It's a structural change: Investec's Michael Power

At a presentation earlier this week, Investec strategist, economist and historian Michael Power selected iconic Economist front covers which, when pieced together, presented the case for a broad change in focus in the global economy from Western democratic capitalism to Eastern dominated who-knows-what.

It is not a new theme for Power, who first spoke about the 'true north in the compass of economic power' shifting from the US-centered Western economy to the Chinese-centered Eastern economy over three years ago. And now, of course, with so much economic upheaval in the US and US-caused contagion in the banking around the world, his case is stronger.

He said that the size of the current financial crisis in the US should not be underestimated. He said that the current economic crisis has cost the US Federal Reserve $4.617 billion. This should be compared with the following inflation adjusted expenses: World War 11 ($3.6 billion), NASA ($851 billion), Vietnam War ($698 billion) and the  invasion of Iraq ($597 billion).

He blames much of the current woes on leveraging as US GDP growth is predicated on the pre-creation of high levels of debt.

'In 2007, an individual had to borrow $5.70 to generate $1.00 of GDP, up from a $1.70/$1 ratio in the 1970s,' he said. 'And the US financial system is still deleveraging and undercapitalized, generating decent growth in the US (and indeed in much of the West and Japan) will be extremely difficult until a new higher savings /higher investment /lower consumption/ lower debt growth model can be devised and implemented'.

He would, however, be the first to acknowledge that the transition will not be smooth, that C-day, (the day when the Chinese GDP exceeds the US GDP, expected to be around 2020) might be further away.

Power said that he expects the US dollar to weaken as  Asian investors in US Treasury Bonds and other savings vehicles find other investment destinations. He expects that by the end of the second quarter next year, the West's 'financial fire will be extinguished and the capital flight to the dollar core of the global economy will be over'. He predicts that the West's GDP growth outlook will remain lacklustre through to 2011.

'If the dollar does fall we should see gold move in the opposite direction - if a there is a serious rout in the dollar gold could go to $2 000 in the next three years.  A serious rout in the dollar would be a fall of 30% in a short space of time,' he said.

Other reasons to support the idea of a weaker US dollar include the fact that over 80% of globally managed funds use the dollar as their unit of account, which means that the dollar is the global funding currency for global capital flows. He sees the lack of savings (particularly in the US and UK) coupled with the demographic changes in Europe, as two very important contributors to the unravelling economic base of the US and 'Old Europe'. When growth does eventually return, he thinks it will be slow.

'We should expect to see the capital from the dollar, the euro and yen zones start to migrate to greener pastures in emerging and frontier markets. This echoes the rationale for the Japan-sourced carry trade of the 1990's - ultra low interest rates at home (as the Bank of Japan desperately tried to promote growth) underwriting flows abroad. If this new carry trade to the New World materializes, it will reverse the US dollar's recent reflex strength and as the latter funding currency appreciates, act as a self-reinforcing spur for further outflows,' he said. 

'Furthermore, US investors have a home bias, investing as much as 85% of their portfolios at home, (compared to the OECD investors who have a 60% home, 40% outside). It is interesting to note that the university endowment funds, long some of the best performers in the US, have started to move more of their money outside of the US. In addition, the S&P has not made positive returns in dollars over the past decade, nor real ones since 1990,'

'Given this cocktail of drivers, it is unrealistic to posit that the conditions precendent required to create the 'mother-of-all-carry-trades' out of the West and into the Rest are falling into place?,' he asked.  

He agreed that the hoped-for or expected  decoupling of Western and Eastern/ emerging markets had not really happened, although he thought that the quicker recovery of the Eastern economies could ensure a quicker global recovery. The 'decoupling' idea was popular about six months ago, when some economists put forward the theory that emerging markets were longer as dependent on developed countries' markets for their growth and would therefore not be adversely affected by a slowdown in the West.

China is still experiencing GDP growth, but the country has decreased interest rates and announced a $600bn stimulus plan to boost the economy.

'Economists like to use letters to describe the recovery pattern of markets. I would say that the US and other Western countries are looking at an 'L' shape, the East is looking at a 'U' shape, and due to the more optimistic scenario the global aggregate will be 'wok' shaped. I would suggest that the low point of the wok will come in the first or second quarter of 2009', said Power.

Power expects that Asia's growth profile will evolve from being heavily export orientated to more domestic in character. Urbanisation will be supplemented by domestic consumerism. He said that in the near future a third of the world's children will be Indian. A team from Disney had visited India recently with a view to designing / investing 30 more Indian-based cartoon characters in order to capture young Asian audiences.

'Resource intensive Asian GDP growth will have slowed to 5-6% with China's down to 7-8%, this added to destruction in the West will mean higher volumes of commodity consumption overall. Indeed, with the US Dollar no longer strengthening, the US Dollar prices of commodities - especially oil, will have bottomed and may even start edging up again, depending on individual inventory cycles,' he said.

And the upshot of all of this?

'First and foremost, put Asia front and center of your investment horizon,' says Power. 'This does not mean only invest directly in Asia, the indirect route, through commodities, resource rich emerging countries and frontier markets, even developed country multi-nationals with high exposure to Asia, will be a viable alternative.'