The Supercycle: A Longer Range View of Emerging Markets

(Corrects Morningstar data in seventh paragraph.)

Lots of investors say they adopt a long view, usually three to five years, when it comes to a particular investment. Some are taking that horizon even further—to 20 or 30 years, the "supercycle" that could last a generation or more. Some investment strategists say that industrialization and the expanding middle class in emerging economies from China to Brazil add up to a third industrial revolution, a prolonged period in which global economic growth shifts from developed nations in Europe and North America to Asia and South America.

Virginie Maisonneuve, head of global and international equities at Schroder Investment Management, uses shifting population growth, climate change, and the long-term outlook for commodities as a framework to understand the world and define the operating environment that companies must navigate. A commodities supercycle is based on the assumption that population growth, infrastructure buildout, and higher protein diets in emerging countries will support long-term demand and higher prices for industrial and agricultural commodities. Competition, demand, pricing, cost, and many other factors that affect how companies function will be touched by those themes, and in her portfolios are stocks that won't benefit or be especially hurt by any of those themes, she says.

Increasing urbanization and expectations for higher living standards as more people join the middle class underlie population growth forecasts for emerging economies, according to a 2010 special report on the supercycle by Standard Chartered Bank.

Conventional View, Shorter Horizon

Although the belief that emerging markets will drive global economic growth in the future is fairly widely held, the supercycle isn't at the forefront of most investment managers' thinking. T. Rowe Price Group (TROW), which manages $32.4 billion in emerging market strategies, prefers to focus on how its assets will perform over the next three to five years, as opposed to the next 20 to 30 years at the heart of the supercycle thesis, says Jason White, a portfolio specialist at T. Rowe Price in Baltimore. Instead of grand themes such as climate change and shifting demographics, White says he considers which industries will likely benefit from emerging market trends. He likes infrastructure, wireless telecom, and banking.

For Schroder, a diversified asset manager in London that runs just under $300 billion in assets, the supercycle doesn't represent such a great stretch of the investing imagination. "The supercycle [describes] the role of large emerging market economies in the global economy," says Maisonneuve. "That is the evolution of the China theme I had for most of the past 25 years," with India and Brazil now joining China as key economic growth drivers for the world economy.

Most emerging market funds are betting that companies based in emerging Asia and Latin America will benefit as these economies expand and shift from an export model toward a domestic consumption model over the next few decades. The supercycle approach is different in that it looks for companies, regardless of geography, that are poised to gain from long-term trends or that will be generating most of their revenue in emerging economies. For Schroder, BG Group (BRGYY) is a bet on rising demand for natural gas as climate change compels reductions in carbon output. Xstrata (XTA), a British company that produces copper, nickel, zinc, and other metals in South America, Africa, and southeast Asia, is a play on increased commodities consumption. Japanese robotics makers Yaskawa Electric (6506:JP) and Fanuc (6954:JP) are bets on greater need for automation as aging populations in developed countries and China create labor shortages. The Schroder International Alpha Fund (SCIEX) has one-third of its assets invested in Europe, 18.9 percent in the U.K., and 32.7 percent in Greater Asia, with more than half of that in Japan and Australia. Its allocations to South America and Africa/Middle East are just 6.7 percent and 3 percent, respectively.

Maisonneuve describes her strategy as aggressive growth, hunting for companies with strong balance sheets and evidence of end-users in the market that can't do without the company's products or services regardless of the economic environment. She manages $10.8 billion in institutional portfolios and about $3.2 billion for individual investors. The Schroder International Alpha Fund, with $72 million in assets, had a one-year gain of 35.5 percent, vs. 32.4 percent for the MSCI EAFE Index, and a 5-year return of 5.0 percent, vs. the MSCI EAFE's 2.43 percent, according to Morningstar (MORN).

Leery of Stocks

To be sure, many investors burned by the financial crisis remain wary of placing bets on equities. In its November report, Standard Chartered Bank acknowledged that the "immediate focus is still on downside risks, not the world economy's upside potential." The possibility of a double-dip recession tripped by a policy mistake, an oil price or other external shock, and a drop in consumer confidence are valid concerns, the report said. It also warned that emerging countries need to watch out for potential market bubbles that can result from huge capital inflows, so as to prevent the emergence of a boom-bust cycle.

The supercycle theory underlies the emerging market focus of at least one ETF provider, Wisdom Tree. Based on a forecast that India will be the world's third-largest economy by 2030, with a globally competitive services industry and a growing middle class, WisdomTree launched the first all-India ETF in February 2008. The WisdomTree India Earnings Fund (EPI) now has $1.5 billion assets and comprises more than 120 companies.

The shares are down 11.1 percent year-to-date and down 6.7 percent since inception, according to Bloomberg data.

"India in particular will be an important equity market for investors and will take up a larger weight in emerging market indexes," says Luciano Siracusano, Wisdom Tree's chief investment strategist. "A lot of institutional money will flow into India. A lot of people are looking at individual Indian company exposure as part of their allocations."

To give investors access to the rising consumer class in emerging economies, the company launched its Emerging Markets Small-Cap Dividend Fund (DGS) in 2007. One-quarter of its $1 billion in assets is allocated to consumer staple and consumer discretionary companies in emerging countries. "If you want to get closer to domestic economies, you need to get smaller companies," says Siracusano. By contrast, broad market, cap-weighted indexes tend to be dominated by large multinational companies that compete globally and have much smaller weights in domestic consumer sectors. Shares of the small-cap fund have risen 4.5 percent since the fund was launched in October 2007, according to Bloomberg. The shares are down 1.2 percent so far this year.

The first industrial revolution spanned 1870 to 1913 and marked the emergence of the U.S. as the world's biggest economy. Japan and the Asian tigers—Hong Kong, Singapore, South Korea, and Taiwan—grew from the second economic surge, which began after World War II. Standard Chartered Bank says the current supercycle will push the world economy from $62 trillion in 2010 to a projected $308 trillion by 2030, with emerging economies accounting for 68 percent of that growth. But strategists warn that investors should be prepared for many shorter-term cycles along the way. Says T. Rowe's White: "There will be air pockets along the way, and [investors should] be opportunistic around those."

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