Productivity

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Productivity

Revisions, revisions

But after commentators have told us how well – or badly – we are doing on the latest quarterly figures, the numbers keep being revised. US statisticians start bullishly, and their British counterparts bearishly, and it takes time for revisions both up and down to be accepted. Generally, by this time, commentators have moved on to other more interesting subjects.

But official data now show that the UK economy has grown 13.4 per cent since 2009, against 13.7 per cent in the US. Britain’s recovery, in other words, is as good as America’s – despite no shale fracking, a shrunken offshore oil sector, worse damaged banks and being within the neighbourhood of the eurozone crisis.

Employment for those aged 16 to 64 is at a record high, and regular pay is growing at an annual rate of 2.9 per cent. With zero inflation, this means real wage growth is at its highest level for 12 years. If this is to continue, then British economic productivity must also improve. That means, as it always has, a willingness by business to invest in the latest equipment.

Valuations and the future

Yet stock markets are spooked, and it was the Chinese devaluation of late August that unbalanced them. Now the question is “are we heading into a bear market?” and, if so, what can we do.

The answer is not very much. Tobin’s Q is the ratio of the replacement cost of business equipment compared to stock market value and, with Robert Shiller’s Cape (cyclically adjusted price/earnings), is the best indicator of fair value in equity markets. Both measures currently show an over-valuation of some 70 per cent. At this level, it is cheaper to buy an existing business than to invest in new capacity.

It is said that equity bull markets climb a wall of worry, and this is what they are doing for the moment with weak world trade, collapsing commodity prices, lower inflationary predictions, and reduced profit expectations.

Bond markets are equally high, but current indications show rising spreads between what is paid on first world bonds and what riskier countries and companies need to pay. Historically, a growing yield gap between different quality bonds has forecast a market crash; nervous lenders become concerned about the repayment of their investment and, as sellers overwhelm buyers, liquidity tightens and panic sets in.

Of course history does not have to repeat itself and in recent years, central banks have taken on the task of being the ultimate buyer of market securities. The main risk that investors are presently running is that central bankers stop acting as a backstop to the markets.

Central banks and market confidence

Economists and bankers alike can sense political and economic monsters underneath the surface of events. Unexplained and unexpected movements of peoples have been a permanent feature of human history, and one such is taking place now from the Middle East and Africa to Europe. Such events have destabilised and even destroyed earlier civilisations and will certainly change the European Union as we have come to know it.

This is perhaps part of another change, only partly understood, but touched upon by a recent Morgan Stanley paper. High levels of debt – both government and private – are constraining demand. Current high corporate profitability is combined with low wages, and an apparently endless flow of labour, and so discourages capital investment, economic growth and productivity improvements – the last being the foundation stone of economic betterment.

So central bankers are currently more worried about deflation than inflation. But recent years could turn out to have been a “labour sweet spot”, although that could be about to go into reverse. The fall of the Soviet Union – and the entry of China into the world economic system – doubled the size of the human work force from the 1980s onwards. But now demographics are going the other way. The Chinese ‘one child’ policy has made China old before it has become rich, while the developed world is not replacing itself.

Average birth rates are below two in the west, hardly enough to keep the population stable, and falling fast in other parts of the world. Business may soon find itself short of labour, and constrained to invest in labour-saving equipment.

Deflation or inflation?

This is the basic guess that investors must make. Conventional wisdom is in favour of deflation and, other things being equal, fixed interest investment is the choice. But central bank policy has kept yields well below their historic averages and, if and when central banks decide to change policy, the effect on capital values of bonds yielding 2 per cent or less could be dramatic. Worse still, if inflation rather than deflation appears, bonds will go into free fall, as investors scramble to protect whatever of their capital is left.

There is no doubt that governments and central bankers prefer inflation to deflation; the former reduces their debts, while the latter increases them. Recent years have not been kind to investors, as financial repression has reduced yields to levels never seen before, but inflation will destroy their wealth more quickly and effectively than deflation.

This is why the prudent investor must concentrate on income-producing assets, and those are mostly equity shares in quoted businesses. At this level, buying equities may seem unwise – a key lesson to equity investment is to buy well (that is, cheaply) and with most sensible forecasts suggesting no return on assets over the next five to seven years, that is certainly not possible today.

But however unwise, both cash and fixed interest securities are worse havens in an inflationary storm. Moreover, many of the products being offered to yield-hungry investors require an unknown level of gearing and use of derivatives, which will become unstable as liquidity tightens.

We have been here before and history is a guide. The 20th century was not the easiest time for investors around the world, and especially not for the British as world wars and inflation destroyed the wealth created over previous centuries.

Nevertheless, over the century that saw America replacing Britain, as well as the great depression, the return on British equities after inflation was 5.8 per cent [nominal 10.1 per cent] compared to the US of 6.7 per cent [nominal 10.1 per cent]. In both countries, and despite America’s better control of inflation, cash returned only a real 1 per cent to investors.

Looking back from 2100 AD, we may see that China replaced America as the great economic engine of the world. But it took more than a century for Britain and America to tame their stock markets of crooked behaviour, and it will certainly take time for the Chinese to do the same thing. And even as the change of leadership took place during the 20th century, investors in British equities did well.

So prudent investors should learn from history – invest in equities but stick to British and American markets.

Rely on long-term management, ensure strong relationships between boards of direction and managers, and be patient. Rising dividends will offset fluctuating markets.