Wednesday, January 9, 2019

On the Demographic Path to Human Self-Extinction

In Chapter 16 of my book Predicting the Markets, I observe that fertility rates have dropped below replacement rates around the world as a result of urbanization. Only in India and Africa are couples having enough babies to replace themselves. Humans are on a demographic path of self-extinction.

Leading the way has been Japan. I have often described the country as the world’s largest nursing home. That distinction undoubtedly will soon belong to China. All around the world, nursing homes will be bulging with more occupants, while the maternity wards will have lots of vacant cribs.

The economic consequences of these demographic trends will be slower growth and subdued inflation, if not outright deflation. That means that interest rates most likely will remain historically low for a very long time. That could be positive for the valuation multiples that investors are willing to pay for the stocks of companies that are able to grow their earnings at an above-average rate. It should also be very positive for the stocks of companies that are able to grow their dividends in this demographically challenged environment.

A global shortage of workers should stimulate more labor-saving and labor-replacing technological innovations. The result should be faster productivity growth. That should give a lift to real wages that should offset some of the slowdown in employment growth attributable to labor shortages.

The scenario I just sketched isn’t a forecast. It is a description of exactly what has been happening in Japan. The forecast is that most of the rest of the world will follow suit. Japan is the poster child for the rest of us who aren’t having enough babies to replace ourselves. Consider the following:

(1) Japan. On a 12-month basis, the number of deaths in Japan exceeded the number of live births for the first time during July 2007 (Fig. 1). On this basis, during July of this year, deaths exceeded live births by a record 351,000 (Fig. 2). The situation has been exacerbated by a record low of only 586,700 marriages over the past 12 months through July (Fig. 3).

So Japan’s population has been falling in recent years and rapidly aging. The percentage of the population that is 65 or older has increased from 25.2% at the start of 2014 to 28.2% at the end of last year (Fig. 4). Yet the total labor force has actually been rising gradually over the past few years (Fig. 5). That’s because the labor force participation rate has been moving higher (Fig. 6). The problem is that more Japanese women have been entering the labor force and not getting married, which depresses the number of births. If that continues, the number of births will remain depressed.

These demographic trends go a long way toward explaining why Japan’s inflation rate remains near zero, despite the ultra-easy monetary policies of the Bank of Japan, which has been targeting a 2.0% inflation rate since January 22, 2013 (Fig. 7). Older people and fewer children aren’t conducive to home-building, car-buying, or the consumption of other durable goods.

(2) China. The demographic profile of China isn’t as geriatric as Japan’s, but it is heading in the same direction, accelerated by the government’s one-child policy that was in force from 1979 through 2015 (Fig. 8). For the first time ever, the percentage of seniors in the population, at 6.6%, matched the percentage of children under five years old during 1998 (Fig. 9). By the middle of this century, the former is projected by the UN to rise to 26.3%, while the latter falls to 4.6%.

Young married adults who have no siblings must accept the burden of taking care of four aging parents. Now that the government has declared that couples can have more than one child, many are likely to be overburdened having even one child.

As I’ve noted in recent months, all this is weighing on Chinese real retail sales growth, which has been on a downtrend for the past several years (Fig. 10).

(3) United States. The good news in the US is that the fertility rate is in line with the replacement rate. However, the demographic trends are heading in the wrong direction. Young people are staying single longer. Newly married older couples are likely to have fewer children than younger couples. The cost of college education is also a downer for many couples, forcing them to consider how many children they can afford.

The proof is in the maternity wards. Over the past 12 months through March, live births in the US totaled 3.84 million, the lowest since November 1997 (Fig. 11). Over the same period, the number of deaths totaled a record 2.36 million. So births exceeded deaths by 1.48 million, the lowest reading on record, dating back to December 1972 (Fig. 12).

Meanwhile, as the Baby Boomers age, they are turning into minimalists. They don’t need their big houses anymore. They don’t need minivans to take the kids to soccer practice. The Millennials are natural-born minimalists, for reasons I have reviewed in the past on many occasions.

I don’t view this as necessarily bad news for the US economy. Rather, I see these demographic trends as reducing the likelihood of an economic boom, which reduces the likelihood of a bust. The business-cycle expansion should continue, and inflation should remain subdued.

Tuesday, January 1, 2019

Video Podcast: Is the Fed Done?

Today is January 1, 2019. I wish you all a healthy, happy, and prosperous New Year! In this video, I discuss why the new year is likely to start with some downbeat economic data that should cause the Fed to pause hiking interest rates. Regional business surveys conducted by five of the Fed district banks were very weak during December. That explains the recent drop in the 10-year Treasury bond yield below 2.70%. The 2-year Treasury yield tends to be a good one-year leading indicator of the federal funds rate, and is currently predicting no change this year. Are the implications bearish or bullish for the stock market?


Monday, December 3, 2018

Less Inflation Gives Fed Room to Pause

The Fed made lots of headlines last week. Evidence mounted that following another likely rate hike at the FOMC meeting on December 18-19, the monetary policy committee might pause during the first half of next year to reevaluate the course of monetary policy. Not as widely noticed last week was that inflationary pressures may be ebbing, which would also argue for a pause. Consider the following:

(1) PCED. While the labor market continues to tighten and wage gains are picking up, price inflation remains subdued according to the most currently available data. For starters, the core PCED rose 1.8% y/y during October, the lowest such pace since February (Fig. 1). Over the past three months through October, this measure is up just 1.1% (saar), the lowest reading since May 2017 (Fig. 2).

(2) Goods. The core PCED for goods fell -0.6% y/y during October (Fig. 3). The US import price index excluding energy has been moving higher since early 2017 after falling the previous two years. Nevertheless, it was up only 0.7% y/y during October, as a strong dollar this year mostly offset Trump’s tariffs.

(3) Services. The PCED for services excluding energy rose 2.6% y/y during October, an eight-month low (Fig. 4). Wireless telephone services prices fell sharply during 2017, but stabilized this year. So some of the upward pressure on inflation this year simply reflected much less deflation in this services category (Fig. 5).

(4) Rent. More importantly, the rate of inflation for rent of primary residences has been moderating over the past two years after rising sharply during most of the current expansion (Fig. 6). It was still high at 3.6% during October. But the boom in multi-family housing construction in recent years may be closing the gap between the demand and the supply of rental housing units.

(5) Medical care. Of even greater importance may be what is happening to prices in the health care industry. They aren’t rising much at all (Fig. 7). Over the past 12 months through October, the PCED for medical care is up just 1.3%, with hospital and physician services up only 1.5% and 0.7%, respectively, and prescription drug prices up just 0.8%! The moderation in the latter might reflect pressure from the Trump administration on drug companies to keep a lid on their prices. The services components of health care may finally be experiencing long-overdue upturns in their productivity, which may be a long-term phenomenon as new competitors—most notably Amazon—enter the field.

(6) Regional price surveys. Five of the Fed’s regional district banks include questions on prices paid and prices received in their monthly surveys. I monitor the averages of each of these two series (Fig. 8). Both peaked during July and have been edging down since then through November.

(7) Oil. Helping to moderate inflationary expectations has been the recent 31% plunge in the price of a barrel of Brent crude oil since October 3 through Friday (Fig. 9). Technological innovation continues to disrupt the global oil industry, as US frackers are now producing almost 12.0mbd (Fig. 10). US crude oil exports have doubled since mid-January 2015 to 7.4mbd currently (Fig. 11).

(8) Real wages and productivity. Average hourly earnings rose 3.2% y/y during October, while the overall PCED rose 2.0% over the same period. As a result, inflation-adjusted wages rose to yet another record high (Fig. 12). This measure has been on a solid uptrend since the mid-1990s, blowing away the myth that real wages have stagnated for decades.

This couldn’t have been happening unless productivity has also been performing better than suggested by the data, which were revised higher for the late 1990s and may be revised higher for the current expansion, in our opinion. Another reason to believe that productivity is underestimated is that the S&P 500 profit margin, which we calculate from industry analysts’ consensus estimates for S&P 500 companies’ earnings and revenues, has been soaring to new record highs since late last year (Fig. 13). How did that happen if productivity has been as weak as widely believed? (It can’t all be explained by the cut in the corporate tax rate at the end of 2017.)

In an 11/27 speech, Fed Vice Chairman Richard Clarida acknowledged as much when he rhetorically asked: “What might explain why inflation is running at or close to the Federal Reserve's long-run objective of 2 percent, and not well above it, when growth is strong and the labor market robust?” He concluded that the answer might be that while “growth in aggregate demand in 2018 has been above the expected long-run growth rate in aggregate supply, it has not been exceeding this year's growth in actual aggregate supply.” The explanation is better-than-expected growth in productivity. If this keeps up, we will all be supply-siders.

Wednesday, November 14, 2018

Analysts Still (Too) High on S&P 500 Earnings

The latest earnings reporting season seemed to contribute to the sharp selloff in stocks during October, as some companies reported bullish earnings that were more than offset by bearish guidance about future earnings prospects. Collectively, however, the S&P 500 companies’ Q3 earnings results reported through the 11/8 week were 4.9% better than analysts had expected during the 9/28 week, i.e., just before the start of the latest earnings season (Fig. 1). As I’ve noted many times before, this pattern is par for the course. (The pattern shows up on our “earnings squiggles” data series as a hook at the end of the line—see our S&P 500 Earnings Squiggles Annual & Quarterly.)

In aggregate, the negative guidance corporate managements provided during earnings conference calls somewhat deflated analysts’ consensus earnings estimates for Q4-2018 and the quarters of 2019 (Fig. 2). However, the 2018 estimated earnings growth rate held steady during the 11/1 week from the week before at 23.6%, the highest reading ever for this data series (Fig. 3 and Fig. 4). The 2019 estimated growth rate edged down to 9.4%. The 2020 projected growth rate remained solid at 10.2%.

In other words, the Q3 results didn’t curb analysts’ enthusiasm for earnings growth this year and the coming two years. I, however, curbed my enthusiasm for the earnings outlook on October 30. Here’s more on why I did so:

(1) Me vs them. I lowered my estimates for earnings growth during 2019 and 2020 to 4.9% and 5.3% from 6.8% and 8.8%. I am predicting S&P 500 earnings per share will be $162 this year, $170 next year, and $179 in 2020 (Fig. 5). During the 11/8 week, the comparable analysts’ consensus estimates were $162.67, $177.69, and $194.55.

(2) Revenues slowdown ahead. The growth rate of S&P 500 revenues has been remarkably strong this year, which has contributed—along with the corporate tax rate cut at the end of last year—to the strength in earnings growth. Revenues per share rose 11.2% y/y during Q2, the highest growth rate since Q2-2011 (Fig. 6).

Industry analysts are expecting a slowdown in revenues-per-share growth from 8.5% this year to 5.5% in 2019 and 4.4% in 2020 (Fig. 7). That makes sense to me, since the trend growth rate of revenues has been roughly 4.0% (Fig. 8).

In addition, the global economic outlook is deteriorating, as evidenced by the weakening trends in recent months in both the OECD Leading Indicators and the Global Composite PMI (Fig. 9 and Fig. 10).

(3) Profit margin unlikely to set new records. What doesn’t make sense to me is the implication of analysts’ consensus earnings and revenues estimates that the S&P 500 operating profit margin will continue to rise to record highs. Their latest numbers imply that the profit margin will rise from 11.9% this year to 12.4% next year and 13.1% in 2020 (Fig. 11). For perspective, Thomson Reuters data show that the operating profit margin rose to a record-high 10.9% at the end of 2017 before the corporate tax cut. After the cut, it rose to fresh record highs of 11.9% during Q1 and 12.3% during Q2 (Fig. 12).

During the Q3 earnings season, many company managements warned that, in addition to their revenues growth being weighed down by the global economic slowdown, their profit margins were likely to be squeezed by higher labor costs as well as the impacts of tariffs, which were raising their materials costs and disrupting their supply chains. They didn’t say whether they expected to offset some of those higher costs with productivity gains.

So I don’t expect the S&P 500 profit margin to rise further from here. If it remains flat in record-high territory over the next two years, then earnings growth will match revenues growth. And if that happens, then industry analysts will be lowering their heady growth rates for earnings.