As investors we have to keep a watchful eye on not just the financial news, and the charts, but the world around us. Are businesses in your local area booming? Are people you know getting pay rises, or are they losing their jobs? Are your friends and family optimistic about the coming year?
Oxford Street in Paddington, Sydney, is one of the most famous streets in Australia, yet today there’s an unsettling number of vacant premises lining the street. Directly across from the Chauvel cinema, in probably the heart of the up-market shopping district, roughly over one in five businesses has closed its doors. Once-bustling fashion boutiques are now empty shells, a dire situation for the few remaining tenants trying to keep up appearances next door.
This week we learnt that Australian banks could be laying off as many as 7000 jobs over the coming two years. ANZ plans to cut 700 staff this year. Retail jobs are getting scarcer as a disappointing Christmas period points to rising insolvencies and closures later this year.
A popular phase for the ongoing financial crisis is the Great Recession. But Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University, and former chief economist at the IMF, refuses to accept the notion that the current crisis is a recession – because recessions are fairly frequent events that rarely last long. Instead, he prefers to coin this crisis the “Second Great Contraction,” and argues that the first great contraction was, of course, the Great Depression. “Great Contractions, as opposed to recessions, are very infrequent events, occurring perhaps once every 70 or 80 years, ” he writes.
Rogoff writes that the global economy is badly overleveraged and there is no quick escape without a scheme to transfer of wealth from creditors to debtors, either through defaults, financial repression or inflation.
Australian economist Steve Keen agrees that the stgeleraging process will take years, even decades, to unravel. The chart below compares today’s crisis to that of the Great Depression. The red line is the debt ratio, or private debt as a percentage of GDP, which you can see is significantly higher today than at the time of the Great Depression. You can also see that the red line has started its steep descent; the dotted black line is hand-drawn by Keen himself as a guide to the future.
Based on Keen’s analysis, if individuals pay back debt at around 7.8% per annum, it could take until 2025 to reach close to the long-term mean. In essence, people will be paying back debt well into the next decade, which will stifle consumption spending, business activity and employment growth.
If you think that this current downturn will be over soon, think again.
The credit crisis has unfortunately coincided with another important event, which is the retirement of the largest and wealthiest demographic group in history, the baby boomers (those born between 1946 and 1964). Today, the youngest members of this group are age 48, and the oldest are age 66. Over the next two decades, this group will move from wealth accumulation to retirement, selling assets, drawing down income, and moving investments from risky to less risky asset classes.
According to two authors at the Economic Research Department of the Federal Reserve Bank of San Francisco, Zheng Liu and Mark Spiegel, the looming concern is that this massive sell-off might depress equity values.
In fact, the authors attribute the sustained asset market booms in the 1980s and the 1990s partly to the fact that baby boomers were entering their middle ages, which is the prime period for accumulating financial assets.
The charts below offer an insight into the relationship between demographic trends and stock prices. The M/O ratio is the ratio of the number of people aged between 40 and 49, to the number of people age 60-69. The higher the M/O ratio, the greater is the number of people in their peak wealth accumulation phase of life. As the M/O declines, more people are in the retirement phase.
Interestingly, the M/O ratio is compared against the P/E of the US stockmarket. As you can see, a higher M/O ratio tends to coincide with a high P/E ratio. This makes sense; when people are racing to save for retirement they shovel as much money as they can into managed funds, stocks, DIY super funds and the like. As a result, shares rise and P/E ratios rise in tandem.
But what happens when the bulk of baby boomers move into the older age bracket? The researchers extrapolate the date into 2030 as you can see in the chart below. Based on this analysis, the P/E of US stocks will fall to around 9 by 2020.
The study concludes that the future for real stock prices is quite bearish. “Real stock prices follow a downward trend until 2021, cumulatively declining about 13% relative to 2010. The subsequent recovery is quite slow. Indeed, real stock prices are not expected to return to their 2010 level until 2027.”
So when can we expect a sustained uplift in equity prices. Not until 2025, according to the study. By 2030, our calculations suggest that the real value of equities will be about 20% higher than in 2010.
Clearly, just because an economist has drawn a pretty graph doesn’t mean that they can foretell the future. Instead, we should use the information to sensibly invest over coming years.
Although the analysis above is bleak, it doesn’t mean that no one will make money over coming decades. Money is still sloshing through the system, and the rich will continue to find the hot spots. The list below offers a guide to the next hot investing spots, and places where your money is more at risk.
Investments to watch
– Leading Asian stocks will only get bigger. The trick is to find the standout performers that are on track to be the next mega-corporations.
HSBC notes that 19 of today’s emerging-market countries will be amongst the 30 largest economies by 2050 – more important than the current mix of OECD countries.
Already there are around 21,500 multinationals in emerging markets, with many leaders in their sectors such as Indian IT outsourcing firm Infosys, Chinese battery manufacturer BYD and Mexican cement company Cemex, according to Javier Santiso, Professor of Economics at ESADE Center for Global Economy and Geopolitics.
China’s telecom company Huawei is already head to head with Sweden’s Ericsson, registering more patents in 2008 than any other company in the world. In the telecommunications sector there are roughly 6 emerging market multinationals in the global top ten. Santiso also mentions that Israel has launched more than 4,000 start-ups – ranking second in the world in the number of companies quoted on the NASDAQ.
The number of rising stars out of Asia is likely to continue. A report from UNESCO notes that China spends over $100 billion per year on Research & Development, almost surpassing the US and Europe combined in the number of researchers on deck. In 2010, some 40% of all Chinese university students were studying for science or engineering degrees, over double the share in the US.
– Stocks that benefit from rising insolvencies such as debt collection agencies are sitting on a gold mine in this climate.
Areas of weakness
– Be wary of large managed funds that replicate underlying sharemarket returns; very large managed funds with billions of funds under management often have little option than to replicate the performance of the underlying index. Smaller, boutique managed funds have more scope to outperform an index by successful stock picking.
– Be wary of stocks exposed to areas of weakness such as sluggish consumer spending, deteriorating business conditions and falling home prices. Property trusts and REITS are a key area of concern. If you look around your neighbourhood and notice a rising number of vacant retail outlets, ensure that it’s not a warning sign for REITS held in your portfolio.
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