Invest Long Term – Speculate Short Term

Source: UN3

Demographics represent the single most important structural trend that we are faced with today, and it will massively impact everything – economic growth, interest rates, public debt, stock markets, consumer demand, etc. One of the most important repercussions to investors is the effect it will have on our pension systems.

Quite a few European countries will see a substantial increase in the old age dependency ratio between 2020 and 2030. In Germany, for example, it will jump from just under 36% to over 47%. Such a drastic increase in the number of elderly will have a dramatic effect on everything, and it is only just beginning.

In the world of mature economies, the U.K. and the U.S. will suffer the least from aging. Only emerging market countries are in better shape, but don’t assume everything is fine in China. It is actually in a worse condition than both the U.K. and the U.S. At some point the one child per family will have a severe effect on demographics.

Unfunded pension liabilities fast approach £10 trillion in the UK with an annual UK GDP of about £1.86 trillion last year. The size of the liability compared to their total earnings as a country is enormous. Younger people today had better accept the fact that they likely won’t receive the pension entitlements that they have been promised. The government simply cannot afford to pay out at this rate over the next few decades. However, nobody wants to start the politically necessary discussion, as it is most certainly not a popular vote winner, bordering on political suicide.

The return to fundamentally driven investing

QE has changed the dynamics of investing. The obvious one is fixed income investing, but it doesn’t stop there. Because investors are now earning such low returns on bonds, much capital has been re-directed towards equities (and other asset classes as well), driving valuations higher. Nowhere has this been the case more so than in the U.S. equity market.

Obviously QE will not last forever. The Fed has already more or less ended its program, and although Europe is way behind in the recovery phase (we expect plenty more easing by the ECB in the short term), it will happen eventually. The big question is what will happen to bond prices when central banks are no longer a significant buyer? We still think inflationary pressures will remain very modest, suggesting low interest rates for quite some time to come.

Regardless of this projection, with no QE to beef up prices, at least in the U.S., investors are likely to pay increasing attention to fundamental factors. As we have argued over the past few months, a return to fundamentally driven investing is likely to happen at a time when those fundamentals are not the most promising to have ever come across. We believe that we have entered a period of below average economic growth and therefore also a period of disappointing earnings growth for many companies, limiting the upside potential on shares. However, don’t ignore the earlier comments about the missing connection between economic fundamentals and equity prices in the short term.

We still expect equity returns to be positive over the next several years but, on average, would expect returns to be lower than we have grown accustomed to since the start of the great equity bull market in the early 1980s.

Because economic growth is likely to disappoint, investors should remain only lukewarm on cyclical companies. Investors will almost certainly pay more attention to dividends than they have done in recent years as we have written extensively about the power of dividends several times before.

Given the ‘damage’ QE has done to valuation levels, as the market returns to a more fundamental approach, we can see that a high quality approach to equity investing is working quite well. Likewise we wouldn’t be surprised to see value stocks begin to outperform growth stocks again.

In a world of managed interest rates, currencies are the primary adjustment factor

The point is the following: When interest rates are managed (some say manipulated), markets are efficient enough to make the necessary adjustments elsewhere and, in this context, currencies play an important role. If one economy outperforms another (e.g. the U.S. outperforms Europe as is presently the case) but interest rates in both areas remain ‘managed’, the currency of the better performing country will simply outperform the currency of the weaker one (as USD presently does vis-à-vis EUR), in effect doing the job that the bond market would have done under normal circumstances.

Having said that, this adjustment mechanism doesn’t work very well in countries where the bond market is almost entirely controlled by domestic investors to whom changes in the exchange rate won’t have the same behavioral effect, which explains why it has never worked in Japan.

With this in mind, we find it difficult not to maintain a long-term bullishness on USD/EUR, despite the U.S. dollar’s recent gains. Current U.S. economic activity is too high to justify the low level of interest rates over

there, and currency markets are likely to make the adjustments that politicians/central bankers are not willing to do.

The end of cheap oil

Despite the recent turmoil in global oil prices, nothing has fundamentally changed. The world will still run out of cheap oil (cheap as in approx. $25 per barrel of production cost, as is currently the average production cost in the Middle East) over the next decade or so. It is hard to predict exactly when, because OPEC members are not the most informative people in the world.

Note that it is fundamentally different from the widely acclaimed theme known as Peak Oil, the consequence of which is that oil production will be in terminal decline once production has peaked. Oil won’t run out anytime soon, but the price will be altogether different from the price the world got used to until relatively recently.

U.S. shale is changing the dynamics of oil