A Plane on the Tarmac
J.P. Morgan Funds
By David Kelly
July 26, 2012
A few weeks ago, I was sitting in a plane on the tarmac at La Guardia. We had pulled away from the gate, but the pilot had just come over in the intercom to let us know that we were number 35 in line for takeoff. Since we were going nowhere fast, I took out my laptop and tried to think of an analogy to describe the current state of the American economy. Then I realized that I was sitting in one.
The American economy today is like a plane stuck on the tarmac, a long way from takeoff. It is moving forward, but doing so very slowly. However, it isn’t really in any danger of “stalling out” because it never took off.
The slow growth is undeniable. The last recession technically ended in June of 2009 so the economy has been growing for just over three years. However, in the first 11 quarters of the recovery, real GDP grew at a rate of just 2.4%. One reason for this has been the fiscal drag from a falling budget deficit. In fiscal 2009, the federal budget deficit came in at 10.2% of GDP, while this fiscal year, it should be roughly 7.6% of GDP. While this fiscal improvement is both welcome and necessary, it is acting as a drag on overall economic growth. During the past 11 quarters, while real private sector output has grown by 3.3% per year, real government spending has fallen at a 1.3% annualized pace.
A second drag on the economy has been very tight credit. Banks have eased lending standards somewhat over the past two years but only to a small degree relative to the prior tightening. This is in part due to regulatory pressure to bolster balance sheets that are already, honestly, healthier than they have been in decades. It also may reflect the results of Fed policy lowering long-term interest rates to levels that should be unattractive to lenders.
The U.S. is also being hurt, to some extent, by the slowdown in global economies, although this should not be overstated. In the first 5 months of 2012, U.S. exports were up a healthy 45% from the same period in 2009, and the U.S. is, in any event, much less dependent on exports for economic growth than other developed nations.
While all of this has slowed the American economic recovery, the danger of a slide back into recession is very slight. Recessions tend to be concentrated in the most cyclical sectors of the economy – autos, home-building, business equipment spending and inventories. These four sectors account for only 20% of our GDP in the long run but roughly 140% of the output lost in a typical recession. The key point is that they can only really collapse if they have rebounded from recessionary levels and this hasn’t happened yet. Even after years of building pent-up demand, auto sales and housing starts are still far below average levels, business equipment spending remains subdued and inventory/sales ratios are very tight. All of this provides a high degree of inoculation against recession, and bolsters prospects for stronger economic growth going forward.
Three other big positives in the outlook include recently lower oil prices, much improved consumer finances and what appears to be the start of a rebound in home prices.
Of course, there are risks to the outlook – issues that could cause economic growth to falter. These include the danger of too-aggressive tax hikes in 2013, renewed turmoil from Europe and the potential for conflict with Iran over its nuclear program. However, the most likely scenario is a slow gathering of momentum in the U.S. economy.
In light of this, the relative pricing of financial assets seems extreme. The Federal Reserve has pushed short-term interest rates to near zero levels, and by buying billions of dollars in government bonds, has succeeded in reducing long-term interest rates to extraordinarily low levels as well. Meanwhile, price/earnings ratios on equities are generally below their long-term averages.
This combination of expensive bonds and cheap stocks has left relative valuations at extreme levels. One measure of this is the gap between the “earnings yield” on stocks, (which is just the inverse of the P/E ratio) and the yield on 10-year Treasury bonds. By early July, this gap was wider than it had been in over 98% of the days in the last 50 years. Indeed by this measure, in early July, stocks were cheaper relative to bonds than was the case in the midst of the Cuban missile crisis, the day after the 1987 stock market crash, the day the market reopened after 9/11 and the day after Lehman declared bankruptcy.
Despite all of this, in the first half of this year, as has been the case for the last four years, investors, on average, took money out of stock mutual funds and put money into bond funds. For long-term investors, this is probably a mistake. While the economy is only slowly moving forward, it is not moving backward, and markets are priced for a far more scary environment than, in fact, exists. This being the case, long-term investors, here at the mid-way point in 2012, should consider being somewhat overweight equities and underweight bonds relative to a normal allocation or, failing that, to at least be balanced in a way that allows them to benefit from gradual economic improvement rather than be victimized by it.
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