This excerpt, taken from Balentine’s 2016 Capital Markets Forecast, discusses five key issues which support our outlook of continued meager growth for the upcoming investment cycle. We take a brief look at those five reasons here. For the full article as written in our Capital Markets Forecast, please click here.
In our 2016 Capital Markets Forecast, we maintain an outlook of continued meager growth for the upcoming investment cycle. Five key reasons support this outlook:
- Economies, in aggregate, remain over-indebted and deflationary.
- Central bank interference.
- Poor demographic trends.
- Corporations’ attempts at cutting expenses, notably labor, in lieu of equity repurchases.
- GDP growth likely will not be enough to outpace the sluggishness.
Despite the sharp run-up in equity markets over the last seven years, the name of the game is still the four Ds: Debt, Deleveraging, Deflation, and Demographics. As long as the world struggles to manage debt ratios, deleveraging and deflation will cap worldwide economic growth. Despite fits of starting and stopping among various global economies since the Global Financial Crisis, nothing sustainable has emerged. As a result, central banks have remained all too accommodative in an effort to drive growth. The question we now ask: have central banks’ efforts hit a wall given the little bang they are getting for their buck?
Overleveraged economies need to work off the excesses in the system, often over a long period of time. That translates to a plethora of false starts in economic growth. Deleveraging historically results in deflation that runs its course only when debt has been moderated.
Colloquially, deflation is often referred to as falling prices; however, falling prices do not define deflation but rather are a symptom. Deflation is really a function of slowing money velocity and a persistent shortfall in aggregate demand versus capacity, both of which drive the resulting price declines.
Given the heightened focus on central bank actions all over the globe, it has become more essential to understand the reasons for and potential impacts of central bank policies. Not only have central bank policies been relatively ineffective in stemming the tide of deflation, but their actions may actually be perpetuating the issue, as deflationary signs exist all over the world today.
- In Europe, there is a lack of aggregate demand and now an influx of potentially cheap labor in the form of migrants.
- A debt crisis is brewing in the Emerging Markets.
- US companies are not investing enough in growth and productivity.
Central banks’ attempts to inflate their own domestic economies via low interest rates are exporting deflation elsewhere via currency devaluation (for those on a fixed currency system such as China) or currency depreciation (for those on a floating exchange rate system). In isolation, each central bank’s actions may have been effective within its own country. Globally, however, this course of action has had an inverse effect, as foreign central banks collectively have overwhelmed each central bank’s domestic inflationary intentions. Thus the world remains deflationary. Falling commodity prices and weakening credit conditions support this.
Short-term interest rates have been trending down over the last 30-35 years, with rates brought to effectively 0% in 2008 in the face of the Global Financial Crisis. Although lowering interest rates is generally the course of action to stimulate a slowing economy, excessively low interest rates in the wake of the crisis were brought about for an additional reason: to alleviate the burden on debtors’ abilities to service their bloated balance sheets. All else equal, the reduced interest burden on debtors would allow more household cash flow to go toward productive economic spend and servicing debt principal. While this dynamic was a factor in assets’ comeback from the brink after the Global Financial Crisis, it has also brought about a disconnect between asset prices and economic growth. Moreover, capital allocation discipline has not allowed for the proper economic healing, as savers have been forced further out on the risk spectrum in order to achieve desired yields. Additionally, the risk tolerance mismatch in portfolios over the last few years has driven down investment yields as the demand for risky investments outweighed the supply, similar to what occurred during the housing bubble.
Low interest rates have created a conundrum for the Fed, as two concerning consequences have resulted: 1) much of the excess reserves in the banking system were channeled into financial assets rather than into the real economy, and 2) artificially low hurdle rates encouraged companies to borrow to repurchase increasing amounts of equity and investors to borrow to fund investments. We have seen this cycle multiple times, notably with the 1991 recession, the bursting of the internet bubble, and then the bursting of the housing bubble. Subsequent rate hikes never made it back to the prior peak. Moreover, low rates as a result of central bank policies have become self-perpetuating, effecting a permanent impairment of returns.
Demographics present another headwind. We have heard for years about Japan’s aging population and the concerns that may present for economic growth; however, additional concerns have asserted themselves globally. In the US, the labor participation rate has been in decline since 2000, after peaking at slightly above 67%. Some estimate that the US labor participation rate may not begin to grow again in the mid-2020s. That would make for almost 35 years without substantive appreciation domestically. Amazingly, the US experience pales in comparison to Europe, where labor participation force declines are estimated to continue until nearly 2050, amplified by the ongoing and forthcoming immigration. Aside from immigration and aging baby boomers, there is one tremendous demographic hurdle that is strongly deflationary – automation. A recent Bank of America research report estimates that within a decade, robots will take 50% of manufacturing jobs and save $9 trillion in labor costs. While this sounds great for company profits, the reality is that companies cannot make money in the long run simply by cutting costs. As long as a substantive level of the labor force is not participating, aggregate demand will remain low, which should eventually affect the companies’ top lines – a classic deflationary spiral.
In the face of challenging leverage and demographics conditions and in the absence of central banks and governments making the hard decisions to cause short-term pain (something they have been loath to do so far), how do economies begin to grow again? Quite simply, it will take another leap up in economic productivity, with those remaining in the labor force generating even more per capita. Additional productivity through more efficient capital allocation and better alignment of worker skill sets and required tasks will have to come about in order for substantive real GDP growth to resume.
What does this mean for asset markets in the future? While any seven-year cycle may be able to deliver tactical opportunities among the different asset classes, structural bull markets in most asset classes likely will not assert themselves until after deleveraging and deflation run their course. This creates a difficult environment for investors to bridge the gap between their goals and what opportunities are available. It is not enough for us to point out these concerns looking forward. Rather, it is our job to be vigilant and creative in finding these opportunities, despite the challenges created by global secular headwinds.