Investing in a slow-growth world
In the coming decades, the labour force in many of the world’s largest economies will stagnate or shrink, severely hampering economic growth. Demographics are already a net detractor in Europe and Japan and demographic inputs now contribute just 0.2% to US economic growth. Even China is approaching this demographic turning point.
Labour productivity will therefore become crucial for economic growth, yet productivity gains have been slowing since the industrial revolution. There is an ongoing debate about whether productivity will slow further in the future as a result of factors such as ageing, climate change and resource constraints, or accelerate on the back of technological advances.
In the absence of faster productivity growth we face a bleak picture of significantly lower structural growth, or even persistent recession in many developed countries. Intuitively, lower growth would appear to be negative for equity markets – corporate profits should and do grow roughly in-line with the economy over time. However, there is no clear link between historic GDP growth and stock market returns.
This is because investor returns are driven not by overall corporate profits but by growth in share values. Contrary to popular belief, earnings per share have historically not grown in-line with GDP, primarily because growth is not something that happens to companies, it is generated by companies, and requires capital investment. Companies fund investment by issuing equity or debt, or by retaining profits rather than paying them out in dividends – all of which reduce total shareholder return. Buybacks, new and unlisted companies, and M&A activity also drive a wedge between profits and shareholder returns.
The corollary is that, in a lower-growth world, companies should reduce investment and instead buy back stock and raise dividends (as the last few years bear out). Overall market capitalisation may grow more slowly, but individual investors will do no better or worse than in the past. As counter-intuitive as it may seem, in an efficient market, total shareholder returns should stay the same as profit growth slows.
That said, we do not believe markets are efficient, and there are three ways we would expect lower growth to translate into lower equity returns. First, investors could be caught out by lower growth, meaning shares are incorrectly priced and de-rate more dramatically when growth disappoints. Second, it may take time for companies to adapt to a lower growth environment – if they continue to invest based on historic growth rates, cash returns to shareholders will be insufficient to compensate for slower growth, putting downward pressure on equity returns.
We would expect both of these scenarios to play out as companies and investors adjust to the new environment. This creates a real opportunity for active managers to add value by correctly anticipating the transition to lower growth – refusing to overpay for companies where unrealistic growth expectations are priced-in, and identifying companies with the appropriate capital allocation strategies. It is also possible to generate above-average returns by finding stocks where growth can be maintained or accelerate but where the stock is underpriced because the market expects growth to slow. Especially for rapidly-growing companies, analysts tend to assume an aggressive deceleration beyond their forecast period.
Third, lower GDP growth will probably lead to lower real interest rates because of reduced demand for capital. Because equity returns are a function of the risk-free rate and the risk premium, equity returns will also fall. This suggests not just a temporary adjustment but structurally lower real returns, though the excess return versus cash and bonds will remain unchanged.
It is also important to consider the direct impact of an ageing population, which will arguably put downward pressure on stock markets because individuals accumulate savings during their prime earnings years and run down their financial assets in retirement.
We are sceptical of this argument, primarily because the empirical evidence for ‘life cycle’ behaviour is mixed at best. For example, retirees run down assets much later and slower than theory would dictate, to leave assets to their children and because of potential health or long-term care costs. One academic study found that using actual survey data rather than theoretical behaviour generated a doubling, versus a halving, of real stock prices by 2050.
A related argument is that de-risking by pension funds and tighter regulation will drive a shift into bonds. Some de-risking has already happened and may well continue, but this shift could be undermined by the fact that many plans are severely underfunded and reliant on a high rate of return to manage longevity risk.
It is also important to take a global perspective: worldwide, the proportion of prime savers in the overall population will grow rapidly until 2030. Furthermore, equity allocation tends to increase with income and financial sophistication. Therefore, as emerging market households increase their equity allocation (which is currently as low as 10% but over 40% in the US and over 30% in developed Asia), this should provide a tailwind for all equities, given the globalisation of financial markets.
So, while we broadly agree that demographics will contribute to structurally lower GDP growth in the developed world, we do not believe this necessarily implies lower equity returns, at least relative to other asset classes.
In fact, there is potential to generate significant alpha by identifying mispriced growth, and demographic analysis can provide investors with a powerful framework to find these opportunities. As demographic variables are slow moving they are easier to predict. Furthermore, despite their value, demographic trends tend to be neglected by investors focusing on the next year of earnings, giving an edge to those that can understand and exploit them.