Happy Unrecession: The Alice in Wonderland Economy
While curious developments have brought about seemingly impossible things in this unrecession, investors can make sense of it and learn to adapt.
In our view, the modest gain in the stock market this year is not as misguided or illogical as it may at first seem.
While volatility may lie ahead for stocks, a prolonged bear market and recession seem unlikely for 2017.
On November 26, 1864, the first copy of Alice in Wonderland was given by the author to the real Alice. One-hundred and fifty two years later, the global economy has investors feeling that they too have been handed something strange and bewildering to read.
Down the rabbit hole
Investors have been confronted by odd, upside-down and seemingly illogical developments such as:
- Negative interest rates where lenders pay borrowers.
- A steadily growing global economy where business leaders remain pessimistic.
- Rising stock prices while corporate profits fall.
- Statements by politicians that seem ambiguous or contradictory.
The Alice in Wonderland economy has been confusing and disconcerting to many investors. Fortunately, while much of it may seem mad, investors can make sense of it.
Six impossible things before breakfast
The White Queen advises Alice to practice believing in the impossible. As investors have been confronted with negative interest rates, once thought to be impossible, this unorthodox habit seemingly becomes relevant. The impossibility of negative interest rates was challenged in recent years as government bond yields across the globe and maturities across the spectrum fell below zero, driven by low inflation and unconventional central bank policies.
When inflation is high, central banks usually adjust their policy interest rates to be even higher, to help cool demand and bring inflation back down. The opposite is true when inflation is low or even flat; rates are adjusted lower than inflation in order to try to lift demand. As inflation fell to around zero in recent years, this logic led most central banks in developed countries to do the seemingly illogically act of lowering rates below zero.
While this was unprecedented, it isn’t as unusual as it may seem. While most of the world’s developed countries have adopted negative interest rate policy since 2014, they have had negative inflation-adjusted (real) interest rates for much longer, as you can see in the chart below.
Negative interest rate policy isn’t really a new thing
Source: Charles Schwab, Factset data as of 11/22/2016.
Based on a study of 24 developed economies’ central banks.
Shaded area represents IMF forecast.
With inflation starting to pick back up, central banks may raise policy rates while maintaining negative real policy rates to continue to try to fuel demand. Even as nominal rates begin to climb, the negative real policy rates that have become commonplace over the past decade may be with us for years to come, and are not as unusual as they may at first seem.
The Mad Hatter wishes Alice a merry unbirthday because it isn’t her birthday. We haven’t experienced a normal economic expansion since global economic growth has been below average, but it has continued to grow. So the global economy falls somewhere between a typical expansion and recession, something the Hatter might call an unrecession. What makes the current economic environment a happy unrecession is just that: it isn’t a recession.
Looking ahead, we may be in for an especially happy unrecession in 2017. Global economic growth measured by real GDP in 2017 may be similar to 2016; the International Monetary Fund predicts 3.4% real GDP growth in 2017, close to the growth rate of 3.1% in 2016. However, the pace of global inflation is expected to continue to rise from just 0.3% in 2015 and 0.8% in 2016 to 1.7% in 2017. Combining the forecasts for real GDP growth and the pace of inflation means nominal GDP growth is forecast to exceed 5% in 2017 for the first time in six years. Since nominal world GDP growth acts as a proxy for global revenue growth, company sales may grow in 2017 for the first time in several years and help to lift profits after a decline in 2016, as you can see in the chart below.
Revenues may rise in 2017 for the first time in five years
Source: Charles Schwab, Bloomberg and Factset data as of 11/22/2016.
The return of sales growth after a four year slump may lift the sentiment of business leaders, including those at big companies in Europe (where the IFO Eurozone business climate index sits at 93.4, below its 20 year average of 97.0) and small companies in the United States (where the National Federation of Independent Business Small Business Optimism survey stands at 94.9, below its 20 year average of 96.9).
How long is forever?
The White Rabbit replies “Sometimes, just one second” when asked how long forever is by Alice. Investors have fretted that the decline in the earnings of global companies seems to have gone on forever, while analysts have concluded that forever isn’t likely to take very long.
While actual earnings results have been sliding over the past two years, expectations for future profits have been back on the rise since February. Since stock markets tend to look forward and not backwards, they have followed the trend in those estimates and climbed since February, as you can see in the chart below.
Stocks have tracked earnings expectations and not actual earnings
EPS = earnings per share
Source: Charles Schwab, Factset data as of 11/22/2016.
What does it mean?
Humpty Dumpty told Alice that “when I use a word it means just what I choose it to mean.” In 2017, investors should get used to the market volatility that accompanies political leaders making confusing or ambiguous statements. For instance, UK Prime Minster Teresa May recently stated, “Brexit means Brexit.”
While central bankers’ statements are often lengthy and difficult to parse, politicians are often short and direct. That could mean markets may react sharply to statements that appear to set a new direction for policy. Politicians may have more influence over the markets’ direction and volatility than central bankers in 2017.
Curiouser and curiouser
While curious developments have brought about seemingly impossible things in this unrecession, investors can make sense of it and learn to adapt. In our view, the modest gain in the stock market this year is not as misguided or illogical as it may at first seem. While volatility may lie ahead for stocks, a prolonged bear market and recession seem unlikely for 2017.
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