Business Conditions, Sentiment, the USD and Gold

File under confirmation bias:

The Philly Fed’s Business Conditions Index is still hanging tough after its most recent update, though it’s still slightly negative relative to historical data.

A point of interest we came across on the Philly Fed’s site is its regional July Business Outlook survey (pdf). The apparent downturn in sentiment in early 2010 appears to coincide with our “strong dollar” call in January 2010, which was based heavily on increasing verbal hawkishness (pdf) from the Obama administration on fiscal matters:

The timing could very well be coincidental, but we think sentiment and fiscal expectations are related at some level, which may be supported by some other interesting features in that graph, from a “sectoral balances” point of view.*  

One is that business sentiment was most buoyant at the time of President Bush and the GOP’s major fiscal easings in 2001 and 2003 (blue circle); the other is the steady downward trend in  sentiment as the Clinton administration’s and Dole-Gingrich GOP’s widely revered budget surpluses were materializing (green line):

Again, this is purely circumstantial evidence, and would require much more analysis to see if anything academic can be made of it. But it does fit nicely with the theoretical frameworks we’re relying on to guide clients through these “interesting times”.

It might also be reassuring that the USD has taken a slight break from its strengthening trend (the red line below is the inverted trade weighted USD index inverted, and the blue line is foreign commercial paper, a measure of foreign credit and business activity in the private sector).

While it’s not at a level that augurs an imminent return to the headiness of 2007 and early 2008, some stability at current levels would be a welcome sign for the world’s credit, goods, and services markets:

There’s also an interesting new bit of evidence that supports our Nov-Jan warnings of a strengthening USD and weakening gold prices. From the FT:

…more than 10 [banks] based in Europe…swapped gold with the Bank for International Settlements in a series of unusual deals that caused confusion in the gold market and left traders scratching their heads…

The Financial Times has learnt that the swaps, which were initiated by the BIS, came as the so-called “central banks’ bank” sought to obtain a return on its huge US dollar-denominated holdings. The BIS asked the commercial banks to pledge a gold swap as guarantee for the dollar deposits they were taking from the Basel-based institution…

Some analysts speculated that the swap deals were a surreptitious bail-out of the European banking system ahead of last week’s publication of stress tests…

…two central bank officials said some of the commercial banks…needed the US dollar funding and were keen to act as a counterparty with the BIS. The gold swaps began in December and surged in January, when the Greek debt crisis erupted and European commercial banks were facing funding problems…

In other words, large banks on the continent were more than willing to swap gold for USDs with the BIS when facing credit strains and stress tests. This is something to keep in mind among all the gold bug chatter — unbacked paper or “fiat” money can become dear, even relative to precious metals. Witness gold’s long term decline against the Yen as Japan’s balance sheet recession and negative turn in age structure unfolded:

 The wrench, as we always try to point out, is the USD’s global reserve status. More dovish monetary policy in the U.S. (which can only be accomplished via renewed “quantitative easing” and its distorting impacts) could very well stoke renewed inflationary pressures abroad, with feedback effects on certain components of U.S. price levels. In fact, the deep decline in Yen per gold ounce might have been driven in part by the absence of Yen carry trade mechanisms. Once those mechanisms were in place and more widely available (circa late 1990s or early 200s?), Yen-gold was freed to the upside.

The fact that the USD is the traditional carry trade currency is a reminder that USD-gold could still have plenty of room to run, and that uncertainty is why we are not placing any bets on gold prices, either to the upside or the downside. But to the extent that any rally is driven by Ponzi-style leverage — which is still quite possible due to the anemic and slow moving nature of some of the reform measures in Dodd-Frank – gold will, like residential real estate before it, eventually come crashing back down to more normal levels.

It may even be near “normal” levels now. The caveat we’re trying to put forth is that if fiscal, trade, or monetary policymakers err on the hawkish side in the next five to ten years, then USDs will be in scarcer supply, and all else equal, that would mean lower prices generally — even for gold.

One last note — preliminary second quarter GDP came in light at 2.4%. This is a steep fall from recent quarters, and it too lends some support to our argument (and others’) that federal stimulus played a significant role in driving and/or supporting private sector activity in 2H09 and early 2010.  That’s why we think that any concerted move towards fiscal tightening in the quarters ahead — whether through tax cut expirations (we’re talking to you, Democrats) or spending cuts (ahem-ahem-ahem, GOP) — will substantially raise the probability of a second recession.

* We note that the New School’s History of Economic Thought (HET) website has yet to publish anything on the recently deceased Wynne Godley, who helped to articulate the intersectoral balances approach. As with age structure, underappreciation implies to us that Godley’s balances framework can be put to an investor’s advantage. 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. You should consult with your personal financial advisor before engaging in any investment activity. Any mention of investable companies and/or securities is incidental and for illustrative purposes only.

When Smart People Are Wrong

In a recent interview (July 16th), Roger Lowenstein recommends that investors sell bonds “yesterday”.

Nassim Taleb claimed earlier this year that ”It’s a no-brainer. Every single human being should have that trade: short Treasury bonds in the U.S.” (quoted on p. 22 in the August 2010 issue of Smart Money; see also http://www.bloomberg.com/apps/news?pid=newsarchive&sid=azLmks3BmQm4)

Lowenstein sees parallels to the 1970s (according to Bloomberg, Taleb did not elaborate on the rationale behind his statement). As our recent interview with Diane Macunovich shows, the 1970′s are a poor benchmark for today. The experiences of the U.S. in the 1930s and Japan since 1990 are far more relevant. And in both periods shorting domestic treasury debt was a “black widow” trade.

There may well be a time during Lowenstein’s and Taleb’s lives when U.S. Treasuries lose significant value. But barring large, forceful, and persistent fiscal stimulus, that time is not now.

Rob Arnott, another smart guy, is (like many other smart people) sweating U.S. deficits and debt, claiming that the U.S. has “a government and a society addicted to debt financed consumption.” He asserts that GAAP accounting would put total U.S. federal debt at 800% of GDP, and predicts several inflationary shocks in the decades ahead, recommending inflation insurance such as TIPS and commodities. He’s absolutely right that one should buy insurance when it’s cheap, but to estimate the value of insurance, you need to estimate the probability of whatever outcome you’re insuring against. Arnott clearly believes that it’s almost a sure thing U.S. inflation will run above the current premium on TIPS.

However, we place a far higher probability on the U.S. following a path similar to Japan’s in the decade ahead. Thus, investors should be prudent about how much they’re willing to “spend” — in foregone nominal returns on other securities – for inflation insurance. There is no free lunch, after all. Insurance always costs something.

Besides the similarities to Japan’s situation a decade earlier, competing macro frameworks also argue against the inflation bulls and Treasury bears. The alternate view of deficits, debt, and inflation was captured well in a recent paper from the Levy Institute entitled “Uncle Sam Won’t Go Broke”:

Many investors, policymakers, and economists take it as fact that soaring government debt inevitably leads to inflation. This fear comes in several versions. Sometimes the emphasis is on the prospect of a stealth default by the government as inflation shrinks real debt service payments; sometimes it is on the consequences of serious future inflation for the economy as a whole. Many analysts assert that spiraling public debt growth will force central banks to monetize the government debt and that this action will assure worsening inflation. Others argue that central banks will choose to pursue policies of high inflation in order to chip away at the debt burden. In fact, deflation, not inflation, is the danger during the next several years in the United States and most of the world’s advanced economies. Moreover, the fears of inflation are based on flawed logic and contrary to the historical record. In the United States and many other developed countries, as in Japan in the 1990s, the macrofinancial circumstances that are presently causing the continuing, large deficits will also keep the economy unusually weak and disinflationary even as monetary policy remains accommodative. Deflation has already been a problem in Japan for over a decade, and it is not far away in the United States, where inflation, measured using the core CPI, was well below 1% and falling in the latest six months…

Could we see a surge in inflation a decade down the road? Perhaps, but it will not be because government debt caused it or the government stealthily engineered it. The biggest inflation threat will be the effect of a secular revival of rapid demand growth on scarce resources. In all probability, the end of the contained depression will bring an era of private sector balance sheet revival, involving not only robust growth, strong tax revenues, and shrinking public debt but also strong investment, which will lead to productivity gains. Those productivity advances, along with deflationary expectations ingrained during the contained depression, will tend to offset the inflationary pressures of rising resource prices. Most likely, deflationary conditions will give way not to galloping price increases but to moderate inflation.

Because Japan is roughly a decade ahead of us in age structure, it should provide us with a glimpse of the outcome described in that last paragraph in the decades ahead.

And the “intersectoral balances” folks, who were among the only economists to see the crisis coming, argue that federal government deficits have long fallen short of where they needed to be to accomodate the demands of the private sector. Consider this now classic 2003 brief from Randy Wray (emphasis added):

Partially due to budget-balancing agreements, partially due to large increases of Social Security taxes in the 1980s, and partially due to a long-term trend to devolve spending responsibility to the states, the federal budget has become excessively biased to run surpluses at moderate rates of economic growth. These surpluses, in turn, require that the nongovernment sector taken as a whole (including households, firms, and the foreign sector) must run deficits. Indeed, the record budget surpluses achieved during the Clinton years were matched by unprecedented domestic private sector deficits—that reached above 6% of GDP.This leads to the second headwind. The US private sector has been spending more than its income every year since 1996. The long-term legacy is record indebtedness that burdens households and firms. As is widely recognized, firms have already cut back spending as they try to work off some of this debt; short-term tax incentives will not induce firms to undertake new projects given idle capacity and heavy indebtedness. American households are widely given credit for the recovery (albeit, an anemic one) as they have continued to borrow and spend. However, no one doubts that consumption is running out of steam. No “revenue neutral” tax cut plan is going to reduce the burden on households and encourage continued growth of consumption…

[D]evolution has placed more responsibilities on state budgets. This is undesirable for two reasons. First, state taxes are regressive (highly so in some cases), placing the heaviest burden on those least able to pay. More importantly, states must act procyclically, increasing spending in a boom (fueling the boom) while slashing spending and raising taxes in a slump (there is little doubt that states helped to turn the early 1990s recession into a “double dip”). It is time for the federal government to increase grants to states, especially on a counter-cyclical basis. Only the federal government can lean against the wind, cutting taxes and increasing spending in a recession. 

Finally, the US trade deficit has trended upward over the past two decades. Unlike many economists, we do not view this with alarm. In our view, the trade deficit results mostly from insufficient demand in the export surplus nations, and a trade deficit allows American consumers to enjoy real benefits (after all, exports are a cost and imports are a benefit). At the same time, however, we recognize that all else equal, a trade deficit reduces American demand for domestic output. Given a balance of payments deficit equal to about 4% of GDP, the US government sector must run a deficit of 4% of GDP simply to allow our private sector to balance its own budget (with spending equal to after-tax income). Hence, all else equal, the federal budget should be biased toward a deficit—not a surplus—at moderate rates of economic growth. The appropriate structural adjustment is on the order of 6-7% of GDP( $600-700 billion).

As we’ve always been careful to point out, domestic monetary policy and trade deficits can contribute to inflation via tradable goods prices — logically, that’s the only way that ”stagflation” can occur (stubbornly refusing to lower tax rates on corporate profits earned abroad — much less raising them! – might add marginally to those pressures, but their more important effect is to limit domestic investment by U.S. multi-nationals). 

But with household consumption on a lower trajectory in the U.S., we should be so lucky as to have to worry about importing inflation. Referring again to our interview with Diane Macunovich, without the explosion of household formation that was led by baby boomers from the late 1950s to 1980 — in many countries – we just don’t see a repeat of 1960s and 70s style inflation as a remotely possible outcome.

Wray’s missive also brings up an important political consideration. Instead of continuing to laud the Clinton-Dole-Gingrich era surpluses, Democrats and others on the left should read and re-read the Wray piece, in which he endorsed the deficits likely to result from the Bush tax cuts (if not the particular types of cuts themselves). The longer they hew to the ‘fiscal discipline’ dogma of the New Democratic Leadership Council and the old Bentsen-Rubin-Summers axis of Clinton Treasury Secretaries, the more likely they are to be turned out on their ears in 2010 and 2012.

Finally, for those who still need confirmation that fiscal policy should remain loose until the private sector is in better balance (ideally via well designed spending and tax cuts, for a decade or more if that’s what it takes), consider these recent comments from former Fed chair Alan Greenspan:

Greenspan, in a telephone conversation…said his position is that all the expiring Bush tax cuts should end, for middle-class and high- income families alike.

Ending the cuts “probably will” slow growth, Greenspan, 84, said in the TV interview. The risk posed by inaction on the deficit is greater, he said.

“Unless we start to come to grips with this long-term outlook, we are going to have major problems,” said Greenspan, who led the U.S. central bank from 1987 to 2006. “I think we misunderstand the momentum of this deficit going forward.”

Greenspan said reducing the deficit is “going to be far more difficult than anybody imagines” after “a decade of major increases in federal spending and major tax cuts.”

Ask yourself how many things the man has been wrong about in the past two decades, and then ask yourself if he’s likely to be right about this issue. We don’t need to, but if we did, our answer would be a resounding “No.”

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Some clients of the firm own TIP, TLT, nominal Treasuries, and Treasury Inflation Indexed Securities (also known by the acronym TIIS or “TIPS”).

Philly Fed’s Business Conditions Index Update

The Philly Fed’s Aruoba-Diebold-Scotti index recently fell to its lowest level since the middle of 2009:

This isn’t necessarily a reason to panic. The way the index is constructed, its most recent reading is only slightly below its long term average, which is deliberately set at zero. Historically, the index has fallen well below -1.0 during recessions (with 1977 and 2005 the notable exceptions):

Our takeaway from the ADS data:

• We do appear to be in the midst of a soft patch. 
• A near-term (2010) double dip into recession still looks unlikely to us.
• Considerable uncertainty remains in 2011-2012 and beyond.
• There are very few upside risks to economic growth on the horizon.

Whether the current ”soft patch” is due to seasonal or other factors is unclear, and the same cross-currents affecting most economic data are also at work in real time indicators of economic activity like shipping and trucking. For example, the Journal of Commerce reports that only 2% of the world’s container ships are currently idle (some sleuthing is called for, e.g., do non-idle tonnages include ships being leased for storage purposes?). Meanwhile, rail shipments continue to improve upon 2009, but we’ve heard a couple of troubling (and note: unverified!) anecdotes: first, that this may be due to the diversion of freight from Canada to the U.S. due to a strike at the Port of Montreal; and second, that the usual seasonal back-to-school traffic isn’t being seen by folks on the ground.

The recent Railfax data on Kansas City Southern (KSC) also raises some questions about the health of the U.S. and/or Mexican economies (if memory serves, KSC transports a relatively high volume of automobiles, but the cash-for-clunkers program ended in 2009):

It might be worthwhile to investigate the final destinations for other carriers’ traffic volumes which have help up better as of late. For example, what proportion of their shipments have been headed to Canada versus the U.S.? A higher than normal proportion to Canada would make sense, as we expect it to be the strongest of the three North American economies in the years ahead. It would also lend support to the Port of Montreal thesis, and imply that the U.S. economy is not as healthy as overall rail volumes suggest. The Port of Montreal strike ended over the weekend, so we’ll be watching the Railfax report to see what impact this might have, if any, on other carriers’ volumes, and what the potential implications are for U.S. GDP. It’s within the realm of possibility that those data could support the double dip in 2010 camp. We’ll see…

If our four-point assessment above proves to be well grounded, then inflation risk is low, sovereign debt is decidedly not in a bubble, and equity markets will continue to be range bound, unless or until there’s a significant break with the status quo in terms of slow expansion, current fiscal and monetary policies, and/or renewed credit stresses. Our approach in this kind of environment:

• We are being selective with our riskier investments (primarily equities). Healthy cash flows and prices below estimated fair value are critically important (as always!). And long-term investors should consider that a buy-and-hold approach to equity index funds could very well under perform Treasuries for several more years, if not another decade. At the very least, a sound rebalancing process, and adherence to it, is called for.
• We are not shying away from longer term sovereign debt. If long term growth in developed countries will be in the 1-2% range in the years ahead, and inflation is tame or negative, then a nominal 3-4% on long term Treasuries makes for a respectable real yield. Japan since 1990 is a far more reliable benchmark in this case than the 1960s and 70s, in our view.
• We still believe that the rush into gold is somewhat overdone. But that bubble could have a ways to go, so at the moment, we are avoiding it on both the long and the short sides. If desired as a portfolio holding, exposure to other precious metals — though they tend to be more volatile than gold — could be worth a look.
• Where appropriate, we are holding significant cash allocations as a hedge against volatility and uncertainty, and in order to take advantage of opportunities as they arise.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Neither the firm, its clients, nor its principals hold any positions in securities issued by KSC. Any mention of investable companies and/or securities is incidental and for illustrative purposes only.

Optimistic analysts and another stimulus debate

A friend sent us a great new study from McKinsey on equity analysts’ persistent tendency to make rosier forecasts of the future than actually occur, apparently due to thinking in (very human) linear terms, when the underlying dynamics are decidedly non-linear. We intended to post the piece when time allowed, but noticed that Prieur de Plessis beat us to the punch: http://seekingalpha.com/article/215325-a-generation-of-overoptimistic-equity-analysts

Prieur also linked a video to yet another stimulus debate, this one between Keith McCullough (“cut spending now”) and Barry Ritholtz (“don’t repeat the errors of 1936-37″).

When Keith McCullough says government needs to tighten its budget alongside households to get more in line with the economy, he shows that he doesn’t yet grasp the reality of sectoral balances (government, corporate, household) under a sovereign fiat monetary system. 

He’s also way too myopic when he says that a negative multiplier to government spending has been “proven over decades of history”. That’s bunk — bunk that we ourselves subscribed to in the not too distant past – as we’ve pointed out here, here, here, here, here, and here.

And several recent “decades of history” probably make for a very poor sample, as articulated in our recent interview with economist Diane Macunovich.

Ritholtz urges Obama to follow the Reagan playbook and invokes a payroll tax holiday (for employers, not employees, unfortunately). At the end of it, they’re nodding in agreement and talking about the potential value of tax holidays, while observing that states have had to cut back on traditional seasonal sales tax holidays.

The endpoint of this kind of discussion should be patently obvious — with households and state and local governments on their backs, with no ability to produce the dollars needed to meet their obligations, the federal government must spend new dollars into existence (or spend existing savings, if the traditionalists insist, even though the direct beneficiaries are the corporate/financial sector and not local governments or households) in ways that are fair, equitable, and supportive of those sectors if we are to avoid a deflationary spiral.

A payroll tax holiday for individuals, and a more certain (and dovish) outlook on tax rates are both great places to start.

Long term, we also like Ritholtz’ Manhattan Project approach to energy production technology. The economic returns — not to mention the social ones — on greater energy efficiency would be substantial.

New Idle Speculator: An Interview With Diane Macunovich

The following is an excerpt from our latest Idle Speculator, in which we interview economist Diane Macunovich about age structure and its effects on employment, GDP, asset prices, interest rates, and inflation. The full interview (pdf) is available here: http://654advisors.com/idlespeculation/20100721_interview_macunovich.pdf

—

Could the pronounced shifts in age structure caused by the baby boom cohort in many nations have been a primary cause of the economic volatility and inflation of the 1970s, or the ‘Great Moderation’ of the 1980s and 90s? If so, what are the implications for widely held assumptions and longstanding disagreements regarding appropriate economic policy? And what are the implications for emerging economies, interest rates, inflation, or expected returns on various asset classes in the years ahead?

Regular readers of our website know that since 2008-2009, we’ve become fascinated by demographics, specifically the underlying age structure of a population, as a key factor in economic and financial market outcomes. We think it’s a powerful domain of knowledge for a couple of reasons. First, empirical studies support the idea that age structure can have significant and far reaching effects in economies, markets, and other areas of social interest. And second, very few people in the investment business have paid attention to recent developments in the field (though strategist Ajay Kapur is a notable exception).

As Exhibit A, we present the following Amazon Bestsellers Ranks: Birth Quake, an essential primer on age structure, is currently ranked 1,851,062nd. This Time Is Different, by Ken Rogoff and Carmen Reinhart, one of our industry’s current “must reads,” is ranked 96th. Yet we humbly submit that reading Birth Quake and related research on age structure offers much greater value to investment strategy and public policy in the years ahead than Reinhart and Rogoff’s work. More value in a book that ranks 1.8 millionth versus one that ranks 96th. That’s a situation that contrarians of all political stripes should love!

Economist Diane Macunovich, the author of Birth Quake, kindly agreed to an interview with Symmetry Capital Management (Macunovich: soft a, hard c, soft u, accent on “un”). Diane holds a Ph.D. and an M.A. in Economics from the University of Southern California, and completed her undergraduate studies at MIT. She has worked as a consultant, a researcher, and an educator, and is currently a Professor at the University of Redlands in California, and a Research Scholar at the Institute for the Study of Labor (IZA) in Germany. Her full curriculum vitae (.doc) and publications list are available online.

Excerpts from our interview follow. We believe investors should pay especially close attention to her less-than-bullish outlook for the U.S. economy and financial markets in the years ahead:

DM: I was working in the 1970s and 1980s as an economic consultant for developers and municipalities in Canada, often conducting housing market analyses, and realized there were tremendous effects of the post-WWII baby boom on housing demand. I was able to predict, for my clients, the housing slump that occurred in the late 1980s and early 1990s. That led to work on a PhD. and a great deal of subsequent research in the area.

As an example of the magnitude of the baby boom’s effect, a 2007 study of mine found that the passage of the U.S. baby boom from childhood through the teen years and into family formation caused marked swings in patterns of aggregate consumption demand in the United States during the second half of the twentieth century. Applying that study’s estimated age-group effects to time trends of national U.S. population age structure suggested that, holding other factors constant (including income and total population size), baby boom-generated changes in age structure accounted for swings of about 25% in real aggregate personal consumption.

It is important to work with fairly small age groupings – to divide the population into a fairly large number of age groups – in order to allow for effects which may vary significantly, even between age groups that are fairly close…Time patterns of changes in these smaller age groups can be quite pronounced, whereas changes in larger aggregates such as the total adult population, or median age, move only very gradually and can be difficult to relate to any economic effects. In my own work I have found that it is most advantageous to focus on young adults in the household formation stage: the growth rate of their population share, and their numbers relative to older prime age adults.

A significant portion of the growth in demand in the economy comes from new household formation. Some of this new household formation will result from immigration, but the vast majority of it results from young adults leaving their parents’ homes and forming their own households. Historically over the twentieth century that has been the 15-24 age group. They generate additional demand for housing and consumer durables including automobiles. They also, obviously, generate significant educational expenditures. If there is growth in this segment of the population, there will be overall growth in consumption. Similarly, rates of growth in consumption will fall with declines in the growth rate of this significant group.

In general, I use the growth rate in the population share of this age group (15-24), in examining effects on GDP. I wouldn’t try to actually forecast GDP with this variable, but rather use it to indicate points where it’s likely that there might be a reversal in GDP growth.

I think it’s a major shortcoming of most economic models that they omit demographics. The swings that I just mentioned could have been projected as much as twenty years earlier if demographics had been used. And the beauty of demographics is that current birth rates provide us with so much information for projecting future patterns.

SCM: Although much of your work focuses on first and second order effects of changes in demographic composition, you have also done some interesting research on third order effects like asset prices, interest rates, economic growth, and inflation, which are clearly relevant for investors and financial markets. What are some of the key insights you’ve developed into those effects, and how might an investor put them to use in decision making?

DM:The curve on the graph represents a three year moving average of the (one year) lagged annual rate of change in the proportion of young adults in the U.S. population, as reported by the U.S. Census Bureau. “Young adults” are defined as those aged 15-19 prior to 1950, and 20-24 in the years after, given changing levels of education. The vertical lines mark the start of recessions, as defined by NBER. There is a very close correspondence between the vertical lines, and peaks in the curve, as well as points where the curve goes negative.

I have found a very significant relationship between the growth rate of the population share of young adults, and the incidence of recessions, over the past 110 years.

Figure 1

Globally over the past 50 years, 80% of such demographic declines have been associated with declines in GDP growth. This is true whether one looks at countries’ own demographics, or at the relationship between their economies and U.S. demographics. Over 50% of the time, globally, there has been a direct one-to-one correspondence between turning points and outright recessions.

It should be noted that I’m not saying that only demographic effects are at work in these cycles. Rather, I believe that the demographics determine when the crises happen: the straw that breaks the camel’s back. The magnitude of crises and recessions has to do with a host of other economic and institutional effects.

The relationship shown in the previous graph is bolstered by the pattern observed in Japan in recent decades in Figure 2. One can see there the remarkable decline in the growth rate of this crucial 20-24 age group that corresponded with Japan’s “lost decade”.

Figure 2

As you can see in Figure 1 for the U.S., the growth rate in the share of this crucial population of young adults will turn negative in 2012, and then remain negative until the late 2020s. This would suggest another recession around 2012 (unless, of course, economic actors were to recognize trends ahead of time, and act accordingly!), and then possibly a period of very slow growth thereafter. In terms of the stock market, I’ve prepared projections for various moving averages of the DJIA, based on the changing overall population age structure (not just the young adults). They also do not bode well for the next ten years, suggesting a long period of bear markets until the early 2020s, similar to what we saw in the 1970s. The period after that should begin to be more buoyant, however. 

SCM: One interesting feature of Japan’s “lost decades” was that an increasing number of young adults chose to live with their parents, possibly due to the difficulties many of them had finding permanent employment. Empirically, it looks like the U.S. has entered a period where permanent employment is much harder to come by for young adults, with the 16 to 24 year old unemployment rate at levels not seen since the last of the baby boomers entered young adulthood (Figure 3). And anecdotally, we’ve been seeing more stories in the press and in our personal lives about young adults, especially recent college graduates, moving back home while they look for a first career. Is it reasonable to expect that new household formation in the U.S. could be stagnant in the coming decade, much as it was in Japan?

DM: I definitely believe new household formation will be stagnant. We just reached the peak growth rate of the proportion aged 18-20, and although their growth rate is still positive, it’s counteracted by the high unemployment inflicted on them by the recession. By the time the economy recovers and unemployment has declined for this age group, we’ll be into a long period of declining growth rates among those in the household formation stage. So even if they don’t move in with Mom and Dad, there will be fewer of them to replace the disappearing baby boomers… [B]ecause of the low birth rates we’ve seen since the 1980s, nearly all industrialized nations are facing declines in the young adult age group by about 2012-2015. Nearly all the former Soviet block countries, and many South American countries, are already into negative growth rates in this crucial age group’s share, as you can see from the graphics in one of my working papers for IZA (pdf). 

SCM: Clearly, this is powerful stuff for investors, and it raises some challenging questions, for example: Can we confidently model economic or asset return expectations without taking into account the massive dislocations caused by age structure in the twentieth century? Should we really be concerned about inflation or rising interest rates in the coming decade? Is age structure a more important variable (at times, at least) than the economic policies we all love to debate? And if slow to no growth is likely to be the norm in the years ahead, what public policy measures are most appropriate — especially when you consider that we’re also in the midst of a household balance sheet recession?

The complete interview (pdf), with additional insights into the relationships between age structure, economic growth, credit cycles, asset prices, and inflation is available on our website. Thank you Diane!

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. SCM earns a revenue sharing commission for qualified ‘click through’ purchases from Amazon.com’s website. Any mention of investable companies and/or securities is incidental and for illustrative purposes only. Neither the firm, its clients, or its principals own securities issued by Amazon.com.

Recommended reading: Austerity debate in the FT

The FT commentary page is running daily debates on stimulus versus austerity this week. Martin Wolf teed it up yesterday, and Brad DeLong and Niall Ferguson held court in round one. Unfortunately we’re not going to have time to provide play by pay to our blog readers, but for anyone with an interest in or an opinion on the issue, we strongly recommend it.

For non-subscribers, you can buy the daily FT for $2.50, or register for online access — though there’s a limit to how many articles you can view in a day: www.ft.com

Were We Right About Gold?

Were we right about gold earlier in the year? In May, we began to question the contradiction between deflationary pressures and a rising gold price.  As we wrote in a June 1st post:

David Rosenberg sounds some important cautionary notes on the economy and stock markets, and then predicts that gold will top out somewhere around $3,000.  We’ve argued against this call recently, but admit to having some misgivings.  If Zulauf is right, and deflation is en route, then it is entirely irrational to chase gold — unless you believe, like most of the world does, that something like “disdeflation” does not exist.  We’re well aware that history is replete with episodes of fairly persistent irrational asset pricing — gold might thus have a ways to go.  And if central bankers and other policymakers lose their heads in the fashion that Zulauf fears, then higher gold prices might turn out to be rational in hindsight.  Thus, we continue to watch gold prices closely.  Some of our clients continue to hold shares of GLL [in our Opportunistic Portfolio model], but if gold prices take out their November 2009 highs, we will close them out and look for a better entry point. 

We eventually did close out clients’ positions in GLL as gold set new highs about three weeks after we wrote that. And as it likes to do, the market made the trade look pretty dumb in hindsight, with gold falling sharply since then.

A couple of outlets, ETF Trends and the WSJ, have recently been pondering the decline in gold’s price. It’s a no-brainer in our view, but we’re still wary that the bubble has yet to run its course, and it could gain traction again if the pro-stimulus crowd eventually wins the debate.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a state registered investment adviser in the Commonwealth of Pennsylvania. The views expressed by the author are as of the publication date, and are subject to change based on market and other conditions. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy or a solicitation to sell any security, or to engage in any investment strategy. Investors should not use this information as a basis for any investment decisions without first consulting their own financial adviser. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

http://654advisors.com/index.php/blog/2010/06/disdeflation-revisited/

http://www.etftrends.com/2010/07/why-gold-etfs-are-declining/

http://blogs.wsj.com/marketbeat/2010/07/19/gold-down-what-gives/?mod=rss_WSJBlog&mod=marketbeat

Roger Horn: No need to stress, Europe

Our friend Roger Horn posted an interesting take on the impending bank “stress tests” in Europe on his Global Credit Risk blog:

I don’t expect many surprises, except maybe on the margin (meaning banks that are not that important anyway).  Each country already has its own bank recapitalization plan in place and EU commissioner Olli Rehn stated on July 6th that “should an EU member state have exhausted its own financial support fund, it can expect financial assistance from the EU in capitalizing its banks.”

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a state registered investment adviser in the Commonwealth of Pennsylvania. The views expressed by the author are as of the publication date, and are subject to change based on market and other conditions. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy or a solicitation to sell any security, or to engage in any investment strategy. Investors should not use this information as a basis for any investment decisions without first consulting their own financial adviser. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

http://globalcreditrisk.blogspot.com/2010/07/no-need-to-stress-over-european-bank.html

GOP Lips to Sink November Ships?

Republicans have been eagerly expecting their ship to come in during November’s midterm elections. But recent comments from GOP leadership call to mind Jude Wanniski’s description of them, even while a registered Republican, as “the stupid party.”

Sahil Kapur of the Guardian (TOH Credit Writedowns) wrote a devastating critique of the party’s credibility on deficit reduction, concluding that:

It’s fine and fair for Republicans to stand on large tax cuts for the rich as a principle. But they can’t do so while claiming to care a whit about the deficit. The budget is a result of money coming in (tax revenues) and money going out (spending). They can’t disregard 50% of this equation and claim to be concerned with the outcome. Or at least be taken seriously while they’re at it.

And Paul Krugman joyfully called them out, of course, as he is paid to do:

Republicans are feeling good about the midterms — so good that they’ve started saying what they really think. This week the party’s Senate leadership stopped pretending that it cares about deficits, stating explicitly that while we can’t afford to aid the unemployed or prevent mass layoffs of schoolteachers, cost is literally no object when it comes to tax cuts for the affluent.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a state registered investment adviser in the Commonwealth of Pennsylvania. The views expressed by the author are as of the publication date, and are subject to change based on market and other conditions. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy or a solicitation to sell any security, or to engage in any investment strategy. Investors should not use this information as a basis for any investment decisions without first consulting their own financial adviser. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

http://www.polyconomics.com/memos/mm-020619.htm

http://www.guardian.co.uk/commentisfree/cifamerica/2010/jul/15/republicans-dont-give-damn-about-deficit

http://www.creditwritedowns.com/2010/07/republicans-dont-give-a-damn-about-deficit.html

http://www.nytimes.com/2010/07/16/opinion/16krugman.html?_r=1

Martin Wolf, not Goldman Sachs, is doing “God’s work”

Martin Wolf continues to be a voice of reason in a landscape filled with bad ideas, something that Paul McCulley of PIMCO picked up on in his own tour-de-force piece on sector fiscal balances, austerity, and deflation  (TOH Credit Writedowns, which is quickly becoming our RSS aggregator by proxy):

…any notion that fiscal austerity in the developed world will not be a cyclical drag on global aggregate demand growth, much less boost it, must rest on the presumption that (1) the household and business sectors in the developed world will reduce their surpluses and/or (2) that the emerging world will reduce its surpluses with the developed world.

…current evangelists of front-loaded fiscal austerity preach that if only governments would reduce their deficits, the private sector, freed from the fear of future tax increases, will spontaneously reduce their surpluses. Put differently, it is argued, if only governments would put their fiscal houses in order, the private sector would immaculately regain confidence in their own financial affairs, pull down their savings and borrow more, boosting aggregate demand. Really, that is the argument, made with a straight face….

But, you retort, the private sector is ultimately on the hook for the government’s liabilities, so how can those liabilities be considered the private sector’s asset? Simple: They can be sold for hard cold cash. To be sure, someday the government’s debt must be rolled over, or retired. But in real time, government securities are assets of the private sector (or the foreign sector). And for a fiat currency country, there is no reason to think that the debt cannot be rolled over, as such countries have a technology called a money printing press.

To be sure, using the printing press in the context of full employment would tend to generate higher inflation. But in the context of full employment, fiscal deficits would be dramatically lower – nothing like getting the unemployed off the dole and onto the tax rolls to cut fiscal deficits! And the developed world is a long, long way from full employment.

Thus, front-loaded fiscal austerity makes absolutely no sense, unless you believe that Ricardo was right and that the private sector in the developed world has no balance sheet problems, only fear of future taxes. And that the moon is made of green cheese…

What the developed world faces is a cyclical deficiency of aggregate demand, the product of a liquidity trap and the paradox of thrift, in the context of headwinds borne of ongoing structural realignments. Front-loaded fiscal austerity would only add to that deflationary cocktail. And that’s what the market vigilantes are wrapped around the axle about: They are not fleeing the sovereign debt of fiat currency countries but rather fleeing risk assets, which depend on growth for valuation support.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a state registered investment adviser in the Commonwealth of Pennsylvania. The views expressed by the author are as of the publication date, and are subject to change based on market and other conditions. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy or a solicitation to sell any security, or to engage in any investment strategy. Investors should not use this information as a basis for any investment decisions without first consulting their own financial adviser. A principal of the firm owns shares of Goldman Sachs. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. 

http://www.creditwritedowns.com/2010/07/paul-mcculley-does-modern-monetary-theory.html