Saturday, October 24, 2015

Investment crystal ball: Demographics and Inflation

I just bought another investment book to read – it came highly recommended. It is written by yet another famous investor: Howard Marks. What makes this book unique is that Mr. Marks writes essays about what he thinks are the most important things an investor should be aware of and three(3) other top investors: Seth Klarman, Christopher C. Davis and Paul Johnson annotate their comments. Wow! This is great fun. 
I just opened the first essay and there in the first paragraph something hit home like a missile: a quote from Benjamin Graham! “The art of investment has one characteristic that is not generally appreciated. A credible, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom” I
So, when you aim to build your retirement nest egg, things don’t have to be difficult you can just buy the entire market and get market performance. Buy a bunch of ETFs and you'll do OK. This simplistic strategy is often advocated on this blog. If your aim is to become one of the great investors then things become a lot more difficult – you have to think out-of-the box and be right and… execute right!  Before doing anything else, ask yourself are you happy with ‘normal’ returns of  4 to 6% above the rate of inflation or are you going to be the next Warren Buffett?
“Because investing is at least as much art as it is science, it’s never my goal … to suggest it can be routinized. In fact, one of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic”
I for one, do not have to be a great investor. Having a retirement nest egg that is large enough to have the lifestyle I enjoy and help me achieve my goals in life is enough. For that average market returns from a diversified portfolio with a long term outlook is sufficient. However, for me investing is also intriguing and I want to understand it better as it is such an important part of understanding what makes the world go around… and yes that is one of my personal goals.  
I want to do things that are worthwhile – not just for me but also for my sphere of influence. I have my core portfolio of investments and a portfolio where I experiment to learn and test what works better in today's world.
When looking out over today’s investment landscape I see two common themes: Low economic growth and low inflation if not deflation. Now, if you want to define what inflation and economic growth exactly are, then doing a couple of PHD theses may bring you a tiny step closer. But here they are expressed in terms of simple GDP growth and CPI increases  which should do for now. 
We live indeed in a low growth and low inflation world. Harry Dent one of the world’s most read and most popular demographers showed in the 1980s how demographics, in particular baby boomer demographics, correlates very well with stock market performance.  Dent made a basic assumption – the behavior of a generation follows closely the patterns of previous generations.  Thus you are first a toddler, you go to ECS or Kindergarten, next you are off to elementary school,  high school and then university. You leave your parents’ home, shack up and protest against previous generations (in particular your parents). Next you get married, have a career, have kids, become empty nester, retire and die. Just lovely!
As a child you earn no money and you costs your parents a lot of money. Also the state will invest a lot in your education without getting an immediate return. So the idea was that after buying their first home, a lot of baby boomers would not only incur a mortgage but also have a lot of expensive kids while governments incurred a lot of deficits to finance the education of those kids. In other words lots of debt by governments and parents as well as a booming economy with high inflation. Next the baby boomer's kids get older and earn their own money while baby boomers themselves pay down their debts and save for retirement rather than spend. Same for governments, especially if later generations are smaller and have less children.  In that stage deficits fall and so do interest rates while economic growth slows and while inflation falls.  That is basically what has happened happening from 1980 until now. 
Today we live in a period where baby boomers are saving more, borrowing less and buying less real estate; that translates into low economic growth and low inflation.  China seemed to be our savior in terms of economic growth, but guess what; the effects of their one-child-per-family policy created a graying population in China as well.  Japan was a bit ahead of the curve and so it had its lost decade a bit earlier (starting with the 1989 crash?). Europe lies in between Japan and North America demographically - hence the European debt crisis and quantitative easing.
BUT… BUT…  is it all demographics and is there no hope?  Well, Harry Dent’s assumption was that all generations have similar spending patterns over their lives and that is a gross oversimplification if not untrue. We’re forgetting that the world is changing at ever increasing rates.  I am not kidding; progress was minimal and glacially slow [pun intended] during prehistoric time. There were few inventions like fire, wheel, spear etc. During the middle ages people definitely lived in a different world with some progress and things started evolve at a slightly more measurable rate during the industrial revolution. 
So yes, new generations used to live similar lives as their parents did. But in the 20th century, we progressed dramatically and when the baby boomers came in, the mantra was that this was a generation that did everything different than their parents. Now progress is accelerating even more with the advance of computers and the internet. Next industrial internet, 3-D printing, immunology, biotech, etc. We're changing at mind numbing speed.
You may have read on this block that medical science advances our life-expectancy now nearly one year per year. That means we  theoretically have become immortal. Just do the math: my life expectancy is around 84 years but next year it will be 85 years and in 2017 my life expectancy will be 86 years. Now with progress in medicine accelerating what will my life expectancy be in 2020? 93 years or even older? Yes young man, we’re theoretically immortal unless we (better you) are hit by a truck or if you think that quality of life is unimportant (I am talking about becoming a vegetable)! 
Point is that behavior of generations do change. Look at this example on a small macro-economic aspect. The millennium generation is as large if not larger than the baby boomer generation. But with baby boomers reaching retirement the economy has slowed dramatically. So now it is difficult for millenniums to have a secure income (made even worse by changing technology and associated productivity). The effect: the millennium generation experiences a delayed adult hood. They can’t afford to life on their own and stay longer with Mommy and Daddy; they won’t start families right away or buy houses as early as the baby boomers did. Spending behavior of the millennium generation has shifted to later years if it hasn’t changed entirely.
That is why demographic patterns aren’t as predictable as Mr. Dent assumed. The same is true for energy and metals. Everything is changing and this makes our world much less predictable, So my expectation is that Millenniums are likely to form families and buy houses over the coming 5 years and thus economic growth will resume and so stock markets and investment returns will go back to ‘normal’. 
However, it is also forecast that later this century worldwide population growth is likely to slow down or even stagnate. Our workplace will change dramatically. Not everyone will have a traditional job; a basic form of lifestyle may become quite comfortable and affordable  for everyone while our economic system changes dramatically. What if food comes from a replicator and is just an energy conversion? What if robotic labor becomes the norm and persons are not part of the manufacturing process. Instead they pursue their own goals which not necessarily result in increased monetary wealth. I wouldn’t be surprised that economic measures such GDP growth become less meaningful and that measurement of personnel wellness becomes critical.
I foresee a significant change in our capitalistic society coming soon in a neighborhood near you. Here is another ‘tiny change’ coming up right now! Alarm Force and other home security companies may be passé with the rise of Nest thermostats, Camera’s and Smoke Alarms; with Lutron Light switches and garage doors opened from a cell phone. My 1980s house was just converted to a ‘smart home’ for around $1000.00 Good riddance Protectron or ADP.
My feeling is that over the long term technology is likely to cause significant deflation – much more than the cheap labor costs of China ever did. This will be bad for credit markets and retirees living on fixed income. To offset this will be governments that continue printing money and quantitative easing that hollow out our monetary system because our meaningless GDP numbers will falsely indicate continued 'slow' growth. Interest rate policy appears to have become ineffective if not obsolete. Yet, our lifestyle will continue to improve. 
What this all will mean for the economic stability of our society and the nations we currently live in?  I have a feeling that social change may prove to get even more dramatic than technological change. I hope we can avoid internet lynching of people’s reputation but I feel this trend is just the beginning.
Imagine this. Alberta’s latest premier Rachel Notley has been given a majority and 4 year mandate – although more because of disenchantment with the Conservatives than a strong believe in Notley’s NDP. The Royalty Review and New Climate Change policy turn not out to be what the average Albertan really wanted. Next thing, Notley’s gives a speech that is not entirely politically correct – especially when taken out-of-context.  Or worse, Notley is caught on a security camera kicking her cat in the elevator. A YouTube video on the topic goes viral and 4 hours later the internet lynch mob demands resignation of Notley and here NDP cabinet. With her moral credibility destroyed in hours, will her government survive? What would be the effect on our democracy if she perished despite a legal election and the 4 year mandate given to her just a few months earlier? If you think this cannot happen I urge you to think again.
So with this in mind how do you feel about Demographics and inflation?  Is the present still key to the past, as they say in geology?  Is the present key to forecasting the future or are we standing at the dawn of an entirely new world with the rules of economics and investing about to change completely?  Would you still live in a house? Would you still eat?  Would need you need heating and other forms of energy?  I would invest in hard assets – assets that are not depending on the mood swings of central banks and public policy. But I also would look forward with eagerness to a world that continuously changes (in general) for the better.

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