Someone Is Spending Your Pension Money

By John Mauldin

“Retirement is like a long vacation in Las Vegas. The goal is to enjoy it to the fullest, but not so fully that you run out of money.”

– Jonathan Clements

“In retirement, only money and symptoms are consequential.”

– Mason Cooley

Retirement is every worker’s dream, even if your dream would have you keep doing the work you love. You still want the financial freedom that lets you work for love instead of money.

This is a relatively new dream. The notion of spending the last years of your life in relative relaxation came about only in the last century or two. Before then, the overwhelming number of people had little choice but to work as long as they physically could. Then they died, usually in short order. That’s still how it is in many places in the world.

Retirement is a new phenomenon because it is expensive. Our various labor-saving machines make it possible at least to aspire to having a long, happy retirement. Plenty of us still won’t reach the goal. The data on those who have actually saved enough to maintain their lifestyle without having to work is truly depressing reading.
Living on Social Security and possibly income from a reverse mortgage is limited living at best.

In this issue, I’ll build on what we said in the last two weeks on affordable healthcare and potentially longer lifespans. Retirement is not nearly as attractive if all we can look forward to is years of sickness and penury. We are going to talk about the slow-motion train wreck now taking shape in pension funds that is going to put pressure on many people who think they have retirement covered. Please feel free to forward this to those who might be expecting their pension funds to cover them for the next 30 or 40 years. Cutting to the chase, US pension funds are seriously underfunded and may need an extra $10 trillion in 20 years. This is a somewhat controversial letter, but I like to think I’m being realistic. Or at least I’m trying.

The Transformation Project

But first, let me update you on the progress on my next book, Investing in an Age of Transformation, which will explore the changes ahead in our society over the next 20 years, along with their implications for investing. Our immediate future promises far more than just a lot of fast-paced, fun technological change. There are many almost inevitable demographic, geopolitical, educational, sociological, and political changes ahead, not to mention the rapidly evolving future of work that are going to significantly impact markets and our lives. I hope to be able to look at as much of what will be happening as possible. I believe that the fundamentals of investing are going to morph over the next 10 to 15 to 20 years.

I mentioned a few weeks ago at the end of one of my letters that I was looking for a few potential interns and/or volunteer research assistants to help me with the book. I was expecting 8 to 10 responses and got well over 100. Well over. I asked people to send me resumes, and I was really pleased with the quality of the potential assistance. I realize that there is an opportunity to do so much more than simply write another book about the future.

What I have done is write a longer outline for the book, detailing about 25 separate chapters. I’d like to put together small teams for each of these chapters that will not only do in-depth research on their particular areas but will also make their work available to be posted upon publication of the book. We’re going to create separate Transformation Indexes for many of the chapters, which will certainly be a valuable resource and a challenge for investors.

If you are interested in getting involved, drop me a note with your resume to I will send you the book outline, and you can decide what area you would like to work in or whether you are willing to go where we need you.

And now let’s look at what pension funds are going to look like over the next 20 years.

Midwestern Train Wreck

Four months ago we discussed the ongoing public pension train wreck in Illinois (see Live and Let Die). I was not optimistic that the situation would improve, and indeed it has not. The governor and legislature are still deadlocked over the state’s spending priorities. Illinois still has no budget for the fiscal year that began on July 1. Fitch Ratings downgraded the state’s credit rating last week. It’s a mess.

Because of the deadlock, Illinois is facing a serious cash flow crisis. Feeling like you’ve hit the jackpot through the Illinois lottery? Think again. State officials announced Wednesday that winners who are due to receive more than $600 won’t get their money until the state’s ongoing budget impasse is resolved. Players who win up to $600 can still collect their winnings at local retailers. More than $288 million is waiting to be paid out. For now the winners just have an IOU and no interest on their money (Fox).

As messy as the Illinois situation is, none of us should gloat. Many of our own states and cities are not in much better shape. In fact, the political gridlock actually forced Illinois into accomplishing something other states should try. Illinois has not issued any new bond debt since May 2014. Can many other states say that?

Unfortunately, that may be the best we can say about Illinois. The state delayed a $560 million payment to its pension funds for November and may have to delay or reduce another contribution due in December.

Illinois and many other states and local governments are in this mess because their politicians made impossible-to-keep promises to public workers. The factors that made them so impossible apply to everyone else, too. More people are retiring. Investment returns aren’t meeting expectations. Healthcare costs are rising. Other government spending is out of control.

Nonetheless, the pension problem is the thorniest one. State and local governments spent years waving generous retirement benefits in front of workers. The workers quite naturally accepted the offers. I doubt many stopped to wonder if their state or city could keep its end of the deal. Of course, it could. It’s the government.

Although state governments have many powers, creating money from thin air is, alas, not one of them. You have to be in Washington to do that. Now that the bills are coming due, the state’s’ inability to keep their word is becoming obvious.

Now, I’m sure that many talented people spent years doing good work for Illinois. That’s not the issue here. The fault lies with politicians who generously promised money they didn’t have and presumed it would magically appear later.

On the other hand, retired public workers need to realize they can’t squeeze blood from a turnip. Yes, the courts are saying Illinois must keep its pension promises. But the courts can’t create money where none exists. At best, they can force the state to change its priorities. If pension benefits are sacrosanct, the money won’t be available for other public services. Taxes will have to go up or other essential services will not be performed. This is certainly not good for the citizens of Illinois. As things get worse, people will begin to move.

What happens then? Citizens will grow tired of substandard services and high taxes. They can avoid both by moving out of the state. The exodus may be starting. Crain’s Chicago Business reports:

High-end house hunters in Burr Ridge have 100 reasons to be happy. But for sellers, that’s a depressing number. The southwest suburb has 100 homes on the market for at least $1 million, more than seven times the number of homes in that price range – 14 – that have sold in Burr Ridge in the past six months. The town has the biggest glut by far of $1 million-plus homes in the Chicago suburbs, according to a Crain’s analysis.

“It's been disquietingly slow, brutally slow, getting these sold,” said Linda Feinstein, the broker-owner of ReMax Signature Homes in neighboring Hinsdale. “It feels like the brakes have been on for months.”

We don’t know why these people want to sell their homes, of course, but they may be the smart ones. They’re getting ahead of the crowd – or trying to. Think Detroit. I have visited there a few times over the last year, and the suburbs are really quite pleasant (except in the dead of winter, when I’d definitely rather be in Texas). But those who moved out of the city of Detroit and into the suburbs many decades ago had a choice, because Michigan’s finances weren’t massively out of whack.

I’ve been to Hinsdale. It’s a charming community and quite upscale. It is an easy train commute to downtown Chicago.

Look at it this way: with what you know about Illinois public finances, would you really want to move into the state and buy an expensive home right now? I sure wouldn’t. That sharply reduces the number of potential homebuyers. The result will be lower home prices. I’m not predicting Illinois will end up like Detroit… but I don’t rule it out, either.

Further, more and more cities and counties around the country are going to be looking like Chicago. Wherever you buy a home, you really should investigate the financial soundness of the state and the city or town.

Pension Math Review

Political folly is not the only problem. Illinois and everyone else saving for retirement – including you and me – make some giant assumptions. Between ZIRP and assorted other economic distortions, it is harder than ever to count on a reasonable real return over a long period.

Small changes make a big difference. Pension managers used to think they could average 8% after inflation over two decades or more. At that rate, a million dollars invested today turns into $4.7 million in 20 years. If $4.7 million is exactly the amount you need to fund that year’s obligations, you’re in good shape.

What happens if you average only 7% over that 20-year period? You’ll have $3.9 million. That is only 83% of the amount you counted on.

At 6% returns you will be only 68% funded. At 5%, you have only 57% of what you need. At 4%, you will be only 47% of the way there.

This math works the same way no matter how many zeroes you put behind the numbers. Each percentage point of return makes a huge difference. Missing your target just slightly can have big consequences.

Keep in mind these need to be real, after-inflation returns. Inflation is not a problem right now. How much will you bet that it will stay under control for the next two decades? You might be right – and then again you might be wrong, so you really need to aim even higher. Retirement incomes are not something that should be gambled with.

Pension managers know this, of course. The National Association of State Retirement Administrators has some good data on its member’s activities. Their Public Fund Survey has data on public retirement systems covering 12.6 million active workers and 8.2 million retirees and beneficiaries. At the end of FY 2013 (the latest data they show), members had $2.86 trillion in assets. That is about 85% of all state and local government retirement assets. This data is comprehensive, though a little outdated.

The average public retirement system funding level in FY 2013 was 71.8%. That number has been trending steadily downward since the survey began. In 2001, it was a healthy 100.8%.

This is not a good trend. What is the problem? Here is how NASRA explains it.

Figure B [shown above] presents the aggregate actuarial funding level since 1990, measured by Standard & Poor’s from 1990 to 2000 and the Survey since 2001. This figure illustrates the substantial effect investment returns have on a pension plan’s funding level: investment market performance was relatively strong during the 1990s, followed by two periods, from 2000–2002 and 2008–09, of sharp market declines.  Other factors that affect a plan’s funding level include contributions made relative to those that are required, changes in benefit levels, changes in actuarial assumptions, and rates of employee salary growth.

The average state and local retirement system can pay only roughly 72% of its obligations as of now. That means state and local governments need to come up with an additional $1 trillion or more. Some states, of course, are 100% funded. Some have barely half the needed funding. That is a lot of money for financially strapped states to come up with. I can’t think of any reason to believe the situation will get better. I can imagine quite a few scenarios in which it will get worse.

Looking at the assumptions, the median plan in the Public Fund Survey assumed 7.9% annual investment returns and 3.0% inflation. The average asset allocation was 50.7% equities, 23.2% fixed income, 7.2% real estate, and 15.1% alternatives, with the rest in cash and “other.”

I’ve played with those numbers using what I think are reasonable return expectations. I can’t find any combination that would bring the real return after inflation up to the 5% area that the plans need. That means the 71.8% funding ratio is too optimistic. It is somewhere below that level. How far below? We’ll know in 20 years. (We will look at some scholarly projections of future portfolio potentials in a moment.)

If you are a state or city worker in one of these severely underfunded systems, or a recently retired one, now is an excellent time to develop your Plan B. Your chance of getting the full amount you were promised is somewhere between slim and none. The money simply isn’t there.

Private Plans No Better

If you are a corporate worker and think your plan is better than those managed by politically driven bureaucracies, you may want to rethink your position.

First, you should (probably) thank your lucky stars if you have some kind of defined benefit plan. Such plans are an endangered species outside of government and union-run plans. Most workers now are lucky to get a 401K that shifts responsibility off the company’s shoulders and onto theirs.

On the off chance that you do have a defined benefit pension, on average that pension plan is likely to be in the same boat as the governmental plans discussed above. Actuarial firm Milliman, Inc., tracks these plans and has a handy “Milliman 100 Pension Funding Index.” It tracks the 100 largest corporate defined benefit plans.

As of September 2015, Milliman data shows these 100 plans had a funded percentage of 81.7%. They are collectively $312 billion below where they ought to be. This is actually better than where they began 2015. The chart below shows this figure monthly since 2010.

The dotted lines are Milliman’s optimistic, baseline, and pessimistic forecasts. The baseline scenario’s expected rate of return is 7.3%. I would call that excessive, for the same reasons we will discuss in a moment. I think their optimistic 11.3% return is very unlikely to pan out, and the pessimistic 3.3% is not pessimistic enough.

In short, the suggestion I made for public workers applies to private workers, too. If you don’t have Plan B, start working on one now.

Central Banks Print Money – Pension Funds Assume

Pension fund boards are typically populated by political appointees and representatives from the various pension groups. In an effort to make sure they are making realistic projections (and after they have been on the board for a few months, when they understand how serious the task is), they hire outside consultants. The pension-consulting gig is lucrative and very competitive. It is also quite political.

It is political because the assumptions you make about your future returns directly affect state and city budgets. Typically, states require themselves to “dollar-cost average” their funding over time so that pension funds stay fully funded. If you reduce the future returns you expect to make on your investments, you increase the amount of present-day funding needed from the various government entities.

The average pension fund is 71.8% funded. But that’s assuming high returns. What are returns actually likely to be? Let’s look at a few estimates by professionals. First, the folks at GMO annually make a seven-year real return forecast. This is the one from the end of last year:

Note that US stocks are projected to produce negative returns. US pension funds are heavily weighted to US markets. Even adding in developing-market equities would still leave you with negative returns. I highly doubt that any pension-fund consultant would suggest that their clients aggressively overweight emerging-market equities. Now, look at the returns for bonds.

This forecast would suggest that, over the next seven years, returns will be negative for the balanced portfolios that most pension funds have. If GMO is correct, pension funds will require significant state and local funding to make up the difference, .

The Macro Research Board (MRB) recently developed a total portfolio forecast for dollar, euro, and pound sterling portfolios. They made detailed forecasts for equities, bonds, currencies, and commodities, taking into consideration inflation and global growth. These are guys I take very seriously, as their forecasting methods are rigorous. Let’s go straight to their 10-year forecast.

The average US pension fund, according to the data above, can expect returns somewhere between MRB’s balanced and aggressive portfolio projections. That suggests positive real returns of around 3.6% for US pension funds – a far cry from the almost 6% that most funds are projecting and nearly two full points lower than many pension funds are currently anticipating. MRB’s projections mean that today such funds actually have only 68% of what they need to be fully funded in 20 years.

Do you think MRB’s forecasts are pessimistic? Actually, the assumptions they make and their projections are more generous than the ones I would make and also exceed the more conservative GMO assumptions. I could go tick off a whole host of reasons why I think growth is going to be slow (though not fall off the cliff), but there isn’t enough room today. Suffice it to say that I still believe in my Muddle Through economic scenario.

But since funds are already funded at only about 72% of what it would take to pay promised benefits to retirees, the math means that funds have less than 50% of the money they need currently in their accounts. Since funds have $2.86 trillion (give or take), then no matter how you slice it, pension funds are underfunded today by about $2 trillion, if you assume MRB’s projections are correct. Since pension funds are forecasting that they will grow their funds almost fivefold, that means a future shortfall in the neighborhood of $10 trillion, which during the intervening time is going to have to be made up from tax revenues.

Of course, I made a lot of assumptions in the preceding paragraph. What if states decide to aggressively start making up the shortfall? That would certainly reduce the ending deficit. There are other factors that could positively affect returns as well. This is certainly a back-of-the-napkin estimate; but if I am wrong, it is only in the final destination and not in the direction of the problem. Pension funding is going to be a huge burden on government budgets everywhere, in a time when they are already strained.

On top of that, add in the cost to the government of Social Security and other entitlements. Further compounding the problem, as I demonstrated over the past two weeks, is the very real potential that the average person retiring today will live 10 years longer than actuaries currently predict. Various estimates say entitlements in the US will run to the tune of $80 trillion over time. And the situation is just as bad in Europe. In fact, many countries in Europe are in worse shape than the US.

You’re On Your Own

There are no easy answers for individuals here. I think more and more potential retirees will find it necessary to continue working. Further, you should plan on living a great deal longer than you probably assume in your current financial plan. And unless your financial manager is a wizard, you should seriously think about what kind of returns she can produce for you and what level of withdrawals you can actually afford. The 5% annual withdrawal that many financial planners use in their models is simply not realistic in today’s low-yield world.

Making sure you have enough money for your retirement, whatever that looks like, is very serious business. It is okay to hope that governments figure it all out and can send you your pension and meet their other obligations. But hope is not a strategy, just as denial is not a river in Egypt. We (and I do include myself here) need to be very realistic about the assumptions we are making for returns and what our future retirement portfolio values will be.

Washington DC, Tulsa, and a New Granddaughter

Tomorrow morning (way too early) I get on a plane to go to Washington, DC, where I will attend the wedding of my friend Steve Moore (Wall Street Journal editor, now with the Heritage Foundation) who will have his wedding ceremony at the Jefferson Memorial on a hopefully nice-weather day.

I was intending to stay in DC and see friends, but it turns out that the doctors have decided that my daughter Abigail is about to give me my new granddaughter, Riley Jane, who will be here sometime within the next 48 hours; and so I need to be in Tulsa on Sunday! This will be grandchild number seven, which sounds like it has something lucky about it. That will make two granddaughters in Tulsa, as Abigail’s twin Amanda has Addison, who is now two years old.  (Yes, their husbands Allen and Stephen were somewhat responsible.) Oddly, I had no grandchildren just six years ago. But a rapid run of grandchildren is what you get when you have seven kids, otherwise known as cost centers. (Seriously, I don’t want to hear you bragging about your PhD/rocket scientist/entrepreneur child who is sending money back to you to express their love for all the effort you put in.) It seems almost like yesterday that I was at the airport meeting a “personal courier&rd quo; who was carrying my twins, whom we adopted from Korea.

The girls will kill me for saying this, but all we had seen was their baby pictures. And frankly, these were the ugliest baby pictures I think I’ve ever seen. I’m not allowed to show them, but if you took a peek, you would agree. I pretty much know for a fact that one couple turned the twins down because of their pictures. The girls were premature, with blotchy faces and shaved heads because they evidently do intravenous injections in the head in Korea. Long story short, the courier walked off the plane and presented us with two of the most beautiful baby girls you could possibly imagine. I mean seriously beautiful. They made the cover of Twins magazine when they were two. Modeling agencies would approach them in malls, and they did a few commercials here and there, although it wasn’t something we pursued. They were far more into cheerleading. Seventeen years later one was Homecoming Queen and the other Senior Queen – one of the proude st and most emotional days of my life. No one had prepared dad for that one. Their high school also had Miss Tulsa, who almost won Miss Oklahoma, and she was the consensus-projected winner, so it was a serious competition. But then, look at my girls, who also happen to be the nicest human beings you will ever meet. Of course, I’m just a proud dad, and what do I know?

I rather doubt that Steve will be partying until the wee hours, which is just as well as I try to make sure that early flights mean early nights. I really am working on getting enough sleep these days, and it’s making a difference.

It feels a little bit odd to be 66 and not even thinking remotely about retirement. For the younger generation, retiring at 65 is just the way we thought about things 40 years ago. Sixty-six really doesn’t feel like I thought it was going to feel. Maybe it’s all the supplements and the diet that Pat Cox and Mike Roizen have me on. (Don’t tell them how much I cheat – but I’m mostly good.) Or maybe it’s just happenstance and genetics.

Whatever it is, I’ll take it. I’m starting businesses and ventures that realistically require my participation for at least 7 to 10 years into the future at a minimum. I’m not even thinking of winding down. I’m actually busier than I’ve ever been in my life, even when I actually had seven kids at home and just thought I was busy. I know we all have to be realistic, but right now working for another 10 years or more doesn’t feel like it’s going to be a problem. We’ll see. And from what my friends tell me, seven grandchildren will have me working even harder. But then, what’s a few more cost centers? You have a great week and work on postponing retirement for at least 10 years! It’s more fun doing what you love, anyway.

(And yes I know that’s maybe an obscure reference to a more or less long-forgotten country western song [even though Eric Clapton covered it], but there’s a certain segment of you that will pick up on it. I guess you had to live through that era.)

Your getting ready to live on Tulsa (granddaughter) time analyst,

John Mauldin

Economics, The Art Of Deception Vs. Demographics, The Simple (Yet Ugly) Reality

- Population growth is the main driver of economic growth, and population growth is ending in developed nations and slowing in developing nations.
- As core 16-54 year old population growth ends, oil consumption has peaked and declined indefinitely, indicating slowing economic activity.
- Interest rate cuts and debt are substituted for decelerating population growth... but population growth is not coming back in our lifetime. Thus, how will ever fewer repay ever more debt?
- The Federal Reserve's economic ineptitude has likely resulted in a self-reinforcing negative cycle of deflation, depression, and depopulation with unknowable depth, duration, and collateral damage. 
World Population Growth is Decelerating From the Bottom Up
I'll make what is somehow an objectionable claim among economists... the world is finite. So, a financial and economic system premised on infinite growth and returns was an absurd concept to begin with. However, the absurdity isn't reached until a finite limit is hit. Many believed it would be a resource-driven limit, such as peak oil or peak fresh water. But alas, the resource limit the world is hitting is consumer growth, also known as population growth.

The quantity and quality of population growth is primarily what one needs to know to understand changes in global demand and subsequent supply. To understand a global or national economy, quantity (number of participants or population) plus quality (income, savings, plus leverage or credit) tells the story. The caveat being that changes in wages and credit for the existing population plus trade balances also play a role in growth.

Still, the tiny marginal change in population (in relation to the total population) has impacts magnitudes larger than the numbers suggest. Population growth is the primary driver for all increases in demand, from housing, to cars, to consumer goods, to large infrastructure build-ups to accommodate all these.

Quantity of Growth

Population growth is pretty much the nexus of all GROWTH. Funny, we hear so little about demographics and yet so much about growth?!? Consider, the below chart shows the quantity of global population growth (yearly average by decade) from 1850 to 2050 versus total global population (all population data and estimates are via OECD.stat). Annual global population growth peaked in the 1980s, and by 2050, is set to decelerate back to the same gross growth as in the 1950s (despite a total population three times larger than that of the 1950s).

Quality of Growth

The chart below shows both total global growth and a breakdown by 0-64 year olds versus those in the 65+ year old category. Growth in the 0-64 year old segments represents true population growth (incoming births over outgoing old... 65+), while 65+ growth represents those living longer, thanks to improved medicine, nutrition, fewer wars, etc.

However, 65+ year olds are typically leaving the workforce to draw on retirement in developed nations or be supported by their children in most developing nations. Either way, the "QUALITY" of their consumption level and willingness to utilize credit declines precipitously after 65, and they generally exhibit weak levels of growth in demand.

Likewise, the chart below shows where the growth in the 0-64 year old global population is happening. Said otherwise, where the QUALITY of growth resides (quality simply used to mean the ability and resources to consume). The collective population growth among the wealthier nations of the OECD, plus China, Russia, and Brazil is moving toward zero, followed by decades of population decline. About 90% of the decelerating 0-64 year old growth is taking place in Africa, India, and the poorest nations on earth.

The chart below outlines the collective OECD members population growth and the makeup between those under 65 and those over 65. Deceleration and declines among the younger core population offset by growth of 65+ segments is plainly visible.

In the chart below, the US annual population growth peaked in 1992, when 85% of that growth was under 65 years old. US population growth has fallen by about a third since that peak, but the makeup of that growth has reversed itself. Now, 60% of that growth is among the 65+ year olds living longer, and less than 40% among greater quantities of 0-64 year olds. This trend continues for at least another decade.

So, as the wealthy nations of the world saw decelerating population-driven growth and slowing economic growth, they turned to the developing markets for additional growth. And these developing nations looked to grow via utilizing cheap wage-driven exports back to the wealthy nations. Chief among them being China.

China's annual population growth peaked in 1988 with the addition of 21.5 million Chinese that year. 90% of that year's growth was among the under-65 segment. Compare that with 2015's total annual population growth, which fell 60% to 8 million. The 65+ year old growth now represents 2/3rds of all Chinese population growth, and growth among the under-65 year olds has fallen nearly 90% since that 1988 peak. The numbers only get significantly worse (from a growth standpoint) from here. China's role as an engine of growth is over.

Brazilian demographics look like Chinese demographics (and China looks an awful lot like Japan).

Indian annual population growth peaked in 1990, and will continue decelerating indefinitely... declining numbers of the young being hidden by rising numbers of the old.

Africa (well represented by Nigeria in the chart below) will be responsible for the vast majority of global population growth now and in the coming decades. In particular, it will produce the vast majority of 0-64 year old population growth. The same Africa where 1/3rd of the nations have annual income below that of Haiti and continent-wide per capita income is under $5000/year.

In 2015, Africa represents 37% of the global population increase, but 45% of global 0-64 year old population growth.

By 2030, the chart below highlights that Africa will represent an est. 55% of global population growth... but far more importantly, in 2030, Africa will likely represent 90% of all 0-64 year old population growth. A continent without income, savings, access to credit, and dwindling-growth nations to purchase their exports. Given these circumstances, the likely "quality" of African consumption and demand growth will be almost nil, and the global impacts of declining demand are only accelerating.

Population Growth Ends... Oil Consumption Peaks and Declines in Sympathy

When the 15-64 year old core population growth peaks, stalls, and or outright declines, oil consumption falls (despite overall populations continuing to grow). This triggers central bank interest rate cuts to incent increases in credit and debt in an attempt to maintain consumption, leveraging up the system among flattening or declining populations. However, if we look at oil consumption in the below charts as a proxy for economic growth... it ain't working now, and it really isn't going to work given what's upcoming.

FYI, the charts below show annual changes to the core population, total oil consumption, and total debt.

I could go on and on with developed nations following this pattern... but all that really matters is China. The country was the last great engine of growth. China followed the developing to developed pattern, with slowing core population masked by the greatest credit / debt increase in history, but the credit binge has gone bust. So, a declining core population, a housing-driven credit bust, and slowing global export markets are why Chinese peak oil consumption is very likely in 2015 or 2016, and China (like Japan) will no longer see organic growth or increasing consumption of much of anything.

The Fed Made the Inevitable Transition into a Catastrophe

I have gone a fair ways to outline that population growth was a limited feature that is now coming to an end. Central banks' models premised on the fallacy that this is a cyclical downturn rather than the structural revolution from high population to low/no population growth are entirely mismanaging fiscal and economic policy.

The chart below makes it plain that US federal deficit spending (and periods of slowing economic growth) has been used to offset what are simply periods of slow core population growth.

And worst of all, the Federal Reserve is simply hiking and lowering the Federal funds rate to incentivize this credit and debt in lieu of core population growth (chart below). However, the US core population will be at its slowest growth since well before WWII (and this assumes continued lax US immigration policies), and the globe (x-Africa) will be slowing even more dramatically. Larger federal deficits and lowering of interest rates have been the only answer (now coupled with QE) the Fed has known to this natural slowing of the population.

And US (and global) employment will continue to slow due to this slowing demand, coupled with innovation, technology, outsourcing, etc. The chart below shows the peak to peak population, full-time, and manufacturing jobs since 1970. It's plain to see that job creation capable of facilitating family formation (full-time, manufacturing, etc.) is slowing in relation to population growth. In short, a world needing ever more consumers is consistently creating fewer good jobs (not to mention little-to-no wage growth). How those without good jobs can consume is our modern-day conundrum.

And just because I tire of the false argument that declining jobs are due to Boomers retiring.

The chart below highlights that although there have been no net full-time job gains since 2007, the 55+ year olds have taken over 4 million full-time jobs at the expense of 4 million jobs lost among 16-54 year olds. The old are experienced and continuing to work to maintain their benefits, in order to augment their insufficient retirement funds and COLA-less SS benefits.

The core generation is being left to chose from part-time and service industry positions that will never allow them to be strong enough to support economic growth, fund the tax base and unfunded liabilities, or family creation.


Slowing population growth, particularly among the under-65 crowd, is the malady that afflicts the economic and financial world, and is the reason central banks are now doing back-flips to sustain the unsustainable system they created. However, now debt is maxed out and massive Fed interest rate-created overcapacities are resulting in deflationary and depressionary economic activity, meaning a self-reinforcing negative cycle is underway, of which the depth, duration, and collateral damage are simply unknowable.

Typically, a recession or depression would rebalance supply with demand, but this has always been amid population growth and the rising demands of this new, larger populace. In this case, demand is likely to continue falling indefinitely with falling populations. This means supply will need to consistently shrink until some equilibrium is found. Quite a pickle the Fed and the central banks have driven us into.

The Fed could never have avoided the population slowdown, but it clearly should have never goosed post-WWII decades that were already aided by secular demographic tailwinds. In fact, its actions should have been entirely opposite slowing growth with rate hikes to have all the tools available to us now. This would have avoided the overleveraged induced overcapacity reality we face. Instead, the Fed has left us not only without options for the demographic headwinds we face, but the bills for its prior ineptitude are now due when we can least pay them.

This is why Negative Interest Rate Policies, or NIRP, are almost a sure bet in the US and worldwide.

Corporations and banks which now get ZIRP will be paid to take money and buy up their own stock as well as US Treasuries. Simply put, we are now in a world with more sellers than buyers, who are asset-rich and cash-poor, so central bankers have determined they will pay the largest entities to maintain the bid and ensure that asset prices continue rising. Mortgage rates will fall to new all-time lows. Savers and investors will be locked into their positions by the reality (not fear) that selling and moving to cash will result in sure losses as rates only go NIRP'ier. Of course, this will almost certainly result in the greatest financial "bull market" ever coinciding with economic depression.

Of course, this is a Potemkin world, or maybe more simply, a global, central bank-run Ponzi where new customers are running short and will soon run dry. Central banks are representing the greatest and wealthiest among us, and are "all in" on the perpetuation of this Ponzi.

Unfortunately, new and entirely worse policies (for the vast majority of the world) will likely follow NIRP unless fundamental and foundational changes are made.


Out of fashion

Investors have become pessimistic about emerging markets

LIKE hemlines and hairstyles, emerging markets swing in and out of fashion. A burst of enthusiasm in the late 1980s was followed by the financial crises of the late 1990s. In the first decade of the 21st century, they were all the rage again, and the term BRIC (for Brazil, Russia, India and China) was coined. When the economies of the rich world swooned in 2008, emerging markets seemed to be the best hope for the future.

But the past few years have seen their popularity wane once more (see chart). The change in mood is understandable. The IMF has forecast that 2015 will be the fifth successive year in which economic growth in emerging markets has slowed. Two of the BRICs—Brazil and Russia—are in recession. Many are uncertain whether the Chinese authorities can engineer a soft landing for their economy, as it slows from the furious growth of previous decades. Emerging markets’ advantage over rich countries, in terms of a faster growth rate, will be the smallest this year since 2001, according to IMF forecasts.

It is easier these days to find pessimists than optimists. Andrew Haldane, the Bank of England’s chief economist, sees emerging markets becoming the “third wave” of the series of crises that began in 2007-08 with American subprime mortgages and continued through 2010-12 in the euro zone. The third-wave theme was echoed in a recent research note by Goldman Sachs.

The underlying problem is that a slowdown in emerging-market growth has been accompanied by a build-up of corporate debt. Excluding financials, emerging-market companies have an average debt level of 90% of GDP, according to HSBC; in Asia, non-financial corporate debt has jumped from 80% of GDP in 2009 to 125% today. Slower growth will make it more difficult to repay that debt; declining currencies will make it more difficult to repay the portion of that debt (just under a third, according to HSBC) that is denominated in dollars. According to a poll of fund managers conducted by Bank of America Merrill Lynch, investors think the two biggest risks to the world economy are a Chinese recession and an emerging-market debt crisis.

Corporate profits have not been growing as quickly as many investors may have hoped.

Goldman Sachs calculates that Asian companies have not managed double-digit growth in earnings per share since 2010. John-Paul Smith of Ecstrat says that, more generally, the return on equity at emerging-market firms has fallen by more than seven percentage points since the financial crisis.

Mr Smith worries that a vicious circle is starting to develop, “whereby poor governance and policymaking, currency depreciation and downward pressure on living standards are beginning to behave in a reflexive manner.” Sluggish growth will encourage governments to intervene more in the economy, imposing higher taxes or price controls. Governments may also deflect criticism by blaming foreign speculators or companies for their problems.

Nationalistic rhetoric, in turn, will weaken investor confidence, reduce foreign direct investment and provoke capital flight. The effect, Mr Smith says, will “put further downward pressure on the currency and hence household living standards and encourage more populist policymaking.”

Some of this pessimism has clearly filtered through to investors. In the Merrill Lynch poll, the share of fund managers whose exposure to emerging-market equities was lower than normal exceeded those with an unusually high allocation by 28 percentage points. Capital Economics reckons that more than $260 billion flowed out of emerging markets in the third quarter of the year. In nominal terms, this was even bigger than the outflow during the 2008-09 crisis. (As a proportion of emerging-market GDP, it was smaller: 4% versus 6% in 2008.)

When financial assets have been underperforming and investors are heading for the exits, contrarians naturally start to wonder whether it is a good moment to fill their boots. Emerging markets usually trade at a lower valuation than their rich-world counterparts, although there are moments when they are sufficiently fashionable to trade at a premium to rich-country shares (see light-blue line on chart).

On this basis, they were most in vogue in the autumn of 2010, but are now trading at a discount again.

But that discount is not as big now as it was in the late 1990s. Until bargain-hunters see some sign of an improvement in the economic fundamentals, they will be forgiven for sitting on their hands.

China’s Economy at the Fifth Plenum

Andrew Sheng, Xiao Geng

Shanghai skyscrapers

HONG KONG – The Chinese government’s intervention in the stock market and devaluation of the renminbi this summer provided a loud reminder that economic developments in China affect everyone. Now, China is set to take some more world-shaping decisions at this month’s Fifth Plenary Session of the 18th Communist Party of China Central Committee.
Two years ago, at the Third Plenum, China’s leaders committed to pursue far-reaching reforms, declaring that markets must “play a decisive role in allocating resources.” While the state sector would continue to play the leading role in the provision of public goods and services, policymakers would “unwaveringly encourage, support, and guide the development of the non-public sector, and stimulate its dynamism and creativity.”
Last year, the Fourth Plenum focused on leveling the economic playing field – in terms of rights, opportunities, and regulations – by strengthening the rule of law and improving the accountability, transparency, and legitimacy of government decision-making. Specific reforms included establishing circuit courts to reduce local governments’ control over the legal system, and a larger role for the National People’s Congress Standing Committee to ensure official compliance with China’s constitution.
This year, the Party must agree on the direction of China’s 13th Five-Year Plan, which is to be launched in 2016 and is supposed to enable the country to graduate from middle-income status by 2020. The question is how to balance the need for continued growth with the imperative for reforms that disrupt traditional pro-growth incentives.
China certainly faces serious challenges. Economic growth has slowed to below 7%, at a time when the rest of the world is facing the threat of secular stagnation (very low growth and near-zero inflation). Internal debts are rising; the renminbi is facing continued depreciation pressure; and investors are still digesting the implications of the recent stock-market intervention. Add to that the bureaucracy’s increasing reluctance to take bold action – an unintended consequence of President Xi Jinping’s aggressive anti-corruption campaign – and the scale of the task China is facing becomes clear.
But there is also some good news. On Xi’s recent state visit to the United States, he and US President Barack Obama reaffirmed their countries’ bilateral trade and economic relations.
Moreover, China is moving forward with its “one belt, one road” initiative, aimed at deepening China’s economic ties with countries throughout Central and Southeast Asia, the Indian Ocean, the Middle East, and eventually Europe. Such efforts will complement those of the US-led Trans-Pacific Partnership trade agreement, which does not currently include China, in shaping the global trade and investment environment.
In fact, despite worrying short-term signals, China seems to be in the midst of a major transformation into a “lean, clean, and green” consumption-driven economy. Of course, the process will be far from easy, owing not just to the complexity of China’s economy, but also to its globally integrated nature, which makes it vulnerable to external shocks. But, despite the difficulty of coordinating China’s huge bureaucracy, the government has made considerable headway in addressing four serious challenges: corruption, environmental degradation, excessive local-government debt, and overcapacity.
Xi’s anti-corruption campaign has gone as far as taking down a retired member of the Politburo Standing Committee, China’s most powerful body. Likewise, carbon-dioxide emissions have fallen dramatically since the beginning of this year, and the authorities appear to be well on the way to hitting the carbon-intensity target established in 2010. Regulatory reforms are beginning to mitigate shadow-banking risks, and even some ghost towns are being revived by market forces.
At the upcoming Fifth Plenum, China’s leaders must build on this progress, agreeing to keep up the reform momentum. To succeed, the government must, as Xi put it, “gnaw even tough bones” – that is, overcome vested interests that are resisting change.
At the same time, China’s rulers must recognize that reforms have significant short-term deflationary effects. Officials initially underestimated these effects, resulting in this summer’s unanticipated volatility. If China is to avoid the debt-deflation trap, its leaders must make some adjustments.
Beyond setting a slightly lower growth target of 6% per year, the authorities must provide more monetary and fiscal support to offset the expected slowdown in investment, consumption, and government expenditures. At the same time, they must deal with the disruptions associated with technological advances.
As it stands, China’s inland cities are benefiting considerably from the improvements in market access and distributional efficiency enabled by the rise of e-commerce. Moreover, automation is helping to offset the decline in the growth of the labor force (the result of population aging and slowing migration).
By contrast, China’s coastal cities, where manufacturing activities are concentrated, are experiencing creative destruction – a necessary process that nonetheless presents significant short-term challenges.
To cope, the government must create incentives for officials to overcome their risk aversion and become proactive in managing change.
Finally, as China’s leaders seem to recognize, an increase in real wages is vital to bolster domestic consumption. Beyond reducing China’s dependence on external demand and helping to propel the country up the value chain, more spending in renminbi would help spur the use of renminbi in trade and investment. The International Monetary Fund’s impending decision – which the US has now agreed not to oppose – to add the renminbi to the basket of currencies that comprise its reserve asset, the Special Drawing Right, would enhance the currency’s international position further.
With the right approach, the 13th Five-Year Plan can bring about significant improvements in the quality of market competition, government accountability, and the provision of public goods and services in China. Given China’s global influence, this is good news for everyone.

Europe’s banks face a difficult global retreat
The simplest way to increase profits in a shrinking market is to cut costs
Ingram Pinn illustration
Credit Suisse is raising SFr6bn of fresh capital while cutting back the amount that it allocates to securities trading; Deutsche Bank is dividing its investment banking division in two and wants to trim it; Barclays’ intended chief executive, Jes Staley, is likely to curtail its investment bank outside the UK and the US. It does not take a genius to notice a common theme for European investment banks: retreat.
In April, I wrote that Europe needed at least one investment bank to compete head on with US giants such as Goldman Sachs and JPMorgan Chase. Shortly afterwards, Anshu Jain resigned as co-chief executive of Deutsche Bank and Europe’s banks headed in the opposite direction. UBS, which has raised its profitability since cutting bond trading in 2012, is the new model.

One can see their point. It is very hard to break into Wall Street and even Goldman is having difficulties with bond trading, the dominant revenue producer of the pre-2008 boom. It is even harder for European banks such as Deutsche to make a decent return when such activities have been hit by higher capital and liquidity requirements. Shareholders are no longer willing to tolerate them dallying.
Global investment banking is an expensive business that involves paying a lot of employees very highly to do many different things — from advising companies to underwriting equities and bonds, to trading currencies and precious metals — in many places at once. When enough of these activities are doing well they support the rest; when few are, it is painful.

But as Napoleon discovered on his way back from Moscow in 1812, retreating can be at least as hard and risky as advancing. In theory, it makes sense to ditch the parts of investment banks that do not achieve high returns and retain the parts that do. In practice, it is not as simple as that. If it were, European banks would not have expanded as much in the first place.

The first difficulty with retreating is that you need somewhere better to retreat to. UBS did the obvious three years ago because its fixed income division was not only facing regulatory pressure but was barely profitable in the first place. Meanwhile, it owned one of the world’s best private banks and wealth management divisions. What would you have done?

Credit Suisse has a comparable ease of choice, although less obviously than UBS since its wealth management arm is smaller and it operates the former First Boston on Wall Street.
Tidjane Thiam, its new chief executive, has now set it firmly on the UBS path. Similarly, Barclays has a decent investment bank in the US and UK, and a strong UK retail bank, although it faces the problem of the UK capital ringfence.
John Cryan, the new chief executive of Deutsche Bank, has a tougher task. Not only is Deutsche’s domestic retail bank outmatched by German savings bank, but bond trading was its biggest strength. It wants to build up equities and wealth management but that will take time — meanwhile, it cannot retreat at the speed of UBS because it would be left with too little.

The second difficulty is that the various parts of a global investment bank fit together in a way that makes it tricky to drop the lossmaking ones while retaining the profitable ones. Equity trading and broking, for example, is a commoditised business with low margins but it enables profitable activities such as equity underwriting. There is collateral damage if you cut it.
Every bank yearns to have a big wealth management division; to advise companies on mergers and acquisitions; to underwrite initial public offerings and to operate in profitable markets without having to keep offices open in countries that are in recession. But it took banks such as Morgan Stanley decades of investment — and consistency — to achieve their lead.
Third, doing some things but not others is a tricky brand offering. Most of us know what a global investment bank offers — broad financial services for corporates and institutional investors. We also understand what a banking boutique does — a few services for companies, including advisory work. But what about a medium-sized European bank with global reach?

UBS, for example, is big in equities and trades precious metals and currencies but has cut back sharply in bonds. It has a limited advisory business in the US, focusing on a few industries such as healthcare. The result is nicely profitable — it earned more than twice its target of a 15 per cent return on equity in the second quarter — but it is not easy to define.

Retreat can work if it is executed well — the simplest way to increase profits in a shrinking market is to cut costs — but it requires a clear destination and strong management. The latter is extremely scarce in investment banking, which has generally been run by stringing financial activities loosely together and giving the largest year-end bonuses to those who earn the most.

European banks need leaders to grapple with operations in detail, cutting some while hurting others as little as possible. Deutsche has brought in Mr Cryan, formerly of UBS; and Barclays plans to exchange Antony Jenkins, a retail banker with little sympathy for Wall Street, for Mr Staley, who worked at JPMorgan.

If they cannot solve the puzzle, no one else is likely to.


Reinventing the company

Entrepreneurs are redesigning the basic building block of capitalism

NOW that Uber is muscling in on their trade, London’s cabbies have become even surlier than usual. Meanwhile, the world’s hoteliers are grappling with Airbnb, and hardware-makers with cloud computing. Across industries, disrupters are reinventing how the business works. Less obvious, and just as important, they are also reinventing what it is to be a company.

To many managers, corporate life continues to involve dealing with largely anonymous owners, most of them represented by fund managers who buy and sell shares listed on a stock exchange.

In insurgent companies, by contrast, the coupling between ownership and responsibility is tight.

Founders, staff and backers exert control directly. It is still early days but, if this innovation spreads, it could transform the way companies work.  

Listing badly
The appeal of the insurgents’ model is partly a result of the growing dissatisfaction with the public company. True, the best public companies are remarkable organisations. They strike a balance between quarterly results (which keep them sharp) and long-term investments (which keep them growing). They produce a stream of talented managers and innovative products. They can mobilise talent and capital.

But, after a century of utter dominance, the public company is showing signs of wear. One reason is that managers tend to put their own interests first. The shareholder-value revolution of the 1980s was supposed to solve this by incentivising managers to think like owners, but it backfired. Loaded up with stock options, managers acted like hired guns instead, massaging the share price so as to boost their incomes.

The rise of big financial institutions (that hold about 70% of the value of America’s stockmarkets) has further weakened the link between the people who nominally own companies and the companies themselves. Fund managers have to deal with an ever-growing group of intermediaries, from regulators to their own employees, and each layer has its own interests to serve and rents to extract. No wonder fund managers usually fail to monitor individual companies.

Lastly, a public listing has become onerous. Regulations have multiplied since the Enron scandal of 2001-02 and the financial crisis of 2007-08. Although markets sometimes look to the long term, many managers feel that their jobs depend upon producing good short-term results, quarter after quarter.

Conflicting interests, short-termism and regulation all impose costs. That is a problem at a time when public companies are struggling to squeeze profits out of their operations. In the past 30 years profits in the S&P 500 index of big American companies have grown by 8% a year. Now, for the second quarter in a row, they are expected to fall, by about 5%. The number of companies listed on America’s stock exchanges has fallen by half since 1996, partly because of consolidation, but also because talented managers would sooner stay private.

It is no accident that other corporate organisations are on the rise. Family companies have a new lease of life. Business people are experimenting with “hybrids” that tap into public markets while remaining closely held. Astute investors like Jorge Paulo Lemann, of 3G Capital, specialise in buying public companies and running them like private ones, with lean staffing and a focus on the long term.

The new menagerie
But the most interesting alternative to public companies is a new breed of high-potential startups that go by exotic names such as unicorns and gazelles. In the same cities where Ford, Kraft and Heinz built empires a century ago, thousands of young people are creating new firms in temporary office spaces, fuelled by coffee and dreams. Their companies are pioneering a new organisational form.

The central difference lies in ownership: whereas nobody is sure who owns public companies, startups go to great lengths to define who owns what. Early in a company’s life, the founders and first recruits own a majority stake—and they incentivise people with ownership stakes or performance-related rewards. That has always been true for startups, but today the rights and responsibilities are meticulously defined in contracts drawn up by lawyers. This aligns interests and creates a culture of hard work and camaraderie. Because they are private rather than public, they measure how they are doing using performance indicators (such as how many products they have produced) rather than elaborate accounting standards.

New companies also exploit new technology, which enables them to go global without being big themselves. Startups used to face difficult choices about when to invest in large and lumpy assets such as property and computer systems. Today they can expand very fast by buying in services as and when they need them. They can incorporate online for a few hundred dollars, raise money from crowdsourcing sites such as Kickstarter, hire programmers from Upwork, rent computer-processing power from Amazon, find manufacturers on Alibaba, arrange payments systems at Square, and immediately set about conquering the world. Vizio was the bestselling brand of television in America in 2010 with just 200 employees. WhatsApp persuaded Facebook to buy it for $19 billion despite having fewer than 60 employees and revenues of $20m.

Three objections hang over the idea that this is a revolution in the making. The first is that it is confined to a corner of Silicon Valley. Yet the insurgent economy is going mainstream. Startups are in every business from spectacles (Warby Parker) to finance (Symphony). Airbnb put up nearly 17m guests over the summer and Uber drives millions of people every day. WeWork, an American outfit that provides accommodation for startups, has 8,000 companies with 30,000 workers in 56 locations in 17 cities.

The second is that the public company will have the last laugh, because most startups want eventually to list or sell themselves to a public company. In fact, a growing number choose to stay private—and are finding it ever easier to raise funds without resorting to public markets.

Those technology companies that list in America now do so after 11 years compared with four in 1999. Even when they do go public, tech entrepreneurs keep control through “A” class shares.

The third objection is that ownership in these new companies is cut off from the rest of the economy. Public companies give ordinary people a stake in capitalism. The startup scene is dominated by a clique of venture capitalists with privileged access. That is true, yet ordinary people can invest in startups directly through platforms such as SeedInvest or indirectly through mainstream mutual funds such as T. Rowe Price, which buys into them during their infancy.

Today’s startups will not have it all their own way. Public companies have their place, especially for capital-intensive industries like oil and gas. Many startups will inevitably fail, including some of the most famous. But their approach to building a business will survive them and serve as a striking addition to the capitalist toolbox. Airbnb and Uber and the rest are better suited to virtual networks and fast-changing technologies. They are pioneering a new sort of company that can do a better job of turning dreams into businesses.