I start this week's letter somewhere over Kansas on the way to Lake Louise outside of Calgary, Canada. I have been giving a great deal of thought to a speech I will do tomorrow and have decided to make the speech the subject of this week's letter. I have been given no particular topic other then to talk about something that I find of interest, but to keep it to 40 minutes and 20 minutes for questions.
I am speaking to a conference sponsored by Peters and Company, which is a boutique energy investment bank. The 150 investors and clients are all in the energy investment business in one form or another. To me, that means they have a longer term time horizon than most investors, as investing in/finding a source of energy and bringing it to the markets is not a short term endeavor.
Having just finished (!) a 400 plus page book on the future of the global economy and markets, it was tempting to focus on one particular chapter and drill down in-depth on a subject. However, it seems to me that since the energy business is particularly subject to the ebb and flow of trends, we will look this week at what I call the Super-Trend Puzzle. We will pick up right after the obligatory joke, sparing you my shop-worn humor.
The Super Trend Puzzle
I am a big fan of puzzles of all kind, especially picture puzzles. I love to figure out how the pieces fit together and watch the picture emerge, and have spent many an enjoyable hour at the table struggling to find the missing piece that helps connect the patterns.
Perhaps that explains my fascination with economics and investing, as there is no greater puzzle (except possibly the great theological puzzles or the mind of a woman, for which I have only a few clues).
The great problem with the economic puzzle is that the shape of the pieces can and will change as they come into contact with each other. One often finds that fitting two pieces together will change the way they meld with the other pieces you thought were already nailed down, which may of course change the pieces with which they are adjoined, and suddenly your neat economic picture no longer looks like anything close to the real world.
There are two types of major economic puzzle pieces. The first are those pieces which represent trends which are inexorable: they will not themselves change, or if they do it will be slowly, but they will force every puzzle piece which touches them to shift to the force of their power. Demographic shifts, which we will explore in a moment, would be an example of this type of trend.
The second is what I think of as the balancing trends or trends which affect each other. As an example, President Bush in a speech this week once again called for the Chinese to float their currency, which will supposedly help our balance of payments deficit with China, as well as make US products more affordable.
As Dennis Gartman noted, Bush should be careful of what he asks for, as he might get it. Right now, the Chinese are plowing their surplus dollars into buying US debt. If they did not have such a surplus they needed to invest, who would finance the monstrous government budget deficits? How would interest rates stay low stimulating the economy? There are answers, of course, but they change as the Chinese currency puzzle piece changes.
If you play the Chinese currency piece, it affects the balance of trade piece which influences the budge deficit piece which changes the shape of the interest rate piece which affects growth rate of the GDP and on and on and on. Thus this type of economic puzzle piece is what I term a balancing piece. When you play it, everything else must balance with it.
Today I want to deal with five pieces of the puzzle that are Super Trends. They will force the other pieces of the puzzle that is the world economy to bend to their power and will shape our future. Betting your investments and business that these trends will change is destined to be frustrating at best and seriously damaging at worst.
The Aging of the Developing World
The first trend is an old friend, or perhaps it would be better to say that it is the trend of our friends getting older: The Aging of the Developing World, and its off-spring, the Retirement Crisis.
Let's quickly survey a few facts. The fertility rate in the West and China is below population replacement rate. Italy, Spain and Russia are below 1.25 children per family. The US is at 2 children per family, but the strong immigration policy keeps the population growing. Pakistan, Nigeria and Saudi Arabia average over 5 children per family. Yemen has an astounding 7.3 children per family!
As the developing nations get older, it means the percentage of working age population decreases. Since it takes 3 times as much resources to support a retired person as a child, and since there will be fewer workers to support a growing cohort of retirees, it stands to reason that the growth of these economies will slow.
Bank Credit Analyst, a venerable Canadian research group, forecasts that US GDP will drop from the recent 3% trend of the 1990's to an average of 2.4% for the next 25 years and to an average of only 2% for the years 2025-2050. That is slow growth indeed by historical standards.
But it is worse in Europe. Growth is projected to slow to 1.4% for the next 25 years, and to be barely an anemic 0.6% in the next 25 years. Japan, whose working age population decline is slated to drop 23%, will see growth slow to 1.4% and then to nothing in the next 25 years. And these figures factor in sizeable productivity growth. It is no wonder that economics is called the dismal science.
The percentage share of the developing countries of the global population will drop from over 30% in 1950 to less than 14% in 2050. The Islamic nations of the world will be roughly equal in population to the developed world in 50 years. Yemen will be larger than Germany. Iraq, less than 40% the size of Italy today, will be 30% larger than Italy. Likewise, Russia's small neighbor to the south, Iran, will have a higher population, as the populace of Russia implodes by 30%. (This brings to mind a whole host of issues concerning military power and armed forces, but that is not the subject of this letter.)
The number of elderly merely increases by 60% in the US, while almost doubling in many European countries and Japan. Neil Howe and Richard Jackson in a study for the Center for Strategic and International Studies show how the percentage of GDP devoted to supporting the elderly (that will be me all to soon!) will grow from 9% in the US to 20% by 2040. In Europe and Japan it rises from around 12% to over 25% and in some countries over 30%. The well-written study is available at http://www.csis.org/gai/aging_index.pdf
If the total amount of obligations by governments to the retired populace is paid for by tax increases, the blow to the economies by 2040 is staggering. Total taxes as a percent of GDP rises in the United States to 44%. In Europe it rises to over 55% and in France to 62%. Clearly these levels are not possible, so things will change. Either benefits will be cut or inflation will erode the purchasing power of the pensions, etc. What young worker would stay in a country where 50% of his income went to pay retirement plans for the elderly? They would vote with their feet, as did 99% of our forbears in the US. This of course, only makes the problem greater?
Of course, the answer could be to promote greater immigration to the developed countries, but that is a tough political call right now. However, as this morning's speaker, Professor Ken Deffeyes of Princeton noted, that today's antipathy to nuclear power will soften a great deal when it costs $100 to fill the tank of your Ford F-150 pickup. The same will be true of immigration in a decade or so.
The Balancing Of Globalization
The United States has been responsible for 96% of the growth in world GDP since 1996. We are the engine that pulls the world. However, to do it we have run ever increasing trade deficits, which now run well over $500 billion. This is an unsustainable trend. As the dollar continues it slide, at some point the world will cease to finance our deficits at today's level.
However, this presents the world's central bankers with a dilemma. If they let the dollar fall too far, too fast or somehow damage the US economy, the main source of their economic growth would be reduced. If the US economy catches cold, many of the nations of the world might also catch our colds or develop economic pneumonia.
The hope among especially Asian Central Bankers is that they can build a middle class which becomes capable of supplying its own consumer spending and growth engine and they will become less dependent upon the American consumer. So far, they seem to feel that it is better to take dollars which are decreasing in value than to risk recessions and turmoil in their own economies. The goal seems to be to try and slowly transition to a more balanced world economy.
But whether that new balance is slow or fast, it will happen. Asia has tasted the fruits of a free market for decades. China has drunk the Kool-Aid of Capitalism. There is no turning back. Further, as these economies grow and become increasingly privatized and a new emerging middle class develops, they will increasingly become their own growth engines.
While I am concerned that the transition may not be as smooth as the world might like, and in fact might be quite rocky when the United States falls into recession, this is a trend that is locked in place.
As an aside, the world is currently obsessed with China and the powerful growth in the Chinese economy. And rightly so. But I would keep my eye on India. The economy there has been disappointing for decades, as their government pursued a socialist policy which did not foster trade and development. That is changing. As a younger and highly educated population begins to eye the rest of the world, they will force India to become more open. I think India is a sleeping giant. In a few decades we could be talking about the Indian Miracle.
One other prediction: China will be griping about the unfairness of cheap labor from western Asia within 20-30 years.
All this is going to increase global trade as the developing world increases trade with each other and with the developed world. Despite cries from luddites like Senator Charles Shumer of New York and other protectionists, there is no stepping down from increasingly free markets. Any attempt to close barriers in a significant way or to impose tariffs will precipitate a trade war and a world wide depression. The US has in fact lost fewer manufacturing jobs (percentage wise) than Europe or even many third world countries like Brazil. We are producing only slightly less than we did at the peak in 2000. We are simply doing it with fewer workers, as productivity has increased. The US will not be a third world country in 20 years as Paul Craig Roberts, a former Reagan Treasury official, predicts.
In 1975, as things looked bleak and we were sending jobs to Japan, there were those who predicted the demise of the US. The economy was in terrible shape. (Do you remember the Whip Inflation Now buttons?) Where would we find jobs in the future? The correct answer was, "I don't know, but we will, because that is what free markets and American entrepreneurs do." It is still the correct answer today. 25% of workers in the US today hold jobs that were not even on the government list of jobs in 1967. That has been the case for the last two centuries of American history. That does not mean the transition is a walk in the park. It might be quite daunting. But it will happen.
A Secular Bear Market
As I have often written about my view that we are in a long-term secular bear market, I will spare readers of the letter with a longer section, but will focus on a few facts.
Since 1900, there have been 8 complete bear and bull market cycles. In every case of a secular bear cycle, inflation either rose or fell from low inflation to serious deflation. The opposite happened in bull cycles. Today inflation is about as low as it can go. When that changes, as it will, whether it drops into deflation or rises back to higher levels, it will not be good for the stock market.
Further, in every case bear markets went from high P/E ratios to low P/E ratios. That is to say, that valuations based on earnings dropped. The opposite happened in bull cycles. Valuations for large cap stocks are clearly quite high. There has never been a secular bull market start (anywhere!) from such high valuation levels. As Jeremy Grantham noted, this is a sucker's rally.
From 1993 until late last year, earnings only grew by an average of 4% per year on the S&P 500 and less than 1% after inflation. In a raging bull market, earnings growth was less than stellar. 80% of the growth of the stock market was from increasing investor valuations and were not attributable to earnings growth. For the stock market to resume a bull cycle and 8-10% annual growth, valuations would have to double over the next decade to levels never see before, far above the recent bubble.
Earnings cannot grow above GDP plus inflation over the long term. With excess capacity and increased competition, it is hard to see how earnings can grow at a 10-15% rate over long periods. That type of growth would be necessary for the stock market to achieve the next bull market.
Finally, there has never been a ten year period in history when valuations have been as high as they are now that broad stock market indexes out-performed money market funds. Never.
The implications are not good for those who are counting on an ever-rising stock market to fund their retirement in the next decade or so. It means pension plans, which are betting their future on an ever-rising stock market, will require massive funding to stay solvent, and local and state governments will have to raise taxes or cut services to fund the approximate $1 trillion dollars that will be necessary to meet retirement plan obligations.
The Muddle Through Economy
Again, so as to not weary my readers, I have developed my thoughts on what I feel will be the decade of the Muddle Through Economy. While that does not preclude years where growth will be quite good, as 2004 appears it will be, I think overall growth for the decade will be less than 3%, and probably closer to 2%. Another recession, and perhaps two, is in our future over the next 10 years as we deal with the problems of personal debt and imbalance in our trade and government budget deficits. The current economy is due in no small part to stimulus from tax cuts, a low interest rate policy established by the Fed, tax rebates and consumer borrowing, especially home debt re-financing. There are limits to the growth that this type of stimulus will maintain.
The clear hope of the Federal Reserve is that if they can maintain a low interest rate environment until business investment and spending become sustainable, that they will be able to raise rates slowly without damaging the consumer or employment. I still believe the Fed will not raise rates until after the election, barring some sharp rise in employment. Yesterday's unemployment numbers do not yet show such a rise, and the GDP rise of a more normal "only" 4% disappointed, showing as it were that the powerhouse growth of the third quarter was indeed stimulus induced.
The Next New Thing
Acknowledging the above trends does not mean I am pessimistic about the future. In many ways, the above problems are not any more difficult than those faced in prior periods in American and world history, and in many cases far less difficult. It is simply a different set of issues which must be addressed. Each decade has its own set of problems and opportunities.
But the one trend which must be recognized, and from where the solutions to the problems will come, is the rise of freedom and free markets. It is the spirit of discovery and entrepreneurism that creates new and ever more beneficial technologies: steam engines, railroads, electricity, the telephone, computers and medicines. Every major period of growth has been spurred by the introduction of some new innovation which for awhile does indeed change everything.
What will be the Next New Thing? That there will be one seems to be far more reasonable than to make the ridiculous suggestion that all the important discoveries and inventions have already been done.
However, today I tend to think that the future innovation cycle sparked by the Next New Thing will not be some large invention, but rather the combination of 1,000 smaller new things in dozens of fields, each creating a new market and combining with each other in totally unpredictable ways.
As an example, Rodney Brooks, Director of MIT's Computer Science and Artificial Intelligence Laboratory wrote in the February edition of Technology "I am convinced robots today are where computers were in 1978."
He goes on to talk about the technologies to make the vision and the dexterity of robots better. He thinks that will happen in the labs soon. He concludes: "Robots with the vision capabilities of a two year old and manipulation capabilities of a six year old will be more disruptive to our way of life than any robot portrayed by the governor of California. They will reorder the world labor markets that have developed over the last 50 years. They will change immigration patterns and the massive shift of labor from developed to developing countries. But the most important impact might well be on elder care: care giving robots could help us weather the tsunami of aging baby-boomers about to submerge the economies of Europe, North America, and Japan. But more on that in a later column. For now, suffice it to say: the robots are here."
Is Brooks right? Who today knows? But what of George Gilder's Telecosm about which he addressed the conference this morning? The seemingly one-a-day announcements of gee whiz drugs from the biotech world spark great hope. The amazing advances in the field of nanotechnology offer the potential for a world of amazing productivity and increased standards of income.
How will all these combine to create new opportunities and markets? We moan about the migration of knowledge jobs to India and China, but what about the effects upon our economy as very bright people are freed up (or forced) to dream up entirely new ways to support themselves. It was from a technology bust in Silicon Valley in the 70's that many of the great companies of today were developed, as engineers and scientists felt compelled to invent new ways and technologies to support themselves. Left to themselves, how many would have been content to stay in their jobs? It is Schumpeter's creative destruction at its best. While not initially comfortable for the participants, ultimately it created an entire new world.
It is not inconsistent to suggest we are in a secular bear market and a Muddle Through Economy and to also believe that there are remarkable opportunities at our doorstep. It is simply to say that as investors the opportunities and the way we should exploit them are not the same as we would have done in the last two decades.
It is why I can worry about pension plans and retirement programs and still be optimistic about the future. It is my firm belief that in 20 years we will not look back and want to return to the good old days of 2004.
Let It Snow
Although next weekend I will be in Miami, on Wednesday we arrived in Calgary to a temperature of -30 below, which is a tad cool for this Texas boy. Interestingly, up in the mountain resort of Lake Louise it was 20 degrees warmer and maybe tomorrow will be closer to reasonable. I finish this letter writing from a corner suite provided by the conference sponsors (I am afraid to ask the price!), looking out over the lake and mountains in what may be the most beautiful place I have ever been. With two huge picture windows for my writing "office," it is clearly the finest place I have ever written this letter. It is snowing. Below me are ice castles, skiers, skaters and kids on sleds. It is quite the winter wonderland and tomorrow after listening to an expert on Russia and then George Gilder, I will go dog-sledding, cross country on snow shoes and then some well deserved time in the spa. Without any kids for the weekend, my bride is acting as social director and has lots of activity and fun planned. Sometimes life is really, really nice. It is quite easy to be an optimist this weekend.
Next week, I will write about some of the presentations I have heard. One that is very interesting is on the supply of oil in the world. In the meantime, enjoy your weekend.
Your watching out for snowballs from his bride analyst,
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