World faces productivity challenge as ageing gloom hits equity markets

 
Fredrik Nerbrand
OFTEN investors are so preoccupied with the short-term drivers of financial markets – like corporate earnings or central bank actions – that they forget about the long term.

However, there are other significant factors – like demographics – which drive markets on both a long and short-term basis. Age, in particular, is a key determinant of asset allocation. Any shift in global demographics could have a significant impact on how equity and bond markets perform over the next decades. Demographics are also of crucial importance when it comes to growth.

Normally, economic growth can be split into two parts: population growth and productivity. But these two variables are not independent. Think about it like this: your largest productivity gains happen as you just enter the workforce, and the largest declines are in the years just before and during retirement. An ageing population, therefore, is not good news for an economy’s capacity to grow.

While it’s possible to measure demographic trends in numerous ways, we find that the ratio of new workers to those who are about to retire is the most important: the grad-to-granny ratio as we call it. In the UK, there are now 0.8 20-29 year olds for every 55-69 year old. This ratio has come down from 1.1 in 1990, and is projected to drop to 0.5 in 2030. In Italy, the ratio is already 0.6, but is likely to drop to 0.3 in 2030. Japan, often seen as the country with one of the world’s worst demographic profiles, actually looks more stable – its ratio of 0.5 today is set to fall to 0.4 in 2030.

But the story does not end there. The Middle East, for example, is set for massive relative ageing. Indeed, of the 99 countries that we analysed in a recent report, only Uganda is likely to see a positive move in this ratio over the next couple of decades. And as Uganda is unlikely to single-handedly solve the world’s demographic issues, we need to assess the likely investment implications of this trend.

Given that there are only really three ways to get out of the global debt trap (productivity growth, inflation or default), any changes in productivity growth are key to future investment implications.

And these investment implications are also stark. The older a person is, the more likely they are to become loss averse – they have fewer years to live and tend to have fewer alternative sources of income outside of their past savings. Consequently, this is more likely to make them investors in bonds, which have a greater certainty of income, than buyers of shares.

The old rule that an individual’s bond allocation (in percentage terms) should be equal to his or her age may be overly simplistic, but is often close to what academic research indicates is the most appropriate asset allocation based on age.

And we should add to this the fact that, with the global population ageing, a higher proportion of wealth now lies with the older, risk-averse, cohort. In the developed world that means the baby-boomers – the generation born between 1946 and 1964 – who are now starting to retire. They own relatively more of the global assets cake than the corresponding age group did at the end of the 1980s.

The most likely scenario, therefore, is that we see a rebalancing of global assets away from equities into cash and bonds not the opposite, as is often touted by perennial equity bulls.

So is this the beginning of an investment Malthusian catastrophe? It depends on the ability of the global economy to continue its trajectory in terms of wealth creation. In recent years, the main driver behind improvements in global prosperity has been emerging markets. But even if this trend were set to continue, we calculate that these markets would, on average, need to grow by 1.9 times their trend growth rate in order for equity weights even to stay constant from a demographic point of view.

Our conclusion is that ageing populations will cause equity holdings to fall over the next 40 years. We predict that the global allocation to equities will fall from 51 per cent today to 43 per cent by 2050. The allocation to cash will rise from 33 per cent to 41 per cent, and bond holdings will remain flat at 16 per cent.

As for today’s markets, to avoid getting carried away with short-term optimism over the success of monetary policy, these long-term trends should be taken into consideration. We should expect bond yields to remain low for much longer.

Fredrik Nerbrand is global head of asset allocation at HSBC, and author of its recent report Baby Boom to Ageing Gloom.