Will changing demographics change the stock market?

The issue of demographic change is attracting greater attention nowadays, as the UK population ages and the implications for public policymaking come to the fore. It’s a global issue with influence that stretches beyond national boundaries and across the public and private sectors. That means even investors who devote their time and energies in pursuing the ‘value’ mantra would be well advised to consider demographic trends when building or redefining their portfolios.

Economically speaking, the consensus is already in. A general viewpoint has emerged over the impact of a ‘greying’ population on economic productivity, and it isn't positive. But the danger always exists that any orthodox position may be grounded in flawed logic or overly reliant on untested assumptions. And even if current thinking about demographics' impact economic growth stands up to critical examination, it doesn’t automatically follow that it will also have a profound impact on future stock market valuations. In this regard, there are reasons to think demographics may not be as deterministic as some believe.

Productivity and developing markets

History shows that economies with a relatively high proportion of workers in the 25 to 49 age group generally have better rates of productivity – the so-called ‘demographic dividend’. This has certainly been the case whenever countries have been industrialising, although it’s rather less obvious in those economies which are overly reliant on primary production.

It isn't just the western world that's dealing with demographic challenges nowadays. Developing nations may still be working their way through the demographic transition, but China’s ‘one-child’ policy, implemented between 1979 and 2015, may have skewed that process in the People's Republic – and the Asia-Pacific region in general. The controversial policy implemented by China’s Communist Party has had unforeseen consequences, most of which have been unfavourable. Consider, for instance, that the determination of Beijing to develop the country’s internal consumer market has been hampered by the artificial ageing of the nation’s populace, which is doubly significant given that China’s export cost advantages are now in retreat.

Other economic powerhouses in the Asia-Pacific region are also facing demographic tests. South Korea has had the lowest fertility rate in the world over the past decade, and as of last year the average number of children expected to be born per woman had fallen to 0.78 — well adrift of the 2.1 ratio necessary to sustain a country’s population.

Japan, meanwhile, currently has the highest percentage of citizens aged 65 and over – 28 per cent and rising. That represents three times the global average, but the OECD estimates that 29 countries and territories will have a greater percentage of seniors than Japan by 2050.

In a typical industrialisation scenario, the labour force grows more rapidly than the population dependent on it, albeit temporarily, thereby liberating resources for investment in further economic development. A ‘virtuous circle’ emerges in the early phase of the process, although history shows that it is often followed by reduced fertility rates and, eventually, a steady increase in the ratio of individuals aged 65 and over per 100 people of working age.

This age dynamic is straightforward enough, if somewhat brutal in its simplicity. If we bookend our lives, it is often the case that the cost of our day-to-day activities will outweigh our productivity the closer we are to the peripheries of the age spectrum. Naturally, there are exceptions to this rule, and it is conceivable that the age dynamic may evolve in response to technological innovation. It could be argued that innovations which reduce the manual labour associated with manufacturing disproportionately benefit older workers. This last point is worth keeping in mind whenever you’re pondering the potentially disruptive impact of evolving technologies such as artificial intelligence.

Other received wisdoms are also up for debate. According to research from the International Monetary Fund, the older-population share in middle-income countries is increasing at a much faster rate than in low- and high-income economies. And though it may seem counterintuitive to some, the IMF says “today’s middle-income countries are projected to have appreciably greater real incomes when their older-population shares reach comparably elevated levels”. In short, the view that “developing economies are getting old before they get rich” is a somewhat jaundiced one.

Investment implications

We should not automatically assume ageing population is wholly burdensome. A population with a growing proportion of older working-age groups has an enhanced incentive to accumulate assets to fund an extended period of retirement. Regardless of whether these assets are invested domestically or overseas, national income should grow, at least when a significant proportion of the population is within their prime working-age years. Naturally, once they have left the workforce, they will tap their savings to varying degrees.

Unfortunately, the corollary to this proposition is that the marginal propensity to consume will dissipate accordingly – another issue worth examining whenever you’re assessing the relative sector merits of your investment portfolio. Broadly speaking, workers in their early years of employment will borrow and spend more as a proportion of their income.

But the biggest investment implication of an ageing population relates to one of the core tenets of investing. It’s generally held that equity market valuations increase over the long haul, albeit in a non-linear path. However, there is a theory that suggests the post-war ‘boomer’ generations, those who are most heavily invested in the stock market, could be in the process of reducing their exposure simply to fund their retirement plans.

This seems like a reasonable, albeit slightly worrying proposition, and has been touted since the early part of the millennium. Doubtless, the speculation has gained support in some quarters simply because of the unusually large size of the boomer cohort, although it would be pure folly to imagine that it is monolithic in nature.

There is a parallel concern over whether succeeding generations – millennials and Generation Z – will be able, or indeed willing, to take up the slack, both in economic terms and, from an investment point of view, due to concerns over the rate of market participation. However, there is evidence to suggest that the pandemic acted as an inflection point in this regard, as young investors piled into the market on the back of zero-fee and app trading systems. Subsequent market performance, particularly in the US, might have dampened enthusiasm towards equities. But the fact remains that participation rates are being supported by a tech-driven ecosystem, a must where those aged 18 to 25 are concerned. Structural factors are also crucial: over time, the take-up of equities and bonds will be influenced by the decline in traditional defined-benefit pensions and other forms of guaranteed retirement income. The populace is, therefore, becoming increasingly reliant on individual investments and related returns.

It would be unwise to imagine that the influence of younger investors will not ultimately match that of the boomers. Consider that the largest age demographic right now is 20-34, while millennials are about to enter their peak earning years. That should equate to an upsurge in investable capital going forward, whatever the impact of withdrawals elsewhere.

Correlations are far from clear

But do those withdrawals have a meaningful impact? The question of the post-war generations' stock allocations continues to concentrate minds – there is potentially a lot at stake here, after all. Age aside, it may be logical to assume that if saving trends were the most important factor in terms of valuations and market volumes, there would be strong correlations over time between asset prices and demographics. But while this may be evident in certain real estate markets, it’s hard to identify a link when it comes to stocks and bonds.

The accompanying table shows the effect of ageing and low fertility rates on dependency levels. A theory exists that there is a demonstrable relationship between price/earnings ratios and the proportion of over-65s relative to those of working age. The problem with this assumption is that we should have been able to discern some impacts on stock market performance from the retirement of the first waves of baby boomers – that doesn’t appear to have played out, or if it has, it’s certainly not immediately obvious.

A study conducted in the early part of the millennium by the US Government Accountability Office (GAO) found that typical macroeconomic and financial levers – such as dividends and industrial production – had a more noticeable bearing on stock market performance 1948 and 2004 than demographics, despite changes in population age over that lengthy period. This conclusion not only seems intuitive to a certain extent, but it suggests that the retirement plans of successive post-war generations are unlikely to trigger a sudden decline in prices, even if it’s certainly true that small changes in average rates of return can affect the amount of capital and income generated through retirement plans.

Defined-benefit pensions and portfolio rebalancing

There are related issues that have probably had a far more profound impact on stock valuations, but while they do involve retirement savings, demographics themselves are not the cause here. Consider that midway through 1990s, the average UK defined-benefit pension fund had 75 per cent of its money in equities and just over 70 per cent of that in the UK. By 2022, that exposure had been reduced to just 13 per cent. That said, it is difficult to conclusively argue whether even this level of disinvestment has had a pronounced impact on stock market valuations.

Some individuals may soon follow a similar path. Mike Shamrell, vice president of thought leadership at Fidelity Investments, said recently that 37 per cent of baby boomers have more equity holdings than Fidelity would recommend for their time of life. It’s assumed that investors will reduce their exposure to risk assets as they approach retirement age, but the average percentage of equity within their retirement accounts is 65.8 per cent, which is within the suggested range. None of this indicates that a wholesale sell-off is in the offing.

At the margin, it wouldn’t be surprising if there was a general rebalancing of portfolios away from risk assets given the existing risk-free rate of return. Offsetting this is the thought that the immediate imperative to offload assets may not be as pressing due to the cost-of-living crisis and its consequent influence on those approaching retirement age.

Though it’s true that the number of over-65s is steadily increasing and people are living longer, the recent economic turmoil is likely to forestall retirement plans for many would-be pensioners. According to US publication Kiplinger's Personal Finance, around one-in-five boomers across the pond plan to delay their retirement as recessionary fears mount. It’s difficult to know if this will play out over time, but it appears to be backed by anecdotal evidence. 

The overlooked wealth divide

When assessing the likelihood of a multi-generational sell-off, perhaps the most overlooked demographic factor centres on the concentration of wealth. The accompanying chart details the gradual hollowing-out of the US middle class in the era of globalisation, but if you dig down into the underlying data, you get some idea of the extent of the wealth disparity.

At the end of Q1 2023, the wealthiest 10 per cent of the population accounted for 89 per cent of corporate equities and mutual fund holdings, up from 82.1 per cent in Q4 1989, and in stark contrast to the residual 11 per cent holding for the remainder of the populace. The upshot is that the households that would be more likely to need to offload financial assets to fund retirement do not collectively own a large portion of the total stocks and bonds in the market.

The reality is that the middle class has most of its wealth tied up in the primary household residence. Another reality is that the wealthiest people in society do not spend significant portions of their assets during retirement and in most cases die leaving bequests. Many retirees, even those in the mid-tier income bracket, are reluctant to offload assets to finance consumption because they might need those assets to meet unexpected costs at some point in the future.

Congressional insights

The US Congressional Budget Office is also of the mind that stock valuations could come under pressure because the anticipated increase in the rate of retirement (as the population ages) will “cause the demand for assets to fall more rapidly than the stock of capital will be reduced, causing asset prices to fall while the capital stock adjusts”. But there is little empirical evidence to suggest this is the case.

The Congressional body also makes the point that foreign demand for US assets will help to support valuations, particularly from developing countries with emerging economies. That’s hardly a startling conjecture given that the US is the world’s largest recipient of foreign direct investment, accounting for just under a quarter of global inward investment flows.

And despite the general trend towards doom-mongering, the latest Kearney Foreign Direct Investment Confidence index shows that the UK is the fifth most popular destination on that basis. By the end of 2020, the proportion of UK shares held abroad increased again to set a record high, at 56.3 per cent of the overall value of the UK stock market. Overseas investors remain a plank of support for the market. 

Moreover, we can get a direct steer on the likelihood of any demographic-driven sell-off by appraising retirees’ existing investment behaviour. The GAO study revealed that most retirees take a conservative approach to their accumulated assets, but another factor that mitigates against the chances of a sharp and sudden decline in asset prices is the two-decade timespan over which boomers will reach retirement age.

There is, however, a note of caution. The study warns that the wave of retirements is expected to reduce the growth rate of the labour supply. In turn, this could conceivably reduce returns to capital and, by extension, the returns to stocks. Here too, there is arguably reason for optimism, even as shortages persist in some areas. Although some commentators have expressed concerns over the labour participation rate in the aftermath of the pandemic and what this means for state provision, those fears may have been misplaced. Domestically, the rate increased to 63.7 per cent in April of this year, up by 10 basis points on the previous month, and 60 basis points in advance of the long-term average.

The GAO study also throws some light on the risk tolerances of retirees, although when it was originally published it couldn’t have anticipated the periodic turmoil in bond markets brought about by liquidity issues. Debate has intensified in recent years over the concept of the 60/40 portfolio and the ideal balance between growth assets and lower-risk alternatives. Ostensibly, retirees might be expected to have a reduced appetite for risk assets and would routinely divest themselves of equities in favour of bonds. But the study found that there was “only a small difference in aggregate stock and bond allocation across portfolios”. We at Investors’ Chronicle know from shared experience that there is no shortage of retirees who continue to build their portfolios after leaving the workforce.

In sum, there appears to be scant evidence to suggest that the immediate post-war generations have been in the process of reducing their asset holdings en masse to fund their golden years. And for the UK, perhaps a more significant consideration is the extent to which the investment preferences of those born after 1981 will have on secondary markets due to the effective dismantling of defined benefit provision. The imperative for a large section of the population to gain exposure to wealth-generating assets has, in truth, never been more pressing.