The Perils of Increased Linkages
The legendary long-term investor, Peter Lynch, takes a dim view of economic statistics. He is recorded as saying, "The way you lose money in the market is to start off with an economic picture." Today, this view might be myopic. Although his stewardship of the Fidelity Magellan Fund from 1977 to 1990 was spectacular, had his strategy continued after 2000, his fund holders would not have fared so well. In the 1980's, Mr. Lynch could perform above average while ignoring the economy. Today, he would not have this luxury.
There are key economic indicators that all long-term Seeking Alpha investors must have in the back of their mind when evaluating any strategy. If they are ignored, additional unnecessary risks will be added to their portfolios and they could incorrectly evaluate long-term growth opportunities. These indicators show that over the next three decades, we will enter a period that has never been experienced by history and this means that old established investing methods will not continue to work. While it is essential to know and understand these indicators when doing due diligence, knowing them alone will not be sufficient.
One important change since Mr. Lynch's tenure is that the world has become increasingly interdependent. One measure of this interdependency is the share of World Gross Domestic Product (GDP) that comes from trade among countries. The chart below shows how the export share of World GDP has slowly climbed since the middle 1980's. (Imports have followed the same path and it would be redundant to also plot them. The data for this chart comes from the International Monetary Fund [IMF]). During Mr. Lynch's Magellan tenure, it was often below 20% and except for a hiccup in the Financial Crisis, it is now above 30% and will probably continue to grow. Never in history have we experienced this level of interdependence. Certainly, the global economy has benefited since more efficiencies are created when each country can focus more on those industries where it has a comparative advantage.
Despite the benefits of this slowly increasing interdependence, it has also slowly increased challenges for diversifying portfolios to reduce risk. Increased world trade means that both domestic and foreign companies are relying on an increasingly common set of customers for their growth. An increasing share of the revenues of US domestic firms comes outside the US. Likewise, many foreign corporations are expanding in the US. This ultimately increases the statistical dependence between the returns of different securities and asset classes. The closer economic linkages among the emerging markets and developed countries tie their business cycles more closely together. Correlations are the commonly used measure of this statistical dependence. As increasing worldwide trade induces higher return correlations, wealth managers who are constrained to long only portfolios (as Peter Lynch was) will have increasing difficulty managing the volatility of their portfolios as these linkages increase.
For example, take Colgate-Palmolive (CL) and the spot price for Europe Brent Petroleum. These are two different asset classes and industries. The chart below plots their rolling annual correlation. Today 79% of Colgate's Oral product revenues come from foreign sources, although it is a domestic corporation. (See Colgate's 2012 10-K page 79.) Colgate products are considered as American as apple pie. But, more Colgate toothpaste goes into non American mouths than American. Over the past five years, the customers that provide the growth for both Colgate toothpaste and petroleum come from the same source. This perhaps explains the increased correlation between the two. The bottom line is that the Colgate-Brent combination was an easier and better diversification combination in the 1980s and 1990s than it is today. The correlation is not near one, but nonetheless, there still is a growing statistical dependence, and holding them together creates more risk today than it did twenty years ago. This Colgate-Europe Brent correlation is merely an example. Investors need be aware of the truth that increased economic linkages will make it increasingly difficult to diversify a "long only" portfolio. The efficient frontier for the tradeoff between expected return and volatility for a long only portfolio has contracted. Many long-term investors who are currently "long only" might need to consider starting short positions either with equities or through the purchase of put options. Shorting will become an increasingly necessary risk management tool.
While many claim to understand how increased trade blurs the distinction between different sectors and geographies, they are often prone to forget this when analyzing markets. Recently, the S&P 500 has outperformed both emerging markets and the MSCI Index. Many forecast that this outperformance will continue because US economic performance will be better than the rest of the world. There is an implicit assumption that the US economy can stand on its own, and by itself, induce domestic public equities to continue to outperform their foreign counterparts. However, even if this were true, this explanation presumes that companies in the S&P 500 mostly serve domestic markets and the MSCI index serve mostly foreign markets. However, while the US looks relatively strong now, it cannot remain strong in the long term without support coming outside its borders. If the recent S&P 500 rally is to be sustained in the long term, there needs to be growth outside the US economy. The US consumer can no longer be the driving engine behind US economic growth much less worldwide economic growth. In the short term, the US can outperform without the support of emerging markets but investors should not bank on this outperformance to last forever.
Even after the 2008-2009 Financial Crisis, correlations remain high although they are below peak levels. The Financial Crisis was not a onetime anomaly when all correlations seemed to be going to 100%. International credit markets are still closely tied together and when one node is stressed, the interdependence stresses other nodes. While global credit markets are currently calm, even the Basel III reforms cannot completely mitigate risks in a particular area from spreading again. When and if shocks in one part of the global financial system occur, they will still have large immediate effects on the rest of the world. At best, the Basel III reforms reduce the probability that any one major institution defaults, but it does not eliminate the probability. The Wall Street Journal article, "Policy in U.S. Echoes in Emerging Markets," August 26, 2013, echoes this truth as it describes how US monetary policy has negative effects on emerging nations' capital markets.
The US is no longer "the only Game in Town"
The chart below compares the cumulative growth rates in inflation adjusted GDP (real GDP) from 1999 to 2012 among the World, Advanced Economies, Emerging Markets, Developing Asia and the US. (The data can be accessed from the IMF.) Even with recent "bumps" in Emerging Markets, the US has grown more slowly than most of the undeveloped countries of the world, and no longer is the US economy the "only game in town." So, not only is increased interdependence making it more difficult to lower portfolio risks, wealth managers must increasingly look outside the US for growth opportunities. There are recent reports that emerging markets' growth is growing more slowly than the developed nations. (See Wall Street Journal, 08/12/2013, "Emerging World Loses Growth Lead.") Yet, even if this persists for another five years, the US will never recover its 1990 share of world GDP.
Many wealth managers use the historical performance of the S&P 500 to justify their current position in domestic equities. They show their clients that over the past 100 years that the S&P 500 returned 6.5% adjusted for inflation. This is a bad and faulty justification. Today's economy is not your father's or your grandfather's economy and the factors (particularly the demographic ones and the real growth in incomes) that drove this historical growth no longer exist. If the S&P 500 continues to do well, it will be because the companies in the S&P 500 have successfully adapted to the new economic environment. The most dangerous guarantee provided by wealth managers is that US domestic equities will automatically continue to increase inflation adjusted earning power since they have done so in the past. History is no longer a reliable guide.
Your father's economy was driven by US consumer spending. For many years, it drove the world economy. Yet, recently, the typical US consumer has not been and is still not in good financial shape. This did not matter so much before the 2008-2009 Financial Crisis because easy lending policies allowed all US consumers to use their homes as ATM machines. Many spent beyond their means. They bought bigger homes that they could not afford with switches, fixtures, and curtains made in China, Thailand and India. Today, however, they must face the onus of decreasing purchasing power as inflation adjusted median income has continuously fallen. (See the chart below that uses US Census Bureau data.) No longer can they use their homes as ATM machines. In Peter Lynch's time, real median incomes were rising and this provided reliable fuel for his security selections. Today, the story is different. Today's investor must always remember that the US has limited long-term opportunities as the typical individual is suffering a reduction in purchasing power, is aging, and does not have adequate resources to retire comfortably. There is a record high number and fraction of non elderly adults who are not employed and therefore not paying Medicare or Social Security payroll taxes. This will add stress to the solvency of both programs. This sad state of affairs helps neither the US nor the World economy. US economy history has never experienced such a state of affairs.
Every responsible investor needs to know the median income trends depicted in the above chart. There is not one indicator that this will improve soon. Many have talked of a "manufacturing renaissance" in the US. If there is one, it is not showing in manufacturing employment. The most recent employment report from the US Bureau of Labor Statistics shows a drop of manufacturing employment from July 2012 (8.435 million) to July 2013 (8.377 million).
Sources for Growth
As business cycles among different countries become more closely linked, relying solely on the US economy becomes increasingly risky. Solely relying on the US means a lower return and a higher volatility coming from the volatility of other countries. I have already argued that future US average growth is compromised and one needs to look at new sources of growth.
If the US can no longer be the driving force behind world growth, where do long-term wealth managers look for long-term growth? A good place to start is to look at demographics. A useful device for analyzing demographics is the "population pyramid." A population pyramid provides a visual of the population shares of each sex and age cohort of the population. When looking at a population pyramid, the length of the lowest "left branch" gives the share of males in the youngest age cohort (0 to 4) while the length of the lowest "right branch" gives the share of females in the youngest cohort. The left side always gives the male share and the right side gives the female share. As one moves up the pyramid, the age cohorts get older. The quality of a region's demographics can be easily determined by the population pyramid shape. The pyramid for the best demographics for growth is shaped like a triangle (∆). The worst are shaped more like an upside down triangle. The reason that the triangle shape is best is that the youngest cohort has the largest population share followed by the next youngest cohort and this continues up the age cohorts. This means that the younger will greatly outnumber the older for the long term and there are few older retirees per younger person. The triangle shaped pyramid also signals that there is a high fraction of working age citizens relative to retired elderly citizens. Countries whose largest cohorts are children have a greater potential for growth because the working age population is guaranteed to grow.
The shape of the population pyramid is certainly not the only factor determining a region's or a growing country's growth potential. There are other important factors such as the country's economic policies and the educational and skill level of the working population. Yet, it does indicate whether the demographics are providing either a headwind or a tailwind, and part of the necessary due diligence process is to understand the demographics of each country where the business under review does business. Infrastructure, government fiscal policies, and a rule of law also play a role. Even if a country's government has sound policies, an inverted triangle will usually offset any positive role that a government can play. (I show Japan as an example below.) Likewise, I show that even if a country has good demographics, unsound government policies can offset the positive demographics. (I show India as an example below.) If a country has both pro growth government policies and good demographics, it will generate many growth opportunities. (I show Tanzania as an example below.)
The shape of a country's population pyramid is not an indicator of how the equity prices of firms headquartered in the country will fare. It is merely a necessary signal of the growth potential for firms that actually sell in the country or plan to expand in the country. When doing due diligence today, investors need to know the shares of a company's revenue for every country where it does business. Additionally, they need to determine whether the demographics are working for or against the countries where the company does business. The population pyramid is a quick and useful tool for this due diligence.
The charts below depict the population pyramids of various regions and countries. I start showing the 1980 population pyramid for the US when Peter Lynch was in the early stages of his Magellan career, and then I show the 2013 US population pyramid. I analyze the demographics from the population pyramids, and I also review the non demographic issues that affect economic growth. I show below that world wide fertility rates are dropping to a point where eventually older generations outnumber younger. Never in history we experienced this situation.
Notice the change that 33 years make. In 1980, the 20-24 cohort dominated. In 2013, it is the 50-54 cohort that dominates. The demographics when Peter Lynch was investing for Fidelity was far better suited for US growth than today's demographics. Mr. Lynch's investments were US centric and they could be because the US was still relatively young. These charts show strong evidence that US growth prospects in 2013 are not as bright as they were in 1980. If he were using the same US centric approach today, he would be facing a greater headwind. Please note that had there been no immigration to the US, the demographics in the US would look worse. However, even immigration was not enough to keep the 2013 pyramid in the same shape as the 1980 pyramid. Fertility rates are dropping even among American immigrants. Obviously, as time passes, the US population pyramid will become worse and worse.
The final data for 2011 from the US National Center for Health Statistics (NCHS) reports a record-low birth rate (63.2 births per 1,000 women ages 15-44). This is not good news for US demographic trends. In 2011, the US was already recovering from a recession when birthrates should be rising. Long-term investors need to always remember that the current US birth rate will affect the future number of working citizens and in turn the long-term growth of the US economy. If this drop in birth rates continues, long-term economic growth will face greater challenges.
The charts below are population pyramids for non US regions and countries. They start with the worst demographic areas for 2013 (Japan) and end with the best for 2013 (Tanzania). Not only are pyramids included for specific countries but also for the world, for Latin America and for the less developed regions. This helps us understand how major countries compare to the world, the US and other regions.
Japan's demographics generate tremendous headwinds for doing business inside the country regardless of the country's economic policies. The largest population cohort in Japan is the 60-64. The ability of this cohort to add value to Japan's economy will diminish quickly. The number of 35-year-olds and younger are greatly outnumbered by those 35 and older. There is almost no immigration into Japan. Currently, Mr. Abe has no policy to improve the productivity and real income of the younger cohorts so that they can replace the lost demand of the older cohorts as they enter retirement. Companies such as Aflac (AFL) that depend disproportionately on Japanese customers could suffer revenue headwinds.
It is important to note that this population headwind will only constrain business activity within Japan. It does not need to constrain the companies listed on the Nikkei Index such as Toyota (TM), Sony (SNE) or Hitachi (HTHIY) as these all have facilities and customers outside of Japan.
While China's population picture is not as bad as Japan's, it is following close behind. The "one child" policy in patriarchal China has not only crushed the fertility rate, but also unbalanced the gender ratios where young men vastly outnumber young women. While the largest cohort is 40-44, this can be deceiving when compared to Japan since the population share of newborns to ten-year-olds is closely similar to Japan. Because China has such a large population, there is a large absolute number of youth. However, they will be crushed by the astounding burden of supporting the elderly who will vastly outnumber them. This is a substantial headwind for economic growth. Even though the 40-44 cohort dominates, where as the 60-64 dominates in Japan, China has a smaller share of 0 to 9-year-olds, and it too has low immigration rates. This means that China will age almost as poorly as Japan. Pity China's children today; their adult burdens will be massive.
China has 19.8% of the world's population. This large share of the world's population makes the entire world's economy dependent on the performance of the Chinese economy.
The China National Bureau of Statistics reports GDP growth of 7.5%. Yet, this is even disputed by deputy Prime Minister, Li Keqiang, who has created his own index for economic performance. Even if recent government statistics are true, in the long term the only way that China can contribute to future world growth is if the Chinese consumer saves less and consumes more. If this does not happen, China's economy can only grow through increased exports to countries such as the US. This seems unlikely since in most developed countries, consumers are facing declines in inflation adjusted incomes as described above. The future performance of domestically headquartered companies such as Yum (YUM), General Motors (GM), Boeing (BA), Nike (NKE) and Mettler-Toledo (MTD) that have a large revenue shares from China depends on the Chinese consumer spending growth. When doing due diligence on these companies, one needs to make judgment about China's ability to generate growth through increased consumer spending.
The pyramid for the world is more triangular than the developed economies, but it is beginning to deteriorate at the lower age cohorts. It owes its almost triangular shape to the undeveloped countries in the world. The contraction in the lower cohorts comes from decreasing world fertility rates as depicted in the table below.
World Fertility Rates
Source * Projected
The rates are still high enough to replace the population, but they are inadequate enough to ensure that the younger cohorts will not be outnumbered by older cohorts.
India's demographics are slightly better than the demographics for the entire world. This is the second most populous country in the world. The recent drop in fertility rates has tapered the 0 to 4, 5 to 9 and 10 to 14 cohorts. Similar to China, India's younger cohorts are disproportionately male.
While India's demographics are superior to China's, the country is "shooting itself in the foot" with government policies that stifle long-term economic growth. Foreign investment has exited this country and its protectionist trade policies create a headwind for anyone doing business in this country. Commodity subsidies generate many perverse incentives. The latest 5% GDP growth rate is not adequate to sustain a growing living standard for a majority of Indian households.
India did enact minor economic reforms in the 1990's and the growth results were outstanding. India's intellectual capital showed its brilliance. Pepsico (PEP) and General Electric (GE) expanded and did well. There were many successful startups. But, the corruption, the large government deficit, the infrastructure constraints and the political dysfunction finally took its toll to smoother this growth. Yet, there was a brief moment when this relatively young country showed the world its massive potential when the government was able to make a few reforms.
If government policy could be redirected to effectively promote economic development, much could be going in India's favor. Many can speak English. There are many topnotch engineering schools such as IIT Karagpar and IIT-Kanpur. There are many competent and ambitious entrepreneurs. For example, Dr. Prathap Reddy, an entrepreneurial cardiologist, can perform a heart bypass at $2,000 with the same probabilities of recovery as in American hospital where the cost averages $50,000 per year.
The Latin American population pyramid is better than most developed countries. Yet, signs of deterioration are setting in at the youngest cohort as the region's birthrates taper. The 10-14 age cohort dominates. This means that for the next thirty years, this region's economy can grow if their youth of today can be employed in value creating jobs in future years. This is a resource rich area and with the relatively youthful population, there are extraordinary opportunities if governments do not use companies such as Vale S.A. (VALE) and Petrobras (PBR) as social welfare agencies. These companies need to be efficient wealth generating entities that can provide a multitude of opportunities. Treating them as an arm of the state inhibits their ability to make wise operating and capital decisions.
Brazil will host the 2014 World Cup and the 2016 Olympics. These events should give US companies such as Nike and Coca-Cola (KO) new opportunities to win Latin America's current 10 to 24 age cohorts as permanent customers. These age cohorts are far greater than in other developed countries. If these companies cannot exploit these opportunities in Latin America, their future earnings growth could be compromised. Presently, less than 7% of both Nike's and Coke's revenues come from Latin America but by 2020 this region should have 15% of the world's population.
Both China's and Latin America's business cycles are highly interdependent since China is the region's largest customer. For example, 17% of Brazil's exports go to China, and 11% go to the US. Little diversification can be achieved by investing in both China and Latin America. If China could rely more heavily on consumer spending, both areas could be helped and the relatively young Latin American could be instrumental in providing new products for China's growing elderly population where a substantial number (but not all) will have adequate savings to finance comfortable years of retirement. For example, General Electric has purchased the Brazilian imaging company XPRO. This company has many opportunities to help early detection of disease among the Chinese elderly. Thus, Latin America need not just be a commodity supplier. There will be a relatively larger youthful presence in Latin America than in China. The GE example shows an opportunity to put this youthful population to work by producing high quality manufactured goods that Chinese consumers would be willing to purchase at top notch prices. They can also be put to work providing labor intensive assisted living services for those of Chinese elderly who are willing to go to Latin America and get this service at a lower price than in China. Again, this depends on sound economic policies and a greater use of Chinese savings to finance elderly needs. Living assistance will certainly be something that the US will not be able to do well mostly because of demographic factors.
As a whole, the less developed countries have the healthiest population pyramid than all the other country groupings. Long-term investors need to always keep this fact in mind. The challenge is for investors to make investments that allow an expanding middle class who can become increasingly productive and who can consume an increasing amount of products and services from the current developed economies. Presently, many Chinese companies are already established or entering the less developed countries and US domestic firms need to catch up. China has focused on countries with bountiful commodities such as petroleum, coffee, cocoa or industrial minerals such as Angola. Domestic US firms perhaps have opportunities in countries that China has overlooked.
Tanzania is one such country that China has tended to overlook. This country seems to be running on all eight cylinders. It has great demographics and its government has slowly continued to liberalize the economy and temper its government debt. The World Bank has issued a glowing analysis of this economy. This country is an example of what can happen when both demographics and economic policy are promoting growth. Unfortunately, there are very few publicly traded firms that are accessible to American investors who do business in Tanzania. Hopefully, the large capitalization American firms will look at Tanzania as a new source of revenue. For example, the Lindsay Corporation (LNN) is a company that should be able to successfully sell its water pumps in Tanzania as it has a water shortage problem. Presently, the country relies on Indian companies for its water infrastructure needs.
We are entering a period that has never been experienced by history. Today's level of interdependency among national economies is at an historical high. The US has never suffered a decade drop in real median income. Never has there been a period when the old begin to outnumber the young.
No longer can long-term investors ignore today's economic trend toward increasing interdependence and key demographic trends that will take place throughout the world. While increased world trade is increasing statistical dependence among the returns of various countries, investors must look beyond the US not so much for diversification but rather for better growth opportunities. "Long only" portfolios might no longer be a viable option since they will not provide adequate diversification. Focusing entirely on the US leaves an investor vulnerable to large volatility and lower long-term growth. Looking abroad will not reduce risk, but is necessary to increase the expected return of a portfolio.
A country's economic growth potential depends partly on its demographics. Demographics are working against developed countries and are working for emerging market and undeveloped economies. Since there are limits to US long-term growth, long-term investors need to look outside the US for future long-term economic growth opportunities. No longer is the US economy "the only game in town." Unless growth rates in US median income drastically improves, the US will never return to its former global dominance.