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economy Archives | R | W Investment Management

Remaining Steadfast

Once in a great while, there comes a year in the economy and the markets that serves as a tutorial for the principles of successful long-term, goal-focused investing.  Two thousand twenty was just such a year.

On December 31, 2019, the S&P 500 stock index closed at 3,230.78.  This past New Year’s Eve, it closed at 3,756.07, some 16.26% higher.  With reinvested dividends, the total return of the S&P 500 was +18.4%.

From these facts, you might conclude that the equity market had a good year.  And you would be right.  What should be instructive to the long-term investor is how it got there.

From a new all-time high on February 19, the market reacted to the onset of the greatest public health crisis in a century by going down roughly a third in five weeks.  The Federal Reserve and Congress responded with massive intervention, the economy learned to work around the lockdowns, and the S&P 500 fully recovered by mid-August.

The lifetime lesson here is:  At their most dramatic turning points, the economy can’t be forecast, and the market cannot be timed.  Instead, having a long-term plan and sticking to it—acting as opposed to reacting—once again demonstrated its enduring value.   Waiting for a “pullback” once a market recovery gets under way, and/or waiting for the economic picture to clear before investing, turned out to be formulas for significant underperformance in 2020.

The American economy, and its leading companies, continued to demonstrate their fundamental resilience through the balance of the year, such that all three major stock indexes reached multiple new highs.   And despite headwinds caused by the coronavirus pandemic and subsequent lockdowns, companies in the S&P 500 paid out a dividend of $58.28 per share in 2020, surpassing the 2019 record of $58.24 and setting the ninth consecutive annual record.

Meanwhile, at least two vaccines were developed and approved in record time and were going into distribution as 2020 came to an end.  There seems to be hope that the most vulnerable population groups could receive vaccines by spring, and that everyone who wants to be vaccinated can do so by year-end, if not sooner.

The second lifetime lesson of 2020 had to do with the presidential election cycle.  To say that it was the most partisan in living memory would not adequately express it.  Supporters of both candidates were genuinely convinced that the other would, if elected/reelected, result in the end of American democracy.  For investors who exited the market in anticipation of the election, they were surprised only to realize the enduring historical lesson which is: Never get your politics mixed up with your investment policy.

As we begin 2021, there remains more than enough uncertainty to go around.  Is it possible that the economic recovery has been largely discounted in soaring stock prices, especially those of the largest growth companies? If so, perhaps the coming year could be lackluster or even a declining year for the equity market?

Yes, it’s possible.  But how do we, as long-term, goal-focused investors, make investment policy out of that possibility?   Our answer:  We don’t, because one can’t.  Our strategy, as the new year dawns, is driven by the same steadfast principles as it has always been.  It is goal-focused and planning-driven, as sharply distinguished from an approach that is market-focused and current-events-driven.

The Federal Reserve has assured that it is prepared to hold interest rates near current levels until such time as the economy is functioning at something close to full capacity, perhaps as long as two or three more years.  As investors, this makes it difficult to see how we can pursue our long-term goals with fixed income investments.  Equities, with their potential for long-term growth of capital, and especially their long-term growth of dividends, seem to be a more rational approach.  Therefore, we must tune out “volatility” and act as opposed to react.  This proved to be the most effective approach in 2020.  We believe it always will be.

May this year bring peace and joy to you and your families.  As always, we thank you for the trust and confidence you have placed in us and we look forward to serving you in 2021!

Where’s all this fear coming from?

As I discussed in my last market outlook, economists are fearful of, slow productivity growth. Such fear is not unreasonable given the importance of productivity to our standard of living over the long term.

However, some economic policymakers today are displaying a fear that is unwarranted – the fear that the strength of today’s labor market, as evidenced by a historically low unemployment rate, will lead to a high rate of inflation.

Consider the economic theories on which such concerns are based.

The idea that a government-controlled central bank can adequately control inflation through its policies on the amount of money in circulation or on deposit at banks began in earnest with the theories of John Maynard Keynes during the Great Depression.[1]

In his 1936 treatise, The General Theory of Employment, Interest and Money, Keynes explained how the fiscal and monetary policies of the government could possibly smooth out short-run fluctuations in the economy. When the economy slows, the government should step in and increase overall demand. When the economy is growing the government should do the opposite.

That is, government should buy when everyone is selling and sell when everyone is buying.

While Keynes’s theory was widely accepted, it was never fully implemented or tested.  That is, Keynesian economics is incomplete.

For example, Keynes proposed that governments run budget surpluses throughout periods of positive economic growth. Before 1930, the U.S. government had a budget surplus in two out of every three years. In the subsequent 82 years we have seen only twelve. Currently, government spending is rising faster than tax receipts; the exact opposite of what the theory calls for.

Monetary policy is any action undertaken by a central bank to influence the availability and cost of money and credit.  Through a myriad of different actions in our banking system the U.S. Federal Reserve can push interest rates higher so as to influence banks’ ability to provide credit.  If the banks respond to such incentives they may reduce lending, thereby reducing the likelihood that prices will rise.

But just as with fiscal policy, government policymakers have rarely followed Keynes’s monetary advice. In the early 1980s members of the Federal Reserve’s policymaking committee followed the lead of Chairman Paul Volcker and dramatically raised interested rates to counteract the inflationary policies of the day.

For these reasons and more there has yet to be a full test of the Keynes’s theory, and thus a complete understanding of how fiscal or monetary policy affects the real economy. In the eighteenth century, economist David Hume argued that monetary policy has no real effect on the economy.  This idea of monetary neutrality means that over time changes in the supply of money and credit affects only nominal variables, such as interest rates and exchange rates. Such changes have no effect, however, on real variables like income and consumption.

Some economists claim that the Fed’s actions do nothing but increase financial repression. Financial repression occurs when such actions channel funds from one area of the economy to another, often the government’s own debt. Under this theory, the low interest rate policy from the Fed these ten years has simply distorted the value of stocks and other financial assets while increasing the level of uncertainty in the overall economy.[2]

Regardless of all these academic debates, policymakers continue to follow a Keynesian model known as the Phillips Curve.[3]

Economist A. W. Phillips published a report many years ago that suggested a negative correlation between inflation rates and unemployment. According to the theoretical model behind this supposed relationship, when the Fed keeps interest rates too low the money supply expands too fast. The economy moves along the Phillips curve to a point of lower unemployment but at the cost of higher inflation.

So it is fear of inflation that is keeping policymakers up at night.

According to the minutes from their most recent meeting, Fed policy makers expressed the view that “the labor market has continued to strengthen and that economic activity has been rising at a strong rate.” From this observation they concluded “that further gradual increases in [interest rates] will be consistent with sustained expansion of economic activity…”[4] However, as noted above there is no certainty as to what effect such interest rate increases will have on the real economy.

So what is an investor to do if Keynes’s theory is incomplete and such policy concerns are unwarranted?  Keep your eye on the long-run goal! Don’t let the fears of some economists and some policymakers distract you.

We invest so as to secure a better future for ourselves and our families. We invest to provide a stable level of income in retirement or protect against health or other risks.

Over the long term, the current fiscal and monetary policies are likely to have little or no effect on the performance of my investments. As long as these policies don’t substantially deter businesses from investing in their operations and new products or services the US economy will continue to grow, even after adjusting for inflation. Historically, the only consistent hedge against inflation is stocks. The return on bonds tends to only match inflation.[5]

Fear in the financial markets is mostly unwarranted. Stick to your long-run investing plan.

[1] https://www.econlib.org/library/Enc/bios/Keynes.html
[2] http://www.imf.org/external/pubs/ft/fandd/2011/06/Reinhart.htm
[3] https://www.econlib.org/library/Enc/PhillipsCurve.html
[4] https://www.federalreserve.gov/newsevents/pressreleases/monetary20180801a.htm
[5] https://fred.stlouisfed.org/graph/?g=l4pF

Measuring Our Economy

We economists continue to earn our reputation as dismal scientists. By most measures, the US economy is strong, but economists continue to fret over how fast it will grow in the future.

Consider the numbers ….

The broadest measure of our standard of living, real gross domestic product (real GDP), grew 2.3 percent in 2017, up from only 1.5 percent in 2016.  In the most current estimates for this year, the U.S. Bureau of Economic Analysis (BEA) estimates that the economy is growing at an annual rate of 2.2 percent.

Meanwhile, the rate of inflation remains below historical averages. Through April, the U.S. Bureau of Labor Statistics (BLS) reports that the Consumer Price Index (CPI) is up 2.4 percent over the same period last year, compared to a 3.5 percent annual average since the end of World War II.

The third most widely studied measure of the overall economy is employment. The national unemployment rate now stands at only 3.8 percent, well below the historical average of 5.8 percent.  This figure is also well below the level economists consider normal.  A “normal” rate of unemployment is not an exact number but refers to the amount of unemployment the economy experiences when everyone is producing goods and services at their full potential. According to the Congressional Budget Office (CBO), US real GDP is just at, or slightly above, its potential.

Everything looks fine. So, what is there to fret about?

A key debate amongst economists today is whether or not our economy can continue to grow at 2 percent or higher each year with lower than normal productivity rates.

First, consider why the rate of real GDP growth matters. If the economy grows at 2 percent a year it takes approximately 36 years for the standard of living to double. The standard of living for just about every generation in America was twice that of their grandparents. But if the economy falls back to the rates last seen in 2016, it will take much longer for our kids to be better off.  The ultimate source of growth in our standard of living is higher productivity. Since World War II, the output per hour worked in the non-farm sector of the United States has grown at an average of more than 2 percent per year. Our standard of living is much better than our parents and grandparents because workers and businesses keep finding ways to produce more with less.

However, the rate of increase in productivity over the last decade has slowed to an average of only 1.2 percent per year. Lower productivity growth will show itself in slower economic growth over time.

So how can we improve productivity and keep growing at 2 percent or more per year?

Economic theory and historical experience show that productivity is determined by the amount of physical capital, human capital, and natural resources each worker has at his or her disposal, along with the technological knowledge to use all these resources. When businesses invest in these resources, and develop new technologies to use them, worker productivity grows faster.  Looking again at the BEA data, real Gross Private Domestic Investment has increased at an average rate of only 1.5 percent over the last decade, well below an average of 4.5 percent annually since the end of World War II.  We can’t expect to keep up the current 2 percent growth rate unless business investment picks up.

Over the course of last year, the stock market did well as the economy grew faster, but a continued rise is unlikely without continued business investment. Still, investors face limited choices. As I wrote in my last quarterly report, “stocks remain the better value over bonds or cash.”  Investors are continuing to seek the safety of U.S. government debt, keeping its yield low. The rate of return on a current 10-year Treasury note remains well below its historical average. The yield spread, or difference between the 2 and 10-year notes, is only 0.5 percent, or half its historical average.  The bond market is telling us to expect slow growth and low inflation ahead.

Over the past year or so, small company stocks have done well as growth picked up. But a slow growth economy, with low interest rates and low inflation, should favor large-capitalization stocks, particularly in the consumer staples and healthcare sectors.  Without more sustained investment, the consumer discretionary and industrial sectors are not likely to do as well.

Economists will always find something to fret about, but the economy is doing well, and all types of companies should profit from it. What we must hope for is a rise in business investment that keeps the economy growing at rates that make our children better off.

The views expressed here are those solely of the author and do not represent Northwest Nazarene University or R|W Investment Management.

Peter R. Crabb, Ph.D.

Professor of Finance and Economics

Department of Business and Economics

School of Business, Northwest Nazarene University

[email protected]

 

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado.  His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others.  Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.

Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.

[i] http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
[ii] http://fred.stlouisfed.org/series/CPIAUCSL
[iii] https://fred.stlouisfed.org/series/UNRATE
[iv] https://fred.stlouisfed.org/series/GDPPOT#0
[v] https://fred.stlouisfed.org/series/OPHPBS#0
[vi] https://fred.stlouisfed.org/series/GPDICI#0
[vii] https://fred.stlouisfed.org/series/T10Y2Y#0