- Slower global growth will have a much stronger impact on corporate earnings than interest rate increases.
- US productivity is declining and GDP growth is based on increased consumption amidst cheap financing.
- Corporate earnings are the source of your investment returns, and the picture is not one of growth.
Amid all the fuss around interest rates, Yellen, jobs, Clinton and Trump there is one piece of information that is very significant for investors but is often disregarded.
The World Bank has revised its 2016 global growth forecast down to 2.4 percent from the 2.9 percent pace projected in January. The cut comes mostly due to sluggish growth in emerging markets, weaker growth in developed economies, stubbornly low commodity prices and lackluster global trade and capital flows. A faster growth rate is expected only in 2018 and it’s still not spectacular as it will be only 3%.
There are more downside risks coming from the limited use of monetary policies at this point as rates are already close to zero, worsening conditions among key commodity exporters and softer than expected activity in advanced economies. On the upside, hope lies in structural reforms as space for fiscal and monetary policies is narrow.
This article is going have a look at what the World Bank says about US growth in order to get a FED-independent opinion and to discuss how slower global growth affects a portfolio, the economy and corporate earnings.
The World Bank’s Look at the US Economy
This a different analysis than the FED’s as it looks from a structural perspective and has no political goal attached to it.
Softer than expected activity since January has led to downward revisions of growth projections. Low oil prices led to a collapse in capital expenditures, while a strong US dollar and weakening demand from emerging markets contributed to stalling exports. The current growth is mostly a result of higher disposable income due to lower commodity pricing and cheap financing that increase consumption.
Figure 1: Non-financial investments in the US are down. Source: World Bank.
In relation to labor, the trend is one of declining productivity amidst low corporate investments and most of the growth comes from services which do not contribute to sustainable GDP growth as much manufacturing does.
Figure 2: Consumption is the biggest driver of GDP growth. Source: World Bank.
The World Bank revised its US GDP growth forecast from 2.7% to 1.9% due to rising external risks and the inability of monetary policies to reach their set targets. In the longer term it forecasts US GDP growth at around 2% as investment growth remains modest, demographic pressures are intensifying, and a significant turnaround in productivity growth is unlikely in the short-term.
An interesting thing which is not commented on but is of great importance is that the US economy has reached its natural rate of unemployment which means that further employment or growth will come with increased costs. That should spur inflation which would leave the FED no choice on interest rate increases, no matter the state of the economy.
Figure 3: US labor force. Source: World Bank.
To sum up the situation in the US we can say it is fragile. The FED is not increasing interest rates as is knows that it would hurt the economy. Such a long period of quantitative easing and low interest rates should have had a much stronger influence on the economy, so the missed targets have the FED navigating in uncharted territory.
From an economic perspective, productivity is the main contributor to long term growth and it has not been increasing. Typically in the US, productivity has grown by an average of 2.2% since World War II, but has been growing at only 0.5% in the last 5 years and even fell by 0.6% in the second quarter of 2016.
The global economy still hasn’t reached the growth rates from before the Great Recession.
Figure 4: Global GDP growth rate. Source: Trading Economics.
The global economy typically was growing at levels around 4%, which would fall to 2% under the influence of a global shock like the 1970 oil crisis. Currently there is no shock in the global economy and central banks are stimulating the economy as never before. Any shock would therefore soon resend global growth into negative territory as we saw in 2009. A risk to keep in mind.
Impact on Corporate Earnings
As about 50% of S&P 500 corporate revenues come from abroad, global GDP growth is essential for earnings. The US is reaching full employment any growth potential will be subdued by increased hiring costs, and abroad growth is subdued by lower growth rates as countries like Russia and Brazil are still in a recession and China is slowing down.
Figure 5: S&P 500 corporate earnings. Source: Charts.
There is a high probability that corporate earnings are going to continue on their declining trend as companies are investing less and less while wage expenses are increasing and demand from abroad is weakening due to a strong dollar.
The above described structural trends bring to a conclusion that more investing activity than just buying the S&P 500 is required in order to reach satisfactory returns. As productivity decreases and global growth decreases, companies dependent on exports or with larger parts of their revenue coming from abroad should become underweight in a portfolio. Also companies that base their business model on services should have more difficulties in keeping their margins as the economy has reached natural unemployment level and wages are bound to go up.
As the economy still looks fragile, it is also opportune to look for companies that can withstand shocks, like a potential inflation shock coming from prolonged low interest rates or an interest expenses shock coming from inevitable future FED rate increases.