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International News Title: Demographics, Destiny and Asset Markets, Will it be Deflation or Inflation? Demographics, Destiny and Asset Markets The evolving financial crisis in the West and its long-term consequences has exposed deep-seated structural flaws in our economies, and in the global economic system. These span our susceptibility to deflation, the loss of traditional economic growth drivers, the integrity of public finance, the regulation of the banking system, weaknesses in labour markets, and the lack of discipline that obliges creditor countries, such as China, Japan and Germany to share the with a less visible and slow moving phenomenon that has a direct bearing on many of the structural problems we face, namely the onset of rapid aging. Although demographic projections of population, life expectancy, and fertility are not free from error, the nature of aging means that for all intents and purposes, demographics are our destiny. A lively debate about rapid aging in richer economies has been going on for at least the last 30 years, and in its simplest form, it is about the essential question of “who’s going to look after grandma?” A more contentious and neo-Malthusian form resides in the perceived threats of overpopulation, aided and abetted universally by longer life expectancy. The world’s existing population of 6.5 billion is expected to grow by a further 2.7 billion by 2050, almost all in emerging and developing nations. Although the populations of the U.S., and other Anglo- and northern-European countries are expected to rise slowly over time, those of Japan and Russia are already declining, and those of Germany, Italy and Spain will join them in the next five years. But population aging also has other weightier economic, social and political consequences that are emerging from the dark shadows cast by the financial crisis. Some are about the efficiency of our economic coping mechanisms as the labour force ages, and stagnates or declines. Others are about the pressure to rebuild public and private savings, and strengthen our ability to finance aging societies without punitive levels of taxation on our children or ourselves. What are asset markets supposed to make of these game-changing, but glacial demographics, especially as they pertain to one of the hotly discussed topics “du jour”, namely, whether inflation or deflation will get the upper hand? Tracking, let alone, predicting the impact of demographics on asset markets is prone to exaggeration and hyperbole. Demographics are slow moving and relatively predictable, and asset markets are sensitive to an array of economic and financial developments, most notably the credit cycle. But people are quick to point out that the halcyon era of sustained equity and real estate price appreciation from the 1980s until the financial crisis occurred in tandem with the entry of the boomers in to the labour force. This brought unprecedented numbers of women into work, and they brought with them higher educational attainment levels than their parents. As the quantity and the quality of labour increased, aggregate consumption rose, and aggregate savings rose too. In most countries, except possibly Japan, savings went increasingly into equities directly or otherwise, and in some countries, such as the U.S. and the UK, these savings increasingly took the form of real estate investments. Let’s put it another way. The core of the debate is about the so-called demographic dividend, which occurs when falling fertility lowers child dependency, and when the working age population (aged 15-64) expands, but before old age dependency starts to rise significantly. This dividend is associated with rising investment and accelerating economic growth, and describes the situation that western economies have enjoyed for the last 30 years or so. But they have now exhausted this benefit, because weak fertility is keeping the supply of new workers in check, while the long-living boomers are going to be increasingly visible, bringing to their children hefty bills for income support and care costs. Consumption patterns will change, brands and spontaneous purchases will give way to more regular and common-or-garden consumption, and aggregate savings will decline over time. While the boomers may delay the asset switch equities could fall well short. In the real estate market, the crisis will be the principal determinant of prices for a while, but it is worth noting that the number of 20-44 year-olds, deemed to be the prime first time home buyer cohort, will fall by 10-20% in the next two to three decades in most advanced nations, but by 30% in Spain and China, and by a whopping 40% in South Korea. So, by the time the leading edge of the boomers is aged 80-90, that is 2025-2035, we might well ask, who will buy the homes they are going to sell to fund residential care or when they downsize? Losing our Growth Drivers So do we now turn the graphs upside down, and anticipate an extended period of declining asset values? This would be to attribute the entire asset appreciation of the last 30 years to demographics, which is patently absurd, ignoring not least the effects of financial deregulation and innovation, and a virulent expansion of credit. But for a long-term trend, the unique combination of rising life expectancy and weak fertility rates will define the economic and asset environment. Unless the effects of population aging are offset by purposeful shifts in micro and macro policy, we are losing an important driver of economic growth, and therefore, of top-line revenues. Take away the labour supply from economic growth, and all you’re left with, for the time being, is a stagnant stock of capital, and uncertain, but almost certainly lower, productivity growth. Not good. Moreover, population aging is weakening our labour markets in unexpected ways. No self-respecting economist or investor can ignore the monthly labour market reports, especially in the U.S. A lot of people now know that the so-called U6 rate, which comprises headline unemployment, people loosely associated with the labour force, and those forcibly working partstudies done by the Federal Reserve Bank of St. Louis and the Centre of Economic and Policy Research have tried to adjust the unemployment rate to allow for the fact that the labour force age structure has risen over the past 20-30 years. In other words, there are proportionately fewer young people, and more older people in the work force. The significance of the age shift is that older unemployed and underemployed are more likely to remain that way. In addition, modern labour surveys are smaller than they used to be and so they are more likely to miss people who have been unemployed and given up looking for work for good. Both studies reckon that the U.S. unemployment rate, properly measured and comparable with earlier times, is now about 1.5% higher than the official rate. This is bad news when we want to get people back to work in the private sector as quickly as possible, while public cutbacks are announced and before another economic downturn commences. The loss of growth drivers arising from labour supply and labour market developments doesn’t mean that equity values are going to decline absolutely and persistently, but it does suggest that the rate of return on equity will drop compared with the last decades. Simply, capitalism rewards scarcity, and as labour supply fades relative to the availability of capital, returns will shift towards the former. For skilled and highly educated workers, this is good news. Not so for those that aren’t, as production technologies demand ever more skilled human capital. We actually have no template about what to expect because 21st century population aging is unique. But it seems reasonable to expect lower rates of return in those countries where labour supply tightens significantly, while conceding that the directional change in equity markets will continue to reside in macroeconomic management, profits, innovation, governance, financial stability and so on. As far as real estate is concerned, all we know is that the cycles are protracted in both directions. While government and central bank policies have supported housing markets and values, and continue to do so, it would be rash to declare that the downswing in prices is over. There are too many bad mortgage loans that haven’t been written off or restructured, too many banks whose main aim is to shrink assets, too many properties for sale (or hidden in bank ownership), and it’s far too early for households to come back from their balance sheet repairs. The UK’s chronic under building of housing may offer some protection, but not in the event that the economy should slip back in to recession—a possibility that becomes increasingly likely in a lot of places in the face of concerted fiscal retrenchment in 2011-2012. In the longer-term, the weaker age structure, especially of younger, first time home buying citizens, will most likely dampen the housing cycle, certainly in real terms. Losing our Financing Ability The changes in the young, working age and older cohorts mean that the dependency ratio of growing cohorts of older citizens on the working age population, is going to double. Put another way, today there are between 2.5 and 4 workers per pensioner in advanced nations, but by 2050, there will only be 1 to 2. And that means that the financial task of supporting an aging population is going to become more intense, raising crucial questions about the adequacy of individual savings, and the affordability of public pensions and healthcare schemes. Individuals generally don’t save enough for their retirement. In a recent UK survey, a quarter of those who could save didn’t, and half of men and more than half of women who did, didn’t save enough. It’s not dissimilar in most other countries, and in the United States, the Fed’s latest Survey of Consumer Finances revealed that current or close retirees have roughly $50,000 of retirement savings, excluding the now questionable equity in their homes. Those born before In a macabre sense, the financial crisis couldn’t have been better timed, if it focuses attention on the need for people to save more for retirement. The paradox, of course, is that what’s good for the individual goose is not good for the aggregate gander. If we all end up saving more, we impart a strong deflationary bias to the economy that’s bound to unsettle equity and real estate markets, unless governments can use their balance sheets to offset the effects. The trouble is they can’t. Governments have now become ensnared in the financial crisis, and while Americans and Europeans argue now, as they did in the 1930s, about the balance in policy between economic growth and budgetary austerity, we all face a protracted period of concerted fiscal drag. The austerity impetus may be voluntary and planned, or it may be forced by financial markets—let’s call them more appropriately, creditors—capitulating in the face of policy inertia or non-credible financial reforms. What’s worrisome about the current situation is that it’s unprecedented in peacetime for so many large economies to be facing the same way, fiscally. And part of the reason they are in such a fiscal black hole resides in the explosion in their structural, age-related liabilities. According to the IMF, the net present value of pensions, healthcare and long-term care out to 2050 dwarfs the costs of the banking crisis everywhere. Based on policy commitments in mid-2009, it is over 600% of GDP in Spain and Greece, 500% GDP in the U.S., 335% in the UK, and between 200 and 300% in other major EU countries. The precise numbers are less important than the orders of magnitude, and the implications for public policy. for example, budgetary pressures have forced governments to implement or consider a variety of demographically driven policies. These include an increase in the retirement age, a temporary freeze on pensions, higher public employee contributions to pension schemes, and schemes to get citizens to pay more towards healthcare, or to specific conditions. Will it be Deflation or Inflation? There’s little doubt that, while an acceleration in inflation is always possible under closely specified conditions, the biggest risk that asset markets face in the foreseeable future is deflation. Banks and consumers are on the back foot, government balance sheets are shot through, and listed and medium-sized companies do what they can by seeking out markets and volumes in emerging markets. That’s just a verbose way of saying there’s a shortage of aggregate demand, and that’s what defines deflation. In real time, population aging is of peripheral significance. But it is most likely that population aging, itself, is a deflationary phenomenon—at least for now—to the extent that it is starting to sap actual and potential economic growth performance, and necessitate a sharp improvement in both private and public savings. Just look at Japan, whose baby boomers came into the world several years earlier than in the West, and whose bubble burst just about the time when the demographic dividend started its long erosion. If there’s a vital difference between Japan and say, the U.S., it is that Japan’s creditor status meant there was never any pressure for a rather rigid political structure to change tack and get to grips with either its economy or its demographics. Perversely, an economic and demographic crisis may be—repeat, may be—just the ticket for debtor nations in the West to do so. But so far, there is little evidence the crisis is bad enough yet to force such a change, and it is safely that any structural reform-*****-reflation strategic shift isn’t going to happen for a while. Even if it did so, the implications of population aging, and savings and consumption shifts would be a long-lasting weight on inflation. There is perhaps a caveat, which I referred to earlier when stipulating that capitalism rewards scarcity. If labour is in relatively short supply, and wages and salaries benefit as a result at the expense of profits, could there be a new cycle of skilled and general wage inflation? Some consider it possible in economies that are relatively closed to immigration, have rather inflexible labour markets, and an accommodating central bank. But Japan is or has all of these and isn’t anywhere close to inflation. Is There no Hope? The answers to many economic and financial issues we consider nowadays aren’t rocket-science, but the political will and imagination to do something about them are in short supply. To countenance the effects of demographic change, there are many things that governments can do. They can increase employee participation in the work force, for example, raising the pensionable or retirement age, changing pension systems, retirement patterns, and working practices, encouraging companies to retain and retrain older workers, and in some nations, making it possible for more women to enter the labour force. They can help to create a climate for stronger productivity growth, by trying to avoid the financial strangulation of schools and higher education during the coming fiscal cutbacks, and by using public policy levers to encourage entrepreneurs and innovation, and by targeting the new sectors that will drive future growth. This last idea, by the way, is a long-established form of public support for industry, not least in the United States. These initiatives all sound rather fanciful in 2010, but in the end, but they will provide the means for us to adapt to aging societies. In the meantime, even though it’s hard to find positives for real estate as an asset class, some types of equities will remain the investor’s asset of choice, cyclical volatility notwithstanding. Demographic change will bring forth new consumer products and patterns, significant changes in information, bio and resource and materials technologies that could revolutionise manufacturing processes, mind-boggling changes in medical science and treatment, new forms of asset gathering and insurance and, lest we forget, the next billion consumers in emerging markets and all that jazz. Emerging market demographics, as I have suggested, are, for the most part, strongly supportive of the demographic dividend. Even in China, the pool of rural migrants should serve as an offset to the fall in the working age population for a little while longer. It is in emerging markets, with massive demand for infrastructure and capital, where returns will be the greatest, even barring the odd bubble and bust now and then. It would certainly help relatively poor countries, with weak social security systems, to learn from the experience of the rich world what works and what doesn’t in dealing with destiny.
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