Nearly a decade of crises produced a prolonged period of subpar economic activity. First there was the financial crisis, then the European debt crisis, and finally the 2015-2016 commodity price rout. Nominal GDP growth collapsed. In fact, in 2015, world nominal GDP contracted as commodity and oil prices floundered. Feeble growth came about because of poor demand, but also as productivity—a building block of economic growth—broke down. Fears of a double-dip or even triple recession weighed on sentiment. Businesses were hesitant to invest, consumers did not want to spend, and investors refused to take on risk. Poor demand and excess capacity fueled deflation. Deflation disincentivized consumers from spending and made debt harder to pay down. Many analysts thought we’d be in this tepid economic environment, the New Normal, forever.
The New Normal economy had consequences for financial markets. Little economic and price growth meant low interest rates. Extraordinary monetary policy put even more downward pressure on rates. Ultralow interest rates and massive central bank intervention fueled asset price inflation. Despite unenthusiastic economic growth, market returns were wonderful.
But now the economic environment is changing. Deflation is over. No major country has declining producer or consumer prices. US inflation is in line with the Federal Reserve’s (Fed) target. Inflation should firm in Europe as wage growth picks up. Confidence is up. US consumer sentiment is at an 18-year high, small business confidence hit a record high in August. European consumer sentiment reached the highest level since 2000 in January. In the United States, productivity growth, which had constrained overall GDP growth, is turning around. Output per hour grew 3.0% in the second quarter and 2.2% in the third quarter, well above its 1.26% 10-year average pace. Going forward, productivity growth should accelerate further given the recent upturn in investment spending. Fixed-asset investment spending is a good leading indicator of productivity growth. More broadly, we expect the recent break out in US growth to continue. US GDP growth may not sustain its second or third-quarter pace, but growth in 3.0% range may last a few more quarters.
The end of the New Normal, while good for the economy, may be challenging for financial markets. Depressed interest rates and extraordinary monetary policy are finished. As the market adjusts to these changes, financial conditions are tightening, and volatility is picking up. Today’s inflated multiples—that came about because of ultralow interest rates—mean future returns will likely be muted. Forward returns are negatively correlated with a stock’s starting price-to-earnings ratio. Investors got used to abnormally high market returns over the last 10 years. As the New Normal era comes to an end, investors can adjust their economic growth expectations up but must adjust their market return expectations down.
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