Cutting Through The Noise

Walking the Slow Growth Tightrope

Cutting Through the Noise - a financial blog by Bill Martin, CFA

 

“Greed is good.”

Gordon Gecko, the infamous mogul from the iconic 1987 film Wall Street

“Growth is good.”

Nearly every Central Banker on the planet

Stories of unbridled greed rarely end well.  During the rampant real-estate speculation that led to the financial crisis, Mr. Gecko’s audacious theory was tested yet again in financial markets. The Great Recession was the result.  Nevertheless, Mr. Gecko had it partially right. Something virtuous happens when people compete for relative wealth gains. That virtuous something is growth. Growth makes everything just a little bit better than it otherwise would be. Growth is so good, in fact, that you often find economic stress and difficulty in its absence.

Faster global economic growth is something that almost all economists agree would be welcome. Now that every major central bank in the world has undertaken unprecedented policies to increase economic growth, why has growth remained so elusive?  To dive deeper into the causes, let’s take a look at the economy:

  • U.S. and global growth have been disappointing since the recovery began in 2009, following the Great Recession.
  • Labor force growth and labor productivity—the twin engines of any economy—have been running at approximately half their historical rates.
  • The debate over the reasons for slow growth is divided into two camps:  one side posits that the global economy may have slipped into secular stagnation, while the other side argues that the economy is working through a prolonged cyclical recovery.  
  • Policy makers seeking to revive economic growth since the Great Recession have repeatedly pulled the usual levers of monetary and fiscal policy. Every time these economic levers are pulled, they generate less energy or response, while draining the potential energy stored up for the next pull.  

Strong growth tends to be a salve for other societal problems, while weak growth tends to accentuate underlying economic and social tensions. To understand where we are now and where we might be headed, we need to spend some time using the past for perspective.

There’s somethin’ happening here…

Source: St. Louis Fed It doesn’t take a PhD in Economics to see that something out of the ordinary was happening in the 1960s, as well as in the recent decade. In the 1960s, easy money worked well for awhile until the great inflation of the 1970s. Thereafter, steady growth, cyclically fluctuating around the long-term average, persisted for several decades until the early 2000s. In the new millennium, long-term economic growth has steadily eroded to the lowest point in the post-WWII era. 

Source: St. Louis Fed

It doesn’t take a PhD in Economics to see that something out of the ordinary was happening in the 1960s, as well as in the recent decade. In the 1960s, easy money worked well for awhile until the great inflation of the 1970s. Thereafter, steady growth, cyclically fluctuating around the long-term average, persisted for several decades until the early 2000s. In the new millennium, long-term economic growth has steadily eroded to the lowest point in the post-WWII era. 

What it is, ain’t exactly clear…

Economists’ best guesses for the economy’s potential growth have missed the mark by a wide margin. Year after year, economists have been lowering their growth expectations, yet the economy’s performance has still fallen short of even these lowered standards. This is a sign of a major disconnect between expectations and reality. Economic models might be missing some major factors that have been influencing the economy since 2000.

Economists’ best guesses for the economy’s potential growth have missed the mark by a wide margin. Year after year, economists have been lowering their growth expectations, yet the economy’s performance has still fallen short of even these lowered standards. This is a sign of a major disconnect between expectations and reality. Economic models might be missing some major factors that have been influencing the economy since 2000.

Growth is elusive in the Eurozone

The view from the bridge for the Eurozone has been even more disappointing and is actually more akin to what Japan has experienced since 1990. Economists have been too optimistic about the economy’s prospects, and the Eurozone economy has not been able to live up to such great expectations. 

The view from the bridge for the Eurozone has been even more disappointing and is actually more akin to what Japan has experienced since 1990. Economists have been too optimistic about the economy’s prospects, and the Eurozone economy has not been able to live up to such great expectations. 

When three of the four largest economies in the world—the Eurozone, the U.S., and Japan—are showing the same slow growth with the same unrealistic expectations, it’s probably time to take note, and well past time to understand the root causes of such slow growth. 

Taking Stock

Investors are trying to figure out what to make of the economy’s strange economic behavior with so many swirling crosscurrents and so many underlying assumptions coming under question. Former Treasury Secretary Larry Summers offered up a compelling theory for why growth has been so slow despite central banks’ herculean efforts to lift the global economy. Summers believes the economy has entered a period of secular stagnation that has causes, effects, and cures that are separate from an ordinary recession.

The secular stagnation theory

Secular stagnation implies that there is too much savings, partially from income inequality, and partially because companies literally have more cash than they know how to profitably deploy. Their operations are chugging along reasonably successfully, but the top brass has so much spare cash that finding a home for it—or finding investments that will boost the bottom line—has become increasingly difficult.

A number of the large tech companies would be good examples of these cash-rich companies.  Larry Summers’ pet example is Facebook’s purchase of the four-year-old WhatsApp and their 55 employees for $19 Billion.  This is in comparison to 70+ year-old Sony Corp having more than 100,000 employees and a market cap of only $18 Billion.  Now, this is not suggesting that one company has greater or less future economic value, but it does feed into the narrative that more money in the hands of fewer individuals in less capital intensive industries will have an impact on the larger ecosystem and the equilibrium level of interest rates; a “hollowing out” of sorts.  

These “over” savings in the hands of the few go hand in hand with not enough final demand from consumers and businesses. For example, Facebook’s $19 billion could have been spent elsewhere—adding services to their platform, hiring, increasing wages, building their own messaging app, etc. Putting $19 billion to work in those ways could have had a marginally larger impact on the broader economy, but when you add up several similar deals, it begins to make a big difference. And high tech is not alone—the S&P 500 companies, as a group, have the largest cash coffers in more than 60 years, while mergers and acquisitions have been happening at a fast pace in some sectors of the economy.  For purposes of this discussion, we need to separate the impact of short-term cash hoarding vs long-term earnings outlook.  We will save our earnings outlook for next month.

With less demand for their products, companies are less inclined to forge into the wilderness by making risky, long-term investments.   Long-term investment tends to lead to increased productivity, higher incomes, and an increased standard of living.  Without a jolt to the system, this stagnation can stretch for a long period of time, as less demand can beget less investment, and less investment begets lower productivity in a self-reinforcing downward arc.

The Other Camp— “Move along, there’s nothing to see here.”

On the other side of the debate, some economists believe we are simply in a prolonged cyclical recovery. Cyclical recovery is akin to a typical recovery.  In a typical, cyclical recovery, borrowers eventually get their balance sheets in order and unproductive businesses get forced out.  This tends to bring supply and demand into equilibrium.  At that point, lower rates and expansive fiscal policy tend to operate in conjunction with pent-up demand and voila, we have a typical recovery.   A typical post-War cyclical recovery has tended to bring 4% growth after subtracting the inflation rate, or about 7% growth before inflation.

Our current economic recovery is very weak by any standards or comparisons. The economy has grown in fits and starts with an overall pace that’s about half of what it has been in past recoveries.  And it hasn’t been for lack of trying.  For the last seven years, global central banks have been performing an unprecedented, global experiment to kick-start the economy. That implies that either something is different from previous recessions/recoveries (secular stagnation) or the financial crisis was a helluva lot worse than we realized and any cyclical recovery will take longer to materialize. Are artificially low-interest rates, brought about through Central Bank QE (Quantitative Easing) policies, enabling weak firms to compete beyond their usefulness?  Thus, keeping capacity artificially elevated…and, is this combined dynamic preventing new and more productivity enhancing investment?  Possibly.

GDP Growth Components = Labor Increase + Productivity Increase

Economic growth can come from two sources—more jobs and more hours or doing more on the job in the same amount of time. Unfortunately, a closer look at our economy shows that labor is weak and productivity has declined. The combined effect of decreased productivity + subdued/declining labor force trends have a chilling effect on the GDP growth outlook. 

The labor portion has been relatively weak, particularly when considering that we are bouncing back from so many lost jobs following the financial crisis.  The labor portion of the equation has been contributing roughly 1.5% to GDP growth over the past 6 years with a small variation.  The more concerning side of the job growth equation is the growing number of people that either can’t find work or choose not to look.  The higher jobless number (see graph below) makes it tougher on the economy to provide necessary services and infrastructure with a relatively lower taxable base. 

Take This Job and Shove It!

The group of people not working is growing more than twice as fast as the actual working labor force.  This fastest (non-working) growing portion of the population is partially a byproduct of demographics and a choice of some to drop out of the labor pool – see declining participation rate, below.  One aspect that will put significant strain on this equation is the outlook for people to continue to live longer and need their government benefits, such as medi-care and social security, for a much longer time period.

The group of people not working is growing more than twice as fast as the actual working labor force.  This fastest (non-working) growing portion of the population is partially a byproduct of demographics and a choice of some to drop out of the labor pool – see declining participation rate, below.  One aspect that will put significant strain on this equation is the outlook for people to continue to live longer and need their government benefits, such as medi-care and social security, for a much longer time period.

I got better things to do…

The labor participation rate—the percentage of the population that has a job or is looking for one—has declined to a 35-year low. Our aging population is the primary reason and set to drive this chart much lower. The baby-boom generation drove up the labor participation rate, but started driving it back down at the turn of the new millennium. 

The labor participation rate—the percentage of the population that has a job or is looking for one—has declined to a 35-year low. Our aging population is the primary reason and set to drive this chart much lower. The baby-boom generation drove up the labor participation rate, but started driving it back down at the turn of the new millennium. 

Unfortunately, I don’t have space for yet another graph on this topic, so please allow me to summarize…based on demographics associated with an aging workforce and immigration control, the expectation is for the rate of change of NON-workers to dramatically increase over the next 20-30 years.  Additionally, the participation rate highlighted above is forecast to drop down close to 50%.  Is this environment of having a lower % of workers paying for services for a growing % of non-workers sustainable over the long term?  Perhaps, but unlikely AND only with soaring productivity gains…we’ll get to that outlook next.   Lastly, I’m not sure if this is good or bad news, but as dismal as the job picture looks in the US, it is a much prettier view than most of the World’s other large economies are facing.

Productivity has not kept up its end of the bargain

In the post-WWII era, many of the largest developed nations have experienced very high productivity growth rates. Massive investment in cutting-edge technology meant that what a human being can accomplish on the job today is drastically more than what a human being could get done in the 1950s.  Now, productivity is growing at a much slower rate and investment is weak, which means that the next generation may not see quite the same quantum leaps in productivity that we experienced in the past.   

Could some of this stagnation in productivity be the result of big cut backs in infrastructure build…either by government or corporations?  With government not pulling its share, corporations are less likely to take all the risk.  Think of all the advancements that occurred when government worked somewhat in a hand/glove fashion with business – interstate highway project, electrification, the space race and NASA and all the products and advancements that came from that gov’t led effort, Sematech non-profit consortium between gov’t and chip manufacturers, the internet (no, it was not all Al Gore), cell phone technology led by the Department of Defense.   The list goes on and on.  This is the angle that most concerns the crowd that is putting forth the secular stagnation argument.

Monetary and Fiscal Medicine

We’ve established that economic growth has been pinched by technical difficulties in both of its twin engines, labor and productivity. What could jolt the economy into a higher growth gear? 

Monetary stimulus - Lower interest rates can spark economic growth.  Unfortunately, most developed nations have cut short-term interest rates to near-zero percent, and some central banks are even experiencing negative nominal (before inflation) interest rates out the curve.

Real interest rates are the return that a bond investor receives after subtracting the rate of inflation. Our entire financial system relies on positive real interest rates. After all, it doesn’t make any sense to lend someone your hard-earned money if their interest payments are less than the cost of rising inflation. In that scenario, you could buy more with your money now, rather than taking the risk of lending it, only to get back less spending power later on. It would make more sense to spend the money now. Global central bankers were counting on sparking a spending spree when they forced real interest rates below zero. For the most part, that has not happened. Instead, people are spending less and either paying down debt or investing in riskier assets, defying the conventional wisdom of economics. This dynamic hurts savers, while giving borrowers access to the cheapest capital in generations. In our current economy, savers are taking the pain, while businesses are certainly taking the cheap capital, but they are not deploying it for growth-enhancing activities.

Real interest rates are the return that a bond investor receives after subtracting the rate of inflation. Our entire financial system relies on positive real interest rates. After all, it doesn’t make any sense to lend someone your hard-earned money if their interest payments are less than the cost of rising inflation. In that scenario, you could buy more with your money now, rather than taking the risk of lending it, only to get back less spending power later on. It would make more sense to spend the money now. Global central bankers were counting on sparking a spending spree when they forced real interest rates below zero. For the most part, that has not happened. Instead, people are spending less and either paying down debt or investing in riskier assets, defying the conventional wisdom of economics. This dynamic hurts savers, while giving borrowers access to the cheapest capital in generations. In our current economy, savers are taking the pain, while businesses are certainly taking the cheap capital, but they are not deploying it for growth-enhancing activities.

Fiscal stimulus - The government can also kick-start the economy by borrowing from the future to spend money now. Unfortunately, most developed nations have done this for quite some time, which has left them with elevated debt levels and less room to borrow money for economic stimulus. The two charts below show the constraining debt situation the country faces. 

This chart shows government debt securities as a % of GDP, but does not include promised future obligations , such as Social Security or Medi-Care/Aid.  Once again, the relatively good news is that the U.S. actually looks better from a Debt/GDP perspective than most of the rest of the developed world.  Nevertheless, we still have very little wiggle room. 

This chart shows government debt securities as a % of GDP, but does not include promised future obligations , such as Social Security or Medi-Care/Aid.  Once again, the relatively good news is that the U.S. actually looks better from a Debt/GDP perspective than most of the rest of the developed world.  Nevertheless, we still have very little wiggle room. 

Aside from government debt, corporate and consumer debt levels limit a jump start to the economy through lower interest rates and easy credit.  This chart displays the disheartening effect that ever-increasing debt levels have had on our ability to grow our economy. All told, the U.S. economy’s total debt is approximately FOUR times the annual output of our economy.   

Aside from government debt, corporate and consumer debt levels limit a jump start to the economy through lower interest rates and easy credit.  This chart displays the disheartening effect that ever-increasing debt levels have had on our ability to grow our economy. All told, the U.S. economy’s total debt is approximately FOUR times the annual output of our economy. 

 

But Why Isn’t It Working?...

The velocity of money measures how many times money changes hands. In a robust economy, money typically changes hands rapidly, as people are generally buying each other’s goods and services. Right now, money is changing hands at the slowest pace in more than 50 years.  This chart seems to indicate something is different.  This could be the missing link in our sub-par economic growth question and the single best indicator to if/when we get faster economic growth and inflationary fears.  We will be keeping an eye on this indicator in the future.

The velocity of money measures how many times money changes hands. In a robust economy, money typically changes hands rapidly, as people are generally buying each other’s goods and services. Right now, money is changing hands at the slowest pace in more than 50 years.  This chart seems to indicate something is different.  This could be the missing link in our sub-par economic growth question and the single best indicator to if/when we get faster economic growth and inflationary fears.  We will be keeping an eye on this indicator in the future.

Daunting Challenges, Underwhelming Government Response

When we look around the world for government solutions to economic problems, we instead see gridlock in the U.S. on any major fiscal stimulus plan, a Grexit scare, and the Brexit reality. With Brexit in the headlines, I feel compelled to add my 2 cents.  I will use one of those pennies to simply remark that much of the initial response to Brexit has already been digested and discounted by the market. 

Going forward, we will see if this action creates a positive unifying response or a negative contagion effect within the rest of Europe.  The U.K. had only one foot in the European Union from the start because they kept the British Pound.  Exits for other EU countries could bring more turmoil because they would have to change their currency, in addition to changing trade agreements. 

Was Brexit a canary in the coal mine for other nations to follow with protectionist policies that ultimately lead to shrinking global growth?   In an era of stagnant growth, policy missteps or even de-synchronized policies can lead to business and investor retrenchment. Voters are reacting to the lingering pain of slow growth and resulting social strains.

Keeping score across the globe, most of the largest economies have a thin margin for error. The U.S., Japan and Europe have been growing at only 1-2% since 2010.  Inflation in these regions has been 0-1.5%.  Rates are pretty much at the bottom around the globe, while debt levels are more or less stretched to the max relative to GDP level.  With that as a background, how comfortable do you feel as an investor knowing that one of the key causes for the Great Depression was nationalism and protectionist policies crimping global trade and tossing the world into decline?  Bottom line, misidentifying the reasons for weak growth is a significant political risk for global markets.  

The Take-Away

The argument between secular stagnation and cyclical recovery will not be decided for some time.  However, I believe there are enough headwinds with markets priced for near perfection, that investors should consider de-risking into rallies to avoid volatility drag. 

Policy makers are walking a tight-rope with little wiggle room for additional monetary and fiscal policy.  The unprecedented policies pursued by the Fed to this point tell us how essential they view growth and fear the alternative.  Keep in mind, it will not be in the Fed’s best interest to ring the alarm bells.  One of the unspoken goals of the Fed is for stable and orderly markets.  As such, investors must look out for themselves and look to do as Warren Buffet preaches— “look to buy when others are fearful and sell when others are greedy.”   By definition, it is not a natural human emotion to be contrarian, but it has historically been one of the best paths to profits. 

Lastly, I must clarify that I am not expecting a revisit of the Great Financial Crisis.  We have many more policies and safeguards in place to protect against that outcome and the banks do appear to be in better financial shape.  However, the market’s valuation multiples are ultimately based on investor confidence in elected/appointed officials and in industry leaders.  That said, investors will vote and re-vote quickly and they will provide opportunity for gain and loss in this increasingly interconnected BOOM-BUST world.  As an investor, be prepared to embrace and capitalize on volatility.

Here’s to being more right than wrong…