- World economy is back on a gently positive track
- Global equities up 20% since February
- Brexit was not the disaster some claimed it would be
- Very low or negative interest rates will be here a while yet
- Corporate investments growing slower than in previous recoveries
- Very low productivity growth is suppressing overall economic growth
- Today’s investor must address a multitude of conflicting challenges
The global economy has hit a spot of sunshine but many challenges loom. Pic: iStock
By Teis Knuthsen
The global economic outlook improves...
The global economy is on a moderately positive track these months, and for many this comes as a surprise. The simplest way to measure this is in the economic surprise indices that show how key macro variables develop relative to analysts' estimates. Since February, the “macro momentum” has risen considerably and contributed to a prolonged period of "risk-on" in the financial markets during which global equities have risen by close to 20%.
The primary reason for a more positive economic development is a combination of a declining oil price shock, and a turn in the inventory cycle. This movement is supported by a continued decline in unemployment rates in all major geographic regions, which in turn stimulates consumption and housing market activity. At the same time it is now clear that Brexit was not the disaster for either the global or the British economy that many were busy proclaiming (though not here, I hasten to add).
...but rates stay low
Central banks have stayed mostly sidelined during this period of positive economic news, thanks to very low inflation rates in most places, and the outlook is for the period of very low, and in several places negative, interest rates to continue for some time yet. Low interest rates affect housing markets positively through ever-lower financing costs. Similarly, the effect on stock markets is positive, partly in comparison to alternative asset classes, partly by encouraging companies to finance share buybacks by debt issuance. As prices rise on both asset classes, the expected returns decline. However, this is a problem for another day.
The macroeconomic impact of low interest rates is somewhat more questionable, though, as consumers are forced to increase their savings to ensure unchanged consumption opportunities in the future, and because there are signs that businesses borrow to fund share buybacks, rather than for investment. Not surprisingly, asset markets remain somewhat more buoyant than economic trends to.
Fiscal stimulus finally arriving?
Finally, as a potential driver of an increase in economic forecasts, it is worth keeping an eye on a possible move towards a higher degree of fiscal stimulus in the near future. Not least in the US, the two presidential candidates both argue for increased government spending, but the arrow also points to a more expansionary fiscal policy in Europe, Japan and China. (Many will probably think that increased public investment in the future ought to be a no-brainer, given that many finance ministers can borrow at negative interest rates: If this does not encourage infrastructure investments, what does?)
Not everything is positive. A good example is the recent announcement from Federal Reserve chair Janet Yellen that freely translated reads like this: "We recognise that recent economic development has been better than expected. If this were to continue, then there will be room to raise interest rates". What is interesting here is not so much that monetary policy appears to have become a rather short-term affair, but more that Yellen again expressed a pronounced fear of standing on top of the economic cycle, with a view to a new crisis. This comes after sustained economic growth since 2009 and a halving of unemployment in the United States. L’esprit du temps, in other words, is negative.
In one were to lift the hood to the economic engine room, one would recognise that corporate investments are growing slowly compared to previous recoveries. Simultaneously – and closely linked to it – productivity growth is very low, which helps to lower overall growth rates.
In the long term perspective, one cannot escape the consequences of the demographic development. The Japanese population peaked in 2005, while Europe's population is peaking now. A declining population equals a decline in potential growth rates. A growing proportion of elderly people in both regions also pulls down the potential growth rate.
The USA stands out from this development, since the population is expected to grow steadily in the coming generations. This gives an expectation of a significantly higher economic growth in the United States in coming decades than what we can achieve on this side of the Atlantic. In a sense, global equity markets are already on to this development, with far better returns in the US equity markets recently.
Other countries have a surplus population and massive pressure from a desperate youth population. On paper, nothing should be easier than mixing populations across the globe. In practice, this is anything but simple, what refugee and migration problems in Europe are a sad example of. In Europe we are with our secular and Christian traditions not adept at absorbing North African and Middle Eastern Muslims, who also sometimes seem to have trouble accepting that the appeal of Europe is based on industriousness and personal freedom.
Since it does not currently seem politically possible to manage the current specific conflict, the response instead becomes more general in nature, resulting in ever increasing surveillance and reduced trust among people, which again reduces both productivity as well as welfare. On top of that runs a technological meta-trend that will eventually see robots and artificial intelligence replacing most forms of employment.
Tactical, strategic, structural
All this - and more – today’s investor must relate to. It may then help to work with separate timelines. I see the tactical horizon (6-9 months) as being positive, in anticipation of a further recovery in the short-term business cycle. I also see the strategic horizon (1-3 years) as positive, since we are still in a long-term recovery after the financial crisis of 2008/09, where there are still plenty of untapped resources to draw on.
In contrast, I consider the West to have been in a political and socioeconomic crisis for more than 10 years, where we are engaged in a major shift of priorities of society in relation to the individual. These crises can be up to 20 years long, and have historically often been brought to a conclusion through wars. When they are finished, a new long-term upturn starts, which in this case will be able to ride on the back of the technological revolution that is unfolding, that has further about 40 years ahead of it.
In my portfolios this year I have reduced the allocation to short-term bonds and European corporate bonds, both due to expectations of low future returns. Within bonds, I have instead increased the allocation to emerging markets and US high yield, just as I have included gold as an alternative.
I have been overweight equities compared to bonds, but have preferred stable/low-volatility stocks. I have also closed an underweight of emerging markets in favour of a higher allocation to low-beta EM equities.
In a world of low nominal growth and low interest rates equities are almost alone in being able to offer attractive returns. In anticipation of continued growth, loose monetary policy and an likely rise in corporate earnings, equities should also in future be able to deliver higher returns than bonds, and – as in August - one should expect a further rotation towards the more cyclically sensitive sectors. In the coming month we will also again have to assess whether a US interest rate rise is imminent and whether this could have negative effects on, for example, emerging markets.
– Edited by Clare MacCarthy