Your mission, should you choose to accept it, is to predict the future. As always, should you or any member of your team be caught or killed, the Secretary will disavow any knowledge of your actions. This message will self-destruct in five seconds …
Actually, you don’t get to choose whether or not to accept this mission. You’re an investor. And an investor’s job is – quite simply – to predict the future.
Predict it correctly, and the future will funnel untold wealth into your hands. But get it wrong, and your investment portfolio will go up in smoke, just like every one of Ethan Hawk’s archnemeses.
When it comes to predicting the future, we must first determine what timescale to focus on. Are we trying to predict tomorrow’s price action? Where will the stock market be at the end of this year? Or what the economy will look like 15-20 years from now?
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All of these timescales are important, and we spend a lot of time analyzing shorter-term developments. So today, we’re going to take a step back and go through a thought experiment that should help us prepare for what the world may look like in the not-too-distant future.
To get us started, the chart below shows US annualized GDP growth by quarter, going back to about 1950. I’ve included a basic regression line, or line of “best fit,” to help discern the underlying trend.
There are two specific developments here to recognize. The first is that our regression line is downward sloping, meaning that economic growth is in a secular downtrend. What does secular mean in this context? The best way to interpret it is “non-cyclical,” meaning this is a permanent feature.
The next thing to notice is how much more volatile economic growth was back in the 50’s, 60’s and 70’s. From the early 1980’s on, we see a major phase shift in the economy, as it enters a period of not only slower growth, but lower volatility.
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This effect is better captured in the following chart, which shows us the average volatility (based on standard deviation) of economic growth for various periods. As you can see, volatility has completely collapsed over the years.
In effect, what has happened is that both upside and downside spikes in economic growth have become more muted. Our economy now has a difficult time getting above 3% growth (let alone 5%, which we used to surpass quite regularly), and we also see fewer episodic moves below 0% growth, which represent economic contraction or recession.
As a quick aside, notice (in the first chart) that the plunge in 2008 was just as large in magnitude as we experienced on several occasions earlier in our country’s history. However, unlike previous recessions, that dip was not followed by a period of massive 5-10% growth. This is why people refer to this recovery as one of the slowest and weakest in history. When you only grow at 2%, it takes a long time to recover from a massive economic downturn.
Moving on, the natural questions that arise from looking at this data are a) what is causing this trend toward lower economic growth? and b) what will the economy look like if this trend continues?
In terms of the causal factors, it's very simple. Economic growth can be distilled into a function of just two variables: productivity growth and labor force growth.
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As I’ve explained before, Gross Domestic Product is a measure of the total output of goods and services from a particular nation. In order for this to rise (in real terms), one of two conditions must be met. Either the same number of workers must produce more goods and services than in the prior year (an increase in productivity), or there must be more workers producing goods and services (an increase in the labor force).
Every single other piece of economic data that you hear about, from jobless claims to wages to PMIs to corporate investment, etc., all funnel their way into these two variables.
Calculating economic growth from these two variables is very simple: GDP growth is simply the sum of Productivity Growth and Labor Force Growth.
Here is a look at how both of these are trending:
In the top portion of this chart, we can see that labor productivity appears to be flatlining, as it has averaged about one-half percent since the financial crisis. The lower chart provides us with an indication of labor force growth, which also sits around one half percent. Taken together, these factors point toward GDP growth of around 1%.
It’s worth mentioning that both of these metrics are relatively predictable as well, especially labor force growth. The Congressional Budget (CBO) currently projects that labor force growth will average less than half a percent for the next five years.
As for productivity, that could rise (and many Republicans are betting their careers that it will, partially as a result of the tax cuts, which are supposed to help give companies cash to invest), but those of us who actually study this stuff know that companies already had PLENTY of cash, and that whenever they get more cash, it just goes toward buybacks and dividends.
So, barring some unforeseen major breakthroughs that cause a spike in productivity, there’s a good chance we had better get used to this low growth environment. But where will it end? If these trends continue, is it possible the global economy could simply stop growing altogether?
As crazy as that concept sounds, I think many of us alive today will live to see that happen, and here’s why. First, it’s not just the US economy experiencing weak productivity growth and weak labor force growth.
Germany is typically considered the economic workhorse of Europe, and here is what their labor productivity and labor force growth look like:
Notice the massive downshift in productivity? Notice the negative labor force growth? Based on this, do you think Germany’s economy is going to take off anytime soon? I sure hope not.
I hate to say it, but it’s not just Germany, either. This great chart, which I’ve shown before, and is also courtesy of ECRI (the Economic Cycle Research Institute), shows longer-term trends in labor productivity and labor force growth for many large economies. Can you see the pattern?
In this chart, labor productivity is shown on the vertical axis and labor force growth is shown on the horizontal axis. The sloping light-grey lines represent levels of GDP growth based on these two factors. The big takeaway here is that all major economies are converging toward 0-1% GDP growth, “effectively becoming Japan,” as ECRI puts it.
Based on this chart, is seems rather intuitive to conclude that yes, eventually the world will stop growing. If that happens, what does it mean for financial assets?
At this point, we’re getting into the realm of pure speculation, but I do want to mention a couple of things. As I’ve pointed out many times, and as recently as last week, long-term interest rates such as the yield on the 10-year note tend to track the sum of real GDP growth and inflation.
If real GDP growth goes to zero, then the yield on the 10-year note will effectively track inflation (that’s almost all it does now anyway). With zero growth, it’s likely that inflation will be almost nonexistent as well. Therefore, in my humble opinion, our future is one of low, almost nonexistent interest rates.
Of course there will still be ebbs and flows in our economy, and interest rates will rise and fall accordingly. But based on the decreasing volatility our economy is seeing, combined with the trend toward 0% growth, I think it’s fair to say that we’re going to be in a low interest rate environment as far as the eye can see.
If that’s the case, then it means that this trend toward riskier assets and higher valuation levels is likely to continue. When lending money ceases to provide a return (as we’ve already seen in many parts of the world with negative interest rates), then TINA (the idea that There Is No Alternative to risky assets) may well be the siren song of the next generation of investors.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.
