These days, it often feels that we’re totally enveloped in a mood of pessimism.

At one level, that’s understandable; start with subpar market returns for ten years and counting, severe debt problems in Europe and a slow growth economy in North America.  Add in a generalized “austerity” mindset and a work environment that for many combines stress and insecurity, and it’s no surprise that many Canadians are in, to use the technical description, “a funk.” 

Chances are that this mood will be with us for a while.  The only question is how we choose to respond.

The short term reality

Start by recognizing that given the level of uncertainty and volatility, talking to clients about projected performance in the next 12 to 36 months is a fool’s game.  Using one set of metrics, you can make the argument that the market is significantly overvalued, then turn around and make the case with a different set of valuation measures that it’s substantially undervalued.

In truth, there are only three things about the market outlook for the next two to three years we can tell clients with a high degree of confidence:

1.       Macro events and government fiscal and monetary policy will continue to play a much bigger role in market direction than was historically the case.

2.       There’s a high likelihood of continued levels of very high market turbulence and volatility.

3.       If clients don’t have the timeframe or the stomach for that turbulence and volatility, then together you need to reassess their portfolios.   

A conversation about the long term

These days, talking about the “long term” has fallen into disrepute.  Some members of the media and some investors view a focus on the long term as abdicating responsibility for what’s happening in the here and now.

And while we can’t ignore the impact of short term developments, the truth is that the large majority of clients have a timeframe that is out ten and twenty years.  In conversations with these clients, we need to strike a balance between talking about what’s happening now (which is all too often in the “no one knows” category in any event) and focusing on the mid and long term.

A common view is that having come out of a ten year period of substandard returns, we’re going into another ten years of poor economic growth and inferior market performance (sometimes referred to as “the new normal.”)  That’s why I was struck by a commentary released this fall by Michael Nairne of Tacita Capital, pointing to some optimistic research on the outlook for global growth.

Positive prognosis for growth

The research was conducted by Willem Buiter and Ebrahim Rabhari of Citi Investment Research and Analysis (CIRA), based on detailed bottom up forecasts of growth for the next four decades in countries around the world.

The chart below shows the results:  Real global growth for the next thirty years is projected to be on par with the post world war two period – and 50% higher than growth in the last thirty years.

Here’s some of the commentary by Tacita on this study:

Capital investment, technological imitation, institutional development, human capital availability and industrialization were the key factors in the post WWII boom.  Notwithstanding the strong real annual GDP growth rate of 3.9% in the US from 1950 to 1973, it was the 9.3% and 5.5% respective annual growth rates of Japan and the European Union-15 that really lifted world GDP growth.

These same fundamental drivers of growth are at work again in the emerging economies and this is expected to replicate the brisk global growth achieved after WWII.  In particular, CIRA forecasts that developing Asia will continue its ascent in the world economy.  Developing Asia grew from 14% of real world GDP in 1990 to 27% in 2010; a nearly doubling of its share of global GDP - and is forecast to reach 44% of real world GDP by 2030.

The CIRA is not alone in projecting more robust long-term global growth.  The Conference Board Global Economic Outlook 2011 has forecast a 4.4% real annual growth in world GDP over the next decade, while Goldman Sachs has projected a 4.1% real annual growth rate over the next twenty years.  In general, the developed nations are forecast to expand at a tepid pace while emerging markets grow robustly.  As emerging economies become a bigger share of the world economy, their faster growth accelerates total world GDP growth.

Long-term GDP growth is ultimately a key determinant in the growth in corporate earnings which, in turn, drive stock price appreciation and dividend increases.  For example, during the period 1991 to 2010 when the world real GDP grew by a more moderate 3.2% per annum, the real price appreciation of the MSCI All Country World Index was similar at 2.9% per annum.  Hence, an increased real annual growth rate for the global economy of 1.0% to 1.5% per annum in coming decades would, all other things being equal, enhance real capital appreciation by an equivalent amount.

Identifying the drivers of global growth

CIRA’s research identifies 11 countries that it calls global growth generators or 3G drivers, based on three sources of information.

1. A set of bottom up individual country forecasts of GDP prepared by the 50 economists on Citi’s Economics team.
2. Historical GDP data for the most recent 10-year period.
3. A few centuries of economic research on the drivers of long-term growth.

Here’s an excerpt from CIRA’s report:

Our 3G countries, there are 11 of them, comprise Bangladesh, China, Egypt, India, Indonesia, Iraq, Mongolia, Nigeria, Philippines, Sri Lanka, and Vietnam.

They were selected on the basis of their average real per-capita GDP growth over the period 2010-2050; 5% or higher at PPP exchange rates.  There was a distinct discontinuity of more than 0.5% in projected per-capita growth rates between the 11 3G countries and the fastest-growing country not included in the 3G category, which was Thailand.

Of the 11 countries we identify as global growth generators, nine are in emerging Asia.  This is probably not surprising, but our next finding, that the other two are African nations may well be something of a surprise.  We believe that this may well turn out to be Africa’s century as well as Asia’s century.

China will overtake the US to become the largest economy in the world by 2020 (at PPP exchange rates; it would take a decade longer at market exchange rates) and will itself be overtaken by India by 2050.

There are several reasons why two of the BRICs, Brazil and Russia, are not in the 3G category.  One is that they are significantly richer than the 3G countries.  A lot of catch-up has already occurred and most of the low-hanging fruit is gone.  The second reason is their low investment rates.  The third is that, for the later stages of the convergence process, the quality of institutions and policies matters more than for the early stages.  Brazil and especially Russia have material weaknesses in the quality of their key economic institutions and policies which limit their growth prospects.

Implications for investors

The last time we saw a change in global power on this order of magnitude was in the 1800s, when the United States replaced Great Britain as the preeminent driver of global growth.

This forecast for buoyant economic growth and the shift in the locus of growth to emerging countries has profound implications for companies around the world, and also for investors.  We’ve already seen sophisticated investors increase their allocation to emerging economies; this is a trend that will only accelerate in the period ahead.

Meanwhile, the outlook from Citigroup and other credible economic forecasters gives advisors the opportunity to have conversations with clients about the positive mid and long term growth prospects for the global economy and what that means to investors with a long term view.

To read more, here’s the link to the CIRA study

http://www.cepr.org/pubs/PolicyInsights/PolicyInsight55.pdf 

And here’s the commentary from Tacita:

http://tacitacapital.com/files/The_Global_Old_Normal_September_30_2011.pdf