Author: Bruno Siriani

Governmental aid has also allowed households to accumulate significant savings. This graph indicates that excess savings in Japan presently constitute 10% of GDP, maintaining a robust position compared to the sharp decline in the US that we discussed earlier. The Japanese still have a lot of extra money in their pockets. Theoretically, this could enable Japanese consumers to drive economic growth at trend levels solely based on these excess savings for the upcoming five years, not including any income. Additionally, considerations are being made to extend support measures, such as fuel and gas subsidies. Signs of growing consumer confidence are becoming evident across various sectors including employment prospects, income growth, and purchasing intent for durable goods. In our view, only an exogenous shock could derail the Japanese economy at this moment. Some other risks include a deceleration in the pace of foreign machinery orders and machine tool orders. In addition, after a substantial surge over the previous two years, Japanese exports are experiencing a waning despite the currency’s depreciation. However, given the substantial war chest of excess reserves amounting to 10% of GDP, Japanese consumers should be able to weather any storm quite well.

It is a well-known fact that the pandemic caused births globally to collapse and that they remain below levels necessary to stabilize population growth. We also know that aging populations place a major strain on pension and health care systems as fewer workers have to support more consumers and retirees.

This graph demonstrates that after rising steadily since the 1980s, the global support ratio, or the ratio of workers to consumers, peaked a few years ago and is projected to collapse to levels last seen during the 1970s.

The news is filled with alarmist predictions of the “greying” of European, North Asian, and North American populations, coupled with their dire repercussions. After many years of failed government policy to boost fertility rates (e.g., China lifting its one-child policy), there is a sense among policymakers that there is not much that they can do to encourage people to have more children. Studies show us that as people retire, they save less and spend more. As the pool of global savings decreases, it places upward pressure on equilibrium real interest rates and bond yields. Faced with these prospects, governments are likely to further increase spending to encourage more childbearing. Permanent and/or larger fiscal budget deficits will similarly deplete national savings and push rates higher. These demographic considerations have underpinned one of our most recent fundamental investment calls, the end of the 40-year bond bull market. A major corollary of that thesis is that interest rates have begun a structural uptrend with successively higher highs and higher lows, although they will temporarily fall during recessionary periods.

But what if birth rates will eventually increase on their own despite government policy? What if global fertility rates, instead of further declining, may be bottoming and poised to rise sharply? A 2019 study in the journal of Evolution and Human Behavior by Jason Collins and Lionel Page suggests that our population modeling is incorrect because they use assumptions of constant long-term fertility rates. In their place, the authors introduce a dynamic model incorporating inheritable fertility based on evolutionary biology. Rather than stabilizing around a long-term level for developed nations, fertility rates tend to increase as children from larger families represent a larger share of the population and partly share their parents’ trait of having more offspring. In other words, both cultural and genetic evolution will select for families that wish to have more children. To further clarify, the desire to have more children is as inheritable as height or IQ. As cultural forces have suppressed fertility over the last few hundred years (really since the Industrial Revolution), an ever-growing proportion of people with a higher propensity to have more children will have children. When the environment changes so quickly (since the early 1800s, for example) that existing reproductivity strategies become suboptimal, natural selection responds quickly. Their results suggest that the global population will grow much faster than currently anticipated.

In their model, without the inheritability effect, the global fertility rate declines to 1.82 by the end of this century, which is below the human replacement threshold. But once heritability effects are factored in, that rate increases to 2.21, well above the threshold. If true, this would have massive global policy implications from climate change to migration patterns to global conflict and even extraplanetary human settlement. And as this chart demonstrates, the effects are most pronounced in the two areas you would least expect: Europe and North America. Their model projects the European and North American fertility rates to rise to 2.46 and 2.67, respectively, above the global averages and against all conventional wisdom given current population modeling and projections. At a recent event, Elon Musk said, “if people don’t have more children, civilization is going to crumble.” He is right. Progress, technology, and network effects work better with higher “n” variables: the more people the better. But we might not have to do anything about it from a policy perspective as natural selection pressures might already be breeding out those of us less inclined to have children. As Dr. Ian Malcolm in Jurassic Park reminded us, “life finds a way”.

While Putin may have made a grievous mistake when he invaded Ukraine, he may not have been the only one that committed an error in judgment, although he is certainly more obvious. However, the Americans, Europeans, and Swiss may too have committed a major policy blunder, even if a more subtle one that may not be apparent for many years. By freezing the Central Bank of Russia’s foreign currency reserves, the West has announced to the rest of the world that their Dollars, Euros, and Swiss Francs are no good anymore. When the Dollar is weaponized as an instrument of foreign policy, it is reasonable to expect defensive maneuvers.

Of course, the Western retort would be that this sort of pariah status is only reserved for “aggressors” and “enemies.” But in the world of geopolitics, your friend in one generation can be a foe in another. Two current and strident allies of the US were our main enemy combatants in World War II – Germany and Japan.

Eighty years is a long time, but central banks should have the long view when deciding where to place their country’s surpluses. Another issue that looms against the demand for Dollars is the US’s deteriorating fiscal position. American fiscal deficit spending because of the pandemic reached 25% of GDP. In Europe and China, those figures were much lower, 15% and 5%, respectively. According to IMF forecasts, structural budget deficits in the country will average 4.9% of GDP until 2026, versus 2% before the pandemic. Over time, persistent budget deficits will reduce savings and ultimately drive the neutral rate of interest higher. A higher neutral rate, in turn, will push bond yields upwards as well. Even though the move up has been quite dramatic so far this year, look for yields to grind higher over the next several years, characterized by successively higher highs and higher lows. Nothing lasts forever and trends always reverse. This chart shows that US treasury yields peaked in the early 1980s amid Fed Chair Paul Volker’s inflation-fighting regime and have been making successive lows ever since – lower lows and lower highs. Has this 40-year bond bull market ended? We think this may be likely and would position for a reversal of this Reagan-era trend.

Now, let us be clear, we are not arguing that the US Dollar is about to lose its place as the global reserve currency overnight or even suddenly. It is not easy to dislodge the world’s reserve currency because there is a certain inertia to that standing due to positive network effects. The Greenback’s pole position is underpinned by the strength of the US economy, the depth of its capital markets, and the fact that most of the global trade is still settled in US Dollars. As the next chart shows, the level of Dollar reserves has held rather steady over the past five years. In fact, more than 60% of all foreign bank reserves and 40% of the world’s debt are denominated in Dollars. But the most important reason it still dominates is that there is no credible alternative out there currently.

The European Union is like the US in terms of economic size and the strength of its financial markets, but the Continent has many structural impediments to attaining dominant reserve status, primarily the lack of both a fiscal union and military power. The UK and Switzerland are both too small as a share of global GDP to seriously consider the British Pound Sterling or the Swiss Francs as alternatives. The Chinese Renminbi is an obvious candidate, but China too has issues that prevent this, namely that the country maintains a closed capital account and it is not freely traded. Indeed, the Renminbi only accounts for 2% of global foreign exchange reserves, despite the country approaching a quarter of global GDP. It Is not surprising to read the news that the Saudis are negotiating with the Chinese to settle oil purchases in the Renminbi, and the Russians surely are accepting it as payment for their energy exports today to circumvent Western sanctions. Yes, it would be premature to signal the Dollar’s demise as it will not yet go the way of the Roman Aureus, the Spanish Real, or the British Pound Sterling until US power wanes significantly from current levels, and that is not likely soon. But we could see a situation where the level of Dollar reserves matches the geopolitical reality we mentioned earlier – the first among many – as the marginal demand for Dollars falls as central bankers continue placing less of their surpluses in Treasuries. In that sense, the most important development over the last few weeks may not be Cold War II, but the first stage of declining Dollar hegemony.

If this thesis holds, US rates will have to go up to entice further buying of Treasuries as they cheapen. The more likely asset bubble, then, exists not in US equity markets but in its sovereign bond market where real yields are still negative despite the recent selloff. As interest rates grind higher, investors would want to own real assets: rental properties, high dividend compa- nies, farmland, agricultural commodities, and industrial metals. “Old” economy sectors like industrials, energy (both hydrocarbons and renewables), miners, and utilities. As central banks around the world purchase and repatriate as much gold as they can, investors would not want to stand in front of that trend either. The precious metal has the added luster of being an attractive geopolitical hedge and outperformer during periods of higher inflation and lower growth. Owning Chinese government bonds is also an attractive option as that, in our view, remains the most attractive bond market in the world. As more trade and reserves settle in Renminbi, it should keep them well bid and it has an attractive carry. Imagine the flows into that market if global reserves rise from the paltry 2% of current reserves to 5% or even 10%. These levels seem conser- vative in a world where the US has weaponized the Dollar and other countries have taken note.