Premise #2 - The Muddle Through
Era
John Mauldin
October 16, 2004
Headwind #1: The Next Recession
Headwind #3: Consumer Spending Will Slow Down
Headwind #4: Stall Speed on Employment
Headwind #9: The Shakeout from the Information Age
And Why I am a Long Term Optimist
A Short Break, Stanford, and Points Beyond
We are doing a series on my
basic investment premises: the themes which drive my overall
investment strategies. Last week we looked at some of the reasons
why I think we are in a secular bear market. This week we look
at my Major Premise #2: We are in a long-term Muddle Through
Economy.
A few years ago, many readers thought I was far too optimistic
thinking things would not get worse than Muddle Through. Now
I seem like some troglodyte bear as the economy is doing well
(see more optimism below). But I think the case for my Muddle
Through scenario is stronger than ever. This week's letter will
be the basis for my speech next week at George Gilder's Telecosm.
George, that unrepentant bull, has asked me to make the case
for a Muddle Through Economy. It may not be the most receptive
of venues, but it should be a lot of fun.
But a little history first. A reader sent me a note a few years
ago, asking if I had seen what George said about one of my recent
letters discussing the poor quality of earnings in the NASDAQ
100 after you account for options expense. Not surprisingly,
he disagreed. But he started the letter with what is my favorite
and may be the best back-handed compliment I have ever received.
"I have a confession to make, a sinful predilection to divulge.
Every week as I sweep through my emails, inadvertently zapping
precious letters from my children... I find myself helplessly
clicking through to the weekly commentary of John Mauldin...
thus joining some million morbid folk avidly consuming his casual
doom-laden prose." -George Gilder.
George and I later met and have become friends. He was kind enough
to write about my book, "Bull's Eye Investing is a lucidly
written, lambently cautionary, edifying, and diverting must-read
guide to the ways and means of hitting the gyrating target of
a 'Muddle Through Economy.' Mauldin is the Ben Graham of the
new millennium, but unlike Graham, he combines investment savvy
with a sense of humor and a gift of style."
If you would like to read a lambently cautionary, must-read guide
to investing you can go to www.absolutereturns.net or read the reviews
at Amazon.
The Perfect Economic Environment
Other than disappointing employment numbers and oil prices, you
can make a case that the last year has been pretty good. In fact,
Larry Kudlow did just that in this week's Wall Street Journal.
Let's look at his list of the good things that has happened in
the last year:
- Inflation-adjusted consumer
spending is up 3.6%
- Residential housing investment
is up 13.2%
- Capital-goods investment by
business is up 13.9%
- Spending on machine tools
for heavy-industry manufacturing is up a whopping 54.2%
- Exports and imports are up
nearly 11%
- After-tax corporate profits
are up 19%
- Industrial production is up
5.2%
- High-tech production is up
23.7%
- Productivity has reached an
astonishing 4.6% rate
- Household wealth is up 11.1%
hitting a record high of $45.9 trillion
- The GDP deflator is up only
2.2%
- The core consumer-spending
deflator (excluding food and energy) is up only 1.4%
- Interest rates are at 45-year
lows, with short-term rates at less than 2%
- 15-year mortgage rates are
just above 5%
- Home ownership stands at a
record 69.2%
Not much of a case for a Muddle
Through Economy. And George Gilder (that name again) wrote a
powerhouse op-ed piece on Kerry's economic advisors in the Wall
Street Journal on Friday, October 8.
"While regularly incurring trade gaps and budgetary deficits,
our economy has grown since the early 1980s from a level, depending
on dollar valuation, between one-fifth and one-fourth of global
GDP to close to one-third of global GDP last year. During this
upsurge entirely unexpected by the same economists now advising
Sen. Kerry, U.S. per capita GDP surged from 4.7 times per capita
global GDP in 1980 to 6.5 times per capita global GDP in 2003.
The U.S. created some 36 million net new jobs at even higher
levels of productivity and earnings, while Europe and Japan created
scant employment at all outside of government and entered a productivity
slump that continues today. Meanwhile, the U.S. won the Cold
War, and since 1990 its stock markets soared from less than one-third
to roughly one-half of global market cap. The net wealth of U.S.
households in real terms trebled to all-time records ($45.9 trillion
at last report). Debt has been shrinking as a share of overall
national assets, which now stand at a level near $80 trillion."
If you want more optimism, I highly encourage you to read the
latest 75th Anniversary Issue of Business Week on the Innovation
Economy. (It's also somewhat amusing to look at some of their
covers from the last 75 years, although I note they did not mention
the infamous "Death of Equities" cover from 1982.)
Research and Development funding, as an example, is up 10 times
in real terms, to over $250 billion, in the last 50 years.
In short, there is no end of good things to encourage us to believe
the economy is going to do well in the coming years. And that's
good, because we are going to need every positive force we can
muster to offset the problems we face. It is the juxtaposition
between the extremes of optimism and pessimism that persuade
me to believe we can Muddle Through. The "good stuff"
combined with American entrepreneurs and free enterprise will
balance the "bad stuff."
Let's start with what I mean by Muddle Through: I see it as a
long period of below trend growth caused by a series of economic
headwinds and the potential/probable return of stagflation. The
highest probability is that we do not slide into a soft depression,
but neither do we see a return of the 80's and 90's, at least
not for a long period of time. I do believe there is yet another
boom in our future, and possibly an even bigger one than we have
ever experienced. But it will not be this decade and maybe even
well into the next one before we return to normal growth patterns.
The 80's and 90's were the opposite of the Perfect Storm. So
many things came together to create the Perfect Economic Environment.
Ronald Reagan's tax cuts provided a powerful economic stimulus.
Paul Volker's (and later Greenspan') successful war on inflation
and a two decades long drop in interest rates boosted corporate
profits, lowered consumer costs, spurred investment and housing
and provided a relatively stable and predictable business environment.
We saw the birth of the Next New Thing - The Information Age
- which drove investment and resulted in the highest productivity
growth in history.
We started with the lowest stock market valuations in decades
and watched those valuations rise five times in the next 20 years.
We witnessed the evolution of the US financial markets, which
provided the capital necessary for business to invest and added
monster numbers to our national net worth. As Gilder noted, our
share of world market cap has risen to one-half.
But it was Nobel laureate Hyman Minsky who noted that the longer
things remained stable, the more likely it was that things would
become unstable. And the longer the stability, the more unstable
the period which would follow. Greenspan failed to increase margin
requirements in the late 90's and gunned the money supply in
the face of Y2K, thus inadvertently encouraging a stock market
investment bubble. The dotcom mania separated people from rationality
and their money. And then came the Crash and the recession of
2001.
When coupled with 9/11, we should have seen one of the worst
recessions in five decades. Why didn't we? Because we had a massive
arsenal of recession fighting weapons: George Bush's tax cuts;
Alan Greenspan's aggressive interest rate cuts; the stimulus
of deficit spending and massive mortgage refinancing.
So what now? As I noted, the Muddle Through Economy is a long
period of below trend growth caused by a series of economic headwinds
and the potential/probable return of stagflation. Let's look
briefly at just 9 of those headwinds, though each one could be
several letters (or books!) in and of itself. Remember, not all
of these headwinds happen at once (thank God!). These are forces
that will play out over longer periods of time, but each will
have the effect of slowing the economy.
Headwind #1: The Next Recession
When we come to the next recession, the recession fighting arsenal
is bare of conventional weapons. There are no more tax cuts to
be had, mortgage refinancing is essentially over, we are at a
limit (I hope) of increased deficit spending and there are only
a few potential and meager interest rate cut bullets left.
Therefore it is reasonable to assume the next recession is going
to be worse than the last two we have had. Recessions by definition
are deflationary. The Fed, viscerally afraid of deflation, will
provide massive stimulus probably by fixing the ten year bond
at ever lower rates. They will not protect the dollar. They will
force inflation into the system which will ultimately increase
interest rates.
Headwind #2: A Secular Bear Market
We covered this in detail last week. Summarizing: when starting
from the valuation levels we have today, history would suggest
that we will see modest, if any appreciable returns for the next
10 years. The last bull market cycle was characterized by rising
P/E valuations, which accounts for well over half of the current
market values, let alone the market tops of March, 2000. If today's
valuations were at 1982 levels, the S&P 500 would be below
450 (from today's 1100). Over the long run, Value is King, and
the market will revert to the mean and then go far below trend.
For it to not do so would be without historic precedent.
If the broad stock market does note rise significantly over the
next ten years, that will mean much pain for pension funds and
future retirees. Corporations will be forced to dip into profits
to meet their obligations, taxes will be raised by states and
cities to pay for dramatically underfunded public pension plans
and consumers will be forced to save more and work longer. We
are now at the lowest level of personal savings in US history.
We have dropped from over 12% during the Reagan era to under
1% today. Which brings us to:
Headwind #3: Consumer Spending Will Slow Down
By definition, if consumers begin to save more, they will consume
less. I am not suggesting a fall-off-the-cliff type moment, but
slower consumer spending growth will mean a slower growing economy.
We are now at the lowest levels of saving in modern US history.
When rising savings are coupled with rising oil and energy prices,
consumers will have less to spend.
Unless we see far lower rates than today, there is little room
for any significant stimulus from refinancing our mortgages.
We have run through that well-spring. Debt levels are at all-time
highs. While I don't see that as a current disaster, as we have
the ability to service current debt, the problem is that we cannot
add nearly as much debt in the next five years as we did in the
last five years without creating real problems. Since increasing
our debt was a large part of the equation for the continued rise
in consumer spending, that source of funds is drying up.
Nonetheless, consumer are now borrowing to keep up their spending.
Sadly, we are not seeing personal income rise significantly nor
as much as consumer spending. Year over year rises in income
is less than 2%, while the number of hours worked is down. This
is a trend which cannot continue. Since two-thirds of the economy
is consumer spending, this will have a major impact.
Headwind #4: Stall Speed on Employment
We need to create 150,000 jobs a month just to keep up with population
growth. Clearly, we have not done that for the last four months.
Producing less than that is what Dr. Lacy Hunt of Hoisington
Investment Management calls stall speed for the economy. Given
today's large rises in productivity, the economy needs to grow
at 3.8% in order to produce enough jobs to keep unemployment
even.
Obviously, if we are not adding enough jobs and unemployment
starts to rise, pretty soon this pushes the economy over the
edge into a recession.
Why, if the economy is so good, are we not adding jobs? I can
think of several reasons. As noted above, average work weeks
are around 33 hours. Why would employers add more workers if
there is plenty of under-utilized time from current employees?
It costs a great deal in benefits to add new employees. The international
labor arbitrage is holding down wages or allowing some jobs to
be outsourced. Current employees are far more productive and
new ones are not needed even as demand may be rising for certain
products.
Headwind #5: Interest Rates Will Rise over the Longer Term
I believe rates will fluctuate modestly in the short term and
actually drop during the next recession, possibly to the lowest
long-term levels of our lifetimes. But over time, rates are going
to rise as a Fed-induced return to inflation will push rates
back up. After we come through the next recession, higher rates
will not be good for housing, consumer spending or corporate
profits. They will be a headwind for the stock market as well.
Headwind #6: The Federal Deficit
Briefly, the US government is running large deficits. We must
lower spending (or at least the rate of increase) or raise taxes.
The adjustments, which will be necessary if we are ever to be
able to deal with the $60 Trillion problems of Social Security
and Medicare, will not be easy. They will be a drag on the economy.
We are going to need some pretty powerful forces for good to
get us out of this one.
Headwinds #7 and 8: The Dollar and the Trade Deficit
If we do not see 4% inflation and 4-5% short term rates between
now and the next recession, which I do not think will happen,
the Fed will be forced to use what Ben Bernanke calls "Unconventional
Weapons" to keep from having an "unwelcome drop in
inflation" otherwise known as deflation or Japanese disease.
As I noted in a recent letter, he suggests moving out the yield
curve and possibly fixing the rate on ten year notes for a period
of time at a rate which would significantly lower mortgage rates
and encourage investment (or at least speculation).
Of course, this will not be good for the dollar. The normally
upbeat (and always on target) Martin Barnes of Bank Credit Analyst
recently released a report on the problem of a low US savings
rate. Since I cannot come close to doing as good a job as he
does, let's look at how he summarized the problem:
"From a medium-term perspective, the problem of low U.S.
savings and a large external deficit can play out in one of three
ways. Let's call these scenarios the good, the bad and the ugly.
"The Good - In this scenario, the adjustment to lower
imbalances is entirely benign. Continued strong productivity
gains support steady growth in real incomes, and allow profit
margins to hold at a historically high level. Steady income growth
allows consumers to both gradually rebuild savings and sustain
spending at a decent pace. Meanwhile, the government takes action
to cut the deficit in ways that do not overly restrain private
sector demand. Finally, strengthening overseas demand boosts
U.S. exports, and a steady but panic-free drop in the dollar
helps boost U.S. competitiveness. In this near-perfect scenario,
the pace of economic growth averages close to potential and inflation
stays low. Equity prices grow in line with corporate earnings,
and overseas investors are happy to keep buying U.S. assets.
The current account deficit slowly shrinks.
"The Bad - This scenario involves more pain for the
economy and markets. Consumers embark on a more determined rebuilding
of savings, causing a major headwind for spending, undermining
profits and leading to below trend economic growth. Weaker corporate
cash flow and a rising federal deficit make it harder to rebuild
national savings. The dollar suffers a much steeper decline than
in the previous scenario, to the detriment of the stock market
and credit spreads. A slowdown in U.S. demand growth does curb
imports and, together with the much lower dollar, reduces the
current account deficit. However, the world economy is adversely
impacted by U.S. trends and export growth is also affected. The
ultimate outcome is a U.S. recession and an equity bear market.
"The Ugly - This is where the markets riot in order
to force a change in trend. A vicious plunge in the dollar triggers
a crash in equity prices and risk spreads spike higher. A credit
crunch takes hold as the credit markets seize up. The Fed eases
aggressively, but that just feeds further dollar weakness. Central
bank intervention is not able to stem the hemorrhaging of capital
leaving the country. The economy grinds to a halt and a long-overdue
consumer retrenchment occurs with a vengeance. With profits also
imploding, employment falls sharply, encouraging further consumer
cutbacks. The economy is at the edge of a deflationary precipice
and policymakers are relatively powerless because there is not
much fiscal or monetary ammunition to deal with the crisis. The
current account improves dramatically, but the adjustment is
extremely painful. The global economy is severely impacted, not
only by a U.S. economic downturn, but also by the deflationary
effect of a sharp appreciation in overseas currencies. This encourages
protectionism and attempted competitive devaluations in the major
regions, but that just makes markets even more volatile.
"Greenspan is banking on the 'Good' outcome, judging by
the quote shown at the start of this article. However, the odds
of this fairy-tale scenario may be no higher than 25%. The probability
of the 'Ugly' scenario is also relatively low, perhaps also about
25%. That leaves a 'Bad' outcome as the most likely.
"In all scenarios, the dollar is headed lower. Also, it
seems that a major adjustment to the saving rate and the current
account will likely occur only in the context of a recession
and equity bear market. That could still be a few years away,
implying that the U.S. will live with its imbalances for a while
longer."
Whichever scenario, and right now I think the bad scenario is
more likely, it will not result in a powerful economy. All scenarios
point to a Muddle Through Era.
Headwind #9: The Shakeout from the Information Age
There are five phases of the innovation cycle for every new "Next
Big Thing." Whether steam engines, railroads, telephones,
electricity, automobiles or airplanes, it is pretty much the
same experience. We start with the (1) actual innovation phase
and then switch to a (2) growth boom. This leads to too much
investment and overbuilding and we get a (3) shakeout. After
the shakeout, in which weak players go belly up or are swallowed
by stronger players, we are ready for the (4) maturity boom,
which is often as big as the original growth boom. Finally, the
new innovation (railroads, electricity) reaches its (5) economic
peak and is pervasive throughout an economy, and grows no faster
than the overall economy.
We are now close to the end of period two, or the growth boom
of the Information Age. We will soon enter the shakeout phase.
Some might reasonably argue that we already have started that
phase. But there is still much pain to be felt. Voice over Internet
Protocol will change the way we talk to one another and is driving
costs down. Wi-Fi and a hundred other minor Information Age innovations
are changing the landscape.
And Why I am a Long Term Optimist
That phase will also beget a maturity boom and the information
companies that survive will power a new growth phase for the
economy.
But this time, 10-20-30 million scientists, inventors and entrepreneurs
worldwide will also build on that success and launch not one
Next New Thing, but several simultaneously. I don't know exactly
what, but add a new (or several new) bio-tech discoveries, throw
in a few world altering innovations from the nanotech world (and
they are coming), add a new energy paradigm and stand back. The
combined economic power of increased knowledge and multiple new
innovations will surpass anything we have seen in the past.
Yes, first we have to Muddle Through a few very thorny problems.
It will not happen overnight. It may last another decade or longer.
It will not be fun if you are mired in the past or have no way
to adapt to massive and ever accelerating change. But for those
who are ready to adapt, and who can work their way through the
Muddle Through Era, it is going to be a helluva ride. Our kids
are gonna have fun. With a little luck and a few new medical
discoveries, many of us boomers will live to see them work and
play in the Millennium Wave - a period of time at the beginning
of this millennium when multiple transformational changes all
happen at once. But that's a subject for another book.
A Short Break, Stanford, and Points Beyond
As you read this, I am either on my way or already in Tahoe with
my bride, taking a few days rest before speaking at the Gilder/Forbes
Telecosm conference. I will probably make that the focus of next
week's letter, and then back to our series on my major economic
premises.
I will be speaking at Stanford November 12 -14 for the Accelerating
Change 2004 conference. (www.accelerating.org). I will also be one
of the keynote speakers in Toronto on November 18 at the Strategy
Institute's conference on Alternative Investments for the High
Net Worth Investor.
(www.strategyinstitute.com/111804_hnwalt/dsp_hnwalt.php).
After that I will be speaking in St. Louis December 6 (details
later). Things slow up after that, although I am sure something
will conspire to get me on a plane.
Fall is in the air in Texas. I love this time of year. Cool mornings,
but not yet cold. The Dallas Mavericks will be playing in a week
or so. This could be the year.
It's time to hit the send button and go home. #2 son is turning
16 in a week or so, and wants to continue intense discussions
about a car. I think he should pay at least half plus operating
costs. He sees that as a beginning point for negotiations. "You
bought cars for my (4) sisters! And what about Henry?" Telling
him I learned good lessons about over indulgence is not yet persuasive.
Of course, he has to get a job. In Texas, government "protects"
our kids from working before 16. (Thankfully, I was not subject
to their protection as a kid of 12.) I helped him fill out his
first employment application this week. Although he didn't notice,
it was quite the moment for Dad.
Your 'watching them grow up too fast' analyst,
John Mauldin
 John@frontlinethoughts.com
Copyright ©2004 John Mauldin.
All Rights Reserved.
John Mauldin
is president of Millennium Wave Advisors, LLC, a registered investment
advisor. All material presented herein is believed to be reliable
but we cannot attest to its accuracy. Investment recommendations
may change and readers are urged to check with their investment
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in these reports may change without prior notice. John Mauldin
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