Low Economic Growth – Do A Grouch A Favor
February 16th is Do a Grouch a Favor Day. Therefore as the resident grouch at Columbia Threadneedle Investments, I would like you to do me a favor. Since 2009 I have been grumbling and complaining that economic growth will be structurally lower than many investors expect. I called this outlook for economic growth the “square root” economy in which, after initially bouncing back from the great recession, we faced a prolonged period of low economic growth averaging approximately 2%.
Low growth in the “square root” economy
I believe we are still in this low growth area because of trends in demographics, private sector deleveraging, education and corporate investment policies. Economic growth is a function of the growth in the number of workers, the growth in their productivity and the amount of leverage. Most are fully aware of the ageing trends in the U.S., Europe and Japan, but trends in other parts of Asia including China and South Korea are also poor for growth. If the number of workers in the developed areas is growing slowly or declining then we are even more reliant on productivity growth and increasing leverage. Immigration helps but remains politically charged. Productivity growth requires increased investment in education and training and investment in plant equipment and infrastructure. This is not happening at a sufficient rate. With the demographic trends hampering growth rates, we need more investment than we experienced when the demographic trends were favorable, not just the same amount. I hope we will not return to the careless lending and borrowing practices of the pre-2008 decade anytime soon therefore increased private sector leverage is unlikely.
Growth does not occur evenly
Of course growth does not occur evenly as suggested by the first chart. There will be periods of higher and lower growth as suggested by the blue line on the following chart.
This is normal: the world economy is too complex to grow steadily, and there are too many variables. However, our behavior toward these variations, while predictable, is hard to control as they are emotional. We become too optimistic when growth is higher than the yellow trend line and too pessimistic when growth disappoints. That is reflected, indeed exacerbated, in the optimism and pessimism about financial markets. Actual GDP growth has followed a pattern similar to the path predicted by the “square root” theory. The chart below illustrates the projection and the reality.
GDP trends follow a similar path predicted by the “square root” theory
Therefore the issue we are dealing with today in markets is the pattern of over-optimism and pessimism we experience as a result of the low growth economy.
While there are MANY economic and geo political issues to be concerned about there are encouraging signs on employment, housing and car sales, to name a few. Therefore the market correction which I described in an earlier article as “good” because it relieved the pressure caused by overly optimistic predictions has created a reasonable valuation base supported by strong earnings. Note, I am referring to the level of earnings rather than the growth of earnings. Growth in net income will be muted because economic growth will be modest. Earnings per share may increase more because of share buy backs but investors will increasingly need to question if the buy back is at the expense of investing in projects/people that could help future growth.
I believe that fair value for the S&P 500 is in the range of 1800 to 1850. That does not mean that pessimism won’t drive it lower. If it does, there is probably a buying opportunity. Because of low growth there is only modest upside, yet the swings from optimism to pessimism mean we are likely to experience volatility. Columbia Threadneedle Investments’ asset allocation team expects equities to have a relatively modest nominal but reasonable relative return versus other financial market asset classes over the next five years. I support this, but believe very strongly that most investors will not enjoy that return. The cycle of optimism and pessimism tends to lead investors to “sell low and buy high,” therefore their actual returns fail to match the market average.
Aim for consistency of return
Therefore, do the grouch a favor. Rebalance your clients’ portfolios away from attempting to maximize the return in favor of maximizing the consistency of the return. That probably means less equity exposure either in dollars invested or beta adjusted. A dividend income fund may have a beta of 0.85 (implying 85 cents of exposure to equity volatility for every dollar invested) versus high growth funds which may have a beta of 1.1 or higher. I also strongly recommend portfolios that aim to directly manage the volatility rather than the return. Investors employing these recommendations are likely to have lower projected returns but are more likely to achieve the projected return because the lower volatility means they will stay with their investments longer.