The US 10-year Treasury bond is the benchmark for global interest rates and stock markets. And for the past 30 years it has been heading steadily downwards as the chart shows:
- US inflation rates finally peaked at 13.6% in 1980 (having been just 1.3% in 1960) as the BabyBoomers began to move en masse into the Wealth Creator 25 – 54 age group
- Instead of simply boosting demand, as during the 1960s-1970s, they began to work and create new supply
- This meant supply/demand began to rebalance and interest rates then peaked at 16% in 1981
By 1983, the average Western Boomer (born between 1946-1970) had arrived in the Wealth Creator cohort, which dominates consumer spending, and the economy really began to hum. There was a final inflation scare in 1984, when US inflation suddenly jumped from 3% to 5%, but after that the trend was downwards all the way.
The Boomers were the largest and wealthiest generation that the world had ever seen. Their move to become Wealth Creators completely transformed the inflation outlook, as more and more Boomers joined the workforce. And they transformed the economy by moving it into the NICE era of Non-Inflationary Constant Expansion.
Central bankers took credit for this move, claiming it was due to monetary policy. But in reality, people are the key element in an economy, not monetary policy. You can’t have an economy without people. And sadly, the idea that the US Fed Chairman Alan Greenspan had somehow become a Maestro, blinded everyone to 2 key issues for the future:
- Life expectancy was rising rapidly, meaning that the Boomers would not normally die just after retirement. Instead, they would likely live for another 15 – 20 years after reaching age 65
- From 1970, fertility rates had fallen below replacement level (2.1 babies/woman) across the Western world
This combination of a rise in life expectancy and a collapse in fertility rates was creating a timebomb for the economy.
THE RISE IN LIFE EXPECTANCY AND COLLAPSE OF FERTILITY RATES CREATED AN ECONOMIC TIMEBOMB
Western economies are based on consumer spending. And spending declines once people reach the age of 55 – they already own most of what they need, and their incomes decline as they approach retirement, as the second chart shows:
- There were 65m US Wealth Creator households in 2000, who spent an average of $62k ($2017)
- There were only 36m in the 55+ cohort, who spent just $45k each
- In 2017, there were 66m Wealth Creators (almost the same as in 2000) who spent $64k each
- But there were now 56m in the 55+ cohort, who spent just $51k each
The rise in 55+ spending was also only temporary, as large numbers of Boomers have just reached 55+ and have not yet retired. Spending by those aged 74+ was down by nearly 50% versus the peak spending 45-54 age group.
BELIEF IN MONETARISM LED TO THE DOTCOM AND SUBPRIME DISASTERS
The dot-com crash in 2000 should have been a wake-up call for the failure of monetarism. It also, after all, marked the moment when the oldest Boomers began to join the 55+ cohort. But instead, policymakers thought monetarism could solve “the problem” and cut interest rates to boost the housing market – causing the subprime crash in 2008.
One might have thought – as we wrote in Boom, Gloom and the New Normal in 2011 – that this disaster would have destroyed the monetarism myth. But no. Abandoning monetarism would have led to a difficult conversation with voters about the need for everyone to retrain in their 50s, and prepare to take on new, and less physically demanding, roles.
Instead, policymakers tried to replace lost BabyBoomer demand by printing vast amounts of free money via the Quantitative Easing and Zero Interest Rate Policies. Their aim was to avoid deflation, as inflation had fallen to just 0.6% in 2010 – although why this was a “bad thing” was never explained. But in reality, they were running uphill, and the pace of the climb was becoming more vertical, as the average Western Boomer joined the 55+ cohort in 2013.
Of course, flooding the market with cheap money boosted asset prices, as they intended. Stock markets and house prices soared for a second time. But it also created a major new risk. More and more investors began to panic as they hunted through the markets, trying to obtain a decent “return on capital”. They assumed central banks would never let markets fall, and so gave up worrying about the risk of making a dud investment.
INTEREST RATES ARE NOW HEADED HIGHER AS PEOPLE WORRY ABOUT RETURN OF CAPITAL
The end of the Bitcoin bubble has highlighted the fact that that risk and reward are normally related. Most investments that offer potentially high rewards are also high risk – a lot has to go right, for them to make the possible return. This process of price discovery – the balance of risk and reward – is the key role of markets.
Left to themselves, markets will price risk properly. But they have been swamped for the past decade by central bank liquidity and their crucial role has been temporarily destroyed. Now, the fact that the US 10-year bond has broken out of its 30-year downtrend tells us that markets they are finally starting to regain their role.
How high will interest rates now go? We cannot yet know, and we can also be sure they will not move in a straight line as central banks will continue to intervene. But as more and more investments, like Bitcoin, prove to be duds, so more and more investors will start to worry about return of capital when they invest.
4% therefore looks like the next level for rates, as we are now trading within the blue bars on the chart. It may not take very long for this level to be reached, given the fact that the world now has a record $233tn of debt – 3x the size of the global economy. After that, we shall have to wait and see.
I strongly believe that forecasts should be monitored, which is why I always review the previous Annual Budget forecast before issuing the next Outlook, and always publish the complete list of Annual Budget Outlooks.
I now plan to begin monitoring my blog forecasts, using the percentage mechanism highlighted in Philip Tetlock’s masterly “Superforecasting” book. The first forecasts relate to last week’s post on US polyethylene exports and today’s forecast for the US 10-year Treasury bond. I will change confidence levels as and when circumstances change.
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“Average UK wages in 2022 could still be lower than in 2008”
UK Office for Budget Responsibility
While Western stock markets boom under the influence of central bank money-printing, wages for ordinary people are not doing so well. So it is no wonder that Populism is rising, as voters worry their children will be worse off than themselves at a similar age.
The chart above is the key to the story. It shows births in the G7 countries (Canada, France, Germany, Italy, Japan, UK, USA) since 1921. They are important as until recently, they represented around 50% of the global economy. Equally important is the fact that consumer spending represents 60% – 70% of total GDP in each country.
As the chart shows, the absolute number of consumers saw a massive boost during what became known as the BabyBoom after the end of World War 2:
- The US Boom lasted from 1946 – 1964, and saw a 52% increase in births versus the previous 18 years
- The Boom lasted longer in the other G7 countries, from 1946 – 1970, but was less intense
- In total, there were 33 million more G7 births in 1946 – 1970 versus the previous 25 years
- This was the equivalent of adding a new G7 country the size of Canada to the global economy
Today’s dominant economic theories were also developed during the BabyBoom period, as academics tried to understand the major changes that were taking place in the economy:
- Milton Friedman’s classic ‘A Monetary History of the United States’ was published in 1963, and led him to argue that “inflation is always and everywhere a monetary phenomenon”
- Franco Modigliani’s ‘The Life Cycle Hypothesis of Saving‘ was published in 1966, and argued that consumers deliberately balanced out their spending through their lives
Today’s problem is that although both theories appeared to fit the facts when written, they were wrong.
We cannot blame them, as nobody during the 1960s realised the extraordinary nature of the BabyBoom. The word “BabyBoom” was only invented after it had finished, in 1970, according to the Oxford English Dictionary.
Friedman had no way of knowing that the number of US babies had risen by such an extraordinary amount. As these babies grew up, they created major inflation as demand massively outgrew supply. But once they entered the Wealth Creator 25 – 54 age cohort in large numbers and began working, supply began to catch up – and inflation to fall.
Similarly, Modigliani had no way of knowing that people’s spending began to decline dramatically after the age 55, as average US life expectancy during the BabyBoom was only around 68 years.
But today, average US life expectancy is over 10 years higher. And as the second chart shows, the number of households in the 55+ age group is rocketing, up by 55% since 2000. At 56m, it is fast approaching the 66m households in the critical 25 – 54 Wealth Creator cohort, who dominate consumer spending:
- Each Wealth Creator household spent an average of $64k in 2017, versus just $51k for those aged 55+
- Even this $51k figure is flattered by the large number of Boomers moving out of the Wealth Creator cohort
- Someone aged 56 spends almost the same as when they were 55. But at 75+, they are spending 47% less
- Older people already own most of what they need, and their incomes decline as they approach retirement
Unfortunately, today’s central bankers still base policy on these theories, just as Keynes’ warned:
“Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back”.
The result is seen in the third chart from the Brookings Institute. It highlights how labour’s share of income has collapsed from 64% in 2000 to 57% today. The date is particularly significant, given that the oldest Boomers (born in 1946), reached 55 in 2001 and the average US Boomer became 55 in 2010.
- Fed Chairman Alan Greenspan tried to compensate for this paradigm shift from 2003 by boosting house prices – but this only led to the 2008 subprime crisis which nearly collapsed the global economy
- Since then, Fed Chairs Ben Bernanke and Janet Yellen have focused on boosting the stock market, as Bernanke noted in November 2010:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
But fewer Americans own stocks than houses – only 54% versus 64% for homes. So “printing babies” cannot work.
The real issue is that the dramatic increase in life expectancy has created a paradigm change in our life cycle:
- It is no longer based on our being born, educated, working, retiring and then dying
- Instead, we have a new stage, where we are born, educated, work, and then retrain in our 50s/60s, before working again until we retire and then die
This transition would have been a difficult challenge to manage at the best of times. And having now gone in the wrong direction for the past 15 years, we are, as I warned last year, much closer to the point when it becomes:
“Obvious that the Fed could not possibly control the economic fortunes of 321m Americans. Common sense tells us that demographics, not monetary policy, drive demand. Unfortunately, vast amounts of time and money have been wasted as a result. The path back to fiscal sanity will be very hard indeed.”
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These are difficult times for companies and investors. It is becoming more and more apparent that central bank stimulus policies have failed to counter today’s demand deficit, caused by ageing populations. It is also clear that central bankers themselves have little idea of what is happening in the real economy.
They have based their programmes on outdated and unreliable theories from former gurus such as Milton Friedman and Franco Modigliani:
- Friedman didn’t realise that a BabyBoom was taking place when he developed his theory that “inflation is always and everywhere a monetary phenomenon”. He therefore confused cause and effect, as hindsight tells us it was clearly excess demand from the young Boomers – when supply was literally “bombed-out” after World War 2 – that caused the inflationary problems of the 1960s/1970s
- Modigliani’s lifecycle consumption theory was similarly flawed. His view that people would even out their consumption in the best possible manner over their lifetimes appeared to make sense in the 1950s, when most people died before or close to pension age. But it makes no sense at all when 65-year old Western pensioners now have 20 years of unexpected life expectancy ahead of them
Both Friedman and Modigliani can be forgiven their mistakes, as there was no reliable data at the time they were working, to explain the errors in their thinking. But today’s central bankers have no such excuse. Western fertility rates have been below the replacement level of 2.1 babies/woman since 1970 – making it obvious that spending and hence economic growth would slow, and then probably decline, as the Boomers moved into retirement. And slowing demand would automatically reduce inflation, no matter what they did to the monetary supply.
Investors have chosen to ignore these factors until recently. Instead they have taken advantage of the free cash available from central banks to boost the prices of financial assets – whether these were commodities such as oil and copper, or houses or stocks and shares. But all good things come to an end. And they are becoming unpleasantly aware that if central banks really don’t know what is happening in the real economy, then populist solutions provided by Donald Trump or Brexit leaders may end up causing chaos in their markets.
We saw these first signs of doubts on Friday, when the major decline in US jobs growth – which fell back to 2010 levels – clearly shocked the US Federal Reserve. But far from celebrating the potential for new stimulus programmes, investors pushed US share prices down for the day.
This new caution is also reflected in this month’s Boom/Gloom Index above. It has fallen back again after the euphoria that followed the Fed’s decision to back off the promised interest rate rise in March. Now, I suspect, many investors would prefer an increase to come quickly, to reassure them that recovery was still possible.
It could be a long and difficult summer, particularly if the Leave campaign maintains its current opinion poll lead into the vote itself – now less than 3 weeks away. Attention is also shifting to the potential implications of a narrow Remain vote for the ruling Conservative Party. Many believe the Party could split if this occurred, such has been the bad feeling during the campaign. This could end up handing the keys for 10 Downing Street to the opposition Labour Party.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 52%
Naphtha Europe, down 52%. “The loss of naphtha supply from French refineries has been offset by loss of naphtha demand from French crackers”
Benzene Europe, down 57%. “a steady flow of imports into Europe since the start of 2016 have kept the market well supplied.”
PTA China, down 41%. “Demand from spot buyers in the market was also lower, as the peak seasonal demand has started dipping”
HDPE US export, down 29%. “China’s market outlook is cautiously negative due to expectation of increased supply”
¥:$, down 4%
S&P 500 stock market index, up 7%
After 6 years of largely-wasted stimulus efforts, the world’s economic advisory bodies are finally having to accept that ageing populations really do impact economic growth.
The latest International Monetary Fund’s latest World Economic Outlook finally breaks half of the taboo that has stopped most economists from accepting this seemingly common sense conclusion. Its Summary argues as follows:
- “Potential output growth has declined since the global financial crisis
- Decline reflects impact of aging; lower capital and productivity growth
- Policy action required to boost productivity, foster capital growth, and offset the effects of aging”
Thus the impact of “aging” is highlighted twice in the Fund’s 35-word Summary. And the IMF then focuses on the adverse employment impact in the above 2 charts. These show a major decline underway in both the working age population (blue column) and labor force participation rates (red) in the Advanced and Emerging economies. In turn, this means the previously positive net effect (yellow line) on growth is now disappearing.
Of course, this is major progress, and must be welcomed with both arms. But as with the recent Bank for International Settlement paper, “Can demography affect inflation and monetary policy?”, the IMF still holds on to the other half of the taboo – that aging does not affect demand.
In many ways, this is not surprising. The world has never before had an aging population. Even as recently as 1950, most people in developed countries died fairly soon after retirement. And most people in emerging economies died before retirement. So there is no previous history for economists to model.
Equally important is that most have learnt to model demand as a multiple of GDP growth. In petrochemicals, for example, ethylene growth is typically assumed to be 1x GDP. So few have seen a need to separately model demand.
However, there is plenty of evidence to confirm that consumption is age-related. National consumption surveys consistently highlight this key feature, as I noted in the Financial Times last week for the UK economy:
“Consumption is around 60% of GDP. Thus the boomers created an economic supercycle as they moved into the 25-50 age group, when spending and incomes typically peak. But now the pendulum is swinging the other way. The ageing of the boomers means the majority of UK households have been headed by someone aged over 50 since 2002.
These older households already own most of what they need, and their incomes are declining as they head into retirement. At the same time, lower fertility rates mean there are fewer households in the highest-spending 30-49 age group. Thus average household expenditure has been in steady decline since 2006 in real terms”
The problem is that this data is not commonly tracked by economists, who have been taught by Friedman and others to focus only on the supply side of the economy. Thus as another economist, JM Keynes, wrote as long-ago as 1936:
“Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.”
Demand is, however, the key determining factor in the New Normal. Companies and investors who recognise this will have an unbeatable competitive advantage for years to come. Others will simply have to wait for the world’s advisory bodies to wake up to the other side of this ‘New Reality’.
The blog found it hard to believe, when it started to research for Boom, Gloom and the New Normal, how little information existed on basic facts such as population size and annual births. Some countries such as the UK and Japan have data going back a century. But they are the exceptions:
This helps to explain why economists have generally failed to understand that changing demographics have economic impact. Milton Friedman, the famous monetarist and Nobel Prize-winner, is the obvious example. Working in the 1960s, he could have had no idea that the US BabyBoom was underway:
- We know today that there was a 52% increase in births between 1946-64, compared to the previous 18 years
- But he couldn’t possibly have understood what was happening, as the data didn’t exist at that time
- The word ‘BabyBoom’ itself doesn’t appear in the blog’s 1973 edition of the Oxford English Dictionary
- Web research suggests the first use of the word in this context was as late as 1977
This simple bit of history has vast implications for economic policy.
Friedman won his Nobel Prize for his work associating increases in money supply with inflation. But with the benefit of hindsight, it is clear he confused cause and effect.
The US, like the rest of the developed world, experienced a surge in demand in the post-War period. The reason was the unprecedented increase in the number of babies being born – and staying alive. A century ago, large numbers of babies died in their first 5 years of life. But this suddenly stopped once drinking water became safe to drink (due to the use of chlorine), and vaccines became available to protect against dangerous diseases such as tuberculosis.
So as these babies grew up, they needed more and more things. Yet the wartime economy was still in recovery mode. It takes time to turn factories made to produce tanks into plants that can produce washing machines. The situation in Europe was even worse, as much of the industrial landscape was bombed out.
Tpday, it is therefore obvious that the inflation from 1970 onwards was due to a surplus of demand relative to supply. Markets were doing their job, and allocating product by raising prices. What else could they do? Even when governments introduced price controls, they inevitably failed, as President Ford found with his 1976 WIN programme – Whip Inflation Now!
DEFLATION IS NOW INEVITABLE
The 1980s saw this process start to reverse as the chart shows above. As the Boomers reached the 25-54 age range and their Wealth Creation period, so supply began to increase to meet demand. And their savings became available to further increase supply via pension fund investment in the stock market.
Crucially, however, inflation meant it made sense to borrow money, as its real value then declined. And it made sense to borrow to buy the products one needed, as their cost would reduce. Thus an early MasterCard slogan to highlight the benefits of a credit card was ‘Take the Waiting out of Wanting’.
Now, of course, we are living in the reverse of this world. We have relatively few people in the Wealth Creation generation. And for the first time in history, we have large and increasing numbers of people in the New Old 55 plus generation. They of course are a replacement economy, as they already own most of what they need. And their incomes are declining as they enter retirement.
Policymakers thus made an critical mistake in assuming that monetary policy could boost demand and restore inflation. It is obviously unfair to blame Friedman for this, as he couldn’t have known this background. But they could, and should, have known their policies were based on a false premise.
Now we are simply waiting for the catalyst to arrive that will cause deflation to become normal. And that catalyst could well be a fall in the oil price.
This would have a dramatic impact on purchasing decisions down the chain:
- Today, of course, we now have too much supply and too little demand – the reverse of 1973
- The collapse of fertility rates along with increased life expectancy means yesterday’s ‘demographic dividend’ has become a ‘demographic deficit
- The arrival of deflation will make people realise it is instead sensible to postpone purchases as prices will be lower in the future.
- They will also try to repay debt, as it will become more expensive in real terms.
Another critical transition will follow from this:
- Income will become the key metric for consumption again
- ‘Wealth effects’ from increased asset prices will disappear, further reducing demand
Policymakers’ stimulus programmes have wasted $tns by failing to recognise the obvious economic impact of today’s massive changes in demographics. The US, for example, has spent $10tn alone over the past 6 years – $6.27tn in federal deficits and $3.63tn on the Federal Reserve’s money printing programme.
Now the rest of us will have to pick up the bill from their mistake.