STEP

Title Research

Demographic shift

  • Author : Martin Perry
  • Date : September 2010
ABOUT THE AUTHOR: Martin Perry is Investment Director at Heartwood Wealth Management Limited

T he past decade has been one of the worst ever for equity markets. Between the start of 2000 and the end of June 2010 – a period that encompassed the two bear markets of 2001-03 and 2007-09 – the MSCI World Index of global equities registered a total return (including dividends) of -20.9 per cent in sterling terms. That was the first decade of negative total returns since the Great Depression.

Investment managers are constantly asked by anxious investors whether this disappointing trend is likely to continue. And one of the arguments often heard advanced for this dismal outcome is demographics.

The reasoning goes something like this. Over recent decades, the demographics have been positive for western economies. This was partly responsible for the strong returns on equities in the 1980s and 1990s as the Baby Boomer generation accumulated investments to keep it in its old age. Now, that generation is starting to retire and is therefore likely to start selling equities and buying bonds in order to fund its retirement.

The favourable demographics of recent decades have enabled politicians to avoid tackling an increasingly pressing problem. However, the proportion of state spending paid out on retirement benefits has been increasing exponentially as life expectancy has risen while retirement ages have remained the same – and, in some cases, have even been lowered. To make matters worse, the spending has been unfunded in almost all countries.

In some developed economies – particularly western Europe – the demographics are set to deteriorate further, the argument continues. The population is ageing, so fewer and fewer taxpayers will be available to help fund the retirement and health costs of an increasing number of economically unproductive older people. That will add to the burden from already-high levels of public debt, which will depress future economic growth and hence returns on investments. To fund the level of benefits to which people wish to be entitled, the European economy would have to grow by over 3 per cent a year, according to Herman Van Rompuy, the President of the European Union. However, growth is being kept well below that level by the weight of public-sector debt and the rising share of government as a proportion of GDP, which lowers trend growth.

Investors should be wary of making decisions based purely on demographic factors

In my view, concerns about demographics have considerable validity. According to economic theory, the growth of a country’s gross national product in real terms (that is, leaving aside the effects of inflation) should be a function of the level of population growth, the increase in productivity and the accumulation of capital.

Yet, after several centuries of strong population growth in developed countries, the United Nations (UN) now forecasts a negligible rise (of only 30 million) by 2050. The populations of Japan and most of western Europe are actually expected to decline. Indeed, barring migration, developed countries’ population in aggregate would have fallen by some 80 million. At the same time, populations in both developed and developing countries are ageing rapidly. In the developed world, the number of older people (above 60) exceeded the number of children (below 15) in 1998, and the UN forecasts that the same will happen in the developing world by 2045.

The key factor is what demographers call the dependency ratio – the proportion of retirees and children relative to people in employment. That ratio has fallen significantly over the past 50 years but is set to reverse, despite falling fertility rates in many developed countries. Clearly, this rise in the dependency ratio will put massive pressure on workers to support their elders in retirement.

Decision making

However, demographics is a hugely complicated subject, and investors should be wary of making decisions based purely on demographic factors. As noted above, the boom and bust in equity markets since the early 1980s has been linked to the demographics of the Baby Boomer generation. But other factors have also been at play. The 1980s and 1990s were times of falling interest rates, deregulation, globalisation and declining tax rates, which further encouraged increasing leverage in the economy. Together, these trends were responsible for a significant divergence between economic growth and investment returns. Just as demographics were not the sole factor driving the 1980s-90s boom, they will be only one of several influences on growth over the years ahead.

Moreover, it is a common mistake to project current trends too far into the future. For example, life expectancy has been constantly rising for many decades. Yet that might not continue indefinitely. The current epidemic of obesity in many developed (and now developing) nations may reduce average life expectancy at some point. And it would be unwise to assume that the historical controllers of population growth – such as famine, war and disease – can be permanently eradicated by human progress. That is one reason why demographic trends need to be monitored constantly.

Social indicators on child and elderly populations, 2010
Country
% population under 15 years
% population aged 60+
Men
Women
France
18
21
26
Germany
13
23
29
Italy
14
24
29
United Kingdom
17
21
25
Brazil
25
9
11
Russian Federation
15
13
22
India
31
7
8
China
20
12
13
Somalia
45
4
5
Uganda
49
3
4
United Republic of Tanzania
45
4
5
Source: United Nations Statistics Division
Social indicators on health
Country
Life expectancy at birth
Men
Women
France
79
85
Germany
78
83
Italy
79
85
United Kingdom
78
82
Brazil
70
77
Russian Federation
62
74
India
64
67
China
72
76
Somalia
50
53
Uganda
55
56
United Republic of Tanzania
57
59
Source: United Nation, Department of Economic and Social Affairs
Opportunities

Above all, it is important to analyse demographics for each particular country, looking for key turning points in the dependency ratio. Although population growth is expected to stagnate in developed countries, the population worldwide is expected to rise from 5.6 billion in 2009 to 7.9 billion in 2050, according to UN calculations. Western investors may be able to find interesting investment opportunities in the equity markets of developing nations with favourable demographics.

Yet they are not necessarily those with the strongest rate of population growth. For example, high population growth in parts of North Africa and the Middle East could well lead to increased poverty and conflict, as people squabble over scant resources and the economy is overwhelmed by the numbers of new entrants each year. Indeed, one key factor is not just whether a population is growing but which part of it is growing. In India, the highest rate of fertility is in the poorest segment of the population, which will act as a drag on economic growth. However, in India’s case, we would not expect this to be enough to offset increased productivity in the better-educated, if less prolific, segment of the population.

It is equally crucial to see demographics in conjunction with each country’s economic and political fundamentals

It is equally crucial to see demographics in conjunction with each country’s economic and political fundamentals. In developed countries, much will depend on the steps taken to restore developed countries’ fiscal positions to health. The current crisis seems at last to be forcing politicians into a more realistic approach to pensions, and it is dawning on people that many promised benefits cannot be paid. However, the political will to tackle the problem will vary from country to country.

In the UK, the retirement age was originally set at 65 because that was roughly the average longevity in the UK at the time. In effect, the many people who didn’t survive to 65 helped to fund the pensions of those who did. Nowadays, however, life expectancy at birth is over 78 years for men and 82 years for women, according to the UN. In addition, men who reach 65 should on average live another 17 years and women around 20 years (though male longevity is now rapidly catching up).

Clearly, the present level of unfunded state benefits is unsustainable. Changes will have to be made, with retirement ages rising and benefits set to fall. That should help to redress the fiscal imbalances. The good news is that the retirement age doesn’t have to be raised that far. Indeed, with a retirement age above 70, the problem would be largely solved – for now, at least. However, it is crucial that electorates face reality and allow reforms to be pushed through. The sooner they do so, the more comfortable their retirements will ultimately be. In addition, they are likely to have to continue working – if only in part-time roles – even after retirement.

For individual investors, I would reiterate that demographics are a complex area, requiring informed advice. However, we can draw some conclusions. For one thing, the increased life expectancy for those reaching retirement age will affect asset allocation. Formerly, many retirees tended to convert equity holdings into bonds or even cash. However, if you can expect to live a further 20 years or so, it may make more sense to retain a larger proportion of holdings in risk assets (such as equities and corporate bonds) in order to preserve capital for longer and possibly even boost income. This tendency may well have implications for dividend policies, with companies coming to pay out more of their profits in dividends in response to investor demand.

In addition, when investing in equities, it is important to consider where companies’ profits come from. Large multinationals – such as many of those in the FTSE 100 – may derive much of their earnings from overseas. So the demographics of the countries in which those earnings are generated will be one of the factors that need to be analysed when making investment decisions.

Conclusion

In summary, we acknowledge the threat posed to financial markets by increasingly unhelpful demographics, particularly in developed nations. Many of these economies are in uncharted territory – the population has not shrunk for centuries, possibly not since the Black Death – and there are so many variables that we cannot forecast with much confidence what the precise outcomes will be.

However, the demographic shift makes it all the more important for investors to act now in order to protect themselves in their later years. If one thing is abundantly clear, it is that governments will no longer be willing – or indeed able – to make adequate provision for us.


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