Change is inevitable, but the recent pace and magnitude of economic change has left many investors disoriented, to say the least. Perhaps most importantly, it’s unlikely we’ll revert back to a more familiar environment any time soon. It’s my belief that the sooner investors accept this new world order and view their portfolios through this lens, the better off they’ll be.
To gain an understanding of just how far we’ve come, let’s take a look at the many ways in which the economic and investment landscape has evolved over the past five years:
- Slower growth
From the end of World War II through 2008, the US economy expanded by roughly 3.4% a year. Since exiting the recession in 2009, growth has averaged 2.1%, with personal consumption particularly weak.
- More volatile growth
Not only has growth been weaker, it has become more erratic. In the United States, the volatility of quarterly changes in industrial production is four times higher than it was back in late 2007. Nor is this just a US phenomenon; current economic volatility is also near a record high in Europe.
- More volatile inflation
Economic volatility is also rising in other areas. The volatility of US inflation – measured by the standard deviation of monthly changes – is twice as high as it was in early 2005.
- Negative real rates
Even so called “risk free” assets, like Treasury Bills, typically produce a return above the rate of inflation. However, since 2010 short-term interest rates have been consistently negative. With the Fed determined to keep short-term rates anchored at zero, real rates are likely to remain negative for the foreseeable future.
- Bloated central bank balance sheets
The Federal Reserve’s balance sheet has risen from $800 billion in the summer of 2008 to approximately $3 trillion today. The ECB and Bank of England have followed a similar path. The wide-spread adoption of unconventional monetary policy makes the future path of money supply growth and inflation highly uncertain.
What has caused these changes, and how long are they likely to last? My own view is that the world is still in the early stages of reversing a four-decade long credit binge. For example, between 1952 and 2008 US households enjoyed 56 years of uninterrupted credit expansion. In other words, prior to Q2 of 2008 there was not a single quarter when household debt contracted.
Obviously, things have changed since then. While the consumer and financial sectors have been deleveraging for four years, given the duration and magnitude of the credit expansion, this process is likely to take even more time to unwind.
In addition, while the household and financial sectors have at least begun the deleveraging process, other parts of the economy continue to add to the imbalances. The fiscal position in Europe and the United States has deteriorated dramatically since the financial crisis – Japan had a head start. And while you would not know it from watching sovereign bond yields, few nations have witnessed as rapid a decline in their current account as the United States. Federal debt held by the public has doubled in five years, from roughly $5 trillion in 2007 to nearly $11 trillion today.
Given all of this, it is very hard to envision the world going back to the way it was anytime soon. For investors this means that investment process and philosophy need to be geared to the current environment, rather than the way the world was. In my next post on this topic, I’ll outline 3 strategies for doing just that.
[i] Economists routinely refer to Treasuries as being “risk free”, in order to provide a base against which the risk of other debt can be measured. However, an investment in a Treasury ETF or Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.