Moving Forward to the Real Economy
2 Copyright © 2011
Contents
Introduction
4
Section 1 - The Perfect Storm
7
- Rise of Fiat Money 8
- Demographic Tailwind 10
- Technology Explosion
12
- Globalization and World Trade
14
- Financial Innovation
18
Section 2 - The Crisis Years
23
- Global Credit Crisis
24
- Sovereign Suicide
26
- Emerging Market Bust
30
- Debt Destruction
34
- End of Globalization
40
Section 3 - The Real Economy
45
- Demographic Transition
46
- Resource Conservation
50
- Infrastructure Revival
52
- Technology Renaissance
54
- Consumer Evolution
56
Conclusions
59
Acknowledgements and Disclaimer
60
Auvest Capital Management Limited 3
Introduction
“You’re entitled to your own opinion, but not your own facts.” – Daniel Patrick Moynihan
History shows that the pace of change is generally slow but accelerates due to either a
technological breakthrough or a major crisis. The invention of the steam engine resulted in
a major rise in productivity while the Second World War led to the Bretton Woods monetary
system. What change has the recent financial crisis brought? A few months later we made our
peace by blaming it all on sub-prime debt, greedy bankers and the decision to let Lehman
Brothers fail. However, a lot of questions still remain unanswered.
At Auvest, we believe that asking the right questions is as important as finding the answers and this is what we have
attempted to do in this report. The challenge we faced was to condense an internal research project that was much
bigger in size and scope into something that would be concise and yet do justice to the subject. We hope that this report
will raise a few questions while providing a perspective on the past drivers of global growth, an analysis of the current
crisis and its implications and an overview of the opportunities and challenges in the coming years.
Financial Vandalism is a term we use to describe the current supremacy of finance over the real economy (the part of
the economy that produces goods and services) as reflected in the era of excessive leverage, financial speculation and
easy money. Finance, which is meant to facilitate the growth of the real economy by enabling the efficient allocation of
capital has become disconnected from reality. This state of affairs is unsustainable, which is why we are making a call
for the end of Financial Vandalism and a return to the real economy.
As presented in Section 1 of this report, global growth over the twenty five year period ending in 2007 was driven by
five key engines: rise of fiat money and the ascent of the US Dollar as the world’s major reserve currency, demographic
tailwind with the US baby boomers and young emerging market population, technology explosion enhancing
productivity and impacting everything from communications to healthcare, globalization and world trade with the
move in manufacturing and services from the developed world to emerging markets and financial innovation leading to
increased leverage with a consequent rise in global money supply, lower interest rates and higher asset prices.
Apart from technology, which will remain a driver of growth going forward, the four other engines of the boom
period are losing momentum. The status of the US Dollar as a reserve currency is under threat as the fiscal situation
deteriorates and America’s imperial power wanes. Global demographics are turning negative with aging populations
in the developed world and China, while income inequality and high unemployment threatens globalization and world
trade. Increased regulation and higher capital requirements in the financial industry will suppress innovation, reduce
leverage and lead to lower returns.
This structural transition exacerbates the current crisis. While the massive amount of government stimulus seems to have
created a moment of calm, the global economy that emerges towards the middle of this decade will look very different
from the one that entered the crisis in 2008. The illusion of prosperity created by the reflation of risk assets has resulted
in the collapse being dismissed as an aberration, and now everyone is back to the party.
The level of debt in the developed world is unsustainable and significant debt destruction is needed. Deleveraging of the
economy is critical for sustainable growth but it would involve a significant asset price correction and mass bankruptcies
which the authorities are unwilling to allow. Despite the wishes of the financial magicians in charge, this problem of too
much debt cannot be solved by taking on more debt.
4 Copyright © 2011
Asset prices across the world have been buoyed by the huge increase in leverage during the last decade as well as the
current high level of liquidity. In the absence of real organic demand, the only way to sustain growth and keep asset
prices stable is to add more debt and keep interest rates low, a strategy being followed across the world. The futile
attempts at reviving the global economy through more debt will only make the problem bigger and the eventual bust
more painful and damaging to the real economy.
According to our assessment in Section 2 of this report, the current crisis will last until around the middle of this decade.
The first act was the fall of the highly leveraged entities like Lehman, AIG and others which caused the credit crisis. In
the second act, Sovereigns stepped in and took the bullet meant for the leveraged players through bailouts and fiscal
stimulus thereby leading to deterioration of their balance sheets.
Act three is where we are at present, with liquidity induced inflation from the developed world’s loose monetary
policies creating social instability in emerging markets which will force interest rate hikes and a consequent asset price
correction. The developed world is importing this inflation from the emerging markets and central banks (especially the
European Central Bank and the Bank of England) may be forced to raise interest rates.
Act four will see the crisis come back to the developed world as the bust in emerging markets raises concerns about
global growth and the inability to service debt finally forces defaults and bankruptcies. This will be the most savage part
of the crisis and may lead to the nationalization of many financial institutions. Act five will be the last act of this crisis,
with every man for himself as governments realize that there is insufficient global demand to create employment at
home and simultaneously engage in free trade, leading to a major trade war and eventually a new monetary system.
Once the crisis is over and a proper monetary system is in place along with a sustainable model of globalization, the
world will be able to move forward to the real economy with a sense of optimism. Section 3 of this report presents
a broad picture of the post crisis return to the real economy around the middle of this decade in the context of the
significant demographic transition that the world is about to witness. The consumer of tomorrow will look very different
from the one of today due to the retirement of the baby boomers in the US, rapid aging in Europe, a decline in the
working age population in China and many more people in Africa and India. This new consumer will have different needs
and current business models would have to adapt and new ones emerge to capture the opportunity.
We hope you find this report valuable and we welcome your comments and feedback.
Humayun Shahryar
Founder and Chief Executive Officer
March 2011
Auvest Capital Management Limited 5
6 Copyright © 2011
Section 1 - The Perfect Storm
The Perfect Storm
1982 - 2007
The Crisis Years
2008 - 2015
The Real Economy
2016 - onwards
Rise of Fiat Money
The end of the Bretton Woods system led to the rise of fiat money and the
emergence of the US Dollar as the world’s reserve currency. The absence of a gold
standard resulted in large trade imbalances and excess liquidity globally.
Demographic Tailwind
The US baby boomers and a higher female labor participation rate in the west
combined with a large, fast growing emerging market working age population led
to increased economic growth and wealth creation.
Technology Explosion
Rapid advancement in technology facilitated strong productivity growth and price
disinflation. Major strides in healthcare and biotechnology along with abundance
of resources like food, water and energy enhanced life expectancy worldwide.
Globalization and
World Trade
Outsourcing of manufacturing and services along with growth in world trade led
to massive foreign exchange reserve accumulation, rise in money supply and large
foreign and domestic investment in installed capacity in emerging markets.
Financial Innovation
Financial innovations like securitization and derivatives along with the shadow
banking system led to rapid credit growth. Easy access to credit created a
consumption boom and resulted in an asset bubble which subsequently went bust.
Auvest Capital Management Limited 7
The Perfect Storm
1982 - 2007
Rise of Fiat Money
The Crisis Years
2008 - 2015
Demographic Tailwind
Highlights
Technology Explosion
The Real Economy
2016 - onwards
Globalization and World Trade
Financial Innovation
Rise of Fiat Money
The Bretton Woods agreement was replaced in 1971 by the fiat money system and the
• The end of the Bretton
Woods system led to the
rise of fiat money and
the emergence of the US
Dollar as the world’s reserve
currency.
US Dollar became the world’s primary reserve currency. Under this system countries
• The absence of a gold
standard resulted in large
trade imbalances and
excess liquidity globally.
trade and the resultant surge in global liquidity as a consequence of foreign
• The persistent weakening of
the US Dollar against most
currencies gave an artificial
boost to global GDP and
lifted asset and commodity
prices.
occurred in a short span of time between 2001 to 2007.
can accumulate persistent trade deficits as long as the shortfall is funded by foreign
investors. This is in contrast to the gold standard which kept a lid on money supply
making trade imbalances both unsustainable and self-correcting.
The fiat money system played a key role in contributing to the increase in world
exchange reserve accumulation. This rise in global liquidity was a key factor
underpinning growth, with world Gross Domestic Product (GDP) growing by US$42
trillion between 1982 and 2007 (Exhibit 1). US$22 trillion (52%) of this increase
Global Imbalances
US$ Reserve
Currency

Fiat Money

Forex Reserves
Strong Growth
Between 2000 and
2007, the cumulative
current account
deficit of the US
was more than twice
the cumulative deficit
between 1980 and 1999.
Exhibit 1
The ability to expand money supply under the fiat money system enabled the US
economy to grow at a much faster rate than it would have under the constraint of
a gold standard. Americans were able to consume more of the low priced goods
produced by emerging economies as the US was able to run large trade deficits.
Source: Exhibit 1 - Federal Reserve Board, Haver Analytics, Auvest Research
8 Copyright © 2011
The US current account deficit reached a peak of 6% of GDP in 2006 whilst the Chinese current account surplus recorded
a high of 11% of GDP in 2007. Between 2000 and 2007, the cumulative current account deficit of the US was more than
twice the cumulative deficit between 1980 and 1999.
A surge in exports to the developed world was a key driver for the increase in China’s current account surplus with the
pace of export growth accelerating after it joined the World Trade Organization (WTO) in 2001 (Exhibit 2). Chinese
merchandise exports to the US grew from US$1.8 billion in 1982 to US$233 billion in 2007 and to the Euro Area* from
US$1.7 billion to US$184 billion during the same period.
Exhibit 2
The rise in the current account surplus of many emerging markets combined with monetary authorities keeping their
currencies competitive for exporters added to the surge in liquidity with global foreign exchange reserves
more than tripling between 2001 and 2007 (Exhibit 3).
Exhibit 3
The growth in global money supply facilitated by the fiat money system enabled world trade to expand rapidly.
The US Dollar was a major driver of growth during this period of prosperity, especially from 2001 to 2007, as low
interest rates and high current account deficits in the US supplied the world with large amounts of liquidity. The
persistent weakening of the US Dollar against most currencies gave an artificial boost to global GDP and lifted
asset and commodity prices.
Source: Exhibit 2 - China State Administration of Foreign Exchange, Bureau of Economic Analysis, Haver Analytics, Auvest Research
Exhibit 3 - International Monetary Fund, Haver Analytics, Auvest Research
Note: * Countries that use the Euro as their currency
Auvest Capital Management Limited 9
The Perfect Storm
1982 - 2007
Rise of Fiat Money
The Crisis Years
2008 - 2015
Demographic Tailwind
Highlights
Technology Explosion
The Real Economy
2016 - onwards
Globalization and World Trade
Financial Innovation
Demographic Tailwind
The rise of the baby boomers, higher female labor force participation and
• The baby boomers in the
west and a large emerging
market working age
population led to increased
economic growth.
increased service sector employment in the west, combined with industrialization
• The number of employed
women in the US increased
from 25 million in 1965 to
68 million in 2007.
The size of the boomer generation in the US, estimated at 79 million people, is
• The working age
population ratio between
the emerging markets
and the developed world
increased from 2.8 in 1982
to 4.2 in 2007.
in emerging markets led by a large, young and low cost labor force created a
powerful tailwind for growth. As a result, world GDP per capita grew 3.5 times
between 1982 and 2007.
large in both absolute and relative terms compared to other cohorts (Exhibit 4).
The average age of the boomer population over the period 1982 to 2007 ranged
between 27 to 52 years which coincided with the peak spending period for big
ticket items like housing and durable goods.
Exhibit 4
The greater participation of women in the labor force was a key feature of the
boomer generation with the number of employed women rising from 25 million
in 1965 to 68 million in 2007. The number of jobs in the service sector (generally
better paying compared to manufacturing) increased significantly during the
working life of the boomers.
The growth in
emerging market
working age population
between 1982 and
2007
exceeded the
total population in the
developed world.
Safety nets such as pension and social security and the evolution of health and
life insurance led to reduction in saving requirements. Better paid, double income
households with enhanced safety nets were able to significantly boost consumption.
The growth in emerging market working age population between 1982 and 2007
exceeded the total population in the developed world which kept wages low in
emerging markets. Higher government spending on education played a major role
in increasing literacy in emerging markets leading to a better skilled workforce
thereby attracting more foreign direct investment.
Source: Exhibit 4 - Talkin’ ‘Bout My Generation: The Economic Impact of Aging US Baby Boomers, June 2008,
McKinsey Global Institute, p. 24
10 Copyright © 2011
Enhanced use of technology aided globalization by providing connectivity and thereby removing distance as an
impediment to the relocation of manufacturing and services to emerging markets (Exhibit 5).
Exhibit 5
Manufacturing wages in emerging economies like China and India were much lower than in the developed world
(Exhibit 6) due to the large size of the labor force. The working age population ratio between the emerging markets and
the developed world increased from 2.8 in 1982 to 4.2 in 2007. This wage differential persists despite faster wage growth
in emerging markets in recent years compared to the developed world.
Exhibit 6
The symbiotic production and consumption relationship between emerging markets and the developed world as a
result of favorable demographics was a key factor driving global prosperity between 1982 and 2007. The emerging
market population were like the worker ants that produced and saved and then recycled their savings into developed
world assets while the developed world population were like the grasshoppers that consumed.
Source: Exhibit 5 - Haver Analytics, Auvest Research
Exhibit 6 - Stephen Roach, The Next Asia, Opportunities And Challenges For A New Globalization, John Wiley & Sons,
Inc., Hoboken, New Jersey, 2009, p.185
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The Perfect Storm
1982 - 2007
Demographic Tailwind
• Rapid advancement in
technology facilitated
strong productivity growth
and price disinflation.
Technology Explosion
Globalization and World Trade
Financial Innovation
Technology Explosion
Significant advances were made in information and communication technologies.
An abundant supply of natural resources (food, water, energy and materials) aided
by the development of efficient extraction methods and sophisticated global
logistics networks, along with higher life expectancy due to better health care
enhanced productivity resulting in lower inflation (Exhibit 7).
• Major strides in healthcare
and biotechnology along
with abundance of food,
water and energy enhanced
life expectancy worldwide.

ICT*
Enhanced
Productivity
Increased
Production
Healthcare
Rise in
Life Expectancy

• The internet in particular
played a major role by
providing high speed
connectivity, facilitating
globalization and growth in
world trade.
Natural Resources

Highlights
The Real Economy
2016 - onwards

Rise of Fiat Money
The Crisis Years
2008 - 2015

Price
Disinflation
Lower Bond Yields
Exhibit 7
The rise of the venture capital industry contributed to the flow of capital into
technology companies, especially in the US. The massive jump in the processing
Global food production
almost doubled
between 1982 and
power of computer chips resulted in the pervasive use of computers in every field
from medicine to education. For example, the Human Genome Project would not
have made progress without the exponential increase in computing power.
world
population only
Mobile phone and internet penetration rates strongly increased in emerging markets
increased by 45% during
high speed connectivity, facilitating globalization and growth in world trade.
2007 while
the same period.
since 2000 (Exhibit 8).The internet in particular played a major role by providing
Higher technology penetration and capital equipment investment were key
factors behind enhanced labor productivity with China registering average annual
productivity growth of 9% between 1997 and 2007.
Source: Exhibit 7 - Bureau of Labor Statistics, Federal Reserve Board, Bureau of Economic Analysis, Haver Analytics, Auvest Research
Note: * Information and Communication Technologies
12 Copyright © 2011
Exhibit 8
Global food production almost doubled between 1982 and 2007 due to better agricultural methods (Exhibit 9) while
availability was enhanced due to improvements in logistics and food preservation technology. World population only
increased by 45% during the same period. The share of population with access to water sources in the emerging markets
grew from 72% in 1990 to 84% in 2008.
Exhibit 9
The price of food, energy, metals and fertilizers remained relatively stable from 1982 to 2003 which kept inflation tame
despite global growth remaining robust. Strong demand from emerging markets led to a spike in commodity prices after
2003 which attracted additional investment into the sector.
Better healthcare along with access to food and water led to higher life expectancy, especially in emerging markets.
Production of generic pharmaceuticals in emerging markets enhanced access to medication for large parts of the
population and treatment for common illnesses like Malaria, Cholera, Polio, etc. lowered mortality rates. This enlarged
the labor pool in emerging markets and kept wages low which contributed to global disinflation.
Technology played a major role in global growth by enhancing productivity and enabling the developed world to shift
its manufacturing base to emerging markets. The availability of low cost goods from emerging markets increased
consumption in the developed world and resulted in consumption becoming a bigger part of the developed economies.
Stable prices enabled central banks to keep interest rates low which significantly added to global growth.
Source: Exhibit 8 - World Bank, Haver Analytics, Auvest Research
Exhibit 9 - World Bank, Haver Analytics, Auvest Research
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The Perfect Storm
1982 - 2007
Rise of Fiat Money
The Crisis Years
2008 - 2015
Demographic Tailwind
Highlights
• Outsourcing of
manufacturing and services
along with growth in
world trade led to foreign
and domestic investment
in installed capacity in
emerging markets.
Technology Explosion
The Real Economy
2016 - onwards
Globalization and World Trade
Financial Innovation
Globalization and World Trade
The outsourcing of manufacturing and services aided by undervalued emerging
market currencies led to rapid growth in world trade. Central banks in most
emerging markets accumulated large foreign exchange reserves to prevent their
currencies from appreciating which led to consequent growth in money supply.
Foreign direct investment in emerging markets increased significantly from
US$11 billion in 1982 to over US$500 billion in 2007 which was equivalent to
3.6% of emerging market GDP (Exhibit 10). This was due to large scale relocation
• Emerging markets foreign
exchange reserves increased
by around six times between
1995 and 2007.
of manufacturing and services by firms from the developed world.
• China’s foreign exchange
reserves increased close to
ten times between 1999
and 2007.
Exhibit 10
Companies from the developed world invested in emerging markets for competitive
advantage and as a result facilitated industrialization and urbanization (Exhibit 11).
The growth in urban population in emerging markets (share of population living in
cities grew from 32% in 1982 to 44% in 2007) promoted investment in areas like real
estate and infrastructure increasing aggregate demand and employment.
Global trade
increased over seven
times between 1982
and 2007 accounting for
30% of
World GDP.
Exhibit 11
Source: Exhibit 10 - World Bank, Haver Analytics, Auvest Research
Exhibit 11 - World Bank, Haver Analytics, Auvest Research
14 Copyright © 2011
Global trade rose over seven times between 1982 and 2007 accounting for 30% of World GDP (Exhibit 12). This reflects
the impressive strides made by globalization enabling increased cross border movement of goods. The success of the
WTO in reducing trade barriers and improvements in transportation and logistics were major contributors to the rapid
growth in world trade.
Exhibit 12
As world trade went up substantially, the underlying imbalances widened due to exports from the emerging markets
growing at a much faster pace than exports from the developed world (Exhibit 13). The relocation of manufacturing to
emerging markets, especially from the US, added to this growth in exports. The rise in emerging markets exports created
significant employment opportunities in the manufacturing and services sectors and led to an improvement in the
overall standard of living.
Exhibit 13
Emerging markets foreign exchange reserves grew by around six times between 1995 and 2007 and represented 64% of
global reserves in 2007 (Exhibit 14). A persistent current account surplus along with foreign direct investment combined
with portfolio and hot money inflows led to the accumulation of reserves as emerging market central banks expanded
domestic money supply to prevent currency appreciation.
Source: Exhibit 12 - Stephen Roach, The Next Asia, Opportunities and Challenges for a New Globalization, John Wiley & Sons, Inc.,
Hoboken, New Jersey, 2009, p. 124, International Monetary Fund, Morgan Stanley Research, Haver Analytics, Auvest Research
Exhibit 13 - UNCTAD, Auvest Research
Auvest Capital Management Limited 15
The Perfect Storm
1982 - 2007
Rise of Fiat Money
Demographic Tailwind
The Crisis Years
2008 - 2015
Technology Explosion
The Real Economy
2016 - onwards
Globalization and World Trade
Financial Innovation
This de-facto quantitative easing was aimed at keeping the export sector competitive via an undervalued currency.
Newly acquired US Dollars were recycled into assets ranging from treasuries to mortgage backed securities which
helped underpin the US credit market and led to an expansion in leverage across the US economy.
Exhibit 14
China’s foreign exchange reserves increased close to ten times between 1999 and 2007 due to rising trade surpluses
and capital flows resulting in its money supply growing at a double digit pace since 1999 (Exhibit 15).
Exhibit 15
Fixed asset investment as a share of GDP in Japan was at 32% in 1990 coinciding with the start of the lost decade. In
comparison, the ratio of fixed asset investment to GDP for China was 39% in 2007 (Exhibit 16) having exceeded 33% each
year since 1998 as a consequence of money supply growth. Rapid investment led to significant installed capacity in many
sectors contributing to lower inflation in the developed world.
Source: Exhibit 14 - International Monetary Fund, Haver Analytics, Auvest Research
Exhibit 15 - International Monetary Fund, People’s Bank of China, Haver Analytics, Auvest Research
16 Copyright © 2011
Exhibit 16
China accounted for only 6% of world GDP in 2007; however it represented 32% of the global demand for aluminum,
40% to 45% of iron, steel and coal and 10% of world oil demand. The scale of China’s industrial production was equally
unmatched making up for half of global steel and cement and one third of aluminum output. China’s insatiable appetite
for commodities was a result of the large role in the economy played by investment and exports, which together
contributed 78% of GDP in 2007.
The WTO was a major factor driving globalization and world trade as tariffs were lowered. An era of abundant liquidity,
the desire of the developed world to consume and willingness of emerging markets to supply led to an apparent win-win
situation for the global economy with goods, services and capital moving seamlessly across borders.
Source: Exhibit 16 - Cabinet Office Japan, China National Bureau of Statistics, Haver Analytics, Auvest Research
Auvest Capital Management Limited 17
The Perfect Storm
1982 - 2007
Rise of Fiat Money
The Crisis Years
2008 - 2015
Demographic Tailwind
Highlights
• Financial innovations
like securitization and
derivatives led to rapid
credit growth.
• Financial sector earnings
increased from 11% of total
corporate sector earnings in
1982 to 21% in 2007 with a
peak at 33% in 2003.
• Easy access to credit
created a consumption
boom and resulted in
an asset bubble which
subsequently went bust.
Technology Explosion
The Real Economy
2016 - onwards
Globalization and World Trade
Financial Innovation
Financial Innovation
Low interest rates and financial deregulation that led to the rise of the shadow
banking sector, derivatives and securitization resulted in rapid growth in credit
which in turn fuelled a consumption and asset boom.
The Glass-Steagall Act 1933, which separated commercial banking from
investment banking, was repealed in 1999 enabling commercial banks to take on
more risk. The explosive growth of the derivatives market (notional value of over
the counter derivatives in 2007 was 10 times global nominal GDP), especially the
emergence of the credit default swaps market, justified greater risk appetite in a
low yield environment as risk was assumed to be insured.
Despite general wage growth, significant disparity remained among US
households. Between 1976 and 2007 the income for the top 1% earning households
grew 4.4% annually while the income for the rest of the economy grew by a
mediocre 0.6% per annum (Exhibit 17).
This implies that for every dollar of real income growth that was generated
between 1976 and 2007, 58 cents accrued to the top 1% of households.
This income inequality was a key factor that prompted both the Clinton and Bush
administration to promote home ownership by enhancing credit access, especially
among lower and middle income segments, as they recognized the danger
inherent in large parts of society not participating in economic growth.
In 2007, the US
shadow banking
system at US$20
trillion was twice the
size of the traditional
banking system.
Exhibit 17
In 1985, the shadow banking system was less than half the size of traditional
banks, but by 2007 at US$20 trillion it was twice the size of the traditional banking
system. The rise of shadow banking led to explosive growth of credit as evidenced
by the rapid increase in securitization (Exhibit 18).
Source: Exhibit 17 - Raghuram G. Rajan, Fault Lines, Princeton University Press, 2010, p. 8, A. Atkinson, T.Piketty and E. Saez,
Top Incomes in the Long Run of History, NBER Working Paper 15408, National Bureau of Economic Research, Cambridge, MA, 2009
18 Copyright © 2011
Exhibit 18
Rapid credit growth led to financial sector earnings growing from 11% of total corporate sector earnings in 1982 to 21%
in 2007 with a peak at 33% in 2003 (Exhibit 19). Employment growth in the financial sector was more muted over the
same period increasing by only 60% implying enhanced profitability per employee.
Exhibit 19
The rise in leverage was not a US centric phenomenon. The size of the financial sector debt in the Euro Area and
the UK also expanded facilitating the growth of credit to households and firms. The UK’s rise in financial sector debt was
particularly pronounced, growing from 111% of GDP in 1999 to 379% of GDP in 2007.
A large number of people, especially those in the lower income segment who could not previously access credit, were
now able to borrow. The majority of borrowing at the household level was utilized to finance property acquisition
which provided a boost to real estate markets and associated sectors (like furnishing, appliances, etc.), while
creating employment.
As a result, the ratio of debt to disposable income in a number of developed countries increased significantly reflecting
easy access to credit (Exhibit 20).
Source: Exhibit 18 - Securities Industry and Financial Markets Association, Auvest Research
Exhibit 19 - Bureau of Economic Analysis, Haver Analytics, Auvest Research
Auvest Capital Management Limited 19
The Perfect Storm
1982 - 2007
Rise of Fiat Money
Demographic Tailwind
The Crisis Years
2008 - 2015
Technology Explosion
The Real Economy
2016 - onwards
Globalization and World Trade
Financial Innovation
*
Exhibit 20
The rapid growth of credit resulted in significant price appreciation across a number of asset classes including housing,
equities and commodities. House prices in developed markets like the US, UK, Spain, Ireland and Australia went up by
over 100% despite a smaller increase in the size of the population (Exhibit 21).
**
Exhibit 21
Financial innovation and the resultant rise in leverage was a major driver for asset prices and the consequent increase in
consumption in the developed economies during 2001 to 2007.
Source: Note: Exhibit 20 - Haver Analytics, Auvest Research
Exhibit 21 - Haver Analytics, Auvest Research
* Household debt values are for 2002 and 2007
** Mortgage growth between 2000 and 2007
20 Copyright © 2011
Global growth, especially between 2001 and 2007, was dependent on the expansion of debt and asset prices continuing to
rise fuelled by benign credit market conditions. A number of central banks around the world started tightening monetary
policy in 2004 to combat inflation which made debt servicing difficult for highly leveraged market participants.
The rise of fiat money, positive demographics, technology explosion and rise in world trade all made major contributions
to growth. However, financial innovation and the rise in leverage were the lubricants that accelerated global growth.
Financial innovation in a deregulated world took on a life of its own and created an illusion of never ending prosperity
through the drug of credit as consumers across the developed world borrowed and spent beyond their means. This
created a massive boom in housing, commodities and financial assets and it was the ultimate bursting of this bubble
which led to the financial crisis.
Auvest Capital Management Limited 21
22 Copyright © 2011
Section 2 - The Crisis Years
The Perfect Storm
1982 - 2007
The Crisis Years
2008 - 2015
The Real Economy
2016 - onwards
Global Credit Crisis
The build-up in leverage and the subsequent asset price collapse led to a banking
crisis resulting in credit contraction. A sudden drop in consumer demand and
lack of trade finance led to a sharp decline in world trade.
Sovereign Suicide
Widespread state bailouts and large fiscal stimulus along with lower tax revenues
resulted in a spike in government debt. With fiscal policy options limited, central
banks turned to unconventional monetary policy to generate growth.
Emerging Market Bust
Liquidity is driving asset, commodity and consumer price inflation in emerging
markets as pressure for currency revaluation increases from the West. Rising
inflation is causing policy challenges and leading to social and political unrest.
Debt Destruction
Large debt raising requirements over the coming years will lead to an increase
in the cost of borrowing. Many borrowers will default on or restructure their debt
obligations and the resultant contagion will cause asset prices to collapse.
End of Globalization
Lack of final demand, high unemployment in the developed world and inflation in
emerging markets will lead to protectionism and eventually a currency and trade
war. A new monetary system will replace the current fiat currency regime.
Auvest Capital Management Limited 23
The Perfect Storm
1982 - 2007
Global Credit Crisis
The Crisis Years
2008 - 2015
Sovereign Suicide
Highlights
Emerging Market Bust
The Real Economy
2016 - onwards
Debt Destruction
End of Globalization
Global Credit Crisis
The low interest rate environment and unchecked financial innovation post the
• The build-up in leverage
and the subsequent asset
price collapse led to a
banking crisis resulting in
credit contraction.
2001 recession led to a rise in leverage in many developed world countries. The US
• A lack of liquidity and
panic selling by investors
exacerbated the collapse
in risk assets.
The fall in house prices was largely responsible for the run on the shadow banking
• A sudden drop in consumer
demand and lack of trade
finance led to a sharp
decline in world trade.
Federal Reserve commenced tightening monetary policy in June 2004 to contain
inflation resulting in higher delinquencies as highly leveraged households were
unable to service debt obligations.
system causing asset prices to collapse and real demand to decline pushing the
global economy into a severe recession in 2008.
A deterioration in the value of mortgage related assets and lack of access to
credit due to the run on money market funds was primarily responsible for the fire
sale of Bear Stearns and the bankruptcy of Lehman Brothers. AIG was bailed out
from the brink of bankruptcy by the US government as payments on credit default
swaps, mainly related to mortgages, triggered significant losses.
The shadow banking system shrank massively with total liabilities declining from
US$20 trillion in Q1 2008 to US$16 trillion in Q1 2010. This affected securitization
and deposit taking banks’ ability to extend credit since the shadow banking
system was their key source of funding.
The souring of mortgage backed assets also adversely impacted the ability of
European banks to extend credit (Exhibit 22).
shadow
banking system
shrank from US$20
The
Exhibit 22
trillion in Q1 2008 to
US$16 trillion in Q1 2010.
A lack of liquidity and panic selling by investors exacerbated the collapse in risk
assets and the combination of falling home and equity prices led to a significant
decline in US household wealth (Exhibit 23).
Source: Exhibit 22 - Haver Analytics, Respective Central Banks, Auvest Research
24 Copyright © 2011
Exhibit 23
The fall in household wealth negatively impacted consumer confidence resulting in a drop in retail sales and a
subsequent decrease in world industrial production and global trade (Exhibit 24). The impact would have been worse
without the coordinated intervention of authorities who provided fiscal and monetary stimulus to the global economy.
Exhibit 24
The credit crisis led to a severe shortage of US Dollars as a significant increase in counterparty risk resulted in the
freezing up of the interbank lending market as evidenced by the spike in the LIBOR-OIS spread. In September 2008,
the US Federal Reserve established swap lines totaling US$620 billion with nine key central banks to provide US
Dollar liquidity. The establishment of swap lines with other central banks was a major step to alleviate the shortage
of US Dollars in the global economy which prevented the US Dollar from appreciating and further damaging asset
and commodity markets. In addition, the Fed commenced quantitative easing with an aim to revive credit growth by
purchasing treasuries and mortgage backed securities.
The credit crisis was the first innings in the bigger game of deleveraging and impacted the leveraged financial
institutions, corporates and individuals who in turn sought government help. Sovereigns across the world stepped up to
the plate and took the bullet that was meant to punish those that were highly leveraged. As a result of bailouts, fiscal
stimulus and guarantees, the reasonably healthy sovereign balance sheets dramatically deteriorated in a short span of
time thereby putting the taxpayer on the hook to pay the bill.
Source: Exhibit 23 - Federal Reserve Board, Haver Analytics, Auvest Research
Exhibit 24 - Netherlands Bureau of Economic Policy Analysis, Haver Analytics, Auvest Research
Auvest Capital Management Limited 25
The Perfect Storm
1982 - 2007
Global Credit Crisis
The Crisis Years
2008 - 2015
Sovereign Suicide
Highlights
• Widespread state bailouts
and large fiscal stimulus
along with lower tax
revenues resulted in a spike
in government debt.
The Real Economy
2016 - onwards
Emerging Market Bust
Debt Destruction
End of Globalization
Sovereign Suicide
State bailouts of the private sector, large fiscal stimulus and lower tax revenue
caused an increase in the budget deficit of many developed economies leading
to a rise in the stock of public debt (Exhibit 25). The untenable sovereign debt
situation has already forced Greece and Ireland to seek aid from the European
Union and the International Monetary Fund and has pushed Portugal to the edge.
• With fiscal policy options
limited, central banks
turned to unconventional
monetary policy to
generate growth.
Fiscal Stimulus
Lower Tax Revenue

State Bailouts
Budget
Deficit

• Gross financing needs for
Germany, France, Belgium
and the PIIGS amount to
€3.3 trillion over the next
three years.
Sovereign Debt Shock
*
Exhibit 25
The US Treasury disbursed US$560 billion to bail out AIG, Fannie Mae, Freddie Mac,
Citibank, General Motors, Chrysler and others. In addition, the UK government’s
support to the British banking system is estimated to be £850 billion.
42% of
outstanding
US treasury debt
needs to be
refinanced over the
next two years.
In February 2009, the US Congress passed the American Recovery and
Reinvestment Act of 2009 (US$787 billion) to stimulate economic activity, create
employment and save existing jobs. Similarly, a number of other countries
including Germany, Japan, China, Australia and France also implemented various
fiscal stimulus programs to counter the fall in private sector demand.
An increase in budget deficits due to higher expenditure and lower tax revenue
resulted in soaring government deficits in the developed world (Exhibit 26). It is
likely that further assistance to troubled banks in Spain, Ireland and the UK and
lower economic growth in a number of countries like Greece, Portugal, Italy, the
US and Ireland will put further strain on public finances.
Source: Exhibit 25 - OECD
Note: * 2010 and 2011 values are OECD estimates
26 Copyright © 2011
The fiscal situation in most developed economies is dire and the bond markets appear nervous regarding the ability of
these countries to honor their debt. Rising inflation in many countries remains a wild card that could lead central banks
to raise interest rates which would add further pressure on already stretched public and private sector balance sheets.
Exhibit 26
*
The average maturity of most developed government debt (as of August 2010) is between four and eight years, with the
UK being an exception with an average maturity of over thirteen years (Exhibit 27). Recently, a number of countries like
the US have been issuing longer dated paper with the aim of extending their debt maturity profile and to lock in the
current low interest rates.
Exhibit 27
Gross financing needs (the sum of projected budget deficits and maturing debt) for Germany, France, Belgium and the
PIIGS (Portugal, Italy, Ireland, Greece and Spain) amount to €1.5 trillion, €1.0 trillion and €800 billion in 2011, 2012 and
2013 respectively (Exhibit 28).
The funding needs of Italy and Spain alone until the end of 2013 are €819 billion and €467 billion respectively. Similar to
Greece and Ireland, it is quite possible that either one or both of these countries need external support to finance their
budget deficit and roll over existing debt.
Source: Exhibit 26 - International Monetary Fund, Haver Analytics, Auvest Research
Exhibit 27 - IMF Fiscal Monitor November 2010, Auvest Research
Note: * Ireland 2007: 0.051
Auvest Capital Management Limited 27
The Perfect Storm
1982 - 2007
Global Credit Crisis
The Crisis Years
2008 - 2015
Sovereign Suicide
Emerging Market Bust
The Real Economy
2016 - onwards
Debt Destruction
End of Globalization
Assuming a bailout program for Portugal (estimated at €70 billion), the combined bailout facilities announced by the
European authorities and the IMF will likely have additional funding capacity between €345 billion and €420 billion,
which will be insufficient to fund even Spain for three years, let alone Italy. This presumably explains the recent rush by
European policy makers to expand the size of the rescue facilities.
Exhibit 28
As of June 2010, around two thirds of both Belgian and Portuguese sovereign debt is held externally which makes both
these countries dependent on the kindness of strangers to finance their deficits (Exhibit 29).
Exhibit 29
The average cost of borrowing for Portugal, Ireland, Italy, Greece and Spain had been decreasing since 2000 (Exhibit 30),
until the disclosure that Greece was much more indebted than declared sent peripheral yields spiralling in 2010. The
low yields between 2000 and 2009 were largely due to these countries’ admission into the Euro Area resulting in yield
convergence with low risk countries such as Germany. This phenomenon encouraged and enabled these countries to
borrow much more than they would otherwise have been able to.
UK, German and French banks have significant exposure to Greece, Ireland, Portugal and Spain reflecting the intertwined
nature of the issues facing Europe. A sovereign default or restructuring by one of these countries will increase losses at
banks, hamper credit growth and further dent the already fragile European banking system.
Source: Exhibit 28 - IMF WEO, Bloomberg, Citi Investment Research and Analysis, Auvest Research
Exhibit 29 - World Bank, Eurostat, ECB, National Central Banks, Citi Investment Research and Analysis
28 Copyright © 2011
Exhibit 30
To date, the sovereign debt crisis has largely been confined to Europe. However, government debt is high and rising in
the US and Japan and both these countries do not appear to exhibit any fiscal restraint. Further, the US and Japan have
the shortest debt maturity profile in the developed world making them susceptible to rollover risk due to combined
refinancing requirements for 2011 and 2012 equivalent to 42% and 38% of total central government debt respectively.
Japan has been able to fund its fiscal deficit at extremely low yields due to a captive domestic savings base. However, as
the Japanese population ages and draws down on its savings, the prospects of higher yields loom for Japan as foreigners
are unlikely to lend at the current low rates.
The unprecedented amount of monetary and fiscal stimulus was probably required to halt a complete meltdown of the
financial system and total collapse of the real economy. However, organic growth in the developed world remains tepid
and in the middle of 2010 it appeared that the US economy was likely to fall back into a recession. In response to this,
the US Federal Reserve unleashed a second round of quantitative easing (US$600 billion) in November 2010 which has
further bloated its balance sheet.
Similarly, the Bank of England pursued quantitative easing to revive economic growth while the European Central Bank
has been a buyer of peripheral European sovereign debt to contain yields.
Global leaders staged a coordinated intervention to prevent the credit crisis from morphing into a depression. The
situation is now like a poker game and markets are testing the sovereign resolve to save the system at any cost. This
has resulted in authorities following a loose fiscal and monetary policy stance which has released a surge of liquidity.
The absence of investment opportunities in the developed world combined with the markets’ perception that developed
world currencies will continue to weaken (thereby encouraging the carry trade) has unleashed this flood of liquidity into
emerging markets creating an inflation problem.
Negative real interest rates in most emerging markets have led to asset price appreciation further encouraging hot
money inflows. As these economies raise interest rates, asset prices will decline and lead to an exodus of capital thereby
exacerbating the fall and leading to a bust.
Source: Exhibit 30 - Eurostat, Auvest Research
Auvest Capital Management Limited 29
The Perfect Storm
1982 - 2007
Global Credit Crisis
The Crisis Years
2008 - 2015
Sovereign Suicide
Emerging Market Bust
The Real Economy
2016 - onwards
Debt Destruction
End of Globalization
Emerging Market Bust
Highlights
Loose monetary policy and sovereign credit concerns in the developed world as
• Liquidity is driving asset,
commodity and consumer
price inflation in emerging
markets as pressure for
currency revaluation
increases from the West.
• In the last quarter of 2010
China’s reserves increased
by US$200 billion, which
is approximately equal to
the size of the entire Irish
economy.
a result of the credit crisis have led to significant capital flows to fast growing
emerging markets, especially to developing Asia. Monetary authorities in emerging
markets have resisted currency appreciation which has resulted in massive
accumulation of foreign exchange reserves and an expansive monetary policy.
This has been the primary driver of recent asset price appreciation, inflation and
pressure for currency revaluation from the developed world.
Foreign exchange reserves in emerging markets have increased significantly
(and account for close to 65% of total global reserves) as these countries struggle
to keep their currencies competitive for exports (Exhibit 31). The recent flows to
emerging markets are dominated by speculative capital looking for a quick return
rather than the foreign direct investment needed for sustainable growth.
• Rising inflation is causing
policy challenges and
leading to social and
political unrest.
Exhibit 31
China and other emerging market economies accumulated foreign exchange
reserves at a rapid pace over the last two years (Exhibit 32). In the last quarter of
2010 China’s reserves increased by US$200 billion, which is approximately equal to
the size of the entire Irish economy.
Money supply in
China
grew by more than
50% over the two
year period ending
Recent comments of support for the peripheral European bond markets by Chinese
government officials presumably reflect China’s need to diversify its reserves away
from US Dollar assets. This also shows support for the Euro and ensures that the
Chinese Yuan does not appreciate significantly as the Euro Area is one of China’s
largest trading partners.
in 2010.
Although, the absolute growth in foreign exchange reserves in other emerging
markets is small compared to China, the growth rate is meaningful when compared
to the countries’ nominal GDP growth. For instance, Indonesia’s nominal GDP in US
Dollar terms increased by 38% from 2008 to 2010 while reserves surged by 69%.
Source: Exhibit 31 - International Monetary Fund, Haver Analytics, Auvest Research
30 Copyright © 2011
Exhibit 32
Loose monetary policy in the developed world has been primarily responsible for the flow of capital to emerging markets
but capital flows (especially portfolio and hot money inflows) can reverse due to a number of reasons and this poses
significant challenges for countries that run a current account deficit and are reliant on foreign funding.
High inflation and recent corporate governance scandals along with a fiscal and current account deficit make India a
likely candidate for capital outflows similar to that witnessed by the Asian Tiger economies during the Asian crisis in 1997.
Reserve accumulation led to expansive monetary policy with a number of emerging markets registering double digit
money supply growth over the last two years. This was particularly high in the case of China with year over year
increases of 30% and 20% respectively in 2009 and 2010 (Exhibit 33).
Exhibit 33
Supply side constraints, especially in the food and energy sectors, combined with the growth in money supply have
resulted in a spike in inflation which will force emerging markets to allow faster appreciation of their currencies.
Central banks in emerging markets have embarked on monetary policy tightening. However, real interest rates remain
either low or negative (with the exception of Brazil) implying further tightening in the near term to contain inflation
(Exhibit 34).
Source: Exhibit 32 - Haver Analytics, Auvest Research
Exhibit 33 - Haver Analytics, Auvest Research
Auvest Capital Management Limited 31
The Perfect Storm
1982 - 2007
Global Credit Crisis
The Crisis Years
2008 - 2015
Sovereign Suicide
Emerging Market Bust
The Real Economy
2016 - onwards
Debt Destruction
End of Globalization
Exhibit 34
Negative real interest rates essentially act as a tax on cash thereby encouraging speculation in financial assets. Between
March 2009 (when the US Federal Reserve embarked on its first round of quantitative easing) and December 2010, real
estate and equities in emerging markets, commodities and gold have all experienced significant price appreciation.
A key trigger behind the recent social and political unrest in a number of emerging markets like Tunisia, Algeria and
Egypt was a rise in food prices. Food has a high weighting in emerging market inflation indices and hence controlling
food inflation is critical to maintaining social order. As an example, a rise in the price of onions was responsible for the
ouster of at least two governments in India, once in 1980 and again in 1998.
There is a high probability that governments will impose export bans on commodities in short supply and even consider
imposing price controls. Governments are well aware of the dangers of spiralling inflation and certain countries have
started to stockpile essential commodities like wheat and rice which has the potential to further exacerbate the rise in
food prices.
Rising inflation in emerging markets presents policy makers with significant challenges. Raising interest rates to combat
inflation will attract further capital inflows which will put upward pressure on the currency. Also, higher interest rates
negatively affect the investment sector which has been a key contributor to GDP growth in emerging markets.
Allowing the currency to appreciate will adversely impact exports which are a primary source of GDP growth and
employment in emerging markets. Pressure from the developed world (especially from the US) for currency revaluation
is likely to intensify as its unemployment remains stubbornly high despite unprecedented amounts of fiscal and
monetary stimulus.
Hence, policy makers in emerging markets face the difficult task of fighting inflation, avoiding a slowdown in growth,
containing social unrest and preventing rhetoric over currency undervaluation from escalating into a trade war. It is
likely that emerging markets will increase interest rates and allow appreciation of their currencies to tame inflation and
to appease the developed world. However, substantial appreciation of emerging market currencies would result in global
liquidity tightening which would negatively impact risk assets.
Source: Exhibit 34 - Haver Analytics, Auvest Research
32 Copyright © 2011
The surge in liquidity leading to a rise in leverage was primarily responsible for the credit and banking crisis, but the
US Federal Reserve still continues to believe that keeping the liquidity spigots open will revive economic growth which
in turn will create employment and income. This is an untested and potentially dangerous strategy with possibly
unintended consequences. The recent spike in inflation in emerging markets which is slowly spreading to the developed
world may be a case in point.
Emerging markets will suffer from the volatility created by policy experiments as their relatively smaller size makes
them vulnerable to any reversal of capital flows and to sudden spikes in inflation and commodity prices. The dream of
emerging market decoupling will still take many years to materialize and will only come true after large scale structural
reforms in these economies.
The end of the emerging market bubble will be swift when investors realize that these markets will take much longer to
move from export and investment dependent economies to consumer driven ones. Investors will find out that the risks in
these markets are much higher than they appear because they have been smoothed over by the excess liquidity in the
global economy.
The world is faced with the stark reality of too much debt which will weigh on future growth. The strategy that everyone
seems to be following today is to avoid any kind of debt write-off or conversion to equity in the hope that growth will
come back and lead to a reduction in debt over time. The irony is that any growth in itself is now predicated on the
ability of consumers to borrow and spend rather than on growth in real organic income. The inevitable collapse of this
debt fuelled strategy will end in defaults and bankruptcies.
Auvest Capital Management Limited 33
The Perfect Storm
1982 - 2007
Global Credit Crisis
The Crisis Years
2008 - 2015
Sovereign Suicide
Highlights
Emerging Market Bust
The Real Economy
2016 - onwards
Debt Destruction
End of Globalization
Debt Destruction
Sovereigns in the developed world have high gross financing needs over the coming
• Debt levels have grown
dramatically in the
developed world and in
China since the start of the
credit crisis.
years. At the same time these countries are contemplating fiscal austerity measures
• Large debt raising
requirements over the
coming years will lead to
an increase in the cost of
borrowing.
will exert upward pressure on government bond yields leading to a rise in defaults
• Many borrowers will
default on or restructure
their debt obligations and
the resultant contagion
will cause asset prices to
collapse.
largely accounted for the increase in leverage between 2000 and 2007. However,
to rein in budget deficits, which combined with private sector deleveraging and a
fragile banking system will adversely impact economic growth.
The combination of significant funding requirements and low economic growth
and a decline in asset prices.
Total domestic debt in the US nearly doubled between 2000 and 2009. The private
sector, which consists of households, financial and non-financial businesses
since 2007 the government sector has been borrowing heavily to fund the various
bailouts and stimulus programs (Exhibit 35).
Exhibit 35
The value of owner occupied real estate in the US declined by around 27% from
the peak while the amount of outstanding mortgage debt remained constant
(Exhibit 36). This implies a ratio of mortgage debt to housing value of around
domestic
debt in both the US
0.6 while the long run average of this ratio historically was around 0.4.
and Euro Area almost
to reduce mortgage debt by around US$3.5 trillion which indicates that the
Total
doubled between
2000 and 2009.
Assuming mean reversion and no further fall in home prices, US households have
process of household deleveraging in the US is still in its infancy. This process of
deleveraging is being slowed down by various government measures to prevent a
second collapse in home prices.
Source: Exhibit 35 - Federal Reserve Board, Haver Analytics, Auvest Research
34 Copyright © 2011
Exhibit 36
As of February 2011, the Congressional Budget Office forecast that the US budget deficit will grow by around US$9
trillion over the next ten years. This implies that a 1% rise in the cost of funding will increase interest expense by US$90
billion. Although core inflation in the US remains contained, a rise in treasury yields cannot be ruled out as the size of US
government debt ventures into uncharted territory and bond investors demand a return commensurate with the level of
sovereign leverage.
Similar to the US, Euro Area domestic debt almost doubled between 2000 and 2009 with the private sector being the
primary driver of the increase between 2000 and 2007 while the government has been responsible for the rise since 2007
(Exhibit 37).
Exhibit 37
Gross financing needs (the sum of projected budget deficits and maturing debt) for Germany, France, Belgium and the
PIIGS (Portugal, Italy, Ireland, Greece and Spain) amount to €1.5 trillion, €1.0 trillion and €800 billion in 2011, 2012 and
2013 respectively. In addition, European banks need to refinance €1.6 trillion of term funding (senior paper and covered
bonds) over the next three years which will require continued access to the capital markets.
A blow up in sovereign yields could result in banks being shut out of the wholesale funding markets leading to stress
within the banking system. Peripheral banks account for close to €700 billion (44%) of the refinancing needs over the
next three years with Spain and Italy requiring the bulk.
Source: Exhibit 36 - Federal Reserve Board, Haver Analytics, Auvest Research
Exhibit 37 - Statistical Office of the European Communities, Haver Analytics, Auvest Research
Auvest Capital Management Limited 35
The Perfect Storm
1982 - 2007
Global Credit Crisis
The Crisis Years
2008 - 2015
Sovereign Suicide
Emerging Market Bust
The Real Economy
2016 - onwards
Debt Destruction
End of Globalization
Household balance sheets in a number of European (Ireland, Portugal, Spain) and other developed countries (Australia,
Canada and New Zealand) remain stretched with household debt to disposable income significantly higher than at the
start of this century (Exhibit 38).
Low interest rates fuelled a household lending boom that was largely utilized to finance real estate acquisitions.
Although property prices in some of these countries have deflated significantly, household debt has only declined
marginally (or even increased) indicating the process of balance sheet repair is in its early stage. Interest rates remain
low by historical standards in most of these countries which has made debt servicing manageable but the recent rise in
inflation could force central banks to raise interest rates triggering a wave of mortgage defaults.
*
Exhibit 38
Total domestic debt in the UK rose over five times between 2000 and 2008 with the private sector contributing to majority
of the increase. Government debt has risen over the last two years, similar to the US and the Euro Area (Exhibit 39).
The household sector in the UK remains one of the most leveraged in the developed world with debt to disposable income
of around 160%. House prices have started to decline again and unemployment is likely to increase as the coalition
government implements its austerity plan. Inflation has been running above the Bank of England’s target rate which could
force interest rate increases and adversely impact households as two thirds of mortgages in the UK are floating rate.
Exhibit 39
Source: Exhibit 38 - Haver Analytics, Auvest Research
Exhibit 39 - Office for National Statistics, Haver Analytics, Auvest Research
Note:
* Household debt figures for 2002 and 2009
36 Copyright © 2011
Japan’s total domestic debt has remained relatively constant between 2000 and 2009. However, the composition has
changed with the private sector (especially households and businesses) deleveraging while the government accumulated
debt to fund its budget deficits (Exhibit 40).
Although Japan’s debt has been relatively stable, the ratio of debt to nominal GDP has been steadily increasing
reflecting the impact of deflation on the economy. Despite Japan having its own idiosyncratic issues due to a declining
and aging population, the Japanese economy arguably provides a good template of what could happen to a number of
developed world economies that have experienced a credit induced bubble and a subsequent collapse.
Exhibit 40
The notion of global decoupling was in vogue prior to the credit crisis with the assumption that the world economy,
in particular Asia, was not dependent on the state of the US economy. Asian exports during the credit crisis tumbled
highlighting Asia’s reliance on an export led growth model. China’s exports declined by 17% in 2009 (first yearly decline
since 1983) which led to a fall in employment.
In order to create employment and maintain social stability, China significantly ramped up its spending on fixed asset
investment like real estate and infrastructure which led to investment as a share of GDP reaching a record high of 46%
in 2009 (Exhibit 41). In comparison, the same ratio for Japan was at 32% in 1990, coinciding with the start of the lost
decade whereas it has been above 33% for China every year since 1998.
Exhibit 41
Source: Exhibit 40 - Bank of Japan, Haver Analytics, Auvest Research
Exhibit 41 - World Bank, Haver Analytics, Auvest Research
Auvest Capital Management Limited 37
The Perfect Storm
1982 - 2007
Global Credit Crisis
The Crisis Years
2008 - 2015
Sovereign Suicide
Emerging Market Bust
The Real Economy
2016 - onwards
Debt Destruction
End of Globalization
Rapid loan demand to fund the increase in fixed asset investment has resulted in total loans disbursed by financial
institutions more than doubling between 2006 and 2010 (Exhibit 42). With the developed world consumer in deleveraging
mode China is increasingly dependent on fixed asset investment and credit for its economic growth. However, the recent
increase in inflation in China has led to a rise in interest rates (further increases are expected as the real interest rate is
still negative) which will make debt servicing difficult for borrowers.
Exhibit 42
Over the last decade, China has been able to generate high economic growth while maintaining relatively stable prices
mainly due to a significant increase in the working age population that has resulted in productivity growth outpacing
the increase in wages. However, over the next twenty years from 2011 to 2030, the working age population in China is
only expected to increase by 3 million (compared to an increase of 206 million between 1991 and 2010) which will put
upward pressure on wages and inflation (Exhibit 43).
Exhibit 43
The aging of China is likely to lead to a relocation of manufacturing to other low cost destinations like India, Africa and
South East Asia. The steep drop in new workers coming into the labor force in China, consequent wage inflation and
higher interest rates will make many businesses unviable leading to large scale bankruptcies. China has huge installed
capacities which have been funded through bank debt and the spate of bankruptcies will cause a banking crisis.
Source: Exhibit 42 - People’s Bank of China, China National Bureau of Statistics, Haver Analytics, Auvest Research
Exhibit 43 - United Nations, Haver Analytics, Auvest Research
38 Copyright © 2011
Total domestic debt in the US, Euro Area, Japan and the UK (all taken together) doubled from US$78 trillion to US$158
trillion between 2000 and 2009 resulting in a debt to GDP ratio of 466%. Despite the recent credit crisis being triggered
by excessive leverage, total debt has not decreased since the onset of the crisis largely due to the transfer of private debt
onto the public balance sheet.
This high level of total debt makes the global economy vulnerable to a rise in interest rates. For instance, a 1% rise in the
cost of borrowing for the US, Euro Area, Japan and the UK will lead to a combined increase in annual interest expense of
US$1.58 trillion.
It is unlikely the quantum of debt outstanding will be serviced especially in a low growth environment that is
characterized by high unemployment in the developed world. In this context, debt must be purged from the system
which involves debt write-offs or conversion of debt into equity or a combination of both. The authorities have kicked the
can down the road but this is clearly an unsustainable situation that will only be resolved with either the bondholders or
the shareholders taking a haircut.
Debt destruction in Europe, the US and China will lead to large scale bankruptcies. Extreme levels of income inequality
globally and a rise in unemployment will make the current model of globalization untenable and ultimately lead to a
currency war culminating in a major trade war.
Auvest Capital Management Limited 39
The Perfect Storm
1982 - 2007
Global Credit Crisis
The Crisis Years
2008 - 2015
Sovereign Suicide
Highlights
• A number of developed
world countries presently
have higher unemployment
than before the financial
crisis.
• Lack of final demand,
high unemployment in
the developed world and
inflation in emerging
markets will lead to
protectionism and
eventually a currency and
trade war.
• A new monetary system
will replace the current fiat
currency regime.
Emerging Market Bust
The Real Economy
2016 - onwards
Debt Destruction
End of Globalization
End of Globalization
Growth in the developed world since the beginning of the crisis has mainly been
a function of aggressive fiscal and monetary stimulus with organic demand
remaining tepid. The high level of unemployment and income inequality will lead
to a rise in protectionism and eventually a currency and trade war as governments
in the developed world aim to eliminate the significant amount of spare capacity
that exists, especially in the labor market.
The threat to globalization emanating from protectionism and a trade war will put
the current system of fiat money under strain leading to a new monetary system.
Globalization is essentially the integration of the world through cross border
trade, capital, information and labor flows. In theory, it is meant to be a winwin situation whereby emerging markets export low cost consumer goods to the
developed world and use the income earned to buy more sophisticated goods
from the developed world.
The significant growth in emerging market GDP per capita and consequent
improvement in the standard of living lends credence to the first part of the
argument. However, income and employment in the developed world have
stagnated and the level of income inequality is globally at extremely high levels.
The level of US nominal GDP is above its pre-crisis level but the economy is still
short of over 7 million jobs (Exhibit 44) compared to the peak in employment
despite the recent uptick in hiring. Firms remain reluctant to hire even though
economic activity has rebounded.
Despite several attempts by the authorities to stimulate the economy and revive
growth, real consumer spending on an annualized basis has surpassed 3% only
once since 2007.
The level of US nominal
above its
pre-crisis level
GDP is
but the economy is still
short
of over
7 million jobs.
Exhibit 44
Source: Exhibit 44 - Bureau of Economic Analysis, Bureau of Labor Statistics, Haver Analytics, Auvest Research
40 Copyright © 2011
In contrast, exporting nations like Germany and China which run a large trade surplus have seen a rapid return to full
employment on the back of export demand created by large fiscal and monetary stimulus, primarily in the US. This
‘stealing’ of demand has led to high friction between China and the US and between Germany and the peripheral
countries of southern Europe. As a result of these mercantilist policies China and Germany have been exporting deflation
to the US and southern Europe delaying their recovery from recession and hurting their efforts to create employment.
A breakdown of US employment by industry indicates that manufacturing, financial services and construction accounted
for 62% of reduction in employment between December 2007 and December 2010. By comparison, employment in the
government sector which accounted for 17% of total employment as of December 2010, has barely declined.
The construction sector in the US has historically employed three workers for every housing start while currently the ratio
is over ten. Mean reversion implies the construction sector could shed anywhere between three to four million additional
jobs unless the housing market recovers which appears unlikely given the demand and supply dynamics.
Slower credit growth due to deleveraging by the household sector along with increased financial regulation is also likely
to hamper job growth in financial services. Job losses at the state and local government level will probably accelerate as
these fiscally challenged entities rein in spending by reducing payrolls.
A further deterioration in construction, financial services as well as local and state government employment will provide
significant headwind for growth as these sectors account for a non-trivial 25% share of total US employment.
Adverse labor market conditions have kept organic personal income growth in check resulting in a steady decline of
wages and salaries as a share of personal income. However, larger government transfers and lower taxes have to some
extent offset the impact of falling salaries and wages on personal disposable income (Exhibit 45).
Exhibit 45
Source: Exhibit 45 - Bureau of Economic Analysis, Haver Analytics, Auvest Research
Auvest Capital Management Limited 41
The Perfect Storm
1982 - 2007
Global Credit Crisis
The Crisis Years
2008 - 2015
Sovereign Suicide
Emerging Market Bust
The Real Economy
2016 - onwards
Debt Destruction
End of Globalization
The recent extension of the Bush tax cuts will lead to a temporary increase in household income, and possibly
consumption, while worsening the government’s already precarious fiscal situation.
High, sticky unemployment is not just confined to the US. A number of developed world countries presently have higher
unemployment (Exhibit 46) than before the financial crisis with the exception being Germany, which has recorded
impressive job growth due to a rebound in exports, especially to emerging Asia.
Countries that experienced significant declines in house prices like the US, Spain and Ireland are the ones most impacted
by high unemployment. A meaningful reduction in the jobless rate in these countries in the short term is likely to prove
difficult given the significance of real estate and associated sectors to job creation.
Exhibit 46
A lack of final demand in many developed countries mainly due to high levels of debt and structural unemployment will
result in policy makers trying to steal demand from other countries by manipulating exchange rates. Both developed
world countries and emerging markets are currently trying to lower the value of their currencies, the former through
quantitative easing and the latter through the accumulation of foreign exchange reserves.
However, expansive monetary policy will lead to accelerating inflation in economies that have little or no spare capacity
and the recent increase in the price of energy and food supports this argument. Also, many emerging markets like
Taiwan, Brazil, South Korea and Indonesia have imposed currency controls to moderate the flow of speculative capital.
The following accounting identity indicates that the domestic private sector and the government sector cannot both
deleverage at the same time unless a trade surplus can be achieved and sustained.
Domestic Private Sector Financial Balance + Government Fiscal Balance = Current Account Balance
Most developed countries have a troubled private and government sector balance sheet which makes them
dependent on the external sector as the key driver of growth. A lower currency aids export competitiveness, so further
unconventional monetary policy in the developed world cannot be ruled out. However, not all countries can devalue their
currencies at the same time and also run a trade surplus.
Source: Exhibit 46 - Haver Analytics, Auvest Research
42 Copyright © 2011
The job of maintaining credibility in the fiat money system rests with the central banks as they control the monetary
base. After unprecedented levels of stimulus administered to the global economy organic recovery remains elusive and
trigger happy central banks have resorted to the printing press with the intent to reflate asset prices and revive growth.
The volatility in currencies resulting from government manipulation will lead to trade friction and a major trade war
with countries fighting to keep high unemployment from leading to social instability. The current monetary system has
led to a model of globalization that is unbalanced and unsustainable. A monetary system that needs a constant increase
in debt to sustain growth (through an expansion of money supply) and which requires the US to run persistent trade
deficits in order to maintain the global supply of US Dollars will not last forever.
A sustainable model of globalization needs to create a win-win situation for both rich and poor countries. Unfortunately,
the current model of globalization is unbalanced, and the fiat money system with the US Dollar as its lynchpin is a major
factor in its failure. The trade war that will end the current mercantilist model of globalization will also lead to a major
overhaul of the current monetary system. This will draw the curtain on the era of Financial Vandalism and bring the
focus back to the real economy.
Auvest Capital Management Limited 43
44 Copyright © 2011
Section 3 - The Real Economy
The Perfect Storm
1982 - 2007
The Crisis Years
2008 - 2015
The Real Economy
2016 - onwards
Demographic
Transition
World population will increase by 1.3 billion over the next 20 years. Working age
population in Europe and China will start declining while India and Africa will see
the largest increase in working age population.
Resource
Conservation
Significant opportunities will arise in sectors linked to resource conservation and
environmental sustainability as people become more resource conscious due to the
rising cost of energy, food and water.
Infrastructure
Revival
Emerging markets will experience strong growth in hard and soft infrastructure
due to continuing urbanization. Major upgrades and additions to infrastructure
will happen in the developed world to cope with technological change and aging.
Technology
Renaissance
The new age of technology will make past achievements look small as major
progress will be made in tackling resource constraints. Developments in
technology will further change how we live, travel, work and communicate.
Consumer
Evolution
Aging population in the developed world and China along with young, growing
population in India and Africa will create a new consumer class with very different
needs from today’s economy requiring new business models.
Auvest Capital Management Limited 45
The Perfect Storm
1982 - 2007
Demographic Transition
The Crisis Years
2008 - 2015
Resource Conservation
Highlights
• World population will
increase by 1.3 billion over
the next 20 years.
• Working age population in
Europe and China will start
declining while India and
Africa will see the largest
increase in working age
population.
• The size of the above 65
year old population cohort
will increase significantly in
China and India.
Infrastructure Revival
The Real Economy
2016 - onwards
Technology Renaissance
Consumer Evolution
Demographic Transition
World population is expected to increase by 1.3 billion between 2011 and
2030 with Asia and Africa accounting for close to 1.2 billion of the growth. The
population in North America is forecast to rise by a modest 55 million while in
Europe it will decline by 10 million over the same period.
Among the industrialized or newly industrialized countries, working age
populations (15 years – 64 years) in Japan and Germany are already in decline
while they will start declining in Italy and France in 2011, South Korea in 2016 and
China in 2017. The working age population in the US and the UK will continue to
rise over the next twenty years making job creation even more critical to economic
growth and social stability (Exhibit 47).
Exhibit 47
Countries like China, Germany, Japan and South Korea that have invested heavily
in industrial capacity will experience a decline or a small increase in working age
population which will put upward pressure on wages and consequently inflation.
Population growth in the developing world over the coming two decades presents
major challenges and opportunities. For example, China will add only 3 million
India will add 226 million
workers over the next twenty years compared to 206 million during the previous
people to its
twenty. This dramatic decline in the addition to the working age population,
working
age population
between 2011 and 2030
while China will add only
3 million.
primarily due to the one child policy, could result in companies relocating
operations, especially low end manufacturing, to places like India, South East Asia
and Africa.
In comparison, India will add 226 million people to its working age population
between 2011 and 2030 making it the single largest contributor to the growth in
global working age population. Africa will add 341 million people with the single
biggest increase of 52 million coming from Nigeria (Exhibit 48).
Source: Exhibit 47 - United Nations, Haver Analytics, Auvest Research
46 Copyright © 2011
Exhibit 48
Source: Exhibit 48 - United Nations, Haver Analytics, Auvest Research
Auvest Capital Management Limited 47
The Perfect Storm
1982 - 2007
Demographic Transition
Resource Conservation
The Crisis Years
2008 - 2015
Infrastructure Revival
The Real Economy
2016 - onwards
Technology Renaissance
Consumer Evolution
The world population is progressively getting older with the median age increasing from 29 years in 2011 to 34 years
in 2030 due to a fall in birth rates and a rise in life expectancy. Aging will be more pronounced in Europe and North
America while Latin America and Asia will have a relatively younger population. The median age in Asia would be even
lower were it not for aging populations in Japan, China and South Korea. Africa will have the youngest population in
2030 with a median age of just 25 years (Exhibit 49).
Exhibit 49
The decline in the working age population in China will signal a significant demographic transition for its economy as
abundant labor has been a key driver of growth in China over the last twenty years. The number of people over 65 years
of age will increase by over 100 million between 2011 and 2030 resulting in a higher dependency ratio.
The dramatic growth in working age population in India and Africa over the next two decades will provide them with
the opportunity to reap the demographic dividend by employing the large labor pool into productive economic activity
through further investment in education and technology. The over 65 year old cohort will increase significantly in India
over the next twenty years resulting in opportunities in sectors (e.g. healthcare) that cater to the older population.
One important aspect of the change over the coming two decades is a decline in the population of 0-14 year olds in both
China and India while Africa will add 94 million people to this age group (Exhibit 50).
The world is about to witness a transformation of the demographic structure which will have ramifications for trade and
investment flows over the coming years. The regions of the world with the installed manufacturing capacities are about
to experience a concurrent decline in working age populations impacting labor availability and wage inflation.
This demographic transition holds important implications for resource availability and conservation and will result in
higher requirements for infrastructure globally.
Source: Exhibit 49 - United Nations, Haver Analytics, Auvest Research
48 Copyright © 2011
*
0-14 years
15-64 years
65+ years
Exhibit 50
Source: Exhibit 50 - United Nations, Haver Analytics, Auvest Research
Note:
* Population declined by 400,000
Auvest Capital Management Limited 49
The Perfect Storm
1982 - 2007
Demographic Transition
The Crisis Years
2008 - 2015
Resource Conservation
Infrastructure Revival
The Real Economy
2016 - onwards
Technology Renaissance
Consumer Evolution
Resource Conservation
Highlights
The world will add 1.3 billion people between now and 2030 and the supply
• Rising food prices since
June 2010 have driven an
estimated 44 million people
in developing countries
into poverty.
of energy, food and water will be inadequate to cater to everyone. Significant
• Demand for food, water
and energy is expected to
rise considerably over the
next twenty years.
The recent rise in food prices that triggered political unrest in a number of low
• Significant opportunities
will arise in sectors linked
to resource conservation
and environmental
sustainability.
developments will occur in the field of resource conservation and replacement as
investment flows are directed to capture these opportunities. Consumers will be
more open to resource conservation as the cost of energy, food and water increases.
income countries highlights the importance of food price stability. The World Bank
estimates that rising food prices since June 2010 have driven an estimated 44
million people in developing countries into poverty.
The Food and Agricultural Organization (FAO) estimates that by 2050, food
production must grow by 70% (with cereal production increasing by around 25% by
2030) to meet demand (Exhibit 51). In developing countries, 80% of the necessary
increase in production is expected from enhanced yield and crop intensity which
would require significant investment in farm technology. The other 20% increase in
production is expected to be achieved from expansion of arable land.
A key concern for food production is that much of the natural resource base
already in use worldwide shows signs of degradation. According to the Millennium
Ecosystem Assessment, 15 out of 24 ecosystem services examined are already
being degraded or used unsustainably as evidenced by soil nutrient depletion,
erosion, loss of freshwater reserves and tropical forests. Hence, significant
opportunities exist to implement methods that make agricultural land use
practices more sustainable.
Global water
requirement
will grow from 4,500
billion cubic meters
today to 6,900 billion
cubic meters
by 2030.
Exhibit 51
Source: Exhibit 51 - FAO, How to Feed the World in 2050
50 Copyright © 2011
Globally, a significant quantity of food gets wasted between production and consumption due to inefficient supply
chain and logistics. This is especially prevalent in emerging markets primarily due to a lack of distribution and storage
facilities and problems with refrigeration due to erratic power supply. This is again an area where large improvements
can be made with far reaching consequences for food supply.
World energy consumption is expected to increase by 39% between 2007 and 2030 with Non-OECD countries demand
increasing by 66% whilst OECD rises by 11% (Exhibit 52). Efficient extraction technology will be essential to ensuring
maximum utilization of available energy resources. A huge amount of electricity is lost during transmission and
distribution and an upgrading of these networks provides a major opportunity for energy conservation. Appliances
that consume less energy, fuel efficient means of transport, energy efficient buildings etc., can all contribute to
BTU, Quadrillion
energy conservation.
Exhibit 52
The 2030 Water Resources Group estimates that by 2030 global water requirement will grow from 4,500 billion cubic
meters today to 6,900 billion cubic meters which is 40% above current accessible and reliable supply. The rise in
demand for water reflects increased usage by the agricultural and industrial sectors predominantly in India and China.
Substantial investment into this sector will be required to ensure adequate supply is available to meet the demands of a
growing population. Conservation and efficient use of water will be a major theme in the coming years.
In recent years, the earth’s climate has turned more extreme with eleven of the twelve hottest years recorded between
1995 and 2006. Rise in the frequency of droughts, hurricanes like Katrina and significant heat waves in Europe provide
further evidence of extraordinary weather conditions. Scientists believe that emission of greenhouse gases like carbon
dioxide, methane and nitrous oxide is the principal cause of climate change. Recent adverse weather conditions that
triggered a sharp spike in food prices and increased social unrest highlights the catastrophic impact of climate change.
Weather related disruptions are expected to occur more frequently in the future and hence greater emphasis has to be
placed on the conservation of food, water and energy to deal with sudden supply shocks.
Source: Exhibit 52 - EIA, International Energy Statistics Database
Auvest Capital Management Limited 51
The Perfect Storm
1982 - 2007
Demographic Transition
The Crisis Years
2008 - 2015
Resource Conservation
Highlights
• Emerging markets will
experience strong growth
in hard and soft
infrastructure due to
continuing urbanization.
Infrastructure Revival
The Real Economy
2016 - onwards
Technology Renaissance
Consumer Evolution
Infrastructure Revival
Emerging markets will urbanize at a rapid pace over the next two decades led by
countries in developing Asia like India and China. Post urbanization over the next
twenty years, Asia will be home to nearly 55% of the world’s urban population
(Exhibit 53) with India and China alone accounting for 30% of urban dwellers.
By 2030, China will have 221 cities with more than 1 million residents each while
India will have 68 cities*.
• Major upgrades and
additions to infrastructure
will happen in the
developed world to cope
with technological change
and aging.
• The infrastructure sector in
both the developed world
and emerging markets has
the potential to create a
significant number of jobs.
Exhibit 53
The process of urbanization will require significant investment in infrastructure
like roads, ports, power plants, water systems and real estate which implies that
emerging markets are likely to increase their already rapid pace of investment
(Exhibit 54). As an example, India needs to build 350 to 400 kilometres of metro
rail every year to keep up with demand which is twenty times the capacity that
has been built in the past decade.
The construction sector will be a major employer of the large working age
populations in India and Africa which will lead to higher income and a better
standard of living.
Over the next twenty
years, Asia will be
55%
of the world’s urban
population.
home to nearly
Exhibit 54
Source: Exhibit 53 - http://www.foreignpolicy.com/articles/2010/08/16/prime_numbers_megacities
Exhibit 54 - Farewell to cheap capital? The implications of long - term shifts in global investment and saving,
McKinsey Global Institute, Auvest Research
* http://www.foreignpolicy.com/articles/2010/08/16/prime_numbers_megacities
52 Copyright © 2011
Urbanization will lead to a significant increase in carbon dioxide emissions with India’s expected to increase seven fold
by 2030 while China’s are expected to double (Exhibit 55). Managing the pollution arising from urbanization will be a
key challenge for policy makers in emerging markets and will require considerable investment in the infrastructure for
pollution control.
Exhibit 55
The majority of arable land that is not currently used in crop production is located in countries in Sub-Saharan Africa
and Latin America (Exhibit 56). Although these countries have an abundant supply of labor, they lack the necessary
infrastructure for irrigation and transportation of agricultural produce from the farm to the end consumer. Agriculture
and related sectors in Africa and Latin America will witness significant capital flows from countries like China that need
to ensure food security for their population and have the ability to pursue major investments.
Exhibit 56
Countries like the US and the UK could witness a revival in infrastructure spending as they have invested at a slower
pace compared to other developed countries since 1980. Infrastructure spending in these countries could put a number
of unemployed people back into the work force and create jobs for new entrants while enhancing the productive
capacity of the overall economy. This will be a better alternative to the current practice of simply extending the term of
unemployment insurance claims which doesn’t incentivize people to look for jobs or enhance their skills.
Source: Exhibit 55 - http://www.foreignpolicy.com/articles/2010/08/16/prime_numbers_megacities
Exhibit 56 - Bruinsma (2009), FAO, How to Feed the World in 2050
Auvest Capital Management Limited 53
The Perfect Storm
1982 - 2007
Demographic Transition
The Crisis Years
2008 - 2015
Resource Conservation
Highlights
• Major progress will be
made in tackling resource
constraints through the use
of technology.
• Collaborative technology
and the power of networks
will change the future
organization dramatically.
• The coming Technology
Renaissance will lead
to one of the greatest
transfers of wealth in
human history.
Infrastructure Revival
The Real Economy
2016 - onwards
Technology Renaissance
Consumer Evolution
Technology Renaissance
The exponential rise in computing power over the last two decades has brought
dramatic changes to the way we work, live and communicate. The standalone
computer gave way to networks and these networks are enabling progress in
fields like nanotechnology, biotechnology and neurosciences. This will bring major
breakthroughs in the fields of natural resource conservation and replacement
(energy, food, water), business and medicine among others.
The global energy industry is probably one of the most inefficient industries and
the current state of play is unsustainable. Security issues with oil supply and
its depleting sources, the polluting nature of coal fired power plants and the
inefficiency of the transmission and distribution networks make energy a perfect
candidate for dramatic change as the focus shifts back to the real economy. The
initial move will come from a shift in the current oil and coal based economy to
cleaner gas and nuclear sources as these can be easily plugged into the existing
transmission and distribution infrastructure.
Solar, hydrogen, wind and other alternative energy sources have not yet reached
the scale to make them competitive against current energy sources. Resistance by
the incumbent energy players who want to maintain the status quo has also held
back the alternative energy industry. A fragile geopolitical situation and higher
energy prices have put the spotlight back on energy security and it is anticipated
that substantial breakthroughs will happen in this field over the coming years.
The biggest challenge in the move to new sources of energy is the huge write-off
that would have to be taken on the existing infrastructure of refineries, pipelines,
gas stations etc., if the world were to suddenly discover a way to efficiently
generate, store and transport energy.
With recent progress in battery technology, it is only a matter of time when a
solar power plant in the middle of a desert would be able to charge batteries
and distribute them just like bottled water today. People would go to the battery
station to get their car battery replaced and the power company would send
Project ITER
someone to their house to change their home battery pack.
in France aims to
Distributed energy with solar generation and battery based consumption will be
generate 500 Megawatts
the most likely winner in the medium term, at least for small scale use like cars
of
and motorbikes as well as smaller home applications like televisions and lighting.
fusion power
from a net input of 50
Megawatts of power.
Further into the future, the work that is happening in the fields of nuclear
fusion, nanotechnology and hydrogen based energy will dramatically alter
the energy landscape.
54 Copyright © 2011
In fact, a major experiment in fusion is already underway in France. Project ITER (www.iter.org), agreed between China,
the EU, India, Japan, Korea, Russia and the USA aims to generate 500 Megawatts of fusion power from a net input of
50 Megawatts of power – the first fusion experiment to produce net energy. Similarly, work is underway to harness the
power of hydrogen to generate clean, abundant energy.
The world will not run out of oil, just like it never ran out of wood and instead found cement and steel for construction or
never ran out of coal but just replaced it with oil. In the past one naturally occurring substance was replaced with another
but now new substances will be created by manipulating atoms which will soon address current resource constraints.
Food is the other important sector that will see dramatic change with the requirement to feed many more people. With
increased prosperity in the developing world, the propensity to consume meat (which requires more water to produce)
is increasing. Faced with the prospect of social instability due to inadequate food supply, the world will rely a lot more
on genetically modified food to address the needs of a hungry population. Further developments in hydroponics and the
spread of aquaculture will also contribute to solving the food problem.
Technology has dramatically changed how business is done in the last two decades but in its next phase, it will change
business itself. Collaborative technology and the power of networks will transform the future organization dramatically
and the concept of full-time employment may well cease to exist in most knowledge industries as networks of
knowledge workers organize themselves into different organizational forms.
Medicine will see big strides in prediction, detection and prevention of disease with further progress in genetic science
making it possible to accurately predict disease. Enhanced life expectancy with better mental and physical health will
enable people to work longer and help the developed world to cope with a decline in its working age population.
Advances in technology over the next two decades will make progress achieved during the previous two decades look
primitive. According to current estimates, Moore’s Law (which states that the number of transistors on a chip will double
about every two years) is expected to hold for another decade or two which means that computing power will keep
expanding at a blinding pace while at the same time its cost comes down dramatically. At this rate a smartphone that
sells for US$600 today would cost less than one Dollar in 2030, roughly the same as a pocket calculator today which
used to sell for US$500 in the early 70’s.
Technology is the only driver of growth mentioned in Section 1 of this report that will pick up momentum over the
coming years and help solve some of the major problems the world faces. A significant transition is about to happen,
much like the one that occurred when the discovery of oil changed the energy industry or the one where the aeroplane
replaced the ship for travel. The coming Technology Renaissance will lead to one of the greatest transfers of wealth in
human history as old industries give way to new and old business models are torn apart.
Auvest Capital Management Limited 55
The Perfect Storm
1982 - 2007
Demographic Transition
The Crisis Years
2008 - 2015
Resource Conservation
Infrastructure Revival
The Real Economy
2016 - onwards
Technology Renaissance
Consumer Evolution
Consumer Evolution
Highlights
The dependency ratio, number of children (under 14 years) and old age (65+) to
• Aging population in the
developed world and China
along with young, growing
population in India and
Africa will create a new
consumer class.
working age population, in developed countries like the US, Germany, Japan and
• The median household in
the US headed by a person
aged 60 to 62 has less than
a quarter of what is needed
to maintain the current
standard of living
in retirement.
Retirement Research, the median household in the US headed by a person aged 60
France and China will increase (Exhibit 57). The number of people over the age
of 65 will double in China and South Korea between 2011 and 2030 while it will
increase by 30%, 23% and 73% in Germany, Japan and the US respectively.
According to the Wall Street Journal which quoted a study by the Centre for
to 62 with a 401(k) account has less than a quarter of what is needed to maintain
the current standard of living in retirement. Even counting social security, pensions
or other savings, most 401(k) participants appear to have insufficient funds for
retirement. Hence, savings will increase as households put away more of their
income to fund retirement.
• India and Africa will
witness a significant rise in
the prime borrowing age
population between 2011
and 2030 driving demand
for big ticket items like real
estate and durable goods.
Exhibit 57
The retirement age in most developed countries will rise as governments find it
difficult to make the promised pension payments. Older people remaining in the
labor force for longer could result in increased youth unemployment which would
escalate social tensions. A revival of infrastructure spending in the developed
Approximately 10,000
baby boomers in
the US will be turning 65
every day for the
19 years.
next
world could potentially be an avenue to reduce unemployment.
Population aging could lead to increased allocation of savings towards fixed
income instruments and dividend paying equities as a stable, recurrent income
is important for retirees. As an example, currently equities and mutual funds
account for close to 18% of US household assets while credit instruments represent
only 6% and the coming retirement of the baby boomers has the potential to alter
the asset mix.
Source: Exhibit 57 - United Nations, Haver Analytics, Auvest Research
56 Copyright © 2011
The 25 – 39 year cohort is considered the prime borrowing age as these years usually coincide with the purchase of
big ticket items like property and consumer durables which most households finance with debt. India and Africa will
witness a significant rise in the prime borrowing age population between 2011 and 2030 (Exhibit 58) which will increase
demand for residential real estate and consumer loans. Although low income levels in both these countries could be an
impediment to demand, urbanization and relatively unleveraged household balance sheets will fuel the real estate and
associated sectors. The low income housing segment in particular could see significant investment flows.
Exhibit 58
The demographics for spending on big ticket items do not appear favorable for the Euro Area and the UK and although
demographics are more positive for the US (Exhibit 59), stretched household balance sheets are likely to curb spending.
Hence, the developed world will consume less as it moves towards retirement.
*
Exhibit 59
It is estimated that for the next 19 years starting now, approximately 10,000 baby boomers in the US will be turning 65
every day which combined with young population in Asia and Africa and the aging of China will lead to a significant
shift in consumer demand and preferences. Over the next 20 years, Asia will be home to over 55% of the world’s urban
population requiring major infrastructural investment and creating large employment opportunities. This consumer
evolution will redefine industries and business models and provide significant opportunities for wealth creation.
Source: Exhibit 58 - United Nations, Haver Analytics, Auvest Research
Exhibit 59 - United Nations, Haver Analytics, Auvest Research
Note:
* 2001 - 2010 population declined by 100,000
Auvest Capital Management Limited 57
58 Copyright © 2011
Conclusions
•
The financial crisis that started in 2008 is not yet over and still has some time to play out.
•
The problem of too much debt cannot be solved by taking on more debt.
•
The emerging markets will not save the world from the next phase of this crisis as they have weak domestic demand
and are too dependent on investment and exports.
•
Significant debt destruction has to happen before the global economy can get back on a path to sustainable
growth. Many defaults and bankruptcies will occur as a result.
•
This debt destruction will cause a large correction in asset prices globally.
•
High and rising unemployment and income inequality globally will lead to protectionism and a trade war.
•
A new monetary system will replace the current system around the middle of this decade.
•
The world will recover from the crisis and the focus will return to the real economy.
•
Major demographic changes are about to happen globally which will impact everyone.
•
The world is positioned badly for these changes as regions with current installed manufacturing capacity will have
labor shortages and regions with surplus labor have little installed capacity.
•
Resource conservation and replacement, infrastructure and technology will be important sectors in the coming years
and will see major investment.
•
These changes will provide many opportunities and a large transfer of wealth will take place as many people will be
caught on the wrong side of this transition.
Auvest Capital Management Limited 59
Acknowledgements
Santi Rasanayagam and Tina Pfeil were instrumental in taking this project to completion with the research, analysis,
data audit, visuals and project management. Marios Kalochoritis, Hemaad Khan and Katerina Ioannidou provided
valuable critique and input.
Thanks to the team at Insignia for the overall concept and production and Gaurav Sinha for inspiring the cover design.
Disclaimer
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60 Copyright © 2011
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