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Archive for February 2016

Archive for February, 2016

3 Reasons Saudi Arabia Is So Desperate for Cash

Early this year, the Crown Prince of Saudi Arabia revealed that Saudi Arabia is considering an initial public offering for state-owned oil company Aramco. Chairman of Aramco Khalid al-Falih later clarified that the IPO would not include Saudi Arabia’s oil reserves, estimated at 268 billion barrels.

“The reserves will remain sovereign,” al-Falih said in an interview with Al-Arabiya. He added that the kingdom is mulling options for an IPO of the firm’s “ability to convert these reserves into a financial gain.”

The statements were vague and the Saudis’ actual plan for the IPO remains unclear. However, whether or not the IPO happens is not important. What is vitally important is that it was publicly discussed by the Crown Prince of Saudi Arabia.

Aramco is the world’s most valuable company. It’s also one of the most important sources of geopolitical power for Saudi Arabia. And the Crown Prince was fully aware of the consequences the statement would cause.

All of this reveals what a desperate situation record-low oil prices have pushed the Saudi’s regime into.

The Kingdom Has Only 3–5 Years of Cash Reserves Left

There is one key principle driving Saudi Arabia to sell shares in Aramco: the kingdom needs money to buy time.

The Saudi Arabia Monetary Authority (SAMA) acknowledges that the country ran a deficit of 21.6% of GDP in 2015—a quantum leap from 3% the prior year. They hope to cut that to 13% in 2016. However, the IMF expects a deficit of 20% in 2016.

They have burned through almost $100 billion in reserves the last few years. A second, similarly sized deficit would consume another $100 billion. Reserves now stand at roughly $650 billion.

The problem with those estimates is that they assume an average price for Saudi light crude of $50 in 2016. As we write this article, West Texas Intermediate (WTI) is priced around $30. And that is the delivered price of oil. The actual price a producer gets is even less.

So, what happens to Saudi Arabia’s budget deficit if oil stays in the $30 rather than $50 range?

Bank of America Merrill Lynch gives us the following estimates:

3_Reasons_Saudi_Arabia_Is_So_Desperate_for_Cash

Even with a 25% budget cut, Saudi Arabia would have just three to five years of reserves and borrowing available at $30 oil. We note that several respected investment banks are projecting that oil will fall to $20 this year.

If a crisis in Europe or China were to even slightly reduce global demand, $20 oil seems a very real possibility.

The Saudis Need Money to Hold the Arab World Together

Saudi Arabia has been spending lots of money to keep the Arab world—itself in a state of crisis— intact. Many Arab states have either collapsed or been severely weakened.

Saudi Arabia now confronts at least two key external challenges: Iran and the Islamic State.

Saudi Arabia sees itself as an enemy of Iran. As neither side is powerful enough to wage war on the other, they instead wage various (and very expensive) proxy conflicts throughout the region.

Beyond fighting proxy wars, Saudi Arabia also supports Arab states in economic turmoil, including Bahrain, Jordan, Morocco, and Egypt. They are attempting to lead a Sunni Arab coalition against Iran—and using their wealth to cement those relationships.

Saudi Arabia’s other external challenge is the rise of jihadist groups. The most significant of these groups is the Islamic State (IS). At this point, IS is behaving much like a state and has declared a caliphate in large parts of Syria and Iraq.

Saudi Arabia, therefore, is committing large amounts of monetary support to rebels in Syria fighting IS because it fears they could attack the kingdom. IS has been already staging attacks on Shiite mosques in Saudi Arabia and leveraging the region’s polarized sectarian climate to undermine the kingdom’s security.

Saudi Arabia Faces Serious Internal Challenges

The foundation of the country’s social system is the state’s ability to maintain a safety net for various segments of Saudi society. 70% of Saudi Arabia’s population is under the age of 30.

The government provides large subsidies for commodities like food and oil and offers social services and education for its majority Sunni Arab population.

The Saudi government currently provides free healthcare, free education, subsidized water and electricity, no income tax, and paid-for public pensions. Nearly 90% of Saudis are employed by the government, often at higher wages than the private sector offers.

Saudi Arabia also has a significant Shiite minority—possibly 20% of the total population. Riyadh has to somehow manage this group so that Tehran cannot overly influence it.

The Kingdom’s current financial straits render it unable to dramatically increase the money it throws at problematic groups in the country like dissident, reformist Shiites and jihadists. State-sponsored domestic spending that keeps the kingdom cohesive has also been cut, which poses serious risks to the social and economic stability of Saudi Arabia.

Desperate Times Call for Desperate Measures

The kingdom is built on oil money, and that money was used to create a technologically advanced and powerful country.

But the plummet in oil prices with no sign of a quick recovery, a brewing crisis of succession, the potential for domestic unrest due to budget cutbacks, and unprecedented external challenges have pushed Saudi Arabia in a hazardous direction: the consideration of an IPO for their most valuable asset, Aramco.

How the Fall of Saudi Arabia Could Lead the World to the Edge of Disaster

Grab the free report Saudi Arabia—a Failing Kingdom from John Mauldin and George Friedman, which is a must read for every investor who wants to protect their assets… and profit from what happens next.

Even if you have no oil stocks in your portfolio, this report could be vitally important to prepare you for coming events. Because whenever oil and the Middle East are in play, ultimately the whole world will be affected. Claim your free copy right now!

The article was excerpted from the report Saudi Arabia—a Failing Kingdom.

Thoughts From the Frontline: The Fed Prepares to Dive

 

“No one will lend at a negative interest rate; potential creditors will simply choose to hold cash, which pays zero nominal interest.”

– Ben Bernanke, 2009

“I think negative rates are something the Fed will and probably should consider if the situation arises.”

– Ben Bernanke, December 2015

“In theory there is no difference between theory and practice. In practice there is.”

– Yogi Berra

Economists used to think below-zero interest rates were impossible. Necessity (as central banks see it) is the mother of invention, though; and multiple central banks now think negative rates are a necessary step to restore growth.

Are they right? Will negative rates pull the global economy out of its funk? Probably not; but for better or worse, several central banks are already below zero. The Federal Reserve just sent its clearest signal yet that it is headed that way, too. The Fed has warned banks to get ready. We had all better do the same.

This week’s letter has two parts. The first deals with some of the practical aspects of negative rates and what the Fed is really signaling. The second part, which is somewhat philosophical, deals with why the Fed will institute negative rates during the next recession. This letter is longer than usual, but I think it’s important to understand why we will see negative rates in the world’s reserve currency (and the currency in which most global trade is conducted). This policy trend is truly a foray into unexplored territory.

Be Careful What You Wish For

The idea of negative rates isn’t new; what’s new is the willingness to try them out. The Ben Bernanke quote above comes from a November 2, 2009, Foreign Policy article in which the Fed chairman wrestled with how to keep inflation at the “right” level in a weak economy.

Set aside the question of whether there is any “right” level of inflation. As of six years ago, the head of the world’s most important central bank thought no one would ever lend at a negative interest rate. We now know he was wrong, at least with regard to Japan and most of Europe. Central banks there have instituted negative rate policies, and people are still borrowing and lending.

The Fed staff has also speculated on the possibility. Earlier this month my good friend David Kotok sent around links to several academic and central bank negative-rate studies. One was a 2012 article by Kenneth Garbade and Jamie McAndrews of the Federal Reserve Bank of New York. Their title tells you what they thought at the time: “If Interest Rates Go Negative… Or, Be Careful What You Wish For.”

Their point was less about the theoretical wisdom of NIRP and more about the actual potential consequences. They believed we would see a variety of odd responses to a very odd policy situation. All kinds of incentives would reverse, for starters.

Under negative deposit rates, buyers would want to pay their invoices as soon as possible, while sellers would want to delay receiving cash as long as possible. Think about your credit card bill. If you normally spend $10,000 a month, your best move would be to send the bank that much money before you spend it, then draw down the resulting credit balance. The bank would no doubt try to discourage this practice. Could they? We don’t know.

Garbade and McAndrews throw out another interesting idea: special-purpose banks:

If rates go negative, we should expect to see financial innovations that emulate cash in more convenient forms. One obvious candidate is a special-purpose bank that offers conventional checking accounts (for a fee) and pledges to hold no asset other than cash (which it immobilizes in a very large vault). Checks written on accounts in a special-purpose bank would be tantamount to negotiable warehouse receipts on the bank’s cash. Special-purpose banks would probably not be viable for small accounts or if interest rates are only slightly below zero, say -25 or -50 basis points (because break-even account fees are likely to be larger), but might start to become attractive if rates go much lower than that.

Ludwig von Mises fans will recognize that this approach is not far from the Austrian economics goal of 100% reserve banking. It isn’t quite there because the vault contains fiat currency instead of gold, but I think Mises would recognize it as a step in the right direction. (The fact that Fed economists see it only as an exotic theoretical possibility wouldn’t surprise him, either.)

The consequences of such banking would be more than theoretical. If enough people wanted to use these special-purpose banks, demand for physical cash would go through the roof. There simply wouldn’t be enough to go around if it just sat in vaults instead of circulating. Furthermore, if the vaulted cash in these banks reduced deposits in normal loan-making banks, the whole banking system might grind to a halt.

That being the case, I suspect the Fed would prohibit banks from operating this way – but they can’t stop people from hoarding cash under their mattresses. The one thing they could do is eliminate physical cash. Denmark, Sweden, and Norway are already considering ways to do so.

Even more ominously, Bloomberg reported on. Feb. 9 that a move is afoot for the European Central Bank to get rid of 500-euro notes, the Eurozone’s largest-denomination bills. They portray this move mainly as a crime-fighting measure, but it would clearly make cash hoarding much more difficult.

And if Larry Summers and a few other well-known economists like Ken Rogoff have their way, we will see the demise of the $100 bill in the US. You thought you were just carrying those Ben Franklins around for convenience, not realizing that they make you a potential drug dealer in some people’s eyes.

And of course, hoarding cash would undermine the Fed’s goal of fighting deflation. Holding cash is by definition deflationary.

If Crazy Doesn’t Work, Try Crazier

All of the above is just speculation at the moment. We don’t know how deeply negative rates would have to go before people change their behavior. So far the negative rates in Europe and Japan apply mainly to interbank transactions, not to individual depositors or borrowers. Unless of course you are buying government bonds.

That said, we’ve seen a clear tendency on the part of central banks since 2008: if a crazy policy doesn’t produce the desired results, make it even crazier. I believe Yellen, Draghi, Kuroda, and all the others will push rates deep below zero if they see no better alternatives. And my best guess is they won’t.

 Turns out negative rates aren’t exactly new. My good friend David Zervos, chief market strategist for Jefferies & Co., sent out a note this week pointing out that many “real,” inflation-adjusted rates have actually been negative for years. Such rates have thus far not produced the kind of reflation that central banks want to see. David thinks the ECB and BOJ should push nominal rates down to -1%, launch new quantitative easing bond purchases of at least $200 billion per month, and commit to do even more if their economies don’t respond.

Is Zervos losing his mind? No, he actually makes a pretty good case for such a policy – if you buy into his economic theories, which I discuss in the second part of this letter. (Over My Shoulder subscribers can read Zervos’s note here.) It is painfully clear to most of us that what the central banks have done thus far has not worked. I have a hard time imagining that a major NIRP campaign will help, but I’ve been wrong before.

Former Minneapolis Fed President Narayana Kocherlakota, who was for years the FOMC uber-dove, says going negative would be “daring but appropriate.” He has a number of reasons for this stance. In a note last week, he said the federal government is missing a chance to borrow gobs of money at super-attractive interest rates.

Kocherlakota would like to see the Treasury issue as much paper as it takes to drive real rates back above zero. He would use the borrowed money to repair our rickety infrastructure and to stimulate the economy.

It is an appealing idea – in theory. In reality, I have no faith that our political class would spend the cash wisely. More likely, Washington politicians would collude to distribute the money to their cronies, who would build useless highways and bridges to nowhere. The taxpayers would end up stuck with more debt, and our infrastructure would be little better than it is now.

The fact that this is a “monumentally” bad idea doesn’t mean it will never happen. There’s an excellent chance it will happen. Yellen and the Fed are clearly looking in that direction.

Yellen & the Spirit of Prudent Planning

Yellen might face one small problem on the road to NIRP: no one is completely sure if the Fed has legal authority to enact such a policy. An Aug. 5, 2010, staff memo says that the law authorizing the Fed to pay interest on excess reserves may not give it authority to charge interest.

This potential snag is interesting for a couple of reasons. With last month’s release of this memo, we now know the Fed was actively considering NIRP less than a year after Bernanke himself said publicly that “no one will lend at a negative interest rate.” Meanwhile, some at the Fed were clearly examining the possibility.

What else was happening at the time? The bond-buying program we now call QE1 had just wrapped up in June 2010. The Fed launched QE2 in November 2010. This memo came about because the Fed realized it needed to do more and was considering options. QE2 apparently beat out NIRP as the crazy policy du jour.

The question of the legality of negative rates came up again in congressional testimony a couple of weeks ago. Rep. Patrick McHenry (R-NC) directly asked Yellen if the Fed had authority to impose negative interest rates. According to press reports, she skirted a definitive answer:

In the spirit of prudent planning we always try to look at what options we would have available to us either if we needed to tighten policy more rapidly than we expect or the opposite. So we would take a look at [negative rates]. The legal issues I’m not prepared to tell you have been thoroughly examined at this point. I am not aware of anything that would prevent [the Fed from taking interest rates into negative territory]. But I am saying we have not fully investigated the legal issues.

We know the Fed was investigating the legal issues as long ago as 2010. I would be shocked to learn that they did not investigate those issues thoroughly in the six subsequent years. Various Fed officials – including Yellen – have openly speculated about NIRP. The Fed’s legal team should be disbarred for malpractice if it hasn’t fully investigated yet. I think Yellen’s testimony was a way to deflect the potential controversy as long as possible. I believe the Yellen Fed will telegraph the markets about negative rates prior to implementing them, but evidently Yellen feels it is too soon to send that signal now.

Of course, Yellen also says she is “not aware of anything that would prevent” a NIRP move. So she may do it and then blame her lawyers if someone cries foul. By then the policy would be in place and probably irreversible. In Washington, forgiveness comes easier than permission does.

In the same testimony, Yellen hinted that the previously forecast March rate hike is probably off the table now. We will get new “dot plot” forecasts, though. It will be interesting to see how dovish they are.

As I’ve said, I am firmly convinced that the Fed will not raise the federal funds rate even to 1% this year. December may well have been the last hike we will see for some time. I can see the Fed holding steady for several months. And they are clearly getting ready to introduce negative rates during the next recession. They are already telling banks to get ready for them, too.

Y2K All Over Again?

The Dodd-Frank Act requires the Fed to conduct yearly “stress tests” on major banks. They do this by giving the banks a set of hypothetical economic scenarios. They released this year’s scenarios on Jan. 28.

The “severely adverse” scenario instructs banks to test their systems for a deep recession, a 10-year Treasury yield as low as 0.2%, 5-year notes yielding 0%, and a -0.5% 3-month T-bill yield from Q2 2016 through 2019.

Is this “severely adverse?” It’s far less adverse than what Japan has already experienced. BOJ purchases have driven Japanese government bond yields negative 10 years out the curve. Rates are also negative far out the yield curve all over Europe, even in countries that don’t deserve such rates, let alone midterm rates with even a one or a two handle.

The stress test scenarios aren’t a forecast, per se, but they mean the Fed at least sees those conditions as possible. The whole exercise is pointless if the scenarios could never happen. I think this stress test scenario is the clearest sign yet that the Fed views NIRP as a legitimate alternative.

It doesn’t mean NIRP is guaranteed. I believe Yellen when she says their policy is “data-dependent.” They are no more prescient about the future than the rest of us are. All they can do is look at the data and try to respond appropriately. I don’t envy them that job.

I think the Fed is right now in a position much like the one that was portrayed in that 2010 staff memo. They see their last big move as not having had the desired effect and are considering a new set of options. NIRP is on their list.

Having decided to put NIRP on the list, the Fed has to make sure the banking system can handle it. Whether it can is far from clear right now. The technology issues alone could unleash chaos if the Fed went negative without warning. I think putting negative rates in the stress test scenarios is the Fed’s not-so-subtle message to Wall Street: “Get ready; this could really happen.”

If Europe’s experience means anything, it seems likely our banks aren’t ready yet. Consider this Mar. 4, 2015, Wall Street Journal story.

Widespread negative interest rates, once only a theoretical possibility, have become a real-life problem for Europe’s financial system.

From Sweden to Spain, banks, brokers and other financial firms are grappling with technical and legal glitches thrown up by negative rates, forcing them to redesign computer systems, tear up spreadsheets and redraft legal contracts.

The issue echoes the scrambles around the Year 2000 computer bug and the launch of the euro, when some bank systems couldn’t handle the introduction of a new currency, said Kevin Burrowes, head of U.K. financial services at PricewaterhouseCoopers. A handful of malfunctioning computer programs can cause “huge problems,” while working around problems manually makes more controls necessary and increases the risk that something could go wrong, Mr. Burrowes said.

Preparing for NIRP is a far smaller challenge than preparing for Y2K, which required years of reprogramming and hundreds of billions of dollars, but it is still a huge project. Some reports say European banks are still dealing with the programming issues. And technology is only part of the problem. Think of all the contracts and other legal documents that might need rewriting and renegotiation. If nothing else, the Fed just stimulated the securities and contract law businesses.

One small example from my personal experience: I have been involved in the management of several large commodity funds over the past 25 years. Back in the day, commodity funds had a significant advantage in that they could put 90% of their money into short-term government bonds to generate the capital for their futures contracts. This interest offset a lot of their fees in the ’80s and ’90s. Not so much today. I suspect that many of the organizational documents required still state that such funds will use short-term Treasuries as their cash base.

Requiring these funds to lose ½% would mean they start in the hole. Not what a fund manager wants to do. But it has to be short-term cash, as the money has to be available on very short notice since it’s the collateral for a futures contract. I’ve sat and thought about this and still haven’t come up with a way around this. I wonder how many other funds will have the same issue. (We will discuss this subject in further depth in a few paragraphs.)

Go Thou and Do Likewise

The Fed is specifically warning banks, but NIRP will affect the whole economy. If you own any kind of business or you are an active investor, I expect that NIRP will create significant headaches for you. Are you ready?

Most of us have no idea whether we’re ready, but we might be able to find out. Here’s a simple test. Go to whatever accounting software or spreadsheet program you use, find the interest rate setting and see if it will let you enter a negative number.

If it won’t accept a negative rate at all, now might be an excellent time to update your software.

If the program does let you show a negative rate, dig a little and see how that rate affects the rest of your bookkeeping. Most of us have created numerous Excel spreadsheets. You know that if you get your programming off a little bit, you end up with  ##### signs in some of the cells. When you enter negative interest rates into your software, you may find similarly weird things happening. They could be good-weird or bad-weird, but in either case you might want to consult your brokerage firms, investment advisors, accountants, and tax advisors about possible consequences.

While you’re at it, think about how the rest of the Fed’s “severely adverse” scenario might affect you. Here is the guidance the Fed gave the banks:

(Yes, I know they spelled severely wrong. Clearly the Fed needs a new proofreader along with new policies. That said, you just can’t catch all the mistakes. There are at least three professional editors who read my letter prior to publication, and misteaks still happen.)

I didn’t even mention the Fed’s stock market scenario in the right column above. It shows the Dow dropping almost to 10,000 by the end of this year and recovering very slowly. In a world where anything is possible, I suppose it is prudent to ask what if questions. I do not see the Dow’s dropping 10,000 points this year, but in a deep recession? That plunge would not be out of the realm of historical precedent. If banks are planning for adverse scenarios, it would be a good idea for you to do so, too, even if you think there is no chance in hell those scenarios will play out. Contingency planning is simply prudent management. Don’t let a recession catch you without a plan.

The Religion of Economics

The problems posed by negative rates are mostly practical in nature, but they come with some deeply disturbing side effects. In the discussion above I didn’t venture into the theoretical problems of misallocation of capital, the negating of Schumpeter’s creative destruction cycle, the even more intense repression of savers and retirees, and the absolute devastation negative rates would wreak up on pension, endowment, and insurance company portfolios.

In a world of ultralow rates, pension funds that are targeting 7½% growth in order to meet their funding needs 20 years out will find those targets are impossible to attain (as they are today, only moreso). It is not yet obvious to the general public how deeply underfunded pensions are, because pension funds are still assuming that future returns will be in the 7½-8% range. That pension or annuity you are counting on for your retirement is most likely in serious trouble. And as people get older and have no practical way to go back to work, pension funds that are forced to reduce payments in 10 or 15 years (and some even sooner) will destroy the lifestyles of many of our elderly. You think there is a violent backlash among voters today? Just screw around with pensions…

So what would make central bankers around the world agree that negative rates are a solution to our current economic malaise? And that, with all their known negative consequences, not to mention their unknown unintended consequences, negative rates are better than the alternative?

I have been trying to devise an explanation of the negative rates proposition that most people can grasp by likening prevailing economic theories to a religion. Everyone understands that there is an element of faith in their own religious views, and I am going to suggest that a similar act of faith is required if one is believe in academic economics. Economics and religion are actually quite similar. They are belief systems that try to optimize outcomes. For the religious that outcome is getting to heaven, and for economists it is achieving robust economic growth – heaven on earth.

I fully recognize that I’m treading on delicate ground here, with the potential to offend pretty much everyone. My intention is to not to belittle either religion or economics, but to help you understand why central bankers take the actions they do.

This explanation will need a little set-up. I have noted before, in an effort to be humorous, that when you become a central banker you are taken into a back room and given gene therapy that makes you always and everywhere opposed to deflation. Actually, this visceral aversion is imparted during academic training in the generally elite schools from which central bankers are chosen.

This is our heritage; it’s learning derived not only from the Great Depression but from all of the other deflationary crashes in our history, too, not just in the US but globally. When you are sitting on the board of a central bank, your one overriding rule is never to allow deflation to occur on your watch. No one wants to be thought responsible for bringing about another Great Depression.

And let’s be clear, without the radical actions taken in 2008–09 to bail out the banks, drop rates to the zero bound, and institute quantitative easing, we would likely have been facing something similar to the Great Depression. While I don’t like the manner in which we chose to bail out the banks, some form of bailout was a necessary evil.

Think deflationary depressions can’t happen today? Clearly, they can. Greece, for all intents and purposes, has sunk into a massive deflationary depression. That reality is not necessarily reflected in the prices of their goods, which are denominated in euros. No, the deflationary depression in Greece is in their labor market.

Normally, when a sovereign country gets into financial trouble (generally because of too much debt), it will devalue its currency so that the prices of products it imports go up and labor costs and the prices of products it sells abroad go down. But since Greece could not devalue its currency (the euro), it was essentially forced to allow its labor costs to fall drastically. Since it is basically impossible to go to everyone in Greece and say, “You need to take a 25% cut in your pay, even though the prices of everything you’ll be buying will still be in euros,” the real world simply produced massive Greek unemployment – precisely what you would expect in a deflationary depression. Greece will likely continue to suffer for a very long time, whereas if the Greeks had left the euro, defaulted on their debts, and devalued their currency, they would likely be enjoying a quite robust recovery.

Greece’s present is a possible near future for other countries in Europe (Portugal is likely to be next, and Italy will surprise everyone with its severe banking problems), which is why the European Central Bank is so desperately fighting the deflationary impulse embedded in the very structure of the European Union.

Now, the United States is clearly not Greece. However, we are subject to the same laws of economics.

By definition, recessions are deflationary. Whenever we enter the next recession, we are going to do so with interest rates close to the zero bound. Most of the academic research both inside and outside the Fed suggests that quantitative easing, at least in the way the Fed did it the last time, is not all that effective. If you are sitting on the Federal Reserve Board, you do not want to allow deflation to happen on your watch. So what to do? You try to stimulate the economy. And the one tool you have at hand is the interest-rate lever. Since rates are already effectively at zero, the only thing left is to dip into negative-rate territory. Because, for you, allowing a deflationary malaise to set in is a far worse thing than all of the potential negative consequences of negative rates put together. It’s a Hobson’s choice; you see no other option.

Let’s do a little sidebar here. There’s lots of discussion in the media of the possible moves the Federal Reserve could make. Some people talk about the Fed’s buying the government’s infrastructure bonds, or buying equities or corporate bonds, or even doing the infamous “helicopter drop” of money into outstretched consumer hands. Those are not legal options for the Fed. The Fed is actually fairly restricted in what it can purchase. All of these outside-the-box transactions would require congressional approval and amendment of the Federal Reserve Act.

I can tell you that there is almost no stomach in the leadership of Congress or at the Fed to bring up the Federal Reserve Act for congressional action. Everyone is worried about potential mischief and political sideshows. Quite frankly, if the Federal Reserve decides that it wants to do more quantitative easing, I would much prefer that Congress authorize the Fed to purchase a few trillion dollars of 1% self-liquidating infrastructure bonds – or, as a last resort, to do an actual helicopter drop. The infrastructure bonds would create jobs and give our children something for their future, a much healthier outcome than the ephemeral boosting of stock and bond prices yielded by the last rounds of quantitative easing. In those instances, the benefits of QE went primarily to the well-off. But I digress.

The reigning academic orthodoxy for central bank believers is Keynesianism. Saint Keynes postulated that consumption is the fundamental driver of the economy. If the country is mired in recession or depression, then government and monetary policy should be geared toward increasing consumption in order to spur a recovery. Keynes argued that the government should be the consumer of last resort, running deficits as deep as necessary during recessions. (He also advocated paying down the debt during the good times, prudent advice roundly ignored.)

The current belief in vogue is that another way to increase consumption is to get businesses and consumers to borrow money and spend it. Hopefully, businesses will invest it and create new jobs, which will in turn enable more consumption. One way to stimulate more borrowing is to lower the cost of borrowing, which the Federal Reserve does by lowering interest rates. The opposite is also true: if inflation is a problem, the Fed raises rates, taking some of the inflationary steam out of the economy.

How would negative rates work? The Federal Reserve would charge a negative interest rate on the excess reserves that banks deposit at the Fed. Note this is not a negative interest rate on all deposits, just on “excess reserves” on deposit at the Fed. An excess reserve is a regulatory and political concept that is a necessary feature of the fractional reserve banking systems of the modern world. Banks are required to maintain a reserve of their assets against possible future losses from their loan portfolios. The riskier the assets the banks hold, the less those assets count towards the required level of reserves. Reserves are required to keep a bank solvent. Banks are closed and sold off when their reserves and capital are depleted below the allowed levels.

Any reserves in excess of the regulatory requirements are counted as “excess.” The theory is that if the central bank charges banks interest on their excess reserves, the banks will be more likely to lend that money out, even if at a lower rate, in order to at least make something on those reserves. Right now, banks are paid by the central bank for their excess reserves on deposit. Given the level of excess reserves at the Fed, these interest payments amount to multiple billions of dollars that are fed into the banking system each quarter; and that is one of the reasons why US banks have been able to get healthier in the wake of the Great Recession.

Consumers and businesses would borrow this cheaper money from the banks and presumably spend it or otherwise put it to use, thereby stimulating the economy and vanquishing the evil of deflation. In theory, as the economy recovers, interest rates are allowed to rise back above the zero bound.

Of course that was the theory when we went to zero rates some six years ago. At some point the economy would recover and the Fed would normalize rates. Except the economy never got to a place where the Fed felt comfortable raising rates even minimally – until last December. And now the high priests of the FOMC are signaling that it might be longer than they originally thought before they swing their incense orbs and raise rates again.

There are some (including me) who would argue that, rather than focusing on consumption, monetary and fiscal policy should focus on increasing production and income. By lowering (repressing) the amount of income savers get on their money, you push savers into riskier assets. That is generally not what you tell people to do with their retirement portfolios, (nor can we overlook the fact that the country is getting older). Thus if interest rates are artificially low because of Fed policy, that reduces the amount of money retirees have to spend. The Federal Reserve and central banks in general seems to think it’s better to have consumers borrow than save.

It’s a Keynesian conundrum. If nobody spends and everybody saves, the economy slows down. While it may be a good thing for you individually to save and prepare for your retirement, if everybody does so at the same time the economy plunges into recession.

Now let’s get back to the intersection of economics and religion. There are multiple competing economic theories on the government’s role in monetary policy making. The operative word is theories. Each is an attempt to describe how to manage a vastly complex modern economy. Some see too much debt as the cause of our current malaise. Others think that lowering taxes would allow consumers and businesses to keep more of their income and hopefully spend it.

In the not too distant human past, shamans and soothsayers conjured theories about how the world worked and how to predict the future. Some examined the entrails of sheep, while others read meaning into the positions of the stars (or whatever their prevailing theory dictated) and told leaders what policies they should pursue. An astute priest would pretty quickly figure out that the best route to priestly job security was to foretell success for the politician’s/king’s/tribal chief’s pet policy course.

In today’s world, economists serve exactly the same function. They skry their data sets – a latter-day version of throwing the bones – and then, based on the theory by which they believe the data should be interpreted, they confirm the orthodox policy choices of their political masters – and so their careers prosper.

This is not to disparage economists – not at all. They really do try to come up with the best possible policies – but the range of policy alternatives is constrained by the economists’ (and the general society’s) belief system. If you believe in a Keynesian world, then you will prescribe lower rates and more fiscal stimulus during times of recession.

If, however, you believe in a competing model, such as the Austrian theory postulated by Ludwig von Mises, then you believe that smaller government, far less fractional reserve banking (if any at all), and a gold standard are appropriate. A recession should be allowed to “clear,” permitting defaulting borrowers to reduce their debts and putting the assets that collateralized their loans back on the market at reduced prices, thereby encouraging businesses to employ those now-cheaper assets in income-producing activities. (This is a very simplified explanation.)

There are other competing theories, each with its own model of how the world works. There is convincing logic and a believable rationale behind each theory. If we had adopted an Austrian model in 2008–09, we would have had a much deeper recession and unemployment would have risen higher, but the recovery would theoretically have come more quickly as prices cleared and debt was resolved. However, that period of time before the recovery began would have been devastating to the millions of families who would have faced even more crippling unemployment than we saw. That is an experiment we did not conduct, so we will never truly know whether that path might have been less painful in the long run.

Austrians are willing to face a series of small recessions as part of the price of maintaining a free economy, rather than postponing recession and trying to fine-tune what is supposedly a free market economy by means of monetary and fiscal policy. An analogy would be the theory that allowing small and controllable forest fires today might prevent a large, utterly devastating forest fire in the future. Nassim Taleb’s important book Antifragile makes a strong case that businesses, markets, and whole societies are much better off if they allow relatively minor random events, errors, and volatility to correct as quickly as possible rather than continually patching them over to avoid short-term pain. Decentralized experimentation in the economy by numerous complex actors capable of taking risks works better than a directed economy that encourages the buildup of excessive risk throughout the entire economy.

The problem is, there really is no one clearly right answer as to which economics belief system is best. I know what I believe to be the correct answer, but that belief is based on the way I understand the world – and the world is vastly more complex than anyone’s theory can be. No theory allows for a perfect solution for all participants. Rather, each theory picks winners and losers, with the overall objective of creating an economy that has maximal potential to grow and prosper.

(Sidebar: Let me tell you where Bernie Sanders and I agree. He rails against the privileges of Wall Street, crony capitalists, corporate insiders, and lobbyists, and the political favors and laws they get passed that benefit them and not Main Street. The deck is stacked in their favor. In that he is right. But his and my solutions to the problem are not similar, as he wants to create even more regulation and taxation, and I would prefer to remove all of the tax preferences and greatly reduce the regulatory morass that favors large businesses over small. I don’t want the government involved in picking winners and losers; that’s the role of the marketplace.)

So this is what it comes down to: The reigning academic theory/belief system is Keynesianism. The head Keynesians are signaling that they are going to give us negative rates. In fact, according to their theory, it would be irresponsible not to do so. They believe that if they sit back and allow the economy to sort itself out, the outcome would be far worse than anything that could be wrought by the intended and unintended consequences of negative interest rates.

We can differ with those in charge, but the experiment with negative rates is going to happen, and we need to begin to adjust – to think through how to position our portfolios and our investment strategies, our businesses, and our lives.

The Fed is run by True Believers. Just as Christianity or Islam or any other religion has believers that range across a spectrum of faith and beliefs, so does Keynesianism. At the Fed, these are deeply held beliefs: our central bankers are well convinced that the facts demonstrate the validity of their belief system.

I am reminded of the apologetics courses that I took in seminary (yes I graduated from seminary in 1974 – go figure). Apologetics courses basically teach you reasoned arguments in justification of a particular view, typically a theory or religious doctrine. We would look for logic and evidence that our particular version of Christianity was the correct and true position. Apologetics gave us the techniques and facts that would back us up!

I am not really trying to equate religion and economics, but I am saying that both rely on belief systems about how the world works, and that the behavior of believers is modeled on those systems. Paul Krugman tells us that fiscal stimulus and quantitative easing didn’t give us enough of a recovery simply because we didn’t do enough. If we had just believed more, had more faith in the effectiveness of Keynesian doctrine, we would now be well on our way to the economic promised land!

The fact that neither Europe nor Japan nor the United States have seen a recovery – that much of Europe is either in recession or on the borderline of recession, that Japan is dealing with severe deflationary pressures, and that the US is visibly slowing down does not create a question in Keynesian minds with respect to the correctness and effectiveness of their policies. I believe that both Japan and Europe are going to double down on quantitative easing and negative rates in their respective countries, and the US will soon follow.

I am glad I am not a central banker. The pressure to “do something” in the midst of a crisis must be horrific. To feel a responsibility and not be able to respond would be emotionally draining. I do not envy any of them. I think my own current belief system would probably take us in the optimal direction over the long term, but I can assure you that in the short term quite a few of my fellow citizens would not be happy with the process. And whether it is I or the Keynesians selling a particular theory, promising people pie in the sky doesn’t help them much to deal with the problems they face here and now.

The fact is that all of these economic theories have at their core political views about how the economy should be organized and managed. Including mine. That doesn’t necessarily mean mine is right and theirs is wrong. To determine the “rightness” of a theory, you generally try to conduct controlled experiments that give reproducible results. That kind of gold-standard research is simply not possible in today’s world. So we actually are forced to rely upon our pet theories as to how the world works. I am certainly not a believer in moral equivalency, but until one operative theory is thoroughly discredited (as communism was) it can remain the controlling theory for a long time.

I have a lot more to say and will do so in the future, but this letter is getting overly long, and I need to close it. I leave you with one of my favorite Yogi Berra quotes: “In theory there is no difference between practice and theory. In practice there is.” In theory the economy should respond to stimulus, and an economy that is demonstrably overburdened with debt should be pushed to increase that debt. In practice, the outcome may not be quite as salutary as the theory suggests. Adjust your world accordingly.

Your meditating on belief systems analyst,

John Mauldin
subscribers@mauldineconomics.com

If you enjoyed John’s article, sign up for Thoughts from the Frontline, a free weekly letter, at mauldineconomics.com. You can follow John Mauldin on Twitter @johnfmauldin

Here’s Why Nobody Understands the Markets

BY JARED DILLIAN

I used to be a big astronomy nerd when I was a kid, locked up in my room, reading space books. I actually was once interested in planetary science. Now I study finance. How depraved.

Nassim Taleb is right—finance actually is depraved. If you study finance, you study money, of course. But why is money interesting?  Because it doesn’t sit around in static piles that you shuffle and count. It can grow asymptotically, or else simply disappear.

This is true not just of stocks and bonds, but also of currencies, which are supposed to be worth something, and even commodities, which are really supposed to be worth something.

Then you have gold, which is totally useless from a practical standpoint and whose value fluctuates dramatically.

Funny thing about money exploding or disappearing is that it’s so hard to understand that we hire physicists to figure it out. 

And then they come up with these really mundane solutions, like an options pricing model that doesn’t work, or a way to forecast future volatility (that also doesn’t work). 

None of this ever comes close to figuring out why money explodes or disappears.

Human Behavior is Unquantifiable

The reason we aren’t any closer to the answer is because we keep using the wrong methods. 

You can get the math geeks to come up with equations to describe human behavior, but then human behavior changes or does something new, and you are back to square one.

The study of money is the study of people, and people behave in sometimes predictable, but often unpredictable ways. Just when you think you have a rubric (like Nate Silver with elections, a related field), along comes a Trump who blows apart the whole model.

I’ve always felt that finance is a very qualitative discipline. You are no worse off hiring English or history majors. It’s no accident that all the heavy hitters in this business are also really great writers.

The quants are starting to catch on, and a lot of the algorithmic traders are writing programs to mimic and predict human behavior… though it’s really just technical analysis and trend following in a computer program. Technical analysis has an uneven reputation, but when you can quantify and backtest it and it works, the reputation gets markedly better.

Hard to argue nowadays that even weak-form EMH holds when you have a cottage industry of very profitable systematic strategies.

Of course, there is a lot of math behind the quant stuff, and the guys doing it are mathematical geniuses, but the best of them are also very sharp market folks with a nose for when trades start to get crowded. 

The quant blowup of 2007 happened because all the smart quants were in all the same ideas. So even in the world of high-level mathematics, you still have to deal with unquantifiable stuff: human behavior.

When someone like hedge fund manager Bill Ackman sees his portfolio get slaughtered by about 20% in 2015 and then double digits in the first month of 2016, that’s not just bad stock-picking. This is what happens when crowded trades become un-crowded.

Computers may be computers, but the people who program the computers are just human and utterly fallible.

Why I Believe in Behavioral Finance 

When I taught my college finance class last semester, I’d say the most consensus long among the students was Disney (DIS) because of Star Wars.
 

Here’s Why Nobody Understands the Markets

Of course, I had been doing a bunch of work on the short side for months.
Disney has some serious problems like declines in sports viewing and superhero movies and cable industry trends—secular stuff that’s completely out of their control. 

Suffice it to say that by the time the MBA students in South Carolina get bulled up on a stock, it is probably pretty close to the end.
That’s behavioral finance in a nutshell.

This is what I do for a living. I watch the market, not the stocks, if that makes any sense. I am always collecting data. Every person I talk to on the phone, every chart I look at, every tweet or article I read, it all goes into the soup, and from that soup, I am trying to gauge sentiment.

Sentiment tells you everything. Cheap things get cheap, and expensive things get more expensive. Markets are alternately rational and irrational because people are alternately rational and irrational. Seems like a crazy way to allocate resources, but it works better than all the alternatives.

If you want to read more about my investment process, you can choose between the monthly version or the daily.

Subscribe to The 10th Man
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The article Here’s Why Nobody Understands the Markets was originally published at mauldineconomics.com.

Tech Digest: Avatars vs. Zombies: Calculating the Apocalypse Away

A colleague sent me the link for a Washington Post article titled, “Risk of dementia is declining, but scientists don’t know why.” It is inspired by another article published in the New England Journal of Medicine, “Is Dementia in Decline? Historical Trends and Future Trajectories.”

Dear Reader,

A colleague sent me the link for a Washington Post article titled, “Risk of dementia is declining, but scientists don’t know why.” It is inspired by another article published in the New England Journal of Medicine, “Is Dementia in Decline? Historical Trends and Future Trajectories.”

Essentially, the NEJM article presents good news and bad news. To this, I’ll add worse news.

The good news is that the risk of getting Alzheimer’s disease (AD) or some other form of dementia has gone down a little. The bad news is that the incidence and cost of dementia are still going up. This isn’t a contradiction—people live longer, so the aged population continues to grow and dementia increases, albeit a little more slowly.

The worse news is that we can’t afford this growing population of the demented. Despite slight reductions in risk, the Alzheimer’s Association predicts that the cost of AD will reach $1.1 trillion by 2050.

Let’s put this in context.

Last year’s federal budget was officially $3.9 trillion. Hopefully, you are aware that the US government borrows almost a third of our annual budget and has amassed a nearly $20 trillion debt, not counting unfunded future liabilities.

Presidential candidates promise to spend even more money. This is theoretically possible if taxes are raised high enough to increase spending and begin paying off the debt. While this sounds simple and attractive to many, it would further slow our already stalled economy by draining the private sector of the resources needed to innovate and create the jobs that generate taxes.

Since we’re already maxing out the national credit card, it will be even more difficult to cover the healthcare costs for a huge number of older people with dementia… unless the economy grows. The economy is slow today, however; partly because the dependency ratio (contributors to dependents) continues to worsen.

In plain English, the number of the older sick and retired (the dependents) is skyrocketing while the number of young people (the contributors) entering the workforce is not.

Already, about 30% of government spending goes to cover transfer payments to the aged. Because a static or shrinking workforce is expected to fund Social Security, Medicare and other entitlements for older people, the problem will continue to escalate as the aged population increases. Eventually—unless we solve the medical problems that shorten people’s health spans—the entire system collapses.

You may think I’m exaggerating, and I wish I were. I’m not.

This is one reason why I refer to the growing dementia problem as the “zombie apocalypse.” The other reason is that people with late-stage dementia eerily resemble the mindless and often violent zombies of modern horror movies.

I am, by the way, somewhat puzzled by the NEJM article. It lists a number of risk factors for dementia but omits any mention of the biggest preventable contributor to dementia: smoking.

I know some of the world’s top Alzheimer’s researchers, and they all agree that smoking dramatically increases the likelihood of dementia, probably more than any other single factor.

The Washington Post’s assertion that scientists don’t know why individual risk has decreased in recent years is true only in the strict sense of peer-reviewed science. That means nobody has done the expensive, time-consuming work necessary to prove that slightly reduced rates of dementia correlate to the fact that the number of smokers in the US today has been cut in half from the early 1970s. The following Gallup chart shows this trend clearly.

Like the scientists referred to in the Washington Post article, I can’t “know” that the recent slight reduction in dementia risk is the result of fewer people smoking… but it’s the result of fewer people smoking.

This is actually pretty good news, despite the fact that we don’t have the peer-reviewed data. In fact, it’s very good news because getting this kind of data is now easier than ever due to revolutions in genomics, digital healthcare records, and mobile health applications.

When it first became possible to sequence an individual’s entire genome, it generated a lot of headlines. The lack of media coverage today doesn’t mean the potential of this revolutionary science is not being fulfilled. Behind the scenes, genomicists are making remarkable discoveries about the nearly infinite factors that interact with our genomes.

I don’t know how many people have had their genomes sequenced at this point, though that is not really relevant. A sequenced genome is of use to scientists only if it is associated with actual patient medical records. They can then connect the dots between specific genetic characteristics, medical conditions, and extraneous factors such as smoking that activate genetic weaknesses. In fact, some chain smokers have the genetic capacity to live more than a 100 years while others will get lung cancer from even occasional smoking. The combination of genomic and medical information lets us pinpoint personal risk factors.

Even better are genomes matched to constantly updated longitudinal electronic medical records, which allows bioinformaticians to correlate environmental influences, from smoking and exercise regimens to drug and supplement use, in real time.

It’s difficult to overstate the importance of these new tools. Until very recently, medicine was based on the disease model for the imaginary statistically average person. Even if a drug candidate produced a miracle cure for 90% of test subjects in clinical trials, it would be rejected if the remaining 10% experienced severe side effects.

This made sense in the old days when we couldn’t determine the genetic differences that cause people to react differently to the same drug. Today, we are entering the era of personalized medicine, allowing us to link specific drug treatments with specific genotypes. The consequences will be enormous.

In a similar vein, we will also be able to clear up the incredible confusion surrounding diet and supplements. I write a lot about nutritional discoveries, but it always bothers me when I recommend something because we know that genetics influences response. Some supplements may be beneficial for most people, but useless or even dangerous for others.

For the first time in history, emerging tools allow scientists to determine—based on real evidence—whether a drug or supplement will be beneficial or a dangerous waste of money for a particular individual. This is critical especially when a person takes multiple drugs with potential interactions. Finally, we’ll be able to calculate with mathematical certainty what treatment makes the most sense for any individual.

Recently, I’ve been talking to a group of scientists who have spent millions of dollars and many years developing in-silico computer tools that create avatars of patients based on their individual genomes and medical records.

Using artificial intelligence, they test vast numbers of hypothetical drug combinations and treatments for a variety of serious diseases on patients’ avatars. Work that would take years if done by humans is done in seconds by a massively parallel array of computers. Already, this process seems to produce superior prescription recommendations, allowing doctors to dramatically improve treatment outcomes.

But that’s not all. Soon, we will move beyond the disease model and into anti-aging therapeutics. Then these bioinformatics tools will become even more important. Based on your genome, electronic medical records, and information gathered from millions of other people tracking their own conditions via mHealth technologies, AIs will be able to develop regimens of drugs, supplements, and behaviors that will dramatically extend your health span.

This bioinformatics revolution will significantly forestall or prevent the diseases of aging, including dementia. It will also repair the dependency ratio, promoting the economic growth needed to pay off this generation’s profligacy.

If you want to read more in-depth analysis of the coming anti-aging revolution—and get my top stock recommendations in this booming biotech sector—give my monthly newsletter, Transformational Tech Alert, a risk-free try today.

To begin reading Patrick’s Tech Digest newsletter for free each Friday, simply click here. At Patrick’s Transformational Technologies site, you can join Tech Digest by entering your email address at the top right of the page. 

The 10th Man: Interstellar

Unless you were trapped under something heavy, you probably heard the news that a team of scientists detected gravitational waves emanating from two black holes colliding a billion light-years away. This is a really big deal, one of the biggest discoveries in theoretical physics.

A gravitational wave is actually a ripple in the fabric of space-time. If you picture the universe as a two-dimensional plane, a gravitational wave would push the plane into three-dimensional space. Since we live in a four-dimensional world (including time as the fourth dimension), a ripple in space-time actually pushes the known universe into what is known as the “bulk,” or the fifth dimension.

Huge implications here for travel through space (or time).

I used to be a big astronomy nerd when I was a kid, locked up in my room, reading space books. I actually was once interested in planetary science. Now I study finance. How depraved.

Nassim Taleb is right—finance actually is depraved. If you study finance, you study money, of course. But why is money interesting?  Because it doesn’t sit around in static piles, that you shuffle and count. It can grow asymptotically, or else simply disappear.

This is true not just of stocks and bonds, but also of currencies, which are supposed to be worth something, and even commodities, which are really supposed to be worth something.

Then you have gold, which is totally useless from a practical standpoint and whose value fluctuates dramatically.

Funny thing about money exploding or disappearing is, it’s so hard to understand that we hire physicists to figure it out. And then they come up with these really mundane solutions, like an options pricing model that doesn’t work, or a way to forecast future volatility (that also doesn’t work). None of this ever comes close to figuring out why money explodes or disappears.

Of course, the goal is to get exposure to money exploding or negative exposure to it disappearing, but people seem to do a pretty bad job of that, too.

The reason we aren’t any closer to the answer is because we keep using the wrong methods. You can get the math geeks to come up with equations to describe human behavior, but then human behavior changes or does something new, and you are back to square one.

The study of money is the study of people, and people behave in sometimes predictable, but often unpredictable ways. Just when you think you have a rubric (like Nate Silver with elections, a related field), along comes a Trump who blows apart the whole model.

I’ve always felt that finance is a very qualitative discipline. You are no worse off hiring English or history majors. It’s no accident that all the heavy hitters in this business are also really great writers.

The quants are starting to catch on, and a lot of the algorithmic traders are writing programs to mimic and predict human behavior, though it’s really just technical analysis, trend following, in a computer program. Technical analysis has an uneven reputation, but when you can quantify and backtest it and it works, the reputation gets markedly better.

Hard to argue nowadays that even weak-form EMH holds, when you have a cottage industry of very profitable systematic strategies.

Of course, there is a lot of math behind the quant stuff, and the guys doing it are mathematical geniuses, but the best of them are also very sharp market folks, with a nose for when trades start to get crowded. The quant blowup of 2007 happened because all the smart quants were in all the same ideas. So even in the world of high-level mathematics, you still have to deal with unquantifiable stuff: human behavior.

When someone like hedge fund manager Bill Ackman sees his portfolio get slaughtered by about 20% in 2015 and then double digits in the first month of 2016, that’s not just bad stock-picking. This is what happens when crowded trades become un-crowded.

Computers may be computers, but the people who program the computers are just human, and utterly fallible.

Behavioral Finance

When I taught my college finance class last semester, I’d say the most consensus long among the students was Disney (DIS), because of Star Wars.

Of course, I had been doing a bunch of work on the short side for months.

Disney has some serious problems, like declines in sports viewing and superhero movies and cable industry trends—secular stuff that’s completely out of their control. Suffice it to say that by the time the MBA students in South Carolina get bulled up on a stock, it is probably pretty close to the end.

That’s behavioral finance, in a nutshell.

This is what I do for a living. I watch the market, not the stocks, if that makes any sense. I am always collecting data. Every person I talk to on the phone, every chart I look at, every tweet or article I read, it all goes into the soup, and from that soup, I am trying to gauge sentiment.

Sentiment tells you everything. Cheap things get cheap, and expensive things get more expensive. Markets are alternately rational and irrational, because people are alternately rational and irrational. Seems like a crazy way to allocate resources, but it works better than all the alternatives.

If you want to read more about my investment process, you can choose between the monthly version or the daily.

Jared Dillian
Jared Dillian

If you enjoyed Jared’s article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. Follow Jared on Twitter @dailydirtnap

The article The 10th Man: Interstellar was originally published at mauldineconomics.com.

Outside the Box: 70 Is the New 65

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
subscribers@mauldineconomics.com

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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Important Disclosures

The article Outside the Box: 70 Is the New 65 was originally published at mauldineconomics.com.

The “Strong” Jobs Numbers Are a Big Lie

Washington is pretty proud of the employment numbers it has been pumping out. The Labor Department recently reported that the US unemployment rate dropped to 4.9% in January. That’s an eight-year low going back to the 2008–2009 Financial Crisis.

The_“Strong”_Jobs_Numbers_Are_a_Big_Lie

The actual number of new jobs was a little on the light side, at 151,000 versus the expected 190,000. Most of the Wall Street crowd, however, was impressed with the +0.4% monthly increase in wages.

Not so fast.

The Employment Data Needs a Reality-Check

As always, the devil is in the details, and the jobs situation doesn’t look so rosy beneath the headline numbers.

•    Downward Revisions: The October and November jobs numbers were revised down.

•    Would You Like Fries with That, Sir? Of all those newly created jobs, 96% were retail, leisure/hospitality, and healthcare/social assistance. Social assistance? That’s largely people who help others understand and/or sign up for Obamacare.

Retail:                                              +57,700
Healthcare/Social Assistance:        +44,000
Leisure/Hospitality:                         +44,000

•    Crash and Burn: One of the themes I’ve been touting in this column is the slumping transportation industry. In January, 20,300 jobs in the transportation/warehousing industry were lost.

•    Good Old Government BS: The retail sector supposedly created 57,700 jobs in January, but that is the “seasonally adjusted” figure. The actual or non-seasonally adjusted number is a loss of 584,000 jobs!

•    Wages Rise… Yeah, for Teenagers: That +0.4% increase in wages was nothing more than a bump in the minimum wages in 14 different states.

December 31, 2015: New York, West Virginia

January 1, 2016: Alaska, Arkansas, California, Colorado, Connecticut, Hawaii, Massachusetts, Michigan, Nebraska, Rhode Island, South Dakota, and Vermont.

Examples: The minimum wage in New York went up to $9/hour; in California and Massachusetts, it was raised to $10/hour.

•    Poof, You’re a Worker! The labor force was said to have increased by 502,000 people, but that is more smoke and mirrors. The 502,000 increase is some cryptic “population control effect” the government conjures up every January. However, the “population control effect” was 218,000 jobs, which means the labor force actually grew by 284,000 instead.

75,100 Layoffs and the Nasdaq in Free Fall

As you can see, there is a lot of hocus-pocus in the labor numbers—but isn’t that the type of fun and games you expect from your government? So let’s take a look at the layoff report from Challenger, Gray & Christmas.

In January, a total of 75,100 layoffs were announced, a number not seen since January of 2009.

Oops! There is that 2008–2009 Financial Crisis again.

And on a year-over-year basis, layoff announcements are up by 41%.

But you know what number I paid the most attention to? The 146-point plunge in the Nasdaq Composite on the release of those “strong” jobs numbers.

The_“Strong”_Jobs_Numbers_Are_a_Big_Lie

The Nasdaq lost 3.3% of its value that day and closed at lows not seen since October 2014.

Investment Implications

If you own companies whose business it is to help people get jobs, you might want to reconsider. I’m talking about companies like ManpowerGroup (MAN), Kelly Services (KELYA), Robert Half International (RHI), On Assignment (ASGN), Kforce (KFRC), and TrueBlue (TBI).

Or, if you are a more aggressive investor looking for ways to profit from falling stock prices, the above is a pretty good list of short-selling candidates.

For more information on bearish bets and my very best plays in that sector, try my monthly newsletter Rational Bear risk-free.

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Markets rise or fall each day, but when reporting the reasons, the financial media rarely provides investors with a complete picture. Tony Sagami shows you the real story behind the week’s market news in his free publication, Connecting the Dots.

The article The “Strong” Jobs Numbers Are a Big Lie was originally published at mauldineconomics.com.

Connecting the Dots: Don’t Fall for the Government Fake-Out

Washington, DC is pretty proud of the employment numbers it has been pumping out. Most recently, the Labor Department reported that the US unemployment rate dropped to 4.9% in January.

That’s an eight-year low going back to the 2008–2009 Financial Crisis.

The actual number of new jobs was a little on the light side, at 151,000 versus the expected 190,000, but most of the Wall Street crowd was impressed with the +0.4% monthly increase in wages.

Not so fast. As always, the devil is in the details, and the jobs situation doesn’t look so rosy beneath the headline numbers.

  • Downward Revisions: The October and November jobs numbers were revised down.
  • Would You Like Fries with That, Sir? Of all those newly created jobs, 96% were retail, leisure/hospitality and healthcare/social assistance. Social assistance? That’s largely people who help others understand and/or sign up for Obamacare.

Retail:                                                  +57,700
Healthcare/Social Assistance:        +44,000
Leisure/Hospitality:                         +44,000

  • Crash and Burn: One of the themes I’ve been touting in this column is the slumping transportation industry. In January, 20,300 jobs in the transportation/warehousing industry were lost.
  • Good Old Government BS: The retail sector supposedly created 57,700 jobs in January, but that is the “seasonally adjusted” figure. The actual or non-seasonally adjusted number is a loss of 584,000 jobs!
  • Wage Rise… Yeah, for Teenagers: That +0.4% increase in wages was nothing more than a bump in the minimum wages in 14 different states.

December 31, 2015: New York, West Virginia

January 1, 2016: Alaska, Arkansas, California, Colorado, Connecticut, Hawaii, Massachusetts, Michigan, Nebraska, Rhode Island, South Dakota, and Vermont.

Examples: The minimum wage in New York went up to $9/hour; in California and Massachusetts, it was raised to $10/hour.

  • Poof, You’re a Worker! The labor force was said to have increased by 502,000 people, but that is more smoke and mirrors. The 502,000 increase is some cryptic “population control effect” the government conjures up every January. However, the “population control effect” was 218,000 jobs, which means the labor force actually grew by 284,000 instead.

As you can see, there is a lot of hocus-pocus in the labor numbers—but isn’t that the type of fun and games you expect from your government? So let’s take a look at the layoff report from Challenger, Gray & Christmas.

In January, a total of 75,100 layoffs were announced, a number not seen since January of 2009.

Oops! There is that 2008–2009 Financial Crisis again.

And on a year-over-year basis, layoff announcements are up by 41%.

But you know what number I paid the most attention to? The 146-point plunge in the Nasdaq Composite on the release of those “strong” jobs numbers.

The Nasdaq lost 3.3% of its value that day and closed at lows not seen since October 2014.

If you own companies whose business it is to help people get jobs, you might want to reconsider. I’m talking about companies like ManpowerGroup (MAN), Kelly Services (KELYA), Robert Half International (RHI), On Assignment (ASGN), Kforce (KFRC), and TrueBlue (TBI).

Or, if you are a more aggressive investor looking for ways to profit from falling stock prices, the above is a pretty good list of short-selling candidates.

For more information on bearish bets and my very best plays in that sector, try my monthly newsletter Rational Bear risk-free, with 3-month money-back guarantee.

Tony Sagami
Tony Sagami

30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

Friedman: The 2016 Election Isn’t All That Important for Investors

As an outsider to the investment community, I am constantly struck by its obsession with politics… and particularly with the role of the president. Attention and money flow to candidates in the belief that there is a unique importance to the president in shaping the republic’s future.

I find that interesting because, in my view, the American president is one of the least powerful national leaders in the world. This is particularly true in domestic affairs where he is a very visible, but a rather minor player in crafting policy.

Russian President Vladimir Putin or Chinese President Xi Jinping are obviously more powerful than the American president. But so is British Prime Minister David Cameron, who operates in a parliamentary system where his ability to pass legislation is far greater than the American president’s.

The President Has Little Control over the Legislative Process

The president represents one of three branches of government, presiding over 50 states, which also have their own rights to legislate. All legislation must pass through Congress.

Both the Senate and House of Representatives have the power to determine whether legislation is adopted or rejected. The Speaker of the House can frequently choose simply not to allow a bill to come to a vote. In the Senate, any senator can prevent a bill from coming to a vote, and a handful of senators can take the floor and block the vote.

The president can veto legislation, but Congress can override the veto. The president cannot compel action or control the outcome.

So for example, while President Barack Obama got healthcare reforms through Congress, the final legislation was far from the bill he wanted. He had to bargain away part of his legislative agenda just to get these reforms through Congress. The level of effort required to achieve anything is enormous.

Then there is the third branch of government, the Supreme Court, which has the power to invalidate any legislation or presidential decision. For example, the court blocked implementation of Obama’s plans to cut power plant emissions.

The US federal government is composed of these three branches. However, we should also mention the Federal Reserve, which is the government body that has the most influence over the economy. Like the Supreme Court, the Fed was designed to operate independently of the president and Congress.

Although the members of its Board of Governors are nominated by the president and confirmed by the Senate, the Fed is not answerable to either.
The president ultimately has limited powers over Congress and the Supreme Court. He can nominate Supreme Court justices, but only with the concurrence of Congress.

Justice Antonin Scalia died this weekend, and Senate Majority Leader Mitch McConnell has already declared that he wants the next president, not Obama, to appoint Scalia’s replacement. There is good reason to believe that he can make that happen.

The president may propose any legislation he wishes and nominate any candidate to the high court he wants. Whether his bill becomes law, and whether his nominee takes office, is not up to him.

The Constitution Restricts the President’s Domestic Powers

The US was designed to be this way. The founders did not believe in the goodness of man… but in his corruption. They understood the need for government, but wanted its authority to be limited.

When necessary, they wanted the government to act with general conviction. Barring that condition, they expected gridlock.

It is interesting that Americans now regard the paralysis of government as pathological and a government that gets things done as healthy.

There is frequently discussion of government being run in a businesslike manner. This misses the obvious point: government is not a business. The purpose of business is to make money.

The purpose of the American government is to contain the worst impulses of human beings by making the legislative process as difficult as possible, without rendering it impossible.

The founders valued business. They knew business thrives on rapid decision making. But they feared an efficient government. That’s why the American government was designed to slow down decision making.

The President’s Major Role Is to Fight Wars

The exception of course is in foreign policy. The founders understood that it was a dangerous world and the need to go to war might arise suddenly. Therefore, they gave the president another post in government: commander in chief.

It is that post that causes people to think the president is powerful… because in that role he is. That role didn’t come to define the presidency until Franklin D. Roosevelt’s presidency.

Roosevelt managed to introduce some significant reforms through the New Deal. It was his response to World War II, however, that brought the commander-in-chief role to the fore.

World War II set the stage for a new type of republic, the republic at war, near war, or preparing for war. From 1941 until today, the primary responsibility of the president has been to prepare to act as commander in chief.

The advent of nuclear weapons made this role central to the presidency. The declaration of war became obsolete. In the event of a nuclear attack, decisions would have to be fast. The country couldn’t wait the time needed for the political system to function.

This declaration had never been as respected as the founders may have wanted. The wars against the Native Americans (recognized by treaty as nations) did not involve declarations of war. Countless interventions in the first half of the twentieth century, from Haiti to China, had no such declarations.

The declaration of war petered out after Roosevelt, and the constant state of war and near war elevated the role of commander in chief to the prime function of the president. As commander in chief, the president became enormously powerful outside the United States.

The great symbol of this power was the passing of the nuclear codes from the outgoing president to the new one—something both symbolic and very real. And the power he derived from the threat of nuclear war was extended to all other aspects of foreign policy.

Congress could intervene by withholding money or blocking an agreement, but blocking presidential initiatives in foreign affairs was difficult.

And the Supreme Court repeatedly ruled that the president’s actions in foreign affairs was outside its sphere of authority. Congress couldn’t act and the Supreme Court wouldn’t. After World War II, however, the president’s power in foreign affairs and matters of war became unchallenged.

Since then, the president has filled two roles. One related to domestic policy, the other as commander in chief.

The nuclear threat during the Cold War made the president’s major role become the owner of the nuclear arsenal. Even as the nuclear threat declined, the role of the president in managing this new reality increased.

This was in spite of Congressional attempts, through the War Powers Resolution of 1973, to boost its decision-making abilities regarding foreign interventions.

George H.W. Bush invaded Panama and intervened in Somalia and Kuwait. Bill Clinton intervened in Haiti and went to war in Serbia. And of course following 9/11, when war became what appears to be a permanent feature, the president’s role as commander in chief became central.

The founders always wanted a paradoxical president: weak in domestic politics, but not in foreign policy or war. What shifted was not the office… but the world.

The president had not been regarded as a decisive figure before Roosevelt. Roosevelt spoke of the bully pulpit as the means of compensating for the lack of power in the office. But as the United States entered a state of permanent near war, the president’s role in foreign policy became the core of his authority.

The Illusion of Power

As foreign policy became the core of the presidency, this illusion of the president as enormously powerful grew. And the financial community became obsessed with who would become president. Whether Donald Trump, Bernie Sanders, or whomever.

A careful reading of a presidential candidate’s policy papers is one of the most pointless exercises imaginable. Even assuming that a candidate has read these documents and believes in them, he is not in control of what his own policies look like.

In terms of domestic proposals, a candidate’s options are profoundly limited. And in terms of foreign policy, a candidate is limited by not knowing what the US will face in the next four years.

George W. Bush opposed nation building during the campaign. Bush did not anticipate that 9/11 would render all his positions meaningless. Obama assumed that he could reverse the hatred of the Islamic world for the United States by being conciliatory, but he was forced to become involved in the region’s conflicts.

It is essential to remember that presidents don’t make history, but history makes them. History causes us to remember FDR for his role in World War II. It causes us to remember Lyndon B. Johnson for his role in Vietnam. LBJ did not expect to be remembered in that way.

In the end, policies—like plans in war—die the first day in office. But the character of the president might make a difference. It’s not that the president doesn’t matter. It is just that he doesn’t matter nearly as much as the financial markets and others think.

And if we ask why almost half the country doesn’t vote in presidential elections, it may be that they are on to something.

The intentions of the president are unimportant. They are subject to many forces that can block and overpower him. They are hostage to events that might make his intentions pointless.

The obsession with the American president is partly due to the fact that he is the only official directly elected by all of the people. It is partly due to the role of commander in chief, in an age of nuclear weapons and global presence.

In domestic affairs the president can be an influencer or a bystander. But he is never, by himself alone, a decision maker. The presidential election is interesting, but it does not define the future of the republic.

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George Friedman provides unbiased assessment of the global outlook—whether demographic, technological, cultural, geopolitical, or military—in his free publication This Week in Geopolitics. Subscribe now and get an in-depth view of the forces that will drive events and investors in the next year, decade, or even a century from now.