Demographics do Matter
(August 11, 2005)
Dear Subscribers and Readers,
We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. The Dow Industrials as of the close on Wednesday night is 10,594.41 - giving us a slight gain of 21 points. A gain is a gain - so we will take it (actually, I am finishing this up the DJIA is at 10,678). For now, we will remain 25% short, as the combination of an ever-rising oil price, continuing monetary tightening, and a pouring out of offerings (on the heels of a very successful offering by Baidu.com) should continue to put pressure on the major market indices in the next for the rest of this week.
In our commentary over the weekend, I made the point that the issue of demographics may perhaps be more important than the other two important issues that we discussed in our August 29, 2004 "Three Important Questions" special report, namely the scarcity of energy resources such as oil and natural gas and the need to know your own investing psyche and to make independent investing and economic decisions (for readers who want to read more about the later topic, I shamelessly recommend our April 7, 2005 special report on the legacy of Jesse Livermore). Throughout our commentaries over the last 12 months, we have discussed the demographics issue periodically (please see our June 24, 2004 commentary on the topic of "Aging Demographics" for a brief introduction on the subject) - but in this commentary, we will attempt to discuss the issue of demographics with a focus on how it will affect the financial markets of the developed world going forward, with a primary focus on the United States and Japan. My conclusion is based on the many articles I have read over the last 12 months and in conversations with other investors - but the charts and virtually all the information that I will be using in this commentary are going to come from the latest McKinsey report entitled: "The Coming Demographic Deficit: How Aging Population Will Reduce Global Savings." For readers who are genuinely interested (and everybody should be as this is an issue that I believe the financial markets will be paying attention to in a few years), you can read the entirety of the report on the McKinsey Global Institute website.
In their report, McKinsey projects a huge shortfall of global wealth in the next two decades should historical asset returns and consumption patterns remain uniform going forward (they based their return assumptions on the historical returns from 1974 to 2003). McKinsey focused their attention on five developed countries, namely the U.S., Japan, the UK, Italy, and Germany. McKinsey defines the "shortfall" as the difference between households' net financial wealth should demographic trends remain how they were during the 1974 to 2003 period and what they are projected to be in the next two decades given current birthrates and the aging of the general population, etc. This "shortfall," McKinsey projects, is expected to be ultimately $31 trillion in 2024 - if historical returns remain the same going forward. Should the financial markets enter a period of low returns (such as the 1966 to 1982 period in the U.S. or the post-1990 period in Japan), then this "shortfall" is expected to be much greater going forward. The gist of the McKinsey report is that this projected shortfall in households' net financial wealth will have profound consequences - requiring solutions that may be seen as extreme or "radical" in today's economic environment. Moreover, the "problem" of an aging population and declining birthrates is worldwide in nature. Dr. Jeremy Siegel, in his latest book "The Future for Investors" suggests that the upcoming "wholesale liquidation" of financial assets by baby boomers can be hugely alleviated by the entry of Chinese and Indian investors going forward - as the globalization of the world will enable this new breed of wealthy to invest in financial assets in the United States, for example. The McKinsey report dispels this notion, as the authors claim that even if both the Chinese and Indian economies continue to grow at their current blistering pace going forward, the newly-acquired savings and resources of the two most populous countries in the world will be nowhere near enough to support financial asset prices in the developed world. Moreover, readers should keep in mind that the Chinese population is also aging rapidly - and more importantly, the life savings cycle of a typical Chinese is very similar to that of a Japanese citizen, in that savings tend to fall very steeply (much more steeply than their Western counterparts) as they moved to their early 50s.
The authors of this McKinsey report do not try to discuss the implications of the financial markets given the projected shortage of global savings just right up ahead. The logical question for our readers to ask is this: How could the historical return assumptions (1974 to 2003) be a good measure of projected performance for the next two decades, given that the period 1974 to 2000 saw the emergence one of the greatest global bull markets of all time - both in bonds and in stocks - and more importantly, given a huge shortage of current global savings? For us, this decrease of households' net financial worth is only a side story as McKinsey is assuming that historical returns is a good predictor of future returns. Of more importance to us in the projected shortage of global savings driven by aging demographics and by the declines in both rates over the last two decades in the developed world - and how this will affect financial asset returns going forward as both Chinese and Indian citizens are not projected to be able to absorb the upcoming "wholesale liquidation" of financial assets (particularly equities) as a greater amount of the general population nears retirement age. I will now attempt to give you a coherent story of what I am currently seeing (and it is not too pretty), starting with not the U.S., but Japan - which is projected to fair the worst in this global demographics race to the oldest country in the world in the next two decades. Again, before you proceed, you can get a brief refresher on the topic of "Aging Demographics" by re-reading our June 24, 2004 commentary. All the following charts that you will see are courtesy of the McKinsey report.
To start off, McKinsey is projecting an ultimate shortfall of US$8 trillion (in real terms basis 2000 dollars) of households' net financial wealth by 2024, assuming both current savings behavior and financial assets return remain the same, and given the current demographics trends in Japan. More significantly, Japan is the only developed country in the study that is projected to experience an ABSOLUTE DECLINE in net financial wealth starting last year. While the U.S., UK, Italy and Germany are all expected to experience a slowing growth in net financial wealth in the next two decades, none of those countries are projected to experience an absolute decline in net financial wealth.
The popular media has always treated the Japanese as the ultimate savers. This is characterized by the fact that even as the Nikkei surged nearly 1,000% from 1975 to 1989, equities were only responsible for approximately 15% of this building up of wealth during this boom period. Meanwhile, Japanese households still held approximately 50% of their financial assets in cash and cash equivalents - and 25% in fixed income. The general patterns of savings and consumption today (the savings to consumption ratio has been steadily declining since 1975) is vastly different to what they were back in 1989, however, and they are projected to continue to worsen in the next two decades. As the report states: "New household formation is coming to a standstill, and in 20 years there will be nearly the same number of households available to save as there are today. Of these households, an increasing number of older households are moving into the lower saving or dissaving part of their life cycle. The remaining younger households are part of younger generations which save less and borrow more than older generations at all ages. All of this results in a meager follow of aggregate new savings, and produces an actual decline in aggregate NFW [net financial wealth] by 2024."
Following is a chart (courtesy of McKinsey) showing the historical Japanese household savings, and as I mentioned - this savings rate is projected to continue to decline going forward. In fact, the Japanese household savings rate is expected to decline to a negligible 0.2% by 2024 (not shown on this chart):
Following is the relevant chart (courtesy of McKinsey) showing the breakdown of average household savings by three Japanese cohorts. Please note that the youngest cohort is saving significantly less than their counterparts only ten years ago. The age of mass consumerism is also well and alive in Japan as well as the US!
The combination of an aging population, a low birth rate, the lack of a historical immigration policy, and the fact that today's younger households are saving significantly less than their older cohorts all serve to present a bleak picture for the Japanese going forward. Ever since the stock market and real estate bubble burst in 1989, the net acquisition of financial assets by the Japanese has been declining at an average rate of 30.5% per year - and for the first time in modern history, Japanese households actually sold more financial assets than they acquired in 2003. Finally, the McKinsey reports concluded that assuming historical return assumptions are met going forward, the net financial wealth of Japanese households will actually decline absolutely going forward - as opposed to the projected experiences of the U.S., the UK, Italy and Germany - where the growth of net financial wealth is only projected to slow down - not enter an absolute decline. To help offset this unfavorable demographics trend going forward, structural reforms will need to be implemented. As the McKinsey report stated, "The policies followed during the boom years have left a legacy that continues to constrain growth today. In effect, these policies have left a legacy that continues to constrain growth today. In effect, these policies have created a dual economy. The world-beating portion - autos, steel, machine tools, and consumer electrons - accounts for only 10 percent of all economic activity in Japan. The remaining 90 percent takes place in companies geared towards satisfying domestic demand. The productivity of this portion of the Japanese economy stands at a mere 63 percent of US levels. The Japanese economy will not rebound until the performance of these companies improves." The relevant chart (again, courtesy of McKinsey) follows:
It is very difficult to see how significant reforms can be implemented; however, as the mere fact that the Japanese population is aging suggests that reforms will be very difficult to sell (simply because an older population is less susceptible to change)! Just think of the recent vote on the privatization of the Japanese postal system.
Let's now discuss the demographics situation of the United States. First of all, the demographics situation in the United States is definitely not as bleak as that of Japan - as the historical birth rate and the immigration policy of the United States have been both much more favorable than those policies in Japan. As shown by the following chart (again courtesy of McKinsey), the median age of the U.S. is projected to remain steady at 37 to 38 over the next two decades, as compared to an increase from 43 to 50 in Japan within the next two decades:
Nonetheless, the U.S. is also projected to experience a sharp slowdown in the accumulation of net financial wealth - projecting to have an ultimate "shortfall" of US$19 trillion (in 2000 dollars) in 2024 (the highest of all the countries that McKinsey studied). The reason for this is two-fold:
1) Similar to Japan, the younger cohorts of the U.S. population have been historically spending more and saving less of their disposable income than their counterparts a decade and two decades ago. Moreover, the household savings rate has been declining steadily since 1982 and is now basically at zero (see following chart courtesy of McKinsey) - just where is the new money going to come from for investing in financial assets? Moreover, a significant amount of investment has also been coming from foreign inflows - and that is expected to slow down significantly going forward as the savings in the entire developed world is expected to decline substantially in the next two decades. As the McKinsey report states: "There is no country outside the aging triad that can generate enough new financial wealth over the next two decades to meaningfully address the global wealth shortfall we project. China's stock of financial assets has been growing at a remarkable 14.5 percent compounded annual rate over the past decade, but its share of global financial assets remains just 4 percent - less than one-third that of Japan. Other fast-growing economies have yet to accumulate enough financial assets to make a difference: India's financial assets have grown at 11.9 percent per annum over the past decade but account for less than 1 percent of the global total. Similarly, Easter Europe's financial assets have grown at 19.3 percent per annum since 1993 but remain less than 1 percent of the global total."
2) The U.S. "Prime Saver to Elderly Households Ratio" peaked in 2000 - right at the top of the bubble in technology stocks. Coincidence? Maybe - but at the very least, this suggests a continuing anemic growth in savings. Again, let's ask the question: where is the demand of financial assets going to come from in the next two decades?
That question has somewhat been answered by the following chart - which shows the net acquisition of financial assets by U.S. households on a historical basis and going forward. Part of the answer is: Not from U.S. households - which is one reason why our current account deficit has been ballooning so much in recent years. The demand has been coming from foreigners - and going forward, chances are that foreigners (even if they want to or would love to) would just not have the means to support a continuing growth in the current account deficit.
It is interesting to note that Trimtabs has been very perplexed over the last 12 months - stating that given the current rate of cash acquisitions and stock buybacks of U.S. companies - the U.S. stock market (as measured by the S&P 500) should be approximately 30% higher where they are now. The one variable that has not been "cooperating" is retail investors. The fact of the matter is that retail investors are still not purchasing equities en masse. A popular argument is that retail investors are still very much scarred by the technology bubble and its aftermath, but could it also be because they are also running out of buying power? The charts that we have just discussed surely indicate such a possibility.
Conclusion: Given the dismal demographics trends in the developed world, the chances of financial asset returns remaining close to historical returns going forward are pretty slim - all the more so given that the savings of China, India, and Eastern Europe will not be sufficient to support the "wholesale liquidation" of equities by the aging population of the developed world, especially the aging population of the United States. I will attempt to discuss a little bit about the situation in the UK, Italy, and Germany in this weekend's commentary - but such a situation (combined with our current energy situation) could very well be the trigger for the reassertion of the secular bear market (as defined by the Dow Theory) sometime in the next few years.
Henry K. To, CFA