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

10 year outlook for investors: U.S. dollar Inflation, Devaluation, and Structural economic changes

It's notoriously difficult to predict the future of complex systems like human societies, and betting hard-earned money on predictions is not my idea of investing. Nonetheless, long term investing requires us to have a long term view of the economy, to allow us to think through investing possibilities and to test our investment ideas. As Eisenhower is reputed to have said, "the plan is useless, but planning is essential".

So here's my thought exercise on the outlook for the future:


Outlook for 2008 to 2010
(Immediate future)

In the immediate future (2008-2010) or so, we will likely see a severe recession as the misallocation of savings invested into unproductive assets starts to work itself out. The misallocation of resources brought about by excessively cheap credit was extreme. The excessive growth in credit (reflected as M3 money supply growth) relative to GDP growth over the last decade strongly suggests this.

The fact that core inflation was low during this period of M3 growth suggests that most of this credit was used for capital asset formation (e.g. housing, machinery and equipment) and/or channeled into financial assets. Cheap imports from China may have had some impact on keeping inflation low, but imports are actually a relatively small component of the US economy, and cannot completely explain the lack of inflation in consumption goods (products and services). 

It is beginning to look like that the recent U.S. fixed capital formation was mostly in housing, and not productive assets like machinery. This could make the recession a longer and deeper one, as the U.S. economy may not have a whole lot of spare productive capacity (capital assets such as machinery) to form the foundation for economic growth. There isn't a lot of spare machinery lying around that we can just turn on when demand sentiment picks up. This can slow the recovery process because businesses will need to invest in new machinery before they can increase economic output. And they will only do if they see sustained customer demand or a general improvement in the mood of the country. This means there is an "energy barrier/step-function" to cross before the overall economy will start growing again. Without an uptick in consumer demand, businesses won't invest in capital assets. And without investments in capital assets, there is one less mechanism to get people back to work and earning income.

On the other hand, if businesses had spare machinery, it would be an easier decision to reactivate one of the idle machines and cater to minor increases in demand. The economy wouldn't have a step-function barrier to economic growth, but rather would be able to inch its way forward and slowly increase overall economic activity. While this chicken-and-egg catch-22 is an unfortunate hurdle to economic recovery, it also means that once the step-function is crossed, the economy will likely experience strong and sustained growth as economic activity lurches forward to produce both capital and consumption goods.

The sheer quantum of the misallocation of resources (manifested as credit losses) in the boom leading up to 2007 also suggest that it will take a prolonged period of time for the economy to untangle the web of work wasted on building white elephants. A large amount of claims on future work will not be honored, because the economy did not build enough productive capacity to honor these future claims. The work was wasted on creating white elephants instead, and it will take some time for economic participants to get over this and move forward. The sheer size of the problem also makes it likely that consumer demand will drop a lot in the short term, which may lead to deflation as businesses cutprices to cover their fixed costs.


Outlook for 2010 - 2020
(Long term)

In the longer term, over the next decade (2010-2020) or so, I believe there is a significant probability that we will see (1) monetary (forex and pricing) instability, (2) the general reduction (reversion to mean) in corporate profits as a % of GDP, and (3) structural changes in the factors of production.

(1) Monetary instability may come about because:

• To combat the current credit crisis, central bankers around the world are injecting money into the banking system to counteract the destruction of money caused by the massive debt writeoffs. While some economists might argue that this merely delays the reallocation of credit to productive resources, I agree with the current approach because a reduction in money supply would cause the flow of money to freeze as banks try to bring themselves back into solvency. This would push the real economy into a depression, which could bring about a change in social and political outlook that would steer us away from free market capitalism.
  
  But over the longer term, this massive injection of money into the money supply base will cause a strong inflationary bias in the economy. While the Treasury was sterilizing some of the money supply injections earlier, I believe it will ultimately stop doing so, or sterilize less than the amount of money injected, to allow for a net quantitative increase in money supply. In other words, the Fed will turn on its printing press and print out money.
  
  

• The U.S. government has huge, unfunded social security and medicare obligations to the baby boomer generation who will be retiring over the next 15 years. By some accounts, the unfunded obligations total up to 35 trillion dollars, which more than twice the GDP of the United States. The government can issue Treasury debt to fund these obligations, but the size of the government existing debt ($10 trillion) combined with the sheer size of the unfunded obligations, suggests that there simply won't be enough people to buy the debt that the Treasury will need to issue. Given the short-term focus of the political process, political expediency would likely pressure the Federal Reserve into buying this debt from the Treasury, in effect printing money for the government. This will cause further money-supply inflation, and effectively short change the beneficiaries of Social Security and Medicare.

Both these factors will cause the money supply to grow in excess of the underlying productive capacity of the U.S. economy. This will in turn, lead to a sustained depreciation of the US dollar against many other currencies. While Asian central banks will try to stem this depreciation to support their economies, which are structured to rely on exports to keep running, it is probable that they will eventually reduce their buying of US dollars as (1) it becomes politically difficult to keep buying US dollars as US inflation destroys the value of their dollar holdings, (2) this attempt to fix currency exchange rates starts importing inflation into the local economy, and (3) the continued monetary sterilization carried out to balance the sale of local currency (through selling government bonds or increasing banking reserve requirements) leads to rising local interest rates that distort the domestic economy. If central banks do not manage this process well, there is a potential for currency and monetary instability as currencies see-saw and whiplash repeatedly. 

Unfortunately, the odds are that central bankers will not be able to manage this process as they would like, because as long as political systems reward short-term results, governments in export-oriented economies will favor the central banks' continued currency intervention because it supports jobs in their export-oriented economies. The depreciation of the US dollar will be a long term trend, but there is a high probability is that it will take place in a lurching, see-saw fashion, with bursts of rapid devaluation offset by periods of appreciation or sideways movement.

The US dollar will only stop its long term depreciation when the U.S. economy's productive capacity allows it to produce excess goods, and its depreciated currency makes its goods attractive in international markets. The turning point will be reached when the US export machine starts firing up on all cylinders. Such a period of changing expectations and changes in the direction of capital flows will probably also cause volatile currency movements.


(2) Reversion to mean of Corporate Profits as % of GDP

This will happen because of the continuing economic growth of China and India. As their workforces become fully employed and linked up to the global economy, the source of cheap labor will gradually dry up. The labor surplus over the last 2 decades which depressed wages and allowed companies to earn outsized profits will go away. The result is that more of the US GDP income will accrue to labor as opposed to corporate profits.


(3) Structural Changes in the Factors of Production

The Earth's increasingly affluent consumers will put strains on the planet's capacity to supply these basic resources. If this is simply a problem of increasing supply capacity, then any jump in commodity prices will be temporary since it will induce additional investments in commodity extraction capacity.

However, if we are hitting the planet's resource limits (e.g. peak oil), then it means that each unit of resource may require more capital intensity to produce (e.g. difficult-to-extract oil located in geographically challenging areas). This would mean that higher real commodity prices may be here to stay, and it implies that we will face structural shifts in the economy as more of GDP income needs to be diverted to pay for basic resources which require more effort / technology to extract. For example, each hour of work we put in now buys less products, because more of that effort has to put into pumping hard-to-reach oil out of the ground instead of making the products we want.

This could make a whole host of products that we currently enjoy economically unfeasible to produce. This could radically alter the economic landscape. Companies which have existed since the dawn of the automotive age could go out of business as their economic models become impractical. For example, will big box stores be practical in a world where oil is ultra-expensive? For that matter, the concept of suburbia itself could be threatened as the cost of living in spread out spaces becomes prohibitive. We could return to an era of living in high-density living, like in Victorian England.