A more nuanced picture on global GDP growth

As is obvious when looking at chart 1, in most countries, real GDP growth post 2008 has been significantly below the growth levels we experienced in the years leading up to the financial crisis. Having said that, some modest recovery has taken place almost everywhere since 2010, resulting in annualised global GDP growth of 4.7% between 2010 and 2014.

A few brief observations: (i) many EM countries have experienced a slowdown in economic growth that has been much more dramatic than that of China, and (ii) idiosyncratic reasons are often behind such slowdowns.

Example: A dramatic fall in the oil price largely explains Russian GDP falling out of bed. Having said that, the fall in the price of oil has been a net positive for economic growth in the vast majority of countries around the world. As a consequence, one cannot point to just one or two factors to explain the subdued GDP growth.

Why 2008 doesn’t really explain today’s low GDP growth

Let’s revisit the celebrated economist Jan Tinbergen’s now famous economic theorem: If a country has n macroeconomic goals, it must have at least n independent macroeconomic policy levers, for those goals to be achieved. That is now a widely accepted approach to economic policy – acknowledged by most economists, if not always by policy makers.

For many years, we had two macroeconomic goals in most OECD countries, (i) low and stable inflation, and (ii) economic growth sufficiently high to enjoy full, non-inflationary, employment. To meet those two goals we also had two policy levers, namely fiscal policy and monetary policy, doing precisely what Tinbergen had prescribed. 2008 changed all that. Suddenly policy makers wanted to also control asset prices with monetary policy, effectively increasing the number of goals to three, but keeping the number of policy levers unchanged at two.

Without going into too much detail, it is obvious that this very overt change of economic policy has caused many problems – and continues to do so (see for example the October Absolute Return Letter here). It is therefore fair to say that the financial crisis per se is not causing many of the problems we are facing today; inferior economic policy is.

Another example of inferior policy making: For large parts of the 20th century inventory cycles were the primary cause of business cycles, but that all changed with the introduction of better inventory management system (the most successful probably being just-in-time inventory management).

All other things being equal, that should have dramatically reduced the risk of severe recessions like the one we had in 2008, but something else happened. Loosening credit standards created boom-and-bust like conditions that gave birth to a new root cause of recessions – the financial system.

We saw it in connection with the bust of the dot.com bubble in 2000, and we saw it again in 2008 and, today, asset bubbles are a much bigger risk to overall economic stability than inventory cycles.

Why China is not guilty as charged

China is, as everyone knows, growing quite rapidly, even if its growth rate has slowed recently – and even if the official numbers have been ‘massaged’ a bit. According to people who allocate considerably more time to China than I do, official numbers are probably one or two percentage points higher than the real growth rate, but that is not my point.

The key point is that China is not that important (yet) – neither to global GDP growth, nor to growth in Europe or North America. China accounts for ‘only’ 13% of global GDP, still lightyears away from the three largest economic blocks – EM ex. China, the EU and the United States (chart 2).

In addition to that, 80% of the U.S. workforce now provides services, and the EU is not far behind on that account. A slowdown in China has little, if any, impact on most service sectors which, by their nature, are domestically focused. It goes without saying that a slowdown in China will have some meaningful impact on its neighbouring countries, on countries that export a lot to China (e.g. Germany), and on commodity producing countries such as Australia and Canada, but to suggest that China is now the main factor behind global GDP growth is a gross exaggeration.

The real reasons behind the sluggish GDP growth

Before we suggest what is actually causing the slowdown, let’s spend a minute or two on economic theory. At the most basic level, only two factors explain GDP growth, and that is the number of hours worked and productivity improvements. Algebraically, it can be expressed as follows:

∆GDP = ∆Hours Worked + ∆Productivity

The total number of hours worked is almost impossible to measure but, assuming that people on average work pretty much the same number of hours from one year to the next, the size of the workforce is a good proxy for the number of hours worked, and that is much easier to track. By taking advantage of that, the formula above can be expressed as follows:

∆GDP ≈ ∆Workforce + ∆Productivity

We know approximately how much the workforce will change between now and 2050. In the Eurozone it will fall approximately 0.5% per annum; in the UK it will remain largely unchanged, and in the U.S. it will grow by 0.5-0.6% per annum.  Unless the door is suddenly opened to millions of immigrants, or unless productivity suddenly spikes (which it rarely does), relatively low GDP growth for a very long time to come is in the cards. Two of the countries to be hit the hardest by a shrinking workforce are Japan and South Korea, both of which are expected to see an annual decline of almost 1% between now and 2050; however, those countries are beyond the scope of this research paper.

The assumption behind that prediction is that productivity will grow approximately 0.5-1.0% per annum in most OECD countries – in line with current trends, but perhaps a touch optimistic given that productivity typically falls as the workforce ages.

These productivity numbers lead to estimates for annualised GDP growth as follows:

• United Kingdom: 0.5-1.0%
• United States: 1.0-1.5%
• The Eurozone: 0.0-0.5%

Those numbers are annual averages over the next many years, but we do admit that idiosyncratic reasons can accelerate (or slow down) actual GDP growth over shorter periods of time.

So reason number one for GDP growth to be comparatively low, and to stay low for a long time to come, is adverse demographics – something that will affect most parts of the world, the one major exception being Africa.

The second reason may surprise you. Let’s call it the decline in the cost of capital goods. The digital revolution has effectively reduced the cost of many goods, in reality reducing the price x quantity equation that goes into calculating GDP. The digital revolution has thus reduced the GDP growth rate, even if the actual value of the output has risen far beyond what the sheer numbers suggest. The more technology intensive the country is, the bigger the impact. This was first recognised by Brent Neiman of Chicago University about a year ago.

And a few idiosyncratic ones

Beyond these two (largely) global reasons there is a whole host of idiosyncratic reasons why GDP growth is lower now than it has been for a long time. Take the U.S. The widespread distrust of government in general, and of public spending of any kind in particular, makes it extraordinarily difficult to get meaningful discretionary spending programmes approved by Congress. When you travel to the U.S., you notice almost immediately how dilapidated the infrastructure is. Combine that with the knowledge that a better infrastructure would positively impact productivity, and it appears to be a no-brainer. Yet most Americans don’t buy the argument.

Here in Europe, and in particular in Southern Europe, over-regulated labour markets hold back productivity gains in a major way. Some good friends of mine chose to close their business in the aftermath of 2008. Making people redundant was simply too costly.

Rising transfer payments are another big issue in Europe. A transfer payment is a payment of money or in-kind benefit that is given to individuals by the government without the government receiving any goods or services in exchange. One example (amongst many) would be unemployment benefits.

Now, we are not at all suggesting that transfer payments are notoriously bad or wrong; they are in fact sometimes very necessary, but all research suggests that discretionary spending on, say, research, education or infrastructure is good for productivity. Transfer payments are not.

Some would probably argue that rising transfer payments are ‘just’ a function of deteriorating demographics, but we don’t agree. Yes, demographics do affect the magnitude and growth in transfer payments, but the real problem is weak political leadership, keen to please the electorate instead of doing what is right for their country.

One final example: Many (but not all) EM countries need to address serious corruption issues. Corruption is bad, not only because it is immoral, but also because it destroys economic growth, and the reason is simple. For growth to be optimal, capital must be allocated optimally, and capital is not allocated optimally when corruption is in play.

With all these examples we make the point that there is no single reason why GDP growth continues to disappoint. The reality is somewhat more complex than that. The good news is that productivity can certainly be improved through policy measures, but it would take something far more dramatic than what is currently on the table.

Opportunities in a low growth environment

If our long term projection for GDP growth in the U.S. and Europe proves accurate, inflation in those countries will in all likelihood remain relatively benign (as in positive but at a very low level). If that turns out to be broadly correct, interest rates are not likely to move a great deal in either direction for quite a while to come. We believe all the scaremongering is grossly exaggerated. Interest rates are not likely to go back to the levels we saw prior to the financial crisis anytime soon, but we could obviously be proven wrong.

From a risk management point of view, we believe the risk of outright deflation is considerably higher than the risk of high inflation, even if it is still quite low. The one area to avoid in our opinion is long-only exposure to corporate credit in the riskier end of the universe. Poor quality balance sheets combined with low GDP growth will almost certainly cause a few hiccups.

Ageing investors will increasingly demand respectable incomes from their equity investments. Historically, private investors have almost always switched from equities to bonds as they approached retirement, but this trend could be about to change. With a 10-year T-bond yield around 2.2% and a dividend yield on the S&P 500 of 2.06% at present, it wouldn’t take much for U.S. companies to be competitive vis-à-vis bonds. Here in Europe, with much lower bond yields and a dividend yield on the Eurostoxx 50 of 3.37%, the switch from bonds to equities is even more compelling.

The other significant impact we expect low GDP growth to have on equities have to do with fees in the investment management industry. Assuming that, over time, low GDP growth will translate into low(ish) equity returns, investors will increasingly bark at existing fee structures – a trend that is already in full swing. At present, a significant amount of capital is migrating from active to passive mandates every day. As investors come to realise that low returns will be here for a long time to come, the pressure on fees will grow.

In the alternative space, we see some polarisation amongst institutional investors. With bond yields being as low as they are, a growing number look for alternative sources of income, whereas others look for more attractive returns, provided the equity beta is low. Few institutional investors are actually on the outlook for alternative investment strategies, offering attractive expected returns with no strings attached.

A couple of examples:

We are currently looking into healthcare lending. The equity risk is not significant so, in that respect, it is an attractive alternative to bonds. Some find 7-8% too low for an alternative investment strategy, but it obviously depends on what you compare it to. If the alternative is a bond yielding 2%, the expected return is suddenly very attractive. On top of everything else, the strategy benefits from demographic trends.

Secondly, we have recently invested in aircraft leasing. Whereas many turned it down as too cyclical, the work we did suggested otherwise. Leasing of small regional aircraft is in fact almost counter-cyclical, as large airlines downgrade to smaller aircraft in more challenging times. The combination of an attractive income profile and some, but not excessive, equity risk, persuaded us.

There are many attractive investment cases like these two in the alternative space; the problem is capacity. The amount of institutional capital looking for a new home in a low return environment vastly exceeds the number of opportunities available.

Conclusion

Our message is straightforward. The reasons behind the relatively low growth rate in GDP are almost exclusively structural in nature. They are not cyclical, which also explains why we are very confident that our prediction that GDP growth will stay low for a very long time is correct.

By far the easiest structural factor to put a timeline on is demographics. Based on information currently available to us, U.S. GDP growth will be negatively impacted by demographics until at least 2025, whereas euro zone growth will be negatively impacted until at least 2040 and possibly a bit longer.

Japan is the true horror story. It will most likely experience no significant growth in GDP until well after 2050, and possibly forever, which leads to our next prediction. Before this is all over, governments around the world will no longer publish GDP data on a regular basis, as they have done for many years. They will instead publish GDP on a per capita basis. If you think about it, in a world of declining workforces and shrinking populations, it sort of makes sense.

Having said that, it should be pretty obvious from the above that, for many years to come, there is only one way to create respectable economic growth (and in some countries any growth at all), and that is through productivity enhancements. There simply is no other way.

Now, productivity enhancements can take place as a result of changed legislation or otherwise but, unless they suddenly change their typical approach, political leaders won’t take the necessary steps until the situation becomes a great deal uglier than it is at present.

One final comment: If the average GDP growth rate in Europe turns out to be no more than 0.5% per annum as stated above, and interest rates stay around current levels, an average equity risk premium of 3-4% would suggest annual equity returns in Europe of no more than 4-5% over the next few decades on average.

In the light of that, the expected return level on many alternative income strategies of 6-8% is not as unattractive as it looks at first glance, and we would encourage investors to ignore what sort of returns were achievable in a higher interest rate environment of the past, and focus on what returns are feasible going forward.

Niels C. Jensen

4 November 2015