Sports fans know that a team’s performance depends on more than luck. From game to game every team experiences ups and downs, accompanied by intense speculation about trades and strong opinions about the coaches’ resourcefulness or the players’ agility under pressure. Luck does, of course, count; injuries can sideline star players for weeks. But fundamentals make the difference over the course of a season. No matter what journalists, retired players, and fans might suggest—and no matter how vehemently they might express themselves—there are no short cuts: A championship team needs a combination of talented players, expert coaches, and competent general management.
Economies, like sports teams, also experience ups and downs. Fortunately, most fluctuations in real GDP growth are nothing more than short-lived deviations from a stable long-run path. Nonetheless, it is during these episodes that the talking heads and economic pundits leap into action with convincing stories to justify high and low projections. If you tune in your favorite network, you will find the economic equivalent of sports talk shows, flooding the airwaves with an endless stream of breaking news.
A recent notable “down” of the U.S. economy took place in the first quarter of 2014. By the beginning of summer, the growth rate was revised down to −2.9%, more than 6% below the previous quarter. To justify this swing, the phrase “polar vortex” entered the financial lexicon. An abnormal pattern of exceedingly cold temperatures, the story went, discouraged consumers from going to the mall to spend their hard-earned cash. Was the “polar vortex” narrative a valid interpretation of what was happening? Probably only in part; however, in the spring of 2014, there were just as many commentators talking about the temporary weather phenomenon as there were prognosticators arguing that the first quarter augured oncoming headwinds.
The polar vortex was quickly forgotten when, in the second and third quarters, the U.S. economy enjoyed growth rates that even some emerging economies would envy. According to the latest revisions, the economy made up the ground lost in the first quarter and grew at annualized rates around 4% in the second and third quarters, numbers that the media hailed as “the strongest six-month performance in more than a decade” (Cohen, 2014). While this quote is technically correct, its rhetoric hides the disappointing fact that in the first nine months of 2014 the U.S. economy grew at an annualized rate of 2%—an anemic rate if compared to estimates of the current output gap.1 It seems that every season has its story, which in turn is quickly forgotten as a new one emerges to capture the breaking news banner. Which stories should we focus on? What are investors to do?
In our opinion, the largest and most persistent active investment opportunity is long-horizon mean reversion in asset returns. The short term will be ridden with noise,2 false projections, fanciful stories, and bogus interpretations, most of which don’t mean anything. We at Research Affiliates suggest that long-term investors turn their attention to long-term growth fundamentals.
Cutting Through the Noise
Building on the growth-accounting literature,3 we can break out four main drivers of growth in real GDP:
Real GDP Growth = Productivity + α × Physical Capital + (1 - α) × (Workers + Human Capital)
All the variables other than alpha (α) are growth rates. Alpha is the share of national income that goes to the owners of capital, while the complement (1 - α) is the share that goes to labor. This equation tells us that national production results from the combination of industrious, educated workers and physical capital, such as machines and equipment. Productivity captures the contribution of technological progress and improvements in efficiency of the production process, while human capital represents the contribution to national production coming from advances in education.
Estimating how these components will contribute to future GDP growth is not an intuitive exercise because their impact is time varying. In Figure 1, we decompose the average real GDP growth rate in the United States over the last six decades. Between the 1960s and the 1980s, advances in education and increases in the labor force, driven by strong demographics, contributed more than half of the total growth. After the 1980s, when most of the baby boomers had already joined the workforce, the demographic dividend started to fade. Fortunately, extraordinary advances in technology in the 1990s offset the early demographic headwinds, contributing 40% of total output growth. These advances were impelled by the progressive incorporation of the Internet into work and, as Fernald (2014) recently argued, this technological expansion will not be easily replicated in future decades.