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Why most economists have it wrong

The sculpture 'Le Penseur' by Auguste Rodin
Chesnot | Getty Images
The sculpture 'Le Penseur' by Auguste Rodin

Many economists and investors fear that the prevailing global economic expansion is near an end, after enjoying a run of more than seven years. We take the contrarian view and contend that the current cycle remains at its midpoint – with a high likelihood that economic expansion will be sustained as productivity growth replaces liquidity growth.

The current economic expansion, in place since 2008, has been driven largely by central bank policies characterized by exceptionally low interest rates. The resulting low yields opened the floodgates to a significant pool of liquidity, which then cascaded into stocks and bonds, raising valuations for those asset classes.

As the Federal Reserve raised interest rates in December, and is expected to continue tightening in 2017, liquidity growth is likely to slow markedly. As liquidity ebbs, we believe conditions will be ripe for an increase in corporate capital investment that will result in growing productivity. As such, the next phase of the economic cycle will be driven by an expansion of corporate earnings, rather than excess liquidity chasing stocks and bonds.

Our view is reinforced by a number of data points, which are reminiscent of – and consistent with – previous economic expansions. For example, U.S. productivity growth remains at the lowest point of the past 20 years, and near the lowest point of the past 60 years, but is poised for a CapEx-fueled rebound.

At the present time, however, U.S. business investment as a share of GDP is also well below trend, underscoring the pressing need for corporations to invest. The last time we saw metrics on this order was in 1993-94, a period that was followed by an economic expansion lasting 7 years.

"Even amidst all of the questions about what a Trump presidency will mean for America, there is a bigger case to be made for why we should be bullish on U.S. stocks over the next few years."

There is a strong argument that corporations are reaching a turning point where they must begin to invest in productivity improvements and earnings growth. While share valuations have been elevated, as noted earlier, U.S. corporate profit margins have actually been declining, largely due to rising wage inflation.

Profit margins of the S&P 500 (average for the past four quarters) are now at 8 percent, or about 300 basis points below the U.S. profit share of GDP. Liquidity, rather than fundamental earnings, has been the source of the equity over-valuation. At the same time, rather than use their substantial cash flow to fund growth-generating investments, many corporations have engaged in stock buybacks.

As liquidity is withdrawn from the stock market, and no longer drives equity valuations, we believe corporations will turn their attention to the need to invest in productivity and better earnings. In addition, as the new administration in Washington delineates its policies in areas such as taxation, trade and infrastructure investment, this will reduce some of the uncertainty that has been an impediment to capital investment by U.S. corporations.

Given the clear relationship between CapEx and worker productivity, there is compelling evidence that investing in productivity is an effective strategy. Accordingly, valuations that now appear full on a forward PE basis should increase as corporate investments drive earnings growth. Rising earnings will be supportive of growth sensitive and cash flow generating sectors, even though rising interest rates will adversely impact liquidity sensitive and highly priced sectors.

What does all of this mean for investors? Even amidst all of the questions about what a Trump presidency will mean for America, there is a bigger case to be made for why we should be bullish on U.S. stocks over the next few years. We believe that some of the world's best investment opportunities lie in the U.S. technology sector, which is well-positioned to benefit from a rise in business investment.

We have been positive on the technology sector for the last three years, and upgraded our view of the sector in the third quarter. Since that time, the S&P 500 Information Technology Sector has returned over 9.5 percent, versus the S&P 500 at 5.8 percent. While the sector has under performed in the weeks following the election, we believe that this represents one of the most compelling buy opportunities across global markets.

Earlier this year, we also saw an opportunity in U.S. housing stocks, which stand to benefit from favorable demographics, a rising working age population and a strong banking sector. Other sectors that may benefit from the new administration's apparent interest in easing regulation and taxation include banking/finance, consumer discretionary, and industrials/commodities.

We cannot predict the magnitude and duration of the next phase of expansion, which will depend on the extent to which productivity growth can replace liquidity growth, and fiscal stimulus and private sector participation can substitute for monetary stimulus. That said, we believe that the transition from a liquidity-driven market to one propelled by growing productivity will sustain the current economic expansion for several more years.

Commentary by Atul Lele, chief investment officer at Deltec International Group. His investment framework has been developed over the past decade, and his theses analyze the interaction between global liquidity conditions, growth and asset prices at an asset class, region, sector and stock level.