Patrick Chovanec, chief strategist at Silvercrest Asset Management, has released his first quarter Investment Strategy Note, which argues that the global economy remains afflicted by a lack of demand and excess capacity, which is likely to pose a major obstacle to growth in the year ahead. Below are some key extracts:
The main obstacle to stronger economic growth is lack of sufficient demand. Though consumer spending is rising, the economy is still operating way below capacity. U.S. non- financial corporations are sitting on a record $1.25 trillion in cash because they are unsure where to invest it. Portfolio investors are in the same boat, with $2.7 trillion parked in U.S. money market funds. Former Treasury Secretary Larry Summers posits that the U.S., like Japan since the 1990s, has entered an era of “secular stagnation” where the “natural interest rate” (the rate where the desire to save is matched by the willingness to invest) has fallen below zero, meaning return expectations are so low or uncertain that investors essentially must be paid to put their money to work (or penalized, via inflation or other means, for not doing so).
There are many domestic reasons, in the U.S., why demand is depressed. They include cyclical causes like the wealth effect from assets that lost value during the financial crisis, especially housing, as well as the delay in household formation due to high unemployment among young people. There are also structural reasons, which may prove more persistent. We are in the midst of a technological revolution that, alongside globalization, is reducing the need for and the value of the sort of routine mental and physical labor that long provided the foundation for mass middle-class employment in the US…
These kinds of efficiency gains are good for the U.S. economy. They mean we are doing more with less. But they also mean the rewards to value-creation are often spread among fewer people, and many people with more mundane skills may struggle to add much value at all. Before the crisis, the impact on consumer purchasing power was masked by easy access to consumer credit: what people could not earn, they could borrow. Not anymore.
The conventional response, among economists, is that the government must take action to boost domestic demand in the United States, with either monetary or fiscal stimulus, or by redistributing wealth. But the limits of intervention are also apparent. While Fed QE was essential to preventing a credit collapse during the financial crisis, a nearly fourfold increase in the base money supply has done less than one might expect to get people lending and spending again. The case for more aggressive policies must be weighed against legitimate concerns they could destabilize the economy’s future by piling up too much debt, distorting incentives, or inflating asset bubbles. In any case, the political impasse in Washington makes any agreement on these matters nearly impossible…
For the past several decades, the U.S. has served as the world’s consumer of last resort. That allowed developing countries – namely Japan, and later China – to turbo-charge growth by producing more than they consumed, confident in the knowledge that Americans would provide the demand by consuming more than they produced. (A parallel pattern emerged within the EU, with Germany playing net producer and the rest of Europe net consumer). The surplus countries kept the game going by taking their export proceeds and lending them back to their customers so the deficit countries could keep buying. This is the global growth model we all became comfortable with…
We’re not going back to the past. The old growth model is broken. Here’s what will replace it, with a number of positive implications:
1) China faces a major correction. As its credit binge is either brought under control, or buckles under its own weight, GDP growth will fall, perhaps abruptly. We may see signs of financial stress, or instability. The end of China’s investment boom will hurt metals and mining, as well as makers of capital goods, on a global basis… Far from being a catastrophe, a correction that forced China to transform its huge accumulated savings into demand could turn the Chinese consumer into a major driver of global growth…
2) It will become increasingly evident that other Europeans can’t earn their way out of Germany’s debt until the Germans start saving less and buying more. Until the EU’s leaders recognize this, Europe is simply marking time between crises…
3) Abenomics is an experiment, a calculated bet that printing money will spark controlled inflation which, along with much-needed structural reforms… I’m cautiously optimistic, but I suspect all the good news is already priced into the market, while the toughest choices are yet to be faced. Meanwhile, the risk of some kind of armed conflict with China, over disputed islands in the East China Sea, is quite real and cannot be ignored…
4) The American consumer isn’t going to re-leverage and drive global demand, and the government is in no position to replace him. Domestic demand will grow, but mainly on the back of a production story driven by global rebalancing, which we are already seeing take shape. The U.S. will capitalize on traditional strengths in agriculture and technology, as well as new ones, such as its energy cost advantage from shale oil and gas. Stagnant wages may be hurting domestic demand, but they are making the U.S. more competitive.
As the U.S. economy gradually gains momentum, the Fed will have to taper, then unwind, its QE bond purchases. Interest rates will rise…
The shift to a new global growth model is a positive story, but it’s also an extremely disruptive one. People who don’t see it coming will be inclined to panic in reaction to the changes it involves. Investors who understand it will find opportunity where others see only uncertainty and upheaval…
The full report, which is worth reading, can be downloaded here.
