Sunday, April 4, 2010

How Demographics affects Equity Investors (and people saving/investing for retirement)

Some investment theses rely in part, on making a broad bet on the economic prospects of a country. (For example: buying an equity index fund) The economic prospects of a country are determined by two key factors: its resources and scheme of organization (its legal, cultural, financial and political framework), and its demographics. The former is understood and often acknowledged; the rule of law, respect for private property, and so on, are seen as essential to unleashing the economic instincts of human beings. However, the impact that a country's demographics have on its economic prospects is sometimes overlooked. Why? Because much of recent economic history has unfolded over an era when populations were growing in almost all the major countries. But this is now changing as many countries have crossed the tipping point and are now starting to age.

To see how demographics affects economics, we can examine the 2 extremes that population demographics can take: a growing population that is predominantly young and growing, and a shrinking population that is predominantly old and aging. (You can check up the population pyramid of most countries at this U.S. Census Site)

Growing Population

All things being equal, a country with a growing population will generally report positive economic growth. As the population grows, the population will create and consume more products and services to sustain itself as a given standard of living. So even if the economy does not grow on a per capita basis, investors betting on general economic growth will have the bet work out in their favor. Within the economy itself, we can expect to see real estate values grow in real terms, as the growing population has more productive output that it can cede to land owners to secure rights to the land. (This is assuming constrained land resources - if there's huge tracts of usable land adjacent to major cities that are already zoned for development, then its a different calculus). Investors in such an economy can protect the value of their savings by using it to either (a) buy a share of the profits of economic production (via equities) or (b) buying land. Since the dawn of the industrial age around 200 years ago, this has been the demographic pattern of most countries in the world.

However, we are now at a turning point in many countries, and populations are beginning to shrink. This portends a very different economic reality for investors. Countries like Japan, whose populations have peaked and are beginning to shrink, are giving us a preview of what is to come in Europe and other soon-to-be aging countries.

Inflection point between Growing and Declining Population

At the point when the population begins to turn from growth to decline, the economy will begin to have excess productive capacity because the capacity was built by a larger population to sustain itself. As the population declines, we can expect the productive capacity of the economy to exceed the needs of its shrinking population. There will literally be too many houses, machines, car, and equipment for the shrinking number of people. Because capital equipment tends to increase and decrease in step-function jumps, we can expect that the excess productive capacity will remain for a while. During this time, it is probable that businesses will try to cut prices in order to retain the nominal amount of business in a shrinking pie. The implication for shareholders is that they face a declining ROCE. The shrinking consumer needs will ultimately lead to reduced production needs, and reduce the number of workers needed, hence preventing wage inflation from pushing prices up. Deflation is the likely result during this inflection point period. This would suggest that investors would do best simply to hold on to cash during this time, since cash would increase in real value as prices continue to drop.

This deflationary trend will probably be hard to reverse using monetary policy:

1. The first monetary tool that central banks can use to induce inflation is to grow the money supply through credit growth. Unfortunately this is unlikely to cause inflation because credit is predominantly extended for capital stock creation, of which there is already too much of it relative to the shrinking consumption. If anything, it will probably exacerbate the deflationary trend for the reasons we've seen. (This monetary tool to induce inflation is probably more effective with a growing population, because the increased capital stock will eventually be utilized as the increasing population requires more products and services. The increasing population may temporarily freeze their consumption, thus making this monetary tool ineffective in the short run as the extra capital stock sits idle. But over time, the growing population will eventually start demanding more soap, food, electricity and other products which are produced by the capital stock. Once this kicks-in, the deflationary trend will probably be reversed.)

2. The second monetary tool is for the government to turn on the printing presses and grow the money stock through the government spending of printed money. This too is unlikely to induce inflation, because the surplus productive capacity of the economy would easily create the goods and services for the government to buy with its freshly printed money, without increasing the price level because supply capacity is abundant. If the economy has a high savings rate, then this extra money will probably go back into investments in capital stock, further reinforcing the deflationary trend.

Unfortunately, the tendency to over-invest in capital stock can be expected during the period when population gradually shifts from growth to decline, because people tend to extrapolate from the past when making decisions. In the past the population was growing, which required (and rewarded) a continuing increase capital stock. So businesses will likely persist in this behavior and over-invest in capital stock, until it finally sinks in over time that what worked in the past no longer applies because of the shift in demographic trends.

In such an environment, deflation will be sustained, and investors would do well to simply hold on to cash.

Declining Population

However once the country's economic participants adjust to the new reality of a shrinking population, and reduces its investment in capital stock as a proportion of GDP (i.e. reduces its savings), then a different set of economic forces come into play. The more normal level of capital stock relative to consumption will remove the incentive for businesses to cut prices because they are no longer operating under high fixed overheads. The systemic deflationary forces will then disappear.

Over time, the total overall economic production will continue to decline in line with the shrinking population's reduced need for material goods and services. Unless exports are an overwhelming proportion of the economy, the economy can be expected to shrink in line with the decline in population. (Technically speaking under today's economic terminology, such an economy would be considered to be in a prolonged recession.)

Investors would not profit by buying a share of the profits of economic output (by buying equities), since overall production and productive capacity will keep shrinking. In practice, equity investors will see this happening though shrinking corporate profits. (With the shrinking population, businesses will also have to get used to shrinking revenues as overall sales volume goes down.)

Investors would also do well not to buy land, since the shrinking population will have less economic production to cede for the finite land, and indeed, on a per capita basis, the increased available land per capita would also increase and further reduce the real value of land.

How about cash? Would investors (or people planning for retirement) in such an economy do well to hold cash over the long run? In all probability, no. In a declining population economy, both savers will likely earn negative real returns. The savings (either held as cash or in equities) generated by an earlier generation when the population was larger, will have less real value as the population declines. Why? There are 2 reasons:

  1. Because society requires less and less capital over time, and hence owners of capital (savers and equity owners) will find that their returns will drop. Conceptually what's happening is that at the earlier time, and forgone consumption of the larger population (i.e. savings) was basically work spent to build up capital stock in the form of buildings and machinery. As time passes and the population declines, the smaller population requires less buildings and machinery than what was built (through savings) of the larger population. So the capital stock built by the earlier generation will now be used to produce fewer products(profits) than what the earlier generation would have been able to get if the population stabilized at the earlier generation's level. In effect, the earlier generation will experience low nominal returns (negative real returns) on its savings.

  2. Inflation will also likely set in, as the total economic production drops and the money supply chases fewer and fewer goods. The central bank may forstall this effect over the short run by absorbing excess money through bond issuances, but over the long run, the inflationary trend is likely to persist.

NOTE: In a steady state economy, capital stock investments as a % of GDP should increase or decrease in line with population growth or decline. (This implies the same for savings, since in a clearing economy, Savings = Investment). The capital investments should be to get ready for the increasing or decreasing needs of a increasing or decreasing population.

Rule of Thumb for Equity Investors (wrt to Demographics)

On balance, investors would in general, do well to avoid investing in economies with declining populations. It is difficult to profit from holding scare resources like land, because as the population declines, the amount of production that the population can use to purchase the resources also declines. In such economies, the reducing need for capital also means that returns for capital owners will be poor. Persons in such economies who are saving for retirement will probably fare best if they hold on to inflation protected bonds. Unlike persons in growing population economies, their prospects for increasing real wealth through passive investing is lower, because there isn't a future generation of more people and more consumption which requires the capital they provide as investors.

This is an important realization, because recent economic history has been one founded on continuous population growth. A declining population presents a different economic environment.

Image by TerriersFan, via Wikimedia Commons, released under the GNU Free Documentation License Version 1.2