As I will demonstrate in this article, high levels of debt and an ageing world mean lower growth, lower yields, higher taxes and higher economic volatility. The world’s population is retiring in bulk, requiring greater social support and leaving behind vast amounts of debt to be paid for by a dwindling working population. This isn’t a great recipe for markets or living standards, and there are no easy fixes. Reform is essential to escape the enormous debt burden governments have accumulated. This means a higher retirement age and more flexible immigration policies and labour laws. But austerity has already been painful and has proven very hard to enforce politically.
World War II left developed nations swamped in debt. Fortunately, the baby boomers, including women entering the work force over the last half century, swelled the working population while education, globalisation and urbanisation improved productivity. In addition, the establishment of consumer credit facilities and social security nets enabled consumers to live beyond their means. This combination of improving demographics, productivity growth and access to credit generated significant economic growth. This in turn generated more tax and reduced public debt.
Since the 1980s public debt has increased again (see Fig. 1) and this time, unlike after World War II, we don’t have the luxury of economic growth to reduce it. Even before the 2008 recession, Western countries experienced falling growth. Growth from the 1960s to 2000 in the US averaged 3.5 percent, but dropped to 2.5 percent between 2000 and 2008. Since the recession hit, it has fallen to below one percent. Europe has suffered a similar fate. This is despite massive government fiscal spending; over 300 rate cuts globally; and in excess of $9trn liquidity from quantitative easing. Just because the US and Europe learned from Japan’s debt crisis, does not mean they will be able to avoid it.
The IMF predicts that by 2018 (a decade after the recession), world trend growth will be four percent lower than pre-recession and the only region to recover to pre-crisis levels will be Latin America. The two main culprits for lower growth in the future are an ageing population and high debt levels.
The United Nations predicts that the global dependency ratio (retired-to-working population ratio) will more than double by 2050. While developing nations have younger populations, their dependency ratios will actually grow faster than developed regions (see Fig. 2). More worryingly, research from Deutsche Bank predicts that the world’s population will hit replacement level fertility by 2025. This is a point at which human beings will no longer be reproducing enough to expand themselves as a species. Some of the effects of an ageing population are:
- Structurally lower growth due to a shrinking workforce. The direct impact of an ageing population is a shrinking work force. The US Congressional Budget Office (CBO) forecasts a labour participation rate falling to 52 percent by 2038. This translates this into real US GDP growth of only 1.4 percent over the next 25 years; half the rate at which it has grown over the past 50 years.
- Maturing urbanisation, which provides another growth headwind. One of the primary drivers of Chinese growth in productivity over the last 30 years was the transfer of workers from primary to secondary sectors as the population moved from rural to urban areas. However, this move is stabilising and is one of the reasons the Chinese government’s official growth forecast over the next decade is 30 percent lower than what was achieved in the past.
- Taxes will increase due to higher social spending. Public expenses will increase due to the ageing population. The US CBO projects that social spending will reach around 15 percent of GDP in 2043 from 9.6 percent today, driven mostly by the cost of Medicare as the baby boomer generation retires. This will have to be paid for by higher taxes.
- The ageing populations will create a savings glut. An ageing population lowers the demand for investment, as fewer new workers means less capital is required to produce new tools. Developing countries (particularly China) are only just now reaching the point of reduced investment. This means that more money will be chasing fewer investment opportunities, leading to higher valuations and lower yields.
Drowning in debt
Despite the huge stimulus from 300 rate cuts and $9trn quantitative easing, debt hasn’t come down. The developed world has seen a rotation from private debt to public debt, but total developed world debt is higher than before the recession. Similarly, emerging markets increased their debt levels, both private and public, to new highs, as quantitative easing provided cheap debt, which was used for consumption rather than investment. This had the advantage of closing the developed market growth gap after the recession but has led to a number of painful distortions in emerging markets, which are only now being addressed. The effects of high debt are:
- Lower growth. Unwinding the high debt burden (government and private, emerging market and developed market) will be a constraint to growth. Some emerging markets will continue to drive consumption, but many have run up considerable current account and budget deficits and will have to reduce their spending. According to Capital Economics, most of the peripheral EU states are going to have to save more than they spend for the next 10 to 20 years to get debt down to safe levels.
- Higher volatility. Another impact of high debt is increased economic volatility. The Economic Cycle Research Institute predicts that recessions will be deeper and more frequent over the next decade. When growth is low, even a small contraction can lead to a recession and when debt is high, any shock has a magnified effect and can cause a contraction.
Over the next decade, returns are going to be lower than we need and taxes will be higher than is fair. We will have to save more and spend less, starting today. Developed markets (and others such as South Africa) have too many headwinds to produce decent returns, but the complexity of their markets allows for good active returns through absolute and hedge funds. But diversification into emerging and frontier markets with low debt and growing working populations is a must. Nigeria and Mexico are two current favourites.
For further information visit argonassetmanagement.co.za