Stuck in 2nd Gear

What happens when one variable that countless textbooks hold to be true, turns out to be wrong? It can render entire theories obsolete. In economics and finance there is a variable that is always assumed a constant, and it effects everything from corporate mergers & acquisitions to your retirement account. That variable is growth. GDP growth, dividend growth, revenue growth, organic growth, subscriber growth, productivity growth, sustainable growth, growth, growth, growth. It might be the most used word in business. Well, what if growth didn’t really….grow….anymore? It’s a topic we’ve been discussing within the walls of FMPWA and it’s a very real possibility in the future. Not that there won’t be any growth in the future, but the possibility that growth rates as we know them will cease to exist. It could change how companies implement forecasts, how central banks set policy, and how we look at investing.

The accompanying chart shows annual economic growth in the United States over the past 50 years displayed as a 20 year moving average. What we can see is a descending line as the growth rate decelerates toward 2% annually, less than half of where it stood in 1969. A chart of China’s GDP would look similar, though perhaps even more dramatic as Chinese GDP has slowed to 6.5% annually after hovering in the 12% - 14% range just over a decade ago. One of the main drivers of this trend is population growth, or lack thereof. If you were to graph the global GDP growth rate overlaid by the global population growth rate, the descending lines would be strikingly similar. The concept of peak population or peak population growth might be a topic deserving of its own article, but I will touch on it here. The world population growth rate peaked in 1963 at 2.2% and has been declining ever since. The world’s absolute population is still climbing because of momentum from large birth rate increases that occurred in developing countries in the 1950’s and 1960’s, but fertility rates are falling all over the world. The birthrate needed to maintain the current population in the U.S. is 2.1 children per woman during her lifetime. The birthrate is now at 1.9 in the U.S. and falling. As developing countries transition toward developed nations, many factors, including increased education, lower infant mortality rates, urbanization, expanding rights, increasing job opportunities for women, environmental awareness, and increased access to family planning services all contribute to falling birth rates. Projections show the population growth rate heading toward zero by 2050 and perhaps negative after that. That implies that we will reach a point in the next century where the world’s population will peak and then begin to decline. The economic implications of this are many, not the least of which is how we will view growth in the future.

Given the current economic and demographic backdrop, it’s hard not to wonder about the possibility of an extended period of deflation. Deflation occurs when the inflation rate falls below 0%, increasing the value of currency over time. It allows one to buy more goods and services than before with the same amount of currency. This creates several problems. First, when people expect that prices will be lower in the future, they spend less today. If you’re thinking of buying a new car and expect the price will be a lot lower six months from now, why not wait? This creates high supply and low demand situations (oversupply). Second, deflation raises the inflation-adjusted interest rate, which increases the cost of borrowing and can depress business investment and consumer spending on big ticket items like cars, appliances and houses that are purchased with credit. As consumption and investment spending fall, aggregate demand declines, and that causes prices to fall even further. The result is even more deflation, less consumption and spending, further decreases in prices, and eventually the economy descends into what is known as a debt-deflation spiral. The third problem with deflation is that wages and prices are generally inelastic. That is, they don’t adjust as quickly as needed to keep supply and demand balanced. Wages tend to be particularly inelastic in the downward direction. So when prices are falling but wages aren’t, it increases the inflation-adjusted cost of labor, and that leads to unemployment. The rise in unemployment leads to less spending, and that causes prices to fall further. Once again, the economy can enter a deflationary spiral. Finally, it’s important to note that outright deflation isn’t required for these problems to occur. Disinflation -- when inflation rates are above zero but declining -- can also be problematic. Central bankers have an aversion to inflation, but what they really should fear is deflation. Evidence from the Great Recession, when prices fell by around 25 percent, and from the “lost decade quarter century” in Japan suggests it can lead to big problems for an economy.

What does all of this mean for investors? Several years ago I wrote a piece titled “(Not So) Great Expectations” arguing that investor expectations for returns going forward should be adjusted downward from the historical rates we so often see used in projections. It is imperative to realize that the returns from the decade just ended are unlikely to be repeated. Over the 10 years from April 1, 2009 to March 31, 2019, the S&P 500 cumulative return with dividends reinvested was +350%, good for an annualized return of 16.3% over that time. Those are video game numbers folks. Each year Northern Trust publishes their Capital Market Assumptions which detail their expectations for investment returns over the next five years. Northern’s most recent report forecasts a return of 6.2% for global equities and a 2.7% return for global bonds over the next five years. That results in a forecasted return for a global balanced portfolio (60% equity/40% bond) of 4.8%. Estimates from MFS Investment Services expect a return of 4.3% for a similar portfolio, and Vanguard’s estimates come in at 4.3% as well. Research Affiliates has a nifty tool on their website called Asset Allocation Interactive. It allows you to create a portfolio made up of foreign and domestic stocks, corporate and government bonds, TIPS, commodities, real estate, private equity, hedge funds and cash. You can manipulate the allocation of these asset classes in 1,000 different ways and it’s next to impossible to come up with a diversified portfolio that has an expected 10 year return that is greater than 5%. If all of the elements converge to create a deflationary spiral, the economy and, yes, the markets may indeed become stuck in 2nd gear for some time. Rest assured we at FMPWA are discussing this possibility and working to provide solutions that will allow you to meet your financial goals in any economic landscape.

Travis McEowen,
Portfolio Manager
First Merchants Private Wealth Advisors

First Merchants Private Wealth Advisors products are not FDIC insured, are not deposits of First Merchants Bank, are not guaranteed by any federal government agency, and may lose value. Investments are not guaranteed by First Merchants Bank and are not insured by any government agency. This material has been prepared solely for informational purposes. First Merchants shall not be liable for any errors or delays in the data or information, or for any actions taken in reliance thereon. Any views or opinions in this message are solely those of the author and do not necessarily represent those of the organization.