The “New Normal”
The “New Normal” is shorthand for an economic forecast that concludes the world will have unusually slow growth for an extended period of time. According to NN, the US will struggle to repair itself from the financial crisis and the rest of the world will search unsuccessfully to find some other source of growth than selling things to the US. Full details of the “New Normal” forecast, championed by the bond manager PIMCO, can be found in the first post in this series.
PIMCO’s conclusion:
invest in (shorter-term) bonds and in dividend-paying stocks (no indication about industry or geographical focus of assets and earnings [although to pay dividends to US holders, a company must have money available in the US]).
What the NN assumes
I’m not sure the “New Normal” is the highest probability outcome for the world over the next few years.
Maybe events will turn out this way.
But NN depends on the idea that countries like China will be unable to shift their focus from exports to the US to trading with each other or to building up their domestic economies –this, despite the fact they realize the present export-oriented growth model won’t work while Americans are refusing to spend.
Does this make sense? Should we bet on the NN?
As a stock market person, this last part troubles me.
For one thing, post-WWII China has been an almost continuous–and many times bizarre–petrie dish for social changes, as Jonathan Spence has recently outlined.
Maybe they can’t turn on a dime again. And it’s true that elsewhere the record is mixed. Tiny places like Singapore and Hong Kong, as well as Brazil and Mexico and an older generation in Japan, have made dramatic alterations to their economies in relatively short periods of time when they needed to.
On the other hand, today’s Japan, Korea, and almost any natural resource-rich country you may care to name, have not.
What really bothers me, though, is having to depend on the other guy knowing what he needs to get done and yet failing to get it done. In my experience, it’s better to overestimate the other guy than to underestimate him.
Things could work out differently in two main ways
Let’s assume during this post, however ,that the NN is the highest probability outcome. How could things work out differently?
I think there are two main possibilities, and a third–highly unlikely–one:
1. the bad outcome: the rest of the world loses faith in the US and in the dollar, either gradually or all at once. Concern would manifest itself in some combination of two results: decline in the dollar vs. other currencies, and a rise in the interest rate that issuers of dollar-denominated bonds would have to pay to buyers.
Though politicians in the US would doubtless wish the entire economic loss to occur through currency weakness, and thus be less clearly attributable to them, the large continuing requirement for foreign buyers to help fund the budget deficit probably means a rise in interest rates as well.
The consequences for stocks and bonds?
Higher interest rates mean bond prices decline. They also have a negative influence on stocks as well. In theory, dividend-paying stocks suffer less than their payout-less brethren. But the effect of a dollar decline could be much more important than potential yield support (which hasn’t worked so well in the past year, anyway–see my posts on this topic). Companies with large businesses outside the US, or which either compete against (now more expensive) imports or export products/services made in the US may end up with substantially increased profits.
The net result: bonds do poorly;
stocks with foreign currency revenue streams go up in a flat to down overall market.
2. the good outcome: the world ex US checks out of intensive care in the next year or so—or at any rate much sooner than the NN expects. Where or how the economic vigor comes from is less important than that it emerges. This is, by the way, the verdict world stock markets have reached.
One possibility, being promoted vigorously by Goldman Sachs, is that people in the US underestimate the economic power in developing economies, which have been relatively untouched by the financial meltdown in the US and the EU.
Another is that trading partners of the US and EU adjust to the new realities faster than the “never” that the NN assumes.
A third is that the US is saddled with slow growth and chronic high unemployment, sort of like the Europe of the Eighties and Nineties, but the rest of the globe hums along nicely.
In this scenario, whatever the cause, the rest of the world raises interest rates back to normal, while the US does not. The dollar weakens and domestic interest rates rise. The effect on bonds is negative.
But in this case, because foreign growth is vigorous, US exports revive. Tourists flock to Disneyworld, New York, Las Vegas and other vacation destinations. Foreigners begin to buy up US urban and resort real estate, which looks like an absolute steal compared with possibilities elsewhere. The infusion of foreign buying power helps the US economy rise off the floor. Stocks generally rise, led by the same winners from the first case–those with foreign assets or which provide goods and services to foreign buyers.
The net result: bonds go down, stocks go up–with companies catering to foreigners doing the best.
3. The unlikely possibility: the US recovers much more quickly than anyone expects–as it typically has done in the past.
In this case, bonds go down a lot, stocks go up–led by issues focused on domestic demand.
Conclusion: NN is an all-or-nothing bet
For a strategy of buying bonds at historically low interest rates to work, it looks like the “New Normal” had better be correct. The US economy must have a dark-side “Goldilocks” character–not too strong, but not too weak.
It must show enough strength that foreign investors don’t worry about buying our government bonds. At the same time, the whole world must show enough weakness that interest rates don’t rise to normal and no more attractive investment opportunities than US bonds arise.
Even in NN, however, foreign bonds may end up performing better than US bonds, although a dollar-oriented holder of the latter won’t have a dollar loss. Dividend-paying stocks perform at least as well as domestic bonds.
If events turn out either better or worse than NN expects, bonds are a bad place to be. Well-selected stocks do well whether NN is right or not.
Stocks may be a better bet, even if NN turns out to be right
In all three cases, there will likely be stocks that will outperform bonds. The common threads appear to be having a dividend yield (if NN turns out to be right) and selling to foreigners as a way of combatting potential weakness among domestic consumers or in the dollar (if it doesn’t).
PIMCO argues that stocks overall will return about 5% per year in a “New Normal” world. Their reasoning, however, contains a basic error that biases their number downward. More about this in my third NN post.
Note: While I’ve been writing this post, the Reserve Bank of Australia has raised interest rates there, citing the recovery in Asian economies, notably China. See my post dated today on the subject.