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Scary Stuff

Jonathan Clements  |  October 31, 2020

IT’S HALLOWEEN, but not much frightens me—at least financially. My portfolio is broadly diversified, I have the insurance I need, and I have enough set aside for retirement. The highly improbable could happen, but I’m not going to lose sleep over that.

Still, even for those of us in decent financial shape, I see two key reasons for concern. We have no control over either—which is why they might seem scary—but we can take steps to limit the potential fallout.

Rising rates. I’m not forecasting a sharp increase in interest rates. But if that came to pass, not only would bonds take it on the chin, but also we could see grim short-term stock market returns.

U.S. stocks have spent much of the past three decades at what was once considered nosebleed valuations. The long decline in interest rates is a key reason. As the yields on bonds and cash investments have fallen since the early 1980s, investors have become increasingly willing to buy stocks, and that’s driven up price-earnings multiples.

On top of that, U.S. stocks have been nudged higher by two other factors. Corporate tax rates have fallen sharply in recent decades, while company profit margins have been at historically high levels. But these tailwinds could become headwinds: Interest rates might climb, corporate tax rates could rise and profit margins may narrow further.

Still, I think there are two reasons to believe stocks will continue to sport above-average price-earnings multiples. First, as the world has grown more prosperous, investors have more money to invest and an increased appetite for risk, and that’s led them to buy stocks.

Second, today’s big technology companies—as well as other businesses focused on building intellectual capital—almost inevitably look overpriced based on standard market yardsticks, and that’s affecting average valuations for the broad market indexes. What’s the issue? Current accounting standards punish the earnings of companies that spend heavily on research and development, while the intangible assets that often result typically don’t appear on corporate balance sheets.

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The upshot: I believe stocks remain an investor’s best bet for earning healthy long-run returns that beat back the twin threats of inflation and taxes, and I don’t think share prices will return to average historical valuations. But because of the risk from rising interest rates, it’s crucial to keep money you’ll need from your portfolio over the next five years in bonds or cash investments, and you might opt for even more if you have a low tolerance for risk. At the same time, I’d also favor shorter-term bonds, so any rise in interest rates doesn’t badly damage your bond portfolio’s value.

Needing workers. There’s been a lot of handwringing over the dwindling Social Security trust fund and the yawning federal government budget deficit. This handwringing was widespread even before this year’s massive COVID-19 government stimulus spending. But as I’ve argued before, these are just symptoms of a far bigger problem: The U.S. and other developed nations have increasingly unbalanced economies, with too few workers and too many people dependent on their labor.

This fundamental problem shouldn’t be news to anybody. We’ve known for decades that the retirement of the baby boom generation would create this unbalance, and yet (no surprise here) we’ve done very little about it. From an accounting point of view, we could “fix” this problem by, say, cutting Social Security benefits or raising taxes. But these fixes only truly work to the extent that they push folks to stay in the workforce for longer.

The fact is, in the absence of major technology breakthroughs that raise the productivity of workers or a widespread willingness to spend less, we simply can’t have people continue to leave the workforce at an average age of 62, because we won’t have enough folks producing the goods and services that society demands.

And, no, encouraging workers to save more for retirement is unlikely to solve this problem. What would happen when these folks spend their savings? We’d still have the same fundamental problem—not enough workers producing the goods and services that society wants. The only solution is to get workers to postpone retirement.

If that doesn’t happen, we could potentially see all kinds of economic dysfunction. Demand could outstrip supply, leading to rising inflation. Government budget deficits would balloon further, as tax revenues fall, while the cost of Social Security and Medicare increases. Trade deficits may widen as we try to solve our supply shortage by importing more goods. Eventually, the result would be some mix of inflation, smaller government benefits and higher taxes that, taken together, would force retirees back into the workforce or dissuade them from retiring in the first place.

You might respond that we shouldn’t be much bothered, because a rising average retirement age is almost inevitable. You might also respond that it probably isn’t great to have folks sitting around doing nothing for the last 20 or 25 years of their life, so a rising retirement age would be a healthy development. And you might note that, while others may be forced to work longer, you and I should be okay, as long as we’ve done a decent job of saving for retirement.

Perhaps.

But even if you and I are okay financially, retirement won’t be much fun if our fellow seniors are struggling financially and the economy is in turmoil. What’s the solution? I think it starts with better political leadership. We need policies that encourage folks to stay in the workforce for longer and encourage businesses to create jobs suitable for older workers. That way, we might avoid the economic distress caused by inflation, painful cuts in government benefits and sharp increases in tax rates—and those in their early 60s might not feel so shortchanged when they discover that they need to delay retirement by a few years.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Irksome AdversariesWhere We Stand and Game Over.

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