Advisors’ most successful clients learned their formative investing lessons in the late 20th century—a “perfect storm” of favorable demographics and economic trends.
But the past decade revealed starkly different conditions.
This column describes three inescapable trends that will drive investments in the developed world for the next few decades; a companion column will suggest specific portfolio changes.
Governments throughout the world have spent more than the tax revenues they collect, accumulating debt that has risen to levels much higher than their countries’ GDPs.
Each 50% increase in a nation’s debt-to-GDP ratio lowers economic growth by more than 1% per year. When debt levels approach unaffordability, lenders shut their wallets: they stop lending.
Governments then must throw spending and taxation into sudden reverse, which often can stifle a recovery or bring on a depression. Greece is only the most recent example.
Research by Professors Carmen Reinhart and Kenneth Rogoff suggests that the effective limit on government debt to avoid these malignant economic side effects is about 90% of GDP. Every advanced nation’s debt is far above this level; Greece isn’t even the worst.
When lenders go on strike, governments will first respond with spending cuts and higher tax rates (or taxing things that never were taxed before).
Taxpayers will shelter income by doing less of the activity being taxed, moving funds offshore to lower-tax jurisdictions, or searching for loopholes. The revenue raised will fall short of projections, so governments will turn to monetizing the debt by expanding the money supply–which will bring on higher inflation.
This unholy combination is stagflation: slow growth along with high inflation. This last occurred in the U.S. in the late 1970s. (Dust off your leisure suit!) Stagflation is typically bad for stocks, as it was then.
As societies prosper, birthrates drop. Urbanization brings households off the farm, where large families are an economic asset, into cities where they are a liability.
Economic opportunities for women cause many to defer motherhood. A long term measure of this trend is the “total fertility ratio” (TFR)—the average number of children born per woman during her lifetime.
Population levels are stable at TFRs near 2.0, perhaps 2.05 to compensate for infant mortality. The rich world’s TFRs fell below 2 a few decades after World War II. When fewer babies are born to replace deaths, populations age and eventually shrink. There are fewer kids in schools, then fewer workers in jobs.
Younger populations must work and save to prepare for eventual retirement, while older populations spend accumulated assets. Aging has a profound effect on economies, and on different industries. A young population will have vibrant education and construction sectors, while the strongest sectors among an older population will be health care and funeral homes.
Societies with entitlement programs like retirement pensions (such as Social Security in the U.S.), will see their costs rise as the number of older residents grows. Programs will also become less affordable when the number of workers who fund the entitlement system shrinks.
And like individuals, societies take fewer risks and innovate less as they age. So an aging population means a less dynamic economy: less invention, and more resources used to support dependent populations.
The advanced economies felt the demographic slowdown first: Japan most severely, followed by Western Europe. America’s demographic slowdown has been muted by immigration.
But for many developing countries entering the global middle class, their birthrates are also falling rapidly, and their societies are aging. China’s median age will exceed America’s by 2020. The longtime flow of Asian investments into American assets, will reverse when their profits must be repatriated home to pay for a growing elderly population.
An aging global society will mean higher interest rates, and a drag on economic growth and stock prices.
Democratization in the late 20th century introduced three billion new capitalists (in Clyde Prestowitz’s phrase) in Asia to the opportunities available by trading with the West.
They will sell their labor in exchange for our technology. The trade made possible by democratization has propelled more people out of poverty in a shorter time than any event in history.
This trend of democratization and globalization was been a boon for the world, lifting billions out of poverty and filling Western stores with cheap goods. But those new capitalists will not be content with low skilled manufacturing jobs: they will climb the value ladder and increasingly compete directly with a growing span of Western industries.
Even skilled middle class professions in the West are under intense competitive pressure. This is one of the main reasons why median incomes in the U.S. have made no real progress for the past few decades.
A unique historical moment
Debt, demographics, and democratization combined to supercharge economic growth in the late 20th century. But clients should not simply extrapolate, or they will grossly overestimate our growth prospects in the early 21st century.
The 1980s through early 2000s—what some economists have called the period of “Great Moderation” when both unemployment and inflation were low—was the party.
The first few decades of the 21st century will be the hangover. We may still grow, but more slowly than in the past: 1 or 2% per year (as the pattern since 2009), not the typical 4 to 5%.
Professor Larry Summers calls this “secular stagnation.” We call it the “new normal.”
Be income focused
Clients approaching retirement should turn from a growth focus to an income focus; not only due to their own needs, but also due to the realities of the new normal.
These mandate scaling back clients’ return expectations and taking less risk with their investments: emphasizing income, not growth.