Introducing the Tortoise Economy
“Push it. Pull it. Or prod it. It’s going to be slow.”
By Sam Stewart, Founder and Chief Investment Officer, Wasatch Funds
Welcome to the new slow-growth economy. It’s not the economy we had been accustomed to, but it is the economy we have. This new economy results, in part, from a structural change that has taken place over the last few decades. If we look around the globe, in almost all of the mature countries — and even in China and Brazil — fertility rates have dropped below the replacement rate. So we now have a substantial segment of the global population with a large number of retirees and a relatively smaller labor force. We have less economic growth coming from young people going to work and spending money. A younger population was part of what had made for a vibrant economy. Now economic growth in much of the world, including the U.S., is slower and less dynamic.
Our new economy is a bit like a tortoise. We can push it. Pull it. Or prod it all we want. Maybe for a short while we can get the economy to pick up the pace somewhat. But we’re not going to make it grow fast. No matter what we do, it’s going to be slow — at least for some time. Most of us, including many in Washington, are only now coming to understand that we have a tortoise economy. And the ramifications are becoming clear. After years of significant fiscal and monetary stimulus, job growth continues — but at an anemic pace. While there have been recent improvements in automobile sales and in the housing market, overall consumer spending and consumer confidence have taken an unexpected turn for the worse.
In mid-September, citing less-than-robust economic data, the U.S. Federal Reserve (Fed) decided to delay the taper of “quantitative easing.” Investors in the financial and commodity markets, who had previously anticipated that the Fed would finally begin the taper, initially reacted favorably to the news. From my vantage point, however, I found the Fed’s decision disappointing. I think the moderately higher interest rates that might have resulted from the taper would have been consistent with a healthier lending environment, which is important for economic growth. In addition, with inflation in check and recent improvements in the federal budget deficit relative to gross domestic product (GDP), I believe the Fed should be erring on the side of reduced intervention.
As we adjust to this tortoise economy, it is especially important that we as a country set priorities. For some time now, we’ve been using a combination of monetary stimulus and broad fiscal stimulus. Monetary stimulus, mainly quantitative easing, is a blunt weapon that has outlived its usefulness. Even though the Fed refrained from tapering in September, it’s clear the Fed perceives the shortcomings of ongoing monetary stimulus. Indeed, just days after declining to act, the Fed hinted it might begin tapering in October.
Many investors, myself included, believe the Fed has done all it can to improve economic conditions. While the Fed may still be able to influence market psychology and interest rates, I think the Fed is “pushing on a string” when it comes to meaningful economic growth and employment. Could the economy grow slightly faster? Perhaps. But it may be that we’re now living with real GDP growth of around 2%, and nominal growth with inflation of 3% to 4%. That’s roughly half the growth rate to which we had grown accustomed, real growth of 3% to 4% and nominal growth of 5% to 6% or even 7%. Growth potential is lower now, and I don’t think the Fed can change that.
Unlike monetary stimulus, fiscal stimulus can be targeted at a specific problem, such as unemployment. Direct government spending on job skills training and infrastructure — combined with indirect measures, including tax credits and incentives to private industry for research & development (R&D) and the construction of productive facilities — could lead to long-term growth in jobs and employment. Unfortunately, I think much of the spending we see today is misplaced. For example, erecting a new university building may provide some construction jobs in the short run. But I doubt a new building generally leads to significant improvements in the quality of the education provided. The most likely long-term results are even higher tuition costs and greater debt burdens for our young people, which are especially damaging in a tortoise economy.
A better use of fiscal stimulus would be to maintain and expand our infrastructure, much of which has been allowed to deteriorate over the years. Fixing our crumbling roads and bridges, building a “smart” electrical grid, and making fast Internet services available nationwide would create tens of thousands of jobs and, indirectly, stimulate our economy for decades. Looking back in our history, we can see the long-term positive benefits that resulted from the transcontinental railroad in the 19th century, the interstate highway system post World War II, and the incredible technology that was spawned by the space age. It is interesting to note how the American launch 36 years ago of Voyager 1 is still paying dividends, as the spacecraft is now the first man-made object to hurtle out of our solar system. And this was accomplished with only 68 kilobytes of on-board computer memory. To put that in perspective, it’s been widely reported that an 8-gigabyte iPod Nano is 100,000 times more powerful.
Given our health-care challenges today, if we funded additional researchers at the National Institutes of Health (NIH), for example, we’d be creating good, permanent jobs. Although the payoff might seem nebulous right now, I’m willing to bet that something important would come from this spending. And, by the way, we’d be improving the market for highly skilled jobs and raising some wages. This is the type of fiscal stimulus that I think will help deal with many of our problems and keep the U.S. competitive in the global economy.
During the past several years, my messages have been largely optimistic about both the economy and the stock market. More recently, I have cautioned that we could see a rise in interest rates and a corresponding decline especially in long-term bond prices. These conditions have, in fact, unfolded over the past year. The S&P 500 Index gained 5.24% for the third quarter and 19.34% for the 12 months ended September 30, 2013. At the same time, the intermediate-term Barclays Capital U.S. Aggregate Bond Index was up 0.57% for the quarter but declined 1.68% for the 12 months. And long-term government bonds, as represented by the Barclays U.S. 20+ Year Treasury Bond Index, fell 2.70% for the quarter and lost 11.84% for the 12 months.
As equity investors accustomed to large swings in stock prices, we may not be focused on bond prices and the impact of changes in interest rates. While the yield on 30-year Treasury bonds rose from a low of 2.45% on July 25, 2012 to 3.68% on September 30, 2013, many equity investors paid scant attention to the seemingly small increase. In terms of principal value, however, the movement was significant. As pointed out by Allan Sloan in Fortune magazine, the market price of 30-year Treasury bonds fell about 4.1% in one day on July 5, 2013. This was the equivalent of a 615-point drop in the Dow Jones Industrial Average. The good news, in spite of that, is stocks have continued to advance.
While I believe that we now have a tortoise economy, I remain upbeat. I think we’ll have to learn to live with slower growth, and I’d argue that’s OK. We’ll have to be careful about valuations. In some cases, current stock prices reflect high future growth rates that may not be fully achieved. This doesn’t mean investors should sell stocks indiscriminately. But I think that as stock prices advance, investors should be wary about paying too much. And it may be wise to trim the expensive, more-speculative stocks in a portfolio.
I’m less concerned about the possibility of a further rise in interest rates. Though many investors believe the eventual tapering of quantitative easing will put substantial upward pressure on interest rates, I think there’s a reasonable chance that much of the rise in rates has already occurred — at least for the near term. Counteracting a possible Fed taper, we’re seeing relatively little demand for credit, one of the results of the slow-growth economy. Additionally, there’s a very high demand from savers for assets that produce even modest amounts of income. As our population ages, the pool of retirees seeking good, safe yields is growing by the day. These two factors (low demand for credit and high demand for yield) may exert some downward pressure on interest rates. So, on balance, I think it’s unclear as to whether we’ll see a small rise or a small dip in rates. Either way, for the time being, I don’t expect any movement in rates to be significant.
If interest rates do rise modestly or even more than I expect, I don’t anticipate that higher rates will have substantial adverse effects on the stock market overall. There is, in fact, no consistent historical relationship between interest rates and stock prices. It is normal for rates to rise during an economic recovery. Only when there are signs of overheating in the economy do higher rates usually represent a threat to the stock market. Especially in the current low-inflation environment, I don’t think equity investors need be overly worried about a small or moderate uptick in interest rates.
The key ingredients to investing going forward will be focusing on high-quality companies, staying diversified, and maintaining some cash to buffer volatility and to take advantage of particularly attractive valuations during periodic corrections. I define high-quality companies as those that have sufficiently strong balance sheets so they can self-fund their operations even under difficult economic conditions. Companies with low debt, high returns on capital, and strong cash flows should be able to grow and take advantage of opportunities when other, less-sound companies are pulling back.
I also think investors should pay attention to dividend-paying companies, which have tended to outperform non-dividend-paying companies in slow-growth environments. In a tortoise economy, dividends increase in importance. In an accelerating economy, by contrast, a company with 10% top-line growth, for example, might have a relatively easy time generating 15% bottom-line growth. In a more-subdued economy, with top-line growth of just 3% to 4%, a company will find it more difficult to get the operating leverage. So the bottom-line growth might be just 5% or 6%. In an environment where growth is slower, a 3% dividend yield, for example, may look quite attractive.
I remain partial to fast-growing companies, too. But I caution investors to examine them very closely. It is one thing to pay a premium for growth. It is quite another to pay the seemingly absurd valuations that some of these companies now exhibit, especially given that we have entered an economy that is expanding at a slower pace overall. Right now, I believe many large-cap companies, and large-cap technology companies in particular, represent compelling valuations.
Looking abroad, I think targeted investments in high-quality companies in emerging markets might be attractive. Emerging markets, including the BRICs (Brazil, Russia, India and China), have broadly lagged this year, though it’s not entirely clear why in every case. India has been experiencing challenges due to its wide trade deficit, volatile currency, and government bureaucracy. In China, money had been pouring into potentially unproductive companies. Yet we should not lose sight of the fact that over time these economies are likely to continue growing at high rates, while we’ll have more-subdued growth in the U.S. and the rest of the developed world.
There may also be attractive company-specific opportunities in Europe, which appears to have come out of its long recession. Stock markets in the region have generally done well over the past year. But there are structural challenges that remain with the euro currency. How integrated are the European countries going to be? Might they deal with the integration effectively? Yes. Might they just continue to muddle through? Yes. But I think the complicated, interconnected risks of dealing with multi-country politics and economics are extremely difficult to quantify.
All things considered, large U.S. companies that operate globally appear to be particularly attractive right now. Because many of these companies are generating significant portions of their sales outside the U.S., investors are effectively getting some international exposure with what I consider to be more-quantifiable risks.
© Wasatch Funds