It has become consensus in the investment community that the way to play the emerging market growth story is via the resource sector. Indeed, emerging markets and commodity-related sectors have been positively correlated as energy and materials account for a large share of emerging-market large caps. In the coming decade, however, commodity-related stocks are unlikely to provide leadership. Rather, our hunch is that technology and more specifically health care equipment stocks will be a play on emerging market growth and offer the highest returns (Chart 1). The Commodities Story Has Been Discovered We have been highlighting the risk to the commodity complex for several months and in the May 25 Weekly Bulletin, we made the case why the theme of investing in commodities is unlikely to generate excess returns going forward. Below we further elaborate our key points from the report: First, this theme is already well over a decade old and has been discovered by the average investor. Many popular press reports and articles refer to commodities as a play on emerging markets growth, and our meetings with investors over the past several months confirmed that the investment community has largely embraced this theme (Chart 2). By definition, when an investment theme becomes well known, it no longer generates outsized returns. This does not mean that an asset class will go into a bust, but its ability to generate excess profits will certainly be undermined. Second, China, more specifically its boom in construction, has been responsible for skyrocketing commodity prices. This segment of the Chinese economy is currently at risk because of an unwinding of speculative excess in the real estate market. Consistently, Chinas intake of metals and bulk commodities has surged by much more than its GDP in the past 10 years (Chart 3), implying that growth has been extremely commodity (i.e., construction) intensive. Although we remain positive on Chinas ability to generate solid per capita income in the long run, the medium-term outlook for its intake of raw materials is unfavorable. Third, when major players in the industry go public it often marks a top in an asset class. This occurred with U.S. stocks when Goldman Sachs went public in 1999 just before the secular peak in American share prices in 2000; with the private equity industry, it happened when KKR and Blackstone went public in 2007 at the peak of the credit markets and just before the credit crisis began (Chart 4). Similarly, the largest commodity trader, Glencore, has been considering an IPO in recent months, which could well be a sign of some sort of a top in commodity prices. Fourth, although commodity demand from regions other than China and developing nations is unlikely to weaken much, the scope of demand is very small compared with China. India is where potential large demand for commodities lies, as the country is severely underinvested, especially in infrastructure; and the odds are that Indian investment and demand for commodities will continue to grow briskly. However, Indias consumption of key commodities, such as copper, aluminum and nickel, is only less than 3%, while China accounts for over 40% of total global consumption of key industrial metals (Chart 5). Hence, if Chinese commodity demand slows, India and other emerging markets are unlikely to offset it at least for the time being. To be sure, one qualifier to note is that all of the above points do not relate to all commodities. Clearly, oil is a different story, as supply is constrained and demand in both China and emerging markets is likely to stay strong. A large chunk of oil demand comes from households and one of our investment themes is being long whatever Chinese consumers buy/shorting Chinese capital spending (construction) plays.1 That said, oil inventories in the U.S. and G7 are high, at a time when oil demand in these countries is still sluggish. As investors question Chinese demand for commodities, oil will initially suffer alongside base metals, though it will likely be the first to stabilize. Bottom Line: The leadership of commodity-related sectors within the global equity index has matured and their secular outperformance is probably over. While this does not mean a structural bear market looms, our sense is that the trend in these sectors will be highly cyclical rather than secular. Meanwhile, materials and energy stocks in absolute terms are still vulnerable from a cyclical perspective. Technology As A Play On Emerging Market Consumers One way to play the emerging market consumer theme is via technology. We focus on Chinese consumers in exploring this theme, given the sheer size of the Chinese economy, but the theme can be applied to most other emerging economies as well. Chinese consumers now purchase more cars than U.S. consumers. Chinese households annual vehicle purchases are running at around 16 million compared with 11 million in the U.S. (Chart 6). Each car produced for developing nations or G7 consumers has the same number of gadgets, electronics and semiconductors. Hence, the total final demand for related tech products is already high and will be higher in the emerging world compared with G7. Consistently, there is pent-up demand for other tech and electronic products both in China (Chart 7) and other emerging markets. Hence, their consumption trends will remain strong.Even within the U.S. economy there is pent up demand for tech-related capital spending. In the sluggish demand growth world that we are currently in, companies will continue to strive to boost efficiency by investing in new technologies. Finally, the tech sector has gone through a decade of restructuring after the bubble burst in 2000 and is ready to shine again, in our view. Bottom Line: Technology stocks have entered a genuine bull phase relative to the broader market (Chart 8), in part because pent-up tech demand out of emerging markets is large and will expand briskly. A Potential Mania Candidate For Coming Decade: Health Care Equipment Stocks A clear equity sector leader has emerged each decade, regardless of whether it was a bull or bear market in share prices. This decade will likely be no different. Moreover, by the end of a decade, the leaders have experienced exponential prices gain and become frothy. Needlessly to say, identifying leaders in advance and sticking with them throughout the decade would have been a profitable strategy in the past several decades. Although it is difficult to forecast dynamics for an entire 10-year period, our speculation is that this decade will be about technology and health care, with health care equipment producers being the most probable mania candidates. We examine the case of health care equipment stocks as a play on emerging market consumers in the context of China; but many of these points are also relevant to other nations with large populations such as India, Indonesia, Brazil and Mexico. Not only will income growth in emerging markets be decent but also the share of income spent on health care will rise significantly. For example, in China, the share of medical expenditures in total household income is just 5% compared with a much higher share in other countries. The reason is that as income grows and basic needs such as food and shelter are being met, demand for health care services will rise. Charts 9A and 9B show that per capita spending on health care, both in absolute terms and relative to GDP, is extremely low in developing countries, which is set to rise materially. More importantly, governments in developing countries will allocate a rising share of their spending on health care. For example, in China, the health care insurance program has been expanded from covering less than 20% of urban employees in 2001 to about 50% in 2007 (Chart 10), and it is the Chinese governments target to extend the coverage to 90% of the entire population by 2011. Chart 11 provides perspective on the share of government spending on health care as a share of total government expenditures among various countries. As income levels rise, governments in emerging markets tend to boost the share of health care spending. Populations in the G7 as well as in some emerging economies (China, in particular) will be aging (Chart 12) and demand for health care will rise exponentially. There are already signs that Chinese imports of medical equipment and pharmaceutical products are growing much faster than overall imports excluding raw materials (the reason raw materials are being excluded is to remove the price impact) (Chart 13). This trend is secular in nature and will accelerate into the future. Consistent with this positive outlook, profit margins of medical equipment and pharmaceutical products sector in China are high and rising, while the overall corporate sectors profit margins are lower and stagnating (Chart 14). Profitability of this sector will stay strong because of demand and pricing power. It is almost impossible to forecast where mania dynamics will unfold, but the medical equipment sector is the primary candidate as it possesses key elements needed for bubble formation dynamics to unfold. Manias require a displacement event, a story that can capture investors imaginations and liquidity. The rising share of the aging population, especially in China, could be one displacement event. It might capture investors imaginations leading them to pay higher multiples. Another displacement event could be the number of patents on medical equipment, which have been rising briskly since early last decade (Chart 15), with many technologies close to being commercialized. Like with the Internet and tech bubble, this could be a critical element in boosting the medical technology sector outlook in the long run, leading investors to pay much higher multiples. Bottom Line: The health care equipment industry could be the new main growth area of the coming decade, with the sector a prime candidate to experience mania-type dynamics at some point in the 2010s. Investment Conclusions Commodity-related sectors have been leaders of the 2000s and are unlikely to outperform on a consistent basis going forward. Commodity stocks are cyclically vulnerable as Chinese construction decelerates. Technology stocks are one way to play the emerging markets consumer story going forward. Hence, we are reiterating the long tech/short materials position that we instituted on February 23 (Chart 16). Health care equipment stocks could be the next equity mania candidate. Even though they are a play on developing nation consumers, winners could be American, German or Japanese companies, who are global leaders in medical technology. Chart 17 shows that the share of world medical technology patents for major countries; the U.S., Japan, Germany, China and Korea are the leaders. Investors should focus on these countries/companies. Finally, Israeli medical companies have a large presence in the stock market. The country is known for leadership in this area. Arthur Budaghyan Managing Editor Emerging Markets Strategy