Rising Costs and Wage Inflation

Rising costs globally have had detrimental effects on company profits and a fundamental cause of this has been wage inflation particularly in emerging markets.

As Asia contributes to a large proportion of global manufacturing, company profits are being squeezed as it becomes more costly to produce in these countries.  Costs have been further amplified by the rising currencies.  Emerging markets have seen their currencies rise as investors seek to capitalise on high GDP growth.

Asia has seen soaring wages and average pay has almost doubled over the past 10 years compared to 5% increase per annum in developed countries.  China led the way almost tripling over this period, and as the country develops from an emerging market, workers began to demand minimum wage levels.

This rising wage inflation is not isolated to Asia, South America has also seen similar rises, and as workers demand higher pay, their demands then mature for better consumer products, food and standard of living.  This is the common path from an emerging market country to a developed.  However there are many obstacles to overcome, read more on this in Rural Expansion and the Control of Urbanisation.  

For companies based in the US or other developed nations it may become more economical to bring manufacturing and production back to their country.  As wages become closer between the countries, after eradicating shipping costs, the difference is not that high.  With energy prices reducing in the US this is becoming more common, and reshoring may gather further pace.

Whilst wages have increased significantly, one must remember it started from a lower base, Asia is still a very cheap place to produce, and many have shifted from China, to South East Asian countries such as Indonesia, Vietnam and Thailand, where the minimum wage in Thailand is 300 Baht a day, a little over $10.

There will undoubtedly be a lot of change in emerging market economies over the next 10 years, however as a large proportion of growth is derived from manufacturing and production of goods for overseas companies, one must remember to maintain the competitive edge otherwise growth may evaporate.

What next for Markets?

Market optimism faded after a bailout for €10bn was hashed together on Sunday evening.   The second largest bank in Cyprus takes the fall and as expected the Eurozone remains intact (for now).   Whilst depositors first €100,000 will remain, those holding bank debt and deposits over this amount will likely loose all of their money.  With a huge chunck of the banking system taken out, questions will be asked to whether sufficient available credit to Cypriot people will be made?  The largest bank, the Bank of Cyprus will be restructured and absorb the safe deposits from Popular Bank and whilst this is a relief for many Cypriot nationals, this will almost certainly ostracise both foreign banks and overseas investors for the foreseeable future and presents a cautionary tale for other European countries teetering on the edge of economic turmoil.

Markets reacted positively this morning, bucking the biggest weekly decline in 2013 as risk on appetite crept back into view.  However with uncertainty still in front for Cyprus investors remain uneasy. 

Correlation between global equity markets has quite noticably been diverging as economic recovery shows in certain countries more than others.  This global correlation has been inherent as economic crisis has struck so often in the past 5 years following the credit crisis and last week was a prime example. 

Emerging markets have lagged significantly behind developed equities and whilst risk/reward suggests emerging market equities should outperform, it is not the case.  This is down to a number of reasons; as economic recovery gains momentum, people tend to invest in equities that they know about, from here, smaller cap equities will follow.  Emerging markets have faced some different problems as Russia lost a lot of ground over the past week with large exposure to Cyprus. 

It presents an opportunity for those who wish to increase their equity exposure, in the long run these markets offer significant upside potential and it is where I would invest.  There are a number a excellent emerging maket funds, performance of which had been superb.  First State Global Emerging Market Leaders provides exposure to top companies across these markets however, a more leveraged play would be investing in Russian equities, with historically low PE ratios and a maturing consumer base, this could be a top performer over the next few years.

Check out our Top 10 Funds of the Month for some more investment ideas.

Rural Expansion and the Control of Urbanization

The process of economic development usually begins in the capital city, or most built up areas.  As we have seen with China over the last decade, rapid expansion occurred within its major cities prompting a necessity for huge investment in infrastructure and housing.

This pathway to becoming a developed economic country is a tricky one as acceleration within urban areas can cause the economy to collapse onto itself if this occurs too quickly.

China, over the past decade has had double digit growth as a cheap workforce stormed this huge nation into a competitive superiority over other developed countries.  As with all things, this cannot go on forever.  Industry and construction fuelled demand on a global scale for raw materials and machinery boosting company profits around the world.  Infrastructure spending in China was vast, Bejing’s underground railway had only two lines up until the start of the century, today there are 15 lines spanning  300 miles, with just under 8 million people using it daily and further expansion planned.  As with the underground system, housing has expanded at a similar pace.  With urban areas reaching capacity, there are a number concerns around the state of the economy in China.  The property market has seen rapid price increases and the government has warned it may increase taxes on second homes in order to curb further inflows into the property market.

The problem arises from rapid expansion in the urban areas, with little development outside.  This results in a greater demand for the built up areas causing a further divide.   This process is unsustainable and will eventually lead to asset bubbles and subsequent crashes.  A tempered approach is needed to structurally grow the rural areas as well.   In China this is starting to occur, but savvy infrastructure spending is a necessity.  

China has a long way to go in developing its vast nation further, but with wage increases and growth slowing, a number of hurdles are still to come.  The property and banking sectors are in my opinion the areas of major concern.  Such a rapid demand for new homes and mortgages begs the question, can these people repay their debt?  If this is not controlled, it may lead to a banking crisis similar to what we saw in 2008.

Enough about China… Another major economic player is Latin America.  Brazil especially has seen similar rises in its urban areas (maybe not at such an extreme pace).  With a majority of the wealth within its major cities, there will come a point where more rural areas begin to follow suit.

Wage inflation has started to occur and demand for more mature food stuffs are on the up.  There is much development still needed. The amenities available in rural areas are slim, and this follows through into demand for temporary measures such as generators.  Companies benefiting from this specifically are Aggreko, the largest generator maker globally.  Also, JCB announced strong demand for their vehicles(diggers) as construction ahead of the Rio Olympics is well under way.  After some good results recently, it is inherent demand in emerging markets is on the up and up. 

Emerging market investment funds will be your best bet to capture some of this upside.  First State Global Emerging Market Leaders would be my choice, however with such a pull on infrastructure spending still such a necessity, First States Global Listed Infrastructure fund is prime for growth.

These rapidly expanding countries have the size and ability to become some of the leading economies in the world, however it will not be a smooth ride and the management of growth throughout the whole country is needed.