Growth is picking up in the main regions of the world. The latest forecasts from the International Monetary Fund (IMF) indicate an improvement in the economic situation. A cyclical upturn in a context of growth weakened by various structural factors. Damien Petit, Head of Portfolio Management at Banque de Luxembourg, offered some explanations in the 8 December edition of the Luxemburger Wort.

The IMF’s latest forecasts show an upward revision of global growth to 3.6% in 2017 and 3.7% in 2018. This represents the strongest increase in the global economy since 2011. Another encouraging point mentioned by the IMF is the increasing synchronisation of this growth, with all the major economic areas recording an increase in their gross domestic product, especially in Europe. The various leading indicators are also holding up at high levels, and therefore not suggesting any significant weakening of economic momentum in the short term. However, although the economic situation is improving, current rates of growth are still well below pre-financial-crisis levels. Potential growth has clearly weakened in recent years. What can this be attributed to? 

Demography and productivity: an unfavourable trajectory

The two springboards for long-term growth, namely demography and productivity, do not augur well. On the one hand, the increase in the working population in advanced economies is slowing, due largely to an ageing population. On the other hand, the statistics also show a marked slowdown in productivity growth. While it is no easy task to determine the course of productivity with precision, the diminutive proportion of investment in the gross domestic product of developed countries over recent years – a hangover from the financial crisis – is a negative factor for productivity. In America, this is reflected by the large number of companies preferring to buy back their shares instead of engaging in productive investment, despite a high level of profitability. 

However, a sluggish outlook for potential growth is not inevitable. An effective increase in the retirement age, a policy favouring a better fit between work availability and demand, or measures favourable to immigration, for example, could mitigate the effects of an ageing population on the labour market. Policies aimed at stimulating investment in innovation or education could also have a positive influence on productivity. However, it will take time and the adoption of ambitious reforms to instil fresh momentum. Growth is also being undermined by several other structural factors. Among these are record debt in the global economy and growing social inequalities that threaten to undermine social cohesion.

Economic environment not unfavourable to equity markets

Although fragile and modest, a cyclical upturn is clearly underway. Inflation continues to be very contained, largely as a consequence of globalisation and digitisation. The central banks are therefore unlikely to significantly tighten their monetary policy in the short term. This economic environment is not inherently unfavourable to equity markets, and equities remain the preferred asset class, despite high valuations. Investors with too much exposure to cash will suffer a loss of purchasing power since the remuneration for cash – zero or negative – will be eroded by inflation. In any case, the bond market risk/return profile is very unappealing, particularly on the European sovereign debt market (depressed yields) or non-investment grade corporate debt (spreads narrowing sharply).

High valuations on the equity markets are justified by the low interest rate environment and reasonably favourable corporate earnings momentum. Valuation is not a leading indicator of performance in the short term but with such high levels, investors will clearly have to revise their expectations for investment returns downwards in the coming years. On a historic basis, current valuations would suggest performance below the long-term average for the next ten years.