Secular Stagnation or Regular Recession?
A summary of the views and possible investment implications
One of the major themes in the investment world at the moment is the question of whether the current period of slow global growth is the recovery from a regular recession - albeit a more drawn out one than an average recession - or a new phenomenon that has been termed "secular stagnation." (Or even "SecStag" if you want to sound like you really know what you're talking about).
The facts are that more than five years after the global financial crisis, average growth in the global economy remains modest and growth rates of the largest developed countries remain at historically low levels, even in some cases coming close to recessionary rates of growth. (While the US has shown some positive signs over the last two quarters of returning to more 'normal' growth rates, the overall growth for 2014 is still likely to remain below the long-term historical average).
The important question for the investment world (or in fact the world at large) is whether this is a new prolonged era of economic growth that will be characterized by countries converging to historically low trend rates of potential growth with low inflation and close to zero percent neutral real policy rates for many years to come. Or is the world simply going through a slightly longer recessionary phase than has been seen historically, from which it will emerge in the next couple of years to a 'business as usual' scenario?
This is by no means a thesis on the subject, rather a short informative essay on the main characteristics of the two lines of thought, a look at who are the proponents of each and the (possible) investment implications for the two outcomes.
A word about paddle boats and my daughters
We have a large park near to where we live with a lake and paddle boats that you power with your feet. I have on occasion taken my two daughters out on the lake where they take turns to turn the paddle on one side with their feet while I paddle the other side. Invariably, because they are smaller than me and prone to getting tired and bored quite quickly, they stop paddling and let me do all the work. Which, as you can guess, just leads us to going round and round in circles.
So, where am I going with this? Well, one characteristic of the last few years has been that the traditional role of guiding major economies has shifted from being a dual-engine role powered by monetary policy and fiscal policy, to being one where central banks have pulled out every policy tool in the box and governments have sat back and let them get on with it because structural and budgetary changes would be far too much hard work.
Which, a bit like the paddle boats, has led to economies going round and round in circles and not getting very far. And even though it looks like a huge amount of policy initiatives have been thrown at the world's economies to get them chugging along again, much like me in the paddle boat who seemed to be doing a lot of work - unless the other side was putting in the effort it was mostly a waste of time.
So, with that in mind, let us have a look at where things stand.
What is it?
The definition (NYSE:FT):
Secular stagnation is a condition of negligible or no economic growth in a market-based economy. .. The absence of  investments (and consequently of the economic growth) leads to declining levels of per capita income (and consequently of per capita savings). With the reduced percentage savings rate converging with the reduced investment rate, economic growth comes to a standstill - i.e., it stagnates."
The term is not new, but was made popular again by ex-Treasury secretary Larry Summers in an IMF speech given in November 2013.
It has been characterized by:
- The weighing down in developed countries of excessive debt burdens accumulated prior to and following the financial crisis,
- Demographic pressures that have slowed labor force growth (and thus potential GDP growth), and increased the dependent / worker ratio (placing added pressure on social security systems and government budgets).
- Central banks that have had to engineer much lower policy rates
- The psychological impact of the financial crisis on households, which left many cautious after the dramatic recession and asset price decreases (especially housing) in 2007-8.
Why do some people think we are in a period of secular stagnation - what do the economic indicators say about it?
The following chart is reproduced from the Geneva Reports on the World Economy, titled "Deleveraging? What deleveraging?" -
The graph and the report (which is well worth reading in its entirety) makes it very clear that the financial crisis of 2008 only registered a tiny blip in the deleveraging of debt that will be necessary to sustain strong long-term growth.
The drag on growth from deleveraging could be lessened in a world of strong growth and increased productivity. But the advocates of secular stagnation are pessimistic about both of these trends. Two examples of their pessimism stem from the decreasing labour force participation in the US showing rates dropping to multi-decade lows ….
Source: US BLS
… as well as productivity post-recession falling to levels not seen since the 1980s:
To compound all this less-than-cheery news, is the fact that Central Banks have nowhere left to go with the traditional policy tool of lower rates:
Who is talking about secular stagnation?
PIMCO has a very similar thesis, which is the "new neutral," a development earlier in 2014 that morphed from their now well-known "new normal" theory. In this, they see a number of serious issues preventing the return to a normal growth path, including:
- An absence to date of aggregate deleveraging in the global economy
- A sharp increase in leverage in China funneled through a vast, complex and fragile shadow banking system
- A pronounced slowdown in the contribution of international trade to global growth and the imposition of capital controls by many emerging economies in the name of macroprudential policy
- A re-regulation of the international financial system
Perhaps more significantly, the secular stagnation argument may have supporters within the policy-setting world including the Federal Reserve, notably the Vice Chairman Stanley Fischer.
A few months ago (August 2014) noting slow growth in "labor supply, capital investment and productivity" Fischer warned that "this may well reflect factors related to or predating the recession that are also holding down growth". He continued to add that, "how much of this weakness on the supply side will turn out to be structural-perhaps contributing to a secular slowdown - and how much is temporary but longer than usual lasting remains a crucial and open question" (emphasis added).
Fed Chairs Bernanke and Yellen have both referred to 'headwinds' that could keep policy rates below longer term 'normal' levels even after the economy returns to full employment.
Central Banks are undoubtedly holding interest rates down at unprecedented low levels for the foreseeable future. The ECB have embarked on an almost historically unseen policy of negative rates, and now having launched asset purchases are possibly on the verge of buying sovereign bonds. Though the Federal Reserve has ended its direct liquidity injections, no one expects a normalization of rates anytime soon - indeed PIMCO argue that the new neutral rates will see rates peaking much lower than the market is expecting (and that the Fed is forecasting).
So, with international yields low, and with the protagonists of secular stagnation arguing that Fed rates will not be returning to normal levels, there will be a persistent and long lasting influence on Treasury yields. In the world of equities, PIMCO argues that with Shiller P/E ratios above historical norms there appears to be "more risk than reward on the horizon."
In summary, both in bonds and equities, the outlook for the "SecStag"s is a world of exceptionally low returns when compared to historical norms.
Okay, it's not quite a 'regular' recession but it gives a catchier ring to the title of this piece. This recession was undoubtedly deeper and longer than any other recession since the 1930s. And the recovery has been more tepid and less strong than any other recovery over the same time period.
The average business cycle over the last 150 years, as measured by the NBER, has consisted of an expansionary period of just less than five years. Which would suggest to some, that five years after the Great Recession, it may be time for the economy to actually take a turn downwards. But those who argue the economy is getting back to a normal footing see this recovery as being slow but over the last few years argue that the developed world economies have moved back to the early stages of a normal recovery.
Reasons for hoping that expansion is round the corner
The arguments for the "regular recession" camp, that the economy is slowly healing and in a place to see a continued and normal expansion, include:
- Unemployment is slowly approaching (or even reached) pre-crisis historical levels
- Though on a global basis, debt levels remain higher than in 2008 (as mentioned above), in certain areas deleveraging is proceeding and almost complete, such as for private and household debt in developed markets.
- Consumer confidence levels and other surveys looking more robust
The fact that yields are at historically low levels is not a sign of stagnation for the expansionary camp, but a positive fact that results in ultra-low interest payments on debt burdens and the potential for significant upturns in consumer and capital spending.
The optimists, if that is the correct word, think that the Fed will initiate the tightening cycle sooner than expected.
The 'regular recession' camp are obviously more wary of fixed income investments, fearing losses when rates start to rise throughout the different sectors.
They are more positive on equities however - perhaps seeing an 8%-10% return over a five year horizon. With continued low inflation, a continued (relative) easy monetary policy in the States and an improving economy there are reasons for the 'regular recession' protagonists to see further equity market gains.
Seventy-six years ago, Alvin Hansen introduced the term 'secular stagnation' in a speech that highlighted concerns about the depressed economy, the low level of birth-rates and the lack of discoveries of new resources. He was concerned about the rate of technological progress and the ability to keep the economy growing at historical levels.
His concerns are eerily similar to the concerns of some commentators today, as highlighted above. Hansen's original speech was insightful and persuasive - and turned out to be entirely wrong. Instead, his speech was the prelude to several decades of economic boom during and after World War II. Strong growth saw the US rise quickly to global economic dominance on the back of a baby boom, soaring investment and strong aggregate demand.
The question remains then whether Alvin Hansen's concerns were accurate, but were made seven decades too early. It is certainly possible that some major exogenous event will occur that raises spending or lowers saving in a way that cannot be predicted. It may well be that there is some new unforeseen technological development round the corner that will radically alter the future prospects of growth.
But for now the debate of whether the developed world is at the early stages of a strong recovery, or languishing in a new era of economic stagnation, is set to run for a while.
And if you, like me, are prone to sitting in a paddle boat on a sunny afternoon going round in circles, you may find it a useful way of passing the time to think about the role of monetary policy and fiscal policy in future economic progress. Maybe monetary policy has done all the hard work over the last few years, and if governments are brave enough to embark on some serious structural and budgetary reforms, the global economic paddle boat could stop going round in circles.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.