National economic development cycle and investors

The significance of the economic cycle for the investor depends on few things. Index investors are in a particular need to understand that in addition to price. The stage and direction of the development cycle tell about the potential for long-term returns. The duration of the phases can be decades or centuries. In such a long run, the investor is often dead. The nation´s internal direction of the phase indicates about the return opportunities. A downward-going state is rarely able to change direction before moving on to the next development phase. Changes in direction require radical changes in social systems and citizens' thought patterns. Here are some examples of my estimates for countries at different stages of development:

1. Ethiopia, South Africa, Bangladesh, India, Ukraine, Bulgaria, Brazil, Bolivia, Cuba
2. Malta, Czech Republic, Slovenia, Cyprus, Puerto Rico, China mostly
3. Luxembourg, Singapore, Switzerland, Norway, Denmark, the Netherlands, Sweden, Canada, Germany, Australia, major cities on and around the east coast of China
4. United States
5. Portugal, Japan, Spain, Italy, Finland, Belgium, France, United Kingdom

My thought process was not entirely clear in which category any country should be placed. Instead, the direction of development was easier to notice. It is clear that many impoverished countries that are clearly going downhill have been rich, but whether they are impoverished or still rich is more difficult to assess. Such countries, I think, include at least Japan, Britain, Finland, and France. It is clear that the direction is downwards. The location of the countries in the second phase can also be difficult to see. As an outsider, it’s hard to see if people really feel poor. China is a difficult country to evaluate because the countryside is poor, but big cities are more prosperous. The United States is an exception because of its reserve currency status. It will allow it to become more indebted than other countries without moving to the fifth stage.

The importance of a direction to stock index investors often depends on the state. For example, the direction in Finland is downwards, but most of the large companies on the Helsinki Stock Exchange are export companies, whose results and turnover mostly come from elsewhere. The same does not apply to all other countries, such as the United States and all its indices. The Russell 2000 Small Business Index is more dependent on the direction of the state. Equity investments, mainly in companies operating in the internal market, are subject to the same rules as for equity index funds.

One of the main factors behind the change in direction is the taxation of investors. A downward trend often means tightening taxation and an upward trend. Investors in export-dependent countries need to monitor tax developments. Bond investors also need to understand where countries are and in what direction they are going. On average, the debt of improving countries is falling and that of backward moving countries is rising. Debt securities of a leading economic country are generally considered to be the best asset hedges. Their attractiveness only diminishes when the position begins to look precarious. It may then be too late to respond to maintain status.

National economic development cycle and its stages

 First stage

In the first stage of the national economy, states are poor and citizens consider themselves poor. Many countries have not escaped this stage. The average income is poor and the standard of living is not soaring. People live hand to mouth and don’t waste their money. They have to spend a lot of time getting food and clean water. They have small savings and no one will lend them money unless international organizations do so. Everyone capable of leaving moves for more prosperous places. Citizens receive support from abroad. Birth rates are high. Average life expectancy is low. Corruption is a major reason why countries are not rising. Often countries are dictatorships.

For those countries, location and culture are of great importance. Significant natural resources facilitate opportunities to move forward. It will also be easier for those on the side of richer countries to move forward if they do not have to wage war against their neighbors. Belief in work, opportunities for better conditions in the home country and one's own development facilitate the development of people and the country. People are slowly earning more money than living from hand to mouth. They do so to improve their chances of surviving in the future and do not consume everything because they are worried about their financial future.

The low cost of labor enables countries to develop. Low birth rates ​​are common denominators. The number of employees in relation to the use of machinery is poor. The textile industry and similar labor-intensive industries deliver the best export products. Industry is taking advantage of obsolete machines in richer countries, whose productivity is nowhere near the level of the new ones. Focusing on price competition, usually foreign companies, operate in these countries due to low costs. They consider the risks to be the highest and want a high return on their investment. In general, countries also generate high returns. Old machines and other crap is being exported to countries that richer countries want to get rid of, such as decades-old vans.

Currencies are weak and nations do not have decent capital markets. The real values ​​of the currencies can be found on the black market and it is not worth relying on the official exchange rate. There are a few companies on the stock exchanges and there is no reliability on the financial statements. Foreign investors may be weak in disputes. Citizens who save money either invest in their own businesses or in real estate such as real estate. They believe their money is better safe than stocks or bonds. Countries are only suitable for a few investors.

Second stage

In the second stage, the state is rich, but the citizens feel poor. The behavior is not significantly different from the first stage, but the basic living conditions are better. There is less corruption, people are freer and dictators do not control the lives of citizens as much. Birth rates are higher. Food is easier to buy and clean water requires less energy and life expectancy is higher.

In this phase, personal savings and investment are growing rapidly. People have more money left to save and invest, which can be seen in e.g. on stock exchanges. The number and quality of machines to help with the work is significantly higher than in the first stage. People are motivated employees and work long hours. Exchange rates are often pegged to the reserve currency or to fixed assets such as gold. The economies of the countries are export-driven. They invest efficiently in industrial production. Competitiveness is high because wages are low and exchange rates are deliberately kept too low. Productivity growth will be rapid and debt will not increase too much relative to income.

Supply of many products in these countries is growing more slowly than demand, which is accelerating inflation. Nominal interest rates are not as high as inflation due to currency pegs. Everything is reflected in excessive investment and a balance of payments surplus. Eventually, states will have to switch to their own monetary policy. At the same time, capital markets are becoming more attractive. Private sector borrowing will begin and investors from both home and abroad will participate in the investment. New cities are growing, savings rates are high as revenues rise and foreign exchange reserves are growing.

These economies can be gold mines for the investor. Many of them are progressing to the third stage. It means decades of economic growth. According to Jim Rogers, one important milestone for the country is cutting the currency peg. It tells of the country doing well on its own. The market economy is working well enough. Bureaucracy should be minimal for the investor and adequate liquidity is mandatory. This may limit investments in major listed companies or indices.

Third stage

The third stage is the most prosperous for most nations. State is rich and citizens are rich, both in their own minds and in reality. Productivity growth is at its peak as citizens, businesses and governments invest in products and product development. Enjoying the fruits of work is the prevailing psychological state of affairs as citizens move into it from work and preparing for the worst of times. New generations have not experienced difficult times, so they do not understand the importance of saving and investing. Statistics show that this is reflected in reduced working hours and an increase in demand for luxury goods and services. They also put more money into necessities.

States are moving from net exporters to net importers. Foreign products are cheap compared to domestic ones, and especially cheap ones are imported. The investments of domestic industrial companies is growing in cheaper countries and it is moving away more and faster. Third stage countries and stock exchanges are seen as safe alternatives, which increases speculation in the financial markets by using leverage. The majority of the nations in this phase increase their military performance to advance their interests in the world. Few achieve the status of a dominant economic country. The rest will soon begin to decline and move on to the fifth stage.

Fourth stage

The fourth stage is for the country to become a leading economic nation. Only a few and selected countries do this. The fourth stage country has a reserve currency and its bonds are the best safe haven until the country moves to the next stage. In practice, a country does not have to be the richest, but its economy needs to be big enough to function as a ruling state. The phase lasts for about a lifetime. When a country acts as a holder of a reserve currency, it is a safe investment. However, the prices of assets cannot be forgotten.

Fifth stage

In the fifth stage, countries become impoverished, but citizens feel rich. The delusions of the latter are due to over-indebtedness, as incomes grow slower than debt. The limits of indebtedness are being met and must be reduced. The ultimate reason for this is that there are too few citizens who remember poor periods and the majority have not had to worry about the adequacy of money. Prices are rising when wages and consumption are too high. Savings rates are falling and leverage is rising. Real wealth is deteriorating, even though people think it is growing. Productivity growth will slow as investment in product development, infrastructure and capital-intensive products declines. Competitiveness is deteriorating and deficits are growing. Some countries in the phase are also investing in warfare to protect their own interests.

Economic booms and busts are more common in the final years of a phase because people live in the success of the past and believe the future will match it. The reality is hard to accept. With revenue growth and investment returns lower than debt service costs, the booms will be effectively wiped out. The losses brought about by the collapses are accelerating the downturn. The value of the currency depreciates, destroying the ability to pay debts. Finally, the countries will lose their status at the end of the phase.

The debt burden and the downturn of the nation are facts. Debt repayment is causing a negative self-reinforcing trend in which private sector consumption and wealth are declining. Government debt and deficit are rising. They are paid with central bank money printing, which lowers real interest rates. At the same time, the currency is weakening. Nominal GDP is growing faster than nominal interest rates. This is done to reduce the pain of paying off debt. Investment returns are low due to weak currency and deteriorating economic conditions. States start to compete against weaker nations. The superpower positions are disappearing from countries that were once successful economies. The likelihood of totalitarianism increases when citizens find themselves impoverished.

National economic development cycle, a short introduction

Ray Dalio has divided national economies into four different stages of development. I will use his assessment, but I will add more to the phase of the country that dominates the world economy. This position encounters few countries and even less often the same country reaches it more than once. Every economy has started from the first or lowest level of development which means that the country is poor and its citizens feel poor. Few countries reach the top level, the dominant economy in the world.

Most third-stage nations do not reach this stage. They jump straight to the fifth. The paths contain similarities and the same cause-and-effect relationships, but no country follows exactly the same path as the others. The levels will remain for decades and their changes will not happen fast. Each phase includes both ups and downs and booms and busts. Psychology contributes to the rise and destruction of nations or to their own level of development. It has five levels:

1. A poor nation that feels poor
2. A rich nation that feels poor
3. A rich nation that feels rich
4. A country that dominates the world economy
5. An impoverished country that feels rich

Stages are estimates of how the government and citizens, on average, see things. In many countries, individual provinces, geographies, cities, and residents do not feel that their state is at the same stage as the majority. Often the capitals of countries are richer than others which can be due to many things like corruption in poorer countries. The definitions are not clear. They are based on the opinions of the person making the assessment, with the exception of the country that dominates the world economy, which is self-evident to almost everyone.

The foreign investor needs to look at the transitions between stages. They last for years or decades. The functioning of a market economy increases as nations develop. The opposite trend is likely on the downside. The cause-and-effect relationships of transitions are not simple. Their effects often last for decades. Moving from a lower level to a higher one can mean a long period of favorable economic development. It is reflected in increased returns for investors. Dropping to a lower level weakens the expected returns. Changes are difficult to detect without visiting the country. This is especially true for lower tier countries. Reality and the outward image are not always close.