The Magnus article
I’ve been a big fan of George Magnus, an economist who consults for UBS and contributes to the Financial Times, for a long time. He was one of the first to warn that the financial crisis we are now dealing with would be far worse than the consensus thinks. Last Friday, in an article in the FT, he argues that “the current consensus about secular stagnation… (could: read will)…be wrong again.” He makes three main points:
1. generally speaking, the main forces creating economic growth are:
–growing labor force
–lowering barriers to the movement of goods and capital
–the interplay of capital investment with technological change.
2. Over the past thirty years or so, the drivers of economic expansion have been:
–increased female participation in the workforce, especially in the advanced economies of the West
–worldwide trend toward lower interest rates–causing, however, increasing financial leverage
–worldwide efforts to lower barriers to the movement of goods and capital
–technological change, including: personal computers, enterprise networking hardware and software, and the internet.
3. Assuming, as Mr. Magnus does, that the Baby Boom is tapped out as a source of growth in the labor force (and consequently in growth in spending power) and that the negative effects of excessive borrowing to fund stuff that yields no economic returns (like big houses, fancy clothes, the wars in Iraq and Afghanistan) will be with us for some time, then where will future growth come from?
–population growth in emerging markets
–dismantling barriers to agricultural trade (good luck in getting agreement here!)
–technological change, in, for example, IT, new materials, genetic engineering and nanotechnology.
As usual, I agree with almost everything that Mr. Magnus says. I recall vividly how fashionable it was in 1990 to worry that the US economy would be eclipsed by Japan (now much more heavily indebted than the US and not growing at all). At the beginning of a decade to be dominated by US computer technology, biotech and specialty retailing companies, that the country had nothing worthwhile that foreigners would want except for, perhaps, its military force. Even if so, the consensus worried, it was scarcely a foregone conclusion that US troops could handle the battle-hardened veterans commanded by Saddam Hussein. Sounds crazy now, but it was what people thought back then.
The conclusions of the Magnus article are ambiguous in an interesting way. To him, it is clear that “new growth drivers will emerge, unless we act to suppress them.” But he doesn’t say that all countries or companies will share in that growth equally. Quite the opposite.
In fact, although he doesn’t emphasize it, he seems to imply that it would be futile to look to Western Baby Boomer as a growth driver from this point on. Older Americans (and UK citizens) are more likely a spent force that will be licking housing and pension fund wounds for quite a long time.
Better education will likely accelerate the rate at which emerging economies raise themselves by their own bootstraps. But in the West as well, there are likely to be fewer chances in the coming years to just show up at the local plant after high school with good will and a strong back and expect to be hired. Unfortunately, I’m skeptical that meaningful change here will come before the need for it is driven home by the pain of an unemployment rate that’s much higher than we’ve become used to since the Seventies.
To deal with these challenges, having an intelligent and effective national government will be more important than it has been in the adult lifetime of anyone still working today.
With or without a supportive government, the US will continue to be a major participant in the world’s technological change. given that we are the epicenter of today’s economic problems, new technology and our ability to trade profitably with the rest of the world will be a greater proportion of our contribution to growth than it has been in the past.
Implications for investors
These are my thoughts:
1. Economic growth will continue to be stronger outside the developed economies than inside. This means, for all their perils, most investors should have some exposure to emerging markets. This can come through emerging markets funds/ETFs or through stocks in developed markets that have a portion–a third or half–of their business in the developing world.
2. The world has always underestimated the pragmatic willingness of Americans to adapt to new circumstances, as well as the speed at which we are able to do so. As a result, I think our stay among the growth laggards of world economies will be much shorter than most expect.
My only fear on this account is that it would help, during a time of secular change, to have a legislature able to act in the national interest. The drop in the S&P 500 from 1000 to 660 earlier this year mainly reflected, I think, the thought that Congress was desperately needed to help defuse the financial crisis, but that both sides of the aisle were populated by economic illiterates concerned mostly with using the situation to their own advantage. This perception may come back to haunt us.
3. At some point, it will be good to look away from industry leaders to the #2 or #3 firm, which will benefit unusually strongly from increasing demand. That point isn’t now. For the moment, it’s better to stick with industry leaders and with industries of the future, rather than to bet that a rising economic time will lift all boats.
4. Look away from the Baby Boom and toward the post-internet generation. Look at the companies, like AAPL or GOOG, that serve the latter’s needs, not the former’s.
5. Geographically and in mindset, San Francisco may end up being the center of the US investment universe over the next few years–not New York or Michigan.
6. Financials without emerging markets exposure continue to worry me. As investors, their fabulous performance over the past six months should make us more nervous (since they’re so much more expensive) than less.
7. About a quarter of the stocks in the S&P 500 have dividend yields of 3% or more. My guess is that in the aggregate they underperform other stocks and that is the message contained in their high yields. I haven’t analyzed these companies and am not making any stock recommendations. But, if these dividends are unlikely to be cut, these securities may end up being way better than most fixed income.
8. One of the big imponderables (for me, anyway) is how the role of the US dollar as the world’s de facto reserve currency will affect the market. I’ll spell out what I think are the most important issues in a post later this week.
Magnus’ points, especially re emerging markets, seem quite reasonable.
Among your points, can you expand upon #7? If (relatively) high yielding stocks are better than FI, but in aggregate worse than other stocks, is this any different, in aggregate, than historical norms? (ie small stocks do better than large stocks do better than bonds, at least over the long pull)
Oh yeah, and your point #5… don’t forget Washington DC….
Hi Steve. Thanks for your comments. You’re right, of course. For good or ill, we’re entering a period of bigger government. Also, I think the decisions Washington makes about whether/how we reduce our government deficit as a percent of GDP will have a profound effect on the future strength of our economy. In contrast, during most of my working career, Wall Street’s take on Washington was that what our lawmakers did was basically irrelevant.
On the question of high-yielding stocks vs. fixed income, I have several thoughts:
1. In general, stocks are riskier securities than government bonds, so they have higher returns. Over long periods of time, stocks have historically returned something like inflation + 6% annually, bonds inflation + 3%.
2. We’re not in normal times today. To fight the financial crisis, the Fed has pushed short-term interest rates to practically zero. They have no place to go but up. This is unequivocally bad for bond prices when it happens. Rate rises won’t occur, though, until the economy is on a firmer footing, meaning corporate profits will be rising. So, although stocks are subject to the same negative force from higher interest rates as bonds, this effect will likely be mitigated to some degree by higher profits.
3. We really haven’t had the phenomenon of stocks with substantial dividend yields in the US market for about twenty years, so who knows how relevant past experience is now. But typically such stocks have paid out a fixed percentage of cash flow to shareholders. As cash flow rises, so too do dividend payments. This could mean that a stock yielding 3% today with cash flow growing 7% a year would be yielding 6% in ten years, assuming the stock price doesn’t change. I think this is another plus.
4. Right now, I think stocks are cheap and bonds are very expensive. If the 10-year bond were yielding over 5%, I’d think a 3% dividend yield without growth in the dividend wouldn’t seem as attractive as it does now. But at today’s prices, I think high dividend-paying stocks are much more attractive than bonds.
5. My guess about high yielding stocks underperforming the S&P 500 is a more “conceptual” one than I might like. Right now, the overall S&P 500 offers investors a total return comprised of two financial attributes: an anticipated (but less certain) capital gain + a (more certain) dividend yield of about 2.5%. Around the 2.5% yield mark, you should be able to trade a unit of capital gain in exchange for a roughly equal unit of dividend yield. But as you move further from the overall market position, it should cost you progressively more in forgone capital gains to get an extra unit of dividend yield. To just pluck numbers out of the air, you might reach a point at, say, a 4.5% yield that you have traded away virtually any chance of capital gain.
How could what I’ve just said be wrong? You could reasonably argue that because investors haven’t thought about dividends for a long time, dividend-paying stocks are badly mispriced. You might also add that as the Baby Boom marches toward retirement dividends could come back into vogue.
Also, there is some evidence that the least-risky stocks perform somewhat better than they should (as well as that the most risky stocks underperform their somewhat-less-risky counterparts).