Understanding why economies have slowed simultaneously across the globe, despite differnt roads to get there, is the first task in devising an investment strategy that will profit in the decade ahead, writes MoneyShow's Jim Jubak, also of Jubak's Picks.
In today's world, no matter the region, no matter the economic policy response, no matter the economic system, growth is very hard to come by.
- Economic systems based on state-controlled/state-directed demand—such as China and Russia—have seen growth rates fall.
- Economic systems based on the creation of consumer credit—such as Brazil—have stumbled and can't seem to get up.
- Systems hoping to use cheap central bank money to stimulate growth—such as the United States—haven't seen growth commensurate with the trillions in debt added to central bank balance sheets.
- Economies, such as the Eurozone, that have combined cheap debt with budget austerity, can't—now that Ireland has moved back into recession—point to a significant success story.
The big question for investors is, why?
If you want to figure out where to put your money for the decade ahead, how much risk you can afford to take, and what kind of returns you might expect, understanding the reason behind the growth slowdown—I'd go so far as to call it a "global growth crisis"—is critical.
I've got an explanation. I'll lay it out below and you can judge if it makes any sense to you, and if you think it can help guide investment decisions.
I think the global crisis in growth has been brought on by decades of really, really bad decisions on how to allocate capital. Too much has gone into unproductive uses-frequently, ironically, in an effort to support economic growth.
The flood of cheap money from the world's central banks has multiplied the effects of this misallocation of capital by:
- making everyone believe that capital was really cheap and abundant just as the world is approaching an era of scarce and expensive capital
- allowing governments to believe that they could paper over the problems in their economies with cheap money
- letting countries put off necessary decisions and investments until dangerously late in the game
Even now, many countries are still behaving as if cheap money can fix their problem. Many, but not all.
If you're an investor with a long-term view, this is a time to overweight economies that show the best chance of escaping this crisis (either through intelligence or luck), to underweight those economies that show every sign of stumbling deeper into a growth crisis, and to adopt stock-picking strategies that will let you avoid the worst of these potholes.
I'd put Mexico and Brazil in the overweight group. I'd put Russia and the European Union in the underweight group. And I'd put the United States and China into a toss-up group.
Of course, there could really be no global growth crisis. It could simply be coincidence. The Brazilian model of growth, founded on expanding cheap credit for a rising "middle class," could be failing at the same time the Russian model of state-controlled kleptocracy has run out of gas. Possible, but given the differences of the economies involved, it seems unlikely.
It could all be global blowback from a slowdown in China's economy. That might (and does, to my mind) explain a good part of the slowdown in Australia and Brazil. But given how little, relatively, the US economy depends on exports, it seems unlikely.
It could all be a result of the moneyprinting, blow-up-their-balance-sheet policies of the world's central banks. Central bank policies certainly play a role in the current stage of the crisis, but I see those policies more as a reaction to the growth crisis than a cause of it. Central banks launched their campaign of printing money and expanding their balance sheets in response to a global growth crisis already in progress.
To take a look at root causes, let's turn to Russia and Brazil, two countries with very different economies but both facing a growth crisis. Russia first:
There's no real argument between experts inside and outside Russia that the Russian economy is in trouble. In May, the European Development Bank cut its forecast for 2013 GDP growth to 1.8% from 3.5%. A month earlier, the Russian Ministry for Economic Development had cut its forecast for 2013 to 2.4% from 3.6%. In addition, the ministry warned that the country risked falling into recession by the fall of 2013.
Experts both inside and outside the economy say the country needs to act immediately to revive growth. But the experts outside and inside the government offer very different growth prescriptions.|pagebreak|
The outside experts emphasize reforms to the country's financial system that would make Russia more attractive to foreign and domestic capital. We're not talking minor reforms—we're talking about changing the financial and legal systems so that investors and entrepreneurs don't wind up in jail because someone with powerful political connections wants to take over their business or eliminate a competitor.
About 110,000 people are in jail in Russia for economic crimes. Some of those imprisoned have lost ownership of their companies to the police or other officials who brought them to court on fraud charges. You know there's a big problem because the government has proposed amnesty for 13,000 of those in jail for economic crimes.
But recent stimulus proposals from the Putin government focus on business as usual. Putin has proposed taking up to $43.5 billion from state pension funds and investing it in three big infrastructure projects: a modernization of the Trans-Siberian Railway, a new 500-mile high-speed rail line between Moscow and Kazan, and a new superhighway ring road around Moscow.
In other words, when the country desperately needs to attract foreign capital to modernize and expand the energy industry that provides the bulk of government revenue, the Putin government has proposed the same kind of centrally controlled, big-ticket projects that haven't worked very well for the Russian economy as a whole.
The contrast between Russia's big infrastructure, state-controlled, export-driven economic strategy and the strategy that has driven Brazil's growth in recent years couldn't be more extreme.
Brazil's economic strategy under the Lula and Rousseff governments was to grow a new consumer class by increasing incomes, using conditional cash transfers from the government to lift families out of poverty and to try breaking the generational patterns of poverty.
For example, the Bolsa Familia—which by 2011 covered 26% of the country's population—provided monthly cash payments to poor families. The government then leveraged that higher household income through policies that provided cheap and easily accessible credit for the purchase of household appliances and other consumer goods.
That economic strategy has major success to its credit. In 2010, Brazil's economy grew by 7.5%. And Brazil had seen its GINI co-efficient of economic inequality fall from 0.596 in 2001 to 0.518 in 2009.
(The closer a GINI score is to zero, the more economically equal a country is. For comparison, the United States had a GINI score of 0.468 in 2009. China's GINI was 0.474 in 2012, according to the CIA World Factbook. Denmark, among the world's most economically equal countries had an estimated GINI coefficient of 0.248 in 2011.)
But recently, that strategy has fallen apart. Brazil's growth slowed to 0.9% in 2012, and the economy expanded by only 1.9% in the first quarter of 2013.
At the same time, inflation has climbed until it hit an annualized 6.46% in May. That's within spittin' distance of the central bank's 4.5% inflation target. All this leaves the Banco Central do Brasil with a no-win choice of slowing the economy to fight inflation, or risking that inflation will run out of control.
You don't have to be an economist to figure out what's wrong with Brazil's economy. The protesters that have taken to the streets across the country in recent weeks point, accurately, to neglected infrastructure—a 9-cent fare increase for terrible bus service in Sao Paulo triggered these protests. The country has spent billions on soccer stadiums, yet let education languish. Health care is in scant supply and expensive.
Economists can put more specific numbers to those charges, but they don't disagree. A record grain harvest in 2013 has overwhelmed Brazil's roads and ports, with 12% of grain spoiling before it reaches consumers. Only 5% of Brazil's roads are paved, versus 50% in China. The country's ports and airports are rated among the worst in the world, and the country's road infrastructure is worse than India's.
In 2012, Brazil became the sixth-largest economy in the world, overtaking the United Kingdom. But only 17% of Brazilians aged 18 to 24 are enrolled in university degree programs or have a degree. Less than 50% of Brazil's workers have finished high school.
Is it any wonder that productivity growth in Brazil has turned abysmal? From 4.1% in 2010, productivity has tumbled to 0.7% in 2011 and to 0.3% in 2012.
As with Russia, when the economy hits a crisis, the impulse in Brazil has been to try more of the same—an impulse made easier, as in Russia and other economies, by having more of the same require only more debt rather than tougher structural changes.
In Brazil, though, that impulse has run dead-on into a consumer who is drowning in debt. Credit outstanding to households grew to 44% of disposable income from 18% in a decade. It's impossible to fix Brazil's growth problem by engineering an increase in consumer borrowing.
I don't mean to suggest the Brazil and Russia are unusual. Indeed, my point in picking two countries with such disparate economic strategies is to argue that we're looking at a global growth problem that transcends national differences in economic policy.|pagebreak|
The United States tried to use cheap mortgages and a housing boom to bridge its way back to growth after the slowdown in growth in 2001 (1.1% growth) and 2002 (1.8%) after the heady uptrend of the late 1990s (4.2% growth in 2000 and 4.9% growth in 1999). And we know how that turned out.
China used massive stimulus to avoid the worst consequences of the global financial crisis, but the result has been an economy that's getting less bang for every stimulus buck.
State-owned enterprises get the bulk of available capital because they provide huge numbers of jobs for local governments. But profits have been dropping, in good part because all that capital has created massive overcapacity in industries such as steel and solar.
In the first quarter of 2013, profit growth for state-owned enterprises dropped to 5.3%, from 7.7% growth in the first quarter of 2012. Total productivity growth in China dropped to 2% in 2011.
As in the United States, where it's easier to have the Fed do it than to actually introduce structural changes in the economy, China's economic policy has been to hope that the People's Bank can generate the growth the country needs while keeping inflation and asset prices under control.
If we do indeed have a global growth crisis that's likely to be with us for a while, how should investors respond? Here are five rules for a global growth crisis.
First, inflation should be tame. If global growth is going to be slow, I don't think investors are going to see much in the way of price inflation.
Interest rates will almost certainly go up as central banks and governments struggle to pay for the huge debt they've run up (and that debt will be harder to pay off without price inflation). But I don't think investors can count on inflation to run up the price of commodities, for example.
Second, the expected rate of return on stocks is going to be modest. On bonds, it's likely to be very, very modest if interest rates are climbing.
I know dividend stocks are getting pummeled right now on interest-rate fears, and because they had such strong run-up. But I continue to believe that if you can find a 5% yield in the stock of a company that can increase dividends over time, you should snap up those shares.
Third, some countries will struggle and then fail to meet the challenges of an era of slower economic growth.
They won't make the structural changes they need to make or those structural changes will be just too tough to implement. Other countries have a better chance to find policies that will result in better than average (for their peer group) economic growth.
In the "they've got a very tough row to hoe" group, I'd put Russia, Japan and most of the Eurozone. In the "they'll beat the averages" group, I'd put Brazil, Mexico, Norway, Poland, Canada, and Singapore.
The big toss-up countries are the United States and China. I'd put the United States in the "beat the averages" group, largely on the luck of the US energy boom. China's course will depend on the political skills and ideological flexibility of its new leadership team. It's way too early to render that judgment.
In general and over the long term, I think you should overweight "beat the averages" economies and underweight the laggards.
Fourth, while a rising tide lifts all boats, a lagging economy doesn't sink all companies.
Even lagging economies claim national stars that are global leaders. The fact that they're headquartered in Brazil or France or Japan is close to irrelevant for companies that manufacture or deliver from facilities around the world, and compete not with domestic-sector peers, but with the handful of true global leaders.
Fifth, slow growth will actually work to the benefit of some companies. There are companies that deliver the kinds of solutions that governments need, for example.
In Brazil, Kroton Educacional (Sao Paulo: KROT3) has held its own and even climbed on some days since the protests have taken down the overall market. The thinking is that the company, which is the largest provider of private education in Brazil, will benefit as the government spends more to meet protesters' demands for more access to higher education.
In the same vein, I'd look for shares of companies that give governments the ability to keep the lid on social protest, either by providing better services, such as more sewers in the Philippines from Manila Water (Manila: MWC), or more roads and airports in Brazil from infrastructure investor and operator CCR (Sao Paulo: CCR3).
I'd put food-staples companies in this category, too, since I think governments stressed by demands for more jobs or better health care will do everything they can to make sure that their populations have something to eat. The Roman emperors were onto something with that bread and circuses thing.
And it suggests retailers that can bring a wider variety of goods to underserved consumer populations. That would include 7-Eleven owner Seven & I (Tokyo: 3382) and Hengan International Group (Hong Kong: 1044).
Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. For a full list of the stocks in the fund as of the end of March, see the fund's portfolio here.