Update on the New Normal 2
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This document discusses reasons for slower economic growth in the US as the "new normal" compared to previous decades. It notes factors such as high household, business, and government debt levels; a more competitive global economy; demographic changes like retiring Baby Boomers; stagnant wage growth; cautious corporate behavior focused on financial engineering over hiring and investment; industry consolidation; the impact of technology in eliminating jobs; and income volatility among many workers. The document examines these trends in depth through data and examples to argue the US faces structural economic challenges compared to the post-WWII era.
Update on the New Normal 2
- 1. Update on the New Normal 2 This economic cycle has seen subpar growth with little wage growth, and fewer high paying jobs. Is this the “new normal”? Before the global financial crisis of 2008, Dr. Mohamed El-Eraian (former CEO, and co-CIO of Pimco, one of the world’s largest bond money managers), wrote a book, When Markets Collide. The book received quite a bit of buzz when it came out. One of the main tenets of the book is that the U.S. will face a “new normal” of slower economic growth. So far Dr. El Eraian has been correct, in terms of a slower growth U.S. economy. Some of the reasons describing the new normal have been wrong. But many economists and analysts agree, and that the book explains, that the biggest reason for the slowdown is – too much debt from households, businesses, sovereign entities including national, state and local governments. Ray Dalio, one of the most successful hedge fund managers in the world, produced a YouTube video on how the economy works. The video is more about how leverage, debt has played an important role in the growth of the U.S. economy. The video also explains that there are economic super cycles where the debt piles up that eventually lead to a major economic debt crisis. The debt crisis takes about seven to ten years to recover from. The Great Recession started in 2008, so we are into our 6th year, so according to Dalio and other economist we have a few more years to recover from our debt crisis. Click here to view the video. Also as we get late in this economic cycle we can’t expect the economy to get stronger. I’ve been following this story since the book came out, and I’ve identified other reasons for the slowdown in the U.S. economy, the “new normal”: • Too much debt - consumers, government, businesses are going through balance sheet repair, reducing debts (see Dalio YouTube video). • Law of large numbers • Globalization and a more competitive global economy • Baby Boomers getting ready to retire and spending less • Younger Americans are changing economic and social trends: sharing services (starting with Napster, Uber, Airbnb…), getting married, starting families or buying homes less than previous generations • Slow wage growth • Overly cautious corporations, financial engineering versus capital spending and hiring • Consolidation of most industries • Technology and the loss of jobs Of course there are other reasons for the “new normal”: high corporate taxes (effective tax rates are much lower), regulations (especially in financial services - getting a mortgage, small business loans are more difficult to get due to Dodd Frank), cost of living keeps rising leaving the poor and middle class behind,
- 2. high college education costs, dysfunction in Washington D.C., decaying U.S. infrastructure (roads, bridges, airports….). I was going to analyze the slow growth in bank and mortgage lending, but loan demand is down (many sectors of economy are focused on reducing debt). Also alternative sources of capital are available and growing (peer to peer lending, source funding, capital markets, private equity, venture capital….). Bottom line, we face a very different economy than previous generations. Law of Large Numbers We can see the law of large numbers working in our largest public companies. Many of our larger companies are no longer growth companies but slower growing, mature companies. Below is a 10-year history of the revenue for Walmart, symbol WMT: Source: S & P Stock Report for WMT SST15 PIC 2 In the 1970s and 1980s WMT was a high growth company, but now it’s a mature, dividend paying slow growth company. The average growth rate over the 10-year period is about 5%, but last year revenue grew only 2%. As WMT grows larger, growth slows. Below is the 10-year revenue history for Exxon Mobil: XOM and many energy companies’ fortunes depends on oil prices. We can see that XOM’s revenues peaked in 2011 matching WMT’s current revenue. XOM’s 2014 revenue are essentially the same as ten years ago, when adjusted to inflation. Below is the 10-year revenue history for General Motors: General Motors emerged from reorganization in 2009. Revenue has barely grown since 2011, adjusted to inflation. Below is the 10-year revenue history for General Electric:
- 3. GE’s revenue is actually less (when adjusted) to inflation than ten years ago. If you look at most companies that are over $100 billion in revenue you see growth slows or is stagnant. Apple is an exception. Below is a long-term chart for GDP growth: The grey highlighted area are periods of recession; fortunately they are few. The average U.S. recession lasts about 10 months. Notice that as time goes on, the growth rate slows. Below is a table that shows U.S. GDP at the start of each decade, and 2014:
- 4. Source: Bureau of Economic Analysis, Dan Hassey database From 1970 to 1980 the economy grew about 170%. From 2000 to 2010 the economy slowed to about 48% for the decade. We can’t expect the economy to grow above 3% on a sustainable basis when we have an $18 trillion economy. We are starting to see China slow from 10% to 7% now that its economy is around $10 trillion. We can also expect China’s growth to slow going forward because of the law of large numbers. The Financial Crisis of 2008 and Impact on Baby Boomers and Millennials The financial crisis of 2008 that led to the Great Recession created many hardships and destroyed the confidence of many Americans especially among Baby Boomers and Millennials. The U.S. economy is about 70% consumer driven. The lack of confidence and high debt levels has caused weak demand from these important groups and is another reason for the subpar growth of the U.S. economy. Baby Boomers Baby Boomers are individuals who were born from around 1946 to 1964. There were around 76 million births during this period. Baby Boomers were responsible for many social, economic and investment trends, and they will probably continue to do so. Baby boomers have been hit especially hard. Their homes and 401ks and retirement accounts have declined and they’re insecure about their jobs and the job market. They have changed their spending habits. There are approximately 77 million baby boomers, and they are a significant part of the economy. Baby Boomers are also starting to retire and will start applying for Social Security and Medicare. Politicians often complain about entitlements, they will only increase as Baby Boomers retire in mass. Americans, especially women, are living longer, so the growth in “entitlement” spending could increase and last for many years. A problem for retired baby boomers (and many retirees) is historically low interest rates. Below is a long- term chart for the 10-Year Treasury:
- 5. I started my investment career as a stock broker for Merrill Lynch in 1980. I mostly sold income producing investments because interest rates were so high. I tried to get my clients to buy long-term bonds, to lock in high rates. My pitch then was “I hope when I retire that rates are double digits.” I had no idea rates would go as low as they are now. Investors locking in double digit rates did well, not today. Below is a char that shows the net worth of an individual investor over the last few decades:
- 6. If an investor invested $200,000 in a 10-Year Treasury at the prevailing rate of about 12% during the early 1980s, the income generated about $24,000 in income. Back then $24,000 could go a lot further than today. Today if a retiree invested the majority of their nest egg, about $200,000 (average net worth of a retiree) into a 10-Year Treasury at 2.5%, they would only generate about $5,000 in income. Today’s retirees have less to spend from their portfolios, leading to less aggregate demand in the U.S. economy. Millennials Millennials, also known as Generation Y. They number approximately 80 million (close to baby boomer numbers), and were born from the early 1980s to the early 2000s. Millennials are also creating many social, economic and investment trends. They faced many economic headwinds during this difficult economic cycle: high post high school education and training costs and debts, poor job markets where many are underemployed, working part- time or remain unemployed. This generation started and made many technologies popular that are free or where goods and services are shared or rented. The first such popular service was Napster, a free file sharing service that was mostly used by users to download free music. Millennials have also invented and made popular services like bitcoin, Uber, Airbnb, Netflix, Hulu, and crowdsourcing. Car buying, marriage, family formations, and home buying trends have changed and are less from previous generations. Could these economic, demand trends change? Maybe for Millennials. Baby Boomers leaving the work force and retiring, probably not unless they have substantial portfolios, and if interest rates rise substantially from current levels. If interest rates rose substantially, it would probably mean much higher inflation, and a rise in interest income would be a wash with a higher cost of living. The Global Economy Is More Competitive and Has More Participants Post WWII the U.S. was the economic engine of the world, but this is changing. The dominant, developed economies (Europe, U.S., Japan) are all slowing due to the size of their economies, large debt levels, aging populations, high costs, bureaucratic economies with more regulations and complacency. Emerging economies in Latin America, South East Asia including China are the opposite: they have younger populations, they’re hungrier, they have less regulations, lower costs, and less net debt. The U.S. now operates in a more competitive global economy and this leads to outsourcing and the consolidation of industries, fewer high paying jobs, and stagnant wages. Outsourcing Unions and politicians complain how U.S. companies outsource jobs overseas. U.S. companies have been very good at expanding internationally to grow their businesses. It does not make sense for Coca Cola, or
- 7. General Motors to make a can of coke or cars in the U.S. and ship to their customers overseas. Those jobs need to be close to their markets. Some jobs do go overseas because of lower costs and regulations. Below is a chart that shows the labor costs per hour for shoe manufacturing: Source: BusinessWeek, Bloomberg The average hourly wage of an American worker is about $21. If you were to locate a shoe factory, where would you locate it? Would it be the U.S.? New Technology, Innovation Technology has improved the lives of many in the world, and has made the workplace and workers much more productive. The downside of technology is that it has eliminated millions of jobs. In the 1990s, I read an article that the vision of many technology companies was to help companies and governments across the globe automate tasks and jobs to make them more productive. Technology companies have been very successful at their goals. Again, the downside is many jobs were eliminated. There are many jobs that have been reduced because of technology: bank tellers, gas station attendants, checkout clerks at grocery stores, telephone land line workers, travel agents, newspaper employees…. Consolidation of Many Industries, and Downsizing among Many Companies The consolidation of many industries, and the downsizing of companies have laid off millions of workers. As a shareholder of some of some of these companies, gaining scale, entering new markets and offerings through mergers and acquisitions had lowered costs and increased revenue and is good for the bottom line and stock prices, but is has been bad for the millions of workers that have been laid off. When I graduated from business school I interviewed with Goldman Sachs, Merrill Lynch, Kidder Peabody, Smith Barney, and Chemical Bank. I had three job offers early on, so I quit looking. Notice the list, only one company is independent, Goldman Sachs. The rest were swallowed up by bigger companies and basically don’t exist anymore. I know that if I graduated today, I would not have the same opportunities that graduates had 30 years ago.
- 8. Our generation has been impacted by these consolidations, mergers and acquisitions. I’ve lost several jobs due to mergers and downsizing. I’m sure if you think about it, how many companies have you’ve worked for still exist, and how many times have you’ve been laid off because of downsizing and mergers? No matter what industry graduates are looking to start a career in, the options they have are much fewer than our generation. Below is a list of a few industries and the consolidation they have gone through: This list is a sample of the many companies that existed 35 years ago, and a sample of the few large companies that remain today. The lists of companies above are important because most of these companies were where graduates go to start their careers, receive valuable expensive training, and experience.
- 9. Visually one can see that in 1980 there were many more companies that existed compared to today, and our economy is much bigger and has a much larger work force. When companies consolidate, or in the case of sectors like record and book stores, many high paying jobs were lost in accounting, marketing, management, finance that will not come back. Not all companies were acquired or merged; some went bankrupt or are out of business: E.F. Hutton, Burnham Lambert, Lehman Brothers, Woolworth, Continental Illinois. Also, many of these industries have many companies in them, but many of these industries are dominated by a handful of huge international companies. For example banks, there are thousands of banks, but the major banks listed above hold most of the deposits and make most of the loans. Notice that technology is an area in the economy that has expanded and provides high paying jobs, but not all graduates studied information technology. Graduates with degrees in information technology, engineering, business or healthcare will probably do better than other graduates. The questions is - where do young graduates go for their first career job, training and experience? Cautious Employers and Financial Engineering As shareholders we’ve benefitted from financial engineering and a prudent corporate America, but it has been hard on the economy and workers. At the start of the Great Recession corporations cut capital spending by about 20% and laid off millions of workers. The economy contracted about 8% at the start of the Great Recession, so corporations overreacted. If we look at the energy industry, it spent about $1 trillion on capital spending during this economic cycle and created a shale energy boom that created lots of wealth and high paying jobs and has made us less dependent on foreign oil. Most other industries cut capital spending, downsized and increased share buybacks and dividends otherwise known as financial engineering. Again, this is good for shareholders but bad for the economy and workers. Stagnant and Volatile Pay The financial media, the Fed and politicians all talk about stagnant wages and the need to put more income into the pockets of lower income and middle class consumers. Below is a chart that shows the trend in household income:
- 10. We can see that wages increased about 25% from the 1970s to the later part of the 1980s. Wages are essentially the same today as they were in the late 1980s. As the chart states, these numbers are in constant 2010 dollars. I read a study that if you have a family and or are divorced you are being left behind economically. Families are being left behind economically because the cost of education, childcare and healthcare costs are growing much faster than wages. If you’re single, you should be in better shape financially. Some politicians and economists blame cautious employers for the lack of wage growth. In the above section about cautious corporations and financial engineering we can see the chart below does show that wages have dropped as a percentage of national income: Below is a chart that shows that corporate profits as a percentage of GDP is at historic highs:
- 11. Some economists argue that employers have increased spending on employee health care costs and other benefits. Some of these benefits don’t show up in wage costs. I found another reason why there is less spending, demand. Entrepreneurs, the self-employed, part-time workers, workers dependent on tips, employees who work on commissions, temporary employees, and workers that have multiple jobs have volatile incomes. Making the situation worse is they don’t have the savings to get them through times when their incomes fall. JP Morgan did a study on household savings and household income volatility. Below is a chart that shows the problem:
- 12. The chart shows that poor to middle income households that have volatile incomes don’t have the savings to get them through periods when their income drops. For example, a middle class household typically has expenses of $4,800 a month, but they only have $3,000 worth of savings. The situation is better for more affluent households. According to a Federal Reserve study, income volatility impacts about 40% of the workforce. Unemployment, the Underemployed and Part-Timers Again, a more competitive global economy, outsourcing, technology, globalization, consolidation of many industries, more cautious companies have all lead to stagnant wages, fewer high paying jobs, more part-time and underemployed workers. With such a large economy and population and the many economic headwinds the U.S. economy faces, it is hard to move the needle on the economy.
- 13. Conclusion Investors need to realize our economy is very different than previous cycles and generations and we must adjust to these new realities. These new economic conditions could persist. They could improve under different monetary and fiscal policies, balance sheets are repaired, and if new technologies, industries emerge. This will take more time. It is very rare in the late stages of an economic cycle (we are in the 6th year of this economic cycle, and most economic cycles last 4 to 5 years) that the economy picks up steam. Most economic and market cycles are like a 10K race: in the beginning a runner has more energy, but toward the end the pace slows and most runners don’t have the same energy they had at the beginning of the race, so we can’t expect the economy to grow faster this late in the economic cycle. Most economic cycles are disrupted by a strong economy that creates demand pull inflation, and the Fed responds by raising rates too much and the economy goes into a recession. Because the economy is not heating up, inflation and interest rates can stay lower, and lower inflation and interest rates are good for the economy and markets. This means that the “New Normal” could cause economic and market cycles to last longer, a good thing. One of the trends that investors need to keep an eye on are game changings technologies, services, or products. In a book, It Was a Very Good Year, by Martin S. Fridson, the author describes the conditions that create great market years, cycles. One of the conditions is the introduction of new technologies/industries. In the past they’ve included: autos, aviation, electronics, and recently the internet and digital revolution including social media. I’m always looking for these new trends. Admittedly it is difficult, especially entering these emerging trends at the right time and valuations, and who will be the winners in these emerging technologies and industries. The way to think about the markets going forward could be similar to a freeway: there is a slow lane (large capitalization stocks, mature slower growing companies) and the fast lane (technology, biotech, some small capitalization stocks, emerging markets, read It Was a Very Good Year). To improve returns, investors will have to include investments from the fast lane of the market. One of the strategies that I use frequently is to follow and invest in companies that have short-term problems that causes the stock price to plummet. In the past I’ve recommended companies like Toyota (car acceleration problem), British Petroleum (Gulf of Mexico oil spill tragedy), Target (data breach), and energy stocks (last year’s collapse in oil and energy stocks). The strategy is called – buy low, sell high. Older and conservative investors should also consider investing in companies that pay dividends and have a history of raising them. I recently wrote an article about investing for income in a low interest rate environment. Click here to read the article. Investors should also consider writing options against some of their holdings. The fundamentals of the company you own, technical analysis (especially support and resistance levels and medium and long-term moving averages), and the Black-Sholes options pricing model should be mastered before pursuing this strategy. Option writing could increase the total return of your portfolio.