The Federal Reserve Board met last week and raised interest rates by 25 basis points (0.25 percentage point). The case for a hike was strong:
We’re at more or less full employment.
Inflation, which has slowly accelerated, hovers near the Fed’s 2% target.
We expect two to three rate hikes by year-end, which would put the federal funds rate at 1.25% to 1.50%, a level consistent with the Fed’s—and Vanguard’s—assessment of the economy’s strength.
Market behavior reminiscent of the ‘80s
The more interesting, and puzzling, economic analysis is happening in the stock market. U.S. stocks have been on a tear. The market is priced for long-term economic growth rates of 3%-plus, maybe 4%. (This estimate is based on our calculation of the earnings growth estimates implied by current stock prices.)
But like big hair and acid-washed jeans, those growth rates are an artifact of the ’80s. These days, the labor force is increasing slowly. Productivity growth, which could be turbocharged by a 21st-century Edison or Ford, is modest for now. And we’ve sworn off the growth-boosting but risky leverage that inflicted so much pain during the global financial crisis. The economy’s long-term potential growth rate is about 2%.
During the ’80s, the 10-year U.S. Treasury note yielded an average of more than 10%. At the end of 2016, it yielded 2.5%. The following drivers, illustrated in the chart below, explain the change:
Lower inflation. In the ’80s, prices rose at an annualized 5% per year. A cart of groceries that cost $100 at the start of the decade cost more than $160 at the end. Today, inflation is barely 2%.
Slower productivity and labor-force growth. An aging population means slower labor-force growth. And workers’ hourly output is increasing more slowly—a rate of 1.6% per year in the ’80s, about 1% today. (That’s not bad! Before 1700, Europe experienced no productivity growth. As a result, a farmer born in the 14th century had the same standard of living as his great-great-great-grandson born in the 17th, though the latter had Shakespeare.)
A lower term premium. The term premium measures the additional yield paid by longer-term relative to shorter-term bonds. It’s related to inflation risks, which have declined significantly.
Greater demand for U.S. bonds. The remaining drivers are increasing global demand for the world’s safest asset—the U.S. Treasury—and unexplained (residual) causes.
The ’80s aren’t coming back
Maybe new fiscal policies—tax reform that boosts investment, infrastructure projects that produce economic efficiencies—will nudge growth higher. Uncaged animal spirits, evident in business and consumer confidence surveys, could put near-term growth at 3%. But none of the new administration’s proposals include a flux capacitor that will take us back to the ’80s.
Our asset class forecasts, anchored on a future of 2% growth, assign the highest probabilities to:
Global bond market returns of 2.5%–3% over the next decade.
Global equity returns of 6%–8% over the next decade.
The U.S. stock market is giddier, suggesting a different economic future. Our advice: