Animal Spirits and the New Normal
Given the dizzying pace of change in the global economy and capital markets over the past several quarters, we should all be forgiven for feeling like we’ve been taken to the limits of our tolerance for stress. After looking into the abyss (toes well over the edge) late in the first quarter of 2009, the global economy has shown it still has some fight in it. Equity markets and growth forecasts suggest economic activity has stopped shrinking in all the world’s big economies. Global stock markets have rallied by over 60% since their trough in early March and the central tendency for global GDP growth over the next year is over 3%, more than 1 percentage point faster than forecast early this year. Some corporate credit markets are thawing fast and bearish analysts are once again on the defensive.
But is there cause for caution? Has the improvement in economic fundamentals created too much optimism, encouraging more spending and hiring decisions which led to the improvement in the first place? After all, the world economy is still far from normal in many respects. Unemployment is still rising and much of the world’s manufacturing capacity remains (perhaps for a long time) idle. The process of rebuilding business inventories cannot last forever; nor can the massive fiscal and monetary stimulus. Perhaps the current perceptions about the economic recovery do not reflect collective rationality, but rather the work of exuberant “animal spirits” replacing investor fear.
Thanks to groundbreaking work in the behavioral finance field, we are learning more about the limitations of the human mind, particularly with respect to making “rational” economic judgments and decisions. For instance, people have a tendency to overweight the most recent news and extrapolate more of the same into the future. Thus, perceptions about the future – optimism or pessimism – can seem the inescapable conclusion one day, only to be replaced by a very different sense soon thereafter.
The chart above shows a stylized business cycle overlaying a long-term (upward) trend in the level of GDP. If we extrapolate the current activity at any point (by extending a line whose slope is equal to the second derivative, or rate of change, of the cycle), we can get wildly different expectations than we would at another very close point. For example, extrapolating the actual economic activity taking place in Q1, would give us very different expectations than extrapolating from Q2. Maybe even more surprisingly, there is a huge difference between Q2 and Q3, even though the level of activity (relative to the trend, say 3% economic growth) is very similar. This analysis assumes that we know the level of economic activity and the rate of its change perfectly and instantaneously. This, of course, is untrue in reality. And, if we’re interested in expectations about future stock prices (as opposed to the underlying economic activity), the differences would be magnified since equity market prices are a multiple of current activity.
So while we recognize the role of emotional/behavior factors in changing expectations about the future economy and stock market performance, there are also logical, rational, but still flawed reasons why expectations can change rapidly. Combining the two (one weak, the other imperfect) elements gives us a better understanding of market behavior around transition periods, such as the one we’re in, than looking at either in isolation. The two are almost certainly not merely coincidentally, but related. Emotional responses are not arbitrary or capricious but grounded, however imperfectly, in fundamental reality.
But how confident can we be that we are returning to the prior long-term trend rather than some "new normal?" Expert opinions vary. According to a number of recent studies looking at the performance of economies after financial crisis, the world economy should return roughly to its pre-crisis rate of growth. Another theory, proposed by a number of well-respected academics and investment managers, is that growth will stay at a longer term lower rate, with investment, employment, and productivity growth all lower than before.
It is true that economic policy makers around the world must balance a number of difficult issues: buttressing economic demand, now, without over-extending the public finances; limiting unemployment without eliminating the “creative destruction” of uncompetitive companies and industries; and, most importantly, fostering innovation and trade while avoiding the protectionist backlash which often erupts in times of stress. On balance, we believe that the fundamental economic backdrop will support a return to growth, with risks to the upside. There are several billion people in the world (especially in still developing countries) operating well below their economic potential. With technological and business model innovation harnessing the energy of a truly global labor and capital pool, it would take monumental policy blunders indeed to permanently lower growth and opportunity.
Jason Thomas, Ph.D.
Chief Investment Officer