Research summary on urbanization and the case for emerging markets

The case for emerging markets equities rests on their superior  long-term growth prospects, which in turns depends on the rate of urbanization of the population as workers  migrate from rural areas to  cities, thereby increasing income levels and productivity. The McKinsey Global Institute has recently released a fascinating report on urbanization and how the rise of these cities is driving the growth of the consumer class, particularly  in emerging markets 

. To summarise:

-Until 1500, Asia was the centre of gravity of the world economy and contributed roughly two-thirds of global growth. The urbanization and industrialization of Europe and the US led to a shift in the centre gravity to the west, which is now rapidly being reversed on an unprecedented scale (see diagram below).

-One billion people will enter the global consuming class (with incomes of more than $10 per day at PPP) by 2025,  becoming significant consumers of goods and services. Around 600 million of them will live in 440 cities in emerging markets (the "Emerging 440") and are likely to account for about half of global GDP growth between 2010 and 2025.

-The income of these  new consuming classes will rise faster than the size of the class, leading to many products and services reaching take-off points at which their consumption increases rapidly.

-Urban consumers are expected to contribute $20 trillion of additional spending to the world economy by 2025,  requiring a boom in construction and infrastructure  investment from $10 trillion today to $20 trillion by 2025, with most of the growth coming from emerging markets.

-This huge amount  consumption and investment  is likely to inject more than $30 trillion of additional spending into the world economy by 2025, leading to  even more demand for natural and capital resources and driving their prices higher.

-The Great Recession has hit the US and Europe particularly hard and has accelerated the global economic rebalancing. During the 2007-2010 period;  the GDP of large Chinese cities has risen from 20% to 37% of GDP of large US cities,  including  the  rise of 3 new Chinese megacities with populations of more than 10 million . In contrast, Chicago is the only city in the  developed world  which will reach megacity status by 2025.

-The Emerging 440  includes 20 megacities which will likely generate $5.8 trillion of GDP growth by 2025, with a compound growth rate of 7.6% which is about double the growth rate expected for the global economy during this period.  

-But the 400  cities of the Emerging 440 which are middleweight cities with populations between 200,000 and ten million, that are likely to grow at even a faster rate of 8% and contribute $ 17.7 trillion in GDP growth by 2025.

-In the Emerging 440, China has 6 megacities and 232 middleweight (?) cities, Latin America has 4 megacities and 53 middleweight cities, India/South Asia has 8 megacities and 28 middleweight cities , and Africa and the Middle East have 2 megacities and 37 middleweight cities.

-Of the $20 trillion expected increase in consumption in all large cities across the world, $14 trillion will be in large emerging market cities out of which $10 trillion will take place  in the Emerging 440  alone.

-By 2025,  80% of households in the Emerging 440 will be part of the global consuming class (annual incomes more than $3,500), 55% of households as part of the middle-income class (annual incomes more than $20,000) and account for 50% of the global growth of high-income households (annual income more than $70,000).

-China will alone account for 19% of the new high-income households, India 6%, Russia and Brazil 4% each and Mexico 3%, with these five countries accounting for 33 million high-income households out of a total of 60 million households in the Emerging 440.
-As the populations of many large emerging economies increase their annual incomes,  discretionary spending on  goods and services takes off rapidly – for example, dining  out (at $3,000), transport and communication (at $6,000),  washing machines (at $10,000) and retail banking and leisure travel (at $18,000).

-In addition to the demand for goods and services, cities will need to invest heavily in infrastructure with a doubling of annual physical investment from $10 trillion today to $20 trillion by 2025.

- In particular, buildings (construction equivalent to 85% of all today's residential and commercial building stock requiring a  cumulative investment of $80 trillion), port container capacity (investment of $200 billion to cater for a 2.5 times rise of global traffic) and municipal water (investment of $480 billion to increase consumption equivalent to 40% of today's level).

-This consumption and investment is already straining the global supply of capital and natural resources. The urban world has  resulted in a jump in the global investment rate from 20.8% of GDP in 2002 to 23.7% in 2008, followed by a dip during the global recession, and is projected to increase to 25% by 2025.

-Increases in the prices of energy, land, food and water in the first decade of the 2000s has already wiped out the 48% decline in prices observed during the entire 20th century.

-However, cities that under-invest in infrastructure and fail to keep pace with their expanding populations and their demands, or invest inefficiently or in the wrong things – can find themselves hitting barriers to growth.

-Lastly, urban markets are highly diverse, and many of the fastest-growing segments are likely to be in middleweight  cities in emerging economies that are simply not on the radar screens of many multinational companies.

Fascinating research  - and the single most important phenomena which is will positively influence  investment returns over the course of the next decade (the deleveraging phenomena in the developed world being a negative influence on investment returns!) . It is the irreversible trend in urbanization in the emerging world which will eventually overpower the numerous negatives cited for  developing countries - to name a few -  corruption, inequality, bad policy, overinvestment and low consumption-and lead to a rebalancing in the global distribution of growth (see chart below).  It is therefore critical to  maintain a core weighting in emerging markets, particularly China and India (favouring  domestic companies rather than multinationals as they have better access to the middleweight cities), and in natural resources which face increasing price pressure from this massive scale of consumption and investment spending.  Rising inflation and interest rates  will go hand-in-hand with this increasing consumption and investment spending, implying higher allocations to equities, natural resources and hard assets like land.


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