Investing In The New Economy: Secular Economic Trends

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Includes: EWG, EWI, EWJ, EWP, FEZ, GLD, SPY, TLT, VGK
by: Eric Basmajian
Summary

US population growth is slowing. This will put a drag on trend level GDP growth.

Excessive levels of debt are hindering US productivity growth.

A combination of lower population growth and lower productivity growth will work to lower trend GDP potential.

This is a secular trend that is not unfamiliar to countries such as Japan.

Note: This note was last updated and published to members of EPB Macro Research on February 18, 2019.

In order to successfully invest in the future, it is critical to have a deep understanding of the secular trends that are driving the global economy and the domestic economy. Extrapolating past stock market returns into the future in order to plan for retirement or using asset allocations that heavily rely on stocks may not work as well as it has in the past, and there is a massive amount of evidence to support that. To ensure you are making the right investment decisions, having a secular view of the economy, a long-term view of the most powerful driving forces of growth and inflation is the most critical asset to have in your investing tool kit.

The model we follow at EPB Macro Research can be loosely defined below. There is the secular trend GDP potential which is comprised of population growth and productivity growth, the business cycle which oscillates around trend growth and the growth rate cycle which occurs within the business cycle.

A lot of time is spent on the growth rate cycle, followed by the business cycle but not much attention is given to what is actually the most powerful force, the secular trend GDP environment.

In the United States, trending GDP growth has been in a secular decline since the 1980s and that is what we will focus on in this note. What is causing that trend and where is it going in the future?

A Framework of Economic Trends:

Source: EPB Macro Research

In this note, we will dive into the current secular trends in the United States and use global trends to guide our analysis. We will take a look at what these secular trends mean for the future of financial assets using real-life data in other countries that may be just a few years ahead of the United States, discuss what the chances of these trends reversing are and what potential solutions to the problem may be, as improbable as those solutions are.

To have the best chance at successfully allocating capital over the next several decades, you can no longer look to the past for an idea of how stocks, bonds, and gold will perform because the driving forces of the economy are changing and have changed. Betting on 8% compounded returns in the S&P 500 (SPY) ad infinitum will likely not materialize the way it has in the past.

As Greg Jensen of Bridgewater Associates, the world's largest hedge fund, said in an interview with Bloomberg, which you can find here:

We are secularly in a situation, both from a debt perspective and from a demographic perspective that makes most of our experiences irrelevant. The last 40 years of how markets have worked are not as much of a guide as most people think."

This statement is painfully true and planning for the future with past performance, given the phase transition in these large secular trends is a recipe for disaster and will leave you woefully underprepared for the new economy, parts of which we are watching develop right before our eyes.

In this note, we will cover the pernicious effect of debt accumulation, a phenomenon that is plaguing the world economy and having much more severe consequences than most investors understand, as well as the shifting demographics that ensure the next 20-40 years will not be the same as the last couple of decades. We will also dive into the ominous connection between debt and demographics that harbor a relationship not commonly discussed made popular by economist Lacy Hunt.

After understanding these secular forces, the two largest factors driving the world economy, debt and demographics, you will be better served for what is to come. Shifts in financial markets and the outcomes that are most probable will not come as a surprise as they will to most investors. While nothing is guaranteed, that should go without saying, the goal with investing and forecasting trends is to have a deep understanding of what is probable; which situations have the highest degree of certainty. We are not preparing for tail events that may happen with a 5% chance or a 1% probability of occurring, but rather identifying the shifting landscape in the global economy that is very clearly the most probable outcome. Tail events like a return to the gold standard are possible and hedging an event such as that is necessary (having a percentage of your net wealth in physical gold for example), but missing the more significant trends at the expense of tail events is not a wise strategy.

We are going to start by identifying some trends in the US employment market, understanding why they are occurring, and use that to branch out and understand the secular forces more broadly.

The Secular Shift Is Already Occurring In The US Employment Market

When the employment report is released each month, there is a rush to analyze the details and understand what it may mean for the next few months of monetary policy or determine whether the wage gains are bullish for the stock market. While the short-term trends are important, there are secular trends that are embedded in the employment report that detail the changes in the economy that we all need to understand.

To start at a very high level, we must consider the changes to the employment to population ratio.

Employment To Population Ratio:

Source: BLS, EPB Macro Research

Starting in the early 1950s through the late 1990s and leading up to the tech bubble, there was a secular increase in the employment to population ratio. Part of this trend was a result of women entering the labor force as well as accelerating rates of economic growth.

Looking at real GDP on a 10-year annualized basis shows growth increasing from roughly 2% annualized in 1950 to 5% in the late 1960s and holding steady above 3% through the late 1990s. Since the turn of the century, annualized GDP growth has trailed off to about 1.5% over the last decade.

As trending economic growth is compressed, the number of people employed as a percentage of the population has been trending lower. There is no question a part of this trend is related to demographics, but the actual numbers may be surprising.

The employment to population ratio for the 25-54 age cohort mirrors the decline above, sitting below the 2000 peak and the 2007 peak.

Employment To Population Ratio 25-54 Age Cohort:

Source: BLS, EPB Macro Research

While the participation rate of the strongest segment of the economy has been declining over the past two economic cycles, albeit modestly, the participation rate for the 55-64 age cohort has been rising and is at a new all-time high.

Employment To Population Ratio 55-64 Age Cohort:

Source: BLS, EPB Macro Research

While the number of people in this cohort has increased due to demographic shifts, the percentage of people working has increased. The life expectancy has not changed much since 2007, so the increase above the last economic cycle is more probably associated with an inability to leave the labor force or afford retirement as GDP growth has been compressed and wage growth has been anemic.

The argument in today's politics tends to revolve around the idea of increasing wages in insolation, but this concept misses the key point about economics. GDP growth is synonymous with national income. If GDP growth is 2% on a trending basis, national income growth is 2% on a trending basis. It is therefore impossible to get wage growth, on average, above national income growth for a sustained period of time.

The chart below shows the 10-year annualized rate of GDP growth and the 10-year annualized rate of disposable personal income. The two are linked.

Trending GDP Growth & Trending Income Growth:

Source: BEA, EPB Macro Research

The compression of GDP growth, which has occurred for factors that we will get into later in this note, has resulted in a compression of wage growth, making it increasingly difficult for the older cohort of American's to exit the labor force.

To further show this point, if we look at the net job gains since 2007, we see that there was a massive loss of jobs in the 2008 recession and we now gained all those jobs back plus an additional 12.7 million jobs.

Total Nonfarm Payrolls - Net Addition Since 2007:

Source: BLS, EPB Macro Research

Of the 12.7 million net jobs created since the last economic cycle, a staggering 92% has gone to employees that are 55 years and older.

Since 2007, there has been an increase of 26 million people in the 55+ age cohort and a net increase of 11.8 million jobs.

What is also of note is the lack of job losses in this age bracket. As the recession hit, older Americans stayed in the labor force and took employment that they were likely overqualified for and this created a crowding-out effect of younger Americans.

Total Nonfarm Payrolls - Net Addition Since 2007 - 55+ Age Cohort:

Source: BLS, EPB Macro Research

For the 25-54-year-old age cohort, there has been a population decrease of 420,000 people since 2007 and a net increase of just 71,000 jobs. Nearly all the job losses came in the 25-54-year-old cohort.

Total Nonfarm Payrolls - Net Addition Since 2007 - 25-54 Age Cohort:

Source: BLS, EPB Macro Research

Due to weaker levels of economic growth and thus lower income prospects, younger age demographics have been crowded out of a labor market. This impact is harmful to the economy because as the income level of 25-54-year-olds is reduced, not only is this the peak spending cohort, but household formation is delayed.

If Americans that are 25-35 years old have not generated sufficient income to purchase a home and start a family, the household formation process is delayed, and this has an adverse impact on future population growth, a relationship commonly discussed by economist Lacy Hunt.

The chart below shows the 10-year annualized rate of household growth. From 1950-1980, when income and growth prospects were high, household formation growth was averaging 1.8%-2.4% per annum. There has been a massive plunge in household formation growth down to 0.9% due to the issue discussed above.

Total Household Growth 10-Year Annualized Rate:

Source: BLS, EPB Macro Research

As we will discuss in the next section, the product of population growth and productivity growth equates to trend GDP potential.

As household formation growth declines, population growth thus declines as the fertility rate drops and the prime age cohort is unable to start the family process. This shift in demographics then serves to reinforce lower rates of growth due to lower population growth, exacerbating the problem outlined above.

Declining demographics is a symptom of compressed economic growth and lower income prospects.

In the next section we will quickly prove that population growth and productivity growth equates to trend GDP potential before moving on to the root cause of the decline and a look at Europe and Japan, two countries that are further along in this process than the United States and what ramifications these trends have brought to those countries.

The Trend Growth Formula

The trend GDP potential of a nation can be very easily calculated using the product of population (or labor force) growth and productivity growth. This intuitively should make sense. If there are zero new people in the labor force but the existing people are 1% more productive, GDP growth is 1%.

Now, there are factors in the short-term that can make economic growth above or below potential such as debt spending which is an exchange, allowing an economy to grow above potential in the here and now at the expense of below-trend growth in the future.

In the United States, population growth has been running at roughly 0.7% per annum over the past 10-years.

US Population Growth:

Source: Census Bureau, EPB Macro Research

Productivity growth has been running at roughly 1.25% per annum over the past 10 years defined by the real output per hour data series released by the BLS.

US Productivity Growth:

Source: BLS, EPB Macro Research

The product of these two factors results in trend GDP potential of 1.9%, magically (or not) what the average GDP growth has been (roughly) over the last 10-years.

Real GDP growth on an annualized basis over the past 10 years has actually been lower than trend potential but in the long-run, over a trending 10 year or 20-year basis, an economy will not be able to sustain growth rates above the product of population growth and productivity growth. In the short-term and on a year to year basis, growth can oscillate strongly, but trending growth is what the concern is. If trend GDP growth is 1.9% and current GDP growth is 3%, you can be all but assured that a reversion to the trend is in the future.

This was one easy way to forecast the deceleration in economic growth (and lower interest rates) in 2019 relative to 2018.

The chart below shows the product of the working age population growth and productivity growth for the United States along with trending GDP growth. The two results track each other closely with periods of outperformance (above trend growth) and underperformance.

US GDP Growth & Trend Potential:

Source: BLS, BEA, Census Bureau, EPB Macro Research

From 1970 through 1980, the economy was growing slightly below trend potential. Starting in 1980, the economy grew above trend potential for nearly 20 years straight. How did this happen? As we will cover in the debt section below, the explosion of debt from 1980 through 2000 was incredibly simulative in the short-term, but as we know, debt is simply an exchange of current growth at the expense of future growth.

As we will discuss below, the build-up of debt starts to have a non-linear negative impact on GDP growth as debt levels get too high. The accumulation of debt which has been remarkable is starting to have a non-linear impact on growth which can partly explain the massive underperformance relative to trend since the 2000s.

Total Economic Debt Increase - Federal, State & Local, Household, and Corporate:

Source: Federal Reserve, FRED, BEA, BLS, Census Bureau, EPB Macro Research

Starting in the 1980s, the growth of total economic debt ballooned and now sits at a massive $68 trillion. There has been no deleveraging, not even after the 2008 recession so the symptoms of an overindebted society have been manifesting in the form of slower economic growth and a demographic shift described above.

Other factors including overregulation have certainly contributed to the lack-luster GDP growth relative to trend, but the main issue is debt. Not just debt but unproductive debt, defined as an accumulating liability that does not generate a stream of income sufficient to repay principal and interest.

The next section will dive into the devastating effects of unproductive debt, taking a look at Europe and Japan who are both further down this road than the United States, circle back to population growth and lastly, cover what the impact has been to both Europe and Japan.

The Adverse Effect Of Unproductive Debt

To recap, the US has a secular shift that is occurring in the employment market. Older Americans are unable to leave the workforce due to falling levels of income growth (GDP growth) which is crowding out younger Americans. This crowding out effect is delaying household formation, further reducing population growth and reinforcing the problem of low growth as trend GDP potential is a function of population growth and productivity growth. The root cause of this negative circular flow is an accumulation of unproductive debt which we will now study below.

The first question to address is whether all debt is bad. The easy answer is no; not all debt is by default bad debt. The distinction comes from unproductive debt compared to productive debt.

Unproductive debt can be easily defined by a use of debt that does not generate an income stream sufficient to repay principal and interest. If this condition is not met, income from other sources is needed to repay debt, thereby reducing the velocity of money.

A country that has taken on productive debt typically sees a rise in the velocity of money as an income stream is being produced to repay the debt and additional money is used in circulation after the principal and interest is repaid. This is good, however, it is very uncommon in the global economy.

Financial debt is almost always unproductive debt. Financial debt meaning share buybacks, M&A, dividends, etc. are not good uses of debt and in the long run, act as a negative force on the velocity of money which slows economic growth.

Consumptive type debt, debt used for consumption purposes, is the most dangerous kind of debt and a flashing red light that the consumer is unhealthy. When an economy experiences a large rise in consumer debt that is used for consumption, a severe decline in the velocity of money is typically seen as consuming a good in the here and now does not produce an income stream yet that debt needs to be repaid for years into the future with other sources of income.

The velocity of money is an extremely important metric in an economy and while the calculation and the factors that drive the velocity of money are not perfectly understood, declining rates of velocity signify a weakening of economic activity as a larger share of national income is being used to repay interest and not re-invested into higher velocity uses of money.

GDP = Money Supply (M2) * Velocity

If you take the money supply and multiply it by the velocity of money, you arrive at the nominal GDP. This is the equation of exchange.

The velocity of money is a controversial topic for reasons I don't quite understand, but that is irrelevant for this discussion. If you know the amount of money in circulation (M2), how many times that money turns over is equivalent to GDP. Described another way, how much GDP growth does each marginal dollar of money supply create?

The beautiful part about the velocity of money is that it takes into account all economic activity that is not easily monitored including the shadow banking system. If we know the gross level of sales (price * quantity) for the entire economy, and we know the level of money supply in the economy, velocity is the missing link that squares the equation. Thus, falling rates of velocity are highly important to study as it indicates money is turning over at a slower pace, highlighting unproductive uses of capital.

US Velocity Of Money:

Source: BEA, FRED, EPB Macro Research

The velocity of money has been plunging since the mid-1990s as the economy has become massively overindebted and the blend of debt has shifted towards consumptive type debt.

Another important point to consider is that lower rates of velocity make monetary policy increasingly ineffective.

In the 1990s, one dollar of increased money supply created $2.20 of GDP. Today that number has fallen to $1.40. If the Federal Reserve can increase the money supply as their primary tool of stimulus, they need to stimulate nearly twice as much today to achieve the same result as in the early 1990s.

This is also understood as the diminishing returns of debt. Higher levels of unproductive debt reduce the velocity of money and make monetary policy increasingly ineffective, thereby requiring larger and larger bouts of stimulus to achieve a similar result.

To further demonstrate this point, if we look at the debt levels, public and private, of the major economies, we can see where the debt problem is the worst and compare what has happened to the velocity of money.

Total Public & Private Debt:

Source: Hoisington Management, BOJ, Cabinet Office, Statistics Canada, BEA, Reserve Bank of Australia, Haver Analytics, Statistical Office of the European Communities

As the chart clearly shows, Japan is the most highly indebted economy followed by the Eurozone as a whole. China has outpaced the United States in recent years, but the 250% line is the important metric.

The studies have shown that when economies have a debt to GDP ratio that rises above 250% in the public and private sector that the negative impact on growth and the velocity of money starts to become nonlinear.

In the US, we crossed the line in the late 1990s, uncoincidentally when the velocity of money peaked, employment to population ratios peaked, and a variety of other key metrics of economic health peaked.

Each year a country stays above the line and the larger the debt burden becomes, the worse the impact on the economy.

As the chart below shows, the higher levels of debt, the worse the velocity of money. Japan now has a velocity of money that is below 0.6, less than half the rate of the US.

Velocity Of Money:

Source: Hoisington Management, BOJ, Cabinet Office, Statistics Canada, BEA, Reserve Bank of Australia, Haver Analytics, Statistical Office of the European Communities

The velocity of money in Japan would suggest that the Japanese economy would require more than two times the amount of stimulus as the United States economy for the same result. When velocity crashes to the levels seen in Europe and Japan, monetary policy and fiscal policy is completely ineffective.

It is for this reason that Japan has done virtually unlimited amounts of stimulus over the past decade and achieved four recessions and trend growth below 1% as a result. Europe is similar as the EU was never able to get off the zero bound this economic cycle, long-term interest rates converged to 0% and the EU is now in the process trying to avoid the second recession since 2009 despite the record amount of stimulus.

As economies become so highly indebted, specifically with unproductive debt, economic growth is suppressed, the velocity of money falls, and monetary/fiscal policy is no longer effective; a troubling situation that has been plaguing Japan for years and is now playing out vividly in Europe.

The chart below shows the amount of GDP growth generated for each $1 of new economic debt by country.

There are diminishing marginal returns to debt, and that effect becomes non-linear as debt levels increase and as the type of debt shifts more towards unproductive debt.

Growth Generated From $1 Of New Debt:

Source: Hoisington Management

We know the debt is being used for unproductive uses as the dollar generation of GDP is going down. Also, we can look at simple economic indicators such as core capital goods orders which is a proxy for business investment or capex. The chart below shows the nominal figure (left) and the amount of capital goods spending adjusted for inflation (right). In nominal dollars, since 1999, capex is virtually unchanged while adjusted for inflation the amount of capex spending in the economy is dramatically lower.

Capital Goods Spending:

Source: Census Bureau, BLS, EPB Macro Research

Japan is a few decades ahead of the US, Europe less so, perhaps a decade, so following the same path of indebtedness, fiscal policy that is ineffective and monetary policy that has no efficacy, the expected result should be the same; lower rates of velocity, lower rates of economic growth, lower interest rates, and a further deterioration in the demographics. This decline in the demographics then reinforces the negative growth rate trend.

To prove this point, Japan has the worst debt situation, the weakest economic growth and thus national income prospects, and has a catastrophic demographics situation.

The population growth in Japan is negative, is forecast to get more negative, and will not trough until 2070, in which it simply gets less negative.

Japan Population & Forecast:

Source: World Population Review

Going back to our function of trend GDP potential (population growth and productivity growth), Japan will have a drag on GDP growth from demographics for the foreseeable future, and the impact gets worse through 2070.

With the velocity of money at 0.6, rendering monetary policy ineffective, and negative population growth (and decelerating), lower rates of growth in Japan are all but assured. Incomes cannot rise, growth cannot accelerate (which is why interest rates are 0%), and the stock market (EWJ) has not made a new high since 1989.

Nikkei 225 Index:

Source: Bloomberg

Holding equities for 30 years in Japan has yielded a negative return. This compounds the problem as the ability to generate a rate of return on savings (retirement, pensions, etc.) is diminished. Buying and holding equities have certainly not worked in Japan. How can the corporations that comprise the stock market generate higher profits if economic growth (national income) is 0%?

Conversely, if you had bought 10-year Japanese government bonds in 1989, you would have received a whopping 8% yield plus the staggering capital gains of that interest rate going to 0%, several hundred percent total return. Pension funds and long-term liability managers must buy these assets when economic growth is 0% and perhaps going to be negative year in and year out as the alternative, stocks, cannot yield any gains.

10-Year Interest Rates: Germany, Japan, United States:

Source: Bloomberg

Over the last 10 years, as a result of the debt and subsequent deterioration of the demographic picture in Japan, trending economic growth per capita has been 0.6% and trending lower. What should interest rates be in an economy growing nearly 0%? We know based on the population forecast that it is more or less set in stone that this trend growth rate will be moving lower, converging towards 0% per capita, not higher.

Japan GDP Per Capita 10-Year Growth:

Source: Trading Economics, EPB Macro Research

If we flip over to the next worst problem, Europe, the demographics have deteriorated as we'd expect given the analysis above and is about to go negative. This is a major problem for Europe.

Europe Population & Forecast:

Source: World Population Review

As we speak, Europe is dealing with this problem. They are near a recession with interest rates still at 0%. The velocity of money is at a secular low which makes monetary and fiscal policy ineffective and the debt burden that they have accumulative which compressed economic growth to below 1% has already had a massive impact on the demographic profile. Similar to Japan, population growth in Europe is moving into negative territory and will not bottom in growth rate terms until 2060 by the current forecast.

An overindebted society creates slow economic growth, low-income prospects, household formation declines and contraction in the population result. For the next 40 years, Europe will have a negative drag on GDP growth coming from the population. The only offset to declining population is increasing productivity (higher velocity) but as we know, unproductive debt, which is abundant in these countries, hinders productivity growth.

If we look at some of the stock markets around Europe, we see a similar result as Japan, although about one economic cycle behind.

In Italy (EWI), there has been no return in stocks for decades.

FTSE MIB Index:

Source: Bloomberg

In Spain (EWP), stocks are flat since the late 1990s.

Now, just to clarify, of course there is money to be made in all of these markets by timing tops and bottoms but the structural issue of stocks remaining unchanged for decades is a massive problem for the majority of money in financial markets which are pension funds, retirement funds, etc. that do not move in and out but rather match liabilities and buy a portfolio of stocks and bonds.

How will retirement obligations be met if over 30 years, there are no returns in equities?

IBEX 35 Index:

Source: Bloomberg

The entire Euro Stoxx 50 Index (FEZ) is below the level it was in the late 1990s. Another case in Europe of zero returns in risk assets. With economic growth that is converging to 0% and likely to be negative year in and year out like in Japan, how do corporations make money? How do banks function with 0% short-term interest rates and 0% long-term interest rates?

This is not a cherry-picked country either as the Euro Stoxx 50 index measures the performance of the top blue-chip companies across Europe.

Euro Stoxx 50:

Source: Bloomberg

The Stoxx Europe 600 (VGK) has not made a new high since 1999. This index represents 600 companies across 17 European countries.

Stoxx Europe 600:

Source: Bloomberg

The FTSE 100 index (VGK) is marginally above the level in 1999. Again, there are times where money can be made by calling tops and bottoms but the concept to understand is that despite the volatility that can create opportunities, if you are not in financial markets as a profession, and over 30 years or 40 years the stock market has churned and is at the same level or represents gains of 2% per annum, that is a problem for the population.

FTSE 100 Index:

Source: Bloomberg

Germany (EWG) is the strongest country in Europe, but the effects are more similar to the United States. While Germany is experiencing the same problems as Japan and broader Europe in terms of dwindling economic growth, the German Dax has performed slightly better over the past 30 years, but still, far less than many pension and retirement funds would have budgeted. If Italy, Spain, Britain, and the broader European basket are any indication, future performance will be underwhelming.

Since 1999, the Dax has increased less than 2% per annum.

German Dax:

Source: Bloomberg

Since the early 1990s, the 10-year German government bond has fallen from 9% to 0%. Again, hundreds of percent gains in total return terms.

10-Year Interest Rates: Germany, Japan, United States:

Source: Bloomberg

We have to remember, interest rates are priced for a reason. This chart is also a reminder that interest rates have been falling for decades. I challenge you to spot QE in the above interest rate chart. You cannot identify when QE became a world regime because that has not been the driver of interest rates. Over-indebtedness causing a secular decline in growth is what has caused interest rates to plunge for decades.

All assets are priced off the risk-free rate which is the sovereign government bond yield. If a country is pricing a 10-year risk free rate at 0.1%, what should that tell you about the growth outlook and thus, the ability for risk assets to generate returns? If the 30-year bond in Japan is 0.5%, it is not realistic to assume you are entitled to buy equities, hold them for an equivalent 30 years and make 10%.

If the 30-year bond is priced at 0%, the outlook for growth and inflation is so dire over the next 30 years that the market is pricing in virtually 0% growth which we know based on the population trends in Japan, may even be a rosy estimate.

If we now come full circle and look again at the population trends in the US, we can see that the United States is moving in exactly the same direction as Europe and Japan. We have already damaged the demographics in the country as a result of massive debt, crimping growth and reducing income prospects.

If we followed the same fiscal and monetary path as Europe and Japan, why should the US expect different results?

I happen to believe that these estimates for population growth are likely too high and are more of a linear extrapolation. When we look at Europe or Japan, the impacts are non-linear but nonetheless, the US is going to have rapidly declining rates of population growth, dragging GDP growth lower from a secular standpoint.

US Population Growth:

Source: Census Bureau, EPB Macro Research

It makes sense that the US equity (SPY) market has performed the best in the world as growth in the US has been better. The US is relatively less indebted than Europe and Japan, and the population trends are not as bad (yet).

The gains in the S&P 500 since 2000, however, have only been about 3.3% annualized.

Even if you started the clock in 1997, let's say, the market is only up about 6% annualized. If the best days for growth and population trends are in the rearview mirror, should we expect better or worse gains than this going forward?

Circling back to the first part of this note, Bridgewater's Greg Jensen said:

We are secularly in a situation, both from a debt perspective and from a demographic perspective that makes most of our experiences irrelevant. The last 40 years of how markets have worked are not as much of a guide as most people think."

S&P 500:

Source: Bloomberg

We are now in a position to understand this statement. What should the US expect in terms of equity gains going forward? Should we extrapolate 6%-8% gains for US equities over the next 30 years or use Europe and Japan, whose path we are undoubtedly on, as a guide for what the next 30 years may look like?

10-Year Interest Rates: Germany, Japan, United States:

Source: Bloomberg

Again, to reiterate the point, a 10-year Treasury bond (TLT) in the mid-1990s would have provided a nearly 8% coupon plus massive capital appreciation with the current 10-year rate sitting at 2.7%.

Investing For The Future Secular Trends

Now that we have a firm understanding of the secular trends that have governed the trend GDP growth around the world, the secular decline in interest rates (not QE), and the resulting equity market performance, as well as the future demographic trends, we can have a more informed guide to judge what the future may look like.

Using the last 40 years as a guide will surely end quite poorly.

US Productivity Growth:

Source: Hoisington Management

We now know that high levels of unproductive debt squeeze economic growth by reducing productivity gains and reducing the velocity of money. Lower economic growth (GDP Growth) is synonymous with national income. If GDP growth is 2% and trending lower on a secular basis due to debt, productivity and demographics then we can except lower GDP growth in the future. That does not mean a crash or a banking crisis but a slow grind lower in terms of GDP growth is all but ensured.

Lower GDP growth (national income) will make it impossible to increase the national average for wage growth despite the political efforts. Average wage growth cannot exceed the national income growth.

Lower velocity of money makes monetary policy and fiscal policy ineffective which is why massive trillion dollar tax cuts or omnibus government spending bills only result in 2-3 quarters of transitory gains. We cannot stimulate (with debt) every year and even if we did, what we know about debt, ensures that this has a diminishing effect, all while pushing debt levels to new highs, further exacerbating all the problems discussed.

Velocity Of Money:

Source: Hoisington Management

You cannot solve a debt problem with more debt.

When countries fall into trouble, and the solution is to add more debt on top of the problem debt, the future result will be a near certainty, even just using the two case studies of Europe and Japan as a guide.

The lower income prospects will continue to reduce household formation, delaying the family process and further deteriorating the demographic picture.

US Birth Rate:

Source: Hoisington Management

Interest rates will continue to grind lower over a secular period with lower rates of GDP growth. The daily moves are part of the short-term growth rate cycle, and longer-term moves are part of the business cycle, but the secular trend will remain lower as it has since the 1980s.

There will come a day when the bond market no longer sees a possibility of repayment and interest rates rise due to credit risk but I would submit that problem would arise in both Japan and Europe before the United States, making the US Treasury still the safest asset in the world.

All currencies may devalue against gold simultaneously but that is a tail event that can easily be hedged by having a percentage of your portfolio in gold (GLD), physical gold preferably for this reason; a devalue against gold rather than a bet on the short-term price movement. Again, this is a tail event and does not need to be addressed by your entire portfolio but rather a small slice.

Until the day comes where the bond market closes the doors to sovereign debt which is likely in Japan first given higher levels of debt and worse growth/population trends, as long as governments try and solve a debt problem with more debt, growth will decline, and interest rates will fall.

If the US does follow the same path as Europe and Japan, which we already have, and the results end up the same, a 30-year Treasury at 3% will seem generous if sometime in the future, the US growth and inflation picture look like Europe as yields will be near 0%.

This is not a note arguing for 0% equity exposure at all times, remember the chart in the first part, the secular trends are one factor to consider, likely the most important factor, but the short-term growth rate cycle and the business cycle can make all assets profitable for years at a time.

When thinking about secular trends, over the next 30-years, the choice between stocks and bonds is not as clear as history may suggest. In fact, history suggests given the current secular trends, interest rates will grind lower and wildly outperform stocks if corporations struggle with increasing rates of profitability like Europe and Japan.

Given the lack of ability for corporations to generate accelerating earnings and revenue in a growth environment that is secularly trending lower, corporate profits are likely to slow. There are many case studies as discussed above of countries that are simply a few years ahead of the US in terms of growth, population, and debt that have not seen equity gains over 20-30 year periods.

Is that a foregone conclusion in the US? No. Is the probability rising that interest rates in the US will start to look like Europe and interest rates in Europe will start to look like Japan? Certainly. If the prevailing economic conditions warrant 0% or negative 10-year interest rates in Europe and Japan and if the US follows the most probable path to higher debt and lower interest rates, what will that say about the strength of economic conditions?

Will corporations be able to generate the same level of profit growth as years in the past? Unlikely.

We are secularly in a situation, both from a debt perspective and from a demographic perspective that makes most of our experiences irrelevant. The last 40 years of how markets have worked are not as much of a guide as most people think."

We need to start thinking about what economic conditions will look like over the next 20 years relative to conditions today. It is not the nominal rate of growth that is most important but the rate of change. If trending economic growth compresses from 2% to 1% in the coming years, a 50% reduction in trend economic growth will have massive implications for inflation, interest rates, debt burdens, income-prospects, social unrest and more.

These are not wild or alarmist or bearish forecasts but rather a very simple analysis of what is the most probable outcome based on hard economic and demographic data.

Population growth in the US, Europe, and Japan is slowing and will not likely trough for several decades.

If we agree that population growth is one critical factor to trending economic growth, then the rate of increase will assuredly slow. Economies around the world will be increasingly reliant on productivity gains to boost economic growth and reverse this trend of slowing growth globally. The globe needs a secular transition in productivity growth but with gross over-indebtedness compressing the very same productivity growth we are trying to improve, the probability of that outcome is low.

Productive debt is good. Unproductive debt that slows productivity growth and reduces the velocity of money is bad. We have too much bad debt and diminishing quantities of productive debt that produces an income stream.

Nearly all debt in today's world has gone to finance financial transactions or consumptive debt, including many government programs/policies that do not produce an income stream sufficient (or at all) to repay principal and interest.

Solving The Problem

The solution to the problem of over-indebtedness is quite simple. Reduce debt as a percentage of GDP.

While the solution is simple, it is quite painful and politically unappetizing. A sustained rise in the national savings rate, or austerity, to put it another way, is the only way to revive an economy that is weakening with each passing year due to a crushing debt overhang.

It is not necessarily the nominal amount of debt that needs to be reduced but the ratio of debt to total output or GDP.

We can discuss policy solutions to this major issue but given the probability of any serious reforms taking place, it is a moot point.

The idea of this research note was to thoroughly explain and prove the impacts to the economy of debt and unproductive debt more specifically, as well as explain the most probable scenario going forward.

If we know what the debt is doing to the economy, the knock-on effects that come with it including low-interest rates, low-income prospects, slower economic growth and a continued decline in the demographics, and we also know that there is no will to solve the issue and this path is likely to continue, then we should know the outcome.

Some say the definition of insanity is doing the same thing over and over again and expecting a different result.

We know we are doing the same thing as years in the past and we know we are doing what other major countries who are several years ahead of us have done.

If we are following the same path as Japan, should we expect a different result?

If we go down the road of the Europeans, which we are already clearly on, should the outcome differ?

Even if we look at our own history of declining economic growth since the 1980s, knowing the cause of that issue, should we expect it to magically reverse?

Tax cuts that are debt-financed, more government spending that requires large deficits will result in more of the same.

The misconception about debt and deficits is that there is not an acute problem in the short-term (inflation or higher interest rates) so most assume the debt and deficit are acceptable without understanding that this path of fiscal and monetary policy manifests itself in slow grind lower of national income (growth), not felt immediately, but rather over decades.

The population will not realize a change in growth from 3% to 2.9%. If growth on a secular basis, however, moves from 3% to 1.5%, a 50% reduction, that will be felt in a massive way and the debt is to blame.

You cannot solve a debt problem by taking on more debt. You can call the debt any name you like or move the spending off the balance sheet as "investment," but the result will be the same.

It is critical to understand this concept as it shapes the modern world as every major developed nation, and many emerging nations, have chosen the path of debt. Misguided central bank policies have made it easy and encouraged the build-up of debt around the world and the result has been the weakest decade of economic growth in generations. There, in fact, has been very little true growth. If we net out the increase in debt, it becomes clear that nearly all the growth over the last decade was a result of debt. Borrow a dollar and spend a dollar. Sure, that increases growth today but at what cost?

These are the trends that we need to fully understand.

To summarize with one simple quote, "Debt is future consumption denied. Excessive debt is economic stagnation ensured."

Disclosure: I am/we are long SPY, GLD, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.