The Future of Growth

Source:  Bloomberg; in local currency

As shown, the economies of North America have provided fairly consistent growth on a decade-by-decade basis with real GDP growth for the first four decades averaging about 3.5% per annum. This past decade took its toll as we entered the decade with the second worst recession since the Great Depression, and ended the decade with the worst recession in the past 90 years.  So, we can forgive this past decade for coming in below a growth rate of 3% per annum.

The stock market in Canada delivered fairly consistent performance over the past five decades – with the last decade coming in below the long-term average for the reasons mentioned above.  The U.S. stock market delivered mid-teen returns through the 1980s and 1990s – the only time in the past 11 decades when the U.S. market delivered double-digit returns back-to-back.

Interest rates in North America rose rapidly through the Sixties and Seventies before retreating from the mid-teens in the early 1980s – the result has been double-digit bond returns for the first four decades.

I will outline below the four major influences on the North American economies and capital market components and why I refer to this as the “greatest stimulation package – of all time”.

DRIVERS OF PAST GROWTH

1)  Demographics

The first main stimulus for North American economic growth and capital market returns was the result of the Baby-Boomer generation – those individuals born in the period 1946 to 1964.  The War ended, people began to procreate. The fertility rate (number of births per woman) in Canada averaged 3.7, while in the U.S. the average was 3.5.  This compares with numbers today at 1.6 for Canada and 2.1 for the U.S.

In 1965, just over 40% of the total population of Canada and the U.S. was under the age of 20.  This is what is referred to, by demographers and economists, as a “demographic dividend” to a local economy.  A demographic dividend due to the fact that this age cohort would be entering the labour market over the next 20 years and become “producers”.  First, this generation, at the time, was the most educated generation to come along – both for men and women.  Good jobs were fairly easy to come by.  In those days, family formations started in the early- to mid-twenties – versus the early thirties we see today.  Family formations resulted in a significant demand for housing (and all that went with it), cars, every kind of electronic gadget, all types of services, etc.  One of the greatest gifts from this generation was: choices.  Manufacturers and service providers began to isolate certain segments of the Baby Boomer generation to custom-design their products and services to meet specific needs and wants – think of something as basic as radio providing music: from country-only (classic and new), jazz, oldies, rock, pop, comedy, easy-listening, etc.

In summary, in North America there had never been a demographic segment as large, or as well educated, as the baby-boomer generation.  As this generation aged, their demand and consumption patterns changed.  And manufacturers and service providers changed with them.  From 1950 to 1965, the Canadian population grew at a rate of 2.4% per annum.  The U.S. at 1.6% per annum.  Over the next 15 years the projected growth rate in population for Canada is 0.8% per annum and, for the U.S., the population growth rate is projected to be at 0.7% per annum.  This is a major headwind for economic growth.  The economy is dependent on growth in the labour force (which will be slower than the growth rate in total population as the baby-boomers retire over the next 10 years coupled with a lower number of entrants into the labour force due to the low fertility rates of the past 20 years), productivity (output) and utilization (hours worked).

So, the first of the baby-boomers reached 65 beginning in 2011 – the “traditional” retirement age (although the actual average retirement age is currently around 62).  As they move through the next 20 years, the greatest demand from this group will be on government revenues.  The Baby-Boomer generation is moving from producing to consuming.  As the growth rate in the population slows (for Canada, one-fourth the rate from the 1950-1965 period), the result will be a slower economic pace as measured by real GDP – unless productivity improves significantly (which is difficult in a predominately service-oriented economy).  This slower growth in the labour force will likely shave 0.50%-0.75% per annum from real GDP over the next two decades.

2)  Savings Rates

In Canada, the savings rate rose steadily from the early 1960s to the early 1980s – rising steadily from 5% to just over 20%.  The parents of the Baby Boomers came through the Great Depression and, as a result, were very conservative.  They paid down debt as quickly as possible (with, typically, the only debt they had being a mortgage against their house) and were great savers.  The parents of the Baby-Boomers did not grow up with credit cards or lines of bank credit.  Their parents had taught them that if they did not own a mortgage the banks could not foreclose.

The Chart below shows the historical savings rate for Canada:

Source:  Statistics Canada

As shown, once the baby-boomers began to form households, the savings rate went into freefall – moving from the high teens in the early Eighties to 4%, where we are today.  The Baby-Boomer generation is the most competitive generation to come along.  As a result, success was, generally, assessed by the material possessions one had.  Houses were bigger than they had to be, cars were bigger, TVs were bigger, etc.  He/she who died with the most toys won.

In summary, you had the largest demographic bulge in history earning good wages in order to expand consumption; however this wasn’t enough to satisfy their “wants”.  Long-term savings was used to pay for short-term pleasures.

As a result, the drawdown of savings resulted in significant stimulus to the North American economies – while reducing an “insurance fund” to protect against an economic downturn and/or provide a desired living standard in retirement.  The savings level will likely rise slightly in the future as Baby-Boomers realize that they do not have enough to maintain their standard of living in retirement; however, for many it is too late. The National Research Center in the U.S. estimates that “one-fifth to two-thirds of the older generation have under-saved for retirement”.  A rising savings rate will, likely, shave another 0.5% from real GDP growth.

3)  Debt / Interest Rates

The third main economic and capital market stimulus came from the significant increase in debt.  The Chart below shows the Debt/Personal Disposable Income (D/PDI) percentage from the early 1970s to today.

Source:  Statistics Canada

Whereas the savings rate is now one-fifth of what it was in the early 1980s, the ratio of debt-to-personal-disposal-income increased three-fold from its level just over 30 years ago – moving from 50% of Personal Disposable Income to the current level of 164%.

The Baby Boomers were not shy about borrowing to provide a lifestyle that suited their needs/wants.  Where their parents had, typically, only a mortgage as a debt (and when that 20-year mortgage was paid off, they did not re-finance), Baby Boomers used debt to pay for education (an acceptable debt obligation), to mortgage their house, to purchase cars, etc.  As well, credit card use expanded at a great rate to cover other purchases (e.g., furniture, appliances, electronics, etc.).  A new debt category also appeared: the line of credit.  This has been the fastest growing debt instrument.

Debt, at some point, has to be repaid – at least, that has been the theory.  Declaring personal bankruptcy does not carry the negative stigma it used to.  The Baby Boomer generation has leveraged their balance sheet more than any other generation.  Time is running out.  The deleveraging from this generation will have a major negative impact on economic growth over the next two decades – my best guess, it will reduce real GDP growth by a further 0.75% per annum.

However, the increase in the debt-to-personal-disposal-income level has not had a significant impact on the Baby Boomer’s net income due to the decline in interest rate levels over the past 35 years.

With interest rates declining from the mid-teens in the early Eighties to the current level of just over 2%, the carrying cost burden has not had any adverse impact on the household bottom line. Debt levels tripled while interest rates are now 80% lower than they were at their peak.

Low interest rates have made borrowing to purchase all too easy.  In the U.S., Debt / PDI hit just under 130% in 2008 – about the same level as Canada at that time.  Since then, Debt / PDI in the U.S. has declined to under 120%, while, in Canada, the level continued to rise over the past seven years to the current level of 167%.  This, pure and simple, is unsustainable.  Any significant increase in interest rates will have a major negative impact on the household bottom line.  Given this, I do not expect interest rates to move significantly above current levels as inflation is under control and demands for products and services will be muted due to the changing consumption patterns of the Baby-Boomers.

As well, governments at all levels will have to cut back on their spending habits as future revenues will slow and social payouts will increase as the boomers retire.

4)  Participation Rate: Women

The last main component driving economic growth and capital market returns over the past three decades was the doubling of the participation rate for women in the labour force – moving from a rate of 30% in the early 1960s to over 60% today, as shown in the Chart below:

Source:  Statistics Canada

As an aside, for men, the participation rate has been in slight decline for the past 60 years.

Women entering the labour force resulted in households now having two “bread-winners” – adding about a 60% increase to household earnings.  The participation rate for women will not likely rise much further from this level.  As shown, the level is already beginning to flatten.  However, the opportunities have changed for women.  In the 1960s and 1970s, the main occupations were teachers and administration. Today, there are more women graduating from university than men in North America and the corporate world is more inviting.

IN CONCLUSION

As shown above, economic growth has been driven by four main sources:

• Baby-Boomers moving through the last three decades, with the unprecedented demand for products and services; the age group under 20 represented over 40% of the population in 1965 and this group now represents around 30% of the population today;

• the savings rate declined from a high of 20% to just under 4% today: real wage increases in the past couple of decades have been virtually non-existent and were not enough to support the lifestyles of the Baby-Boomers – they tended to focus on instant gratification rather than planning for the future;

• as wages and savings still did not satisfy their wants; individuals increased their debt levels by three times; the threefold increase in debt did not result in an increase in the segment of net income devoted to “service charges” as interest rates declined from the mid-teens to around 2% today – making adding debt very easy; and,

• the participation rate for women doubled over the past 50 years; the result was a significant addition to household income.

LOWERED EXPECTATIONS

For the return of the capital market components (and I will only be addressing stocks and bonds), I will tackle the easier one first: bonds. Bonds are mainly influenced by the level of inflation (and its anticipated changes over time) and supply and demand.  I do not expect inflation levels to rise much from current levels.

First, real wages have not had any significant growth over the past 20 years.

Second, I expect consumers to retrench and begin to pay down debt and/or increase savings over the next 10-year period.

Third, Federal governments are expected to keep interest rates low to keep the economies from stalling.  So, no demand-pull inflation.

The greater uncertainty comes from cost-push factors such as weather affecting crops, or terrorist attacks that might affect the price of oil and other necessary commodities.

For much of the North American economies, there appears to be as many deflationary pressures as inflationary pressures.  So, interest rates will stay close to current levels.

For supply, governments at all levels will still be issuing debt – the major source of supply (and one of the reasons governments don’t want to see interest rates rise).  However, governments are under pressure to cut expenditures in order not to raise taxes.  As well, corporations are in great shape – with a significant number of public companies actually using cash in the till for stock buybacks. Individuals also need income as they move into retirement and move their risk appetite to less volatile instruments, and ones with a steady income stream.

Austerity programs initiated around the world after the 2008 financial crisis have not been successful as people are tired of the pain inflicted and are now revolting – electing pro-spending governments.

For the Canadian stock market, the Table below highlights the historical return, as well as my best-educated guess for the next ten years:

Dividend income is the first component.  On a historical basis, dividends represented approximately 45% of the total return of the Canadian stock market.  The going-in yield today is about half the historical level.  To achieve the return of 10% (the most often quoted historical return for both the U.S. and Canadian stock markets), the capital appreciation component would move from 55% of the total return to 77% of the total return – which would likely result in significantly more volatility.

The next component is “real earnings growth”.  This number has a high correlation with real GDP growth in our economy.  For reasons stated above, the slower growth of the labour force and the deleveraging at the individual level and at all levels of government, I believe it very unlikely that real GDP growth will average more than 1.5% per annum over the next 10 years.  I fear I might be optimistic here; however, I put in 1.7% per annum growth for real earnings growth, allowing for some, hoped for, improvement in productivity.

The last component is the change in the market multiple over the next 10 years.  The stock market benefited from a rising multiple over the past four decades.  Since 1956, the multiple on the S&P/TSX Composite has averaged 17 times.  For the S&P 500 in the U.S., the average has been close to 16 times.  Both of these averages have been heavily influenced upward by the tech era of the 1990s.  The current market multiple for both North American markets is about 19 times.  The decline from the current level to the longer term average multiple takes away a half-a-percent per annum.

There is one caveat on the multiple component: if real earnings growth comes in at about half the long-term average, it could result in a multiple that falls significantly below the longer term average.  Once again, I believe I am being slightly optimistic.  Investors might be willing to pay a higher multiple for less growth.

The bottom line: I do not see the Canadian and U.S. stock markets doing much better than 3.5% per annum over the next 10-year period (2+% in dividends and the rest in capital improvement) – well below the rate required to build wealth for individuals for retirement and well below the rate to reduce the current deficits in defined benefit pension plans.  With a “balanced” portfolio (let’s say for the typical 60% equity/40% fixed-income allocation) a return of less than 3% per annum would be expected.  For pension plans, with an assumed actuarial return of 7.5%, on average, there will be a significant short-fall in covering future benefits.

SUMMARY

As indicated by the last main heading, the purpose of this article is to manage investor expectations.  I have been in this business long enough not to rely on exact projections or longer term averages.  I am also not a doomsayer.  There will be opportunities to exploit market inefficiencies over the next 10 years.  However, the main headwind is the aging of the Baby Boomers who will take an increasing portion of government expenditures and the deleveraging at the individual and government levels.  The Baby Boomers have not been successful at building wealth – and time has run out.