What comes next? Craig explores anticipated characteristics of the new global economy and ways governments might stimulate growth, concluding with a few themes for investors to consider
What were low interest rates supposed to achieve?
In normal conditions, central banks lower interest rates to encourage more investment and/or spending. Either stimulates the economy. But this is not alchemy; it does not create demand. It merely encourages companies to invest today what they would have invested tomorrow, and encourages consumers to borrow more to spend today – but as it has to be paid back, that also comes from tomorrow’s spending.
So lower interest rates, including ultra low interest rates and the other extreme monetary policy measures such as Quantitative Easing (QE) applied recently, are all designed to bring forward demand – not create demand. That means any extra demand created today will have to be paid back through lower demand, and therefore lower economic growth in the future.
Why didn’t it work?
Given extraordinarily low interest rates and the unprecedented period of time that they have been held below their equilibrium levels, demand should have been stronger. Total global debt has grown from US$142 trillion to US$240 trillion since 2007. But demand is still not strong by historic standards, and that is finally leading governments and central banks to ask why.
Firstly, we actually don’t know whether it worked or not and we never will. Demand might have been even lower were it not for these low interest rate policies. However we can now confidently say that if they were effective, they have lost much of that effectiveness. Any spending that was going to be encouraged forward by lower rates has now happened.
But the underlying reasons are more relevant to us as investors. The reality is that certain socioeconomic trends had started to work against global growth as far back as the 1990s. Birth rates around the world have fallen dramatically since the 1960s – the average number of births per 1,000 people was 35 in 1965, and is now 19 in 2016. Japan’s birth rate has fallen from 20 to 7 since the 1970s, sliding first on socioeconomic trends relating to age and higher female participation rates in the workforce, but then sliding a further 40% as their 20 year stagnation period rolled on.
The other major trend has to do with wealth distribution. While global wealth was being distributed more evenly between countries, within developed economies such as the US, it was only the top 1% and the bottom 25% of the population that were experiencing any increase in wealth. The bottom 25% saw incomes rising through higher social security and lower tax rates, but that part of the population does very little for economic growth. The top 1% are getting wealthier because of the investment opportunities created by emerging markets (see below) and the new technology revolution. But these opportunities were reducing the demand for labour in developed economies, which in turn reduced middle class wealth.
Here is the central point of this note – An economy needs middle class wealth to increase in order to grow.
The top 1% do not create economic growth, nor do the bottom 25%. A broad based increase in incomes is the only way that an economy can grow in real terms over any meaningful (10yrs+) period. With slowing population growth and jobs being replaced by emerging markets or technology, this has not been possible for the developed world for at least 20 years.
Emerging markets tailwind has become a headwind
We didn’t feel the effects of these socioeconomic trends in the 1990s or 2000s. However, the wealth effect of China and other emerging markets creating cheaper goods, and then investing to grow their economic capacity, created a once off economic boom that had a natural life.
That natural life ended around 2007 to 2009, but economic stimulus applied in China dragged it out a few more years. Now we are paying the price for this artificially created demand as China exports deflation to the rest of the world. The longer that China continues to stimulate manufacturing using loose credit (debt), the longer the payback period for the rest of the world via export price weakness and therefore lower income growth.
So without the tailwind of the investment boom in emerging markets, we now face the full impact of the weakening demand that stems from socioeconomic, largely demographic, trends worldwide.
So what comes next?
In the next 5 to 10 years, we keep muddling through. The reason we are muddling rather than applying the medicine needed is that economists don’t know what medicine is needed. Unlike the human body, economies have a nasty habit of evolving every hundred years or so and the cycle is shortening. While that is happening, the real question for investors, such as the issues that create or destroy wealth over the next generation, relate to how the world economy evolves in the face of slower growth.
The new world economy will be shaped by:
- Backlash against globalisation. Globalisation is good for poorer economies with the infrastructure to produce and export goods and services as they can take advantage of their lower wages to compete with wealthier economies. No matter what the circumstances, it will cost jobs in wealthier economies. It isn’t one for one, but there is no question that jobs are lost. The eventual result is social backlash – unrest amongst youth finding themselves unable to get a job for years; voter backlash against the politicians seen to be reasonable; and migration as families move to countries that are better managing the transition such as the US, UK and Australia.
- Political radicalisation. A consequence of middle class underemployment, opportunistic political players will, and have, emerged. Trump is only one example; Europe is full of anti trade, anti immigration, anti EU political movements.
- Banking system stressed further. Social movements looking for someone to blame for their falling real incomes – and the residual anti banks sentiment created by the GFC, likely to be extended by inevitable bailouts of some European banks – could result in more pressure being put on the banking system. Bank profitability has been stressed by low interest rates and tighter regulations so further political pressure, as seen in Australia and the US for example, will only stress bank profitability and balance sheets further. There is a point beyond which this becomes a major risk for global economic health.
- Search for taxes by governments. As demand drops and social security promises become unaffordable, governments will search for new taxes. The so called “Apple Tax” movement across the world is an early example of this.
- Shifting working patterns. Technology now enables more people to work remotely, to run their own business and work their own hours. As this has coincided with economic displacement for so many people, there has already been a major shift in this direction. More flexible work patterns will mean lower average working hours but more people in work, a trend already apparent in the US, UK and Australia. For the more mobile parts of the population that can work as much as they want or need to, there are clear benefits of this. For those without the skills in demand in the modern economy, this is just another threat to their incomes, fuelling the unrest in the first three points above.
What else could be done?
As mentioned above, economists don’t have a cure because this is unchartered territory. Population growth combined with severely stretched balance sheets globally mean that new sources of stimulus are hard to find. The best answers I’ve seen so far relate either to infrastructure or how one economy can gain an advantage over the other:
- Infrastructure spending creates demand rather than stealing it from the future or from the neighbours. Infrastructure includes transport, social (health and education), technology and economic infrastructure. The theory goes that if transport infrastructure reduces waste, such as time in traffic, productivity goes up, which means income goes up, and also people have got more time to spend, so demand goes up. Similarly, less people out of the economy due to poor health and less money spent on recovery due to more invested on good health upfront, means more aggregate demand. Infrastructure isn’t a magic pudding – it converts “wastage” into demand and brings it into the economy. It is far from the perfect solution; infrastructure spending can, and often is, used as a political tool to sway swing seats rather than apply it where the economy will benefit most. But, it is better than cheap interest rates or many other government driven stimulus initiatives aka “pink batts”.
- Support for long term productive parts of the economy. Flexible work arrangements, cheaper access to technology and a shift to a global service economy will encourage more entrepreneurial activity. Small business creation creates employment; always has. So support for small business, whether they are “start ups” or just old school small business (whatever the difference might be) tends to be more positive than other government spending programs. But increased activity in small business tends to take away from big business and/or other economies rather than add to global demand overall. Good for the economy in question; positive for investors exposed to that economy; but not as much of a global solution as infrastructure.
Conclusion
Normally we would conclude with the “so what” for readers, so you can action the themes discussed. This article is more in response to questions from our clients.
There are some strategies that can be followed in response to the above. The first of these is looking for ways to profit from more infrastructure spending, should global governments finally listen to the logic of spending more on infrastructure. Construction, engineering, and similar service providers should benefit, obviously depending on their management’s ability to access projects.
The second is to accept the inevitability of low interest rates. If governments don’t spend more on infrastructure, it is hard to see where demand improvements are going to come from, so rates will remain low while the economy continues transitioning to lower growth resulting from lower population growth. If they do increase spending, already stretched balance sheets will be even more stretched; ensuring interest rates are held lower for longer.
The third is to keep one step ahead in identifying which countries are doing a better job at transitioning to the new world economy. Economies supporting entrepreneurial activity will win over those slow to adapt. So far the US, China and the UK are winning this battle over Europe and Japan. Australia is saying the right things, but so far doing little, so the jury is out.