Is 70 the New 65?

By John Mauldin

As some of us know far too well, forecasting the future with any precision is extremely difficult. There’s at least one exception to the rule, though. Population trends show themselves decades and even centuries in advance. If we know how many people were born in a given year, we can extrapolate what the population will look like far in the future.

On the other hand, demographic forecasting still requires assumptions. At what age will people start having children, and how many will they have? How will new medical advances affect life spans? When will people start working, stop working, and enter retirement? Small changes in any of those assumptions can quickly affect population numbers.

Today’s Outside the Box wrestles with that last question. In the United States we allowed the federal government to set 65 as the retirement age by making Social Security available to most workers at that point in their lives. The retirement age is going up to 67 for the younger members of the Baby Boom generation, but even that may be too “young” to retire in the future.

We Baby Boomers were never big on conformity. Voluntarily or not, a large number of us fully intend to stay in the workforce to age 70 and beyond. If 70 is the new 65, we will see significant changes in the ways people spend their money and the kinds of investments they want.

Matthew Tracey and Joachim Fels of PIMCO outline some of the possibilities in this report. I found it very interesting, and I think you will, too.

Speaking of things changing, the weather in Texas has been nothing like anything in the past. It is mid-February and I’m having to turn the air conditioner on at night. The forecasters tell us it’s going to get into the 80s on Friday. Talking with my long-term Texas friends, none of us can remember weather like this. Cooler than normal summers, milder than normal winters. I guess it’s a good thing it’s not like this every year, because then we’d have a wave of tax refugees showing up from California. Then again, this is Texas. If we wait a bit I’m sure we’ll get our usual ice storms and other nasty stuff. Winter is coming. Maybe.

I am struggling to keep up with the research my 20 some teams are developing for the chapters of The Age of Transformation. Thankfully I have a small team helping me review the research, which is on top of the research I’m doing for the five or so chapters that I’m personally writing. Plus, there’s my regular reading for doing the weekly letters and so forth. It is forcing me to sort through the pile of items in my inbox as to what is must read, what can wait, and what I just don’t have time for. I really am learning to depend on people to make sure the things that I must read get on my radar screen.

I’m going to go ahead and hit the send button, as I have to prepare for an interview with CNBC Asia on Japan and related topics. You have a great week, and I hope that wherever you are, your weather is as good as ours.

Your marveling at the speed of things changing analyst,

John Mauldin

70 Is the New 65: Demographics Still Support 'Lower Rates for Longer'

By Matthew Tracey and Joachim Fels
PIMCO.com, February, 2016
The so-called demographic cliff remains at least a decade away; meanwhile, global demographics should continue fueling the savings glut.

Is global aging about to end the savings glut? Some observers think so. More and more baby boomers are reaching retirement age, and they will soon not only save less but also start to dump their accumulated assets to fund retirement … or so the story goes. If this were true, the consequences for interest rates would be profound. The real long term equilibrium interest rate, which has been on a secular downtrend for decades partly due to strong working age cohorts saving hard for retirement, would start to rise – and what we here at PIMCO call The New Neutral might soon be history.

We strongly disagree with that thesis of an imminent demographics induced savings drought. Rather, we have argued in recent work that the global excess supply of saving over investment, which has been largely responsible for the secular decline in equilibrium interest rates, is not only here to stay but likely to increase further in the coming years for a host of reasons including demographics (see PIMCO Macro Perspectives, “No End to the Savings Glut,” September 2015). As a consequence, we continue to expect the fundamental forces of elevated desired saving to keep the equilibrium real rate depressed and to limit the extent to which other (cyclical) factors can drive up market interest rates.

However, given the popularity of the thesis that demographics will soon end the savings glut, we undertook a deep dive into the data to investigate the link among demographics, saving behavior and the demand for fixed income assets – with some surprising results. Here’s what we found.

A ‘demographic reversal?’ Not so fast!

People of the world, we’re getting old. It’s a well-known fact that, after decades of decline, the global dependency ratio – traditionally defined as the ratio of individuals younger than 15 and older than 64 to the working-age population aged 15-64 – is now rising (see Figure 1).

Some financial market observers argue that this demographic trend reversal will begin to drive interest rates higher, and soon. Why? First, a declining share of high-saving workers and a rising share of dissaving elderly will (the argument goes) erode the demand for saving – and drive interest rates higher via the savings-investment equilibrium. Second, these observers argue, a rapidly growing share of retirees will have to consume (i.e., sell down) their financial asset holdings to fund spending in retirement, and these drawdowns will create selling pressure in financial markets that pushes asset prices down and interest rates up.

Our core thesis in a nutshell: Yes, global aging may someday drive U.S. interest rates structurally higher. But “someday” remains at least a decade away – for two reasons. First, we proffer that global saving will remain stronger than many expect, supporting a low global neutral interest rate. (As investors, we care about the neutral rate because it anchors fixed income yields in the market.) Second, U.S. demographic demand for fixed income assets should remain robust until at least 2025 – and in the meantime should continue to put downward pressure on market yields, all else equal. Combine a low global “anchor” and strong domestic fixed income demand, and what do you get? Lower rates for longer in the U.S.

Continuing robust demographic demand for saving

Remember the link between saving and interest rates: In the savings-investment equilibrium, rising demand for saving pushes down the equilibrium (or neutral, or natural) rate of interest, all else equal, and vice-versa. Our task, then, is to assess how demographic changes affect aggregate saving. We find that the traditional “dependency ratio,” used in many other studies on this topic, is flawed.

We suggest two modifications to address those flaws. First, the young, considered “dependents,” contribute very little to global saving and dissaving in dollar terms (they’re “non-savers”). We therefore prefer to focus on the ratio of “Peak Savers” (mature adult workers who earn and save a lot) to “Elderly” (who save less as they age and ultimately consume their savings in retirement). Let’s preliminarily define “Peak Savers” as individuals aged 35 to 64, for two reasons:

• People 35–64 have generally exhibited much higher savings rates than people in younger and older age groups;
  
• People 35–64 earn considerably more income than people younger and older – so for any given savings rate, this age group’s saving behavior will have an outsized effect on saving and investment flows in dollar terms.
  

Let’s preliminarily define “Elderly” as everyone 65 and older (the traditional definition). Thus, the global Peak Savers versus Elderly ratio in Figure 2 reflects a static 35–64 Peak Saver cohort – and reveals what appears to be a demographic cliff in about year 2010. Those who argue that demographic support for saving will fall sharply in the coming years typically will try to prove their point using a ratio like this one.

But we ask: Is it sensible to define the Peak Saver and Elderly groups by the same static age ranges over long periods of time? Put differently: Might working and saving behavior evolve over time, warranting a dynamically modified dependency ratio? Seniors’ ability to work (and save) later in life should continue to rise; in our increasingly services-based “knowledge economy,” jobs are becoming less physically demanding and often require more experience, while advances in health technology boost functional age in life’s later stages. Seniors’ willingness (and incentives) to work longer also should rise along with their ability.

True, the retirement age, globally, has not kept pace with rising longevity. But policymakers are slowly catching on. In the U.S., the Social Security full benefit retirement age is increasing to 67 and will go higher still – a government incentive telling people to stay in the workforce. Meanwhile, years of low interest rates have left impending retirees playing catch up in retirement saving. More generally, around the world, longer lives must ultimately be supported by longer working lives. Anything less will prove unsustainable. Our colleague Jim Moore summed up the state of affairs (in the U.S.) in a PIMCO Viewpoint from 2012: “Work a little longer. Save a little more. Get by with a little less.¹

We think this insight applies abroad as well. In fact, global trends already underway support our argument that people will work later and later in life. In many economically important geographies – notably the U.S., eurozone, UK and Japan – senior (age 65+) labor force participation has been trending higher. And China is contemplating steadily raising its retirement age in the coming years.

However, what matters most for global saving demand are those who earn the most income. Consider the U.S. as an example. Top-income-quintile households control nearly two-thirds of U.S. household income, three-quarters of household wealth and more than 80% of household financial assets. Apart from the major social ramifications of wide (and widening) income and wealth inequality, the implications for aggregate saving are critical: Rather obviously, high earners’ working and saving behavior has an outsized effect on global saving in dollar terms.

If the highest earners are working (and saving) later in life, we should pay attention. Witness the dramatic rise in labor force participation within the top income quintile (Figure 3): Over 60% of top-quintile individuals in the 65–74 age group are employed or seeking work, a 19-percentage-point increase in participation over the 15 years through 2013. ² Moreover, participation among top-income-quintile seniors 75 and older has more than doubled over the same period.^4,/sup>

What about seniors’ late life saving behavior? Consider the top two income quintiles, collectively accounting for about 80% of U.S. personal income. Based on 2014 data from the BLS’s Consumer Expenditure Survey, these high earners exhibit no decline in savings rates as they enter retirement (due in part to a strong bequest motive and high conservatism). In Figure 4, note how high and consistent these top earners’ savings rates remain even in their late 60s and 70s.

(Aside: We find it curious that savings rates, based on the BLS’s Consumer Expenditure Survey, do not become negative for lower income quintile seniors even in their late 70s. We suspect that other data sources may show a negative savings rate for these elderly groups, likely due to methodological differences in data collection. Our focus here, however, is on age-related trends in saving behavior rather than savings rates themselves.)

To recap: The most impactful seniors are working (and saving) later in life as functional age and the duration of retirement both increase.³ Therefore, our preferred measure of the demographic support for saving is a dynamic, not static, ratio that accounts for the trend toward longer working lives. Let’s revisit our Peak Savers versus Elderly ratio from Figure 2. In decades past, age 64 may well have been the sensible upper bound for the Peak Saver group.

But what about the coming decades? In Figure 5, we have added a dynamic ratio (red line) that assumes seniors work roughly five years later in life in 2050 than they did in 2000. In other words, our age definition of “Peak Saver” evolves dynamically from 35–64 in 2000 to 35–69 by 2050, and consequently our definition of “Elderly” evolves dynamically from 65+ to 70+ over the same period.

What a different picture the dynamic ratio paints! It suggests that demographic support for saving could well be as strong a decade from now as it has been in recent decades – and illustrates the extent to which traditional static ratios may be flawed.

We concede that our dynamic ratio forecast is only a guess as to what the future may look like if current trends persist. But there is some method to the madness. For example, the reason we start to phase the 65- to 69 year olds into our Peak Saver group specifically in 2000 is that senior labor force participation began to rise rapidly in that year (after two stagnant decades).

Our five years later in life by 2050 employment assumption is slightly more arbitrary, but reasonable given that, globally, the largest increases in retirement age likely lie ahead of us. And our dynamic ratio does not account for the rising share of seniors 70+ who remain working, introducing an element of conservatism to our assumptions. So while our dynamic ratio embeds some simplifying assumptions, to be more scientific risks missing the forest for the trees.

Almost regardless of the assumptions used, if you define a dependency ratio dynamically – based even loosely on observable trends – you are likely to paint a very different (and more accurate) picture of the future than you will paint using a static ratio.

What about the rest of the world? It appears we’ve made an argument about global demographics supported mainly with U.S. data. However, publicly available data for other economically significant regions does not permit as granular an analysis as we have shown for the U.S. We do have reason to believe similar trends are occurring outside the U.S.: Elderly labor force participation is rising in Europe, the UK and Japan, and some countries – including China – are contemplating raising the retirement age.

In Japan, whose demographic cliff materialized many years ago, senior labor force participation has been trending higher, and as a result the labor force shrank only about 0.8% over the past decade even as the “working-age population” (aged 15 to 64) fell almost 9%. Patterns like this one are likely to repeat in other aging countries as societies adapt to meet their demographic challenges.

Bottom line: The people who move the needle most in saving demand, the highest earners, are the people working and saving later in life. This trend should be a tailwind for saving demand in the years to come that will push the global demographic cliff at least a decade into the future – and support a low global neutral interest rate, per the savings-investment equilibrium. 70 is the new 65!

U.S. household (demographic) demand for fixed income assets: a decade-long tailwind for bonds

We’ve just argued that demographics should help keep the global neutral rate low over the coming decade – which means that market yields in the U.S. should have a low “anchor.” But waves of baby boomers are retiring (albeit, as we have argued above, increasingly later), and many will eventually draw down (i.e., sell) their financial asset holdings to fund late life consumption. Are we fast approaching the point when boomer drawdowns create selling pressure in fixed income markets that pushes interest rates higher? Or might U.S. aging (boomers included) actually bolster the (net) demand for bonds and help maintain a low ceiling for market yields?

Consider two key observations.

• First, as we should expect, investors generally de-risk away from equities and toward fixed income with age – most aggressively once they reach their 60s (and beyond).⁵
  
• Second, individual asset accumulation and drawdown patterns vary significantly by income level. In the U.S., individuals in the lowest income quintile tend to sell their limited financial assets beginning in their 50s and completely exhaust their assets by, or before, death (relying on social assistance to meet their basic needs in life’s latest stages). Middle-income individuals tend to draw down financial assets beginning in their 60s but not at a rate that would deplete their assets before death. Individuals in the highest income quintile, however, are shown to have rising financial asset balances until roughly age 80 (after which they decline only very gradually). In other words, for top-income-quintile individuals, portfolio drawdowns don’t tend to begin until roughly age 80 (an important point). 
  

The highest earners have historically been able to fund retirement consumption from income (generally employment income, investment portfolio income and annuitized income), “leaving their financial assets virtually untouched.”⁶Here’s the key: Top-income-quintile households own over 80% of U.S. household financial assets. Consider how significantly this group’s future asset accumulation and drawdown profile will impact financial markets!

Back to our question about whether U.S. demographics will be a headwind or tailwind for bond flows in the years ahead. For starters, we assess when (demographics-driven) bond buying might peak relative to bond selling. We define “Bond Buyers” as individuals aged 60–74 and “Bond Sellers” as individuals 80 and older.

These age definitions are somewhat arbitrary, but they’re based on the two previously introduced empirical observations about households in the top quintile of the U.S. income distribution (which hold over 80% of U.S. household financial assets):

1. Bond buying tends to peak during individuals’ 60s and early 70s (aggressive de-risking);
   
2. Bond selling tends to peak in the years after age 80 (as individuals sell down their financial assets to fund consumption in retirement).
   

Figure 6 shows the ratio of Bond Buyers to Bond Sellers, which we use to gauge when net demographic buying demand might theoretically peak. On this metric, U.S. demographic demand for bonds should continue to rise in the next five years or so before peaking and may still be as strong in 2025 as it is today. (Our age definitions are based on patterns observed among U.S. households, so we focus primarily on the blue U.S. line in the figure. We include a global version of the Buyers versus Sellers ratio as well – the green line – which reveals an even later potential peak in global demographic demand for bonds.⁷

Our interpretation of this Buyers versus Sellers ratio assumes that each buyer exerts about the same influence on markets as each seller, an assumption that may be conservative given high-earning sellers draw down their portfolios only very gradually, whereas buyers likely will be de-risking aggressively in their 60s and early 70s. We “stress test” this assumption and result with scenario analysis in the Appendix.

Next, we explore the demographics of U.S. financial asset ownership at a very high level. Figure 7 shows household financial asset holdings by both age and income.⁸

^{Click to enlarge}

The lion’s share of the $31 trillion in U.S. household financial assets⁹ ($21 trillion, or about 70%) is held within – or over the next 10 years will be held within – age cohorts that typically need to grow their fixed income allocation. This $21 trillion, outlined in green in Figure 7, is expected to remain in an accumulation or de-risking phase and won’t enter a drawdown phase within the next decade (based on the age-related asset drawdown patterns we described earlier). This $21 trillion will likely be a demographic tailwind for bonds over the next decade (especially for municipal bonds given high earners’ need for tax-free income). Conversely, only about $5 trillion (approximately 15%) of household financial assets seems likely to be a headwind for bonds during this period (outlined in red).

One caveat: Many factors other than demographics influence investors’ asset allocation decisions – among them changes in valuations, evolving expectations about future asset returns, individual risk preferences, U.S. investor preference for domestic versus foreign assets, foreign investor preference for U.S. assets, and market disruptions that may trigger significant portfolio rebalancing. Our analysis here focuses only on demographic effects, holding all else equal.

Now let’s go a level deeper. In the Appendix we model the potential demographics-related asset flows we might see over time from the gradual de-risking and drawdown of household financial assets. We analyze 10 unique scenarios in order to test a range of assumptions. Our “baseline” scenario reflects a set of assumptions about de-risking behavior and asset decumulation that we think is realistic (and possibly conservative) based on historical patterns. Our modeling suggests that U.S. demographics driven fixed income inflows are likely to be almost as strong 10 years from now as we project them to be today – and that demographics may not be a material headwind for bonds until the 2030s.

How can we explain these conclusions? In our analysis, for at least the next decade, de-risking flows and rebalancing flows into fixed income more than compensate for seniors’ portfolio drawdowns. In stress testing our baseline assumptions we found it hard to come up with a plausible scenario in which U.S. demographics become a fixed income headwind within 10 years. Yet we found it easy to imagine realistic scenarios in which demographic demand for bonds remains robust for the next 15 years or more.

Consider as an example the high-earning elderly, for whom longevity risk is rising rapidly as life-extending medical technologies proliferate. High earners, historically, have been overly cautious in recalibrating their spending to meet anticipated future needs – a finding that could warrant an even more gradual asset-drawdown trajectory for this next generation of retirees than we have modeled based on historical experience. See the Appendix for our assumptions, baseline scenario modeling and alternative scenarios.

A brief aside: Our focus here has been U.S. demographics and, implicitly, U.S. fixed income. However, U.S. demographics are likely to influence global fixed income markets given U.S. households account for over 40% of global household financial assets. For context, Western Europe and Asia each account for about 25%.¹⁰

Finally, a quick note on changes in the composition of household retirement savings. The shift from defined benefit (DB) to defined contribution (DC) plans in the U.S. persists, and in our estimation U.S. DB plans hold a lower allocation to bonds than a market-average glide path suggests is optimal for DC participants.¹¹ In aggregate, therefore, the continued shift toward DC may represent an additional tailwind for bonds in the coming years.

Bottom line on U.S. aging and the demand for bonds: Persistent demographic support for fixed income should, all else equal, drive net flows into bonds and help maintain low yields over the next decade.

‘Speed read’ and key conclusions

Some financial market observers believe in the following dramatic scenario:

• We’ve just gone over a demographic cliff; globally, the ratio of high-saving adult workers to dissaving elderly is now declining. This demographic reversal will erode the demand for saving.
  
• The global savings glut will reverse as the demand for saving falls, pushing the global neutral interest rate higher.
  
• Baby boomers in the U.S. will compound the problem as they sell their financial assets (including bonds) to fund retirement consumption, driving U.S. fixed income yields higher.
  

In this note, we challenge traditional thinking about the timing of the feared “demographic cliff.” A demographics-induced structural rise in U.S. interest rates remains at least a decade away:

1. Global demand for saving will remain robust, supporting a low global neutral interest rate (the “anchor” for U.S. fixed income yields):
   • Traditional dependency ratios – which use fixed, static age definitions – are flawed because they fail to account for how the world is changing.
     
   • U.S. elderly, especially the highest earners, are working and saving later in life. High earners matter a lot because they drive the lion’s share of global saving. 70 is the new 65.
     
   • Similar trends can be observed in economically significant economies outside the U.S.
     
   • We argue for a dynamic, not static, ratio of mature adults to elderly that does account for how working and saving behaviors are changing. Our dynamic ratio suggests that demographic support for saving may be as strong over the next decade as it has been over the past several. Possibly stronger.
     
   • Strong saving demand should support a low global neutral interest rate in the coming years – and should continue fueling the global savings glut.
     
2. In financial markets, strong U.S. demographic demand for fixed income assets should – all else equal – help maintain low U.S. bond yields over the next decade:
   • The lion’s share of U.S. household financial assets is held within age cohorts that will need to grow their fixed income allocation over the next ten years.
     
   • Top-income-quintile households own over 80% of these assets, and high earners sell financial assets only very gradually in retirement to fund consumption.
     
   • For another decade or more, demographics should remain a net contributor to fixed income flows, as high earners’ de-risking into bonds should dominate bond outflows due to portfolio drawdowns.
     

Combine a low global neutral interest rate and strong domestic demand for bonds, and what do you get? Lower rates for longer in the U.S.
The authors would like to thank PIMCO colleague Jim Moore for his contributions.

Appendix: U.S. household financial assets and fixed income flows – scenario analysis

This Appendix details the assumptions used in our baseline scenario for U.S. (demographics-driven) fixed income flows and offers a number of alternative scenarios.
Baseline scenario assumptions:

• Financial asset portfolios consist of two asset types (for simplicity): “risk assets” (excluding fixed income) and fixed income.
  • Long-term annual risk asset return: 5% nominal.
    
  • Long-term annual fixed income return: 2.5% nominal.
    
• Investors de-risk their portfolios into fixed income over time according to a market-average glide path,¹² interpolated as necessary. (We conservatively assume that de-risking into fixed income ceases at age 75 and that investors’ asset allocations remain constant thereafter. This assumption is driven by a lack of available data on market-average glide path allocations for ages older than about 75.)
  
• Each year, top-income-quintile households re-optimize to draw down 50% of their financial assets by the end of their planning horizon, beginning at age 80 and ending at age 95. (50% may be a conservatively high drawdown percentage.)
  
• Each year, households in the bottom four income quintiles re-optimize to draw down 75% of their financial assets by the end of their planning horizon, beginning at age 65 and ending at age 90. (75% may be a conservatively high drawdown percentage.)
  
• Financial asset drawdowns occur proportionally across risk assets and fixed income. (This assumption is fair to conservative, given there is evidence that people draw down their riskiest assets first.¹³)
  
• Financial asset portfolios do not exist in perpetuity; mortality effects (based on the most recent mortality tables from the Society of Actuaries) lead to bequests that generate “re-risking” flows from fixed income into risk assets.¹⁴
  

Alternative scenarios:
Each alternative scenario represents a modification relative to our baseline scenario.

• Alternative 1: De-risking into fixed income proves significantly faster than expected (ultimate fixed income allocation of 50% is reached 10 years earlier than baseline glide path suggests).
  
• Alternative 2: De-risking into fixed income proves significantly slower than expected (ultimate fixed income allocation of 50% is not reached until 10 years after baseline glide path suggests).
  
• Alternative 3: Seniors 50+ ultimately de-risk much less significantly than baseline glide path suggests (fixed income allocation reaches 15% at age 50, per glide path, but then flat-lines for 10 years before gradually increasing to a level only half that suggested by baseline glide path, i.e., a terminal allocation of 25% instead of 50%).
  
• Alternative 4: Annual fixed income returns equal annual risk asset returns, such that market-return-driven rebalancing flows no longer support fixed income (5% annual nominal return assumed for both asset types). (This scenario has a natural hedge property; if ex ante fixed income returns ever were expected to equal ex ante risk asset returns, the relative attractiveness of fixed income probably would increase on a risk-adjusted basis, likely triggering non-demographics-related reallocations into fixed income – which we have not modeled here.)
  
• Alternative 5: Top-income-quintile households re-optimize each year to ultimately draw down 75% of their financial assets by the end of their planning horizon, while households in the bottom four quintiles re-optimize to draw down 100% (for both groups, a far higher drawdown percentage than is likely).
  
• Alternative 6: Top-income-quintile households commence drawdowns a full decade earlier than history suggests is likely, i.e., at age 70 (if anything, as life expectancies and planning horizons lengthen, one might expect drawdowns to begin later).
  
• Alternative 7: A combination of alternatives 5 and 6 (i.e., a highly conservative mix of assumptions).
  
• Alternative 8: Households commence drawdowns five years later and lengthen their planning horizon by five years (optimistic, but plausible given rising longevity risk and rising labor force participation among the high-earning elderly).
  
• Alternative 9: Top-income-quintile households re-optimize to draw down 25% of their financial assets by the end of their planning horizon (instead of 50%), consistent with a high bequest motive and historical excess conservatism during retirement.
  

The chart below shows our estimate of future demographics-driven U.S. household fixed income flows by scenario. These projections are NOT meant to be interpreted as forecasts of the actual dollar volume of flows, in part because the $31 trillion stock of household financial assets used to model these flows omits certain large asset pools (see our technical note further on). So focus on the trends depicted, not on the dollars.

As you can see in the chart, across almost all of our scenarios demographics remain a fixed income tailwind for the next 10 years, and in most scenarios longer. Note that this analysis may lean conservative in that we have modeled potential flows based only on the existing stock of financial assets. Yet every year, mature adult workers (especially the high income earners) will invest some portion of their savings in financial assets, including bonds, both inside and outside their retirement plans. These flows, all else equal, represent a tailwind for all financial assets that we haven’t attempted to model.

Finally, a technical note on our primary source for U.S. household financial asset data: the Federal Reserve’s 2013 Survey of Consumer Finances. To our knowledge, there are two primary sources for U.S. household balance sheet detail: the Federal Reserve’s Survey of Consumer Finances (“SCF”), a triennial survey of a cross-section of U.S. households, and the U.S. national flow of funds accounts. We use the SCF, which is widely used in Federal Reserve analysis, academic research at major economic research centers, and private financial industry analysis and writings. The SCF is, to our knowledge, unparalleled in its demographic granularity across age groups, income quintiles and other key variables.

Significant differences are worth highlighting between the SCF and the household balance sheet data contained in the U.S. national accounts. Of note, the 2013 SCF excludes about $19 trillion in DB pension entitlements and $2.4 trillion in assets of nonprofit institutions. As a result of these and certain other omissions, the SCF identifies a materially lower total value for U.S. household financial assets than the national accounts identify. The question, for us, is whether there is any reason to think that the omissions made by the SCF, notably DB pension entitlements, will bias our results. 

We see no obvious bias. At a high level, DB pension plan asset allocations tend to be a function more of the level of interest rates and plan funding status than of the age profile of plan beneficiaries. Also, as we’ve argued in the body of our note, as the U.S. shifts from defined benefit to defined contribution schemes we may see additional support for fixed income given that DB plans seem to allocate less to bonds than a market average glide path suggests is optimal for DC participants. For these reasons, we think using a source that excludes DB pension entitlements likely leads us – if anything – to underestimate demographics-related fixed income demand over the next decade.

See the recent research paper linked below, from the Federal Reserve, for a more detailed explanation of the differences between SCF data and data from the U.S. national flow of funds accounts, as well as a defense of the use of SCF data in economic research: http://www.federalreserve.gov/econresdata/feds/2015/files/2015086pap.pdf

Works consulted

• Mercedes Aguirre and Brendan McFarland, “2014 Asset Allocations in Fortune 1000 Pension Plans,” Towers Watson, October 2015.
  
• Robert Arnott and Denis Chaves, “Demographic Changes, Financial Markets, and the Economy,” Financial Analysts Journal Volume 68 Number 1, 2012.
  
• Charles Bean et al., “Low for Long? Causes and Consequences of Persistently Low Interest Rates,” Geneva Reports on the World Economy 17, International Center for Monetary and Banking Studies, October 2015.
  
• Lisa Dettling et al., “Comparing Micro and Macro Sources for Household Accounts in the United States: Evidence from the Survey of Consumer Finances,” Finance and Economics Discussion Series 2015-086, Washington: Board of Governors of the Federal Reserve System, 2015.
  
• “The Eurosystem Household Finance and Consumption Survey,” Statistical Paper Series No 2, European Central Bank, April 2013.
  
• “2013 Survey of Consumer Finances (SCF),” Federal Reserve, September 2014.
  
• Michael Gapen, “Demand for safe havens to remain robust,” Barclays Equity Gilt Study, February 2013.
  
• Michael Gavin, “Population dynamics and the (soon-to-be-disappearing) global ‘savings glut,’” Barclays, February 2015.
  
• Charles Goodhart et al., “Could Demographics Reverse Three Multi-Decade Trends?” Morgan Stanley, September 2015.
  
• Dr. Michaela Grimm et al., “Allianz Global Wealth Report 2015,” Allianz SE, August 2015.
  
• Markus Lorenz et al., “Man and Machine in Industry 4.0: How Will Technology Transform the Industrial Workforce Through 2025?” Boston Consulting Group, September 2015.
  
• Dr. Susan Lund, “The Impact of Demographic Shifts on Financial Markets,” McKinsey Global Institute, June 2012.
  
• “Pension Markets in Focus,” The Organisation for Economic Co-operation and Development, 2015.
  
• James Poterba et al., “The Composition and Draw-Down of Wealth in Retirement,” NBER Working Paper 17536, October 2011.
  
• Karen Smith et al., “How Seniors Change Their Asset Holdings During Retirement,” Center for Retirement Research at Boston College Working Paper 2009-31, December 2009.
  

¹ PIMCO Viewpoint “What’s Your Number at the Zero Bound”, by Dr. James Moore, 2012.
² 2013 represents most current data available.
³ Our argument would be even stronger if we could show that the personal savings rate among high-earning seniors in their late 60s and early 70s has been increasing over time (parallel to the rise in labor force participation). However, the BLS has advised us that a comparison between 2014 data and prior-year data may be misleading due to recent changes in survey methodology.
⁴ From 2000 to 2050, our dynamic ratio – mechanically – is a weighted average of two individual static ratios (35–64 versus 65+ and, separately, 35–69 versus 70+); the weights change each year to reflect our assumption about rising longevity.
⁵ See, for instance, “The Impact of Demographic Shifts on Financial Markets” (McKinsey Global Institute, 2012).
⁶ “How Seniors Change Their Asset Holdings During Retirement” (Smith et al, 2009).
⁷Validity of global Buyers versus Sellers Ratio depends on the extent to which asset accumulation-drawdown patterns among the high-earning elderly outside the U.S. mirror the patterns observed among U.S. elderly. We have not explored this question empirically and include the global ratio only for interest and context.
⁸ See Appendix for a technical note on our choice of the Federal Reserve’s Survey of Consumer Finances for U.S. household financial asset detail.
⁹ U.S. household financial assets, as depicted in the Federal Reserve’s 2013 Survey of Consumer Finances, total $31 trillion across all age groups.
¹⁰ Source: Allianz Global Wealth Report, 2015.
¹¹ For color on U.S. DB pension plan asset allocations, see, for example, the OECD’s “Pension Markets in Focus” (2015) and Towers Watson’s “2014 Asset Allocations in Fortune 1000 Pension Plans” (2015).
¹² Source: NextCapital.
¹³ See “Demographic Changes, Financial Markets, and the Economy” (Arnott and Chaves / CFA Institute, 2012).
¹⁴ For simplicity, we assume that anyone who dies younger than age 65 bequeaths assets to a spouse of comparable age (i.e., no change in asset allocation) while those who die at or after age 65 bequeath assets to someone (presumably children) 30 years younger (i.e., a generation earlier in risk tolerance). We recognize that not every elderly person bequeaths assets to a younger heir; some assets are passed on to charitable organizations and friends or other family members of comparable age, for instance. We assume, arbitrarily, that 50% of financial assets are passed to younger heirs. Our general results are not particularly sensitive to changes in these assumptions.

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How Big the Gig Economy Really Is

By John Mauldin

There is growing awareness of what is being called the “gig economy.” It’s not just Uber driving or Airbnb. There are literally scores of websites and apps where you can advertise your services, get temporary or part time work, and do so from anywhere you happen to be.

Some “gigs” actually pay pretty good money, but they are for people with specialized skills who prefer to live a somewhat different lifestyle than the typical 9 to 5’er does. My hedge fund friend Murat Köprülü has been busy researching and documenting this phenomenon and regularly regales me with what he finds.

He goes and spends evenings and weekends with young gig workers, trying to figure out what it is they really do and how they make ends meet in New York City. It turns out they need a lot less to support their lifestyle than you might imagine, and they prefer working intermittent gigs, being able to do what they want, and having no boss.

A close look at the data indicates that the gig economy is indeed big and growing. But there is a great deal of debate among economists about how big it really is.

It’s Much Bigger Than the Employment Data Suggests

Gig workers don’t seem to show up clearly in the BLS employment data. Typically, we would expect those working in the gig economy to appear in the self employed category, but that category is actually drifting downward in numbers—relatively speaking.

But Harvard economist Larry Katz and Princeton’s Alan Krueger, who are working on research to document the rise of the gig economy in America, says that our current measures ignore the bulk of the gig economy.

 From a story at fusion.net:

Katz said two pieces of evidence suggest current measures of self-employment and multiple-job holding are “missing a large part of the gig economy.” The first is that the share of the employed (and of the adult population) filing a 1099 form, the tax document “gig economy” workers must file, increased in the 2000s, even as standard measures of self-employment declined in the 2000s. Other groups have confirmed this: Zen Payroll, a site that tracks the sharing economy, found increases in the share of 1099 workers across many major U.S. metros.

Source: Zen Payroll via Small Business Labs

And data from research group EconomicModeling.com show the share of traditional, 9-to-5 workers in the labor force has declined…..

Source: Fusion, data via EconomicModeling.com

… while those who categorize themselves as “miscellaneous proprietors” is climbing.

Source: Fusion, data via EconomicModeling.com

A recent survey found 60 percent of such workers get at least 25 percent of their income from gig economy work.

The problem with the BLS estimates is that they overlook a sizable chunk of the true gig economy.
And this report absolutely squares with what my friend Murat’s research is showing: that gig economy is not shrinking. On the contrary, it’s on the rise, and a quite rapid rise.

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By John Mauldin 

There is presently a bull market in complacency. There are very few alarm bells going off anywhere; and frankly, in reaction to my own personal complacency, I have my antenna up for whatever it is I might be missing that would indicate an approaching recession.

It was very easy to call the last two recessions well in advance because we had inverted yield curves. In the US at least, that phenomenon has a perfect track record of predicting recessions. The problem now is that, with the Federal Reserve holding the short end of the curve at the zero bound, there is no way we can get an inverted yield curve, come hell or high water. For the record, inverted yield curves do not cause recessions, they simply indicate that something is seriously out of whack with the economy. Typically, a recession shows up three to four quarters later.

I know from my correspondence and conversations that I am not the only one who is concerned with the general complacency in the markets. But then, we’ve had this “bull market in complacency” for two years and things have generally improved, albeit at a slower pace in the current quarter.

With that background in mind, the generally bullish team at GaveKal has published two short essays with a rather negative, if not ominous, tone. Given that we are entering the month of October, known for market turbulence, I thought I would make these essays this week’s Outside the Box. One is from Pierre Gave, and the other is from Charles Gave. It is not terribly surprising to me that Charles can get bearish, but Pierre is usually a rather optimistic person, as is the rest of the team.

I was in Toronto for two back-to-back speeches before rushing back home this morning. I hope you’re having a great week. So now, remove sharp objects from your vicinity and peruse this week’s Outside the Box.

Your enjoying the cooler weather analyst,

John Mauldin

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A Worrying Set Of Signals

By Pierre Gave
Regular readers will know that we keep a battery of indicators to gauge, among other things, economic activity, inflationary pressure, risk appetite and asset valuations. Most of the time this dashboard offers mixed messages, which is not hugely helpful to the investment process. Yet from time to time, the data pack points unambiguously in a single direction and experience tells us that such confluences are worth watching. We are today at such a point, and the worry is that each indicator is flashing red.

Growth: The three main indices of global growth have fallen into negative territory: (i) the Q-indicator (a diffusion index of leading indicators), (ii) our diffusion index of OECD leading indicators, and (iii) our index of economically-sensitive market prices. Also Charles’s US recession indicator is sitting right on a key threshold (see charts for all these indicators in the web version).

Inflation: Our main P-indicator is at a maximum negative with the diffusion index of US CPI components seemingly in the process of rolling over; this puts it in negative territory for the first time this year.

Risk appetite: The Gavekal velocity indicator is negative which is not surprising given weak market sentiment in recent weeks. What worries us more is the widening of interest rate spreads—at the long end of the curve, the spread between US corporate bonds rated Baa and treasuries is at its widest since 2009; at the short-end, the TED spread is back at levels seen at the height of the eurozone crisis in 2012, while the Libor-OIS spread is at a post-2008 high. Moreover, all momentum indicators for the main equity markets are at maximum negative, which has not been seen since the 2013 “taper tantrum”.

These weak readings are especially concerning, as in recent years, it has been the second half of the year when both the market and growth has picked up. We see three main explanations for these ill tidings:

1) Bottoming out: If our indicators are all near a maximum negative, surely the bottom must be in view? The contrarian in us wants to believe that a sentiment shift is around the corner. After all, most risk-assets are oversold and markets would be cheered by confirmation that the US economy remains on track, China is not hitting the wall and the renminbi devaluation was a one-off move. If this occurs, then a strong counter-trend rally should ramp up in time for Christmas.

2) Traditional indicators becoming irrelevant: Perhaps we should no longer pay much attention to fundamental indicators. After all, most are geared towards an industrial economy rather than the modern service sector, which has become the main growth driver. In the US, industrial production represents less than 10% of output, while in China, the investment slowdown is structural in nature. The funny thing is that employment numbers everywhere seem to be coming in better than expected. In this view of things, either major economies are experiencing a huge drop in labor productivity, or our indicators need a major refresh (see Long Live US Productivity!).

3) Central banks out of ammunition: The most worrying explanation for the simultaneous decline in our indicators is that air is gushing out of the monetary balloon. After more than six years of near zero interest rates, asset prices have seen huge rises, but investment in productive assets remains scarce.

Instead, leverage has run up across the globe. According to the Bank for International Settlements’ recently released quarterly review, developed economies have seen total debt (state and private) rise to 265% of GDP, compared to 229% in 2007. In emerging economies, that ratio is 167% of GDP, compared to 117% in 2007 (over the period China’s debt has risen from 153 to 235% of GDP). The problem with such big debt piles is that it is hard to raise interest rates without derailing growth.

Perhaps it is not surprising that in recent weeks the Federal Reserve has backed away from hiking rates, the European Central Bank has recommitted itself to easing and central banks in both Norway and Taiwan made surprise rate cuts. But if rates cannot be raised after six-years of rising asset prices and normalizing growth, when is a good time? And if central banks are prevented from reloading their ammunition, what will they deploy the next time the world economy hits the skids?

Hence we have two benign interpretations and one depressing one. Being optimists at heart, we want to believe that a combination of the first two options will play out. If so, then investors should be positioned for a counter-trend rally, at least in the short-term. Yet we are unsettled by the market’s muted response to the Fed’s dovish message. That would indicate that investors are leaning towards the third option. Hence, we prefer to stay protected and for now are not making a bold grab for falling knifes. At the very least, we seek more confirmation on the direction of travel.

Positioning For A US Recession

By Charles Gave
Since the end of last year I have been worried about an “unexpected” slowdown, or even recession, in the world’s developed economies (see Towards An OECD Recession In 2015). In order to monitor the situation on a daily basis, I built a new indicator of US economic activity which contains 17 components ranging from lumber prices and high-yield bond spreads to the inventory-to-sales ratio. It was necessary to construct such an indicator because six years of extreme monetary policy in the US (and other developed markets) has stripped “traditional” cyclical economic data of any real meaning (see Gauging The Chances Of A US Recession).

Understanding this diffusion index is straightforward. When the reading is positive, investors have little to worry about and should treat “dips” as a buying opportunity. When the reading is negative a US recession is a possibility. Should the reading fall below – 5 then it is time to get worried – on each occasion since 1981 that the indicator recorded such a level a US recession followed in fairly short order. At this point, my advice would generally be to buy the defensive team with a focus on long dated US bonds as a hedge. This is certainly not a time to buy equities on dips.

Today my indicator reads – 5 which points to a contraction in the US, and more generally the OECD. Such an outcome contrasts sharply with official US GDP data, which remains fairly strong. Pierre explored this discrepancy in yesterday’s Daily (see A Worrying Set Of Signals), so my point today is to offer specific portfolio construction advice in the event of a developed market contraction. My assumption in this note is simply that the US economy continues to slow. Hence, the aim is to outline an “anti-fragile” portfolio which will resist whatever brickbats are hurled at it.

During periods when the US economy has slowed, especially if it was “unexpected” by official economists, then equities have usually taken a beating while bonds have done well. For this reason, the chart below shows the S&P 500 divided by the price of a 30 year zero coupon treasury.

A few results are immediately clear:

• Equities should be owned when the indicator is positive.
   
• Bonds should be held when the indicator is negative.
   
• The ratio of equities to bonds (blue line) has since 1981 bottomed at about 50 on at least six occasions. Hence, even in periods when fundamentals were not favorable to equities (2003 and 2012) the indicator identified stock market investment as a decent bet. 
Today the ratio between the S&P 500 and long dated US zeros stands at 75. 

This suggests that shares will become a buy in the coming months if they underperform bonds by a chunky 33%. The condition could also be met if US equities remain unchanged, but 30 year treasury yields decline from their current 3% to about 2%. Alternatively, shares could fall sharply, or some combination in between. 


Notwithstanding the continued relative strength of headline US economic data, I would note that the OECD leading indicator for the US is negative on a YoY basis, while regional indicators continue to crater. The key investment conclusion from my recession indicator is that equity positions, which face risks from worsening economic fundamentals, should be hedged using bonds or upping the cash component.

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Muddling Through Shanghai

By John Mauldin

“He who knows when he can fight and when he cannot, will be victorious.”

– Sun Tzu

A couple of weeks ago I was complaining about 47,000 China reports clogging my email. The number now feels like it is well into six figures (perhaps a slight exaggeration). Maybe my memory is going, but there wasn’t nearly as much China talk on the way up. Funny how that works.

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Is China collapsing? I think parts of China are under severe pressure if not outright recession, and clearly the stock market is a disaster. Anyone who bought Shanghai or Shenzhen stocks on margin this year is probably on the brink.

That said, China itself is not collapsing. There are parts of China that are doing just fine, thank you very much. It does have serious problems, though. The Pollyannas and the Cassandras are both wrong. The change in tone in the Financial Times is quite amusing. Their recent hyperbolic, bearish section called “China Tremors” is a case in point. Of the last 30 articles on China on their website, I found less than a handful that were positive on China. My take? China will muddle through, at least for the near term.

China is in transition, a transition that was clearly telegraphed if you have been paying attention. Our recent book on China (A Great Leap Forward?) clearly laid out this new path. Today we are going to talk about this precarious, difficult transition, which may impose profound impacts on much of the rest of the world. This transition is going to change the way global trade has worked in the past. There will be winners and losers.
But first, a brief comment on today’s employment report and how it impacts the need for a rate hike by the Federal Reserve in September. I offer a little different perspective on the coming decision.

To Hike or Not To Hike – That Is the Question

Today’s unemployment report was lackluster, as has been the case for the initial reporting for the last two Augusts. Both were revised significantly upward – August 2012 was eventually revised up 96,000 jobs, while August 2013 saw a final revision upward of 69,000 jobs, and August 2014 saw a final count of +213,000 jobs. Part of the reason for the major revisions is that only some 70% of the potential survey participants actually responded (hat tip Joan McCullough).

Evidently the United States is becoming like Europe, and we are all going on vacation in August. Or at least the department personnel responsible for handling employment figures are. Expect to see significant upward revisions in the coming months, just as July saw another 30,000 added and June saw a plus 14,000.

This report was not so ugly that it would take the breath away from hawks wanting to raise rates or force doves into agreeing to a rate increase. Nothing changed, really. That is illustrated by the two articles below that were side-by-side on the New York Times website within an hour of the release of the report (hat tip Brent Donnelly). Everybody got to see what they wanted to see.

I can’t remember a time when there was such serious disagreement over what the Federal Reserve should do regarding a rate hike. I have been in several groups of analysts and economists in the last few months, and I must confess to being surprised at the split in opinions.

Upon reflection, I think I can actually understand both positions. First, the Fed keeps reiterating that they are “data dependent” – thus the focus on every little bit of data, no matter how trivial. Let me see if I can explain why both sides can feel they are right and then why, to my way of thinking, they are missing the point.

On the side of those who feel that a rate hike should be postponed at the September meeting, it must be remembered that most rate hikes are in anticipation of an economy beginning to pick up speed. The Fed has said they want to see low unemployment, and under the leadership of Bernanke and now Yellen, they have a 2% inflation target. Remember, their congressional mandate is to promote stable prices and full employment.

While unemployment did drop to 5.1%, that is a “soft” unemployment figure. The participation rate is down. The number of part time workers wanting full time jobs is still high. And the new employment trend is not encouraging.

August's gains were well below trend. The average of the previous five months is 211,000; for the previous six before that it was 282,000. The yearly employment gain, 2.1%, is off 0.2 point from the late 2014/early 2015 rate. The private sector gain is 60,000 below the average of the previous six months. (The Liscio Report)

We are not close to 2% inflation; and, frankly, it doesn’t look like we’re going to get there for a while. The economy is, at best, stuck in a low, Muddle Through gear (as I predicted years ago); and getting back to a stable 3% growth rate, let alone the occasional 4–5% that we used to see, seems out of reach. The dollar is strong and getting stronger and is not only holding down inflation but also, anecdotal evidence suggests, slowing down exports in various sectors of the economy.

There were those who argued that a bubble was developing in the stock market, but it appears the stock market is taking care of itself to make sure it doesn’t become overheated. There is no need to pile on to see if we can drive asset prices even lower. Further, we are just in the beginning of a housing recovery. Why raise mortgage rates, etc., at the beginning?

In such an environment, why would you raise rates in order to keep the economy from overheating? The last thing we seem to be doing is overheating, let alone even getting to a slow boil. Instead, we may already be cooling down. If the economy does start to pick up and inflation becomes an issue, we could raise rates then as fast as we would need to. Or so Kocherlakota and his friends on the FOMC say. And thus we should postpone a rate increase until we see a reason for it. Kind of like, don’t shoot till you see the whites of their eyes.

Those who think we should raise rates likewise have an array of data to support their case. GDP grew 3.7% in the second quarter. If you take out the weather related first quarter 2015 GDP figure, GDP growth is running well over 3%. Given the global headwinds currently buffeting economies, that’s about as good as it’s going to get.

This economy has weathered tax increases and the abrupt changes of Obamacare, as well as a significant drop in capital spending related to oil production and has “kept on ticking.” If there is a recession in our near future, as David Rosenberg points out, it would be the first recession ever that did not see consumer spending or employment go down for the count.

We’ve always been able to find negatives in the unemployment rate. Even if unemployment were somehow to ratchet down to less than 200,000 per month, it will be for only two quarters at the most; and it may be that before the end of the year we will be under 5% unemployment. We just set a record for all measures of corporate profits in absolute terms. We finally set a new record for real disposable personal income in July, again in absolute terms. As Jim Smith says,

What all this means is that when the FOMC meets on September 16 and 17, they will be looking at a US economy in which more people are employed than ever before, earning more money than ever before, producing more goods and services than ever before, and with personal consumption expenditures and corporate profits at the highest levels ever seen. If that is not a prescription for finally raising the Fed Funds rate, then I can't imagine what it would take to get them to move. (source)

Despite the significant slowdown in the oil patch, the level of investment in the second quarter was almost 4% higher than last year. Businesses are optimistic. Even given the turmoil in Canada, China, the Eurozone, and the rest of the BRICS, and even though global trade is beginning to fall off a little bit, the US economy seems to be doing quite well in spite of it all.

What else do you need in order to begin to normalize rates? Inflation is under control and according to most Fed economists seems to be ticking higher. Unemployment is moving lower. The economy is doing quite well. If not now, when? How much better do you want things to get before rates are taken back to something close to normal?

I must confess that I personally lean toward the latter argument, but I have a few additional reasons for thinking the Federal Reserve should act in September. As I have presented in previous letters, there are real reasons to think that low interest rates are not only creating malinvestment but also encouraging companies to use financial engineering and to buy their competition rather than purchasing the tools of production and actually competing head on. These behaviors distort an economy over the long term. They frustrate Schumpeter’s forces of creative destruction.

Further, what policy tools does the Federal Reserve still have available if we enter a recession? I admit that doesn’t seem to be a likely possibility today, but there are many potentials for exogenous shocks to the US economy that could cause a recession. Further, in the history of the United States we have never had a period longer than nine years without a recession. This recovery, relatively weak though it is, is getting long in the tooth. Do we want the Fed to confront the next recession with another round of massive quantitative easing as the only policy tool left to deploy? When their own research shows that QE wasn’t very useful and when we can clearly see the distortions caused by QE in emerging markets around the world?

The Federal Reserve is functionally incapable of not feeling the need to “do something” in the midst of a recession. If the only tool they have is further massive quantitative easing, they will use it. Damn the distortions, full speed ahead!

I would not argue for a rapid rate hike. In fact, I would prefer 1/8 of a point at every meeting, rather than the typical quarter point. But there is no reason not to raise a quarter of a point at this meeting, skip a meeting to make sure everybody can take a deep breath, and then raise once more before the end of the year.

I mean, really? Does the Fed think this economy is so fragile that it can’t take a lousy quarter of a point increase in interest rates? The Federal Reserve needs to begin to restock its policy tool chest now. While I personally think we are a long way from ever seeing 5% Fed funds rates again, a 2% rate can probably easily be absorbed if it comes slowly. And that rate would give the Fed some policy tools when, not if, we enter the next recession.

Now, let’s turn back to China.

Repeat After Me: Chinese Stocks Are Not the Chinese Economy

It’s easy to assume that a country’s stock market reflects the condition of its economy, but that is not always the case. Further, what the stock market really does reflect is the consensus estimate of an economy’s future condition. More specifically, stock prices reveal future expectations for corporate profits.

This generally applies to both the United States and China. One key difference, though, is that most American stocks represent companies that seek to make profits. In China, that isn’t necessarily the case. The Chinese stock market includes many state-owned enterprises (SOEs), whose executives answer to bureaucrats in Beijing. The government views them as public policy tools. Everyone is happy if the SOEs make a profit, but profit is not the first priority.

If US stock prices generally tell us more about the future than the present, except in times of serious over- or undervaluation, then Chinese stock prices tell us even less about either. Just as last year’s incredible run-up in Chinese stocks did not signal an economic boom, the ongoing decline does not signal an economic bust. The correlations aren’t just weak, they are nonexistent. China’s official economic data is also questionable and would be so even if GDP were a precise measurement tool. As we discussed last week, it usually isn’t.

It is no stretch to say we are flying blind about China.

Fortunately, we have diligent researchers like Leland Miller of China Beige Book, whose research firm does the hard work of gathering reliable data each quarter from thousands of companies in China and assembling it in comprehensible form. His data shows that China’s economy has actually been in good shape since China stopped acting Chinese last year. But even then, you have to separate the Chinese economy into several categories.

China Good, China Bad, & China Ugly

Among the many letters and reports on China that I received over the last month, I’d like to single out an excellent research note that the team at Gavekal Dragonomics published last week, called “What to Worry About and What Not to in China.” I appreciated this piece, because it really helped me structure my worrying. I dislike spending energy worrying about the wrong things. Further, worrying about the wrong things can be dangerous. It’s when you are paying attention to the wrong things that what you should have been paying attention to jumps up and bites you on the derrière.

In the spirit of the Gavekal note, here is the good side of China. We’ll get to the bad and the ugly below.
Chinese real estate prices will stabilize. We hear a lot about China’s massive infrastructure boom and the resulting “ghost cities.” These aren’t just rumors. The government mandated the construction of entire cities to house the formerly agrarian population as it shifts to industrial jobs. Provincial governments earned as much as 80% of their revenues from land sales. Essentially, this is a process where they take possession of rural land that has very little value in price terms, declare it to be available for development, and can make profits several orders of magnitude greater than their costs. Nice work if you can get it.

The ghost cities will not stay empty forever. They will fill with people over the next few years (in some cases more than a few). The recent housing bubble is more a function of young people wanting to cram into certain popular areas. The broader internal migration will support housing prices even as the bubble areas pop.

It might be helpful to think of the Chinese ghost cities as analogous to the overbuilt condos in Florida. Prices in Florida did in fact collapse, and places were selling for a fraction of their construction cost. I wrote at the time that I thought they would be very good investments, because the number of people wanting to retire to Florida is actually a fairly steadily growing figure. Low taxes, good weather, positive infrastructure, excellent medical care – what’s not to like, other than it’s not Texas? Just saying…..

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The article Thoughts from the Frontline: Muddling Through Shanghai was originally published at mauldineconomics.com.

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A Great Insight into Why Commodity Weakness Will Persist

By John Mauldin 

In today’s Outside the Box, good friend Gary Shilling gives us deeper insight into the global economic trends that have led to China’s headline making, market shaking devaluation of the renminbi. He reminds us that today’s currency moves and lagging growth are the (perhaps inevitable) outcome of China massive expansion of output for many products that started more than a decade ago. China was at the epicenter of a commodity bubble that got underway in 2002, soon after China joined the World Trade Organization.

As manufacturing shifted from North America and Europe to China –with China now consuming more than 40% of annual global output of copper, tin, lead, zinc and other nonferrous metal while stockpiling increased quantities of iron ore, petroleum and other commodities – many thought a permanent commodity boom was here.

Think again, Australia; not so fast, Brazil. Copper prices, for instance, have been cut nearly in half as world growth, and Chinese internal demand, have weakened. Coal is another commodity that is taking a huge hit: China’s imports of coking coal used in steel production are down almost 50% from a year ago, and of course coal is being hammered here in the US, too.

And the litany continues. Grain prices, sugar prices, and – the biggee – oil prices have all cratered in a world where the spectre of deflation has persistently loomed in the lingering shadow of the Great Recession. (They just released grain estimates for the US, and apparently we’re going to be inundated with corn and soybeans. The yield figures are almost staggeringly higher than the highest previous estimates. Very bearish for grain prices.)

Also, most major commodities are priced in dollars; and now, as the US dollar soars and the Fed prepares to turn off the spigot, says Gary, “raw materials are more expensive and therefore less desirable to overseas users as well as foreign investors.” As investors flee commodities in favor of the US dollar and treasuries, there is bound to be a profound shakeout among commodity producers and their markets.

See the conclusion of the article for a special offer to OTB readers for Gary Shilling’s INSIGHT. Gary’s letter really does provide exceptional value to his readers and clients. It’s packed with well-reasoned, outside-the-consensus analysis. He has consistently been one of the best investors and analysts out there.

There are times when you look at your travel schedule and realize that you just didn’t plan quite as well as you could have. On Monday morning I was in the Maine outback with my youngest son, Trey, and scheduled to return to Dallas and then leave the next morning to Vancouver and Whistler to spend a few days with Louis Gave. But I realized as Trey and I got on the plane that I no longer needed to hold his hand to escort him back from Maine. He’s a grown man now. I could’ve flown almost directly to Vancouver and cut out a lot of middlemen. By the time that became apparent, it was too late and too expensive to adjust.

Camp Kotok, as it has come to be called, was quite special this year. The fishing sucked, but the camaraderie was exceptional. I got to spend two hours one evening with former Philadelphia Fed president Charlie Plosser, as he went into full-on professor mode on one topic after another. I am in the midst of thinking about how my next book needs to be written and researched, and Charlie was interested in the topic, which is how the world will change in the next 20 years, what it means, and how to invest in it. Like a grad student proposing a thesis, I was forced by Charlie to apply outline and structure to what had been only rough thinking.

There may have been a dozen conversations like that one over the three days, some on the boat – momentarily interrupted by fish on the line – and some over dinner and well into the night. It is times like that when I realize my life is truly blessed. I get to talk with so many truly fascinating and brilliant people. And today I find myself with Louis Gave, one of the finest economic and investment thinkers in the world (as well as a first class gentleman and friend), whose research is sought after by institutions and traders everywhere. In addition to talking about family and other important stuff, we do drift into macroeconomic talk. Neither of us were surprised by the Chinese currency move and expect that this is the first of many
.
I did a few interviews while I was in Maine. Here is a short one from the Street.com. They wanted to talk about what I see happening in Europe. And below is a picture from the deck of Leen’s Lodge at sunset. Today I find myself in the splendor of the mountains of British Columbia. It’s been a good week and I hope you have a great one as well.

Oops, I’ve just been talked into going zip-trekking this afternoon with Louis and friends. Apparently they hang you on a rope and swing you over forests and canyons. Sounds interesting. Looks like we’ll do their latest and greatest, the Sasquatch. 2 km over a valley. Good gods.

Your keenly aware of what a blessing his life is analyst,

John Mauldin, Editor

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Commodity Weakness Persists

(Excerpted from the August 2015 edition of A. Gary Shilling’s INSIGHT)

The sluggish economic growth here and abroad has spawned three significant developments – falling commodity prices, looming deflation and near-universal currency devaluations against the dollar. With slowing to negative economic growth throughout the world, it’s no surprise that commodity prices have been falling since early 2011 (Chart 1). While demand growth for most commodities is muted, supply jumps as a result of a huge expansion of output for many products a decade ago. China was the focus of the commodity bubble that started in early 2002, soon after China joined the World Trade Organization at the end of 2001.

China, The Manufacturer

As manufacturing shifted from North America and Europe to China – with China now consuming more than 40% of annual global output of copper, tin, lead, zinc and other nonferrous metal while stockpiling increased quantities of iron ore, petroleum and other commodities – many thought a permanent commodity boom was here.

So much so that many commodity producers hyped their investments a decade ago to expand capacity that, in the case of minerals, often take five to 10 years to reach fruition. In classic commodity boom-bust fashion, these capacity expansions came on stream just as demand atrophied due to slowing growth in export-dependent China, driven by slow growth in developed country importers. Still, some miners maintain production because shutdowns and restarts are expensive, and debts incurred to expand still need to be serviced. Also, some mineral producers are increasing output since they believe their low costs will squeeze competitors out. Good luck, guys!

Copper, Our Favorite

Copper is our favorite industrial commodity because it's used in almost every manufactured product and because there are no cartels on the supply or demand side to offset basic economic forces. Also, copper is predominantly produced in developing economies that need the foreign exchange generated by copper exports to service their foreign debts. So the lower the price of copper, the more they must produce and export to get the same number of dollars to service their foreign debts. And the more they export, the more the downward pressure on copper prices, which forces them to produce and export even more in a self reinforcing downward spiral in copper prices. Copper prices have dropped 48% since their February 2011 peak, and recently hit a six year low as heavy inventories confront subdued demand (Chart 2).

Even in 2013, after two solid years of commodity price declines, major producers were in denial. That year, Glencore purchased Xtrata and Glencore CEO Ivan Glasenberg called it “a big play” on coal. “To really screw this up, the coal price has got to really tank,” he said at the time. Since then, it’s down 41%. But back in February 2012 when the merger was announced, coal was selling at around $100 per ton and Chinese coal demand was still robust.

Nevertheless, Chinese coal consumption fell in 2014 for the first time in 14 years and U.S. demand is down as power plants shift from coal to natural gas. Meanwhile, coal output is jumping in countries such as Australia, Colombia and Russia. China’s imports of coking coal used in steel production are down almost 50% from a year ago. Many coal miners lock in sales at fixed prices, but at current prices, over half of global coal is being mined at a loss. U.S. coal producers are also being hammered by environmentalists and natural gas producers who advocate renewable energy and natural gas vs. coal.

Losing Confidence?

Recently, major miners appear to be losing their confidence, or at least they seem to be facing reality. Anglo-American recently announced $4 billion in writedowns, largely on its Minas-Rio $8.8 billion iron ore project in Brazil, but also due to weakness in metallurgical coal prices. BHP took heavy writedowns on badly timed investments in U.S. shale gas assets. Rio Tinto’s $38 billion acquisition of aluminum producer Alcan right at the market top in 2007 has become the poster boy for problems with big writeoffs due to weak aluminum prices and cost overruns.

Glencore intends to spin off its 24% stake in Lonmin, the world’s third largest platinum producer. Iron ore-focused Vale is considering a separate entity in its base metals division to “unlock value.” Meanwhile, BHP is setting up a separate company, South 32, to house losing businesses including coal mines and aluminum refiners. That will halve its assets and number of continents in which it operates, leaving it oriented to iron ore, copper and oil.

Goldman Sachs coal mines suffered from falling prices and labor problems in Colombia. It is selling all its coal mines at a loss and has also unloaded power plants as well as aluminum warehouses. The firm’s commodity business revenues dropped from $3.4 billion in 2009 to $1.5 billion in 2013. JP Morgan Chase last year sold its physical commodity assets, including warehouses. Morgan Stanley has sold its oil shipping and pipeline businesses and wants to unload its oil trading and storage operations.

Jefferies, the investment bank piece of Leucadia National Corp., is selling its Bache commodities and financial derivatives business that it bought from Prudential Financial in 2011 for $430 million. But the buyer, Societe Generale, is only taking Bache’s top 300 clients by revenue while leaving thousands of small accounts, and paying only a nominal sum. Bache had operating losses for its four years under Jefferies ownership.

Grains and other agricultural products recently have gone through similar but shorter cycles than basic industrial commodities. Bad weather three years ago pushed up grain prices, which spawned supply increases as farmers increased plantings. Then followed, as the night the day, good weather, excess supply and price collapses. Pork and beef production and prices have similar but longer cycles due to the longer breeding cycles of animals.

Sugar prices have also nosedived in recent years (Chart 3). Cane sugar can be grown in a wide number of tropical and subtropical locations and supply can be expanded quickly. Like other Latin American countries, Brazil – the world's largest sugar producer – enjoyed the inflow of money generated from the Fed’s quantitative easing. But that ended last year and in combination with falling commodity prices, those countries’ currencies are plummeting (Chart 4). So Brazilian producers are pushing exports to make up for lower dollar revenues as prices fall, even though they receive more reals, the Brazilian currency that has fallen 33% vs. the buck in the last year since sugar is globally priced in dollars.

Oil Prices

Crude oil prices started to decline last summer, but most observers weren’t aware that petroleum and other commodity prices were falling until oil collapsed late in the year. With slow global economic growth and increasing conservation measures, energy demand growth has been weak. At the same time, output is climbing, especially due to U.S. hydraulic fracking and horizontal drilling. So the price of West Texas Intermediate crude was already down 31% from its peak, to $74 per barrel by late November.

Cartels are set up to keep prices above equilibrium. That encourages cheating as cartel members exceed their quotas and outsiders hype output. So the role of the cartel leader – in this case, the Saudis – is to accommodate the cheaters by cutting its own output to keep prices from falling. But the Saudis have seen their past cutbacks result in market share losses as other OPEC and non-OPEC producers increased their output. In the last decade, OPEC oil production has been essentially flat, with all the global growth going to non-OPEC producers, especially American frackers (Chart 5). As a result, OPEC now accounts for about a third of global production, down from 50% in 1979.

So the Saudis, backed by other Persian Gulf oil producers with sizable financial resources – Kuwait, Qatar and the United Arab Emirates – embarked on a game of chicken with the cheaters. On Nov. 27 of last year, while Americans were enjoying their Thanksgiving turkeys, OPEC announced that it would not cut output, and they have actually increased it since then. Oil prices went off the cliff and have dropped sharply before the rebound that appears to be temporary. On June 5, OPEC essentially reconfirmed its decision to let its members pump all the oil they like.

The Saudis figured they can stand low prices for longer than their financially-weaker competitors who will have to cut production first. That list includes non-friends of the Saudis such as Iran and Iraq, which they believe is controlled by Iran, as well as Russia, which opposes the Saudis in Syria. Low prices will also aid their friends, including Egypt and Pakistan, who can cut expensive domestic energy subsidies.

The Saudis and their Persian Gulf allies as well as Iraq also don’t plan to cut output if the West's agreement with Iran over its nuclear program lifts the embargo on Iranian oil. As much as another million barrels per day could then enter the market on top of the current excess supply of two million barrels a day.

The Chicken-Out Price

What is the price at which major producers chicken out and slash output? It isn’t the price needed to balance oil-producer budgets, which run from $47 per barrel in Kuwait to $215 per barrel in Libya (Chart 6). Furthermore, the chicken out price isn’t the “full cycle” or average cost of production, which for 80% of new U.S. shale oil production is around $69 per barrel.

Fracker EOG Resources believes that at $40 per barrel, it can still make a 10% profit in North Dakota as well as South and West Texas. Conoco Phillips estimates full cycle fracking costs at $40 per barrel. Long run costs in the Middle East are about $10 per barrel or less (Chart 7).

In a price war, the chicken out point is the marginal cost of production – the additional costs after the wells are drilled and the pipelines laid – it’s the price at which the cash flow for an additional barrel falls to zero. Wood Mackenzie’s survey of 2,222 oil fields globally found that at $40 per barrel, only 1.6% had negative cash flow. Saudi oil minister Ali al-Naimi said even $20 per barrel is “irrelevant.”

We understand the marginal cost for efficient U.S. shale oil producers is about $10 to $20 per barrel in the Permian Basin in Texas and about the same on average for oil produced in the Persian Gulf. Furthermore, financially troubled countries like Russia that desperately need the revenue from oil exports to service foreign debts and fund imports may well produce and export oil at prices below marginal costs – the same as we explained earlier for copper producers. And, as with copper, the lower the price, the more physical oil they need to produce and export to earn the same number of dollars.

Falling Costs

Elsewhere, oil output will no doubt rise in the next several years, adding to downward pressure on prices. U.S. crude oil output is estimated to rise over the next year from the current 9.6 million level. Sure, the drilling rig count fell until recently, but it’s the inefficient rigs – not the new horizontal rigs that are the backbone of fracking – that are being sidelined. Furthermore, the efficiency of drilling continues to leap. Texas Eagle Ford Shale now yields 719 barrels a day per well compared to 215 barrels daily in 2011. Also, Iraq’s recent deal with the Kurds means that 550,000 more barrels per day are entering the market. OPEC sees non-OPEC output rising by 3.4 million barrels a day by 2020.

Even if we’re wrong in predicting further big drops in oil prices, the upside potential is small. With all the leaping efficiency in fracking, the full-cycle cost of new wells continues to drop. Costs have already dropped 30% and are expected to fall another 20% in the next five years. Some new wells are being drilled but hydraulic fracturing is curtailed due to current prices. In effect, oil is being stored underground that can be recovered quickly later on if prices rise Closely regulated banks worry about sour energy loans, but private equity firms and other shadow banks are pouring money into energy development in hopes of higher prices later. Private equity outfits are likely to invest a record $21 billion in oil and gas start ups this year.

Earlier this year, many investors figured that the drop in oil prices to about $45 per barrel for West Texas Intermediate was the end of the selloff so they piled into new equity offerings (Chart 8), especially as oil prices rebounded to around $60. But with the subsequent price decline, the $15.87 billion investors paid for 47 follow-on offerings by U.S. and Canadian exploration and production companies this year were worth $1.41 billion less as of mid-July.

Dollar Effects

Commodity prices are dropping not only because of excess global supply but also because most major commodities are priced in dollars. So as the greenback leaps, raw materials are more expensive and therefore less desirable to overseas users as well as foreign investors. Investors worldwide rushed into commodities a decade ago as prices rose and many thought the Fed’s outpouring of QE and other money insured soaring inflation and leaping commodity prices as the classic hedge against it.

Many pension funds and other institutional investors came to view them as an investment class with prices destined to rise forever. In contrast, we continually said that commodities aren’t an investment class but a speculation, even though we continue to use them in the aggressive portfolios we manage.

We’ve written repeatedly that anyone who thinks that owning commodities is a great investment in the long run should study Chart 9, which traces the CRB broad commodity index in real terms since 1774. Notice that since the mid-1800s, it’s been steadily declining with temporary spikes caused by the Civil War, World Wars I and II and the 1970s oil crises that were soon retraced. The decline in the late 1800s is noteworthy in the face of huge commodity-consuming development then: In the U.S., the Industrial Revolution and railroad building were in full flower while forced industrialization was paramount in Japan.

At present, however, investors are fleeing commodities in favor of the dollar, Treasury bonds and other more profitable investments. Gold is among the shunned investments, and hedge funds are on balance negative on the yellow metal for the first time, according to records going back to 2006. Meanwhile, individual investors have yanked $3 billion out of precious metals funds.

Commodity Price Outlook

Commodity prices are under pressure from a number of forces that seem likely to persist for some time.

1. Sluggish global demand due to continuing slow economic growth.
2. Huge supplies of minerals and other commodities due to robust investment a decade ago.
3. Chicken games being played by major producers in the hope that pushing prices down with increasing supply will force weaker producers to scale back. This is true of the Saudis in oil and hard rock miners in iron ore.
4. Developing country commodity exporters’ needs for foreign exchange to service foreign debt. So the lower the prices, the more physical commodities they export to achieve the same dollars in revenue. This further depresses prices, leading to increased exports, etc. Copper is a prime example.
5. Increased production to offset the effects on revenues from lower prices, which further depresses prices, etc. This is the case with Brazilian sugar producers.
6. The robust dollar, which pushes up prices in foreign currency terms for the many commodities priced in dollar terms. That reduces demand, further depressing prices.

It’s obviously next to impossible to quantify the effects of all these negative effects on commodity prices. The aggregate CRB index is already down 57% from its July 2008 pinnacle and 45% since the more recent decline commenced in April 2011. To reach the February 1998 low of the last two decades, it would need to drop 43% from the late July level, but there’s nothing sacred about that 1998 number.

In any event, ongoing declines in global commodity prices will probably renew the deflation evidence and fears that were prevalent throughout the world early this year. And they might prove sufficient to deter the Fed from its plans to raise interest rates before the end of the year.

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The article Outside the Box: Commodity Weakness Persists was originally published at mauldineconomics.com.

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