The New Normal

David Rosenbloom

ICN Consulting

“We reiterated in very strong terms our offer, we come down a trillion from our top number, which is three, four. They go up a trillion from their top number, which was one, and that way we could begin to meet in the middle.”

Democratic New York Senator Chuck Schumer on the stimulus negotiations, 7 August, 2020

We all spend a lot of time reading opinions of others to aid the forming of our own. It is an interesting, if not circular past time. In that vein, ever since the great experiment that is our current monetary policy began at the onset of the GFC there has been a multitude of views regarding the path back to normal. And this was prior to the pandemic. So, what is “normal”? Great question. Historically it has not been what we are currently experiencing: unlimited liquidity, infinite budget deficits (the preferred unit of measurement has moved quickly from billion to trillion), sky high market multiples and direct government intervention in markets. Unless, of course, we have a new normal whereby these attributes are not concerning as they have been in the past.

Equity markets having largely recovered from the brief, but sharp, sell off in March while credit spreads are closing in on pre-virus levels. This is no doubt the result of the continuation and extension of the policies implemented at the onset of the GFC. Policies, if memory serves, which were considered at the time emergency measures to be reversed when the economy regained traction. However, despite the very sluggish growth of the past decade, the longest expansion in recent memory ensued and the policies were sustained giving their architects confidence in their efficacy. Like the boiling frog analogy, we slowly, if not surreptitiously, moved from the framework that had been in place for decades to the current situation outlined above. Many have raised alarm bells along the way, but if the Modern Monetary Theorists (MMT) are correct, it does not matter.

The fact is I do not believe that anyone can know with any certainty. The MMT’ers may be correct. They may not be. I’ll be the first to admit that I don’t really know, though I am more than a bit sceptical, especially in the longer term. However, right, or wrong the actual outcome of this set of policies will have profound impacts on economies and markets alike. What investors should therefore note is that the status quo is very unlikely to hold.  Simply standing pat may prove very costly indeed.

Of course, short term-ism dominates nowadays, as does the comfort from the apparent knowledge that policymakers have investors' backs. But the question remains, as always, where to from here? Do we still have a journey back to “normal” or are we already there? Policy used to be set with the economy in mind and investors would do their numbers and make investment decisions based on both company and economic outlooks. However, it appears that the opposite is now happening; policy is now set with markets as the primary audience.

Of course, most importantly, does any of this matter? To answer the questions, however, we must first be clear about what is happening. While complex, I believe it boils down to these two overarching points:

Point 1: The Tail Now Wags the Dog

The actions of governments and central banks clearly reflects a shift in beliefs. Historically markets were driven by economic outlooks. Policymaker actions were aimed at the economy and markets would take care of themselves. Importantly, excesses that inevitably built up during the up cycles would also be taken care of; there was moral hazard. The invisible hand was at work. Clearly this has been turned on its head. Central bankers now plainly believe in the wealth effect and their actions are thus aimed at propping up markets. The result is the unprecedented and previously unthinkable level of intervention. The thought process is that if markets go up the economy will follow, not the other way around as has previously been the case.

Point 2: Market Loves Socialism

What? Well yes, it does! It must or it wouldn’t have rebounded like it has. I am sure that most readers, if not all, would categorise themselves as staunch capitalists, or they likely wouldn’t be visiting this site. Big believers in the invisible hand. Market purists. However, the fact is without previously inconceivable unlimited government handouts and intervention in markets, record declines in GDP would be even worse and investors would not have had the confidence to wade in to stocks so early in what is the greatest economic downturn of our lifetime. Let’s be clear, what is happening now dwarfs the actions of the GFC. $700 one-off checques and pink batts have given way to payments of $1500 per fortnight, mortgage deferrals, rent moratoriums and cheques written to certain industries. The timeline for the end of these measures has been, as we all knew it would, ripped up. In the US, $25 a week extra for unemployed in 2009 is now $600. $700bn in stimulus is now trillions. The fact is that the actions of 2009 gave policymakers confidence that this works. The result had been the longest expansion, albeit at below trend levels, in recent memory. Therefore, these handouts won’t go away. And no one can honestly believe for one minute that without it markets would be where they are. Nor can we honestly believe this is one-off “crisis” action; its been with us for more than a decade.

The Outcomes

Importantly, there is no market consensus. On the one hand the bulls take great comfort in policymakers’ ability to eliminate risk which, coupled with liquidity, means the only way is up. Bears, on the other hand, point to historical valuation metrics and the supposed inherent risk in the new-age policy manoeuvres as a path toward disaster.  The philosophical tug of war has left liquidity as the winner and markets have steadily ground higher from the March lows. However, there will be an outcome and today’s policies will either be the new “normal” or will be considered a failure, and a very painful one at that. This new consensus will have a profound impact for investors, impacts to which, in my view, investors should not be complacent.

Bulls Win

Should we already be in the new normal it will become clear that the old views of capitalism have given way to the new order. A world where, except for extremely rare exogenous shocks like the pandemic, the amplitude of economic cycles will be muted as they have been for some time. Handouts are ok and deficits largely meaningless. Frankly, a utopia. Is this plausible and/or probable? Maybe. As for what this would mean for investors, there would likely be a marked rotation from growth to value/cyclical. Since the GFC the world has experienced slow growth and thus investors paid up for this scarce commodity. Despite the rebound in indices, cyclical stocks have still been largely left behind and market breadth has been poor. This has culminated in the huge multiples now being paid for growth stocks and, more importantly, a huge gulf in valuations between the two groups. Investors need look no further than the all-time high at which the tech-heavy NASDAQ now trades. Furthermore, it would likely mean a secular sell off in bonds generally, even if credit spreads tighten further, as confirmation of sustainable, rising economic activity results in a return to positive real rates and a full, risk-on reality. 

Bears Win

The experiment finally backfires. At best, very low growth and more of the same with dreaded deflation, the enemy we were originally fighting during the GFC, coming through. The worst case is this finally gives way to runaway inflation resulting in a return of stagflation, a condition not experienced by the majority of today’s investors. In either case, valuations again come to the forefront, risk assets sell off and credit spreads blow out as zombie companies fail. We’d really just be arguing over the order of magnitude.  Look out below.

The Wash Up

Unless the US political system results in an abrupt pulling of stimulus, we probably won’t know the outcome for a little while yet. It is likely that the catalyst of a forming of the new consensus view of the great experiment will be the resolving of the pandemic, either by a vaccine, acknowledging we just need to learn to live with it, or it burns itself out like the Spanish flu. At that juncture the focus will move from conjecture and news flow to economic reality. Has the experiment worked?

To date the broader markets indices, especially in the US, have placed and each way bet. Big tech stocks have been seen as the safe haven driving overall indices higher, giving the appearance that investors think everything is ok. Yet breadth is poor with the majority of stocks closer to their March lows than their February highs, gold has gone through the roof and real rates are flat or negative, not exactly signals of a growth boom. At some stage in the not-too-distant future the fog clears and a new consensus forms: it’s either worked or it hasn’t. And when that occurs it’s highly unlikely what has been working recently for investors will continue to be profitable. In other words, it is doubtful the status quo endures and the price of complacency will be high, either in large opportunity costs or real losses.  

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ICN Consulting

David is the principal of ICN, an investment consultancy providing investment and asset allocation advice to Australian businesses and investment companies. Prior to ICN, David was an institutional portfolio manager, both long only and absolute...

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