The concept of a “New Normal” was born nearly 10 years ago in the wake of the Great Recession. The theory posited that over-indebtedness and the subsequent deleveraging would lead to structurally slower economic growth for an extended period. This, in turn, would lead to subdued revenue and earnings growth and mediocre markets. With the benefit of hindsight, this proved to be an accurate framework for predicting the economic backdrop in the post-crisis years. But as a tool for forecasting markets, it failed miserably. While GDP growth and revenues were indeed subdued, earnings growth far exceeded revenue growth in the post-Lehman era, pushing markets to a V-shaped recovery, with the 500 more than quadrupling since its March 2009 bottom.
How could calling the economy right lead to being so wrong on the market? We believe the answer is what we call Industrial Revolution 3.0 (IR 3.0). Over the last decade, companies have become structurally more efficient, largely by substituting much cheaper yet more productive technology for both labor and capital. This has helped them generate double-digit earnings growth on low single-digit revenue growth—a phenomenon that not only is continuing but accelerating, with S&P companies experiencing 25% earnings growth on high single-digit revenue growth the past two quarters. Further, lower corporate tax rates and accelerated expensing, as well as deregulation and the repatriation of foreign capital, are fueling a capital expenditures boom that should further harness productivity enhancements from artificial intelligence, robotics, 3D printing and other IR 3.0 innovations.
Yet, many investors continue to fail to grasp the full implications of this sea change. Not only is this digital revolution changing the relationship between revenue and earnings, it also has far-reaching implications for labor markets, inflation, interest rates and productivity. We believe the inability of investors to fully appreciate these changes has them missing the forest for the trees. This is best seen in the consensus view that the economy is in late cycle, with wages and inflation poised to rise unabated, interest rates on the precipice of hitting levels not seen since the mid-2000s, and a recession right around the corner. Here’s what we think investors are missing:
- Inflation IR 3.0 is disinflationary. Despite strong economic growth and an increase in cyclical inflationary forces caused by a tighter labor market, we believe that inflation will only grind higher, at a slow measured pace, as the relentless assault on production costs accelerates and the endless assault on pricing from Amazon and other disruptors help cap how fast and far prices can rise.
- Productivity Productivity growth languished for much of the past 10 years, sitting at levels not seen since World War II, on a reticence to invest, an onerous regulatory regime and a steady supply of cheap labor. This is starting to change, however, as IR 3.0 and Trump administration tax reforms reshape behavior. McKinsey & Co. estimates that over a 50-year period, the boost to productivity from automation and other IR 3.0 components could be on order of magnitude between four to five times that which was provided by the steam engine nearly 100 years ago. Such a surge would mean that most economic models will prove too bearish as this productivity growth frees the economy to grow at a higher rate without creating the inflationary buildup that typically leads the Fed to become overly restrictive.
- Interest rates/Fed Speaking of the Fed, it seems many investors believe we are in late cycle in part because they believe policymakers will raise rates by 25 basis points per quarter from now until eternity—or at least through the remainder of this year and in 2019. We do not subscribe to this view. Chair Jerome Powell has indicated on numerous occasions that he intends to be patient, which we think will likely cause the Fed to pause or slow the pace of rate hikes significantly next year as inflation remains well-behaved even as economic growth continues. This would be market friendly as late-cycle fears abate.
The bottom line is it is incumbent upon investors to think big. As always, in a world where we are inundated with data, it is easy to get lost in the details. By taking a step back and evaluating the world through a larger framework—in this case, IR 3.0 and the relationship between technology, economic growth and markets—the bullish view should come into sharper focus, with higher productivity abetting robust economic growth, tame inflation and a patient Fed. We think that’s the new “New Normal,’’ and it should take the markets higher.