The New Normal

The bond fund PIMCO popularized the term New Normal to explain the investment environment for the next five years: low growth, high unemployment, slow banking, slower securities, and steady erosion of productive capital stock. In their words:   

Global growth will be subdued for a while and unemployment high; a heavy hand of government will be evident in several sectors; the core of the global system will be less cohesive and, with the magnet of the Anglo-Saxon model in retreat, finance will no longer be accorded a preeminent role in post-industrial economies. Moreover, the balance of risk will tilt over time toward higher sovereign risk, growing inflationary expectations and stagflation. ...

The result is a prolonged pause, or in some cases, a violent reversal in certain concepts that markets had taken for granted. 

McKinsey and others had also used the phrase The New Normal to describe the next few years: less leverage, more government, new protectionism, less consumption and a focus on Asia. They think innovation will continue, and investment in human capital. 

Now John Mauldin in his weekly newsletter takes issue with these projections as too optimistic, dismal though they may seem. He had been a proponent of the Muddle Through economy, one of slack growth (1-2%) and slack employment - kind of like the New Normal. He developed his Muddle Through concept before we had $1T deficits as far as the eye can see. He is even more worried that the optimistic projections underlying the White House estimates (see chart) are unrealistic: they assume 3% growth and a return to 5% unemployment, much better than expected in the New Normal. Hence $2T deficits may be the real New Normal. 

The problem he sees is that deficits of this magnitude crowd out private investment, and will continue to suppress consumption in favor of savings (in this case buying Treasuries mostly!). GDP is measured as:

 GDP = C + I + G + X

or Consumption + Investment + Government Spending + Net Exports (exports in excess of imports). 

The Keynesian plan is for an increase in G to make up for a drop in C. But if that G is funded by huge deficits, it crowds out private investment, and I drops. In order for GDP to continue to grow, we must have an increase in I to fund the private sector. It would have to come from the outside, measured as a positive X (net exports); but for a long time we have run a trade deficit and have had negative X. Will that change? One of the common themes of the New Normal is for capital to leave the US for Asia. This will not create a positive X.

You could take issue with the chart above, as the worst case deficit projections come from the Heritage Organization, a conservative group opposed to Obama. But Société Générale came up with a similar analysis, concluding that we will quickly have a Trillion Dollar Gap with no clear way to fill it. See chart, courtesy The Big Picture. 

Now, heretofore the overseas US investments have had returns back in higher than the trade deficits have bled out. This seems likely to change, and also puts pressure on X and how to fund the huge deficits. Right now the US banks are getting deposits at very low rates and buying Treasuries at 2% or higher - such a deal! It enhances the Fed's QE but does nothing for investment in the private economy. 

Picking up on my theme from yesterday, as we starve private investment and send capital overseas, we starve the Golden Goose.

Prognosis: after the inevitable dead-cat bounce in GDP, we should see slow growth with periods of negative growth: The New Normal. Taxes should go up first in 2011 with the Bush cuts expiring and then in 2012 and beyond if any of the bills get passed (the healthcare bills all raise taxes, as does Cap&Trade). Tax increases will further suppress GDP. 

In this environment, hard assets and bonds should do better than stocks. 

Comments

[jwalker46]

Yelnick, You wrote "Taxes should go up first in 2010 with the Bush cuts expiring..." Au contraire, the Bush tax cuts extend through the end of 2010, so taxes rise in 2011 (not 2010).

[jwalker46]

Yelnick, Mauldin can write whatever he wants; he has the advantage of not being burdened by any education in economics. As Friedman and Stiglitz have written (two quite polar political opposites), /how/ the gov't funds its spending is irrelevant, 'cept at two extremes: full employment, and a recession. In the latter (which, you /have/ noticed, is where we are today), gov't spending does not crowd out private investment.

[yelnick]

jwalker, me bad, thanks for the clarification! I will update the post

[yelnick]

Jwalker, if it doesn't, explain to me why private investment is in the toilet? Yes, Friedman didn't care how the government maw was funded, but then in the 70s ad 80s he never faced deficits of this magnitude amidst an overall debt to GDP of this size. In the Great Depression debt got written down rapidly before the government ran up larger deficits (largely in WWII) and those clearly crowded out private investment.

[jwalker46]

Yelnick,

Historically (with the 1930s as an exception), private investment is /the/ swing variable in recessions. Consumer spending just does not vary enough to precipitate recessions. Read Modigliani or Friedman re "life cycle hypothesis" to understand how consumers smooth out debt/spending, and do /not/ react to transitory events - e.g. 1987 market crash (after which NYT, WSJ and Prechter all forecast a recession which never arrived).

The "shadow banking system" (securitization) fed corporate American and consumers - it came to a grinding halt. So, of course investment cratered.

Re debt: read Robert Barro (ca 1975) why gov't debt is /not/ net debt (i.e. we owe it to ourselves): how we as an economy fund investment (debt v equity) is not all that important.

What you should focus on (imvho etc etc) is are two facts, which you have discussed:

(1) the "eternal money machine" (real estate, fed by tax & other subsidies) may have broken. IF so (and I think "yes"), the consumer is in for a long period of retrenchment, and GDP growth will not be very high.

(2) the "monkey in the system" (dodgy accounting, outright fraud), often seen after long periods of credit expansion. Again, a retrenchment follows in consumer spending/investment.

An example of #2: when will the Eurotrash regulators force Deutsche Bank (etc) to mark to market their insolvent mortgage loans in Spain and eastern Europe? Answer that (I cannot), and you will know when the dollar soars past parity. ;-)

[yelnick]

jw, we have to be a little careful with some of these stats. consumer spending as a % of GDP went up in the GD as the others went down & GDP dropped, but consumer spending didn't actually drop. this time around consumer spending is actually dropping. it is unlikely to go up as a % since govt spending is going up pretty fast and GDP hasn't fallen much. this idea of Barco that we owe to ourselves was a rationalization back then as it is now; whatever, we overspend and malinvest the govt money and so we have to pay off the mistakes for years after. Friedman's insight that it is the overall government spending is sound, especially as governments tend to spend poorly in terms of future growth.

I just don't see where you find optimism in private investment in the New Normal. in WWII with high debt to GDP we lent to the govt but clearly crowded out private investment. I suppose Japan is a better model to look at, from 1989 to 2009, where we see pathetic growth and a huge overhang of debt that they are having a problem getting out from under. Slow GDP, low to down private investment, capital moving to Asia - what is to like?

[jwalker46]

Yelnick,

Please re-read what I wrote, which was: in most recessions, consumer spending barely declines if at all (e.g. '94-75); the entire recession can be measured in investment. The GD was an exception, since investment was not "the" swing variable (consumer spending declined over 25% during 1930-33).

Secondly, I didn't express optimism, I merely pointed out that Mauldin has his head up his posterior re the notion that gov't spending (in today's economy) is or will crowd out private investment.

[Mamma Boom Boom]

jwalker, lookout, here comes a car!

[Michael Locker]

... and it just dropped off 100 Dow points and sped off safely.

[Mamma Boom Boom]

... not before busting a cap on the simp standing on the curb.

[Michael Locker]

... , Ned Bushong, whose dying words were, "When do the bulls start their celebration? Where's the volume?"

Onlookers sighed and shook their heads sadly as poor Ned bled to death, but were grateful it came faster than the demise of his slowly, inexorably bleeding portfolio.

[Michael Locker]

jest havin fun

hope you and your portfolio are fine

[Mamma Boom Boom]

>>hope you and your portfolio are fine<<

Better than most, if you use a 2 year timeframe. Small underwater short position if you use a shorter timeframe.

Fall of 07, sold my stocks, couple months later sold my bonds. All pretty much at the top. Everything in the middle has been nibbling.

[Michael Locker]

I will be nibbling on puts when I see more euphoria. I don't mind seeing lots of bears but I want the bulls to be gloating more and I want to see more people totally believing the recession is over.

[Mamma Boom Boom]

Here's a good one:

A new global study has confirmed what many market participants may already feel - that technical analysis doesn't work.

Interestingly, this latest study appears to have been conducted by Massey University in cooperation with Australia's Macquarie Capital and Macquarie Bank.

SSRN: Technical analysis is not consistently profitable in the 49 countries that comprise the Morgan Stanley Capital Index once data snooping bias is accounted for. There is some evidence that technical trading rules perform better in emerging markets than developed markets, which is consistent with the finding of previous studies that these markets are less efficient, but this result is not strong. While we cannot rule out the possibility that technical analysis compliments other market timing techniques or that trading rules we do not test are profitable, we do show that over 5,000 trading rules do not add value beyond what may be expected by chance when used in isolation.

[Mamma Boom Boom]

Divergence:

Some new highs were made today. But my intermediate timing indicator, I call MaxHeadRoom, is about 2% below its high.

Does it mean anything? Time will tell.

[Kallidromos]

I see all these numbers and charts and sophisticated analysis and I wonder?
When are these guys, I mean the good ole' US of A going to realize that you have to make stuff (refrigerators, clothes, shoes, wheat, corn, computers etc etc etc) the old fashioned honest way, when the customer was respected and got goods that lasted for a fair price, for the economy to get better.
You know, all these charts are telling the same story. You can't distort ethics and values beyond recognition and expect to prosper.
I also wonder who's worse; Al Quaeda or the Americans who undermine their own country through outsourcing in an effort to maximize (as opposed to optimize) their returns. Don't they like what they have? Do they think that it will ever be possible for Americans to work for Chinese wages?
I also believe that the charts are telling us that history has a geometry;
a complicated fractal geometry that is telling a very frightening story. There is financial bubble under way that will eventually will drive the Dow to the 20-30 K, or even higher within the next 5-8 years as an ending diagonal fifth wave of a fifth wave that also develops as a diagonal triangle. It is only then, that the current system will become untenable as the norm of economic behavior and the geopolitical repercussions will be immense.

[psycho_puppies]

"The market is stupid over bought, but it's performance is attracting more money," one traders said to me this afternoon. ... LOL they call this investing?

http://www.cnbc.com/id/33384410

[Account Deleted]

Breaking alert for bulls/bears:

With the new market high today, Naz and Amex A/D lines are not confirming and diverging, making a lower high instead. NYSE A/D line is still confirming, but very barely.

http://stockcharts.com/scripts/php/candleglance.php?$NYAD,$NYHL,$NAAD,$NAHL,$AMAD,$AMHL

Now, these A/D lines have been incredibly strong throughout this rally, as the market was too oversold and stocks particiapated broadly in the rally. It is really a long wait to finally see these (last) breadth indicators starting to break down, along with other breadth and momemtum indicators.

I will leave it to you to draw the conclusion.

[miguel stone crow]

Kallidromos writes

"I also wonder who's worse; Al Quaeda or the Americans..." blah blah blah

As a person who watched his friends and countrymen jump from the flaming Towers, I can assure you that Bin Laden's bunch are not on the side of the righteous, intelligent or nice. Evidently you know nothing about Americans.

[Kallidromos]

Obviously Mr. Crow did not understand what I wrote and more importantly I certainly meant no offense, to the country I consider a second homeland.

He is not alone in mourning a loss.

One young woman that died in the Twin Towers was from Crete and I know her family, another young man from Greece also died that day.

My point is this:
There are external threats to the US in the form of the likes of Al Quaeda, and there are internal threats that sap the US through their greed.
The third point is that the economy will recover when the huge productive potential of the US goes back in high gear under a new set of rules, closer to what the founding fathers had in mind.