As savers and investors, most of us oncern ourselves with the short-term. And these days, the short-term concerns have been keeping us quite busy.
The impact of Britain’s momentous decision to leave the European Union, the testy US Presidential elections, major central banks’ seemingly incessant policy manoeuvres to forestall an economic hard landing come to mind. Yet, in order to successfully invest in a rapidly changing world, it is perhaps equally important to understand the longer-term forces that are likely to impact future investment returns.
The four big long-term structural drivers of investment returns are economic growth, interest rates, inflation and corporate profits. These factors are inter-related. Two other trends also play a fundamental role: geopolitical risk and technological innovation. We believe examining these forces in more detail could help us make a more informed decision on how to allocate our capital for sustainable returns.
Over the last 50 years, economic expansion worldwide has been fuelled in equal measure by a fast growth in global population and productivity growth. A growing share of working age people, initially the “baby-boomers” in the US, Europe and Japan, passed the baton to young workers in the emerging markets from the 1990s onwards. Meanwhile, productivity was propelled by shift from agriculture to manufacturing and services, automation and process efficiency, facilitated in the past couple of decades by rapid globalisation.
As a result, global economic growth averaged around 3.6 percent since the 1970s.
However, the demographic and other drivers of growth appear to have reversed since the Global Financial Crisis. Population in the developed economies have been aging for the past few decades, although this was partly replenished by younger migrants from other parts of the world. In recent years, the working age population in China, which accounts for a fifth of the world’s population, has also started to decline. Meanwhile, global productivity growth rates have fallen sharply over the past five years, compared with the first decade of the new millennium.
These changes have contributed to a significant deceleration in global growth to around 3 percent since the crisis. Pointedly, the outperformance of emerging markets over developed economies has narrowed in recent years as China’s economy slows and commodity-driven economies undergo a sharp downturn.
Although working age population is rising fast in South Asia, the Middle East and Africa, this may not be sufficient to revive global growth unless productivity rises significantly in these markets and elsewhere. This re-emphasizes the need for greater public investment into the key drivers of productivity growth - education, technological innovation, infrastructure and urbanisation and more, not less, globalisation. As productivity rises, so will income and consumption.
The world’s main challenge today is reviving demand. This is daunting in a world of growing economic disparity where increasing share of income is going to higher-income households. Since high-income earners are less likely to spend and more likely to save, global consumption slows down. And because business investment follows consumption, there is less demand for capital and more savings looking for investment opportunities. And thus we fall into the vicious cycle of lower growth, higher saving and lower investment.
What are the potential implications for investors?
For one, interest rates, the primary source of return for savers and income-seeking investors and a key driver of asset values, are likely to remain depressed for longer as too much savings chase too few investment opportunities. The excessively high debt levels across the developed and some emerging markets since the financial crisis and tighter regulation, which have forced businesses and the financial sector to deleverage, is adding to the downward pressure on interest rates. Moreover, central bank policies, which have pushed benchmark rates to historically low levels, remain a key driver of low rates.
As benchmark rates on government bonds stay depressed, yield premiums on corporate debt too are likely to remain low, especially for higher grade bonds. This, in turn, is pushing investors to accept riskier grades of bonds.
Equity market returns too are likely to be suppressed in a world of low growth and subdued interest rates. This is because long-term equity returns are driven by growth in corporate profits as well as the premium on those expected profits investors are willing to pay. Over the longer term, earnings growth is highly correlated with economic growth. Also, investors are normally unwilling to pay higher premiums for expected corporate earnings when they are not so sure about future economic prospects.
Low return, high risk
Thus, whether we lend (through bonds) or invest (through equities) we should expect lower returns in the foreseeable future. Today, those seeking a return equivalent to what a bank deposit would have generated a decade ago will have to invest in a diversified basket of income generating assets such as investment grade corporate bonds, higher-risk/high-yielding debt, alternative assets such as real estate investment trusts and stable dividend-paying equities.
For an investor, the need to accept greater risks for generating the same amount of returns does not end here. Many prognosticators believe the world faces growing geopolitical risks as a unipolar led by the US (the so-called Pax Americana) fades away, to be replaced by a multi-polar world, with new regional powers. History shows a multi-polar world is likely to face a greater risk of conflicts.
Globalisation too could come under threat in a multi-polar world as barriers rise against trade, flow of people, capital and technology. The rise of protectionist parties and agendas across Europe and the US is a warning sign. The Brexit vote in the UK is only the latest manifestation of this evolving trend. A continuation of this trend could roll-back decades of hard work in fostering global trade and investments, which has lifted billions of people out of poverty and has boosted prosperity through increased productivity.
One must emphasize that these are not foregone conclusions. The world is still debating these trends and their implications. But, as investors, we will need to watch closely how they unfold. There are many factors which have the potential to reverse these developments.
For instance, increased spending by the rising middle class in the developing world, or even dis-saving by the growing number of people retiring from the workforce in the developed world, could be a potent driver of growth going forward.
While household debt continues to rise worldwide (eg. the surge in auto and student loans in the US), there is significant scope for millions of households in emerging Asia and other developing economies to increase borrowing. This could be a key driver of consumption. Disruptive technologies are another trump card which have the power to boost productivity, find innovative solutions to global problems and generate immense wealth.
And of course, the trillions of dollars in investment which are required to build modern infrastructure in the emerging markets and to replace aging facilities in the developed world have the potential to drive growth for decades to come.
Hence, as an investor, while the present environment of heightened risk warrants a balanced and diversified allocation to an array of income generating assets, one needs to be alert to the longer-term growth opportunities and capitalise on them as they arise. Adaptability and agility will be key ingredients of an investor’s success.
(Alexis Calla is Global Head of Investment Advisory and Strategy at Standard Chartered’s Wealth Management unit.)