World Bank Warns Of 'Lost Decade': Stock Market Implications

Summary

• The World Bank recently warned of a 'lost decade' for the global economy.
• We look at the impact that such a scenario would have on the market.
• We also share our approach to continue to generate outsized returns in such an environment.
• Looking for a portfolio of ideas like this one? Members of High Yield Investor get exclusive access to our subscriber-only portfolios. Learn More »

Дмитрий Ларичев/iStock via Getty Images

The global economy could experience its slowest rate of growth in decades due to financial instability, high inflation, and other factors, according to a recent report by the World Bank. In this article, we look at the impact that such a scenario would have on the stock market (SP500)(SPX)(DJI)(NDX) and then we also share our approach to continue to generate outsized returns in such an environment.

The World Bank's Warning

The World Bank recently warned of a 'lost decade' for the global economy. The report estimated that the global economy's potential growth rate could average 2.2% for the next 10 years, compared to 3.5% in the early 2000s and 2.6% for the most recent decade. The report suggested that ongoing inflation pressures, war in Ukraine, financial uncertainty, unfavorable demographics, and the lingering repercussions of the COVID-19 pandemic will negatively impact growth. However, potential GDP growth could be boosted as high as 2.9% if nations focus on growing labor supply, increasing productivity, and incentivizing investment.

As World Bank chief economist Indermit Gill stated:

A lost decade could be in the making for the global economy... The ongoing decline in potential growth has serious implications for the world's ability to tackle the expanding array of challenges unique to our times-stubborn poverty, diverging incomes, and climate change.

One of the biggest factors that they are concerned about is the current turmoil and volatility in the banking sector, which could have negative secondary effects on developing countries which are highly dependent on foreign loans and investment to finance economic growth. As Ayhan Kose - director of the World Bank's forecasting group - said:

The slowdown we are describing ... could be much sharper, if another global financial crisis erupts, especially if that crisis is accompanied by a global recession.

Thanks to all of the aforementioned factors and risks, the World Bank sees the past roughly three decades of sustained global economic growth slowing to a crawl, if not stopping altogether. This global slowdown will likely hit developing economies hard as well, even if no banking crisis develops, as the report sees reduced investment from developed economies slowing emerging markets growth to 4% for the remainder of this decade, down from 5% in the past decade and 6% in the decade before that. Furthermore, slowing productivity gains, weaker income growth, and higher inflation will also weigh on developing economy growth.

Global productivity declines are due to factors like burnout and job dissatisfaction, as well as a larger worldwide trend: a decline in skilled young workers. This demographic issue is becoming increasingly prevalent as birth rates decline worldwide, leading to an aging labor force that is already weighing down economic growth prospects in countries like Japan and South Korea. Aging populations are also leading to concerns about strained government budgets, and efforts to raise retirement ages are often met with public resistance. The COVID-19 outbreak and the strong government restrictions it catalyzed further exacerbated these issues by causing global learning losses for children.

Effectively what the World Bank is saying is that virtually every single factor that drove the robust global growth we have seen over the past three decades is not only vanishing, it could indeed reverse itself sometime this decade. If war between China and the United States were to break out, Russia's war in Europe escalates, or a major financial crisis breaks out, the growth headwinds would undoubtedly be even more pronounced. As World Bank President David Malpass wrote in the report's forward:

Today nearly all the economic forces that drove economic progress are in retreat. The result could be a lost decade in the making-not just for some countries or regions as has occurred in the past-but for the whole world.

Stock Market Implications

What does all of this mean for the stock market? The obvious conclusion is that it is a clear headwind for total returns.

Take for example large S&P 500 index funds like NYSEARCA:SPY, NYSEARCA:VOO, and NYSEARCA:IVV. Their largest holdings are all mega-cap technology companies like Apple (AAPL), Microsoft (MSFT), Alphabet (GOOG)(GOOGL), Tesla (TSLA), and Meta Platforms (META) with a global presence, a global slowdown will seriously impact their growth potential.

SPY Top 10 Holdings (Seeking Alpha )

Moreover, if economic weakness and demographic challenges in places like Communist China motivate leadership to pursue a more imperialistic foreign policy in order to provide a distraction from domestic problems and unite the populace against a foreign adversary, things could get very bad for companies like AAPL and TSLA that remain very dependent on China for sales, production, and supply chain needs.

Moreover, when you take into account that the market is overvalued by virtually every market measure, things look even bleaker for the index:

First, the Buffett Indicator Ratio - the ratio of the total value of the US stock market versus the most current measure of total GDP - is 0.8 standard deviations above the historic trend line, putting it well above fair value and just about in Overvalued territory:

currentmarketvaluation.com

Second, the Price to Earnings Ratio Model - which compares the Cyclically Adjusted Price to Earnings ratio (i.e., CAPE) - is currently 1.0 standard deviations above the trend line, making it overvalued:

currentmarketvaluation.com

Third, the Interest Rate Model - which compares the relative market level with interest rates - is definitely the kindest major market valuation model to the market right now. It indicates that the market is only slightly overvalued as the market stands at 0.9 standard deviations above the historical trend line, while the 10-year U.S. Treasury interest rates is 0.84 standard deviations above the historical trend line. Nevertheless, it still indicates that the market leans more towards being expensive rather than towards being undervalued.

currentmarketvaluation.com

Finally, the Mean Reversion Model - which evaluates the market based on its level relative to its historical trend line - indicates that it is 34% above its fair value based on the historical trend line:

currentmarketvaluation.com

Investor Takeaway

The World Bank's warning is certainly not good news for the stock market. Slowing global economic growth takes a big bite out of the total return equation for the leading U.S. index. If global economic growth is expected to slow to 2.2% over the next decade - with developing economies growing at 4% - it is unlikely that the U.S. will grow at over 2% during that period. Combined with the paltry 1.6% dividend yield currently being offered by the S&P 500, the annualized total returns will be lucky to reach 4% over the next ten years.

Moreover, with the stock market trading at valuation multiples that appear to be quite elevated, it is very possible that even these returns get largely - if not entirely - negated by a contracting valuation multiple for the index. This will prove to be especially true if AAPL's and TSLA's China business gets severely impaired at some point in the coming years. Given that AAPL and TSLA combined account for nearly 9% of the S&P 500's total portfolio at the present, a major impairment to these two businesses alone (along with the many others with substantial exposure to China) would have severely negative impacts on SPY's total returns in the coming years.

What are we doing instead? At High Yield Investor we are investing in highly defensive businesses that do not rely on continued global economic growth to generate satisfactory total returns. Businesses like investment grade regulated utilities (XLU), high quality REITs (VNQ) with lengthy leases and contractual rent bumps and credit-worthy tenants, and energy/commodities businesses (XLU)(GDX) are also looking quite attractive to us at the moment. We are also invested in a few businesses that are poised to generate tremendous profits should the market crash due to a major war or financial crisis breaking out. With high and safe income yields and defensive or even antifragile business models, we are well-positioned to continue outperforming the broader market should the World Bank's forecast of a lost decade come to fruition.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.