Commentary – Quarterly bulletin, December 2013

What happened to trickledown economics?

31 December 2013

As we enter 2014 there is increasing optimism that global growth is rising but the reality is that the 5-year moving average of global nominal GDP growth is at the lowest rate since the 1930’s. As well as the weakness from a debt-laden developed world, the emerging world has continued to slow after credit inspired booms at the turn of the last decade morphed into busts. The reaction of the last 5 years has been to keep the cost of the debt as low as possible and engineer recoveries through aggressive money printing. The positive from this exercise has been a wealth effect created by asset price appreciation, the negative is the absence of money supply growth which is typically associated with aggressive money creation.

Despite the growing number of central bankers committing to the merits of QE the influence has been felt primarily through asset prices not the real economy. The missing ingredient since the financial crisis remains the lack of nominal growth for the global economy. Indeed it is a measure of how highly prized that growth is that the US stockmarket capitalisation is 125% of gross national income (exceeded only twice in the last 85 years –unhelpfully 2000 and 2007). Many assets have been inflated by the QE process as all assets appear cheap versus a zero return in the bank. However the gap between nominal growth and profitability cannot persist for eternity. Real wage growth has been persistently negative for years and the impact is becoming tangible. In the UK, the standing joke is the speed at which discount supermarkets are springing up in traditionally conservative middle-class rural England.

As we enter 2014 we face another year where escape velocity is being muted for the global economy and indeed a positive inventory cycle is possible given that the aggregate demand picture is less bad globally. However the assumption that a secular growth trend will emerge remains a great source of debate. The reality of the 2000’s is that we witnessed a credit bubble in the truest sense and levered the growth that we did have. It is no accident that a commodity boom co-incided so perfectly with co-ordinated global growth and that we have been unwinding that boom since then. A quote that still resonates from the midst of the financial crisis is that “the America housing boom saw us sell the last house to the poorest person”.

The weight of evidence also suggests that recoveries from financial crisis are far more protracted than from traditional recessions due to the excessive debt in the system. In this instance we have also continued to add to the debt pile. The numbers are stark. In 2002, G7 total debt amounted to $80 Trillion. At the end of 2012 this had grown to $142 Trillion (Source Deutsche Bank). Indeed given that the growth in debt has been in the hands of governments for the last few years it is they that have the most to gain from higher levels of nominal GDP. This issue is very topical currently and is at the centre of the debate in Davos. There the debate centres on income inequality but this is two sides of the same coin. Current wealth creation in the form of asset price appreciation benefits the few in practice and has had a limited multiplier effect in the wider economy. Apart from the obvious observation that this is inherently unfair, it misses the point that sharing the spoils would benefit the broader economy – trickledown economics in the truest sense. The lack of a multiplier effect also explains the absence of inflation. The ability to supply goods has barely skipped a heartbeat while aggregate demand has been incremental slower.

So as we stand today global authorities have undertaken the most extreme form of monetary easing ever witnessed yet growth has failed to respond as anticipated. Banks and corporates have hoarded cash and debt-laden consumers remain in a quandary. We suspect that the authorities will continue to aspire to the nirvana of previous economic growth rates. Expect to see even more radical steps in the free money bonanza until they realise that fundamental supply side reforms remain the only viable option. Japan is the final chance to prove the efficacy of the monetary only solution.

In terms of our reaction to these events we are looking to capture the effects of a belief that we are reaching escape velocity for the global economy or failing that the likely beneficiaries of further monetary innovations. Gold was deeply unloved in 2013 but remains the likely beneficiary of the inflationary implications of stronger growth or alternatively further stimulus and has been added to portfolios. Emerging markets have also fallen out of favour as global growth has remained relatively muted and offer decent relative value. They would be equal beneficiaries of any perceived or real reflation trade. We are also working hard to identify managers that realise that the expensively priced high-quality growth trade will eventually give way to a deep-value cyclical trade regardless of how we arrive there. The best is past for yield for the sake of yield but this does not preclude us from focusing upon managers that favour dividend growers. Finally, regardless of how we travel the road will be bumpy. As such portfolio protection will remain uppermost in our thoughts.

— Peter Toogood

Peter is the Investment Director at City Financial

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