Market Outlook

Key Themes and the Nature of Economic Growth
October 14, 2020
By: Arun Kaul

In terms of wealth and debt, financial markets dwarf the real economy. In a levered economic system, with debt markets 2x the size of GDP, economic growth is very sensitive to financial conditions – creating both negative and positive feedback loops (Figure 1).

“Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion” (Ben Bernanke, Chairman, Federal Reserve Op-Ed, Washington Post, November 4, 2010).

Bernanke’s ‘virtuous circle’ will also work in reverse.

Figure 1: U.S. GDP vs U.S. Financial Markets Trillions $ (Source: SIFMA for U.S. credit markets, March 31, 2020, World Federation of Exchanges for U.S. equity markets, June 30, 2020, U.S. Bureau of Economic Research for GDP, June 30, 2020)
Figure 2: Federal Reserve Balance Sheet as % of U.S. GDP (Source: SIFMA for U.S. credit markets, March 31, 2020, U.S. Bureau of Economic Research for GDP, June 30, 2020)

The Fed is now the ‘asset manager of last resort.’ The U.S. economic system is not more centrally managed. Prior to the 2000 recession, the Fed balance sheet, used for management of short-term rates, was near 7% overall GDP and had been stable. Post 2009, the balance sheet grew to 25% and now post 2020 it is 36% (Figure 2)

There are now larger debt markets and larger central bank balance sheets. The U.S., ECB, Japan have all expanded central bank balance sheets dramatically. Japan’s is now larger than country GDP. The Central Bank’s ownership of asset classes is expanding with regards to government bonds, MBS, corporate bonds, gold, equities, ETFs, direct corp lending, and potentially munis and credit quality. Growing Central Bank balance sheets impede true ‘price discovery’ in capital markets (Figure 3).

Figure 3: Total Assets from Japan and the Euro Area Central Bank (Source: Bank of Japan, ECB and Federal Reserve for Central Bank balance sheets via Federal Reserve Data (FRED), September 22, 2020).
Figure 4: Contribution to Global Growth 2021 (Source: SIFMA for U.S. credit markets, March 31, 2020, World Federation of Exchanges for U.S. equity markets, June 30, 2020, U.S. Bureau of Economic Research for GDP, June 30, 2020)

The U.S. and China are disproportionately more significant in contribution to global growth than any other nation. The U.S is responsible for 19.6% of 2021 global growth contribution, and China is responsible for 20.1%. The nest largest nations, Germany, the U.K., France, India, Japan, Italy, Brazil, Korea, and Russia, all fall between 1% to 4% (Figure 4).

The U.S. economy is still 30% larger than the Chinese but is not forecasted to grow at less that 2% a year while China grows 4% to 5% a year. This is partly due to the economic class between the two largest economies that operate under very different systems. The key issues between the economies of the U.S. and China include trade, stealing intellectual property, forced technology transfers, state owned enterprises receiving heavy subsidies, product dumping, currency manipulation, hacking, and cyber security.

The changing nature of the economy drives enterprise value. As the U.S. economy evolves further toward a knowledge-based economy, opportunities for industries to drive exponential sales growth proliferate. Successful firms feature innovate ideas but more importantly, they typically provide higher margin businesses with faster segment penetration ratios. Scarcity vs abundance changes the dynamics dramatically (Figure 5).

Figure 5: Growth Potential and Margins (Source: Boutique CIO, Illustrative Purposes only).