Decelerating Growth And Accelerating Debt In Largest Economies

by: James Hickman

Summary

A fifteenth year of significantly slower trending U.S. and world production growth - structural underpinnings.

Deceleration in global growth and high sovereign debt portend earnings headwinds.

Low rates supportive, but dear market and sluggish fundamentals warrant investor caution.

Note: This article is an updated version of this Instablog post, published September 2, 2014.

Let us begin by saying quarterly GDP prints are lumpy and should always be considered in the context of trends and factor attribution. The weighted average trailing-four-quarter growth rate for the eleven largest global economies, accounting for over 67% of global output, crossed the 3% threshold in the fourth quarter of 2013, dipped slightly the next quarter, and fell to 2.5% in Q2, where it has hovered since. Other than a hopeful bounce in 2013, the trend has been on the decline since 2010 (see table below).

The fourth quarter showed modest sequential bounces from either contraction or anemic growth in six while the other five, including the US and China, were flat to down. World growth forecasts have recently been reduced by the World Bank (from 3.4% to 3.0% in January after a June cut - while raising US growth to 3.2% from 3.0%), the IMF (3.5% to 3.0% in January, also after a cut in July - also increasing US to 3.6% from 3.1%), the UN (from 3.2% to 3.1% in November after also lowering estimates in May). All three, and most economists and Wall Street strategists have the US growing above 3% in real terms in 2015 for the first time since 2005. Virtually all of them had the same forecast entering 2014 (actual US growth in 2014 was 2.5%).

GDP Growth Trends for 11 Largest Global Economies - 67% of World Economy

Sub-2% real growth compounded is into a fifteenth year in the US (1.8% from 2001 to 2014), without a 4% annual print in any year, versus a long-term average prior to 2001 closer to 3.5%. Gross world product growth has been 2.5% compounded since 2000 compared to 3.2% from 1960-2000,[1] and per capita GDP growth in the US has been in decline since the 1950s (less worrisome if income disparities were narrowing rather than widening). These trends are largely structural, relating to:

  • An actual private sector capital allocation response to historically high sovereign debt levels and the attendant threat of austerity/suboptimal capital allocation in the economies needing to reduce those public debt levels (cyclical but bearing material implications - note in US, e.g., Budget Control Act/"sequestration" cuts of $12.5 billion in Federal R&D spending in 2013, and continued uncompetitive corporate tax regime).
  • Contractionary demographic trends in advanced economies that account for the lion's share of global economic activity (secular).
  • A more general lack of reinvestment optimism among capital allocators related not only to the factors cited, but other public policy trends and geopolitical dynamics (episodic but showing legs).
  • Educational de-emphasis of mathematics and sciences in the US and other developed markets, with potential implications for innovation.
  • Increasing wealth and income inequality with potential implications for aggregate consumption and social stability.

Advanced economies may also have simply reached the point at which the production base is so large that long-term trend growth from current levels simply cannot be sustained, absent innovations significantly more impactful than the transformational breakthroughs spurring the "three industrial revolutions … IR #1 (steam, railroads) from 1750 to 1830; IR #2 (electricity, internal combustion engine, running water, indoor toilets, communications, entertainment, chemicals, petroleum) from 1870 to 1900; and IR #3 (computers, the web, mobile phones) from 1960 to present." Growth prior to the industrial revolution was negligible for four centuries, and according to the work of Angus Maddison, there was less than 1/100th of 1% compounded growth in per capita GDP in England from years 1 to 1280, raising reasonable questions about axiomatic economic growth assumptions among economists and policy makers.

Slower structural GDP growth has implications for valuation of securities exposed to the relevant geographies, both equities and debt. Does it make sense for the cyclically-adjusted price-to-earnings ratio of the S&P 500 to be at its fourth highest level in history (trailing 1929, 2000 and 2007) if 1) corporate profit margins are almost 80% above long-term averages, and 2) future economic growth is going to be significantly slower than the pace supporting historical PE ratios? Of course not, and unless growth is going to return to a trajectory not seen since the 1990s, normalized equity earnings multiples will be ratcheted down to compensate investors for the lower long-term growth expectations via higher dividend yields. Moreover, slower-than-expected GDP growth will result in greater deficits, already projected to explode in the US and most developed countries.

Notes: [1] World Bank World Development Indicators, International Financial Statistics of the IMF, IHS Global Insight, and Oxford Economic Forecasting, as well as estimated and projected values developed by the Economic Research Service all converted to a 2005 base year.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.