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The Problem of French LandscapersJohn Mauldin
Today we look at the connections between French farming, China, poor economic forecasting, page 16, single derivative thinking and our investments. We wander and wonder far afield in order to get some insight into our own backyard. Let's start in the south of France. I was visiting Bill Bonner, of Daily Reckoning fame, last weekend, deep in the heart of Southern French farming country. Riding on the train to his home in Ouzilly with Tiffani (my daughter and assistant), you could see the countryside pass swiftly out the window. My impression was that French farmers are not so much farmers as they are landscapers. The further from Paris we got, the more the entire landscape seemed to resemble an enormous botanical garden, designed to delight the eye and soul. The fields are neat. The hay is stacked just so. Trees are planted to make the proper visual impact. It is organized. Even the cattle seem to be placed to provide the right ambience. If ever a people deserved to be prosperous farmers by virtue of manifest pride in their craft, then certainly they do. And they would agree. They feel they have a right to some of the largest farm subsidies in the world. Threaten those subsidies and they quickly and aggressively protest. The End of Farm Subsidies As we drove to the rather picturesque town of Montmorillon where Bill could buy a gallon of paint for $80 that sells for $20 in the US, I noted that the forces of demographic change were going to overwhelm the pastoral peace. It is simply a matter of time. But it will not be a pretty thing. It was not that long ago, "just over there," Bill pointed out, "that there were mass demonstrations, burning of tires and so on, at the hint of cuts." Change, at least that which threatens a lifestyle, is not easily accepted in most societies. Whether it is union workers seeing their jobs go to China or farmers losing their subsidies, change is not welcome. This week, the World Trade Organization ruled that Europe is unfairly subsidizing sugar (they clearly are) and that the United States is unfairly subsidizing cotton (we clearly are, which is shameful for a country that promotes free trade). There will be much wrangling and negotiating, but eventually those subsidies are going to come down. And when they do, farmers in third world developing countries will get a chance to earn a better living. But farmers in Europe, the US and Japan will have to adjust to some rather painful changes. The subsidies will go, not because it is the right thing to do or because developed countries want to allow third world farmers a better life, but because at some point in the future there will simply be no money in the governmental coffers. Today it is sugar and cotton. But tomorrow it will be other agricultural items. European governments, as well as the US, are going to use this as a cover to lower these subsidies over time. It is not because they have it in for the poor farmer, but because there are going to be difficult choices in the future. Farm subsidies or pensions? Count the votes to see who wins. There are more elderly than there are farmers. A whole lot of something's will have to give to fund government guaranteed benefits and health care, and among them will be the farm subsidies. The Demographic Imperative Why will that be? Let's review a few paragraphs on demographics and aging that I wrote in Bull's Eye Investing. And after a few more comments which might appear a bit doom and gloomish, let's see why things will not turn out as we think today. There is opportunity in these problems. "Let's next look at a lengthy report entitled "The 2003 Aging Vulnerability Index" by Neil Howe and Richard Jackson. (Howe was co-author of the seminal books on generational behavior trends, Generations and The Fourth Turning.) "The report analyzes the cost of public pension funds (like Social Security, the state retirement funds mentioned earlier, etc.) for 12 different developed countries. It then analyzes how the various countries will fare in the future, factoring in their economies, taxes, costs, and the actual circumstances surrounding retirement. (For instance, it makes a difference whether you are likely to be supported by your kids or out on your own.) "In short, it clearly shows us that there will be staggering budget problems for these countries, and some more than others. The report categorizes Australia, the United Kingdom, and the United States as low vulnerability countries. Given what we know of potential U.S. problems from an aging population, this means the report posits grim news for certain countries, especially the mainstay countries in Europe (France, Germany, Italy, Spain, and the Netherlands). Jackson and Howe give a whole new meaning to the concept of "Old Europe." "Let's look at a few salient items: Today, there are 30 pension-eligible elders in the developed world for every 100 working age adults. By the year 2040, there will be 70. In Italy, Japan, and Spain, the fastest-aging countries, there will be 100. In other words, there will be as many retirees as workers. This rising old age dependency ratio will translate into sharply rising costs for pay-as you- go retirement programs--and a heavy burden on the budget, on the economy, and on working age adults in any country that does not take serious steps to prepare. . . . Public benefits to the elderly will reach an average of 25 percent of GDP in the developed countries by 2040, double today's level. . . . In Japan, they will reach 27 percent of GDP; in France, they will reach 29 percent; and in Italy and Spain, they will exceed 30 percent. "This growth will throw into question the sustainability of today's retirement systems--and indeed, society's very ability to provide a decent standard of living for the old without overburdening the young. . . . It is unclear whether they can change course without economic and social turmoil. (Emphasis mine) "For most of history, the elderly--here defined as adults aged 60 and over--comprised only a tiny fraction of the population, never more than 5 percent in any country. Today in the developed countries, they comprise 20 percent. Forty years from now, the share will reach roughly 35 percent. And that's just the average. In Japan and some of the fast-aging countries of continental Europe, where the median age is expected to exceed 50, the share will be approaching 50 percent. "Today, looking at the data, the five main economies of the European Union spend about 15 percent of their GDP on public benefits to the elderly. This will rise rapidly to almost 30 percent by 2040. Japanese benefits will rise 250 percent to 27 percent in 2040 from today's "mere" 11.8 percent. How do you pay for such increases? If the increase were paid for entirely by tax hikes, not one European country would pay less than 50 percent of its GDP in taxes, and France would be at 62 percent. By comparison, the U.S. tax share of GDP would rise from 33 percent to 44 percent (according to the report; I assume this includes all level of taxes). Japan's taxes would be 46 percent of GDP. "It should be clear to everyone that such an outcome would be an utter economic disaster. Taxes for the working population would be consuming 80 to 90 percent of their income. It would be an economic death spiral. Whatever economic growth might be possible in an aging United States, Europe, or Japan would be completely squelched by such high taxes. The "giant whooshing sound" would be that of young workers leaving for more favorable working and tax conditions. "If the increase in benefit costs were paid for entirely in cuts to other spending projects, Japan would see its public benefits rise to 66 percent of total public spending, France and the United States to 53 percent, and Germany to 49 percent. Today, these expenditures are all around 31 percent. What do you cut? In the United States, you might cut defense spending, but there is little to cut in Europe and Japan. Education? Welfare? Parks? Transportation? Medical or health programs for the working? It gets so very ugly... "Since such an outcome (50 percent of GDP for pensions) is impossible, long before that type of debacle is reached, other solutions, painful as they are, will have been chosen. Europe is already spending a very small percentage of its budget on defense. As one wag puts it, they will be faced with the choice of "guns or rocking chairs." With a declining population, they will be hard-pressed to find enough bodies to man their military as it currently exists. Unless they unwind their pension promises, European countries will play a smaller role in the world of the future, notwithstanding the view from France. The role of Asia, especially China and India, will be far more significant in the future world of our children... "In short, for the world economy to grow, developing countries are going to have to look to themselves for growth. The aging developed countries will simply not provide the growth engine that they provided for the latter half of the twentieth century. For forward-looking investors, that means there will be real business growth opportunities in the emerging markets and those countries that can sell to them." The Rule of Page 16 Let's hold this thought for a few minutes and look at the problems of economic forecasting. Forecasting economic events is a pretty tough business. What makes it particularly tough is that the consensus is usually wrong. As human beings, we seem to be herd animals, which is especially true for economists. Witness that a perfect 50 out of 50 of the Blue Chip Economists simply did not forecast the last recession, in spite of an inverted yield curve appearing 12 months earlier. And if the consensus somehow manages to be right, there is still little profit potential. It is what Donald Coxe, of the BMO Financial Group, calls the Rule of Page 16: "You neither make nor lose serious money by the outcome of a story on Page One. You make or lose serious money from the outcome of a story that's now on Page 16 but is headed for Page One." Right now, there is too much bearishness on the dollar. Long-term (over the next year), that would include me. But when everyone "knows" something, where is the person on the other side of the trade? You could see that dollar rise in the near term. When people are once again on the dollar band wagon, I will be happier about my bearish dollar call. But being a herd of one or two is not necessarily the answer. Witness that Gregory Mankiw, the very smart and capable gentleman who is now the chairman of President Bush's Council of Economic Advisors, and David Weill of Harvard published a paper in 1988 that showed that housing values were going to fall 47% in real terms by 2007. They lined up the demographics of the "baby bust" generation with housing prices and said there would be less demand for housing. The data seemed to show them that housing demand would grow more slowly on the 90s than for any previous period in the last 40 years. (The Economist, 09-04) They took the single derivative - the single dimension - of fewer babies and came up with their forecast. Of course, increased immigration, lower interest rates, Federal programs to make housing more affordable and the belief that housing is the best investment all combined to disprove their thesis. It is this penchant for other factors to come along and mess with our nice, neat charts that makes life so difficult for analysts. The trade deficit, by most thinking, should be killing the dollar. And it has dropped significantly against the Euro and many other currencies over the last two years, but that drop stalled out. But there are other factors which re clearly holding the dollar up. For how long, who knows? But there are clearly more factors than the trade deficit which affect the dollar. In this letter for the last two weeks we have looked at single derivative thinking: taking one trend or concept and forecasting that into the future without regard as to other factors which may impact the trend. As I look back on my own business and investing mistakes and missed opportunities (and I have had my ample share), the vast majority of them have come from that very problem. As an example, Donald Coxe writes: "For instance, it is easy to look at the oil crisis which will face us in the future decades. This week Ed Hyman's ISI, reporting on the latest International Energy Agency statistics, advises that world oil demand since 1988 is up 25%, from 64.95 million b/d to 82.15 million b/d. In those sixteen years, European consumption is up exactly 16%, US consumption up 18%, Japan's up 25%, and China's up 175%. Yes, China's Great Leap Forward in Oil Demand comes off a small base, but its absolute consumption has risen more than the US in that period--with American consumption up 3.08 million b/d and China's up 3.98 million b/d. China now consumes more oil than Japan--7.6% of the world total, compared with 7.4% for the world's second largest economy. Economics 101: all commodity prices are set at the margin. "China's fast-growing demand for oil at a time Russian oil production is constrained by Putin Petropower Politics has had enormous impact. By moving in just four years from being an oil exporter to being the world's second largest oil importer, China turned a short-term global oil surplus into a long-term global deficit. As The Wall Street Journal reported yesterday, neither OPEC nor Big Oil are reinvesting their remarkable oil profits in exploration and development." I have seen estimates that suggest world oil demand will grow yet another 25%. Where will the oil come from? The short answer is that it will not come at even $50 a barrel oil. Maybe at some much higher price, but that will short circuit world growth and demand. But given that, oil could drop significantly if there is a worldwide slowdown. It would be a temporary blip on the charts when viewed a hundred years from now, but it will give today's traders a lot of excess stomach acid. Of course, it is not just oil. China's surging economic expansion, which accounted for all the growth in world demand for copper, 99% of growth for nickel and 95% of growth for steel. There is no question that when you look at the very daunting problems facing the US, Europe and Japan - debt, aging populations, oil, massive bureaucracies, etc. - you could get discouraged. The data and trends I cited above are quite real. But it is my bet they do not come to pass. At least not in a way we can conceive of today. If a Trend is Unsustainable, It Will Stop For one thing, they simply cannot. You cannot have a modern economy where citizens pay 80-90% in taxes, or government spending is 75% of GDP. It would utterly collapse long before we ever get to such a situation. Western governments are going to have to face up, sooner or later, to massive restructuring of their obligations. This week, polls showed that East German voters strongly resist a cut in their unemployment benefits. Yet even the liberal Schroeder knows that Germany cannot continue along its current path without experiencing severe problems and recessions. Change will either come through the ballot box as enough voters wake up to the facts that they simply cannot afford their current government benefits and total expenditures, or it will be forced upon them by the realities of the marketplace. This is not a problem that will force events next year or perhaps even this decade, but the longer that dealing with the problems are avoided, the more wrenching the changes that will follow. Denial will not keep change from coming to your doorstep or pasture. This will happen not just in Germany, but in every major Western nation. Space does not permit a speculation here about those changes, but they will engender trends, even if outwardly uncomfortable, from which astute investors will be able to profit. There will also be places (both economic and physical) which thinking people should avoid. Second, one man's problem is another man's opportunity. Higher oil prices means that other forms of energy will become more competitive and replace oil. Considering how massive the world wide use of oil and gas is, that change is going to mean massive new investment opportunities. My side bet is that within 40-50 years we will be using some form of electrical energy production system that has yet to be invented. The fact that Western nations will not be the engine for world growth, that emerging market countries will have to develop their own consumer led growth, is an opportunity to stake out new investment horizons. If an aging developed world has less to spend, then the opportunity will be to those companies and countries who can manufacture products and services that are needed for less costs. Why does simple paint cost $80 a gallon in rural France? The answer is government. Rather randomly, my daughter and I sat at what looked to be a nice sidewalk restaurant in Paris. Turns out that it is owned by an ex-pat American. He has owned restaurants in France for 8 years. He is selling out and moving. "Regulations are killing me. Every time I turn around it is a new rule or another tax. It is driving me crazy," he complained. "It just keeps getting worse every year." Is he coming back to the States? Hardly. He is going to that "new" frontier city of freedom, Prague, in the Czech Republic. I have close friends who have specialized in doing business in developing countries and done so for decades. They now spend much of their time traveling throughout Eastern Europe, in search of new business. They extol the potential prospects. They acknowledge the problems and risks, but think there is a real window of opportunity. Chinese Opportunity It is not a one way street, of course. We have seen the Chinese stock market drop nearly 25% on the last four months. It is quite possible (even likely) it will fall further, as the government is clearly intent upon slowing down their white hot economy. But at the end of the cycle another nice bull run will follow. There will be values in the market which will be solid investment opportunity. Just like I want to be a US stock market investor after the next bear market, this will create opportunity as well. Stratfor.com writes: "The falling market is a double whammy for Chinese firms. Faced with declining loans from state banks, the firms now are unlikely to find financing through equity markets. In fact, the situation is so poor that Beijing's China Securities Regulatory Commission announced Aug. 31 that it was temporarily halting initial public offerings in the face of declining stock markets. This could put more pressure on the banks to make iffy loans to keep the Chinese expansion going. The falling market at home is prompting the government to let Chinese companies find more investors abroad. The China Securities Regulatory Commission announced in early September it is planning to revise its share-sale approval rules and make it easier for domestic companies to seek overseas listings." One man's (or country's) problems is another opportunity. The world has recently witnessed the largest migration of human beings in the last few decades in history. Not tens of millions but over two hundred million Chinese have left poverty stricken western China and moved to within 100 miles of the eastern Chinese coast, seeking economic opportunity and new jobs. That is one of the most impressive statistics I have ever heard. How do you logistically plan for an invasion of 200,000,000 people? The answer is, you let them plan for themselves. They were not moving as much out of desperation, as some might think, but because they saw opportunity. I find that a cause for optimism about the future of China. "Investment bank Goldman Sachs has forecast that in less than 40 years China will overtake the US to become the world's economy. Yet, with a per capita income that will be then only one-sixth the American level, it should have most of its growth still to come beyond that." says Martin Spring in On Target. He further notes: "Within ten years 'its appetite for base metals, food, and probably also luxury goods, will strain the world's ability to produce them,' Financial Times bureau chief James Kynge told the conference I've been attending in Shanghai. 'Its people will be traveling abroad, buying property abroad, and educating their children abroad, in numbers that will shock the world.' " 'China's competition for resources will cause great problems' with other countries. For example, some analysts forecast that over the next five years China will become a major importer of grain, perhaps even the world's biggest importer. China has emerged from its period of Maoist failure (thanks to the wipe-out of the 'cultural revolution,' a whole generation had no advanced education), to become a highly successful mixed economy with an increasingly free-market character. 'The best capitalists live in Communist China,' says the well-known investment commentator Jim Rogers. "Globalization and domestic reform are releasing the enormous potential of one-fifth of mankind united by a single culture, language and state. They are perhaps the hardest-working people on earth, very thrifty (saving on average more than 40 per cent of their incomes), intelligent, aggressively materialistic, and with a high level of natural commercial skills." Monster opportunities and problems exist side by side in the coming decades. You can focus upon the problems, or try and figure out how they will be solved and profit from the solutions. It will require multi-dimensional thinking and a willingness to think outside the box. But the one thing that you will not be able to do is avoid the changes. They are coming. Outside the Box, Early to Rise and San Francisco This Monday evening is the inaugural edition of my new e-letter, Outside the Box. It will showcase the writing of other analysts that I think will stimulate your thinking. I will not agree with all of the essays, and some of them will make us uncomfortable, but if you only read what you agree with, then what's the point? We will start with a study by Gary Shilling which outlines why he thinks the Consumer Price Index overstates inflation. It will make good friend Bill King apoplectic. Perhaps he will write why Gary is wrong. I will give you one of my little secrets: my friend Mark Ford writes the excellent (and free) daily e-letter, Early to Rise. Spending a few minutes reading it each day is like having my own personal business coach. It focuses on business and marketing issues as well as personal goal setting strategies, etc. ETR is one of my must reads. You can get it at http://www.earlytorise.com/SuccessStrategies.htm. Mark is one of the best marketing minds in the world. The final details are on the web for Telecosm 2004, hosted by George Gilder and Steve Forbes at Lake Tahoe, Nevada on October 20-21 here. Telecosm 2004 has a pretty powerful line-up of speakers, especially for those interested in technology. George writes me that: "Any of your subscribers registering though the link below will receive over 80% off the conference list price of $2,995, plus qualify to register a guest for FREE (if registered before Sept. 17, 2004). http://www.gildertech.com/public/Mauldin-Subscriber-Offer-2004.htm." Now there's big discount just for reading this far in a free e-letter. I am speaking three times at the next Money Show event in San Francisco on September 22-24, 2004. For free registration and complete details click the link below. Don't forget to mention me and Thoughts From the Frontline, along with priority code 003336. If you would like to schedule some time with me, please let me know at mauldin@2000wave.com. My daughter will be in touch and set up the meetings. More info on the conference here. I certainly enjoyed my time in London and Paris, although the cost increase from only 2-3 years ago seems staggering. The dinner tabs my hosts at Absolute Return Partners picked up in London were simply breath-taking. Thanks, Niels. I marvel at the burdensome overhead costs that business in London (admittedly the high cost Mayfair district) have to bear. If the Euro does indeed go over 140, as I think, there will be far fewer tourists in Paris, which is a shame, as it is a beautiful city and country. But then that is an opportunity for other lower cost destinations to come to the fore. As a parting thought, the best wine I had in London was a Sicilian Chardonnay and the best in Paris was a Chardonnay from Chile. Wine sales from France are way down in the US, while wine sales from Australia are way up. Is it American frustration with France? Hardly. There is a large cost differential, and Australia is closing the quality gap. It is the consumer who is voting with his pocketbook. Not just in wine, but in hundreds of markets, this will be a trend as the world opens up. It is a good thing, but it will not be comfortable for the high cost producers. And with that, I see a great California chardonnay in my very near future. It will help me contemplate the changes, I am sure. Your 'thinking about the ways the world will change' analyst,
John Mauldin Copyright ©2004 John Mauldin. All Rights Reserved. John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Thoughts from the Frontline may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. This information
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