While there are obvious differences from country to country, one could reasonably generalize by saying that what we have today is a combination of low growth, low inflation, increasingly ineffective economic policies, and increasingly destructive politics. Global growth has been stuck below its long-term average for five years; 2017 may be the sixth (Figure 1).
While exasperation at this inability to reach “escape velocity” is understandable, it is worth remembering it could also be worse. Indeed, for those choosing to look at the glass half full, there is some comfort to be had in the fact that we also don’t have reason to anticipate a bad stumble either; indeed, the risks of a recession (both in the United States and globally) seem fairly low despite the unusually long duration of the current business cycle.
Before we get into why has growth been so disappointing, it is important to point out that much of the global growth deceleration since the Global Financial Crisis (GFC) has actually occurred not in developed economies, whose performance is by no means stellar but is actually close to historical trends. Rather, it is emerging markets—the BRICs, the Turkeys and the South Africas of the world—where growth has slowed materially. For instance, the emerging markets’ “growth premium,” i.e., the positive growth differential relative to developed markets, peaked at 5.7 percentage points in 2007. By 2010 it was just 3.6 percentage points and this year it will likely settle below 2.0. That’s a big shift. And while 2016 probably marks the bottom of this EM underperformance given deep recession in Brazil and Russia are nearing an end, the reduction is here to stay. Put differently, we’ve collectively slowed, but emerging markets have slowed disproportionately more.
Why Constrained Growth?
Acknowledging country to country variations, we’d point to three main factors:
2. Low productivity
3. Less globalization.
These forces affect different economies to a different extent but they are almost universally present.
For instance, we often tend to think of deteriorating demographics as an issue confined to the developed world. We’ve long heard about the challenges posed by Japan’s shrinking population and those raised by the aging baby boomers in the United States. But, obscured by China’s undeniable success as a low-cost manufacturing location, is the fact that China, too, faces a big demographic challenge. Consider this: In 2003, China’s working age population was growing at a 1.9% annual rate. Last year it was essentially flat, and this year it looks set to marginally contract (Figure 2).
Given that potential output is a direct function of the available labor supply, China’s demographic headwind (in absolute terms) is quite staggering. The “glass half full” interpretation of the trend (there is always one, if you choose to look for it) is that the headwind will diminish in intensity from here on. While China’s working age population will continue to shrink through 2025, the rate at which it is projected to do so will be more or less the same as today—it won’t continue to worsen.
The second challenge is that even as the labor supply dwindles, the workers we do have seem to have become less productive. We won’t get into any of the “measurement” arguments raging within the economics profession (i.e., are we underestimating economic activity, thereby underestimating productivity?) and simply take official GDP data at face value. Dividing that by the number of employees, we get a measure of employee productivity.
We discern a downward trend that has occurred pretty much everywhere. Europe is an interesting case, as there is some incipient evidence that the productivity downtrend may be turning the corner. It would be not a moment too soon if that were the case, but it’s too early to get overly confident and excited about it.
Perhaps the most worrisome aspect of the productivity slump is not so much that is has occurred—though of course we’d rather it had not—but rather the fact that we don’t exactly know why. Explanatory theories range from the downright pessimistic assessment that all the worthwhile technological advances that truly had a significant beneficial effect on productivity (think electricity, the steam engine or the computer) are now behind us, with little more productivity gains to be had.
At the more optimistic end of the spectrum are those who argue that recent technological advances have triggered a proliferation in “new economy” activities that may not be fully captured in macroeconomic statistics that were originally designed to serve the needs of an industrial world. Therefore, we are probably underestimating GDP and, by implication, productivity. The truth is probably somewhere in the middle, which still leaves us with some degree of productivity erosion.
Economic Integration… or Not?
Finally, in a phenomenon that likely has contributed to the productivity slump, the worldwide trend towards increased economic integration seems to have come to an end and might even be going into reverse. A series of watershed political events over the past 25 years, ranging from the collapse of the Soviet Union to China’s accession to the World Trade Organization, collectively led to a much fuller integration of these regions into the world economy. The main (though not sole) channel through which this integration occurred was trade. From the mid-1990s to 2008 the ratio of global trade to global GDP increased by roughly 10 percentage points to a peak of almost 25%. It then collapsed in 2009 in the midst of the recession and while it bounced back thereafter, it has recently relapsed; so rather than exceeding the 2008 peak we are moving further away from it.
This big picture discussion points to one important conclusion: The headwinds faced by the global economy today are primarily structural, not cyclical, in nature. However, the policy response to these structural challenges has been exceedingly—and, with the exception of the immediate period following the onset of the crisis, almost exclusively—reliant on cyclical elements.
To deal with this, just one tool in particular—monetary policy—has been deployed to the point of not just ineffectiveness, but of counter-productiveness. And by this I mean negative interest rates, which may help at the margin when deployed for a brief period of time, but generally speaking run counter to common-sense economic ideas such as the fact that savings should be rewarded and borrowing should involve some cost.
There are some signs this is changing, not least because central banks themselves are turning more vocal in calling for complementary fiscal policies to stimulate demand, break the deflationary spell, and reignite growth. A number of important elections also offer the promise of a stronger political mandate for fiscal stimulus in a number of the largest economies. It is one of the reasons why, while modest, we do anticipate an uptick in global growth in 2017-2018.
There is also something to be said about the economy’s natural healing process. While the recovery hasn’t been particularly strong, it has been ongoing for a long enough time now that labor markets have tightened considerably in many countries, with the US being the obvious example. There has been much discrediting of the Phillips curve (the economic relationship linking lower unemployment to higher inflation) of late since we’ve had little inflation so far despite sharply lower unemployment. But it is hard to dismiss altogether the common sense idea that as the supply (in this case labor) diminishes, its price (in this case wages) should go up. And if wages increase, then aggregate demand increases, which raises the price of goods purchased with that extra income, which triggers a supply response, etc., keeping the economic cycle ongoing.
In this age of increasingly complex models and theories, a suggestion of simply being patient and allowing the economy to undergo its natural healing process and resisting the temptation of deploying ever more “creative” monetary policy responses may seem disconcerting. However, given we don’t fully understand the long-term effects of negative interest rates, a commitment to “first do no harm” is worth keeping in mind.
For the Valve Industry…
What does all this mean for the valve industry in 2017? Broadly speaking, count on continued moderate growth, slightly improved pricing power and a more sizable pick-up in wages. In the United States, the energy sector, residential construction and infrastructure investment should all pick up, but only modestly. While stabilizing oil prices and efficiency improvements should lead to some more drilling activity, we won’t get back to where we were. Housing has better fundamental support given considerable pent-up demand. U.S. housing starts are close to where they were in the mid-1990s, while population has since increased by over 40 million. But residential construction is constrained by lack of available land for development and by labor shortages.
Finally, with infrastructure investment—including in areas directly relevant to valve manufacturers such as water infrastructure—it will take a while for this impulse to be materially felt. On the other hand, don’t be exceedingly concerned about an impending recession. The squeeze from the strong dollar will probably abate slightly as business cycles in emerging markets strengthen. As I said in the beginning, not a wonderful world, but not the worst outcome either.
*The views expressed in this article are the author’s own and do not represent investment advice.