticed the German export success story and believe it is, to a significant degree, based on a very competitive currency. All other equal, QE weakens the currency in question. Governments all over the world are now facing the dilemma that nearly everyone is doing QE these days; i.e. governments/central banks are afraid of putting a stop to it as the currency could rally and make the country in question uncompetitive. In addition to QE, Germany has also benefitted from the dodgy behaviour of some of the other Eurozone members, e.g. Greece and Italy.

Now, the Rise of the East adds another dimension to the QE conundrum. Even if one ought to put a stop to the practice and potentially replace it with QT, the sheer might of Asia will probably drive many governments and/or central banks around the world to conclude that a weak currency is the best weapon against an advancing East.

The tricky part is to identify uncorrelated investment strategies that stand to benefit from this sub-trend. In principle, CTAs should be able to benefit, but their systematic approach has not worked particularly well in recent years (with the exception of 2019) – mostly due to low volatility in financial markets. Consequently, I think this sub-trend is most effectively adopted at the tactical level, i.e. how the currency risk should be managed (i.e. hedged or not).

## Globalisation

Globalisation is a relatively vaguely defined term, being used to describe all those dynamics that bring different parts of the world closer to each other. In economic terms, globalisation means the rising integration of markets – both financial and non-financial markets – which leads to rising interconnectedness between nations. Away from economics, globalisation simply means that the world is getting smaller; that we are all on the same social media, that we all watch the same films and that we all listen to the same music, etc.

The implications for financial markets are numerous. The mobility of capital has risen dramatically as a result of globalisation; so has the mobility of labour. One of the most obvious beneficiaries of globalisation is international trade. 30 years ago, international trade accounted for 25% of national income across the OECD. The corresponding number today is 40%. Across emerging economies, the ratio has risen from 15% to 60% (source: World Bank).

International trade will almost certainly continue to rise, and my logic is relatively simple. As a bigger and bigger slice of the workforce retires, many countries will become increasingly dependent on international trade to supply the goods and services the elderly require but no longer produce.

Growing international trade is a key driver of GDP growth around the world; hence the importance of globalisation. The current wave of rising populism could put a stop to that, and that would have a major, negative impact on economic growth, but stranger things have happened. Here in the UK, never have more people been employed, and almost never have the unemployment rate been lower than it is at present. In spite of that, ordinary people demand that the government protect them from competition from abroad, and the current cohort of political leaders are only too happy to comply.

In terms of investment opportunities that stand to benefit from globalisation (other than trade finance), allow me to mention a few. Strong consumer brands, which will increasingly be in demand from Asian consumers, will most definitely benefit. So will music royalties. Not only are younger people around the world increasingly subscribing to the same music taste, more effective piracy laws in the developing world make emerging markets in general, and Asia in particular, the biggest growth opportunity worldwide for this industry.

## The Digital Revolution

The Digital Revolution is likely to gain much pace from the Rise of the East. Companies across the West will increasingly be pressurised to change the business model in order to compete effectively with the East, and one obvious answer to that question is increased automation.

The number of advanced robotics for industrial use is growing very fast already (Exhibit A2). So far, the industry that has been penetrated the most by robots is the automobile industry, but other industries will follow in the years to come.

The Digital Revolution has affected many industries, even if they have no explicit need for robots. Let me give you an example of how impactful the Digital Revolution can be. In a growing number of airports around the world, you can now check in, hand over your luggage, go through security (assuming you haven’t got anything dodgy on you) and all the way to the aircraft without having to deal with a single human being.

## Urbanisation

50 years ago, only one-third of all people on Earth lived in urban areas. That number is now up to 55% and is expected to reach 66% by 2050 (Source: The Open University). Nowhere is urbanisation happening at a faster pace than in Asia (Exhibit A3).

Urbanisation is the result of people seeking a better life. All over the world, a city life offers more job opportunities than a rural life does. Even in the most mature countries in the world, young people continue to move to the bigger cities in search of a job, once they have completed their education.

At the other extreme, Africans migrate in an attempt to escape the poverty trap. Asia has been hit by the biggest wave of urbanisation as it has been affected by both of those trends. Younger, educated people migrate to the cities in search of a job, and the poor underclasses migrate to the cities to escape poverty (which doesn’t always work to plan). The implications are numerous. City-life affects the environment and it affects health. Living in Delhi, one of the most polluted cities in the world, is akin to smoking no less than 44 cigarettes every day (source: CNN).

From an investment point-of-view, the healthcare industry will therefore likely benefit immensely from this sub-trend. So will the water industry and the agricultural industry. City-life almost always leads to higher per capita meat consumption and higher per capita water consumption.