1. Demographic Changes, Financial Markets, and the Economy Robert D. Arnott Research Affiliates, LLC (joint work with Denis Chaves) Inquire Europe and Inquire UK Spring 2012 Seminar

2. 2 ©Research Affiliates, LLC U.S. and Japan Age Distribution, 2010 and 2020 Source: Research Affiliates, based on data from United Nations Population Division.

3. 3 ©Research Affiliates, LLC Whither U.S.? Whither Japan? Source: Research Affiliates, based on data from United Nations Population Division.

4. 4 ©Research Affiliates, LLC Can Germany Save Greece? Source: Research Affiliates, based on data from United Nations Population Division.

5. 5 ©Research Affiliates, LLC Motivation An aging demography should make a difference. For the economy, for sure. Perhaps also for the markets. This has been done before, but without much success garnering statistical significance. Let’s Explore Six Linkages! Economic Growth Stock Market Returns Bond Market Returns Demographic Profile Of a Nation / Economy Nature of the Link? Rate of Change of Demographic Profile Nature of the Link?

6. 6 ©Research Affiliates, LLC Literature Review  Mixed evidence so far  Typically using five year age cohorts.  Or using ad hoc age groups, which tend to suggest data mining.  No strong significance found.  Criticisms – Poterba (2001) Few degrees of freedom, lack of statistical power.  GDP growth Lindh and Malmberg (1999)  OECD countries, 1950-1990  Positive effect for 50-64 and negative effect for 65+  Ambiguous effects under age 50  Critique: Why select these age groups?

7. 7 ©Research Affiliates, LLC Literature Review  Mixed evidence so far  Criticisms – Poterba (2001) Few degrees of freedom, lack of statistical power.  GDP growth Lindh and Malmberg (1999)  Stock and/or Bond returns Yoo (1994) – weak statistical significance in U.S. sample Ang and Maddaloni (2003)  International sample increases power  Negative effect for 65+  Weak evidence for working age

8. 8 ©Research Affiliates, LLC First … Our Findings  GDP per capita growth Highest GDP Growth associated with young adults 20-39. Late teens and early middle-age population helps a bit. Transition between age 50-55, from helping to hurting GDP growth. Young children hurt GDP growth, a little. Senior citizens hurt GDP growth, a lot. Little difference between results for demographic composition and rate of change of composition. High statistical significance.

9. 9 ©Research Affiliates, LLC First … Our Findings (Part II)  GDP per capita growth Highest GDP Growth associated with young adults 20-39. Young children hurt GDP growth, a little. Senior citizens hurt GDP growth, a lot.  Stocks perform better When there are many in the 35-59 age cadres,  And much worse when there are many senior citizens or children. When 45-64 age cadres are growing faster,  But much worse with young adult or 70+ age cadres growing fast. Age shift for rates of demographic change.  Demography affects bonds With roughly a 5-year age difference from stocks. With greater statistical significance than stocks.

10. 10 ©Research Affiliates, LLC Our Strategy to Increase Statistical Power  5-year (non-overlapping) returns and growth rates  Control for valuation levels, business cycles  Large cross section of countries  Include all 15 5-year age cadres in the regression  Use polynomials to eliminate noise on adjacent age cadres  Robustness checks

11. 11 ©Research Affiliates, LLC Data Sources  UN Population Division Demographics data in 5-year intervals, 1950-2050 (projections)  Global Financial Data (with some extensions) Stock, Bond and cash returns for 22 developed countries, 1950-2010 Dividend yield and bond yields, 1950-2010  Penn World Table Real GDP per capita for almost 200 countries, 1950-2008 PPP adjustments in 2005 levels for comparisons Consumption/GDP ratio, 1950-2008

12. 12 ©Research Affiliates, LLC Variables  Stock and (10-year) bond returns 5-year non-overlapping local return (in excess of cash return)  GDP Per capita real growth  PPP-adjusted GDP for weighting  Yields Dividend-yield, 3-month and 10-year yields  Demographics 15 age groups {0-4,5-9,…,75+} Shares of total population and changes thereof

13. 13 ©Research Affiliates, LLC Econometric Methodology Age groups Age group shares Valuation or other control variables

14. 14 ©Research Affiliates, LLC Econometric Methodology Polynomial order Age groups Demographic shares Modified shares

15. 15 ©Research Affiliates, LLC Regression Results, 1950-2010 Demographic Shares Change in Demographic Shares StocksBondsGDP StocksBondsGDP Dividend Yield3.39 3.38 (6.23)(6.30) 10-year Yield 0.66 0.62 (4.98)(4.07) 3-month Yield -0.15 -0.19 (2.97)(4.14) D 1 (x1)-0.81-1.560.09 3.09-0.020.21 (1.63)(3.33)(3.77)(2.90)(0.04)(3.56) D 2 (x10)1.693.47-0.07 -10.27-1.83-0.14 (2.47)(3.10)(4.39)(3.57)(1.42)(3.51) D 3 (x100)-0.83-2.72 11.812.96 (3.05)(2.74)(4.25)(2.58) D 4 (x1000) 0.69 -4.22-1.17 (2.37)(4.77)(3.32) R2R2 28%34%30% 31%30%17% Observations203241255 203241255 Countries22 k=3 → k=2 (%)0.30.025.7 7.73.413.4 k=4 → k=3 (%)28.41.812.4 0.00.153.6 Polynomial coefficients Tests for polynomial order Valuation controls

16. 16 ©Research Affiliates, LLC Relationship between GDP Growth and Demographic Composition (R 2 = 0.30), Net of Valuation Effects Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data.

17. 17 ©Research Affiliates, LLC Relationship between GDP Growth and Demographic Composition (R 2 = 0.30), Net of Valuation Effects Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data. Intuition for the coefficient? 0.14 means that a 1% difference in size of 30-34 age cadre is worth 0.14% in annual GDP growth. That’s big.

18. 18 ©Research Affiliates, LLC Relationship between GDP Growth and Demographic Composition (R 2 = 0.30), Net of Valuation Effects Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data. Demographic Sweet Spot: Fastest GDP Growth, Age 20-44 Demographic Trouble, Age 55 & Up Terrible Twos

19. 19 ©Research Affiliates, LLC Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data. Relationship between GDP Growth and Demographic Rate of Change (R 2 = 0.17), Net of Valuation Effects Demographic Sweet Spot: Fastest GDP Growth, Age 25-44 Trouble, Age 65 & Up Terrible Twos

20. 20 ©Research Affiliates, LLC Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data. Relationship between Stock Returns and Demographic Composition (R 2 = 0.28), Net of Valuation Effects Demographic Sweet Spot: Best Stock Returns, Age 35-59 Trouble, Age 65 & Up Adolescent Double Trouble

21. 21 ©Research Affiliates, LLC Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data. Relationship between Stock Returns and Demographic Rate of Change (R 2 = 0.31), Net of Valuation Effects Demographic Sweet Spot: Best Stock Returns, Age 50-64 Trouble, Age 70 & Up Live for Today, Or Spend on Kids Ages 20-34

22. 22 ©Research Affiliates, LLC Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data. Relationship between Bond Returns and Demographic Composition (R 2 = 0.34), Net of Valuation Effects Demographic Sweet Spot: Best Bond Returns, Age 35-59 Trouble, Age 70 & Up Trouble, Ages 5-24

23. 23 ©Research Affiliates, LLC Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data. Relationship between Stock Returns and Demographic Composition (R 2 = 0.28), Net of Valuation Effects Demographic Sweet Spot: Best Stock Returns, Age 35-59 Trouble, Age 65 & Up Trouble, Ages 5-19

24. 24 ©Research Affiliates, LLC Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data. Relationship between Bond Returns and Demographic Rate of Change (R 2 = 0.30), Net of Valuation Effects Demographic Sweet Spot: Best Bond Returns, Age 50-69 Live for Today, or Spend on Kids Ages 15-39

25. 25 ©Research Affiliates, LLC Robustness Check – Do the Same Relationships Apply in Emerging Markets? Yes, they do. Developed Emerging Confidence Interval

26. 26 ©Research Affiliates, LLC So … What Does This Work Say About the Future?

27. 27 ©Research Affiliates, LLC Caveat  Forecasts are what they are: an extrapolation of ex ante relationships  Large confidence intervals  Should not be taken at face value, but as indications of the future demographic forces  Some variables that might influence the actual outcomes, but are not considered here: Changing retirement ages and life expectancy Male/Female participation in the workforce Increased access to international financial assets And so forth … (list is too long to fit here)

28. 28 ©Research Affiliates, LLC Forecasts for GDP Growth, 2011–2020, Based on Demographic Composition Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data.

29. 29 ©Research Affiliates, LLC Forecasts for Stock Returns, 2011–2020, Based on Demographic Composition Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data.

30. 30 ©Research Affiliates, LLC Forecasts for Bond Returns, 2011–2020, Based on Demographic Composition Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data.

31. 31 ©Research Affiliates, LLC Conclusion We find a strong link between demographic shares (or changes thereof) and:  Per capita real GDP growth  Stock excess returns  Bond excess returns Polynomials give us a powerful and intuitive way to understand these relationships. Forecasts for the next 10 years are sobering, to say the least.

32. Appendix: Demographics Around the World The Geography of Demographics

33. 33 ©Research Affiliates, LLC United States The aging of the baby boom dominates U.S. demographics. They appear in the upper left hand graph as a bump in each line. That “bump” is well into the orange today which constitutes the 50-60 year age cadres. It is set to move into the dark red, age 65 and older, in the coming years; these are presumably retirees. We can see in the upper right graph that the 65- and–up age group is poised to soar from 13% to 21% of the population between now and 2050. It’s also noteworthy that the working-age cadre (20-64) grew rapidly, as a percentage of the total population, from 1965 to 2010, and is poised to drop sharply over the next 20 years. The lower right graph shows the effect the baby boom has on the growth of the working age population with the blue line indicating zero growth by 2045. Part of the “new normal” must be slower GDP growth. GDP is produced by those who work. The daunting spike of prospective retirees to the far left cannot fail to draw resources that might have fueled GDP growth. The new normal is very real. Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data.

34. 34 ©Research Affiliates, LLC Japan Japan’s demographic challenges are well known. It is less well known that Japan was the youngest nation in the developed world in 1950, with a median age of 22. That doubled to 44 by 2010, and is poised to exceed 55 by 2050. The U.S. “crossover,” in which the number of new senior citizens exceeds the net new working-age people, happens in late 2012. For Japan, the crossover was in 1988. The other “crossover” in which senior citizens outnumber those under 20, which occurs after 2050 for the U.S., already happened in 2003 in Japan. Nor does Japan have a graceful transition to steady state: their birth rate remains well below replacement rates in the years ahead. In 2050, the number of people over 65 in Japan will rival the number under 45. There are solutions, such as a massive change in immigration policies. But, this picture is quite daunting. Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data.

35. 35 ©Research Affiliates, LLC Western Europe In the Euro-zone, the bankrupt are looking to the near-bankrupt to bail them out. And, all of the countries are aging fast. This points to a serious impediment to solving their sovereign debt challenges. Note that the slopes on the lines to the far left are steeper, for the next ten years, than ever before or in the future. The pace of aging is also steeper than anywhere but China, from a younger current average, and Japan. The percentage that’s already past 65 is poised to cross the number under 20 later this decade. Note also that the average percentage growth in the working age cadre has been about 0.6% per year for the past half- century, and is poised to be negative for the next 40 years. This does not bode well for regional geopolitics… entitlement promises and the social compact will both be abrogated and debt repayment will be in doubt. Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data.

36. 36 ©Research Affiliates, LLC China The number of young people was enormous in past decades, and the number of older working-age people modest. Chinese support ratios are far less problematical than for most of the developed world. But, note the rate of change. In 1970, the median age in China was 19. No wonder there was a Cultural Revolution. Today the average age is 34. By 2050, it will reach 50. Their median age will not exceed ours for another 15 years. China does not reach our current 13% senior citizen roster until 2023, and doesn’t pass us in support ratios until after 2040. They have time to plan ahead. Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data.

37. 37 ©Research Affiliates, LLC Russia and Eastern Europe The population for Russia and Eastern Europe is shrinking and aging fast. The median age is 38, and rises to 47 in the next quarter-century (then plateaus). The working age cadre has soared over the past 40 years, and drops to new lows over the next 40. The prospective dip in working age population, the blue line on the lower right graph, can be traced to the dearth of new children from 1990 onward. These are disturbing trends that may sow regional disaffection or worse. Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data.

38. 38 ©Research Affiliates, LLC Emerging Markets Emerging Markets countries that face serious demographic challenges include Russia, Eastern Europe, and eventually China. The size of the working age cadre has risen rapidly from 1970, and continues for another decade. Most of this group is still young adults. The median age in Emerging Markets is only 28 today. The size of the seniors population is expected to cross the under- 20 crowd in about 2065. While the working age cadre has been growing at 2% per year for a half-century, that growth halves in the coming 30 years. The torrid GDP growth will slow. Source: Research Affiliates, based on data from United Nations, Penn World Table and Global Financial Data.

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