Developed market corporate sectors and stock markets stand to benefit from a number of powerful, structural trends, many of which are independent of the rise in emerging markets.
Onshoring, automation and technical advances such as nanotechnology and additive manufacturing (3D printing) could support a gradual renaissance of industrial sectors in developed markets.
The greater use of domestic shale reserves has the potential to create an energy-independent US and revive its manufacturing sector.
Developed markets remain leading innovators globally and are key exporters of high-end manufactures as well as services. They are also home to the world’s most developed and trusted global brands.
Developed market economies are still clearing away the wreckage of the financial crisis. Five years on, the US, Europe and Japan continue to suffer from a lingering hangover of high sovereign debts, challenging fiscal policy and sluggish economic growth.
However, investors should be wary of writing off developed stock markets, despite the challenging macro picture. Corporate sectors in developed economies are set to benefit from some powerful structural trends. A combination of onshoring, energy supply shifts, and innovation is helping to revive beleaguered industrial sectors in developed economies.
There is growing evidence of an industrial resurgence in developed economies, thanks to some powerful structural drivers that are allowing companies to localise production and take greater control over their supply chains.
A growing number of developed market firms are choosing to onshore (or re-shore) their production. Apple’s headline-grabbing decision to make computers in the US is not an isolated case. Last year, General Electric moved the manufacture of washing machines and refrigerators from China to Kentucky. Ford has re-shored car production from China and Mexico to Ohio and Michigan. Google is assembling its Nexus Q media streaming device in San Jose, and Caterpillar is opening a new factory in Texas. A 2012 survey by MIT of 198 US manufacturing firms with multinational operations found that 15% of them had firm plans to re-shore some production back to the US, while as much as one-third were considering such a move.
The trend is also visible in other markets. In the UK last year, GlaxoSmithKline announced plans to invest £500m in a new bio-pharma manufacturing facility; the first time in 40 years the company has built a factory on British soil. The firm also launched a £50m venture capital fund focusing on investments in ‘early-stage healthcare companies and spin-outs from academia in the UK’.
The critical catalyst for this on-shoring trend has been wage rises in Asia making off-shoring less of an obvious benefit. According to the International Labour Organisation, real wages in Asia between 2000 and 2008 rose by over 7% per year. In China, growth in wages has been even faster, hitting 19% a year from 2005 to 2010, according to Boston Consulting Group (BCG). Chart 1 shows the steep rise in average Chinese wages. Compare this to developed economies, where McKinsey estimate that wages have risen only 0.5-0.9% a year between 2000 and 2008; in fact, since 2005, real wages in US manufacturing have actually declined by 2%.
There are other factors encouraging onshoring. Shale gas is bringing down input costs for manufacturers in the US. Automation and other technical advances are also making manufacturing less labour intensive. This is allowing many developed market companies to shorten supply chains and localise production around their highest-income markets. Long and complex supply chains run the risk that capital is tied up on ocean tankers, and there are increased vulnerabilities in terms of quality control, labour practices, environmental crisis and even political turmoil. High oil prices have raised the cost of transportation. All of this is encouraging companies to give serious consideration to manufacturing their products closer to their largest, high-income end markets.
So what are the implications? The next few decades could see manufacturing become more localised as supply chains shrink considerably. Companies in developed markets will design, manufacture and then sell their goods in those markets. We could see a revival of industries that have been in decline in developed markets. In total, these trends could be a novel and valuable source of economic growth for developed economies during a period of debt-induced sluggishness.
The next twenty years could see a revolution in how and where things are made. Advances in automation, additive manufacturing and nanotechnology offer huge potential, particularly when combined with intelligence from ‘big data’ and the application of greater processing power. Together, these advances will gradually shift the nature of manufacturing from mass production of generic products towards efficient, localised production of personalised products.
Over the last few decades, manufacturing advances have been relatively limited as companies sought out the easy option of significantly cheaper labour in developing markets. As wages now rise in key emerging markets, this outsourcing phase is likely to have peaked and the use of automation and additive manufacturing is now forecast to grow strongly. Since 1990, the cost of automation is estimated to have fallen relative to labour by 40-50% in the developed world.
Labour input costs are a key catalyst for automation, but the benefits are actually much broader. The use of automated production lines and robotics allows manufacturers to collect data, improve efficiency, cut waste and reduce operating costs. By embedding sensors in the production process companies can monitor output, predict problems and intervene automatically to resolve issues. By applying computing power and exploiting ‘big data’, manufacturers can also use software analysis to optimise production and simulate how well new products would perform on a functional basis.
Machines and 3D printers can, of course, operate 24-hours a day, reducing costs associated with training, health and safety, and employee administration. They can produce high quality products to consistent, precise standards. Significantly, there is no additional cost for complexity.
At present, the electronics and auto sectors are the biggest users of automation and robotics (see chart 2) but their use is expected to broaden significantly in the coming years. Automation and additive manufacturing have the potential to level the productive playing field globally, allowing companies in developed markets to onshore, retake control of production processes and cut supply chains. China is also expected to be a major adopter of robotic automation though - the International Federation of Robotics predicts China could become one of the largest markets for automation.
Siemens, General Electric and Mitsubishi Electric are large players in the automation area. Siemens provides integrated automation solutions, drive technologies and process control systems. The company has the scale and expertise to be a long-term winner based on strong positions in core markets. General Electric provides industrial automation solutions through their Intelligent Platforms arm, while their Aviation arm recently acquired additive manufacturing specialist Morris Technologies to supply specialised components to GE’s business. GE believe that by 2020, 100,000 end-use parts in the jet engines they produce will be made via additive manufacturing. Japanese companies, Mitsubishi Electric and FANUC have a strong presence in automation and robotics, while German company KUKA also stands to benefit from increased demand for industrial robots.
BASF the German chemical firm stands to be a beneficiary of the growth in additive manufacturing as it makes the thermoplastic materials used in many 3D printing processes. Danaher is an American company that makes sensors and instrumentation for automated manufacturing processes. Dassault Systemes, based in France, is a leading provider of the software and services that support automated and additive industrial processes. Their 3D visualisation and design software allows companies to define, create, monitor and control production processes, from process planning to product assembly simulation. The company could double its addressable market by expanding into new industries and is another potential long term winner of the advanced manufacturing theme.
William Demant is a good example of a manufacturer that has adopted 3D printing techniques in the manufacture of its ‘in-ear’ hearing aid products which can be shaped to fit the ear canals of individual patients. Similarly, Smith & Nephew has been an early adopter of additive technology to improve its personalised orthopaedic products.
“I am finding many interesting investment opportunities in the European industrials sector. There is a diverse group of companies benefiting from positive structural themes. Siemens is a core holding as I expect the company to organically grow its business on a medium-term view.”
Alexandra Hartmann, portfolio manager, European equities
“The rising production of shale oil & gas in the US and the greater forecast use of automation are two powerful themes that are reflected within my global equity funds. Anadarko and National Oilwell are two of my principal holdings directly exposed to the shale theme. Meanwhile, General Electric and Danaher are two companies that I expect to benefit from broader use of automation.”
Amit Lodha, portfolio manager, global equities
The technological resolve that has made the extraction of shale hydrocarbons commercial is an example of how technical progress can have huge implications that ripple across many industries. The US is estimated to have more recoverable natural gas than Russia, Iran, Qatar, Saudi Arabia and Turkmenistan combined. Its estimated recoverable shale oil reserves are estimated to be four times that of Saudi Arabia’s proven reserves.
Shale reserves are already lowering US energy costs and are expected to provide a significant competitive boost for US industry. It is estimated that the US could save $11 billion a year in manufacturing costs from shale energy and create more than a million new jobs by 2025. Cheaper energy costs would also leave households with more disposable income benefiting the broader economy. Citigroup has estimated that shale could add 2.0%-3.0% to real GDP in the US by 2020. US imports of oil will also fall, which could see the US trade deficit reverse for the first time in years.
“The US shale revolution has led to an abundance of cheap natural gas. This is a development that could lead to significant re-shoring of a range of industries to the US. It will lower the cost of energy, which is an important input cost of production. This is likely to help boost cashflows and improve earnings and create innovation hubs for US manufacturers.”
Chris Moore, portfolio manager, global equities
There will be many US beneficiaries, especially those companies involved in the extraction and distribution of shale oil and gas. Valero Energy for example, is a US refiner which is using cheap shale oil as feedstock in gasoline production. William Bros is a company that is building pipeline infrastructure to bring shale oil and gas to the market. Equipment providers will also benefit. Schlumberger, National Oilwell Varco and Halliburton provide hydraulic fracturing technology and drilling services to the shale energy industry.
However, it is not just companies in the US that will benefit. In Europe, Aggreko can benefit from the need for temporary power generation. Weir Group produces hydraulic pumps used in shale rigs, while Elementis specialises in making liquids that are used to cool and seal drills in bore holes during the shale extraction process. Shale energy could also benefit gas-turbine companies as US power companies switch to cheap gas. Siemens and Alstom can benefit from this infrastructure power plant build-out. In the staffing industry, increased demand for specialist roles will hand pricing power to companies that specialise in providing staff to the energy sector, such as Michael Page.
Innovation has been a key ingredient in keeping corporate sectors in developed markets dynamic and powerful. Although emerging markets enjoy higher levels of economic growth, this does not always translate neatly to corporate sector development and stock market performance.
High innovation rates based on a complex nexus between universities, government support and private companies have tended to bestow an important competitive advantage on developed markets and companies. As table 1 shows, the global leaders in innovation are all high-income, developed markets. The World Intellectual Property Organization estimates that 70% of global Research and Development expenditure is accounted for by high-income countries. This innovation edge is reflected at the corporate level with research by Boston Consulting Group** showing that 44 of the world’s 50 most innovative companies are based in developed markets.
Emerging markets have been catching up. China boasts the greatest export volume of high-tech products in the world, however, the designs are often created by companies in the West, who derive the largest economic benefit by selling them onto end consumers. China is changing though, moving not only towards a consumption economy, but within manufacturing, moving up the value chain from a ‘made in China’ to a ‘designed in China’ model. This is a more challenging phase of economic development though and gains are hard-won.
Innovation is a key component of the economic and corporate development process. It could be argued that innovation is a more advanced indicator of economic development than GDP. Nobel prize winning economist, Robert Solow estimated that ‘87% of economic growth is driven by technical change over time’.13 This includes the invention, innovation and final diffusion of new products into the marketplace. Innovation is a critical aspect of Schumpeter’s ‘creative destruction’ process in capitalist economies, where incumbent products and firms are replaced by new entrants. In music distribution, online/mp3 have replaced CDs which, in turn, had replaced vinyl.
Innovation in the developed economies has encouraged the development of robust legal systems that protect intellectual property rights and instilled a strong corporate governance culture amongst companies. Much of these factors are intangible and difficult to measure by GDP. The World Bank has estimated that 80% of US wealth is made up of intangible assets.
“Significant supply growth for gas and gas liquids is expected to come from the US in the next few years. This should provide US industrial companies with lower energy costs than international competitors, which is positive for selected industrial and energy stocks. Companies like National Oilwell Varco, Helmerich & Payne and EOG Resources in the energy sector are key beneficiaries of this trend.”
Adrian Brass, portfolio manager, US equities
A company’s brand is one of its most valuable assets. Developed markets currently enjoy a virtual monopoly on the world’s leading brands; most brands or the companies which manage them are headquartered in developed economies. This lead in terms of branding makes many developed market companies major beneficiaries of consumption growth wherever it happens in the world.
The demand for luxury goods is being driven by China, making China a critical consideration for European luxury retailers. It is estimated that by 2020, China will be the world’s largest luxury goods market.15 Although variants of these goods could be manufactured in China, their European provenance makes them highly desirable. Their reputation for quality taps into a strong sense of history and geography. For instance, Switzerland is synonymous with fine watches, while Germany is associated with high-quality engineering in terms of its automobile brands.
Ted Baker is a good example of a clothing brand that our investment teams believe is well positioned for long-term growth. The company is increasing its addressable market by expanding its presence in the US, Japan, South Korea and China. Spanish fashion company Inditex has grown its Zara brand into one of the world’s leading mainstream fashion retail brands. A pioneer of ‘fast fashion’, Inditex draws on the latest catwalk fashions to make low-cost versions for fast delivery to end markets.
It is not just luxury and clothing brands that are in high demand in emerging markets. Thanks to rising income levels, there is burgeoning demand for many of the basics that are taken for granted in the developed world: soap, razors, disposable nappies, confectionery and beverages for example. Multinationals like Unilever and Nestle stand to be long-term winners of this growth. Nestle benefits from economies of scale that provide a cost advantage over smaller competitors and it generates enough cash to take a long-term view on investing in its business. Unilever, which owns a range of cleaning, food, and personal care brands (such as Dove, Knorr, Surf, and VO5) is well positioned to benefit from consumption growth in Asia. Similarly, PZ Cussons, McDonalds, Coca-Cola, and Disney are other example of companies that can organically grow their business by expanding their strongly branded franchises into new markets.
“Nestle, Coca-Cola, Disney and McDonalds are favoured holdings of mine, which I expect to benefit from their exceptionally strong brands. They all have the ability to significantly increase their addressable markets by addressing structural growth in consumption, particularly in developing countries.”
Nicola Stafford, portfolio manager, global consumer equities
In recent years, investors could be forgiven for writing off developed economies and stock markets, as they struggled with financial and sovereign crisis. Now, such avoidance looks misguided - not just because the evidence for economic growth translating to stock market performance is limited in the short to medium term.
There is a growing renaissance in manufacturing with many developed market companies now choosing to manufacture goods closer to home rather than outsource. In the US, this is being underpinned by a revolution in shale energy extraction, which is lowering industrial input costs.
Meanwhile, developed markets remain major innovators. Advances in manufacturing are increasing productivity, enabling industries in developed markets to play a major role in the high-tech manufacturing space but also compete in the broader basic manufacturing space. Lastly, developed markets enjoy some of the most powerful global brands. Many of these brands already enjoy a footprint in emerging markets with rapidly growing consumer populations.
Developed market companies are adapting to competitive shifts and tapping into the potential that technological innovation, energy shifts and branding can offer. Investors should certainly be wary of writing off developed markets; on the contrary, there is much to be excited about.
*Additive manufacturing (also known as 3D printing) is an innovation that allows objects to be machine ‘printed’ by laying down successive layers of material, based on three-dimensional computer software models. Additive manufacturing is already used to make products as diverse as aircraft parts and hearing aids.
Greater use of the technique is likely to encourage onshoring, localised production, shortened supply chains and a reduction in the number of suppliers on which manufacturers depend. Inventories could fall as spare parts are stored digitally and only “printed” as required.
The additive manufacturing industry has grown annually at a rate in excess of 20% since inception in the late 1980s.
**Boston Consulting Group produce an annual survey of the world’s 50 most innovative companies based on the views of 1500 global executives. Their 2012 survey shows developed companies retain a clear upper hand. 24 of the top 50 were American (Apple was first, Google was second); 12 were European; 5 were Japanese and 3 were Korean; emerging markets were represented by 5 Chinese companies and one Indian firm.
Interbrand’s Best Global Brands 2012 Report is dominated by brands and companies headquartered or managed in developed markets. The top ten is Coca Cola, Apple, IBM, Google, Microsoft, General Electric, McDonalds, Intel, Samsung and Toyota.
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