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

Bank stocks - The Business of Banking, and Investing in Banks

We have recently seen many big-name banks declaring huge losses and raising capital from investors. They look like they are tip-toeing through a credit minefield, and stepping on a mine every few weeks as their portfolio of loans and assets deteriorate and new credit exposures surface. Is this the nature of the banking industry? Are banks just one of those lousy businesses that investors should stay away from?

Not in my opinion.

At its core, the business of banking is the business of (1) attracting customers and (2) managing risks.

Credit Risk Management
Banks, both investment banks and commercial banks, borrow money from one group of people and lend it to another group of people. They make money when the people they lend to are credit worthy, and lose money when they make bad loans or buy bad assets. It's as simple as that. From the perspective of the banking system, the whole system is sound as long as all banks make sound credit risk assessments. If the system as a whole makes a lot of un-creditworthy loans, then the inevitable result is a contractionary monetary base as loans are written off, and money is destroyed via the bank multiplier effect. This is one key reason why governments are loathe to let large banks fail, because a rapidly shrinking money supply would be disastrous for the economy as a whole. I believe this is why the Federal Reserve has maintained a loose monetary policy throughout the credit crisis. Some commentators contend that this stokes the fires of inflation and I have to agree. But I don't see any other choice.

Commercial banks also have to manage the risk of using short term funds (deposits, debt) to fund long term loans. This is a problem that all banks face, and a good bank should be able to manage this risk to an acceptable level. If we look at it from the perspective of the banking system then this risk becomes a non-issue, as long as bank depository institutions continue to be the only institutions allowed to take deposits and make loans. At the system level, all deposits (short and long term) have to remain within the system, and will continue to fund the issuance of loans (short and long term) which are also completely held within the banking system.

Why banks are good investments
The banking system as a whole channels all the money supply in the economy, so the profits from the banking system will generally grow in line with the growth of the money supply. And since the money supply tends to grow in line with economic growth, the profits from the banking system are a core-inflation protected stream of earnings that grow at the pace of economic growth. In a broad based economy with sound fundamentals, buying a share of the banking system is an excellent way to preserve your wealth. The best lowest risk banks, assuming that not all banks are run identically, would be excellent investments.

Risks and Attracting Customers
Unfortunately, it is difficult to figure out whether a bank is managing its risks well. It is very easy for a bank to make loans to un-creditworthy customers, and it is very difficult for someone reading a bank's financials to know when this has happened. An un-creditworthy customer may be able to pay his/her installments for a few years before finally defaulting on the loan. It's not something you can see coming just by looking at the financials. Assessing a bank's credit risk profile is an art. Among other things, we need to look at the bank's business model, operating culture, and compensation incentives. The price of credit is also an integral part of assessing a bank's credit risk profile. A bank can be financially sound if it makes loans to less creditworthy customers, as long as it charges a higher interest rate for each loan. Netted over a large base of customers, the higher interest rates can make up for the higher number of loan defaults. But it is generally difficult to know whether a bank has adequately priced for the risks that it is undertaking, because loan default typically only show up after a loan has aged for a while. Because of this, it is also easy for a bank to underprice its loans to gain market share, without showing signs of distress in the initial few quarters.

Good banks also need to be able to attract customers. But banking is the business of supplying money, which is the ultimate commodity product. A dollar bill from one bank is as good as a dollar bill from another bank. This doesn't mean that banks can't differentiate themselves using clever retailing, marketing, better service and so on. But it does suggest that, as with all commodity businesses, customers will be willing to switch to a competitor if the competitor's price is low enough. Because banks (1) are such highly leveraged businesses, and (2) it is easy for competitors to underprice their product, a bank can easily become susceptible to a loss if irrationally aggressive competitors attract their customers away with unrealistically low prices. The corollary of this is that a sound bank is one that has customers who don't see it as a commodity provider. Identifying a sound bank means knowing which banks have such customers.

Investing in Banks
Investing in individual banks is not for the uninformed. A bank's high level of leverage means that small errors of judgment by the bank can send the bank into a downward spiral. Flighty customers, underpriced risks, bad credit risk management can precipitate a deadly run on the bank.

The premise that regulator will not let a bank fail, and hence a bank is a failsafe investment, is a false one. I think it is true that bank regulators are loathe to let the bigger banks fail, but this only means that they will protect the assets and liabilities of the bank. They will have to let the shareholders be wiped out, in order to prevent moral hazard from creeping in. The experience of failed banks like Northern Rock and Continental Illinois support this observation.

I believe sound banks are an excellent investment, and the recent downturn in the stock market presents a good opportunity to buy into good banks at a good price. The trick is to pick out the good banks from the bad, before the market cottons on.