After years of fighting against the forces of deflation, many areas of the world, including the US, are experiencing a rebound in inflation and growth prospects. The promise of rising prices and accelerating economic growth are causing asset prices to head higher, but how long will this phenomenon last?
There’s no question that things have gotten a lot rosier over the past few months. The chart below shows inflation levels rising in the US, the EU, and Japan.
Much of this increase has come on the back of rising commodity prices, and particularly oil. When oil plunged during 2014 and 2015, it took many segments of the global economy with it. Deflationary pressures increased and central banks were forced to up their antes with lower rates and additional bond purchases.
Then came the bottom in early 2016. Once oil found a bottom in the mid-20’s, it turned higher and has been taking the entire commodity complex with it (chart above). Our current semi-stable ~ oil prices have led to rising inflation and a modest uptick in expected growth.
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Layer on a dose of Trumponomics, including the prospect of large doses of fiscal stimulus and deregulation, and it’s no wonder economists have been raising their growth forecasts.
But against this positive outlook are long-term secular trends which stand to suppress growth and limit expansion. Said differently, this concept of global reflation is likely to be short-lived.
To understand why, we must look at the fundamental drivers of economic growth. Exactly what is it that causes GDP to rise and fall through the years?
Stripping out the cyclical factors, we find that long-term economic growth is a function of two main variables: productivity growth and labor force growth.
This should make sense intuitively. Gross Domestic Product represents 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 the prior year (an increase in productivity), or there must be more workers producing goods and services (labor force growth).
Breaking economic growth into these two key variables makes it much easier to forecast how long-term economic growth is likely to change.
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At the forefront of this forecasting methodology is ECRI, the Economic Cycle Research Institute. They complied the following two charts that we are going to review.
This first chart shows long-term trends in both labor productivity and the overall labor Force.
As you can see, and as discussed previously, labor productivity growth currently sits near its lowest level in over three decades. Worse, it appears that productivity growth has downshifted from that of previous decades, currently averaging a mere one half percent per year.
Growth in the labor force has also stalled, resulting in a labor force growth rate that is also near a half percent. The Congressional Budget Office (CBO) currently projects that labor force growth will average less than a half percent for the next six years, based on current demographics.
Taking our productivity growth of a half percent, and adding a labor force growth rate of a half percent, we arrive at an expected long-term real GDP growth rate of just 1%.
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As an interesting side note, ECRI points out that, “Given that potential labor force growth can’t really change in the short- to medium-term, to achieve the ‘sustained 3-4% GDP growth’ promised by incoming Treasury Secretary Mnuchin we’d need six times the last six years’ productivity growth – or twice what we saw over the Reagan years.”
Moving on, ECRI has combined this data into another phenomenal chart that allows us to look at longer term global trends.
This next chart shows the trend in labor productivity growth and labor force growth for the G7 countries over the last six decades. There’s a lot of information on this chart so let’s walk through it step by step.
On the Y-axis, we have Labor Productivity Growth, and on the X axis, we have Labor Force Growth. The slanted gray lines represent different combinations of these two factors that add up to various levels of GDP growth (see the small gray numbers next to each line).
The starting coordinates for each country represent the average productivity growth over the 50-year period from 1957 – 2007. The ending coordinates (all near the lower left corner, see the tiny black arrows at the endpoints), show average productivity growth for the past five years, and potential labor force growth for the next five years.
As you can see, each one of the G7 nations is showing a long-term secular trend toward lower labor productivity growth and lower labor force growth. As ECRI notes, “ … pretty much everybody is converging to 0-1% trend GDP growth, … effectively becoming Japan.”
If you’re a bit deflated by this chart, you’re not alone. The prospect of 1% global GDP growth is not exciting in the least. But keep in mind that these numbers are intended to reflect long-term secular growth trends in the absence of cyclical factors. When the economy is on an upswing, we’re likely to see growth surpass these levels.
That being said, it’s very likely that we are in one of those periods now. The current administration is taking steps to juice the economy, and it’s likely that many of these will have their intended effects.
But the key here is to recognize that these effects will be temporary. They will bring forward consumption from the future, but they will not change the long-term dynamics that are at play. For that to happen, we really need to see a long-term catalyst for productivity growth, or we better start having a lot more kids.
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