SG Kleinwort Hambros CIO Blog June 2023
It’s all been a bit much, hasn’t it? In quick succession, a pandemic, an armed conflict, and a banking crisis upended life as we know it. Demand shifted, inflation ensued, and central banks sprang into action. Financial markets, startled by the speed and magnitude of monetary withdrawal, plummeted. They had become addicted to the liquidity largesse of the past 15 years and oblivious to the fundamental driver of investment returns for the past seven decades: a golden era of economic growth.
But this party is about to stop. And it's not the pandemic, war, or banking failures shutting it down. Countless such events occurred since reliable records began some 400 years ago. More fundamentally however, two of the main drivers of economic expansion - population growth and labour productivity - are now beginning to stagnate.
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The banking failures in March raised uncomfortable memories of the great financial crisis of 2008. But lenders have failed much earlier than that. In 1672, King Charles II effectively defaulted on debts racked up over years of waging war in France. The dire economic consequences of the resulting collapse of goldsmith bankers led to the founding of the Bank of England to support the management of public finances going forward.
In the 350 years since, the United Kingdom never defaulted on its debt again. Meanwhile, inflation has been more erratic and interest rates were higher than today, but the empire prospered: economic growth not only nurtured private wealth, but significantly improved the standard of living of the general population. Life expectancy rose steadily, child mortality dropped, and the public enjoyed the spoils of an increasingly global economy.
Economic growth in England remained erratic throughout most of the 17th and 18th century. Sustainable growth only took hold in the early 1800s. Ostensibly, a rising empire utilised the immense technological progress of the industrial revolution. Upon closer inspection though, the pace of expansion hinged on two main factors that not only outlasted the empire but indeed accelerated following its demise: population growth and labour productivity. Now, both are beginning to slow.
In a modern economy, a growing population is invaluable. Rising consumption leads to higher income and, ultimately, enhanced economic growth. The implications for financial markets, too, are stark: a paper by the Federal Reserve shows population growth and the related distribution between young and old explains over 60% of the movement in the long-run trends in the equity market.
In the early 1800s, the average woman of childbearing age would give birth to five children in her lifetime, although life expectancy was still around 40 years. By 1960, the fertility rate had fallen but was offset by a significant increase in life expectancy. England’s population grew without precedent, propelled by an interplay of expansive post-WW2 government policies and geopolitical stability. In the near future however, for the first time in recorded human history, the global population is likely to peak. Dramatically improved standards of living pushed life expectancy past 80 years, but progress is naturally diminishing. At the same time, fertility is falling below the crucial replacement rate of 2.1 children per woman in developed countries. Why this is happening is beyond the scope of this essay, but rests on a complex confluence of multi-generational shifts in societal norms regarding work, contraception, and the real and perceived costs of children.
China’s population seems to have already reached its high point. Estimates for the timing and magnitude of the global population peak vary, but researchers largely agree that it will happen in this century.
To offset the effects of a smaller labour pool, resources must be used more efficiently. Indeed, the acceleration of technological advance over the past few hundred years has truly been colossal, especially in the latter half of the 20th century. The invention of the steam engine and the light bulb were roughly 100 years apart; generations of workers would retire in broadly the same technological paradigm in which they first took up their trade. In comparison, the seven decades following the development of the first computer in the 1950s saw the invention of the space shuttle, internet, smart phones, and, lately, artificial intelligence.
Of course, technology is not the only factor to productivity growth. Consider a tailor: using a needle and thread, they used to produce two shirts an hour. Adding a sewing machine, their output rose to ten. With additional training and process optimisation, they soon produced twelve shirts an hour. Improve order management and logistics, supply chain and financing, and their output would climb to 14 shirts; but eventually the marginal gain of those improvements will dwindle.
After decades of soaring productivity, we are beginning to see this stagnation on a global scale. In developed economies, processes are sophisticated; supply chains optimised. Future technological innovation is naturally unfathomable - imagine explaining the merits of even the humble spreadsheet software to an office worker of the 1950s - and the rise of artificial intelligence may ring in a new era of productivity gains. Nonetheless, in developed economies, a return to the advances of old is unlikely.
In the wake of the financial crisis of 2008, investment returns became detached from real economic growth. Asset prices were driven by an unprecedented rise in money supply, artificially masking the lack of fundamentals. The emerging paradigm – a return to less remarkable growth and money supply - does not signal the end of prosperity, innovation, or wealth creation. However, for investors it will become more challenging to identify value and capitalise on it, and we must remain agile to adapt to the new, low-growth environment. In this context it will be crucial to:
Challenge assumptions: Economic growth has been anything but normal over the past seven decades. Indeed, its drivers and impact on asset returns will almost certainly change over the next seven. We cannot rely solely on our experience of the recent past and must keep adapting our assumptions in the future.
Think quality: The era of cheap money “lifted all financial boats” and rewarded passive investment strategies. As liquidity drains from the system, it becomes even more critical to assess how investment opportunities will fare in the new environment.
Think global: Growth can arise from the most unexpected places. The nexus of population growth and productivity is the new holy grail. We may be entering the Chinese century – or the Indian, African, or South Asian one. It will pay to be flexible and avoid unnecessary restrictions.
Successful investors endure because they constantly re-evaluate their environment, challenge their assumptions and adapt their processes. Flexibility will be key, and active management more important than ever.