Investing for the Long-term: Productivity of Capital Markets Expectations, and Portfolio Management

DSC_3571CFA Society Chicago presented a two-part symposium on Investing for the Long-term on March 7th at the Standard Club. Approximately 150 members and guests attended to hear Robert Gordon, Professor of Economics at Northwestern University and Deirdre Nansen McCloskey, Emerita Professor at the University of Illinois Chicago present their perspectives on productivity trends. Francisco Torralba, CFA, Senior Economist, Morningstar, Robert Browne, CFA, Northern Trust Bank, and Rick Rieder, CIO Global Fixed Income, BlackRock, then presented their outlooks for the capital markets.

Gordon highlighted the sharp slowdown in US GDP growth from 3.12% from the 1974 to 2004 to 1.56% from 2004 to 2015. He said that this slowdown resulted from a reduction in productivity growth and the labor force participation rate. He noted the Kalman Trend Annualized Growth in Total Economic Productivity, which rose to 2.5% in the 1990s because of the technology revolution, but has recently fallen to near 0.5%. The labor force participation rate has been affected by an aging population, fewer 18 to 25-year-old people in the work force, and passing the peak rate of growth for women in the labor force.

DSC_3590Gordon noted that growth and productivity are probably under estimated, but have always been under stated. He sees no indications that the distortions are worse today. He expects that both lower productivity growth and labor force growth will produce slower economic growth over the next decade.

McCloskey acknowledged that the current level of productivity growth has fallen. She observed that “falling sky” DSC_3579forecasts always follow events like the 2008 financial crisis and noted the perils of trying to predict future enhancements in productivity. She also stated that global economic growth will be positively impacted by developments in countries like China and India.

DSC_3587McCloskey highlighted her work on the role a change in attitude toward capitalism in the 1700s that augmented the 1st Industrial Revolution. She noted the evolution in literature from Shakespeare to Jane Austin in the portrayal of capitalist and the return on capital that they earn. Changes in attitude toward capitalism could drive growth in emerging economies.

An area of agreement between Gordon and McCloskey is the role of minimum wage laws and other restrictions on the labor market that prevent economic growth in areas like the west side of Chicago. They also support efforts to stop the “war on drugs” and support a negative income tax for low income people.

Outlook for Investors

DSC_3591Rick Rieder, CIO Global Fixed Income, BlackRock, noted the aging population and its demand for income and the role of technology pressing down inflation. He believes that the US economy is exiting an investment & goods recession. He also believes that September 2016 marked a turning point away from expansionary global monetary policy. He sees better economic growth leading to higher interest rates, and the potential for higher stock prices because of sales growth.

Francisco Torralba, CFA, Senior Economist, Morningstar, supports McCloskey view that trends in productivity cannot be predicted. He also foresees a pickup in economic growth and cited a Financial Analyst Journal article that links the payout growth rate to the GDP growth rate. A higher level of economic growth could be a positive development for equity investors through higher dividends.

Robert Browne, CFA, Northern Trust Bank, suggested that forecasters begin with “what’s easier to forecast.” He believes that identifying what is cheap is easier that what is expensive. In contrast, much of the forecast has been centered on the expensive, low yield bond market. He also noted that anticipating a range over the short-term is easier. Here, he believes that the election of President Trump may pull forward economic growth, which would be a positive for equity investors.

The consensus outlook seemed to be that long-term real returns for equities would be in the 4% to 5% range. These analysts generally favor US equities, US high yield bonds, natural resources, and emerging markets debt.

Distinguished Speaker Series: Charles Evans, Federal Reserve Bank of Chicago

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Charles Evans, President and Chief Executive Officer, Federal Reserve Bank of Chicago (Photo courtesy of Ping Homeric)

Charles Evans, president and chief executive officer of the Federal Reserve Bank of Chicago, addressed approximately 250 members and guests of the CFA Society Chicago on Thursday, February 9th at the Standard Club. The event was also webcast for those who could not attend the luncheon. Mr. Evans spoke about the U.S. economy, fiscal stimulus and monetary policy. He completed his presentation with responses to questions from the audience.

Mr. Evans expects a modest acceleration in economic growth to the 2.0% to 2.5% rate, and a rise in inflation to near 2.0% over the next several years. As a result, the Fed’s most likely course of action is three 0.25% increases in the Fed Funds rate in each of the next three years. These increases would elevate this rate to near 3.0% by the end of 2019. The primary risk to this outlook is that inflation does not rise to 2.0%.

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Chicago Fed President Charles Evans and CFA Society Chicago Board Members (Photo courtesy of Ping Homeric)

Fiscal policy could positively impact growth by near 0.25% a year. Lower tax rates might contribute to higher growth over the intermediate term. Additionally, optimistic consumer sentiment, resulting from healthy employment data, should contribute to growth. Average monthly gains of 180K employees over the past year have reduced the unemployment rate to 4.8%. A constraint has been business investment during the recovery, which shows no real sign of improvement.

Mr. Evans expects a decline in the unemployment rate to 4.25% by late 2019. His forecast is slightly lower than Fed’s consensus of 4.5%. The natural rate appears to be near 4.7%. A decline to the 4.25% to 4.50% range would suggest a Fed move from ease to neutral to tightening over the next several years. The downside risk to this outlook is weak foreign economies. The upside would be a greater boost from fiscal policy and regulatory ease.

Inflation has averaged 1.5% since 2009. The “Core” rate has moved up to 1.7%. Mr. Evans expects core inflation to reach 2.0% over the next three years. The downside risk is low global inflation and a strong dollar.

The structural equilibrium neutral Fed Funds rate has fallen to a lower level. Low interest rates, throughout the world, provide the central banks with less room for ease in the next downturn. The Fed has typically lowered the Fed Funds by greater than 5.0%, during easing periods and currently believes that the neutral rate is near 3.0% (1% real and 2.0% inflation). Therefore, they may not have as much room to lower rates during next recession. The secondary tools would be quantitative easing and guidance for how long rates would remain low. These non-conventional methods are “second best” to the ability to lower rates.

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Distinguished Speaker Series featuring Charles Evans

 

From 1960 to 2000, the economy grew at a 3.5% annual rate. Post 2000, the growth rate has been lower. The labor force participation rate has fallen over the past 15 years; because of retiring baby boomers, passing the peak inflow of women into the labor force, and a falling rate of employment for 18 to 24-year-old individuals. The potential real GDP growth rate has probably fallen to near 1.75%.

During the questions and answers segment, Mr. Evans addressed the following topics:

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    President Charles Evans responds to questions from the audience.              (Photo courtesy of Ping Homeric)

    Long-term interest rates have risen 0.50% since the election, suggesting that the markets expect some positive impact from fiscal and regulatory policies. He noted that changes in tax policy (i.e. eliminate deductions, border adjusting tax, etc.) can be disruptive in the intermediate term, even though positive in the long-term.

  2. The Fed’s balance sheet grew from $800 M to $4.5 T. Eventually, this level is likely to fall back to near $1.5 T. The Most likely path would be through not re-invest principal payments.
  3. The impact of technology on productivity was apparent in 1995 to 2005 data. Since then, it has not been. He referenced the “gee-wiz” nature of more recent new technologies and quick obsolescence.
  4. The Fed chose not to use negative interest rates, even though the Taylor Rule suggested -4.0% at the low point. The Fed chose quantitative easing instead- sold short bonds and bought long. He noted some positive effect in Europe, which could influence future Fed boards.
  5. Finally, he noted that more global trade is better, provided it’s fair. Trade increases competition, which encourages higher productivity. The United Kingdom is likely to face a complicated period ahead to exit from the EU and establish new trade agreements.