You didn't build that ..........
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I built that ....................... 206
Well, I guess that settles it: you didn’t build that
after all. Or maybe you did, but not all of it. Or maybe like the convoluted
John Lennon above “you think you know a yes, but it’s all wrong. That is you
think you disagree.” Whatever. Rather than an economic mandate, November’s
election was more of social commentary on the Republicans’ habit of living with
eyes closed. Their positions on what Conan O’Brien labeled “female body parts”
– immigration, gay rights and student loans – proved to be big losers, and they
will have to amend rather than defend those views if they expect to compete in
2016. I suspect they will. Political parties are living social organisms that
mutate in order to survive. We will see straight talking Chris Christie or Hispanic
flavored Marco Rubio leading the Republican charge four years from now versus a
reenergized Hillary Clinton. It should be quite a show with a “No Country for
Old (White) Men” caste to it.
But whoever succeeds President Obama, the next
four years will likely face structural economic headwinds that will frustrate
the American public. “Happy days are here again” was the refrain of FDR in
the Depression, but the theme song from 2012 and beyond may more closely
resemble Strawberry Fields Forever, as Lennon laments “It’s getting hard to be
someone but it all works out.” Why is it so hard to be someone these days, to
pay for college, get a good-paying job and retire comfortably? That really was
the economic question of the 2012 election towards which very few specifics
were applied from either side. “There’s a better life out there for us,”
Governor Romney bellowed to a crowd of thousands in Des Moines, Iowa just days
before the election, but in truth he never told us how we were going to achieve
it or, importantly, why we weren’t realizing it in the first place. The
president’s political mantra of “Forward” was even more vague.
Their words were mum if only because the real cause of
slower economic growth lies hidden in a number of structural as opposed to cyclical
headwinds that may be hard to reverse. While there are growth potions that
undoubtedly can reduce the fever, there may be no miracle policy drugs this
time around to provide the inevitable cures of prior decades. These structural
headwinds cannot just be wished away as we move “forward” whether it be to the
right, the left or dead center. Last month in a major policy speech at the New
York Economic Club, Fed Chairman Ben Bernanke concurred that the U.S. economy’s
growth potential had been reduced “at least for a time.” He in effect confirmed
PIMCO’s New Normal which has been in place for three years now, laying the
blame in part on the financial crisis, diminished productivity gains, and
investment uncertainty due to the near-term fiscal cliff. We do not disagree.
However, there are numerous other structural headwinds that may reduce real
growth even below the New Normal 2% rate that Bernanke has just confirmed, not
only in the U.S. but in developed economies everywhere.
They are:
1) Debt/Delevering
Developed global economies have too much debt – pure
and simple – and as we attempt to resolve the dilemma, the resultant austerity
should lower real growth for years to come. There are those that believe in the
“Brylcreem” approach to budget balancing – “a little dab‘ll do ya.” Just knock
a few percentage points off the deficit/GDP ratio, they claim, and the private
sector will miraculously reappear to fill the gap. No such luck after 2–3 years
of austerity in Euroland, however. Most of those countries are mired in
recession and/or depression. Political leaders there should have studied the
historical evidence presented by Carmen Reinhart and Ken Rogoff in a critically
important paper titled, “Growth in a Time of Debt.” They conclude that for the
past 200 years, once a country exceeded a 90% debt/GDP ratio, economic growth
slowed by nearly 2% for both developed and developing nations
for an average duration of nearly a decade. Their work displayed below in Chart
1 shows the result in the United States from 1790–2009. The average annual U.S.
GDP rate growth, while clearly influenced by the Great Depression, was -1.8%
once the 90% barrier was exceeded. The U.S., by the way, is now at a 100%
debt/GDP ratio on the basis of the authors’ standard measuring yardstick. (Note
as well the 5½% average inflation rate during the same periods.)
In addition to sovereign debt levels which were the
primary focus of the Reinhart/Rogoff studies, it is clear that financial
institutions and households face similar growth headwinds. The former needs to
raise equity via retained earnings and the latter to increase savings in order
to stabilize family balance sheets. The combined need to increase our “net
national savings rate” highlighted in last month’s Investment Outlook is
a long-term solution to the debt crisis, but a near/intermediate-term growth
inhibitor. The biblical metaphor of seven years of fat leading to seven years
of lean may be quite apropos in the current case with the observation that the
developed world’s growth binge has been decades in the making. We may
need at least a decade for the healing.
2) Globalization
Globalization has been an historical growth stimulant,
but if it slows, then the caffeine may wear off. The fall of the Iron Curtain
in the late 1980s and the emergence of capitalistic China at nearly the same
time was a locomotive of significant proportions. Adding two billion consumers
to the menu made for a prosperous restaurant, increasing profits and growth in
developed economies despite the negative internal effects on employment and
wages. Now, however, these tailwinds are diminishing, producing an airspeed
which inexorably slows relative to the standards of prior decades. Is it any
wonder that markets now move up or down as much on the basis of policy changes
coming out of China as opposed to the U.S. or Euroland? If China and the
accompanying benefits of globalization slow, so too may developed economy
growth rates.
3) Technology
Technology has been a boon to productivity and
therefore real economic growth, but it has its shady side. In the past decade,
machines and robotics have rather silently replaced humans, as the U.S. and
other advanced economies have sought to counter the influence of cheap Asian
labor. Almost a century ago, Keynes alerted the economic community to a “new
disease,” what he called “technological unemployment” where jobs couldn’t be
replaced as fast as they were being destroyed by automation. Recently, Erik Brynjolfsson
and Andrew McAfee at MIT have affirmed that workers are losing the race against
the machine. Accountants, machinists, medical technicians, even software
writers that write the software for “machines” are being displaced without
upscaled replacement jobs. Retrain, rehire into higher paying and value-added
jobs? That may be the political myth of the modern era. There aren’t enough of
those jobs. A structurally higher unemployment rate of 7% or more is the feared
“whisper” number in Fed circles. Technology may be leading to slower, not
faster economic growth despite its productive benefits.
4) Demographics
Demography is destiny, and like cancer, demographic
population changes are becoming a silent growth killer. Numerous studies and
common sense logic point to the inevitable conclusion that when an economic
society exceeds a certain average “age” then demand slows. Typically the
dynamic cohort of an economy is its 20 to 55-year-old age group. They are the
ones who form households, have families and gain increasing experience and
knowhow in their jobs. Now, however, almost all developed economies, including
the U.S., are gradually aging and witnessing a larger and larger percentage of
their adult population move past the critical 55-year-old mark. This means
several things for economic growth: First of all from the supply side, it means
productivity and employment growth rates will slow. From the demand side, it
suggests a greater emphasis on savings and reduced consumption. Those
approaching their seventh decade need fewer cars and new homes as shown in
Chart 2. Almost none of them have babies (thank goodness!). Such low birth
rates and a significant reduction in demand have imperiled Japan for several
lost decades now. A similar experience will likely turn many developed economy
“boomers” into “busters” within the next several years.
Conclusions
I’m fond of reminding that you can’t buy GDP futures – at least not yet. Hypotheses about real growth
rates, no matter how accurate, must be translated into investment decisions in
order to justify the discussion. Before doing so, let me acknowledge that these
structural headwinds can and will likely be somewhat countered by positive
thrusts. Cheaper natural gas and the possibility of reversing or even
containing the 40-year upward trend of energy costs may be a boon to
productivity and therefore growth. There is talk of the U.S. being energy
independent within a decade’s time. Housing as well may be experiencing a
multiyear revival. In addition, unforeseen productivity breakthroughs may be
just over the horizon. How many gloomsters could have forecast the Internet or
any other technical breakthrough before it actually happened? Jules Verne we
are not.
But if a 2% or lower real growth forecast holds for
most of the developed world over the foreseeable future, then it is clear that
there will be investment consequences. Shown below, as recently published in a TIME
Magazine article by Rana Foroohar, is a PIMCO list of future Picks and
Pans based upon these ongoing structural changes:
Picks
Picks
- Commodities like Oil and Gold
- U.S. Inflation-Protected Bonds
- High-Quality Municipal Bonds
- Non-Dollar Emerging-Market
Stocks
Pans
- Long-Dated
Developed-Country Bonds in the U.S., U.K. and Germany
- High-Yield Bonds
- Financial
Stocks of Banks and Insurance Companies
The list to a considerable extent reflects the view
that emerging economy growth will continue to be higher than that of developed
countries. Their debt on average will remain much lower, and their demographic
age much younger. In addition, the inevitable policy response of developed
economies to slower growth will be to reflate in order to minimize the impact
of the aforementioned structural headwinds. If successful, reflationary
policies will gradually move 10 to 30-year yields higher over the next several
years. The 30-year Treasury hit its secular low of 2.50% in July and such a
yield may seem ludicrous a decade hence. Investors should expect future
annualized bond returns of 3–4% at best and equity returns only a few
percentage points higher.
As John Lennon forewarned, it is getting
harder to be someone, and harder to maintain the economic growth that investors
have become accustomed to. The New Normal, like Strawberry Fields will “take
you down” and lower your expectation of future asset returns. It may not last
“forever” but it will be with us for a long, long time.
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