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Generation games

Why long-term investors need to pay attention to the world's demographic transition
August 2, 2018

There is no such thing as foreknowledge. Futurology is not a social science. Trend forecasting is deterministic at worst, unverifiable at best. But if tomorrow was entirely unknowable, life would cease to hold meaning. In a world where predictive powers count for nothing, investing makes little sense. Within the chaos, there is enough order to plan, and much of that order has a source: people.

One of the greatest tools at investors’ disposal – so too governments, companies and all large institutions – is demography. Ultimately, human populations are the product of billions of private decisions and interactions, influenced by myriad unpredictable policies, events and attitudes. Yet taken together, they often follow currents that point to probable futures.

Such an observation, arriving midway through a corporate earnings season, might sound a bit broad. But in the context of long-term investing, population patterns matter a great deal. Demographers, like economists, have their flaws, and have long been guilty of underestimating life expectancy and overestimating mortality rates.

And like economics, demography is often the basis for doom-laden visions of the future.

One is the fear of overpopulation – think Thomas Malthus. Another, of arguably greater concern, is with the age of the world’s people. Fertility rates across the world are falling, and increasingly, come in below two children per woman. Advances in healthcare mean we are living longer. Around the world – with the notable exception of a booming African population – this is placing a growing strain on a dwindling working cohort. For countries where population growth is shrinking, the obvious solution to this trend – migration – looks set to remain a politically fraught topic.

Japan captures these trends in an extreme way. Plummeting birth rates, the oldest citizens on the planet and an aversion to immigration mean the country’s population will at best decline by around a third by the end of the century, according to the United Nations. It could more than halve. Unsurprisingly, studies show that the country has one of the highest ratios of industrial robots to workers. Similar dynamics are in evidence in Germany, South Korea, and increasingly, China.

It would be wrong to pretend this is anything but a momentous shift. Growing, youthful populations have been one the foundations of the industrial economy, and with it, modern investment theory. Such a demographic reversal represents an enormous social and financial challenge.

Yet an ageing world should be celebrated as a miracle of human progress. Not knowing what adaptation will look like does not mean adaptation is impossible.

If we place some faith in these projections – and there is some evidence that forecasts for larger populations carry greater accuracy – then this leaves investors with two sets of concerns. The first is which kinds of businesses will benefit from a continuation of current trends. The second is what impact demographic shifts will leave on economies and financial markets.

Added to this is how these changes will in turn affect societies. For example, one by-product of ageing populations is an increased demand for healthcare. In the UK, healthcare spending is forecast to double by the 2060s – a natural boon to pharmaceutical giants such as AstraZeneca (AZN) or medical equipment companies such as Smith & Nephew (SN). How that social cost will be paid for, and what that will likely mean for politics and cultural attitudes, is another strain of demography altogether. As we will suggest, it should matter equally to investors.

 

 

Healthcare spending in the UK is forecast to double by the 2060s – a natural boon to pharmaceutical giants such as AstraZeneca

Age concern

The UK’s demographic trends are fairly typical of western societies. That is to say the population is steadily getting older. In 2016, the proportion of the country’s 65.6m inhabitants in working age (that is 16 to 64) stood at 63.1 per cent, with 18 per cent aged 65 and above. By 2046, the Office for National Statistics predicts the latter category will have climbed to almost a quarter of the population. In that same period, the dependency ratio – that is the number of non-workers (old and young) to workers – is set to increase from 58 per cent to 73.5 per cent.

There are important caveats to this. By 2046, the definition of working age will have broadened – the state pension age is on course to hit 67 within a decade – and the population is expected to grow by 16 per cent.

More significantly, that forecast uplift in population extrapolates past rates of immigration. Depending on one’s take of the Brexit referendum, that might look like a misreading of social attitudes. If immigration stalls, investment management group Rathbones estimates that the dependency ratio “will increase by an additional two percentage points over the next 20 years”.

This comes with added financial pressures. In his 2009 book The Age of Aging, economist George Magnus cited evidence that younger workers are saving less than their elders, and may not be saving enough for retirement. In fact, the UK household savings ratio has been in decline for about two decades. This has serious implications for economic consumption, and raises questions about the ability of older generations to pass on assets to their children. Spending continues to increase over the average lifetime, as research compiled by an academic group called National Transfer Accounts suggests.

These trends offer investors both headaches, and ideas. The first is whether these factors are inflationary. Look to Japan, and one might conclude the opposite is true. A 2016 paper by three International Monetary Fund economists suggested that the associated falls in growth and land prices were both deflationary, and further compounded by elderly savers’ repatriation of foreign assets.

At the same time, there are good reasons to think an ageing economy might lead to inflation. If the non-working, non-productive population is growing relative to the working population, this increases the relative demand (and competition) for goods and services. A greater dependency on workers potentially gives greater bargaining power to labour, another inflationary pressure.

In the UK, much will likely depend on changing attitudes towards saving, which has long been a deflationary signal. In its outlook, Rathbones concludes that the country’s demographic trends are “likely to start to exert net upward pressure on inflation, but not to any alarming extent”.

The Bank for International Settlements (BIS) agrees. In a paper published last year, the central banks’ central bank concluded that an ageing world will lead to a rise in real interest rates, stoking inflation and wage growth and a fall in inequality. The greatest challenge, according to the BIS, will be the ability of the global economy to swallow the bitter pill of tighter monetary policy, in order to combat the threat of major inflation.

 

Winners – at first glance

Beyond inflation, an ageing population will inevitably create several real economic demands: for income-generating securities, medicine and healthcare, life insurance, and innovations in robotics and technology.

The latter, particularly in the associated area of artificial intelligence, remains an ethically vexed area of business. Writing recently in The Atlantic, none other than Henry Kissinger drew a frightening historical parallel between recent developments in AI and the Incas, “faced with a Spanish culture incomprehensible and even awe-inspiring to them”. But greater technological assistance, in more benign forms, is a near-certain requirement of growing worker dependency.

One way to play this could be through the ROBO Global (US3015057074) or a UK equivalent, L&G R080 Global Robotics & Automation UCITS ETF (ROBG), an exchange-traded fund which invests in sectors that “focus specifically on the intersection between technology and its applications” – which is another way of saying it focuses on technology. Spread widely between 84 holdings in 14 countries, with a distinct weighting to Japan and the US, the fund’s managers focus on what they describe as an “unusually dynamic environment where the largest players change as quickly as the technologies themselves”.

Other stocks which will likely benefit from an ageing world include a pair of French businesses: AXA (Fr:CS), whose life insurance business has a strong reach into a rapidly ageing Asian market, and pharma major Sanofi (Fr:SAN), whose portfolio of prescription drugs are used to treat a wide range of age-related diseases. For a geographically-diversified fund that focuses on both healthcare and life insurers, BlackRock markets the Sipp-ready iShares Ageing Population ETF (IE00BYZK4669).

Vivo Energy (VVO), a petrol station and fuels business that raised £548m in its London IPO this year, fits neatly with another major demographic trend: the rise of Africa. Until the middle of the century, the continent is set to account for over half of the world’s population growth, although unless the continent is to suddenly leapfrog the rest of the world and roll out an efficient electric vehicle grid infrastructure, its growing economies and vehicle fleets will need fuelling the old-fashioned way. Across Africa, Vivo is licensed to supply Shell products, for which demand is forecast to grow between 3.2 and 3.8 per cent a year until 2021, alongside a 7.4 per cent annual growth in vehicles.

 

Secondary effects

Naturally, the combination of slowing population growth and falling worker numbers will halt total demand in some industries and geographies. It will also have a role in asset allocation – or rather intensify the nascent trend for income-generating financial assets. These include dividend-paying equities, although in the UK fears over stock market valuations have resulted in a distinct preference among retail investors for the low-volatility promises of fixed income.

At least that’s according to the Investment Association, whose data shows that 2017 was the best-selling year for fixed income, which became the best-selling asset class among retail investors, in particular the growing popularity of strategic bond funds such as IC Top 100 constituent MI TwentyFour Dynamic Bond Fund (GB00B5KPRZ34), whose wide mandate aims to provide both an attractive level of income and capital growth.

Another potential knock-on effect of the demographic transition is on household liquidity. As we previously noted, falling savings rates represent a ticking time bomb for younger generations in the UK. On the other side of the Atlantic, some believe that bomb is about to explode, as growing numbers of baby boomers retire with insufficient assets to meet their consumption patterns. Research from Boston College suggests that around half of American retirees are at risk of falling short in retirement. There are also big questions of baby boomers’ reliance on equities to fund their retirement.

In theory, one second-order effect of this imbalance – through recession or drawdowns – is the potential for another housing crisis, as retirees are forced to liquidate their largest assets and downsize to keep up their consumption levels. One company that will likely benefit from this scenario is Equity Lifestyle Properties (US:ELS), which operates more than 400 manufactured housing and recreational vehicle resorts across North America.

 

A political battle

While the knock-on effects of a peaking human population have potential solutions, demographic shifts also carry unforeseeable consequences.

In its 2017 paper, the BIS came to the conclusion that “the prime working age population and the aged are likely to find themselves in a political battle”. In a sense, this could be framed as a battle between labour and a powerful voting bloc; a workforce facing greater demands on its productivity, output and income, and a non-working population keen to prevent government from reneging on its pension obligations.

Although it often helps to assume that actors will act in rational ways, there is no guarantee that societies can or will always find ways to adapt their social contract, and balance the interest of competing groups. But it helps to start with well-managed countries that are already actively planning for an ageing future.

Sweden, a high-tech, low-debt and export-led capitalist economy, offers one example. In recent years, the country has invested in preventive health and social care to enable people to prolong their working life and boost the earliest age at which people can draw their old age pension. 

Sweden also possesses a highly educated population, which provides added flexibility to ageing economies, as higher education levels tend to offer. Sweden has also retained a relatively open policy to migration, in a bid to soften the increase in retiree dependency. For retail investors, a catch-all fund such as iShares OMX Stockholm Uncapped ETF (IE00BD3RYZ16) is one way get exposure (albeit approximately) to a country that is taking efforts to offset its demographic headwinds.

 

Demographics and the state

In The Age of Aging, Mr Magnus argues that “it is unlikely that we will be willing to depend on market-based outcomes as our societies age”, and that the role of the state “may have to be expanded again as populations become older and possibly smaller at the same time”. For clarity, that’s UBS’s former chief economist essentially saying that demographic shifts will be sufficiently profound to warrant calls for governments to either intervene in markets, or grow their own remit.

Some might argue this is already happening. It is a common refrain that global politics is undergoing something of a populist renaissance, and that this is itself the product of demographic trends.

On its own, demographic shifts will not dictate social change, but they will play an important role – particularly when you consider the role population changes have played in taking us here. One of the biggest demographic trends of recent decades has been the shift in China’s population. With the introduction of the one-child policy in 1979, the country effectively created an enormous reserve labour force with fewer dependents, and a rapidly rising life expectancy. This helped to accelerate the shift in manufacturing to Asia, and reduce inequality between countries. But there is also evidence that the trend depressed wages and exacerbated inequality in advanced economies.

In the west, this has been accompanied by an erosion of faith in institutions, and in the eyes of some political commentators, rising appetite for strong leaders who can guarantee results, and a return to order, whatever form that may take.

It’s a worldview echoed by two demographers, Neil Howe and William Strauss. In 1991, the pair created a generational theory, published in The Fourth Turning, in which they espoused the idea that American history follows a cycle, in which social institutions are built, degraded and rebuilt every four generations (see table, below).

 

First (High)

Second (Awakening)

Third (Unravelling)

Fourth (Crisis)

Families

Strong

Weakening

Weak

Strengthening

Institutions

Reinforced

Attacked

Eroded

Founded

Culture

Innocent

Passionate

Cynical

Practical

Social structure

Unified

Splintering

Diversified

Gravitating

Special priority

Maximum community

Rising individualism

Maximum individualism

Rising Community

Coming of age generation

Silent

Baby Boomers

Generation X

Millennial

According to Mr Howe, we are in the midst of a fourth turning. The supply of order is failing to meet increased demand, a charge chiefly raised by millennials – that is, the generation born between 1982 and 2000, and whose coming-of-age moment arrived amidst a financial crisis and the realisation it will be worse off than its parents. With distrust at its peak, so the theory goes, a fulcrum is needed to re-establish faith in institutions and a return to civic engagement. An ageing population, and swelling dependency on the working-age populations, looks set to heighten those tensions.

 

Does history repeat itself?

This philosophy has some flaws. History can move in cycles, but predicting the next epoch is both deterministic and imprecise. The focus on the US makes it important, but limits its global application.

Turning this into an investment framework might seem like a convoluted and vague exercise, too. A view on the economic ricochets of generational change requires a lot of patience, and doesn’t point to a clear path. If investors are to brace themselves for the “creative destruction of public institutions”, to quote Mr Howe, then it’s hard to predict which kinds of investments would do well – or to what degree financial markets will be affected.

Still, we can try. In economic terms, ‘crisis’ tends to involve recession. Investors would likely bid up the price of gold. A recession would likely lead to a fall in consumption, and when consumption falls, discount retailers tend to benefit. Walmart’s (US:WMT) sales rocketed in the three years after the financial crash; a parallel closer to home would be B&M European Value Retail (BME).

A re-set in institutional could likely benefit the construction industry, as the act of “re-making” public institutions is often accompanied by symbolic public works. In this event, infrastructure specialists would likely benefit – a sweeping speculative bull call for Balfour Beatty (BBY) if ever there was one.

Beyond that, long-term investors would be advised to consider what nascent trends might mean for their portfolios.

 

The Generation Game Portfolio

HoldingDemographic theme
AXA Group (Fr:CS)Aging populations place a greater demand on life insurance
B&M Retail (BME)Discount retailers stand to benefit from a tumultuous economic shift
Balfour Beatty (BBY)Fourth turnings accompanied by higher infrastructure spending
Equity Lifestyle Properties (US:ELS)US retirees being forced to downsize their housing
GoldHigher inflation, or demographic-linked crises
MI TwentyFour Dynamic Bond (GB00B57TXN82)The growing desire for fixed-income securities from retirees
OMX Stockholm Uncapped ETF (IE00BD3RYZ16)A country that is already planning for demographic change
Robo GlobalRobotics and technology will have to close the workforce gap
Sanofi (Fr:SAN)Growing need for age-related disease medicines
Vivo Energy (VVO)The rise of Africa’s population