The Economy in Six Songs

In his book The World in Six Songs, neuroscientist Daniel Levitan of McGill University seeks to outline and explain our emotional lives and heritage in a mere six songs – songs of friendship, joy, comfort, knowledge, religion and love.  I am attempting a task no less daunting.  I hope to condense and explain our current economic condition in just six songs.

So here goes.

 

“You know I work all day; to get you money to buy you things.”

For the economy, the “rubber meets the road” precisely at this point. We need more people working so that they can “buy you things” for the economic climate to improve.  In other words, our primary economic problem is a lack of aggregate economic demand. As McKinsey points out, “the single greatest fear among executives everywhere is weak consumer demand for their companies’ products and services.”

The following chart shows velocity as the ratio of the money supply (M2) to nominal GDP. It rose from 1.85 in 2003 to 1.96 in 2006 but has since fallen to a current level of 1.572 as households reduced spending and increased saving while banks and businesses hoard cash. 

 

Simply put, money needs to get moving again.

 

The Fed is practically giving money away in its attempts to juice the economy — essentially trying to force everyone into equities and giving capital away to try to spur growth.  But it isn’t working.  Meanwhile, savers, retirees and others on fixed incomes are being punished by the low interest rate environment in that no relatively safe yield-producing investment vehicles are available.  Because of the crazy-low interest rates, interest income is down over 30 percent since August, 2008.

Money for nothing indeed.

 

On the other hand, the plutocrat class continues to outperform.  Republicans say they support equal opportunity and the entrepreneurial spirit while Democrats say they look out for the disaffected.  But pretty much everyone in office forgets their alleged principles in order to get or stay close to those with the money — perhaps to finance the next campaign.  Their principles don’t mean very much when it comes to sucking up to the rich and famous.

That’s takin’ care of business at its most crass.

 

The American economy (not to mention the American Dream) is predicated upon the idea that we all have the opportunity to get ahead. Sadly, it doesn’t seem to be working out that way today. Real wages have steadily declined and benefits continue to decline too.

It’s not supposed to be “all takin’ and no givin’.”  

 

While corporate earnings and profits are very high, employees are not sharing in that success.  Indeed, those workers with good jobs have to keep working harder and harder without being rewarded for it (see below) — even with job security.

That’s working very hard for the money indeed.

 

Even though the recession is said to have ended, the newly employed don’t seem often to have obtained very good jobs.  For example, 20-something college degree holders here in California, where I live, are still finding professional jobs extremely hard to come by more than 3 years into the alleged recovery. At 15 percent, the U-3 unemployment rate for California’s college grads under 30 is nearly twice the national rate, and the most common jobs for those who find them are retail, clerical, and food service positions — hardly dream jobs. And according to the U.S. Census Bureau,  more than half of California’s half-million degree holders in their 20′s are underemployed. In fact, the most popular job for the most populous state’s young professionals is retail store floor sales. 

They may as well be workin’ at the car wash.

What Will 2030 Look Like?

The National Intelligence Council is composed of the 17 U.S. government intelligence agencies.  The Council’s Global Trends Report has, since 1997, worked with a variety of experts both in and out of government service to examine factors such as globalization, demography and the environment to produce a forward-looking document to aid policymakers in their long-term planning on key issues of worldwide importance. 

“We are at a critical juncture in human history, which could lead to widely contrasting futures,” wrote Christopher Kojm, the Council’s Chair, in his introduction to the current Report, published just this week.

The Report is intended to stimulate thinking about the rapid and vast geopolitical changes characterizing the world today and possible global trajectories over the next 15 years. Significantly, it does not seek to predict the future – we have a dreadful track record in the regard – but instead it seeks to provide a framework for thinking about possible futures and their implications.

The Report argues that the breadth of global change we are facing today is comparable to that during and surrounding the French Revolution and the rise of the Industrial Age in the late 18th century, but it is being realized at a much faster rate. While it took Britain more than 150 years to double its per capita income, India and China are set to undergo the same level of growth in a tenth of the time, with 100 times more people.

I encourage all investors to read it carefully.  Despite the vital importance of the “long cycle,” it isn’t likely to change your current portfolio outlook, but it will provide a helpful backdrop to your overall thinking and to your longer-term outlook and analysis.

Among the Report’s conclusions is that there are certain “megatrends” that are relative certainties and that we should prepare to deal with them.  These include the following (and note that all have investment implications, some of them potentially enormous).

• For the first time in history, a majority of the world’s population will no longer live in poverty by 2030, leading to a healthier global population and a major expansion of the middle classes in most countries.
• Life expectancies will continue to expand rapidly.  “Aging” countries (such as those in the West – particularly Europe – and Japan) face the possibility of a significant decline in economic growth.
• Asia is set to surpass North America and Europe in global economic power, but there will not be any hegemonic power.
• Demand for resources will increase owing to global population growth from 7.1 billion people today to about 8 billion by 2030.
• Demand for food is likely to rise by 35 percent and energy by 50 percent over the next 15-20 years.
• Nearly half of the world’s population will live in areas with severe water stress by 2030.  Fragile states are most at risk, but China and India are vulnerable to volatility of key resources.

These megatrends will inevitably lead to a variety of vexing and potentially “game-changing” questions.  Each has profound political, economic, market and human implications.

1. Will divergences and increased economic volatility result in more global breakdown or will the development of multiple growth centers lead to increased resiliency?  For much of the West, the challenges involve sustaining growth in the face of rapidly aging populations. For China and India, the main challenge will be to avoid “middle income traps.” In general, the global economy will be increasingly crisis-prone and won’t return to pre-2008 growth levels for “at least” the next decade.
2. Will current governments and international institutions be able to adapt fast enough to harness and channel change instead of being overwhelmed by it?  While this sounds generally like the investment challenge we face daily, there are a variety of major global issues in this regard.  Potentially (more) serious government deficits driven by rapid political and social changes are likely to exist. Countries moving from autocracy to democracy are often unstable and about 50 emerging market countries fall into this major risk group.  All of them could – at least potentially – grow out of their governance incongruities by 2030 if economic advances continue.
3. Will rapid changes and shifts in power lead to conflicts?  The general answer is surely duh, with uncertainty only as to the number, extent and nature of the conflicts.  Limited natural resources—such as water and arable land—in many of the same countries that will have disproportionate levels of young men—particularly in Sub-Saharan Africa, South Asia, and parts of the Middle East—increase the risk of intrastate conflict.  It is particularly troubling to note that any future wars in (at least) Asia and the Middle East may well include a nuclear element. Many of these conflicts, once begun, would not be easily containable and would (obviously) have global impacts.
4. Will regional instability, especially in the Middle East and South Asia, spill over and create global insecurity?  See the commentary re #3 above.  Wash; rinse; repeat.
5. Will technological breakthroughs occur in time to solve the problems caused by rapid urbanization, strains on natural resources, and climate change?  The report identifies 16 key “disruptive” technologies with potential global significance out to 2030. They are generally grouped around potential energy breakthroughs, food- and water-related innovations, big data and the forecasting of human behavior, and the enhancement of human mental and physical capabilities, including anti-aging.
6. Will the United States, as the leading actor on the world stage today, be able to reinvent the international system, carving out potential new roles in an expanded world order?  The Report anticipates that the U.S. will likely remain primus inter pares (first among equals) among the other great powers in 2030 because of the multifaceted nature of its power and legacies of its leadership.  But it also expects that the “unipolar moment” is over. Overall, power will likely shift to networks and coalitions in a multipolar world. The United States’ (and the West’s) relative decline is seen as inevitable but its future role in the international system is much harder to project. China is deemed unlikely to replace the U.S. as international leader by 2030.  Non-state actors and even individuals, empowered by new media and technology, will be an increasing threat.  A reinvigorated U.S. economy – spurred perhaps by U.S. energy independence – could increase the prospects that the growing global and regional challenges would be addressed. However, if the U.S. fails to rebound, a dangerous global power vacuum would be created.

From these building blocks and issues, the Report posits potential  futures including a best-case scenario of increased cooperation between the U.S., China and Europe as economic and security interests increasingly align, a worst case scenario of conflict and fragmentation in a stalled global economy where political, social and economic inequalities work against integration and stability, and a scenario involving a “nonstate world,” where the nation-state does not disappear, but countries increasingly organize and orchestrate “hybrid” coalitions of state and nonstate actors which shift depending on the issue.

There is no earth-shaking news here.  But it is helpful to take a step back and look at the bigger picture once in a while.  Because change is so often incremental, it is easy to underestimate how quickly it can happen and how much impact it can have in the aggregate.  In the markets as in life, caveat emptor.

Demography as Destiny

Josh Brown had an interesting post yesterday based upon a report from Tobias Levkovich of Citi (Bloomberg story here) focusing on the anticipated boom in 35- to 39-year-olds — those in their key “savings years.” This age group is said to be poised to increase for the next 17 years. Saving and investing by these echo boomers “would generate a new set of equity fund inflows,” Levkovich claims. Levkovich expects the S&P 500 to rise to 1,615 in 2013, about 50 points higher than the index’s October 2007 record and about 12 percent above current levels. Besides demographics, he argues that expansion in U.S. manufacturing, energy, mobile technology and housing and efforts to curb federal budget deficits will combine to drive stocks higher.  He also sees valuations as attractive.

Obviously, Levkovich is generally paid to be bullish, so his forecast needs to be considered in that light.  But still, I hope he’s right.  However, I’m not sold on the growing strength of the economy, anything other than ongoing governmental dysfunction (see here and here, for example) or attractive valuations — even though I could easily be wrong.  I’m also skeptical of his view of the demographics.

The ongoing demography as destiny argument is a fascinating one. A useful paper called Demography and the Long-Run Predictability of the Stock Market back in 2002 argued that P/E ratios are correlated to the ratio of middle-aged people to young adults (the “MY ratio”). When MY rises, the market P/E will tend to rise and when it falls, P/Es tend to fall.  This study claimed that we should see a continued fall in P/E ratios from then (2002) through and until a long-term bottom in stock prices forming about 2018.  So by that measure, Levkovich is about five years early.  It may be hard to imagine a Wall Street analyst being too bullish too soon, but there you go.

On the other hand, a report on Boomer retirement and demand for stocks by researchers from the Federal Reserve Bank of San Francisco got a fair amount of play about a year ago and came to a different conclusion. The full report is available here. They see a strong relationship between the age distribution of the U.S. population and stock market performance too. But they see the aging of the baby boom generation as the key demographic. As Boomers reach retirement age, they are seen as likely to shift from buying stocks to selling their equity holdings to finance retirement. They report that their statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades. 

A helpful discussion of the methodological differences between the papers cited above by Cam Hui is available here.  Hui’s analysis also carefully notes that the differences between the respective findings are not all that great.  The San Francisco Fed researchers concluded that stock prices will bottom in 2021, instead of 2018 as implied by the other paper cited above.   That’s not much more than a rounding error for this types of analysis.

On the other hand (although, like Tevye in Fiddler on the Roof, there is no other hand), a Congressional Budget Office background paper published in 2009 comes to a different conclusion from that offered by the San Francisco Fed researchers.   The CBO paper argues that Boomers won’t sell assets very rapidly to finance retirement on account of several factors.

1. Boomers will be careful — they are concerned that they might live longer than expected or might face higher than anticipated medical costs.
2. Boomers desire to transfer assets to the next generation, which should also blunt asset sales.
3. Since the wealthiest one percent of Americans own about one-third of the nation’s financial assets and, for the most part, the very wealthy don’t sell assets to finance retirement, this asset concentration will help to keep demand steady.
4. Many Boomers may work longer than they otherwise would have due to losses of retirement assets due to the 2008-09 financial crisis (but the empirical evidence on this point is inconclusive and the impact might be small).

Wharton’s Jeremy Siegel, author of Stocks for the Long Run, says (unsurprisingly) that growth in developing countries should generate enough demand to absorb a baby-boomer selloff and “keep stock prices high.”

The CBO conclusion may be the key one in this context.

Although the retirement of the baby boomers is not likely to cause a large decline in aggregate demand for assets, several economic studies suggest that the retirement and aging of baby boomers could cause a temporary decrease in asset prices. … Empirical evidence, however, has not revealed much connection between demographic trends and the changes observed in financial markets.

Demographics surely matter. Correlations are important (even if distinctly different from causation). But so do lots of other things — like (duh) the strength of the economy or lack thereof and market valuations.  The market did not tank in 2000 on account of demographics and demographics isn’t controlling the nature and extent of this secular bear market even if and as it is a noteworthy factor.  Demographic trends are interesting, useful and important for the markets.  But there is no evidence that demographics is destiny.

Digital Future, Dimly Foreseen

In my 7th grade music class, every student was required by Miss Perkins to give a report on a piece of music.  I picked a popular subject: Iron Butterfly‘s psychedelic hit, In-A-Gadda-Da-Vida. It was a 17 minute reflection of or on something-or-other. My “research” was straight off the album cover (for those of you who remember what album covers were).  “Iron” signifies heavy, man, and so on. I worked hard to learn the drum solo too.

For those of you looking for a frame of reference, Kevin and Winnie Cooper of The Wonder Years are exactly my age and year in school and In-A-Gadda-Da-Vida was playing in the first kiss episode from the 8th grade where Kevin and Winnie are at their first couples party and they head to the make-out room.  That episode also features The Turtles‘ terrific Happy Together. Anyway, here’s the song, which we thought sounded like the future, and a pretty exciting (if drug-induced) one at that.

 

I wanted very much to be groovy but wasn’t.  It didn’t stop me from trying, however, as with my silly report. In-A-Gadda-Da-Vida indeed.

And my parents — founding members of the Establishment that I saw them to be — were anything but groovy and, in fact, were unalterably opposed to anything with even a whiff of groovy.  They were even…Republicans.

To be clear, my parents were hardly of the “country club Republican” sort.  We didn’t belong to a country club.  In retrospect, there was nothing “establishment” about them either.  Neither of them went to college. We didn’t own or run a business. My mom worked outside the home. We weren’t anything remotely close to rich. 

But we were Republicans. Hard work was good.  Entitlements were bad.  Saving was good.  Profligate spending was bad.  Traditional values were sacred.  The idea of turning on, tuning in and dropping out was anathema. Our leaders — all authority figures really — deserved and got our respect if not necessarily our support (Jacob Javits was pretty liberal, after all).

Vietnam was an unfortunate but necessary evil.  Dick Nixon hadn’t been their first choice (or second or third), but he would deal with those hippies and the Soviets too. Watergate (waiting just over the horizon) was horrible and wrong, but it was also stupid and silly.  Nobody was going to vote for McGovern anyway. And FDR had done stuff just as bad.  We were sure of it.

Our government was a creeping socialism and politicians weren’t statesmen anymore.

The clothes worn by “the youth” were just plain bizarre. So was the hair.  So was the lingo.  And the music….

So whenever my school lessons featured FDR saving us from the Great Depression, my parents were quick to point out that it wasn’t FDR.  It was World War II. 

They weren’t wrong, of course.  Producing and distributing what we needed to fight the Axis powers propelled the country out of the Depression and went a long ways toward making us the strongest and greatest economy in the world, not to mention the #1 (with a bullet, literally and figuratively) superpower. 

To hear Paul Krugman tell it, the key was demand (it didn’t and doesn’t matter for what) and we can fix the current mess by spending our way out of it just like FDR did.  As Keynes argued in the 1930s, the only solution in such circumstances is major fiscal stimulus to close the gap between actual and potential output. TARP wasn’t enough.  QE1 wasn’t enough.  QE2 wasn’t enough.  Operation Twist wasn’t enough.  QE3 won’t be enough.

I get his point, but he’s missing something crucial, I think, besides the reality that all the demand we spur will need to be paid for eventually and we have shown no willingness to do so even assuming we had the ability.  It wasn’t just that WWII put people back to work. There was a fundamental change in the nature of the output.

A key problem during the Great Depression was that increased (and increasing) productivity meant that a largely rural and agrarian workforce didn’t have nearly enough work to do.  The War, essentially by force, transitioned that work force to the cities and into industrial and manufacturing jobs. Once the war was over, heavy-duty military spending was still necessary to maintain our new-found status and the other stuff we produced was being used here and shipped abroad too as American hegemony was extended around the globe.

Today, increased (and increasing) productivity and cheaper labor overseas leaves our workforce underemployed again.  Since the internet boom of the 1990s, we have recognized — if dimly — that our future is a digital one.  But we haven’t yet figured out how to make the transition and there has been no great catalyst (the way the War was then) to force and complete the “creative destruction” needed to make the structural shift once-and-for-all.  The process is a messy one.  It is often unpleasant.  Workers will be pushed out of their comfort zones or even displaced. Some individual results will be unfortunate, tragic even. Creative destruction is still destruction.

Even so, we piddle along, on a slow boat not-even-to China.  Today’s employment numbers provide another series of data points reiterating the obvious.  We have no idea (economically speaking) where we’re going and thus, of necessity, have no idea how to get there.  We’re stuck between preserving a past that no longer works and attempting to forge a future that is unfocused and uncertain (Facebook, anyone?).  The alleged “new economy” isn’t defined a whole lot better today than it was back when almost any kid with a computer and a dream could get a boat-load of start-up money.

The process of “making the future” (to use President Obama’s phrase) is an inductive one that progresses primarily by discovering what doesn’t work so as to ascertain, oh-so-tentatively, what might work.

As the expression goes, if you don’t know where you’re going, any road will take you there.  Unfortunately, today we don’t even seem to be moving much at all. And while we have a pretty good idea what the future consists of, we don’t know what it ought to look like.  Until we do, it’s going to be hard for us to put this Great Recession behind us, no matter how much demand we spur. As my friend Tom Brakke noted on Twitter when he read this piece, economy-wise, we’re not In-A-Gadda-Da-Vida.

Not by a long shot.

Worth Watching

Peter Diamond is a professor emeritus at MIT and the winner of the 2010 Nobel Prize in Economics for his work on unemployment and labor market policy. He recently spoke with Dan Richards at the annual Meeting of the American Economic Association held in Chicago about our debt problem and our unemployment crisis.  Video is available here.  A transcript of this interview appears here.

What Scares Me

In honor of Halloween, and since six is said to be the number of the devil, here is my listing of six very scary financial threats.

(1) I’m not sold on the strength of the economy — not by a long shot.  Household incomes are poor and so is consumer confidence.  Moreover… 

(2) Housing prices don’t seem to have bottomed and, overall, I fear that more substantial deleveraging will be required before recovery can be meaningful.

(3) I’m not convinced that the Eurozone “solution” is one.

(4) The debt ceiling debacle isn’t the end of the story.  Disfunctionality remains (especially with the 2012 elections looming), the “super committee” hasn’t done anything yet, and deficits remain a long-term problem.

(5) I fear that bank earnings numbers are too predicated upon free float from the Fed and mask still-toxic assets that remain over-valued.

(6) Despite everything that has happened since 2007,  I still sense excessive faith in the markets and in the benefits of diversification (if holding stocks for the long run or being diversified really did make investing safe, mutual fund companies would gladly guarantee your investments, but none do).

A Chart is Worth a Thousand Words

Source:  Political Calculations

Worth Watching

On September 18, 2011 I gave a presentation focusing upon 2011 year-to-date investment performance in light of my 2011 Investment Outlook (available here) which was issued back at the beginning of the year. The presentation is entitled “Investment Recap 2011) and is available here.

What Bernanke Really Said

As I noted a week ago, the Fed has effectively conceded that it is out of bullets.  Via a speech yesterday afternoon in Cleveland and the Q&A session that followed, Fed Chairman Ben Bernanke reiterated the point more directly.  Bernanke acknowledged that long-term unemployment is a “national crisis” and suggested that Congress should take further action to combat it.  He argued that Congress could be especially helpful in the areas of long-term unemployment, budgetary discipline and housing policy. Bernanke then went on to offer both a sort of justification for what the Fed has done (or not done) to this point along with an admission that he’s out of ideas. 

“The Federal Reserve has made enormous efforts to try to help this economy recover and stabilize” though its control of interest rates, or monetary policy, he said. “Monetary policy can do a lot, but monetary policy is not a panacea,” Bernanke said.

The Bond Markets: No Safe Haven

The most typical response to market difficulty is to “hide out” in bonds. Indeed, in recent years, bonds have offered one of the better (sometimes only!) sources of capital gains available.  Unfortunately, bonds do not always provide the safe haven that many assume they do and simply cannot do so today. As a starting point, remember that both stocks and bonds can have sizable drawdowns, as illustrated below.

From 1990 through June, 2010, long-term interest rates declined roughly from 8% to 3%. That isn’t likely to repeat. Indeed, it cannot.  At best, rates will be generally stable (especially after the recent surge), but probably they will increase. Bond bulls seem to expect the 30-year interest rate decline they have experienced over most or all of their working lives to remain a given. It isn’t (see below).

Increasing government deficits can only increase pressure on interest rates.  According to the Congressional Budget Office, the red line in the chart below reflects the current obligations of the federal government while the blue line represents revenue. These deficits mean that the federal government will continue to need to borrow money to finance government operations. This added supply of bonds will necessarily impact demand.

Notice that these deficits are getting bigger and bigger while tax rates remain low amidst political pressure to keep them low – which emphasizes the extent of the problem.  The recent debt ceiling “solution” resulted in surprisingly little actual progress.  Moreover, the tendency of voters to demand more in the way of services while paying less in taxes is as consistent as politicians’ willingness to pander to them.  This nonsense is a problem anytime.  In difficult economic times, it is a recipe for disaster.

Foreign investment in U.S. bonds, which has offered consistent support to bond prices and low rates, may well have peaked, which could also begin to put pressure on interest rates.

 

 

In an effort to stimulate the economy, the Fed has been an enormous buyer of bonds – keeping rates low.  Recent debate (since the end of QE2) over what the Fed can and should do (QE3?) as well as continued economic weakness makes potential Fed buying going forward a significant unknown. 

 

Source: Federal Reserve

Notice, however, that the Fed has been funding most of the deficit.

If the Fed stops its active bond buying and foreign governments reduce their buying, demand will dwindle, hurting bond prices and pushing interest rates higher.

Finally, Standard & Poor’s became the first of the big three rating agencies to downgrade U.S. debt. That downgrade has not pushed rates higher, at least so far, and continued economic weakness should offer some support for bond prices (as we have seen today in response to a weak jobs report).  However, at the very least, the long-expected new era of U.S. Treasury price volatility may finally be here.  In any event, the situation is unsustainable over the longer-term, and what is unsustainable tends to stop.

Note, too, that a rising interest rate environment will have an adverse impact on other types of investments.   The following chart shows historical yields for U.S. Treasury 10-year notes.  Inflation-adjusted returns reflect the average consumer price index (CPI) of 5% (1954–1981) and 3% (1981–2010), and reinvestment of capital gains and dividends, if any. Equities are represented by the S&P 500 Index and fixed-income is represented by the Barclays Capital Aggregate Bond Index.  Obviously, rising rates will hurt equities too.

Sources: St. Louis Federal Reserve Bank; Morningstar  

Investors are not generally surprised by these facts. What they are not typically aware of is the extent of the risks in bonds. Research Affiliates calculated how much investors would lose on certain Treasuries over two years (from January 1, 2011-January 1, 2013) if yields reverted to their 50-year averages. It isn’t pretty.

The Research Puzzle had a helpful piece earlier this week amplifying the point.

Is a bond bubble on the horizon? No one can say for sure (I think so, but — like Bill Gross — I may well be wrong), and it is always dangerous to risk fighting the Fed, but I can say with certainty that the recent high bond market returns are over. The math demands it. Three years ago, five-year Treasury notes were yielding roughly 4.125%. A similar-duration bond fund should have returned this yield plus price appreciation, producing a three-year annual return of around 6.75%. Even with rising rates in the latter stages of 2010, a five-year Treasury note as of year-end still yielded around 2%.

In order for a bond fund of similar duration to generate 6.75% annually over the next three years, the yield from interest rate declines must contribute around 5% annually to the total return.  Thus rates would have to decline by about another 5% – and that simply (obviously!) cannot happen. A decline of five percentage points would translate to a substantially negative yield. On the other hand, under less favorable scenarios for bond investors, such as if rates go back up to where they were three years ago, a soundly negative return will result. If rates go up quickly, the decline in value will be even sharper.

Bonds simply cannot continue to be the safe haven so many investors expect them to be. The best that bond investors can hope for right now is relative stability.