What if secular growth, and not stagnation, is the new normal? - Angles & Perspectives

What if secular growth, and not stagnation, is the new normal?

Have market participants been misled by the prevailing narrative of the past decade or so, aimed at explaining low growth despite highly accommodative monetary policy? We believe there is compelling evidence that the low growth, low interest rate environment following the Global Financial Crisis (GFC) was an anomaly, rather than the new normal. The implications for portfolio constructors are profound.

A stagnating world…
Since the GFC ended in 2009, the US and most other developed economies have battled with mediocre growth. Real GDP growth averaged just 1.7% in the US from 2009 to 2018. Since 2009, the US has endured three industrial recessions, the shale oil industry collapsed, and Europe had to deal with an existential debt crisis. Low growth persisted despite policymakers lowering interest rates to zero, and (when that didn’t work) engaging in quantitative easing and yield curve control to lower bond yields further out on the curve. Even then, monetary policy seemed powerless to end the growth malaise – not only in the US, but also in the Eurozone, UK and Japan.

Diagnosing the ‘secular stagnation’
The ‘secular stagnation’ narrative articulated the consensus explanation for poor growth in the US and other developed markets, focusing on pressure from the ‘three D’s’:

• Debt: high and growing debt levels diverted income towards debt service.
• Demographics: ageing populations meant less consumption.
• Disruption: globalisation of supply chains and digital disruption were hollowing out whole sectors in developed economies.

The three D’s were seen to exert strong deflationary pressure and restrain growth in developed market economies. These forces were believed to be so pervasive and enduring that secular stagnation was described as the ‘new normal’. Further evidence for the new normal narrative was that even the most accommodative monetary policy since the Second World War had failed to kick-start stronger growth.

Covid-19 marks an inflection point
The pandemic lockdowns dramatically changed consumer behaviour in 2020, providing a massive initial boost to mega-tech companies at the same time as real economy sectors were being decimated. This was perhaps the ultimate validation of the ‘growth is scarce, new normal’ narrative. What is apparent in hindsight, is that the wild price swings of 2020 also marked a secular and cyclical low for the ignored value sectors that play such an important role in the real economy.

In terms of the new normal narrative, any bouts of inflation would be transient, brought about by temporary dislocations, and the three D’s would quickly restore the secular stagnation status quo. Covid-19 did disrupt supply chains, but the expectation was that the impact would quickly subside.

Experience proves otherwise
In May 2021, the Bloomberg consensus US CPI forecasts were 2.5% for 2021 and 2.2% for 2022. The final CPI print for 2021 was 7%, and while the inflation rate is likely to decline in 2022, it has a high probability of averaging substantially above the US Federal Reserve’s (the Fed’s) target. Despite expectations to the contrary, rapid wage growth and low unemployment are driving a positive inflation feedback loop via strong consumer spending. Sustained inflation, together with the strong recovery in nominal growth (now back at levels last seen in the 1970s and 1980s as per the charts below), directly contradicts the new normal narrative, and forces us to look for other explanations for the weak post-GFC growth.

What if the last decade was not the new normal, but an anomaly?
US hedge fund manager Mike Masters gives a compelling thesis that contradicts the secular stagnation narrative, and he expects strong growth in the decade ahead. US households suffered greatly during the GFC, many consumers lost their jobs and houses, and sold their investments at market lows. The banking sector also suffered substantial losses and faced a huge increase in regulatory capital requirements.

Both consumers and the banks subsequently had to rebuild their balance sheets. This has taken many years but today US banks and US households are in the healthiest position in at least 50 years (chart below). Masters points out it is high private sector debt burdens that should be regarded as deflationary - governments can print money to meet their debt service obligations.

Fiscal policy finally embraced with immediate success
Policymakers’ response following on the GFC was to apply easy monetary policy but severe fiscal austerity (even the likes of Japan and Italy ran primary surpluses). This is because, in terms of conventional wisdom, fiscal stimulus was seen as a risky alternative. But after the long deflationary hangover from the GFC, tight fiscal policy was exactly the wrong choice, and the healing process took much longer than necessary. And while easy monetary policy delivered a massive boost for financial actors, it had very little effect on the real economy. Thus, the unintended consequence has been that wealth inequality has been severely exacerbated. It was only with the arrival of Covid-19 that governments across the globe embraced massive fiscal spending as a key policy response. The rapid growth recovery that followed will make fiscal stimulus an important policy tool in the future.

Large capital expenditure and housing deficits built up since the GFC
Strong demand post Covid-19 has broken global just-in-time supply chains optimised for the past decade of weak growth, and many years of under-investment in energy, materials and real-world infrastructure will cause bottlenecks for the foreseeable future. Disruptions from the pandemic (and sanctions in response to Russia’s invasion of Ukraine) have merely highlighted and brought forward the constraints, rather than caused them. A massive capital expenditure (capex) programme is necessary to enable supply chains to be resilient and handle higher demand.

Similarly, US housing starts have averaged some 900 000 per annum over the post-GFC decade, compared to around 1.5 million prior to the GFC. Population growth has not stopped, and it is estimated that there is a housing deficit of up to 6 million units. Residential fixed investment, supply chain and infrastructure capex, together with spending on the energy transition, will also be a substantial growth tailwind in the decade ahead.

How investors were positioned for the new normal
When growth is hard to come by, investors are prepared to pay a premium for those few companies that deliver, and growth has been scarce in the decade or so since the GFC. Large platform IT-centric businesses have thrived, such as Amazon, Apple, Meta (Facebook), Alphabet (Google) and Microsoft. Their strong growth was accompanied by premium ratings as investors made them cornerstones of their portfolios. This became a virtuous cycle as the strong returns attracted more investors, further boosting ratings.

While the Fed’s massive QE programme may not have boosted growth, it certainly lowered bond yields, in turn lowering discount rates used in discounted cash flow valuations and boosting equity valuations. This discount rate decline disproportionately boosted ‘long duration’ stocks epitomised by the mega-cap IT stocks. Their growing weight in the indices also helped passive mandates outperform, attracting massive flows of funds. Since the end of the GFC in 2009, the market cap of these five IT giants has gone from some 5% of the S&P 500 to a recent peak of 25%!

A whole generation of equity analysts and portfolio managers have cut their teeth in this market. Generating performance required a focus on growth stocks, and that growth came primarily from mega-cap IT stocks in the US, with secondary roles played by second-tier technology and consumer-facing growth stocks. There was no need or incentive to focus on out-of-favour jurisdictions such as emerging markets, Japan and Europe, or out-of-favour sectors such as energy, materials and capital-heavy industrial companies. Importantly, these were also the sectors penalised as large carbon emitters by the checklist-based environment, social and governance (ESG) methodology adopted by most asset managers. Their poor ESG scores and the entrenched new normal growth narrative made them irrelevant. The respective sector weightings within the S&P 500 Index of IT and media, in contrast to energy and materials, illustrate the impact of the post-GFC period (chart below).

Has the market abandoned the ‘secular stagnation’ positioning?
The energy sector is currently only 3.6% of the S&P 500. Long-only funds are dominated by passive and benchmark-hugging mandates. Even if these managers believe they should reposition in a growth abundant world, a combination of restrictions on active bets away from the index, ESG checklist exclusions and a reluctance to take career risk, will keep them invested in big tech stocks and prevent significant energy and materials exposure. Nor have we seen any sign that US hedge funds are exploiting this opportunity, with less than 2% of their portfolios dedicated to materials and energy.

There is a long runway for the growth rotation
We believe there is compelling evidence that the new ‘new normal’ is likely to be a decade of stronger growth, and the anomaly was the so-called secular stagnation after the GFC. Mike Masters raises two important points that will make the transition to a growth positioning a drawn-out process. Firstly, we are all prisoners of our own biases, and we over-weight the recent experience the most. This means most market participants believe we will go back to the secular stagnation of the past 10 years, once we get through Covid-19 and the sanctions against Russia subside. This view is implied by the US yield curve and most portfolios’ massive weightings in growth/quality stocks. Any cyclical slowdowns in demand will be seized upon as compelling evidence that the new normal still prevails.

Secondly, the market has great difficulty conflating time horizons. It cannot focus on near-term cyclical issues (e.g. a growth slowdown triggered by a combination of higher rates and energy prices) and a strong secular growth outlook for the next decade. This means investors who are prepared to take a longer view will have a rich opportunity set in growth-sensitive or value sectors, as markets misdiagnose any periods of weakness in the years ahead.

PSG Asset Management.