Investment View: Why slow growth is not troubling equities
Cost-cutting, productivity improvements and restructuring cannot be repeated endlessly
While economic growth and corporate earnings disappoint, stock prices have recorded strong gains. In 2012, the MSCI All-Country World index of equities increased 16.9 per cent including dividends. The US S&P 500 index increased 13 per cent, the most since 2009.
The German economy slowed, recording only marginal growth, yet the DAX rose 29 per cent. France performed even worse, but the CAC 40 rose 15 per cent. Despite the fact Italy faced serious economic problems, the stock market rose 8 per cent. While Spain tottered on the edge of a bailout, stocks fell a modest 5 per cent.
The phenomenon extended to emerging markets. Although India's economy stagnated, the Sensex index increased 26 per cent. The South Korean and Brazilian stock markets both rose as growth slowed. Argentina's stock market grew 17 per cent despite its dysfunctional economy.
Changes in the economic environment have altered the dynamics of stock markets. Macroeconomic factors, slowing growth and especially policy measures such as the global regime of zero-interest rates and quantitative easing colour most markets, driving the valuation and performance of firms.
Profit margins and cash flow improve, perversely, in a period of low growth. Initially, companies cut costs, improving profitability. As revenues are stagnant, companies have no need to invest in expanding capacity or working capital, releasing cash flow. Reduction in depreciation charges and the ability to use cash flow to cut debt reduces interest expenses.
In the present cycle, sharp decreases in interest rates, though not necessarily interest margins, have also improved profit margins. But plant must eventually be replaced. Cost-cutting, productivity improvements and restructuring cannot be repeated endlessly.
In the long run, increases in profitability require revenue growth. But lower growth translates into lower demand, slowing revenue increases.
Lower demand and also overcapacity in many industries have reduced corporate pricing power, decreasing profitability.
A striking feature of recent corporate history has been low and poor-quality revenue growth. Earnings have increased more than revenues. Where companies or sectors experience revenue growth, the causes are interesting. Those on the receiving end of government spending targeted at increasing demand have benefited. Artificially low interest costs have encouraged substitution of technology and mechanised equipment for human resources, boosting revenues of technology and industrial equipment manufacturers.
Commodity producers' revenues have benefited from rises in volumes and higher prices. Some firms have increased revenue by cannibalising competitors and adjacent industries.
The build-up of cash on corporate balance sheets is frequently cited as a sign of corporate health.
In the US, since 2008 companies have been net lenders rather than borrowers and now hold around US$1trn (£622bn) in cash. Japanese companies hold liquid assets of $2.8trn. European companies also hold large cash balances. Mark Carney, the newly appointed Governor of the Bank of England, referred to the $300bn of cash held by companies in his native Canada as "dead money".
Cash surpluses affect stock prices and returns. Many companies have returned capital, through stock buybacks and higher or special dividends. In the US, fear of tax changes has also been a factor. But investors are now faced with the problem of where to deploy the cash.
Other companies have used surplus cash to purchase competitors, businesses or assets. Given the indifferent results of many mergers and acquisitions, it is unclear that this will benefit anyone other than shareholders of the acquired company and investment bankers.
Changing demographics affect stocks. Investors approaching retirement may switch to more defensive asset and seek steady income, favouring bonds and cash. Low and declining returns over time have also undermined demand for equities. The reduction is evident in outflows from equity funds into other assets.
Low interest rates have driven stock prices. Dividend-paying stocks have benefited from the attention of investors seeking income. Algorithmic trading now dominates stock markets, making up between 30 per cent and 70 per cent of all activity. Computerised trading may increase volatility. Revelations of insider trading also undermines investment interest, especially from retail investors.
These changes make valuations based on history more difficult.
The American comedian Will Rogers provided sage advice about investing: "Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it."
Fundamental changes in the drivers of stocks and trading in equities now make Rogers' views on investing success more important than ever.
Satyajit Das is a former banker and the author of 'Extreme Money' and 'Traders, Guns & Money'
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