IN THIS ISSUE: One year after “The Crash of 2008” and the world’s economic landscape has unmistakably shifted. There is an uncertainty in the air that many have defined as “The New Normal.” In this issue of Tactics, John Nicola recounts what others have said about this new status quo, while adding his own insights on what it means for investors. What is The New Normal? More importantly, is there anything really new about it?
Over the past few months some very good economists and investment advisors have begun to write about a “New Normal” that will have profound effects on our financial futures. In effect, they describe a new reality that most of us are not expecting and worse, one where we are in denial.
Are these financial realities simply the persistent illusions referred to by Einstein, or are they just too difficult for us to grasp because they are now so close they seem incredible? In this newsletter, I would like to explain the New Normal as written about by others and then add my own thoughts as to how impactful financial change could be, and, perhaps more importantly, how and where we feel investments should be focused.
Pimco is the world’s largest fixed income manager ($840-billion at last count). Its major principals are Bill Gross, Mohammed El-Erian and Paul McCulley. Earlier this year, I had the pleasure of hearing McCulley speak on how the New Normal is our current situation and will be our future reality.
The senior management of this well respected investment firm expect the following:
- Global interest rates to stay low for an extended period of time.
- Government stimulus (both fiscal and quantitative easing – in simple terms, governments spending money they don’t have and creating new money by having their central banks purchase government bonds).
- Governments are (and will continue to be) a larger piece of the economic pie, and investments should be made accordingly.
- Asia and suppliers of Asia will dominate global growth (that would include Brazil and Australia and, although not specifically mentioned, Canada as well).
- The U.S. dollar is vulnerable over the long term.
- Unemployment in the developed world should stay relatively high for several years.
- This, combined with consumers increasing savings and repaying debt, will keep inflation low for now; however, if governments stimulate the economy for too long, inflation will return. They have to know when to take away the punch bowl.
Other factors that the Pimco team sees as adding complexity are:
- Past market failures vs. future government failures
- Paper wealth destruction vs. real wealth destruction (see chart: Impoverished)
- Globalization vs. nationalization (think “Buy America”)
- Economic desirability vs. political feasibility
Each of these makes the current situation more challenging. Governments want to create a result that reduces the impact of declining asset values. However, their solutions involve the risk of significant inflation and increased government debt, which destroys the value of paper currencies and may simply replace past failures of the marketplace with future failures of government policy. How has real wealth destruction been a result of past market failures? By March of 2009, global wealth had declined by more than $40-trillion from the year prior.
Globalization has been a huge factor in the increased standards of living for developing nations, while simultaneously creating benefits of lower costs for goods and services for developed nations. If as a result of this economic crisis nations resort to focus on their own national interests at the expense of trade and reduction in tariffs, then they will more than likely lengthen and deepen the effects of this recession.
The last factor (economic desirability vs. political feasibility) refers to the fact that when it comes to government policies, the Great Depression trumps everything. Policy makers will spend and print as much money as it takes to prevent a repeat of the 1930’s. As the chart “Impoverished” shows, real wealth has shrunk significantly in the U.S. (and elsewhere).
And of course the bad news bears don’t stop there. Global banking has already shrunk to Lilliputian levels of its former self. If consumers save and don’t spend, how will companies increase revenue and bottom line profits without resorting to more layoffs which will simply exacerbate the reduction in consumer spending? As the chart below shows, all developed countries are experiencing big increases in unemployment which will not peak until the end of 2010. Canada is actually doing quite well.
And even though the West will likely increase its savings rates, we are mere pikers when compared to the Chinese who save 50% of their annual income when you combine households with companies and the government. Of course, much of the household savings is earmarked for health care and pensions not provided by the state (as one writer put it, “a form of self-imposed taxation”).
And most developed countries are running massive deficits that will see their overall debt rise to historic levels (see chart: A sea of red ink).
While Canada is not on this chart, our combined federal and provincial deficit for 2009/2010 is expected to be $90-billion with total debt at $850-billion. Surely all of this will significantly damage our standards of living for many years, won’t it? Well perhaps not. We are a glass half full kind of firm and these debt numbers help illustrate that all is not bleak. Let’s take Canada for example.
- At $90-billion, this year’s deficit is 6% of our GDP. While both high and unsustainable in the long run, we have been here before. In 1992 our total deficit was more than $63-billion (about 10% of our GDP) and it stayed well above 6% for more than five years during the early 90’s. Yet we are still here and have since regained our AAA debt rating.
- At $850-billion of debt, our overall debt to GDP is about 60%; well below the 100% level it hit during the 1990’s. Furthermore, we are far less dependent on foreign lenders and, as you can see, at 60% we are 40% lower than the average of the G20 industrialized countries.
- I agree with many of the comments and observations of those who write about the New Normal, but one thing I take issue with is the idea that this is all new and something we have not experienced before. To me that is simply not true. We have experienced these kinds of crises before and in the not too distant past. Perhaps one contributing factor is that writers often suggest something is new if they have not personally lived through a similar period of time.
Take a look at the following graphs. One is comparing the long-term secular bear market of 1965-1982 (S&P 500 in $CDN) based on price alone, while the second chart adds back the impact of dividends. While not enough to make historical equity returns, the addition of dividends doubles the overall return.
Secular bear markets are not unusual. One could argue the current bear market was necessary to mean revert many years of “irrational exuberance.” (Perhaps if Greenspan had been less exuberant with easy money we would not be here in the first place.)
We have argued that equity markets have been going through a secular bear market since 2000, and it could easily last another five to seven years. Consider the results below when compared to the first nine years of the previous bear market (1965-1974). While the current market is considerably worse for Canadian investors, much of that is because our dollar has come back from an embarrassing $0.62 U.S. to almost par (where it spent most of the 60’s and 70’s). After nine years, the S&P 500 index was down 29% and 26% in U.S. dollars respectively. Just what you would expect in a long term secular bear market.
It took another eight years for the 1965-1982 bear market to end, but from the depths of 1974 the return on the S&P 500 index was more than 9% annually between 1974 and 1982 (15%/yr if you include reinvested dividends). If we achieve anywhere near that performance in the next eight years, we would be thrilled. More likely we will find capital gains hard to come by, which is why we continue to focus on dividend paying stocks and other asset classes.
Is there a “New Normal”?
Perhaps there is, but one does not need to go too far back to see other periods of time when we have had to repair our balance sheets, increase government debt and recognize that sometimes earning a return in equities feels like swimming upstream.
At first it may seem very difficult to earn a good return in markets where interest rates are near zero and equities struggle to get traction, but of course there is always that half full glass.
- Lower interest rates reduce mortgage costs on income producing real estate. For us it means that for the first time in about two years we can find good quality investment grade real estate where the cap rate (income yield) is 3% higher than the cost of financing. (We like to see at least 2.5% so that we can earn a good cash flow with long term potential for capital appreciation.)
- Rates on many corporate bonds and preferred shares are still attractive. And in the case of the preferred shares, the tax is less than half of what it would be on interest income.
To us good investing is the acquisition of a balanced portfolio of assets at good prices that generate reliable cash flows. And we would argue that there is nothing “New” in that “Normal.”
“At first it may seem very difficult to earn a good return in markets where interest rates are near zero and equities struggle to get traction, but of course there is always that half full glass.”