Strategy Bulletin  

16/09/2014

INVESTORS SHOULD PREPARE FOR LOWER LONG-TERM POTENTIAL GROWTH

Over the past few years, global economies have gone through a major transition. Current account surpluses in emerging countries narrowed while developed economies erased their aggregate external deficit. Central banks around the world reshaped the “art” of monetary policy. Most European countries implemented demanding structural reforms in an attempt to boost competitive gains and absorb past excesses. A correct reading of this environment has been necessary to build well-performing portfolios, but it is fair to say that the economic landscape is again changing. While we acknowledge the importance of short term events, the role of the longer term structural economic environment should not be underestimated. What will its main feature over the next 5 to 10 years be? If we were to pick out just one, it would be lower global potential growth, which has far-reaching consequences for portfolio construction. Before delving into the rationale of this scenario, let us recall that lower potential growth is neither always bad, nor particularly exceptional. As Thomas Piketty1 has shown, real GDP growth since 1700 has averaged 1.6% per year, with half stemming from demography, and the other half from productivity. Whilst in stark contrast with the strong growth in the 2nd half of the 20th century (e.g. the “30 Glorieuses” in Europe), it is a useful reminder that real growth between 1% and 2% per year is not that low when taking a long-term view.

Why expect lower potential growth in the coming years?
First: deleveraging. Be it in the US or Europe, private debt build-ups boosted growth between 2001 and 2008, and eventually triggered the global financial crisis. The ensuing deleveraging process has since weighed on growth. The process is admittedly well advanced in the US, yet one should not count on private re-leveraging to boost growth in a similar (unbalanced) way to before the crisis. In Europe, the deleveraging has barely started, and will keep weighing on growth over the coming years.
Second: demography and productivity. GDP per capita growth is made up of two components: a demographic factor and a productivity factor.

Regarding demography, ageing populations mean that the working age population ratios are already set to decline in 2015 in the world’s largest economies (US, China, Japan, Europe) according to the United Nations (UN), and are expected to keep falling until the end of the 21st century. This will directly impact the rate of GDP per capita growth. Historically, the US example empirically supports the positive correlation between the growth of real GDP per capita and that of the working age population ratio. Moreover, GDP growth is also affected by the fact that the world population is growing more slowly. UN data shows that while the world population grew above 1% during the 2nd half of the 20th century, it will gradually decline towards 0% by the end of the 21st century. With a flat population, world demographics will not be a support to growth.

Productivity is far more difficult to forecast. Since the 1980’s, global productivity growth has gradually weakened in advanced economies, making lower highs and lower lows every 5 to 10 years. The same holds true at the national levels, each country for its own reasons – albeit mostly structural in nature. In the US, the information technology (IT) revolution is having less of an impact on productivity. In Japan and the UK, productivity is constrained by the rising share of non-regular or involuntarily part-time workers, who are less productive. Germany needs to boost productivity outside of its manufacturing sector, and while Spain’s productivity has cyclically improved after the crisis on the back of substantial labour shedding, the latest data already shows a slowdown. What should we expect in the years to come? While we cannot pretend to be able to give a definite answer, several factors point towards continued subdued productivity growth. First, the downtrend mostly stems from structural factors, which tend to last. Second, as argued by Robert J. Gordon2, the last “industrial revolution”, IT, does not improve the total productivity of the economy as much as its predecessors (electricity, running water, internal combustion engine, petroleum in 1870-1900), and we do not yet foresee an innovation shock of similar magnitude to the internet. Third, taking the long view, moderate productivity growth from here (in the order of 1% to 2%) would not be abnormal. It would simply be back at more sustainable levels. All told, we do not expect future productivity growth to be high enough to offset the impact of deleveraging and demography on long-term global potential growth.

What are the consequences for financial assets and portfolio construction?
First, lower potential growth implies that the output gap (the difference between actual and potential GDP growth) is smaller than it seems. In the US, for example, the economy is likely closer to potential than most investors think, and the Zero Interest Rate Policy (ZIRP) should end soon. Second, lower long-term potential growth implies a lower equilibrium level for yields at the long end of the curve, especially with economic players’ bias to deleverage and high levels of global savings, which should leave 10-year yields consistently below nominal trend growth for a while. This means a lower downside risk at the long end of the US and European yield curves.
Third, lower potential growth implies lower returns on capital, which drives investors’ search for yields and leads to structurally higher asset prices. Thus, equities price-to-earnings ratios are higher (which means that earnings yields are lower), but lower bond yields partially offset the impact on the equity risk premium (earnings yield minus bond yield). As long as this premium does not shrink too much, equity investors remain rewarded for the risk they take relative to bonds.
Fourth, when yields are low, losses of confidence or changes in investors’ expectations can lead to sharp de-ratings in financial assets. Hence, this type of environment is conducive to higher bouts of volatility. This requires greater tactical skills from investors, as well as a stronger capacity to put in place the appropriate hedges to ensure portfolios’ robustness.
Finally, a smaller output gap in conjunction with accommodative central bank policies could create rapid – even if only temporary – shifts regarding inflation expectations. This could lead to simultaneous corrections in both bonds and equities. The correlation amongst assets could thus tend to be higher, making it particularly important to diversify portfolios into alternative sources of return like hedge funds, asset-backed securities and real assets.

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