The Only “Raise” You’re Not Excited About

The U.S. Federal Reserve Board met on March 14 and 15. As expected, the Fed raised its key interest rate target by 25 basis points (0.25 percentage point). As the United States is at more or less full employment and Inflation, which has slowly accelerated, hovers near the Fed’s 2% target, this should not come at as a surprise.

We can expect two to three rate hikes by year-end, which would put the federal funds rate at 1.25%–1.50%, a level consistent with the Fed’s — and Vanguard’s — assessment of the U.S. economy’s strength.

The more interesting, and puzzling, economic analysis concerns what is happening in the U.S. equity market.

Wall Street has been on a tear, as has the TSX. The U.S. market is priced for long-term economic growth rates of 3%-plus; maybe 4%. (This estimate is based on our calculation of corporate earnings growth estimates implied by current share prices.)

But like big hair and Wayne Gretzky’s glory days, those growth rates are an artifact of the 1980s. These days, the labour force is increasing slowly. Productivity growth, which could be turbocharged by a 21st-century innovator like Thomas Edison or Henry Ford, is for now modest. And we’ve sworn off the growth-boosting but risky leverage that inflicted so much pain in the global financial crisis. The U.S. economy’s long-term potential growth rate is about 2%.

Where we were, where we are

We can see the economic differences between the 1980s and today through the lens of bond yields.

During the 1980s, the 10-year U.S. Treasury note yielded an average of more than 10%. At the end of 2016, it yielded 2.5%. The following drivers, illustrated in below, explain the change:

  • Lower inflation. In the 1980s, U.S. prices rose at an annualized 5% per year. A cart of groceries that cost USD 100 (about CAD 135) at the start of the decade cost more than USD 160 (about CAD 215) at the end. Today, inflation is barely 2%.
  • Slower productivity and labour-force growth. An aging population means slower labour-force growth. And workers’ hourly output is increasing more slowly — a rate of 1.6% per year in the 1980s, about 1% today. (That’s not bad! Before 1700, Europe experienced no productivity growth. As a result, a farmer born in the 14th century had the same standard of living as his great-great-great-grandson born in the 17th, though the latter did have Shakespeare.)
  • A lower term premium. The term premium measures the additional yield paid by longer-term bonds relative to shorter-term bonds. It’s related to inflation risks, which have declined significantly.
  • Greater demand for U.S. bonds. The remaining drivers are increasing global demand for the world’s safest asset — the U.S. Treasury note — and unexplained (residual) causes.

Drivers of U.S. interest rates since the 1980s

Decline in inflation has been the key

No time machine

Maybe new fiscal policies — tax reform that boosts investment, infrastructure projects that produce economic efficiencies — will nudge growth higher. Uncaged “animal spirits,” evident in business and consumer confidence surveys, could put near-term U.S. growth at 3%.

But none of the new White House administration’s proposals include a time machine that will take us back to the 1980s.

Our asset class forecasts, anchored on a future of 2% U.S. growth, assign the highest probabilities to:

  • Global bond market returns of 1%–2% over the next decade.
  • Global equity returns of 6%–8% over the next decade.

For the moment, the U.S. equity market is giddier, suggesting a different economic future. Our advice: Stick to your target asset allocation, even as stock and bond prices swing with changing sentiment. Rebalance to that allocation as necessary. We’re not going back to the 1980s. The calendar and the outlook have changed.

Discipline is what it takes to block out the noise, commitment is what it takes to walk the path to financial success and patience is what it takes to reach the goal.

Clement Chung

I sit here writing & documenting this as an amateur writer wondering if anyone will ever read this but I realize that as long as I am able to help just one person get out of poverty, then I will consider this side project a success. Until then, I’ll keep posting.