Why China et al can't make up for the loss of consumption from USA and Europe...at least in the medium term

The bottom line is that consumer markets in Western developed countries have peaked, and will never again return to their former level.

--Gwyn Morgan, The Globe & Mail

Writing for The Globe & Mail, Gywn Morgan esentially nails home the point that is obvious to everyone. Namely, consumption in America, Canada, and Europe have likely peaked and will decline. Now let's be clear: in nominal terms, consumption will likely be higher in 10 years than now (unless population declines precipitously or we enter a massively deflationary period.) Instead, I am referring to consumption in real terms and consumption growth. We have just seen a peak of sorts in real terms or in terms of growth.

Why is consumption important? Because if consumption shrinks, production will shrink. This generally results asset price declines, along with unemployment, loss of income, and so on.

There is some thinking that China and other developing countries will make up for the loss of consumption from the developed countries. I, as well as many others, have argued that this is almost impossible in the short-run due to various structural issues (without a social safety net, consumption is not going to go up much in these countries.) In the long run the story may be different but we are talking about the next 5 to 10 years rather than the next 20.

There is another reason why it will be very difficult for developing countries to make up the consumption. This has to do with size.


Developing Countries Are Small

A lot of newbie investors who are bullish on developing countries don't realize how small their economies are. The smaller size offers a huge upside in the long run, but the short and medium term is always a mystery. Anyone who has looked at a multinational company will quickly realize the scope of the difference.

For instance, a non-luxury product that is sold in China may cost five times less than in USA (for a comparable product.) For an international company to make the same amount of money, it has to literally sell 5x as much in China than in USA. One could argue that China, as well as many other developing countries, have larger populations so they can buy 5x more. Yes, that's true in the long run. The problem, unfortunately, is that almost everyone is poor and don't have enough income to make up for the difference. The following chart from wikipedia.org lists the nominal GDP of the top 20 countries in the world in 2007:



As you can see from the table, United States and Europe, two regions living outside their means by leveraging up over the last 20 years, have total nominal GDP of around $30 trillion out of the world total of $55 trillion. If you add other countries running current account deficits and/or having large consumer debts, such as Canada, the picture gets ugly. If you assume consumption is 60% of developed world GDP and it declines by 10% in the next few years, you are looking at a need to make up $1.8 trillion. This is more than half the yearly GDP of China!

It will be extremely difficult for the developing countries to make up the consumption decline within a few years--especially when cost of capital is rising due to the financial crisis. They must try their best, since many of these countries are export-oriented and will see their export sector completely implode otherwise, but it is not going to be a smooth recovery in a short period of time. We already see difficulties in export-oriented Eastern European nations and developing countries in Asia are going to have some serious declines in industrial production and exports (exports from Taiwan, Japan, and Korea have fallen off a cliff but countries like Vietnam, Indonesia, and Thailand are more worrisome.)

Investment Implications

The only conclusion I have from thinking about world trade is that it is going to be really rough for a while. It is very dangerous for investors right now. The Asian Flu in 1998 saw the demolision of the Asian Tigers, and I think some countries will suffer mightily this time around as well. Unlike past crises, almost all regions of the world, ranging from South-east Asia, to South Asia, to Latin America, to Eastern Europe are vulnerable (but not necessarily for the same reasons.) It's not clear who the survivors will be but you, as an investor, shouldn't get caught losing your fortune in these volatile regions. I would just wait for the tide to clear--unless you are surfer or daredevil ;)--and then make big decisions. Remember, very few questioned Asian Tigers such as Thailand and Indonesia back in 1995. Yet it turned into a disaster, with the currency plunge alone wiping out most of the investment.

Even though I'm macro-oriented, unlike value investors, I'll be the first to admit that stocks are not correlated with the economy. It's possible for stocks to collapse while the economy is doing ok, or for stocks to rise while the economy is doing terribly. Also, if you find some highly attractive investment, it is worth investing, assuming you have a big margin of safety, even if the macro outlook is very dicey.

I think consumer discretionary companies, or even possibly branded consumer staples, may never perform as they have in the last 20 years. If the consumer in the developed world is cutting consumption, these areas will suffer. I see a lot of value investors overload on consumer staples or pharmaceuticals* that have done really well in the last 20 years. I am not sold on the merits of these companies. Consumer durables, in particular, seem a bit risky to me. For example, I'm not sure if manufacturers of cars, boats, motorcycles, and so on, will outperform the market for the next 10 years.


(* I don't follow pharmaceuticals but they may have a positive macro trend with the aging baby boomers. So they may be worth considering for macro investors who share that view.)