In the late 19th century, the U.S. experienced an era of rapid economic growth and industrialization. Immigrants from Europe flooded the country in the hopes of earning higher wages, many taking work in the booming railroad industry. All did not go smoothly, though, as the U.S. economy experienced several shocks, including two nationwide depressions in 1873 and 1893. Europeans who avoided investing in the U.S. likely had a good laugh over the “cowboys” out West foolishly building railroads, toiling in factories and mining for gold. They failed to see the real economic forces at hand and the long-term opportunities that existed.
This period in U.S. economic history, often termed the Gilded Age, saw supply-driven deflation. Notwithstanding this deflationary environment, U.S. productivity rose because of the effects of technology, reform and increased competition. Although the deflationary period of the 20th century’s Great Depression was devastating for U.S. equity prices, equity investing in the key growth sectors in the Gilded Age was quite profitable.
Why do we believe this is relevant to institutional investors today? Because history, it seems, has a way of repeating itself. The parallels between the late 1800s, when the U.S. emerged as an industrial powerhouse, and the current decade, as China undertakes significant reforms in its attempts to take the economic lead, are significant.
When you look at the world from an East-to-West perspective, you see clearly that it is deflating — negative price movement is occurring. Currency devaluation and the persistent downward march of global bond yields are manifestations of a long-term deflationary trend. We shouldn’t confuse deflation with depression, though, or automatically infer that such an environment will be negative for equities.
Deflation does not necessarily spell another Great Depression, which in fact was an outlier in terms of output losses. The outcome very much depends on what is driving deflation. Deflation associated with a demand shortfall pushes down prices, incomes and output, whereas supply-driven deflations depress prices while raising incomes and output. We are not seeing the massive destruction of aggregate demand witnessed during the Great Depression. Rather, we are in supply-driven deflation.
A major culprit of this excess supply has been China’s emergence over the past decade as the world’s largest manufacturer, with its industries creating tremendous amounts of capacity. At the same time, global technological advances in energy and food production, communications and information industries are conspiring to cause an oversupply of goods and excess capacity in many sectors. Together, these factors have caused a distorted view of supply and demand. Commodity producers extrapolated from the years of ever-rising demand and overinvested. As growth has started to slow, they have recently met with the economic reality of diminishing returns. The normalization of Chinese growth (which many external observers interpret as a crash landing for the Chinese economy) is to be expected and is completely healthy. This adjustment of the demand-and-supply imbalance will likely take a few years, and will feel deflationary in nature.
There are excellent opportunities for investors who can identify those sectors and companies that will profit from China’s growth normalization. The winners will be companies that can maintain pricing power in a deflationary environment and continue to grow while maintaining or expanding their profit margins because of product differentiation or innovation. As a result, through this transformational phase it is most prudent to invest using a concentrated stock-picking approach to capture the new sources of growth. Companies well positioned in sectors such as health care, tourism, insurance and the environment will be able to grow despite a deflationary climate, being able to maintain pricing power and even expand market share and profit margins. These sectors will capitalize on the natural aging trends in Asia and in the West, while also taking advantage of the fact that China is being forced to go up the economic value chain by becoming more high tech and less focused on low-cost manufacturing.
As with any transition, there will be challenges, of course, much like the U.S. during the Gilded Age. We believe that, as with the U.S., China’s rise is a once-in-a-century event. Any shorter-term negative perspective misses the significant opportunities that China presents, particularly in terms of global equity investment. A well-researched, high-conviction equity portfolio containing quality companies in key growth sectors should provide the best way to profit in this supply-driven deflationary environment.
Yu-Ming Wang is global head of investment and international CIO at Nikko Asset Management Co. in Tokyo.
