In an earlier article on this blog, I mentioned ageing is another ticking time bomb under economic recovery in Europe.
Yesterday the Economist has explained quite clearly why this is. Unfortunately they merely mention US data and leave up to imagination how the time bomb could explode, or better yet how it would look when rich world economies implode.
I will make an attempt to illustrate the consequences of reversion. But please remember:
– I am not clairvoyant
– the future could look much different
– no, my name is not Roubini
– and all the facts, data and graphs used are borrowed from the economist.com or other sources.
Baby-Boomers, a bubble deflating
Back to the issue at hand. The baby-boom generation has profited and is still profiting from the demographic dividend. As household and per capita income rose and spending per household decreased, more households were able to save up, invest in pension assets, purchase houses, companies and could stay debt free. Just think: income – spending = saving, and it will make more sense.
Rising numbers of working age (and more work), making more hours and with women entering the labor force all led to higher household incomes. At the same time people had less children, so less household spending lead to more capital to save and invest.
More savings and higher asset prices
For their article, the Economist mentions research by Liu and Spiegel (2011) who found a close correlation between number of middle age cohort (40-49) to old age cohort (60-69) and P/E ratios of equities indicating a larger group of middle aged savers* led to higher P/E ratios. Simply translated: more people saving and investing led to higher stock market valuations…
*People under 35 are often indebted and invest in houses not the stock market.
Sizable political influence, less taxes
Various worrying facts on baby-boomers, profiting from political influence, are also mentioned:
- 7% decline in US federal tax rates alone between 1980 and 2011, yet there was no halt in generous spending on health care leading to exploding deficits
- Eschker estimates that Americans born in 1945 can expect almost $2.2 mln dollar in net transfers from the state
- The IMF finds that Americans aged 65 in 2010 may receive $ 333 billion in net benefits. Source: IMF WP 2011 Intergenerational imbalances
Some anecdotal evidence exists that for European countries the problem is currently even larger. In Italy current workers will pay 14% more pension related taxes than current retirees have paid in their lifetime.
Reversion to the long-run mean
So how would a reversion process look as the demographic pyramid is turning into the shape of a mushroom?
A vicious cycle
Remember the simple equation: income – spending = saving.
As the ratio non-working to working quickly deteriorates, and if mere gradual changes are made to subsidies for the non-working, the workers will have to pay an increasing amount in taxes. This leaves less household income to save and spend.
Just imagine: in France, public sector workers are paid out of the current account. What will happen when 1 pensioner on 10 workers changes into 1 pensioner on 2 workers? Will they cut pensions or raise taxes? Or both? Either way it doesn’t look good for general household income and savings. And France is not the only country with this problem….
Hence my hypothesis that current across-the-board austerity measures (subsidy cuts on daycare, schooling and tax hikes) are the beginning, but certainly not the end.
Increasing taxes, higher current life costs and expected higher future life costs will be a major drag on consumption, depressing employment and company revenues.
In Portugal lowering salaries and cutting back on deductibility of schooling already lead to various families taking their children out of private school and assigning them to free public ones, putting even more strains on public finances.
Less savings, higher costs of capital, lower asset prices
With less savings by the young generations and baby-boomers consuming their savings, less funds are also left to be productively invested in the economy, limiting economic growth and increasing the cost of capital for companies, depressing asset prices.
As P/E ratio’s fall and do not move back to recent historical means, companies will be sold for lower prices than historically recorded leading to value destruction for current company owners and higher required returns on capital by new entrants to justify current prices.
Entrepreneurs currently buying companies should beware that historical valuations and transaction prices are not representative of future exit prices and the opportunity costs of waiting to buy a business are high.
Be careful buying a house now
House prices are just another asset that have changed hands for inflated prices in the last two decades. According to an analyses of the economist houseprices in the Netherlands France and Belgium are 33%, 38% and 42% above the normal rent-to-income ratio and thus still have a steep decline to come.
This indicates the over-indebted generation until 35 are about to become more indebted unless they start withdrawing a larger proportion of their income from consumption and start repaying their debt overhang.
Asset prices would be stable if the generational numbers are stable, however as the baby-boomers are retiring they could decide to move to smaller houses, elderly homes and put their houses up for sale. This is expected to put more pressure on houseprices rather than less.
Often I hear, this time it’s different arguments from real estate buyers or agents, however an illustration on the reversion to the mean in real Dutch houseprices over the centuries leaves nothing to imagination.
Anybody still wanting to buy a house should stop listening to the brokers and perform at least some form of fundamental value analysis (e.g. rental value) or add the expected loss of value to the cost of purchasing vs. renting.
Can economic growth be the answer?
Now back to the macro picture (and the Economist’s storyline).
Economic growth for Europe has become a problematically distant vision and with less savings available for productive investments, this vision is more dream than reality.
Contrary, as costs of capital run up and returns decrease, it is probably natural to expect a period of increased bankruptcies, less jobs like we are seeing now in Spain and Greece.
Also be careful with recent 30 years historical evidence on growth solutions (e.g. Sweden, Finland). They are distorted by EU subsidies, EU accession and a rich world credit boom. Without such a catalyst and even worse, with similar problems in neighboring countries, the recovery will take much longer than historical success stories indicate.
Furthermore as I wrote in an earlier post, economic growth is just not possible as long as Europe doesn’t get on with restructuring its debt and keeps on muddling to resolve a debt overhang and an uncompetitiveness problem at the same time.
Does Austerity help?
Again the babyboom generation is still an electorate of size. Politicians are normal people living from election to election searching for short term solutions and compromises instead of visionary long term solutions.
With Spain’s insiders (babyboomers with fixed contracts) and outsiders (50% unemployed youth) the people paying for the austerity bills are the young. Unable to generate income, they cannot spend, save and become productive members of society. Unfortunately as soon as they find work, they also will have to start paying for the baby-boom bills , higher health care costs and education tuition fees for their children.
In the Netherlands the government recently decided pension funds should calculate their present value of liabilities with an artificial investment rate (UFR), so pension cuts can be avoided at costs for the young. Another indication the balance of power tilts into the baby-boom direction and the bill of austerity will be paid later.
Politicians are almost understandable, let’s not forget, general austerity in Argentina led to overthrowing of various governments in two weeks and an eventual exit of the currency peg, a debt default and loss of savings and pensions. Who in her right mind would want that for her political career?
As long as the young are unorganized, don’t speak up and the pain is far away and spread out, the youngsters are just an easier target for austerity.
Inflation as a solution?
This looks like the easiest way out, decreasing the real value of debt (mostly of younger generations until 35) and decreasing the real value of savings and pensions of everyone, but to a larger proportion that of the elderly as they have accumulated more net assets in pensions, housing and savings.
With the political weight the baby-boomers still bring to the table the question is whether inflation will be accepted and will result in pension cuts or lower pension benefits for the less organized younger generations.
Researchers of the St. Louis Fed, indicate the answer is no. They find as a country ages the tolerance for inflation decreases.
Asset managers beware of inflation!
A large issue also with inflation is the current general regulatory and asset managers consensus, that government debt and high grade credits are the safest assets around.
- Due to this ‘herd’ like consensus the Dutch government bond yields currently at lowest level in almost 500 years
- Corporate bond yields are at their lowest levels since 1958, and just 1.1 percentage point away from their all-time low in March 1946 (2.5%).
- And the current spread between European dividend yields and German bund yields, are at an all-time (320 bps).
Picture: Please not these are stock prices (not yields or P/E levels) versus bond yields.
As soon as inflation will appear on the horizon the ‘herding’ effect will work reversely and take its damaging toll on the average portfolio manager and their average investment portfolios of Credits and Treasuries. Taking away yet another portion of the saved up wealth by (future) pensioners.
Equities and inflation
However don’t consider equities to be a safe haven from inflation either. The evidence on the relationship between inflation and company returns are terrible too.
In a famous article in Forbes (1977) Warren Buffett documented that actually nominal returns are fairly stable over decades at 12% (McKinsey now increases this to 13.5%) and higher inflation decreases realized returns to investors and vice versa. This conclusion is in 2010 again confirmed and explained by McKinsey in their 5th edition of Valuation by Koller, Goedhart and Wessels.
As economic growth seems far away, austerity messes with company revenues levels and inflation will hit savings and pension assets, there’s no overall solution helping us out. In hindsight we will discover what have been the best picks. I have a hypothesis, but I will save that for a later post.
My Conclusion (Yours could be different)
Younger generations should start realizing they are on the losing end of the wealth transfer. Current tax bills are high and increasing, leaving little room to save up for costs of education of their children, healthcare and anything currently subsidized by the state (children’s daycare, elderly homes etc.) Unfortunately also their assets (houses and pensions) decline so they will have to start working harder, spend less and invest smarter.
The baby-boomers will have to be smart as well. Selling they’re company and house now is better than tomorrow and they’ll too will have to eventually count on some harsh pension and subsidy cuts.
Asset managers should finally do away with trying to replicate benchmarks, because the benchmarks have a high chance of trending downwards and consequently the capital they manage. In investing, the case for bottom-up value investing becomes stronger and many investment decisions made based on recent data will prove value traps (remember real estate, banks?)
The differences in wealth between the well-prepared and the average population will become larger (again)…and in general, it looks like the ‘rich world’ should prepare to become poorer…