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There are times in economic history when demographics becomes a topic of focus. Demographics, the study of trends in populations, ought to get much more attention in general, but it does not as the forces creating population trends play out very s-l-o-w-l-y. That shouldn’t translate to boring. Far from it. Understanding demographic trends is crucial to understanding the backdrop of long-term economic forces and the underpinning of those forces affecting the financial markets. We may well be going through an inflection period which, if it plays out, could alter the way we should be viewing the financial markets for quite a while.

The trend to which I refer is the possible end of the more-than-generation-long trend of labor losing ground to capital. Think of GDP as a pie that is shared between capital and labor. Those shares are usually steady; labor gets two-thirds of the pie in the form of wages, commissions, and bonuses, while capital, in the form of interest, rents, and profits, gets the balance.
 

The Decline of Labor’s Share of the Pie and What’s Driving Its Reversal

As can be seen in the prior chart, starting in the early 1970s, wage income as a percent of GDP began a relatively steady decline that bottomed in 2012. Without making this a history essay, the combination of the baby boomers entering the labor force (early ‘70s) and the opening of China and the Soviet bloc (early ‘90s) created two surges of increase to the supply of labor. In addition, deregulation in heavily regulated industries, such as airlines and telecommunications, forced managements to become more efficient, particularly as foreign competition increased. At the same time, technological advances hit, first on the factory floor (in the 1980s) and then in the service sector (early 2000s). In both instances, the manufacturing and service sectors saw productivity gains fall more to capital than to labor.
 

Although this poor labor environment was in full throttle, a solution to the imbalance was developing. Quietly and to a degree so small it was barely noticed, the growth in the labor force was about to begin shrinking. China was in the grip of Mao Zedong’s one-child policy. Elsewhere around the globe, fertility rates were also beginning to fall, voluntarily everywhere (but China). It is well known in demographics that fertility rates fall when female educational levels rise and when family incomes rise. Declining fertility rates and their consequences on the population take time to develop. It is only now that we are seeing this decline in economic statistics. The declining workforce will also be impacted as the current workforce ages into retirement.
 

As an aside, in many countries in the developed world, it is not just the workforce that is declining. The birth rate is so low that many countries will soon start to be older and smaller. Developed countries such as Japan, Russia, Italy, and France either meet this definition now (Japan) or will within the decade. This is worth keeping in mind because slowing population growth also has the effect of slowing potential economic growth.
 

Meanwhile, Back at the Ranch, Capital Is Running into Its Own Problems

At the same time, stresses on the returns available to capital are growing, largely due to the consequences of the Great Financial Crisis in 2009. To maintain and restore financial system stability, the central banks of the world cut interest rates to zero (and lower!) and have felt obliged to keep them suppressed for almost a decade. Pools of capital that have been accumulated based on a targeted return (think pension funds, endowment funds, and insurance companies) have been forced to move much further up the risk curve to try to maintain a targeted rate of return. For example, as we noted in a previous Quarterly Review1, the allocation of the return from stocks in the 20th century was roughly split evenly between income and appreciation. In the market environment of today, virtually none of the gain can be expected from dividends, no matter how fast the dividend is growing. In similar fashion, interest rates on investment grade bonds are less than nominal growth or even real growth in the economy, meaning that returns leave a bond holder falling short of the growth rate in the economy. And that doesn’t even reflect the $17+ trillion in face value of sovereign bonds outside the U.S. that generate negative returns at current prices in an absolute sense, let alone compared to growth in the economy.
 
Or, to put it in a slightly different light, $296 trillion in debt is being serviced on roughly $84 trillion of global GDP. The Financial Times estimates that this debt is broken into four buckets: Government ($86 trillion, which includes the negative yielding $17 trillion referenced above), non-Financial corporate ($86 trillion), Financial sector ($69 trillion), and Households ($55 trillion).2 If interest rates were to rise for whatever reason, the share of total global income required to simply service this existing debt would increase sharply. Using current interest rates to approximate the interest cost for each of the four sectors, the interest cost of all this debt consumes about 6% of global GDP. Raise the rate for each sector by one percentage point across the board and the total servicing cost jumps to 17% of nominal GDP. How a rate rise would affect each of the four sectors listed above cannot be forecast other than to say it wouldn’t be good, either economically or socially.
 

What Does this All Mean for the Financial Markets?

This sounds like a very treacherous period ahead in the financial markets. The 30 to 40 year growing share of the pie flowing to capital owners is in the midst of shifting from a tailwind to a headwind. The valuations of many financial assets—stocks or bonds—almost assuredly do not reflect that. Refer to two long-term measures of the valuations of common stocks below, Tobin’s Q Ratio and the Shiller-CAPE Price-to-Earnings Ratio3, both of which show extreme valuations. There are many objections that can be made to using either Tobin’s Q measure or the Shiller CAPE measure to value stocks, and we do not dispute that. We merely note that both measures, whatever flaws they have, are clearly not at the cheap end of the ranges by any stretch of the imagination, at a time when risks to stock valuations are growing.
 

When the monetary authorities conclude they can’t evade or stop interest rates from rising, re-pricing of stocks and bonds will be a threat. In the face of these twin risks, what can and should investors be doing to protect their capital?

It may be not so much what a portfolio owns, but why it owns it. Investments historically have been made to generate a stream of income back to the owner to allow the portfolio to fulfill its objective over the planned investment horizon. In periods in which the return is not coming from income distributions (for all the reasons referenced above) but rather from the portion of return that comes from changing the discount rate on which those cash flows are valued, we can say we are in a speculative era with “animal spirits”4 as J.M. Keynes, one of the great economists of the 20th century, put it in the early 1920s. In this kind of environment, the focus must be, as it has for the past decade, on determining which securities can go up faster than their peers. As Keynes (who was an excellent speculator and a brilliant economist) put it, stock market valuation levels in the short run are built on expectations about what other investors think, rather than expectations about the fundamental profitability of a particular investment. Or, as Benjamin Graham, another great investor, summed it up, “in the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

If the scenario we worry about—headwinds to returns on capital, higher interest rates siphoning off what capital earns away from the portion going to profits, and lower “animal spirits” because of higher interest rates depressing stock valuations—comes to pass, then owning stocks either indiscriminately or because of their perceived appeal to others, will be a strategy to re-think. “A rising tide lifting all boats” may be undergirding the index fund phenomenon. Being on any boat matters more than which boat because they will all do more or less the same. Why pay a higher ticket price (“expense ratio”) when the cheap fare will get you the same ride and take you—on average—as fast as the most expensive vessel? If the seas are always and forever calm, why spend unnecessarily on safety gear no one needs, that is, until they do?

It’s only when the tide goes out that those vessels with the right navigational equipment and experienced captains will steer through the shoals and the rocks to reach safe open waters or sail to safe ports in times of great storms. In the world of investments, this is known as fundamental, bottom-up research with a healthy appreciation of the risks to capital. For our part, we are concerned and ready to help our clients maintain the gains they have accumulated in the last 27 years since the firm was formed. The historical experience of our investment strategies, both equity and fixed, show that they have tended to do better, relative to their benchmarks, in markets that decline. We are mindful and respectful of the statement that past returns are not indicative of future results, but we can say that the philosophy and processes we have used in our work since inception have not changed over time.
 
We wish you calm waters and a safe voyage.
 
I would like to acknowledge the substantial assistance to this edition from Tom Dzien, research analyst in our Quantitative and Alternatives Research Group.
 
 

1Thoughts on the Current Environment Second Quarter 2021
2Financial Times, September 16, 2021, "Global debt is soaring - and we need to talk about it" available at: https://www.ft.com/content/be32e263-0d55-4df4-a214-855bcad2c60d
3Tobin’s Q is a theory of investment behavior in which ‘Q’ represents the ratio of a company’s existing shares (share capital) to the replacement cost of its physical assets. A high Q ratio might indicate that the company’s stock is overvalued. The Shiller-CAPE Price-to-Earnings Ratio is based on average inflation-adjusted earnings from the previous 10 years. It eliminates fluctuations caused by profit margins during business cycles.
4“Animal spirits” refers to the exuberant behavior investors can show in the later stages of a bull market that can push valuations to irrationally high levels.
 
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