We have been thinking about the notion of potential lately.

Potential — or the possibility of becoming something — is hard to quantify outside of the hard sciences. We were recently reminded of this notion listening to a sports commentator discuss the Cleveland Cavaliers, our favorite professional basketball team. Despite having three superstar players — Lebron James, Kyrie Irving and Kevin Love — and finishing first in their division, the Cavs did not really play up to their full potential during the regular season. For whatever reason the team did not "click" despite the enormous talent on the court. They did not reach their potential.

However, during the first two rounds of the playoffs they are 8-0, and it now seems the Cavs are playing at their potential. All three of the superstars are clicking, they broke a team record for most three-pointers scored in a game the other night and even their defense has improved handedly. We do not want to jinx it, but if the Cavs keep playing at their potential for the rest of the post-season, the probability of a championship title improves greatly.

While we are optimistic about the Cavs, we are more pessimistic on the potential for the U.S. economy currently. A very simple equation for an economy's potential is the growth in its productivity plus the growth in the number of "working age" (16-64) adults. Breaking the equation down a bit further, productivity is a measure of economic output (aggregate revenue of an economy) per unit of input (scarce resources such as labor and capital). Maximizing productivity gains of employable individuals is vital to the economy, because it allow us to accomplish more with less.

In the U.S. today, both parts of the economic potential equation are challenged compared to past business cycles:

The current demographic profile in the U.S. was obviously set in the past based on the Baby Boomer population's child-bearing proficiency, i.e., we are stuck with the current working-age population and, outside of immigration, you cannot just create new workers out of thin air.

Assuming productivity does not improve meaningfully anytime soon, the U.S. is stuck with an economic potential that is around 2%, the lowest on record since the 1950s. From an investment perspective this is problematic because equity-return potential, to some degree, is held captive by the economy's potential. In other words, we expect future U.S. equity returns to be lower than previous business cycle periods. This is the primary reason we keep a global perspective in our approach to equity investing — regions outside of the U.S. have better economic potential simply because the demographic trends have showcased much higher working-age population growth in recent years.

One final comment: please do not interpret our observation on the economic potential in the U.S. as to be damned forever. We are optimistic over the longer term.

Why?

Productivity growth will trump demographics as the innovative capacity of the American people will once again prove to be unbounded.

 

 

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