The New Normal

Eric Linser, CFA | Dec. 22, 2009

There has been a lot of mention of the phrase "the New Normal" so I thought I'd define it, and discuss the ramifications and opportunities that such a philosophy represents.

We have just witnessed, and hopefully survived, the worst financial crisis since the Great Depression and the ensuing recession  has forced many Americans to change their lives in ways large and small. It's a world of new normals, with more belt-tightening, less income and, in many cases, a new found gratitude for the most basic human comforts: family, home and health.

The New Normal isn't really new at all. It's what those who were raised in the 1920s and 1930s call frugality . Things are currently grim for many people now as then. While this recession can't quite compare to what transpired in the late 1920s and continued for another decade, this recession may create similar habits that were formed and have been kept for generations by the children of the Great Depression -- basically, living within one's means. And now, living within our means could well be the silver lining of our current Great Recession. If more embrace the change and maintain better financial habits, they will benefit in the long run, and the economy will too. 

Let's look back and see how things have changed.  In the '40s, '50s, and '60s, it was fairly easy to plan for a secure future. People picked a career, a spouse, and a place to live, and those basic decisions put them on a predictable course for the rest of their lives, especially if they were lucky enough to land at a big corporation with great benefits and smart enough to buy stocks. In the '70s, '80s, and '90s, technology and global competition transformed the world. An increasingly strong economy masked spiraling instability in the workplace and the world. A rising stock market lulled people into thinking they were in control of their lives.

Economic Impact

When the economy was booming, steady paychecks and soaring home values and investment portfolios lulled many into lifestyles that they could not sustain. They rang up thousands of dollars in credit card debt, financed luxury cars, and took out home-equity lines of credit to renovate their houses and buy items that they wanted but did not really need.  Finally, an economic earthquake hit -- the stock market collapsed, home values dropped, and millions lost their jobs -- not only in the US but throughout the world. These woes have really scared some into getting their house in order.

Wiser habits in each household will eventually help strengthen an economy that still shows vulnerabilities. The economy represents decisions made by tens of millions of people every day. In our new normal our retooled economy will be fueled less by consumer spending. In the next decade, consumer spending will contribute about 65% of our gross domestic product (GDP), a broad measure of economic output, down from the traditional 70% +, while exports and business spending will contribute more to GDP growth.

As we embark on this new era, the New Normal, it’s a time of great uncertainty—about terrorism, corporate scandals, the outsourcing of jobs overseas, and much more. The old safety nets aren’t coming back, even when the economy recovers. But the good news is that the New Normal also offers tremendous opportunities. You can still make the most of your life, career, and money by embracing the future.

The New Normal is the era of the individual. In companies large and small, each person now matters more than ever before. The Internet has finally made it easy to launch and grow a real business. For entrepreneurs and managers, the global economy opens previously untapped sources of supply and demand, cost savings and innovation. Individual investors now have access to tools and knowledge that were, until recently, restricted to professionals.

Investment Expectations

On the investment front, the New Normal is a term bandied about by Bill Gross, fixed-income master and co-chief investment officer at Pacific Investment Management Company (PIMCO). To PIMCO, the term refers to a supposedly new investment market, and they are sounding the alarm to be defensive in the current environment. One that Mr. Gross says, “It's a world where growth slows down and where investment returns are half of what we have grown used to over the past 10 to 25 years” believing investors shouldn't expect returns and profits ever to get back to the levels of a few years ago. Slower growth and greater government regulation will restrain corporate profits and put a damper on stock returns. Gross predicts that even high-growth companies will start to act more like utilities, so investors should think about actually buying utility stocks, which could hold up better in slow-growth times.

Mr. Gross cited several reasons that advisers should lower their, and clients', expectations:

• The United States is deleveraging as a result of the subprime mortgage crisis. “That means that banks don't loan money like they used to and it basically means that the small investor doesn't take risk as much as they had used to.”

• The government's push to “re-regulation,” will keep profits and growth in check. “It probably slows the economy down,” Mr. Gross said. “To us, regulation and re-regulation are not an investor's friend.”

•  In a new climate of “de-globalization,” other countries are focusing more on their internal growth rather than expanding trade.
  

As a result of these three factors, economic growth will be half of what it was—averaging around 4% annually, and profits will remain around 4% to 5%, instead of the previous levels of 8 to 9%, Mr. Gross said. Similarly, investors shouldn't expect the double-digit returns of the old days, Mr. Gross said. “This isn't a forecast that says, ‘Bear market, run for the hills,'” Mr. Gross said. “It's a world where if we have less growth, less leverage and the inability to siphon funds from Main Street to Wall Street, you'd better expect rates of return in the general vicinity of 5% to 6% total.”

It is increasingly clear that the current downturn is fundamentally different from recessions of recent decades. We are experiencing not merely another turn of the business cycle, but a restructuring of the economic order. For some organizations, near-term survival is the only agenda item. Others are peering through the fog of uncertainty, thinking about how to position themselves once the crisis has passed and things return to normal. The question is, “What will normal look like?” While no one can say how long the crisis will last, what we find on the other side will not look like the normal of recent years. The new normal will be shaped by a confluence of powerful forces—some arising directly from the financial crisis and some that were at work long before it began.

Despite news that the economy is stabilizing and that job losses are diminishing, scores of Americans continue to play the Grinch when it comes to the stock market's prospects. After being caught largely unaware by the recent financial crisis, gun-shy investors have become wary of this year's market rally and seem to expect another correction in the near future. And some of the smartest minds in the business appear to agree with them.

The best offense is a good defense. Investors have good reasons for being suspicious of the market's comeback. So far, the rally has been largely concentrated in lower-quality sectors and securities -- the very areas of the market that got knocked for a loop last fall at the apex of the financial crisis. Stable companies with solid fundamentals and strong balance sheets haven't participated in the market run-up nearly as much. And practically no one is predicting that a period of robust growth is in store for the US economy. As a result, many folks are getting defensive and hoping to ride out the expected period of subpar growth ahead of us.

All is not lost 

 Of course, even if our economy drags its feet for the next couple of years, that's not to say there won't be pockets of greater opportunity out there. It’s important to remember that the greatest growth prospects in the world over the next decade are likely to come from beyond our border. So don't forget to dust off your passport and go in search of some foreign names for your portfolio -- especially from emerging markets. This spicy sector will serve up some volatility along the way, so be prepared for a wild ride. However, longer-term results here should help offset the anemic growth the US is likely to encounter in the years to come.

No one knows exactly what is in store for our economy in the next decade,but we can be pretty sure that a return to heady, 1990s-style growth is not it. Investors may want to step up their portfolio's defenses, but at the same time, shouldn't totally give up on growth. A well-balanced and well-diversified range of holdings is most likely to achieve success even if Bill Gross's New Normal proves to be reality.

In a broad sense, I believe, “you feel the pain before you really make a change.” The longer it takes for the economy to feel normal again, the higher the chances that we’ll see longer-term effects on our spending habits, and the more ingrained these habits of thrift will become – just ask any octogenarian.

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