When the long-term becomes short term

Tuesday, 25 July 2023 — Gold Coast

[8 min read]

Dear Reader,

For those baffled by Wall Street’s miraculous ‘recovery’ in 2023, today’s morning edition of Sky News solved the mystery…

Bad news for the Bulls…park rangers have now released the Bear.

Watch out. Grrrrr.

Two long term trends on a collision course

In last Tuesday’s Daily Reckoning Australia, we looked at the powerful drivers that propelled the S&P 500 to an extraordinary 48-fold gain over the past four decades.

The period of gain — which has been almost, but not quite, all my adult life — is why we expect the share market to be our retirement benefactor for the remainder of our adult lives.

It has gone on for so long that we simply expect it’ll continue in a ‘business as usual’ fashion. But that’s not how long-term cycles work.

There are prolonged periods of outperformance followed by underperformance.

Even the US Federal Reserve recognises the factors behind the last four decades of outperformance on Wall Street, are all but exhausted.

To quote from last week’s Daily Reckoning Australia…

‘In June 2023, the Fed published this discussion paper…

‘After studying 60-years (from 1962–2022) of earnings data and S&P 500 performance, the paper concluded (emphasis added):

“…the 30-year period prior to the pandemic was exceptional.

“During these years, both interest rates and corporate tax rates declined substantially. This had the mechanical effect of significantly boosting corporate profit growth.

“Specifically…the reduction in interest and corporate tax rates was responsible for over 40% of the growth in real corporate profits from 1989–2019.

“Moreover, the decline in risk-free rates over this period explains the entirety of the expansion in price-to-earnings (P/E) multiples.

“Together, these two factors therefore account for the majority of this period’s exceptional stock market performance.”

‘The three unrepeatable drivers of stock returns

‘Earnings were boosted by…

‘Falling interest rates.

‘Falling Corporate Tax Rates.

‘Share prices were increased by…

‘P/E multiple expansion.’

As discussed last week, each of these three factors has (just about) had its day and is unlikely to be repeated. The next decade or two for share investors is shaping up to be rather difficult.

The timing of this reversal in fortunes could not be worse.

Why?

Because it also coincides with a slow-moving change in another longer-term trend.

In a world of instant everything, waiting patiently for trends to play out is definitely not most people’s cup of tea.

And that’s completely understandable.

There is so much content vying for our attention these days.

Taking time out to ponder the shifting patterns of society is a luxury few can afford.

However, those trends are what influence the economy and financial markets…and they are on a collision course.

The 20th century was like no other century in history

From 1900–1999 so much changed…and most of it in the second half of the 20th century.

Population growth on an unprecedented scale (due to lower infant mortality rates, baby booms and longer life expectancies).
Industrial Revolution leading to the technology revolution.
Quantum leaps in medical science.
The sophistication of financial markets.
Fractional banking.
Women entering and remaining in the workforce.
Expansive welfare systems.
Pension funds.

What we take for granted as ‘normal’, is, in the context of history, far from normal.

The society we know today has largely been a construct of the past 70 years.

The problem is that the 21st century now must deal with the legacies from the 20th century.

An ageing population…the ratio of non-workers to workers is increasing.
Unfunded welfare and healthcare commitments.
Society’s increased expectations of a certain standard of living (irrespective of whether we can afford it or not).
Declining birth rates.
The immense financial cost of trying to reduce carbon emissions.
Financing national defence systems against renewed external threats.
An economy caught in a massive debt trap.

The demographic and debt trends responsible for creating these legacies are on the cusp of changing.

Are we turning Japanese?

We know from Japan’s experience that a society's transformation process can be long and (financially) painful.

Japan’s demographic sweet spot (when the ratio of non-working age citizens was lower than the working age cohort of over 15s and under 65s) was the key driver behind Japan’s economic glory…especially in the 1980s.

When Japan’s ratio of non-working age population to working age population began to increase, sustainable economic growth became a distant memory…a forlorn ideal from glory days past.

The US is now where Japan was 25–30 years ago.

Is this slowing economic growth trend going to impact the US and the rest of the West in the same way?

Highly likely.

The power of the demographic trend on asset prices is evident in these next two charts.

Follow the leader

In 1960, the Nikkei 225 and the Dow Jones were at similar starting levels.

The Nikkei 225 began the year at 1000 points and the Dow Jones Index was around 700 points.

But after that, it was a tale of two indices.

While the US future labour force was making its way out of the labour ward, Japan’s share market was making its way to much higher levels…steadily at first, then exponentially.

Whereas the Dow, well, was stuck in that sub-1000-point range for over two decades.

And, when the Nikkei surged to almost 39,000 points in late 1989, the Dow was nudging a mere 2500 points.

Then the Dow played follow the leader.

Repeating an all too familiar pattern…steadily at first, followed by the exponential.

Trends take time (years, decades and even centuries) to evolve…but what usually happens at the end of a very long trend is a hastening of action borne from conviction.

Society becomes so convinced that what they’re experiencing is a permanent state of affairs. What has been will continue to be so.

Time marches on and so do the dynamics that were instrumental in creating those (as we know it, temporary) state of affairs.

It’s taken decades for the debt and demographic trend in the US to reach a turning point.

Japan’s post-1990 experience provides an insight into the fate that possibly awaits over-valued asset markets.

As Ray Dalio identified in his extensive research on empires…

‘… going from one extreme to another in a long cycle has been the norm, [is] not the exception—that it is a very rare country in a very rare century that doesn’t have at least one boom/harmonious/prosperous period and one depression/civil war/revolution, so we should expect both.

‘Yet, I saw how most people thought, and still think, that it is implausible that they will experience a period that is more opposite than similar to that which they have experienced.’

Human nature is why the patterns, down through the ages, are so repeatable.

While the US and Japan are not a perfect overlay, the similarities in debt-funded economic ‘success’; transitioning out of the demographic sweet spot and the exponential asset pricing phase that comes with trend extrapolation, are too great to ignore.

In my opinion, the US is going to continue to play follow the Japanese leader.

This is why a 60% or even, 70% collapse on Wall Street will come as no surprise.

The only unknowns are…when it starts and how long it takes.

That baby boom bulge is now moving its way into retirement…at precisely the time when the primary wealth creator of Boomer retirement capital (shares) is poised to spring a very nasty and unexpected surprise.

The choices we make today are likely to have a profound impact on the trend each of our lives takes in the coming years and decades.

Regards,

Vern Gowdie,
Editor, The Daily Reckoning Australia

Dear Reader,

‘He just refuses to die.’

Our neighbour came over for an ‘apero’ yesterday. She told us about her poor father:

‘He’s 96 years old. He and my mother have been married more than 70 years. But he pointed to her last week and asked me: “Who’s that woman?”

‘It’s sad. He’s lived in that house for 50 years…but he can’t remember where the bathroom is.

‘When he got the COVID virus, we all thought he was going to die. But he just lost his mind.’

What has to happen will happen, sooner or later. Often, it takes longer than you expect.

The Fed has increased its key lending rate faster and more than any Fed ever did. But the stock market hasn’t crashed. Unemployment is still low. And we’re still waiting for the recession.

How come?

The big switch

Last week, we were exploring the issue. The secret, we believe, is that the federales have lost their minds. The Trump Team went bonkers in the COVID Hysteria with a deficit of US$4.2 trillion in 2020…then the Biden Bunch followed up with another US$1.4 trillion deficit in 2021.

In the meantime…

It’s still ‘inflate or die.’ But now, consumer prices are coming down…and the economy still lives. The reason, we believe, is that the source of inflation has largely switched from the monetary front (the Fed’s interest rates) to the fiscal front (federal deficits). The Fed is still lending at around zero cost in real terms. But now, in addition, the federal government is running the biggest budget deficits in history.

‘Inflation’ refers, technically, to an increase in the money supply…which typically leads to an increase in prices. In today’s global economy, you don’t even have to spike your own punchbowl; about half of the world’s central banks are still lending money below the inflation rate…some as low as 6% below consumer price increases. Some of it is likely to leak in your direction.

But there are other ways to enliven a party. Turn up the music. Bring in a stripper. Pass out the hard drugs.

For the last 12 months, the US Government has been throwing the biggest shindig in history — spending about $130 billion per week — or nearly 14% more than the year before…and 40% more than before the COVID era blowout.

Bank bailouts…the slaughter in Ukraine…a boondoggle for the silicon chip industry — it adds up. And now, Government spending is headed toward 39% of the US economy (see below). Not since the Second World War has so much of US output been squandered by the Government.

Bananaless republic

The federales are taking charge of everything — deciding which industries will prosper and which won’t …which news reports are ‘disinformation’, and which are truth…telling foreigners what kind of governments they must have, where their borders should be, and with whom they should trade. The feds rig US markets…crony-fy its capitalism…and run deficits more suited to a Banana Republic (without the bananas!) than to a serious, developed country.

The Biden Administration, like the Trump Team before it, is not holding back.

David Stockman:

‘… for fiscal year 2023 to date the US federal deficit is up a staggering $900 billion to nearly US$1.4 trillion. That’s because YTD revenues are down $422 billion while outlays are higher by US$455 billion.

‘You can’t make this up. The one-time capital gains windfall harvested in FY 2022 is long gone, but they are still spending like drunken sailors. During the first nine months of FY 2023 receipts of US$3.4 trillion covered only 71% of outlays at US$4.8 trillion.

'Back in the day that would have been called Keynesian fiscal stimulus with a vengeance. But, alas, we supposedly have an overheated economy with a historically low unemployment rate of 3.6% but are running a budget deficit at 7% of GDP.’

Here’s The Financial Times with further comments:

‘Within 10 years, US Government interest payments will exceed spending on defence and on social programmes such as Medicaid. Through 2025, the trillions unleashed by this administration will push government spending up to 39% of GDP, most of it not covered by new revenue. In other big developed economies, spending is poised to fall sharply as a share of GDP, while revenues hold up relatively well. Under pressure from Congress last month, Biden signed the Fiscal Responsibility Act of 2023, creating the appearance of a new restraint. Despite what looks like large spending cuts of US$1.3 trillion over 10 years, the US deficit is still projected to hover near 6% of GDP throughout the next decade.’

When the music stops

The Fed, trying to pin the blame on anyone but itself, did a study showing that while more than 60% of the price increases came from ‘excess demand,’ half of that demand came from the federal government’s deficits.

Government spending is not in itself ‘inflationary’. If the funds were borrowed honestly, the money supply would not increase. Consumer prices would not necessarily go up. Instead, as the Feds’ borrowing increased, eventually interest rates would go up…stifling investment and spending, leading to a weaker economy and lower prices.

That is what is happening now…but slowly. The yield on the US two-year note has gone from around 2.7% a year ago to nearly 5% today…while the price of oil has fallen from over $120 a barrel last summer to under $80 today.

Like monetary inflation, fiscal inflation (bigger deficits) can keep the party going…for a while. But the underlying pattern is much the same — bringing spending forward while depriving the future of savings and investment. And either way, whether the source is fiscal or monetary, the formula is the same: either the inflation continues…or the boom dies.

Regards,

Bill Bonner,
For The Daily Reckoning Australia