GDP Growth: the Road Ahead and the Investment Climate

The second revision of the fourth quarter GDP number was released this past week and everything pretty much stayed the same.  The year-over-year rate of growth for the fourth quarter came in at 1.6 percent…following a third quarter of 1.5 percent growth and a second quarter of 1.6 percent growth.  In the following chart, the trajectory for real economic growth in the United States is shown since the beginning of the recession in December 2007.

A very nice cycle is shown in the chart as the recovery has been going on since June 2009.  The two major differences between this recovery and many previous recoveries are the strength of the major revival and the level at which the economy continues to grow.

In many previous cycles, year-over-year growth initially jumped up over 5.0 percent sometimes reaching 6.0 percent.  This time, economic growth in the United States only reached a level of about 3.5 percent. 

In the early 2000 recession, the upswing began in November 2001 and economic growth reached a height of a little more than 4.0 percent before leveling off.

In terms of the second difference, economic growth, year-over-year, currently seems to be running modestly below 2.0 percent.  I have argued that, as we go forward, growth will continue above 2.0 percent but will probably stay somewhat below the 3.0 percent level. (See my post http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad.)

Economic growth leveled off in 2004 through 2006 period in the 3.0 percent range but dropped off to about 2.0 percent in the period preceding the beginning of the last recession in December 2007.

The point is, in our recent experience, economic growth is not anywhere as robust as it was in the last half of the 20^th century and my guess is that it will not regain that robustness for some time.

The current economic situation is also mirrored in the year-over-year growth rates for industrial production.  We see, in the following chart, that although the growth rate of industrial production is greater than the growth rate of real GDP for the same period, the trajectories of the two charts are roughly the same.

I believe that this is the economic environment that we will continue to face for the near future.  The general economic situation is dominated by the fact that there still is a tremendous debt overhang in the economy, where under-employment will continue to remain high, and where the state of the housing market has not yet bottomed out.  As a consequence, economic growth will remain tepid. 

The Federal Reserve will be continue to make sure that the economy has plenty of liquidity to avoid any major problems in the banking system (http://seekingalpha.com/article/465951-commercial-banks-how-safe-is-the-banking-system).  However, as I quote in this previous post, Harvey Rosenblum, the head of the research department at the Dallas Federal Reserve Bank has written: “Monetary policy cannot be effective when a major portion of the banking system is undercapitalized. Many of the biggest banks have sputtered, their balance sheets still clogged with toxic assets accumulated in the boom years.” 

In other words, the Fed cannot have much impact on economic growth when the banks are in the condition they are…but the Fed needs to keep the banks liquid enough so that the banking system causes no further disruption to the growth that has already been started.

This environment should be a positive one for investments, although one still needs to be cognizant of all the possible “bumps in the road” that exist, like the European recession, a slowdown in China, higher gas prices, and so forth.  Burton Malkiel, in the Wall Street Journal, argues that common stocks should return around a 7.0 percent yield, calculated from the dividend yield on stocks (around 2.0 percent) plus the long-run growth of nominal corporate earnings (around 5.0 percent).  And, this gives a “five-percentage point equity risk premium (over the 10-year Treasury yield now around 2.0 percent)” that “is close to the historical average.” (http://professional.wsj.com/article/SB10001424052702304692804577285712326880238.html?mod=ITP_opinion_0&mg=reno64-sec-wsj)

Malkiel goes on that “Only the so-called Shiller price/earnings ratio (based on the past 10 years of earnings) would suggest that stocks are too high.  But the average earnings over the past 10 years are likely to be well below the current nominal earning power of U. S. corporations.”

Thus, the Shiller “ratio” (CAPE) will revert to the mean, but because corporate earnings are rising in the current economic environment, not because stock prices should fall.  Furthermore, an index of market liquidity and a confidence index related to market performance are both supporting rising stock prices at this time, re-enforcing the argument that stock prices should rise in the near-term future. (See my http://seekingalpha.com/article/440181-economy-vs-markets-and-the-winner-is.)   

Bottom line: I think common stocks are a good place to invest right now.)

Key to Future Bank Performance: How to Get Around the Regulations

Interested in investing in a commercial bank these days?

What should be the key factor in determining whether or not to invest in a specific bank?

How about the ability of the management of the bank to get around the rules and regulations now being written up or proposed by the bank regulatory agencies?

A New York Times article this morning, “Consumer Inquiry Focuses on Bank Overdraft Fees” contains the following subtitle: “Wondering whether banks are working around new rules.” (http://www.nytimes.com/2012/02/22/business/bank-overdraft-fees-to-be-scrutinized-by-consumer-bureau.html?_r=1&ref=business)

My answer?

Yes!  The banks are working around new rules!

I began my banking career in the 1960s, a period when commercial banks began the process of financial innovation that just grew and grew through the latter part of the century.  In that decade we saw the introduction of the negotiable certificate of deposit (negotiable CDs), the formation of bank holding companies, the issuance of bank liabilities through the bank holding companies, and the creation of the Eurodollar.  Then we saw banks attempting to get around state branching laws and interstate branching laws and so on and so forth.  The rest is history!

When I was working in the Federal Reserve System in the late 1960s and early 1970s the “rule of thumb” was that the Fed was about six months behind what the commercial banks were doing.  New rules or regulations would go into effect on the banking system…the commercial banks would move to “get around” the new rules or regulations…and, it would take about six months for the Fed to catch on to what the commercial banks were doing.

Times haven’t changed…and won’t change.

Given the rapidly changing environment created by information technology, the financial institutions will just have more ways to quickly and effectively avoid any banking rules or regulations they believe it is worthwhile to avoid.

To me, what Congress and the regulators are trying to do is silly!

For one, the “powers that be” are trying to avoid 2007-2008 from happening again.

Guess what?

2007-2008 will not happen again.  We have already moved way beyond that.

Furthermore, the technology has changed to the point where it is almost impossible for regulators and legislators to understand what is going on, let alone write rules and regulations that will control what is going on. 

Look at the Dodd-Frank financial reform act.  Most of the rules and regulations included in this bill HAVE NOT BEEN WRITTEN YET!

And, President Obama signed the act into law in July 2010.  We are ready to celebrate the 2^nd anniversary of the signing of the bill and the most of the rules and regulations incorporated into the bill have not been written.

And where is this “writing” taking place?  Primarily in back rooms, with no intrusion from the public, and no review.  See the enlightening piece in the Wall Street Journal this week, “Fed Writes Sweeping Rules From Behind Closed Doors.” (http://professional.wsj.com/article/SB10001424052970204059804577225122892450312.html?mod=ITP_pageone_0&mg=reno64-wsj)

Here are some of the goodies: “the Fed has held 47 separate votes on financial regulations, and scores more are coming.  In the process it is reshaping the U. S. financial industry by directing banks on how much capital they must hold, what kind of trading they can engage in and what kind of fees they can charge retailers on debit-card transactions.”

I understand that one rule relating to when Governors of the Federal Reserve System could go to the bathroom has been removed.  The writers of the rules did not want to get into gender differences they felt were necessary and instead of raising this issue…they just dropped the whole provision.

 These rules and regulations do have effects.  The problem is that they may not always have the effects that are desired. 

In some cases they do.  For example, in the New York Times we read the headlines: “Under Volcker, the Old Dividing Line in Banks May Return.” (http://dealbook.nytimes.com/2012/02/21/under-volcker-old-dividing-line-in-banks-may-return/?ref=business)  That is, financial institutions may divide back into the distinction between commercial banks and investment banks.

This is just what Paul Volcker would like to have happen.

However, in many other cases, the rules and regulations will result in outcomes that are far from what was intended by Congress or by the regulators that wrote the regulations.  What those outcomes might be are, of course, unknown because they haven’t happened yet.

And, some of the outcomes may be totally unexpected because the outcomes will be related to the new things that information technology will allow institutions to do.  In five years, finance may be done in an entirely different way than it is now.  (See my forthcoming review of the new book “The End of Money,”)

What bank…or financial institution…should one invest in? 

Congress and the regulators have created so much uncertainty in the world of banking that it is almost impossible to say anything about bank performance in the future.  All bets on banks are nothing more than gambling, at this stage. 

I do not expect this environment to change much in the near future.  Investing in banks is not where I would want to put my money at this time because there is nothing really to base an investment decision on when it comes to the banking industry.