Structural changes are slowing global growth, while global equity indices have been powering higher for the last eight years. In times of a divergence like this, investors are well advised to place their focus on diversification and quality.
Despite his theatricality both before and after taking office, Donald Trump scores very low in public approval polls. No other president in modern history has been this unpopular in the period since inauguration. Trump has presented the prospect of an annual economic growth rate of four percent and takes the Reagan era as his model. He wants to achieve this goal by becoming the “greatest job-producing American president God ever created.” He wants to invest billions in road, bridges and airports and relieve the tax burden on companies and employees through the largest tax reform in decades. Although Trump claims otherwise on the news program on his Facebook page, he still has not fulfilled his promises.
In fact, the American economy has not grown at an annual rate of four percent since the year 2000. The British weekly magazine “The Economist” presented this very clearly on its cover page, on which a frustrated jockey draped in an American flag is seen trying to get a groggy giant turtle to start running. Headline: “America’s lost oomph.” This is true not only of the USA but also of all mature economies. According to the Berlin Institute for Population and Development, the economy is not simply in a cyclical trough. Declining growth is due to structural changes. The growth drivers of the past are losing their dynamics. The rate of population growth is slowing and societies are aging, while innovative capacity and productivity – i.e. making more goods at the same or lower expense – are increasing more slowly. In addition, rising inequality in many societies is having a negative impact on consumption. It should not be forgotten that environmental damage due to the consumption of commodities and the emissions of billions of people is having a braking effect. A low growth rate could be the new normal going forward.
If growth has been declining, then why have global equity indices been steadily climbing over the past eight years? Instinctually, one would say that the real economy and the financial economy are closely linked to each other. If that is true, the returns that companies generate must reflect the economic growth trend. The Austrian economist Joseph Schumpeter compared the financial economy to a dog. A dog will follow its master (the real economy) on a walking path even if at times it runs ahead and then at other times lags behind. In reality, however, the connection is not all that clear.
The decomposition of equity returns is one reason for the lack of a relationship between economic growth and stock returns. Equity returns are made up of three components: the dividend, the change in the valuation level and the increase in earnings per share. Studies show that only the third component, if at all, has any connection to economic growth. But it is not economic growth that everyone expects that is relevant but rather the growth that takes everyone by surprise. However, predicting surprises is a notoriously tricky exercise for forecasters. Similarly, investors should not automatically avoid companies that are operating in countries with a low growth rate and which therefore may appear uninteresting at first sight. The more globalization advances, the less crucial the relationship between the economic output of a country and the equity return is. All in all, focusing on valuation is a much better investment strategy. It is, admittedly, no longer easy to find undervalued stocks due to the run-up that equities have had, so investors should be selective and thorough in making their stock choices.
With this in mind, the magic words to look out for are “diversification” and “quality”. Investors have already accomplished a lot if they place in their portfolios several globally active companies with attractive valuations whose business model can withstand periods where the outlook is less rosy. These investors can smile in all confidence that Trump and his administration will be more successful at getting a top ranking in the ratings for late night TV shows than at implementing their economic program.
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