Facebook Blogging

Edward Hugh has a lively and enjoyable Facebook community where he publishes frequent breaking news economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking the Facebook link at the top of the right sidebar.

Tuesday, June 5, 2007

Ageing and Financial Markets - Going for Yield?

By Claus Vistesen: Copenhagen

Financial markets have evolved with breathtaking pace in the last decade. In what follows I will both attempt to sketch an outline of the bigger picture and I try to pinpoint the effect of ageing on financial markets. This task entails a broad view on many of the major participants in today's rapidly evolving financial markets as well as demanding sensitivity towards the fact that ageing is only one of many factors which affect financial markets in the medium to long run. Consequently, the impact of ageing on financial markets involves musings on longer term dynamics which are essentially, I would say, very difficult to predict even for the most ardent analyst. However, I will argue with some force that before we reach the state of 'rapid dissaving' which many analysts hold to be the end point in terms of ageing, it seems as if the main dictum for global markets, at least for a somewhat prolonged period, could ultimately add up to one thing: too much liquidity chasing too little yield, a reality not entirely caused by, but rather somehow exacerbated by, ageing. My account begins with a brief discussion of a hypothesis recently proposed by Morgan Stanley's Stephen Jen concerning a global asset shortage. The discussion will unfold in the context of equities and sovereign debt* before moving on to a discussion on how households and thus the agers themselves - represented in all this by the so-called retail investors - might act to affect global financial capital markets.

Sovereign Debt - Enough Assets to go Around?

As noted above, Stephen Jen has recently suggested that the world is suffering from a shortage of financial assets relative to evolving demand. Jen especially notes that the recent decade - which has been caharcterised by comparatively high rates of economic growth and 'relatively' modest pressures on governments to resort to heavy-duty counter cyclical fiscal policy (Japan and Italy excluded) - has seen the supply of sovereign debt dwindle. Notional empirical evidence seems to support Jen's hypothesis on sovereign debt as the total world sovereign debt oustanding relative to world GDP stagnated in 1997 at a ratio of about 75%. In short; there is not enough sovereign debt in the world to satisfy demand - a feature which also subsequently lies behind the 'conundrum' of low bond yields. Yet, all this simply begs the question of what drives the supply of sovereign debt in the longer run. According to Jen, one of the drivers of the low supply of sovereign debt relative to demand has been the relative buoyant global growth rate which suggests that if global growth (or growth in key global economies?) begins to falter the supply of sovereign debt should begin to nudge back up. Yet, is this plausible? The first point here of note is that this is somewhat structurally tied to the global macroeconomic imbalances and the subsequent discourse on Bretton Woods II as maintained, for example, by Brad Setser.

It is thus clear that in a world where the large emerging markets (save perhaps India), and the petro exporters, are pegging to the Dollar consquently amassing a fluctuating volume of US sovereign debt and of FX reserves in general these countries are not going to aggressively issue sovereign debt since this would of course entail a de-facto appreciation (re-valuation) of their currencies. Moreover it seems, there is little need at this juncture for big emerging markets to issue debt since they have no substantial deficits to cover. In terms of the imbalances themselves this, of course, means that they have to prop up the currency(ies) to which they are pegging by supporting the external deficit of the countries involved through purchase of debt or equity. This is of course also at the heart of the matter in terms of Bretton Woods II since capital flows are running counter to textbook theory from the point of view of the traditional relationship between developed and developing economies. In short, instead of running current account deficits which would entail issuance of sovereign debt, big emerging markets such as for example Brazil and China represent substantial global net demand, in particular for US sovereign debt but also essentially and more generally for sovereign debt or equity from all countries whose external deficit constitutes the counterpart to their external surpluses.

Another point here is the ageing process itself - which as we know is not only occuring in the developed world but also, and with some force, in many emerging market countries as the final stage of their demographic transition ripples through. In this way ageing will affect the supply of sovereign debt in the long run through two interconnected mechanisms. First of all, as Edward and I have argued before, an ageing economy, such as for example Germany, Japan and perhaps Italy, will have a tendency to revert to a growth path structurally prone to the generation of an external surplus. At least, this seems to be a sound assumption about the general picture before we finally get to a period of 'rapid' dissaving ,whatever this may look like.

Secondly, it seems as if these ageing economies are now embarking on fiscal belt-tightening instead of issuance of new debt, a transition which makes some sense since it is pretty difficult for e.g. Japan or Italy to continue issuing sovereign at debt at this juncture given the rapid ageing they now have on the horizon, and given the sovereign debt to GDP levels which in both cases now constitute over 100% of GDP. This also goes for other large economies in the Eurozone which are in theory bound by the EMU's demand for a maximum limit of debt to GDP at 60%. These countries most likely will not issue new debt in substantial quantities either since ageing and rising dependancy ratios are already pushing heavily on existing debt levels. In fact, it does seem as if the whole idea of sovereign debt rating by the likes of Standard and Poor and Moodys will need to be re-thought as a result of ageing. Take a look for example at the figure below from a paper at the Australian Reserve Bank which plots hypothetical future sovereign debt ratings primarily as a result of ageing. Whether or not this corresponds to a future reality is, of course, a different question, but take a look at Japan which is set to become 'non-investment grade' by 2020, that is a mere 13 years from now!

This suggests then that the future for sovereign debt is set to remain a story of shortage of assets relative to demand. This is, in part, due to ageing on the one side and Bretton Woods II on the other, since the former acts as a de-facto impediment for the already indebted countries to issue new portions of long term sovereign debt, and the latter operates through the lack of meaningful and tradable debt issuance by emerging markets and petro exporters who are pegging to the dollar. Add to this Stephen Jen's point about how growth in the last decade has been extraordinarily strong coupled with a strong growth in liquidity which has, of course, been further exacerbated by the lack of supply of sovereign debt on a global aggregate basis (increased leverage should perhaps also be noted here). My point is just that I do not necessarily think that a sudden turn in the impressive global growth spurt will prompt a resurgence in sovereign debt issuance, at least not from rapidly ageing economies which is of course part of the whole damn problem here since how will Japan and Italy ever be able to repay if the current surge in growth does not continue over a very prolonged period, which, at this point, seems rather unlikely I think. Having said that, a gradual shift in the Bretton Woods II regime could prompt countries such as, for example, Brazil to issue more long term debt, and China might also join in, but such a large change won't happen from one day to the next.

What about Equities then?

Bonds are of course not the only assets around, and equities are also currently offering yield to pension funds, sovereign wealth funds (SWFs), other institutional investors and retail investors. Yet, equities are also included in Stephen Jen's asset shortage hypothesis and the overall theme is the same as with bonds. A decade of impressive corporate profits and growth has reduced the demand for companies to issue shares for financing purposes. Yet, this I feel is not the entire story in terms of stocks and equities. Here we also need to look at the rise of private equity which has hit capital markets like a tornado in the recent years with their buy-out deals (often leveraged, i.e. LBOs). This frenzy has of course pushed prices higher but crucially, since buyout deals often also entail public delisting, this has had the effect of squeezing the supply of equities, at least from the point of view of retail investors, and of index/equity based mutual funds. It is not as if the assets go away just because they become part of a private equity portfolio, but I still think there is an important point here, since private equity for the most part is not available for retail investors. This brings us to the pension funds, and these, of course, and given the rise in saving which ageing involves, are finding it increasingly more difficult to manage their incoming wealth given the pressure to produce yield. This then means that pensions funds are increasingly more actively looking for stakes in private equity, or hedge funds for that matter, in order to produce an adequate return. At this juncture we also need to note the SWFs which increasingly are diversifying into equities, and straying ever farther afield from their traditional and plain reserve management through investing in sovereign debt. A great deal of fuss was made recently about the participation in the IPO of private equity group Blackstone from China via a US 3bn stake.

More generally, as also noted recently by the FT's Alphaville and Morgan Stanley's GEF, the size of SWFs is going to grow substantially as we move towards 2015. Stephen Jen's napkin calculations suggest a whopping amount of about US 12bn in assets. As such, even if equity investments perhaps will continue to be on the margin, such activity is sure to push equity valuations higher, and more generally in terms of sovereign debt the continuing accumulation of reserves are sure to keep those bond yields compressed too. Yet, it is really difficult to make an analytical call on the long term trend here whilst keeping a straight face. On that note, the recent market.view column at the Economist provides an interesting perspective, and one which was also picked up by Brad Setser.

Whether ageing will directly affect the supply of equities is not easy to gauge; most likely it will not do so in any direct sense. The most important driving forces for the de-facto supply of equities seem to be of institutional nature. For example, David Gaffen from the WSJ noted recently how legislation in the US has also decreased the stock of initial public offerings (IPOs). I would also note the continuing, and most likely lingering, trend of private equity buy-outs which is going to nudge up valuations as well as diminishing the supply of assets particularly for those who don't have the financial muscle to directly participate in private equity or hedge funds since these also represent assets beyond the reach of the average retail investor. On this point, I also feel the need to note the recent Buttonwood column which takes on precisely the question of who actually loses out to the emergence private equity and hedge funds; the answer; shareholders (pension funds, insurance funds and retail investors). When all this is said however there is still, presumably, plenty of capital deepening to come in the form of public listings and IPOs in big emerging markets which will act as a long term structural force pushing up the supply of global equities.

Household Behaviour - What Comes Next?

Arguably the most powerful force acting as a proxy for the ageingeffect on financial markets comes from the agers themselves, the households which, in connection with the bird's eye view of financial markets above, could be considered as potential retail investors. This latter point is important, since it is getting increasingly more difficult for the average retail investor to look through an opaque financial market where equities and bonds are spiced up with a myriad of structured and leveraged products. Add to this that retail investors are often exposing themselves to risks they have no idea off. I mean, does John Doe really know the investment strategy of the pension fund in which he is pooling his savings?

However, the real nut to crack in order to gauge the effect of ageing on financial markets relates to the nature and shape of the life cycle path for consumption and saving. It is of course futile to try to identify a global life cycle path but as more and more developed, and in some instances developing, countries enter a stage of rapid ageing and rising dependency ratios important questions are raised. In general, there are two overall narratives. The first one has been widely debated and relates to the concept of rapid dissaving. On this view the fact that ageing occurs more or less across the same time period in many developed countries should lead towards a global movement of rapid dissaving at some point as retired workers begin to spend their savings. It is argued that this will then lead to a steady erosion of the aggregate saving rates and, as a consequence, have a slowing effect on long term growth. Yet, we need to ask ourselves, is this story plausible and, even more crucially, if it happens, when will it happen?

This issue draws attention to an important point about this whole narrative in the sense that what is normally involved is a good deal of speculation about the state of the world in 2040, or 2050, and perhaps further even beyond. Now this entire perspective seems rather imprudent in my opinion mainly because it involves the prediction of things far out in the future which no-one really can claim to adequately make. Moreover it makes the assumption that things which happen between now and then will make no notable impact, and again, and in particular in this regard, the discourse often ignores the fact that even though all the developed countries are ageing, they are not all ageing at the same rate, and thus we need to take into account the possibility that these differences might exert some influence on the final outcome.

Here I think another, rather more interesting, approach would be to start by looking at what may happen during the transition path towards such a hypothetical end point of rapid dissaving, and in particular start from what we can actually see happening right now.

Looked at in this way, the principle of dissaving on an aggregate basis should not be too difficult to understand. As the ratio of retired households to working households rises in an economy there could be a tendency to dissaving on an aggregate basis. But will there be?

I don't have any definitive answers to all this yet, but it is clear that as working households build up expectations about enjoying a period of retirement in relative abundance, as well as taking into account rising life expectancy, we may begin to see that existing savings levels must be stretched and stretched by the increasing demands this will present and this in itself may put pressure on households to begin to save earlier. Moreover, as the governor of the Bank of Finland excellently note recently, theoretical models of dissaving tend to predict that retired households realize their assets far more quickly than is likely going to be the case in reality. Lastly, there will also exogenous pressures on working households to increase their savings in part in order to support a rising dependancy ratio but also because of the general perception that working households will need to ramp up savings to support future economic growth and thereby investment.

All this is of course not imprudent when viewed from a macroeconomic perspective, but as some of the authors here at GEM have pointed out on several occasions, in an ageing society, where working and supporting cohorts will be ever smaller, domestic demand will tend to be depressed over time. Moreover, capital flows will (at least before we get to point zero and rapid dissaving) tend to flow from ageing economies towards higher yielding regions. Examples of this could be Japan and Germany at the current juncture. This also means that in the medium to long term, as more and more countries join the league of countries (potentially!) running external surpluses, there will be even more capital chasing even less yield. And this is perhaps my main point here, in that before we get to a point where ageing will result in rapid dissaving and asset realization by retired households something else will happen. We could think about this something in terms of liquidity, since if an ever-rising median age in a country is a proxy for what is happening in Japanese - ie very low real interest rates in the domestic economy and an external surplus - then ageing economies could be viewed as net suppliers of liquidity to global markets.

In Summary

In this note I have reflected on the effect of ageing on financial markets. Ageing is not, of course, the only determinant of the evolution in financial markets but given the trajectory of the process in the developed world it is likely to have a significant impact. Many commentators have pointed to the transition towards a process of rapid dissavings where households and most notably retiring baby-boomers realize their assets at great pace. I have tried to nuance and qualify that claim.

Firstly, I talked about the supply of and demand for sovereign debt in the light of Stephen Jen's hypothesis of a shortage of assets. Apart from Jen's point that the recent years of extraordinary strong economic growth have deterred, or removed the need as it were, for economies to issue new bulks of sovereign debt (save most notably the US), ageing itself, I think, is already having a strong impact on the issuance of sovereign debt. This is particularly the case in countries where ageing has already entered the prolonged stage where the countries in question will find it very difficult to issue more debt. Also for example under the EMU framework there are very concrete institutional boundaries as to the issuance of debt beyond a long term threshold of 60% of GDP, which of course is a level that could be nudged upwards more or less at will (or perhaps as part of a battle of wills between the EU Commission and the ECB).

Secondly, I noted the situation of Bretton Woods II where some energy exporters and key emerging markets have piled up massive amounts of reserves, a situation which does not make it likely that we will see substantial issuance of sovereign debt from this angle either. Instead, these countries are pushing yields down - most notably on US treasuries - as a result of their dollar (or whatever) peg. On equity markets SWFs are bound to make their presence felt to an even greater extent. More specifically on equity markets it is difficult to see a direct impact on the supply of equities as a result of ageing. However, as with pension funds and ageing, retail investors hungry for yield are moving more aggressively into equities, and thus demand could potentially outstrip supply on a long term basis thus pushing up valuations, especially if the current wave of private equity deals continue along the same path. Another point here are the IPOs and also M&As in emerging markets where there seems plenty of room for increased capital deepening which could push the supply of assets up.

On balance I think that there are reasons to believe that ageing will affect financial markets in the following ways. First of all ageing will most likely increase the demand for assets, and more specifically for yield, and this in turn will mean that ageing also will be a source of global liquidity. Another point which is of note is how ageing might influence financial markets indirectly by prompting governments to intervene. As such, and even though it does not form part of my general analysis, the paper (noted above) by W Todd Groome, Nicolas Blancher, Parmeshwar Ramlogan and Oksana Khadarina from the Australian Reserve Bank offers the proposal that governments act alongside financial markets to insure and essentially hedge against longevity risks associated with ageing. More generally, and in the same tune, the paper speaks of 'financial innovation' as a way to deal with the obvious financial risk associated with ageing. Finally, and very much to the point I think, the financial literacy of households needs to increase, especially in a world where the challenges of ageing to an increasing degree will rest on the individual household.

*In this note I have left out detailed description of the increase in leverage and sophisticated structured products. This is clearly a caveat, but to the extent that these instruments are important (I think that they are) I believe a seperate note should be devoted to them.