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Demographics – Inexorable Trend, Inevitable Outcome?

Demographics – Inexorable Trend, Inevitable Outcome? by Colin Moore, Columbia Threadneedle Investments

  • Demographic change is likely to have a profound impact on financial markets, and investors can use demographic analysis to point the way to the most worthwhile areas for further research.
  • The most significant impact on investing will be the gradual migration from traditional country-based asset allocation models to those based on exposures to demographic trends.
  • The need for better investment solutions in a growth-challenged world will lead to greater use of detailed demographic analysis to identify the richest sources of opportunity.

The 800-pound gorilla

Geopolitical risks are persistent, attract lots of media attention and raise investor angst. Yet rarely do such risks have a sustained impact on financial markets. In contrast, demographic change attracts little media attention, yet it is likely to have a profound impact on financial markets. Rob Arnott, the founder of Research Affiliates, addressed the impact of demographic trends in a recent interview with Barron’s:

“Demography is the 800-pound gorilla for the macro economy and the capital markets. In the 20th century, we had a demographic tailwind in the developed countries, particularly in the century’s second half. The death rate tumbled, allowing people to work longer. The birthrate tumbled, allowing families to have fewer kids to support. There were better support ratios—that is, more workers per non-worker, including kids. There were very few senior citizens to support because, while people were living longer, there weren’t that many oldsters yet. So we had the most benign demography in the history of mankind. That unleashed entrepreneurialism, innovation, and invention, permitting rapid productivity growth. The crescendo of growth, which started in the industrial revolution, continued through the electronic age, with computers and the Internet.”

Analyzing a country’s or region’s demographics can be a powerful indicator of potential economic growth. But are those trends so inexorable that they are fully discounted into financial markets? To answer that question, we will explore how demographic trends should be analyzed and the potential impact for investors.

How demographic trends should be analyzed

Demographic research tends to focus on age cadres. However, other structural changes in populations and their behavioral aspects may be more relevant to investors. Logically, we should focus on investment opportunities that appear primed to benefit from these changes. Traditional asset allocation often focuses on a country’s interest rates, GDP growth, corporate earnings and, occasionally, on demographic trends such as aging/youthful populations and/or rising/declining wage growth. But how wages/incomes will be spent or saved also matters. So does the growth of ethnic groups within a country. Consider the growth of the Hispanic population within the United States. The United States is aging, but an investment strategy that looks only at that aggregate issue without also considering the implications of a young, growing Hispanic cohort is likely to miss an opportunity.

The focus on age cadres often leads to a discussion of dependency ratios. The dependency ratio expresses the dependent part of the population, defined as the number of non-working-age people (i.e., children and the elderly) as a percentage of the productive part of the population (defined as those of working age). A ratio of 1.2 means there are twelve non-working people to every ten working people.

Total dependency ratio = Number of people aged 0–14 plus those ages 65 and above

Number of people ages 15–65

As the ratio increases, there may be an increased burden on the productive part of the population to maintain the benefits, services and pensions of the dependent part. This results in direct impacts on and potential clashes over national budgets, taxation, social security, political influence and spending patterns.

This analysis is simplistic and does not reflect the facts that: 1) many people ages 14–65 are effectively economically dependent and 2) many people over 65 remain economically productive. Students, people on disability allowance, long-term unemployed (i.e., those who have given up looking for work), those who retire early or late, and parents looking after children at home are examples of people not properly accounted for by the total dependency ratio.

The real (or effective) dependency ratio looks at the ratio of productive workers, regardless of age cadre, compared to those who are dependent also regardless of age.

This definition reorients investors to a growing, active workforce that should be more conducive to GDP growth than a shrinking workforce. However, this definition is also too broad to really help investors. We must also factor productivity — which tends to vary significantly across age groups — into the equation. As these groups enter or re-enter the workforce and move from dependent to productive, they should increase GDP. They increase their productivity over time, further increasing GDP before finally moving into retirement (although not necessarily at 60–65). It should be noted that investors benefit or suffer from the change in the growth rate of economic output or profits rather than the absolute level.

Analyzing the general productive workforce demographic cadres along with the potential for productivity improvement by cadre can provide more insight into the change in economic growth rates. Productivity growth expectations are based on certain assumptions — for example, that the new growing active workforce will be well-educated, healthy and equipped with the basic tools and infrastructure. If government and corporate policies are aligned with those assumptions, then a large group of young, healthy, educated workers becoming active should first increase GDP as the volume and productivity of active workers increases. Younger, active workers tend to be a disproportionate source of productivity growth, while people over 65 tend to require a disproportionate share government spending due to factors like healthcare. Therefore, the weighted support ratio gives a higher weighting to dependents over 65.

Demographic studies often refer to the impact of all of this as the “demographic dividend.” However, it can also be negative, as, ultimately, the rate of output growth improvement declines as volume/productivity peaks. It is important to note that we are looking for the peak in the growth rate of output, which may occur at a different point in time than when total output peaks.

In its definition of aging, the World Bank report “Golden Aging” refers to the work of International Institute for Applied Systems Analysis (IIASA) researchers Warren Sanderson and Sergei Scherbov. They argue that if new measures of aging are applied that take into account increasing lifespans and declining disability rates, many populations are aging more slowly compared to what is predicted using conventional measures based purely on chronological age. In other words, much of the dire prognostications about aging populations may be overstated:

“The approach in most of this literature is simple and, because of its simplicity, clear and convincing. It consists of presenting scenarios wherein age-specific levels or ratios of human capital, labor participation, and savings are kept constant (at current levels or following past trends), while the population is growing old. In such scenarios, as old-age dependency ratios rise, output per capita rapidly drops; intergenerational transfer systems become either unsustainable or inadequate; and, more generally, declining welfare becomes inevitable.

Even with their appealing simplicity and apparent inescapability, the projections of impending doom due to population aging are probably overstated, as was the case of the predictions of Malthus (1798) and all of his successors (for example, the Club of Rome and the World Bank in the 1970s). Another strand of the literature argues that these pessimistic views are not warranted when two important points are fully and properly considered:

(1) the interactions between labor and other factors of production; and
(2) behavioral responses to changes in a population’s demographics

This opportunity to boost human and physical capital and, ultimately, productivity, for the smaller young age groups is being transformed into reality in some countries but not in all of them. Successful countries are those able to navigate the complex political economy of older societies where the strong political power of older people will favor keeping high and often unaffordable old-age benefits rather than investing in education.”

The potential impact for investors

Investors should consider opportunities to take advantage of the most favorable demographic trends. However, too much of the current advice on the subject leads to fairly traditional country-based asset allocation. Traditional dependency-ratio analysis regularly leads to overweighting developing countries and underweighting developed aging countries. This is not a bad place to start, but it is an inadequate place to stop. There are two reasons for this:

  1. The more obvious trends are more likely to be at least partially discounted by efficient markets.
    2. As we have defined the important nuances of dependency ratios, the real opportunity will lie outside traditional country-based asset class definitions.

The first issue is fairly self-explanatory, so we will focus on opportunities outside traditional country-based asset class definitions. Throughout this article, we refer to important refinements for analyzing growth of output and incomes based on age-based demographics. These refinements relate to levels of mortality and morbidity and the availability of healthcare, education and infrastructure (including communication technology). In addition, changes in income levels and age generally lead to behavioral changes in what people spend money on.

It is well understood that an aging population requires more healthcare. That has led to considerable research on biotechnology and pharmaceutical companies. If we want to offset the pace of age-based demographic trends, we will need to maintain the potential output level of older workers, probably into their seventies, if not eighties. Therefore, while investing in treatments for diseases remains important, “wellness” will become critical as the focus moves to vitality rather than just mortality.

Energy, specifically, and commodities, generally, will become increasingly scarce. The global population is growing, and therefore demand for goods will increase. The obvious investments are in energy and mining companies. The distribution of populations and incomes (and the scarcity of traditional commodities) will accelerate the growth in new sources of energy and alternative construction materials. Younger people in developing countries will want better accommodation. That need will be served in part by lighter, flexible construction materials with localized energy sources rather than heavy materials supported by large energy grids. The wealthy elderly are seeking accommodation that meets their needs. This affects the design of the home (e.g., fewer stairs, bathroom access, etc.), including ease of access to services such as healthcare and security.

Although average ages in the world are increasing, there are still plenty of young people. They are just not in the same place as current centers of demand. Therefore, the growth of infrastructure is critical, not only to aid the development of local economies but also to bridge the gap in the distribution of wealth, demand and workforce. This will take many forms, such as clean water, transport and communication. Unless you believe that we will see significant changes to immigration policies globally, we are not going to find a way to move the young people to where the demand is. Also, the cultural ramifications of large-scale relocation would need to be considered. Technology and transport infrastructure that allow the work to be moved rather than moving the people presents real opportunities. The growth of high-speed internet, technology advances, and developments such as 3D printing may simultaneously enhance the ability to utilize younger workers in remote regions and increase the ability to retain older workers and family caregivers in developed regions. This has significant implications for the real dependency ratio.

Education (including retraining) is essential for improving productivity. As such, it has traditionally been one of the fastest growing areas in developing and developed countries. Given the pressure demographic trends are putting on government budgets, the increasing need for education should provide an opportunity for appropriately regulated for-profit services. However, it is not clear that such services will be a big opportunity within the public security markets.

Several of the demographic trends require countries to increase the percent of annual revenue spent on public benefits. We can only hope that governments will face the tough choices this pressure on public revenue imposes. However, the burden is not completely consistent with traditional developed/emerging definitions. Countries with less generous benefits — including the United States and some developing nations — are less exposed than some European countries like France. However, China is seen as both developing and rapidly aging due to the historical impact of the “one child” policy. To achieve higher growth, China would like to see a decline in saving, but that is usually inconsistent with poor social benefits. However, the impact of demographic trends on interest rates needs to be carefully considered. Globally, will lower growth potential and increasing social benefit demands lead to higher rates generally, or just bigger spreads between the relative winners and losers?

The motor vehicle industry is an interesting case. Improving incomes generally results in people upgrading their cars. However, this leads to the question of asset allocation by traditional country-based definitions. Is Toyota a Japanese company? Are BMW and Volkswagen German companies? The answer is obviously yes in terms of the country of incorporation. But if investors make money by assessing changes in growth potential, then these companies may be considered Chinese or Indian since these countries are the source of demographic-led demand for the companies’ products.

Demographic study suggests changes in investor behavior. More people are becoming interested in the broader impact of economic activity beyond the financial profit it produces. The growth of socially and environmentally aware investing is a long-term trend supported by the views of the younger generations. This means that asset managers and advisors must take social impact, immediate environmental impacts and sustainability into account when assessing potential investments for this cadre of clients. Investor attitudes about risk are also changing, which will lead to a considerable increase in attention paid to volatility rather than just return.

My conclusion is that investors can use demographic analysis to point the way to the most worthwhile areas for further research. The analysis needs to be significantly more nuanced than simple age cadres, but those insights may be very valuable. The greatest impact on investing will be the gradual migration from traditional country-based asset allocation models to those based on exposures to these trends. It will not be immediate, as many consultants, pension funds and asset managers are heavily invested in the former. However, the need for better investment solutions in a growth-challenged world will lead to greater use of detailed demographic analysis to identify the richest sources of opportunity.

Demographics - Inexorable Trend, Inevitable Outcome?