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The Implications of Global Aging on Fixed Income

By 2050, the global population growth rate will likely decelerate from 1.25% currently to only 0.25%. This will raise the world’s age structure—the share of the young falling and the old rising. At the global level, the elderly population is expected to rise from the current 7% of the total population to 16% of the total population by 2050. This is a historically unprecedented demographic transition as fertility and mortality rates decline.

In Europe this is due more to fertility decline than mortality decline. By 2050, according to the United Nations, in some central and eastern European countries, populations will likely contract by around 30%, Italy’s population will likely contract by 22% and Japan by 14%. China faces a similar ageing problem in twenty years. The ‘dependency ratio’—defined as the share of population over the age of 65 as a percentage of the working age (15-64) population—is expected to increase dramatically in Japan and Europe. The dependency ratio is expected to increase less sharply in the U.S., due to higher birth rate and immigration.

Deutsche Bank in a 2013 report called “Confessions of a Rogue Demographer” took a view going out to 2100. What you find in this longer term population forecast is a view of Asia that indicates relative stabilization in most places. It also shows an epic crash in China the likes of which the world has only seen before in the presence of the plague or global war.

Asian Population, in millions.

Old people.jpg

Source: Deutsche Bank

Population forecasts going out to 2100 could be viewed as going off the reservation a bit. They do function as a mental exercise that show some basic directionality.

What is agreed is that population growth is slowing except perhaps in a few isolated areas. And in time total population is set to decline. This will have definite impact on fixed income.

Some preliminaries about life in an aging world.

It will suck to be a kid. The labor supply will decline. Medical and healthcare related spending will increase, and crowd out the education expenses needed to enhance the productivity of the shrinking work force. The average wage bill will shrink, reducing tax receipts. So the end result is a shrinking tax base and rising budgetary demands.

Problems will work themselves out. They always do. These demographic changes will pressure the fiscal position of governments and pensions in particular. Some European countries already have unfunded liabilities of up to 250% of the size of their GDPs. In the United States this is 115%, according to the Office of the Actuary estimates. This means that the levels of real interest rates in countries with ageing populations may rise above what could be justified by their potential growth rates, as public borrowing needs grow and the private sector starts to dis-save during retirement. “Pay-as-you-go” pension systems (SSI and Medicare) are never really stable outside of the Ponzi sense, and they will absolutely not be sustainable. There is no choice here, they will cease to exist. It’s tough, but problem solved.

Ergo, the level of real long-term interest rates will rise until a nation reaches its fiscal breaking point, contingent on its changing fiscal outlook.

The long-term interest rate will be commensurate with the new, lower, potential growth rate. This implies a flatter yield curve. The accelerating potential growth rates in younger countries tend to have steepening yield curves.

Ergo, yield curves flatten in countries with ageing populations.

Ever improving life expectancy has created ‘longevity risk’. This means retirees can no longer count on public assistance or their ability to defend their lifestyle if they end up living much longer than they expect at the time of their retirement. This more than anything has created the carry trade of home currency investing into local currency, higher yielding bonds.

Ergo, yield curves will flatten in countries with younger populations.

The carry trade implies more risk-taking, not less, as retirees try to enhance their expected investment returns by diversifying from assets with low credit risk. As the global population ages, the carry tradef from aging to younger countries will grow a great deal. Carry trades do bring more FX volatility and credit volatility in return crashes. Some countries have a long-standing taste for stocks, so this could imply a bigger appetite for equities. I think it is crazy for a retiree to throw most of their money into stocks, but whatever. It could happen.

Ergo, Ageing will have an ambiguous effect on the preferred structure of financial portfolios but risk appetite will increase and volatility will increase.

Consumption in nations with declining populations slows dramatically. Consumption will be anemic for the next fifty years.

Consumers in the developed world will resemble Germans, who have kept their purse strings very tight, stoically ignoring any improving income situation, and fretting about their old-age income prospects and the sustainability of their welfare systems.

Ergo, countries with high dependency ratios have flaccid growth even now. This will not change. Ever. Inflation? Forget about it.

The nice thing is you don’t need to depend on a central bank argument for any of this to make sense. Central banks can’t alter these trends much, they don’t matter in terms of arresting such trends. And they can't impact x-factors.

China is the x-factor. The one-child policy served a short-term purpose,but the longer-term impact could be disatrous. There is no way to guess what effects its implied population crash will actually mean. There is no telling what a nation of people growing up with no brothers or sisters will mean. I'm thinking that the culture capable most equipped to handl it would be one with Confucian elements to it. Maybe technological advance will work it all out relatively easily.

Thankfully, every living system is capable of working through these problems. Cruelly and coldly maybe, but sometimes that is the only way.

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