Some years ago, Mohamed El-Erian, then chief strategist at Pimco Asset Management, dubbed this now commonly used phrase to describe economic growth that is less than that of historical norms. This is not without controversy, as any claims that sound like “it’s different this time” is nearly blasphemous to most investment professionals, trained to expect and position portfolios for “reversion to the mean.”
If such a “new normal” exists, what does it mean and why does it matter? Do we, at Fundamentum, subscribe to this theory and if so, what are the implications?
First, we would suggest the “new normal” incorporates most basic economic conditions. Most important to us include:
- GDP growth rates
- Levels of inflation, and the
- “Equilibrium” Fed Funds rates.
Today, despite full employment and healthy economic growth both here and abroad, and with the USD declining over the course of the year, measures of inflation remain stubbornly below the Fed’s desired 2% level and have, for some time.
Is this an example of the new normal?
Similarly, although the most recent quarter showed Real GDP growth of 3%, the U.S. economy has been stuck in the 2% range for some time, despite massive amounts of liquidity injected into the banking system by the Federal Reserve ($3.5T since 2008), near-zero percent interest rates for over eight years, and every economy measured by the IMF is registering positive economic growth for the first time in nearly 30 years.
Is this an example of the new normal?
Another example of what might be this new normal is the Yield Curve. While the yield curve (2/10 year is most of interest) is still upward sloping at ~77bps, and not indicative of near-term recessionary conditions, it surely doesn’t register on the “long end” levels that are historically associated with solid economic growth, full employment and rising commodity costs in certain areas (copper, steel, aluminum, iron ore).
Surely, this must be an example of the new normal at work.
At Fundamentum, we continue to believe in the laws of economics. Supply and demand WILL dictate price levels in the future, as they have in the past. Said simply, there WILL continue to be cycles, even in a new normal environment.
As the Federal Reserve Bank of San Francisco pointed out in a recent white paper, there is now strong evidence to support the notion of new normal economic environment.
Consider an excerpt from the San Francisco Federal Reserve, written the fall of 2016….
Estimates suggest the new normal for U.S. GDP growth has dropped to between 1½ and 1¾%, noticeably slower than the typical postwar pace. The slowdown stems mainly from demographics and educational attainment. As baby boomers retire, employment growth shrinks. And educational attainment of the workforce has plateaued, reducing its contribution to productivity growth through labor quality. The GDP growth forecast assumes that, apart from these effects, the modest productivity growth is relatively “normal”—in line with its pace for most of the period since 1973….
It is a fact that in the U.S., labor markets are not growing at the pace of the post-war era. In addition, productivity remains stuck at historically low rates of growth, something we believe, can, and will, revert to the mean, especially with the implementation of business-friendly fiscal policy. Still, with one of the two main building blocks (labor market growth) expected to remain depressed for some time, it is difficult to NOT accept the premise of a new normal economic condition.
The Investment Committee at Fundamentum has attempted to identify other factors in addition to demographics that argue for a new normal. While not tested, or proven, these are in the narrative of most economic and business writers we read and are well-accepted by most:
1. China – While China remains an important engine of growth for the world economy, it’s impressive high-single digit rate of economic growth is roughly half that of the 1990-2012 period. Now the second largest economy, this diminished rate of change lowers the potential for world GDP growth.
2. The Internet – the internet imposes a price discovery mechanism that wasn’t available in most post-war periods. This has important implications for pricing for many items that would tend to depress the historic inflation rates.
3. Globalization – certainly globalization, or the ability to offshore production to lower-cost regions – was not the factor in much of the post-war periods. This too, has important implications for pricing power and the levels of wage inflation today, versus the past.
Our conclusion is that there are strong reasons to expect a new normal for economic growth and inflation rates in the foreseeable future. Still, we want to be clear that this does NOT make laws of economics less applicable.
There will still be cycles but compare to the past, perhaps the amplitude won’t likely be what they have historically been. This has direct implications for the level of the equilibrium Fed Funds rate (lower), inflation (lower) and GDP growth (lower).
Perhaps the dampening of inflation (and interest rate) cycles will have positive implications for valuation levels for equities, as today’s somewhat elevated valuation levels may not be the impediment to future returns that most observers (including ourselves) think they will be, if the magnitude of the inflation cycle is lowered. Perhaps this offsets the less-than-normal rates of return from fixed income vehicles, supporting our tactical position of favoriting equities over fixed income.
Evidence of a new normal also factors into our belief that 10-year expected returns for both stocks and bonds are lower today compared to most 10-year look-back periods historically. This is important for financial planning exercises.
Here’s another excerpt from the San Francisco Federal Reserve on their conclusions regarding the evidence of a “new normal” ….
This lower pace of growth has numerous implications. For workers, it means slow growth in average wages and living standards. For businesses, it implies relatively modest growth in sales. For policymakers, it suggests a low “speed limit” for the economy and relatively modest growth in tax revenues. It also suggests a lower equilibrium or neutral rate of interest. Is the new normal a bad thing? We don’t necessarily believe that it is, but it must be understood to prevent policy mistakes or for political parties to be aiming for objectives based on past conditions that aren’t likely to be met in the future. We certainly can’t change the factors that have led to a new normal, but recognition of them can assist us in positioning our client portfolios for realistic returns and in meeting expectations, which is surely a hallmark of successful wealth management.
Paul Danes, CFA
Fundamentum Investment Committee November 1, 2017
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