Growth dynamics have changed a bit and are in between times…

Historical equity returns reflect past growth dynamics, dynamics which may be either weaker or in transition, or both – indeed, dynamics in mature economies are weaker, and combined global dynamics are in transition.  Return expectations need to be cognisant of these structural drivers of return.

The main drivers of growth are well known: a) population growth and employment participation rates, b) capital investment and c) increases in total factor productivity, or rather efficiency gains from the combination of a and b.

At the present moment in time we have historically weak investment growth in developed economies, high levels of unemployment and weakening participation rates, but most importantly high debt levels constraining final demand and structural imbalances globally between high consumption/low saving and low consumption/high investment economic blocks.  

Take out debt and structural imbalances, and the underlying growth dynamics, given the potential within emerging markets and high levels of unemployment, are most likely still robust, but are dominated by significant short term structural headwinds/imbalances.  

Add to the mix considerable uncertainty in Europe, and the potential for a large shock to the global economy, and we have a) a low prospective growth rate at the upper bound, for possibly the next say 10 years, as debt and structural imbalances work themselves out, and b) a significant risk of deterioration in output and demand as a lower bound in the event of potential economic shocks. 

Merely extrapolating past returns based on higher growth eras in key economies is dangerous.

The post war growth spurt of the 1950s and 1960s (US data  is exemplified) was followed by a slower period of real growth, higher inflation and commodity price shocks from the late 1960s to the early 1980s, with a resurgence in the late 1990s.  The following chart (source data BEA) shows annual geometric real US GDP growth based on 5 year and 10 year rolling periods.    

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Labour and total factor productivity growth peaked in the US in the 1950s and 1960s and slowed down significantly in the 70s, 80s and early 90s: productivity growth recovered in the late 1990s/early 2000s, although there is some disagreement over the precise value of the revival in productivity.  

Productivity Impacts of Offshoring and Outsourcing: A Review: Over the second half of the 1990s, the United States experienced a strong economic expansion and an increase in productivity growth. There is little dispute that this was primarily driven by large IT investments facilitated by falling hardware prices, and the transformation of economic activities that these investments brought.

WHERE DID THE PRODUCTIVITY GROWTH GO? INFLATION DYNAMICS AND THE DISTRIBUTION OF INCOME  Ian Dew-Becker
Robert J. Gordon:

The post-1995 productivity growth revival did not automatically signal good news for the majority of American workers and households. Indeed, to the extent that the productivity growth “explosion” of 2001-2004 was achieved by cost-cutting, layoffs, and abnormally low employment growth (as suggested in Gordon, 2003), then the historical link between productivity growth and higher living standards falls apart. Not only have the bottom 90 percent of American workers failed to keep up with productivity growth, many have been harmed by it.

The following chart is drawn from BLS labour productivity data and shows annual geometric increases in productivity over rolling 5 and 10 year periods – recently overall productivity growth has weakened. 

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While productivity growth should not be directly impacted by increases/decreases in unit labour costs (the BLS define productivity as total output/divided by total man hours worked), there is clearly an intuitive inverse relationship with growth in unit labour costs:  this may mean that offshoring to lower labour cost areas provides a more effective and profitable avenue for the introduction of new capital investment and new manufacturing techniques, thereby enhancing productivity.   However, this separation of production from consumption, which had become an increasing feature of the global landscape in the current decade, and hence debt from revenue generation and remuneration could be a risk to final demand going forward, and hence growth in GDP in both the PCE dominated economies and Gross Fixed Capital Investment dominated economies..

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The improvement in productivity in the latter part of the 90s and early part of the 2000s has been ascribed to service sector process improvements, technology (especially semi conductor component cost reductions) and offshore production, with much research suggesting little of the financial returns going to labour itself: this is an important and necessary feedback from productivity to consumption and to saving/investment.

Just as GDP growth has been declining, so has income growth in the world’s major developed economy: note the following chart showing the steady decline in the real growth of per capita personal disposable income since the 50s and 60s.

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Weak income growth, combined with high levels of debt, is not going to be a driver of returns going forward.

Population growth and civilian labour force growth were also key factors in growth in the 50s and 60s, and less so in later decades: according to US Census Bureau figures, US population growth declined from 19% in the 10 years to 1959, to 14% in the 10 years to 1969 and to 9.7% in the 10 years to 1989.  

Note the strong growth in the civilian labour force in the US in the 1960s and 1970s and low unemployment rates relative to the current point in time.

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Growth in civilian labour force, low unemployment, and strong real GDP growth, in the 1960s, also coincided with a high point in the share of wages and salaries as a % of GDP/national income, which has since fallen back to levels last seen shortly after the war:

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If much of the post 1995 recovery in productivity and profitability is tied into the strong expansion of world trade post 2000, then future growth is dependent on increasing the consumption of global goods and services in these economies – increases in productivity are meant to drive returns to labour, but this critical link may be severed in a global economy where high PCE component economies rely on debt to fund expenditure growth and where high gross fixed capital investment economies are overly reliant on high PCE component economies for growth – excessive global imbalances between PCE and Gross Fixed Capital Investment may harm the natural rhythm of productivity growth. 

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The next growth cycle will be dependent on economies like China and Germany consuming more and more globally produced goods and services, but even here nominal GDP growth may be constrained by world population growth and a slowdown in the rate of capital accumulation.  We are also in transition, one in which productivity growth in the new and the old is likely to be constrained by the significant structural imbalances that have developed.

In other words, if you are relying on return expectations for investment planning and, in particular, asset and liability management, then select expected rates of return that are at the lower end of the boundaries and that accommodate the risks of the present.

Useful references 

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