Where Will the Economic Growth Come From?

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The major stock markets around the world are at, or very near, record highs. The monetary magic sprinkled on stocks by global central bankers has done, or is doing, its job.

No matter that easy money is as much the problem as the solution to the world’s ills. For now, ebullient stock prices are anaesthetising investors. They look at the Dow or the S&P500 each day and think all is right with the world.

But here we are, seven years into an economic expansion and we’re still crawling along at the bottom. The global economy isn’t generating enough strength to result in a lifting of interest rates. Indeed, two of the biggest economies in the world — Europe and Japan — are still pressing the QE button hoping it will ‘do something’.

The US is experiencing its worst recovery on record. As the Financial Times editorialised yesterday:

The Fed has kept its pedal to the floor for seven straight years. Yet US growth since the collapse of Lehman Brothers in 2008 has consistently undershot previous recoveries. According to HSBC, average US growth in the seven years from the previous peak was 3.5 per cent after 1981, 3.1 per cent after 1990, 2.1 per cent after 2000 and 1.1 per cent since 2007.

It might be the worst economic recovery, but it’s one of the best stock market recoveries. From the low, the S&P500 is up about 220%. And as you can see from the chart below, the upward trend is still very strong.

Despite the slower pace of recent gains, the moving averages (the red and blue lines) keep moving higher. Right now, there’s not even a hint that this trend is about to falter. It could of course, but there are no signs of it yet.



Source: Stockcharts.com

Click to enlarge

The biggest problem the world faces is that it is horribly ill equipped to face the next downturn in the business cycle. And being seven years into an expansion, we’re not far off experiencing that downturn.

As the UK’s Telegraph writes:

Stephen King from HSBC warns that the global authorities have alarmingly few tools to combat the next crunch, given that interest rates are already zero across most of the developed world, debts levels are at or near record highs, and there is little scope for fiscal stimulus.

"The world economy is sailing across the ocean without any lifeboats to use in case of emergency," he said.

In a grim report – "The World Economy’s Titanic Problem" – he says the US Federal Reserve has had to cut rates by over 500 basis points to right the ship in each of the recessions since the early 1970s. "That kind of traditional stimulus is now completely ruled out. Meanwhile, budget deficits are still uncomfortably large," he said.

That means you can expect central banks to remain in the game for years to come. They’ll continue to ‘do something’ despite the evidence that QE does nothing to promote a robust recovery.

The simple fact is there cannot be a robust recovery when global debt levels are as high as they are. Debt acts as a weight on the global economy. A great deal of this debt is ‘bad debt’. That is, it’s supporting assets that in a normal interest rate environment would have to be written down. In turn, this would damage bank balance sheets.

That’s why higher interest rates are not possible in this environment. Central banks are trapped. Everyone knows it. Which is why global stock markets around the world remain near record highs. They are discounting continued central bank involvement and easy money forever.

Unfortunately for Aussie investors, our market isn’t so ‘lucky’, if you want to put it like that. The ASX 200 is still well off its pre-GFC highs. And recently, the index hit a wall around the 6,000 mark.

The problem with our market is the lack of diversity. ‘Financials’ make up 44.2% of the index, with ‘materials’ (basically BHP and RIO) accounting for 14.4%. ‘Industrials’, that group of diversified companies that produce real goods and services, make up just 7.6% of the market.

That tells you a lot about the make-up of the Australian economy.

The ‘materials’ sector generates the income (think iron ore exports) while the financial sector leverages this income up (with the help of the RBA when it lowers interest rates) to produce speculative asset price gains (think housing).

This leveraging effect has created banking behemoths with balance sheets massively exposed to residential housing.

Don’t get me wrong. Every economy needs a healthy banking sector. But the days of banks financing industry (industrials!) to generate productive economic growth are no longer.

These days, the banking business model is simply to lend as much as they can to households. Mortgage lending is much more profitable than business lending. This creates a nasty cycle for an economy. It’s good in the short term but leaves massive long term problems.

These long term problems are already surfacing if you care to look. That is, we now have record low interest rates but we still have sub-par economic growth. Our economic structure is deformed by low interest rates and unproductive debt accumulation.

Making matters worse, the one growth engine in the stock market, bank earnings growth, seems to be stalling. The last set of earnings results from the big four banks indicate the best days are behind the sector.

And now, the banking regulator, APRA, is finally getting results in trying to make the banks ease off on lending to property investors.

So where will the growth come from? What will give the market another leg up? Lower interest rates will help. But there is a limit to how low the RBA can go. As a massive importer of capital, the market will now have just as great a say in Australia’s borrowing rates as the RBA.

But as the saying goes, the market is a market of stocks, not a stock market. That means they are always opportunities if you work hard enough to find them.

I’ve been doing just that over the past few months and have found an interesting group of stocks that I think could well be starting on a major growth phase.

These are blue chip stocks I’m talking about, not high risk punts. If I’m right, these stocks will deliver income AND growth over the next few years. The banks on the other hand, could well produce income AND capital losses.

This week, the market confirmed my positive prognosis. Two of the stocks I recently recommended to subscribers just broke out to new yearly highs, which is a very bullish sign. Another one looks like gearing up for a strong move higher.

To find out what this new growth sector is, you can check out my special report here.

Greg Canavan+,
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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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slewie the pi-rat
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i’m hearing that the Brits are itching to re-invade Libya.
you know, to help them out.

well, i guess!
last time all their pilots stayed in Italian hotels!
the cost over-runs that had to be reported to Parliament, the first time, were so enormous, they became State Secrets!
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