Investing in a Low-Growth World
This quarter I will review any new data that has come out on the topic of likely lower GDP growth. Then I will consider any investment implications that might come with lower GDP growth: counter intuitively, we find that investment returns are likely to be more or less unchanged – a little lower only if lower growth brings with it less instability, hence less risk. Finally I will take a look at the reaction to last quarter’s letter, specifically about my outlook for lower GDP growth.
Recent Inputs on a Low-Growth Outlook Some information came out after the 4Q 2012 Letter or was missed by us and is worth mentioning. First, the Congressional Budget Office slashed its estimate of the U.S. long-term growth trend from 3.0% to 1.9%! Given the source and the magnitude of the adjustment, I think it is fair to say that their number is “close enough for government work” to our 1.5%. At least it is within negotiating distance. Next, a report from Chris Brightman of Research Affiliates actually came out a week before ours and concluded that long-term GDP was 1.0%, a number that really corresponds to our 1.5% because his report has no reference to our two special factors, resources and climate, which take our 1.5% to 0.9%. I was encouraged by the solidness of his research. It also led me to an article in the Financial Analysts Journal (January-February 2012) by Rob Arnott and Denis Chaves. Rob has been writing about the effects of age cohorts on investment returns for almost as long as I can remember, with the central idea that older people are sellers of assets – houses as well as stocks – that younger members of the workforce buy. But they also include the aging effect on GDP growth, which he shows taking a real hit in all developed countries (except Ireland). They are commendably careful in suggesting that their model may be wrong. When or if you read this article, you will certainly hope that it is indeed wrong, for their models estimate from past experience a far greater drop in GDP growth than our work assumed last quarter. And they certainly attacked that aspect in far greater detail than we did. We had included in our report the effect of aging on the total percentage of the population of working age: there are simply fewer workers and more retirees in the distribution. But Rob and Denis (sorry for the liberty) introduce the incremental idea, apparently provable, that older workers lose productivity, no doubt much more in heavy manual work than, say, in writing this. But definitely alas, including all activities with dire consequences, they argue for productivity and GDP growth.HT: naked capitalism
Would Lower GDP Growth Necessarily Lower Stock Returns?
This is where I break ranks with many pessimists because I believe theory and practice strongly indicate that lower GDP growth does not directly affect stock returns or corporate profitability. (At least not in a major way for, as we shall see later, there may be some indirect or secondary effects that may very modestly lower equity returns.)
All corporate growth has to funnel through return on equity. The problem with growth companies and growth countries is that they so often outrun the capital with which to grow and must raise more capital. Investors grow rich not on higher margins. In fact, it is slightly the reverse.
For there to be a stable equilibrium, assets, including entire corporations in the stock market, must sell at replacement cost. If they were to sell below that, no one would invest and instead would merely buy assets in the marketplace cheaper than they could build themselves until shortages developed and prices rose, eventually back to replacement cost, at which price a corporation would make a fair return on a new investment, etc.
The history of market returns completely supports this replacement cost view. The fact that growth companies historically have underperformed the market – probably because too much was expected of them and because they were more appealing to clients – was not accepted for decades, but by about the mid-1990s the historical data in favor of “value” stocks began to overwhelm the earlier logically appealing idea that growth should win out. It was clear that “value” or low growth stocks had won for the prior 50 years at least. This was unfortunate because the market’s faulty intuition had made it very easy for value managers or contrarians to outperform. Ah, the good old days! But now the same faulty intuition applies to fast-growing countries. How appealing an assumption it is that they should beat the slow pokes. But it just ain’t so. And we at GMO have (somewhat reluctantly for competitive reasons) been talking about it for a few years. Exhibit 1, shown by us before, shows the moderately negative correlation between GDP growth by country along with their market returns. This is shown for the last 30 years only and for developed countries only, but in earlier work (which can be found on our website1) we went back a hundred years for some developed countries and looked at emerging country equity markets as well and all had the same negative correlations....MUCH MORE (14 page PDF)
