Absolute Return Partners letter for the month of December 2015, titled, “The Next Driver Of Productivity.”
“There cannot be a crisis next week. My schedule is already full.” – Henry A. Kissinger
We are blessed with regular feedback on the Absolute Return Letter, but last month we had far more than normal. Rarely have so many readers responded (which is very much appreciated), most of whom asked us to elaborate on various parts of the letter. Although we always make an effort to respond directly to our readers when asked a question, we invariably miss one or two. If that happened to you, we apologize.
The substantial interest in last month’s topic has encouraged me to take an unusual step this month. Not only do I cover the same topic in the December letter as I did in November but, for the first time ever, it has been structured as a Q&A session. A first after twelve years is acceptable, I suppose. If you didn’t read the November letter, I suggest you do so before going any further. You can find it here.
The many questions raised by our readers fell in to four broad categories and, with one or two tweaks, those four questions are as follows:
- What do you understand by ‘crisis’, and will Mean Variance Optimization (‘MVO’) outperform in a crisis?
- Have you learned anything from the Global Financial Crisis (‘GFC’) that can be used in the context of portfolio construction?
- You say that European GDP will only grow approx. 0.5% per annum between now and 2050. What GDP growth rate do you expect in other regions?
- What is likely to be the next major driver of productivity?
As you go through my answers in the following, you will note that I have allocated considerably more space to answering the last question than I have to any of the other questions. That is no coincidence. Given the unattractive demographic outlook in most countries, the only way to generate respectable economic growth for many years to come is through productivity improvements. If you add to that the sad reality that the world is drowning in debt, and servicing that debt very much requires economic growth, I am probably not exaggerating when I say that productivity enhancement is not only desirable but absolutely critical in the years ahead. With those notes, let’s begin with the first question.
Absolute Return – Question 1: What do you understand by ‘crisis’, and will MVO outperform in a crisis?
‘Crisis’ is one of the most abused words in the English language, and what is often portrayed as a crisis is in truth no more than a hiccup. The GFC was one – in fact one of the more serious ones – and so was the Asian calamity in 1997-98, but much of what happened in between was not – at least not in financial terms.
I use a very simple approach to decide whether it is a regular sell-off or a true crisis. It goes as follows:
Rule no. 1: Correlations between risk assets always approach 1 in a crisis.
Rule no. 2: If correlations are not fast approaching 1, it is not a crisis.
It is almost too simple to be credible, but it rarely fails to work. Example: In early 2013, many risk assets sold off as global trade weakened, but equities didn’t – in fact they moved in the opposite direction (see Chart 1). The same thing happened in early 2015. The low correlation between equities and other risk assets told me not to worry unduly.
On that basis, I don’t think a crisis is imminent, but that wasn’t the question. Assuming another crisis is looming, most investors using MVO will underperform as all three sets of input data (expected returns, standard deviations and correlations) will prove horribly incorrect. Simple as that.
Chart 1: When correlations don’t go to one
Absolute Return – Question 2: Have you learned anything from the GFC that can be used in the context of portfolio construction?
If I don’t restrict myself now, this could develop into a very long answer and may actually be something I return to in a future Absolute Return Letter. Here is the short version:
2008 and the subsequent downturn, now characterised by many as the GFC, was not the result of a black swan, as many continue to argue, but rather the result of a debt overhang. Because bankers applied a very conformist approach to monetary policy by focusing on very conventional measures, nobody saw the GFC coming; not because some black swan suddenly emerged.
If one of the key lessons from 2008 is that massive crises can emerge from growth-less credit booms, the chances are that interest rates will stay relatively low for many years to come. This view is further supported as a consequence of BIS’1 take on things. Because BIS has demonstrated how important the debt service burden was to the unfolding of the GFC, and because BIS is the central bank of central banks, one shouldn’t expect interest rates to suddenly ‘normalize’.
As a consequence, fixed income investors in need of income will increasingly look at alternative sources of income, and equity investors will increasingly realise that what worked well pre 2008 won’t necessarily work that well for many years to come.
Absolute Return – Question 3: You say that European GDP will only grow approx. 0.5% per annum between now and 2050. What GDP growth rate do you expect in other regions?
We haven’t looked into every single region around the world; however, we expect U.S. GDP on average to grow at 1.0-1.5% per annum, U.K. GDP at 0.5-1.0% and Eurozone GDP at only 0.0-0.5% for many years to come. I deliberately say ‘for many years to come’ rather than ‘until 2050’ because demographic headwinds will come to an end more quickly in the U.S. than they will here in Europe. Expect a falling workforce to be a significant headwind in most of Europe until at least 2050 and ‘only’ until the mid-2020s in the U.S.
Japan is facing the most significant drop in the workforce of any DM country. Between now and 2050, it will drop nearly 1% per annum, making it very difficult for the Japanese to generate any economic growth at all between now and 2050 and possibly for much longer.
This all assumes that immigration policy in the various countries doesn’t change meaningfully, and that productivity will continue to grow at approx. 0.5-1.0% per annum, as it has done more recently (give or take). As mentioned last month, OECD countries have only benefited from significantly higher productivity growth twice since World War II – the first one being in the 1950s and 1960s when the highway/motorway system was first established, and the second one being around the Millennium when the dot.com boom allowed many of us to change the way we work (see Chart 2).
Chart 2: U.S. utilization-adjusted total factor productivity
Either of those assumptions could obviously be wrong, in which case our GDP projections would be revised – most likely upwards, as I would