investing james saft |
Relatively scarce labor may in the next decades reverse some of the huge trends of the past three: rising inequality and falling real interest rates and wages.
The upshot for asset markets may be equally profound, challenging the central place government bonds hold at the core of investment portfolios as well as the value of equities.
The rise of China, the integration of the global economy and the opening of the economies of Eastern Europe have coincided with, and likely driven, rising economic inequality in the developed world, as well as falling real wages and interest rates.
The beneficiaries, as noted by French economist Thomas Piketty, have been the owners of capital, with falling interest rates driving higher bond returns and record corporate profits.
A new report by economists at Morgan Stanley and consultant Charles Goodhart, formerly a member of the interest rate-setting panel at the Bank of England, argues that what demographic trends have driven, demographic trends can also take away.
"Is Piketty history? We think so," Goodhart, Manoj Pradhan and Pratyancha Pardeshi argue in a study released last week. "Just as a larger labor force pushed real wages lower and inequality much higher in the advanced economies, a smaller labor force will inevitably lead to rising wages, a larger share of income for labor and a decline in inequality."
World population growth, now about 1.25 percent annually, will fall to 0.75 percent globally and near zero in the developed world by 2040, according to United Nations projections. The aging of the West will put local pressures on wage supply, as it implies a booming need for health care workers.
Most economists agree interest rates have been driven down by past demographic trends, as western workers were unable to negotiate wage gains, and due to very high savings rates in China and other developing nations. It also gave Western companies less incentive to invest, as the use of more or cheaper labor promised better returns.
Negative demographics should in theory lower growth and reduce savings — as the old consume their assets — and investment. The Goodhart paper argues that savings will fall faster than investment, driving up interest rates.
It is fair to note that the Morgan Stanley analysis rests on some assumptions that may not hold. Firstly, that developed countries will respond to demographic developments by maintaining social safety nets and pension provisions, moves that require the political will to tax and spend. Secondly, there is the unknowable issue of technology. While the argument is that companies will respond to scarce, more expensive workers by investing in labor-saving technology it is unclear which force will be more powerful.
Falling inequality, asset prices?
Many economists have argued that a demographic slowdown will be bad for asset prices, in part because there will be fewer natural buyers saving for old age and more natural sellers funding their lives in retirement.
Add in rising interest rates and wages to this scenario and the damage to major asset classes could be substantial. One of the arguments for current elevated equity prices is that corporations now enjoy high profit margins. These, however, will be eaten away in part by rising wages, resulting in lower profits. Companies may have some success in holding down wages through investment, but this will tend to drive interest rates higher. Add in slower overall economic growth and it will be a more difficult environment for companies.
As interest rates have a powerful effect on the future value of expected earnings, it is fair to expect equities to trade at a reduced premium as a result of the demographic slowdown.
The impact of rising natural interest rates also poses a problem for government bonds, which lose value as rates rise.
Toby Nangle, head of multi-asset allocation at Columbia Threadneedle Investments, has argued along similar lines to Goodhart and concluded that government bonds may lose their allure, and the central place they hold in the construction of most portfolios.
Given that many government bonds already yield precious little, the losses investors suffer as interest rates rise will be particularly painful. The old idea that bonds "balance" out the risk of equities or other assets over market cycles may not hold, leading investors to look elsewhere. That, of course, would exacerbate the rise in market interest rates.
The past 35 years have been great for capital and lousy for labor, at least in the developed world. The next 15 may be quite the reverse.
James Saft is a Reuters columnist.