In 2000, China produced about 10 million tons of steel each month. Last year, that number had grown to more that 60 million tons—a six-fold increase in a little more than a decade. The growth was dramatic, but it was also just one small example of how infrastructure construction drove demand for raw materials and helped shape the investment landscape in emerging markets during the last decade.
But a massive shift is underway in China that could change that investment calculus. With many of the highways, skyscrapers, and ports now built, China is trying to navigate a shift from an infrastructure-led economy to a consumer-driven one. Add to that rising wages, and emerging-market investors may benefit by shifting focus from commodities to consumers.
"The infrastructure build-out created a massive increase in demand, and the world was not set up to provide that. So you actually had the perfect storm for commodity producers," says Sammy Simnegar, portfolio manager of Fidelity® Emerging Markets Fund (FEMKX). "But now a new dominant trend is taking shape: the arrival of emerging-market consumers. After you build the cities and ports and highways, you don’t build them again—you sell the TVs and furniture for the houses, and the cars for the roads."
For investors, that shift could have major implications. Many of the largest emerging-markets stocks in the major emerging-market indexes are state-owned commodity producers. But, according to Simnegar, investors may be better served with a focus on consumer brands.
China's shift to consumption
At the heart of the commodity-driven decade was China. China now consumes roughly half the industrial commodities the world produces, but it is has also been responsible for more than 80% of the growth in commodity consumption. However, that trend is changing.
"In the last decade, Chinese real GDP saw roughly 8% compound annual growth, and I’d estimate six out of the eight points of GDP came from fixed infrastructure investment," says Simnegar. "If in the next five years GDP growth is 6% to 8%, I would estimate one-third of that will come from fixed infrastructure investment, and two-thirds will be consumption oriented."
That shift reflects significant changes in China’s population. First of all, a huge migration to the cities has taken place. Today China’s population is 50% urban, and over the next 5 to 10 years, it is estimated this will increase to 60% urban—a key level many economists point to for the acceleration of consumption.
But demographics are also part of the shift. The Chinese labor force is expected to peak in the next three to five years and then start to shrink. The smaller population may be able to demand higher wages and the country could become wealthier. Already there are more households with $10,000 of discretionary income in China than in the U.S., but that number is expected to double in the next five years. "With less need for additional infrastructure and greater disposable income, there could be a shift toward a more consumption-based economy," says Simnegar.
Just as the scale of the infrastructure build-out in China was large enough to create investment tailwinds over many years, the scope of the transition into consumption could have a similar impact. For instance, in the U.S., the biggest shopping day of the year is Black Friday—the day after Thanksgiving, which last year accounted for about $10 billion in gross sales. So if the largest shopping day in the U.S. was multiplied by seven to last a week, it would account for $70 billion in gross sales. In China, the largest shopping event is called Golden Week, which has gross sales of roughly $100 billion. And, yet, the number of consumers in China is still just a fraction of the population—meaning the growth potential remains huge.
Why investors may want to check their commodity exposure
The outlook for commodities may be less robust. As China moves toward a consumption-based model, there will be less fixed investment. Therefore, commodity prices are unlikely to rise at the same clip, and, at the same time, the costs of production have gone up, according to Simnegar.
This is important for emerging-market investors, particularly index investors, because a lot of the universe of emerging-market companies is made up of commodities stocks—energy and materials made up more than 23% of the MSCI Emerging Markets Index.
According to Simnegar, another key concern about some of the big benchmark companies is that they are state owned. "Five of the 10 largest stocks, and 10 of the 20 largest stocks in the EM benchmark are state-owned companies," according to Simnegar. "I like companies with management teams that come in every day looking to maximize value for their shareholders, and these companies don’t do that. They have little transparency and often exist to implement government policy."
Choosing consumer plays
If you are looking to play emerging-market consumers, Simnegar says one attractive approach is to invest in local subsidiaries of global brands. "I’m very attracted to those types of businesses, because I get the direct exposure of that country with the management team and the governance that I like," says Simnegar.
For instance, he invests in beverage companies Nigerian Breweries PLC (NB:NL), a local subsidiary of Heineken (HEIA:NA), or United Spirits (UNSP: IN), which is partially owned by beverage giant Diageo (DGE: LN).
Simnegar is also investing in a local subsidiary of engine and generator company Cummins Inc.—he owns stock of the Indian subsidiary Cummins India. Finally, he is invested in another consumer product, tobacco. He likes Imperial Tobacco Canada (ITC) Ltd (1536Q:CN) and Brazilian tobacco company Souza Cruz (CRUZ3:BZ), both subsidiaries of British American Tobacco.