China and India were the largest economies in the world before the mid-19th century, due to their large populations. In those days, economic output was a function of the population rather than productivity. The Industrial Revolution added productivity to the equation; the U.S. then became the world’s largest economy by 1890. Innovations in manufacturing, finance, and technology have helped the U.S. maintain this status to the current day.
Will the U.S. stay in the top spot in the years to come? Economists are predicting changes as emerging markets like Vietnam increase their economic footprint. Keep these changes in mind to make the most of your investments.
- The U.S. has been the world's largest economy since 1890, but other countries are catching up.
- China is closing its gap with the U.S., and many predictions maintain that it will eventually take the number-one spot.
- Other emerging markets are gaining global momentum and can benefit investors as well.
- Investors should take note of the changing international landscape to make the most of it.
The U.S. has been experiencing a shift in productivity. Manufacturing and non-farm business sector productivity have been declining since the early 2000s. One of the key indicators used to measure productivity is Gross Domestic Product, or GDP, which has been rising in the U.S. since the 1950s.
Countries with larger populations have been closing their gaps between their productivity and GDP and the U.S. At the same time, globalization driven by communication technology has accelerated the transfer of technology around the world.
These trends suggest that population size, rather than innovation, will once again become a key driver of economic growth. PricewaterhouseCoopers (PwC), a global consulting firm based in London, published a report called "The World in 2050" in February 2017, detailing how the global economic order will likely change by 2050. The report forecasts that the U.S. economy will fall to third place—after India and China—and predicts that many countries in Europe not remain among the top 10 largest economies. These trends could have significant implications for international investors.
Changing Global Economy Size
The PwC "The World in 2050" report suggests that emerging markets will constitute many of the world’s top ten economies by GDP and purchasing power parity (PPP) by 2050. It also looks at the fastest-growing economies between 2016 and 2050. These include frontier markets by today’s definition.
PwC expects that France will no longer be a top 10 economy by 2050. It's being pushed out by Mexico, which PwC projects will become the seventh-largest economy in the world by 2050.
Overall, PwC believes that the global economy will double in size by 2042, growing at an average rate of 2.6% between 2016 and 2050. These growth rates will be primarily driven by emerging market countries, including Brazil, China, India, Indonesia, Mexico, Russia, and Turkey. These countries are expected to grow at an above-average 3.5% rate, compared to just a 1.6% average rate for Canada, France, Germany, Italy, Japan, the United Kingdom, and the U.S.
Investor Home-Country Bias
Most investors tend to be overweight in investments within their own country. For instance, Vanguard found that U.S. investors held U.S. stocks at a rate 1.4 times greater than market capitalization of U.S. stocks, which was 58.3% of the global market as of September 30, 2020. This means that although U.S. stocks account for 58.3% of the global market, U.S. investors hold 81.62% of U.S. stock in their portfolio, resulting in a bias towards U.S. stocks.
Financial theory suggests that investors should allocate more to foreign securities. This helps increase diversification and long-term risk-adjusted returns.
Home-country bias could become even more problematic. These days, the U.S. accounts for less and less of global market capitalization.
If U.S. investors maintain the same allocations to foreign investments despite a drop in the U.S. share of global market capitalization, they will have a greater home-country bias. Smart investors should allocate more to emerging markets over the coming years to avoid this costly bias.
The U.S. has enjoyed a leadership role in the global economy for many years, but those dynamics could begin to change with the rise of emerging markets. For instance, the U.S. dollar has long been the world’s reserve currency. It's likely the Chinese yuan could overtake the dollar over the coming years. That could have a negative impact on the valuation of the U.S. dollar over time. It could potentially destabilize the global economy if the yuan is volatile.
The stabilizing presence of Western and European alliances could deteriorate, causing financial instability in areas that have been expanding for many years.
China, Russia, and many other emerging markets have also taken an increasingly large role in global conversations. That could present a challenge for the U.S. and Europe over the coming years, particularly in trade issues or global conflicts. Moreover, these dynamics could alter the current risk profile of the global markets by potentially increasing geopolitical risks as power struggles play out among countries over time.
The Bottom Line
The U.S. has been the world’s largest economy for a long time, but those dynamics are quickly changing as China, India, and other emerging markets gain momentum.
Investors should be aware of these global changes and position their portfolios to avoid home-country bias through increased international diversification. Diversification also helps with hedging against potential geopolitical risks that may arise from power struggles.