REAL TALKS RECAP

For Current and Prospective Client Use

Has growth gone cold for the US economy? Have American principles of democracy taken a back seat to economic concerns as we head into the 21st century? And are investors focusing too much on the noise as they try to tune in to portfolio ideas? On May 1, 2017, Gerstein Fisher hosted a special Real Talks event, “The Future of America, In Context,” to wrestle with these and other salient questions. The evening’s guest speakers included award-winning macroeconomist and Northwestern University Professor Robert Gordon and Harvard Business School’s David Moss, an award-winning professor of business, government, and international economy and the author of Democracy: A Case Study.

One response to current political and economic challenges was articulated by the evening’s host, Gregg S. Fisher, Head of Quantitative Research and Portfolio Strategy. He underscored the importance of embracing a global worldview tilted toward broad diversification among developed and emerging economies and both large and small cap businesses. “World trade is a zero sum game,” Fisher reminded the audience, “if someone is running a deficit, someone else is looking at a surplus.” Following are key takeaways from the evening’s discussion.

ROBERT GORDONStanley G. Harris Professor in the Social Sciences, Northwestern University Member, NBER Business Cycle Dating Committee ‘Why Is U.S. Economic Growth So Slow? Can It Be Revived?’

The US economy has been growing at 2% per year in the current recovery, much less than in past economic upturns. The expansion has been fueled by employment growth of 1.5% a year and a decline in the unemployment rate from 10% in early 2010 down to 4.4% now. Given that unemployment is bottoming out, how fast can we expect the economy to grow at a constant unemployment rate?

Growth, Past and Future

To answer that question, I took the last quarter of 2016, which had an unemployment rate of 4.7%, and found quarters in 2006 and 1970 with the same 4.7% unemployment rate. Exhibit 1 compares growth in the period

From left: Robert Gordon, Gregg Fisher, David Moss

between 1970 and 2006 to the last 10 years. It’s a story of dramatically slowing growth, output per hour, and hours of work (which combined, add up to real GDP growth).

Exhibit 2 shows the capability of the American economy to grow since the early 1950s. After a long period of 3% growth, with a brief bump up in the late 1990s to 3.5%, the economy’s capacity to grow (at a constant unemployment rate) has plummeted to 1.4%, which is just about the same as the actual growth rate over the last 10 years.

A key aspect of understanding long-term economic growth rates is productivity growth. To examine productivity growth in historical context, let’s review the chronology of the three industrial revolutions we have experienced over our country’s history. The first one, the one most of us associate with the term “industrial revolution,” occurred in the late 18th century, when steam engines made possible railroads and steamships; cotton spinning and weaving arrived; and there was a transition from wood to steel.

2Gerstein Fisher | Real Talks Recap

Exhibit 2: Slowing Real GDP Trend Trend for Capacity to Grow

Source: Robert Gordon

If you look at the blue areas, you see that in 1920–1970 TFP grew three times faster than in the two other periods. Following healthy growth in the ‘50s and ‘60s, a slowdown in the ‘70s and ‘80s, a temporary revival in the late ‘90s and early 2000s, TFP growth has been abysmal for the last eight to 10 years.

Exhibit 3: The Three Eras of Productivity Growth Average Annual Growth Rates of Output per Hour, with Components (1890–2014)

Source: Robert Gordon

Exhibit 1: Growth with the Same Unemployment Rate

Source: Robert Gordon

The second industrial revolution happened in the late 19th century and made possible rapid productivity growth until the middle of the 20th century. This included the invention of electricity and everything that went with it: the internal combustion engine, which made possible motor and air transport; the telephone, phonograph, radio, motion pictures, and television.

The third industrial revolution encompassed advances in information technology, including mobile phones and productivity enhancers like the ATM machine and barcode scanner. While these developments have had a meaningful impact on our daily lives, how has their effect on productivity growth compared to that of the prior two industrial revolutions?

The total height of each bar in Exhibit 3 represents labor productivity growth. As Exhibit 3 shows, the second industrial revolution triggered productivity growth of almost 3% per year for a full 50 years, clearly eclipsing the first and third periods.

The top portion of each bar represents the contribution to productivity growth coming from education. The middle area shows the effect of capital deepening, or having more machines per worker. After we subtract out those two areas, we’re left with what we interpret as the role of innovation, which includes such big societal changes as the shift from a rural to an urban society and everything that went along with that. We call this Total Factor Productivity (TFP).

ACTUAL REAL GDP GROWTH (%)

1970 to 20063.2

2006 to 20161.3

SOURCES OF SLOWING GDP GROWTH (%)

Output per Hour (1.8 to 0.9)

Hours of Work (1.4 to 0.4)

Population 16+ (1.4 to 1.0) Hours per Person (0.0 to -0.6)

%

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1.0

0.5

1.5

2.0

2.5

3.0

4.5

3.5

4.0

1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013

Output

1890–1920

1.50

1970–2014

1.62

1920–1970

2.82

Per

cent

per

Yea

r

0.0

1.0

0.5

1.5

2.0

2.5

3.0 EducationCapital DeepeningTFP

3Gerstein Fisher | Real Talks Recap

The Disappointing Digital Revolution

The overall rate of growth for the third industrial revolution is only a third of what it was before 1970, and it only boosted or revived growth for about nine years, from 1996 to 2004–2005. Why has the “digital revolution” failed the test of TFP growth? Because it was mainly about business methods, this was a narrower revolution.

Looking back at the impact of technology on businesses, we started the 1970s with repetitive retyping and clunky calculators before moving on to the personal computer and spreadsheet software in the ‘80s. By the late 1980s, before the arrival of the internet, we already had e-mail, electronic catalogs, and personal computers connected inside firms that worked with proprietary software. Then came internet search engines and e-commerce in the late 1990s. By 2005, however, this set of innovations was largely over.

Offices today use desktop and laptop computers much the same way they did 10 or 15 years ago, and aside from e-commerce, we see relative stasis in retail from a technology standpoint. The shelves of brick-and-mortar stores are still stocked by humans, who are also still checking us out at the grocery store.The big revolution in medical care over the last 10 years has been electronic medical records, but that has not eliminated the jobs of doctors or nurses. Take another fairly recent innovation: 3D printing. It’s great for prototypes, but not mass production. You do not make 17 million new automobiles and trucks every year with 3D printers.

Significant progress has been made in artificial intelligence, part of which is big data. Big data is used primarily in marketing to figure out ways for one firm to steal customers away from others by making their products more accessible or attractive. But this is merely market share shifting, which is not a benefit to society that raises overall productivity. The McKinsey Quarterly conducted a survey of 350 business firms, asking them what impact artificial intelligence and big data had had either on their revenue or costs over the previous year. Three-quarters of the respondents said it had made a difference of less than 1%. In the real world, computers are complements as often as they’re substitutes for humans; they are not always driving people out of jobs.

We have innovation: plenty of people inventing applications, creating virtual reality, convincing us to wear smart watches, but the overall impact on business productivity – as yet – is still relatively limited. This, in my view, is the explanation for slow productivity growth.

Facing Strong Headwinds

The American economy is facing other headwinds that do not portend well for growth: education, demographic trends, income inequality, and the fiscal outlook.

While education was a significant driver of growth in the 20th century, high school completion rates have barely budged since 1970. In the OECD, in terms of educational attainment of 15-year-olds, the United States is ranked 17th in reading, 20th in science, and 27th in math. The US once sent more of its kids to college than any other country, but has now slipped in rank to number 16 in college graduation rates and to number 14 in high school attainment. It is estimated that this education headwind alone will reduce economic and productivity growth by about 0.3% per year in the future.

On demography, baby boomers are retiring and we are seeing the labor force participation rate of prime-aged men and women shrink. The income inequality gap is widening: over the last 20 years, 52% of all income growth accrued to the top 1% of income earners. At the same time, our fiscal deficit and level of federal debt relative to GDP have skyrocketed. Projected out to the year 2040, net debt/GDP is well on its way to 100% from the current level of about 75%.

So what do these various headwinds mean for growth? The education headwind brings down productivity growth; a deteriorating demographic picture reduces hours of work per member of the population; income inequality reduces median growth compared to average growth; and the fiscal headwind will eventually require some fix that will take the form of either a tax increase, a benefit reduction, or some combination of the two. Exhibit 4 compares what we’ve accomplished in terms of average annual percent rate of growth since 1920 (dark bars) and what I predict for the next 25 years (light bars).

4Gerstein Fisher | Real Talks Recap

Exhibit 4: Growth Rates: Actual Outcomes, 1920–2014; Projected Values, 2015–2040

Source: Robert Gordon

In conclusion, despite promises from Washington, we are not going to see 3.5% to 4% growth. Recent US growth has been made possible by a continuous decline in unemployment for the last seven years, which cannot persist indefinitely. We will continue to experience retirement of the baby boom generation. We don’t see anything on the horizon that’s going to raise productivity growth above the 1.2% that I’ve forecasted. The silver lining in this picture is that slow productivity growth means that jobs are not disappearing at the rate of destruction predicted by the techno-optimists. The US economy is creating 2.5 million jobs per year, and that job creation is going to continue for quite a while.

DAVID MOSSPaul Whiton Cherington Professor, Harvard Business School Founder, The Tobin Project ‘Is American Democracy in Trouble?’

In a recent survey, Harvard Business School graduates ranked the US political system the second biggest detractor from US competitiveness (right behind the tax code) out of 19 aspects of the business environment. With rancor and discord in Washington at a fever pitch, many Americans are not only dispirited, but concerned for the future. Yet conflict has been a thread that has run throughout this country’s history. In fact, political conflict turns out to be a profoundly American phenomenon.

Productive Tension or Destructive Conflict?

When examining the history of this country’s democracy, it becomes clear that it has never been a “consensus democracy;” rather, many achievements have been the result of bitter, albeit in the end productive, tension. A critical question examined in the book, Is American Democracy in Trouble, is, what distinguishes productive from destructive conflict?

The Civil War presents a stark example of destructive conflict. In the middle of the 19th Century, tensions boiled between the north and south as Abraham Lincoln, who was known to oppose the expansion of slavery, had been elected President. While Lincoln would not be inaugurated until March of 1861, the southern states, starting with South Carolina, began to secede in December of 1860. No one was calling for a recount or debating the outcome of that election – the southern states simply did not accept the results. Conflict becomes destructive, as it did in this dark chapter of American history, when a common faith in democracy and the democratic process no longer holds people together.

Fortunately, productive conflict has been much more abundant in our history. In the 1840s, the political left in New York State was pushing the Common School Movement, which had started in Massachusetts and called for tax-financed public education. It proved immensely controversial, with many citizens opposed to paying for their neighbors’ children’s education. After rancorous debate, in the end voters were swayed in favor of the movement. Why? Because they were persuaded of the value of an educated electorate to our democracy. In contrast to the prior example, in this situation a common faith in democracy was central to the constructive resolution to a conflict.

Output perHour

Disposable MedianIncome Per Person

Output perPerson

Median Outputper Person

%

0.0

1.0

0.5

1.5

2.0

2.51920–20142015–20402.26

1.20

2.11

1.821.69

0.80

0.400.30

5Gerstein Fisher | Real Talks Recap

Losing Our Way?

From anti-trust policy to financial regulation, the clear majority of policy debates, up until about the time of World War II, included some consideration of democracy. What has enabled both sides on a given issue to move forward despite divergent interests and not fall prey to paralysis has been a common faith in our democratic system. Since World War II, however, economic growth, and not democracy, has become the driving force behind many policy debates. Today’s discussions about education reform, for example, center around the importance of education to economic competitiveness and to raising incomes, not its importance to democracy.

And it’s not just policymakers who seem to have lost the thread. As Exhibit 5 shows, nearly half of Americans appear to have little trust and confidence in our democracy.

This stark reality is the heart of the problem in our political system today. Partisanship, money in politics, and gerrymandering are themes we often hear about as “what’s wrong” with American politics. Yet these are the symptoms of what’s really wrong. What’s wrong is that we seem to have forgotten what most powerfully binds us together: a common faith in democratic self-governance.

Exhibit 5: Losing Faith Percent saying “not very much” or “none at all” when asked “how much trust and confidence do you have in the American people as a whole when it comes to making judgments under our democracy system about the issues facing our country.”

Sources: Gallup, David Moss

The Task Ahead

A weakened culture of democracy is an easy threat to ignore, but is potentially very dangerous, both politically and economically.

There is reason to be optimistic, however. Thus far in history, American democracy has been tremendously resilient. If we focus on properly diagnosing the current crisis in our political system and start to work on the root cause instead of the symptoms – if we recognize that we need to strengthen our culture of democracy – there is hope that we will be able to look back on this chapter in our country’s history as another example of productive versus destructive conflict.

GREGG S. FISHER, CFAFounder, Head of Quantitative Research and Portfolio Strategy, Gerstein Fisher

The world has changed profoundly since World War II. From the way we work, to how we communicate, to what we produce and consume, we have seen a dramatic evolution. Global trade, which totaled approximately $270 billion in 1900, stood at nearly $16 trillion in 2016. Yet that growth has not been a straight line. After a marked climb from about the late 1970s, global trade has essentially flatlined over the past decade. Is this just another bump in the road, or are we headed for a protracted period of shrinking global trade? While we can’t predict the future, we can and should think about what various scenarios might mean.

The Evolving Global Landscape

As the world has grown more interconnected, the global economic balance of power has also shifted. We are moving to a multi-polar world in which the US is no longer the dominant contributor to world GDP. In terms of global output, what the US has lost has been picked up by the emerging markets, as shown in Exhibit 6.

1974 20150

30

25

20

15

10

5

35

40

45

50%

6Gerstein Fisher | Real Talks Recap

Exhibit 6: Moving Toward a Multi-Polar World Breakdown of World GDP by Region

Sources: World Bank, Gerstein Fisher Research

At the same time, the opportunity set for investors is shifting away from the US, with the number of publicly listed companies in the United States dropping between 1995 and 2015, while the number of publicly listed companies in the rest of the world grew.

While there are mixed views on whether globalization is a good thing, it’s irrefutable to say it is happening. Case in point: the production of a simple pencil requires raw materials from no less than a dozen countries, ranging from the US to Mozambique and Kazakhstan. We are arguably too far down the path of global interconnectedness to turn back.

Yet the winds of protectionism are blowing hard in the United States. Any country’s individual decision to effectively shut itself within its own borders has serious implications for the rest of the world. A Chinese pencil manufacturer that earns 35% of its revenues from US sales has reason to be worried about US protectionism. While individual companies may suffer from insular trade policies, however, the global economic ecosystem will adapt. In global trade, by definition, one country’s trade surplus must translate into others’ deficits.

Why Do We Care About Global Trade?

As investors, we care about global trade because it affects virtually every component of the global capital markets, as seen in Exhibit 7.

Exhibit 7: Global Trade’s Impact

Source: Gerstein Fisher Research

Recently, news headlines have painted a grim picture of the state of global trade. It seems that more countries want to be connected, but only on their own terms (case in point: Brexit). Slow growth is another headwind facing the global economy, as seen in Exhibit 8.

Exhibit 8: Slowing Long-Term Global Growth Global GDP Growth – 10-Year Moving Average Average Annual GDP Change: Jan. 1960–Dec. 2015

Sources: World Bank, Gerstein Fisher Research

Out of Balance

As growth has slowed, debt has grown, particularly for the developed economies. As recently as 2007, average OECD debt as a percentage of GDP stood at 56%. In 2015, that figure had climbed to 82% (Source: OECD).

GLOBALTRADE

Employment

GDP Growth

Currency

Inflation

Income Inequality

Consumption

Savings

Interest Rates

Innovation

GLOBALCAPITAL

MARKETS

%

3

7

5

9

11

13

15

1970 1979 1988 1997 2006 2015

US

40%

24%

Developed Countries

38% 40%

Emerging Markets

22%

36%

0

30

25

20

15

10

5

35

40

45% 1960

2017

7Gerstein Fisher | Real Talks Recap

Trade imbalances have been created in large part due to a bifurcation between countries that are saving too much and spending too little (e.g., China, Germany) and those that are consuming too much and saving too little (e.g., the US).

Government policies around taxes and tariffs in different countries are a meaningful variable to this imbalance between spending and saving. The United States has generally kept taxes on consumption and imports low, compared to the rest of the world and to other major export-focused nations. Combined with a currently-strong US dollar, this makes it relatively cheap to import goods and services from abroad into the United States. And the consequences show up in the fact that the United States has been running a trade deficit for more than 40 years. The frantic pace of US consumption seems unstoppable. Even as our homes are getting larger (according to the US Census Bureau, the median size of new single family homes has risen from 1,535 square feet in 1975 to 2,467 in 2016), the self-storage industry has seen explosive growth, as people are consuming more than they even have room to keep.

As noted earlier, one by-product of too much consumption and too little saving is mounting public debt. Interestingly, while the United States’ public debt has tripled since 2000 from approximately $6 trillion to $20 trillion, the cost of servicing that debt has barely risen: from $360 billion in 2000 to around $400 billion today (Source: US Treasury Department). How is this possible? The answer is the prevailing very low interest rate environment we’ve seen

over the past decade. When interest rates inevitably begin to climb, debt service is going to become a significant challenge for this country. If we are serious about investing in our future, as a country we must save more and spend less.

Amid Trade Imbalances and Economic Shifts, What Is an Investor to Do?

Arguably, US companies are more protected from trade wars and protectionism than most of our global counterparts. Nearly two-thirds of the revenues of American companies come from the domestic market, with the balance coming from overseas. The developed foreign markets are virtually a mirror image, with most their revenues coming from markets outside their own (Sources: MSCI, Gerstein Fisher Research).

Against a backdrop of rising nationalism, investors would be wise to target factors that enhance global diversification in a portfolio: for example, investing in countries or companies with geographically diverse revenue bases. As seen in Exhibit 9, just by investing a portion of your equity holdings in a global versus a US-only index fund, you are accessing a much broader opportunity set.

Further, research conducted by Gerstein Fisher has shown that diversification is enhanced even more by reallocating some capital away from the largest (as measured by market capitalization) countries and toward smaller ones. (For more on this, see our Investing Insights piece, “International Investing and The Small Country Effect.”)

Exhibit 9: If You Can’t Predict the Future, Which Would You Rather Hold?

Home Market: Index Portfolio Global Market: Index Portfolio

Sources: S&P, MSCI, Gerstein Fisher Research

S&P 5001 country, 500 stocks

MSCI ACWI Investable Market Index46 countries, ~9000 stocks

8Gerstein Fisher | Real Talks Recap

Perhaps allocating capital to a diversified mix of countries and companies and holding it for several decades does not sound exciting. Yet, in our view, this is the soundest, most rational way to grow wealth over time. Behaviorally, for several reasons, this can be hard to do. Besides being “boring,” this approach is sometimes difficult to stick to when investors see particular countries, regions, styles, or investment factors fall out of favor. Motivated by fear, too often they sell at just the wrong time.

In Exhibit 10, we can see that, over the long term, investors holding a globally diversified, multi-factor equity portfolio would have seen their wealth grow to nearly four times the amount it would have been if only invested in the S&P 500.

Over shorter time periods, different trends emerge. For the past five or six years, for example, we’ve seen the US market performing better than foreign markets. In fact, many investors are wondering if the US stock market is getting “too expensive.” Looking at history, we observe that overpricing and underpricing in markets are delicate

Exhibit 10: A Multi-Factor Global Approach Has Outperformed Over the Long Term Growth of $1000 Jan. 1, 1970–Dec. 31, 2016

matters. Many of you will remember then-Fed-Chairman Alan Greenspan’s famous “irrational exuberance” speech, delivered in the heat of the dot-com bubble of the 1990s. What you may not remember is that, in the three years following that speech, the market went up 107%.

Indeed, the markets can run longer than fundamentals suggest they should. This is not a new phenomenon, and it makes it that much harder to try to predict when the tide will turn. Fortunately, at Gerstein Fisher we do not rely on market timing to earn investment returns. As John Maynard Keynes so eloquently said, “The markets are moved by animal spirits and not by reason.” Thus, we don’t believe that trying to estimate whether the market is overpriced or underpriced or when a correction will happen is time well spent.

Instead, we apply deep research and a thoughtful approach to building well-diversified portfolios with tilts toward investment factors that, over the long term, have rewarded patient investors.

$

0

200,000

100,000

500,000

300,000

400,000

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Risk & Return Comparison Annualized Return Annualized Standard Deviation

Multi-Factor Global Equity Strategy* 13.6% 15.6%

S&P 500 Index 10.3% 15.2%

*The Global Multi-Factor Portfolio is comprised of: 24% domestic large value, 24% domestic large momentum, 6% domestic small value, 6% domestic small momentum, 28% international value, and 12% emerging value (but 40% international value from 1970-1988).Sources: S&P, Morningstar, Gerstein Fisher Research

9Gerstein Fisher | Real Talks Recap

The Future of America, In Context: Key Takeaways

The outlook for US growth is not bright (Robert Gordon) ■ The US economy has been growing at 2% per year in the current recovery, much less than in prior

economic upturns. ■ The latest expansion was largely fueled by employment growth, now constrained, as unemployment is low. ■ Slowing productivity growth has been a key contributor to recent sluggish GDP growth trends. ■ Fundamental differences in the substance of the three historical revolutions in industry indicate that the current

phase has not and will not have a large impact on productivity. ■ Future growth prospects in the US are facing four key headwinds: we are falling behind in education,

demographic trends are shrinking the labor force, income inequality is reducing median growth, and the fiscal outlook is troubling.

■ The silver lining is that slow productivity growth means that jobs are not disappearing at the rate predicted by “techno-optimists,” who envisioned robots replacing humans across the labor force.

The strength of American democracy is being put to the test – but hardly for the first time (David Moss) ■ Rancor and discord in Washington have many Americans feeling concerned about the current state and the

future of our political system. ■ In examining this country’s history, we can see that political conflict is a distinctly American phenomenon. ■ It’s critical to distinguish between productive tension and destructive conflict, however. Thus far in our history,

destructive conflict (such as the Civil War) has been the exception rather than the rule. ■ Productive tension is resolved when people’s common faith in democracy brings compromise and moves an

agenda forward. ■ Issues of partisanship and money in politics are not the problems the country needs to solve – they are

symptoms of the real problem, which is a populace losing faith in its democratic institutions. ■ For American democracy to continue to be as resilient as it has been throughout our history, we need to address

not just the symptoms of this loss of faith, but the root cause itself.

The global trade picture is shifting to a multi-polar system, and the winds of protectionism are blowing (Gregg S. Fisher, CFA)

■ As the world has grown more interconnected, the global economic balance of power has shifted. ■ We are moving away from US economic hegemony to a multi-polar world where dominance is shifting toward

other countries, many of them in emerging markets. ■ While globalization is entrenched, we are also seeing a resurgence in protectionism and isolationism by some

countries (US, UK) that want to be connected, but on their own terms. ■ Trade imbalances are largely the result of some countries saving too much and consuming too little (China), while

others consume too much and save too little (US). ■ Global GDP growth is slowing and OECD debt levels are climbing. ■ Investors should care about global trade because it impacts virtually every aspect of capital markets, including

investments in US and foreign businesses.

What is an investor to do? Stick to sound investment principles (Gregg S. Fisher, CFA) ■ Against a backdrop of raising trade isolationism, US investors would be wise to focus on investing in countries

and/or companies with geographically diverse revenue bases. ■ Research by Gerstein Fisher has revealed an additional benefit from reallocating some capital in a portfolio away

from the largest (market cap) countries and toward smaller ones. ■ While allocating assets to a diversified mix of countries and companies and holding it for several decades does

not sound exciting, it is a sound, rational way to compound long-term wealth. ■ Over the long term, a multi-factor global approach to investing has outperformed the S&P 500.

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