The CEO of $445 billion fund giant Principal Global Investors says everyone has the economy all wrong

Business Insider recently spoke with Jim McCaughan, CEO of Principal Global Investors, a fund manager with $445 billion in assets.
McCaughan thinks the economy is growing faster than GDP numbers suggest, because of the improvement in technology and quality of goods and services.
“I think we’re better off than the numbers say we are and there’s maybe 1% more growth and 1% less inflation than most people think,” he said when asked about current economic indicators.
“Tech stocks are the future and I think that's one of the reasons why the equity market is justified at this level and why the economy is changing the way it is,” he said when asked about the future of tech stocks.

Following is a transcript of the interview as aired on "The Bottom Line." It has been edited for clarity.

Sara Silverstein: So when you look at the economic picture right now, what do you think people are missing?

Jim McCaughan: I think they're missing the impact of technology, and I think it's being underestimated by a lot of commentators. What I mean by that is the consistent improvement in quality of goods and services is not reflected in the official data. If you think about it, the economy is really growing faster than the GDP numbers suggest, because the improvement in quality has accelerated. It's always been built into the GDP numbers, but inadequately. I'd also point out on the economy that capital investment is now a lot more productive than it used to be.

Technology makes sure of that, whether it's the sharing economy that brings assets into productive use, like say Airbnb. Or maybe it's if you have a factory that's working 24/7 with robots, or as it used to be, a shift system with people. So the capital stock is working much harder. All of this means the interest rates are and will stay lower than most people thought. And I think they're missing this and I think it's important for the valuation of every other asset, including equities.

Silverstein: Can you just start with valuations and tell me why you're not worried about equities dropping from the historically high valuations measured by things like the CAPE ratio?

McCaughan: Well, I would suggest that equities are not yet in anything like bubble territory. With tax reform having gone through and reduced the tax rate on corporations, like it or loathe it, it does improve corporate earnings. And what you've got is corporate earnings and a market on about 20 times, which is a 5% earnings yield. Now the 10-year yield which you'd compare it with is 250.

So that's a pretty good margin for equity risk. I would regard equities in the current situation, so long as we don't expect a recession in the next two or three years, as a buy on setbacks.

Silverstein: And what about tech stocks?

McCaughan: Tech stocks are the future and I think that's one of the reasons why the equity market is justified at this level and why the economy is changing the way it is. And, you know, I'd point out that in the US market as a whole, the top four or five stocks are mostly technology. Facebook, Amazon, Google, Microsoft, those are the really big stocks in the US market. That means there is a market here that can grow and can develop and can really drive a lot of the future of the world. If you look at other markets around the world, they're old economy stocks.There are many fine companies in Europe, but they're financials, they're manufacturing stocks. HSBC, BP,those are the biggest stocks in the European market. That isn't really where the economy's going in the future. So I think Europe, relative to the US, has been a value trap for the last two or three years and will continue to be so.

Silverstein: You say that technology is building in some deflation and that that'll keep interest rates low?

McCaughan: I suspect that's right. You know, it's one of the puzzles, most economic commentators if they'd been shown four or five years ago what the US economy has done, they'd have said, 'Woah, rates will be high, the 10-year will be 4% or 5%, the short rates will be 3%.' You know, they'd have said that rates had to go up, because at the current sort of economy 20 years ago, they would have. What they're missing is the fact that the prospective inflation is a lot less, because of the rapid adoption of technology. And I think that means that the valuations remain OK on equities. The same's true of commercial real estate. It's done very well,but it's still not overly extended, given the likely outlook for interest rates.

Silverstein: So for 2018,you think that the economy can continue to expand and that US equities can continue to rise?

McCaughan: Here's what I would say, which I hope is a helpful comment. There's a 80% probability it continues to be pretty good; 80% probability you get 2% or 3% growth on the flawed GDP numbers that we've been talking about; that you see profit growth even after the acceleration caused by lower tax rates. So a 80% probability things are all pretty benign; inflation doesn't really hit.So you've got bond yields around the current level, maybe up a bit at the short end. And as the Fed tightens further, you could see equities be a bit better. What's the other 20%?

Silverstein: What is it?

McCaughan: The other 20% is the negative tail risk mostly from geopolitics. Something bad happening in Korea. It looks less likely at the moment, but you know military hostilities are still possible. Something bad happening in the Gulf; there's a lot of change going on in Saudi Arabia that we hope goes well. But if it goes badly, it could interrupt oil supplies to a lot of the world.

A trade war, you know, it doesn't look at the moment as if we're going to pull out of NAFTA, but if we did, that would hurt supply chains. Any of those and a number of other things could cause the market to go down quite sharply, and could bring the next bear market forward, but I don't think it's the most likely outcome. That's why I give it a 20% probability. I think that the real decline — absent policy errors — is two or three years away. If you like, in terms of the '98, '99 internet boom,we are still in early '98;we're not in late '99. If that's true, that's quite a long way to go on the markets.

Silverstein: And just to go back to the improper measures of where we are economically speaking, what percentage are we missing in GDP and inflation? How much are those off by?

McCaughan: Well I suspect inflation may be overstated by about 1% per annum. And that GDP therefore may be understated by about 1% per annum. And, you know, if you want to have a very general understanding of how that works, here's a question sometimes asked of graduate students in economics — if you took a typical income, say $70,000 a year, would you rather live now or in 1900? And most people will say there's been so much inflation, I'll go for 1900. But then if you really think about it, you wouldn't have technology, you wouldn't have antibiotics, routine diseases that are easily cured now would kill you, life would be pretty uncomfortable, no appliances. How do you keep in contact with people? You can't travel and see the world. In a 1900, even if you are rich, would be pretty miserable. There's an example of the very long term quality improvement I'm talking about. And I think that continues at a very rapid rate. So I think we're better off than the numbers say we are and there's maybe one percent more growth and one percent less inflation than most people think.

Silverstein: I have to ask about bitcoin. What do you think and what do you think people don't understand?

McCaughan: Well, I'm not sure any of us really understand it, because things will come through over the next few years. It's a big enough phenomenon to be quite important. The thing I'd say about bitcoin is — there is no fundamental value. It could just as easily double as it could go to zero. It did an enormous rise last year; it's roughly halved in the last couple of weeks. This is not a surprising behavior. From $10,000, it could go to near zero, and it could go easily up to well beyond its previous high, just because there's no fundamental value there. But there could be fundamental value in the future if it became, for example, a medium of exchange — a real coin. But I would argue that with all the funds that have been set up, all the financial instruments using bitcoin, the prospect of it becoming a medium of exchange is more distant now than it was. So I think the fundamentals don't look very good for creating any fundamental value in bitcoin. It's become a kind of substitute for gold, but at the moment. It doesn't look like it will displace it.

The CEO of $445 billion fund giant Principal Global Investors says everyone has the economy all wrong

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