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The stagnation threat

The stagnation threat
July 25, 2014
The stagnation threat

Such concerns have been popularised by former US Treasury Secretary Larry Summers who has suggested that the west is doomed to "secular stagnation". A rise in savings by companies - even innovative ones such as Apple have been stock-piling cash - and weak capital spending, he said, have caused the natural rate of interest to become negative, with the result that even super-loose monetary policy isn't sufficient to generate strong growth. His fears have been supported by Robert Gordon at Northwestern University, who says a lack of technical progress is holding back growth.

Such pessimism is not simply a legacy of the financial crisis. Nine years ago, then Fed chairman Ben Bernanke warned that the west has "a dearth of investment opportunities". And contrary to the popular belief that the recession was payback for a previous boom, the UK economy was slowing down even before the crisis. Giles Wilkes, a former special advisor at the Department for Business, Innovation and Skills, points out that growth in UK consumer spending was actually below average in 2006 and 2007, because income growth was slowing. He says: "as for the years running up to 2007, for many these were tough times".

There's a simple reason for this slowdown - companies slowed down their spending. Usually in booms, companies borrow to invest; their capital spending exceeds their retained profits. For example, in the late 80s boom companies' investment was equivalent to 150 per cent of their retained profits. At the peak of the tech boom, it was 112 per cent. But in 2007 companies invested only 80 per cent of their retained profits. This decline in capital spending relative to savings drove down real interest rates. Yields on longer-term index-linked gilts had been over 3 per cent in the mid-90s, but were under 1 per cent at the end of 2007.

There was, therefore, a trend towards stagnation even before the crisis. Many, though, fear the crisis has exacerbated this trend. "The recent recessions have had dire effects on economies' productive capacity," says Laurence Ball of Johns Hopkins University. He's corroborated research by IMF economists, which has found that recoveries from financial crises tend to be slower than recoveries from ordinary recessions.

You might object here: doesn't our strong recovery show that all this is just out-dated doom-mongering?

No. For one thing, short periods of decent growth are quite consistent with low trend growth; believers in secular stagnation don't say that economic cycles have disappeared. Put it this way. Since 1946, the standard deviation of annual UK GDP growth has been just over two percentage points. This implies that even if trend growth has fallen to 1 per cent - half its post-war average - we would expect one year in six to post 3 per cent growth or better. And, of course, we'd expect such years to bunch together.

Reasons to be nervous

What's more, there are at least three reasons to doubt the sustainability of this recovery.

One is that labour productivity is falling. GDP per worker is lower now that it was at the start of 2010 even though GDP itself is 5 per cent higher. This is odd - even the Bank of England says it's a puzzle - because you would usually expect rising output to be accompanied by rising output per worker. This could slow down growth because falling productivity means higher unit wage costs, which in turn mean either higher inflation and hence higher interest rates or a squeeze on profit margins and hence a disincentive to invest.

Productivity growth and real equity returns 1880 to 2013

Second, the recovery is being financed by borrowing from abroad. In the last six months, the current account deficit has been over 5 per cent of GDP - close to a record. This might not be sustainable.

Third, those economists who do expect a strong upturn believe it will be led by a rise in capital spending. The Bank of England, for example, expects this to rise by 42 per cent between 2013 and 2016. However, previous investment booms have ended in busts. Salman Arif and Charles Lee, two US economists, point out that, around the world, increased capital spending leads to more profits disappointments and slower growth.

Stagnation and shares

All this poses the question: if we have entered an era of long-term stagnation or near-stagnation, what would it mean for equities?

You might think the answer's obvious: lower economic growth should mean lower growth in dividends, and expectations of this are clearly bad for shares.

It's not so simple. Stagnation also means low long-term real interest rates which should in theory be good for shares. Yes, future dividends will be lower. But thanks to lower interest rates, we should discount them less heavily. Net, the impact on share prices should cancel out.

What's more, basic economic theory, and common sense, tell us that equities should outperform cash and gilts simply because they are riskier and so should earn a risk premium. In this sense, stagnation means low returns on all assets. That's not a case for changing one's asset allocation, but for being prepared for low returns on assets generally.

In fact, things might not even be this bad. Some shares might even benefit from stagnation, in three different ways.

Non-financial companies investment as a percentage of retained profits

First, the lack of investment opportunities means that companies have paid off debt and built up cash; in the last six years non-financial companies have reduced bank debt by 22.6 per cent and increased cash holdings by 21.4 per cent. This reduction in gearing means companies - on average - are safer now and less likely to get into financial trouble in the next downturn. This should mean the risk premium on shares now is lower - which means prices should be sustainably higher.

Second, a lack of technical progress can actually benefit larger quoted companies. Technical change is a process of creative destruction; although it allows the creation of new companies, it destroys old ones that cannot adapt. "Major technical change," says Boyan Jovanovic at New York University "destroys old firms." Less technical change therefore means incumbents face less danger of becoming obsolete.

Third, a lack of real growth opportunities plus low interest rates and high cash balances are the perfect recipe for more takeovers. If companies can't grow organically, they'll look to buy growth by taking over those companies that are innovating; this has been the case in pharmaceuticals for some time. The prospect of such takeovers could put a bid premium into the prices of the minority of companies that are innovating.

If all this sounds encouraging, it shouldn't. There's also some bad news in secular stagnation.

One problem is that if trend growth is lower but volatility is unchanged, then there is a greater risk of recessions, and of deeper recessions. Worse still, there's less that policy-makers can do to alleviate them. If short-term rates are normally around 2.5 per cent - as Bank of England governor Mark Carney has suggested - then interest rates can only be cut by 2.5 percentage points in an emergency. But this might not be enough to pull the economy out of recession. If governments are loath to use counter-cyclical fiscal policy, the result will be deeper downturns. This danger should require equities to carry a higher risk premium.

A further problem is simply that slow growth is usually accompanied by weaker investors' sentiment. Stock market bubbles are most likely if investors can tell themselves stories of how new technologies will transform the economy - such as radio and electricity in the 1920s or IT in the 1990s. In a stagnant economy without exciting technologies, such big - if transitory - returns are unlikely.

On balance, history tells us that stagnation is more likely to be bad for equities than good. Looking at 10-year periods shows that there has been a moderately positive correlation between real equity returns and labour productivity growth since the 19th century. Strong growth in the 1920s, 80s and 90s was accompanied by good equity returns, while productivity slowdowns in the 1910s and 2000s saw weaker returns.

Cause for optimism

So, what might pull us out of stagnation? Normally, pundits at this stage of the story suggest some policy measures that will raise growth. Doing so overestimates the ability of governments to affect long-term growth. John Landon Lane of Rutgers University and Peter Robertson at the University of New South Wales have shown that, over long periods, developed economies tend to grow at similar rates, despite different cultures, policies and institutions. This suggests that national governments' policies might not have much impact upon long-term growth.

Nor is it certain that a new wave of scientific discoveries will trigger a faster expansion, contrary to what George Osborne claimed recently. Companies don't invest simply because new technologies are available. They do so if they expect to make money. And the link between technical change and profits is weak. Yale University's William Nordhaus has found that "only a minuscule fraction" of the benefits of technical progress have been captured by companies; most were competed away and so benefited customers instead. If companies believe this fate will befall future innovations, they won't invest in them. In fact, one reason why economies have stagnated recently might be precisely because companies have learned that investment in some new technologies doesn't pay.

Instead, there are two other reasons why secular stagnation might end. Christopher Gunn at Carleton University in Ottawa provides one. "Changes in expectations cause changes in productivity," he says. This is because if a manager wants to raise productivity, he needs to do a lot of work in reorganising workplaces, training staff or introducing new technology. He will only want to take on all this hassle if he's confident that rising demand will make such investments pay off. Increases in business confidence should therefore eventually lead to rises in productivity. With CBI surveys showing that business optimism has indeed increased recently, this points to productivity rising soon. And rising productivity should allow for sustainable economic growth.

A second reason has been proposed by Erik Brynjolfsson and Andrew McAfee in their recent book, The Second Machine Age. They point out that it can take decades for scientific breakthroughs to fully affect productivity. For example, electricity was first introduced into US factories in the 1890s, but productivity growth didn't accelerate until the 1920s. This, they say, was because electric motors at first merely replaced steam ones. It was only when managers accustomed to the steam era retired, to be replaced by younger ones familiar with electricity's potential, that factories were reorganised to take advantage of electricity. There is, they say, an "eerily close" parallel between the electricity age and the digital one; we have yet to reap the full benefits of the innovations in IT of years ago. What looks like stagnation might therefore be just a lull before a new phase of growth.

We can't therefore be sure whether stagnation will persist.

For investors, this has a simple but dull implication - that there's something to be said for holding cash even at low interest rates. This is because if we are condemned to stagnation then cash will protect us from wobbles in equities, while if we are not then it will protect us from a sell-off in bonds while we benefit from rising interest rates.

BOX: PREPARING FOR STAGNATION

■ Expect low returns on all assets: cash, bonds and equities. This means that if you're preparing for retirement you should be prepared to work longer, save more, or reduce your idea of how much you'll spend in retirement.

■ Beware of companies in debt. In a stagnant economy, revenues might not rise sufficiently for companies to grow their way out of trouble.

■ Hold cash and bonds, as a hedge against equities being hurt by growth disappointments, or by the next recession.

■ Prefer big, secure defensive stocks, and companies that don't rely upon growth to justify their valuations.

■ Expect the small minority of stocks that can generate growth to do very well, by virtue of their scarcity. Spotting such stocks, however, is very difficult.