THE NEW ECONOMY TESTED
Prepared by MCM, Inc.
(November 24, 2000) The claim that there is a "new economy" remains open to doubt. In part, it is a question of definition. "New economy" can mean there has been a modest, permanent rise in the pace of productivity growth and hence a rise in the non-inflationary pace of GDP growth. To some, the expression means a sort of super-charged new economy has arisen from the application of new technology to the economy (along the lines of extreme "supply side" faith in the magic of marginal tax rates). Both notions may be in for a test next year. This is a larger question than whether there will be a recession in 2001, but has much to do with the extent and duration of any slowing, so has important implications for investors.
A look back at the GDP data over several decades shows a clear drop in volatility beginning around 1984. Since then, there has been a single, short and shallow recession. The persistent rapid growth of the past few quarters is "rapid" only in the context of the post-1984 era. Prior to that, quarters of 10% growth were not uncommon, with growth topping 16% in Q2 of 1978. That more level growth for a decade and a half is very likely part of what has convinced Fed officials that the more recent period of moderately faster growth (4%-4.5%) with low inflation is sustainable.
One thing to note about the post-1984 period is the absence of an extended period of elevated oil prices - till now. One lesson of the 1970s was that persistent high oil prices lead to recession. High oil prices are also often blamed for the slower pace of productivity growth through the 1970s to the early 1990s, as well as the related period of "stagflation" in the late 1970s. (The spike in oil prices due to the Iraqi war was too brief, and too late, to cause the brief recession in the early 1990s.) It may even be that very strong growth combined with low inflation in late 1999 and early 2000 was the result of a positive price shock combined with the stimulative impact of Fed easing.
If much of the analysis above is true, then it is possible the US will return to a period of higher inflation, slower GDP and productivity growth and a higher non-inflationary rate of unemployment. That is the worst case scenario. An intermediate case, in which just some of those results, or all in a mild form, occur for a limited period, is a more likely outcome - the moderate "new economy" view prevails and prevents the worst from happening.
The next few quarters, then, represent a test of the notion that something special has happened in the US economy, something that makes it sturdier and less prone to adverse shocks. Equity and bond market participants have behaved this year as if they have this test clearly in mind. The NASDAQ peaked in March, as oil reached a recent high (oil prices have since climbed higher). The DJIA had already peaked in January while oil prices marched upward.
The question for those who maintain a moderate stance on the "new economy" question is not so much whether the economy will slow in response to higher oil prices and interest rates (that has already happened), but how much. If another short, shallow recession is suffered next year, it is evidence the US is, indeed, better able to handle shocks. The moderate view does not require that recessions be banished forever, merely that they be weathered more easily than in the past. A period of below-trend positive growth would have similar implications. It would mean the steady economic progress since 1984 is now the norm, even when conditions are not benign. That would accommodate low long-end Treasury rates and higher than traditional price/earnings multiples.
The two extremes, either a continuation of very strong growth without inflation or a full-blown, several-quarter recession would end the "new economy" debate altogether. The former case (unlikely to be tested, if the Fed has anything to say about it) would mean the radical "new economy" religionists are right. The latter, unhappy case, would mean the US is still vulnerable to the same old shocks and swings, that there is nothing at all "new" about the economy. Our outlook is for the middle ground. Slower growth in the US, perhaps a very mild recession, should provide confirmation that the US is far more resilient than in the past.
November 24, 2000 MCM, Inc. 294 Washington Street, Suite 734, Boston, Massachusetts 617-338-9219
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