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14 Years Of Decelerating Growth And Accelerating Debt In Largest Economies - Implications For Markets

Let us begin by saying quarterly GDP prints are lumpy and should always be considered in the context of trends and factor attribution (hence, inclusion of trailing 4 quarters annualized GDP growth in Table below). Seven of the world's ten largest economies, accounting for 65% of global output, showed a deceleration of growth in the second quarter (including Brazil, reporting August 29 but expected to show a meaningful down tick). Two of the remaining three were essentially flat (China and the UK), and the US was significantly up, but much of that comparison owed to a shift in production from Q1 (-2.1%) to Q2 (+4%) - see GDP, Capex, EPS and Jobs Review August 2014. When comparing the annualized rate of GDP growth currently being observed in these economies to 2013, all of them are meaningfully decelerating except the UK (see Table below). World growth forecasts have recently been reduced by the World Bank (June), the IMF (July) the UN (May) and every credible economist with a forecast.

GDP Growth Trends for Ten Largest Global Economies - 65% of World Economy

  2010 2011 2012 2013 Q2 2014 Print T4Qs Ending Q2 2014 (Annualized) Debt/GDP 2012
US (22%) 2.4% 1.8% 2.2% 2.6% 4.0% 2.4% 102%
China (11.5%) 10.4% 9.3% 7.8% 7.7% 7.5% 7.5% 200%
Japan (8.3%) 4.7% -0.1% 1.9% 2.5% -6.8% -0.1% 212%
Germany (4.7%) 4.2% 3.0% 0.7% 1.3% -0.2% 0.8% 81%
France (3.6%) 1.7% 2.0% 0.0% 0.8% 0.0% 0.3% 90%
UK (3.4%) 1.8% 1.0% 0.3% 2.7% 0.8% 3.1% 89%
Brazil (3.3%) 7.5% 2.7% 0.9% 2.2% 0.0% 1.9% 65%
Russia (2.8%) 4.5% 4.3% 3.4% 2.0% 0.8% 0.8% 8%
Italy (2.8%) 1.7% 0.4% -2.4% -0.9% -0.3% -0.5% 127%
India (2.5%) 10.5% 6.3% 3.2% 4.8% 0.0% 4.6% 68%
Weighted Average 4.7% 3.2% 2.6% 3.2% 1.8% 2.6% 122.8%
Note: Shadow banking system included in China Debt/GDP (estimated to be ~200%).  
Source: World Bank and various primary, country-specific sources.    

Sub-2% real growth is into a fourteenth year in the US, 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[2] (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 as a percentage of the base 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 to1900; and IR #3 (computers, the web, mobile phones) from 1960 to present."[3] 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[4] 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, via higher dividend yields, for the lower long-term growth expectations (see Complacency Always Ends in Tears June 12, 2014 and Buffet's Market Drivers Portend Below Trend Equity Returns June 30, 2014). Moreover, slower than expected GDP growth will result in greater deficits, already projected to explode in the US and most developed countries. Look for an analysis on unfunded US liabilities to be published shortly.

James F. Hickman, 617.816.0497 August 17, 2014

[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.

[2] Robert J. Gordon, Working Paper 18315, Is U.S. Economic Growth Over? Faltering Innovation Confronts The Six Headwinds, August 2012, National Bureau of Economic Research.

[3] Ibid.

[4] New Maddison Project Database.

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