The recovery from the Great Recession has been the most sluggish in post-WWII economic history. This is vividly displayed in the nation’s recent GDP report. The Commerce Department estimated that the economy grew at a snail’s pace over the last 3 quarters: 0.9% in Q4, 0.8% in Q1, and 1.2% in Q2. Yet, all of the major U.S. stock market indexes recently closed at all-time highs. For many, warning lights are flashing – how can the economy be so slow and the market so fast?
Growth Issues are Worldwide
Growth issues are not just confined to the U.S. In fact, the U.S. economy is still considered the strongest of the majors. In Europe, Q2 also slowed to 1.2% from 2.2% in Q1 and corporate profits are down 11.3% from year ago levels (vs. -2.6% in the U.S.). In July, the Purchasing Managers’ Index there showed business contractions in France and the U.K. and significant slowing in Germany. Worse, due to increased terrorism, tourism, which is 10% of their GDP, is down significantly. And we have yet to see any economic fallout from Brexit.
Japan has announced $272 billion of new stimulus spending. Normally, the markets would react positively, but, because of the increasing ineffectiveness of monetary policy, the markets were disappointed that $272 billion won’t be enough. Then, the Bank of England put forth a stimulus package that did not disappoint, reducing their overnight rate from 0.50% to 0.25% and adding a huge amount of both government and corporate debt purchases.
Luckily, the consumer portion of the U.S. economy is alive and well (70% of GDP), with consumption up 4.2% in Q2. That consumption growth was fueled by a drawdown in the savings rate. That means consumers had confidence in their employment and future income situation. So, as long as employment growth continues, as it did in June (292,000) and July (255,000), there is no reason for consumers to close their pocketbooks.
Most of the issues in the U.S. economy are on the business side. Construction spending has now fallen 3 months in a row (yes, no one is building shopping centers anymore due to internet shopping, but, that still equals sluggish construction!), and there is a continued lack of investment in plant and equipment which has had a large negative impact on worker productivity. Part of this is surely due to corporate tax issues (highest rate in the developed world), a general anti-business political atmosphere, and, perhaps, due to the general dislike of both major candidates for President. Yet, even with such ugly business data, because of a strong consumer, there is still no recession in sight.
The 1% Economy
The 1% economy is largely influenced by demographics. Japan has had negative population growth and a retiree/working aged population issue for the past 25 years, and during that period, their economic growth has stagnated. The U.S. and Europe have similar issues in their demographic distributions, but these have been partially mitigated by their willingness to admit immigrants. Still, these demographic issues are not going to change for decades.
To compound the demographic issues, over the past two decades, the governments of the industrialized world abdicated the use of fiscal policy as a pro-cyclical tool, relying solely on monetary policy. This has led to such insanity as negative interest rates in both Japan and Europe with more than $13 trillion of sovereign debt now sporting negative rates. As long as the U.S. government continues to rely solely on monetary policy, we are stuck with economic growth equal to the sum of the growth of the labor force (0.6%) and productivity growth (quite sluggish of late). Thus, the 1% economy.
Thankfully, we have recently seen a shift toward the use of fiscal policy as a growth tool – first in Canada and China, and now being discussed in Australia, Korea, and the U.K. Mercifully, both U.S. Presidential candidates have promised massive infrastructure spending. Such spending, if actually implemented, increases growth by creating projects that would not be done if left to the private sector, improves productivity, and provides jobs to formerly discouraged workers.
Reconciling Slow Growth with Record Stock Prices
As I said above, sluggish growth and record stock prices don’t appear compatible. But, we are not in “normal” times.
Negative interest rates play a huge role in equity values. Unable to earn any sort of “normal” return in the fixed income space, those baby boomers (now retiring at the rate of 10,000/day) have substituted dividend paying stocks for their normal holdings of bonds. Look at the P/E ratio of utility companies, traditionally the most reliable sector for dividends. That P/E ratio is now 2 standard deviations above its historical mean level.
In addition, given the additional monetary stimulus in Japan, the added stimulation from the Bank of England and the expected further easing by the European Central Bank, worldwide interest rates are more likely to fall further than they are to rise. That means that foreign investors will keep downward pressure on U.S. rates as they buy U.S. Treasury debt, which near 1.50% on the 10 year T-Note, looks like a bargain when compared to what is offered in Germany (-0.04%), Japan (-0.08%) or the U.K. (+0.80%).
Until worldwide growth picks up and deflationary pressures ease, which don’t appear to be in the forecastable future, interest rates won’t rise, and the use of the dividend as a substitute for fixed income returns will continue.
Given current circumstances: the industrial world’s demographic issues; the yield hungry baby-boomers who control a significant portion of the world’s wealth; the exclusive use of monetary policy to stimulate the world’s economies (the overuse of which has led to ineffectiveness) and the resulting negative interest rate regimes, rising equity prices, especially among dividend payers, is not illogical. And, this could well continue, as long as the economy doesn’t sink into another recession.