With our little research business, we are very lucky in that we get to speak to all sorts of investors. Some of our readers focus on equity markets, others on bonds, some on commodities or exchange rates etc…. Some may take a one-day view while others (usually endowments, pension funds or sovereign wealth funds) will worry about the outlook for the next decade. This diversity in our client base is such that, over the years, we have come to regard it as one our biggest comparative advantages; as we never tire of saying, some 80% of our ideas come from our own clients. But amidst the wide tapestry of opinions to which we are confronted every day, there are two things that we have come to expect:

 

1. Fixed income managers will always be the most bearish on economic growth, usually followed by the macro hedge-fund investors, followed in turn by the value equity investors, while the growth equity investors will always be the most enthusiastic about economic prospects.
2. Most managers will always find a very logical, and convincing, economic rationalization for bullishness on their own asset class. So with that in mind, is it surprising that the biggest fixed income investment house in the world is also the largest single proponent behind the idea of the ‘New Normal’?

After all, what better reason to keep investing one’s time, effort and money in fixed-income instruments than the belief that economic growth is bound to stay below par for as far as the eye can see? More importantly, it seems that the markets are today agreeing with Pimco; both US government bond and equity markets are currently priced for a long period of “New Normal”.

• The US Government Bond Market Today

 

In our experience, one should approach investments in the US governments bonds by taking into account three variables:

 

• Real rates, computed by subtracting from the nominal bond yields the average inflation of the previous ten years. We are not quite sure why the average 10-year inflation works so well but it seems to give the best signal in every market—perhaps because it eliminates random noise to focus on key long-term trends? Or perhaps because most traders and portfolio managers with responsibility have around 10 years of experience/memory? In any case, we find that, historically, real rates on long-dated US bonds have hovered between 1.5% (sell point) and 4% (buy point).

 

• The spread between real rates and the structural growth rate of the economy, defined as the average growth rate of the previous ten years (again). This is an attempt at a “Wicksellian” analysis, after the Swedish economist who showed that market rates oscillate around a ‘natural rate’ equivalent to the structural growth rate of the economy, and that the divergences of market rates away from the ‘natural rate’ are the main reasons behind the economic cycle (more on this later).

• A simple overbought/oversold indicator. Such a simple tool helps identify the periods of panic-selling, or panic-buying. This is important so as to avoid confusing a panic with a change in trend. Combining these three variables into one single indicator, our GaveKal US bond indicator, we get a sell signal. Yet, interestingly, it is not at its lower extreme advocating the fire-sale of bonds (such as in 1994, 1998, 2003 or early 2009):

 

And the reason for the absence of a maximum negative signal is simple: the spread between the 10-year average growth rate and the ten-year real yield is not yet flashing ‘sell’; a development which brings us to the crux of the matter: namely, are things different this time?

2– Bond Market is Pricing in A Lower Structural Growth Rate

Since 1960, the average decennial real growth rate of the US economy has been slightly above +3%. However, the average growth of the past decade has now dipped below +2% for the weakest compounded performance since 1945.

 

 

So are proponents of the ‘New Normal’ simply describing the new reality, or are they projecting forward the recent, abnormal past—thereby drawing dangerous conclusions? Simply put, should investors revise their models to a new reality where the US grows below 2% on average? Or is US growth going to return it long-term structural growth rate of around 3%? Needless to say, the answer to that question matters tremendously for all investors, but most of all for those involved in the fixed income markets.

Indeed, in the modern era, the average US real long rate has been very close to 3%, which is what Wicksell would have expected given that the structural growth rate of the US economy was also around +3% (see chart on p. 1). Why? Given that over the very long term, corporate profits grow at the same rate as GDP, it stands to reason that when rates are above 3% real, it will pay to shift from risk assets to government bonds. Moreover, higher real rates encourage savings, further boosting government bond buying. Together, the increased demand for US government bonds will bring real rates back down to the structural growth rate of the economy—i.e., back to Wicksell’s equilibrium. Of course, while real rates are fluctuating above and below the equilibrium, it hampers and stimulates growth respectively.

Which brings us to today. As the chart on the first page highlights, market real rates have been below the historical ‘natural rate’ of 3% for three years now and, so far, we have yet to witness much traction in economic growth and even less in overall credit growth. Enter the ‘New Normal’ hypothesis: the only way to reconcile the fact that interest rates have collapsed and that the economy is not accelerating is that the structural growth rate of the US economy is now much lower than it has historically been. After all, this is what happened in Japan in the 1990s and in Europe in the 2000s as populations aged. So why should the US be any different? The reason this matters is that if we assume that the structural growth rate of the economy is now lower than it used to be, then long bonds are not two standard deviations overvalued (as shown in the chart on p. 1), but are instead right where one would expect them to be. This we show in the chart below, in which we subtract out the 10 year average growth rate (shown on p. 2), from the real interest rate (on p.1), and find that this growth-adjusted rate is not far off its long-term mean. In other words, it appears that the bond market is today pricing in the assumption that the average growth rate of the past 10 years, of less than 2%, is the new structural growth rate; instead of the historical 3%. And, again, this explains why our bond indicator is not at a maximum sell point today. In a very unemotional way, one of the three series of our indicator looks back at the past ten years’ worth of US growth and concludes that real rates are roughly where they should be (within one standard deviation):

 

3– Stocks are Also Pricing in a Lower Structural Growth Rate

We have just explained that UST yields are fairly valued, if we assume that the past 10-years of sub-par growth are to be projected forward—i.e., for real yields to stay where they are, the US economy has to continue growing at an average of less than 2% per year. Do equity markets agree? Interestingly, it seems equities have also boarded the ‘New Normal’ train! Indeed, valuing the US stock market against the average cash flow of the previous decade (grey line below), we find that, since 1962, the US equity market has only been significantly cheaper three times: in 1974 (following the first oil shock), in 1982 (following the US double-dip recession, the Latam bust and the spike in US long rates) and of course in 2008 (following the Lehman and AIG bust). Given current valuations, we can thus only conclude that the US stock market is also projecting forward the sub-par growth of the past 10 years (in red).

The above chart once again highlights the most important question for investors today: Will the US growth rate return, as it has in the past, to its historical average rate of 3%? If it does, the bond market will crash, and the stock market will go up in a repeat of 1994. But what could be a catalyst for such a ‘return to the mean’?

 

4– The Importance of the Coming US Election

 

As we have highlighted time and again (see Arithmetic View of Economics Will Leadto Disaster) a strong inverse relationship exists between government spending as a % of GDP, and the structural growth rate of an economy. This much is clear from the chart below (or to anyone who has lost money in Japan):

 

 

Unsurprisingly, there also exists a strong inverse relationship between government spending and PE ratios (see Why Do P/Es Vary Structurally):

 

These relationships make plenty of theoretical sense. In government activities, there is no ‘creative destruction’, which implies that there is no internal growth. So if the part of the economy in which there is no internal growth gets bigger, then the average growth rate of the economy is bound to fall. And given that, in modern times, government growth is all too rarely financed by tax increases but instead by debt issuance, and given that a leveraged system is by definition more fragile than a non-leveraged one, then it follows that increased government spending should lead to lower PEs….

 

Which brings us to the current situation in the US. Could it be that the past decade’s plunge in the US structural growth rate is somewhat more linked to the sustained increase in government spending that started under President George W. Bush and accelerated under President Obama, rather than any shift in the US demographic growth or the productivity of labor? (see also our August 17th Daily)

 

 

If so, then investors could be in front of a much simpler decision tree then would initially appear! Indeed, either:

• The upcoming US elections, in a repeat of 1994, will bring about a Congress able to reduce the pace of government spending in the economy (this is what is already happening in the UK and interestingly, the UK political cycle has often preceded the US one by a year or two). As in 1994, this would trigger a massive sell-off in government bonds and a significant rally in equity markets (while marginally down for the year, the FTSE is outperforming all European markets except for Sweden and Switzerland… and this is including a massive ‘BP drag’), or

1. The current expansion of the US government will continue, in which case investors in US government bond markets will likely thrive in a repeat of what happened in Japan in the past two decades.
2. With that in mind, no prizes for guessing which course of action the proponents of the ‘New Normal’ are advising policymakers to follow!

For further information about GaveKal's services, please contact Shawn Paulk at SPaulk@gavekal-usa.com.

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