In four quick years, the concept of the "new normal" has gone from being viewed as unlikely by most analysts and policymakers to becoming consensus. The popular application of the phrase now extends well beyond its original conceptualization that simply encompassed economic and financial prospects. It has also been used to describe medical procedures, unusual weather patterns and geopolitical shifts. It even gave rise to a television series.
Yet all is not well for the concept of the new normal. Yes, its popularity has expanded. Yes, it has become conventional wisdom in most policy and market circles. And yes, the concept has proven consequential for evaluating the effectiveness of policies and the potency of traditional investment approaches. But there is also an important qualification: The concept itself is morphing, evolving to describe a contextual configuration that is less stable and more unpredictable.
The purpose of this paper is to analyze what lies ahead for the new normal, and why.
After summarizing how the new-normal concept emerged at Pimco and eventually became consensus view, this paper explains why it is likely to morph in the years ahead. Specifically, it argues that, within the next five years, the popular characterization of the phrase will evolve—away from the notion of an equilibrium, as unsatisfactory as its economic components have been for the West, to the neck of a what the British call a "T-junction." And the consequences are material for policies, investing and the well-being of current and future generations.
Allow me to take you back to the beginning of 2009. Severe disruptions from the global financial crisis still dominated financial markets. Economic damage was substantial and spreading. Governments and central banks were throwing in all they had to counter and overcome this costly storm. And institutional investors and professional money managers were trying to both navigate the dislocations and position their clients' resources for what would follow.
Having understood relatively early on the nature of the "sudden stops" and what they entailed, including the early 2008 notion that "unthinkables were thinkable," Pimco was spending many long hours detailing the different ways this global storm could evolve.
Would the storm eventually exhaust itself, or would policy measures change its course and limit further damage? Would it analytically prove the equivalent of a severe cyclical shock, or would it involve material structural and secular shifts? And how would the institutional underpinning withstand its direct and collateral damage?
These were just some of the questions that we discussed. As we debated the various related scenarios, we came across an important finding that would shape much of our subsequent analysis: The eventual recovery that Western countries would follow would be far from a traditional one (and particularly so for the highly finance-dependent economies such as Ireland, the United Kingdom and the United States).1
We concluded that the global economy was experiencing much, much more than a traditional cyclical downturn. It was in the midst of a paradigm change that was also secular and structural in nature. And most policymakers and market participants, understandably consumed by severe crisis management, were yet to comprehend the world's new reality, let alone formulate the type of responses required.
The more we analyzed the situation, the clearer it appeared to us. Advanced countries, and especially the highly levered ones, were facing a very unusual outlook; and the longer it would take for both the public and private sectors to realize it and act on it, the greater the number of unthinkables that would become fact and the longer they would persist.2
As a global firm, we needed a simple way to convey what we thought was a material (nonconsensus) finding. We came out with a simple phrase, "the new normal," which we disseminated widely in May 2009 following our annual Secular Forum.
The new normal was meant to convey the notion that, for a host of reasons, economies would not reset in the traditional cyclical sense. Instead, absent a material change in policymaking and its mindset, the West was facing the unfortunate probability of several years of unusually sluggish growth, persistently high unemployment, and periodic debt and deficit concerns.
The new normal also postulated a contrasting outlook for emerging economies in what we labeled a "multispeed" world.3 Rather than be pulled down by the malaise in the West, as most expected, emerging countries (and particularly the systemically important ones, including Brazil, China, India, Indonesia, Mexico and Russia) would rebound quite quickly—thereby also accelerating the global convergence of income and wealth.
This multispeed world would entail significant global economic and geopolitical shifts. Accordingly, we also analyzed the agility of the multilateral system. Worried by the slow adaptation in global governance, including multilateral institutions with long-standing representation and legitimacy deficits, we worried about global reconciliation issues.
At first, most observers dismissed the notion and characterization of the new normal. Words such as "unlikely," "idiotic" and "naive" accompanied much of the outside commentary. Some even claimed that our analysis was "fatalistic," rather than seeing it for what it was; namely, projections of what was likely to occur absent major changes in both public and private sector behavior.
In dismissing the new normal, some analysts pointed to the self-generating and mean-reverting forces within advanced economies. Others were comforted by the extent to which both fiscal and monetary policies had been activated to compensate for the disorderly deleveraging of private balance sheets. And all were encouraged by global policy coordination that reached an impressive high at the G-20 Summit held in London in March 2009.
However, while all these forces were indeed operating, they only succeeded in stabilizing the situation. They did not overcome the underlying tectonic shifts.
Yes, with trillions of dollars devoted to the task, a form of financial calm was restored to a banking system that had put the world on the verge of a global depression. But the sharp "V"-shaped economic recovery that many had anticipated thereafter failed to materialize. Western economies did not achieve escape velocity. Lost output was slow to be reclaimed.
The most consequential disappointment was on the employment front. Given the enormity of the damage to the labor market, job creation was painfully slow. Long-term unemployment climbed to alarming levels, as did youth joblessness. Already-fragile safety nets were stretched yet further. Income and wealth distribution worsened. And governments and central banks scrambled to revise—repeatedly—economic and financial projections that erred only on one side, that of over-optimism.
The growth and jobs disappointments were particularly disruptive for countries with high deficits and debts, whether accumulated due to fiscal reasons (e.g., Greece) or on account of decisions to bail out irresponsible banks (Ireland). Access to market financing became more costly. In some cases, it stopped altogether, pushing countries to seek emergency funding from other sources.
Analysts were transfixed by the image of one advanced eurozone country after the other (i.e., from the elite group of countries within the European Union) seeking bailout packages from the Troika of the European Commission, the European Central Bank and the International Monetary Fund. They were even more stunned to see one (Greece) default and another (Cyprus) confiscate bank deposits. And who would have thought that a eurozone country (again, Greece) would end up being relegated from developed-country status to MSCI's emerging markets index?
All this served to aggravate another problem that had been brewing for a while—that of declining opportunities and increasing income and wealth inequalities within several Western economies. While the middle class stagnated and too many in lower-income segments fell into poverty, the upper class mostly recovered quickly and continued to prosper.
It should come as no surprise that sociopolitical systems had problems dealing with all this.
Rather than unite behind a national and regional vision, political systems fell victim to greater polarization. In the United States, this dynamic paralyzed most new legislative initiatives, including the annual passage of a budget (the most basic element of economic governance). In Europe, seemingly endless political summits became the norm as leaders sought to overcome internal divisions aggravated by very divergent analyses of the past, present and future. Japan saw a series of government changes culminating in the return of Prime Minister Shinzo Abe, armed with the country's boldest postwar policy experiment.
Naturally, social tensions increased. Facilitated by a social media revolution that enabled millions to overcome coordination challenges, an increasing number of citizens took to the street demanding change. Some voted for fringe political parties that were set on dismantling the past but lacked a coherent agenda for building a better future.
Meanwhile, a very different situation prevailed in most emerging economies. Growth paths were resumed quickly, debt declined and international reserves increased. Some even participated in supporting struggling Western economies through aid and investments. In the process, they climbed the convergence ladder even faster and higher.
As the West struggled, emerging economies complained louder about the long-standing deficits in global governance. They questioned more forcefully, but did not overcome, outmoded and feudalistic practices. Whether it was historical European and U.S. claims to the leadership of the IMF and World Bank (based on geographic entitlement rather than merit and experience), or the West's disproportionate control of voting power, louder criticism led to few material changes.
With all this going on, it is not surprising that consensus moved to adopting the multispeed new normal as the new paradigm for the global economy. This remarkable change in attitude was highlighted in April 2013 when Christine Lagarde, the managing director of the IMF, defined the world as "a three-speed global economy" ahead of the gathering of country officials in Washington for the semiannual meetings of the IMF and World Bank.4
It also spoke to a set of experimental policy responses that would change the underlying dynamics of the new normal, rendering it more unstable and less predictable.
Of all the policymaking entities, central banks were the ones most able to recognize the unusual dynamic of the new normal and sought to do something about it.
There were many reasons for the quicker responsiveness of central banks. Their DNA encompasses important crisis management and prevention components. In the case of both the U.S. Federal Reserve (Chairman Ben Bernanke) and the Bank of England (Governor Mervyn King), they were led by individuals who understood the risks of a Great Depression, all of which resulted in much greater policymaking agility.
Importantly, these institutions had also been provided over the years with an important degree of operational autonomy and independence. As such, they were less constrained by the polarized politics. Moreover, having met regularly, especially under the auspices of the Bank for International Settlements, they were more effective in cross-border policy coordination.
Recognizing the need to avert a "Great Depression" and contain a "Great Recession," central banks led by the Federal Reserve pivoted in 2010 from targeting market normalization to also targeting macroeconomic outcomes.5 But with policy rates either near, or floored at, zero and facing a paralyzing liquidity trap, they ventured into experimental policy territory, focusing on two measures in particular: 1) communication policy with a heavy emphasis on expectation-forming forward policy guidance; and 2) aggressive use of the balance sheet to alter behavior and asset prices.
Much has been written (and will be written) on this phase of hyperactivism by experimenting central banks. For the purpose of this analysis, it suffices to note that these institutions were compelled into action with an inevitably partial and imperfect set of policy tools. As such, and as acknowledged early on by Chairman Bernanke, their use of unconventional measures targeted not just "benefits" but also entailed "costs and risks."6
The intention of central banks—a correct one—was to provide time for other policymaking entities (with more comprehensive tools) to get their act together. Unfortunately, this intention was frustrated by a host of factors, including dysfunctional politics. As such, central bankers found themselves venturing much deeper into experimental mode than they ever expected; and they stayed there for much longer than they ever expected.
As hard as they tried, central banks were not able to transition fully from their policy bridge into the destination of high growth, ample job creation, and declining income and wealth inequalities. As well as they succeeded in containing the interest bill on government debt (and facilitating its refinancing and terming out), they were not able to deliver the income growth that would have safely deleveraged the still-overextended segments in the economy. As such, some of the problems faced by the West risked becoming embedded in the structure of their economies, rendering the subsequent solutions even more challenging.
Given the delicate balance between "benefits, costs and risks," the consequences were not just domestic. Cross-border spillover effects became possible, especially given the U.S. role in the provision of key global goods (including the reserve currency and the deepest and most liquid markets for financial re-intermediation).
The longer Western central banks persisted with their unconventional policy stance, the larger the externalities for the emerging world; and this became obvious to all the moment the Bank of Japan went unconventional in a big way following the election of Prime Minister Abe.7
At first, the reaction of the emerging world was to express concerns—mostly through discreet private channels. The one notable exception was Brazil, where officials repeatedly spoke out publicly against the negative global externalities of the West's experimental monetary policies, including the risk of a "currency war."
Ultimately, one emerging economy after the other felt that it had no choice but to essentially subjugate part of its policy approach to counter the impact of unconventional policies elsewhere. Just witness the statements that followed policy steps taken by countries as diverse as Brazil, China, Israel, Mexico and South Korea.
The Growing Instability Of The New Normal
As consensus (and policymaking) finally adopted the new normal, its basic underpinnings were evolving into what we felt at Pimco could be best described as a "stable disequilibrium"; that is, an economic and financial configuration that superficially appeared stable but was in fact increasingly unstable in its key foundations and drivers.
There were five main reasons for this.
First, overdependence on central banks and the persistent delay in comprehensively adjusting the policy response allowed a growing number of dislocations to become structurally embedded into economies around the world.
This was most visible in the labor market, where labor participation rates fell and were slow to recover, hourly average wages stagnated and long-term unemployment remained too high—all raising legitimate and consequential questions about skill atrophy and the ability of many citizens to resume gainful employment at prior levels of earnings and opportunities.
Most alarming of all, youth unemployment remained at frightening levels—not only in the periphery of the eurozone (62 percent in Greece, 56 percent in Spain and 42 percent in Portugal),8 but also in the United States, where teen joblessness remained close to 25 percent.9 At that stage of life, a persistently out-of-work youth can go from being unemployed to being unemployable.
Second, the highly unbalanced policy stance fueled price disconnections, cascading market irregularities, unusual liquidity patterns and increasing resource misallocations. Ironically, only five years after a global financial crisis fueled by excessive leverage and irresponsible risk-taking, a growing number of analysts and officials were warning of the risk of new financial bubbles.
Third, rather than self-correct, political polarization grew.
Ironically, central-bank success in averting an immediate financial crisis took the pressure off feuding politicians. In the United States, this translated into inaction on virtually all economic policy initiatives due to congressional dysfunction. In Europe, pronounced enthusiasm to pursue the four pillars of a more complete union—namely, supplementing monetary union with fiscal union, greater political integration and banking union—dissipated in the months following the dramatic July 2012 statements by ECB President Mario Draghi. 10
Fourth, witnessing persistent economic and political uncertainties, strong segments of the national and global economies remained hesitant to engage their healthy balance sheets. Large companies kept stunningly large amounts of cash on their balance sheets; and when some of it was deployed, it was for dividend and share buybacks rather than investing in new plants, equipment and hiring. For their part, rather than lend out their excess reserves, banks kept significant amounts of cash on deposit at central banks.
Finally, the global economy faced growing difficulties in reconciling competing and divisive forces.
After reaching its March 2009 peak, global policy coordination virtually ceased. Emerging economies faced difficult challenges in navigating the negative externalities of the West's experimental policies—so much so that several of them started to slip into inconsistent and confusing policy responses. Multilateral agencies sought to compensate, but their effectiveness continued to be undermined by justifiable concerns about their representation, credibility and legitimacy deficits.
These considerations have all led us to conclude at Pimco that the new normal is morphing—from an unsatisfactory low-level equilibrium to a stable disequilibrium. And we believe that a good way to visualize the underlying dynamics is through the use of a "T-junction" construct, with its two principal components; namely, the eventual end of the current road, and the possibility of two quite distinct and contrasting outcomes thereafter.11
For an illustration, consider the four largest economies in the world.
The "T-junction" dynamics are most evident in Europe. Yes, ECB hyperactivism has maintained a financial equilibrium. But being unable to dramatically improve the underlying economic fundamentals, it is just a matter of time (and certainly within the next five years) before the eurozone embarks on one of two very different roads: that of seriously pursuing a less imperfect and more complete union that can deliver growth and jobs to its member countries, or a messy reorganization with the risk of major economic, financial, political and social dislocations. In other words, Europe's new normal is now a "forced normal," if not a "fake normal."
Japan is also on a rather short road to the neck of the "T." It has embarked on its most ambitious policy experiment, and done so with a remarkably challenging set of initial conditions. It is yet to be seen whether the initial burst of growth will be sustained due to the implementation of comprehensive structural reforms (the "third arrow" of the prime minister's bold initiative); tolerance on the part of the country's main trading partners; and the ability to overcome demographic head winds. Alternatively, growth will peter out, leaving the country more exposed to financial instability.
The United States is also heading toward a T-junction, albeit one with a longer road and less dramatic alternatives. Either the political system will transition from constituting a head wind to a tail wind for the economy's ongoing endogenous healing, thereby allowing for economic escape velocity, proper job creation and continued safe deleveraging; or it will create additional self-inflicted wounds, increase the possibility of another recession, allow alarmingly high unemployment to become more structural in nature, and complicate longer-term debt, deficit and inequality issues.
As complicated as they seem, the issues in Europe, Japan and the U.S. boil down primarily to creating and reinvigorating growth engines.12 There is also the case for China.
Here the "T" is truly a secular one, involving the historically complicated middle-income development transition. In the next decade, China will either succeed in adapting its growth model—including a needed pivot from external to internal sources of growth, with all the political and social changes that this entails—or, alternatively, this systemically critical economy will find it difficult to sustain high growth, thereby also increasing the risk of social and political instability.
All this adds up—to use Bernanke's elegant phrase—to an "unusually uncertain outlook." As such, the investment implications are consequential; and they are quite different from what worked well during the equilibrium phase of the new normal.
Up to now, the best investor response to the new normal was to downplay the fundamentals and ride the enormous wave of central-bank liquidity. After all, lacking comprehensive tools, central banks could only achieve their policy objectives by going through the financial markets—and, particularly, hope that a policy-inspired combination of the wealth effect and animal spirits would result in higher domestic aggregate demand (through both consumption and investment).
Simply put, central banks were focused on inserting a wedge between sluggish fundamentals and more buoyant prices. In the process, they would take virtually all asset prices to artificially high levels. Accordingly, the best new-normal policy approach was essentially the widespread implementation of quite a simple theme: "Central banks are investors' best friends."
Look for the effectiveness of this theme to be increasingly challenged as the new normal morphs into a stable disequilibrium. Artificial asset prices will need to be supported by more than what will be increasingly ineffective central-bank policies. Fundamentals will now have to move to validate pricing, i.e., the sunny sides of the above-mentioned T-junctions will need to prevail. Alternatively, prices will collapse down to the levels warranted by the more sluggish fundamentals (the less sunny sides).
In essence, investors face increasingly binary outcomes whose aggregate impact is further complicated by genuine global adding-up questions. This is why Pimco has been stressing the following key investment considerations:
- Investors should gradually "kick out" from riding a central-bank wave that will prove more unstable and less effective.
- They should focus on investment opportunities away from the wave: those associated with its "costs and risks," and those that arise from the inevitable technical overshoots that will occur in certain markets (particularly those subject to considerable but volatile crossover investment interest, including segments of emerging markets).
- They should expect asset-class variances and covariances to become more volatile and less predictable.
- They should be more cautious in their expectations of risk-adjusted returns going forward.
- They should evolve their risk management to extend well beyond asset-class diversification, including cost-effective tail-risk hedging where appropriate.
- Given that the world is changing, they should guard against falling hostage to outdated benchmarks, guidelines and investment labels.
- Finally, they should resist the illusionary safety of old comfort zones, and do so through greater awareness of the limitations imposed by inadequate framing, unconscious biases, active inertia and overly narrow cognitive diversity.
The new normal was Pimco's early recognition that, after the run-up to and the ravages of the global financial crisis, the West would not reset in a traditional cyclical manner. Instead, it would also face some important secular and structural challenges that policymakers would find hard to respond to. In the process, key global economic and financial relationships would move in new directions, delivering quite a few unthinkables.
On the surface, the new normal appeared as an unsatisfactory low-level equilibrium. It also triggered, however, an inherently unbalanced policy response in the West; and its international reconciliation was slowed by outmoded approaches to global governance.
In the process, the new normal has morphed into something that is less stable. In some cases, it is now a forced normal. In others, it has evolved fully into a fake normal.
Absent comprehensive and coordinated policy responses, it is only a matter of time until the surface stability is overcome by the meaningful set of underlying disequilibria, resulting in a set of highly contrasting potential outcomes—all of which would constitute an eventual departure from the low-level equilibrium of the new normal.
This morphing warrants equally consequential adaptation in investment approaches. Time is running short for the strategy of simply riding the wave of central banks committed to disconnecting market pricing from fundamentals. A much-less-certain investment outlook is ahead, and one that requires change not only in what investors do, but also in how they think about their overall investment positioning.
1 Please see Pimco Secular Outlook: "A New Normal," May 2009.
2 Please see El-Erian, October 2012, "Navigating the New Normal in Industrial Countries," Per Jacobsson Lecture, IMF.
3 Please see Pimco Secular Outlook: "Navigating the Multi-Speed World," May 2011.
4 Please see IMF Survey, "Move From 'Three-speed' to 'Full-speed' Global Recovery, Urges Lagarde," April 2013
5 Please see El-Erian "Evolution, Impact and Limitations of Unusual Central Bank Policy Activism," Federal Reserve Bank of St. Louis Review, July/August 2012 http://research.stlouisfed.org/publications/review/article/9321.
6 Please see Chairman Bernanke's speech, "The Economic Outlook and Monetary Policy," at the August 2010 Jackson Hole symposium.
7 Please see El-Erian in Project Syndicate, "Beggar Thy Currency or Thy Self?", January 2013, and "The Japanese Experiment," May 2013.
8 Eurostat, http://epp.eurostat.ec.europa.eu/statistics_explained/index.php/Unemployment_statistics
9 U.S. Bureau of Labor, http://www.bls.gov/news.release/empsit.nr0.htm.
10 In his remarks at the July 2012 Global Investment Conference in London, President Draghi said, "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."
11 Please see Pimco Secular Outlook: "New Normal ... Morphing," May 2013.
12 Please see El-Erian, "The Global Growth Quest," Project Syndicate, April 2013.