Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
The inconvenient truth on energy and GDP
Peter Garnry
Chief Investment Strategist
Summary: Before the Q1 earnings season kicks into a high tonight with earnings from Microsoft, Alphabet and Visa, we are exploring the ideas of a recent economic paper suggesting productivity is linear (additive) and thus the main driver of economic growth is the energy input into the system. Since we are going through an energy crisis we have a problem. It also means that the disruptive innovation idea by Cathie Wood is wrong. As a result, the world needs a major breakthrough in energy technology to unleash the next leg of significant growth.
Productivity is likely linear and thus an energy miracle is needed
As we wait for the big US technology earnings tonight from Microsoft and Alphabet, and other important earnings from Visa, UPS, PepsiCo, General Electric, and Mondelez (read our earnings take from yesterday and listen in on today’s podcast), we will talk about GDP growth, energy, and productivity, and the apparent road block the physical world has hit.
The economic paper Additive Growth* this month by Thomas Philippon has got a lot of attention because it shows that total factor productivity (TFP) is linear and not exponential (see chart below for difference in linear and exponential growth) which is a huge deal for the economic growth theory. We always here that productivity is the most important factor, but if it is linear the growth from productivity will converge over time to zero. Standard of living will continue to increase but at a slower pace. That might be the reason why the technology progression seems less “explosive” in 2022 compared to the steam engine, electricity or the invention of combustion engines (cars)?
But now it gets interesting. Despite GDP is a terrible measure for measuring economic activity due to the ensemble vs time average issue, economic activity can be formulated as GDP = energy input x productivity (TFP). If productivity is linear (additive) to economic growth and we observe exponential GDP growth over 500 years, then the only explanation is that energy input is exponential. Energy input by the way can be seen as a combined input of humans (the machines before the machine age if you will) and energy such as coal, oil, gas etc. The chart below by Ole Peters shows this dynamic by plotting GDP against CO2 emissions (burning coal, oil and natural gas) on a logarithmic scale. Grow energy input and we grow the economy.
Source: Ole Peters
One could provocatively say that humans are not that innovative between periods of true major breakthroughs (steam engines, kerosene, electricity, internal combustion engine, airplanes, radio, nuclear power, transistors, lithium-ion batteries etc.). Edwin Drake discovered oil in 1859 which unleashed the beginning of the oil age which until the discovery of nuclear energy was the biggest increase in energy input to the economy relative to required capital. It immediately unleashed unprecedented economic growth and raising living standards. As the chart above shows, we have basically replicated the process of burning hydrocarbons (coal, oil and natural gas) to fuel ever higher GDP and living standards. The reason could be that – because productivity is additive (linear) and thus does not contribute enough to rise GDP over a long period; only a big increase in energy input increases GDP meaningfully.
If this hypothesis of growth is true, then Cathie Wood’s idea of disruptive innovation is plain wrong and the world will gallop into a catastrophic climate crisis unless we either make a significant breakthrough in energy technology (fusion maybe?) or significantly reduce our growth and redistribute the available GDP. If we cannot make a breakthrough in energy technology (part of the solution will naturally be renewable energy – view our theme basket on renewable energy) that materially decouple GDP from expanding hydrocarbons, and we are not willing to reduce economic activity, then we will power on and live with the climate crisis of higher temperatures and all the fallouts from that.
A tsunami of GDP growth as energy and metals investments soar?
Last section ended on a depressing note for most people, but one should remain optimistic and it is likely that powered by necessity scientists will make a breakthrough in energy technology enabling the next leg of substantial wealth increase and growth for the world. The high prices on energy and metals will create a super cycle and new investment boom which in turn could have the likely impact of significantly increasing GDP growth because investments in energy and mining are activities that are will captured by GDP unlike streaming or social media platforms.
On Friday, Exxon Mobil and Chevron will report Q1 earnings and we will naturally focus on their plans for capital expenditures as the world need significantly more investments in energy to both substitute Russian oil and gas, but also grow the overall energy input.
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