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Demographic Changes, Financial Markets and the Economy | Sean Barron

Sean Barron, Portfolio Manager at Delta Trust, examines Financial Analysts Journal’s recent article, Demographic Changes, Financial Markets, and the Economy.

Financial Analysts Journal published Demographic Changes, Financial Markets, and the Economy, an interesting article about the long-term themes that will reshape our world. The Journal investigates how demographics play a role in a country’s GDP growth, stock market returns, and bond market returns. Trust me, this is interesting.

The article seeks to find a link to abnormal returns using demographic trends as the coefficient. To make sure that the researcher is measuring abnormal returns, control variables are used to adjust for market valuation. The three control variables were dividend yield for stocks, 10 year yield for bonds (higher yields signal risk aversion, depressed prices, and higher expected returns) and three month yield for GDP (Fed keeps short yield at low levels during recessions, which are inevitably followed by periods of faster growth in GDP).

Here is the hypothesis: Per capita GDP growth should peak as a large generation moves into the work force. These young adults however, are usually spenders (against their future human capital) as they work on establishing themselves and start a family. As they age, their total contribution to GDP should grow, but at a slower rate and they will start saving for longer term needs, including retirement. First they invest in stocks, then as they approach retirement, their allocation to stocks decreases and the allocation to bonds increases. As they enter retirement, GDP starts to fall, and they begin to sell assets (stocks first) to buy goods and services they no longer produce. Given that demographics trends are readily available and predictable, if this pattern holds true in practice, there is an opportunity to profit by participating in these trends.

Skeptics would point out that since demographic trends are fairly predictable and visible, any effect on financial markets would be arbitraged away by rational and forward-looking agents. The rational as to how abnormal returns could still exist was best explained by the International Monetary Fund (2004) in its World Economic Outlook: “This is because only living generations trade in financial markets at a point in time, meaning that differences in the demand and supply of financial assets – a reflection of differences in size across generations – cannot be arbitraged away ahead of time” (p. 151) I would point out that this would only be true in a closed market or for the world as a whole, as financial flows across borders should be able to arbitrage away some of the abnormal returns. Since global investing is relatively new, the correlations found in this research report are probably accurate. In the future, the simple fact that most developed economies tend to have an aging population, the arbitrage opportunity may continue to exist.

The charts on page 30 show that there is a correlation and it does work as common sense would predict. GDP growth peaks around 30-34 years old and decreases after, finally going negative (in relation to normal) after age 50-54. Abnormal stock returns are positive and growing from the late 20s to early 50s, decreasing and going negative after around age 65. Abnormal bond returns are positive and growing from the early 30s to late 40s, decreasing and going negative after around age 65. Bond returns have a slower decline in coefficient after the peak, implying that they do not decline as quickly.

The illustrations of page 36 take those three coefficients and projects abnormal returns for most of the countries in the world. As a reminder, the regression controlled for stock and bond valuations, so this would project abnormal returns from a fairly valued market. Where I think the most opportunity would lie is with countries that are relatively closed and have limited access to capital, but are in the process of opening up their markets. Maybe combine this analysis with countries that are on the verge of becoming investment grade??

Some outtakes from the charts that are mentioned in the article. “Japan, Finland, and Sweden have a dangerous combination of very low birth rates and an exploding number of retirees, giving them a strong demographic headwind.” … “The results for Canada, the United States, and central Europe are mixed” … “The European periphery – including Ireland, Portugal, Spain, and Greece – has slightly better forecasts for stock and bond returns, showing there is hope for those countries despite their recent troubles.” … “Much of sub-Saharan Africa has too many young people and too few savings-age adults for stock markets in the region to fare well.” … “Finally, the BRIC countries seem to have a bright future ahead of them, at least for the next 10 years.”

Outside of this article’s scope is what effect this cycle will have on fiscal deficits and debt. But it does relate to one of our other long-term trends, the debt super-cycle. In an aging economy, GDP growth is lower than trend and therefore, all things equal, taxes are decreasing. Also, retirees income mainly comes from investments, which are taxed at a lower rate. On the other side, spending in the form of social programs will increase. Revenue decreasing and spending increasing when you are already running a deficit does not make a good trend.

Source: Financial Analysts Journal. Volume 67, Number 1. Demographic Changes, Financial Markets, and the Economy. Robert D. Arnott and Denis B. Chaves.

Sean Barron
Portfolio Manager
Delta Trust & Bank

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