Mind the productivity gap
Structural changes across the global economy are having unexpected consequences for the economy's recovery
We have now seen nearly eight consecutive years of growth since the end of the ‘great’ recession. When the process of recovery began, we suggested that growth for the foreseeable future would be much duller than had been recorded during the 15 years prior to the recession, but it would be safer. To date, that seems to have been true. What we did not foresee, however, was that job creation would be as strong as it has been in the countries that have topped the growth league, or that productivity growth would be so weak. So, the next challenge facing advanced economies is how to encourage stronger productivity growth.
The weakness in productivity has had meaningful consequences. In particular, it is necessarily reflected in weak real wage growth. As a result, there has been a growing feeling in advanced economies that working people are not sharing in the benefits of growth. The benefits of growth are more apparent in the sharp declines in unemployment in countries such as the US, Germany and the UK. This feeling that working people are not experiencing the income growth that might have been anticipated has had effects not just on the economic arena but also in election results on both sides of the Atlantic – the rise in votes going to anti-establishment politicians and parties.
Over the past 40 years, there have been many economic cycles, each with its own characteristics. What is becoming more evident in the current cycle is the distinct lack of cyclicality in most advanced economies. This has led to problems for the economics profession, which is paid to analyse and anticipate developments in the economic cycle. As a result, most current economic commentaries attempt to superimpose cyclical analysis on a world that is more beholden to longer-term structural trends such as the disruption from technology, demographics and globalisation.
That is not to say that all economies are showing the same pace of growth – but the differences are proving more nuanced. In the UK, slower real income growth and Brexit uncertainty have caused a modest loss of momentum, although not to the extent that was initially predicted. The US has gained momentum during 2017, although not to the extent some anticipated at the start of the year. Meanwhile, the eurozone, having lagged the rest of the developed world, has seen a notable improvement during 2017 and looks set to record the best annual gain in GDP since 2010 – but still only just over 2%. Japan, also, looks set to beat forecasts, while lagging in the growth rankings for advanced economies.
Unsurprisingly, the structural trends alluded to previously, have been reflected in subdued inflationary pressure across the world, although there are still cyclical influences that can see inflation pick-up. In the UK, post-referendum weakness in the pound and a recovery in commodity prices have put upward pressure on prices. The continuing low wage inflation in the UK, US and Germany, where labour markets have tightened to a degree that would normally lead to higher labour costs, with labour demand remaining strong, and employment rates at high levels, remains a conundrum. Why this is not feeding through more directly to wages is not immediately obvious. In Germany and the UK, migration may have had an influence as would greater participation in the US labour force by those who dropped out during the recession. Even so, wage inflation should have become a more obvious problem by now!
Low wage inflation has taken pressure off policymakers. The tone of global policy debate seems, however, to have changed, particularly in the US, where a gentle process of normalising interest rates is under way. Whereas in the past, the US Federal Reserve (The Fed) had been looking for excuses not to raise interest rates, it now appears that rates will edge higher unless there are conspicuous reasons not to. In the UK, it is expected that rates will start rising by the end of this year, and in the eurozone, the ECB is expected to tone down the extent of its quantitative easing over the coming year. The approach is still softly-softly, but there does appear to have been a mood change.
We believe that by maintaining a near-zero interest rate policy over a prolonged period, central banks have inhibited productivity growth. By forcing down the risk-free rate, central banks have taken away the challenge to grow profits at a rate faster than GDP growth.
If we are correct in our views about the impact of low interest rates on productivity, then rising rates should be associated with stronger output per person, first in the US and then elsewhere. This will prove the next and potentially more exciting chapter of the recovery and normalisation story. If productivity growth does not respond, however, even the current dull growth rates will prove impossible to sustain.It is important to also consider valuation, sentiment and risk when building your portfolios, as economics alone will not provide the answer!
There are very few equity markets that can currently be described as cheap on traditional long-term measures such as price/earnings or price/book, although the strong earnings growth we are currently seeing gives an element of comfort. Bond markets are not offering compellingly attractive returns at current yields, especially when inflation is taken into account.
It is always a concern when sentiment and consensus is as unanimous as it is today, with commentators and investors both universally positive on equities and negative on government bonds. This ‘chorus of consensus’ does temper our enthusiasm for being overweight in equities – our positioning is more neutral. We do, however, concur with the negative view on bonds, where we maintain our long-held underweight position.
There are a number of potential risks that could upset the current calm and low volatility in investment markets; the biggest risk currently would be an unexpected downturn in developed economies, something that we watch for very closely. There is a risk as central banks try to ‘normalise’ monetary policy through higher interest rates and reversing quantitative easing, that asset markets are adversely impacted, but the respective central banks have been working very hard to communicate clearly the measures well in advance of implementation. Closer to home, a disorderly and hard Brexit would have an impact on all UK asset prices in the short term, as would a Corbyn government, and we watch very closely the level of foreign currency exposure in portfolios.
Overall, we remain comfortable with our positioning given the supportive environment of dull but synchronised global growth and subdued inflation, but are vigilant for the risks we have identified.
Chief Investment Officer
Caspar Rock joined Cazenove Capital in September 2016 and is Chief Investment Officer. He joined from Architas Multi-Manager Ltd, a part of the AXA group, where he was Chief Investment Officer and responsible for all aspects of the investment activities, including investment philosophy, process and team. He also oversaw portfolio management at two of AXA group’s private banks. He previously headed up the multi-manager business at AXA Framlington from 2006 to 2008. Prior to that, he managed a range of directly invested equity and bond portfolios, and was Head of European Equities at Framlington as well as a member of the Healthcare team. He has 33 years’ investment experience.
Richard Jeffrey was Chief Economist at Cazenove Capital until he retired in January 2018.
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All data contained within this document is sourced from Cazenove Capital unless otherwise stated.