Population change and capital markets: Should we be worried?


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Survey results, from executives active in capital markets, suggest that aging populations will drive increased risk aversion and greater government expenditure on pensions and healthcare. The reality is more nuanced: investment implications vary widely as countries and individuals adapt to changing longevity. A greying population however holds opportunities as well as risks...

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Population change and capital markets: Should we be worried?

  1. 1. Global Financial Institute Your entry to in-depth knowledge in finance www.DeAWM.com . Population ageing and capital market performance: Should we be worried? March 2014 Dr. Paul Kielstra Deutsche Asset & Wealth Management S3SPECIAL ISSUE
  2. 2. Population Ageing and Capital Market Performance2 Deutsche Asset & Wealth Management’s Global Finan- cial Institute asked the Economist Intelligence Unit to produce a series of white papers, custom articles, and info-graphics focused specifically on global capital market trends in 2030. While overall growth has resumed, and the value traded on capital markets is astoundingly large (the world’s financial stock grew to $212 trillion by the end of 2010, according to McKinsey & Company) since the global financial crisis of 2008, the new growth has been driven mainly by expansion in developing economies, and by a $4.4 trillion increase in sovereign debt in 2010. The trends are clear: Emerging mar- kets, particularly in Asia, are driving capital-raising; in many places debt markets are fragile due to the large Global Financial Institute Introduction to “Global Capital Markets in 2030“ component of government debt; and stock markets face weakening demand in many mature markets. In short, while the world’s stock of financial assets (e.g. stocks, bonds, currency and commodity futures) is grow- ing, the pattern of that growth suggests that major shifts lie ahead in the shape of capital markets. This series of studies by Global Financial Institute and the Economist Intelligence Unit aims to offer deep insights into the long term future of capital markets. It will employ both secondary and primary research, based on surveys and interviews with leading institutional investors, corpo- rate executives, bankers, academics, regulators, and others who will influence the future of capital markets.
  3. 3. Population Ageing and Capital Market Performance3 About the Economist Intelligence Unit The Economist Intelligence Unit (EIU) is the world’s lead- ing resource for economic and business research, fore- casting and analysis. It provides accurate and impartial intelligence for companies, government agencies, finan- cial institutions and academic organisations around the globe, inspiring business leaders to act with confidence since 1946. EIU products include its flagship Country Reports service, providing political and economic analy- sis for 195 countries, and a portfolio of subscription- based data and forecasting services. The company also undertakes bespoke research and analysis projects on individual markets and business sectors.The EIU is head- quartered in London, UK, with offices in more than 40 cities and a network of some 650 country experts and analysts worldwide. It operates independently as the business-to-business arm of The Economist Group, the leading source of analysis on international business and world affairs. This article was written by Dr. Paul Kielstra and edited by Brian Gardner. Dr. Paul Kielstra is a Contributing Editor at the Economist Intelligence Unit. He has written on a wide range of top- ics, from the implications of political violence for busi- ness, through the economic costs of diabetes. HIs work has included a variety of pieces covering the financial services industry including the changing role relation- ship between the risk and finance function in banks, pre- paring for the future bank customer, sanctions compli- ance in the financial services industry, and the future of insurance. A published historian, Dr. Kielstra has degrees in history from the Universities of Toronto and Oxford, and a graduate diploma in Economics from the London School of Economics. He has worked in business, aca- demia, and the charitable sector. Brian Gardner is a Senior Editor with the EIU’s Thought Leadership Team. His work has covered a breadth of business strategy issues across industries ranging from energy and information technology to manufacturing and financial services. In this role, he provides analysis as well as editing, project management and the occasional speaking role. Prior work included leading investiga- tions into energy systems, governance and regulatory regimes. Before that he consulted for the Committee on Global Thought and the Joint US-China Collabora- tion on Clean Energy. He holds a master’s degree from Columbia University in New York City and a bachelor’s degree from American University in Washington, DC. He also contributes to The Economist Group’s management thinking portal. Global Financial Institute Introduction to Global Financial Institute Global Financial Institute was launched in November 2011. It is a new-concept think tank that seeks to foster a unique category of thought leadership for professional and individual investors by effectively and tastefully combining the perspectives of two worlds: the world of investing and the world of academia.While primarily tar- geting an audience within the international fund inves- tor community, Global Financial Institute’s publications are nonetheless highly relevant to anyone who is inter- ested in independent, educated, long-term views on the economic, political, financial, and social issues facing the world. To accomplish this mission, Global Financial Insti- tute’s publications combine the views of Deutsche Asset & Wealth Management’s investment experts with those of leading academic institutions in Europe, the United States, and Asia. Many of these academic institutions are hundreds of years old, the perfect place to go to for long-term insight into the global economy. Fur- thermore, in order to present a well-balanced perspec- tive, the publications span a wide variety of academic fields from macroeconomics and finance to sociology. Deutsche Asset & Wealth Management invites you to check the Global Financial Institute website regularly for white papers, interviews, videos, podcasts, and more from Deutsche Asset & Wealth Management’s Co-Chief Investment Officer of Asset Management Dr. Asoka Wöhrmann, CIO Office Chief Economist Johannes Mül- ler, and distinguished professors from institutions like the University of Cambridge, the University of California Berkeley, the University of Zurich and many more, all made relevant and reader-friendly for investment pro- fessionals like you.
  4. 4. 4 Ageing: A developed- and emerging-market trend Rapid streams of numbers flashing across electronic screens in trading rooms and brokerage offices worldwide seem to reflect the deeply impersonal nature of the world’s capital markets. Ultimately, though, these exchanges are driven by the decisions of individuals – whether executed as one-off trades or adopted as strategies programmed into machines. Therefore, the attributes of the people buying and selling assets, as well as of the wider populations in which they live, are intrinsically linked to how markets perform.This is most evident during a bubble or an ensuing panic, where emotions can quickly inflate or destroy the value of any number of securities overnight. More generally, though, any widespread changes to the prevailing needs, wants, productive capacity or views on risk in a society are likely to feed through, sooner or later, to asset prices on capital markets. Several such shifts may be driven by societies’ ageing. One economically important result of this demographic change is the increase in the proportion of people who are retired and a reduction in their working-age populations. In 2010 in the developed world, according to data from the United Nations Population Division, 16% were already 65 – a common retirement age – or older. In the oldest societies, such as Japan, Germany and Italy, the figure was over 20%. In the years ahead, for the developing world as a whole, the total number of the over 65s is expected to rise by about 2% annually, so that it reaches 22% of the population by 2030. This issue also has particular resonance in Asia. Because China’s retirement age is 60, the proportion of people beyond normal working years is 15% and is expected to reach 24% by 2030. This makes the issue much more immediate there than in the United States, where the equivalent figures are 15% and 20%. As the Chinese example suggests, one way to reduce the impact of these changescouldbetoincreasetheageatwhichemployment typicallyends.Thepoliticaldifficultiesofdoingso,however, raise questions about whether increases in the retirement age will keep up with advances in life expectancy. A policy challenge Older populations will require societies to make a wide range of adjustments, many with direct impacts on national economies and, indirectly, on capital markets. According to respondents to a survey conducted by the Economist Intelligence Unit of 353 senior executives of companies actively involved in capital markets, one of the biggest predicted impacts of population ageing will come from increased government spending to cover the associated costs in areas such as healthcare and pensions (cited by 41% of respondents). James Poterba, Mitsui professor of economics at the Massachusetts Institute of Technology, believes that “the greying of the population in the United States is an important driver of long-term [government] spending to GDP. We are seeing that today.” America is far from alone. Thisspendinginturnpresentssocietieswithafundamental choice. Alexander Ludwig, professor of macroeconomics at the University of Cologne and an expert on the economics of ageing, explains that governments can choose debt or taxes to fund the coming spending needs for the elderly. Too high a tax burden, though, will reduce savings by those in their middle years, and therefore investment in capital markets. Too high a level of government debt, on the other hand, may crowd out demand for other relatively risk-free assets. Furthermore, if households foresee that higher debt today will have to be financed by increased taxes in the future, private spending will also go down. Population ageing and capital market performance A collaboration between Deutsche Asset & Wealth Managment‘s Global Financial Institute and Economist Intelligence Unit March 2014 Population Ageing and Capital Market Performance Global Financial Institute Written by
  5. 5. 5 Population Ageing and Capital Market Performance According to Professor Ludwig, “it is certainly true that increased government spending will have an impact on capital markets one way or the other”. The shape of that impact, though, will depend on the specifics – and the success or failure – of the policies chosen to address the changing needs of ageing societies. Global Financial Institute
  6. 6. 6 Population Ageing and Capital Market Performance A people challenge? The difficulty in predicting what capital markets will look like in a world where investors, like the population in general, are older is that the world has never seen population ageing on the current and predicted scale. Hard data about what will happen do not exist. Expressions of concern tend to begin with references to the life- cycle hypothesis. This holds that, as individuals attempt to smooth out consumption over the years, they save during their working lives and spend those savings in retirement to cover living expenses. A higher proportion of retirees in the population therefore means that there are more people selling off accumulated capital assets and fewer interested in buying, leading to a general drop in asset values. Another issue – which survey respondents identified – is a shift by older, more risk-averse individuals into traditionally safer investments, such as government bonds, from more volatile ones such as equities. Done en masse, this would reduce share prices and lower interest rates, as more retirees seek security in debt instruments. This theory, however, is far from airtight. While it has substantial predictive value, this hypothesis ignores two important investor motives: precautionary savings by the elderly, who know neither how long they will live nor all the expenses they might face; and the bequest motive. As Professor Poterba notes: “Research of the last decade has shown that late life behaviour isn’t driven only by drawing down capital. A simple life cycle model is an oversimplification.” Similarly, any movement away from risk may be more apparent than real. For many individuals, pensions and annuities form a significant proportion of personal assets in retirement. Increasingly, however, the pension fund managers and insurance firms which oversee the assets used to fund private pension payments are finding that traditionally safe government bonds – long a default asset for the industry – now pay far too little to meet their obligations to pension and annuity holders. Therefore, managers are buying a wider range of assets, including alternative investments, in the search for yield. Furthermore, underlying assumptions about retirement ages – and therefore the time when retirement-related expenditures begin – are not as solid as they seem, in part because people are, on average, healthier and therefore able to work longer. For example, in the United States between 2003 and 2013, even without pension reform, the Bureau of Labour Statistics reports that the labour market participation rate of those aged between 65 and 69 rose from 27% to 33%. Indeed, of those Americans still working at 65, the majority do not retire. And according to Statistics New Zealand, the labour market participation rate in that country for those over 65 doubled between 2002 and 2012, from just under 10% to 20%. Cultural differences may slow change. International Labour Organisation (ILO) data show that European countries, although they too have seen some increase over the last decade, still have very small labour market participation rates among the elderly. Nevertheless, as Professor Ludwig notes, even there, “if you live longer, and need higher savings, the average retirement age will probably increase without regulatory reforms”. Looking for evidence These problems with the theory may explain why it has been difficult for researchers to find conclusive evidence – although population ageing has been taking place for some time – of an impact on capital markets. A study by Professor Poterba, for example, found very little, if any, sign of a link between the changing age structure of the US population over several decades and the value of equities or government debt in the United States. It also found that, although household asset holdings do rise when people are in their 30s and 40s, they remain largely stable throughout retirement except for defined benefit pensions - which decline by design.1 The best evidence so far of a link between ageing and equity values relates not to asset prices specifically, but to the price/earnings (P/E) ratios of equity assets. Research carried out by economists at the Federal Reserve Bank of San Francisco found a surprisingly tight positive correlation between average US P/E ratios and the ratio of middle-aged people – which the study defines as those aged between 40 and 49 – and the old-age cohort likely to be selling off shares – those aged 60 to 69.2 Presumably, 1 James Poterba, “The Impact of Population Aging on Financial Markets in Developed Countries”, in Gordon H Sellor Jr, ed., Global Demographic Change: Economic Impact and Policy Challenges, Federal Reserve Bank of Kansas City, 2005, pp. 163-216. 2 Zheng Liu and Mark M Spiegel, “Boomer Retirement: Headwinds for U.S. Equity Markets?”, FRBSF Economic Letter, August 2011. Global Financial Institute
  7. 7. 7 Population Ageing and Capital Market Performance where the number of middle-aged people is higher, their greater interest in shares compared with other securities drives up prices. Even with such an apparently good data fit, however, the study warns that many other factors could obliterate this effect. Moreover, Mark Spiegel, vice president, economic research at the Federal Reserve Bank of San Francisco and one of the study’s authors, explains: “It is correct that a lot of people hold a lot of scepticism. The study works off very clear patterns in historical data, but you can tell a special story for the sub-periods going back to the 1950s for each of the big swings in the trends. The ultimate test [of whether there is a link] is if it shows up in data [in the coming years].” Examinations of other types of assets yield a similar combination of possible pressure on asset prices owing to ageing, alongside high levels of uncertainty about what might actually happen. Real estate is one of the more studied, as housing, along with pensions, is among the most widely held assets for retirees. A Bank of International Settlements (BIS) working paper which looked at house prices over 40 years in 22 countries found a link between ageing and lower prices. It therefore predicted downward pressure on prices resulting from older populations. The paper stressed, however, that projected house price “headwinds” would be insufficient to produce an asset meltdown and offered the well-deserved caveat: “Long- run projections and estimates should be treated very cautiously as their track record is dismal.”3 The international dimension Capitalmarketsarenotjustaboutlong-termassets,butalso about flows of money. International differences in the rate of ageing might affect these transfers and, indirectly, asset values in different markets. In particular, economic theory would suggest that investment should flow from wealthier, older countries with surplus capital and restricted labour supply towards developing, younger ones, where capital will be more productive and yield a higher return. Questions of international labour and capital availability go beyond demographics to include areas such as pension and labour market reform. To address how this range of issues might interact with ageing to affect capital markets in an internationally open economy, Professor Ludwig and his colleagues have put together a complex model.4 Its projections, though, vary dramatically based on government policy and individual lifestyle choices. In scenarios in which people take advantage of opportunities to work later in life and where governments do not reduce spending on pay-as-you-go pensions, the model suggests that asset returns will drop by about 5% between 2015 and 2030, but then rise by the same amount again by 2050. However, without a change in labour regulations and working habits but with a shift to funded pensions, which increases the capital available, asset returns could drop by over one-quarter. Put simply, the policy response is likely to define how asset returns, and therefore capital markets, react to ageing. Like most experts, Professor Ludwig advises caution. The study itself suggests that continued high growth in Asia would counteract any downward pressure and more than compensate for reductions in asset returns in several scenarios. Moreover, he warns that the available data are based on the “baby boom” and “baby bust” years in developed countries, which are insufficient to draw firm conclusions. “This is why we have to work with simulation models grounded in economic theory,”he adds. Whatever the other uncertainties, Professor Ludwig, citing existing, separate research, feels confident that differential ageing patterns promote the flow of capital from older, wealthier countries to younger, emerging markets.5 Others, though, are less certain. If this were the case, says Professor Poterba, “you would have expected North America and Europe to be large saving countries, to be lending to other parts of world.That is not what we see.This reminds us that many other factors also affect capital flows – demography is not everything.” The most relevant economic theory, however, raises red flagsaboutpopulationageing.Itcouldplacesomepressure on asset prices in the coming decades, and while the full Global Financial Institute 3 Előd Takáts, “Ageing and asset prices”, BIS Working Papers No 318, August 2010. 4 Axel Börsch-Supan and Alexander Ludwig, “Aging, Asset Markets, and Asset Returns: A View From Europe to Asia”, Asian Economic Policy Review, 2009. 5 See, for example, Melanie Lührmann, “Demographic change, foresight and international capital flows”, Mannheim Research Institute for the Economics of Ageing, Discussion Paper 38-03, 2003.
  8. 8. 8 Population Ageing and Capital Market Performance scope is unclear, the extent does not seem likely to cause a crisis. Moreover, such evidence as exists does not provide solid support for strong predictions. It may be unlikely ever to do so: demographic changes are highly predictable. A market made up of rational actors should foresee them and may have already priced in any relevant risk. Similarly, companies facing a reduction in labour capacity can alter their production models to ones that optimise the likely future mix of labour and capital. What applies to rational markets hopefully applies to rational policymakers. Capital markets are not facing an unavoidable “silver tsunami”. Population ageing may well affect asset values, just as it will affect society in general, but the way it does will be shaped largely by choices those societies make addressing the new demographic environment. Global Financial Institute
  9. 9. Disclaimer Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries. Clients will be provided Deutsche Asset & Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. This material was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank AG and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. Neither Deutsche Bank AG nor any of its affiliates, gives any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of the Deutsche Bank Group, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. The opinions and views presented in this document are solely the views of the author and may differ from those of Deutsche Asset & Wealth Management and the other business units of Deutsche Bank. The views expressed in this docu- ment constitute the author’s judgment at the time of issue and are subject to change. The value of shares/units and their derived income may fall as well as rise. Past performance or any prediction or forecast is not indicative of future results. Any forecasts provided herein are based upon the author’s opinion of the market at this date and are subject to change, dependent on future changes in the market. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. Investments are subject to risks, including possible loss of principal amount invested. Publication and distribution of this document may be subject to restrictions in certain jurisdictions. © Deutsche Bank · March 2014 9 R-xxxxx-x (x/xx) Global Financial Institute