In this quarter’s Chat with the CIO, Eric P. Leve, CFA (Bailard’s Chief Investment Officer) discusses the implications of demography with Anthony Craddock, Bailard’s Senior Vice President of International Equity Research.
September 30, 2019
Eric P. Leve: People say demography is destiny, but rarely delve into the meaningful details. So, stepping back, how might it affect us as citizens as well as investors?
Anthony Craddock: Agreed—when swirling headlines of the world’s immediate economic and governmental challenges occupy the brain—it’s hard to give the longer-term consequences of demographic change the proper focus and consideration. But, not only are the impacts certain to be massive, the outline and direction of the transition are reasonably predictable.
Eric: More than predicable, I’d say inevitable. Nothing is going to reverse the aging of populations across the developed world and in China. Advances in healthcare should allow people to live longer, the large “baby boom” working cohort will enter retirement, and birth rates should fall or remain low. All else being equal, once a society grows old it does not then somehow grow young once again.
Tony: Let me stop you there for a second. I imagine most people around long enough would agree that, on a personal level, getting old can be problematic (though it beats the alternative). Likewise, an aging society generates its own difficulties. But, first, let’s observe the beneficial phase of demographic transition. Based on historic data studying the implications of a developing economy, an increasing proportion of workers in the population goes hand-in-hand with a country’s development from low-income to high-income. A country exiting poverty usually brings down its mortality rates with better healthcare, nutrition, and education. Children survive and fewer working age adults die young.
As development proceeds, and barring other factors, those children age into the workforce and the rate of new births starts to decline, while the number of elderly is still relatively small. This is the sweet spot where the economy can reap its demographic dividend, as a growing proportion of workers to dependents leads to a growing output (GDP) per capita, even with no increase in labor productivity (output per worker hour). Combine this with a growing overall population and you’ll likely get a rapidly growing GDP in aggregate, increasing opportunities for scale and profit in the business sector as well as for creating a larger tax base for public services. If labor productivity is also increasing, this all goes into overdrive.
Eric: That’s all well and good, but now look at what happens next. Generally, as development continues, life expectancies continue to rise while birth rates stay low; it seems that advanced economy levels of health, material comfort, and personal freedom naturally guide a society towards a fertility rate closer to two, rather than three or four. Workers age into retirement and, all else being equal, are replaced with a smaller group of new workers. In this case, the expanding cohort of elderly increases and all of the beneficial trends we just talked about can start to stall and go into reverse. Most countries today still have a high enough birth rate (sometimes augmented by immigration from faster-growing populations) to sustain positive population growth overall. For them, the labor force is still growing, just not as fast as the elderly. In a few countries, notably Japan, a low enough birth rate over time has caused both the workforce and overall population to shrink. Barring other factors, a larger number of non-workers combined with falling population make positive GDP growth increasingly difficult to come by.
In short, an aging society, all else being equal, will act as a drag on economic growth.
Tony: And, the problem is exacerbated in countries with pay-as-you-go pension and benefit systems that transfer wealth across generations from younger taxpayers to old. This is seen today in the U.S. as working age income-earners face an ever larger burden supporting retirees drawing Social Security and Medicare benefits. Each year, the government borrows more to bridge a gap in the budget that becomes increasingly difficult to close. So the debt keeps growing relative to the size of the economy, at just the time the demographic headwinds make it harder to grow the economy and service the debt load.
Slower economic growth as well as changing spending patterns will tend to keep a lid on inflation (reduced discretionary spending along with the loss of earned income, big-ticket items having already been purchased earlier in life). So the public and private debt likely will not be inflated away either.
Eric: In short, an aging society, all else being equal, will act as a drag on economic growth. But what can be done to mitigate the effects? First of all, expanding the working-age population by increasing the standard retirement age seems a sensible adjustment to lengthening life spans.
Second, working-age population is not necessarily the same thing as workers or worker hours: if a too-small share of the working-age population is actually employed full-time, this suggests a way to strengthen the economy while playing the demographic hand already dealt. For starters, in many countries female labor participation rates have ample room to rise. Policies to increase labor participation among those who gave up and left the workforce entirely, and who are not included in headline unemployment rates, would also be undeniably beneficial. Increased labor productivity—whether achieved through intensity of capital employed per worker or improvements in technology or more advanced education and training—would be the silver bullet of choice for economists and entrepreneurs everywhere.
It could be that there is some practical upper limit on the amount of economic juice that can be squeezed from the fruit of the average human’s working hours.
So let’s spend some time here on the productivity puzzle. In contrast to what the current situation cries out for, studies by the Organisation for Economic Co-operation and Development (OECD) and others have found rates of productivity growth are on the decline, and in many places, rates are flattening to zero or going negative. Is the world growing lazy and less innovative?
It could be that there is some practical upper limit on the amount of economic juice that can be squeezed from the fruit of the average human’s working hours. It’s possible that we’ve done the great big impactful things already: specialization, industrialization, and urbanization; infrastructure for reliable power, sanitation, transport, and communication; legal and financial frameworks allowing corporations to efficiently organize production; widespread adoption of information technology, automating factory and office. It could be that we are well into an era of diminishing returns. I’ll admit that the ability to summon a ride at any time from a random fellow citizen is pretty cool, but I don’t think it meaningfully increases the value of a typical employee’s efforts. In my opinion, nothing else we’re going to download onto our phones or laptops is going to move the needle much.
Tony: OK, I’ve heard that before. But not so fast. I agree we can’t discover penicillin or invent the electric light bulb a second time, but are we really at the tail end of gains from automation? I’d argue that we are still in early days. Advances in machine learning and artificial intelligence will one day make the idea of a physical or virtual robot acting on its own initiative feel commonplace. At that point, with several TED conferences’ worth of tireless, quick-thinking research agents chewing over the world’s problems, there’s no telling what new ideas will come forth.
Eric: Sure, Tony, all our worldly problems will be solved by the super-smart bots. Are you suggesting humans will at last be freed from toil, leading lives of art and leisure, enjoying a living wage from the surplus generated by the fully-automated, hyper-efficient global economy?
Tony: Not necessarily. Don’t forget quality. It’s important to measure productivity beyond the crude equation of price multiple by quantity. A worker’s annual output puts a dollar amount on the purchasing power in the economy enabled by that individual’s labor. In judging whether that amount is growing quickly enough—say now, versus 30 years ago—you need to consider the standard of living supported by those dollars at the start and end. Today we are able to purchase certain products, think cars or computers, of a much higher quality than previously available. And then consider quality of life, including those things whose value is non-monetary (or difficult to monetize, for those producing them). It may be that every shared ride priced below true market value subtracts a little from the economy’s output. But on the other side of the (non-monetary) ledger I’d put the convenience and overall satisfaction enjoyed by the rider. And playing free smartphone games anywhere I happen to be standing makes me happy... I don’t see that benefit measured anywhere by the statisticians.
Eric: Perhaps let’s now discuss implications of demographic change for investors. First, I’d note the likelihood of lower inflation and real interest rates persisting into the future. As the elderly become a larger part of the population, their spending becomes a more important piece of the overall economy as they hold much of the wealth and power relative to their younger counterparts.
Studies indicate the older cohort is averse to inflation, as they are often drawing down a pool of retirement savings or earning a fixed income smaller than that earned in the working years. Barring other factors, they have different needs than before, and make consumption decisions accordingly. Empirically, this is borne out by Japan’s ongoing battle with deflation and, more recently, Europe’s similar struggle.
Interest rates are harder to figure: slower economic growth in older countries should keep rates down, but less saving or negative saving by seniors could mean a rise in interest rates as banks and borrowers need to make their offers more attractive. If there is a consensus among economists it is that growth is the more important factor and lower rates the more likely result.
So what can we expect to come with a future of potentially lower nominal and real interest rates? Clearly, government and company pension plans would have even more trouble meeting their return projections and funding their payouts. Retirees depending on income from cash and low-risk bonds would need to draw down their savings faster or else need to reduce consumption. Central banks that have kept rates near zero would have less room for conventional monetary easing in the event of economic weakness—a situation faced by the European Central Bank (ECB) and Bank of Japan (BOJ) for some years now—and requiring increasingly creative and heroic measures to accomplish, well, not very much.
On the other hand, governments and corporations could issue bonds at ultra-low, even negative yields. Individuals would be able to borrow cheaply with predictable debt service and no shocking rate adjustments. In a low-growth, low-yield world, however, they wouldn’t see the same effect that comes with inflation and expansion; that is, debts would become less painful to pay down as time goes on.
Tony: This sounds like an environment where investors would have to endure some volatility in order to seek out pockets of growth and earn a decent rate of return. One possibility—for investors who could handle the risk—is putting money to work in faster-growing markets outside the U.S. In the long run, economic growth matters a great deal for the profitability of a country’s corporate sector and the value of its financial assets.
In contrast to the aging population profiles seen in most of the world, many countries in Southeast Asia and sub-Saharan Africa appear poised to enjoy the benefits of an increasing share of population in working age. This should underpin growth as well as a rise in living standards. Translating this into prospective investment performance for those higher-risk markets can be tricky, requiring fair and functioning legal and political systems as well as a modicum of good corporate governance. But, with the right demographic and growth backdrop, emerging and frontier markets (both beaten down as an asset class in recent years) could see a renewed wave of interest.
Eric: And, what does this mean for China? China is following the same aging pattern as the high income countries, partly due to its draconian one-child policy that was in place until 2013. If a country engineers itself into demographic difficulty, can it do the same to escape it? The current two-child policy could be relaxed even further or replaced with no policy, but that’s likely not sufficient to create a future demographic dividend. And assuming the leader(s) of a centrally-controlled nation of 1.4 billion souls agreed that rapid population growth was the answer, I don’t think a coercive four-child policy would be at all enforceable.
So, no, China’s not getting any younger either. In fact, the current trade war comes at a time when the country is already adjusting to decelerating growth and facing a steep demographic wall. For all the well-founded concerns out there about China’s rise, I think it is unlikely to supplant the U.S. in global importance over the next generation.
Considering demography makes for a multifaceted lens to view both global changes and implications in the equity markets. For me, broadly, demographics help explain today’s global dislocations, forecast China’s trajectory, and inform our understanding of the future investment landscape.