The End of the New Normal Economy?
In the early years of the Great Recession, PIMCO economists coined the phrase the “New Normal.” The New Normal posited that the economy would not see a sharp recovery as it had after previous recessions (i.e. the “Old Normal” behavior), but instead would have a prolonged period of slow growth as the country worked to pay down debt levels accrued during the housing bubble. While this view was not the consensus when PIMCO announced it, it has become the standard economic outlook for many investors. Indeed, both the Congressional Budget Office and the Federal Reserve make assumptions about future economic trends that align with a New Normal view of the world. Mostly simplistically, the New Normal view of the world suggests nominal GDP in the US will grow at around 4% a year going forward vs pre-Financial Crisis growth rate of around 5% that persisted for much of the post world war II period.
At Ensemble, we’ve been talking about the potential end of the New Normal and a return to the Old Normal economic pattern a lot this year. While PIMCO’s view has been spot on the last few years, we never believed that the New Normal would persist forever. The housing crisis was a huge deal – the worst crisis in 100 years – but it didn’t make sense to us that this crisis had permanently changed the country’s growth potential.
Our outlook was less of an economic prediction than a belief in mean reversion. Since our assumption has been out of step with the consensus, it means we’ve shifted our portfolio into more economically-sensitive companies as the market has priced in less long-term growth potential than we have. Since interest rates are positively correlated to growth (interest rates are higher when growth is strong), we’ve also implicitly assumed that rates will move up over time causing us to prefer short term bonds and avoid conservative, high-dividend paying stocks.
Economists Rogoff and Reinhardt wrote a book in 2011 related to the New Normal thesis in which they showed that long periods of low growth are not seen after normal recessions, but are common after a debt-related financial crisis. Their work, looking at 500 years of economic data, showed that these low growth periods lasted about 10 years on average.
As we’ve approached the 10-year anniversary of the Great Recession, we’ve been hopeful that the New Normal conditions would dissipate and the Old Normal paradigm of higher economic growth, higher inflation and higher interest rates would return. And that’s exactly what we’ve been seeing play out over the past year.
This chart of year over year nominal GDP growth in the US shows clearly how since the end of the last recession, US GDP has grown at average rate of 4% while mostly staying in a 3%-5% channel with the most recent GDP report showing the growth rate moving out of the post-recession range.
Still, it is difficult to know if we are just witnessing the relatively-strong final throes of a New Normal expansion or if we are seeing the reemergence of the more typical growth rate of an Old Normal economy. If the former, we’re likely close to the next recession. If the later, economic conditions will likely persist or even continue to strengthen in the years ahead.
Today, real economic growth and inflation is running near Old Normal average levels. However, interest rates are still well below normal. While it seems hard to imagine, if we assume Old Normal economic growth and inflation has returned, it suggests the Federal Reserve rate should be approximately 4% instead of the current 2% and the 10-year treasury should be around 5% rather than the current 3%. This is likely the logic Jamie Dimon, the CEO of JP Morgan, was drawing on when he said recently that he thinks the 10-year treasury could reach 5% over time and should already be at 4% today.
We’ve been watching closely for signs of which ways things are going. Recently, however, Mohamed El-Erian one of the former chief economists of PIMCO who developed the New Normal thesis said in an interview that he believes the US economy has exited the New Normal and is reentering an Old Normal paradigm of higher growth, higher inflation and higher interest rates. We sure hope he is right!
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