The new economy
It’s a new era for equity investing. A tumultuous couple of decades were marked by consistently low inflation, low interest rates and low earnings growth. That has all changed. Over the next two posts we’ll explore what this means for the shape of the economy over the next decade, and for portfolios.
Inflation
While the 10% inflation of the post-pandemic world was likely transitory, it will likely stay higher than it was post-global financial crisis (GFC). China has run out of workers, and geopolitical tensions coupled with the pandemic experience of long supply chains make labour arbitrage less appealing. On/nearshoring is the new path, and labour costs will be higher. The transition to low carbon energy sources has also begun. While many of these have near zero marginal cost, the upfront capital cost is large and potentially inflationary. Technology and the promise of artificial intelligence will drive productivity, but will it offset the falling number of workers?
Economic Growth
GDP=C+I+G+(X-M) is a formula representing aggregate demand. Ignore X-M (net exports); as for the world, it must sum to zero, though it is likely that trade will not outpace the world economy as it did up to the GFC. The consumer balance sheet is healthy and the cost of servicing debt manageable. Worker shortages mean wage growth should remain healthy, and consumption should develop at least in line with wages.
Investment prospects for the coming decade appear strong. When thinking about global problems, the solution seems to be capital expenditure: geopolitics/nearshoring – capex; decarbonisation – capex; worker shortages – capex; crumbling infrastructure – capex; shortage of housing – capex; war – capex (sadly). Investment should be a significant contributor to GDP growth. Who pays for all this may be an issue.
Government
Figure 1: What percentage of revenue does the UK spend on debt interest payments?
Source: PNS and LGB, as at 12 June 2023
As such, rising interest rates are likely to lead to a crisis in government bonds. There was austerity post-GFC, and judging from all the problems in health, education, social care etc the solution this time around is unlikely to be massive spending cuts. The answer must be increased taxation. But politicians need to face a crisis to change direction. Maybe Liz Truss’s 50 days in office are a precursor the world should worry about. Against that backdrop equities look pretty good.
Despite recession fears, the economic outlook for the next decade should be better than the past 13 years – possibly in real terms, and definitely in nominal terms as inflation will be higher. For equity investors that is an important change.
Equities versus bonds
Equities should trade richer to bonds than they have post-GFC. Higher nominal GDP growth implies higher sales growth for companies – and hopefully cash flows and profitability. After 13 years of no profit growth, the coming decade offers better prospects.
The average company will grow earnings, though not without headwinds – wage growth, rising interest costs, and governments potentially raising taxes. Combine this with crisis risks in government bonds and equities appear ever more appealing – although as equity investors we are biased!
Much of the shift in equity valuations relative to bonds has already occurred (Figure 2). Yes, equities look expensive relative to the post-GFC experience, but they are appropriately valued given the higher nominal GDP growth prospects.
Figure 2: ACWI versus Global BBB yield-to-worst
Source: Bloomberg, as at November 2023
So we can expect a different environment in which to invest. And one we think will be conducive to equities. How will we approach this? We’ll cover that in the next post …
