The New Normal
In a recent speech Bill Gross of PIMCO outlined what his firm has termed the "New Normal." In a world of more regulation, private-sector deleveraging and less consumption, "it's hard for PIMCO to imagine" the Dow Jones Industrial Average/quotes/comstock/10w!i:dji/delayed climbing back to 14,000 or home prices returning to 2006 levels, growth will be stunted," he said. "It will be a different type of world and we have to get used to that."
“The U.S. economy will grow at between 1 and 2 percent a year rather than 2 to 3 percent a year for the next three to five years at least, that will make a significant difference for corporate profit growth," he said. Moreover, unemployment will hover around 7 to 8 percent rather than the recently typical 4 to 5 percent, he added, and the higher rate would be around "for a long time to come." Gross added that inflation would also start to accelerate in the near future.
This “New Normal” economic climate prompts investment advisors to question many previously held assumptions -- especially about whether stocks will outperform bonds, and what this means for their portfolios. Data shows that over certain time cycles, bonds have outperformed stocks.
Many experts have been pointing out how great U.S. government bonds have done the past 30 years – which they have - but in our view at RKM it's nearly mathematically impossible for bonds to do that again, based on current yields. The future can't be like the past; in fact it might be a mirror image – that is a reversed image.
We are convinced that equities now are priced more attractively. Government bond yields coupled with the looming threat of inflation - the curse of fixed-income investors - as the government prints money to combat the financial crisis provides more ammunition for this case.
What about the Banks? Financial engineering had supplanted real engineering in cities like London and New York and whole economies (Iceland) became dominated by the fast growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10 percent in the early 1980’s to 40 percent in 2007! The stock market value of financial services firms increased from 6 percent in the early 1980’s to 23 percent in 2007! Why didn’t they see this crisis coming?
Relying on financial innovation has proved disastrous - think 80’s S&L crisis, 90’s international banking and LTCM crisis and the debacle we are still living. In “A Short History of Financial Euphoria,” economist John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version." At this point we recommend avoiding bank stocks and bank sector mutual funds until the smoke clears.
What to do
Maintaining your wealth in the future will require strategies that reflect this changed vision of global economic growth. Bond investors should confine purchases to shorter maturities where price protection is more probable and as inflation increases, cash from maturing notes can be reinvested at higher rates. Investors may experience lower rates of return than what they grew accustomed to until 2008. Returns are the result of an economic environment.
In light of this “new normal” reality, investors should look for stable income from a portion of their investments, rather than reaching for returns. Short-term bond ladders and income paying stocks are two good examples.
Also, there is a chance that the dollar will lose its reserve status. The U.S. simply has too much debt. To be ready for that day, investors should invest outside the U.S., in faster growth economies. In particular, the BRIC countries - Brazil, Russia, India and China, for instance, consumption in China is 35 percent of GDP compared to nearly 70 percent in the U.S.- that shows huge growth potential.
PIMCO’s co-CIO’s Gross and El-Erian sum things up succinctly with the following half dozen sentences. “For the next 3–5 years, we expect a world of muted growth, in the context of a continuing shift away from the G-3 [U.S., Japan and Europe] and toward the systemically important emerging economies, led by China. It is a world where the public sector overstays as a provider of goods that belong in the private sector.”
“The banking system will be a shadow of its former self. With regulation more expansive in form and reach, the sector will be de-risked, de-levered, and subject to greater burden sharing. The forces of consolidation and shrinkage will spread beyond banks, impacting a host of non-bank financial institutions as well as the investment management industry.”
“In the next few years, the historical pace of growth in potential output will face many headwinds. Excessive regulation, higher taxation, and government intervention will be among the factors that will constrain the growth.”
If the above holds true and you are paying your advisor 2 or 3 percent in total fees your portfolio may suffer needlessly, therefore think about lowering your costs. As John Bogle was recently quoted saying, “A financial system that takes too much out of investor returns doesn't create additional value. We want to beat the market but will inevitably fail because of [transaction] costs, so I question our values and what is really enough.”
Chris Blakely, June 2009
Sources: PIMCO, Bloomberg LP, JK Galbraith, John Bogle, Morningstar, Marketwatch.com, NBER
