
Independent Thinking®
What Next? Investing in Turbulent Markets
July 21, 2016

Creative destruction, which the economist Joseph Schumpeter said is the essence of capitalism, is all around us – and it continues to accelerate. Technological changes are displacing old industries and creating opportunities that are magnified by globalization. Investors benefit from both corporate growth and low inflation, a byproduct of global competition.
Why then is economic growth now slowing? If creative destruction fosters innovation and growth, why have yields on sovereign debt declined to record lows? As the chart on page 8 shows, over $10 trillion worth of government bonds across 10 countries are now trading at negative interest rates. Stocks have held up remarkably well, but volatility has increased and should remain at elevated levels.
Some of the reasons are clear: Productivity, labor force growth and inflation are the well-known components of nominal economic growth, and the growth rates for all three are in decline. Of these, productivity is by far the most important because it is the sole driver of real per capita economic growth and improving standards of living. The jury is still out on what is causing the recent deterioration in the productivity growth rate. Most likely, it relates to the growing dominance of the service sector over manufacturing. Either it is inherently harder to increase productivity in the service sector than it is in manufacturing, or productivity is not being accurately measured in the service sector. We believe the real answer contains elements of both – and that productivity growth is actually better than the official estimates.
Less clear is the relationship between economic growth and populism. Globalization, sparked by the fall of the Berlin Wall in 1989 and ignited in 2001 when China joined the World Trade Organization, has lifted millions of people in the emerging world out of poverty and has reduced inequality at the global level. But it has done little for the industrial working classes in the developed world, who have seen their livelihoods migrate to emerging markets or disappear altogether.
Indeed, the technological advances of the past few decades have cut far more jobs than they have created. Stagnant wages and, for white middle-age Americans, recent evidence of declining life expectancy caused by suicides and drug addiction, are among the grim consequences of growing inequality. (This same demographic was also hardest hit by the subprime credit bubble, in which many became grossly overextended.)
The recent rise of populist movements on both sides of the Atlantic is a wake-up call to investors. Just about all of us were surprised by the Brexit vote. Many seem equally surprised by the rise of Donald Trump and the enthusiasm for Bernie Sanders. Populist movements are also surging in France, Germany, Austria, the Netherlands, and other European countries. (See the chart on attitudes toward the European Union below). Italian Prime Minister Renzi has staked his own political future on reforms designed to keep populists at bay, but even if he wins the October referendum, he may still lose the general election to follow. This growing divide between the relatively prosperous and those who feel threatened by creative destruction, as manifested in the perceived threat of immigration and the very real challenges of technological change, is now impossible to ignore.
The question that investors must now address is to what extent these populist movements will disrupt the status quo in the developed world as a whole. This is not something that monetary policy can fix. In fact, zero and even negative interest rates have been an important contributor to inequality, as the wealthy owners of assets benefit from inflated asset prices and small savers are stymied by record low interest rates.
We will be watching developments closely. The United States is in relatively good shape, and we do not expect a recession anytime soon. We remain underweight in international equities in general and significantly underweight in international developed markets, including Europe. We see opportunity now in the U.S. stock market, especially in the technology sector. (See the related article on managing innovation and regulation on page 3). We have no exposure to foreign currency-denominated bonds. Our defensive assets are generating positive returns and adding stability to portfolios in these volatile market conditions.
We lowered our capital market return assumptions one year ago and remain confident that our expectations are reasonable in light of current market conditions. If, however, the populist trend does gain majorities in the United States and other developed countries, we will need to further reduce our global growth expectations, expect interest rates to stay lower for longer, and further reduce nominal expected returns from most of the major asset classes.

Managing Innovation
If productivity is the driver of real economic growth, regulation is the brake. Uber and Airbnb are currently waging battles around the world as they disrupt vested interests in the traditional taxi and hotel businesses. Amazon and the big U.S. technology companies, including Facebook, Google and Microsoft, face government-sponsored opposition to their hegemonies in Europe and China.
Of course, some regulation is necessary to protect the public interest. There are, for example, many unsettled questions around security and privacy that will need to be fought over among regulators and lawmakers around the world, even at the expense of slowing the dissemination of some innovative products and services.
The challenge is to strike the right balance, so that we can capitalize on innovations while keeping the negative potential consequences to a minimum. It is not yet clear that governments are striking that balance.
A disproportionate amount of major technological innovation and commercialization happens in the United States because we have a relatively friendly small-business regime. However, impediments have been growing, notably on small businesses. That’s unfortunate, as startups and small businesses do the heavy lifting in figuring out business models that exploit new technologies and create opportunity. Indeed, most of the new jobs and productivity improvements in recent years have come from businesses with fewer than 50 employees.
There’s a great deal at stake, as extremely exciting innovations on the horizon hold the promise of boosting productivity and jump-starting the economy. Driverless cars, drones, robots, new disease therapies, and high-quality voice recognition are all tantalizingly close to broad-based implementation.
Investors in innovation must be careful not to be swept up in market enthusiasms, which can push valuations to unreasonable levels. We prefer to invest in companies in, for example, the semiconductor industry, which are creating the underlying building blocks for many of the new technologies.
In this low-growth economic environment, innovation and its applications offer investors some of the brightest chances of generating healthy returns.
– J.A.
John Apruzzese is the Chief Investment Officer at Evercore Wealth Management. He can be contacted at [email protected].