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The coming population bust



This chart comes from a recent article in The Economist on the amazing decline in worldwide fertility rates. It reminded me of something I wrote over three years ago, summarizing what I thought were the high points in the 2005 book Fewer: How the New Demography of Depopulation Will Shape Our Future, by Ben Wattenberg. The theme of both is similar: fertility rates in virtually all countries in the world have fallen further and faster than anyone could have imagined just a few years ago. World population is no longer exploding, and will soon be shrinking. Here's my summary of the Wattenberg book:


We are only a decade or two away from a new era in human existence: global population will begin to decline.

Not too long ago world population was projected to surge from the current 6 billion to 14 billion or more by the end of this century, creating great strain on the world’s resources, and in part fueling the whole environmental movement. Now, the UN Population Division’s projections have been dramatically scaled back. One plausible scenario shows global population peaking around 2040 at 7.5 billion, then falling to 5.5 billion by 2100. Yet if recent trends in fertility rates continue, these numbers are too high, and global population could peak within a few decades. One long-term scenario projects world population shrinking to only 2.3 billion people by 2300!

The most significant change in global demographics in the past few decades has been a dramatic decline in fertility rates in almost every country on the planet. In order for population to remain constant over time, total fertility rates must be approximate 2.1. Every woman must on average have 2.1 children; one to replace herself, one to replace her partner, and a little extra to make up for women who don’t have children.

As recently as 1970, fertility rates in less-developed nations were about 6. They have subsequently collapsed, at a faster rate than anyone could have imagined. Total fertility rates in LDCs are now 2.75, and they are still falling. Fertility rates have fallen faster in LDCs than they ever fell in developed countries.

Fertility rates in Greater Europe have fallen from 1.8 in 1980 to 1.3 today, a level previously thought unimaginably low. Europe is already losing about 700,000 people per year, a figure that will grow to about 3 million per year or more by mid-century. By the year 2050, Europe will have lost about 100 million people; population will likely decline from today’s 730 million to 630 million or (probably) less. If fertility rates and immigration in Europe do not increase from current levels, European population could fall by 130 million by 2050. That’s equivalent to losing almost half the current population of the U.S. Italy has a fertility rate of 1.2, Germany 1.35, Russia 1.1, Spain 1.15, Switzerland 1.4.

Europe has about twice the population of the U.S., but only takes in about 376,000 immigrants per year, about one-third as much as the U.S. does. In order to keep its population from shrinking, Europe would have to “import” almost 2 million immigrants per year. If Europe wanted to maintain a constant dependency ratio (retired workers/active workers), annual immigration would need to be over 27 million! The majority of European immigrants are muslims, mostly Arabs. Given current political realities, a significant increase in immigration is extremely unlikely. Thus, significant population decline is virtually certain.

The inevitable population decline that developed countries will suffer will dramatically reduce the influence of “Western” civilization in the world. In 1950, the West represented about one-third of global population. By 2000 this had declined to 20%, due to the population explosion of LDCs. By 2050 the West will shrink to 14% or less. Europe’s share of world population was 22% in 1950, 12% in 2000, and will be 7% or less in 2050.

Good-bye Europe… One demographer estimates that for every 1,000 Europeans in the year 2000, there will be only 232 in the year 2100!

Russia is losing almost 1 million people per year and its fertility rate is only 1.1. Russia could lose 30% or more of its current population by 2050!

Japan’s population will begin to decline within a few years. Its fertility rate is only about 1.3. The number of people 15 years and older will likely stop rising in the next year or two, and it only increased 90,000 in the past year (0.08%). Japan’s workforce peaked in 1998. The number of people employed peaked in 1997 and has fallen by 215,000 since.

Fertility rates have probably already fallen below replacement level in countries such as Mexico, Brazil, and Iran. This was almost inconceivable just a decade ago. South Korea and Hong Kong are among the countries with the lowest fertility rates in the world: only 1.17 and 1.0, respectively.

The U.S. is the only developed country in the world that will continue to grow in coming decades; U.S. population will grow by about 100 million (one-third) by 2050. The fertility rate in the U.S. is about 2, and that is by far the highest fertility rate of any modern nation. U.S. population growth will be driven exclusively by immigration.

China’s population will grow about 13% between now and 2025, reaching 1.45 billion, but then it will begin to shrink. Its fertility rate is 1.8, despite its “one child” policy.

India will become the most populous country in the world by 2035, and its population will continue to grow, reaching a peak of about 1.5 billion by 2050. India’s fertility rate has plunged from 5.4 in the early 1970s to less than 3 today.

There are about 1 billion Muslims in the world. Fertility rates in Muslim countries have also collapsed. Muslim countries will begin to lose population around 2050. Muslims will continue to represent about one-sixth of the global population.

Government-sponsored retirement schemes are in trouble. The problem is a combination of increased life expectancy and a baby bust. Populations in all developed countries will be aging dramatically in coming years. The median age in the U.S. in 1950 was 30; by 2000 it was 35; in 2050 it will be 40 or more. The median age in Europe in 1950 was 29; in 2000 38; in 2050 it will be 48 or more. Japan will age even more dramatically: 22, 41, and 53.

The easiest solution to the problem of a population bust is more immigration. But the competition for immigrants, currently just 3% of global population, may intensify in the future, especially since fertility rates in those countries traditionally supplying most of the immigration for Europe and the U.S. are falling dramatically. Another solution is for people to retire at much older ages. (My view: this is probably the only feasible solution.)

When populations cease growing and start shrinking, economies become more like a zero-sum game. To increase your share of the wealth pie, someone else has to accept a smaller share. Construction doesn’t open new expanses of land to development, it mainly concentrates on replacing and improving existing structures. Productivity becomes the key to growth.

If real economic growth in Europe approaches zero (a shrinking labor force offset by positive productivity gains), must real yields on inflation-linked bonds also approach zero? (If real yields are not equal to or less than real growth, then inflation-linked bond returns will equal or exceed nominal growth, and that poses competition to equities, since earnings growth on average is limited by nominal GDP growth.)

Demographic trends are already influencing differential growth rates in the U.S., Japan, and Europe, and this will only intensify in coming years. If you were a member of an aging Japanese or European economy with minimal growth prospects, wouldn’t you prefer to invest your retirement funds in the biggest, most modern economy in the world, especially since it is virtually guaranteed to be the only one to grow significantly over the balance of your lifetime? Doesn’t this help explain why the U.S. has a persistent and growing current account deficit? By this same logic, capital inflows to India and China could be intense in coming years; it seems virtually certain that the world will have only three main economic engines in coming decades: the U.S., India, and China.

Equity panic attack is likely temporary



The stock market is spooked today, with prices dropping and implied volatility soaring. This is arguably the most significant "panic attack" the market has had since earlier this year. In my informal survey of the news today, I see almost universal concern that the positive GDP report yesterday was just a blip, that the economy remains very weak and vulnerable to another decline. Of 10 stories about the economy, at least 9 look at the numbers and can't find any reason to be hopeful. I think this is an exaggeration, but panic attacks like this are part of any recovery story.

When the market suddenly gets scared, my first reaction is to check the status of the market-based indicators of economic fundamentals to see if anything has changed. I can't find any evidence of deterioration in the numbers. Take this chart, for example, that shows spot commodity prices at their highest level of the year.



Swap spreads (next chart) show absolutely no sign of any increased tensions in the market. In fact, you couldn't ask them to be better-behaved. CMBX and ABX prices are still in a rising trend. Inflation expectations built into TIPS prices are near their highs of the year, suggesting that the bond market isn't worried at all about a deflationary slump. Sep. '10 eurodollar futures are trading at all-time highs, suggesting that the market is not concerned at all about an imminent Fed tightening which might upset the economic applecart.



The dollar is weak, but it hasn't moved much for the past six weeks. Gold hasn't gone anywhere for the past three weeks. Oil is only a few dollars higher than it was last June. The Baltic shipping index is 50% above its average for the past year. Credit spreads are within inches of their lows for the year

Perhaps it's just that Halloween has come a day early.

Fed and Treasury update





The Fed continues to expand bank reserves (first chart), but its balance sheets remains relatively unchanged in aggregate over the past year (second chart, source here). Further, as seen in the second chart, the Fed has bought enough Treasury bonds by now to replenish what it "lost" in last year's panic, flight-to-quality. They will continue to buy agency and mortgage-backed securities, but these purchases will likely be offset by declines in the "other" categories.

The big question thus remains: how and when will the Fed start reversing this huge addition to bank reserves? The Fed will eventually have to sell, by hook or by crook (and it is already experimenting with ingenious ways to do this) about $1 trillion worth of agency and MBS. Whether this by itself will push interest rates up, or whether rates will rise because the economy is picking up and that is the justification for the Fed to reverse its liquidity injections, it doesn't much matter. The bottom line is this: if the economy continues to grow at a 3-4% rate, as seems likely to me, then interest rates on Treasury bonds are going to go up significantly, and rising Treasury yields will in turn push agency and MBS yields higher as well.

The market is currently happy with 3.5% yields on 10-yr T-bonds, but only because the market doesn't believe that this economy has the potential to post continued, decent rates of growth. If and when that perception changes to one of expecting 3-4% growth (or even more: see my previous post), then Treasury yields will inevitably move significantly higher. So it's not worth your time worrying about how the Fed will reverse its quantitative easing; the main driver of interest rates will be economic growth. And of course inflation is going to play a role in rising rates as well, but the market won't worry about inflation until it first becomes convinced that the economy has the ability to grow by at least some decent rate.

When it comes to Treasury yields, it's all about economic growth.

Getting growth back on track could be very rewarding








As the first chart shows, GDP growth has snapped back to "normal" following a record 4 quarters of negative growth. But as the blue and green lines in the second chart suggest, the economy today is  about 10% below its "trend" or potential level (extrapolating from the past). Stated another way, our national income is about $1.4 trillion less than it otherwise might have been if we hadn't suffered from the real estate/financial system collapse of the past few years.

Before proceeding further, I'm going to step back and engage in some "inside" thinking (see my post on this subject yesterday). We all know that the economy is facing enormous headwinds: 10% unemployment that is going down very slowly; an administration determined to ramp up government spending and tax burdens to new post-war levels; trillion-dollar federal deficits for as far as the eye can see; states and municipalities that are bitterly strapped for cash; broken credit markets; a commercial real estate disaster waiting to happen; a second wave of residential foreclosure sales; consumers retrenching and deleveraging; and a Fed that will soon have to withdraw over $1 trillion in liquidity or face an explosion in inflation.

Add all these concerns up and you have the "new normal" environment where the economy struggles to grow by 2% or so per year in perpetuity. Since the market is fully aware of these abundant "inside" facts, it is no wonder that 10-yr Treasury yields are only 3.5% despite the prospects of a multi-year, trillion-plus annual deluge of Treasury supply. It is no wonder that the S&P 500 today trades at the same level as it did over 10 years ago, even though corporate profits (per NIPA) have risen some 70% over that same period and are currently beating expectations almost every day. It's no wonder that corporate credit spreads are trading at levels that in the past have signaled the onset of recession. In short, the outlook is miserable and the market is priced to miserable expectations.

Now let's engage in some "outside" thinking. That's summed up in the purple, dashed line in the second chart. (New readers might want to refer back to this post on Milton Friedman's "plucking" theory of growth, and to this post from the Atlanta Fed that demonstrates how the strength of a recovery is largely a function of the depth of the preceding recession.) For the past 40 years, the economy has managed to grow on average about 3.1% per year: this would be the economy's "potential" growth rate. Currently the economy is about 10% below this potential, making this recession the most painful, in some respects, of any since the Depression. Let's say that because of all the headwinds out there that it takes the economy eight full years to recover to its potential; this would mark by far the slowest recovery to trend ever observed since the Depression. Yet despite being a miserable recovery, we would still see growth of 4.4% per year, and that is about double the rate of growth that many optimists are calling for.

The inside view says the outlook for growth is miserable, while the outside view says that there is a decent chance (not a certainty of course) that growth could be much stronger than the market expects, and for many years, even though the economy faces significant obstacles (headwinds) to growth. Since the market is not even remotely prepared for such an outcome, risky financial assets such as equities and high-yield debt could enjoy excellent returns even as the economy struggles to get back to its trend growth path. Imagine what could happen if some of the assumptions held by the inside view were to be challenged: what if electoral upsets next week and next year result in fiscal policies which rely more on supply-side incentives and less on Keynesian fiscal stimulus? What if faster-than-expected growth reduces the deficit and makes tax cuts possible, instead of tax hikes? The possibilities are endless, and you don't have to be a congenital optimist to see them. Just use a little "outside" thinking.

Unemployment claims update



A quick update to this chart, which I haven't shown for several weeks. The 4-week moving average of claims continues to move down, even though claims recently have slightly exceeded expectations. The important thing is that progress is being made.

The inside vs. the outside view

I've known Bill Miller, Legg Mason's top equity manager, for a long time. He's had his ups (beating the S&P 500 for 15 straight years) and downs (especially last year when he was crushed), but I continue to admire his wisdom and insights (could it be because we both majored in philosophy in college?). I highly recommend reading his most recent commentary, since we are both thinking along the same lines these days, but coming from different directions. He starts with an insight from Michael Mauboussin's new book Think Twice (he's also a Legg Mason guy) which describes two very different ways of analyzing a problem: from the inside and from the outside.

The inside view considers a problem by focusing on the specific task and by using information that is close at hand. The outside view...asks if there are similar situations that can provide a statistical basis for making a decision. The outside view wants to know if others have faced comparable problems, and if so, what happened. It’s an unnatural way to think because it forces people to set aside the information they have gathered.

Those who are pessimistic on the economy and the prospects for the market are using an inside view, according to Bill:

PIMCO’s Mohamed El-Erian is the most prominent advocate of the “new normal”, a term he coined to describe a recovery with real growth of 1-2%, persistently high unemployment, and much greater government involvement in the economy. He has recently warned of a big letdown from the “sugar high” we are now experiencing in the market and the economy as the effects of the abatement of the credit crisis and massive government stimuli, both fiscal and monetary, begin to wear off.

He may be the most prominent, but he is not alone. In fact, it looks like he is the leader of a not so silent majority. The current consensus growth rate for the U.S. economy in 2010 is 2.4%. This is way below “normal” for the first year of a recovery.

Projections such as these follow the classic inside view pattern: they look at current conditions, current trends, anchor on the most recent data, and adjust from there.
A variant of the argument has it that with consumption elevated at 70% of GDP and the consumer retrenching, growth must be sluggish, profits will disappoint, and it will be hard for the stock market to make any headway. 

He goes on to note that past periods of huge consumer deleveraging and increased savings have not prevented the economy from growing at fairly impressive rates. He borrows from another friend of mine, economist Michael Darda, who notes that "The most important determinant of the strength of an economic recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-1939 period." I've argued quite a few times that deleveraging need not mean slow growth, because growth doesn't come from leverage, it comes from work and investment. Debt and leverage can facilitate growth, by helping to distribute spending power to the nooks and crannies of the economy, but debt doesn't create growth since the money that one man borrows must come from another man's pocket.

I have been arguing for months now that the stock market is not overpriced because the mood of the market is still very pessimistic. To back up my claim I've pointed to credit spreads which are still quite high, to implied volatility which is still quite elevated, and to Treasury bond yields, which are still quite low. Bill makes a similar point from a different approach:

As market veteran John Mendelson often points out, it is not what people say that matters, it is what they do. And what they are doing is buying bonds and selling stocks. Through the first 9 months of this year, domestic equity funds had net outflows of $8 billion. During the first week of October, another $5 billion was redeemed. Bond funds, in contrast, had inflows of nearly $300 billion in the first 9 months of this year. Of the top 10 selling funds in America this year, 9 are bond funds and only one is a stock fund, and that one is the Vanguard 500 index fund.

Finally, he notes that "every time stocks have performed poorly for 10 years, they have performed better than average for the next 10 years, and they have beaten bonds every time by an average of 2 to 1."

Both Bill and I agree that these days it pays to be optimistic.

Capex rebounding



One way businesses invest for the future is through capital goods orders (aka capex). Capex has risen smartly this year, probably for several reasons: 1) the decline last year was so severe that it was probably overdone, 2) businesses believe that there is hope for the future, and 3) corporate profitability is improving. Through September, Capex was up at a 10.8% annual rate since the freefall of last year ended last January, and up at a 8.1% annual rate since the low of last April. By either measure, capex is doing much better in the current recovery than it did following the 2001 recession. This makes sense given the severity and depth of the decline last year, but it is also an important confirmation of the fact that we are now in a recovery and things are improving and are likely to continue to improve. Capex is the seedcorn of future productivity, after all.

No shortage of money (15)



This is the longest-running theme on this blog: whatever problems the economy has, a shortage of money is not one of them. I've used it to counter the widespread belief at the end of last year that the economy faced the threat of deflation. When money is plentiful, deflation is nearly impossible. We know money is plentiful, because the price of money, as reflected in the exchange rate of the dollar and the price of gold, has fallen. The Fed has tried very hard to ensure that its supply of dollar money meets and/or exceeds the world's demand for it, and it looks like they have succeeded.

I've also used this theme to explain how the cause of last year's recession was a sudden decline in money velocity; people scrambled to increase their money balances by spending less and by effectively stuffing dollars under their mattress. This meant the recession was a giant shock to confidence which resulted in a huge increase in the demand for dollars. As confidence returned, I argued, money that was hoarded would get spent, and the economy thus had the ability to rebound rather quickly from its slump. All the signs I see suggest that the economy is pretty much following this script closely.

We now have the data for M2 money growth in the third quarter: -1.9% (annualized). This is not a fluke, since M2 growth has been effectively zero since the end of March. The initial estimate of third quarter GDP is due on Thursday, and the consensus calls for nominal growth of 4.6% (3.2% real growth plus 1.4% inflation, annualized). Thus we can estimate that M2 velocity in the third quarter rose at a 6.7% annualized rate. (see chart above) I think GDP probably did a little better in the third quarter, which would make the increase in velocity even more impressive. Bottom line: money that was hoarded is now being spent, and this is driving the recovery.

Money velocity (GDP divided by M2) is the inverse of money demand (M2 divided by GDP). So we can say that the big news in the quarter that just ended was a significant decline in money demand, after a major rise in money demand that dominated the economic news last year and earlier this year. Lots of evidence comes together to support this: as money demand has fallen, the dollar's value on the foreign exchanges has also fallen; growth in dollar currency has also fallen; and commodity and equity prices have risen as the world attempts to reduce money balances and increase exposure to more risky assets. It's all tied together with confidence: as evidence accumulates that the economy is not falling off a cliff and banks are not going to disappear massively, money comes out of hiding. Dollars that were stored are being spent, converted to other currencies, and/or exchanged for more risky assets.

I still see lots of people worrying that the U.S. could end up like Japan—unable to pump up the economy no matter how hard the central bank tries to ease monetary policy. I don't see many parallels to worry about, however. For one, the yen's value has been rising for decades, which is prima facie evidence that the Bank of Japan hasn't really tried all that hard to increase the supply of yen relative to the world's demand for yen. In contrast, the dollar is very near its all-time low relative to other major currencies, so we know the Fed has been far more accommodative, historically, than the BoJ. Second, M2 velocity in Japan has been declining almost nonstop for the past 30 years, whereas M2 velocity in the U.S. has been relatively stable on balance (though quite volatile at times). This suggests strongly that there are some big structural differences between the two economies. The BoJ has traditionally been much more cautious than the Fed, and the Japanese have been much more willing to hold on to their currency (e.g., by saving more and borrowing less) than U.S. consumers.

All the evidence points to rising money velocity in the U.S. This, coupled with the Fed's continued willingness to supply tons of money to the system, strongly suggests that 1) the U.S. will avoid depression, 2) the U.S. economy is very likely to continue growing, and 3) rising inflation, not deflation, is the most relevant concern for investors. For the time being, this should translate into continued weakness for the dollar, and continued strength for commodities, gold, and equity markets.

Housing prices are rebounding





No one seems quite prepared yet to proclaim that we've seen the bottom in housing, but from the looks of this chart the bottom occurred quite awhile ago. After adjusting for inflation (I'm using the PCE deflator here), real home prices have risen four months in a row, at a 12% annualized pace. Since the Case Shiller data involve a lag of several months (i.e., the August figure is the average of prices for the April-June period), it would appear that the bottom in housing prices happened last March. At that point, prices in real terms had fallen by about one-third relative to their all-time high in mid-2006.

Once again we see evidence that markets can solve apparently intractable problems. All it took to fix the housing bubble was lower prices and lower interest rates. Demand is now outpacing supply, as the second chart shows. Skeptics will counter that the rebound is only temporary, because banks have been very slow to put their foreclosed properties on the market, and the government's $8K tax credit for first-time homebuyers is going to be phased out. I can't refute those arguments, but it seems to me that there has been a sea-change in the dynamics of the housing market. Clearly we are no longer in free-fall; there has been a major price adjustment, and there has been plenty of time for attitudes and underlying dynamics to adjust. It is also the case that the broader economic and financial fundamentals have improved considerably in the past six months, and monetary policy has been extraordinarily accommodative for the past year. I think the turnaround in the housing market is for real.

P.S.: Of course, this index is an average of 20 major housing markets, and so it could mask difficulties in one or more areas. Housing is a local phenomenon, and aggregating to national trends is risky. But still I think the evidence is pointing to improvement in a market that has suffered for several years.