Some Recent Observations of Demographics & Budget Deficits

Written by Gareth Witten via Investor Literature.

Doing scenario analysis for clients is extremely exciting and rewarding because it allows me to take the “outside view” for firms in different countries. It also allows me to make sense of some of the emerging trends that I can share with you. Some trends may lead to reform or social disruption, others may lead to technological advances or peril. This is not about prediction, its about reducing the cone of uncertainty and cutting out the noise. At the end, this information will be used by you and me to make investment decisions so it may begin at the 40,000-feet level but it must be distilled into decisions, which is the ultimate test. One “sign-post” that is ticking away in the background and has formed a definite trend is the changing demographics of the world’s population. The implications of these shifts are more far-reaching than one would expect, and the impact can be felt on growth rates, fiscal sustainability and the valuation of short and longer-term assets. A quick story…a friend told me a story about his mentor who in 1988 said that if Japan’s property market crashed then it would never recover. The market crashed in 1990. His observations were based on demographics. Why is this important? In 1970, Japans debt/GDP was approximately 43% today it is about 260%.

We make 2 short observations in this article:

  1. The fastest growing population group is the group of people 80 years of age and older. They behave differently (consume different stuff) from the group between 65 and 79 years of age and they are more expensive. This also has implications on solvency of pension plans globally. It is easy to say that one way to fix the pension problem is to work longer but given our highly pressured life and work conditions and general fast pace of daily lives, health and vitality may only be a blessing to relatively few.
  2. Several “forces” play important roles in market dynamics currently, for example, the Fed’s balance sheet shrinkage, interest rates, the US treasury increasing its bond issuance.

Demographics is not only about the aging of the world’s population but a growing mass of older people being supported by a shrinking mass of young people. For example, in the US, we see that in 1970 there were 5.4 people between the ages of 20 and 64 for every person 65 or older, according to the US Census Bureau. This ratio has since dropped to 4 and will drop to 2.6 within the next 20 years (see figure from BCA below). What does this imply?

This implies more financial strain on social security and medicare systems. For example, in 2017, social security and Medicare systems used 76% of federal revenues in the US. The Congressional Budget Office (CBO) estimates that this will rise to 100% by 2028. If we include other costs, then spending will be larger than total federal government revenues in 2019. Yes, next year! What does this mean? It means that to finance these entitlements, the federal government in the US will have to increase tax (what a silly concept after last years tax cuts).

Another alternative is to issue more bonds, which is exactly what the CBO said it would do recently. Before we get into the deficit debate and its possible implications for markets, let’s look at some interesting newspaper articles from the past week or two. Sarah Krouse reported in the WSJ an insightful article: The Pension Hole for US cities and States is the size of Germany’s Economy. She argued that many cities and states can no longer afford the retirement promises and estimates that they are short $4 trillion, an amount roughly equal to the output of the world’s 4th largest economy, Germany. Furthermore, Pew Charitable Trusts estimates that the unfunded state pensions liabilities are $1.4 trillion. (See figure on the left from WSJ). Pension funds face the prospect of being insolvent unless governments increase taxes, divert funds or persuade workers to relinquish what they are owed. We have seen the latter strategy in action in a small town in Rhode Island, Central Falls, where retired police and firefighters had to cut their monthly pension checks by as much as 55%. Furthermore, New Jersey’s pension system for state workers is so underfunded that it could run out of money in 12 years (according to a Pew Charitable Trusts study).

The Federal Reserve has now raised interest rates 7 times since 2015 towards its target of between 2.25 and 2.5% by the end of the year. The US 10 -year government bond yield again toys with the 3% mark. Structural factors, not cyclical ones, will determine whether yields should go higher. (By the way, I believe that demographics will have an inflationary consequence in the years to come…in addition to further trade tariffs). It is reasonable to think that Treasury yields are rising because the Treasury has and will continue to increase its bond issuance programme to fund its budget deficit. However, there are other “forces” at play that sometimes goes unnoticed. For example, the Fed’s balance sheet shrinkage is quickening and Fitch estimates that its bond portfolio will shrink by $315bn in 2018 and $437bn in 2019 (reported by the FT, 09 August 2018). The 3-month Libor has climbed to 2.3% and the 3-month Treasury bill yield is above 2%. Simply holding cash can earn investors a descent return. The demand from foreign investors for longer-dated 10-year US bonds (flight to quality effect) has also kept yields lower than expected and resulted in a flatter yield curve. Firstly, the likelihood of a significant increase in inflation over the coming years is greater than the market believes. Secondly, the pedestrian way the Fed is using monetary policy by waiting for data on inflation and minimizing systemic consequences in Europe that may include a massive sovereign default (…the likes of Italy), is a difficult balance to maintain.

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