Welcome to the Depressing Future?

Yesterday's report that the U.S. economy expanded by +1.7% in the second quarter was largely greeted as "good news" by Wall Street.

Here's an excerpt from what the New York Times reported this morning:

The mixed picture facing the country was evident on Wednesday, as the Commerce Department reported that the economy, adjusted for inflation, expanded at a better-than-expected annual rate of 1.7 percent in the April-June quarter, even as inflation-adjusted growth in the first part of the year now appears slower than first thought....

Optimists point to improved levels of job creation in recent months, a more robust housing sector and a surging stock market that has lifted the value of investment and retirement accounts for millions of consumers. Pessimists focus on the fact that the estimated economic growth rate of about 1.4 percent so far in 2013 is well below last year’s levels of 2.8 percent, even as automatic cuts in federal spending and higher taxes continue to bite. 

http://www.nytimes.com/2013/08/01/business/economy/us-economy-grew-by-1-7-in-2nd-quarter-faster-than-expected.html?ref=todayspaper

We are now in the fourth year of an economic recovery that started in the summer of 2009.  However, real wage growth remains non-existent for a large part our country, and the unemployment rate hovers at levels (7.6%) that would have been unacceptable a generation ago:
 

 The growth of real GDP remains depressed, and has never reached the levels seen in the 1990's; note the general decline in the following chart:




Many analysts blame today's subdued growth rates on the large amounts of debt accumulated in the past decade.  Growth will remain depressed until this debt burden is reduced, they argue, but will once again return to previous levels once more funds are flowing back into investment rather than debt repayment.

Others blame Washington's obsession with deficit reduction, and are urging a new round of government fiscal expansion. Austerity policies are killing the economy, in this view.

But there is another more depressing possibility: Perhaps there are structural reasons that the growth rates that were experienced over the past couple centuries were historic anomalies, and that we are not likely to return to robust (+4% or higher) growth rates for decades.

In this view, there is nothing that any policy changes can do to alter the subdued future.

An aging population, coupled with declining birth rates in many industrialized countries, could be the real culprit for anemic growth. If this is the new reality, no amount of government intervention can make a material difference in the economy.

That's the suggestion that Robert Gordon, a well-respected economist from Northwestern raised in a paper published last year.  The story was picked up by New York Magazine last week.

I hope Gordon is wrong, of course, but this is not another wild-eyed pessimist calling for doom-and-gloom.  Instead, Gordon argues that for much of human history economic growth was fairly minimal.  It was not until the industrial revolution beginning in the 1840's that any significant changes in the human condition occurred.

Subsequent improvements in the global standard of living followed technological breakthroughs. The discovery of ways to distribute electricity, for example, completely changed society, as activities no longer had to be structured around sunlight.

More recent technological innovations have been exciting, but not "game changers" when it comes to the way that most of us live our lives.  Air conditioning may make summers more bearable, but they do not appreciably change our lives in the same way that improvements in public health facilities once did.

I could go on, but here's an excerpt from the New York article:

Then two things happened that did matter, and they were so grand that they dwarfed everything that had come before and encompassed most everything that has come since: the first industrial revolution, beginning in 1750 or so in the north of England, and the second industrial revolution, beginning around 1870 and created mostly in this country. That the second industrial revolution happened just as the first had begun to dissipate was an incredible stroke of good luck. It meant that during the whole modern era from 1750 onward—which contains, not coincidentally, the full life span of the United States—human well-being accelerated at a rate that could barely have been contemplated before. Instead of permanent stagnation, growth became so rapid and so seemingly automatic that by the fifties and sixties the average American would roughly double his or her parents’ standard of living. In the space of a single generation, for most everybody, life was getting twice as good.

At some point in the late sixties or early seventies, this great acceleration began to taper off. The shift was modest at first, and it was concealed in the hectic up-and-down of yearly data. But if you examine the growth data since the early seventies, and if you are mathematically astute enough to fit a curve to it, you can see a clear trend: The rate at which life is improving here, on the frontier of human well-being, has slowed.

http://nymag.com/news/features/economic-growth-2013-7/?mid=longreads

There are numerous investment implications if Gordon is right.

It is widely assumed, for example, that interest rates will spike higher once the Fed begins to "taper" its presence in the credit markets.  However, an aging population with a need for fixed income in retirement may continue to keep interest rates lower than the levels seen during more robust growth periods. What if rates stay below 3% for years to come?

The growth companies of the past were companies who offered goods and services to a growing and dynamic population.  However, while there has been no lack of retailing activity, retailing companies themselves are struggling, as more of shopping is done on-line.  Just look at how few of the companies in the consumer discretionary space in the S&P 500 are growing revenue at reasonable growth rates.  And shopping malls - once a mecca of suburban activity - are seeing dramatically lower traffic levels, or are even going out of business.

Worth a read if you have the time.

Dow Two Million

The United Nations came out with a report yesterday indicating that it expects the world's population to top 10 billion by the end of this century. Reading the news reports got me thinking about the power of compound interest.

I don't view the United Nations report as necessarily gloomy. It really just reflects a very modest global population growth over the next century.

The world's population today is roughly 7 billion. Reaching 10 billion by 2100 implies a compound growth rate of just 0.40% per year for the next 89 years.

That said, this forecast has potentially a number of implications for our planet and our limited natural resources. Commodity prices, for example, will almost certainly be moving sharply higher unless we change the way we power our cars and feed ourselves.

From an investor's standpoint, population growth can also represent an opportunity, especially since historically demographics seem to play an important role in determining the longer term trend of capital markets.

Much of the forecasted population growth is expected to occur in Africa, where there are already numerous countries struggling to provide even the most basic needs of food and water. Large investments in food and infrastructure will be needed in many African countries.

Compounding even small increases over long period of time can lead to some fairly startling results. And while doomsayers since Malthus have projected that population growth will overwhelm mankind's ability to cope, I am optimistic that it is also possible that we will develop better ways to use our limited resources so that basic needs can be met.

For example, the great investor John Templeton used to say that he would not be surprised to see the Dow Jones Industrial average hit 2 million in the next century.

How did he come up with this? Well, historically, stocks have returned about 6% per year, not including dividends.

The Dow Jones Industrial Average today is trading around 12,700. If stocks follow the historic trend of the last century, a 6% compound growth rate for the next 89 years implies the Dow would be trading around 2,000,000.

U.N. Forecasts 10.1 Billion People by Century’s End - NYTimes.com

Demographics Determine Longer Term Market Trends

I was first introduced to the work of Dick Hokenson when he was an analyst and then chief economist at Donaldson, Lufkin & Jenrette. After stops at other Wall Street firms, he currently has his own company (Hokenson & Company).

Dick's specialty is demographics. More specifically, Dick attempts to come up with investment ideas and themes based on his work on areas like population growth; labor force trends; and productivity. The idea is that factors like the average age of a population will have a greater impact on areas like, say, housing than interest rates.

For example, Dick has always used the age of a country's population as a means to predicting future economic growth and stock market returns. He was bullish on the emerging markets long before the consensus simply because stronger population growth in countries like Brazil. Younger people buy houses and consume more products than older citizens, which helps the overall economy.

His work has always been unique. Unlike most Wall Street analysts, Dick tries to figure out how demographics will impact the investment markets. Although his views are naturally longer term in nature, his work is always thought-provoking.

The most recent issue of CFA Magazine carried an interview with Dick. Here's a couple of excerpts, with the full link below.

First, Dick notes that many parts of the world - notably Japan - are not only seeing an aging population, but are also seeing a shrinking population. This is one of the reasons that Japanese interest rates are so low:

What’s the relationship between shrinking populations and low interest rates?

There is a very strong relationship between nominal long term interest rates and nominal long-term GDP growth. I have seen studies that tracked this relationship back to the 1800s. If you do a supply-side decomposition of the GDP,in terms of population, labor force, and productivity, you end up with a very strong causal relationship between labor force and nominal GDP. And labor force growth is slowing—it is slowing worldwide. That will continue to pull down nominal GDP and nominal interest rates

And then there's the themes that Random Glenings has been sounding for at least the past year:

What’s the biggest demographic story investment-wise?

If you think about one of the most important things somebody who manages money has to make a decision about, it’s the outlook for inflation. If you get that wrong, you are going to have a big negative impact on your performance. In the 1960s and 1970s, people underestimated inflation and got burned. But for much of the past 30 years, it has been the other way around. People have underestimated the structural disinflation. Otherwise, in 1981, you would have bought the 14¾ U.S. 30-year Treasury bond. In 1981, there were no buyers. And as interest rates were falling, there were still no buyers. Those people said, “They are declining, but they will start rising again,” and that has been part of the issue for the past 20 years. I have talked for 20 years about low interest rates, and people look at me and say, “You went to too many Grateful Dead concerts and inhaled too heavily.” If you look in the press, everybody believes in inflation—that [Federal Reserve Chairman] Bernanke is going to reflate us, that inflation is going to be back next year or a year after, and that interest rates will be higher.
Why don’t you think there will be inflation?

If you have very low interest rates and you have an age structure where people don’t borrow money (aging populations), it doesn’t matter what the price of money is. You can push out money, but it doesn’t go anywhere.

So that’s the question—is inflation caused by money supply or money demand? If it is money supply, then it is a central bank issue and the Central Bank is going to control it. But if it’s money demand, then it is a demographic issue. I think it’s a demographic issue. The age structure of the population matters in terms of whether you can reflate. And since the population of the world is aging, reflation becomes less and less likely.

http://www.cfapubs.org/loi/cfm

Japan and Aging Populations

Commenting on a several recent articles discussing demographics, and the aging of the population in many countries around the world:

First, on the front page of the New York Times yesterday, there was long article about the long-running economic malaise in Japan. Japan, of course, has been mired in a deflationary, slow growth world for more than 20 years despite massive fiscal and monetary stimulus.

Although I have read and written about Japan frequently over the last few years, what was striking to me was the depressing effect that deflation can have on a society:

But perhaps the most noticeable impact here has been Japan’s crisis of confidence. Just two decades ago, this was a vibrant nation filled with energy and ambition, proud to the point of arrogance and eager to create a new economic order in Asia based on the yen. Today, those high-flying ambitions have been shelved, replaced by weariness and fear of the future, and an almost stifling air of resignation. Japan seems to have pulled into a shell, content to accept its slow fade from the global stage.

http://www.nytimes.com/2010/10/17/world/asia/17japan.html?pagewanted=2&sq=japan&st=cse&scp=2

What the article does not discuss is the decline in birth rate in Japan, which is slowly becoming an important issue not only in that country but globally as well.

There was the piece in the Times's Business Section talking about aging, and how important a role that demographics can have in determining government finances. This paragraph in particular caught my eye (I have added the highlighting):

For the first time in human history, people aged 65 and over are about to outnumber children under 5. In many countries, older people entitled to government-funded pensions, health services and long-term care will soon outnumber the work force whose taxes help finance those benefits. This demographic shift also means that the number of people living with dementia, whose treatment is estimated to cost $604 billion worldwide this year, is expected to more than triple, to 115 million, by 2050, according to a report this year by Alzheimer’s Disease International, a group representing 73 Alzheimer’s associations around the world.

Slipstream - How Aging Populations May Crimp the World’s Finances - NYTimes.com

Besides the effect on government finances, the private sector is obviously affected as well. In particular, many older Americans have viewed their houses as sources of funds if they need money in their later years. However, in the midst of the current housing crunch, a large amount of supply coming from seniors looking to "cash out" could also prolong the decline in housing prices, not to mention the strain it could put on seniors.

So the question for the investor: What should one do to protect your future?

Well, to me at least, common stocks need to play an important role for savers, especially if one has a longer term time horizon. While not screaming "buys" based on current valuations, stocks can offer reasonable returns along with, in many cases, dividend yields that are higher than many higher grade bonds.

But apparently my views are not shared by everyone, according to this morning's Wall Street Journal. Pension funds - pools of cash that should have a very long time horizon, especially given the trend towards longer lives noted in yesterday's Times - are pulling back from stocks:

After making the same kinds of investment blunders as many individuals, corporate pension funds now are seeking the same remedies: fleeing stocks for the perceived safety of bonds.

A growing number of pension managers are concluding their pursuit of maximum returns was a mistake, interviews with managers and consultants show. Instead, many funds are trying to achieve stable returns that more or less keep pace with the plan's obligations.

http://online.wsj.com/article/SB10001424052748704540904575451793471885092.html?mod=WSJ_hpp_LEFTWhatsNewsCollection

This to me makes no sense. There were several reports last week that pension plans in the public sector continue to use return assumptions of around 8% in deciding whether they are actuarially sound. With bonds yielding around 3% (unless you're buying much longer maturities), why does an increased allocation to fixed income make sense for a fund with a longer term time horizon?

The Way We Live Now - The Public Pension Crisis - NYTimes.com

Roger Lowenstein has written a number of insightful books and articles on Wall Street and finance over the years (I would suggest, for example, that his biography of Warren Buffett is probably the most useful on the market).

Lowenstein wrote a book a couple of years ago entitled While American Aged which described the pension problems that plagued General Motors, New York City, and San Diego. It's an interesting read, as it describes in detail the past pension deals that corporations and politicians made that were never properly financed. Now those obligations are coming due, and there isn't enough money to pay for the benefits.

Pensions - and Social Security - have gradually emerged to become one of the major financial problems facing the public sector. It's not enough to say, "Well, we just have to cut the benefits", because it's not legally possible. On the other hand, when you read stories of teachers and policemen being laid off for lack of funding, it is clear that something has to be done.

One of the big problems, by the way, is the unrealistic investment returns that pension plans have used to calculate their required contributions. For years annual return figures of 8% to 10% were assumed, despite the fact that the funds were not returning anywhere close to those figures. Even today, with bond yields at 3% and the past return of the S&P 500 essentially flat since 1998, pension returns assume that somehow private equity and hedge funds will produce enough magic to bail out the funds.

Here's an excerpt from Lowenstein's piece in the New York Times last week, with the full link below:

....Pension obligations are a form of off-balance-sheet debt. As funds approach exhaustion, states will be forced to borrow to replenish them. Some have already done so. Thus, pension obligations will be converted into explicit liabilities (think of a family’s obligation to pay for grandma’s retirement being added to its mortgage)... if the unfinanced portion of all public pension obligations were converted to debt, total state indebtedness would soar from $1 trillion to $4.3 trillion.

Such an explosion of debt would threaten desperate governments with bankruptcy. Alternately, states could try to defray pension costs from their operating budgets. Illinois, once its funds were depleted, would be forced to devote a third of its budget to retirees; Ohio, fully half. This would impoverish every social (and other) program; it would invert the basic mission of government, which is, after all, to serve constituents’ needs.

The Way We Live Now - The Public Pension Crisis - NYTimes.com

"DIY U": The end of university prestige - Nonfiction - Salon.com

Like fine wines, the prestige of a college tends to rise in the estimation of the buyer when the price of the service (i.e. tuition) rises.

Many of the most prestigious colleges in the United States now cost more than $50,000 per year - a pretty healthy charge, to say the least.

For years there have been discussions that perhaps there would be a backlash against the cost of higher education, but this has not come to pass - not yet, at least. Application volumes at the most desirable colleges and universities remain at very high levels, with the concomitant admission rates very low.

Still, it would seem likely that the rate of tuition increases will eventually have to slow down.

This article in this morning's Slate has a good discussion about this topic.



"DIY U": The end of university prestige - Nonfiction - Salon.com

Reflections on the American Dream - column from the FT

I did alot of reading over the past few days, trying nightly to recover from skiing with my 16 year old daughter. I'll be posting a couple of book reviews this weekend on these books.

When I got home this evening, however, I came across this column from Clive Crook of the Financial Times. It echoes some of the same thoughts that Malcolm Gladwell writes about in his best-selling book Outliers, which I'll review later. However, it is an interesting perspective from a British writer.

Excerpt here, link follows:

Reflections on the American dream

February 19, 2010 11:47pm

Back in November I wrote glowingly in a column for the FT about Creating an Opportunity Society, a new book by Isabel Sawhill and Ron Haskins. Earlier this week I attended a dinner with other journalists, scholars, and policy-makers to talk over some of its ideas. The conversation (off the record, in any event) was frustrating, because the budgetary obstacles to any action requiring outlays are so severe at the moment. If nothing else, though, it moved me to recommend the book again. It’s the best thing of its kind I’ve read for a long time.

The finding that would surprise most Americans is that the American dream is something of a fraud. Intergenerational social mobility–your chances of moving up from poverty, or down from great wealth–are lower in the US than in most of Europe. This is something I have written about before. Research suggests plenty of mobility in the middle part of US income distribution, but not much at the ends. The American dream is a kind of opportunity club, and the very poor and very rich aren’t members.

http://blogs.ft.com/crookblog/2010/02/reflections-on-the-american-dream/

Changing Demographics on College Campuses

My favorite college student in the world attends Wesleyan University (Michael T. Glen, Class of 2013). Since Michael is a student, last week we received the most recent copy of Wesleyan's emagazine.

The article I found most interesting focused on the trends in admissions. Wesleyan has received 6% more applications this year than last, despite the poor economy. The caliber of the applicant pool also seems incredibly high.

From an analytical standpoint, however, what caught my eye was the disproportionate amount of female applicants to males. I have already put a couple of posts up about the changing demographics on college campuses, so this article continues the trend, I guess.

Why aren't more men applying to college? What will male job prospects be in the future, when education plays such an important role in employment? Does this lack of a strong education background help explain why one out of five American men are currently unemployed?

Mind you, I think this is terrific news for American women. I have a daughter who is a sophomore in high school, and I am very excited about the prospects for her future (OK, so I'm very biased - it is Valentine's Day, after all). But I am puzzled by what the younger members of my gender might be thinking.

I have edited the article, but here's the key points in my opinion:

Applications Up By 6 Percent Over Record Year

Feb. 8, 2010 by Olivia Bartlett Drake

This year, 10,645 seniors from around the world applied to Wesleyan University, an increase of 6 percent from 2009, which was a record year for applications, despite the sour economy.

“Last year we reached an all-time high for applications, up by 22 percent, and this year is 6 percent over that,” says Greg Pyke, senior associate dean of admission.

Of these students, 41 percent are male and 59 percent are female.

The applicant pool contains 362 candidates for the Freeman Asian Scholars program, 860 for early decision admission and 9,423 applications in the regular review process. Two-hundred-and-twenty-nine of these students are alumni sons and daughters.

Compared to 2008 data, this year Wesleyan received 203 more applications from the Midwest, 266 more applications from the South and 619 from the West. Applicants from the Northeast increased by 392 since 2008.

The Office of Admission.

So, why are so many more people applying to Wesleyan? According to a Jan. 29 blog on “Admission and Recognition” by Wesleyan President Michael Roth, it isn’t easy to point to any specific factors with confidence.

“Clearly, we have benefitted from positive press thanks to the great work of our faculty, students, staff and alumni. Our admissions and communications departments have been in high gear making sure that we get the word out about what makes Wesleyan an extraordinary institution,” Roth wrote. “The campus looks great, and investments in our physical plant have had compelling results. We have been emphasizing some of the distinctive aspects of a Wes education, and above all, students and their families have been talking to others about their own experiences.”

Twenty-two percent of the Class of 2014 applicants hail from New England; 20 percent are from New York; 13 percent are from the mid-Atlantic; 7 percent are from the Midwest; 7 percent are from the south; 19 percent are from the west; and 13 percent are from elsewhere in the United States. Twelve percent of the applicants are international.

The applicants come from diverse racial backgrounds. Eleven percent of applicants are Asian or Asian-American, 8 percent are black or African-American, 8 percent are Latino or Hispanic and 1.2 percent, or 125 students are Native American. Sixteen Native Hawaiians also applied to Wesleyan this year.

Of the 10,645 applicants approximately 745 are expected to join the Class of 2014. Sixty-three percent of the applicants, including Freeman Scholars, applied for financial aid.

The median ACT score for the applicant pool is 31 and the median SAT scores are 690 for critical reading and 690 for math. About 25 percent of applicants are sending ACT scores, Meislahn reports.