Late last year, markets had a pretty robust view of the path of U.S. interest rates in 2016. Reality has intervened, as it has a habit of doing; global market volatility has seemed to sap whatever will the Federal Reserve had to normalize rates.
Or was it just the markets? Is the Fed completely at the mercy of global market volatility, of geopolitics, of its own internal politics, of the economic convictions of its Open Market Committee? Is it absurd to keep rates at their current levels? (On a global basis, with negative interest rates appearing in many developed-market banking systems, rates are at multi-century lows.)
Secular Stagnation
We wrote back in January about an apparent downshift in U.S. GDP growth in the period since the dotcom bubble. The shift in trend looks something like this:
Data Source: Bureau of Economic Analysis, Wall Street Journal Economic Forecasting Survey
We wrote:
“Looking at U.S. GDP growth from World War II to the present (starting in 1947), we see an annual mean growth of 3.5 percent from 1947 to 2000, and an annual mean growth of 1.8 percent from 2001 to 2015. Ultimately, that gap is the reason that middle-class voters are now sufficiently angry that they’re contemplating the election of candidates on both sides of the aisle who make their party leaders very nervous. That gap also illustrates in the simplest way what the ‘secular stagnation’ discussion is about.”
Larry Summers, Bill Clinton’s former Treasury Secretary, brought the term “secular stagnation” to prominence in a 2013 speech. There he noted this apparent downshift in the trend of GDP growth and offered some speculations as to its cause. Of course, GDP growth is the underpinning of corporate profit growth, and corporate profit growth is the underpinning of stock price appreciation.
That means that this is not a merely theoretical issue for investors. If secular stagnation is a reality, that implies that for a prolonged period of time, investors seeking appreciation in stock prices will be “swimming against the tide” as sluggish economic growth challenges corporate profit growth. Of course it is always possible to find individual companies who through innovation and adept management will buck the trend -- it simply becomes more difficult to do so when there is an undercurrent pulling the economy and the market in the opposite direction.
Secular Stagnation: Why Is It Happening?
We have our own views about why U.S. GDP growth has downshifted and why secular stagnation seems to be a reality. Back in January we noted that the acceleration in the decline post-2000 seems to be associated with declining business dynamism and a marked slowdown in new business formation.
Data show that new, small, hungry businesses are the prime generators of productivity, employment, and GDP growth -- so a decline in business dynamism would naturally translate into poorer growth performance. We traced that decline in business dynamism primarily to increasing regulatory burdens, increasing tax burdens, and an increasing debt burden, both public and private.
In larger terms, many phenomena we see correspond to the so-called “long-wave” theory of Russian economist Nikolai Kondratiev, who studied long trends in economic life, characterizing them as seasons. A Kondratiev “winter,” according to his theory, is characterized by stagnant growth, among other things (sometimes, unfortunately, including global conflict). Analysts who use Kondratiev’s theory identify the world as presently experiencing a Kondratiev winter.
Source: The Automatic Earth
Kondratiev’s theory is not widely accepted among academic economists, but many financial professionals believe it and find its insights useful. We’re agnostic about it, but think it provides an interesting addition to the evidence for secular stagnation. It also suggests that there are powerful, long-term, deep processes at work that are unlikely to shift dramatically as the result of this or that specific policy effort by politicians.
What It Means For Investors
So where do these converging big-picture observations mesh with the landscape investors face every day?
Although secular stagnation implies that the economy is enduring long-lasting disinflationary impulses -- for example, from excessive debt, declining productivity growth, and technological and demographic changes -- that does not mean that such an economy never experiences inflation. Indeed, it can -- and there may be an instructive example in the “stagflation” of the 1970s, where contrary to economic orthodoxy, stagnant growth and high inflation occurred together.
We think that a similar situation may be unfolding at present, with economic growth experiencing a period of persistent stagnation, and inflation beginning to come to life -- especially as commodity prices lap their recent big declines and come off of their lows.
If this is true, then in spite of the disinflationary character of a Kondratiev winter, that argues for higher demand for gold and silver. With oil having made a multi-decade low in February, we believe that in spite of sluggish GDP growth, oil could also continue its recovery.
Stocks and Stagflation
What about stocks? Many observers note that by a number of metrics, the U.S. market is expensive. The tone of the market since it made an all-time high last May confirms this psychological orientation of market participants, as the market has struggled to break out above those highs -- seemingly derailed by every piece of negative global economic news.
Stocks can do very well in inflationary periods. (Look at Venezuela, where stock market participants were at least able to protect their capital during the first few years of hyperinflationary incompetence on the part of the country’s socialist rulers.) But can they do well under present conditions, where trend GDP growth is also sluggish?
Inflation creates demand for assets that can earn and grow in spite of inflationary impulses. Stocks in many industries are exellent inflation hedges.
Are Stocks Expensive? Not Necessarily
So, are stocks expensive? To that question, we can only reply with another question: expensive compared to what?
Let’s compare stocks to bonds. To make an appropriate comparison, we can compare bond yields with stocks’ earnings yield -- that is, the ratio of a stock’s earnings per share to the share price. For example, 2-year U.S. Treasury bonds currently yield 0.74%, and 10-year bonds yield 1.68%. The S&P 500 index taken as a whole currently has an earnings yield of 5.81%. (Note that the earnings yield -- that is, the earnings-to-price ratio -- is simply the inverse of the price-to-earnings ratio. Mathematically, a lower earnings yield simply means a higher P/E ratio.) That is a large spread compared to historical norms.
(Of course, we would expect a stock’s earnings yield to be somewhat higher than a bond’s yield.)
The key question is why rates are so low. Some observers argue that it is simply a matter of central bank intervention. If that were the whole story, the large spread between bond yields and stocks’ earnings yields would not necessarily be very meaningful. Others, including those who follow Kondratiev cycles, believe that central bank policy is contributing, but that there are also underlying cyclical social, economic, and technological conditions which are also creating a low-rate environment. If that’s the case, low rates can’t be completely discounted as a piece of accurate pricing information, as they tend to be by those who throw up their hands and say, “It’s all manipulation, and the data don’t mean much anymore.”
If rates are low for real economic reasons, and not just because of central bank intervention, then the spread between bond yields and stocks’ earnings yields does matter. That spread is historically high. If it reverted to its historical average by a fall in stocks’ earnings yields, their price-to-earnings ratio would rise. Basically, if the markets accepted that the environment of sluggish growth and low rates is here for longer, as Nikolai Kondratiev suggests may be the case, they would be willing to pay a higher P/E ratio for stocks.
We looked at an old economic concept which has recently gotten a lot of comment from Fed officers and economists, the so-called “natural interest rate.” The Brookings Institution defined it in this way:
“The natural rate of interest, also called the long-run equilibrium interest rate or neutral real rate, is the rate that would keep the economy operating at full employment and stable inflation… One indication of the concept’s significance is the frequency with which it is referenced by policymakers. In 2015, over half of the 16 FOMC participants have publicly discussed it, including Chair Janet Yellen, Vice-Chair Stanley Fischer, and NY Fed President Bill Dudley.”
Some Fed officials and economists believe that this “natural rate” is in a long downward trend, which would be consistent with Kondratiev analysis (falling rates being one characteristic of Kondratiev autumns and winters).
These calculations are trying to get at underlying economic facts that are hard to analyze, so take them with a big pinch of salt. They are more useful for showing a trend than for arriving at hard-and-fast numbers.
How do stocks’ earnings yields stack up against this long-run equilibrium interest rate? Are they high or low? The average spread between this rate and stocks’ earnings yields has been about 3.5 percentage points over the past half century. However, now, that spread is relatively high -- about 5 percentage points.
That spread could narrow back to its long-term average in one of two ways. The “natural rate” could rise, or the earnings yield of the S&P 500 could fall. However, the “natural rate,” according to Fed analysis and in harmony with Kondratiev theory, is in a long pattern of decline, apparently driven by secular forces.
So it is certainly possible that the S&P’s earnings yield could fall -- which would mean that the market was willing to pay a higher P/E multiple for stocks. If the spread between the “natural rate” and the current earnings yield reverted to its long-term average right now, it would imply a price-to-earnings ratio for the S&P 500 of about 29, similar to the levels seen in the blow-off of the dotcom era. We’re not saying that this will happen -- we’re saying that under current conditions, it is not outlandish or impossible for stocks to move much higher.
Data Source: Measuring the Natural Rate of Interest Redux, Thomas Laubach and John C. Williams, Federal Reserve Bank of San Francisco Working Paper 2015-16, October 2015
This case would only be strengthened by the advent of higher inflation, as investors seek the relatively riskier environment of equities in an attempt to preserve capital.
In short, the market may be expensive by some metrics -- but there is abundant reason to believe that in an environment characterized by persistently lower rates and the return of inflation, the market could get more expensive.
We do not offer this as a prediction. We offer it as a contrast to current thinking about the stock market’s supposedly high price. It is very possible that emerging data and developments and shifting psychology will lead investors to be willing to pay an even higher price.
That is to say, beyond current negativity and fear, there is the potential for stocks to perform well -- and investors should watch carefully, and not write them off simply because of the common sentiment that they are too expensive.
Investment implications: What investments have the potential to perform well under the economic and market conditions that are taking shape around us? From many different angles, the concept of “secular stagnation” suggests that we are in a period of sluggish growth and persistently low interest rates -- partly because of central bank actions, but partly because of deep and long-term cyclical economic effects. We are also in a period where after a long slumber, inflation may begin to make itself felt again. This environment begins to feel something like the “stagflation” of the 1970s. Such an environment can be beneficial for gold, silver and oil, but it can also be beneficial for stocks. With underlying interest rate expectations persistently low, there is room for stock earnings yields to fall, and price-to-earnings ratios to rise. In addition, stocks could be boosted even in a slow-growth inflationary environment when investors buy equities in an effort to protect their capital from inflation. We like gold, silver, and oil -- but don’t count out the possibility that U.S. stocks could break out to new highs.