The Death of “New Normal” – Preparing for Normal

The term, New Normal became the new paradigm in business and economics to describe the financial environment in the wake of the 2008 crisis and the global recession that followed. Mohammed El-Erian, the then head of PIMCO, first used the term in 2010 in a lecture titled “Navigating the New Normal in Industrial Countries.”

For market practitioners, the conditions underpinning “new normal” ironically sowed the seeds for one of the longest bull markets in recent history. Reluctant money managers have only slowly adjusted to this new set of conditions. The notion of “This Time It’s Different” was famously debated between long-time market sages, Jeremy Grantham of GMO and Jim Grant, of the Interest Rate Observer at last year’s Grant’s conference. Grantham argued that a combination of slow burning low interest rates, high profit margins and low inflation has created the conditions for much higher valuations down the road. He famously asked the question, “when does dry powder become dead weight?”

As we begin the new year, investors are again perplexed by a market which is not giving the public a chance to “buy the dip.” Volatility as measured by the VIX continues to be low and we have not had a 3%-plus correction in the market since the last presidential election, the longest in history. Earnings continue to rise and interest rates are on the move. The market is signaling a return to more normal conditions.

What does “normal” mean for investors?

• Stocks and bonds will no longer move in the same direction.
• Our financial system will move back to being based on positive interest rates: inflation & deflation is what sets risk premiums.
• Deficits will matter: as corporations adjust to lower corporate tax rates in the US, the added cost to the fiscal deficit could be substantial. The current tax deal may add at least 600 billion annually to the current deficit.
• Crowding out: as we learned in the 1980s, the government will get its money given that 50% of total outstanding debt matures in the next 3 years. The average coupon rate of this outstanding debt is less than 2%. To refinance that debt, rates should rise substantially.
• High profit margins will come under pressure due to rising interest expenses and wage costs. To sustain profitability, successful companies need to demonstrate pricing power.
• Business cycles will become more compressed. The tax bill has certainly been a boost to US-GDP growth, but it will shorten the current cycle. As a result, we will worry about the next recession much sooner.
• The cost of capital will go up. For investors, this mean finding companies and management teams that are good allocators of capital rather than financial engineers. Using debt to finance growing dividends and stock buybacks will become less common.
• The relative strength of currencies, including reserve currencies like the US-Dollar, will be dictated by the relative strength of their economies rather than central bank interference.
• The key challenge for money managers will be to be more active. A return to more “normal” conditions means there will be winners and losers.

BK
1/17/18

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