- It’s possible to estimate a country’s economic growth with precision and I have done so in this article. Perhaps it’s better to say that I used the available—and free—research done by 1,500 Bridgewater employees.
- As future economic trends are pretty clear, it’s important to position one’s portfolio accordingly.
- However, don’t just jump into emerging markets at any price. Compare the fundamentals and the growth in relation to your investment horizon.
There’s a lot of talk about economics, economic growth, what drives it, etc., but there aren’t many facts that properly show links between causes and effects.
One person who researched those links and shared the findings is Ray Dalio, hedge fund manager of Bridgewater Associates. In today’s article, I’ll describe what Ray found and then analyze how we can best position our portfolios in order to be more exposed to positive forces and less to negative forces.
Formula For Economic Success: Economic Health Indicators
What Ray Dalio puts out for free is a 305-page research report on economics and economic principles with the goal of providing policy makers with actual data on which to base their decisions, i.e. to make the decision-making process more analytical and less ideological. I wish us all luck with that, but what we can do is check the data and findings and then properly adjust our portfolio strategies as Dalio’s data explains subsequent 10-year future real economic growth of a country within 2% of the realized growth about 80% of the time. That is extremely precise, so, let’s get started.
What many forget is that “productivity growth is ultimately what matters for long-term prosperity, and the effects of debt cycles cancel out over time. The big shifts in economic growth are about two-thirds driven by productivity and one-third driven by indebtedness. “Luck” (e.g., having a lot of resources when the resources are valuable) and “conflict” (especially wars) are also drivers.”
In summarizing Dalio’s economic indicators, we come to the following list to analyze:
- Countries that offer the best value per dollar of cost: Look for the most productive workers.
- Culture is one of the biggest drivers of productivity: Drive to success, corruption, value of innovation, and commercialism.
- Indebtedness: Debt effects cancel out over time. When debt growth is faster than income growth, the trend has to reverse at some point which leads to a credit crunch. There are short term and long term debt cycles where short term cycles last over a decade, and long term cycles last more than 75 years. Countries with low amounts of debt relative to income, low debt growth rates in relation to income growth, and easier monetary policies, will grow faster. As countries grow wealthier, more credit goes to consumption than to investments. According to Dalio, many countries are becoming poor even though they are still behaving as though they are rich.
- Luck and wars: U.S. shale oil was a lucky thing, while wars are an exceptional factor that are difficult to predict but that also have to be watched.
As all of the above influences productivity and indebtedness, a good summary of how things work in the short and long term is provided by the figure below.
Figure 1: Productivity is the driver while growth can be distorted by short-term and long-term debt cycles. Source: Economic Principles.
The above theory was put into a model where two thirds of the weight impacting economic growth was put on productivity and one third on indebtedness. The below factors and weights were tested on a universe of 20 countries over the last 65 years where the model measures the countries’ future 10 year economic growth.
Figure 2: Factors to estimate future economic growth rates. Source: Economic Principles.
I must say, the results from the test are impressive and have shown an 84% correlation with future 10-year economic growth rates.
Figure 3: Correlation and projecting precision. Source: Economic Principles.
The data and models explained briefly above, and freely shared by Dalio, are extremely valuable. It’s unfortunate that very few actually care. Politicians can’t win elections by saying to people “let’s invest more and consume less for a while” as we humans prefer immediate satisfaction. Therefore, even if Dalio’s data won’t change the world, it can certainly help us make better investment decisions for our portfolios.
But that isn’t all that Dalio shared. Let’s now analyzing his economic projections.
As economic growth is a function of the output per worker and the number of workers, it isn’t that difficult to estimate future growth. Thanks to Dalio, we don’t even have to bother much with calculations as the work has been done for us. The figure below is essential for proper portfolio positioning in the next decade and longer.
Figure 4: Projected real economic growth per country. Source: Economic Principles.
The economies that will grow the most are India, China, Singapore, and Mexico, while the U.S. is the strongest economy from the developed world with Europe and Japan being weaker performers. Countries with a heavy debt load like Italy and Greece will fare the worst. This data is extremely important when approaching international portfolio diversification.
What has also been offered is a precise reconciliation of the reasons for the numbers identified above. As the working age population is the most productive, it’s logical that countries with an increasingly working age population will see greater benefits.
Figure 5: Growth in working age population per country. Source: Economic Principles.
The following are the countries that have the best value/income ratios and culture for future success.
Figure 6: What you pay vs. what you get. Source: Economic Principles.
The country lists are almost the same as the breakdown in figure 4. India and China are at the top, the U.S. is the best of the developed world, and Europe is at the bottom of everything.
The cost of an educated worker compared to the U.S. again shows how emerging markets have the advantage. Even if India has a low level of educational quality, its adjusted cost per educated worker is just 1/20 of the cost in the U.S., making it an extremely competitive country.
Figure 7: Cost of educated worker adjusted by quality of education. Source: Economic Principles.
Among many other factors analyzed by Dalio, I‘ll finish with the indebtedness level, i.e. which countries still have the potential to leverage their growth for investments like infrastructure.
Figure 8: Indebtedness estimate of future growth. Source: Economic Principles.
Not surprisingly, Europe has the worst outlook, the U.S. leads the developed world while India is again unmatched.
To sum it all up, the following figure shows the projected growth rates per country.
Figure 9: Projected growth per country. Source: Economic Principles.
How To Approach This From An Investing Perspective
As investors, we can expect current earnings to grow alongside the above growth rates on average over the long term for our investments exposed to those countries. Thus, as the U.S. is expected to grow at 2% over the longer term, you can expect S&P 500 earnings to also grow around 2% in real numbers. This allows you to calculate your long-term investing returns. Don’t be fooled by the faster earnings growth we have now as that is all a short-term cyclical trend based on consumer debt.
The obvious from all of the above is that we have to look for the cheapest investments among the growth rates. The best thing to do is to look at price earnings (P/E) ratios and cyclically adjusted price earnings ratio (CAPE – article available here). For example, a P/E of 10 in Italy, even with the negative growth, will yield around 10% in the future while a P/E of 30 from India would need approximately 15 years to reach an equal yield as the Italian investment.
So don’t put your money blindly into emerging markets. Carefully assess the risks, valuations, and growth rates, plot them against domestic valuations, and see which ones are the best for your investment horizon.
Keep reading Investiv Daily as we’re always looking for the best investment opportunities around the world. Currently, China is the cheapest when looked at by valuations and growth, but there are also others that offer great investment returns.