The Fed has been doing all it can to keep rates low yet there are several structural trends discretely aiding policy makers today. More importantly, these trends will only strengthen over time and have the potential to cap interest rates, lower equity returns and further stifle economic activity. The principal trend I will cover today deals with our aging populations, but there are several other technical and fundamental factors that enhance my argument and are covered below.
For those interested in an abridged version, you are in luck ...
- On the demand side, institutional investors like banks (Basel III) and insurance companies (Solvency II) are going to run a more conservative regulatory balance sheet. This will favor zero risk weighted assets and create a natural buyer for sovereigns - the doctrine of captive capital.
- On the retail demand side, John and Jane Doe are getting older which means under modern portfolio theory they will throttle back their risk appetite and switch from equity to debt.
- At the same time, the near term supply of fixed income paper (aside from troubled sovereigns) is forecast to be tight over the coming years as continued deleveraging, a defunct structured products market, and an aggressive refinancing run in 2010/11 will limit bond issuance.
- Even though near term growth statistics have surprised on the upside, fiscal tightening will eventually reign in any momentum we build. Longer term, many developed economies will also not see the type of growth they once did (in part because of the demographic trends I will discuss shortly). Lower economic growth, and in theory inflation, should translate into lower base rates.
- And finally as rates stay lower for longer, book yields will come under pressure and money managers will stretch for yield, reinforcing lower base rates and putting in a bid for credit investments.
All this supports the idea that lower rates and spreads are here to stay: the New Normal if you will. No one is denying the fact that bond rates are extremely low on nominal terms and negative on real, but if you must play in the space you will be compensated for extending duration and playing the curve. Moreover, even though credit has rallied quite a bit this year, the fundamentals for these issuers remain strong by historic standards. So go ahead, take those credit and duration bets!
The latter half of this article deals with how demographics are changing the game in capital markets and putting increasing pressure on what has historically been a successful capitalist model.
For decades, countries around the world have been able to ride their demographic trends toward higher GDP, yet these same favorable trends have started to crest and many will soon begin to experience them, not as convenient tailwinds, but rather formidable headwinds.
Current trajectories are calling for an aging protracted global population that will put strain on our infrastructure, resources, and ultimately our capital markets. While not all economies are headed there at the same time, we will all inevitably "run aground". Whilst today there exists a sizable gap between the BRIC economies (notably India and Brazil) and the G-7, eventually this arbitrage goes away.
As asset allocators figuring out how these structural trends impact our investment universe is important and an equally interesting debate. In equity markets for instance, growth is a quintessential piece of the valuation framework and an aging population is a huge drag on growth. The most immediate impact will be on consumption. Not only the absolute level but also the industries in which they are spent. (Think quality of life industries like pharmaceuticals and personal care products).
Capital markets will be further impacted as an aging population throws off the traditional balance between supply and demand. The argument is fairly simple but undeniably logical. If traditional portfolio theory holds, we should see retirees throttle back their risk exposure and shift demand from risky assets (like equity) to safe haven, income producing assets (like fixed income). This will put pressure on equities while supporting bond prices. At the same time we have another powerful demand player converging with the retail investor. Increased regulatory supervision and new, intensive capital requirements will force institutional investors into only the safest of assets. Combined these two demand shifts will change the way capital markets function and may lead to certain anomalies.
An aging and protracted population also puts strain on our resources and the choice in how we divide up those resources. Today some 18.4% of our national income comes from government transfer payments with the lion's share of that funding the retired and infirm. Are there better channels and uses of our funds? Say government funded research or infrastructure spending? Is this the stuff of capitalism ... or self-directed nepotism?
When Social Security and Medicare were introduced we were neither old nor insolvent. Today we are coming under increasing pressure to meet our social and financial obligations so the hard choice about which promises we keep will have to be made.
What makes an aging and protracted population even more precarious is the fact that our topical solution is worse than the disease. In its most rudimentary form you battle an aging population by simply expanding the youth-base with favorably immigration and family formation policies. But longer term, this only exacerbates the problem, but allows the current generation to skip out on footing the bill.
What's interesting to think about is the fact that history has never provided us a view into how capitalism fares under an aging population. Capitalism has existed mostly in periods where there were favorable demographic trends (aka shorter life expectancies). The closest proxy we have is Japan, known as the widow maker for its graying population, ultra low interest rates and lackluster equity returns. Is this what we can expect from other graying economies?
What happens when the favorable trends we've been riding on reverse and we can no longer count on them for incremental growth? Having defeated the likes of socialism and communism, capitalism has flourished and helped lift the standards and quality of lives around the world, but is its strength also its Achillian weakness? Put another way, is an aging population the logical result of a successful capitalist model?