By Michael Jones, RiverFront Investment Group

Since the 2008 financial crisis, the global economy has struggled with sluggish growth and periodic fears of a deflationary spiral similar to the Great Depression. Many economists and prominent investors have dubbed this environment the “new normal” under the assumption that demographics and government debt burdens make this lackluster economic environment a permanent fact of life.  We disagree.  We believe that the cumulative impact of policy changes in the US and Europe creates the potential for a significant acceleration in global economic growth. At the same time, we think the undeniable disinflationary pressures in the global economy are likely to keep inflation subdued and central bankers relatively accommodative even as growth accelerates. In our view, demographics will continue to depress overall wage growth, but rapidly rising wages for new workers could prevent the kind of populist backlash that would derail an economic boom. The combination of faster growth, modest inflation and accommodative monetary policy could allow the current bull market in global equities to continue for many years in the future, and potentially rival the long disinflationary boom of the 1980s and 1990s.

Characteristics of a Disinflationary Boom

A disinflationary boom is a relatively rare economic condition in which structural forces keep inflation low despite an extended period of strong economic growth. The last disinflationary boom began in 1985 when the Volker Fed’s anti-inflationary policies got a boost from collapsing oil prices – the subsequent economic boom lasted for nearly 15 years with US growth averaging about 3.5%.  By contrast, economic growth since the Great Recession of 2008 has averaged only about 1.5% in the largest developed economies (US, Eurozone and Japan). Policy mistakes produced a prolonged double dip recession in the Eurozone (2012-2013) and triple dip recessions in Japan (2011 and 2014).

Despite this dismal recent experience, we believe that conditions are in place for average growth in developed economies to accelerate closer to 2.5%. That could boost global GDP (including emerging economies) from its current desultory 3.0% to 3.5% range into a potential range of 4.0% to 4.5%, with a corresponding acceleration in corporate profitability. Despite faster growth, we believe that the deflationary forces of demographics, technology (especially energy extraction technology such as fracking) and global competition should keep inflation in developed economies under 2%. Such modest inflation pressures would allow global central banks to remain relatively accommodative as growth picks up, providing a very favorable backdrop for global growth and equity prices.

We first identified the potential for a global disinflationary boom in our 2016 outlook. We only assigned a 30% probability to this “Optimistic Scenario” in recognition that a retreat from globalization in the UK and US, or stalled economic reforms in Europe and China, could derail an optimistic forecast. These potential obstacles to a global deflationary boom became all too real in the wake of 2016’s unexpected political and economic developments (Brexit, Trump’s campaign pledge to withdraw from NAFTA, defeat of the Italian reform referendum, China’s suspension of its State-Owned Enterprise reform program and resumption of capital controls).  However, we believe these setbacks have thus far proven far less severe than initially feared and been largely offset by 2017’s positive political and economic developments (extensive deregulation in the US, an economic reform mandate in France and accelerating infrastructure spending through China’s “One Belt, One Road” initiative).  As a result, the potential for a global disinflationary boom is back on track and we believe the odds of such a boom have risen to about 50%.

Primary Catalysts for a Boom – Growth-Oriented Policies in the US and Europe

Demographics and the aftereffects of the 2008 Great Recession are often blamed for the subdued growth seen in the global economy since 2008, but we believe that significant policy mistakes in major developed economies were also to blame. The US reacted to undeniable recklessness by major financial institutions with a comprehensive re-regulation of the banking industry.  The combination of higher capital requirements, innumerable new regulations and billions in fines for not following the old regulations diverted bank resources away from fostering economic growth though small business lending.  Unlike large corporations, small businesses are largely dependent upon bank funding in order to grow.  Increased health care, labor and environmental regulations also disproportionately impacted small businesses since they typically lack the legal resources to cope with a flood of new regulatory requirements.

Much of the policy stimulus hoped for in the wake of President Trump’s election has been delayed by internal divisions within the Republican Party. By contrast, the regulatory initiatives that President Obama implemented with his “phone and pen” are rapidly being undone by President Trump’s application of the same tools. The result has been a surge in small business confidence, as shown in the adjacent chart.

These small companies are the primary source of job creation in the US economy.  Renewed confidence and funding availability for this critical sector of the US economy could provide a significant source of incremental growth in the US.

European policymakers tightened fiscal and monetary policies in 2011 despite an escalating debt crisis across southern Europe (Greece, Italy, Spain, etc.), thereby triggering a second deep recession in 2012 and 2013.  Mario Draghi’s leadership at the European Central Bank brought a much better policy mix and improved economic growth, but could not erase the deep structural flaws in the euro bloc exposed by the European debt crises.

Germany embraced sweeping labor market reforms in the early 2000s and transformed its economy into the super-efficient export machine of recent years. Countries within the euro bloc that refuse to embrace similar reforms simply cannot compete. Although better policies from Draghi can buy time, every country in the Eurozone will eventually have to decide whether to embrace reform or leave the common currency, in our view.  This uncertainty over the future of the euro has weighed on business confidence and depressed economic growth.

We believe the recent French elections have the potential to transform the growth prospects for both the Eurozone (as the world’s largest economic bloc) and the global economy. French President Macron has been granted an overwhelming parliamentary majority and a mandate to enact sweeping labor market reforms.  If he is able to achieve these reforms, then France could experience the kind of reform-driven growth seen in the US and UK in the 1980s, Germany in the 2000s, and Spain over the past two years. French reforms could also secure the future of the euro by ensuring that both France and Germany remain at the heart of the euro bloc.  That reassurance could profoundly improve the investment environment in Europe and across the global economy.

Disinflation is Likely to Continue, but Demographics are Masking Accelerating Wage Gains

Despite years of extraordinary monetary policy and the recent upsurge in economic growth, inflation in the major developed economies appears to be once again rolling over and headed back down. As shown in the chart below, US inflation has fallen below 2%; European inflation is back below 1.5%, while Japanese inflation is hovering just above 0.0%.

Globalization and competition among global companies are well-established sources of downward pressure on prices, as are technological innovation in industries such as retail and financial services. Manufacturing costs are plummeting thanks to robotics and the increasing adoption of 3-D printing – CPI data indicates that US prices for core manufactured goods have fallen between -0.5% and -1.0% per year for the past three years. Fracking and the emergence of the US as the swing producer in oil markets has kept oil prices range-bound between $40 and $60, and as technology advances we believe that trading range will likely decline over time.

This relentless price pressure is painful for the impacted industries and workers, but disinflation driven by global competition and technological change is generally considered good for the global economy so long as worker wages rise despite the disinflation.  If real wages don’t rise for the average worker, the populist backlash we have already seen could get worse and derail any potential boom.

Wage growth data paints a somewhat gloomy picture about current labor market conditions. Despite low unemployment, wage gains have only accelerated to about 2.5% and remain only slightly better than the rate of inflation. However, we believe that demographics may be distorting these figures. The first baby boomers turned 65 in 2011, and each year more and more baby boomers retire.  These workers are typically near the top of the wage scale because they have been in the workforce for so long.

As these baby boom workers fall out of the workforce they are replaced with younger, lower paid millennial workers.  According to the Bureau of Labor Statistics, a 16 to 24 year old worker makes less than 60% of the average worker income. Therefore, every millennial that replaces a baby boomer retiree depresses overall wage growth in the US economy. This turnover in the workforce keeps wage pressures and overall inflation low, but also masks a rapid improvement in the wages earned by these young millennial workers. The chart to the right indexes to 100 the weekly wages of all workers (blue line) and 16 to 24 year old workers (green line) as of the year 2000.

Indexing to 100 adjusts for the fact that 16-24 year olds make so much less than the average worker and allows us to better compare the relative wage gains of the two sets of workers. The chart shows that average worker pay gains slowed after the 2008 financial crisis, but average worker pay didn’t completely stagnate (before accounting for inflation). By contrast, millennials entering the workforce after the financial crisis saw their pay remain virtually unchanged for nearly 6 years – average pay for 16-24 year old workers did not rise above 2008 levels until 2014. After accounting for inflation, these workers saw significant real wage declines during this period.

Over the past three years, however, pay gains for these entry-level workers have accelerated much faster than the average worker. As shown on the chart, recent pay gains have been strong enough to almost catch up with increases in average worker pay that millennials missed during the long period of stagnation. These improved wage prospects help account for an increased rate of US household formation (millennials are moving out of their parents’ basements) and set the stage for improved consumer spending from this key demographic (millennials outnumber baby boomers).

Investment Implications of a Disinflationary Boom

  1. We believe the current bull market in equities could be extended for many more years because the inflationary pressures and tightening monetary policy that typically bring a bull market to an end may be deferred for far longer than has historically been the case. Global interest rates could remain near current record lows. Both the ECB and BOJ have pledged to continue QE policies until inflation rises to their targeted levels. As shown on the chart below, the money printed by these central banks would likely dwarf any reduction in the Fed’s balance sheet for a considerable time into the future. This liquidity being pumped into financial markets should continue to mitigate the costs of excessive government debt burdens and support higher global equity valuations, in our view.
  2. The Fed is unlikely to push short rates above the rate of inflation (about 1.5% to 2.0%) if disinflationary forces remain in place, as we expect. That could limit the downside price risk for longer maturity bonds, with 10-year treasury rates unlikely to break above 3.0%. Even so, we think bond market returns will be disappointing given low starting yields and tight credit spreads.
  3. If Macron is successful in implementing reform, as we expect, then we believe Europe is likely to lead global equity markets higher. US markets could be second best despite lofty comparative valuations and a gradually tightening Fed, as higher wages for the largest segment of US society (millennials) accelerates consumer spending and home sales. Japan remains a wildcard.  Investors have consistently dumped Japanese equities and bought the yen when inflation undershoots Bank of Japan targets. We believe investors are underestimating the impact of Abenomics reforms and the earnings power of Japanese companies even in the face of disinflation, but need to see market acceptance of this thesis before getting too aggressive.
  4. China’s “One Belt, One Road” initiative is likely to keep its growth on target provided they can contain growing backlash over “Colonialism with a Chinese Face” among development partners such as Pakistan. We do not think One Belt, One Road momentum will falter for the foreseeable future, but emerging markets could still be increasingly bifurcated. In our view, the “arms merchants” of disinflation (China, South Korea, India and Taiwan) are likely to continue doing well, but One Belt, One Road expenditures may not save commodity-dependent emerging markets (Brazil, South Africa, Russia) from the global disinflationary trends.
  5. WE believe technology and production efficiencies will likely keep most commodity prices under pressure, and the energy sector could suffer deflationary pressures that OPEC may not be able to contain.
  6. The dollar is likely to be range bound, in our view, with higher relative interest rates in the US offset by improved growth and investment prospects in the Eurozone, Japan and select emerging markets.

Conclusion

Since the 2008 Great Recession, investors have become accustomed to a sluggish global economy always seeming to teeter on the edge of a renewed economic slump. Each year seems to bring a new reason to fret about the global economy (e.g. hard landing in China, deflationary spiral, Brexit, and now a special counsel investigating the Trump administration).

In addition, the long bull market in US equities inevitably prompts a question as to when the party must end. We think these periodic panics are a reassuring indication that the market continues to climb a wall of worry, and that valuations and investor sentiment are not at the levels that have historically brought a bull market to an end.

If the current positive policy and economic trends remain in place in the US and Europe, as we expect, then the next surprise confronting investors may be the robustness of the global economy and the potential longevity of the equity bull market.

This article was written by Michael Jones, CFA, Chairman and Chief Investment Officer at RiverFront Investment Group, a participant in the ETF Strategist Channel.

Important Disclosure Information

Past results are no guarantee of future results and no representation is made that a client will or is likely to achieve positive returns, avoid losses, or experience returns similar to those shown or experienced in the past.

Strategies seeking higher returns generally have a greater allocation to equities. These strategies also carry higher risks and are subject to a greater degree of market volatility.

RiverFront’s Price Matters discipline compares inflation-adjusted current prices relative to their long-term trend to help identify extremes in valuation. Diversification does not ensure a profit or protect against a loss. In a rising interest rate environment, the value of fixed-income securities generally declines.

Investing in foreign companies poses additional risks since political and economic events unique to a country or region may affect those markets and their issuers. In addition to such general international risks, the portfolio may also be exposed to currency fluctuation risks and emerging markets risks as described further below.

Changes in the value of foreign currencies compared to the U.S. dollar may affect (positively or negatively) the value of the portfolio’s investments. Such currency movements may occur separately from, and/or in response to, events that do not otherwise affect the value of the security in the issuer’s home country. In addition, the value of the portfolio may be influenced by currency exchange control regulations. The currencies of emerging market countries may experience significant declines against the U.S. dollar, and devaluation may occur subsequent to investments in these currencies by the portfolio.

Technical analysis is based on the study of historical price movements and past trend patterns. There are no assurances that movements or trends can or will be duplicated in the future.

RiverFront Investment Group, LLC, is an investment adviser registered with the Securities Exchange Commission under the Investment Advisers Act of 1940. The company manages a variety of portfolios utilizing stocks, bonds, and exchange-traded funds (ETFs). RiverFront also serves as sub-advisor to a series of mutual funds and ETFs. Opinions expressed are current as of the date shown and are subject to change. They are not intended as investment recommendations. Any discussion of the individual securities that comprise the portfolios is provided for informational purposes only and should not be deemed as a recommendation to buy or sell any individual security mentioned. Copyright ©2017 RiverFront Investment Group. All rights reserved.

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