The Achilles' Heel Of The U.S. Economy

Includes: EWZ, IXC
by: Russ Koesterich, CFA

The Achilles' Heel of the U.S. economy may just be that entitlement programs haven’t kept pace with U.S. demographics, a fact that has long-term implications for investors.

According to a recent annual government report on entitlement programs, the Social Security trust fund is likely to run out of money in 2033, three years earlier than previously projected. Meanwhile, both Social Security and Medicare aren’t sustainable in the long-term without structural changes.

As I point out in my recent Market Perspectives piece, one reason that these entitlement programs, which rely on current workers to fund current retirees, are facing such problematic outlooks is that they were designed decades ago for a population that looked very different demographically from today’s aging U.S. population.

Social Security, for instance, was formed in the 1930s when there were approximately 40 working age Americans per retiree. Medicare was introduced in 1965 when there were approximately 25 workers per retiree. Today there are roughly 3.3 workers per retiree and at some point before 2050, the ratio is likely to drop to approximately 2 workers per retiree. Due to demographic shifts in the U.S. population, today there are more and more retirees, and fewer and fewer workers.

At the same time, Americans are living much longer and (paradoxically) retiring earlier than previous generations. Back in the 1950s, the average age of retirement was about 67. Today, it’s 62. Longer lives coupled with earlier retirements mean longer retirements that have to be funded by these programs.

Without significant reform, U.S. entitlement programs are likely to pose a growing economic strain on the economy. For example, without a change to current laws, federal spending on Medicare and Medicaid combined will grow to almost 10% of gross domestic product by 2035, up from roughly 5% today. If left unchecked, Social Security and Medicare will eventually help crowd out all other government spending.

And if the United States continues to fail to tackle unfunded liabilities, the economic strain from entitlement spending is likely to be greater in the United States than in other developed countries.

For investors, especially those who don’t believe the strain is going to be alleviated anytime soon, here are three long-term implications:

1.) Consider raising allocations to equities in emerging markets with younger populations such as Brazil, Mexico, India, Indonesia and the Philippines. Developed world countries with aging populations are likely to grow slower, and trade at lower valuations, than younger, faster growing economies (potential iShares solution: the iShares MSCI Brazil Index Fund (NYSEARCA:EWZ)).

2.) Remain underweight Treasuries. The massive spending pressure on the federal government from unreformed entitlement programs will likely mean a larger supply of Treasuries. In the absence of the Federal Reserve or other public institutions buying the larger supply, yields should rise, a negative for Treasury bonds.

3.) Opt for certain sectors. If rates rise thanks to a larger supply of Treasuries, certain segments of the equity market are likely to get hurt more, while others should prove more resilient. Typically sectors such as healthcare, energy and technology hold up the best when rates rise. Meanwhile, sectors such as consumer discretionary, financials and utilities suffer the most (potential iShares solution: the iShares S&P Global Energy Sector Index Fund (NYSEARCA:IXC)).

To be sure, there’s always the chance that Congress will figure out a way to fix the programs. One potential solution, probably the easiest and most obvious, is to gradually raise the retirement age one must reach to take part in the entitlement programs. Raising the retirement age could shorten the retirement period that has to be funded, which would shorten the funding burden on the programs and on the government.

What do you think of this potential solution? What do you think should be done to extend the longevity of U.S. entitlement programs and why?

Sources: Bloomberg, Congressional Budget Office.

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