Global View Weekly

Stock markets continued to perform well, gaining another half a percent last week, with the US again scoring a new historic high. In local terms, YTD stock returns are approaching the 10% return mark that we consider a great return. Bonds and credit are mixed last week and commodities were down again heavily on a collapsing oil price. For a change, EM was no longer underperforming and in places was beating DM.

In the current cycle, we expected weak growth, but for four years running, got even less than that.
Initially, we thought we were just facing a post crisis demand side problem with a large number of economic agents in a continued and under-appreciated need to repair damaged balance sheets. But now, almost six years after the crisis, and still no pickup in growth, it is becoming clearer we are also having a supply-side problem, with much slower growth in both labor supply and productivity. What are the implications of a weak supply side for markets?

Besides giving it a name - secular stagnation - the economists profession has not yet agreed on its cause or on how long it will last, except that it is a reality and that such realities usually do not go away fast. Partial explanation range from the crisis having left capital in all the wrong places and that greater constraints are preventing banks from aggressively helping to reallocate capital, to the possiblity that technology and the web have completed their role in making us more productive and that EM ecomonies are not as effective anymore in importing DM economic know how. It will take a long time before we know all answers. In the meantime, investors have to deal with the reality of much weaker supply side.

The most important impact of a weak supply side, in our mind, is a lower reutrn on capital. For financial assets, this means a lower than normal required IRR; for bonds, a lower real interest rate. In micro, we teach that the equilibrium interest rate is set by the interplay of time preference and the marginal return on investment. In macro, this becomes the intersection of the investment and savings curve. The post-crisis rise in savings and now also a lower return on capital thus produce a much lower interest rate.