Opinion: Why indexing will fail investors in the coming dismal decade for stocks

Slow global growth, low corporate profits could bring negative returns for U.S. market, writes Niels Jensen.

© Provided by Dow Jones & Company, Inc. Estimated annual workforce growth in selected countries (%)

By Niels Jensen, MarketWatch

Stock investors are now in an environment where the benign, bullish conditions of the past 35 years are highly unlikely to be repeated. Investment strategies that have worked so well — including indexing — will no longer deliver acceptable returns. A fundamentally different, outside-the-box approach to investing will be required.

Indeed, passive, indexed investing will at best deliver 0%-5% annually (inflation-adjusted) over the next few decades. Returns for the U.S. are at the lowest end of that forecast range, partly because U.S. equities are so richly valued at present, and partly because the wealth-to-GDP ratio is more out of sync in the U.S. than it is anywhere else. Accordingly, my 10-year return target for U.S. stocks is negative 5% to 0% annualized, after inflation.

The reasons for such a disappointing outlook are found in six crucial, worldwide structural trends that will constrain global GDP growth for years to come:

1. The end of the debt super-cycle

Debt super-cycles typically last 50- to 70 years and always end with drama. The current debt super-cycle is now ending. Servicing a growing mountain of debt ties up more and more capital, which could otherwise be used to enhance productivity. Rising debt-to-GDP is holding back GDP growth, which is a big problem in a deeply indebted global economy that requires growth to service all that debt. The fact that productivity has started to decline in many countries is a powerful indication that the end is not far.

2. Retirement of the baby boomers

Across the member nations of the Organisation for Economic Co-operation and Development (OECD), 150 million people will retire in the next 15 years — a trend that will have massive implications worldwide.

Before going further, consider this important equations in economic growth theory:

GDP = Workforce + Productivity

In plain English, the equation states that economic growth equals the sum of workforce and productivity growth. Now to the critical point: The workforce will shrink in many countries between now and 2050. In the worst-affected country, Japan, it will shrink by no less than 1% per annum (see chart, below).

Unless productivity grows by at least 1% annually, the Japanese economy will be smaller in 2050. Although other OECD countries are not as badly affected by aging as Japan, the outlook in the eurozone isn’t promising, with Italy and Germany in the worst shape. In those two countries, the workforce will shrink by about 0.8% annually between now and 2050.

Aging will also have a massive impact on government debt levels, as servicing the elderly is costly and will further tie up capital that could otherwise enhance productivity. In short, GDP growth will continue to decelerate. According to the United Nations, longevity in the developed world will improve by three years between now and 2030. That said, according to the IMF, debt-to-GDP will increase by 50% as a result.

3. Declining spending power of the middle class

Many countries have not experienced meaningful growth in real wages for years. Low- or no real wage growth negatively affects aggregate demand and partially explains why GDP growth is so low everywhere.

Low- or no real wage growth affects the political landscape as well, as the middle classes of the developed world underwrite political stability. In this regard, it is no coincidence that Donald Trump became president of the U.S., that the U.K. opted for Brexit, and that Italy’s biggest political party is run by a comedian. The middle classes of those three countries have experienced the biggest decline in spending power within the OECD.

4. The rise of the East

Asia’s growth could affect the global economy positively, but the jury is still out. Rising living standards in the East will most definitely have a positive impact on economic growth in the West. On the other hand, given comparatively low GDP growth in the West, capital will increasingly look eastwards for more attractive opportunities, further inhibiting access to productivity enhancing capital in the West.

Additionally, the first thing people spend money on when living standards improve is more and better-quality food. Sixty percent of all water usage globally is consumed by the agricultural industry. As living standards rise in the East, water scarcity is increasingly likely to become a global crisis.

5. The death of fossil fuels

Electrification of heating and transportation is a policy pursued by governments worldwide, and the two key drivers are global warming and water scarcity. The rollout of blockchain should further accelerate the move towards electrification. Electrification will reduce the need for fossil fuels . Coal and natural gas will eventually be phased out, as they are used almost exclusively for heating and transportation. The chemical industry uses 20%-25% of all oil, primarily to produce plastic products, and electrification won’t reduce the need for plastics. Having said that, many European governments are on the warpath against plastic products, and the trend is spreading rapidly, meaning that the demand for oil is likely to fall dramatically.

6. Mean reversion of wealth-to-GDP

Asset prices have grown much faster than GDP for years and, in the long run, one cannot outgrow the other. Total wealth in society, measured as a percentage of GDP, has a well-established mean value. Think of wealth as capital and GDP as output. Wealth-to-GDP is therefore capital-to-output, or how many units of capital it takes to produce one unit of output. In other words, it is a measure of capital efficiency. In the U.S., the mean value is about 3.8 times; in Europe, it is more than four times. This implies that Americans use the capital at their disposal more efficiently than Europeans do.

That said, the U.S. wealth-to-GDP ratio currently at five times implies that Americans use their capital less efficiently than they used to. There are some highly technical reasons embedded in economic growth theory as to why wealth-to-GDP will eventually return to its long-term mean value; accordingly, it is only a question of time before U.S. wealth will drop 25%-30%.

Together, these six trends have the potential to create conditions resembling a perfect storm, which will result in low economic growth for years — possibly decades — and mediocre returns on stocks and other risk assets.

Given this abysmal outlook, what should investors do? When constructing portfolios, stay clear of broad market risk, which is the only risk factor you have significant exposure to when investing passively. In addition, consider the following:

• Invest in value stocks rather than growth stocks or, even better, go long value and short growth (using ETFs). Value has underperformed growth for years but often does better in a rising interest rate environment like now (at least in the U.S.).
• Seek income from stocks rather than bonds. With a rapidly growing elderly population, the need for income-generating investment strategies will explode.
• Invest in water. Water scarcity is widely perceived to be a serious issue in only a few countries in North Africa, the Middle East, and Australia, but the reality is different.
• Invest in illiquidity. Since the Global Financial Crisis erupted in 2007-08, many investors have demanded instant access to their capital, driving up returns on investment strategies where capital is locked up for years.

Niels Jensen, author of The End of Indexing: Six structural mega-trends that threaten passive investing (Harriman House), is chief investment officer of London-based Absolute Return Partners LLP.