Friday, August 22, 2014

Secular Stagflation - the big issue

The issue of secular stagflation runs through all discussions of global macro investing. Call it the "new economy", the "new normal" or something else, but this is the benchmark theme that has to be used to assess current management strategy and portfolio structure.

Any discussion of secular stagnation needs to divide the conversation into three parts: long-run growth, the deviation or gap away from the long-run (cyclical), and  level changes in growth. Confusion arises when the discussion does not make a distinction between these three. Any discussion of output gaps, inflation, natural rates of interest and unemployment all have to account for economic growth trends, cycles, and levels 

Most of the discussion concerning macroeconomics is about cyclical variation around the trend and not the trend itself. This focus is misplaced.  Of course policy-makers and investor always are looking at what is going on in the short-run, but the big money and the overall wealth of the economy is driven by growth trend. Cycles grab headlines but trend growth drives long-term economic well being. Any policy-maker who is not engaged in discussion on the growth trend is really wasting his time. Not that the cyclical will always take care of itself, but inventory or credit distortions do have a way of solving themselves. The one-off level changes also cannot be solved. It can be thought of as a dead-weight loss. You cannot get back part of economy that is destroyed in a bubble. 

The long-run growth trend in the US is likely to be lower because there are strong headwinds that are not easily solved. There is a slowdown in the growth of productive inputs and there is a lowering of total factor productivity. The post-WWII period was an unusual period of high productivity that is unlikely to be repeated. These headwinds cannot be easily solved and certainly will not be solved by just lowering interest rates. The demographics are also working against higher growth. Workers are getting older and their consumption patterns are changing. The growth and productivity boost from higher education is also behind us. The educational requirements are higher now to be more productive but the percentage who can go for higher education is hitting limits. Clearly, the boom in education post-WWII was significant. There was a major step-up in education and knowledge but current gains are more marginal. Income inequality has devastated the middle class which affects productivity and consumption patterns. This hurts growth. The size of the public debt is a net drag on any marginal government investments. Government investment will usually have lower returns on capital especially if it is focused on redistribution and not infrastructure development. How you spend the money matters. 

If this trend is lower for the US and the developed world, return on capital will be lower. The big money is going to be made in those places where trend growth is higher. Long-term rates of interest will be lower which leads to lower bound problems in rates. This issue of low rates affects our ability to get out of any cyclical growth shortfalls or gaps. There is less room for policy-makers to maneuver.  Finally, crises or shocks that lower the level of GDP will have a long-term effect. Some formerly productive assets will not be put back to work. Some loses will not be recouped.

On top of this backdrop there is the fact that monetary policy, through excessively low rates, will increase the chance of bubbles which may mask these secular trends. How can you trade stagnation when a bubble is pushing asset prices higher? You have to embrace bubble risk. Clients demand return, so the short-run cannot be forgotten. This is a sobering story, but one that has to be digested. 

No comments: