There was a time when applying the word “new” to a product was a surefire way to stimulate buying. Not so with economic theory.
The “New Normal” is a phrase minted by PIMCO CEO Mohamed el-Erian, and echoed by company founder Bill Gross, to describe a Malthusian future — not an age of starvation, exactly, but an age of economic misery, characterized by slow economic growth, high unemployment, rising inflation and high taxes. In this New Normal — the proximate cause of which was the 2008 financial meltdown — PIMCO envisions a shift in global economic leadership from the U.S. and the West to developing nations (China and other poor nations to which we used to condescend).
No doubt, things are different in the current economic environment — different, at the very least, from the salad days preceding the 2008 collapse of Lehman Bros. The current recession isn't likely to end with a typical rebound to the pre-crash levels of economic activity, either. No, this, says David Rosenberg, chief economist and strategist at Toronto investment advisor Gluskin Sheff, is more like an honest-to-goodness depression.
“The recessions of the post-WWII experience were merely small, backward steps in an inventory cycle, but in the context of expanding credit,” says Rosenberg. “Whereas now, we are in a prolonged period of credit contraction, especially as it relates to households and small businesses.”
That “depression” bit has got to be, well, depressing, for investors and advisors who thought they'd seen signals that a “V”-shaped recovery was underway. Keep in mind that the PIMCO doom-and-gloom assessment was originally derived from the frightening economic data of 2009's first quarter. Most telling — and scary — was a gut-wrenching nose-dive in OECD industrial production to a low not seen since the organization was founded. In the second and third quarters of 2009, however, production rebounded sharply. (See chart 1.) You really can't get any more “V”-shaped than that. (And, by the way, S&P 500 earnings are expected to grow 210 percent in the fourth quarter, according to consensus estimates; In 2010, analysts expect earnings growth of more than 20 percent.)
Come On In, The Economy Is Fine
These roller coaster economic antics should not whet investors' appetite for riskier assets, says PIMCO's el-Erian. He attributes the robust improvement in some economic indicators to an “unprecedented amount of global fiscal and monetary stimulus.” Stimulus alone is insufficient, in el-Erian's view, for a sustainable recovery. Private sector demand, in the form of consumption, investment or exports, is needed.
Personal consumption was, in fact, kindling for the fire that ultimately melted down the financial system. Consumption has been on a tear over the past three decades, stair-stepping from 61.6 percent of gross domestic product in 1973 to 70.1 percent in 2008. (See chart 2.)
The story isn't completely told by those statistics, though. Personal spending is still rising. By the third quarter of 2009, in fact, personal consumption expenditures represented 71.1 percent of gross domestic product, fully a percentage point higher than the year-end 2008 rate. Blame that stimulus money sloshing about.
Of course, money that is spent can't be saved. Or can it? Americans have been lousy savers until recently. Personal savings as a fraction of disposable income slumped during the go-go days preceding the crisis, reaching a nadir of just 1.2 percent by the first quarter of 2008. Up until then, home equity doubled as the household piggy bank for many while margin loans against stocks and bonds fed others.
Things have changed radically since then: The domestic savings rate hit 5.4 percent in the second quarter of 2009 and was last clocked at 4.5 percent. This makes it seem like we're eating our cake and having it, too. We're increasing spending and savings at the same time. How does that make sense? Should we once again blame government stimulus?
The New Normal Landscape
Just what does the so-called New Normal economy look like anyway? Pretty bleak if you've become accustomed to GDP growth rates of six and seven percent annually. “We expect nominal GDP growth rates to trend lower … probably around 3-4 percent,” says PIMCO's Bill Gross. “And because of the financial and operational deleveraging we are seeing, returns on assets will likely be half of what they were during the previous 10 to 20 years.”
That means we'd be lucky to see average annual returns of five percent on equities, hardly enough reward to justify the ownership risk.
Not that the environment will be that much more hospitable for bond investors. A large part of the financing of the U.S. budget deficit comes from foreign buyers. As the deficit widens, rates will likely have to be bumped up to attract future foreign bidders. Higher interest rates mean lower bond prices. Think back to Bill Gross' estimate for asset returns: half of what you've been receiving over the past decade. Not a pretty picture. In fact, it'll feel a little like Jimmy Carter's presidency.
Proponents of the New Normal also believe the American dollar's hegemony as a reserve currency is in twilight. Confidence in the greenback is being eroded by massive fiscal and monetary stimulus, they say. Faith in U.S. markets as predictable “safe” havens for excess savings is also likely to weaken. This, say the New Normalites, is the flip-side of re-regulation. Summed, these two phenomena argue for a shift in economic leadership away from the U.S.
Adherents of the New Normal theory shouldn't bank on this being an overnight shift, though. The dollar's position as a reserve currency has been chipped away for the past decade. Since the launch of the euro in 1999, dollar allocations have been whittled down from 70.1 percent to 64 percent. (See chart 3.)
So, erosion in dollar confidence isn't new or novel. There's no doubt, however, that the degree of stimulus in the U.S. economy risks further cheapening of the dollar. Remember, though, that foreign exchange is a market of “pair's trades.” A currency's value is always determined relative to the other currency in the transaction. If the other guy's economy is a bigger mess than yours, your money's going to look relatively strong.
That said, your economy is likely to be a bigger mess if there is slack private demand. And that's where the emerging markets of China and India have an edge. The vast sea of potential consumers in those nations provide fuel for an economic growth engine.
A leadership handoff isn't likely for some time, though. The yuan renminbi is still a heavily managed currency and not mature as a stand-alone currency. As for the Indian rupee, well, it hardly has any reach beyond the Subcontinent. Yet.
Much of the dollar's relative value is determined by the degree of inflation embedded in the U.S economy. Inflation now is mostly latent, though both year-over-year PPI and CPI figures just turned positive — that is, inflationary — for the first time in many months. How inflation figures in the New Normal economy largely depends upon the dexterity of the Fed in mopping up all the liquidity being dropped from helicopters.
We've seen industrial production bounce back — thanks, maybe, to stimulus steroids — but is there sufficient demand to soak up all that output? Inflation, serious inflation, still seems remote. Until, at least growing demand trims the output gap.
Another way to close the gap is to constrain production. That, the New Normalites believe, could happen as industry is re-regulated and as new taxes are levied. That, more or less, makes the inflationary environment fairly benign in the short-term, but potentially virulent later on.
Now For Something Completely Different
Now, there's no guarantee that all this will actually come to pass. There are, not surprisingly, plenty of pundits and financial professionals who pooh-pooh the notion of a New Normal. One of the most vocal is Barry Ritholtz, CEO of the New York-based Fusion IQ research and asset management firm. (He also runs a popular blog, The Big Picture.)
“The New Normal is just a different way of saying, ‘It's different this time,’ and that's often a recipe for disaster,” Ritholtz contends. “The mathematician in me says we're just reverting to the mean.”
And the mean is, by Ritholtz' lights, recession. A B-I-G recession to be sure, but one he thinks parallels the 1973-75 downturn, a 633-trading day cycle punctuated by a 48 percent loss in the S&P 500. (See chart 4.) In the current recession, the blue-chip benchmark is currently rebounding from a 57 percent dip. Oddly, the equity loss three decades ago was as bad as it is now — 28 percent — at 552 days in. Talk about eerie parallels.
Ritholtz thinks the light at the end of this recessionary tunnel isn't reflected off a New Normal landscape. Once the equity market recovers — and recover it will, he avers -some time will be spent dithering in a trading range which will be the launch pad for a powerful bull market. The timing largely depends upon the Fed.
Major recessions, Ritholtz says, are typically characterized by 70-percent swings over 18 months, followed by “the bill coming due,” the withdrawal of the Fed's accommodation. That usually precipitates a 20- to 30-percent correction.
What To Do?
If you're a cynic, you'll immediately note there's no serendipity in PIMCO's principals advancing the New Normal notion. Doubtless Messieurs Gross and el-Erian have investors' best interests at heart, but you can still hear the faint sound of an axe being ground whenever they expound upon the theory and its investment implications. The slow-growth world they've envisioned gives rise to a recommended pullback in equity exposure and a stepped-up allocation to fixed income assets. PIMCO is, recall, a bond fund shop and, as such, stands to benefit by taking in a flood of equity market refugees.
Investing for the New Normal is akin to donning a hair shirt for the excesses of the Great Moderation. Really, when you think about, a lot of the New Normal rationale is advice your mother would have given you. Keep a nest egg. Don't gamble. Eat your vegetables.
There are some tweaks investors can make to their portfolio allocations to better orient themselves to the New Normal without sacrificing the benefits of diversification.
Domestic Equity: In the extreme, the low reward potential for common equity foreseen in the PIMCO model makes stocks singularly unattractive. That, however, only means their capital appreciation potential may be wan. Dividend-paying issues offer returns of another sort, so adding dollops of utilities and preferred shares may be the ticket. Your mother would certainly approve.
The quickest and cheapest way to get such exposure is to carve some space in the allocation for exchange-traded products. No dealer agreement is needed and the assets are completely portable. They also offer some attractive yields.
Take the Utilities Select SPDR (NYSE Arca: XLU), for example. The largest of the utilities exchange-traded funds has only appreciated 4.4 percent this year, but pays out a 4.2 percent dividend yield as compensation.
The best of both worlds is seemingly available to holders of the iShares S&P U.S. Preferred Stock Index Fund (NYSE Arca: PFF) which currently spins off an 8.6 percent yield on top of its year-to-date appreciation of 33.6 percent.
Global Equity: There are now a number of choices for investors who want to tilt their allocation toward the East's demand centers. The granddaddy of them all is the $10.1 billion iShares FTSE/Xinhua China 25 Index Fund (NYSE Arca: FXI) which holds the largest and most liquid Chinese stocks.
Exposure to India can be obtained with either a fund such as the WisdomTree India Earnings Index Fund (NYSE Arca: EPI), or, as a note, namely the iPath MSCI India Index ETN (NYSE Arca: INP). Advisors should take pains to explain to investors in the iPath product that in addition to Indian equity exposure, they're also taking on credit risk in these Barclays Bank-issued obligations. (But ETNs offer some tax benefits.)
If dividend-paying equities can enhance a domestic stock allocation, there's no reason they can't do the same for an investor's international exposure. The WisdomTree Emerging Markets Income Fund (NYSE Arca: DEM) does just that by cranking out a 6.7 percent current yield.
Fixed Income: The New Normal environment could turn toxic for long-dated paper if interest rates crank up. Better, then, to live in the short end of the yield curve. The iShares Barclays Capital 1-3 Year Treasury Bond Fund (NYSE Arca: SHY) provides a current yield of 2.3 percent with short duration risk.
An additional allocation to the iShares Barclays Capital TIPS Bond Fund (NYSE Arca: TIP) can provide a hedge against incipient inflation together with a 3.4 percent current yield.
Commodities: Another inflation hedge, as well as a beneficiary of emerging market demand, is the commodities sector. Care should be taken, however, to avoid overexposure to the petroleum complex which right now suffers with a rather nasty condition known as “contango” which erodes portfolio returns. The equal-weighted GreenHaven Continuous Commodity Index Fund (NYSE Arca: GCC) bestows exposure to 17 different commodities, minimzing the energy segment's influence.
No one's crystal ball — or Magic 8-Ball — can tell us if the New Normal will actually materialize but it's fairly certain that we're not headed back to the overleveraged world of highly engineered finance that brought us to this crossroad. Investors — and their mothers — may want to hunker down into a defensive posture, the lesson worth remembering from the “old normal.” A well-diversified portfolio is still more likely to achieve success and mitigate risk no matter what the landscape looks like.