Mackenzie Canadian Growth Team
The second quarter came to a chaotic close as the unexpected “leave” vote in Britain began the Brexit process. The past decade has been difficult and crisis filled, leading many to wonder what has changed and what, if anything, can we do about it?
Part of the story is clearly regional. We have cautioned for a number of years that Europe and China have deep structural challenges and have invested accordingly. Much as the market chaos in January of this year drew attention to China’s difficult and halting transition away from over-building, Brexit refocused the world on Europe’s political strains. Although Brexit, which ultimately is a multi-year trade negotiation, is not expected to have a material economic impact globally, it once again highlights that the EU, in its current form, is failing many of Europe’s citizens.
Yet there is something deeper happening here, something that goes beyond regional economic problems. In our view, the core of the problem is a slowdown in global growth. It is this slowdown that has led to a disturbing increase in global debt and increasingly, a backlash against globalization. To us, the key questions are why has growth slowed and, as growth investors, how are we approaching this lower growth environment.
In our minds, there are three very different explanations for the step down in growth, and all of them have quite different implications for both government policy and for what we, as investors, should expect going forward. We focus on the United States below, as it is the world’s largest economy at around 25% of global GDP, and has been the strongest of the developed economies since the financial crisis.
The first explanation is that the problem is a hangover effect from the US housing bubble and global financial crisis. After a crisis, GDP growth tends to be lower for a number of years, while public debt levels skyrocket, on average nearly doubling. This time has not been different, with US public debt jumping from 65% to 100% of GDP, while growth has remained anemic.
The good news is that we are coming up to ten years after the crisis, and many of the cyclical drags on US growth have begun to resolve. US house prices have begun to move upwards, unemployment has returned to a normal range, incomes have begun to grow again, and lenders are, once again, extending credit more broadly. Public debt as a percentage of GDP has recently stabilized, with mild deficits offset by growth in underlying GDP, the combination of which, if maintained, will gradually push the ratio of debt to GDP lower.
Although the growth in public debt has returned to a normal range, the level of debt is extremely high. It is surprisingly hard to tell if we should expect the higher level to be a major drag on growth or, more worryingly, if it will lead to a future debt-oriented crisis. History suggests that there are a number of paths to deleveraging, some of which are benign, while some are distinctly not. Unfortunately, we do not know any way to determine what will happen this time, or even if historical examples are truly meaningful. These are events that happened decades ago and there have been many changes to the global economy since they occurred. Positive cases, like Britain going from 250% debt to GDP post-World War Two to less than 50% by the 1970s through low interest rates and economic growth, are offset by negative examples, like the depression/deflation of the US during the Great Depression and the default/inflation of the Weimar Republic during the 1920s.
Also, since many of the cyclical headwinds to US growth are now lifting, we should expect a noticeable increase in US GDP growth. That this has yet to happen suggests that there may be other, more structural, reasons why growth rates have slowed.
In fact, there is strong evidence that US growth began to slow, and debt clearly began to rise, well before the global financial crisis. Real GDP growth from 2002-2007 was well below historical levels. This was a period that saw both a recovery from a mild recession and a massive housing bubble, both of which are extremely supportive of shorter term growth. In addition, macroeconomic policy during this period is generally viewed as very loose, with excessive lending growth tied to weak regulatory oversight and growth oriented monetary policy. Having below normal growth in this environment suggests a structural change in either the demand or supply side of the economy had already occurred.
The “Secular Stagnation” hypothesis suggests that the economy has seen a structural decline in demand caused by demographics, less capital intensive growth, and a hollowing of the middle-class. All of these factors are well supported by economic data. In addition, the lack of demand should, over time, lead to extremely low real (inflation adjusted) interest rates, which we have also seen over the past decade. Post-crisis there was a common argument that interest rates were “artificially low” as a result of extreme monetary policy measures. However, despite the US exiting its QE programs and slightly raising short-term interest rates, a continued decline in mid and long-term bond yields provides further support for a structural change in demand.
There is a risk that the fall off in demand can start to feed on itself. When this happens, weak demand leads companies to delay capacity expansion. Since capacity is not being added, this leads to less employment. Lower employment results in companies seeing weaker demand, which further results in them delaying capacity expansion. This story is consistent with discussions we have had with a number of companies, who are limiting expansion until revenue growth picks up.
From a policy standpoint, secular stagnation should be addressable by direct government spending on investment, in particular infrastructure construction. Broad infrastructure build would raise demand generally in the economy, resulting in companies once again seeing the opportunity for revenue growth, and leading to a return to investment in capacity. In addition, interest rates would be expected to gradually return to a more normal range as the demand for investment gradually picks up.
The second structural explanation is on the supply side. Issues here are both the most persistent and the most difficult to deal with from a policy perspective, with headwinds including: demographics, stagnant educational attainment, and rising inequality.
The most troubling supply-side concern is around innovation. Despite the fairly common belief that the rate of innovation is accelerating, from an economic perspective, the opposite appears true. The growth rate of economic productivity slowed noticeably during the 1970s and has yet to reaccelerate on a sustained basis. Arguably, the slowdown is structural in nature, and is due to reaching the end of the growth benefits from the long tailed gains of innovation from the Industrial Revolution. The impact from electricity, internal combustion engines, and running water, followed by second order impact from airplanes, air conditioning, home appliances, and interstate highways, had a one-time benefit on growth rates that is unlikely to be repeated and dwarfs the current productivity benefits accruing from recent innovations like computing and the internet. Put simply: inventing electric self-driving cars is less significant than inventing cars themselves and while iPhones are useful, they are dwarfed by the impact of electricity and running water.
From a policy perspective, a structural supply slow-down does not have a simple solution. Demographics, education, and inequality are difficult to address, and a falloff in the impact of innovation is equally troubling.
The challenge for policy is that the likely causes for slower growth all suggest very different responses making the correct course of action dependant on your assumption as to what the main cause is. This, to our minds, is the reason why there is so little consensus as to the correct course of action and such differing views as to what the actual problem is.
If the problem is mostly cyclical, then it will resolve by itself over time, and the safest course is one of medium term austerity, keeping government debts under control, while waiting for the inevitable reacceleration of growth. Problems on the demand side of the economy call for opposite policy, with a strong policy response of infrastructure investments potentially “snapping” the economy out of stagnation, leading to a sustained increase in both the growth rate of GDP and interest rates. Finally, supply side problems are difficult to address through policy, which suggests that the best course may simply be to adjust growth expectations lower.
One of the important lessons of history is that severe or lengthy economic problems tend to lead to political problems. As Brexit has shown, this time is not different in politics either. Weak economic growth is a recipe for political stress. In the case of Britain, national sovereignty over regulation and immigration, along with “elites in Brussels” were key concerns, while in the current US political cycle, trade and immigration and with “elites in Washington” have been repeated themes.
Recently there has been a fair amount of focus on the impact of globalization and trade on the US economy. While earlier economic work tended to stress gains from trade—why would two parties trade unless they both gained?—more recent work stresses the importance of how those gains are shared. There is mounting evidence for a large drop in both employment and incomes for workers in US based industries exposed to import competition. Importantly, these effects were not offset by gains for workers elsewhere. This is a clear reason for the rising conflict over trade and globalization.
Rising inequality, which is noted as a source of slower growth on both the Demand and Supply side above, has also been a frequent political theme. Both automation and outsourcing have had significant impacts as jobs featuring routine tasks or capable of being performed at a distance have been replaced by machines or outsourced in developed countries globally. The gains from automation and outsourcing have gone to a small segment of the population, while displaced workers have tended to be “pushed down” into lower skilled and lower paying jobs, often in the service industry.
Although reversing globalization and automation is, at best, very difficult, we expect to see continued political stress around these themes. In particular, the role of global trade is likely to be a significant concern and we expect rising trade friction to continue.
In our view, the uncertainty surrounding the cause(s) of slower growth combined with rising political unrest, suggests the most sensible course is to assume that growth will continue to be slower and invest accordingly. We have been following this path post the financial crisis. Not counting on economic growth acceleration to generate returns makes it ever more imperative to find businesses that can both create and serve new markets or have some unique skill set that allows them to gain market share against weaker players. We have many holdings in our funds that have been doing this successfully for many years. Companies like CCL Industries, Dollarama and Gildan are great examples.
CCL has been able to consistently deliver mid-single digit organic growth, which is largely de-coupled from the macro environment. This has been a function of both the relative inelastic demand for their products, and superior management, which has empowered them to continually gain share through product innovation, quality and consistency. A careful and methodical approach to capital deployment supplements this growth via acquisitions, which has significantly enhanced shareholder value as evidenced from the consistently rising return on equity metrics. We continue to expect stable organic growth going forward as they leverage their global manufacturing footprint to service the needs of increasingly global customers. As a significant free cash flow generator, they have both the expertise and the means to capitalize on growth opportunities as they may emerge.
Gildan has been taking share from its larger US rivals for over a decade now from their reinvestment in manufacturing that has driven a 25% cost advantage versus their American peers. In addition, Gildan has backward integrated into yarn spinning to create a superior quality end product. They have spent three times more than their peers over the last decade which has given them this edge. Gildan’s end markets grow in line with GDP, but the combination of lower prices and a superior product has allowed them to take market share each year, and we don’t see this abating. Three years ago they won business from Walmart and last year they displaced the Cherokee brand within Target stores. Most of their growth has been achieved by internally generated funds and as a result, their leverage is still so low that they are buying back their shares. They are a huge free cash flow generator and that allows them to continue to build on their global low cost position.
In retailing, Dollarama is a true category killer. They have a very unique retailing concept that no one else in Canada is able to compete against. Their expertise in merchandising and operational excellence has allowed them to continue to deliver same store sales growth in excess of 5%. Recent results show continued strong results in all geographies, even those exposed to oil and gas, including Alberta. This is astonishing given the recessionary environment in that province. With store rollouts continuing we continue to expect strong growth going forward.
Another aspect of what we do is to find companies that can innovate and create superior growth. Spin Master is an outstanding example of this. They are a Canadian toy company competing against Hasbro and Mattel. The toy industry has an approximate 4% CAGR over a 10 year cycle and Spin Master has far exceeded this growth rate. Growth is driven by new product innovation and execution and the company has a healthy 3 year pipeline of new products which we believe will continue to deliver superior growth.
There are also sectors of the economy that have been faring better than the overall economy and these are areas where we tend to have significant exposure. IT and healthcare are two sectors of the economy that suit our style as there are a number of businesses that are very stable, have strong organic growth, and have competitive dominance in their field. Companies like Becton Dickinson, Zoetis, IMS Health, and Gartner Group, are just a few examples of businesses that we expect will continue to outgrow the general economy.
In addition, there are always displacement trends occurring within the economy where newer products are replacing more traditional methods. Holdings like Amphenol, Ansys, and National Instruments are good examples. In the case of Amphenol, the increasing use of electronics as a replacement for mechanical products requires a greater use of Amphenol’s connectors and sensors. One area of growth for them is connectors for electric vehicles and hybrids, an area which we believe will continue to grow strongly over the next 10+ years. Ansys is the world’s leading simulation software provider, and as product design continues to become more complex, customers are increasingly turning to simulation to speed up design cycles and reduce product recalls. Finally, National Instruments is the dominant global supplier of software based virtual test and measurement systems. National’s LabVIEW platform has a long history of displacing expensive “big iron” testing systems.
Ultimately, there are a number of features of our investment style that we believe give us the opportunity to succeed in a lower growth environment. By owning only 30-35 companies from the over 2,000 we could potentially invest in, we are able to be highly selective and choose companies that have the capacity to grow faster than the average business. Our emphasis on total return: the combination of sales growth, margin expansion, and the generation of free cash flow, allows us to find companies that will generate steady returns across a cycle for us as shareholders without taking the risk of chasing businesses with unsustainably high growth rates. Finally, our emphasis on management teams and corporate culture allows us to find companies that can displace competitors and create innovative opportunities for growth in an environment where weaker companies may struggle.