The Muddle Through Economy

John Mauldin | Thoughts from the Frontline
May 30, 2003

This week we will visit one of my main themes for the last two years: the Muddle Through Economy. This is a summary (and first draft) chapter on the topic from my book-in-progress. I also, with a great deal of trepidation, set out my thoughts on the US economy for the rest of the decade. Making predictions is a scary thing.

(To those who sent in book title suggestions, we are slowly sifting through the almost 1,000 book titles that were submitted. In a few weeks, I will narrow them down to three and let you decide which is the best.)

My publisher tells me there are a significant number of new readers this week, taking us to over 2,000,000. I welcome you. As a quick intro to this letter, my thesis is that we are in a long-term secular bear market; that stock market valuations will go to low double digits over the next decade; and, that investors should be looking for investments which offer Absolute Returns.

The Muddle Through Economy

"...but if you think of the US as a stock, it was overall one helluva mover." Warren Buffett commenting on the growth of the US economy in the last century

I have demonstrated in previous chapters that there is little statistical correlation between the performance of the stock market and the performance of the economy. But that is not to say the economy does not matter. In the long run, it not only matters a great deal - it is the driving force for all investments.

I have used the phrase Muddle Through Economy in the preceding 14 chapters to describe my view of what we face in the coming years. By that, I mean an economy which will indeed be growing, but that growth will be below the long term trend. The Muddle Through Economy will be more susceptible to recession, similar to the period from 1969 to 1982. This is an economy which must strive to move forward burdened with the heavy baggage of old problems created in the last century while facing the strong headwinds of new challenges.

Understanding this concept is critical to your recognition of how to invest and plan for the future. Like generals who plan for future battles based upon the last war, if you plan for a future which looks like the 80's and 90's, you will not be happy with the outcome of your investment battles.

This is not a message of gloom and doom. To suggest we will face recessions in our future is not to say the world is not coming to an end. It is simply changing. Successful investors must acknowledge the fact that we face a different set of challenges. I believe this chapter is a realistic assessment of the challenges we face. You can focus on the problems, but that is not productive. It is much better to see them coming and work to avoid their investment consequences by finding better alternatives. There are any number of exciting opportunities available to the prepared and creative mind, as we will see in the remainder of the book.

The Muddle Through Economy means businesses and entrepreneurs will have to adjust to new and different ways of growing their companies and making a profit. Individuals, especially the Baby Boomer generation, will have to adjust their expectations about retirement and the future. The good news is that "adjusting" is what Americans do better than any people in any country in the world. Change is something we have lived with all our lives. Responding to change and new opportunities is what drives the American free enterprise economy.

To get an idea of what we are facing, we will look at some historical numbers to give us a proper perspective. Then, let's look at the challenges to economic growth. Some we have dealt with in detail in past chapters, and some we will look at anew. After we have this concept down, for the remainder of the book we will explore what absolute return types of investments are likely to do better for the rest of this decade. Finally, we have a final discussion of where the seeds are being planted which will yield the next economic boom.

The American Growth Machine

* Since 1940, there has only been one decade when per capita Gross National Product did not grow by 24% or more. That was in the 1950's, when it "only" grew by 18%. It was 50% in the 40's, 33% in the 60's and 24% for the last three decades. That is a remarkable record of increasing productivity and economic growth.

But just like the stock market, the growth was not in a straight line. From 1965 through 1981, the Gross National Product grew 373%. From 1981 through 1988 the GNP grew 177%. In the first period the Dow rose by less than one point, while in the latter it rose over ten times, topping out at 13 times in 2000.

* From 1967 until 1981, real GDP only grew 2.37%. From 1988 through 2003, real GDP grew at 3.42%, which includes two recessions. That small difference of 1% is a large difference over time.

You can pick any start date and any end date since the end of WWII and find no period, even in the worst recessions, where the economy did not grow over a two and one/half year period.

* The Fed began collecting data on Gross Domestic Product (GDP) in1947, and has "real" or inflation adjusted data from 1967. The Fed uses the GDP-deflator instead of CPI to determine real GDP growth. (The Fed believes the GDP deflator has an advantage over the consumer price index [CPI] because the deflator isn't a fixed basket of goods and services. Changes in consumption patterns or the introduction of new goods and services will be automatically reflected in the deflator.)

Real GDP for the years 1947 through 2003 is around 3%, which not coincidentally is close to the very long term growth rate trend for the US. Various economists use various measures to approximate growth since 1800, but by and large they come to the same general conclusions.

* Inflation is also a factor in the apparent "growth" of the economy. The decade of the 70's saw an average of 7.2% inflation, with several years over 10%. Thus, the growth of the 1965-1981 period looks twice as large as the next 17 years, but in real terms they were quite close.

Even in a period of stagflation as we had in the 70's with high prices and unemployment, the economy grew. Yet as we have seen, stock market valuations went to single digit P/E ratios.

History shows us there is every good reason to believe the economy will grow in the remainder of this decade. The question is, "How Much?"

I believe the period in which we now find ourselves, and in which will be in for at least for another 7-10 years, will mark a below trend period of growth for the US economy. It will be more like the period of `67 through `82, where real growth was "only" 2.37%. I also believe the overall behavior of the economy will be more like that period, with more frequent recessions and a secular bear market cycle.

Let's look at the possible reasons for slower growth.

There are three accepted cornerstones of the US economic engine: consumer spending, the housing industry and capital investment by business. Each of these areas has problems that must be dealt with before the economy can once again begin to grow above trend.

The US Consumer Begins to Withdraw from the Consumption Wars

Two-thirds of the US economy is based upon consumer spending. Food, clothing and shelter make up a good portion of this, and the need for these will not go away. But as we saw in the chapter on demographics, the population of the US is slowly aging. As the Boomer generation gets closer to retirement they are going to see the need to save more. "Double up to catch up" will become the mantra of my generation. Add in the fact that retirees tend to spend less, as they have already purchased much of what they need, the growth that we have seen in the fast few decades in consumer spending is going to slow down. (The one real exception will be health care and there the trend is accelerated growth, especially among retirees.)

That is not to say there will not be growth in consumer spending over time. There will be. We are adding approximately 1,000,000 immigrants per year, plus families have not stopped having babies.

It is simply that the spending growth that has come from the largest part of the population, the Baby Boomers, will slow down, and that gradual effect will work its way through the economy. This natural brake upon the economy will start slowly and last for years.

There is one positive aspect to this. While the studies show that Boomers will have to work longer than their parents in order to be able to afford to retire, it also means that as they do retire, there will be a fresh demand for workers, which should work effectively to bring down unemployment, which will hopefully be one real difference between this decade and the high unemployment of the 70's.

One other limiting factor on consumer spending relates to the housing market. A good portion of the increase in consumer spending of the last 20 years has come from mortgage refinancing. There is the obvious method where consumers refinance their homes and take part of their equity in cash, spending it on home improvements or other items. There is also the increased available cash flow when consumers lower their monthly payment. Both have helped to propel the economy, not only of the US, but also of the world.

We are coming to the natural end of this phase in the economy. Mortgage rates can only go so low, and we are near that bottom. In late 1998, I wrote that I thought 30 year mortgage rates would drop to around 5% by the end of this cycle. As I write today, we are below 5.3%. While I think we have some further room to drop, it is not much. Thus, the positive effects from dropping mortgage rates are about to end.

This will have a large influence upon the housing market and home prices. Most people purchase a home based upon their available cash flow. As rates rise, and they eventually will, the amount of home they can afford will drop. This will put an upper limit on the rise in the value of homes. In some areas, we will see actual drops in the price of homes.

Before you get too alarmed, I should point out that 3% inflation (which I think will be the average over the next ten years - see below) means the natural price of a home will double in 24 years, all things being equal, so those buyers who have a longer term time horizon should do ok. Those who have bought homes at high prices in hot markets may not be able to sell their home a few years later for more than they paid. Those of us in Texas painfully remember the 80's when homes most decidedly did not go up in value.

The housing market has held up remarkably well during this last recession. Indeed, it is one of the main reasons the recession was so mild. Clearly, one of the primary thrust for this was low rates. As rates rise, the housing market will slow. Again, that is not to say it will fall off the cliff. There will always be a demand for homes. But a slower growth housing market means a slower growth economy.

Secondly, a soft housing market will affect consumer spending. We looked at studies which showed the real Wealth Effect (which effects consumer spending) is the price of one's home. Housing values have far more psychological importance than stock market values on the mood of the consumer. When a home is rising in value, consumers are happy. If, or rather when, this growth stops, it would affect the psyche of the consumer. It is just one more straw on the back of consumer spending growth.

The last problem to look at is the business spending excesses of the 90's. We simply created too much capacity throughout the world to manufacture every conceivable product. Capacity utilization is one of my favorite bellwether statistics. As of May, 2003, US manufacturing was using less than 75% of its capacity. Economists tell us that capacity utilization must be in excess of 80% for significant new business investment to occur. This can happen in two ways: demand can pick up OR companies can go bankrupt thereby reducing capacity.

The Three Amigos

How can we gauge the strength of the economic climate for business investment? I have three statistics which help me gauge the strength of the business climate. I call them the Three Amigos. They are capacity utilization, the monthly ISM numbers and junk bonds. Capacity utilization, as noted above, simply measures the amount of manufacturing capacity that is being utilized. Capacity utilization is one of the hundreds of statistics on the St. Louis Federal Reserve Bank Website: http://www.stls.frb.org/.

The ISM (The Institute for Supply Management, formerly known as the National Association of Purchasing Managers) puts out a monthly statistic called the Purchasing Managers Index (PMI) on business activity. When the number is above 50 business is expanding and when it is below 50 it is contracting. When the number is below 45 and stays there for a few months, it is time to become concerned. Conversely, when the number rises above 55, that is a very good sign. Typically, the numbers drop below 40 during recessions and rebound strongly afterwards. You can see this number at http://www.NAPM.org.

One clear exception to the strong rebound pattern was the recession in 1980, when the ISM numbers only briefly rose above 55 before slowly dipping once again into negative territory signaling a second recession in 1982. We are once again watching the ISM numbers not show a true recovery since the 2001 recession. Given the general "softness" (to use Greenspan's term), this is worrisome.

The final Amigo I watch is the price of high yield or "junk" bonds. When the prices are rising, that means interest rates are dropping and financing is easier for business. This is good for the huge number of companies that do not qualify for the lowest bank rates. When junk bonds are falling in value, this means investors are getting more conservative and want more yield for the risks. I find this a useful economic barometer, in conjunction with the other indicators. (You can observe this statistic easily by looking at various highly rated Morningstar high yield mutual bond funds.)

Right now, the Three Amigos are sending very mixed signals, which seems appropriate in that the business world in general is also sending mixed signals. Capacity utilization is terrible. The ISM purchasing Manager's Index is so-so and high yield bonds are rising.

There are other factors which will contribute to a slow growth Muddle Through Economy. The entire world economy is out of balance. As the world goes from being dependent upon the US consumer to being forced by the continuing devaluation of the dollar to develop new consumer markets, the world economy will slow down, and to the extent we depend upon the world economy for our growth, we will be affected.

Rising local tax rates will affect both personal incomes and business profits. Increased pension funding costs and increased health care costs will put pressure on profits for businesses and constraints on spending by consumers.

Balanced against these factors is the large amount of monetary and economic stimulus being applied by the government and the Federal Reserve. There are those who think it will be enough to bring us back to a new economic boom - a return to the good old days of the 90's. I have serious doubts, as we now see.

The Next Recession Begins When?

Now we come to the most dangerous part of the book (for me). This is where I peer into the crystal ball and try to augur what lies ahead. Let's look at a few facts and try to come to a conclusion.

* The one thing that would make the prediction business easier is if we had a reliable indicator which could tell us when the next recession starts. We used to have one. Sadly, it has been put to rest by the Fed.

Since the 1960's, recessions have always been preceded by four quarters by inverted yield curves. An inverted yield curve is when long term rates drop below short term rates. The classic Fed study in 1996 showed that when yields became inverted for an average of 90 days, a recession followed within four quarters. In a later private study, they looked at 19 other possible predictors of recessions and found none of them to be reliable. There was only one bullet in the prediction gun.

Thus, it was not to daring to predict, as I did, that a recession would begin in the summer of 2001 when the yield curve became inverted in the fall of 2000. Since stock markets drop an average of 43% during recessions, suggesting to readers that they should exit the stock market entirely, also seemed quite logical. (I had long since said that tech and the NASDAQ was over-valued, writing that in 1998. I was early.)

Today, the Fed is artificially holding down short term interest rates. Thus, the possibility of an inverted yield curve is simply not in the cards. (Simply holding down short term rates will not in and of itself avoid a recession. Ask the Japanese.)

* The Federal Reserve is applying a large amount of stimulus to the economy, both by increasing the money supply by significant amounts and by holding down interest rates. The result has been a very mild recession and because of the resultant low interest rates, a buoyant consumer and robust housing market.

If the Fed were to raise rates, mortgage rates would rise and the housing market would fall. Consumer spending would slow down. Thus, they cannot raise rates until the economy is much stronger.

They are hoping that business spending will pick back up, creating jobs and economic growth, thus taking up the slack before they have to raise rates.

* After fighting inflation for 20 years, the Fed is ready to declare victory. We are now close enough to outright deflation that several members of the Fed openly worry about the prospect. The Fed has made it very clear they will not allow the US, to the extent they have the power, to fall into deflation. This is not something they are doing in secret. They have made their plans well known, as documented in earlier chapters.

* Recessions are by nature deflationary. If the Fed thinks we are going into recession, I believe their main course of attack will be to lower long term rates, thus lowering mortgage rates and helping to maintain that important part of the economy. This will be in addition to expanding the money supply and watching the dollar drop.

Pity the Poor Fed

Thus the Fed is between the devil and the deep blue sea. They cannot raise rates because it will throw the economy into recession. However, we have not worked through much of the excesses of the last boom, so eventually, sooner or later (probably sooner), there will be a recession. When there is a recession, they will not be able to lower short term rates, as rates are already low. I believe they will then work to lower long term rates (thus mortgage rates) in an attempt to bring us out of recession and avoid deflation. We will see stimulus from the Fed that only few can imagine now.

My guess is this will work to some degree, but it will also bring back inflation. As inflation comes back, rates will rise. The Fed will let inflation go beyond its unstated 2% target in the hope the economy will be growing steadily, before they raise rates. However, unless they carefully maintain balance, we could see inflation rise too much or we could slip back into recession, or very slow growth. This will be the most critical period for the Fed in this cycle, as they will have few, if any, bullets left. Long term rates will be as low as they can practically go. Even lower rates will have little effect upon the economy.

Slow growth and inflation? Recessions? We have seen this movie before -- it is called "Stagflation: The Return of the 70's." Only this time it will star Alan Greenspan in the role of scapegoat.

The Fed is hoping we can grow our way out of the problems left over from the Bubble 90's: excessive debt, too little savings for retirement, a possible mini-bubble in housing, government deficits, and a world economy inordinately imbalanced. Their hope is that we can do this without another recession, or at least only a mild one, simply by applying enough stimulus.

The Fed has little choice but to continue to provide a great deal of stimulus and continued monetary easing. If they allowed the economy to slip into deflation, they would be roundly vilified. If they decided that they needed to cure the excesses of the bubble by raising rates, they would be taken out and hung. Their choice is simply to do more of the same. They are like the doctor treating you after a week long drinking binge. All he can do is tell you to drink lots of liquid, take Advil and lay off the hard stuff. The Fed can give us water and Advil, but we are still going to have to deal with the hangover.

I strongly believe that we have to take the Fed at its word when they say they will not allow deflation. When the economy slows, they are going to give us more stimulus. The problem is that more of the same stimulus will eventually lead to inflation and thus force them to raise rates. This will have the effect of slowing the economy and creating stagflation. There will be anguished howls from many quarters. The 90's were a wonderful time to be Fed Chairman. I cannot imagine why Alan Greenspan would willingly choose to stay in that role. There will be few applauding him, or calling him the Greatest Central Banker in History, for choosing stagflation.

My best guess is that we will have two recessions within the next 7-10 years, and one of those within the next 2-3 years. That is not going too far out on a limb, as we have had five recessions in the last 30 years. We have just gone through the largest economic bubble in history. It is not reasonable to think the excesses of that time can be marked "paid in full" in a mere three years with only one mild recession.

As an aside, if we have a recession within the next few years, mortgage rates will drop below 5%. This will be your once in a lifetime opportunity to load up the truck with long term money at very low rates. I for one intend to take full advantage of it.

During the Muddle Through Decade the economy will still grow 2%+ on average over the entire cycle. Inflation will go back over 3%. Since corporate profits grow by GDP plus inflation, it is likely to see profits almost double in the next 10 years, as well as see the economy grow substantially. The second recession should also correspond to the end of the secular bear market in stock market valuations.

Just as the recession of 1982 (the third in that cycle) created the best stock market values for decades, I think this is one historical fact likely to happen again. I doubt Business Week will again signal the bottom by making their cover headline "The Death of Equities," but the interest in the stock market will be at a cycle low. Thus, it will be time to buy with both fists. Value investors will be happy, as there will be much of value from which to choose.

The key for investors during the period of the Muddle Through Economy will be investments and funds which offer absolute returns, high dividends, strong value and relative safety. There are lots of reasonable choices. They are just not the ones we had grown to love in the 90's. Gather your assets for the next boom, or husband them in retirement, should be your theme. A Muddle Through Decade is not the time to take large risks in the stock market.

Some Final Thoughts on the Muddle Through Decade

* What are the risks to this scenario? The major downside risk is a world-wide recession that leads to trade protection wars rather than a global rebalancing. The upside risk is the very straightforward one of under-estimating the strength of the US economy.

* From time to time you will hear analysts say when we will be in the midst of a strong bear market rally, "The market is telling us the economy is coming back."

What was the market telling us in March of 2000? Or in 1982? Or in 1987 or 1998? In the short term the market is driven by emotion. The stock market has risen, often by more than 20%, in 50% of the years of every secular bear market in history. Yearly stock market movements are random, and reflect the hopes and fears of investors and not some collective prescient knowledge.

It is perfectly consistent to think the economy will grow by 25% in real terms and 50% in nominal terms over the next 10 years and still think the stock market will be flat over that period. The stock market is all about value. Secular bear markets occur over long periods when values fall, even as the economy grows. The link between the economy and the stock market is only valid over multiple stock market cycles which generally mean 30-40 years or longer.

The End of The Day

This is a chapter I will be working on right up until the final day of writing, which I hope is in June. I will appreciate your feedback. Do remember, however, that there are 14 chapters in front of this explaining many of the statements I make. I trust long time readers will be familiar with them. It is late in the afternoon on Friday, and time to go home and spend a night with the boys. I can confidently make this prediction: I see red meat and a night out in my very near future at the local video game establishment.

New York and San Francisco

I will be in New York speaking at the Hedge Fund Forum June 23-25. Attendees who I will have some time to meet with clients and prospective clients. You can check this out at www.iirusa.com/hedgefundforum. Use the code XUSPKR and get a 15% discount. I will also be in San Francisco August 13-17 at the 2003 Agora Wealth Symposium. This should be a very interesting conference for active investors. You can learn more by going to http://www.agora-inc.com/AGW03/home.cfm?code=18. Again, I will set aside time to meet with investors. You can email me if you are interested in meeting.

Have a great weekend, and remember that you are in control of your future. The 70's were great times for a lot of people and the next decade can be great for you.

Your wondering which prediction will be wrong first analyst,

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