Roaring Twenties or Multi-Year Depression: Two Views of the US Economy and Equity Market
I’ve been attending the BCA Research Fall Investment Conference regularly for about 20 years. It always offers a great opportunity to ponder big-picture investment themes and connect with other investment professionals. It typically brings together an impressive array of speakers, who address key issues related to the outlook for the global economy and the financial markets. The conference is usually held in New York, but, due to the COVID-19 pandemic, it was held virtually for the first time. What follows is a recap of a particularly interesting session, “Debating the U.S. Economic and Market Outlook,” which featured two prominent economists/strategists with very different views, Ed Yardeni, president and chief strategist at Yardeni Research, and David Rosenberg, founder and president of Rosenberg Research & Associates.
Ed Yardeni: Get Ready for the Roaring Twenties
We are fighting a “World War” against the COVID virus on three fronts (health, financial, and economic), and we have made significant progress on all of them, according to Yardeni. He believes US economic growth will be very robust in Q4 (around 10% annualized) and that the Federal Reserve’s forecast of 3% to 4% growth over the next few years is realistic. Inventory depletion, pent up demand, and a housing boom (that has just begun and is likely to be sustained) will more than make up for the drag from COVID-19 on hard-hit areas of the economy (travel, restaurants, entertainment, etc.).
Both the Fed and US Treasury have embraced Modern Monetary Theory (MMT)1 and “QE2 forever,” and the significance of this can’t be overstated, in Yardeni’s view. The combination of quantitative easing and MMT have put us in a “twilight zone,” as we have never seen such extraordinary fiscal and monetary stimulus. Yardeni said he can’t think of anyone who has embraced MMT more than Fed Chair Jerome Powell, who previously dismissed it. He has even put himself in the “borderline inappropriate position” of lobbying Congress for additional fiscal stimulus. The upshot is that we can now run huge deficits, and the Fed will finance them through increased bond purchases. Consistent with MMT, we can keep doing this until inflation becomes a problem. Yardeni believes that if bond yields were to rise above 1%, the Fed would implement yield-curve control policies, committing to keep longer-term rates between 0.5% to 0.75% to support the economic recovery.
The environment Yardeni foresees would be very bullish for stocks, and he does not believe current equity valuations are excessive. He is bullish over the longer term, as well, noting that we may have entered another “roaring twenties.” He notes the historical analogy of the 1918 pandemic, which was accompanied by a world war and followed by a recession in 1920. Pessimism was even more pervasive back then than today, and few in the United States anticipated the innovation and prosperity that followed the Spanish Flu and the First World War. Today, he noted, there is no shortage of transformative technologies that are starting to have a strongly positive impact, and the next 10 years could see innovation accelerate.
David Rosenberg: We are in a Multi-Year Depression
Rosenberg noted that a depression is not defined by continual declines in GDP; it’s distinguished from a normal recession by a secular change in people’s behavior. He thinks we are seeing this now in real time with individuals now viewing their homes as their new gym and office space. He believes we will see five million to six million American jobs lost permanently from this crisis and that this will result in a sustained “deadweight loss” on aggregate demand., Today’s economy likely represents the “good part” of recovery, he argues, as we have seen personal incomes grow during the downturn thanks to enormous generosity (i.e., relief payments) from “Uncle Sam.” Rosenberg believes the economy’s ills will return once the government programs end and that the current recovery’s shape is “backward.” That is, we are likely to see the following pattern of economic growth: bad (March and April 2020), better (May through today) and bad again (soon or whenever the stimulus subsides).
When I saw Rosenberg speak at the Strategic Investment Conference in early May, he was very bearish on equity markets, suggesting that the S&P 500 index could retest its March low. He no longer believes this will be the case, as he thinks the Fed’s extraordinary actions have reduced investor perception of tail risk. Having crossed a red line by purchasing corporate credit and even speculative-grade debt, the Fed has “created the pervasive belief” among investors that it will follow the Bank of Japan and purchase equity ETFs if necessary, Rosenberg adds. Investors are now less concerned with the fundamentals of the economy and earnings and more concerned with what the Fed will do next and with other policy-related items, including fiscal stimulus, vaccines, and elections.
The Fed’s extraordinary interventions have made it the equivalent of the blackjack dealer handing out the chips for free, says Rosenberg, who believes capitalism, as we know it, has been changed forever. Asset bubbles have become the norm (if not, the aim of national economic policy) now rather than the exception, and financial markets are being propped up at the expense of the economy. Hurdle rates for investment have been totally distorted, Rosenberg says, and the price discovery mechanism has been impaired. In short, markets are no longer functioning properly. We ultimately will pay the price in the form of misallocation of capital, zombie companies, and both zero capital deepening and zero productivity growth. While the equity market is unlikely to experience a major downturn in the near term, it has limited upside, as equity valuation is already exceptionally high, Rosenberg argues.
The Yardeni-Rosenberg debate mirrors a larger, ongoing debate within the investment community—one fueled by a massive divergence in the performance of different economic and market segments. Simply put, the pandemic has enhanced the performance of certain sectors of the economy and badly damaged others. This has prompted some economists to describe the current recovery as K-shaped. The key question going forward is which forces will win the day, those of expansion or of contraction?
Even before the pandemic, the economy was undergoing broad structural changes. COVID-related lockdowns, however, forced entire populations to work, shop, socialize and attend school online. This resulted in increased adoption of technology/digitization, turbocharging related industries and stocks. A study released by Mckinsey3 noted that “we have vaulted five years forward in consumer and business digital adoption in a matter of around eight weeks.”
Rosenberg may be right that five million to six million jobs could permanently disappear due to this crisis. Open Table has estimated that 25% to 30% of existing restaurants may permanently close. But might those jobs losses be more than made up for by increased job creation in other areas? As one example, housing and home renovation could see a sustained boom fueled by both the post-COVID-19 work-from-home demand shock and the sustained ultra-low interest rate environment. This and other areas of pent up demand, or changing demand patterns, (in addition to job gains from reshoring supply chains) could be a potent source of new job creation. Moreover, after a vaccine is widely available, will our desire to frequent restaurants be any less strong than it was prior to the pandemic? Might a post-pandemic surge of restaurant visitors create windfall profits and expansion opportunities for surviving restaurants, as well as opportunities for new restaurants to open?
We lean more toward the Yardeni view in that we think the economic recovery will be sustained and that we are unlikely to lapse back into a period of falling output or outright stagnation. But it’s impossible to know whether we’ll enjoy a Roaring Twenties-like boom despite the promising prospect of technological advancement. Working-age population growth, for example, was much stronger during the 1920s than it is expected to be in the 2020s. More positively, we think fiscal stimulus is likely to be sustained well into 2021 (and perhaps beyond) and that rising animal spirits (after a vaccine is widely available) will make the eventual fiscal retrenchment manageable. The moral hazard issues Rosenberg raises are real risks. Asset bubbles and misallocation of capital could weigh on productivity and undermine future economic growth. However, the unprecedented policy stimulus could also buy the economy the time it needs to harness structural changes in the digital era and develop new growth drivers. Finally, we are bullish on the underlying technology innovation story, which is that creative destruction, fueled by pandemic-driven technology adoption, could bolster productivity growth.
2 QE refers to quantitative easing
3 The Next Normal: The Recovery Will Be Digital, McKinsey & Company, August 2020