A slower growth environment

- from information supplied by GSJBWere Asset Management


It is now apparent that markets were expecting  a depression scenario at the turn of the year. However the measures taken by governments and evidence that the global economy is stabilising has been enough to drive the markets upwards. Equity markets have, since March 2009, risen in excess of 50%  and credit markets trading with the highest spreads this century have attracted investors’ capital.

Those who were convinced of slower global growth and a disappointing recovery missed the rally. The point appears to have been that markets had fallen to such an extent that the shape and drivers of the recovery were irrelevant; the mere presence of stability was enough to entice risk capital back into markets that were trading at historically low valuation levels.

With the extreme valuations now corrected, it is now more important to understand what is driving the global economy. Many of the drivers of global growth are unlikely to be as prevalent moving forward as they have been in the last two decades.

For instance, the world’s largest customer, the US consumer, has seen their wealth fall markedly through the rapid depreciation in US housing prices and the pullback in equity markets. Consumption patterns, previously suppported by rising wealth, are likely to be pared back, resulting in more subdued US economic growth going forward.

Furthermore, governments globally have had to rapidly increase their spending to compensate for weaker demand. As a result, they are now saddled with increased debt which will result in more strict policies and potentially higher taxes in the future. All these factors add up to a conservative outlook for risky assets and a case for changing the traditional growth/defensives asset mix.

GSJBWere analysts looked through historical data and found that it is not quite as conclusive. hey looked at the rate of economic growth in the United States over the past 60 years and the real equity returns that were associated with each era. They were able to identify four separate eras, characterised by different economic growth, employment cycles and inflation environments.

• The post-war era, 1948-1961, was characterised by regular boom/bust cycles and a trend of rising unemployment. Economic growth was average but volatility was high.
• The years of 1961-1972 leading up to the oil shock was a prosperous period of strong economic growth and falling unemployment. Worker productivity grew strongly and led to a newly flourishing middle class.
• 1972-1985. The 1970s and 1980s contrasted strongly with the oil shocks introducing stagflation and restrictively high interest rates. Economic growth was volatile and elevated inflation became entrenched. Central bank policies that were used to tame inflation lead in the most recent era.
• 1985-2006. The US economy ‘flat-lined’ at moderate, stable economic growth rates with only infrequent dips in 1992 and 2001 into the recessionary periods. These stable and predictable economic conditions, labeled ‘the great moderation’, would typically be associated with strong returns to equities, given the environment combined decent economic growth and low variability in demand.

Despite contrasting economic characteristics of each of these periods, they found that the return from asset markets is not well-explained by either the average economic growth rate or indeed the cyclicality of demand through each of the eras. Real equity returns were highest in the period of greatest economic cyclicality (1948-1961) and were below average in the period of highest economic growth (1961-1972).

Similarly, unemployment rates and government debt have not led to predictable economic scenarios. Whilst it has been many years since the US economy has had an unemployment rate as high as today or government debt over 100% of GDP, US economic history records show that it has had both. The US economy exited the 1982 recession with an unemployment rate of 10.8% and entered the postwar period with high levels of outstanding debt. In both cases it is difficult to see any association with these legacy issues and the future performance of markets.

The strongest conclusion the analysts could make from looking at historical data is that asset markets perform poorly during periods of volatile and elevated inflation.

The analysts then tried an alternative way of looking at the relationship between economic growth and equity markets by dividing the 60-year period into five-year blocks and looking at the relationship between growth and equity market returns. The five-year periods were chosen to align investment periods with the minimum investment horizon that investors should have when setting up an investment portfolio. This showed that the relationship is not particularly tight. Equity markets tend to deliver stronger returns in more rapid periods of economic growth and vice versa. Whilst the relationship exists, it is both weaker than most forecasters would typically suggest, and it is less categorical than one would want it to be in order to justify making a radical change to portfolios. After all, the US equity market has delivered both a poor -10% p.a. and an acceptable +8% p.a. five-year return during periods when growth has averaged a below trend of 2.5% p.a.

Given that ‘known’ economic growth predicts less than 40% of the variability in equity market returns, it is very difficult to argue that investors should make strategic portfolio allocations any differently today based on a view that global growth may be slower in the future. Tactical allocation is a different matter. Historically, strong returns have been generated using tactical timing around the business cycle, provided asset allocation is pre-emptive rather than reactive.