While a low growth environment seems to be the best outcome for developed economies there are signs of economic improvement, Conrad Burge writes.
Christine Lagarde, managing director of the International Monetary Fund (IMF) broke new ground last year when she declared that the world was close to being in “a low-growth trap”. This was perhaps the first time that someone in a prominent public institutional position had been prepared to say that the developed world was close to being caught in a situation in which strong growth could no longer be achieved.
In the year or so since these words were put on paper by Lagarde in July 2016, she, and the IMF more generally, have toned down their rhetoric but concerns about the economic outlook for the advanced economies remains.
As Maurice Obstfeld, the IMF’s economic counsellor, recently put it in April 2017, “significant downside risks continue to cloud the medium-term outlook and indeed may have intensified”. In its latest report (Economic Update, July 2017), the IMF notes that “growth remains below pre-Global Financial Crisis [GFC] averages”, with “many advanced economies facing excess capacity as well as headwinds to potential growth from ageing populations, weak investment and slowly advancing productivity”.
Indeed, it is this issue of sluggish productivity growth that is at the heart of the problem. Despite the experience of a marginal improvement in outlook in recent months, the developed world in particular continues to struggle with underlying structural problems that have been holding back growth.
These structural problems include a low propensity to invest and historically low rates of productivity growth. As Janet Yellen, chair of the US central bank (the ‘Fed’) recently explained, “labor productivity – that is, the output of goods and services per hour of work – has increased by only about 0.5 per cent a year, on average, over the past six years or so and only one per cent to 1.25 per cent a year over the past decade. That contrasts with the previous 30 years when productivity grew a bit more than two per cent a year. This productivity slowdown matters enormously because Americans’ standard of living depends on productivity growth”.
Yellen added that “this implies that the economy’s usual rate of output growth... will be significantly slower than the post-World War II average”.
This applies also to most of the rest of the developed world, as productivity growth has, if anything, been even weaker across most of Europe and in Japan in recent years. Yellen has also noted that “structural challenges lie substantially beyond the reach of monetary policy”.
Furthermore, “monetary policy cannot improve the productivity of workers – fiscal and regulatory policies, which are the responsibility of the Administration and the Congress, are best suited to address such adverse structural trends”.
Over-regulation of industry and the economy more generally has become widespread across the advanced economies and needs to be wound back, as does excessive government spending, although this is easier said than done.
As Alan Greenspan, the famous ex-chairman of the Fed from 1987 to 2006 recently emphasised, welfare spending in the US is growing at over nine per cent per annum and is “crowding out savings and hence, capital investment, which is the critical issue in productivity growth and productivity growth in turn is the crucial issue in economic growth”.
It thus appears that fundamental issues, including how to boost investment and productivity, may need to be addressed before real economic recovery can be achieved, not only in the world’s largest economy, the US, but also in the rest of the developed world, including most of Europe, as well as Japan.
The IMF’s Lagarde set out a comprehensive approach to this issue when she declared last year that what was needed is a “three-pronged” approach to the current global challenge.
The first of these is structural reform, including deregulating product and services markets and reforming labour markets.
The second and third prongs are supportive of fiscal and monetary policies and, of course, such policies have been in place to a greater or lesser extent since the advent of the GFC in 2008 and the resultant Great Recession of 2009.
Fiscal policies recommended by Lagarde vary from ‘fiscal consolidation’ (deficit and debt reduction) where government debt is too large to ‘fiscal expansion’ where there is room to do so.
In the latter case, which includes countries such as Germany, large-scale investment in new infrastructure could be very beneficial (particularly given the current historically low cost of borrowing for such programs), while according to the IMF, “if private research and development investment was raised by 40 per cent, GDP [gross domestic product] in advanced economies could increase by five per cent over the next two decades.
Incidentally, in the case of the developing world, a big reduction in energy subsidies could pay huge dividends as “the direct and indirect cost of these is estimated at about $5.3 trillion”.
The final prong is the one that has been relied on most in recent years, namely accommodative monetary policy. In Lagarde’s view, “successive rounds of quantitative easing, combined with the successive lowering of interest rates has been invaluable” and “should continue in most advanced economies”, while developing economies should continue to utilise exchange rate flexibility “especially to help cushion against terms of trade shocks”.
In fact, floating exchange rates have proved to be highly beneficial to many developing economies over recent years and it could be added that the lack of such flexibility for individual countries within the Eurozone appears to have exacerbated economic difficulties for some of them, particularly in the so-called ‘periphery’ (Greece, Spain, Portugal, Italy and, to a degree, even France).
However, despite the difficulties posed by the structure of the Euro itself and by an environment of severe over-regulation of economic activity within the European Union, even in Europe there have been signs of some improvement in the economic outlook in recent months.
The IMF in its July 2017 report is forecasting growth of two per cent for the advanced economies this year and 1.9 per cent next year, although this is not up much from growth of 1.7 per cent in 2016.
The IMF notes that “the pickup is primarily driven by higher projected growth in the US, where activity was held back in 2016 by weak investment”. The IMF also makes clear that this improved outlook for the US “reflects the assumed fiscal policy easing and an uptick in confidence, especially after the November Presidential election, which, if it persists, will reinforce the cyclical momentum”. Furthermore, “the outlook has also improved for Europe and Japan, based on a cyclical recovery in global manufacturing and trade”.
The issue is that while, at least in the case of the US, it had been hoped that the new Administration under President Trump might be able to make some progress by implementing fiscal reforms, including significantly lowering taxes (particularly corporate tax rates), while also reducing the regulatory burden on businesses, the reality is that, as the IMF notes, “expectations of fiscal stimulus (in the US) have receded”.
While some positive signs are there, much remains to be done and progress so far has been painfully slow (especially in getting changes through the Congress).
At least the Trump program, broad as it is at this stage, to some extent meets the IMF’s call for ‘forceful policy actions’ to boost growth in the advanced economies by reducing bureaucratic regulation of business, lowering taxation burdens, boosting innovation, reinvigorating trade and liberalising labour markets.
In the case of Europe, there has been little response by Germany to the IMF’s July 2016 call for “greater reliance on measures to support domestic demand, especially in creditor countries with policy space”. Germany continues to run a massive trade surplus, while also running a fiscal surplus.
So, the question for investors remains: how are we to invest in a world in which low growth seems to be the best outcome that the developed economies are likely to be able to achieve at least over the near-term?
The answer seems to be that with evidence mounting that growth could continue to slowly gain momentum, this could be expected to be broadly positive for equity markets.
At the same time, in fundamental valuation terms and assuming ongoing earnings growth, most share markets still appear to be fairly valued, despite upward movement in some key interest rates.
In contrast, most bond markets continue to appear expensive, with bond yields (interest rates) still at historically low levels despite increases in some sovereign bond yields.
In other words, we should favour equities over bonds and cash in the current economic environment in which stimulatory measures have to remain in place for some time to come and in which central banks have to remain cautious about lifting interest rates too precipitously.
Conrad Burge is investment manager at Fiducian.