Practical analysis for investment professionals
25 November 2014

Tracing the Connections between Economic Growth, Capital Markets, and Demography

The CFA Institute Fixed-Income Management Conference is an annual event focused on global debt markets, fixed-income sectors, security selection, and portfolio construction. The Fixed-Income Management 2019 Conference will bring together researchers, analysts, portfolio managers, and top strategists in Boston, Massachusetts, on 17–18 October.

Robert Arnott, chairman and CEO of Research Affiliates, understands the uncertainty involved in forecasting markets, but some things are more certain. In fact, some things are destiny. At the CFA Institute Fixed-Income Management 2014 Conference, Arnott discussed how people are vastly underestimating the impact of three things in our world that are predictable: debt, deficits, and demography.

Debt and Deficits

“Deficits are much, much, much bigger than anyone realizes, and total debt in the United States is vastly larger than anyone acknowledges,” Arnott said to a crowd of fixed-income managers in Huntington Beach, California. “The current reported measurement of deficit, as 3% of GDP, is pure fiction,” lamented Arnott.

The US government is using the clever accounting notion of “off-balance-sheet spending,” in other words, pretending certain expenditures are not part of deficit spending. What’s included in off-balance-sheet items today? Medicare and Social Security trust funds, incremental GSE obligations, and the cost of the US presence in Afghanistan and Iraq. “The list will only grow as Congress discovers how easy it is to move expenditures off balance sheet,” said Arnott.

Public debt and entitlement obligations are growing at a frightening pace. The US National Debt is reported at 100% GDP. If you add in unfunded obligations for Social Security, Medicare, Medicaid, Government Sponsored Enterprises (GSEs), and state and local government debt, it adds up to $108 trillion in total national debt on a GAAP basis, or 650% of GDP. (Greece’s total debt/GDP is only 180%.) The US government takes in $3 trillion in taxes, but it owes $108 trillion. ”Do the math. We will not be able to honor these debts. US politics of the last decade will look benign as promises for Social Security, Medicare, and Medicaid are broken and renegotiated in the years ahead,” according to Arnott.


Demography does not make our debt problems look any better. In 1950, the median age in the G8 was 30, and only 9% of the population was over age 65. Sixty years later, in 2010, 16% of the population was over 65 and the median age was 40. By 2030, according to United Nations (UN) forecasts, 23% of the population in the G8 will be over 65. “This is a daunting structural change and we’re just at the beginning of this trend in developed countries,” where demographic headwinds start to have a major impact, said Arnott, although Japan, an exception, is in the middle.

The picture in today’s emerging markets is much different, with a median age of 30 in the BRICS, workforces at peak productivity growth, and demographic tailwinds at their backs.

Life expectancy is also changing dramatically (for more, see: “What Happens When We All Live to 100?”). Arnott looked at the United States, Japan, and China, finding that the average life expectancy was 73 in 1950 and 86 in 2010 — a 13-year improvement in life expectancy over 60 years, or 2–3 months’ improvement per year, which continues today. The latest US Census suggests we may already be at levels previously expected for 2050 (living 22 years after age 65). In addition, both death rates and birth rates have fallen — accelerating the tilt toward aging populations in developed nations.

Today, Arnott sees a demographic inflection point as growing retirement cohorts outnumber working cohorts. He studied the change in the working population (ages 20–65) versus the change in the population of senior citizens. In 2012, for the first time in US history, the population of senior citizens is rising more rapidly than the population of working-age people.   

“Support ratios,” or the number of working age people per retiree are also deteriorating. In 1950, the support ratio in the United States was 7 to 1; today, as people are living longer, the ratio is about 4 to 1, but it is poised to move to 2.7 in the United States in 2030 — just 15 years from now — with similar declines in all the major developed countries. “This is a sea change,” said Arnott, intentionally referencing the dramatic change from Shakespeare’s The Tempest. China and India’s support ratios (7 to 1 and 10 to 1, respectively), do not decline until much later. Demographically speaking, growth could continue in those countries for some time.

“We can either accept the troubling support ratios or we can work longer,” Arnott suggested, adding that “support ratios can be stabilized at 4 to 1 if we ratchet up the retirement age to 71. We’re living 15 years longer than our great-grandparents. Why should we expect to retire at the same age?”

How Demography Affects GDP Growth and Market Returns 

In their 2012 paper, “Demographic Changes, Financial Markets, and the Economy,” Arnott and his co-author modeled the linkages between GDP growth and market returns to demography (absent other factors). Their results found a tailwind in the United States from about the mid-1970s to 2010, because baby boomers were young and working at peak productivity levels. Starting around 2020, as baby boomers age, the tailwind becomes a headwind. The United States will have a demographic drag that troughs in about 10–15 years, sucking 1% from normal GDP growth. (For more, see: “How Demographics Affect GDP Growth around the World.”)

“Brace yourself for slower economic growth,” Arnott warned. “If we demand 3% growth from our political elite, when normal GDP growth should be 1% or maybe 2%, they will create the illusion of growth with massive deficit spending and front-end load our future growth.” Notice that Japan had a 3% tailwind starting in the mid-1950s that reversed in 2000. Arnott expects it will trough with a headwind of -2.2% in 2045. The post-war Japanese economic miracle was partly a demographic miracle.

Abnormal GDP Growth
Arnott also looked at the annual performance boost or drag to stocks and bonds attributable only to demography for the G8 and the BRIC countries. At any given equity valuation level, stocks’ performance should be biased due to demographic trends — either equity returns are higher (or lower), or the Shiller P/E goes higher (or lower). Stocks perform well when there are many individuals in the “savings cadre” (age 35–59), accumulating wealth and starting to plan for retirement. Stocks perform worse when the 70+ age cadres are growing fast and disinvesting, or when the young adult segment is growing fast and not saving.

Arnott’s findings indicate that emerging markets should offer about 4% higher returns than developed economies in the years ahead, based on a more benign demographic profile alone.

Demographic Relationship

Performance Boost

For bonds, Arnott found that for any given level of real yield from the early 1990s to today, demography alone suggests that bonds should experience returns higher than historical norms (i.e., positive abnormal returns). In other words, the natural real yield on bonds, as demographic profile implies, should be lower than historical norms. This means that today we are at the lowest natural real yield we will ever see on bonds in our lifetimes, and demography helps to explain why. There are so many mature workers scrambling to save for retirement that the purpose of bonds has changed. Bonds no longer act as diversifiers to stocks offering modest real returns, they have become an insurance policy if stocks crash. And like all insurance, they come with a cost: negative real rates. In 10 years, we will have much different pictures as these trends reverse.

Demography matters. The good news is that prosperity is a common theme among mature societies with a lot of gray hair. “Would you rather be in a slow growth, prosperous society, or a high growth society with much less prosperity? I’ll take prosperity any day,” said Arnott. However, Arnott likes higher growth emerging markets from an investment perspective, preferring their young, productive workforces. They’re on pace to catch up with the standards of living of the developed world pretty quickly — that is, if governments don’t screw it up.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Julie Hammond, CFA, CPA

Julia S. Hammond, CFA, CPA, is Director, Events Programming on the Marketing & Customer Experience (MCX) team at CFA Institute, where she leads the content planning for the Alpha Summit series of events. Previously she was the lead content director for a number of annual and specialty conferences at CFA Institute, including the Fixed-Income Management Conference, the Equity Research and Valuation Conference, the Latin America Investment Conference, the Alpha and Gender Diversity Conference, and the Seminar for Global Investors, formerly known as the Financial Analysts Seminar. Prior to joing CFA Institute, she developed strategies for pension, endowment, and foundation fund clients at Equitable Capital Management (now AllianceBernstein), and she has also worked as an auditor for Coopers & Lybrand (now PricewaterhouseCoopers). Hammond served for a number of years as chair of the investment committee for the Rockbridge Regional Library Foundation. She holds a BS in accounting from the McIntire School of Commerce and an MBA from the Darden School at the University of Virginia.

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