The Covid-19 pandemic took us all unawares, inflicting severe damage on the global economy and killing millions of people. We now have better tools and knowledge to manage the virus as an endemic disease, in a sustainable way — with highly effective vaccines and, soon, easy-to-administer treatment. But the fallout from the pandemic is significant. And, due to disparities in countries’ responses during and after the pandemic, the longterm repercussions will turn out to be equally unexpected.
The pandemic has, without doubt, given businesses — big and small — a much greater appreciation of the digital economy. It will spur new investments and hasten digital transformation, and the resulting advancements in technology will have long-lasting, negative implications for developing countries.
We have alluded to this in previous articles. This week, we will bring together all the pieces and present what we think is a picture of the future. We foresee increased technology-driven investments, reshoring and capital flows into developed markets (DMs), leading to higher growth potential and job creation — at the expense of emerging markets (EMs). It will be, to a certain degree, a reversal of globalisation and the flow of trade of the past three decades.
Growth in emerging economies will end up being slower than the projected trajectory pre-pandemic, while that for developed economies will be higher than previously anticipated. This narrowing of the potential growth gap will, in turn, present greater challenges to low-income emerging countries. It is especially so for those banking on an export-driven economic model — predicated on cheap labour that has proven so successful across Asia and, in particular, China — to spur development, generate jobs and lift hundreds of millions of people out of poverty. That said, we think China will be the exception going forward, as its economy transitions from one that is primarily export-driven to one with greater reliance on domestic consumption, underpinned by its 1.4 billion population and fast-rising disposable incomes. This view is totally controversial as it contradicts present mainstream conventional thinking.
The capacity of rich countries to spend on record fiscal stimulus has long-lasting implications
The divide between rich and poor countries was evident from the outset of the pandemic. Although most governments and central banks reacted very quickly to protect financial systems, productive capacities and jobs to limit the damage to livelihoods, there was clearly a huge difference in their ability to do so.
For starters, few, if any, central banks in EMs can undertake the level of quantitative easing (QE) we have seen in the US and European Union (EU) or cut interest rates to zero, and not suffer negative consequences. Developed countries were also able to implement fiscal relief-aid packages of unprecedented size. We have read many narratives predicting the next crisis based on the now record-high public debt. It may yet come to pass. But in the real world, high levels of public debt are sustainable as long as there are takers to roll over the borrowings, without the country having to pay higher interest rates and/or depreciating its currency. The value of money rests in perception and power.
Clearly, there is strong underlying demand for both the greenback and Treasury bonds, which are viewed as safe havens in times of crisis. It is well established that the US dollar holds a special privileged position as the world’s reserve and primary transactional currency, at least for the foreseeable future. This is also true, though to a lesser extent, for major currencies such as the euro and yen. Debt mutualisation in the EU — joint borrowings and sanctioned fiscal transfers from “frugal” to “profligate” member countries — means sustainable high public debt, without triggering a repeat of the sovereign debt crisis. And member countries are taking full advantage to spend big.
By contrast, the consequences of a high budget deficit and excessive public debt can be extremely dire for EMs. A case in point: Malaysia is very aware of its limited capacity for direct fiscal stimulus, given its high public debt-to-GDP. Hence, despite the critical need for more aid, our fiscal packages (as a percentage of GDP) have been far smaller than that in the US and Europe. The government has to resort to more imaginative measures such as loan moratoriums and allowing withdrawals from pension funds. While these measures alleviate short-term liquidity needs, they are effectively pulling forward future spending power. US households, by comparison, are sitting on massive excess savings that are bolstered by generous government handouts. Consumer spending is now driving the US economic recovery.
Historically, strong consumer demand in the US will have positive spillover effects on export-oriented emerging economies, boosting growth and investments. This time, however, the domestic economies of most EMs are weak, constrained by limited fiscal and monetary stimulus, pandemic-related disruptions as well as uneven recovery, owing to slow vaccination rollouts.
Vaccine distribution inequality drives DM-EM growth divergence
Much has been written about the inequality of vaccine distribution. A handful of rich countries have effectively locked up supplies far in excess of their requirements, including for a third booster shot, leaving the majority of the world unvaccinated. According to the World Health Organization (WHO), 62.8% of the people in high-income countries had received at least one dose (as at Oct 20) compared with a mere 4.5% of the population in low-income countries.
Many EMs are slow to reopen and normalise economic activities. Indeed, we saw countries across Asia having to revert to more stringent measures to combat variant-driven Covid-19 resurgence. And this difference in response is not just driven by Covid-19 cases and their severity but also by cultural and social values and fears.
This start-stop in the economy is very damaging to longer-term potential output, in terms of public and private (households and businesses) finances as well as human capital development.
The recovery in GDP and per capita income for low-income developing countries is likely to be weak in the short term and may not reach their pre-pandemic predicted potential for many, many years. By comparison, high-income countries are expected to reach their pre-pandemic economic output trajectory by 2022. A case in point: US economic output in 2Q2021 already exceeded its pre-pandemic levels.
This divergence in reopening and recovery has two broad economic implications. One, it means prolonged global supply chain disruptions, creating shortages in a wide range of goods and raising inflationary pressures around the world. And two, the growth differential between DMs and EMs is narrowing. The combination of these two events, in turn, will further complicate the recoveries in emerging countries.
Inflation and faster interest rate hikes will further hurt EMs
The US Federal Reserve has indicated an accelerated timetable for the normalisation of its monetary policy, on the back of more persistent inflationary pressures. It is now expected to start tapering in November 2021 and could raise the short-term policy rate in mid-2022. That said, the Fed could still afford to keep interest rates lower for longer — as long as it can convince markets that the current inflationary spike is transitory. The same, though, cannot be said for EMs.
The Fed’s pivot to a more hawkish stance, coupled with a narrowing GDP growth differential and rising inflation domestically, is creating outsized pressure on EMs. Some EM central banks have already begun to raise interest rates — ahead of the Fed — to prevent capital outflows and depreciation of their currencies. By raising interest rates, they also hope to temper price increases, including for food and energy, which are hurting affordability. A higher interest rate, however, is clearly detrimental to households and businesses struggling to recover from the pandemic, likely dragging out the recovery further — and making it even less conducive to new investments.
To summarise, the ability of rich countries to spend huge on fiscal support — by socialising private debt — has protected the balance sheets of consumers and businesses. It will now underpin a new cycle of consumer spending, which will drive economic growth going forward. Their economies are also getting the jump on sustainable reopening — thanks to the lopsided Covid-19 vaccine distribution and, quite likely, treatments once they are available. And higher interest rates (as prescribed by conventional monetary policy with an increase in inflationary expectations) in EMs now will be detrimental in the medium to longer term.
Capital investment resurgence yet another key growth driver for DMs
What’s more, the massive government fiscal stimulus does not stop with reopening. The Biden administration is working hard to pass infrastructure and social spending bills worth several trillion dollars. The European Commission has put together its biggest budget ever, currently valued at €2 trillion or $3.1 trillion (including the Next Generation EU fund) to finance recovery efforts through both public and private investments. For instance, the US and EU are in the process of passing legislation to provide incentives to the semiconductor industry to set up domestic research, design and production facilities.
US businesses, by and large, have emerged from the pandemic relatively intact, thanks to a wide range of government support packages. Save for those critically affected by lockdown measures — such as airlines and the hospitality sector — most are flush with cash. Borrowings are cheap and liquidity aplenty. Earnings and margins are at or near record highs, underpinned by consumer pent-up demand and a spending binge, which may well persist if we are right about a new cycle of consumption. The underlying potential for growth has improved post-pandemic.
Evidently, companies are optimistic. They have resumed share buybacks and dividends — boosting share prices and net wealth for shareholders and thus creating a positive feedback loop for the economy. More importantly, optimism is fuelling a resurgence in M&A activities and capital investments — after years of anaemic capex post-global financial crisis. Capex is now above the pre-pandemic peak.
Business investments are shaping up to be yet another key driver for US economic growth. Remember, GDP = C+I+G+(X-M). Critically, the nature of this capex boom, focused on technology and productivity enhancement, will have negative long-term implications for EM growth, well beyond the pandemic.
Next-generation technology advancements will make labour cost less important
Over the past three decades, supply chains have become more global and grown more complex as businesses sought to minimise costs — and maximise profits — for each and every component. Often, to the extent of removing nearly all redundancies while inventories were kept to the minimum.
This was made possible by the shift in political paradigm — the opening of borders across Europe, Asia and Latin America — and technological progress (in particular, the internet, software and proliferation of smartphones) that allowed for the easier flow of humans, capital and information. The admission of China into the World Trade Organization in 2001 was a key milestone for globalisation.
Outsourcing and offshoring became the de facto strategies for companies in the West, capitalising on cheap labour in emerging countries that translate into bigger and bigger profits for shareholders.
We saw the beginnings of the backlash against globalisation in recent years, in the rise of populism and protectionism following years of the hollowing out of manufacturing jobs in developed countries. There are rising trade tensions, especially between the US and China, and there was Brexit. Still, these were really more about political posturing while major strategic changes were slow. We see some diversion of investments from China, but they were still redirected to other low-cost countries such as Vietnam. The pandemic, however, is a real game changer. It crystallised the risks of over-reliance on complex global supply chains. The severe disruptions to production, made worse by work hesitancy, and a gridlock in logistics are causing shortages and rising prices across a wide range of goods and commodities. And businesses are hit where it hurts most — profits.
Covid-19 brought to the forefront the importance of supply security and supply chain resilience, right at a time when big data analytics, enabled by rapid progress in artificial intelligence (AI) and smart algorithms, is driving the shift from mass production to mass customisation. Reshoring — bringing production closer to the centre of demand — addresses both issues. And 3D technology reduces the cost advantages of super-size manufacturing facilities. Governments and corporates in DMs are well positioned to spend on investments — for new machinery, equipment and technology, including the hardware and productivity-enhancing software for digitalising operations — to meet the consumer demand surge.
The forced changes during the pandemic, such as e-commerce, remote working, cashless digital payments and automation, will carry forward. The current US labour shortage (that news media call the Great Resignation, where workers are leaving the workforce in numbers) could be temporary — for instance, until savings from the pandemic run out or fear of the virus recedes — or of a more permanent nature. Either way, we think it will further accelerate the digital transformation.
Investments in semiconductor manufacturing, 5G, climate change and renewable energy projects, including electric vehicles and battery manufacturing, will form the foundations for new ecosystems that will precipitate the reshoring of downstream manufacturing that is now mostly located in Asia.
Huge amounts of money are being poured into intellectual property, AI, automation, robotics and 3D scanning-modelling-printing and so on, which will lead to greater innovations — all of which will further strengthen the economic case for reshoring the manufacturing of everything from cars to shoes.
We think mass customisation, driven by customer unique needs and preferences at low cost, will be the next big secular trend. For example, robotics with multi-tooling can easily be programmed to switch between variant models without loss of efficiency. 3D printing could simplify the entire multicomponent production chain and assembly into a single manufacturing point, reduce lead time, parts count and assembly costs while maintaining (even improving) structural integrity. Automated production lines can run 24/7, with little human interference and disruptions, and operate at maximum efficiency and minimum wastage. Autonomous trucks will revolutionise logistics, solve the labour shortage issue and reduce costs and improve efficiency to boot. Robots are already being deployed in kitchens and customer-facing services in pilot programmes.
We believe the pandemic and its fallout will not only narrow the difference in GDP growth potential between developed and emerging economies in the short term but also more permanently so.
Intensified new capital investments and the resulting technological advancements will translate into greater productivity — that will, in turn, continuously whittle away at the advantages of low-cost labour. In short, we foresee investment money — and jobs — shifting from EMs back to DMs.
We understand that this is not the consensus opinion today. Indeed, our conclusion contradicts that of Thomas Friedman in his international bestselling book, The World Is Flat (first published in 2005).
His argument was that technology (internet, devices, information) eliminates boundaries and distances among people, thereby making the world more competitive, interconnected and globalised — in short, more “flattened”, as he calls it. And this is supposedly good as it alleviates poverty and promotes greater freedom worldwide. Examples in the book include outsourcing call centres to India and offshoring manufacturing to China. These provide low-cost solutions and produce cheaper products worldwide.
While it may be true in the early stage of digital technology transformation, it will unlikely be true as we deploy AI, the Internet of Things (IoT), robotics, machine learning, 3D printing and so on, which favour mass customisation. After all, production and trade depends on capital and labour. As the intensity of labour reduces, labour cost will become less important.
The Global Portfolio fell 0.9% for the week ended Oct 27. The big losers were PayPal (-9.1%), Alibaba Group Holding (-6.5%) and General Motors Co (-5.9%). On the other hand, Microsoft (+5.1%), Home Depot (+3.9%) and Alphabet (+3.1%) were the notable gainers. Last week’s losses pared total returns since inception to 67.5%. Nonetheless, this portfolio is still outperforming the benchmark MSCI World Net Return Index, which is up 60.2% over the same period.
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