Sequestration is much in the news this week. It seems increasingly likely that the government will succumb to a forced reduction in spending on Friday (March 1). Despite much hand-wringing and recrimination by both political parties an alternative seems not in store. And after that comes a debate over lifting the debt limit of the Federal government, which runs out of cash of March 27th. March blows in like a lion and out like a…bear.
If sequestration is implemented, politicians and experts point to all manner of ills, affecting air travel, crime prevention, health care delivery, and so on. Virginia’s Governor fears that the sequester will push the Commonwealth into a recession. One estimate suggests a loss of 5% of the Virginia’s jobs over two years. ((“The Enemy Within,” The Economist February 23, 2013, page 27.))
Curiously, financial markets and executives haven’t seemed to notice. The stock market has returned to its all-time peak, up 6.3% since the start of the year. The index of uncertainty (VIX) has fallen dramatically. There is a bull market for condos in Miami. And the announcement of two huge LBOs (Dell and Heinz) presage a new wave in mergers and acquisitions. A survey of executives shows a large turn toward optimism in early 2013. ((“A Bit Brighter,” ibid. p. 64.)) Perhaps they don’t think the sequester and its ill-effects will come calling.
I think the sequester and debt-limit controversy are interesting mainly as harbingers of bigger challenges. Congress might well mitigate the ill effects of the sequestration. And on the other hand, the buoyant economic indicators most likely reflect the impact of financial repression by the Fed and the lowest interest rates in a lifetime, rather than deep-seated economic recovery. Perhaps the best advice is to keep your eyes on the big issues and not get too distracted by the forthcoming events of March.
The Big Issues
Since the Global Financial Crisis, I’ve been arguing that the only way for the U.S. and world economies to truly recover is to grow their way out of the crisis: no amount of taxes or wealth transfers will accomplish genuine, lasting recovery.
A wave of recent writing and research has sketched the drivers of this slump: adverse demographic trends, environmental degradation, deleveraging, the lack of blockbuster innovations, declining social mobility, growing income disparities, globalization, populism, geopolitics, and so on. I commend the reader to a sampling of such analysis:
- At our UVA Investing Conference last November, keynoter Jeremy Grantham summarized the argument of a subsequently much-circulated research report, “On the Road to Zero Growth.” Grantham, one of the true gurus of equity investing, attained cult status for calling several prescient turns in the financial markets over the past 50+ years. His recent report declares, “The U.S. GDP growth rate that we have become accustomed to for over a hundred years – in excess of 3% a year – is not just hiding behind temporary setbacks. It is gone forever. Yet most business people (and the Fed) assume that economic growth will recover to its old rates. Going forward, GDP growth (conventionally measured) for the U.S. is likely to be about only 1.4% a year, and adjusted growth about 0.9%.” He attributes a future of zero growth to low population growth, the decline of manufacturing, the diminishment of cheap natural resources, climate damage, food shortages, and perverse incentives (what he calls the “bonus culture.”)
- Last August, Northwestern University economist, Robert J. Gordon, published a working paper that has garnered extraordinary attention owing to the sobering argument and the eminence of the writer. The paper is titled, “Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds.” Gordon’s answer: yes, it’s over. He says that it is hard to foresee any breakthrough innovations like steam power, electricity, or indoor plumbing that might overcome the enormous drag of deteriorating K-12 education in the U.S., income inequality, globalization, resource and environmental constraints, and adverse demographic trends. In fact, he says that the growth rate in Real GDP/Capita has been slowing down since the middle of the 20th Century.
- Professor Tyler Cowen of our neighbor, George Mason University, published his own analysis of the trend of long-term stagnation. The book is titled, The Great Stagnation: How America Ate All the Low-Hanging Fruit of Modern History, Got Sick, and Will(Eventually) Feel Better. Cowen writes, “We have been living off low-hanging fruit for at least three hundred years. We have built social and economic institutions on the expectation of a lot of low-hanging fruit, but that fruit is mostly gone.” The three major forms of low-hanging fruit that he cites are free land, major technological breakthroughs, and an abundance of smart-but-uneducated kids. By exploiting land, technology, and education, the U.S. sustained an extraordinary trajectory of economic growth. He summarizes some research by Charles I. Jones at Stanford finding that from 1950 to 1993, 80% of the economic growth of that period came from exploiting previously discovered ideas along with added investment—Cowen writes, “In other words, we’ve been riding off the past…Meaningful innovation has become harder, and so we must spend more money to accomplish real innovations, which means a lower and declining rate of return on technology.” As if to confirm Cowen’s bleak outlook, The Economist reports stagnation in Silicon Valley: “Peter Thiel, a founder of PayPal…an the first outside investor in Facebook…says that innovation in America is “somewhere between dire straits and dead.” ((“Has the ideas machine broken down?” The Economist January 12, 2013 page 21.))
- The book by Carmen Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly, adds a final consideration to this sobering perspective. They find that rising debt levels precede financial crises and are excellent predictors of low economic growth and long recovery cycles after the crises. Much-quoted is their assertion that Debt-to-GDP levels of greater than 90% are associated with low economic growth. Today, the Debt-to-GDP ratio for the U.S. government is over 100% and by some economic forecasts is headed beyond 200% in a few decades. Combining U.S. governments, households and businesses, the Debt-to-GDP ratio exceeded 380% as seen in the following figure—and it will take years to bring debt down to manageable levels. Until then, consumers must save more, pay more taxes, work more, and probably retire later.
Source: www.ecominoes.com
Low growth hypothesized by Grantham, Gordon, Cowen, Reinhart-Rogoff, and others means slow job creation. It will take longer to restore the economy to full employment (and fuller rates of consumption) until jobs get created. The following graph shows that the Global Financial Crisis and Great Recession are associated with stunningly slow recovery of employment.
What could be wrong with this negative picture?
History shows that periods of economic stagnation can be extraordinarily fruitful in terms of innovation. Perhaps adversity is the mother of invention—actually, I think that invention has many parents, including civil rights, geographic clusters of talent, abundant resources, a culture of risk-taking and reward, education, and luck (I’ve discussed these in other blog posts.) In a recent book, A Great Leap Forward: 1930s Depression and Economic Growth, Alexander Field argues that the Great Depression years of the 1930s featured very high rates of innovation. And in his latest paper, Robert J. Gordon associates a second industrial revolution with the years 1870-1900, roughly the years of the “long depression”—the leading innovations then included the commercialization of electricity, the internal combustion engine, and indoor plumbing with running water.
Perhaps some major new technology will come along that creates significant value for the US economy. Wishful thinking won’t feed hungry mouths. But it is also true that innovation has been declared dead before. Henry Leavitt Ellsworth, U.S. Commissioner of Patents, declared in 1843, “The advancement of the arts, from year to year, taxes our credulity, and seems to presage the arrival of that period when human improvement must end.” As Yogi Berra apparently said, “It´s tough to make predictions, especially about the future.”
A Path Forward: Some Implications for Business Leaders
The odds seem greater than ever, and rising, that America and the world will experience a longish stretch of disappointingly low growth. I earnestly hope that I’m wrong and that today’s buoyant stock market is right. But even if I’m wrong in the particulars, I doubt very strongly that any return to greater rates of growth will restore the post World War II environment where a rising tide lifted all the boats—a return to the growth rates of that era won’t even restore the U.S. back to potential GDP even if the government worked well. Recovery from credit-related slumps is slow. Therefore, I believe that the best strategies for the long term will include considerations such as these:
- Expect disruption and intensified competition. A future of low growth and austerity means that more companies will face a dogged share of market fight in order to sustain growth. Your firm can grow, but only by taking someone else’s lunch. In technical terms, this is a zero-sum future, rather than a positive-sum game where all firms could enjoy the benefits of a growing economy. Gentlemanly agreements not to poach a competitor’s clients, or intellectual property, or employees may fall by the way. Also, in times of financial austerity customers become more receptive to the lure of disruptive innovations. Low growth may make some managers sleepy. Instead, you must stay very alert to changing rules of competition.
- Relentlessly restructure, reinvent, and renew—because you can be sure that your best competitors will do so. In particular, identify the true “core” of your business and focus on improving it. Defer, delay, or discontinue the “nice to haves.” In a time of austerity, it is easy to be lured into other businesses than your core. A recent article in HBR by Evan Hirsh and Kasturi Rangan, “The Grass Isn’t Greener,” argues that high performance is less a matter of jumping into other industries than it is of gaining a strong competitive position within your core industry.
- Stay flexible. Austerity breeds uncertainty about the field of competition; therefore flexibility becomes extremely valuable. Flexibility is another name for real options and is evident in leasing (with cancellation clauses) rather than buying; in modular, rather than fixed, manufacturing operations; in dual-fuel rather than single fuel boilers; and in redundant sources of supply. Generally, flexibility entails the avoidance of large fixed costs. Therefore, stay lean and asset-lite. Now is not the time to relax your discipline on headcount, working capital, or capital spending.
- Innovate through small bets. Experiment before jumping into a new business or project with both feet. In the hysteria of a rapidly-growing market, project managers may recommend a major investment to grab market share before the competition piles in. But in an environment of austerity, the opportunity may be a mirage. I commend Peter Sims’ book, Little Bets, as a primer for how to proceed—it highlights path-breaking research by my Darden colleague, Saras Sarasvathy.
Some Implications for Investors
Many of the themes of this post were highlighted in the 2012 University of Virginia Investing Conference. The vision of low economic growth over the longer term sobers all investors. It has driven some investors to chase higher yields, as in non-investment grade debt, alternative assets, and exotic stock markets, such as Mongolia—if higher returns are associated with higher risk, then such strategies may face an unhappy reckoning.
An alternative approach would be to follow the thread of the Cowen-Gordon-Grantham-Reinhart-Rogoff argument and hypothesize a world of low macroeconomic growth and higher uncertainty. This raises interesting questions as the foundation for possible investing strategies:
Asset allocation. How will central banks unwind quantitative easing? How should investors hedge against the increased tail risk arising from shifts in monetary policy? Can financial systems withstand shocks from unexpected corners, such as Cyprus? Anyway, austerity is not evenly spread globally: which regions and countries will be relative winners and losers in the competition for growth? What does the maturation of emerging economies imply for demand for natural resources, food, consumer goods, and a sustainable environment?
Stock picking. As Robert J. Gordon noted, intensive innovations yield high growth over long periods; extensive innovations yield lower returns over shorter periods—where can investors look to find intensive innovations? How can investors find and take positions in disruptive innovations that will become mainstream in a decade or more? Since innovations occur at the levels of firms and their business units, information about these is likely to be distributed asymmetrically—how can investors engage in the search for plays in growth-driving innovations? In an environment of low growth and high competition, quality of management is more important than ever. Andy Grove, the former CEO of Intel, famously wrote, “Only the paranoid survive.” What kind of managerial attributes should investors seek?
Risk management. Low growth economic environments are vulnerable conditions for firms and their investors. Under such conditions, relatively small macro or micro surprises could yield outsized results. Changes in government policy are a major uncertainty, as last week’s anxiety over the release of the January Federal Reserve meeting minutes and the possibility of ending the Fed’s asset purchase program before the previously set unemployment targets are met. And then there are “black swans,” very low probability but very high adversity events.
Conclusion
The excitement over sequestration and the Federal Government debt ceiling should be put in perspective. These events—even if they should be resolved to anyone’s satisfaction—are not the conclusion of anything. Rather, they are symptoms of much deeper challenges. Such challenges seem to entail a “new normal” that could last for many years. And they present dangers and opportunities to managers and investors.