The value of know-how

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In the tussle for post-crisis investments, emerging markets have two obvious advantages over the developed world: high growth and low costs. While the developed world has greater political stability to make up for its lower growth, it is increasingly unclear how it will compensate for its higher wages and prices.

In the recent past, the developed world has held its own through the unique quality and sophistication of its products, allowing it to charge more for what it makes. Its saving grace has been its intellectual property. As the educated middle class grows in emerging markets, however, it is debatable whether it can maintain even this advantage for long.

Could intellectual property be the key wealth of the new decade? In the absence of financial engineering, it is the only way many companies in the developed world can prop up their returns. Professional investors are flocking to large, developed-world multinationals with strong brands and the knowledge base to sustain them. To take the UK stock market as an example, influential investors such as John White, head of UK equities at GLG Partners, Tim Steer, UK equity manager at Artemis Fund Managers and Nick McLeod-Clarke, UK equity income manager at BlackRock, have all been leaping on international brands. The argument is these companies can benefit from emerging-market growth by selling sophisticated, desirable products in developing nations and beating local manufacturers on quality, rather than price.

But a cheap and increasingly refined workforce in the developing world is undermining this advantage. Workers are receiving a better education. Regions such as the Middle East are investing millions in universities and centres of higher learning. Countries such as China are churning out science PhDs. To access emerging-world resources, developed-world countries are entering joint ventures with emerging-market peers, sharing intellectual property and skilled labour – TNK-BP in Russia is a classic example.

The developing world, in other words, could end up making more for less. Not only will it be the predominant source of cheap products, but it will also be able to hold its own at the more expensive end of the market. This process has already started in China, where Lenovo has forged ahead in the laptop market, and South Korea, where Samsung is a world leader in electronics and local manufacturers are global experts in shipbuilding. In the case of South Korea, investors are even murmuring over whether to classify the country as a developed market, given its level of technological innovation. Even in areas where they have less expertise of their own, developing-world companies are buying up established developed-world companies – witness Indian conglomerate Tata’s takeover of Jaguar.

This is not to say developed-world brands will disappear. Even if an emerging-market technology catches up with its developed-world equivalent, it will take a while for consumers to trust the underlying brand. But even developed-world brands cannot last forever in the face of quality competition, no matter how culturally different their opponents. To take a more sophisticated developing country as an example, South Korean companies such as Hyundai have built up western-style brands and hired local staff to assist with their sales campaigns.

The best example of this has been Japan. Once considered an emerging market, it became a technological and corporate powerhouse that was the envy of the rest of the developed world – some even considered Japanese the business language of the future. But after the country attained its highest level of financial recognition at the end of the 1980s, when Tokyo’s Imperial Palace was worth more than all the real estate in California, aspects of its developed-world mentality started impeding its future growth.

First, and now in common with much of the developed world, the Japanese population started to age. According to the Barclays Capital Equity Gilt Study, there was a peak in the number of savers whose long-term investments would be weighted towards the stock market – the so-called equity cohort. This peak occurred at almost exactly the same time as the Japanese stock market crash of 1989. During the tech market bubble of the 1990s and 2000, and the consolidation of the new tech industries throughout the past decade, Japan showed little stomach for the high-risk equity investments that drove the tech boom, which it would theoretically have been well placed to feed into.

In the 2000s, ageing continued to be a major economic concern. Following the Japanese banking crisis at the end of the 1990s, institutions’ attention turned increasingly to even lower-risk Japanese government bonds, where domestic investors hold 94 per cent of the market, according to Chris Taylor, head of research at Neptune Investment Management. Despite a temporary stock market rally in the middle of the decade, corporations were further starved of debt and accumulated gigantic hoards of cash. In areas such as semiconductors, competition from emerging areas such as South Korea and Taiwan became intense, according to CLSA Securities, although Japan still retained its status as the world’s second-largest economy and a key hub of technological innovation.

The result? In the absence of radical economic reform, investment in intellectual property has been insufficient to return the country to vibrant growth. At the same time, Taylor points out, Japan’s developed-world labour force has continued to incur huge costs for corporates. In response, companies have outsourced increasingly to the developing world, which, he warns, could further undermine Japan’s fragile domestic economy.

Throughout this period, Japan limited its losses by developing intellectual property and selling products off the back of it. In a land of expensive labour, it was one of the few ways Japanese companies could charge a premium for their products and grow fast enough to combat declining stock ratings.

This situation could remain static for the foreseeable future. High-quality Japanese companies could force the government to devalue the yen, Taylor notes, as this would make their legendary exports more affordable. But the country’s huge government debt burden depends on domestic investors, who may allocate overseas if they see the yen weaken.

Nor should investors expect immigration to change the country’s demographics. Foreign faces are an infrequent sight, even on the streets of Tokyo. With temporary employment or unemployment so high, according to Neptune, mass labour imports would prove to be politically unacceptable.

This dire picture is not specific to Japan. The west is undergoing some of the same problems with an 11-year time lag. In the US, the equity cohort peaked in 2000, when the tech bubble burst. It subsequently initiated one of the greatest credit boom-and-busts in history. According to Financial Express, the S&P 500 has still not returned to its 2000 levels. If the Japanese model proves to be correct, domestic investors could still shift gradually from the private sector into government bonds, although international or sophisticated investors could yet disrupt these patterns.

All the more need, then, for intellectual property to produce high-margin products and combat weak financing and increasing labour costs – that is, if emerging markets do not catch up first.

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