I hear it every day on the business channels or see it in the business media print: “The economy has to get back to normal.” But normal means different things to different constituencies. Wall Street and equity investors certainly don’t want to see the stock market behave normally, if indeed, normal means that PE ratios mean revert and that we have periodic 10%-20% corrections. Everyone, especially the President, would like to see the economy grow at a sustained 3%-4% pace, which hasn’t happened in this post-recession period. Interest rates, on the other hand, are said to be abnormally low, and the Fed, along with tens of millions of retirees, would like those rates to return to normal, where normal is defined as what we had pre-recession.
To summarize, a normal stock market sets record highs 50 times per year; a normal economy grows at 3%-4%, and normal interest returns are at least twice as high as today’s. Unfortunately, the business media, perhaps for self-interest reasons, has all of these views backward.
Wall Street, and most investors, celebrate every time the Dow Jones Industrial Average (DJIA) crosses another 1,000 milestone. The latest was 23,000 on October 17th. It only took 76 days from the time that index crossed 22,000 for it to forge this new, higher, milestone. For perspective, it took 154 days for that index to rise from 21,000 to 22,000, 35 days for it to go from 20,000 to 21,000, and 64 days to advance from 19,000 to 20,000.
But, here is the part no one is talking about: how long it takes to achieve a new milestone after a recession. Here are the undiscussed facts: It took nearly 6 years, from July ’07 when the DJIA hit 14,000, for it to cross 15,000 (May, ’13). Before that, it took 7.5 years from the time the DJIA first hit 11,000 (May, ’99) for it to climb to 12,000 (October, ’06). There was a lot of financial pain in those long years. The historical record on this file is the same for every recession. It takes years for the indexes to climb out of the hole a recession digs for them. And that, by historical standards, appears to be normal.
The Economic Growth Story
The financial meltdown and ensuing recession came at a time of significant changes in the demographic structure of the world’s industrial economies. In the U.S., baby-boomers began retiring at the rate of 10,000 per day. The Bureau of Labor Statistics expects the labor force to grow at a mere 0.5% rate until 2025. “Demographic factors,” they say (Monthly Labor Review, December, 2015), “including slower population growth and the aging of the U.S. population – in addition to the declining labor force participation rate,” are responsible. Given the fact that GDP growth is dependent on the growth in the labor force and rising productivity (productivity growth has been flat to negative over the recent past), a return to a normal sustainable 3%-4% growth rate is unlikely anytime soon.
The Impact of Rising Interest Rates
In early ’05, an investor purchasing investment grade corporate debt in the 5-7 year duration range could expect a 5%-7% yield. Wouldn’t it be nice for rates to go back to these normal levels? Sorry! Not happening! Interest rates are a function of two principal factors: inflation, and a real rate of return. As I have explained in my writings over the past year, despite the stated desires of the Fed’s leadership, inflation’s return is not anywhere in sight. This is due to the demographic factors discussed above, to technology and the AI revolution which lowers production costs, to overcapacity in the goods producing and retail industries, to a misleading headline unemployment rate (redefined in the ‘90s to make politicians look better), and to the failure of the recession to alleviate its underlying cause, excess debt.
While many believe that the enormous debt generated by the housing bubble was dissipated by the recession, that isn’t the case at all. Instead of mortgage debt, today we have U.S. consumers burdened by high auto debt (sub-prime), by high credit card debt, and, for many families, by high and rising student debt. On the corporate side, there has been a debt binge, used mainly for stock buy-backs and to pay dividends. The debt/GDP ratio for the U.S. is currently 251%; it stood at 228% in Q4/’07. For China, those statistics are 258% today, vs. 145%. Japan: 372% vs. 308%.
If rates rise enough, the debt servicing burden, for both consumers and corporations, will drain resources from growth activities. It is really doubtful that today’s higher debt levels can handle rates much higher than they currently are without a significant slowdown in economic activity. Thus, my view that upcoming Fed rate hikes are likely a policy misstep.
The business media narrative is that it is normal for the stock market to regularly set new highs, while it is abnormal for our country’s economic growth to be tepid and for interest rates to be so low. Be careful what you believe.
Robert Barone, Ph.D.