Tag Archives: new normal

The “New Normal” (IV): final thoughts

October 13, 2009 By in Constructing a Portfolio, Current Market Thoughts, Strategy Tags: , , , , , , , , 2 Comments

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.

The “New Normal” (ll): how things could turn out differently

October 7, 2009 By in Asian economic development, economics, Strategy Tags: , , , , , , , Leave a comment

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.

The “New Normal” (l): What it means

October 5, 2009 By in Current Market Thoughts, Strategy Tags: , , , , , , , , Leave a comment

Stability is the “new” growth

Recently, commentators in the US have been framing many economic discussions in terms of the “new,” meaning post-recession, ______ (fill in the blank).  One might hear that Atlantic City, or some other local beach, is the new Riviera.  Or that Hyundai is the new Cadillac, or  Macy’s the new Neiman’s.  Or that companies with flat year-on-year revenues are the new growth stocks.

This shifting downward in consumer behavior–and, therefore, in near-term expectations for economic performance in the US–has been neatly summarized in the catchphrase “the New Normal” being promoted by PIMCO, the California-based bond management company  now a part of the German insurer Allianz.

Three posts, the first today

I’m going to address this topic in three posts.  This one will be about what the New Normal is.  The second will be about how world economies could develop in different directions.  The third will be about implications for stocks.

What about bonds?  First of all, my expertise is in stocks, so you have to take what I say about bonds with a grain of salt.  Second, bonds seem to me to be extraordinarily expensive.  Governments around the world have pushed interest rates down to as close to zero as possible in order to and a panic in financial markets.  Rates don’t seem to me to be able to go down any farther.  They can only remain the same or go up.  In the latter case, bond prices will tumble.  So sub-par growth around the world for as far as the eye can see is the only scenario in which bonds make sense.  Perhaps by coincidence, this is the New Normal that PIMCO describes.

What the “New Normal” is

The New Normal seems to me to have four main points:

1.  The long-term growth rate of the US economy is no longer the 3%+ that we have experienced over the past generation, but rather 2% or so.

This is actually not new, since the Federal Reserve has been talking about this development over the past decade.  Reasons?  slowing growth of the work force, caused by slowing population growth and a plateauing of female work force participation.

2.  The recent years of consumer feast, based on easy credit and inflated house values, must be followed by a period of  GDP famine, while consumers use their cash flow to repay excessive debt and rebuild savings rather than buy new things.

Although we may have to go back to the Eighties (i.e., pre-Greenspan) to see this kind of adjustment, this also makes sense.

Here come the controversial ones—

3.  The damage done to the economy during the easy money era will take much longer to repair than the consensus expects.  “New Normal”  real GDP growth will be 1%-2% annually.  And growth will only be that high because the economy will be on continuing government life support.  Interest rates will therefore remain at current low levels indefinitely.

4.  Developing countries which have been dependent on exports to the US for their own GDP expansion will be unable to adjust to the new situation.  They won’t be able to develop domestic sources of growth to replace lost sales to the US.  In consequence, their GDP growth rates will plummet to close to the (new, anemic) US GDP growth rate.

This would imply three things:

You won’t be able to avoid the mess in the US by looking abroad.

You also won’t be able to find  companies in the US with large foreign exposure which will be able to weather the domestic storm with profits intact.

The US won’t be rescued by demand from Brazil, China, India, Russia or the Middle East.  Their growth stories will just melt away.

PIMCO on stocks as an alternative to bonds

Bill Gross, one of the founders of PIMCO, has given the firm’s views on stocks in a recent Bloomberg interview.  In it, he seems to argue that:

1.  nominal GDP growth in the US will be around 3% annually for a long time

2.  the earnings of publicly-listed stocks are linked to domestic GDP

3.  therefore, stocks will have annual returns of about 5%.

What did he say??

This argument makes no sense.  The second point is incorrect.  The third, if it does indeed follow from the second, is at best not particularly relevant, and is potentially misleading.  (To be fair to Mr. Gross, I didn’t hear the interview reported by Bloomberg and have contacted Bloomberg, without success, to try to see precisely what Mr. Gross said.  In his monthly PIMCO commentaries, however, it does seem to me that he believes about stocks something like what I’ve just outlined.)

More on the New Normal in my next posts.