December 27, 2015
Robert Brooke Zevin, Chairman, Senior Portfolio Manager
For the past 18 years, we have purposely opted out of the annual investment industry ritual of providing forecasts for the coming year. An important principle of our investment approach has been and remains to avoid having a single forecast for the next year, or any other period of time. Many investment losses are caused by investor confidence that he or she knows what will happen in the future. Our preference is always to consider a number of different things that might happen, and to invest in ways that provide protection against losses in bad market outcomes irrespective of how optimistic — or pessimistic — we might feel as the year draws to an end.
However, we are at a historical moment when a number of very large changes are underway, each of them likely to persist for decades. Global warming and global aging of the human population are two clear examples. Both are baked into the cake. More precisely, the sky is already full of greenhouse gases, and human society is still strongly dependent on further carbon emissions for transportation, heating, manufacturing, and even agriculture. In its most optimistic scenario, the most recent UN Report on Climate Change has carbon fuel use persisting until the end of this century. As for population aging, fertility rates have been declining over the world for 200 years or more, in lockstep with declining infant mortality and increasing levels of income. Unless these trends suddenly reverse, population aging is guaranteed for at least several more generations.
It is very likely that economic growth will remain slow in the most advanced countries, where the population is already increasing slowly or declining, and labor force growth is even lower. These countries — Western Europe, Japan, and the United States — constitute about one-half of the global economy. In China as well, the labor force is shrinking for demographic reasons that will not change for 20 years or longer. A demographic shift to falling or negative population growth, and large increases in the proportion of older people, is already the case in over three-quarters of the global economy. So again, it is not much of a stretch to think it likely that low growth rates, which have already been the case for some time in Japan, Europe, and America, will continue in these countries, and spread to new ones.
Economic growth depends not only on population growth, but also on growth in output per person and per worker. Productivity growth also has receded in recent years. And many experts do not expect a resurgence in countries that have already achieved very high levels of goods and services available per person. Climate change, pollution, falling water tables, and other environmental consequences of economic growth have also increasingly become impediments to further growth.
In our last Update (Stormy Weather, September 28) we laid out substantial evidence for an already successful social/political movement toward higher wages. Subsequent data show real wages are now rising as fast as or faster than they did in the “Golden Age” from 1945 to 1973. For both political and economic reasons, wages are very likely to continue rising at a fast pace. In the period from the Korean War to the early 1970s, some of the increase in wages was passed along by corporations to consumers in the form of higher prices. But a large part also came out from corporate profit margins, which were at record highs when the Korean War started in 1950, along with corporate cash holdings. Both of these measures are again back at record highs, only this time corporations have far less ability to increase prices, for various reasons discussed in our last Update.
U.S. wages are likely to rise at a faster rate in 2016, while inflation increases much less rapidly. Other costs from health care to interest rates will also increase. Economic and social/political pressures will limit price increases. With no productivity increases, the only remaining way for corporations to pay higher wages will be at the expense of profits. As in the years after 1950, corporations again have amply inflated margins and cash on their balance sheets to coast through many years of declining margins without undue strains. Higher taxes and government pressures on price increases will increase the rate at which profit margins decline, but corporate pain will still be negligible, and corporate tears of the crocodile variety.
Under these conditions, unadulterated earnings per share for most U.S. companies are likely to show no growth in 2016, despite continued reductions in shares outstanding from corporate buybacks. This is also not so much a bold prediction as a mere description of what has already happened in the past three years. We also anticipate little or no change in the price of U.S. stocks, which again has already been the case for the past year. When measured in dollars, we forecast equally disappointing results for stocks in most of the world. Investor returns will be close to the dividend yields on stocks. With bond yields rising slightly and prices falling, U.S. bonds will probably lose money in 2016 after taking account of price changes as well as interest payments; while stocks will earn two or three percent.
Our one-year forecast could easily turn out to be wrong because of fluctuations in financial markets, for good reasons or not, near the end of next year. This is precisely why we have avoided such forecasts in the past. However, in this case, we believe our forecasts reflect important and long-lasting changes that are underway in our political economy. Paradoxically, because they are about long-lasting changes, they are more likely to look correct after 12 years than a mere 12 months.
Thinking about the next year and these longer horizons, we believe that with such low expected returns, it makes sense to keep some money out of the stock market and in cash, even though stocks do not seem to have large downside risk. With such low expected returns, stocks will probably continue to wobble up and down around their flat trend. We have been using cash to buy individual stocks that appear to offer much better returns after declining, and raising fresh cash when other stocks appear over-priced after appreciating. The stocks we do own are still very concentrated in the U.S., which has the strongest economy (and currency) of the major world economies, and the best record of reducing debt burdens since the Financial Crisis.
In addition we favor stocks that are likely to grow earnings substantially in a slow-growth environment, particularly companies that are among the causes of falling prices rather than the victims — as in e-commerce vs. luxury brand stores. Health care companies are also likely to grow at above-average rates because of global aging, rising incomes in emerging countries and a blooming of powerful new therapies. We also seek companies with very safe and sustainable dividends that are priced to yield substantially more than stock and bond market averages. In these ways we hope to achieve a steadier, higher return than the stock and bond market indices. Even so, we would not expect our clients’ portfolios to earn more than five to 10 percent a year on average over the next decade.
We can reasonably hope that these modest returns will be the cost of a dramatic improvement in the fortunes of the 99%. And on that thought, a happy holiday season to all followed by a fruitful and (against the odds) peaceful New Year,