Jubak's Journal
5 big trends investors must watch
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The environment we face a decade from now will be far different, a world reshaped by debt, demographics and the dollar.
By Jim Jubak
The short-term direction of this stock market and economy remains wrapped in a fog. There simply isn’t enough data to say if the rally will run another couple of months or melt in the August heat, let alone predict whether the much- anticipated economic recovery will kick in during September, October, or next year.
(My own view is that after an August-September drift lower, stocks will move ahead in the last quarter as the rally resumes on hopes for the fourth quarter.)
In contrast, the long-term picture is remarkably clear. The trends that will have the most influence on the financial markets over the next 10 years are already in place. The way they’ll work out certainly isn’t preordained, but investors can pretty easily identify the forces that will shape the future.
And those trends -- I’ll spell out the big five in this column -- say the investing world will be radically different 10 years from now and probably much more challenging. And woe to investors who think all they have to do to position their portfolios for future years is to follow past strategies and tactics.Money 2004.
Smarter, faster and easier
than ever.
So instead of fretting about the short-term and wishing that we had data that we can’t get yet, I’m going to look ahead and identify five trends likely will drive prices of financial assets and bear watching. I’ll also lay out the steps that investors should take both to profit from those trends and to protect their assets when necessary for the next 10 years.
A leveraged world
Where better to start than by looking at the forces set in motion by Federal Reserve Chairman Alan Greenspan, like it or not, the most powerful financial and economic figure in the world. Greenspan, in his efforts to smooth out the swings in the business cycle and to limit the damage inflicted by risk-takers who get their bets wrong, is presiding over a huge increase in global leverage. It didn’t start yesterday, and it won’t unwind tomorrow. Unwind it will, however, and, when it does, investors should be ready.
We’re all familiar with part of this leverage, the part that shows the U.S. consumer taking on ever-increasing amounts of debt. Total consumer debt, which does not include home mortgages, stood at $1.32 trillion in 1998, according to the Fed. By May 2003 the total was up to $1.76 trillion. That’s a 33% increase.
Mortgage debt has more than kept pace. Mortgage debt climbed 12.4% in the United States last year. The five-year increase is about 60%.
But consumer debt is just one part of an ocean of debt. Wall Street is on a pace to sell more corporate bonds, from investment grade to junk, this year than ever before. States have been selling bonds to bridge huge budget shortfalls. California, for example, faces a deficit in its two-year budget of about $38 billion, a gap that the state will fill, if the politicians can ever agree on a plan, by some mix of borrowing and more borrowing. (Standard & Poor’s puts the deficit at about 31% of the state’s annual budget.)
And, of course, the leverage doesn’t stop there. The federal government just announced that the 2003 deficit is likely to come in at $450 billion and to hit $475 billion for 2004. Estimates for the cumulative deficit for 2004-2008 run from an optimistic $1.5 trillion from the White House’s Office of Management and Budget to $2 trillion by Wall Street economists. Add that to the current total $6.7 trillion national debt, and you’re starting to talk about real money.
Of course, it could be worse. In 1983, the deficit hit a postwar high of 6% of gross domestic product. Thanks to growth in the U.S. economy, the current deficit is larger in absolute terms, but smaller as a percentage of the economy. The U.S. deficit stands at just 4.6% of gross domestic product -- short, if not comfortably so, of the 1983 record. (If you take out the current surplus in the Social Security Trust Fund, the deficit is 5.7% of GDP.)
An aging, slow growth (industrialized) world
Not in every part of the globe, I grant you, but in most of the developed world, low birth rates and restrictive immigration policies add up to rapidly aging populations. In the European Union, for example, the median age of the population is projected to climb from 38 in 2000 to 49 by 2050. Among the industrialized world, Japan is aging fastest: By 2050, demographers project that the country will have 1 million residents who are over 100 and 30% fewer people (a decline of about 36 million). The United States is the only industrialized nation showing population growth, thanks to immigration, and the relative youth of these immigrants means the United States is aging less quickly than its industrialized counterparts.
And since all the data say that economic growth is higher when a population is younger, this demographic trend portends slower growth for the globe’s currently industrialized nations. That stands to reason. These economies will have to divert capital away from investment in factories and product research to paying pensions and providing health care. Population growth is a major component of economic growth as more people mean more workers making more things and providing more services for consumption by a larger population. Aging countries with falling populations won’t get this economic boost.
An inflationary world.
History says that individuals and countries can grow their way out of debt. A dangerously leveraged company can use increasing profits to reduce its debt over time, and economic expansion in the 4% to 5% range would solve many of the budget problems in Sacramento and Washington.
History also says that, absent growth, debtors can solve their problems by inflating their way out of them.
Here debtors that also happen to be national governments have a decided advantage. A homeowner with a huge mortgage can hope that general economic inflation will increase the value of his house and his equity. But the homeowner can’t actually do anything to create that inflation.
National governments, on the other hand, own printing presses. They can create inflation by running those presses and printing more money. And that’s exactly what the U.S. Federal Reserve has been doing lately. The Fed has been increasing the money supply to the U.S. economy at an annual rate of about 10% lately.
And the phenomenon doesn’t stop at U.S. borders. Global money growth has increased by about 7% over 2002, according to a recent study by the ISI Group.
With moderate inflation, the $6.7 trillion current U.S. national debt, plus the $2 trillion more the federal government is projected to tack on by 2008, starts to seem more manageable. Look what 4% inflation can do, for example. If the U.S. economy grows at 2% a year without inflation, current GDP climbs to $11.8 trillion in five years and the projected $8.7 national debt rises to 74% of GDP from the current 63%. But if the economy grows at 2% a year with 4% inflation (for nominal growth of 6%), then the GDP climbs to $14.3 trillion and the $8.7 trillion national debt falls to just 61% of GDP. That’s below today’s level even though the national debt is $2 trillion bigger.
But the national debt -- money that we often owe to ourselves -- isn’t the only debt that makes inflation look attractive. The United States is now a huge net global debtor. Foreign central banks own $936 billion in U.S. Treasurys and paper from quasi-agencies such as Fannie Mae (FNM, news, msgs). And that’s only part of what the United States owes the rest of the world. From a net creditor as late as the mid-1980s, the country has swung to a net debtor to the tune of more than $2.3 trillion. A decline in the value of the U.S. dollar, otherwise known as inflation, would do wonders for that debt burden too.
A dollar-saturated world
In the first quarter of 2003, the United States ran a current account deficit of $130 billion. We imported about $136 billion more in goods than we exported; slight surpluses in the flow of services and income reduced the final deficit. How did we pay for that deficit? With dollars. Germans, Japanese, Chinese, and other non-U.S. inhabitants of our world accepted this paper IOU in exchange for their goods. They’re willing to hold that IOU because they believe in the long-term political stability and the long-term economic viability of the United States, and because the competing brands of paper IOU, the euro and the yen, are less attractive.
But that willingness to hold increasing numbers of dollars isn’t guaranteed. This year, for example, overseas holders of dollars and dollar-denominated investments decided they’d like to hold fewer dollars and they sold that currency to buy assets denominated in Euros, for instance. Projections for U.S. economic growth and inflation made holding dollars less desirable.
The selling pressure on the dollar would have been more intense except that foreign central banks intervened to buy dollars. That wasn’t a vote of confidence in the U.S. economy but rather a self-interested attempt to keep the value of euros and yen from rising so far that goods sold with price tags in euros and yen didn’t get priced out of the global market by cheaper offerings from U.S. companies. Foreign central banks holdings of Treasurys and other dollar-denominated agency paper climbed by 22% in the last year.
None of these overseas holders of dollars would be happy to see inflation eat away at the value of the dollars they hold. So while domestic pressure in the United States argues in favor of inflation, the U.S. status as a global debtor makes inflation undesirable. The only way to get investors who hold dollars to put up with higher inflation is to offer them a better return on their dollar holdings. The conventional tool for fighting a weakening dollar is higher interest rates.
The U.S. need for inflation goes hand in hand with the need for higher interest rates to convince current debtors, especially overseas debtors, to hold the dollar-denominated IOUs.
A world of broken promises
The current age for retiring on full Social Security and Medicare benefits is 65. That is scheduled to rise, very slowly, to 67 by 2027. Any one who thinks that “promise” is likely to hold there is going to be sadly disappointed.
The only question isn’t how quickly the age for retiring with full benefits will rise, but whether baby boomers will also see the size of those “full benefits” fall.
The potential for broken promises isn’t limited to a cash-strapped federal government. Corporate pensions at many companies do not have the funds to meet projected liabilities, and some companies are clearly going to be unable to come up with the cash to live up to their obligations. Workers will either have to strike deals with the company itself for lower benefits or have the company unilaterally cut benefits by shifting the burden to the federal government’s Pension Benefits Guarantee Corp., which does insure pensions but doesn’t pay the full value of promised benefits.
And the United States isn’t the only country where promises will be broken, or forestalled. Since 1970, Germany has seen an 80% jump in the number of citizens on pensions or who are without jobs in what used to be West Germany. The number of workers paying payroll taxes grew by just 4%. Under that pressure, the Germans have begun, tentatively, to talk about changing the benefits provided by its social welfare system.
That’s the end of my five trends, and, by themselves, they make up pretty depressing reading. The world is destined for inflation, higher interest rates, slower growth, and skimpier retirement and health-care benefits.
But it’s important to remember that these trends aren’t destiny. People aren’t puppets. For example, people will work longer to compensate for falling retirement benefits and in response to increasing healthy life spans. Investors will shift capital from slower-growth countries to younger and more rapidly growing economies, increasing the growth rate in those economies and pulling the global growth rate higher in the process. Financial markets will create new instruments to hedge some of the risk in the dollar so dollar-holders won’t have to sell. Existing businesses and entrepreneurs will respond to demographic trends with new products and services that increase productivity.
Will these responses be enough for us all to avoid the worst possibilities inherent in the five trends that I’ve outlined? Probably not. Human history rarely turns out quite that neatly.
Will the next decade see periods of extreme turmoil as societies adjust to these huge changes? Very likely.
And will investors who try to adapt as best they can to the potential risks and opportunities in these trends be more successful than investors who keep their heads thrust firmly into the sand? Absolutely.
In my next column I’ll take a look at five potential ways to adapt to what we know of the future. |
