If you are among the many Australians paying a mortgage, lower for longer probably sounds like good news when it comes to interest rates. But if you are a business owner or CEO seeking to grow your business, your earnings, and your profits, low rates and low inflation are not always good news. Because they generally signal weaker economic growth.
The same goes for equity investors who analyse businesses on the basis of their ability to compete and perform into the future – low economic growth makes their job more difficult. This is because when business conditions are difficult, only those companies with strong fundamentals survive.
The reality is that low global economic growth is likely to be our economic reality– at least for the next decade – so how do we go about identifying businesses likely to weather the storm?
The answer is that quality must be king. When times are tough, return expectations may need to be downgraded, but quality businesses can continue to survive and prosper. In a rising market, the tailwinds of low-cost debt and consumer demand, propelled by accommodative monetary policy, can prop up average businesses and speculative stocks. And in the past 18 months or so, that’s exactly what we’ve seen.
When we look to the future however, the situation appears very different, and it’s not necessarily positive. As the tailwinds fade, headwinds are simultaneously blowing up, so that only companies with fundamentally solid business propositions, including strong management, large and growing addressable markets, a high-quality business franchise and the potential for organic (as opposed to debt-fuelled) growth will be left standing.
So are there really headwinds ahead likely to affect the global economy, and the ability of businesses here and overseas to compete and win? In our view, there are some very significant challenges, and we examine a few of these below.
Automation and technological innovation means fewer jobs for many
Throughout the ages, humans have always innovated to improve production output, and reduce human labour hours for economic gain. And at a number of points in history, technological advancement has triggered huge leaps in productivity and average standards of living.
However, since the late twentieth century, technological changes in the form of computing, communication, robotics and artificial intelligence have not resulted in higher levels of productivity despite offering other benefits and, subsequently, average wage levels have remained suppressed in most developed countries.
In fact, some of the advances, in the field of robotics for example, mean we have reached a point where there is a real possibility that many of the jobs currently undertaken by humans will be replaced by machines and artificial intelligence. And, it’s likely that the nature of jobs will change fundamentally. At the moment, we are seeing the emergence of some major changes that are already impacting the workforce: increasing use of robotics and 3D printing in warehouses, manufacturing and medicine, just to name a few. Businesses generally benefit from automation through lower costs, whereas workers only benefit if they can be redeployed into better quality, higher paying jobs.
Globalisation drives wealth inequality
The rise of globalisation has brought undeniable benefits. Markets are more interconnected, and materials and workforces can be sourced from countries with the lowest cost. The upside is that 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, but has simultaneously placed downward pressure on the income of workers in developed countries. At the same time, migration rates and the declining influence of unions in developed countries, like the U.S., have led to lower labour costs.
One of the corollaries of globalisation has been the increasing numbers of high net worth individuals in countries such as China and India. From 2012 to 2017, individuals with US$50 million or more in the Asia-Pacific region grew by 37%, and it’s predicted that the number of ultra-wealthy individuals in China will double in the next five years.
Unfortunately, global wealth distribution is changing, in that the wealth of high net worth individuals is growing more quickly than the wealth of individuals in the middle and lower economic brackets. A hollowing out of the middle class is occurring as downward pressure on wages and increases in automation force middle-incomes down. Also, a general trend towards 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.
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.
High levels of debt increase financial risk
Consumer and government debt have both increased substantially in most major economies over the past decade. Gross government debt to GDP in the U.S. has risen from around 40% in the 1980s to approximately 105% in 2017. Over the same period, household debt to GDP in the U.S. has risen from just under 50% to around 80%. And the same story has played out in China, where gross government debt to GDP has risen from under 25% in the 1990s to approximately 48% in 2017, and household debt to GDP in China has increased from under 20% to 48%.
As debt rose, it provided a one-off boost to economic growth rates by bringing forward consumption and investment, but investors will pay a high long-term price because high debt also means higher levels of financial risk, and increased sensitivities to interest rate hikes. Inevitably, this has an adverse effect on central banks and governments to respond in the case of an economic downtown.
An ageing population will suppress real economic growth
Since the 1960s, the population growth rate worldwide has been declining on average, while the number of people 65 years and older has been steadily increasing.
An ageing population has implications for labour force growth, both in terms of the number of work hours per person, and also consumer spending. As a population ages, fewer people are engaged in full-time employment and/or earning an income from human labour activities. 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.
At the same time, living longer means that individuals’ living costs and other requirements need to be funded for longer. This may be through government pensions, pension funds or working longer. However, lower incomes mean lower income taxes, just as the increasing numbers of retirees place strains on pension systems around the world.
Environmental-related growth constraints including climate change
According to the Worldwide Fund for Nature (WWF), “By 2012, the bio capacity equivalent of 1.6 earths was needed to provide the natural resources and services humanity consumed in that year”, and the inconvenient truth is that the situation has only worsened since then. Demand by humans for natural resources is fast outpacing the rate at which resources can be renewed, and the burning of fossil fuels is most to blame – representing 60% of our footprint in 2012.
The link between climate change and investment markets may not be immediately obvious, but it is nonetheless significant, and becoming more so. In fact, our view is that every business and household in the world will be negatively affected.
Extreme weather events, including prolonged drought and super storms adversely affect agricultural production, and acidification of the ocean as it absorbs excess CO2 does the same to the marine ecosystem and fishing. It is difficult to predict with certainty what the specific outcomes will be, but there is no doubt that the geographic distribution of the supply and demand of goods and services will change, redefining global trade. According to the 2006 Stern Review on the Economics of Climate Change, climate change reduces global GDP by 5% every year. Most experts now consider this estimate to be conservative.
And the conclusion is….
The medium to longer term outlook for the global economy remains subdued and business conditions are likely to remain challenging, despite the cyclical uptick of the past few years. Most asset classes are likely to produce relatively low total returns – our view is global equities will average total returns of between 3.5%-4.5% p.a.
Against this backdrop, many sectors of the market will find it difficult to maintain current levels of earnings in real terms over the next decade.
For investment managers, tackling low growth is a challenging conundrum. When the economic tide turns, average businesses frequently fail, and only those businesses with strong fundamentals, in the form of high-quality business models, including low gearing, and large addressable markets will have the ability to offer earnings growth and long-term returns for investors. Key to success will be the ability to consistently identify these businesses, and to invest for the long term.