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Investing Times Classics

Evidence for the long-term: economic growth could increase until 2026 then slow thereafter

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If Brexit and Donald Trump have taught us anything, the world is getting tired of the slow growth status-quo. According to exit-polls from the USA election, the biggest reason for voter dissatisfaction is the state of the economy.

While it is not exactly clear what voters expect to see from the economy (unemployment is near cyclical lows and both economies have been recession free for several years), what is clear is that people are desperate for greater wage growth and GDP growth at a household level.

Therefore, we are digging under the hood of this economic concern by looking deeper into the population statistics. What we find is not particularly favourable in absolute terms, although we find that Australia and India are better placed than most. As a part of this analysis, we conclude Donald Trump is pushing uphill to “double the growth rate” as he suggests.

Is there a link between the population and economy?

The real economy relies heavily on population growth; both logically and practically. There are many ways we can verify this importance, however one of the best ways is to illustrate it over the very long-term by showing the 20-year trend of the economy, household spending and population growth. This is an effective method because it massages out economic cycles and shows that all three are intricately linked and generally mean-reverting in the long-term. Below is the case for Australia, showing a strongly aligned relationship.

The unemployment rate will be a critical factor to household spending in the short-term, however is generally seen to be cyclical. Therefore, while an unemployment spike is very likely to coincide with an economic downturn, over the very long-term it gets largely massaged out as excess capacity shifts in waves. Similarly, household savings could have a material impact in the medium term, as people spend more or save more depending on the state of the economy. However, in the very long-term this can also be expected to remain somewhat cyclical.

Employment considerations should be contemplated more broadly though. With an ageing population and extended life expectancies, we can anticipate that the percentage of the elderly workers will increase (as in the case of Japan). We may also see a higher percentage of individuals enter the workforce (especially in countries with a low female participation rate), which could provide further upside. These factors all materially impact the growth outlook.

What does it mean going forward? Why slow-growth may be the new-normal after 2026.

Using population and peak spender logic, we can illustrate the “population effect” and the added “ageing population effect” as per the chart below. This uses the Australian Bureau of Statistics expected population projection (accounting for expected changes in birth rates, death rates and an estimate of net migration) and is adjusted for the “peak spender theory” in the dark blue dotted line. We find the ageing population is expected to support the Australian economy in the short-term but will slow thereafter.

 

Take it as a grain of salt

While our analysis is a brave attempt to provide clarity and logic to an uncertain dynamic, it should not be considered a guarantee by any means. It must be understood there is significant scope for error. To provide full transparency on the scope for error as we see it, below are some of the points worth considering.

First and foremost, the entire premise of this analysis is that the economy and household spending are intricately linked. If this breaks down, the accuracy of the analysis breaks down. While we are confident in the link remaining to some extent (there appears no logical reason it wouldn’t), the reality is that household spending accounts for 55% of GDP which leaves 45% unaccounted for. Therefore, if we see a period of structural change in the remaining 45%, GDP could move markedly from the population trend.

There are also significant risks to any changes in what we’ve labelled as “household effectiveness”. The pace of innovation and technological development continues to drive progress at a household level, but our assumption this will continue at approximately 2% has inherent scope for error. Whether it is 1%, 2% or 5% is anyone’s guess in a world of robots and driverless cars.

The projection data is also subject to potential error, as birth rates or migration rates could change between now and 2100. There are also event risks, such as a world war that could materially impact both population numbers and household spending. A major asset market crash could have a similar impact and interrupt the trend significantly to the downside.

Lastly, from a technical perspective we have considered GDP in real terms throughout our analysis, meaning inflation has been discounted. The reason is that the relationship between population change and inflation is complex, due to the interaction between money supply and the velocity of money. Withstanding this, any period of hyper-inflationary or deflationary conditions could create further inaccuracies.

 

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Could Donald Trump send the USA bankrupt? And why the first challenge is February next year.

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IMG_5997 (481x640)Donald Trump and economic stability rarely go hand-in-hand. While Trump insists he’ll “make this country rich again”, his path to riches has been subjected to four bankruptcy negotiations and his vagueness as a potential President can be summarised in “I want to be unpredictable.”

With the expectation for a close race to the White House in November this year (betting odds apparently have it as 1/3 vs 5/2 in favour of Clinton), it seems likely Donald Trump or Hilary Clinton will inherit a ticking bomb that is called the “debt ceiling”.

The debt ceiling is a piece of legislation that is intended to limit the amount the United States Government can borrow. However, well before Donald Trump rose to prominence politically, the USA Government has been amassing more and more debt, to the tune of $19.29 trillion at the latest recording and counting. This equates to a potentially dangerous ‘Debt to GDP ratio’ of 105.4% and a trajectory that means the last extension of the debt ceiling to March 2017 will need to be renegotiated again early next year.

The problem is this. If the vote is close, which it could easily be, and a majority is not created in Congress, either Trump or Clinton will have a very difficult time agreeing on terms to extend the debt ceiling further. If no agreement is made, the United States Government can’t pay its bills which leads to an abrupt default. The seriousness of this event for the USA should not be under-estimated:

“A default would be unprecedented and has the potential to be catastrophic: Credit markets could freeze, the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse.” — U.S. Treasury report in 2011

It may not be Donald Trump or Hilary Clinton’s fault that the debt grew so substantially, and it is a complex story on why the United States has opted to take on so much debt along with the majority of the world, but whether it is Donald Trump or Hilary Clinton in office, they will hardly have had a chance to warm their seat before having to deal with this mess. Historically, debt ceiling negotiations have required an 11th hour agreement because the two political parties (Trump’s Republicans and Clinton’s Democrats) cannot agree on policy direction and block it in Congress as a re-negotiation tool.

The last occasion this “debt ceiling” was breached, it was Barack Obama’s “Obamacare” in the firing line. This would seem far less controversial than many of Donald Trump’s policies, meaning a greater risk of a stalemate and increased recessionary risks.

While Trump is known for his comments such as “Rich people are rich because they solve difficult problems”, it is another thing altogether managing a Congress that have conflicting views on policy to the extent as this 2016 Presidential Election.

It would seem Donald Trump himself has been an advocate of a stalemate and willingness to let the United States go into shutdown. His remarks prior to the 2013 debt ceiling negotiation went along the lines of “I don’t think [the United States is] going to go into default, but I do think if we allow laws like this to go through, we’re going to be in much bigger trouble long term” — Donald Trump in 2013

It begs the question on who is a more suitable candidate to lead the United States through a very tricky time politically. Forget the lacklustre growth forecast, the ageing population or the unemployment concerns, the real concern between now and the start of next year is how to handle a potential United States default.

Hilary Clinton does not have a perfect record, and it would appear likely the debt train would continue under her wing, but the alternative is Donald Trump who has been subjected to four Chapter 11 negotiations either directly or indirectly before attempting to take the White House (Trump Taj Mahal in 1991, Trump Plaza in 1992, Trump Hotel & Casino Resorts in 2004 and Trump Entertainment in 2009).

Regardless of the outcome, it is unlikely to be comical if the debt ceiling isn’t dealt with prudently and promptly. So with this in mind, which nominee do you think is better suited?

Quotes on the Debt Ceiling and its Risks:

“We’ve never gotten to the point where the United States government has operated without the ability to borrow. It’s very dangerous. It’s reckless, because the reality is, there are no good choices if we run out of borrowing capacity and we run out of cash.” Senator Jack Lew

“There is precedent for a government shutdown. There’s no precedent for default. We’re the most important economy in the world. We’re the reserve currency of the world. … If money doesn’t flow in, then money doesn’t flow out, so we really haven’t seen this before, and I’m not really anxious to be part of the process that witnesses it.” — Lloyd Blankfein, chief executive of Goldman Sachs

“The debt ceiling is such a calamitous possibility that you could go to a recession or even a depression worse than Lehman and AIG in 2008.” — Senator Chuck Schumer

“To tie [the debt ceiling] to something about whether you break the promises of the United States government to people all over the world as well as its own citizens, just makes no sense. So it ought to banned as a weapon, it should be like nuclear bombs, basically too horrible to use.” — Warren Buffett

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“Would you rather be a miserable millionaire or happy and homeless?” How do you answer these questions?

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IMG_0801 (480x640)The game of “would-you-rather” is a favourite past-time, usually involving an alcoholic beverage and a willingness to be embarrassed. However have you ever played a clean, moral-based version of the game that helps decode what’s most important to you? See how you answer these tricky questions.

Before we start, let’s clear up the rules. Each question starts with “would you rather” and there will be two options that follow. You must select only one – and your answer can’t be both or neither. As you go through them, you will hopefully find how much importance you place on money in comparison to the other important things in your life.

The 29 questions

“Would you rather have more time or more money?”

“Would you rather go back in time to meet your ancestors or go into time to meet your great grand-children?” (74% say the future)

“Would you rather live one life that lasts 1,000 years or live 10 lives that last 100 years each?”

“Would you rather know when I’m going to die or know how I’m going to die?” (59% say how)

“Would you rather be the best looking person or the smartest person?”

“Would you rather live in a world where there are no problems or live in a world where you rule?” (66% say no problems)

“Would you rather find true love or find $10 million?” (53% true love)

“Would you rather be the richest person on the planet or be immortal?” (53% richest)

“Would you rather secretly lose $500,000 on a bad investment or have everyone think you lost $500,000 even though you didn’t?” (53% would secretly lose)

“Would you rather receive $10 billion or give $10,000 to 100,000 African families?”

“Would you rather be famous or be the best-friend of someone who is famous?”

“Would you rather win the lottery or live two lives worth?” (60% say lottery)

“Would you rather always know when someone is lying or always get away with lying?” (54% say know)

“Would you rather have no-one turn up to your wedding or have no-one turn up to your funeral?”

“Would you rather be able to speak every language in the world fluently or be the best in the world at something of your choosing?”

“Would you rather change the past or be able to see into the future?”

“Would you rather email an embarrassing email to your entire company or secretly lose $10,000 on a bet?”

“Would you rather lose $1000 or lose all of your phone contacts?”

“Would you rather have been the smartest kid in school or the most popular kid in school?”

“Would you rather have lived like a king but have no family or live on the poverty line but have all your friends and family?” (74% say the latter)

“Would you rather go on a world tour with your enemy or never have a vacation?”

“Would you rather be a musician and have a number one hit or be an unknown with 50% more intelligence?”

“Would you rather have a small fulfilling life or a long unsatisfying life?”

“Would you rather have all your dreams fulfilled but have a 10% chance of instant death or be completely average with nothing special about you?” (63% say dreams)

“Would you rather visit a small house with your 10 loved ones or a mansion but not know anyone?”

“Would you rather change into someone else or just be you?” (52% say change)

“Would you rather be a hideous but popular person or happy but unrecognised?”

“Would you rather invest in a start-up which has lots of information or invest in a property chosen for you at random?”

“Would you rather be a miserable genius or a happy moron?” (56% say miserable)

As you can probably tell, the questions tell more about you than you first realise. Do you crave social attention, even at the detriment to your monetary objectives? Does money buy happiness in your mind or do you value other things more? Regardless, it might tell you a bit about your inner drivers and hopefully made you think twice about what is really important.

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Facts about the Chinese economy: How likely is a financial crisis in China?

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IMG_0174 (640x480)China is undoubtedly important to the global economy and with embedded signs of rising bad debts, there are enormous concerns surrounding China’s ongoing stability.

Since 2005, China has accounted for approximately 40% of total global growth with the economy growing five-fold in just 15 years. However, jitters are now apparent and the past six months has seen the biggest test for emerging markets since the Asian crisis of 1997. A combination of three key factors are being cited; enormous growth in shadow-banking, bubbling asset markets and indebted local governments.

But just how likely is a financial crisis in China? What is their debt position in comparison to other countries and/or history? And what should an investor need to know in order to make educated decisions in related markets?

The Debt Expansion is Fearsome

A scary and newsworthy chart often put forward by media outlets shows the rapid growth in total debt across China. There are many versions of these articles, however even highly respected news outlets such as the Wall Street Journal (WSJ) and Bloomberg have caused stir with headlines such as “China’s Debt Bomb” and “A Debt Balloon With Nowhere to Go But Down”.

Of course, they are intended to inform their audience, but they also use such headlines to sell newspapers. Therefore, it is important to obtain a balanced view of the data.

The reality shows two important but contradictory points. Firstly, China’s debt has ballooned relative to history on both a nominal basis and in comparison to the size of their economy. In this sense, both the WSJ and Bloomberg are correct. However secondly, this debt expansion was from a very low base which means China is still in line with global peers on both a relative and absolute basis.

A Global Comparison

China’s total debt – accumulated by households, corporates and central/local governments – reportedly rose from 121% of GDP in 2000 to 158% in 2007 and 282% in 2014. This 161% expansion in debt looks unhealthy, but looks considerably worse in absolute terms.

Nominal GDP in China is estimated to have grown approximately 474% in the fourteen years to 2014, meaning the nominal total debt position has increased over 12x from around US$2.1 trillion to $28.2 trillion.

In comparison, no other country has ever encountered the same debt expansion on both a relative and nominal level. However, before everyone runs for the hills it is important to also illustrate the debt position of other key economies that many consider “perfectly safe”.

For example, the latest total debt figures – including public, corporate and household debts – show China has 282% estimated total debt to GDP, the USA has 269%, Germany has 258% and Australia has 274%. Relatively, all four countries have less debt than Japan’s governmental debt level alone.

Therefore, even after factoring in the misunderstood shadow banking, the Western World faces very similar levels of total debt as China according to the Bank of International Settlements. On this basis, China appears to be on track. The only problem is whether they can handle the next inevitable bad debt cycle.

IMG_0153 (640x480)Bad Debt cycles explained

It would be imprudent to brush off China’s debt expansion, including the shadow banking, on the basis of a global comparison. There are many valid reasons to be cautious about China’s debt expansion. Firstly, the composition of the debt is considerably different to its Western peers, with a much greater portion of higher risk corporate debt (especially lower grade non-financial corporate debt). In China, corporate debt represents 67% or two thirds of total debt compared to Australia which has less than half in corporate debt (47%) and the USA which has only 38%.

This debt composition is important on many levels, no less because it affects the speed and severity of any financial crisis, should it occur, plus it tends to lack the same levels of regulation and hence attracts riskier lending. This is a major risk for an economy known for volatility.

Bad and Doubtful Debts

Using the analogy of an individual that over-leverages on debt, it can be universally agreed upon that the greater the amount of debt relative to assets or income, the greater the risk of a severe collapse. For example, a couple earning $200,000pa with a $2 million home and a $1.8 million debt faces severe risk if either the asset or income falls. On the contrary, it also provides the greatest opportunity for growth if the asset value grows at a rate greater than the interest expense. On a country level, this is no different, and for China a high debt level creates this leverage.

The lesson from the “PIGS crisis” in Europe (the debt crisis of Portugal, Ireland, Greece and Spain) was that the real risk of a financial crisis comes from two sources; rising interest costs, typically beyond 7%, or a spike in bad and doubtful debts.

At present, the effective borrowing rate for China, assessed via its bond yield, is healthy at approximately 2.88%. Therefore, the real risk would be a spike in bad and doubtful debts, which is a key dataset to watch.

Will we see a spike in bad debts?

Whether we will see a spike in bad debts in China will relate to the ability of corporate China to meet its debt obligations. In the current environment, this is heavily reliant on three issues; 1) the overall exposure to resource-related debt, 2) whether the property market stabilises to constrain defaults, and 3) whether Chinese capital outflows can be constrained. In many ways, this is no different to the Western World, with the possible exception of capital outflows.

The biggest difference between China and its global peers is the historical analysis of bad debt cycles, with Chinese downturns far more severe and worrisome than Western counterparts. For example, a commonly cited downturn was the 1997 Asian debt crisis, which reportedly wiped more than 10% of bank assets in China. To put this in perspective, a similar episode today based on current Chinese debt levels would create a financial crisis up to 3.5x bigger than the 2007 crisis in the USA. This is scary stuff.

What to do?

It would seem contradictory to expect and/or fear a financial crisis in China without expecting something similar elsewhere in the indebted Western World. In reality, the backdrop of high debt and high asset prices are a common theme among many of the world’s most important economies.

Regardless of whether you think a crisis will occur, it is reasonable to worry about the impact a Chinese financial crisis would have on the global economy (including share-markets), particularly because of its size and historical volatility. Emerging market bond spreads are one way to monitor proceedings, as this is the markets way of telling us the risk of corporate debt, which China happens to have a lot of. Asset prices are another area to monitor, as a sharp fall in either property or equities could be an obvious trigger for a rise in defaults and the commencement of a bad debt cycle.

Patrick Hess from the European Central Bank said it well, when he was quoted as saying, “a domestic financial crisis is not unlikely to happen in China, and very likely to spread globally, should it indeed happen. To implement all the reforms necessary to avert a Chinese crisis is almost a “mission impossible,” or at least very difficult in the complex Chinese policymaking context, which involves a high degree of institutional overlap, conflicting goals and interests, and political bargaining. Even such a strong leader like Xi Jinping cannot change this context”.

At present, it could be plausibly stated that China faces its greatest debt-related risk since the 2007 GFC and possibly since the 1997 Asian Crisis, with capital outflows and asset values showing weakness. For now, Xi Jinping seems to be aware of the risks and we have seen the introduction of numerous reforms in recent times to counter or reduce these risks, and property values appear to have commenced a mild recovery.

Recent economic data shows the debt-train continues in China as it continues stimulating to avoid further capital outflows. However, rather ironically, the more China borrows the greater the risks become. In summary, investors should exercise a high degree of vigilance and monitor Chinese developments very closely.

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