Demographics exert a significant influence on both economies and financial markets, an impact that will grow in the coming years. The graying of the developed world is hitting an inflection point and is forecast to accelerate. While we don't necessarily envision some of the more dire predictions-an aging society does not necessarily lead to generational war-an unprecedented shift in demographics is likely to impact everything from economic growth to equity multiples.
Absent significant changes in immigration policy or retirement age, most developed countries will see slower growth in the labor force as more people retire. All else equal, slower growth in the working age population-and in some cases actual shrinkage in the work force-should translate into modestly slower economic growth.
From an investment standpoint, there are at least three implications:
1) Historically, slower growth and less demand for capital have been associated with lower real interest rates, suggesting that an eventual rise in real rates may be more tempered than many analysts expect.
2) Equity multiples in developed countries are likely to remain low relative to their historical averages, suggesting that further gains will need to be predicated on earnings growth rather than higher multiples.
3) Slower growth countries are likely to trade at lower valuations versus faster growing economies, suggesting that the historical premium that developed markets have enjoyed relative to emerging markets is likely to compress over time.
All of the above implies that in an aging world growth is likely to command a premium. Among the developed countries, US demographics appear better than virtually any other developed country. However, they are still generally much worse than emerging markets. To the extent that demographics drive growth, investors can consider equities in Brazil, Mexico, India, Indonesia and the Philippines. At the same time, we believe investors should avoid Japan at all costs.
Do Not Go Gentle Into That Good Night
I don't want to achieve immortality through my work. I want to achieve it through not dying.
-- Woody Allen
Death is not only predictable in the individual sense, but also in the aggregate. Demographic predictions are usually an exception to the rule that long-term forecasts should be treated with healthy skepticism. Birthrates and mortality tables provide a surprisingly accurate view of what a population will look like in 10, 20, or 30 years. As a result, on this topic we know one thing with about as high a degree of precision as is possible in the social sciences: over the next several decades, most of the developed world and China will age at an unprecedented rate.
In considering the magnitude of the change, it is important to note that this trend has been in place for a long time. In 1900, life expectancy at birth was 47, the median age was 22.9 and only 4.1% of Americans were over 65.Today, 15% of Americans are over 65.
While the trend toward an older population has been in place for decades, the pace is set to increase. Thanks to a relatively high birthrate and immigration, the trend will be somewhat gentler in the United States. That said, even in the United States, the proportion of elderly will rise to unprecedented levels. In the United States, the median age will rise from 35.5 in 2000 to nearly 40 by 2025.
The increase in median age in the United States is relatively modest, but the economic impact of an aging population is still likely to be severe given the precarious state of US entitlement programs. Today, there are roughly five working age Americans per retiree. Over the next decade that ratio will slip to 4-to-1 and by 2030 will fall to nearly 3-to-1 (see Figure 1). In other words, the proportion of retirees to working age adults will rise to roughly 35%, and in the process put an enormous strain on the economy and government finances.
In other parts of the world, the aging will be even more acute. In Europe, by 2025 the median age will have risen to over 45. Worst of all will be Japan. By 2025, the median age of a Japanese citizen will be 50. Ironically, although Japan will clearly be the oldest country, the nation that is graying the fastest is an emerging market, China. Looking at the change in the median age between 2000 and 2050, China will age faster than any other large country (see Figure 2).
Work Till You Drop
While all the societal implications of the aging of the world's population are unclear, there is almost certain to be a significant economic impact. To start, aging populations will put an enormous strain on government resources, as the number of individuals receiving pensions and state-supported healthcare surges. As mentioned above, the problem is particularly acute in the United States. The unfunded nature of the US entitlement system and the aging of its population will intersect to put an existential strain on the US pension and federally funded healthcare systems.
US demographics are by no means the worst in the world, but in many ways the United States is uniquely unprepared. To start, the United States spends more money-both per capita and as a percentage of GDP-on healthcare than any other country in the world. Furthermore, pension and healthcare systems were designed at a time when the demographic ratios were far different. At the time Social Security was enacted, there were approximately 25 workers per retiree. Today, the number is closer to three.
In addition to fewer workers, Americans are both retiring earlier and living much longer than previous generations. The combination of these trends-an aging population, earlier retirement and longer life expectancy-implies that the US programs are particularly vulnerable, even when compared to other developed countries. For example, without a change to current laws, federal spending on Medicare and Medicaid combined will grow from roughly 5% of GDP today to almost 10% by 2035 (see Figure 3). If left unchecked, Social Security and Medicare-along with interest on the debt-will eventually crowd out all other government spending.
Interestingly, this same situation does not hold for all developed countries. For example, Australian demographics are likely to be worse than the United States, but given the nature of the country's pension system the Australians are not facing any large unfunded liabilities.
In Australia, the country has revamped its retirement system so as to minimize the unfunded liability through what is known as the superannuation retirement system. Employers are required by law to pay an additional amount of employees' salaries and wages (currently 9%) into a fund. Funds can be accessed when an employee meets conditions of release. After a decade of compulsory contributions, Australian workers have more than US$1.2 trillion, more money invested in managed funds per capita than any other economy.So while Australia faces a similar demographic problem, it is arguably much better prepared for these changes than the United States.
Fewer Workers, Slower Growth
In the March unemployment report, investors were understandably frustrated by the deceleration in net job formation. Another part of that report, which received less attention but may be of more significance over the long term, was the drop in the labor force participation rate, which is now at its lowest rate since 1981 (see Figure 4).
The drop in the participation rate appears to have accelerated since the financial crisis as frustrated job seekers eventually give up and leave the labor force. However, while the trend has accelerated, its origins go back more than a decade.
Labor force participation peaked in the United States in 1998 at 67.2%. Since then, it has fallen by approximately 3.7 percentage points, recently hitting the lowest level since the early 1980s when women were first entering the labor force in large numbers. This drop in the participation rate has coincided with a general slowdown in US growth. At the time participation peaked in the mid-to-late-1990s, the United States was growing at an average annual rate of 4.3% (average growth from 1996 to 2000). Since 2000, US real GDP has averaged roughly 1.7% annualized.
Slower US growth can be attributed to a number of factors, not the least of which are the side effects of the bursting of two bubbles, first in stocks and then real estate. However, it is hard to argue that the decline in labor force participation has not exacerbated the slowdown in growth. Over the long term, a country's secular growth rate is a function of the growth in the work force plus the growth in productivity.
The relationship between economic growth and changes in the participation rate has been evident for most of the post-World War II period. Historically, annual changes in the labor force have had a strong relationship-they explain roughly 25% of the annual variation in growth-with changes in real GDP (see Figure 5). To the extent labor force participation continues to decline, growth in the United States is likely to face a modest headwind.
We can get a glimpse of what may be in store for the United States by looking at Japan, where in a somewhat frightening parallel, economic growth has averaged 0.9% annually over the past two decades, and just 0.7% in the 2001 to 2010 period. Obviously, this trend has coincided with a number of factors, but it has almost certainly been influenced by the rapid aging in Japan.
In the case of Japan, this trend is likely to get even worse. While per capita growth may stay the same at around 1% to 1.5%, Japan's population will shrink at an even faster rate in the future. With the productive population declining by 1.1% annually, versus just 0.6% during the 2000s, this suggests future overall trend growth will be just 0% to 0.5%.
To the extent that a higher proportion of older Americans results in diminishing participation in the labor force, the United States may face a similar although less severe headwind. US demographics look much better than Japan's, but the basic relationship holds. If an aging population implies fewer workers there will be some modest lowering of the long-term secular growth rate for the United States-and many other developed countries.
Real Yields, Low for Long?
A modestly lower secular growth rate has many implications. One, which seems to go hand in hand with slower growth, is lower real yields. Historically, both in the United States and in other developed countries, the slower growth associated with an aging population and less participation in the workforce has been accompanied by lower real yields.
In the United States, nominal rates have been falling for three decades, a period that has coincided with a gradual aging of the population. Accordingly, there has been a strong correlation between demographics and interest rates. As the population has aged, rates have dropped (see Figure 6).
There was another important trend going on throughout this period: a secular decline in inflation. Arguably, that has been a much more powerful driver of the drop in yields than any change to the country's demographics.
However, even when you control for inflation, the basic relationship between demographics and interest rates remains exceptionally strong. Looking at real, or inflation-adjusted, yields produces a similar result. Even after accounting for the impact of falling inflation, changes in demographics explain more than 65% of the variation in yields (see Figure 7).
Aging may impact real yields through a variety of mechanisms. As previously demonstrated, as a population ages and work force participation drops, economic growth tends to slow. All else equal, slower growth tends to be associated with lower real rates. An aging population is also likely to be associated with less demand for capital, which should also exert a modest downward pressure on real rates.
This latter explanation appears to extend to other countries. Research into Japanese interest rates by the Bank of Japan (BOJ) also suggests that an aging population will exert a significant impact on interest rates. The model by the BOJ predicts that a decline in workers-to-total population ratio lowers the real interest rate and concludes that demographic changes impact the equilibrium, or natural, real interest rate through less demand for capital.
This theory is also supported by a similar study by the European Central Bank (ECB), which found that demographic changes contribute over time to a decline in the equilibrium interest rate, although the impact is slow and not visible over shorter time frames.
We have argued in previous pieces that real rates in the United States look too low, especially after taking into account the country's deteriorating fiscal picture. While we still believe that real rates are likely to rise over the long term, the findings from the BOJ and ECB-coupled with what appears to be a similar dynamic witnessed in the United States-suggest that the backup in yield may be more modest than predicted by models that ignore demographics.
Anyone Want to Buy a Stock?
Just as over the long term a country's growth rate is driven by growth in the work force and productivity, over the long term corporate profits are driven by real economic growth. Margins can expand or contract for prolonged periods, but over the very long term they have generally tended to mean revert, leaving revenue growth as the chief driver of aggregate corporate earnings. While accessing faster growing emerging markets may provide a tailwind for revenue, for companies with revenues that are dependent on US consumption, earnings growth will ultimately be a function of overall US economic growth.
All else equal, slower economic growth suggests that revenues from domestic operations are likely to grow slower than in the past (see Figure 8). As the accompanying chart illustrates, over the past 50 years economic growth has been the principal driver of US corporate profitability, explaining more than 35% of the variation in profits.
Slower growth caused by an aging population may have a secondary, but perhaps even more pernicious, impact on equities: it may lower multiples. In a 2010 paper, Tim Bond of Barclays Capital argued that demographics tend to drive equity multiples based on the notion that as investors age demand for equities falls, thus lowering the amount investors are willing to pay for a dollar of earnings.Mr. Bond predicts that forward projections suggest that US P/E should fall to around 11x by around 2015 before recovering slightly to 12x by 2020.
To the extent that aging populations in developed countries do indeed post modestly lower growth rates, there is a second reason we may experience lower multiples going forward. Our own research demonstrates that growth rates, both relative to other countries and relative to a country's own history, impact valuations. Historically, countries that grow faster have commanded higher multiples, while slower growing countries typically trade at a discount (see Figure 9).
As the above figure illustrates, there is roughly a 0.50 correlation between growth rates and multiples. While this average holds for both developed and emerging market countries, it is instructive to note that for certain fast growing emerging markets the relationship can be much stronger. For example, China's and India's correlations are much higher at 0.80 and 0.72, respectively. The lesson being, for countries perceived as growth stories, growth is both more rewarded and more penalized.
The relationship between growth and multiples has two implications for investors. First, while equities still appear reasonably priced and probably cheap relative to bonds, equity returns may be more muted to the extent that multiples do not fully revert back to their long-term average. Under this scenario, investors will have to rely on earnings growth and dividends, rather than rising multiples, to drive future returns.
Second, in a world in which developed markets slow, we would suggest that their multiples are likely to fall relative to emerging markets, with slower growth countries suffering the worst. This suggests that the traditional premium that developed markets have commanded versus emerging markets-historically about 35%-is likely to contract over time.
Age vs. Youth
Given all of this, what countries are likely to enjoy the most favorable demographics and which ones look the most dangerous? Not surprisingly, emerging markets tend to have younger populations. In particular, most of Latin America and Asia look particularly good from a demographic standpoint (see Figure 10). Both Brazil and Mexico have favorable demographics, with the percentage of the population under 15 3.50 and 3.80 times that of the percentage over 65, respectively. However, for investors looking for the best demographics in the larger emerging markets, it is hard to beat Asia. In Indonesia, the under 15 set outnumbers those over 65 by more than 4-to-1, in India the ratio is nearly 5-to-1 and in the Philippines it is an astounding 7.5-to-1.
The notable exception among emerging markets is China. While China's demographics look favorable compared to Japan, Europe and even the United States, the Chinese population is set to age much faster than several of its emerging market competitors, most notably India, Brazil and Indonesia.
China's demographics can be blamed on several factors, starting with the country's notorious one-child policy. As a result of this policy, China's fertility rate is a relatively low 1.58, below some developed markets including the United States. In parts of China, the birthrate is even lower. Shanghai reported a fertility rate of just 0.60% in 2010, perhaps the lowest in the world. As a result, over the next few decades, the median age will rise sharply in China to 48.7 by 2050; meanwhile, the population will fall slightly from 1.34 billion in 2010 to just under 1.30 billion in 2050.
While China's demographics look poor compared to the other emerging markets, Europe and Japan look awful compared to everyone. Japan in particular stands out as a demographic nightmare. A combination of low fertility rates, no immigration and rising longevity make Japan an outlier, even when compared with the rest of the developed world. The percentage of Japanese over 65 is already more than 25%, the highest in the world. While in the Philippines the young outnumber the old by 7.5-to-1, in Japan the old outnumber the young by more than 2-to-1.
The inevitability of gradualness cannot fail to be appreciated.
-- Sidney Webb
Demographics are like genetics; it would be a gross exaggeration to suggest that they are all that matters, but they will exert a subtle but persistent influence on a country's economic well-being. Given the long-term nature of demographic trends, it is worth taking note.
For investors, there are several implications. In the absence of a productivity surge-or the even more unlikely possibility of a major change in immigration policy-trend growth in developed countries is likely to slow. This effect should be more pronounced in Europe and Japan than in the United States. Instead, the principal risk for the United States revolves around government spending. Without significant reform, the strain on entitlement spending in the United States is likely to be greater than in other developed countries due to the persistent failure to tackle unfunded liabilities.
The second likely effect revolves around interest rates. While real rates should rise in the coming years, the rise may be slower and gentler than some expect as demand for capital slows. Third, equity multiples may not revert back to their long-term average in many developed countries. This also suggests that the historical discount between emerging market and developed market stocks is likely to narrow over time.
Investors looking to mitigate or avoid the impact of aging populations should consider raising their allocation to younger emerging markets-particularly India, Brazil, Indonesia, Mexico and the Philippines-and to companies that generate a growing percentage of their sales from these regions. Finally, if there were not enough reasons already, investors should probably avoid long-term positions in Japanese stocks.
 Kotlikoff, Laurence and Scott Burns, The Coming Generational Storm
(MIT Press, 2004) 2.
 Wikipedia, (accessed October 20, 2011).
 Bank of Japan Monetary Affairs Department, The Effects of Demographic Changes on the Real Interest Rate in Japan, Daisuke Ikeda and Masashi Saito, February 2012.
 European Central Bank Working Paper Series, Interest Rate Effects of Demographic Changes in A New-Keynesian Life-Cycle Framework, No. 1273/December 1970.
 Barclays Capital, Equity Gilt Study, 2010.
 "China's Achilles heel," The Economist, April 21, 2012.