From time to time I am asked to present my thoughts on the economy to various groups. I usually put a lengthy slide show together, which puts me in a race against time to finish within the allotted time. One of the main arguments that I have been trying to convey this year is that yes, the economy is improving at a moderate pace. Given the recent economic data, especially within the labor market, I think this is a fairly indisputable point. Jobs are being created at a pace of roughly 200K-250K per month, the unemployment rate is down sharply, consumer confidence has improved dramatically, household net worth is at record levels, interest rates are low, inflation is low, corporate profits are at records levels, and I could go on and on. I have also argued that there are significant problems still plaguing the economy (too much debt, income inequality, lack of wage growth), but let's put that aside for now.
The bigger points I have been trying to get across in my presentations are these: 1) It has taken an incredible amount of stimulus to achieve the moderate economic growth we are now enjoying; and 2) the removal or reversal of some of these stimulants will put a ceiling on the rate of economic growth we can expect over the next few years. As you read the following list, try to imagine the effects on economic growth if/when each trend begins to stabilize or even reverse:
- A doubling (from $9 trillion to $18 trillion) in gross federal government debt
- A $3.5 trillion increase in the size of the Fed's balance sheet
- A 200% increase in stock prices
- A drop in consumer savings rate to around 5% from the long-term average of about 8.8%
- Government guarantees on the overwhelming majority of new mortgages
- 50% decrease in long-term interest rates (from around 4% to around 2%)
- A massive drop in energy prices
Given the sheer magnitude of stimulus (that could reverse over time), I believe we will continue to see an environment of sub-par growth (2.0%-2.5%) for the foreseeable future. What are the biggest risk factors to this forecast? On the downside I would say that a rapid rise in interest rates or a significant correction in stock prices would cause the most damage. Why? Because the Fed has employed a trickle-down strategy of targeting asset prices as a way to lower the unemployment rate. Indeed, ultra-low interest rates have led directly to a rebound in the housing market and a huge increase in stock prices. The wealth created by higher asset prices has boosted consumer spending (which accounts for more than two-thirds of GDP), and has therefore created jobs (at least in theory). Now, we have argued at great length that the income, wealth and spending increases since the end of the recession have been heavily concentrated on the high end of the income spectrum. This remains true today, but any decrease in spending will have a deleterious effect on the economy.
On the upside, the biggest risk is the ignition of the "animal spirits" associated with economic opportunity. We could see a scenario whereby the masses become so energized and confident as to overcome the removal of record amounts of liquidity in the system. Companies would start bidding wars over new and existing employees, and middle-class incomes would increase in a virtuous cycle of economic activity. Under this scenario, however, the Fed would find itself "behind the curve" and would need to rapidly increase interest rates. Proactive efforts to remove liquidity and decrease the threat of inflation would limit economic growth rates. Additional upside potential might be limited by higher energy prices if and when economic activity begins to accelerate. The point is that there may be a ceiling on strength of "animal spirits", and thereby economic growth, due to the reversal of some of the stimulus that put a floor on economic growth during/after the recession.
One final thought. A far less likely catalyst for better economic growth would be a successful resolution of the problem of entitlements and long-term structural budget deficits. The resolution of entitlements (through means testing Medicare and raising the age of retirement) could have dramatically positive effects for the economy at large. Given the dysfunction within Congress, though, we would assign a very low probability to that.
Sub-par growth of 2.0%-2.5% is not necessarily bad! The stock market has done extremely well in this low-growth environment. However, the stakes are now high due to valuation levels. We advocate sticking with quality and increasing focus on valuation. No need to chase the nose-bleed stocks!
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