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 helped 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. Leep 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 the gap between it and the U.S, and 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. But 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 the gap 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. PwC, a global consulting firm based in London, published a report called "The World in 2050" in February 2017. The report detailed how the global economic order will change by 2050.
In the report, the researchers believe that the U.S. economy will fall to third place—after India and China. They also predict that many countries in Europe will fall from 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.
The report also looks at the fastest-growing economies between 2016 and 2050. These include frontier markets by today’s definition.
PwC expects France to no longer be a top 10 economy by 2050. It's being pushed out by Mexico, which PwC projects to 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 about 1.5 times more in U.S. stocks than the U.S. market capitalization, which was 55.1% as of September 30, 2018.
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 most important reserve currency.
But it's likely the Chinese yuan could overtake the dollar over the coming years. This 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. This 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 between 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 these power struggles.