- The outlook for investors in the 2020s will depend on how governments respond to a wave of retirees in the world's biggest economies.
- My base case is policymakers will "thread the needle" between inflation and deflation, and a diversified mix of stocks and bonds should continue to work well. For stocks, I would look for competitive yield and reasonable valuation.
- But it makes sense to protect against "tail risks." If you are concerned about inflation, consider Treasury Inflation Protected Securities (TIPS) and commodities. If you're concerned about deflation, think about minimum volatility strategies and long-duration bonds.
I find it hard to believe that an entirely new decade is but a few months away: the 2020s. Wow, how time flies. But first, (cue metaphor) ...
I am a huge David Lynch fan, and I can't tell you how thrilled I was when the 1990s' Twin Peaks returned to the airwaves in 2017 for a third season (Twin Peaks: The Return). The series was even more deliciously weird than I remember it from 25 years ago. I must have watched each of 2017's 18 episodes at least 3 or 4 times, attempting to put the pieces of the puzzle together.
In my view, our post-crisis markets (i.e., since 2008) have been at least conceptually comparable. In a way, we are all just would-be sleuths chasing down clues to help us decipher the markets' mysteries, casting about for that elusive meta-narrative that might pull the whole story arc together in real time.
The 2010s have proven surreal enough, showcasing everything from:
- Financial repression1 (low to negative interest rates coupled with quantitative easing (QE)—or rather, "not QE") and a $13+ trillion mountain of negative-yielding debt
- The potential for "helicopter drops"2 or even outright debt monetization3 (whereby the Fed essentially conjures money out of thin air)
- Escalating friction between the 2 biggest economies (and, arguably, military powers) in the world
- The storm brewing ahead of a stranger-than-fiction US presidential campaign
All amid a "silver tsunami" of aging people in the world's largest economies. And yet markets sailed atop it all, seemingly immune to the elements. So, here we are on the cusp of a new decade, and the questions outnumber answers by a mile.
Perhaps the most fundamental one is how profound is the demographic sea change, and how much does it explain the prevalence of low inflation, slow economic growth, dovish central bank policy, accelerating wealth inequality, and rising populism?
The silver tsunami
The UN publishes population data back only to 1950, but my guess is that the world has never seen a demographic wave like the one we're in now. To give some context, the slowdown in labor force growth currently underway affects mainly the US, Europe, Japan, and China. While those 4 regions represent only about 31% of the world's population, they make up 62% of world GDP and 69% of the world's equity-market capitalization.
And this has been a very long wave. The 5-year annualized growth rate of the world's total labor force peaked in 1985 at +2.3%. In 2019, that stat sits at around +1.0%, and by 2055 the global labor growth rate is expected to have dwindled to just +0.2%.
Looking at just the US, Europe, Japan, and China, the labor growth rate also peaked in 1985 (+2.2%) and has since dropped an average 6 or 7 basis points per year. The mean labor growth rate for these 4 major regions recently dropped to zero—and by 2055 is projected to have sunk to about -1.0%.
A secular surge that affects two-thirds of the global economy is not something I want to bet against, especially considering that labor force growth is 1 of the 2 main drivers of potential GDP (the other being productivity growth).
What it could mean for investors
In my view, one of today's (and tomorrow's) most important strategic investment questions is whether governments in the affected countries are successful in creating inflation (despite longer term deflationary trends). They would likely do this by printing money to keep their economies humming. In its extreme, this economic policy approach is known as Modern Monetary Theory (MMT).4
If the answer is yes, then inflation protection in the form of Treasury Inflation-Protected Securities (TIPS) and commodities—along with any currencies not affected, India's perhaps—could fare well for a long while, whereas the diversified mix of stocks and bonds that has been so successful since 2000 (with both stocks and bonds rising) could revert to the old days when stock prices were negatively correlated with bond yields. That's what inflation does, after all.
Does inflation mean that interest rates would rise? Well, not necessarily. In a world where the Federal Reserve is monetizing US debt and the aging population is starving for yield, the Fed may well be able to hold down nominal rates to low levels while at the same time pushing real (inflation-adjusted) rates further and further into the negative. In other words, increased demand for interest income from a surging retiree population could act to limit interest rate increases in the face of Fed stimulus. So, in an extreme scenario, it's not inconceivable that we could have both high inflation and low nominal rates.
That is exactly what happened during the latter half of the 1940s: Inflation spiked due to the financial demands of World War II, nominal yields stayed low (at around 2%), and real rates went sharply negative. This was possible because (1) the deflationary mindset from the Great Depression remained pervasive, and (2) the Fed—at the behest of the Treasury—was monetizing war debt and, at the same time, screwing interest rate caps on both the short (at 0.375%) and long (2.5%) ends of the yield curve.
However, if the deflationary effects of the age wave overwhelm the inflationary effects of MMT, then in all likelihood we are facing a continuation of the trends in place for the past 5 years or so: an emphasis on stable dividends and free cash flow against a persistent low-inflation backdrop; low yields and negative real rates; growth stocks leading value; domestic outdoing international markets; and "low forever" interest rates.
In this scenario, the current rotation would be just a minor counter-cyclical ripple against a powerful deflationary tide.
Markets could well thread the inflation/deflation needle, with technology (artificial intelligence, automation, robots) solving the demographics problem via enhanced productivity and US yields keeping above water. After all, it's human nature to "figure things out," so maybe we will collectively solve the demographics conundrum in the coming years.
If that is the case, bond yields could reset back to "normal" (around 2% to 3% for the US). Demand for income-producing strategies might abide at less-than-stratospheric extremes. And the S&P 500 could conceivably carry on cranking out a 5% free-cash-flow yield and a double-digit return. This trend has endured since the end of the Great Financial Crisis, and it often pays to assume a trend will extend, albeit with one important caveat: "The trend is your friend except at the end when it bends."
I don't know what the 2020s will bring. But I want to be aware of—and prepared for—the unknown. For now, I am sticking with the expectation that the positivity of the 60/40 stock/bond paradigm, or an otherwise appropriately diversified mix of stocks and bonds, should carry forward. It's worked for 2 decades, after all. Within equities, I like that part of the market that combines competitive yield with reasonable valuation.
But I also think the times call for some protection against the tails—whether inflation or deflation. Inflation protection could include TIPS and commodities. To guard against deflation one might consider some minimum-volatility5 strategies, perhaps coupled with some long-duration debt. Minimum volatility strategies aim to provide market-like exposure with less risk. But these strategies don't eliminate risk and may not prevent a loss in the event of a market downturn.
Inflation or deflation? Bull or bear? Darkness or light? It's a range of possible outcomes worthy of a season 4 of Twin Peaks. Stay tuned!