Keep on borrowing and buying

Despite a catastrophic decline in GDP in the first half of last year, the US economy managed to stage an almost complete rebound in the second half. By the end of 2020 the economy was only 2.5% smaller than its year-end 2019 level. Most observers expect at least a few more strong quarters of growth, which will almost certainly allow the economy to break new high ground within the next several months.

Unfortunately, economic growth is not about to set any long-term records. For 50 years, from 1966 through 2007, the US economy grew at an average annualized rate of about 3.1%—a great and dynamic expansion which saw the economy almost quintuple in size. The came the Great Recession of 2008-9. Not only did the economy fail to recover to that long-term 3.1% trend in subsequent years—for the first time ever, following a recession—it went on to post only slightly more than 2.1% annual growth in the decade from 2009 through early 2019. It was the weakest economic expansion on record, and it looks set to continue for the foreseeable future, I'm sorry to say.

Chart #1

Chart #1 uses the magic of a logarithmic y-axis to show how the US economy followed a 3.1% annualized growth track for 50 years. (With a logarithmic y-axis, a line with a constant slope represents a constant rate of growth.) Then, beginning in 2009, it managed to grow only 2.1% per year for the subsequent decade. (See this post for more details as to why.) We've been living in a sub-par recovery since I first anticipated it back in early 2009, thanks to too much regulation, high taxes, and too much government spending. Those same forces will act as headwinds for the economy in the years to come, with Biden promising a virtual replay of all of Obama's anti-growth policies—and possibly even more. Slow growth has left the economy substantially weaker and smaller (by about $4.5 trillion per year, as shown by the gap between the blue and green lines) than it might have been had the prior 3.1% growth trend persisted. 

Chart #2

Chart #2 is similar to Chart #1, but it zooms in on just the past two decades. The green line shows the same 3.1% trend growth rate that features in the first chart. The dashed red line shows the trend that persisted throughout the Obama years and into Trump's first year. Note how the economy perked up a bit in 2018 and 2019 as Trump's policies boosted growth above the 2.1%, a period which culminated in record-breaking real household median income growth, as shown in Chart #3.

Chart #3

The US economy would need to grow by 5.2% (after inflation) this year in order to reattain its 2.1% trend growth by the end of this year (see Chart #2). Most analysts are optimistic, but few, if any, expect growth to exceed 5%. I wouldn't be surprised if it did, however, but I would not expect to see more than 2% annual growth beyond this year, especially if Biden manages to implement his green energy policies and higher taxes on wealth and business. Looking long-term, we're likely to be stuck in a slow-growth world, much as we've seen over the past decade or so.

Chart #4

Near term, though, growth should be pleasantly robust, as the economy emerges from its Covid travails and a return of confidence boosts consumer confidence and business investment (see Chart #4, which shows capital goods orders, which are a good proxy for business investment). There's a lot of slack in the economy that will be put back to work as the Covid problem slowly recedes; already, daily new Covid cases are declining nearly everywhere and vaccinations are proceeding at an impressive pace. At the same time, Covid-related restrictions have forced the economy to do more with fewer resources, thus providing a one-time boost to productivity, which surged at a 7.5% annualized pace in the second and third quarters of last year and likely closed out the year on an unusually strong note.

Chart #5

Not all is sweetness and light, however. Chart #5 compares the real yield on 5-yr TIPS to the 2-yr annualized growth rate of GDP—not surprisingly, real yields tend to track the real growth potential of the economy. With 5-yr real yields now abysmally low (-1.8%), we can infer that the market sees very little growth potential for the US economy in the years ahead. A charitable interpretation of this chart would suggest the market expects real economic growth to average about 1-2% per year for the foreseeable future. Thus, although my expectation for 2% annual growth seems rather modest in an historical context, I'm only essentially agreeing with the market's expectations.

This modest growth outlook would ordinarily not provide much support for equity prices. However, in the context of a zero-percent cash environment, equities still have a better expected return than cash or cash equivalents. And with the Fed seemingly determined to keep short-term rates very low for a long time (the market currently expects the Fed funds target rate to remain roughly unchanged for the next two years), the inflation-adjusted return on holding cash is going to be negative for a long time. Holding cash is virtually guaranteed to be a losing strategy in terms of purchasing power. And that effectively boosts the demand for just about anything and everything other than cash and short-term bonds. Equity, commodity, and real estate prices are all rising, and that's not surprising given the Fed's policy stance.

Chart $6

A final note: inflation expectations embedded in TIPS and Treasury prices are now approaching 2.33%, as Chart #6 shows. This cannot go on much longer, I fear. Sooner or later Treasury yields are going to have to start rising. But in the meantime, it pays to borrow, since interest rates are so low relative to inflation, and it pays to buy, since expected returns on non-cash assets are much higher. It's not unreasonable to think we are in the early stages of an inflating "asset bubble."

All of these considerations leave me nervously optimistic about the long-term outlook for equities. I don't think the Fed's desire to boost inflation is consistent with a long-term healthy economic outlook, because higher inflation will eventually undermine confidence and the economy. Unprecedented monetary expansion in recent years has not yet resulted in any significant increase in inflation, but only because the demand for cash has been extremely strong. Sooner or later the Fed will get its way and money demand will fall (market sages are fond of saying you should never bet against the Fed's ability to get what it wants, and I think they are right). But just how long the Fed can undermine the world's demand for cash and avoid an unhealthy increase in inflation is really the only issue at this point. If the Fed doesn't thread this needle just right, inflation expectations could become "unmoored," and that eventually would lead to a significant tightening of monetary policy which in turn would most likely result in yet another recession somewhere down the road.

Meanwhile, "borrow and buy" should continue to be your mantra, even if it makes you nervous.