This week I will be addressing the Manning Centre Conference in Ottawa on the topic of debt, demographics and the long-term implications for Canada. Having followed global financial markets for the past three decades, I've seen several bulls and bears. The one thing that has never changed in 30 years of ups and downs in equity markets is the disinflation trend and that on average interest rates have been declining. The essence of these secular long-term trends are demographics – what we collectively all do together to drive aggregate demand.
I recall back in October, 2001, the last time investors were calling the end of the bond bull market, when the U.S. Treasury had a surplus and declared the entire debt would be paid off in less than a decade. They cancelled the new issuance of long-term bonds and the bond market rallied sharply. I was shorting long bonds at the time and that one black swan announcement cost me half my portfolio gains that year. Turn the clock forward a decade and a half and debt as a percentage of the U.S. economy is 105 per cent – and it will never be paid off. Governments have a way of deficit financing their way to re-election and until the idea of fiscal policy changes as a major policy tool, debt as a percentage of the economy will likely continue to grow.
Japan has been the poster child for deficit spending that intends to stimulate the economy. The country has been monetizing debt (central bank buying the debt with creation of money) for two decades and they are worse off today than they were in 1997. The headwinds of an aging population, low birth rates, and massive government debts are simply toxic for economic growth – if you do not see that you are blind to the reality of structural debt. Political influencers like Paul Krugman and others that suggest the debt is not a problem are only fuelling the issue. U.S. President Donald Trump's infrastructure spending and economic stimulation plans, while not addressing the massive entitlement issue, will only add to the long-term structural debt obligation.
I was excited to see that the findings of Canadian Finance Minister Bill Morneau's Growth Commission have highlighted some of these important demographic challenges that policies need to address. But they did not go far enough in terms of recommendations that will really move the needle. Increasing household incomes is nice to say, but not an easy task to be sure. It sounds like they will just expand the government, which will not solve the problem – it is the problem.
Over 100 per cent of world gross domestic product since the Lehman Bros. bankruptcy on Sept. 15, 2008, has been fuelled by government debt and expansion of corporate and personal debt – these policies, if they continue, will make it far worse for our grandchildren. Politicians don't want to talk about it because it is hard to get elected by telling people we have lived beyond our means and that we have to start making tough choices – but that is the reality we face.
The world has a fundamental growth problem. According to estimates by the World Bank, population growth in the world will take us to around nine billion by Canada's 200th birthday. The vast majority of that growth will be in India, sub-Saharan Africa, and parts of the Middle East where the average age of the population is twenty-something. Japan, Germany, China, Canada, the United States and most of the developed world have much older populations. In Canada, the average age of the population is about 38; in Japan, it's 48, the oldest economy in the world. At that age, you just do not have the natural population growth.
The International Monetary Fund's world GDP calculation has been falling on average over the past few decades while use of debt has been accelerating, largely due to 36 years of declining interest rates, to offset the natural slowing in birth rates and productivity.
All these macro trends tell me that interest rates are likely to stay low for decades to come because we cannot afford for them to go up. The yield to maturity of the entire world of fixed-income is under 2 per cent and after inflation and tax you are worse off each year. There is no real return in the safety of fixed-income.
The current market narrative is about Mr. Trump's policies goosing inflation, economic growth and corporate profitability and thus bearish for bond yields. Bonds still have a place in portfolios, not because we love them for income or growth, but because during the next recession, they will likely save your portfolios.
At the moment, my largest bond position is in short-term Canadian corporate bonds (ZCS). It has a distribution yield of about 3.07 per cent because of higher bond coupons, but the yield to maturity is about 1.80 per cent. We do not see the Bank of Canada raising rates for several years and this is the best place in the short term.
But if we do see the Federal Reserve manage to raise rates again this year and bond yields in the United States 10-year hit 3 per cent, buying U.S. Long Bonds (TLT) would be the best way to protect your portfolio in the next recession. All the talk about Mr. Trump's policies driving inflation higher might be possible, but the economy cannot handle the higher rates.
Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder, and is a U.S.-registered Commodity Trading Adviser.