Waterworld: The Submerging Economies Of The Developed World

This story was first published for subscribers only on November 5 but is now open to all readers.

By Greg Peel

If one looks up the real time US “debt clock”, one sees a national debt in excess of seventeen trillion (US) dollars. It’s not a number that means much to anyone, but if we note that gross domestic product (GDP) is approaching sixteen trillion the figures gain more context. The mind nevertheless starts to boggle again when one sees a US total debt figure in excess of sixty trillion dollars, and more so when one spies an unfunded liabilities total in excess of 126 trillion.

By the time the reader looks up the clock, all these numbers will have risen further.

It is a truth universally acknowledged that while many factors conspired to create the Global Financial Crisis, the US private sector was a fundamental culprit. In order to save the US economy, and by default the global economy, private debt was passed into public hands. That debt was then largely funded by the Federal Reserve, which in effect printed fresh money to lend to the US government and has been doing so ever since, most recently to the tune of US$85bn per month.

As the GFC spread across the globe, developed world economies from Japan to Europe and the UK followed suit and passed private debt into public hands, printing money to fund that debt. Japan, under a new government, has been the most recent convert to extraordinary monetary stimulus and is now making the Fed look like a pretender.

As soon as the Fed began its initial quantitative easing program in 2009, the naysayers began to scream hyperinflation. Yet four years on, not only has Weimar-style hyperinflation failed to manifest, the current US inflation rate is a mere 1.5%. And may yet fall further. The Fed knew it could print money with gay abandon immediately after the GFC, given global deleveraging of balance sheets would prove highly disinflationary. But it was always assumed the central bank would eventually have to wind back the QE once the US economy began to show signs of recovery, lest the inflation monster were to arise.

The primary driving force behind the Fed’s initial QE program is illustrated in the following graph:
 

Figure 1.

 

This is a graph of Japanese GDP growth from the bursting of the country’s asset bubble in 1990 to today. If one draws a straight line from about 1974 to today, it is clear Japan’s GDP growth has been stagnant for around twenty years: the famous “lost decades”. This is exactly what Fed chairman Ben Bernanke was determined to avoid when the US asset bubble burst in 2008. Bernanke had, spookily, been dubbed “Helicopter Ben” by the pundits after a paper he presented long before the GFC suggested the central bank could simply fly around in helicopters throwing cash out the window if it had to, in order to avoid making the same mistakes the Japanese made. America, suggested Helicopter Ben, could print as much money as it wanted to.

Bernanke was soon provided with the opportunity to put his rhetoric into practice. Yet QE1 gave way to QE2 and QE2 gave way to QE3 and it wasn’t until this year that Bernanke, set to leave the post of Fed chairman, suggested it might be time to start winding back the money printing. But that didn’t happen. One reason it didn’t happen is because the US Congress and Administration argued over the magnitude of US debt, as they have been doing for five years, and now more lending is required from the Fed for the foreseeable future.

The big question heading into 2014 remains: when will the Fed start tapering? Here’s another question: what if it never actually can?

Here is a graph of US debt since 2009 when QE began:
 

Figure 2.

 

No real surprises there. But let’s look at a graph of Japanese debt:
 

Figure 3.

 

This graph begins at 1998. Yet in terms of rate of debt growth, it looks little different to that of US post-GFC. Indeed, we recall from the debt clock that the US national debt to GDP ratio is a little over 100%, but this graph indicates a ratio in excess of 200%. Bernanke believes cutting the US cash rate to zero and printing money will save the US economy. Japan cut its cash rate to zero after its 1990 crash and began printing money as well. Only now is it printing extraordinary amounts of money. Could it be that in trying to avoid the Japanese experience, the Fed is actually copying it?

Or is there more to it than mere central bank policy?

Consider the following graph:
 

Figure 4.

 

This represents Japan’s growth rate as the black dotted line, similar to the GDP graph above (Figure 1), alongside the growth rate of Japan’s working population. Note the point at which the working population growth rate tips over – just before the 1990 crash. Japan’s working population has fallen as a percentage. The missing element is the now infamous Ageing Population.

Now consider a slightly different graph, this time relating to the US:
 

Figure 5.

 

This is a graph of the US “dependency ratio” and yes, the numbers here are difficult to read. Suffice to say, the ratio was 48.2% in 2000 and has reached 58.2% in 2013. This means that in 2000, 48.2% of the US population (children, welfare recipients, age pensioners) was dependent upon the other 51.8% of the population (working) but now 58.2% is dependent on 41.8%. The nadir has clearly been reached. From here on, the Baby Boomers retire.

Ever since the GFC, the primary concern of developed world retirees, and of those looking ahead to retirement, is that of having enough savings to survive. This is certainly true in Australia, even with compulsory superannuation, and is very much true in the US, for example, which has no compulsory requirement. While some developed world retirees will be able to buy yachts, farms or enjoy round-the-world trips, for most retirement will simply be a case of worrying about having enough money to live on. And that means squirrelling away one’s pennies, living frugally and not spending unnecessarily.

Not spending. Let’s return to Japan, and consider the following graph:
 

Figure 6.

 

Here the orange line equates to the grey line in Figure 4. The yellow line is the rate of core Japanese consumer inflation. Now, it is fair to say that the bursting of as asset bubble, as occurred in Japan in 1990, is enough to curb consumer spending for a while, just as the GFC has curbed spending in Australia for example. But two decades?

Old people do not spend, they save, and attempt to live off the interest from their savings. Young people spend: on houses, cars, furniture, holidays, entertainment and “stuff”. Working people drive inflation. It thus stands to reason, as the above graph suggests, that a diminishing workforce implies less inflation. An ageing population implies disinflation. Japan has suffered two decades of deflation, despite a zero interest rate. Is it just because of the 1990 crash?

Japan is a standout. Is it all that fish? Japanese people seem to live longer. Japan’s extraordinary place in the world is demonstrated by the next graph, which plots significant economies on a measure of dependency ratio versus CPI:
 

Figure 7.

 

Australia’s dot is actually lost somewhere in the midst of that cluster which includes the US, Canada, UK and most of Europe. What we notice here, apart from Japan being a very lonely dot, is that outside of Malta and Luxembourg, every economy sitting below the dependency rollover line is either Asian or Brazil. Yes, Turkey competes in the Eurovision Song Contest, but the bulk of the country sits on the Asian side of the Bosphorus.

India clearly has an inflation problem, but not much of a dependency problem, although we won’t talk about life expectancy comparisons. Inflation is an easier problem for an economy, or a central bank, to have than deflation. The face value of debt does not change, but inflation decreases the “real” value. A fundamental assumption behind bank mortgage lending, for example, is that wages rise over time. Deflation increases the “real” value of debt.

GDP growth equals population growth plus productivity. So Economics 101 suggests. Population growth alone is not enough to grow GDP. That population must be productive (witness China’s peasants moving from subsistence to wage-earning, and China’s subsequent growth). Technology improves productivity, but any economy will face an uphill battle to grow if the population falls. Japan’s working population percentage peaked before 1990 and its total population peaked in 2000. A lower working population produces less income to pay for the cost of an ageing population which itself is growing. A lower population means less economic growth, thus a diminishing capacity to pay off existing debt. As net income falls and the dependency ratio rises, what is needed to fill the fiscal gap?

More debt.

Let’s return to the US. The following graph shows the US labour force participation rate from 1962 to now. The participation rate is the percentage of the population available for work.
 

Figure 8.

Again the numbers are difficult to see, but that’s 1962 on the left and 2012 on the right, and the red line lines up 2012 with 1981. The primary focus of the Fed’s QE is to reduce unemployment. The official rate of unemployment has reduced from double digits in 2009 to 7.2% most recently, but the participation rate has also fallen steeply over that time. The participation rate excludes those who could work but have given up looking (hence the “actual” US unemployment rate is still in double digits), but also excludes those who have retired from work.  

The graph begins at the point the Baby Boom supposedly ended (give or take, no one seems to agree exactly). The post-GFC period has seen the first Baby Boomers retire. The Baby Boom will now become the Baby Bust. Developed world parents are producing less children than their parents. Even if the US economy improves to the point those unemployed but willing to work return to seek employment (increases participation rate), those retiring will increasingly affect a drag (decreases participation rate).

The participation rate conundrum is not lost on the Fed. The central bank has targeted a 6.5% official unemployment rate as the day it will begin to increase rates again, but only as a general guide. If the unemployment rate only reaches the target rate with the aid of a still-falling participation rate, the Fed will hold off on raising its cash rate.

Japan’s cash rate has been zero (or as good as) for twenty years. And counting.

But if all that QE is being poured into the US financial system, what impact is it having?
 

Figure 9.

This graph no doubt speaks for itself. And the fact the US stock market this year recovered the 50% lost in the GFC and is making new highs. There is no CPI inflation, only asset inflation. And while on the subject of the stock market:
 

Figure 10.

Here we see the US stock market price to earnings ratio from 1954 to today (the black line), overlaid with the ratio of the number of 40-49 year-olds in the population to the number of 60-69 year-olds (red dotted line), projected to 2023. The correlation is uncanny, but unsurprising. Your 40-49 year-old is buying shares (pushing share prices up) to grow funds for retirement while your 60-69 year-old is selling shares (pushing share prices down) to fund retirement. Retirees don’t want growth, they need income. Shares can also provide dividends, but they are high risk. Cash and government bonds provide no growth but they provide low risk income. Consider another graph:
 

Figure 11.

 

Here we see the average yield on a US ten-year Treasury (blue dots) from 1981 to 2011. As it happens, 1981 was around the time then Fed chairman Paul Volcker decided central banks need to use monetary policy to control inflation as well as economic growth, thus sparking a thirty year bond rally (falling yields). But it is interesting to note that over the same time period, the ratio of over 65 year-olds to under 15 year-olds within the US population has risen from 50:50 to 65:35.

Older people prefer the safety and income of bonds over the risk of equities. An ageing population will buy bonds rather than equities, applying downward pressure on yields.

In Australia, attractive term deposit rates have ensured cash has been king for retirees and investors alike since the GFC. But Australia’s thirst for cash pales into insignificance compared to that of Japan:
 

Figure 12.

 

This is a snapshot from end-2012. In Australia, falling term deposit rates are now encouraging a shift into other assets, including equities, but very slowly. Japan’s cash ratio would tend to suggest a zero cash rate is no impediment to cash investment. (Note that inflation erodes the “real” value of cash, but deflation increases it.)

If we consider the balance of risk and return, and how our preferred balance shifts as we approach, and reach, retirement, consider what a standard risk/return curve looks like for financial asset classes:
 

Figure 13.

 

Or at least used to look like, when it comes to the US. Today the curve looks the same, except for one slight difference:
 

Figure 14.

 

We have now arrived at the crux of the matter. This feature article was inspired by presentation from Michael Power, strategist at Investec Asset Management. All the graphs herein are sourced from that presentation. Power’s title is Waterworld, (For As Far As The Eye Can See), or Is The End Drawing Nigh?

Power references Kevin Costner’s famous lemon of a movie from the nineties, Waterworld. That the movie was a dud is irrelevant, rather the premise provides a useful analogy. Costner is afloat on a seemingly endless ocean in search of dry land, a legacy of the melting of the polar ice caps and the disappearance of most of the world under water. Powers suggests the developed world is quietly slipping underwater, with the above graphs (Figures 13 and 14) illustrating the metaphor.

As has been often noted, the yield on a developed world government bond can no longer be considered a “risk free return”, but rather a “return free risk”.

When the GFC hit, investors abandoned the risk of equities and piled into the safety of bonds. Even as developed world central banks cut their cash rates down to zero or not far from it, investors continued to buy bonds. Even as equity markets continued to rally from GFC depths, investors continued to eschew such risk. Wall Street may have reclaimed pre-GFC levels and beyond on the recovery of price/earnings ratios, but prices have been driven only by the few and not by the many. Bonds may now be returning negative real (inflation adjusted) returns, but still the many are prepared to lend rather than invest.

The following graph tracks cumulative flows into bonds and equities:
 

Figure 15.

 

Recently, global corporate giant Apple bought back US$55bn of its equity capital – the biggest buyback in corporate history – and suggested it will look to buy back US$100bn in total out to 2015. The company is able to do so because of the extent of cash held on its balance sheet – a legacy of selling so many iThings to the world while not requiring nearly as much as an R&D kitty to develop new products. Yet despite having cash to burn, Apple funded the buyback with an equivalent value bond issue. Why? Primarily because debt funding saved almost US$100m in tax, but also because the world is screaming out for yield and interest rates are at historical lows.

That’s tax the US government missed out on. Apple retired equity to replace it with debt. An ageing population affects a shift towards a greater demand for the safety of bonds and away from demand for risky equities. Corporate bonds issued by the likes of Apple have become more attractive to investors than sovereign bonds because sovereign bonds in many cases have suffered from credit rating downgrades. They have become riskier investments. The risk free return has become return free risk.

Note that the average credit rating of developed world countries Ireland, Portugal and Greece is now lower than the average of Brazil, Chile and Colombia. Not only has the former average fallen, the latter average has risen. Even the US credit rating was downgraded in 2011, and 2013’s Congressional stand-off prompted ratings agencies to warn of further downgrades.

Super-cap multinational corporations like Apple, and McDonalds, Disney, Shell, Nestle and others, have become the new “sovereigns”. While not quite offering a “risk free return”, these super-caps are still deemed safer than the “return free risk” of government bonds. It is thus no surprise that corporations across the globe have seized on the opportunity of low funding costs and high demand for yield (low interest rates) as a source of financing instead of more costly equity, for which the demand has waned.

Consider the following two graphs. The first (Figure 16) shows net US corporate equity issuance since 2000. Negative issuance implies retired equity, or share buybacks. Clearly the US capital base has shrunk this century. The second (Figure 17) shows global corporate bond issuance since the GFC.
 

Figure 16.

Figure 17.

In line with Figure 17, Figure 18 shows the subsequent average yield on global corporate bonds.
 

Figure 18.

Once upon a time, investors would create portfolios on a balance of income, through the yield on government bonds, and growth, through the capital appreciation of equities. Corporations also pay dividends on their shares but in the past this has been more of a token (on average) than an attraction for yield seekers. Not any more:
 

Figure 19.

As the developed world population ages, the workforce as a percentage of population decreases and the dependency ratio rises. Government income falls increasingly short of obligations, and the balance needs to be funded with debt. An ageing population affects a shift towards a preference for income over capital growth, and thus a preference for bonds over equities. Corporate bonds are increasingly being considered as safer than government bonds in many cases. Corporations are using the opportunity to finance activities through cheaper debt funding than more expensive equity funding.

Central bank monetary policy is ensuring historically low returns on government debt while the desire for yield is ensuring investment grade corporate bonds are also being issued at low rates. The abundance of debt has pushed yields below the rate of inflation. Investor returns can only be positive if inflation falls, and indeed an increasingly ageing population affects disinflation through its reducing desire to spend. Deflation would provide positive returns for lenders, given negative inflation implies the “real” value of debt rises over time. Developed world governments continue to build debt. Corporations are replacing equity with debt. Deflation would increase the real value of that debt.

The developed world is slipping underwater.
 

Figure 20.

 

We tend to split the global economy into “developed” markets and “emerging markets”. Michael Power prefers to portray the bulk of the developed world as the “submerging” markets. It will not be long before the emerging markets are contributing a greater share of global GDP than the developed markets. Using the Waterworld analogy, the emerging markets will offer dry land while the submerging markets will disappear underwater. Also offering dry land (thankfully) are commodity-rich Canada, Australia and New Zealand, and the frugal, hard-working nations of Northern Europe. The commodity-rich nations remain afloat thanks to emerging market demand.

Here is an interesting fact to consider:
 

Figure 21.

It is thus of no surprise as to where near-term global economic growth is anticipated to come from:
 

Figure 22.

Note that if we add China, India, South Korea, Indonesia, Turkey and Russia (geographically more Asian than European), we get 51%.

Meanwhile, investors in developed world bonds are beginning to appreciate that there is little point in holding an investment that’s underwater, offering negative real returns. The alternative is not all that attractive, particularly to low risk funds, but becoming rapidly necessary. As long as the Fed keeps pouring in the money, equities are the place to be.
 

Figure 23.

 

If the Fed keeps on pouring in the money, the US dollar will remain weak and the currencies of other economies will remain under upward pressure, thus undermining the capacity to generate export revenues. The more the Fed continues to support the US economy, the more it adversely affects other economies. Does the Fed care? Not a zot.

The Fed is supposedly contemplating the tapering of its bond purchase program. The implicit argument arising from the Waterworld analogy is that QE will nevertheless be here to stay in some quantum. As one observer has suggested, “QE is now a creature of Washington, forever and ever amen”. Perhaps we might have a look at that US debt clock again, and note the unfunded liabilities total of US$126 trillion, against a GDP count of US$16 trillion.

“When money is artificially and abundantly created,” says Michael Power, “under-priced investment capital is tempted to go on strike…to go sailing into uncharted waters…or to go in search of terra firma.”

Where is this dry land?

It lies in the demography of the New World. In the “Sinosphere”, as Power has dubbed it, of Figure 21 above. In Latin America. In the African frontier.

In fixed income terms, dry land lies in emerging markets currencies as a cash proxy, in emerging market debt, hard and local currencies. And in emerging market credit. In equity terms, dry land is visible both directly and indirectly. Directly via geographies (emerging Asia, Latin America) and indirectly via themes (global franchises, real assets, especially property, and commodities).

As the Bernanke era comes to an end, we note that successor-apparent, Janet Yellen, is even more “dovish” than the man who gave us QEs 1,2 and 3, hence more likely to maintain QE for a longer period.

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