The Real Old Europe
This week, it is hard to sit down and think about anything other than Iraq, especially given the circumstances in which our troops and those of our allies and the citizens of Iraq find themselves. Our prayers are for all those and their families involved. Last week, I wrote that it was likely that the war would have begun before the next weekly letter. I hope that next week's letter finds the war is over.
We look briefly at the uncertainty surrounding the US economy and then look at the economic, investment and geopolitical implications of the long term consequences of international demographic changes, which have implications not only for the aftermath of the war but for the world economy. There are large and significant changes headed your way, which can present either opportunity or crisis. You get to choose.
But first, a few comments about last week's letter on the crisis with under-funded state public pensions. A study by Wilshire Associates showed a significant deterioration in the assets of state funded public pension funds over the past few years. My calculations show Wilshire assumed a growth rate approaching 10% for the stock market over the next ten years. I wrote last week that under my secular bear market scenario, which suggests little stock market growth over ten years, that the 123 stated funded pension plans in the study could be under-funded by as much as $1 trillion dollars.
Predictably, that has not made some people happy. Fundfire reports "...the latest report on the funding levels and asset allocations of state retirement systems has drawn criticism from the National Association of State Retirement Administrators. The organization contends the report's tone is alarmist and paints a misleading picture of state plan funding. 'We don't differ with the numbers that Wilshire is publishing,' according to Keith Brainard. He is NASRA's director of research in Georgetown, Texas. 'It's the narrative that they are associating with the numbers. It seems to ignore the positives and focuses on the negatives.' Another sticking point with NASRA: Wilshire's use of market value, rather than actuarial value, to determine the aggregated pension asset-to-liability funding ratio. State plans use the latter to smooth out investment returns and lessen market volatility."
I would reply to Mr. Brainard with two points. First, actuarial accounting is the equivalent of current FASB standards which just allowed nine of the largest U.S. companies to report $30.61 billion in pension-fund losses as billions of dollars in profits in 2002 because of an accounting rule. Smoke and mirrors, or buy and hope, do not fund pension accounts. Pension funds will have to have real dollars when retirees ask for them.
Secondly, if you do not dispute the numbers in the Wilshire study, then what are the plans for your member funds if their expected returns on equities do not approach the 10% annual returns they currently envision? If the Dow does not double in the next 7 years, what are the consequences?
The answer is simple: you will scream "crisis," go to states and cities and ask them to raise taxes, perhaps significantly, or cut other services to pay for your funding. When you raise taxes, you are affecting the retirement of every taxpayer.
Let me point out that the study looks at just 123 of the larger funds. If you throw in other state, municipal and county funds, the numbers could easily approach double my suggested $1 trillion. In an economy expected to have a GDP of $150 trillion over the next ten years, that may not be the end of the world. But if we wait until the wolf is at the door, taxes will rise significantly as we run to play "catch up." It is very realistic to think the rise in new local taxes could approach 1% of annual GDP (only about $150 billion) in ten years. But if you couple this with other rising costs, especially medical costs, along with the need for increased savings by Boomers wanting to retire, it would represent a seismic shift in funds available for consumer purchases. This will be a serious drag on the economy.
Frankly, in the abstract, the problem with corporate pension funds does not concern me too much. I do not have to buy GE or Ford stock or any other firm with pension problems. But I do have to pay local taxes, and this problem is going to make them rise significantly, even as services I need (fire, police and streets) will come under pressure.
The Economic Sandstorm
Evidently the Federal Reserve could use some of the night vision goggles in use in Iraq.Their visibility about our economic future is not even as good as our soldiers in an Iraqi sandstorm. I give you just one paragraph from their press release this Tuesday:
"In light of the unusually large uncertainties clouding the geopolitical situation in the short run and their apparent effects on economic decision making, the Committee does not believe it can usefully characterize the current balance of risks with respect to the prospects for its long-run goals of price stability and sustainable economic growth. Rather, the Committee decided to refrain from making that determination until some of those uncertainties abate. In the current circumstances, heightened surveillance is particularly informative."
This can be interpreted in plain language as, "We have no clue." Actually, I commend them for being honest. Anybody who claims to have a clue either has divine connections or is simply guessing.
Paul Kasriel, head of economic research at Northern Trust Co. (and one of my favorite analysts) wrote today:
"Indicators of income and output suggest that the U.S. economy is growing, but employment has stalled. Unless there is a turnaround on the employment front, the [Federal Reserve] will have to take action in the near term, barring a sudden pickup after the Iraq situation is resolved. If the U.S. economy slips again, Europe and Japan are not in any state to take over as engines of growth. However, even if the U.S. economy muddles along, it is likely to be a tepid performance because excesses of the late 1990s have not been worked through as yet. Households and firms still need to clean up their balance sheets. In light of the evidence presented here, it appears that the economy has lost momentum, with the war only a temporary aberration."
That sums up my case for what I first called the Muddle Through Economy two years ago. If we see a pick-up in employment and business spending as the uncertainty from the war melts, then we could avoid a recession this year. The stock market certainly seems to think we will see as much. Again, we will need more "stimulus" from both the Fed and federal tax cuts to insure such a recovery.
It is easy to predict a recession or depression scenario beginning this year, and some more volatile writers have. Main stream economists talk again of a "significant second half recovery." Neither of these positions is warranted given the current data. Yes, we will have to work through a great deal of problems, and there is clearly another recession in our future, but it is not clear that it begins this quarter or even this year. I continue to think that the Muddle Through scenario is the most likely, with risks to the downside as outlined in previous letters.
I suppose I should take some small comfort that even the Fed admits they have no idea what will happen. But being in the same boat with a group that can write what is clearly in the Top Ten Most Gratuitous and Meaningless Fed statements of all time does not make me comfortable. To wit: "In the current circumstances, heightened surveillance is particularly informative."
Is It Something In the Water?
I have written in previous letters about the problems we face in the US as the Baby Boomer generation approaches retirement. We can predict that the average retirement age will rise, medical costs as a percentage of GDP will rise, lifestyles will not be what we expect and that there will be downward pressure on stocks as boomers sell assets to finance retirement, among other issues.
Today, we are going to look not at the US, but at the rest of the world. If we think of the US problems as severe, then the facts suggest the rest of the developed world is facing a major crisis. Over the next few decades, we are going to see a shift in economic and political power that is simply staggering in its implications. Let's look at facts first, and then draw conclusions.
I am going to quote at length from a study by the respected Bank Credit Analyst. Martin Barnes and his crew at BCA are some of the most respected analysts in the world, earning their reputation by simply being as accurate as any letter in the world for decades. (You can see their work and subscribe at www.bcaresearch.com) They give us some sobering thoughts:
* The population of the "developed countries" will drop rapidly over the next 50 years, while those of undeveloped countries, especially Islamic countries, will rise dramatically. Germany will experience no population growth and remains at 80 million people, while Yemen grows from 18 million to over 84 million.
Russia will drop from 145 million to slightly over 100 million. Iran grows from 66 million to 105 million. Japan drops to 109 million, while Iraq and Saudi Arabia grow to 110 million. Italy declines from 57 million to 45 million, while Afghanistan grows from 21 to 70 million.
This underscores the 100-page CIA report released in July 2001, entitled Long-Term Global Demographic Trends: Reshaping the Geopolitical Landscape. The following are some quotes from that report:
"Dramatic population declines have created power vacuums that new ethnic groups exploit. Differential population growth rates between neighbors have historically altered conventional balances of power....Our allies in the industrialized world will face an unprecedented challenge of aging. Both Europe and Japan stand to lose global power and influence... "The failure to adequately integrate large youth populations in the Middle East and Sub-Saharan Africa is likely to perpetuate the cycle of political instability, ethnic wars, revolutions and anti-regime activities that already affect many of these countries. Unemployed youth provide exceptional fodder for radical movements and terrorist organizations, particularly in the Middle East."
The Canadian based BCA concludes: "The cynical view is that the U.S. desire to attack Iraq is mainly about oil. That may be part of the agenda, but other long-term strategic considerations are probably at work. The growing number of young people in a number of unstable or troubled countries could work both ways. For example, there are signs that many young people in Iran want the country to move away from fundamentalism toward a more relaxed regime. The rising power of youth can be a force for positive change as opposed to instability. However, there will be a huge challenge in bringing democracy to countries that have no history of it. This will be especially true if the global economy is struggling because poor demographics are undermining demand in the industrialized world." (emphasis mine)
Let's look at some of their other conclusions (the following are quotes):
Declining aggregate demand in the developed world. Sharp declines in working-age populations in Europe and Japan will lead to large falls in the demand for consumer goods and real estate. Demand for aging-related services will rise, but not by enough to offset the growth-sapping impact of falling demand in the prime income-earning age group.
Full employment and labor shortages in the industrialized economies. There will not be any problem finding jobs and a negligible unemployment rate implies that real wages should tend to rise. This will be good for per capita incomes, but not for profit margins.
Steady demand growth in emerging countries. Rising populations hold out the hope that demand growth in many parts of the developing world will offset the weakness in industrialized countries. However, there will be huge regional differences within the emerging markets, with Asia likely to be the star performer, and Africa remaining mired in crisis.
Continued transfer of manufacturing production to Asia. The shift in manufacturing capacity to Asia will continue, not least because of weak demand and labor shortages in the developed world. Even the auto industry may eventually move away from Europe and the U.S. The developed economies will thus continue to become increasingly service oriented.
The welfare state will be under threat. It will be difficult to maintain the current level of public sector services and transfer payments as fiscal strains rise. It is almost inevitable that the retirement age will rise in most advanced economies and real benefits may be cut. Meanwhile, aging populations will put immense pressure on state-funded health care facilities. New medical technologies could even exacerbate the problems by creating expensive new treatments and boosting life expectancy rates.
It may be difficult to keep the euro area intact. Europe's grim fiscal outlook raises a big question mark about the sustainability of the euro zone. The Stability and Growth pact will eventually have to be scrapped, and different fiscal positions across countries will create enormous strains, given a common monetary policy and currency. Meanwhile, expanding the European Union eastwards will not alleviate Europe's demographic problems as all the new prospective members (Turkey excepted) have even weaker population dynamics than existing EU members.
China will face many of the same problems as the West. The Chinese economy currently is booming, but it too faces demographic challenges down the road. The fertility rate is below replacement level and the working-age population is projected to peak in around 2025. This will make it easier to employ those workers flowing from rural areas to cities, but, as in other countries, the aging population will create a large fiscal problem, albeit later than in the West. Other important issues discussed in the CIA report include the implications of increased urbanization in a number of unstable countries, the global spread of infectious diseases, and the adverse environmental consequence of rapid population growth in the developing world.
The long-run picture for Europe and Japan looks bleak in that a deteriorating fiscal picture will be bearish for bonds while weak aggregate demand is bearish for stocks. Those two trends would be consistent if the eventual outcome is a stagflationary environment, which could occur in the context of labor shortages and attempts to inflate out of a government debt trap. (emphasis mine)
Age Vulnerability: Your Pension or Your Life
Let's next look at a lengthy report entitled "The 2003 Aging Vulnerability Index" by the Center for Strategic and International Studies and Watson Wyatt Worldwide (Richard Jackson and Neil Howe were the authors of this extremely well researched article. They are to be congratulated for avoiding the usual indecipherable academic language and writing a very readable paper. You can read the entire piece at http://www.csis.org/gai/challengeglobalaging.pdf. FYI, Howe is also the co-author of one of the more important books on the future I have read called The Fourth Turning.)
The report analyzes the cost of public pension funds (like Social Security, the state retirement funds mentioned above, etc.) for 12 different developing countries. It then analyzes how the various countries will fare in the future, factoring in their economies, taxes, costs, and the actual circumstances surrounding retirement. (For instance, it makes a difference on whether you are likely to be supported by your kids or out on your own.)
In short, it clearly shows us that there will be staggering budget problems for these countries, and some more than others. The report categorizes Australia, the UK and the US as low vulnerability countries. Given what we know of potential US problems from an aging population, this means the report posits grim news for certain countries, especially the mainstay countries in Europe (France, Germany, Italy, Spain and the Netherlands). Howe and Jackson give a whole new meaning to the concept of "Old Europe."
Let's look at a few salient items:
"Today, there are 30 pension-eligible elders in the developed world for every 100 working age adults. By the year 2040, there will be 70. In Italy, Japan, and Spain, the fastest-aging countries, there will be 100. In other words, there will be as many retirees as workers. This rising old-age dependency ratio will translate into a sharply rising costs for pay-as-you-go retirement programs - and a heavy burden on the budget, on the economy, and on working age adults in any country that does not take serious steps to prepare... public benefits to the elderly will reach an average of 25% of GDP in the developed countries by 2040, double today's level."
"... In Japan, they will reach 27% of GDP; in France, they will reach 29%; and in Italy and Spain, they will exceed 30%. This growth will throw into question the sustainability of today's retirement systems - and indeed, society's very ability to provide a decent standard of living for the old without overburdening the young.... It is unclear whether they can change course without economic and social turmoil. (emphasis mine)
"For most of history, the elderly - here defined as adults aged 60 and over - comprised only a tiny fraction of the population, never more than five percent in any country. Today in the developed countries, they comprise 20 percent. Forty years from now, the share will reach roughly 35 percent. And that's just the average. In Japan and some of the fast-aging countries of continental Europe, where the median age is expected to exceed 50, the share will be approaching 50 percent."
Today, looking at the data, the five main economies of the European Union spend about 15% of their GDP on public benefits to the elderly. This will rise rapidly to almost 30% by 2040. Japanese benefits will rise 250% to 27% in 2040 from today's "mere" 11.8%.
How do you pay for such increases? If the increase were paid for entirely by tax hikes, not one European country would pay less than 50% of its GDP in taxes, and France would be at 62%. By comparison, the US tax share of GDP would rise from 33% to 44% (I assume this includes all level of taxes). Japan's taxes would be 46% of GDP.
If the increase in benefit costs were paid for entirely in cuts to other spending projects, Japan would see its public benefits rise to 66% of total public spending, France and the US to 53% and Germany to 49%. Today, these expenditures are all around 31%.
The following is a quick table of when government debt reaches 150% of GDP if the various governments decide to pay for the costs by running deficits (borrowing).
Some other gleanings: a mere 10% cut in benefits pushes over approximately 5% of the elderly population into poverty in Europe - think what a 20% cut in benefits would do. Japan is ranked in the middle of the vulnerability pack, despite their poor economic outlook, because over 50% of the elderly live with their children. The three most vulnerable countries are France, Italy and Spain. Australians will live longer (86.7 years) than any group except the Japanese, who are expected to live to an average of 91.9 years.
In France, 67% of the income of their elderly population comes from public funding, in Germany it is 61%, compared with 35% in the US and Japan. These are projected to rise only slightly over the coming decades, but because the elderly population is growing so rapidly, actual outlays will soar.
Not surprisingly, if you add in medical costs, the percentage of public spending increases significantly, assuming no new benefits.
Demography Is Destiny
The world economy is currently dominated by the US, Europe and Japan. These studies show that there will be little or no help from Europe and Japan in regards to world growth. The world is already far too US-centric. Everyone wants to sell to the US consumer. Our international trade deficit for January was over $41 billion, which simply cannot be sustained.
BCA suggests that the Japanese government debt will grow to 300% of GDP over the coming decades. To put this into perspective, that would be the equivalent of $36 trillion dollar US debt. Even with zero interest rates, that is a staggering sum. The Japanese economy cannot handle such a deficit without turning on the printing press in a manner unprecedented for major countries. It is hard to imagine the dollar, as weak as some think it is, to drop against such massive and mounting deficits financed by attempts at inflation.
Europe is already spending a very small percentage of its budget on defense. As one wag puts it, they will be faced with the choice of "guns or rocking chairs?" With a declining population, they will be hard-pressed to find enough bodies to man their military as it currently exists.
Unless they unwind their pension promises, Europe will play a smaller role in the world of the future, notwithstanding the view from France. The role of Asia, especially China and India, will be far more significant in the future world of our children.
The problems outlined in the two studies suggest that turmoil is coming to the developed countries of Europe and Japan. They cannot pay for their promises to retirees and still grow their economies. They will have to choose one or the other. If they choose higher taxes and fewer opportunities, the best of young Europe will vote with their feet, as did their ancestors in the 18th and 19th century. That will only make their situation worse. But can a majority retiring population vote to cut their benefits?
In short, for the world economy to grow, developing countries are going to have to look to themselves for growth. The aging developed countries will simply not provide the growth engine they have been for the last half of the last century.
For forward looking investors, that means there will be real business growth opportunities in the emerging markets and those countries which can sell to them.
As strange as it may seem today, in a few decades China will be complaining about cheap labor in the Middle East and Western Asia. If that sounds too far-fetched, think Japan only a few decades ago. The next stock market bubbles will be to the west of our shores.
As BCA noted, it is critical that the Iraqi experiment in democracy be successful for the future stability of the world. In 1945, there were many who thought it would be impossible for the regimented Japanese to establish a successful democracy. Today we watch as China moves to a capitalist economy and democracy. What stock market did the best last year? It was Russia, who not coincidentally has some of the lowest tax rates.
Call me naive, but I do not think the primary consideration for the Iraqi war was/is oil, American hegemony or establishing a democracy in Iraq. But I think that the current US administration intends to use the event to do its best to bring about a thriving Islamic democracy.
The Iraqi people are educated, are quite entrepreneurial and business oriented. Given the chance, I expect they may surprise many in the world with how fast they rebound. Given their explosive population growth rate, they could become an engine for growth in the region. If Bush is serious about helping Iraq, he should get rid of any and all trade barriers with the new regime and stand back and let the free market work.
Only a few years ago, we were fearful of the Chinese hordes and their army. They were the enemy. Today, our economies are so inextricably interwoven that it is our best interest to work any problems our peacefully. We now depend upon each other. If we want to find peace with Iraq and the Arab world, we need to find ways to establish economic ties with them as well. I hope this is a beginning. If it is not, the demographic issues I outlined above will have very negative consequences for us, our children and our grandchildren.
Speaking of Public Pensions
I will be speaking to the TEXPERS conference in Austin, Texas on Monday. This is the major Texas public pension fund conference. As you might imagine, I may be one of the more colorful and controversial of the speakers. Rudolph Giuliani will be speaking later, and I confess to hoping to get his book autographed.
I should remind readers that the current stock market rally should not be a surprise, as I have outlined why it is happening. It remains to be seen whether this can last through the summer doldrums. I hope so, but remember the long term trend is sideways for a decade at best, and severely down before then at worst. This is a trader's rally, so use it to lighten up, or reposition into deep value or very special situation stocks.
For those who keep asking when I will finish, I have imposed a deadline of May 15 on my book writing, and hopefully it will be out in July. The hardest part is to resist the temptation to add just "one more important, you gotta read this chapter." As my publisher points out, save something for the next book. I think it will be one you will like. (for more information and some chapters in the book, click on the book link at www.johnmauldin.com)
Tonight is another guy's night out with my boys. I like those nights. I will get a night away with my wife on Saturday, and then spend Sunday evening with friends and colleagues in Austin. Next week, my good friend Pat Mitchell and his wife Annie come in from South Africa for a very special time. This week, while I was in DC, a truck drove into the Tidal Pool and threatened to blow up the nuclear bomb inside. That brought traffic to a halt. Since I was with an Irishman and it was Saint Patrick's, we headed to a bar for an adult beverage. If there was a nuke, I figured that being in a bar on St. Pat's with an Irishman would get you a straight pass to heaven.
All of the above serves to remind me that one of the benefits of the aging of the world is that we get to age with it, along with our friends and family. I spend a lot of time worrying about the future, but my wife constantly reminds me to enjoy the present.
Your hoping for a swift conclusion to the war analyst,