In 2009, in the aftermath of the Great Recession, Bill Gross coined the term, “new normal.” Describing the new normal nearly five years ago, Gross told Forbes that “our future will likely include a lowered standard of living, high unemployment, stagnate corporate profits, heavy government intervention in the economy and disappointing equity returns [and low returns from bonds].”
Bill Gross is once again defining the future markets in a simple thematic phrase. His new phrase, “new neutral,” represents a view that the Fed will keep rates close to zero (on a real basis) for at least the next three to five years, if not longer. As reported in a recent Reuters article, “Pimco's Gross sees 'New Neutral' Real Policy Rate Close to Zero Percent,” unlike the new normal, the picture is one of less volatility and more rationale pricing, especially as it relates to equities. The lower volatility will result from the Fed maintaining, for an extended period of time, close to zero rates which pulls down bond yields as well as providing justification for higher than normal equity valuations. Said differently, on an absolute basis stocks may not be that attractive, but compared to what debt vehicles pay, they may be considered to be more attractive on a relative basis — compared, that is, with other investment options.
“Stuck in neutral” is an interesting metaphor which portends that if the Fed raises rates (above the real rate of zero), this will pull the economy into recession. The new neutral also sounds like the U.S. markets will be stuck in a place in which it is difficult to move forward. With rates kept on the bottom, the U.S. markets are expected to simply limp along, waiting for a better day.
The New York Times recently published a article, “How the Everything Boom Might End: The Good, the Bad and the Ugly,” which seeks to answer this question: What does this simple fact, that globally prices are high and expected returns are low, mean for the future? The article goes on to describe three different possible scenarios: “the good, the bad and the ugly.”
The “good” is described as a situation in which the “low price of capital will help unleash productive new investments that create higher growth in the future — and that the economy will in effect grow into the current market valuations.” This would be a Keynesian dream come true. The Fed makes a smooth exit and the U.S. economy will have evolved into a robust growth engine so as to offset the huge deficit, the result of many years of stimulus.
With deflation being the other side of the coin (which the Fed is also battling), it would seem to indicate that “increasing the longer-term productive capacity of the global economy” would mostly result in the more efficient use of labor in a world already awash in cheap labor. As noted in the book, The Age of Oversupply: Overcoming the Greatest Challenge to the Global Economy, “what we have seen in the past few decades is an unprecedented global expansion of cheap labor and cheap money.” Consumption seems to be a bigger challenge then production.
At least in the mid-term, such a Keynesian smooth exit seems unlikely. The challenge is to deal with debt reduction while battling the twin evils of inflation and deflation. A tricky proposition to say the least.
The “bad,” as described by the Times article, is characterized by “continued low to nonexistent growth, low interest rates and low inflation.” The article goes on to describe “bad” as a world “buckled in for the kind of slow-growth, low-interest-rate world of the last few years for a long time to come.” This outcome — although addressing a longer time period — sounds a lot like “new neutral.” Nothing exciting, just the U.S. keeping its head above water with low interest rates, low volatility and minimal asset growth.
The “ugly” is one in which the Times article describes a “world [that] may not work the way standard Keynesian economic models suggest it will.” The article considers a few ugly scenarios centered on such things as out-of-control inflation, debt crisis and economic collapse. The article does not mention deflation. However, that is something, no doubt, that could have a devastating impact on the economy as well. One should at least consider the argument laid out in Harry Dent’s new book, The Demographic Cliff: How to Survive and Prosper During the Great Deflation of 2014-2019.
Conclusion
The Times article concludes that “the pattern of the last few years shows that the ‘bad’ scenario has been closest to the reality.” It also points out that given the fact that the “good” and “ugly” outcomes have not come about so far, “should prompt those predicting the [good] or [ugly] outcome to wrestle with why they have been wrong so far.” This seems a little too early to make this statement given that a lot more will be known once the Fed ends the tapering and the U.S. economy must stand on its own. Can it limp along supported by low interest rates and not be overwhelmed by its debt? This is a question that has yet to be answered.
Both Bill Gross’ “new neutral” theme and the Times article’s “bad” scenario seem to be likely outcomes. Japan has set the precedent on how a country can survive slow growth, low prices and low interest rates. Indeed, what the Japanese have shown is that an economy can survive for quite sometime in this environment without experiencing an economic calamity. The U.S. may travel the same road given the possibility that it could be stuck in the “new neutral” for some time to come, teetering between its efforts to dig out of a massive amount of debt while keeping the economy from falling back into a major recession.
