Welcome to the “Rounded Bottom”.
That is how I look at the economy right now. As I outlined in my 2011 economic outlook, business investment has recovered to normalized levels. Government policies have propped up personal incomes, allowing savings to recover a normal level and maintaining consumer spending at a pre-recession level of GDP. Real estate investment has plunged from more than 8% of GDP prior to the recession to a record low of less than 4% as of Q4 2010. This has created a good deal of the nation’s output gap. Manufacturers of wood products and furniture, construction workers, real estate agents, and lenders have all seen business decline heavily as a result of the recession and not really recover. The decline in house prices has also reduced consumers’ ability (and desire) to borrow, which combined with rising prices for food, gas and health care is crimping consumers’ ability to spend on discretionary items.
Thus we have the great economic dichotomy of the Rounded Bottom. The business side of the economy is doing fine, with record profits and rising investment (funded largely from internal cash flow), a technology and energy boom, high productivity, ever-growing cash balances and rising exports. The consumer side of the economy, on the other hand, is struggling, with weak real estate investment, high debt levels, high unemployment and a tight squeeze on middle class finances.
Now the government sector is moving from a slight positive (propping up consumer incomes with the Fed buying the newly issued debt) to a slight negative (spending cuts, tax increases and an end to the Fed buying long term bonds). The same scenario is playing out in Europe as well.
All of the statements above are well-documented and understood by the market, and they are pretty well reflected in market interest rates:
Source: Treasury and muni rates from Bloomberg.com; corporate rates from Vanguard Funds; equity returns from tylernewton.com model based on information from Standard and Poors and Economy.com. Equilibrium rates based on tylernewton.com model.
Treasury rates are generally below their equilibrium levels largely because of the collapse in real interest rates, as reflected by the rates on Treasury Inflation Protected Securities (“TIPS”). Super-low real interest rates (notice that the 5 year TIPS rate is negative) reflect that the supply of capital exceeds demand. In other words, investors demand more treasuries than are available, which certainly separates our situation from that of Greece. In addition, the fact that real interest rates are expected to be negative for the next five years reflects that the markets expect the current economic situation to persist for a while.
In addition, there is not just strong demand for treasuries, but the risk spreads for corporate securities (both debt and equity) are below their long term equilibrium levels as well. The supply of investment capital for corporations exceeds the demand for capital. Only municipal bonds have consistently higher-than-normal risk spreads, as the problems of state and local governments are well documented.
The markets also believe that the Fed will succeed in maintaining positive inflation over both the short and long term, as it is a stated goal of fed policy to maintain inflation of around 2%.
So where does the market have it wrong?
If we want to produce investment alpha, however, we have to figure out where the market is wrong and bet against it. In the super-big picture, it is good to know in which general context we are operating. In my 2009 essay “These are not ‘Unprecedented’ Times,” I put forth the hypothesis that we are in the “winter” phase of the Kondratiev Cycle. The dominant financial impulse of the winter phase is that of deleveraging, which is consistent with what is going on today. With debt to GDP at record high levels, it is difficult to envision a scenario where the private sector reengages in a process of systematic financial leveraging like it had from 1982 to 2006.
Without re-leveraging, it is hard to produce sustained inflation. With de-leveraging the natural impulse is deflation. In addition, the absolutely essential reform of tighter bank capital standards are also disinflationary as the banks’ loan books will be forced to grow more slowly than their equity bases for at least several more years. To maintain positive inflation, the Federal Reserve will need to continue to engage in “quantitative easing” beyond its just-ended program. I’m not sure the Fed would want to engage in another such program unless absolutely necessary, given the opprobrium to which it has been subject. Thus, we should expect continued disinflation and low interest rates for the intermediate term.
When judged by their earnings yield vs. trend earnings, stocks aren’t cheap.
Stock valuations are very sensitive to long term inflation expectations, and are vulnerable if expectations were to change suddenly. Earnings are currently very high both historically and relative to the inflation-adjusted trend.
Source: tylernewton.com, Standard and Poors earnings estimates
Two conclusions can be drawn. Either something structurally has changed and earnings will continue to stay well above trend, or earnings are vulnerable to mean reversion in the next few years. I actually think the truth lies somewhere in between. Something has changed structurally since the 1960s and 1970s, but earnings are vulnerable because of a global demand shortage and developed world deleveraging. The big swings in aggregate S&P 500 earnings in recent years have largely been due to swings in bank earnings, which could easily fall from recent levels.
Wait, it’s not all bad
Because overall corporate balance sheets are in good shape and the cost of capital is low, business investment momentum is building. Real estate investment has nowhere to go but up, as well. A return to normalcy in real estate investment (back up to about 6% of GDP) will arrive when the high inventory of unsold homes is worked off. I expect real estate investment levels to turn back up sometime in the next 12 months, with perhaps faster-than-expected growth in 2013 and 2014 as the market reverts to trend from extremely depressed levels. I do not, however, expect there to be a return to a bull market in real estate prices, as cap rates are already low and the policy environment is likely to lean against housing (higher bank capital requirements, a scaling back of Fannie and Freddie, and a potential rollback of mortgage interest deductions).
Hence I expect the Rounded Bottom scenario through at least 2012 and probably beyond:
- Continued disinflation, de-leveraging and low interest rates
- Weak consumer spending
- A long term bottoming process in housing
- Decent performance in the business sector, including strong M&A activity
- Weakness in developed markets offset by good growth in emerging markets
- Continued high unemployment and overall output gap
In other words, favor long term bonds and keep your money safe, but don’t panic. Diversification is still the rule.