I think whether the New Normal idea is right or not will end up being a crucial question about the future course of stock and bond markets. Like most investment questions, it’s not so important to have the answer definitively and right now. It’s more important to keep it in mind and keep coming back to it.
Ideally, one would develop a strategy that avoids having to answer the question–one that will do okay no matter how events turn out. But I’m not sure that’s possible in this case, other than through the difficult task of building a portfolio full of secular growth stocks, since the alternative outcomes to NN are so sharply different. Failing the avoidance strategy, it’s only important to have an answer before most investors have made up their minds and acted on their new beliefs.
This means, I think, the New Normal will be a topic of investment discussion for at least the next year, with continuing revisions to investment strategy as new pertinent data are developed.
The two alternatives, in polar form, are:
“New Normal”–the US and UK economies take years to recover from the financial crisis and show little growth over that span. Thirties-like deflation is the biggest economic problem. The apparently superior economic performance of developing countries shows itself to have been radically dependent on demand from the US. Growth in these countries collapses as they are unable to develop alternative customers (each other, for example) for their goods and services.
“BRICs to the rescue”–heads-in-the-sand observers in the US and UK radially underestimate the size and economic power of emerging markets, which will be a key support of world economic growth in the years to come (more about this in a post tomorrow). Not only will these economies readjust quickly, but, combined with continuing depreciation of the dollar and sterling, will ultimately serve as a more important destination for exports of US and UK goods and services. Domestically-oriented businesses in the US and UK may have suffered a serious setback, but internationally-minded firms, especially in the services industries, will continue to go from strength to strength. Also, the US overall may prove more resilient than pessimists expect–as it has typically done in the past.
The investment conclusion of the New Normal is that bonds and stocks both stagnate and deliver annual returns of, say, 3% for bonds and 5% for stocks for a long time.
If BRICs do come to the rescue, stocks go up. Bonds go down as interest rates rise by maybe 200 basis points. After that, bonds become a reasonable investment. yielding maybe 5%+ for long-dated governments.
The most aggressive proponent of New Normal is PIMCO, a leading bond manager in the US. PIMCO seems to be staking its reputation on NN being correct. It certainly has a lot to lose if NN turns out to be wrong and bonds suffer multi-year losses as global growth resumes.
I’m sure the company is trying not to think of this when formulating its strategy. But for anyone who has seen bonds make almost continuous, surprisingly strong, gains over 25 years may have trouble believing that the party is over–even temporarily.
Support for the more optimistic case seems much more diffuse. It comes from experts on developing economies and from Goldman Sachs, which coined the term BRICs (Brazil, Russia, India, China). The former group have the same kind of self-interest issue as PIMCO, the latter seem to me more professionally indifferent to the outcome.
As for me, my bias is toward the optimistic case. It would be surprising if it weren’t, since growth investors are serial optimists. But it also seems to me that the data are beginning to show stabilization in the US and unexpected strength abroad. More on this too in subsequent posts.
One other thing: One aspect of the current situation comes as a surprise, at least to me–the extent of the greed of the financial industry, the corruption of legislators and the ineptitude of regulators. The combination of these factors have made the financial meltdown much larger that I believe almost anyone expected.
But several others do not:
–the gradual aging of the US workforce and slowing in the growth of the working population is well-known–new twenty-somethings don’t just magically appear; also,
–the large number of graduates pouring out of universities in the developing world, willing to work for far less than their US counterparts;
–the deterioration of the US education system in its standing in the world;
–the surprising–to most people in the US–size and power of the economies of developing nations, which the World Bank has been stressing for many years.
Contrary to what the man in the street might think, planning and action by corporations in the US to reorient themselves to a new world order is not just beginning now, in reaction to the drying up of domestic growth after the financial crisis. The transition has been going on for some time. And even large hidebound corporate dinosaurs like GE and IBM have been moving in the past couple of years.
This movement, initially bad for US employment, has been masked for a while by the explosion in housing demand during most of this decade. But, as stock investors, we have to consider the possibility that the de-linking of US domiciled corporations from the domestic US economy may be much farther along than we expect. If so, corporate profits for publicly-traded firms could be equal to, if not better than, an (always too) optimistic brokerage house consensus expects.
Very enlightening series and a fascinating contrarian view of the gloomy “New Normal” mantra. Two key points stand out to me: (1) the persuasive argument that stocks are actually de-coupled from GDP, i.e., the stock market is not the economy of a country; and (2) the unlikely scenario that developing countries will roll over and die as a result of a “flat” U.S. economy. I see no reason why the Chinese, for example, cannot prosper nicely selling to other BRICs/developing nations and to themselves. China with a dynamic service economy alongside its manufacturing sector? I think it’s a likely development and is already happening: travel and tourism, business services, retail, liesure products, education companies, internet portals, etc. And all this in a country with tons of money under the mattresses and which is just now learning to say, “I want to buy!”
Thanks for your comment. When I began looking at emerging markets in the mid-Eighties, it was generally assumed that they were nothing more than highly leveraged ways of playing the business cycle in the US. At that time, their domestic economies were too small to absorb much of any potential shortfall in trade with the US. In the twenty-five years since then, very rapid growth in emerging nations has changed the situation. China and India are together now about 20% of world GDP, and roughly equal in size to the US (see my post on Purchasing Power Parity).
We should remember, too, that the Chinese leadership wants to avoid the social instability–and the resulting threat to their grip on power–that would come if the workforce can’t absorb the millions of workers who come into the job market there each year. Worries about another Tiananmen Square are a powerful incentive for China to reshape its economy if large numbers of new jobs can no longer be created through trade with the US.