Global market view: Margin mayhem

With the world’s population set to rise gradually, we must rely on improvements to productivity to sustain growth. But are they enough?

Summary: The global economy has grown sixfold in the past 50 years but, according to the latest projections, is only expected to grow threefold in the next 50.  The big change in the future will be the slow growth in population. Fertility rates are declining, and the average age of the population in Europe, China and Japan is rising. Improvements to productivity could compensate for the slower rise in population, but it would have to be 80 per cent faster than the already rapid growth of the last half century.

Key take-out:  For investors, this means that profit margins are likely to be under pressure if the boost from productivity improvements diminishes. It also means that revenue increases may be modest as the population grows more slowly.

Key beneficiaries: General investors. Category: Economics and Investment Strategy.

Over the past fifty years, world gross domestic product growth has been averaging 3.6 per cent, driven by employment increases and productivity improvements in roughly equal proportions. An exhaustive and important study by the McKinsey Global Institute concludes that over the next 50 years population growth will decline to 0.3 per cent annually. If productivity continues to contribute 1.8 per cent, overall growth will decline to 2.1 per cent, a rate 40 per cent less than during the past half-century.

The developing world can improve its growth potential by adopting operational practices and technology used by the advanced countries (that is, by catching up), but the United States, Europe and Japan will continue to depend heavily on innovation to approach anything like their historical rate of growth. Those subscribing to Mohamed El-Erian’s concept of “the new normal” or Harvard Professor Alvin Hansen’s “secular stagnation” may turn out to be right, but for reasons somewhat different than they originally thought. I have been worried about a lack of demand causing a slowdown in growth. I had not thought that the main problem might be that there aren’t enough people out there to do the buying.

The global economy grew sixfold in the past 50 years. Taking into account the projections above, it is only expected to grow threefold in the next 50. The productivity improvement resulted from a shift from agriculture to manufacturing and services. Technology obviously played an important role.

The big change in the future will be the slow growth in population. Fertility rates are declining, and the average age of the population in Europe, China and Japan is rising.

The McKinsey study states that productivity improvement could compensate for the slower rise in population, but over the next 50 years it would have to be 80 per cent faster than the already rapid growth of the last half century. Given all the technology breakthroughs of the last few decades, including the cell phone, the personal computer and the Internet, that accelerated rate seems unlikely to me.

The study concludes that, world-wide, as much as three-quarters of productivity growth will come from a broader adoption of best practices. These opportunities exist in certain geographic areas and include using more effective retail formats, increasing the scale and capacity of automobile assembly, improving operational efficiency in health care and reducing waste in food service. The developing world would be the greatest beneficiary of the adoption of best practices, which would account for 82 per cent of its estimated productivity improvement. In contrast, the developed world would realize only 55 per cent of its productivity improvement from the implementation of best practices. The rest would come from “pushing the frontier” or innovation.

While one usually thinks adopting best practices applies mainly to manufacturing and services, agriculture continues to provide considerable opportunities. On the innovative side, the study argues that the technological advances of the last 50 years will continue to have a significant impact on productivity. Profit margins for the Standard & Poor’s 500 are currently above 10 per cent, having risen sharply since the end of the recession in 2009. Historically they have never been much higher than that.

Margins have improved as a result of employing technology and keeping labour costs low. Capital equipment has been used to replace labour and the vast pool of people looking for a job has enabled companies to hire workers without significant increases in wages. As a result, unit labour costs have been rising very slowly.

Productivity growth has actually slowed in the developed economies, from 3.2 per cent in the 1964-74 period to 0.8 per cent during 2004-14. In the emerging markets, however, it has more than doubled from 2.6 per cent during 1964-74 to 5.6 per cent in 2004-14. In 1964, the differential between the dollar output per employee in the developed economies versus the developing economies (on a purchasing power parity basis) was $32,000. Even though productivity has improved faster in the developing economies, the differential in 2014 was dramatically higher at $73,000.

In the recent past, companies were clearly willing to spend a significant part of their operating cash flow on capital equipment. They were not, however, building new plants. Instead, they were buying hardware, software and robotics to enable them to increase the output of goods and services using fewer workers. While the net income per employee has increased in each cycle, capital spending as a percentage of operating cash flow has actually declined in the last three cycles. I still expect capital spending to be one of the positives for the economy in 2015, but this factor may be less robust than I originally thought.

We will need to focus on the implications of only modest population growth on economic expansion. The McKinsey report lists ten enablers of growth. They include:

  • improving the regulatory environment to encourage innovation;
  • focusing on matching skills to employment opportunities in education;
  • removing barriers to competition in service industries;
  • improving cross border activity through trade pacts;
  • encouraging more women to participate in the work place;
  • asking productive employees to work beyond the normal retirement age;
  • improving infrastructure, and;
  • stepping up research and development spending.

Every one of these would contribute to growth but, since both government policy and established practices are hard to change, any positive shifts are likely to be seen only over a long period.

For investors, this means that profit margins are likely to be under pressure if the boost from productivity improvements diminishes. It also means that revenue increases may be modest as the population grows more slowly. Because these factors will have a negative impact on earnings growth, companies will focus more on financial engineering, including share buybacks and leverage, as well as mergers and acquisitions, to increase earnings. A premium will be paid for innovation, and investors will seek out the industries and companies that can provide it.

For the largest countries, the decline in the growth rate is projected to be serious, according to the McKinsey study. The United States drops from a rate of 2.9 per cent in the past 50 years to 1.9 per cent in the next 50, Germany from 2.2 per cent to 1 per cent, Japan from 3.3 per cent to 2.1 per cent and the United Kingdom from 2.2 per cent to 2.0 per cent. In the emerging markets, China moderates from 7.5 per cent to 5.3 per cent and India from 5.1 per cent to 3.0 per cent.

One way to create more jobs is to reduce the work week. Presumably, that also improves the quality of life. Shortening the work week has been going on around the world for the past fifty years. South Korea had the longest work week at 42 hours in 2012, but even that was down two hours from 1964, according to the McKinsey study. Other notable changes were Turkey, down to 36 hours from 45 in 1964, Italy down to 34 from 45, France down to 28 from 41, the United Kingdom, down to 32 from 42 and Germany down to 27 from 40. In the United States the reduction was only down three hours to 33 from 36.

Investors tend to assess the outlook primarily on a short-term basis. Right now the focus is the effect of lower oil prices and the strong US dollar on 2015 earnings. Some investors may also be concerned about the implications of geopolitical issues including Greece possibly leaving the European Union, Russia’s expansionary policies or the Iran nuclear agreement. The purpose of looking at growth projections for the next fifty years is to consider their impact on other important factors that could have a negative influence on earnings going forward. If population growth slows as projected, productivity must improve significantly to maintain world-wide growth at anything like the rate of the last fifty years. That seems like a difficult hurdle to me. As investors, we would see the manifestations of this trend in a slower rate of earnings improvement and more modest rates of equity market appreciation. The fact that 2015 S&P 500 earnings are expected to increase by only a small amount may be the dawn of this condition, obscured by the short-term factors of the oil price drop and the strong dollar.

I have been doing strategy analysis for a long time. I remember back in the 1970s, there was an alarming report by something called the Club of Rome (CoR), a group of respected macro-economic thinkers of that era. The first report of the CoR was called “The Limits to Growth,” published in 1972, and it purportedly sold an incredible 30 million copies in 37 languages. The study focused on the environment and the links among energy, food and population over the coming 100 years. While “The Limits to Growth” was very controversial and widely discussed, the recommendations for economic self-denial were largely ignored and you rarely hear much about the Club of Rome today (but it still exists). Although the conclusions of the report were directionally right, its tone was apocalyptic and the consensus today is that the analysis was incorrect.

The equity markets in the early 1970s were very unstable because of near-term economic factors, and the CoR report unsettled them further. As events played out, the financial markets drifted to a long-term low in 1982 and then began one of the greatest periods of positive performance in history. Perhaps the McKinsey Global Institute’s concern about future growth rates declining because of slow increases in population will be similar to the CoR phenomenon, and the trend will develop differently than the report suggests. Most of us worry that there are currently too many people in the world for the number of productive jobs, and that this mismatch causes many to live in desperate circumstances.

A proper understanding of the actual trajectory of population growth and productivity around the world will be critical to determining an effective investment strategy going forward.


Wien is vice chairman of Blackstone Advisory Partners LP, where he acts as a senior advisor to both Blackstone and its clients in analyzing economic, social and political trends.

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