Eric J. Freedman
CAPTRUST Chief Investment Officer
"And so castles made of sand, slip into the sea, eventually." (Jimi Hendrix)
Our (no longer new) car has seen its odometer revolve 22,000 times in its first eight months. With three kids in travel sports, we spend a lot of time on the road. Music is our cure for highway hypnosis and, to ensure fairness, we alternate who picks out the next song. I have approached this policy as an opportunity to provide a musical education to our kids. Thanks to streaming music services, we have a wide selection. When it is my turn, I prescribe a steady diet of classic rock, with an emphasis on early Rolling Stones, plus a sprinkling of other durable bands.
Using famous quotes, movie lines, song lyrics, and Warren Buffett-isms to start an investment strategy piece is a terrible cliché, but a Saturday morning sojourn in the midst of last quarter’s market movement forced me to borrow Jimi’s quote above. The third quarter’s volatility across riskier asset classes was at least in part a response to global economic growth concerns. Some economists and investors suggest that subdued growth expectations are a natural function of the business cycle. Others express more profound unease.
Those deeper concerns represent the capital market’s corollary to Jimi’s lyrics above, a suggestion that the economic trajectory we have enjoyed since 2008 and 2009’s financial crisis is built on a sandy foundation. To explore these concerns and their implications, we need to review recent economic history and the two dominant forces that have been driving markets.
The End of Pro-Growth Policies?
In response to the financial crisis, global central banks launched a uniform policy response: slash interest rates and adopt stimulus programs designed to stoke consumer demand. In the U.S., the Federal Reserve cut its key interest rate effectively to zero, where it has stood since December 2008. The U.S. government also unleashed a series of programs reminiscent of Roosevelt’s alphabet soup to motivate timid consumers and businesses back to spending and hiring.
Even after the immediate crisis response, the Fed launched three separate quantitative easing episodes, buying Treasury and mortgage bonds to push down borrowing costs for businesses and consumers. The last installment ended in late 2014, nearly six years after the first round of asset purchases began. During that period, the Federal Reserve’s balance sheet grew from $900 billion in assets to $4.5 trillion today.
The U.S. has not been alone in unconventional policymaking. The UK, Europe, China, Japan, Canada, and other economies recognized the financial crisis’ gravity and designed policies with similar intentions. As Figure One shows, selected countries’ balance sheets and their aggregate reveals a significant upward trend. Their collective balance sheets have grown from $6 trillion in 2008 to more than $15.5 trillion in August.
Figure One: Select Central Bank Balance Sheets (in $trillion), 2008-2015
Individual and regional economies have responded disparately to the mass policy elixir. The U.S. and UK have shown improved economic growth. Their stock and housing markets have rebounded and inflationary expectations, while still below historical levels, are positive. Meanwhile, Europe’s economy remains sluggish. Japan has seen some signs of life after decades of deflationary pressure, and China is in an entrenched economic slowdown.
The U.S. has the largest economy and the most influential central bank, and the Federal Reserve has signaled its intent to raise interest rates. While other central banks, including the European Central Bank and the Bank of Japan, have committed to ongoing stimulus measures, the Fed’s interest rate policy shift will reflect a ceremonious departure that could amplify growth concerns. Many fear that raising interest rates during a still-fragile economic period may have negative implications for stocks and bonds.
China: Trees Don’t Grow to the Sky
China’s growth trajectory is well documented. The International Monetary Fund ranks China as the world’s second largest economy based on its total share of global gross domestic product (GDP). When adjusted for country price level differentials, China ranks as the largest. Its resource consumption has been insatiable. As an example, China used more cement between 2011 and 2013 than the U.S. used in the entire twentieth century. Mass population movement from rural farms to urban locales has been a major growth catalyst.
Urbanization is consistent with China’s goal of moving from an export-driven economy to one grounded in domestic consumer spending and services. However, China’s massive city building has led to vast ghost cities with unused public transit and vacant housing units. Figure Two shows China’s slowing growth, with GDP reaching a 12 percent annual growth rate after the financial crisis and declining to an estimated 7 percent today. Its manufacturing has also slowed. (Note that these are official Chinese government numbers, prone to overstatement.)
Figure Two: Chinese GDP and Manufacturing Growth (% Change), 2005-2015
Some experts continue to tout China’s current and future economic prominence. Others, including Harvard economists Lant Pritchett and Larry Summers, recently offered a sobering reminder about growth trends. In their paper “Asiaphoria Meets Regression to the Mean,” they conduct a robust analysis of Chinese growth, comparing growth trends across countries and time. The authors find that “there is strong regression to the mean in the growth process, hence very little persistence in country growth rate differences over time, and consequently current growth has a low predictive power for future growth.” In other words, high growth rates like those seen in China tend to revert back to lower, more sustainable levels.
Pritchett and Summers note that this is not the first case of Asiaphoria. The overhyped 1960s Japanese growth story led to decades of stagnation, and the 1990s Asian Tiger infatuation ended in an East Asian crisis. The authors do not conclude that disaster is imminent. Instead, they suggest that observers, including investors, should not extrapolate high growth rates ad infinitum.
Investment Strategy Implications
Does Jimi's refrain provide a forewarning about growth prospects? We expect tepid near-term growth but remain optimistic about the global economy over the next two years. August and September’s volatility seemed to price in a Chinese slowdown direr than previously thought, and we anticipate upcoming corporate earnings to provide more clues into Chinese business health. Our belief is that markets are too concerned about China and that any slowdown will be deliberate. As always, that view is subject to change based on emerging data.
Interpreting the implications of divergent central bank policy decisions is more challenging. In prior Investment Strategy pieces, we have shown the relationship between the Fed’s balance sheet size and equity market gains. Losing that dynamic could prove to be a challenge for equity investors as they seek other return drivers. Other central banks see the balance-sheet-to-equity-market relationship and like the results (even if they won’t admit it in public). We expect Europe, Japan, and China will continue stimulus programs and perhaps even add to them.
While U.S. and UK stimulus is on the wane and their central banks have declared a bias for raising interest rates, we forecast interest rates well below historical norms for at least the next 18 to 24 months. With interest rates as the basis for all other asset prices, we foresee a more subdued return environment than investors have experienced in recent years. Low unemployment, oil prices, and interest rates are positives for consumers, but markets could remain choppy until we get more clarity on the Fed’s interest rate path and Chinese growth.
What’s our best advice? Ratchet down your return expectations and don’t expect riskier asset classes to move higher in a linear fashion.
And expect the Freedman family truckster to get at least three more oil changes by the time this piece appears next quarter.
 "Credit and Liquidity Programs and the Balance Sheet." FRB: Recent Balance Sheet Trends. Accessed October 12, 2015.
 "Adjusting to Lower Commodity Prices." World Economic Outlook, 2015, page 147.
 Swanson, Ana. "How China Used More Cement in 3 Years than the U.S. Did in the Entire 20th Century." The Washington Post, March 24, 2014, Wonkblog. Accessed October 12, 2015. http://www.washingtonpost.com/news/wonkblog/wp/2015/03/24/how-china-used-more-cement-in-3-years-than-the-u-s-did-in-the-entire-20th-century/.
 Pritchett, Lance and Summers, Larry. “Asiaphoria Meets Regression to the Mean.” NBER Working Paper Number 20573. October 2014, copyright 2014 by Lant Pritchett and Lawrence H. Summers.