Broker Check

The Death of Secular Stagnation

April 02, 2024

US Economy

A year ago, the consensus expectation was that the US would fall into a recession.  The argument was well reasoned, as numerous tried and true indicators were flashing recessionary warnings.  It seemed to be just a matter of time until something in the economy broke and forced firms to undertake painful layoffs and begin the downward spiral to recession.  Other than a brief regional banking dust-up, the US economy was solid in 2023, growing by 3% (better than the 2.4% average growth rate of the previous decade).  This surprising economic growth was reflected in stock market performance.

In a twist of irony that only happens in the “dismal science” of economics, the concern now is that the economy is too strong.  Inflation is proving to be sticky at 3%.  Wage growth is holding at around 5%, which is consistent with this level of inflation.  Corporate profits for S&P 500 companies blew past expectations in the most recent quarter, growing by 8% when the market was expecting 1.25%.  The US economy is advancing more than expected despite the Fed’s best efforts to slow it down to achieve 2% target inflation.

Attempting to understand the strength of the economy over the past several quarters, and with the prominence of artificial intelligence (AI) in today’s market narrative, investors are looking to the 1990s for parallels. 

1990s Redux?

The last time the Fed increased interest rates to slow inflation and the economy responded by speeding up was the mid-nineties.  For the decade of the nineties, inflation averaged 3.03%, the Fed Funds rate averaged 5.24%, and GDP growth averaged 3.3%.  That’s almost exactly where we are today for all measures.  The 1990s saw a few economic wiggles with the collapse of Long-Term Capital Management ($4.6 billion hedge fund) and the Asian Financial Crisis, but the similarities in big macro numbers, like growth, inflation, and interest rates, are surprising.

Allen Greenspan was the Chairman of the Federal Reserve in 1996 when he delivered his often-quoted speech calling out the “irrational exuberance” of investors’ hopes and dreams about the riches the internet would produce.  In hindsight, it was a magical time to be an investor.  The main indicator of success was how many times “.com” appeared on your brokerage account statement. Every CEO wanted to have their company involved in the internet.  Large investments in internet infrastructure were made.  No financial forecast seemed too far-fetched, and employees were going to become more productive with the miraculous new powers of the World Wide Web. 

Sounds like AI today.

Was ChatGPT’s release in November of 2022 the modern version of Netscape Navigator from 1995? The fact that you can buy an AI-enabled toothbrush or washing machine today suggests that the comparison isn’t too far off.  Even grocery stores like Kroger have highlighted to Wall Street their investments in AI technologies.

It’s a fun exercise to go back and look at the valuations of the leading firms of the 90s tech bubble.  We’ll spare you the boring details but will summarize by saying if AI is going to be a bubble on a similar scale to the tech bubble of the ‘90s, it has a long way to go from here.  For example, Cisco Systems was the “picks and shovels” merchant of the tech bubble, trading at peak valuation of 381 times earnings in the first quarter of 2000.  The AI equivalent today is clearly computer chip designer Nvidia, which as of now trades at a pedestrian value of 76 times earnings.

AI may go on to change the world in a similar fashion to the internet.  Just like the internet, the change may be measured in decades.  Some skepticism is warranted.  Winners and losers will come and go, and a crash may be in there somewhere.  No one can forecast exactly how the technology will develop, but it is exciting to watch.

The 30,000 Foot View

The comparisons between today and the 90s are interesting, but it’s more important to understand the larger economic picture.

The period from the end of the financial crisis to COVID was dubbed the era of “secular stagnation” by former Treasury Secretary Larry Summers.  The general idea was that the global economy needed time to work out of the debt and misallocation of resources stemming from the housing bubble.  During this period, money that could have gone to capital investments to help improve economic potential instead went to servicing bad debt and repairing balance sheets.  Collectively, firms and consumers couldn’t invest in the future because they were paying for mistakes of the past. The economy stalled.

The stock market performed well over that timeframe, but according to a Federal Reserve research paper, this success is mainly attributable to falling interest and tax rates.  Companies could borrow more cheaply, and Uncle Sam took a smaller portion of the profits.  That’s financial engineering, not real sustainable growth. Interest and tax rates can only go so low.

The massive government stimulus that followed COVID put a nail in the coffin of the secular stagnation era.  After a decade of underinvestment, firms, and the country as a whole, need to make capital investments in areas ranging from single-family homes, to roads, bridges, factories, and most importantly, people.  The lingering effects of stimulus money and the record low interest rates available during the worst of the pandemic have given US corporations the impetus to invest, instead, in themselves.  The Inflation Reduction Act (IRA Act) and CHIPs Act are government attempts to encourage such private investment.  Artificial Intelligence hype adds fuel to the fire.

As an aside, the investment world is highly focused on interest rate cuts and inflation.  This fascination is based on the idea that the world should return to the conditions that prevailed during the last decade.  But circumstances have changed.  We have shifted from a financial engineering approach (most typically used in a crisis), to the more traditional capital investment approach.  This is a positive development and should bode well going forward.

Debt Monetization

During the back half of the 90s, the US government ran a budget surplus.  Uncle Sam took in more money than he spent, which is hard to imagine today.

Currently, the government is running a significant deficit of roughly 6% of GDP and is forecasted to continue this trend for many years into the future.  Large deficits are what governments do to encourage economic growth during hard times, like COVID and the Great Financial Crisis.  The consequences of large deficits can be higher inflation and interest rates once the economy recovers.  The Federal Reserve and US Treasury have a plan for that challenge.

One aspect of the March meeting of the Federal Open Market Committee (the Fed) that received little attention is the plan to buy short-term US Treasuries with the income generated by the securities they bought during COVID.  The Fed has around seven trillion dollars in Treasuries and mortgage-backed securities producing income every month.  The Fed is planning to buy a portion of the short-term debt that the Treasury issues to finance the deficit with the income from their bond portfolio.

This type of arrangement is what was done in the aftermath of World War II, when the debt from fighting the war and rebuilding Europe was a major impediment to economic stability.  It’s referred to as “debt monetization” because the Fed is transforming Treasury debt into cash for use in the economy.  If you really want to learn more about this dynamic and how it affects capital markets, we suggest the slightly controversial book Capital Wars, by Michael Howell.

The US can get away with this economic slight of hand due to our position in the global economy and the importance of the dollar.  The important takeaway from this Fed/Treasury arrangement is the US economy has a strong tailwind for the near term.  The Fed’s actions essentially suppress interest rates, allowing the government to finance their large deficit without crowding out private investment.  This, and improving wage growth due to demographic shifts, should lead to a more robust economy overall.  That’s good news for shareholders and workers alike, but it does suggest that a steady 2% inflation rate may be difficult to achieve.

Final Thoughts

COVID-era record low borrowing rates and stimulus programs, the IRA Act, the CHIPs Act and the Fed’s debt monetization program all point to capital investment in US corporations and therefore, the US economy.  Gone, at least for now, are the crisis management financial engineering schemes (however necessary they may have been) of the past two periods of significant economic stress.  We suggested in a recent communication our hope for a return to normalcy in capital markets.  We appear to be heading in that direction.

A client recently asked when she might begin to see good returns from both her bond and equity investments.  If our thesis is right, that time should be now.  The investment implication of the end of secular stagnation is that interest rates for longer-term bonds should remain steady.  That means a balanced bond portfolio should give investors about 5-6% instead of the 3.65% average from the previous decade.  For the equity market, companies are finally willing and able to invest in their own businesses.  This suggests that sectors of the stock market, other than technology, may start to perform well without the aid of financial engineering.

There are always going to be challenging periods in capital markets, and it would be naïve to think that the S&P 500 will continue to push all-time highs without fail.  Even the magical 90s saw troubling phases that challenged investor confidence, and we all know how that period ended.  So it’s critical to guard against “irrational exuberance”.  It is also prudent to occasionally look up from the minutia of quarter-to-quarter market/ economic data and monthly inflation readings to recognize overall trends in the economy and the longer-term big picture.

 

 

We consider it a great privilege to serve as your investment manager and financial counselor.  If you have questions about this communication, or anything else, please don’t hesitate to contact your PIM Financial Advisor.

Our very best wishes for a glorious spring.

 

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