-A multi-year reallocation by global investors away from developed markets into emerging markets will facilitate both global economic and portfolio rebalancing.

-The global economy has been built on servicing the needs of consumers in the developed world, particularly in the US. At the heart of the problem is consumers in industrial economies consuming too much and those in emerging countries consuming too little.

-The extent of global dependence on the US is reflected in the dependence of EM growth on the US current account deficit – a 1% increase in the US deficit has historically led to a 1% increase in EM growth.

-Global rebalancing requires a decline in the US deficit and a resulting fall in EM growth rates, implying profound structural changes in the global economy relating to the consumption and production of goods.

-The relative prices of goods, of credit and currencies will play a critical role in determining the type of goods that will get consumed, where they get produced, and into which sectors and countries is investment capital to be channelled to produce these goods..

-While the ready availability of cheap finance to US consumers was one side of the global imbalance story, the insufficient access to finance for some key sectors in emerging markets was the other less noticed side.

-For example, investment ratios for small companies in Asia have stagnated since the Asian crisis in the late 1990s. These firms are, on average, more labour-intensive and serve the domestic-oriented service side of the economy.

-A flow of investment capital into the small business sectors in emerging markets will reduce their cost of capital, encouraging more investment and employment which in turn would boost incomes and domestic consumption- a virtuous cycle.

-In addition, increased capital flows into emerging markets will lead to an appreciation of their currencies which in turn will increase demand for domestic goods and shift production away from the export sector to the domestic sector.

-Another impact will be the shift in production chains between the developed world and emerging markets – for example, in areas like electrical machinery and office and data processing machines, cost differences account for 70% of decisions to move production from the US to China. Exchange rate movements are critical to relative costs of production.

-However, the mental and organizational structure of the asset management industry in the developed world has been built around a world with a sharp distinction between "developed countries" and "emerging markets".

-An illustration of this outdated distinction was made clear during the recent crisis – where asset managers made the mistake of equating "hard" interest rate versus "soft" credit duration risk with developed markets versus emerging markets, rather than economic fundamentals.

-This led them to hold large developed country bonds which were supposed to have only interest rate risk (i.e. Greece, Italy, Spain) but now have credit risk, and not holding bonds in some emerging markets countries which were traditionally supposed to be credit risk (i.e. Brazil, South Africa) but actually enjoyed price gains due to interest rate cuts.

-It would be a mistake to assume that asset management would remain static; according to a 2011 IMF survey of asset managers, the top two factors cited as driving country allocations were "economic growth prospects" and "sovereign debt issues", which will ultimately favour capital flows into EM.

-Lopsided allocations to developed world assets are inconsistent with the weight of emerging markets in the global economy - EM accounts for 36% of global output and 68% of GDP growth, but only represents 4% of global equity portfolios of US investors. The representation in bond portfolios is even lower.

-Portfolio reallocation is poised to be global phenomenon spanning across retail and institutional investors – and this reallocation potential is massive.

-At a structural level, GDP weighting, rather than market-capitalization weighting which dubiously skews bond portfolios into having higher weightings in countries with high debt, is getting widespread adoption. For example, Norway's $600 BN sovereign wealth fund recently announced a switch to a GDP-weighted allocation for its global bond portfolio, thereby boosting its EM weighting.

-The same economic and debt fundamentals that make economic rebalancing imperative also induce capital flows from the developed world into emerging markets, which in turn effect key prices like exchange rates and interest rates that govern the behaviour of households, companies and investors leading to further global economic rebalancing. Policy makers, regulators and investors are only beginning grapple with this profound shift.

A deeply insightful note which reinforces the theme reiterated in previous newsletters- to construct a well diversified portfolio with exposure to key emerging markets (China, India, Brazil, Indonesia, Russia as well as other "global growth generators " to borrow a term from Citibank's economics team and as described in a previous newsletter), in stocks, bonds as well as currencies. In addition, exposure to global and US energy, natural resources and multinational companies which will benefit from emerging market growth would make sense. Drilling down further, having a reasonable weighting in small and medium-sized EM stocks would be appropriate as this sector is currently capital constrained and would benefit from the above described portfolio reallocation. Yes this portfolio reallocation will be gradual over the course of this decade, but being positioned to take advantage of these flows would be important so as not to miss the big market moves.