Conceptually, economic growth is a function of two factors: the growth of jobs, and the productivity of those employed. In a world where the labor force of industrialized nations is stagnating, or, worse, shrinking, one might reasonably ask: “Why is economic growth, as measured by the increase in real GDP, so important to the economy?” A good argument can be made that real GDP per capita would be a better barometer, as it measures the growth of the average individual’s overall well-being, and would eliminate the need to worry about changes in demographics.
Capital Markets Need Growth
On the surface, the logical answer would appear to be that GDP per capita, would be the appropriate measure. But, that isn’t the correct answer. In today’s industrial economies, the citizenry’s balance sheets are heavily invested in the capital markets, and the high valuations of those capital assets are dependent on corporate growth rates. The fact is, a positive overall growth rate of the economy is necessary for the market indexes to advance because growth is a fundamental valuation metric.
The Japanese Experience
Think of the angst that would be created if the DJIA or S&P 500 were only half of their current levels 28 years from now, in 2045. Wouldn’t sit well, would it? And likely that would have meant three decades of deflation and recession. Yet, this is exactly what has happened in Japan over the past 28 years. The growth engine that was Japan’s economy in the 1980s gave way to stagnating population growth in the 1990s. In reaction, the Nikki 225 today is near 20,000, about half of the value is was at its peak on December 29, 1989 (38,957). Today, Japan’s population, currently approximately 126 million, is expected to fall by 25% to under 100 million by 2050 with seniors (65+) set to make up 40% of the population (from today’s 26%).
To think for a moment that a milder version of this couldn’t happen in the U.S. might be a significant miscalculation, because U.S. demographics are telling us that potential non-inflationary growth rates have slowed significantly over the past decade and will continue to be tepid as far as the eye can see.
Beware of Passive Investing
Rational markets, then, will eventually reflect such slow economic growth, and as this slow growth unfolds, it will behoove investors to examine each portfolio holding for its growth characteristics. The successful investor of the future will have to take a more active interest in his/her portfolio holdings, as holding indexes of a slow growth economies are not going to produce good performance. Unfortunately, in this latest bull market, investors have been lured into believing that index investing is safe; that you really don’t need to know the individual securities in your portfolio because the general market is going to keep rising and you are indexed to it.
The Fed Says Slow Growth is “Transitory”
I’m told that we shouldn’t worry about slowing growth just yet. The Fed believes that the slow growth in Q1 was “transitory” and they are proceeding to raise interest rates, even as soon as mid-June. But, given the poor hard data, now showing up as underwhelming job growth and a real lack of any upward wage pressure, a couple of more rate hikes could result in an inverted yield curve (short-term rates higher than longer-term ones), and that is almost always a precursor to recession. The Fed has also told us that they will begin to unwind their balance sheet by year’s end, i.e., a reverse QE. Even if this is very gradual, it is still monetary tightening, and it may be tightening into the teeth of a recession. Remember, the bell doesn’t ring, nor does a bugle play, nor do we stand for the national anthem at a recession’s onset. Most of the time we don’t even know we are in a recession until the National Bureau of Economic Research announces it, sometimes twelve months or more after it starts. Most of the time, however, the markets know it, and their signal is a lack of growth.
The hard data continue to be ugly; the sentiment indexes have rolled over now that the Trump policy package is DOA.
• Not only was April’s employment growth (138,000 vs. 185,000 expected) disappointing, but February and March job growth were significantly reduced (-66,000);
• The second pass a Q1 GDP revealed that the corporate profit portion shrank at a seasonally adjusted annual rate of -7.3% versus Q4;
• Inflation is weakening now that Q1/16 oil prices ($26/bbl) are no longer the baseline comparison; headline core inflation, year over year, is now in full retreat;
• Commodity prices, too, are in full retreat; that says something about worldwide demand;
• The housing data (new, existing, permits) have disappointed; so even the industry considered the most robust is lagging.
Bond Market Gurus
It is recognized by professional investors that, due to the nature of markets, bond traders usually have a better take on the pulse of the economy than do equity investors. With that in mind, consider that the 10 year Treasury Note has retreated from its post-election 2.6% high, and from its interim 2.4% peak back toward 2.2%. Hardly an endorsement of sustainable growth.
• The net speculative long futures position for the week of May 22nd for the 10 year U.S. Treasury Note was 365,000 contracts, just the inverse of the -365,000 net short position of traders the week of February 28th. This is the largest net long position since December, ’07 and the swing over the last 12 weeks is the largest on record. Back in ’07, loading up on 10 year Treasuries with coupons of 4%+ was a brilliant move!
• Economic growth is the lifeblood of rising equity prices; without it, the current high PE ratios cannot be sustained;
• The industrial post-WWII world is slowing, mainly due to demographics;
• Passive index investing, with no analysis of the growth potential of assets in the portfolio, is the wrong approach when economic growth is stagnant;
• The Fed appears to be on a mission to tighten monetary conditions despite the lack of hard data supporting such moves; but the reduction in long-term interest rates and the recent record paced move to a speculative long position in the 10 year Treasury Note futures indicates that Wall Street has a different view of the foreseeable economic environment than does the Fed. Who do you trust?
Robert Barone, Ph.D.