volume demographics destiny and asset markets july 132010

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BOECKHINVESTMENTSINC.,17501002SHERBROOKESTREETWEST,MONTREAL,QUEBEC.H3A3L6TEL.5149040551,[email protected]

VOLUME 2.9

JULY 13,2010

Demographics,DestinyandAssetMarketsBy George Magnus (Contributing Editor)

Demographics,DestinyandAssetMarketsThe 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

Dear Subscriber,

As the world economy and financial system struggle to regain their footing, they must contend with a

number of problems. One of these is a negative change in demographics. The population is aging rapidly and

the proportion of retired to working people is rising sharply. While these are slow moving forces compared to,

say, banking crises, they are powerful and inexorable trends that cannot be fixed. Rather, we, and governments,

must adjust to them and investors must pay attention to the complex investment implications.

This letter contains a special feature on the subject by Contributing Editor, George Magnus, Senior

Economic Advisor, UBS Investment Bank. I have had the good fortune to share a platform with George at a

prestigious Family Investment conference in Europe for a number of years and I have read his work for much

longer. He is an original thinker with a very sharp intellect and a competency that stretches over many areas of

economics and finance.

He has written theAge of Aging (John Wiley 2008), which I strongly recommend to anyone interested in

one of the most potent factors influencing our long-run destiny.

He has also just completed a book called Uprising: Will Emerging Markets Shape or Shake the World(forthcoming in the fall).

J.A.B.


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THEBOECKHINVESTMENTLETTER WWW.BOECKHINVESTMENTLETTER.COM 2

responsibilities for economic leadership and reform. But we are also starting to come to terms

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 whos going to look

after grandma?

A more contentious and neo-Malthusian form resides in the perceived threats of over-

population, aided and abetted universally by longer life expectancy. The worlds 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?


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TheBabyBoomersBoomTracking, 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.

Lets 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


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from equities to bonds, the switch will occur regardless, and the new flow of savings into

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?

LosingourGrowthDriversSo 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 youre 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 part-


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time or short-time, is running at about 17.5%, almost double the headline rate. But, a couple of

studies 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

doesnt 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 arent, 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.


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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 havent 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 its far too early for households to come back from their balance sheet repairs.

The UKs chronic under building of housing may offer some protection, but not in the event that

the economy should slip back in to recessiona 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.

LosingourFinancingAbilityThe 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 dont save enough for their retirement. In a recent UK survey, a

quarter of those who could save didnt, and half of men and more than half of women who did,

didnt save enough. Its not dissimilar in most other countries, and in the United States, the Feds

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


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1945 are a relative class apart, but younger baby boomers save less, and their progeny even less.

In a macabre sense, the financial crisis couldnt have been better timed, if it focuses attention on

the need for people to save more for retirement.

The paradox, of course, is that whats 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 thats bound to unsettle equity and real estate markets, unless governments can use

their balance sheets to offset the effects.

The trouble is they cant. 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 marketslets call them more appropriately, creditorscapitulating in the face of

policy inertia or non-credible financial reforms. Whats worrisome about the current situation is

that its 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.


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It is no accident that this year, in Greece, Spain, France, the UK, and several U.S. states,

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.

WillitbeDeflationorInflation?Theres 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. Thats just a verbose way of saying theres a shortage of

aggregate demand, and thats what defines deflation. In real time, population aging is of

peripheral significance.

But it is most likely that population aging, itself, is a deflationary phenomenonat least

for nowto 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 theres a vital difference between Japan and say, the U.S., it is that Japans 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 berepeat, may bejust 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


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by no means clear that all nations will be up to the task. In any event, we can assume relatively

safely that any structural reform-cum-reflation strategic shift isnt 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 isnt

anywhere close to inflation.

IsTherenoHope?The answers to many economic and financial issues we consider nowadays arent 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.


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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 its hard to find positives

for real estate as an asset class, some types of equities will remain the investors 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 doesnt in dealing with destiny.

July 13, [email protected]

P.S. Dont forget to order The Age of Aging.It is a terrific book. (J.A.B)

volume demographics destiny and asset markets july 132010

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