Increasing signs of a trend fall-back in productivity growth in developed economies are becoming a hot topic with respect to the medium-term outlook for the economy and markets. Yet we are sceptical as whether the recent disappointing trend is the best guidance for the future evolution of productivity growth. For now there is little reason to step away from our risk-on stance.
US productivity trends
Source: Thomson Reuters Datastream, NN Investment Partners
Structural fall-back by no means certain
For investors the medium-term consequences of weak productivity growth are straightforward: it creates less investment opportunities, lower return expectations and more systemic risks. At the same time, however, any assumption of structurally lower productivity growth is itself uncertain and is not necessarily in line with historical experience or current observations on technological progress in many sectors in the economy.
“Payback” for earlier advances
Historical patterns in productivity growth show large and sometimes long-lasting swings, but mainly reveal unpredictability rather than easily identifiable shifts into structural accelerations or declines. Looking at US productivity growth, for example, the trend has indeed been sliding down over the last 10 years (see chart). At the same time, it is still averaging 1.5% growth per year, compared with a 2% growth rate over the last 55 years. Moreover, it followed on a 10-year boom period between 1995 and 2005 when productivity grew 3.1% on average per year. Some of the recent disappointments may have been partially a “payback” for advances made in the previous decade and basically reflected some sort of reversion to the mean.
Little cause for despair…
For every instance of the corporate sector’s unwillingness to invest or lack of new breakthrough technologies, there is at least one example of a new digital business model or an innovation in healthcare or energy. Whether or not any of these developments will prove to be effective economic applications that raise productivity, they certainly help to keep us sceptical of the view that the disappointing trend in productivity growth in recent years is the best guidance for its future evolution.
…and little reason to change our stance
For the near term, other factors will drive the market and the direction of the global business cycle, and the willingness of investors to take risk will drive the adaptation in our allocation stances. For now there is little reason to step away from our risk-on stance, with a strong underweight in government bonds and healthy overweights in equities and real estate. This stance is also supported by our medium-term thinking on productivity trends. A gradual recovery in productivity growth will support higher interest rates over time and allow for additional earnings growth and risk premium contraction that supports risky asset returns.
Eurozone equities overweight scaled back to medium
Within equity space, we have scaled back our exposure to the Eurozone from a large to a medium overweight position. This move is in line with the trends we observe in investor surveys, whereby the extreme differences in regional positioning are scaled back. Despite this reduction, the euro region remains our preferred region to invest in. The fundamentals are invariably supportive. The economic surprise indicators are at very high levels, not only relative to the US but also to Japan.
Eurozone earnings momentum still high
Regional earnings data are moving in opposite directions. The earnings momentum for the Eurozone is currently the highest in the world. US momentum is at the other end of the spectrum. There are several explanations but the most important one is undoubtedly the weakness of the euro, which is boosting foreign profits. Next to that, there is the improvement in the economic data in the Eurozone and a further drop in interest rates.
Japanese equities remain attractive; EM neutral
Japan also remains attractive thanks to high earnings growth, positive earnings momentum, attractive valuations and last but not least policy making. We stick to our view that 2015 will gradually become less US-centric given these earnings and policy trends. Emerging market equities are neutral. Flows improve and stable commodity prices should underpin the region. We also observe loosening of monetary policy in several EM countries. On the other hand, EM currencies are weak and Chinese data are showing further slowdown.
Energy to a small overweight position
We also made a change in our sector allocation: we upgraded the energy sector from neutral to a small overweight. The oil price is no longer falling and capital expenditures at oil companies have been cut aggressively. Both elements are positive for the cash flow preservation of these companies. Hence, the dividend risk for the sector has come down. The interesting dividend yield of 3.7% (the highest within our global sector universe) is certainly attractive for investors looking for yield.