“Those who don't know history are destined to repeat it.” – Edmund Burke
Having studied engineering and finance in college and graduate school, the last history class I took was my senior year of high school – U.S. history, with Mrs. Horgan. I remember class discussions about mistakes past leaders had made and becoming quite pleased with myself: “I would never make those mistakes. I know history and would surely do better". I don’t think I was alone in my overconfidence. Implicit in Edmund Burke’s famous line is that people who do know history will avoid repeating it. They are wise. They can view what has happened in the past, and project it into the future. Recognizing potential pitfalls, they will succeed where earlier generations failed.
But this leads me to a question that philosophers have debated – and Hollywood has exploited – for years: If we could see the future, would we be bound to it? Would we be able to change course to materially affect the outcome?
Remember the Terminator series of movies about a woman, Sarah Connor, who learns that machines controlled by a military computer system, Skynet, take over the planet in the future? She tries desperately to stop it from happening. Yet, despite all of her efforts, she fails. The machines take over the planet.
Is it possible that certain events have already happened that have put us on a path whose destination we can not alter, despite all of our wisdom and effort?
Perhaps the historical leaders that Mrs. Horgan taught us about who made those mistakes didn’t simply lack wisdom. Perhaps they were trying to prevent an outcome that was rendered unavoidable based on decisions and events that had already taken place. Perhaps with all the knowledge we have gained in the ensuing decades we could have done no better.
Today, economists studying the Great Depression are quick to identify obvious policy mistakes: The Federal Reserve raised interest rates when it should have kept them low. Congress passed the Smoot-Hawley Tariff Act enacting trade barriers when it should have encouraged free trade. With all that we know now, we tell ourselves that the Great Depression wouldn’t have been so great.
Experts look at Japan, their real estate bubble, banking crisis, and lost decade of no growth and deflation and conclude Japanese policymakers were timid. The Bank of Japan should have been much more aggressive to battle deflation. Knowing what we know now, we wouldn’t have made those mistakes. Japan’s lost decade was avoidable, we tell ourselves.
Perhaps.
Or perhaps in each case there were a series of events, conditions, and constraints that predetermined the outcome. Perhaps the wisest people today, transported to the past, wouldn’t have done much better. Perhaps when society massively misallocates its resources, profound economic consequences inevitably follow.
Perhaps today policymakers are trying desperately to prevent a painful economic adjustment that is likely inevitable after our society spent some 30 years accumulating debt to fuel consumption, rather than saving to drive investment. Perhaps the housing bubble and resulting financial crisis was largely unavoidable given our culture of debt. Perhaps the ballooning of our government’s balance sheet was inevitable in response to the crisis. Perhaps we really are in for a lengthy, multi-year period of slow growth and private sector deleveraging, and there are no policy tools to prevent that from happening.
Washington has certainly tried to prevent it: Quantitative Easing. Stimulus. Cash for Clunkers. Homebuyer tax credits. None have led to sustainable economic growth.
Is this really surprising? It is easy to generate strong economic growth when we are borrowing money to boost consumption. But now the private sector is paying down debt -- a good thing, yet it results in slower economic growth, and painful, sustained unemployment. How could we expect a short-term boost of government spending (of virtually any magnitude) to make up for a long-term reduction in private sector demand?
The economy needs to continue adjusting, and frantic activity by policymakers won’t change that, any more than Sarah Conner’s years of planning were able to stop Skynet.
In their comprehensive historical review of financial crises, This Time is Different, Ken Rogoff and Carmen Reinhart document that financial crises often lead to sovereign debt crises, as governments borrow heavily to try to mitigate the fallout. Governments often default on their obligations, either explicitly, by not paying back creditors on time, or implicitly, by devaluing their currency or inflation. Economies then go through five- to ten-year adjustment periods causing severe hardship for their citizens until debts are worked off and sustainable growth restored.
Today the Federal Reserve continues to pursue aggressive policies to meet its dual objectives of price stability and maximum employment. Operation Twist is its latest initiative. With unemployment stuck at 9%, its aggressiveness is understandable. Chairman Bernanke has been clear that the Federal Reserve will not inflate away America’s debts. He will be aggressive so long as inflation expectations remain anchored.
But, one has to wonder, if, with the noblest of intentions, we are nonetheless on a course that will eventually lead to inflation and devaluation, just as Reinhart and Rogoff have warned. Perhaps the choices our society has made in the past have predetermined that outcome, but we haven’t realized or admitted it yet.
If this extended New Normal period of slow growth and deleveraging is unavoidable, does it mean equity markets will languish for the next decade? We don’t think that has to be so.
Let’s consider how equities offer returns to investors and see what markets today are telling us:
1) Multiple expansion.
Today, trailing twelve month earnings multiples for the MSCI World are at 12.2x compared with an average of 14.3x for the past year and 19.5x for the past 10 years. Emerging markets, as designated by the MSCI Emerging Markets Index, are cheaper yet, at 9.7x. While we aren’t forecasting strong multiple expansion from here, valuations today don’t seem excessive as long as the U.S. and global economy avoid recession.
2) Earnings growth.
Corporations have enjoyed very strong earnings in the past couple of years due to aggressive cost cutting, continued adoption of efficiency-enhancing technologies, as well as exports to higher growth markets. MSCI World earnings grew approximately 4% per year the last three years, with significant earnings growth coming from outside global developed economies. While a slow developed economy won’t help corporate earnings grow quickly, many companies can generate faster growth by continuing to export to higher growth markets. The New Normal does not necessarily doom corporate earnings – and careful stock selection can help.
3) Dividends.
In an extended period of slow economic growth and deleveraging, interest rates are likely to remain low, with the real return on bonds low or even negative. No longer having a debt-induced rising tide to continue lifting asset prices endlessly higher, actual income generation from investments is important. The MSCI World today offers a dividend yield of 2.9% which compares favorably to nominal 10-year Treasury yields at around 2%. Whereas the Treasury coupon is fixed, dividends on stocks tend to grow over time. Emerging markets are also offering yields of around 3.3% today.
Based on all three factors -- reasonable valuations, healthy earnings growth and attractive dividends -- we believe with careful stock selection investors can earn attractive returns during this extended period of slow economic growth.
But we must stress one additional aspect of the New Normal that is likely here to stay: heightened volatility. We have all experienced it watching equity markets rally and plummet on an almost daily basis, in part due to economic factors and in part due to a lack of confidence in political processes on both side of the Atlantic.
PIMCO is a long-term investor, and we do not try to time short-term swings in equity markets. Doing so successfully is almost impossible. We focus on whether near-term events change our long-term outlook for the companies we like. We also work to limit the downside risk of equity portfolios through the use of “tail-risk” hedges.
For long-term investors, meaning those prepared to stay invested for three, five and even 10 years, who can endure volatility, we believe equities can offer attractive returns. If you are saving to buy a house in six months, you likely don’t want to invest in equities today. However, if you are saving for your retirement or a child’s education, then investing in equities makes sense.
Even if the New Normal doesn’t doom equities, it is inflicting real pain on millions of people who have lost their jobs. Are policymakers really powerless to do anything about it? While short-term, consumption-oriented stimulus policies have failed to generate sustainable economic growth, long-term, pro-growth economic policies could help. It is well known that large corporations are sitting on record cash levels and are nervous about investing to expand and hire more workers. Offering a one-year tax incentive won’t have much effect when it takes three years to build a new factory which then has a five-year payback period. Fundamentally reforming our tax code to eliminate deductions and encourage long-term investment could have a powerful effect on our economic prospects; tax changes can affect investment behavior the moment they are signed into law. They can also be part of a grand bargain that reforms our entitlement programs and puts us on a path to fiscal balance. And smart infrastructure investments can expand the productive capacity of our economy. These long-term policies all seem obvious but are hard politically in a polarized country.
Yes, Sarah Connor failed to stop Skynet. But she did successfully prepare her son, John Connor, to lead the resistance against the machines. While we may not be able to avoid sluggish growth, we believe investors can earn attractive risk-adjusted returns by looking globally for the companies with strong balance sheets that are best positioned to thrive in the multi-speed global economy. And, hopefully society can institutionalize the lessons from this crisis so that future generations don’t repeat it: Individuals, corporations and countries should only borrow to fund long-term investment, not current consumption.