Well over a decade ago I sat in a large conference hall next to a fellow investment manager at a weekend boondoggle put on by a large institutional client. He had a great sense of humor and an intellect best described as down home wisdom that was downright scholarly. His name was Paul McCulley and he went on to become a fixture at PIMCO until he retired in 2010. McCulley recently rejoined PIMCO as chief economist, a role that again provides him a platform for sharing his erudite thoughts on the economy and the market. McCulley has had many prescient investment calls over the years and was responsible for coining the phrases “Minsky Moment” and “Shadow Banking.” When warning of the impending Russian financial crisis in 1998, McCulley cited the Asian Debt crisis of 1997 as a Minsky Moment, referring to the Keynsian economist, Hyman Minsky, who helped us to understand the fragility of the business cycle and the consequences of speculation and debt. Shadow Banking was McCulley’s reference to non-bank financial intermediaries, including hedge funds, credit insurance providers (AIG), and the like, which he suggested were causing the real estate bubble that led to the Great Recession.
For the last decade or more the Fed has set its policy rate (Fed Funds Target Rate) based on the assumption that nominal GDP growth of 4% could be sustained if inflation remained at a stabilized rate of 2% (see below). Accordingly, the Fed Funds target rate was 4% and the neutral or natural rate of interest was 2% (Nominal GDP minus stabilized inflation). The “New Neutral” is a phrase coined by PIMCO in May of this year and a concept that McCulley has been writing about for 10 years. PIMCO makes a compelling argument that the post-crisis world of deleveraging, deglobalization, reregulation, and austerity, has lowered domestic and global nominal growth prospects to the 2% range, which when offset by 2% inflation results in a New Neutral real rate of 0%!
Inflation: The New Reality
If PIMCO is correct that the New Neutral is 0%, then by historical formula the Fed would lower its target policy rate to 2%. It is important to remember that financial assets are priced off of this lower “risk free” rate of interest. Present value calculations that discount future earnings back at a lower rate of interest result in higher stock prices. As such, current equity market valuations seem far less extreme. To wit, over the last 15 years the S&P 500 has averaged about 15X earnings with a 10-year Treasury averaging 6.7%, which makes today’s S&P 500 earnings multiple of 16 with a 10-year Treasury rate of 2.5% seem quite reasonable. However, lower interest rates go hand-in-hand with slower economic growth and it is important to remember that slower economic growth begets lower rates of return on financial assets. As such, expectations for portfolio returns must be adjusted accordingly.