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The US economy is stuck in a structurally low growth economic environment which will cap upside in the market, and investors are underappreciating the potential for volatility in financial markets.
Structurally Low Growth
In recent months, the majority of macroeconomic data points continue to miss expectations with the exception of the monthly jobs report. At the March Federal Reserve meeting, the Fed acknowledged this weakness in growth and supported a stance of continuing to wait to raise interest rates until the economy shows further improvement.
Unfortunately, I believe the economy will continue to struggle in achieving sustainably strong growth because of one primary reason: debt. Consumers are still saddled with debt, and now after the past seven years of aggressive government spending, the federal government is also saddled with debt. The chart below illustrates why the US economy is struggling to grow.
The blue line represents federal government debt as a % of GDP. The red line is consumer debt as a % of GDP and the green line is combined consumer + federal. Since the mid-1970s, we’ve had a steady march upwards in the level of borrowing by both the consumer and the government. Since economic activity (consumer + government spending) can be funded by both borrowings and savings, the economic growth of the last forty years has been boosted by this continuous increase in borrowing.
However, since 2008, the US consumer has basically been tapped out. Consumer debt as a % of GDP has trended down due to the growth in GDP, but total consumer debt levels have hardly changed since 2008. Furthermore, having grown by $8 trillion dollars since 2008, federal government debt has made up for the lack of consumer borrowing, but even the US government cannot maintain budget deficits and this rate of debt growth into perpetuity. The government will ultimately have to slow its rate of spending (or increase taxes) – both of which will slow GDP growth.
Given these dynamics, it is no surprise that seven years of zero interest rate policy have done little to encourage real economic growth, but instead has simply boosted asset prices across all asset classes.
The Fed’s zero rate policy aims to increase economy activity by encouraging lending to consumers, but instead of achieving this goal, the Fed has unintentionally created a financial market that is wholly conditioned to easy money. Investors have been conditioned to “buy the dip,” to not expect surprises, and to believe in the vision that the Fed will support the equity market until the economy is strong enough to support markets on its own.
Since no one currently believes that there is any probability of the Fed failing to achieve this vision, I think the odds of surprise relative to current expectations is quite high, and for investors, surprise = volatility.