Are You Expecting the Great Convergence?

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We all know that investing is a game of expectations. The market “prices in” certain information, and then we adjust our outlook and positions as those expectations change. A key operating rule of this “game” is that when the best that can be seen ahead is fully discounted, the market tops out.

A perfect example of this in action (on a micro scale) is the classic “beat and raise.” When a company reports earnings, the best thing possible – at least for those who are long the stock – is for the company to beat earnings expectations for the prior quarter, then raise their guidance for subsequent quarters.

This resets the expectations of investors, and the stock almost always trades higher.

When it comes to managing our investments, we set expectations across a wide variety of different elements. Right now, I see particularly unrealistic expectations being set in two main areas: future returns, and economic growth.

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Without question, these two depend on one another. It’s very difficult for investors to see substantial returns sans economic growth. But I’d like to briefly attack these as two separate issues.

First is the idea of long-term returns. A 2016 study by Natixis Global Asset Management suggests that ordinary investors expect to earn an 8.5% annual return after inflation. I have one word for this … seriously?

Tack on the Federal Reserve’s inflation target (2%), and it means these investors are expecting to earn a 10.5% long-term compound annual return, at a time when global bond yields sit in a 1-3% range.

The problem with unrealistic expectations like this is the type of action that it drives. Those who believe these levels of returns are attainable have a tendency to take on too much risk in pursuit of those returns.

It also causes major problems with regard to retirement planning because these unrealistic long-term return projections cause investors to believe they don’t have to stuff as much money into their retirement accounts each year.

Both of these unintended consequences – taking on too much risk and not saving enough capital – have the potential to destroy the retirement dreams of many investors.

What makes matters even worse is that equity markets are currently trading near the upper end of their historical valuation levels. During periods like this, new capital committed to the market historically achieves lower than average returns across subsequent years. This is simply a byproduct of the cyclical nature of our economy and financial markets.

So if long-term average returns of 10.5% are the stuff of fantasy, what’s more realistic?

We can frame this out a couple of ways.

Many of those who arrive at these rosy projections look to historical market returns, assuming that the future will look much like the past. Over the prior 100 years through August of 2016, Morningstar calculates that U.S. stocks have returned an annualized 10% (6.9% real return when average inflation of 2.9% is taken into account).

But you have to realize a couple of things here. First, that’s just for stocks. Most people do not have their entire portfolio always allocated to stocks. Other investments have historically acted as a performance drag on the equity component of a portfolio.

Next, and we’ll get more into this in a moment, the productivity growth and labor force growth that occurred over the last 100 years is very unlikely to be duplicated moving forward. Yes, new innovations will come that will act as growth catalysts, but will they be as revolutionary as electricity, interstate highways or the internet? All of these helped pour kerosene on returns over the past few decades.

If you want a more pragmatic approach to predicting future returns, see this article I wrote previously. As for my estimate for future growth, I’d say a 4-5% real return over the next decade would be more realistic.

Moving on, the other area in which I see unrealistic expectations being set is this administration’s estimates for long-term real GDP growth. Treasury Secretary Steven Mnuchin has said that “Our most important priority is sustained economic growth, and I think we can absolutely get to sustained 3% to 4% GDP.”

While 3% annual growth would be a nice feat (it eluded three of the last four presidents), it’s frankly just unrealistic based on the laws (I hate calling them that, they’re more like guidelines) of economics.

We can certainly achieve 3% growth for one year or even a few, but this unrealistic expectation of achieving 3% growth, in the long run, may have disastrous consequences. Again, this comes down to how people behave as a result of their expectations.

Our economy contracts (goes through a recession) roughly every 5-10 years specifically because in previous years we experience above-trend growth. Think about it like this. If we take the size of our economy now and compare it to our economy 100 years ago, we can extrapolate a growth rate that if achieved every year, would have led us to where we are today.

That steady growth rate can be dubbed the long-term growth rate of our economy. Now, as we all know, we didn’t get here in straight-line fashion. Rather, a whole series of booms and busts played out as we overshot, and then undershot, this long-term growth rate.

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Any periods of above-trend growth were met by periods of below-trend growth where many us experienced hard times as a result of recessionary conditions. In more philosophical terms, we take the bad with the good.

The better our boom times (the more the economy overshoots its long-run trajectory) the bigger price we have to pay down the road (recession)to get back on course. Make sense?

For the last few years, I’ve heard people endlessly complain about how dismal this recovery has been. I’ll absolutely agree that we face a lot of problems from income inequality to the lack of wage growth, to the types of jobs being created. But I have a different perspective on the “paltry” growth that we’ve experienced.

I think this is about as good as it gets (speaking from an economic growth perspective only). Believe it or not, I’m one of those crazy people who thinks sustainability is an important part of not just the environment, but also our economy.

Why try and stimulate growth to above-trend levels when we KNOW that we’ll ultimately pay the price down the road?

Over the past few years, our economy’s growth rate has been low, but it’s been in line with our economy’s longer-term growth rate, meaning … we could perhaps continue this economic expansion for many more years if we’re not tempted to step on the accelerator.

You may counter my argument here by suggesting (as Trump and Mnuchin do) that 3-4% is the long-term growth rate of our economy. Well, sadly to say, it’s not. And this is very simple to prove.

Our economy only grows as a result of changes in two variables: The number of people working, and the productivity of those workers. To put it more simply, our economy can only expand at a growth rate that is the sum of the growth rate of its working population, and the growth rate in productivity.

Most economists have those figures slotted around 1.8% (total) for the next decade. This is also the Federal Reserve’s current long-run projected growth rate.

In case you’re wondering, here’s what the trends in those two key variables look like:

growth labor productivity

One thing to keep in mind here is that growth in the labor force can’t really change in the short to medium-term, as it’s mostly a function of demographics. Also, keep in mind that actions such as restricting immigration can suppress this even further. This implies that the emphasis on productivity growth (which is also absent) becomes even greater.

I’ll leave you with one last chart which I’ve also shown before. This chart takes us beyond the U.S. economy and looks at global trends in labor productivity and labor force growth. As you can see, each of the G7 nations is showing a long-term secular trend towards lower economic growth.

g7 labor force growth rates

In the words of ECRI (the Economic Cycle Research Institute), “... everybody is converging to 0-1% trend GDP growth.”

If you think that the U.S. will be able to maintain a 3-4% long-term economic growth rate while the rest of the world converges toward 1%, shoot me an email … I have a bridge to sell you.

Wait, never mind. The Trump administration just bought it.

The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.

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About Matthew Kerkhoff