Wednesday, 31 August 2016 15:03

Megatrends impacting investment markets

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Key points

 

- Key megatrends relevant for investors are: slower growth in household debt; the backlash against economic rationalism &rise of populism; geopolitical tensions; aging and slowing populations; low commodity prices; technological innovation &automation; the Asian ascendancy &China's growing middle class; rising environmental awareness; and the energy revolution.  

 

- Most of these are constraining growth and hence investor returns. However, technological innovation remains positive for profits and some of these point to inflation bottoming.  

 
 
 

Introduction

Recent  developments – including the rise of populism, developments in the South China  Sea and around commodity prices along with relentless technological innovation  – have relevance for longer term trends likely to affect investors. So this  note updates our analysis on longer term themes that will likely impact  investment markets over the medium term, say the next 5-10 years. Being aware  of such megatrends is critical given the short term noise that surrounds  markets.

 

 

 

The super cycle slowdown in household debt

Household  debt to income ratios surged from the late 1980s fuelled by low starting point  debt levels, financial de-regulation and the shift from high to low interest  rates. But it's likely run its course as the GFC and constrained economic  growth have left consumers wary of adding to already high debt levels and banks'  lending standards are now tougher. This has seen growth in debt slow & households run higher savings rates.

 

Source:  OECD, RBA, AMP Capital

Implications – slower growth in household debt likely means slower growth in  consumer spending, lower interest rates and central banks having to ease more  to achieve a desired stimulus. Slower credit growth is also a drag for banks.

The backlash against economic rationalism

Its arguable that support for  economic rationalist policies (deregulation, privatisation and globalisation)  peaked over a decade ago. The corporate scandals that followed the tech wreck  and the financial scandals that came with the GFC have seen an increase in regulation, the Doha trade round has been stalled for years and now the combination of slow post GFC growth and rising inequality (see the next chart) in  the absence of the ability to take on more debt to maintain consumption growth are leading to growing populist angst. This is evident in the success of Donald  Trump, the Brexit vote and the recent Australian Federal election.  Of course this is just the way the secular  political pendulum swings - from favouring free markets in the 1920s to  regulation and big government into the 1970s, back to free markets in the 1980s  and 1990s and now back the other way with each swing ultimately sowing the  seeds for the next. But the risk is that the shift away from economic rationalist policies in favour of more populist policies will lead to slower productivity  growth and ultimately rising inflation as the supply side of economies are  damaged & easy fiscal policy is adopted.

 

Data  is after taxes and welfare transfers. Source: OECD, AMP Capital

Implications – populist polices could slow productivity and set the scene for the next  upswing in inflation.

Geopolitical tensions

The end of the cold war and the  stabilising influence of the US as the dominant global power in its aftermath  helped drive globalisation and the peace dividend post-1990. Now the relative  decline of the US, the rise of China, Russia's attempt to revisit its Soviet  past and efforts by other countries to fill the gap left by the US in various  parts of the world are creating geopolitical tensions – what some have called a  multi-polar world. This is evident in increasing tension in the Middle East between (Sunni) Saudi Arabia and (Shia) Iran; Russia's intervention in Ukraine;  and tensions in the South China Sea (which have recently been increased by a UN sponsored international court ruling in favour of The Philippines regarding  island disputes) and between China and Japan.

Implications –geopolitical tensions have the potential to disrupt investment markets at  times.
 
Aging and slowing populations

The  demographics of aging and slowing populations have long been talked about but  their impact is now upon us. We are living longer and healthier lives (eg,  average life expectancy in Australia is already around 83 years and is  projected to rise to 89 years by 2050) but falling fertility rates are leading  to lower population growth. The impact is more significant in some countries,  which are seeing their populations fall (eg, Japan, Italy and even China) than  others (eg, Australia, where immigration and higher fertility is providing an  offset) and others still where population growth remains rapid (eg, India,  Africa and the Middle East). 

Implications – at the macro  level this means: slowing labour force growth which weighs on potential  economic growth; increasing pressure on government budgets from health and  pension spending and a declining proportion of workers relative to retirees; a  "war for certain types of talent"; and pressure to work longer. At  the industry level it will support growth in industries like healthcare and leisure. At the investment level it will likely see an ongoing focus on strategies  generating income (yield) while at the same time providing for "more stable"  growth to cover longevity.
 
The commodity super cycle may be close to bottom

Since  around 2008 (for energy) and 2011 (for metals) the commodity super cycle has  been in decline as the supply of commodities rose in response to last decade's commodity  price boom combined with somewhat slower growth in China. However, after 50 to  80% peak to trough price declines and with supply starting to adjust for some  commodities (eg oil) it's quite likely that we have seen the worst (in the absence  of a 1930s style recession). This doesn't mean the next super cycle commodity upswing  is near – rather a long period of base building is likely as we saw in the  1980s and 90s.

 

Source: Global Financial Data, Bloomberg, AMP  Capital

Implications –  Low commodity prices will act as a constraint on inflation and interest rates but  the likelihood that we have seen the worst may also mean that the deflationary  threat will start to recede. In other words it adds to the case for a bottom in  global inflation. A range bound environment less clearly favours commodity user  countries over producers.  

Technological innovation & automation

The impact of technological  innovation is continuing to escalate as everything gets connected to the  internet. The work environment is being revolutionised enabling companies to increasingly  locate parts of their operation to wherever costs are lowest and increasingly  to automate and cut costs via automation, nanotechnology, 3D printing, etc. The  intensified focus on labour saving is likely good for productivity and profit margins  but ambiguous for consumer spending as it may constrain wages and worsen inequality and could ultimately hamper growth in emerging countries. There is  also the ongoing debate that with so many "free" apps and productivity  enhancements, growth in activity (GDP and hence productivity) is being underestimated/inflation  overestimated and consumers are doing a lot better than weak wages growth  implies. So fears around inequality and stagnant real incomes may be exaggerated. Time will tell.

Implications –  technological innovation remains a reason for inflation to stay low and profit  margins to remain high. But also a potential positive for growth.

Asian ascendancy & China's growing middle class

Low levels of urbanisation, income  and industrialisation continue to mean that the emerging world offers far more  growth potential than the developed world. While big parts of the emerging  world have dropped the ball (South America and Russia particularly), the reform  and growth story remains mostly alive in Asia – from China to India. Both China  and India are seeing a surging middle class, with China's growing from just 5  million people 15 years ago to now 225 million. This means rising demand for  services like healthcare, leisure & tourism.

Implications – favour non-Japan Asian shares (allowing of course for risk). Tourism and  services should benefit particularly from the rising middle class in China and  India.

The environment and social values

Concern about the environment is continuing  to grow and higher social standards are being demanded of governments and corporates. This reflects a range of developments including increasing evidence  of the impact of human activity on the environment, younger generations  demanding higher standards and social media that can destroy reputations in a  flash.

Implications – this will favour companies that adhere to high environmental, social and  governance standards.

The energy revolution

Renewables share of power production  will only grow as alternatives like solar continue to collapse in cost and  solar energy storage becomes mainstream. Likewise advances in battery  technology are seeing a massive expansion in the use of electric cars which  will feed on itself.

Implications – this has huge negative implications for oil and coal and along with the  impact of shale oil production will keep a ceiling on energy prices.

Implications

At  a general level there are several implications for investors

 
    • Firstly – several of these trends will help keep inflation  low, eg, slower growth in household debt, low commodity prices automation &  the energy revolution. By the same token if commodity prices have seen the  worst and government policy shifts towards stimulus we may have seen the worst  of deflationary and disinflationary pressures.
 
    • Secondly – several are also consistent with constrained  economic growth, notably aging and slowing populations, slower growth in debt,  the backlash against free markets and geopolitical tensions. This is not  universal though as increasing automation is positive for profits.
 
    • This is all still consistent with ongoing relatively low interest  rates (albeit we are likely around the bottom) and relatively constrained  medium term investment returns.
 
  • Several sectors stand out as winners including health care  and leisure but producers of energy from fossil fuels are potential losers.
Dr Shane Oliver 
Head of Investment Strategy and Chief Economist 
AMP Capital
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