Quantitative & Strategy

Cam Hui, CFA [email protected]

THE “OK BOOMER” DECADE

December 30, 2019

Table of Contents EXECUTIVE SUMMARY

‘Tis the season for strategists to publish their year-end forecasts for 2020. Instead of Is Demographics Really Destiny? ...... 2 participating in that ritual, this is the second of a series of think pieces of what might lie

ahead for the new decade (for the first see China: Paper Tiger). A Focus on Inequality ...... 3 It is said that demographics is destiny. As the Baby Boomers age and fade into their golden

A Tilted Playing Field? ...... 5 years, the Millennial generation is entering its prime and is poised to seize the baton of consumer spending and, eventually, political leadership.

Future Policy Implications ...... 7 We believe the coming decade is likely be the “OK Boomer” decade that sees a passing of the baton to the Millennial cohort characterized by: A Leftward Political Shift ...... 9  A greater focus on the effects of inequality Expect Rising Inflationary Expectations .. 12  A political shift to the left

The Dawn of ESG Investing ...... 13  There are two policy effects that can be easily identified: o The rise of MMT as a policy tool o The rise of ESG investing The question of whether these developments are good or bad is beyond our pay grade. However, investors should be prepared for these changes in the years to come.

Confidential — Do not duplicate or distribute without written permission from Pennock Idea Hub

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December 30, 2019 Quantitative & Strategy

Is Demographics Really Destiny? ‘Tis the season for strategists to publish their year-end forecasts for 2020. Instead of participating in that ritual, this is the second of a series of think pieces of what might lie ahead for the new decade (for the first see China: Paper Tiger). It is said that demographics is destiny. Tom Lee at Fundstrat recently highlighted changes in spending and debt patterns. As the Baby Boomers age and fade into their golden years, the Millennial generation is entering its prime and is poised to seize the baton of consumer spending, and eventually, political leadership. Exhibit 1: The Millennials Enter Their Prime

Source: Fundstrat Demographics is destiny holds true only inasmuch as people’s desires at different ages are roughly the same. But their desires are constrained by financial circumstances. The combination of a generational shift and differences in financial circumstances has profound implications for the political landscape, policy and investing.

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December 30, 2019 Quantitative & Strategy

A Focus on Inequality The biggest issue is inequality. While every generation thinks it had a hard time, inter- generational inequality is very real. Yiqin Fu, a political science Ph.D. candidate at Stanford, found that the wealth accumulation of each generation, Boomers, Gen X and Millennial, at specific ages have diminished. In particular, the flatness of the Millennial line is astounding, and graphically illustrates the headwinds faced by the age cohort. Exhibit 2: Millennial Wealth Accumulation Lags Older Cohorts

Source: Yiqin Fu This inequality gap can be observed in many ways. Variant Perception pointed out that an enormous gulf in consumer confidence has opened up between the people under 35 compared to those over 55.

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December 30, 2019 Quantitative & Strategy

Exhibit 3: A Generational Gulf in Consumer Confidence

Source: Variant Perceptions A Yahoo Finance article documented how Millennials simply cannot afford to buy a house: Many millennial renters won’t be homeowners anytime soon – even if they want to be. Among young adult renters who want to buy a home, 7 in 10 say they simply cannot afford one, according to a recent study by Apartment List, an online real estate company. The analysis was based on responses from over 10,000 millennial renters across America. Renters said poor credit and the burden of future monthly mortgage payments were major obstacles. But the most commonly cited challenge was saving for a down payment, with 60% of young adult renters saying this is what has kept them from buying a home. “Millennials today will need a 20% larger down payment than baby boomers,” said Dean Baker, chief economist at the Center for Economic and Policy Research. “Housing prices are higher [even] when adjusted for inflation.” A Bloomberg podcast with freelance writer Karen Ho explained the circumstances that Millennials find themselves in. Simply put, the Great Financial Crisis has scarred the cohort. Millennials began entering the workforce just as the GFC cratered the global economy, and many were unable to get on the first rung of the ladder to wealth and financial stability. Instead, the economy restructured them out of promising entry-level jobs, leaving them only gig work with little stability, benefits and pensions. Is it any wonder Millennials can’t afford to buy houses, or their wealth accumulation is so low compared to previous cohort?

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December 30, 2019 Quantitative & Strategy

A Tilted Playing Field? We are starting to see a radical re-think of economic assumptions and policy since the GFC. Martin Wolf recently reviewed a book by Thomas Philippon in the Financial Times that concluded that the U.S. is no paragon of laissez-faire free market economics: It began with a simple question: “Why on earth are U.S. cell phone plans so expensive?” In pursuit of the answer, Thomas Philippon embarked on a detailed empirical analysis of how business actually operates in today’s America and finished up by overturning much of what almost everybody takes as read about the world’s biggest economy. Over the past two decades, competition and competition policy have atrophied, with dire consequences, Philippon writes in this superbly argued and important book. America is no longer the home of the free-market economy, competition is not more fierce there than in Europe, its regulators are not more proactive and its new crop of superstar companies not radically different from their predecessors. Competition policy has allowed large corporations to earn monopolistic or oligopolistic profits: [Philippon] crisply summarises the results: “First, U.S. markets have become less competitive: concentration is high in many industries, leaders are entrenched, and their profit rates are excessive. Second, this lack of competition has hurt U.S. consumers and workers: it has led to higher prices, lower investment and lower productivity growth. Third, and contrary to common wisdom, the main explanation is political, not technological: I have traced the decrease in competition to increasing barriers to entry and weak antitrust enforcement, sustained by heavy lobbying and campaign contributions.” All this is backed up by persuasive evidence. Those prices of broadband access in the U.S. are, for example, roughly double what they are in comparable countries. Profits per passenger for airlines are also far higher in the U.S. than in the EU. The analysis demonstrates, more broadly, that “market shares have become more concentrated and more persistent, and profits have increased.” Moreover, across industries, more concentration leads to higher profits. Overall, the effect is large: the post-tax profit share in U.S. gross domestic product has almost doubled since the 1990s.

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December 30, 2019 Quantitative & Strategy

Exhibit 4: American Companies Enjoy Better Margins

Source: Financial Times Brad Setser at the Council on Foreign Relations described the US external position as "A Big Borrower and a Giant Corporate Tax Dodge". The argument that the United States functions as a financial intermediary that borrows cheaply to buy higher yielding financial assets—e.g. a skilled user of leverage—has a long intellectual history. And it naturally has a certain amount of appeal to many American financiers. It dates back to the original French critique of the exorbitant privilege the Bretton Woods system accorded the United States. Under the (brief) gold-dollar standard, the rest of the world was more or less required to build up dollar reserves—providing an inflow to the United States. And back in the 1960s, the U.S. current account was in balance, so the United States was using the inflows to fund riskier and higher yielding investment abroad. France was complaining that it was funding the takeover of Europe by U.S. multinationals… The belief that the U.S. uses its position to buy higher returning assets while issuing debt is no longer true. Setser found that the excess return on foreign investment is largely attributable to tax arbitrage, or a favourable tax treatment of offshore corporate profits embedded in the U.S. tax code. The excess return is entirely a function of the large profits U.S. firms book in the world’s corporate tax havens — the U.S. surplus stems from the large returns the United States appears to earn on its investments in Ireland, the Netherlands, and Bermuda. Basically, it looks to be a function of the United States’ willingness to tolerate a world where American tech and pharma companies’ offshore earnings aren’t really taxed by the United States at anything like the rate onshore profits are taxed at. Previously those profits were tax deferred, now they are largely taxed at the low GILTI rate of 10.5 percent. In short, U.S. policy has tilted the playing field in favor of large corporations, and this has exacerbated inequality.

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December 30, 2019 Quantitative & Strategy

Future Policy Implications There are signs that the Overton window, or the ideas that define the spectrum of acceptable discussion, is changing on inequality policy. Even the Federal Reserve is becoming more concerned. In an economic environment where the labour market is viewed as tight, economists in a more traditional framework would normally be concerned about the low unemployment rate causing inflationary pressures. Instead, Jerome Powell made a speech on November 25, 2019 which devoted four paragraphs to “spreading the benefits of employment”. First, he acknowledged the tight labour market has begun to benefit “low and middle income communities”: Many people at our Fed Listens events have told us that this long expansion is now benefiting low- and middle-income communities to a degree that has not been felt for many years. We have heard about companies, communities, and schools working together to help employees build skills — and of employers working creatively to structure jobs so that employees can do their jobs while coping with the demands of family and life beyond the workplace. We have heard that many people who in the past struggled to stay in the workforce are now working and adding new and better chapters to their lives. These stories show clearly in the job market data. Employment gains have been broad based across all racial and ethnic groups and all levels of educational attainment as well as among people with disabilities. He further gave a nod to Millennials by observing that the U.S. prime age labour force participation rate had fallen behind other major industrialized countries in 2018 compared to 1995. Exhibit 5: US Prime Age LFPR Lags Other Industrialized Countries

Source: Federal Reserve

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December 30, 2019 Quantitative & Strategy

In a surprising “the dog that did not bark” manner, Powell did not sound like a conventional economist and raise the risks of rising inflationary pressure from low unemployment. Recent years’ data paint a hopeful picture of more people in their prime years in the workforce and wages rising for low- and middle-income workers. But as the people at our Fed Listens events emphasized, this is just a start: There is still plenty of room for building on these gains. The Fed can play a role in this effort by steadfastly pursuing our goals of maximum employment and price stability. The research literature suggests a variety of policies, beyond the scope of monetary policy, that could spur further progress by better preparing people to meet the challenges of technological innovation and global competition and by supporting and rewarding labor force participation. These policies could bring immense benefits both to the lives of workers and families directly affected and to the strength of the economy overall. Of course, the task of evaluating the costs and benefits of these policies falls to our elected representatives. Is the Phillips Curve dead? Not yet, but it seems to be in the ambulance and policy makers trying to revive it using extraordinary means by redefining u*, or the natural rate of unemployment. Here is what Powell said at the December FOMC press conference: “It’s already understood, I think, that even though we’re at 3.5% unemployment, there’s more slack out there, in a sense. The risks to using accommodative monetary policy...to explore that are relatively low." The Fed is conducting a review of its policy approach, and the review will not be complete until June 2020. Until then, the Phillips Curve remains part of the Fed’s monetary policy framework. Fed watcher Tim Duy also noticed a shift towards a focus on inequality: Persistently excessive unemployment has its costs. Not only does the period of low unemployment not extend long enough to spread its benefits to the most challenged sections of the labor market, but it also tips the scales toward employers when it comes to wage bargaining. Workers who are always fearful of losing their jobs have little incentive to derive a hard bargain for higher wages. Boesler credits Minneapolis Fed President Neel Kashkari with leading the charge on this issue, arguing that the Fed policy does have a role in distribution outcomes. And he is not wrong; indeed, Kashkari tendency toward dovishness has proven more correct than not since he came on board. His concerns about inequality helped prompt him to launch the Minneapolis Fed’s Opportunity and Inclusive Growth Institute and has now found its new leader in the highly-respected economist Abigail Wozniak. The implication for policy of a broad acceptance of idea that the Fed may have contributed to inequality in the past is that the Fed is likely to be much more cautious when raising rates and respond to economic weakness much more quickly. In other words, this adds another reason to expect rates will remain lower than what we might have thought the Fed’s reaction function would suggest. The Overton window for economic policy is indeed shifting. Bloomberg reported that the latest Nobel laureate Abhijit Banerjee is arguing for raising taxes for redistribution as a way to spur economic growth: How do you spur demand in an economy? By raising taxes, not cutting them, says this year’s winner of the Nobel prize for economics. Reducing taxes to boost investment is a myth spread by businesses, says Abhijit Banerjee, who won the prize along with Esther Duflo of the Massachusetts Institute of Technology and Michael Kremer of Harvard University for their approach to alleviating global poverty. “You are giving incentives to the rich who are already sitting on tons of cash.”

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December 30, 2019 Quantitative & Strategy

A better approach would be to raise some taxes and distribute the money to people to spend, Banerjee said in an interview Monday in New Delhi, where he was promoting his book ‘Good Economics for Hard Times.’ “You don’t boost growth by cutting taxes, you do that by giving money to people,” he said. “Investment will respond to demand.” Move over, Reagan style laissez-faire economics. Elizabeth Warren style redistribution is taking over.

A Leftward Political Shift It is said that science advances, one funeral at a time, meaning that as the old guard dies off new ideas take their place. As the demographic profile of the American population changes, the same is likely to happen with political discourse. The Economist documented that people don’t often change their minds, but societies do because of demographic changes. Since 1972 the University of Chicago has run a General Social Survey every year or two, which asks Americans their views on a wide range of topics. Over time, public opinion has grown more liberal. But this is mostly the result of generational replacement, not of changes of heart. For example, in 1972, 42% of Americans said communist books should be banned from public libraries. Views varied widely by age: 55% of people born before 1928 (who were 45 or older at the time) supported a ban, compared with 37% of people aged 27-44 and just 25% of those 26 or younger. Today, only a quarter of Americans favour this policy. However, within each of these birth cohorts, views today are almost identical to those from 47 years ago. The change was caused entirely by the share of respondents born before 1928 falling from 49% to nil, and that of millennials — who were not born until at least 1981, and staunchly oppose such a ban — rising from zero to 36%. Exhibit 6: Changes in Attitude Mainly Due to Demographics

Source: The Economist The Millennial Young Turks are far more left leaning than older cohorts. Gallup also found that Millennials and Gen Z are far more favourably disposed to socialism than older generations.

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December 30, 2019 Quantitative & Strategy

Exhibit 7: A Socialist Generation

Source: Gallup The age demographic profile of the U.S. 2018 midterm elections also tell a similar story of a shift in the political pendulum. Expect the Democrats to gain ground over the Republicans in the coming decade.

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December 30, 2019 Quantitative & Strategy

Exhibit 9: A Clear Shift in Voting Patterns

Source: New Deal democrat Another article in The Economist explained that Millennial socialism boils down to three big ideas, namely more government, a “Green New Deal”, and capitalism robs people of dignity and freedom. According to the millennial socialists, more radical changes are required. Collectively, their manifesto boils down to three big ideas. First, they want vastly more government spending to provide, among other things, free universal health care, a much more generous social safety-net and a “Green New Deal” to slash carbon-dioxide emissions. Second, many argue for looser monetary policy, to reduce the cost of funding these plans. The third plank of their thinking is the most radical. The underlying idea is that capitalism does not just produce poverty and inequality (though it does), but that, by forcing people to compete with each other, it also robs them of dignity and freedom. “The power imbalances are obvious when you enter into your employment contract,” says Mr. Sunkara. For Mr Adler, capitalism “has sucked the life out of democracy”. Millennial socialists, therefore, support the “democratisation” of the economy (or socialisme participatif, as Mr. Piketty puts it), whereby ordinary people play a greater role in the production process, the market is removed from as many aspects of everyday life as possible, and the influence of the rich is drastically curtailed. Such reforms, they argue, will create happier and more empowered citizens. These big political shifts have broad investment implications.

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December 30, 2019 Quantitative & Strategy

Expect Rising Inflationary Expectations The first is the ascendancy of the Modern Monetary Theory (MMT) as an economic paradigm. For the uninitiated, MMT states that a government that issues debt in its own currency is only constrained by the willingness and ability of the bond market to fund its debt. Japan is a prime example. Austrian economic orthodoxy would have called for a collapse of the Japanese economy from the immense debt burden, but the short JGB trade has been a widowmaker for traders for decades. Michael Pettis set out some policy guidelines of what he called “MMT Heaven and Hell”.

Exhibit 9: MMT Heaven and Hell

Source: Michael Pettis MMT isn’t just about printing money, but what happens after the government prints money and the mechanisms that cause inflation. The government could print money by giving it to the rich. If the economy is capacity constrained, and the rich spend the money on productive investments, the stimulus is “MMT heaven”, or non-inflationary growth. If the government prints money to give to the poor, and the economy suffers from too little demand, the funds in the hands of the poor spurs non-inflationary growth. A third alternative is for the government to print money and spend it on productive infrastructure, which has the same economic effect as giving money to the rich in a capacity constrained economy. In other words, MMT adoption does not always lead to inflation. Christine Harper, the co- author of Paul Volcker’s memoir, revealed in a Bloomberg article that Volcker the Great Slayer of Inflation was surprisingly agnostic about MMT: Another time, I asked for his view of Modern Monetary Theory, which posits that a government with its own central bank and currency can and should keep spending until the economy is running at full employment. Surely the greatest living inflation fighter would recoil at such a prospect? But instead he simply pointed out that MMT hadn’t really been tested. For investors, this means that inflationary expectations are likely to rise, though the jury is still out on whether any implementation of MMT is necessarily inflationary. Bonds have been in a secular bull market since Volcker began to squeeze inflationary expectations out of the system around 1980. As bond yields have fallen, so has bond portfolio duration, or the price sensitivity of bonds to interest rate changes. At a minimum, expect greater price volatility from bonds.

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December 30, 2019 Quantitative & Strategy

The Dawn of ESG Investing Another trend to expect in the coming decade is the rise of ESG (environmental, social and governance principled) investing. Time magazine’s designation of Greta Thunberg as “person of the year” is a signal that ESG principles are inexorably on the rise.

Exhibit 10: Greta Thunberg, Person of the Year

Source: Time

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December 30, 2019 Quantitative & Strategy

John Authers also recounted how ESG investing has invaded the hallowed halls of Harvard and Yale, and why that’s important: If you want to see the future of climate-based investing, you need to look at Harvard and Yale. For those tired of debates dominated by elite universities, note that I am not talking about what goes on inside those hallowed halls...Students from the two universities’ campaigns to divest from fossil fuels (Yale Endowment Justice Coalition and Divest Harvard), staged a joint invasion of the field. Both want their endowments (the two largest university nest eggs on the planet) to get rid of all exposure to oil, coal and gas. They also called for divesting from holdings in Puerto Rican debt. This is important because university divestment campaigns have a history of working. In the 1980s, when the apartheid regime in South Africa was the target, such campaigns contributed to the pressure on the country that eventually led to the release of Nelson Mandela and black majority rule. Universities tend to be averse to negative publicity, while trustees of their endowments tend to prefer the quiet life. Authers also highlighted an InfluenceMap report of how major funds are deviating from climate investing. Their analysis found that the world’s 15 largest investment institutions, which have $37 trillion in assets under management between them, are collectively deviating from the “Paris-aligned” allocations needed to reach the Paris Agreement goal of stopping global temperatures rising by 2 degrees. Doing this primarily requires divestment from automakers, while making big investments in alternative energy producers. World markets as a whole deviate by 18%; the big institutions deviate by 15% to 21%. Jeroen Blokland observed that ESG just forms 2% of the overall market, indicating enormous scope for growth. The initial shift will likely begin in Europe, as a political consensus is forming that climate change is an emergency. By contrast, the climate change threat remains a subject of debate in the U.S.

Exhibit 11: ESG Penetration Is Still Low

Source: JP Mothsn

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December 30, 2019 Quantitative & Strategy

It is easier to identify the losers than the winners under ESG. ESG standards are still in their infancy and are evolving. Different providers are producing highly different results. However, we can definitively say that carbon emitting energy sectors are going to be the losers, such as energy giant Saudi Aramco, which staged an IPO into an unfortunate headwind. To be sure, the poor relative returns to the oil and gas industry over the last five years has put a brake on capital investment, and the under-investment will be reflected in supply constraints in the near future that is likely to boost energy prices. While energy prices may rise, the coincidental rise in ESG investing may also serve to restrain the returns of oil and gas equities and fixed income instruments. That’s the idea behind ESG, raise the cost of capital sufficiently to discourage further investment in carbon spewing projects. In conclusion, the coming decade is likely be the “OK Boomer” decade that sees a passing of the baton to the Millennial cohort characterized by:

 A greater focus on the effects of inequality  A political shift to the left  There are two policy effects that can be easily identified: o The rise of MMT as a policy tool o The rise of ESG investing The question of whether these developments are good or bad is beyond our pay grade. However, investors should be prepared for these changes in the years to come.

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December 30, 2019 Quantitative & Strategy

Disclaimer

I, Cam Hui, certify that the views expressed in this commentary accurately reflect my personal views about the subject company (ies). I am confident in my investment analysis skills, and I may buy or already own shares in those companies under discussion. I prepare and edit every report published under my name. I depend on my colleagues for constructive criticism on my research methods and conclusions but final responsibility is my own.

I also certify that I have not and will not be receiving direct or indirect compensation from the subject company(ies) in exchange for publishing this commentary.

This investment analysis excludes any target price, and is not a recommendation to buy or sell a stock. It is intended to provide a means for the author to share his experience and perspective exclusively for the benefit of the clients of Pennock Idea Hub (PIH). My articles may contain statements and projections that are forward-looking in nature, and therefore subject to numerous risks, uncertainties, and assumptions. The author does not assume any liability whatsoever for any direct or consequential loss arising from or relating to any use of the information contained in this note.

This information contained in this commentary has been compiled from sources believed to be reliable but no representation or warranty, express or implied, is made by the author or any other person as to its fairness, accuracy, completeness or correctness.

This article does not constitute an offer or solicitation in any jurisdiction.

Confidential — Do not duplicate or distribute without written permission from Pennock Idea Hub

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