Outlook 2017: What could challenge markets in 2017?

We have a two- to three-year investment horizon, which we believe helps reveal attractive investment opportunities by accounting for both cyclical and structural market drivers.

Given this investment horizon we form a central economic thesis which summarizes the path we believe the global economy will follow over the next two to three years. This economic outlook does not drive the selection of our investment ideas, but is one of the tests for each idea before it is approved for the portfolio – we must believe that each idea has the potential to generate a positive return against our two- to three-year view of the world.

One of our intentions in choosing this time horizon is to avoid the tendency by some market observers and participants to focus on short-term noise. However, we are acutely conscious of the fact that our central economic thesis could be wrong and that short-term noise can cause major market volatility. That is why scenario testing is embedded into our portfolio management process. This is when we look at a range of possible, if not probable scenarios, and test the portfolio against them.

These scenarios tend to be extreme, yet feasible scenarios that we feel have a probability of occurring in the following 12 months, however low that probability may be. This helps us identify what risks we are taking within the portfolio and hopefully provides us with the information we need to make the portfolio more robust in the face of potential market events.

In this post, I’ll provide an insight into some of the structural issues or challenges that currently face the global economy and that are important considerations when constructing our portfolios. Some of these issues will underpin either the central economic thesis or the scenarios discussed above which we use to test the portfolio. The issues we discuss are productivity, the velocity of money (or lack of), the debt burden, especially in regard to China, the vulnerability of the euro currency union and the potential for a cyclical downturn in the U.S.

Productivity

Eight years after the global financial crisis, the world is still in a low-growth environment that looks set to continue despite the ongoing pace of technological change and the ongoing provision of money. One factor used to explain this weak growth environment is that global productivity has been on a declining trend since the late 1980s – measured using either the number of hours worked or all factors of production.

Germany has seen productivity growth fall from 4.5% in the 1970s to 2% in 2000 and 1% today. Japan has seen productivity slip from 5.2% in the 1970s to 2% in 2000 and to 1% today, while the U.S. has seen productivity fall from 2.1% to 2% to below 1% over the same time period.¹

The trend has long been a puzzle for economists, especially when set alongside greater globalization, automation and the rise of new technology. Globalization and automation have continued at a strong pace over the last 40 years and the received knowledge was that these should encourage ever-higher productivity. This can be seen in that durables (manufacturing) productivity is much higher than non-durables. However, is there a base effect meaning that the impact of these forces has diminished, leading productivity back to a lower, long-term trend?’

The impressive growth of the financials sector is also a consideration. In the U.S. alone, as a share of GDP, the financial services sector more than doubled in the three decades leading up to 2010.² However, it only acts as an intermediary, so its contribution to productivity is highly questionable.

It could be said that this financial sector growth has been spurred by the maintenance of the corporate and governmental debt overhang, which could in itself be another factor reducing productivity. For example, in any normalization of interest rates, the need to service this debt becomes a priority. Any rise in the cost of capital could logically reduce the capital-to-labour ratio and hence productivity.

However, the big concern is that even as interest rates have been coming down, productivity has continued to fall, which points to the misuse of capital due to badly incentivized banks, meaning that too-low rates could be more directly responsible for this fall in productivity or, in other words, an ineffective use of debt.

It can also be argued that some of the new technologies that have become dominant, such as e-mail and social media, actually impede productivity rather than enhance it.

Regardless of the explanation for this weakening trend in productivity, it looks unlikely to reverse and, coupled with weaker demographic trends, continued slow GDP growth seems a realistic prospect.

Debt

The global response to the Global Financial Crisis (GFC) time has been to increase debt further. From US$142 trillion in 2007 (across household, government, corporate and financial), McKinsey & Company measured this at US$199 trillion by mid-2014 and it was still rising.

China is a key focus in this conversation, given its recent debt expansion stands out since 2000 and its now significant role in driving global markets. Its private sector debt now amounts to 220% of GDP and the median Chinese company has cash flows lower than its interest payments. However, identifying when high debt levels become excessive and need to be corrected is very difficult.

Being optimistic, it is possible that China can grow out of its debt problems, even with slowing real growth, a reasonable pace of nominal GDP growth is likely to be maintained (circa 6.5% currently). In addition, the current account surplus means that a measured decline in the currency is possible, as long as capital flight is kept under control. Furthermore, China’s capital stock, at just one tenth of the U.S. level per person, is still low even after investment as a percentage of GDP was 48% in 2011. This implies that investment led growth is still a valid proposition and could carry on increasing – but most logically, this would require more debt financing.

However, there are some concerns. Shadow banking in China is growing aggressively. For example, wealth management products that feel like deposits to the customers are actually funding for corporate lending. Increasingly, these are used to repay existing debt and interest, which appears a poor use of capital. Also, companies have low cash flow relative to interest payments – so investment has likely been inefficient and there is considerable default risk if either debt costs rise or their cash flow dries up.

The Chinese government has also recently indicated that it is willing to tackle some of their state-owned zombie companies (i.e., those requiring state bailouts) with a few illustrations of debt-to-equity swaps being instigated. Some forecasts suggest that the banking system might need to write off around 20% of GDP in non-performing loans. While it is difficult to know what approach the Chinese government will take, this potential credit deterioration could have significant negative consequences both domestically and internationally.

Velocity of money

Another underlying concern is that the money created as a result of quantitative easing seems to have had little feed-through to the financing of productive, healthy investment spending. Indicative of this, the velocity of money has declined sharply in recent years, not risen, as it did from the late 1930s onwards.³

Rising velocity is normally a good thing as it is a useful measure of the efficiency of new money supply (i.e. new debt). So, the inevitable question is, have interventions following the global financial crisis contributed to the malaise by allowing capital to be misallocated? John Greenwood, Invesco Ltd.’s Chief Economist, has been a strong critic of Japanese and European central bank policies of quantitative easing (QE). These governments have bought assets from banks, who then place the cash on deposit with their respective central banks. This does not increase the velocity of money, unlike the U.K. and U.S. QE programs which do so by backing non-bank players who then re-invest cash.

The impact of this is twofold: Firstly it could continue to underpin the low-growth world in which we find ourselves. Secondly given that the extensive QE programs to-date have not necessarily found their way into all economic sectors, further unusual policy measures may have to be employed, or the onus may move back on politicians to underpin the next stimulus package for economies.

Euro currency union

Concerns about Europe have been re-ignited by the Brexit vote and, beyond the political issues, we see a number of continuing concerns for the eurozone.

One of these is the imbalances in the European Central Bank’s TARGET2 system, which is the cross border payment system that involves the national central banks and the European Central Bank. With Germany’s claims on other eurozone countries increasing once again, mirroring behaviour from 2011 and 2012, this may signal that the relative competitiveness of the peripheral countries is diminishing – hence a slow withdrawal and transfer to Germany. Concerns are that Portugal, Greece and Spain have increasingly limited opportunities to grow out of their large private sector debts, raising the prospect of defaults.

This comes at a time when peripheral European government bond spreads are around the lowest levels since before the global financial crisis, suggesting the market has all but forgotten the ongoing issues for these vulnerable peripheral eurozone countries. For example, yields on Spanish and Italian 10-year notes are around only 1% higher than German bunds.⁴

U.S. cyclical concerns

Another concern is the U.S. economic recovery. Here a number of factors point to the potential onset of a recession. In aggregate, the U.S. consumer still appears to be in relatively good health. However, one risk is that consumer strength is being underpinned by credit growth, which is arguably unsustainable if economic growth does not pick up. Typically, a strong consumer would be accompanied by wage growth but here the news is also relatively disappointing. The average weekly number of hours worked by individuals in the U.S. has been falling on a year-on-year basis for most of this year and the general move in the revisions of the payroll numbers has been downward. Furthermore, rent versus wage growth has been rising steadily suggesting the consumer could come under some pressure if wages do not start to catch up with other day-to-day costs. Any pick up in wage inflation is typically underpinned by a strong corporate sector but with tax receipts on the decline and profits weakening, a red flag is potentially emerging for the strength of the consumer as we move into 2017.

While the above do not form our central outlook, they provide plenty of food for thought and help us in the construction of our portfolio, feeding into the scenarios we create to test the strategy against. Clearly, there are more optimistic outcomes out there, but in a strategy where risk management forms the basis of our portfolio construction, it is crucial to examine both the downside and the upside. This is a key element of building a robust portfolio that has the potential to withstand market shocks.