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Demographic Reckoning

This note was originally published at 8am on February 29, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Demography is destiny.”

-Auguste Comte

 

This Friday we are hosting a conference call for our macro subscribers on Japan titled, “Japan’s Debt, Deficit and Demographic Reckoning”.  (If you aren’t a macro subscriber and want to get access to the presentation, email sales@hedgeye.com  for subscription details.)  During the presentation, we will spend a fair amount of time framing up the economic history of Japan starting with the American occupation post World War II.  When contemplating economic history, I’m often reminded of George Santayana’s quote:

 

“Those who cannot learn from history are doomed to repeat it.”


Certainly, history provides a critical frame of reference for Japan.  In particular, the last twenty years of economic history in Japan, which witnessed a massive build up in Japanese sovereign debt (currently 220% debt to EBITDA) and stagnating economic growth (just +8.5% nominal growth over the last 20 years), have set the table for Japan’s future.  But as my colleagues (hat tip to Darius Dale and Josefine Allain) and I have been grinding through this 80+ page presentation, the idea that Demography is Destiny truly represents the next chapter for Japan.

 

Currently, according to estimates from the CIA fact book, 23% of the Japanese population is over 65 years old.  This compares to only 13% in the United States and approximately 8% for the rest of the world.  As one of the world’s oldest countries, the burdens of supporting this aging population are seen directly in the Japanese federal budget.  In the 2012 Japanese federal budget, social security spending will be just over 29% of the entire budget.  This compares to 17% of the federal budget in 1990.

 

Due to a low fertility rate, the Japanese death rate currently exceeds the Japanese birth rate.  In the absence of meaningful immigration, this implies that the Japanese population is in decline.  As I outline in the Chart of the Day, based on the Japanese government’s own projections, their population will decline by more than 25% by 2050.  In conjunction with said declines, the Japanese population is aging and by 2050 more than 40% of the population will be over 65. (And to think at 38 I thought I was getting old!) The demographic future of Japan will only accelerate social security entitlement spending. 

 

The other concern with an aging population is growth.  Robert Arnot and Denis Chaves recently wrote a paper for the Financial Analysts Journal called, “Demographic Changes, Financial Markets, and the Economy”, in which they attempt to quantify the relationship between demographics, growth and capital market returns based on 60 years of data.  They conclude that:

 

“ . . . senior citizens contribute to neither GDP growth nor stock and bond market returns; they divest to buy goods that they no longer produce.”


Based on their projections, the aging population will negatively impact Japanese growth over the next decade by ~-5% in aggregate. 

 

In theory an aging Japanese population, even if a major headwind for growth, could be overcome by the appropriate mechanisms and policy.  Unfortunately, after more than twenty years of deficit spending, Japan’s proverbial hands are increasingly tied by debt.  Specifically, Japan has massive non-negotiable financial burdens due to the second largest component in the proposed 2012 Japanese budget being debt service.

 

Servicing and interest on sovereign debt outstanding are projected to total 24% of Japan’s federal budget in 2012.  This line item has almost doubled since fiscal 1980, when it was at 13%.  I may not have a PHD in economics, but even I can tell you that if 1/4thof the Japanese federal budget is going towards debt service that spending is not generating an incremental return, either in the way of GDP growth or a higher standard of living, for Japanese society.

 

In a scenario analysis, we used a more normalized interest rate of 5.5%, which last occurred back in 1995, and applied that interest rate to the current debt servicing burden.  At this interest rate level, the Japanese debt servicing burden would be 100% of the current federal budget.  Clearly, increasing interest rates would squeeze out the government’s ability to more proactively invest in the nation and/or support rising social security expenditures.

 

To be sure, we are not projecting an imminent Japanese default, but in the short term with Japanese maturities accelerating in 2012, and specifically in March, there is increased concern as to Japan’s creditworthiness.  Based on the scenario I described above, the longer term question is whether Japan will be able to fund its future.  For the last twenty years, this funding has been enabled by a combination of high savings rates (both corporate and individual) and a current account surplus. Currently, we are seeing negative inflection points in both areas.

 

Ultimately, as Shakespeare wrote, “What is past is prologue”, and as it relates to Japan the past is indeed written.  Increasingly, Japan’s future is also already largely written by her Demographic Destiny.

 

Our immediate-term support and resistance ranges for Gold, Oil (Brent), USD/JPY, and the SP500 are $1752-1806, $122.01-126.19, $79.71-80.98, and 1361-1376, respectively.

 

Keep your head up and your aging stick on the ice,

 

Daryl G. Jones

Director of Research

 

Demographic Reckoning - Chart of the Day

 

Demographic Reckoning - Virtual Portfolio


IGT CATCHING UP

The stock has been a laggard but better near-term trends, investor friendly cash deployment, and some international visibility may quickly narrow the performance gap.

 

 

IGT’s belief that they can drive their international market share from 15% to 30% over the next several years certainly raises eyebrows.  Considering that the international slot base is 50% larger and growing twice as fast as North America, that would be a very lucrative accomplishment.  We’ll remain a bit skeptical on the 30% but we do think evidence will emerge this year and this quarter to show that IGT is making progress.  Incremental sales will leverage an already beefed up sales and content infrastructure.  In other words, the cost infrastructure needed to drive significant growth in international sales is already hitting the P&L.

 

International growth is not the only catalyst, however.  IGT’s recent large investments in the online gaming space have investors worried about ROIC.  We think management is done making large acquisitions for a while which means their sizable free cash flow needs to be invested elsewhere.  Aggressive and accretive stock buybacks are the most likely vehicle for returning cash to shareholders.  Ultimately, we expect the company to raise its dividend modestly and potentially accretively take out the convertible.  Management appears happy with its current leverage.

 

IGT trades at 13x our fiscal 2013 EPS estimate, yet EPS growth could be 20% for a few years.  The story is coming together and is getting out there.  Management is meeting with investors in Boston and New York this week and a big investor conference is being held in Las Vegas next week.  We think incremental investors may be persuaded by more prudent cash flow deployment going forward (read: buyback) and the progress being made toward the company’s lofty international goals.



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Being Wrong

“No amount of experimentation can ever prove me right; a single experiment can prove me wrong.”

-Albert Einstein

 

If your portfolio is 50% long SPY and 50% long AAPL, you are all set – Bonds, Gold, Currencies are all getting crushed. So much for Global Macro diversification.

 

In terms of US Equities, I’m sure most people absolutely nailed it yesterday, but I didn’t. I’d already sold my Long Financials (XLF) position (Sector Rotation into Utilities) and I wasn’t long anything big beta Basic Materials or Energy yesterday.

 

For those keeping score since February, not being long anything Commodities or International Currencies has actually been a very good risk management decision. Not to call out crashing currencies, but the Japanese Yen is down -9.1% since February 1st. Small Caps (Russell 2000) are dead flat from that same date.

 

Back to the Global Macro Grind

 

Since no one who made money in 2011 was long the Financials (XLF) and now, less than 3 months later, everyone I see on TV proclaims to be long them, what are we to do with this Storytelling about a “successful stress test” by the US Federal Reserve?

 

Well, my Being Wrong about the US stock market yesterday is one thing, but being wrong about what this test was all about is not what we do. Check out the parameters of this so called “test”:

  1. US GDP Growth: “stress” was measured using a down -8% GDP scenario
  2. US Unemployment: 13% was the bogey there (after Bernanke is celebrating his contributions to full employment)
  3. US Stock Market (not clear why this is such a critical part of Bernanke’s test) = Dow 5,500

Not a typo. Not Dow 15,000. Dow 5,500. Good thing most of these revolutionary banking outfits passed the test!

 

If I had the insider information that some apparently traded in front of on the pre-release of the “stress test” (someone bought a boat load of Citigroup $38 puts, right before they “failed” the “test”), I wouldn’t have changed my positioning ahead of it anyway. That’s illegal, last I checked.

 

I don’t know what level of experimentation my risk management models could have been stress tested with for me to have not made the risk adjusted decisions I’ve made throughout March either.

 

To put yesterday’s Global Macro move in context, it was a 3.7 standard deviation event across asset classes. Since I have scored/back-tested my model (2007), this has happened less than 1% of the time. Evidently, the 1% in this country still matters.

 

Moreover, what I learned the hard way yesterday was that “a single experiment can prove me wrong.” I cannot understate the 3 dimensional risk associated with US interest rates rising from the ZERO bound. This baby is all on Bernanke’s lap too – don’t forget that he’s the one who has trained us, like Pavlovian dogs, to carry trade 3D Risk:

  1. Daring us to chase yield (got dividends?)
  2. Delaying Balance Sheet restructuring (bad sovereign deficit spending, including the USA)
  3. Disguising Financial Market Risk

Again, if you are long the 50/50 AAPL/SPY portfolio, no worries about this. But, in the rare case that you are long Gold, Bonds, or Currencies, this Disguise of Financial Market Risk doesn’t need to be explained to you. This morning, it’s in your account.

 

For March 2012 to-date:

  1. GOLD = -3.1% (down -7% from its FEB 2012 peak)
  2. TREASURIES = 2 and 10-year UST Bond yields are up +24% and +13%, respectively (bonds smoked)
  3. CURRENCIES = the 2 majors vs the USD (Yen and Euro) are down -3.7% and -1.8%, respectively

So what do I do from here?

 

My risk management process doesn’t chase stock prices on no volume and bombed out volatility signals – so don’t expect me to change my process after Being Wrong on that asset class for a few days. It was only last Tuesday when I was getting long at 1345.

 

Across durations, here’s what my core 3-factor risk management ranges (PRICE, VOLUME, VOLATILITY) are telling me to do:

 

1.   PRICE: immediate-term risk range = 1, so we are immediate-term TRADE overbought or I wouldn’t have shorted SPY yesterday at 3:08PM into the close. Long-term, lower-highs (down -10.9% versus all-time high) are obvious – so is intermediate-term TREND support at 1290.

 

2.   VOLUME: flat out nasty volume signals, across durations, will only be considered irrelevant by people who have blown up in any of the massive Q1 to Q3 US Equity draw-downs of 2008, 2010, and 2011. Long-term volume signals are at generational lows, while yesterday’s immediate-term volume was only the AVERAGE volume of the 30-day composite in my model.

 

3.   VOLATILITY: Yesterday’s Chart of the Day showed you how, like clockwork, this 14-15 Equity Volatility (VIX) zone has been as clear a signal to sell long Equity and Commodity exposure as the sun rising in the East. Snapshot VIX: up +9% in 30mins yesterday to 15.89 before the almighty “stress test” leaked, then straight back down to close at 14.80. Fast.

 

Being Wrong doesn’t make me happy. I have no excuse for it – neither am I searching for one. As Billy Beane said in Moneyball, “I hate losing more than I do winning.” Today, I’ll wait and watch. Being forced to move is no way to win.

 

My immediate-term support and resistance levels for Gold, Oil (WTIC), US Dollar Index, and the SP500 are now $1, $124.21-127.41, $79.59-80.49, and 1, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Being Wrong - 1. Bern

 

Being Wrong - 11. VP 3 14




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