There’s been an active discussion as to whether we should expect an “L” recovery or a “V” recovery. For those not familiar with these terms, each letter resembles the shape of a GDP graph of the respective scenario. In other words, an “L” recovery represents a sharp economic decline followed by a period of zero growth. The “V” scenario represents a similar drop, but one followed by a robust recovery. Those seeking to fit our current economic environment into one or the other of these categories miss the point — we are in a recovery that has elements of both scenarios. I argue that we are in the early stages of a “Q” recovery. The letter “Q,” after all, is the letter precisely between an “L” and a “V.” But this is more than a mere hybrid or average of these latter two. The “Q” recovery is a distinct animal that must be understood on its own terms.
"V", "L" or "Q"?
History certainly favors the “V” scenario. Most recessions snap back relatively quickly. The pattern is straightforward as businesses cut production in the midst of a downturn, but retain the capacity for greater output while reducing their costs and inventories. When demand improves, the lack of inventory means that demand translates almost immediately into increased production, taking advantage of the excess capacity. With the leaner cost structure and no need for increased capital expenditure to meet the production needs, corporate profits soar (an important GDP component). The higher corporate profits, in turn, both reflect a pickup in existing demand as well as spurring future demand through higher employment and investment. The current aggressive monetary policy and the large fiscal stimulus package all support the case for the traditional V-shaped rebound.
Despite the historical case for the “V,” there’s a compelling, and I think, stronger argument for an “L” recovery. It is increasingly apparent that the fiscal stimulus was poorly constructed, and that we won’t get much bang for the buck. Monetary policy is only effective if it results in the extension of credit and a pickup in consumption. Credit remains constrained by our wounded and undercapitalized financial system — it will take years for earnings to fill in the holes in the balance sheets of some of our largest banks. Even where credit is available, some of the traditional routes by which that was transformed into consumption no longer function as they did in the past. In particular, the inventory overhang in housing means that even low-cost and accessible mortgages won’t necessarily result in new construction.
The most convincing case for the “L” recovery lies with the broader case for weaker consumption. Unlike past recessions, the U.S. consumer will not return to pre-recession spending. The past decade’s wealth effect, whereby higher stock portfolios and higher home prices spurred consumption, now works in reverse. Income once directed to spending will now be diverted to rebuilding shrunken retirement savings. Demographics will be our economic destiny as aging baby boomers have entered the phase of life where acquisition tails off and downsizing begins. Finally, the spirit of the times reflects a certain frugality and seriousness; starting in mid-2008, the number of Google searches for “coupons” exceeded the number of searches for “Paris Hilton,” and the trend continues – these are somber times indeed!
Some Bright Spots
Despite the strong case for a zero-growth environment, there are some bright spots that suggest that things are not as bad as they seem, and this strange “Q” recovery will be our future. Internationally, decades of outsourcing business to India and China can alternatively be viewed as building the future prosperity of those nations. We may soon reap dividends from that investment. The emergence of a middle class in those populous countries brings demand for U.S. exports of technology, agriculture and airplanes, to name but a few. Domestically, productivity continues to improve in defiance of set patterns of earlier recessions. Labor flexibility has clearly played a role here, but this also reflects the fact that internet and telecommunications technology will continue to enhance economic growth. All these positives will not be enough to fully offset the unusal weaknesses of this business cycle, but they argue that proponents of the “L” scenario are overly pessimistic.
For investors, what does the “Q” recovery mean? The equity market rebound since early March has already given us a glimpse of the future. The characteristics of the current rally defy our historical experience, with growth stocks leading the way and large company performance in a dead heat with small-caps, contrary to most early stage moves. Whenever markets move against historic patterns, the best bet is to assume that trend will continue. Certainly fundamentals point to the continued dominance of large companies, with their superior access to credit, global markets and lobbyists who shape new regulations to their advantage. Those companies able to garner growth will gain superior multiples in the slow growth “Q” recovery. Those that do succeed will find their growth may be largely driven by business investment and emerging market demand, rather than domestic consumers, yet another twist in our unusual environment.
For most of this decade, investment advisors “beat the S&P” not only by loading up on U.S. small cap companies, but by benefitting from the superior returns of foreign stocks. Much of the overseas outperformance was due to currency translations; as the greenback fell in value, the price of foreign-denominated securities gained in dollar terms. In the “Q” recovery, the dollar is likely to be range-bound, and that inherent currency advantage will not be present. This doesn’t mean there are no opportunities abroad, particularly in the emerging markets, but it does suggest that investors will no longer “have the wind at their backs” in this asset class. Recent data have suggested that European economies are ahead of the U.S. in recovering from the global recession. This does raise the possibility that investment flows to those economies could boost their currencies, but investor expectations should focus on foreign stocks as a valuable diversification rather than the star of their portfolios. While emerging markets offer far more growth potential for outperformance, the size of those markets relative to global inflows suggests volatile boom/bust cycles ahead for equity investors in that sector; prudent participants would be well advised to be more tactical in approach.
For the first time in years, corporate bonds and select tax-exempt bonds offer the opportunity for competitive investment returns, and will likely outperform cash and money markets. Fears of government deficits and the reliance on global capital for financing that debt could well keep real U.S. Treasury rates high. While the commodity price component of inflation measures may be resilient, slack domestic growth and continued productivity gains will moderate overall inflation. Credit spreads can contract from current levels, but the past year’s interventionist government policies will leave a legacy of uncertainty as to “rules of the road,” preventing a return to the narrow spreads of 2005/2006. Municipal bonds will suffer from credit uncertainty as their issuers struggle to rationalize their commitments with a slow-growth economy. From current levels, munis are best viewed as “coupon-clipping” opportunities, but, on a risk-adjusted basis, not unattractive relative to other capital markets.
The “Q Recovery” will offer investors diverse opportunities, but not broad opportunities. This will be far from the “rising tide” markets of past cyclical upturns. However, within the more narrow circle of winners, we believe returns will more than justify the risks of investment.