Reflections on structural macro headwinds…and what they mean for long-term equity market returns

We face a low growth, low inflation and low interest rate world over the next decade and beyond due to multiple structural headwinds that are expected to dampen economic growth and inflation. Structural headwinds include: high debt levels, rising wealth inequality, increasing computerisation and automation, an ageing population, and environmental factors. Businesses that achieve superior long-term growth will need structural tailwinds supported by strong value propositions, under-penetrated markets and creative organisational cultures that use technology well.

In the past two years, there has been a cyclical improvement in global economic growth that has provided a temporary tailwind for average businesses and speculative stocks. The recent outperformance of average businesses and speculative stocks is unlikely to be sustained long term in a low growth economy. Hyperion’s investment style of buying high quality businesses with structural tailwinds is well suited to a low growth world. In this thought piece, we outline the key structural headwinds the world is facing.

High debt levels

Over the past few decades consumer and government financial gearing levels in most major economies have increased substantially. The increase in financial leverage has boosted historical economic growth rates by bringing forward consumption and investment.  Gross government debt to GDP in the U.S. has increased from less than 40% in the 1980’s to approximately 105% in 2017.1 Over the same period, household debt to GDP in the U.S. has increased from under 50% to approximately 80%.2 Gross government debt to GDP in China has increased from less than 25% in the 1990’s to approximately 48% in 2017.3 Over the last decade, household debt to GDP in China has increased from under 20% to 48%.4 Gross government debt to GDP in Japan has increased from 50% in 1980 to 253% in 2017.5 Over the same time period, household debt to GDP in Japan has increased from 45% to 57%.6

The trend towards higher financial gearing has time shifted economic activity levels by giving a one-off boost to historical economic growth. These higher levels of financial gearing have increased financial risk levels generally, reduced the global economy’s ability to respond to economic shocks and increased society’s sensitivity to future increases in interest rates. High consumer debt levels, a hollowing out of the middle class, low productivity levels and an ever expanding “gig” economy of “subsistence” workers means that future rate increases are likely to be modest because most consumers will have limited capacity to handle higher rates. This increased level of financial risk and associated sensitivity to higher interest rates is expected to have a dampening effect on the economy and increases the probability of future policy mistakes by central banks and governments. Higher financial leverage increases the fragility of consumers and the flexibility of government to respond in the case of an economic downturn.

Rising income and wealth inequality

As the world has become more interconnected, materials and workforces can be more effectively sourced from countries with the lowest cost. This has led to greater equalisation in the distribution of wealth globally. Access to foreign capital has improved the lot of workers in less developed countries, while globalisation has placed downward pressure on the income of workers in developed countries. Further, migration rates and the declining influence of unions in developed countries, such as the U.S., have also had the effect of reducing labour costs (Gordon, 2016). The benefits of globalisation have become particularly evident by the increasing growth rate of high net worth individuals in countries such as China and India. Development of emerging markets and strengthening of currencies in these markets are also factors that have contributed to this growth. From 2012 to 2017, the growth in individuals with US$50 million or more in the Asia Pacific grew by 37% and it is predicted that the number of ultra-wealthy individuals in China will double in the next five years.

In conjunction with the shift in the distribution of wealth globally, we are also seeing the wealth of high net worth individuals growing at an increasing rate relative to individuals in the middle and lower economic brackets. A hollowing out of the middle class is occurring due to downward pressure on wages and increases in automation at the middle-income level. Further, a general trend toward lower corporate tax rates and lower effective marginal tax rates for high-income earners over the past few decades has also accelerated the trend towards inequality.7 This has led to mounting concern about an intensifying wealth inequality. According to the World Inequality Database, in 2014 the wealthiest 1% in the U.S. owned 39% of total wealth, up from 22% in 1978. Similar long-term inequality trends have developed in many countries since the 1970’s.

The capitalist system has an inherent long-term bias towards inequity because income is derived from two primary sources: (1) personal exertion; and (2) capital. Criticism about the extreme level of remuneration paid to the highest-level executives of corporations has been prominent in the media and has been an area of increasing focus by regulators over the past decade. In addition to personal exertion income, the wealthy have more capital, so their income earnings potential is superior to the rest of society and this advantage compounds and becomes more extreme through time. “When the rate of return on capital exceeds the rate of growth of output and income, as it did in the nineteenth century and seems quite likely to do again in the 21st, capitalism automatically generates arbitrary and unsustainable inequities that radically undermine the meritocratic values on which democratic societies are based”.8 Concern exists that increasing inequality has the potential to lead to a future of disruptive social conflict.

Increasing automation and technological innovation

Throughout the ages humans have innovated to develop technologies that attempt to improve production output and reduce human labour hours for economic gain. At certain points in time technological advancement has caused huge leaps in both productivity and the average standard of living, such as the development of the steam engine in the eighteenth century and the advent of electricity, indoor plumbing, motor vehicles and air travel in the late 19th and early 20th centuries. Since the late twentieth century, technological changes have seen the advancement of computers, communication devices and networks, robotics and artificial intelligence. However, over this same period productivity levels and average wage levels have remained depressed in most developed countries. It appears that the significant leaps in productivity and higher standards of living associated with new technology break throughs over a century ago have not been repeated with the information technology innovations of the past couple of decades.9

We have reached a point where some predict that most of the jobs currently undertaken by humans will be replaced by machines and artificial intelligence and the nature of jobs will change fundamentally. The number of human labour hours associated with productivity and economic growth could be minimal.10 At the present point in time, we are seeing the emergence of some fundamental changes that are already impacting the workforce: increasing use of robotics and 3D printing in warehouses, manufacturing and medicine; the use of artificial intelligence in algorithms used in professions such as law and finance; and the invention of autonomous vehicles that will impact the transportation industry. Businesses generally benefit from automation through lower costs, whereas workers only benefit if they can be redeployed into better quality, higher paying jobs.

In addition, it can be argued that much of this technology is replacing human effort with marginal increase in overall economic productivity.11 Technology has also resulted in a shift between goods and services and a shift from an ownership to a rental model. As such automation is a dampener on economic growth, first with its impact on employment with automation replacing more skilled mid-tier employees permanently and pushing them into less skilled, more poorly paid activities. Second, as goods shift to services and ownership shifts to rental, fewer ‘physical things’ are needed resulting in a reduction in consumer spending and an associated decline in manufacturing activity. Consequently, we expect that over the next decade automation will create headwinds that will dampen economic growth and place downward pressure on wage inflation.

Ageing population

Since the 1960’s, the population growth rate worldwide has, on average, been declining while the number of people 65 years and older has been steadily increasing.12  Japan has the oldest population in the world (its population started declining in 2011) followed by European countries such as Italy, Germany and Greece. In China, it is forecast that about a quarter of the population will be 60 and over by 2030.13

An ageing population has implications for labour force growth, number of work hours per person, and consumer spending. As a population ages, fewer people will be engaged in full time employment or be able to generate an income from human labour activities due to physical and mental constraints. The retirement of the baby boomers is predicted to negatively impact the growth in labour hours per person from 2008 to 2034 and this has implications for real economic growth (Gordon, 2016). At the same time, living longer means that individuals will have extended economic requirements that will need to be funded in some manner. This may be through government pensions, pension funds or working longer but perhaps for shorter hours. However, lower income means fewer income taxes collected by governments and increasing numbers of retirees placing strains on pension systems. Headwinds arising from an ageing population are expected to have a dampening effect on economic growth in the next decade. The economic impacts of an ageing population can be seen in Japan.

Consumer spending patterns change with an ageing population with greater spending on services particularly in the areas of healthcare and aged care. As people age and live longer there will be increased expenditure on healthcare associated with ageing. Currently, medical researchers are investigating ways to eliminate many of the diseases associated with ageing and in the process; humans will likely live even more extended lives.

Environmental related growth constraints including climate change

There are approximately 7.6 billion people in the world currently. The aggregate demand by humans on natural capital resources is outpacing the rate at which resources can be renewed. Since 1987 the world has been in a natural resource deficit and this deficit has been trending up over the past 3 decades. The WWF in their Living Planet Report (2016) stated “By 2012, the biocapacity equivalent of 1.6 Earths was needed to provide the natural resources and services humanity consumed in that year”. The Living Planet Report also states that Carbon (CO2) production from the burning of fossil fuels represented 60% of humanity’s ecological footprint in 2012.

There is likely to be increasing levels of economic disruption due to the adverse effects of climate change over the next decade. More extreme weather, floods, droughts, heat waves, super storms and changing weather patterns are likely to adversely affect agricultural production and reduce productivity levels over time. The ocean is absorbing a significant proportion of the CO2 that is being released into the atmosphere. This process results in ocean acidification and has the potential to disrupt the food chain in the ocean destroying coral reefs and adversely affecting shell forming organisms. Which, in turn, has the potential to adversely impact the fishing industry and tourism.

We believe the economic impacts of climate change are likely to be significant and far-reaching and ultimately affect every household and business in the world. The ramifications are varied and complex, with the most salient consequences likely to manifest in changes to agricultural and fishery yields, the consumption and demand profile of energy resources, healthcare and aid expenditures as well as the flow of tourism. Not least, it is estimated that climate change will result in significant changes to the geographic distribution of the supply and demand of goods and services, redefining global trade. It is also likely to fundamentally affect migration flows and result in the loss of land and capital infrastructure due to higher sea levels. According to the Stern Review on the Economics of Climate Change (2006), economic models estimate that the overall costs and risks of climate change will be the equivalent to losing at least 5% of global GDP each year, now and forever. Published over more than 10 years ago by economist Nicholas Stern for the British Government, this estimate is now considered to be conservative.

Inexpensive renewable energy

We are only beginning to see the potential disruptive effect of rapid declines in the cost of renewable energy, primarily solar and wind, on the traditional electricity and energy sectors. Inexpensive renewable energy has long-term negative implications for the traditional utilities, coal and oil and gas industries. Increasing access to inexpensive solar power and energy storage as well as the development of electricity trading platforms should see the decentralisation of the energy sector over the long term. Cheaper, cleaner electricity will reduce the cost of manufacturing, transport and the general cost of living. This is another factor that is likely to exert downward pressure on inflation and interest rates over the long term.

Conclusion

There has been a cyclical increase in global economic activity over the past couple of years, but we believe the longer-term outlook for economic growth remains subdued with risks to the downside because of the structural headwinds outlined in this article.

In a low growth world most asset classes will produce relatively low total returns. Our base case is for Global equites to produce total real returns that average around 3.5% to 4.5% pa (5% to 6% nominal) driven by very low single digit profit growth. Many sectors of the market will find it difficult to even maintain their current levels of earnings in real terms over the next ten years. For example, it’s likely that oil and thermal coal businesses will face declining demand over the next decade and beyond as the cost of renewable energy, electric vehicles and batteries continue to decline.

A low growth world is a good environment for our investment style. Our portfolios tend to perform best in low growth and/or decelerating economic environments. The most difficult economic environment is the one we experienced in the decades leading up to the GFC. In the pre-GFC economic world of high economic growth levels it was possible for average and below average businesses to grow their sales and earnings at reasonable rates and to use increasing levels of financial leverage to boost their returns. In this type of robust environment, the economic performance gap between high quality structural growth businesses and average businesses reduced because of the improved performance of the average businesses.

Conversely, in a low growth economic environment it is much more difficult for average businesses to grow their sales and profits. This low growth economic environment makes the gap between the sustained growth in EPS between our portfolios and the average business that dominate the stock market much wider. We expect our portfolios to produce double digit organic sales and EPS growth over the next ten years compared with the key stock markets that are dominated by old world businesses that will likely be stuck in a very low single digit growth range.

 

 

Mark Arnold (CIO) and Jason Orthman (Deputy CIO)

July 2018

 

References

1 https://tradingeconomics.com/united-states/government-debt-to-gdp Historical Chart of U.S. Gross Federal Debt to GDP

2 https://tradingeconomics.com/united-states/households-debt-to-gdp Data from Historical Chart of U.S. Households debt to GDP

3 https://tradingeconomics.com/china/government-debt-to-gdp Historical Chart of China Gross Federal Debt to GDP

4 https://tradingeconomics.com/china/households-debt-to-gdp Data from Historical Chart of China Households debt to GDP

5 https://tradingeconomics.com/japan/government-debt-to-gdp Historical Chart of Japan Gross Federal Debt to GDP

6 https://tradingeconomics.com/japan/households-debt-to-gdp Data from Historical Chart of Japan Households debt to GDP

7 Lower corporate tax rates primarily benefit the wealthy because they are the biggest owners of businesses.

8 Picketty, Thomas “Capital in the Twenty-First Century” (2014)

9 Gordon (2016) provides detailed discussion of this.

10 Refer to Diamandis and Kotler (2012).

11 Refer Gordon (2016)

12 The World Bank https://data.worldbank.org/indicator/SP.POP.65UP.TO

13 https://www.straitstimes.com/asia/east-asia/chinas-next-debt-bomb-is-an-ageing-population

Gordon, Robert, J. “The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War (The Princeton Economic History of the Western World). 2016 Princeton University Press, New Jersey USA

Diamandis, P. H. and Kotler, S. “Abundance: The Future is Better Than You Think” September 2014

Picketty, Thomas “Capital in the Twenty-First Century” The Belknap Press of Harvard University Press, (2014)

Stern Review on the Economics of Climate Change (2006)

WWF Living Planet Report (2016)

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