Get Ready for the Middle-Class Boom
10/18/2011 8:00 am EST
It will happen around the world—but not here—as the middle class grows globally. Two big questions for investors trying to catch this trend: How big it will be, and how long it will last.
It’s big and it’s growing fast.
But that’s about all the experts agree on about the global middle class.
I don’t expect investors to achieve enlightenment where a generation of political and social scientists, development experts, investment strategists, and economists have tied themselves into statistical knots.
But because I think the growth of the global middle class will be the single most important investing trend for the next 20 years, I think investors ought to make a start at sorting through the myths.
I’d start by trying to distinguish myth from our imperfect grasp on reality in four areas.
Myth Vs. Reality No. 1: Middle Class at $2 a Day?
We don’t have a good head count on the rising global middle class.
The global middle class numbers 1.8 billon, or 28% of the world’s population, according to the Organisation for Economic Co-operation and Development.
According to The Economist magazine, however, in February 2009, more than half of the world’s population was already middle class. The World Bank projects that between 16% and 19% of the world’s population will be middle class by 2030.
When you’re talking about a world population of 7 billion, a difference of ten or 20 percentage points, or a decade or two, amounts to a lot of people.
The projections don’t necessarily get a whole lot closer when you go from a global perspective to an individual country.
The McKinsey Global Institute projects that India’s middle class of 50 million, less than 5% of the country’s population, will explode to 583 million by 2030. But economist Nancy Birdsall, the president of the Center for Global Development, calculates that India has no middle class at all.
McKinsey Global puts China’s middle class at 43% of its population today, on its way to 76% in 2025. Birdsall calculates that China’s middle class was just 3% of the population in 2005.
The extraordinary difference in these estimates comes from the difficulty in defining the middle class. By Birdsall’s definition, the middle class consists of people who earn more than $10 a day but who aren’t in the top 5% of the population by income. In 2005, India’s extremes of income inequality put just about everyone making more than $10 a day in the top 5% of the population.
The World Bank uses a range between the mean income levels in Brazil and Italy to define middle class. Other estimates say the middle class begins at either $2 a day (twice the World Bank’s $1-a-day definition of extreme poverty), or at $6 a day.
Myth Vs. Reality No. 2: No Single Middle Class
Forget about the search for a single definition of a global middle class. There isn’t one global middle class—there are at least two.
When I look at all these struggles to define “middle class,” the thing that jumps out is how much of the difficulty comes from trying to mash together the income levels of the existing middle class of the developed world with the income levels of the developing world.
If we take a behavioral approach to our definition of “middle class,” economists see middle-class activities such as discretionary buying for status or the use of credit to turn future wealth into current consumption emerging, to a degree, at income levels of $2 or $6 a day.
But while it may make an interesting intellectual challenge to try to somehow unify all these people at such disparate income levels under a single heading of middle class, from a business perspective—and thus an investing perspective—it makes no sense at all, and may in fact be dangerous to a company’s top line...and your portfolio.
This division into two—or more—middle classes shows up, for example, in the way Coca-Cola (KO) markets its products in China.
In urban areas, where incomes and aspirations are higher, Coke sells its products at prices that are just slightly lower than in Western markets. The relatively high price is part of a strategy to brand Coke as a product that consumers aspire to as incomes rise.
In rural areas, Coke sets its prices lower, sells in slightly smaller bottles, and requires customers to drink their Cokes on site and return the bottles to vendors. Coke is still an aspirational product for rural Chinese consumers with rising incomes, but the income bar is set lower.
Coke’s pricing strategy is being duplicated by other consumer companies, such as Procter & Gamble (PG), that sell their products in developing economies in smaller sizes and at lower prices, but the strategy suggests that there’s a sizable opening for companies to develop new products and create new brands that fit different price points for the developing-economy middle class.
If this massive developing-economy middle class doesn’t have the income of its developed-economy peers—at least not yet—it still has the aspirations to signal its new wealth and status.
Investors shouldn't assume that the fruits of the growth of the developing-economy middle class will automatically flow to developed-economy consumer companies. We’re seeing a process in the cellphone sector, for example, where Taiwan’s HTC and Korea’s Samsung have created brands that are displacing phones from Nokia (NOK) and successfully waging mind-share battles with Apple (AAPL).|pagebreak|
One of the reasons that companies such as Nestlé (NSRGY) are investing so much money to set up research, development, and marketing centers in developing economies is a belief—well-founded, I think—that the rise of a developing-economy middle class requires more than simply transporting middle-class products from the developed economies to the developing world with, perhaps, some tinkering of price points.
Following this perspective just a bit down the road raises the possibility that there are more than two middle classes—developed and developing-economy models. There’s sufficient difference in income levels between the BRICS economies (Brazil, Russia, India, China, and South Africa) and the next wave of developing economies that look ready for global takeoff (countries such as Vietnam and Indonesia) to create openings for another group of companies catering to the aspirations and price points of these new middle class consumers.
Myth Vs. Reality No. 3: Falling from the Middle Class?
Yes, the story is the rise of the global middle class, but it’s also about the relative decline of the developed-world middle class—and how that will shift global middle-class consumption and the global economy in general.
Projections from the Organisation for Economic Co-operation and Development (yes, I know this data has its problems, but we’ve got to work with what we’ve got) show that the North American and European share of the global middle class in population will drop to 10% from 18% and to 22% from 36%, respectively, by 2020 from 2009. Over the same period, the middle-class population of the Asia-Pacific region will climb to 54% in 2020 from 28% in 2009.
But in terms of spending instead of numbers, the middle-class consumers of the Asia-Pacific region won’t reach a global majority position by 2020. Instead, their share of global middle-class spending will climb to just 42% by 2020 from 23% in 2009. Global consumer spending by the North American and European middle class will drop as a percentage of the global total to 46% in 2020, from 64% in 2009.
In other words, because numerically the biggest growth in the global middle class will take place in developing economies with relatively lower income levels, the global middle class will be increasingly dominated by consumers with lower incomes than those of middle-class consumers in developed economies.
The world will have more middle-class consumers, but they will have relatively lower incomes than middle-class consumers do now.
Some projections by Goldman Sachs capture this changing global economy. In 2007, the top seven countries in the world by the size of their economies were the United States, Japan, Germany, China, the United Kingdom, France, and Italy. All of these countries, except for China, ranked among the top 25 in the world by income as well.
But while the United States ranked No. 9 in income and the United Kingdom No. 10, China ranked No. 56. The average income ranking for the seven largest economies by gross domestic product was No. 21.
By 2030, only the United States, Japan, and Germany will remain in a top seven that will be headed by China, Goldman projects. And the average income ranking will have fallen to 37.
By 2050, according to Goldman, the income ranking for the top seven will have fallen to 43. And from today’s developed world, only the United States will be among a top seven by GDP rank that will also include China, India, Brazil, Russia, Indonesia, and Mexico.
The global economy is going to be a lot more of a middle-income kind of place by 2030 and 2050 than it is now, thanks to the rise of the global middle class, driven largely by the developing world.
Myth Vs. Reality No. 4: A Trend, Not a Lock
None of this may happen. What’s striking about all the studies of the rise of the global middle class that I read for this column is how little attention is paid to the (readily apparent) factors that might derail this trend.
How about resource competition, as this 1.8-billion-strong middle class demands more houses, more cars, more oil, and more gasoline? And what about the possible regional resource wars that will almost certainly result?
What about scarcities of such basics as clean water or farmland that are already apparent in China and India? What about global climate change? Or the weak institutions of countries like Russia?
If we’re going to project trends out to 2030 or 2050, don’t these need to get figured into the mix?
It’s not that there isn’t vast literature on these problems. It’s just that the literature on the rise of the global middle class and the literature of Thomas Robert Malthus, the literature that emphasizes the limits to growth, seem to talk past each other.
That leaves investors facing a huge challenge. Not only do they have to prepare for the monumental changes to the global economy laid out by the rise of the global middle class, but they have to stay alert to the possibility that something in China or India or Brazil or Europe or the United States will derail this trend.
Yes, these are interesting times—when both good and bad times promise massive uncertainty.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.