The long-term link between demographic supply-demand shifts and the dynamics of asset price changes is hard to quantitatively dismiss and while it is just as difficult to trade these long-term shifts, as Credit Suisse notes, it is a useful context for considering tactical and strategic asset allocation. Based on projections of two interesting ratios (Middle-/Old-age ratio for equity multiples and Yuppie/Nerd ratio for bond yields), they find that US and European equity P/E multiples are set to structurally fall for the next decade (while Japan may see expansion) and similarly Japan is expected to see bond yields continue to structurally fall while US and European yields will rise (with US yields rising only modestly - though still painfully for governments - and UK quite significantly). While, of course, significant differences exist in the equity and debt market participation level and demand and supply mechanics of foreign investors, the relationships have stood the test of time and should warrant concern for the medium-term in both US and European markets as perhaps monetary policy's extreme experimentation is fundamentally fighting these trends that are exaggerated in the short-term by the cyclical-to-secular end of the leverage super-cycle.
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5. Asset Prices and Demographics in the G5 Countries
We conduct a quantitative assessment of the historical link between stock and bond prices and demographic indicators. We focus on the five developed markets (the US, UK, France, Germany and Japan) from as early as 1950 to 2011.
Stock Price and Middle/Old Ratio
The link between stock prices and demographic trends is impacted by the life cycle theory of asset accumulation/decumulation and portfolio choice. The middle-aged individuals are in their peak savings years and invest heavily in stocks, driving up stock prices. The old-aged individuals decumulate assets and sell stocks to finance their retirement, depressing stock prices. In addition, the investors become more risk averse and prefer less holdings of stocks as they grow older. In similar spirit, as discussed in the paper by Goyal (2004) that we discussed earlier, we construct and compute a ratio of the middle-aged population to old-age population, known as the “Middle/Old ratio,” to explain the price-earnings ratio of the stock index. The middle/old ratios should be positively correlated to stock P/E ratios.
For the US, we use the 40-49 age groups as the middle-aged population and the 60-69 age groups as the old-aged population, based on the results from the Survey of Consumer Finance. The Middle/Old ratio and the real S&P500 P/E ratio have a strong correlation, at 0.73, during the period 1950-2011 as shown in Exhibit 23.
We also show the demographic projections for the Middle/Old ratio from 2012 to 2025 using data from the United Nations. The Middle-Old ratio in the US is expected to continue to fall. Using this projected data for the Middle-Old ratio, we forecast a declining P/E ratio for the US from 16.1 currently to 5.2 in 2025. This is consistent with the findings in the paper by Liu and Spiegel of the San Francisco Fed (2011), but differences could be due to different demographic sources as well as differences in the regression specification.
So, the drop in the P/E ratio based on the Middle-Old Ratio is quite dramatic. Post-1950, the US has not seen such a sharp drop in the middle-old ratio. We want to strongly caution against taking forecasts based on single demographic age variables too seriously because of other important factors through the business cycle, which may lead to much higher P/E ratios such as technological breakthroughs, innovation, cheaper resources and efficient labour practices as well as management. As we stressed earlier too, while the number of Middle-aged to Old may be projected to decrease, the savings/dis-savings decisions of the old may be very different than what we have seen from the old n the past. This could also result in delayed dis-saving and postponement of stock sales.
Will the increasing number of elderly people in the US dis-save and sell their assets during retirement and will that cause the stock market to fall? As we have already discussed, this is an issue of great debate and has divided academic researchers in the fields of finance and economics. We believe that the 65-year olds cannot be dis-saving like the 65-year olds of the past as they face a longer and far more uncertain post-retirement life.
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Bond Yield and Yuppie/Nerd Ratio
Higher amounts of borrowing and lending are likely to occur at the young and middle ages for individuals. The Yuppies (the 20-34 year olds) borrow to purchase houses and cars, placing upward pressure on the cost of borrowing. Nerds (the 40-54 year olds), on the other hand, save and invest in bonds for college education of children as well as their own retirement needs, leading to higher bond prices and lower interest rates/bond yields. The “Yuppie/Nerd ratio” is the ratio the number of 20-34 year olds to the number of 40-54 year olds. For yields, we select the nominal long-term government bond yield (10 year) as it has a longer and more reliable data history. Based on theory, the Yuppie-Nerd ratio should be positively correlated to the bond yields.
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Exhibit 30 presents the correlation between Yuppie/Nerd ratios and nominal 10-year government bond yields in the US, UK, Japan, France, and Germany from 1950 to 2011.
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The correlations are high, particularly in the US (0.80), UK (0.81), and France (0.83). In Exhibit 31, we plot the historical 10-year government bond yield against the Yuppie/Nerd ratio in each of the five markets up to 2011. Government bond markets are older and are more familiar to the traditional family with savings habits in Europe and the other markets. So the accumulated savings of a saver typically found a home in domestic government bond markets and that is a reflection of both direct as well as indirect bond investments through commercial banks, rural banks and cooperatives.
In all five markets, the bond yields tend to go up when the Yuppie/Nerd ratios rise, and go down when the Yuppie/Nerd ratios fall. The decline of yields in the past decades and the current low yield environment in these markets are well associated with the decline in the Yuppie/Nerd ratio.
In Exhibit 31, we present projections of the Yuppie/Nerd ratio from 2012 to 2025 for the five countries that we focus on. The ratio in the US started to increase in the late-2000s and is expected to continue the upward trend. Similarly, the ratios are starting to increase in the UK, France, and Germany, however, will likely continue to decline in Japan. Based on these projections, in 2025, we expect the 10-year bond yields to rise towards 4.49% (US), 6.48%(UK), 4.1% (France) and 4.63% (Germany). In Japan, the 10-year yield based on our pure demographic projection should decrease to 1.1%. We want to strongly caution against taking forecasts based on single demographic age variables too seriously because of other important factors through the business cycle, which may lead to active monetary policy exercises like QE, especially during crises and recessions.
In our view, age ranges used to define the Yuppie/Nerd ratio and Middle/Old ratio will undergo changes in the future as people are living longer and consumers and workers are changing their behaviour.
In today’s globalized world, however, a substantial amount of government bonds is held by foreign investors. For instance, 31.4% of the U.S. Treasury securities outstanding are in the hands of foreign holders. China is the largest holder, with a share of 7.5% of total treasury securities outstanding, followed by Japan, with a share of 6.9%. For the long-term U.S. Treasury, an even higher proportion is held by foreigner investors (53.0% in mid 2010). China’s holdings are mostly long term, equal to 17.6% of total long-term Treasury. Hence, the demand for government bonds from foreign investors also plays a role in determining how demographics affect bond yields in open economy financial markets such as the US, UK, Japan, Germany, etc..