By David Stubbs
Determining the mix of productivity, pricing, and pain across economies and sectors will define the absolute and relative returns across financial markets for investors
The Federal Reserve’s “pivot” – transitioning from hiking rates nine times between 2015 and 2018, to cutting rates three times in 2019 – was the defining driver of markets last year. Along with the European Central Bank’s commitment to maintain its policy settings until its goals are achieved, 2019 represented a final acceptance of a “new normal” for the economy.
As central banks shifted their focus from normalising monetary policy towards easing policy, risk assets rallied accordingly.
This world of low inflation, sluggish productivity growth and strong labour markets has defined the recent years of the post-crisis expansion. As durable as this combination has proved, there are some signs we will eventually transition into a different economic environment. A different pivot, the economic one, is coming.
The key lies in margins. Corporate profits as a share of GDP, a proxy for economy-wide profit margins, rose as we remerged from the crisis, but have been contracting since 2012 in the United States and are following a similar trend in the Eurozone. Pressure has come amid high unit labour cost growth, as compensation expenses have exceeded tepid productivity growth year after year.
Despite being weakened by the forces of globalisation and declining unionisation, it seems labour markets are now tight enough for workers to secure wage increases.
In our competitive world rampant with disruption and price discovery, firms have resisted raising prices for fear of losing market share.
Instead, they’ve been forced to take a hit on margins. But margins can’t go down forever. They will eventually decline to the point where one of three outcomes will likely unfold and the cycle will move into a new phase, where companies either: defend their margins by raising their productivity; look to achieve the same result by finding a way to raise prices (sparking faster inflation); or they will be forced to fold and industries will undergo significant restructuring.
Productivity, prices or pain: which route will we take and what does it mean for investors?
First, a look at the scenario of better pricing. A rise in inflation in most of the developed world would, initially, be a good thing. Most central banks have consistently undershot their inflation targets in recent years. Equity valuations tend to be highest when inflation is close to 2 percent.
In this sense, an initial rise in inflation would be a signal of healthy economic demand, likely positive for equities and only modestly damaging to fixed income. However, a more dramatic breakout in which core inflation exceeds 3 percent would likely be a messy outcome for markets.
However, most analysts view that outcome as highly unlikely, for now. The powerful structural deflationary forces dominating our world, such as high debt levels, aging demographics, technological disruption will require much to be overcome.
Even if cyclical economic tightness was to overwhelm such deflationary forces, it would likely be a slow, gradual process that would struggle to take hold.
The second route is through faster productivity growth – firms would protect margins by doing more with less. Productivity growth started slowing before the crisis as key technologies like personal computers reached a saturation point, and the crisis itself made matters worse. There are signs this is on the cusp of changing. Business investment has actually been very strong in areas that matter most for services-led economies: software and IT.
Since 2012, that category of private sector capex (capital expenditure) has risen 58 percent in the US and 46 percent in the Eurozone – much faster than other capex categories which have risen 39 percent and 26 percent, respectively.
As new technologies infiltrate the mainstream economy, we could see a boost in productivity, which could help drive corporate earnings and keep inflation contained. Equities, particularly technology suppliers, stand to benefit from this build out.
Last, if prices can’t be raised, some firms will likely succumb to falling margins and go out of business. Whilst some creative destruction is a consistent feature of a capitalist system, this would be an undesirable outcome in the short-term.
Unemployment would increase, bond and loan defaults would rise, and sentiment be hurt. In an extreme scenario, a recession could unfold. Yet, if such restructuring unfolded at a manageable pace, it could actually restore economic vigour as “superstar” firms leave unproductive companies behind. A similar result could be achieved through enlarged waves of merger activity. In this type of environment, long-short active equity and debt asset managers could help identify winners and losers in this new world order.
In reality, we’ll likely walk down some combination of all three paths at the same time. As referenced above, wage inflation is creeping higher and unit labour costs are rising. Productivity growth is beginning to stir in some economies with tight labour markets. And, a glance at any high street will tell you that those sectors seeing the greatest margin and pricing pressure are seeing significant disruption.
The Fed’s pivot defined last year, and the “economic pivot” looks set to define the 2020s.