Changing demographics, globalisation and technology are just some of the factors pushing capital from Western economies to Eastern economies over the past thirty years. Are multi-asset portfolios at risk of being left behind amid such historic regime shifts? Parit Jakhria, Director of Long-term Investment Strategy at Prudential Portfolio Management Group (PPMG) explores these regime shifts.
West to East
There are a range of fundamental characteristics of markets and economies that help drive multi-asset portfolio allocation decisions. Yet few long-term assumptions are cast in stone, and given the current confusing investment outlook, the need to step back from market noise and take note of the wider and more impactful economic ‘shifts’ happening around us has never been more important.
"There is so much high-frequency analysis involved in the investment process today that the real challenge is being able to step back and think about how certain themes are having a dramatic effect on long-term portfolio allocation," notes Parit Jakhria, Director of Long-term Investment Strategy at Prudential Portfolio Management Group (PPMG). “Some of the changes have been occurring for decades, but it is only when you think about them in the context of the investment market today that their impact on society makes sense.”
For Jakhria, one of the biggest structural shifts being seen today is the ongoing shift of the world’s economic centre, which in less than three decades will have transferred from the west of the globe to the east. This has been seen with the rise of China and Asia as a whole, which continue to grow in terms of their economic and investment influence.
“Historically, the economic centre of gravity was broadly in line with the size of the global population and early civilisations grew around the banks of rivers like the Nile, Euphrates, Indus and Yangtse Kiang. Until 1500AD, the agrarian economy and trade in agricultural goods was primarily within Asian and African civilisations. At that point, Western Europe, North America and Australasia accounted for less than 20% of the world’s economic output,” explains Jakhria.
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McKinsey Global Institute, Angus Maddison (University of Gronongen, MGI Cityscope version 2.0)
This however changed rapidly with the arrival of the Renaissance era, and Western Europe emerged as a hub of scientific evolution (see graphic over). Both Europe and the Americas came to dominate the global landscape from the early 1800s onwards, using an accumulation of knowledge and ideas alongside its imperial military strength to maintain its position as the economic centre for some time.
The two World Wars reversed this trend in the mid-20th century. European empires suffered at the same time as countries such as Japan, China and other ‘tiger’ economies experienced growth. Eastern economies were the main beneficiary of the globalisation of trade and the free flow of capital, labour, goods and services. Even today, the overall narrative remains focused on the economic importance of emerging economies in Asia and Africa in investment markets (see graphic above).
The macroeconomic implications of this shift are likely to alter many of the fundamental pillars of our world economy, according to Jakhria, and impact geographical asset allocation significantly.
For example, major OECD countries have followed a common template for the interaction between monetary and fiscal policy ever since the 1980s and 1990s. Over the years it has become accepted wisdom that an independent central bank with a primary mandate to keep inflation in the low single digits is best for the overall health of the economy.
However, the rise of China could see the Chinese model become the norm as an alternative; where the primary goal of monetary policy is political and economic stability, rather than price stability.
Jakhria explains: "If the Chinese economy was to avoid any major blow-ups in the immediate future, it would be a successful example of limiting the independence of central banks and running a centrally managed economy through monetary, fiscal and regulatory oversight."
Changing demographics are for a large part the reason behind such shifting economic centres. Those with larger populations and a younger demographic, such as India and Africa, have much higher prospects for GDP going forward. As such, this shifting ‘centre of gravity’, as Jakhria refers to it, is a core investment theme that all multi-asset investors should be aware of.
"Our in-house economic growth model suggests that the shift ‘eastwards’ will continue largely due to demographics and productivity catch-up. In spite of the fact levels of education, rule of law and political stability all need to improve, countries in Africa parts of Asia don’t suffer from ageing populations in the same way as advanced economies. The improving level of per capita GDP from a low base also makes a material difference over the longer term."
"Africa, for example, has leapt three generations in terms of technology in the space of ten years. Take something fundamental like banking; 10 years ago large parts of Africa were striving for establishing local branches to access other banks across the country. Large parts of Africa have gone straight to internet banking (largely bypassing telephone banking) and, in some areas, African countries are innovating and are moving to electronic cash, which in many ways is even more advanced relative to Western economies. Given their low starting point and the huge potential for technological catch-up, these countries don’t need to get everything right to advance rapidly."
It is not just shifting economics driving PPMG's long-term assumptions. The group uses a similar analogy to model a number of potential regime changes. Not all of them are clear cut however. Take technology for example.
"Predicting technological change is a big challenge, especially when trying to frame long-term assumptions. This is because the current stock of human knowledge is vast and there are a huge number of areas where technology is still developing, whilst the pace of technological change is accelerating. Thus, it’s almost impossible to man mark each new technology, and one needs to think about it in aggregate."
Secondly, the pace of change is increasing, and this is why Jakhria believes it is important to look at all regime shifts in context and analyse the effects of change over long time periods rather than be too exact as to what changes could occur. In the case of technology for example, Jakhria aims to model the effects of technological change for the group’s multi-asset strategies, rather than predict the exact forms of technology that could cause those changes.
“Establishing a new economic order and an equilibrium around these sorts of ideas is a significant unknown, which is something we are very much aware of as we understand nothing can predict the future. But by properly analysing and incorporating long-term trends like these into our asset allocation process we are able to stay ahead of the curve.
"For example, long-term illiquid asset classes are potentially adversely impacted by technology; a classic example being retail shops. On the other hand the geographical distribution of technological innovations could be at a historical inflection point" Jakhria explains.
From a multi-asset investment viewpoint, Jakhria believes the revolution at a long-term structural level needs to be echoed in asset allocations too.
"We believe our portfolio allocation must at least keep up and ideally foresee shifting pattern as market economics accelerate away from the West. Thus, in our multi-asset portfolios we already have a lower allocation to the UK, US and Europe compared to most of our competitors and a correspondingly higher allocation to some of the high growth and developing areas in Asia and Africa. Importantly, we aim to have this theme across all asset classes (not just equities), which allows us to incorporate a lot more diversification into our portfolios than a lot of our peers."