In our previous letter, we argued that the topdown approach to monetary policy was dying because of the diverging trajectories of  the “old” and the “new” economies. Using services as a proxy for the new economy and industry as a proxy for the old economy, we found that the services sector was back to trend in terms of growth and inflation, while the (indebted) industrial sector was still suffering from low growth and deflation.

We concluded that “thinking global”, i.e. in aggregate terms, can therefore be misleading. It certainly misleads  central banks, which can only address issues in aggregate, with the result that when the output gap is negative, monetary policy is driven by the weakest sector of the economy. We can assume that if the output gap turns positive, the “problem” will shift then to the dynamics of the strongest sector. In each scenario, only one part of the economy is optimized, never both.

In this letter, we develop our analysis and examine the risks of a new growth regime emerging in the US. We analyse why this could be bad news for financial markets.

The current state of the US economy is well known: low-growth, low-inflation. This phase is referred to by economists as “the great moderation”. So why is growth lower in this cycle than in previous ones? There is no easy answer, but there are a number of identifiable components to the low-growth phenomenon.

First, investment has been tepid, while consumption has been strong. The chart (below, left) illustrates the unusual divergence of employment and private domestic demand in recent years, implying a weak investment dynamic.

On the right, it is interesting to see that this relationship has not been broken by the financial crisis (the gradient of the slope remains constant), but the intercept of the regression line is one full percentage point lower. In other words, today, for a given level of employment growth, domestic demand is growing 1% slower than in the previous cycle.

How did this come about? Why would investment be a smaller component of economic growth than in the past? Is it a New Normal?

Classic models for estimating non-residential investment are based on factors such as expected demand (confidence), interest rates and profitability. From these perspectives, the weak level of investment in the US in this cycle is a conundrum, since models based on these factors point to a higher level of growth.

Our intuition is that new variables have emerged. Aside from some specific events (the collapse of mining investment in the aftermath of the decline in oil prices between 2014 and 2015) we think that the high levels of profitability in the US (using the share of profits in GDP as a proxy) have become unproductive.

We suspect that confidence is not high enough to allow companies to take risks on their short-term profitability by investing for higher returns in the future. In other words, the emphasis on the present could have damaged investment levels. We cannot prove this intuition with any certainty, but we see, below, that the average age of non-residential assets has increased significantly without triggering a strong investment cycle, as happened in similar contexts in the past.

It is difficult to assess if the current strong technology cycle should lead companies to more rapidly upgrade their assets and if the average age of equipment should be lower today than in the 1980s and 1990s.

Although we do not know the answer to this, we see from the above charts that the current average age of assets is high compared to the historical average. Despite very attractive financial conditions and high levels of profitability, companies have been reluctant to renew their equipment.

That is why we conclude that there must be alternative reasons for the lack of investment. Our thesis of an overly-high share of profits in GDP and a preference for present profits over future earnings, however, is not shared by many economists. In fact, there is little literature on this theme at all.

Most economists who do address the issue say that data is distorted by profits realized abroad, which are reported by the US Bureau of Economic Analysis (BEA), while investment realized abroad goes unreported. Whether this is true or not, it appears that many countries have experienced a sluggish investment cycle so this cannot be a complete explanation. The debate goes on.

Turning to residential investment, we see a similar story: the recovery has been shallow despite a friendly environment. However, in the case of residential investment, a preference for the present cannot be blamed, as accommodation expenditure is unavoidable. So here, also, there is a conundrum.

All this represents both good and bad news. The bad news is that animal spirits could have been structurally dampened by the last financial crisis and a structural crisis of confidence could have led to structurally weaker investment spending.

The good news is that a slower recovery should mean a longer recovery, with a high probability that this cycle will be the longest in history (commensurate with  the strength of the shock of the financial crisis).

This is our conviction. We talked of a New Normal, but we very much dislike, and disown, this expression. The New Normal rhetoric is pseudo-smart analysis of the economic situation in order to say that things now work in a different way. But the reality is there has never been normality in the business cycle. There is no “normal” mode. That’s true for both the economy and financial markets.

The recent repricing of the inflation/term premia in bond markets is a case in point, and should cause investors to challenge the hypothesis that low interest rates are structural.

It is important to understand that something that lasts for a while is not necessary something that is becoming structural. It could be a super-cycle rather than a structural shift in the equilibrium (if, indeed, any equilibrium exists).

Investors have, until now, anchored their expectations to a regime of low growth and low inflation that supports low interest rates. But the entry of Mr Trump into the game has acted as a shock to these expectations.

Before the election, the consensus was that “remaining slack in the economy” was about to disappear, justifying the end of the 0% rate policy. And because the speed of the economy had no reason to change, normalization was expected to be moderate, gradual. Post-election, given the high probability of a fiscal shock, the risk of the economy overshooting has risen. In our opinion, the re-pricing of the US bond market illustrates: 1) this risk; and 2) the de-anchoring of investors’ expectations from a low-growth, low-inflation regime.

The consequences are potentially powerful, especially for the rest of the world, which is highly dependent on US dollar financing. If US dollar interest rates accelerate because the US economy grows faster, the non-US dollarized world will suffer a shock. It  is not prepared for such event - it cannot afford it, it is too soon.

The destabilization of emerging markets in the wake of a stronger dollar and/or higher US interest rates will become a key theme. Paradoxically, the pro-growth strategy of the new US President would put at risk the ongoing, but fragile recovery, of emerging markets.

To sum up, investors could soon realize that the “great moderation in the US” was less an optimal equilibrium for the US and more optimal for the rest of the world (particularly for financial markets). With the intention of the new President to pursue higher trend growth domestically, we could see significant destabilisation of this equilibrium. 

 

Tristan Abet

Senior Fund Manager




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