The S&P 500 Index ended the first quarter of 2016 at 2,060, 16 points higher than where it started the year (2,044) and 1 point higher than the level it began 2015 (2,059). Once again, the proximity of these data points mask volatility that took the Index as high as 2,135 in May of 2015 and as low as 1,810 in February of 2016.
Global economic growth is influenced by many factors. We pay particular attention to three fundamental factors that, we believe, influence both long term economic growth and returns on investments. They are demographics, productivity and debt.
Demographics – Global population growth is slowing. As a result, growth in demand for all sorts of things is also slowing. In the developed world, the primary exceptions are the Anglo Saxon countries (U.S., U.K., Canada, Australia and New Zealand). The U.S. has a natural advantage because it is one of very few developed countries where the birth rate replaces its own population. Immigration is then additive which in the U.S provides further economic benefit because the fastest growing group, Asian-Americans, is the best educated and has the highest incomes of all current immigrant groups. While most other Anglo Saxon countries have birth rates somewhat lower than replenishment rates, Canada, Australia and New Zealand are concertedly striving to import economically advantaged immigrants.
Japan is the most demographically challenged country in the world. There are no good models for population shrinkage, i.e., having things that are no longer needed. Depopulation has already resulted in Japan having eight million empty houses.
China’s workforce began declining in 2012 and its fastest growing population segment is those over 65, not a good combination for economic growth or productivity. China’s fertility rate (the number of births per woman per lifetime) is between 1.2 and 1.6. This is well below the 5.9 rate in the early 1970s and less than the 2.1 needed to maintain a stable population. Interestingly, although China abolished the one-child policy, the fertility rate has barely changed.
Continental Europe is also demographically challenged and in need of productive immigration. Among the many complexities with the current migrant and refugee crisis, they have not contributed any meaningful economic productivity. While over one million people have entered the European Union in 2015 alone, only half have had a first determination on asylum application. It will take years for this population to integrate into the labor force.
It is difficult, if not impossible, to reverse or overcome negative demographic trends. As population growth slows and in some cases declines, so will economic growth.
Productivity – Gross Domestic Product, or GDP, is the value of all finished goods and services produced. It is essentially a function of three components: labor (very much tied to demographics), capital and productivity. Slowing global GDP growth in the current expansion has been primarily driven by a productivity growth slowdown. On a year-over-year basis, productivity growth peaked in 2004 and is now only 0.5%, its slowest pace since 1983.
Productivity growth has fallen sharply in every major economy and in almost every sector. This has enormous economic and financial market implications. Productivity gains have accounted for most of the increase in material well-being since the Industrial Revolution. If productivity growth stays weak, young people today will not see the improvement in living standards enjoyed by prior generations. In addition, subpar productivity growth increases the risk that tax revenues may not keep up with rising pension and health care obligations.
The biggest slowdown in productivity growth since 2004 has been in sectors that benefited the most from the adoption of new information technologies over the prior decade. By 2004, most of the transitions were largely complete, ushering in a decade of lower productivity gains. In addition, the Great Recession put further downward pressure on labor productivity growth. Weak investment spending in many economies since 2008 has meant that less capital has been allocated to workers.
Secular factors also contribute to low productivity growth in the U.S. The decline in the share of workers in their 40s, the age bracket when people are most productive, will be a drag on future growth. A 5% increase in the relative size of this segment would translate into a 1-2% increase in productivity growth.
There are some signs of reversal. Spending on research and development, which tends to lead multifactor productivity growth by about four to five years, has increased lately. This reflects a cyclical rebound from the Great Recession as well as recognition by companies and countries that they will need to do more with fewer workers.
Productivity is the most important contributor to a better long term standard of living. A sustained productivity improvement of 2% per year would double the standard of living in 35 years. Given that consumer spending represents over two-thirds of GDP, the economic well-being of the consumer is material.
Debt – Global debt is growing as a percentage of GDP and recently surpassed its September 2009 peak of 151%. Since 2009, global debt has increased by about $60 trillion and now exceeds $200 trillion. Emerging market debt is less than developed country debt, but is rising much faster. High debt is almost always consistent with lower future growth. Credit growth usually translates into economic growth, but that has not happened in this cycle, in part because a lot of debt has financed buybacks or acquisitions rather than capital and R&D spending.
In China the ratio of private debt-to-GDP has grown from 117% in 2009 to over 205% today. Historically, this magnitude of debt growth in other countries has been followed by financial crisis. Perhaps China can navigate this problem, but at the very least, China’s growth rate will slow significantly. The country now requires about $6 of debt to produce $1 of incremental GDP, up from $1.50 of debt a few years ago.
By definition, debt is borrowing resources from the future to use today. This constrains future growth. Low interest rates (even negative rates in some geographies) have made debt manageable in the short run. If interest rates move higher, current debt levels will be an even greater weight on economic activity. High debt and higher cost of debt will make future growth much more difficult to achieve.
Liquidity is an important driver of market direction in the short and intermediate term. From the end of the financial crisis to 2015, global liquidity increased from three major sources:
- China’s foreign exchange reserves climbed from less than $2 trillion in 2008 to $4 trillion in 2014; most of that growth was exported to other markets.
- Petro dollars contributed approximately $2 trillion in global liquidity when the price of oil was above $100 per barrel for almost four years.
- QE2 and QE3 occurred in the U.S. along with multiple monetary easings globally.
These factors contributed to a bull market in equities from 2009-2015, despite subpar economic growth. The first two factors ceased to add liquidity by the end of 2015 and the contributions from the third declined.
We entered 2016 relatively defensive, with overweights in utilities and telecom as well as in one of the deepest cyclicals, energy. Our defensive positioning is a direct result of the longer term structural issues and shorter term reduction in liquidity. The energy overweight was tactical based on negative sentiment and dramatic underperformance in 2015. Fundamentals do not support a long term overweight in energy or commodities. We intend to market weight energy and underweight materials.
Healthcare and financials have been the two worst performing sectors year-to-date. Financials have been hurt by a flattening yield curve. We have been underweight financials, but will likely invest if credit spreads continue to contract (narrowing credit spreads are second only to a steepening yield curve among macro factors which act as a tailwind to banks) and/or the Fed becomes more hawkish on rates. Underperformance of non-U.S. financials has grown extreme (80% relative underperformance in certain instances). We are currently researching company and country-specific opportunities in non-U.S. financials.
Our automation and robotics theme has driven stock selection in the Industrials and Technology sectors. The slowdown in productivity growth is having direct negative consequences on global economic growth. We believe that select companies well-positioned in robotics and industrial automation will be large beneficiaries of investments that will be made to reverse this slowdown.
We anticipated a pull-back in U.S. dollar strength and marginally increased our non-U.S. exposure at the end of 2015. Between 10-15% of our holdings are currently domiciled in developed markets outside the U.S. and we will be selectively adding non-U.S. market exposure. The multi-year outperformance of U.S. equity markets has resulted in a significant valuation gap. In addition, the U.S. is several years ahead of other developed markets in terms of margin expansion and adoption of shareholder friendly policies, including buybacks and dividend increases. As these practices are more widely employed in Europe and Japan, their markets should respond.
We are still avoiding most emerging markets. While a softer dollar has served as a temporary reprieve by reducing deflationary stress and by stabilizing commodity prices, fundamentally, little has changed. The vast majority of natural resource-rich emerging markets did not use the windfall from higher commodity prices over the past decade to implement structural and productivity enhancing reforms. Returns on capital continue to fall in almost every emerging region (unlike improving returns in many developed geographies). Once the U.S. dollar weakness runs its course, we expect these regions to continue an underperforming trend.
The 10 year Treasury Note started the year at a yield of 2.27% and fell to a low of 1.66% before recovering to end the quarter at 1.77%. As mentioned, we think yields will remain relatively low for the foreseeable future as slowing demographic and productivity growth, coupled with high debt levels, serve as an anchor on potential output growth.
As a result of these macroeconomic forces, we have extended our durations modestly. Because the yield curve has also flattened, going too far out in duration is less attractive.
We continue to believe that while interest rates remain low for now, at some point, a few years out, the risks will tilt toward higher rates, perhaps higher than markets currently anticipate.
There are four reasons why rates will ultimately move up:
1. Weak productivity growth will eventually cause economies to bump up against supply-side constraints.
2. Population aging will erode excess savings, as workers begin to retire.
3. Low commodity prices will move from being a headwind to a tailwind for growth.
4. Monetary and fiscal policy will become too stimulative.
Inflation will then become a real concern and short term rates should rise. We are analyzing fixed-income segments that could outperform by getting ahead of this likely inflection point.