Pick a letter–L, U, V, or W–to describe the shape of the economic recovery. Combine that with a forecast for inflation or deflation, and you can reliably determine your asset allocation.
Or can you?
Those who forecast, for example, a v-shaped recovery with moderate inflation would naturally allocate a healthy dose of equities to their portfolios. Historically, a sharp economic recovery coupled with low to moderate inflation has been very good for stocks. That logic, however, ignores one variable that will likely obscure the importance of the alphabet soup of economic recovery scenarios.
Unemployment will have a greater role in forecasting returns in this market than the lettered descriptor of the shape of the recovery. Whether we face inflation or deflation, too, will be largely dictated by unemployment.
We are undergoing a structural shift in the economy, as jobs migrate from the manufacturing to the service sector. That transformation parallels the experience of the Great Depression, when the global economy shifted from an agricultural to a manufacturing focus. As Columbia Professor Bruce Greenwald explained in a recent interview in Advisor Perspectives, it was not until the industrial policy of the U.S. succeeded in moving large segments of our population from farming towns and industries to industrial centers that we emerged from the Depression.
I am not suggesting that we are entering another Depression. The U.S. economy of the next 50 years, though, will be very different from that of the last 50. Our automobile industry will not return to its pre-crisis production levels any time soon, if ever. Nor will any industries that are part of the automotive supply chain. Consumer spending will remain depressed, and as households defer their high-ticket expenses, key manufacturing industries–housing, appliances, and electronics–will remain depressed.
The consequence will be relentlessly high unemployment.
Forecasting when unemployment will peak is incredibly difficult. Gary Shilling, who publishes a widely read newsletter, Insight, has correctly predicted major turns in the economy and the markets over the last several decades, says it will peak at 11%.
Shilling has closely studied the relationship between changes in GDP and unemployment over the last 60 years. His data show that to keep unemployment from rising, real GDP must grow 3.3% annually. His Insight publication provides the following data illustrating the critical relationship between these variables:
If PIMCO’s forecast of a New Normal proves accurate, real GDP will grow by a mere 2%, potentially increasing the ranks of the unemployed 10.7% annually. Therefore, one cannot reconcile Shilling’s forecast of 11% unemployment with his data and PIMCO’s New Normal. Greenwald said equilibrium in unemployment may be closer to 14%–a forecast which is more consistent with PIMCO’s scenario.