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OPINION

The stagnation threat

The stagnation threat
May 10, 2016
The stagnation threat

Although official figures next week are expected to show that industrial production rose last month, this would follow months of weakness with the result that output is not only lower than it was in the autumn, but below 2007's level. US growth "has been disappointingly weak for a number of years", says Erik Britton of Fathom Consulting.

This matters even for the most parochial UK investor simply because there has for years been a strong correlation between annual changes in US industrial production and in the All-Share index. Since 1996 the correlation has been 0.61, with each percentage point below-average output growth associated on average with equity returns being 2.2 percentage points below average.

Granted, correlation isn't wholly causality: some of the things that are bad for output are also bad for equities, such as 2008's banking collapse. But there is causality here too: lower output growth means lower profits growth and weaker investor sentiment, both of which are bad for equities.

This is worrying, because the recent weakness might persist. Chris Williamson at Markit says the strong dollar, weak global demand and uncertainty about the presidential election could continue to hold back the economy.

Behind those short-term fears, however, lies a bigger problem - the ongoing weakness of capital spending, which is causing economists to talk about secular stagnation, or permanently weak growth. The volume of private non-residential investment fell at an annualised rate of 5.9 per cent in the first quarter, its biggest quarterly drop since 2009. Although this is being blamed on energy firms cutting investment in response to low oil prices, it poses two questions: why aren't low oil prices boosting the capital spending of energy users? And why has there been a long-term fall in the share of non-residential investment in GDP? (Even before its recent fall this share was under 13 per cent of GDP compared to over 14 per cent in the mid-1980s or late 1990s.)

In fact, there are many things constraining investment and output growth, among them:

A lack of profitable investment opportunities. Back in 2005 Ben Bernanke, the chairman of the Federal Reserve, complained of a "dearth of domestic investment opportunities" in western economies. Robert Gordon at Northwestern University says this might be because technical progress has slowed down.

A fear of future competition. You might object that talk of robots and artificial intelligence refutes Professor Gordon's pessimism. It might, in fact, give us another reason for low investment. Quite simply, the fear of future competition depresses capital spending today: nobody will spend £10m on robots if they fear a rival will be able to buy better ones in a few months' time for £5m.

Falling profits. Figures from the US Federal Reserve show that the return on capital - measured by pre-tax non-financial profits as a percentage of non-financial companies' non-financial assets at historic cost - was 10.6 per cent at the end of 2015, compared with over 12 per cent in 2006.

A low price elasticity of demand. Gregory Thwaites at the LSE points out that if, for technical reasons, capital is only weakly substitutable for labour then falling capital goods prices (relative to other prices) will lead to a less than one-for-one rise in demand for investment goods. This will reduce the nominal amount that companies spend on capital equipment, and hence reduce interest rates.

These are all long-term reasons for weak investment, but they have been magnified by the effects of the 2009 recession. This has had a scarring effect: memories of the deep recession then are still depressing animal spirits. This isn't wholly irrational because at low interest rates companies face an asymmetric risk. If demand falls for any reason the Fed can't cut interest rates sufficiently to support the economy, so we could see a deep recession. But if demand recovers well, interest rates will rise. This asymmetry is a good reason for companies to be wary of expanding.

What's more, adds Mr Britton, low interest rates are encouraging inefficient firms to linger on. Competition from these hinders healthier firms from expanding, which is depressing both investment and productivity growth.

All of this suggests that the US economy has shifted to a lower rate of growth, which implies lower returns on equities. In the past five years, for example - which should have seen strong growth because of low interest rates and a low starting base - industrial production has grown by just 2.2 per cent a year, compared with 3.3 per cent a year in the 50 years to December 2007.

Things aren't entirely bleak, though. Tom Porcelli at RBC sees "some upside in the offing" for manufacturers. He points to surveys showing that orders are rising and that inventories are low - two things that usually lead to rising output.

Sadly, though, this might be only a modest upturn against a background of weak average long-term growth.