As many people focus on U.S. GDP these days and how it needs to be higher, they seem to be missing something. While the level of recent U.S. GDP has trended lower than in the past, it has become much more stable and steady. While high GDP seems desirable, unsustainably high GDP tends to crash, creating a boom-bust cycle. One can argue that a steadier GDP, even at a somewhat lower level, without the bust would be a more desirable choice. Steadier GDP should lead to steadier earnings, and historically a more predictable earnings stream has led to higher equity valuations, as stocks trend towards more dependable, fixed income-like payment streams. For instance, in today’s interest rate environment, 10-yr U.S. Treasury Bonds have a P/E ratio of 36, with no chance for change after an investor has made their fixed income purchase.
In the chart below, we can see the annual percentage change of Quarterly U.S. Real GDP data. Prior to 1986, year-over-year fluctuations regularly exceeded +2, +3, and sometimes +4 standard deviations to the upside. The upward spikes were often followed by downside crashes, usually to -1 standard deviation, with the exception of the Great recession, which exceeded -1.5 standard deviation down. This volatility in GDP gave a boom-bust flavor to the economy. In the period prior to 1986, the quarterly GDP averaged 3.71%. Since 1986, the quarterly U.S. Real GDP has averaged 2.45%. While this lower average GDP might seem like a step back, we believe that the movement away from a boom-bust cycle is step forward for the U.S. economy. Prior to 1986, there were seven GDP dips into negative territory, whereas in the period since there have been only two. We can also see that GDP had 10 spikes above +2 standard deviations in the pre-1986 period yet has only had one in since 1986, obviously a much more stable economy as measured by GDP.
In this current environment, where people talk of the “new normal” or “economic stagnation”, hardly anyone is giving credit to a more stable “Steady as She Goes” economy that has moved us away from the boom-bust cyclicality of the past.
There are many possible explanations for this less volatile GDP outcome:
- The U.S. economy has become much more diverse and less dependent on any one economic sector to drive its growth. In years gone by, the U.S. economy was heavily dependent on manufacturing, but has evolved into a service-driven and technologically-oriented economy. Of course, manufacturing is still a considerable aspect of the U.S. GDP, but there are now other drivers of growth to pick up the slack when manufacturing activity falters.
- The government has probably played a role with regulations, partly leading to slower, but more regulated growth. While not technically a government entity, the Federal Reserve has also become much more involved in regulation and modulating the economy than it has in the past. Also, one must consider the expansion of state and local governments. Government is larger, employing more people in jobs that are more stable and less prone to ups and downs, also leading to greater stability. Interestingly, government hiring increases “government expenditures”, giving GDP an immediate boost, while private sector hiring only increases GDP indirectly, via the workers’ production of a good or service.
- The Federal Reserve has become more involved in the economy. The Federal Reserve has become an increasingly involved entity in the U.S. economy as the financial and real estate sectors have grown and private credit creation has become increasingly integral to stable growth. This has been most evident in the mortgage industry where the stability of mortgage debt and mortgage markets in general has become increasingly important.
- Another contributor to the U.S. GDP’s more steady growth is globalization and world trade. This globalization has created diversification and helped to lend stability to the U.S. economy. Less dependency on U.S. domestic demand has helped to smooth some of the economic cycles.
- Growth of Technology in the economy has boosted stability in many ways. Technology has created greater efficiencies, doing more with less. Increasing direct job creation becoming one of the largest employers in the U.S. workforce. Fostering the emergence of new services and industries helping to transform the U.S. economy.
- Just-In-Time (JIT) delivery business model has also increased economic efficiencies. From obtaining the raw materials needed for manufacturing to ensuring timely delivery, every aspect of JIT production is synchronized. Businesses gain high production level benefits from the economy of scale: as production increases, the average cost of producing each item actually decreases.
- A long period of relative peace has allowed the economy to become more stable. Much of the volatility early on, 1948 through the early 1970’s were periods racked by wars i.e. after effects of World War II, Korean War, and Vietnam War. The current period of relative peace has dampened the volatility of the U.S. and Global economies.
All in all, while GDP may be at a lower level, it is on a steadier path and has moved further away from the boom-bust cycles of the past, which is a positive development.
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